SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTIONS 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
(MARK ONE)
|X| ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED: DECEMBER 31, 2003
OR
|_| TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER: 1-13447
ANNALY MORTGAGE MANAGEMENT, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
MARYLAND 22-3479661
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OF ORGANIZATION) IDENTIFICATION NUMBER)
1211 AVENUE OF THE AMERICAS, SUITE 2902
NEW YORK, NEW YORK 10036
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
(212) 696-0100
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
TITLE OF EACH CLASS NAME OF EACH EXCHANGE ON WHICH REGISTERED
COMMON STOCK, PAR VALUE $.01 PER SHARE NEW YORK STOCK EXCHANGE
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
NONE.
INDICATE BY CHECK MARK WHETHER THE REGISTRANT (1) HAS FILED ALL REPORTS REQUIRED
TO BE FILED BY SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 DURING
THE PRECEDING 12 MONTHS (OR FOR SUCH SHORTER PERIOD THAT THE REGISTRANT WAS
REQUIRED TO FILE SUCH REPORTS), AND (2) HAS BEEN SUBJECT TO SUCH FILING
REQUIREMENTS FOR THE PAST 90 DAYS:
YES |X| NO |_|
INDICATE BY CHECK MARK IF DISCLOSURE OF DELINQUENT FILERS PURSUANT TO ITEM 405
OF REGULATION S-K IS NOT CONTAINED HEREIN, AND WILL NOT BE CONTAINED, TO THE
BEST OF REGISTRANT'S KNOWLEDGE, IN DEFINITIVE PROXY OR INFORMATION STATEMENTS
INCORPORATED BY REFERENCE IN PART III OF THIS FORM 10-K OR ANY AMENDMENT TO THIS
FORM 10-K. |_|
INDICATE BY CHECK MARK WHETHER THE REGISTRANT IS AN ACCELERATED FILER (AS
DEFINED IN RULE 12B-2 OF THE ACT). YES |X| NO |_|
AT JUNE 30, 2003, THE AGGREGATE MARKET VALUE OF THE VALUE OF THE VOTING STOCK
HELD BY NON-AFFILIATES OF THE REGISTRANT WAS $1,862,268,868.
THE NUMBER OF SHARES OF THE REGISTRANT'S COMMON STOCK OUTSTANDING ON MARCH 4,
2004 WAS 117,866,932.
DOCUMENTS INCORPORATED BY REFERENCE
THE REGISTRANT INTENDS TO FILE A DEFINITIVE PROXY STATEMENT PURSUANT TO
REGULATION 14A WITHIN 120 DAYS OF THE END OF THE FISCAL YEAR ENDED DECEMBER 31,
2003. PORTIONS OF SUCH PROXY STATEMENT ARE INCORPORATED BY REFERENCE INTO PART
III OF THIS FORM 10-K.
ANNALY MORTGAGE MANAGEMENT, INC.
- --------------------------------------------------------------------------------
2003 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
PART I
PAGE
ITEM 1. BUSINESS 1
ITEM 2. PROPERTIES 32
ITEM 3. LEGAL PROCEEDINGS 32
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 32
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
STOCKHOLDER MATTERS 33
ITEM 6. SELECTED FINANCIAL DATA 35
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS 36
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 51
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA 53
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE 53
ITEM 9A. CONTROLS AND PROCEDURES 53
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT 53
ITEM 11. EXECUTIVE COMPENSATION 53
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT AND RELATED STOCKHOLDER MATTERS 53
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS 53
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES 54
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON
FORM 8-K 55
FINANCIAL STATEMENTS F-1
SIGNATURES II-1
EXHIBIT INDEX II-2
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
Certain statements contained in this annual report, and certain statements
contained in our future filings with the Securities and Exchange Commission (the
"SEC" or the "Commission"), in our press releases or in our other public or
shareholder communications may not be, based on historical facts and are
"forward-looking statements" within the meaning of the Private Securities
Litigation Reform Act of 1995. Forward-looking statements which are based on
various assumptions, (some of which are beyond our control) may be identified by
reference to a future period or periods, or by the use of forward-looking
terminology, such as "may," "will," "believe," "expect," "anticipate,"
"continue," or similar terms or variations on those terms, or the negative of
those terms. Actual results could differ materially from those set forth in
forward-looking statements due to a variety of factors, including, but not
limited to, changes in interest rates, changes in yield curve, changes in
prepayment rates, the availability of mortgage backed securities for purchase,
the availability of financing and, if available, the terms of any financing. For
a discussion of the risks and uncertainties that could cause actual results to
differ from those contained in the forward-looking statements, see "Risk
Factors." We do not undertake, and specifically disclaim any obligation, to
publicly release the result of any revisions that may be made to any
forward-looking statements to reflect the occurrence of anticipated or
unanticipated events or circumstances after the date of such statements.
PART I
ITEM 1. BUSINESS
THE COMPANY
BACKGROUND
Annaly Mortgage Management, Inc. owns and manages a portfolio of primarily
mortgage-backed securities, including mortgage pass-through certificates,
collateralized mortgage obligations ("CMOs") and other securities representing
interests in or obligations backed by pools of mortgage loans. Our principal
business objective is to generate net income for distribution to our
stockholders from the spread between the interest income on our investment
securities and the costs of borrowing to finance our acquisition of investment
securities. We have elected to be taxed as a real estate investment trust
("REIT") under the Internal Revenue Code. Therefore, substantially all of our
assets consist of qualified REIT real estate assets (of the type described in
Section 856(c)(5)(B) of the Internal Revenue Code). We commenced operations on
February 18, 1997. We are self-advised and self-managed.
We have financed our purchases of investment securities with the net
proceeds of equity offerings and borrowings under repurchase agreements whose
interest rates adjust based on changes in short-term market interest rates.
As used herein, "Annaly," "we," "our" and similar terms refer to Annaly
Mortgage Management, Inc., unless the context indicates otherwise.
ASSETS
Under our capital investment policy, at least 75% of our total assets must
be comprised of high-quality mortgage-backed securities and short-term
investments. High quality securities means securities that (1) are rated within
one of the two highest rating categories by at least one of the nationally
recognized rating agencies, (2) are unrated but are guaranteed by the United
States government or an agency of the United States government, or (3) are
unrated but we determine them to be of comparable quality to rated high-quality
mortgage-backed securities.
The remainder of our assets, comprising not more than 25% of our total
assets, may consist of other qualified REIT real estate assets which are unrated
or rated less than high quality, but which are at least "investment grade"
(rated "BBB" or better by Standard & Poor's Corporation ("S&P") or the
equivalent by another nationally recognized rating agency) or, if not rated, we
determine them to be of comparable credit quality to an investment which is
rated "BBB" or better.
1
We may acquire mortgage-backed securities backed by single-family
residential mortgage loans as well as securities backed by loans on
multi-family, commercial or other real estate-related properties. To date, all
of the mortgage-backed securities that we have acquired have been backed by
single-family residential mortgage loans.
To date, all of the mortgage-backed securities that we have acquired have
been agency mortgage-backed securities which, although not rated, carry an
implied "AAA" rating. Agency mortgage-backed securities are mortgage-backed
securities for which a government agency or federally chartered corporation,
such as the Federal Home Loan Mortgage Corporation ("FHLMC"), the Federal
National Mortgage Association ("FNMA"), or the Government National Mortgage
Association ("GNMA"), guarantees payments of principal or interest on the
securities. Agency mortgage-backed securities consist of agency pass-through
certificates and CMOs issued or guaranteed by an agency. Pass-through
certificates provide for a pass-through of the monthly interest and principal
payments made by the borrowers on the underlying mortgage loans. CMOs divide a
pool of mortgage loans into multiple tranches with different principal and
interest payment characteristics.
At December 31, 2003, approximately 56% of our investment securities were
adjustable-rate pass-though certificates, approximately 27% of our investment
securities were fixed-rate pass-through certificates or CMOs, and approximately
17% of our investment securities were CMO floaters. Our adjustable-rate
pass-through certificates are backed by adjustable-rate mortgage loans and have
coupon rates which adjust over time, subject to interest rate caps and lag
periods, in conjunction with changes in short-term interest rates. CMO floaters
are tranches of mortgage-backed securities where the interest rate adjusts in
conjunction with changes in short-term interest rates. Our fixed-rate
pass-through certificates are backed by fixed-rate mortgage rates which do not
adjust over time. CMO floaters may be backed by fixed-rate mortgage loans or,
less often, by adjustable-rate mortgage loans. In this Form 10-K, except where
the context indicates otherwise, we use the term "adjustable-rate securities" or
"adjustable-rate investment securities" to refer to adjustable-rate pass-through
certificates, CMO floaters, and Agency debentures. At December 31, 2003, the
weighted average yield on our portfolio of earning assets was 2.96% and the
weighted average term to next rate adjustment on adjustable rate securities was
23 months.
We also invest in Federal Home Loan Bank ("FHLB"), FHLMC, and FNMA
debentures. We refer to the mortgage-backed securities and agency debentures
collectively as "Investment Securities." We intend to continue to invest in
adjustable-rate pass-through certificates, fixed-rate mortgage-backed
securities, CMO floaters, and Agency debentures. Although we have not done so to
date, we may also invest on a limited basis in mortgage derivative securities
representing the right to receive interest only or a disproportionately large
amount of interest. We have not and will not invest in real estate mortgage
investment conduit ("REMIC") residuals, other CMO residuals or any
mortgage-backed securities, such as inverse floaters, which have imbedded
leverage as part of their structural characteristics.
BORROWINGS
We attempt to structure our borrowings to have interest rate adjustment
indices and interest rate adjustment periods that, on an aggregate basis,
correspond generally to the interest rate adjustment indices and periods of our
adjustable-rate investment securities. However, periodic rate adjustments on our
borrowings are generally more frequent than rate adjustments on our investment
securities. At December 31, 2003, the weighted average cost of funds for all of
our borrowings was 1.51%, the weighted average original term to maturity was 203
days, and the weighted average term to next rate adjustment of these borrowings
was 90 days.
We generally expect to maintain a ratio of debt-to-equity of between 8:1
and 12:1, although the ratio may vary from time to time depending upon market
conditions and other factors that our management deems relevant. For purposes of
calculating this ratio, our equity is equal to the value of our investment
portfolio on a mark-to-market basis, less the book value of our obligations
under repurchase agreements and other collateralized borrowings. At December 31,
2003, our ratio of debt-to-equity was 9.6:1.
HEDGING
To the extent consistent with our election to qualify as a REIT, we may
enter into hedging transactions to attempt to protect our investment securities
and related borrowings against the effects of major interest rate changes. This
hedging would be used to mitigate declines in the market value of our investment
securities during periods of
2
increasing or decreasing interest rates and to limit or cap the interest rates
on our borrowings. These transactions would be entered into solely for the
purpose of hedging interest rate or prepayment risk and not for speculative
purposes. To date, we have not entered into any hedging transactions.
COMPLIANCE WITH REIT AND INVESTMENT COMPANY REQUIREMENTS
We constantly monitor our investment securities and the income from these
securities and, to the extent we enter into hedging transactions in the future,
we will monitor income from our hedging transactions as well, so as to ensure at
all times that we maintain our qualification as a REIT and our exempt status
under the Investment Company Act of 1940, as amended.
MANAGEMENT
Our executive officers are:
o Michael A.J. Farrell, Chairman of the Board, Chief Executive Officer
and President;
o Wellington J. Denahan, Vice Chairman of the Board and Chief
Investment Officer;
o Kathryn F. Fagan, Chief Financial Officer and Treasurer;
o Jennifer S. Karve, Executive Vice President and Secretary;
o James P. Fortescue, Senior Vice President and Repurchase Agreement
Manager.
Mr. Farrell and Ms. Denahan have an average of 23 years experience in the
investment banking and investment management industries where, in various
capacities, they have each managed portfolios of mortgage-backed securities,
arranged collateralized borrowings and utilized hedging techniques to mitigate
interest rate and other risk within fixed-income portfolios. Ms. Fagan is a
certified public accountant and, prior to becoming our Chief Financial Officer
and Treasurer, served as Chief Financial Officer and Controller of a publicly
owned savings and loan association. Mrs. Karve has worked for us since December
1996. Mr. Farrell is the President and Chief Financial Officer of Fixed Income
Discount Advisory Company (or FIDAC). Since 1994, Mr. Farrell and Ms. Denahan
have managed Fixed Income Discount Advisory Company ("FIDAC"), a registered
investment advisor which, at December 31, 2003, managed, assisted in managing or
supervised approximately $13.6 billion in gross assets for a wide array of
clients, all of which assets on that date were managed on a discretionary basis.
Mr. Farrell, our Chairman of the Board, Chief Executive Officer and President,
Wellington J. Denahan, our Vice Chairman and Chief Investment Officer, Kathryn
F. Fagan, our Chief Financial Officer and Treasurer, Jennifer S. Karve, our
Executive Vice President and Secretary, and other officers and employees are
shareholders of FIDAC.
We have entered into a merger agreement to acquire FIDAC. Under the merger
agreement with FIDAC, the purchase price will be payable in shares of our common
stock. Upon the consummation of the merger, we will issue shares of our common
stock worth $40.5 million, based upon a valuation of shares of our common stock
as of December 31, 2003, to the shareholders of FIDAC. The merger agreement
includes an earn-out feature, under which we will pay up to an additional $49.5
million, which will be payable in shares of our common stock, to the
stockholders of FIDAC if FIDAC meets certain revenue and pre-tax profit margin
targets over the next three years as described in the Merger Agreement. See
"Business Strategy - Acquisition of FIDAC."
Management's duties on behalf of FIDAC's clients may create conflicts of
interest if members of management are presented with corporate opportunities
that may benefit both us and clients for which FIDAC acts as investment advisor.
In the event that an investment opportunity arises, the investment will be
allocated to another entity or us by determining the entity or account for which
the investment is most suitable. In making this determination, our management
will consider the investment strategy and guidelines of each entity or account
with respect to acquisition of assets, leverage, liquidity and other factors
which management determines appropriate.
We had 20 full-time employees at December 31, 2003.
3
DISTRIBUTIONS
To maintain our qualification as a REIT, we must distribute substantially
all of our taxable income to our stockholders for each year. We have done this
in the past and intend to continue to do so in the future. We also have declared
and paid regular quarterly dividends in the past and intend to do so in the
future. We have adopted a dividend reinvestment plan to enable holders of common
stock to reinvest dividends automatically in additional shares of common stock.
4
BUSINESS STRATEGY
GENERAL
Our principal business objective is to generate income for distribution to
our stockholders, primarily from the net cash flows on our investment
securities. Our net cash flows result primarily from the difference between the
interest income on our investment securities and borrowing costs on our
repurchase agreements. To achieve our business objective and generate dividend
yields, our strategy is:
o to purchase mortgage-backed securities, the majority of which we
expect to have adjustable interest rates based on changes in
short-term market interest rates;
o to acquire mortgage-backed securities that we believe:
- we have the necessary expertise to evaluate and manage;
- we can readily finance;
- are consistent with our balance sheet guidelines and risk
management objectives; and
- provide attractive investment returns in a range of scenarios;
o to finance purchases of mortgage-backed securities with the proceeds
of equity offerings and, to the extent permitted by our capital
investment policy, to utilize leverage to increase potential returns
to stockholders through borrowings;
o to attempt to structure our borrowings to have interest rate
adjustment indices and interest rate adjustment periods that, on an
aggregate basis, generally correspond to the interest rate
adjustment indices and interest rate adjustment periods of our
adjustable-rate mortgage-backed securities;
o to seek to minimize prepayment risk by structuring a diversified
portfolio with a variety of prepayment characteristics and through
other means; and
o to issue new equity or debt and increase the size of our balance
sheet when opportunities in the market for mortgage-backed
securities are likely to allow growth in earnings per share.
We believe we are able to obtain cost efficiencies through our
facilities-sharing arrangement with FIDAC and by virtue of our management's
experience in managing portfolios of mortgage-backed securities and arranging
collateralized borrowings. We will strive to become even more cost-efficient
over time by:
o seeking to raise additional capital from time to time in order to
increase our ability to invest in mortgage-backed securities;
o striving to lower our effective borrowing costs over time by seeking
direct funding with collateralized lenders, rather than using
financial intermediaries, and investigating the possibility of using
commercial paper and medium term note programs;
o improving the efficiency of our balance sheet structure by
investigating the issuance of uncollateralized subordinated debt,
preferred stock and other forms of capital; and
o utilizing information technology in our business, including
improving our ability to monitor the performance of our investment
securities and to lower our operating costs.
5
MORTGAGE-BACKED SECURITIES
GENERAL
To date, all of the mortgage-backed securities that we have acquired have
been agency mortgage-backed securities which, although not rated, carry an
implied "AAA" rating. Agency mortgage-backed securities are mortgage-backed
securities where a government agency or federally chartered corporation, such as
FHLMC, FNMA or GNMA, guarantees payments of principal or interest on the
securities. Agency mortgage-backed securities consist of agency pass-through
certificates and CMOs issued or guaranteed by an agency.
Even though to date we have only acquired securities with an implied "AAA"
rating, under our capital investment policy, we have the ability to acquire
securities of lower quality. Under our policy, at least 75% of our total assets
must be high quality mortgage-backed securities and short-term investments. High
quality securities are securities (1) that are rated within one of the two
highest rating categories by at least one of the nationally recognized rating
agencies, (2) that are unrated but are guaranteed by the United States
government or an agency of the United States government, or (3) that are unrated
or whose ratings have not been updated but that our management determines are of
comparable quality to rated high quality mortgage-backed securities.
Under our capital investment policy, the remainder of our assets,
comprising not more than 25% of total assets, may consist of mortgage-backed
securities and other qualified REIT real estate assets which are unrated or
rated less than high quality, but which are at least "investment grade" (rated
"BBB" or better by S&P or the equivalent by another nationally recognized rating
organization) or, if not rated, we determine them to be of comparable credit
quality to an investment which is rated "BBB" or better. We intend to structure
our portfolio to maintain a minimum weighted average rating (including our
deemed comparable ratings for unrated mortgage-backed securities) of our
mortgage-backed securities of at least single "A" under the S&P rating system
and at the comparable level under the other rating systems.
Our allocation of investments among the permitted investment types may
vary from time-to-time based on the evaluation by our board of directors of
economic and market trends and our perception of the relative values available
from these types of investments, except that in no event will our investments
that are not high quality exceed 25% of our total assets.
We intend to acquire only those mortgage-backed securities that we believe
we have the necessary expertise to evaluate and manage, that are consistent with
our balance sheet guidelines and risk management objectives and that we believe
we can readily finance. Since we generally hold the mortgage-backed securities
we acquire until maturity, we generally do not seek to acquire assets whose
investment returns are attractive in only a limited range of scenarios. We
believe that future interest rates and mortgage prepayment rates are very
difficult to predict. Therefore, we seek to acquire mortgage-backed securities
which we believe will provide acceptable returns over a broad range of interest
rate and prepayment scenarios.
At December 31, 2003, our mortgage-backed securities consist of
pass-through certificates and collateralized mortgage obligations issued or
guaranteed by FHLMC, FNMA or GNMA. We have not, and will not, invest in REMIC
residuals, other CMO residuals or mortgage-backed securities, such as inverse
floaters, which have imbedded leverage as part of their structural
characteristics.
DESCRIPTION OF MORTGAGE-BACKED SECURITIES
The mortgage-backed securities that we acquire provide funds for mortgage
loans made primarily to residential homeowners. Our securities generally
represent interests in pools of mortgage loans made by savings and loan
institutions, mortgage bankers, commercial banks and other mortgage lenders.
These pools of mortgage loans are assembled for sale to investors (like us) by
various government, government-related and private organizations.
Mortgage-backed securities differ from other forms of traditional debt
securities, which normally provide for periodic payments of interest in fixed
amounts with principal payments at maturity or on specified call dates. Instead,
mortgage-backed securities provide for a monthly payment, which consists of both
interest and principal. In
6
effect, these payments are a "pass-through" of the monthly interest and
principal payments made by the individual borrower on the mortgage loans, net of
any fees paid to the issuer or guarantor of the securities. Additional payments
result from prepayments of principal upon the sale, refinancing or foreclosure
of the underlying residential property, net of fees or costs which may be
incurred. Some mortgage-backed securities, such as securities issued by GNMA,
are described as "modified pass-through." These securities entitle the holder to
receive all interest and principal payments owed on the mortgage pool, net of
certain fees, regardless of whether the mortgagors actually make mortgage
payments when due.
The investment characteristics of pass-through mortgage-backed securities
differ from those of traditional fixed-income securities. The major differences
include the payment of interest and principal on the mortgage-backed securities
on a more frequent schedule, as described above, and the possibility that
principal may be prepaid at any time due to prepayments on the underlying
mortgage loans or other assets. These differences can result in significantly
greater price and yield volatility than is the case with traditional
fixed-income securities.
Various factors affect the rate at which mortgage prepayments occur,
including changes in interest rates, general economic conditions, the age of the
mortgage loan, the location of the property and other social and demographic
conditions. Generally prepayments on mortgage-backed securities increase during
periods of falling mortgage interest rates and decrease during periods of rising
mortgage interest rates. We may reinvest prepayments at a yield that is higher
or lower than the yield on the prepaid investment, thus affecting the weighted
average yield of our investments.
To the extent mortgage-backed securities are purchased at a premium,
faster than expected prepayments result in a faster than expected amortization
of the premium paid. Conversely, if these securities were purchased at a
discount, faster than expected prepayments accelerate our recognition of income.
CMOs may allow for shifting of prepayment risk from slower-paying tranches
to faster-paying tranches. This is in contrast to mortgage pass-through
certificates where all investors share equally in all payments, including all
prepayments, on the underlying mortgages.
FHLMC CERTIFICATES
FHLMC is a privately-owned government-sponsored enterprise created
pursuant to an Act of Congress on July 24, 1970. The principal activity of FHLMC
currently consists of the purchase of mortgage loans or participation interests
in mortgage loans and the resale of the loans and participations in the form of
guaranteed mortgage-backed securities. FHLMC guarantees to each holder of FHLMC
certificates the timely payment of interest at the applicable pass-through rate
and ultimate collection of all principal on the holder's pro rata share of the
unpaid principal balance of the related mortgage loans, but does not guarantee
the timely payment of scheduled principal of the underlying mortgage loans. The
obligations of FHLMC under its guarantees are solely those of FHLMC and are not
backed by the full faith and credit of the United States. If FHLMC were unable
to satisfy these obligations, distributions to holders of FHLMC certificates
would consist solely of payments and other recoveries on the underlying mortgage
loans and, accordingly, defaults and delinquencies on the underlying mortgage
loans would adversely affect monthly distributions to holders of FHLMC
certificates.
FHLMC certificates may be backed by pools of single-family mortgage loans
or multi-family mortgage loans. These underlying mortgage loans may have
original terms to maturity of up to 40 years. FHLMC certificates may be issued
under cash programs (composed of mortgage loans purchased from a number of
sellers) or guarantor programs (composed of mortgage loans acquired from one
seller in exchange for certificates representing interests in the mortgage loans
purchased).
FHLMC certificates may pay interest at a fixed rate or an adjustable rate.
The interest rate paid on adjustable-rate FHLMC certificates ("FHLMC ARMs")
adjusts periodically within 60 days prior to the month in which the interest
rates on the underlying mortgage loans adjust. The interest rates paid on
certificates issued under FHLMC's standard ARM programs adjust in relation to
the Treasury index. Other specified indices used in FHLMC ARM programs include
the 11th District Cost of Funds Index published by the Federal Home Loan Bank of
San Francisco, LIBOR and other indices. Interest rates paid on fully-indexed
FHLMC ARM certificates equal the applicable index rate plus a specified number
of basis points. The majority of series of FHLMC ARM certificates
7
issued to date have evidenced pools of mortgage loans with monthly, semi-annual
or annual interest adjustments. Adjustments in the interest rates paid are
generally limited to an annual increase or decrease of either 100 or 200 basis
points and to a lifetime cap of 500 or 600 basis points over the initial
interest rate. Certain FHLMC programs include mortgage loans which allow the
borrower to convert the adjustable mortgage interest rate to a fixed rate.
Adjustable-rate mortgages which are converted into fixed-rate mortgage loans are
repurchased by FHLMC or by the seller of the loan to FHLMC at the unpaid
principal balance of the loan plus accrued interest to the due date of the last
adjustable rate interest payment.
FNMA CERTIFICATES
FNMA is a privately-owned, federally-chartered corporation organized and
existing under the Federal National Mortgage Association Charter Act. FNMA
provides funds to the mortgage market primarily by purchasing home mortgage
loans from local lenders, thereby replenishing their funds for additional
lending. FNMA guarantees to the registered holder of a FNMA certificate that it
will distribute amounts representing scheduled principal and interest on the
mortgage loans in the pool underlying the FNMA certificate, whether or not
received, and the full principal amount of any such mortgage loan foreclosed or
otherwise finally liquidated, whether or not the principal amount is actually
received. The obligations of FNMA under its guarantees are solely those of FNMA
and are not backed by the full faith and credit of the United States. If FNMA
were unable to satisfy its obligations, distributions to holders of FNMA
certificates would consist solely of payments and other recoveries on the
underlying mortgage loans and, accordingly, defaults and delinquencies on the
underlying mortgage loans would adversely affect monthly distributions to
holders of FNMA.
FNMA certificates may be backed by pools of single-family or multi-family
mortgage loans. The original term to maturity of any such mortgage loan
generally does not exceed 40 years. FNMA certificates may pay interest at a
fixed rate or an adjustable rate. Each series of FNMA ARM certificates bears an
initial interest rate and margin tied to an index based on all loans in the
related pool, less a fixed percentage representing servicing compensation and
FNMA's guarantee fee. The specified index used in different series has included
the Treasury Index, the 11th District Cost of Funds Index published by the
Federal Home Loan Bank of San Francisco, LIBOR and other indices. Interest rates
paid on fully-indexed FNMA ARM certificates equal the applicable index rate plus
a specified number of basis points. The majority of series of FNMA ARM
certificates issued to date have evidenced pools of mortgage loans with monthly,
semi-annual or annual interest rate adjustments. Adjustments in the interest
rates paid are generally limited to an annual increase or decrease of either 100
or 200 basis points and to a lifetime cap of 500 or 600 basis points over the
initial interest rate. Certain FNMA programs include mortgage loans which allow
the borrower to convert the adjustable mortgage interest rate of the ARM to a
fixed rate. Adjustable-rate mortgages which are converted into fixed-rate
mortgage loans are repurchased by FNMA or by the seller of the loans to FNMA at
the unpaid principal of the loan plus accrued interest to the due date of the
last adjustable rate interest payment. Adjustments to the interest rates on FNMA
ARM certificates are typically subject to lifetime caps and periodic rate or
payment caps.
GNMA CERTIFICATES
GNMA is a wholly owned corporate instrumentality of the United States
within the Department of Housing and Urban Development ("HUD"). The National
Housing Act of 1934 authorizes GNMA to guarantee the timely payment of the
principal of and interest on certificates which represent an interest in a pool
of mortgages insured by the Federal Housing Administration ("FHA") or partially
guaranteed by the Department of Veterans Affairs and other loans eligible for
inclusion in mortgage pools underlying GNMA certificates. Section 306(g) of the
Housing Act provides that the full faith and credit of the United States is
pledged to the payment of all amounts which may be required to be paid under any
guaranty by GNMA.
At present, most GNMA certificates are backed by single-family mortgage
loans. The interest rate paid on GNMA certificates may be a fixed rate or an
adjustable rate. The interest rate on GNMA certificates issued under GNMA's
standard ARM program adjusts annually in relation to the Treasury index.
Adjustments in the interest rate are generally limited to an annual increase or
decrease of 100 basis points and to a lifetime cap of 500 basis points over the
initial coupon rate.
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SINGLE-FAMILY AND MULTI-FAMILY PRIVATELY-ISSUED CERTIFICATES
Single-family and multi-family privately-issued certificates are
pass-through certificates that are not issued by one of the agencies and that
are backed by a pool of conventional single-family or multi-family mortgage
loans. These certificates are issued by originators of, investors in, and other
owners of mortgage loans, including savings and loan associations, savings
banks, commercial banks, mortgage banks, investment banks and special purpose
"conduit" subsidiaries of these institutions.
While agency pass-through certificates are backed by the express
obligation or guarantee of one of the agencies, as described above,
privately-issued certificates are generally covered by one or more forms of
private (i.e., non-governmental) credit enhancements. These credit enhancements
provide an extra layer of loss coverage in the event that losses are incurred
upon foreclosure sales or other liquidations of underlying mortgaged properties
in amounts that exceed the equity holder's equity interest in the property.
Forms of credit enhancements include limited issuer guarantees, reserve funds,
private mortgage guaranty pool insurance, over-collateralization and
subordination.
Subordination is a form of credit enhancement frequently used and involves
the issuance of classes of senior and subordinated mortgage-backed securities.
These classes are structured into a hierarchy to allocate losses on the
underlying mortgage loans and also for defining priority of rights to payment of
principal and interest. Typically, one or more classes of senior securities are
created which are rated in one of the two highest rating levels by one or more
nationally recognized rating agencies and which are supported by one or more
classes of mezzanine securities and subordinated securities that bear losses on
the underlying loans prior to the classes of senior securities. Mezzanine
securities, as used in this Form 10-K, refers to classes that are rated below
the two highest levels, but no lower than a single "B" rating under the S&P
rating system (or comparable level under other rating systems) and are supported
by one or more classes of subordinated securities which bear realized losses
prior to the classes of mezzanine securities. Subordinated securities, as used
in this Form 10-K, refers to any class that bears the "first loss" from losses
from underlying mortgage loans or that is rated below a single "B" level (or, if
unrated, we deem it to be below that level). In some cases, only classes of
senior securities and subordinated securities are issued. By adjusting the
priority of interest and principal payments on each class of a given series of
senior-subordinated mortgage-backed securities, issuers are able to create
classes of mortgage-backed securities with varying degrees of credit exposure,
prepayment exposure and potential total return, tailored to meet the needs of
sophisticated institutional investors.
COLLATERALIZED MORTGAGE OBLIGATIONS AND MULTI-CLASS PASS-THROUGH
SECURITIES
We may also invest in CMOs and multi-class pass-through securities. CMOs
are debt obligations issued by special purpose entities that are secured by
mortgage loans or mortgage-backed certificates, including, in many cases,
certificates issued by government and government-related guarantors, including,
GNMA, FNMA and FHLMC, together with certain funds and other collateral.
Multi-class pass-through securities are equity interests in a trust composed of
mortgage loans or other mortgage-backed securities. Payments of principal and
interest on underlying collateral provide the funds to pay debt service on the
CMO or make scheduled distributions on the multi-class pass-through securities.
CMOs and multi-class pass-through securities may be issued by agencies or
instrumentalities of the U.S. Government or by private organizations. The
discussion of CMOs in the following paragraphs is similarly applicable to
multi-class pass-through securities.
In a CMO, a series of bonds or certificates is issued in multiple classes.
Each class of CMOs, often referred to as a "tranche," is issued at a specific
coupon rate (which, as discussed below, may be an adjustable rate subject to a
cap) and has a stated maturity or final distribution date. Principal prepayments
on collateral underlying a CMO may cause it to be retired substantially earlier
than the stated maturity or final distribution date. Interest is paid or accrues
on all classes of a CMO on a monthly, quarterly or semi-annual basis. The
principal and interest on underlying mortgages may be allocated among the
several classes of a series of a CMO in many ways. In a common structure,
payments of principal, including any principal prepayments, on the underlying
mortgages are applied to the classes of the series of a CMO in the order of
their respective stated maturities or final distribution dates, so that no
payment of principal will be made on any class of a CMO until all other classes
having an earlier stated maturity or final distribution date have been paid in
full.
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Other types of CMO issues include classes such as parallel pay CMOs, some
of which, such as planned amortization class CMOs ("PAC bonds"), provide
protection against prepayment uncertainty. Parallel pay CMOs are structured to
provide payments of principal on certain payment dates to more than one class.
These simultaneous payments are taken into account in calculating the stated
maturity date or final distribution date of each class which, as with other CMO
structures, must be retired by its stated maturity date or final distribution
date but may be retired earlier. PAC bonds generally require payment of a
specified amount of principal on each payment date so long as prepayment speeds
on the underlying collateral fall within a specified range.
Other types of CMO issues include targeted amortization class CMOs (or TAC
bonds), which are similar to PAC bonds. While PAC bonds maintain their
amortization schedule within a specified range of prepayment speeds, TAC bonds
are generally targeted to a narrow range of prepayment speeds or a specified
prepayment speed. TAC bonds can provide protection against prepayment
uncertainty since cash flows generated from higher prepayments of the underlying
mortgage-related assets are applied to the various other pass-through tranches
so as to allow the TAC bonds to maintain their amortization schedule.
A CMO may be subject to the issuer's right to redeem the CMO prior to its
stated maturity date, which may diminish the anticipated return on our
investment. Privately-issued CMOs are supported by private credit enhancements
similar to those used for privately-issued certificates and are often issued as
senior-subordinated mortgage-backed securities. We will only acquire CMOs or
multi-class pass-through certificates that constitute debt obligations or
beneficial ownership in grantor trusts holding mortgage loans, or regular
interests in REMICs, or that otherwise constitute qualified REIT real estate
assets under the Internal Revenue Code (provided that we have obtained a
favorable opinion of our tax advisor or a ruling from the IRS to that effect).
ADJUSTABLE-RATE MORTGAGE PASS-THROUGH CERTIFICATES AND FLOATING RATE
MORTGAGE-BACKED SECURITIES
Most of the mortgage pass-through certificates we acquire are
adjustable-rate mortgage pass-through certificates. This means that their
interest rates may vary over time based upon changes in an objective index, such
as:
o LIBOR OR THE LONDON INTERBANK OFFERED RATE. The interest rate that
banks in London offer for deposits in London of U.S. dollars.
o TREASURY INDEX. A monthly or weekly average yield of benchmark U.S.
Treasury securities, as published by the Federal Reserve Board.
o CD RATE. The weekly average of secondary market interest rates on
six-month negotiable certificates of deposit, as published by the
Federal Reserve Board.
These indices generally reflect short-term interest rates. The underlying
mortgages for adjustable-rate mortgage pass-through certificates are
adjustable-rate mortgage loans ("ARMs").
We also acquire CMO floaters. One or more tranches of a CMO may have
coupon rates that reset periodically at a specified increment over an index such
as LIBOR. These adjustable-rate tranches are sometime known as CMO floaters and
may be backed by fixed or adjustable-rate mortgages.
There are two main categories of indices for adjustable-rate mortgage
pass-through certificates and floaters: (1) those based on U.S. Treasury
securities, and (2) those derived from calculated measures such as a cost of
funds index or a moving average of mortgage rates. Commonly utilized indices
include the one-year Treasury note rate, the three-month Treasury bill rate, the
six-month Treasury bill rate, rates on long-term Treasury securities, the 11th
District Federal Home Loan Bank Costs of Funds Index, the National Median Cost
of Funds Index, one-month or three-month LIBOR, the prime rate of a specific
bank, or commercial paper rates. Some indices, such as the one-year Treasury
rate, closely mirror changes in market interest rate levels. Others, such as the
11th District Home Loan Bank Cost of Funds Index, tend to lag changes in market
interest rate levels. We seek to diversify our investments in adjustable-rate
mortgage pass-through certificates and floaters among a variety of indices and
reset periods so that we are not at any one time unduly exposed to the risk of
interest rate fluctuations. In selecting
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adjustable-rate mortgage pass-through certificates and floaters for investment,
we will also consider the liquidity of the market for the different
mortgage-backed securities.
We believe that adjustable-rate mortgage pass-through certificates and
floaters are particularly well-suited to our investment objective of high
current income, consistent with modest volatility of net asset value, because
the value of adjustable-rate mortgage pass-through certificates and floaters
generally remains relatively stable as compared to traditional fixed-rate debt
securities paying comparable rates of interest. While the value of
adjustable-rate mortgage pass-through certificates and floaters, like other debt
securities, generally varies inversely with changes in market interest rates
(increasing in value during periods of declining interest rates and decreasing
in value during periods of increasing interest rates), the value of
adjustable-rate mortgage pass-through certificates and floaters should generally
be more resistant to price swings than other debt securities because the
interest rates on these securities move with market interest rates.
Accordingly, as interest rates change, the value of our shares should be
more stable than the value of funds which invest primarily in securities backed
by fixed-rate mortgages or in other non-mortgage-backed debt securities, which
do not provide for adjustment in the interest rates in response to changes in
market interest rates.
Adjustable-rate mortgage pass-through certificates and floaters typically
have caps, which limit the maximum amount by which the interest rate may be
increased or decreased at periodic intervals or over the life of the security.
To the extent that interest rates rise faster than the allowable caps on the
adjustable-rate mortgage pass-through certificates and floaters, these
securities will behave more like fixed-rate securities. Consequently, interest
rate increases in excess of caps can be expected to cause these securities to
behave more like traditional debt securities than adjustable-rate securities
and, accordingly, to decline in value to a greater extent than would be the case
in the absence of these caps.
Adjustable-rate mortgage pass-through certificates and floaters, like
other mortgage-backed securities, differ from conventional bonds in that
principal is to be paid back over the life of the security rather than at
maturity. As a result, we receive monthly scheduled payments of principal and
interest on these securities and may receive unscheduled principal payments
representing prepayments on the underlying mortgages. When we reinvest the
payments and any unscheduled prepayments we receive, we may receive a rate of
interest on the reinvestment which is lower than the rate on the existing
security. For this reason, adjustable-rate mortgage pass-through certificates
and floaters are less effective than longer-term debt securities as a means of
"locking in" longer-term interest rates. Accordingly, adjustable-rate mortgage
pass-through certificates and floaters, while generally having less risk of
price decline during periods of rapidly rising interest rates than fixed-rate
mortgage-backed securities of comparable maturities, have less potential for
capital appreciation than fixed-rate securities during periods of declining
interest rates.
As in the case of fixed-rate mortgage-backed securities, to the extent
these securities are purchased at a premium, faster than expected prepayments
would accelerate our amortization of the premium. Conversely, if these
securities were purchased at a discount, faster than expected prepayments would
accelerate our recognition of income.
As in the case of fixed-rate CMOs, floating-rate CMOs may allow for
shifting of prepayment risk from slower-paying tranches to faster-paying
tranches. This is in contrast to mortgage pass-through certificates where all
investors share equally in all payments, including all prepayments, on the
underlying mortgages.
OTHER FLOATING RATE INSTRUMENTS
We may also invest in structured floating-rate notes issued or guaranteed
by government agencies, such as FNMA and FHLMC. These instruments are typically
structured to reflect an interest rate arbitrage (i.e., the difference between
the agency's cost of funds and the income stream from specified assets of the
agency) and their reset formulas may provide more attractive returns than other
floating rate instruments. The indices used to determine resets are the same as
those described above.
MORTGAGE LOANS
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We have not as of December 31, 2003, but we may from time-to-time invest a
small percentage of our assets directly in single-family, multi-family or
commercial mortgage loans. We expect that the majority of these mortgage loans
would be ARM pass-through certificates. The interest rate on an ARM through
certificate is typically tied to an index (such as LIBOR or the interest rate on
Treasury bills), and is adjustable periodically at specified intervals. These
mortgage loans are typically subject to lifetime interest rate caps and periodic
interest rate or payment caps. The acquisition of mortgage loans generally
involves credit risk. We may obtain credit enhancement to mitigate this risk;
however, there can be no assurances that we will able to obtain credit
enhancement or that credit enhancement would mitigate the credit risk of the
underlying mortgage loans.
CAPITAL INVESTMENT POLICY
ASSET ACQUISITIONS
Our capital investment policy provides that at least 75% of our total
assets will be comprised of high quality mortgage-backed securities and
short-term investments. The remainder of our assets (comprising not more than
25% of total assets), may consist of mortgage-backed securities and other
qualified REIT real estate assets which are unrated or rated less than high
quality but which are at least "investment grade" (rated "BBB" or better) or, if
not rated, are determined by us to be of comparable credit quality to an
investment which is rated "BBB" or better.
Our capital investment policy requires that we structure our portfolio to
maintain a minimum weighted average rating (including our deemed comparable
ratings for unrated mortgage-backed securities) of our mortgage-backed
securities of at least single "A" under the S&P rating system and at the
comparable level under the other rating systems. To date, all of the
mortgage-backed securities we have acquired have been pass-through certificates
or CMOs issued or guaranteed by FHLMC, FNMA or GNMA which, although not rated,
have an implied "AAA" rating.
We intend to acquire only those mortgage-backed securities which we
believe we have the necessary expertise to evaluate and manage, which we can
readily finance and which are consistent with our balance sheet guidelines and
risk management objectives. Since we expect to hold our mortgage-backed
securities until maturity, we generally do not seek to acquire assets whose
investment returns are only attractive in a limited range of scenarios. We
believe that future interest rates and mortgage prepayment rates are very
difficult to predict and, as a result, we seek to acquire mortgage-backed
securities which we believe provide acceptable returns over a broad range of
interest rate and prepayment scenarios.
Among the asset choices available to us, our policy is to acquire those
mortgage-backed securities which we believe generate the highest returns on
capital invested, after consideration of the following:
o the amount and nature of anticipated cash flows from the asset;
o our ability to pledge the asset to secure collateralized borrowings;
o the increase in our capital requirement determined by our capital
investment policy resulting from the purchase and financing of the
asset; and
o the costs of financing, hedging, managing and reserving for the
asset.
Prior to acquisition, we assess potential returns on capital employed over the
life of the asset and in a variety of interest rate, yield spread, financing
cost, credit loss and prepayment scenarios.
We also give consideration to balance sheet management and risk
diversification issues. We deem a specific asset which we are evaluating for
potential acquisition as more or less valuable to the extent it serves to
increase or decrease certain interest rate or prepayment risks which may exist
in the balance sheet, to diversify or concentrate credit risk, and to meet the
cash flow and liquidity objectives our management may establish for our balance
sheet from time-to-time. Accordingly, an important part of the asset evaluation
process is a simulation, using risk management models, of the addition of a
potential asset and our associated borrowings and hedges to the
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balance sheet and an assessment of the impact this potential asset acquisition
would have on the risks in and returns generated by our balance sheet as a whole
over a variety of scenarios.
We focus primarily on the acquisition of adjustable-rate mortgage-backed
securities, including floaters. We have, however, purchased a significant amount
of fixed-rate mortgage-backed securities and may continue to do so in the future
if, in our view, the potential returns on capital invested, after hedging and
all other costs, would exceed the returns available from other assets or if the
purchase of these assets would serve to reduce or diversify the risks of our
balance sheet.
Although we have not yet done so, we may purchase the stock of mortgage
REITs or similar companies when we believe that these purchases would yield
attractive returns on capital employed. When the stock market valuations of
these companies are low in relation to the market value of their assets, these
stock purchases can be a way for us to acquire an interest in a pool of
mortgage-backed securities at an attractive price. We do not, however, presently
intend to invest in the securities of other issuers for the purpose of
exercising control or to underwrite securities of other issuers.
We may acquire newly issued mortgage-backed securities, and also will seek
to expand our capital base in order to further increase our ability to acquire
new assets, when the potential returns from new investments appears attractive
relative to the return expectations of stockholders. We may in the future
acquire mortgage-backed securities by offering our debt or equity securities in
exchange for the mortgage-backed securities.
We generally intend to hold mortgage-backed securities for extended
periods. In addition, the REIT provisions of the Internal Revenue Code limit in
certain respects our ability to sell mortgage-backed securities. We may decide
however to sell assets from time-to-time, for a number of reasons, including our
desire to dispose of an asset as to which credit risk concerns have arisen, to
reduce interest rate risk, to substitute one type of mortgage-backed security
for another, to improve yield or to maintain compliance with the 55% requirement
under the Investment Company Act, and generally to re-structure the balance
sheet when we deem advisable. Our board of directors has not adopted any policy
that would restrict management's authority to determine the timing of sales or
the selection of mortgage-backed securities to be sold.
We do not invest in principal-only interests in mortgage-backed
securities, residual interests, accrual bonds, inverse-floaters, two-tiered
index bonds, cash flow bonds, mortgage-backed securities with imbedded leverage
or mortgage-backed securities that would be deemed unacceptable for
collateralized borrowings, excluding shares in mortgage REITs.
As a requirement for maintaining REIT status, we will distribute to
stockholders aggregate dividends equaling at least 90% of our REIT taxable
income (determined without regard to the deduction for dividends paid and by
excluding any net capital gain) for each taxable year. We will make additional
distributions of capital when the return expectations of the stockholders appear
to exceed returns potentially available to us through making new investments in
mortgage-backed securities. Subject to the limitations of applicable securities
and state corporation laws, we can distribute capital by making purchases of our
own capital stock or through paying down or repurchasing any outstanding
uncollateralized debt obligations.
Our asset acquisition strategy may change over time as market conditions
change and as we evolve.
CREDIT RISK MANAGEMENT
We have not taken on credit risk to date, but may do so in the future. In
that event, we will review credit risk and other risk of loss associated with
each investment and determine the appropriate allocation of capital to apply to
the investment under our capital investment policy. Our board of directors will
monitor the overall portfolio risk and determine appropriate levels of provision
for loss.
CAPITAL AND LEVERAGE
We expect generally to maintain a debt-to-equity ratio of between 8:1 and
12:1, although the ratio may vary from time-to-time depending upon market
conditions and other factors our management deems relevant, including the
composition of our balance sheet, haircut levels required by lenders, the market
value of the mortgage-backed
13
securities in our portfolio and "excess capital cushion" percentages (as
described below) set by our board of directors from time to time. For purposes
of calculating this ratio, our equity (or capital base) is equal to the value of
our investment portfolio on a mark-to-market basis less the book value of our
obligations under repurchase agreements and other collateralized borrowings. At
December 31, 2003, our ratio of debt-to-equity was 9.6:1.
Our goal is to strike a balance between the under-utilization of leverage,
which reduces potential returns to stockholders, and the over-utilization of
leverage, which could reduce our ability to meet our obligations during adverse
market conditions. Our capital investment policy limits our ability to acquire
additional assets during times when our debt-to-equity ratio exceeds 12:1. Our
capital base represents the approximate liquidation value of our investments and
approximates the market value of assets that we can pledge or sell to meet
over-collateralization requirements for our borrowings. The unpledged portion of
our capital base is available for us to pledge or sell as necessary to maintain
over-collateralization levels for our borrowings.
We are prohibited from acquiring additional assets during periods when our
capital base is less than the minimum amount required under our capital
investment policy, except as may be necessary to maintain REIT status or our
exemption from the Investment Company Act of 1940, as amended (the "Investment
Company Act"). In addition, when our capital base falls below our risk-managed
capital requirement, our management is required to submit to our board of
directors a plan for bringing our capital base into compliance with our capital
investment policy guidelines. We anticipate that in most circumstances we can
achieve this goal without overt management action through the natural process of
mortgage principal repayments. We anticipate that our capital base is likely to
exceed our risk-managed capital requirement during periods following new equity
offerings and during periods of falling interest rates and that our capital base
could fall below the risk-managed capital requirement during periods of rising
interest rates.
The first component of our capital requirements is the current aggregate
over-collateralization amount or "haircut" the lenders require us to hold as
capital. The haircut for each mortgage-backed security is determined by our
lenders based on the risk characteristics and liquidity of the asset. Haircut
levels on individual borrowings generally range from 3% for certain FHLMC, FNMA
or GNMA mortgage-backed securities to 20% for certain privately-issued
mortgage-backed securities. At December 31, 2003, the weighted average haircut
level on our securities was 3.52%. Should the market value of our pledged assets
decline, we will be required to deliver additional collateral to our lenders to
maintain a constant over-collateralization level on our borrowings.
The second component of our capital requirement is the "excess capital
cushion." This is an amount of capital in excess of the haircuts required by our
lenders. We maintain the excess capital cushion to meet the demands of our
lenders for additional collateral should the market value of our mortgage-backed
securities decline. The aggregate excess capital cushion equals the sum of
liquidity cushion amounts assigned under our capital investment policy to each
of our mortgage-backed securities. We assign excess capital cushions to each
mortgage-backed security based on our assessment of the mortgage-backed
security's market price volatility, credit risk, liquidity and attractiveness
for use as collateral by lenders. The process of assigning excess capital
cushions relies on our management's ability to identify and weigh the relative
importance of these and other factors. In assigning excess capital cushions, we
also give consideration to hedges associated with the mortgage-backed security
and any effect such hedges may have on reducing net market price volatility,
concentration or diversification of credit and other risks in the balance sheet
as a whole and the net cash flows that we can expect from the interaction of the
various components of our balance sheet.
Our capital investment policy stipulates that at least 25% of the capital
base maintained to satisfy the excess capital cushion must be invested in
AAA-rated adjustable-rate mortgage-backed securities or assets with similar or
better liquidity characteristics.
A substantial portion of our borrowings are short-term or variable-rate
borrowings. Our borrowings are implemented primarily through repurchase
agreements, but in the future may also be obtained through loan agreements,
lines of credit, dollar-roll agreements (an agreement to sell a security for
delivery on a specified future date and a simultaneous agreement to repurchase
the same or a substantially similar security on a specified future date) and
other credit facilities with institutional lenders and issuance of debt
securities such as commercial paper, medium-term notes, CMOs and senior or
subordinated notes. We enter into financing transactions only with
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institutions that we believe are sound credit risks and follow other internal
policies designed to limit our credit and other exposure to financing
institutions.
We expect to continue to use repurchase agreements as our principal
financing device to leverage our mortgage-backed securities portfolio. We
anticipate that, upon repayment of each borrowing under a repurchase agreement,
we will use the collateral immediately for borrowing under a new repurchase
agreement. At present, we have entered into uncommitted facilities with 29
lenders for borrowings in the form of repurchase agreements. We have not at the
present time entered into any commitment agreements under which the lender would
be required to enter into new repurchase agreements during a specified period of
time, nor do we presently plan to have liquidity facilities with commercial
banks. We may, however, enter into such commitment agreements in the future. We
enter into repurchase agreements primarily with national broker-dealers,
commercial banks and other lenders which typically offer this type of financing.
We enter into collateralized borrowings only with financial institutions meeting
credit standards approved by our board of directors, and we monitor the
financial condition of these institutions on a regular basis.
A repurchase agreement, although structured as a sale and repurchase
obligation, acts as a financing under which we effectively pledge our
mortgage-backed securities as collateral to secure a short-term loan. Generally,
the other party to the agreement makes the loan in an amount equal to a
percentage of the market value of the pledged collateral. At the maturity of the
repurchase agreement, we are required to repay the loan and correspondingly
receive back our collateral. While used as collateral, the mortgage-backed
securities continue to pay principal and interest which are for our benefit. In
the event of our insolvency or bankruptcy, certain repurchase agreements may
qualify for special treatment under the Bankruptcy Code, the effect of which,
among other things, would be to allow the creditor under the agreement to avoid
the automatic stay provisions of the Bankruptcy Code and to foreclose on the
collateral agreement without delay. In the event of the insolvency or bankruptcy
of a lender during the term of a repurchase agreement, the lender may be
permitted, under applicable insolvency laws, to repudiate the contract, and our
claim against the lender for damages may be treated simply as an unsecured
creditor. In addition, if the lender is a broker or dealer subject to the
Securities Investor Protection Act of 1970, or an insured depository institution
subject to the Federal Deposit Insurance Act, our ability to exercise our rights
to recover our securities under a repurchase agreement or to be compensated for
any damages resulting from the lender's insolvency may be further limited by
those statutes. These claims would be subject to significant delay and, if and
when received, may be substantially less than the damages we actually incur.
Substantially all of our borrowing agreements require us to deposit
additional collateral in the event the market value of existing collateral
declines, which may require us to sell assets to reduce our borrowings. We have
designed our liquidity management policy to maintain a cushion of equity
sufficient to provide required liquidity to respond to the effects under our
borrowing arrangements of interest rate movements and changes in market value of
our mortgage-backed securities, as described above. However, a major disruption
of the repurchase or other market that we rely on for short-term borrowings
would have a material adverse effect on us unless we were able to arrange
alternative sources of financing on comparable terms.
Our articles of incorporation and bylaws do not limit our ability to incur
borrowings, whether secured or unsecured.
INTEREST RATE RISK MANAGEMENT
To the extent consistent with our election to qualify as a REIT, we follow
an interest rate risk management program intended to protect our portfolio of
mortgage-backed securities and related debt against the effects of major
interest rate changes. Specifically, our interest rate risk management program
is formulated with the intent to offset the potential adverse effects resulting
from rate adjustment limitations on our mortgage-backed securities and the
differences between interest rate adjustment indices and interest rate
adjustment periods of our adjustable-rate mortgage-backed securities and related
borrowings.
Our interest rate risk management program encompasses a number of
procedures, including the following:
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o we attempt to structure our borrowings to have interest rate
adjustment indices and interest rate adjustment periods that, on an
aggregate basis, generally correspond to the interest rate
adjustment indices and interest rate adjustment periods of our
adjustable-rate mortgage-backed securities; and
o we attempt to structure our borrowing agreements relating to
adjustable-rate mortgage-backed securities to have a range of
different maturities and interest rate adjustment periods (although
substantially all will be less than one year).
We adjust the average maturity adjustment periods of our borrowings on an
ongoing basis by changing the mix of maturities and interest rate adjustment
periods as borrowings come due and are renewed. Through use of these procedures,
we attempt to minimize the differences between the interest rate adjustment
periods of our mortgage-backed securities and related borrowings that may occur.
Although we have not done so to date, we may purchase from time-to-time
interest rate swaps, interest rate collars, interest rate caps or floors,
"interest only" mortgage-backed securities and similar instruments to attempt to
mitigate the risk of the cost of our variable rate liabilities increasing at a
faster rate than the earnings on our assets during a period of rising interest
rates or to mitigate prepayment risk. We may hedge as much of the interest rate
risk as our management determines is in our best interests, given the cost of
the hedging transactions and the need to maintain our status as a REIT. This
determination may result in our electing to bear a level of interest rate or
prepayment risk that could otherwise be hedged when management believes, based
on all relevant facts, that bearing the risk is advisable.
We seek to build a balance sheet and undertake an interest rate risk
management program which is likely to generate positive earnings and maintain an
equity liquidation value sufficient to maintain operations given a variety of
potentially adverse circumstances. Accordingly, our interest rate risk
management program addresses both income preservation, as discussed above, and
capital preservation concerns. For capital preservation, we monitor our
"duration." This is the expected percentage change in market value of our assets
that would be caused by a 1% change in short and long-term interest rates. To
monitor duration and the related risks of fluctuations in the liquidation value
of our equity, we model the impact of various economic scenarios on the market
value of our mortgage-backed securities and liabilities. At December 31, 2003,
we estimate that the duration of our assets was 0.9%. We believe that our
interest rate risk management program will allow us to maintain operations
throughout a wide variety of potentially adverse circumstances. Nevertheless, in
order to further preserve our capital base (and lower our duration) during
periods when we believe a trend of rapidly rising interest rates has been
established, we may decide to enter into or increase hedging activities or to
sell assets. Each of these actions may lower our earnings and dividends in the
short term to further our objective of maintaining attractive levels of earnings
and dividends over the long term.
We may elect to conduct a portion of our hedging operations through one or
more subsidiary corporations which would not be a qualified REIT subsidiary and
would be subject to federal and state income taxes. To comply with the asset
tests applicable to us as a REIT, the value of the securities of any taxable
subsidiary we hold must be limited to less than 5% of the value of our total
assets as of the end of each calendar quarter and we may not own more than 10%
of the voting securities of the taxable subsidiary. We could, however, elect to
treat a subsidiary as a "taxable REIT subsidiary," in which case we could own
100% of the voting stock of such subsidiary, provided that the value of the
stock that we own in all such taxable REIT subsidiaries does not exceed 20% of
the value of our total assets at the close of any calendar quarter. A taxable
subsidiary would not elect REIT status and would distribute any net profit after
taxes to us and its other stockholders. Any dividend income we receive from the
taxable subsidiary (combined with all other income generated from our assets,
other than qualified REIT real estate assets) must not exceed 25% of our gross
income.
We believe that we have developed a cost-effective asset/liability
management program to provide a level of protection against interest rate and
prepayment risks. However, no strategy can completely insulate us from interest
rate changes and prepayment risks. Further, as noted above, the federal income
tax requirements that we must satisfy to qualify as a REIT limit our ability to
hedge our interest rate and prepayment risks. We monitor carefully, and may have
to limit, our asset/liability management program to assure that we do not
realize excessive hedging income, or hold hedging assets having excess value in
relation to total assets, which would result in our disqualification as a REIT
or, in the case of excess hedging income, the payment of a penalty tax for
failure to
16
satisfy certain REIT income tests under the Internal Revenue Code, provided the
failure was for reasonable cause. In addition, asset/liability management
involves transaction costs which increase dramatically as the period covered by
the hedging protection increases. Therefore, we may be unable to hedge
effectively our interest rate and prepayment risks.
PREPAYMENT RISK MANAGEMENT
We seek to minimize the effects of faster or slower than anticipated
prepayment rates through structuring a diversified portfolio with a variety of
prepayment characteristics, investing in mortgage-backed securities with
prepayment prohibitions and penalties, investing in certain mortgage-backed
security structures which have prepayment protections, and balancing assets
purchased at a premium with assets purchased at a discount. We monitor
prepayment risk through periodic review of the impact of a variety of prepayment
scenarios on our revenues, net earnings, dividends, cash flow and net balance
sheet market value.
FUTURE REVISIONS IN POLICIES AND STRATEGIES
Our board of directors has established the investment policies and
operating policies and strategies set forth in this Form 10-K. The board of
directors has the power to modify or waive these policies and strategies without
the consent of the stockholders to the extent that the board of directors
determines that the modification or waiver is in the best interests of our
stockholders. Among other factors, developments in the market which affect our
policies and strategies or which change our assessment of the market may cause
our board of directors to revise our policies and strategies.
ACQUISITION OF FIDAC
Michael A.J. Farrell, our Chairman of the Board, Chief Executive Officer
and President, on behalf of FIDAC, approached us about the possibility of us
acquiring FIDAC. Our board of directors formed a special committee of
independent directors to consider this matter and the special committee retained
independent counsel and Lehman Brothers Inc. to act as its financial advisor in
connection with the proposed acquisition. Following negotiations between FIDAC
and the special committee, the special committee determined that we should
acquire FIDAC and we entered into a Merger Agreement, dated December 31, 2003,
by and among, us, FIDAC, FDC Merger Sub, Inc., and the FIDAC stockholders (the
"Merger Agreement"). A copy of the Merger Agreement has been filed as an exhibit
to the Form 8-K filed with the SEC.
Pursuant to the Merger Agreement, FIDAC will be merged into a newly formed
wholly owned subsidiary of ours. The closing of the merger is subject to a
number of conditions, including the approval of our stockholders as described
below.
Mr. Farrell, our Chairman of the Board, Chief Executive Officer and
President, Wellington J. Denahan, our Vice Chairman and Chief Investment
Officer, Kathryn F. Fagan, our Chief Financial Officer and Treasurer, Jennifer
S. Karve, our Executive Vice President and Secretary, and other of our officers
and employees are shareholders of FIDAC. Mr. Farrell, Ms. Denahan and other
officers and employees are actively involved in managing mortgage-backed
securities and other fixed income assets on behalf of FIDAC.
FIDAC is a registered investment advisor which, at December 31, 2003,
managed, assisted in managing or supervised approximately $13.6 billion in gross
assets for a wide array of clients on a discretionary basis. FIDAC is a
fee-based asset management business with a global distribution reach. FIDAC
generally receives annual net investment advisory fees of approximately 10 to 15
basis points of the gross assets it manages, assists in managing or supervises.
We anticipate that the acquisition will have a positive effect on our earnings
per share under current market conditions. However, it is uncertain whether the
acquisition will be accretive to our earnings per share on a prospective basis.
Under the Merger Agreement with FIDAC, the purchase price will be payable
in shares of our common stock. Upon the consummation of the merger, we will
issue shares of our common stock worth $40.5 million, based upon a valuation of
shares of our common stock as of December 31, 2003, to the stockholders of
FIDAC. The Merger Agreement includes an earn-out feature, under which we will
pay up to an additional $49.5 million, which
17
will be payable in shares of our common stock, to the stockholders of FIDAC if
FIDAC meets certain revenue and pre-tax profit margin targets over the next
three years as described in the Merger Agreement.
The shares of our common stock issued upon consummation of the merger with
FIDAC will be registered under federal securities laws. The shares issued to the
stockholders of FIDAC upon consummation of the merger will be subject to
restrictions on resale for three years after completion of the merger, subject
to certain exceptions. The shares issued to the stockholders of FIDAC under the
earn-out feature will be subject to restrictions on resale for either two years
or one year after the applicable earn-out period, subject to certain exceptions.
The Merger Agreement is subject to the approval of our stockholders and
several other conditions. A vote on the Merger Agreement will be held at the
next meeting of our stockholders. Approval of the Merger Agreement will require
the affirmative vote of the holders of a majority of our shares of common stock
voting at the stockholder meeting as long as the total vote cast at the
stockholder meeting represents a majority of the shares entitled to vote at the
stockholder meeting. Pursuant to the Merger Agreement, the FIDAC stockholders
have agreed to vote any shares of our common stock owned of record by them in
accordance with, and in the same proportion as, the votes cast by our
stockholders who are not FIDAC stockholders in connection with the merger. We
are not certain that our stockholders will approve the Merger Agreement or that
the other conditions to the merger will be satisfied. If the merger is not
completed, we expect to continue to operate under our facilities-sharing
arrangement that we currently have with FIDAC.
The information contained herein with respect to the proposed merger and
issuance of our shares of common stock therein is neither an offer to sell nor a
solicitation of an offer to buy any shares of our common stock. In connection
with the proposed transaction, we will file a Form S-4 registration statement,
which contains a proxy statement/prospectus, with the SEC. The proxy
statement/prospectus will provide important information, including detailed risk
factors, regarding the proposed acquisition. A copy of the proxy
statement/prospectus and other relevant documents will be available free of
charge at the SEC's website (www.sec.gov) or can be obtained free of charge by
directing a request to us at Annaly Mortgage Management, Inc., 1211 Avenue of
the Americas, Suite 2902, New York, NY 10036, Phone: (212) 696-0100, Facsimile:
(212) 696-9809, Attention: Kathryn Fagan, or can be obtained free of charge
through our website (www.annaly.com) as soon as reasonably practicable after
such material is filed with or furnished to the SEC. There is no assurance that
the proposed acquisition will be consummated or that the terms of the
acquisition or the timing or effects thereof will not differ materially from
those described in the proxy statement/prospectus and other relevant documents.
POTENTIAL ACQUISITIONS, STRATEGIC ALLIANCES AND OTHER INVESTMENTS
From time-to-time we have had discussions with other parties regarding
possible transactions including acquisitions of other businesses or assets,
investments in other entities, joint venture arrangements, or strategic
alliances. To date, except for the acquisition of FIDAC, none of these
discussions have gone beyond the preliminary stage. We have also considered from
time-to-time entering into related businesses, although to date we have not
entered into such businesses.
We may, from time-to- time, continue to explore possible acquisitions,
investments, joint venture arrangements and strategic alliances. Prior to making
any equity investment, we will consult with our tax advisors.
DIVIDEND REINVESTMENT AND SHARE PURCHASE PLAN
We have adopted a dividend reinvestment and share purchase plan. Under the
dividend reinvestment feature of the plan, existing shareholders can reinvest
their dividends in additional shares of our common stock. Under the share
purchase feature of the plan, new and existing shareholders can purchase shares
of our common stock. We have filed and the SEC has declared effective a Form S-3
registration statement registering 2,000,000 shares that may be issued under the
plan.
LEGAL PROCEEDINGS
There are no material pending legal proceedings to which we are a party or
to which any of our property is subject.
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AVAILABLE INFORMATION
Our investor relations website is WWW.ANNALY.COM. We make available on
this website under "Financial Reports and SEC filings," free of charge, our
annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on
Form 8-K and amendments to those reports as soon as reasonably practicable after
we electronically file or furnish such materials to the SEC.
COMPETITION
We believe that our principal competition in the business of acquiring and
holding mortgage-backed securities are financial institutions such as banks,
savings and loans, life insurance companies, institutional investors such as
mutual funds and pension funds, and certain other mortgage REITs. The existence
of these competitive entities, as well as the possibility of additional entities
forming in the future, may increase the competition for the acquisition of
mortgage-backed securities resulting in higher prices and lower yields on
assets.
RISK FACTORS
An investment in our stock involves a number of risks. Before making an
investment decision, you should carefully consider all of the risks described in
this Form 10-K. If any of the risks discussed in this Form 10-K actually occur,
our business, financial condition and results of operations could be materially
adversely affected. If this were to occur, the trading price of our common stock
could decline significantly and you may lose all or part of your investment. On
January 2, 2004, we announced that we have signed a definitive merger agreement
to acquire FIDAC. Certain of the risk factors discussed below include a
discussion of the material risks associated with the acquisition of FIDAC and
related transactions and should be considered by holders of our common stock.
RISKS RELATED TO OUR BUSINESS
AN INCREASE IN THE INTEREST PAYMENTS ON OUR BORROWINGS RELATIVE TO THE INTEREST
WE EARN ON OUR INVESTMENT SECURITIES MAY ADVERSELY AFFECT OUR PROFITABILITY.
We earn money based upon the spread between the interest payments we earn
on our investment securities and the interest payments we must make on our
borrowings. If the interest payments on our borrowings increase relative to the
interest we earn on our investment securities, our profitability may be
adversely affected.
The interest payments on our borrowings may increase relative to the
interest we earn on our adjustable-rate investment securities for various
reasons discussed in this section.
DIFFERENCES IN TIMING OF INTEREST RATE ADJUSTMENTS ON OUR INVESTMENT SECURITIES
AND OUR BORROWINGS MAY ADVERSELY AFFECT OUR PROFITABILITY.
We rely primarily on short-term borrowings to acquire investment
securities with long-term maturities. Accordingly, if short-term interest rates
increase, this may adversely affect our profitability.
Most of the investment securities we acquire are adjustable-rate
securities. This means that their interest rates may vary over time based upon
changes in an objective index, such as:
o LIBOR. The interest rate that banks in London offer for deposits in
London of U.S. dollars.
o Treasury rate. A monthly or weekly average yield of benchmark U.S.
Treasury securities, as published by the Federal Reserve Board.
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o CD Rate. The weekly average of secondary market interest rates on
six-month negotiable certificates of deposit, as published by the
Federal Reserve Board.
These indices generally reflect short-term interest rates. On December 31,
2003, approximately 73% of our investment securities were adjustable-rate
securities.
The interest rates on our borrowings similarly vary with changes in an
objective index. Nevertheless, the interest rates on our borrowings generally
adjust more frequently than the interest rates on our adjustable-rate investment
securities. For example, on December 31, 2003, our adjustable-rate investment
securities had a weighted average term to next rate adjustment of 23 months,
while our borrowings had a weighted average term to next rate adjustment of 90
days. Accordingly, in a period of rising interest rates, we could experience a
decrease in net income or a net loss because the interest rates on our
borrowings adjust faster than the interest rates on our adjustable-rate
investment securities.
INTEREST RATE CAPS ON OUR INVESTMENT SECURITIES MAY ADVERSELY AFFECT OUR
PROFITABILITY.
Our adjustable-rate investment securities are typically subject to
periodic and lifetime interest rate caps. Periodic interest rate caps limit the
amount an interest rate can increase during any given period. Lifetime interest
rate caps limit the amount an interest rate can increase through maturity of an
investment security. Our borrowings are not subject to similar restrictions.
Accordingly, in a period of rapidly increasing interest rates, we could
experience a decrease in net income or experience a net loss because the
interest rates on our borrowings could increase without limitation while the
interest rates on our adjustable-rate investment securities would be limited by
caps.
BECAUSE WE ACQUIRE FIXED-RATE SECURITIES, AN INCREASE IN INTEREST RATES MAY
ADVERSELY AFFECT OUR PROFITABILITY.
While the majority of our investments consist of adjustable-rate
investment securities, we also invest in fixed-rate mortgage-backed securities.
In a period of rising interest rates, our interest payments could increase while
the interest we earn on our fixed-rate mortgage-backed securities would not
change. This would adversely affect our profitability. On December 31, 2003,
approximately 27% of our investment securities were fixed-rate securities.
AN INCREASE IN PREPAYMENT RATES MAY ADVERSELY AFFECT OUR PROFITABILITY.
The mortgage-backed securities we acquire are backed by pools of mortgage
loans. We receive payments, generally, from the payments that are made on these
underlying mortgage loans. When borrowers prepay their mortgage loans at rates
that are faster than expected, this results in prepayments that are faster than
expected on the mortgage-backed securities. These faster than expected
prepayments may adversely affect our profitability.
We often purchase mortgage-backed securities that have a higher interest
rate than the market interest rate at the time. In exchange for this higher
interest rate, we must pay a premium over the market value to acquire the
security. In accordance with accounting rules, we amortize this premium over the
term of the mortgage-backed security. If the mortgage-backed security is prepaid
in whole or in part prior to its maturity date, however, we must expense the
remaining unamortized portion of the premium that was prepaid at the time of the
prepayment. This adversely affects our profitability. On December 31, 2003,
approximately 97% of the mortgage-backed securities we owned were acquired at a
premium.
Prepayment rates generally increase when interest rates fall and decrease
when interest rates rise, but changes in prepayment rates are difficult to
predict. Prepayment rates also may be affected by conditions in the housing and
financial markets, general economic conditions and the relative interest rates
on fixed-rate and adjustable-rate mortgage loans.
We may seek to reduce prepayment risk by acquiring mortgage-backed
securities at a discount. If a discounted security is prepaid in whole or in
part prior to its maturity date, we will earn income equal to the amount of the
remaining discount. This will improve our profitability if the discounted
securities are prepaid faster than
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expected. On December 31, 2003, approximately 3% of the mortgage-backed
securities we owned were acquired at a discount.
We also can acquire mortgage-backed securities that are less affected by
prepayments. For example, we can acquire CMOs, a type of mortgage-backed
security. CMOs divide a pool of mortgage loans into multiple tranches that allow
for shifting of prepayment risks from slower-paying tranches to faster-paying
tranches. This is in contrast to pass-through or pay-through mortgage-backed
securities, where all investors share equally in all payments, including all
prepayments. As discussed below, the Investment Company Act of 1940 (or the
Investment Company Act) imposes restrictions on our purchase of CMOs. On
December 31, 2003, approximately 23% of our mortgage-backed securities were CMOs
and approximately 77% of our mortgage-backed securities were pass-through or
pay-through securities.
While we seek to minimize prepayment risk to the extent practical, in
selecting investments we must balance prepayment risk against other risks and
the potential returns of each investment. No strategy can completely insulate us
from prepayment risk.
AN INCREASE IN INTEREST RATES MAY ADVERSELY AFFECT OUR BOOK VALUE.
Increases in interest rates may negatively affect the market value of our
investment securities. Our fixed-rate securities, generally, are more negatively
affected by these increases. In accordance with accounting rules, we reduce our
book value by the amount of any decrease in the market value of our investment
securities.
OUR STRATEGY INVOLVES SIGNIFICANT LEVERAGE.
We seek to maintain a ratio of debt-to-equity of between 8:1 and 12:1,
although our ratio may at times be above or below this amount. We incur this
leverage by borrowing against a substantial portion of the market value of our
investment securities. By incurring this leverage, we can enhance our returns.
Nevertheless, this leverage, which is fundamental to our investment strategy,
also creates significant risks.
OUR LEVERAGE MAY CAUSE SUBSTANTIAL LOSSES.
Because of our significant leverage, we may incur substantial losses if
our borrowing costs increase. Our borrowing costs may increase for any of the
following reasons:
o short-term interest rates increase;
o the market value of our investment securities decreases;
o interest rate volatility increases; or
o the availability of financing in the market decreases.
OUR LEVERAGE MAY CAUSE MARGIN CALLS AND DEFAULTS AND FORCE US TO SELL ASSETS
UNDER ADVERSE MARKET CONDITIONS.
Because of our leverage, a decline in the value of our investment
securities may result in our lenders initiating margin calls. A margin call
means that the lender requires us to pledge additional collateral to
re-establish the ratio of the value of the collateral to the amount of the
borrowing. Our fixed-rate mortgage-backed securities generally are more
susceptible to margin calls as increases in interest rates tend to more
negatively affect the market value of fixed-rate securities.
If we are unable to satisfy margin calls, our lenders may foreclose on our
collateral. This could force us to sell our investment securities under adverse
market conditions. Additionally, in the event of our bankruptcy, our borrowings,
which are generally made under repurchase agreements, may qualify for special
treatment under the Bankruptcy Code. This special treatment would allow the
lenders under these agreements to avoid the automatic stay provisions of the
Bankruptcy Code and to liquidate the collateral under these agreements without
delay.
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LIQUIDATION OF COLLATERAL MAY JEOPARDIZE OUR REIT STATUS.
To continue to qualify as a REIT, we must comply with requirements
regarding our assets and our sources of income. If we are compelled to liquidate
our investment securities, we may be unable to comply with these requirements,
ultimately jeopardizing our status as a REIT.
WE MAY EXCEED OUR TARGET LEVERAGE RATIOS.
We seek to maintain a ratio of debt-to-equity of between 8:1 and 12:1.
However, we are not required to stay within this leverage ratio. If we exceed
this ratio, the adverse impact on our financial condition and results of
operations from the types of risks described in this section would likely be
more severe.
WE MAY NOT BE ABLE TO ACHIEVE OUR OPTIMAL LEVERAGE.
We use leverage as a strategy to increase the return to our investors.
However, we may not be able to achieve our desired leverage for any of the
following reasons:
o we determine that the leverage would expose us to excessive risk;
o our lenders do not make funding available to us at acceptable rates;
or
o our lenders require that we provide additional collateral to cover
our borrowings.
WE MAY INCUR INCREASED BORROWING COSTS WHICH WOULD ADVERSELY AFFECT OUR
PROFITABILITY.
Currently, all of our borrowings are collateralized borrowings in the form
of repurchase agreements. If the interest rates on these repurchase agreements
increase, it would adversely affect our profitability.
Our borrowing costs under repurchase agreements generally correspond to
short-term interest rates such as LIBOR or a short-term Treasury index, plus or
minus a margin. The margins on these borrowings over or under short-term
interest rates may vary depending upon:
o the movement of interest rates;
o the availability of financing in the market; or
o the value and liquidity of our investment securities.
IF WE ARE UNABLE TO RENEW OUR BORROWINGS AT FAVORABLE RATES, OUR PROFITABILITY
MAY BE ADVERSELY AFFECTED.
Since we rely primarily on short-term borrowings, our ability to achieve
our investment objectives depends not only on our ability to borrow money in
sufficient amounts and on favorable terms, but also on our ability to renew or
replace on a continuous basis our maturing short-term borrowings. If we are not
able to renew or replace maturing borrowings, we would have to sell our assets
under possibly adverse market conditions.
WE HAVE NOT USED DERIVATIVES TO MITIGATE OUR INTEREST RATE AND PREPAYMENT RISKS.
Our policies permit us to enter into interest rate swaps, caps and floors
and other derivative transactions to help us mitigate our interest rate and
prepayment risks described above. However, we have determined in the past that
the cost of these transactions outweighs the benefits. In addition, we will not
enter into derivative transactions if we believe they will jeopardize our status
as a REIT. If we decide to enter into derivative transactions in the future,
these transactions may mitigate our interest rate and prepayment risks but
cannot insulate us from these risks.
OUR INVESTMENT STRATEGY MAY INVOLVE CREDIT RISK.
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We may incur losses if there are payment defaults under our investment
securities.
To date, all of our mortgage-backed securities have been agency
certificates which, although not rated, carry an implied "AAA" rating. Agency
certificates are investment securities where FHLMC, FNMA or GNMA guarantees
payments of principal or interest on the certificates.
Even though we have only acquired "AAA" securities so far, pursuant to our
capital investment policy, we have the ability to acquire securities of lower
credit quality. Under our policy:
o 75% of our investments must have a "AA" or higher rating by S&P, an
equivalent rating by a similar nationally recognized rating
organization or our management must determine that the investments
are of comparable credit quality to investments with these ratings;
o the remaining 25% of our investments must have a "BBB" or higher
rating by S&P, or an equivalent rating by a similar nationally
recognized rating organization, or our management must determine
that the investments are of comparable credit quality to investments
with these ratings. Securities with ratings of "BBB" or higher are
commonly referred to as "investment grade" securities; and
o we seek to have a minimum weighted average rating for our portfolio
of at least "A" by S&P.
If we acquire mortgage-backed securities of lower credit quality, we may
incur losses if there are defaults under those mortgage-backed securities or if
the rating agencies downgrade the credit quality of those mortgage-backed
securities.
WE HAVE NOT ESTABLISHED A MINIMUM DIVIDEND PAYMENT LEVEL.
We intend to pay quarterly dividends and to make distributions to our
stockholders in amounts such that all or substantially all of our taxable income
in each year (subject to certain adjustments) is distributed. This enables us to
qualify for the tax benefits accorded to a REIT under the Code. We have not
established a minimum dividend payment level and our ability to pay dividends
may be adversely affected for the reasons described in this section. All
distributions will be made at the discretion of our board of directors and will
depend on our earnings, our financial condition, maintenance of our REIT status
and such other factors as our board of directors may deem relevant from time to
time.
BECAUSE OF COMPETITION, WE MAY NOT BE ABLE TO ACQUIRE MORTGAGE-BACKED SECURITIES
AT FAVORABLE YIELDS.
Our net income depends, in large part, on our ability to acquire
mortgage-backed securities at favorable spreads over our borrowing costs. In
acquiring mortgage-backed securities, we compete with other REITs, investment
banking firms, savings and loan associations, banks, insurance companies, mutual
funds, other lenders and other entities that purchase mortgage-backed
securities, many of which have greater financial resources than us. As a result,
in the future, we may not be able to acquire sufficient mortgage-backed
securities at favorable spreads over our borrowing costs.
WE ARE DEPENDENT ON OUR KEY PERSONNEL.
We are dependent on the efforts of our key officers and employees,
including Michael A. J. Farrell, our Chairman of the board of directors, Chief
Executive Officer, and President, Wellington J. Denahan, our Vice Chairman and
Chief Investment Officer, Kathryn F. Fagan, our Chief Financial Officer and
Treasurer, and Jennifer S. Karve, our Executive Vice President and Secretary.
The loss of any of their services could have an adverse effect on our
operations. Although we have employment agreements with each of them, we cannot
assure you they will remain employed with us.
SOME OF OUR DIRECTORS, OFFICERS, AND EMPLOYEES HAVE OWNERSHIP INTERESTS AND
MANAGE ASSETS FOR OTHER CLIENTS THAT CREATE POTENTIAL CONFLICTS OF INTEREST.
23
Some of our directors, officers, and employees have potential conflicts of
interest with us. The material potential conflicts are as follows:
Mr. Farrell, Ms. Denahan and other officers and employees are actively
involved in managing mortgage-backed securities and other fixed income assets
for institutional clients through FIDAC. FIDAC is a registered investment
adviser that on December 31, 2003 managed, assisted in managing or supervised
approximately $13.6 billion in gross assets on a discretionary basis for a wide
array of clients. FIDAC may also manage other funds in the future. These
officers will continue to perform services for FIDAC, the institutional clients,
and other funds managed by FIDAC. Mr. Farrell, Ms. Denahan, Ms. Fagan, Ms.
Karve, and other of our officers and employees are the shareholders of FIDAC.
We have entered into a merger agreement to acquire FIDAC. The merger is
subject to the approval of our stockholders of the merger agreement and several
other conditions. If the acquisition is not approved, these responsibilities may
create conflicts of interest for these officers and employees if they are
presented with corporate opportunities that may benefit us, the institutional
clients, and other funds managed by FIDAC, if applicable. If the acquisition is
not approved, our officers will continue to allocate investments among us, the
institutional clients, and other funds managed by FIDAC, if applicable, by
determining the entity or account for which the investment is most suitable. In
making this determination, our officers consider the investment strategy and
guidelines of each entity or account with respect to acquisition of assets,
leverage, liquidity, and other factors that our officers determine appropriate.
If the acquisition is not approved, our management expects to continue to
allocate rent and other office expenses between our affiliates and us. These
allocations may create conflicts of interest. Our management currently allocates
rent and other expenses 90% to us and 10% to FIDAC. Our audit committee must
approve any change in these allocation percentages. In addition, we may enter
into agreements, such as technology sharing or research agreements, with our
affiliates in the future. These agreements would present potential conflicts of
interest. Our management will obtain prior approval of our audit committee prior
to entering into any agreements with our affiliates.
FEDERAL INCOME TAX RISKS RELATED TO OUR QUALIFICATION AS A REIT
OUR FAILURE TO QUALIFY AS A REIT WOULD HAVE ADVERSE TAX CONSEQUENCES.
We believe that since 1997 we have qualified for taxation as a REIT for
federal income tax purposes. We plan to continue to meet the requirements for
taxation as a REIT. Many of these requirements, however, are highly technical
and complex. The determination that we are a REIT requires an analysis of
various factual matters and circumstances that may not be totally within our
control. For example, to qualify as a REIT, at least 75% of our gross income
must come from real estate sources and 95% of our gross income must come from
real estate sources and certain other sources that are itemized in the REIT tax
laws. We are also required to distribute to stockholders at least 90% of our
REIT taxable income (determined without regard to the deduction for dividends
paid and by excluding any net capital gain). Even a technical or inadvertent
mistake could jeopardize our REIT status. Furthermore, Congress and the Internal
Revenue Service, or IRS, might make changes to the tax laws and regulations, and
the courts might issue new rulings that make it more difficult or impossible for
us to remain qualified as a REIT.
If we fail to qualify as a REIT, we would be subject to federal income tax
at regular corporate rates. Also, unless the IRS granted us relief under certain
statutory provisions, we would remain disqualified as a REIT for four years
following the year we first fail to qualify. If we fail to qualify as a REIT, we
would have to pay significant income taxes and would therefore have less money
available for investments or for distributions to our stockholders. This would
likely have a significant adverse effect on the value of our securities. In
addition, the tax law would no longer require us to make distributions to our
stockholders.
WE HAVE CERTAIN DISTRIBUTION REQUIREMENTS.
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As a REIT, we must distribute at least 90% of our REIT taxable income
(determined without regard to the deduction for dividends paid and by excluding
any net capital gain). The required distribution limits the amount we have
available for other business purposes, including amounts to fund our growth.
Also, it is possible that because of the differences between the time we
actually receive revenue or pay expenses and the period we report those items
for distribution purposes, we may have to borrow funds on a short-term basis to
meet the 90% distribution requirement.
WE ARE ALSO SUBJECT TO OTHER TAX LIABILITIES.
Even if we qualify as a REIT, we may be subject to certain federal, state
and local taxes on our income and property. Any of these taxes would reduce our
operating cash flow.
RISKS OF OWNERSHIP OF OUR COMMON STOCK
ISSUANCES OF LARGE AMOUNTS OF OUR STOCK COULD CAUSE THE MARKET PRICE OF OUR
COMMON STOCK TO DECLINE.
As of March 4, 2004, 117,866,932 shares of our common stock were
outstanding. If we issue a significant number of shares of common stock or
securities convertible into common stock in a short period of time, there could
be a dilution of the existing common stock and a decrease in the market price of
the common stock.
WE MAY CHANGE OUR POLICIES WITHOUT STOCKHOLDER APPROVAL.
Our board of directors and management determine all of our policies,
including our investment, financing and distribution policies. Although they
have no current plans to do so, they may amend or revise these policies at any
time without a vote of our stockholders. Policy changes could adversely affect
our financial condition, results of operations, the market price of our common
stock or our ability to pay dividends or distributions.
LIMITS ON OWNERSHIP OF OUR COMMON STOCK COULD HAVE ADVERSE CONSEQUENCES TO YOU
AND COULD LIMIT YOUR OPPORTUNITY TO RECEIVE A PREMIUM ON OUR STOCK.
To maintain our qualification as a REIT for federal income tax purposes,
not more than 50% in value of the outstanding shares of our capital stock may be
owned, directly or indirectly, by five or fewer individuals (as defined in the
federal tax laws to include certain entities). Primarily to facilitate
maintenance of our qualification as a REIT for federal income tax purposes, our
charter will prohibit ownership, directly or by the attribution provisions of
the federal tax laws, by any person of more than 9.8% of the lesser of the
number or value of the issued and outstanding shares of our common stock and
will prohibit ownership, directly or by the attribution provisions of the
federal tax laws, by any person of more than 9.8% of the lesser of the number or
value of the issued and outstanding shares of any class or series of our
preferred stock. Our board of directors, in its sole and absolute discretion,
may waive or modify the ownership limit with respect to one or more persons who
would not be treated as "individuals" for purposes of the federal tax laws if it
is satisfied, based upon information required to be provided by the party
seeking the waiver and upon an opinion of counsel satisfactory to the board of
directors, that ownership in excess of this limit will not otherwise jeopardize
our status as a REIT for federal income tax purposes.
The ownership limit may have the effect of delaying, deferring or
preventing a change in control and, therefore, could adversely affect our
shareholders' ability to realize a premium over the then-prevailing market price
for our common stock in connection with a change in control.
OUR GOVERNING DOCUMENTS AND MARYLAND LAW IMPOSE LIMITATIONS ON THE ACQUISITION
OF OUR COMMON STOCK AND CHANGES IN CONTROL THAT COULD MAKE IT MORE DIFFICULT FOR
A THIRD PARTY TO ACQUIRE US.
MARYLAND BUSINESS COMBINATION ACT
The Maryland General Corporation Law establishes special requirements for
"business combinations" between a Maryland corporation and "interested
stockholders" unless exemptions are applicable. An interested stockholder is any
person who beneficially owns 10% or more of the voting power of our
then-outstanding voting stock. Among other things, the law prohibits for a
period of five years a merger and other similar transactions
25
between us and an interested stockholder unless the board of directors approved
the transaction prior to the party's becoming an interested stockholder. The
five-year period runs from the most recent date on which the interested
stockholder became an interested stockholder. The law also requires a super
majority stockholder vote for such transactions after the end of the five-year
period. This means that the transaction must be approved by at least:
o 80% of the votes entitled to be cast by holders of outstanding
voting shares; and
o two-thirds of the votes entitled to be cast by holders of
outstanding voting shares other than shares held by the
interested stockholder or an affiliate of the interested
stockholder with whom the business combination is to be
effected.
As permitted by the Maryland General Corporation Law, we have elected not
to be governed by the Maryland business combination statute. We made this
election by opting out of this statute in our articles of incorporation. If,
however, we amend our articles of incorporation to opt back in to the statute,
the business combination statute could have the effect of discouraging offers to
acquire us and of increasing the difficulty of consummating any such offers,
even if our acquisition would be in our stockholders' best interests.
MARYLAND CONTROL SHARE ACQUISITION ACT
Maryland law provides that "control shares" of a Maryland corporation
acquired in a "control share acquisition" have no voting rights except to the
extent approved by a vote of the stockholders. Two-thirds of the shares eligible
to vote must vote in favor of granting the "control shares" voting rights.
"Control shares" are shares of stock that, taken together with all other shares
of stock the acquirer previously acquired, would entitle the acquirer to
exercise voting power in electing directors within one of the following ranges
of voting power:
o One-tenth or more but less than one third of all voting power;
o One-third or more but less than a majority of all voting
power; or
o A majority or more of all voting power.
Control shares do not include shares of stock the acquiring person is
entitled to vote as a result of having previously obtained stockholder approval.
A "control share acquisition" means the acquisition of control shares, subject
to certain exceptions.
If a person who has made (or proposes to make) a control share acquisition
satisfies certain conditions (including agreeing to pay expenses), he may compel
our board of directors to call a special meeting of stockholders to consider the
voting rights of the shares. If such a person makes no request for a meeting, we
have the option to present the question at any stockholders' meeting.
If voting rights are not approved at a meeting of stockholders then,
subject to certain conditions and limitations, we may redeem any or all of the
control shares (except those for which voting rights have previously been
approved) for fair value. We will determine the fair value of the shares,
without regard to voting rights, as of the date of either:
o the last control share acquisition; or
o the meeting where stockholders considered and did not approve
voting rights of the control shares.
If voting rights for control shares are approved at a stockholders'
meeting and the acquirer becomes entitled to vote a majority of the shares of
stock entitled to vote, all other stockholders may obtain rights as objecting
stockholders and, thereunder, exercise appraisal rights. This means that you
would be able to force us to redeem your stock for fair value. Under Maryland
law, the fair value may not be less than the highest price per share paid in the
control share acquisition. Furthermore, certain limitations otherwise applicable
to the exercise of dissenters' rights would not apply in the context of a
control share acquisition. The control share acquisition statute would not
26
apply to shares acquired in a merger, consolidation or share exchange if we were
a party to the transaction. The control share acquisition statute could have the
effect of discouraging offers to acquire us and of increasing the difficulty of
consummating any such offers, even if our acquisition would be in our
stockholders' best interests.
REGULATORY RISKS
LOSS OF INVESTMENT COMPANY ACT EXEMPTION WOULD ADVERSELY AFFECT US.
We intend to conduct our business so as not to become regulated as an
investment company under the Investment Company Act. If we fail to qualify for
this exemption, our ability to use leverage would be substantially reduced, and
we would be unable to conduct our business as described in this Form 10-K.
The Investment Company Act exempts entities that are primarily engaged in
the business of purchasing or otherwise acquiring mortgages and other liens on
and interests in real estate. Under the current interpretation of the SEC staff,
in order to qualify for this exemption, we must maintain at least 55% of our
assets directly in these qualifying real estate interests. Mortgage-backed
securities that do not represent all of the certificates issued with respect to
an underlying pool of mortgages may be treated as securities separate from the
underlying mortgage loans and, thus, may not qualify for purposes of the 55%
requirement. Our ownership of these mortgage-backed securities, therefore, is
limited by the provisions of the Investment Company Act. In addition, in meeting
the 55% requirement under the Investment Company Act, we treat as qualifying
interests mortgage-backed securities issued with respect to an underlying pool
as to which we hold all issued certificates. If the SEC or its staff adopts a
contrary interpretation, we could be required to sell a substantial amount of
our mortgage-backed securities, under potentially adverse market conditions.
Further, in order to insure that we at all times qualify for the exemption from
the Investment Company Act, we may be precluded from acquiring mortgage-backed
securities whose yield is somewhat higher than the yield on mortgage-backed
securities that could be purchased in a manner consistent with the exemption.
The net effect of these factors may be to lower our net income.
COMPLIANCE WITH PROPOSED AND RECENTLY ENACTED CHANGES IN SECURITIES LAWS AND
REGULATIONS ARE LIKELY TO INCREASE OUR COSTS.
The Sarbanes-Oxley Act of 2002 and rules and regulations promulgated by
the SEC and the New York Stock Exchange have increased the scope, complexity and
cost of corporate governance, reporting and disclosure practices. We believe
that these rules and regulations will make it more costly for us to obtain
director and officer liability insurance, and we may be required to accept
reduced coverage or incur substantially higher costs to obtain coverage. These
rules and regulations could also make it more difficult for us to attract and
retain qualified members of management and our board of directors, particularly
to serve on our audit committee.
RISKS RELATED TO THE ACQUISITION
BECAUSE THE MARKET PRICE OF OUR COMMON STOCK MAY FLUCTUATE, YOU CANNOT BE
CERTAIN OF THE PRECISE VALUE OF THE FUTURE ADDITIONAL SHARES THAT FIDAC
SHAREHOLDERS MAY RECEIVE IN THE ACQUISITION.
You cannot be certain of the precise value of the total acquisition
consideration to be received by the FIDAC shareholders. Upon completion of the
acquisition, each share of FIDAC stock will be converted into the right to
receive approximately 2,935 shares of our common stock. FIDAC shareholders may
also receive additional shares of our common stock as an earn-out in 2005, 2006,
and 2007 worth up to $49,500,000 if FIDAC meets specific performance goals under
the merger agreement. We cannot calculate how many shares we will issue under
the earn-out provisions since that will vary depending upon whether and the
extent to which FIDAC achieves specific performance goals. Even if FIDAC
achieves specific performance goals for a fiscal year, the number of additional
shares to be issued to the FIDAC shareholders will vary depending on our average
share price for the first 20 trading days of the following fiscal year.
In addition, the price of our common stock and the value of shares of
FIDAC stock at the closing of the acquisition may vary from the respective
values on the date the merger agreement was executed. For example,
27
during 2003, our common stock ranged from a low sale price of $15.65 per share
to a high sale price of $21.10 per share. These variations may be the result of
various factors, including:
o changes in the business, operations or prospects of us, FIDAC or the
post acquisition entities;
o governmental, regulatory and/or litigation developments;
o market assessments as to whether and when the acquisition will be
consummated;
o the timing of the consummation of the acquisition;
o changes in interest rates; and
o general stock market, economic and political conditions.
THE MARKET PRICE FOR OUR COMMON STOCK MAY BE AFFECTED BY FACTORS DIFFERENT FROM
THOSE AFFECTING THE SHARES OF FIDAC.
Upon completion of the acquisition, FIDAC shareholders will become holders
of additional shares of our common stock. Our business differs from that of
FIDAC, and accordingly our future results of operations will be affected by
factors different from those currently affecting our results of our operations.
UNCERTAINTIES ASSOCIATED WITH THE ACQUISITION OR OUR OWNERSHIP OF FIDAC MAY
CAUSE FIDAC TO LOSE CLIENTS.
FIDAC's clients may, in response to the announcement of the acquisition,
delay or defer decisions concerning their use of FIDAC products and services
because of uncertainties related to the consummation of the acquisition. FIDAC's
clients may also determine to withdraw assets under FIDAC's management, because
of uncertainties associated with the acquisition and/or because FIDAC will no
longer be an independently run company following the acquisition. Any of these
matters could have an adverse effect on our business, results of operations or
financial condition following the acquisition and the adverse effect may be
material.
RISKS RELATED TO THE COMBINED BUSINESSES
SOME MEMBERS OF OUR MANAGEMENT AND SOME MEMBERS OF OUR BOARD OF DIRECTORS HAVE
INTERESTS IN THE ACQUISITION THAT ARE DIFFERENT FROM OR IN ADDITION TO THE
INTERESTS THEY SHARE WITH YOU AS OUR STOCKHOLDERS.
The FIDAC shareholders will be receiving shares of our common stock upon
completion of the acquisition. The FIDAC shareholders also may receive
additional shares of our common stock if FIDAC reaches specific performance
targets for the fiscal years 2004, 2005, and 2006, and, therefore, the FIDAC
shareholders may have different interests from our other stockholders in the
performance of FIDAC. The special committee was formed because of, and our board
of directors was aware of, these different interests and considered them, among
other matters, in approving the merger agreement and the acquisition. In
addition, Michael A.J. Farrell, through his ownership of shares of FIDAC common
stock, upon completion of the acquisition, will control approximately 2% of the
outstanding voting power of our common stock, without including any additional
voting power he may acquire upon FIDAC's achievement of specific performance
goals for its 2004, 2005 and 2006 fiscal years.
A REIT CANNOT INVEST MORE THAN 20% OF ITS TOTAL ASSETS IN THE STOCK OR
SECURITIES OF ONE OR MORE TAXABLE REIT SUBSIDIARIES; THEREFORE, FIDAC CANNOT
CONSTITUTE MORE THAN 20% OF OUR TOTAL ASSETS.
A taxable REIT subsidiary is a corporation, other than a REIT or a
qualified REIT subsidiary, in which a REIT owns stock and which elects taxable
REIT subsidiary status. The term also includes a corporate subsidiary in which
the taxable REIT subsidiary owns more than a 35% interest. A REIT may own up to
100% of the stock of one or more taxable REIT subsidiaries. A taxable REIT
subsidiary may earn income that would not be qualifying income if earned
directly by the parent REIT. Overall, at the close of any calendar quarter, no
more than 20% of the value of a REIT's assets may consist of stock or securities
of one or more taxable REIT subsidiaries.
28
As a result of the acquisition, FIDAC will become our taxable REIT
subsidiary. At that time, the stock and securities of FIDAC held by us is
expected to represent less than 20% of the value of our total assets.
Furthermore, we intend to monitor the value of our investments in the stock and
securities of FIDAC (and any other taxable REIT subsidiary in which we may
invest) to ensure compliance with the above-described 20% limitation. We cannot
assure you, however, that we will always be able to comply with the 20%
limitation so as to maintain REIT status.
TAXABLE REIT SUBSIDIARIES ARE SUBJECT TO TAX AT THE REGULAR CORPORATE RATES, ARE
NOT REQUIRED TO DISTRIBUTE DIVIDENDS, AND THE AMOUNT OF DIVIDENDS A TAXABLE REIT
SUBSIDIARY CAN PAY TO ITS PARENT REIT MAY BE LIMITED BY REIT GROSS INCOME TESTS.
A taxable REIT subsidiary must pay income tax at regular corporate rates
on any income that it earns. FIDAC will pay corporate income tax on its taxable
income, and its after-tax net income will be available for distribution to us.
Such income, however, is not required to be distributed.
Moreover, the annual gross income tests that must be satisfied to ensure
REIT qualification may limit the amount of dividends that we can receive from
FIDAC and still maintain our REIT status. Generally, not more than 25% of our
gross income can be derived from non-real estate related sources, such as
dividends from a taxable REIT subsidiary. If, for any taxable year, the
dividends we received from FIDAC, when added to our other items of non-real
estate related income, represented more than 25% of our total gross income for
the year, we could be denied REIT status, unless we were able to demonstrate,
among other things, that our failure of the gross income test was due to
reasonable cause and not willful neglect.
The limitations imposed by the REIT gross income tests may impede our
ability to distribute assets from FIDAC to us in the form of dividends. Certain
asset transfers may, therefore, have to be structured as purchase and sale
transactions upon which FIDAC recognizes taxable gain.
IF INTEREST ACCRUES ON INDEBTEDNESS OWED BY A TAXABLE REIT SUBSIDIARY TO ITS
PARENT REIT AT A RATE IN EXCESS OF A COMMERCIALLY REASONABLE RATE, OR IF
TRANSACTIONS BETWEEN A REIT AND A TAXABLE REIT SUBSIDIARY ARE ENTERED INTO ON
OTHER THAN ARM'S-LENGTH TERMS, THE REIT MAY BE SUBJECT TO A PENALTY TAX.
If interest accrues on an indebtedness owed by a taxable REIT subsidiary
to its parent REIT at a rate in excess of a commercially reasonable rate, the
REIT is subject to tax at a rate of 100% on the excess of (i) interest payments
made by a taxable REIT subsidiary to its parent REIT over (ii) the amount of
interest that would have been payable had interest accrued on the indebtedness
at a commercially reasonable rate. A tax at a rate of 100% is also imposed on
any transaction between a taxable REIT subsidiary and its parent REIT to the
extent the transaction gives rise to deductions to the taxable REIT subsidiary
that are in excess of the deductions that would have been allowable had the
transaction been entered into on arm's-length terms. We will scrutinize all of
our transactions with FIDAC in an effort to ensure that we do not become subject
to these taxes. We cannot assure you, however, that we will be able to avoid
application of these taxes.
RISKS RELATED TO FIDAC'S BUSINESS
A DECLINE IN THE VALUE OF SECURITIES OR LEVEL OF BORROWING ON FAVORABLE TERMS
COULD LEAD TO A DECLINE IN FIDAC'S ASSETS UNDER MANAGEMENT, REVENUES AND
EARNINGS.
FIDAC's revenue is derived from fees it receives from investment advisory
contracts with its clients. Under these contracts, the investment advisory fee
FIDAC receives is typically based on the gross market value of assets under
management. The gross assets FIDAC manages are increased by the borrowing of the
portfolios and funds. Accordingly, a decline in the value of securities
generally or the inability of the portfolio or the funds FIDAC manages to borrow
on favorable terms may cause FIDAC's revenues and income to decline by:
o causing the value of its assets under management to decrease,
which would result in FIDAC receiving lower investment
advisory fees; or
29
o causing its clients to withdraw funds in favor of investments
they perceive offer greater opportunity or lower risk, which
would also result in FIDAC receiving lower investment advisory
fees.
If FIDAC's revenues decline without a commensurate reduction in its
expenses, its net income will be reduced.
Declines in the value of securities could be the result of several factors
including economic downturn in the U.S. or foreign markets, political events,
defaults by major financial institutions or adverse public or investor
perceptions. The inability of the portfolio or the funds FIDAC manages to borrow
on favorable terms could result from several factors including a narrowing of
the difference between short term and long term interest rates or disruptions
caused by rapid changes in interest rates. We cannot assure you that securities
markets will not move in a direction which results in a loss of FIDAC revenues
and earnings.
FIDAC COULD LOSE CLIENTS AND SUFFER A DECLINE IN FIDAC'S REVENUES AND EARNINGS
IF THE INVESTMENTS IT CHOOSES PERFORM POORLY, REGARDLESS OF THE TREND IN THE
VALUE OF SECURITIES.
Investment performance is one of the most important factors for the growth
of assets under FIDAC's management. Poor investment performance could impair
FIDAC's revenues and growth because:
o existing clients might withdraw funds in favor of better
performing products, which would result in FIDAC receiving
lower investment advisory fees;
o its ability to attract funds from existing and new clients
might diminish; or
o firms and individuals with which FIDAC has strategic alliances
may terminate their relationships, and future strategic
alliances may be unavailable.
The portfolios and funds FIDAC manages are generally similar in strategy
and risks to our investments, although FIDAC's clients are not generally
attempting to qualify as REITs. The performance of these portfolios and funds
are likely to be affected by the same factors that affect FIDAC's investment
returns. If FIDAC's revenues decline without a commensurate reduction in its
expenses, its net income will be reduced.
FIDAC'S CLIENTS CAN REMOVE THE ASSETS FIDAC MANAGES ON SHORT NOTICE.
FIDAC's investment advisory and administrative contracts are generally
terminable upon 90 days' notice, and depending on the client, investors may
redeem their investments in the funds from one day to one month with or without
written notice.
Institutional and individual clients, and firms with which FIDAC has
strategic alliances, can terminate their relationship with FIDAC, reduce the
aggregate amount of assets under management, or shift their funds to other types
of accounts with different rate structures for any of a number of reasons,
including investment performance, changes in prevailing interest rates and
financial market performance, particularly in the market for mortgage-backed
securities. If the yield on mortgage-backed securities declines without a
similar reduction in FIDAC's cost of financing, we would expect the pace of
redemptions of FIDAC managed funds and accounts to increase. The decrease in
revenues that could result from any such event could have a material adverse
effect on FIDAC's business.
THE INVESTMENT ADVISORY BUSINESS IS INTENSELY COMPETITIVE.
The investment advisory business is intensely competitive, with
competition based on a variety of factors including:
o the range of products offered;
30
o brand recognition and business reputation;
o investment performance;
o the continuity of client relationships and of assets under
management;
o the quality of service provided to clients;
o the level of fees and commissions charged for services;
o the level of commissions and other compensation paid;
o the level of expenses paid to financial intermediaries related
to administration and/or distribution; and
o financial strength.
FIDAC competes in all aspects of its business with a large number of
investment management firms, commercial banks, investment banks, broker-dealers,
insurance companies and other financial institutions. A number of factors
increase FIDAC's competitive risks:
o a number of FIDAC's competitors have greater capital and other
resources, and offer more comprehensive lines of products and
services, than FIDAC does;
o there are relatively few barriers to entry by new investment
advisory firms, and the successful efforts of new entrants
into FIDAC's lines of business of mortgage-backed securities,
including major banks, insurance companies and other financial
institutions, have resulted in increased competition;
o other industry participants may from time to time seek to
recruit FIDAC's investment professionals from FIDAC; and
o FIDAC competitors are seeking to expand market share in the
products and services it offers or intends to offer in the
future.
This competitive pressure may reduce FIDAC's revenues and earnings.
FIDAC DEPENDS ON ACCESSING CLIENTS THROUGH INTERMEDIARIES.
FIDAC's ability to market its advisory and subadvisory services is highly
dependent on access to its base of securities firms, banks, insurance companies
and other intermediaries which generally offer competing investment products.
The inability to have adequate client access could have a material adverse
effect on FIDAC's business.
FIDAC's distribution extends globally, including into many foreign markets
but the portfolios and funds FIDAC manages are denominated in U.S. dollars.
Foreign exchange rate changes could make U.S. dollar denominated investments
less attractive to foreign investors and result in withdrawals by such investors
or difficulty in attracting assets.
FIDAC IS SUBJECT TO EXTENSIVE REGULATION AND VIOLATIONS OF REGULATORY
REQUIREMENTS COULD IMPAIR ITS ABILITY TO OPERATE OR RESULT IN FINES OR DAMAGE TO
ITS REPUTATION.
As with all investment advisors, FIDAC's business is heavily regulated.
Noncompliance with applicable statutes or regulations could result in sanctions,
including:
o the revocation of licenses to operate its business;
31
o the suspension or expulsion from a particular jurisdiction or
market of FIDAC or its key personnel;
o the imposition of fines and censures; and
o reputational loss.
Any of these events could have a material adverse effect on FIDAC's
business.
FIDAC IS DEPENDENT ON ITS KEY PERSONNEL.
FIDAC is dependent on the efforts of its key officers and employees,
including Michael A. J. Farrell, our Chairman of the board of directors, Chief
Executive Officer, and President, Wellington J. Denahan, our Vice Chairman and
Chief Investment Officer, Kathryn F. Fagan, our Chief Financial Officer and
Treasurer, and Jennifer S. Karve, our Executive Vice President and Secretary.
The loss of any of their services could have an adverse effect on FIDAC's
operations. Although we have employment agreements with each of them, we cannot
assure you they will remain employed with us.
ITEM 2. PROPERTIES
Our executive and administrative office is located at 1211 Avenue of the
Americas, Suite 2902 New York, New York 10036, telephone 212-696-0100. This
office is leased under a non-cancelable lease expiring December 31, 2009.
ITEM 3. LEGAL PROCEEDINGS
At December 31, 2003, there were no pending legal proceedings to which we
were a party, or to which any of our property was subject.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
We did not submit any matters to a vote of our stockholders during the
fourth quarter of 2003.
32
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our common stock began trading publicly on October 8, 1997 and is traded
on the New York Stock Exchange under the trading symbol "NLY". As of March 4
2004, we had 117,866,932 shares of common stock issued and outstanding which
were held by approximately 108,943 holders of record.
The following table sets forth, for the periods indicated, the high, low,
and closing sales prices per share of common stock as reported on the New York
Stock Exchange composite tape and the cash dividends declared per share of our
common stock.
Stock Prices
High Low Close
First Quarter ended March 31, 2003 $19.55 $16.54 $17.47
Second Quarter ended June 30, 2003 $20.80 $17.43 $19.91
Third Quarter ended September 30, 2003 $21.10 $16.13 $16.42
Fourth Quarter ended December 31, 2003 $19.00 $15.65 $18.40
High Low Close
First Quarter ended March 31, 2002 $17.62 $15.30 $16.98
Second Quarter ended June 30, 2002 $21.50 $16.20 $19.40
Third Quarter ended September 30, 2002 $20.40 $14.00 $18.45
Fourth Quarter ended December 31, 2002 $19.95 $15.25 $18.80
Cash Dividends
Declared Per Share
First Quarter ended March 31, 2003 $0.60
Second Quarter ended June 30, 2003 $0.60
Third Quarter ended September 30, 2003 $0.28
Fourth Quarter ended December 31, 2003 $0.47
First Quarter ended March 31, 2002 $0.63
Second Quarter ended June 30, 2002 $0.68
Third Quarter ended September 30, 2002 $0.68
Fourth Quarter ended December 31, 2002 $0.68
We intend to pay quarterly dividends and to distribute to our stockholders
all or substantially all of our taxable income in each year (subject to certain
adjustments). This will enable us to qualify for the tax benefits accorded to a
REIT under the Code. We have not established a minimum dividend payment level
and our ability to pay dividends may be adversely affected for the reasons
described under the caption "Risk Factors." All distributions will be made at
the discretion of our board of directors and will depend on our earnings, our
financial condition, maintenance of our REIT status and such other factors as
our board of directors may deem relevant from time to time.
33
EQUITY COMPENSATION PLAN INFORMATION
We have adopted a long term stock incentive plan for executive officers,
key employees and nonemployee directors (the "Incentive Plan"). The Incentive
Plan authorizes the Compensation Committee of the board of directors to grant
awards, including incentive stock options as defined under Section 422 of the
Code ("ISOs") and options not so qualified ("NQSOs"). The Incentive Plan
authorizes the granting of options or other awards for an aggregate of the
greater of 500,000 shares or 9.5% of the outstanding shares of our common stock.
For a description of our Incentive Plan, see Note 8 to the Financial Statements.
The following table provides information as of December 31, 2003,
concerning shares of our common stock authorized for issuance under our existing
Incentive Plan.
Number of securities remaining
Number of securities to be available for future issuance
issued upon exercise of Weighted-average exercise price under Incentive Plan (excluding
Plan Category outstanding options of outstanding options previously issued)
- ----------------------------------------------------------------------------------------------------------------------------------
Incentive Plan approved by
shareholders 1,063,259 $14.28 8,063,780(1)
Incentive Plan not approved by
shareholders -- -- --
----------------------------------------------------------------------------------------------
Total 1,063,259 $14.28 8,063,780
==============================================================================================
(1) The Incentive Plan authorizes the granting of options or other awards for an
aggregate of the greater of 500,000 or 9.5% of the outstanding shares on a fully
diluted basis of our common stock. ( (96,074,096 *9.5%)-1,063,259)
34
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data are derived from our audited
financial statements for the years ended December 31, 2003, 2002, 2001, 2000 and
1999. The selected financial data should be read in conjunction with the more
detailed information contained in the Financial Statements and Notes thereto and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" included elsewhere in this Form 10-K.
SELECTED FINANCIAL DATA
(DOLLARS IN THOUSANDS, EXCEPT FOR PER SHARE DATA)
FOR THE YEAR FOR THE YEAR FOR THE YEAR FOR THE YEAR FOR THE YEAR
ENDED ENDED ENDED ENDED ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31, DECEMBER 31, DECEMBER 31,
2003 2002 2001 2000 1999
----------------------------------------------------------------------------
STATEMENT OF OPERATIONS DATA:
Interest income $ 337,433 $ 404,165 $ 263,058 $ 109,750 $ 89,812
Interest expense 182,004 191,758 168,055 92,902 69,846
---------------------------------------------------------------------------
Net interest income $ 155,429 $ 212,407 $ 95,003 $ 16,848 $ 19,966
Gain on sale of mortgage-backed securities 40,907 21,063 4,586 2,025 454
General and administrative expenses
(G&A expense) 16,233 13,963 7,311 2,286 2,281
---------------------------------------------------------------------------
Net income $ 180,103 $ 219,507 $ 92,278 $ 16,587 $ 18,139
===========================================================================
Basic net income per average share $ 1.95 $ 2.68 $ 2.23 $ 1.18 $ 1.41
Diluted net income per average share $ 1.94 $ 2.67 $ 2.21 $ 1.15 $ 1.35
Dividends declared per share $ 1.95 $ 2.67 $ 1.75 $ 1.15 $ 1.38
DECEMBER 31, DECEMBER 31, DECEMBER 31, DECEMBER 31, DECEMBER 31,
BALANCE SHEET DATA: 2003 2002 2001 2000 1999
----------------------------------------------------------------------------
Mortgage-Backed Securities, net $11,956,512 $11,551,857 $ 7,575,379 $ 1,978,219 $ 1,437,793
Total assets 12,990,286 11,659,084 7,717,314 2,035,029 1,491,322
Repurchase agreements 11,012,903 10,163,174 6,367,710 1,628,359 1,338,296
Total liabilities 11,841,066 10,579,018 7,049,957 1,899,386 1,388,050
Stockholders' equity 1,149,220 1,080,066 667,357 135,642 103,272
Number of common shares outstanding 96,074,096 84,569,206 59,826,975 14,522,978 13,581,316
OTHER DATA:
Average total assets $12,975,039 $10,486,423 $ 5,082,852 $ 1,652,459 $ 1,473,765
Average earning assets 12,007,333 9,575,365 4,682,780 1,564,491 1,461,254
Average borrowings 11,549,368 9,128,933 4,388,900 1,449,999 1,350,230
Average equity 1,122,633 978,107 437,376 117,727 117,685
Yield on average interest earning assets 2.81% 4.22% 5.62% 7.02% 6.15%
Cost of funds on average interest bearing
liabilities 1.58% 2.10% 3.83% 6.41% 5.17%
Interest rate spread 1.23% 2.12% 1.79% 0.61% 0.98%
FINANCIAL RATIOS:
Net interest margin (net interest
income/average total assets) 1.20% 2.03% 1.87% 1.02% 1.35%
G&A expense as a percentage of average
total assets 0.13% 0.13% 0.14% 0.14% 0.15%
G&A expense as a percentage of average
equity 1.45% 1.43% 1.67% 1.94% 1.94%
Return on average total assets 1.39% 2.09% 1.82% 1.00% 1.23%
Return on average equity 16.04% 22.44% 21.10% 14.09% 15.41%
35
ITEM 7.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
Certain statements contained in this annual report, and certain statements
contained in our future filings with the Securities and Exchange Commission (the
"SEC" or the "Commission"), in our press releases or in our other public or
shareholder communications may not be, based on historical facts and are
"forward-looking statements" within the meaning of the Private Securities
Litigation Reform Act of 1995. Forward-looking statements which are based on
various assumptions, (some of which are beyond our control) may be identified by
reference to a future period or periods, or by the use of forward-looking
terminology, such as "may," "will," "believe," "expect," "anticipate,"
"continue," or similar terms or variations on those terms, or the negative of
those terms. Actual results could differ materially from those set forth in
forward-looking statements due to a variety of factors, including, but not
limited to, changes in interest rates, changes in yield curve, changes in
prepayment rates, the availability of mortgage backed securities for purchase,
the availability of financing and, if available, the terms of any financing and
risks related to our acquisition of FIDAC. For a discussion of the risks and
uncertainties that could cause actual results to differ from those contained in
the forward-looking statements, see "Risk Factors." We do not undertake, and
specifically disclaim any obligation, to publicly release the result of any
revisions that may be made to any forward-looking statements to reflect the
occurrence of anticipated or unanticipated events or circumstances after the
date of such statements.
OVERVIEW
We are a real estate investment trust that owns and manages a portfolio of
mortgage-backed securities and agency debentures. Our principal business
objective is to generate net income for distribution to our stockholders from
the spread between the interest income on our investment securities and the
costs of borrowing to finance our acquisition of investment securities.
We are primarily engaged in the business of investing, on a leveraged
basis, in mortgage pass-through certificates, collateralized mortgage
obligations and other mortgage-backed securities representing interests in or
obligations backed by pools of mortgage loans (collectively, "Mortgage-Backed
Securities"). We also invest in Federal Home Loan Bank ("FHLB"), Federal Home
Loan Mortgage Corporation ("FHLMC"), and Federal National Mortgage Association
("FNMA") debentures. The Mortgage-Backed Securities and agency debentures are
collectively referred to herein as "Investment Securities."
Under our capital investment policy, at least 75% of our total assets must
be comprised of high-quality mortgage-backed securities and short-term
investments. High quality securities means securities that (1) are rated within
one of the two highest rating categories by at least one of the nationally
recognized rating agencies, (2) are unrated but are guaranteed by the United
States government or an agency of the United States government, or (3) are
unrated but we determine them to be of comparable quality to rated high-quality
mortgage-backed securities.
The remainder of our assets, comprising not more than 25% of our total
assets, may consist of other qualified REIT real estate assets which are unrated
or rated less than high quality, but which are at least "investment grade"
(rated "BBB" or better by Standard & Poor's Corporation ("S&P") or the
equivalent by another nationally recognized rating agency) or, if not rated, we
determine them to be of comparable credit quality to an investment which is
rated "BBB" or better.
We may acquire mortgage-backed securities backed by single-family
residential mortgage loans as well as securities backed by loans on
multi-family, commercial or other real estate-related properties. To date, all
of the mortgage-backed securities that we have acquired have been backed by
single-family residential mortgage loans.
36
We have elected to be taxed as a REIT for federal income tax purposes.
Pursuant to the current federal tax regulations, one of the requirements of
maintaining its status as a REIT is that we must distribute at least 90% of our
REIT taxable income (determined without regard to the deduction for dividends
paid and by excluding any net capital gain) to our stockholders, subject to
certain adjustments.
The results of our operations are affected by various factors, many of
which are beyond our control. The results of our operations primarily depend on,
among other things, the level of our net interest income, the market value of
our assets and the supply of and demand for such assets. Our net interest
income, which reflects the amortization of purchase premiums, varies primarily
as a result of changes in interest rates, borrowing costs and prepayment speeds,
the behavior of which involves various risks and uncertainties. Prepayment
speeds, as reflected by the Constant Prepayment Rate, or CPR, and interest rates
vary according to the type of investment, conditions in financial markets,
competition and other factors, none of which can be predicted with any
certainty. In general, as prepayment speeds on our Mortgage-Backed Securities
portfolio increase, related purchase premium amortization increases, thereby
reducing the net yield on such assets. The CPR on our Investment Securities
portfolio averaged 42% and 33% for the years ended December 31, 2003 and 2002,
respectively. Since changes in interest rates may significantly affect our
activities, our operating results depend, in large part, upon our ability to
effectively manage interest rate risks and prepayment risks while maintaining
our status as a REIT.
The following table presents the CPR experienced on our Mortgage-Backed
Securities portfolio, on an annualized basis, for the quarterly periods
presented.
Quarter Ended CPR
- ------------- ---
December 31, 2003 37%
September 30, 2003 48%
June 30, 2003 44%
March 31, 2003 41%
December 31, 2002 43%
We believe that the CPR in future periods will depend, in part, on changes
in and the level of market interest rates across the yield curve, with higher
CPRs expected during periods of declining interest rates and lower CPRs expected
during periods of rising interest rates.
We have extended contractual maturities on borrowings, such that, our
weighted average contractual maturity on our repurchase agreements was 203 days
at December 31, 2003, as compared to 166 days at December 31, 2002.
The table below provides quarterly information regarding our average
balances, interest income, interest expense, yield on assets, cost of funds and
net interest income for the quarterly periods presented.
Yield on
Average Interest Average Average
Investment Income on Total Interest Balance of Average Net
Securities Investment Average Cash Interest Earning Repurchase Interest Cost of Interest
Held (1) Securities Equivalents Income Assets Agreements Expense Funds Income
---------- ---------- ------------ -------- -------- ---------- -------- ------- --------
(Ratios for the four quarters in 2003 have been annualized, dollars in thousands)
For the Quarter Ended
December 31, 2003 $11,799,730 $89,186 -- $89,186 3.02% $11,235,908 $42,264 1.50% $46,922
For the Quarter Ended
September 30, 2003 $12,577,165 $66,855 -- $66,855 2.13% $12,186,985 $43,922 1.44% $22,933
For the Quarter Ended
June 30, 2003 $12,815,290 $93,892 -- $93,892 2.93% $12,311,329 $51,770 1.68% $42,122
For the Quarter Ended
March 31, 2003 $10,837,147 $87,500 -- $87,500 3.23% $10,463,251 $44,048 1.68% $43,452
(1) Does not reflect unrealized gains/(losses).
We continue to explore alternative business strategies, alternative
investments and other strategic initiatives to complement our core business
strategy of investing, on a leveraged basis, in high quality Investment
Securities.
37
No assurance, however, can be provided that any such strategic initiative will
or will not be implemented in the future.
CRITICAL ACCOUNTING POLICIES
Management's discussion and analysis of financial condition and results of
operations is based on the amounts reported our financial statements. These
financial statements are prepared in conformity with accounting principles
generally accepted in the United States of America. In preparing the financial
statements, management is required to make various judgments, estimates and
assumptions that affect the reported amounts. Changes in these estimates and
assumptions could have a material effect on our financial statements. The
following is a summary of our policies most affected by management's judgments,
estimates and assumptions.
Market valuation of Investment Securities: All assets classified as
available-for-sale are reported at fair value, based on market prices. Although
we generally intend to hold most of its investment securities until maturity, we
may, from time to time, sell any of our Investment Securities as part of its
overall management of our statement of financial condition. Accordingly, this
flexibility requires us to classify all of our investment securities as
available-for-sale. Our policy is to obtain market values from three independent
sources and record the market value of the securities based on the average of
the three. Unrealized losses on Investment Securities that are considered other
than temporary, as measured by the amount of decline in fair value attributable
to factors other than temporary, are recognized in income and the cost basis of
the Mortgage-Backed Securities is adjusted. There were no such adjustments for
the years ended December 31, 2003, 2002, and 2001.
Investment Securities transactions are recorded on the trade date.
Purchases of newly issued securities are recorded when all significant
uncertainties regarding the characteristics of the securities are removed,
generally shortly before settlement date. Realized gains and losses on such
transactions are determined on the specific identification basis.
Interest income: Interest income is accrued based on the outstanding
principal amount of the outstanding principal amount of the Investment
Securities and their contractual terms. Premiums and discounts associated with
the purchase of the Investment Securities are amortized into interest income
over the lives of the securities using the interest method. Our policy for
estimating prepayment speeds for calculating the effective yield is to evaluate
historical performance, street consensus prepayment speeds, and current market
conditions.
Repurchase Agreements: We finance the acquisition of our Investment
Securities through the use of repurchase agreements. Repurchase agreements are
treated as collateralized financing transactions and are carried at their
contractual amounts, including accrued interest, as specified in the respective
agreements. Accrued interest is recorded as a separate line item.
Income Taxes: We have elected to be taxed as a REIT and intend to comply
with the provisions of the Internal Revenue Code of 1986, as amended (the
"Code") with respect thereto. Accordingly, we will not be subjected to federal
income tax to the extent of its distributions to shareholders and as long as
certain asset, income and stock ownership tests are met.
RESULTS OF OPERATIONS
NET INCOME SUMMARY
For the year ended December 31, 2003, our net income was $180.1 million or
$1.95 basic earnings per average share, as compared to $219.5 million or $2.68
basic earnings per average share for the year ended December 31, 2002. For the
year ended December 31, 2001, our net income was $92.3 million, or $2.23 basic
earnings per average share. Net income per average share decreased by $0.73 and
total net income decreased $39.4 million for the year ended December 31, 2003,
when compared to the year ended December 31, 2002. The reason for the decline in
net income was due to the interest rate spread decreased to 1.23% in 2003 from
2.12% for the prior year. The primary reason for the decline in interest rate
spread is the amortization of premium paid on the mortgage-backed securities.
The total amortization for the year ended December 31, 2003 was $216.6 million
and for the year ended December 31, 2002 was $106.2 million. The trend of record
prepayment levels began to decline in the fourth
38
quarter of the year. This was evidenced by the amortization for the fourth
quarter of $38.4 million, in comparison to the third quarter of 2003 of $72.0
million. Net income per average share increased by $0.45 and total net income
increased by $127.2 million for the year ended December 31, 2002, when compared
to the year ended December 31, 2001. The increase in 2002 net income over 2001
is attributable to our acquisition of additional mortgage-backed securities
using proceeds raised from our January 2002 public offering and Equity Shelf
Program during the year and the increase in the interest rate spread between our
interest-earning assets and our interest-bearing liabilities. We compute our net
income per share by dividing net income by the weighted average number of shares
of outstanding common stock during the period, which was 92,215,352 for the year
ended December 31, 2003, 82,044,141 for the year ended December 31, 2002, and
41,439,631 for the year ended December 31, 2001. Dividends per share for the
year ended December 31, 2003 were $1.95, or an aggregate of $179.3 million.
Dividends per share for the year ended December 31, 2002 were $2.67 per share,
or $223.6 million in total. Dividends per share for the year ended December 31,
2001 were $1.75 per share, or $88.4 million in total. Our return on average
equity was 16.04% for the year ended December 31, 2003, 22.44% for the year
ended December 31, 2002, and 21.1% for the year ended December 31, 2001. The
decrease in return on equity in 2003 compared to 2002 is primarily due to a
decline in spread income. The table below presents the net income summary for
the years ended December 31, 2003, 2002, 2001, 2000, and 1999.
NET INCOME SUMMARY
(DOLLARS IN THE THOUSANDS, EXCEPT FOR PER SHARE DATA)
Year Ended Year Ended Year Ended Year Ended Year Ended
December 31, December 31, December 31, December 31, December 31,
2003 2002 2001 2000 1999
----------------------------------------------------------------------------
Interest income $ 337,433 $ 404,165 $ 263,058 $ 109,750 $ 89,812
Interest expense 182,004 191,758 168,055 92,902 69,846
----------------------------------------------------------------------------
Net interest income 155,429 $ 212,407 $ 95,003 $ 16,848 $ 19,966
Gain on sale of mortgage-backed securities 40,907 21,063 4,586 2,025 454
General and administrative expenses 16,233 13,963 7,311 2,286 2,281
----------------------------------------------------------------------------
Net income $ 180,103 $ 219,507 $ 92,278 $ 16,587 $ 18,139
============================================================================
Average number of basic shares outstanding 92,215,352 82,044,141 41,439,631 14,089,436 12,889,510
Average number of diluted shares outstanding 93,031,253 82,282,883 41,857,498 14,377,459 13,454,007
Basic net income per share $ 1.95 $ 2.68 $ 2.23 $ 1.18 $ 1.41
Diluted net income per share $ 1.94 $ 2.67 $ 2.21 $ 1.15 $ 1.35
Average total assets $12,975,039 $10,486,423 $ 5,082,852 $ 1,652,459 $ 1,473,765
Average equity 1,122,633 978,107 437,376 117,727 117,685
Return on average total assets 1.39% 1.43% 1.82% 1.00% 1.23%
Return on average equity 16.04% 22.44% 21.10% 14.09% 15.41%
INTEREST INCOME AND AVERAGE EARNING ASSET YIELD
We had average earning assets of $12.0 billion for the year ended December
31, 2003. We had average earning assets of $9.6 billion for the year ended
December 31, 2002. We had average earning assets of $4.7 billion for the year
ended December 31, 2001. Our primary source of income for the years ended
December 31, 2003, 2002, and 2001 was interest income. A portion of our income
was generated by gains on the sales of our mortgage-backed securities. Our
interest income was $337.4 million for the year ended December 31, 2003, $404.2
million for the year ended December 31, 2002, and $263.1 million for the year
ended December 31, 2001. Our yield on average earning assets was 2.81%, 4.22%,
and 5.62% for the same respective periods. Our yield on average earning assets
decreased by 1.41% for the year ended December 31, 2003 in comparison to the
prior year. The declining yields were the direct result of increased
amortization on our assets due to the rise in prepayments, especially in the
39
third quarter of 2003. The homeowners' prepayment option makes the average term,
yield and performance of a mortgage-backed security uncertain because of the
uncertainty in timing the return of principal. In general, prepayments decrease
the total yield on a bond purchased at a premium, because over the life of the
bond that premium has to be amortized. The faster prepayments, the shorter the
life of the security, which results in increased amortization. Our average
earning asset balance increased by $2.4 billion for the year ended December 31,
2003, when compared to the prior year. Our asset base increased resulting from
the inflow of capital from our public offering and Equity Shelf Program during
the year ended December 31, 2003. Even with increased average earning assets,
interest income declined because of the 141 basis point decline in yield on
average earning assets. Our yield on average earning assets decreased by 140
basis points and our average earning asset balance increased by $4.9 billion for
the year ended December 31, 2002, when compared to the prior year. Due to the
increase in assets resulting from the three public offerings during the year
ended December 31, 2002, interest income increased by $141.1 million. The table
below shows our average balance of cash equivalents and investment securities,
the yields we earned on each type of earning assets, our yield on average
earning assets and our interest income for the years ended December 31, 2003,
2002, 2001, 2000, and 1999, and the four quarters in 2003.
AVERAGE EARNING ASSET YIELD
(RATIOS FOR THE FOUR QUARTERS IN 2003 ARE ANNUALIZED, DOLLARS IN THOUSANDS)
Yield on Yield on Yield on
Average Average Average Average Average Average
Cash Investment Earning CASH Investment Earning Interest
Equivalents Securities Assets Equivalents Securities Assets Income
----------- ---------- ------ ----------- ---------- ------ ------
For the Year Ended December 31, 2003 -- $12,007,333 $12,007,333 -- 2.81% 2.81% $337,433
For the Year Ended December 31, 2002 $ 2 $ 9,575,365 $ 9,575,365 1.14% 4.22% 4.22% $404,165
For the Year Ended December 31, 2001 $ 2 $ 4,682,778 $ 4,682,780 3.25% 5.62% 5.62% $263,058
For the Year Ended December 31, 2000 $263 $ 1,564,228 $ 1,564,491 4.18% 7.02% 7.02% $109,750
For the Year Ended December 31, 1999 $221 $ 1,461,033 $ 1,461,254 4.10% 6.15% 6.15% $ 89,812
- ------------------------------------------------------------------------------------------------------------------------------------
For the Quarter Ended December 31, 2003 -- $11,799,730 $11,799,730 -- 3.02% 3.02% $ 89,186
For the Quarter Ended September 30, 2003 -- $12,577,165 $12,577,165 -- 2.13% 2.13% $ 66,855
For the Quarter Ended June 30, 2003 -- $12,815,290 $12,815,290 -- 2.93% 2.93% $ 93,892
For the Quarter Ended March 31, 2003 -- $10,837,147 $10,837,147 -- 3.23% 3.23% $ 87,500
The Constant Prepayment Rate increased to 42% for the year ended December
31, 2003, as compared to 33% for the year ended December 31, 2002 and 26% for
the year ended December 31, 2001. The homeowners' prepayment option makes the
average term yield and performance of a mortgage-backed security uncertain
because of the uncertainty in timing the return of principal. In general,
prepayment decrease the total yield on a bond purchased at a premium, because
over life of the bond that premium has to be amortized. The faster prepayments,
the shorter the life of the security, which results in the increased
amortization. The total amortization for the year ended December 31, 2003, 2002,
and 2001 was $216.6 million , $106.2 million, and $36.9 million, respectively.
For the first, second, third, and fourth quarters of 2003, amortization was
$48.6 million, $57.6 million, $72.0 million, and $38.4 million, respectively.
The third quarter experienced the highest level of prepayments and in the fourth
quarter we experienced a decline in the prepayment speeds, providing evidence
that the trend was not continuing.
INTEREST EXPENSE AND THE COST OF FUNDS
We had average borrowed funds of $11.5 billion for the year ended December
31, 2003, $9.1 billion for the year ended December 31, 2002 and $4.4 billion for
the year ended December 31, 2001. Interest expense totaled $182.0 million,
$191.8 million and $168.1 million for the years ended December 31, 2003, 2002,
and 2001, respectively. Our average cost of funds was 1.58% for the year ended
December 31, 2003, 2.10% for the year ended December 31, 2002 and 3.83% for the
year ended December 31, 2001. The cost of funds rate decreased by 52 basis
points and the average borrowed funds increased by $2.4 billion for the year
ended December 31, 2003. Interest expense for the year ended December 31, 2003
declined $9.8 million, even with the increase in the average borrowed funds for
the year. Since a substantial portion of our repurchase agreements are short
term, market rates are directly reflected in our interest expense. The average
one-month LIBOR for the year ended December 31, 2003 was 1.21%, as compared to
1.77% for the year ended December 31, 2002. This downward trend of short-term
interest rates stabilized in the third and fourth quarters of 2003, with the
average One-Month LIBOR at 1.11% for the third quarter and 1.13% for the fourth
quarter. Interest expense for the year ended December 31, 2002 increased
40
$23.7 million, from $168.1 million to $191.8 million. We increased our asset
base by raising approximately $379.5 million of additional capital in 2002. As a
result, we increased the amounts borrowed under repurchase agreements.
Consequently, the increased interest expense for the year 2002 is the result of
our growth. The table below shows our average borrowed funds and average cost of
funds as compared to average one-month and average six-month LIBOR for the years
ended December 31, 2003, 2002, 2001, 2000, and 1999, and the four quarters in
2003.
AVERAGE COST OF FUNDS
(Ratios for the four quarters in 2003 have been annualized, dollars in
thousands)
Average
One-Month Average Cost of Average Cost of
Average Average Average LIBOR Relative Funds Relative Funds Relative
Average Interest Cost of One-Month Six-Month to Average to Average to Average
Borrowed Funds Expense Funds LIBOR LIBOR Six-Month LIBOR One-Month LIBOR Six-Month LIBOR
-------------- ------- ----- ----- ----- --------------- --------------- ---------------
For the Year Ended
December 31, 2003 $11,549,368 $182,004 1.58% 1.21% 1.23% (0.02%) 0.37% 0.35%
For the Year Ended
December 31, 2002 $ 9,128,933 $191,758 2.10% 1.77% 1.88% (0.11%) 0.33% 0.22%
For the Year Ended
December 31, 2001 $ 4,388,900 $168,055 3.83% 3.88% 3.73% 0.15% (0.05%) 0.10%
For the Year Ended
December 31, 2000 $ 1,449,999 $ 92,902 6.41% 6.41% 6.66% (0.25%) -- (0.25%)
For the Year Ended
December 31, 1999 $ 1,350,230 $ 69,846 5.17% 5.25% 5.53% (0.28%) (0.08%) (0.36%)
- ------------------------------------------------------------------------------------------------------------------------------------
For the Quarter Ended
December 31, 2003 $11,235,908 $ 42,264 1.50% 1.13% 1.23% (0.10%) 0.37% 0.27%
For the Quarter Ended
September 30, 2003 $12,186,985 $ 43,922 1.44% 1.11% 1.17% (0.06%) 0.33% 0.27%
For the Quarter Ended
June 30, 2003 $12,311,329 $ 51,770 1.68% 1.26% 1.20% 0.06% 0.42% 0.48%
For the Quarter Ended
March 31, 2003 $10,463,252 $ 44,048 1.68% 1.34% 1.33% 0.01% 0.34% 0.35%
NET INTEREST INCOME
Our net interest income, which equals interest income less interest
expense, totaled $155.4 million for the year ended December 31, 2003, $212.4
million for the year ended December 31, 2002, and $95.0 million for the year
ended December 31, 2001. Our net interest spread, which equals the yield on
average interest-earning assets for the period less the average cost of funds
for the period, was 1.23% for the year ended December 31, 2003, which is a 0.89%
decrease over the prior year. Our net interest income decreased $57.0 million
for the year ended December 31, 2003 over the prior year. This was the direct
result of the CPR, which increased from 33% in the prior year to 42%. The CPR
for the four quarters in 2003 was 41%, 44%, 48%, and 37%, respectively. The
third quarter of 2003 was the highest weighted average CPR in our history. The
net interest spread for the year ended December 31, 2002 was 2.12%, as compared
to 1.79% for the year ended December 31, 2001. Our net interest income increased
by $117.4 million for the year ended December 31, 2002 over the prior year. The
increase in our balance sheet which resulted from our raising additional capital
in 2002, along with the 0.33% increase in the interest rate spread. Net interest
margin, which equals net interest income divided by average total assets, was
1.20% for the year ended December 31, 2003, 2.03% for the year ended December
31, 2002, and 1.87% for the year ended December 31, 2001.
41
The table below shows our interest income by earning asset type, average
earning assets by type, total interest income, interest expense, average
repurchase agreements, average cost of funds, and net interest income for the
years ended December 31, 2003, 2002, 2001, 2000, and 1999, and the four quarters
in 2003.
NET INTEREST INCOME
(Ratios for the four quarters in 2003 have been annualized, dollars in
thousands)
Yield on
Average Interest Average Average
Investment Income on Total Interest Balance of Average Net
Securities Investment Average Cash Interest Earning Repurchase Interest Cost of Interest
Held Securities Equivalents Income Assets Agreements Expense Funds Income
---------- ---------- ------------ -------- --------- ---------- -------- ------- --------
For the Year Ended $12,007,333 $337,433 -- $337,433 2.81% $11,549,368 $182,004 1.58% $155,429
December 31, 2003
For the Year Ended
December 31, 2002 $ 9,575,365 $404,165 $ 2 $404,165 4.22% $ 9,128,933 $191,758 2.10% $212,407
For the Year Ended
December 31, 2001 $ 4,682,778 $263,058 $ 2 $263,058 5.62% $ 4,388,900 $168,055 3.83% $ 95,003
For the Year Ended
December 31, 2000 $ 1,564,228 $109,739 $263 $109,750 7.02% $ 1,449,999 $ 92,902 6.41% $ 16,848
For the Year Ended
December 31, 1999 $ 1,461,033 $ 89,801 $221 $ 89,812 6.15% $ 1,350,230 $ 69,846 5.17% $ 19,966
- ------------------------------------------------------------------------------------------------------------------------------------
For the Quarter Ended $11,799,730 $ 89,186 -- $ 89,186 3.02% $11,235,908 $ 42,264 1.50% $ 46,922
December 31, 2003
For the Quarter Ended
September 30, 2003 $12,577,165 $ 66,855 -- $ 66,855 2.13% $12,186,985 $ 43,922 1.44% $ 22,933
For the Quarter Ended
June 30, 2003 $12,815,290 $ 93,892 -- $ 93,892 2.93% $12,311,329 $ 51,770 1.68% $ 42,122
For the Quarter Ended
March 31, 2003 $10,837,147 $ 87,500 -- $ 87,500 3.23% $10,463,251 $ 44,048 1.68% $ 43,452
GAINS AND LOSSES ON SALES OF MORTGAGE-BACKED SECURITIES
For the year ended December 31, 2003, we sold mortgage-backed securities
with an aggregate historical amortized cost of $2.9 billion for an aggregate
gain of $40.9 million. For the year ended December 31, 2002, we sold
mortgage-backed securities with an aggregate historical amortized cost of $2.1
billion for an aggregate gain of $21.1 million. For the year ended December 31,
2001, we sold mortgage-backed securities with an aggregate historical amortized
cost of $1.2 billion for an aggregate gain of $4.6 million. For the year ended
December 31, 2000, we sold mortgage-backed securities with an aggregate
historical amortized cost of $487.8 million for an aggregate gain of $2.0
million. The gain on sale of assets for the year ended December 31, 2003
increased by $19.8 million over the prior year. The gain on sale of assets for
the year ended December 31, 2002 increased by $16.5 million over the prior year.
The gain on sale of assets for the year ended December 31, 2001 increased by
$2.6 million over the prior year. Even though the gain for the year 2001
increased over the prior year, as a percentage of total income it declined. We
do not expect to sell assets on a frequent basis, but may from time to time sell
existing assets to move into new assets, which our management believes might
have higher risk-adjusted returns, or to manage our balance sheet as part of our
asset/liability management strategy.
GENERAL AND ADMINISTRATIVE EXPENSES
General and administrative ("G&A") expenses were $16.2 million for the
year ended December 31, 2003, $14.0 million for the year ended December 31,
2002, and $7.3 million for the year ended December 31, 2001. G&A expenses as a
percentage of average total assets was 0.13%, 0.13% and 0.14%, for the years
ended December 31, 2003, 2002, and 2001, respectively. G&A expense has increased
proportionately with our increased capital base and the growth in staff from 15
at the end of 2002 to 20 at the end of 2003. Salaries and bonuses for the years
ended December 31, 2003, 2002, and 2001 were $11.5 million, $10.8 million, and
$4.7 million. Even with the increased asset base, G&A expense as a percentage of
average assets has not increased. The table below shows our total G&A expenses
as compared to average total assets and average equity for the years ended
December 31, 2003, 2002, 2001, 2000, 1999, and the four quarters in 2003.
42
G&A EXPENSES AND OPERATING EXPENSE RATIOS
(Ratios for the four quarters in 2003 have been annualized, dollars in
thousands)
Total G&A Total G&A
Expenses/Average Expenses/Average
Total G&A Expenses Assets Equity
------------------ ---------------- ----------------
For the Year Ended
December 31, 2003 $16,233 0.13% 1.45%
For the Year Ended
December 31, 2002 $13,963 0.13% 1.43%
For the Year Ended
December 31, 2001 $ 7,311 0.14% 1.67%
For the Year Ended
December 31, 2000 $ 2,286 0.14% 1.94%
For the Year Ended
December 31, 1999 $ 2,281 0.15% 1.94%
- -------------------------------------------------------------------------------------------------
For the Quarter Ended
December 31, 2003 $ 4,225 0.13% 1.47%
For the Quarter Ended
September 30, 2003 $ 4,110 0.12% 1.42%
For the Quarter Ended
June 30, 2003 $ 4,201 0.12% 1.50%
For the Quarter Ended
March 31, 2003 $ 3,697 0.12% 1.37%
NET INCOME AND RETURN ON AVERAGE EQUITY
Our net income was $180.1 million for the year ended December 31, 2003,
$219.5 million for the year ended December 31, 2002, and $92.3 million for the
year ended December 31, 2001. Our return on average equity was 16.04% for the
year ended December 31, 2003, 22.44% for the year ended December 31, 2002, and
21.1% for the year ended December 31, 2001. Net income decreased by $39.4
million in the year 2003 over the previous year, due to the declining interest
rate spread. Net income increased by $127.2 million in the year 2002 over the
previous year, due to the increased asset base and the increase in the average
interest rate spread. In addition to spread income, we were able to take
advantage of appreciation in asset value in 2003, 2002, and 2001. The table
below shows our net interest income, gain on sale of mortgage-backed securities
and G&A expenses each as a percentage of average equity, and the return on
average equity for the years ended December 31, 2003, 2002, 2001, 2000, 1999,
and for the four quarters in 2003.
COMPONENTS OF RETURN ON AVERAGE EQUITY
(Ratios for the four quarters in 2003 have been annualized)
Gain on Sale of
Net Interest Mortgage-Backed G&A
Income/Average Securities/Average Expenses/Average Return on
Equity Equity Equity Average Equity
-------------- ------------------ ---------------- --------------
For the Year Ended December 31, 2003 13.85% 3.64% 1.45% 16.04%
For the Year Ended December 31, 2002 21.72% 2.15% 1.43% 22.44%
For the Year Ended December 31, 2001 21.72% 1.05% 1.67% 21.10%
For the Year Ended December 31, 2000 14.31% 1.72% 1.94% 14.09%
For the Year Ended December 31, 1999 16.97% 0.38% 1.94% 15.41%
- -----------------------------------------------------------------------------------------------------------------------
For the Quarter Ended December 31, 2003 16.36% -- 1.47% 14.89%
For the Quarter Ended September 30, 2003 7.95% 3.35% 1.42% 9.88%
For the Quarter Ended June 30, 2003 15.06% 7.23% 1.50% 20.79%
For the Quarter Ended March 31, 2003 16.11% 4.09% 1.37% 18.83%
43
FINANCIAL CONDITION
INVESTMENT SECURITIES
All of our Mortgage-Backed Securities at December 31, 2003, 2002, and 2001
were adjustable-rate or fixed-rate mortgage-backed securities backed by
single-family mortgage loans. All of the mortgage assets underlying these
mortgage-backed securities were secured with a first lien position on the
underlying single-family properties. All our mortgage-backed securities were
FHLMC, FNMA or GNMA mortgage pass-through certificates or CMOs, which carry an
implied "AAA" rating. We mark-to-market all of our earning assets at fair value.
All of our Agency Debentures are callable and carry an implied "AAA"
rating. We mark-to-market all of our agency debentures at fair value.
We accrete discount balances as an increase in interest income over the
life of discount investment securities and we amortize premium balances as a
decrease in interest income over the life of premium investment securities. At
December 31, 2003, 2002, and 2001, we had on our balance sheet a total of $1.5
million, $664,000, and $2.1 million respectively, of unamortized discount (which
is the difference between the remaining principal value and current historical
amortized cost of our investment securities acquired at a price below principal
value) and a total of $301.3 million, $274.6 million, and $139.4 million
respectively, of unamortized premium (which is the difference between the
remaining principal value and the current historical amortized cost of our
investment securities acquired at a price above principal value).
We received mortgage principal repayments of $8.3 billion for the year
ended December 31, 2003, $4.7 billion for the year ended December 31, 2002, and
$1.7 billion for the year ended December 31, 2001. The overall prepayment speed
for the year ended December 31, 2003, 2002, 2001 was 42%, 33%, and 27%
respectively. During the year ended December 31, 2003, the annual prepayment
speed was the highest in our history at 42%. The result was record returns of
principal for the year, relative to the asset size. The increase in prepayments
in 2002 from 2001 was primarily because we acquired more mortgage-backed
securities following our three public offerings. Given our current portfolio
composition, if mortgage principal prepayment rates were to increase over the
life of our mortgage-backed securities, all other factors being equal, our net
interest income would decrease during the life of these mortgage-backed
securities as we would be required to amortize our net premium balance into
income over a shorter time period. Similarly, if mortgage principal prepayment
rates were to decrease over the life of our mortgage-backed securities, all
other factors being equal, our net interest income would increase during the
life of these mortgage-backed securities as we would amortize our net premium
balance over a longer time period.
The table below summarizes our Investment Securities at December 31, 2003,
2002, 2001, 2000, and 1999, and September 30, 2003, June 30, 2003, and March 31,
2003.
INVESTMENT SECURITIES
(dollars in thousands)
Amortized Estimated Fair Weighted
Net Amortized Cost/Principal Estimated Value/Principal Average
Principal Value Premium Cost Value Fair Value Value Yield
--------------- ------- --------- -------------- ---------- --------------- --------
At December 31, 2003 $12,682,130 $299,810 $12,981,940 102.36% $12,934,679 101.99% 2.96%
At December 31, 2002 $11,202,384 $273,963 $11,476,347 102.45% $11,551,857 103.12% 3.25%
At December 31, 2001 $ 7,399,941 $137,269 $ 7,537,210 101.86% $ 7,575,379 102.37% 4.41%
At December 31, 2000 $ 1,967,967 $ 23,296 $ 1,991,263 101.18% $ 1,978,219 100.52% 7.09%
At December 31, 1999 $ 1,452,917 $ 22,444 $ 1,475,361 101.54% $ 1,437,793 98.96% 6.77%
- -------------------------------------------------------------------------------------------------------------------------------
At September 30, 2003 $12,363,260 $293,694 $12,656,954 102.38% $12,605,085 101.96% 2.35%
At June 30, 2003 $13,939,447 $322,838 $14,262,285 102.32% $14,263,475 102.32% 2.87%
At March 31, 2003 $11,957,710 $289,360 $12,247,070 102.42% $12,318,070 103.01% 2.83%
The tables below set forth certain characteristics of our investment
securities. The index level for adjustable-rate Investment Securities is the
weighted average rate of the various short-term interest rate indices, which
determine the coupon rate.
44
ADJUSTABLE-RATE INVESTMENT SECURITY CHARACTERISTICS
(dollars in thousands)
Principal
Value at
Weighted Weighted Weighted Period End as
Average Weighted Weighted Average Term Weighted Average % of Total
Principal Coupon Average Average Net to Next Average Asset Investment
Value Rate Index Level Margin Adjustment Lifetime Cap Yield Securities
--------- -------- ----------- ----------- ------------ ------------ -------- -------------
At December 31, 2003 $9,294,934 3.85% 2.25% 1.60% 23 months 9.86% 2.47% 73.29%
At December 31, 2002 $7,007,062 4.10% 2.51% 1.59% 11 months 10.37% 2.33% 62.55%
At December 31, 2001 $5,793,250 5.90% 3.95% 1.95% 24 months 11.49% 3.87% 78.29%
At December 31, 2000 $1,454,356 7.61% 5.76% 1.85% 15 months 11.47% 7.24% 73.90%
At December 31, 1999 $ 951,839 7.33% 5.84% 1.49% 11 months 10.30% 7.64% 65.51%
- ------------------------------------------------------------------------------------------------------------------------------------
At September 30, 2003 $8,498,116 3.76% 2.17% 1.59% 22 months 9.75% 1.77% 68.74%
At June 30, 2003 $8,889,012 3.69% 2.18% 1.51% 18 months 9.70% 2.47% 63.77%
At March 31, 2003 $7,716,248 3.93% 2.31% 1.62% 13 months 10.04% 2.20% 64.53%
FIXED-RATE INVESTMENT SECURITY CHARACTERISTICS
(dollars in thousands)
Weighted
Weighted Average Average Asset Principal Value as % of Total
Principal Value Coupon Rate Yield Investment Securities
--------------- ---------------- ------------- -----------------------------
At December 31, 2003 $3,387,197 5.77% 4.29% 26.71%
At December 31, 2002 $4,195,322 6.76% 4.78% 37.45%
At December 31, 2001 $1,606,691 6.92% 6.33% 21.71%
At December 31, 2000 $ 513,611 6.62% 6.68% 26.10%
At December 31, 1999 $ 501,078 6.58% 7.01% 34.49%
- --------------------------------------------------------------------------------------------------------------------
At September 30, 2003 $3,865,171 5.86% 3.63% 31.26%
At June 30, 2003 $5,050,434 5.97% 3.58% 36.23%
At March 31, 2003 $4,241,462 6.53% 3.98% 35.47%
At December 31, 2003 we held investment securities with coupons linked to
the one-year, two-year, three-year, and five-year Treasury indices, one-month
and one-year LIBOR, six-month Auction Average, twelve-month moving average and
the six-month CD rate. At December 31, 2002 we held investment securities with
coupons linked to the one-year, three-year, and five-year Treasury indices,
one-month and six-month LIBOR, six-month Auction Average, twelve-month moving
average and the six-month CD rate.
ADJUSTABLE-RATE INVESTMENT SECURITIES BY INDEX
DECEMBER 31, 2003
Six- 12- 11th
One- Six- Twelve Month Month District Interest
Month Month Month Auction Moving Cost of Rate Step
Libor Libor Libor Average Average Funds Up
----- ----- ----- ------- ------- -------- ---------
Weighted Average Term to
Next Adjustment 1mo. 25 mo. 34 mo. 2 mo. 1 mo. 1 mo. 175 mo.
Weighted Average Annual
Period Cap None 2.14% 2.09% 1.00% 0.14% None 2.00%
Weighted Average Lifetime
Cap at December 31, 2003 8.88% 9.88% 10.12% 13.04% 10.70% 12.42% 6.76%
Investment Principal Value
as Percentage of Investment
Securities at
December 31, 2003 17.26% 1.73% 12.00% 0.01% 0.53% 2.13% 2.21%
Monthly
1-Year 2-Year 3-Year 5-Year Federal
Six-Month Treasury Treasury Treasury Treasury Cost of
CD Rate Index Index Index Index Funds
--------- -------- -------- -------- -------- -------
Weighted Average Term to
Next Adjustment 2 mo. 23 mo. 15 mo. 16 mo. 26 mo. 1 mo.
Weighted Average Annual
Period Cap 1.00% 1.88% 2.00% 2.00% 2.00% None
Weighted Average Lifetime
Cap at December 31, 2003 11.62% 10.05% 11.92% 12.89% 12.63% 13.40%
Investment Principal Value
as Percentage of Investment
Securities at
December 31, 2003 0.09% 35.10% 0.01% 0.44% 0.17% 1.61%
45
ADJUSTABLE-RATE INVESTMENT SECURITIES BY INDEX
DECEMBER 31, 2002
Six-Month 12-Month 1-Year 2-Year 3-Year 5-Year
One-Month One-Year Auction Moving Six-Month Treasury Treasury Treasury Treasury
LIBOR LIBOR Average Average CD Rate Index Index Index Index
--------- -------- --------- -------- --------- -------- -------- -------- --------
Weighted Average Term to
Next Adjustment 1mo. 41 mo. 2 mo. 1 mo. 2 mo. 22 mo. 10 mo. 20 mo. 31 mo.
Weighted Average Annual
Period Cap None 2.00% 2.00% None 1.00% 1.93% 2.00% 2.00% 2.00%
Weighted Average Lifetime
Cap at December 31, 2002 9.01% 11.31% 13.00% 10.37% 11.60% 11.83% 11.93% 12.83% 12.57%
Mortgage Principal Value as
Percentage of Mortgage-
Backed Securities at
December 31, 2002 32.43% 0.33% 0.03% 0.58% 0.14% 27.67% 0.03% 0.92% 0.42%
BORROWINGS
To date, our debt has consisted entirely of borrowings collateralized by a
pledge of our investment securities. These borrowings appear on our balance
sheet as repurchase agreements. At December 31, 2003, we had established
uncommitted borrowing facilities in this market with 29 lenders in amounts,
which we believe are in excess of our trends. All of our investment securities
are currently accepted as collateral for these borrowings. However, we limit our
borrowings, and thus our potential asset growth, in order to maintain unused
borrowing capacity and thus increase the liquidity and strength of our balance
sheet.
For the year ended December 31, 2003, the term to maturity of our
borrowings ranged from one day to three years, with a weighted average original
term to maturity of 203 days at December 31, 2003. For the year ended December
31, 2002, the term to maturity of our borrowings ranged from one day to three
years, with a weighted average original term to maturity of 166 days at December
31, 2002. For the year ended December 31, 2001, the term to maturity of our
borrowings ranged from one day to three years, with a weighted average original
term to maturity of 119 days at December 31, 2001.
At December 31, 2003, the weighted average cost of funds for all of our
borrowings was 1.51% and the weighted average term to next rate adjustment was
90 days. At December 31, 2002, the weighted average cost of funds for all of our
borrowings was 1.72% and the weighted average term to next rate adjustment was
124 days. At December 31, 2001, the weighted average cost of funds for all of
our borrowings was 2.18% and the weighted average term to next rate adjustment
was 85 days.
LIQUIDITY
Liquidity, which is our ability to turn non-cash assets into cash, allows
us to purchase additional investment securities and to pledge additional assets
to secure existing borrowings should the value of our pledged assets decline.
Potential immediate sources of liquidity for us include cash balances and unused
borrowing capacity. Unused borrowing capacity will vary over time as the market
value of our investment securities varies. Our balance sheet also generates
liquidity on an on-going basis through mortgage principal repayments and net
earnings held prior to payment as dividends. Should our needs ever exceed these
on-going sources of liquidity plus the immediate sources of liquidity discussed
above, we believe that in most circumstances our investment securities could be
sold to raise cash. The maintenance of liquidity is one of the goals of our
capital investment policy. Under this policy, we limit asset growth in order to
preserve unused borrowing capacity for liquidity management purposes.
At present, we have entered into uncommitted facilities with 29 lenders
for borrowings in the form of repurchase agreements. Borrowings under our
repurchase agreements increased by $850 million to $11.0 billion at December 31,
2003, from $10.2 billion at December 31, 2002. This increase in leverage was
facilitated by the increase in our equity capital as a result of the issuance of
common stock primarily through public offerings during 2003.
We anticipate that, upon repayment of each borrowing under a repurchase
agreement, we will use the collateral immediately for borrowing under a new
repurchase agreement. We have not at the present time entered into any
commitment agreements under which the lender would be required to enter into new
repurchase agreements during a specified period of time, nor do we presently
plan to have liquidity facilities with commercial banks.
46
Under our repurchase agreements, we may be required to pledge additional
assets to our repurchase agreement counterparties (i.e., lenders) in the event
the estimated fair value of the existing pledged collateral under such
agreements declines and such lenders demand additional collateral (a "margin
call"), which may take the form of additional securities or cash. Specifically,
margin calls result from a decline in the value of the our Mortgage-Backed
Securities securing our repurchase agreements, prepayments on the mortgages
securing such Mortgage-Backed Securities and to changes in the estimated fair
value of such Mortgage-Backed Securities generally due to principal reduction of
such Mortgage-Backed Securities from scheduled amortization and resulting from
changes in market interest rates and other market factors. Through December 31,
2003, we did not have any margin calls on our repurchase agreements that we were
not able to satisfy with either cash or additional pledged collateral. However,
should prepayment speeds on the mortgages underlying our Mortgage-Backed
Securities and/or market interest rates suddenly increase, margin calls on our
repurchase agreements could result, causing an adverse change in our liquidity
position.
The following table summarized the effect on our liquidity and cash flows
from contractual obligations for repurchase agreements and the non-cancelable
office lease at December 31, 2003.
2004 2005 2006 2007 2008 Thereafter
---- ---- ---- ---- ---- ----------
(dollars in thousands)
Repurchase Agreements $9,812,903 $ 950,000 $ 250,000 -- -- --
Long-term lease obligations 500 500 530 532 532 532
--------------------------------------------------------------------------------
Total $9,813,403 $ 950,500 $ 250,530 $ 532 $ 532 $ 532
================================================================================
STOCKHOLDERS' EQUITY
We use "available-for-sale" treatment for our investment securities; we
carry these assets on our balance sheet at estimated market value rather than
historical amortized cost. Based upon this "available-for-sale" treatment, our
equity base at December 31, 2003 was $1.1 billion, or $11.96 per share. If we
had used historical amortized cost accounting, our equity base at December 31,
2003 would have been $1.2 billion, or $12.45 per share. Our equity base at
December 31, 2002 was $1.1 billion or $12.77 per shares. If we had used
historical amortized cost accounting, our equity base at December 31, 2002 would
have been $1.0 billion, or $11.88 per share. Our equity base at December 31,
2001 was $667.4 million, or $11.15 per share. If we had used historical
amortized cost accounting, our equity base at December 31, 2001 would have been
$629.2 million, or $10.52 per share.
Through the Equity Shelf Program, in which we sell shares from
time-to-time at market prices, we raised approximately $34.7 million in net
proceeds and issued 1,879,600 shares during 2003 and $28.1 million in net
proceeds and issued 1,484,100 shares during 2002. In 2003, 231,893 shares were
purchased through our dividend reinvestment and share purchase plan, totaling
approximately $4.2 million, and in 2002, 165,480 shares were purchased through
our dividend reinvestment and share purchase plan, totaling approximately $3.0
million. We did not sell any shares through our Equity Shelf Program in the
fourth quarter of 2003. In January 2004, we completed an offering of common
stock issuing 20,700,000 shares, with aggregate net proceeds of approximately
$363.6 million. In 2003, we completed an offering of common stock in the second
quarter issuing 9,300,700 shares, with aggregate net proceeds of approximately
$151.3 million. In 2002, we completed an offering of common stock in the first
quarter issuing 23,000,000 shares, with aggregate net proceeds of approximately
$347.4 million. We completed three public offerings during the year ended
December 31, 2001 in which we issued a total of 45,060,100 shares of common
stock, and received aggregate net proceeds of approximately $474.2 million.
With our "available-for-sale" accounting treatment, unrealized
fluctuations in market values of assets do not impact our GAAP or taxable income
but rather are reflected on our balance sheet by changing the carrying value of
the asset and stockholders' equity under "Accumulated Other Comprehensive Income
(Loss)." By accounting for our assets in this manner, we hope to provide useful
information to stockholders and creditors and to preserve flexibility to sell
assets in the future without having to change accounting methods.
As a result of this mark-to-market accounting treatment, our book value
and book value per share are likely to fluctuate far more than if we used
historical amortized cost accounting. As a result, comparisons with companies
that use historical cost accounting for some or all of their balance sheet may
not be meaningful.
47
The table below shows unrealized gains and losses on the Investment
securities in our portfolio.
UNREALIZED GAINS AND LOSSES
(dollars in thousands)
At December 31,
2003 2002 2001 2000 1999
----------------------------------------------------------------
Unrealized Gain $ 24,886 $ 90,507 $ 53,935 $ 3,020 $ 1,531
Unrealized Loss (72,147) (14,997) (15,766) (16,064) (39,100)
----------------------------------------------------------------
Net Unrealized Gain (Loss) ($47,261) $ 75,510 $ 38,169 ($13,044) ($37,569)
================================================================
Net Unrealized Gain (Loss) as % of Investment
Securities Principal Value (0.37%) 0.67% 0.52% (0.66%) (2.59%)
Net Unrealized Gain (Loss) as % of Investment
Securities Amortized Cost (0.37%) 0.67% 0.51% (0.66%) (2.54%)
Unrealized changes in the estimated net market value of investment securities
have one direct effect on our potential earnings and dividends: positive
marked-to-market changes increase our equity base and allow us to increase our
borrowing capacity while negative changes tend to limit borrowing capacity under
our capital investment policy. A very large negative change in the net market
value of our investment securities might impair our liquidity position,
requiring us to sell assets with the likely result of realized losses upon sale.
The net unrealized gains (loss) on available for sale securities was $(47.3)
million, or (0.37%) of the amortized cost of our investment securities as of
December 31, 2003, $75.5 million, or 0.67% of the amortized cost of our
investment securities as of December 31, 2002, and $38.2 million, or 0.51% of
the amortized cost of our investment securities as of December 31, 2001. The
Mortgage-Backed Securities with a carrying value of $809.0 million have been in
a continuous unrealized loss position over 12 months at December 31 2003 in the
amount of $8.2 million. The Mortgage-Backed Securities with a carrying value of
$6.7 billion have been in an unrealized loss position for less than 12 months at
December 31, 2003 in the amount of $52.2 million. The reason for the decline in
value of these securities is due to changes in interest rates. All of the
Mortgage-Backed Securities are "AAA" rated or carry an implied "AAA" rating.
These investments are not considered other-than-temporarily impaired since we
have the ability and intent to hold the investments for a period of time
sufficient for a forecasted market price recovery up to or beyond the cost of
the investments. Also, we are guaranteed payment on the par value of the
securities.
The table below shows our equity capital base as reported and on a
historical amortized cost basis at December 31, 2003, 2002, 2001, 2000, and
1999, and September 30, 2003, June 30, 2003 and March 31,2003. Issuances of
common stock, the level of earnings as compared to dividends declared, and other
factors influence our historical cost equity capital base. The reported equity
capital base is influenced by these factors plus changes in the "Net Unrealized
Gains (Losses) on Assets Available for Sale" account.
48
STOCKHOLDERS' EQUITY
Historical Net Unrealized Gains Reported Historical Reported Equity
Amortized Cost (Losses) on Assets Equity Base Amortized Cost (Book Value) Per
Equity Base Available for Sale (Book Value) Equity Per Share Share
---------------------------------------------------------------------------------------------
(dollars in thousands, except per share data)
At December 31, 2003 $1,196,481 $ (47,261) $1,149,220 $12.45 $11.96
At December 31, 2002 $1,004,555 $ 75,511 $1,080,066 $11.88 $12.77
At December 31, 2001 $ 629,188 $ 38,169 $ 667,357 $10.52 $11.15
At December 31, 2000 $ 148,686 ($ 13,044) $ 135,642 $10.24 $ 9.34
At December 31, 1999 $ 140,841 ($ 37,569) $ 103,272 $10.37 $ 7.60
- ----------------------------------------------------------------------------------------------------------------------
At September 30, 2003 $1,197,598 $ (51,870) $1,145,728 $12.48 $11.94
At June 30, 2003 $1,160,248 $ 1,190 $1,161,438 $12.34 $12.35
At March 31, 2003 $1,005,712 $ 71,000 $1,076,712 $11.88 $12.72
LEVERAGE
Our debt-to-equity ratio at December 31, 2003, 2002, and 2001 was 9.6:1,
9.4:1, and 9.5:1, respectively. We generally expect to maintain a ratio of
debt-to-equity of between 8:1 and 12:1, although the ratio may vary from this
range from time to time based upon various factors, including our management's
opinion of the level of risk of our assets and liabilities, our liquidity
position, our level of unused borrowing capacity and over-collateralization
levels required by lenders when we pledge assets to secure borrowings.
Our target debt-to-equity ratio is determined under our capital investment
policy. Should our actual debt-to-equity ratio increase above the target level
due to asset acquisition or market value fluctuations in assets, we will cease
to acquire new assets. Our management will, at that time, present a plan to our
board of directors to bring us back to our target debt-to-equity ratio; in many
circumstances, this would be accomplished over time by the monthly reduction of
the balance of our Mortgage-Backed securities through principal repayments.
ASSET/LIABILITY MANAGEMENT AND EFFECT OF CHANGES IN INTEREST RATES
We continually review our asset/liability management strategy with respect
to interest rate risk, mortgage prepayment risk, credit risk and the related
issues of capital adequacy and liquidity. Our goal is to provide attractive
risk-adjusted stockholder returns while maintaining what we believe is a strong
balance sheet.
We seek to manage the extent to which our net income changes as a function
of changes in interest rates by matching adjustable-rate assets with
variable-rate borrowings. In addition, although we have not done so to date, we
may seek to mitigate the potential impact on net income of periodic and lifetime
coupon adjustment restrictions in our portfolio of investment securities by
entering into interest rate agreements such as interest rate caps and interest
rate swaps.
Changes in interest rates may also affect the rate of mortgage principal
prepayments and, as a result, prepayments on mortgage-backed securities. We will
seek to mitigate the effect of changes in the mortgage principal repayment rate
by balancing assets we purchase at a premium with assets we purchase at a
discount. To date, the aggregate premium exceeds the aggregate discount on our
mortgage-backed securities. As a result, prepayments, which result in the
expensing of unamortized premium, will reduce our net income compared to what
net income would be absent such prepayments.
OFF-BALANCE SHEET ARRANGEMENTS
We do not have any relationships with unconsolidated entities or financial
partnerships, such as entities often referred to as structured finance or
special purpose entities, which would have been established for the purpose of
facilitating off-balance sheet arrangements or other contractually narrow or
limited purposes. Further, we have not guaranteed any obligations of
unconsolidated entities nor do we have any commitment or intent to provide
additional funding to any such entities. As such, we are not materially exposed
to any market, credit, liquidity or financing risk that could arise if we had
engaged in such relationships.
49
INFLATION
Virtually all of our assets and liabilities are financial in nature. As a
result, interest rates and other factors drive our performance far more than
does inflation. Changes in interest rates do not necessarily correlate with
inflation rates or changes in inflation rates. Our financial statements are
prepared in accordance with GAAP and our dividends based upon our net income as
calculated for tax purposes; in each case, our activities and balance sheet are
measured with reference to historical cost or fair market value without
considering inflation.
OTHER MATTERS
We calculate that our qualified REIT assets, as defined in the Internal
Revenue Code, are 100.0% of our total assets at December 31, 2003, 2002, and
2001 as compared to the Internal Revenue Code requirement that at least 75% of
our total assets be qualified REIT assets. We also calculate that 100% of our
revenue qualifies for the 75% source of income test, and 100% of its revenue
qualifies for the 95% source of income test, under the REIT rules for the years
ended December 31, 2003, 2002, and 2001. We also met all REIT requirements
regarding the ownership of our common stock and the distribution of our net
income. Therefore, as of December 31, 2003, 2002, and 2001 we believe that we
qualified as a REIT under the Internal Revenue Code.
We at all times intend to conduct our business so as not to become
regulated as an investment company under the Investment Company Act of 1940, as
amended (the "Investment Company Act"). If we were to become regulated as an
investment company, then our use of leverage would be substantially reduced. The
Investment Company Act exempts entities that are "primarily engaged in the
business of purchasing or otherwise acquiring mortgages and other liens on and
interests in real estate" (qualifying interests). Under current interpretation
of the staff of the SEC, in order to qualify for this exemption, we must
maintain at least 55% of our assets directly in qualifying interests. In
addition, unless certain mortgage securitites represent all the certificates
issued with respect to an underlying pool of mortgages, the mortgage-backed
securities may be treated as securities separate from the underlying mortgage
loans and, thus, may not be considered qualifying interests for purposes of the
55% requirement. We calculate that as of December 31, 2003, 2002, and 2001 we
were in compliance with this requirement.
RECENT DEVELOPMENTS
On January 2, 2004, we announced that we had entered into an agreement to
acquire FIDAC. At our annual meeting of stockholders, our stockholders will vote
on whether or not to approve the merger agreement we have entered into in
connection with the acquisition. The acquisition also remains subject to final
confirmation by our Board of Directors that no events have occurred and no
circumstances have arisen that would alter our Board's earlier determination
that such acquisition is in the best interests of us and our stockholders.
Under the merger agreement, our wholly owned Delaware subsidiary, FDC
Merger Sub, Inc., will merge with and into FIDAC, and FIDAC will be the
surviving corporation. The merger agreement provides that FIDAC shareholders
will receive approximately 2,935 shares of our common stock for each share of
FIDAC common stock they own. In addition, FIDAC shareholders have the right to
receive additional shares of our common stock, upon the achievement by FIDAC of
specific performance goals, on or about March 3, 2005, 2006 and 2007, calculated
based on the price of our common stock and the number of FIDAC shares they
owned. The value of the shares of our common stock to be issued to the FIDAC
shareholders immediately upon the consummation of the acquisition was fixed at
$40,500,000 based upon the closing price of our shares on December 31, 2003,
which is to be paid by delivering 2,201,080 shares of our common stock. The
value of the additional shares to be paid to FIDAC shareholders has been fixed
as up to a maximum dollar amount of $49,500,000; however, we cannot calculate
how many shares we will issue in the future since that will vary depending on
our share price at the time of each issuance.
50
ITEM 7A QUANTITATIVE AND QUALITIATIVE DISCLOSURES ABOUT MARKET RISK
MARKET RISK
Market risk is the exposure to loss resulting from changes in interest
rates, foreign currency exchange rates, commodity prices and equity prices. The
primary market risk to which we are exposed is interest rate risk. Interest
rates are highly sensitive to many factors, including governmental monetary and
tax policies, domestic and international economic and political considerations
and other factors beyond our control. Changes in the general level of interest
rates can affect our net interest income, which is the difference between the
interest income earned on interest-earning assets and the interest expense
incurred in connection with our interest-bearing liabilities, by affecting the
spread between our interest-earning assets and interest-bearing liabilities.
Changes in the level of interest rates also can affect the value of our
investment securities and our ability to realize gains from the sale of these
assets. We may utilize a variety of financial instruments, including interest
rate swaps, caps, floors and other interest rate exchange contracts, in order to
limit the effects of interest rates on our operations. If we use these types of
derivatives to hedge the risk of interest-earning assets or interest-bearing
liabilities, we may be subject to certain risks, including the risk that losses
on a hedge position will reduce the funds available for payments to holders of
securities and that the losses may exceed the amount we invested in the
instruments. To date, we have not purchased any hedging instruments.
Our profitability and the value of our portfolio may be adversely affected
during any period as a result of changing interest rates. The following table
quantifies the potential changes in net interest income and portfolio value
should interest rates go up or down 75 basis points, assuming the yield curves
of the rate shocks will be parallel to each other and the current yield curve.
All changes in income and value are measured as percentage changes from the
projected net interest income and portfolio value at the base interest rate
scenario. The base interest rate scenario assumes interest rates at December 31,
2003, and various estimates regarding prepayment and all activities are made at
each level of rate shock. Actual results could differ significantly from these
estimates.
Projected Percentage Change in Projected Percentage Change in
Change in Interest Rate Net Interest Income Portfolio Value
- -------------------------------------------------------------------------------------------
- -75 Basis Points (4.26%) 0.43%
- -50 Basis Points (2.83%) 0.31%
- -25 Basis Points (1.41%) 0.17%
Base Interest Rate
+25 Basis Points 2.44% (0.19%)
+50 Basis Points 3.22% (0.41%)
+75 Basis Points 6.45% (0.66%)
ASSET AND LIABILITY MANAGEMENT
Asset and liability management is concerned with the timing and magnitude
of the repricing of assets and liabilities. We attempt to control risks
associated with interest rate movements. Methods for evaluating interest rate
risk include an analysis of our interest rate sensitivity "gap", which is the
difference between interest-earning assets and interest-bearing liabilities
maturing or repricing within a given time period. A gap is considered positive
when the amount of interest-rate sensitive assets exceeds the amount of
interest-rate sensitive liabilities. A gap is considered negative when the
amount of interest-rate sensitive liabilities exceeds interest-rate sensitive
assets. During a period of rising interest rates, a negative gap would tend to
adversely affect net interest income, while a positive gap would tend to result
in an increase in net interest income. During a period of falling interest
rates, a negative gap would tend to result in an increase in net interest
income, while a positive gap would tend to affect net interest income adversely.
Because different types of assets and liabilities with the same or similar
maturities may react differently to changes in overall market rates or
conditions, changes in interest rates may affect net interest income positively
or negatively even if an institution were perfectly matched in each maturity
category.
The following table sets forth the estimated maturity or repricing of our
interest-earning assets and interest-bearing liabilities at December 31, 2003.
The amounts of assets and liabilities shown within a particular period were
51
determined in accordance with the contractual terms of the assets and
liabilities, except adjustable-rate loans, and securities are included in the
period in which their interest rates are first scheduled to adjust and not in
the period in which they mature. The interest rate sensitivity of our assets and
liabilities in the table could vary substantially if based on actual prepayment
experience.
More than 1
Within 3 Year to 3 3 Years and
Months 4-12 Months Years Over Total
(dollars in thousands)
------------------------------------------------------------------------------
Rate Sensitive Assets:
Investment Securities $2,882,906 $1,222,596 $3,483,954 $5,092,674 $12,682,130
Rate Sensitive Liabilities:
Repurchase Agreements 9,298,736 514,387 1,199,780 -- 11,012,903
------------------------------------------------------------------------------
Interest rate sensitivity gap ($6,415,830) $ 708,209 $2,284,174 $5,092,674 $ 1,669,227
==============================================================================
Cumulative rate sensitivity gap ($6,415,830) ($5,707,621) ($3,423,447) $1,669,227
==============================================================
Cumulative interest rate sensitivity
gap as a percentage of total
rate-sensitive assets (50.59%) (45.01%) (26.99%) 13.16%
==============================================================
Our analysis of risks is based on management's experience, estimates,
models and assumptions. These analyses rely on models which utilize estimates of
fair value and interest rate sensitivity. Actual economic conditions or
implementation of investment decisions by our management may produce results
that differ significantly form the estimates and assumptions used in our models
and the projected results shown in the above tables and in this report. These
analyses contain certain forward-looking statements and are subject to the safe
harbor statement set forth under the heading, "Special Note Regarding
Forward-Looking Statements."
52
ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Our financial statements and the related notes, together with the
Independent Auditors' Report thereon, are set forth on pages F-1 through F-16 of
this Form 10-K.
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 our management, including our
Chief Executive Officer (the "CEO") and Chief Financial Officer (the "CFO"), of
the effectiveness of the design and operation of our disclosure controls and
procedures as of the end of the period covered by this annual report. Based on
that review and evaluation, the CEO and CFO have concluded that our current
disclosure controls and procedures, as designed and implemented, were effective.
There have been no significant changes in our internal controls or in other
factors that could significantly affect our internal controls subsequent to the
date of their evaluation. There were no significant material weaknesses
identified in the course of such review and evaluation and, therefore, we have
taken no corrective measures.
PART III
ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by Item 10 as to our directors is incorporated
herein by reference to the proxy statement to be filed with the SEC within 120
days after December 31, 2003. The information required by Item 10 as to our
compliance with Section 16(a) of the Securities Exchange Act of 1934 is
incorporated by reference to the proxy statement to be filed with the SEC within
120 days after December 31, 2003.
We have adopted a Code of Business Conduct and Ethics within the meaning
of Item 406(b) of Regulation S-K. This Code of Business Conduct and Ethics
applies to our principal executive officer, principal financial officer and
principal accounting officer. This Code of Business Conduct and Ethics is
publicly available on our website at www.annaly.com. If we make substantive
amendments to this Code of Business Conduct and Ethics or grant any waiver,
including any implicit waiver, we intend to disclose these events on our
website.
ITEM 11 EXECUTIVE COMPENSATION
The information required by Item 11 is incorporated herein by reference to
the proxy statement to be filed with the SEC within 120 days after December 31,
2003.
ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
The information required by Item 12 is incorporated herein by reference to
the proxy statement to be filed with the SEC within 120 days after December 31,
2003.
ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by Item 13 is incorporated herein by reference to
the proxy statement to be filed with the SEC within 120 days after December 31,
2003.
53
ITEM 14 PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information 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,
2003.
54
PART IV
ITEM 15 EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) Documents filed as part of this report:
1. Financial Statements.
2. Schedules to Financial Statements:
All financial statement schedules not included have been omitted because
they are either inapplicable or the information required is provided in our
Financial Statements and Notes thereto, included in Part II, Item 8, of this
Annual Report on Form 10-K.
3. Exhibits:
EXHIBIT INDEX
Exhibit Exhibit Description
Number
3.1 Articles of Incorporation of the Registrant (incorporated by
reference to Exhibit 3.1 to our Registration Statement on Form
S-11 (Registration No. 333-32913) filed with the Securities and
Exchange Commission on August 5, 1997).
3.2 Articles of Amendment and Restatement of the Articles of
Incorporation of the Registrant (incorporated by reference to
Exhibit 3.2 to our Registration Statement on Form S-11
(Registration No. 333-32913) filed with the Securities and
Exchange Commission on August 5, 1997).
3.3 Articles of Amendment of the Articles of Incorporation of the
Registrant (incorporated to Exhibit 3.1 of the Registrant's
Registration Statement on Form S-3 (Registration Statement
333-74618) filed with the Securities and Exchange Commission on
June 12, 2002).
3.4 Bylaws of the Registrant, as amended (incorporated by reference
to Exhibit 3.3 to our Registration Statement on Form S-11
(Registration No. 333-32913) filed with the Securities and
Exchange Commission on August 5, 1997).
4.1 Specimen Common Stock Certificate (incorporated by reference to
Exhibit 4.1 to Amendment No. 1 to our Registration Statement on
Form S-11 (Registration No. 333-32913) filed with the Securities
and Exchange Commission on September 17, 1997).
4.2 Specimen Preferred Stock Certificate (incorporated by reference
to Exhibit 4.2 to the Registrant's Registration Statement on Form
S-3 (Registration No. 333-74618) filed with the Securities and
Exchange Commission on December 5, 2001).
10.1 Long-Term Stock Incentive Plan (incorporated by reference to
Exhibit 10.3 to our Registration Statement on Form S-11
(Registration No. 333-32913) filed with the Securities and
Exchange Commission on August 5, 1997).*
10.2 Form of Master Repurchase Agreement (incorporated by reference to
Exhibit 10.7 to our Registration Statement on Form S-11
(Registration No. 333-32913) filed with the Securities and
Exchange Commission on August 5, 1997).
10.3 Amended and Restated Employment Agreement, effective as of May 1,
2001 between the Registrant and Michael A.J. Farrell
(incorporated by reference to Exhibit 10.1 to our Form 10-Q/A for
its quarterly period ended June 30, 2001 filed with the
Securities and Exchange Commission on August 27, 2001).*
10.4 Amended and Restated Employment Agreement, effective as of May 1,
2001, between the Registrant and Wellington J. Denahan
(incorporated by reference to Exhibit 10.2 to our Form 10-Q/A for
its quarterly period ended June 30, 2001 filed with the
Securities and Exchange Commission on August 27, 2001).*
10.5 Amended and Restated Employment Agreement, effective as of May 1,
2001 between the Registrant and Kathryn F. Fagan (incorporated by
reference to Exhibit 10.3 to our Form 10-Q/A for its quarterly
period ended June 30, 2001 filed with the Securities and Exchange
Commission on August 27, 2001).*
55
10.6 Amended and Restated Employment Agreement, effective as of May 1,
2001, between the Registrant and Jennifer S. Karve (incorporated
by reference to Exhibit 10.4 to our Form 10-Q/A for its quarterly
period ended June 30, 2001 filed with the Securities and Exchange
Commission on August 27, 2001).*
10.7 Agreement and Plan of Merger, dated as of December 31, 2003, by
and among the Registrant, Fixed Income Discount Advisory Company,
FDC MergerSub, Inc., Michael A.J. Farrell, Wellington J. Denahan,
Jennifer S. Karve, Kathryn F. Fagan, Jeremy Diamond, Ronald D.
Kazel, Rose-Marie Lyght, Kristopher R. Konrad, and James P.
Fortescue (incorporated by reference to Exhibit 99.2 to our Form
8-K filed with the Securities and Exchange Commission on January
2, 2004).
23.1 Consent of Independent Auditors.
31.1 Certification of Michael A.J. Farrell, Chairman, Chief Executive
Officer, and President of the Registrant, 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 Kathryn F. Fagan, Chief Financial Officer and
Treasurer of the Registrant, 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 Michael A.J. Farrell, Chairman, Chief Executive
Officer, and President of the Registrant, 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 Kathryn F. Fagan, Chief Financial Officer and
Treasurer of the Registrant, pursuant to 18 U.S.C. Section 1350
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.
* Exhibit Numbers 10.1 and 10.3-10.6 are management contracts or compensatory
plans required to be filed as Exhibits to this Form 10-K.
(b) Reports on Form 8-K
We filed the following current reports on Form 8-K:
o Our Current Report on Form 8-K reporting under item 12 as filed on
October 21, 2003 announcing our financial results for the fiscal
quarter ended September 30, 2003.
Subsequent to December 31, 2003, we filed the following current reports on
Form 8-K:
o Our Current Report on Form 8-K as filed on January 2, 2004 reporting
under item 5 announcing our agreement to acquire Fixed Income
Discount Advisory Company;
o Our Current Report on Form 8-K as filed on January 16, 2004
reporting under items 5 and 7 announcing our entering into an
underwriting agreement with UBS Securities LLC and Merrill Lynch,
Pierce, Fenner & Smith Incorporated as representatives of the
several underwriters, relating to the sale of 18,000,000 shares of
common stock, par value $0.01 per share (the "Common Stock"), and
the granting of an over-allotment option for an additional 2,700,000
shares of Common Stock to the Underwriters to fulfill
over-allotments; and
o Our Current Report on Form 8-K reporting under item 12 as filed on
February 6, 2004 announcing our financial results for the fiscal
quarter and year ended December 31, 2003.
56
INDEPENDENT AUDITORS' REPORT
FINANCIAL STATEMENTS
Years Ended December 31, 2003, 2002, and 2001
ANNALY MORTGAGE MANAGEMENT, INC.
NOTES TO FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------
PAGE
INDEPENDENT AUDITORS' REPORT F-1
FINANCIAL STATEMENTS FOR THE YEARS ENDED
DECEMBER 31, 2003, 2002, and 2001:
Statements of Financial Condition F-2
Statements of Operations F-3
Statements of Stockholders' Equity F-4
Statements of Cash Flows F-5
Notes to Financial Statements F-6-F-16
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders of
Annaly Mortgage Management, Inc.
We have audited the accompanying statements of financial condition of Annaly
Mortgage Management, Inc. (the "Company") as of December 31, 2003 and 2002 and
the related statements of operations, changes in stockholders' equity, and cash
flows for each of the three years in the period ended December 31, 2003. 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 auditing standards generally accepted
in the United States of America. 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, such financial statements present fairly, in all material
respects, the financial position of the Company at December 31, 2003 and 2002
and the results of its operations and its cash flows for each of the three years
in the period ended December 31, 2003, in conformity with accounting principles
generally accepted in the United States of America.
/s/ Deloitte & Touche LLP
New York, New York
March 5, 2004
F-1
ANNALY MORTGAGE MANAGEMENT, INC.
STATEMENTS OF FINANCIAL CONDITION
DECEMBER 31, 2003 AND 2002
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
DECEMBER 31, DECEMBER 31,
2003 2002
------------ ------------
ASSETS
Cash and cash equivalents $ 247 $ 726
Mortgage-Backed Securities, at fair value 11,956,512 11,551,857
Agency Debentures, at fair value 978,167 --
Receivable for Mortgage-Backed Securities sold -- 55,954
Accrued interest receivable 53,743 49,707
Other assets 1,617 840
------------ ------------
Total assets $ 12,990,286 $ 11,659,084
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Repurchase agreements $ 11,012,903 $ 10,163,174
Payable for Mortgage-Backed Securities purchased 761,115 338,691
Accrued interest payable 14,989 14,935
Dividends payable 45,155 57,499
Other liabilities 4,017 2,812
Accounts payable 2,887 1,907
------------ ------------
Total liabilities 11,841,066 10,579,018
------------ ------------
Stockholders' Equity:
Common stock: par value $.01 per share; 500,000,000
Authorized 96,074,096 and 84,569,206 shares
issued and outstanding, respectively 961 846
Additional paid-in capital 1,194,159 1,003,200
Accumulated other comprehensive income (loss) (47,261) 75,511
Retained earnings 1,361 509
------------ ------------
Total stockholders' equity 1,149,220 1,080,066
------------ ------------
Total liabilities and stockholders' equity $ 12,990,286 $ 11,659,084
============ ============
See notes to financial statements.
F-2
ANNALY MORTGAGE MANAGEMENT, INC.
STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
FOR THE FOR THE FOR THE
YEAR ENDED YEAR ENDED YEAR ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31,
2003 2002 2001
------------ ------------ ------------
INTEREST INCOME $ 337,433 $ 404,165 $ 263,058
INTEREST EXPENSE 182,004 191,758 168,055
------------ ------------ ------------
NET INTEREST INCOME 155,429 212,407 95,003
GAIN ON SALE OF MORTGAGE- BACKED SECURITIES 40,907 21,063 4,586
GENERAL AND ADMINISTRATIVE
EXPENSES 16,233 13,963 7,311
------------ ------------ ------------
NET INCOME 180,103 219,507 92,278
------------ ------------ ------------
COMPREHENSIVE INCOME (LOSS)
Unrealized gain (loss) on available-
for-sale securities (81,865) 58,405 55,800
Less: reclassification adjustment
for net gains included in net income (40,907) (21,063) (4,586)
------------ ------------ ------------
Other comprehensive income (loss) (122,772) 37,342 51,214
------------ ------------ ------------
COMPREHENSIVE INCOME $ 57,331 $ 256,849 $ 143,492
============ ============ ============
NET INCOME PER SHARE:
Basic $ 1.95 $2 .68 $ 2.23
============ ============ ============
Diluted $ 1.94 $ 2.67 $ 2.21
============ ============ ============
WEIGHTED AVERAGE NUMBER OF SHARES OUTSTANDING:
Basic 92,215,352 82,044,141 41,439,631
============ ============ ============
Diluted 93,031,253 82,282,883 41,857,498
============ ============ ============
See notes to financial statements.
F-3
ANNALY MORTGAGE MANAGEMENT, INC.
STATEMENTS OF STOCKHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 2003, 2002, AND 2001
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
COMMON ADDITIONAL ACCUMULATED OTHER
STOCK PAID-IN COMPREHENSIVE RETAINED COMPREHENSIVE
PAR VALUE CAPITAL INCOME EARNINGS INCOME (LOSS) TOTAL
--------------------------------------------------------------------------------
BALANCE, DECEMBER 31, 2000 $ 144 $ 147,845 $ 697 $ (13,045) $ 135,641
Net Income $ 92,278 92,278
Other comprehensive income:
Unrealized net loss on securities,
net of reclassification adjustment 51,214 51,214
-----------
Comprehensive income $ 143,492 143,492
===========
Exercise of stock options 3 2,972 2,975
Shares exchanged upon exercise of stock options (587) (587)
Proceeds from direct purchase and dividend
reinvestment -- 142 142
Proceeds from follow-on offerings 451 473,614 474,065
Dividends declared for the year
ended December 31, 2001,
$1.75 per share (88,371) (88,371)
------------------------- --------------------------------------
BALANCE DECEMBER 31 2001 $ 598 $ 623,986 $ 4,604 $ 38,169 $ 667,357
Net Income $ 219,507 219,507
Other comprehensive income:
Unrealized net loss on securities,
net of reclassification adjustment 37,342 37,342
-----------
Comprehensive income $ 256,849 256,849
===========
Exercise of stock options 1 1,089 1,090
Shares exchanged upon exercise of stock options (76) (76)
Proceeds from direct purchase and dividend
reinvestment 2 3,007 3,009
Proceeds from follow-on offering 230 347,106 347,336
Proceeds from equity shelf program 15 28,088 28,103
Dividends declared for the year
ended December 31, 2002
$2.67 per share -- -- (223,602) (223,602)
------------------------- --------------------------------------
BALANCE, DECEMBER 31, 2002 $ 846 $ 1,003,200 $ 509 $ 75,511 $ 1,080,066
Net Income $ 180,103 180,103
Other comprehensive income:
Unrealized net loss on securities,
net of reclassification adjustment (122,772) (122,772)
-----------
Comprehensive income $ 57,331 57,331
===========
Exercise of stock options 1 913 914
Proceeds from direct purchase and dividend
reinvestment 2 4,199 4,201
Proceeds from follow-on offering 93 151,222 151,315
Proceeds from equity shelf program offering 19 34,625 34,644
Dividends declared for the year
ended December 31, 2003, $1.95 per share (179,251) (179,251)
------------------------- --------------------------------------
BALANCE, DECEMBER 31, 2003 $ 961 $ 1,194,159 $ 1,361 $ (47,261) $ 1,149,220
========================= ======================================
See notes to financial statements.
F-4
ANNALY MORTGAGE MANAGEMENT, INC.
STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 2003, 2002, AND 2001
(DOLLARS IN THOUSANDS)
FOR THE YEAR FOR THE YEAR FOR THE YEAR
ENDED ENDED ENDED
DECEMBER 31, DECEMBER 31, DECEMBER 31,
2003 2002 2001
-------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 180,103 $ 219,507 $ 92,278
Adjustments to reconcile net income to net cash
provided by operating activities: --
Amortization of mortgage premiums and discounts, net 216,570 106,198 36,865
Gain on sale of Mortgage-Backed Securities (40,907) (21,063) (4,587)
Stock option expense 121 240 790
Market value adjustment on long-term repurchase
agreement 1,607 1,204 986
Increase in accrued interest receivable (2,833) (2,903) (35,301)
(Increase) decrease in other assets (776) (641) 61
Increase (decrease) in accrued interest payable 55 (1,109) 7,729
Increase in other liabilities and accounts payable 979 673 950
-------------------------------------------------
Net cash provided by operating activities 354,919 302,106 99,771
-------------------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of Mortgage-Backed Securities (11,404,133) (11,079,561) (8,194,215)
Purchase of agency debentures (1,735,940)
Proceeds from sale of Mortgage-Backed Securities 2,899,267 2,076,800 1,248,812
Proceeds from callable agency debentures 746,000
Principal payments of Mortgage-Backed
Securities 8,290,724 4,728,666 1,685,874
-------------------------------------------------
Net cash used in investing activities (1,204,082) (4,274,095) (5,259,529)
-------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from repurchase agreements 117,066,588 87,463,924 49,773,650
Principal payments on repurchase agreements (116,217,261) (83,668,862) (45,033,275)
Proceeds from exercise of stock options 792 774 1,597
Proceeds from direct purchase and dividend reinvestment 4,201 3,010 142
Net proceeds from offerings 185,959 375,439 474,065
Dividends paid (191,595) (201,999) (56,105)
------------- ------------- -------------
Net cash provided by financing activities 848,684 3,972,286 5,160,074
------------- ------------- -------------
Net (decrease) increase in cash and cash equivalents (479) 297 316
Cash and cash equivalents, beginning of period 726 429 113
-------------------------------------------------
Cash and cash equivalents, end of period 247 726 429
=================================================
Supplemental disclosure of cash flow information:
Interest paid $ 181,949 $ 190,650 $ 160,327
=================================================
Noncash financing activities:
Net change in unrealized (loss) gain on available-
for-sale securities net of reclassification
adjustment ($ 122,772) $ 37,342 $ 51,214
=================================================
Dividends declared, not yet paid $ 45,155 $ 57,499 $ 35,896
=================================================
See notes to financial statements.
F-5
ANNALY MORTGAGE MANAGEMENT, INC.
NOTES TO FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2003, 2002, AND 2001
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
Annaly Mortgage Management, Inc. (the "Company") was incorporated in Maryland on
November 25, 1996. The Company commenced its operations of purchasing and
managing an investment portfolio of Mortgage-Backed Securities and Agency
Securities on February 18, 1997, upon receipt of the net proceeds from the
private placement of equity capital. An initial public offering was completed on
October 14, 1997.
A summary of the Company's significant accounting policies follows:
CASH AND CASH EQUIVALENTS - Cash and cash equivalents includes cash on
hand and money market funds. The carrying amount of cash equivalents
approximates their value.
MORTGAGE-BACKED SECURITIES AND AGENCY DEBENTURES - The Company invests
primarily in mortgage pass-through certificates, collateralized mortgage
obligations and other mortgage-backed securities representing interests in or
obligations backed by pools of mortgage loans (collectively, "Mortgage-Backed
Securities"). The Company also invests in Federal Home Loan Bank ("FHLB"),
Federal Home Loan Mortgage Corporation ("FHLMC"), and Federal National Mortgage
Association ("FNMA") debentures. The Mortgage-Backed Securities and agency
debentures are collectively referred to herein as "Investment Securities."
Statement of Financial Accounting Standards No. 115, Accounting for
Certain Investments in Debt and Equity Securities, requires the Company to
classify its investments as either trading investments, available-for-sale
investments or held-to-maturity investments. Although the Company generally
intends to hold most of its Investment Securities until maturity, it may, from
time to time, sell any of its Investment Securities as part of its overall
management of its statement of financial condition. Accordingly, this
flexibility requires the Company to classify all of its Investment Securities as
available-for-sale. All assets classified as available-for-sale are reported at
fair value, based on market prices provided by certain dealers who make markets
in these financial instruments, with unrealized gains and losses excluded from
earnings and reported as a separate component of stockholders' equity.
Unrealized losses on Investment Securities that are considered other than
temporary, as measured by the amount of decline in fair value attributable to
factors other than temporary, are recognized in income and the cost basis of the
Mortgage-Backed Securities is adjusted. There were no such adjustments for the
years ended December 31, 2003, 2002, and 2001.
Interest income is accrued based on the outstanding principal amount of
the Investment Securities and their contractual terms. Premiums and discounts
associated with the purchase of the Investment Securities are amortized into
interest income over the lives of the securities using the interest method. The
Company's policy for estimating prepayment speeds for calculating the effective
yield is to evaluate historical performance, street consensus prepayment speeds,
and current market conditions.
Investment Securities transactions are recorded on the trade date.
Purchases of newly issued securities are recorded when all significant
uncertainties regarding the characteristics of the securities are removed,
generally shortly before settlement date. Realized gains and losses on such
transactions are determined on the specific identification basis.
CREDIT RISK - At December 31, 2003 and December 31, 2002, the Company has
limited its exposure to credit losses on its portfolio of Investment Securities
by only purchasing securities issued by Federal Home Loan Mortgage Corporation
("FHLMC"), Federal National Mortgage Association ("FNMA"), Government National
Mortgage Association ("GNMA"), or Federal Home Loan Bank ("FHLB"). The payment
of principal and interest on the FHLMC and FNMA and FHLB Investment Securities
are guaranteed by those respective agencies and the payment of principal and
interest on the GNMA Mortgage-Backed Securities are backed by the
full-faith-and-credit of the U.S. government. At December 31, 2003 and 2002 all
of the Company's Investment Securities have an actual or implied "AAA" rating.
F-6
REPURCHASE AGREEMENTS - The Company finances the acquisition of its
Investment Securities through the use of repurchase agreements. Repurchase
agreements are treated as collateralized financing transactions and are carried
at their contractual amounts, including accrued interest, as specified in the
respective agreements. Accrued interest is recorded as a separate line item.
INCOME TAXES - The Company has elected to be taxed as a Real Estate
Investment Trust ("REIT") and intends to comply with the provisions of the
Internal Revenue Code of 1986, as amended (the "Code") with respect thereto.
Accordingly, the Company will not be subjected to federal income tax to the
extent of its distributions to shareholders and as long as certain asset, income
and stock ownership tests are met.
USE OF ESTIMATES - The preparation of financial statements in conformity
with generally accepted accounting principles 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.
F-7
2. MORTGAGE-BACKED SECURITIES
The following tables pertains to the Company's Mortgage-Backed Securities
classified as available-for-sale as of December 31, 2003 and 2002, which are
carried at their fair value:
FEDERAL HOME LOAN FEDERAL NATIONAL GOVERNMENT
MORTGAGE MORTGAGE NATIONAL MORTGAGE TOTAL MORTGAGE-
DECEMBER 31, 2003 CORPORATION ASSOCIATION ASSOCIATION BACKED SECURITIES
-----------------------------------------------------------------------------------
(dollars in thousands)
Mortgage-Backed
Securities, gross $ 3,763,364 $ 7,509,544 $ 419,223 $ 11,692,130
Unamortized discount (198) (1,034) (209) (1,441)
Unamortized premium 87,726 206,580 7,005 301,311
---------------------------------------------------------------------------------
Amortized cost 3,850,892 7,715,090 426,019 11,992,000
Gross unrealized gains 8,301 16,133 452 24,886
Gross unrealized losses (18,114) (39,984) (2,277) (60,374)
---------------------------------------------------------------------------------
Estimated fair value $ 3,841,079 $ 7,691,239 $ 424,194 $ 11,956,512
=================================================================================
GROSS UNREALIZED GROSS UNREALIZED ESTIMATED FAIR
AMORTIZED COST GAIN LOSS VALUE
----------------------------------------------------------------------------------
(dollars in thousands)
Adjustable rate $ 8,565,873 $ 13,118 ($ 35,490) $ 8,543,501
Fixed rate 3,426,127 11,768 (24,884) 3,413,011
---------------------------------------------------------------------------------
Total $ 11,992,000 $ 24,886 ($ 60,374) $ 11,956,512
=================================================================================
FEDERAL HOME LOAN FEDERAL NATIONAL GOVERNMENT
MORTGAGE MORTGAGE NATIONAL MORTGAGE TOTAL MORTGAGE-
DECEMBER 31, 2002 CORPORATION ASSOCIATION ASSOCIATION BACKED SECURITIES
-----------------------------------------------------------------------------------
(dollars in thousandS)
Mortgage-Backed
Securities, gross $ 5,120,929 $ 5,860,987 $ 220,468 $ 11,202,384
Unamortized discount (544) (120) -- (664)
Unamortized premium 105,872 164,071 4,684 274,627
---------------------------------------------------------------------------------
Amortized cost 5,226,257 6,024,938 225,152 11,476,347
Gross unrealized gains 31,731 58,239 90,507
537
Gross unrealized losses (9,554) (5,318) (125) (14,997)
---------------------------------------------------------------------------------
Estimated fair value $ 5,248,434 $ 6,077,859 $ 225,564 $ 11,551,857
=================================================================================
GROSS UNREALIZED GROSS UNREALIZED ESTIMATED FAIR
AMORTIZED COST GAIN LOSS VALUE
----------------------------------------------------------------------------------
(dollars in thousands)
Adjustable rate $ 7,144,741 $ 35,349 $ (12,424) $ 7,167,666
Fixed rate 4,331,606 55,158 (2,573) 4,384,191
---------------------------------------------------------------------------------
Total $ 11,476,347 $ 90,507 $ (14,997) $ 11,551,857
=================================================================================
F-8
The Mortgage-Backed Securities with a carrying value of $809.0 million
have been in a continuous unrealized loss position over 12 months at December 31
2003 in the amount of $8.2 million. The Mortgage-Backed Securities with a
carrying value of $6.7 billion have been in an unrealized loss position for less
than 12 months at December 31, 2003 in the amount of $52.2 million. The reason
for the decline in value of these securities is due to changes in interest
rates. All of the Mortgage-Backed Securities are "AAA" rated or carry an implied
"AAA" rating. These investments are not considered other-than-temporarily
impaired since the Company has the ability and intent to hold the investments
for a period of time sufficient for a forecasted market price recovery up to or
beyond the cost of the investments. Also, the Company is guaranteed payment on
the par value of the securities.
The adjustable rate investment securities are limited by periodic caps
(generally interest rate adjustments are limited to no more than 1% every six
months) and lifetime caps. The weighted average lifetime cap was 9.9% at
December 31, 2003 and 8.8% at December 31, 2002.
During the year ended December 31, 2003, the Company realized $40.9
million in gains from sales of Mortgage-Backed Securities. During the year ended
December 31, 2002, the Company realized $21.1 million in gains from sales of
Mortgage-Backed Securities.
3. AGENCY DEBENTURES
At December 31, 2003, the Company owned callable agency debentures
totaling $990.0 million par value and a total discount of $60,000. FHLMC, FNMA,
and FHLB are the issuers of the debentures. All of the Company's agency
debentures are classified as available-for-sale. The agency debentures with a
carrying value of $978.2 million have been in an unrealized loss position for
less than 12 months at December 31, 2003 in the amount of $11.8 million. The
unrealized loss on the Company's agency debentures at December 31, 2003 was
$11.8 million. The Company's agency debentures are adjustable rate and fixed
rate with a weighted average lifetime cap of 5.80%. At December 31, 2002, the
Company did not own any agency debentures.
4. REPURCHASE AGREEMENTS
The Company had outstanding $11.0 billion and $10.2 billion of repurchase
agreements with a weighted average borrowing rate of 1.51% and 1.72% and a
weighted average remaining maturity of 90 days and 124 days as of December 31,
2003 and December 31, 2002, respectively.
At December 31, 2003 and December 31, 2002, the repurchase agreements had
the following remaining maturities:
DECEMBER 31, 2003 DECEMBER 31, 2002
----------------------------------------
(dollars in thousands)
Within 30 days $ 8,589,184 $ 7,778,003
30 to 59 days 709,552 816,906
60 to 89 days -- 104,500
90 to 119 days -- --
Over 120 days 1,714,167 1,463,765
----------------------------------------
Total $11,012,903 $10,163,174
========================================
5. OTHER LIABILITIES
In 2001, the Company entered into a repurchase agreement maturing in July
2004, at which time, the repurchase agreement gives the buyer the right to
extend, in whole or in part, in three-month increments up to July 2006. The
repurchase agreement has a principal value of $100,000,000. The Company accounts
for the extension option as a separate interest rate floor liability carried at
fair value. The initial fair value of $1.2 million allocated to the
F-9
interest rate floor resulted in a similar discount on the repurchase agreement
borrowings that is being amortized over the initial term of 3 years using the
effective yield method. At December 31, 2003 and 2002, the fair value of this
interest rate floor was $4.0 million and $2.8 million, respectively, and was
classified as other liabilities.
6. COMMON STOCK
During the year ended December 31, 2003, the Company declared dividends to
shareholders totaling $179.3 million or $1.95 per share, of which $45.2 million
which was paid on January 28, 2004. On April 1, 2003 the Company entered into an
underwriting agreement pursuant to which the Company raised net proceeds of
approximately $151.3 million in equity in an offering of 9,300,700 shares of
common stock. During the year ended December 31, 2003, 1,879,600 shares were
issued through the Equity Shelf Program, totaling net proceeds of $34.6 million.
During the year ended December 31, 2003, 92,697 options were exercised under the
long-term compensation plan at $914,000. Also, 231,893 shares were purchased in
the dividend reinvestment and direct purchase program at $4.2 million.
During the Company's year ended December 31, 2002, the Company declared
dividends to shareholders totaling $223.6 million, or $2.67 per share, of which
$57.5 million was paid on January 29, 2003. During the year ended December 31,
2002, the Company completed an offering of common stock in the first quarter
issuing 23,000,000 shares, with aggregate net proceeds of approximately $347.3
million. Through the Equity Shelf Program, the Company raised $28.1 million in
net proceeds and issued 1,484,100 shares. During the year ended December 31,
2002, 97,095 options were exercised at $1.1 million. Total shares exchanged upon
exercise of the stock options were 4,444 at a value of $76,000. Also, 165,480
shares were purchased in dividend reinvestment and share purchase plan, totaling
$3.0 million.
7. EARNINGS PER SHARE (EPS)
For the year ended December 31, 2003, the reconciliation is as follows:
FOR THE YEAR ENDED DECEMBER 31, 2003
(dollars in thousands, except per share amounts)
------------------------------------------------
Weighted Average
Income Shares Per-Share
(Numerator) (Denominator) Amount
---------------------------------------------
Net income $ 180,103
----------
Basic earnings per share 180,103 92,215,352 $1.95
=====
Effect of dilutive securities:
Dilutive stock options -- 815,901
------------------------------
Diluted earnings per share $ 180,103 93,031,253 $1.94
=============================================
Options to purchase 12,500 shares of stock were outstanding and considered
anti-dilutive as their exercise price exceeded the average stock price for the
year.
For the year ended December 31, 2002, the reconciliation is as follows:
FOR THE YEAR ENDED DECEMBER 31, 2002
(dollars in thousands, except per share amounts)
---------------------------------------------------
Weighted Average
Income Shares Per-Share
(Numerator) (Denominator) Amount
---------------------------------------------------
Net income $ 219,507
-----------
219,507 82,044,141
Basic earnings per share $ 2.68
==========
Effect of dilutive securities:
Dilutive stock options -- 238,742
-------------------------------
Diluted earnings per share $ 219,507 82,282,883 $ 2.67
===================================================
F-10
Options to purchase 6,250 shares of stock were outstanding and considered
anti-dilutive as their exercise price exceeded the average stock price for the
year.
For the year ended December 31, 2001, the reconciliation is as follows:
FOR THE YEAR ENDED DECEMBER 31, 2001
(dollars in thousands, except per share amounts)
------------------------------------------------
Weighted Average
Income Shares Per-Share
(Numerator) (Denominator) Amount
---------------------------------------------
Net income $ 92,278
----------
Basic earnings per share $ 92,278 41,439,631 $2.23
=====
Effect of dilutive securities:
Dilutive stock options 417,867
------------------------------
Diluted earnings per share $ 92,278 41,857,498 $2.21
=============================================
Options to purchase 6,250 shares of stock were outstanding and considered
anti-dilutive as their exercise price exceeded the average stock price for the
year.
8. LONG-TERM STOCK INCENTIVE PLAN
The Company has adopted a long term stock incentive plan for executive
officers, key employees and nonemployee directors (the "Incentive Plan"). The
Incentive Plan authorizes the Compensation Committee of the board of directors
to grant awards, including incentive stock options as defined under Section 422
of the Code ("ISOs") and options not so qualified ("NQSOs"). The Incentive Plan
authorizes the granting of options or other awards for an aggregate of the
greater of 500,000 shares or 9.5% of the fully diluted outstanding shares of the
Company's common stock.
The following table sets forth activity relating to the Company's stock
options awards.
2003 2002 2001
---------------------------------------------------------------------------------
Weighted Weighted Weighted
Number of Average Number of Average Number of Average
Shares Exercise Shares Exercise Shares Exercise
Price Price Price
---------------------------------------------------------------------------------
Options outstanding at the beginning
of period 512,706 $ 8.59 635,826 $ 8.48 903,807 $ 8.28
Granted 643,450 $18.00 6,250 20.35 6,250 13.69
Exercised (92,697) $ 8.54 (97,095) 8.75 (274,231) 7.95
Expired (200) $17.97 (32,275) 8.28
---------------------------------------------------------------------------------
Options outstanding at the end of
period 1,063,259 $14.28 512,706 $ 8.59 635,826 $ 8.48
=================================================================================
Options exercisable at end of period 384,694 $ 8.85 393,076 $ 8.67 335,328 $ 8.63
=================================================================================
F-11
The following table summarizes information about stock options outstanding at
December 31, 2003:
Weighted Average
Weighted Average Remaining Contractual
Range of Exercise Prices Options Outstanding Exercise Price Life (Years)
$7.94-$19.99 1,050,759 $14.21 9.0
$20.00-$29.99 12,500 20.53 4.5
-------------------------------------------------------------------------
1,063,259 $14.28 9.0
=========================================================================
The Company accounts for the incentive plan under the intrinsic value
method in accordance with APB Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO
EMPLOYEES, and related Interpretations. No stock-based employee compensation
cost is reflected in net income, as all options granted under those plans had an
exercise price equal to the market value of the underlying common stock on the
date of grant. The following table illustrates the effect on net income and
earnings per share if the company had applied the fair value recognition
provisions of FASB Statement No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION,
to stock-based employee compensation.
For the Year Ended December 31,
2003 2002 2001
(dollars in thousands, except per share data)
Net income, as reported $ 180,103 $ 219,507 $ 92,278
Deduct: Total stock-based employee compensation expense
determined under fair value based method (48) (33) (266)
-----------------------------------------------
Pro-forma net income 180,055 $ 219,474 $ 92,012
===============================================
Net income per share, as reported
Basic $ 1.95 $ 2.68 $ 2.23
Diluted $ 1.94 $ 2.67 $ 2.21
Pro-forma net income per share
Basic $ 1.95 $ 2.68 $ 2.22
Diluted $ 1.94 $ 2.67 $ 2.20
The weighted average fair value at date of grant for stock options granted
during the year ended December 31, 2003, 2002, and 2001 was $1.52, $0.83 and
$0.89 per option, respectively. The fair value of stock options at date of grant
was estimated using the Black-Scholes option pricing model utilizing the
following weighted average assumptions:
For the Year Ended December 31,
2003 2002 2001
---------------------------------
Risk-free interest rate 4.28% 4.02% 4.21%
Expected option life in years 10 5 5
Expected stock price volatility 29% 26% 28%
Expected dividend yield 9.15% 13.57% 15.32%
F-12
9. COMPREHENSIVE INCOME
The Company adopted Statement of Financial Accounting Standards No. 130,
REPORTING COMPREHENSIVE INCOME. Statement No. 130 requires the reporting of
comprehensive income in addition to net income from operations. Comprehensive
income is a more inclusive financial reporting methodology that includes
disclosure of certain financial information that historically has not been
recognized in the calculation of net income. The Company at December 31, 2003
and 2002 held securities classified as available-for-sale. At December 31, 2003,
the net unrealized loss totaled $47.3 million and at December 31, 2002, the net
unrealized gain totaled $75.5 million.
10. LEASE COMMITMENTS
The Company has a non-cancelable lease for office space, which commenced
in May 2002 and expires in December 2009.
The Company's aggregate future minimum lease payments are as follows:
Total per Year
(dollars in thousands)
2004 500
2005 500
2006 530
2007 532
2008 532
2009 532
------
Total remaining lease payments $3,126
======
11. RELATED PARTY TRANSACTION
Michael A.J. Farrell, the Company's Chairman of the Board, Chief Executive
Officer and President, on behalf of FIDAC, approached the Company about the
possibility of the Company acquiring FIDAC. The Company's board of directors
formed a special committee of independent directors to consider this matter and
the special committee retained independent counsel and Lehman Brothers Inc. to
act as its financial advisor in connection with the proposed acquisition.
Following negotiations between FIDAC and the special committee, the special
committee determined that the Company should acquire FIDAC and the Company
entered into a Merger Agreement, dated December 31, 2003, by and among, the
Company, FIDAC, FDC Merger Sub, Inc., and the FIDAC stockholders (the "Merger
Agreement"). A copy of the Merger Agreement has been filed as an exhibit to the
Form 8-K filed with the SEC.
Pursuant to the Merger Agreement, FIDAC will be merged into a newly formed
wholly owned subsidiary of the Company. The closing of the merger is subject to
a number of conditions, including the approval of the Company's stockholders as
described below.
Mr. Farrell, the Company's Chairman of the Board, Chief Executive Officer
and President, Wellington J. Denahan, the Company's Vice Chairman and Chief
Investment Officer, Kathryn F. Fagan, the Company's Chief Financial Officer and
Treasurer, Jennifer S. Karve, the Company's Executive Vice President and
Secretary, and other of the Company's officers and employees are shareholders of
FIDAC. Mr. Farrell, Ms. Denahan and other officers and employees are actively
involved in managing mortgage-backed securities and other fixed income assets on
behalf of FIDAC.
FIDAC is a registered investment advisor which, at December 31, 2003,
managed, assisted in managing or supervised approximately $13.6 billion in gross
assets for a wide array of clients on a discretionary basis. FIDAC is a
fee-based asset management business with a global distribution reach. FIDAC
generally receives annual net investment advisory fees of approximately 10 to 15
basis points of the gross assets it manages, assists in managing or supervises.
The Company anticipates that the acquisition will have a positive effect on the
Company's earnings per share under current market conditions. However, it is
uncertain whether the acquisition will be accretive to the Company's earnings
per share on a prospective basis.
F-13
Under the Merger Agreement with FIDAC, the purchase price will be payable
in shares of the Company's common stock. Upon the consummation of the merger,
the Company will issue shares of its common stock worth $40.5 million, based
upon a valuation of shares of the Company's common stock as of December 31,
2003, to the stockholders of FIDAC. The Merger Agreement includes an earn-out
feature, under which the Company will pay up to an additional $49.5 million,
which will be payable in shares of the Company's common stock, to the
stockholders of FIDAC if FIDAC meets certain revenue and pre-tax profit margin
targets over the next three years as described in the Merger Agreement.
The shares of the Company's common stock issued upon consummation of the
merger with FIDAC will be registered under federal securities laws. The shares
issued to the stockholders of FIDAC upon consummation of the merger will be
subject to restrictions on resale for three years after completion of the
merger, subject to certain exceptions. The shares issued to the stockholders of
FIDAC under the earn-out feature will be subject to restrictions on resale for
either two years or one year after the applicable earn-out period, subject to
certain exceptions.
The Merger Agreement is subject to the approval of the Company's
stockholders and several other conditions. A vote on the Merger Agreement will
be held at the next meeting of the Company's stockholders. Approval of the
Merger Agreement will require the affirmative vote of the holders of a majority
of the Company's shares of common stock voting at the stockholder meeting as
long as the total vote cast at the stockholder meeting represents a majority of
the shares entitled to vote at the stockholder meeting. Pursuant to the Merger
Agreement, the FIDAC stockholders have agreed to vote any shares of the
Company's common stock owned of record by them in accordance with, and in the
same proportion as, the votes cast by the Company's stockholders who are not
FIDAC stockholders in connection with the merger. The Company is not certain
that its stockholders will approve the Merger Agreement or that the other
conditions to the merger will be satisfied. If the merger is not completed, the
Company expects to continue to operate under the facilities-sharing arrangement
that it currently has with FIDAC.
12. INTEREST RATE RISK
The primary market risk to the Company is interest rate risk. Interest
rates are highly sensitive to many factors, including governmental monetary and
tax policies, domestic and international economic and political considerations
and other factors beyond the Company's control. Changes in the general level of
interest rates can affect net interest income, which is the difference between
the interest income earned on interest-earning assets and the interest expense
incurred in connection with the interest-bearing liabilities, by affecting the
spread between the interest-earning assets and interest-bearing liabilities.
Changes in the level of interest rates also can affect the value of the
mortgage-backed securities and the Company's ability to realize gains from the
sale of these assets.
The Company seeks to manage the extent to which net income changes as a
function of changes in interest rates by matching adjustable-rate assets with
variable-rate borrowings. In addition, although the Company has not done so to
date, the Company may seek to mitigate the potential impact on net income of
periodic and lifetime coupon adjustment restrictions in the portfolio of
mortgage-backed securities by entering into interest rate agreements such as
interest rate caps and interest rate swaps.
Changes in interest rates may also have an effect on the rate of mortgage
principal prepayments and, as a result, prepayments on mortgage-backed
securities. The Company will seek to mitigate the effect of changes in the
mortgage principal repayment rate by balancing assets purchased at a premium
with assets purchased at a discount. To date, the aggregate premium exceeds the
aggregate discount on the mortgage-backed securities. As a result, prepayments,
which result in the expensing of unamortized premium, will reduce net income
compared to what net income would be absent such prepayments.
F-14
13. SUMMARIZED QUARTERLY RESULTS (UNAUDITED)
The following is a presentation of the quarterly results of operations for
the year ended December 31, 2003.
MARCH 31, JUNE 30, SEPTEMBER 30, DECEMBER 31,
2003 2003 2003 2003
(dollars in thousands, except per share data)
--------------------------------------------------------------
Interest income from investment securities $ 87,500 $ 93,892 $ 66,855 $ 89,186
Interest expense on repurchase agreements 44,048 51,770 43,922 42,264
--------------------------------------------------------------
Net interest income 43,452 42,122 22,933 46,922
Gain on sale of Mortgage-Backed Securities 11,020 20,231 9,656 --
General and administrative expenses 3,697 4,201 4,110 4,225
--------------------------------------------------------------
Net income $ 50,775 $ 58,152 $ 28,479 $ 42,697
==============================================================
Net income per share:
Basic $ 0.60 $ 0.62 $ 0.30 $ 0.44
==============================================================
Diluted $ 0.60 $ 0.62 $ 0.30 $ 0.44
==============================================================
Average number of shares outstanding:
Basic 84,606,786 93,384,128 94,685,685 96,027,468
==============================================================
Diluted 84,837,390 93,588,024 95,500,486 96,232,899
==============================================================
The following is a presentation of the quarterly results of operations for
the year ended December 31, 2002.
MARCH 31, JUNE 30, SEPTEMBER 30, DECEMBER 31,
2002 2002 2002 2002
(dollars in thousands, except per share data)
--------------------------------------------------------------
Interest income from investment securities $ 92,900 $ 109,423 $ 109,201 $ 92,641
Interest expense on repurchase agreements 40,012 47,860 54,012 49,874
--------------------------------------------------------------
Net interest income 52,888 61,563 55,189 42,767
Gain on sale of Mortgage-Backed Securities 3,410 1,343 4,747 11,563
General and administrative expenses 3,255 3,536 3,268 3,904
--------------------------------------------------------------
Net income $ 53,043 $ 59,370 $ 56,668 $ 50,426
==============================================================
Net income per share:
Basic $ 0.69 $ 0.72 $ 0.68 $ 0.60
==============================================================
Diluted $ 0.69 $ 0.71 $ 0.68 $ 0.60
==============================================================
Average number of shares outstanding:
Basic 76,709,836 82,910,206 83,668,422 84,525,171
==============================================================
Diluted 77,017,431 83,186,865 83,939,870 84,766,747
==============================================================
F-15
The following is a presentation of the quarterly results of operations for
the year ended December 31, 2001.
MARCH 31, JUNE 30, SEPTEMBER 30, DECEMBER 31,
2001 2001 2001 2001
(dollars in thousands, except per share data)
--------------------------------------------------------------
Interest income from investment securities $ 42,434 $ 64,790 $ 75,775 $ 80,059
Interest expense on repurchase agreements 33,453 45,284 48,620 40,698
--------------------------------------------------------------
Net interest income 8,981 19,506 27,155 39,361
Gain on sale of Mortgage-Backed Securities 269 482 1,184 2,651
General and administrative expenses 921 1,393 1,993 3,004
--------------------------------------------------------------
Net income $ 8,329 $ 18,595 $ 26,346 $ 39,008
==============================================================
Net income per share:
Basic $ 0.38 $ 0.48 $ 0.58 $ 0.65
==============================================================
Diluted $ 0.37 $ 0.48 $ 0.57 $ 0.65
==============================================================
Average number of shares outstanding:
Basic 21,851,481 38,473,928 45,503,179 59,776,777
==============================================================
Diluted 22,535,210 39,054,488 45,959,693 60,155,994
==============================================================
******
F-16
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, in the city of New York,
State of New York.
ANNALY MORTGAGE MANAGEMENT, INC.
Date: March 5, 2004 By: /s/ Michael A. J. Farrell
Michael A. J. Farrell
Chairman, Chief Executive Officer,
and President
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 date indicated.
Signature Title Date
/s/ KEVIN P. BRADY Director March 5, 2004
Kevin P. Brady
/s/ SPENCER I. BROWNE Director March 5, 2004
Spencer Browne
/s/ KATHRYN F. FAGAN Chief Financial Officer and Treasurer March 5, 2004
Kathryn F. Fagan (principal financial and accounting officer)
/s/ MICHAEL A.J. FARRELL Chairman of the Board, Chief Executive Officer, March 5, 2004
Michael A. J. Farrell President and Director (principal executive officer)
/s/ JONATHAN D. GREEN Director March 5, 2004
Jonathan D. Green
/s/ JOHN A. LAMBIASE Director March 5, 2004
John A. Lambiase
/s/ DONNELL A. SEGALAS Director March 5, 2004
Donnell A. Segalas
/s/ WELLINGTON DENAHAN Vice Chairman of the Board and Director March 5, 2004
Wellington Denahan
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EXHIBIT INDEX
Exhibit Exhibit Description
Number
3.1 Articles of Incorporation of the Registrant (incorporated by
reference to Exhibit 3.1 to our Registration Statement on Form
S-11 (Registration No. 333-32913) filed with the Securities and
Exchange Commission on August 5, 1997).
3.2 Articles of Amendment and Restatement of the Articles of
Incorporation of the Registrant (incorporated by reference to
Exhibit 3.2 to our Registration Statement on Form S-11
(Registration No. 333-32913) filed with the Securities and
Exchange Commission on August 5, 1997).
3.3 Articles of Amendment of the Articles of Incorporation of the
Registrant (incorporated to Exhibit 3.1 of the Registrant's
Registration Statement on Form S-3 (Registration Statement
333-74618) filed with the Securities and Exchange Commission on
June 12, 2002).
3.4 Bylaws of the Registrant, as amended (incorporated by reference
to Exhibit 3.3 to our Registration Statement on Form S-11
(Registration No. 333-32913) filed with the Securities and
Exchange Commission on August 5, 1997).
4.1 Specimen Common Stock Certificate (incorporated by reference to
Exhibit 4.1 to Amendment No. 1 to our Registration Statement on
Form S-11 (Registration No. 333-32913) filed with the Securities
and Exchange Commission on September 17, 1997).
4.2 Specimen Preferred Stock Certificate (incorporated by reference
to Exhibit 4.2 to the Registrant's Registration Statement on Form
S-3 (Registration No. 333-74618) filed with the Securities and
Exchange Commission on December 5, 2001).
10.1 Long-Term Stock Incentive Plan (incorporated by reference to
Exhibit 10.3 to our Registration Statement on Form S-11
(Registration No. 333-32913) filed with the Securities and
Exchange Commission on August 5, 1997).*
10.2 Form of Master Repurchase Agreement (incorporated by reference to
Exhibit 10.7 to our Registration Statement on Form S-11
(Registration No. 333-32913) filed with the Securities and
Exchange Commission on August 5, 1997).
10.3 Amended and Restated Employment Agreement, effective as of May 1,
2001 between the Registrant and Michael A.J. Farrell
(incorporated by reference to Exhibit 10.1 to our Form 10-Q/A for
its quarterly period ended June 30, 2001 filed with the
Securities and Exchange Commission on August 27, 2001).*
10.4 Amended and Restated Employment Agreement, effective as of May 1,
2001, between the Registrant and Wellington J. Denahan
(incorporated by reference to Exhibit 10.2 to our Form 10-Q/A for
its quarterly period ended June 30, 2001 filed with the
Securities and Exchange Commission on August 27, 2001).*
10.5 Amended and Restated Employment Agreement, effective as of May 1,
2001 between the Registrant and Kathryn F. Fagan (incorporated by
reference to Exhibit 10.3 to our Form 10-Q/A for its quarterly
period ended June 30, 2001 filed with the Securities and Exchange
Commission on August 27, 2001).*
10.6 Amended and Restated Employment Agreement, effective as of May 1,
2001, between the Registrant and Jennifer S. Karve (incorporated
by reference to Exhibit 10.4 to our Form 10-Q/A for its quarterly
period ended June 30, 2001 filed with the Securities and Exchange
Commission on August 27, 2001).*
10.7 Agreement and Plan of Merger, dated as of December 31, 2003, by
and among the Registrant, Fixed Income Discount Advisory Company,
FDC MergerSub, Inc., Michael A.J. Farrell, Wellington J. Denahan,
Jennifer S. Karve, Kathryn F. Fagan, Jeremy Diamond, Ronald D.
Kazel, Rose-Marie Lyght, Kristopher R. Konrad, and James P.
Fortescue (incorporated by reference to Exhibit 99.2 to our Form
8-K filed with the Securities and Exchange Commission on January
2, 2004).
23.1 Consent of Independent Auditors.
31.1 Certification of Michael A.J. Farrell, Chairman, Chief Executive
Officer, and President of the Registrant, 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 Kathryn F. Fagan, Chief Financial Officer and
Treasurer of the Registrant, pursuant to 18 U.S.C. Section 1350
as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of
2002.
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32.1 Certification of Michael A.J. Farrell, Chairman, Chief Executive
Officer, and President of the Registrant, 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 Kathryn F. Fagan, Chief Financial Officer and
Treasurer of the Registrant, pursuant to 18 U.S.C. Section 1350
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.
* Exhibit Numbers 10.1 and 10.3-10.6 are management contracts or compensatory
plans required to be filed as Exhibits to this Form 10-K.
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