SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTIONS 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED: DECEMBER 31, 2002
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM TO
COMMISSION FILE NUMBER: 1-13447
ANNALY MORTGAGE MANAGEMENT, INC.
(Exact Name of Registrant as Specified in its Charter)
MARYLAND 22-3479661
(State or other jurisdiction of incorporation of organization) (I.R.S. Employer
Identification
Number)
1211 Avenue of the Americas, Suite 2902
New York, New York 10036
(Address of Principal Executive Offices) (Zip Code)
(212) 696-0100
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class Name of Each Exchange on Which Registered
Common Stock, par value $.01 per share New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act:
None.
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days:
Yes X No
- --------------------------------------------------------------------------------
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act). Yes X No
--- ---
At March 21, 2003 the aggregate market value of the voting stock held by
non-affiliates of the Registrant was $1,471,163,839
The number of shares of the Registrant's Common Stock outstanding on March 21,
2003 was 84,646,859
DOCUMENTS INCORPORATED BY REFERENCE:
Portions of the Registrant's definitive Proxy Statement issued in connection
with the 2003 Annual Meeting of Stockholders of the Registrant to be held on May
15, 2003 are incorporated by reference into Part III.
ANNALY MORTGAGE MANAGEMENT, INC.
- --------------------------------------------------------------------------------
2002 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
PART I
PAGE
ITEM 1. BUSINESS 1
ITEM 2. PROPERTIES 26
ITEM 3. LEGAL PROCEEDINGS 26
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 26
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY
AND RELATED STOCKHOLDER MATTERS 27
ITEM 6. SELECTED FINANCIAL DATA 29
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS 30
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 44
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA 46
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE 46
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT 46
ITEM 11. EXECUTIVE COMPENSATION 46
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS 46
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS 46
ITEM 14. CONTROLS AND PROCEDURES
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K 47
FINANCIAL STATEMENTS F-1
SIGNATURES II-1
CERTIFICATIONS II-1
EXHIBIT INDEX II-4
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
Certain statements contained in this annual report, and certain
statements contained in our future filings with the Securities and Exchange
Commission (the "SEC" or the "Commission"), in our press releases or in our
other public or shareholder communications may not be, based on historical facts
and are "forward-looking statements" within the meaning of the Private
Securities Litigation Reform Act of 1995. Forward-looking statements which are
based on various assumptions, (some of which are beyond our control) may be
identified by reference to a future period or periods, or by the use of
forward-looking terminology, such as "may," "will," "believe," "expect,"
"anticipate," "continue," or similar terms or variations on those terms, or the
negative of those terms. Actual results could differ materially from those set
forth in forward-looking statements due to a variety of factors, including, but
not limited to, changes in interest rates, changes in yield curve, changes in
prepayment rates, the availability of mortgage backed securities for purchase,
the availability of financing and, if available, the terms of any financing. For
a discussion of the risks and uncertainties that could cause actual results to
differ from those contained in the forward-looking statements, see "Risk
Factors." We do not undertake, and specifically disclaim any obligation, to
publicly release the result of any revisions that may be made to any
forward-looking statements to reflect the occurrence of anticipated or
unanticipated events or circumstances after the date of such statements.
PART I
ITEM 1. BUSINESS
THE COMPANY
Background
Annaly Mortgage Management, Inc owns and manages a portfolio of
mortgage-backed securities, including mortgage pass-through certificates,
collateralized mortgage obligations (" CMOs") and other securities representing
interests in or obligations backed by pools of mortgage loans. Our principal
business objective is to generate net income for distribution to our
stockholders from the spread between the interest income on our mortgage-backed
securities and the costs of borrowing to finance our acquisition of
mortgage-backed securities. We have elected to be taxed as a real estate
investment trust ("REIT") under the Internal Revenue Code. Therefore,
substantially all of our assets consist of qualified REIT real estate assets (of
the type described in Section 856(c)(5)(B) of the Internal Revenue Code). We
commenced operations on February 18, 1997. We are self-advised and self-managed.
We have financed our purchases of mortgage-backed securities with the
net proceeds of equity offerings and borrowings under repurchase agreements
whose interest rates adjust based on changes in short-term market interest
rates.
As used herein, "Annaly," "we," "our" and similar terms refer to Annaly
Mortgage Management, Inc., unless the context indicates otherwise.
Assets
Under our capital investment policy, at least 75% of our total assets
must be comprised of high-quality mortgage-backed securities and short-term
investments. High quality securities means securities that (1) are rated within
one of the two highest rating categories by at least one of the nationally
recognized rating agencies, (2) are unrated but are guaranteed by the United
States government or an agency of the United States government, or (3) are
unrated but we determine them to be of comparable quality to rated high-quality
mortgage-backed securities.
The remainder of our assets, comprising not more than 25% of our total
assets, may consist of other qualified REIT real estate assets which are unrated
or rated less than high quality, but which are at least "investment grade"
(rated "BBB" or better by Standard & Poor's Corporation (S&P) or the equivalent
by another nationally recognized rating agency) or, if not rated, we determine
them to be of comparable credit quality to an investment which is rated "BBB" or
better.
1
We may acquire mortgage-backed securities backed by single-family
residential mortgage loans as well as securities backed by loans on
multi-family, commercial or other real estate-related properties. To date, all
of the mortgage-backed securities that we have acquired have been backed by
single-family residential mortgage loans.
To date, all of the securities that we have acquired have been agency
mortgage-backed securities which, although not rated, carry an implied "AAA"
rating. Agency mortgage-backed securities are mortgage-backed securities for
which a government agency or federally chartered corporation, such as the
Federal Home Loan Mortgage Corporation ("FHLMC"), the Federal National Mortgage
Association ("FNMA"), or the Government National Mortgage Association ("GNMA"),
guarantees payments of principal or interest on the securities. Agency
mortgage-backed securities consist of agency pass-through certificates and CMOs
issued or guaranteed by an agency. Pass-through certificates provide for a
pass-through of the monthly interest and principal payments made by the
borrowers on the underlying mortgage loans. CMOs divide a pool of mortgage loans
into multiple tranches with different principal and interest payment
characteristics.
At December 31, 2002, approximately 30% of our mortgage-backed
securities were adjustable-rate pass-though certificates, approximately 37% of
our mortgage-backed securities were fixed-rate pass-through certificates or
CMOs, and approximately 33% of our mortgage-backed securities were CMO floaters.
Our adjustable-rate pass-through certificates are backed by adjustable-rate
mortgage loans and have coupon rates which adjust over time, subject to interest
rate caps and lag periods, in conjunction with changes in short-term interest
rates. CMO floaters are tranches of CMOs mortgage-backed securities where the
interest rate adjusts in conjunction with changes in short-term interest rates.
Our fixed-rate pass-through certificates are backed by fixed-rate mortgage rates
which do not adjust over time. CMO floaters may be backed by fixed-rate mortgage
loans or, less often, by adjustable-rate mortgage loans. In this Form 10-K,
except where the context indicates otherwise, we use the term "adjustable-rate
securities" or "adjustable-rate mortgage-backed securities" to refer to
adjustable-rate pass-through certificates and CMO floaters. At December 31,
2002, the weighted average yield on our portfolio of earning assets was 3.25%,
and the weighted average term to next rate adjustment on adjustable rate
securities was 11 months.
We intend to continue to invest in adjustable-rate pass-through
certificates, fixed-rate mortgage-backed securities and CMO floaters. Although
we have not done so to date, we may also invest on a limited basis in mortgage
derivative securities representing the right to receive interest only or a
disproportionately large amount of interest. We have not and will not invest in
real estate mortgage investment conduit ("REMIC") residuals, other CMO residuals
or any mortgage-backed securities, such as inverse floaters, which have imbedded
leverage as part of their structural characteristics.
Borrowings
We attempt to structure our borrowings to have interest rate adjustment
indices and interest rate adjustment periods that, on an aggregate basis,
correspond generally to the interest rate adjustment indices and periods of our
adjustable-rate mortgage-backed securities. However, periodic rate adjustments
on our borrowings are generally more frequent than rate adjustments on our
mortgage-backed securities. At December 31, 2002, the weighted average cost of
funds for all of our borrowings was 1.72%, the weighted average original term to
maturity was 166 days, and the weighted average term to next rate adjustment of
these borrowings was 124 days.
We generally expect to maintain a ratio of debt-to-equity of between
8:1 and 12:1, although the ratio may vary from time to time depending upon
market conditions and other factors that our management deems relevant. For
purposes of calculating this ratio, our equity is equal to the value of our
investment portfolio on a mark-to-market basis, less the book value of our
obligations under repurchase agreements and other collateralized borrowings. At
December 31, 2002, our ratio of debt-to-equity was 9.4:1.
Hedging
To the extent consistent with our election to qualify as a REIT, we may
enter into hedging transactions to attempt to protect our mortgage-backed
securities and related borrowings against the effects of major interest rate
changes. This hedging would be used to mitigate declines in the market value of
our mortgage-backed securities during periods of increasing or decreasing
interest rates and to limit or cap the interest rates on our borrowings.
2
These transactions would be entered into solely for the purpose of hedging
interest rate or prepayment risk and not for speculative purposes. To date, we
have not entered into any hedging transactions.
Compliance With REIT and Investment Company Requirements
We constantly monitor our mortgage-backed securities and the income from these
securities and, to the extent we enter into hedging transactions in the future,
will monitor income from our hedging transactions as well, so as to ensure at
all times that we maintain our qualification as a REIT and our exempt status
under the Investment Company Act.
Management
Our executive officers are:
- - Michael A.J. Farrell, Chairman of the Board, Chief Executive, Officer and
President;
- - Wellington J. Denahan, Vice Chairman of the Board and Chief Investment
Officer;
- - Kathryn F. Fagan, Chief Financial Officer and Treasurer;
- - Jennifer A. Stephens, Secretary and Investment Officer; and
- - James P. Fortescue, Senior Vice President and Repurchase Agreement
Manager
Mr. Farrell and Ms. Denahan have an average of 22 years experience in
the investment banking and investment management industries where, in various
capacities, they have each managed portfolios of mortgage-backed securities,
arranged collateralized borrowings and utilized hedging techniques to mitigate
interest rate and other risk within fixed-income portfolios. Mr. Farrell was
appointed our President effective as of January 1, 2002. Ms. Fagan is a
certified public accountant and, prior to becoming our Chief Financial Officer
and Treasurer, served as Chief Financial Officer and Controller of a publicly
owned savings and loan association. Ms. Stephens and Mr. Fortescue have worked
for us since December 1996. Since 1994, Mr. Farrell and Ms. Denahan have managed
Fixed Income Discount Advisory Company ("FIDAC"), a registered investment
advisor which, at December 31, 2002, managed, assisted in managing or supervised
approximately $8 billion in gross assets for a wide array of clients, all of
which, assets on that date were managed on a discretionary basis. Mr. Farrell is
the sole stockholder of FIDAC.
Management's duties on behalf of FIDAC's clients may create conflicts
of interest if members of management are presented with corporate opportunities
that may benefit both us and clients for which FIDAC acts as investment advisor.
In the event that an investment opportunity arises, the investment will be
allocated to another entity or us by determining the entity or account for which
the investment is most suitable. In making this determination, our management
will consider the investment strategy and guidelines of each entity or account
with respect to acquisition of assets, leverage, liquidity and other factors
which management determines appropriate.
Distributions
To maintain our qualification as a REIT, we must distribute substantially
all of our taxable income to our stockholders for each year. We have done this
in the past and intend to continue to do so in the future. We also have declared
and paid regular quarterly dividends in the past and intend to do so in the
future. We have adopted a dividend reinvestment plan to enable holders of common
stock to reinvest dividends automatically in additional shares of common stock.
3
BUSINESS STRATEGY
General
Our principal business objective is to generate income for distribution
to our stockholders, primarily from the net cash flows on our mortgage-backed
securities. Our net cash flows result primarily from the difference between the
interest income on our mortgage-backed security investments and our borrowing
costs on our mortgage-backed securities. To achieve our business objective and
generate dividend yields, our strategy is:
- - to purchase mortgage-backed securities, the majority of which we expect to
have adjustable interest rates based on changes in short-term market
interest rates;
- - to acquire mortgage-backed securities that we believe:
- we have the necessary expertise to evaluate and manage;
- we can readily finance;
- are consistent with our balance sheet guidelines and risk management
objectives; and
- provide attractive investment returns in a range of scenarios;
- - to finance purchases of mortgage-backed securities with the proceeds of
equity offerings and, to the extent permitted by our capital investment
policy, to utilize leverage to increase potential returns to stockholders
through borrowings;
- - to attempt to structure our borrowings to have interest rate adjustment
indices and interest rate adjustment periods that, on an aggregate basis,
generally correspond to the interest rate adjustment indices and interest
rate adjustment periods of our adjustable-rate mortgage-backed securities;
- - to seek to minimize prepayment risk by structuring a diversified portfolio
with a variety of prepayment characteristics and through other means; and
- - to issue new equity or debt and increase the size of our balance sheet when
opportunities in the market for mortgage-backed securities are likely to
allow growth in earnings per share.
We believe we are able to obtain cost efficiencies through our
facilities-sharing arrangement with FIDAC and by virtue of our management's
experience in managing portfolios of mortgage-backed securities and arranging
collateralized borrowings. We will strive to become even more cost-efficient
over time by:
- - seeking to raise additional capital from time to time in order to increase
our ability to invest in mortgage-backed securities;
- - striving to lower our effective borrowing costs over time by seeking direct
funding with collateralized lenders, rather than using financial
intermediaries, and investigating the possibility of using commercial paper
and medium term note programs;
- - improving the efficiency of our balance sheet structure by investigating
the issuance of uncollateralized subordinated debt, preferred stock and
other forms of capital; and
- - utilizing information technology in our business, including improving our
ability to monitor the performance of our mortgage-backed securities and to
lower our operating costs.
4
Mortgage-Backed Securities
General
To date, all of the mortgage-backed securities that we have acquired
have been agency mortgage-backed securities which, although not rated, carry an
implied "AAA" rating. Agency mortgage-backed securities are mortgage-backed
securities where a government agency or federally chartered corporation, such as
FHLMC, FNMA or GNMA, guarantees payments of principal or interest on the
securities. Agency mortgage-backed securities consist of agency pass-through
certificates and CMOs issued or guaranteed by an agency.
Even though to date we have only acquired securities with an implied
"AAA" rating, under our capital investment policy, we have the ability to
acquire securities of lower quality. Under our policy, at least 75% of our total
assets must be high quality mortgage-backed securities and short-term
investments. High quality securities are securities (1) that are rated within
one of the two highest rating categories by at least one of the nationally
recognized rating agencies, (2) that are unrated but are guaranteed by the
United States government or an agency of the United States government, or (3)
that are unrated or whose ratings have not been updated but that our management
determines are of comparable quality to rated high quality mortgage-backed
securities.
Under our capital investment policy, the remainder of our assets,
comprising not more than 25% of total assets, may consist of mortgage-backed
securities and other qualified REIT real estate assets which are unrated or
rated less than high quality, but which are at least "investment grade" (rated
"BBB" or better by S&P or the equivalent by another nationally recognized rating
organization) or, if not rated, we determine them to be of comparable credit
quality to an investment which is rated "BBB" or better. We intend to structure
our portfolio to maintain a minimum weighted average rating (including our
deemed comparable ratings for unrated mortgage-backed securities) of our
mortgage-backed securities of at least single "A" under the S&P rating system
and at the comparable level under the other rating systems.
Our allocation of investments among the permitted investment types may
vary from time-to-time based on the evaluation by our board of directors of
economic and market trends and our perception of the relative values available
from these types of investments, except that in no event will our investments
that are not high quality exceed 25% of our total assets.
We intend to acquire only those mortgage-backed securities that we
believe we have the necessary expertise to evaluate and manage, that are
consistent with our balance sheet guidelines and risk management objectives and
that we believe we can readily finance. Since we generally hold the
mortgage-backed securities we acquire until maturity, we generally do not seek
to acquire assets whose investment returns are attractive in only a limited
range of scenarios. We believe that future interest rates and mortgage
prepayment rates are very difficult to predict. Therefore, we seek to acquire
mortgage-backed securities which we believe will provide acceptable returns over
a broad range of interest rate and prepayment scenarios.
At December 31, 2002, our mortgage-backed securities consist of
pass-through certificates and collateralized mortgage obligations issued or
guaranteed by FHLMC, FNMA or GNMA. We have not, and will not, invest in REMIC
residuals, other CMO residuals or mortgage-backed securities, such as inverse
floaters, which have imbedded leverage as part of their structural
characteristics.
Description of Mortgage-Backed Securities
The mortgage-backed securities that we acquire provide funds for
mortgage loans made primarily to residential homeowners. Our securities
generally represent interests in pools of mortgage loans made by savings and
loan institutions, mortgage bankers, commercial banks and other mortgage
lenders. These pools of mortgage loans are assembled for sale to investors (like
us) by various government, government-related and private organizations.
Mortgage-backed securities differ from other forms of traditional debt
securities, which normally provide for periodic payments of interest in fixed
amounts with principal payments at maturity or on specified call dates. Instead,
mortgage-backed securities provide for a monthly payment, which consists of both
interest and principal. In
5
effect, these payments are a "pass-through" of the monthly interest and
principal payments made by the individual borrower on the mortgage loans, net of
any fees paid to the issuer or guarantor of the securities. Additional payments
result from prepayments of principal upon the sale, refinancing or foreclosure
of the underlying residential property, net of fees or costs which may be
incurred. Some mortgage-backed securities, such as securities issued by GNMA,
are described as "modified pass-through." These securities entitle the holder to
receive all interest and principal payments owed on the mortgage pool, net of
certain fees, regardless of whether the mortgagors actually make mortgage
payments when due.
The investment characteristics of pass-through mortgage-backed
securities differ from those of traditional fixed-income securities. The major
differences include the payment of interest and principal on the mortgage-backed
securities on a more frequent schedule, as described above, and the possibility
that principal may be prepaid at any time due to prepayments on the underlying
mortgage loans or other assets. These differences can result in significantly
greater price and yield volatility than is the case with traditional
fixed-income securities.
Various factors affect the rate at which mortgage prepayments occur,
including changes in interest rates, general economic conditions, the age of the
mortgage loan, the location of the property and other social and demographic
conditions. Generally prepayments on mortgage-backed securities increase during
periods of falling mortgage interest rates and decrease during periods of rising
mortgage interest rates. We may reinvest prepayments at a yield that is higher
or lower than the yield on the prepaid investment, thus affecting the weighted
average yield of our investments.
To the extent mortgage-backed securities are purchased at a premium,
faster than expected prepayments result in a faster than expected amortization
of the premium paid. Conversely, if these securities were purchased at a
discount, faster than expected prepayments accelerate our recognition of income.
CMOs may allow for shifting of prepayment risk from slower-paying
tranches to faster-paying tranches. This is in contrast to mortgage pass-through
certificates where all investors share equally in all payments, including all
prepayments, on the underlying mortgages.
FHLMC Certificates
FHLMC is a privately-owned government-sponsored enterprise created
pursuant to an Act of Congress on July 24, 1970. The principal activity of FHLMC
currently consists of the purchase of mortgage loans or participation interests
in mortgage loans and the resale of the loans and participations in the form of
guaranteed mortgage-backed securities. FHLMC guarantees to each holder of FHLMC
certificates the timely payment of interest at the applicable pass-through rate
and ultimate collection of all principal on the holder's pro rata share of the
unpaid principal balance of the related mortgage loans, but does not guarantee
the timely payment of scheduled principal of the underlying mortgage loans. The
obligations of FHLMC under its guarantees are solely those of FHLMC and are not
backed by the full faith and credit of the United States. If FHLMC were unable
to satisfy these obligations, distributions to holders of FHLMC certificates
would consist solely of payments and other recoveries on the underlying mortgage
loans and, accordingly, defaults and delinquencies on the underlying mortgage
loans would adversely affect monthly distributions to holders of FHLMC
certificates.
FHLMC certificates may be backed by pools of single-family mortgage
loans or multi-family mortgage loans. These underlying mortgage loans may have
original terms to maturity of up to 40 years. FHLMC certificates may be issued
under cash programs (composed of mortgage loans purchased from a number of
sellers) or guarantor programs (composed of mortgage loans acquired from one
seller in exchange for certificates representing interests in the mortgage loans
purchased).
FHLMC certificates may pay interest at a fixed rate or an adjustable
rate. The interest rate paid on adjustable-rate FHLMC certificates ("FHLMC
ARMs") adjusts periodically within 60 days prior to the month in which the
interest rates on the underlying mortgage loans adjust. The interest rates paid
on certificates issued under FHLMC's standard ARM programs adjust in relation to
the Treasury index. Other specified indices used in FHLMC ARM programs include
the 11th District Cost of Funds Index published by the Federal Home Loan Bank of
San Francisco, LIBOR and other indices. Interest rates paid on fully-indexed
FHLMC ARM certificates equal
6
the applicable index rate plus a specified number of basis points. The
majority of series of FHLMC ARM certificates issued to date have evidenced pools
of mortgage loans with monthly, semi-annual or annual interest adjustments.
Adjustments in the interest rates paid are generally limited to an annual
increase or decrease of either 100 or 200 basis points and to a lifetime cap of
500 or 600 basis points over the initial interest rate. Certain FHLMC programs
include mortgage loans which allow the borrower to convert the adjustable
mortgage interest rate to a fixed rate. Adjustable-rate mortgages which are
converted into fixed-rate mortgage loans are repurchased by FHLMC or by the
seller of the loan to FHLMC at the unpaid principal balance of the loan plus
accrued interest to the due date of the last adjustable rate interest payment.
FNMA Certificates
FNMA is a privately-owned, federally-chartered corporation organized
and existing under the Federal National Mortgage Association Charter Act. FNMA
provides funds to the mortgage market primarily by purchasing home mortgage
loans from local lenders, thereby replenishing their funds for additional
lending. FNMA guarantees to the registered holder of a FNMA certificate that it
will distribute amounts representing scheduled principal and interest on the
mortgage loans in the pool underlying the FNMA certificate, whether or not
received, and the full principal amount of any such mortgage loan foreclosed or
otherwise finally liquidated, whether or not the principal amount is actually
received. The obligations of FNMA under its guarantees are solely those of FNMA
and are not backed by the full faith and credit of the United States. If FNMA
were unable to satisfy its obligations, distributions to holders of FNMA
certificates would consist solely of payments and other recoveries on the
underlying mortgage loans and, accordingly, defaults and delinquencies on the
underlying mortgage loans would adversely affect monthly distributions to
holders of FNMA.
FNMA certificates may be backed by pools of single-family or
multi-family mortgage loans. The original term to maturity of any such mortgage
loan generally does not exceed 40 years. FNMA certificates may pay interest at a
fixed rate or an adjustable rate. Each series of FNMA ARM certificates bears an
initial interest rate and margin tied to an index based on all loans in the
related pool, less a fixed percentage representing servicing compensation and
FNMA's guarantee fee. The specified index used in different series has included
the Treasury Index, the 11th District Cost of Funds Index published by the
Federal Home Loan Bank of San Francisco, LIBOR and other indices. Interest rates
paid on fully-indexed FNMA ARM certificates equal the applicable index rate plus
a specified number of basis points. The majority of series of FNMA ARM
certificates issued to date have evidenced pools of mortgage loans with monthly,
semi-annual or annual interest rate adjustments. Adjustments in the interest
rates paid are generally limited to an annual increase or decrease of either 100
or 200 basis points and to a lifetime cap of 500 or 600 basis points over the
initial interest rate. Certain FNMA programs include mortgage loans which allow
the borrower to convert the adjustable mortgage interest rate of the ARM to a
fixed rate. Adjustable-rate mortgages which are converted into fixed-rate
mortgage loans are repurchased by FNMA or by the seller of the loans to FNMA at
the unpaid principal of the loan plus accrued interest to the due date of the
last adjustable rate interest payment. Adjustments to the interest rates on FNMA
ARM certificates are typically subject to lifetime caps and periodic rate or
payment caps.
GNMA Certificates
GNMA is a wholly owned corporate instrumentality of the United States
within the Department of Housing and Urban Development ("HUD"). The National
Housing Act of 1934 authorizes GNMA to guarantee the timely payment of the
principal of and interest on certificates which represent an interest in a pool
of mortgages insured by the Federal Housing Administration ("FHA") or partially
guaranteed by the Department of Veterans Affairs and other loans eligible for
inclusion in mortgage pools underlying GNMA certificates. Section 306(g) of the
Housing Act provides that the full faith and credit of the United States is
pledged to the payment of all amounts which may be required to be paid under any
guaranty by GNMA.
At present, most GNMA certificates are backed by single-family mortgage
loans. The interest rate paid on GNMA certificates may be a fixed rate or an
adjustable rate. The interest rate on GNMA certificates issued under GNMA's
standard ARM program adjusts annually in relation to the Treasury index.
Adjustments in the interest rate are generally limited to an annual increase or
decrease of 100 basis points and to a lifetime cap of 500 basis points over the
initial coupon rate.
7
Single-Family and Multi-Family Privately-Issued Certificates
Single-family and multi-family privately-issued certificates are
pass-through certificates that are not issued by one of the agencies and that
are backed by a pool of conventional single-family or multi-family mortgage
loans. These certificates are issued by originators of, investors in, and other
owners of mortgage loans, including savings and loan associations, savings
banks, commercial banks, mortgage banks, investment banks and special purpose
"conduit" subsidiaries of these institutions.
While agency pass-through certificates are backed by the express
obligation or guarantee of one of the agencies, as described above,
privately-issued certificates are generally covered by one or more forms of
private (i.e., non-governmental) credit enhancements. These credit enhancements
provide an extra layer of loss coverage in the event that losses are incurred
upon foreclosure sales or other liquidations of underlying mortgaged properties
in amounts that exceed the equity holder's equity interest in the property.
Forms of credit enhancements include limited issuer guarantees, reserve funds,
private mortgage guaranty pool insurance, over-collateralization and
subordination.
Subordination is a form of credit enhancement frequently used and
involves the issuance of classes of senior and subordinated mortgage-backed
securities. These classes are structured into a hierarchy to allocate losses on
the underlying mortgage loans and also for defining priority of rights to
payment of principal and interest. Typically, one or more classes of senior
securities are created which are rated in one of the two highest rating levels
by one or more nationally recognized rating agencies and which are supported by
one or more classes of mezzanine securities and subordinated securities that
bear losses on the underlying loans prior to the classes of senior securities.
Mezzanine securities, as used in this Form 10-K, refers to classes that are
rated below the two highest levels, but no lower than a single "B" rating under
the S&P rating system (or comparable level under other rating systems) and are
supported by one or more classes of subordinated securities which bear realized
losses prior to the classes of mezzanine securities. Subordinated securities, as
used in this Form 10-K, refers to any class that bears the "first loss" from
losses from underlying mortgage loans or that is rated below a single "B" level
(or, if unrated, we deem it to be below that level). In some cases, only classes
of senior securities and subordinated securities are issued. By adjusting the
priority of interest and principal payments on each class of a given series of
senior-subordinated mortgage-backed securities, issuers are able to create
classes of mortgage-backed securities with varying degrees of credit exposure,
prepayment exposure and potential total return, tailored to meet the needs of
sophisticated institutional investors.
Collateralized Mortgage Obligations and Multi-Class Pass-Through
Securities
We may also invest CMOs and multi-class pass-through securities. CMOs
are debt obligations issued by special purpose entities that are secured by
mortgage loans or mortgage-backed certificates, including, in many cases,
certificates issued by government and government-related guarantors, including,
GNMA, FNMA and FHLMC, together with certain funds and other collateral.
Multi-class pass-through securities are equity interests in a trust composed of
mortgage loans or other mortgage-backed securities. Payments of principal and
interest on underlying collateral provide the funds to pay debt service on the
CMO or make scheduled distributions on the multi-class pass-through securities.
CMOs and multi-class pass-through securities may be issued by agencies or
instrumentalities of the U.S. Government or by private organizations. The
discussion of CMOs in the following paragraphs is similarly applicable to
multi-class pass-through securities.
8
In a CMO, a series of bonds or certificates is issued in multiple
classes. Each class of CMOs, often referred to as a "tranche," is issued at a
specific coupon rate (which, as discussed below, may be an adjustable rate
subject to a cap) and has a stated maturity or final distribution date.
Principal prepayments on collateral underlying a CMO may cause it to be retired
substantially earlier than the stated maturity or final distribution date.
Interest is paid or accrues on all classes of a CMO on a monthly, quarterly or
semi-annual basis. The principal and interest on underlying mortgages may be
allocated among the several classes of a series of a CMO in many ways. In a
common structure, payments of principal, including any principal prepayments, on
the underlying mortgages are applied to the classes of the series of a CMO in
the order of their respective stated maturities or final distribution dates, so
that no payment of principal will be made on any class of a CMO until all other
classes having an earlier stated maturity or final distribution date have been
paid in full.
Other types of CMO issues include classes such as parallel pay CMOs,
some of which, such as planned amortization class CMOs ("PAC bonds"), provide
protection against prepayment uncertainty. Parallel pay CMOs are structured to
provide payments of principal on certain payment dates to more than one class.
These simultaneous payments are taken into account in calculating the stated
maturity date or final distribution date of each class which, as with other CMO
structures, must be retired by its stated maturity date or final distribution
date but may be retired earlier. PAC bonds generally require payment of a
specified amount of principal on each payment date so long as prepayment speeds
on the underlying collateral fall within a specified range.
Other types of CMO issues include targeted amortization class CMOs (or
TAC bonds), which are similar to PAC bonds. While PAC bonds maintain their
amortization schedule within a specified range of prepayment speeds, TAC bonds
are generally targeted to a narrow range of prepayment speeds or a specified
prepayment speed. TAC bonds can provide protection against prepayment
uncertainty since cash flows generated from higher prepayments of the underlying
mortgage-related assets are applied to the various other pass-through tranches
so as to allow the TAC bonds to maintain their amortization schedule.
A CMO may be subject to the issuer's right to redeem the CMO prior to
its stated maturity date, which may diminish the anticipated return on our
investment. Privately-issued CMOs are supported by private credit enhancements
similar to those used for privately-issued certificates and are often issued as
senior-subordinated mortgage-backed securities. We will only acquire CMOs or
multi-class pass-through certificates that constitute debt obligations or
beneficial ownership in grantor trusts holding mortgage loans, or regular
interests in REMICs, or that otherwise constitute qualified REIT real estate
assets under the Internal Revenue Code (provided that we have obtained a
favorable opinion of our tax advisor or a ruling from the IRS to that effect).
Adjustable-Rate Mortgage Pass-Through Certificates and Floating Rate
Mortgage-Backed Securities
Most of the mortgage pass-through certificates we acquire are
adjustable-rate mortgage pass-through certificates. This means that their
interest rates may vary over time based upon changes in an objective index, such
as:
- - LIBOR or the London Interbank Offered Rate. The interest rate that banks in
London offer for deposits in London of U.S. dollars.
- - Treasury Index. A monthly or weekly average yield of benchmark U.S.
Treasury securities, as published by the Federal Reserve Board.
- - CD Rate. The weekly average of secondary market interest rates on six-month
negotiable certificates of deposit, as published by the Federal Reserve
Board.
These indices generally reflect short-term interest rates. The underlying
mortgages for adjustable-rate mortgage pass-through certificates are
adjustable-rate mortgage loans ("ARMs").
We also acquire "floating rate CMOs" or "floaters." One or more tranches
of a CMO may have coupon rates that reset periodically at a specified increment
over an index such as LIBOR. These adjustable-rate tranches are sometime known
as "floating-rate CMOs" or "floaters" and may be backed by fixed or
adjustable-rate mortgages.
9
There are two main categories of indices for adjustable-rate mortgage
pass-through certificates and floaters: (1) those based on U.S. Treasury
securities, and (2) those derived from calculated measures such as a cost of
funds index or a moving average of mortgage rates. Commonly utilized indices
include the one-year Treasury note rate, the three-month Treasury bill rate, the
six-month Treasury bill rate, rates on long-term Treasury securities, the 11th
District Federal Home Loan Bank Costs of Funds Index, the National Median Cost
of Funds Index, one-month or three-month LIBOR, the prime rate of a specific
bank, or commercial paper rates. Some indices, such as the one-year Treasury
rate, closely mirror changes in market interest rate levels. Others, such as the
11th District Home Loan Bank Cost of Funds Index, tend to lag changes in market
interest rate levels. We seek to diversify our investments in adjustable-rate
mortgage pass-through certificates and floaters among a variety of indices and
reset periods so that we are not at any one time unduly exposed to the risk of
interest rate fluctuations. In selecting adjustable-rate mortgage pass-through
certificates and floaters for investment, we will also consider the liquidity of
the market for the different mortgage-backed securities.
We believe that adjustable-rate mortgage pass-through certificates and
floaters are particularly well-suited to our investment objective of high
current income, consistent with modest volatility of net asset value, because
the value of adjustable-rate mortgage pass-through certificates and floaters
generally remains relatively stable as compared to traditional fixed-rate debt
securities paying comparable rates of interest. While the value of
adjustable-rate mortgage pass-through certificates and floaters, like other debt
securities, generally varies inversely with changes in market interest rates
(increasing in value during periods of declining interest rates and decreasing
in value during periods of increasing interest rates), the value of
adjustable-rate mortgage pass-through certificates and floaters should generally
be more resistant to price swings than other debt securities because the
interest rates on these securities move with market interest rates.
Accordingly, as interest rates change, the value of our shares should be
more stable than the value of funds which invest primarily in securities backed
by fixed-rate mortgages or in other non-mortgage-backed debt securities, which
do not provide for adjustment in the interest rates in response to changes in
market interest rates.
Adjustable-rate mortgage pass-through certificates and floaters typically
have caps, which limit the maximum amount by which the interest rate may be
increased or decreased at periodic intervals or over the life of the floater. To
the extent that interest rates rise faster than the allowable caps on the
adjustable-rate mortgage pass-through certificates and floaters, these
securities will behave more like fixed-rate securities. Consequently, interest
rate increases in excess of caps can be expected to cause these securities to
behave more like traditional debt securities than adjustable-rate securities
and, accordingly, to decline in value to a greater extent than would be the case
in the absence of these caps.
Adjustable-rate mortgage pass-through certificates and floaters, like
other mortgage-backed securities, differ from conventional bonds in that
principal is to be paid back over the life of the security rather than at
maturity. As a result, we receive monthly scheduled payments of principal and
interest on these securities and may receive unscheduled principal payments
representing prepayments on the underlying mortgages. When we reinvest the
payments and any unscheduled prepayments we receive, we may receive a rate of
interest on the reinvestment which is lower than the rate on the existing
security. For this reason, adjustable-rate mortgage pass-through certificates
and floaters are less effective than longer-term debt securities as a means of
"locking in" longer-term interest rates. Accordingly, adjustable-rate mortgage
pass-through certificates and floaters, while generally having less risk of
price decline during periods of rapidly rising interest rates than fixed-rate
mortgage-backed securities of comparable maturities, have less potential for
capital appreciation than fixed-rate securities during periods of declining
interest rates.
As in the case of fixed-rate mortgage-backed securities, to the extent
these securities are purchased at a premium, faster than expected prepayments
would accelerate our amortization of the premium. Conversely, if these
securities were purchased at a discount, faster than expected prepayments would
accelerate our recognition of income.
10
As in the case of fixed-rate CMOs, floating-rate CMOs may allow for
shifting of prepayment risk from slower-paying tranches to faster-paying
tranches. This is in contrast to mortgage pass-through certificates where all
investors share equally in all payments, including all prepayments, on the
underlying mortgages.
Other Floating Rate Instruments
We may also invest in structured floating-rate notes issued or guaranteed
by government agencies, such as FNMA and FHLMC. These instruments are typically
structured to reflect an interest rate arbitrage (i.e., the difference between
the agency's cost of funds and the income stream from specified assets of the
agency) and their reset formulas may provide more attractive returns than other
floating rate instruments. The indices used to determine resets are the same as
those described above.
Mortgage Loans
We have not as of December 31, 2002, but we may from time-to-time
invest a small percentage of our assets directly in single-family, multi-family
or commercial mortgage loans. We expect that the majority of these mortgage
loans would be ARMs. The interest rate on an ARM is typically tied to an index
(such as LIBOR or the interest rate on Treasury bills), and is adjustable
periodically at specified intervals. These mortgage loans are typically subject
to lifetime interest rate caps and periodic interest rate or payment caps. The
acquisition of mortgage loans generally involves credit risk. We may obtain
credit enhancement to mitigate this risk; however, there can be no assurances
that we will able to obtain credit enhancement or that credit enhancement would
mitigate the credit risk of the underlying mortgage loans.
Capital Investment Policy
Asset Acquisitions
Our capital investment policy provides that at least 75% of our total
assets will be comprised of high quality mortgage-backed securities and
short-term investments. The remainder of our assets (comprising not more than
25% of total assets), may consist of mortgage-backed securities and other
qualified REIT real estate assets which are unrated or rated less than high
quality but which are at least "investment grade" (rated "BBB" or better) or, if
not rated, are determined by us to be of comparable credit quality to an
investment which is rated "BBB" or better.
Our capital investment policy requires that we structure our portfolio
to maintain a minimum weighted average rating (including our deemed comparable
ratings for unrated mortgage-backed securities) of our mortgage-backed
securities of at least single "A" under the S&P rating system and at the
comparable level under the other rating systems. To date, all of the
mortgage-backed securities we have acquired have been pass-through certificates
or CMOs issued or guaranteed by FHLMC, FNMA or GNMA which, although not rated,
have an implied "AAA" rating.
We intend to acquire only those mortgage-backed securities which we
believe we have the necessary expertise to evaluate and manage, which we can
readily finance and which are consistent with our balance sheet guidelines and
risk management objectives. Since we expect to hold our mortgage-backed
securities until maturity, we generally do not seek to acquire assets whose
investment returns are only attractive in a limited range of scenarios. We
believe that future interest rates and mortgage prepayment rates are very
difficult to predict and, as a result, we seek to acquire mortgage-backed
securities which we believe provide acceptable returns over a broad range of
interest rate and prepayment scenarios.
Among the asset choices available to us, our policy is to acquire those
mortgage-backed securities which we believe generate the highest returns on
capital invested, after consideration of the following:
- - the amount and nature of anticipated cash flows from the asset;
- - our ability to pledge the asset to secure collateralized borrowings;
11
- - the increase in our capital requirement determined by our capital
investment policy resulting from the purchase and financing of the asset;
and
- - the costs of financing, hedging, managing and reserving for the asset.
Prior to acquisition, we assess potential returns on capital employed over the
life of the asset and in a variety of interest rate, yield spread, financing
cost, credit loss and prepayment scenarios.
We also give consideration to balance sheet management and risk
diversification issues. We deem a specific asset which we are evaluating for
potential acquisition as more or less valuable to the extent it serves to
increase or decrease certain interest rate or prepayment risks which may exist
in the balance sheet, to diversify or concentrate credit risk, and to meet the
cash flow and liquidity objectives our management may establish for our balance
sheet from time-to-time. Accordingly, an important part of the asset evaluation
process is a simulation, using our risk management model, of the addition of a
potential asset and our associated borrowings and hedges to the balance sheet
and an assessment of the impact this potential asset acquisition would have on
the risks in and returns generated by our balance sheet as a whole over a
variety of scenarios.
We focus primarily on the acquisition of adjustable-rate
mortgage-backed securities, including floaters. We have, however, purchased a
significant amount of fixed-rate mortgage-backed securities and may continue to
do so in the future if, in our view, the potential returns on capital invested,
after hedging and all other costs, would exceed the returns available from other
assets or if the purchase of these assets would serve to reduce or diversify the
risks of our balance sheet.
Although we have not yet done so, we may purchase the stock of mortgage
REITs or similar companies when we believe that these purchases would yield
attractive returns on capital employed. When the stock market valuations of
these companies are low in relation to the market value of their assets, these
stock purchases can be a way for us to acquire an interest in a pool of
mortgage-backed securities at an attractive price. We do not, however, presently
intend to invest in the securities of other issuers for the purpose of
exercising control or to underwrite securities of other issuers.
We may acquire newly issued mortgage-backed securities, and also will
seek to expand our capital base in order to further increase our ability to
acquire new assets, when the potential returns from new investments appears
attractive relative to the return expectations of stockholders. We may in the
future acquire mortgage-backed securities by offering our debt or equity
securities in exchange for the mortgage-backed securities.
We generally intend to hold mortgage-backed securities for extended
periods. In addition, the REIT provisions of the Internal Revenue Code limit in
certain respects our ability to sell mortgage-backed securities. We may decide
however to sell assets from time-to-time, for a number of reason, including our
desire to dispose of an asset as to which credit risk concerns have arisen, to
reduce interest rate risk, to substitute one type of mortgage-backed security
for another, to improve yield or to maintain compliance with the 55% requirement
under the Investment Company Act, and generally to re-structure the balance
sheet when we deem advisable. Our board of directors has not adopted any policy
that would restrict management's authority to determine the timing of sales or
the selection of mortgage-backed securities to be sold.
We do not invest in principal-only interests in mortgage-backed
securities, residual interests, accrual bonds, inverse-floaters, two-tiered
index bonds, cash flow bonds, mortgage-backed securities with imbedded leverage
or mortgage-backed securities that would be deemed unacceptable for
collateralized borrowings, excluding shares in mortgage REITs.
As a requirement for maintaining REIT status, we will distribute to
stockholders aggregate dividends equaling at least 90% of our taxable income
(excluding capital gains) for each taxable year. We will make additional
distributions of capital when the return expectations of the stockholders appear
to exceed returns potentially available to us through making new investments in
mortgage-backed securities. Subject to the limitations of applicable securities
and state corporation laws, we can distribute capital by making purchases of our
own capital stock or through paying down or repurchasing any outstanding
uncollateralized debt obligations.
12
Our asset acquisition strategy may change over time as market
conditions change and as we evolve.
Credit Risk Management
We have not taken on credit risk to date, but may do so in the future.
In that event, we will review credit risk and other risk of loss associated with
each investment and determine the appropriate allocation of capital to apply to
the investment under our capital investment policy. Our board of directors will
monitor the overall portfolio risk and determine appropriate levels of provision
for loss.
Capital and Leverage
We expect generally to maintain a debt-to-equity ratio of between 8:1
and 12:1, although the ratio may vary from time-to-time depending upon market
conditions and other factors our management deems relevant, including the
composition of our balance sheet, haircut levels required by lenders, the market
value of the mortgage-backed securities in our portfolio and "excess capital
cushion" percentages (as described below) set by our board of directors from
time to time. For purposes of calculating this ratio, our equity (or capital
base) is equal to the value of our investment portfolio on a mark-to-market
basis less the book value of our obligations under repurchase agreements and
other collateralized borrowings. At December 31, 2002, our ratio of
debt-to-equity was 9.4:1.
Our goal is to strike a balance between the under-utilization of
leverage, which reduces potential returns to stockholders, and the
over-utilization of leverage, which could reduce our ability to meet our
obligations during adverse market conditions. Our capital investment policy
limits our ability to acquire additional assets during times when our
debt-to-equity ratio exceeds 12:1. Our capital base represents the approximate
liquidation value of our investments and approximates the market value of assets
that we can pledge or sell to meet over-collateralization requirements for our
borrowings. The unpledged portion of our capital base is available for us to
pledge or sell as necessary to maintain over-collateralization levels for our
borrowings.
We are prohibited from acquiring additional assets during periods when
our capital base is less than the minimum amount required under our capital
investment policy, except as may be necessary to maintain REIT status or our
exemption from the Investment Company Act of 1940, as amended (the "Investment
Company Act"). In addition, when our capital base falls below our risk-managed
capital requirement, our management is required to submit to our board of
directors a plan for bringing our capital base into compliance with our capital
investment policy guidelines. We anticipate that in most circumstances we can
achieve this goal without overt management action through the natural process of
mortgage principal repayments. We anticipate that our capital base is likely to
exceed our risk-managed capital requirement during periods following new equity
offerings and during periods of falling interest rates and that our capital base
could fall below the risk-managed capital requirement during periods of rising
interest rates.
The first component of our capital requirements is the current
aggregate over-collateralization amount or "haircut" the lenders require us to
hold as capital. The haircut for each mortgage-backed security is determined by
our lenders based on the risk characteristics and liquidity of the asset.
Haircut levels on individual borrowings generally range from 3% for certain
FHLMC, FNMA or GNMA mortgage-backed securities to 20% for certain
privately-issued mortgage-backed securities. At December 31, 2002, the weighted
average haircut level on our securities was 3.96%. Should the market value of
our pledged assets decline, we will be required to deliver additional collateral
to our lenders to maintain a constant over-collateralization level on our
borrowings.
The second component of our capital requirement is the "excess capital
cushion." This is an amount of capital in excess of the haircuts required by our
lenders. We maintain the excess capital cushion to meet the demands of our
lenders for additional collateral should the market value of our mortgage-backed
securities decline. The aggregate excess capital cushion equals the sum of
liquidity cushion amounts assigned under our capital investment policy to each
of our mortgage-backed securities. We assign excess capital cushions to each
mortgage-backed security based on our assessment of the mortgage-backed
security's market price volatility, credit risk, liquidity and attractiveness
for use as collateral by lenders. The process of assigning excess capital
cushions relies on our management's ability to identify and weigh the relative
importance of these and other factors. In assigning
13
excess capital cushions, we also give consideration to hedges associated
with the mortgage-backed security and any effect such hedges may have on
reducing net market price volatility, concentration or diversification of credit
and other risks in the balance sheet as a whole and the net cash flows that we
can expect from the interaction of the various components of our balance sheet.
Our capital investment policy stipulates that at least 25% of the
capital base maintained to satisfy the excess capital cushion must be invested
in AAA-rated adjustable-rate mortgage-backed securities or assets with similar
or better liquidity characteristics.
A substantial portion of our borrowings are short-term or variable-rate
borrowings. Our borrowings are implemented primarily through repurchase
agreements, but in the future may also be obtained through loan agreements,
lines of credit, dollar-roll agreements (an agreement to sell a security for
delivery on a specified future date and a simultaneous agreement to repurchase
the same or a substantially similar security on a specified future date) and
other credit facilities with institutional lenders and issuance of debt
securities such as commercial paper, medium-term notes, CMOs and senior or
subordinated notes. We enter into financing transactions only with institutions
that we believe are sound credit risks and follow other internal policies
designed to limit our credit and other exposure to financing institutions.
We expect to continue to use repurchase agreements as our principal
financing device to leverage our mortgage-backed securities portfolio. We
anticipate that, upon repayment of each borrowing under a repurchase agreement,
we will use the collateral immediately for borrowing under a new repurchase
agreement. At present, we have entered into uncommitted facilities with 25
lenders for borrowings in the form of repurchase agreements. We have not at the
present time entered into any commitment agreements under which the lender would
be required to enter into new repurchase agreements during a specified period of
time, nor do we presently plan to have liquidity facilities with commercial
banks. We may, however, enter into such commitment agreements in the future. We
enter into repurchase agreements primarily with national broker-dealers,
commercial banks and other lenders which typically offer this type of financing.
We enter into collateralized borrowings only with financial institutions meeting
credit standards approved by our board of directors, and we monitor the
financial condition of these institutions on a regular basis.
A repurchase agreement, although structured as a sale and repurchase
obligation, acts as a financing under which we effectively pledge our
mortgage-backed securities as collateral to secure a short-term loan. Generally,
the other party to the agreement makes the loan in an amount equal to a
percentage of the market value of the pledged collateral. At the maturity of the
repurchase agreement, we are required to repay the loan and correspondingly
receive back our collateral. While used as collateral, the mortgage-backed
securities continue to pay principal and interest which are for our benefit. In
the event of our insolvency or bankruptcy, certain repurchase agreements may
qualify for special treatment under the Bankruptcy Code, the effect of which,
among other things, would be to allow the creditor under the agreement to avoid
the automatic stay provisions of the Bankruptcy Code and to foreclose on the
collateral agreement without delay. In the event of the insolvency or bankruptcy
of a lender during the term of a repurchase agreement, the lender may be
permitted, under applicable insolvency laws, to repudiate the contract, and our
claim against the lender for damages may be treated simply as an unsecured
creditor. In addition, if the lender is a broker or dealer subject to the
Securities Investor Protection Act of 1970, or an insured depository institution
subject to the Federal Deposit Insurance Act, our ability to exercise our rights
to recover our securities under a repurchase agreement or to be compensated for
any damages resulting from the lender's insolvency may be further limited by
those statutes. These claims would be subject to significant delay and, if and
when received, may be substantially less than the damages we actually incur.
Substantially all of our borrowing agreements require us to deposit
additional collateral in the event the market value of existing collateral
declines, which may require us to sell assets to reduce our borrowings. We have
designed our liquidity management policy to maintain a cushion of equity
sufficient to provide required liquidity to respond to the effects under our
borrowing arrangements of interest rate movements and changes in market value of
our mortgage-backed securities, as described above. However, a major disruption
of the repurchase or other market that we rely on for short-term borrowings
would have a material adverse effect on us unless we were able to arrange
alternative sources of financing on comparable terms.
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Our articles of incorporation and bylaws do not limit our ability to
incur borrowings, whether secured or unsecured.
Interest Rate Risk Management
To the extent consistent with our election to qualify as a REIT, we
follow an interest rate risk management program intended to protect our
portfolio of mortgage-backed securities and related debt against the effects of
major interest rate changes. Specifically, our interest rate risk management
program is formulated with the intent to offset the potential adverse effects
resulting from rate adjustment limitations on our mortgage-backed securities and
the differences between interest rate adjustment indices and interest rate
adjustment periods of our adjustable-rate mortgage-backed securities and related
borrowings.
Our interest rate risk management program encompasses a number of
procedures, including the following:
- we attempt to structure our borrowings to have interest rate
adjustment indices and interest rate adjustment periods that, on an
aggregate basis, generally correspond to the interest rate adjustment
indices and interest rate adjustment periods of our adjustable-rate
mortgage-backed securities; and
- we attempt to structure our borrowing agreements relating to
adjustable-rate mortgage-backed securities to have a range of
different maturities and interest rate adjustment periods (although
substantially all will be less than one year).
We adjust the average maturity adjustment periods of our borrowings on
an ongoing basis by changing the mix of maturities and interest rate adjustment
periods as borrowings come due and are renewed. Through use of these procedures,
we attempt to minimize the differences between the interest rate adjustment
periods of our mortgage-backed securities and related borrowings that may occur.
Although we have not done so to date, we may purchase from time-to-time
interest rate caps, interest rate swaps, interest rate collars, interest rate
caps or floors, "interest only" mortgage-backed securities and similar
instruments to attempt to mitigate the risk of the cost of our variable rate
liabilities increasing at a faster rate than the earnings on our assets during a
period of rising interest rates or to mitigate prepayment risk. We may hedge as
much of the interest rate risk as our management determines is in our best
interests, given the cost of the hedging transactions and the need to maintain
our status as a REIT. This determination may result in our electing to bear a
level of interest rate or prepayment risk that could otherwise be hedged when
management believes, based on all relevant facts, that bearing the risk is
advisable.
We seek to build a balance sheet and undertake an interest rate risk
management program which is likely to generate positive earnings and maintain an
equity liquidation value sufficient to maintain operations given a variety of
potentially adverse circumstances. Accordingly, our interest rate risk
management program addresses both income preservation, as discussed above, and
capital preservation concerns. For capital preservation, we monitor our
"duration." This is the expected percentage change in market value of our assets
that would be caused by a 1% change in short and long-term interest rates. To
monitor duration and the related risks of fluctuations in the liquidation value
of our equity, we model the impact of various economic scenarios on the market
value of our mortgage-backed securities and liabilities. At December 31, 2002,
we estimate that the duration of our assets was .5%. We believe that our
interest rate risk management program will allow us to maintain operations
throughout a wide variety of potentially adverse circumstances. Nevertheless, in
order to further preserve our capital base (and lower our duration) during
periods when we believe a trend of rapidly rising interest rates has been
established, we may decide to enter into or increase hedging activities or to
sell assets. Each of these actions may lower our earnings and dividends in the
short term to further our objective of maintaining attractive levels of earnings
and dividends over the long term.
We may elect to conduct a portion of our hedging operations through one
or more subsidiary corporations which would not be a qualified REIT subsidiary
and would be subject to federal and state income taxes. To comply with the asset
tests applicable to us as a REIT, the value of the securities of the any taxable
subsidiary we hold must be limited to less than 5% of the value of our total
assets as of the end of each calendar quarter and we may not own
15
more than 10% of the voting securities of the taxable subsidiary. We could,
however, elect to treat a subsidiary as a "taxable REIT subsidiary," in which
case we could own 100% of the voting stock of such subsidiary, provided that the
value of the stock that we own in all such taxable REIT subsidiaries does not
exceed 20% of the value of our total assets at the close of any calendar
quarter. A taxable subsidiary would not elect REIT status and would distribute
any net profit after taxes to us and its other stockholders. Any dividend income
we receive from the taxable subsidiary (combined with all other income generated
from our assets, other than qualified REIT real estate assets) must not exceed
25% of our gross income.
We believe that we have developed a cost-effective asset/liability
management program to provide a level of protection against interest rate and
prepayment risks. However, no strategy can completely insulate us from interest
rate changes and prepayment risks. Further, as noted above, the federal income
tax requirements that we must satisfy to qualify as a REIT limit our ability to
hedge our interest rate and prepayment risks. We monitor carefully, and may have
to limit, our asset/liability management program to assure that we do not
realize excessive hedging income, or hold hedging assets having excess value in
relation to total assets, which would result in our disqualification as a REIT
or, in the case of excess hedging income, the payment of a penalty tax for
failure to satisfy certain REIT income tests under the Internal Revenue Code,
provided the failure was for reasonable cause. In addition, asset/liability
management involves transaction costs which increase dramatically as the period
covered by the hedging protection increases. Therefore, we may be unable to
hedge effectively our interest rate and prepayment risks.
Prepayment Risk Management
We seek to minimize the effects of faster or slower than anticipated
prepayment rates through structuring a diversified portfolio with a variety of
prepayment characteristics, investing in mortgage-backed securities with
prepayment prohibitions and penalties, investing in certain mortgage-backed
security structures which have prepayment protections, and balancing assets
purchased at a premium with assets purchased at a discount. We monitor
prepayment risk through periodic review of the impact of a variety of prepayment
scenarios on our revenues, net earnings, dividends, cash flow and net balance
sheet market value.
Future Revisions in Policies and Strategies
Our board of directors has established the investment policies and
operating policies and strategies set forth in this Form 10-K. The board of
directors has the power to modify or waive these policies and strategies without
the consent of the stockholders to the extent that the board of directors
determines that the modification or waiver is in the best interests of our
stockholders. Among other factors, developments in the market which affect our
policies and strategies or which change our assessment of the market may cause
our board of directors to revise our policies and strategies.
Potential Acquisitions, Strategic Alliances and Other Investments
From time-to-time we have had discussions with other parties regarding
possible transactions including acquisitions of other businesses or assets,
investments in other entities, joint venture arrangements, or strategic
alliances. To date, none of these discussions have gone beyond the preliminary
stage. We have also considered from time-to-time entering into related
businesses, although to date we have not entered into such businesses.
During 1998, we made an initial investment of $49,980 in Annaly
International Money Management, Inc., ("Annaly International"). Annaly
International was formed to explore business opportunities overseas, including
the origination of mortgages. Annaly International did not commence operations
beyond this exploratory stage. We owned 33% of the equity of Annaly
International in the form of non-voting securities. The remaining equity of
Annaly International was owned by FIDAC, Michael A.J. Farrell, our Chairman,
Chief Executive Officer, and President, Wellington J. Denahan, our Vice
Chairman, Chief Investment Officer, Kathryn F. Fagan, our Chief Financial
Officer and Treasurer, Jennifer A. Stephens, our Secretary and Investment
Officer and other persons. Annaly International Money Management, Inc. was
liquidated on June 30, 2002, resulting in a $44,000 loss.
16
During 1998, Annaly International made an initial investment of $20,400
in Annaly.com, Inc, ("Annaly.com"). Annaly.com explores opportunities to acquire
or originate mortgages in the United States. Annaly.com has established a
website at http://www.annaly.com but did not commence the acquisition or
origination of mortgages. Annaly International owned 51% of the equity of
Annaly.com. The remaining equity of Annaly.com is owned by FIDAC I Partners,
whose partners include FIDAC and our executive officers. Annaly.com, Inc. was
dissolved on June 30, 2002.
Prior to making our investment in Annaly International, we consulted
with our tax advisors to ensure that the investment would not cause us to fail
to satisfy the asset and source of income tests applicable to us as a REIT.
Prior to making any other equity investment, we will similarly consult with our
tax advisors.
We may, from time-to- time, continue to explore possible acquisitions,
investments, joint venture arrangements and strategic alliances.
Dividend Reinvestment and Share Purchase Plan
We have adopted a dividend reinvestment and share purchase plan. Under
the dividend reinvestment feature of the plan, existing shareholders can
reinvest their dividends in additional shares of our common stock. Under the
share purchase feature of the plan, new and existing shareholders can purchase
shares of our common stock. We have filed and the SEC has declared effective a
Form S-3 registration statement registering 2,000,000 shares that may be issued
under the plan.
Legal Proceedings
There are no material pending legal proceedings to which we are a party or
to which any of our property is subject.
Available Information
Our investor relations website is www.annaly.com. We make available on
this website under "Financials," free of charge, our annual reports on Form
10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments
to those reports as soon as reasonably practicable after we electronically file
or furnish such materials to the SEC.
COMPETITION
We believe that our principal competition in the business of acquiring
and holding mortgage-backed securities are financial institutions such as banks,
savings and loans, life insurance companies, institutional investors such as
mutual funds and pension funds, and certain other mortgage REITs. The existence
of these competitive entities, as well as the possibility of additional entities
forming in the future, may increase the competition for the acquisition of
mortgage-backed securities resulting in higher prices and lower yields on
assets.
RISK FACTORS
An investment in our stock involves a number of risks. Before making an
investment decision, you should carefully consider all of the risks described in
this Form 10-K. If any of the risks discussed in this Form 10-K actually occur,
our business, financial condition and results of operations could be materially
adversely affected. If this were to occur, the trading price of our common stock
could decline significantly and you may lose all or part of your investment.
If the interest payments on our borrowings increase relative to the interest we
earn on our mortgage-backed securities, it may adversely affect our
profitability
17
We earn money based upon the spread between the interest payments we earn
on our mortgage-backed securities and the interest payments we must make on our
borrowings. If the interest payments on our borrowings increase relative to the
interest we earn on our mortgage-backed securities, our profitability may be
adversely affected.
The interest payments on our borrowings may increase relative to the
interest we earn on our adjustable-rate mortgage-backed securities for various
reasons discussed in this section.
- - Differences in timing of interest rate adjustments on our mortgage-backed
securities and our borrowings may adversely affect our profitability
We rely primarily on short-term borrowings to acquire mortgage-backed
securities with long-term maturities. Accordingly, an increase in short-term
interest rates may adversely affect our profitability.
Most of the mortgage-backed securities we acquire are adjustable-rate
securities. This means that their interest rates may vary over time based upon
changes in an objective index, such as:
- - LIBOR or the London Interbank Offered Rate. The interest rate that banks in
London offer for deposits in London of U.S. dollars.
- - Treasury Index. A monthly or weekly average yield of benchmark U.S.
Treasury securities, as published by the Federal Reserve Board.
- - CD Rate. The weekly average of secondary market interest rates on six-month
negotiable certificates of deposit, as published by the Federal Reserve
Board.
These indices generally reflect short-term interest rates. On December 31,
2002, approximately 63% of our mortgage-backed securities were adjustable-rate
securities.
The interest rates on our borrowings similarly vary with changes in an
objective index. Nevertheless, the interest rates on our borrowings generally
adjust more frequently than the interest rates on our adjustable-rate
mortgage-backed securities. For example, on December 31, 2002, our
adjustable-rate securities had a weighted average term to next rate adjustment
of 11 months, while our borrowings had a weighted average term to next rate
adjustment of 124 days. Accordingly, in a period of rising interest rates, we
could experience a decrease in net income or a net loss because the interest
rates on our borrowings adjust faster than the interest rates on our
adjustable-rate mortgage-backed securities.
- - Interest rate caps on our mortgage-backed securities may adversely affect
our profitability
Our adjustable-rate mortgage-backed securities are typically subject to
periodic and lifetime interest rate caps. Periodic interest rate caps limit the
amount an interest rate can increase during any given period. Lifetime interest
rate caps limit the amount an interest rate can increase through maturity of a
mortgage-backed security. Our borrowings are not subject to similar
restrictions. Accordingly, in a period of rapidly increasing interest rates, we
could experience a decrease in net income or a net loss because the interest
rates on our borrowings could increase without limitation while the interest
rates on our adjustable-rate mortgage-backed securities would be limited by
caps.
- - Because we acquire fixed rate securities, an increase in interest rates may
adversely affect our profitability
While the majority of our investments consist of adjustable-rate
mortgage-backed securities, we also invest in fixed-rate mortgage-backed
securities. In a period of rising interest rates, our interest payments could
increase while the interest we earn on our fixed rate mortgage-backed securities
would not change. This would adversely affect our profitability. On December 31,
2002, approximately 37% of our mortgage-backed securities were fixed rate
securities.
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An increase in prepayment rates may adversely affect our profitability
The mortgage-backed securities we acquire are backed by pools of mortgage
loans. We receive payments, generally, from the payments that are made on these
underlying mortgage loans. When borrowers prepay their mortgage loans at rates
that are faster than expected, this results in prepayments that are faster than
expected on the mortgage-backed securities. These faster than expected
prepayments may adversely affect our profitability.
We often purchase mortgage-backed securities that have a higher interest
rate than the market interest rate at the time. In exchange for this higher
interest rate, we must pay a premium over the market value to acquire the
security. In accordance with accounting rules, we amortize this premium over the
term of the mortgage-backed security using the effective yield method. If the
mortgage-backed security is prepaid in whole or in part prior to its expected
maturity date, we must amortize the premium that was prepaid at the time of the
prepayment. This adversely affects our profitability. On December 31, 2002,
approximately 97% of the mortgage-backed securities we owned were acquired at a
premium.
Prepayment rates generally increase when interest rates fall and decrease
when interest rates rise, but changes in prepayment rates are difficult to
predict. Prepayment rates also may be affected by conditions in the housing and
financial markets, general economic conditions and the relative interest rates
on fixed-rate and adjustable-rate mortgage loans.
We may seek to reduce prepayment risk by acquiring mortgage-backed
securities at a discount. If a discounted security is prepaid in whole or in
part prior to its expected maturity date, we will earn income equal to the
amount of the remaining discount. This will improve our profitability if the
discounted securities are prepaid faster than expected
We can also acquire mortgage-backed securities that are less affected by
prepayments. For example, we can acquire collateralized mortgage obligations or
CMOs, a type of mortgage-backed security. CMOs divide a pool of mortgage loans
into multiple tranches that allow for shifting of prepayment risks from
slower-paying tranches to faster-paying tranches. This is in contrast to
pass-through or pay-through mortgage-backed securities, where all investors
share equally in all payments, including all prepayments. As discussed below,
the Investment Company Act imposes restrictions on our purchase of CMOs. On
December 31, 2002, approximately 33% of our mortgage-backed securities were CMOs
and approximately 67% of our mortgage-backed securities were pass-through or
pay-through securities.
While we seek to minimize prepayment risk to the extent practical, in
selecting investments we must balance prepayment risk against other risks and
the potential returns of each investment. No strategy can completely insulate us
from prepayment risk.
An increase in interest rates may adversely affect our book value
Increases in interest rates may negatively affect the market value of our
mortgage-backed securities. Our fixed-rate securities, generally, are more
negatively affected by these increases. In accordance with accounting rules, we
reduce our book value by the amount of any decrease in the market value of our
mortgage-backed securities.
Our strategy involves significant leverage
We seek to maintain a ratio of debt-to-equity of between 8:1 and 12:1,
although our ratio may at times be above or below this amount. We incur this
leverage by borrowing against a substantial portion of the market value of our
mortgage-backed securities. By incurring this leverage, we can enhance our
returns. Nevertheless, this leverage, which is fundamental to our investment
strategy, also creates significant risks.
- - Our leverage may cause substantial losses
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Because of our significant leverage, we may incur substantial losses if our
borrowing costs increase. Our borrowing costs may increase for any of the
following reasons:
- - short-term interest rates increase
- - the market value of our mortgage-backed securities decreases
- - interest rate volatility increases; or
- - the availability of financing in the market decreases
Our leverage may cause margin calls and defaults and force us to sell assets
under adverse market conditions
Because of our leverage, a decline in the value of our mortgage-backed
securities may result in our lenders initiating margin calls. A margin call
means that the lender requires us to pledge additional collateral to
re-establish the ratio of the value of the collateral to the amount of the
borrowing. Our fixed-rate mortgage-backed securities generally are more
susceptible to margin calls as increases in interest rates tend to more
negatively affect the market value of fixed-rate securities.
If we are unable to satisfy margin calls, our lenders may foreclose on our
collateral. This could force us to sell our mortgage-backed securities under
adverse market conditions. Additionally, in the event of our bankruptcy, our
borrowings, which are generally made under repurchase agreements, may qualify
for special treatment under the Bankruptcy Code. This special treatment would
allow the lenders under these agreements to avoid the automatic stay provisions
of the Bankruptcy Code and to liquidate the collateral under these agreements
without delay.
- - Liquidation of collateral may jeopardize our REIT status
To continue to qualify as a REIT, we must comply with requirements
regarding our assets and our sources of income. If we are compelled to liquidate
our mortgage-backed securities, we may be unable to comply with these
requirements, ultimately jeopardizing our status as a REIT.
- - We may exceed our target leverage ratios
We seek to maintain a ratio of debt-to-equity of between 8:1 and 12:1.
However, we are not required to stay within this leverage ratio. If we exceed
this ratio, the adverse impact on our financial condition and results of
operations from the types of risks described in this section would likely be
more severe.
- - We may not be able to achieve our optimal leverage
We use leverage as a strategy to inhance the return to our investors.
However, we may not be able to achieve our desired leverage for any of the
following reasons:
- - we determine that the leverage would expose us to excessive risk;
- - our lenders do not make funding available to us at acceptable rates; or
- - our lenders require that we provide additional collateral to cover our
borrowings
- - We may incur increased borrowing costs which would adversely affect our
profitability
Currently, all of our borrowings are collateralized borrowings in the form
of repurchase agreements. If the interest rates on these repurchase agreements
increase, it would adversely affect our profitability.
20
Our borrowing costs under repurchase agreements generally correspond to
short-term interest rates such as LIBOR or a short-term Treasury index, plus or
minus a margin. The margins on these borrowings over or under short-term
interest rates may vary depending upon:
- - the movement of interest rates;
- - the availability of financing in the market; or
- - the value and liquidity of our mortgage-backed securities,
If we are unable to renew our borrowings at favorable rates, our profitability
may be adversely affected
Since we rely primarily on short-term borrowings, our ability to achieve
our investment objectives depends not only on our ability to borrow money in
sufficient amounts and on favorable terms, but also on our ability to renew or
replace on a continuous basis our maturing short-term borrowings. If we are not
able to renew or replace maturing borrowings, we would have to sell assets under
possibly adverse market conditions.
We have not used derivatives to mitigate our interest rate and prepayment risks
Our policies permit us to enter into interest rate swaps, caps and floors
and other derivative transactions to help us mitigate our interest rate and
prepayment risks described above. However, we have determined in the past that
the cost of these transactions outweighs the benefits. In addition, we will not
enter into derivative transactions if we believe they will jeopardize our status
as a REIT. If we decide to enter into derivative transactions in the future,
these transactions may mitigate our interest rate and prepayment risks but
cannot insulate us from these risks.
Our investment strategy may involve credit risk
We may incur losses if there are payment defaults under our mortgage-backed
securities.
To date, all of our mortgage-backed securities have been agency
certificates which, although not rated, carry an implied "AAA" rating. Agency
certificates are mortgage-backed securities where FHLMC, FNMA, or GNMA
guarantees payments of principal or interest on the certificates.
Even though we have only acquired "AAA" securities so far, pursuant to our
capital investment policy we have the ability to acquire securities of lower
credit quality. Under our policy:
- - 75% of our investments must have a "AA" or higher rating by Standard &
Poor's Corporation ("S&P"), or an equivalent rating by a similar nationally
recognized rating organization, or our management must determine that the
investments are of comparable credit quality to investments with these
ratings;
- - the remaining 25% of our investments must have a "BBB" or higher rating by
S&P, or an equivalent rating by a similar nationally recognized rating
organization, or our management must determine that the investments are of
comparable credit quality to investments with these ratings. Securities
with ratings of "BBB" or higher are commonly referred to as "investment
grade" securities; and
- - we seek to have a minimum weighted average rating for our portfolio of at
least "A" by S&P.
If we acquire mortgage-backed securities of lower credit quality, we may
incur losses if there are defaults under those mortgage-backed securities or if
the rating agencies downgrade the credit quality of those mortgage-backed
securities.
We have not established a minimum dividend payment level
We intend to pay quarterly dividends and to make distributions to our
stockholders in amounts such that all or substantially all of our taxable income
in each year (subject to certain adjustments) is distributed. This will enable
21
us to qualify for the tax benefits accorded to a REIT under the Code. We have
not established a minimum dividend payment level and our ability to pay
dividends may be adversely affected for the reasons described in this section.
All distributions will be made at the discretion of our board of directors and
will depend on our earnings, our financial condition, maintenance of our REIT
status and such other factors as our board of directors may deem relevant from
time to time.
Because of competition, we may not be able to acquire mortgage-backed securities
at favorable yields
Our net income depends, in large part, on our ability to acquire
mortgage-backed securities at favorable spreads over our borrowing costs. In
acquiring mortgage-backed securities, we compete with other REITs, investment
banking firms, savings and loan associations, banks, insurance companies, mutual
funds, other lenders and other entities that purchase mortgage-backed
securities, many of which have greater financial resources than us. As a result,
in the future, we may not be able to acquire sufficient mortgage-backed
securities at favorable spreads over our borrowing costs.
We are dependent on our key personnel
We are dependent on the efforts of our key officers and employees,
including Michael A. J. Farrell, Chairman of the board of directors, Chief
Executive Officer, and President, Wellington J. Denahan, Vice Chairman and Chief
Investment Officer, Kathryn F. Fagan, Chief Financial Officer and Treasurer, and
Jennifer A Stephens, Secretary and Investment Officer. The loss of any of their
services could have an adverse effect on our operations. Although we have
employment agreements with each of them, we cannot assure you they will remain
employed with us.
Some of our directors, officers and employees have ownership interests and
manage assets for other clients that create potential conflicts of interest.
Mr. Farrell, Ms. Denahan and other officers and employees are actively
involved in managing mortgage-backed securities and other fixed income assets
for institutional clients through Fixed Income Discount Advisory Company. FIDAC
is a registered investment adviser which on December 31, 2002 managed, assisted
in managing or supervised approximately $8 billion in gross assets on a
discretionary basis for a wide array of clients. The U.S. Dollar Floating Rate
Fund is a fund managed by FIDAC. Mr. Farrell is a Director of the Floating Rate
Fund. FIDAC may also manage other funds in the future. These officers will
continue to perform services for FIDAC, the institutional clients, the Floating
Rate Fund, and other funds managed by the FIDAC. FIDAC is currently owned 100%
by Mr. Farrell, our Chairman of the Board, Chief Executive Officer, and
President.
These responsibilities may create conflicts of interest for these officers
and employees if they are presented with corporate opportunities that may
benefit us and the institutional clients, the Floating Rate Fund, and other
funds managed by FIDAC. Our officers allocate investments among us, the
institutional clients and the Floating Rate Fund, and other funds managed by
FIDAC by determining the entity or account for which the investment is most
suitable. In making this determination, our officers consider the investment
strategy and guidelines of each entity or account with respect to acquisition of
assets, leverage, liquidity, and other factors that our officers determine
appropriate.
Our management allocates rent and other office expenses between our
affiliate and us. These allocations may create conflicts of interest. Our
management currently allocates rent and other expenses 90% to Annaly and 10% to
FIDAC. Our audit committee must approve any change in these allocation
percentages. In addition, we may enter into agreements, such as technology
sharing or research agreements, with our affiliates in the future. These
agreements would present potential conflicts of interest. Our management will
obtain prior approval of our audit committee prior to entering into any
agreements with our affiliates.
We and our shareholders are subject to certain tax risks
|X| Our failure to qualify as a REIT would have adverse tax consequences
22
We believe that since 1997 we have qualified for taxation as a REIT for
federal income tax purposes. We plan to continue to meet the requirements for
taxation as a REIT. Many of these requirements, however, are highly technical
and complex. The determination that we are a REIT requires an analysis of
various factual matters and circumstances that may not be totally within our
control. For example, to qualify as a REIT, at least 75% of our gross income
must come from real estate sources and 95% of our gross income must come from
real estate sources and certain other sources that are itemized in the REIT tax
laws. We are also required to distribute to stockholders at least 90% (95% with
respect to taxable years beginning before January 1, 2001) of our REIT taxable
income (excluding capital gains). Even a technical or inadvertent mistake could
jeopardize our REIT status. Furthermore, Congress and the Internal Revenue
Service ("IRS") might make changes to the tax laws and regulations, and the
courts might issue new rulings that make it more difficult or impossible for us
to remain qualified as a REIT.
If we fail to qualify as a REIT, we would be subject to federal income tax
at regular corporate rates. Also, unless the IRS granted us relief under certain
statutory provisions, we would remain disqualified as a REIT for four years
following the year we first fail to qualify. If we fail to qualify as a REIT, we
would have to pay significant income taxes and would therefore have less money
available for investments or for distributions to our stockholders. This would
likely have a significant adverse effect on the value of our securities. In
addition, the tax law would no longer require us to make distributions to our
stockholders.
- - We have certain distribution requirements
As a REIT, we must distribute 90% (95% with respect to taxable years
beginning before January 1, 2001) of our annual taxable income. The required
distribution limits the amount we have available for other business purposes,
including amounts to fund our growth. Also, it is possible that because of the
differences between the time we actually receive revenue or pay expenses and the
period we report those items for distribution purposes, we may have to borrow
funds on a short-term basis to meet the 90% distribution requirement.
- - We are also subject to other tax liabilities
Even if we qualify as a REIT, we may be subject to certain federal, state
and local taxes on our income and property. Any of these taxes would reduce our
operating cash flow.
Proposed legislation for dividend exclusions could affect the value of our stock
On January 7, 2003, the Bush Administration released a proposal intended to
eliminate one level of the federal "double taxation" that is currently imposed
on corporate income for regular C corporations. Under this proposal, dividends
from a regular C corporation may be excluded, in whole or in part, from a
stockholder's federal taxable income to the extent that corporate income tax has
been paid on the earnings from which the dividends are paid. REITs currently are
tax-advantaged relative to regular C corporations because they are not subject
to corporate-level federal income tax on income that they distribute to
stockholders. The Bush Administration's proposal, if enacted in its original
form, could decrease the tax advantage of a REIT relative to a regular C
corporation because part or all of the dividends received by a stockholder from
a regular C corporation would be exempt, in whole or in part, from federal
income tax and, as a result, could cause individual investors to view stocks of
regular C corporations as more attractive relative to stocks of REITs than is
the case currently. It is not possible to predict whether the Bush
Administration's proposal ultimately will be enacted, the form which it might
take, and, if enacted, the effects it may have on the value of our common stock.
Loss of Investment Company Act exemption would adversely affect us
We intend to conduct our business so as not to become regulated as an
investment company under the Investment Company Act. If we fail to qualify for
this exemption, our ability to use leverage would be substantially reduced and
we would be unable to conduct our business as described in this Form 10-K.
The Investment Company Act exempts entities that are primarily engaged in
the business of purchasing or otherwise acquiring mortgages and other liens on
and interests in real estate. Under the current interpretation of the SEC staff,
in order to qualify for this exemption, we must maintain at least 55% of our
assets directly in these qualifying real estate interests. Mortgage-backed
securities that do not represent all of the certificates issued with respect to
an underlying pool of mortgages may be treated as securities separate from the
underlying mortgage loans and, thus, may not qualify for purposes of the 55%
requirement. Our ownership of these mortgage-backed securities, therefore, is
limited by the provisions of the Investment Company Act. In addition, in meeting
the 55% requirement under the Investment Company Act, we treat as qualifying
interests mortgage-backed securities issued with respect to an underlying pool
as to which we hold all issued certificates. If the SEC or its staff adopts a
contrary interpretation, we could be required to sell a substantial amount of
our mortgage-backed securities, under potentially adverse market conditions.
Further, in order to insure that we at all times qualify for the exemption from
the Investment Company Act, we may be precluded from acquiring mortgage-backed
securities whose yield is somewhat higher than the yield on mortgage-backed
securities that could be purchased in a manner consistent with the exemption.
The net effect of these factors may be to lower our net income.
Issuances of large amounts of our stock could cause our price to decline
23
As of March 21, 2003 we had 84,646,859 shares of our common stock were
outstanding. We may issue additional shares of common stock or shares of
preferred stock that are convertible into common stock. If we issue a
significant number of shares of common stock or convertible preferred stock in a
short period of time, there could be a dilution of the existing common stock and
a decrease in the market price of the common stock.
We may change our policies without stockholder approval
Our board of directors and management determine all of our policies,
including our investment, financing and distribution policies. Although they
have no current plans to do so, they may amend or revise these policies at any
time without a vote of our stockholders. Policy changes could adversely affect
our financial condition, results of operations, the market price of our common
stock or our ability to pay dividends or distributions.
Maryland Business Combination Act
The Maryland General Corporation Law establishes special requirements for
"business combinations" between a Maryland corporation and "interested
stockholders" unless exemptions are applicable. An interested stockholder is any
person who beneficially owns 10% or more of the voting power of our
then-outstanding voting stock. Among other things, the law prohibits for a
period of five years a merger and other similar transactions between us and an
interested stockholder unless the board of directors approved the transaction
prior to the party becoming an interested stockholder. The five-year period runs
from the most recent date on which the interested stockholder became an
interested stockholder. The law also requires a super majority stockholder vote
for such transactions after the end of the five-year period. This means that the
transaction must be approved by at least:
- - 80% of the votes entitled to be cast by holders of outstanding voting
shares; and
- - two-thirds of the votes entitled to be cast by holders of outstanding
voting shares other than shares held by the interested stockholder or an
affiliate of the interested stockholder with whom the business combination
is to be effected.
As permitted by the Maryland General Corporation Law, we have elected not
to be governed by the Maryland business combination statute. We made this
election by opting out of this statute in our articles of incorporation. If,
however, we amend our articles of incorporation to opt back in to the statute,
the business combination statute could have the effect of discouraging offers to
acquire us and of increasing the difficulty of consummating any such offers,
even if our acquisition would be in our stockholders' best interests.
Maryland Control Share Acquisition Act
Maryland law provides that "control shares" of a Maryland corporation
acquired in a "control share acquisition" have no voting rights except to the
extent approved by a vote of the stockholders. Two-thirds of the shares eligible
to vote must vote in favor of granting the "control shares" voting rights.
"Control shares" are shares of stock that, taken together with all other shares
of stock the acquirer previously acquired, would entitle the acquirer to
exercise voting power in electing directors within one of the following ranges
of voting power:
- - One-tenth or more but less than one third of all voting power;
- - One-third or more but less than a majority of all voting power; or
- - A majority or more of all voting power.
Control shares do not include shares of stock the acquiring person is
entitled to vote as a result of having previously obtained stockholder approval.
A "control share acquisition" means the acquisition of control shares, subject
to certain exceptions.
24
If a person who has made (or proposes to make) a control share acquisition
satisfies certain conditions (including agreeing to pay expenses), he may compel
our board of directors to call a special meeting of stockholders to consider the
voting rights of the shares. If such a person makes no request for a meeting, we
have the option to present the question at any stockholders' meeting.
If voting rights are not approved at a meeting of stockholders then,
subject to certain conditions and limitations, we may redeem any or all of the
control shares (except those for which voting rights have previously been
approved) for fair value. We will determine the fair value of the shares,
without regard to voting rights, as of the date of either:
- - the last control share acquisition; or
- - the meeting where stockholders considered and did not approve voting rights
of the control shares.
If voting rights for control shares are approved at a stockholders' meeting
and the acquirer becomes entitled to vote a majority of the shares of stock
entitled to vote, all other stockholders may obtain rights as objecting
stockholders and, thereunder, exercise appraisal rights. This means that you
would be able to force us to redeem your stock for fair value. Under Maryland
law, the fair value may not be less than the highest price per share paid in the
control share acquisition. Furthermore, certain limitations otherwise applicable
to the exercise of dissenters' rights would not apply in the context of a
control share acquisition. The control share acquisition statute would not apply
to shares acquired in a merger, consolidation or share exchange if we were a
party to the transaction. The control share acquisition statute could have the
effect of discouraging offers to acquire us and of increasing the difficulty of
consummating any such offers, even if our acquisition would be in our
stockholders' best interests.
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ITEM 2. PROPERTIES
Our executive and administrative office is located at 1211 Avenue of the
Americas, Suite 2902 New York, New York 10036, telephone 212-696-0100. This
office is leased under a noncancelable lease expiring December 31, 2009.
ITEM 3. LEGAL PROCEEDINGS
At December 31, 2002, there were no pending legal proceedings to which we
were a party, or to which any of our property was subject.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
We did not submit any matters to a vote of our stockholders during the
fourth quarter of 2002.
26
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS
Our common stock began trading publicly on October 8, 1997 and is traded on
the New York Stock Exchange under the trading symbol "NLY". As of March 21,
2003, we had 84,646,859 shares of common stock issued and outstanding which were
held by approximately 66,568 holders of record.
The following table sets forth, for the periods indicated, the high, low,
and closing sales prices per share of common stock as reported on the New York
Stock Exchange composite tape and the cash dividends declared per share of our
common stock.
Stock Prices
High Low Close
First Quarter ended March 31, 2002 $17.62 $15.30 $16.98
Second Quarter ended June 30, 2002 $21.50 $16.20 $19.40
Third Quarter ended September 30, 2002 $20.40 $14.00 $18.45
Fourth Quarter ended December 31, 2002 $19.95 $15.25 $18.80
High Low Close
First Quarter ended March 31, 2001 $11.50 $8.75 $11.26
Second Quarter ended June 30, 2001 $13.76 $10.50 $13.71
Third Quarter ended September 30, 2001 $14.93 $12.70 $14.45
Fourth Quarter ended December 31, 2001 $17.01 $13.20 $16.00
Cash Dividends
Declared Per Share
First Quarter ended March 31, 2002 $0.63
Second Quarter ended June 30, 2002 $0.68
Third Quarter ended September 30, 2002 $0.68
Fourth Quarter ended December 31, 2002 $0.68
First Quarter ended March 31, 2001 $0.30
Second Quarter ended June 30, 2001 $0.40
Third Quarter ended September 30, 2001 $0.45
Fourth Quarter ended December 31, 2001 $0.60
We intend to pay quarterly dividends and to distribute to our stockholders
all or substantially all of our taxable income in each year (subject to certain
adjustments). This will enable us to qualify for the tax benefits accorded to a
REIT under the Code. We have not established a minimum dividend payment level
and our ability to pay dividends may be adversely affected for the reasons
described under the caption "Risk Factors." All distributions will be made at
the discretion of our board of directors and will depend on our earnings, our
financial condition, maintenance of our REIT status and such other factors as
our board of directors may deem relevant from time to time.
EQUITY COMPENSATION PLAN INFORMATION
The Company has adopted a long term stock incentive plan for executive
officers, key employees and nonemployee directors (the "Incentive Plan"). The
Incentive Plan authorizes the Compensation Committee of
27
the board of directors to grant awards, including incentive stock options
as defined under Section 422 of the Code ("ISOs") and options not so qualified
("NQSOs"). The Incentive Plan authorizes the granting of options or other awards
for an aggregate of the greater of 500,000 shares or 9.5% of the outstanding
shares of the Company's common stock. For a description of the Company's
Incentive Plan, see Note 7 to the Financial Statements.
The following table provides information as of December 31, 2002,
concerning shares of the Company's common stock authorized for issuance under
Annaly Mortgage Management, Inc.'s existing Incentive Plan.
Number of securities
remaining available for
Number of securities to be Weighted-average exercise future issuance under
issued upon exercise of price of outstanding Incentive Plan (excluding
Plan Category outstanding options options previously issued)
- -------------------------------------------------------------------------------------------------------------------
Incentive Plan approved by
shareholders 512,706 $8.59 7,570,074(1)
Incentive Plan not approved
by shareholders - - -
---------------------------- ---------------------------- ----------------------------
Total 512,706 $8.59 7,570,074
============================ ============================ ============================
(1) The Incentive Plan authorizes the granting of options or other awards for an
aggregate of the greater of 500,000 or 9.5% of the outstanding shares on a fully
diluted basis of the Company's common stock.
((85,081,912*9.5%)-512,706)
28
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data are derived from our audited
financial statements for the years ended December 31, 2002, 2001, 2000, 1999 and
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 Form 10-K.
SELECTED FINANCIAL DATA
(dollars in thousands, except for per share data)
For the Year For the Year For the Year For the Year For the Year
Ended Ended Ended Ended Ended
December 31, December 31, December 31, December 31, December 31,
2002 2001 2000 1999 1998
-----------------------------------------------------------------------
Statement of Operations Data:
Interest income $404,165 $263,058 $109,750 $89,812 $89,986
Interest expense 191,758 168,055 92,902 69,846 75,735
-----------------------------------------------------------------------
Net interest income $212,407 $95,003 $16,848 $19,966 $14,251
Gain on sale of mortgage-backed securities 21,063 4,586 2,025 454 3,344
General and administrative expenses
(G&A expense) 13,963 7,311 2,286 2,281 2,106
-----------------------------------------------------------------------
Net income $219,507 $92,278 $16,587 $18,139 $15,489
=======================================================================
Basic net income per average share $2.68 $2.23 $1.18 $1.41 $1.22
Diluted net income per average share $2.67 $2.21 $1.15 $1.35 $1.19
Dividends declared per share $2.67 $1.75 $1.15 $1.38 $1.21
December 31, December 31 December 31, December 31, December 31,
Balance Sheet Data: 2002 2001 2000 1999 1998
-----------------------------------------------------------------------
Mortgage-Backed Securities, net $11,551,857 $7,575,379 $1,978,219 $1,437,793 $1,520,289
Total assets 11,659,084 7,717,314 2,035,029 1,491,322 1,527,352
Repurchase agreements 10,163,174 6,367,710 1,628,359 1,338,296 1,280,510
Total liabilities 10,579,018 7,049,957 1,899,386 1,388,050 1,401,481
Stockholders' equity 1,080,066 667,357 135,642 103,272 125,871
Number of common shares outstanding 84,569,206 59,826,975 14,522,978 13,581,316 12,648,424
Other Data:
Average total assets $10,486,423 $5,082,852 $1,652,459 $1,473,765 $1,499,875
Average earning assets 9,575,365 4,682,780 1,564,491 1,461,254 1,461,791
Average borrowings 9,128,933 4,388,900 1,449,999 1,350,230 1,360,040
Average equity 978,107 437,376 117,727 117,685 131,265
Yield on interest earning assets 4.22% 5.62% 7.02% 6.15% 6.16%
Cost of funds on interest bearing liabilities 2.10% 3.83% 6.41% 5.17% 5.57%
Interest rate spread 2.12% 1.79% 0.61% 0.98% 0.59%
Annualized Financial Ratios:
Net interest margin (net interest
Income/average total assets) 2.03% 1.87% 1.02% 1.35% 0.95%
G&A expense as a percentage of average
assets 0.13% 0.14% 0.14% 0.15% 0.14%
G&A expense as a percentage of average
equity 1.43% 1.67% 1.94% 1.94% 1.60%
Return on average assets 2.09% 1.82% 1.00% 1.23% 1.03%
Return on average equity 22.44% 21.10% 14.09% 15.41% 11.80%
29
ITEM 7.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Special Note Regarding Forward-Looking Statements
Certain statements contained in this annual report, and certain
statements contained in our future filings with the Securities and Exchange
Commission (the "SEC" or the "Commission"), in our press releases or in our
other public or shareholder communications may not be, based on historical facts
and are "forward-looking statements" within the meaning of the Private
Securities Litigation Reform Act of 1995. Forward-looking statements which are
based on various assumptions, (some of which are beyond our control) may be
identified by reference to a future period or periods, or by the use of
forward-looking terminology, such as "may," "will," "believe," "expect,"
"anticipate," "continue," or similar terms or variations on those terms, or the
negative of those terms. Actual results could differ materially from those set
forth in forward-looking statements due to a variety of factors, including, but
not limited to, changes in interest rates, changes in yield curve, changes in
prepayment rates, the availability of mortgage backed securities for purchase,
the availability of financing and, if available, the terms of any financing. For
a discussion of the risks and uncertainties that could cause actual results to
differ from those contained in the forward-looking statements, see "Risk
Factors." We do not undertake, and specifically disclaim any obligation, to
publicly release the result of any revisions that may be made to any
forward-looking statements to reflect the occurrence of anticipated or
unanticipated events or circumstances after the date of such statements.
Overview
We are a real estate investment trust that owns and manages a portfolio
of mortgage-backed securities. Our principal business objective is to generate
net income for distribution to our stockholders from the spread between the
interest income on our mortgage-backed securities and the costs of borrowing to
finance our acquisition of mortgage-backed securities.
Critical Accounting Policies
Management's discussion and analysis of financial condition and results
of operations is based on the amounts reported in our financial statements.
These financial statements are prepared in accordance with accounting principles
generally accepted in the United States of America. In preparing the financial
statements, management is required to make various judgments, estimates and
assumptions that affect the reported amounts. Changes in these estimates and
assumptions could have a material effect on our financial statements. The
following is a summary of our policies that is the most affected by management's
judgments, estimates and assumptions.
Market Valuation of Securities: All assets classified as
available-for-sale are reported at fair value, based on market prices. Our
policy is to obtain market values from three independent sources and record the
market value of the securities based on the average of the three.
Amortization of premiums and accretion of discounts: Premiums and
discounts associated with the purchase of the Mortgage-Backed Securities are
amortized into interest income over the lives of the securities using the
interest method. Our policy for estimating prepayment speeds for calculating the
effective yield is to evaluate historical performance, street consensus
prepayment speeds, and current market conditions.
Results of Operations
Net Income Summary
For the year ended December 31, 2002, our net income was $219.5 million
or $2.68 basic earnings per average share, as compared to $92.3 million or $2.23
30
basic earnings per average share for the year ended December 31, 2001. For the
year ended December 31, 2000, our net income was $16.6 million, or $1.18 basic
earnings per average share. Net income per average share increased by $0.45 and
total net income increased by $127.2 million. The increase in 2002 net income
over 2001 is attributable to our acquisition of additional mortgage-backed
securities using proceeds raised from our January 2002 public offering and
Equity Shelf Program during the year and the increase in the interest rate
spread between our interest-earning assets and our interest-bearing liabilities.
The same is true for the increase in net income for the year 2001, when compared
to the year 2000. We consummated three public offerings in the year 2001 and the
interest rate spread increased. We compute our net income per share by dividing
net income by the weighted average number of shares of outstanding common stock
during the period, which was 82,044,141 for the year ended December 31, 2002,
41,439,631 for the year ended December 31, 2001, and 14,089,436 for the year
ended December 31, 2000. Dividends per share for the year ended December 31,
2002 were $2.67, or an aggregate of $223.6 million. Dividends per share for the
year ended December 31, 2001 were $1.75 per share, or $88.4 million in total.
Dividends per share for the year ended December 31, 2000 were $1.15 per share,
or $16.3 million in total. Our return on average equity was 22.44% for the year
ended December 31, 2002, 21.10% for the year ended December 31, 2001, and 14.09%
for the year ended December 31, 2000. The increase in return on equity in 2002
compared to 2001 is primarily due to the favorable interest rate environment.
The table below presents the net income summary for the years ended December 31,
2002, 2001, 2000, 1999, and 1998.
31
Net Income Summary
(dollars in the thousands, except for per share data)
Year Ended Year Ended Year Ended Year Ended Year Ended
December 31, December 31, December December 31, December 31,
2002 2001 31, 2000 1999 1998
-------------- --------------- ------------- -------------- --------------
Interest Income $404,165 $263,058 $109,750 $89,812 $89,986
Interest Expense 191,758 168,055 92,902 69,846 75,735
-------------- --------------- ------------- -------------- --------------
Net Interest Income $212,407 $95,003 $16,802 $19,966 $14,251
Gain on Sale of Mortgage-Backed Securities 21,063 4,586 2,025 454 3,344
General and Administrative Expenses 13,963 7,311 2,286 2,281 2,106
-------------- --------------- ------------- -------------- --------------
Net Income $219,507 $92,278 $16,587 $18,139 $15,489
============== =============== ============= ============== ==============
Average Number of Basic Shares Outstanding 82,044,141 41,439,631 14,089,436 12,889,510 12,709,116
Average Number of Diluted Shares Outstanding 82,282,883 41,857,498 14,377,459 13,454,007 13,020,648
Basic Net Income Per Share $2.68 $2.23 $1.18 $1.41 $1.22
Diluted Net Income Per Share $2.67 $2.21 $1.15 $1.35 $1.19
Average Total Assets $10,486,423 $5,082,852 $1,652,459 $1,473,765 $1,499,875
Average Equity 978,107 437,376 117,727 117,685 131,265
Annualized Return on Average Assets 1.43% 1.82% 1.00% 1.23% 1.03%
Annualized Return on Average Equity 22.44% 21.10% 14.09% 15.41% 11.80%
Interest Income and Average Earning Asset Yield
We had average earning assets of $9.6 billion for the year ended
December 31, 2002. We had average earning assets of $4.7 billion for the year
ended December 31, 2001. We had average earning assets of $1.6 billion for the
year ended December 31, 2000. Our primary source of income for the years ended
December 31, 2002, 2001, and 2000 was interest income. A portion of our income
was generated by gains on the sales of our mortgage-backed securities. Our
interest income was $404.2 million for the year ended December 31, 2002, $263.1
million for the year ended December 31, 2001, and $109.8 million for the year
ended December 31, 2000. Our yield on average earning assets was 4.22%, 5.62%,
and 7.02% for the same respective periods. Our yield on average earning assets
decreased by 1.40% and our average earning asset balance increased by $4.9
billion for the year ended December 31, 2002, when compared to the prior year.
Due to the increase in the asset base resulting from the inflow of capital from
our public offering and Equity Shelf Program during the year ended December 31,
2002, interest income increased by $141.1 million. Our yield on average earning
assets decreased by 1.40% and our average earning asset balance increased by
$3.1 billion for the year ended December 31, 2001, when compared to the prior
year. Due to the increase in assets resulting from the three public offerings
during the year ended December 31, 2001, interest income increased by $153.3
million. The table below shows our average balance of cash equivalents and
mortgage-backed securities, the yields we earned on each type of earning assets,
our yield on average earning assets and our interest income for the years ended
December 31, 2002, 2001, 2000, and 1999, and 1998 the four quarters in 2002.
Average Earning Asset Yield
(ratios for the four quarters in 2002 are annualized)
Yield on
Average Yield on Average Yield on
Average Mortgage- Average Average Mortgage- Average
Cash Backed Earning Cash Backed Earning Interest
Equivalents Securities Assets Equivalents Securities Assets Income
----------- ---------- ------- ----------- ---------- ------- -------
(dollars in thousands)
For the Year Ended December 31, 2002 $2 $9,575,365 $9,575,367 1.14% 4.22% 4.22% $404,165
For the Year Ended December 31, 2001 $2 $4,682,778 $4,682,780 3.25% 5.62% 5.62% $263,058
32
Average Yield on Average Yield on
Average Mortgage- Average Average Mortgage- Average
Cash Backed Earning Cash Backed Earning Interest
Equivalents Securities Assets Equivalents Securities Assets Income
----------- ---------- ------- ----------- ---------- ------- -------
(dollars in thousands)
For the Year Ended December 31, 2000 $263 $1,564,228 $1,564,491 4.18% 7.02% 7.02% $109,750
For the Year Ended December 31, 1999 $221 $1,461,033 $1,461,254 4.10% 6.15% 6.15% $89,812
For the Year Ended December 31, 1998 $2 $1,461,789 $1,461,791 4.32% 6.16% 6.16% $89,986
- ----------------------------------------------------------------------------------------------------------------------------
For the Quarter Ended December 31, 2002 $2 $10,400,894 $10,400,896 0.88% 3.56% 3.56% $92,641
For the Quarter Ended September 30, $2 $10,661,228 $10,661,230 1.14% 4.10% 4.10% $109,201
2002
For the Quarter Ended June 30, 2002 $2 $9,629,332 $9,629,334 1.23% 4.55% 4.55% $109,423
For the Quarter Ended March 31, 2002 $2 $7,610,006 $7,610,008 1.29% 4.88% 4.88% $92,900
The constant prepayment rate ("CPR") on our mortgage-backed securities
for the year ended December 31, 2002 was 33%, for the year ended December 31,
2001 was 26%, and for the year ended December 31, 2000 was 11%. CPR is an
assumed rate of prepayment for our mortgage-backed securities, expressed as an
annual rate of prepayment relative to the outstanding principal balance of our
mortgage-backed securities. CPR does not purport to be either a historical
description of the prepayment experience of our mortgage-backed securities or a
prediction of the anticipated rate of prepayment of our mortgage-backed
securities.
Principal prepayments had a negative effect on our earning asset yield
for the years ended December 31, 2002, 2001, and 2000 because we adjust our
rates of premium amortization and discount accretion monthly based upon the
effective yield method, which takes into consideration changes in prepayment
speeds.
Interest Expense and the Cost of Funds
Our largest expense is the cost of borrowed funds, primarily through
repurchase agreements. We had average borrowed funds of $9.1 billion for the
year ended December 31, 2002, $4.4 billion for the year ended December 31, 2001,
and $1.4 billion for the year ended December 31, 2000. Interest expense totaled
$191.8 million, $168.1 million, and $92.9 million for the years ended December
31, 2002, 2001, and 2000, respectively. Our average cost of funds was 2.10% for
the year ended December 31, 2002, 3.83% for the year ended December 31, 2001,
and 6.41% for the year ended December 31, 2000. The cost of funds rate decreased
by 1.73% and the average borrowed funds increased by $4.7 billion for the year
ended December 31, 2002. Interest expense for the year ended December 31, 2002
increased $23.7 million, from $168.1 million to $191.8 million. We increased our
asset base by raising approximately $379.5 million of additional capital in
2002. As a result, we increased the amounts borrowed under repurchase
agreements. Consequently, the increased interest expense for the year 2002 is
the result of our growth. The cost of funds rate decreased by 2.58% and the
average borrowed funds increased by $3.0 billion for the year ended December 31,
2001. Interest expense for the year ended December 31, 2001 increased $75.2
million. We increased our asset base by raising approximately $474.2 million of
additional capital in 2001. Consequently, the increased interest expense for the
year 2001 is the result of our growth.
Changes in our short-term cost of funds are expected to be closely
correlated with changes in short-term LIBOR, although we have chosen to extend
the maturity on a portion of our liabilities to three years. Our average cost of
funds was 0.33% greater than average one-month LIBOR for the year ended December
31, 2002, and 0.22% greater than average six-month LIBOR. Our average cost of
funds was 0.05% less than average one-month LIBOR for the year ended December
31, 2001, and 0.10% greater than average six-month LIBOR. Our average cost of
funds was equal to average one-month LIBOR for the year ended December 31, 2000,
and 0.25% less than average six-month LIBOR. During the year ended December 31,
2002, average one-month LIBOR, which was 1.77%, was 0.11% less than average
six-month LIBOR, which was 1.88%. During the year ended December 31, 2001,
average one-month LIBOR, which was 3.88%, was 0.15% greater than average
six-month LIBOR, which was 3.73%. During the year ended December 31, 2000,
average one-month LIBOR, which was 6.41%, was 0.25% lower than average six-month
LIBOR, which was 6.66%. The table below shows our average borrowed funds and
average cost of funds as compared to average one-month and average six-month
33
LIBOR for the years ended December 31, 2002, 2001, 2000, 1999, 1998, and the
four quarters in 2002.
Average Cost of Funds
(Ratios for the four quarters in 2002 have been annualized)
Average
One-Month Average Cost Average Cost
LIBOR of Funds of Funds
Relative to Relative to Relative to
Average Average Average Average Average Average Average
Borrowed Interest Cost of One-Month Six-Month Six-Month One-Month Six-Month
Funds Expense Funds LIBOR LIBOR LIBOR LIBOR LIBOR
--------- -------- -------- -------- -------- ---------- ------------- ------------
(dollars in thousands)
For the Year Ended
December 31, 2002 $9,128,933 $191,758 2.10% 1.77% 1.88% (0.11%) 0.33% 0.22%
For the Year Ended
December 31, 2001 $4,388,900 $168,055 3.83% 3.88% 3.73% 0.15% (0.05%) 0.10%
For the Year Ended
December 31, 2000 $1,449,999 $92,902 6.41% 6.41% 6.66% (0.25%) - (0.25%)
For the Year Ended
December 31, 1999 $1,350,230 $69,846 5.17% 5.25% 5.53% (0.28%) (0.08%) (0.36%)
For the Year Ended
December 31, 1998 $1,360,040 $75,735 5.57% 5.57% 5.54% 0.03% - 0.03%
- ------------------------------------------------------------------------------------------------------------------------
For the Quarter Ended
December 31, 2002 $10,097,676 $49,874 1.98% 1.57% 1.55% 0.02% 0.41% 0.43%
For the Quarter Ended
September 30, 2002 $10,122,840 $54,012 2.13% 1.82% 1.82% - 0.31% 0.31%
For the Quarter Ended
June 30, 2002 $9,102,992 $47,860 2.10% 1.85% 2.11% (0.26%) 0.25% (0.01%)
For the Quarter Ended
March 31, 2002 $7,192,222 $40,012 2.23% 1.85% 2.06% (0.21%) 0.38% 0.17%
Net Interest Income
Our net interest income, which equals interest income less interest
expense, totaled $212.4 million for the year ended December 31, 2002, $95.0
million for the year ended December 31, 2001, $16.8 million for the year ended
December 31, 2000. Our net interest spread, which equals the yield on our
average assets for the period less the average cost of funds for the period, was
2.12% for the year ended December 31, 2002, which is a 0.33% increase over the
prior year. The net interest spread for the year ended December 31, 2001 was
1.79%, as compared to 0.61% for the year ended December 31, 2000. Our net
interest income increased by $117.4 million for the year ended December 31, 2002
over the prior year. The increase in our balance sheet which resulted from our
raising additional capital in 2002, along with the 0.33% increase in the
interest rate spread. The substantial increase in our balance sheet in 2001
which resulted from our raising additional capital in that year, along with the
1.18% increase in the interest rate spread, caused the $78.2 million increase in
net interest income. Net interest margin, which equals net interest income
divided by average interest earning assets, was 2.03% for the year ended
December 31, 2002, 1.87% for the year ended December 31, 2001, and 1.02% for the
year ended December 31, 2000. The principal reason that net interest margin
exceeded net interest spread is that average interest earning assets exceeded
average interest bearing liabilities. A portion of our assets is funded with
equity rather than borrowings.
The table below shows our interest income by earning asset type,
average earning assets by type, total interest income, interest expense, average
repurchase agreements, average cost of funds, and net interest income for the
years ended December 31, 2002, 2001, 2000, 1999, 1998, and the four quarters in
2002.
Net Interest Income
(Ratios for the four quarters in 2002 have been annualized)
Yield on
Average Interest Average Average
Mortgage Income on Average Total Interest Balance of Average Net
-Backed Mortgage Cash Interest Earning Repurchase Interest Cost of Interest
Securities -Backed Equivalents Income Assets Agreements Expense Funds Income
Held Securities
------------ ---------- ----------- -------- -------- ----------- --------- ------- --------
(dollars in the thousands)
For the Year Ended
December 31, 2002 $9,575,365 $404,165 $2 $404,165 4.22% $9,128,933 $191,758 2.10% $212,407
For the Year Ended
December 31, 2001 $4,682,778 $263,058 $2 $263,058 5.62% $4,388,900 $168,055 3.83% $95,003
For the Year Ended
December 31, 2000 $1,564,228 $109,739 $263 $109,750 7.02% $1,449,999 $92,902 6.41% $16,848
For the Year Ended
December 31, 1999 $1,461,033 $89,801 $221 $89,812 6.15% $1,350,230 $69,846 5.17% $19,966
For the Year Ended
December 31, 1998 $1,461,789 $89,986 $2 $89,986 6.16% $1,360,040 $75,735 5.57% $14,251
----------------------------------------------------------------------------------------------------------------------
For the Quarter
Ended
December 31, 2002 $10,400,894 $92,641 $2 $92,641 3.56% $10,097,676 $49,874 1.98% $42,767
For the Quarter
Ended $10,661,228 $109,201 $2 $109,201 4.10% $10,122,840 $54,012 2.13% $55,189
September 30,
2002
For the Quarter
Ended $9,629,332 $109,423 $2 $109,423 4.55% $9,102,992 $47,860 2.10% $61,563
June 30, 2002
For the Quarter
Ended $7,610,006 $92,900 $2 $92,900 4.88% $7,192,222 $40,012 2.23% $52,888
March 31, 2002
Gains and Losses on Sales of Mortgage-Backed Securities
For the year ended December 31, 2002, we sold mortgage-backed
securities with an aggregate historical amortized cost of $2.1 billion for an
aggregate gain of $21.1 million. For the year ended December 31, 2001, we sold
mortgage-backed securities with an aggregate historical amortized cost of $1.2
billion for an aggregate gain of $4.6 million. For the year ended December 31,
2000, we sold mortgage-backed securities with an aggregate historical amortized
cost of $487.8 million for an aggregate gain of $2.0 million. The gain on sale
of assets for the year ended December 31, 2002 increased by $16.5 million over
the prior year. We were able to take advantage to the appreciation in our
portfolio, while maintaining a book value of $12.77. The gain on sale of assets
for the year ended December 31, 2001 increased by $2.6 million over the prior
year. Even though the gain for the year 2001 increased over the prior year, as a
percentage of total income it declined. We do not expect to sell assets on a
frequent basis, but may from time to time sell existing assets to move into new
assets, which our management believes might have higher risk-adjusted returns,
or to manage our balance sheet as part of our asset/liability management
strategy.
Credit Losses
We have not experienced credit losses on our mortgage-backed securities to date.
We have limited our exposure to credit losses on our mortgage-backed securities
by purchasing only securities, issued or guaranteed by Federal Home Loan
Mortgage Corporation, the Federal National Mortgage Association, or the
Government National Mortgage Association, which, although not rated, carry an
implied "AAA" rating. Under our capital investment policy, however, up to 25% of
our securities could be rated "BBB" or better or if unrated, securities we deem
to be of a quality "BBB" or better.
General and Administrative Expenses
General and administrative expenses ("G&A") were $14.0 million for the
year ended December 31, 2002, $7.3 million for the year ended December 31, 2001,
and $2.3 million for the year ended December 31, 2000. G&A expenses as a
percentage of average assets was 0.13%, 0.14%, and 0.14% for the years ended
December 31, 2002, 2001, and 2000, respectively. G&A expense has increase
proportionately with our increased capital base. Increases in salaries were the
primary reason for the overall increase in G&A. The staff increased to 15
employees by the end of 2002 from 10 employees at the end of 2001. In 2002, we
paid aggregate salaries and bonuses of $10.8 million compared to $4.7 million
in 2001. G&A expenses in total were materially unchanged for the years ended
December 31, 2001, and 2000. The table below shows our total
35
G&A expenses as compared to average assets and average equity for the years
ended December 31, 2002, 2001, 2000, 1999, 1998, and the four quarters in 2002.
G&A Expenses and Operating Expense Ratios
(Ratios for the four quarters in 2002 have been annualized)
Total G&A Total G&A
Total G&A Expenses/Average Expenses/Average
Expenses Assets Equity
(dollars in the thousands)
For the Year Ended
December 31, 2002 $13,963 0.13% 1.43%
For the Year Ended
December 31, 2001 $7,311 0.14% 1.67%
For the Year Ended
December 31, 2000 $2,286 0.14% 1.94%
For the Year Ended
December 31, 1999 $2,281 0.15% 1.94%
For the Year Ended
December 31, 1998 $2,106 0.14% 1.60%
- ---------------------------- ---------------- ----------------- -------------------
For the Quarter Ended
December 31, 2002 $3,904 0.13% 1.44%
For the Quarter Ended
September 30, 2002 $3,268 0.12% 1.22%
For the Quarter Ended
June 30, 2002 $3,536 0.13% 1.37%
For the Quarter Ended
March 31, 2002 $3,255 0.14% 1.55%
Net Income and Return on Average Equity
Our net income was $219.5 million for the year ended December 31, 2002,
$92.3 million for the year ended December 31, 2001, and $16.6 million for the
year ended December 31, 2000. Our return on average equity was 22.44% for the
year ended December 31, 2002, 21.1% for the year ended December 31, 2001, and
14.1% for the year ended December 31, 2000. Net income increased by $127.2
million in the year 2002 over the previous year, due to the increased asset base
and the increase in the average interest rate spread. The increase in net income
for the year ended December 2001, as compared to the year ended December 31,
2000, is a direct result of growth in our balance sheet following our three
public offerings in 2001, as well as the favorable interest rate environment
during the year 2001.
We were able to take advantage of appreciation in asset value in 2001.
The gain on sale of securities increased by $2.6 million for the year ended
December 31, 2001, as compared to the prior year. The table below shows our net
interest income, gain on sale of mortgage-backed securities and G&A expenses
each as a percentage of average equity, and the return on average equity for the
years ended December 31, 2002, 2001, 2000, 1999, and 1998, and for the four
quarters in 2002.
Components of Return on Average Equity
(Ratios for the four quarters in 2002 have been annualized)
Gain on Sale of
Net Interest Mortgage-Backed G&A Return on
Income/Average Securities/Average Expenses/Average Average
Equity Equity Equity Equity
For the Year Ended December 31, 2002 21.72% 2.15% 1.43% 22.44%
For the Year Ended December 31, 2001 21.72% 1.05% 1.67% 21.10%
For the Year Ended December 31, 2000 14.31% 1.72% 1.94% 14.09%
For the Year Ended December 31, 1999 16.97% 0.38% 1.94% 15.41%
36
For the Year Ended December 31, 1998 10.85% 2.55% 1.60% 11.80%
- -------------------------------------------------------------------------------------------------------
For the Quarter Ended December 31, 2002 15.80% 4.27% 1.44% 18.63%
For the Quarter Ended September 30,
2002 20.68% 1.78% 1.22% 21.24%
For the Quarter Ended June 30, 2002 23.93% 0.52% 1.37% 23.08%
For the Quarter Ended March 31, 2002 25.24% 1.63% 1.55% 25.32%
Financial Condition
Mortgage-Backed Securities
All of our mortgage-backed securities at December 31, 2002, 2001, and
2000 were adjustable-rate or fixed-rate mortgage-backed securities backed by
single-family mortgage loans. All of the mortgage assets underlying these
mortgage-backed securities were secured with a first lien position on the
underlying single-family properties. All our mortgage-backed securities were
FHLMC, FNMA or GNMA mortgage pass-through certificates or CMOs, which carry an
implied "AAA" rating. We mark-to-market all of our earning assets at liquidation
value.
We accrete discount balances as an increase in interest income over the
life of discount mortgage-backed securities and we amortize premium balances as
a decrease in interest income over the life of premium mortgage-backed
securities. At December 31, 2002, 2001, and 2000, we had on our balance sheet a
total of $664,000, $2.1 million, and $989,000, respectively, of unamortized
discount (which is the difference between the remaining principal value and
current historical amortized cost of our mortgage-backed securities acquired at
a price below principal value) and a total of $274.6 million, $139.4 million,
and $24.3 million, respectively, of unamortized premium (which is the difference
between the remaining principal value and the current historical amortized cost
of our mortgage-backed securities acquired at a price above principal value).
We received mortgage principal repayments of $4.7 billion for the year
ended December 31, 2002, $1.7 billion for the year ended December 31, 2001, and
$168.5 million for the year ended December 31, 2000. The overall prepayment
speed for the year ended December 31, 2002, 2001, 2000 was 33%, 27%, and 11%,
respectively. During the quarter ended December 31, 2002, the prepayment speeds
were the highest in our history at 43%. The result was record returns of
principal for the year, relative to the asset size. The increase in prepayments
in 2001 from 2000 was primarily because we acquired more mortgage-backed
securities following our three public offerings. Given our current portfolio
composition, if mortgage principal prepayment rates were to increase over the
life of our mortgage-backed securities, all other factors being equal, our net
interest income would decrease during the life of these mortgage-backed
securities as we would be required to amortize our net premium balance into
income over a shorter time period. Similarly, if mortgage principal prepayment
rates were to decrease over the life of our mortgage-backed securities, all
other factors being equal, our net interest income would increase during the
life of these mortgage-backed securities as we would amortize our net premium
balance over a longer time period.
The table below summarizes certain characteristics of our
mortgage-backed securities at December 31, 2002, 2001, 2000, 1999, and 1998,
September 30, 2002, June 30, 2002, and March 31, 2002.
Mortgage-Backed Securities
Estimated
Amortized Fair Weighted
Net Amortized Cost/Principal Estimated Value/PrincipaAverage
Principal Value Premium Cost Value Fair Value Value l Yield
(dollars in thousands)
At December 31, 2002 $11,202,384 $273,963 $11,476,347 102.45% $11,551,857 103.12% 3.25%
At December 31, 2001 $7,399,941 $137,269 $7,537,210 101.86% $7,575,379 102.37% 4.41%
At December 31, 2000 $1,967,967 $23,296 $1,991,263 101.18% $1,978,219 100.52% 7.09%
At December 31, 1999 $1,452,917 $22,444 $1,475,361 101.54% $1,437,793 98.96% 6.77%
At December 31, 1998 $1,502,414 $24,278 $1,526,692 101.62% $1,520,289 101.19% 6.43%
- -----------------------------------------------------------------------------------------------------------------------
At September 30, 2002 $11,170,379 $244,777 $11,415,156 102.19% $11,489,538 102.86% 3.67%
37
At June 30, 2002 $10,833,374 $224,114 $11,057,488 102.07% $11,124,771 102.69% 3.90%
At March 31, 2002 $9,982,678 $193,048 $10,175,726 101.93% $10,206,228 102.24% 4.31%
The tables below set forth certain characteristics of our
mortgage-backed securities. The index level for adjustable-rate mortgage-backed
securities is the weighted average rate of the various short-term interest rate
indices, which determine the coupon rate.
Adjustable-Rate Mortgage-Backed Security Characteristics
Principal
Value at
Weighted Period End
Weighted Weighted Average Weighted Weighted as % of
Average Average Weighted Term to Average Average Total
Principal Coupon Index Average Net Next Lifetime Asset Mortgage-Backed
Value Rate Level Margin Adjustment Cap Yield Securities
(dollars in thousands)
At December 31, 2002 $7,007,062 4.10% 2.51% 1.59% 11 months 10.37% 2.33% 62.55%
At December 31, 2001 $5,793,250 5.90% 3.95% 1.95% 24 months 11.49% 3.87% 78.29%
At December 31, 2000 $1,454,356 7.61% 5.76% 1.85% 15 months 11.47% 7.24% 73.90%
At December 31, 1999 $951,839 7.33% 5.84% 1.49% 11 months 10.30% 7.64% 65.51%
At December 31, 1998 $1,030,654 6.84% 5.18% 1.66% 12 months 10.63% 6.42% 68.60%
- ------------------------------------------------------------------------------------------------------------------------
At September 30, 2002 $7,583,147 4.37% 2.80% 1.57% 10 months 10.36% 2.90% 67.89%
At June 30, 2002 $7,939,126 4.57% 2.96% 1.61% 12 months 10.46% 3.17% 73.28%
At March 31, 2002 $7,248,832 4.94% 3.25% 1.69% 16 months 10.73% 3.52% 72.61%
- -------------------------------------------------------------------------------------------------------------------------
Fixed-Rate Mortgage-Backed Security Characteristics
Principal Value
Weighted Weighted as % of Total
Principal Average Coupon Average Mortgage-Backed
Value Rate Asset Yield Securities
(dollars in thousands)
At December 31, 2002 $4,195,322 6.76% 4.78% 37.45%
At December 31, 2001 $1,606,691 6.92% 6.33% 21.71%
At December 31, 2000 $513,611 6.62% 6.68% 26.10%
At December 31, 1999 $501,078 6.58% 7.01% 34.49%
At December 31, 1998 $471,760 6.55% 6.47% 31.40%
- -------------------------- -------------- ---------------- -------------- ------------------
At September 30, 2002 $3,587,232 6.95% 5.29% 32.11%
At June 30, 2002 $2,894,248 7.09% 5.91% 26.72%
At March 31, 2002 $2,733,846 7.01% 6.40% 27.39%
At December 31, 2002 we held mortgage-backed securities with coupons
linked to the one-year, two-year, three-year, and five-year Treasury indices,
one-month and one-year LIBOR, six-month Auction Average, twelve-month moving
average and the six-month CD rate. At December 31, 2001 we held mortgage-backed
securities with coupons linked to the one-year, three-year, and five-year
Treasury indices, one-month and six-month LIBOR, six-month Auction Average,
twelve-month moving average and the six-month CD rate.
38
Adjustable-Rate Mortgage-Backed Securities by Index
December 31, 2002
Six-Month 12-Month 2-Year
---------- Auction Moving 1-Year Treasury 3-Year 5-Year
One-Month One-Year Average Average Six-Month Treasury Index Treasury Treasury
LIBOR LIBOR CD Rate Index Index Index
Weighted Average Adjustment
Frequency 1mo. 12 mo. 6 mo. 1 mo. 6 mo. 12 mo. 24 mo. 36 mo. 60 mo.
Weighted Average Term to
Next Adjustment 1mo. 41 mo. 2 mo. 1 mo. 2 mo. 22 mo. 10 mo. 20 mo. 31 mo.
Weighted Average Annual
Period Cap None 2.00% 2.00% None 1.00% 1.93% 2.00% 2.00% 2.00%
Weighted Average Lifetime
Cap at December 31, 2002 9.01% 11.31% 13.00% 10.37% 11.60% 11.83% 11.93% 12.83% 12.57%
Mortgage Principal Value as
Percentage of Mortgage-
Backed Securities at
December 31, 2002 32.43% 0.33% 0.03% 0.58% 0.14% 27.67% 0.03% 0.92% 0.42%
Adjustable-Rate Mortgage-Backed Securities by Index
December 31, 2001
Six-Month 12-Month
---------- Auction Moving 1-Year 3-Year 5-Year
One-Month Six-Month Average Average Six-Month Treasury Treasury Treasury
LIBOR LIBOR CD Rate Index Index Index
-----------
-----------
Weighted Average Adjustment
Frequency 1mo. 6 mo. 6 mo. 12 mo. 6 mo. 12 mo. 36 mo. 60 mo.
Weighted Average Term to
Next Adjustment 1mo. 55 mo. 2 mo. 11 mo. 2 mo. 33 mo. 16 mo. 33 mo.
Weighted Average Annual
Period Cap None 2.00% 0.50% None 1.00% 1.98% 2.00% 1.96%
Weighted Average Lifetime
Cap at December 31, 2001 9.09% 11.50% 12.53% 10.63% 11.40% 12.22% 13.08% 12.92%
Mortgage Principal Value as
Percentage of Mortgage-
Backed Securities at
December 31, 2001 18.32% 0.13% 0.12% 1.06% 0.22% 56.20% 1.35% 0.89%
Adjustable-Rate Mortgage-Backed Securities by Index
December 31, 2000
3-Year
One-Month Six-Month 1-Year Treasury 5-Year
LIBOR CD Rate Treasury Index Index Treasury Index
Weighted Average Adjustment Frequency 1 mo. 6 mo. 12 mo. 36 mo. 60 mo.
Weighted Average Term to Next Adjustment 1 mo. 2 mo. 23 mo. 20 mo. 40 mo.
Weighted Average Annual Period Cap None 1.00% 1.98% 2.00% 1.76%
Weighted Average Lifetime Cap at
December 31, 2000 9.11% 11.37% 12.61% 13.24% 12.42%
Mortgage Principal Value as Percentage of
Mortgage-Backed Securities at
December 31, 2000 24.08% 1.21% 44.52% 2.97% 1.12%
39
Borrowings
To date, our debt has consisted entirely of borrowings collateralized
by a pledge of our mortgage-backed securities. These borrowings appear on our
balance sheet as repurchase agreements. At December 31, 2002, we had established
uncommitted borrowing facilities in this market with 25 lenders in amounts,
which we believe, are in excess of our needs. We believe that we have used
approximately 57% of our uncommitted borrowing line. All of our mortgage-backed
securities are currently accepted as collateral for these borrowings. However,
we limit our borrowings, and thus our potential asset growth, in order to
maintain unused borrowing capacity and thus increase the liquidity and strength
of our balance sheet. At December 31, 2002, we had collateral in excess of the
required haircut on our repurchase agreements in the amount of $677.7 million.
For the year ended December 31, 2002, the term to maturity of our
borrowings ranged from one day to three years, with a weighted average original
term to maturity of 166 days at December 31, 2002. For the years ended December
31, 2001 and 2000, the term to maturity of our borrowings ranged from one day to
three years, with a weighted average original term to maturity of 119 days at
December 31, 2001, and 56 days at December 31, 2000. At December 31, 2002, the
weighted average cost of funds for all of our borrowings was 1.72% and the
weighted average term to next rate adjustment was 124 days. At December 31,
2001, the weighted average cost of funds for all of our borrowings was 2.18% and
the weighted average term to next rate adjustment was 85 days. At December 31,
2000, the weighted average cost of funds for all of our borrowings was 6.55% and
the weighted average term to next rate adjustment was 29 days. At December 31,
2001, the weighted average original term increased because of the use of three
year repurchase agreements.
Liquidity
Liquidity, which is our ability to turn non-cash assets into cash,
allows us to purchase additional mortgage-backed securities and to pledge
additional assets to secure existing borrowings should the value of our pledged
assets decline. Potential immediate sources of liquidity for us include cash
balances and unused borrowing capacity. Unused borrowing capacity will vary over
time as the market value of our mortgage-backed securities varies. Our balance
sheet also generates liquidity on an on-going basis through mortgage principal
repayments and net earnings held prior to payment as dividends. Should our needs
ever exceed these on-going sources of liquidity plus the immediate sources of
liquidity discussed above, we believe that our mortgage-backed securities could
in most circumstances be sold to raise cash. The maintenance of liquidity is one
of the goals of our capital investment policy. Under this policy, we limit asset
growth in order to preserve unused borrowing capacity for liquidity management
purposes.
Stockholders' Equity
We use "available-for-sale" treatment for our mortgage-backed
securities; we carry these assets on our balance sheet at estimated market value
rather than historical amortized cost. Based upon this "available-for-sale"
treatment, our equity base at December 31, 2002 was $1.1 billion, or $12.77 per
share. If we had used historical amortized cost accounting, our equity base at
December 31, 2002 would have been $1.0 billion, or $11.88 per share. Our equity
base at December 31, 2001 was $667.4 million, or $11.15 per share. If we had
used historical amortized cost accounting, our equity base at December 31, 2001
would have been $629.2 million, or $10.52 per share. Our equity base at December
31, 2000 was $135.6 million, or $9.34 per share. If we had used historical
amortized cost accounting, our equity base at December 31, 2000 would have been
$148.6 million, or $10.24 per share.
Through the Equity Shelf Program, in which we sell shares from
time-to-time at market prices, we raised approximately $28.1 million in net
proceeds and issued 1,484,100 shares during 2002. Also in 2002, 165,480 shares
were purchased through our dividend reinvestment and share purchase plan,
totaling approximately $3.0 million. We also completed an offering of common
stock in the first quarter issuing 23,000,000 shares, with aggregate net
proceeds of approximately $347.4 million. We completed three public offerings
during the year ended December 31, 2001 in which we issued a total of 45,060,100
shares of common stock, and received aggregate net proceeds of approximately
$474.2 million.
40
With our "available-for-sale" accounting treatment, unrealized
fluctuations in market values of assets do not impact our GAAP or taxable income
but rather are reflected on our balance sheet by changing the carrying value of
the asset and stockholders' equity under "Accumulated Other Comprehensive Income
(Loss)." By accounting for our assets in this manner, we hope to provide useful
information to stockholders and creditors and to preserve flexibility to sell
assets in the future without having to change accounting methods.
As a result of this mark-to-market accounting treatment, our book value
and book value per share are likely to fluctuate far more than if we used
historical amortized cost accounting. As a result, comparisons with companies
that use historical cost accounting for some or all of their balance sheet may
not be meaningful.
The table below shows unrealized gains and losses on the
mortgage-backed securities in our portfolio.
Unrealized Gains and Losses
(dollars in thousands)
At December 31,
2002 2001 2000 1999 1998
------------ --------------- ----------- --------------- -------------
Unrealized Gain $90,507 $53,935 $ 3,020 $ 1,531 $3,302
Unrealized Loss (14,997) (15,766) (16,064) (39,100) (9,706)
------------ --------------- ----------- --------------- -------------
Net Unrealized Gain (Loss) $75,510 $38,169 ($13,044) ($37,569) ($6,404)
============ =============== =========== =============== =============
Net Unrealized Gain (Loss) as % of Mortgage-
Backed Securities Principal Value 0.67% 0.52% (0.66%) (2.59%) (0.43%)
Net Unrealized Gain (Loss) as % of Mortgage-
Backed Securities Amortized Cost 0.67% 0.51% (0.66%) (2.54%) (0.42%)
Unrealized changes in the estimated net market value of mortgage-backed
securities have one direct effect on our potential earnings and dividends:
positive marked-to-market changes increase our equity base and allow us to
increase our borrowing capacity while negative changes tend to limit borrowing
capacity under our capital investment policy. A very large negative change in
the net market value of our mortgage-backed securities might impair our
liquidity position, requiring us to sell assets with the likely result of
realized losses upon sale. The net unrealized gains (loss) on available for sale
securities was $75.5 million, or 0.67% or the amortized cost of our
mortgage-backed securities as of December 31, 2002, $38.2 million, or 0.51% or
the amortized cost of our mortgage-backed securities as of December 31, 2001,
and ($13.0) million, or (0.66%) of the amortized cost of our mortgage-backed
securities at December 31, 2000.
The table below shows our equity capital base as reported and on a
historical amortized cost basis at December 31, 2002, 2001, 2000, 1999, and
1998, and September 30, 2002, June 30, 2002 and March 31,2002. Issuances of
common stock, the level of earnings as compared to dividends declared, and other
factors influence our historical cost equity capital base. The reported equity
capital base is influenced by these factors plus changes in the "Net Unrealized
Losses on Assets Available for Sale" account.
41
Stockholders' Equity
Historical
Historical Net Unrealized Reported Amortized Cost Reported Equity
Amortized Cost Gains on Assets Equity Base Equity Per (Book Value) Per
Equity Base Available for Sale (Book Value) Share Share
(dollars in thousands, except per share data)
At December 31, 2002 $1,004,555 $75,511 $1,080,066 $11.88 $12.77
At December 31, 2001 $629,188 $38,169 $667,357 $10.52 $11.15
At December 31, 2000 $148,686 ($13,044) $135,642 $10.24 $9.34
At December 31, 1999 $140,841 ($37,569) $103,272 $10.37 $7.60
At December 31, 1998 $132,275 ($6,404) $125,871 $10.46 $9.95
- --------------------------------------------------------------------------------------------------------------
At September 30, 2002 $1,010,623 $74,382 $1,085,005 $11.96 $12.84
At June 30, 2002 $982,348 $67,283 $1,049,631 $11.84 $12.65
At March 31, 2002 $978,186 $30,502 $1,008,688 $11.80 $12.17
Leverage
Our debt-to-equity ratio at December 31, 2002, 2001, and 2000 was
9.4:1, 9.5:1, and 12.0:1, respectively. We generally expect to maintain a ratio
of debt-to-equity of between 8:1 and 12:1, although the ratio may vary from this
range from time-to-time based upon various factors, including our management's
opinion of the level of risk of our assets and liabilities, our liquidity
position, our level of unused borrowing capacity and over-collateralization
levels required by lenders when we pledge assets to secure borrowings.
Our target debt-to-equity ratio is determined under our capital
investment policy. Should our actual debt-to-equity ratio increase above the
target level due to asset acquisition or market value fluctuations in assets, we
will cease to acquire new assets. Our management will, at that time, present a
plan to our board of directors to bring us back to our target debt-to-equity
ratio; in many circumstances, this would be accomplished over time by the
monthly reduction of the balance of our mortgage-backed securities through
principal repayments.
Asset/Liability Management and Effect of Changes in Interest Rates
We continually review our asset/liability management strategy with
respect to interest rate risk, mortgage prepayment risk, credit risk and the
related issues of capital adequacy and liquidity. Our goal is to provide
attractive risk-adjusted stockholder returns while maintaining what we believe
is a strong balance sheet.
We seek to manage the extent to which our net income changes as a
function of changes in interest rates by matching adjustable-rate assets with
variable-rate borrowings. In addition, although we have not done so to date, we
may seek to mitigate the potential impact on net income of periodic and lifetime
coupon adjustment restrictions in our portfolio of mortgage-backed securities by
entering into interest rate agreements such as interest rate caps and interest
rate swaps.
Changes in interest rates may also affect the rate of mortgage
principal prepayments and, as a result, prepayments on mortgage-backed
securities. We will seek to mitigate the effect of changes in the mortgage
principal repayment rate by balancing assets we purchase at a premium with
assets we purchase at a discount. To date, the aggregate premium exceeds the
aggregate discount on our mortgage-backed securities. As a result, prepayments,
which result in the expensing of unamortized premium, will reduce our net income
compared to what net income would be absent such prepayments.
Inflation
Virtually all of our assets and liabilities are financial in nature. As
a result, interest rates and other factors drive our performance far more than
does inflation. Changes in interest rates do not necessarily correlate with
inflation rates or changes in inflation rates. Our financial statements are
prepared in accordance with GAAP and our dividends based upon our net income as
42
calculated for tax purposes; in each case, our activities and balance sheet are
measured with reference to historical cost or fair market value without
considering inflation.
Other Matters
We calculate that our qualified Real Estate Investment Trust ("REIT")
assets, as defined in the Internal Revenue Code, are 100.0% of our total assets
at December 31, 2002, 2001, and 2000 as compared to the Internal Revenue Code
requirement that at least 75% of our total assets be qualified REIT assets. We
also calculate that 100% of our revenue qualifies for the 75% source of income
test, and 100% of its revenue qualifies for the 95% source of income test, under
the REIT rules for the years ended December 31, 2001, 2000, and 1999. We also
met all REIT requirements regarding the ownership of our common stock and the
distribution of our net income. Therefore, as of December 31, 2002, 2001, and
2000 we believe that we qualified as a REIT under the Internal Revenue Code.
We at all times intend to conduct our business so as not to become
regulated as an investment company under the Investment Company Act of 1940, as
amended (the "Investment Company Act"). If we were to become regulated as an
investment company, then our use of leverage would be substantially reduced. The
Investment Company Act exempts entities that are "primarily engaged in the
business of purchasing or otherwise acquiring mortgages and other liens on and
interests in real estate" (qualifying interests). Under current interpretation
of the staff of the SEC, in order to qualify for this exemption, we must
maintain at least 55% of our assets directly in qualifying interests. In
addition, unless certain mortgage securitites represent all the certificates
issued with respect to an underlying pool of mortgages, the mortgage-backed
securities may be treated as securities separate from the underlying mortgage
loans and, thus, may not be considered qualifying interests for purposes of the
55% requirement. We calculate that as of December 31, 2002, 2001, and 2000 we
were in compliance with this requirement.
43
ITEM 7A QUANTITATIVE AND QUALITIATIVE DISCLOSURES ABOUT MARKET RISK
MARKET RISK
Market risk is the exposure to loss resulting from changes in interest
rates, foreign currency exchange rates, commodity prices and equity prices. The
primary market risk to which we are exposed is interest rate risk. Interest
rates are highly sensitive to many factors, including governmental monetary and
tax policies, domestic and international economic and political considerations
and other factors beyond our control. Changes in the general level of interest
rates can affect our net interest income, which is the difference between the
interest income earned on interest-earning assets and the interest expense
incurred in connection with our interest-bearing liabilities, by affecting the
spread between our interest-earning assets and interest-bearing liabilities.
Changes in the level of interest rates also can affect the value of our
mortgage-backed securities and our ability to realize gains from the sale of
these assets. We may utilize a variety of financial instruments; including
interest rate swaps, caps, floors and other interest rate exchange contracts, in
order to limit the effects of interest rates on our operations. If we use these
types of derivatives to hedge the risk of interest-earning assets or
interest-bearing liabilities, we may be subject to certain risks, including the
risk that losses on a hedge position will reduce the funds available for
payments to holders of securities and that the losses may exceed the amount we
invested in the instruments. To date, we have not purchased any hedging
instruments.
Our profitability and the value of our portfolio may be adversely
affected during any period as a result of changing interest rates. The following
table quantifies the potential changes in net interest income and portfolio
value should interest rates go up or down 100 basis points, assuming the yield
curves of the rate shocks will be parallel to each other and the current yield
curve. All changes in income and value are measured as percentage changes from
the projected net interest income and portfolio value at the base interest rate
scenario. The base interest rate scenario assumes interest rates at December 31,
2002, and various estimates regarding prepayment and all activities are made at
each level of rate shock. Actual results could differ significantly from these
estimates.
Projected Percentage Change in Projected Percentage Change in
Change in Interest Rate Net Interest Income Portfolio Value
- ---------------------------------------- -------------------------------------- --------------------------------------
- -100 Basis Points (5%) 2%
- -50 Basis Points (3%) 1%
- -25 Basis Points (1%) 1%
Base Interest Rate
+25 Basis Points 3% (1%)
+50 Basis Points 3% (1%)
+100 Basis Points 1% (2%)
ASSET AND LIABILITY MANAGEMENT
Asset and liability management is concerned with the timing and
magnitude of the repricing of assets and liabilities. We attempt to control
risks associated with interest rate movements. Methods for evaluating interest
rate risk include an analysis of our interest rate sensitivity "gap", which is
the difference between interest-earning assets and interest-bearing liabilities
maturing or repricing within a given time period. A gap is considered positive
when the amount of interest-rate sensitive assets exceeds the amount of
interest-rate sensitive liabilities. A gap is considered negative when the
amount of interest-rate sensitive liabilities exceeds interest-rate sensitive
assets. During a period of rising interest rates, a negative gap would tend to
adversely affect net interest income, while a positive gap would tend to result
in an increase in net interest income. During a period of falling interest
rates, a negative gap would tend to result in an increase in net interest
income, while a positive gap would tend to affect net interest income adversely.
Because different types of assets and liabilities with the same or similar
maturities may react differently to changes in overall market rates or
conditions, changes in interest rates may affect net interest income positively
44
or negatively even if an institution were perfectly matched in each maturity
category.
The following table sets forth the estimated maturity or repricing of
our interest-earning assets and interest-bearing liabilities at December 31,
2002. The amounts of assets and liabilities shown within a particular period
were determined in accordance with the contractual terms of the assets and
liabilities, except adjustable-rate loans, and securities are included in the
period in which their interest rates are first scheduled to adjust and not in
the period in which they mature. Mortgage-backed securities reflect estimated
prepayments that were estimated based on analyses of broker estimates, the
results of a prepayment model that we utilized and empirical data. Our
management believes that these assumptions approximate actual experience and
considers them reasonable; however, the interest rate sensitivity of our assets
and liabilities in the table could vary substantially if different assumptions
were used or actual experience differs from the historical experience on which
the assumptions are based.
More than 1
Within 3 Months Year to 3 Years 3 Years and
4-12 Months Over Total
(dollars in thousands)
-------------------------------------------------------------------------------------
---------------- ----------------- ---------------- ---------------- ----------------
Rate Sensitive Assets:
Mortgage-Backed Securities $3,833,919 $847,137 $1,853,611 $4,667,717 $11,202,384
Rate Sensitive Liabilities:
Repurchase Agreements 8,699,409 $1,463,765 10,163,174
---------------- ----------------- ---------------- ---------------- ----------------
Interest rate sensitivity gap ($4,865,490) $847,137 $389,846 $4,667,717 $1,039,210
================ ================= ================ ================ ================
Cumulative rate sensitivity gap
($4,864,990) ($4,018,353) ($3,628,507) $1,039,210
================ ================= ================ ================
Cumulative interest rate
sensitivity gap as a percentage
of total rate-sensitive assets
(43.43%) (35.87%) (32.39%) 9.28%
Our analysis of risks is based on management's experience, estimates,
models and assumptions. These analyses rely on models which utilize estimates of
fair value and interest rate sensitivity. Actual economic conditions or
implementation of investment decisions by our management may produce results
that differ significantly form the estimates and assumptions used in our models
and the projected results shown in the above tables and in this report. These
analyses contain certain forward-looking statements and are subject to the safe
harbor statement set forth under the heading, "Special Note Regarding
Forward-Looking Statements."
45
ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Our financial statements and the related notes, together with the Independent
Auditors' Report thereon, are set forth on pages F-1 through F-17 of this Form
10-K.
ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
PART III
ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by Item 10 as to our directors is incorporated herein
by reference to the definitive proxy statement we are filing pursuant to
Regulation 14A. The information required by Item 10 as to our compliance with
Section 16(a) of the Securities Exchange Act of 1934 is incorporated by
reference to the definitive proxy statement we are filing pursuant to Regulation
14A.
ITEM 11 EXECUTIVE COMPENSATION
The information required by Item 11 is incorporated herein by reference to the
definitive proxy statement we are filing pursuant to Regulation 14A.
ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
The information required by Item 12 is incorporated herein by reference to the
definitive proxy statement we are filing pursuant to Regulation 14A.
ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by Item 13 is incorporated herein by reference to the
definitive proxy statement we are filing pursuant to Regulation 14A.
ITEM 14 CONTROLS AND PROCEDURES
Within 90 days prior to the date of this report, we carried out an evaluation,
under the supervision and with the participation of our principal executive
officer and principal financial officer, of the effectiveness of the design and
operation of our disclosure controls and procedures. Based on this evaluation,
our principal executive officer and principal financial officer concluded that
our disclosure controls and procedures are effective in timely alerting them to
material information required to be included in our periodic SEC reports. It
should be noted that the design of any system of controls is based in part upon
certain assumptions, and there can be no assurance that any design will succeed
in achieving its stated goals.
In addition, we reviewed our internal controls, and there have been no
significant changes in our internal controls or in other factors that could
significantly affect those controls subsequent to the date of their last
evaluation.
46
PART IV
ITEM 15 EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) Documents filed as part of this report:
1. Financial Statements.
2. Schedules to Financial Statements:
All financial statement schedules not included have been omitted
because they are either inapplicable or the information required is provided in
our Financial Statements and Notes thereto, included in Part II, Item 8, of this
Annual Report on Form 10-K.
3. Exhibits:
EXHIBIT INDEX
Exhibit Exhibit Description
Number
3.1 Articles of Incorporation of the Registrant (incorporated by reference
to Exhibit 3.1 to our Registration Statement on Form S-11
(Registration No. 333-32913) filed with the Securities and Exchange
Commission on August 5, 1997).
3.2 Articles of Amendment and Restatement of the Articles of Incorporation
of the Registrant (incorporated by reference to Exhibit 3.2 to our
Registration Statement on Form S-11 (Registration No. 333-32913) filed
with the Securities and Exchange Commission on August 5, 1997).
3.3 Articles of Amendment of the Articles of Incorporation of the
Registrant (incorporated to Exhibit 3.1 of the Registrant's
Registration Statement on Form S-3 (Registration Statement 333-74618)
filed with the Securities and Exchange Commission on June 12, 2002).
3.4 Bylaws of the Registrant, as amended (incorporated by reference to
Exhibit 3.3 to our Registration Statement on Form S-11 (Registration
No. 333-32913) filed with the Securities and Exchange Commission on
August 5, 1997).
4.1 Specimen Common Stock Certificate (incorporated by reference to
Exhibit 4.1 to Amendment No. 1 to our Registration Statement on Form
S-11 (Registration No. 333-32913) filed with the Securities and
Exchange Commission on September 17, 1997).
4.2 Specimen Preferred Stock Certificate (incorporated by reference to
Exhibit 4.2 to the Registrant's Registration Statement on Form S-3
(Registration No. 333-74618) filed with the Securities and Exchange
Commission on December 5, 2001).
10.1 Purchase Agreement, dated February 12, 1997, between the Registrant
and Friedman, Billings, Ramsey & Co., Inc. ("FBR") (incorporated by
reference to Exhibit 10.1 to our Registration Statement on Form S-11
(Registration No. 333-32913), filed with the Securities and Exchange
Commission on August 5, 1997).
10.2 Registration Rights Agreement, dated February 12, 1997, between the
Registrant and FBR (incorporated by reference to Exhibit 10.2 to our
Registration Statement on Form S-11 (Registration No. 333-32913) filed
with the Securities and Exchange Commission on August 5, 1997).
10.3 Long-Term Stock Incentive Plan (incorporated by reference to Exhibit
10.3 to our Registration Statement on Form S-11 (Registration No.
333-32913) filed with the Securities and Exchange Commission on August
5, 1997).*
10.4 Form of Master Repurchase Agreement (incorporated by reference to
Exhibit 10.7 to our Registration Statement on Form S-11 (Registration
No. 333-32913) filed with the Securities and Exchange Commission on
August 5, 1997).
10.5 Form of Purchase Agreement, between the Registrant and the purchasers
in the Direct Offering (incorporated by reference to Exhibit 10.8 to
our Registration Statement on Form S-11 (Registration No. 333-32913)
filed with the Securities and Exchange Commission on August 5, 1997).
10.6 Amended and Restated Employment Agreement, effective as of May 1, 2001
between the Registrant and Michael A.J. Farrell (incorporated by
reference to Exhibit 10.1 to our Form 10-Q/A for its quarterly period
ended June 30, 2001 filed with the Securities and Exchange Commission
on August 27, 2001).*
10.7 Amended and Restated Employment Agreement, effective as of May 1,
2001, between the Registrant and Wellington St. Claire (incorporated
by reference to Exhibit 10.2 to our Form 10-Q/A for its quarterly
period ended June 30, 2001 filed with the Securities and Exchange
Commission on August 27, 2001).*
10.8 Amended and Restated Employment Agreement, effective as of May 1, 2001
between the Registrant and Kathryn F. Fagan (incorporated by reference
to Exhibit 10.3 to our Form 10-Q/A for its quarterly period ended June
30, 2001 filed with the Securities and Exchange Commission on August
27, 2001).*
10.9 Amended and Restated Employment Agreement, effective as of May 1,
2001, between the Registrant and Jennifer A. Stephens (incorporated by
reference to Exhibit 10.4 to our Form 10-Q/A for its quarterly period
ended June 30, 2001 filed with the Securities and Exchange Commission
on August 27, 2001).*
23.1 Consent of Independent Auditors.
99.1 Certification of Michael A.J. Farrell, Chairman, Chief Executive
Officer, and President of the Registrant, pursuant to 18 U.S.C.
Section 1350.
99.2 Certification of Kathryn F. Fagan, Chief Financial Officer and
Treasurer of the Registrant, pursuant to 18 U.S.C. Section 1350.
* Exhibit Numbers 10.3 and 10-6-10.9 are management contracts or
compensatory plans required to be filed as Exhibits to this Form 10-K.
II-4
(b) Reports on Form 8-K
On January 25, 2002, we filed a Form 8-K with respect to our entering into an
underwriting agreement with UBS Warburg LLC, Merrill Lynch, Pierce Fenner &
Smith Incorporated, ABN AMRO Rothschild, LLC, Friedman, Billings, Ramsey & Co.,
Inc., RBC Dain Rauscher Inc., and U.S. Bancorp Piper Jaffray Inc., as
representatives of the several underwriters.
On July 8, 2002, we filed a Form 8-K with respect to our entering into a Sales
Agency Agreement with UBS Warburg LLC.
None
Annaly Mortgage Management, Inc.
Independent Auditors' Report
Financial Statements
Years Ended December 31, 2002, 2001, and 2000
Annaly Mortgage Management, Inc.
NOTES TO FINANCIAL STATEMENTS
- --------------------------------------------------------------------------------------------------------------------------
Page
INDEPENDENT AUDITORS' REPORT F-1
FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2002, 2001, AND 2000:
Statements of Financial Condition F-2
Statements of Operations F-3
Statements of Stockholders' Equity F-4
Statement of Cash Flows F-5
Notes to Financial Statements F-6-F-17
F-1
INDEPENDENT AUDITORS' REPORT
To the board of directors and Stockholders of Annaly Mortgage Management, Inc.
We have audited the accompanying statements of financial condition of Annaly
Mortgage Management, Inc. (the "Company") as of December 31, 2002 and 2001, and
the related statements of operations, changes in stockholders' equity, and cash
flows for each of the three years in the period ended December 31, 2002. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with auditing standards generally accepted
in the United States of America. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material
respects, the financial position of the Company at December 31, 2002 and 2001,
and the results of its operations and its cash flows for each of the three years
in the period ended December 31, 2002, in conformity with accounting principles
generally accepted in the United States of America.
/s/ Deloitte & Touche LLP
- -------------------------
New York, New York
February 26, 2003
F-1
ANNALY MORTGAGE MANAGEMENT, INC.
STATEMENTS OF FINANCIAL CONDITION
DECEMBER 31, 2002 AND 2001
- ------------------------------------------------------------------------------------------------------------------------
2002 2001
ASSETS (dollars in thousands)
---------------------------------------------
CASH AND CASH EQUIVALENTS $ 726 $ 429
MORTGAGE-BACKED SECURITIES - At fair value 11,551,857 7,575,379
RECEIVABLE FOR MORTGAGE-BACKED
SECURITIES SOLD 55,954 94,503
ACCRUED INTEREST RECEIVABLE 49,707 46,804
OTHER ASSETS 840 199
---- ---
TOTAL ASSETS $ 11,659,084 $ 7,717,314
============= ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES:
Repurchase agreements $ 10,163,174 $ 6,367,710
Payable for Mortgage-Backed Securities purchased 338,691 627,064
Accrued interest payable 14,935 16,043
Dividends payable 57,499 35,896
Other liabilities 2,812 2,010
Accounts payable 1,907 1,234
------ -----
Total liabilities 10,579,018 7,049,957
----------- ---------
STOCKHOLDERS' EQUITY:
Common stock: par value $.01 per share;
500,000,000 authorized, 84,569,206 and 59,826,975
shares issued and outstanding, respectively 846 598
Additional paid-in capital 1,003,200 623,986
Accumulated other comprehensive income 75,511 38,169
Retained earnings 509 4,604
---- -----
Total stockholders' equity 1,080,066 667,357
---------- -------
TOTAL LIABILITIES AND STOCKHOLDERS'
EQUITY $ 11,659,084 $ 7,717,314
============= ===========
See notes to financial statements
F-2
ANNALY MORTGAGE MANAGEMENT, INC.
STATEMENTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 2002, 2001, AND 2000
- ------------------------------------------------------------------------------------------------------------------------
2002 2001 2000
(dollars in thousands, except for per share data)
-------------------------------------------------------
INTEREST INCOME:
Mortgage-Backed Securities and cash equivalents $ 404,165 $ 263,058 $ 109,751
INTEREST EXPENSE -
Repurchase agreements 191,758 168,055 92,902
-------- -------- ------
NET INTEREST INCOME 212,407 95,003 16,849
GAIN ON SALE OF MORTGAGE-BACKED
SECURITIES 21,063 4,586 2,025
GENERAL AND ADMINISTRATIVE EXPENSES 13,963 7,311 2,287
------- ------ -----
NET INCOME 219,507 92,278 16,587
-------- ------- ------
OTHER COMPREHENSIVE GAIN:
Unrealized gain on available-for-sale securities 58,405 55,800 26,549
Less reclassification adjustment for gains included in net
income (21,063) (4,586) (2,025)
--------- -------- -------
Other comprehensive gain 37,342 51,214 24,524
------- ------- ------
TOTAL COMPREHENSIVE INCOME $ 256,849 $ 143,492 $ 41,111
========== ========== ========
NET INCOME PER SHARE:
Basic $ 2.68 $ 2.23 $ 1.18
======= ======= ======
Diluted $ 2.67 $ 2.21 $ 1.15
======= ======= ======
AVERAGE NUMBER OF SHARES OUTSTANDING:
Basic 82,044,141 41,439,631 14,089,436
=========== =========== ==========
Diluted 82,282,883 41,857,498 14,377,459
=========== =========== ==========
See notes to financial statements.
F-3
ANNALY MORTGAGE MANAGEMENT, INC.
STATEMENTS OF STOCKHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 2002, 2001, AND
2000
(dollars in thousands)
- ------------------------------------------------------------------------------------------------------------------------------------
Accumulated
Common Additional Other
Stock Paid-in Comprehensive Retained Comprehensive
Par Value Capital Income Earnings Income Total
(Loss)
BALANCE, DECEMBER 31, 1999 135 140,263 443 (37,569) 103,272
Other comprehensive income:
Unrealized net gains on
securities,
net of reclassification
adjustment - - 24,524 - 24,524
-------------
Comprehensive income - - $41,111 - - 41,111
=============
Exercise of stock options 198 - - 198
Proceeds from direct purchase 9 7,384 - - 7,393
Dividends declared for the year ended
December 31, 2000, $1.15 per
share - - (16,333) - (16,333)
----- -------- -------- -------- --------
BALANCE, DECEMBER 31, 2000 144 147,845 697 (13,045) 135,641
Net income $92,278 92,278
Other comprehensive income:
Unrealized net gains on securities,
net of reclassification
adjustment - - 51,214 - 51,214
-------------
Comprehensive income - - $143,492 - - 143,492
=============
Exercise of stock options 3 2,972 - - 2,975
Shares exchanged upon exercise
of stock options (587) (587)
Proceeds from direct purchase 142 - - 142
Proceeds from secondary
offerings 451 473,614 474,065
Dividends declared for the year
ended
December 31, 2001, $1.75 per
share - - (88,371) - (88,371)
----- -------- -------- -------- --------
BALANCE, DECEMBER 31, 2001 $598 $623,986 4,604 38,169 667,357
Net income $219,507 219,507
Other comprehensive income:
Unrealized net gains on
securities,
net of reclassification
adjustment 37,342 - 37,342
-------------
Comprehensive income $256,849 - - 256,849
=============
Exercise of stock options 1 1,089 - - 1,090
Shares exchanged upon exercise
of stock options (76) (76)
Proceeds from direct purchase 2 3,007 - - 3,009
Proceeds from secondary
offerings 230 347,106 347,336
Proceeds from equity shelf
program 15 28,088 28,103
Dividends declared for the year
ended
December 31, 2002, $2.67 per
share - - (223,602) - (223,602)
----- ---------- -------- -------- ------------
BALANCE, DECEMBER 31, 2002 $846 $1,003,200 $509 $75,511 $1,080,066
===== ========== ======== ======== ============
See notes to financial statements
F-4
ANNALY MORTGAGE MANAGEMENT, INC.
STATEMENT OF CASH FLOWS
YEARS ENDED DECEMBER 31, 2002, 2001, AND 2000
- ------------------------------------------------------------------------------------------------------------------------------------
2002 2001 2000
(dollars in thousands)
------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 219,507 $ 92,278 $ 16,587
Adjustments to reconcile net income to
net cash provided by operating activities:
Amortization of mortgage premiums and discounts, net 106,198 36,865 2,647
Market value adjustment on long term
repurchase agreement 1,204 986
Gain on sale of Mortgage-Backed Securities (21,063) (4,587) (2,025)
Stock option expense 240 790
Increase in accrued interest receivable (2,903) (35,301) (4,645)
(Increase) decrease in other assets (641) 61 (62)
(Decrease) increase in accrued interest payable (1,109) 7,729 1,631
Increase in other liabilities and accounts payable 673 950 120
---- ---- ---
Net cash provided by operating activities 302,106 99,771 14,253
-------- ------- ------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of Mortgage-Backed Securities (11,079,561) (8,194,215) (952,738)
Proceeds from sale of Mortgage-Backed Securities 2,076,800 1,248,812 489,810
Principal payments on Mortgage-Backed Securities 4,728,666 1,685,874 168,517
---------- ---------- -------
Net cash used in investing activities (4,274,095) (5,259,529) (294,411)
------------ ------------ ---------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from repurchase agreements 87,463,924 49,773,650 14,196,953
Principal payments on repurchase agreements (83,668,862) (45,033,275) (13,906,890)
Proceeds from exercise of stock options 774 1,597 199
Proceeds from direct equity offering 3,010 142 7,393
Proceeds from secondary offerings 375,439 474,065 -
Dividends paid (201,999) (56,105) (17,456)
---------- --------- --------
Net cash provided by financing activities 3,972,286 5,160,074 280,199
---------- ---------- -------
NET INCREASE IN CASH AND CASH EQUIVALENTS 297 316 41
CASH AND CASH EQUIVALENTS,
BEGINNING OF YEAR 429 113 72
---- ---- --
CASH AND CASH EQUIVALENTS, END OF YEAR $ 726 $ 429 $ 113
====== ====== =====
SUPPLEMENTAL DISCLOSURE OF CASH FLOW
INFORMATION:
Interest paid $ 190,650 $ 160,327 $ 91,270
========== ========== ========
NONCASH FINANCING ACTIVITIES:
Net change in unrealized loss on available-for-sale
securities $ 37,342 $ 51,214 $ (24,524)
========= ========= ==========
Dividends declared, not yet paid $ 57,499 $ 35,896 $ 3,631
========= ========= =======
See notes to financial statements.
F-5
Annaly Mortgage Management, Inc.
NOTES TO FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2002, 2001, AND 2000
- --------------------------------------------------------------------------------
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
Annaly Mortgage Management, Inc. (the "Company") was incorporated in Maryland on
November 25, 1996. The Company commenced its operations of purchasing and
managing an investment portfolio of Mortgage-Backed Securities on February 18,
1997, upon receipt of the net proceeds from the private placement of equity
capital. An initial public offering was completed on October 14, 1997.
A summary of the Company's significant accounting policies follows:
Cash and Cash Equivalents - Cash and cash equivalents includes cash on
hand and money market funds. The carrying amount of cash equivalents
approximates their value.
Mortgage-Backed Securities - The Company invests primarily in mortgage
pass-through certificates, collateralized mortgage obligations and
other mortgage-backed securities representing interests in or
obligations backed by pools of mortgage loans (collectively,
"Mortgage-Backed Securities").
Statement of Financial Accounting Standards No. 115, Accounting for
Certain Investments in Debt and Equity Securities, requires the Company
to classify its investments as either trading investments,
available-for-sale investments or held-to-maturity investments.
Although the Company generally intends to hold most of its
Mortgage-Backed Securities until maturity, it may, from time to time,
sell any of its Mortgage-Backed Securities as part of its overall
management of its balance sheet. Accordingly, this flexibility requires
the Company to classify all of its Mortgage-Backed Securities as
available-for-sale. All assets classified as available-for-sale are
reported at fair value, based on market prices provided by certain
dealers who make markets in these financial instruments, with
unrealized gains and losses excluded from earnings and reported as a
separate component of stockholders' equity.
Unrealized losses on Mortgage-Backed Securities that are considered
other than temporary, as measured by the amount of decline in fair
value attributable to factors other than temporary, are recognized in
income and the cost basis of the Mortgage-Backed Securities is
adjusted. There were no such adjustments for the years ended December
31, 2002, 2001, and 2000.
Interest income is accrued based on the outstanding principal amount of
the Mortgage-Backed Securities and their contractual terms. Premiums
and discounts associated with the purchase of the Mortgage-Backed
Securities are amortized into interest income over the lives of the
securities using the interest method.
Mortgage-Backed Securities transactions are recorded on the trade date.
Purchases of newly issued securities are recorded when all significant
uncertainties regarding the characteristics of the securities are
removed, generally shortly before settlement date. Realized gains and
losses on Mortgage-Backed Securities transactions are determined on the
specific identification basis.
F-6
Credit Risk - At December 31, 2002 and 2001, the Company has limited
its exposure to credit losses on its portfolio of Mortgage-Backed
Securities by only purchasing securities issued by Federal Home Loan
Mortgage Corporation ("FHLMC"), Federal National Mortgage Association
("FNMA"), or Government National Mortgage Association ("GNMA"). The
payment of principal and interest on the FHLMC and FNMA Mortgage-Backed
Securities are guaranteed by those respective agencies and the payment
of principal and interest on the GNMA Mortgage-Backed Securities are
backed by the full-faith-and-credit of the U.S. government. At December
31, 2002 and 2001, all of the Company's Mortgage-Backed Securities have
an implied "AAA" rating.
Repurchase Agreements - The Company finances the acquisition of its
Mortgage-Backed Securities through the use of repurchase agreements.
Repurchase agreements are treated as collateralized financing
transactions and are carried at their contractual amounts, including
accrued interest, as specified in the respective agreements. Accrued
interest is recorded as a separate line item.
Income Taxes - The Company has elected to be taxed as a Real Estate
Investment Trust ("REIT") and intends to comply with the provisions of
the Internal Revenue Code of 1986, as amended (the "Code") with respect
thereto. Accordingly, the Company will not be subjected to federal
income tax to the extent of its distributions to shareholders and as
long as certain asset, income and stock ownership tests are met.
Use of Estimates - The preparation of financial statements in
conformity with generally accepted accounting principles requires
management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets
and liabilities at the date of the financial statements and the
reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
New Accounting Pronouncement - In December 2002, the FASB issued
Statement of Financial Accounting Standard (SFAS) No. 148, "Accounting
for Stock-Based Compensation-Transition and Disclosures, an Amendment
of FASB Statement No123." This Statement provides alternative methods
of transition for companies who voluntarily change to the fair
value-based method of accounting for stock-based employee compensation
in accordance with SFAS NO. 123, "Accounting for Stock-Based
Compensation." (SFAS 123). SFAS No. 148 does not permit the use of the
original SFAS No. 123 prospective method of transition for changes to
the fair value based method made in fiscal years beginning after
December 15, 2003. The Statement also requires prominent disclosures in
both annual and interim financial statements about the method of
accounting for stock-based compensation and the effect of the method
used on reported results. This Statement is effective upon issuance
F-7
2. MORTGAGE-BACKED SECURITIES
The following table pertains to the Company's Mortgage-Backed Securities
classified as available-for-sale as of December 31, 2002, which are carried at
their fair value:
Federal Federal Government Total
Home Loan National National Mortgage-
Mortgage Mortgage Mortgage Backed
Corporation Association Association Securities
(dollars in the thousands)
----------------------------------------------------------------------------------
Mortgage-Backed
Securities, gross $ 5,120,929 $ 5,860,987 $ 220,468 $ 11,202,384
Unamortized discount (544) (120) - (664)
Unamortized premium 105,872 164,071 4,684 274,627
-------- -------- ------ -------
Amortized cost 5,226,257 6,024,938 225,152 11,476,347
Gross unrealized gains 31,731 58,239 537 90,507
Gross unrealized losses (9,554) (5,318) (125) (14,997)
-------- -------- ------ --------
Estimated fair value $ 5,248,434 $ 6,077,859 $ 225,564 $ 11,551,857
============ ============ ========== ============
Amortized Cost Gross Unrealized Gain Gross Unrealized Loss Estimated Fair Value
Adjustable Rate $ 7,144,741 $ 35,349 $ (12,424) $ 7,167,666
Fixed Rate 4,331,606 55,158 (2,573) 4,384,191
---------- ------- -------- ----------
Total $ 11,476,347 $ 90,507 $ (14,997) $ 11,551,857
============= ========= =========== ============
F-8
The following table pertains to the Company's Mortgage-Backed Securities
classified as available-for-sale as of December 31, 2001, which are carried at
their fair value:
Federal Federal Government Total
Home Loan National National Mortgage-
Mortgage Mortgage Mortgage Backed
Corporation Association Association Securities
(dollars in thousands)
---------------------------------------------------------------------------------
Mortgage-Backed \
Securities, gross $ 4,426,195 $ 2,894,026 $ 79,720 $ 7,399,941
Unamortized discount (1,346) (755) - (2,101)
Unamortized premium 83,775 54,118 1,477 139,370
------- ------- ------ -------
Amortized cost 4,508,624 2,947,389 81,197 7,537,210
Gross unrealized gains 32,636 21,224 75 53,935
Gross unrealized losses (7,986) (7,314) (466) (15,766)
-------- -------- ------ --------
Estimated fair value $ 4,533,274 $ 2,961,299 $ 80,806 $ 7,575,379
============ ============ ========= ===========
Amortized Cost Gross Unrealized Gain Gross Unrealized Loss Estimated Fair Value
Adjustable Rate $ 5,908,236 $ 44,469 $ (10,049) $ 5,942,656
Fixed Rate 1,628,974 9,466 (5,717) 1,632,723
---------- ------ -------- ---------
Total $ 7,537,210 $ 53,935 $ (15,766) $ 7,575,379
============ ========= =========== ===========
The adjustable rate Mortgage-Backed Securities are limited by periodic caps
(generally interest rate adjustments are limited to no more than 1% every six
months) and lifetime caps. The weighted average lifetime cap was 8.8% and 11.5%
at December 31, 2002 and 2001, respectively.
During the year ended December 31, 2002, the Company realized $21.1 million in
gains from sales of Mortgage-Backed Securities. During the year ended December
31, 2001, the Company realized $6.8 million in gains from sales of
Mortgage-Backed Securities. Losses totaled $2.2 million for the year ended
December 31, 2001. During the year ended December 31, 2000, the Company realized
$2.0 million in gains from sales of Mortgage-Backed Securities.
3. REPURCHASE AGREEMENTS
The Company had outstanding $10,163,174,000 and $6,367,710,000 of repurchase
agreements with a weighted average borrowing rate of 1.72% and 2.18% and a
weighted average remaining maturity of 124 days and 85 days as of December 31,
2002 and 2001, respectively. At December 31, 2002 and 2001, Mortgage-Backed
Securities pledged had an estimated fair value of $10,517,558,000 and
$6,564,250,000, respectively.
F-9
At December 31, 2002 and 2001 the repurchase agreements had the following
remaining maturities:
2002 2001
---------------------------------------------
(dollars in thousands)
Within 30 days $ 7,778,003 $ 5,380,006
30 to 59 days 816,906 206,947
60 to 89 days 104,500 66,202
90 to 119 days 65,037
Over 120 days 1,463,765 649,518
---------------------- ---------------------
$ 10,163,174 $ 6,367,710
============= ===========
4. OTHER LIABILITIES
In 2001, the Company entered into a repurchase agreement maturing in July 2004,
at which time, the repurchase agreement gives the buyer the right to extend, in
whole or in part, in three-month increments up to July 2006. The repurchase
agreement has a principal value of $100,000,000. The Company accounts for the
extension option as a separate interest rate floor liability carried at fair
value. The initial fair value of $1,200,000 allocated to the extension option
resulted in a similar discount on the repurchase agreement borrowings that is
being amortized over the initial term of 3 years using the effective yield
method. At December 31, 2002, the fair value of this interest rate floor was a
$2,812,000 and was classified as other liabilities. The aggregate charge of
$1,204,000 and $986,000 is included in interest expense for 2002 and 2001,
respectively.
5. COMMON STOCK
During the Company's year ending December 31, 2002, the Company declared
dividends to shareholders totaling $223,602,000, or $2.67 per share, of which
$166,102,000 was paid during the year and $57,499,000 was paid on January 29,
2003. During the year ended December 31, 2002, 97,095 options were exercised at
$1,090,000. Total shares exchanged upon exercise of the stock options were 4,444
at a value of $76,000. Through the Equity Shelf Program, the Company raised
$28,103,000 in net proceeds and issued 1,481,000 shares. Also, 165,480 shares
were purchased in dividend reinvestment and share purchase plan, totaling
$3,009,000. The Company completed an offering of common stock in the first
quarter issuing 23,000,000 shares, with aggregate net proceeds of $347.3
million.
During the Company's year ending December 31, 2001, the Company declared
dividends to shareholders totaling $88,370,451, or $1.75 per share, of which
$52,474,266 was paid during the year and $35,896,185 was paid on January 30,
2002. During the year ended December 31, 2001, 274,231 options were exercised at
$2,974,666. Total shares exchanged upon exercise of the stock options were
41,620 at a value of $588,068. Also, 10,856 shares were purchased in dividend
reinvestment and share purchase plan, totaling $142,456. The Company completed
an offering of common stock in the third quarter issuing 14,991,600 shares, with
aggregate net proceeds of $179.6 million. An offering of common stock during the
second quarter of 2001 was completed issuing 18,918,500 shares, with aggregate
net proceeds of $195.3 million. Additional offerings for 11,150,000 shares were
completed during the first quarter for aggregate net proceeds of $99.3 million.
During the Company's year ending December 31, 2000, the Company declared
dividends to shareholders totaling $16,333,252, or $1.15 per share, of which
$12,702,507 was paid during the year and $3,630,745 was paid on January 30,
2001. During the year ended December 31, 2000, 47,499 options were exercised at
$198,762. Also, 894,163 shares were purchased in direct offerings, totaling
$7,392,859.
F-10
6. EARNINGS PER SHARE (EPS)
For the year ended December 31, 2002, the reconciliation is as follows:
For the Year Ended
December 31, 2002
(dollars in thousands, except for per share data)
----------------------------------------------------------
Income Shares Per-Share
(Numerator) (Denominator) Amount
----------------------------------------------------------
Net income $ 219,507
----------
Basic EPS 219,507 82,044,141 $ 2.68
======
Effect of dilutive securities:
Dilutive stock options - 238,742
-- -------
Diluted EPS $ 219,507 82,282,883 $ 2.67
========== =========== ======
Options to purchase 6,250 shares of stock were outstanding and considered
anti-dillutive as their exercise price exceeded the average stock price for the
year.
For the year ended December 31, 2001, the reconciliation is as follows:
For the Year Ended
December 31, 2001
(dollars in thousands, except for per share data)
----------------------------------------------------
Average
Income Shares Per-Share
(Numerator) (Denominator) Amount
----------------------------------------------------
Net income $ 92,278
---------
Basic EPS 92,278 41,439,631 $ 2.23
======
Effect of dilutive securities:
Dilutive stock options - 417,867
-- -------
Diluted EPS $ 92,278 41,857,498 $ 2.21
========= =========== ======
Options to purchase 6,250 shares of stock were outstanding and considered
anti-dilutive as their exercise price exceeded the average stock price for the
year.
F-11
For the year ended December 31, 2000, the reconciliation is as follows:
For the Year Ended
December 31, 2000
(dollars in the thousands, except per share data)
------------------------------------------------------
Average
Income Shares Per-Share
(Numerator) (Denominator) Amount
------------------------------------------------------
Net income $ 16,587
---------
Basic EPS 16,587 14,089,436 $ 1.18
======
Effect of dilutive securities:
Dilutive stock options - 288,023
-- -------
Diluted EPS $ 16,587 14,377,459 $ 1.15
========= =========== ======
Options to purchase 568,926 shares of stock were outstanding and considered
anti-dilutive. The exercise price exceeded the average stock price for the year.
7. LONG-TERM STOCK INCENTIVE PLAN
The Company has adopted a long term stock incentive plan for executive officers,
key employees and nonemployee directors (the "Incentive Plan"). The Incentive
Plan authorizes the Compensation Committee of the board of directors to grant
awards, including incentive stock options as defined under Section 422 of the
Code ("ISOs") and options not so qualified ("NQSOs"). The Incentive Plan
authorizes the granting of options or other awards for an aggregate of the
greater of 500,000 shares or 9.5% of the fully diluted outstanding shares of the
Company's common stock.
The following table sets forth activity relating to the Company's stock options
awards
2002 2001 2000
Weighted Weighted Weighted
Number of Average Number of Average Number of Average
Shares Exercise Shares Exercise Shares Exercise
Price Price Price
Options outstanding at the
beginning of period 635,826 $8.48 903,807 $8.28 844,056 $8.03
Granted 6,250 20.35 6,250 13.69 122,500 8.00
Exercised (97,095) 8.75 (274,231) 7.95 (47,499) 4.18
Expired (32,275) 8.28 (15,250) 9.17
-------------- -------------- -------------- -------------- ------------- -------------
Options outstanding at the end
of period 512,706 $8.59 635,826 $8.48 903,807 8.28
============== ============== ============== ============== ============= =============
Options exercisable at end of
period 393,076 $8.67 335,328 $8.63 341,226 $8.72
F-12
The following table summarizes information about stock options outstanding at
December 31, 2002:
Weighted Average
Options Weighted Average Remaining Contractual
Range of Exercise Price Outstanding Exercise Price Life (Yrs.)
-----------------------------------------------------------------------------------------------------
$7.94-$19.99 506,456 8.44 6.5
$20.00-$29.99 6,250 20.35 4.5
---------------------------------------------------------------
512,706 8.59 6.5
===============================================================
The Company accounts for the incentive plan under the intrinsic value
method in accordance with APB Opinion No. 25, Accounting for Stock Issued to
Employees, and related Interpretations. No stock-based employee compensation
cost is reflected in net income, as all options granted under those plans had an
exercise price equal to the market value of the underlying common stock on the
date of grant. The following table illustrates the effect on net income and
earnings per share if the company had applied the fair value recognition
provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation,
to stock-based employee compensation.
For the Year Ended December 31,
2002 2001 2000
(dollars in thousands, except per share data)
----------------- --------------- ---------------
Net income, as reported $219,507 $92,278 $16,587
Deduct: Total stock-based employee compensation expense
determined under fair value based method (33) (266) (118)
----------------- --------------- ---------------
Pro-forma net income $219,474 $92,012 $16,469
================= =============== ===============
Net income per share, as reported
Basic $2.68 $2.23 $1.18
Diluted $2.67 $2.21 $1.17
Pro-forma net income per share
Basic $2.68 $2.22 $1.17
Diluted $2.67 $2.20 $1.15
The weighted average fair value at date of grant for stock options
granted during the year ended December 31, 2002, 2001 and 2000 was $0.83, $0.89
and $0.43 per option, respectively. The fair value of stock options at date of
grant was estimated using the Black-Scholes option pricing model utilizing the
following weighted average assumptions:
For the Year Ended December 31,
2002 2001 2000
----------------------------------------------
Risk-free interest rate 4.02% 4.21% 5.16%
Expected option life in years 5 5 5
Expected stock price volatility 26% 28% 28%
Expected dividend yield 13.57% 15.32% 12.69%
F-13
8. COMPREHENSIVE INCOME
The Company adopted Statement of Financial Accounting Standards No. 130,
Reporting Comprehensive Income. Statement No. 130 requires the reporting of
comprehensive income in addition to net income from operations. Comprehensive
income is a more inclusive financial reporting methodology that includes
disclosure of certain financial information that historically has not been
recognized in the calculation of net income. The Company at December 31, 2002
and 2001 held securities classified as available-for-sale. At December 31, 2002,
the net unrealized gains totaled $75,511,000 and at December 31, 2001, the net
unrealized losses totaled $38,169,000.
9. LEASE COMMITMENTS
The Corporation has a noncancelable lease for office space, which commenced in
May 2002 and expires in December 2009.
The Corporation's aggregate future minimum lease payments are as follows:
Total per Year
(dollars in thousands)
2003 500
2004 500
2005 500
2006 530
2007 532
thereafter 1,064
------------------------
Total remaining lease payments $3,626
========================
10. RELATED PARTY TRANSACTION
Included in "Other Assets" on the Balance sheet as of December 31, 2001
is an investment in Annaly International Money Management, Inc. On June 24,
1998, the Company acquired 99,960 nonvoting shares, at a cost of $49,980. Annaly
International Money Management, Inc. was liquidated during the year, resulting
in a $44,000 loss, which is reflected in "Gain on Sale of Securities," in the
Statement of Operations. The officers and directors of Annaly International
Money Management Inc. are also officers and directors of the Company. Officers
and employees of the Company are actively involved in managing Mortgage-Backed
Securities and other fixed income assets for institutional clients through Fixed
Income Discount Advisory Company ("FIDAC"). FIDAC is a registered investment
adviser, which is owned 100% by the Chief Executive Officer of Annaly Mortgage
Management, Inc. Our management currently allocates rent and other general and
administrative expenses 90% to Annaly and 10% to FIDAC.
11. INTEREST RATE RISK
The primary market risk to the Company is interest rate risk. Interest
rates are highly sensitive to many factors, including governmental monetary and
tax policies, domestic and international economic and political considerations
and other factors beyond the Company's control. Changes in the general level of
interest rates can affect net interest income, which is the difference between
the interest income earned on interest-earning assets and the interest expense
incurred in connection with the interest-bearing liabilities, by affecting the
spread between the interest-earning assets and interest-bearing liabilities.
Changes in the level of interest rates also can affect the value of the
mortgage-backed securities and the Company's ability to realize gains from the
sale of these assets.
The Company seeks to manage the extent to which net income changes as a
function of changes in interest rates by matching adjustable-rate assets with
variable-rate borrowings. In addition, although the Company has not done so to
F-14
date, the Company may seek to mitigate the potential impact on net income of
periodic and lifetime coupon adjustment restrictions in the portfolio of
mortgage-backed securities by entering into interest rate agreements such as
interest rate caps and interest rate swaps.
Changes in interest rates may also have an effect on the rate of mortgage
principal prepayments and, as a result, prepayments on mortgage-backed
securities. The Company will seek to mitigate the effect of changes in the
mortgage principal repayment rate by balancing assets purchased at a premium
with assets purchased at a discount. To date, the aggregate premium exceeds the
aggregate discount on the mortgage-backed securities. As a result, prepayments,
which result in the expensing of unamortized premium, will reduce net income
compared to what net income would be absent such prepayments.
12. SUMMARIZED QUARTERLY RESULTS (UNAUDITED)
The following is a presentation of the quarterly results of operations for the
year ended December 31, 2002.
Quarters Ending
March 31, June 30, September 30, December 31,
2002 2002 2002 2002
(dollars in the thousands)
-----------------------------------------------------------------------
Interest income from Mortgage-
Backed Securities and cash $ 92,900 $ 109,423 $ 109,201 $ 92,641
Interest expense on repurchase
agreements 40,012 47,860 54,012 49,874
------- ------- ------- ------
Net interest income 52,888 61,563 55,189 42,767
Gain on sale of
Mortgage-Backed Securities 3,410 1,343 4,747 11,563
General and administrative
expenses 3,255 3,536 3,268 3,904
------ ------ ------ -----
Net income $ 53,043 $ 59,370 $ 56,668 $ 50,426
========= ========= ========= ========
Net income per share:
Basic $0.69 $0.72 $0.68 $0.60
====== ====== ====== =====
Diluted $0.69 $0.71 $0.68 $0.60
====== ====== ====== =====
Average number of shares outstanding:
Basic 76,709,836 82,910,206 83,668,422 84,525,171
=========== =========== =========== ==========
Diluted 77,017,431 83,186,865 83,939,870 84,766,747
=========== =========== =========== ==========
F-15
The following is a presentation of the quarterly results of operations for the
year ended December 31, 2001.
Quarters Ending
March 31, June 30, September 30, December 31,
2001 2001 2001 2001
(dollars in thousands)
-----------------------------------------------------------------------
Interest income from Mortgage-
Backed Securities and cash $ 42,434 $ 64,790 $ 75,775 $ 80,059
Interest expense on repurchase
agreements 33,453 45,284 48,620 40,698
------- ------- ------- ------
Net interest income 8,981 19,506 27,155 39,361
Gain on sale of
Mortgage-Backed Securities 269 482 1,184 2,651
General and administrative
expenses 921 1,393 1,993 3,004
---- ------ ------ -----
Net income $ 8,329 $ 18,595 $ 26,346 $ 39,008
======== ========= ========= ========
Net income per share:
Basic $0.38 $0.48 $0.58 $0.65
====== ====== ====== =====
Diluted $0.37 $0.48 $0.57 $0.65
====== ====== ====== =====
Average number of shares outstanding:
Basic 21,851,481 38,473,928 45,503,179 59,776,777
=========== =========== =========== ==========
Diluted 22,535,210 39,054,488 45,959,693 60,155,994
=========== =========== =========== ==========
F-16
The following is a presentation of the quarterly results of operations for the
year ended December 31, 2000.
Quarters Ending
March 31, June 30, September 30, December 31,
2000 2000 2000 2000
(dollars in thousands)
-----------------------------------------------------------------------
Interest income from Mortgage-
Backed Securities and cash $ 24,617 $ 25,735 $ 28,239 $ 31,160
Interest expense on repurchase
agreements 19,293 21,453 24,779 27,377
------- ------- ------- ------
Net interest income 5,324 4,282 3,460 3,783
Gain on sale of
Mortgage-Backed Securities 107 65 873 981
General and administrative
expenses 582 507 527 670
---- ---- ---- ---
Net income $ 4,849 $ 3,840 $ 3,806 $ 4,094
======== ======== ======== =======
Net income per share:
Basic $0.35 $0.27 $0.27 $0.28
====== ====== ====== =====
Diluted $0.35 $0.26 $0.26 $0.28
====== ====== ====== =====
Average number of shares outstanding:
Basic 13,660,539 14,039,741 14,238,680 14,413,578
=========== =========== =========== ==========
Diluted 13,971,112 14,631,940 14,529,142 14,702,189
=========== =========== =========== ==========
******
F-17
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized, in the city of New York,
State of New York.
ANNALY MORTGAGE MANAGEMENT, INC.
Date: March 24, 2003 By: /s/ Michael A. J. Farrell
Michael A. J. Farrell
Chairman, Chief Executive Officer, and President
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed below by the following persons on behalf of the registrant and
in the capacities and on the date indicated.
Title Date
Signature
/s/ KEVIN P. BRADY Director March 24, 2003
Kevin P. Brady
/s/ SPENCER I. BROWNE Director March 24, 2003
Spencer Browne
/s/ KATHRYN F. FAGAN Chief Financial Officer and Treasurer March 24, 2003
(principal financial and accounting officer)
Kathryn F. Fagan
/s/ MICHAEL A.J. FARRELL Chairman of the Board, Chief Executive Officer, March 24, 2003
President and Director (principal executive
Michael A. J. Farrell officer)
/s/ JONATHAN D. GREEN Director March 24, 2003
Jonathan D. Green
/s/ JOHN A. LAMBIASE Director March 24, 2003
John A. Lambiase
/s/ DONNELL A. SEGALAS Director March 24, 2003
Donnell A. Segalas
/s/ WELLINGTON DENAHAN Vice Chairman of the Board and Director March 24, 2003
Wellington Denahan
II-1
CERTIFICATIONS
I, Michael A.J. Farrell, certify that:
1. I have reviewed this annual report on Form 10-K of Annaly Mortgage
Management, Inc.;
2. Based on my knowledge, this annual report does not contain any
untrue statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by this
annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this annual report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of this
annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in
this annual report whether there were significant changes in internal controls
or in other factors that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
Date: March 24, 2003
/s/ Michael A.J. Farrell
- ------------------------
Michael A.J. Farrell
Chairman, Chief Executive Officer, and President (Principal Executive Officer)
II-2
CERTIFICATIONS
I, Kathryn F. Fagan, certify that:
1. I have reviewed this annual report on Form 10-K of Annaly Mortgage
Management, Inc.;
2. Based on my knowledge, this annual report does not contain any
untrue statement of a material fact or omit to state a material fact necessary
to make the statements made, in light of the circumstances under which such
statements were made, not misleading with respect to the period covered by this
annual report;
3. Based on my knowledge, the financial statements, and other financial
information included in this annual report, fairly present in all material
respects the financial condition, results of operations and cash flows of the
registrant as of, and for, the periods presented in this annual report;
4. The registrant's other certifying officers and I are responsible for
establishing and maintaining disclosure controls and procedures (as defined in
Exchange Act Rules 13a-14 and 15d-14) for the registrant and have:
a) designed such disclosure controls and procedures to ensure that
material information relating to the registrant, including its consolidated
subsidiaries, is made known to us by others within those entities, particularly
during the period in which this annual report is being prepared;
b) evaluated the effectiveness of the registrant's disclosure controls
and procedures as of a date within 90 days prior to the filing date of this
annual report (the "Evaluation Date"); and
c) presented in this annual report our conclusions about the
effectiveness of the disclosure controls and procedures based on our evaluation
as of the Evaluation Date;
5. The registrant's other certifying officers and I have disclosed,
based on our most recent evaluation, to the registrant's auditors and the audit
committee of registrant's board of directors (or persons performing the
equivalent functions):
a) all significant deficiencies in the design or operation of internal
controls which could adversely affect the registrant's ability to record,
process, summarize and report financial data and have identified for the
registrant's auditors any material weaknesses in internal controls; and
b) any fraud, whether or not material, that involves management or
other employees who have a significant role in the registrant's internal
controls; and
6. The registrant's other certifying officers and I have indicated in
this annual report whether there were significant changes in internal controls
or in other factors that could significantly affect internal controls subsequent
to the date of our most recent evaluation, including any corrective actions with
regard to significant deficiencies and material weaknesses.
Date: March 24, 2003
/s/ Kathryn F. Fagan
- --------------------
Kathryn F. Fagan
Chief Financial Officer and Treasurer (Principal Financial Officer)
II-3
EXHIBIT INDEX
Exhibit Exhibit Description Sequentially
Number Numbered
Page
3.1 Articles of Incorporation of the Registrant (incorporated by
reference to Exhibit 3.1 to our Registration Statement on Form S-11
(Registration No. 333-32913) filed with the Securities and Exchange
Commission on August 5, 1997).
3.2 Articles of Amendment and Restatement of the Articles of Incorporation
of the Registrant (incorporated by reference to Exhibit 3.2 to our
Registration Statement on Form S-11 (Registration No. 333-32913) filed
with the Securities and Exchange Commission on August 5, 1997).
3.3 Bylaws of the Registrant, as amended (incorporated by reference to
Exhibit 3.3 to our Registration Statement on Form S-11 (Registration
No. 333-32913) filed with the Securities and Exchange Commission on
August 5, 1997).
4.1 Specimen Common Stock Certificate (incorporated by reference to
Exhibit 4.1 to Amendment No. 1 to our Registration Statement on Form
S-11 (Registration No. 333-32913) filed with the Securities and
Exchange Commission on September 17, 1997.
10.1 Purchase Agreement, dated February 12, 1997, between the Registrant
and Friedman, Billings, Ramsey & Co., Inc. ("FBR") (incorporated by
reference to Exhibit 10.1 to our Registration Statement on Form S-11
(Registration No. 333-32913), filed with the Securities and Exchange
Commission on August 5, 1997).
10.2 Registration Rights Agreement, dated February 12, 1997, between the
Registrant and FBR (incorporated by reference to Exhibit 10.2 to our
Registration Statement on Form S-11 (Registration No. 333-32913) filed
with the Securities and Exchange Commission on August 5, 1997).
10.3 Long-Term Stock Incentive Plan (incorporated by reference to Exhibit
10.3 to our Registration Statement on Form S-11 (Registration No.
333-32913) filed with the Securities and Exchange Commission on August
5, 1997).*
10.4 Form of Master Repurchase Agreement (incorporated by reference to
Exhibit 10.7 to our Registration Statement on Form S-11 (Registration
No. 333-32913) filed with the Securities and Exchange Commission on
August 5, 1997).
10.5 Form of Purchase Agreement, between the Registrant and the purchasers
in the Direct Offering (incorporated by reference to Exhibit 10.8 to
our Registration Statement on Form S-11 (Registration No. 333-32913)
filed with the Securities and Exchange Commission on August 5, 1997).
10.6 Amended and Restated Employment Agreement, effective as of May 1, 2001
between the Registrant and Michael A.J. Farrell (incorporated by
reference to Exhibit 10.1 to our Form 10-Q/A for its quarterly period
ended June 30, 2001 filed with the Securities and Exchange Commission
on August 27, 2001).*
10.7 Amended and Restated Employment Agreement, effective as of May 1,
2001, between the Registrant and Wellington St. Claire (incorporated
by reference to Exhibit 10.2 to our Form 10-Q/A for its quarterly
period ended June 30, 2001 filed with the Securities and Exchange
Commission on August 27, 2001).*
10.8 Amended and Restated Employment Agreement, effective as of May 1, 2001
between the Registrant and Kathryn F. Fagan (incorporated by reference
to Exhibit 10.3 to our Form 10-Q/A for its quarterly period ended June
30, 2001 filed with the Securities and Exchange Commission on August
27, 2001).*
10.9 Amended and Restated Employment Agreement, effective as of May 1,
2001, between the Registrant and Jennifer A. Stephens (incorporated by
reference to Exhibit 10.4 to our Form 10-Q/A for its quarterly period
ended June 30, 2001 filed with the Securities and Exchange Commission
on August 27, 2001).*
23.1 Consent of Independent Auditors.
99.1 Certification of Michael A.J. Farrell, Chairman, Chief Executive
Officer, and President of the Registrant, pursuant to 18 U.S.C.
Section 1350.
99.2 Certification of Kathryn F. Fagan, Chief Financial Officer and
Treasurer of the Registrant, pursuant to 18 U.S.C. Section 1350.
* Exhibit Numbers 10.3 and 10-6-10.9 are management contracts or
compensatory plans required to be filed as Exhibits to this Form 10-K.
Exhibit 23.1
INDEPENDENT AUDITORS' CONSENT
We consent to the incorporation by reference in Registration Statements No.
333-74618 and No. 333-72985 of Annaly Mortgage Management, Inc. on Form S-3 of
our report dated February 26, 2003, appearing in the Annual Report on Form 10-K
of Annaly Mortgage Management, Inc. for the year ended December 31, 2002 and to
the reference to us under the heading "Experts" in the Prospectus, which is part
of these Registration Statements.
/s/ Deloitte & Touche LLP
New York, New York
March 26, 2003
Exhibit 99.1
ANNALY MORTGAGE MANAGEMENT, INC.
1211 AVENUE OF THE AMERICAS
SUITE 2902
NEW YORK, NEW YORK 10036
CERTIFICATION OF CHIEF EXECUTIVE
OFFICER REGARDING PERIODIC REPORT CONTAINING
FINANCIAL STATEMENTS
I, Michael A.J. Farrell, the Chairman of the Board of Directors, Chief
Executive Officer, and President of Annaly Mortgage Management, Inc. (the
"Company") in compliance with 18 U.S.C. Section 1350, as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002, hereby certify that, the
Company's Annual Report on Form 10-K for the period ended December 31, 2002
(the "Report") filed with the Securities and Exchange Commission:
-- fully complies with the requirements of Section 13(a) or 15(d) of the
Securities Exchange Act of 1934; and
-- the information contained in the Report fairly presents, in all
material respects, the financial condition and results of operations
of the Company.
/s/ Michael A.J. Farrell
Michael A.J. Farrell
Chairman of the Board of Directors
Chief Executive Officer, and
President
March 24, 2003
Exhibit 99.2
ANNALY MORTGAGE MANAGEMENT, INC.
1211 AVENUE OF THE AMERICAS
SUITE 2902
NEW YORK, NEW YORK 10036
CERTIFICATION OF CHIEF FINANCIAL
OFFICER REGARDING PERIODIC REPORT CONTAINING
FINANCIAL STATEMENTS
I, Kathryn F. Fagan, the Chief Financial Officer and Treasurer of Annaly
Mortgage Management, Inc. (the "Company") in compliance with 18 U.S.C. Section
1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002,
hereby certify that, the Company's Annual Report on Form 10-K for the period
ended December 31, 2002 (the "Report") filed with the Securities and Exchange
Commission:
-- fully complies with the requirements of Section 13(a) or 15(d) of the
Securities Exchange Act of 1934; and
-- the information contained in the Report fairly presents, in all
material respects, the financial condition and results of operations
of the Company.
/s/ Kathryn F. Fagan
Kathryn F. Fagan
Chief Financial Officer and Treasurer
March 24, 2003