As filed with the Securities and Exchange Commission on March 31, 1999
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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
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FORM 10-K
(Mark One)
[X]ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
1934
For the period ended December 31, 1998; or
[_]TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
For the transition period from to
Commission File No. 001-13709
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ANWORTH MORTGAGE ASSET CORPORATION
(Exact name of Registrant as specified in its charter)
Maryland 52-2059785
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
1299 Ocean Avenue, #200, Santa Monica, California 90401
(Address of principal executive offices)
Registrant's telephone number, including area code: (310) 394-0115
Securities registered pursuant to Section 12(b) of the Act:
Title of each class Name of exchange on which registered
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Common stock, par value $0.01 per share American Stock Exchange
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Indicate by a 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 shorter period that the registrant was
required to file such reports), and (2) has been subject to filing
requirements for the past 90 days. Yes [X] No [_]
Indicate by a check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Annual Report on Form
10-K or any amendment to this Annual Report on Form 10-K. [_]
At March 5, 1999 the aggregate market value of the voting stock held by non-
affiliates of the Registrant was $10,890,263, based on the closing price of
the common stock on the American Stock Exchange.
As of March 5, 1999, 2,317,100 shares of Common Stock, $0.01 par value per
share were issued and outstanding.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's definitive Proxy Statement which the Company
intends to issue within 120 days of the end of the fiscal year, are
incorporated by reference into Part III.
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ANWORTH MORTGAGE ASSET CORPORATION
1998 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
Page
----
PART 1.................................................................. 1
ITEM 1. BUSINESS................................................... 1
ITEM 2. PROPERTIES................................................. 39
ITEM 3. LEGAL PROCEEDINGS.......................................... 40
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS........ 40
PART II................................................................. 40
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED
SHAREHOLDER MATTERS....................................... 40
ITEM 6. SELECTED FINANCIAL DATA.................................... 41
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS................................. 42
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
RISK...................................................... 48
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA................ 48
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE.................................. 48
PART III................................................................ 49
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT......... 49
ITEM 11. EXECUTIVE COMPENSATION..................................... 49
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT................................................ 49
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS............. 49
PART IV................................................................. 49
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON
FORM 8-K.................................................. 49
GLOSSARY
FINANCIAL STATEMENTS
SIGNATURES
EXHIBITS
i
INTRODUCTORY NOTE
Certain statements contained herein are not, and certain statements
contained in future filings by the Company with the Securities and Exchange
Commission (the "Commission") in the Company's press releases or in the
Company's other public or shareholder communications may not be, based on
historical facts and are "forward-looking statements" within the meaning of
applicable federal securities laws. Forward looking statements which are based
on various assumptions (some of which are beyond the Company's control) may be
identified by reference to a future period or periods, or by the use of
forward-looking terminology, such as "may", "will," "intend," "should,"
"expect," "anticipate," "estimate" or "continue" or the negatives thereof or
other comparable terminology. Forward-looking statements included herein
regarding the actual results, performance and achievements of the Company are
dependent on a number of factors. The Company's actual results could differ
materially from those anticipated in such forward-looking statements as a
result of certain factors, including but not limited to, changes in interest
rates, changes in yield curve, changes in prepayment rates, the availability
of mortgage-backed securities for purchase, the availability of financing and,
if available, the terms of any such financing. For a discussion of the risks
and uncertainties which could cause actual results to differ from those
contained in the forward-looking statements, see "Risk Factors" commencing on
page 28 of this Annual Report on Form 10-K. The Company does not undertake,
and specifically disclaims any obligation, to publicly release the result of
any revisions which may be made to any forward-looking statements to reflect
the occurrence of anticipated or unanticipated events or circumstances after
the date of such statements.
Reference is made to the Glossary commencing on page 51 of the report for
definitions of terms used in the following description of the Company's
business and elsewhere in this report.
PART 1
ITEM 1. BUSINESS
SUMMARY OF THE COMPANY
General
The Company was formed in October 1997 to invest in mortgage assets,
including mortgage pass-through certificates, collateralized mortgage
obligations, mortgage loans and other securities representing interests in, or
obligations backed by, pools of mortgage loans which can be readily financed
and short-term investments. On March 17, 1998, the Company completed its
initial public offering of 2,200,000 shares raising $18,414,000 in proceeds.
In connection with the underwriters' over-allotment allowance, approximately
one month later, an additional 127,900 shares of Common Stock were sold
raising $1,071,000 in proceeds. The Company utilized the equity capital raised
in its offering and short term borrowings to generate income based on the
difference between the yield on its mortgage assets and the cost of its
borrowings. The Company will elect to be taxed as a REIT under the Code, and
therefore is not generally subject to federal taxes on its income to the
extent it distributes its net income to its stockholders and maintains its
qualification as a REIT. See "Federal Income Tax Considerations--Requirements
for Qualification as a REIT--Distribution Requirement."
The goal of the Company is to generate a competitive yield through its use
of leverage and active management of the asset/liability yield spread.
The Company acquires mortgage assets primarily in the secondary mortgage
market through its manager, Anworth Mortgage Advisory Corporation (the
"Manager"). The Manager manages the day-to-day operations of the Company,
pursuant to the policies established by the Company's Board of Directors and
the authority delegated to the Manager under the Management Agreement. The
Manager is under common control with Pacific Income Advisers, Inc. ("PIA"), an
investment advisory firm which began operations in 1986. The Manager's
management team are selected members of PIA's management. The Company is
externally managed by the Manager, taking advantage of the economies of scale
associated with the Manager while avoiding duplicate
1
administrative functions and incurring the costs of creating a new
administrative infrastructure. The Company has no ownership interest in the
Manager.
The Company's mortgage assets consist primarily of mortgage securities
("Mortgage Securities") bearing interest rates that adjust periodically based
on changes in short-term interest rates. The Company uses short-term
borrowings utilizing its Mortgage Assets as collateral to acquire additional
Mortgage Assets, while generally maintaining a debt-to-equity ratio of between
8:1 and 12:1, although the ratio may vary from time to time based upon market
conditions and other factors deemed relevant by the Manager and the Company's
Board of Directors. The Company manages actively, on an aggregate basis, both
the interest rate indices and interest rate adjustment periods of its
borrowings against the interest rate indices and interest rate adjustment
periods on its Mortgage Assets.
While at least 70% of the total assets acquired by the Company must be
Primary adjustable-rate Mortgage Securities and Short-Term Investments
(investments with an average life of one year or less), all of the assets
acquired to date by the Company have been Primary adjustable rate Mortgage
Securities. "Primary" as used herein means either (i) securities that are
rated within one of the two highest rating categories by at least one of
either Standard & Poor's Rating Services, a division of The McGraw-Hill
Companies, Inc. ("Standard & Poor's") or Moody's Rating Service, Inc.
("Moody's" and together with Standard & Poor's, the "Rating Agencies"), or
(ii) securities that are unrated but are either obligations the United States
or obligations guaranteed by the United States government or an agency or
instrumentality of the United States government.
The remainder of the Company's investment portfolio, comprising not more
than 30% of its total assets, may consist of Mortgage Assets which are
unrated, or, if rated, are less than Primary, including (i) Mortgage Loans
secured by first liens on single-family (one-to-four units) residential
properties, (ii) Mortgage Securities backed by loans on single-family, multi-
family, commercial, or other real estate-related properties which are rated at
least Investment Grade (rated at least "BBB" or "Baa" by Standard & Poor's or
Moody's, respectively) or (as to single-family and multi-family Mortgage
Securities) the equivalent, if not rated, (iii) fixed-rate Mortgage Assets,
including the acquisition of such assets for the purpose of being combined
with hedging instruments to obtain investment characteristics similar to
adjustable-rate Mortgage Assets, and (iv) Other Mortgage Securities. "Other
Mortgage Securities" as used herein means securities representing interests
in, or secured by Mortgages on, real property other than Pass-Through
Certificates and CMOs and may include non-Primary certificates and other
securities collateralized by single-family loans, Mortgage Warehouse
Participations, Mortgage Derivative Securities, Subordinated Interests,
securities of other REITs and other mortgage-backed and mortgaged
collateralized obligations.
Summary of Strategy
The principal business objective of the Company is to generate a competitive
yield through its use of leverage and active management of the asset/liability
yield spread. Following is the Company's strategy to achieve its business
objective:
Investment Strategy
The Company applies a disciplined approach to managing its investments in an
attempt to achieve competitive yields while managing portfolio risk. The
Company utilized the proceeds of its initial public offering and short-term
borrowings to generate income based on the difference between the yield on its
Mortgage Assets and the cost of its borrowings. The Company seeks to minimize
prepayment risk by structuring a diversified portfolio with a variety of
prepayment characteristics and by analyzing the prepayment risk of the
Mortgage Assets, as well as the deviations between projected and realized
prepayment rates.
Financing Strategy
The Company employs a strategy of attempting to increase profitability
through growth in Mortgage Asset volume achieved by leverage based upon short-
term borrowings, primarily reverse repurchase agreements and
2
dollar-roll agreements. The Company generally maintains a debt-to-equity ratio
of between 8:1 and 12:1, although the ratio varies from time to time depending
on market conditions and other factors deemed relevant by the Manager and the
Company's Board of Directors. Depending on the different cost of borrowing
funds at different maturities, the Company varies the maturities of its
borrowed funds to attempt to produce lower borrowing costs. The Company's
borrowings are short-term and the Company attempts to actively manage, on an
aggregate basis, the interest rate indices and interest rate adjustment
periods of its borrowings against the interest rate indices and interest rate
adjustment periods on its Mortgage Assets.
Although it has not yet done so, over time, to the extent the Company
believes it can lower its cost of funds or increase its return to investors,
it may seek to raise additional capital through accessing the capital markets.
In addition, to the extent the Company develops appropriate infrastructure, it
may access the securitization market to raise additional funds for operations.
Risk Management Strategy
Interest Rate and Volatility Risk. If the general level of interest rates
increases or the expected level of volatility of interest rates increases, the
Company's assets are likely to decline in value. The Company uses mathematical
modeling and quantitative analysis to monitor the interest rate sensitivity of
its Mortgage Asset portfolio. The analysis includes the use of mathematical
assumptions regarding the effect of mortgage loan prepayments and interest
rate caps incorporated in most adjustable-rate mortgage securities, as well as
interest rate volatility on its portfolio of Mortgage Assets. Comparison of
interest rate sensitivity factors to the quantitative and qualitative nature
of the Company's borrowings provides the Company with a qualitative measure of
the impact that interest rate movements could have on the Company's net
interest income. Management evaluates continually these mathematical
assumptions and, if necessary, adjusts its Mortgage Asset portfolio
accordingly.
Credit Risk. The Company has invested in Mortgage Assets, primarily mortgage
pass-through certificates and short-term investments. Although it has not yet
done so, the Company may also invest in collateralized mortgage obligations,
mortgage loans and other securities representing interests in or obligations
backed by pools of mortgage loans which can be readily financed. If an issuer
of a security owned by the Company defaults, the value of the security is
likely to decline, either temporarily or permanently. The Company continually
monitors the credit quality of its Mortgage Assets and maintains appropriate
capital levels for allowances and possible credit losses. The Company manages
the credit risk of its Mortgage Assets through, among other activities,
(i) complying with the Company's policies with respect to credit risk
concentration, (ii) actively monitoring the ongoing credit quality and
servicing of its Mortgage Assets and (iii) maintaining appropriate capital
levels and allowances for possible credit losses.
Hedging. Although it has not yet done so, the Company may enter into hedging
transactions designed to protect itself to varying degrees against interest
rate changes. The Company may purchase interest rate caps and interest rate
swaps to mitigate the risk of its short-term borrowings increasing at a
greater rate than the yields on its Mortgage Assets during a period of rising
interest rates. The Company may also, to the extent consistent with its
qualifications as a REIT and Maryland law, utilize financial futures contracts
and put and call options on financial futures contracts and trade forward
contracts as a hedge against future interest rate changes. However, no hedging
strategy can completely insulate the Company from interest rate risks and
market movement, and the federal tax laws applicable to REITs may
substantially limit the Company's ability to engage in hedging transactions.
Additionally, hedging strategies have significant transaction costs and the
Company will not be able to significantly reduce or eliminate the risk
associated with its investment portfolio without reducing or perhaps even
eliminating the return on its investments.
There can be no assurance that the Company will successfully implement its
strategies. See "Risk Factors" for a discussion of factors that could affect
the Company's ability to successfully implement its strategy.
3
The Manager
The Manager implements the Company's business strategy on a day-to-day basis
and performs certain services for the Company, pursuant to policies
established by the Company's Board of Directors and the authority delegated to
the Manager under the Management Agreement. The Manager is responsible
primarily for two areas of activity: (i) asset/liability management, which
consists of the acquisition, disposition, financing, hedging and management of
Mortgage Assets and includes credit and prepayment risk management; and
(ii) capital management, which consists of structuring, analysis, capital
raising and investor relations activities. With respect to the Company's
investment strategy, the Manager employs mortgage analytical tools to
generally construct a diversified Mortgage Asset portfolio. With respect to
the Company's financing strategy, the Manager arranges for various types of
financing for the Company and manages actively the interest rate structure of
the Company's assets and liabilities and monitors the Company's portfolio
leverage. With respect to the Company's risk management strategy, the Manager
monitors the projected change in the portfolio's value based upon assumed
changes in interest rates and, if necessary, attempts to adjust the portfolio
accordingly. The Manager monitors the credit quality of each asset in the
Company's portfolio and seeks to ensure that the overall credit quality of the
portfolio is in keeping with the Company's credit policies as adopted by the
Company's Board of Directors. The Manager evaluates the Company's interest
rate risk levels and performs such analyses as may be required to determine
what types and amounts of hedging transactions are advisable for the Company
given the configuration of its portfolio and seeks to execute trades to
maintain hedges. The Manager is also be required to perform the following
services for the Company: (i) providing regular reports regarding the Company
to the Board of Directors, (ii) monitoring the Company's status as a REIT from
tax and compliance standpoints and (iii) providing managerial, administrative
and management information systems support for the Company.
Prior to its association with the Company, the Manager had not previously
managed a REIT. In particular, the Manager had not previously managed a
highly-leveraged pool of Mortgage Assets or utilized hedging instruments, nor
did the Manager have experience in complying with the asset limitations
imposed by the REIT Provisions of the Code. Although management of the Company
and the Manager have investment management experience, there can be no
assurance that the past experience of the executive officers of the Company
and the Manager is appropriate to the business of the Company. Further, the
experience of the officers of the Manager and PIA should not be viewed as a
reliable gauge of the potential success of the Company. See "Risk Factors--
Lack of Prior Experience."
The Company has entered into a management agreement (the "Management
Agreement") between the Company and the Manager for an initial term of five
years from the date of the closing of the Company's initial public offering.
Pursuant to the Management Agreement with the Manager, the Company pays the
Manager an annual base management fee based on Average Net Invested Assets,
payable monthly in arrears, equal to 1% of the first $300 million of Average
Net Invested Assets, plus 0.8% of the portion above $300 million of Average
Net Invested Assets. Average Net Invested Assets is generally defined as total
assets less total debt incurred to finance assets; accordingly, incurring debt
to finance asset purchases does not necessarily increase Average Net Invested
Assets.
The Company also pays the Manager, as incentive compensation for each fiscal
quarter, an amount equal to 20% of the Net Income of the Company, before
incentive compensation, in excess of the amount that would produce an
annualized Return on Equity equal to the Ten Year U.S. Treasury Rate (average
of weekly average yield to maturity for U.S. Treasury securities (adjusted to
a constant maturity of 10 years), as published weekly by the Federal Reserve
Board during a quarter) plus 1%. A deduction for the Company's interest
expenses for borrowed money is taken in calculating Net Income. "Return on
Equity" is computed on Average Net Worth and has no necessary correlation with
the actual distributions received by stockholders. The incentive compensation
calculation and payment to the Manager is made quarterly in arrears before any
income distributions are made to stockholders for the corresponding period.
After the expiration of the initial five-year term, the Management Agreement
will be automatically renewed for additional one-year terms unless terminated
by the Company or the Manager upon written notice. Except in
4
the case of a termination or non-renewal by the Company for cause, upon
termination or non-renewal of the Management Agreement by the Company, the
Company is obligated to pay the Manager a termination or non-renewal fee equal
to the fair market value of the Management Agreement without regard to the
Company's termination or non-renewal right as determined by an independent
appraisal. The selection of the independent appraiser shall be subject to the
approval of the Unaffiliated Directors. The payment of such a termination or
non-renewal fee by the Company would adversely affect the cash available for
distribution to the Company's stockholders and may have a material adverse
effect on the Company's operations.
OPERATING POLICIES AND PROGRAMS
Asset Acquisition Policy
The principal business objective of the Company is to earn a competitive
yield through the management of Mortgage Assets and their risks, the use of
leverage, the active management of the asset/liability yield spread, and the
employment of the Company's risk management strategies. In addition, the
Company's structure provides investors with a vehicle to participate in the
mortgage securities market. The Company's Mortgage Assets are held primarily
for investment. The Company generally buys and holds Mortgage Assets to
maturity and, therefore, has a low portfolio turnover rate. The Company's
ability to sell Mortgage Assets for gain is restricted by the REIT Provisions
of the Code and the rules, regulations and interpretations of the Service
thereunder. See "Federal Income Tax Considerations--Requirements for
Qualification as a REIT--Gross Income Tests."
At least 70% of the total assets acquired by the Company are Primary
adjustable-rate Mortgage Securities and Short-Term Investments (investments
with maturities of one year or less). "Primary" as used herein means either
(i) securities that are rated within one of the two highest rating categories
by at least one of either Standard & Poor's or Moody's, or (ii) securities
that are unrated but are either obligations the United States or obligations
guaranteed by the United States government or an agency or instrumentality of
the United States government.
The remainder of the Company's investment portfolio, comprising not more
than 30% of its total assets, may consist of Mortgage Assets which are
unrated, or, if rated, are less than Primary, including (i) Mortgage Loans,
(ii) Mortgage Securities backed by loans on single-family, multi-family,
commercial, or other real estate-related properties which are rated at least
Investment Grade (rated at least "BBB" or "Baa" by Standard & Poor's or
Moody's, respectively) or (as to single-family and multi-family Mortgage
Securities) the equivalent, if not rated, (iii) fixed-rate Mortgage Assets,
including the acquisition of such assets for the purpose of being combined
with hedging instruments to obtain investment characteristics similar to
adjustable-rate Mortgage Assets, and (iv) Other Mortgage Securities. "Other
Mortgage Securities" as used herein means securities representing interests
in, or secured by Mortgages on, real property other than Pass-Through
Certificates and CMOs and may include non-Primary certificates and other
securities collateralized by single-family loans, Mortgage Warehouse
Participations, Mortgage Derivative Securities, Subordinated Interests,
securities in other REITs and other mortgage-backed and mortgaged
collateralized obligations.
The Company has not acquired and generally will not acquire Inverse
Floaters, Remic Residuals or First Loss Subordinated Bonds. The Company may
acquire mortgage derivative securities, including, but not limited to,
interest only, principal only or other Mortgage Securities that receive a
disproportionate share of interest income or principal, either as an
independent stand-alone investment opportunity or to assist in the management
of prepayment and other risks (collectively, "Mortgage Derivative
Securities"), but only on a limited basis due to the greater risk of loss
associated with Mortgage Derivative Securities. See "Risk Factors--Failure to
Successfully Manage Interest Rate Risks May Adversely Affect Results of
Operations."
The Company's Board of Directors has adopted the investment policies set
forth in the Company's Prospectus as its initial investment policies. The
policies may be changed at any time, and have been modified slightly during
the reporting period, by the Board of Directors (subject to approval by a
majority of Unaffiliated
5
Directors) without the consent of stockholders. The Company's Board of
Directors will establish and approve (including approval by a majority of
Unaffiliated Directors) at least annually the investment policies of the
company, which will include investment criteria that each Mortgage Asset must
satisfy to be eligible for investment by the Company. The Company will not
purchase any Mortgage Assets from its Affiliates other than Mortgage
Securities that may be purchased from a taxable subsidiary of the Company that
may be formed in connection with the securitization of Mortgage Loans.
Capital and Leverage Policy
The Company financed its purchase of Mortgage Assets initially through
equity from the proceeds of its initial public offering and thereafter
primarily by borrowing against existing Mortgage Assets and using the proceeds
to acquire additional Mortgage Assets. The borrowings are in the form of
reverse repurchase agreements and dollar-roll agreements and may, in the
future, be in the form of loan agreements, lines of credit and other credit
facilities. The Company's borrowings are secured by Mortgage Assets owned by
the Company.
The Company employs a leveraging strategy to increase its investment assets
by borrowing against existing Mortgage Assets and using the proceeds to
acquire additional Mortgage Assets. The Company generally maintains a debt-to-
equity ratio of between 8:1 and 12:1, although the ratio may vary from time to
time depending on market conditions and other factors deemed relevant by the
Manager and Company's Board of Directors. The Company believes that this will
leave an adequate capital base to protect against interest rate environments
in which the Company's borrowing costs might exceed its interest income from
Mortgage Assets. For example, these conditions could occur when the interest
adjustments on Mortgage Assets lag behind interest rate increases in the
Company's short-term borrowings or when the interest rate of the Company's
short-term borrowings are mismatched with the interest rate indices of the
Company's Mortgage Assets. See "Risk Factors--Failure to Successfully Manage
Interest Rate Risks May Adversely Affect Results of Operations" and "Risk
Factors--Interest Rate Fluctuations May Decrease Net Interest Income." The
Company enters into the collateralized borrowings described herein only with
financially sound institutions meeting credit standards approved by the
Company's Board of Directors, including approval by a majority of Unaffiliated
Directors and monitors the financial condition of such institutions on a
regular, periodic basis.
Depending on the different cost of borrowing funds at different maturities,
the Company varies the maturities of its borrowed funds to attempt to produce
lower borrowing costs. The Company's borrowings are short-term and the Company
manages actively, on an aggregate basis, both the interest rate indices and
interest rate adjustment periods of its borrowings against the interest rate
indices and interest rate adjustment periods on its Mortgage Assets.
Mortgage Assets are financed primarily at short-term borrowing rates through
reverse repurchase agreements (a borrowing device evidenced by an agreement to
sell securities to a third party and a simultaneous agreement to repurchase
them at a specified future date and price, the difference constituting the
borrowing rate) and dollar-roll agreements (an agreement to sell a security
for delivery on a specified future date and simultaneous agreement to
repurchase the same or substantially similar security on a specified future
date). In the future the Company may also employ borrowings under lines of
credit and other collateralized financings which the Company may establish
with approved institutional lenders. Currently reverse repurchase agreements
and dollar-roll agreements are the principal financing devices utilized by the
Company to leverage its Mortgage Assets portfolio. Generally, upon repayment
of each reverse repurchase agreement, or repurchase pursuant to a dollar-roll
agreement, the collateral is immediately pledged to secure a new reverse
repurchase agreement or is sold pursuant to a new dollar-roll agreement.
A reverse repurchase agreement, although structured as a sale and repurchase
obligation, effects a financing under which the Company pledges its Mortgage
Assets as collateral to secure a short term loan. Generally, the creditor will
make the loan pursuant to the repurchase agreement in an amount equal to a
percentage of the market value of the collateral, typically 80% to 98%. Given
the Company's investing activities since inception, this percentage has ranged
from 93% to 97% during the reporting period. At the maturity of the reverse
6
repurchase agreement, the Company is required to repay the loan pursuant to
the agreement and correspondingly receives back its collateral. Under reverse
repurchase agreements, the Company generally retains the incidents of
beneficial ownership, including the right to distributions on the collateral
and the right to vote on matters as to which certificate holders are entitled
to vote. Upon a payment default under a repurchase agreement, the lending
party may liquidate the collateral.
Similar to a reverse repurchase agreement as a method of financing Mortgage
Securities, a dollar-roll is a transaction in which the Company sells Mortgage
Securities for delivery on a specified future date and simultaneously
contracts to repurchase the same or substantially the same type of security on
a specified future date. During the roll period, the Company forgoes the
principal and interest payments on the Mortgage Securities. The Company,
however, is compensated by the interest earned on the cash proceeds of the
initial sale and by the typically lower repurchase price at the future date.
Because the roll provides funds to the Company for the period of the roll, its
value can be expressed in terms of an "implied financing rate." This method of
financing is favorable to the Company when the repurchase price is low enough
in comparison to the initial sale price so that the implied financing rate is
below other alternative short-term borrowing rates (e.g., the rate for reverse
repurchase agreements or other short-term borrowings). The Company's ability
to enter into dollar-roll agreements may be limited in order to maintain the
Company's status as a REIT and to avoid the imposition of tax on the Company.
See "Federal Income Tax Considerations--Requirements for Qualification as a
REIT" and "--Taxation of the Company."
Reverse repurchase agreements take the form of a sale of pledged securities
to the lender at a discounted price in return for the lender's agreement to
resell the same or similar securities to the borrower at a future date (the
maturity of the borrowing) at an agreed price. In the event of the insolvency
or bankruptcy of a lender during the term of a reverse repurchase agreement,
provisions of the Federal Bankruptcy Code, if applicable, may permit the
lender to consider the agreement to resell the securities to be an executory
contract that, at the lender's option, may be either assumed or rejected by
the lender. If a bankrupt lender rejects its obligation to resell pledged
securities to the Company, the Company's claim against the lender for the
damages resulting therefrom may be treated as simply one of many unsecured
claims against the lender's assets. These claims would be subject to
significant delay and, if and when received, may be substantially less than
the damages actually suffered by the Company.
Credit Risk Management Policy
The Company reviews credit risk and other risks of loss associated with each
investment. In addition, the Company seeks to diversify the Company's
portfolio of Mortgage Assets to avoid undue geographic, insurer, industry and
certain other types of concentrations. The Company seeks to reduce certain
risks from sellers and servicers through representations and warranties. The
Company's Board of Directors monitors the overall portfolio risk and
determines appropriate levels of provision for loss.
With respect to its Mortgage Securities, the Company is exposed to various
levels of credit and special hazard risk, depending on the nature of the
underlying Mortgage Assets and the nature and level of credit enhancements
supporting such securities. Agency Certificates are covered by credit
protection in the form of a 100% guarantee from a government sponsored entity
(GNMA, Fannie Mae or FHLMC). Privately Issued Certificates represent interests
in pools of residential mortgage loans with partial credit enhancement. Credit
loss protection for Privately Issued Certificates is achieved through the
subordination of other interests in the pool to the interest held by the
Company, through pool insurance or through other means. The degree of credit
protection varies substantially among Privately Issued Certificates.
The Company reviews the quality of Mortgage Loans at the time of acquisition
and on an ongoing basis. During the time it holds Mortgage Loans, the Company
is subject to risks of borrower defaults and bankruptcies and special hazard
losses (such as those occurring from earthquakes or floods) that are not
covered by standard hazard insurance. However, individual Mortgage Loans may
be covered by FHA insurance, VA guarantees or
7
private mortgage insurance and, to the extent securitized into Agency
Certificates, by such government sponsored entity obligations or guarantees.
Compliance with the Company's credit risk management policy guidelines is
determined at the time of purchase of Mortgage Assets (based upon the most
recent valuation utilized by the Company) and will not be affected by events
subsequent to such purchase, including, without limitation, changes in
characterization, value or rating of any specific Mortgage Assets or economic
conditions or events generally affecting any Mortgage Assets of the type held
by the Company.
Asset/Liability Management Policy
Interest-Rate Risk Management. To the extent consistent with its election to
qualify as a REIT, the Company follows an interest rate risk management
program intended to protect its portfolio of Mortgage Assets and related debt
against the effects of major interest rate changes. Specifically, the
Company's interest rate management program is formulated with the intent to
offset to some extent the potential adverse effects resulting from rate
adjustment limitations on its Mortgage Assets and the differences between
interest rate adjustment indices and interest rate adjustment periods of its
adjustable-rate Mortgage Assets and related borrowings. The Company's interest
rate risk management program encompasses a number of procedures, including the
following: (i) monitoring and adjusting, if necessary, the interest rate
sensitivity of its Mortgage Assets compared with the interest rate
sensitivities of its borrowings; and (ii) attempting to structure its
borrowing agreements relating to adjustable-rate Mortgage Assets to have a
range of different maturities and interest rate adjustment periods (although
substantially all will be less than a year). As a result, the Company expects
to be able to adjust the average maturity/adjustment period of such borrowings
on an ongoing basis by changing the mix of maturities and interest rate
adjustment periods as borrowings come due or are renewed. Through use of these
procedures, the Company attempts to reduce the risk of differences between
interest rate adjustment periods of adjustable-rate Mortgage Assets and
related borrowings.
Depending on market conditions and the cost of the transactions, the Company
may conduct certain hedging activities in connection with the management of
its Mortgage Asset portfolio, although it has not done so since inception. To
the extent consistent with the Company's election to qualify as a REIT, the
Company follows a hedging strategy intended to mitigate the effects of
interest rate changes and to enable the Company to earn net interest income in
periods of generally rising, as well as declining or static, interest rates.
Specifically, the Company's hedging program is formulated with the intent to
offset to some extent the potential adverse effects of (i) changes in interest
rate levels relative to the interest rates on the Mortgage Assets held in the
Company's investment portfolio, and (ii) differences between the interest rate
adjustment indices and periods of the Company's Mortgage Assets and the
borrowings of the Company. As part of its hedging strategy, the Company also
monitors on an ongoing basis the prepayment risks that arise in fluctuating
interest rate environments.
The Company's hedging policy encompasses a number of procedures. First, the
Company attempts to actively manage, on an aggregate basis, the interest rate
indices and interest rate adjustment periods of its borrowings against the
interest rate indices and interest rate adjustment periods on its Mortgage
Assets. In addition, the Company structures its reverse repurchase borrowing
agreements and dollar-roll agreements to have a range of different maturities
(although substantially all have maturities of less than one year). As a
result, the Company is able to adjust the average maturity of its borrowings
on an ongoing basis by changing the mix of maturities as borrowings come due
and are renewed. In this way, the Company reduces differences between the
interest rate adjustment periods of its Mortgage Assets and related borrowings
that may occur due to prepayments of Mortgage Loans or other factors.
The Company may hedge to some extent against the short-term indebtedness
incurred by the Company to finance its acquisition of Mortgage Assets to
mitigate the effects of interest rate fluctuations or other market movements.
With respect to assets, hedging can be used either to increase the liquidity
or decrease the risk of holding an asset by guaranteeing, in whole or in part,
the price at which such asset may be disposed of prior to
8
its maturity and may also be used to receive interest income in excess of
specified interest rate caps. With respect to indebtedness, hedging can be
used to limit, fix, or cap the interest rate on short-term indebtedness.
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 seller's 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 contract.
Financial futures contracts are the sale of a futures contract, typically on
Treasury Bills or Eurodollar contracts, creating a firm obligation to deliver
a specific financial instrument at a specified future date and price. Options
on financial futures contracts are similar to options on securities except
that a futures option gives the purchaser the right, in return for the premium
paid, to assume a position in a futures contract and obligates the seller to
deliver that position. Financial futures contracts and options on financial
futures contracts are classified as "commodities" under the federal Commodity
Exchange Act and may also be classified as "securities" for securities law
purposes. The Company does not intend to invest in any other types of
commodities and will not engage in commodities trading. The purchase of
Mortgage Derivative Securities and Excess Servicing Rights can be effective
hedging instruments in certain situations as these investments tend to
increase in value and their yields tend to increase as interest rates rise.
The Company intends to limit its purchases of Mortgage Derivative Securities
and Excess Servicing Rights to those investments qualifying as Qualified REIT
Real Estate Assets. Income from such investments qualifies for purposes of the
95% and 75% sources of income tests applicable to REITs. See "Federal Income
Tax Considerations--Requirements for Qualification as a REIT--Gross Income
Tests."
The Company may acquire Excess Servicing Rights, but only to the extent such
rights constitute a Qualified REIT Real Estate Asset. Excess Servicing Rights
would entitle the Company to receive the interest portion of monthly mortgage
payments not already allocated to either a pass-through certificate or the
administration of mortgage servicing. Because Excess Servicing Rights
represent interest only cash flows from mortgage loans, they behave in a
fashion similar to "interest only" Mortgage Derivative Securities. The Excess
Servicing Rights also will be subject to the general credit of the Servicer
(the entity performing the loan servicing function on Mortgage Loans or Excess
Servicing Rights owned by the Company) and the risk that the Servicer could be
terminated. As part of its loan servicing function, the Servicer collects and
is responsible for distributing the interest payments attributable to the
Excess Servicing Rights.
Fixed-rate Mortgage Assets may also be acquired for the purpose of being
combined with hedging instruments to obtain investment characteristics similar
to adjustable-rate Mortgage Assets.
These hedging transactions are designed to reduce the fluctuation in the
value of the Company's portfolio in changing interest rate environments. No
hedging strategy can completely insulate the Company from such risks, and
certain of the federal income tax requirements that the Company must satisfy
to qualify as a REIT limit the Company's ability to hedge. The Company intends
to carefully monitor and may have to limit its hedging strategies 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. See "Federal
Income Tax Considerations--Requirements for Qualification as a REIT."
In addition, hedging involves transaction costs, and such costs increase
dramatically as the period covered by the hedging protection increases and
that may also increase during periods of rising and fluctuating interest
rates. Therefore, the Company may be prevented from effectively hedging or may
determine it is not advantageous to hedge its short-term indebtedness incurred
to acquire Mortgage Assets. Certain losses incurred in connection with hedging
activities may be capital losses that would not be deductible to offset
ordinary REIT income. In such a situation, the Company would have incurred an
economic loss of capital that would not be deductible to offset the ordinary
income from which dividends must be paid.
Prepayment Risk Management. The Company seeks to minimize the risk that
borrowers of mortgage loans underlying Mortgage Assets may prepay such loans
at a faster or slower than anticipated rate and the effects
9
caused by such prepayments by attempting to structure a diversified portfolio
with a variety of prepayment characteristics, investing in Mortgage Assets
with prepayment prohibitions and penalties, investing in certain Mortgage
Security structures that have prepayment protections, and balancing Mortgage
Assets purchased at a premium with Mortgage Assets purchased at a discount.
The Company invests in Mortgage Assets that on a portfolio basis do not have
significant purchase price premiums. Under normal market conditions, the
Company seeks to keep the aggregate capitalized purchase premium of the
portfolio to 3% or less. In addition, the Company may in the future purchase
Principal Only Derivatives to a limited extent as a hedge against prepayment
risks. Prepayment risk is monitored by Management and the Company's Board of
Directors through periodic review of the impact of a variety of prepayment
scenarios on the Company's revenues, net earnings, dividends, cash flow and
net balance sheet market value.
The Company believes that it has developed cost-effective asset/liability
management policies to mitigate interest rate and prepayment risks. However,
no strategy can completely insulate the Company from interest rate changes,
prepayment risks and defaults by counter-parties. Further, as noted above,
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
and prepayment risks. Management monitors carefully, and may have to limit,
its asset/liability management program to assure that the Company does not
realize excessive hedging income, or hold hedging Mortgage Assets having
excess value in relation Mortgage 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. See "Federal
Income Tax Considerations--Requirements for Qualification as a REIT." In
addition, asset/liability management involves transaction costs that increase
dramatically as the period covered by the hedging protection increases and
that may increase during periods of fluctuating interest rates. Therefore, the
Company may be prevented from effectively hedging its interest rate and
prepayment risks.
Description of Mortgage Assets
The Company invests principally in the following types of Mortgage Assets
subject to the operating restrictions described in "--Operating Policies and
Programs" above. Within such operating restrictions there are no limitations
on the amount of each of the following Mortgage Assets the Company can
acquire.
Pass-Through Certificates
General. The Company's investments in Mortgage Assets are expected to be
concentrated in Pass-Through Certificates. The Pass-Through Certificates to be
acquired by the Company will consist primarily of pass-through certificates
issued by Fannie Mae, FHLMC and GNMA, as well as Primary privately issued
adjustable-rate mortgage pass-through certificates. The Pass-Through
Certificates acquired by the Company represent interests in mortgages that
will be secured primarily by liens on single-family (one-to-four units)
residential properties, or on multi-family, commercial or other real estate-
related properties.
The ARM Pass-Through Certificates acquired by the Company are subject to
periodic interest rate adjustments which may be less frequent than the
increases or decreases in the borrowings or financings utilized by the
Company. In a period of increasing interest rates, the Company could
experience a decrease in Net Cash Flow because the interest rates on its
borrowings could increase faster than the interest rates on ARM Pass-Through
Certificates owned by the Company. Additionally, ARMs backed by loans secured
by liens on single-family (one-to-four) residences are subject to periodic and
lifetime interest rate caps which limit the amount an ARM interest rate can
change during any given period. The Company's borrowings are generally not
subject to similar restrictions. The impact on Net Cash Flows of such interest
rate changes depends on the adjustment features of the Mortgage Assets owned
by the Company and the maturity schedules of the Company's borrowings.
Privately Issued ARM Pass-Through Certificates. Privately issued ARM Pass-
Through Certificates are structured similarly to the Fannie Mae, FHLMC and
GNMA pass-through certificates discussed below and are
10
issued by originators of and investors in Mortgage Loans, including savings
and loan associations, savings banks commercial banks, mortgage banks,
investment banks and special purpose subsidiaries of such institutions.
Privately issued ARM Pass-Through Certificates are usually backed by a pool of
conventional adjustable-rate Mortgage Loans and are generally structured with
credit enhancement such as pool insurance or subordination. However, privately
issued ARM Pass-Through Certificates are typically not guaranteed by an entity
having the credit status of Fannie Mae, FHLMC or GNMA guaranteed obligations.
Existing Fannie Mae ARM Programs. Fannie Mae is a federally chartered and
privately owned corporation organized and existing under the Federal National
Mortgage Association Charter Act (12 U.S.C. (S) 1716 et seq.). Fannie Mae
provides funds to the mortgage market primarily by purchasing Mortgage Loans
on homes from local lenders, thereby replenishing their funds for additional
lending. Fannie Mae established its first ARM programs in 1982 and currently
has several ARM programs under which ARM certificates may be issued, including
programs for the issuance of securities through REMICs under the Code.
Each Fannie Mae ARM Pass-Through Certificate issued to date has been issued
in the form of a Pass-Through Certificate representing a fractional undivided
interest in a pool of ARMs formed by Fannie Mae. The ARMs included in each
pool are fully amortizing conventional Mortgage Loans secured by a first lien
on either one-to-four family residential properties or multifamily properties.
The original terms to maturities of the Mortgage Loans generally do not exceed
40 years. Currently, Fannie Mae has issued several different series of ARMs.
All of Fannie Mae's series of ARMs are in its lender (or Swaps) mortgage-
backed securities program where individual lenders swap pools of Mortgage
Loans that they originated or purchased for a Fannie Mae security backed by
those same Mortgage Loans. Each series bears an initial interest rate and a
margin tied to an index based on all Mortgage Loans in the related pool, less
a fixed percentage representing servicing compensation and Fannie Mae's
guarantee fee. The specified index used in each series has included the One-
Year U.S. Treasury Rate published by the Federal Reserve Board, the 11th
District Cost of Funds Index published by the Federal Home Loan Bank of San
Francisco and other indices. In addition, the majority of series of Fannie Mae
ARMs issued to date have had a monthly, semi-annual or annual interest rate
adjustment.
Adjustments to the interest rates on Fannie Mae ARMs are typically subject
to lifetime caps. In addition, some pools contain ARMs that are subject to
semi-annual or annual interest rate change limitations, frequently 1% to 2%,
respectively. Some pools contain ARMs that provide for limitations on the
amount by which monthly payments may be increased but have no limitation on
the frequency or magnitude of changes to the mortgage interest rate of the ARM
except for the lifetime cap. In cases where an increase in the rate cannot be
covered by the amount of the scheduled payment, the uncollected portion of
interest is deferred and added to the principal amount of the ARM. In such
cases, interest paid on the Fannie Mae Certificates is a monthly pass-through
of the amount of interest on each ARM rather than a weighted average pass-
through rate of interest.
Fannie Mae guarantees to the registered holder of a Fannie Mae Certificate
that it will distribute amounts representing scheduled principal and interest
(at the rate provided by the Fannie Mae Certificate) on the Mortgage Loans in
the pool underlying the Fannie Mae Certificate, whether or not received, and
the full principal amount of any such Mortgage Loan foreclosed or otherwise
finally liquidated, whether or not the principal amount is actually received.
The obligations of Fannie Mae under its guarantees are solely those of Fannie
Mae and are not backed by the full faith and credit of the United States. If
Fannie Mae were unable to satisfy such obligations, distributions to holders
of Fannie Mae Certificates would consist solely of payments and other
recoveries on the underlying Mortgage Loans and, accordingly, monthly
distributions to holders of Fannie Mae Certificates would be affected by
delinquent payments and defaults on such Mortgage Loans.
Existing FHLMC ARM Programs. The Federal Home Loan Mortgage Corporation is a
corporate instrumentality of the United States created pursuant to an Act of
Congress (Title III of the Emergency Home Finance Act of 1970, as amended, 12
U.S.C. (S) 1451-1459), on July 24, 1970. The principal activity of FHLMC
currently consists of the purchase of Conforming Mortgage Loans or
participation interests therein and the resale of the loans and participations
so purchased in the form of guaranteed Mortgage Securities. FHLMC established
its first regular ARM program in 1986 and currently has several regular ARM
programs available for the issuance
11
of ARM certificates and a number of special programs that may be offered to
Mortgage Loan sellers. All of the Mortgage Loans evidenced by FHLMC
Certificates are conventional Mortgage Loans, and are not guaranteed or
insured by, and are not obligations of, the United States or any agency or
instrumentality thereof, other than FHLMC.
Each FHLMC Certificate issued to date has been issued in the form of a Pass-
Through Certificate representing an undivided interest in a pool of ARMs
purchased by FHLMC. The ARMs included in each pool are fully amortizing,
conventional Mortgage Loans with original terms to maturity of up to 40 years
secured by first liens on one-to-four unit family residential properties or
multi-family properties. An ARM certificate issued by FHLMC may be issued
under one of two cash programs (comprised of Mortgage Loans purchased from a
number of sellers) or guarantor programs (comprised of Mortgage Loans
purchased from one seller in exchange for participation certificates
representing interests in the Mortgage Loans purchased). The interest rate
paid on FHLMC Certificates adjusts on the first day of the month following the
month in which the interest rates on the underlying Mortgage Loans adjust. The
interest rates paid on ARM certificates issued under FHLMC's standard ARM
programs adjust annually in relation to the One-Year U.S. Treasury Rate as
published by the Federal Reserve Board. The specified index used in each FHLMC
series has also included the 11th District Cost of Funds Index published by
the Federal Home Loan Bank of San Francisco and other indices. Interest rates
paid on FHLMC Certificates equal the applicable index rate plus a specified
number of basis points ranging typically from 125 to 250 basis points. In
addition, the majority of series of FHLMC Mortgage Securities issued to date
have had a monthly, semi-annual or annual interest adjustment. Adjustments in
the interest rates paid are generally limited to an annual increase or
decrease of either 1% or 2% and to a lifetime cap of 5% or 6% over the initial
interest rate. Certain FHLMC programs include Mortgage Loans that allow the
borrower to convert the adjustable mortgage interest rate of his ARM to a
fixed rate. ARMs that are converted into fixed-rate Mortgage Loans are
repurchased by FHLMC or by the seller of such Mortgage Loans to FHLMC, at the
unpaid principal balance thereof, plus accrued interest to the due date of the
last adjustable rate interest payment.
Some FHLMC pools contain ARMs that provide for limitations on the amount by
which monthly payments may be increased but have no limitation on the
frequency or magnitude of changes to the mortgage interest rate of the ARM
except for the lifetime cap. In cases where an increase in the rate cannot be
covered by the amount of the scheduled payment, the uncollected portion of
interest is deferred and added to the principal amount of the ARM. In such
cases, interest paid on the FHLMC Certificates is a monthly pass-through of
the amount of interest on each ARM rather than a weighted average pass-through
rate of interest.
FHLMC guarantees to each holder of its ARM certificates the timely payment
of interest at the applicable pass-through rate and ultimate collection of all
principal on the holder's pro rata share of the unpaid principal balance of
the related ARMs, but does not guarantee the timely payment of scheduled
principal of the underlying Mortgage Loans. The obligations of FHLMC under its
guarantees are solely those of FHLMC and are not backed by the full faith and
credit of the United States. If FHLMC were unable to satisfy such obligations,
distributions to holders of FHLMC Certificates would consist solely of
payments and other recoveries on the underlying Mortgage Loans and,
accordingly, monthly distributions to holders of FHLMC Certificates would be
affected by delinquent payments and defaults on such Mortgage Loans.
Existing GNMA ARM Programs. GNMA is a wholly owned corporate instrumentality
of the United States within the Department of Housing and Urban Development
("HUD"). Section 306(g) of Title III of the National Housing Act of 1934, as
amended (the "Housing Act"), authorizes GNMA to guarantee the timely payment
of the principal of and interest on certificates that represent an interest in
a pool of Mortgage Loans insured by the FHA under the Housing Act or Title V
of the Housing Act of 1949, or partially guaranteed by the VA under the
Servicemen's Readjustment Act of 1944, as amended, or Chapter 37 of Title 38,
United States Code and other loans eligible for inclusion in mortgage pools
underlying GNMA Certificates. Section 306(g) of the Housing Act provides that
"the full faith and credit of the United States is pledged to the payment of
all amounts which may be required to be paid under any guaranty under this
subsection." An opinion, dated December 12, 1969, of an Assistant Attorney
General of the United States, states that such guarantees under Section 306(g)
of mortgage-backed certificates of the type that may be purchased by the
Company or pledged as security for a series of
12
Mortgage Securities are authorized to be made by GNMA and "would constitute
general obligations of the United States backed by its full faith and credit."
The interest rate paid on the certificates issued under GNMA's standard ARM
program adjusts annually in relation to the One-Year U.S. Treasury Rate as
published by the Federal Reserve Board. Interest rates paid on GNMA
Certificates typically equal the index rate plus 150 basis points. Adjustments
in the interest rate are generally limited to an annual increase or decrease
of 1% and to a lifetime cap of 5%.
CMOs
The Company may, from time to time, invest in variable-rate and short-term
fixed-rate CMOs. "CMOs" as used herein means variable-rate debt obligations
(bonds) that are collateralized by mortgage loans or mortgage certificates
other than Mortgage Derivative Securities and Subordinated Interests. CMOs are
structured so that principal and interest payments received on the collateral
are sufficient to make principal and interest payments on the bonds. Such
bonds may be issued by United States government agencies or private issuers in
one or more classes with fixed or variable interest rates, maturities and
degrees of subordination which are characteristics designed for the investment
objectives of different bond purchasers. The Company will only acquire CMOs
that constitute beneficial interests in grantor trusts holding Mortgage Loans,
or regular interests issued by REMICs, or that otherwise constitute Qualified
REIT Real Estate Assets (provided that the Company has obtained a favorable
opinion of counsel or a ruling from the Service to that effect).
CMOs ordinarily are issued in series, each of which consists of several
serially maturing classes ratably secured by a single pool of Mortgage Loans
or Pass-Through Certificates. Generally, principal payments received on the
mortgage-related assets securing a series of CMOs, including prepayments on
such mortgage-related assets, are applied to principal payments on one or more
classes of the CMOs of such series on each principal payment date for such
CMOs. Scheduled payments of principal of and interest on the mortgage-related
assets and other collateral securing a series of CMOs are intended to be
sufficient to make timely payments of interest on such CMOs and to retire each
class of such CMOs by its stated maturity.
CMOs may be subject to certain rights of issuers thereof to redeem such CMOs
prior to their stated maturity dates, which may have the effect of diminishing
the Company's anticipated return on its investment. The Company will not
acquire any CMOs that do not qualify as Qualified REIT Real Estate Assets.
Mortgage Warehouse Participations
The Company also may from time to time acquire Mortgage Warehouse
Participations as an additional means of diversifying its sources of income,
provided that such investments, together with the Company's investments in
Limited Investment Assets, will not in the aggregate exceed 30% of its total
Mortgage Assets. These investments are participations in lines of credit to
Mortgage Loan originators that are secured by recently originated Mortgage
Loans that are in the process of being sold to investors. Mortgage Warehouse
Participations do not qualify as Qualified REIT Real Estate Assets.
Accordingly, this activity will be limited by the REIT Provisions of the Code.
See "Federal Income Tax Considerations--Requirements for Qualification as a
REIT."
Other Mortgage Securities
General. The Company may acquire Other Mortgage Securities or interests
therein if it determines that it will be beneficial to do so and it will not
adversely affect qualification of the Company as a REIT. Such Other Mortgage
Securities may include non-Primary Mortgage Assets and other Mortgage
Securities collateralized by single-family Mortgage Loans, Mortgage Warehouse
Participations, Mortgage Derivative Securities, Subordinated Interests,
securities of other REITs and other mortgage-backed and mortgage-
collateralized obligations, other than Pass-Through Certificates and CMOs.
Mortgage Derivative Securities. The Company may acquire Mortgage Derivative
Securities on a limited basis as market conditions warrant, either as an
independent stand-alone investment opportunity or to assist in
13
the management of prepayment and other risks. Mortgage Derivative Securities
provide for the holder to receive interest only, principal only, or interest
and principal in amounts that are disproportionate to those payable on the
underlying Mortgage Loans. Payments on Mortgage Derivative Securities are
highly sensitive to the rate of prepayments on the underlying Mortgage Loans.
In the event of more rapid than anticipated prepayments on such Mortgage
Loans, the rates of return on interests in Mortgage Derivative Securities
representing the right to receive interest only or a disproportionately large
amount of interest ("Interest Only Derivatives") would be likely to decline.
Conversely, the rates of return on Mortgage Derivative Securities representing
the right to receive principal only or a disproportionate amount of principal
("Principal Only Derivatives") would be likely to increase in the event of
rapid prepayments.
The Company presently intends to acquire Mortgage Derivative Securities,
including Principal and Interest Only Derivatives. Interest Only Derivatives
may be an effective hedging device since they generally increase in value as
Mortgage Securities representing interests in adjustable-rate mortgages
decrease in value. The Company also may invest in other types of floating-rate
derivatives that are currently available in the market. The Company also may
invest in other Mortgage Derivative Securities that may in the future be
developed if the Board of Directors, including a majority of Unaffiliated
Directors, determines that such investments would be advantageous to the
Company. The Company will generally not acquire Inverse Floaters, Remic
Residuals or First Loss Subordinated Bonds. However, the Company may retain
residual interests in its own securitizations of Mortgage Loans. Moreover, the
Company will not purchase any Mortgage Derivative Securities that do not
qualify as Qualified REIT Real Estate Assets.
Subordinated Interests. The Company also may acquire Subordinated Interests,
which are classes of Mortgage Securities that are junior to other classes of
such series of Mortgage Securities in the right to receive payments from the
underlying Mortgage Loans. The subordination may be for all payment failures
on the Mortgage Loans securing or underlying such series of Mortgage
Securities. The subordination will not be limited to those resulting from
certain types of risks, such as those resulting from war, earthquake or flood,
or the bankruptcy of a borrower. The subordination may be for the entire
amount of the series of Mortgage Securities or may be limited in amount.
Any Subordinated Interests acquired by the Company will be limited in amount
and bear yields that the Company believes are commensurate with the risks
involved. The market for Subordinated Interests is not extensive and may be
illiquid. In addition, the Company's ability to sell Subordinated Interests
will be limited by the REIT Provisions of the Code. Accordingly, the Company
intends to purchase Subordinated Interests for investment purposes only.
Although publicly offered Subordinated Interests generally will be rated, the
risks of ownership will be substantially the same as the ownership of unrated
Subordinated Interests because the rating does not address the possibility
that the Company might suffer a lower than anticipated yield or fail to
recover its initial investment. The Company will only purchase Subordinated
Interests that are consistent with its credit risk management policy and will
not purchase any Subordinated Interests that do not qualify as Qualified REIT
Real Estate Assets.
Mortgage Loans
General. In the future, following the development of an appropriate
infrastructure, the Company intends to acquire and accumulate Mortgage Loans
as part of its investment strategy until a sufficient quantity has been
accumulated for securitization into Primary Mortgage Securities. The Mortgage
Loans acquired by the Company and not yet securitized, together with the
Company's investments in Limited Investment Assets, will not constitute more
than 30% of its total Mortgage Assets at any time. All Mortgage Loans will be
acquired with the intention of securitizing them into Primary Mortgage
Securities. However, there can be no assurance that the Company will be
successful in securitizing the Mortgage Loans. After a pool of Mortgage Loans
has been securitized, the Mortgage Loans will no longer be considered Limited
Investment Assets. To meet the Company's investment criteria, the Mortgage
Loans to be acquired by the Company will generally conform to the underwriting
guidelines established by Fannie Mae, FHLMC or other credit insurers.
Applicable banking laws generally require that an appraisal be obtained in
connection with the original issuance of Mortgage Loans
14
by the lending institution. The Company does not intend to obtain additional
appraisals at the time of acquiring Mortgage Loans.
The Mortgage Loans may be originated by or purchased from various Suppliers
of Mortgage Assets throughout the United States, such as savings and loan
associations, banks, mortgage bankers, home builders, insurance companies and
other mortgage lenders. The Company may acquire Mortgage Loans directly from
originators and from entities holding Mortgage Loans originated by others. The
Board of Directors of the Company has not established any limits upon the
geographic concentration of Mortgage Loans to be acquired by the Company or
the credit quality of Suppliers of Mortgage Assets. See "Risk Factors--
Interest Rate Fluctuations May Decrease Net Interest Income."
The Company will acquire ARMs. The interest rate on ARMs is typically tied
to an index (such as the One-Year U.S. Treasury Rate published by the Federal
Reserve Board, the 11th District Cost of Funds Index published by the Federal
Home Loan Bank of San Francisco or LIBOR) and is adjustable periodically at
various intervals. Such Mortgage Loans may be subject to lifetime or periodic
interest rate or payment caps.
Conforming and Nonconforming Mortgage Loans. In the future, the Company may
acquire both Conforming and Nonconforming Mortgage Loans for securitization.
Conforming Mortgage Loans comply with the requirements for inclusion in a loan
guarantee program sponsored by GNMA, FHLMC or Fannie Mae. Under current
regulations, the maximum principal balance allowed on Conforming Mortgage
Loans ranges from $214,600 for one-unit residential loans ($321,000 for such
residential loans secured by mortgage properties located in either Alaska or
Hawaii) to $412,450 for four-unit residential loans ($618,875 for such
residential loans secured by mortgaged properties located in either Alaska or
Hawaii). Nonconforming Mortgage Loans are Mortgage Loans that do not qualify
in one or more respects for purchase by Fannie Mae or FHLMC under their
standard programs. The Company expects that a majority of Nonconforming
Mortgage Loans it purchases will be nonconforming primarily because they have
original principal balances which exceed the requirements for FHLMC or Fannie
Mae programs.
Commitments to Mortgage Loan Sellers. The Company may issue commitments
("Commitments") to originators and other sellers of Mortgage Loans who follow
policies and procedures that generally comply with Fannie Mae and FHLMC
regulations and guidelines and that comply with all applicable federal and
state laws and regulations for Mortgage Loans secured by single-family (one-
to-four units) residential properties. In addition, Commitments may be issued
for Agency Certificates as well as privately issued Pass-Through Certificates
and Mortgage Loans. Commitments will obligate the Company to purchase Mortgage
Assets from the holders of the Commitments for a specific period of time, in a
specific aggregate principal amount and at a specified price and margin over
an index. Although the Company may commit to acquire Mortgage Loans prior to
funding, all Mortgage Loans are to be fully funded prior to their acquisition
by the Company. Following the issuance of Commitments, the Company will be
exposed to risks of interest rate fluctuations similar to those risks on
adjustable-rate Mortgage Assets.
Securitization of Mortgage Loans. The Company anticipates that in the
future, if it obtains personnel with the appropriate expertise, it may create,
through securitization, Primary Mortgage Securities with all Mortgage Loans it
acquires. Such Securities would be structured as collateralized borrowing and
not as a sale for accounting purposes. The Company's decision at any time to
acquire Mortgage Loans for securitization will be based on the Company's
determination that it can earn a higher yield on the Mortgage Securities
created through securitization than on comparable Mortgage Securities
purchased in the market. In making this determination, the Company will
consider the demand for the Mortgage Securities to be created from such
Mortgage Loans, the cost of securitization, the relative strength of issuers
and other market participants active in such securities, Rating Agency
requirements and other factors affecting the structure, cost, rating and
benefits of such securities relative to each other and to other investment
alternatives.
The Company may elect to conduct its operations of acquiring and
securitizing Mortgage Loans through one or more taxable subsidiaries formed
for such purpose.
15
In connection with the creation of a new Mortgage Security through
securitization of Mortgage Loans, the issuer generally will be required to
enter into a master servicing agreement with respect to such series of
Mortgage Securities with an entity acceptable to the rating agency that
regularly engages in this activity (the "Master Servicer"). At the present
time, the Company does not engage in this business and no Affiliates of the
Company or the Manager will be appointed as a Master Servicer for any issue of
Mortgage Securities created by the Company.
To the extent that Management determines that it is not in the best
interests of the Company to securitize mortgage loans, it may engage in whole
loan sale transactions with respect to loans accumulated in its portfolio.
Protection Against Mortgage Loan Risks. It is anticipated that any Mortgage
Loan purchased will have a commitment for mortgage pool insurance from a
mortgage insurance company with a claims-paying ability in one of the two
highest rating categories by either of the Rating Agencies. Mortgage pool
insurance insures the payment of certain portions of the principal and
interest on Mortgage Loans. In lieu of mortgage pool insurance, the Company
may arrange for other forms of credit enhancement such as letters of credit,
subordination of cash flows, corporate guaranties, establishment of reserve
accounts or over-collateralization. The Company expects that any Mortgage
Loans acquired will be reviewed by a mortgage pool insurer or other qualified
Mortgage Loan underwriter to ensure that the credit quality of the Mortgage
Loans meets the insurer's guidelines. The Company intends to rely primarily
upon the credit evaluation of such third-party mortgage pool insurer or
underwriter issuing the commitment rather than make its own independent credit
review in determining whether to purchase a Mortgage Loan. Credit losses
covered by the pool insurance policies or other forms of credit enhancement
are restricted to the limits of their contractual obligations and may be lower
than the principal amount of the Mortgage Loan. The pool insurance or credit
enhancement will be issued when the Mortgage Loan is subsequently securitized,
and the Company will be at risk for credit losses on that loan prior to its
securitization.
In addition to credit enhancement, the Company anticipates that it will also
obtain a commitment for special hazard insurance on the Mortgage Loans, if
available at reasonable cost, to mitigate casualty losses that are not usually
covered by standard hazard insurance, such as vandalism, war, earthquake and
floods. This special hazard insurance is not in force during the accumulation
period, but is activated instead at the time the Mortgage Loans are pledged as
collateral for the Mortgage Securities. Accordingly, the risks associated with
such special hazard losses exist primarily between the times the Company
purchases a Mortgage Loan and the inclusion of such Mortgage Loan within a
newly created issue of Mortgage Securities.
It is expected that when the Company acquires Mortgage Loans, the seller
will generally represent and warrant to the Company that there has been no
fraud or misrepresentation during the origination of the Mortgage Loans and
generally agree to repurchase any loan with respect to which there is fraud or
misrepresentation. The Company will provide similar representations and
warranties when the Company sells or pledges the Mortgage Loans as collateral
for Mortgage Securities. If a Mortgage Loan becomes delinquent and the pool
insurer is able to prove that there was fraud or misrepresentation in
connection with the origination of the Mortgage Loan, the pool insurer will
not be liable for the portion of the loss attributable to such fraud or
misrepresentation. Although the Company will generally have recourse to the
seller based on the seller's representations and warranties to the Company,
the Company will be at risk for loss to the extent the seller does not perform
its repurchase obligations.
Other REITs
The Company may purchase securities in other REITs or stock in similar
companies when the Company believes that such purchases will yield fairly
attractive returns on capital employed. When the stock market valuations of
such companies are low in relation to the market value of their assets, the
Company believes that such stock purchases provide a method for the Company to
acquire an interest in a pool of Mortgage Assets at an attractive price. The
Company does not, however, presently intend to invest in the securities of
other issuers for the purpose of exercising control or to underwrite the
securities of other issuers. During the period ended December 31, 1998 the
Company acquired an approximately $500,000 position in Thornburg Mortgage
Asset Corporation preferred stock.
16
Other Policies
The Company intends to operate in a manner that will not subject it to
regulation under the Investment Company Act. The Company does not currently
intend to (i) originate loans, or (ii) offer securities in exchange for real
property.
Future Revisions in Policies and Strategies
The Board of Directors has established the investment policies, operating
policies and strategies set forth in the Company's Prospectus. The Board of
Directors has the power to modify or waive such policies and strategies
without the consent of the stockholders to the extent that the Board of
Directors (including a majority of the Unaffiliated Directors) determines that
such modification or waiver is in the best interests of stockholders. Among
other factors, developments in the market that affect the policies and
strategies mentioned herein or which change the Company's assessment of the
market may cause the Company's Board of Directors to revise its policies and
strategies. However, if such modification or waiver relates to the
relationship of, or any transaction between, the Company and the Manager or
any Affiliate of the Manager, the approval of a majority of the Unaffiliated
Directors is also required.
The Company monitors closely its purchases of Mortgage Assets and the income
from such assets, including from its hedging strategies, so as to ensure at
all times that it maintains its qualification as a REIT and its exemption
under the Investment Company Act. The Company has engaged qualified
accountants and tax experts to assist in developing accounting systems and
testing procedures and to conduct quarterly compliance reviews designed to
determine compliance with the REIT Provisions of the Code and the Company's
exempt status under the Investment Company Act. See "Federal Income Tax
Considerations--Requirements for Qualification as a REIT" and "Risk Factors--
Failure to Maintain Exemption from the Investment Company Act Would Adversely
Affect Results of Operations" and "--Failure to Maintain REIT Status Would
Result in the Company Being Subject to Tax as a Regular Corporation and
Substantially Reduce Cash Flow Available for Distribution to Stockholders." No
changes in the Company's investment and operating policies, including credit
criteria for Mortgage Asset investments, may be made without the approval of
the Company's Board of Directors, including by a majority of the Unaffiliated
Directors.
DISTRIBUTION POLICY
The Company intends to distribute substantially all of its taxable income to
stockholders in each year (which does not ordinarily equal net income as
calculated in accordance with GAAP). The Company intends to declare four
regular quarterly distributions. In addition, taxable income, if any, not
distributed through regular quarterly dividends may be distributed annually,
at or near year end, in a special dividend. The distribution policy is subject
to revision at the discretion of the Board of Directors. All distributions
will be made by the Company at the discretion of the Board of Directors and
will depend on the earnings of the Company, the financial condition of the
Company, maintenance of REIT status and such other factors as the Board of
Directors deems relevant. See "Federal Income Tax Considerations--Requirements
for Qualification as a REIT--Distribution Requirement."
In order to qualify as a REIT under the Code, the Company must make
distributions to its stockholders each year in an amount at least equal to (i)
95% of its Taxable Income before deduction of dividends paid (less any 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, minus (iii) any
excess noncash income. The "Taxable Income" of the Company for any year means
the taxable income of the Company for such year (excluding any net income
derived either from property held primarily for sale to customers or from
foreclosure property) subject to certain adjustments provided in the REIT
Provisions of the Code.
It is anticipated that distributions generally will be taxable as ordinary
income to stockholders of the Company, although a portion of such
distributions may be designated by the Company as capital gain or may
constitute a return of capital. The Company will furnish annually to each of
its stockholders a statement setting
17
forth distributions paid during the preceding year and their characterization
as ordinary income, return of capital or capital gains. For a discussion of
the federal income tax treatment of distributions by the Company, see "Federal
Income Tax Considerations--Taxation of Stockholders."
COMPETITION FOR MORTGAGE ASSETS
In acquiring Mortgage Assets, the Company competes with other REITs,
investment banking firms, savings and loan associations, banks, mortgage
bankers, insurance companies, mutual funds, other lenders, GNMA, Fannie Mae,
FHLMC and other entities purchasing Mortgage Assets, most 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.
Increased competition for the acquisition of eligible Mortgage Assets or a
diminution in the supply could result in higher prices and, thus, lower yields
on such Mortgage Assets that could further narrow the yield spread over
borrowing costs.
The Company has been able to compete effectively and generate competitive
rates of return for stockholders by utilizing leverage through accessing
wholesale markets for collateralized borrowings and as a result of its
exemption from certain forms of regulation and the tax advantages of its REIT
status.
EMPLOYEES
As of December 31, 1998 the Company had no employees. The Manager carries
out the day to day operations of the Company, subject to the supervision of
the Board of Directors and under the terms of the Management Agreement.
FEDERAL INCOME TAX CONSIDERATIONS
General
The following discussion summarizes the material federal income tax
considerations that may be relevant to a holder of shares of Common Stock of
the company. This discussion is based on current law. the following discussion
is not exhaustive of all possible tax considerations. It does not discuss any
state, local or foreign tax considerations, nor does it discuss all of the
aspects of federal income taxation that may be relevant to a prospective
stockholder in light of such stockholder's particular circumstances or to
certain types of stockholders (including insurance companies, certain tax-
exempt entities, financial institutions, broker/dealers, foreign corporations
and persons who are not citizens or residents of the United States) subject to
special treatment under federal income tax laws.
Each stockholder and prospective stockholder of Common Stock of the Company
is urged to consult with his own tax advisor regarding the specific
consequences to him of the purchase, ownership and sale of stock in an entity
electing to be taxed as a REIT, including the federal, state, local, foreign
and other tax considerations of such purchase, ownership, sale and election
and the potential changes in applicable tax laws.
The Code provides special tax treatment for organizations that qualify and
elect to be taxed as REITs. The discussion below summarizes the material
provisions applicable to the Company as a REIT for federal income tax purposes
and to its stockholders in connection with their ownership of shares of Common
Stock. However, it is impractical to set forth in this Annual Report on Form
10-K all aspects of federal, state, local and foreign tax law that may have
tax consequences with respect to an investor's purchase of the Common Stock.
The discussion of various aspects of federal taxation contained herein is
based on the Code, administrative regulations, judicial decisions,
administrative rulings and practice, all of which are subject to change. In
brief, if certain detailed conditions imposed by the Code are met, entities
that invest primarily in real estate assets, including Mortgage
18
Loans, and that otherwise would be taxed as corporations are, with certain
limited exceptions, not taxed at the corporate level on their taxable income
that is currently distributed to their stockholders. This treatment eliminates
most of the "double taxation" (at the corporate level and then again at the
stockholder level when the income is distributed) that typically results from
the use of corporate investment vehicles. A qualifying REIT, however, may be
subject to certain excise and other taxes, as well as normal corporate tax, on
Taxable Income that is not currently distributed to its stockholders. See "--
Taxation of the Company" below.
The Company will elect to become subject to tax as a REIT, for Federal
income tax purposes, commencing with the taxable year ending December 31,
1998. The Board of Directors of the Company currently expects that the Company
will continue to operate in a manner that will permit the Company to maintain
its qualification as a REIT for the taxable year ending December 31, 1998, and
in each taxable year thereafter. This treatment will permit the Company to
deduct dividend distributions to its stockholders for Federal income tax
purposes, thus effectively elimination the "double taxation" that generally
results when a corporation earns income and distributes that income to its
stockholders in the form of dividends. It must be emphasized that the
Company's qualification and taxation as a REIT depends upon its ability to
meet on a continuing basis through actual annual operating results,
distribution levels and stock ownership, the various qualification tests
imposed under the Code that are discussed below. No assurance can be given
that the actual results of the Company's operations for any particular year
will satisfy such requirements.
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 immediately 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 Common 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 (as defined by the Code to
include certain entities). If, for any taxable year, the Company complies with
regulations requiring the maintenance of records to ascertain ownership of its
outstanding stock and the Company does not know or have reason to know that it
failed to satisfy this test, it will be treated as satisfying this test for
any such taxable year. In determining whether the Company's shares are held by
five or fewer individuals, the attribution rules of Sections 544 of the Code
apply. For a description of these attribution rules, see "Description of
Capital Stock." The Company's Charter impose certain repurchase provisions and
transfer restrictions to avoid more than 50% by value of any class of the
Company's stock being held by five or fewer individuals (directly or
constructively) at any time during the last half of any taxable year. Such
repurchase and transfer restrictions will not cause the stock not to be
treated as "transferable" for purposes of qualification as a REIT. 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 will use 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 Real Estate
Assets, government securities, cash and cash items (the "75% of Assets Test").
The Company expects that substantially all of its assets will be Qualified
REIT Real Estate Assets. Qualified REIT Real Estate 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. Hedging contracts (other than those which are Qualified REIT Real
Estate Assets) and certain types of other Mortgage Assets may be treated as
securities of the entity issuing such agreements or interests. The Company
will take measures to
19
prevent the value of such contracts, interests or assets issued by any one
entity to exceed 5% of the value of the Company's assets as of the end of each
calendar quarter. Moreover, pursuant to its compliance guidelines, the Company
intends to monitor closely (on not less than a quarterly basis) the purchase
and holding of the Company's assets in order to comply with the above assets
tests. In particular, as of the end of each calendar quarter the Company
intends to limit and diversify its ownership of hedging contracts and other
Mortgage Securities that do not constitute Qualified REIT Real Estate Assets
to less than 25%, in the aggregate, by value of its portfolio, to less than 5%
by value as to any single issuer, and to less than 10% of the voting stock of
any single issuer (collectively the "25% of Assets Test"). 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.
When purchasing Mortgage Securities, the Company may rely on certain
opinions of counsel for the issuer or sponsor of such securities given in
connection with the offering of such securities, or statements made in related
offering documents, for purposes of determining whether and to what extent
those securities (and the income therefrom) constitute Qualified REIT Real
Estate Assets (and income) for purposes of the 75% of Assets Test (and the
source of income tests discussed below). If the Company invests in a
partnership, it will be treated as receiving its share of the income and loss
of the partnership and owning a proportionate share of the assets of the
partnership and any income from the partnership will retain the character that
it had in the hands of the partnership. If the Company forms a taxable
affiliate to conduct mortgage origination and other activities, it will obtain
an opinion of counsel that the proposed organization and ownership of an
interest in the taxable affiliate will not adversely affect the Company's
status as a REIT.
Where a failure to satisfy any of the asset tests discussed above results
from an acquisition of securities or other property during a quarter, the
failure can be cured by a disposition of sufficient non-qualifying assets
within 30 days after the close of such quarter. The Company intends to
maintain adequate records of the value of its assets to determine its
compliance with the asset tests, and intends to take such action as may be
required to cure any failure to satisfy the test within 30 days after the
close of any quarter.
Gross Income Tests. The Company must meet two separate 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 the following sources:
(i) rents from real property, (ii) interest (other than interest based in
whole or in part on the income or profits of any person) on obligations
secured by mortgages of real property or on interests in real property; (iii)
gains from the sale or other disposition of interests in real property and
real estate mortgages other than gain from stock in trade, inventory or
property held primarily for sale to customers in the ordinary course of the
Company's trade or business ("Dealer Property"); (iv) dividends or other
distributions on shares in other REITs and, provided such shares are not
Dealer Property, gain from the sale of such shares; (v) abatements and refunds
of real property taxes; (vi) income from the operation, and gain from the
sale, of property acquired at or in lieu of a foreclosure of the mortgage
secured by such property or as a result of a default under a lease of such
property ("Foreclosure Property"); (vii) income received as consideration for
entering into agreements to make loans secured by real property or to purchase
or lease real property (including interests in real property and interests in
mortgages on real property) (for example, commitment fees); (viii) gain from
the sale of other disposition of a real estate asset which is not a prohibited
transaction; and (ix) income attributable to stock or debt instruments
acquired with the proceeds from the sale of stock or certain debt obligations
("New Capital") of the Company received during the one-year period beginning
on the day such proceeds were received ("Qualified Temporary Investment
Income").
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 or disposition of stock or other securities
that are not Dealer Property (the "95% of Income Test"). Income attributable
to Mortgage Warehouse Participations. Mortgage Securities (other than
Qualified REIT Real Estate Assets) that the Company holds directly, dividends
on stock
20
interest on any other obligations not secured by real property, and gains from
the sale or disposition of stock or other securities that are not Qualified
REIT Real Estate Assets will constitute qualified income for purposes of the
95% of Income Test only, but will not be qualified income for purposes of the
75% of Income Test. Income from mortgage servicing contracts, loan guarantee
fees (or other contracts under which the Company would earn fees for
performing services) and hedging (other than from Qualified REIT Real Estate
Assets) will not qualify for either the 95% or 75% of Income Tests. The
Company intends to severely limit such income and its acquisition of any
assets or investments the income from which does not qualify for purposes of
the 95% of Income Test. Moreover, in order to help ensure compliance with the
95% of Income Test and the 75% of Income Test, the Company limits
substantially all of the assets that it acquires to Qualified REIT Real Estate
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. At December 31, 1998, over 95% of the Company's assets were Qualified
REIT Real Estate Assets.
For purposes of determining whether the Company complies with the 75% of
Income Test and the 95% of Income Test detailed above, gross income does not
include gross income from "Prohibited Transactions." A "Prohibited
Transaction" is one involving a sale of Dealer Property, other than
Foreclosure Property. Net income from Prohibited Transactions is subject to a
100% tax. See "--Taxation of the Company" below.
The Company maintains its qualifications for REIT status by carefully
monitoring its income, including income from hedging transactions, futures
contracts and sales of Mortgage Assets to comply with the 75% of Income Test
and the 95% of Income Test. In order to help assure its compliance with the
REIT Provisions of the Code, the Company will adopt guidelines the effect of
which will be to limit its ability to earn certain types of income. See
"Operating Policies and Policies." 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% of Income Test or the 95% of Income Test, reduced by estimated related
expenses or (b) loss of REIT status. There can be no assurance that the
Company will always be able to maintain compliance with the gross income tests
for REIT qualification despite its periodic monitoring procedures. Moreover,
there is no assurance that the relief provisions for a failure to satisfy
either the 95% or the 75% of Income Tests will be available in any particular
circumstance.
Distribution Requirement. In order to be taxed as a REIT, the Company is
required to distribute dividends (other than capital gain dividends) to its
stockholders on a pro rata basis each year in an amount at least 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
excess noncash income (the "95% Distribution Test"). See "Distribution
Policy." The Company intends to make distributions to its stockholders in
amounts sufficient to meet this 95% distribution requirement. Such
distributions must be made in the taxable year to which they relate or, if
declared before the timely filing of the Company's tax return for such year
and paid not later than the first regular dividend payment after such
declaration, in the following taxable year. 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, and (iii) income not distributed in earlier
years.
The Service has ruled that if a REIT's dividend reinvestment plan allows
stockholders of the REIT to elect to have cash distributions reinvested in
shares of the REIT at a purchase price equal to at least 95% of fair market
value on the distribution date, then such cash distributions qualify under the
95% distribution test. The Company intends that the terms of its Dividend
Reinvestment Plan which it intends to adopt in the future will comply with
this ruling.
If the Company fails to meet the 95% Distribution Test as a result of an
adjustment to the Company's tax returns by the Service, the Company by
following certain requirements set forth in the Code, may pay a deficiency
dividend within a specified period that will be permitted as a deduction in
the taxable year to which
21
the adjustment is made. The Company would be liable for interest based on the
amount of the deficiency dividend. A deficiency dividend is not permitted if
the deficiency is due to fraud with intent to evade tax or to a willful
failure to file a timely tax return.
Recordkeeping Requirements. A REIT 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 a specified level of the REIT's shares (e.g., if the
Company has over 200 but fewer than 2,000 stockholders of record, from persons
holding 1% or more of the Company's outstanding shares of stock and if the
Company has 200 or fewer stockholders of record, from persons holding 1/2% or
more of the stock) regarding their ownership of shares. The Company must
maintain, as part of its 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 Treasury Regulations.
Termination or Revocation of REIT Status
The Company's election to be treated as a REIT will be terminated
automatically if it fails to meet the requirements described above. In that
event, the Company will not be eligible again to elect REIT status until the
fifth taxable year that begins after the year for which its election was
terminated unless all of the following relief provisions apply: (i) the
Company did not willfully fail to file a timely return with respect to the
termination taxable year, (ii) inclusion of incorrect information in such
return was not due to fraud with intent to evade tax, and (iii) the Company
establishes that failure to meet the requirements was due to reasonable cause
and not willful neglect. The Company may also voluntarily revoke its election,
although it has no intention of doing so, in which event it will be
prohibited, without exception, from electing REIT status for the year to which
the revocation relates and the following four taxable years.
If the Company fails to qualify for taxation as a REIT in any taxable year,
and the relief provisions do not apply, the Company would be subject to tax
(including any applicable alternative minimum tax) on its taxable income at
regular corporate rates. Distributions to stockholders of the Company with
respect to any year in which it fails to qualify as a REIT would not be
deductible by the Company nor would such distributions be required to be made.
In such event, to the extent of current and accumulated earnings and profits,
all distribution to stockholders will be taxable as ordinary income and
subject to certain limitations in the Code, stockholders may be eligible for
the dividends received deduction. Failure to qualify as a REIT would result in
a reduction of the Company's distributions to stockholders in order to pay the
resulting taxes. If, after forfeiting REIT status, the Company later qualifies
and elects to be taxed as a REIT again, the Company could face significant
adverse tax consequences.
Taxation of the Company
In any year in which the Company qualifies as a REIT, it generally will not
be subject to federal income tax on that portion of its Taxable Income or net
capital gain which is distributed to its stockholders. The Company will,
however, be subject to tax at normal corporate rates upon any Net Income or
net capital gain not distributed. The Company intends to distribute at least
95% of its Taxable Income to its stockholders on a pro rata basis in each
year. See "Distribution Policy."
Notwithstanding its qualification as a REIT, the Company will also be
subject to a tax of 100% of net income from any prohibited transaction and
will be subject to a 100% tax on the greater of the amount by which it fails
either the 75% or 95% of Income Tests, reduced by estimated related expenses,
if the failure to satisfy such tests is due to reasonable cause and not
willful neglect and if certain other requirements are met. The Company may be
subject to the alternative minimum tax on certain items of tax preference.
22
If the Company acquires any real property as a result of foreclosure, or by
a deed in lieu of foreclosure, it may elect to treat such real properly as
Foreclosure Property. Net income from the sale of Foreclosure Property is
taxable at the maximum federal corporate rate, currently 35%. Income from
Foreclosure Property will not be subject to the 100% tax on prohibited
transactions. The Company has the right determine whether to treat such real
properly as Foreclosure Property on the tax return for the fiscal year in
which such property is acquired.
If the Company itself were to sell Mortgage Securities on a regular basis,
there is a substantial risk that such Mortgage Securities would be deemed
Dealer Property with all of the profits from such sales subject to tax at the
rate of 100% as income from prohibited transactions. However, the Company,
subject to limitations, may invest in taxable subsidiaries which themselves
may securitize Mortgage Loans and sell such Mortgage Securities without being
subject to this 100% tax on income derived from prohibited transactions, as
such a tax is only applicable to a REIT. See "--Taxable Subsidiaries" below.
The Company may elect to retain and pay income tax on all or a portion of
its net long-term capital gains for any taxable year, in which case the
Company's stockholders would include in their income as long-term capital
gains their proportionate share of such undistributed capital gains. The
stockholders would be treated as having paid their proportionate share of the
capital gains tax paid by the Company, which amounts would be credited or
refunded to the stockholders.
The Company will also be subject to a nondeductible 4% excise tax if it
fails to make timely dividend distributions for each calendar year. See "--
Requirements for Qualification as a REIT--Distribution Requirement" above. The
Company intends to declare its fourth regular annual dividend, as well as a
fifth special dividend, if any, during the final quarter of the year and to
make such dividend distribution no later than 31 days after the end of the
year in order to avoid imposition of the excise tax. Such a distribution would
be taxed to the stockholders in the year that the distributions were declared,
not in the year paid. Imposition of the excise tax on the Company would reduce
the amount of cash available for distribution to its stockholders.
Taxable Subsidiaries
The Company may, in the future, cause the creation and sale of Mortgage
Securities through a taxable corporation. The Company and one or more persons
or entities will own all of the capital stock of that taxable corporation,
sometimes referred to as a "taxable subsidiary." In order to ensure that the
Company will not violate the prohibition on ownership of more than 10% of the
voting stock of a single issuer and the prohibition on investing more than 5%
of the value of its assets in the stock or securities of a single issuer, the
Company will own only shares of nonvoting preferred stock of that taxable
subsidiary corporation and will not own any of the taxable subsidiary's Common
Stock. The Company will monitor the value of its investment in the taxable
subsidiary on a quarterly basis to limit the risk of violating any of the
tests that comprise the 25% of Assets Test. In addition, the dividends that
the taxable subsidiary pays to the Company will not qualify as income from
Qualified REIT Real Estate Assets for purposes of the 75% of Income Test, and
in all events would have to be limited, along with the Company's other
interest, dividends, gains on the sale of securities, hedging income, and
other income not derived from Qualified REIT Real Estate Assets to less than
25% of the Company's gross revenues in each year. The taxable subsidiary will
not elect REIT status, will be subject to income taxation on its net earnings
and will generally be able to distribute only its net after-tax earnings to
its stockholders, including the Company, as dividend distributions. If the
taxable subsidiary creates a taxable mortgage pool, such pool itself will
constitute a separate taxable subsidiary of the taxable subsidiary. The
taxable subsidiary would be unable to offset the income derived from such a
taxable mortgage pool with losses derived from any other activities.
In the proposed Fiscal Year 2000 Budget released February, 1999, the Clinton
Administration recommended changing the 10% asset test to prohibit a REIT from
owning more than ten percent (10%) of vote or value of certain other
corporations. Such a provision has been included in President Clinton's prior
tax proposals but has not been enacted into law. Were such a proposal to
become law, the Company's continued qualification as a REIT might require
modification of the Company's current or future ownership of taxable
subsidiaries. Before the Company engages in any hedging or securitization
activities or forms any such taxable subsidiary
23
corporations, the Company will consult with its tax advisors to determine
whether such activities or the formation and contemplated method of operation
of such corporation would cause the Company to fail to satisfy the REIT asset
tests and REIT gross income tests as defined above.
Taxation of Stockholders
For any taxable year in which the Company is treated as a REIT for federal
income tax purposes, amounts distributed by the Company to its stockholders
other than tax-exempt entities out of current or accumulated earnings and
profits will be includable by the stockholders as ordinary income for federal
income tax purposes unless such distributions are 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 Common Stock 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 Common Stock by such stockholders.
All or a portion of any loss realized upon a taxable disposition of shares may
be disallowed if other shares are purchased within 30 days before or after
disposition. In general, any gain realized upon the taxable disposition of the
Company's Common Stock by a stockholder who is not a dealer in securities will
be treated as capital gain. Lower marginal tax rates for individuals may apply
in the case of capital gains, depending upon the holding period of the shares
that are sold.
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. Instead, such losses would be carried
over by the Company for potential offset against its future income (subject to
certain limitations). If the Company makes distributions to its stockholders
in excess of its current and accumulated earnings and profits, those
distributions will be considered first as a tax-free return of capital,
reducing the tax basis of a stockholder's shares until the tax basis in such
shares is zero. Thereafter, distributions in excess of the tax basis will be
taxable as gain realized from the sale of the Company's stock.
Taxable distributions from the Company and gain from the disposition of the
Company's Common Stock will not be treated as passive activity income and,
therefore, stockholders will not generally be able to apply any passive
activity losses against such income. In addition, taxable distributions from
the Company generally will be treated as investment income for purposes of the
investment interest limitation. Capital gains from the disposition of the
shares (or distributions treated as such) will be treated as investment income
only if the stockholder so elects, in which case such capital gains will be
taxed at ordinary income rates.
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 and the portions that constitute either return of capital or 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 in fact paid
before February 1 of the following year.
The Company does not expect to acquire residual interests issued by REMICs.
Such residual interests, if acquired by a REIT, may generate excess inclusion
income. Excess inclusion income cannot be offset by net operating losses of a
stockholder. If the stockholder is a Tax-Exempt Entity, the excess inclusion
income is fully taxable as UBTI. If allocated to a foreign stockholder, the
excess inclusion income is subject to federal income tax withholding without
reduction pursuant to any otherwise applicable tax treaty. Potential
investors, and in particular Tax-Exempt Entities, are urged to consult with
their tax advisors concerning this issue.
The Company intends to finance the acquisition of Mortgage Assets by
entering into, among other things, reverse repurchase agreements, which are
essentially loans secured by the Company's Mortgage Assets. The Company may
enter into master repurchase agreements with secured lenders known as
"Counter-parties." Typically, such master repurchase agreements have cross-
collateralization provisions that afford the counter-party the right to
foreclose on the Mortgage Assets pledged as collateral. If the Service were to
successfully take
24
the position that the cross-collateralization provisions of the master
repurchase agreements result in the Company having issued debt instruments
(the reverse repurchase agreements) with differing maturity dates secured by a
pool of Mortgage Loans, a portion of its income could be characterized as
"excess inclusion income." See "Risk Factors--Risk of Adverse Tax Treatment of
Excess Inclusion Income."
Taxation of Tax-Exempt Entities
In general, a Tax-Exempt Entity that is a stockholder of the Company is not
subject to tax on distributions. The Service has ruled that amounts
distributed by a REIT to an exempt employees' pension trust do not constitute
UBTI and thus should be nontaxable to such a Tax-Exempt Entity. Based on that
ruling, but subject to the discussion of excess inclusion income set forth
under "--Taxation of Stockholders" above, indebtedness incurred by the Company
in connection with the acquisition of real estate assets such as Mortgage
Loans will not cause dividends of the Company paid to a stockholder that is a
Tax-Exempt Entity to be UBTI. However, if a Tax-Exempt Entity has financed the
acquisition of any of its stock in the Company with "acquisition
indebtedness," within the meaning of the Code, distributions on such stock
could be treated as UBTI. Under certain conditions, if a tax-exempt employee
pension or profit sharing trust were to acquire more than 10% of the Company's
stock, a portion of the dividends on such stock could be treated as UBTI.
For social clubs, voluntary employee benefit associations, supplemental
unemployment benefit trusts, and qualified group legal services plans exempt
from federal income taxation under Code Sections 501(c)(7), (c)(9), (c)(17)
and (c)(20), respectively, income from an investment in the Company will
constitute UBTI unless the organization is able to properly deduct amounts set
aside or placed in reserve for certain purposes so as to offset the UBTI
generated by its investment in the Company. Such entities should review Code
Section 512(a)(3) and should consult their own tax advisors concerning these
"set aside" and reserve requirements.
State and Local Taxes
The Company and its stockholders may be subject to state or local taxation
in various jurisdictions, including those in which it or they transact
business or reside. The state and local tax treatment of the Company and its
stockholders may not conform to the federal income tax consequences discussed
above. Consequently, prospective stockholders should consult their own tax
advisors regarding the effect of state and local tax laws on an investment in
the Common Stock.
Certain United States Federal Income Tax Considerations Applicable to Foreign
Holders
The following discussion summarizes certain United States tax consequences
of the acquisition, ownership and disposition of the Common Stock by an
initial purchaser of the Common Stock that, for United Stares income tax
purposes, is not a "United States person" (a "Foreign Holder"). For purposes
of this discussion, a United States persons means: a citizen or resident of
the United States; a corporation, partnership, or other entity created or
organized in the United States or under the laws of the United States or of
any political subdivision thereof (unless, in the case of a partnership, the
Service provides otherwise by regulations); an estate whose income is
includable in gross income for United States income tax purposes regardless of
its source; or, a trust if a court within the United States is able to
exercise primary supervision over the administration of the trust and one or
more United States persons have the authority to control all substantial
decisions of the trust. This discussion does not consider any specific facts
or circumstances that may apply to a particular Foreign Holder. Prospective
investors are urged to consult their tax advisors regarding the United States
tax consequences of acquiring, holding and disposing of the Common Stock, as
well as any tax consequences that may arise under the laws of any foreign,
state, local or other taxing jurisdiction.
Dividends. Dividends paid by the Company out of earnings and profits (and
not otherwise designated as capital gains dividends), as determined for United
States income tax purposes, to a Foreign Holder will generally be subject to
withholding of United States federal income tax at the rate of 30%, unless
reduced or eliminated by an applicable tax treaty or unless such dividends are
treated as effectively connected with a United States trade
25
or business conducted by the Foreign Holder. A Foreign Holder eligible for a
reduction in withholding under an applicable treaty must so notify the Company
by completing the appropriate IRS form. Distributions paid by the Company in
excess of its earnings and profits will be treated as a tax-free return of
capital to the extent of the holder's adjusted basis in his Common Stock, and
thereafter as gain from the sale or exchange of a capital asset as described
below. If it cannot be determined at the time a distribution is made whether
such distribution will exceed the Company's earnings and profits, the
distribution will be subject to withholding at the same rate as dividends.
Amounts so withheld, however, will be refundable or creditable against the
Foreign Holder's United States tax liability if the Company subsequently
determines that such distribution was, in fact, in excess of the earnings and
profits of the Company. If the receipt of the dividend is treated as being
effectively connected with the conduct of a trade or business within the
United States by a Foreign Holder, the dividend received by such holder will
be subject to the same United States federal income tax on net income that
applies to United States persons generally (and, with respect to foreign
corporate holders and under certain circumstances, the 30% branch profits
tax).
For any year in which the Company qualifies as a REIT, distributions to a
Foreign Holder that are attributable to gain from the sales or exchanges by
the Company of "United States real property interests" will be treated as if
such gain were effectively connected with a United States business and will
thus be subject to tax at the normal capital gain rates applicable to United
States stockholders (subject to applicable alternative minimum tax) under the
provisions of the Foreign Investment in Real Property Tax Act of 1980
("FIRPTA"). Also, distributions subject to FIRPTA may be subject to a 30%
branch profits tax in the hands of a foreign corporate stockholder not
entitled to a treaty exemption. The Company is required to withhold 35% of any
distribution that could be designated by the Company as a capital gains
dividend. This amount may be credited against the Foreign Holder's FIRPTA tax
liability.
Gain on Disposition. A Foreign Holder will generally not be subject to
United States federal income tax on gain recognized on a sale or other
disposition of the Common Stock unless (i) the gain is effectively connected
with the conduct of a trade or business within the United States by the
Foreign Holder, (ii) in the case of a Foreign Holder who is a nonresident
alien individual and holds the Common Stock as a capital asset, such holder is
present in the United States for 183 or more days (computed in part by
reference to days present in the 2 prior years) in the taxable year and
certain other requirements are met, or (iii) the Foreign Holder is subject to
tax under the FIRPTA rules discussed below. Gain that is effectively connected
with the conduct of a United States business will be subject to the United
States federal income tax on net income that applies to United States persons
generally (and, with respect to corporate holders and under certain
circumstances, the branch profits tax) but will not be subject to withholding.
Foreign Holders should consult applicable treaties, which may provide for
different rules.
Gain recognized by a Foreign Holder upon a sale of its Common Stock will
generally not be subject to tax under FIRPTA if the Company is a "domestically
controlled REIT," which is defined generally as a REIT in which at all times
during a specified testing period less than 50% in value of its shares were
held directly or indirectly by non-U.S. persons. Because only a minority of
the Company's stockholders are expected to be Foreign Holders, the Company
anticipates that it will qualify as a "domestically controlled REIT."
Accordingly, a Foreign Holder should not be subject to U.S. tax from gains
recognized upon disposition of the Common Stock. However, because the Common
Stock will be publicly traded, no assurance can be given that the Company will
continue to be a "domestically controlled REIT."
Information Reporting and Backup Withholding. The Company will report to its
U.S. stockholders and the IRS the amount of distributions paid during each
calendar year, and the amount of tax withheld, if any. Under the backup
withholding rules, a stockholder may be subject to a backup withholding at the
rate of thirty-one percent (31%) with respect to distributions paid unless
such holder (i) is a corporation or comes within certain other exempt
categories, and, when required, demonstrates this fact, or (ii) provides a
taxpayer identification number, certifies as to no loss of exemption from
backup withholding and otherwise complies with the applicable requirements of
the backup withholding rules. A stockholder who does not provide the Company
with its correct taxpayer identification number also may be subject to
penalties imposed by the IRS. In addition, the Company
26
may be required to withhold a portion of the capital gain distribution to any
stockholders who fail to certify their non-foreign status to the Company. U.S.
stockholders should consult their own tax advisors regarding their
qualification for an exemption from backup withholding and the procedure for
obtaining such an exemption. Backup withholding is not an additional tax.
Rather the amount of any backup withholding with respect to a payment to a
U.S. stockholder will be allocated as a credit against the U.S. stockholder's
United States federal income tax liability and may entitle the U.S.
stockholder to a refund, provided that the required information is furnished
to the IRS.
Backup withholding tax and information reporting generally will not apply to
distributions paid to non U.S. stockholders outside the United States that are
treated as (i) dividends subject to the thirty percent (30%) (or lower treaty
rate) withholding tax discussed above, (ii) capital gain dividends, or (iii)
distributions attributable to gain from the sale or exchange by the Company of
U.S. real property interests. As a general matter, backup withholding and
information reporting will not apply to a payment of the proceeds of a sale of
the Company's Common Stock by or through a foreign office or a foreign broker.
Information reporting (but not backup withholding) will apply, however, to a
payment of the proceeds of a sale of the Company's by a foreign office of a
broker that (i) is a United States person, (ii) derives fifty percent (50%) or
more of its gross income from certain periods from the conduct of a trade or
business in the United States, or (iii) is a controlled foreign corporation
for United States tax purposes, unless the broker has documentary evidence in
its records that the holder is a non-U.S. stockholder and certain other
conditions are satisfied, or the stockholder otherwise establishes an
exemption. Payment to or through a United States office of a broker of the
proceeds of a sale of the Company's Common Stock is subject to both backup
withholding and information reporting unless the stockholder certifies under
penalties of perjury that the stockholder is a non-U.S. stockholder otherwise
established as an exemption. A non-U.S. stockholder may obtain a refund of any
amounts withheld under the backup withholding rules by filing the appropriate
claim for a refund with the IRS.
The Treasury Department issued final regulations in October, 1997 concerning
the withholding of tax and information reporting for certain amounts paid to
non-resident alien individuals and foreign corporations. These new withholding
rules alter the current withholding regime, and generally will be effective
for distributions made after December 31, 1999. Investors should consult their
tax advisors concerning the impact, if any, of these new regulations on an
investment in the Company's Common Stock.
REPURCHASE STRATEGY
From time to time and at the direction of the Board of Directors, the
Company may repurchase shares of Common Stock in the open market. To date, the
Board of Directors of the Company has authorized the Company to repurchase
50,000 shares of Common Stock in the open market. As of December 31, 1998, the
Company had not purchased any shares of Common Stock. As of March 5, 1999, the
Company had purchased 10,900 shares of Common Stock.
27
RISK FACTORS
An investment in the Company involves various risks, including the risk that
an investor can lose capital. There is no guarantee that the Company can
successfully implement its business strategy, reach its investment objectives
or achieve a positive return for stockholders.
The various risks the Company faces can be separated into two categories,
Operational Risks and Legal and Other Risks.
OPERATIONAL RISKS
Use of Reverse Repurchase Agreements and Other Financing Agreements Could
Limit the Company's Ability to Acquire or Dispose of Mortgage Assets
Substantially all of the Company's Mortgage Assets are pledged to secure
reverse repurchase agreements, bank borrowings or other credit arrangements.
Therefore, such Mortgage Assets may not be available to the stockholders in
the event of the liquidation of the Company, except to the extent that the
market value thereof exceeds the amounts due to the Company's creditors. The
market value of the Mortgage Assets will fluctuate as a result of numerous
market factors (including interest rates and prepayment rates) as well as the
supply of and demand for such Mortgage Assets. In the event of the bankruptcy
of a counter-party with whom the Company has a reverse repurchase agreement,
the Company might experience difficulty recovering its pledged Mortgage
Assets, which may adversely affect the Company's results of operations. See
"Operating Policies and Programs--Capital and Leverage Policy."
In the event the Company is not able to renew or replace maturing
borrowings, it could be required to sell Mortgage Assets under adverse market
conditions and, as a result, could incur permanent capital losses. In
addition, in such event, the Company may be required to terminate hedge
positions, which could result in further losses. 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 or a similar event or development 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 its
Mortgage Assets at disadvantageous prices with consequent losses, which would
have a material adverse effect on the Company and could render it insolvent.
Additionally, although the Company intends generally to hold its Mortgage
Assets to maturity, because such assets will be pledged under reverse
repurchase agreements or other financing agreements, the ability of the
Company to sell Mortgage Assets and realize the cash therefrom is greatly
limited due to the obligation to repay amounts outstanding under such
agreements. If the Company desires to sell Mortgage Assets, its inability to
realize the cash therefrom could have a material adverse affect on its
financial condition and results of operations.
The Company Faces Significant Competition For Mortgage Assets and Financing
In acquiring Mortgage Assets, the Company competes with other REITs,
investment banking firms, savings and loan associations, banks, mortgage
bankers, insurance companies, mutual funds, other lenders, Fannie Mae, FHLMC,
GNMA and other entities purchasing Mortgage Assets, most of which have greater
financial resources than the Company. In addition, there are many REITs
similar to the Company, and others are expected to be organized in the future.
There is little that differentiates the Company from these REITs. The
existence of these competitors may increase competition for the available
supply of Mortgage Assets suitable for purchase by the Company. Increased
competition for the acquisition of eligible Mortgage Assets or a diminution in
the supply could result in higher prices and, thus, lower yields on such
Mortgage Assets that could further narrow the yield spread over borrowing
costs. Further, in fluctuating interest rate environments, the spread between
interest rates on adjustable-rate Mortgage Loans and interest rates on fixed
rate Mortgage Loans may decrease, and may cease to exist or become negative.
It could also result in the Company's inability to deploy funds in acceptable
28
investments, potentially decreasing the yields on the Company's portfolio and
the ability to generate earnings for its stockholders. Under such conditions,
mortgagors tend to favor fixed-rate Mortgage Loans, thereby decreasing the
supply of adjustable-rate Mortgage Securities available to the Company for
purchase. The relative availability of adjustable-rate Mortgage Securities may
also be diminished by a number of other market and regulatory considerations.
The Company also faces competition for financing sources, and the effect of
the existence of additional mortgage REITs may be to deny the Company access
to sufficient funds to carry out its business strategy and/or to increase the
cost of funds to the Company.
The Company's inability due to competitive pressures to acquire certain
types or classes of Mortgage Assets could have a material adverse affect on
the Company's financial condition and results of operations. For example, if
the Company were unable to acquire a sufficient volume of Primary Mortgage
Assets due to competition for such assets, it would not be able to fully
invest monies available for investment in Mortgage Assets due to the
requirement that no more than 30% of its portfolio may be comprised of Limited
Investment Assets. This would have a material adverse affect on the aggregate
yield the Company would earn on its assets, which would narrow the margin the
Company could earn over the cost of its borrowings. Moreover, if the Company
is unable to acquire a desired level of Limited Investment Assets due to
competition for such assets, the Company's yields could also be negatively
affected.
Interest Rate Fluctuations May Decrease Net Interest Income
Adjustable-rate Mortgage Assets are typically subject to periodic and
lifetime interest rate caps that limit the amount an adjustable-rate Mortgage
Asset's interest rate can change during any given period. For example, a
typical periodic interest rate cap may limit the amount the interest rate on a
Mortgage Asset can increase annually to 1.5%, and a typical lifetime interest
rate cap may limit the amount the interest rate on Mortgage Asset may increase
during the life of the asset to 5% over the interest rate at origination of
the asset. Adjustable-rate Mortgage Securities are also typically subject to a
minimum interest rate payable. The Company's borrowings will not be subject to
similar restrictions. Hence, in a period of increasing interest rates,
interest rates on its borrowings could increase without limitation by caps,
while the interest rates on its Mortgage Assets could be so limited. This
problem will be magnified to the extent the Company acquires Mortgage Assets
that are not fully indexed (i.e., not yielding a rate equivalent to the
applicable index plus the specified margin over the index). 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 less
cash income on its adjustable-rate Mortgage Assets than is required to pay
interest on the related borrowings. These factors could lower the Company's
net interest income or cause a net loss during periods of rising interest
rates, which would negatively impact the Company's liquidity and its ability
to make distributions to stockholders.
The Company often purchases a substantial portion of its adjustable-rate
Mortgage Assets with borrowings that have interest rates based on indices and
repricing terms similar to, but of somewhat shorter maturities than, the
interest rate indices and repricing terms of the Mortgage Assets. Thus, in
most cases the interest rate indices and repricing terms of its Mortgage
Assets and its funding sources are not identical, thereby creating an interest
rate mismatch between assets and liabilities. While the historical spread
between relevant short-term interest rate indices has been relatively stable,
there have been periods, especially during the 1979-1982 and 1994 interest
rate environments, when the spread between such indices was volatile. During
periods of changing interest rates, such interest rate mismatches could
negatively impact the Company's Net Income, dividend yield and the market
price of the Common Stock.
A substantial portion of the Company's Mortgage Securities are adjustable-
rate Pass-Through Certificates or floating rate CMOs which also are subject to
periodic interest rate adjustments based on such objective indices as LIBOR,
the Treasury Index or the CD Rate. "LIBOR" means the London Interbank Offered
Rate as it may be defined, and for a period of time specified, in a Mortgage
Security or borrowing of the Company. "Treasury Index" means the
monthly/weekly average yield of the benchmark U.S. Treasury securities, as
published by the Board of Governors of the Federal Reserve System. "CD Rate"
means the weekly average of secondary market
29
interest rates on six-month negotiable certificates of deposit, as published
by the Federal Reserve Board in its Statistical Release H. 15(519), Selected
Interest Rates. To the extent any of the Company's Mortgage Securities are
financed with borrowings bearing interest based on or varying with an index
different from that used for the related Mortgage Securities, so-called
"basis" interest rate risk results. In such event, if the index used for the
Mortgage Securities is a "lagging" index that reflects market interest rate
changes on a delayed basis, and the rate borne by the related borrowings
reflects market rate changes more rapidly, the Company's net interest income
will be adversely affected in periods of increasing market interest rates.
The Company expects that the net effect of these factors, all other factors
being equal, could be to lower the Company's net interest income or cause a
net loss during periods of rapidly rising market interest rates, which could
negatively impact the level of dividend distributions and reduce the market
price of the Common Stock. This reduction in net income, or net loss, could
occur in an increasing interest rate environment as a result of interest rate
increases in borrowings which are more rapid than interest rate increases on
the Company's Mortgage Securities or as a result of periodic and lifetime
interest rate caps on the Company's Mortgage Securities. See Operating
Policies and Procedures -- Asset Acquisition Policy.'
Failure To Successfully Manage Interest Rate Risks May Adversely Affect
Results of Operations
The Company follows a policy intended to minimize the impact of interest
rate changes. Although the Company has not yet engaged in such practices, the
Company may minimize the impact of interest rate changes through the use of
interest rate caps, swaps, futures contracts, puts, calls and trade forward
contracts. However, developing an interest rate risk strategy is complex and
no strategy can completely insulate the Company from risks associated with
interest rate changes. See "Operating Policies and Programs." In addition,
hedging strategies typically involve transaction costs that increase
dramatically as the period covered by the hedging transaction increases and
that may also increase during periods of rising and fluctuating interest
rates. The REIT Provisions of the Code may substantially limit the Company's
ability to engage in these hedging transactions, and may prevent the Company
from effectively implementing hedging strategies that it determines, absent
such restrictions, would best insulate the Company from the risks associated
with changing interest rates.
The adjustable-rate Mortgage Assets that the Company acquires are generally
subject to periodic and lifetime interest rate caps. The Company may purchase
Mortgage Derivative Securities for investment and to seek to mitigate the
negative impacts of those interest-rate caps in a rising interest rate
environment, but only on a limited basis due to the increased risk of loss
associated with such securities. Hedging techniques, when applied, will be
based, in part, on assumed levels of prepayments of the Company's Mortgage
Assets. If prepayments are slower than assumed, the life of the Mortgage
Assets will be longer and the effectiveness of the Company's hedging
techniques will be reduced. Hedging techniques involving the use of Mortgage
Derivative Securities are highly complex and may produce volatile returns. The
financial futures contracts and options thereon in which the Company may
invest are subject to periodic margin calls that would result in additional
costs to the Company. Financial futures held at fiscal year end are also
required to be marked to market and valued for tax purposes, which could
result in taxable income to the Company with no corresponding cash available
for distribution. There can be no assurance that these hedging techniques will
have a beneficial impact on the Net Income of the Company and the dividend
yield of the Common Stock. If a hedging instrument utilized by the Company
were found to be legally unenforceable, the Company's portfolio would be
exposed to interest rate fluctuations which could materially and adversely
affect the Company's business and results of operations. Additionally, hedging
strategies have significant transaction costs and the Company will not be able
to significantly reduce or eliminate the risk associated with its investment
portfolio without reducing or perhaps even eliminating the return on its
investments.
Federal tax laws applicable to REITs may substantially limit the Company's
ability to engage in asset/liability management transactions. Such Federal tax
laws may prevent the Company from effectively implementing hedging strategies
that the Company determines, absent such restrictions, would best insulate the
Company from the risks associated with changing interest rates and
prepayments. See "Federal Income Tax Considerations--Requirements for
Qualification as a REIT" and "--Taxation of the Company." In this regard,
30
the amount of income the Company may earn from its interest rate caps and
other hedging instruments may be subject to substantial limitations under the
REIT Provisions of the Code. In particular, income generated by such
instruments is non-qualifying income for purposes of the 75% Gross Income Test
and is income from the sale of a security subject to the 30% Gross Income
Test. Additionally, the Company will treat such income as non-qualifying
income for the 95% Gross Income Test unless it receives advice from its tax
advisors that such income constitutes qualifying income for purposes of such
test. Pursuant to recently enacted legislation, the 30% Gross Income Test has
been repealed for taxable years beginning after August 5, 1997, but such
income would still not qualify for the 759E, Gross Income Test or, subject to
the preceding sentence, the 95% Gross Income Test. See "Federal Income Tax
Considerations--Requirements for Qualification as a REIT--Gross Income Tests."
This determination may result in management electing to have the Company bear
a level of interest rate risk that might otherwise be hedged. The "75% Gross
Income Test" means the requirement for each taxable year that at least 75% of
the Company's gross income must be derived from certain specified real estate
sources including interest income and gain from the disposition of Qualified
REIT Real Estate Assets or "qualified temporary investment income" (i.e.,
income derived from "new capital" within one year of the receipt of such
capital). The "95% Gross Income Test" means the requirement for each taxable
year that at least 95% of the Company's gross income for each taxable year
must be derived from sources of income qualifying for the 75% Gross Income
Test, dividends, interest, and gains from the sale of stock or other
securities (including certain interest rate swap and cap agreements entered
into to hedge variable rate debt incurred to acquire Qualified REIT Real
Estate Assets) not held for sale in the ordinary course of business.
If the Company purchases interest rate caps or other interest rate
agreements to hedge against lifetime and periodic rate or payment caps, and
the provider of interest rate agreements become financially unsound or
insolvent, the Company may be forced to unwind its interest rate agreements
with such provider and may take a loss on such interest rate agreements.
Although the Company intends to purchase interest rate agreements 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.
Substantial Leverage and Potential Net Interest and Operating Losses in
Connection with Borrowings
The Company employs a leveraging strategy of increasing the size of its
Mortgage Assets portfolio by borrowing against its existing Mortgage Assets to
acquire additional Mortgage Assets. The Company's financing strategy is
designed to increase the size of its Mortgage Asset investment portfolio by
borrowing a substantial portion (which may vary depending upon the mix of the
Mortgage Assets in the Company's portfolio and the Company's requirements to
such mix of Mortgage Assets) of the market value of its Mortgage Assets. If
the coupon income on the Mortgage Assets purchased with borrowed funds fails
to cover the cost of the borrowings, the Company will experience net interest
losses and may experience net losses. Such losses could be increased
substantially as a result of the Company's substantial leverage.
The Company generally maintains a debt-to-equity ratio of between 8:1 and
12:1, although the ratio may vary from time to time depending upon market
conditions and other factors deemed relevant by management. Additionally,
there is no limitation on the amount of borrowings the Company may incur.
However, the Company is not limited under its Bylaws in respect of the amount
of its borrowings, whether secured or unsecured, and the debt-to-equity ratio
could at times be greater than 12:1. For purposes of calculating the debt-to-
equity ratio, the Company's equity equals the value of the Company's
investment portfolio on a mark-to-market basis less the book value of the
Company's obligations under repurchase agreements, dollar-roll agreements and
other collateralized borrowings. See "Operating Policies and Programs--Capital
and Leverage Policy."
The ability of the Company to achieve its investment objectives depends on
its ability to borrow money in sufficient amounts and on favorable terms.
Through increases in haircuts (i.e., the over-collateralization amount
required by a lender), decreases in the market value of the Company's Mortgage
Assets, increases in interest rate volatility, changes in the availability of
financing in the market, conditions then applicable in the lending market and
other factors, the Company may not be able to achieve the degree of leverage
it believes to be
31
optimal, which may cause the Company to be less profitable than it would be
otherwise. In addition, as a result of the Company's decision to structure its
investment portfolio to qualify for an exemption from regulation as an
investment company, the Company is limited in the types and amounts of
Mortgage Assets it can purchase which, in turn, may affect the ability of the
Company to achieve the degree of leverage it believes to be optimal.
Increased Levels of Prepayments from Mortgage Assets May Adversely Affect Net
Interest Income
Prepayments are the full or partial repayment of principal prior to the
original term to maturity of a Mortgage Loan and typically occur due to
refinancing of Mortgage Loans. Prepayments rates on Mortgage Securities vary
from time to time and may cause changes in the amount of the Company's net
interest income. Prepayments of adjustable-rate Mortgage Loans usually can be
expected to increase when mortgage interest rates fall below the then-current
interest rates on such loans and decrease when mortgage interest rates exceed
the then-current interest rate on such loans, although such effects are not
predictable. Prepayment experience also may be affected by the conditions in
the housing and financial markets, general economic conditions and the
relative interest rates on fixed-rate and adjustable-rate mortgage loans
underlying Mortgage Securities. Prepayments due to defaults and foreclosures
on non-Primary Assets tend to be more uncertain than those of Primary Mortgage
Assets due to greater credit risk and interest rate risk associated with non-
Primary Mortgage Assets. When prepayments due to defaults and foreclosures on
non-Primary Mortgage Assets are greater than expected, the Company will likely
receive a lower level of Net Interest Income. Some Mortgage Securities are
structured so that certain classes are provided protection from prepayments
for a period of time. However, in a period of extremely rapid prepayments,
during which earlier-paying classes may be retired faster than expected, the
protected classes may receive unscheduled payments of principal earlier than
expected and would have average lives that, while longer than the average
lives of the earlier-paying classes, would be shorter than originally
expected. The purchase prices of Mortgage Securities are generally based upon
assumptions regarding the expected amounts and rates of prepayments. Where
slow prepayment assumptions are made, the Company may pay a premium for
Mortgage Securities. To the extent such assumptions materially and adversely
differ from the actual amounts of prepayments, the Company would experience
losses. The Company seeks to minimize prepayment risk through a variety of
means, including structuring a diversified portfolio with a variety of
prepayment characteristics, investing in certain Mortgage Security structures
which have prepayment protection, and balancing assets purchased at a premium
with assets purchased at a discount. No strategy, however, can completely
insulate the Company from prepayment risks arising from the effects of
interest rate changes. Prepayment risk may be increased if the Company
purchases Interest Only Derivatives to protect against interest rate
increases. Certain Mortgage Securities may have underlying mortgage loans
which are convertible to fixed-rate loans. Since converted loans are required
to be repurchased by either FHLMC, Fannie Mae or GNMA or a servicer, the
conversion of a loan results, in effect, in the prepayment of such loan.
Prepayments of Mortgage Assets could adversely affect the Company's results
of operations in several ways. A substantial portion of the Company's
adjustable-rate Mortgage Assets may, from time to time, bear initial "teaser"
interest rates that 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 while it was less
profitable 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 at 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,
its financial condition, cash flows and results of operations could be
materially adversely affected.
Risk of Decline of Market Value of Mortgage Securities; Margin Calls and
Defaults
Certain of the Company's Mortgage Assets may be cross-collateralized to
secure multiple borrowing obligations of the Company to a single lender. A
decline in the market value of such assets could limit the
32
Company's ability to borrow or result in lenders initiating margin calls
(i.e., requiring a pledge of cash or additional Mortgage Assets to reestablish
the ratio of the amount of the borrowing to the value of the collateral). The
Company could be required to sell Mortgage Assets under adverse market
conditions in order to maintain liquidity. If these sales were made at prices
lower than the carrying value of its Mortgage Assets, the Company would
experience losses. A default by the Company under its collateralized
borrowings could also result in a liquidation of the collateral, including any
cross-collateralized assets, and a resulting loss of the difference between
the value of the collateral and the amount borrowed. Additionally, in the
event of a bankruptcy of the Company, certain reverse repurchase agreements
may qualify for special treatment under the Bankruptcy Code, the effect of
which is among other things, to allow the creditors under such agreement to
avoid the automatic stay provisions of the Bankruptcy Code and to liquidate
the collateral under such agreements without delay. Conversely, in the event
of a bankruptcy of a party with whom the Company had a reverse repurchase
agreement, the Company might experience difficulty repurchasing the collateral
under such agreement if it were to be repudiated and the Company's claim
against the bankrupt lender for damages resulting therefrom were to be treated
simply as one of an unsecured creditor. Should this occur, the Company's
claims would be subject to significant delay and, if and when received, may be
substantially less than the damages actually suffered by the Company. Although
the Company enters into reverse repurchase agreements with several different
parties to reduce such third party risks, no assurance can be given that the
Company will be able to avoid such risks. To the extent the Company is
compelled to liquidate Mortgage Assets classified as Qualified REIT Real
Estate Assets to repay borrowings, the Company may be unable to comply with
the REIT asset and income tests, possibly jeopardizing the Company's status as
a REIT. See "Operating Policies and Programs--Capital and Leverage Policy."
Value of Mortgage Assets May Be Adversely Affected by Defaults on Underlying
Mortgage Obligations
The Company bears the risk of loss on any Mortgage Securities it purchases
in the secondary mortgage market or otherwise. However, such Mortgage
Securities are generally structured with one or more types of credit
enhancement. Such forms of credit enhancement are intended to provide
protection against risk of loss due to default on the underlying Mortgage
Loan, or bankruptcy, fraud and special hazard losses. To the extent third
parties are contracted to insure against these types of losses, the Company is
dependent in part upon the creditworthiness and claims-paying ability of the
insurer and the timeliness of reimbursement in the event of a default on the
underlying obligations. Further, the insurance coverage for various types of
losses is limited in amount, and losses in excess of the limitation would be
borne by the Company.
The Company also purchases Mortgage Assets issued by Fannie Mae, FHLMC or
GNMA. These entities provide guarantees against risk of loss for securities
they issue. Fannie Mae guarantees the scheduled payments of interest and
principal and the full principal amount of any mortgage loan foreclosed or
liquidated on its obligations. In the case of GNMA, the timely payment of
principal and interest on its certificates is guaranteed by the full faith and
credit of the United States government. FHLMC guarantees the timely payment of
interest and ultimate collection of principal on its obligations. For Fannie
Mae and FHLMC, payment of principal and interest on its certificates are
guaranteed only by the respective entity and not by the full faith and credit
of the United States government.
Value of Mortgage Loans May Be Adversely Affected by Characteristics of
Underlying Property and Borrower Credit and Other Considerations
Mortgage Loan Credit Risks. A portion of the Company's Mortgage Assets
(subject to the 30% policy on Limited Investment Assets) may consist of
Mortgage Loans. During the time it holds any Mortgage Loans, the Company will
be subject to increased 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, less any payments
33
from an insurer or guarantor, and the amount owing on the Mortgage Loan.
Mortgage Loans in default 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. Although the Company intends to establish
reserves in amounts it believes are adequate to cover these risks, in view of
the Company's lack of operating history, there can be no assurance that
reserves that are established will be sufficient to offset losses on Mortgage
Loans in the future.
Even assuming that properties secured by any 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 it from
receiving proceeds sufficient to repay all amounts due on the related Mortgage
Loan. Some properties that may collateralize the Company's Mortgage Loans may
have unique characteristics or may be subject to seasonal factors that could
materially prolong the time period required to resell the property.
The risk of defaulted Mortgage Loans is heightened by the fact that the
Company's Mortgage Loans will be adjustable-rate Mortgage Loans. In the event
interest rates increase, which would result in an increase in the monthly
payment amount owing by borrowers, such borrowers may become less likely to
make payments on the Mortgage Loans.
Inability to Securitize Mortgage Loans May Result in Additional Risk
Respecting Borrower Defaults. The Company anticipates that it may in the
future acquire and accumulate (subject to the 30% limitation on Limited
Investment Assets) Mortgage Loans as part of its investment strategy until a
sufficient quantity has been acquired for securitization into Mortgage
Securities. Such securities would be structured as collateralized borrowings
and not as sales for accounting purposes. There can be no assurance that the
Company will be successful in securitizing the Mortgage Loans. During the
accumulation period, the Company will be subject to risks of borrower defaults
and bankruptcies, fraud losses and special hazard losses. In the event of any
default under Mortgage Loans 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 mortgage collateral and the principal amount of the Mortgage Loan. Also
during the accumulation period, the costs of financing the Mortgage Loans
through reverse repurchase agreements, dollar-roll agreements and other
borrowings and lines of credit with warehouse lenders could exceed the
interest income on the Mortgage Loans. It may not be possible or economical
for the Company to complete the securitization of all Mortgage Loans that it
acquires, in which case the Company will continue to hold the Mortgage Loans
and bear the risks of borrower defaults and special hazard losses.
Seller's Inability to Repurchase Mortgage Loans Following Breach of
Representations Could Cause Loan Losses. It is expected that when the Company
acquires Mortgage Loans, the seller will represent and warrant to the Company
that there has been no fraud or misrepresentation during the origination of
the Mortgage Loans and will agree to repurchase any Mortgage Loan with respect
to which there is fraud or misrepresentation. The Company will provide similar
representations and warranties when the Company sells or pledges the Mortgage
Loans as collateral for Mortgage Securities. Although the Company will have
recourse to the seller based on the seller's representations and warranties to
the Company, the Company will be at risk for loss to the extent the seller
does not perform its repurchase obligations.
Risk of Inadequate Subservicing Could Negatively Impact Mortgage Loan
Repayments. The Company intends to contract with third-party subservicers for
sub-servicing all Mortgage Loans it purchases, securitizes or holds for sale
or investment. As with any external service provider, the Company will be
subject to risks associated with inadequate or untimely services, such as the
risk that a sub-servicer becomes financially unsound and cannot perform its
duties. Additionally, each of the Company's sub-servicing agreements with its
third-party sub-servicers will likely provide a termination fee if the sub-
servicer is terminated without cause, limiting the Company's alternatives in
the event it desires to change sub-servicers. With respect to such securitized
loans, poor performance by a sub-servicer with respect to any such
securitization may result in greater than expected delinquencies and losses on
the related loans, which would adversely impact the value of any "interest-
only,"
34
"principal-only" and subordinated securities held by the Company in connection
with such securitization, which are more sensitive to credit risk.
Yields on Subordinated Interests, Interest Only Derivatives and Principal Only
Derivatives May Be Affected Adversely By Interest Rate Changes
The yield on Subordinated Interests generally will be affected by the rate
and timing of payments of principal on the collateral underlying a series of
mortgage securities. The rate of principal payments may vary significantly
over time depending on a variety of factors such as the level of prevailing
mortgage loan interest rates and economic, demographic, tax, legal and other
factors. Prepayments on the mortgage loans underlying a series of mortgage
securities generally are allocated to the more senior classes of Mortgage
Securities until those classes are paid in full or until the end of a lock-out
period, typically of five years or more. Thus, prepayments of principal from
the collateral generally are not received by the subordinated class holders
for a period of at least five years. As a result, the weighted-average lives
of the subordinated classes may be longer than would be the case if, for
example, prepayments were allocated pro rata to all classes of Mortgage
Securities. To the extent that the holder of a subordinated class is not paid
compensating interest on interest shortfalls due to prepayments, liquidations
or otherwise, the yield on the subordinated class may be affected adversely.
See "Description of Mortgage Assets--Other Mortgage Securities--Subordinated
Interests."
The Company may acquire Interest Only Derivatives, which are classes of
Mortgage Securities that are entitled to no (or only nominal) payments of
principal, but only to payments of interest. The yield to maturity of Interest
Only Derivatives is very sensitive to changes in the weighted average life of
such securities, which in turn is dictated by the rate of prepayments on the
underlying mortgage collateral. In periods of declining interest rates, rates
of prepayments on mortgage loans generally increase, and if the rate of
prepayments is faster than anticipated, then the yield on Interest Only
Derivatives will be affected adversely. Inverse Interest Only Derivatives are
a class of Mortgage Securities that bear interest at a floating rate that
varies inversely with (and often at a multiple of) changes in a specified
index. Moreover, because all Interest Only Derivatives only receive interest
payments, their yields are extremely sensitive not only to default losses but
also to changes in the weighted average life of the relevant classes, which in
turn will be dictated by the rate of prepayments on the underlying mortgage
collateral.
The Company may acquire Principal Only Derivatives, which are classes of
Mortgage Securities that are entitled to no payments of interest, but only to
payments of principal. The yield to maturity of Principal Only Derivatives is
very sensitive to changes in the weighted average life of such securities,
which in turn is dictated by the rate of prepayments on the underlying
Mortgage Collateral. In periods of declining interest rates, rates of
prepayment on mortgage loans generally increase, and if the rate of
prepayments is faster than anticipated, the yield on Principal Only
Derivatives will be positively affected. Conversely, the yield on Principal
Only Derivatives will be affected adversely by slower than anticipated
prepayment rates, which generally are associated with a rising interest rate
environment. See "Description of Mortgage Assets--Other Mortgage Securities--
Subordinated Interests."
The Company has not and in the future will generally not acquire Inverse
Floaters, Remic Residuals or First Loss Subordinate Bonds. The Company will
acquire interest only, principal only or other Mortgage Securities that
receive a disproportionate share of interest income or principal, either as an
independent stand-alone investment opportunity or to assist in the management
of prepayment and other risks (collectively, "Mortgage Derivative
Securities"), but only on a limited basis due to the greater risk of loss
associated with Mortgage Derivative Securities. See "--Failure to Successfully
Manage Interest Rate Risks May Adversely Affect Results of Operations."
35
LEGAL AND OTHER RISKS
Control by the Company's Board of Directors of the Company's Operating
Policies and Investment Strategies
The Company's established operating policies and strategies may be modified
or waived by the Board of Directors without the consent or approval of the
Company's stockholders. The ultimate effect of any such changes is uncertain.
Dependence on the Manager and its Personnel for Successful Operations
The Company is wholly dependent for the selection, structuring and
monitoring of its Mortgage Assets and associated borrowings on the diligence
and skill of its officers and the officers and employees of the Manager,
particularly Lloyd McAdams, Pamela Watson, Heather U. Baines, Evangelos
Karagiannis and Joseph E. McAdams. The Company does not anticipate having
employment agreements with its senior officers, or requiring the Manager to
employ specific personnel or dedicate employees solely to the Company and
there are no restrictions on any competing business activities of such
individuals if they are no longer employed by the Manager. The Manager's loss
of any key person, particularly Mr. McAdams, would have a material adverse
effect on the Company's business, financial condition, cash flows and results
of operations.
Failure to Maintain REIT Status Would Result in the Company Being Subject to
Tax as a Regular Corporation and Substantially Reduce Cash Flow Available for
Distribution to Stockholders
Limitation on Mortgage Assets to Comply with REIT Requirements. In order to
maintain its qualification as a REIT for Federal income tax purposes, the
Company must continue to satisfy certain tests with respect to the sources of
its income, the nature and diversification of its Mortgage Assets, the amount
of its distributions to stockholders and the ownership of its stock. See
"Federal Income Tax Considerations--Requirements for Qualification as a REIT."
Among other things, these restrictions may limit the Company's ability to
acquire certain types of assets that it otherwise would consider desirable,
limit the ability of the Company to securitize Mortgage Loans for sale to
third parties, and require the Company to make distributions to its
stockholders at times when it may deem it more advantageous to utilize the
funds available for distribution for other corporate purposes (such as the
purchase of additional assets or the repayment of debt) or at times that the
Company may not have funds readily available for distribution. Even if the
Company continues to qualify for taxation as a REIT, it may be subject to
certain federal taxes based on certain activities, which could result in
decreased dividend income available for distribution to stockholders. See
"Federal Income Tax Considerations--Taxation of the Company."
Limitations Imposed by REIT Requirements on Hedging and Investments. The
REIT Provisions of the Code substantially limit the ability of the Company to
hedge its Mortgage Assets and the related Company borrowings. The Company must
limit its income in each year from Qualified Hedges (together with any other
income generated from other than Qualified REIT Real Estate Assets) to less
than 25% of the Company's gross income. In addition, the Company must limit
its aggregate income from hedging and services from all sources (other than
from Qualified REIT Real Estate Assets or Qualified Hedges) to less than 5% of
the Company's gross income each year. As a result, the Company may have to
limit its use of certain hedging techniques that might otherwise have been
advantageous. Any limitation on the Company's use of hedging techniques
results in greater interest rate risk. The Company intends to monitor closely
any income from such swap or cap agreements so as to comply with the 5% income
limitation. If the Company were to receive income in excess of the 25% or 5%
limitation, it could incur payment of a penalty tax equal to the amount of
income in excess of those limitations, or in the case of a willful violation,
loss of REIT status for federal tax purposes. See "Federal Income Tax
Considerations--Requirements for Qualification as a REIT--Gross Income Tests."
The Company must also ensure that at the end of each calendar quarter at
least 75% of the value of its assets consists of cash, cash items, government
securities and Qualified REIT Real Estate Assets, and of the
36
investments in securities not included in the foregoing, the Company does not
hold more than 10% of the outstanding voting securities of any one issuer and
no more than 5% by value of the Company's assets consists of the securities of
any one issuer. Failure to comply with any of the foregoing tests requires the
Company to dispose of a portion of its assets within 30 days after the end of
the calendar quarter or face loss of REIT status and adverse tax consequences.
See "Federal Income Tax Considerations--Requirements for Qualification as a
REIT--Asset Tests."
Distribution Requirements to Maintain REIT Status May Require the Company to
Borrow Funds to Make Distributions. The Company's operations may from time to
time generate Taxable Income in excess of its Net Income for financial
reporting purposes (such as from amortization of capitalized purchase
premiums). The Company may also experience circumstances in which its Taxable
Income is in excess of cash flows available for distribution to stockholders.
To the extent that the Company does not otherwise have funds available, either
situation could result in the Company's inability to distribute substantially
all of its Taxable Income as required to maintain its REIT status. In either
situation, the Company could be required to borrow funds in order to make the
required distributions that could increase borrowing costs and reduce the
yield to stockholders, to sell a portion of its Mortgage Assets at
disadvantageous prices in order to raise cash for distributions, or to make a
distribution in the form of a return of capital, which would have the effect
of reducing the equity of the Company. See "Federal Income Tax
Considerations--Requirements for Qualification as a REIT--Distribution
Requirement."
Disqualification as a REIT May Result in Substantial Tax Liability. If the
Company should not qualify as a REIT in any tax year, it would be taxed as a
regular domestic corporation and, among other consequences, distributions to
the Company's stockholders would not be deductible by it in computing its
taxable income. Any resulting tax liability could be substantial and would
reduce the amount of cash available for distribution to the Company's
stockholders. In addition, the unremedied failure of the Company to be treated
as a REIT for any one year would disqualify the Company from being treated as
a REIT for four subsequent years. See "Federal Income Tax Considerations--
Termination or Revocation of REIT Status."
Effect of Future Offerings of Debt and Equity on Market Price of the Common
Stock
The Company may in the future increase its capital resources by making
additional offerings of equity and debt securities, including classes of
preferred stock, Common Stock, commercial paper, medium-term notes, CMOs and
senior or subordinated notes. All debt securities, other borrowings and
classes of preferred stock will be senior to the Common Stock in a liquidation
of the Company. The effect of additional equity offerings may cause
significant dilution of the equity of stockholders of the Company or the
reduction of the price of shares of the Common Stock, or both. The Company is
unable to estimate the amount, timing or nature of additional offerings as
they will depend upon market conditions and other factors. Additionally, other
than leverage or the implementation of a dividend reinvestment plan, the
aforementioned offerings are the only means by which the Company can finance
its operations.
Failure to Maintain an Exemption from the Investment Company Act Would
Adversely Affect Results of Operations
The Company believes at all times since its inception and intends to conduct
its business in the future so as not to become regulated as an investment
company under the Investment Company Act. Accordingly, the Company does not
expect to be subject to the restrictive provisions of the Investment Company
Act. The Investment Company Act exempts entities that are primarily engaged in
the business of purchasing or otherwise acquiring Mortgages and other liens on
and interests in real estate ("Qualifying Interests in Real Estate"). Under
the current interpretation of the staff of the Commission, in order to qualify
for this exemption, the Company must, among other things, maintain at least
55% of its assets directly in Mortgage Loans, qualifying Pass-Through
Certificates and certain other Qualifying Interests in Real Estate. In
addition, unless certain Mortgage Securities represent all the certificates
issued with respect to an underlying pool of Mortgage Loans, such Mortgage
Securities may be treated as securities separate from the underlying Mortgage
Loans and, thus, may
37
not qualify as Qualifying Interests in Real Estate for purposes of the 55%
requirement. The Company's ownership of certain Mortgage Assets, therefore,
may be limited by the provisions of the Investment Company Act. If the Company
fails to qualify for exemption from registration as an investment company, its
ability to use leverage would be substantially reduced, and it would be unable
to conduct its business as described herein. Any such failure to qualify for
such exemption would have a material adverse effect on the Company.
Interest Rate Fluctuations May Adversely Affect the Market Price of the Common
Stock
It is likely that the market price of the shares of the Common Stock will be
influenced by any variation between the net yield on the Company's Mortgage
Assets and prevailing market interest rates. The Company's earnings will be
derived primarily from any positive spread between the yield on its Mortgage
Assets and the cost of its borrowings. Such positive spread will not
necessarily be larger in high interest rate environments than in low interest
rate environments. However, in periods of high interest rates, the Net Income
of the Company and, therefore, the dividend yield on the Common Stock, may be
less attractive compared with alternative investments, which could negatively
impact the price of the Common Stock. If the anticipated or actual net yield
on the Company's Mortgage Assets declines or if prevailing market interest
rates rise, thereby decreasing the positive spread between the net yield on
its Mortgage Assets and the cost of its borrowings, the market price of the
Common Stock may be adversely affected. See "--Interest Rate Fluctuations May
Decrease Net Interest Income."
Active Formation and Operation of Competing Mortgage REITs May Adversely
Affect the Market Price of the Common Stock
In addition to existing companies, other companies may be organized for
purposes similar to that of the Company, including companies organized as
REITs focused on purchasing Mortgage Assets. A proliferation of such companies
may increase the competition for equity capital and thereby adversely affect
the market price of the Common Stock. In addition, adverse publicity about
this sector of the capital market due to, for example, lower than expected
operating results or significant operating failures of other REITs, may
adversely affect the market price of the Common Stock.
Risk of Adverse Tax Treatment of Excess Inclusion Income
In general, dividend income that a Tax-Exempt Entity receives from the
Company should not constitute unrelated trade or business income as defined in
Section 512 of the Code ("UBTI"). If, however, excess inclusion income were
realized by the Company and allocated to stockholders, such income cannot be
offset by net operating losses and, if the stockholder is a Tax-Exempt Entity,
is fully taxable as UBTI under Section 512 of the Code and, as to foreign
stockholders, would be subject to federal income tax withholding without
reduction pursuant to any otherwise applicable income tax treaty. See "Federal
Income Tax Considerations--Taxation of Stockholders" and "--Taxation of Tax-
Exempt Entities," for discussions of the treatment of excess inclusion income.
Excess inclusion income would be generated if the Company were to issue debt
obligations with two or more maturities and the terms of the payments on such
obligations bore a relationship to the payments that the Company received on
its Mortgage Assets securing those debt obligations. The Company intends to
arrange its borrowings in a manner to avoid generating significant amounts of
excess inclusion income. The Company may, however, enter into one or more
master reverse repurchase agreements (i) pursuant to which the Company would
issue various reverse repurchase agreements that would have differing maturity
dates, and (ii) that would afford the counter-party lender the right to sell
any of the Company's Mortgage Securities that have been pledged to the
counter-party if the Company were to default on its obligation to that
counter-party lender. There can be no assurance that the Service might not
successfully maintain that any such borrowing arrangements would give rise to
excess inclusion income that would be allocated among stockholders in some
appropriate fashion. See "Federal Income Tax Considerations--Taxation of
Stockholders." Furthermore, certain types of Tax-Exempt Entities, such as
voluntary employee benefit associations and entities that have borrowed to
acquire their shares of Common Stock, may be required to treat a portion of or
all of the dividends they may receive from the Company as UBTI. See "Federal
Income Tax Considerations--Taxation of Tax-Exempt Entities."
38
Restrictions on Ownership of the Common Stock
Ability to Issue Preferred Stock May Limit Dividend Rights to Holders of
Common Stock. The authorized capital stock of the Company includes preferred
stock issuable in one or more series. The issuance of preferred stock could
have the effect of making an attempt to gain control of the Company more
difficult by means of a merger, tender offer, proxy contest or otherwise. The
preferred stock, if issued, could have a preference on dividend payments that
could affect the ability of the Company to make dividend distributions to the
common stockholders.
9.8% Ownership Restriction May Limit Market Activity. In order that the
Company may meet the requirements for qualification as a REIT at all times,
the Charter prohibits any person from acquiring or holding, directly or
indirectly, shares of capital stock in excess of 9.8% in value of the
aggregate of the outstanding shares of capital stock or in excess of 9.8% (in
value or in number of shares, whichever is more restrictive) of the aggregate
of the outstanding shares of common stock of the Company. The Charter further
prohibits (i) any person from beneficially or constructively owning shares of
capital stock that would result in the Company being closely held under
Section 856(h) of the Code or otherwise cause the Company to fail to qualify
as a REIT, and (ii) any person from transferring shares of capital stock if
such transfer would result in shares of capital stock being owned beneficially
by fewer than 100 persons. If any transfer of shares of capital stock occurs
which, if effective, would result in any violation of the transfer or
ownership limitations, then that number of shares of capital stock in excess
or in violation of the above transfer or ownership limitations, the beneficial
or constructive ownership of which otherwise would cause such person to
violate such limitations (rounded to the nearest whole shares) shall be
automatically transferred to a Trustee of a Trust for the exclusive benefit of
one or more Charitable Beneficiaries, and the intended transferee shall not
acquire any rights in such shares. Subject to certain limitations, the
Company's Board of Directors may increase or decrease the ownership
limitations or waive the limitations for individual investors.
Requirement That Stockholders Give Notice of 5% Ownership May Limit Market
Activity. Every owner of more than 5% (or such lower percentage as required by
the Code or the regulations promulgated thereunder) of all classes or series
of the Company's capital stock, within 30 days after the end of each taxable
year, is required to give written notice to the Company stating the name and
address of such owner, the number of shares of each class and series of stock
beneficially owned and a description of the manner in which such shares are
held. Each such owner shall provide to the Company such additional information
as the Company may request in order to determine the effect, if any, of such
beneficial ownership on the Company's status as a REIT and to ensure
compliance with the ownership limitations.
The foregoing provisions may inhibit market activity and the resulting
opportunity for the holders of the Common Stock to receive a premium for their
Common Stock that might otherwise exist in the absence of such provisions.
Such provisions also may make the Company an unsuitable investment vehicle for
any person seeking to obtain ownership of more than 9.8% of the outstanding
shares of the Company's Common Stock.
Provisions of Maryland Law Restricting Takeovers May Limit Takeover Attempts
That Might be Beneficial to Stockholders. Certain provisions of the Maryland
General Corporation Law relating to "business combinations" and a "control
share acquisition" and of the Charter and Bylaws of the Company may also have
the effect of delaying, deterring or preventing a takeover attempt or other
change in control of the Company that would be beneficial to stockholders and
might otherwise result in a premium over then prevailing market prices.
Although the Bylaws of the Company contain a provision exempting the
acquisition of Common Stock by any person from the control share acquisition
statute, there can be no assurance that such provision will not be amended or
eliminated at any time in the future.
ITEM 2. PROPERTIES
The Company's office space is provided by the Manager. The office of the
Manager is located at 1299 Ocean Avenue, Second Floor, Santa Monica,
California.
39
ITEM 3. LEGAL PROCEEDINGS
At December 31, 1998 there were no 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
No matters were submitted to a vote of the Company's stockholders during the
fourth quarter of 1998.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS
The Company's stock began trading on March 17, 1998 and is traded on the
American Stock Exchange under the trading symbol ANH. As of March 5, 1999, the
Company had 2,317,100 shares of common stock issued and outstanding which was
held by 16 holders of record and approximately 1,336 beneficial owners.
The following sets forth, for the periods indicated, the high, low and
closing sales prices on a per share of common stock basis, as reported on the
American Stock Exchange and the cash dividends per share of common stock.
Stock Prices
--------------------
High Low Close
------- ----- ------
For the quarter ended June 30, 1998..................... 9 1/8 7 3/4 8 1/4
For the quarter ended September 30, 1998................ 8 4 1/4 4 5/8
For the quarter ended December 31, 1998................. 4 11/16 3 1/8 4 1/16
Cash Dividends
Declared
Per Share
--------------
First quarter ended March 31, 1998...... $0.00 (partial period, 15 days)
Second quarter ended June 30, 1998...... $0.15
Third quarter ended September 30, 1998.. $0.10
Fourth quarter ended December 31, 1998.. $0.12
The Company intends to pay quarterly dividends and to make such
distributions to its stockholders in amounts such that all or substantially
all of its taxable income in each year (subject to certain adjustments) is
distributed so as to qualify for the tax benefits accorded to a REIT under the
Code. All distributions will be made by the Company at the discretion of the
Board of Directors and will depend on the earnings of the Company, the
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.
40
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data are derived from the audited financial
statements of the Company for the period from commencement of operations on
March 17, 1998 to December 31, 1998. The selected financial data should be
read in conjunction with the more detailed information contained in the
Financial Statements and Notes thereto and "Management's Discussion and
Analysis of Financial Condition and Results of Operations" included elsewhere
in this Annual Report on Form 10-K.
For the period from March 17, 1998 (commencement of operations) through
December 31, 1998
(Dollars in thousands except per share data)
STATEMENT OF OPERATIONS DATA:
Days in period.................................................... 290
Interest and dividend income...................................... $ 8,570
Interest expense.................................................. 7,378
----------
Net interest income............................................... 1,192
General and administrative expenses (G&A expenses)................ 307
----------
Net income........................................................ $ 885
Basic and diluted earnings per average share...................... $ 0.38
Dividends declared per average share.............................. $ 0.37
Weighted average common shares outstanding........................ 2,315,651
BALANCE SHEET DATA AT DECEMBER 31, 1998:
Mortgage backed securities, net................................... $ 184,245
Total assets...................................................... 199,458
Repurchase agreements............................................. 170,033
Total liabilities................................................. 182,216
Stockholders' equity.............................................. 17,242
Number of common shares outstanding............................... 2,328,000
OTHER DATA
Average earnings assets........................................... $ 181,445
Average borrowings................................................ 165,496
Average equity(1)................................................. 18,177
Yield on interest earning assets for the period................... 5.94%
Cost of funds on interest bearing liabilities for the period...... 5.61%
ANNUALIZED FINANCIAL RATIOS(1)(2)
Net interest margin (net interest income/average assets).......... 0.83%
G&A expense as a percentage of average assets..................... 0.21%
G&A expense as a percentage of average equity..................... 2.02%
Return on average assets.......................................... 0.61%
Return on average equity.......................................... 5.84%
- --------
(1) Average equity excludes fair value adjustment for ARM securities
(2) Each ratio has been computed by annualizing the results for the 290-day
period ended December 31, 1998
41
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Certain statements contained in the following discussion are "forward-
looking statements" within the meaning of applicable federal securities laws.
Forward looking statements which are based on various assumptions (some of
which are beyond the Company's control) may be identified by reference to a
future period or periods, or by the use of forward-looking terminology, such
as "may", "will," "intend," "should," "expect," "anticipate," "estimate" or
"continue" or the negatives thereof or other comparable terminology. Forward-
looking statements included herein regarding the actual results, performance
and achievements of the Company are dependent on a number of factors. The
Company's actual results could differ materially from those anticipated in
such forward-looking statements as a result of certain factors, including but
not limited to, changes in interest rates, changes in yield curve, changes in
prepayment rates, the availability of mortgage-backed securities for purchase,
the availability of financing and, if available, the terms of any such
financing. The Company does not undertake, and specifically disclaims any
obligation, to publicly release the result of any revisions which may be made
to any forward-looking statements to reflect the occurrence of anticipated or
unanticipated events or circumstances after the date of such statements.
GENERAL
The Company is a REIT formed in October 1997 to invest in mortgage assets,
including mortgage pass-through certificates, collateralized mortgage
obligations, mortgage loans and other securities representing interests in, or
obligations backed by, pools of mortgage loans which can be readily financed
and short-term investments.
The Company's principal business objective is to generate net income for
distribution to stockholders from the spread between the interest income on
its Mortgage Assets and the costs of borrowing to finance its acquisition of
Mortgage Assets. The Company commenced operations on March 17, 1998 upon the
closing of its initial public offering which raised net proceeds of
$18,414,000. Since then the Company has deployed its capital and grown its
balance sheet through the acquisition of mortgage assets and the financing of
those assets in the credit markets. The financial statements included in this
Annual Report on Form 10-K should be read in light of this growth process and
are not necessarily representative of what they may be in the future.
The Company will seek to generate growth in earnings and dividends per share
in a variety of ways, including through (i) issuing new Common Stock and
increasing the size of the balance sheet when opportunities in the market for
Mortgage Assets are likely to allow growth in earnings per share, (ii) seeking
to improve productivity by increasing the size of the balance sheet at a rate
faster than the rate of increase in operating expenses, (iii) continually
reviewing the mix of Mortgage Asset types on the balance sheet in an effort to
improve risk-adjusted returns, and (iv) attempting to improve the efficiency
of the Company's balance sheet structure through the issuance of
uncollateralized subordinated debt, preferred stock and other forms of
capital, to the extent management deems such issuances appropriate.
The Company is organized for tax purposes as a REIT and therefore generally
passes through substantially all of its taxable earnings to stockholders
without paying federal or state income tax at the corporate level.
FINANCIAL CONDITION
At December 31, 1998, the Company held total assets of $199 million,
consisting of $172 million of ARM securities, $10 million of fixed-rate
mortgage-backed securities, $.5 million of REIT preferred stock and
$17 million of cash equivalents and other receivables. At December 31, 1998,
95% of the qualified real estate assets held by the Company were Primary
assets. Of the ARM securities owned by the Company, 83% were adjustable-rate
pass-through certificates which reset at least once a year. The remaining 17%
were new origination 3/1 and 5/1 hybrid ARMS. Hybrid ARM securities have an
initial interest rate that is fixed for a certain period, usually three to
five years, and then adjust annually for the remainder of the term of the
loan.
42
The following table presents a schedule of ARM securities owned at December
31, 1998 classified by type of issuer.
ARM SECURITIES BY ISSUER
Portfolio
Agency Carrying Value Percentage
------ --------------- ----------
(Dollar amounts
in thousands)
FNMA.............................................. $128,884 75
FHLMC............................................. 43,237 25
-------- ---
Total Portfolio................................. $172,121 100
======== ===
The following table classifies the Company's portfolio of ARM securities by
type of interest rate index.
ARM ASSETS BY INDEX
Carrying Portfolio
Index Value Percentage
----- --------------- ----------
(Dollar amounts
in thousands)
Six-month LIBOR................................... $ 14,656 8.5%
Six-month Certificate of Deposit.................. 8,461 4.9%
One-year Constant Maturity Treasury............... 142,459 82.7%
Cost of Funds Index............................... 6,545 3.8%
-------- ------
Total........................................... $172,121 100.0%
======== ======
The ARM portfolio had a weighted average coupon of 6.85% at December 31,
1998. The weighted average three-month constant prepayment rate ("CPR") of the
Company's MBS portfolio was 31.1% as of December 31, 1998. At December 31,
1998 the unamortized net premium paid for the mortgage-backed securities was
$4.6 million.
The Company analyzes its mortgage-backed securities and the extent to which
prepayments impact the yield of the securities. When actual prepayments exceed
expectations, the Company amortizes the premiums paid on mortgage assets over
a shorter time period, resulting in a reduced yield to maturity on the
Company's mortgage assets. Conversely, if actual prepayments are less than the
assumed constant prepayment rate, the premium would be amortized over a longer
time period, resulting in a higher yield to maturity. The Company monitors its
yield expectations and its actual prepayment experience on a monthly basis in
order to adjust the scheduled amortization of the net premium.
The fair value of the Company's portfolio of ARM securities classified as
available-for-sale was $1.8 million less than the amortized cost of the
securities, resulting in a negative adjustment of 0.96% of the amortized cost
of the portfolio as of December 31, 1998. This price decline reflects the
possibility of increased future prepayments which would have the effect of
shortening the average life of the Company's ARM securities and decreasing
their yield and market value.
RESULTS OF OPERATIONS FOR THE PERIOD ENDED DECEMBER 31, 1998
For the period ended December 31, 1998, the Company's net income was
$885,000, or $0.38 per share (basic and diluted EPS), based on an average of
2,315,651 shares outstanding. Net interest income for the period totaled
$1,192,000. Net interest income is comprised of the interest income earned on
mortgage investments less interest expense from borrowings. During the period
ended December 31, 1998, the Company incurred general and administrative
expenses of $307,000, consisting operating expense of $161,000, a base
management fee of $144,000 and an incentive management fee of $2,000.
43
The Company's annualized return on average equity was 5.84% for the period
ended December 31, 1998. The table below shows the annualized components of
return on average equity.
ANNUALIZED COMPONENTS OF RETURN ON AVERAGE EQUITY (1)
Net Interest G&A Net
Income/Equity Expense/Equity Income/Equity
------------- -------------- -------------
For the period ended December 31,
1998.............................. 7.86% 2.02% 5.84%
- --------
(1) Average equity excludes unrealized gain (loss) on available-for-sale
securities.
The following table shows the Company's average balances of cash equivalents
and mortgage assets, the annualized yields earned on each type of earning
assets, the yield on average earning assets and interest income (dollar
amounts in thousands).
Annualized
Yield on
Average Annualized Average Annualized
Amortized Yield on Amortized Yield on Dividend
Average Cost of Average Average Cost of Average and
Cash Mortgage Earning Cash Mortgage Earning Interest
Equivalents Assets Assets Equivalents Assets Assets Income
----------- --------- -------- ----------- ---------- ---------- --------
For the period ended
December 31, 1998...... $6,647 $174,798 $181,445 5.65% 6.04% 5.94% $8,570
The table below shows the Company's average borrowed funds and annualized
average cost of funds as compared to average one- and average three-month
LIBOR (dollar amounts in thousands).
Average Average Average
One-month Cost of Cost of
LIBOR Funds Funds
Average Average Relative Relative Relative
Average Average One- Three- to Average to Average to Average
Borrowed Interest Cost of Month Month Three-month One-month Three-month
Funds Expense Funds LIBOR LIBOR LIBOR LIBOR LIBOR
-------- -------- ------- ------- ------- ----------- ---------- -----------
For the period ended
Dec. 31, 1998.......... $165,496 $7,378 5.61% 5.55% 5.54% +0.01% +0.06% +0.07%
For the period ended December 31, 1998, the annualized yield on the
Company's total assets, including the impact of the amortization of premiums
and discounts, was 5.94%. The Company's weighted average cost of funds for the
period ended December 31, 1998, was 5.61%.
The Company pays the Manager an annual base management fee, generally based
on average net invested assets, as defined in the Management Agreement,
payable monthly in arrears as follows: 1.0% of the first $300 million of
Average Net Invested Assets, plus 0.8% of the portion above $300 million.
In order for the Manager to earn a performance fee, the rate of return on
the stockholders' investment, as defined in the Management Agreement, must
exceed the average ten-year U.S. Treasury rate during the quarter plus 1%.
During the period ended December 31, 1998, the Company's annualized return on
common equity was 5.86%. The ten-year U.S. Treasury rate for the corresponding
period was 5.75%. As a result of the quarterly calculations, the Manager
earned a performance fee of $2,000.
44
The following table shows operating expenses as a percent of total assets:
ANNUALIZED OPERATING EXPENSE RATIOS
Management Fee & Performance Total G&A
Other Expenses/Total Fee/Total Expenses/Total
Assets Assets Assets
-------------------- ----------- --------------
For the period ended December
31, 1998.................... 0.21% 0.00% 0.21%
INTEREST RATE AGREEMENTS
The Company has not entered into any interest rate agreements to date. As
part of its asset/liability management process, the Company may enter into
interest rate agreements such as interest rate caps, floors and swaps. These
agreements would be entered into to reduce interest rate risk and would be
designed to provide income and capital appreciation to the Company in the
event of certain changes in interest rates. The Company reviews the need for
interest rate agreements on a regular basis consistent with its capital
investment policy.
The Company has not experienced credit losses on its portfolio of ARM
securities to date, but losses may be experienced in the future. At December
31, 1998, the Company had limited its exposure to credit losses on its
portfolio of ARM securities by purchasing only Agency Certificates, which,
although not rated, carry an implied "AAA" rating.
COMMON DIVIDEND
As a REIT, the Company is required to declare dividends amounting to 85% of
each year's taxable income by the end of each calendar year and to have
declared dividends amounting to 95% of its taxable income for each year by the
time it files its applicable tax return and, therefore, generally passes
through substantially all of its earnings to stockholders without paying
federal income tax at the corporate level. Since the Company, as a REIT, pays
its dividends based on taxable earnings, the dividends may at times be more or
less than reported earnings.
On December 17, 1998 the Company declared a dividend of $0.12 per share
payable on January 14, 1999 to holders of record as of January 4, 1999.
LIQUIDITY AND CAPITAL RESOURCES
The Company's primary source of funds for the period ended December 31, 1998
consisted of reverse repurchase agreements, which totaled $170 million at
December 31, 1998. The Company's other significant source of funds for the
period ended December 31, 1998 consisted of payments of principal and interest
from its ARM securities portfolio in the amount of $53.4 million. In the
future, the Company expects its primary sources of funds will consist of
borrowed funds under reverse repurchase agreement transactions with one to
twelve-month maturities and of monthly payments of principal and interest on
its ARM securities portfolio. The Company's liquid assets generally consist of
unpledged ARM assets, cash and cash equivalents.
The borrowings incurred during the quarter ended December 31, 1998 had an
annualized average interest cost during the period of 5.61%. As of December
31, 1998, all of the Company's reverse repurchase agreements were fixed-rate
term reverse repurchase agreements with original maturities that range from
three months to one year. The Company has borrowing arrangements with ten
different financial institutions, and on December 31, 1998, had borrowed funds
under reverse repurchase agreements with six of these firms. Because the
Company borrows money based on the fair value of its ARM securities and
because increases in short-term interest rates can negatively impact the
valuation of ARM securities, the Company's borrowing ability could be limited
and lenders may initiate margin calls in the event short-term interest rates
increase or the value of the Company's ARM securities declines for other
reasons. During the period ended December 31, 1998, the Company had adequate
cash flow, liquid assets and unpledged collateral with which to meet its
margin requirements during the
45
period. Further, the Company believes it will continue to have sufficient
liquidity to meet its future cash requirements from its primary sources of
funds for the foreseeable future without needing to sell assets.
The Company uses "available-for-sale" treatment for its Mortgage-Backed
Securities. These assets are carried on the balance sheet at fair value rather
than historical amortized cost. Based upon such "available-for-sale"
treatment, the Company's equity base at December 31, 1998 was $17.2 million,
or $7.41 per share. If the Company had used historical amortized cost
accounting, the Company's equity base at December 31, 1998 would have been
$19.0 million, or $8.17 per share.
With the Company's "available-for-sale" accounting treatment, unrealized
fluctuations in market values of assets do not impact financial reporting or
taxable income but rather are reflected on the balance sheet by changing the
carrying value of the asset and reflecting the change in stockholders' equity
under "Other comprehensive income, unrealized gain (loss) on available for
sale securities." By accounting for its assets in this manner, the Company
hopes to provide useful information to stockholders and creditors and to
preserve flexibility to sell assets in the future without having to change
accounting methods.
As a result of this mark-to-market accounting treatment, the book value and
book value per share of the Company are likely to fluctuate far more than if
the Company used historical amortized cost accounting. As a result,
comparisons with companies that use historical cost accounting for some or all
of their balance sheet may be misleading.
Unrealized changes in the fair value of Mortgage-Backed Securities have one
direct effect on the Company's potential earnings and dividends: positive
mark-to-market changes will increase the Company's equity base and allow the
Company to increase its borrowing capacity while negative changes will tend to
limit borrowing capacity under the Company's Capital Investment Policy. A very
large negative change in the net market value of the Company's Mortgage-Backed
Securities might impair the Company's liquidity position, requiring the
Company to sell assets with the likely result of realized losses upon sale.
"Other comprehensive income, unrealized gain (loss) on available for sale
securities" was $1.8 million, or 0.96% of the amortized cost of mortgage
backed securities at December 31, 1998.
EFFECTS OF INTEREST RATE CHANGES
The Company has invested in adjustable-rate mortgage securities. Adjustable-
rate mortgage assets are typically subject to periodic and lifetime interest
rate caps that limit the amount an adjustable-rate mortgage securities'
interest rate can change during any given period. Adjustable-rate mortgage
securities are also typically subject to a minimum interest rate payable. The
Company's borrowings are not subject to similar restrictions. Hence, in a
period of increasing interest rates, interest rates on its borrowings could
increase without limitation by caps, while the interest rates on its mortgage
assets could be so limited. This problem would be magnified to the extent the
Company acquires mortgage assets that are not fully indexed. 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 less
cash income on its adjustable-rate mortgage assets than is required to pay
interest on the related borrowings. These factors could lower the Company's
net interest income or cause a net loss during periods of rising interest
rates, which would negatively impact the Company's liquidity and its ability
to make distributions to stockholders.
The Company intends to fund the purchase of a substantial portion of its
adjustable-rate mortgage securities with borrowings that may have interest
rates based on indices and repricing terms similar to, but of somewhat shorter
maturities than, the interest rate indices and repricing terms of the mortgage
assets. Thus, the Company anticipates that in most cases the interest rate
indices and repricing terms of its mortgage assets and its funding sources
will not be identical, thereby creating an interest rate mismatch between
assets and liabilities. During periods of changing interest rates, such
interest rate mismatches could negatively impact the Company's net income,
dividend yield and the market price of the Common Stock.
46
Prepayments are the full or partial repayment of principal prior to the
original term to maturity of a mortgage loan and typically occur due to
refinancing of mortgage loans. Prepayment rates on mortgage securities vary
from time to time and may cause changes in the amount of the Company's net
interest income. Prepayments of adjustable-rate mortgage loans usually can be
expected to increase when mortgage interest rates fall below the then-current
interest rates on such loans and decrease when mortgage interest rates exceed
the then-current interest rate on such loans, although such effects are not
predictable. Prepayment experience also may be affected by the conditions in
the housing and financial markets, general economic conditions and the
relative interest rates on fixed-rate and adjustable-rate mortgage loans
underlying mortgage securities. The purchase prices of mortgage securities are
generally based upon assumptions regarding the expected amounts and rates of
prepayments. Where slow prepayment assumptions are made, the Company may pay a
premium for mortgage securities. To the extent such assumptions materially and
adversely differ from the actual amounts of prepayments, the Company would
experience losses. The total prepayment of any mortgage asset that had been
purchased at a premium by the Company would result in the immediate write-off
of any remaining capitalized premium amount as a reduction of the Company's
net interest income. Finally in the event that the Company is unable to
acquire new mortgage assets to replace the prepaid mortgage assets, its
financial condition, cash flows and results of operations could be materially
adversely affected.
OTHER MATTERS
As of December 31, 1998, the Company calculates its Qualified REIT Assets,
as defined in the Code, to be greater than 98% of its total assets, as
compared to the Code requirement that at least 75% of its total assets must be
Qualified REIT Assets. The Company also calculates that greater than 96% of
its 1998 revenue for the period ended December 31, 1998 qualifies for both the
75% source of income test and the 95% source of income test under the REIT
rules. The Company also met all REIT requirements regarding the ownership of
its common stock and the distributions of its net income. Therefore, as of
December 31, 1998, the Company believes that it will continue to qualify as a
REIT under the provisions of the Code.
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. 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 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 of 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. The
Company calculates that it is in compliance with this requirement.
INFLATION
Virtually all of the Company's assets and liabilities are financial in
nature. As a result, interest rates and other factors drive the Company's
performance far more than does inflation. Changes in interest rates do not
necessarily correlate with inflation rates or changes in inflation rates. The
Company's financial statements are prepared in accordance with GAAP and the
Company's dividends are determined by the Company's net income as calculated
for tax purposes; in each case, the Company's activities and balance sheet are
measured with reference to historical cost or fair market value without
considering inflation.
YEAR 2000 COMPUTER ISSUE
The Year 2000 ("Y2K") computer issue affects virtually all companies and
organizations. Many currently installed computer systems were designed to use
only a two-digit date field. This can cause problems in the systems
distinguishing a 21st century date (i.e., 20--) from a 20th century date
(i.e., 19--). Until the date fields are updated, systems or programs could
fail or give erroneous results when referencing dates following December 31,
1999.
47
To address these risks the Company has implemented a plan whereby it will
evaluate both its internal systems and the readiness of the systems used by
the Company's External Counterparties. The Company intends to develop
contingency plans for implementation in the event of failure of critical
systems on which its business relies.
Internal Systems. Currently, the Company uses a general ledger software
application to prepare its books and records, as well as spreadsheet software
to construct subsidiary ledgers. Throughout the fourth quarter of 1998 and
into the first and second quarters of 1999 the Company intends to create
parallel files within these applications to test these packages' ability to
interpret the year 2000 in various data fields on which calculations are made.
In the event that either application is found not to be Year 2000 compliant,
the Company will obtain replacement software from the suppliers.
To date, the Company has not incurred any additional expense in connection
with the evaluation of internal systems. Since the Company is externally
managed, the testing and potential software replacement referred to above
should not result in additional cost to the Company.
External Counterparties. The Company has implemented a plan of communicating
with those companies and persons who provide service to the Company and the
Manager ("External Counterparties") regarding the state of readiness of their
Year 2000 plans. During the fourth quarter of 1998, the Company compiled a
list of these counterparties and solicited information from each one regarding
their Year 2000 plans. Many of these counterparties are prominent broker-
dealers and investment banks or government mortgage agencies who are known by
the Company to be involved in Year 2000 review processes currently being
performed by securities industry regulators (such as the New York Stock
Exchange or the Securities and Exchange Commission) and self-regulatory
organizations. The Company intends to monitor the progress of each of these
counterparties over the course of 1999 and report to shareholders regarding
progress made by these counterparties. There can be no guarantee that the
system or other organizations on which the Company relies will be Y2K
compliant, which could have a material adverse effect on the Company.
Contingency Plans. During the second and third quarters of 1999, after
gathering data through the processes described above, the Company will develop
plans to address potential failures in critical internal or external systems.
In its normal course of business the Company relies heavily on the accurate
functioning of many computer applications. The Company's ability to perform
its normal business functions depends heavily on the Company's ability to
perform mathematical calculations quickly and accurately and its ability to
send and receive funds quickly and accurately. While the Company believes that
completion of its Year 2000 Plan will reduce some of the uncertainty that
currently surrounds the Year 2000 problem, the Company acknowledges that Year
2000-related breakdowns in either the internal or external systems on which
the Company depends could cause significant disruptions in the Company's
operations.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not Applicable.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements of the Company and the related notes, together with
the Independent Auditor's report thereon, are set forth beginning on page F-1
of this Annual Report on Form 10-K.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
48
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information required by this item is incorporated by reference to the
information set forth under the caption "DIRECTORS AND EXECUTIVE OFFICERS" in
Anworth's definitive proxy statement proxy statement which Anworth intends to
file no later than 120 days after the end of fiscal year 1998, pursuant to
Regulation 14A.
ITEM 11. EXECUTIVE COMPENSATION
Information required by this item is incorporated by reference to the
information set forth under the caption "EXECUTIVE COMPENSATION" in Anworth's
definitive proxy statement proxy statement which Anworth intends to file no
later than 120 days after the end of fiscal year 1998, pursuant to Regulation
14A.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information required by this item is incorporated by reference to the
information set forth under the caption "SECURITY OWNERSHIP OF CERTAIN
BENEFICIAL OWNERS AND MANAGEMENT" in Anworth's definitive proxy statement
proxy statement which Anworth intends to file no later than 120 days after the
end of fiscal year 1998, pursuant to Regulation 14A.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information required by this item is incorporated by reference to the
information set forth under the caption "CERTAIN RELATIONSHIPS AND RELATED
TRANSACTIONS" in Anworth's definitive proxy statement proxy statement which
Anworth intends to file no later than 120 days after the end of fiscal year
1998, pursuant to Regulation 14A.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) Documents filed as part of this report:
1. Financial Statements.
2. Schedules to Financial Statements. All financial statement schedules
not included have been omitted because they are either inapplicable or the
information required is provided in the Company's Financial Statements and
Notes thereto, included in Part II, Item 8 of this Annual Report on Form
10-K.
3. Exhibits:
3.1 Charter of the Registrant (incorporated by reference to Exhibit
3.1 to the Company's Registration Statement on Form S-11(Registration
No. 333-38641) filed with the Securities and Exchange Commission on
October 24, 1997.).
3.2 Bylaws of the Registrant (incorporated by reference to Exhibit
3.2 to the Company's Registration Statement on Form S-11(Registration
No. 333-38641) filed with the Securities and Exchange Commission on
October 24, 1997.).
4.1 Form of Stock Certificate of the Registrant (incorporated by
reference to Exhibit 4.1 to the Company's Registration Statement on
Form S-11(Registration No. 333-38641) filed with the Securities and
Exchange Commission on December 12, 1997.).
49
10.1 Management Agreement between the Registrant and Anworth Mortgage
Advisory Corporation (incorporated by reference to Exhibit 10.1 to the
Company's Registration Statement on Form S-11(Registration No. 333-
38641) filed with the Securities and Exchange Commission on February
25, 1998.).
10.2 Form of 1997 Stock Option and Awards Plan (incorporated by
reference to Exhibit 10.2 to the Company's Registration Statement on
Form S-11(Registration No. 333-38641) filed with the Securities and
Exchange Commission on December 12, 1997.).
27 Financial Data Schedule
(c) Reports on Form 8-K.
No reports on Form 8-K have been filed during the last quarter of the period
covered by this report.
50
GLOSSARY
There follows an abbreviated definition of certain capitalized terms used in
this Annual Report on Form 10-K.
"Affiliate" means, when used with reference to a specified person, (i) any
person that directly or indirectly controls or is controlled by or is under
common control with the specified person, (ii) any person that is an officer
of, partner in or trustee of, or serves in a similar capacity with respect to,
the specified person or of which the specified person is an officer, partner
or trustee, or with respect to which the specified person serves in a similar
capacity, and (iii) any person that, directly or indirectly, is the beneficial
owner of 5% or more of any class of equity securities of the specified person
or of which the specified person is directly or indirectly the owner of 5% or
more of any class of equity securities.
"Agency Certificates" means GNMA ARM Certificates, Fannie Mae ARM
Certificates and FHLMC ARM Certificates.
"ARM" means a Mortgage Loan or any mortgage loan underlying a Mortgage
Security that features adjustments of the underlying interest rate at
predetermined times based on an agreed margin to an established index. An ARM
is usually subject to periodic and lifetime interest rate and/or payment caps.
"Average Net Invested Assets" means for any period the difference between
(i) the aggregate book value of the consolidated assets of the Company and its
subsidiaries, before reserves for depreciation or bad debts or other similar
noncash reserves and (ii) the book value of average debt associated with the
Company's ownership of Mortgage Assets, computed by taking the average of such
net values at the end of each month during such period.
"Average Net Worth" means for any period the arithmetic average of the sum
of the gross proceeds from the offerings of its equity securities by the
Company, before deducting any underwriting discounts 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)
computed by taking the average of such values at the end of each month during
such period.
"Bankruptcy Code" means Title 11 of the United States Code, as amended.
"Bylaws" means the bylaws of the Company, a copy of which is filed as an
exhibit to the Registration Statement of which this Prospectus forms a part.
"Charitable Beneficiaries" means a charitable beneficiary of a Trust.
"Charter" means the charter of the Company, a copy of which is filed as an
exhibit to the Registration Statement of which this Prospectus forms a part.
"CMOs" means variable-rate debt obligations (bonds) that are collateralized
by mortgage loans or mortgage certificates other than Mortgage Derivative
Securities and Subordinated Interests. CMOs are structured so that principal
and interest payments received on the collateral are sufficient to make
principal and interest payments on the bonds. Such bonds may be issued by
United States government agencies or private issuers in one or more classes
with fixed or variable interest rates, maturities and degrees of subordination
which are characteristics designed for the investment objectives of different
bond purchasers. The Company will only acquire CMOs that constitute beneficial
interests in grantor trusts holding Mortgage Loans, or regular interests
issued by REMICs, or that otherwise constitute Qualified REIT Real Estate
Assets (provided that the Company has obtained a favorable opinion of counsel
or a ruling from the Service to that effect).
"Code" means the Internal Revenue Code of 1986, as amended.
51
"Collateral" means Mortgage Assets, debt service funds and reserve funds,
insurance policies, servicing agreements or master servicing agreements.
"Commission" means the Securities and Exchange Commission.
"Commitments" means commitments issued by the Company which will obligate
the Company to purchase Mortgage Assets from or sell them to the holders of
the commitment for a specified period of time, in a specified aggregate
principal amount and at a specified price.
"Common Stock" means the Company's shares of Common Stock, $0.01 par value
per share.
"Company" means Anworth Mortgage Asset Corporation, a Maryland corporation.
"Conforming Mortgage Loans" means conventional Mortgage Loans that either
comply with requirements for inclusion in credit support programs sponsored by
FHLMC, Fannie Mae or GNMA or are FHA or VA Loans, all of which are secured by
first mortgages or deeds of trust on single-family (one to four units)
residences.
"Counter-party" means a third-party financial institution with which the
Company enters into an interest rate cap agreement or similar agreement.
"Dealer Property" means real property and real estate mortgages other than
stock in trade, inventory or property held primarily for sale to customers in
the ordinary course of the Company's trade or business.
"Dollar-Roll Agreement" means an agreement to sell a security for delivery
on a specified future date and a simultaneous agreement to repurchase the same
or substantially similar security on a specified future date.
"11th District Cost of Funds Index" means the index made available monthly
by the Federal Home Loan Bank Board of the cost of funds to members of the
Federal Home Loan Bank 11th District.
"Excess Servicing Rights" means contractual rights to receive a portion of
monthly mortgage payments of interest remaining after those payments of
interest have already been applied, to the extent required, to Pass-Through
Certificates and the administration of mortgage servicing. The mortgage
interest payments are secured by an interest in real property.
"Excess Shares" means the number of shares of capital stock held by any
person or group of persons in excess of 9.8% of the outstanding shares.
"Exchange Act" means the Securities Exchange Act of 1934, as amended.
"Federal Reserve Board" means the Board of Governors of the Federal Reserve
System.
"Fannie Mae" means the Federal National Mortgage Association.
"Fannie Mae Certificates" means guaranteed mortgage Pass-Through
Certificates issued by Fannie Mae either in certified or book-entry form.
"FHA" means the United States Federal Housing Administration.
"FHA Loans" means Mortgage Loans insured by the FHA.
"FHLMC" means the Federal Home Loan Mortgage Corporation.
"FHLMC Certificates" means mortgage participation certificates issued by
FHLMC, either in certificated or book-entry form.
52
"FIRPTA" means the Foreign Investment in Real Property Tax Act of 1980.
"First Loss Subordinated Bonds" means any bonds that bear the "first loss"
from losses incurred in respect of Mortgage Assets upon foreclosure sales and
other liquidations of underlying mortgaged properties that result in failure
to recover all amounts due on the loans secured thereby.
"Foreclosure Property" means property acquired at or in lieu of foreclosure
of that mortgage secured by such property or a result of a default under a
lease of such property.
"Foreign Holder" means an initial purchaser of Common Stock that, for United
States tax purposes, is not a United States person.
"GNMA" means the Government National Mortgage Association.
"GNMA Certificates" means fully modified pass-through mortgage backed
certificates guaranteed by GNMA and issued either in certificated or book-
entry form.
"Housing Act" means the National Housing Act of 1934, as amended.
"HUD" means the Department of Housing and Urban Development.
"Interest Only Derivatives" mean Mortgage Derivative Securities representing
the right to receive interest only or a disproportionately large amount of
interest.
"Inverse Floaters" means a class of CMOs with a coupon rate that moves
inversely to a designated index, such as LIBOR or the 11th District Cost of
Funds Index. Income floaters have coupon rates that typically change at a
multiple of the changes at the relevant index rate. Any rise in the index rate
(as a consequence of an increase in interest rates) causes a drop in the
coupon rate of an Inverse Floater while any drop in the index rate causes an
increase in the coupon of an Inverse Floater.
"Investment Company Act" means the Investment Company Act of 1940, as
amended.
"Investment Grade" means a security rating of BBB or better by Standard &
Poor's or Baa or better by Moody's Investors Service, Inc., or, as to unrated
Pass-Through Certificates and CMOs backed by single-family or multi-family
properties, a determination that the security is of comparable quality (by the
rating of at least one of the Rating Agencies) to a rated Investment Grade
security on the basis of credit enhancement features that meet Investment
Grade credit criteria approved by the Company's Board of Directors, including
approval by a majority of the Unaffiliated Directors.
"IRAs" means Individual Retirement Accounts.
"ISOs" means incentive stock options granted under the Stock Option and
Awards Plan which meet the requirements of Section 422 of the Code.
"LIBOR" means London-Inter-Bank Offered Rate.
"Management" means the Company's and the Manager's management team.
"Management Agreement" means the agreement by and between the Company and
the Manager whereby the Manager agrees to perform certain services to the
Company in exchange for certain fees.
"Manager" means Anworth Mortgage Advisory Corporation, a California
corporation.
53
"Master Servicer" means an entity that will administer and supervise the
performance by servicers of the duties and responsibilities under Servicing
Agreements in respect of the Collateral for a series of Mortgage Securities.
"Mortgage Assets" means (i) Mortgage Securities, (ii) Mortgage Loans and
(iii) Short-Term Investments. All Mortgage Securities and Mortgage Loans shall
be Qualified REIT Real Estate Assets.
"Mortgage Derivative Securities" means Mortgage Securities which provide for
the holder to receive interest only, principal only, or interest and principal
in amounts that are disproportionate to those payable on the underlying
Mortgage Loans. The Company will only acquire Mortgage Derivative Securities
that constitute beneficial interests in grantor trusts holding Mortgage Loans,
or are regular interests issued by REMICs, or that otherwise constitute
Qualified REIT Real Estate Assets (provided the Company has obtained a
favorable opinion of counsel to that effect).
"Mortgage Loans" means Conforming and Nonconforming Mortgage Loans, FHA
Loans and VA Loans. All Mortgage Loans to be acquired by the Company will be
ARMs and will be secured by first mortgages or deeds of trust on single-family
(one-to-four units) residential properties.
"Mortgage Securities" means (i) Pass-Through Certificates, (ii) CMOs and
(iii) Other Mortgage Securities.
"Mortgage Suppliers" means mortgage bankers, savings and loan associations,
investment banking firms, banks, home builders, insurance companies and other
concerns or lenders involved in mortgage finance and their Affiliates.
"Mortgage Warehouse Participations" means participations in lines of credit
to mortgage originators that are secured by recently originated Mortgage Loans
which are in the process of being either securitized or sold to permanent
investors.
"Net Cash Flows" means the difference between (i) the cash flows on Mortgage
Assets together with reinvestment income thereon and (ii) borrowing and
financing costs of the Company.
"Net Income" means the taxable income of the Company before the Manager's
incentive compensation, net operating loss deductions arising from losses in
prior periods and deductions permitted by the Code in calculating taxable
income for a REIT plus the effects of adjustments, if any, necessary to record
hedging and interest transactions in accordance with generally accepted
accounting principles.
"New Capital" means the proceeds from the sale of stock or certain debt
obligations.
"Nonconforming Mortgage Loans" means conventional Mortgage Loans that do not
conform to one or more requirements of FHA, FHLMC, Fannie Mae, GNMA or VA for
participation in one or more of such agencies' mortgage loan credit support
programs, such as the principal amounts financed or the underwriting
guidelines used in making the loan.
"One-Year U.S. Treasury Rate" means average of weekly average yield to
maturity for U.S. Treasury securities (adjusted to a constant maturity of one
year) as published weekly by the Federal Reserve Board during a yearly period.
"Other Mortgage Securities" means securities representing interests in, or
secured by Mortgages on, real property other than Pass-Through Certificates
and CMOs and may include non-Primary certificates and other securities
collateralized by single-family loans, Mortgage Warehouse Participations,
Mortgage Derivative Securities, Subordinated Interests and other mortgage-
backed and mortgage-collateralized obligations.
54
"Pass-Through Certificates" means securities (or interests therein) other
than Mortgage Derivative Securities and Subordinated Interests evidencing
undivided ownership interests in a pool of mortgage loans, the holders of
which receive a "pass-through" of the principal and interest paid in
connection with the underlying mortgage loans in accordance with the holders'
respective, undivided interests in the pool. Pass-Through Certificates include
Agency Certificates, as well as other certificates evidencing interests in
loans secured by single-family, multi-family, commercial and/or other real
estate related properties.
"PIA" means Pacific Income Advisers, Inc., a Delaware corporation.
"Primary" means either (i) securities which are rated within one of the two
highest rating categories by at least one of the Rating Agencies, or (ii)
securities that are unrated but are obligations of the United States or
obligations guaranteed by the United States government or an agency of the
United States government.
"Principal Only Derivatives" means Mortgage Derivative Securities
representing the right to receive principal only or a disproportionate amount
of principal.
"Privately Issued Certificates" means mortgage participation certificates
issued by certain private institutions. These securities entitle the holder to
receive a pass-through of principal and interest payments in the underlying
pool of Mortgage Loans and are issued or guaranteed by the private
institution.
"Prohibited Transaction" means a transaction involving a sale of Dealer
Property, other than Foreclosure Property.
"Qualified Hedges" means bona fide interest rate swap or cap agreements
entered into by the Company to hedge short-term indebtedness only that the
Company incurred to acquire or carry Qualified REIT Real Estate Assets and any
futures and options, or other investments (other than Qualified REIT Real
Estate Assets) made by the Company to hedge its Mortgage Assets or borrowings
that have been determined by a favorable opinion of counsel to generate
qualified income for purposes of the 95% source of income test applicable to
REITs.
"Qualifying Interests in Real Estate" means "mortgages and other liens on
and interests in real estate," as defined in Section 3(c)(5)(C) under the
Investment Company Act.
"Qualified REIT Real Estate Assets" means Pass-Through Certificates,
Mortgage Loans, Agency Certificates, and other assets of the type described in
Section 856(c)(6)(B) of the Code.
"Qualified REIT Subsidiary" means a corporation whose stock is entirely
owned by the REIT at all times during such corporation's existence.
"Qualified Temporary Investment Income" means income attributable to stock
or debt instruments acquired with new capital of the Company received during
the one-year period beginning on the day such proceeds were received.
"Rating Agencies" means either Standard & Poor's or Moody's.
"REIT" means Real Estate Investment Trust.
"REIT Provisions of the Code" means Sections 856 through 860 of the Code.
"REMIC" means Real Estate Mortgage Investment Conduit. The Company will
limit the REMIC interests that it acquires to interests issued by REMICs, at
least 95% of whose assets consist of Qualified REIT Real Estate Assets.
55
"Residuals" means the right to receive the remaining or residual cash flows
from a pool of Mortgage Loans or Mortgage Securities after distributing
required amounts to the holders of interests in or obligations backed by such
loans or securities and after payment of any required pool expenses.
"Return on Equity" means an amount calculated for any quarter by dividing
the Company's Net Income for the quarter by its Average Net Worth for the
quarter.
"Securities Act" means the Securities Act of 1933, as amended.
"Service" means the Internal Revenue Service.
"Servicers" means those entities that perform the servicing functions with
respect to Mortgage Loans or Excess Servicing Rights owned by the Company.
"Servicing Agreements" means the various agreements the Company may enter
into with Servicers.
"Short-Term Investments" means short-term bank certificates of deposit,
short-term United States treasury securities, short-term United States
government agency securities, commercial paper, repurchase agreements, short-
term CMOs, short-term asset-backed securities and other similar types of
short-term investment instruments, all of which will have maturities or
average lives of less than one (1) year.
"Stock Option and Awards Plan" means the stock option plan adopted by the
Company.
"Suppliers of Mortgage Assets " means mortgage bankers, savings and loan
associations, investment banking firms, banks, home builders, insurance
companies and other concerns or lenders involved in mortgage finance or
originating and packaging Mortgage Loans, and their Affiliates.
"Subordinated Interests" means a class of Mortgage Securities that is
subordinated to one or more other classes of Mortgage Securities, all of which
classes share the same collateral. The Company will only acquire Subordinated
Interests that are beneficial interests in grantor trusts holding Mortgage
Loans, or are regular interests issued by REMICs, or that otherwise constitute
Qualified REIT Real Estate Assets (provided the Company has obtained a
favorable opinion of counsel to that effect).
"Tax-Exempt Entity" means a qualified pension, profit-sharing or other
employee retirement benefit plans, Keogh plans, bank commingled trust funds
for such plans, and IRAs, and other similar entities intended to be exempt
from federal income taxation.
"Taxable Income" means for any year the taxable income of the Company for
such year (excluding any net income derived either from property held
primarily for sale to customers or from foreclosure property) subject to
certain adjustments provided in the REIT Provisions of the Code.
"Ten Year U.S. Treasury Rate" means the arithmetic average of the weekly
average yield to maturity for actively traded current coupon U.S. Treasury
fixed interest rate securities (adjusted to a constant maturity of ten years)
published by the Federal Reserve Board during a quarter, or, if such rate is
not published by the Federal Reserve Board, any Federal Reserve Bank or agency
or department of the federal government selected by the Company. If the
Company determines in good faith that the Ten Year U.S. Treasury Rate cannot
be calculated as provided above, then the rate shall be the arithmetic average
of the per annum average yields to maturities, based upon closing asked prices
on each business day during a quarter, for each actively traded marketable
U.S. Treasury fixed interest rate security with a final maturity date not less
than eight nor more than twelve years from the date of the closing asked
prices as chosen and quoted for each business day in each such quarter in New
York City by at least three recognized dealers in U.S. government securities
selected by the Company.
"Trust" means a trust that is the transferee of that number of shares of
Common Stock the beneficial or constructive ownership of which otherwise would
cause a person to acquire or hold, directly or indirectly, shares
56
of Common Stock in an amount that violates the Company's Charter, which trust
shall be for the exclusive benefit of one or more Charitable Beneficiaries.
"Trustee" means a trustee of a Trust for the Charitable Beneficiary.
"UBTI" means "unrelated trade or business income" as defined in Section 512
of the Code.
"Unaffiliated Directors" means those directors that are not affiliated,
directly, or indirectly, with the Manager, whether by ownership of, ownership
interest in, employment by, any material business or professional relationship
with, or serving as an officer or director of the Manager or an affiliated
business entity of the Manager.
"VA" means the United States Veterans Administration.
"VA Loans" means Mortgage Loans partially guaranteed by the VA under the
Servicemen's Readjustment Act of 1944, as amended.
57
FINANCIAL STATEMENTS
ANWORTH MORTGAGE ASSET CORPORATION
FINANCIAL STATEMENTS AND INDEPENDENT AUDITORS' REPORT
FOR INCLUSION IN FORM 10-K
ANNUAL REPORT FILED WITH
SECURITIES AND EXCHANGE COMMISSION DECEMBER 31, 1998
ANWORTH MORTGAGE ASSET CORPORATION
INDEX TO FINANCIAL STATEMENTS
INDEPENDENT AUDITORS' REPORT............................................... F-2
FINANCIAL STATEMENTS:
Balance Sheet -- December 31, 1998....................................... F-3
Statement of Operations for the period March 17, 1998 (commencement of
operations) to December 31, 1998........................................ F-4
Statement of Stockholders' Equity for the period March 17, 1998
(commencement of operations) to December 31, 1998....................... F-5
Statement of Cash Flows for the period March 17, 1998 (commencement of
operations) to December 31, 1998........................................ F-6
Notes to Financial Statements............................................ F-7
F-1
INDEPENDENT AUDITOR'S REPORT
To the Board of Directors
Anworth Mortgage Asset Corporation
Santa Monica, California
We have audited the accompanying balance sheet of Anworth Mortgage Asset
Corporation as of December 31, 1998 and the related statements of operations,
stockholders' equity and cash flows for the period from March 17, 1998
(commencement of operations) to December 31, 1998. These financial statements
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these financial statements based on our audit.
We conducted our audit 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 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 Anworth Mortgage Asset
Corporation as of December 31, 1998, and the results of its operations and its
cash flows for the period then ended, in conformity with generally accepted
accounting principles.
McGLADREY & PULLEN, LLP
New York, New York
January 9, 1999
F-2
ANWORTH MORTGAGE ASSET CORPORATION
BALANCE SHEET DECEMBER 31, 1998
ASSETS
Mortgage backed securities (Notes 2, 3 and 6).................. $184,245,000
Other marketable securities (Notes 2 and 6).................... 488,000
Cash and cash equivalents (Note 3)............................. 13,299,000
Accrued interest receivable.................................... 1,411,000
Prepaid expenses and other..................................... 15,000
------------
$199,458,000
============
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities
Reverse repurchase agreements (Note 3)......................... $170,033,000
Payable for purchase of mortgage-backed securities............. 10,047,000
Accrued interest payable....................................... 1,799,000
Dividends payable.............................................. 279,000
Accrued expenses and other..................................... 58,000
------------
182,216,000
------------
Stockholders' Equity
Preferred stock, par value $.01 per share; authorized
20,000,000 shares; no shares issued and outstanding...........
Common stock; par value $.01 per share; authorized 100,000,000
shares; 2,328,000 shares issued and outstanding............... 23,000
Additional paid-in capital..................................... 18,971,000
Accumulated other comprehensive income, unrealized gain (loss)
on available for sale securities (Note 2)..................... (1,775,000)
Retained earnings.............................................. 23,000
------------
17,242,000
------------
$199,458,000
============
See notes to financial statements.
F-3
ANWORTH MORTGAGE ASSET CORPORATION
STATEMENT OF OPERATIONS
Period from March 17, 1998 (commencement of operations) to December 31, 1998
Interest and dividend income, net of amortization of premium........ $8,570,000
Interest expense.................................................... 7,378,000
----------
Net interest income................................................. $1,192,000
General and administrative expenses: (Note 6)
Management fee..................................................... 144,000
Incentive fee...................................................... 2,000
Other.............................................................. 161,000
----------
Net Income.......................................................... $ 885,000
==========
Basic and diluted earnings per share................................ $ 0.38
==========
Average number of shares outstanding................................ 2,315,651
==========
See notes to financial statements.
F-4
ANWORTH MORTGAGE ASSET CORPORATION
STATEMENT OF STOCKHOLDERS' EQUITY
Period from March 17, 1998 (commencement of operations) to December 31, 1998
Common
Common Stock Additional Accum. Other
Stock Par Paid-in Comprehensive Retained Comprehensive
Shares Value Capital Income (Loss) Earnings Income (Loss) Total
--------- ------- ----------- ------------- --------- ------------- -----------
Balance, March 17,
1998................... 100 $ -- $ 1,000 $ 1,000
Issuance of common
stock................. 2,327,900 23,000 18,970,000 18,993,000
Available-for-sale
securities, Fair value
adjustment............ (1,775,000) (1,775,000) (1,775,000)
Net income............. 884,000 884,000 884,000
-----------
Other comprehensive
income (loss).......... $ (891,000)
===========
Dividends declared--
$0.37 per share....... (861,000) (861,000)
--------- ------- ----------- ----------- --------- -----------
Balance, December 31,
1998................... 2,328,000 $23,000 $18,971,000 $(1,775,000) $ 23,000 $17,242,000
========= ======= =========== =========== ========= ===========
See notes to financial statements.
F-5
ANWORTH MORTGAGE ASSET CORPORATION
STATEMENT OF CASH FLOWS
Period from March 17, 1998 (commencement of operations) to December 31, 1998
Operating Activities:
Net income.................................................... $ 885,000
Adjustments to reconcile net income to net cash provided by
operating activities:
Amortization................................................ 1,489,000
(Increase) in accrued interest receivable................... (1,411,000)
(Increase) in prepaid expenses and other.................... (15,000)
Increase in accrued interest payable........................ 1,799,000
Increase in accrued expenses and other...................... 58,000
-------------
Net cash provided by operating activities................. 2,805,000
Investing Activities:
Available for sale securities:
Purchases................................................... (231,361,000)
Principal payments.......................................... 53,409,000
-------------
Net cash (used in) investing activities................... (177,952,000)
Financing Activities:
Net borrowings from reverse repurchase agreements............. 170,033,000
Proceeds from common stock issues, net........................ 18,994,000
Dividends paid................................................ (582,000)
-------------
Net cash provided by financing activities................... 188,445,000
-------------
Net increase (decrease) in cash and cash equivalents.......... 13,298,000
Cash and cash equivalents at beginning of period.............. 1,000
-------------
Cash and cash equivalents at end of period.................... $ 13,299,000
=============
See notes to financial statements.
Supplemental Disclosure of Cash Flow Information
Cash paid for interest........................................ $ 5,579,000
Supplemental Disclosure of Investing and Financing Activities
Mortgage securities purchased, not yet settled................ $ 10,047,000
See notes to financial statements.
F-6
ANWORTH MORTGAGE ASSET CORPORATION
NOTES TO FINANCIAL STATEMENTS
Period from March 17, 1998 (commencement of operations) to December 31, 1998
NOTE 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
Anworth Mortgage Asset Corporation (the "Company") was incorporated in
Maryland on October 20, 1997. The Company commenced its operations of
purchasing and managing an investment portfolio of primarily adjustable-rate
mortgage-backed securities on March 17, 1998, upon completion of its initial
public offering of the Company's common stock.
A summary of the company's significant accounting policies follows:
CASH AND CASH EQUIVALENTS
Cash and cash equivalents include cash on hand and highly liquid investments
with original maturities of three months or less. The carrying amount of cash
equivalents approximates their fair market value.
SECURITIES
The Company invests primarily in adjustable-rate mortgage pass-through
certificates and hybrid adjustable-rate mortgage-backed securities ("ARM"
securities). Hybrid ARM securities have an initial interest rate that is fixed
for a certain period, usually three to five years, and then adjusts annually
for the remainder of the term of the loan.
The Company classifies its investments as either trading investments,
available-for-sale investments or held-to-maturity investments. Management
determines the appropriate classification of the securities at the time they
are acquired and evaluates the appropriateness of such classifications at each
balance sheet date. The Company currently classifies all of its securities as
available-for-sale. All assets that are classified as available-for-sale are
carried at fair value and unrealized gains or losses are included in other
comprehensive income or loss as a component of stockholders' equity.
Interest income is accrued based on the outstanding principal amount of the
ARM securities and their contractual terms. Premiums associated with the
purchase of ARM securities are amortized into interest income over the
estimated lives of the asset adjusted for estimated prepayments using the
effective yield method.
Securities are recorded on the date the securities are purchased or sold.
CREDIT RISK
At December 31, 1998 the Company had limited its exposure to credit losses
on its portfolio of ARM securities by purchasing primarily securities from
Federal Home Loan Mortgage Corporation ("FHLMC") and Federal National Mortgage
Association ("FNMA"). The payment of principal and interest on the FHLMC and
FNMA ARM securities are guaranteed by those respective agencies. At December
31, 1998, because of the government agencies' guarantee, all of the Company's
ARM securities have an implied "AAA" rating.
INCOME TAXES
The Company intends to elect to be taxed as a Real Estate Investment Trust
and to comply with the provisions of the Internal Revenue Code with respect
thereto. Accordingly, the Company is not subject to Federal income tax to the
extent that its distributions to stockholders satisfy the REIT requirements
and certain asset, income and stock ownership tests are met.
F-7
ANWORTH MORTGAGE ASSET CORPORATION
NOTES TO FINANCIAL STATEMENTS--(Continued)
EARNINGS PER SHARE (EPS)
Basic EPS is computed by dividing net income by the weighted average number
of common shares outstanding during the period. Diluted EPS assumes the
conversion, exercise or issuance of all potential common stock equivalents
unless the effect is to reduce a loss or increase the income per share. Stock
options that could potentially dilute basic EPS in the future were not
included in the computation of diluted EPS because to do so would have been
antidilutive.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements and the reported amounts of revenues and expenses during the
reporting period. Actual results could differ from those estimates.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1997, the Financial Accounting Standards Board ("FASB") issued SFAS
No. 130, Reporting Comprehensive Income. This statement requires companies to
classify items of other comprehensive income, such as unrealized gains and
losses on available-for-sale securities, by their nature in a financial
statement and display the accumulated balance of other comprehensive income
separately from retained earnings and additional paid-in capital in the equity
section of a statement of financial position. The Company adopted this
statement in the first quarter of 1998.
In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities, which is effective for all fiscal quarters
beginning after June 15, 1999. SFAS No. 133 established a framework of
accounting rules that standardize accounting for all derivative instruments.
The Statement requires that all derivative financial instruments be carried on
the balance sheet at fair value. The Company has not yet acquired any
derivative instruments.
In October 1998, the FASB issued SFAS No. 134, Accounting for Mortgage-
Backed Securities Retained after the Securitization of Mortgage Loans Held for
Sale by a Mortgage Banking Enterprise. This Statement, which is effective for
the first fiscal quarter beginning after December 15, 1998, provides guidance
to mortgage banking entities who securitize mortgage loans such that their
accounting for securitized loans will be the same as their accounting for
marketable securities. The Company has not yet acquired any mortgage loans.
NOTE 2. SECURITIES
The following table summarizes the Company's ARM securities classified as
available-for-sale as of December 31, 1998, which are carried at their fair
value ($000's):
Federal Federal
Home Loan National Other Total
Mortgage Mortgage ARM ARM
Corporation Association Assets Assets
----------- ----------- ------ --------
Amortized Cost.................... $43,643 $130,207 $0 $173,850
Unrealized gains.................. 80 76 156
Unrealized losses................. (486) (1,399) 0 (1,885)
------- -------- --- --------
Fair value........................ $43,237 $128,884 $0 $172,121
======= ======== === ========
F-8
ANWORTH MORTGAGE ASSET CORPORATION
NOTES TO FINANCIAL STATEMENTS--(Continued)
In addition, at December 31, 1998 the Company held a position in a position
in a fixed-rate mortgage backed security and a preferred stock, which had fair
values of $10,051,000 and $488,000, respectively. The following table
summarizes the Company's securities as of December 31, 1998 at their fair
value ($000's):
Fixed REIT
Rate Preferred
ARMS MBS Stock Total
-------- ------- --------- --------
Amortized Cost...................... $173,850 $10,120 $464 $184,434
Unrealized gains.................... 156 0 24 180
Unrealized gains (losses)........... (1,885) (69) 0 (1,954)
-------- ------- ---- --------
Estimated fair value................ $172,121 $10,051 $488 $182,660
======== ======= ==== ========
NOTE 3. REVERSE REPURCHASE AGREEMENTS
The Company has entered into reverse repurchase agreements to finance most
of its ARM securities. The reverse repurchase agreements are short-term
borrowings that bear interest rates that have historically moved in close
relationship to LIBOR (London Interbank Offer Rate). These agreements are
collateralized by ARM securities with a fair value of $172,121,000 and by cash
of $4,439,743.
At December 31, 1998, the repurchase agreements had a weighted average
interest rate of 5.38%, an average maturity of 64 days and the following
remaining maturities:
Within 59 days.............................................. $122,819,000
60 to 89 days............................................... 8,354,000
90 to 119 days.............................................. 10,856,000
Over 120 days............................................... 28,004,000
------------
$170,033,000
============
NOTE 4. FAIR VALUES OF FINANCIAL INSTRUMENTS
ARM securities and other marketable securities are reflected in the
financial statements at estimated fair value. Management bases its fair value
estimates for ARM securities and other marketable securities primarily on
third-party bid price indications provided by dealers who make markets in
these financial instruments when such indications are available. However, the
fair value reported reflects estimates and may not necessarily be indicative
of the amounts the Company could realize in a current market exchange. Cash
and cash equivalents, interest receivable, reverse repurchase agreements and
payables for securities purchased are reflected in the financial statements at
their costs, which approximates their fair value because of the short-term
nature of these instruments.
NOTE 5. INITIAL PUBLIC OFFERING AND CAPITAL STOCK
On March 17, 1998 the Company completed its initial public offering of
common stock, $0.01 par value. The Company issued 2,200,000 shares of common
stock at a price of $9 per share and received net proceeds of $18,414,000, net
of underwriting discount of $0.63 per share. Offering costs in connection with
the public offering, including the underwriting discount and other expenses,
which total $491,182, have been charged against the proceeds of the offering.
Prior to March 17, 1998, the Company had no operations other than activities
relating to its organization, registration under the Securities Act of 1933
and the issuance of 100 shares of its common stock to its initial shareholder.
F-9
ANWORTH MORTGAGE ASSET CORPORATION
NOTES TO FINANCIAL STATEMENTS--(Continued)
The Company granted the underwriters of the initial public offering of the
Company's common stock a 30-day option to purchase additional shares of common
stock solely to cover over-allotments, if any, at the public offering price of
$9 per share. On April 14, 1998, the underwriters purchased an additional
127,900 shares under the terms of this option. As a result, the Company
received additional net proceeds of $1,070,523, net of the underwriting
discount of $0.63 per share.
The Company's authorized capital includes 20 million shares of $.01 par
value preferred stock. The preferred stock may be issued in one or more
classes or series, with such distinctive designations, rights and preferences
as determined by the Board of Directors.
During the period ended December 31, 1998, the Company declared dividends to
stockholders totaling $.37 per share, of which $.25 has been paid and $.12 is
payable on January 14, 1999. For Federal income tax purposes, such dividends
are ordinary income to the Company's stockholders.
NOTE 6. TRANSACTIONS WITH AFFILIATES
The Company entered into a Management Agreement (the "Agreement") with
Anworth Mortgage Advisory Corporation (the "Manager"), effective March 12,
1998. Under the terms of the Agreement, the Manager, subject to the
supervision of the Company's Board of Directors, is responsible for the
management of the day-to-day operations of the Company and provides all
personnel and office space.
The Company pays the Manager an annual base management fee equal to 1% of
the first $300 million of Average Net Invested Assets (as defined in the
Agreement), plus 0.8% of the portion above $300 million (the "Base Management
Fee").
In addition to the Base Management Compensation, the Manager shall receive
as incentive compensation for each fiscal quarter an amount equal to 20% of
the Net Income of the Company, before incentive compensation, for such fiscal
quarter in excess of the amount that would produce an annualized Return on
Equity (calculated by multiplying the Return on Equity for such fiscal quarter
by four) equal to the Ten-Year U.S. Treasury Rate for such fiscal quarter plus
1% (the "Incentive Management Compensation").
For the period ended December 31, 1998, the Company paid the Manager
$144,000 in base management fees and $2,000 in Incentive Management
Compensation.
NOTE 7. STOCK OPTION PLAN
The Company has adopted the Anworth Mortgage Asset Corporation 1997 Stock
Option and Awards Plan (the "Stock Option Plan") which authorizes the grant of
options to purchase an aggregate of up to 300,000 of the outstanding shares of
the Company's common stock. The plan authorizes the Board of Directors, or a
committee of the Board of Directors, to grant incentive stock options ("ISOs")
as defined under section 422 of the Internal Revenue Code of 1986, as amended,
options not so qualified ("NQSOs"), dividend equivalent rights ("DERs") and
stock appreciation rights ("SARs"). The exercise price for any option granted
under the Stock Option Plan may not be less than 100% of the fair market value
of the shares of common stock at the time the option is granted. During the
period ended December 31, 1998, the Company had granted 148,000 options at an
exercise price of $9 per share and 136,000 DERs. Options granted to officers
become exercisable over a three year period following their date of grant.
Options granted to directors become exercisable six months after their date of
grant. All options granted expire on March 11, 2008. The DER's are payable
only when their associated stock options are exercised, thereby reducing the
effective strike price of such options. The Company will recognize
compensation expense at the time the average market price of the stock exceeds
the effective strike price. The Company has not yet recognized any
compensation expense related to the DERs because the current market price of
the common stock is substantially less than the effective strike price.
The Company adopted the disclosure-only provisions of Statement of Financial
Accounting Standards No. 123, "Accounting for Stock-Based Compensation."
Accordingly, no compensation cost has been recognized for grants under the
Stock Option Plan. Had compensation cost for the Company's stock option plan
been
F-10
ANWORTH MORTGAGE ASSET CORPORATION
NOTES TO FINANCIAL STATEMENTS--(Continued)
determined based on the fair value at the grant date for awards in 1998
consistent with the provisions of SFAS No. 123, the Company's net income and
earnings per share would have been reduced to the pro forma amounts indicated
in the table below. The fair value of each option grant is estimated on the
date of grant using the Black-Scholes option-pricing model:
Period From March
17, 1998
(commencement
of operations) to
December 31, 1998
-----------------
Net income--as reported.................................... $885,000
Net income--pro forma...................................... $811,000
Basic and diluted earnings per share--as reported.......... $ 0.38
Basic and diluted earnings per share--pro forma............ $ 0.35
Assumptions:
Dividend yield........................................... 10%
Expected volatility...................................... 35%
Risk-free interest rate.................................. 5.5%
Expected lives........................................... 7 years
The fair value of options granted during 1998 was $1.90 per share.
NOTE 8. SUMMARIZED QUARTERLY RESULTS (UNAUDITED)
First Second Third Fourth
Quarter (A) Quarter Quarter Quarter
----------- ---------- ---------- ----------
Interest and dividend income..... $ 74,000 $2,799,000 $2,978,000 $2,719,000
Interest expense................. 42,000 2,318,000 2,611,000 2,407,000
--------------------------------------------
Net interest income.............. 32,000 481,000 367,000 312,000
Expenses......................... 15,000 124,000 123,000 45,000
--------------------------------------------
Net Income....................... $ 17,000 $ 357,000 $ 244,000 $ 267,000
============================================
Basic and diluted earnings per
share........................... $ 0.01 $ 0.15 $ 0.10 $ 0.12
============================================
Average number of shares
outstanding..................... 2,200,100 2,309,729 2,328,000 2,328,000
============================================
- --------
(A) The Company commenced operations on March 17, 1998
F-11
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized,
Dated: March 30, 1999 ANWORTH MORTGAGE ASSET CORPORATION
By /s/ Lloyd McAdams
_____________________________________
Lloyd McAdams,
Chief Executive Officer
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, this Annual Report on Form 10-K has been signed by the
following persons in the capacities and on the dates indicated.
Signature Capacity Date
--------- -------- ----
/s/ Lloyd McAdams Chairman of the Board, Chief March 30, 1999
____________________________________ Executive Officer and
Lloyd McAdams Director (Principal
Executive Officer)
/s/ Pamela J. Watson Chief Financial Officer March 30, 1999
____________________________________ (Principal Financial and
Pamela J. Watson Accounting Officer)
/s/ Joe E. Davis Director March 30, 1999
____________________________________
Joe E. Davis
/s/ Charles H. Black Director March 30, 1999
____________________________________
Charles H. Black
II-1
EXHIBIT INDEX
3.1 Charter of the Registrant (incorporated by reference to Exhibit 3.1 to
the Company's Registration Statement on Form S-11(Registration No. 333-
38641) filed with the Securities and Exchange Commission on October 24,
1997.).
3.2 Bylaws of the Registrant (incorporated by reference to Exhibit 3.2 to the
Company's Registration Statement on Form S-11(Registration No. 333-38641)
filed with the Securities and Exchange Commission on October 24, 1997.).
4.1 Form of Stock Certificate of the Registrant (incorporated by reference to
Exhibit 4.1 to the Company's Registration Statement on Form S-
11(Registration No. 333-38641) filed with the Securities and Exchange
Commission on December 12, 1997.).
10.1 Management Agreement between the Registrant and Anworth Mortgage Advisory
Corporation (incorporated by reference to Exhibit 10.1 to the Company's
Registration Statement on Form S-11(Registration No. 333-38641) filed
with the Securities and Exchange Commission on February 25, 1998.).
10.2 Form of 1997 Stock Option and Awards Plan (incorporated by reference to
Exhibit 10.2 to the Company's Registration Statement on Form S-
11(Registration No. 333-38641) filed with the Securities and Exchange
Commission on December 12, 1997.).
27 Financial Data Schedule