EXHIBIT 99.01
RISK FACTORS
Investing in our company involves various risks, including the risk that
you might lose your entire investment. The results of our operations depend upon
many factors, including the availability of opportunities to acquire assets and
make loans, the level and volatility of interest rates, the cost and
availability of short- and long-term credit, financial market conditions, and
general economic conditions. We will strive to attain our objectives through,
among other things, FBR Management's research and portfolio management skills.
There is no guarantee, however, that we will perform successfully, meet our
objectives, or achieve positive returns.
The following risks are interrelated, and you should treat them as a whole.
CONFLICTS WITH FBR GROUP MAY RESULT IN DECISIONS THAT DO NOT REFLECT OUR BEST
INTERESTS.
We are subject to various conflicts of interest arising from our
relationship with FBR. Those conflicts include the following:
- We invest in the equity securities of or make loans to companies whose
securities have been underwritten or placed by FBR and companies to which
FBR has provided financial advisory services. FBR and its employees,
including some of the officers of FBR Asset, are paid substantial fees
for underwriting, placement agent and financial advisory services, and to
the extent that the success of a new offering or transaction depends on
our significant investment, FBR Management, because of its affiliation
with FBR, will have a conflict of interest in recommending that
investment to us. In those instances, our shareholders will rely on the
investment recommendation of our investment committee, which must be
approved by the Contracts Committee of our Board of Directors (comprised
of the three independent members of our Board). The investment committee
will in part rely on information provided by FBR Management.
- FBR Group and its affiliates, including FBR Management, manage other
funds that are authorized to invest in assets similar to those in which
we invest. In particular, FBR manages mutual and private equity funds,
and may in the future manage other funds, that invest in private equity
securities and in REITs and other real estate-related securities. In
addition, FBR or its affiliates may choose to invest directly in these
investment opportunities. There may be investment opportunities that are
favorable to us and to the other funds managed by FBR or to FBR or its
affiliates directly. In those cases, FBR will allocate investment
opportunities among funds based upon primary investment objectives,
applicable investment restrictions, and any other factors that FBR deems
appropriate and fair under the circumstances.
- Under the terms of our agreement with FBR, we will be entitled to receive
a portion of the fees earned by FBR as a result of engagements of FBR by
companies in which we commit to invest or make a loan where our
commitment is a contributing factor in the engagement of FBR or assists
in facilitating the completion of a transaction. The existence of this
agreement may discourage FBR from presenting investment opportunities to
us in situations which may result in a fee-sharing arrangement with us.
- FIDAC, our mortgage portfolio manager, is an affiliate of Annaly Mortgage
Management, Inc., an investment banking client of FBR Group. As a result
of this investment banking relationship, Annaly has paid investment
banking fees to FBR Group as follows: $7.0 million in 1997, $0 in 1998,
$0 in 1999, $0 in 2000, and $7.6 million in 2001, and may pay FBR Group
additional investment banking fees in the future. As a result, FBR
Management has a conflict of interest with respect to decisions regarding
the renewal or termination of the sub-management agreement between FBR
Management and FIDAC.
- The incentive portion of the management fee, which is based on our
income, may create an incentive for FBR Management to recommend
investments that have greater potential for income or appreciation, but
that are generally more speculative. If the management fee did not
include a performance
1
component, FBR Management might not otherwise recommend those investments
because of their speculative nature.
- Two of the members of our board of directors, and each of our executive
officers, also serve as executive officers or employees of FBR and its
affiliates and devote substantial time to FBR. These persons devote the
time and attention to our business that they, in their discretion, deem
necessary, but conflicts may arise in allocating management time,
services or functions between our company and FBR and its affiliates. The
failure by these people to devote adequate time to us could result in our
failure to take advantage of investment opportunities or failure to take
other actions that might be in our best interests.
- Because of our relationship with FBR, we may obtain confidential
information about the companies in which we have invested. If we do
possess confidential information about other companies, we may be
restricted in our ability to dispose of, increase the amount of, or
otherwise take action with respect to our investment in those companies.
WE ARE HEAVILY DEPENDENT UPON FBR MANAGEMENT IN A COMPETITIVE MARKET FOR
INVESTMENT OPPORTUNITIES.
We can gain access to good investment opportunities only to the extent that
they become known to FBR Group or FBR Management. Gaining access to good
investment opportunities is a highly competitive business. FBR, FBR Management,
and our company compete with other companies that have greater capital, more
long-standing relationships, broader product offerings, and other advantages.
Competitors include, but are not limited to, business development companies,
small business investment companies, commercial lenders and mezzanine funds.
Increased competition would make it more difficult for us to purchase or
originate investments at attractive yields.
We are heavily dependent for the selection, structuring, and monitoring of
our investments on the diligence and skill of FBR Management's officers and
employees. We do not have employment agreements with our senior officers or
require FBR Management to employ specific personnel or dedicate employees solely
to us. FBR Management, in turn, is dependent on the efforts of its senior
management personnel. Although we believe that FBR Management could find
replacements for its key executives, the loss of their services could have an
adverse effect on our operations and the operations of FBR Management.
THE TERMINATION OR NON-RENEWAL OF THE FBR MANAGEMENT AGREEMENT WOULD BE HARMFUL
TO US.
We and FBR Management may terminate the management agreement without cause.
The management agreement requires us to pay FBR Management a substantial
termination fee in the event that we terminate the agreement without cause
before expiration of its term. The termination fee would equal twelve months of
base and incentive fees. For example, if we had terminated the management
agreement in January 2001, the termination fee would have been $1.1 million, the
amount of the base fee expensed in 2000. Because no incentive fee was earned in
2000, no additional termination fee would have been due.
Payment of a termination fee could have an adverse effect on our financial
condition, cash flows, and results of operations and could reduce the amount of
funds available for distribution to shareholders. In the event of termination,
if we do not have sufficient cash to pay the termination fee, we may have to
sell assets even though we would not otherwise choose to do so.
FBR Management may terminate the management agreement without cause and
without penalty. In addition, in any year, it could elect not to renew the
management agreement. It may be difficult or impossible to find a substitute
management arrangement at a reasonable price or in a reasonable amount of time.
In addition, it may be difficult or impossible to find a substitute manager who
can identify investment opportunities to the same extent FBR Management and FBR
Group currently do.
If the management agreement is terminated or expires, our fee-sharing
agreement with FBR would terminate automatically. As a result, we would no
longer be entitled to share in the net cash fees earned by FBR pursuant to the
terms of the fee-sharing agreement.
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OUR LIMITED OPERATING HISTORY DOES NOT INDICATE FUTURE RESULTS.
We were organized in November 1997, became a public reporting company in
1999 and have a limited operating history. In addition, our increased emphasis
on mezzanine loans and on investments in other industries is a divergence from
our previous emphasis on investments in equity securities and mortgage-backed
securities. Because of this limited history, investors should be especially
cautious before drawing conclusions about our future performance, including any
conclusion about the future results of our expanded mezzanine loan program. Our
past performance is not necessarily indicative of future results.
WE MAY INVEST IN ANY ASSET CLASS SUBJECT ONLY TO MAINTAINING OUR REIT
QUALIFICATION AND OUR INVESTMENT COMPANY ACT EXEMPTION.
We make our investment decisions based in large part upon market
conditions. Subject only to maintaining our REIT classification and our
Investment Company Act exemption, we do not have any fixed guidelines for
industry or asset diversification. As a result, we may decide to allocate a
substantial portion of our assets or capital to a limited number of industries
or asset classes. This potential concentration could make us more susceptible to
significant losses and volatility than if we had further diversified our
investments.
DECLINES IN THE MARKET VALUES OF OUR ASSETS MAY ADVERSELY AFFECT CREDIT
AVAILABILITY AND PERIODIC REPORTED RESULTS.
Currently, our assets are primarily real estate and mortgage assets, which
include indirect holdings through investments in other companies. Those assets
are classified for accounting purposes as "available-for-sale." Changes in the
market values of those assets are directly charged or credited to our
shareholders' equity. As a result, a general decline in trading market values
may reduce the book value of our assets.
A decline in the market value of our assets may adversely affect us in
instances where we have borrowed money based on the market value of those
assets. At December 31, 2001, we had approximately $1.1 billion in outstanding
repurchase agreements that were based on the market value of specific mortgage
assets. The market value of those assets as of December 31, 2001, was
approximately $1.2 billion. If the market value of those assets declines, the
lender may require us to post additional temporary collateral to support the
loan. If we were unable to post the additional collateral, we would have to sell
the assets at a time when we would not otherwise choose to do so.
USE OF LEVERAGE COULD ADVERSELY AFFECT OUR OPERATIONS.
At December 31, 2001, our outstanding indebtedness for borrowed money under
repurchase agreements was 8.30 times the amount of our equity in the
mortgage-backed securities, based on book values. FBR Management has the
authority to increase or decrease our overall debt-to-equity ratio on our total
portfolio at any time and has not placed any limits on the amount we may borrow.
At December 31, 2001, our total debt-to-equity ratio was 5.42 to 1. If we borrow
more funds, the possibility that we would be unable to meet our debt obligations
as they come due would increase. Financing assets through repurchase agreements
exposes us to the risk that margin calls will be made and that we will not be
able to meet those margin calls.
While we have not leveraged our equity securities or loan investments, we
may choose to do so in the future. This leverage could expose us to the risk
that margin calls will be made and that we will not be able to meet them. A
leveraged company's income and net assets will tend to increase or decrease at a
greater rate than if borrowed money were not used.
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OUR ABILITY TO RECEIVE A SHARE OF THE INVESTMENT BANKING FEES EARNED BY FBR MAY
CAUSE US TO MAKE INVESTMENTS IN OR LOANS TO COMPANIES THAT WOULD OTHERWISE NOT
MEET OUR INVESTMENT OR CREDIT STANDARDS.
The decision to make an investment or loan will be made by our investment
committee, which will have a duty to make its decision based on its analysis of
the risks and rewards to us through the application of our normal investment
criteria. The prospect of receiving a portion of the investment banking fees
that FBR earns as a result of an engagement by a company where our commitment to
invest in or make a loan to the company is a contributing factor to such
engagement or assists in facilitating the completion of a transaction may,
however, give us an incentive to invest in or make a loan to a company that we
might not otherwise choose to make. If we commit to make an investment in or a
loan to a company with the expectation of receiving a portion of any investment
banking fees that FBR earns, there can be no assurance that the expected
engagement will materialize, which could result in returns that are not
commensurate with the level of risk we took in making the investment.
Consequently, the overall level of risk inherent in our investment and loan
portfolio may increase as a result of our fee-sharing arrangement with FBR.
OUR ASSETS INCLUDE MEZZANINE OR SENIOR LOANS THAT MAY HAVE GREATER RISKS OF LOSS
THAN A TYPICAL SECURED SENIOR LOANS.
In connection with our expanded mezzanine and senior loan program, we
expect our assets to include a significant amount of loans that involve a higher
degree of risk than long-term senior secured loans. First, our loans may not be
secured by mortgages or liens on assets. Even if secured, our loans may have
higher loan-to-value ratios than a typical senior secured loan. Furthermore,
our right to payment and the security interest are usually subordinated to the
payment rights and security interests of the senior lender. Therefore, we may
be limited in our ability to enforce our rights to collect our loans and to
recover any of the loan balance through a foreclosure of collateral.
Our loans typically have an interest only payment schedule, with the
principal amount remaining outstanding and at risk until the maturity of the
loan. A borrower's ability to repay its loan is often dependent upon a liquidity
event that will enable the repayment of the loan. Accordingly, we may not
recover some or all of our investments in our loans.
In addition to the above, numerous other factors may affect a company's
ability to repay its loan, including the failure to meet its business plan, a
downturn in its industry or negative economic conditions. A deterioration in a
company's financial condition and prospects may be accompanied by deterioration
in the collateral for the loan.
THE COMPANIES TO WHICH WE MAKE LOANS MAY BE HIGHLY LEVERAGED.
Leverage may have material adverse consequences to the companies to which
we make loans and to us as an investor. These companies may be subject to
restrictive financial and operating covenants. The leverage may impair these
companies' ability to finance their future operations and capital needs. As a
result, these companies' flexibility to respond to changing business and
economic conditions and to business opportunities may be limited. A leveraged
company's income and net assets will tend to increase or decrease at a greater
rate than if borrowed money were not used.
DEPLOYMENT OF ANY NEW CAPITAL WE RAISE IN INVESTMENTS IDENTIFIED BY SOURCES
OTHER THAN FBR MAY INCREASE THE LEVEL OF RISK IN OUR PORTFOLIO.
We may look to other entities for investment opportunities. If we do, we
may not have as much information about these opportunities as we have with
respect to companies identified by FBR. Consequently, the reduced amount of
information available to us could cause the level of risk inherent in our
investment portfolio to increase.
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THE INDIRECT NATURE OF OUR INVESTMENTS EXPOSES US TO ADDITIONAL RISKS.
Approximately 5% of our total assets, as of December 31, 2001, were
investments in equity securities. Approximately 1% of our total assets as of
December 31, 2001 were short-term loans. Obtaining interests in assets
indirectly by investing in other enterprises carries the following risks:
- Returns on investments are not directly linked to returns on investee
companies' assets. We own equity securities of and have made loans to
other companies. As an equity or debt holder, our return on investment is
not directly linked to returns on any company's assets, but will depend
upon either the payment of dividends and changes in the price of the
equity securities or the payment of principal and interest on the
outstanding debt, as applicable. Furthermore, as a common shareholder or
junior debt holder, our claims to the assets of the companies in which we
invest are junior to those of creditors and, with respect to our equity
investments, senior shareholders.
- Obstacles to success may remain hidden if due diligence is
inadequate. Before making an investment in another business entity, we
will assess the strength and skills of the entity's management and other
factors that we believe will determine the success of our investment. In
making our assessment and otherwise conducting our customary due
diligence, we will rely on the resources available to FBR Management and,
in some cases, an investigation by third parties. This process is
particularly important and subjective with respect to newly-organized
entities because there may be little or no information publicly available
about the companies. Against this background, we can give no assurance
that the due diligence processes of FBR Management will uncover all
relevant facts or that any investment will be successful.
- Dependence on management of other entities. We do not control the
management, investment decisions, or operations of the enterprises in
which we have invested. Management of those enterprises may decide to
change the nature of their assets, or management may otherwise change in
a manner that is not satisfactory to us. We have no ability to affect
these management decisions, and as noted below, we may have only limited
ability to dispose of our investments.
THE LIMITED LIQUIDITY OF SOME OF OUR INVESTMENTS EXPOSES US TO ADDITIONAL RISKS.
The equity securities of a new entity in which we invest are likely to be
restricted as to resale and may otherwise be highly illiquid. We expect that
there will be restrictions on our ability to resell the securities of any
newly-public company that we acquire for one year after we acquire those
securities. Thereafter, a public market sale may be subject to volume
limitations or dependent upon securing a registration statement for a secondary
offering of the securities. As of December 31, 2001, none of our equity
investments was restricted in this manner.
The securities of newly-public entities may trade less frequently and in
smaller volume than securities of companies that are more widely held and have
more established trading patterns. Thus, sales of these securities may cause
their values to fluctuate more sharply. Furthermore, and because of our
affiliation with FBR, our ability to invest in companies may be constrained by
applicable securities laws and the rules of the National Association of
Securities Dealers, Inc. This is because FBR is a registered broker-dealer and
its investment and trading activities are regulated by the SEC and NASD. For
example, the NASD's prohibition on "free-riding and withholding" may limit the
number of shares we can acquire in a "hot issue" public offering that is
underwritten by FBR.
The short- and medium-term loans we make are based, in part, upon our
knowledge of the borrower and its industry. In addition, we do not yet nor may
we ever have a significant enough portfolio of loans to easily sell them to a
third party. As a result, these loans are and may continue to be highly
illiquid.
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THE VOLATILITY OF THE MARKET PRICES OF SOME OF OUR INVESTMENTS EXPOSES US TO
ADDITIONAL RISK.
Prices of the equity securities of new entities in which we invest are
likely to be volatile, particularly when we decide to sell those securities. We
make investments in significant amounts, and resales of significant amounts of
securities might adversely affect the market and the sales price for the
securities.
THE DISPOSITION VALUE OF OUR INVESTMENTS IS DEPENDENT UPON GENERAL AND SPECIFIC
MARKET CONDITIONS.
Even if we make an appropriate investment decision based on the intrinsic
value of an enterprise, we have no assurance that the trading market value of
the investment will not decline, perhaps materially, as a result of general
market conditions. For example, an increase in interest rates, a general decline
in the stock markets, or other market conditions adverse to companies of the
type in which we have invested could result in a decline in the value of our
investments.
OUR REAL ESTATE-RELATED INVESTMENTS MAY INCUR LOSSES.
We invest in real estate-related assets and in other entities, such as
REITs, that themselves invest in real estate-related assets. Investments in real
estate-related assets are subject to a variety of general, regional and local
economic risks, as well as the following:
- Changes in interest rates could negatively affect the value of our
mortgage loans and mortgage-backed securities. We have invested
indirectly in mortgage loans by purchasing mortgage-backed securities.
Some of the companies in which we have invested also own mortgage loans
and mortgage-backed securities. At December 31, 2001, all of the
mortgage-backed securities we held directly were backed by pools of
fixed-rate and adjustable-rate residential mortgage loans. Under a
normal yield curve, an investment in fixed-rate mortgage loans or
mortgage-backed securities will decline in value if long-term interest
rates increase. Although Fannie Mae, Freddie Mac or Ginnie Mae may
guarantee payments on the mortgage-backed securities we own directly,
those guarantees do not protect us from declines in market value caused
by changes in interest rates.
- A significant risk associated with our current portfolio of
mortgage-backed securities is the risk that both long-term and
short-term interest rates will increase significantly. If long-term
rates were to increase significantly, the market value of our
mortgage-backed securities would decline and the weighted average life
of the investments would increase. We could realize a loss if the
securities were sold. At the same time, an increase in short-term
interest rates would increase the amount of interest owed on our
repurchase agreement borrowings.
- An increase in our borrowing costs relative to the interest we receive
on our mortgage-backed securities may adversely affect our
profitability. We earn money based upon the spread between the interest
payments we receive on our mortgage-backed security investments and the
interest payments we must make on our borrowings. We rely primarily on
short-term borrowings of the funds to acquire mortgage-backed securities
with long-term maturities. The interest we pay on our borrowings may
increase relative to the interest we earn on our mortgage-backed
securities. If the interest payments on our borrowings increase relative
to the interest we earn on our mortgage-backed securities, our
profitability may be adversely affected.
- Use of leverage can amplify declines in market value resulting from
interest rate increases. We, and several of the REITs in which we have
invested, borrow funds to finance mortgage related investments, which
can worsen the effect of a decline in value resulting from an interest
rate increase. For example, assume that our company or a REIT in which
we have invested borrows $90 million to acquire $100 million of 8%
mortgage-backed securities. If prevailing interest rates increase from
8% to 9%, the value of the mortgage loans may decline to a level below
the amount required to be maintained under the terms of
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the borrowing. If the mortgage assets were then sold, our company or the REIT
that owned the mortgage assets would have to find funds from another source to
repay the borrowing.
Market values of mortgage loans and mortgage-backed securities may decline
without any general increase in interest rates for any number of reasons, such
as increases in defaults, increases in voluntary prepayments and widening of
credit spreads.
PREPAYMENT RATES COULD NEGATIVELY AFFECT THE VALUE OF OUR MORTGAGE-BACKED
SECURITIES.
In the case of residential mortgage loans, there are seldom any
restrictions on borrowers' abilities to prepay their loans. Homeowners tend to
prepay mortgage loans faster when interest rates decline and when owners of the
loans, such as our company or the REITs in which we have invested, do not want
them to be prepaid. Consequently, owners of the loans have to reinvest the money
received from the prepayments at the lower prevailing interest rates.
Conversely, homeowners tend not to prepay mortgage loans when interest rates
increase and when owners of the loans want them to be prepaid. Consequently,
owners of the loans are unable to reinvest money that would have otherwise been
received from prepayments at the higher prevailing interest rates.
Although Fannie Mae, Freddie Mac or Ginnie Mae may guarantee payments on
the mortgage-backed securities we own directly, those guarantees do not protect
investors against prepayment risks.
RAPID CHANGES IN THE VALUES OF OUR REAL ESTATE ASSETS MAY MAKE IT MORE DIFFICULT
TO MAINTAIN OUR REIT STATUS.
If the market value or income potential of our mortgage-backed securities
and mezzanine loans decline as a result of increased interest rates, prepayment
rates or other factors, we may need to increase our real estate investments and
income and/or liquidate our non-qualifying assets in order to maintain our REIT
status or exemption from the Investment Company Act. If the decline in real
estate asset values and/or income occurs quickly, this may be especially
difficult to accomplish. This difficulty may be exacerbated by the illiquid
nature of many of our non-real estate assets. We may have to make investment
decisions that we otherwise would not want to make absent the REIT and
Investment Company Act considerations.
HEDGING AGAINST INTEREST RATE EXPOSURE MAY ADVERSELY AFFECT OUR EARNINGS.
During 2001, we entered into a $50 million notional amount interest rate
swap agreement to limit, or "hedge," the adverse effects of rising interest
rates on our short-term repurchase agreements. In the future, we may enter into
other interest rate swap agreements. Our hedging activity varies in scope based
on the level and volatility of interest rates and principal prepayments, the
type of mortgage-backed securities held, and other changing market conditions.
The companies in which we have invested also enter into interest rate
hedging transactions to protect themselves from the effect of changes in
interest rates. Interest rate hedging may fail to protect or adversely affect a
company because, among other things:
- interest rate hedging can be expensive, particularly during periods of
rising and volatile interest rates;
- available interest rate hedging may not correspond directly with the
interest rate risk for which protection is sought;
- the duration of the hedge may not match the duration of the related
liability;
- the amount of income that a REIT may earn from hedging transactions to
offset interest rate losses is limited by federal tax provisions
governing REITs;
- the party owing money in the hedging transaction may default on its
obligation to pay; and
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- the credit quality of the party owing money on the hedge may be
downgraded to such an extent that it impairs our ability to sell or
assign our side of the hedging transaction.
MULTIFAMILY AND COMMERCIAL REAL ESTATE MAY LOSE VALUE AND FAIL TO OPERATE
PROFITABLY.
Some of the companies in which we may invest may own multifamily and
commercial real estate. In the future, we may invest in other companies that
invest in multifamily and commercial real estate or we may invest in those
assets ourselves. Those investments and other similar investments are dependent
on the ability of the real estate to generate income. Investing in real estate
is subject to many risks. Among these are:
- property managers may not have the ability to attract tenants willing to
pay rents that sustain the property and to maintain and operate the
properties on a profitable basis;
- the value of real estate may be significantly affected by general,
regional and local economic conditions, and other factors beyond the
investor's control;
- the value of real estate may be significantly affected by unknown or
undetected environmental problems; and
- the value of real estate may be significantly affected by changes in
zoning or land use regulations or other applicable laws.
INVESTING IN SUBORDINATED INTERESTS EXPOSES US TO INCREASED CREDIT RISK.
In the future, we may invest in companies that invest in subordinated
interests or may ourselves invest in those interests. Subordinated interests are
classes of commercial mortgage-backed securities and mortgage loans that are
subject to the senior claim of mortgage-backed debt securities. Losses on the
underlying mortgage loans may be significant to the owner of a subordinated
interest because the investments are leveraged. For example, assume a REIT
acquires a $10 million principal amount subordinated interest in a $100 million
pool of mortgage loans that is subject to $90 million of senior mortgage-backed
securities. If thereafter there are $7 million of losses on the $100 million of
loans, the entire loss will be allocated to the owner of the subordinated
interest. In essence, a 7% loss on the loans would translate into a 70% loss of
principal and the related interest for the owner of the subordinated interest.
COMPETITION IN THE PURCHASE, SALE AND FINANCING OF MORTGAGE ASSETS MAY LIMIT THE
PROFITABILITY OF COMPANIES IN WHICH WE INVEST.
Although we do not directly own commercial mortgage-backed securities or
subordinated interests, in the future, we may invest in other companies that
invest in commercial mortgage-backed securities or subordinated interests or may
ourselves invest in those assets. Mortgage REITs derive their net income, in
large part, from their ability to acquire mortgage assets that have yields above
borrowing costs. In 1997 and 1998, increased competition for subordinated
interests developed as new mortgage REITs entered the market. These mortgage
REITs raised funds through public offerings and sought to invest those funds on
a long-term basis. The amount of funds available for investment, however,
exceeded the amount of available investments, which resulted in significant
competition for assets. That competition resulted in higher prices for
subordinated interests, lowering the yields and narrowing the spread of those
yields over borrowing costs.
Competitors for the acquisition of mortgage assets include other mortgage
REITs, such as Anthracite Capital, Inc., AMRESCO Capital Trust, and other REIT
and non-REIT investors, such as Lennar Corporation and Capital Trust.
INCREASED LOSSES ON UNINSURED MORTGAGE LOANS CAN REDUCE THE VALUE OF OUR EQUITY
INVESTMENTS.
Although our mortgage-backed securities are supported by instrumentality
guarantees, companies in which we have invested may own uninsured mortgage
loans. In the future, we may invest directly in uninsured mortgage loans.
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Owners of uninsured mortgage loans are subject to the risk that borrowers
will not pay principal or interest on their mortgage loans as they become due.
Borrowers become unable to pay their mortgage loans for a wide variety of
reasons, including general, regional, local and personal economics and declines
in business activity or real estate values. Generally, if a borrower defaults,
the owner of the mortgage loan will incur a loss to the extent the value of the
property securing the mortgage loan is less than the amount of the mortgage
loan. Defaults on mortgage loans often coincide with declines in real estate
values, which can create greater losses than anticipated. Increased exposure to
losses on uninsured mortgage loans can reduce the value of our equity
investments.
PREPAYMENT SENSITIVITY OF INVESTMENTS IN INTEREST-ONLY SECURITIES.
We have no direct investments in interest-only securities. Interest-only
securities are mortgage-backed securities that entitle the holder to receive
only interest on the outstanding principal amount of the underlying mortgage
loans, and no principal. The companies in which we invest do not own material
amounts of interest-only securities as of December 31, 2001, but may do so in
the future. We may also invest in other companies that invest in interest-only
securities or we may invest in those securities directly. The value of these
interest-only securities can be adversely affected if the underlying mortgage
loans are prepaid faster than anticipated and the interest stream decreases. For
example, an interest-only security with an initial notional amount of $100
million may entitle a holder to interest equal to 1% on the outstanding notional
amount. The holder may anticipate that 10% of the loans will prepay at the end
of each year; however, the actual experience is that 20% of the loans prepay at
the end of each year. In that case, the anticipated and actual cash paid to the
holder would be:
<Table>
<Caption>
YEAR ANTICIPATED ACTUAL
- ---- ----------- ----------
1.......................................................... $1,000,000 $1,000,000
2.......................................................... 900,000 800,000
3.......................................................... 800,000 600,000
4.......................................................... 700,000 400,000
5.......................................................... 600,000 200,000
6.......................................................... 500,000 --
7.......................................................... 400,000 --
8.......................................................... 300,000 --
9.......................................................... 200,000 --
10.......................................................... 100,000 --
---------- ----------
Total....................................................... $5,500,000 $3,000,000
========== ==========
</Table>
Some interest-only securities pay interest based on a floating rate that
varies inversely with, and at a multiple of, a specified floating interest rate
index, such as LIBOR. The yield on these securities is sensitive not only to
prepayments, but also to changes in the related index. For example, a security
might bear interest at a rate equal to forty percent minus the product of five
and LIBOR, or 40%-(5 x LIBOR). An increase in LIBOR by only 1%, from 6% to 7%,
would cause the interest rate on the investment to decline from 10% to 5%.
FEDERAL INCOME TAX REQUIREMENTS MAY RESTRICT OUR OPERATIONS.
We have operated and intend to continue operating in a manner that is
intended to cause us to qualify as a REIT for federal income tax purposes.
However, the REIT qualification requirements are extremely complex. Qualifying
as a REIT requires us to meet tests regarding the nature of our assets and our
income, the ownership of our outstanding stock, and the amount of our
distributions on an ongoing basis. Some of our investments are in equity
securities of other REITs, which generally are qualifying assets and produce
qualifying income for purposes of the REIT qualification tests. The failure of
the REITs in which we invest to maintain their REIT status, however, could
jeopardize our own REIT status. Accordingly, we cannot be
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certain that we have been or will continue to be successful in operating so as
to qualify as a REIT. At any time, new laws, interpretations, or court decisions
may change the federal tax laws or the federal income tax consequences of
qualification as a REIT. In addition, compliance with the REIT qualification
tests could restrict our ability to take advantage of attractive investment
opportunities in non-qualifying assets. Specifically, we may be required to
limit our investment in non-REIT equity securities and mezzanine loans to the
extent that such loans are not secured by real property.
FAILURE TO MAKE REQUIRED DISTRIBUTIONS WOULD SUBJECT US TO TAX.
In order to qualify as a REIT, we must distribute to our shareholders, each
calendar year, at least 90% of our taxable income, other than any net capital
gain. For years before 2001, we were required to distribute at least 95% of our
taxable income annually. To the extent that we satisfy the 90% distribution
requirement, but distribute less than 100% of our taxable income, we will be
subject to federal corporate income tax on our undistributed income. In
addition, we will incur a 4% nondeductible excise tax on the amount, if any, by
which our distributions in any calendar year are less than the sum of:
- 85% of our ordinary income for that year,
- 95% of our capital gain net income for that year, and
- 100% of our undistributed taxable income from prior years.
We generally intend to distribute all of our taxable income each year in
order to satisfy the 90% distribution requirement and avoid corporate income tax
and the 4% excise tax.
See "Federal Income Tax Consequences of Our Status as a REIT-Distribution
Requirements."
Our taxable income may substantially exceed our net income as determined
based on generally accepted accounting principles because, for example, capital
losses will be deducted in determining our GAAP income, but may not be
deductible in computing our taxable income. In addition, we may invest in assets
that generate taxable income in excess of economic income or in advance of the
corresponding cash flow from the assets, referred to as phantom income. Although
some types of phantom income are excluded in determining the 90% distribution
requirement, we will incur corporate income tax and the 4% excise tax with
respect to our phantom income items if we do not distribute those items on an
annual basis. See "Federal Income Tax Consequences of Our Status as a
REIT-Distribution Requirements." As a result of the foregoing, we may have less
cash than is necessary to distribute all of our taxable income each year.
Consequently, we may be required to incur debt or liquidate assets at rates or
times that we regard as unfavorable in order to satisfy the distribution
requirement and to avoid corporate income tax and the 4% excise tax in a
particular year.
FAILURE TO QUALIFY AS A REIT WOULD SUBJECT US TO FEDERAL INCOME TAX.
If we fail to qualify as a REIT in any taxable year, we would be required
to pay federal income tax on our taxable income. We might need to borrow money
or sell assets in order to pay that tax. Our payment of income tax would
decrease the amount of our income available for distribution to our
shareholders. Furthermore, if we cease to be a REIT, we no longer would be
required to distribute substantially all of our taxable income to our
shareholders. Unless our failure to qualify as a REIT were excused under federal
tax laws, we could not re-elect REIT status until the fifth calendar year
following the year in which we failed to qualify.
THERE IS A RISK THAT YOU MAY NOT RECEIVE DIVIDENDS.
Our current intention is to continue to distribute at least 90% of our
taxable income to our shareholders. There can be no assurance that we will
achieve investment results or maintain a tax status that will allow any
specified level of cash distributions.
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OWNERSHIP LIMITATION MAY RESTRICT CHANGE OF CONTROL OR BUSINESS COMBINATION
OPPORTUNITIES.
In order for us to qualify as a REIT, no more than 50% in value of our
outstanding capital stock may be owned, directly or indirectly, by five or fewer
individuals during the last half of any calendar year. "Individuals" include
natural persons, private foundations, some employee benefit plans and trusts,
and some charitable trusts. In order to preserve our REIT status, our Articles
generally prohibit:
- shareholders, other than FBR and some mutual funds and pension plans,
from directly or indirectly owning more than 9.9% of the outstanding
common stock or preferred stock of any series,
- FBR from directly or indirectly owning more than 20% of the outstanding
common stock or preferred stock of any series, and
- some mutual funds and pension plans from directly or indirectly owning
more than 15% of the outstanding common stock or preferred stock of any
series.
Our Board has exempted FBR from the 20% ownership limit applicable to it.
The exemption permits FBR to own, directly or indirectly, up to 62% of the
outstanding common stock or preferred stock of any series. Our Board also has
exempted some of our principal shareholders from the 9.9% ownership limit.
These ownership limitations could have the effect of discouraging a
takeover or other transaction in which holders of some, or a majority, of our
common stock might receive a premium for their shares over the then prevailing
market price or which holders might believe to be otherwise in their best
interests.
LOSS OF INVESTMENT COMPANY ACT EXEMPTION WOULD ADVERSELY AFFECT US.
We believe that we currently are not, and intend to continue operating so
as not to become, regulated as an investment company under the Investment
Company Act of 1940 because we are "primarily engaged in the business of
purchasing or otherwise acquiring mortgages and other liens on and interests in
real estate." Specifically, we have invested, and intend to continue investing,
at least 55% of our assets in mortgage loans or mortgage-backed securities that
represent the entire ownership in a pool of mortgage loans and at least an
additional 25% of our assets in mortgages, mortgage-backed securities,
securities of REITs, and other real estate-related assets.
If we fail to qualify for that exemption, we could be required to
restructure our activities. For example, if the market value of our investments
in equity securities were to increase by an amount that resulted in less than
55% of our assets being invested in whole pools of mortgage loans or
mortgage-backed securities, we might have to sell equity securities in order to
qualify for exemption under the Investment Company Act. The sale could occur
under adverse market conditions.
AS A REGISTERED BROKER-DEALER, PEGASUS WILL BE SUBJECT TO EXTENSIVE GOVERNMENT
AND OTHER REGULATION WHICH COULD ADVERSELY AFFECT OUR RESULTS.
The securities business is subject to extensive regulation under federal
and state laws. Compliance with many of the regulations applicable to Pegasus
involves a number of risks, particularly in areas where applicable regulations
may be subject to interpretation. In the event of non-compliance with an
applicable regulation, governmental authorities and self-regulatory
organizations such as the NASD may institute administrative or judicial
proceedings that could have a material adverse effect on the operations of
Pegasus, and thus on our operating results.
The regulatory environment is also subject to change. Our business may be
adversely affected as a result of new or revised legislation or regulations
imposed by the NASD, SEC or other governmental regulatory authority. We also may
be adversely affected by changes in the interpretation or enforcement of
existing laws and rules by these governmental authorities and the NASD. These
changes in interpretation or new laws, rules
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or regulations also could adversely affect our ability to share in investment
banking fees earned by FBR, as described in this prospectus.
OUR BOARD OF DIRECTORS MAY CHANGE POLICIES WITHOUT SHAREHOLDER CONSENT.
Our major policies, including our investment policy and other policies with
respect to acquisitions, financing, growth, operations, debt and distributions,
are determined by our Board of Directors. The Board may amend or revise these
and other policies, or approve transactions that deviate from these policies,
from time to time without a vote of the common shareholders. The effect of those
changes may be positive or negative. Our Articles also authorize the Board of
Directors to issue up to 50,000,000 shares of preferred stock and to establish
the preferences and rights of any shares of preferred stock issued. Although we
have no current intention to issue any series of preferred stock, the issuance
of preferred stock could increase the investment risk associated with common
stock ownership, delay or prevent a change in control of our company, or
otherwise change the nature of an investment in our common stock.
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