2005, from 1.14% for 2004. In general, we manage our short-term cash investments relative to our financing and operating requirements and investment opportunities.
Interest expense for 2005 increased by 106.8% to $183.8 million, from $88.9 million for 2004, while the average balance of repurchase agreements for 2005 increased by 20.4% to $6.103 billion, from $5.070 billion for 2004. The increase in borrowings reflects the leveraging of additional equity capital raised during the latter part of 2004 and, to a lesser extent, the earlier part of 2005. Our cost of borrowings, which includes the impact of our Hedging Instruments, increased to 3.01% for 2005, compared to 1.75% for 2004. The net cost of our Hedging Instruments was $1.2 million, which increased our cost of borrowings by two basis points for 2005, from $3.1 million, or six basis points, for 2004. Our Hedging Instruments may result in interest expense or a reduction to interest expense depending on the rates specified in such instruments relative to each instrument’s benchmark market rate. (See Notes 2(l) and 5 to the consolidated financial statements, included under Item 8 of this annual report on Form 10-K.) The U.S. Federal Reserve raised the Federal Funds rate from 1% at June 30, 2004 to 4.25% at December 31, 2005.
For 2005, our net interest income decreased by $32.0 million, to $54.9 million, from $86.9 million for 2004 reflecting the negative impact of rising interest rates, a flattening of the yield curve and high prepayment speeds. These factors all contributed to a compression of our net interest margin and spread. The net yield on interest-earning assets increased by 40 basis points during 2005 from 2004 while the cost of borrowings increased by 126 basis points over the prior year. Our resulting net interest spread and net interest margins decreased to 0.46% and 0.80%, respectively, for 2005, compared to 1.32% and 1.52%, respectively, for 2004.
For the years ended December 31, 2005 and 2004, we had total average assets of $6.854 billion and $5.732 billion, respectively. The table below provides quarterly information regarding our average interest earning assets and interest bearing liabilities, interest income and expense, yields, cost of funds and net interest income for the quarters presented.
During the fourth quarter of 2005, we repositioned our MBS portfolio in response to the adverse interest rate environment. As a result, we incurred a fourth quarter loss of $18.4 million realized upon the sale of 22 MBS with an amortized cost of $583.2 million and an impairment charge of $20.7 million taken against 30 MBS with an amortized cost of $842.2 million. The loss on sale and the impairment charge reflect our reassessment of our portfolio. We recognized the impairment charge against impaired MBS that we determined to be other-than-temporarily impaired, as we no longer intended to continue to hold such MBS until full recovery of impaired market value. All impairment on the MBS was related to changes in interest rates, as all of the MBS sold or identified as other-than-temporarily impaired were either Agency MBS or rated AAA. The impairment charge, which reflects the difference between the amortized cost of MBS considered to be other-than-temporarily impaired and their estimated market value at December 31, 2005, reflects our early application of the FASB Staff Position “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments” released by the FASB on November 3, 2005. Because our MBS portfolio is designated as available-for-sale, the impairment on such MBS was previously recognized in accumulated other comprehensive loss. Upon identifying certain MBS as other-than-temporarily impaired, we recognized the impairment through earnings. The MBS identified as other-than-temporarily impaired remained in our portfolio at December 31, 2005, carried at a new cost basis equal to their fair value at December 31, 2005; gains/losses on such MBS were realized upon sale of such MBS. As part of the overall portfolio management, we assess our MBS on a regular basis, and not less than quarterly, for other-than-temporary impairment. Future impairments will be recognized if we later determine that an impairment on a particular MBS is considered to be other-than-temporary. During 2004, we sold MBS with an amortized cost of $39.6 million, resulting in gains of $371,000.
For 2005 and 2004, revenue from our interest in real estate remained at approximately $1.5 million. We do not consider the results of operations from our real estate investment to be material to us. This property, net of operating expenses and mortgage interest, generated net losses of approximately $200,000 during 2005 and 2004. (See Notes 2(g) and 4 to the consolidated financial statements, included under Item 8 of this annual report on Form 10-K.)
Through wholly-owned subsidiaries, we provide investment advisory services to third-party institutions with respect to their MBS portfolio investments. As of December 31, 2005, we had approximately $773.3 million of assets under management for third parties. In June 2005, through MFA Spartan II, LLC, we began to act as investment advisor in connection with a Canadian investment trust. In addition, through MFA Spartan I, LLC, we continued to provide third-party advisory services. Included in miscellaneous other income, net is advisory income of $444,000 earned during 2005, compared to $65,000 earned during 2004.
During 2005, we incurred operating and other expense of $10.8 million, which included real estate operating expenses of $991,000 and mortgage interest of $682,000 related to our real estate investment. Our costs for compensation and benefits and other general and administrative expense, were $9.2 million for 2005, or 0.13% of average assets, compared to $8.9 million, or 0.16% of average assets, for 2004. The cost of employee compensation and benefits was $5.5 million for 2005, compared to $5.6 million for 2004; included in such expense is non-cash compensation expense of $479,000 and $530,000 for 2005 and 2004, respectively, related to our outstanding stock options. Other general and administrative expense, which were $3.7 million for 2005 compared to $3.3 million for 2004, were comprised primarily of fees for professional services, including legal and accounting, corporate insurance, office rent and Board fees. We incurred expenses of $375,000 during 2005 and $374,000 directly related to complying with the provisions of the SOX Act.
CRITICAL ACCOUNTING POLICIES
Our management has the obligation to ensure that our policies and methodologies are in accordance with GAAP. During 2006, management reviewed and evaluated our critical accounting policies and believes them to be appropriate.
Our consolidated financial statements include our accounts and all majority owned and controlled subsidiaries. The preparation of consolidated financial statements in accordance with GAAP requires management to make estimates and assumptions in certain circumstances that affect amounts reported in the consolidated financial statements. In preparing these consolidated financial statements, management has made estimates and judgments of certain amounts included in the consolidated financial statements, giving due consideration to materiality. We do not believe that there is a great likelihood that materially different amounts would be reported related to accounting policies described below. However, application of these accounting policies involves the exercise of judgment and use of assumptions as to future uncertainties and, as a result, actual results could differ from these estimates.
Our accounting policies are described in Note 2 to the consolidated financial statements, included under Item 8 of this annual report on Form 10-K. Management believes the more significant of these to be as follows:
Classifications of Investment Securities and Valuations of Such Securities
Our investments in MBS are classified as available-for-sale securities, as discussed in Note 2(b) to the consolidated financial statements, included under Item 8 of this annual report on Form 10-K. Although all of our MBS are carried on the balance sheet at their estimated fair value, the classification of the securities as available-for-sale results in changes in the estimated fair value being recorded as adjustments to accumulated other comprehensive income/(loss), which is a component of stockholders’ equity, rather than through earnings. We do not intend to hold any of our securities for trading purposes; however, if available-for-sale securities were classified as trading securities, there could be substantially greater volatility in our earnings.
As noted above, all of our MBS are carried on the balance sheet at their estimated fair value. The estimated fair values of such assets are based on prices obtained from a third-party pricing service; if pricing is not available for an MBS from such pricing service, the average of broker quotes received for such MBS is used to determine the estimated fair value of such MBS. Given that such securities trade in an active market, we believe that the fair market values presented accurately reflect the estimated fair market value of the MBS at the time of valuation.
When the estimated fair value of an available-for-sale security is less than amortized cost, management considers whether there is an other-than-temporary impairment in the value of the security. If, in management’s
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judgment, an other-than-temporary impairment exists, the cost basis of the security is written down to the then-current estimated fair value, with the amount of impairment charged to current earnings. The determination of other-than-temporary impairment is a subjective on-going process, and different judgments and assumptions could affect the timing and amount of losses realized. (See Note 2(d) to the consolidated financial statements, included under Item 8 of this annual report on Form 10-K.)
Interest Income Recognition
Interest income on our MBS is accrued based on the actual coupon rate and the outstanding principal balance of such securities. Premiums and discounts are amortized or accreted into interest income over the lives of the securities using the effective yield method, as adjusted for actual prepayments in accordance with Statement of Financial Accounting Standards (or FAS) No. 91, “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases”.
Derivative Financial Instruments and Hedging Activities
We apply the provisions of FAS No. 133, “Accounting for Derivative Instruments and Hedging Activities,” (or FAS 133) as amended by FAS No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities”.
In accordance with FAS 133, a derivative, which is designated as a hedge, is recognized as an asset/liability and measured at estimated fair value. To qualify for hedge accounting, we must, at inception of a hedge, anticipate and document that the hedge will be highly effective. As long as the hedge remains effective, changes in the estimated fair value of the Hedging Instrument are included in the accumulated other comprehensive income, a component of stockholders’ equity.
For Cap Agreements, upon commencement of the active period and throughout the active period, the premium paid to enter into the Cap Agreement is amortized and reflected in interest expense. The periodic amortization of the premium on a Cap Agreement is based on an estimated allocation of the premium, determined at inception of the hedge based on the original purchase price. If we determine that a Cap Agreement is not effective, the premium would be reduced and a corresponding charge made to interest expense, for the ineffective portion of the Cap Agreement. The maximum cost related to our Cap Agreements is limited to the original purchase price of the derivative. No premium is paid to enter into Swaps. Net payments received on our Swaps, if any, offset interest expense on our hedged liabilities; while net payments made by us on our Swaps increase our interest expense on our hedged liabilities.
In order to continue to qualify for and to apply hedge accounting, our Swaps and Cap Agreements are documented at inception and are monitored, on a quarterly basis to determine whether they continue to be effective or, if prior to the commencement of the active period, whether the hedge is expected to continue to be effective. If during the term of a Hedging Instrument we determine that the hedge is not effective or that the hedge is not expected to be effective, the ineffective portion of the hedge will no longer qualify for hedge accounting and, accordingly, subsequent changes in the fair value of such Hedging Instrument would be reflected in earnings. At December 31, 2006, we had 33 Swaps with an aggregate notional amount of $1.809 billion with gross unrealized gains of $2.4 million and gross unrealized losses of $1.9 million and three Cap Agreements with an aggregate notional amount of $150.0 million, with gross unrealized gains of $83,000. (See Notes 2(l) and 5 to the consolidated financial statements, included under Item 8 of this annual report on Form 10-K.)
Income Taxes
Our financial results generally do not reflect provisions for current or deferred income taxes. We believe that we operate in, and intend to continue to operate in, a manner that allows and will continue to allow us to be taxed as a REIT. As a result of our REIT status, we do not generally expect to pay corporate level taxes. Many of the REIT requirements, however, are highly technical and complex. If we were to fail to meet the REIT requirements, we would be subject to U.S. federal, state and local income taxes.
Accounting for Stock-Based Compensation
On January 1, 2006, we adopted FAS No. 123R, “Share-Based Payment,” (or FAS 123R). The adoption of FAS 123R did not have an impact on us, as we had applied the fair value method of accounting for stock based compensation since January 1, 2003, and our use of stock based compensation historically has not been a key
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component of our compensation structure. The future impact of FAS 123R, will be based on, among other things, the underlying terms of our future grants of stock-based compensation. Estimating the fair value of stock options requires that we use a model to value such options. We use the Black-Scholes-Merton option model to value our stock options. There are limitations inherent in this model, as with all other models currently used in the market place to value stock options, as they typically have not been designed to value stock options which contain significant restrictions and forfeiture risks, such as those contained in the stock options that we issue to certain of our employees. We make significant assumptions in order to determine our option value, all of which are subjective. We expense our options using the straight-line method.
Pursuant to FAS 123R our compensation expense for restricted stock awards is amortized over the vesting period of such awards, based upon the estimated fair value of such restricted stock at the grant date. Restricted stock granted to retirement-eligible employees is expensed upon grant, as there is no risk of forfeiture. (See Note 11(a) to the consolidated financial statements, included under Item 8 of this annual report on Form 10-K.)
Accounting for Certain MBS and Related Repurchase Agreements
In certain instances, we purchased MBS and subsequently financed the acquisition of these MBS through repurchase agreements, which are also collateralized by these MBS, with the same counterparty (or Same Party Transaction). We record the acquisition of these MBS as assets and the related financings under repurchase agreements as liabilities gross on our consolidated balance sheets, with changes in the fair value of these MBS being recorded in other comprehensive income, a component of stockholders’ equity. The corresponding interest income earned on these MBS and interest expense incurred on the related repurchase agreements are reported gross on our consolidated statements of income. As of December 31, 2006 we had no Same Party Transaction and at December 31, 2005, we had 25 Same Party Transactions aggregating approximately $474.5 million in MBS and $471.5 million in financings under related repurchase agreements.
The FASB has placed on its agenda an item that will address Same Party Transactions pursuant to the provisions of FAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (or FAS 140).
While the economics of the Same Party Transactions would not be affected, the FASB may change how transactions are reported on our consolidated financial statements. We believe that our cash flows, liquidity and ability to pay dividend distributions would be unchanged and that our taxable income would not be affected. We believe our historical accounting for Same Party Transactions has been appropriate, but will reevaluate such position upon further clarification by the FASB.
LIQUIDITY AND CAPITAL RESOURCES
Our principal sources of cash consist of borrowings under repurchase agreements, payments of principal and interest we receive on our MBS portfolio, and, depending on market opportunities, proceeds from capital market transactions. We use significant cash to repay principal and interest on our repurchase agreements, purchase MBS, make dividend payments on our capital stock, fund our operations and to make such other investments that we consider appropriate. In addition, based upon market conditions, we may use cash to repurchase shares of our common stock pursuant to our Repurchase Program.
Borrowings under repurchase agreements were $5.723 billion at December 31, 2006, compared to $5.100 billion at December 31, 2005. During the first six months of 2006, we decreased the amount of our borrowings as we sold certain MBS and did not fully reinvest the sales proceeds and cash from repayments on our MBS portfolio. As we identified market opportunities during the third quarter of 2006, we began to increase our investing and related financing activity. As a result, our debt-to-equity ratio increased to 8.4 to 1 at December 31, 2006, up from 5.9 to 1 at September 30, 2006 and 4.3 to 1 at June 30, 2006. At December 31, 2006, we continued to have available capacity under our repurchase agreement credit lines. At December 31, 2006, our repurchase agreements had a weighted average borrowing rate of 5.22%, on loan balances of between $350,000 and $130.5 million.
During 2006, as part of the repositioning of our MBS portfolio, we sold 84 MBS which generated cash proceeds of $1.844 billion and we received cash of $1.637 billion from prepayments and scheduled amortization on our MBS. Since our MBS are generally financed with repurchase agreements, a significant portion of the proceeds from our MBS sales, prepayments and scheduled amortization were used to repay balances under our repurchase agreements. During 2006, we purchased $4.128 billion of ARM-MBS financing these acquisitions with repurchase agreements
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and cash. While we generally intend to hold our MBS as long-term investments, we may sell certain MBS as part of managing our interest rate risk and liquidity needs and in order to meet other operating objectives. As such, all of our MBS are designated as available-for-sale. The timing and impact of future sales of MBS, if any, cannot be predicted with any certainty, as we do not hold any of our MBS for trading purposes.
During 2006, we received cash proceeds, net of selling expenses, of $23.5 million from the sale of two real estate properties, of which we used $12.7 million to satisfy mortgages secured by such properties and $1.3 million to pay a portion of the built-in-gains tax resulting from the sale of one property. Historically, the operations of our real estate interests have not had a material impact on our liquidity. As such, the sale of our real estate interests during 2006 will not have a significant impact on our future liquidity. In addition, our remaining investment in real estate has not had, nor is it expected to have in the future, a significant impact on our liquidity.
During 2006, we paid cash dividends of $8.2 million on our preferred stock and $16.1 million on our common stock. In addition, on December 14, 2006, we declared our fourth quarter 2006 dividend on our common stock, which totaled $4.9 million and will be paid on January 31, 2007 to stockholders of record on December 29, 2006. During the first four months of 2006, we used cash of $6.1 million to repurchase shares of our common stock, pursuant to our Repurchase Program. Subject to applicable securities laws, repurchases of common stock under the Repurchase Program are made at times and in amounts as we deem appropriate, using our available cash resources. The Repurchase Program may be suspended or discontinued by us at any time and without prior notice.
We employ a diverse capital raising strategy under which we may issue our capital stock. During 2006, we issued 1.5 million shares of common stock pursuant to the CEO Program raising net proceeds of $11.1 million and issued 3,500 shares of common stock pursuant to the DRSPP raising net proceeds of $27,000. At December 31, 2006, we had an aggregate of $241,320,086 available under our two effective shelf registration statements on Form S-3 and 9,514,183 shares of common stock remained available for issuance pursuant to our DRSPP shelf registration. We may, as market conditions permit, issue additional shares of common stock and/or preferred stock pursuant to these registration statements.
To the extent we raise additional equity capital from future capital market transactions, we currently anticipate using the net proceeds to purchase additional MBS, to make scheduled payments of principal and interest on our repurchase agreements and for other general corporate purposes. We may also consider acquiring additional interests in residential ARMs, multi-family apartment properties and/or other investments consistent with our investment strategies and operating policies. There can be no assurance, however, that we will be able to raise additional equity capital at any particular time or on any particular terms.
In order to reduce our interest rate risk exposure, we may enter into derivative financial instruments, such as Swaps and Caps. Our Swaps and Caps are designated as cash-flow hedges against a portion of our current and anticipated LIBOR based repurchase agreements. During 2006, Swaps became a more significant component of our financing strategy; we entered into 31 Swaps with an aggregate notional amount of $1.723 billion, which have a weighted average fixed pay rate of 5.01% and had Swaps with an aggregate notional amount of $180.0 million expire. We paid a weighted average fixed rate of 4.31% on our Swaps and received a variable rate of 5.15% during 2006. At December 31, 2006, we had Swaps with an aggregate notional amount of $1.809 billion, with maturities extending through December 21, 2010 at a weighted average fixed pay rate of 4.93% and a weighted average term of 39 months. Our Swaps resulted in a reduction of interest expense of $4.1 million, or 10 basis points, for 2006. At December 31, 2006, we had Caps with an aggregate notional amount of $150.0 million, an average remaining active period of two months and an average cap rate of 3.83%. During 2006, we received payments of $2.8 million on our Caps, which reduced our interest expense. During 2006, we had Caps with $150.0 million notional amount expire and did not purchase any Caps as we expanded our use of Swaps to hedge our interest rate exposure. (See Note 5 to the consolidated financial statements, included under Item 8 of this annual report on Form 10-K.)
Under our repurchase agreements we pledge additional assets as collateral to our repurchase agreement counterparties (i.e., lenders) when the estimated fair value of the existing pledged collateral under such agreements declines and such lenders demand additional collateral (i.e., a margin call). Margin calls result from a decline in the value of our MBS collateralizing our repurchase agreements, generally due to changes in the estimated fair value of such MBS resulting from principal reduction of such MBS from scheduled amortization and prepayments on the mortgages underlying our MBS, changes in market interest rates and other market factors. To cover a margin call, we may pledge additional securities or cash. Cash held on deposit as collateral with lenders, if any, is reported on our balance sheet as “restricted cash”. At the time one of our repurchase agreement matures, any restricted cash on deposit is generally applied against the repurchase agreement balance, thereby reducing the amount borrowed.
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Through December 31, 2006, we satisfied all of our margin calls with either cash or an additional pledge of MBS collateral. At December 31, 2006, we had MBS with a fair value of $275.6 million that were not pledged as collateral and $47.2 million of cash. We believe we have adequate financial resources to meet our obligations, including margin calls, as they come due and to fund dividends we declare as well as to actively pursue our investment strategies. However, should market interest rates and/or prepayment speeds on our MBS suddenly increase, margin calls on our repurchase agreements could result, causing an adverse change in our liquidity position.
The following table summarizes the effect on our liquidity and cash flows from contractual obligations for repurchase agreements, non-cancelable office leases and mortgages on properties held by our real estate subsidiaries at December 31, 2006:
| | | | | | | | | | | | | | | | | | | |
(In Thousands) | | 2007 | | 2008 | | 2009 | | 2010 | | 2011 | | Thereafter | |
| | | | | | | | | | | | | |
Repurchase agreements(1) | | $ | 3,903,400 | | $ | 1,505,311 | | $ | 314,000 | | $ | — | | $ | — | | $ | — | |
Mortgage loan(2) | | | — | | | — | | | — | | | — | | | 9,606 | | | — | |
Long-term lease obligations | | | 474 | | | 349 | | | 358 | | | 358 | | | 358 | | | 238 | |
| | | | | | | | | | | | | | | | | | | |
| | $ | 3,903,874 | | $ | 1,505,660 | | $ | 314,358 | | $ | 358 | | $ | 9,964 | | $ | 238 | |
| | | | | | | | | | | | | | | | | | | |
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(1) | The above table does not include interest due on our repurchase agreements, Swaps, or mortgage loan(s). |
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(2) | Does not include contractual interest due on such mortgage. |
OFF-BALANCE SHEET ARRANGEMENTS
We do not have any material off-balance-sheet arrangements.
INFLATION
Substantially all of our assets and liabilities are financial in nature. As a result, changes in interest rates and other factors impact our performance far more than does inflation. Our financial statements are prepared in accordance with GAAP and dividends are based upon net income as calculated for tax purposes; in each case, our results of operations and reported assets, liabilities and equity are measured with reference to historical cost or fair market value without considering inflation.
FORWARD LOOKING STATEMENTS
When used in this annual report on Form 10-K, in future filings with the SEC or in press releases or other written or oral communications, statements which are not historical in nature, including those containing words such as “anticipate,” “estimate,” “should,” “expect,” “believe,” “intend” and similar expressions, are intended to identify “forward-looking statements” within the meaning of Section 27A of the Act and Section 21E of the Exchange Act and, as such, may involve known and unknown risks, uncertainties and assumptions.
These forward-looking statements are subject to various risks and uncertainties, including, but not limited to, those relating to: changes in interest rates and the market value of our MBS; changes in the prepayment rates on the mortgage loans collateralizing our MBS; our ability to use borrowings to finance our assets; changes in government regulations affecting our business; our ability to maintain our qualification as a REIT for U.S. federal income tax purposes; and risks associated with investing in real estate, including changes in business conditions and the general economy. These and other risks, uncertainties and factors, including those described in the annual, quarterly and current reports that we file with the SEC, could cause our actual results to differ materially from those projected in any forward-looking statements we make. All forward-looking statements speak only as of the date they are made and we do not undertake, and specifically disclaims, any obligation to update or revise any forward-looking statements to reflect events or circumstances occurring after the date of such statements. See Item 1A, “Risk Factors” of this annual report on Form 10-K.
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Item 7A. | Quantitative and Qualitative Disclosures About Market Risk. |
We seek to manage our interest rate, market value, liquidity, prepayment and credit risks, inherent in all financial institutions, in a prudent manner designed to insure our longevity while, at the same time, seeking to provide an opportunity to stockholders to realize attractive total returns through ownership of our stock. While we do not seek to avoid risk, we seek to; assume risk that can be quantified from historical experience, actively manage such risk; earn sufficient returns to justify the taking of such risks and; maintain capital levels consistent with the risks that we undertake.
INTEREST RATE RISK
We primarily invest in ARM-MBS on a leveraged basis. We take into account both anticipated coupon resets and expected prepayments when measuring the sensitivity of our ARM-MBS portfolio to changes in interest rates. In measuring our Repricing Gap, we measure the difference between: (a) the weighted average months until the next coupon adjustment or projected prepayment on the ARM-MBS portfolio; and (b) the months remaining until our repurchase agreements mature, applying the same projected prepayment rate and including the impact of Swaps. The CPR is applied in order to reflect, to a certain extent, the prepayment characteristics inherent in our interest-earning assets and interest-bearing liabilities. Based on historical results, we believe that applying a 25% CPR assumption, provides a realistic approximation of the Repricing Gap for our ARM-MBS portfolio over time. Over the last two years, on a quarterly basis, ending with December 31, 2006, the monthly CPR on our MBS portfolio ranged from a low of 24.1% to a high of 34.9%, with an average quarterly CPR of 28.1%.
The following table presents information at December 31, 2006 about our Repricing Gap based on contractual maturities, applying a 15% CPR and 25% CPR.
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CPR | | Estimated Months
to Asset Reset | | Estimated Months to
Liabilities Reset(1) | | Repricing
Gap | |
| | | | | | | | |
0 | %(2) | | | 41 | | | 15 | | | 26 | |
15 | % | | | 29 | | | 15 | | | 14 | |
25 | % | | | 23 | | | 15 | | | 8 | |
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(1) | Reflects the effect of our Hedging Instruments. |
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(2) | Reflects contractual maturities, which has a prepayment assumption of 0%. |
The interest rates for most of our adjustable-rate assets are primarily dependent on the one-year CMT rate, LIBOR, or MTA, while our debt obligations, in the form of repurchase agreements, are generally priced off of LIBOR. While LIBOR and CMT generally move together, there can be no assurance that such movements will be parallel, such that the magnitude of the movement of one index will match that of the other index. At December 31, 2006, we had 13.7% of our ARM-MBS portfolio repricing from the one-year CMT index, 74.3% repricing from the one-year LIBOR index, 11.1% repricing from MTA and 0.9% repricing from COFI.
Our adjustable-rate assets reset on various dates that are not matched to the reset dates on our borrowings (i.e., repurchase agreements). In general, the repricing of our debt obligations occurs more quickly than the repricing of our assets. Therefore, on average, our cost of borrowings may rise or fall more quickly in response to changes in market interest rates than does the yield on our interest-earning assets.
To finance a significant portion of our assets, we typically enter into repurchase agreements with terms that range from one month to three years. Upon contractual maturity or an interest reset date, these borrowings are refinanced at then prevailing market rates.
As part of our overall interest rate risk management strategy, we periodically use Hedging Instruments to mitigate the impact of significant unplanned fluctuations in earnings and cash flows caused by interest rate volatility. The interest rate risk management strategy at times involves modifying the repricing characteristics of certain assets and liabilities utilizing derivatives. Our Hedging Instruments are intended to serve as a hedge against future interest rate increases on our repurchase agreements, which are typically priced off of LIBOR. At December 31, 2006, we had Swaps with a notional amount of $1.809 billion and Caps with an aggregate notional amount of $150.0 million, all of which were active. During 2006, we received or were due payments of $4.1 million related to our Swaps and
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$2.8 million from counterparties on our Caps. The notional amount of our Swaps are presented in the table below, as they impact the cost of a portion of our repurchase agreements. The notional amounts of our Caps, which hedge against increases in interest rates on our LIBOR-based repurchase agreements, are not considered in the gap analysis, as they do not effect the timing of the repricing of the instruments they hedge, but rather, to the extent of the notional amount, cap the amount of interest rate change that can occur relative to the hedged liability. In addition, while the fair value of our Hedging Instruments are reflected in our consolidated balance sheets, the notional amounts are not.
The mismatch between repricings or maturities within a time period is commonly referred to as the “gap” for that period. A positive gap, where repricing of interest-rate sensitive assets exceeds the maturity of interest-rate sensitive liabilities, generally will result in the net interest margin increasing in a rising interest rate environment and decreasing in a falling interest rate environment; conversely, a negative gap, where the repricing of interest rate sensitive liabilities exceeds the repricing of interest-rate sensitive assets will generate opposite results. At December 31, 2006, we had a negative gap in our less than three month category. The gap analysis below is prepared assuming a 25% CPR; however, actual future prepayment speeds could vary significantly. The gap analysis does not reflect the constraints on the repricing of ARM-MBS in a given period resulting from interim and lifetime cap features on these securities, nor the behavior of various indexes applicable to our assets and liabilities. The gap methodology does not assess the relative sensitivity of assets and liabilities to changes in interest rates and also fails to account for interest rate caps and floors imbedded in our MBS or include assets and liabilities that are not interest rate sensitive.
The following table sets forth our interest rate risk using the gap methodology applying a 25% CPR at December 31, 2006.
| | | | | | | | | | | | | | | | | | | |
| | At December 31, 2006 | |
| | | |
| | Less than 3
Months | | Three Months to
One Year | | One Year to
Two Years | | Two Years to
Three Years | | Beyond Three
Years | | Total | |
| | | | | | | | | | | | | |
(In thousands) | | | | | | | | | | | | | | | | | | | |
Interest-Earning Assets: | | | | | | | | | | | | | | | | | | | |
Adjustable-Rate MBS | | $ | 1,426,285 | | $ | 1,522,218 | | $ | 926,285 | | $ | 749,284 | | $ | 1,716,596 | | $ | 6,340,668 | |
Fixed-Rate MBS | | | — | | | — | | | — | | | — | | | — | | | — | |
Cash | | | 47,200 | | | — | | | — | | | — | | | — | | | 47,200 | |
| | | | | | | | | | | | | | | | | | | |
Total interest-earning assets | | $ | 1,473,485 | | $ | 1,522,218 | | $ | 926,285 | | $ | 749,284 | | $ | 1,716,596 | | $ | 6,387,868 | |
| | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | |
Interest-Bearing Liabilities: | | | | | | | | | | | | | | | | | | | |
Repurchase agreements | | $ | 3,866,200 | | $ | 37,200 | | $ | 1,505,311 | | $ | 314,000 | | $ | — | | $ | 5,722,711 | |
Mortgage Loans | | | — | | | — | | | — | | | — | | | 9,606 | | | 9,606 | |
| | | | | | | | | | | | | | | | | | | |
Total interest-bearing liabilities | | $ | 3,866,200 | | $ | 37,200 | | $ | 1,505,311 | | $ | 314,000 | | $ | 9,606 | | $ | 5,732,317 | |
| | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | |
Gap before Hedging Instruments | | $ | (2,392,715 | ) | $ | 1,485,018 | | $ | (579,026 | ) | $ | 435,284 | | $ | 1,706,990 | | $ | 655,551 | |
Notional Amounts of Swaps | | $ | 1,809,191 | | | — | | | — | | | — | | | — | | $ | 1,809,191 | |
Cumulative Difference Between Interest-Earnings Assets and Interest Bearing Liabilities after Hedging Instruments | | $ | (583,524 | ) | $ | 901,494 | | $ | 322,468 | | $ | 757,752 | | $ | 2,464,742 | | | | |
MARKET VALUE RISK
Substantially all of our MBS are designated as “available-for-sale” assets. As such, they are reflected at their estimated fair value, with the difference between amortized cost and estimated fair value reflected in accumulated other comprehensive income, a component of Stockholders’ Equity. (See Note 10 to the consolidated financial statements, included under Item 8 of this annual report on Form 10-K.) The estimated fair value of our MBS fluctuate primarily due to changes in interest rates and other factors; however, given that, at December 31, 2006, these securities were primarily Agency MBS or AAA rated MBS, such changes in the estimated fair value of our MBS are generally not credit-related. At December 31, 2006, we held $20.0 million of non-Agency MBS that were
30
rated below AAA, of which $3.5 million were non-rated securities. Therefore, to a limited extent we are exposed to credit-related market value risk. Generally, in a rising interest rate environment, the estimated fair value of our MBS would be expected to decrease; conversely, in a decreasing interest rate environment, the estimated fair value of such MBS would be expected to increase. If the estimated fair value of our MBS collateralizing our repurchase agreements decreases, we may receive margin calls from our repurchase agreement counterparties for additional collateral or cash due to such decline. If such margin calls were not met, the lender could liquidate the securities collateralizing our repurchase agreements with such lender, resulting in a loss to us. In such a scenario, we could apply a strategy of reducing borrowings and assets, by selling assets or not replacing securities as they amortize and/or prepay, thereby “shrinking the balance sheet”, as was applied during the first half of 2006. Such an action would likely reduce our interest income, interest expense and net income, the extent of which would be dependent on the level of reduction in assets and liabilities as well as the sale price of the assets sold. Further, such a decrease in our net interest income could negatively impact cash available for distributions, which in turn could reduce the market price of our issued and outstanding common stock and preferred stock.
LIQUIDITY RISK
The primary liquidity risk for us arises from financing long-maturity assets, which have interim and lifetime interest rate adjustment caps, with shorter-term borrowings in the form of repurchase agreements. Although the interest rate adjustments of these assets and liabilities are matched within the guidelines established by our operating policies, maturities are not required to be, nor are they, matched.
Our assets which are pledged to secure repurchase agreements are typically high-quality, liquid assets. As a result, we have not had difficulty rolling over (i.e., renewing) these agreements as they mature. However, we cannot assure that we will always be able to roll over our repurchase agreements. At December 31, 2006, we had cash and cash equivalents of $47.2 million and unpledged securities of $275.6 million available to meet margin calls on our repurchase agreements and for other corporate purposes. However, should market interest rates and/or prepayment speeds on the mortgage loans underlying our MBS suddenly increase, margin calls relating to our repurchase agreements could increase, causing an adverse change in our liquidity position.
PREPAYMENT AND REINVESTMENT RISK
As we receive repayments of principal on our MBS, from prepayments and scheduled amortization, premiums paid on such securities are amortized against interest income and discounts are accreted to interest income. Premiums arise when we acquire a MBS at a price in excess of the principal balance of the mortgages securing such MBS (i.e., par value). Conversely, discounts arise when we acquire a MBS at a price below the principal balance of the mortgages securing such MBS. For financial accounting purposes, interest income is accrued based on the outstanding principal balance of the investment securities and their contractual terms. In general, purchase premiums on our investment securities, currently comprised of MBS, are amortized against interest income over the lives of the securities using the effective yield method, adjusted for actual prepayment activity. An increase in the prepayment rate, as measured by the CPR, will typically accelerate the amortization of purchase premiums, thereby reducing the yield/interest income earned on such assets.
For tax accounting purposes, the purchase premiums and discounts are amortized based on the constant effective yield calculated at the purchase date. Therefore, on a tax basis, amortization of premiums and discounts will differ from those reported for financial purposes under GAAP. At December 31, 2006, the gross premium for ARM-MBS for financial accounting purposes was $98.8 million (1.6% of the carrying value of MBS); while the gross premium for income tax purposes was estimated at $96.3 million.
In general, we believe that we will be able to reinvest proceeds from scheduled principal payments and prepayments at acceptable yields; however, no assurances can be given that, should significant prepayments occur, market conditions would be such that acceptable investments could be identified and the proceeds timely reinvested.
31
TABULAR PRESENTATION
The information presented in the following table projects the potential impact of sudden parallel changes in interest rates on net interest income and portfolio value, including the impact of Hedging Instruments, over the next twelve months based on the assets in our investment portfolio on December 31, 2006. We acquire interest-rate sensitive assets and fund them with interest-rate sensitive liabilities. All changes in income and value are measured as percentage change from the projected net interest income and portfolio value at the base interest rate scenario.
| | | | | | | |
Change in
Interest Rates | | Percentage Change
in Net Interest Income | | Percentage Change
in Portfolio Value | |
| | | | | | |
+ 1.00% | | (24.81 | %) | | (1.05 | %) | |
+ 0.50% | | (11.15 | %) | | (0.43 | %) | |
- 0.50% | | 7.36 | % | | 0.25 | % | |
- 1.00% | | 18.80 | % | | 0.31 | % | |
Certain assumptions have been made in connection with the calculation of the information set forth in the above table and, as such, there can be no assurance that assumed events will occur or that other events will not occur that would affect the outcomes. The base interest rate scenario assumes interest rates at December 31, 2006. The analysis presented utilizes assumptions and estimates based on management’s judgment and experience. Furthermore, while we generally expect to retain such assets and the associated interest rate risk to maturity, future purchases and sales of assets could materially change our interest rate risk profile. It should be specifically noted that the information set forth in the above table and all related disclosure constitutes forward-looking statements within the meaning of Section 27A of the Act and Section 21E of the Exchange Act. Actual results could differ significantly from those estimated in the table.
The table quantifies the potential changes in net interest income and portfolio value should interest rates immediately change (or Shock). The table presents the estimated impact of interest rates instantaneously rising 50 and 100 basis points, and falling 50 and 100 basis points. The cash flows associated with the portfolio of MBS for each rate Shock are calculated based on assumptions, including, but not limited to, prepayment speeds, yield on future acquisitions, slope of the yield curve and size of the portfolio. Assumptions made on the interest rate sensitive liabilities, which are assumed to be repurchase agreements, include anticipated interest rates, collateral requirements as a percent of the repurchase agreement, amount and term of borrowing.
The impact on portfolio value is approximated using the calculated effective duration (i.e., the price sensitivity to changes in interest rates) of 0.68 and expected convexity (i.e., the approximate change in duration relative to the change in interest rates) of (0.74). The impact on net interest income is driven mainly by the difference between portfolio yield and cost of funding of our repurchase agreements, which includes the cost and/or benefit from Hedging Instruments that hedge certain of our repurchase agreements. Our asset/liability structure is generally such that an increase in interest rates would be expected to result in a decrease in net interest income, as our repurchase agreements are generally shorter term than our interest-earning assets. When interest rates are Shocked, prepayment assumptions are adjusted based on management’s expectations along with the results from the prepayment model. For example, under current market conditions, a 100 basis point increase in interest rates is estimated to result in a 8% decrease in the CPR of the MBS portfolio.
32
Item 8. Financial Statements and Supplementary Data.
Index to Financial Statements
| | |
| | Page |
| | |
Report of the Independent Registered Public Accounting Firm | | 34 |
| | |
Financial Statements: | | |
| | |
Consolidated Balance Sheets at December 31, 2006 and December 31, 2005 | | 35 |
| | |
Consolidated Statements of Income for the years ended December 31, 2006, 2005 and 2004 | | 36 |
| | |
Consolidated Statements of Changes in Stockholders’ Equity for the years ended December 31, 2006, 2005 and 2004 | | 37 |
| | |
Consolidated Statements of Cash Flows for the years ended December 31, 2006, 2005 and 2004 | | 38 |
| | |
Consolidated Statements of Comprehensive Income for the years ended December 31, 2006, 2005 and 2004 | | 39 |
| | |
Notes to the Consolidated Financial Statements | | 40 |
All financial statement schedules are omitted because they are not applicable or the required information is included in the consolidated financial statements and/or notes thereto.
Financial statements of subsidiaries have been omitted; as such entities do not individually or in the aggregate exceed the 20% threshold under either the investment or income tests. The Company owned 100% of each of its subsidiaries.
33
Report of Independent Registered Public Accounting Firm
To The Board of Directors and Stockholders of
MFA Mortgage Investments, Inc.
We have audited the accompanying consolidated balance sheets of MFA Mortgage Investments, Inc. as of December 31, 2006 and 2005, and the related consolidated statements of income, changes in stockholders’ equity, cash flows, and comprehensive income for each of the three years in the period ended December 31, 2006. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of MFA Mortgage Investments, Inc. at December 31, 2006 and 2005, and the consolidated results of its operations, its cash flows, and its comprehensive income for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of MFA Mortgage Investments, Inc.’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 14, 2007 expressed an unqualified opinion thereon.
Ernst & Young LLP
New York, New York
February 14, 2007
34
MFA MORTGAGE INVESTMENTS, INC.
CONSOLIDATED BALANCE SHEETS
| | | | | | | |
| | At December 31, | |
| | | |
| | 2006 | | 2005 | |
| | | | | |
(In Thousands, Except Per Share Amounts) | | | | | | | |
|
Assets: | | | | | | | |
Mortgage-backed securities (“MBS”), at fair value (including pledged assets of $6,065,021 and $5,394,144 at December 31, 2006 and 2005, respectively, Notes 3 and 6) | | $ | 6,340,668 | | $ | 5,714,906 | |
Cash and cash equivalents | | | 47,200 | | | 64,301 | |
Accrued interest receivable | | | 33,182 | | | 24,198 | |
Interest rate cap agreements (“Caps”), at fair value (Note 5) | | | 361 | | | 2,402 | |
Swap agreements (“Swaps”), at fair value (Note 5) | | | 2,412 | | | 3,092 | |
Real estate (Note 4) | | | 11,789 | | | 29,398 | |
Goodwill | | | 7,189 | | | 7,189 | |
Prepaid and other assets | | | 1,166 | | | 1,431 | |
| | | | | | | |
Total Assets | | $ | 6,443,967 | | $ | 5,846,917 | |
| | | | | | | |
| | | | | | | |
Liabilities: | | | | | | | |
Repurchase agreements (Note 6) | | $ | 5,722,711 | | $ | 5,099,532 | |
Accrued interest payable | | | 23,164 | | | 54,157 | |
Mortgages payable on real estate (Note 4) | | | 9,606 | | | 22,552 | |
Swaps, at fair value (Note 5) | | | 1,893 | | | — | |
Dividends payable | | | 4,899 | | | 4,058 | |
Accrued expenses and other liabilities | | | 3,136 | | | 5,516 | |
| | | | | | | |
Total Liabilities | | | 5,765,409 | | | 5,185,815 | |
| | | | | | | |
| | | | | | | |
Commitments and contingencies (Note 7) | | | | | | | |
| | | | | | | |
Stockholders’ Equity: | | | | | | | |
Preferred stock, par value $.01; series A 8.50% cumulative redeemable; 5,000 shares authorized; 3,840 shares issued and outstanding at December 31, 2006 and 2005 ($96,000 aggregate liquidation preference) (Note 8) | | | 38 | | | 38 | |
Common stock, par value $.01; 370,000 shares authorized; 80,695 and 80,121 issued and outstanding at December 31, 2006 and 2005, respectively (Note 8) | | | 807 | | | 801 | |
Additional paid-in capital, in excess of par | | | 776,743 | | | 770,789 | |
Accumulated deficit | | | (68,637 | ) | | (52,315 | ) |
Accumulated other comprehensive loss (Note 10) | | | (30,393 | ) | | (58,211 | ) |
| | | | | | | |
Total Stockholders’ Equity | | | 678,558 | | | 661,102 | |
| | | | | | | |
Total Liabilities and Stockholders’ Equity | | $ | 6,443,967 | | $ | 5,846,917 | |
| | | | | | | |
The accompanying notes are an integral part of the consolidated financial statements.
35
MFA MORTGAGE INVESTMENTS, INC.
CONSOLIDATED STATEMENTS OF INCOME
| | | | | | | | | | |
| | For the Year Ended December 31, | |
| | | |
| | 2006 | | 2005 | | 2004 | |
| | | | | | | |
(In Thousands, Except Per Share Amounts) | | | | | | | | | | |
Interest and Dividend Income: | | | | | | | | | | |
MBS income (Note 3) | | $ | 216,871 | | $ | 235,798 | | $ | 174,957 | |
Interest income on short-term cash investments | | | 2,321 | | | 2,921 | | | 807 | |
| | | | | | | | | | |
Total Interest Income | | | 219,192 | | | 238,719 | | | 175,764 | |
| | | | | | | | | | |
| | | | | | | | | | |
Interest Expense (Note 6) | | | 181,922 | | | 183,833 | | | 88,888 | |
| | | | | | | | | | |
| | | | | | | | | | |
Net Interest Income | | | 37,270 | | | 54,886 | | | 86,876 | |
| | | | | | | | | | |
| | | | | | | | | | |
Other (Loss)/Income: | | | | | | | | | | |
Other-than-temporary impairment on MBS (Note 3) | | | — | | | (20,720 | ) | | — | |
Net (loss)/gain on sale of MBS (Note 3) | | | (23,113 | ) | | (18,354 | ) | | 371 | |
Revenue from operations of real estate (Note 4) | | | 1,556 | | | 1,460 | | | 1,480 | |
Miscellaneous other income, net | | | 708 | | | 351 | | | 195 | |
| | | | | | | | | | |
Total Other (Loss)/Income | | | (20,849 | ) | | (37,263 | ) | | 2,046 | |
| | | | | | | | | | |
| | | | | | | | | | |
Operating and Other Expense: | | | | | | | | | | |
Compensation and benefits (Note 11) | | | 5,725 | | | 5,505 | | | 5,603 | |
Real estate operating expense (Note 4) | | | 942 | | | 991 | | | 992 | |
Mortgage interest on real estate (Note 4) | | | 675 | | | 682 | | | 693 | |
Other general and administrative expense | | | 3,843 | | | 3,651 | | | 3,334 | |
| | | | | | | | | | |
Total Operating and Other Expense | | | 11,185 | | | 10,829 | | | 10,622 | |
| | | | | | | | | | |
| | | | | | | | | | |
Income from Continuing Operations | | | 5,236 | | | 6,794 | | | 78,300 | |
| | | | | | | | | | |
| | | | | | | | | | |
Discontinued Operations: (Note 4) | | | | | | | | | | |
Loss from discontinued operations, net | | | (198 | ) | | (86 | ) | | (227 | ) |
Prepayment penalties on mortgages satisfied | | | (712 | ) | | — | | | — | |
Gain on sale of real estate, net of tax of $1,820 for 2006 | | | 4,432 | | | — | | | — | |
| | | | | | | | | | |
Income/(Loss) from Discontinued Operations | | | 3,522 | | | (86 | ) | | (227 | ) |
| | | | | | | | | | |
| | | | | | | | | | |
Net Income Before Preferred Stock Dividends | | | 8,758 | | | 6,708 | | | 78,073 | |
Less: Preferred Stock Dividends | | | 8,160 | | | 8,160 | | | 3,576 | |
| | | | | | | | | | |
Net Income/(Loss) Available to Common Stockholders | | $ | 598 | | $ | (1,452 | ) | $ | 74,497 | |
| | | | | | | | | | |
| | | | | | | | | | |
Earnings/(Loss) Per Share of common stock: (Note 9) | | | | | | | | | | |
(Loss)/earnings from continuing operations – basic and diluted | | $ | (0.03 | ) | $ | (0.02 | ) | $ | 0.98 | |
Earnings from discontinued operations – basic and diluted | | | 0.04 | | | — | | | — | |
| | | | | | | | | | |
Earnings/(loss) per share of common stock– basic and diluted | | $ | 0.01 | | $ | (0.02 | ) | $ | 0.98 | |
| | | | | | | | | | |
| | | | | | | | | | |
Dividends declared per share of common stock (Note 8) | | $ | 0.21 | | $ | 0.41 | | $ | 0.96 | |
| | | | | | | | | | |
The accompanying notes are an integral part of the consolidated financial statements.
36
MFA MORTGAGE INVESTMENTS, INC.
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY
| | | | | | | | | | | | | | | | | | | |
| | For the Year Ended December 31, | |
| | | |
| | 2006 | | 2005 | | 2004 | |
| | | | | | | |
| | Dollars | | Shares | | Dollars | | Shares | | Dollars | | Shares | |
| | | | | | | | | | | | | |
(In Thousands, Except Per Share Amounts) | | | | | | | | | | | | | | | | | | | |
Series A 8.50% Cumulative Redeemable Preferred Stock – Liquidation Preference $25.00 Per Share: | | | | | | | | | | | | | | | | | | | |
Balance at beginning of year | | $ | 38 | | | 3,840 | | $ | 38 | | | 3,840 | | $ | — | | | — | |
Issuance of shares | | | — | | | — | | | — | | | — | | | 38 | | | 3,840 | |
| | | | | | | | | | | | | | | | | | | |
Balance at end of year | | | 38 | | | 3,840 | | | 38 | | | 3,840 | | | 38 | | | 3,840 | |
| | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | |
Common Stock, Par Value $0.01: | | | | | | | | | | | | | | | | | | | |
Balance at beginning of year | | | 801 | | | 80,121 | | | 820 | | | 82,017 | | | 632 | | | 63,201 | |
Issuance of shares | | | 15 | | | 1,501 | | | 4 | | | 368 | | | 188 | | | 18,816 | |
Repurchase of shares | | | (9 | ) | | (927 | ) | | (23 | ) | | (2,264 | ) | | — | | | — | |
| | | | | | | | | | | | | | | | | | | |
Balance at end of year | | | 807 | | | 80,695 | | | 801 | | | 80,121 | | | 820 | | | 82,017 | |
| | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | |
Additional Paid-in Capital, in excess of Par: | | | | | | | | | | | | | | | | | | | |
Balance at beginning of year | | | 770,789 | | | | | | 780,406 | | | | | | 512,199 | | | | |
Share-based compensation expense | | | 539 | | | | | | 493 | | | | | | 558 | | | | |
Issuance of common stock, net of expenses | | | 11,103 | | | | | | 2,994 | | | | | | 175,634 | | | | |
Issuance of preferred stock, net of expenses | | | — | | | | | | — | | | | | | 92,015 | | | | |
Repurchase of common stock | | | (5,688 | ) | | | | | (13,104 | ) | | | | | — | | | | |
| | | | | | | | | | | | | | | | | | | |
Balance at end of year | | | 776,743 | | | | | | 770,789 | | | | | | 780,406 | | | | |
| | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | |
Accumulated Deficit: | | | | | | | | | | | | | | | | | | | |
Balance at beginning of year | | | (52,315 | ) | | | | | (17,330 | ) | | | | | (15,764 | ) | | | |
Net income | | | 8,758 | | | | | | 6,708 | | | | | | 78,073 | | | | |
Dividends declared on common stock | | | (16,920 | ) | | | | | (33,533 | ) | | | | | (76,063 | ) | | | |
Dividends declared on preferred stock | | | (8,160 | ) | | | | | (8,160 | ) | | | | | (3,576 | ) | | | |
| | | | | | | | | | | | | | | | | | | |
Balance at end of year | | | (68,637 | ) | | | | | (52,315 | ) | | | | | (17,330 | ) | | | |
| | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | |
Accumulated Other Comprehensive (Loss)/Income: | | | | | | | | | | | | | | | | | | | |
Balance at beginning of year | | | (58,211 | ) | | | | | (35,100 | ) | | | | | (12,109 | ) | | | |
Unrealized gains/(losses) on MBS, net | | | 30,733 | | | | | | (28,617 | ) | | | | | (24,338 | ) | | | |
Unrealized (losses)/gains on Caps, net | | | (342 | ) | | | | | 2,735 | | | | | | 1,026 | | | | |
Unrealized (losses)/gains on Swaps | | | (2,573 | ) | | | | | 2,771 | | | | | | 321 | | | | |
| | | | | | | | | | | | | | | | | | | |
Balance at end of year | | | (30,393 | ) | | | | | (58,211 | ) | | | | | (35,100 | ) | | | |
| | | | | | | | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | |
Total Stockholders’ Equity at year end | | $ | 678,558 | | | | | $ | 661,102 | | | | | $ | 728,834 | | | | |
| | | | | | | | | | | | | | | | | | | |
The accompanying notes are an integral part of the consolidated financial statements.
37
MFA MORTGAGE INVESTMENTS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
| | | | | | | | | | |
| | For the Year Ended December 31, | |
| | | |
(In Thousands) | | 2006 | | 2005 | | 2004 | |
| | | | | | | |
Cash Flows From Operating Activities: | | | | | | | | | | |
Net income, including discontinued operations | | $ | 8,758 | | $ | 6,708 | | $ | 78,073 | |
Adjustments to reconcile net income to net cash provided by operating activities: | | | | | | | | | | |
Gains on sale of MBS | | | (2,132 | ) | | (10 | ) | | (371 | ) |
Losses on sale of MBS | | | 25,245 | | | 18,364 | | | — | |
Other-than-temporary impairment recognized on MBS | | | — | | | 20,720 | | | — | |
Amortization of purchase premium on MBS, net of accretion of discounts | | | 30,974 | | | 56,515 | | | 47,657 | |
Amortization of premium cost for derivative assets | | | 1,700 | | | 1,578 | | | 2,451 | |
(Increase)/decrease in interest receivable | | | (8,984 | ) | | 2,230 | | | (7,619 | ) |
Decrease/(increase) in receivable under DRSPP | | | — | | | 985 | | | (280 | ) |
Depreciation and amortization on real estate, including discontinued operations | | | 574 | | | 838 | | | 819 | |
Decrease (increase) in other assets and other | | | 18 | | | (65 | ) | | (440 | ) |
(Decrease)/increase in accrued expenses and other liabilities | | | (1,950 | ) | | 2,475 | | | (13,662 | ) |
(Decrease)/increase in accrued interest payable | | | (30,993 | ) | | 25,806 | | | 21,112 | |
Gain on sale of real estate from discontinued operations | | | (6,660 | ) | | — | | | — | |
Loss on sale of real estate from discontinued operations | | | 408 | | | — | | | — | |
Share-based compensation expense | | | 539 | | | 493 | | | 558 | |
Negative amortization on MBS | | | (1,614 | ) | | (443 | ) | | — | |
| | | | | | | | | | |
Net cash provided by operating activities | | | 15,883 | | | 136,194 | | | 128,298 | |
| | | | | | | | | | |
| | | | | | | | | | |
Cash Flows From Investing Activities: | | | | | | | | | | |
Principal payments on MBS | | | 1,637,304 | | | 2,629,887 | | | 2,078,565 | |
Proceeds from sale of MBS | | | 1,843,659 | | | 617,152 | | | 39,950 | |
Purchases of MBS | | | (4,128,466 | ) | | (2,308,134 | ) | | (4,594,995 | ) |
Proceeds from sale of real estate | | | 23,534 | | | | | | | |
Cash increase from initial consolidation of subsidiary | | | — | | | — | | | 258 | |
| | | | | | | | | | |
Net cash (used)/provided by investing activities | | | (623,969 | ) | | 938,905 | | | (2,476,222 | ) |
| | | | | | | | | | |
| | | | | | | | | | |
Cash Flows From Financing Activities: | | | | | | | | | | |
Purchase of Caps | | | — | | | — | | | (2,394 | ) |
Principal payments on repurchase agreements | | | (21,101,718 | ) | | (19,571,976 | ) | | (18,591,961 | ) |
Proceeds from borrowings on repurchase agreements | | | 21,724,897 | | | 18,558,476 | | | 20,680,617 | |
Proceeds from issuance of preferred stock | | | — | | | — | | | 92,053 | |
Proceeds from issuance of common stock | | | 11,118 | | | 2,998 | | | 175,822 | |
Dividends paid on preferred stock | | | (8,160 | ) | | (8,160 | ) | | (3,576 | ) |
Common stock repurchased | | | (6,127 | ) | | (12,697 | ) | | — | |
Dividends paid on common stock and DERs | | | (16,079 | ) | | (47,646 | ) | | (73,816 | ) |
Principal payments on and satisfaction of mortgages, including discontinued operations | | | (12,946 | ) | | (134 | ) | | (187 | ) |
| | | | | | | | | | |
Net cash provided/(used) by financing activities | | | 590,985 | | | (1,079,139 | ) | | 2,276,558 | |
| | | | | | | | | | |
Net decrease in cash and cash equivalents | | | (17,101 | ) | | (4,040 | ) | | (71,366 | ) |
Cash and cash equivalents at beginning of period | | | 64,301 | | | 68,341 | | | 139,707 | |
| | | | | | | | | | |
Cash and cash equivalents at end of period | | $ | 47,200 | | $ | 64,301 | | $ | 68,341 | |
| | | | | | | | | | |
| | | | | | | | | | |
Supplemental Disclosure of Cash Flow Information: | | | | | | | | | | |
Interest paid | | $ | 219,262 | | $ | 159,050 | | $ | 67,024 | |
| | | | | | | | | | |
Mortgage prepayment penalty paid – discontinued operations | | $ | 712 | | $ | — | | $ | — | |
| | | | | | | | | | |
Built-in gains taxes paid on sales of real estate | | $ | 1,320 | | $ | — | | $ | — | |
| | | | | | | | | | |
The accompanying notes are an integral part of the consolidated financial statements.
38
MFA MORTGAGE INVESTMENTS, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
| | | | | | | | | | |
| | For the Year Ended December 31, | |
| | | |
| | 2006 | | 2005 | | 2004 | |
| | | | | | | |
(In Thousands) | | | | | | | | | | |
Net income before preferred stock dividends | | $ | 8,758 | | $ | 6,708 | | $ | 78,073 | |
Other Comprehensive Income/(Loss): | | | | | | | | | | |
Unrealized gain/(loss) on MBS, net | | | 6,165 | | | (68,185 | ) | | (23,529 | ) |
Reclassification adjustment for net loss/(gain) included in net income | | | 24,568 | | | 39,568 | | | (809 | ) |
Unrealized (loss)/gain on Caps, net | | | (342 | ) | | 2,735 | | | 1,026 | |
Unrealized (loss)/gain on Swaps | | | (2,573 | ) | | 2,771 | | | 321 | |
| | | | | | | | | | |
Comprehensive income/(loss) before preferred stock dividends | | $ | 36,576 | | $ | (16,403 | ) | $ | 55,082 | |
| | | | | | | | | | |
| | | | | | | | | | |
Dividends on preferred stock | | | (8,160 | ) | | (8,160 | ) | | (3,576 | ) |
| | | | | | | | | | |
Comprehensive Income/(Loss) Available to Common Stockholders | | $ | 28,416 | | $ | (24,563 | ) | $ | 51,506 | |
| | | | | | | | | | |
The accompanying notes are an integral part of the consolidated financial statements.
39
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
1. Organization
MFA Mortgage Investments, Inc. (the “Company”) was incorporated in Maryland on July 24, 1997 and began operations on April 10, 1998. The Company has elected to be treated as a real estate investment trust (“REIT”) for federal income tax purposes. In order to maintain its qualification as a REIT, the Company must comply with a number of requirements under federal tax law, including that it must distribute at least 90% of its annual net taxable income to its stockholders, subject to certain adjustments. (See Note 8(c).)
2. Summary of Significant Accounting Policies
(a) Basis of Presentation and Consolidation
The accompanying consolidated financial statements are prepared on the accrual basis of accounting in accordance with U.S. generally accepted accounting principles (“GAAP”). The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
The consolidated financial statements of the Company include the accounts of all subsidiaries; significant intercompany accounts and transactions have been eliminated.
(b) MBS
The Company accounts for its MBS in accordance with Statement of Financial Accounting Standards (“FAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities,” which requires that investments in securities be designated as either “held-to-maturity,” “available-for-sale” or “trading” at the time of acquisition. All of the Company’s MBS are designated as available-for-sale and are carried at their estimated fair value with unrealized gains and losses excluded from earnings and reported in other comprehensive income, a component of Stockholder’s Equity. On December 31, 2005, the Company adopted the guidance prescribed in Financial Accounting Standards Board (“FASB”) Staff Position FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and its Application to Certain Investments” (the “FASB Impairment Position”). The application of the FASB Impairment Position resulted in the Company recognizing an other-than-temporary impairment charge of $20.7 million on December 31, 2005. (See Note 2(d).)
Although the Company generally intends to hold its MBS until maturity, it may, from time to time, sell any of its MBS as part of the overall management of its business. The available-for-sale designation provides the Company with the flexibility to sell its MBS in order to act on potential market opportunities or changes in economic conditions to ensure future liquidity and to meet other general corporate purposes as they arise. Upon the sale of a MBS, unrealized gains and losses are reclassified out of accumulated other comprehensive income to earnings as realized gains and losses using the specific identification method. (See Note 3.)
The Company’s adjustable-rate assets are comprised primarily of hybrid and adjustable-rate MBS (collectively, “ARM-MBS”) that are issued or guaranteed as to principal and/or interest by an agency of the U.S. government, such as the Ginnie Mae, or a federally chartered corporation, such as Fannie Mae or Freddie Mac (collectively, “Agency MBS”) or are rated AAA by at least one nationally recognized rating agency. Hybrid MBS have interest rates that are fixed for a specified period and, thereafter, generally reset annually. To a lesser extent, the Company also holds investments in MBS or mortgage-related securities that are rated below AAA. These mortgage-related assets have yields that are determined by the actual and estimated cash flows generated by the underlying mortgage loans on these assets. At December 31, 2006, the Company had MBS with a carrying value of $5.7 million rated below BBB, such MBS were purchased at a deep discount, with the discount, or a portion thereof, recorded as credit protection against future credit losses under various economic environments.
Interest income is accrued based on the outstanding principal balance of the investment securities and their contractual terms. Premiums and discounts associated with the Agency MBS and MBS rated AAA and AA are amortized into interest income over the life of such securities using the effective yield method, adjusted for actual prepayment activity in accordance with FAS No. 91, “Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases.” Certain of the Agency MBS owned by the Company provide for negative amortization, which occurs when the full amount of the stated coupon interest due on the distribution date for an MBS is not received. The Company recognizes such interest shortfall on its Agency MBS as interest income with a corresponding increase in the related Agency MBS principal value (i.e., par) because the
40
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
negative amortization is guaranteed by the issuing agency.
Interest income on the Company’s MBS rated below AA is recognized in accordance with Emerging Issues Task Force of the Financial Accounting Standards Board 99-20, “Recognition of Interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets” (“EITF 99-20”). Pursuant to EITF 99-20, initial cash flows from a security are estimated applying assumptions that were used to determine the fair value of such security and the excess of the future cash flows over the initial investment is recognized as interest income under the effective yield method. The Company reviews and makes adjustments to its cash flow projections at least quarterly and monitors these projections based on input and analysis received from external sources, internal models, and its judgment about interest rates, prepayment rates, the timing and amount of credit losses, and other factors. Changes in cash flows from those originally projected, or from those estimated at the last evaluation, will result in a prospective change in interest income. At December 31, 2006, the Company had $17.7 million, or 0.3% of its assets, invested in MBS rated A or lower.
(c)Cash and Cash Equivalents
Cash and cash equivalents include cash on hand and highly liquid investments with original maturities of three months or less. The carrying amount of cash equivalents approximates their fair value.
(d)Other-Than-Temporary Impairment and Credit Risk
The Company limits its exposure to credit losses on its investment portfolio by requiring that at least 50% of its investment portfolio consist of Agency MBS. Pursuant to its operating policies, the remainder of the Company’s assets may consist of investments in: (i) residential mortgage loans, (ii) residential MBS (iii) direct or indirect investments in multi-family apartment properties; (iv) investments in limited partnerships, REITs or closed-end funds; or (v) investments in other fixed income instruments (corporate or government). At December 31, 2006, 94.9% of the Company’s assets consisted of Agency MBS and related receivables, 3.7% were MBS rated AAA by Standard & Poor’s Corporation, a nationally recognized rating agency, and related receivables and 0.7% were cash and cash equivalents; combined these assets comprised 99.3% of the Company’s total assets.
FASB Impairment Position
On December 31, 2005, the Company adopted the FASB Impairment Position. Among other things, the FASB Impairment Position specifically addresses: the determination as to when an investment is considered impaired; whether that impairment is other-than-temporary; the measurement of an impairment loss; accounting considerations subsequent to the recognition of an other-than-temporary impairment; and certain required disclosures about unrealized losses that have not been recognized as other-than-temporary impairments.
The FASB Impairment Position specifically provides that when the fair value of an investment is less than its cost at the balance sheet date of the reporting period for which impairment is assessed, the impairment is designated as either “temporary” or “other-than-temporary.” If it is determined that impairment is other-than-temporary, then an impairment loss is recognized in earnings reflecting the entire difference between the investment’s cost basis and its fair value at the balance sheet date of the reporting period for which the assessment is made. The measurement of the impairment is not permitted to include partial recoveries subsequent to the balance sheet date. Following the recognition of an other-than-temporary impairment, the fair value of the investment becomes the new cost basis of the investment and is not adjusted for subsequent recoveries in fair value.
Upon a decision to sell an impaired available-for-sale investment on which the Company does not expect the fair value of the investment to fully recover prior to the expected time of sale, the investment shall be deemed other-than-temporarily impaired in the period in which the decision to sell is made. The Company recognizes an impairment loss when the impairment is deemed other-than-temporary even if a decision to sell has not been made. Upon the implementation of the FASB Impairment Position, the Company recorded an impairment charge of $20.7 million, related to other-than-temporary impairments on certain MBS that the Company did not expect to hold until recovery of such impairment. These impairments were the result of decreases in the market value of such MBS due to changes in market interest rates. The Company had no other-than-temporarily impaired MBS at December 31, 2006 and did not recognize any impairment charges against its MBS portfolio during the year ended December 31, 2006. At December 31, 2005, the Company had MBS of $821.5 million on which an impairment charge had been made; all such MBS were sold during the first quarter of 2006, resulting in a net gain of $1.6 million reflecting the amount of market recovery subsequent to December 31, 2005. (See Note 3.)
At December 31, 2006, the Company had non-Agency MBS with an amortized cost of $16.9 million and a fair value/carrying value of $17.7 million rated below AA for which the EITF 99-20 applies. EITF 99-20 applies to
41
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
beneficial interests in securitized financial assets that are rated below AA, as they are not considered to be of a credit quality sufficiently collateralized to ensure that the possibility of credit loss is remote, and to beneficial interests that can contractually be prepaid or otherwise settled in such a way that the Company would not recover substantially all of its recorded investment against such beneficial interests. In accordance with EITF 99-20, when the fair value of the beneficial interest is below the amortized cost of such asset and an adverse change in cash flows has occurred from those previously estimated, due to actual prepayment and credit loss experience, the Company is required to take an impairment charge against such asset and adjust the future yield. Accordingly, the MBS would be written down to fair value, the resulting impairment would be charged against income and a new cost basis of the MBS established. Through December 31, 2006, the Company had not recognized any credit related impairments against any of its MBS.
(e) Goodwill
The Company accounts for its goodwill in accordance with FAS No. 142, “Goodwill and Other Intangible Assets” (“FAS 142”) which provides, among other things, how entities are to account for goodwill and other intangible assets that arise from business combinations or are otherwise acquired. FAS 142 requires that goodwill be tested for impairment annually or more frequently under certain circumstances. At the time the Company adopted FAS 142, the Company had unamortized goodwill of approximately $7.2 million, which represents the excess of the fair value of the common stock issued by the Company over the fair value of net assets acquired in connection with its formation in 1998. Goodwill is tested for impairment at the entity level on an annual basis. Through December 31, 2006, the Company had not recognized any impairment against its goodwill.
(f) Real Estate
At December 31, 2006, the Company indirectly held 100% of the ownership interest in Lealand Place, a 191-unit apartment property located in Lawrenceville, Georgia (“Lealand Place”), which is consolidated with the Company. This property was acquired through a tax-deferred exchange under Section 1031 of the Internal Revenue Code of 1986, as amended (the “Code”). (See Notes 2(g) and 4.)
The property, capital improvements and other assets held in connection with this investment are carried at cost, net of accumulated depreciation and amortization. Maintenance, repairs and minor improvements are charged to expense in the period incurred, while capital improvements are capitalized and depreciated over their useful life. Depreciation and amortization are computed using the straight-line method over the estimated useful life of the asset and its capital improvements.
(g) Real Estate Held-for-Sale/Discontinued Operations
The Company accounts for its real estate assets held-for-sale in accordance with FASB Statement No. 144, “Accounting for the Impairment or Disposal of Long Lived Assets” (“FAS 144”). Among other things, FAS 144 provides that a long-lived asset classified as held-for-sale shall: (i) not be depreciated while classified as held-for-sale; (ii) be measured at the lower of its carrying amount or fair value less cost to sell; (iii) result in a loss recognized for any initial or subsequent write-down to fair value less cost to sell or a gain recognized for any subsequent increase in fair value less cost to sell, but not in excess of the cumulative loss previously recognized. A gain or loss, not previously recognized, that results from the sale of a long-lived asset shall be recognized at the date of sale. In accordance with FAS 144, as amended by Statement No. 154, “Accounting Changes and Error Corrections” (“FAS 154”), revenues and expenses for the Company’s indirect interest in a property classified as held-for-sale or sold have been restated as discontinued operations, on a net basis for each of the periods presented. This reclassification/restatement had no effect on the Company’s reported net income. (See Note 4.)
On June 30, 2006, the Company classified its indirect investment in Cameron at Hickory Grove Apartments, a 201-unit multi-family apartment complex in Charlotte, North Carolina (“Cameron”), as held-for-sale. Upon the reclassification, Cameron was reviewed for impairment and it was determined that Cameron’s carrying value approximated its fair value less cost to sell. The sale of Cameron during the fourth quarter of 2006 ultimately resulted in a net loss of $408,000. In addition, a prepayment penalty of $577,000 was incurred on the satisfaction of the mortgage secured by such property. (See Note 4.)
During the first quarter of 2006, the Company sold its 100% membership interest in Greenhouse Holdings, LLC (“Greenhouse”), which held a 128-unit multi-family apartment building in Omaha, Nebraska known as “The Greenhouse”. The transaction resulted in a gain of $4.8 million net of selling costs and a built-in gains tax of $1.8 million. In addition, a $135,000 mortgage prepayment penalty was incurred on the satisfaction of the mortgage secured by such property. Prior to the quarter in which the sale of Greenhouse occurred, there was no definitive plan to sell such property.
42
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(h) Repurchase Agreements
The Company finances the acquisition of its MBS through the use of repurchase agreements. Under these repurchase agreements, the Company sells securities to a lender and agrees to repurchase the same securities in the future for a price that is higher than the original sale price. The difference between the sale price that the Company receives and the repurchase price that the Company pays represents interest paid to the lender. Under repurchase agreements the Company pledges its securities as collateral to secure a loan which is equal in value to a specified percentage of the estimated fair value of the pledged collateral, while the Company retains beneficial ownership of the pledged collateral. At the maturity of a repurchase agreement, the Company is required to repay the loan and concurrently receives back its pledged collateral from the lender. With the consent of the lender, the Company may renew a repurchase agreement at the then prevailing financing rate. Margin calls, whereby a lender requires that the Company pledge additional collateral to secure borrowings under its repurchase agreements with such lender, are routinely experienced by the Company as the value of MBS pledged as collateral declines due to scheduled monthly amortization and prepayments of principal on such MBS. In addition, margin calls may also occur when the fair value of the MBS pledged as collateral declines due to increases in market interest rates or other market conditions. Through December 31, 2006, the Company had satisfied all of its margin calls.
Original terms to maturity of the Company’s repurchase agreements generally range from one month to 36 months. Should a counterparty decide not to renew a repurchase agreement at maturity, the Company must either refinance elsewhere or be in a position to satisfy this obligation. If, during the term of a repurchase agreement, a lender should file for bankruptcy, the Company might experience difficulty recovering its pledged assets and may have an unsecured claim against the lender’s assets for the difference between the amount loaned to the Company plus interest due to the counterparty and the estimated fair value of the collateral pledged to such lender. To reduce this risk, the Company enters into repurchase agreements only with institutions whose long-term debt rating is single A or better or, if applicable, whose parent or holding company is rated single A or better (“Quality Institutions”) as determined by at least one nationally recognized rating agency, such as Moody’s Investors Services, Inc., Standard & Poor’s Corporation or Fitch, Inc. (collectively, the “Rating Agencies”), where applicable. If the minimum criterion is not met, the Company will not enter into repurchase agreements with a lender without the specific approval of the Company’s Board of Directors (the “Board”). In the event an existing lender is downgraded below single A, the Company will seek the approval of the Board before entering into additional repurchase agreements with that lender. The Company generally seeks to diversify its exposure by entering into repurchase agreements with at least four separate lenders with a maximum loan from any lender of no more than three times the Company’s stockholders’ equity. At December 31, 2006, the Company had outstanding balances under repurchase agreements with 13 separate lenders with a maximum net exposure (the difference between the amount loaned to the Company including interest payable and the fair value of the security pledged by the Company as collateral) to a single lender of $56.7 million. (See Note 6.)
Historically, the Company had in some cases, purchased MBS from a counterparty and subsequently financed the acquisition of these MBS through repurchase agreements, which are also collateralized by these MBS, with the same counterparty (a “Same Party Transaction”). The Company recorded the acquisition of these MBS as assets and the related financings under repurchase agreements as liabilities on its consolidated balance sheets, with changes in the fair value of these MBS recorded in other comprehensive income, a component of stockholders’ equity. The corresponding interest income earned on these MBS and interest expense incurred on the related repurchase agreements were reported gross on the Company’s consolidated statements of income.
Based upon the Company’s understanding of a technical interpretation of the provisions of FAS No. 140, “Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities” (“FAS 140”), Same Party Transactions may not qualify as a purchase by the Company because the MBS purchased by the Company in Same Party Transactions may not be determined to be legally isolated from the counterparty in such transactions. The result of this technical interpretation would be to preclude the Company from having presented (i) these MBS and the related financings under repurchase agreements on a gross basis on its balance sheet and (ii) the related interest income earned and interest expense incurred on a gross basis on its income statement. Instead, the Company may be required to present Same Party Transactions on a net basis, reporting derivatives on its balance sheet and the corresponding change in fair value of such derivatives on its income statement. The value of the derivatives created by these types of transactions would reflect the changes in the value of the underlying MBS and the changes in the value of the underlying credit provided by the applicable counterparty.
If the Company were to determine it was required to apply this technical interpretation of FAS 140, the potential change in its accounting treatment would not affect the economics of the Same Party Transactions, but would affect
43
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
how these transactions were reported on its consolidated financial statements. This issue was presented to the Emerging Issues Task Force of the FASB in early 2006 for guidance, and during the third quarter of 2006 the FASB determined it would consider the issue. As of December 31, 2006, the Company had no Same Party Transactions and, at December 31, 2005, the Company had 25 Same Party Transactions aggregating approximately $474.5 million in MBS and $471.5 million in financings under repurchase agreements.
(i) Earnings per Common Share (“EPS”)
Basic EPS is computed by dividing net income available to common stockholders by the weighted average number of shares of common stock outstanding during the period. Diluted EPS is computed by dividing net income available to common stockholders by the weighted average shares of common stock and common equivalent shares outstanding during the period. For the diluted EPS calculation, common equivalent shares outstanding includes the weighted average number of shares of common stock outstanding adjusted for the effect of dilutive stock options outstanding using the treasury stock method. Under the treasury stock method, common equivalent shares are calculated assuming that all dilutive common stock equivalents are exercised and the proceeds along with future compensation expense for unvested stock options are used to repurchase shares of the Company’s outstanding common stock at the average market price during the reported period. No common share equivalents are included in the computation of any diluted per share amount for a period in which a net operating loss is reported. (See Note 9.)
(j) Comprehensive Income
Comprehensive income for the Company includes net income/(loss), the change in net unrealized gains and losses on MBS and derivative instruments, and is reduced by dividends on preferred stock. (See Note 10.)
(k) U.S. Federal Income Taxes
The Company has elected to be taxed as a REIT under the provisions of the Code and the corresponding provisions of state law. The Company expects to operate in a manner that will enable it to continue to be taxed as a REIT. As such, no provision for current or deferred income taxes has been made in the accompanying consolidated financial statements.
Under the “Built-in Gain Rules” of the Code, a REIT is subject to a corporate tax if it disposes of an asset acquired from a C corporation during the ten-year period following the initial acquisition of such asset. Such built-in gain tax is imposed at the highest regular corporate tax rate on the lesser of (i) the amount of gain recognized by the REIT at the time of the sale or disposition of such asset or (ii) the amount of such asset’s built-in gains at the time the asset was acquired from the non-REIT C corporation. On January 31, 2006, the Company was subject to a built-in gains tax of $1.8 million in connection with the sale of one of its real estate properties, which, net of such tax and selling expenses, resulted in a gain of $4.8 million. (See Note 4.)
(l) Derivative Financial Instruments/Hedging Activity
The Company hedges a portion of its interest rate risk through the use of derivative financial instruments, comprised of interest rate swap agreements (“Swaps”) and interest rate cap agreements (“Caps” and, together with Swaps, “Hedging Instruments”). The Company accounts for Hedging Instruments in accordance with FAS No. 133, “Accounting for Derivative Instruments and Hedging Activities” (“FAS 133”), as amended by FAS No. 138, “Accounting for Certain Derivative Instruments and Certain Hedging Activities,” and FAS No. 149 “Amendment of Statement 133 on Derivative Instruments and Hedging Activities.” The Company’s Hedging Instruments are carried on the balance sheet at their fair value, as assets, if their fair value is positive, or as liabilities, if their fair value is negative. Since the Company’s Hedging Instruments are designated as “cash flow hedges,” the change in the fair value of any such instrument is recorded in other comprehensive income for hedges that qualify as effective and is transferred from other comprehensive income to earnings as the hedged liability affects earnings. The ineffective amount of all Hedging Instruments, if any, is recognized in earnings each quarter. To date, the Company has not recognized any change in the value of its Hedging Instruments in earnings as a result of the hedge or a portion thereof being ineffective.
Upon entering into hedging transactions, the Company documents the relationship between the Hedging Instruments and the hedged liability. The Company also documents its risk-management policies, including objectives and strategies, as they relate to its hedging activities. The Company assesses, both at inception of a hedge and on an on-going basis, whether or not the hedge is “highly effective,” as defined by FAS 133. The Company would discontinue hedge accounting on a prospective basis with changes in the estimated fair value reflected in earnings when: (i) it is determined that the derivative is no longer effective in offsetting cash flows of a hedged item (including hedged items such as forecasted transactions); (ii) it is no longer probable that the forecasted transaction will occur; or (iii) it is determined that designating the derivative as a Hedging Instrument is no longer appropriate.
44
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
To date, the Company has not discontinued hedge accounting for any of its Hedging Instruments, as such instruments have remained highly effective.
The Company utilizes Hedging Instruments to manage a portion of its interest rate risk and does not anticipate entering into derivative transactions for speculative or trading purposes. (See Note 5.) In order to limit credit risk associated with the counterparties to derivative instruments, the Company’s policy is to enter into derivative contracts with Quality Institutions.
Interest Rate Swaps
There is no cost incurred by the Company at the inception of a Swap. When the Company enters into a Swap, it agrees to pay a fixed rate of interest and to receive a variable interest rate, generally based on the London Interbank Offered Rate (“LIBOR”). The Company’s Swaps are designated as cash flow hedges against the benchmark interest rate risk associated with its borrowings.
All changes in the value of Swaps are recorded in accumulated other comprehensive income. If it becomes probable that the forecasted transaction (which in this case refers to interest payments to be made under the Company’s short-term borrowing agreements) will not occur by the end of the originally specified time period, as documented at the inception and throughout the term of the hedging relationship, then the related gain or loss in accumulated other comprehensive income would be recognized through earnings.
Realized gains and losses resulting from the termination of a Swap are initially recorded in accumulated other comprehensive income as a separate component of stockholders’ equity. The gain or loss from a terminated Swap remains in accumulated other comprehensive income until the forecasted interest payments affect earnings. If it becomes probable that the forecasted interest payments will not occur, then the entire gain or loss would be recognized though earnings. (See Note 5.)
Interest Rate Caps
The Company purchases Caps by incurring a one-time fee or premium. Pursuant to the terms of the Caps, the Company will receive cash payments if the interest rate index specified in any such Cap increases above contractually specified levels. Therefore, such Caps have the effect of capping the interest rate on a portion of the Company’s borrowings, equal to the notional amount of the active Caps, above the rate specified in the Cap agreement. (See Note 5.)
In order for the Company’s Caps to qualify for hedge accounting, upon entering into the Cap, the Company must anticipate that the hedge will be “highly effective,” as defined by FAS 133, in limiting the Company’s cost beyond the Cap threshold on its matching (on an aggregate basis) anticipated repurchase agreements during the active period of the Cap. Provided that the hedge remains effective, changes in the estimated fair value of the Caps are included in other comprehensive income. Upon commencement of the Cap active period, the premium paid to enter into the Cap is amortized to interest expense. The periodic amortization of Cap premiums are based on an allocation of the premium, determined at inception of the hedge, for the monthly components on an estimated fair value basis. Payments received in connection with Caps, if any, are reported as a reduction to interest expense. If it is determined that a Cap is not effective, the premium would be reduced and a corresponding charge made to interest expense, for the ineffective portion of the Cap. The maximum cost related to the Company’s Caps is limited to the original price paid to enter into the Cap.
(m) Adoption of New Accounting Standards
Equity Based Compensation
On January 1, 2006, the Company adopted FAS No. 123R “Share-Based Payment” (“FAS 123R”) applying the modified prospective method of accounting for stock options. FAS 123R, among other things, eliminated the alternative to use the intrinsic value method of accounting for stock based compensation and requires entities to recognize the cost of employee services received in exchange for awards of equity instruments based on the grant-date fair value of those awards (with limited exceptions). Prior to the adoption of FAS 123R, the Company accounted for its stock based compensation in accordance with FAS No. 123, “Accounting for Stock-Based Compensation”, as amended by FAS No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure”, which was adopted on January 1, 2003. Based on the Company’s analysis of its outstanding options under the provisions of FAS 123R, the adoption of FAS 123R had no impact on the Company. The Company continues to value its stock-option compensation expense using the Black-Scholes-Merton method, and expenses options using the straight-line method. (See Note 11.)
45
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
Pursuant to FAS 123R the Company’s compensation expense for restricted stock awards is amortized over the vesting period of such awards, based upon the estimated fair value of such restricted stock at the grant date. Restricted stock granted to retirement-eligible employees is expensed upon grant, as there is no risk of forfeiture.
(n) Recently Issued Accounting Standards
FASB Statements and Interpretations
In September 2006, the FASB issued FAS No. 157, “Fair Value Measurements” (“FAS 157”), which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. FAS 157 is effective for fiscal years beginning after November 15, 2007 and all interim periods within those fiscal years. Earlier application is permitted provided that the reporting entity has not yet issued interim or annual financial statements for that fiscal year. The Company is currently evaluating the impact, if any, that FAS 157 may have on the Company’s financial statements.
In June 2006, the FASB issued Interpretation No. 48, “Accounting for Uncertainty in Income Taxes” (“FIN 48”). FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The new FASB standard also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure, and transition. The provisions of FIN 48 are effective for fiscal years beginning December 15, 2006. The Company does not expect that the adoption of FIN 48 will have a material impact on the Company’s financial statements.
In February 2006, the FASB issued FAS No. 155, “Accounting for Certain Hybrid Instruments” (“FAS 155”), an amendment to FAS 133 and FAS 140. Among other things, FAS 155: (i) permits fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation; (ii) clarifies which interest-only strips and principal-only strips are not subject to the requirements of FAS 133; (iii) establishes a requirement to evaluate interests in securitized financial assets to identify interests that are freestanding derivatives or that are hybrid financial instruments that contain an embedded derivative requiring bifurcation; (iv) clarifies that concentrations of credit risk in the form of subordination are not embedded derivatives; and (v) amends FAS 140 to eliminate the prohibition on a qualifying special-purpose entity from holding a derivative financial instrument that pertains to a beneficial interest other than another derivative financial instrument. FAS 155 is effective for all financial instruments acquired, issued, or subject to a remeasurement (new basis) event occurring after the beginning of an entity’s first fiscal year beginning after September 15, 2006. At initial application of FAS 155, the fair value election provided for in paragraph 4(c) may be applied for hybrid financial instruments that were bifurcated under paragraph 12 of FAS 133 prior to the initial application of FAS 155.
In January 2007, the FASB provided a scope exception under FAS 155 for securitized interests that only contain an embedded derivative that is tied to the prepayment risk of the underlying prepayable financial assets, and for which the investor does not control the right to accelerate the settlement. If a securitized interest contains any other embedded derivative (for example, an inverse floater), then it would be subject to the bifurcation tests in FAS 133, as would securities purchased at a significant premium. Following the issuance of the scope exception by the FASB, changes in the market value of the Company’s investment securities would continue to be made through other comprehensive income, a component of stockholders’ equity. The Company does not expect that the January 1, 2007 adoption of FAS 155 will have a material impact on the Company’s financial position, results of operations or cash flows. However, to the extent that certain of the Company’s future investments in securitized financial assets do not meet the scope exception adopted by the FASB, the Company’s future results of operations may exhibit volatility if such investments are required to be bifurcated or marked to market value in their entirety through the income statement, depending on the election made by the Company.
Securities and Exchange Commission Staff issued Staff Accounting Bulletin
In September 2006, the Securities and Exchange Commission (“SEC”) Staff issued Staff Accounting Bulletin (“SAB”) No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements” (“SAB 108”), which addresses how the effects of prior year uncorrected financial statement misstatements should be considered in current year financial statements. The SAB requires registrants to quantify misstatements using both balance sheet and income statement approaches and to evaluate whether either approach results in quantifying an error that is material in light of relative quantitative and qualitative factors. The requirements of SAB 108 are effective for annual financial statements covering the first fiscal year ending after November 15, 2006. The Company’s adoption of SAB 108 during the year ended December 31, 2006 had no impact on the Company’s financial statements.
46
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(o) Reclassifications
Certain prior period amounts have been reclassified to conform to the current period presentation.
3. Mortgage-Backed Securities
All of the Company’s MBS are classified as available-for-sale and, as such, are carried at their estimated fair value, based on prices obtained from a third-party pricing service or, if pricing was not available for an MBS from such pricing service, the average of broker price quotes received for such MBS. At December 31, 2006 and 2005, the Company’s portfolio of MBS consisted of pools of ARM-MBS with carrying values of approximately $6.341 billion and $5.709 billion, respectively. The Company had no fixed-rate MBS at December 31, 2006 and $6.2 million of such MBS at December 31, 2005.
The Company’s MBS portfolio is primarily comprised of Agency MBS, which have an implied AAA rating, or non-Agency MBS that are rated AAA by one or more of the Rating Agencies. The following tables present certain information about the Company’s MBS at December 31, 2006 and 2005.
| | | | | | | | | | |
| | MBS
Amortized
Cost(1) | | Carrying Value/
Estimated
Fair Value | | Net
Unrealized
(Loss)/Gain | |
| | | | | | | |
(In Thousands) | | December 31, 2006 | |
| | | |
Agency MBS: | | | | | | | | | | |
Fannie Mae Certificates | | $ | 5,506,188 | | $ | 5,482,112 | | $ | (24,076 | ) |
Ginnie Mae Certificates | | | 307,472 | | | 304,826 | | | (2,646 | ) |
Freddie Mac Certificates | | | 301,016 | | | 299,505 | | | (1,511 | ) |
Non-Agency MBS(2): | | | | | | | | | | |
AAA | | | 237,805 | | | 234,275 | | | (3,530 | ) |
AA | | | 2,253 | | | 2,218 | | | (35 | ) |
Single A and A- | | | 3,029 | | | 3,014 | | | (15 | ) |
BBB and BBB- | | | 9,007 | | | 8,972 | | | (35 | ) |
BB and below | | | 2,140 | | | 2,255 | | | 115 | |
Non-rated | | | 2,753 | | | 3,491 | | | 738 | |
| | | | | | | | | | |
Total MBS | | $ | 6,371,663 | | $ | 6,340,668 | | $ | (30,995 | ) |
| | | | | | | | | | |
| | | | | | | | | | |
| | MBS
Amortized
Cost(1) | | Carrying Value/
Estimated
Fair Value | | Net
Unrealized
(Loss)/Gain | |
| | | | | | | |
| | December 31, 2005 | |
| | | |
Agency MBS: | | | | | | | | | | |
Fannie Mae Certificates | | $ | 3,950,983 | | $ | 3,906,821 | | $ | (44,162 | ) |
Ginnie Mae Certificates | | | 879,105 | | | 870,234 | | | (8,871 | ) |
Freddie Mac Certificates | | | 354,708 | | | 351,592 | | | (3,116 | ) |
Non-Agency MBS(2): | | | | | | | | | | |
AAA | | | 585,911 | | | 580,317 | | | (5,594 | ) |
AA | | | 2,290 | | | 2,271 | | | (19 | ) |
Single A and A- | | | 1,591 | | | 1,569 | | | (22 | ) |
BBB and BBB- | | | 903 | | | 884 | | | (19 | ) |
BB and below | | | 1,059 | | | 1,133 | | | 74 | |
Non-rated | | | 84 | | | 85 | | | 1 | |
| | | | | | | | | | |
Total MBS | | $ | 5,776,634 | | $ | 5,714,906 | | $ | (61,728 | ) |
| | | | | | | | | | |
| |
(1) | Includes principal payments receivable. |
| |
(2) | Based upon ratings issued by Standard & Poor’s. |
Agency MBS: Although not rated, Agency MBS carry an implied AAA rating. Agency MBS are guaranteed as to principal and/or interest by a federally chartered corporation, such as Fannie Mae or Freddie Mac, or an agency of the U.S. government, such as Ginnie Mae. The payment of principal and/or interest on Fannie Mae and Freddie Mac MBS is guaranteed by those respective agencies and the payment of principal and/or interest on Ginnie Mae MBS is backed by the full faith and credit of the U.S. government.
47
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
Non-Agency MBS: Non-Agency MBS are certificates that are backed by pools of single-family and multi-family mortgage loans, which are not guaranteed by the U.S. government, federal agency or any federally chartered corporation. Non-Agency MBS may be rated from AAA to B by one or more of the Rating Agencies. AAA is the highest bond rating given by Standard & Poor’s and indicates the credit worthiness of the investment (i.e., the obligor’s ability to meet its financial commitment on the obligation). In addition, the Company includes in its portfolio of non-agency MBS its investments in investment and non-investment grade interests in mortgage-related assets, certain of which are non-rated. At December 31, 2006, the Company had $3.5 million of non-rated assets, or less than 1% of total assets.
The Company’s MBS rated below investment grade, including the non-rated MBS, were purchased at a discount, a portion of which was designated as credit protection against future credit losses. The initial credit protection (i.e., discount) of these MBS may be adjusted over time, based on review of the underlying collateral, economic conditions and other factors. If the performance of these securities is more favorable than initially forecasted, a portion of the amount designated as credit protection may be accreted into interest income over time. Conversely, if in the future the performance of these securities is less favorable than initially forecasted, impairment charges and a corresponding write down of such MBS to a new cost basis could result.
The following table presents the amortized cost, gross unrealized gains, gross unrealized losses and fair value of the Company’s MBS at December 31, 2006 and 2005.
| | | | | | | |
| | 2006 | | 2005 | |
| | | | | |
(In Thousands) | | | | | | | |
Principal/notional balance | | $ | 6,257,047 | | $ | 5,662,322 | |
Principal payment receivable | | | 15,819 | | | 18,870 | |
| | | | | | | |
| | | 6,272,866 | | | 5,681,192 | |
| | | | | | | |
Unamortized premium | | | 98,838 | | | 98,689 | |
Unaccreted discount | | | (41 | ) | | (3,247 | ) |
Gross unrealized gains | | | 3,193 | | | 3,988 | |
Gross unrealized losses | | | (34,188 | ) | | (65,716 | ) |
| | | | | | | |
Carrying value/estimated fair value | | $ | 6,340,668 | | $ | 5,714,906 | |
| | | | | | | |
During the fourth quarter of 2005, the Company repositioned its MBS portfolio which resulted in the sale of $564.8 million of MBS, realizing an aggregate loss of $18.4 million, and the recognition of an other-than-temporary impairment charge of $20.7 million. This impairment charge was recognized, in accordance with the FASB Impairment Position, at December 31, 2005 on specifically identified MBS in the Company’s portfolio, with an aggregate estimated market value of $821.5 million, on which the Company had determined to discontinue its previous strategy of holding until such time that the unrealized losses were recovered. Accordingly, the amounts presented in the above table at December 31, 2005 have been reduced by the other-than-temporary impairment charge taken. All of the MBS on which an impairment charge was taken at December 31, 2005 were sold during the first quarter of 2006.
The Company monitors the performance and market value of its MBS portfolio, including these MBS on which it’s had unrealized losses, on an ongoing basis. At December 31, 2006, the Company had 217 MBS, with an amortized cost of $1.696 billion, that had unrealized losses for 12 months or more. All of these MBS were Agency MBS or investment grade (i.e., rated BBB-) or higher. At December 31, 2006, these MBS had gross unrealized losses of $27.1 million.
48
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
The following table presents the gross unrealized losses and estimated fair value of the Company’s MBS, aggregated by investment category or rating and length of time that such MBS have been in a continuous unrealized loss position at December 31, 2006.
| | | | | | | | | | | | | | | | | | | |
| | Unrealized Loss Position for: | | | | | | | |
| | | | | |
| | Less than 12 Months | | 12 Months or more | | Total | |
| | | | | | | |
(In Thousands) | | Estimated Fair
Value | | Unrealized
losses | | Estimated Fair
Value | | Unrealized
losses | | Estimated Fair
Value | | Unrealized
losses | |
| | | | | | | | | | | | | |
Agency MBS: | | | | | | | | | | | | | | | | | | | |
Fannie Mae | | $ | 2,662,907 | | $ | 6,317 | | $ | 1,160,180 | | $ | 19,877 | | $ | 3,823,087 | | $ | 26,194 | |
Ginnie Mae | | | 38,840 | | | 196 | | | 216,078 | | | 2,623 | | | 254,918 | | | 2,819 | |
Freddie Mac | | | 172,691 | | | 505 | | | 102,215 | | | 1,055 | | | 274,906 | | | 1,560 | |
AAA rated MBS | | | 42,515 | | | 60 | | | 186,169 | | | 3,470 | | | 228,684 | | | 3,530 | |
AA rated MBS | | | — | | | — | | | 2,218 | | | 35 | | | 2,218 | | | 35 | |
A rated MBS | | | — | | | — | | | 1,550 | | | 15 | | | 1,550 | | | 15 | |
BBB rated MBS | | | 972 | | | 30 | | | 884 | | | 5 | | | 1,856 | | | 35 | |
| | | | | | | | | | | | | | | | | | | |
Total temporarily impaired securities | | $ | 2,917,925 | | $ | 7,108 | | $ | 1,669,294 | | $ | 27,080 | | $ | 4,587,219 | | $ | 34,188 | |
| | | | | | | | | | | | | | | | | | | |
At December 31, 2006, the Company determined that it had the intent and ability to continue to hold those MBS on which it had unrealized losses until recovery of such unrealized losses or until maturity, such that the impairment of these MBS was considered temporary. However, such assessment may change over time given, among other things, the dynamic nature of interest rate markets and other variables. Future sales or changes in the Company’s assessment of its ability and/or intent to hold impaired MBS until recovery or maturity could result in the Company recognizing other-than-temporary impairment charges or realized losses in the future.
During the year ended December 31, 2006, the Company sold 84 MBS for $1.844 billion, resulting in net realized losses of $23.1 million, comprised of gross losses of $25.2 million and gross gains of $2.1 million. These sales were primarily comprised of the 83 MBS sold for $1.823 billion through June 30, 2006 as part of the Company’s repositioning of the MBS portfolio. Included in the repositioning sales were MBS of $821.5 million on which the Company had taken a $20.7 million impairment charge against at December 31, 2005.
The following table presents interest income and premium amortization on the Company’s MBS portfolio for the years ended December 31, 2006, 2005 and 2004.
| | | | | | | | | | |
| | December 31, | |
| | | |
| | 2006 | | 2005 | | 2004 | |
| | | | | | | |
(In Thousands) | | | | | | | | | | |
Coupon interest on MBS | | $ | 247,845 | | $ | 292,313 | | $ | 222,614 | |
Premium amortization | | | (31,085 | ) | | (56,548 | ) | | (47,683 | ) |
Discount accretion | | | 111 | | | 33 | | | 26 | |
| | | | | | | | | | |
Interest income on MBS, net | | $ | 216,871 | | $ | 235,798 | | $ | 174,957 | |
| | | | | | | | | | |
The following table presents certain information about the Company’s MBS that will reprice or be repaid based on contractual terms, which do not consider prepayments assumptions, at December 31, 2006 and 2005:
| | | | | | | | | | | | | | | | | | | |
| | December 31, 2006 | | December 31, 2005 | |
| | | | | |
(Dollars in Thousands) | | | | | | | | | | | | | | | | | | | |
Months to Coupon Reset or Contractual Payment | | Fair Value(1) | | % of Total | | WAC(2) | | Fair Value(1) | | % of Total | | WAC(2) | |
| | | | | | | | | | | | | | |
Within 30 Days | | $ | 972,867 | | | 15.4 | % | | 6.32 | % | $ | 1,215,074 | | | 21.4 | % | | 5.01 | % |
30 to 90 Days | | | 71,657 | | | 1.1 | | | 6.03 | | | 417,940 | | | 7.3 | | | 4.39 | |
Three to 12 Months | | | 759,762 | | | 12.0 | | | 5.91 | | | 1,406,771 | | | 24.7 | | | 4.50 | |
12 to 24 Months | | | 142,191 | | | 2.3 | | | 4.86 | | | 1,065,926 | | | 18.7 | | | 4.44 | |
24 to 36 Months | | | 318,940 | | | 5.0 | | | 4.93 | | | 301,996 | | | 5.3 | | | 4.78 | |
36 to 60 Months | | | 3,220,190 | | | 50.9 | | | 6.16 | | | 1,282,155 | | | 22.5 | | | 5.04 | |
Over 60 Months | | | 839,242 | | | 13.3 | | | 6.16 | | | 6,174 | | | 0.1 | | | 7.33 | |
| | | | | | | | | | | | | | | | | | | |
Total | | $ | 6,324,849 | | | 100.0 | % | | 6.06 | % | $ | 5,696,036 | | | 100.0 | % | | 4.73 | % |
| | | | | | | | | | | | | | | | | | | |
| |
(1) Does not include principal payments receivable. |
| |
(2) “WAC” is the weighted average coupon rate on the Company’s MBS, which is higher than the net yield that will be earned on such MBS. The net yield is primarily reduced by net premium amortization and the contractual delay in receiving payments, which varies by issuer. |
49
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
The following table presents information about the Company’s MBS pledged as collateral under repurchase agreements and Swaps at December 31, 2006.
| | | | | | | | | | | | | | | | |
| | MBS Pledged Under Repurchase
Agreements | | MBS Pledged Under Swaps | | | |
| | | | | | | |
MBS Pledged | | Estimated
Fair Value/
Carrying Value | | Amortized Cost | | Estimated
Fair Value/
Carrying Value | | Amortized Cost | | Total Fair Value of MBS Pledged | |
| | | | | | | | | | | | |
(In Thousands) | | | | | | | | | | | | | | | | |
Fannie Mae | | $ | 5,348,560 | | $ | 5,370,539 | | $ | 13,538 | | $ | 13,587 | | $ | 5,362,098 | |
Freddie Mac | | | 252,825 | | | 254,018 | | | — | | | — | | | 252,825 | |
Ginnie Mae | | | 216,345 | | | 218,088 | | | — | | | — | | | 216,345 | |
AAA Rated | | | 226,640 | | | 230,130 | | | — | | | — | | | 226,640 | |
BBB Rated | | | 7,113 | | | 7,113 | | | — | | | — | | | 7,113 | |
| | | | | | | | | | | | | | | | |
| | $ | 6,051,483 | | $ | 6,079,888 | | $ | 13,538 | | $ | 13,587 | | $ | 6,065,021 | |
| | | | | | | | | | | | | | | | |
4. Real Estate and Discontinued Operations
The Company’s investments in real estate, all of which were consolidated with the Company at December 31, 2006 and December 31, 2005, were as follows:
| | | | | | | |
| | December 31, | |
| | | |
| | 2006(1) | | 2005(2) | |
| | | | | |
(In Thousands) | | | | | | | |
Real Estate Assets and Liabilities: | | | | | | | |
Land and buildings | | $ | 11,789 | | $ | 29,398 | |
Cash | | | 126 | | | 749 | |
Prepaid and other assets | | | 146 | | | 406 | |
Mortgages payable | | | (9,606 | )(3) | | (22,552 | ) |
Accrued interest and other payables | | | (122 | ) | | (390 | ) |
| | | | | | | |
Real estate assets, net | | $ | 2,333 | | $ | 7,611 | |
| | | | | | | |
| |
(1) | At December 31, 2006, the Company held for investment purposes an indirect 100% ownership interest in Lealand Place. |
| |
(2) | Included in real estate at December 31, 2005 were the assets and liabilities of Greenhouse and Cameron, which had combined assets of $17.3 million, comprised primarily of land and buildings, and combined liabilities of $13.1 million, comprised primarily of mortgages of $12.8 million. Greenhouse was sold on January 31, 2006. Cameron, which was classified as held-for-sale on June 30, 2006, was sold in October 2006. |
| |
(3) | The mortgage collateralized by Lealand Place is non-recourse, subject to customary non-recourse exceptions, which generally means that the lender’s final source of repayment in the event of default is foreclosure of the property securing such loan. At December 31, 2006, the mortgage had a fixed interest rate of 6.87%, contractually matures on February 1, 2011 and is subject to a penalty if prepaid. In January 2005, the Company loaned Lealand Place $150,000 to fund operations which remained outstanding through December 31, 2006; this loan and the related interest is eliminated in consolidation. |
The following table presents the summary results of operations for Lealand Place that were consolidated for the years ended December 31, 2006, 2005 and 2004. The table does not include revenues and expenses for properties classified as held-for-sale or sold through December 31, 2006, as the results for such properties have been restated and reported as a component of discontinued operations on a net basis on each of the Company’s consolidated income statements presented.
| | | | | | | | | | |
| | December 31, | |
| | | |
| | 2006 | | 2005 | | 2004 | |
| | | | | | | |
(In Thousands) | | | | | | | | | | |
Revenue from operations of real estate | | $ | 1,556 | | $ | 1,460 | | $ | 1,480 | |
Interest expense for mortgages on real estate | | | (675 | ) | | (682 | ) | | (693 | ) |
Other real estate operations expense | | | (942 | ) | | (991 | ) | | (992 | ) |
| | | | | | | | | | |
Loss from Real Estate Operations, net | | $ | (61 | ) | $ | (213 | ) | $ | (205 | ) |
| | | | | | | | | | |
50
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
Discontinued Operations
The Company’s discontinued operations reflect the operating results for Cameron and Greenhouse, which were indirectly held by the Company through wholly-owned subsidiaries. These two properties were sold during 2006. The sale of these properties resulted in the Company realizing a net gain of $4.4 million, net of a built-in gains tax of $1.8 million incurred upon the sale of one property and selling costs. In addition, mortgage prepayment penalties of $712,000 were incurred upon the satisfaction of the mortgages secured by these properties. While the historical results of operations for these properties were neither individually nor in the aggregate material to the Company, they have none-the-less been restated and reported net as a component of discontinued operations.
5. Hedging Instruments
In connection with the Company’s interest rate risk management process, the Company hedges a portion of its interest rate risk by entering into derivative financial instrument contracts. The Company uses Swaps and, to a lesser extent, Caps, which in effect modify the repricing characteristics of the Company’s repurchase agreements and cash flows on such liabilities. The use of Hedging Instruments creates exposure to credit risk relating to potential losses that could be recognized if the counterparties to these instruments fail to perform their obligations under the contracts. In addition, the Company is required to pledge assets as collateral for certain of its Swaps, which amount varies over time based on the market value notional amount, and remaining term of the Swap. At December 31, 2006 and December 31, 2005, the Company had MBS pledged as collateral against its Swaps of $13.5 million and $854,000, respectively. In order to mitigate its exposure to any counterparty-related risk associated with its Hedging Instruments, the Company’s policy is to enter into derivative transactions only with Quality Institutions. In the event of a default by the counterparty, the Company would not receive payments provided for under the terms of the Hedging Instrument, could incur a loss for the remaining unamortized premium cost of Caps and could have difficulty obtaining its assets pledged as collateral for Swaps.
The following table sets forth the impact of the Company’s Hedging Instruments on the Company’s other comprehensive income/(loss) for the years ended December 31, 2006, 2005 and 2004.
| | | | | | | | | | |
| | For the Year Ended December 31, | |
| | | |
| | 2006 | | 2005 | | 2004 | |
| | | | | | | |
(In Thousands) | | | | | | | | | | |
Accumulated Other Comprehensive (Loss)/Income from Hedging Instruments: | | | | | | | | | | |
Balance at beginning of year | | $ | 3,517 | | $ | (1,989 | ) | $ | (3,336 | ) |
Unrealized (losses)/gains on Hedging Instruments, net | | | (2,915 | ) | | 5,506 | | | 1,347 | |
| | | | | | | | | | |
Balance at the end of year | | $ | 602 | | $ | 3,517 | | $ | (1,989 | ) |
| | | | | | | | | | |
(a) Interest Rate Swaps
The Company’s Swaps are used to lock-in the fixed Swap rate related to a portion of its current and anticipated future 30-day term repurchase agreements. For the years ended December 31, 2006 and 2005, the Company’s Swaps reduced the cost of interest expense on repurchase agreements by $4.1 million and $108,000, respectively.
The following table presents information about the Company’s Swaps, all of which were active at December 31, 2006.
| | | | | | | | | | | | | | | | | | | | |
| | Weighted
Average
Remaining
Active Period | | Notional
Amount | | Weighted
Average
Swap Rate | | Estimated Fair
Value/Carrying
Value | | Gross
Unrealized
Gains | | Gross
Unrealized
(Losses) | |
| | | | | | | | | | | | | |
(Dollars in Thousands) | | | | | | | | | | | | | | | | | | | | |
Currently Active | | 39 Months | | $ | 1,809,191 | | 4.93% | | $ | 519 | | | $ | 2,412 | | | $ | (1,893) | | |
(b) Interest Rate Caps
The Company’s Caps are designated as cash flow hedges against interest rate risk associated with the Company’s existing and forecasted repurchase agreements. When the 30-day LIBOR increases above the rate specified in the
51
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
Cap Agreement during the effective term of the Cap, the Company receives monthly payments from its Cap counterparty.
The following table presents the impact on the Company’s interest expense of its Caps for the years ended December 31, 2006, 2005 and 2004, respectively.
| | | | | | | | | | |
| | For Year Ended December 31, | |
| | | |
| | 2006 | | 2005 | | 2004 | |
| | | | | | | |
(In Thousands) | | | | | | | | | | |
Premium amortization on Caps | | $ | 1,700 | | $ | 1,578 | | $ | 2,451 | |
Payments earned on Caps | | | (2,807 | ) | | (316 | ) | | — | |
| | | | | | | | | | |
Net increase/(decrease) on interest expense related to Caps | | $ | (1,107 | ) | $ | 1,262 | | $ | 2,451 | |
| | | | | | | | | | |
The following table presents information about the Company’s Caps, all of which were active at December 31, 2006.
| | | | | | | | | | | | | | | | | | | | | |
| | Weighted
Average
Remaining
Active Period | | Weighted
Average LIBOR
Strike Rate(1) | | Notional
Amount | | Unamortized
Premium | | Estimated Fair
Value/Carrying
Value | | Gross
Unrealized
Gains | |
| | | | | | | | | | | | | |
(Dollars in Thousands) | | | | | | | | | | | | | | | | | | | | | |
Currently active | | 2 Months | | 3.83% | | $ | 150,000 | | | $ | 278 | | | $ | 361 | | | $ | 83 | | |
| |
(1) | The 30-day LIBOR strike rate at which payments would become due to the Company under the terms of the Cap Agreement. At December 31, 2006, the 30-day LIBOR was 5.32%. |
6. Repurchase Agreements
The Company’s repurchase agreements are collateralized by the Company’s MBS and typically bear interest at rates that are LIBOR-based. At December 31, 2006, the Company had 353 repurchase agreements with a weighted average remaining contractual maturity of 11 months and an effective repricing period of 15 months given the impact of related derivative hedges. At December 31, 2005, the Company had 415 repurchase agreements with a weighted average remaining contractual maturity of four months and an effective repricing term of four months given the impact of related derivative hedges. The following table presents contractual repricing information about the Company’s repurchase agreements, which does not include the impact of related derivative hedges, at December 31, 2006 and December 31, 2005.
| | | | | | | | | | | | | |
| | December 31, 2006 | | December 31, 2005 | |
| | | | | |
| | Balance | | Weighted Average
Contractual Rate | | Balance | | Weighted Average
Contractual Rate | |
| | | | | | | | | |
(In Thousands) | | | | | | | | | | | | | |
Within 30 days | | $ | 2,848,300 | | | 5.30 | % | $ | 1,606,500 | | | 3.98 | % |
30 days to 3 months | | | 1,017,900 | | | 5.10 | | | 1,806,832 | | | 3.41 | |
Over 3 months to 6 months | | | 37,200 | | | 3.98 | | | 709,000 | | | 3.23 | |
Over 6 months to 12 months | | | — | | | — | | | 774,600 | | | 3.34 | |
Over 12 months to 24 months | | | 1,505,311 | | | 5.16 | | | 202,600 | | | 3.56 | |
Over 24 months to 36 months | | | 314,000 | | | 5.33 | | | — | | | — | |
| | | | | | | | | | | | | |
| | $ | 5,722,711 | | | 5.22 | % | $ | 5,099,532 | | | 3.56 | % |
| | | | | | | | | | | | | |
52
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
The following table presents information about the Company’s MBS that are pledged as collateral under repurchase agreements based upon the term to maturity of the repurchase agreements at December 31, 2006.
| | | | | | | | | | | | | | | | |
Collateral Pledged | | Term to Maturity of Repurchase Agreement | |
| | | | |
MBS Pledged | | Fair Value of MBS Pledged as Collateral | | Up to 30 Days | | 30 to 90 Days | | Over 90 Days | | Total | |
| | | | | | | | | | | | |
(In Thousands) | | | | | | | | | | | | | | | | |
Fannie Mae | | $ | 5,348,560 | | $ | 2,620,010 | | $ | 745,100 | | $ | 1,699,080 | | $ | 5,064,190 | |
Freddie Mac | | | 252,825 | | | 65,190 | | | 23,800 | | | 130,725 | | | 219,715 | |
Ginnie Mae | | | 216,345 | | | 107,100 | | | 83,600 | | | 26,706 | | | 217,406 | |
AAA Rated | | | 226,640 | | | 50,500 | | | 165,400 | | | — | | | 215,900 | |
BBB Rated | | | 7,113 | | | 5,500 | | | — | | | — | | | 5,500 | |
| | | | | | | | | | | | | | | | |
| | $ | 6,051,483 | | $ | 2,848,300 | | $ | 1,017,900 | | $ | 1,856,511 | | $ | 5,722,711 | |
| | | | | | | | | | | | | | | | |
7. Commitments and Contingencies
Lease Commitments
The Company pays monthly rent on each of its operating leases. The Company has a lease through August 31, 2012 for its corporate headquarters, located at 350 Park Avenue, New York, New York. This lease provides for, among other things, annual rent of: (i) $348,000 through November 30, 2008 and (ii) $358,000 from December 1, 2008 through August 31, 2012. The Company also has a lease for additional space at its corporate headquarters, which runs through July 31, 2007 and provides for, among other things, annual rent of $152,000. In addition, the Company has a lease through December 2007 for its off-site back-up facilities located in Rockville Centre, New York. This lease provides for, among other things, annual rent of $26,000 for 2007. The Company is presently reviewing office space alternatives in anticipation of the expiration of one lease for space at our corporate headquarters in July of 2007 and to address our additional space requirements.
At December 31, 2006, the contractual minimum rental payments (exclusive of possible rent escalation charges and normal recurring charges for maintenance, insurance and taxes) were as follows:
| | | | | |
Year Ended
December 31, | | At December 31, | |
| | | | |
| | | (In Thousands) | |
2007 | | | $ | 474 | |
2008 | | | | 349 | |
2009 | | | | 358 | |
2010 | | | | 358 | |
2011 | | | | 358 | |
Thereafter | | | | 238 | |
| | | | | |
| | | $ | 2,135 | |
| | | | | |
8. Stockholders’ Equity
(a) Stock Repurchase Program
On August 11, 2005, the Company announced the implementation of a stock repurchase program (the “Repurchase Program”) to repurchase up to 4.0 million shares of its outstanding common stock. Subject to applicable securities laws, repurchases of common stock under the Repurchase Program are made at times and in amounts as the Company deems appropriate, using available cash resources. From inception of the Repurchase Program through December 31, 2006, the Company repurchased 3,191,200 shares of common stock at an average cost per share of $5.90. On May 2, 2006, the Company announced an increase in the size of the Repurchase Program, by an additional 3,191,200 shares of common stock, resetting the number of shares of common stock that the Company is authorized to repurchase to 4.0 million shares. At December 31, 2006, 4,000,000 shares remained authorized for repurchase. The Repurchase Program may be suspended or discontinued by the Company at any time and without prior notice.
Shares of common stock repurchased by the Company under the Repurchase Program are cancelled and, until reissued by the Company, are deemed to be the authorized but unissued shares of the Company’s common stock.
53
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(b) Preferred Stock
At December 31, 2006, the Company had issued and outstanding 3.8 million shares of Series A preferred stock, with a par value $0.01 per share and a liquidation preference of $25.00 per share. The preferred stock, which is redeemable at $25.00 per share plus accrued and unpaid dividends (whether or not declared) exclusively at the Company’s option commencing on April 27, 2009 (subject to the Company’s right under limited circumstances to redeem the preferred stock prior to that date in order to preserve its qualification as a REIT), is senior to the Company’s common stock with respect to dividends and distributions. The preferred stock must be paid a dividend at a rate of 8.50% per year on the $25.00 liquidation preference before the common stock is entitled to receive any dividends and is senior to the common stock with respect to distributions upon liquidation, dissolution or winding up. The preferred stock generally does not have any voting rights, subject to an exception in the event Company’s fails to pay dividends on the preferred stock for six or more quarterly periods (whether or not consecutive). Under such circumstances, the preferred stock will be entitled to vote to elect two additional directors to the Board, until all unpaid dividends have been paid or declared and set apart for payment. In addition, certain material and adverse changes to the terms of the preferred stock cannot be made without the affirmative vote of holders of at least 66 2/3% of the outstanding shares of preferred stock. Through December 31, 2006, the Company had declared and paid all required quarterly dividends on the preferred stock.
The following table presents dividends declared by the Company on its preferred stock, since such securities were first issued on April 27, 2004.
| | | | | | | | | | | |
| Year | | Declaration Date | | Record Date | | Payment Date | | Dividend
Per share | |
| | | | | | | | | | |
| | | | | | | | | | | |
| 2006 | | February 17, 2006 | | March 1, 2006 | | March 31, 2006 | | $ | 0.53125 | |
| | | May 19, 2006 | | June 1, 2006 | | June 30, 2006 | | | 0.53125 | |
| | | August 21, 2006 | | September 1, 2006 | | September 29, 2006 | | | 0.53125 | |
| | | November 20, 2006 | | December 1, 2006 | | December 29, 2006 | | | 0.53125 | |
| | | | | | | | | | | |
| 2005 | | February 18, 2005 | | March 1, 2005 | | March 31, 2005 | | $ | 0.53125 | |
| | | May 20, 2005 | | June 1, 2005 | | June 30, 2005 | | | 0.53125 | |
| | | August 19, 2005 | | September 1, 2005 | | September 30, 2005 | | | 0.53125 | |
| | | November 18, 2005 | | December 1, 2005 | | December 30, 2005 | | | 0.53125 | |
| | | | | | | | | | | |
| 2004 | | May 27, 2004 | | June 4, 2004 | | June 30, 2004 | | $ | 0.37780 | (1) |
| | | August 24, 2004 | | September 1, 2004 | | September 30, 2004 | | | 0.53125 | |
| | | November 19, 2004 | | December 1, 2004 | | December 31, 2004 | | | 0.53125 | |
(1) Represents dividend for the period of April 27, 2004 through June 30, 2004.
(c) Common Stock
The following table presents dividends declared by the Company on its common stock during the years ended December 31, 2006, 2005 and 2004.
| | | | | | | | | | | |
| Year | | Declaration Date | | Record Date | | Payment Date | �� | Dividend
per Share | |
| | | | | | | | | | |
| | | | | | | | | | | |
| 2006 | | April 3, 2006 | | April 17, 2006 | | April 28, 2006 | | $ | 0.050 | |
| | | July 5, 2006 | | July 17, 2006 | | July 31, 2006 | | | 0.050 | |
| | | October 2, 2006 | | October 13, 2006 | | October 31, 2006 | | | 0.050 | |
| | | December 14, 2006 | | December 29, 2006 | | January 31, 2007 | | | 0.060 | |
| | | | | | | | | | | |
| 2005 | | April 1, 2005 | | April 12, 2005 | | April 29, 2005 | | $ | 0.180 | |
| | | July 1, 2005 | | July 12, 2005 | | July 29, 2005 | | | 0.125 | |
| | | October 3, 2005 | | October 14, 2005 | | October 28, 2005 | | | 0.050 | |
| | | December 15, 2005 | | December 27, 2005 | | January 31, 2006 | | | 0.050 | |
| | | | | | | | | | | |
| 2004 | | April 1, 2004 | | April 12, 2004 | | April 30, 2004 | | $ | 0.260 | |
| | | July 1, 2004 | | July 12, 2004 | | July 30, 2004 | | | 0.250 | |
| | | October 4, 2004 | | October 12, 2004 | | October 29, 2004 | | | 0.230 | |
| | | December 16, 2004 | | December 27, 2004 | | January 31, 2005 | | | 0.220 | |
54
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
For income tax purposes, a portion of each of the dividends declared in December 2006, 2005 and 2004 were treated as a dividend for stockholders in the subsequent year.
In general, the Company’s common stock dividends have been characterized as ordinary income to its stockholders for income tax purposes. However, a portion of the Company’s common stock dividends may, from time to time, be characterized as capital gains or return of capital. For the years ended December 31, 2006 and 2005, the Company’s common stock dividends were characterized as ordinary income to stockholders; for the year ended December 31, 2004, a portion of the Company’s common stock dividends were deemed to be capital gains, with the remainder characterized as ordinary income.
(d) Shelf Registration Statements
On September 25, 2001, the Company filed a shelf registration statement on Form S-3 with the SEC under the Securities Act of 1933, as amended (the “1933 Act”), with respect to an aggregate of $300.0 million of common stock and/or preferred stock that may be sold by the Company from time to time pursuant to Rule 415 of the 1933 Act. On October 5, 2001, the SEC declared this shelf registration statement effective. At December 31, 2006, the Company had $8.7 million remaining on this shelf registration statement.
On June 27, 2003, the Company filed a shelf registration statement on Form S-3 with the SEC under the 1933 Act with respect to an aggregate of $500.0 million of common stock and/or preferred stock that may be sold by the Company from time to time pursuant to Rule 415 of the 1933 Act. On July 8, 2003, the SEC declared this registration statement effective. On July 21, 2004, the Company filed a post-effective amendment to this shelf registration statement, which was declared effective by the SEC on August 12, 2004. At December 31, 2006, the Company had $232.6 million available under this shelf registration statement.
On December 17, 2004, the Company filed a shelf registration statement on Form S-3 with the SEC under the 1933 Act for the purpose of registering additional common stock for sale through the Discount Waiver, Direct Stock Purchase and Dividend Reinvestment Plan (the “DRSPP”). This shelf registration statement was declared effective by the SEC on January 4, 2005 and, when combined with the unused portion of the Company’s previous DRSPP shelf registration statement, registered an aggregate of 10 million shares of common stock. At December 31, 2006, 9.5 million shares of common stock remained available for issuance pursuant to the prior DRSPP shelf registration statement.
On December 17, 2004, the Company filed a registration statement on Form S-8 with the SEC under the 1933 Act for the purpose of registering additional common stock for issuance in connection with the exercise of awards under the Company’s 2004 Equity Compensation Plan (the “2004 Plan”), which amended and restated the Company’s Second Amended and Restated 1997 Stock Option Plan (the “1997 Plan”). This registration statement became effective automatically upon filing and, when combined with the previously registered, but unissued, portions of the Company’s prior registration statements on Form S-8 relating to awards under the 1997 Plan, related to an aggregate of 3.3 million shares of common stock, of which 2.3 million shares remained available for issuance.
(e) DRSPP
Commencing in September 2003, the Company’s DRSPP, which is designed to provide existing stockholders and new investors with a convenient and economical way to purchase shares of common stock (through the automatic reinvestment of dividends and/or optional monthly cash investments) became operational. During the years ended December 31, 2006, 2005 and 2004, the Company issued 3,509, 368,702 and 8,357,302 shares through the DRSPP raising net proceeds of $27,300, $3.0 million and $76.6 million, respectively. From the inception of the DRSPP through December 31, 2006, the Company issued 12,063,632 shares pursuant to the DRSPP raising net proceeds of $110.9 million.
(f) Controlled Equity Offering Program
On August 20, 2004, the Company initiated a controlled equity offering program (the “CEO Program”) through which it may, from time to time, publicly offer and sell shares of common stock through Cantor Fitzgerald & Co. (“Cantor”) in privately negotiated and/or at-the-market transactions. During the years ended December 31, 2006 and 2004, the Company issued 1,461,600 and 1,833,215 shares through the CEO Program raising net proceeds of $11.2 million and $16.5 million, respectively. The Company did not issue any shares through the CEO Program during the year ended December 31, 2005. In connection with such transactions, the Company paid Cantor fees and commissions of $286,361, $0 and $419,942 for the years ended December 31, 2006, 2005 and 2004, respectively.
55
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
The following table presents a reconciliation of the earnings and shares used in calculating basic and diluted EPS for the years ended December 31, 2006, 2005 and 2004.
| | | | | | | | | | | |
| | | 2006 | | 2005 | | 2004 | |
| | | | | | | | |
| | | | | | | | | | | |
| Numerator: | | | | | | | | | | |
| Net income allocable to commons stockholders: | | | | | | | | | | |
| Net income | | $ | 8,758 | | $ | 6,708 | | $ | 78,073 | |
| Net income/(loss) from discontinued operations | | | 3,522 | | | (86 | ) | | (227 | ) |
| | | | | | | | | | | |
| Net income from continuing operations | | | 5,236 | | | 6,794 | | | 78,300 | |
| | | | | | | | | | | |
| Dividends declared on preferred stock | | | (8,160 | ) | | (8,160 | ) | | (3,576 | ) |
| | | | | | | | | | | |
| Net (loss)/income available to common stockholders from continuing operations for basic and diluted earnings per share | | | (2,924 | ) | | (1,366 | ) | | 74,724 | |
| Net income/(loss) from discontinued operations | | | 3,522 | | | (86 | ) | | (227 | ) |
| | | | | | | | | | | |
| Net income/(loss) available to common stockholders from continuing operations | | $ | 598 | | $ | (1,452 | ) | $ | 74,497 | |
| | | | | | | | | | | |
| | | | | | | | | | | |
| Denominator: | | | | | | | | | | |
| Weighted average common shares for basic earnings per share | | | 79,526 | | | 82,025 | | | 76,168 | |
| Weighted average effect of dilutive employee stock options | | | 29 | | | — | * | | 49 | |
| | | | | | | | | | | |
| Denominator for diluted earnings per share | | | 79,555 | | | 82,025 | | | 76,217 | |
| | | | | | | | | | | |
| | | | | | | | | | | |
| Basic and diluted net earnings/(loss) per share: | | | | | | | | | | |
| Continuing operations | | $ | (0.03 | ) | $ | (0.02 | ) | $ | 0.98 | |
| Discontinued operations | | | 0.04 | | | — | | | — | |
| | | | | | | | | | | |
| Total Basic and Diluted earnings (loss) per share | | $ | 0.01 | | $ | (0.02 | ) | $ | 0.98 | |
| | | | | | | | | | | |
| |
* | For the year ended December 31, 2005, securities issuable pursuant to the exercise of the Company’s common stock options that could potentially dilute basic earnings per share in the future are not included in the computation of diluted earnings per share because to have done so would have been anti-dilutive, as 2005 was a loss year. |
| 10. | Accumulated Other Comprehensive Loss |
Accumulated other comprehensive loss at December 31, 2006 and 2005 was as follows:
| | | | | | | |
| | 2006 | | 2005 | |
| | | | | |
(In Thousands) | | | | | | | |
Available-for-sale MBS: | | | | | | | |
Unrealized gains | | $ | 3,193 | | $ | 3,988 | |
Unrealized losses | | | (34,188 | ) | | (65,716 | ) |
| | | | | | | |
| | | (30,995 | ) | | (61,728 | ) |
| | | | | | | |
| | | | | | | |
Hedging Instruments: | | | | | | | |
Unrealized gains on Swaps | | | 519 | | | 3,092 | |
Unrealized gains on Caps | | | 83 | | | 425 | |
| | | | | | | |
| | | 602 | | | 3,517 | |
| | | | | | | |
Accumulated other comprehensive loss | | $ | (30,393 | ) | $ | (58,211 | ) |
| | | | | | | |
56
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
| 11. | 2004 Equity Compensation Plan, Employment Agreements and Other Benefit Plans |
(a) 2004 Equity Compensation Plan
In accordance with the terms of the 2004 Plan, directors, officers and employees of the Company and any of its subsidiaries and other persons expected to provide significant services (of a type expressly approved by the Compensation Committee of the Board as covered services for these purposes) for the Company and any of its subsidiaries are eligible to be granted stock options (“Options”), restricted stock, phantom shares, dividend equivalent rights (“DERs”) and other stock-based awards under the 2004 Plan.
In general, subject to certain exceptions, stock-based awards relating to a maximum of 3.5 million shares of common stock may be granted under the 2004 Plan; forfeitures and/or awards that expire unexercised do not count towards such limit. Authorized but unissued shares are issued pursuant to the 2004 Plan. At December 31, 2006, 2.3 million shares of common stock remained available for grant towards such limit. Subject to certain exceptions, a participant may not receive stock-based awards in excess of 500,000 shares of common stock in any one-year and no award may be granted to any person who, assuming exercise of all Options and payment of all awards held by such person, would own or be deemed to own more than 9.8% of the outstanding shares of the Company’s capital stock. Unless previously terminated by the Board, awards may be granted under the 2004 Plan until the tenth anniversary of the date that the Company’s stockholders approved such plan.
Pursuant to Section 422(b) of the Code, in order for stock options granted under the 2004 Plan and vesting in any one calendar year to qualify as an incentive stock option (“ISO”) for tax purposes, the market value of the common stock, as determined on the date of grant, shall not exceed $100,000 during a calendar year. The exercise price of an ISO may not be lower than 100% (110% in the case of an ISO granted to a 10% stockholder) of the fair market value of the common stock on the date of grant. The exercise price for any other type of Option so issued may not be less than the fair market value on the date of grant. Each Option is exercisable after the period or periods specified in the award agreement, which will generally not exceed ten years from the date of grant. Options will be exercisable at such times and subject to such terms as determined by the Compensation Committee.
The following table presents information about the Company’s Options for the periods presented:
| | | | | | | | | | | | | | | | | | | |
| | 2006 | | 2005 | | 2004 | |
| | | | | | | |
| | Options | | Weighted
Average
Exercise
Price | | Options | | Weighted
Average
Exercise
Price | | Options | | Weighted
Average
Exercise
Price | |
| | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | |
Outstanding at beginning of year: | | | 962,000 | | $ | 9.33 | | | 1,087,000 | | $ | 9.34 | | | 1,012,250 | | $ | 9.32 | |
Granted | | | — | | | — | | | — | | | — | | | 80,000 | | | 9.54 | |
Cancelled/forfeited | | | — | | | — | | | (125,000 | ) | | 9.38 | | | (5,250 | ) | | 10.25 | |
Exercised | | | — | | | — | | | — | | | — | | | — | | | — | |
| | | | | | | | | | | | | | | | | | | |
Outstanding at end of year | | | 962,000 | | $ | 9.33 | | | 962,000 | | $ | 9.33 | | | 1,087,000 | | $ | 9.34 | |
| | | | | | | | | | | | | | | | | | | |
Options exercisable at end of year | | | 949,500 | | $ | 9.32 | | | 824,000 | | $ | 9.18 | | | 793,500 | | $ | 9.07 | |
| | | | | | | | | | | | | | | | | | | |
The Company recorded expenses of $374,000, $493,000 and $558,000 for Options and related DERs for the years ended December 31, 2006, 2005 and 2004, respectively. At December 31, 2006, the Company had 12,500 Options outstanding with an exercise price of $10.23 that were not vested and were scheduled to vest on February 2, 2007. These unvested Options had an unrecognized corresponding aggregate expense of $5,000. As of December 31, 2006, the aggregate intrinsic value of total Options outstanding was $338,000 and the aggregate value of Options currently exercisable was $282,000.
57
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
Certain information about the Company’s Options outstanding as of December 31, 2006 are set forth below:
| | | | | | | | | | | | |
Exercise Price or Price Range | | Options Outstanding | | Weighted Average
Exercise Price | | Weighted Average
Remaining
Contractual Life
(years) | |
| | | | | | | | |
$ | 4.88 | | | | 100,000 | | $ | 4.88 | | | 2.6 | |
| 8.40 | | | | 30,000 | | | 8.40 | | | 7.6 | |
| 9.38 | | | | 330,000 | | | 9.38 | | | 1.3 | |
| 10.23 – 10.25 | | | | 502,000 | | | 10.25 | | | 6.8 | |
| | | | | | | | | | | | |
| | | | | 962,000 | | $ | 9.33 | | | 4.5 | |
| | | | | | | | | | | | |
No Options were granted during 2006 and 2005. The weighted average fair value of Options granted during the year ended December 31, 2004 was $3.34 per Option. The following table presents the assumptions used to calculate the fair value of Options granted during 2004, using the Black-Scholes-Merton model:
| | | | |
| | December 31,
2004 | |
| | | |
Risk-Free Interest Rate | | 3.9 | % | |
Expected Volatility | | 34.1 | | |
Dividend Yield* | | 3.4 | | |
Expected Life | | 7 years | |
| * | 57,500 of the 80,000 stock options granted had DERs attached, for which a dividend yield of zero is applied. |
During the year ended December 31, 2006, the Company issued 35,738 shares of restricted common stock and recognized an expense of $165,000 related to the vesting of 24,917 shares. At December 31, 2006, the Company had unrecognized compensation expense of $84,000 related to the unvested shares of restricted common stock granted. The following table present information about the Company’s restricted stock awards for the periods presented:
| | | | | | | | | | | | | | | | | | | |
| | 2006 | | 2005 | | 2004 | |
| | | | | | | |
| | Shares of
Restricted
Stock | | Weighted
Average
Price on
Grant Date | | Shares of
Restricted
Stock | | Weighted
Average
Price on
Grant Date | | Shares of
Restricted
Stock | | Weighted
Average
Price on
Grant Date | |
| | | | | | | | | | | | | |
| | | | | | | | | | | | | | | | | | | |
Outstanding at beginning of year: | | | — | | $ | — | | | — | | $ | — | | | — | | $ | — | |
Granted * | | | 35,738 | | | 7.00 | | | — | | | — | | | — | | | — | |
Cancelled/forfeited | | | — | | | — | | | — | | | — | | | — | | | — | |
| | | | | | | | | | | | | | | | | | | |
Outstanding at end of year | | | 35,738 | | $ | 7.00 | | | — | | $ | — | | | — | | $ | — | |
| | | | | | | | | | | | | | | | | | | |
Shares vested at end of year | | | 24,917 | | $ | 6.65 | | | — | | $ | — | | | — | | $ | — | |
| | | | | | | | | | | | | | | | | | | |
| |
* | Awards vested 25% upon grant, and vest 25% per year for each of the next three years on the grant date anniversary. Grants for which there is no substantial risk of forfeiture are considered vested at the time of grant. |
A DER is a right to receive, as specified by the Compensation Committee at the time of grant, a distribution equal to the dividend distributions paid on a share of common stock. DERs may be granted separately or together with other awards and are paid in cash or other consideration at such times, and in accordance with such rules, as the Compensation Committee shall determine in its discretion. All DERs granted prior to October 1, 2003 vested on the same basis as the underlying Options. Dividends are paid on vested DERs only to the extent of ordinary income and DERs are not entitled to distributions representing a return of capital. Dividends paid on the Company’s DERs are charged to stockholders’ equity when declared. The Company recorded dividends associated with the DERs to stockholders’ equity of $188,000, $296,000 and $603,000, respectively, for the years ended December 31, 2006, 2005 and 2004. At December 31, 2006, the Company had 960,750 DERs outstanding, of which 948,250 were vested.
58
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
(b) Employment Agreements
The Company has an employment agreement with each of its five senior officers, with varying terms that provide for, among other things, base salary, bonuses and change-in-control provisions that are subject to the occurrence of certain triggering events.
(c) Deferred Compensation Plans
The Company administers the MFA Mortgage Investments, Inc. 2003 Non-employee Directors’ Deferred Compensation Plan and the MFA Mortgage Investments, Inc. Senior Officers Deferred Bonus Plan (collectively, the “Deferred Plans”). Pursuant to the Deferred Plans, directors and senior officers of the Company may elect to defer a certain percentage of their compensation. The Deferred Plans are intended to provide non-employee Directors and senior officers of the Company with an opportunity to defer up to 100% of certain compensation, as defined in the Deferred Plans, while at the same time aligning their interests with the interests of the Company’s stockholders. Amounts deferred are considered to be converted into “stock units” of the Company, which do not represent stock of the Company, but rather the right to receive a cash payment equal to the fair market value of an equivalent number of shares of the common stock. Deferred accounts increase or decrease in value as would equivalent shares of the common stock and are settled in cash at the termination of the deferral period, based on the value of the stock units at that time. The Deferred Plans are non-qualified plans under the Employee Retirement Income Security Act and are not funded. Prior to the time that the deferred accounts are settled, participants are unsecured creditors of the Company. Effective January 1, 2007, the Company’s Board of Directors resolved to suspend indefinitely the directors’ ability to defer additional compensation under the MFA Mortgage Investments, Inc. 2003 Non-employee Directors’ Deferred Compensation Plan.
At the time a participant’s deferral of compensation is made, it is intended that such participant will not recognize income for income tax purposes, nor will the Company receive a deduction until such time that the compensation is actually distributed to the participant. At December 31, 2006 and 2005, the Company had the following aggregate liability under the Deferred Plans, which included amounts deferred by participants, as well as the market value adjustments for the equivalent stock units:
| | | | | | | |
(In Thousands) | | December 31,
2006 | | December 31,
2005 | |
| | | | | |
Directors’ deferred | | $ | 594 | | $ | 337 | |
Officers’ deferred | | | 277 | | | 200 | |
| | | | | | | |
| | $ | 871 | | $ | 537 | |
| | | | | | | |
(d) Savings Plan
The Company sponsors a tax-qualified employee savings plan (the “Savings Plan”), which was established during 2002. Pursuant to Section 401(k) of the Code, eligible employees of the Company are able to make deferral contributions, subject to limitations under applicable law. Participant’s accounts are self-directed and the Company bears all costs associated with administering the Savings Plan. The Company matches 100% of the first 3% of eligible compensation deferred by employees and 50% of the next 2%, subject to a maximum as provided by the Code. Subject to certain restrictions, all of the Company’s employees are eligible to participate in the Savings Plan. The Company has elected to operate the Savings Plan under applicable safe harbor provisions of the Code, whereby among other things, the Company must make contributions for all eligible employees and all matches contributed by the Company immediately vest 100%. For the years ended December 31, 2006, 2005 and 2004 the Company recognized expenses for matching contributions of $78,000, $77,000 and $60,000, respectively.
59
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
| |
12. | Estimated Fair Value of Financial Instruments |
FAS No. 107 “Disclosures about Fair Value of Financial Instruments” defines the fair value of a financial instrument as the amount at which the instrument could be exchanged in a current transaction between willing parties. The relevance and reliability of the estimates of fair values presented are limited, given the dynamic nature of market conditions and numerous other factors over time. The following table presents the carrying value and estimated fair value of the Company’s financial instruments, at December 31, 2006 and 2005.
| | | | | | | | | | | | | |
| | 2006 | | 2005 | |
| | | | | |
| | Carrying
Value | | Estimated
Fair Value | | Carrying
Value | | Estimated
Fair Value | |
| | | | | | | | | |
(In Thousands) | | | | | |
Financial Assets: | | | | | | | | | | | | | |
Cash and cash equivalents | | $ | 47,200 | | $ | 47,200 | | $ | 64,301 | | $ | 64,301 | |
MBS | | | 6,340,668 | | | 6,340,668 | | | 5,714,906 | | | 5,714,906 | |
Hedging Instruments | | | 2,773 | | | 2,773 | | | 5,494 | | | 5,494 | |
Financial Liabilities: | | | | | | | | | | | | | |
Repurchase agreements | | | 5,722,711 | | | 5,717,381 | | | 5,099,532 | | | 5,083,526 | |
Real estate mortgages | | | 9,606 | | | 10,268 | | | 22,552 | | | 25,205 | |
Hedging instruments | | | 1,893 | | | 1,893 | | | — | | | — | |
The following methods and assumptions were used by the Company in arriving at the estimated fair value of its financial instruments presented in the above table:
MBS: Reflects prices obtained from a third-party pricing service or, if pricing is not available for a particular MBS from such pricing service, the average of broker quotes received for such MBS is used to determine the estimated fair value of such MBS.
Cash: Estimated fair value approximates the carrying value of such assets.
Repurchase agreements: Reflects the present value of the contractual cash flow discounted at LIBOR quoted at the valuation date, for the term closest to the weighted average term to maturity of the aggregate repurchase agreements.
Real Estate Mortgages: Reflects the discounted amount of contractual future cash outflows of the mortgages using the approximate rate of borrowing that the Company would expect to pay, if such obligations, based on the remaining terms, were financed at the valuation date, including the impact of prepayment penalties.
Hedging Instruments: Reflects prices obtained from counterparties to the Swaps and Caps, with whom the Company could, at the Company’s option, settle such instruments.
Commitments: Commitments to purchase securities are derived by applying the fees currently charged to enter into similar agreements, taking into account remaining terms of the agreements and the present credit worthiness of the counterparties. The commitments existing at December 31, 2006 and 2005 would have been offered at substantially the same rates and under substantially the same terms as those that existed at December 31, 2006 and 2005, respectively; therefore, the estimated fair value of the commitments was zero at those dates and are not included in the above table.
60
MFA MORTGAGE INVESTMENTS, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
| |
13. | Summary of Quarterly Results of Operations (Unaudited) |
| | | | | | | | | | | | | |
| | 2006 Quarter Ended | |
| | | |
(In Thousands, Except per Share Amounts) | | March 31 | | June 30 | | September 30 | | December 31 | |
| | | | | | | | | |
Interest and dividend income | | $ | 53,995 | | $ | 46,185 | | $ | 47,532 | | $ | 71,480 | |
Interest expense | | | (42,785 | ) | | (38,818 | ) | | (38,205 | ) | | (62,114 | ) |
| | | | | | | | | | | | | |
Net interest and dividend income | | | 11,210 | | | 7,367 | | | 9,327 | | | 9,366 | |
Gain/(loss) on sale of MBS * | | | 1,597 | | | (24,746 | ) | | 36 | | | — | |
Other income | | | 621 | | | 593 | | | 533 | | | 517 | |
Operating and other expenses | | | (3,093 | ) | | (2,891 | ) | | (2,818 | ) | | (2,383 | ) |
| | | | | | | | | | | | | |
Income/(loss) from continuing operations | | | 10,335 | | | (19,677 | ) | | 7,078 | | | 7,500 | |
| | | | | | | | | | | | | |
Income/(loss) from discontinued operations | | | 4,628 | | | (56 | ) | | (1 | ) | | (1,049 | ) |
| | | | | | | | | | | | | |
Net income/(loss) before preferred dividends | | | 14,963 | | | (19,733 | ) | | 7,077 | | | 6,451 | |
| | | | | | | | | | | | | |
Preferred Stock Dividends | | | (2,040 | ) | | (2,040 | ) | | (2,040 | ) | | (2,040 | ) |
| | | | | | | | | | | | | |
Net Income/(Loss) Available to Common Stockholders | | $ | 12,923 | | $ | (21,773 | ) | $ | 5,037 | | $ | 4,411 | |
| | | | | | | | | | | | | |
Per Share: | | | | | | | | | | | | | |
Earnings/(loss) per share – continuing operations, basic and diluted | | $ | 0.10 | | $ | (0.27 | ) | $ | 0.06 | | $ | 0.07 | |
| | | | | | | | | | | | | |
Earnings/(loss) per share – discontinued operations, basic and diluted | | $ | 0.06 | | $ | — | | $ | — | | $ | (0.01 | ) |
| | | | | | | | | | | | | |
Earnings/(loss) per share, basic and diluted | | $ | 0.16 | | $ | (0.27 | ) | $ | 0.06 | | $ | 0.06 | |
| | | | | | | | | | | | | |
| | | | | | | | | | | | | |
| | 2005 Quarter Ended | |
| | | |
(In Thousands, Except per Share Amounts) | | March 31 | | June 30 | | September 30 | | December 31 | |
| | | | | | | | | |
Interest and dividend income | | $ | 61,239 | | $ | 61,142 | | $ | 57,531 | | $ | 58,807 | |
Interest expense | | | (39,766 | ) | | (46,508 | ) | | (49,060 | ) | | (48,499 | ) |
| | | | | | | | | | | | | |
Net interest and dividend income | | | 21,473 | | | 14,634 | | | 8,471 | | | 10,308 | |
Gain/(loss) on sale of MBS * | | | — | | | — | | | 10 | | | (18,364 | ) |
Other-than-temporary impairment on MBS * | | | — | | | — | | | — | | | (20,720 | ) |
Other income | | | 370 | | | 374 | | | 471 | | | 596 | |
Operating and other expenses | | | (2,937 | ) | | (2,835 | ) | | (2,649 | ) | | (2,408 | ) |
| | | | | | | | | | | | | |
Income/(loss) from continuing operations | | | 18,906 | | | 12,173 | | | 6,303 | | | (30,588 | ) |
| | | | | | | | | | | | | |
Loss from discontinued operations | | | (25 | ) | | (14 | ) | | (32 | ) | | (15 | ) |
| | | | | | | | | | | | | |
Net income/(loss) before preferred dividends | | | 18,881 | | | 12,159 | | | 6,271 | | | (30,603 | ) |
| | | | | | | | | | | | | |
Preferred Stock Dividends | | | (2,040 | ) | | (2,040 | ) | | (2,040 | ) | | (2,040 | ) |
| | | | | | | | | | | | | |
Net Income/(Loss) Available to Common Stockholders | | $ | 16,841 | | $ | 10,119 | | $ | 4,231 | | $ | (32,643 | ) |
| | | | | | | | | | | | | |
Per Share: | | | | | | | | | | | | | |
Earnings/(loss) per share – continuing operations, basic and diluted | | $ | 0.20 | | $ | 0.12 | | $ | 0.05 | | $ | (0.40 | ) |
| | | | | | | | | | | | | |
Earnings/(loss) per share – discontinued operations, basic and diluted | | $ | — | | $ | — | | $ | — | | $ | — | |
| | | | | | | | | | | | | |
Earnings/(loss) per share, basic and diluted | | $ | 0.20 | | $ | 0.12 | | $ | 0.05 | | $ | (0.40 | ) |
| | | | | | | | | | | | | |
| |
* | Beginning in the fourth quarter of 2005 through the second quarter of 2006, the Company reduced its asset base through a strategy under which it, among other things, sold higher duration and lower yielding ARM-MBS. During 2006, the Company sold approximately $1.844 billion of MBS, realizing net losses of $23.1 million, comprised of gross losses of $25.2 million and gross gains of $2.1 million. For 2005, the repositioning involved the sale of $564.8 million of MBS, which resulted in an $18.4 million loss on sale, and an impairment charge of $20.7 million against certain MBS with an amortized cost of $842.2 million. |
61
| |
Item 9. | Changes in and Disagreements with Accountants on Accounting and Financial Disclosure. |
None.
| |
Item 9A. | Controls and Procedures. |
A review and evaluation was performed by the Company’s management, including the Company’s Chief Executive Officer (the “CEO”) and Chief Financial Officer (the “CFO”), of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as such terms are defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the period covered by this annual report on Form 10-K. Based on that review and evaluation, the CEO and CFO have concluded that the Company’s current disclosure controls and procedures, as designed and implemented, were effective.
Management Report On Internal Control Over Financial Reporting
Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. Internal control over financial reporting is defined in Rules 13a-15(f) and 15d-15(f) promulgated under the Exchange Act as a process designed by, or under the supervision of, the Company’s principal executive and principal financial officers and effected by the Company’s Board, management and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP and includes those policies and procedures that:
| | |
| • | pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company; |
| | |
| • | provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and |
| | |
| • | provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements. |
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risks that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate.
The Company’s management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006. In making this assessment, the Company’s management used criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in Internal Control-Integrated Framework.
Based on its assessment, the Company’s management believes that, as of December 31, 2006, the Company’s internal control over financial reporting was effective based on those criteria. There have been no changes in the Company’s internal control over financial reporting that occurred during the quarter ended December 31, 2006 that have materially affected, or are reasonably likely to materially affect, its internal control over financial reporting.
The Company’s independent auditors, Ernst & Young LLP, have issued an attestation report on management’s assessment of the Company’s internal control over financial reporting. This report appears on page 63 of this annual report on Form 10-K.
62
Report of Independent Registered Public Accounting Firm
To The Board of Directors and Stockholders of
MFA Mortgage Investments, Inc.
We have audited management’s assessment, included in the accompanying Management Report on Internal Control Over Financial Reporting, that MFA Mortgage Investments, Inc. (the “Company”) maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control—Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the “COSO” criteria). The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that MFA Mortgage Investments, Inc. maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, MFA Mortgage Investments, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of MFA Mortgage Investments, Inc. as of December 31, 2006 and 2005, and the related consolidated statements of income, changes in stockholders’ equity, cash flows, and comprehensive income for each of the three years in the period ended December 31, 2006, and our report dated February 14, 2007 expressed an unqualified opinion thereon.
Ernst & Young LLP
New York, New York
February 14, 2007
63
| |
Item 9B. | Other Information. |
None.
PART III
| |
Item 10. | Directors, Executive Officers and Corporate Governance. |
The information regarding the Company’s directors and certain other matters required by Item 401 of Regulation S-K is incorporated herein by reference to the Company’s proxy statement, relating to its 2007 annual meeting of stockholders to be held on May 22, 2007 (the “Proxy Statement”), to be filed with the SEC within 120 days after December 31, 2006.
The information regarding the Company’s executive officers required by Item 401 of Regulation S-K appears under Item 4A of this annual report on Form 10-K.
The information regarding compliance with Section 16(a) of the Exchange Act required by Item 405 of Regulation S-K is incorporated herein by reference to the Proxy Statement to be filed with the SEC within 120 days after December 31, 2006.
The information regarding the Company’s Code of Business Conduct and Ethics required by Item 406 of Regulation S-K is incorporated herein by reference to the Proxy Statement to be filed with the SEC within 120 days after December 31, 2006.
The information regarding certain matters pertaining to the Company’s corporate governance required by Item 407(c)(3), (d)(4) and (d)(5) of Regulation S-K is incorporated by reference to the Proxy Statement to be filed with the SEC within 120 days after December 31, 2006.
| |
Item 11. | Executive Compensation. |
The information regarding executive compensation and other compensation related matters required by Items 402 and 407(e)(4) and (e)(5) of Regulation S-K is incorporated herein by reference to the Proxy Statement to be filed with the SEC within 120 days after December 31, 2006.
| |
Item 12. | Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters. |
The tables on equity compensation plan information and beneficial ownership of the Company required by Items 201(d) and 403 of Regulation S-K are incorporated herein by reference to the Proxy Statement to be filed with the SEC within 120 days after December 31, 2006.
| |
Item 13. | Certain Relationships and Related Transactions and Director Independence. |
The information regarding transactions with related persons, promoters and certain control persons and director independence required by Items 404 and 407(a) of Regulation S-K is incorporated herein by reference to the Proxy Statement to be filed with the SEC within 120 days after December 31, 2006.
| |
Item 14. | Principal Accountant Fees and Services. |
The information concerning principal accounting fees and services and the Audit Committee’s pre-approval policies and procedures required by Item 14 is incorporated herein by reference to the Proxy Statement to be filed with the SEC within 120 days after December 31, 2006.
64
PART IV
| |
Item 15. | Exhibits and Financial Statement Schedules. |
| | |
(a) | | Documents filed as part of the report |
|
| | The following documents are filed as part of this annual report on Form 10-K: |
| | |
| | Financial Statements.The consolidated financial statements of the Company, together with the independent registered public accounting firm’s report thereon, are set forth on pages 34 through 61 of this annual report on Form 10-K and are incorporated herein by reference. |
| | |
| | Schedules to Financial Statements. |
| | |
(b) | | Exhibits required by Item 601 of Regulation S-K |
| | |
| | 3.1Amended and Restated Articles of Incorporation of the Registrant (incorporated herein by reference to Form 8-K, dated April 10, 1998, filed by the Registrant pursuant to the Exchange Act (Commission File No. 1-13991)). |
| | |
| | 3.2Articles of Amendment to the Amended and Restated Articles of Incorporation of the Registrant, dated August 6, 2002 (incorporated herein by reference to Exhibit 3.1 of the Form 8-K, dated August 13, 2002, filed by the Registrant pursuant to the Exchange Act (Commission File No. 1-13991)). |
| | |
| | 3.3Articles of Amendment to the Amended and Restated Articles of Incorporation of the Registrant, dated August 16, 2002 (incorporated herein by reference to Exhibit 3.3 of the Form 10-Q, for the quarter ended September 30, 2002, filed by the Registrant pursuant to the Exchange Act (Commission File No. 1-13991)). |
| | |
| | 3.4Articles Supplementary of the Registrant, dated April 22, 2004, designating the Registrant’s 8.50% Series A Cumulative Redeemable preferred stock (incorporated herein by reference to Exhibit 3.4 of the Form 8-A, dated April 23, 2004, filed by the Registrant pursuant to the Act (SEC File No. 1-13991)). |
| | |
| | 3.5Amended and Restated Bylaws of the Registrant (incorporated herein by reference to Exhibit 3.2 of the Form 8-K, dated August 13, 2002, filed by the Registrant pursuant to the Exchange Act (Commission File No. 1-13991)). |
| | |
| | 4.1Specimen of common stock certificate of the Registrant (incorporated herein by reference to Exhibit 4.1 of the Registration Statement on Form S-4, dated February 12, 1998, filed by the Registrant pursuant to the Securities Act of 1933 (Commission File No. 333-46179)). |
| | |
| | 4.2Specimen of Stock certificate representing the 8.50% Series A Cumulative Redeemable preferred stock of the Registrant (incorporated herein by reference to Exhibit 4 of the Form 8-A, dated April 23, 2004, filed by the Registrant pursuant to the Exchange Act (Commission File No. 1-13991)). |
| | |
| | 10.1Amended and Restated Employment Agreement of Stewart Zimmerman, dated as of April 16, 2006 (incorporated herein by reference to Exhibit 10.1 of the Form 8-K, dated April 25, 2006, filed by the Registrant pursuant to the 1934 Act (Commission File No. 1-13991)). |
| | |
| | 10.2Amended and Restated Employment Agreement of William S. Gorin, dated as of April 16, 2006 (incorporated herein by reference to Exhibit 10.3 of the Form 8-K, dated April 25, 2006, filed by the Registrant pursuant to the 1934 Act (Commission File No. 1-13991)). |
| | |
| | 10.3Amended and Restated Employment Agreement of Ronald A. Freydberg, dated as of April 16, 2006 (incorporated herein by reference to Exhibit 10.2 of the Form 8-K, dated April 25, 2006, filed by the Registrant pursuant to the 1934 Act (Commission File No. 1-13991)). |
| | |
| | 10.4Amended and Restated Employment Agreement of Teresa D. Covello, dated as of January 1, 2006 (incorporated herein by reference to Exhibit 10.5 of the Form 8-K, dated April 25, 2006, filed by the Registrant pursuant to the 1934 Act (Commission File No. 1-13991)). |
| | |
| | 10.5Amended and Restated Employment Agreement of Timothy W. Korth II, dated as of January 1, 2006 (incorporated herein by reference to Exhibit 10.4 of the Form 8-K, dated April 25, 2006, filed by the Registrant pursuant to the 1934 Act (Commission File No. 1-13991)). |
65
| | |
| 10.6 2004 Equity Compensation Plan of the Company (incorporated herein by reference to Exhibit 10.1 of the Post-Effective Amendment No. 1 to the Registration Statement on Form S-3, dated July 21, 2004, filed by the Registrant pursuant to the Securities Act of 1933 (Commission File No. 333-106606)). |
| | |
| 10.7 MFA Mortgage Investments, Inc. Senior Officers Deferred Compensation Plan, adopted December 19, 2002 (incorporated herein by reference to Form 10-K, for the year ended December 31, 2002, filed with the Securities and Exchange Commission pursuant to the Exchange Act (Commission File No. 1-13991)). |
| | |
| 10.8 MFA Mortgage Investments, Inc. 2003 Non-Employee Directors Deferred Compensation Plan, adopted December 19, 2002 (incorporated herein by reference to Exhibit 10.7 of the Form 10-K for the year ended December 31, 2002, filed with the Securities and Exchange Commission pursuant to the Exchange Act (Commission File No. 1-13991)). |
| | |
| 10.9 Form of Incentive Stock Option Award Agreement relating to the Registrant’s 2004 Equity Compensation Plan (incorporated herein by reference to Exhibit 10.9 of the Form 10-Q, dated September 30, 2004, filed by the Registrant pursuant to the Exchange Act (Commission File No. 1-13991)). |
| | |
| 10.10 Form of Non-Qualified Stock Option Award Agreement relating to the Registrant’s 2004 Equity Compensation Plan (incorporated herein by reference to Exhibit 10.10 of the Form 10-Q, dated September 30, 2004, filed by the Registrant pursuant to the Exchange Act (Commission File No. 1-13991)). |
| | |
| 10.11 Form of Restricted Stock Award Agreement relating to the Registrant’s 2004 Equity Compensation Plan (incorporated herein by reference to Exhibit 10.11 of the Form 10-Q, dated September 30, 2004, filed by the Registrant pursuant to the Exchange Act (Commission File No. 1-13991)). |
| | |
| 12.1 Computation of Ratio of Assets to Equity. |
| | |
| 12.2 Computation of Ratio of Debt to Equity. |
| | |
| 23.1 Consent of Ernst & Young LLP. |
| | |
| 31.1 Certification of the Chief Executive Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| | |
| 31.2 Certification of the Chief Financial Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| | |
| 32.1 Certification of the Chief Executive Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| | |
| 32.2 Certification of the Chief Financial Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| | |
(c) | | Financial Statement Schedules required by Regulation S-X |
| | |
| Financial statement schedules have been omitted because they are not applicable or the required information is presented in the consolidated financial statements and/or in the notes to consolidated financial statements filed in response to Item 8 of this annual report on Form 10-K. |
66
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
| | | |
| MFA Mortgage Investments, Inc. |
| | | |
Date: February 14, 2007 | By /s/ | Stewart Zimmerman | |
| | | |
| | Stewart Zimmerman | |
| | Chief Executive Officer and President |
| | | |
Date: February 14, 2007 | By /s/ | William S. Gorin | |
| | | |
| | William S. Gorin | |
| | Executive Vice President and
Chief Financial Officer
(Principal Financial Officer) |
| | | |
Date: February 14, 2007 | By /s/ | Teresa D. Covello | |
| | | |
| | Teresa D. Covello | |
| | Senior Vice President and
Chief Accounting Officer
(Principal Accounting Officer) |
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.
| | | |
Date: February 14, 2007 | By /s/ | Stewart Zimmerman | |
| | | |
| | Stewart Zimmerman | |
| | Chairman, President and
Chief Executive Officer |
| | | |
Date: February 14, 2007 | By /s/ | Stephen R. Blank | |
| | | |
| | Stephen R. Blank
Director |
| | | |
Date: February 14, 2007 | By /s/ | James A. Brodsky | |
| | | |
| | James A. Brodsky
Director |
| | | |
Date: February 14, 2007 | By /s/ | Edison C. Buchanan | |
| | | |
| | Edison C. Buchanan
Director |
| | | |
Date: February 14, 2007 | By /s/ | Michael L. Dahir | |
| | | |
| | Michael L. Dahir
Director | |
| | | |
Date: February 14, 2007 | By /s/ | Alan Gosule | |
| | | |
| | Alan Gosule
Director |
| | | |
Date: February 14, 2007 | By /s/ | George Krauss | |
| | | |
| | George Krauss
Director |
67
