UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED: JUNE 30, 2006
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 CAPITAL MANAGEMENT, INC.
(Exact name of Registrant as specified in its Charter)
MARYLAND 22-3479661
(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
1211 AVENUE OF THE AMERICAS, SUITE 2902
NEW YORK, NEW YORK
(Address of principal executive offices)
10036
(Zip Code)
(212) 696-0100
(Registrant's telephone number, including area code)
Indicate by check mark whether the Registrant (1) has filed all documents and
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 whether the Registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act.
Large accelerated filer |X| Accelerated filer |_| Non-accelerated filer |_|
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). Yes |_| No |X|
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the last practicable date:
Class Outstanding at August 8, 2006
Common Stock, $.01 par value 164,015,156
ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
FORM 10-Q
TABLE OF CONTENTS
Part I. FINANCIAL INFORMATION
Item 1. Financial Statements:
Consolidated Statements of Financial Condition-June 30, 2006 1
(Unaudited) and December 31, 2005 (Derived from the audited
consolidated financial statement at December 31, 2005)
Consolidated Statements of Operations and Comprehensive Income 2
(Loss) (Unaudited) for the quarters and six months ended June 30,
2006 and 2005
Consolidated Statement of Stockholders' Equity (Unaudited) for 3
the six months ended June 30, 2006
Consolidated Statements of Cash Flows (Unaudited) for the 4
quarters and six months ended June 30, 2006 and 2005
Notes to Consolidated Financial Statements (Unaudited) 5
Item 2. Management's Discussion and Analysis of Financial 17
Condition and Results of Operations
Item 3. Quantitative and Qualitative Disclosures about Market Risk 31
Item 4. Controls and Procedures 32
Part II. OTHER INFORMATION
Item 1. Legal Proceedings 33
Item 1A. Risk Factors 33
Item 4. Submission of Matters to a Vote of Security Holders 34
Item 6. Exhibits and Reports on Form 8-K 33
SIGNATURES 33
CERTIFICATIONS 35
PART I.
ITEM 1. FINANCIAL STATEMENTS
ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(dollars in thousands, except for share data)
June 30, 2006 DECEMBER 31,
(UNAUDITED) 2005(1)
------------------- -----------------------
ASSETS
Cash and cash equivalents $ 53,849 $ 4,808
Mortgage-Backed Securities, at fair value 23,474,006 15,929,864
Receivable for Mortgage-Backed Securities sold - 13,449
Accrued interest receivable 110,647 71,340
Receivable for advisory and service fees 3,114 3,497
Intangible for customer relationships, net 12,206 15,183
Goodwill 22,966 23,122
Interest rate swaps, at fair value 105,435 -
Other assets 1,567 2,159
--------------------- ---------------------
Total assets $23,783,790 $16,063,422
===================== =====================
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Repurchase agreements $21,256,703 $ 13,576,301
Payable for Mortgage-Backed Securities purchased 607,789 933,051
Accrued interest payable 42,100 27,994
Dividends payable 21,322 12,368
Other liabilities - 305
Accounts payable 6,979 8,837
Interest rate swaps, at fair value - 543
--------------------- ---------------------
Total liabilities 21,934,893 14,559,399
--------------------- ---------------------
Minority interest in equity of consolidated affiliate 5,000 -
6.00% Series B Cumulative Convertible Preferred Stock;
4,600,000 and 0 shares authorized, issued and outstanding,
respectively 111,471 -
Stockholders' Equity:
7.875% Series A Cumulative Redeemable Preferred Stock:
7,637,500 authorized, 7,412,500 shares issued and outstanding,
respectively 177,088 177,088
Common stock: par value $.01 per share; 500,000,000 authorized;
164,015,156, 123,684,931; shares issued and outstanding,
respectively 1,640 1,237
Additional paid-in capital 2,131,358 1,679,452
Accumulated other comprehensive loss (384,912) (207,117)
Accumulated deficit (192,748) (146,637)
--------------------- ---------------------
Total stockholders' equity 1,732,426 1,504,023
--------------------- ---------------------
Total liabilities and stockholders' equity $23,783,790 $16,063,422
===================== =====================
(1) Derived from the audited consolidated financial statements at December 31,
2005
See notes to consolidated financial statements.
1
PART I.
ITEM 1. FINANCIAL STATEMENTS
ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)
(UNAUDITED)
(dollars in thousands, except per share amounts)
For the For the For the Six For the Six
Quarter Ended Quarter Ended Months Ended Months Ended
June 30, 2006 June 30, 2005 June 30, 2006 June 30, 2005
----------------- --------------- ---------------- ---------------
Interest income $280,171 $171,595 $475,053 $347,884
Interest expense 242,473 133,758 409,985 247,751
----------------- --------------- ---------------- ---------------
Net interest income 37,698 37,837 65,068 100,133
----------------- --------------- ---------------- ---------------
Other income (loss):
Investment advisory and service fees 5,210 9,669 12,206 15,978
(Loss) gain on sale of Mortgage-Backed Securities (1,239) 11,435 (8,245) 12,016
Impairment of intangible for customer relationships (1,345) - (2,493) -
Loss on other-than-temporarily impaired securities (20,114) - (46,843) -
----------------- --------------- ---------------- ---------------
Total other (loss) income (17,488) 21,104 (45,375) 27,994
----------------- --------------- ---------------- ---------------
Expenses:
Distribution fees 755 2,126 1,925 3,737
General and administrative expenses 8,985 6,800 16,162 13,464
----------------- --------------- ---------------- ---------------
Total expenses 9,740 8,926 18,087 17,201
----------------- --------------- ---------------- ---------------
Income before income taxes 10,470 50,015 1,606 110,926
Income taxes 1,892 3,022 3,977 4,600
----------------- --------------- ---------------- ---------------
Net income (loss) 8,578 46,993 (2,371) 106,326
Dividends on preferred stock 5,163 3,648 8,811 7,297
----------------- --------------- ---------------- ---------------
Net income (loss) available (related) to common
shareholders $3,415 $ 43,345 ($11,182) $99,029
================= =============== ================ ===============
Net income (loss) per share available (related) to
common shareholders:
Basic $0.02 $0.36 ($0.08) $0.82
================= =============== ================ ===============
Diluted $0.02 $0.36 ($0.08) $0.81
================= =============== ================ ===============
Weighted average number of common shares outstanding:
Basic 158,632,865 121,740,256 141,476,532 121,506,858
================= =============== ================ ===============
Diluted 158,703,614 122,013,050 141,476,532 121,785,918
================= =============== ================ ===============
Net income (loss) $8,578 $46,993 ($2,371) $106,326
----------------- --------------- ---------------- ---------------
Comprehensive (loss) income:
Unrealized gain loss on available-for-sale (225,771) 79,862 (338,861) (12,037)
securities
Unrealized gain on interest rate swaps 68,965 - 105,978 -
Reclassification adjustment for net losses (gains)
included in net loss or income 21,353 (11,435) 55,088 (12,016)
----------------- --------------- ---------------- ---------------
Other comprehensive (loss) income (135,453) 68,427 (177,795) (24,053)
----------------- --------------- ---------------- ---------------
Comprehensive (loss) income ($126,875) $115,420 ($180,166) $82,273
================= =============== ================ ===============
See notes to consolidated financial statements.
2
PART I
ITEM 1. FINANCIAL STATEMENTS
ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
FOR THE SIX MONTHS ENDED JUNE 30, 2006
(dollars in thousands, except per share data)
(UNAUDITED)
7.875% Series Common Additional Accumulated Accumulated Total
A Preferred Stock Paid-In Other Deficit
Stock Par Value Capital Comprehensive
Income (Loss)
-------------------------------------------------------------------------
BALANCE, JANUARY 1, 2006 $177,088 $1,237 $1,679,452 ($207,117) ($146,637)$1,504,023
Net loss (10,949)
Other comprehensive loss (42,342)
Comprehensive loss (53,291)
Stock option expense 293 293
Exercise of stock options 159 159
Series A preferred dividend declared,
$0.492188 per share (3,648) (3,648)
Common dividend declared, $0.11 per share (13,607) (13,607)
-------------------------------------------------------------------------
BALANCE, MARCH 31, 2006 177,088 1,237 1,679,904 (249,459) (174,841)$1,433,929
Net income 8,578
Other comprehensive loss (135,453)
Comprehensive income (126,875)
Proceeds from common stock follow-on
offering 392 436,956 437,348
Stock option expense 322 322
Proceeds from equity shelf offering 11 14,176 14,187
Series A preferred dividend declared and,
$0.492188 per share (3,648) (3,648)
Series B preferred dividend declared,
$0.32916 per share (1,515) (1,515)
Common dividend declared, $0.13 per share (21,322) (21,322)
-------------------------------------------------------------------------
BALANCE, JUNE 30, 2006 $177,088 $1,640 $2,131,358 ($384,912) ($192,748)$1,732,426
=========================================================================
3
PART I
ITEM 1. FINANCIAL STATEMENTS
ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands)
(UNAUDITED)
For the Six For the Six
For the For the Quarter Months Ended Months Ended
Quarter Ended Ended June 30, June 30, June 30,
June 30, 2006 2005 2006 2005
--------------- ------------------ --------------- ----------------
Cash flows from operating activities:
Net income (loss) $8,578 $46,993 ($2,371) $106,326
Adjustments to reconcile net income (loss) to net
cash provided by operating activities:
Amortization of Mortgage-Backed Securities
premiums and discounts, net 17,944 42,662 33,736 78,729
Amortization of intangibles 321 117 526 173
Loss (gain) on sale of Mortgage-Backed Securities 1,239 (11,435) 8,245 (12,016)
Loss on other-than-temporarily impaired 20,114 - 46,843
securities
Stock option expense 321 56 637 56
Market value adjustment on long-term repurchase
agreement - (328) (149) (1,578)
Impairment of intangible for customer 1,345 - 2,493
relationships
Increase in accrued interest receivable, net
of purchased interest (35,000) (7,411) (39,621) (6,956)
Decrease in other assets 692 445 550 391
Decrease (increase) in advisory and service fees 691 (1,451) 384 (1,974)
receivable
Increase (decrease) in accrued interest payable 4,361 (4,116) 14,105 (6,067)
Decrease in accounts payable 3,742 2,454 (1,858) (1,562)
--------------- ------------------ --------------- ----------------
Net cash provided by operating activities 24,348 67,986 63,520 155,522
--------------- ------------------ --------------- ----------------
Cash flows from investing activities:
Purchase of Mortgage-Backed Securities (9,318,354) (2,460,318) (12,592,319) (4,822,190)
Proceeds from sale of Mortgage-Backed Securities 980,156 870,767 2,048,917 956,714
Principal payments on Mortgage-Backed Securities 1,189,240 1,744,661 2,315,165 3,262,889
--------------- ------------------ --------------- ----------------
Net cash (used in) provided by investing
activities (7,148,958) 155,110 (8,213,758) (602,587)
--------------- ------------------ --------------- ----------------
Cash flows from financing activities:
Proceeds from repurchase agreements 75,306,249 62,857,935 128,069,003 120,117,481
Principal payments on repurchase agreements (68,679,429) (63,044,950) (120,388,601) (119,573,766)
Proceeds from exercise of stock options - 98 136 196
Proceeds from dividend reinvestment - 149 - 327
Net proceeds from common stock follow-on offering 437,348 - 437,348 -
Net proceeds from equity shelf program 14,187 23,146 14,187 23,146
Net proceeds from Series B preferred stock offering 111,471 - 111,471 -
Dividends paid (18,770) (58,223) (34,786) (122,503)
Minority interest 5,000 - 5,000 -
--------------- ------------------ --------------- ----------------
Net cash provided by (used in) financing 7,171,056 (221,845) 8,213,758 444,881
activities
Net increase (decrease) in cash and cash equivalents 51,446 1,251 49,041 (2,184)
Cash and cash equivalents, beginning of period 2,403 2,418 4,808 5,853
--------------- ------------------ --------------- ----------------
Cash and cash equivalents, end of period $53,849 $3,669 $53,849 $3,669
--------------- ------------------ --------------- ----------------
Supplemental disclosure of cash flow information:
Interest paid $238,111 $137,874 $415,367 $253,818
=============== ================== =============== ================
Income taxes paid $1,255 $3,022 $3,597 $4,600
=============== ================== =============== ================
Noncash investing activities:
Net change in unrealized loss on available-for-sale
securities and interest rate swaps, net of
reclassification adjustment ($135,453) $68,427 ($177,795) $24,053
=============== ================== =============== ================
Noncash financing activity:
Dividends declared, not yet paid $21,322 $44,120 $21,322 $44,120
=============== ================== =============== ================
See notes to consolidated financial statements.
4
ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE QUARTER AND SIX MONTHS ENDED JUNE 30, 2006 AND 2005
(UNAUDITED)
- --------------------------------------------------------------------------------
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
Annaly Capital Management, Inc. (the "Company") was incorporated in
Maryland on November 25, 1996. The Company changed its name from Annaly Mortgage
Management, Inc. to Annaly Capital Management, Inc. effective August 2, 2006.
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. The Company acquired Fixed Income
Discount Advisory Company ("FIDAC") on June 4, 2004. FIDAC is a registered
investment advisor and is a taxable Real Estate Investment Trust ("REIT")
subsidiary of the Company. On June 27, 2006, the Company made a majority equity
investment in an investment fund (the "Fund"). At June 30, 2006, the Fund is
invested 100% in cash and cash equivalents.
A summary of the Company's significant accounting policies follows:
Basis of Presentation - The accompanying unaudited consolidated
financial statements have been prepared in conformity with the instructions to
Form 10-Q and Article 10, Rule 10-01 of Regulation S-X for interim financial
statements. Accordingly, they do not include all of the information and
footnotes required by accounting principles generally accepted in the United
States of America ("GAAP"). The interim financial statements are unaudited;
however, in the opinion of the Company's management, all adjustments, consisting
only of normal recurring accruals, necessary for a fair statement of the
financial positions, results of operations, and cash flows have been included.
These unaudited financial statements should be read in conjunction with the
audited financial statements included in the Company's Annual Report on Form
10-K for the year ended December 31, 2005. The nature of the Company's business
is such that the results of any interim period are not necessarily indicative of
results for a full year.
The consolidated financial statements include the accounts of the
Company, FIDAC and the Fund. All material intercompany balances and transactions
have been eliminated. The minority shareholder in the Fund is reflected as
minority interest in the consolidated statement of financial condition.
Cash and Cash Equivalents - Cash and cash equivalents include cash on
hand and money market funds.
Mortgage-Backed Securities - The Company invests 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" or
"Investment Securities').
Statement of Financial Accounting Standards ("SFAS") No. 115,
Accounting for Certain Investments in Debt and Equity Securities, requires the
Company to classify its Investment Securities as either trading investments,
available-for-sale investments or held-to-maturity investments. Although the
Company generally intends to hold most of its Investment Securities until
maturity, it may, from time to time, sell any of its Investment Securities as
part of its overall management of its portfolio. Accordingly, SFAS No. 115
requires the Company to classify all of its Investment Securities as
available-for-sale. All assets classified as available-for-sale are reported at
estimated 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.
Management evaluates securities for other-than-temporary impairment at
least on a quarterly basis, and more frequently when economic or market concerns
warrant such evaluation. Consideration is given to (1) the length of time and
the extent to which the fair value has been lower than carrying value, (2) the
financial condition and near-term prospects of the issuer, and (3) the intent
and ability of the Company to retain its investment in the issuer for a period
of time sufficient to allow for recovery in fair value. Unrealized losses on
Investment 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 Investment
Securities is adjusted. The loss on other-than-temporarily impaired securities
was $20.1 million and $46.8 million for the quarter and six months ended June
30, 2006, respectively. There was no impairment loss recognized during the
quarter ended June 30, 2005.
5
SFAS No. 107, Disclosure About Fair Value of Financial Instruments,
requires disclosure of the fair value of financial instruments for which it is
practicable to estimate that value. The fair value of Mortgage-Backed Securities
available-for-sale and hedging instruments is equal to their carrying value
presented in the consolidated statements of financial condition. The fair value
of cash and cash equivalents, accrued interest receivable, receivable for
mortgage-backed securities sold, receivable for advisory and service fees,
repurchase agreements, payable for mortgage-backed securities purchased,
dividends payable, accounts payable, and accrued interest payable, generally
approximates cost as of June 30, 2006 and December 31, 2005, due to the short
term nature of these financial instruments.
Interest income is accrued based on the outstanding principal amount of
the Investment Securities and their contractual terms. Premiums and discounts
associated with the purchase of the Investment Securities are amortized into
interest income over the projected lives of the securities using the effective
interest method. The Company's policy for estimating prepayment speeds for
calculating the effective yield is to evaluate historical performance, consensus
prepayment speeds, and current market conditions.
Investment 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 gain and losses on sale of
Investment Securities are determined on the specific identification basis.
Derivative Financial Instruments/Hedging Activity- The Company hedges
interest rate risk through the use of derivative financial instruments such as
interest rate swaps ("Hedging Instruments"). The Company accounts for Hedging
Instruments in accordance with SFAS No. 133, Accounting for Derivative
Instruments and Hedging Activities, ("SFAS 133") as amended and interpreted. The
Company carries all Hedging Instruments at their fair value, as assets, if their
fair value is positive, or as liabilities, if their fair value is negative. As
the Company's interest rate swaps are designated as "cash flow hedges," the
change in the fair value of any such derivative is recorded in other
comprehensive income or loss for hedges that qualify as effective. The
ineffective amount of all Hedging Instruments, if any, is recognized in earnings
each quarter. To date, the Company has not recognized any change in the value of
its interest rate swaps in earnings as a result of the hedge or a portion
thereof being ineffective.
Upon entering into hedging transactions, the Company documents the
relationship between the Hedging Instruments and the hedged liability. The
Company also documents its risk-management policies, including objectives and
strategies, as they relate to its hedging activities. The Company assesses, both
at inception of a hedge and on an on-going basis, whether or not the hedge is
"highly effective," as defined by SFAS 133. The Company discontinues hedge
accounting on a prospective basis with changes in the estimated fair value
reflected in earnings when (i) it is determined that the derivative is no longer
effective in offsetting cash flows of a hedged item (including hedged items such
as forecasted transactions); (ii) it is no longer probable that the forecasted
transaction will occur; or (iii) it is determined that designating the
derivative as a Hedging Instrument is no longer appropriate.
When the Company enters into an interest rate swap, it agrees to pay a
fixed rate of interest and to receive a variable interest rate, generally based
on the London Interbank Offered Rate ("LIBOR"). The Company's interest rate
swaps are designated as cash flow hedges against the benchmark interest rate
risk associated with the Company's borrowings.
All changes in the unrealized gains/losses on any interest rate swap
are recorded in accumulated other comprehensive income or loss. If it becomes
probable that the forecasted transaction, which in this case refers to interest
payments to be made under the Company's short-term borrowing agreements, will
not occur by the end of the originally specified time period, as documented at
the inception of the hedging relationship, then the related gain or loss in
accumulated other comprehensive income or loss would be reclassified to income
or loss.
6
Realized gains and losses resulting from the termination of an interest
rate swap are initially recorded in accumulated other comprehensive income or
loss as a separate component of stockholders' equity. The gain or loss from a
terminated interest rate swap remains in accumulated other comprehensive income
or loss until the forecasted interest payments affect earnings. If it becomes
probable that the forecasted interest payments will not occur, then the entire
gain or loss would be recognized in earnings.
Credit Risk - The Company has limited its exposure to credit losses on
its portfolio of Investment Securities by only purchasing securities issued by
FHLMC, FNMA, or 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. All of the Company's
Investment Securities have an actual or implied "AAA" rating.
Repurchase Agreements - The Company finances the acquisition of its
Investment 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.
Convertible Cumulative Preferred Stock- The Company classifies Series B
Cumulative Convertible Preferred Stock on the consolidated statements of
financial condition using the guidance in SEC Accounting Series Release No. 268,
Presentation in Financial Statements of "Redeemable Preferred Stocks," and
Emerging Issues Task Force ("EITF") Topic D-98, Classification and Measurement
of Redeemable Securities. Serie B Cumulative Convertible Preferred Stock
contains fundamental change provisions that allow the holder to redeem the
preferred stock for cash if certain events occur. As redemption under these
provisions is not solely within the Company's control, the Company has
classified Series B Cumulative Convertible Preferred Stock as temporary equity
in the accompanying consolidated statement of financial condition.
The Company has examined whether the embedded conversion option should
be bifurcated under the guidance in SFAS133 and EITF Issue No. 00-19, Accounting
for Derivative Financial Instruments Indexed to, and Potentially Settled in, a
Company's Own Stock, and the Company determined that bifurcation is not
necessary.
Income Taxes - The Company has elected to be taxed as a 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. The Company and FIDAC have made a joint election to treat FIDAC as a
taxable REIT subsidiary. As such, FIDAC is taxable as a domestic C corporation
and subject to federal and state and local income taxes based upon its taxable
income.
Use of Estimates - The preparation of financial statements in
conformity with GAAP 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.
Intangible assets - The Company's acquisition of FIDAC was accounted
for using the purchase method. Under the purchase method, net assets and results
of operations of acquired companies are included in the consolidated financial
statements from the date of acquisition. In addition, the cost of FIDAC was
allocated to the assets acquired, including identifiable intangible assets, and
the liabilities assumed based on their estimated fair values at the date of
acquisition. The excess of cost over the fair value of the net assets acquired
was recognized as goodwill. Intangible assets are periodically reviewed for
potential impairment. During the quarter and six months ended June 30, 2006, the
Company recorded $1.3 million and $2.5 million in impairment losses on customer
relationships, respectively. During the six months ended June 30, 2005, the
Company did not have impairment losses.
7
Recent Accounting Pronouncements - On December 16, 2004, the Financial
Accounting Standards Board (FASB) issued SFAS No. 123 (Revised 2004) -
Share-Based Payment ("SFAS No. 123R"). SFAS No. 123R, which replaces SFAS No.
123, requires the Company to measure and recognize in the financial statements
the compensation cost relating to share-based payment transactions. The
compensation cost should be reassessed based on the fair value of the equity
instruments issued. We adopted SFAS No. 123R effective January 1, 2006 under the
modified prospective transition method. Accordingly, prior period amounts have
not been restated. Under this application, the Company is required to record
compensation expense for all awards granted or modified on or after January 1,
2006 and for the unvested portion of all outstanding awards that remain
outstanding at the date of adoption. The adoption of SFAS No. 123R resulted in
incremental stock-based compensation expense of $322,000 and insignificant
impact on basic and diluted net loss per share for the quarter ended June 30,
2006.
We elected to recognize compensation expense on a straight-line basis
over the requisite service period for the entire award (that is, over the
requisite service period of the last separately vesting portion of the award).
We estimate fair value using the Black-Scholes valuation model. The assumptions
used to value the options granted during the six months ended June 30, 2006 are
as follows: Expected volatility 26.50%, expected dividends 5.57%, expected term
in years, 6.8, and risk free rate 4.7%. Assumptions used to estimate the
compensation expense are determined as follows:
o Expected term (estimated time of outstanding) is estimated using the
historical exercise behavior of employees
o Expected volatility is measured using the weighted average of
historical daily changes in the market price of our common stock over
the expected term of the award
o Expected dividend yield is based on projected dividend yield over the
expected term of the award
o Risk-free interest rate is equivalent to the implied yield on
zero-coupon U.S. Treasury bonds with a remaining maturity equal to the
expected term of the awards; and,
o Forfeitures are based substantially on the history of cancellations of
similar awards granted by the Company in prior years.
Prior to the adoption of SFAS No. 123R, we used the intrinsic value
method prescribed in APB 25 and also followed the disclosure requirements of
SFAS No. 123, as amended by SFAS No. 148, Accounting for Stock-Based
Compensation - Transition and Disclosure ("SFAS No. 148") which required
certain disclosures on a pro forma basis as if the fair value method had been
followed for accounting for such compensation.
For the For the
Quarter Ended Six Months
June 30, 2005 June 30, 2005
------------------ --------------------
Net income available to common
shareholders, as reported $43,345 $99,029
Deduct: Total stock-based employee
compensation expense determined
under fair value based method (36) (71)
------------------ --------------------
Pro-forma net income available to
common shareholers $43,309 $98,958
================== ====================
Net income per share available to common shareholders, as reported:
Basic $0.36 $0.82
================== ====================
Diluted $0.36 $0.81
================== ====================
Pro-forma net income per share available to common shareholders:
Basic $0.36 $0.81
================== ====================
Diluted $0.36 $0.81
================== ====================
Proposed Accounting Pronouncements- The FASB has added an item to its
current proposed amendment relating to the accounting treatment under SFAS 140,
Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities, a replacement of FASB Statement 125, of transactions where
8
assets purchased from a particular counterparty are financed via a repurchase
agreement with the same counterparty. Currently, the Company records such assets
and the related financing in the consolidated statement of financial condition,
and the corresponding interest income and interest expense in the Company's
consolidated statement of operations and comprehensive (loss) income. For assets
representing available-for-sale investment securities, as in the Company's
case, any change in fair value is reported through other comprehensive income
under SFAS No. 115, with the exception of impairment losses, which are recorded
in the consolidated statement of operations and comprehensive (loss) income as
realized losses.
However, a transaction where assets are acquired from and financed
under a repurchase agreement with the same counterparty may not qualify for a
sale treatment by a seller under an interpretation of SFAS 140, which would
require the seller to continue to carry such sold assets on their books based
on their "continuing involvement" with such assets. Depending on the ultimate
outcome of the FASB deliberations, the result may be that the Company would be
precluded from recording the assets purchased in the transaction described
above as well as the related financing in the Company's consolidated statement
of financial condition and would instead be treating the Company's net
investment in such assets as a derivative.
This potential change in accounting treatment would not affect the
economic substance of the transactions but would affect how the transactions
would be reported in the Company's financial statements. The Company's cash
flows, liquidity and ability to pay a dividend would be unchanged, and the
Company does not believe the Company's taxable income or net equity would be
affected.
9
2. MORTGAGE-BACKED SECURITIES
The following table pertains to the Company's Mortgage-Backed
Securities classified as available-for-sale as of June 30, 2006 and December 31,
2005, which are carried at their fair value:
Government Total
Federal Home Loan Federal National National Mortgage Mortgage-Backed
Mortgage Corporation Mortgage Association Association Securities
June 30, 2006 -------------------- -------------------- ------------------ ------------------
(dollars in thousands)
Mortgage-Backed Securities, gross $8,858,418 $14,686,012 $278,253 $23,822,683
Unamortized discount (15,157) (60,047) (57) (75,261)
Unamortized premium 85,014 127,812 4,106 216,932
June 30, 2006 -------------------- -------------------- ------------------ ------------------
Amortized cost 8,928,275 14,753,777 282,302 23,964,354
Gross unrealized gains 3,327 1,992 - 5,319
Gross unrealized losses (185,929) (302,490) (7,248) (495,667)
June 30, 2006 -------------------- -------------------- ------------------ ------------------
Estimated fair value $8,745,673 $14,453,279 $275,054 $23,474,006
June 30, 2006 ==================== ==================== ================== ==================
Amortized Cost Gross Unrealized Gains Gross Unrealized Estimated Fair
Losses Value
June 30, 2006 -------------------- -------------------- ------------------ ------------------
(dollars in thousands)
Adjustable rate $5,820,168 $977 ($134,202) $5,686,943
Fixed rate 15,885,244 32 (347,652) 15,537,624
Floater 2,258,942 4,310 (13,813) 2,249,439
June 30, 2006 ==================== ==================== ================== ==================
Total $23,964,354 $5,319 ($495,667) $23,474,006
June 30, 2006 ==================== ==================== ================== ==================
Government Total
Federal Home Loan Federal National National Mortgage Mortgage-Backed
Mortgage Corporation Mortgage Association Association Securities
June 30, 2006 -------------------- -------------------- ------------------ ------------------
(dollars in thousands)
Mortgage-Backed Securities, gross $5,689,898 $9,881,672 $344,231 $15,915,801
Unamortized discount (4,043) (17,345) (62) (21,450)
Unamortized premium 92,228 144,726 5,133 242,087
June 30, 2006 -------------------- -------------------- ------------------ ------------------
Amortized cost 5,778,083 10,009,053 349,302 16,136,438
Gross unrealized gains 3,174 1,853 - 5,027
Gross unrealized losses (80,733) (124,330) (6,538) (211,601)
June 30, 2006 -------------------- -------------------- ------------------ ------------------
Estimated fair value $5,700,524 $9,886,576 $342,764 $15,929,864
June 30, 2006 ==================== ==================== ================== ==================
Amortized Cost Losses Gross Unrealized Gains Gross Unrealized Estimated Fair Value
June 30, 2006 -------------------- -------------------- ------------------ ------------------
(dollars in thousands)
Adjustable rate $9,844,261 $3,973 ($120,480) $9,727,754
Fixed rate 6,292,177 1,054 (91,121) 6,202,110
June 30, 2006 -------------------- -------------------- ------------------ ------------------
Total $16,136,438 $5,027 ($211,601) $15,929,864
June 30, 2006 ==================== ==================== ================== ==================
10
Actual maturities of Mortgage-Backed Securities are generally shorter
than stated contractual maturities. Actual maturities of the Company's
Mortgage-Backed Securities are affected by the contractual lives of the
underlying mortgages, periodic payments of principal, and prepayments of
principal. The following table summarizes the Company's Mortgage-Backed
Securities on June 30, 2006 and December 31, 2005 according to their estimated
weighted-average life classifications:
June 30, 2006 December 31, 2005
---------------- ------------------ --------------------- ---------------------
Fair Value Amortized Cost Fair Value Amortized Cost
(dollars in thousands)
---------------- ------------------ --------------------- ---------------------
Less than one year $ 409,456 $ 414,738 $ 508,851 $ 514,560
Greater than one year and less than
five years 10,079,900 10,329,422 12,648,106 12,824,736
Greater than or equal to five years 12,984,650 13,220,194 2,772,907 2,797,142
---------------- ------------------ --------------------- ---------------------
Total $23,474,006 $23,964,354 $15,929,864 $16,136,438
================ ================== ===================== =====================
The weighted-average lives of the Mortgage-Backed Securities at
June 30, 2006 and December 31, 2005 in the table above are based upon data
provided through subscription-based financial information services, assuming
constant principal prepayment rates to the reset date of each security. The
prepayment model considers current yield, forward yield, steepness of the yield
curve, current mortgage rates, mortgage rates of the outstanding loans, loan
age, margin and volatility.
Mortgage-Backed Securities with a carrying value of $6.0 billion were
in a continuous unrealized loss position over 12 months at June 30, 2006 in the
amount of $196.1 million. Mortgage-Backed Securities with a carrying value of
$16.0 billion were in a continuous unrealized loss position for less than 12
months at June 30, 2006 in the amount of $299.6 million. Mortgage-Backed
Securities with a carrying value of $4.6 billion were in a continuous unrealized
loss position over 12 months at December 31, 2005 in the amount of $111.1
million. Mortgage-Backed Securities with a carrying value of $8.4 billion were
in a continuous unrealized loss position for less than 12 months at December 31,
2005 in the amount of $100.5 million. The decline in value of these securities
is solely due to increases in interest rates. All of the Mortgage-Backed
Securities are "AAA" rated or carry an implied "AAA" rating. Also, the Company
is guaranteed payment on the par value of the securities.
With the continued increase in the Federal Funds rate during the fourth
quarter of 2005 and the first and second quarters of 2006, management determined
that it did not intend to hold certain of its securities until maturity and
would reposition a portion of its assets. The Company recorded an impairment
charge of $20.1 million, $26.7 million and $83.1 million for these securities
during the second quarter of 2006, first quarter of 2006 and fourth quarter of
2005, respectively. Of the $20.1million recorded as an impairment charge for the
quarter ended June 30, 2006, $15.7 million resulted from further declines in
value of securities classified as other-than-temporarily impaired at March 31,
2006 and $4.4 million from losses on additional securities that the Company
determined to be other-than-temporarily impaired at June 30, 2006. The remaining
investments are not considered other-than-temporarily impaired since the Company
currently has the ability and intent to hold the investments for a period of
time or to maturity, if necessary, sufficient for a forecasted market price
recovery up to or beyond the cost of the investments.
The adjustable rate Mortgage-Backed Securities are limited by periodic
caps (generally interest rate adjustments are limited to no more than 1% every
nine months) and lifetime caps. The weighted average lifetime cap was 9.8% at
June 30, 2006 and 10.3% December 31, 2005.
During the quarter and six months ended June 30, 2006, the Company
realized $1.2 million and $8.2 million in net loss from sales of Mortgage-Backed
Securities, respectively. During the quarter and six months ended June 30, 2005
the Company realized $11.4 million and $12.0 million in net gains from sales of
Mortgage-Backed Securities, respectively.
11
3. REPURCHASE AGREEMENTS
The Company had outstanding $21.3 billion and $13.6 billion of
repurchase agreements with weighted average borrowing rates of 5.01% and 4.16%,
including the impact of the interest rate swaps, and weighted average remaining
maturities of 48 days and 79 days as of June 30, 2006 and December 31, 2005,
respectively. Mortgage-Backed Securities pledged as collateral under these
repurchase agreements had an estimated fair value of $22.4 billion and $14.3
billion at June 30, 2006 and December 31, 2005, respectively.
At June 30, 2006 and December 31, 2005, the repurchase agreements had
the following remaining maturities:
June 30, 2006 December 31, 2005
(dollars in thousands)
---------------------------------------------------------
Within 30 days $17,230,207 $10,575,945
30 to 59 days 1,976,496 1,250,356
60 to 89 days - -
90 to 119 days - -
Over 120 days 2,050,000 1,750,000
--------------------------- -----------------------------
Total $21,256,703 $13,576,301
=========================== =============================
The Company had an amount at risk greater than 10% of the equity of the
Company with the following counterparties as of June 30, 2006.
Amount at risk(1)(2) Weighted Average Days to Maturity
(dollars in thousands)
--------------------------- -------------------------------------
UBS Securities LLC $218,940 62
Deutsche Bank Securities Inc. $228,835 32
(1) Equal to the sum of fair value of securities sold plus accrued
interest income minus the sum of repurchase agreements plus accrued
interest expense.
(2) Equity includes Series B Cumulative Convertible Preferred Stock which
is classified as temporary equity in the consolidated statement of
financial condition. (See Note 5)
The Company has entered into three structured repurchase agreements, which
provide the buyer with the right to extend their maturity dates. The repurchase
agreements totaled $650.0 million and the market value of the option to extend
is $4.3 million.
4. INTEREST RATE SWAPS
In connection with the Company's interest rate risk management
strategy, the Company hedges a portion of its interest rate risk by entering
into derivative financial instrument contracts. To date, such instruments are
comprised of interest rate swaps, which in effect modify the cash flows on
repurchase agreements. The use of interest rate swaps creates exposure to credit
risk relating to potential losses that could be recognized if the counterparties
to these instruments fail to perform their obligations under the contracts. In
the event of a default by the counterparty, the Company could have difficulty
obtaining its Mortgage-Backed Securities pledged as collateral for swaps. The
Company does not anticipate any defaults by its counterparties.
The Company's swaps are used to lock-in the fixed rate related to a
portion of its current and anticipated future 30-day term repurchase agreements.
12
The table below presents information about the Company's swaps outstanding at
June 30, 2006.
Notional Amount Weighted Weighted Estimated Fair
(dollars in Average Pay Average Value/Carrying Value
thousands) Rate Receive Rate (dollars in thousands)
- --------------------- ----------------- -------------- -----------------------
$8,139,000 5.14% 5.21% $105,435
5. PREFERRED STOCK AND COMMON STOCK
On April 6, 2006, the Company entered into an underwriting agreement
pursuant to which it sold 39,215,000 shares of its common stock for net proceeds
before expenses of approximately $437,737,438. On April 6, 2006, the Company
entered into a second underwriting agreement pursuant to which it sold 4,600,000
shares of its 6% Series B Cumulative Convertible Preferred Stock for net
proceeds before expenses of approximately $111,550,000. Each of these
transactions settled on April 12, 2006.
During the quarter ended June 30, 2006, the Company declared dividends
to common shareholders totaling $21.3 million or $0.13 per share, which were
paid on July 27, 2006. During the quarter ended June 30, 2006, the Company
declared dividends to Series A Preferred shareholders totaling $3.6 million or
$0.492188 per share, and Series B shareholders totaling $1.5 million or
$0.32916 per share which were paid on June 30, 2006.
6. NET INCOME (LOSS) PER COMMON SHARE
The following table presents a reconciliation of the earnings and
shares used in calculating basic and diluted EPS for the quarters ended June 30,
2006 and 2005.
For the Quarters Ended For the Six Months Ended
June 30, 2006 June 30, 2005 June 30, 2006 June 30, 2005
(dollars and shares in thousands)
----------------- ------------------ ----------------- ------------------
Net income (loss) $8,578 $46,993 ($2,371) $106,326
Less: Series A and Series B
Preferred stock dividend 5,163 3,648 8,811 7,297
----------------- ------------------ ----------------- ------------------
Net income (loss) available (related) to
common shareholders $3,415 $43,345 ($11,182) $99,029
----------------- ------------------ ----------------- ------------------
Weighted average shares of common stock
outstanding 158,633 121,740 141,477 121,507
Add: Effect of dilutive stock options 71 273 - 279
----------------- ------------------ ----------------- ------------------
Effect of converted Series B preferred
stock - - - -
----------------- ------------------ ----------------- ------------------
Weighted average shares of common
stock outstanding-diluted 158,704 122,013 141,477 121,786
Basic Earnings per share $0.02 $0.36 ($0.08) $0.82
================= ================== ================= ==================
Diluted Earnings per share $0.02 $0.36 ($0.08) $0.81
================= ================== ================= ==================
Because the Company had a net loss related to common shareholders for
the six months ended June 30, 2006, options to purchase 2,990,430 shares of
common stock were considered anti-dilutive for the six months ended June 30,
2006. Under the if converted method, 7,182,019 shares would be converted to
common stock if they are converted, however, they create anti-dilutive effect.
13
7. LONG-TERM STOCK INCENTIVE PLAN
The Company has adopted a long term stock incentive plan for executive
officers, key employees and non-employee directors (the "Incentive Plan"). The
Incentive Plan authorizes the Compensation Committee of the board of directors
to grant awards, including non-qualified options as well as incentive stock
options as defined under Section 422 of the Code. 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 diluted outstanding shares of the Company's common
stock, up to ceiling of 8,932,921 shares. Stock options are issued at the
current market price on the date of grant, subject to an immediate or four year
vesting in four equal installments with a contractual term of 5 or 10 years. The
grant date fair value is calculated using the Black-Scholes option valuation
model.
The following table sets forth activity relating to the Company's stock
options awards:
For the Six Months Ended June 30,
2006 2005
------------------------------ ----------------------------------
Weighted
Number of Average Number of Weighted Average
Shares Exercise Price Shares Exercise Price
- ---------------------------------------- ------------ ----------------- --------------- ------------------
Options outstanding at the beginning
of period 2,333,593 $16.10 1,645,721 $15.66
Granted 737,205 11.72 6,250 18.26
Exercised (16,725) 8.21 (16,128) 12.21
Forfeited (60,000) 15.39 - -
Expired (3,688) 13.69 (33,750) 17.87
------------ ----------------- --------------- ------------------
Options outstanding at the end of
period 2,990,430 $15.08 1,602,093 $15.66
============ ================= =============== ==================
Options exercisable at the end of
period 970,556 $14.49 693,006 $11.47
============ ================= =============== ==================
The weighted average remaining contractual term was approximately 7.8
years for stock options outstanding and approximately 5.8 years for stock
options exercisable as of June 30, 2006. There were 6,250 stock options granted
during the quarter ended June 30, 2005, with immediate vesting. The amount of
cash received from the exercise of stock options was $99,000 for the quarter
ended June 30, 2005. As of June 30, 2006, there was approximately $3.5 million
of total unrecognized compensation cost related to nonvested share-based
compensation awards. That cost is expected to be recognized over a weighted
average period of 3.0 years.
The following table summarizes information about stock options
outstanding at June 30, 2006:
Weighted Weighted
Weighted Average Average
Range of Exercise Prices Average Remaining Weighted Remaining
Exercise Contractual Average Contractual
Total Price on Life (Years) Total Exercise Life (Years)
Options Total on Total Options Price on on
Outstanding Outstanding Outstanding Exercisable Exercisable Exercisable
- -------------------------- --------------- -------------- --------------- -------------- -------------- --------------
$7.94-$19.99 2,980,430 $15.07 7.84 960,556 $14.42 5.88
$20.00-$29.99 10,000 20.53 1.49 10,000 20.53 1.49
--------------- -------------- --------------- -------------- -------------- --------------
2,990,430 $15.08 7.82 970,556 $14.49 5.84
=============== ============== =============== ============== ============== ==============
8. INCOME TAXES
As a REIT, the Company is not subject to federal income tax on earnings
distributed to its shareholders. Most states recognize REIT status as well. The
Company has decided to distribute the majority of its income and retain a
portion of the permanent difference between book and taxable income arising from
Section 162(m) of the Code pertaining to employee remuneration.
14
During the quarter and six months ended June 30, 2006, the Company
recorded $827,000 and $2.4 million of income tax expense for income attributable
to FIDAC, its taxable REIT subsidiary, and the portion of earnings retained
based on Code Section 162(m) limitations, respectively. During the quarter and
six months ended June 30, 2006, the Company recorded $1.1 million and $1.5
million of income tax expense for a portion of earnings retained based on
Section 162(m) limitations, respectively.
During the quarter and six months ended June 30, 2005, the Company
recorded $2.4 million and $3.5 million of income tax expense for income
attributable to FIDAC, its taxable REIT subsidiary, and the portion of earnings
retained based on Code Section 162(m) limitations, respectively. During the
quarter and six months ended June 30, 2005, the Company recorded $658,000 and
$1.1 million of income tax expense for a portion of earnings retained based on
Section 162(m) limitations.
9. LEASE COMMITMENTS
The Company has a noncancelable lease for office space, which commenced
in May 2002 and expires in December 2009.
The Company's aggregate future minimum lease payments are as follows:
Total per Year
(dollars in thousands)
------------------------
2006 (remainder) $ 265
2007 532
2008 532
2009 532
------------------------
Total remaining lease payments $1,861
========================
10. 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
Investment Securities and the Company's ability to realize gains from the sale
of these assets. A decline in the value of the Investment Securities pledged as
collateral for borrowings under repurchase agreements could result in the
counterparties demanding additional collateral pledges or liquidation of some of
the existing collateral to reduce borrowing levels.
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. The Company may seek to mitigate the potential impact
on net income of periodic and lifetime coupon adjustment restrictions in the
portfolio of Investment Securities by entering into interest rate agreements
such as interest rate caps and interest rate swaps. As of June 30, 2006 and
December 31, 2005, the Company entered into interest rate swaps to pay a fixed
rate and receive a floating rate of interest, with total notional amounts of
$8.1 billion and $479.0 million, respectively.
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.
15
11. CONTINGENCIES
From time to time, the Company is involved in various claims and legal
actions arising in the ordinary course of business. In the opinion of
management, the ultimate disposition of these matters will not have a material
effect on the Company's consolidated financial statements.
16
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Special Note Regarding Forward-Looking Statements
Certain statements contained in this quarterly 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 Section 27A of the
Securities Act of 1933, as amended, and Section 21E of the Securities Exchange
Act of 1934, as amended. 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 financings,
changes in the market value of our assets, changes in business conditions and
the general economy, and risks associated with the investment advisory business
of FIDAC, including the removal by FIDAC's clients of assets FIDAC manages,
FIDAC's regulatory requirements, and competition in the investment advisory
business, changes in governmental regulations affecting our business, and our
ability to maintain our classification as a REIT for federal income tax
purposes. For a discussion of the risks and uncertainties which could cause
actual results to differ from those contained in the forward-looking statements,
see our most recent Annual Report on Form 10-K and all subsequent Quarterly
Reports on Form 10-Q. We do not undertake, and specifically disclaim any
obligation, to publicly release the result of any revisions which may be made to
any forward-looking statements to reflect the occurrence of anticipated or
unanticipated events or circumstances after the date of such statements.
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 investment securities and the costs of borrowing to
finance our acquisition of investment securities and from dividends we receive
from FIDAC. FIDAC is our wholly-owned subsidiary, and is a registered investment
advisor that generates advisory and service fee income. The Company also has a
majority interest in an investment fund.
We are primarily engaged in the business of investing, on a leveraged
basis, 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").
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 are determined by us 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,
determined by us to be of comparable credit quality to an investment which is
rated "BBB" or better. In addition, we may directly or indirectly invest part of
this remaining 25% of our assets in other types of securities, including without
limitation, unrated debt, equity or derivative securities, to the extent
consistent with our REIT qualification requirements.
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.
17
We have elected to be taxed as a REIT for federal income tax purposes.
Pursuant to the current federal tax regulations, one of the requirements of
maintaining our status as a REIT is that we must distribute at least 90% of our
REIT taxable income (determined without regard to the deduction for dividends
paid and by excluding any net capital gain) to our stockholders, subject to
certain adjustments.
The results of our operations are affected by various factors, many of
which are beyond our control. Our results of operations primarily depend on,
among other things, the level of our net interest income, the market value of
our assets and the supply of and demand for such assets. Our net interest
income, which reflects the amortization of purchase premiums and accretion of
discounts, varies primarily as a result of changes in interest rates, borrowing
costs and prepayment speeds, the behavior of which involves various risks and
uncertainties. Prepayment speeds, as reflected by the Constant Prepayment Rate,
or CPR, and interest rates vary according to the type of investment, conditions
in financial markets, competition and other factors, none of which can be
predicted with any certainty. In general, as prepayment speeds on our
Mortgage-Backed Securities portfolio increase, related purchase premium
amortization increases, thereby reducing the net yield on such assets. The CPR
on our Mortgage Backed Securities portfolio averaged 19% and 27% for the
quarters ended June 30, 2006 and 2005, respectively. Since changes in interest
rates may significantly affect our activities, our operating results depend, in
large part, upon our ability to effectively manage interest rate risks and
prepayment risks while maintaining our status as a REIT.
During the fourth quarter of 2005, the Company sold certain assets and
began purchasing assets in the current rate environment. This continued during
the first and second quarter of 2006. With the federal funds interest rate
continuing to rise through the first and second quarter of 2006, the Company
sold lower yielding assets and replaced them with higher yielding assets. The
Company took these actions because it determined that certain assets that were
purchased in the much lower interest rate environment of 2003 and 2004 were
unlikely to recover to their amortized cost basis and were not providing
attractive returns on a cash flow basis.
We have shortened contractual maturities on our borrowings during the
second quarter of 2006, such that our weighted average contractual maturity on
our repurchase agreements was 119 days at June 30, 2006, as compared to 152 days
at June 30, 2005.
The table below provides quarterly information regarding our average
balances, interest income, interest expense, yield on assets, cost of funds and
net interest income for the following quarterly periods presented.
Yield on
Average Average Average
Investment Interest Balance of Total Average Net
Securities Total Interest Earning Repurchase Interest Cost of Interest
Held (1) Income Assets Agreements Expense Funds Income
-----------------------------------------------------------------------------------
(ratios for the quarters have been annualized, dollars in thousands)
-----------------------------------------------------------------------------------
Quarter Ended June 30, 2006 $21,660,089 $280,171 5.17% $20,060,978 $242,473 4.83% $37,698
Quarter Ended March 31, 2006 $16,590,859 $194,882 4.70% $15,296,893 $167,512 4.38% $27,370
Quarter Ended December 31, 2005 $17,551,868 $179,688 4.10% $16,547,972 $165,766 4.01% $13,922
Quarter Ended September 30, 2005 $18,906,350 $177,474 3.75% $17,672,690 $155,043 3.51% $22,431
Quarter Ended June 30, 2005 $18,918,577 $171,595 3.63% $17,658,408 $133,758 3.03% $37,837
Quarter Ended March 31, 2005 $18,798,200 $176,289 3.75% $17,756,241 $113,993 2.57% $62,296
- ----------------------------------------------------------------------------------------------------------------------
(1) Does not reflect unrealized gains/(losses).
The following table presents the CPR experienced on our Mortgage-Backed
Securities portfolio, on an annualized basis, for the following quarterly
periods:
Quarter Ended CPR
- ------------- ---
June 30, 2006 19%
March 31, 2006 18%
December 31, 2005 28%
September 30, 2005 28%
June 30, 2005 27%
March 31, 2005 25%
18
We believe that the CPR in future periods will depend, in part, on
changes in and the level of market interest rates across the yield curve, with
higher CPRs expected during periods of declining interest rates and lower CPRs
expected during periods of rising interest rates.
We continue to explore alternative business strategies, alternative
investments and other strategic initiatives to complement our core business
strategy of investing, on a leveraged basis, in high quality Investment
Securities. No assurance, however, can be provided that any such strategic
initiative will or will not be implemented in the future.
For the purposes of computing ratios relating to equity measures,
throughout this document, equity includes Series B cumulative Convertible
Preferred Stock, which has been treated under GAAP as temporary equity.
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 conformity 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 most affected by management's judgments,
estimates and assumptions; the policies have not changed during 2006.
Market Valuation and Impairment of Investment Securities: All assets
classified as available-for-sale are reported at fair value, based on market
prices. Although we generally intend to hold most of our Investment Securities
until maturity, we may, from time to time, sell any of our Investment Securities
as part our overall management of our portfolio. Accordingly, we are required to
classify all of our Investment Securities as available-for-sale. Our policy is
to obtain market values from independent sources. Management evaluates
securities for other-than-temporary impairment at least on a quarterly basis,
and more frequently when economic or market concerns warrant such evaluation.
Consideration is given to (1) the length of time and the extent to which the
fair value has been less than cost, (2) the financial condition and near-term
prospects of the issuer, and (3) the intent and ability of the Company to retain
its investment in the issuer for a period of time sufficient to allow for any
anticipated recovery in fair value. Investments with unrealized losses are not
considered other-than-temporarily impaired if the Company has the ability and
intent to hold the investments for a period of time, to maturity if necessary,
sufficient for a forecasted market price recovery up to or beyond the cost of
the investments. Unrealized losses on Investment 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 Investment Securities is adjusted. Losses other-than-temporary
impaired on securities totaled $20.1 million for the quarter ended June 30,
2006. There were no such adjustments for the quarter ended June 30, 2005.
Unrealized losses at June 30, 2006 on Investment Securities that are not deemed
impaired totaled $495.7 million.
Interest income: Interest income is accrued based on the outstanding
principal amount of the Investment Securities and their contractual terms.
Premiums and discounts associated with the purchase of the Investment Securities
are amortized or accreted into interest income over the projected 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.
If our estimate of prepayments is incorrect, we may be required to make an
adjustment to the amortization or accretion of premiums and discounts that would
have an impact on future income.
Repurchase Agreements: We finance the acquisition of our Investment
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.
19
Income Taxes: We have elected to be taxed as a Real Estate Investment
Trust (or REIT) and intend to comply with the provisions of the Internal Revenue
Code of 1986, as amended (or 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. The Company and FIDAC have made a joint election to
treat FIDAC as a taxable REIT subsidiary. As such, FIDAC is taxable as a
domestic C corporation and subject to federal and state and local income taxes
based upon its taxable income.
Impairment of Intangibles: The Company's acquisition of FIDAC was
accounted for using the purchase method. The cost of FIDAC was allocated to the
assets acquired, including identifiable intangible assets, and the liabilities
assumed based on their estimated fair values at the date of acquisition. The
excess of cost over the fair value of the net assets acquired was recognized as
goodwill. Intangible assets are periodically reviewed for potential impairment.
This evaluation required significant judgment. During 2006, we recognized
impairment charges totaling $2.5 million.
Results of Operations: For the Quarters and Six Months Ended June 30, 2006
and 2005
Net Income Summary
For the quarter ended June 30, 2006, our net income was $8.6 million,
or $0.02 basic net income per average share available to common shareholders, as
compared to net income of $47.0 million, or $0.36 net income per average share
available to common shareholders, for the quarter ended June 30, 2005. We
attribute the decrease in total net income for the quarter ended June 30, 2006
from the quarter ended June 30, 2005 to the decline in net interest income,
realized losses, impairment charges related to certain securities and
intangibles, reduction in net investment advisory fees, and an increase in
general and administrative expenses. The decrease in total net income per share
was primarily due to the decline in the interest rate spread from 0.60% to
0.34%. The increase in cost of funding from 3.03% for the quarter ended June 30,
2005 to 5.01% for the quarter ended June 30, 2006 was only partially offset by
the increase in yield on assets of 3.63% for the quarter ended June 30, 2005 to
5.42% for the quarter ended June 30, 2006. For the quarter ended June 30, 2006,
the loss on sale of Mortgage-Backed Securities was $1.2 million as compared to
an $11.4 million gain on sale of Mortgage-Backed Securities for the quarter
ended June 30, 2005. Losses on other-than-temporarily impaired securities
totaled $20.1 million and impairment of intangibles totaled $1.3 million for the
quarter ended June 30, 2006. There were no impairment charges for the quarter
ended June 30, 2005. For the quarter ended June 30, 2006, net investment
advisory and service fees totaled $4.4 million, as compared to $7.5 million for
the quarter ended June 30, 2005. For the quarter ended June 30, 2006, general
and administrative expenses totaled $9.0 million, as compared to $6.8 million
for the quarter ended June 30, 2005. Dividends for the quarter ended June 30,
2006 were $0.13 per share of common stock, or $21.3 million in total, and
$0.492188 per share of Series A preferred stock, or $3.6 million in total, and
$0.32916 per share of Series B preferred stock or $1.5 million in total.
Dividends per share for the quarter ended June 30, 2005 were $0.36 per share of
common stock, or $44.1 million in total and $0.492188 per share of Series A
preferred stock, or $3.6 million in total. The Series B Cumulative preferred
stock has been treated under GAAP as temporary equity. For the purpose of
computing ratios relating to equity measures, such Preferred Stock has been
included in equity. Our return on average equity was 2.09% for the quarter ended
June 30, 2006 compared to 11.36% for the quarter ended June 30, 2005.
For the six months ended June 30, 2006, our net loss was $2.4 million,
or $0.08 net loss per average share related to common shareholders, as compared
to net income of $106.3 million, or $0.82 basic earnings per average share
available to common shareholders, for the six months ended June 30, 2005. We
attribute the majority of the decrease in net income for the six months ended
June 30, 2006, from the six months ended June 30, 2005 to the decrease in net
interest spread and realized and unrealized losses. For the six months ended
June 30, 2006, net interest income was $65.1 million, as compared to $100.1
million for the six months ended June 30, 2005. For the six months ended June
30, 2006, loss on sale of Mortgage-Backed Securities was $8.2 million, as
compared to a $11.4 million gain for the quarter ended June 30, 2005. Losses on
other-than-temporarily impaired securities totaled $46.8 million and impairment
of intangibles totaled $1.1 million for the six months ended June 30, 2006.
There were no impairment charges for the six months ended June 30, 2005.For the
six months ended June 30, 2006, net investment advisory and service fees totaled
$10.3 million, as compared to $12.2 million for the six months ended June 30,
2005. Dividends per share for the six months ended June 30, 2006, were $0.24 per
share of common stock, or $34.9 million in total and $0.984376 per share of
preferred stock or $7.3 million in total and $0.329167 per share of Series B
Preferred stock, or 1.5 million in total. Dividends per share for the six months
ended June 30, 2005 were $0.81 per share, or $98.7 million in total and
$0.984376 per share of preferred stock or $7.3 million in total. Our return on
average equity was (0.30%) for the six months ended June 30, 2006 and 12.73% for
the six months ended June 30, 2005.
20
Net Income Summary
(ratios for the quarter have been annualized, dollars in the thousands, except for per share data)
--------------------------------------------------------------------------------------------------
Quarter Quarter Six Months
Ended Ended Six Months Ended Ended
June 30, June 30, June 30, June 30,
2006 2005 2006 2005
--------------- --------------- ----------------- ----------------
Interest income $280,171 $171,595 $475,053 $347,884
Interest expense 242,473 133,758 409,985 247,751
--------------- --------------- ----------------- ----------------
Net interest income 37,698 37,837 65,068 100,133
Investment advisory and service fees 5,210 9,669 12,206 15,978
(Loss) gain on sale of Mortgage-Backed
Securities (1,239) 11,435 (8,245) 12,016
Distribution fees 755 2,126 1,925 3,737
General and administrative expenses 8,985 6,800 16,162 13,464
Impairment of intangible for customer
relationships (1,345) - (2,493) -
Loss on other-than-temporarily impaired
securities (20,114) - (46,843) -
--------------- --------------- ----------------- ----------------
Income (loss) before income taxes 10,470 50,015 1,606 110,926
Income taxes 1,892 3,022 3,977 4,600
--------------- --------------- ----------------- ----------------
Net (loss) income 8,578 46,993 (2,371) 106,326
Dividends on preferred stock 5,163 3,648 8,811 7,297
--------------- --------------- ----------------- ----------------
Net (loss) income (related) available to
common shareholders $3,415 $43,345 ($11,182) $99,029
=============== =============== ================= ================
Weighted average number of basic common
shares outstanding 158,632,865 121,740,256 141,476,532 121,506,858
Weighted average number of diluted common
shares outstanding 158,703,614 122,013,050 141,476,532 121,785,918
Basic net (loss) income per share
(related) available to common shareholders
$0.02 $0..36 ($0.08) $0.82
Diluted net (loss) income per share
(related) available to common shareholders
$0.02 $0.36 ($0.08) $0.81
Average total assets $20,128,249 $19,455,044 $18,773,307 $19,490,129
Average total equity $1,638,913 $1,654,932 $1,593,950 $1,700,488
Annualized return on average assets 0.17% 0.97% (0.03%) 1.09%
Annualized return on average equity 2.09% 11.36% (0.30%) 12.73%
Interest Income and Average Earning Asset Yield
We had average earning assets of $21.7 billion and $18.9 billion for
the quarters ended June 30, 2006 and 2005, respectively. Our primary source of
income for the quarters ended June 30, 2006 and 2005 was interest income. Our
interest income was $280.2 for the quarter ended June 30, 2006 and $171.6
million for the quarter ended June 30, 2005. The yield on average investment
21
securities increased from 3.63% for the quarter ended June 30, 2005 to 5.17% for
the quarter ended June 30, 2006. Our average earning asset balance increased by
2.8 billion and interest income increased by $108.6 million for the quarter
ended June 30, 2006 as compared to the quarter ended June 30, 2005. The average
coupon rate at June 30, 2006 was 5.61% as compared to 4.69% at June 30, 2005.
The prepayment speeds decreased to 19% CPR for the quarter ended June 30, 2006
from 27% CPR for the quarter ended June 30, 2005. The increase in coupon rates
and reduction in prepayment speeds, resulted in an increase in yield.
We had average earning assets of $19.1 billion and $18.9 billion for
the six months ended June 30, 2006 and 2005, respectively. Our interest income
was $475.0 million for the six months ended June 30, 2006 and $347.9 million for
the six months ended June 30, 2005. The yield on average investment securities
increased from 3.69% for the six months ended June 30, 2005, to 4.97% for the
six months ended June 30, 2006. Our average earning asset balance increased by
$200.0 million and interest income increased by $127.1 million for the six
months ended June 30, 2006 as compared to the six months ended June 30, 2005.
The average prepayment speeds decreased to 19% CPR for the six months ended June
30, 2006 from 26% CPR for the six months ended June 30, 2005. The increase in
interest income for the six months ended June 30, 2006, when compared to the six
months ended June 30, 2005, resulted from the increased asset base and the
increase in weighted average yield.
Interest Expense and the Cost of Funds
We anticipate that our largest expense will be the cost of borrowed
funds. We had average borrowed funds of $20.0 billion and total interest expense
of $242.5 million for the quarter ended June 30, 2006. We had average borrowed
funds of $17.7 billion and total interest expense of $133.8 million for the
quarter ended June 30, 2005. Our average cost of funds was 4.83% for the quarter
ended June 30, 2006 and 3.03% for the quarter ended June 30, 2005. The cost of
funds rate increased by 180 basis points and the average borrowed funds
increased by $2.4 billion for the quarter ended June 30, 2006 when compared to
the quarter ended June 30, 2005. Interest expense for the quarter increased by
$108.7 million due to the substantial increase in the cost of funds interest
rate and the average borrowed funds balance. Our average cost of funds was 0.20%
below average one-month LIBOR and 0.44% below average six-month LIBOR for the
quarter ended June 30, 2006. Our average cost of funds was 0.02% below average
one-month LIBOR and 0.40% below for the quarter ended June 30, 2005.
The table below shows our average borrowed funds and average cost of
funds, including the effect of the interest rate swaps, as compared to average
one-month and average six-month LIBOR for the quarters ended June 30, 2006,
March 31, 2006, the year ended December 31, 2005 and the four quarters in 2005.
Average Cost of Funds
(ratios for the quarters have been annualized, dollars in thousands)
Average
Average Average Cost of
One-Month Cost of Funds
LIBOR Funds Relative
Relative Relative to
Average Average Average Average to Average to Average Average
Borrowed Interest Cost of One-MonthSix-Month Six-Month One-Month Six-Month
Funds Expense Funds LIBOR LIBOR LIBOR LIBOR LIBOR
- ----------------------------------------------------------------------------------------------------------------------
Quarter Ended June 30, 2006 $20,060,978 $242,473 4.83% 5.03% 5.27% (0.24%) (0.20%) (0.44%)
Quarter Ended March 31, 2006 $15,296,893 $167,512 4.38% 4.55% 4.84% (0.29%) (0.17%) (0.46%)
- ----------------------------------------------------------------------------------------------------------------------
Year Ended December 31, 2005 $17,408,828 $568,560 3.27% 3.33% 3.72% (0.39%) (0.06%) (0.45%)
Quarter Ended December 31, 2005 $16,547,972 $165,766 4.01% 4.10% 4.46% (0.36%) (0.09%) (0.45%)
Quarter Ended September 30, 2005 $17,672,690 $155,043 3.51% 3.54% 3.91% (0.37%) (0.03%) (0.40%)
Quarter Ended June 30, 2005 $17,658,408 $133,758 3.03% 3.05% 3.43% (0.38%) (0.02%) (0.40%)
Quarter Ended March 31, 2005 $17,756,241 $113,993 2.57% 2.58% 3.02% (0.44%) (0.01%) (0.45%)
- ----------------------------------------------------------------------------------------------------------------------
Net Interest Income
Our net interest income, which equals interest income less interest
expense, totaled $37.6 million for the quarter ended June 30, 2006 and $37.8
million for the quarter ended June 30, 2005. Our net interest income decreased
because the interest rate spread decreased. 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 0.34% for the quarter ended June 30, 2006 as compared
22
to 0.60% for the quarter ended June 30, 2005. This 26 basis point decrease was a
result of the increase in the cost of funding for the quarter ended June 30,
2006 to 4.83% from 3.03% for the quarter ended June 30, 2005. The increase in
cost of funds was only partially offset by the increase in yield on assets,
which increased to 5.17% for the quarter ended June 30, 2006, as compared to
3.63% for the quarter ended June 30, 2005.
Our net interest income totaled $65.0 million for the six months ended
June 30, 2006 and $100.1 million for the six months ended June 30, 2005. Our net
interest income decreased because of the decline in interest rate spread. 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 0.33% for the six months
ended June 30, 2006 as compared to 0.89% for the quarter ended June 30, 2005.
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
quarters ended June 30, 2006, March 31, 2006 the year ended December 31, 2005,
and the four quarters in 2005.
Net Interest Income
(ratios for the quarters have been annualized, dollars in thousands)
Yield
on
Average Average Average Net
Investment Total Interest Balance of Average Net Interest
Securities Interest Earning Repurchase Interest Cost of Interest Rate
Held Income Assets Agreements Expense Funds Income Spread
- ----------------------------------------------------------------------------------------------------------------------
Quarter Ended June 30, 2006 $21,660,089 $280,171 5.17% $20,060,978 $242,473 4.83% $37,698 0.34%
Quarter Ended March 31, 2006 $16,590,859 $194,882 4.70% $15,296,893 $167,512 4.38% $27,370 0.32%
Quarter Ended March 31, 2005 $176,289 $17,756,241 $113,993 2.57% $62,296 1.18%
- ----------------------------------------------------------------------------------------------------------------------
Year Ended December 31, 2005 $18,543,749 $705,046 3.80% $17,408,827 $568,560 3.27% $136,486 0.53%
Quarter Ended December 31, 2005 $17,551,868 $179,688 4.10% $16,547,972 $165,766 4.01% $13,922 0.09%
Quarter Ended September 30, 2005 $18,906,350 $177,474 3.75% $17,672,690 $155,043 3.51% $22,431 0.24%
Quarter Ended June 30, 2005 $18,918,577 $171,595 3.63% $17,658,408 $133,758 3.03% $37,837 0.60%
Quarter Ended March 31, 2005 $18,798,200 $176,289 3.75% $17,756,241 $113,993 2.57% $62,296 1.18%
Investment Advisory and Service Fees
FIDAC is a registered investment advisor which specializes in managing
fixed income securities. FIDAC recently expanded its line of business to include
the management of equity securities, initially for us and an affiliated person,
and management of collaterized debt obligations. FIDAC generally receives annual
net investment advisory fees of approximately 10 to 20 basis points of the gross
assets it manages, assists in managing or supervises. At June 30, 2006, FIDAC
had under management approximately $2.6 billion in net assets and $14.1 billion
in gross assets, compared to $3.1 billion in net assets and $27.8 billion in
gross assets at June 30, 2005. Investment advisory and service fees for the
quarters ended June 30, 2006 and 2005 totaled $4.4 million and $7.6 million
respectively, net of fees paid to third parties pursuant to distribution service
agreements for facilitating and promoting distribution of shares of FIDAC's
clients. Gross assets under management will vary from time to time because of
changes in the amount of net assets FIDAC manages as well as changes in the
amount of leverage used by the various funds and accounts FIDAC manages. At June
30, 2006, net assets under management decreased by $500 million and gross assets
under management decreased by $13.7 billion, when compared to June 30, 2005.
Since the net advisory fees are based on assets under management, the decline in
fees is a result of redemptions, reductions in the market value of the assets,
and lower leverage in the funds.
Gains and Losses on Sales of Mortgage-Backed Securities
For the quarter ended June 30, 2006, we sold Mortgage-Backed Securities
with a carrying value of $1.1 billion for an aggregate loss of $1.2 million,
which had previously been classified as other-than-temporarily impaired
securities. For the quarter ended June 30, 2005, we sold Mortgage-Backed
Securities with an aggregate historical amortized cost of $859.3 million for an
aggregate gain of $11.4 million. For the six months ended June 30, 2006, we sold
Mortgage-Backed Securities with an aggregate historical amortized cost of $2.3
billion for an aggregate loss of $8.2 million. For the six months ended June 30,
23
2005, we sold Mortgage-Backed Securities with an aggregate historical amortized
cost of $944.7 million for an aggregate gain of $12.0 million. The difference
between the sale price and the carrying value of our Mortgage-Backed Securities
will be a realized gain or a realized loss, and will increase or decrease income
accordingly. We do not expect to sell assets on a frequent basis, but may from
time to time sell existing assets to acquire new assets, which our management
believes might have higher risk-adjusted returns as part of our asset/liability
management strategy.
Impairment of Intangible for Customer Relationships
During the quarter ended June 30, 2006, intangibles were evaluated for
possible impairment. It was determined that an impairment charge of $1.3 million
was necessary based on the decline in expected future cash flows on one customer
relationship.
During the first quarter of 2006 we terminated an investment advisory
agreement. The expected cash flows from the contract were valued as an
intangible for customer relationships on June 4, 2004, the date of the
acquisition of FIDAC. The value of $1.1 million was deemed to be impaired and
written off in the quarter ended March 31, 2006. The total impairment of
intangible for customer relationships is $2.5 million for the six months ended
June 30, 2006.
Loss on Other-Than-Temporarily Impaired Securities
During the second quarter of 2006, the Company reviewed each of its
securities to determine if an other-than-temporary impairment charge would be
necessary. It was determined for certain securities that were in an unrealized
loss position, the Company did not intend to hold them for a period of time, to
maturity if necessary, sufficient for a forecasted market price recovery up to
or beyond the cost of the investments. Approximately $126.8 million face amount
of securities were classified as other-than-temporarily impaired, with an
approximate loss of $4.4 million. Securities that had previously been determined
to be other-than-temporarily impaired continued to decline in value and we
recorded a $15.7 million additional loss for these securities. The total loss on
other-than-temporarily impaired securities totaled $20.1 million and $46.8
million for the quarter and six months ended June 30, 2006, respectively.
General and Administrative Expense
General and administrative ("G&A") expenses were $9.0 million for the
quarter ended June 30, 2006 and $6.8 million for the quarter ended June 30,
2005. G&A expenses as a percentage of average assets were 0.18% and 0.14% for
the quarters ended June 30, 2006 and June 30, 2005, respectively. G&A expenses
as a percentage of average equity were 2.19% and 1.64% on an annualized basis
for the quarters ended June 30, 2006 and June 30, 2005, respectively. The
increase in G&A expenses of $2.2 million for the quarter ended June 30, 2006 was
the primary result of an increase in compensation expense from new and existing
employment contracts.
G&A expenses were $16.2 million for the six months ended June 30, 2006
and $13.5 million for the six months ended June 30, 2005. G&A expenses as a
percentage of average assets was 0.17% and 0.14% on an annualized basis for the
six months ended June 30, 2006 and 2005, respectively. G&A expenses as a
percentage of average equity were 2.03% and 1.61% on an annualized basis for the
six months ended June 30, 2006 and 2005, respectively.
The table below shows our total G&A expenses as compared to average
total assets and average equity for the quarter ended June 30, 2006, March 31,
2006, the year ended December 31, 2005, and the four quarters in 2005.
24
G&A Expenses and Operating Expense Ratios
(ratios for the quarters have been annualized, dollars in thousands)
Total G&A Total G&A
Total G&A Expenses/Average Expenses/Average
Expenses Assets (annualized) Equity (annualized)
------------------ ----------------------- ---------------------
Quarter Ended June 30,2006 $8,985 0.18% 2.19%
Quarter Ended March 31, 2006 $7,177 0.18% 1.95%
---------------------------------------- ------------------ ----------------------- ---------------------
Year Ended December 31, 2005 $26,278 0.14% 1.63%
Quarter Ended December 31, 2005 $6,359 0.14% 1.66%
Quarter Ended September 30, 2005 $6,455 0.13% 1.58%
Quarter Ended June 30, 2005 $6,800 0.14% 1.64%
Quarter Ended March 31, 2005 $6,664 0.14% 1.61%
---------------------------------------- ------------------ ----------------------- ---------------------
Net Income and Return on Average Equity
Our net income was $8.6 million for the quarter ended June 30, 2006 and
$47.0 million for the quarter ended June 30, 2005. Our annualized return on
average equity was 2.09% for the quarter ended June 30, 2006 and 11.36% for the
quarter ended June 30, 2005. We attribute the decrease in net income and return
on average equity to the interest rate spread compression for the quarter,
impairment charges related to certain securities and intangibles, reduction in
net investment advisory fees, and an increase in general and administrative
expenses. The decline in spread income totaled $38.4 million. Losses realized
during the quarter ended June 30, 2006 totaled $1.2 million. Unrealized losses
on other-than-temporarily-impaired securities totaled $20.1 million. Our return
on average equity for the quarter ended June 30, 2006 was 2.09%, compared to
11.36% for the quarter ended June 30, 2005. Our net loss was $2.4 million for
the six months ended June 30, 2006 and our net income was $106.3 million for the
six months ended June 30, 2005. Our loss on average equity was 0.30% for the six
months ended June 30, 2006 and 12.73% for the six months ended June 30, 2005. We
attribute the decrease in total net income for the quarter and six months ended
June 30, 2006 from the quarter and six months ended June 30, 2005 to the decline
in net interest income, realized losses, impairment charges related to certain
securities and intangibles, reduction in net investment advisory fees, and an
increase in general and administrative expenses. The table below shows our net
interest income, net investment advisory and service fees, (loss) gain on sale
of Mortgage-Backed Securities, loss on other than temporarily impaired
securities, G&A expenses, and income taxes each as a percentage of average
equity, and the return on average equity for the quarter ended June 30, 2006,
March 31, 2006, the year ended December 31, 2005, and the four quarters in 2005.
Components of Return on Average Equity
(Ratios for the four quarters in 2006 have been annualized)
(Loss) gain
Net on Sale of
Net Investment Mortgage- Loss on
Interest Advisory and Backed other-than- G&A Income Impairment Return
Income/ Service Securities/ temporarily Expenses/ Taxes/ of intangible on
Average Fees/Average Average impaired Average Average for customer Average
Equity Equity Equity securities Equity Equity relationships Equity
--------------------------------------------------------------------------------------
For the Quarter Ended June 30,
2006 9.20% 1.08% (0.30%) (4.91%) (2.19%) (0.46%) (0.33%) 2.09%
For the Quarter Ended March 31,
2006 7.45% 1.59% (1.91%) (7.28%) (1.95%) (0.57%) (0.31%) (2.98%)
- ----------------------------------------------------------------------------------------------------------------------
For the Year Ended December 31,
2005 8.45% 1.71% (3.30%) (5.15%) 1.63% 0.67% - (0.57%)
For the Quarter Ended December
31, 2005 3.64% 1.79% (17.05%) (21.70%) 1.66% 0.73% - (35.71%)
For the Quarter Ended September
30, 2005 5.50% 2.09% 0.01% - 1.58% 0.82% - 5.20%
For the Quarter Ended June 30,
2005 9.15% 1.82% 2.76% - 1.64% 0.73% - 11.36%
For the Quarter Ended March 31,
2005 15.06% 1.13% 0.14% - 1.61% 0.38% - 14.34%
Financial Condition
Investment Securities
All of our Mortgage-Backed Securities at June 30, 2006 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 of our Mortgage-Backed Securities were FHLMC, FNMA
or GNMA mortgage pass-through certificates or collateralized mortgage
obligations, which carry an actual or implied "AAA" rating. We mark-to-market
all of our Mortgage Backed Securities to fair value.
We accrete discount balances as an increase in interest income over the
life of Investment Securities purchased at a discount and we amortize premium
balances as a decrease in interest income over the life of the Investment
Securities purchased at a premium. At June 30, 2006 and December 31, 2005, we
25
had in our statement of financial condition a total of $75.3 million and $21.5
million, respectively, of unamortized discount and a total of $216.9 million and
$242.1 million, respectively, of unamortized premium.
We received mortgage principal repayments of $1.2 billion for the
quarter ended June 30, 2006 and $1.7 billion for the quarter ended June 30,
2005. The overall prepayment speed for the quarter ended June 30, 2006 decreased
to 19%, as compared to 27% for the quarter ended June 30, 2005, due to the
decline in refinancing activity. 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 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 our Investment Securities at June 30, 2006,
March 31, 2006, December 31, 2005, September 30, 2005, June 30, 2005, and March
31, 2005.
Investment Securities
(dollars in thousands)
Amortized Fair Weighted
Principal Amortized Cost/Principal Value/Principal Average
Amount Net Premium Cost Amount Fair Value Amount Yield
- --------------------------------------------------------------------------------------------------------------------
At June 30, 2006 $23,822,683 $141,671 $23,964,354 100.59% $23,474,006 98.54% 5.42%
At March 31, 2006 $16,288,848 $173,428 $16,462,276 101.06% $16,176,348 99.31% 5.03%
- --------------------------------------------------------------------------------------------------------------------
At December 31, 2005 $15,915,801 $220,637 $16,136,438 101.39% $15,929,864 100.09% 4.68%
At September 30, 2005 $18,884,571 $375,985 $19,260,557 101.99% $18,956,001 101.38% 3.96%
At June 30, 2005 $19,300,333 $401,356 $19,701,690 102.08% $19,556,836 101.33% 3.78%
At March 31, 2005 $18,887,801 $416,542 $19,304,343 102.21% $19,091,063 101.08% 3.61%
- --------------------------------------------------------------------------------------------------------------------
The tables below set forth certain characteristics of our Investment
Securities. The index level for adjustable-rate Investment Securities is the
weighted average rate of the various short-term interest rate indices, which
determine the coupon rate of securities.
Adjustable-Rate Investment Securities Characteristics
(dollars in thousands)
Principal Amount
Weighted Weighted at Period End as
Weighted Average Term Weighted Average Asset % of Total
Principal Average Coupon to Next Average Yield Investment
Amount Rate Adjustment Lifetime Cap (annualized) Securities
--------------------------------------------------------------------------------------------
At June 30, 2006 $7,964,221 5.36% 16 months 9.75% 5.26% 33.43%
At March 31, 2006 $7,785,082 4.99% 20 months 10.27% 5.07% 47.79%
- ---------------------------------------------------------------------------------------------------------------------
At December 31, 2005 $9,699,133 4.76% 22 months 10.26% 4.74% 60.94%
At September 30, 2005 $12,437,763 4.56% 23 months 10.26% 3.91% 65.86%
At June 30, 2005 $12,934,382 4.43% 24 months 10.30% 3.69% 67.02%
At March 31, 2005 $13,464,087 4.29% 22 months 10.06% 3.46% 71.28%
26
Fixed-Rate Investment Securities Characteristics
(dollars in thousands)
Principal
Amount at
Weighted Weighted Period End as
Average Average % of Total
Principal Coupon Rate Asset Yield Investment
Amount (annualized) (annualized) Securities
-----------------------------------------------------
At June 30, 2006 $15,858,461 5.73% 5.50% 66.57%
At March 31, 2006 $8,503,766 5.43% 4.99% 52.21%
- ------------------------------------------------------------------------
At December 31,
2005 $6,216,668 5.37% 4.60% 39.06%
At September 30,
2005 $6,446,808 5.23% 4.06% 34.14%
At June 30, 2005 $6,365,952 5.22% 3.96% 32.98%
At March 31, 2005 $5,423,714 5.31% 3.99% 28.72%
The following tables provide information on adjustable-rate Investment
Securities by index at June 30, 2006, and December 31, 2005.
Adjustable-Rate Investment Securities by Index
June 30, 2006
National Treasury
Six- 11th Financial Six- Monthly 6-Month
One- Six- Twelve Month 12-Month DistrictAverage Month 1-Year 2-Year 3-Year 5-Year Federal Auction
Month Month Month Auction Moving Cost of Mortgage CD Treasury Treasury TreasuryTreasury Cost of Invest.
LiborLibor Libor Average Average Funds Rate Rate Index Index Index Index Funds Rate
-------------------------------------------------------------------------------------------------------------
Weighted
Average
Term to
Next
Adjustment 1 mo.40 mo.31 mo. 2 mo. 1 mo. 1 mo. 11 mo. 3 mo. 14 mo. 14 mo. 18 mo. 31 mo. 1 mo. 3 mo.
Weighted
Average
Annual
Period Cap 7.30% 2.00% 2.00% 1.00% 0.19% 0.00% 2.00% 1.58% 1.86% 2.00% 2.02% 1.96% 0.00% 1.00%
Weighted
Average
Lifetime
Cap at
June 30,
2006 6.74%10.92%10.56% 12.96% 10.60% 12.08% 10.90% 9.71% 10.75% 11.93% 13.13 % 12.53% 13.40% 12.50
Investment
Principal
Amount as
Percentage
of
Investment
Securities
at June
30, 2006 9.46% 3.47% 9.65% 0.01% 0.11% 0.57% 0.00% 0.01% 9.54% 0.00% 0.15% 0.04% 0.40% 0.02%
Adjustable-Rate Investment Securities by Index
December 31, 2005
National
Six- 11th Financial Six- Monthly
One- Six- Twelve Month 12-Month District Average Month 1-Year 2-Year 3-Year 5-Year Federal
Month Month Month Auction Moving Cost of Mortgage CD Treasury Treasury TreasuryTreasury Cost of
Libor Libor Libor Average Average Funds Rate Rate Index Index Index Index Funds
------------------------------------------------------------------------------------------------------
Weighted Average
Term to
Next Adjustment 1 mo.42 mo.22 mo. 2 mo. 2 mo. 1 mo. 17mo. 3 mo. 18 mo. 14 mo. 21 mo. 34 mo. 1 mo.
Weighted Average
Annual
Period Cap 7.29% 2.00% 2.00% 1.00% 0.16% 0.00% 2.00% 1.00% 1.90% 2.00% 2.03% 1.96% 0.00%
Weighted Average
Lifetime
Cap at December
31, 2005 7.98%10.78%10.33% 13.03% 10.61% 12.07% 10.90%11.74% 10.54% 11.93% 13.12 % 12.51% 13.40%
Investment
Principal Value
as Percentage of
Investment
Securities at
December 31,
2005 6.33% 6.42%24.46% 0.01% 0.19% 0.94% 0.01% 0.03% 21.55% 0.01% 0.25% 0.06% 0.68%
Borrowings
To date, our debt has consisted entirely of borrowings collateralized
by a pledge of our Investment Securities. These borrowings appear on our balance
sheet as repurchase agreements. At June 30, 2006, we had established uncommitted
borrowing facilities in this market with 30 lenders in amounts which we believe
are in excess of our needs. All of our Investment 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 financial
condition.
27
For the quarter ended June 30, 2006, 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. For the quarter ended June 30, 2005, the term to
maturity of our borrowings ranged from one day to three years, with a weighted
average original term to maturity of 152 days. At June 30, 2006, the weighted
average cost of funds for all of our borrowings was 5.01% and the weighted
average term to next rate adjustment was 46 days. At June 30, 2005, the weighted
average cost of funds for all of our borrowings was 3.20% and the weighted
average term to next rate adjustment was 81 days.
Liquidity
Liquidity, which is our ability to turn non-cash assets into cash,
allows us to purchase additional investment securities and to pledge additional
assets to secure existing borrowings should the value of our pledged assets
decline. Our potential immediate sources of liquidity include cash balances and
unused borrowing capacity. Unused borrowing capacity will vary over time as the
market value of our investment securities varies. Liquidity is also generated on
an on-going basis through mortgage principal repayments and net earnings
retained prior to payment as dividends to our shareholders. Should our needs
ever exceed these on-going sources of liquidity plus the immediate sources of
liquidity discussed above, we believe that in most circumstances our investment
securities could 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.
Borrowings under our repurchase agreements increased by $4.0 billion to
$21.3 billion at June 30, 2006 from $17.3 billion at June 30, 2005. The increase
in our repurchase agreements was a direct result of the increase in our equity
base from common stock offering and a Series B and preferred offering during the
quarter ended June 30, 2006.
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. We have not at the present time entered into any
commitment agreements under which the lender would be required to enter into a
new repurchase agreement during a specified period of time, nor do we presently
plan to have liquidity facilities with commercial banks.
Under our repurchase agreements, we may be required to pledge
additional assets to our repurchase agreement counterparties (i.e., lenders) in
the event the estimated fair value of the existing pledged collateral under such
agreements declines and such lenders demand additional collateral (a "margin
call"), which may take the form of additional securities or cash. Similarly, if
the estimated fair value of the Mortgage-Backed Securities increases due to
changes in market interest rates of market factors, lenders may release
collateral back to us. Specifically, margin calls result from a decline in the
value of the our Mortgage-Backed Securities securing our repurchase agreements,
prepayments on the mortgages securing such Mortgage-Backed Securities and to
changes in the estimated fair value of such Mortgage-Backed Securities generally
due to principal reduction of such Mortgage-Backed Securities from scheduled
amortization and resulting from changes in market interest rates and other
market factors. Through June 30, 2006, we did not have any margin calls on our
repurchase agreements that we were not able to satisfy with either cash or
additional pledged collateral. However, should prepayment speeds on the
mortgages underlying our Mortgage-Backed Securities and/or market interest rates
suddenly increase, margin calls on our repurchase agreements could result,
causing an adverse change in our liquidity position.
28
The following table summarizes the effect on our liquidity and cash
flows from contractual obligations at June 30, 2006.
Within One One to Three to More than
Year Three Years Five Years Five Years Total
--------------- -------------------------- -------------- --------------
(dollars in thousands)
Repurchase agreements $20,706,703 $550,000 - - $21,256,703
Interest expense on repurchase
agreements 88,008 25,068 113,076
Long-term operating lease
obligations 530 1,331 - - 1,861
Employment contracts 18,387 18,387
--------------- ------------- ------------ -------------- --------------
Total $20,813,628 $576,620 - - $21,390,027
=============== ============= ============ ============== ==============
Stockholders' Equity
During the quarter ended June 30, 2006 the Company declared dividends
to common shareholders totaling $21.3 million or $0.13 per share, which were
paid on July 27, 2006. During the quarter ended June 30, 2006, the Company
declared dividends to Series A Preferred shareholders totaling $3.6 million or
$0.492188 per share, and Series B shareholders totaling $1.5 million or $0.32916
per share which were paid June 30, 2006.
On April 6, 2006, the Company entered into an underwriting agreement
pursuant to which it sold 39,215,000 shares of its common stock for net proceeds
before expenses of approximately $437,737,438. On April 6, 2006, the Company
entered into a second underwriting agreement pursuant to which it sold 4,600,000
shares of its 6% Series B Cumulative Convertible Preferred Stock for net
proceeds before expenses of approximately $111,550,000. Each of these
transactions settled on April 12, 2006. The 6% Series B Cumulative Preferred
Stock has been treated under GAAP as temporary equity. For the purpose of
computing ratios relating to equity measures, such Preferred Stock has been
included in equity. During the quarter ended June 30, 2006, the Company raised
$14.2 million in the Equity Shelf Program by issuing 1,098,500 common shares.
During the quarter ended June 30, 2005, the Company declared dividends to
shareholders totaling $44.1 million or $0.36 per share, which was paid on July
28, 2005.
During the quarter ended June 30, 2005, the Company declared dividends
to Series A Preferred shareholders totaling $3.6 million or $0.492218 per share,
which were paid on June 30, 2005. During the quarter ended June 30, 2005, 10,628
options were exercised under the long-term compensation plan for an aggregate
exercise price of $154,000. In addition, the Company sold 7,902 common shares
through the dividend reinvestment and direct purchase program for $149,000
during the quarter ended June 30, 2005. During the quarter ended June 30, 2005,
the Company raised $23.1 million in the Equity Shelf Program by issuing
1,258,603 common shares.
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)."
The table below shows unrealized gains and losses on the investment
securities and interest rate swaps in our portfolio.
Unrealized Gains and Losses
(dollars in thousands)
At At At At At At
June 30, March 31, December, 31 September 30, June 30, March 31,
2006 2006 2005 2005 2005 2005
------------- ------------ -------------- -------------- ------------- --------------
Unrealized gain $110,755 $41,470 $5,027 $6,109 $ 7,956 $23,683
Unrealized loss (495,667) (290,929) (212,145) (310,664) (152,809) (236,963)
------------- ------------ -------------- -------------- ------------- --------------
Net Unrealized loss ($384,912) ($249,459) ($206,118) ($304,555) ($144,853) ($213,280)
============= ============ ============== ============== ============= ==============
Net unrealized loss as % of
Investment Securities
principal amount (1.62%) (1.53%) (1.30%) (1.61%) (0.75%) (1.13%)
Net unrealized loss as % of
Investment Securities'
Amortized Cost (1.61%) (1.52%) (1.28%) (1.58%) (0.74%) (1.11%)
29
Unrealized changes in the estimated net market value of investment
securities and interest rate swaps have one direct effect on our potential
earnings and dividends: positive mark-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 investment securities and
interest rate swaps may impair our liquidity position, requiring us to sell
assets with the likely result of realized losses upon sale. The net unrealized
loss on available for sale securities was $490.3 million, or (2.05%) of the
amortized cost of our Investment Securities as of June 30, 2006 and $206.6
million, or (1.28%) of the amortized cost of our investment securities as of
December 31, 2005.
Mortgage-Backed Securities with a carrying value of $6.0 billion were
in a continuous unrealized loss position over 12 months at June 30, 2006 in the
amount of $196.1 million. Mortgage-Backed Securities with a carrying value of
$16.0 billion were in a continuous unrealized loss position for less than 12
months at June 30, 2006 in the amount of $299.6 million. Mortgage-Backed
Securities with a carrying value of $4.6 billion were in a continuous unrealized
loss position over 12 months at December 31, 2005 in the amount of $111.1
million. Mortgage-Backed Securities with a carrying value of $8.4 billion were
in a continuous unrealized loss position for less than 12 months at December 31,
2005 in the amount of $100.5 million. The decline in value of these securities
is solely due to increases in interest rates. All of the Mortgage-Backed
Securities are "AAA" rated or carry an implied "AAA" rating. Also, the Company
is guaranteed payment on the par value of the securities.
With the continued increase in the Federal Funds rate during the fourth
quarter of 2005 and first and second quarters of 2006, management determined
during that it did not intend to hold certain of its securities until maturity
and would reposition a portion of its assets. The Company recorded an impairment
charge of $20.1 million, $26.7 million and $83.1 million for these securities
during the second quarter of 2006, first quarter of 2006 and fourth quarter of
2005 respectively. The remaining investments are not considered
other-than-temporarily impaired since the Company currently has the ability and
intent to hold the investments for a period of time or to maturity, if
necessary, sufficient for a forecasted market price recovery up to or beyond the
cost of the investments.
Leverage
Our debt-to- equity ratio at June 30, 2006 and June 30, 2005 was 11.5:1
and 10.1:1 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. We seek attractive
risk-adjusted stockholder returns while maintaining 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, we may seek to mitigate the potential
impact on net income of periodic and lifetime coupon adjustment restrictions in
our portfolio of Investment Securities by entering into interest rate agreements
such as interest rate caps and interest rate swaps. At June 30, 2006, we entered
into swap agreements with a total notional amount of $8.1 billion. Pursuant to
these swaps, we are required to pay a weighted average pay rate of 5.14% and
receive a floating rate based on one month LIBOR. At December 31, 2005, we
entered into swap agreements with a total notional amount of $479.0 million.
Pursuant to these swaps, we are required to pay a weighted average pay rate of
4.88% and receive a floating rate based on one month LIBOR. We may enter into
similar derivative transactions by entering into interest rate collars, caps or
floors.
30
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. 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.
Off-Balance Sheet Arrangements
We do not have any relationships with unconsolidated entities or
financial partnerships, such as entities often referred to as structured finance
or special purpose entities, which would have been established for the purpose
of facilitating off-balance sheet arrangements or other contractually narrow or
limited purposes. Further, we have not guaranteed any obligations of
unconsolidated entities nor do we have any commitment or intent to provide
funding to any such entities. As such, we are not materially exposed to any
market, credit, liquidity or financing risk that could arise if we had engaged
in such relationships.
Capital Resources
At June 30, 2006, we had no material commitments for capital
expenditures.
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
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 REIT assets, as defined in the Code,
were almost 100% of our total assets at June 30, 2006 and December 31, 2005 as
compared to the Code requirement that at least 75% of our total assets be
qualified REIT assets. We also calculate that 100% and 95% of our revenue
qualifies for the 75% source of income test, and 100% of our revenue qualifies
for the 95% source of income test, under the REIT rules for the quarters ended
June 30, 2006 and June 30, 2005 respectively. We also met all REIT requirements
regarding the ownership of our common stock and the distribution of our net
income. Therefore, as of June 30, 2006 and December 31, 2005 we believe that we
qualified as a REIT under the 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. 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 and at least 80% of our assets in qualifying interests
plus other real estate related assets. 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 June 30, 2006 and December 31, 2005 we were in compliance with this
requirement.
31
ITEM. 3 QUANTITATIVE AND QUALITATIVE 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, which is
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. When 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.
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 25, 50, and 75 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 June 30, 2006 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
- ---------------------------------------- ---------------------------------- -----------------------------------
- -75 Basis Points 54.88% 1.88%
- -50 Basis Points 31.13% 1.56%
- -25 Basis Points 13.55% 1.14%
Base Interest Rate - -
+25 Basis Points (13.71%) (0.01%)
+50 Basis Points (27.55%) (0.74%)
+75 Basis Points (41.48%) (1.57%)
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
or negatively even if an institution were perfectly matched in each maturity
category.
32
The following table sets forth the estimated maturity or repricing of
our interest-earning assets and interest-bearing liabilities at June 30, 2006.
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. The interest rate sensitivity of our assets and
liabilities in the table could vary substantially if based on actual prepayment
experience.
More than 1 3 Years and
Within 3 Months 4-12 Months Year to 3 Years Over Total
---------------- ----------------- ---------------- ---------------- --------------
(dollars in thousands)
Rate Sensitive Assets:
Investment Securities $ 2,872,224 $2,402,747 $ 2,407,005 $16,140,707 $23,822,683
Rate Sensitive Liabilities:
Repurchase Agreements 19,206,703 1,500,000 550,000 - 21,256,703
---------------- ----------------- ---------------- ---------------- --------------
Interest rate sensitivity gap ($16,334,479) 902,747 1,857,005 16,140,707 2,565,980
================ ================= ================ ================ ==============
Cumulative rate sensitivity gap ($16,334,479) (15,431,732) (13,574,727) 2,565,980
================ ================= ================ ================ ==============
Cumulative interest rate
sensitivity gap as a percentage of
total rate-sensitive assets (69%) (65%) (57%) 11%
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."
ITEM 4. CONTROLS AND PROCEDURES
Our management, including our Chief Executive Officer (the "CEO") and
Chief Financial Officer (the "CFO"), reviewed and evaluated the effectiveness of
the design and operation of our disclosure controls and procedures (as defined
in Rule 13a-15(e) and 15d-15(e) of the Securities Exchange Act) as of the end of
the period covered by this quarterly report. Based on that review and
evaluation, the CEO and CFO have concluded that our current disclosure controls
and procedures, as designed and implemented, (1) were effective in ensuring that
information regarding Annaly and its subsidiaries is made known to our
management, including our CEO and CFO, by our employees, as appropriate to allow
timely decisions regarding required disclosure and (2) were effective in
providing reasonable assurance that information the Company must disclose in its
periodic reports under the Securities Exchange Act is recorded, processed,
summarized and reported within the time periods prescribed by the SEC's rules
and forms. There have been no changes in our internal control over financial
reporting that occurred during the last fiscal quarter that has materially
affected, or is reasonable likely to materially affect our internal control over
financial reporting.
33
PART II. OTHER INFORMATION
Item 1. LEGAL PROCEEDINGS
From time to time, we are involved in various claims and legal actions
arising in the ordinary course of business. In the opinion of management, the
ultimate disposition of these matters will not have a material adverse effect on
our consolidated financial statements.
Item 1A. RISK FACTORS
In addition to the other information set forth in this report, you
should carefully consider the factors discussed in Part I, "Item 1A. Risk
Factors" in our Annual Report on Form 10-K for the year ended December 31, 2005,
which could materially affect our business, financial condition or future
results. The information presented below updates and should be read in
conjunction with the risk factors and information disclosed in that Form 10-K.
Our operations may be adversely affected if we are subject to the Investment
Company Act.
We rely on the exclusion provided by Section 3(c)(5)(C) of the
Investment Company Act of 1940, as amended (or Investment Company Act). Section
3(c)(5)(C), as interpreted by the staff of the SEC, requires us to invest at
least 55% of our assets in "mortgages and other liens on and interests in real
estate" (or Qualifying Real Estate Assets) and at least 80% of our assets in
Qualifying Real Estate Assets plus real estate related assets. The assets that
we acquire, therefore, are limited by the provisions of the Investment Company
Act and the rules and regulations promulgated under the Investment Company Act.
If the Securities and Exchange Commission determines that any of these
securities are not qualifying interests in real estate or real estate related
assets, adopts a contrary interpretation with respect to these securities or
otherwise believes we do not satisfy the above exceptions, we could be required
to restructure our activities or sell certain of our assets. We may be required
at times to adopt less efficient methods of financing certain of our mortgage
assets and we may be precluded from acquiring certain types of higher-yielding
mortgage assets. The net effect of these factors will be to lower our net
interest income. If we fail to qualify for exemption from registration as an
investment company, our ability to use leverage would be substantially reduced,
and we would not be able to conduct our business as described. Our business will
be materially and adversely affected if we fail to qualify for this exemption.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
(a) The annual meeting of stockholders of Annaly Mortgage Management, Inc.
was held on May 25, 2006.
(b) All Class I director nominees were elected.
Director Votes Received Votes Withheld
- --------------------------------------- ---------------------------- ----------------------------
Wellington J. Denahan-Norris 101,001,059 2,785,793
Donnell A. Segalas 93,075,214 10,711,638
The continuing directors of the Company are Kevin P. Brady, Michael A.J.
Farrell, Jonathan D. Green, John A. Lambiase and E. Wayne Nordberg.
(c) In addition to the election of the Class I directors, the ratification
of the appointment of Deloitte & Touche LLP as our independent
registered public accounting firm for 2006 was approved
Proposals and Vote Tabulations
34
Votes Cast
---------------------------------------------
For Against Abstain
------------------------ -------------------- --------------------
Ratification of the appointment of
independent registered public
accounting firm for 2006 102,789,645 613,295 383,912
ITEM 6. EXHIBITS
Exhibits
The exhibits required by this item are set forth on the Exhibit Index attached
hereto.
Exhibit Number Exhibit Description
3.1 Articles of Amendment and Restatement of the Articles of Incorporation
of the Registrant (incorporated by reference to Exhibit 3.2 to the
Registrant's 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 of the Articles of Incorporation of the
Registrant (incorporated by reference 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).
3.3 Articles of Amendment of the Articles of Incorporation of the
Registrant (incorporated by reference to Exhibit 3.1 of the
Registrant's Form 8-K (filed with the Securities and Exchange
Commission on August 3, 2006).
3.4 Form of Articles Supplementary designating the Registrant's 7.875%
Series A Cumulative Redeemable Preferred Stock, liquidation preference
$25.00 per share (incorporated by reference to Exhibit 3.3 to the
Registrant's 8-A filed April 1, 2004).
3.5 Articles Supplementary of the Company designating an additional
2,750,000 shares of the Company's Series A Preferred Stock, as filed
with the State Department of Assessments and Taxation of Maryland on
October 15, 2004 (incorporated by reference to Exhibit 3.2 to the
Registrant's 8-K filed October 18, 2004).
3.6 Articles Supplementary designating the Registrant's 6% Series B
Cumulative Convertible Preferred Stock, liquidation preference $25.00
per share (incorporated by reference to Exhibit 3.1 to the
Registrant's 8-K filed April 10, 2006).
3.7 Bylaws of the Registrant, as amended (incorporated by reference to
Exhibit 3.3 to the Registrant's Registration Statement on Form S-11
(Registration No. 333-32913) filed with the Securities and Exchange
Commission on August 5, 1997).
31.1 Certification of Chief Executive Officer, pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002.
31.2 Certification of Chief Financial Officer, pursuant to 18 U.S.C.
Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002.
32.1 Certification of Chief Executive Officer, pursuant to 18 U.S.C. 1350,
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2 Certification of Chief Financial Officer, pursuant to 18 U.S.C. 1350,
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
35
SIGNATURES
Pursuant to the requirements 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.
ANNALY CAPITAL MANAGEMENT, INC.
Dated: August 8, 2006 By: /s/ Michael A.J. Farrell
------------------------
Michael A.J. Farrell
(Chairman of the Board, Chief
Executive Officer, President and
authorized officer of registrant)
Dated: August 8, 2006 By: /s/ Kathryn F. Fagan
--------------------
Kathryn F. Fagan
(Chief Financial Officer and
Treasurer and principal financial
and chief accounting officer)
36