EXHIBIT 13
CAPSTEAD MORTGAGE CORPORATION AND SUBSIDIARIES
PORTIONS OF THE
ANNUAL REPORT TO STOCKHOLDERS
FOR THE YEAR ENDED DECEMBER 31, 1994
REPORT OF ERNST & YOUNG LLP
INDEPENDENT AUDITORS
Stockholders and Board of Directors
Capstead Mortgage Corporation
We have audited the accompanying consolidated balance sheet of Capstead Mortgage
Corporation and subsidiaries as of December 31, 1994 and 1993, and the related
consolidated statements of income, stockholders' equity and cash flows for each
of the three years in the period ended December 31,1994. 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 generally accepted auditing
standards. 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 finacial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of
Capstead Mortgage Corporation and subsidiaries at December 31, 1994 and 1993,
and the consolidated results of their operations and their cash flows for each
of the three years in the period ended December 31, 1994, in conformity with
generally accepted accounting principles.
Ernst & Young LLP
Dallas, Texas
January 23, 1995
1
CAPSTEAD MORTGAGE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF INCOME
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Year Ended December 31
---------------------------------
1994 1993 1992
-------- -------- --------
Interest income:
Mortgage securities collateral $354,603 $390,690 $383,060
Mortgage investments 202,398 184,136 117,527
-------- -------- --------
Total interest income 557,001 574,826 500,587
-------- -------- --------
Interest and related expenses:
Collateralized mortgage securities 335,656 410,153 353,356
Short term borrowings 139,092 80,923 62,077
Mortgage insurance and other 13,476 20,084 13,821
Provision for possible losses 3,500 2,800 7,750
-------- -------- --------
Total interest and related
expenses 491,724 513,960 437,004
-------- -------- --------
Net margin on mortgage assets 65,277 60,866 63,583
-------- -------- --------
Mortgage servicing revenues:
Servicing fees 28,973 1,539 -
Other 3,913 (132) -
-------- -------- --------
Total mortgage servicing revenues 32,886 1,407 -
-------- -------- --------
Mortgage servicing expenses:
Salaries and related costs 2,867 648 -
General and administrative 3,002 492 -
Amortization of purchased mortgage
servicing rights 5,998 1,323 -
-------- -------- --------
Total mortgage servicing expenses 11,867 2,463 -
-------- -------- --------
Net margin on mortgage
servicing operations 21,019 (1,056) -
-------- -------- --------
Other revenues:
Gain on sales 9,161 61,216 2,910
CMO administration 4,067 1,482 -
Other 950 1,875 952
-------- -------- --------
Total other revenues 14,178 64,573 3,862
-------- -------- --------
Other expenses:
Salaries and related costs 8,263 7,456 4,124
General and administrative 6,632 6,505 4,221
Management fees and termination
costs - 16,166 5,909
-------- -------- --------
Total other expenses 14,895 30,127 14,254
-------- -------- --------
Net income $ 85,579 $ 94,256 $ 53,191
======== ======== ========
Net income $ 85,579 $ 94,256 $ 53,191
Less cash dividends on preferred
stock (38,876) (38,592) (4,707)
-------- -------- --------
Net income available to common
stockholders $ 46,703 $ 55,664 $ 48,484
======== ======== ========
Net income per share:
Primary $ 3.06 $ 3.68 $ 3.37
Fully diluted 3.01 3.57 3.23
Average number of shares outstanding:
Primary 15,278 15,146 14,394
Fully diluted 15,875 15,930 15,591
See accompanying notes to consolidated financial statements.
2
CAPSTEAD MORTGAGE CORPORATION AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEET
(IN THOUSANDS)
DECEMBER 31
------------------------
1994 1993
---------- ----------
Assets
Mortgage securities collateral $5,270,103 $3,995,956
Mortgage investments 3,305,984 2,842,151
---------- ----------
8,576,087 6,838,107
Less allowance for possible losses (7,354) (6,927)
---------- ----------
8,568,733 6,831,180
Cash and cash equivalents 21,741 87,760
Prepaids, receivables and other 70,415 36,238
Purchased mortgage servicing rights 282,969 25,146
---------- ----------
$8,943,858 $6,980,324
========== ==========
Liabilities
Collateralized mortgage securities $5,102,145 $3,891,134
Short term borrowings 3,190,582 2,443,807
Accounts payable and accrued expenses 11,568 7,193
Mortgage servicing rights acquisitions payable 75,888 --
---------- ----------
8,380,183 6,342,134
---------- ----------
Stockholders' Equity
Preferred stock - $0.10 par value;
100,000 shares authorized:
$1.60 Cumulative Preferred Stock, Series A,
623 and 735 shares issued and outstanding
($10,217 aggregate liquidation preference) 8,720 10,295
$1.26 Cumulative Convertible Preferred Stock,
Series B, 30,277 shares and 29,797 shares
issued and outstanding ($344,552 aggregate
liquidation preference) 324,779 319,543
Common stock - $0.01 par value; 100,000 shares
authorized; 15,304 and 15,154 shares issued
and outstanding 153 152
Paid-in capital 310,766 308,140
Undistributed income (deficit) (2,228) 60
Unrealized loss on debt and equity securities (78,515) __
---------- ----------
563,675 638,190
---------- ----------
$8,943,858 $6,980,324
========== ==========
See accompanying notes to consolidated financial statements.
3
CAPSTEAD MORTGAGE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(IN THOUSANDS)
THREE YEARS ENDED DECEMBER 31, 1994
------------------------------------------------------------------------
UNREALIZED
GAIN (LOSS)
PREFERRED STOCK UNDISTRIBUTED ON DEBT
---------------------- COMMON PAID-IN INCOME AND EQUITY
SERIES A SERIES B STOCK CAPITAL (DEFICIT) SECURITIES TOTAL
---------- ---------- ------- -------- ------------- ------------ ---------
Balance at
January 1, 1992 $ 32,616 $ - $116 $221,522 $ (915) $ - $253,339
Stock issuance - 315,025 20 61,623 - - 376,668
Net income - - - - 53,191 - 53,191
Cash dividends:
Common ($3.26 per share) - - - - (47,952) - (47,952)
Preferred:
Series A ($1.60 per share) - - - - (1,823) - (1,823)
Series B ($0.10 per share) - - - - (2,884) - (2,884)
Conversion of preferred stock (19,411) - 12 19,399 - - -
Other - - 1 959 - - 960
-------- -------- ---- -------- -------- -------- --------
Balance at
December 31, 1992 13,205 315,025 149 303,503 (383) - 631,499
Net income - - - 94,256 - 94,256
Cash dividends:
Common ($3.66 per share) - - - - (55,221) - (55,221)
Preferred:
Series A ($1.60 per share) - - - - (1,274) - (1,274)
Series B ($1.26 per share) - - - - (37,318) - (37,318)
Conversion of preferred stock (2,910) (144) 2 3,052 - - -
Other - 4,662 1 1,585 - - 6,248
-------- -------- ---- -------- -------- -------- --------
Balance at
December 31, 1993 10,295 319,543 152 308,140 60 - 638,190
Adjustment to beginning balance for
change in accounting method - - - - - 7,512 7,512
Net income - - - - 85,579 - 85,579
Cash dividends:
Common ($3.21 per share) - - - - (48,991) - (48,991)
Preferred:
Series A ($1.60 per share) - - - - (1,042) - (1,042)
Series B ($1.26 per share) - - - - (37,834) - (37,834)
Conversion of preferred stock (1,575) (18) 1 1,592 - - -
Other - 5,254 - 1,034 - - 6,288
Change in unrealized gain (loss) on
debt and equity securities - - - - - (86,027) (86,027)
-------- -------- ---- -------- -------- -------- --------
Balance at
December 31, 1994 $ 8,720 $324,779 $153 $310,776 $ (2,228) $(78,515) $563,675
======== ======== ==== ======== ======== ======== ========
See accompanying notes to consolidated financial statements.
4
CAPSTEAD MORTGAGE CORPORATION AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CASH FLOWS
(IN THOUSANDS)
Year Ended December 31
-----------------------------------------
1994 1993 1992
----------- ----------- -----------
Operating activities:
Net income $ 85,579 $ 94,256 $ 53,191
Noncash items:
Amortization of discount and premium 6,265 47,988 7,398
Amortization of purchased mortgage servicing rights 5,998 1,323 --
Depreciation and other amortization 1,932 819 140
Provision for possible losses 3,500 2,800 7,750
Net change in prepaids, receivables, other assets and
accounts payable (46,330) (2,273) (19,821)
Net gain from investing activities (9,161) (62,216) (2,910)
----------- ----------- -----------
Net cash provided by operating activities 47,783 83,697 45,748
----------- ----------- -----------
Investing activities:
Mortgage securities collateral:
Principal collections on collateral 1,157,248 2,437,768 1,270,681
Decrease (increase) in accrued interest receivable 9,065 11,302 (13,947)
Decrease (increase) in short term investments 166,150 (25,361) (98,242)
Purchases of mortgage loans (1,935,136) (4,410,950) (5,489,456
Purchases of agency securities (1,631,294) (1,747,931) --
Purchases of mortgage servicing rights (263,821) (26,469) --
Purchase of equity securities (17,808) -- --
Principal collections on mortgage investments 349,806 266,347 99,447
Proceeds from sales of mortgage assets and equity securities 105,288 3,859,993 1,160,920
Net cash from acquisition -- -- 8,236
----------- ----------- -----------
Net cash provided (used) by investing activities (2,060,502) 364,699 (3,062,361)
----------- ----------- -----------
Financing activities:
Collateralized mortgage securities:
Issuance of securities 2,565,540 1,185,482 3,564,780
Principal payments on securities (1,352,288) (2,469,026) (1,168,581)
Increase (decrease) in accrued interest payable (7,636) (14,427) 21,396
Capital stock transactions 6,288 6,248 62,603
Dividends paid (87,867) (93,813) (52,659)
Mortgage servicing rights acquisitions payable 75,888 -- --
Increase in short term borrowings 746,775 994,598 593,637
----------- ----------- -----------
Net cash provided (used) by financing activities 1,946,700 (390,938) 3,021,176
---------- ------------ ----------
Net increase (decrease) in cash and cash equivalents (66,019) 57,458 4,563
Cash and cash equivalents at beginning of year 87,760 30,302 25,739
----------- ----------- -----------
Cash and cash equivalents at end of year $ 21,741 $ 87,760 $ 30,302
=========== =========== ===========
See accompanying notes to consolidated financial statements.
5
CAPSTEAD MORTGAGE CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
December 31, 1994
NOTE A - BUSINESS
Capstead Mortgage Corporation, together with certain affiliated entities,
operates as a mortgage conduit which purchases, securitizes and invests in
various types of single-family residential mortgage loans. In addition, the
Company has formed a mortgage servicing unit to function as the primary mortgage
servicer for loans and mortgage servicing rights acquired by the Company.
Note B - ACCOUNTING POLICIES
Principles of Consolidation
The consolidated financial statements include the accounts of Capstead Mortgage
Corporation ("Capstead"), its mortgage servicing subsidiary ("Capstead Inc."),
its special-purpose finance subsidiaries and certain other entities
(collectively, the "Company"). Intercompany balances and transactions have been
eliminated. Substantially all of the assets of the special-purpose finance
subsidiaries are pledged to secure collateralized mortgage securities and are
not available for the satisfaction of general claims of Capstead. Capstead
has no obligation for the collateralized mortgage securities beyond the assets
pledged as collateral.
Securities Held-to-Maturity and Available-for-Sale
Management determines the appropriate classification of debt securities at the
time of purchase or securitization and reevaluates such designation as of
each balance sheet date. Debt securities are classified as held-to-maturity when
the Company has the positive intent and ability to hold the securities to
maturity. Held-to-maturity securities are stated at amortized cost. Marketable
equity securities and debt securities not classified as held-to-maturity are
classified as available-for-sale. Available-for-sale securities are stated at
fair value, with unrealized gains and losses, net of tax, reported in a separate
component of stockholders' equity.
The amortized cost of debt securities classified as held-to-maturity or
available-for-sale is adjusted for amortization of premiums and discounts over
the estimated life of the security. Such amortization is included in interest
income. Interest and dividends are included in interest income and other
revenues, respectively. Realized gains and losses are included in other
revenues. The cost of securities sold is based on the specific identification
method.
Mortgage Assets
Mortgage investments and mortgage securities collateral held in the form of
mortgage-backed securities are debt securities and classified as either held-to-
maturity or available-for-sale. Mortgage investments held in the form of
mortgage loans are carried at their unpaid principal balance, net of unamortized
discount or premium and adjusted for deferred hedging gains or losses, if any.
The Company may, from time to time, hold mortgage loans for sale. Mortgage loans
held for sale are carried at the lower of cost or market on an aggregate basis.
The cost of these mortgage loans is adjusted for gains or losses generated from
corresponding hedging transactions, if any, prior to the lower of cost or market
valuation. Transfers from loans held for sale to loans held for investment are
recorded at the lower of cost or market. Interest
6
income, net of servicing fees, is recorded as income when earned. Any discount
or premium is recognized as an adjustment to interest income by the interest
method over the life of the related mortgage loan.
Mortgage assets are subject to changes in value because of changes in interest
rates and rates of prepayment as well as failure of the mortgagor to perform
under the mortgage agreement. The Company manages its exposure to these risks by
the issuance of collateralized mortgage securities, the acquisition of mortgage
pool and special hazard insurance, forward sale agreements and other strategies.
Hedging Activities
The Company may enter into forward sales of Federal National Mortgage
Association ("FNMA") mortgage-backed securities to reduce exposure to interest
rate risk primarily on fixed-rate mortgage loans which it has purchased or has
committed to purchase prior to either the placement of permanent financing or
sale of such loans. These forward sale agreements generally have terms of not
more than 90 days. Gains and losses on these hedging transactions are deferred
as an adjustment to the carrying value of the related mortgage loans and
amortized into interest income using the effective yield method over the
expected remaining life of the mortgage loans or taken into income on the date
of sale.
Allowance for Possible Losses
The Company provides for possible losses due to (i) mortgagor default on
mortgage loans not covered by mortgage pool insurance, (ii) fraud in the
origination of mortgage loans, (iii) special hazards on mortgage loans not
covered by special hazard insurance, and (iv) higher than anticipated
prepayments on other mortgage securities.
Cash and Cash Equivalents
Cash and cash equivalents include cash on hand and highly liquid investments
with original maturities of three months or less.
Purchased Mortgage Servicing Rights
The cost of acquiring mortgage servicing rights is capitalized and then
amortized in proportion to and over the period of estimated net servicing
income. Estimated net servicing income is evaluated periodically and adjustments
are made to the rate of amortization.
Borrowings
Collateralized mortgage securities and short term borrowings are carried at
their unpaid principal balances, net of unamortized discount or premium. Any
discount or premium is recognized as an adjustment to interest expense by the
interest method over the expected term of the related borrowings.
Mortgage Servicing Revenues
Mortgage servicing revenues represent fees received for servicing mortgage
loans. Servicing fees are calculated on the basis of the outstanding monthly
principal balance of mortgage loans serviced and are recognized as income when
collected.
7
Income Taxes
Capstead and its qualified real estate investment trust ("REIT") subsidiaries
("qualified REIT subsidiaries") have elected to be taxed as a REIT and intend to
continue to do so. As a result of this election, Capstead is not taxed on
taxable income distributed to stockholders, provided that certain REIT
qualification tests are met. Currently, it is Capstead's policy to distribute
100 percent of taxable income of the REIT within the time limits prescribed by
the Internal Revenue Code (the "Code"), which may extend into the subsequent
taxable year. Accordingly, no provision has been made for income taxes for
Capstead and its qualified REIT subsidiaries.
Capstead's non-REIT subsidiaries, principally Capstead Inc. and subsidiaries,
file a separate federal income tax return. The January 1, 1993 adoption of the
liability method of accounting for income taxes had no cumulative effect on the
consolidated financial statements.
Net Income Per Share
Primary net income per share is computed by dividing net income, after deduction
of preferred stock dividends, by the weighted average number of common shares
and common stock equivalents outstanding during the year. Fully diluted net
income per share is computed by dividing net income, after deducting dividends
on the $1.26 Cumulative Convertible Preferred Stock, Series B ("Series B
Preferred Stock"), by the weighted average number of common shares and common
stock equivalents outstanding during the year, assuming conversion of the $1.60
Cumulative Preferred Stock, Series A ("Series A Preferred Stock"). The Series B
Preferred Stock is not considered convertible for purposes of calculating fully
diluted net income per share as it is currently antidilutive.
Reclassification
Certain amounts for prior years have been reclassified to conform to the 1994
presentation.
NOTE C - MORTGAGE INVESTMENTS
Mortgage investments and the related average effective interest rates
(calculated excluding unrealized gains and losses) were as follows (dollars in
thousands):
As of Year Ended
December 31 December 31
------------------------- ---------------------
1994 1993 1994 1993
---------- ---------- ----- ------
Mortgage loan portfolio:
Fixed-rate mortgage loans $ 55,055 $1,427,031 6.95% 7.40%
Medium-term mortgage loans 21,760 55,280 7.01 6.92
Adjustable-rate mortgage loans 132,692 109,230 5.22 5.33
AAA-rated private mortgage pass-through
securities portfolio:
Fixed-rate mortgage securities 409 - 6.69 -
Medium-term mortgage securities 459,874 425,301 6.92 7.14
Adjustable-rate mortgage securities 755,623 422,528 5.48 5.17
Agency securities portfolio:
Fixed-rate mortgage securities 504,023 402,781 6.44 6.80
Adjustable-rate mortgage securities 1,042,861 - 4.74 -
Callable notes 333,687 - 6.96 -
---------- ----------
$3,305,984 $2,842,151
========== ==========
8
The Company classifies its mortgage investments by term and interest rate
characteristics of the underlying mortgage loans. Fixed-rate mortgage
investments (i) have fixed rates of interest for their entire terms or (ii) have
an initial fixed-rate period of ten years after origination and then adjust
annually based on a specified margin over 1-year United States Treasury
Securities ("1-year Treasuries"). Medium-term mortgage investments (i) have an
initial fixed-rate period of three or five years after origination and then
adjust annually based on a specified margin over 1-year Treasuries or (ii) have
initial interest rates that adjust one time, approximately five years following
origination of the mortgage loan, based on a specified margin over the FNMA
yields for 30-year, fixed-rate commitments at the time of adjustment.
Adjustable-rate mortgage investments either (i) adjust semi-annually based on a
specified margin over the 6-month London Interbank Offered Rate ("LIBOR") or
(ii) adjust annually based on a specified margin over 1-year Treasuries. Fixed-
rate and adjustable-rate mortgage agency securities consist of mortgage-backed
securities issued by government-sponsored entities, either the Federal Home Loan
Mortgage Corporation ("FHLMC"), FNMA or the Government National Mortgage
Association ("GNMA"). Callable agency notes are unsecured, 3-year, fixed-rate
notes issued by FHLMC, FNMA, or the Federal Home Loan Bank Board ("FHLBB") and
mature in 1997, unless redeemed earlier by FHLMC, FNMA or FHLBB.
At December 31, 1994 the AAA-rated private mortgage pass-through securities
("Mortgage Pass-Throughs") portfolio, the agency securities portfolio, and
substantially all of the mortgage loan portfolio were pledged to secure short
term borrowings. As of December 31, 1994, outstanding commitments to purchase
mortgage loans were approximately $37 million. All mortgage loans were held for
investment at December 31, 1994.
For hedging purposes the Company had outstanding forward sales agreements with
an aggregate gross contract amount of $65 million at December 31, 1994. These
hedge positions were terminated in January 1995 at a loss of $202,000, which was
deferred as an adjustment of the carrying value of the related mortgage loans.
Included in mortgage securities collateral at December 31, 1994 was
approximately $5.6 million of net realized gains that have been deferred related
to hedging activities.
NOTE D - MORTGAGE SECURITIES COLLATERAL
Mortgage securities collateral consists primarily of collateral pledged to
secure borrowings through collateralized mortgage securities. All principal and
interest on the collateral is remitted directly to a collection account
maintained by a trustee. The trustee is responsible for reinvesting those funds
in short term investments. All collections on the collateral and the
reinvestment income earned thereon are available for the payment of principal
and interest on the collateralized mortgage securities.
9
The components of mortgage securities collateral are summarized as follows (in
thousands):
December 31
-----------------------------
1994 1993
---------- ----------
Mortgage collateral $5,201,886 $3,754,533
Short term investments 29,308 195,458
Accrued interest receivable 33,221 26,953
---------- ----------
Total collateral 5,264,415 3,976,944
Unamortized premium (discount) (7,962) 6,341
---------- ----------
Net collateral 5,256,453 3,983,285
Other mortgage securities 13,650 12,671
---------- ----------
$5,270,103 $3,995,956
========== ==========
Mortgage collateral consists of fixed-rate, medium-term and adjustable-rate
mortgage securities and fixed-rate agency securities. The weighted average
effective interest rate for mortgage collateral was 7.63 percent and 8.38
percent during the years ended December 31, 1994 and 1993, respectively.
NOTE E - MORTGAGE SERVICING
The following table provides information regarding the mortgage servicing
portfolio and the related investment in purchased mortgage servicing rights (in
thousands, except number of loans):
Unpaid Purchased
Principal Number Mortgage
Balance of Loans Servicing Rights
------------ -------- ----------------
Loans serviced at December 31, 1993 $ 2,393,267 7,746 $ 25,146
Additions 12,524,522 110,078 170,268
Runoff/amortizatio (525,607) (2,215) (5,998)
----------- ------- ---------
Loans serviced at December 31, 1994 14,392,182 115,609 189,416
Purchases pending transfer 5,145,421 52,775 93,553
----------- ------- ---------
Total portfolio at December 31, 1994 $19,537,603 168,384 $ 282,969
=========== ======= =========
The Company services mortgage loans in all 50 states and the District of
Columbia. As of December 31, 1994, 22 percent of loans serviced and loans
pending transfer were located in California (based on the unpaid principal
balances).
In connection with mortgage servicing activities, the Company maintains
segregated escrow deposits which are held in bank trust accounts. At December
31, 1994 and 1993, escrow and fiduciary funds for loans being serviced
approximated $163 million and $41 million, respectively, and are excluded from
the accompanying balance sheet.
NOTE F - COLLATERALIZED MORTGAGE SECURITIES
Each series of collateralized mortgage securities issued consists of various
classes of bonds, most of which have fixed rates of interest. Interest is
payable monthly or quarterly at specified rates for all classes. Typically,
principal payments on each series are made to each class in the order of their
stated maturities so that no payment of principal will be made on any class of
bonds until all classes having an earlier stated maturity have been paid in
full.
10
The components of collateralized mortgage securities along with certain
other information are summarized as follows (dollars in thousands):
December 31
-------------------------------------
1994 1993
-------------- --------------
Collateralized mortgage securities $5,177,445 $3,857,303
Accrued interest payable 51,277 45,362
-------------- --------------
Total obligation 5,228,722 3,902,665
Less unamortized discount (126,577) (11,531)
-------------- --------------
Net obligation $5,102,145 $3,891,134
-------------- --------------
Range of average interest rates 5.87% to 10.00% 4.78% to 10.00%
Range of stated maturities 2007 to 2025 2007 to 2023
Number of series 45 43
The maturity of each series of securities is directly affected by the rate of
principal prepayments on the related mortgage securities collateral. Each series
of securities is also subject to redemption at the Company's option provided
that certain requirements specified in the related indenture have been met
(referred to as "clean-up calls"). As a result, the actual maturity of any
series of securities is likely to occur earlier than its stated maturity. The
average effective interest rate for all collateralized mortgage securities was
7.49 percent and 9.05 percent during the years ended December 31, 1994 and 1993,
respectively.
NOTE G - SHORT TERM BORROWINGS
Short term borrowings are primarily made under repurchase arrangements. At
December 31, 1994 the Company had uncommitted repurchase facilities with
investment banking firms of approximately $5.5 billion to finance the mortgage
loan and Mortgage Pass-Through portfolios, subject to certain conditions.
Interest rates on borrowings under these facilities are based on overnight to
30-day LIBOR rates. The Company also enters into repurchase and dollar
repurchase arrangements with investment banking firms pursuant to which the
Company pledges agency securities and other mortgage assets. The terms and
conditions of these arrangements, including interest rates, are negotiated on a
transaction-by-transaction basis. Other arrangements the Company may use include
repurchase transactions prior to the issuance of collateralized mortgage
securities ("CMOs") or publicly-offered, multi-class mortgage pass-through
certificates ("MPCs") whereby the Company may pledge the mortgage loans that are
expected to secure the issuance as collateral for a repurchase transaction with
the managing underwriter of the related issuance.
Repurchase and dollar repurchase arrangements, which had maturities of less than
31 days, and the related average effective interest rates are classified by type
of collateral as follows (dollars in thousands):
December 31, 1994 December 31, 1993
--------------------- --------------------
Borrowings Average Borrowings Average
Outstanding Rate Outstanding Rate
----------- -------- ----------- -------
Mortgage loan portfolio $ 190,060 6.45% $1,220,094 4.07%
Mortgage Pass-Through portfolio 1,161,894 6.24 824,682 3.62
Agency securities portfolio 1,783,996 5.67 399,031 3.38
Other mortgage assets 44,632 6.47 - -
---------- ----------
$3,180,582 $2,443,807
========== ==========
11
At December 31, 1994 the Company had a $120 million committed line of credit
with an investment banking firm secured by purchased mortgage servicing rights.
Advances have separate maturities and rates of interest with interest due
monthly. Interest rates on advances under this facility are based on LIBOR rates
related to the term of the advance. As of December 31, 1994, the Company had
drawn $10 million on this line of credit at an interest rate of 7.24 percent.
Accrued interest on short term borrowings totaled $4,934,000 at December 31,
1994. The weighted average effective interest rate on all short term borrowings
was 4.64 percent and 3.40 percent during 1994 and 1993, respectively.
NOTE H - DISCLOSURES REGARDING FAIR VALUES
OF FINANCIAL INSTRUMENTS
The estimated fair values of financial instruments have been determined using
available market information and appropriate valuation methodologies. However,
considerable judgment is required in interpreting market data to develop these
estimates. In addition, fair values fluctuate on a daily basis. Accordingly,
the estimates presented herein are not necessarily indicative of the amounts
that could be realized in a current market exchange. The use of different market
assumptions and/or estimation methodologies may have a material effect on the
estimated fair values.
The carrying amount of cash and cash equivalents, receivables and accounts
payable approximates fair value. The fair value of equity securities is based
on quoted market prices. The fair value of mortgage assets was estimated using
either (i) quoted market prices when available, including quotes made by lenders
in connection with designating collateral for repurchase arrangements, (ii)
offer prices by the Company for similar mortgage assets, or (iii) expected
securitization results. The fair value of collateralized mortgage securities is
dependent upon the characteristics of the mortgage securities collateral pledged
to secure the issuance. Therefore, fair value was based on the same method used
for determining fair value for the underlying mortgage securities collateral
adjusted for credit enhancements. The carrying amount of short term borrowings
approximates fair value. The following table summarizes fair values of
financial instruments (in thousands):
December 31, 1994 December 31, 1993
------------------------ ---------------------
Carrying Fair Carrying Fair
Amount Value Amount Value
---------- ---------- ---------- ----------
Assets:
Cash and cash equivalents $ 21,741 $ 21,741 $ 87,760 $ 87,760
Receivables and equity securities 50,558 51,545 19,044 19,044
Mortgage securities collateral 5,270,103 4,850,391 3,995,956 4,094,088
Mortgage investments 3,305,984 3,220,486 2,842,151 3,246,114
Liabilities:
Accounts payable 87,456 87,456 7,193 7,193
Collateralized mortgage securities 5,102,145 4,736,974 3,891,134 4,021,004
Short term borrowings 3,190,582 3,190,582 2,443,807 2,443,807
Off-balance sheet financial
instruments:
Forward sales agreements - 433 - (1,850)
Commitments to acquire mortgage loans - (14) - (890)
12
The Company adopted the provisions of Statement of Financial Accounting
Standards No. 115, "Accounting for Certain Investments in Debt and Equity
Securities" ("SFAS 115") as of January 1, 1994. In accordance with SFAS 115,
prior period financial statements have not been restated to reflect the change
in accounting principle. There was no cumulative effect as of January 1, 1994
of adopting SFAS 115 on net income. The opening balance of stockholders' equity
was increased by $7,512,000 to reflect net unrealized holding gains on
securities classified as available-for-sale that were previously carried at
amortized cost.
The following tables summarize available-for-sale and held-to-maturity
securities as of December 31, 1994 (in thousands):
Available-for-Sale Securities
-----------------------------------------------
Gross Gross
Unrealized Unrealized Fair
Cost Gains Losses Value
---------- ----------- ---------- ----------
Debt securities:
Mortgage Pass-Throughs:
Fixed-rate mortgage securities $ 427 $ - $ 18 $ 409
Medium-term mortgage securities (1) 9,054 - 9,054 -
Adjustable-rate mortgage securities 780,224 - 24,601 755,623
Adjustable-rate mortgage agency
securities 1,088,252 - 45,391 1,042,861
Other mortgage securities 10,369 1,734 810 11,293
---------- ----------- ---------- ----------
Total debt securities 1,888,326 1,734 79,874 1,810,186
Equity securities 1,113 - 375 738
---------- ----------- ---------- ----------
$1,889,439 $1,734 $ 80,249 $1,810,924
========== =========== ========== ==========
Held-to-Maturity Securities
-----------------------------------------------
Gross Gross
Unrealized Unrealized Fair
Cost Gains Losses Value
---------- ----------- ---------- -----------
Medium-term Mortgage Pass-Throughs (1) $ 459,874 $ - $ 12,342 $ 447,532
Agency securities:
Fixed-rate mortgage securities 504,023 - 62,586 441,437
Callable notes 333,687 - 9,690 323,997
Mortgage securities collateral (2) 5,258,810 7,159 61,700 5,204,269
---------- ----------- ---------- -----------
$6,556,394 $7,159 $146,318 $6,417,235
========== =========== ========== ===========
- --------------
(1) The investment in medium-term Mortgage Pass-Throughs was transferred to the
held-to-maturity classification during the third quarter. As a result, the
unrealized loss at the transfer date remains as a component of the recorded
mark-to-market for available-for-sale securities at December 31, 1994,
which is being amortized over the remaining life of these investments.
(2) All mortgage securities collateral has been permanently financed through the
issuance of collateralized mortgage securities and, as a result, the
exposure to changes in the fair value of the underlying assets (and
liabilities) is limited. For this reason, the table above presents the fair
value of the projected net cash flows of the mortgage securities collateral
after payments on the related collateralized mortgage securities discounted
at market rates and prepayment assumptions.
The maturity of mortgage assets is directly affected by the rate of principal
prepayments by mortgagors and clean-up calls by issuers of remaining debt
securities outstanding. Included in mortgage securities collateral is $4,646,000
and $33,277,000 of collateral released from the related indentures at December
31, 1994 and 1993, respectively. During 1994, $77,087,000 of mortgage
securities collateral previously released from the related indentures pursuant
to clean-up calls was sold at gross realized gains aggregating $2,938,000.
During 1994 available-for-sale securities totaling $16,695,000 (cost basis) were
sold at gross realized gains aggregating $6,223,000.
13
NOTE I - ALLOWANCE FOR POSSIBLE LOSSES
The Company has limited exposure to losses on mortgage loans. Losses due to
typical mortgagor default may be reduced by the acquisition of mortgage pool
insurance from AAA-rated mortgage pool insurers, which supplements primary
mortgage insurance, if any, and homeowner equity, if any. The amount of coverage
under mortgage pool insurance policies is the amount (typically 7 to 15 percent
of the aggregate amount in such pool of mortgage loans) determined by one or
more national statistical rating agencies necessary to allow the related
securities to be rated AAA when combined with homeowner equity or other
insurance coverage.
Certain other risks, however, are not covered by mortgage pool insurance and may
subject the Company to losses. These risks include fraud or misrepresentation
during origination of a mortgage loan and special hazards that are not covered
by standard hazard insurance policies (e.g., earthquakes). In cases of fraud,
the Company generally will not be able to recover its losses from the mortgage
insurance company, but will generally have recourse to the prior owner of a loan
based on representations and warranties made at the time the loan was purchased.
However, to the extent the prior owner does not perform its repurchase
obligation, the Company may incur a loss. Special hazards are typically
catastrophic events that are unable to be predicted. The Company limits its
exposure to special hazard losses by acquiring special hazard insurance coverage
from a AAA-rated insurer. As of December 31, 1994, 50 percent of the Company's
mortgage assets (excluding agency securities) were covered by a special hazard
insurance policy. Management does not believe that fraud or special hazard
risks pose a material exposure to the Company; however, underwriting guidelines,
correspondents selling mortgage loans to the Company, as well as the geographic
concentration of its mortgage assets are continually monitored for possible
changes in risk levels.
In late 1993 the Company began issuing CMOs in a senior/subordinate structure
(in lieu of purchasing mortgage pool insurance and special hazard insurance)
where the investor in the subordinate classes assumes credit and special hazard
risks. The Company has retained an aggregate of approximately $2.2 million of
credit and special hazard risk on certain of these issuances. Actual losses to
the Company due to this risk are dependent upon the timing and magnitude of
related collateral defaults. The Company does not currently anticipate a need to
increase its provision for possible losses for this risk.
Activity in the allowance for possible losses was as follows (in thousands):
Year Ended December 31
----------------------
1994 1993
------- -------
Beginning balance $ 6,927 $ 8,228
Provision for losses 3,500 2,800
Charge-offs due to:
Mortgagor default (572) (433)
Fraud/misrepresentation (2,294) (1,567)
Special hazard losses (207) (33)
Impairment of other mortgage
securities - (2,068)
------- --------
$ 7,354 $ 6,927
======= ========
14
As of December 31, 1994, approximately 49 percent of mortgage assets (excluding
agency securities) were secured by properties located in California. Exposure
arising from this geographic concentration is reduced by either the acquisition
of mortgage pool insurance and special hazard insurance or the use of the
senior/subordinate structure for securitizations.
NOTE J - ACQUISITION
On December 2, 1992 the Company acquired the net assets of Tyler Cabot Mortgage
Securities Fund, Inc. ("Tyler Cabot"), a diversified, closed-end management
investment company, in exchange for 29,429,815 shares of the Company's Series
B Preferred Stock. The acquisition has been accounted for as a purchase and,
accordingly, the assets and liabilities have been recorded based on their fair
value at the date of acquisition. The net income earned on the assets and
liabilities acquired have been included in the consolidated statement of income
from the date of the acquisition.
NOTE K - INCOME TAXES
Capstead and its qualified REIT subsidiaries file a separate federal income tax
return which does not include the operations of the non-REIT subsidiaries.
Provided all taxable income of Capstead and its qualified REIT subsidiaries is
distributed to stockholders within time limits prescribed by the Code, no income
taxes are due on this income. Taxable income of the non-REIT subsidiaries is
fully taxable. The Company's effective tax rate will, therefore, differ
substantially from statutory federal income tax rates as depicted in the
following reconciliation (in thousands):
Year Ended December 31
-----------------------------------
1994 1993 1992
---------- -------- ---------
Net income at the statutory rate $ 29,097 $ 32,047 $ 18,085
Income not subject to income tax due to REIT status (27,289) (32,422) (17,700)
------- ------- ---------
Net income (loss) of non-REIT subsidiaries at the
statutory rate 1,808 (375) 385
Losses not benefited for income tax purposes - 375 -
Benefit of previously unrecognized deferred income
tax asset (1,261) - -
Other (547) - (385)
------- -------- --------
$ - $ - $ -
======= ======== ========
Significant components of deferred income tax assets and liabilities are as
follows (in thousands):
December 31
----------------
1994 1993
------- ------
Deferred tax assets:
Net operating loss carryforwards $26,504 $260
Capital loss carryforwards 1,949 185
Securitization timing differences 370 230
------- ----
28,823 675
------- ----
Deferred tax liabilities:
Securitization timing differences 15,429 300
Other 2,185 -
------- ----
17,614 300
------- ----
Net deferred tax assets $11,209 $375
======= ====
Valuation allowance $11,209 $375
======= ====
15
The increase in net deferred tax assets during 1994 (before the valuation
allowance) is primarily the result of the transfer of the mortgage
servicing operation from Capstead to Capstead Inc. and the corresponding
reorganization of the non-REIT subsidiaries.
At December 31, 1994 the non-REIT subsidiaries had net operating loss
carryforwards for tax purposes of approximately $78 million, which expire
beginning in the year 2006. In addition to net operating loss carryforwards, the
non-REIT subsidiaries have capital loss carryforwards of approximately $6
million, which expire in 1996 .
NOTE L - STOCKHOLDERS' EQUITY
The Series A Preferred Stock issued in connection with a 1989 acquisition is
nonvoting. Each share is entitled to a cumulative fixed dividend at an annual
rate of $1.60 and is eligible for conversion into 9/10 of one share of common
stock. The Series A Preferred Stock has a liquidation preference of $16.40 per
share and is currently redeemable at the Company's option, in whole or in part,
at a redemption price equal to the liquidation preference. During 1994, 112,205
shares of the Series A Preferred Stock were converted into 100,983 shares of
common stock.
The Series B Preferred Stock issued in connection with the acquisition of Tyler
Cabot is nonvoting. Each share is entitled to a cumulative fixed dividend at an
annual rate of $1.26 and is eligible for conversion into 0.3196 of one share of
common stock. The Series B Preferred Stock has a liquidation preference of
$11.38 per share and is redeemable at the Company's option, in whole or in part,
at a redemption price of $12.50 after December 2, 1997. During 1994, 1,762
shares of the Series B Preferred Stock were converted into 563 shares of common
stock.
In February 1992 the Company received $61,643,000 in net proceeds from the
offering of 2,046,000 shares of common stock. Proceeds from the offering were
used to acquire mortgage assets. On July 31, 1992 the Company issued a six-year
option to Lomas Financial Corporation ("LFC"), an affiliate of the former
manager, for the purchase of 750,000 shares of common stock at a price of $32.63
per share. The option became 100 percent exercisable in 1994.
During 1994, 1993 and 1992, the Company issued 20,746, 10,362, and 17,408 shares
of common stock through its dividend reinvestment plan on which net proceeds of
$534,000, $395,000 and $526,000 were received, respectively. During 1994 and
1993 the Company also issued 481,384 and 381,473 shares of Series B Preferred
Stock through its dividend reinvestment plan for Series B stockholders on which
net proceeds were received of $5,254,000 and $4,662,000, respectively.
The Company's Charter provides that if the Board of Directors determines in good
faith that the direct or indirect ownership of stock of Capstead has become
concentrated to an extent which would cause Capstead to fail to qualify as a
REIT, the Company may redeem or repurchase, at fair market value, any number of
shares of common stock and/or preferred stock sufficient to maintain or bring
such ownership into conformity with the Code and may refuse to transfer or issue
shares of common stock and/or preferred stock to any person whose acquisition
would result in Capstead being unable to comply with the requirements of the
Code. In addition, the
16
Charter provides that the Company may redeem or refuse to transfer any shares of
capital stock of Capstead necessary to prevent the imposition of a penalty tax
as a result of ownership of such shares by certain disqualified organizations,
including governmental bodies and tax-exempt entities that are not subject to
tax on unrelated business taxable income.
NOTE M - EMPLOYEE BENEFIT PLANS
The Company sponsors two stock option plans, the 1990 Directors' Stock Option
Plan (the "Directors' Plan") and the 1990 Employee Stock Option Plan. The
Company also sponsors the 1994 Flexible Long Term Incentive Plan, which provides
for the issuance of stock options and other incentive-based stock awards. These
plans provide for the issuance of up to 160,000, 240,000 and 1,250,000 shares,
respectively, of common stock. During 1994 the Company granted to employees
567,000 stock options pursuant to the 1994 Flexible Long Term Incentive Plan.
This grant, as well as options granted pursuant to the two stock option plans,
provide for the annual granting of dividend equivalent rights which permit the
option holder to obtain additional shares of common stock based upon formulas
set forth in the plans. Activity in the plans is summarized as follows:
DIRECTORS' PLAN EMPLOYEE PLANS*
------------------------ ----------------------------
NUMBER NUMBER
OF PRICE OF PRICE
SHARES RANGE SHARES RANGE
------ --------------- ------- ---------------
Balance at January 1, 1992 35,000 $13.00 91,500 $13.00 - $25.50
Options granted 6,000 29.38 39,000 34.50
Options exercised (5,114) 13.00 (27,619) 13.00
Dividend equivalent rights earned 802 - 1,205 -
------ -------
Balance at December 31, 1992 36,688 13.00 - 29.38 104,086 13.00 - 34.50
Options granted 22,000 39.13 - 39.25 44,000 38.88
Options exercised (11,663) 13.00 - 29.38 (46,637) 13.00 - 34.50
Dividend equivalent rights earned 1,494 - 2,646 -
------- -------
Balance at December 31, 1993 48,519 13.00 - 39.25 104,095 13.00 - 38.88
Options granted 18,000 24.88 - 41.00 567,000 28.88
Options exercised (18,891) 13.00 - 39.25 (8,733) 13.00 - 25.50
Options canceled (25,418) 13.00 - 41.00 - -
Dividend equivalent rights earned 2,314 - 2,857 -
------- -------
Balance at December 31, 1994 24,524 $16.75 -$41.00 665,219 $13.00-$38.88
======= =======
- --------------
* Includes stock options issued pursuant to the 1990 Employee Stock Option Plan
and the 1994 Flexible Long Term Incentive Plan (together, the "Employee
Plans").
As of December 31, 1994, options were exercisable for 287,219 shares. In
accordance with the terms of the plans, on January 1, 1995 the Company granted
dividend equivalent rights for the issuance of an additional 1,922 and 22,754
shares under the Directors' Plan and Employee Plans, respectively.
The Company also sponsors a qualified defined contribution retirement plan
created in late 1993 for all employees. The Company matches up to 50 percent of
a participant's voluntary contribution up to a maximum of 6 percent of a
participant's compensation. The Company also may make additional contributions
of up to another 3 percent of a participant's compensation. All Company
contributions are subject to certain vesting requirements. Contribution expense
was $369,624 and $16,092 in 1994 and 1993, respectively.
17
NOTE N - MANAGEMENT AND NON-COMPETITION AGREEMENTS
Since its inception in 1985 and through September 30, 1993, the Company operated
under a management agreement with a subsidiary (the "Manager") of Lomas Mortgage
USA, Inc. ("LMUSA"). The agreement provided that the Manager advise the Company
with respect to all facets of its business and administer its day-to-day
operations under the supervision of the Board of Directors. The Manager paid,
among other things, salaries and benefits of its personnel, accounting fees and
expenses, other office expenses and expenses incurred in supervising and
monitoring the Company's investments. During the period from inception through
July 31, 1992, the Manager received management and incentive fees based on
average invested assets and return on common stockholders' equity.
Effective August 1, 1992 the Company entered into a 65-month management
agreement with the Manager. Under the agreement, the management fee was limited
to an amount equal to the Manager's cost plus a fixed profit aggregating
$14,500,000 over the term of the agreement. Capstead also entered into a 65-
month non-competition agreement with LFC, the parent company of LMUSA, in return
for payments aggregating $7 million. In March, and again in September of 1993,
the Company negotiated amendments to these agreements to shorten their terms
and lower the required payments by $1,972,000. Consequently, on October 1, 1993
the Company became fully self-administered. Termination costs incurred in 1993
under the terms of the amended management agreement totaled $7,528,000. Also
included in 1993 management fees and termination costs is $4,363,000 of
unamortized amounts paid under the non-competition agreement.
NOTE O - SUPPLEMENTAL CASH FLOW INFORMATION
The following table provides supplemental cash and noncash information (in
thousands):
Year Ended December 31
------------------------------------
1994 1993 1992
--------- -------- ---------
Interest paid:
Short term borrowings $ 136,442 $ 81,722 $ 62,247
Collateralized mortgage securities 324,229 375,948 323,346
Noncash investing and financing activities:
Transfers from mortgage investments to
mortgage securities collateral 2,688,361 1,197,947 3,603,844
Charges to allowance for
possible losses 3,073 4,101 3,027
Acquisition of Tyler Cabot:
Net assets acquired - - 307,077
Net liabilities assumed - - 288
Preferred stock issued - - 315,025
18
NOTE P - NET INTEREST INCOME ANALYSIS (Unaudited)
The following tables summarize the amount of interest income and interest
expense and the average effective interest rate (dollars in thousands):
1994 1993 1992
------------------- ------------------- -------------------
AVERAGE AVERAGE AVERAGE
AMOUNT RATE AMOUNT RATE AMOUNT RATE
--------- ------- --------- ------- --------- ---------
Interest income:
Mortgage securities collateral $354,603 7.63% $390,690 8.38% $383,060 9.32%
Mortgage investments 202,398 6.07 184,136 6.56 117,527 7.49
--------- --------- ---------
Total interest income 557,001 574,826 500,587
--------- --------- ---------
Interest expense:
Collateralized mortgage securities 335,656 7.49 410,153 9.05 353,356 8.80
Short term borrowings 139,092 4.64 80,923 3.40 62,077 4.43
--------- --------- ---------
Total interest expense 474,748 491,076 415,433
--------- --------- ---------
Net interest $ 82,253 $ 83,750 $ 85,154
========= ========= =========
The following tables summarize the amount of change in interest income and
interest expense due to changes in interest rates versus changes in volume (in
thousands):
1994/1993* 1993/1992*
---------------------------------- -------------------------------
Rate Volume Total Rate Volume Total
-------- -------- --------- -------- -------- --------
Interest income:
Mortgage securities collateral $(34,775) $ (1,312) $ (36,087) $(40,878) $ 48,508 $ 7,630
Mortgage investments (14,544) 32,806 18,262 (16,008) 82,617 66,609
-------- ------- -------- -------- -------- -------
(49,319) 31,494 (17,825) (56,886) 131,125 74,239
-------- ------- -------- -------- -------- -------
Interest expense:
Collateralized mortgage securities (69,859) (4,638) (74,497) 10,057 46,740 56,797
Short term borrowings 33,440 24,729 58,169 (16,887) 35,733 18,846
-------- ------- -------- -------- -------- -------
(36,419) 20,091 (16,328) (6,830) 82,473 75,643
-------- ------- -------- -------- -------- -------
$(12,900) $11,403 $ (1,497) $(50,056) $ 48,652 $(1,404)
======== ======= ======== ======== ======== =======
* The change in interest due to both volume and rate has been allocated to
volume and rate changes in proportion to the relationship of the absolute
dollar amounts of the change in each.
19
NOTE Q - QUARTERLY RESULTS (Unaudited)
The following is a summary of the quarterly results of operations (in thousands,
except per share amounts):
Year Ended December 31, 1994
------------------------------------------------
First Second Third Fourth
Quarter Quarter Quarter Quarter
-------- ------- --------- --------
Interest income $125,734 $135,819 $144,891 $150,557
Interest and related expenses 102,666 118,227 131,208 139,623
Net margin on mortgage assets 23,068 17,592 13,683 10,934
Net margin on mortgage servicing
operations 1,182 4,315 6,494 9,028
Other revenues 3,060 1,724 6,140 3,254
Net income 23,469 20,030 22,267 19,813
Net income per share:
Primary 0.90 0.68 0.82 0.66
Fully diluted 0.88 0.67 0.81 0.65
Year Ended December 31, 1993
------------------------------------------------
First Second Third Fourth
Quarter Quarter Quarter Quarter
-------- ------- --------- --------
Interest income $149,566 $153,129 $149,683 $122,448
Interest and related expenses 127,756 130,861 125,466 129,877*
Net margin on mortgage assets 21,810 22,268 24,217 (7,429)
Net margin on mortgage servicing
operations - (168) (301) (587)
Other revenues 9,611 6,230 12,530 36,202
Net income 22,904 23,255 23,640 24,457
Net income per share:
Primary 0.88 0.90 0.92 0.97
Fully diluted 0.86 0.88 0.90 0.95
- --------------
* Because of high prepayments on mortgage securities collateral during the
fourth quarter of 1993, the Company accelerated amortization of bond discount
on existing collateralized mortgage securities resulting in the recognition of
an additional $28 million in interest expense.
NOTE R - MARKET AND DIVIDEND INFORMATION (UNAUDITED)
The New York Stock Exchange trading symbol for the Company's common stock is
CMO. There were 2,825 holders of record of the Company's common stock at
December 31, 1994. In addition, depository companies held stock for 20,575
beneficial owners. During the last two years, the high and low stock sales
prices and dividends declared on common stock were:
Year Ended December 31, 1994 Year Ended December 31, 1993
--------------------------------- ------------------------------
Stock Prices Stock Prices
--------------------- Dividends ------------------ Dividends
High Low Declared High Low Declared
------- ------ ---------- ------ ------- ---------
First quarter $42 1/8 $27 1/8 $0.83 $42 7/8 $36 1/2 $0.88
Second quarter 29 3/4 23 0.83 42 7/8 35 3/4 0.90
Third quarter 28 3/4 22 5/8 0.83 40 37 1/2 0.92
Fourth quarter 24 3/8 16 3/4 0.72 42 3/8 35 7/8 0.96
20
CAPSTEAD MORTGAGE CORPORATION AND SUBSIDIARIES
SELECTED FINANCIAL DATA
(in thousands, except per share amounts)
YEAR ENDED DECEMBER 31
-----------------------------------------------------------------
1994 1993 1992 1991 1990
------- --------- --------- --------- ---------
Selected consolidated statement
of income data:(1)
Interest income $557,001 $574,826 $500,587 $235,567 $179,702
Interest and related expenses 491,724 513,960 437,004 194,665 147,658
Net margin on mortgage
assets 65,277 60,866 63,583 40,902 32,044
Net margin on mortgage
servicing operations 21,019 (1,056) - - -
Other revenues 14,178 64,573 3,862 2,682 2,213
Net income 85,579 94,256 53,191 33,717 29,082
Net income per share:
Primary(2) 3.06 3.68 3.37 2.92 2.34
Fully diluted 3.01 3.57 3.23 2.46 2.14
Return on average total
stockholders' equity 13.27% 14.65% 16.08% 13.25% 11.50%
Cash dividends paid per share:
Common $ 3.21 $ 3.66 $ 3.26 $ 2.56 $ 2.27
Series A Preferred 1.60 1.60 1.60 1.60 1.60
Series B Preferred 1.26 1.26 0.10 - -
Average number of shares
outstanding:
Primary 15,278 15,146 14,394 8,964 8,700
Fully diluted 15,875 15,930 15,591 13,683 13,619
Selected consolidated balance
sheet data (at year-end):
Mortgage investments $3,305,984 $2,842,151 $1,904,600 $ 983,024 $ 257,537
Mortgage securities collateral 5,270,103 3,995,956 5,269,600 2,806,616 1,570,427
Total assets 8,943,858 6,980,324 7,229,608 3,824,546 1,829,376
Short term borrowings 3,190,582 2,443,807 1,449,209 855,572 108,248
Collateralized mortgage
securities 5,102,145 3,891,134 5,143,157 2,708,630 1,446,508
Stockholders' equity 563,675 638,190 631,499 253,339 251,023
Other data:
Mortgage loans acquired
during the year 1,944,507 4,393,273 5,483,602 2,171,362 279,724
Outstanding commitments
to acquire mortgage
investments (at year-end) 36,751 472,662 573,831 478,909 111,400
Mortgage servicing portfolio
(at year-end)(3) 14,392,182 2,393,267 - - -
(1) On December 2, 1992 the Company acquired the common stock of Tyler Cabot
Mortgage Securities Fund, Inc. in exchange for 29,429,815 shares of the
Series B Preferred Stock. The acquisition has been accounted for as a
purchase and the net income earned on the assets and liabilities acquired
have been included in the Consolidated Statement of Income from the date of
the acquisition.
(2) During the years ended December 31, 1992 and 1991, 1,382,551 and 3,140,304
shares of the Series A Preferred Stock were converted into 1,244,261 and
2,826,256 shares of common stock, respectively. If these conversions had
occurred at the beginning of the respective years, primary net income per
share would have been $3.32 and $2.60 per share for the years ended December
31, 1992 and 1991, respectively.
(3) Excludes $5.1 billion of mortgage servicing rights acquired in 1994 that
will be transferred into the mortgage servicing portfolio by the end of the
first quarter of 1995.
21
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
FINANCIAL CONDITION
During the year ended December 31, 1994, the Company purchased 6,888 mortgage
loans totaling $1.9 billion compared to purchases of 14,089 mortgage loans
totaling $4.4 billion during 1993. Purchase and commitment volumes have fallen
significantly due to increases in mortgage interest rates and corresponding
declines in mortgage loan originations. Improvement in the overall United States
economy and resulting inflation fears have caused interest rates on 30-year
single-family jumbo mortgage loans to rise almost three percentage points during
1994. This increase in interest rates has had the effect of substantially
reducing single-family mortgage originations nationally by as much as 60 percent
from the fourth quarter of 1993.
The Company formed $909 million of AAA-rated private mortgage pass-through
securities ("Mortgage Pass-Throughs") during 1994, $460 million of which were
backed by adjustable-rate mortgage ("ARM") loans. In addition to reducing
exposure to fraud and credit risk, a primary benefit of pooling mortgage loans
into Mortgage Pass-Throughs is the improved liquidity of AAA-rated securities
over that of individual loans. As a result, when securing short term borrowings,
the Company is able to negotiate more favorable terms. In order to lower
interest rate risk on the Mortgage Pass-Through portfolio, the Company pledged
over $300 million of fixed-rate Mortgage Pass-Throughs as partial collateral for
the December 1994 issuance of approximately $351 million of collateralized
mortgage securities ("CMOs"). The Company plans to continue to retain a large
portfolio of primarily ARM Mortgage Pass-Throughs.
In order to expedite growth of the Company's ARM investments, early in 1994 the
Company acquired $1.1 billion of ARM agency securities. The Company also added
$334 million of 3-year, fixed-rate unsecured callable agency notes to its
existing portfolio of fixed rate agency securities.
During the year ended December 31, 1994, the Company issued nine CMOs totaling
$2.7 billion through special-purpose finance subsidiaries secured by fixed-rate
mortgage loans. The net investment in these financings at issuance totaled $122
million. CMO issuances in 1994 were negatively impacted by the general rise in
interest rates. During periods of rising interest rates, CMO issuances have
relatively high interest rates compared to the related collateral which was
committed for purchase when long term interest rates were lower (see "Effects of
Interest Rate Changes"). The CMO investment portfolio at December 31, 1994 was
approximately $168 million compared to a portfolio of approximately $105 million
at December 31, 1993. The December 31, 1994 portfolio includes $4.6 million of
collateral released from related indentures through redemption or pay off of the
related bonds compared to $33.3 million at December 31, 1993.
The mortgage servicing portfolio (excluding pending transfers) increased
substantially during the year to $14.4 billion with a weighted average interest
rate of only 7.16 percent and earning an
22
average annual service fee excluding ancillary revenue and earnings on escrows
(the "Average Service Fee") of 29.59 basis points. The December 31, 1994 balance
of purchased mortgage servicing rights related to this portfolio was
approximately $189 million (132 basis points, or a 4.4 multiple of the Average
Service Fee). Portfolio run off, consisting of prepayments and scheduled
payments on mortgage loans serviced, was 7.22 percent for the year, due to the
low weighted average interest rate of the mortgage servicing portfolio compared
to prevailing mortgage interest rates. In addition, pending transfers as of
year-end totaled another $5.1 billion of mortgage servicing with a weighted
average interest rate of 7.30 percent and earning an Average Service Fee of 34.0
basis points. At an average cost of 182 basis points, these mortgage servicing
rights are being acquired at a 5.4 multiple of the Average Service Fee. Pending
transfers, together with normal jumbo servicing acquisitions, should allow the
Company to end the first quarter of 1995 with a mortgage servicing portfolio of
more than $19 billion. The Company currently plans to grow the mortgage
servicing portfolio to more than $25 billion by the end of 1995.
The following table summarizes the Company's utilization of capital as of
December 31, 1994 (in thousands):
CAPITAL
ASSETS BORROWINGS EMPLOYED
---------- ---------- --------
Mortgage loan portfolio:
Fixed-rate mortgage loans $ 55,055 $ 46,537 $ 8,518
Medium-term mortgage loans 21,760 19,674 2,086
Adjustable-rate mortgage loans 132,692 123,849 8,843
Mortgage Pass-Through portfolio:
Fixed-rate mortgage securities 409 396 13
Medium-term mortgage securities 459,874 430,164 29,710
Adjustable-rate mortgage
securities 755,623 731,334 24,289
Agency securities portfolio:
Fixed-rate mortgage securities 504,023 439,635 64,388
Adjustable-rate mortgage
securities 1,042,861 1,016,148 26,713
Callable notes 333,687 328,213 5,474
CMO investment portfolio 5,270,103 5,146,777(1) 123,326
Purchased mortgage servicing
rights 282,969 85,888(2) 197,081
---------- ---------- --------
$8,859,056 $8,368,615 490,441
========== ==========
Other assets, net of other
liabilities 73,234
--------
Total stockholders' equity $563,675
========
(1) Includes approximately $45 million of related short term borrowings.
(2) Includes approximately $76 million owed under contracts for bulk purchases
of mortgage servicing rights and $10 million drawn on a $120 million line of
credit secured by existing mortgage servicing rights.
As of December 31, 1994, the mortgage loan portfolio and commitments to acquire
mortgage loans ("Pipeline") approximated $243 million. Market value risk
associated with holding or acquiring these loans was reduced by entering into
forward sale agreements totaling $65 million for hedging purposes. In addition,
approximately $143 million was invested or committed for investment in ARM
loans, which are not generally as sensitive to changes in market value as are
fixed-rate investments. The remaining mortgage loan portfolio and Pipeline that
was subject to market value risk as of December 31, 1994 was approximately $30
million (adjusted for expected Pipeline fallout of 20 percent on -best efforts-
commitments).
23
A significant impact of the rise in mortgage interest rates in 1994 has been a
corresponding decline in the value of most mortgage assets. As of December 31,
1994, the Company's $1.9 billion of mortgage assets held available-for-sale had
a $78.5 million net unrealized loss. This net unrealized loss has been reflected
as a separate component of stockholders' equity in accordance with Statement of
Financial Accounting Standards No. 115 "Accounting for Certain Investments in
Debt and Equity Securities," ("SFAS 115") which the Company adopted January 1,
1994. These losses will only be realized if the securities are sold. The Company
does not intend to sell these securities under current market conditions. In
time, as interest rates stabilize or decline, the Company believes these
unrealized losses will be recovered through improvement in the market values or
repayment of the underlying securities. Declines in value and ongoing market
value risk associated with the remaining mortgage assets will not have a direct
impact on earnings as these assets are classified as held-to-maturity and can
only be sold under very limited circumstances.
RESULTS OF OPERATIONS
Comparative net operating results (interest income or fee revenues, net of
interest and related expenses or direct operating costs) by source were as
follows (in thousands, except percentages and per share amounts):
Year Ended December 31
------------------------------------
1994 1993 1992
-------- -------- --------
Mortgage loan portfolio $ 26,467 $ 49,368 $ 35,038
Mortgage Pass-Through portfolio 17,341 30,389 16,466
Agency securities portfolio 15,933 18,355 1,409
CMO investment portfolio 9,036 (34,446) 18,420
Mortgage servicing 21,019 (1,056) -
CMO administration 4,067 1,482 -
Gains from sales 9,161 61,216 2,910
Other income 950 1,875 952
-------- -------- --------
Contribution to income 103,974 127,183 75,195
Provision for possible losses (3,500) (2,800) (7,750)
General and administrative expenses (14,895) (30,127) (14,254)
-------- -------- --------
Net income $ 85,579 $ 94,256 $ 53,191
======== ======== ========
Net income per share:
Primary $ 3.06 $ 3.68 $ 3.37
Fully diluted 3.01 3.57 3.23
Return on average total stockholders'
equity 13.27% 14.65% 16.08%
1994 Compared to 1993
Operating results in 1994 declined over nine percent from those achieved in 1993
primarily because of rising interest rates. Higher mortgage loan interest rates
have had the effect of substantially curtailing purchase and commitment volumes
and shifting the product mix from fixed-rate mortgage loans to relatively lower
rate ARM and medium-term mortgage products. During this period, steadily rising
yields on ARM mortgage investments have not kept pace with increases in
borrowing costs, and net interest spreads on the mortgage loan, Mortgage Pass-
Through and agency securities portfolios have declined markedly. On a more
positive note, the CMO investment portfolio and the mortgage servicing operation
have performed well in this environment.
24
The mortgage loan portfolio contributed significantly less to current year net
operating results than in 1993 due to (i) a lower average mortgage loan
portfolio outstanding: $799 million in 1994 compared to $1.06 billion in 1993,
(ii) lower weighted average yields on mortgage loans: 6.68 percent in 1994
compared to 7.07 percent in 1993, (iii) higher average short term borrowing
costs: 4.50 percent in 1994 compared to 3.93 percent in 1993, and (iv) greater
use of leverage: the average ratio of short term borrowings to capital employed
increased to 2.8:1 in 1994 compared to 1.6:1 in 1993. Lower mortgage loan
purchase volume, particularly in the last three quarters of 1994, is the primary
reason for the decline in size of the mortgage loan portfolio. Average yields
have declined despite higher prevailing mortgage interest rates because of a
shift in the portfolio product mix from predominantly fixed-rate loans in 1993
to lower yielding ARM loans in 1994. Borrowing costs on the mortgage loan
portfolio have risen 238 basis points in 1994. The Company has increased the
leverage of this portfolio in order to employ more capital in the mortgage
servicing portfolio.
The Mortgage Pass-Through portfolio contributed less to net operating results in
1994 than in 1993 primarily due to higher borrowing costs offset by somewhat
higher yields. Borrowing costs for this portfolio rose 262 basis points during
1994, averaging 4.68 percent compared to an average of 3.46 percent in 1993.
Mortgage Pass-Through yields rose 39 basis points during 1994 and averaged 6.17
percent compared to an average of 6.07 percent in 1993. The increase in yields
during 1994 was due primarily to periodic rate adjustments on underlying ARM
loans (see "Effects of Interest Rate Changes") and the formation mid-year of
$310 million of fixed-rate Mortgage Pass-Throughs. The average portfolio
outstanding remained fairly constant at $1.27 billion in 1994 compared to $1.32
billion in 1993.
Despite a sizable increase in the average agency securities portfolio
outstanding to $1.27 billion in 1994 compared to $426 million in 1993, this
portfolio contributed less in 1994 to net operating results than in 1993 due to
lower average agency securities yields: 5.58 percent in 1994 compared to 6.80
percent in 1993, and higher average short term borrowing costs: 4.12 percent in
1994 compared to 2.43 percent in 1993. Lower average yields reflect the decision
in early 1994 to invest in ARM agency securities that have not yet reset to a
fully-indexed rate (i.e. "teaser-rate ARM securities"). These teaser-rate ARM
securities produced an average yield of 4.71 percent in 1994, four basis points
less than related borrowing costs. This reflects the recent period of rapidly
rising short term interest rates which increased borrowing costs more than
periodic rate adjustments on underlying ARM loans. Although yields on teaser-
rate ARM securities had improved to 5.12 percent by December of 1994, related
borrowing costs had increased to 5.77 percent (see "Effects of Interest Rate
Changes"). Additionally, 1994 borrowing rates in the dollar repurchase agreement
market have risen considerably over those experienced in 1993.
The CMO investment portfolio contributed more to net operating results in 1994
than in 1993 primarily due to the impact of the rise in mortgage interest rates
experienced in 1994 on current and expected future prepayments. In the first
quarter of 1994, prepayments began to slow considerably. As a result, estimates
of expected future prepayments were revised, which
25
had the effect of lowering amortization of bond discounts and improving
operating results. During 1994 principal collections on mortgage securities
collateral totaled $1.4 billion compared to $2.4 billion in 1993.
Mortgage service revenues increased significantly during 1994 as a result of the
addition of mortgage servicing rights on $12.5 billion of mortgage loans for an
average servicing portfolio of $7.8 billion compared to the addition of $2.5
billion in 1993 for an average servicing portfolio of $864 million (operations
commenced March 1993). Direct operating costs for mortgage servicing operations
also increased, but not to the same extent as revenues, which is reflective of
efficiencies being gained in the servicing process as the servicing portfolio
continues to grow. Amortization of purchased mortgage servicing rights amounted
to $6.0 million during 1994, representing an annual rate of 6.2 percent of the
average mortgage servicing rights, compared to amortization of $1.3 million
during 1993, representing an annual rate of 15.1 percent of the average mortgage
servicing rights. The reduction in the amortization rate from 1993 to 1994 was
attributable to the decrease in mortgage refinancing activity during 1994 caused
by increased mortgage interest rates.
In 1994 the Company acquired 800,000 shares of the common stock of North
American Mortgage Corporation, a mortgage banking company, for $17.8 million.
Consolidation trends in the mortgage banking industry during 1994 allowed the
Company to realize gains aggregating $6.2 million from the sale of 750,000 of
these shares.
Due to rising interest rates in 1994, the Company has not sold mortgage assets
other than sales of mortgage securities collateral released from CMOs pursuant
to clean-up calls. In 1994, $77 million of released mortgage securities
collateral was sold for gains aggregating $2.9 million. During 1993, $3.9
billion of mortgage assets were sold for gains aggregating $61.2 million.
CMO administration revenues were higher in 1994 than in 1993 due to increased
master servicing of collateral placed into securitizations and administering of
related bonds or pass-through securities. The Company began master servicing
securitized collateral in February 1993 and receiving fees for administering
securitizations in October 1993.
The Company provided $3.5 million for possible losses during 1994 compared to
$2.8 million in 1993. The increase is primarily due to recent experience with
fraud/misrepresentation in the third-party origination of mortgage loans.
After excluding $16.2 million of non-competition and management agreement
expenses and termination costs incurred in 1993, salaries, general and
administrative expenses increased in 1994 primarily due to costs associated with
establishing the infrastructure necessary to take advantage of opportunities in
the mortgage banking industry.
1993 Compared to 1992
The Company's 1993 operating results were heavily influenced by the relatively
steady decline in long term interest rates throughout much of the year. The most
significant positive influence of the decline in long term rates on operating
results was on securitization
26
activity. Gains from the securitization or sale of mortgage assets totaled $61.2
million in 1993 compared to $2.9 million in 1992. These gains more than offset
losses sustained by the CMO investment portfolio. The CMO investment portfolio
experienced a net loss of $34.5 million in 1993 compared to net income of $18.4
million in 1992 primarily because of high prepayments on the related collateral
also brought on by the decline in rates. Another important factor in producing
higher operating results in 1993 was the issuance of $315 million of Series B
Preferred Stock in December 1992, which doubled stockholders' equity and greatly
enhanced earnings potential. Throughout most of 1993 larger mortgage investment
portfolios were maintained as the Company sought to deploy this additional
capital. Lower short term borrowing rates further increased these portfolios'
contributions to net income.
The Company provided $2.8 million for possible losses during the year ended
December 31, 1993 compared to $7.8 million in 1992. A 20 percent reduction in
mortgage loan purchase volume from 1992 to 1993 along with more stringent
underwriting guidelines contributed to lower provision requirements.
Included in general and administrative expenses in 1993 were $11.9 million of
costs associated with terminating the Company's relationship with its former
manager. Effective October 1, 1993 the Company became fully self-administered.
Other increases in general and administrative expenses over 1992 were due
primarily to the formation of the mortgage servicing operation.
LIQUIDITY AND CAPITAL RESOURCES
The Company's primary sources of funds include monthly principal and interest
payments on mortgage loans and mortgage securities, short term borrowings,
excess cash flows on issued CMOs, proceeds from securitizations, servicing fees
and other revenue from its mortgage servicing portfolio, and equity offerings
when available. The Company currently believes that these funds are sufficient
for the acquisition of additional mortgage loans and other mortgage assets,
repayments on short term borrowings, growth of the mortgage servicing portfolio
and the payment of cash dividends as required for Capstead's continued
qualification as a Real Estate Investment Trust ("REIT"). It is the Company's
policy to remain strongly capitalized and conservatively leveraged.
The Company may, from time to time, sell a portion of its fixed-rate mortgage
loans and its investments in other mortgage assets classified as available-for-
sale. Such sales may be accomplished by issuing publicly-offered, multi-class
Mortgage Pass-Through certificates ("MPCs") and may increase quarterly income
volatility because of the recognition of transactional gains or losses. No such
sales were recorded in 1994 other than sales of collateral released from CMOs
pursuant to clean-up calls.
Short term borrowings are primarily made under repurchase arrangements. At
December 31, 1994 the Company had uncommitted repurchase facilities with
investment banking firms of approximately $5.5 billion to finance the mortgage
loan and Mortgage Pass-Through portfolios, subject to certain conditions.
Interest rates on borrowings under these facilities are based on overnight to
30-day London Interbank Offered Rate ("LIBOR") rates. The Company also
27
enters into repurchase and dollar repurchase arrangements with investment
banking firms to whom the Company pledges agency securities and other mortgage
assets as collateral. The terms and conditions of these arrangements, including
interest rates, are negotiated on a transaction-by-transaction basis. Other
short term financing arrangements that the Company may use include entering into
repurchase transactions prior to the issuance of CMOs or MPCs whereby the
Company may pledge the mortgage assets that are expected to secure the issuance
as collateral for a repurchase transaction with the managing underwriter of the
related issuance.
At December 31, 1994 the Company had a $120 million committed line of credit
with an investment banking firm secured by purchased mortgage servicing rights.
Advances have separate maturities and rates of interest with interest due
monthly. Interest rates on advances under this facility are based on LIBOR
rates related to the term of the advance.
EFFECTS OF INTEREST RATE CHANGES
Changes in interest rates may impact the Company's earnings in various ways.
The Company's earnings depend, in part, on the difference between the interest
received on mortgage investments and the interest paid on related short term
borrowings (primarily repurchase arrangements). The resulting spread may be
reduced in a rising interest rate environment. For ARM loans the risk of rising
short term interest rates is offset to some extent by increases in the rates of
interest earned on these loans. Since ARM loans generally limit the amount of
such increase during any single interest rate adjustment period and over the
life of the loan, the interest rates on the repurchase arrangements can rise to
levels that may exceed the interest rates on the underlying ARM loans resulting
in a negative interest spread. This occurred in late 1994 on many of the
Company's ARM investments. The Company expects that once interest rates
stabilize or decline these spreads will recover. Rising interest rates may not
only reduce interest spreads, but also the volume of mortgage loan purchases
through our conduit operations as mortgage loan origination activity slows,
which may result in lower average mortgage loan portfolios outstanding during
these periods.
In addition, earnings are impacted if long term interest rates change during the
period after the Company has committed to purchase fixed-rate mortgage loans but
before these loans have been pledged to secure CMOs and MPCs or otherwise
committed for sale. If long term interest rates increase during this period, the
interest payable on the CMOs issued will increase while the yield on the
underlying mortgage loans pledged to collateralize the CMOs will not change; as
a consequence, the interest spread on the CMO will be lower. Conversely, if long
term interest rates decrease during this period, the interest payable on the CMO
issued will decrease, while the yield on the underlying mortgage loans pledged
to collateralize the CMO will not change; as a consequence, the interest spread
on the CMO will be higher. Similarly, proceeds received on the issuance of MPCs
and other sales, and related gains or losses, will be negatively impacted by an
increase in long term interest rates during this period due to the resulting
decline in market value of the related collateral. Conversely,
28
these transactional gains or losses will be favorably impacted by a decrease in
long term interest rates during this period. The Company attempts to manage its
exposure to long term interest rate changes in part by pricing CMO and MPC
issuances prior to the purchase of, but subsequent to the commitment to
purchase, all of the mortgage loans that will collateralize the issuances and
may from time to time elect to enter into forward sale agreements for hedging
purposes. In 1995 the Company expects to hold mortgage loan acquisitions in its
mortgage portfolio for very brief periods, usually about a week, in an effort to
eliminate the market risk associated with aggregating and securitizing mortgage
loans.
Changes in interest rates also impact earnings recognized from the CMO
investment portfolio, which consists primarily of fixed-rate CMO residuals. The
amount of income that may be generated from the typical CMO residual is
dependent upon the rate of principal prepayments on the underlying collateral.
If mortgage interest rates fall significantly below the interest rate on the
collateral, principal prepayments will increase, reducing or even eliminating
the overall return on the investment in the CMO residual. This is due primarily
to the acceleration of the amortization of bond discounts, a noncash item, as
bond classes are repaid more rapidly than originally anticipated. During 1993
the Company experienced such a period of declining rates and high prepayments.
Another effect of changes in interest rates is that when interest rates
decrease, the rate of prepayment of mortgage loans generally increases. To
the extent the proceeds of prepayments on the mortgage investment portfolios
cannot be reinvested at a rate of interest at least equal to the rate previously
earned on such investments, earnings may be adversely affected. In addition,
the rates of interest earned on ARM loans generally will decline during periods
of falling interest rates.
The above discussion regarding how changes in interest rates impact investments
in mortgage assets also applies to the Company's growing investment in purchased
mortgage servicing rights. When interest rates rise, mortgage servicing rights
become more valuable since the average lives of the related mortgage loans will
tend to be longer and earnings from large, temporarily held cash balances will
be greater. Conversely, lower interest rates will spur prepayments thus
reducing the period of time the Company can service the related loans. Because
the Company began mortgage servicing in 1993, exposure to lower interest rates
is less than for other servicers that acquired servicing portfolios in previous
years when interest rates were substantially higher.
29