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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF
THE SECURITIES EXCHANGE ACT OF 1934.
FOR THE FISCAL YEAR ENDED: DECEMBER 31, 1998
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: 1-13485
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
MARYLAND 33-0741174
(STATE OR OTHER JURISDICTION OF (I.R.S. EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NUMBER)
445 MARINE VIEW AVENUE, SUITE 230 92014
DEL MAR, CALIFORNIA (ZIP CODE)
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE (619) 350-5000
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT:
NAME OF EACH EXCHANGE
TITLE OF EACH CLASS ON WHICH REGISTERED
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COMMON STOCK ($.01 PAR VALUE) NEW YORK STOCK EXCHANGE
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
YES X NO
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Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
At March 1, 1999, the aggregate market value of the voting stock held by
non-affiliates was $45.9 million, based on the closing price of the common stock
on the New York Stock Exchange.
As of March 1, 1999, there were 8,055,500 shares of the registrant's Common
Stock outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant's definitive Proxy Statement issued in
connection with the Annual Meeting of Stockholders of the registrant to be held
on May 19, 1999, are incorporated herein by reference into Part III.
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TABLE OF CONTENTS
PAGE
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PART I
Item 1. Business.................................................... 1
Item 2. Properties.................................................. 31
Item 3. Legal Proceedings........................................... 31
Item 4. Submission of Matters to A Vote of Security Holders......... 31
PART II
Item 5. Market For Registrant's Common Equity and Related
Stockholder Matters......................................... 32
Item 6. Selected Financial Data..................................... 33
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operation.................................... 34
Item 7a. Quantitative And Qualitative Disclosure About Market Risk... 37
Item 8. Financial Statements and Supplementary Data................. 37
Item 9. Changes in and Disagreements With Accountants on Accounting
and Financial Disclosure.................................... 38
PART III
Item 10. Directors and Executive officers of The Registrant.......... 38
Item 11. Executive Compensation...................................... 38
Item 12. Security Ownership of Certain Beneficial Owners and
Management.................................................. 38
Item 13. Certain Relationships and Related Transactions.............. 38
PART IV
Item 14. Exhibits, Financial Statements, Schedules and Reports On
Form 8-K.................................................... 38
Financial Statements.................................................. F-1
Signatures
Exhibit Index
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ITEM 1. BUSINESS
The statements contained in this Form 10-K that are not purely historical
are forward looking statements, including statements regarding the Company's
expectations, hopes, beliefs, intentions, or strategies regarding the future.
Statements which use the words "expects", "will", "may", "anticipates", "goal",
"intends", "seeks", "strategy" and derivatives of such words are forward looking
statements. These forward looking statements, including statements regarding
changes in the Company's future income and future Mortgage Asset acquisitions,
are based on information available to the Company on the date hereof, and the
Company assumes no obligation to update any such forward looking statement. It
is important to note that the Company's actual results could differ materially
from those in such forward looking statements. Among the factors that could
cause actual results to differ materially are the factors set forth below under
the heading "Business Risks". In particular, the Company's future income could
be affected by availability of credit, changes in levels of prepayments, changes
in interest rates, lack of available Mortgage Assets which meet the Company's
acquisition criteria, the type of Mortgage Assets acquired by the Company and
the credit characteristics of the borrowers under Mortgage Loans acquired by the
Company.
GENERAL
American Residential Investment Trust, Inc. (the "Company") was
incorporated in the State of Maryland on February 6, 1997, and is a real estate
investment trust ("REIT"). The Company acquires non-conforming adjustable-rate
and fixed-rate, single-family whole loans (collectively, "Mortgage Loans")
through bulk purchases in the capital markets and through purchases from
originators. It finances its acquisitions with equity and secured borrowings.
The Company generally earns interest on the portion of its portfolio financed
with equity and earns a net interest spread on the portion of its portfolio
financed with secured borrowings. The Company is structured as a real estate
investment trust, thereby generally eliminating federal taxes at the corporate
level on income it distributes to stockholders.
The Company has entered into an agreement with Home Asset Management
Corporation (the "Manager") to manage the day-to-day operations of the Company
(the "Management Agreement"). Accordingly, the Company's success depends
significantly on the Manager. Pursuant to the terms of the Management Agreement,
the Manager advises the Company's Board of Directors with respect to the
formulation of investment criteria and preparation of policy guidelines, and is
compensated based upon the principal amount and type of Mortgage Securities and
Mortgage Loans, (collectively, "Mortgage Assets") held by the Company. See "The
Management Agreement."
INVESTMENTS
MORTGAGE LOANS
The Company acquires non-conforming, adjustable-rate and fixed-rate
residential Mortgage Loans primarily through bulk purchases from the capital
markets and from other financial institutions. The Company also invests in
Mortgage Loans which it acquires directly from originators. Although the Company
invested in Mortgage Securities in the past, the Company believes that it can
enhance the overall yield of its Mortgage Asset portfolio by investing in
Mortgage Loans, which generally are relatively higher yielding (adjusted for
risk) than Mortgage Securities.
The Company only acquires those Mortgage Loans which the Company believes
it has the expertise (with the advice of the Manager) to evaluate and manage and
which are consistent with the Company's balance sheet guidelines and risk
management objectives. The Company also considers (i) the amount and nature of
anticipated cash flows from the Mortgage Assets, (ii) the Company's ability to
pledge the Mortgage Loans to secure collateralized borrowings, (iii) the
increase in the Company's capital requirements resulting from the purchase and
financing of the Mortgage Loans, as determined pursuant to the Company's capital
policies, and (iv) the costs of financing, hedging, managing, servicing,
securitizing and providing for credit losses on the Mortgage Assets. Prior to
the acquisition of Mortgage Loans, potential returns on capital employed are
assessed over the life of the Mortgage Loans and in a variety of interest rates,
yield spread, financing cost, credit loss, and prepayment scenarios. The Board
of Directors of the Company can revise the
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Company's investment policies at its sole discretion, subject to approval by a
majority of the Company's directors who are not employees or officers of the
Company. See "Business Risks -- Policies and Strategies May Be Revised at the
Discretion of the Board of Directors."
The Company initially finances acquisitions of Mortgage Loans with short
term borrowings which generally mature in one year or less. The Company's
objective is to permanently finance its Mortgage Loans ("Bond Collateral") in
long-term non-recourse securitizations. Mortgage Loans are financed with
borrowings that will bear interest at rates which periodically adjust to the
applicable market rate. See "Funding."
All of the Mortgage Loans held by the Company are non-conforming Mortgage
Loans. The Mortgage Loans are non-conforming primarily as a result of credit
rating of the borrower and consist predominantly of "A" and "B" grade,
non-conforming Mortgage Loans and to a lesser extent, "C" and "D" grade Mortgage
Loans. The Company grades each Mortgage Loan based predominantly on the mortgage
credit rating of the borrower. See "Underwriting." Non-conforming Mortgage Loans
generally are subject to greater frequency of loss and delinquency than
conforming Mortgage Loans. See "Business Risks -- Borrower Credit May Decrease
Value of Mortgage Loans." Accordingly, lower credit grade Mortgage Loans
normally bear a higher rate of interest and are subject to higher fees
(including prepayment fees and late payment penalties) than conforming Mortgage
Loans.
For the year 1998, the Company acquired Mortgage Loans with an aggregate
carrying value of approximately $649.6 million. The Company expects to acquire
additional Mortgage Loans in the near future. At December 31, 1998, the Company
had $417.8 million of Bond Collateral.
MORTGAGE SECURITIES
The Company's current investment portfolio includes Mortgage Securities
issued or guaranteed by federal government sponsored agencies ("Agency
Securities"). The Company's Mortgage Securities are securitized interests in
pools of adjustable-rate single family residential Mortgage Loans. These
Mortgage Securities entitle the holder to receive a pass-through of principal
and interest payments on the underlying pool of Mortgage Loans. Interest and
principal are guaranteed by FNMA or FHLMC. The original maturity of the majority
of the Mortgage Securities is over a period of thirty years; the actual maturity
is subject to change based on the prepayments of the underlying Mortgage Loans.
As of December 31, 1998, approximately two-thirds of the Company's Mortgage
Securities were whole-pool Mortgage Securities which represent all the
certificates issued with respect to an underlying pool of Mortgage Loans. In
1998, a significant portion of Mortgage Securities available-for-sale were sold
resulting in a loss of $5.9 million. The remaining Mortgage Securities
available-for-sale had a value of $6.6 million at December 31, 1998.
The Company did not purchase Mortgage Securities in the capital markets in
1998 and, at this time, the Company does not plan to continue to purchase
Mortgage Securities. These Mortgage Securities generally have a higher level of
liquidity than the Mortgage Loans currently held by the Company, however, they
are also more sensitive to prepayment risk and interest rate fluctuations.
REMIC CERTIFICATES
The Company diversified its residential Mortgage Loan sales activities in
1998 to include the securitization of such loans through a Real Estate Mortgage
Investment Conduit ("REMIC"). The REMIC, which consisted of pooled
adjustable-rate first-lien mortgages, was issued by American Residential
Holdings, Inc. ("Holdings"), a non-REIT, taxable affiliate of the Company, to
the public through the registration statement of the related underwriter. The
retained interest in securitization consists of assets generated by the
Company's loan securitization. These assets, REMIC subordinate certificates,
were valued at $8.8 million at December 31, 1998.
While the Company does not currently intend to acquire additional residual
interests issued by REMICs, subordinate interests in Mortgage Securities or
interest-only Mortgage Securities, it is not prohibited from
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doing so under the terms of its Capital Policy. Residual interests, if acquired
by a REIT, would generate excess inclusion income. See "Federal Income Tax
Consequences -- Taxation of Stockholders."
MORTGAGE LOAN ACQUISITIONS
ACQUISITIONS
The Company has acquired the majority of its Mortgage Loans to date on a
bulk basis. In some cases, the Mortgage Loans are purchased directly from large
originators and in other cases through a Wall Street intermediary. Bulk packages
are usually greater than $50 million in size and can be as much as $400 to $500
million.
In addition to acquiring Mortgage Loans through bulk purchases in the
capital markets, the Manager intends to leverage the expertise of its executive
officers in the residential Mortgage Loan industry to develop a program for the
purchase of Mortgage Loans by the Company directly from the originators. Under
this program, the Manager will (i) identify segments of the residential Mortgage
Loan market that meet its general criteria for potential originations, (ii)
arrange for the acquisition by the Company of Mortgage Loans originated, hence
avoiding certain loan broker or other intermediary fees, and (iii) arrange for
the servicing of the Mortgage Loans by entities experienced in servicing the
particular types of Mortgage Loans involved.
The Manager intends to draw upon the experience of its executive officers
in the residential mortgage industry to build a network of originators with
expertise in market segments targeted by the Company. The Manager will make
arrangements for the Company to acquire Mortgage Loans through the Manager's
relationships with these originators. The Manager will identify and work with a
number of originators to generate Mortgage Loan products for the program.
The Company anticipates that in the future an increasing portion of its
Mortgage Loans will consist of loans acquired pursuant to the program. There can
be no assurance that the program will be successful or that the Mortgage Loans
acquired through the program will be higher yielding than loans acquired through
bulk purchases or that of Mortgage Securities. See "Business Risks -- Inability
to Acquire Mortgage Assets."
Pursuant to the Company's program, the Company intends to acquire packages
of Mortgage Loans in aggregate principal amounts of between $5 million and $30
million. The Mortgage Loans will generally be non-conforming Mortgage Loans
secured by single family residential properties. The Mortgage Loans are expected
to be non-conforming primarily as a result of the credit rating of the borrower.
MORTGAGE LOAN PROPERTIES
Although the Company has sought geographic diversification of the
properties which are collateral for the Company's Mortgage Loans, it has not set
specific diversification requirements (whether by state, zip code or other
geographic measure). Concentration in any one area will increase exposure of the
Company's Mortgage Loans to the economic and natural hazard risks associated
with that area. Further, certain properties securing Mortgage Loans may be
contaminated by hazardous substances resulting in reduced property values. If
the Company forecloses on a defaulted Mortgage Loan collateralized by such
property, the Company may be subject to environmental liabilities regardless of
whether the Company was responsible for the contamination.
PRICING
Mortgage Loans acquired on a bulk basis have been priced on either a
negotiated basis with the sellers or pursuant to a bidding process. For Mortgage
Loans to be acquired from originators, the Company expects to review the prices
at which it is purchasing such Mortgage Loans with the Manager and to adjust the
prices on a risk adjusted basis. In each case, different prices will be
established for the various types of Mortgage Loans to be acquired based on
current market conditions, with price adjustments for any "buy-ups" or
"buy-downs" (i.e., where the gross coupon is higher or lower than the standard
coupon set forth in the originator's pricing specifications).
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UNDERWRITING
The Company reviews the aggregate attributes of a package of Mortgage
Loans, as specified by the seller of the Mortgage Loans, to determine if the
package conforms to the Company's acquisition criteria. If the Company then
elects to purchase a package of Mortgage Loans, the Company reviews the Mortgage
Loan documentation for conformance to the seller's specifications. In evaluating
a package of Mortgage Loans to be acquired on a bulk basis, the Company reviews
the loan documentation for 100% of the Mortgage Loans to be acquired. To date,
all of the Company's underwriting reviews have been performed by a nationally
recognized third party underwriting review firm or in-house personnel. The
Company also obtains representations and warranties from the seller with respect
to the quality and terms of the Mortgage Loans being acquired.
The Company considers a variety of factors in determining whether to
acquire a package of Mortgage Loans. These factors generally include the credit
grade and income history of each borrower, the loan-to-value ratio for each
property, the prepayment penalties for the Mortgage Loans, the weighted average
coupon of the Mortgage Loans and the documentation required for approval of the
Mortgage Loans. The Company may also consider other factors with respect to any
individual package under consideration.
Underwriting standards are applied by or on behalf of a lender to evaluate
the borrower's credit standing and repayment ability, and the value and adequacy
of the related mortgaged property as collateral. In general, a prospective
borrower applying for a Mortgage Loan is required to fill out a detailed
application designed to provide to the underwriting officer pertinent credit
information. As part of the description of the borrower's financial condition,
the borrower generally is required to provide a current list of assets and
liabilities and a statement of income and expenses, as well as an authorization
to apply for a credit report which summarizes the borrower's credit history with
local merchants and lenders and any record of bankruptcy. In most cases, an
employment verification is obtained from an independent source (typically the
borrower's employer) which verifies among other things, the length of employment
with that organization, the current salary, and whether it is expected that the
borrower will continue such employment in the future. If a prospective borrower
is self-employed, the borrower may be required to submit copies of signed tax
returns. The borrower may also be required to authorize verification of deposits
at financial institutions where the borrower has demand or savings accounts.
The Company may elect to have the borrower's credit report reviewed, and a
credit score produced, by an independent credit-scoring firm, such as Fair,
Issac and Company ("FICO"). Credit scores estimate, on a relative basis, which
borrowers are most likely to default on Mortgage Loans. Lower scores imply
higher default risks relative to higher scores. FICO scores are empirically
derived from historical credit bureau data and represent a numerical weighing of
a borrower's credit characteristics over a two year period. A FICO score is
generated through the statistical analysis of a number of credit-related
characteristics and variables. Common characteristics include the following: the
number of credit lines (trade lines), payment history, past delinquencies,
severity of delinquencies, current levels of indebtedness, types of credit and
length of credit history. Attributes are the specific values of each
characteristic. A scorecard (the model) is created with weights or points
assigned to each attribute. An individual loan applicant's credit score is
derived by summing together the attribute weights for that applicant.
Substantially all of the Mortgage Assets are residential Mortgage Loans made to
borrowers with credit ratings below the conforming Mortgage Loan underwriting
guidelines. The following matrix generally describes the underwriting criteria
employed by the Company in evaluating the credit quality of non-conforming
Mortgage Loans. Such underwriting criteria may differ from the criteria employed
by the originators of the Mortgage Loans.
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MAXIMUM MORTGAGE MAXIMUM
CREDIT DELINQUENCIES CONSUMER DEBT-TO-INCOME
LEVEL DURING LAST YEAR CREDIT RATIOS
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A Up to two 30-day Generally good credit for the last two years, with 45%
minor derogatory accounts permitted. Overall credit
paid as agreed. No bankruptcy, discharge, or notice
of default filings during preceding two years.
B Up to four 30-day Satisfactory credit with recurring 30-day accounts & 50%
minor 60-day accounts. Isolated judgements and
charge-offs permitted on a case-by-case basis. No
bankruptcy, discharge, or notice of default filings
during preceding two years.
C Up to two 60-day Generally fair credit, as the applicant may have 55%
experienced significant credit problems in the past,
including judgements, charge-offs and collection
accounts. On a case-by-case basis, a notice of
default/foreclosure filing may have occurred in the
last twelve months with a good explanation. Not
currently in bankruptcy, but may have recently
occurred with proof of dismissal/discharge.
D Up to one 120-day Generally poor credit, as the applicant may be 60%
currently experiencing significant credit problems,
including being subject to notice of
default/foreclosure fillings or currently in
bankruptcy.
In determining the adequacy of the mortgaged property as collateral, an
appraisal is made of each property considered for financing. The appraiser is
required to inspect the property and verify that it is in good condition and
that construction, if new, has been completed. The appraisal is based on the
market value of comparable homes, the estimated rental income (if considered
applicable by the appraiser) and the cost of replacing the home. The value of
the property being financed, as indicated by the appraisal, must be such that it
currently supports, and is anticipated to support in the future, the outstanding
Mortgage Loan balance.
Once all applicable employment, credit and property information is
received, a determination generally is made as to whether the prospective
borrower has sufficient monthly income available to meet (i) the borrower's
monthly obligations on the proposed Mortgage Loan (determined on the basis of
the monthly payments due in the year of origination) and other expenses related
to the mortgaged property (such as property taxes and hazard insurance), and
(ii) monthly housing expenses and other financial obligations and monthly living
expenses. The underwriting standards may be permitted to vary in appropriate
cases where factors such as low loan-to-value ratios or other favorable credit
issues exist.
QUALITY CONTROL
The Manager has developed a quality control program to monitor the quality
of Mortgage Loan underwriting at the time of acquisition and on an ongoing
basis. All Mortgage Loans purchased by the Company are subject to this quality
control program. A legal document review of Mortgage Loans to be acquired is
conducted to verify the accuracy and completeness of the information contained
in the Mortgage Loan documents, security instruments and other pertinent
documents in the file. All the Mortgage Loans are submitted to a third party,
nationally recognized underwriting review firm for a compliance check of
underwriting and review of income, asset and appraisal information. In addition,
the Manager has implemented a post-acquisition audit program to monitor ongoing
documentation and servicing compliance.
SERVICING
The Company has acquired Mortgage Loans on both a "servicing released"
basis (i.e., the Company acquired both the Mortgage Loans and the rights to
service them) and on a "servicing retained" basis (i.e., the
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Company acquired the Mortgage Loans but not the rights to service the Mortgage
Loans). Generally, whether the Mortgage Loans are acquired on a servicing
released or servicing retained basis is determined pursuant to negotiations with
the seller.
The Company has contracted with subservicers to provide servicing at a cost
of a fixed percentage of the outstanding mortgage balance and the right to hold
escrow account balances and retain certain ancillary charges. In addition, for a
small portion of the Mortgage Loans, the Company will pay the subservicer a
fixed dollar fee plus a percentage of the outstanding Mortgage Loan balance and
a percentage of all amounts collected. The Company believes that the selection
of third party sub-servicers was more cost effective than establishing a
servicing department within the Company. However, part of the Company's
responsibility is to continually monitor the performance of the sub-servicers
through monthly performance reviews. Depending on these sub-servicer reviews,
the Company may in the future form a separate collection group to assist the
sub-servicer in the servicing of these loans. The Company has arranged for the
servicing of the Mortgage Loans with servicing entities that have particular
expertise and experience in the types of Mortgage Loans being acquired. See
"Business Risks -- Loans Serviced by Third Parties."
FUNDING
The Company employs a debt financing strategy to increase its investment in
Mortgage Assets. By using the Company's Mortgage Assets as collateral to borrow
funds, the Company is able to purchase Mortgage Assets with significantly
greater value than its equity. The Company has a targeted ratio of
equity-to-assets of between 8% and 12%, which is generally greater than the
levels of many other companies that invest in Mortgage Assets, including many
commercial banks, savings and loans, and government agencies. See "Capital
Guidelines".
The Company's financing strategy is designed to maintain a cushion of
equity sufficient to provide required liquidity to respond to the effects under
its borrowing arrangements of interest rate movements and changes in the market
value of its Mortgage Assets. However, a major disruption of the reverse
repurchase or other markets relied on by the Company for short-term borrowings
would have a material adverse effect on the Company unless the Company was able
to arrange alternative sources of financing on comparable terms as evidenced by
the problems that occurred during the fourth quarter of 1998. The Company
continues to finance its acquisition of Mortgage Assets primarily through
reverse repurchase agreements and securitizations and, to a lesser extent,
through lines of credit and other financings.
REVERSE REPURCHASE AGREEMENTS (SHORT-TERM BORROWINGS)
The Company currently finances a portion of Mortgage Assets primarily
through a form of borrowing known as reverse repurchase agreements. In a reverse
repurchase agreement transaction, the Company agrees to sell a Mortgage Asset
and simultaneously agrees to repurchase the same Mortgage Asset one day to six
months later at a higher price with the price differential representing the
interest expense. These transactions constitute collateralized borrowings for
the Company, based on the market value of the Company's Mortgage Assets. The
Company generally will retain beneficial ownership of the Mortgage Security,
including the right to distributions on the collateral and the right to vote.
Upon a payment default under any such reverse repurchase agreement, the lending
party may liquidate the collateral.
The Company's reverse repurchase agreements generally require the Company
to pledge cash or additional Mortgage Assets in the event the market value of
existing collateral declines. To the extent that cash reserves are insufficient
to cover such deficiencies in collateral, the Company may be required to sell
Mortgage Assets to reduce the borrowings. Currently only one of the Company's
borrowing facilities may be used to finance the acquisitions of Mortgage Loans.
The Company is in negotiations to increase the number of reverse repurchase
agreements that may be used to finance Mortgage Loans. There can be no
assurance, however, that the Company will successfully enter into such
additional agreements or that they will be on favorable terms to the Company.
See "Business Risks -- Failure to Implement Company's Leverage Strategy May
Adversely Affect Results of Operations."
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At December 31, 1998, short-term total borrowings outstanding were $166.2
million, with Mortgage Loans valued at $179.0 million pledged to secure such
borrowings. The short-term borrowings were undertaken pursuant to reverse
repurchase agreements. At December 31, 1998, the weighted average borrowing rate
for short-term debt was 5.68% per annum. Upon the expiration of each reverse
repurchase agreement, the Company refinances the debt on a daily basis at the
new market rate. Accordingly, in a period of increasing interest rates, the
Company's interest expense could increase substantially prior to the time that
the Company's interest income with respect to such Mortgage Loans increase. At
December 31, 1998, equity capital to total market value of the Company's
Mortgage Assets was 16.9%. See "Risk Management -- Other Processes."
At December 31, 1998, the Company had no borrowed funds under reverse
repurchase agreements for Mortgage Securities and was using one financial
institutions for reverse repurchase agreements for Mortgage Loans. The Company
intends to expand its committed reverse repurchase agreements and is currently
in negotiations with several lenders. See "Management's Discussion and Analysis
of Financial Condition and Results of Operations -- Liquidity and Capital
Resources."
The Company has entered into reverse repurchase agreements primarily with
national broker/dealers, commercial banks and other lenders who typically offer
such financing. The Manager and the Company will monitor the need for such
commitment agreements and may enter into such commitment agreements in the
future if deemed favorable to the Company. See "Business Risks -- Failure to
Implement Company's Leverage Strategy May Adversely Affect Results of
Operations." There can be no assurance that the Company will be able to continue
to borrow funds using reverse repurchase agreements or otherwise finance its
Mortgage Loans.
In the event of the insolvency or bankruptcy of the Company, the creditor
under reverse repurchase agreements may be allowed to avoid the automatic stay
provisions of the Bankruptcy Code and to foreclose on the collateral agreements
without delay. In the event of insolvency or bankruptcy of a lender during the
term of a reverse repurchase agreement, the lender may be permitted to repudiate
the contract, and the Company's claim against the lender for damages therefrom
may be treated simply as one of the unsecured creditors. Should this occur, the
Company's claims would be subject to significant delay and, if received, may be
substantially less than the damages actually suffered by the Company.
SECURITIZATIONS (LONG-TERM BORROWINGS)
The Company intends to continue to securitize Mortgage Loans as part of its
overall financing strategy. Securitization is the process of pooling Mortgage
Loans and issuing equity securities, such as mortgage pass-through certificates,
or debt securities, such as Collateralized Mortgage Obligations ("CMOs"). The
Company intends to securitize its Mortgage Loans primarily by issuing structured
debt. Under this approach, for accounting purposes, the Mortgage Loans so
securitized remain on the balance sheets as assets and the debt obligations
(i.e., the CMOs) appear as liabilities. A structured debt securitization is
generally expected to result in substituting one type of debt financing for
another, as proceeds from the structured debt issuance are applied against
preexisting borrowings (i.e., borrowings under reverse repurchase agreements).
The structured debt securities issued will constitute limited recourse, long
term financing, the payments on which generally correspond to the payments on
the Mortgage Loans serving as collateral for the debt. Such financings are not
subject to a margin call if a rapid increase in rates would reduce the value of
the underlying Mortgage Loans and, hence, reduce the liquidity risk to the
Company for the Mortgage Loans so financed.
The decision to issue CMOs will be based on the Company's current and
future investment needs, market conditions and other factors. Each issue of CMOs
is fully payable from the principal and interest payments on the underlying
Mortgage Loans collateralizing such debt, any cash or other collateral required
to be pledged as a condition to receiving the desired rating on the debt, and
any investment income on such collateral. The Company earns the net interest
spread between the interest income on the Mortgage Loans securing the CMOs and
the interest and other expenses associated with the CMO financing. The net
interest spread may be directly impacted by the levels of prepayment of the
underlying Mortgage Loans and, to the extent each CMO class has variable rates
of interest, may be affected by changes in short-term interest rates.
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If the Company issues CMOs for financing purposes, it will seek an
investment grade rating for such CMOs by a nationally recognized rating agency.
To secure such a rating, it is often necessary to pledge collateral in excess of
the principal amount of the CMOs to be issued, or to obtain other forms of
credit enhancements such as additional mortgage loan insurance. The need for
additional collateral or other credit enhancements depends upon factors such as
the type of collateral provided and the interest rates paid thereon, the
geographic concentration of the mortgaged property securing the collateral and
other criteria established by the rating agency. The pledge of additional
collateral would reduce the capacity of the Company to raise additional funds
through short-term secured borrowings or additional CMOs and diminish the
potential expansion of its investment portfolio. As a result, the Company's
objective is to pledge additional collateral for CMOs only in the amount
required to obtain an investment grade rating for the CMOs by a nationally
recognized rating agency. Total credit loss exposure to the Company is limited
to the equity invested in the CMOs at any point in time.
The Company believes that under prevailing market conditions, an issuance
of CMOs receiving other than an investment grade rating would require payment of
an excessive yield to attract investors. No assurance can be given that the
Company will achieve the ratings it plans to seek for the CMOs.
In connection with the securitization of "B" and "C" Mortgage Loans, the
levels of subordination required as credit enhancement for the more senior
classes of securities issued in connection therewith would be higher than those
with respect to its "A" grade non-conforming Mortgage Loans. Thus, to the extent
that the Company retains any of the subordinated securities created in
connection with such securitizations and losses with respect to such pools of
"B" and "C" grade Mortgage Loans or Mortgage Loans secured by second liens are
higher than expected, the Company's future operations could be adversely
affected.
During 1998, the Company securitized Mortgage Loans in a CMO through its
wholly owned subsidiary, American Residential Eagle, Inc. ("Eagle"), by issuing
collateralized mortgage bonds (Long-Term Debt) through a Financial Asset
Securitization Investment Trust ("FASIT"). The bonds were assigned to a FASIT
trust and trust certificates evidencing the assets of the trust were sold to
investors. The trust certificates were issued in classes representing senior,
mezzanine, and subordinate payment priorities. Payments received on
single-family mortgage loans ("Bond Collateral") are used to make payments on
the Long-Term Debt. The obligations under the Long Term Debt are payable solely
from the Bond Collateral and are otherwise non-recourse to the Company. The
maturity of each class of trust certificates is directly affected by the rate of
principal repayments on the related Bond Collateral. The Long-Term Debt is also
subject to redemption according to the specific terms of the indenture pursuant
to which the bonds were issued and the FASIT trust. As a result, the actual
maturity of the Long-Term Debt is likely to occur earlier than its stated
maturity. There can be no assurances that the Company will be able to continue
to securitize or otherwise finance its Mortgage Loans.
At December 31, 1998, total long-term borrowings outstanding were
approximately $385.3 million with Mortgage Loans valued at approximately $417.8
million pledged to secure such borrowings. These borrowings are carried on the
balance sheet at historical cost, which approximates market value.
During 1998, the Company also securitized Mortgage Loans in a "REMIC"
through an affiliate Holdings. The Company accounted for the REMIC
securitization as a sale of Mortgage Loans and recorded a gain on the
transaction. Mortgage Loans of $103.5 million were traded for a gain of
approximately $1.6 million.
CAPITAL GUIDELINES
The Company's capital management goal is to strike a balance between the
under-utilization of leverage, which could reduce potential returns to
stockholders, and the over-utilization of leverage, which could reduce the
Company's ability to meet its obligations during period of adverse market
conditions. For this purpose, the Company has established a "Capital Policy"
which limits the Company's ability to acquire additional Mortgage Assets during
times when the actual capital base of the Company is less than a required amount
defined in the Capital Policy. In this way, the Company believes the use of
balance sheet leverage can be better controlled. For purposes of the Capital
Policy, the actual capital base, is equal to the market value of
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total Mortgage Assets, less the book value of total collateralized borrowings.
In addition, when the actual capital base falls below the Capital Policy
requirement, the Manager is required to submit to the Board of Directors of the
Company a plan for bringing the actual capital base into compliance with the
Capital Policy. It is anticipated that in most circumstances this goal will be
achieved over time without specific action by the Company or the Manager through
the natural process of mortgage principal repayments and increases in the market
values of Mortgage Assets as their coupon rates adjust upwards to market levels.
The Company anticipates that the actual capital base is likely to exceed the
Capital Policy requirement during periods following new equity offerings and
during periods of falling interest rates and that the actual capital base is
likely to fall below the Capital Policy requirement during periods of rising
interest rates. The Board of Directors has the discretion to modify or waive the
Company's policies and restrictions without stockholder consent. Aside from the
Capital Policy set by the Board of Directors, there are no restrictions on the
Company's ability to incur debt and there can be no assurance the level of debt
that the Company is authorized to incur will not be increased by the Board of
Directors. See "Business Risks -- Policies and Strategies May Be Revised at the
Discretion of the Board of Directors."
The Company, with the advice of the Manager, assigns to each Mortgage Asset
a specified amount of capital to be maintained against it by aggregating three
component requirements of the Capital Policy. The first component of the
Company's Capital Policy is the current aggregate over-collateralization amount
or "haircut" the lenders require the Company to hold as capital. The Company is
required to pledge as collateral Mortgage Assets with a market value that
exceeds the amount it borrows. The haircut for each Mortgage Asset is determined
by the lender based on the risk characteristics and liquidity of that Mortgage
Asset. For example, haircut levels on individual borrowings could range from 3%
to 5% for Mortgage Securities and Mortgage Loans.
The second component of the Company's Capital Policy is the "liquidity
capital cushion." The Company expects that substantially all of its reverse
repurchase agreements will require the Company to deposit additional collateral
in the event the market value of existing collateral declines. The liquidity
cushion is an additional amount of capital in excess of the haircut maintained
by the Company designed to assist the Company in meeting the demands of the
lenders for additional collateral should the market value of the Company's
Mortgage Assets decline. Alternatively, the Company might sell Mortgage Assets
to reduce the borrowings. See "Business Risks -- Investments in Mortgage Assets
May Be Illiquid."
The third component of the Company's capital requirement is the "capital
cushion" assigned to each Mortgage Asset based on the Manager's assessment of
the Mortgage Asset's credit risk. This represents an assessment of the risk of
delinquency, default or loss on individual Mortgage Assets.
Finally, the Board of Directors establishes, subject to revision from time
to time, a minimum equity to total assets ratio for the Company pursuant to its
Capital Policy. The Board of Directors reviews on a periodic basis various
analyses prepared by the Manager of the risks inherent in the Company's balance
sheet, including an analysis of the effects of various scenarios on the
Company's net cash flow, net income, dividends, liquidity and net market value.
Should the Board of Directors determine, in its discretion, that the minimum
required capital base is either too low or too high, the Board of Directors will
raise or lower the capital requirement accordingly.
The Company expects that its aggregate minimum equity capital required
under the Capital Policy will range between 8% to 12% of the total market value
of the Company's Mortgage Assets. At December 31, 1998, equity capital to total
market value of the Company's Mortgage Assets was approximately 16.9%, higher
than target due to the Company's decision to sell Mortgage Securities in the
fourth quarter. This percentage will fluctuate over time, and may fluctuate out
of the expected range from time to time, as the composition of the balance sheet
changes, haircut levels required by lenders change, the market value of the
Mortgage Assets change and as the capital cushion percentages set by the Board
of Directors are adjusted over time. The Company will actively monitor and
adjust, if necessary, its Capital Policy, both on an aggregate portfolio level
as well as on an individual pool or Mortgage Loan basis. In monitoring its
Capital Policy, the Company expects to take into consideration current market
conditions and a variety of interest rate scenarios, performance of hedges,
performance of Mortgage Assets, credit risk, prepayments of Mortgage Assets, the
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restructuring of Mortgage Assets, general economic conditions, potential
issuance of additional equity, pending acquisitions or sales of Mortgage Assets,
Mortgage Loan securitizations and the general availability of financing. There
can be no assurance that the Company's capital will be sufficient to protect the
Company against adverse effects from interest rate adjustments or the obligation
to sell Mortgage Assets on unfavorable terms or at a loss. See "Business
Risks -- Sudden Interest Rate Fluctuations May Reduce Income from Operations."
RISK MANAGEMENT
Prior to arranging the acquisition of Mortgage Assets by the Company, the
Manager gives consideration to balance sheet management and risk diversification
issues. A specific Mortgage Asset which is being evaluated for potential
acquisition is deemed more or less valuable to the Company 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 the Company may establish for its
balance sheet from time to time. Accordingly, an important part of the Mortgage
Assets evaluation process is a simulation, using the Manager's risk management
model, of the addition of proposed Mortgage Assets and its associated borrowings
and hedgings to the balance sheet and an assessment of the impact any proposed
acquisition of Mortgage Assets would have on the risks in, and returns generated
by, the Company's balance sheet as a whole over a variety of scenarios.
INTEREST RATE RISK MANAGEMENT
To the extent consistent with its election to qualify as a REIT, the
Company has implemented certain processes and follows a hedging program intended
to protect the Company against significant unexpected changes in prepayment
rates and interest rates.
PREPAYMENT RISK MANAGEMENT PROCESS
The Company has sought to minimize the effects on operations caused by
faster than anticipated prepayment rates by purchasing Mortgage loans with
prepayment penalties. The Company believes that the prepayment rates of the
Company's Mortgage Loans will be lower than those of traditional Mortgage
Assets, primarily due to three factors: (i) the substantial prepayment
penalties, (ii) the borrower is unlikely to have as many refinancing options as
a borrower with a higher credit rating and (iii) in declining interest rate
environments, the interest rates for non-conforming Mortgage Loans typically do
not decrease as significantly as conforming Mortgage Loan interest rates,
reducing the incentive for the borrower to refinance. There can be no assurance
that the Company's efforts to reduce prepayment rates will be successful.
The borrowers' prepayment of principal included only the principal repaid
which was not part of the normal amortization of the loan. The borrowers'
repayment of principal is the total payment of principal for the period. For the
year ended December 31, 1998, the annualized principal repayment on Mortgage
Assets was approximately $300 million. The Company experienced an annualized
rate of principal repayment of 34.2%.
The amortized cost of the Company's total Mortgage Assets at December 31,
1998 was equal to 107.1% of the face value of the Mortgage Assets. The amortized
cost of Mortgage Securities at December 31, 1998 was equal to 100.6% of face
value of the Mortgage Securities, the amortized cost of Mortgage Loans was equal
to 104.9% of the face value of the Mortgage Loan, and the amortized cost of the
Company's Bond Collateral at December 31, 1998 was equal to 108.2% of the face
value of the Bond Collateral.
OTHER PROCESSES
The Manager attempts to manage the Company's Mortgage Asset portfolio to
offset the potential adverse effects from (i) lifetime and periodic rate
adjustment caps on its Mortgage Assets, (ii) the differences between interest
rate adjustment indices of its Mortgage Assets and related borrowings, and (iii)
the differences between interest rate adjustment period of its Mortgage Assets
and related borrowings.
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At December 31, 1998, the Company's weighted average Mortgage Loans and
related liabilities were matched within an eighteen-month period in terms of
adjustment frequency and speed of adjustment to market conditions. Approximately
96.3% of the Company's Mortgage Loans at December 31, 1998 had coupon rates with
an initial adjustment period of between six months and two years from the
Mortgage Loan origination date with a weighted average term to reset of
approximately eighteen months. At December 31, 1998, all of the Company's
borrowings used to finance its Mortgage Loans either matured or adjusted to a
market interest rate level within one month of such date. Since December 31,
1998, the Company has continued to acquire Mortgage Loans, many of which have
initial adjustment periods of between six months and two years. The Company is
financing its Mortgage Loans under reverse repurchase agreement with a one month
maturity. The Company anticipates obtaining long-term debt financing for the
balance of the Mortgage Loans currently financed with reverse repurchase
agreements. The long-term debt financing will be structured as a CMO and
registered under a certain underwriter's shelf filing. See "Funding." There can
be no assurance that the Company will be able to obtain long term debt financing
on favorable terms, or at all. In the event that market interest rates increase
prior to the time that the Company is able to complete long term debt financing,
the Company's net interest expense with respect to its Mortgage Loans would
likely increase substantially before the Company's interest income with respect
to such assets would increase. See "Business Risks -- Sudden Interest Rate
Fluctuations May Reduce Income From Operations."
CREDIT RISK MANAGEMENT
The Company reviews with the Manager credit risks and other risks of loss
associated with each investment and determines the appropriate allocation of
capital to apply to such investment under the Company's Capital Policy. In
addition, the Company attempts to diversify its Mortgage Asset portfolio to
avoid undue geographic, issuer, industry and certain other types of
concentrations. The Company has obtained protection against some risks from
sellers and servicers through representations and warranties and other
appropriate documentation. The Board of Directors monitors the overall portfolio
risk and will increase the allowance for Mortgage Loan losses when it believes
appropriate.
In order to reduce the credit risks associated with acquisitions of
Mortgage Loans, the Company, with the advice of the Manager (i) employs a
quality control program, (ii) acquires Mortgage Loans that represent a broad
range of moderate risks as opposed to a concentrated risk, (iii) monitors the
credit quality of newly acquired and existing Mortgage Assets, and (iv)
periodically adjusts the Mortgage Loan loss allowances. See "Management's
Discussion and Analysis of Financial Conditions and Results of Operations". The
Company also has arranged for servicing of its Mortgage Loans with servicing
entities that have particular expertise and experience in the types of Mortgage
Loans acquired. See "Business Risks -- Borrower Credit May Decrease Value of
Mortgage Loans," "Characteristics of Underlying Property May Decrease Value of
Mortgage Loans," and "Loans Serviced by Third Parties."
The Company may sell Mortgage Assets from time to time for a number of
reasons, including, without limitation, to dispose of Mortgage Assets as to
which credit risk concerns have arisen, to seek to reduce interest rate risk, to
substitute one type of Mortgage Asset for another to seek 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 Management deems such
action advisable. The REIT Provisions of the Code limit in certain respects the
ability of the Company to sell Mortgage Assets.
HEDGING
The Company recognizes the need to hedge specific interest rate risks
associated with its Mortgage Asset portfolio and has sought the hedging
instrument most appropriate for the specific risk. Currently, all of the
Company's Mortgage Assets are subject to both lifetime interest rate caps and
periodic interest rate caps. The Company has entered into hedging transactions
with respect to lifetime interest rate caps in order to reduce the negative
impact to the Company's operations which might otherwise result from a
significant rise in interest rates. The Company may enter into additional types
of hedging transactions in the future if Management believes there exists a
significant risk to operations. These types of hedging transactions may include
hedging against risks associated with (i) periodic interest rate adjustment
caps, (ii) Mortgage Assets
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denominated in different interest rate indices, such as U.S. Treasury bills and
Eurodollars and (iii) interest rate swaps or caps or other interest rate hedge
vehicles related to the mismatch of assets/liability maturity and repricing. The
mismatch of assets and liabilities is especially acute with fixed rate Mortgage
Loans and intermediate adjustable Mortgage Loans. Intermediate adjustable
Mortgage Loans are fixed for a set period and then convert to a six-month
adjustable. The fixed period is usually two to five years. The Manager monitors
and evaluates the results of its hedging strategy and adjusts its hedging
strategy as it deems is in the best interest of the Company.
The amortized cost of the interest rate cap agreements at December 31, 1998
was approximately $674 thousand. Cap premiums are amortized from the effective
date of the cap through the termination date on a straight-line basis. For the
year ended December 31, 1998, the interest rate cap agreement amortization
expense was approximately $779 thousand. There was no income from the cap
agreements during this period. There was approximately $300 thousand of floor
expense during this period. There were no sales or termination of caps during
1998. For the year ended December 31, 1998, cap expense equaled approximately
.29% of the average balance of the Company's Mortgage Assets and .35% of the
average balance of the Company's interest bearing liabilities. For such period,
the cap expense was approximately 2.3% of net interest income. At December 31,
1998, the cap range of strike rates was 5.8% to 8.1% and the weighted average
strike rate was approximately 6.2%. At December 31, 1998, the floor range of
strike rates was approximately 5.3% to 5.5% with a weighted average strike rate
of approximately 5.4%. Some of the Company's interest rate cap agreements have
strike rates and/or notional face amounts which vary over time. All of the
interest rate caps reference the one month LIBOR.
Mortgage derivative securities can also be effective hedging instruments in
certain situations as the value and yields of some of these securities tend to
increase as interest rates rise and tend to decrease in value and yields as
interest rates decline, while the experience for others is the converse. As part
of the Company's hedging program, the Manager will monitor on an ongoing basis
the prepayment risks which arise in fluctuating interest rate environments and
consider alternative methods and costs of hedging such risks, which may include
the use of mortgage derivative securities. The Company intends to limit its
purchases of mortgage derivative securities to investments that qualify as
Qualified REIT Assets, as defined below, so that income from such securities
will constitute qualifying income for purposes of the 95% and 75% of income
tests, as defined below. The Company does not currently intend to, but may in
the future, enter into interest rate swap agreements, buy and sell financial
futures contracts and options on financial futures contracts and trade forward
contracts as a hedge against future interest rate changes; however, the Company
will not invest in these instruments unless the Company and the Manager are
exempt from the registration requirements of the Commodities Exchange Act or
otherwise comply with the provisions of that act. The REIT provisions of the
Code may restrict the Company's ability to purchase hedges and may severely
restrict the Company's ability to employ other strategies. In all its hedging
transactions, the Company will contract only with counterparties that the
Company believes are sound credit risks. See "Requirements for Qualification as
a REIT -- Gross Income Tests."
Hedging involves transaction and other costs, and such costs increase as
the period covered by the hedging protection increases and also increase in
periods of rising and fluctuating interest rates. For example, in a typical
interest rate cap agreement, the cap purchaser makes an initial lump sum cash
payment to the cap seller in exchange for the sellers' promise to make cash
payments to the purchaser on fixed dates during the contract term if prevailing
interest rates exceed the rate specified in the interest rate cap agreement.
Because of the cost involved, the Company may be prevented from effectively
hedging its interest rate risks without significantly reducing the Company's
return on equity.
Certain of the federal income tax requirements that the Company must
satisfy to qualify as a REIT limit the Company's ability to fully hedge its
interest rate and prepayment risks. The Manager monitors carefully, and may have
to limit, the Company's asset/liability management program to assure that it
does not realize excessive hedging income, or hold hedging assets having excess
value in relation to total assets, which would result in the Company's
disqualification as a REIT or, in the case of excess hedging income, the payment
of a penalty tax for failure to satisfy certain REIT income tests under the
Code, provided such failure was for reasonable cause. In addition,
asset/liability management involves transaction costs which increase dramati-
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cally as the period covered by the hedging protection increases. Therefore, the
Company may be prevented from effectively hedging its interest rate and
prepayment risks. See "Federal Income Tax Consequences -- Requirements for
Qualification as a REIT."
In particular, income from hedging the Company's variable rate borrowings
(other than with hedging instruments that are Qualified REIT Assets) qualifies
for the 95% of income test, but not for the 75% of income test, for REIT
qualification. The Company must limit its income from such hedging or the sale
of hedging contracts, along with other types of income that qualifies for the
95% of income test, but not for the 75% of income test, to less than 25% of the
Company's gross revenues. In addition, hedging instruments, such as swaps, caps,
floors, collars, and financial futures contracts, are securities for purposes of
the quarterly asset tests for REIT qualification. The Company must ascertain
that securities, including the hedging instruments (other than hedging
instruments that are Qualified REIT Assets), issued by a single issuer do not
account for 5% or more of the value of the Company's assets as of the last day
of each calendar quarter. The Company does not expect to encounter material
problems complying with these tests.
Although the Company believes that, with the advice of the Manager, it has
developed a cost effective interest rate risk management program to provide a
level of protection against interest rate risks, developing an effective program
is complex and no program can completely insulate the Company from the effects
of interest rate changes. Further, the cost of hedging transactions and the
federal tax laws applicable to REITs may limit the Company's ability to fully
hedge its interest rate risks. See "Business Risks -- Failure to Successfully
Manage Interest Rate Risks May Adversely Affect Results of Operations" and
"Federal Income Tax Consequences -- Requirements for Qualification as a REIT."
INTEREST RATE SENSITIVITY GAP
The interest rate sensitivity gap is a tool used by financial institutions
such as banks and savings and loans to analyze the possible effects of interest
rate changes on net income over time. Time gap analysis ignores many important
factors, and, in the Company's case, it ignores, among other factors, the effect
of the Company's hedging activities, the effect of the periodic and lifetime
caps on the Company's Mortgage Assets, and the effect of changes in mortgage
principal repayment rates. Nevertheless, the gap time analysis can provide some
useful information on the interest rate risk profile of a financial services
company.
A negative cumulative gap over a particular period means that the amount of
liabilities that will have an expense rate adjusting to prevailing market
conditions during that period will be greater than the amount of Mortgage Assets
that will have an earning rate adjustment. Thus a negative gap implies that
increasing interest rates would result in a falling level of net interest income
during the time period in question, as the cost of funds on the liabilities
would adjust more quickly to the interest rate increase than would the interest
income from the Mortgage Assets. A negative gap also implies that falling
interest rates would result in an increasing level of net interest during the
period in question.
FEDERAL INCOME TAX CONSEQUENCES
The Company intends to maintain its status as a REIT for federal income tax
purposes. A corporation qualifying as a REIT may avoid corporate income taxation
by distributing dividends equal to its taxable income to its stockholders
annually. The Company is organized in conformity with the requirements for
qualification and taxation as a REIT under the Internal Revenue Code of 1986, as
amended (the "Code").
The provisions of the Code are highly technical and complex. This summary
is not intended to be a detailed discussion of all applicable provisions of the
Code, the rules and regulations promulgated thereunder, or the administrative
and judicial interpretations thereof. The Company has not obtained a ruling from
the Internal Revenue Service (the "Service") with respect to tax considerations
relevant to its organization or operation, or to an acquisition of its common
stock. This summary is not intended to be a substitute for prudent tax planning,
and each shareholder of the Company is urged to consult its own tax advisor with
respect to these and other federal, state and local tax consequences of the
acquisition, ownership and disposition of shares of the common stock of the
Company and any potential changes in applicable law.
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REQUIREMENTS FOR QUALIFICATION AS A REIT
To qualify for tax treatment as a REIT under the Code, the Company must
meet certain tests which are described in brief below.
STOCK OWNERSHIP TESTS
For all taxable years after the first taxable year for which a REIT
election is made, the Company's shares of stock must be transferable and must be
held by a minimum of 100 persons for at least 335 days of a 12 month year (or a
proportionate part of a short tax year). The Company must also use the calendar
year as its taxable year. In addition, at all times during the second half of
each taxable year, no more than 50% in value of the shares of any class of the
stock of the Company may be owned directly or indirectly by five or fewer
individuals. The Company intends to satisfy both the 100 stockholder and 50%/5
stockholder individual ownership limitations described above for as long as it
seeks qualification as a REIT. The Company uses the calendar year as its taxable
year for income tax purposes.
ASSET TESTS
On the last day of each calendar quarter, at least 75% of the value of the
Company's assets must consist of Qualified REIT Assets, government securities,
cash and cash items (the "75% of assets test"). The Company believes that
substantially all of its assets are and will continue to be Qualified REIT
Assets. Qualified REIT Assets include interests in real property, interests in
Mortgage Loans secured by real property and interests in REMICs.
On the last day of each calendar quarter, of the investments in securities
not included in the 75% of assets test, the value of any one issuer's securities
may not exceed 5% by value of the Company's total assets, and the Company may
not own more than 10% of any one issuer's outstanding voting securities. See
"Proposed Tax Legislation" below. If such limits are ever exceeded, the Company
intends to take appropriate remedial action to dispose of such excess assets
within the 30 day period after the end of the calendar quarter, as permitted
under the Code.
GROSS INCOME TESTS
The Company must satisfy the following income-based tests for each year in
order to qualify as a REIT.
1. The 75% Test. At least 75% of the Company's gross income (the "75%
of income test") for the taxable year must be derived from qualified REIT
assets. The investments that the Company has made and intends to make will
give rise primarily to mortgage interest qualifying under the 75% of income
test.
2. The 95% Test. In addition to deriving 75% of its gross income from
the sources listed above, at least an additional 20% of the Company's gross
income for the taxable year must be derived from those sources, or from
dividends, interest or gains from the sale of disposition of stock or other
securities that are not dealer property (the "95% of income test"). In
order to help ensure compliance with the 95% of income test and the 75% of
income test, the Company intends to limit substantially all of the assets
that it acquires to Qualified REIT Assets. The policy of the Company to
maintain REIT status may limit the type of assets, including hedging
contracts, that the Company otherwise might acquire.
If the Company fails to satisfy one or both of the 75% or 95% of income
tests for any year, it may face either (a) assuming such failure was for
reasonable cause and not willful neglect, a 100% tax on the greater of the
amounts of income by which it failed to comply with the 75% test of income or
the 95% of income test, reduced by estimated related expenses or (b) loss of
REIT status.
DISTRIBUTION REQUIREMENT
The Company must distribute to its stockholders on a pro rata basis an
amount equal to (i) 95% of its taxable income before deduction of dividends paid
and excluding net capital gain, plus (ii) 95% of the excess of the net income
from foreclosure property over the tax imposed on such income by the Code less
(iii) any
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"excess noncash income" (the "95% distribution test"). The Company intends to
make distributions to its stockholders in amounts sufficient to meet the 95%
distribution test.
A nondeductible excise tax, equal to 4% of the excess of such required
distributions over the amounts actually distributed will be imposed on the
Company for each calendar year to the extent that dividends paid during the year
(or declared during the last quarter of the year and paid during January of the
succeeding year) are less than the sum of (i) 85% of the Company's "ordinary
income," (ii) 95% of the Company's capital gain net income plus, and (iii)
income not distributed in earlier years.
RECORDKEEPING REQUIREMENTS
As a REIT, the Company is required to maintain records regarding the actual
and constructive ownership of its shares, and other information, and within 30
days after the end of its taxable year, to demand statements from persons owning
above specified level of the Company's shares (generally shareholders owning
more than 1% of the Company's outstanding stock). The Company must maintain, as
part of the Company's records, a list of those persons failing or refusing to
comply with this demand. Stockholders who fail or refuse to comply with the
demand must submit a statement with their tax returns setting forth the actual
stock ownership and other information. The Company also is required to maintain
permanent records of its assets as of the last day of each calendar quarter. The
Company intends to maintain the records and demand statements as required by
these regulations.
TAXATION OF STOCKHOLDERS
For any taxable year in which the Company is treated as a REIT for federal
income purposes, amounts distributed by the Company to its stockholders will be
included by the stockholders as ordinary income for federal income tax purposes
unless properly designated by the Company as capital gain dividends. In the
latter case, the distributions will be taxable to the stockholders as long-term
capital gains. Any loss on the sale or exchange of shares of the stock of the
Company held by a stockholder for six months or less will be treated as a
long-term capital loss to the extent of any capital gain dividend received on
the stock held by such stockholders. If the Company makes distributions to its
stockholders in excess of its current and accumulated operations and profits,
those distributions will be considered first a tax-free return of capital,
reducing the tax basis of a stockholder's share until the tax basis is zero.
Such distributions in excess of the tax basis will be taxable as gain realized
from the sale of the Company's shares.
Distributions by the Company will not be eligible for the dividends
received deduction for corporations. Stockholders may not deduct any net
operating losses or capital losses of the Company.
The Company does not expect to acquire or retain residual interests issued
by REMICs. Such residual interests, if acquired by a REIT, would generate excess
inclusion income that, among other things, is fully taxable as UBTI to Tax
Exempt Entities. Potential investors, and in particular Tax Exempt Entities, are
urged to consult with their tax advisors concerning this issue.
The Company will notify stockholders after the close of the Company's
taxable year as to the portions of the distributions which constitute ordinary
income, return of capital and capital gain. Dividends and distributions declared
in the last quarter of any year payable to stockholders of record on a specified
date in such month will be deemed to have been received by the stockholders and
paid by the Company on December 31 of the record year, provided that such
dividends are paid before February 1 of the following year.
PROPOSED TAX LEGISLATION
The Year 2000 Budget Plan released by the Treasury Department on February
1, 1999 (the "Budget Plan") includes a provision that could adversely affect
certain proposed operations of the Company. That provision would prohibit a REIT
from owning, by vote or value, more than 10% of the capital stock of any
corporation. (The current 10% asset test relates only to voting stock.) That
proposal is intended to limit REITs from conducting through a taxable subsidiary
businesses that would be prohibited to the REIT itself. If adopted, this
proposal would limit the value of the Company's active mortgage origination
activities and other
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businesses conducted through taxable subsidiaries, to less than 5 % of the
Company's gross assets. The Company does not anticipate that the Budget Plan
proposal would have an adverse effect on its operations.
The Budget Plan has been submitted to the Ways and Means Committee of the
U.S. House of Representatives (the "Ways and Means Committee") for review, which
held its first hearing on February 4, 1999, but has not taken any action to
date.
INVESTMENT COMPANY ACT
The Company at all times intends to conduct its business so as not to
become regulated as an investment company under the Investment Company Act of
1940. If the Company were to become regulated as an investment company, then the
Company's 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 interest in real estate"
("Qualifying Interests"). Under current interpretation of the staff of the
Securities and Exchange Commission, in order to qualify for this exemption, the
Company must maintain at least 55% of its assets directly in Qualifying
Interests. In addition, unless certain mortgage securities represent all the
certificates issued with respect to an underlying pool of mortgages, such
mortgage 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. Although the Company sold the majority of its
Mortgage Securities in 1998, the Company calculates that it is in compliance
with this requirement and expects to remain in compliance in 1999.
COMPETITION
The Company's net interest income will depend, in large part, on the
Company's ability to acquire Mortgage Assets on acceptable terms and at
favorable spreads over the Company's borrowing costs. There can be no assurance
that the Company will be able to acquire sufficient Mortgage Assets at spreads
above the Company's cost of funds. In acquiring Mortgage Assets, the Company
will compete with investment banking firms, savings and loan associations,
banks, mortgage bankers, insurance companies, mutual funds, other lenders,
FHLMC, FNMA, GNMA and other entities purchasing Mortgage Assets, many of which
have greater financial resources than the Company. In addition, there are
several REITs similar to the Company, and others may be organized in the future.
The effect of the existence of additional REITs may be to increase competition
for the available supply of Mortgage Assets suitable for purchase by the
Company. The Company will face competition from companies already established in
these markets. There can be no assurance that the Company will be able to
successfully compete with its competition.
The availability of Mortgage Loans meeting the Company's criteria is
dependent upon, among other things, the size and level of activity in the
residential real estate lending market. The size and level of activity in the
residential real estate lending market depend on various factors, including the
level of interest rates, regional and national economic conditions and inflation
and deflation in residential property values. To the extent the Company is
unable to acquire a sufficient number of Mortgage Loans meeting its criteria,
the Company's results of operations will be adversely affected.
EMPLOYEES
Currently, the Company and the Manager each employ five executive officers
and nine additional employees. Each of the executive officers has between 11 and
25 years, and collectively, they have an average of 20 years of experience in
the residential mortgage industry. Four executive officers worked together
previously as a management team.
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THE MANAGEMENT AGREEMENT
TERM OF THE MANAGEMENT AGREEMENT AND TERMINATION FEE
The Company entered into a Management Agreement with the Manager for an
initial term of two years beginning February 11, 1997. The Management Agreement
will be renewed automatically for successive one year periods unless a notice of
non-renewal is timely delivered by the Company. The Company may elect to prevent
the automatic renewal of the Management Agreement only by vote of both a
majority of the Board of Directors and a majority of the directors who are not
executive officers or employees of the Company followed by delivery of a written
notice of non-renewal to the Manager at least 60 days prior to the end of the
then-current period of the Management Agreement. In December 1998, the Board of
Directors unanimously agreed to extend the management contract for one
additional year. The next opportunity for the Board to terminate the contract
will be February 11, 2000. The Management Agreement will terminate at the
expiration of the then-current period in which such notice of non-renewal is
delivered. Upon non-renewal of the Management Agreement without cause, a
termination fee will be payable to the Manager. See "Management Fees." In
addition, the Company has the right to terminate the Management Agreement at any
time upon the happening of certain specified events, after notice and an
opportunity to cure, including a material breach by the Manager of any provision
contained in the Management Agreement. Upon such a termination for cause, no
termination fee will be payable to the Manager.
ADMINISTRATIVE SERVICES PROVIDED BY THE MANAGER
The Manager is responsible for the day-to-day operations of the Company and
performs such services and activities relating to the assets and operations of
the Company as may be appropriate, including:
(i) serving as the Company's consultant with respect to the
formulation of investment criteria and the preparation of policy
guidelines;
(ii) assisting the Company in developing criteria for Mortgage Asset
purchase commitments that are specifically tailored to the Company's long
term investment objectives and making available to the Company its
knowledge and experience with respect to Mortgage Loan underwriting
criteria;
(iii) representing the Company in connection with the purchase of, and
commitment to purchase, Mortgage Assets, including the formation of
Mortgage Asset purchase commitment criteria;
(iv) arranging for the issuance of Mortgage Securities from pools of
Mortgage Loans and providing the Company with supporting services in
connection with the creation of Mortgage Securities;
(v) furnishing reports and statistical and economic research to the
Company regarding the Company's activities and the performance of the
Manager;
(vi) monitoring and providing to the Board of Directors on an ongoing
basis price information and other data, which price information and other
data shall be obtained from certain nationally recognized dealers and other
entities that maintain markets in Mortgage Assets as selected by the Board
of Directors from time to time, and providing advice to the Board of
Directors to aid the Board of Directors in the selection of such dealers
and other entities;
(vii) administering the day-to-day operations of the Company and
performing and supervising the performance of such other administrative
functions necessary in the management of the Company as may be agreed upon
by the Manager and the Board of Directors, including the collection of
revenues and the payment of the Company's expenses, debts and obligations
and maintenance of appropriate computer services to perform such
administrative functions;
(viii) designating a servicer and/or subservicer for those Mortgage
Loans sold to the Company by originators that have elected not to service
such Mortgage Loans and arranging for the monitoring and administering of
such servicer and subservicer;
(ix) counseling the Company in connection with policy decisions to be
made by the Board of Directors;
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(x) evaluating and recommending hedging strategies to the Board of
Directors and, upon approval by the Board of Directors, facilitating the
implementation and monitoring the performance of these strategies;
(xi) supervising compliance with the REIT Provisions of the Code and
Investment Company Act status, including setting up a system to monitor
hedging activities on a periodic basis for such compliance;
(xii) establishing quality control procedures for the Mortgage Assets
of the Company, including audits of Mortgage Loan underwriting files and
the hiring of any agents with such particular knowledge and expertise as
may be appropriate to perform any such quality control procedures, and
administering, performing and supervising the performance of the quality
control procedures of the Company and performing and supervising the
performance of such other functions related thereto necessary or advisable
to assist in the performance of such procedures and the attainment of the
purposes thereof;
(xiii) upon request by and in accordance with the directions of the
Board of Directors, investing or reinvesting any money of the Company;
(xiv) conducting, or causing to be conducted, a legal document review
of each Mortgage Loan acquired to verify the accuracy and completeness of
the information contained in the Mortgage Loans, security instruments and
other pertinent documents in the mortgage file;
(xv) providing the Company with data processing, legal and
administrative services to the extent required to implement the business
strategy of the Company;
(xvi) providing all actions necessary for compliance by the Company
with all federal, state and local regulatory requirements applicable to the
Company in respect of its business activities, including preparing or
causing to be prepared all financial statements required under applicable
regulations and contractual undertakings and all reports and documents, if
any, required under the Securities Exchange Act of 1934, as amended;
(xvii) providing all actions necessary to enable the Company to make
required federal, state and local tax filings and reports and to generally
enable the Company to maintain its status as a REIT, including soliciting
stockholders for required information to the extent provided in the REIT
Provisions of the Code;
(xviii) communicating on behalf of the Company with the holders of the
equity and debt securities of the Company as required to satisfy the
reporting and other requirements of any governmental bodies or agencies and
to maintain effective relations with such holders; and
(xix) performing such other services as may be required from time to
time for management and other activities relating to the assets of the
Company as the Board of Directors shall reasonably request or the Manager
shall deem appropriate under the particular circumstances.
Except in certain circumstances, the Manager may not assign its rights and
duties under the Management Agreement, in whole or in part, without the written
consent of the Company and the consent of a majority of the Company's
independent directors who are not affiliated with the Manager.
SERVICING OF THE MORTGAGE LOANS
The Company has acquired certain of its Mortgage Loans on a servicing
released basis and acts as the servicer of such Mortgage Loans while they are in
the Company's Mortgage Asset portfolio. The Manager has entered into
subcontracts with other parties to provide such services for the Company. The
Manager will monitor the sub-servicing of the Mortgage Loans. Such monitoring
includes, but not be limited to, the following: (i) serving as the Company's
consultant with respect to the servicing of Mortgage Loans; (ii) collection of
information and submission of reports pertaining to the Mortgage Loans and to
moneys remitted to the Manager or the Company by any servicer; (iii) periodic
review and evaluation of the performance of each servicer to determine its
compliance with the terms and conditions of the applicable subservicing or
servicing agreement and, if deemed appropriate, recommending to the Company the
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termination of such agreement; (iv) acting as a liaison between servicers and
the Company and working with servicers to the extent necessary to improve their
servicing performance; (v) review of and recommendations as to fire losses,
easement problems and condemnation, delinquency and foreclosure procedures with
regard to the Mortgage Loans; (vi) review of servicer's delinquency, foreclosure
and other reports on Mortgage Loans; (vii) supervising claims filed under any
mortgage insurance policies; and (viii) enforcing the obligation of any servicer
to repurchase Mortgage Loans from the Company.
LIMITS OF RESPONSIBILITY
Pursuant to the Management Agreement, the Manager will not assume any
responsibility other than to render the services called for thereunder and will
not be responsible for any action of the Company's Board of Directors in
following or declining to follow its advice or recommendations. The Manager, its
directors, officers, stockholders and employees will not be liable to the
Company, any issuer of Mortgage Securities, any subsidiary of the Company, the
Company's independent directors, the Company's stockholders or any subsidiary's
stockholders for acts performed in accordance with and pursuant to the
Management Agreement, except by reason of acts or omissions constituting bad
faith, willful misconduct, gross negligence or reckless disregard of their
duties under the Management Agreement. The Manager does not have significant
assets other than its interest in the Management Agreement. Consequently, there
can be no assurance that the Company would be able to recover any damages for
claims it may have against the Manager. The Company has agreed to indemnify the
Manager, and its respective directors, officers, stockholders and employees with
respect to all expenses, losses, damages, liabilities, demands, charges and
claims arising from any acts or omissions of the Manager made in good faith in
the performance of its duties under the Management Agreement and not
constituting bad faith, willful misconduct, gross negligence or reckless
disregard of its duties. The Management Agreement does not limit or restrict the
right of the Manager or any of its officers, directors, employees or affiliates
to engage in any business or to render services of any kind to any other person,
including the purchase of, or rendering advice to others purchasing Mortgage
Assets which meet the Company's policies and criteria, except that the Manager
and its officers, directors or employees will not be permitted to provide for
any such services to any residential mortgage REIT, other than the Company or
another REIT sponsored by the Manager or its affiliates, which has operating
policies and strategies different in one or more material respects from those of
the Company, as confirmed by a majority of the independent directors of the
Company. See "Business Risks -- The Company has Significant Conflicts with, and
Is Dependent on, an Affiliate of the Executive Officers of the Company."
RELATIONSHIP BETWEEN THE MANAGER AND THE COMPANY
In addition to the Management Agreement between the Manager and the
Company, the Manager also has limited rights in the shares of the Company's
Common Stock held by MDC REIT Holdings, LLC ("MDC-REIT") an intermediate holding
company. The Manager contributed $20 million in 1997 to MDC-REIT which used the
funds to acquire the shares of the Company's Common Stock. In exchange for its
contribution to MDC-REIT, the Manager received a senior right to receive
distributions from MDC-REIT equal to 5% per quarter of the capital contributed
by the Manager, compounded quarterly to the extent unpaid. After payment of the
preference amount in full, the Manager has a right to receive approximately 50%
of any remaining distributions in repayment of its capital contribution. The
Manager has also been appointed to oversee the day-to-day operations of
MDC-REIT. However, after payment in full of its preference amount and return of
its capital contribution, the Manager will have no further rights to
distributions from MDC-REIT. MDC-REIT's sole asset is its shares of the
Company's Common Stock and its sole source of income is dividends declared by
the Company.
MANAGEMENT FEES
The Manager receives an annual base management fee payable monthly in
arrears of an amount representing the monthly portion of the per annum
percentage of "gross mortgage assets" of the Company and
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its subsidiaries. These fees shall be applicable during the entire operational
stage of the Company's business. The Company pays to the Manager the following
management fees and incentive compensation:
- 1/8 of 1% per year, paid monthly (the "Agency Percentage"), of the
principal amount of Agency Securities;
- 3/8 of 1% per year, paid monthly (the "Non-Agency Percentage"), of the
principal amount of all other Mortgage Assets; and
- 25% of the amount by which the Company's net income (calculated prior to
deduction of this incentive compensation fee) exceeds the annualized
return on equity equal to the average Ten Year U.S. Treasury Rate plus
2%.
The term "gross mortgage assets" means for any month the aggregate book
value of the consolidated Mortgage Assets of the Company and its subsidiaries,
before allowances for depreciation or bad debts or other similar noncash
allowances, computed at the end of such month prior to any dividend distribution
made during each month.
The incentive compensation calculation and payment are made quarterly in
arrears. The term "Return on Equity" is calculated for any quarter by dividing
the Company's Net Income for the quarter by its Average Net Worth for the
quarter. For such calculations, the "Net Income" of the Company means the net
income of the Company determined in accordance with GAAP before the Manager's
incentive compensation, the deduction for dividends paid and net operating loss
deductions arising from losses in prior periods. A deduction for the Company's
interest expenses for borrowed money is taken when calculating Net Income.
"Average Net Worth" for any period means (i) $20,165,000 plus (ii) the
arithmetic average of the sum of the gross proceeds from any offering of its
equity securities by the Company, before deducting any underwriting discount and
commissions and other expenses and costs relating to the offering, plus the
Company's retained earnings (without taking into account any losses incurred in
prior periods and excluding amounts reflecting taxable income to be distributed
as dividends and amounts reflecting valuation allowance adjustments) computed by
taking the daily average of such values during such period. The definition
"Return on Equity" is used only for purposes of calculating the incentive
compensation payable, and is not related to the actual distributions received by
stockholders. The incentive compensation payments to the Manager are made before
any income distributions are made to the stockholders of the Company.
The Manager's base management fee is calculated by the Manager within 15
days after the end of each month, and such calculation is promptly delivered to
the Company. The Company is obligated to pay the amount of the final base
management fee in excess of the amount paid to the Manager at the beginning of
the month pursuant to the Manager's good faith estimate within 30 days after the
end of each month. The Company pays the incentive fee with respect to each
fiscal quarter within 15 days following the delivery to the Company of the
Manager's written statement setting forth the computation of the incentive fee
for such quarter. The Manager computes the annual incentive fee within 45 days
after the end of each fiscal year, and any required adjustments are paid by the
Company or the Manager within 15 days after the delivery of the Manager's
written computation to the Company.
TERMINATION FEES
The Company may elect to prevent the automatic renewal of the Management
Agreement by vote of both a majority of the Board of Directors and a majority of
the directors who are not executive officers or employees of the Company
followed by delivery of a written notice of non-renewal to the Manager at least
60 days prior to the end of the then-current period of the Management Agreement.
The Management Agreement shall terminate at the expiration of the then-current
period in which such notice of non-renewal is delivered. Upon non-renewal of the
Management Agreement without cause, a termination fee will be payable to the
Manager, in an amount equal to the greater of (i) the fair value of the
Management Agreement as established by an independent appraiser, or (ii) three
times the total of the base and incentive compensation fees paid to the Manager
for the four most recently completed calendar quarters ending on or prior to the
date of termination. In addition, the Company has the right to terminate the
Management Agreement at any time
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upon the occurrence of certain specified events, after notice and an opportunity
to cure, including a material breach by the Manager of any provision contained
in the Management Agreement. Upon such a termination for cause, no termination
fee will be payable to the Manager. In December 1998, the Board of Directors
unanimously agreed to extend the management contract for one additional year.
The next opportunity for the Board to terminate the contract will be February
11, 2000. The Management Agreement will terminate at the expiration of the
then-current period in which such notice of non-renewal is delivered.
EXPENSES
The Company pays all operating expenses, except those specifically required
to be borne by the Manager under the Management Agreement. The operating
expenses required to be borne by the Manager include the compensation and other
employment costs of the Manager's officers in their capacities as such and the
cost of office space and out-of-pocket costs, equipment and other personnel
required for performance of the Company's day-to-day operations. The expenses
that are paid by the Company will include issuance and transaction costs
incident to the acquisition, disposition and financing of investments, regular
legal and auditing fees and expenses, the fees and expenses of the Company's
directors, premiums for directors' and officers' liability insurance, premiums
for fidelity and errors and omissions insurance, subservicing expenses, the
costs of printing and mailing proxies and reports to stockholders, and the fees
and expenses of the Company's custodian and transfer agent, if any. The Company,
rather than the Manager, is also required to pay expenses associated with
litigation and other extraordinary or non-recurring expenses. Expense
reimbursements are made monthly.
SALARY REIMBURSEMENTS
The Company employs certain employees of the Manager involved in the
day-to-day operations of the Company, including the Company's executive
officers, so that such employees may maintain certain benefits that are
available only to employees of the Company under the Code. These benefits
include the ability to receive incentive stock options under the 1997 Stock
Option Plan and to participate in the Company's Employee Stock Purchase Plan. In
order to receive the aggregate benefits of the Management Agreement originally
negotiated between the Company and the Manager, the Company pays the base
salaries of such employees and is reimbursed monthly by the Manager for all
costs incurred with respect to such payments.
BUSINESS RISKS
SUDDEN INTEREST RATE FLUCTUATIONS MAY REDUCE INCOME FROM OPERATIONS
Substantially all of the Company's Mortgage Assets have a repricing
frequency of two years or less, and a majority of the Company's borrowings have
a repricing frequency of six months or less. The interest rates on the Company's
borrowings may be based on interest rate indices which are different from, and
adjust more rapidly than, the interest rate indices of its related Mortgage
Assets. Consequently, changes in interest rates may significantly influence the
Company's net interest income. While increases in interest rates will generally
increase the yields on the Company's adjustable-rate Mortgage Assets, rising
rates will also increase the cost of borrowings by the Company. To the extent
such costs rise more rapidly than the yields on such Mortgage Assets, the
Company's net interest income will be reduced or a net interest loss may result.
Adjustable-rate Mortgage Assets are typically subject to periodic and
lifetime interest rate caps which limit the amount an adjustable-rate Mortgage
Asset interest rate can change during any given period. The Company's borrowings
will not be subject to similar restrictions. Hence, in a period of increasing
interest rates, the cost of the Company's borrowings could increase without
limitation by caps while the yields on the Company's Mortgage Assets could be
limited. Further, some adjustable-rate Mortgage Assets may be subject to
periodic payment caps that result in some portion of the interest being deferred
and added to the principal outstanding. This could result in receipt by the
Company of a lesser amount of cash income on its adjustable-rate Mortgage Assets
than is required to pay interest on the related borrowings, which will not have
such payment caps. These factors could lower the Company's net interest income
or cause a net interest loss during
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periods of rising interest rates, which would negatively impact the Company's
financial condition and results of operations.
BORROWER CREDIT MAY DECREASE VALUE OF MORTGAGE LOANS
During the time the Company holds Mortgage Loans, it is subject to credit
risks, including risks of borrower defaults and bankruptcies and special hazard
losses that are not covered by standard hazard insurance (such as those
occurring from earthquakes or floods). In the event of a default on any Mortgage
Loan held by the Company, the Company will bear the risk of loss of principal to
the extent of any deficiency between the value of the secured property, and the
amount owing on the Mortgage Loan, less any payments from an insurer or
guarantor. Defaulted Mortgage Loans will also cease to be eligible collateral
for borrowings, and will have to be financed by the Company out of other funds
until ultimately liquidated. At December 31, 1998, $1.3 million Mortgage loans
were ineligible, due to their delinquent or defaulted status, to be pledged as
collateral for financing under the current terms of the Company's repo-financing
arrangements. Although the Company has established an allowance for Mortgage
Loan losses in an amount adequate to cover these risks, in view of its limited
operating history and lack of experience with the Company's current Mortgage
Loans and Mortgage Loans that it may acquire, there can be no assurance that any
allowance for Mortgage Loan losses which is established will be sufficient to
offset losses on Mortgage Loans in the future. See "Business -- Investments."
Credit risks associated with non-conforming Mortgage Loans, especially
non-conforming Mortgage Loans, may be greater than those associated with
Mortgage Loans that conform to FNMA and FHLMC guidelines. The principal
difference between non-conforming Mortgage Loans and conforming Mortgage Loans
include, the credit and income histories of the mortgagors, the applicable
loan-to-value ratios, the documentation required for approval of the mortgagors,
the types of properties securing the Mortgage Loans, loan sizes and the
mortgagors' occupancy status with respect to the mortgaged property. As a result
of these and other factors, the interest rates charged on non-conforming
Mortgage Loans are often higher than those charged for conforming Mortgage
Loans. The combination of different underwriting criteria and higher rates of
interest may lead to higher delinquency rates and/or credit losses for
non-conforming as compared to conforming Mortgage Loans and could have an
adverse effect on the Company to the extent that the Company invests in such
Mortgage Loans or securities secured by such Mortgage Loans.
Even assuming that properties secured by the Mortgage Loans held by the
Company provide adequate security for such Mortgage Loans, substantial delays
could be encountered in connection with the foreclosure of defaulted Mortgage
Loans, with corresponding delays in the receipt of related proceeds by the
Company. State and local statutes and rules may delay or prevent the Company's
foreclosure on or sale of the mortgaged property and may prevent the Company
from receiving net proceeds sufficient to repay all amounts due on the related
Mortgage Loan. In addition, the Company's servicing agent may be entitled to
receive all expenses reasonably incurred in attempting to recover amounts due
and not yet repaid on liquidated Mortgage Loans, thereby reducing amounts
available to the Company. Some properties which will collateralize the Company's
Mortgage Loans may have unique characteristics or may be subject to seasonal
factors which could materially prolong the time period required to resell such
properties. See "Characteristics of Underlying Property May Decrease Value of
Mortgage Loans."
REAL ESTATE MARKET CONDITIONS MAY ADVERSELY AFFECT RESULTS OF OPERATIONS
The Company's business may be adversely affected by periods of economic
slowdown or recession which may be accompanied by declining real estate values.
Any material decline in real estate values reduces the ability of borrowers to
use home equity to support borrowings and increases the loan-to-value ratios of
Mortgage Loans previously made, thereby weakening collateral coverage and
increasing the possibility of a loss in the event of default. In addition,
delinquencies, foreclosures and losses generally increase during economic
slowdowns and recessions.
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CONTINUED HIGH LEVELS OF MORTGAGE ASSET PREPAYMENTS WILL REDUCE OPERATING
INCOME
Prepayments of Mortgage Assets could continue to adversely affect the
Company's results of operations in several ways. The Company anticipates that a
portion of the adjustable-rate Mortgage Assets to be acquired by the Company may
bear initial "teaser" interest rates which are lower than their "fully-indexed"
rates (the applicable index plus a margin). In the event that such an
adjustable-rate Mortgage Asset is prepaid prior to or soon after the time of
adjustment to a fully-indexed rate, the Company will have held the Mortgage
Asset during its least profitable period and lost the opportunity to receive
interest at the fully-indexed rate over the expected life of the adjustable-rate
Mortgage Asset. In addition, the prepayment of any Mortgage Asset that had been
purchased with a premium by the Company would result in the immediate write-off
of any remaining capitalized premium amount and consequent reduction of the
Company's net interest income by such amount. Finally, in the event that the
Company is unable to acquire new Mortgage Assets to replace the prepaid Mortgage
Assets, the Company's financial condition and results of operations could be
materially adversely affected.
Mortgage Asset prepayment rates generally increase when new Mortgage Loan
interest rates fall below the interest rates on the adjustable-rate Mortgage
Assets. Prepayment experience also may be affected by the geographic location of
the property securing the adjustable-rate Mortgage Loans, the assumability of an
adjustable-rate Mortgage Loan, the ability of the borrower to obtain or convert
to a fixed-rate Mortgage Loan, conditions in the housing and financial markets
and general economic conditions. The level of prepayments is also subject to the
same seasonal influences as the residential real estate industry with prepayment
rates generally being highest in the summer months and lowest in the winter
months. The Company experienced high levels of prepayments during 1997 and 1998
and thereafter, and the Company anticipates that prepayment rates are likely to
continue at high levels for an indefinite period. There can be no assurance that
the Company will be able to achieve or maintain lower prepayment rates.
Accordingly, the Company's financial condition and results of operations could
be materially adversely affected. See "Business -- Risk Management -- Interest
Rate Risk Management."
Certain Mortgage Loans acquired by the Company may contain provisions
restricting prepayments of such Mortgage Loans and require a charge in
connection with the prepayment thereof. Such prepayment restrictions can, but do
not necessarily, provide a deterrent to prepayments. Prepayment charges may be
in an amount which is less than the figure which would fully compensate the
Company for a lower yield upon reinvestment of the prepayment proceeds.
INVESTMENTS IN MORTGAGE ASSETS MAY BE ILLIQUID
Although the Company expects that a majority of the Company's investments
will be in Mortgage Assets for which a resale market exists, certain of the
Company's investments may lack a regular trading market and may be illiquid. In
addition, during turbulent market conditions, the liquidity of all of the
Company's Mortgage Assets may be adversely impacted. There is no limit to the
percentage of the Company's investments that may be invested in illiquid
Mortgage Assets. In the event the Company requires additional cash as a result
of a margin call pursuant to its financing agreements or otherwise, the Company
may be required to liquidate Mortgage Assets on unfavorable terms. The Company's
inability to liquidate Mortgage Assets could render it insolvent.
LOANS SERVICED BY THIRD PARTIES
All of the Company's Mortgage Loans are serviced by subservicers. The
Company continually monitors the performance of the subservicers through
performance reviews, comparable statistics for collections and on-site visits.
The Company has arranged for servicing with entities that have particular
expertise in non-conforming Mortgage Loans. Although the Company has established
these relationships and procedures, there can be no assurance that these
subservicers will service the Company's Mortgage Loans in such a way as to
maintain delinquency rates and/or credit losses and not cause an adverse effect
on the Company's Mortgage Loans.
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INABILITY TO ACQUIRE MORTGAGE ASSETS
The Company's net interest income will depend, in large part, on the
Company's ability to acquire Mortgage Assets on acceptable terms and at
favorable spreads over the Company's borrowing costs. There can be no assurance
that the Company will be able to acquire sufficient Mortgage Assets at spreads
above the Company's cost of funds. In acquiring Mortgage Assets, the Company
will compete with numerous investment banking firms, savings and loan
associations, banks, mortgage bankers, insurance companies, mutual funds, other
lenders, federal government sponsored agencies such as FHLMC, FNMA and GNMA, and
other entities purchasing Mortgage Assets, many of which have greater financial
resources than the Company. In addition, there are several REITs similar to the
Company and others may be organized in the future. The effect of the existence
of additional REITs may be to increase competition for the available supply of
Mortgage Assets suitable for purchase by the Company. There can be no assurance
that the Company will be able to successfully compete with its competition.
The availability of Mortgage Loans meeting the Company's criteria is
dependent upon, among other things, the size of and level of activity in the
residential real estate lending market and, in particular, the demand for
nonconforming Mortgage Loans. The size and level of activity in the residential
real estate lending market depends on various factors, including the level of
interest rates, regional and national economic conditions and inflation and
deflation in residential property values. To the extent that the Company is
unable to fully invest in a sufficient amount of Mortgage Loans meeting its
criteria, the Company's results of operations will be materially adversely
affected.
The Company may acquire Mortgage Assets with geographic, issuer, industry
and other types of concentrations. Accordingly, a significant portion of the
Company's Mortgage Assets may be subject to the risks associated with a single
type of occurrence. In the event of such an occurrence, the adverse effects on
the Company's results of operations will be significantly greater than if the
Company's Mortgage Assets were diversified with respect to such factors.
CHANGE IN INTEREST RATES MAY ADVERSELY AFFECT THE VALUE OF THE REMIC CLASS "X"
CERTIFICATE
In 1998, the Company diversified its residential Mortgage Loan sales
activities to include the securitization of such loans through a Real Estate
Mortgage Investment Conduit ("REMIC"). The REMIC consisted of pooled, first-lien
mortgages and was issued by Holdings to the public through a registration
statement of an underwriter. The interest-only strip referred to as the Class
"X" Certificate was created in the process of the securitization and transferred
from Holdings to Eagle. Investments in these types of Mortgage Assets are highly
speculative and, accordingly, the risk of loss associated with investments in
these types of Mortgage Assets is substantially greater than the risk of loss
associated with traditional Mortgage Assets held by the Company. Any investment
in such high risk Mortgage Assets could materially adversely affect the
Company's financial condition and results of operations. See
"Business -- Investments."
MANAGER'S LACK OF PRIOR EXPERIENCE IN MANAGING A REIT AND WITH NON-CONFORMING
LOANS COULD ADVERSELY AFFECT THE COMPANY'S BUSINESS, FINANCIAL CONDITION AND
RESULTS OF OPERATIONS; LIMITED OPERATING HISTORY DOES NOT NECESSARILY PREDICT
FUTURE PERFORMANCE OF COMPANY
The Manager has limited experience in managing a REIT or with
non-conforming loans. Although the Company's and the Manager's executive
officers have expertise in the acquisition and management of Mortgage Assets,
mortgage finance, asset/liability management and the management of corporations
in the real estate lending business, there can be no assurance that the past
experience of the executive officers will be appropriate to the business of the
Company. The lack of prior experience of the Manager in managing a REIT could
have a material adverse affect on the business, financial condition and results
of operations of the Company. The Company has not yet begun acquiring Mortgage
Loans under the Originator Program.
The Company began operations in February 1997 and, accordingly, has not yet
developed an extensive financial history or experienced a wide variety of
interest rate fluctuations or market conditions. Consequently, the Company's
financial results to date may not be indicative of future results.
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FAILURE TO SUCCESSFULLY MANAGE INTEREST RATE RISKS MAY ADVERSELY AFFECT
RESULTS OF OPERATIONS
The Company will follow a program intended to protect against interest rate
changes. However, developing an effective interest rate risk management strategy
is complex and no management strategy can completely insulate the Company from
risks associated with interest rate changes. In addition, hedging involves
transaction costs. In the event the Company hedges against interest rate risks,
the Company may substantially reduce its net income. Further, the federal tax
laws applicable to REITs may limit the Company's ability to fully hedge its
interest rate risks. Such federal tax laws may prevent the Company from
effectively implementing hedging strategies that, absent such restrictions,
would best insulate the Company from the risks associated with changing interest
rates. See "Business -- Risk Management -- Interest Rate Risk Management."
In the event that the Company purchases interest rate caps or other
interest rate derivatives to hedge against lifetime, periodic rate or payment
caps, and the provider of such caps on interest rate derivatives becomes
financially unsound or insolvent, the Company may be forced to unwind such caps
on its interest rate derivatives with such provider and may take a loss thereon.
Further, the Company could suffer the adverse consequences that the hedging
transaction was intended to protect against. Although the Company intends to
purchase interest rate caps and derivatives only from financially sound
institutions and to monitor the financial strength of such institutions on a
periodic basis, no assurance can be given that the Company can avoid such third
party risks.
Currently, the Company has entered into hedging transactions which seek to
protect only against the Mortgage Loans lifetime rate caps and not against
periodic rate caps or unexpected payments. In addition, the Company's lifetime
cap hedges are for a two year period which began the second quarter of 1998.
Accordingly, the Company may not be adequately protected against risks
associated with interest rate changes and such changes could adversely affect
the Company's financial condition and results of operations.
FAILURE TO IMPLEMENT COMPANY'S LEVERAGE STRATEGY MAY ADVERSELY AFFECT RESULTS
OF OPERATIONS
The Company currently relies on short term borrowings to fund the initial
acquisitions of Mortgage Loans. Accordingly, the ability of the Company to
achieve its investment objectives depends on its ability (i) to borrow money in
sufficient amounts and on favorable terms, (ii) to renew or replace on a
continuous basis its maturing short term borrowings and (iii) to successfully
leverage its Mortgage Assets. In addition, the Company is dependent upon a few
lenders to provide the primary credit facilities for its purchases of Mortgage
Assets. Any failure to obtain or renew adequate funding under these facilities
or other financings on favorable terms, could reduce the Company's net interest
income and have a material adverse effect on the Company's operations. The
Company has no long term commitments with its lenders.
In the event the Company is not able to renew or replace maturing
borrowings, the Company could be required to sell Mortgage Assets under adverse
market conditions and could incur losses as a result. In addition, in such
event, the Company may be required to terminate hedge positions, which could
result in further costs to the Company. Any event or development, such as a
sharp rise in interest rates or increasing market concern about the value or
liquidity of a type or types of Mortgage Assets in which the Company's Mortgage
Asset portfolio is concentrated, will reduce the market value of the Mortgage
Assets, which would likely cause lenders to require additional collateral. A
number of such factors in combination may cause difficulties for the Company,
including a possible liquidation of a major portion of the Company's Mortgage
Assets at disadvantageous prices with consequent losses, which could have a
material adverse effect on the Company and could render it insolvent.
Lenders will have claims on the Company's assets superior to the claims of
the holders of the Company's Common Stock and may require that the Company agree
to covenants that could restrict its flexibility in the future and limit the
Company's ability to pay dividends. In the event of the insolvency or bankruptcy
of the Company, any creditor under a reverse repurchase agreement may be allowed
to avoid the automatic stay provisions of the Bankruptcy Code and to foreclose
on the collateral agreements without delay. In the event of the insolvency or
bankruptcy of a lender during the term of a reverse repurchase agreement, the
lender may be permitted to repudiate the contract, and the Company's claim
against the lender for damages therefrom may
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be treated simply as one of the unsecured creditors. Should this occur, the
Company's claims would be subject to significant delay and, if received, may be
substantially less than the damages actually suffered by the Company.
Due to the underlying loan to collateral values established by the
Company's lenders, the Company may be subject to calls for additional capital in
the event of adverse market conditions. Such conditions include (i) higher than
expected levels of prepayments on Mortgage Loans and (ii) sudden increases in
interest rates. To the extent that the Company is highly leveraged, it may not
be able to meet its loan to collateral value requirements, which may result in
losses to the Company. There can be no assurance that the Company will not face
a call for additional capital. See "Business -- Funding," and "-- Capital
Guidelines."
The Company's Capital Policy, which is set by the Company's Board of
Directors, requires the Company to maintain a minimum equity capital of between
8% and 12%. However, the Company is not subject to additional statutory,
regulatory or third party limitations on incurring debt. Accordingly, there are
no restrictions on the Company's ability to incur debt and there can be no
assurance that the level of debt that the Company is authorized to incur
pursuant to its current Capital Policy will not be increased by the Board of
Directors. See "Policies and Strategies May Be Revised at the Discretion of the
Board of Directors."
INTEREST RATE FLUCTUATIONS MAY ADVERSELY AFFECT THE VALUE OF FIXED-RATE
MORTGAGE LOANS HELD FOR SECURITIZATION
Changes in interest rates can have a variety of effects on the Company's
Mortgage Loan acquisition business. The market value of fixed-rate Mortgage
Loans has a greater sensitivity to changes in market interest rates than
adjustable-rate Mortgage Loans. To the extent the Company purchases a fixed-rate
Mortgage Loan, an increase or decrease in the value of the Mortgage Loan may
result from the change in interest rates during the period between the time the
loan was purchased and the time the Mortgage Loan was placed in a
securitization. A sharp rise in interest rates or increasing market concern
about the value or liquidity of a type or types of Mortgage Loans being held by
the Company will reduce the market value of the Mortgage Loans. This may cause
lenders to require additional collateral. Even with stable or declining interest
rates the market value of the type of Mortgage Loans the Company holds could
decrease, making long term securitization expensive or unavailable. In addition,
results of operations from the Company's origination of Mortgage Loans can be
adversely affected to the extent rising interest rates decrease the volume of
Mortgage Loan originations and the revenue derived therefrom.
THE COMPANY HAS SIGNIFICANT CONFLICTS WITH, AND IS DEPENDENT ON, AN AFFILIATE
OF THE EXECUTIVE OFFICERS OF THE COMPANY
The Company is subject to conflicts of interest with the Manager and its
executive officers. The executive officers of the Company generally are
executive officers, employees and stockholders of the Manager, and are therefore
affiliated with the Manager. The Manager manages the day-to-day operations of
the Company. Accordingly, the Company's success depends in significant part on
the Manager. Under the Management Agreement, the Manager receives an annual base
management fee payable monthly in arrears and the Manager has the opportunity to
earn incentive compensation under the Management Agreement based on the
Company's annualized net income. The ability of the Company to achieve the
performance level required for the Manager to earn the incentive compensation is
dependent upon the level and volatility of interest rates, the Company's ability
to react to changes in interest rates and to implement the operating strategies
described herein, and other factors, many of which are not within the Company's
control. In evaluating Mortgage Assets for investment and other strategies, an
undue emphasis on maximizing income at the expense of other criteria, such as
preservation of capital, in order to achieve higher incentive compensation for
the Manager, can result in increased risk to the value of the Company's Mortgage
Asset portfolio. See "Management and Termination Fees."
The Management Agreement does not limit or restrict the right of the
Manager or any of its officers, directors, employees or affiliates to engage in
any business or to render services of any kind to any other person, including
purchasing, or rendering advice to others purchasing, Mortgage Assets which meet
the
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Company's policies and criteria, except that the Manager and its officers,
directors, or employees will not be permitted to provide any such services to
any REIT which invests primarily in residential Mortgage Assets, other than the
Company.
CHARACTERISTICS OF UNDERLYING PROPERTY MAY DECREASE VALUE OF MORTGAGE LOANS
Although the Company intends to seek geographic diversification of the
properties which are collateral for the Company's Mortgage Loans, it does not
intend to set specific diversification requirements (whether by state, zip code
or other geographic measure). Concentration in any one geographic area will
increase the exposure of the Company's Mortgage Assets to the economic and
natural hazard risks associated with that area.
Certain properties securing Mortgage Loans may be contaminated by hazardous
substances resulting in reduced property values. If the Company forecloses on a
defaulted Mortgage Loan collateralized by such property, the Company may be
subject to environmental liabilities regardless of whether the Company was
responsible for the contamination. The results of the Company's Mortgage Loan
acquisition program may also be affected by various factors, many of which are
beyond the control of the Company, such as (i) local and other economic
conditions affecting real estate values, (ii) interest rate levels and the
availability of credit to refinance such Mortgage Loans at or prior to maturity,
and (iii) increased operating costs, including energy costs, real estate taxes
and costs of compliance with regulations.
DEPENDENCE ON KEY PERSONNEL FOR SUCCESSFUL OPERATIONS
The Company's operations depend in significant part upon the skill and
experience of John Robbins and Jay Fuller. Although these executive officers
currently have employment agreements with the Manager, there can be no assurance
of the continued employment of such officers. The Company is also dependent on
other key personnel and on its ability to continue to attract, retain and
motivate qualified personnel. The loss of any key person could have a material
adverse effect on the Company's business, financial condition and results of
operations.
POLICIES AND STRATEGIES MAY BE REVISED AT THE DISCRETION OF THE BOARD OF
DIRECTORS
The Board of Directors has established the investment policies, operating
policies and strategies of the Company. These policies and strategies may be
modified or waived by the Board of Directors without stockholder consent.
Further, the Board of Directors is not limited by the Company's Articles of
Amendment and Restatement ("the Charter") or Bylaws in determining the Company's
policies and strategies. Accordingly, investors are not able to evaluate the
credit or other risks which may be applicable to the Mortgage Assets to be
acquired by the Company. A change in the Company's policies and strategies could
adversely affect the Company's business, financial condition and results of
operations.
The Company does not currently intend to (i) issue, (ii) make loans to
other persons, (iii) invest in the securities of others for the purpose of
exercising control, (iv) underwrite securities of other issuers, or (v) offer
securities in exchange for property.
DEFAULT OF MANAGER UNDER SECURITIES PURCHASE AGREEMENT; RESTRICTIVE COVENANTS
In connection with the private financing of the Manager and the Company,
the Company, the Manager and MDC-REIT entered into a Securities Purchase
Agreement dated as of February 11, 1997 (the "Securities Purchase Agreement")
with the institutional investors therein (the "Investors") providing for, among
other things, the purchase by the Investors of senior secured notes of the
Manager due February 11, 2002 (the "Notes"). Pursuant to the Securities Purchase
Agreement, the Company must comply with various covenants, including covenants
restricting the Company's investment, hedging and leverage policies, leverage
ratio and indebtedness levels, and business and tax status. These restrictions
may limit the Company's ability to adequately respond to changing market
conditions, even when such changes may be in the best interest of the Company,
which could have a material adverse effect on the Company's financial condition
and results of operations.
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The Manager's default on its obligations with respect to the Notes, could
result in a default and termination of the Management Agreement, in which case
the operations of the Company could be materially and adversely affected pending
either the engagement of a new manager or the development internally of the
resources necessary to manage the operation of the Company. The Manager is
currently in default of its covenants. The senior note holders have not issued
waivers, however the parties continue to operate under the terms of the
Management Agreement. In addition, MDC-REIT has pledged 1.6 million shares of
its Common Stock of the Company to secure the Manager's obligations under the
Securities Purchase Agreement. As a result of the defaults under the Securities
Purchase Agreement, the pledged shares could be transferred to the holders of
the Notes, who will then have certain demand registration rights.
EXECUTIVE OFFICERS OF THE COMPANY
The following table presents certain information concerning the executive
officers of the Company:
NAME AGE POSITION(1)
---- --- -----------
John M. Robbins(2) 51 Chairman of the Board, Chief Executive Officer
Jay M. Fuller(2) 48 President, Chief Operating Officer
Mark A. Conger Executive Vice President and Chief Financial
39 Officer
Rollie O. Lynn 44 Senior Vice President, Capital Markets
Lisa S. Faulk 40 Senior Vice President, Operations
- ---------------
(1) Each executive officer holds the same position with the Manager.
(2) Mr. Robbins and Mr. Fuller are founders of the Company.
JOHN M. ROBBINS has served as Chairman of the Board of Directors and Chief
Executive Officer and Director of the Company since its formation in February
1997. Prior to joining the Company, Mr. Robbins was Chairman of the Board of
American Residential Mortgage (AMRES) from 1990 until 1994 and President of
AMRES Mortgage from the time he co-founded it in 1983 until 1994. He also served
as Executive Vice President of Imperial Savings Association from 1983 to 1987.
Mr. Robbins has worked in the mortgage banking industry since 1973. Mr. Robbins
is currently director of the Mortgage Bankers Association of America and has
served two terms on the Board of Governors and the Executive Committee of the
Mortgage Association of America, and has served on FNMA's National Advisory
Board. Mr. Robbins also serves as a director of Pacific Research & Engineering
Corporation, Garden Fresh Restaurant Corporation, Accredited Home Lenders and
the University of San Diego.
JAY M. FULLER has served as President, Chief Operating Officer and Director
of the Company since its formation in February 1997. Prior to joining the
Company Mr. Fuller served as President of Victoria Mortgage from 1995 to 1996.
Mr. Fuller was an Executive Vice President and Chief Administration Officer of
AMRES Mortgage from 1985 to 1994 and Senior Vice President from 1983 to 1985. In
these capacities, at various times, Mr. Fuller was responsible for, among other
things, Mortgage Loan originations and servicing for AMRES Mortgage. Mr. Fuller
has worked in the mortgage banking industry continuously since 1975. Mr. Fuller
currently serves as President of Friends of Santa Fe Christian Schools.
MARK A. CONGER has served as Executive Vice President and Chief Financial
Officer of the Company since August 1997 and served as Senior Vice President and
Chief Financial Officer since its formation in February 1997. From 1994 through
1997 Mr. Conger was the sole proprietor and manager of an unrelated business.
Mr. Conger was a Senior Vice President, Finance, of AMRES Mortgage from 1992 to
1994 responsible for the areas of accounting, treasury and corporate planning.
He was a Vice President of AMRES Mortgage from 1987 to 1992 responsible for
corporate planning and human resources. Prior to joining AMRES Mortgage, Mr.
Conger was an Assistant Vice President, Accounting, for Imperial Savings
Association from 1985 to 1987 and an auditor for KPMG LLP from 1981 to 1985. Mr.
Conger has worked in the mortgage banking industry for ten years. Mr. Conger
received a Bachelor of Science degree from the University of Missouri in 1981
and is a Certified Public Accountant.
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ROLLIE O. LYNN has served as Senior Vice President, Capital Markets,
responsible for the areas of portfolio management for the Company since its
formation in February 1997. Prior to joining the Company, Mr. Lynn served as
Vice President, Capital Markets, of Long Beach Mortgage Company responsible for
managing, hedging and trading the firm's non-conforming residential Mortgage
Loans. Prior to joining Long Beach Mortgage, Mr. Lynn served as Vice President,
Secondary Marketing, of AMRES Mortgage from 1991 to 1994, as Vice President,
Capital Markets, of Imperial Savings from 1988 to 1992, and as Vice President of
Great American First Savings Bank of San Diego from 1985 to 1988. Mr. Lynn has
worked in the mortgage banking business continuously since 1977. Mr. Lynn
received two Bachelor of Arts degrees in 1976 from California State University
at Chico. Mr. Lynn is a licensed real estate broker in the State of California.
LISA S. FAULK has served as Senior Vice President, Operations, of the
Company since October 1997. Prior to joining the Company, Ms. Faulk served as
Vice President, Conduit Underwriting, for Advanta Mortgage Corporation where she
managed the Conduit Division's underwriting, funding and processing functions in
the non-conforming credit markets. Ms. Faulk was Vice President, Manager Credit
Risk Review, for Homefed Bank, Federal Savings Bank from 1984 to 1993.
GLOSSARY
AS USED IN THIS FORM 10-K, THE CAPITALIZED AND OTHER TERMS LISTED BELOW
HAVE THE MEANINGS INDICATED.
"AGENCY SECURITIES" means mortgage participation certificates issued by
FHLMC, FNMA or GNMA. These securities entitle the holder to receive a
pass-through of principal and interest payments on the underlying pool of
Mortgage Loans and are issued or guaranteed by federal government sponsored
agencies.
"CAPITAL CUSHION" is a term defined in the Company's Capital Policy. It
represents the equity reserve amount assigned to each Mortgage Asset which is
adjusted based upon the Company's assessment of the risk of delinquency, default
or loss on such Mortgage Asset.
"CAPITAL POLICY" means the policy established by the Company which limits
Management's ability to acquire additional Mortgage Assets during such times
that the actual capital base of the Company is less than a required amount
defined in the policy. The required amount is the sum the "haircuts" required by
the Company's secured lenders (the required haircut) and the additional capital
levels called for under the policy which are determined with reference to the
various risks inherent in the Company's Mortgage Assets (the liquidity capital
cushion).
"CMO" means Collateralized Mortgage Obligation.
"CODE" means the Internal Revenue Code of 1986, as amended.
"COUPON RATE" means, with respect to Mortgage Assets, the annualized cash
interest income annually received from the asset, expressed as a percentage of
the face value of the asset.
"EARNING ASSETS" means, with respect to Mortgage Assets, the annualized
cash interest income actually received from the asset, expressed as a percentage
of the face value of the asset.
"EQUITY-FUNDED LENDING" means the portion of the Company's earning assets
acquired using the Company's equity capital.
"FASIT" means Financial Asset Securitization Investment Trust.
"FHLMC" means the Federal Home Loan Mortgage Corporation.
"FNMA" means the Federal National Mortgage Association.
"FULLY-INDEXED RATE" means, with respect to adjustable-rate Mortgage
Assets, the rate that would be paid by the borrower ("gross") or received by the
Company as owner of the Mortgage Assets ("net") if the coupon rate on the
adjustable-rate Mortgage Assets were able to adjust immediately to a market rate
without being subject to adjustment periods, periodic caps, or life caps. It is
equal to the current yield of the adjustable-rate Mortgage Assets index plus the
gross or net margin.
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"GNMA" means the Government National Mortgage Association.
"INTEREST RATE ADJUSTMENT INDICES" means, in the case of Mortgage Assets,
any of the objective indices based on the market interest rates of a specified
debt instrument (such as United States Treasury Bills in the case of the
Treasury Index and United States dollar deposits in London in the case of LIBOR)
or based on the average interest rate of a combination of debt instruments (such
as the 11th District Cost of Funds Index), used as a reference base to reset the
interest rate for each adjustment period on the Mortgage Asset, and in the case
of borrowings, is used herein to mean the market interest rates of a specified
debt instrument (such as reverse repurchase agreements for Mortgage Securities)
as well as any of the objective indices described above that are used as a
reference base to reset the interest rate for each adjustable period under the
related borrowing instrument.
"INTEREST RATE ADJUSTMENT PERIOD" means, in the case of Mortgage Assets,
the period of time set forth in the debt instrument that determines when the
interest rate is adjusted and, with respect to borrowings, is used to mean the
term to maturity of a short term, fixed-rate debt instrument (such as a 30-day
reverse repurchase agreement) as well as the period of time set forth in a long
term, adjustable-rate debt instrument that determines when the interest rate is
adjusted.
"LIFETIME INTEREST RATE CAP" or "LIFE CAP" means the maximum coupon rate
that may accrue during any period over the term of an adjustable-rate Mortgage
Loan or, in the case of a Mortgage Security, the maximum weighted average coupon
rate that may accrue during any period over the term of such Mortgage Security.
"LIQUIDITY CAPITAL CUSHION" is a term defined in the Company's Capital
Policy. It represents a portion of the capital the Company is required to
maintain as part of this policy in order to continue to make asset acquisitions.
The liquidity capital cushion is that part of the required capital base which is
in excess of the Company's haircut requirements.
"MORTGAGE ASSETS" means Mortgage Securities, Mortgage Loans, and Bond
Collateral.
"MORTGAGE LOANS" means Mortgage Loans secured by residential or mixed use
properties.
"MORTGAGE SECURITIES" means Agency Securities and Privately Issued
Securities.
"NONCONFORMING MORTGAGE LOANS" means conventional single-family and
multifamily Mortgage Loans that do not conform to one or more requirements of
CHLMC or FNMA for participation in one or more of such agencies' mortgage loss
credit support programs.
"PERIODIC INTEREST RATE CAP" or "PERIODIC CAP" means the maximum change in
the coupon rate permissible under the terms of the loan at each coupon
adjustable date. Periodic caps limit both the speed by which the coupon rate can
adjust upwards in a rising interests rat environment and the speed by which the
coupon rate can adjust downwards in a falling rate environment.
"PRIVATELY ISSUED SECURITIES" means mortgage participation certificates
issued by certain private institutions. These securities entitle the holder to
receive a pass-through of principal and interest payments on the underlying pool
of Mortgage Loans and are issued or guaranteed by the private institution.
"REIT PROVISIONS OF THE CODE" means sections 856 through 860 of the Code.
"REMIC" means Real Estate Mortgage Investment Conduit.
"SPREAD LENDING" means the portion of the Company's earning assets acquired
using borrowed funds.
"TEN YEAR U.S. TREASURY RATE" for a quarterly period shall mean the
arithmetic average of the weekly per annum Ten Year Average Yields published by
the Federal Reserve Board during such quarter. In the event that the Federal
Reserve Board does not publish a weekly per annum ten Year Average Yield during
any week in a quarter, then the Ten Year U.S. Treasury Rate for such week shall
be the weekly per annum Ten Year Average Yield published by any Federal Reserve
Bank or by any U.S. Government department or agency selected by the Company for
such week. In the event that the Company determines in good faith that for any
reason the Company cannot determine the Ten Year U.S. Treasury Rate for any
quarter as provided
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above, then the Ten Year U.S. Treasury Rate for such quarter shall be the
arithmetic average of the Per Annum average yields to maturity based upon the
daily closing bids during such quarter for each of the issues of actively traded
marketable U.S. treasury fixed interest rate securities (other than securities
which can, at the option of the holder, be surrendered at face value in payment
of any federal estate tax) with a final maturity date not less than eight nor
more than twelve years from the date of each such quotation, as chosen and for
each business day or less frequently if daily quotations shall not be generally
available in each such quarterly period in New York City and quoted to the
Company by at least three recognized dealers in U.S. Government securities
selected by the Company.
ITEM 2. PROPERTIES
The Company's and the Manager's executive offices are located at 445 Marine
View Avenue, Suite 230, Del Mar, California. The Company and the Manager
currently occupy approximately 7,000 square feet of space. The Manager leases
facilities pursuant to a lease expiring in March 2000. The cost for this space
for the year ended December 31, 1998, was approximately $144 thousand.
Management believes that these facilities are adequate for the Company's and the
Manager's foreseeable needs.
ITEM 3. LEGAL PROCEEDINGS
At December 31, 1998, there were no material pending legal proceedings to
which the Company was a party or of which any of its property was subject.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
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PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's Common Stock began trading on October 29, 1997 and is traded
on the New York Stock Exchange under the trading symbol INV. As of December 31,
1998, the Company had 8,055,500 shares of Common Stock issued and outstanding
which was held by 54 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 Common Stock.
STOCK PRICES
------------------------
HIGH LOW CLOSE
---- --- -----
1998
Year ended December 31, 1998.................... 14 5/16 3 3/4 5 3/8
Fourth quarter ended December 31, 1998.......... 6 1/4 3 3/4 5 3/8
Third quarter ended September 30, 1998.......... 10 5/32 4 7/8 6 1/4
Second quarter ended June 30, 1998.............. 12 11/16 9 9 11/16
First quarter ended March 31, 1998.............. 14 5/16 11 5/16 12
1997
Fourth quarter ended December 31, 1997.......... 16 5/8 11 7/16 11 7/8
In order to qualify for the tax benefits accorded a REIT under the Code,
the Company must make distributions equal to substantially all of its taxable
income (subject to certain adjustments) in either the year earned or the
following year. See "Business -- Requirements for Qualification as a REIT." Net
income calculated in accordance with GAAP does not ordinarily equal taxable
income. Accordingly, although the Company also intends to declare dividends each
year equal to substantially all of its reported net income, which is calculated
in accordance with GAAP, from time to time aggregate dividends declared in a
year may nevertheless be higher or lower than net income reported for that year.
All distributions will be made by the Company at the discretion of the Board of
Directors and will depend on the operations of the Company, financial condition
of the Company, maintenance of REIT status and such other factors as the Board
of Directors may deem relevant from time to time.
The following table sets forth, for the periods indicated, the dividends
paid in 1997, 1998 and 1999:
CASH DIVIDEND
- -----------------------------------------------
DATE DECLARED DATE PAYABLE AMOUNT PER SHARE
- ------------- ------------ ----------------
12/17/98 1/28/99 0.15
10/15/98 11/2/98 0.12
7/13/98 7/31/98 0.28
4/24/98 4/30/98 0.28
12/19/97 1/21/98 0.16
10/21/97 10/29/97 0.32
7/17/97 7/17/97 0.27
5/1/97 5/1/97 0.09
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ITEM 6. SELECTED FINANCIAL DATA
The following selected Statement of Operations and Balance Sheet data as of
December 31, 1998 and 1997, and for the year ended December 31, 1998 and for the
period from February 11, 1997 (commencement of operations) through December 31,
1997, has been derived from the Company's consolidated financial statements
audited by KPMG LLP, independent auditors, whose report with respect thereto
appears on page F-2. Such selected financial data should be read in conjunction
with those consolidated financial statements and the accompanying notes thereto
and with "Management's Discussion and Analysis of Financial Conditions and
Results of Operations" also included elsewhere herein.
FOR THE PERIOD FROM
FEBRUARY 11, 1997
FOR THE (COMMENCEMENT OF
YEAR ENDED OPERATIONS) THROUGH
DECEMBER 31, 1998 DECEMBER 31, 1997
------------------ --------------------
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
STATEMENT OF OPERATIONS DATA:
Net interest income.................................... $ 10,985 $ 2,914
Provision for loan losses.............................. 3,470 --
Other operating income................................. 2,344 --
Loss on sale of mortgage-backed securities............. 5,912 --
Operating expenses..................................... 5,161 511
Net income (loss)...................................... (1,214) 2,403
Net income (loss) per share of common stock -- basic... (0.15) 0.83
Net income (loss) per share of common
stock -- diluted.................................... (0.15) 0.82
Weighted average number of shares -- basic............. 8,090,772 2,879,487
Weighted average number of shares -- diluted........... 8,090,772 2,929,009
Dividends declared per share........................... 0.83 0.84
Noninterest expense as percent of average assets....... 1.42% 0.18%
AS OF AS OF
DECEMBER 31, 1998 DECEMBER 31, 1997
------------------- -------------------
(DOLLARS IN THOUSANDS, EXCEPT SHARE DATA)
BALANCE SHEET DATA:
Mortgage securities available-for-sale, net............ $ 6,617 $ 387,099
Mortgage loans held-for-investment, net, pledged....... 179,009 162,762
Bond collateral........................................ 417,808 --
Total assets........................................... 656,772 561,834
Reverse repurchase agreements.......................... 166,214 451,288
Long-term debt, net.................................... 385,290 --
Stockholders' equity................................... 101,971 106,569
Number of shares outstanding........................... 8,055,500 8,114,000
33
36
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
The statements contained in this Form 10-K that are not purely historical
are forward looking statements, including statements regarding the Company's
expectations, hopes, beliefs, intentions or strategies regarding the future.
Among the factors that could cause actual results to differ materially are the
factors set forth above under Item 1 under the heading "Business Risks".
OVERVIEW
Due to market conditions, i.e., high prepayments, fueled by declining
interest rates and the need to lower leverage, the majority of the Company's
Mortgage Securities were sold during the fourth quarter. In order to increase
liquidity, the Company divested itself of all but $6.6 million in Mortgage
Securities in the fourth quarter of 1998. The sale of the majority of the
Company's Mortgage Security portfolio caused a loss of approximately $5.9
million.
During 1997, the Company's income consisted of interest income generated
from its Mortgage Assets and its cash balances (collectively, "earning assets").
During 1998, income was also generated by equity in American Residential
Holdings, Inc., prepayment penalty income and management fee income.
The Company funds its acquisitions of earning assets with both its equity
capital and with borrowings. For that portion of the Company's earning assets
funded with equity capital ("equity-funded lending"), net interest income is
derived from the average yield on earning assets. Due to the adjustable-rate
nature of the majority of its earning assets, the Company expects that income
from this source will tend to increase as interest rates rise and will tend to
decrease as interest rates fall.
For that portion of the Company's earning assets funded with borrowings
("spread lending"), resulting net interest income is a function of the volume of
spread lending and the difference between the Company's average yield on earning
assets and the cost of borrowed funds and interest rate hedging agreements (caps
and floors). Income from spread lending may initially decrease following an
increase in interest rates and then, after a lag period, be restored to its
former level as earning assets yields adjust to market conditions. Income from
spread lending may likewise increase following a fall in interest rates, but
then decrease as earning asset yields adjust to the new market conditions after
a lag period.
The Company may seek to generate growth in net income in a variety of ways,
including through (i) improving productivity by increasing the size of the
earning assets at a rate faster than operating expenses increase, (ii) changing
the mix of Mortgage Asset types among the earning assets in an effort to improve
returns, and (iii) issuing new Common Stock and increasing the size of the
earning assets when opportunities in the mortgage market are likely to allow
growth in net income per share of Common Stock, (iv) increasing the efficiency
with which the Company uses its equity capital over time by increasing the
Company's use of debt when prudent and by issuing subordinated debt, preferred
stock or other forms of debt and equity. There can be no assurance, however,
that the Company's efforts will be successful or that the Company will increase
or maintain its income level.
RESULTS OF OPERATIONS
For the year ended December 31, 1998 the Company generated a net loss of
approximately $1.2 million and net loss per share of Common Stock-diluted of
$0.15 compared to the, period February 11, 1997 (commencement of operations)
through December 31, 1997 where the Company generated net income of
approximately $2.4 million and diluted net income per share of $0.82. The net
loss in 1998 was directly attributable to the loss on sale of Mortgage
Securities available-for-sale and provisions for loan losses. The sale of
Mortgage Securities available-for-sale generated a loss of $5.9 million.
Net interest income, after provision for loan losses, increased 157.9% from
$2.9 million for the period February 11, 1997 (commencement of operations)
through December 31, 1997, to $7.5 million for the year ended December 31, 1998.
Also, other operating income was not present in 1997 and was approximately $2.3
million for the year ended December 31, 1998.
34
37
The growth in net interest income between the period February 11, 1997
(commencement of operations) through December 31, 1997, and the year ended
December 31, 1998 was due to an increase in the Company's Mortgage Assets held
during the year. Other operating income increased from income of American
Residential Holdings, Inc., in the amount of $1.1 million, prepayment penalty
income of $806 thousand and management fee income of $420 thousand. Other
expenses increased from $511 thousand for the period February 11, 1997
(commencement of operations) through December 31, 1997 to $5.2 million for the
year ended December 31, 1998 (excluding the loss on sale of Mortgage Backed
Securities of $5.9 million). The increase in general and administrative expenses
between the period February 11, 1997 (commencement of operations) through
December 31, 1997, and the year ended December 31, 1998 is the result of the
Company's increased management fees which resulted from the increase in the
Company's Mortgage Assets.
The Company experienced high levels of prepayments in the year ended
December 31, 1998. The annualized mortgage principal prepayment rate for the
Company was 34.2% for the year ended December 31, 1998 compared with 29.7% for
the period from February 11, 1997 (commencement of operations) through December
31, 1997. Many of the intermediate adjustable rate mortgages have reached their
first adjustment resulting in possible refinancing and principal prepayments.
The Company anticipates that prepayment rates may continue at high levels for an
indefinite period. There can be no assurance that the Company will be able to
achieve or maintain lower prepayment rates or that prepayment rates will not
increase. The Company's financial condition and results of operations could be
materially adversely affected if prepayments continue at high levels.
The Company held Mortgage Assets of approximately $603.4 million as of
December 31, 1998. Mortgage Assets at December 31, 1998 are comprised of
Mortgage Securities available-for-sale, of $6.6 million, Mortgage Loans
held-for-investment, pledged, of $179.0 million and Bond Collateral, of $417.8
million. This compares to Mortgage Assets with a carrying value of approximately
$549.9 million at December 31, 1997, comprising of Mortgage Securities
available-for-sale, of $387.1 million, including a $3.3 million net unrealized
loss recorded as of the year end, and Mortgage Loans held-for-investment,
pledged of $162.8 million.
LIQUIDITY AND CAPITAL RESOURCES
During the year ended December 31, 1998, net cash provided by operating
activities was approximately $11.8 million. The difference between net cash
provided by operating activities and the net loss of $1.2 million was primarily
the result of amortization of mortgage asset premiums and provisions for loan
losses. Both amortization of mortgage premium and provisions for loan losses are
non-cash charges.
Net cash used in investing activities for the year ended December 31, 1998
was approximately $76.0 million. Net cash used for the year was negatively
affected by the purchase of Mortgage Loans in the amount of approximately $649.6
million, the purchase of the retained interest in securitization of
approximately $6.7 million, and the purchase of interest rate cap agreements of
approximately $1.0 million. Net cash used in investing activities for the year
ended December 31, 1998 was positively affected by principal prepayments of
approximately $250.8 million and sale of mortgage assets of approximately $331.3
million.
For the year ended December 31, 1998, net cash provided by financing
activities was approximately $93.0 million. Net cash provided by financing
activities was positively affected by the issuance of CMO/ FASIT bonds in the
amount of approximately $457.0 million. Net cash provided by financing
activities was negatively impacted by a decrease in net borrowings from reverse
repurchase agreements of approximately $285.1 million, payments on CMO/FASIT
bonds of approximately $71.6 million, dividends paid of approximately $6.8
million and repurchase of the Company's stock for approximately $492 thousand.
Although the 1998 U.S. economy was one of the healthiest in decades, much
of the world was experiencing financial crisis. Economic woes of Russia, Japan,
China, Brazil and others shook the confidence of the U.S. markets. Concurrently,
failures at Crimmie Mae, a Commercial Mortgage REIT, and hedge funds, such as
Long Term Capital, as well as sizeable losses arising from some residential
sub-prime originators caused volatility in the price of U.S. financial assets
and eventually led to a liquidity crisis in the fall of 1998. The liquidity
crisis had a negative effect on the Mortgage REIT industry. Financial lines
utilized to accumulate Mortgage assets were reduced or made unavailable by Wall
Street firms and banks. In the event the Company could not meet its financial
obligations, certain assets would be liquidated.
35
38
Financial turmoil in world economics, and a domestic liquidity crisis may
return. There can be no assurance that the Company will be able to secure
financing or that financing will be available at favorable terms. See "Business
Risks -- Failure to Implement Company's Leverage Strategy May Adversely Affect
Results of Operations."
YEAR 2000 ISSUE
The Year 2000 issue is the result of computer programs being written using
two digits rather than four to define the applicable year. Computer systems,
software, and devices with embedded technology that are date-sensitive may
recognize a date using "00" as the year 1900 rather than the year 2000. This
could result in systems failures, miscalculations or disruptions in operations,
including, among other things, a temporary inability to process transactions or
engage in similar normal business activities.
The Company is currently in the process of assessing how it may be impacted
by the Year 2000 issue and formulating and implementing a comprehensive plan to
address all known aspects of the issue.
Based on the Company's recent assessment of its internal computer systems
(including related hardware, software, customized applications and network
systems) with respect to the Year 2000 issue, the Company determined that its
existing network and operating systems are Year 2000 compliant, with minor
issues. The Company has hired an external systems consultant to rectify these
minor issues. The Company believes that these measures, the actual and estimated
costs of which have been and are expected to continue to be immaterial in the
aggregate, will enable its internal computer systems to be Year 2000 compliant.
The Company is also reviewing the efforts of its significant hardware,
software, and service providers to become Year 2000 compliant. The Company has
contacted all critical entities with which the Company does business to assess
their Year 2000 readiness. As of December 31, 1998 a majority of these entities
have responded to the Company's inquiries. The Company is in the process of
reviewing the written responses to the inquiries, and is assessing the impact
that the Year 2000 readiness status of such entities may have on the Company's
operations, and is taking whatever action is deemed necessary. Based on the
responses received to date, there has been no indication that the respondents
have any material concerns related to their ability to address all of their
known significant Year 200 issues on a timely basis. The Company anticipates
that these review activities will be on-going for the remainder of 1999 and will
include any necessary follow-up efforts. The Company, however, cannot presently
estimate the total cost of this phase of its Year 2000 readiness program.
Although the review of such entities is continuing, the Company is not aware of
any third party circumstances with respect to the Year 2000 issue that may have
a material adverse impact on the Company. The Company can provide no assurance
that the Year 2000 compliance plans of such third parties will be successfully
completed in a timely manner.
Based on the results to date of the Company's internal assessment and
external inquiries, the Company does not believe that the Year 2000 issue will
pose significant operational problems for the Company or otherwise have a
material adverse effect on its results of operation or financial position.
Although management believes it has undertaken a careful and thorough analysis,
if all Year 2000 issues are not properly identified, or assessment, remediation
and testing efforts are not completed in a timely manner with respect to the
problems that are identified, there can be no assurance that the Year 2000 issue
will not have a material adverse effect on the Company's results of operations
or adversely affect the Company's relationship with hardware, software, and
service providers. Further, management believes it has undertaken a careful
survey of third party entities and does not believe there to be material concern
based upon the potential third party risks that have been identified, however,
there can be no assurance that the Year 2000 issues of the other entities will
not have a material adverse effect on the Company's systems or results of
operations.
As of December 31, 1998, a contingency plan has not yet been developed for
dealing with the most reasonably likely worst case scenario resulting from the
Year 2000 issues as such scenario has not been clearly identified. The
contingency plan will provide timetables to pursue various alternatives, for all
external systems classified as critical, based upon the failure of a hardware,
software or service provider documentation that there product has been
adequately modified, tested, and validated to ensure Year 2000 compliance. The
Company currently plans to complete such contingency planning by June 30, 1999.
36
39
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISKS
REPRICING/MATURITY OF INTEREST-EARNING ASSETS AND INTEREST-BEARING LIABILITIES
The following table sets forth the amounts of interest-earning assets and
interest-bearing liabilities outstanding at December 31, 1998, which are
anticipated by the Company to reprice or mature in each of the future time
periods shown. The amount of assets and liabilities shown which reprice or
mature during a particular period were determined based on contractual maturity
adjusted for estimated prepayments. Estimated prepayments are based on the
company's historical experience. For fair value of financial instruments as of
December 31, 1998, see Notes to the Consolidated Financial Statements -- Note
10. Fair Value of Financial Instruments. (Dollars in thousands.)
AT DECEMBER 31, 1998
----------------------------------------------------------------------------------------------
MORE MORE
MORE THAN MORE THAN MORE THAN THAN THAN
3 MONTHS 3 MONTHS TO 6 MONTHS TO 1 YEAR TO 3 YEARS TO 5 YEARS TO FAIR
OR LESS 6 MONTHS 1 YEAR 3 YEARS 5 YEARS 10 YEARS TOTAL VALUE
-------- ----------- ----------- --------- ---------- ---------- ------- -------
Interest-earning assets:
Cash and cash equivalents...... 34,645 -- -- -- -- -- 34,645 34,645
Mortgage securities
available-for-sale, net...... 6,617 -- -- -- -- -- 6,617 6,617
Mortgage loans
held-for-investment, net,
pledged(1)................... 10,957 10,286 18,722 55,154 36,702 47,188 179,009 179,009
Bond collateral................ 25,573 24,007 43,697 128,730 85,663 110,138 417,808 417,808
Retained interest in
securitization............... 8,762 -- -- -- -- -- 8,762 8,762
Interest rate agreements....... 674 -- -- -- -- -- 674 (1,529)
Due from affiliate............. 606 -- -- -- -- -- 606 606
-------- ------- ------- ------- ------- ------- ------- -------
Total interest-earning
assets..................... 87,834 34,293 62,419 183,884 122,365 157,326 648,121 645,918
======== ======= ======= ======= ======= ======= ======= =======
Interest-bearing liabilities:
Short-term debt................ 166,214 -- -- -- -- -- 166,214 166,214
Long-term debt, net(1)......... 23,582 22,139 40,296 118,711 78,996 101,566 385,290 385,290
Due to affiliate............... 386 -- -- -- -- -- 386 386
-------- ------- ------- ------- ------- ------- ------- -------
Total interest-bearing
liabilities................ 190,182 22,139 40,296 118,711 78,996 101,566 551,890 551,890
======== ======= ======= ======= ======= ======= ======= =======
Interest rate sensitivity gap
(2).......................... (102,348) 12,154 22,123 65,173 43,369 55,760 96,231 94,028
Cumulative interest rate
sensitivity gap.............. (102,348) (90,194) (68,071) (2,898) 40,471 96,231
- ---------------
(1) Estimated prepayments are based on the company's historical rate of 25%.
(2) Interest rate sensitivity gap represents the difference between net
interest-bearing assets and interest-bearing liabilities.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The consolidated financial statements of the Company and the related notes,
together with the Independent Auditor's Report thereon are set forth on pages
F-2 through F-22 on this Form 10-K and the financial statements of American
Residential Holdings, Inc. and the related notes, together with the Independent
Auditor's Report thereon are set forth on pages F-23 through F-31.
37
40
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
None.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by Item 10 with respect to directors is
incorporated herein by reference to the information contained under the headings
"Election of Directors" and "Section 16(a) Beneficial Ownership Reporting
Compliance" in the Company's definitive Proxy Statement for the Company's annual
meeting of stockholders to be held May 19, 1999 (the "Proxy Statement"). The
information required with respect to executive officers is set forth in Item 1
of this report under the caption "Executive Officers of the Company."
ITEM 11. EXECUTIVE COMPENSATION
The information required by Item 11 is incorporated herein by reference to
the information contained under the heading "Executive Compensation and Other
Matters" in the Company's Proxy Statement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by Item 12 is incorporated herein by reference to
the information contained under the heading "Stock Ownership of Certain
Beneficial Owners and Management" in the Company's Proxy Statement.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by Item 13 is incorporated herein by reference to
the information contained under the headings "Compensation Committee Interlocks
and Insider Participation" and "Certain Transactions" in the Company's Proxy
Statement.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS, SCHEDULES AND REPORTS ON FORM 8-K
(a) Documents filed as part of this report:
1. The following Financial Statements of the Company are included in Part
II, Item 8 of this Annual Report on Form 10K:
Independent Auditors' Report;
Consolidated Balance Sheets as of December 31, 1998 and 1997;
Consolidated Statements of Operations and Comprehensive Income (Loss)
for the year ended December 31, 1998 and for the period from February
11, 1997 (commencement of operations) through December 31, 1997;
Consolidated Statements of Stockholders' Equity for the year ended
December 31, 1998 and for the period from February 11, 1997
(commencement of operations) through December 31, 1997;
Consolidated Statements of Cash Flows for the year ended December 31,
1998 and for the period from February 11, 1997 (commencement of
operations) through December 31, 1997;
Notes to Consolidated Financial Statements.
American Residential Holdings, Inc.
Independent Auditors' Report;
38
41
Balance Sheet as of December 31, 1998;
Statement of Operations for the period from January 28, 1998 (inception)
through December 31, 1998;
Statement of Stockholders' Equity for the period from January 28, 1998
(inception) through December 31, 1998;
Statement of Cash Flows for the period from January 28, 1998 (inception)
through December 31, 1998;
Notes to Financial Statements.
2. Financial Statements Schedules.
All financial statement schedules have been omitted because they are
either inapplicable or the information required is provided in the
Company's Financial Statements and Notes thereto, included in Part II,
Item 8 of this Annual Report on Form 10-K.
3. Exhibits:
39
42
EXHIBIT INDEX
EXHIBIT
NUMBER DESCRIPTION
- --------- -----------
*3.1 Articles of Amendment and Restatement of the Registrant
*3.2 Amended and Restated Bylaws of the registrant
*4.1 Registration Rights agreement dated February 11, 1997
**4.2 Articles Supplementary filed on February 22, 1999
**4.3 Rights Plan by and between the Company and American Stock
Transfer and Trust Company dated as of February 2, 1999
*10.1 Management Agreement between the Registrant and Home Asset
Management Corp. dated February 11, 1997 and Amendment
thereto
*+10.2 Employment and Noncompetition Agreement between Home Asset
Management Corp. and John Robbins dated February 11, 1997
and Amendment thereto
*+10.3 Employment and Noncompetition Agreement between Home Asset
Management Corp. and Jay Fuller dated February 11, 1997 and
Amendment thereto
*+10.4 Mark Conger Employment Letter dated January 7, 1997 and
amendment thereto
*+10.5 Rollie Lynn Employment Letter dated January 7, 1997 and
amendment thereto
***+10.5a Lisa Faulk Employment Letter, as amended
*+10.6 1997 Stock Incentive Plan
*+10.7 Form of 1997 Stock Option Plan as amended
*+10.8 Form of 1997 Outside Directors Stock Option Plan
*+10.9 Form of Employee Stock Purchase Plan
*10.10 Securities Purchase Agreement between Registrant, Home Asset
Management Corp. and MDC REIT Holdings, LLC dated February
11, 1997
*+10.11 Form of Subscription Agreement dated February 11, 1997
*10.12 Secured Promissory Note dated June 25, 1997
*10.13 Lease Agreement with Louis and Louis dated March 7, 1997
*+10.14 Form of Indemnity Agreement
***10.15 Master Repurchase Agreement -- Confidential Treatment
Requested and Granted
***21.1 Subsidiaries of Registrant
23.1 Consent of KPMG LLP re: Registrant
23.2 Consent of KPMG LLP re: American Residential Holdings, Inc.
27.1 Financial Data Schedule
- ---------------
* Incorporated by reference to Registration Statement on Form S-11 (File No.
333-33679)
+ Management Contract or Compensatory Plan
** Incorporated by reference to Current Reports on Form 8-K (File No.
001-13485)
*** Incorporated by reference to the Company's Annual Report on Form 10-K for
the Fiscal year ended 1997
(a) Reports on Form 8-K:
Current Report (File No. 001-13485)
40
43
FINANCIAL STATEMENTS AND INDEPENDENT AUDITORS' REPORT
FOR INCLUSION IN FORM 10-K
FILED WITH
SECURITIES AND EXCHANGE COMMISSION
DECEMBER 31, 1998
INDEX TO FINANCIAL STATEMENTS
PAGE
----
American Residential Investment Trust, Inc.
Report of Independent Auditors.............................. F-2
Consolidated Balance Sheets................................. F-3
Consolidated Statements of Operations and Comprehensive
Income (Loss)............................................. F-4
Consolidated Statements of Stockholders' Equity............. F-5
Consolidated Statements of Cash Flows....................... F-6
Notes to Consolidated Financial Statements.................. F-7
American Residential Holdings, Inc.
Report of Independent Auditors.............................. F-23
Balance Sheet............................................... F-24
Statement of Operations..................................... F-25
Statement of Stockholders' Equity........................... F-26
Statement of Cash Flows..................................... F-27
Notes to Financial Statements............................... F-28
F-1
44
REPORT OF INDEPENDENT AUDITORS
To the Board of Directors
American Residential Investment Trust, Inc.
Del Mar, California:
We have audited the accompanying consolidated balance sheets of American
Residential Investment Trust, Inc. and subsidiary (the Company) as of December
31, 1998 and 1997, and the related consolidated statements of operations and
comprehensive income (loss), stockholders' equity and cash flows for the year
ended December 31, 1998 and for the period from February 11, 1997 (commencement
of operations) through December 31, 1997. These consolidated financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated 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 financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of the Company
as of December 31, 1998 and 1997, and the results of their operations and their
cash flows for the year ended December 31, 1998, and for the period from
February 11, 1997 (commencement of operations) through December 31, 1997 in
conformity with generally accepted accounting principles.
KPMG LLP
San Diego, California
January 15, 1999
F-2
45
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT SHARE DATA)
DECEMBER 31, 1998 DECEMBER 31, 1997
----------------- -----------------
ASSETS
Cash and cash equivalents................................ $ 34,645 $ 5,893
Mortgage securities available-for-sale, net.............. 6,617 387,099
Mortgage loans held-for-investment, net, pledged......... 179,009 162,762
Bond collateral.......................................... 417,808 --
Retained interest in securitization...................... 8,762 --
Real estate owned........................................ 490 --
Interest rate cap agreements............................. 674 411
Accrued interest receivable.............................. 7,265 5,169
Due from affiliate....................................... 606 269
Investment in American Residential Holdings.............. 708 --
Other assets............................................. 188 231
-------- --------
$656,772 $561,834
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Short-term debt.......................................... $166,214 $451,288
Long-term debt, net...................................... 385,290 --
Accrued interest payable................................. 1,226 1,839
Due to affiliate......................................... 386 --
Accrued expenses and other liabilities................... 477 632
Management fees payable.................................. -- 208
Accrued dividends........................................ 1,208 1,298
-------- --------
Total liabilities...................................... 554,801 455,265
Stockholders' Equity:
Preferred stock, par value $.01 per share; 1,000 shares
authorized; no shares issued and outstanding........... -- --
Common stock, par value $.01 per share; 25,000,000 shares
authorized; 8,055,500 and 8,114,000 shares issued and
outstanding at December 31, 1998 and 1997,
respectively........................................... 81 81
Additional paid-in-capital............................... 109,271 109,786
Accumulated other comprehensive income (loss)............ 550 (3,300)
Retained earnings (accumulated deficit).................. (7,931) 2
-------- --------
Total stockholders' equity............................. 101,971 106,569
-------- --------
$656,772 $561,834
======== ========
See accompanying notes to consolidated financial statements.
F-3
46
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)
(IN THOUSANDS, EXCEPT SHARE DATA)
FOR THE PERIOD FROM
FEBRUARY 11, 1997
FOR THE (COMMENCEMENT OF
YEAR ENDED OPERATIONS) THROUGH
DECEMBER 31, 1998 DECEMBER 31, 1997
----------------- -------------------
Interest income:
Mortgage assets........................................... $67,667 $13,975
Cash and investments...................................... 1,819 253
------- -------
Total interest income.................................. 69,486 14,228
Interest expense............................................ 58,501 11,314
------- -------
Net interest income....................................... 10,985 2,914
Provision for loan losses................................... 3,470 --
------- -------
Net interest income after provision for loan losses....... 7,515 2,914
Other operating income:
Management fee income..................................... 420 --
Equity in income of American Residential Holdings, Inc.... 1,118 --
Prepayment penalty income................................. 806 --
------- -------
Total other operating income........................... 2,344 --
------- -------
Net operating income................................. 9,859 2,914
Other expenses:
Loss on sale -- Mortgage-backed Securities................ 5,912 --
Management fees........................................... 2,466 283
Interest rate cap and floor agreement expense............. 1,079 132
General and administrative expenses....................... 1,616 96
------- -------
Total other expenses................................... 11,073 511
------- -------
Net income (loss)........................................... (1,214) 2,403
------- -------
Other comprehensive income (loss) Unrealized holding
gains..................................................... 550 --
Unrealized holding losses................................. (2,612) (3,300)
Reclassification adjustment included in income............ 5,912 --
------- -------
Unrealized holding gains (losses) arising during the
period............................................... 3,850 (3,300)
------- -------
Comprehensive income (loss)................................. $ 2,636 $ (897)
======= =======
Net income per share of Common Stock -- Basic............... $ (0.15) $ 0.83
Net income per share of Common Stock -- Diluted............. (0.15) 0.82
Dividends per share of Common Stock......................... 0.83 0.84
See accompanying notes to consolidated financial statements.
F-4
47
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(IN THOUSANDS, EXCEPT SHARE DATA)
ACCUMULATED
OTHER
COMMON STOCK ADDITIONAL COMPREHENSIVE CUMULATIVE
------------------ PAID-IN INCOME DIVIDENDS RETAINED
SHARES AMOUNT CAPITAL (LOSS) DECLARED EARNINGS TOTAL
--------- ------ ---------- ------------- ---------- -------- --------
Initial capital contribution February 11,
1997....................................... 1,614,000 $16 $ 20,149 $ -- $ -- $ -- $ 20,165
Proceeds from sale of stock, net of offering
costs of $7,798............................ 6,500,000 65 89,637 -- -- -- 89,702
Other comprehensive loss..................... -- -- -- (3,300) -- -- (3,300)
Net income................................... -- -- -- -- -- 2,403 2,403
Dividends declared........................... -- -- -- -- (2,401) -- (2,401)
--------- --- -------- ------- ------- ------- --------
Balance December 31, 1997.................... 8,114,000 81 109,786 (3,300) (2,401) 2,403 106,569
--------- --- -------- ------- ------- ------- --------
Purchase and retirement of common stock...... (58,500) -- (492) -- -- -- (492)
Offering costs............................... -- -- (23) -- -- -- (23)
Other comprehensive income................... -- -- -- 3,850 -- -- 3,850
Net income................................... -- -- -- -- -- (1,214) (1,214)
Dividends declared........................... -- -- -- -- (6,719) -- (6,719)
--------- --- -------- ------- ------- ------- --------
Balance December 31, 1998.................... 8,055,500 $81 $109,271 $ 550 $(9,120) $ 1,189 $101,971
========= === ======== ======= ======= ======= ========
See accompanying notes to consolidated financial statements.
F-5
48
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS, EXCEPT SHARE DATA)
FOR THE PERIOD FROM
FEBRUARY 11, 1997
FOR THE (COMMENCEMENT OF
YEAR ENDED OPERATIONS) THROUGH
DECEMBER 31, 1998 DECEMBER 31, 1997
----------------- -------------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss).......................................... $ (1,214) $ 2,403
Adjustments to reconcile net income to net cash provided
by operating activities:
Amortization of mortgage assets premiums.............. 13,311 1,797
Amortization of interest rate cap agreements.......... 779 132
Amortization of bond premium.......................... (79) --
Provision for loan loss............................... 3,470 --
Equity in income of American Residential Holdings, (1,118)
Inc................................................. --
Deposits to overcollateralization account............. (1,513) --
Increase in accrued interest receivable............... (2,096) (5,169)
Increase (decrease) in other assets................... 43 (231)
Increase in due from affiliate........................ (337) (269)
Increase (decrease) in accrued interest payable....... (613) 1,839
Increase (decrease) in accrued expenses and management (363)
fees payable........................................ 840
Increase in due to affiliate.......................... 386 --
--------- ---------
Net cash provided by operating activities............. 10,656 1,342
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of mortgage securities available-for-sale...... -- (431,037)
Purchases of mortgage loans held for investment.......... (649,605) (162,762)
Principal payments on mortgage securities 150,101
available-for-sale.................................... 38,841
Principal payments on mortgage loans held for 100,675
investment............................................ --
Sale of mortgage securities available-for-sale........... 227,760 --
Sale of mortgage loans held for investment............... 103,525 --
Investment in American Residential Holdings, Inc......... (475) --
Dividends recorded from American Residential Holdings, 885
Inc................................................... --
Purchase of retained interest in securitization.......... (6,699) --
Purchase of interest rate cap agreements................. (1,042) (543)
--------- ---------
Net cash used in investing activities................. (74,875) (555,501)
CASH FLOWS FROM FINANCING ACTIVITIES:
Increase (decrease) in net borrowings from reverse (285,074)
repurchase agreements................................. 451,288
Net proceeds from stock issuance......................... (23) 109,867
Purchase of common stock................................. (492) --
Dividends paid........................................... (6,809) (1,103)
Issuance of CMO/FASIT bonds.............................. 457,011 --
Payments on CMO/FASIT bonds.............................. (71,642) --
--------- ---------
Net cash provided by financing activities............. 92,971 560,052
Net increase in cash and cash equivalents.................. 28,752 5,893
Cash and cash equivalents at beginning of period........... 5,893 --
--------- ---------
Cash and cash equivalents at end of period................. $ 34,645 $ 5,893
========= =========
Supplemental information -- interest paid.................. $ 45,463 $ 7,697
========= =========
Non-cash transactions:
Increase (decrease) in accumulated other comprehensive $ (3,850)
loss.................................................. $ 3,300
Dividends declared and unpaid............................ $ 1,208 $ 1,298
========= =========
Transfers from bond collateral to real estate owned...... $ 490 $ --
========= =========
See accompanying notes to consolidated financial statements.
F-6
49
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC., AND SUBSIDIARY
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND PRACTICES
Basis of Financial Statement Presentation
The consolidated financial statements include the accounts of American
Residential Investment Trust, Inc. ("AmRES") and Eagle, its wholly owned
subsidiary (collectively "AmRIT"). Substantially all of the assets of Eagle are
pledged or subordinated to support long-term debt in the form of collateralized
mortgage bonds ("Long-Term Debt") and are not available for the satisfaction of
general claims of AmRIT. American Residential Holdings, Inc. ("Holdings"), is an
affiliate of AmRes and accounted for under the equity method. AmRIT and Holdings
are together referred to as (the "Company"). The Company's exposure to loss on
the assets pledged as collateral is limited to its net investment, as the
Long-Term Debt is non-recourse to the Company. All significant intercompany
balances and transactions with Eagle have been eliminated in the consolidation
of AmRIT.
During the first half of 1998, the Company formed Holdings, through which a
portion of the Company's Mortgage Loan acquisition and finance activities will
be conducted. AmRIT owns all of the preferred stock and has a non-voting 95%
economic interest in Holdings. Under the equity method, original equity
investments in Holdings are recorded at cost and adjusted by AmRIT's share of
operations or losses and decreased by dividends received.
For financial reporting purposes, references to AmRIT mean AmRES and Eagle;
while references to the "Company" mean AmRES, Eagle, and Holdings. Certain
amounts for the prior period have been reclassified to conform with the current
presentation.
The preparation of consolidated financial statements in conformity with
generally accepted accounting principles requires management of the Company 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 consolidated financial statements and the reported amounts of revenue and
expenses during the reported period. Actual results could differ from those
estimates.
Organization
American Residential Investment Trust, Inc., a Maryland corporation,
commenced operations on February 11, 1997. AmRES was financed through a private
equity funding from its manager, Home Asset Management Corporation (the
"Manager"). AmRES operates as a mortgage real estate investment trust ("REIT")
which has elected to be taxed as a real estate investment trust for Federal
income tax purposes, which generally will allow AmRES to pass through its income
to its stockholders without payment of corporate level Federal income tax,
provided that the Company distributes at least 95% of its taxable income to
stockholders. During 1998, the Company formed Eagle, a special-purpose finance
subsidiary. Holdings, a non-REIT, taxable affiliate of the Company, was
established during the first half of 1998. The Company acquires residential
mortgage-backed securities and mortgage loans (collectively, "Mortgage Assets").
These Mortgage Assets are typically secured by single-family real estate
properties throughout the United States. The Company utilizes both debt and
equity to finance its acquisitions. The Company may also use securitization
techniques to enhance the value and liquidity of the Company's Mortgage Assets
and may sell Mortgage Assets from time to time.
The Company diversified its residential mortgage loan sales activities in
the second quarter of 1998 to include the securitization of such loans through a
Real Estate Mortgage Investment Conduit ("REMIC"). The REMIC, which consisted of
pooled adjustable-rate first-lien mortgages, was issued by Holdings to the
public through the registration statement of the related underwriter.
F-7
50
Cash and Cash Equivalents
For purposes of the statement of cash flows, cash and cash equivalents
include cash on hand and highly liquid investments with original maturities of
three months or less.
Mortgage Assets
The Company's Mortgage Assets consist of interests in mortgage securities
which have been securitized by others prior to acquisition by the Company
(Mortgage Securities) and Mortgage Loans secured by residential properties
(Mortgage Loans).
Mortgage Securities
The Company classifies 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 Mortgage Securities until
maturity, it may, from time to time, sell any of its Mortgage Securities as part
of its overall management of its balance sheet. Accordingly, this flexibility
requires the Company to classify all of its Mortgage Securities as
available-for-sale. All Mortgage Securities classified as available-for-sale are
reported at fair value, with unrealized gains and losses excluded from
operations and reported as a separate component of stockholders' equity, as
accumulated other comprehensive income (loss). A decline in the market value of
any available-for-sale security below cost that is deemed to be other than
temporary results in an impairment which is charged to operations and a new
basis for the security is established. The Company sold a significant portion of
its Mortgage Security portfolio in the last quarter of 1998.
Interest income is accrued based on the outstanding principal amount of the
Mortgage Securities and their contractual terms. Premiums relating to Mortgage
Securities are amortized into interest income over the lives of the Mortgage
Securities using the interest method. Gains or losses on the sale of Mortgage
Securities are based on the specific identification method.
Mortgage Loans Held-For-Investment and Bond Collateral
Fair value is estimated based on estimates of proceeds the Company would
receive from the sale of the underlying collateral of each loan. Mortgage loans
held-for-investment and Bond Collateral include various types of adjustable-rate
and fixed-rate loans secured by mortgages on single-family residential real
estate properties. Premiums and discounts related to these loans are amortized
over their estimated lives using the interest method. Loans are continually
evaluated for collectibility and, if appropriate, the loan may be placed on
non-accrual status, generally if greater than 120 days past due. When loans are
placed on non-accrual status, all interest previously accrued but not collected
is reversed against current period interest income. Income on non-accrual loans
is subsequently recognized only to the extent that cash is received and the
loans principal balance is deemed collectible. Loans are restored to accrual
status when loans become well secured and are in the process of collection.
The Company considers a loan to be impaired when, based upon current
information and events, it believes it will be unable to collect all amounts due
according to the contractual terms of the loan agreement. Give the homogeneous
nature of the loan portfolio, loans are evaluated for impairment collectively.
Many factors are considered in the determination of impairment. The measurement
of collateral dependent loans is based on the fair value of the loan's
collateral.
Allowance for Loan Losses
The Company maintains an allowance for losses on mortgage loans
held-for-investment and Bond Collateral at an amount which it believes is
sufficient to provide adequate protection against future losses in the mortgage
loan portfolio. The allowance for losses is determined primarily on the basis of
management's judgment of net loss potential including specific allowances for
known impaired loans, changes in the nature and volume of the portfolio, value
of the collateral and current economic conditions that may affect the borrower's
ability to pay. A provision is recorded for all loans or portions thereof deemed
to be uncollectible
F-8
51
thereby increasing the allowance for loan losses. Subsequent recoveries on
mortgage loans previously charged off are credited to the allowance.
Interest Rate Agreements
The Company uses interest rate cap agreements (the "Cap Agreements") for
interest rate risk protection. The Cap Agreements are purchased primarily to
reduce the Company's exposure to rising interest rates which would increase the
cost of liabilities above the maximum yield which could be earned on the
adjustable rate Mortgage Assets. The Company periodically evaluates the
effectiveness of these Cap Agreements under various interest rate scenarios.
The cost of the Cap Agreements are amortized over the life of the Cap
Agreements using the straight-line method. The Company has credit risk to the
extent counterparties to the Cap Agreements do not perform their obligations
under the Cap Agreements. In order to lessen this risk and to achieve
competitive pricing , the Company has entered into Cap Agreements only with
counterparties which are investment grade rated.
Income Taxes
The Company has elected to be taxed as a REIT and complies with REIT
provisions of the Internal Revenue Code (the "Code") and the corresponding
provisions of State law. Accordingly, the Company will not be subject to federal
or state income tax to the extent of its distributions to stockholders. In order
to maintain its status as a REIT , the Company is required, among other
requirements, to distribute at least 95% of its taxable income.
Income per Share
Effective December 31, 1997, the Company adopted Statement of Financial
Accounting Standards No. 128, "Earnings per Share" ("SFAS No. 128"). This
statement replaces the previously reported primary and fully diluted income per
share with basic and diluted income per share. Unlike primary income per share,
basic income per share excludes any dilutive effects of options. Diluted income
per share is very similar to the previously reported fully diluted income per
share. Basic net income per share is computed on the basis of the weighted
average number of shares outstanding for the period. Diluted net income per
share is computed on the basis of the weighted average number of shares and
dilutive common equivalent shares outstanding for the period.
The following table illustrates the computation of basic and diluted income
per share:
FOR THE PERIOD FROM
FEBRUARY 11, 1997
FOR THE (COMMENCEMENT OF
YEAR ENDED OPERATIONS) THROUGH
DECEMBER 31, 1998 DECEMBER 31,1997
----------------- -------------------
(IN THOUSANDS, EXCEPT SHARE DATA)
Numerator:
Numerator for basic income per share
net earnings........................ $ (1,214) $ 2,403
Denominator:
Denominator for basic income per
share -- weighted average number of
common shares outstanding during the
period.............................. 8,090,772 2,879,487
Incremental common shares attributable to
exercise of outstanding options........ -- 49,522
---------- ----------
Denominator for diluted income per
share.................................. 8,090,772 2,929,009
Basic income per share................... $ (0.15) $ 0.83
Diluted income per share................. $ (0.15) $ 0.82
F-9
52
At December 31, 1998, there were 695,900 of options that were antidilutive
and, therefore, not included in the calculation above.
Recent Accounting Developments
Comprehensive Income (Loss)
Effective with the quarter ended March 31, 1998, the Company adopted
Statement of Financial Accounting Standards ("SFAS") No. 130, "Reporting
Comprehensive Income." SFAS No. 130 requires all items that are required to be
recognized under accounting standards as components of comprehensive income to
be reported in a financial statement that is displayed in equal prominence with
the other financial statements and to disclose as a part of stockholders' equity
in accumulated other comprehensive income (loss). Comprehensive income is
defined as the change in equity during a period from transactions and other
events and circumstances from non-owner sources. Comprehensive income generally
includes net income, foreign currency items, minimum pension liability
adjustments, and unrealized gains and losses on investments in certain debt and
equity securities (i.e., securities available-for-sale).
Disclosure about Segments of an Enterprise and Related Information
In June 1997, the Financial Accounting Standards Board (FASB) issued SFAS
No. 131, "Disclosure about Segments of an Enterprise and Related Information."
SFAS No. 131 establishes standards for the way that public enterprises report
information about operating segments in annual financial statements and requires
that selected information about these operating segments be reported in interim
financial statements. This statement supersedes SFAS No. 14 "Financial Reporting
for Segments of a Business Enterprise." SFAS No. 131 requires that all public
enterprises report financial and descriptive information about its reportable
operating segments. Operating segments are defined as components evaluated
regularly by the chief operating decision maker in deciding how to allocate
resources and in assessing performance. This statement is effective for fiscal
years beginning after December 15, 1997. In the initial year of application,
comparative information for earlier years should be restated.
The Company recognizes two segments, one which is the REIT and the other
which operates as a taxable subsidiary of the Company which is involved in
transactions that are not allowed by the REIT structure. The financial results
of the taxable subsidiary are disclosed separately.
Accounting for Derivative Instruments and Hedging Activities
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities." SFAS No. 133 establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, (collectively referred to as
derivatives) and for hedging activities. It requires that an entity recognize
all derivatives as either assets or liabilities in the statement of financial
position and measure those instruments at fair value. If certain conditions are
met, a derivative may be specifically designated as (a) a hedge of the exposure
to changes in the fair value of a recognized asset or liability or an
unrecognized firm commitment, (b) a hedge of the exposure to variable cash flows
of a forecasted transaction, or (c) a hedge of the foreign currency exposure of
a net investment in a foreign operation, an unrecognized firm commitment, an
available-for-sale security, or a foreign-currency-denominated forecasted
transaction.
Under SFAS No. 133, an entity that elects to apply hedge accounting is
required to establish at the inception of the hedge the method it will use for
assessing the effectiveness of the hedging derivative and the measurement
approach for determining the ineffective aspect of the hedge. Those methods must
be consistent with the entity's approach to managing risk.
SFAS No. 133 amends SFAS No. 52, "Foreign Currency Translation," to permit
special accounting for a hedge of a foreign currency forecasted transaction with
a derivative. It supersedes SFAS No. 80, "Accounting for Futures Contracts,"
SFAS No. 105, "Disclosure of Information about Financial Instruments with Off-
Balance-Sheet Risk and Financial Instruments with Concentrations of Credit
Risk," and SFAS No. 119,
F-10
53
"Disclosure about Derivative Financial Instruments and Fair Value of Financial
Instruments." It amends SFAS No. 107, "Disclosures about Fair Value of Financial
Instruments," to include in SFAS No. 107 the disclosure provisions about
concentrations of credit risk from SFAS No. 105. This Statement also nullifies
or modifies the consensuses reached in a number of issues addressed by the
Emerging Issues Task Force. This Statement is effective for all fiscal quarters
of fiscal years beginning after June 15, 1999.
NOTE 2. MORTGAGE SECURITIES AVAILABLE-FOR-SALE, NET
At December 31, 1998 and 1997, the Company's Mortgage Securities consisted
of the following mortgage participation certificates issued or guaranteed by
Federal government sponsored agencies:
FEDERAL HOME FEDERAL NATIONAL
LOAN MORTGAGE MORTGAGE
CORPORATION ASSOCIATION TOTAL
------------- ---------------- --------
(DOLLARS IN THOUSANDS)
AT DECEMBER 31, 1998
Mortgage Securities
available-for-sale, principal... $ 4,345 $ 2,232 $ 6,577
Unamortized premium............... 17 23 40
-------- -------- --------
Amortized cost.................... 4,362 2,255 6,617
Unrealized loss................... -- -- --
-------- -------- --------
Fair Value........................ $ 4,362 $ 2,255 $ 6,617
======== ======== ========
AT DECEMBER 31, 1997
Mortgage Securities
available-for-sale, principal... $251,201 $124,255 $375,456
Unamortized premium............... 9,748 5,195 14,943
-------- -------- --------
Amortized cost.................... 260,949 129,450 390,399
Unrealized loss................... (2,441) (859) (3,300)
-------- -------- --------
Fair Value........................ $258,508 $128,591 $387,099
======== ======== ========
At December 31, 1998, all investments in Mortgage Securities consisted of
interests in adjustable rate mortgage loans on residential properties. The
securitized interest in pools of adjustable rate mortgages from the Federal Home
Loan Mortgage Corporation and the Federal National Mortgage Association are
guaranteed as to principal and interest. The original maturity is subject to
change based on the prepayments of the underlying mortgage loans.
At December 31, 1998, the weighted average net coupon on the Mortgage
Securities was 7.60% per annum based on the amortized cost of the Mortgage
Securities. All Mortgage Securities have a repricing frequency of one year or
less.
NOTE 3. MORTGAGE LOANS HELD-FOR-INVESTMENT, NET, PLEDGED
The Company purchases certain non-conforming Mortgage Loans to be held as
long-term investments. At December 31, 1998 and 1997, Mortgage Loans held for
investment consist of the following:
1998 1997
--------- ---------
(DOLLARS IN THOUSANDS)
Mortgage loans held-for-investment, principal........ $171,420 $151,949
Unamortized premium.................................. 8,406 11,573
Allowance for loan losses............................ (817) (760)
-------- --------
$179,009 $162,762
======== ========
F-11
54
A summary of the activity in the allowance for loan losses is as follows:
1998 1997
-------- --------
(DOLLARS IN
THOUSANDS)
Balance
Beginning of year.................................. $ 760 $ --
Provision
Charged to operating expense....................... 1,109 --
Allowance acquired................................... 1,678 760
Transfer to Bond Collateral.......................... (2,730) --
-------- --------
Balance
End of year........................................ $ 817 $ 760
======== ========
At December 31, 1998, the weighted average net coupon on the Mortgage Loans
was 9.31% per annum based on the amortized cost of the Mortgage Loans. All
Mortgage Loans have a repricing frequency of five years or less. At December 31,
1998, approximately 46% of the collateral was located in California with no
other state representing more than 7%.
As of December 31, 1998, there were $2.3 million of Mortgage Loans and
$10.7 million of Bond Collateral loans placed on non-accrual status. There were
no loans on non-accrual at December 31, 1997. Interest income of $981 thousand
would have been recorded for the year ended December 31, 1998 if nonaccrual
loans had been on a current basis, in accordance with their original terms.
Impaired loans included in the Company's loan portfolio as of December 31, 1998
were approximately $36.9 million, which had an aggregate specific related
allowance amount of approximately $4.0 million.
NOTE 4. BOND COLLATERAL
AmRIT has pledged collateral in order to secure the Long-Term Debt issued
in the form of Bond Collateral. This Bond Collateral consists primarily of
adjustable-rate, conventional, 30-year mortgage loans secured by first liens on
one- to four-family residential properties. All Bond Collateral is pledged to
secure repayment of the related Long-Term Debt obligation. All principal and
interest (less servicing and related fees) on the Bond Collateral is remitted to
a trustee and is available for payment on the Long-Term Debt obligation. AmRIT's
exposure to loss on the Bond Collateral is limited to its net investment, as the
Long-Term Debt is non-recourse to AmRIT.
The components of the Bond Collateral at December 31, 1998 are summarized
as follows:
(DOLLARS IN THOUSANDS)
----------------------
Mortgage loans............................................ $390,875
Unamortized premium....................................... 31,899
Allowance for loan losses................................. (4,966)
--------
$417,808
--------
Weighted average gross coupon............................. 10.21%
Weighted average net coupon............................... 9.55%
Weighted average pass-through rate........................ 9.54%
F-12
55
A summary of the activity in the allowance for loan losses is as follows:
1998
----------------------
(DOLLARS IN THOUSANDS)
Balance
Beginning of year..................................... $ --
Provision
Charged to operating expense.......................... 2,361
Loans charged-off
Net of recoveries..................................... (125)
Allowance acquired...................................... --
Transfer from American Residential Investment Trust,
Inc................................................... 2,730
--------
Balance
End of year........................................... $ 4,966
========
NOTE 5. RETAINED INTEREST IN SECURITIZATION
Retained interest in securitization consist of assets generated and
retained in conjunction with the Company's loan securitization. These assets at
December 31, 1998 were as follows:
(DOLLARS IN THOUSANDS)
----------------------
REMIC subordinate certificates.......................... $ 6,699
Overcollateralization account........................... 1,513
Unrealized gain......................................... 550
--------
$ 8,762
========
The Company classifies REMIC securities as available-for-sale securities
and carries them at market value. The fair value of the retained interest is
determined by computing the present value of the excess of the weighted-average
coupon of the residential mortgages sold (9.32%) over the sum of: (1) the coupon
on the senior interest (5.95%), and (2) a servicing fee paid to servicer of the
residential mortgages (0.50%) and other fees, and taking into account expected
estimated losses to be incurred on the portfolio of residential mortgages sold
over the estimated lives of the residential mortgages and using an estimated
future average prepayment assumption (25%) per year. The prepayment assumption
used in estimating the cash flows is based on recent evaluations of the actual
prepayments of the related portfolio and on market prepayment rates on new
portfolios of similar residential mortgages, taking into consideration the
current interest rate environment and its expected impact on the estimated
future prepayment rate. The estimated cash flows expected to be received by the
Company are discounted at an interest rate that the Company believes is
commensurate with the risk of holding such a financial instrument. The rate used
to discount the cash flows coming out of the trust was approximately 12%. To the
extent that actual future excess cash flows are different from estimated excess
cash flows, the fair value of the Company's retained interest could decline.
Under the terms of the securitization, the retained interest is required to
build over collateralization to specified levels using the excess cash flows
described above until set percentages of the securitized portfolio are attained.
Future cash flows to the retained interest holder are all held by the REMIC
trust until a specific percentage of either the original or current certificate
balance is attained which percentage can be raised if certain charge-offs and
delinquency ratios are exceeded. The certificate holders' recourse for credit
losses is limited to the amount of over collateralization held in the REMIC
trust. Upon maturity of the certificates or upon exercise of an option ("clean
up call") to repurchase all the remaining residential mortgages once the balance
of the residential mortgages in the trust are reduced to 10% of the original
balance of the residential mortgages in the trust, any remaining amounts in the
trust are distributed. The current amount of any over collateralization balance
held by the trust is recorded as part of the retained interest.
F-13
56
In future periods, the Company will recognize additional revenue from the
retained interest if the actual performance of the mortgage loans is higher than
the original estimate or the Company may increase the estimated fair value of
the retained interest. If the actual performance of the mortgage loans is lower
than the original estimate, then an adjustment to the carrying value of the
retained interest may be required if the estimated fair value of the retained
interest is less than its carrying value.
NOTE 6. REAL ESTATE OWNED
Other real estate owned consists of seven properties with a principal
balance outstanding of approximately $615 thousand and an average principal
balance outstanding of approximately $87 thousand. Upon transfer of the loans to
real estate owned, the Company recorded a corresponding charge against the
allowance for loan losses to write down the real estate owned to fair value less
cost of disposal. Any subsequent adjustments to real estate owned will be
provided for with the establishment of a valuation allowance. At December 31,
1998, real estate owned had the following characteristics:
(DOLLARS IN THOUSANDS)
----------------------
Real estate owned............... $ 615
Allowance for losses............ (125)
-----
$ 490
=====
NOTE 7. INTEREST RATE AGREEMENTS
The amortized cost of the Company's interest rate agreements was $674
thousand net of accumulated amortization of $368 thousand and $411 net of
accumulated amortization of $132 thousand at December 31, 1998 and 1997,
respectively.
Cap Agreements
The Company had four outstanding Cap Agreements at December 31, 1998.
Potential future earnings from each of these Cap Agreements are based on
variations in the one month London Interbank Offered Rate ("LIBOR"). The Cap
Agreements at December 31, 1998 have contractually stated notional amounts which
vary over the life of the Cap Agreements. Under these Cap Agreements the Company
will receive cash payments should the agreed-upon reference rate, one month
LIBOR, increase above the strike rates of the Cap Agreements. No earnings were
recognized in 1998 or 1997 for Cap Agreements.
All of the adjustable-rate mortgage securities and mortgage loans are
limited by periodic caps (generally interest rate adjustments are limited to no
more than 1% every six months) and lifetime interest rate caps.
Floor Agreements
The Company had two outstanding Floor Agreements at December 31, 1998.
Potential future expenses from each of these Floor Agreements are based on
variations in the one month LIBOR rate. Each of the Floor Agreements at December
31, 1998 have contractually stated notional amounts which vary over the life of
the Floor Agreements. Under these Floor Agreements the Company will make cash
payments should the agreed-upon reference rate, one month LIBOR, decrease below
the strike rates of the Floor Agreements. Approximately $300 thousand hedging
expense was recognized in the fourth quarter of 1998. No expense was recorded in
1997 for Floor Agreements.
F-14
57
Interest rate agreements outstanding at December 31, 1998 are as follows:
AVERAGE CAP FLOOR
NOTIONAL FACE CAP STRIKE FLOOR STRIKE
AMOUNT RATE RATE INDEX EXPIRES
------------- ---------- ------------ ----------- -----------
(DOLLARS IN THOUSANDS)
Lehman Brothers............... 56,159 8.101% -- 1 mo. LIBOR April, 2000
CS First Boston............... 85,378 8.114% -- 1 mo. LIBOR April, 2000
Bear Stearns.................. 450,000 5.800% 5.500% 1 mo. LIBOR May, 1999
Bankers Trust................. 300,000 6.000% 5.250% 1 mo. LIBOR Nov., 1999
NOTE 8. SHORT-TERM DEBT
The Company has entered into uncommitted reverse repurchase agreements
(collectively "short-term" debt), which may be withdrawn at any time, to finance
the acquisition of a portion of its Mortgage Assets. The maximum aggregate
amount available under the uncommitted reverse repurchase agreements is
approximately $230 million and $2.5 billion at December 31, 1998 and 1997,
respectively. These reverse repurchase agreements are collateralized by a
portion of the Company's Mortgage Assets.
Reverse repurchase agreements for Mortgage Loans are currently placed with
two investment banking firms. During 1998, agreements were in place with three
firms and the maximum amount outstanding was approximately $668.7 million. At
December 31, 1998 and 1997, Mortgage Assets pledged had an estimated fair value
of approximately $171.4 million and $471.5 million, respectively.
At December 31, 1998, the Company had approximately $166.2 million of
Mortgage Loans reverse repurchase agreements outstanding with a weighted average
borrowing rate of 5.68% per annum and a weighted average remaining maturity of
one day. At December 31, 1997, the Company had approximately $451.3 million of
reverse repurchase agreements outstanding with a weighted average borrowing rate
of 6.01% per annum and a weighted average remaining maturity of 39 days. The
maximum month end balance and the average balance outstanding for the twelve
months ended December 31, 1998 were approximately $942.0 million and $499.2
million, respectively. The maximum month end balance and the average balance
outstanding for the period from February 11, 1997 (commencement of operations)
through December 31, 1997, was $451.3 million and $230.3 million, respectively.
At December 31, 1998 and at December 31, 1997, the Mortgage Assets reverse
repurchase agreements had the following characteristics:
REPURCHASE UNDERLYING INTEREST RATE
LIABILITY COLLATERAL (PER ANNUM)
---------- ---------- -------------
(DOLLARS IN THOUSANDS)
AT DECEMBER 31, 1998
Bear Stearns................................. $161,773 $166,937 5.66%
Residential Funding Corporation.............. 4,441 4,483 6.32
-------- -------- ----
$166,214 $171,420 5.68%
======== ======== ====
AT DECEMBER 31, 1997
PaineWebber Incorporated..................... $ 58,198 $ 60,742 5.96%
Prudential................................... 94,388 97,758 5.74
Federal National Mortgage Association........ 39,932 41,501 5.72
Federal Home Loan Mortgage Corporation....... 41,166 42,555 5.75
Lehman Brothers.............................. 151,949 162,762 6.47
First Boston................................. 57,159 57,886 5.73
First United................................. 8,496 8,308 5.77
-------- -------- ----
$451,288 $471,512 6.01%
======== ======== ====
F-15
58
NOTE 9. LONG-TERM DEBT, NET
During the second quarter of 1998, AmRIT, through its wholly owned
subsidiary, Eagle, issued approximately $457.0 million of collateralized
mortgage bonds (Long-Term Debt) through a Financial Asset Securitization
Investment Trust (FASIT). The bonds were assigned to a FASIT trust and trust
certificates evidencing the assets of the trust were sold to investors. The
trust certificates were issued in classes representing senior, mezzanine, and
subordinate payment priorities. Payments received on single-family mortgage
loans ("Bond Collateral") are used to make payments on the Long-Term Debt. The
obligations under the Long Term Debt are payable solely from the Bond Collateral
and are otherwise non-recourse to AmRIT. The maturity of each class of trust
certificates is directly affected by the rate of principal repayments on the
related Bond Collateral. The Long-Term Debt is also subject to redemption
according to the specific terms of the indenture pursuant to which the bonds
were issued and the FASIT trust. As a result, the actual maturity of the
Long-Term Debt is likely to occur earlier than its stated maturity.
The components of the Long-Term Debt at December 31, 1998 along with
selected other information are summarized below:
(DOLLARS IN THOUSANDS)
----------------------
Long-Term debt.......................................... $ 385,239
CMO premium, net........................................ 396
Capitalized costs on long-term debt..................... (345)
-----------
Total Long-Term debt.................................... $ 385,290
===========
Range of Certificate pass-through rates................. 5.74%-7.05%
Stated maturities....................................... 2008-2028
NOTE 10. FAIR VALUE OF FINANCIAL INSTRUMENTS
The estimated fair value of financial instruments amounts have been
determined by the Company's management using available market information and
appropriate valuation methodologies; however, considerable judgement is
necessarily required to interpret market data to develop estimates of fair
value. Accordingly, the estimates presented herein are not necessarily
indicative of the amounts the Company could realize in a current market
exchange. The use of different market assumptions and/or estimation
methodologies may have a material effect on the estimated fair value amounts.
The fair value as of December 31, 1998 and 1997 is as follows:
1998 1997
-------------------- --------------------
CARRYING FAIR CARRYING FAIR
AMOUNT VALUE AMOUNT VALUE
-------- -------- -------- --------
(DOLLARS IN THOUSANDS)
Assets:
Cash and cash equivalents.................... $ 34,645 $ 34,645 $ 5,893 $ 5,893
Mortgage Securities available-for-sale....... 6,617 6,617 387,099 387,099
Mortgage Loans held-for-investment........... 179,009 179,009 162,762 162,762
Bond collateral.............................. 417,808 417,808 -- --
Retained interest in securitization.......... 8,762 8,762 -- --
Interest rate agreements..................... 674 (1,529) 411 67
Due from affiliate........................... 606 606 269 269
Liabilities:
Short-term debt.............................. 166,214 166,214 451,288 451,288
Long-term debt............................... 385,290 385,290 -- --
Due to affiliate............................. 386 386 -- --
F-16
59
The following describes the methods and assumptions used by the Company in
estimating fair values.
Cash and Cash Equivalents
The carrying amount for cash and cash equivalents approximates fair value
because these instruments are demand deposits and money market mutual funds and
do not present unanticipated interest rate or credit concerns.
Retained Interest in Securitization
This security is classified as available-for-sale and as such is carried at
fair value. See "Notes to the Consolidated Financial Statements -- Note 5.
Retained Interest in Securitization" for a description of the valuation
methodology.
Mortgage Securities available-for-sale and Mortgage Loans Held-for-Investment
The fair value for Mortgage Securities available-for-sale and Mortgage
Loans and held-for-investment is estimated based on quoted market prices from
dealers and brokers for similar types of Mortgage Assets.
Bond Collateral
The fair value for Bond Collateral is estimated based on quoted market
prices from dealers and brokers for similar types of mortgage loans.
Interest Rate Agreements
The fair value of interest rate agreements is estimated based on quoted
market prices from dealers and brokers.
Due from Affiliate
The fair value of due from affiliate approximates the carrying amount
because of the short-term maturity of the asset.
Short-Term Debt
The fair value of reverse repurchase agreements approximates the carrying
amounts because of the short term maturity of the liabilities.
Long-Term Debt
The fair value of long-term debt is estimated based upon comparable rates
on similar debt instruments.
Due to Affiliate
The fair value of due to affiliate approximates the carrying amount because
of the short-term maturity of the liability.
NOTE 11. STOCK OPTION PLANS
The Company has adopted the 1997 Stock Incentive Plan (the "Incentive
Plan") and the 1997 Stock Option Plan (the "Option Plan") for executive officers
and key employees and has adopted the 1997 Outside Directors Option Plan (the
"Directors Plan") for directors who are not employees of the Company.
The Incentive Plan, the Option Plan and the Directors Plan authorize the
Board of Directors (or a committee appointed by the Board of Directors) to grant
incentive stock options ("ISOs"), as defined under section 422 of the Code,
options not so qualified ("NQSOs"), and stock appreciation rights ("Awards") to
such eligible recipients.
F-17
60
During the period from February 11, 1997 (commencement of operations)
through December 31, 1998, the Company granted 695,900 options as follows:
TOTAL OPTIONS
ISO NON-QUALIFIED OPTIONS W/SAR'S
------- ------------- ------- -------
1997 STOCK INCENTIVE PLAN
February 11, 1997 @ 12.50/share................ 99,200 216,000 315,200 280,000
1997 STOCK OPTION PLAN
October 27, 1997 @ 15.00/share................. 104,801 232,999 337,800 --
1997 STOCK OPTION PLAN
December 15, 1997 @ 15.00/share................ 4,267 72,133 76,400 --
1997 OUTSIDE DIRECTORS STOCK OPTIONS
October 27, 1997 @ 15.00/share................. -- 30,000 30,000 --
------- ------- ------- -------
OPTIONS ISSUED IN 1997......................... 208,268 551,132 759,400 280,000
------- ------- ------- -------
1997 STOCK OPTION PLAN
April 8, 1998 @ 13.69/share.................... 9,000 -- 9,000 --
1997 STOCK OPTION PLAN
October 1, 1998 @ 6.13/share................... 2,500 -- 2,500 --
------- ------- ------- -------
OPTIONS ISSUED IN 1998......................... 11,500 -- 11,500 --
------- ------- ------- -------
OPTIONS FORFEITED IN 1998...................... (26,667) (48,333) (75,000) --
------- ------- ------- -------
TOTAL OPTIONS ISSUED........................... 193,101 502,799 695,900 280,000
======= ======= ======= =======
The Incentive Plan was adopted on February 11, 1997 (the "Effective Date"),
and a total 315,200 shares of Common Stock have been reserved for issuance. All
stock options have been granted under the Incentive Plan and vest at the earlier
of a four-year period from the date of grant or once the Company issues an
aggregate of $150 million of new equity, and will expire within ten years after
the date of grant.
The Company also has adopted the 1997 Employee Stock Purchase Plan (the
"Purchase Plan") which permits eligible employees to purchase Common Stock at a
discount through accumulated payroll deductions. No shares were issued under the
Purchase Plan as of December 31, 1998.
As of December 31, 1998, The following options were reserved for issuance
under the Company's option plans:
1997
1997 OUTSIDE
1997 1997 EMPLOYEE DIRECTOR
STOCK STOCK STOCK STOCK
INCENTIVE PLAN OPTION PLAN PURCHASE PLAN OPTION PLAN TOTAL
-------------- ----------- ------------- ----------- ---------
Total Options Authorized......... 315,200 774,800 20,000 60,000 1,170,000
Total Options Issued............. 315,200 350,700 -- 30,000 695,900
------- ------- ------- ------- ---------
Options Reserved for Issuance.... -- 424,100 20,000 30,000 474,100
======= ======= ======= ======= =========
In November 1995, the FASB issued Statement of Financial Accounting
Standards No. 123 (SFAS 123), "Accounting for Stock Based Compensation." This
statement establishes financial accounting standards for stock-based employee
compensation plans. SFAS 123 permits the Company to choose either a new fair
value based method or the current APB Opinion 25 Intrinsic value based method of
accounting for its stock-based compensation arrangements. SFAS 123 requires pro
forma disclosures of net income (loss) computed as if the fair value based
method had been applied for in financial statements of companies that continue
to follow current practice in accounting for such arrangements under Opinion 25.
SFAS 123 applies to all stock-based employee compensation plans in which an
employer grants shares of its stock or other equity instruments to employees
except for employees stock ownership plans. SFAS 123 also applies to plans in
which the employer incurs liabilities to employees in amounts based on the price
of the employer's
F-18
61
stock, i.e., stock option plans, stock purchase plans, restricted stock plans,
and stock appreciation rights. The statement also specifies the accounting for
transactions in which a company issues stock options or other equity instruments
for services provided by nonemployees or to acquire goods or services from the
outside supplies or vendors.
The Company elected to apply the APB Opinion 25 in accounting for its
plans: the 1997 Stock Incentive Plan, 1997 Stock Option Plan, 1997 Employee
Stock Purchase Plan and 1997 Outside Directors Stock Option Plan and,
accordingly, no compensation cost has been recognized in the financial
statements. Had the Company determined compensation cost based on the fair value
at the grant date for its stock options exercisable under SFAS No. 123, the
Company's net income and income per share for the year ended December 31, 1998
and for the period from February 11, 1997 (commencement of operations) through
December 31, 1997 would have decreased to the pro forma amounts indicated below.
FOR THE PERIOD FROM
FEBRUARY 11, 1997
FOR THE (COMMENCEMENT OF
YEAR ENDED OPERATIONS) THROUGH
DECEMBER 31, 1998 DECEMBER 31, 1997
----------------- -------------------
(DOLLARS IN THOUSANDS EXCEPT SHARE DATA)
Net income as reported................... $(1,214) $ 2,403
======= =======
Pro forma net income..................... $(1,351) $ 2,267
======= =======
Basic income per share as reported....... $ (0.15) $ 0.83
======= =======
Diluted income per share as reported..... $ (0.15) $ 0.82
======= =======
Pro forma basic income per share......... $ (0.17) $ 0.79
======= =======
Pro forma diluted income per share....... $ (0.17) $ 0.77
======= =======
The derived fair value of the options granted during the year ended
December 31, 1998 and the period from February 11, 1997 (commencement of
operations) through December 31, 1997 was approximately $137 thousand and $674
thousand, or a per option fair value of $0.93 and $0.89 respectively, using the
Black-Scholes option pricing model with the following assumptions for 1998; an
expected dividend yield of 10%; a risk-free interest rate of 5.15%, expected
life of 5 years for employees and 4 years for board members, and expected
volatility of 62%, and for 1997; a risk-free interest rate of 6.0%, expected
life of 5 years, and expected volatility of 20%.
NOTE 12. STOCKHOLDERS' EQUITY
On February 11, 1997, the Company issued 1,614,000 shares of Common Stock
at a price of $12.50 per share of Common Stock. The Company received proceeds of
approximately $20.2 million, net of issuance costs of $10 thousand. On November
3, 1997, the Company issued 6,500,000 shares of Common Stock at a price of
$15.00 per share of Common Stock. The Company received proceeds of approximately
$89.7 million, net of issuance costs of approximately $7.8 million. During 1998,
the Company repurchased 58,500 shares of Common Stock. The Company paid
approximately $492 thousand for the repurchased shares.
On December 19, 1997, the Company declared a dividend of $1.3 million or
$0.16 per share. The dividend was paid on January 21, 1998 to holders of record
of Common Stock as of December 31, 1997. On October 21, 1997, the Company
declared a dividend of $519 thousand or $0.32 per share of Common Stock. This
dividend was paid on October 29, 1997 to holders of record of Common Stock as of
September 30, 1997. On July 17, 1997, the Company declared a dividend of $438
thousand or $0.27 per share of Common Stock. This dividend was paid on July 17,
1997 to holders of record of Common Stock as of June 30, 1997. On May 1, 1997,
the Company declared a dividend of $146 thousand or $0.09 per share of Common
Stock. This dividend was paid on May 1, 1997 to holders of record of Common
Stock as of March 31, 1997.
On December 17, 1998, the Company declared a dividend of $1.2 million or
$0.15 per share. The dividend was paid on January 28, 1999 to holders of record
of Common Stock as of December 31, 1998. On
F-19
62
October 15, 1998, the Company declared a dividend of $967 thousand or $0.12 per
share. This dividend was paid on November 2, 1998 to holders of record of Common
Stock as of October 26, 1998. On July 13, 1998, the Company declared a dividend
of $2.3 million or $0.28 per share. This dividend was paid on July 31, 1998 to
holders of record of Common Stock as of July 24, 1998. On April 14, 1998, the
Company declared a dividend of $2.3 million or $0.28 per share. This dividend
was paid on April 30, 1998 to holders of record of Common Stock as of April 24,
1998.
NOTE 13. STOCK SPLIT AND AUTHORIZED SHARES
On August 6, 1997, the Company authorized a 0.8-for-one reverse stock split
of all of the outstanding shares of Common Stock. All references in the
financial statements to the number of shares, per share amounts and prices of
the Company's Common Stock have been retroactively restated to reflect the
decreased number of shares of Common Stock outstanding. On October 20, 1997, the
Company increased the number of total authorized shares of Common Stock to
25,000,000 from 4,000,000. Under the articles of incorporation, as amended on
October 20, 1997, the Company is authorized to issue any class of capital stock,
common stock or preferred stock, up to the aggregate authorized amount of
25,001,000 shares, all of which has been initially designated as Common Stock.
All unissued shares may be reclassified by the Company's Board of Directors as
one or more series of preferred stock.
NOTE 14. MANAGEMENT AGREEMENT
Effective February 11, 1997, the Company entered into a Management
Agreement with the Manager for an initial term of two years, to provide
management services to the Company. The agreement automatically renews unless
terminated by American Residential Investment Trust, Inc.
The Manager receives management fees and incentive compensation as follows:
- 1/8 of 1% per year, to be paid monthly, of the principal amount of
agency securities;
- 3/8 of 1% per year, to be paid monthly, of the principal amount of
all Mortgage Assets other than agency securities; and
- 25% of the amount by which the Company's net income (before
deducting the amount to be paid as incentive compensation) exceeds
the annualized return on equity equal to the average ten year U.S.
Treasury Rate plus 2%.
Management fees of approximately $2.4 million and $249 thousand were
recorded for the year ended December 31, 1998 and for the period from February
11, 1997 (commencement of operations) through December 31, 1997, respectively.
The incentive compensation is calculated for each fiscal quarter, and paid to
the Manager quarterly in arrears before any income distributions are made to
stockholders. Incentive compensation for the year ended December 31, 1998, and
for the period from February 11, 1997 (commencement of operations) through
December 31, 1997 was approximately $24 thousand and approximately $34 thousand,
respectively.
The Company will employ certain employees of the Manager involved in the
day-to-day operations of the Company, including the Company's executive
officers, so that such employees may maintain certain benefits that are
available only to employees of the Company under the Code. These benefits
include the ability to receive incentive stock options under the 1997 Stock
Option Plan and to participate in the Company's Employee Stock Purchase Plan. In
order to receive the aggregate benefits of the Management Agreement originally
negotiated between the Company and the Manager, the Company will pay the base
salaries of such employees and will be reimbursed by the Manager for all costs
incurred with respect to such payments.
The Manager's default on its obligations with respect to the Notes, could
result in a default and termination of the Management Agreement, in which case
the operations of the Company could be materially and adversely affected pending
either the engagement of a new manager or the development internally of the
resources necessary to manage the operation of the Company. The Manager is
currently in default of its covenants. The senior note holders have not issued
waivers, however the parties continue to operate under the
F-20
63
original terms of the Management Agreement. In addition, MDC-REIT has pledged
1.6 million shares of its Common Stock of the Company to secure the Manager's
obligations under the Securities Purchase Agreement. As a result of the defaults
under the Securities Purchase Agreement, the pledged shares could be transferred
to the holders of the Notes, who will then have certain demand registration
rights.
NOTE 15. RELATED PARTY TRANSACTIONS
During the year ended December 31, 1998, the Company purchased
approximately $24 million of Mortgage Loans from an affiliated entity of one of
its directors. These purchases were made in the normal course of business at
terms consistent with the Company's general purchasing policies.
On June 1, 1998, the Company sold approximately $98.2 million par value
Mortgage Loans to Holdings for total consideration of $103.5 million. Management
believes the loans were traded at fair value at the time of the transaction.
On June 30, 1998, Holdings transferred the Class "X" Certificate to the
Company as part of the purchase price of Mortgage Loans purchased from the
Company on June 1, 1998. The Class "X" Certificate had a fair value of $6.6
million at the time of the transfer.
NOTE 16. COMMITMENTS AND CONTINGENCIES
As of December 31, 1998, the Company had a commitment to purchase
approximately $86 million in loans.
NOTE 17. SELECTED QUARTERLY FINANCIAL DATA
Selected quarterly financial data for 1998 and 1997 is as follows (dollars
in thousands, except per share data):
FOR THE FOR THE FOR THE FOR THE
QUARTER QUARTER QUARTER QUARTER
ENDED ENDED ENDED ENDED
DEC. 31, 1998 SEPT. 30, 1998 JUNE 30, 1998 MARCH 31, 1998
------------- -------------- ------------- --------------
Total interest income............... $17,380 $18,642 $19,011 $14,453
Interest expense.................... 13,924 16,974 16,554 11,049
Net interest income................. 3,456 1,668 2,457 3,404
Provision for loan losses........... 2,756 296 282 136
Other operating income.............. 409 765 1,148 22
Other expenses...................... 7,870 1,136 1,054 1,013
Net income.......................... (6,761) 1,001 2,269 2,277
Net income per share of common
stock -- basic.................... (0.84) 0.12 0.28 0.28
Net income per share of common
stock -- diluted.................. (0.84) 0.12 0.28 0.28
FOR THE PERIOD FROM
FOR THE FOR THE FOR THE FEBRUARY 11, 1997
QUARTER QUARTER QUARTER (COMMENCEMENT OF
ENDED ENDED ENDED OPERATIONS) THROUGH
DEC. 31, 1997 SEPT. 30, 1997 JUNE 30, 1997 MARCH 31, 1997
------------- -------------- ------------- -------------------
Total interest income............ $ 5,858 $ 4,222 $ 3,842 $306
Interest expense................. 4,357 3,532 3,275 150
Net interest income.............. 1,501 690 567 156
Other expenses................... 201 171 129 10
Net income....................... 1,300 519 438 146
Net income per share of common
stock -- basic................. 0.22 0.32 0.27 0.09
Net income per share of common
stock -- diluted............... 0.21 0.31 0.26 0.09
F-21
64
NOTE 17. INVESTMENT IN AMERICAN RESIDENTIAL HOLDINGS, INC.
The following financial information summarizes the financial position and
results of operations of American Residential Holdings, Inc. (dollars in
thousands, except per share data):
AMERICAN RESIDENTIAL HOLDINGS INC.
BALANCE SHEET
(IN THOUSANDS, EXCEPT SHARE DATA)
DECEMBER 31, 1998
-----------------
ASSETS
Cash and cash equivalents................................... $ 8
Due from affiliate.......................................... 307
Class "X" Certificate -- CMO/FASIT.......................... 383
Other assets................................................ 500
------
$1,198
======
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Due to affiliate............................................ $ 406
------
Total liabilities......................................... 406
Stockholders' Equity:
Preferred stock, par value $1,000 per share; 10,000 shares
authorized; 475 shares issued and outstanding............. 475
Common stock, par value $.01 per share; 100 shares
authorized; 50 shares issued and outstanding.............. --
Additional paid-in-capital.................................. 25
Cumulative dividends declared............................... (885)
Retained earnings........................................... 1,177
------
Total stockholders' equity................................ 792
------
$1,198
======
AMERICAN RESIDENTIAL HOLDINGS, INC.
STATEMENT OF OPERATIONS
(IN THOUSANDS)
FOR THE PERIOD FROM
JANUARY 28, 1998
(INCEPTION) THROUGH
DECEMBER 31, 1998
-------------------
Income:
Gain on sale of loans..................................... $1,589
Interest income........................................... 379
Other income.............................................. 97
------
Total income........................................... 2,065
Expenses:
Other expenses............................................ 25
------
Income before taxes.................................... 2,040
Income taxes................................................ 863
------
Net income................................................ $1,177
======
F-22
65
REPORT OF INDEPENDENT AUDITORS
To the Board of Directors
American Residential Holdings, Inc.
Del Mar, California:
We have audited the accompanying balance sheet of American Residential
Holdings, Inc., (the Company) as of December 31, 1998 and the related statements
of operations, stockholders' equity and cash flows for the period from January
28, 1998 (inception) through December 31, 1998. These financial statements are
the responsibility of the Company's management. Our responsibility is to express
an opinion in these financial statements based on our audit.
We have conducted our audit in accordance with generally audited 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 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 audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly,
in all material respects, the financial position of the Company as of December
31, 1998 and the results of its operations and its cash flows for the period
from January 28, 1998 (inception) through December 31, 1998, in conformity with
generally accepted accounting principles.
KPMG LLP
San Diego, California
January 15, 1999
F-23
66
AMERICAN RESIDENTIAL HOLDINGS, INC.
BALANCE SHEET
(IN THOUSANDS, EXCEPT SHARE DATA)
DECEMBER 31, 1998
-----------------
ASSETS
Cash and cash equivalents................................... $ 8
Due from affiliate.......................................... 307
Class "X" Certificate -- CMO/FASIT.......................... 383
Other assets................................................ 500
------
$1,198
======
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Due to affiliate............................................ $ 406
------
Total liabilities......................................... 406
Stockholders' Equity:
Preferred stock, par value $1,000 per share; 10,000 shares
authorized; 475 shares issued and outstanding............. 475
Common stock, par value $.01 per share; 100 shares
authorized; 50 shares issued and outstanding.............. --
Additional paid-in-capital.................................. 25
Cumulative dividends declared............................... (885)
Retained earnings........................................... 1,177
------
Total stockholders' equity................................ 792
------
$1,198
======
See accompanying notes to financial statements.
F-24
67
AMERICAN RESIDENTIAL HOLDINGS, INC.
STATEMENT OF OPERATIONS
(IN THOUSANDS)
FOR THE PERIOD FROM
JANUARY 28, 1998
(INCEPTION) THROUGH
DECEMBER 31, 1998
-------------------
Income:
Gain on sale of loans..................................... $1,589
Interest income........................................... 379
Other income.............................................. 97
------
Total income........................................... 2,065
Expenses:
Other expenses............................................ 25
------
Income before taxes.................................... 2,040
Income taxes................................................ 863
------
Net income................................................ $1,177
======
See accompanying notes to financial statements.
F-25
68
AMERICAN RESIDENTIAL HOLDINGS, INC.
STATEMENT OF STOCKHOLDERS' EQUITY
(IN THOUSANDS, EXCEPT SHARE DATA)
PREFERRED STOCK COMMON STOCK ADDITIONAL CUMULATIVE
--------------- --------------- PAID-IN DIVIDENDS RETAINED
SHARES AMOUNT SHARES AMOUNT CAPITAL DECLARED EARNINGS TOTAL
------ ------ ------ ------ ---------- ----------- -------- ------
Proceeds from sale of stock... 475 $475 50 $ -- $25 $ -- $ -- $ 500
Net income.................... -- -- -- -- -- -- 1,177 1,177
Dividends declared............ -- -- -- -- -- (885) -- (885)
--- ---- -- ---- --- ------ ------ ------
Balance December 31, 1998..... 475 $475 50 $ -- $25 $ (885) $1,177 $ 792
=== ==== == ==== === ====== ====== ======
See accompanying notes to financial statements.
F-26
69
AMERICAN RESIDENTIAL HOLDINGS, INC.
STATEMENT OF CASH FLOWS
FOR THE PERIOD FROM
JANUARY 28, 1998
(INCEPTION) THROUGH
DECEMBER 31, 1998
-------------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net income.................................................. $ 1,177
Adjustments to reconcile net income to net cash provided
by operating activities:
Gain on securitization of loans........................ (1,589)
Increase in other assets............................... (807)
Increase in deferred tax asset......................... (75)
Increase in accrued expenses........................... 481
---------
Net cash provided by operating activities.............. (813)
CASH FLOWS FROM INVESTING ACTIVITIES
Purchase of mortgage loans available-for-sale............. (103,525)
Securitization of mortgage loans available-for-sale....... 105,114
Purchase of Class "X" certificate -- CMO/FASIT............ (475)
Paydowns on Class "X" certificate -- CMO/FASIT............ 92
---------
Net cash used in investing activities.................. 1,206
CASH FLOWS FROM FINANCING ACTIVITIES
Net proceeds from stock issuance.......................... 500
Dividends paid............................................ (885)
---------
Net cash used in financing activities.................. (385)
Net increase in cash and cash equivalents at end of
period.................................................... 8
Cash and cash equivalents at beginning of period............ --
---------
Cash and cash equivalents at end of period.................. $ 8
=========
See accompanying notes to financial statements.
F-27
70
AMERICAN RESIDENTIAL HOLDINGS, INC.
NOTES TO THE FINANCIAL STATEMENTS
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Basis of Financial Statement Presentation
The operations of American Residential Holdings, Inc. ("Holdings" or the
"Company") are presented for the period from January 28, 1998 (inception)
through December 31, 1998 as a taxable subsidiary of American Residential
Investment Trust, Inc. ("AmRES") and American Residential Eagle, Inc.,
("Eagle"), its wholly owned subsidiary (collectively "AmRIT"), and accounted for
under the equity method. Under the equity method, original equity investments in
Holdings are recorded by AmRIT at cost and adjusted for its share of operations
or losses and decreased by dividends received. Holdings operations or loss will
be disclosed as a separate line-item on AmRIT's income statement as Investment
in American Residential Holdings, Inc. Holdings was formed to conduct a portion
of AmRIT's mortgage loan acquisition and finance activities. In June of 1998,
Holdings issued a securitization of loans through a Real Estate Mortgage
Investment Conduit ("REMIC") which consisted of pooled adjustable-rate
first-lien mortgages to the public through a registration statement.
The preparation of financial statements in conformity with generally
accepted accounting principles requires management of the Company 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 revenue and expenses during
the period. Actual results could differ from those estimates.
Organization
American Residential Holdings, Inc., a Delaware corporation, was
incorporated on January 28, 1998 and commenced operations on June 1, 1998.
Holdings was capitalized from direct contributions from AmRIT and two executive
officers of AmRIT. AmRIT owns 100% of the preferred stock and has a non-voting
95% of the economic interest in Holdings. Two executive officers of AmRIT own
100% of the voting common stock outstanding and 5% of the economic value of
Holdings. Holdings operates as a mortgage real estate company and is a taxable
affiliate of AmRIT. Holdings was formed to acquire and finance mortgages through
securitizations on behalf of AmRIT.
Cash and Cash Equivalents
For purposes of the statement of cash flows, cash and cash equivalents
include cash on hand and highly liquid investment with original maturities of
three months or less.
Gain on Securitization of Loans
Gains resulting from securitizations of mortgage loans are recognized at
the date of settlement and are based on the difference between the selling price
of the securitizations and the carrying value of the related loans sold. Such
gains may be increased by the amount of any servicing released premiums
received. Nonrefundable fees and direct costs associated with the origination of
mortgage loans are deferred and recognized when the loans are sold.
During 1997, the Company adopted Financial Accounting Standards Board
(FASB) Statement of Financial Accounting Standards No. 125 (SFAS 125),
"Accounting for Transfers and Servicing of Financial Assets and Extinguishment
of Liabilities." Under SFAS 125, a transfer of financial assets in which control
is surrendered is accounted for as a sale to the extent that consideration other
than beneficial interests in the transferred assets is received in the exchange.
Liabilities and derivatives incurred or obtained by the transfer of financial
assets are required to be measured at fair value, if practicable. Also,
servicing assets and other retained interests in the transferred assets must be
measured by allocating the previous carrying value between the asset sold and
the interest retained, if any, based on their relative fair values at the date
of transfer.
F-28
71
SFAS 125 also requires an assessment of interest-only strips, loans, other
receivables and retained interests in securitizations (residuals). If these
assets can be contractually prepaid or otherwise settled such that the holder
would not recover substantially all of its recorded investment, the asset will
be measured like trading securities.
Income Taxes
Income taxes are accounted for under the asset and liability method of
accounting for income taxes. Deferred tax assets and liabilities are recognized
for the future tax consequences attributable to differences between the
financial statement carrying amounts of existing assets and liabilities and
their respective tax basis. Deferred tax assets and liabilities are measured
using enacted tax rates expected to apply to taxable income in the years in
which those temporary differences are expected to be recovered or settled. The
effect on deferred tax assets and liabilities of a change in tax rates is
recognized in income in the period that includes the enactment date.
NOTE 2. GAIN ON SECURITIZATION OF LOANS
Gain on securitization of loans for the period from January 28, 1998
(inception) through December 31, 1998 was comprised of the following components:
(DOLLARS IN THOUSANDS)
----------------------
Non-cash gain from
securitizations............... $3,966
Securitization expenses......... (642)
Accrued interest................ (763)
Provision for losses............ (1,954)
Sale of servicing............... 982
------
Total......................... $1,589
======
NOTE 3. CLASS "X" CERTIFICATE -- CMO/FASIT
At December 31, 1998, the Company's Class "X" Certificate was $383
thousand, at cost, which approximates fair value.
The Company has invested in a subordinate certificate from a Collateralized
Mortgage Obligation/ Financial Asset Securitization Investment Trust
("CMO/FASIT") bond issued by a related party. This security is collateralized by
residential mortgage loans, on which the timely payment of principal and
interest is backed by specified government agencies (e.g., FNMA, FHLMC). The
principal risks inherent in holding CMOs are prepayment risks related to
dramatic decreases or increases in interest rates whereby the value of the CMOs
would be subject to variability on the repayment of principal from the
underlying mortgages earlier or later than originally anticipated. The
contractual maturities of the CMOs occur systematically through the year ending
December 31, 2028.
The Company classifies CMO/FASIT certificates as available-for-sale
securities in accordance with FAS 115, "Accounting for Certain Investments in
Debt and Equity Securities" and carries them at fair value, with unrealized
gains and losses excluded from operations and reported as a separate component
of stockholders' equity as accumulated other comprehensive income (loss). A
decline in the market value of any available-for-sale security below cost that
is deemed to be other than temporary, results in an impairment which is charged
to operations and a new cost basis for the security is established.
Interest income is recognized as monthly distributions take place from the
trustee. This distribution takes place once bond holders are paid and over
collateralization levels are maintained, any excess interest flows are paid to
the investor certificate and then to the Class "X" Certificate. Management has
developed a methodology of allocating proceeds received between amortization of
the Class "X" Certificate and interest, such that the interest income is
recognized using the interest method.
F-29
72
NOTE 4. INCOME TAXES
The components of income taxes consist of the following:
FOR THE PERIOD FROM
JANUARY 28, 1998
(INCEPTION) THROUGH
DECEMBER 31, 1998
----------------------
(DOLLARS IN THOUSANDS)
Current income taxes:
Federal................................................... $717
State..................................................... 221
----
Total current income taxes:............................ 938
Deferred income taxes -- Federal............................ (75)
----
Total income taxes................................... $863
====
The Company's effective income taxes differ from the amount computed by
applying the federal income tax rate of 34% to income before taxes as a result
of the following:
FOR THE PERIOD FROM
JANUARY 28, 1998
(INCEPTION) THROUGH
DECEMBER 31, 1998
----------------------
(DOLLARS IN THOUSANDS)
Computed "expected" income taxes............................ $694
State taxes, net of federal................................. 146
Other....................................................... 23
----
Total.................................................. $863
====
The tax effects that give rise to significant portions of the deferred tax
assets and deferred tax liabilities at December 31, 1998 are presented below:
FOR THE PERIOD FROM
JANUARY 28, 1998
(INCEPTION) THROUGH
DECEMBER 31, 1998
----------------------
(DOLLARS IN THOUSANDS)
Deferred tax assets:
Deferred state liability.................................. $ 75
----
Total deferred tax assets.............................. $ 75
====
The Company believes that the deferred tax asset will more likely than not
be realized due to the reversal of the deferred tax liability and expected
future taxable income.
NOTE 5. FAIR VALUE OF FINANCIAL INSTRUMENTS
The estimated fair value of financial instruments amounts have been
determined by the Company's management using available market information and
appropriate valuation methodologies; however, considerable judgement is
necessarily required to interpret market data to develop estimates of fair
value. Accordingly, the estimates presented herein are not necessarily
indicative of the amounts the Company could realize in a current market
exchange. The use of different market assumptions and/or estimation
methodologies may have a material effect on the estimated fair value amounts.
The fair value as of December 31, 1998 is as follows:
F-30
73
CARRYING FAIR
AMOUNT VALUE
-------- -----
(DOLLARS IN
THOUSANDS)
Assets:
Cash and cash equivalents............................... $ 8 8
Due from affiliate...................................... 307 307
Class "X" Certificate -- CMO/FASIT...................... 383 383
Due to affiliate........................................ 406 406
The following describes the methods and assumptions used by the Company in
estimating fair value:
Cash and Cash Equivalents
The carrying amount for cash and cash equivalents approximates fair value
because these instruments are demand deposits and money market mutual funds and
do not present unanticipated interest rate or credit concerns.
Due from Affiliate
The fair value of Due from Affiliate approximates the carrying amount
because of the short-term maturity of the asset.
Class "X" Certificate -- CMO/FASIT
The Class "X" Certificate is classified as available-for-sale and as such
is carried at fair value. For further information, see "Notes to the Financial
Statements -- Note 3. "Class "X" Certificate CMO/FASIT".
Due to Affiliate
The fair value of Due to Affiliate approximates the carrying amount because
of the short-term maturity of the liability.
NOTE 6. RELATED PARTY TRANSACTIONS
On June 1, 1998, Eagle sold approximately $98.2 million par value Mortgage
Loans to Holdings for total consideration of $103.5 million. Management believes
the sales price represented fair value at the time of the transaction.
On June 30, 1998, Holdings transferred the Certificate "X" to Eagle as part
of the price of Mortgage Loans purchased from Eagle June 1, 1998. The
Certificate "X" had a fair value of $6.6 million at the time of the transfer.
NOTE 7. QUARTERLY FINANCIAL DATA (UNAUDITED)
Information for the quarter ended March 31, 1998 is not applicable as there
were no operations during the first quarter of 1998. Selected quarterly
financial data for 1998:
FOR THE FOR THE FOR THE
QUARTER ENDED QUARTER ENDED QUARTER ENDED
DECEMBER 31, 1998 SEPTEMBER 30, 1998 JUNE 30, 1998
----------------- ------------------ -------------
(DOLLARS IN THOUSANDS)
Income.............................. $208 $272 $1,585
Expense............................. 216 19 653
Net income.......................... (8) 253 932
F-31
74
SIGNATURES
Pursuant to the requirements of the Securities Act of 1933, the Registrant
certifies that it has reasonable grounds to believe that it meets all of the
requirements for filing on Form 10-K and has duly caused this Form 10-K to be
signed on its behalf by the undersigned, thereto duly authorized, in the City of
San Diego, State of California, on the 26th day of March, 1999.
AMERICAN RESIDENTIAL
INVESTMENT TRUST, INC.
/s/ JOHN M. ROBBINS
By:
--------------------------------------
John M. Robbins
Chief Executive Officer
SIGNATURE TITLE DATE
--------- ----- ----
By: /s/ JOHN M. ROBBINS Chairman of the Board and Chief March 26, 1999
---------------------------------------- Executive Officer (Principal
John M. Robbins Executive
Officer)
By: /s/ MARK A. CONGER Chief Financial Officer (Principal March 26, 1999
---------------------------------------- Financial and Accounting Officer)
Mark A. Conger
By: /s/ JAY M. FULLER Chief Operating Officer March 26, 1999
---------------------------------------- President and Director
Jay M. Fuller
By: /s/ JAMES BROWN Director March 26, 1999
----------------------------------------
H. James Brown
By: /s/ DAVID DE LEEUW Director March 26, 1999
----------------------------------------
David De Leeuw
By: /s/ RAY MCKEWON Director March 26, 1999
----------------------------------------
Ray McKewon
By: /s/ RICHARD J. PRATT, PH.D. Director March 26, 1999
----------------------------------------
Richard J. Pratt, Ph.D.
By: /s/ MARK J. RIEDY, PH.D. Director March 26, 1999
----------------------------------------
Mark J. Riedy, Ph.D.
75
EXHIBIT INDEX
EXHIBIT
NUMBER DESCRIPTION
- --------- -----------
*3.1 Articles of Amendment and Restatement of the Registrant
*3.2 Amended and Restated Bylaws of the registrant
*4.1 Registration Rights agreement dated February 11, 1997
**4.2 Articles Supplementary filed on February 22, 1999
**4.3 Rights Plan by and between the Company and American Stock
Transfer and Trust Company dated as of February 2, 1999
*10.1 Management Agreement between the Registrant and Home Asset
Management Corp. dated February 11, 1997 and Amendment
thereto
*+10.2 Employment and Noncompetition Agreement between Home Asset
Management Corp. and John Robbins dated February 11, 1997
and Amendment thereto
*+10.3 Employment and Noncompetition Agreement between Home Asset
Management Corp. and Jay Fuller dated February 11, 1997 and
Amendment thereto
*+10.4 Mark Conger Employment Letter dated January 7, 1997 and
amendment thereto
*+10.5 Rollie Lynn Employment Letter dated January 7, 1997 and
amendment thereto
***+10.5a Lisa Faulk Employment Letter, as amended
*+10.6 1997 Stock Incentive Plan
*+10.7 Form of 1997 Stock Option Plan as amended
*+10.8 Form of 1997 Outside Directors Stock Option Plan
*+10.9 Form of Employee Stock Purchase Plan
*10.10 Securities Purchase Agreement between Registrant, Home Asset
Management Corp. and MDC REIT Holdings, LLC dated February
11, 1997
*+10.11 Form of Subscription Agreement dated February 11, 1997
*10.12 Secured Promissory Note dated June 25, 1997
*10.13 Lease Agreement with Louis and Louis dated March 7, 1997
*+10.14 Form of Indemnity Agreement
***10.15 Master Repurchase Agreement -- Confidential Treatment
Requested and Granted
***21.1 Subsidiaries of Registrant
23.1 Consent of KPMG LLP re: Registrant
23.2 Consent of KPMG LLP re: American Residential Holdings, Inc.
27.1 Financial Data Schedule
- ---------------
* Incorporated by reference to Registration Statement on Form S-11 (File No.
333-33679)
+ Management Contract or Compensatory Plan
** Incorporated by reference to Current Reports on Form 8-K (File No.
001-13485)
*** Incorporated by reference to the Company's Annual Report on Form 10-K for
the Fiscal year ended 1997
(a) Reports on Form 8-K:
Current Report (File No. 001-13485)