ITEM 1. BUSINESS
THE COMPANY
Background
Annaly Mortgage Management, Inc owns and manages a portfolio of mortgage-backed securities, including mortgage pass-through certificates, collateralized mortgage obligations (or CMOs) and other securities representing interests in or obligations backed by pools of mortgage loans. Our principal business objective is to generate net income for distribution to our stockholders from the spread between the interest income on our mortgage-backed securities and the costs of borrowing to finance our acquisition of mortgage-backed securities. We have elected to be taxed as a real estate investment trust (or REIT) under the Internal Revenue Code. Therefore, substantially all of our assets consist of qualified REIT real estate assets (of the type described in Section 856(c)(6)(B) of the Internal Revenue Code). We commenced operations on February 18, 1997. We are self-advised and self-managed.
We have financed our purchases of mortgage-backed securities with the net proceeds of equity offerings and borrowings under repurchase agreements whose interest rates adjust based on changes in short-term market interest rates.
Assets
Under our capital investment policy, at least 75% of our total assets must be comprised of high-quality mortgage-backed securities and short-term investments. High quality securities means securities that (1) are rated within one of the two highest rating categories by at least one of the nationally recognized rating agencies, (2) are unrated but are guaranteed by the United States government or an agency of the United States government, or (3) are unrated but we determine them to be of comparable quality to rated high quality mortgage-backed securities.
The remainder of our assets, comprising not more than 25% of our total assets, may consist of other qualified REIT real estate assets which are unrated or rated less than high quality but which are at least "investment grade" (rated "BBB" or better by Standard & Poor's Corporation (S&P) or the equivalent by another nationally recognized rating agency) or, if not rated, we determine them to be of comparable credit quality to an investment which is rated "BBB" or better.
We may acquire mortgage-backed securities backed by single-family residential mortgage loans as well as securities backed by loans on multi-family, commercial or other real estate-related properties. To date, all of the mortgage-backed securities that we have acquired have been backed by single-family residential mortgage loans.
To date, all of the securities that we have acquired have been agency mortgage-backed securities which, although not rated, carry an implied "AAA" rating. Agency mortgage-backed securities are mortgage-backed securities for which a government agency or federally chartered corporation, such as the Federal Home Loan Mortgage Corporation (or FHLMC), the Federal National Mortgage Association (or FNMA) or the Government National Mortgage Association (or GNMA), guarantees payments of principal or interest on the securities. Agency mortgage-backed securities consist of agency pass-through certificates and CMOs issued or guaranteed by an agency. Pass-through certificates provide for a pass-through of the monthly interest and principal payments made by the borrowers on the underlying mortgage loans. CMOs divide a pool of mortgage loans into multiple tranches with different principal and interest payment characteristics.
At December 31, 2000, approximately 50% of our mortgage-backed securities were adjustable-rate pass-though certificates, approximately 26% of our mortgage-backed securities were fixed-rate pass-through certificates or CMOs, and approximately 24% of our mortgage-backed securities were CMO floaters. Our adjustable-rate pass-through certificates are backed by adjustable-rate mortgage loans and have coupon rates which adjust over time,
subject to interest rate caps and lag periods, in conjunction with changes in short-term interest rates. CMO floaters are tranches of CMOs mortgage-backed securities where the interest rate adjusts in conjunction with changes in short-term interest rates. CMO floaters may be backed by fixed-rate mortgage loans or, less often, by adjustable-rate mortgage loans. In this Form 10-K, except where the context indicates otherwise, we use the term "adjustable-rate securities" or "adjustable-rate mortgage-backed securities" to refer to adjustable-rate pass-through certificates and CMO floaters. At December 31, 2000, the weighted average yield on our portfolio of earning assets was 7.09%, and the weighted average term to next rate adjustment on adjustable rate securities was 15 months.
We intend to continue to invest in adjustable-rate pass-through certificates, fixed-rate mortgage-backed securities and CMO floaters. Although we have not done so to date, we may also invest on a limited basis in mortgage derivative securities representing the right to receive interest only or a disproportionately large amount of interest. We have not and will not invest in real estate mortgage investment conduit (or REMIC) residuals, other CMO residuals or any mortgage-backed securities, such as inverse floaters, which have imbedded leverage as part of their structural characteristics.
Borrowings
We attempt to structure our borrowings to have interest rate adjustment indices and interest rate adjustment periods that, on an aggregate basis, correspond generally to the interest rate adjustment indices and periods of our adjustable-rate mortgage-backed securities. However, periodic rate adjustments on our borrowings are generally more frequent than rate adjustments on our mortgage-backed securities. At December 31, 2000, the weighted average cost of funds for all of our borrowings was 6.55%, the weighted average original term to maturity was 56 days, and the weighted average term to next rate adjustment of these borrowings was 29 days.
We generally expect to maintain a ratio of debt-to-equity of between 8:1 and 12:1, although the ratio may vary from time to time depending upon market conditions and other factors that our management deems relevant. For purposes of calculating this ratio, our equity is equal to the value of our investment portfolio on a mark-to-market basis, less the book value of our obligations under repurchase agreements and other collateralized borrowings. At December 31, 2000, our ratio of debt-to-equity was 12.0:1.
Hedging
To the extent consistent with our election to qualify as a REIT, we may enter into hedging transactions to attempt to protect our mortgage-backed securities and related borrowings against the effects of major interest rate changes. This hedging would be used to mitigate declines in the market value of our mortgage-backed securities during periods of increasing or decreasing interest rates and to limit or cap the rates on our borrowings. These transactions would be entered into solely for the purpose of hedging interest rate or prepayment risk and not for speculative purposes. To date, we have not entered into any hedging transactions.
Compliance With REIT and Investment Company Requirements
We constantly monitor our mortgage-backed securities and the income from these securities and, to the extent we enter into hedging transactions in the future, will monitor income from our hedging transactions as well, so as to ensure at all times that we maintain our qualification as a REIT and our exempt status under the Investment Company Act.
Management
Our executive officers are:
o Michael A.J. Farrell, Chairman of the Board and Chief Executive Officer
o Timothy J. Guba, President and Chief Operating Officer
o Wellington J. St. Claire, Vice Chairman of the Board and Chief Investment Officer
o Kathryn F. Fagan, Chief Financial Officer and Treasurer
Messrs. Farrell and Guba and Ms. St. Claire have an average of 18 years experience in the investment banking and investment management industries where, in various capacities, they have each managed portfolios of mortgage-backed securities, arranged collateralized borrowings and utilized hedging techniques to mitigate interest rate and other risk within fixed-income portfolios. Ms. Fagan is a certified public accountant and, prior to becoming our Chief Financial Officer and Treasurer, served as Chief Financial Officer and Controller of a publicly owned savings and loan association. Since 1994, Messrs. Farrell and Guba and Ms. St. Claire have managed Fixed Income Discount Advisory Company (or FIDAC), a registered investment advisor which, at December 31, 2000, managed, assisted in managing or supervised approximately $1.2 billion in gross assets for a wide array of clients, of which, at that date, approximately $850 million was managed on a discretionary basis.
Management's duties on behalf of FIDAC's clients may create conflicts of interest if members of management are presented with corporate opportunities that may benefit both us and clients for which FIDAC acts as investment advisor. In the event that an investment opportunity arises, the investment will be allocated to another entity or us by determining the entity or account for which the investment is most suitable. In making this determination, our management will consider the investment strategy and guidelines of each entity or account with respect to acquisition of assets, leverage, liquidity and other factors which management determines appropriate.
Distributions
To maintain our qualification as a REIT, we must distribute substantially all of our taxable income to our stockholders for each year. We have done this in the past and intend to continue to do so in the future. We also have declared and paid regular quarterly dividends in the past and intend to do so in the future. We have adopted a dividend reinvestment plan to enable holders of common stock to reinvest dividends automatically in additional shares of common stock.
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
Certain statements contained herein are not, and certain statements contained in our future filings with the Securities and Exchange Commission (the "SEC" or the Commission"), in our press releases or in our other public or shareholder communications may not be, based on historical facts and are "Forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements which are based on various assumptions, (some of which are beyond our control) may be identified by reference to a future period or periods, or by the use of forward-looking terminology, such as "may," "will," "believe," "expect," "anticipate," "continue," or similar terms or variations on those terms, or the negative of those terms. Actual results could differ materially from those set forth in forward-looking statements due to a variety of factors, including, but not limited to, changes in interest rates, changes in yield curve, changes in prepayment rates, the availability of mortgage-backed securities for purchase, the availability of financing and, if available, the terms of any financing. For a discussion of the risks and uncertainties which could cause actual results to differ from those contained in the forward-looking statements, see "Risk Factors." We do not undertake, and specifically disclaim any obligation, to publicly release the result of any revisions 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.
BUSINESS STRATEGY
General
Our principal business objective is to generate income for distribution to our stockholders, primarily from the net cash flows on our mortgage-backed securities. Our net cash flows result primarily from the difference between the interest income on our mortgage-backed security investments and our borrowing costs on our mortgage-backed securities. To achieve our business objective and generate dividend yields, our strategy is:
o to purchase mortgage-backed securities, the majority of which we expect to have adjustable interest rates based on changes in short-term market interest rates;
o to acquire mortgage-backed securities that we believe:
- we have the necessary expertise to evaluate and manage;
- we can readily finance;
- are consistent with our balance sheet guidelines and risk management objectives; and
- provide attractive investment returns in a range of scenarios;
o to finance purchases of mortgage-backed securities with the proceeds of equity offerings and, to the extent permitted by our capital investment policy, to utilize leverage to increase potential returns to stockholders through borrowings (primarily under repurchase agreements);
o to attempt to structure our borrowings to have interest rate adjustment indices and interest rate adjustment periods that, on an aggregate basis, generally correspond to the interest rate adjustment indices and interest rate adjustment periods of our adjustable-rate mortgage-backed securities;
o to seek to minimize prepayment risk by structuring a diversified portfolio with a variety of prepayment characteristics and through other means; and
o to issue new equity or debt and increase the size of our balance sheet when opportunities in the market for mortgage-backed securities are likely to allow growth in earnings per share.
We believe we are able to obtain cost efficiencies through our facilities-sharing arrangement with FIDAC and by virtue of our management's experience in managing portfolios of mortgage-backed securities and arranging collateralized borrowings. We will strive to become even more cost-efficient over time by:
o seeking to raise additional capital from time to time in order to increase our ability to invest in mortgage-backed securities;
o striving to lower our effective borrowing costs over time by seeking direct funding with collateralized lenders, rather than using financial intermediaries, and investigating the possibility of using commercial paper and medium term note programs;
o improving the efficiency of our balance sheet structure by investigating the issuance of uncollateralized subordinated debt, preferred stock and other forms of capital; and
o utilizing information technology to the fullest extent possible in our business, including to improve our ability to monitor the performance of our mortgage-backed securities and to lower our operating costs.
Mortgage-Backed Securities
General
To date, all of the mortgage-backed securities that we have acquired have been agency mortgage-backed securities which, although not rated, carry an implied "AAA" rating. Agency mortgage-backed securities are mortgage-backed securities where a government agency or federally chartered corporation, such as FHLMC, FNMA or GNMA, guarantees payments of principal or interest on the securities. Agency mortgage-backed securities consist of agency pass-through certificates and CMOs issued or guaranteed by an agency.
Even though we have only acquired securities with an implied "AAA" rating so far, under our capital investment policy we have the ability to acquire securities of lower quality. Under our policy, at least 75% of our total assets must be high quality mortgage-backed securities and short-term investments. High quality securities means securities (1) that are rated within one of the two highest rating categories by at least one of the nationally recognized rating agencies, (2) that are unrated but are guaranteed by the United States government or an agency of the United States government, or (3) that are unrated or whose ratings have not been updated but that our management determines are of comparable quality to rated high quality mortgage-backed securities.
Under our capital investment policy, the remainder of our assets, comprising not more than 25% of total assets, may consist of mortgage-backed securities and other qualified REIT real estate assets which are unrated or rated less than high quality, but which are at least "investment grade" (rated "BBB" or better by S&P or the equivalent by another nationally recognized rating organization) or, if not rated, we determine them to be of comparable credit quality to an investment which is rated "BBB" or better. We intend to structure our portfolio to maintain a minimum weighted average rating (including our deemed comparable ratings for unrated mortgage-backed securities) of our mortgage-backed securities of at least single "A" under the S&P rating system and at the comparable level under the other rating systems.
Our allocation of investments among the permitted investment types may vary from time-to-time based on the evaluation by our Board of Directors of economic and market trends and our perception of the relative values available from these types of investments, except that in no event will our investments that are not high quality exceed 25% of our total assets.
We acquire only those mortgage-backed securities that we believe we have the necessary expertise to evaluate and manage, that are consistent with our balance sheet guidelines and risk management objectives and that we believe we can readily finance. Since we generally hold the mortgage-backed securities we acquire until maturity, we generally do not seek to acquire assets whose investment returns are attractive in only a limited range of scenarios. We believe that future interest rates and mortgage prepayment rates are very difficult to predict. Therefore, we seek to acquire mortgage-backed securities which we believe will provide acceptable returns over a broad range of interest rate and prepayment scenarios.
Our mortgage-backed securities consist of pass-through certificates and collateralized mortgage obligations (or CMOs) issued or guaranteed by FHLMC, FNMA or GNMA. We have not and will not invest in REMIC residuals, other CMO residuals or mortgage-backed securities, such as inverse floaters, which have imbedded leverage as part of their structural characteristics.
Description of Mortgage-Backed Securities
The mortgage-backed securities that we acquire provide funds for mortgage loans made primarily to residential homeowners. Our securities generally represent interests in pools of mortgage loans made by savings and loan institutions, mortgage bankers, commercial banks and other mortgage lenders. These pools of mortgage loans are assembled for sale to investors (like us) by various government, government-related and private organizations.
Mortgage-backed securities differ from other forms of traditional debt securities, which normally provide for periodic payments of interest in fixed amounts with principal payments at maturity or on specified call dates. Instead, mortgage-backed securities provide for a monthly payment, which consists of both interest and principal. In effect, these payments are a "pass-through" of the monthly interest and principal payments made by the individual borrower on the mortgage loans, net of any fees paid to the issuer or guarantor of the securities. Additional payments result from prepayments of principal upon the sale, refinancing or foreclosure of the underlying residential property, net of fees or costs which may be incurred. Some mortgage-backed securities, such as securities issued by GNMA, are described as "modified pass-through." These securities entitle the holder to receive all interest and principal payments owed on the mortgage pool, net of certain fees, regardless of whether the mortgagors actually make mortgage payments when due.
The investment characteristics of pass-through mortgage-backed securities differ from those of traditional fixed-income securities. The major differences include the payment of interest and principal on the mortgage-backed securities on a more frequent schedule, as described above, and the possibility that principal may be prepaid at any time due to prepayments on the underlying mortgage loans or other assets. These differences can result in significantly greater price and yield volatility than is the case with traditional fixed-income securities.
The occurrence of mortgage prepayments is affected by various factors including changes in interest rates, general economic conditions, the age of the mortgage loan, the location of the property and other social and demographic conditions. Generally prepayments on mortgage-backed securities increase during periods of falling mortgage interest rates and decrease during periods of rising mortgage interest rates. We may reinvest prepayments at higher or lower interest rates than the original investment, thus affecting the yield of our investments.
To the extent mortgage-backed securities are purchased at a premium, faster than expected prepayments would result in a faster than expected amortization of the premium paid. Conversely, if these securities were purchased at a discount, faster than expected prepayments would accelerate our recognition of income.
CMOs may allow for shifting of prepayment risk from slower-paying tranches to faster-paying tranches. This is in contrast to mortgage pass-through certificates where all investors share equally in all payments, including all prepayments, on the underlying mortgages.
FHLMC Certificates
FHLMC is a privately-owned government-sponsored enterprise created pursuant to an Act of Congress on July 24, 1970. The principal activity of FHLMC currently consists of the purchase of mortgage loans or participation interests in these loans and the resale of the loans and participations in the form of guaranteed mortgage-backed securities. FHLMC guarantees to each holder of FHLMC certificates the timely payment of interest at the applicable pass-through rate and ultimate collection of all principal on the holder's pro rata share of the unpaid principal balance of the related mortgage loans, but does not guarantee the timely payment of scheduled principal of the underlying mortgage loans. The obligations of FHLMC under our guarantees are solely those of FHLMC and are not backed by the full faith and credit of the United States. If FHLMC were unable to satisfy these obligations, distributions to holders of FHLMC certificates would consist solely of payments and other recoveries on the underlying mortgage loans and, accordingly, monthly distributions to holders of FHLMC certificates would be affected by delinquent payments and defaults on such mortgage loans.
FHLMC certificates may be backed by pools of single-family mortgage loans or multi-family mortgage loans. These underlying mortgage loans may have original terms to maturity of up to 40 years. FHLMC certificates may be issued under cash programs (composed of mortgage loans purchased from a number of sellers) or guarantor programs (composed of mortgage loans purchased from one seller in exchange for participation certificates representing interests in the mortgage loans purchased).
FHLMC certificates may pay interest at a fixed rate or an adjustable rate. The interest rate paid on adjustable-rate FHLMC certificates (or FHLMC ARMs) adjusts periodically within 60 days prior to the month in
which the interest rates on the underlying mortgage loans adjust. The interest rates paid on certificates issued under FHLMC's standard ARM programs adjust in relation to the Treasury index. Other specified indices used in FHLMC ARM programs include the 11th District Cost of Funds Index published by the Federal Home Loan Bank of San Francisco, LIBOR and other indices. Interest rates paid on fully-indexed FHLMC ARM certificates equal the applicable index rate plus a specified number of basis points. The majority of series of FHLMC ARM certificates issued to date have evidenced pools of mortgage loans with monthly, semi-annual or annual interest adjustments. Adjustments in the interest rates paid are generally limited to an annual increase or decrease of either 100 or 200 basis points and to a lifetime cap of 500 or 600 basis points over the initial interest rate. Certain FHLMC programs include mortgage loans which allow the borrower to convert the adjustable mortgage interest rate to a fixed rate. Adjustable-rate mortgages which are converted into fixed-rate mortgage loans are repurchased by FHLMC or by the seller of the loan to FHLMC at the unpaid principal balance of the loan plus accrued interest to the due date of the last adjustable rate interest payment.
FNMA Certificates
FNMA is a privately-owned, federally-chartered corporation organized and existing under the Federal National Mortgage Association Charter Act. FNMA provides funds to the mortgage market primarily by purchasing home mortgage loans from local lenders, thereby replenishing their funds for additional lending. FNMA guarantees to the registered holder of a FNMA certificate that it will distribute amounts representing scheduled principal and interest on the mortgage loans in the pool underlying the FNMA certificate, whether or not received, and the full principal amount of any such mortgage loan foreclosed or otherwise finally liquidated, whether or not the principal amount is actually received. The obligations of FNMA under its guarantees are solely those of FNMA and are not backed by the full faith and credit of the United States. If FNMA were unable to satisfy its obligations, distributions to holders of FNMA certificates would consist solely of payments and other recoveries on the underlying mortgage loans and, accordingly, monthly distributions to holders of FNMA certificates would be affected by delinquent payments and defaults on these mortgage loans.
FNMA certificates may be backed by pools of single-family or multi-family mortgage loans. The original terms to maturities of the mortgage loans generally do not exceed 40 years. FNMA certificates may pay interest at a fixed rate or an adjustable rate. Each series of FNMA ARM certificates bears an initial interest rate and margin tied to an index based on all loans in the related pool, less a fixed percentage representing servicing compensation and FNMA's guarantee fee. The specified index used in different series has included the Treasury Index, the 11th District Cost of Funds Index published by the Federal Home Loan Bank of San Francisco, LIBOR and other indices. Interest rates paid on fully-indexed FNMA ARM certificates equal the applicable index rate plus a specified number of basis points. The majority of series of FNMA ARM certificates issued to date have evidenced pools of mortgage loans with monthly, semi-annual or annual interest rate adjustments. Adjustments in the interest rates paid are generally limited to an annual increase or decrease of either 100 or 200 basis points and to a lifetime cap of 500 or 600 basis points over the initial interest rate. Certain FNMA programs include mortgage loans which allow the borrower to convert the adjustable mortgage interest rate of the ARM to a fixed rate. Adjustable-rate mortgages which are converted into fixed-rate mortgage loans are repurchased by FNMA or by the seller of the loans to FNMA at the unpaid principal of the loan plus accrued interest to the due date of the last adjustable rate interest payment. Adjustments to the interest rates on FNMA ARM certificates are typically subject to lifetime caps and periodic rate or payment caps.
GNMA Certificates
GNMA is a wholly owned corporate instrumentality of the United States within the Department of Housing and Urban Development (or HUD). The National Housing Act of 1934 authorizes GNMA to guarantee the timely payment of the principal of and interest on certificates which represent an interest in a pool of mortgages insured by the Federal Housing Administration (or FHA) or partially guaranteed by the Department of Veterans Affairs and other loans eligible for inclusion in mortgage pools underlying GNMA certificates. Section 306(g) of the Housing Act provides that the full faith and credit of the United States is pledged to the payment of all amounts which may be required to be paid under any guaranty by GNMA.
At present, most GNMA certificates are backed by single-family mortgage loans. The interest rate paid on GNMA certificates may be a fixed rate or an adjustable rate. The interest rate on GNMA certificates issued under GNMA's standard ARM program adjusts annually in relation to the Treasury index. Adjustments in the interest rate are generally limited to an annual increase or decrease of 100 basis points and to a lifetime cap of 500 basis points over the initial coupon rate.
Single-Family and Multi-Family Privately-Issued Certificates
Single-family and multi-family privately-issued certificates are pass-through certificates that are not issued by one of the agencies and that are backed by a pool of conventional single-family or multi-family mortgage loans. These certificates are issued by originators of, investors in, and other owners of mortgage loans, including savings and loan associations, savings banks, commercial banks, mortgage banks, investment banks and special purpose "conduit" subsidiaries of these institutions.
While agency pass-through certificates are backed by the express obligation or guarantee of one of the agencies, as described above, privately-issued certificates are generally covered by one or more forms of private (i.e., non-governmental) credit enhancements. These credit enhancements provide an extra layer of loss coverage in the event that losses are incurred upon foreclosure sales or other liquidations of underlying mortgaged properties in amounts that exceed the equity holder's equity interest in the property. Forms of credit enhancements include limited issuer guarantees, reserve funds, private mortgage guaranty pool insurance, over-collateralization and subordination.
Subordination is a form of credit enhancement frequently used and involves the issuance of classes of senior and subordinated mortgage-backed securities. These classes are structured into a hierarchy to allocate losses on the underlying mortgage loans and also for defining priority of rights to payment of principal and interest. Typically, one or more classes of senior securities are created which are rated in one of the two highest rating levels by one or more nationally recognized rating agencies and which are supported by one or more classes of mezzanine securities and subordinated securities that bear losses on the underlying loans prior to the classes of senior securities. Mezzanine securities, as used in this Form 10-K, refers to classes that are rated below the two highest levels but no lower than a single "B" level under the S&P rating system (or comparable level under other rating systems) and are supported by one or more classes of subordinated securities which bear realized losses prior to the classes of mezzanine securities. Subordinated securities, as used in this Form 10-K, refers to any class that bears the "first loss" from losses from underlying mortgage loans or that is rated below a single "B" level (or, if unrated, we deem it to be below that level). In some cases, only classes of senior securities and subordinated securities are issued. By adjusting the priority of interest and principal payments on each class of a given series of senior-subordinated mortgage-backed securities, issuers are able to create classes of mortgage-backed securities with varying degrees of credit exposure, prepayment exposure and potential total return, tailored to meet the needs of sophisticated institutional investors.
Collateralized Mortgage Obligations and Multi-Class Pass-Through Securities
We may also invest in collateralized mortgage obligations (or CMOs) and multi-class pass-through securities. CMOs are debt obligations issued by special purpose entities that are secured by mortgage-backed certificates, including, in many cases, certificates issued by government and government-related guarantors, including, GNMA, FNMA and FHLMC, together with certain funds and other collateral. Multi-class pass-through securities are equity interests in a trust composed of mortgage loans or other mortgage-backed securities. Payments of principal and interest on underlying collateral provide the funds to pay debt service on the CMO or make scheduled distributions on the multi-class pass-through securities. CMOs and multi-class pass-through securities may be issued by agencies or instrumentalities of the U.S. Government or by private organizations. The discussion of CMOs in the following paragraphs is similarly applicable to multi-class pass-through securities.
In a CMO, a series of bonds or certificates is issued in multiple classes. Each class of CMOs, often referred to as a "tranche," is issued at a specific coupon rate (which, as discussed below, may be an adjustable rate subject to a cap) and has a stated maturity or final distribution date. Principal prepayments on collateral underlying a CMO may cause it to be retired substantially earlier than the stated maturity or final distribution date. Interest is paid or accrues on all classes of a CMO on a monthly, quarterly or semi-annual basis. The principal and interest on underlying mortgages may be allocated among the several classes of a series of a CMO in many ways. In a common structure, payments of principal, including any principal prepayments, on the underlying mortgages are applied to the classes of the series of a CMO in the order of their respective stated maturities or final distribution dates, so that no payment of principal will be made on any class of a CMO until all other classes having an earlier stated maturity or final distribution date have been paid in full.
Other types of CMO issues include classes such as parallel pay CMOs, some of which, such as planned amortization class CMOs (or PAC bonds), provide protection against prepayment uncertainty. Parallel pay CMOs are structured to provide payments of principal on certain payment dates to more than one class. These simultaneous payments are taken into account in calculating the stated maturity date or final distribution date of each class which, as with other CMO structures, must be retired by its stated maturity date or final distribution date but may be retired earlier. PAC bonds generally require payment of a specified amount of principal on each payment date so long as prepayment speeds on the underlying collateral fall within a specified range. PAC bonds are always parallel pay CMOs with the required principal payment on the securities having the highest priority after interest has been paid to all classes.
Other types of CMO issues include targeted amortization class CMOs (or TAC bonds), which are similar to PAC bonds. While PAC bonds maintain their amortization schedule within a specified range of prepayment speeds, TAC bonds are generally targeted to a narrow range of prepayment speeds or a specified prepayment speed. TAC bonds can provide protection against prepayment uncertainty since cash flows generated from higher prepayments of the underlying mortgage-related assets are applied to the various other pass-through tranches so as to allow the TAC bonds to maintain their amortization schedule.
A CMO may be subject to the issuer's right to redeem the CMO prior to its stated maturity date, which may have the effect of diminishing the anticipated return on our investment. Privately-issued CMOs are supported by private credit enhancements similar to those used for privately-issued certificates and are often issued as senior-subordinated mortgage-backed securities. We will only acquire CMOs or multi-class pass-through certificates that constitute debt obligations or beneficial ownership in grantor trusts holding mortgage loans, or regular interests in REMICs, or that otherwise constitute qualified REIT real estate assets under the Internal Revenue Code (provided that we have obtained a favorable opinion of our tax advisor or a ruling from the IRS to that effect).
Adjustable-Rate Mortgage Pass-Through Certificates and Floating Rate Mortgage-Backed Securities (or "Floaters")
Most of the mortgage pass-through certificates we acquire are adjustable-rate mortgage pass-through certificates. This means that their interest rates may vary over time based upon changes in an objective index, such as:
o LIBOR or the London Interbank Offered Rate. The interest rate that banks in London offer for deposits in London of U.S. dollars.
o Treasury Index. A monthly or weekly average yield of benchmark U.S. Treasury securities, as published by the Federal Reserve Board.
o CD Rate. The weekly average of secondary market interest rates on six-month negotiable certificates of deposit, as published by the Federal Reserve Board.
These indices generally reflect short-term interest rates. The underlying mortgages for adjustable-rate mortgage pass-through certificates are adjustable-rate mortgage loans (or ARMs).
We also acquire "floating rate CMOs" or "floaters." One or more tranches of a CMO may have coupon rates that reset periodically at a specified increment over an index such as LIBOR. These adjustable-rate tranches are sometime known as "floating-rate CMOs" or "floaters" and may be backed by fixed or adjustable-rate mortgages. To date, fixed-rate mortgages have been more commonly utilized for this purpose.
Adjustable-rate mortgage pass-through certificates and floating-rate CMOs are typically issued with lifetime caps on the coupon rate. These caps, similar to the caps on ARMs, represent a ceiling beyond which the coupon rate on an adjustable-rate mortgage pass-through certificate or a floating-rate CMO may not increase regardless of increases in the interest rate index on which the adjustable-rate mortgage pass-through certificate or floating-rate CMO is based.
There are two main categories of indices for adjustable-rate mortgage pass-through certificates and floaters: (1) those based on U.S. Treasury securities, and (2) those derived from calculated measures such as a cost of funds index or a moving average of mortgage rates. Commonly utilized indices include the one-year Treasury note rate, the three-month Treasury bill rate, the six-month Treasury bill rate, rates on long-term Treasury securities, the 11th District Federal Home Loan Bank Costs of Funds Index, the National Median Cost of Funds Index, one-month or three-month LIBOR, the prime rate of a specific bank, or commercial paper rates. Some indices, such as the one-year Treasury rate, closely mirror changes in market interest rate levels. Others, such as the 11th District Home Loan Bank Cost of Funds Index, tend to lag changes in market interest rate levels. We seek to diversify our investments in adjustable-rate mortgage pass-through certificates and floaters among a variety of indices and reset periods so that we are not at any one time unduly exposed to the risk of interest rate fluctuations. In selecting adjustable-rate mortgage pass-through certificates and floaters for investment, we will also consider the liquidity of the market for the different mortgage-backed securities.
We believe that adjustable-rate mortgage pass-through certificates and floaters are particularly well-suited to our investment objective of high current income, consistent with modest volatility of net asset value, because the value of adjustable-rate mortgage pass-through certificates and floaters generally remains relatively stable as compared to traditional fixed-rate debt securities paying comparable rates of interest. While the value of adjustable-rate mortgage pass-through certificates and floaters, like other debt securities, generally varies inversely with changes in market interest rates (increasing in value during periods of declining interest rates and decreasing in value during periods of increasing interest rates), the value of adjustable-rate mortgage pass-through certificates and floaters should generally be more resistant to price swings than other debt securities because the interest rates on these securities move with market interest rates.
Accordingly, as interest rates change, the value of our shares should be more stable than that of funds which invest primarily in securities backed by fixed-rate mortgages or in other non-mortgage-backed debt securities, which do not provide for adjustment in the interest rates in response to changes in interest rates.
Adjustable-rate mortgage pass-through certificates and floaters typically have caps, which limit the maximum amount by which the interest rate may be increased or decreased at periodic intervals or over the life of the floater. To the extent that interest rates rise faster than the allowable caps on the adjustable-rate mortgage pass-through certificates and floaters, these securities will behave more like fixed-rate securities. Consequently, interest rate increases in excess of caps can be expected to cause these securities to behave more like traditional debt securities than adjustable-rate securities and, accordingly, to decline in value to a greater extent than would be the case in the absence of these caps.
Adjustable-rate mortgage pass-through certificates and floaters, like other mortgage-backed securities, differ from conventional bonds in that principal is to be paid back over the life of the security rather than at maturity. As a result, we receive monthly scheduled payments of principal and interest on these securities and may receive unscheduled principal payments representing prepayments on the underlying mortgages. When we reinvest the payments and any unscheduled prepayments we receive, we may receive a rate of interest on the reinvestment which is lower than the rate on the existing security. For this reason, adjustable-rate mortgage pass-through certificates and floaters are less effective than longer-term debt securities as a means of "locking in" longer-term
interest rates. Accordingly, adjustable-rate mortgage pass-through certificates and floaters, while generally having less risk of price decline during periods of rapidly rising rates than fixed-rate mortgage-backed securities of comparable maturities, have less potential for capital appreciation than fixed-rate securities during periods of declining interest rates.
As in the case of fixed-rate mortgage-backed securities, to the extent these securities are purchased at a premium, faster than expected prepayments would result in a faster than expected amortization of the premium paid. Conversely, if these securities were purchased at a discount, faster than expected prepayments would accelerate our recognition of income.
As in the case of fixed-rate CMOs, floating-rate CMOs may allow for shifting of prepayment risk from slower-paying tranches to faster-paying tranches. This is in contrast to mortgage pass-through certificates where all investors share equally in all payments, including all prepayments, on the underlying mortgages.
Other Floating Rate Instruments
We may also invest in structured floating-rate notes issued or guaranteed by government agencies, such as FNMA and FHLMC. These instruments are typically structured to reflect an interest rate arbitrage (i.e., the difference between the agency's cost of funds and the income stream from specified assets of the agency) and their reset formulas may provide more attractive returns than other floating rate instruments. The indices used to determine resets are the same as those described above.
Mortgage Loans
We may from time to time invest a small percentage of our assets directly in single-family, multi-family or commercial mortgage loans. We expect that the majority of these mortgage loans would be ARMs. The interest rate on an ARM is typically tied to an index (such as LIBOR or the interest rate on Treasury bills), and is adjustable periodically at specified intervals. These mortgage loans are typically subject to lifetime interest rate caps and periodic interest rate or payment caps. The acquisition of mortgage loans generally involves credit risk. We may obtain credit enhancement to mitigate this risk; however, there can be no assurances that we will able to obtain credit enhancement or that credit enhancement would mitigate the credit risk of the underlying mortgage loans.
Capital Investment Policy
Asset Acquisitions
Our capital investment policy provides that at least 75% of our total assets will be comprised of high quality mortgage-backed securities and short-term investments. The remainder of our assets (comprising not more than 25% of total assets), may consist of mortgage-backed securities and other qualified REIT real estate assets which are unrated or rated less than high quality but which are at least "investment grade" (rated "BBB" or better) or, if not rated, are determined by us to be of comparable credit quality to an investment which is rated "BBB" or better.
Our capital investment policy requires that we structure our portfolio to maintain a minimum weighted average rating (including our deemed comparable ratings for unrated mortgage-backed securities) of our mortgage-backed securities of at least single "A" under the S&P rating system and at the comparable level under the other rating systems. To date, all of the mortgage-backed securities we have acquired have been pass-through certificates or CMOs issued or guaranteed by FHLMC, FNMA or GNMA which, although not rated, have an implied "AAA" rating.
We intend to acquire only those mortgage-backed securities which we believe we have the necessary expertise to evaluate and manage, which we can readily finance and which are consistent with our balance sheet guidelines and risk management objectives. Since we expect to hold our mortgage-backed securities until maturity,
we generally do not seek to acquire assets whose investment returns are only attractive in a limited range of scenarios. We believe that future interest rates and mortgage prepayment rates are very difficult to predict and, as a result, we seek to acquire mortgage-backed securities which we believe provide acceptable returns over a broad range of interest rate and prepayment scenarios.
Among the asset choices available to us, our policy is to acquire those mortgage-backed securities which we believe generate the highest returns on capital invested, after consideration of the following:
o the amount and nature of anticipated cash flows from the asset;
o our ability to pledge the asset to secure collateralized borrowings;
o the increase in our capital requirement determined by our capital investment policy resulting from the purchase and financing of the asset; and
o the costs of financing, hedging, managing and reserving for the asset.
Prior to acquisition, we assess potential returns on capital employed over the life of the asset and in a variety of interest rate, yield spread, financing cost, credit loss and prepayment scenarios.
We also give consideration to balance sheet management and risk diversification issues. We deem a specific asset which we are evaluating for potential acquisition as more or less valuable to the extent it serves to increase or decrease certain interest rate or prepayment risks which may exist in the balance sheet, to diversify or concentrate credit risk, and to meet the cash flow and liquidity objectives our management may establish for our balance sheet from time to time. Accordingly, an important part of the asset evaluation process is a simulation, using our risk management model, of the addition of a potential asset and our associated borrowings and hedges to the balance sheet and an assessment of the impact this potential asset acquisition would have on the risks in and returns generated by our balance sheet as a whole over a variety of scenarios.
We focus primarily on the acquisition of adjustable-rate mortgage-backed securities, including floaters. We have, however, purchased a significant amount of fixed-rate mortgage-backed securities and may continue to do so in the future if, in our view, the potential returns on capital invested, after hedging and all other costs, would exceed the returns available from other assets or if the purchase of these assets would serve to reduce or diversify the risks of our balance sheet.
Although we have not yet done so, we may purchase the stock of mortgage REITs or similar companies when we believe that these purchases would yield attractive returns on capital employed. When the stock market valuations of these companies are low in relation to the market value of their assets, these stock purchases can be a way for us to acquire an interest in a pool of mortgage-backed securities at an attractive price. We do not, however, presently intend to invest in the securities of other issuers for the purpose of exercising control or to underwrite securities of other issuers.
We may acquire newly-issued mortgage-backed securities, and also will seek to expand our capital base in order to further increase our ability to acquire new assets, when the potential returns from new investments appears attractive relative to the return expectations of stockholders. We may in the future acquire mortgage-backed securities by offering our debt or equity securities in exchange for the mortgage-backed securities.
We generally intend to hold mortgage-backed securities for extended periods. In addition, the REIT provisions of the Internal Revenue Code limit in certain respects our ability to sell mortgage-backed securities. We may decide to sell assets from time to time, however, for a number of reasons including to dispose of an asset as to which credit risk concerns have arisen, to reduce interest rate risk, to substitute one type of mortgage-backed security for another, to improve yield or to maintain compliance with the 55% requirement under the Investment Company Act, and generally to re-structure the balance sheet when we deem advisable. Our Board of Directors
has not adopted any policy that would restrict management's authority to determine the timing of sales or the selection of mortgage-backed securities to be sold.
We do not invest in principal-only interests in mortgage-backed securities, residual interests, accrual bonds, inverse-floaters, two-tiered index bonds, cash flow bonds, mortgage-backed securities with imbedded leverage or mortgage-backed securities that would be deemed unacceptable for collateralized borrowings, excluding shares in mortgage REITs.
As a requirement for maintaining REIT status, we will distribute to stockholders aggregate dividends equaling at least 95% of our taxable income (excluding capital gains) for the taxable year ending December 31, 2000, and at least 90% of our taxable income (excluding capital gains) for subsequent taxable years. We will make additional distributions of capital when the return expectations of the stockholders appear to exceed returns potentially available to us through making new investments in mortgage-backed securities. Subject to the limitations of applicable securities and state corporation laws, we can distribute capital by making purchases of our own capital stock or through paying down or repurchasing any outstanding uncollateralized debt obligations.
Our asset acquisition strategy may change over time as market conditions change and as we evolve.
Credit Risk Management
We have not taken on credit risk to date, but may do so in the future. In that event, we will review credit risk and other risk of loss associated with each investment and determine the appropriate allocation of capital to apply to the investment under our capital investment policy. Our Board of Directors will monitor the overall portfolio risk and determine appropriate levels of provision for loss.
Capital and Leverage
We expect generally to maintain a debt-to-equity ration of between 8:1 and 12:1, although the ratio may vary from time to time depending upon market conditions and other factors our management deems relevant, including the composition of our balance sheet, haircut levels required by lenders, the market value of our mortgage-backed securities in our portfolio and "excess capital cushion" percentages (as described below) set by our board of directors from time to time. For purposes of calculating this ratio, our equity (or capital base) is equal to the value of our investment portfolio on a mark-to-market basis less the book value of our obligations under repurchase agreements and other collateralized borrowings. At December 31, 2000, our ratio of debt-to-equity was 12.0:1.
Our goal is to strike a balance between the under-utilization of leverage, which reduces potential returns to stockholders, and the over-utilization of leverage, which could reduce our ability to meet our obligations during adverse market conditions. Our capital investment policy limits our ability to acquire additional assets during times when our debt-to-equity ratio exceeds 12:1. Our capital base represents the approximate liquidation value of our investments and approximates the market value of assets that we can pledge or sell to meet over-collateralization requirements for our borrowings. The unpledged portion of our capital base is available for us to pledge or sell as necessary to maintain over-collateralization levels for our borrowings.
We are prohibited from acquiring additional assets during periods when our capital base is less than the minimum amount required under our capital investment policy, except as may be necessary to maintain REIT status or our exemption from the Investment Company Act. In addition, when our capital base falls below our risk-managed capital requirement, our management is required to submit to our board a plan for bringing our capital base into compliance with our capital investment policy guidelines. We anticipate that in most circumstances we can achieve this goal without overt management action through the natural process of mortgage principal repayments. We anticipate that our capital base is likely to exceed our risk-managed capital requirement during periods following new equity offerings and during periods of falling interest rates and that our capital base could fall below the risk-managed capital requirement during periods of rising interest rates.
The first component of our capital requirements is the current aggregate over-collateralization amount or "haircut" the lenders require us to hold as capital. The haircut for each mortgage-backed security is determined by our lenders based on the risk characteristics and liquidity of the asset. Haircut levels on individual borrowings generally range from 3% for certain FHLMC, FNMA or GNMA mortgage-backed securities to 20% for certain privately-issued mortgage-backed securities. At December 31, 2000, the weighted average haircut level on our securities was 3.5%. Should the market value of our pledged assets decline, we will be required to deliver additional collateral to our lenders to maintain a constant over-collateralization level on our borrowings.
The second component of our capital requirement is the "excess capital cushion." This is an amount of capital in excess of the haircuts required by our lenders. We maintain the excess capital cushion to meet the demands of our lenders for additional collateral should the market value of our mortgage-backed securities decline. The aggregate excess capital cushion equals the sum of liquidity cushion amounts assigned under our capital investment policy to each of our mortgage-backed securities. We assign excess capital cushions to each mortgage-backed security based on our assessment of the mortgage-backed security's market price volatility, credit risk, liquidity and attractiveness for use as collateral by lenders. The process of assigning excess capital cushions relies on our management's ability to identify and weigh the relative importance of these and other factors. In assigning excess capital cushions, we also give consideration to hedges associated with the mortgage-backed security and any effect such hedges may have on reducing net market price volatility, concentration or diversification of credit and other risks in the balance sheet as a whole and the net cash flows that we can expect from the interaction of the various components of our balance sheet.
Our Board reviews on a periodic basis various analyses prepared by our management of the risks inherent in our balance sheet, including an analysis of the effects of various scenarios on our net cash flow, earnings, dividends, liquidity and net market value. Should our Board determine that the minimum required capital base set by our capital investment policy is either too low or too high, our Board may raise or lower the capital requirement accordingly.
Our capital investment policy stipulates that at least 25% of the capital base maintained to satisfy the excess capital cushion must be invested in AAA-rated adjustable-rate mortgage-backed securities or assets with similar or better liquidity characteristics.
A substantial portion of our borrowings are short-term or variable-rate borrowings. Our borrowings are implemented primarily through repurchase agreements, but in the future may also be obtained through loan agreements, lines of credit, dollar-roll agreements (an agreement to sell a security for delivery on a specified future date and a simultaneous agreement to repurchase the same or a substantially similar security on a specified future date) and other credit facilities with institutional lenders and issuance of debt securities such as commercial paper, medium-term notes, CMOs and senior or subordinated notes. We enter into financing transactions only with institutions that we believe are sound credit risks and follow other internal policies designed to limit our credit and other exposure to financing institutions.
We expect to continue to use repurchase agreements as our principal financing device to leverage our mortgage-backed securities portfolio. We anticipate that, upon repayment of each borrowing under a repurchase agreement, we will use the collateral immediately for borrowing under a new repurchase agreement. At present, we have entered into uncommitted facilities with 23 lenders for borrowings in the form of repurchase agreements. We have not at the present time entered into any commitment agreements under which the lender would be required to enter into new repurchase agreements during a specified period of time, nor do we presently plan to have liquidity facilities with commercial banks. We may, however, enter into such commitment agreements in the future. We enter into repurchase agreements primarily with national broker-dealers, commercial banks and other lenders which typically offer this type of financing. We enter into collateralized borrowings only with financial institutions meeting credit standards approved by our Board, and we monitor the financial condition of these institutions on a regular basis.
A repurchase agreement, although structured as a sale and repurchase obligation, acts as a financing under which we effectively pledge our mortgage-backed securities as collateral to secure a short-term loan.
Generally, the other party to the agreement makes the loan in an amount equal to a percentage of the market value of the pledged collateral. At the maturity of the repurchase agreement, we are required to repay the loan and correspondingly receive back our collateral. While used as collateral, the mortgage-backed securities continue to pay principal and interest which are for our benefit. In the event of our insolvency or bankruptcy, certain repurchase agreements may qualify for special treatment under the Bankruptcy Code, the effect of which, among other things, would be to allow the creditor under the agreement to avoid the automatic stay provisions of the Bankruptcy Code and to foreclose on the collateral agreement without delay. In the event of the insolvency or bankruptcy of a lender during the term of a repurchase agreement, the lender may be permitted, under applicable insolvency laws, to repudiate the contract, and our claim against the lender for damages may be treated simply as an unsecured creditor. In addition, if the lender is a broker or dealer subject to the Securities Investor Protection Act of 1970, or an insured depository institution subject to the Federal Deposit Insurance Act, our ability to exercise our rights to recover our securities under a repurchase agreement or to be compensated for any damages resulting from the lender's insolvency may be further limited by those statutes. These claims would be subject to significant delay and, if and when received, may be substantially less than the damages we actually incur.
Substantially all of our borrowing agreements require us to deposit additional collateral in the event the market value of existing collateral declines, which may require us to sell assets to reduce our borrowings. We have designed our liquidity management policy to maintain a cushion of equity sufficient to provide required liquidity to respond to the effects under our borrowing arrangements of interest rate movements and changes in market value of our mortgage-backed securities, as described above. However, a major disruption of the repurchase or other market relied that we rely on for short-term borrowings would have a material adverse effect on us unless we were able to arrange alternative sources of financing on comparable terms.
Our articles of incorporation and bylaws do not limit our ability to incur borrowings, whether secured or unsecured.
Interest Rate Risk Management
To the extent consistent with our election to qualify as a REIT, we follow an interest rate risk management program intended to protect our portfolio of mortgage-backed securities and related debt against the effects of major interest rate changes. Specifically, our interest rate risk management program is formulated with the intent to offset the potential adverse effects resulting from rate adjustment limitations on our mortgage-backed securities and the differences between interest rate adjustment indices and interest rate adjustment periods of our adjustable-rate mortgage-backed securities and related borrowings.
Our interest rate risk management program encompasses a number of procedures, including the following:
o we attempt to structure our borrowings to have interest rate adjustment indices and interest rate adjustment periods that, on an aggregate basis, generally correspond to the interest rate adjustment indices and interest rate adjustment periods of our adjustable-rate mortgage-backed securities; and
o we attempt to structure our borrowing agreements relating to adjustable-rate mortgage-backed securities to have a range of different maturities and interest rate adjustment periods (although substantially all will be less than one year).
We adjust the average maturity adjustment periods of our borrowings on an ongoing basis by changing the mix of maturities and interest rate adjustment periods as borrowings come due and are renewed. Through use of these procedures, we attempt to minimize the differences between the interest rate adjustment periods of our mortgage-backed securities and related borrowings that may occur.
Although we have not done so to date, we may purchase from time to time interest rate caps, interest rate swaps, interest rate collars, caps or floors, "interest only" mortgage-backed securities and similar instruments to attempt to mitigate the risk of the cost of our variable rate liabilities increasing at a faster rate than the earnings on
our assets during a period of rising interest rates or to mitigate prepayment risk. We may hedge as much of the interest rate risk as our management determines is in our best interests, given the cost of the hedging transactions and the need to maintain our status as a REIT. This determination may result in our electing to bear a level of interest rate or prepayment risk that could otherwise be hedged when management believes, based on all relevant facts, that bearing the risk is advisable.
We seek to build a balance sheet and undertake an interest rate risk management program which is likely to generate positive earnings and maintain an equity liquidation value sufficient to maintain operations given a variety of potentially adverse circumstances. Accordingly, our hedging program addresses both income preservation, as discussed above, and capital preservation concerns. For capital preservation, we monitor our "duration." This is the expected percentage change in market value of our assets that would be caused by a 1% change in short and long-term interest rates. To monitor duration and the related risks of fluctuations in the liquidation value of our equity, we model the impact of various economic scenarios on the market value of our mortgage-backed securities and liabilities. At December 31, 2000, we estimate that the duration of our assets was 1.6%. We believe that our interest rate risk management program will allow us to maintain operations throughout a wide variety of potentially adverse circumstances. Nevertheless, in order to further preserve our capital base (and lower our duration) during periods when we believe a trend of rapidly rising interest rates has been established, we may decide to enter into or increase hedging activities or to sell assets. Each of these actions may lower our earnings and dividends in the short term to further our objective of maintaining attractive levels of earnings and dividends over the long term.
We may elect to conduct a portion of our hedging operations through one or more subsidiary corporations which would not be a qualified REIT subsidiary and would be subject to Federal and state income taxes. To comply with the asset tests applicable to us as a REIT, the value of the securities of the any taxable subsidiary we hold must be limited to less than 5% of the value of our total assets as of the end of each calendar quarter and we may not own more than 10% of the voting securities of the taxable subsidiary. A taxable subsidiary would not elect REIT status and would distribute any net profit after taxes to us and its other stockholders. Any dividend income we receive from the taxable subsidiary (combined with all other income generated from our assets, other than qualified REIT real estate assets) must not exceed 25% of our gross income.
We believe that we have developed a cost-effective asset/liability management program to provide a level of protection against interest rate and prepayment risks. However, no strategy can completely insulate us from interest rate changes and prepayment risks. Further, as noted above, the Federal income tax requirements that we must satisfy to qualify as a REIT limit our ability to hedge our interest rate and prepayment risks. We monitor carefully, and may have to limit, our asset/liability management program to assure that we do not realize excessive hedging income, or hold hedging assets having excess value in relation to total assets, which would result in our disqualification as a REIT or, in the case of excess hedging income, the payment of a penalty tax for failure to satisfy certain REIT income tests under the Internal Revenue Code, provided the failure was for reasonable cause. In addition, asset/liability management involves transaction costs which increase dramatically as the period covered by the hedging protection increases. Therefore, we may be unable to hedge effectively our interest rate and prepayment risks.
Prepayment Risk Management
We seek to minimize the effects of faster or slower than anticipated prepayment rates through structuring a diversified portfolio with a variety of prepayment characteristics, investing in mortgage-backed securities with prepayment prohibitions and penalties, investing in certain mortgage-backed security structures which have prepayment protections, and balancing assets purchased at a premium with assets purchased at a discount. We monitor prepayment risk through periodic review of the impact of a variety of prepayment scenarios on our revenues, net earnings, dividends, cash flow and net balance sheet market value.
Future Revisions in Policies and Strategies
Our Board of Directors has established the investment policies and operating policies and strategies set forth in this prospectus supplement. The Board has the power to modify or waive these policies and strategies without the consent of the stockholders to the extent that the Board determines that the modification or waiver is in the best interests of our stockholders. Among other factors, developments in the market which affect our policies and strategies or which change our assessment of the market may cause our Board to revise our policies and strategies.
Potential Acquisitions, Strategic Alliances and Other Investments
From time to time we have had discussions with other parties regarding possible transactions including acquisitions of other businesses or assets, investments in other entities, joint venture arrangements, or strategic alliances, including a strategic alliance with Liberty Capital, a privately-held financial services company headquartered in Ohio. To date, none of these discussions have gone beyond the preliminary stage. We have also considered from time to time entering into related businesses.
During 1998, we made an initial investment of $49,980 in Annaly International Mortgage Management, Inc. Annaly International explores business opportunities overseas, including the origination of mortgages. Annaly International has not commenced operations beyond this exploratory stage. We now own 33% of the equity of Annaly International in the form of non-voting securities. The remaining equity of Annaly International is owned by FIDAC, Michael A.J. Farrell, our Chairman and Chief Executive Officer, Timothy J. Guba, our President and Chief Operating Officer, Wellington J. St. Claire, our Vice Chairman and Chief Investment Officer, Kathryn F. Fagan, our Chief Operating Officer, and other persons. Mr. Farrell is the sole shareholder of FIDAC.
During 1998, Annaly International made an initial investment of $20,400 in Annaly.com, Inc. Annaly.com explores opportunities to acquire or originate mortgages in the United States. Annaly.com has established a website at http://www.annaly.com but has not commenced the acquisition or origination of mortgages. Annaly International owns 51% of the equity of Annaly.com. The remaining equity of Annaly.com is owned by FIDAC I Partners, whose partners include FIDAC and our executive officers.
Prior to making our investment in Annaly International we consulted with our tax advisors to ensure that the investment would not cause us to fail to satisfy the asset and source of income tests applicable to us as a REIT. Prior to making any additional equity investment in Annaly International or any other equity investment, we will similarly consult with our tax advisors.
We may, from time to time, continue to explore possible acquisitions, investments, joint venture arrangements and strategic alliances, as well as the further development of the business of Annaly International or Annaly.com.
Dividend Reinvestment and Share Purchase Plan
We have adopted a dividend reinvestment and share purchase plan. Under the dividend reinvestment feature of the plan, existing shareholders can reinvest their dividends in additional shares of our common stock. Under the share purchase feature of the plan, new and existing shareholders can purchase shares of our common stock. We have filed and the SEC has declared effective a Form S-3 registration statement registering 2,000,000 shares that may be issued under the plan.
Legal Proceedings
There are no material pending legal proceedings to which we are a party or to which any of our property is subject.
FEDERAL INCOME TAX CONSIDERATIONS
The following discusses the material United States federal income tax considerations that relate to our treatment as a real estate investment trust ("REIT") and that apply to an investment in our stock. No assurance can be given that the conclusions set out below would be sustained by a court if challenged by the Internal Revenue Service (IRS). This summary deals only with stock that is held as a capital asset, which generally means property that is held for investment. In addition, except to the extent discussed below, this summary does not address tax considerations applicable to a stockholder that is subject to special tax rules, such as:
o a dealer or trader in securities;
o a financial institution;
o an insurance company;
o a stockholder that holds our stock as a hedge, part of a straddle, conversion transaction or other arrangement involving more than one position;
o a stockholder whose functional currency is not the United States dollar; or
o a tax-exempt organization or foreign taxpayer.
The discussion below is based upon the provisions of the United States Internal Revenue Code of 1986 (the "Code") and regulations, rulings and judicial decisions interpreting the Code as of the date of this Form 10-K. Any of these authorities may be repealed, revoked or modified, perhaps with retroactive effect, so as to result in federal income tax consequences different from those discussed below.
The discussion set out below is intended only as a summary of the material United States federal income tax consequences of our treatment as a REIT and of an investment in our stock. We urge our stockholders to consult their own tax advisors regarding the tax consequences of an investment in our stock, including the application to their particular situations of the tax considerations discussed below, as well as the application of state, local or foreign tax laws. The statements of United States tax law set out below are based on the laws in force and their interpretation as of the date of this Form 10-K, and are subject to changes occurring after that date.
General
We elected to become subject to tax as a REIT for federal income tax purposes effective for our taxable year ending December 31, 1997. We plan to continue to meet the requirements for taxation as a REIT. There can be no assurance, however, that we will qualify as a REIT in any particular taxable year given the highly complex nature of the rules governing REITs, the ongoing importance of factual determinations, and the possibility of future changes in our circumstances. If we fail to qualify as a REIT in any particular year, we will be subject to federal income tax as a regular domestic corporation, and our stockholders will be subject to tax in the same manner as stockholders of regular domestic corporations. In that event, we may be subject to a substantial income tax liability in respect of each taxable year that we fail to qualify as a REIT, and the amount of earnings and cash available for distribution to our stockholders could be significantly reduced or eliminated. See "Failure to Qualify" below.
REIT Qualification Requirements
The following is a brief summary of the material technical requirements imposed by the Code that we must satisfy on an ongoing basis to qualify, and remain qualified, as a REIT.
Stock Ownership Requirements
We must meet the following stock ownership requirements:
(1) our capital stock must be transferable;
(2) our capital stock must be held by at least 100 persons during at least 335 days of a taxable year of 12 months (or during a proportionate part of a taxable year of less than 12 months); and
(3) no more than 50% of the value of our capital stock may be owned, directly or indirectly, by five or fewer individuals at any time during the last half of the taxable year. In applying this test, the Code treats some entities as individuals.
Tax-exempt entities, other than private foundations and certain unemployment compensation trusts, are generally not treated as individuals for these purposes. The requirements of items (2) and (3) above did not apply to the first taxable year for which we made an election to be taxed as a REIT. However, these stock ownership requirements must be satisfied in each subsequent taxable year. Our articles of incorporation impose restrictions on the transfer of our shares to help us meet the stock ownership requirements. In addition, Treasury regulations require us to demand from the record holders of designated percentages of our capital stock, annual written statements disclosing actual and constructive stock ownership. The same regulations require us to maintain permanent records showing the information we have received regarding actual and constructive stock ownership and a list of those persons failing or refusing to comply with our demand.
Asset Requirements
We generally must meet the following asset requirements at the close of each quarter of each taxable year:
(a) at least 75% of the value of our total assets must be "qualified REIT real estate assets" (described below), government securities, cash and cash items;
(b) no more than 25% of the value of our total assets may be securities other than securities in the 75% asset class (for example, government securities) ;
(c) no more than 20 % of the value of our total assets may be securities of one or more Taxable REIT subsidiaries (described below); and
(d) except for securities in the 75% asset class, securities in a Taxable REIT subsidiary or "qualified REIT subsidiary," and certain partnership interests and debt obligations--
(1) no more than 5% of the value of our total assets may be securities of any one issuer,
(2) we may not hold securities that possess more than 10% percent of the total voting power of the outstanding securities of any one issuer, and
(3) we may not hold securities that have a value of more than 10 percent of the total value of the outstanding securities of any one issuer. (Under a special transition provision , this restriction does not apply to securities held on July 12, 1999, provided the issuer of those securities does not engage in a substantially new line of business or acquire substantial new assets after that date, and provided we do not acquire additional securities in such issuer. This special transition provision should exempt our ownership of 33% of the equity of Annaly International Mortgage Management, Inc., as operated on July 12, 1999).
"Qualified REIT real estate assets" means assets of the type described in section 856(c)(5)(B) of the Code, and generally include (among other assets) interests in mortgages on real property, and shares in other REITs. A "Taxable REIT subsidiary" is a corporation that may earn income that would not be qualifying income if earned directly by the REIT. A REIT may hold up to 100% of the stock in a Taxable REIT subsidiary. Both the subsidiary and the REIT must jointly elect to treat the subsidiary as a "taxable REIT Subsidiary" by jointly filing a Form 8875 with the IRS. A Taxable REIT Subsidiary will pay tax at the corporate rates on any income it earns. Moreover, the Code contains rules requiring the imposition of taxes on a REIT at the rate of 100% on certain reallocated income and expenses, to ensure contractual arrangements between a Taxable REIT Subsidiary and the parent REIT are at arm's length.
If we fail to meet any of the asset tests as of the close of a calendar quarter due to the acquisition of securities or other assets, the Code allows us a 30-day period following the close of the calendar quarter to come into compliance with the asset tests. If we do cure a failure within the 30-day period, we will be treated as having satisfied the asset tests at the close of the calendar quarter.
Gross Income Requirements
We generally must meet the following gross income requirements for each taxable year:
(a) at least 75% of our gross income must be derived from the real estate sources specified in section 856(c)(3) of the Code, including interest income and gain from the disposition of qualified REIT real estate assets, and "qualified temporary investment income" (generally, income we earn from investing new capital, provided we received that income within one year of acquiring such new capital); and
(b) at least 95% of our gross income for each taxable year must be derived from sources of income specified in section 856(c)(2) of the Code which includes the types of gross income described just above, as well as dividends, interest, and gains from the sale of stock or other financial instruments (including interest rate swap and cap agreements, options, futures contracts, forward rate agreements or similar financial instruments entered into to hedge variable rate debt incurred to acquire qualified REIT real estate assets) not held for sale in the ordinary course of business.
Distribution Requirements
We generally must distribute dividends (other than capital gain dividends) to our stockholders in an amount at least equal to (1) the sum of (a) 90% of our REIT taxable income (computed without regard to the dividends paid deduction and net capital gains) and (b) 90% of the net income (after tax, if any), from foreclosure property, minus (2) the sum of certain items of non-cash income. In addition, if we were to recognize gain on disposition of any assets acquired from a "C" corporation in a transaction in which gain was not recognized, we would be required to distribute at least 90% of the gain recognized net of the tax we would pay on such gain. As to our net capital gains, rather than distribute them, we may elect to retain and pay tax on them, in which case our stockholders will include their proportionate share of the undistributed net capital gains in income and receive a credit for their share of the tax we pay.
Failure to Qualify
If we fail to qualify as a REIT in any taxable year and the relief provisions provided in the Code do not apply, we will be subject to federal income tax, including any applicable alternative minimum tax, on our taxable income in that taxable year and all subsequent taxable years at the regular corporate income tax rates. We will not be allowed to deduct distributions to shareholders in these years, nor will the Code require us to make distributions. Further, unless entitled to the relief provisions of the Code, we also will be barred from re-electing REIT status for the four taxable years following the year in which we fail to qualify. It is not possible to state in what circumstances we would be entitled to any statutory relief.
We intend to monitor on an ongoing basis our compliance with the REIT requirements described above. To maintain our REIT status, we will be required to limit the types of assets that we might otherwise acquire, or hold some assets at times when we might otherwise have determined that the sale or other disposition of these assets would have been more prudent.
Taxation of Annaly Mortgage Management
In any year in which we do qualify as a REIT, we generally will not be subject to federal income tax on that portion of our REIT taxable income or capital gain that we distribute to our stockholders. We will, however, be subject to federal income tax at normal corporate income tax rates upon any undistributed taxable income or capital gain.
Notwithstanding our qualification as a REIT, we may also be subject to tax in the following other circumstances:
o If we fail to satisfy either the 75% or the 95% gross income test, but nonetheless maintain our qualification as a REIT because we meet other requirements, we generally will be subject to a 100% tax on the greater of the amount by which we fail either the 75% or the 95% gross income test multiplied by a fraction intended to reflect our profitability.
o We will be subject to a tax of 100% on net income derived from any "prohibited transaction" which is, in general, a sale or other disposition of property held primarily for sale to customers in the ordinary course of business.
o If we have (1) net income from the sale or other disposition of foreclosure property that is held primarily for sale to customers in the ordinary course of business or (2) other non-qualifying income from foreclosure property, it will be subject to federal income tax at the highest corporate income tax rate.
o If we fail to distribute during each calendar year at least the sum of (1) 85% of our REIT ordinary income for such year, (2) 95% of our REIT capital gain net income for such year and (3) any amount of undistributed ordinary income and capital gain net income from preceding taxable years, we would be subject to a 4% federal excise tax on the excess of the required distribution over the amounts actually distributed during the taxable year.
o If we acquire any asset from a C corporation in a transaction in which the basis of the asset is determined by reference to the basis of the asset in the hands of a C corporation and we recognize gain upon a disposition of such asset occurring within 10 years of its acquisition, then we would be subject to tax to the extent of any built-in gain at the highest regular corporate rate.
o We may also be subject to the corporate alternative minimum tax, as well as other taxes in situations not presently contemplated.
Taxation of Stockholders
Unless a stockholder is a tax-exempt entity, distributions that we make to it, including constructive distributions, generally will be subject to tax as ordinary income to the extent of the our current and accumulated earnings and profits as determined for federal income tax purposes. If the amount we distribute to a stockholder exceeds its allocable share of current and accumulated earnings and profits, the excess will be treated as a return of capital to the extent of the stockholder's adjusted basis in its stock, which will reduce the stockholder's basis in its stock but will not be subject to tax. If the amount we distribute to a stockholder also exceeds the stockholder's adjusted basis, this excess amount will be treated as a gain from the sale or exchange of a capital asset.
Distributions our stockholders receive, whether characterized as ordinary income or as capital gain, are not eligible for the corporate dividends received deduction.
Distributions that we designate as capital gain dividends generally will be subject to tax as long-term capital gains to our stockholders, to the extent such distributions do not exceed our actual net capital gain for the taxable year. In the event that we realize a loss for the taxable year, no stockholder will be permitted to deduct any share of that loss. Further, if we, or a portion of our assets, were to be treated as a taxable mortgage pool, any excess inclusion income that is allocated to a stockholder could not be offset by any losses or other deductions it may have. Future Treasury Department regulations may require a stockholder to take into account, for purposes of computing its individual alternative minimum tax liability, some of our tax preference items.
Dividends that we declare during the last quarter of the calendar year and actually pay to a stockholder during January of the following taxable year generally are treated as if we had paid, and the stockholder had received, them on December 31 of the calendar year and not on the date actually paid and received. In addition, we may elect to treat other dividends distributed after the close of the taxable year as having been paid during the taxable year, so long as they meet the requirements described in the Code, but a stockholder will be treated as having received these dividends in the taxable year in which the distribution is actually made.
If a stockholder sells or otherwise disposes of our stock, it will generally recognize a capital gain or loss in an amount equal to the difference between the amount realized and the stockholder's adjusted basis in the stock, which gain or loss will be long-term if the stock is held for more than one year. Any loss recognized on the sale or exchange of stock held for six months or less generally will be treated as a long-term capital loss to the extent of (1) any long-term capital gain dividends the holder received with respect to the stock and (2) the holder's proportionate share of any long-term capital gains that we retain (see the discussion under the caption Distribution Requirements).
If we fail to qualify as a REIT in any year, distributions we make to our stockholders will be taxable in the same manner discussed above, except that:
o we will not be allowed to designate any distributions as capital gain dividends;
o distributions will be eligible for the corporate dividends received deduction;
o the excess inclusion income rules will not apply to the stockholders; and
o our stockholders will not receive any share of our tax preference items.
In this event, however, we could be subject to substantial federal income tax liability, and the amount of earnings and cash available for distribution to our stockholders could be significantly reduced or eliminated.
Information Reporting and Backup Withholding
For each calendar year, we will report to our domestic stockholders and to the IRS the amount of distributions that we pay, and the amount of tax (if any) that we withhold on these distributions. Under the backup withholding rules, a stockholder may be subject to backup withholding tax at a rate of 31% with respect to distributions paid unless:
o the stockholder is a corporation or comes within another exempt category and demonstrates this fact when required; or
o the stockholder provides a taxpayer identification number, certifies as to no loss of exemption from backup withholding tax and otherwise complies with the applicable requirements of the backup withholding tax rules.
If a stockholder does not provide us with your correct taxpayer identification number, then it may also be subject to penalties imposed by the IRS.
Backup withholding tax is not an additional tax. Any amounts withheld under the backup withholding tax rules will be refunded or credited against the stockholder's United States federal income tax liability, provided the stockholder furnishes the required information to the IRS.
Taxation of Tax-Exempt Entities
The discussion under this heading only applies to tax-exempt stockholders.
Subject to the discussion below regarding a pension-held REIT, distributions received from us or gain realized on the sale of our stock will not be taxable as unrelated business taxable income (UBTI), provided that:
o the tax-exempt stockholder has not incurred indebtedness to purchase or hold our stock;
o the tax-exempt stockholder does not otherwise use our stock in an unrelated trade or business; and
o we, consistent with our present intent, do not hold a residual interest in a REMIC that gives rise to excess inclusion income as defined under section 860E of the Code.
If we were to be treated as a taxable mortgage pool, however, a substantial portion of the dividends a tax-exempt stockholder receives may be subject to tax as UBTI.
In addition, a substantial portion of the dividends a tax-exempt stockholder receives may constitute UBTI if we are treated as a pension-held REIT and the tax-exempt stockholder is a qualified pension trust that holds more than 10% by value of our interests at any time during a taxable year. For these purposes, a qualified pension trust is any pension or other retirement trust that qualifies under section 401(a) of the Code. We would be treated as a pension-held REIT if (1) we would not have qualified as a REIT but for the provisions of the Code which look through qualified pension trust stockholders to the qualified pension trusts beneficiaries in determining stock ownership of a REIT and (2) at least one qualified pension trust holds more than 25% of our stock by value or one or more qualified pension trusts (each owning more than 10% of our stock by value) hold in the aggregate more than 50% of our stock by value. Assuming compliance with the ownership limit provisions set forth in our articles of incorporation, it is unlikely that pension plans will accumulate sufficient stock to cause us to be treated as a pension-held REIT.
If a stockholder qualifies for exemption under sections 501(c)(7), (c)(9), (c)(17), and (c)(20) of the Code, then distributions received by such stockholder may also constitute UBTI. We urge such stockholders to consult their tax advisors concerning the applicable set aside and reserve requirements.
United States Federal Income Tax Considerations Applicable to Foreign Holders
The discussion under this heading applies only to our stockholders that are not U.S. persons (hereafter, "foreign stockholder"). A U.S. person is a person who is:
o a citizen or resident of the United States;
o a corporation, partnership, or other entity created or organized in the United States or under the laws of the United States or of any political subdivision thereof;
o an estate whose income is includible in gross income for United States Federal income tax purposes regardless of its source; or
o a trust, if (1) a court within the United States is able to exercise primary supervision over the administration of the trust and one or more U.S. persons have authority to control all substantial decisions of the trust, or (2) the trust was in existence on August 26, 1996, was treated as a domestic trust prior to such date, and has made an election to continue to be treated as a U.S. person;
This discussion is only a brief summary of the United States federal tax consequences that apply to a foreign stockholder, which are highly complex, and does not consider any specific facts or circumstances that may apply to a foreign stockholder and its particular situation. We urge foreign stockholders to consult their tax advisors regarding the United States federal tax consequences of acquiring, holding and disposing of our stock, as well as any tax consequences that may arise under the laws of any foreign, state, local or other taxing jurisdiction.
Distributions
Except for distributions attributable to gain from the dispositions of real property interests or designated as capital gains dividends, distributions a foreign stockholder receives from us generally will be subject, to the extent of our earnings and profits, to withholding of United States federal income tax at the rate of 30%, unless reduced or eliminated by an applicable tax treaty or unless the distributions are treated as effectively connected with a United States trade or business. If a foreign stockholder wishes to claim the benefits of an applicable tax treaty, it may need to satisfy certification and other requirements, such as providing Form W-8BEN. If a foreign stockholder wishes to claim distributions are effectively connected with a United States trade or business, it may need to satisfy certification and other requirements such as providing Form W-8ECI.
Distributions a foreign stockholder receives that are in excess of our earnings and profits will be treated as a tax-free return of capital to the extent of the foreign stockholder's adjusted basis in its stock. If the amount of the distribution also exceeds such adjusted basis, this excess amount will be treated as gain from the sale or exchange of our stock as described below. If we cannot determine at the time we make a distribution whether the distribution will exceed our earnings and profits, the distribution will be subject to withholding at the same rate as dividends. These withheld amounts, however, will be refundable or creditable against the foreign stockholder's United States federal tax liability if it is subsequently determined that the distribution was, in fact, in excess of our earnings and profits. If a foreign stockholder receives a dividend that is treated as being effectively connected with its conduct of a trade or business within the United States, the dividend will be subject to the United States federal income tax on net income that applies to United States persons generally and may be subject to the branch profits tax if the foreign stockholder is a corporation.
Distributions that we make to foreign stockholders and designate as capital gains dividends, other than those attributable to the disposition of a United States real property interest, generally will not be subject to United States federal income taxation, unless:
o the foreign stockholder's investment in our stock is effectively connected with the conduct of a trade or business within the United States; or
o the foreign stockholder is a nonresident alien individual who is present in the United States for 183 days or more in the taxable year and other requirements are met.
Distributions that are attributable to a disposition of United States real property interests are subject to income and withholding taxes pursuant to the Foreign Investment in Real Property Act of 1980 (FIRPTA), and may also be subject to branch profits tax if a foreign stockholder is a corporation that is not entitled to treaty relief or exemption. However, because we do not expect to hold assets that would be treated as United States real property interests as defined by FIRPTA, the FIRPTA provisions should not apply to investment in our stock.
Gain on Disposition
A foreign stockholder generally will not be subject to United States federal income tax on gain recognized on a sale or other disposition of our stock unless:
o the gain is effectively connected with your conduct of a trade or business within the United States;
o the foreign stockholder is a nonresident alien individual who holds our stock as a capital asset and is present in the United States for 183 or more days in the taxable year and other requirements are met; or
o the foreign stockholder is subject to tax under the FIRPTA rules discussed below.
Gain that is effectively connected with the conduct of a trade or business within the United States will be subject to the United States federal income tax on net income that applies to United States persons generally and may be subject to the branch profits tax if a foreign stockholder is a corporation. However, these effectively-connected gains will not be subject to withholding. We urge our foreign stockholders to consult applicable treaties, which may provide for different rules.
Under FIRPTA, a foreign stockholder may be subject to tax on gain recognized from a sale or other disposition of our stock if we were to both (1) hold United States real property interests and (2) fail to qualify as a domestically-controlled REIT. A REIT qualifies as domestically-controlled as long as less than 50% in value of its shares of beneficial interest are held by foreign persons at all times during the shorter of (1) the previous five years and (2) the period in which the REIT is in existence. As mentioned above, we do not expect to hold any United States real property interests. Furthermore, we will likely qualify as a domestically-controlled REIT, although no assurances can be provided because our shares are publicly-traded.
State and Local Taxes
We and our stockholders may be subject to state or local taxation in various jurisdictions, including those in which we or they transact business or reside. The state and local tax treatment that applies to us and our stockholders may not conform to the federal income tax consequences discussed above. Consequently, we urge our stockholders to consult their own tax advisors regarding the effect of state and local tax laws.
COMPETITION
We believe that our principal competition in the business of acquiring and holding mortgage-backed securities are financial institutions such as banks, savings and loans, life insurance companies, institutional investors such as mutual funds and pension funds, and certain other mortgage REITs. The existence of these competitive entities, as well as the possibility of additional entities forming in the future, may increase the competition for the acquisition of mortgage-backed securities resulting in higher prices and lower yields on assets.
RISK FACTORS
An investment in our stock involves a number of risks. Before making an investment decision, you should carefully consider all of the risks described in this Form 10-K. If any of the risks discussed in this Form 10-K actually occur, our business, financial condition and results of operations could be materially adversely affected. If this were to occur, the trading price of our common stock could decline significantly and you may lose all or part of your investment.
If the interest payments on our borrowings increase relative to the interest we earn on our mortgage-backed securities, it may adversely affect our profitability
We earn money based upon the difference between the interest payments we earn on our mortgage-backed security investments and the interest payments we must make on our borrowings. If the interest payments on our borrowings increase relative to the interest we earn on our mortgage-backed securities, our profitability may be adversely affected.
The interest payments on our borrowings may increase relative to the interest we earn on our mortgage-backed securities for various reasons discussed in this section.
Differences in timing of interest rate adjustments on our mortgage-backed securities and our borrowings may adversely affect our profitability
We rely primarily on short-term borrowings to acquire mortgage-backed securities with long-term maturities. Accordingly, if short-term interest rates increase, this may adversely affect our profitability.
Most of the mortgage-backed securities we acquire are adjustable-rate securities. This means that their interest rates may vary over time based upon changes in an objective index, such as:
o LIBOR or the London Interbank Offered Rate. The interest rate that banks in London offer for deposits in London of U.S. dollars.
o Treasury Index. A monthly or weekly average yield of benchmark U.S. Treasury securities, as published by the Federal Reserve Board.
o CD Rate. The weekly average of secondary market interest rates on six-month negotiable certificates of deposit, as published by the Federal Reserve Board.
These indices generally reflect short-term interest rates. On December 31, 2000, approximately 74% of our mortgage-backed securities were adjustable-rate securities.
The interest rates on our borrowings similarly vary with changes in an objective index. However, the interest rates on our borrowings generally adjust more frequently than the interest rates on our mortgage-backed securities. For example, on December 31, 2000, our adjustable-rate securities had a weighted average term to next rate adjustment of 15 months, while our borrowings had a weighted average term to next rate adjustment of 29 days. Accordingly, in a period of rising interest rates, we could experience a decrease in net income or a net loss because the interest rates on our borrowings adjust faster than the interest rates on our mortgage-backed securities.
Interest rate caps on our mortgage-backed securities may adversely affect our profitability
Our adjustable-rate securities are typically subject to periodic and lifetime interest rate caps which limit the amount an interest rate can increase during any given period. Our borrowings are not subject to similar restrictions. Accordingly, in a period of rapidly increasing interest rates, we could experience a decrease in net income or a net loss because the interest rates on our borrowings could increase without limitation while the interest rates on our adjustable-rate mortgage-backed securities would be limited by caps.
Because we acquire fixed rate securities, an increase in interest rates may adversely affect our profitability
While the majority of our investments consist of adjustable-rate securities, we also invest in fixed-rate mortgage-backed securities. In a period of rising interest rates, our interest payments would increase while the interest we earn on our fixed rate securities would not change. This would adversely affect our profitability. On December 31, 2000, approximately 26% of our mortgage-backed securities were fixed rate securities.
An increase in prepayment rates may adversely affect our profitability
The mortgage-backed securities we acquire are backed by pools of mortgage loans. We receive payments, generally, from the payments that are made on these underlying mortgage loans. When borrowers prepay their mortgage loans at faster rates than expected, this results in faster prepayments than expected on the mortgage-backed securities using the effective yield method. These faster than expected prepayments may adversely affect our profitability.
We often purchase mortgage-backed securities that have a higher interest rate than the market interest rate at the time. In exchange for this higher interest rate, we must pay a premium over market value to acquire the security. In accordance with accounting rules, we amortize this premium over the term of the mortgage-backed security using the effective yield method. If the mortgage-backed security is prepaid in whole or in part prior to its expected maturity date, however, we must expense the premium that is being prepaid at the time of the prepayment. This adversely affects our profitability. On December 31, 2000, approximately 87% of the mortgage-backed securities we owned had been acquired at a premium.
Prepayment rates generally increase when interest rates fall and decrease when interest rates rise, but changes in prepayment rates are difficult to predict. Prepayment rates also may be affected by conditions in the housing and financial markets, general economic conditions and the relative interest rates on fixed-rate and adjustable-rate mortgage loans.
We may seek to reduce prepayment risk by acquiring mortgage-backed securities at a discount. If a discounted security is prepaid in whole or in part prior to its expected maturity date, we will earn income on the amount of the discount that is being prepaid. This will improve our profitability if there are faster than expected prepayments. On December 31, 2000, approximately 13% of the mortgage-backed securities we owned had been acquired at a discount.
We can also acquire mortgage-backed securities that are less affected by prepayments. For example, we can acquire collateralized mortgage obligations or CMOs, a type of mortgage-backed security. CMOs divide a pool of mortgage loans into multiple tranches that allow for shifting of prepayment risks from slower-paying tranches to faster-paying tranches. This is in contrast to pass-through or pay-through mortgage-backed securities, where all investors share equally in all payments, including all prepayments. As discussed below, the Investment Company Act imposes restrictions on our purchase of CMOs. On December 31, 2000, approximately 24% of our mortgage-backed securities were CMOs and approximately 76% of our mortgage-backed securities were pass-through or pay-through securities.
While we seek to minimize prepayment risk to the extent practical, in selecting investments we must balance prepayment risk against other risks and the potential returns of each investment. No strategy can completely insulate us from prepayment risk.
An increase in interest rates may adversely affect our book value
Increases in interest rates may negatively affect the market value of our mortgage-backed securities. Our fixed-rate securities, generally, are more negatively affected by these increases. In accordance with accounting rules, we reduce our book value by the amount of any decrease in the market value of our mortgage-backed securities.
Our strategy involves significant leverage
We seek to maintain a ratio of debt-to-equity of between 8:1 and 12:1, although our ratio may be above or below this amount. We incur this leverage by borrowing against a substantial portion of the market value of our mortgage-backed securities. By incurring this leverage, we can enhance our returns. However, this leverage, which is fundamental to our investment strategy, also creates significant risks.
Our leverage may cause substantial losses
Because of our significant leverage, we may incur substantial losses if our borrowing costs increase. Our borrowing costs may increase for any of the following reasons:
o Short-term interest rates increase
o The market value of our mortgage-backed securities decreases
o Interest rate volatility increases
o The availability of financing in the market decreases
Our leverage may cause margin calls and defaults and force us to sell assets under adverse market conditions
Because of our leverage, a decline in the value of our mortgage-backed securities may result in our lenders initiating margin calls. A margin call means that the lender requires us to pledge additional collateral to re-establish the ratio of the value of the collateral to the amount of the borrowing. Our fixed-rate mortgage-backed securities generally are more susceptible to margin calls as increases in interest rates tend to more negatively affect the market value of fixed-rate securities.
If we are unable to satisfy margin calls, our lenders may foreclose on our collateral. This could force us to sell our mortgage-backed securities under adverse market conditions. Additionally, in the event of our bankruptcy, our borrowings, which are generally made under repurchase agreements, may qualify for special treatment under the Bankruptcy Code. This special treatment would allow the lenders under these agreements to avoid the automatic stay provisions of the Bankruptcy Code and to liquidate the collateral under these agreements without delay.
Liquidation of collateral may jeopardize our REIT status
To continue to qualify as a REIT, we must comply with requirements regarding our assets and our sources of income. If we are compelled to liquidate our mortgage-backed securities, we may be unable to comply with these requirements, ultimately jeopardizing our status as a REIT. For further discussion of these asset and source of income requirements and the consequences of our failure to continue to qualify as a REIT, please see the "Federal Income Tax Considerations" section above.
We may exceed our target leverage ratios
We seek to maintain a ratio of debt-to-equity of between 8:1 and 12:1. However, we are not required to stay within this leverage ratio. If we exceed this ratio, we will incur additional risks of the types described in this section.
We may not be able to achieve our optimal leverage
We use leverage as a strategy to increase the return to our investors. However, we may not be able to achieve our desired leverage for any of the following reasons:
o we determine that the leverage would expose us to excessive risk
o our lenders do not make funding available to us at acceptable rates
o our lenders require that we provide additional margin to cover our borrowings
We may incur increased borrowing costs which would adversely affect our profitability
Currently, all of our borrowings are collateralized borrowings in the form of repurchase agreements. If the interest rates on these repurchase agreements increase, it would adversely affect our profitability.
Our borrowing costs under repurchase agreements generally correspond to short-term interest rates such as LIBOR or a short-term Treasury index, plus or minus a margin. The margins on these borrowings over or under short-term interest rates may vary depending upon:
o the movement of interest rates
o the availability of financing in the market
o the value and liquidity of our mortgage-backed securities
If we are unable to renew our borrowings at favorable rates, our profitability may be adversely affected
Since we rely primarily on short-term borrowings, our ability to achieve our investment objectives depends not only on our ability to borrow money in sufficient amounts and on favorable terms, but also on our ability to renew or replace on a continuous basis our maturing short-term borrowings. If we are not able to renew or replace maturing borrowings, we would have to sell mortgage-backed securities under possibly adverse market conditions.
We have not used derivatives to mitigate our interest rate and prepayment risks
Our policies permit us to enter into interest rate swaps, caps and floors and other derivative transactions to help us mitigate our interest rate and prepayment risks described above. However, we have determined in the past that the cost of these transactions outweighs the benefits. In addition, we will not enter into derivative transactions if we believe they will jeopardize our status as a REIT. Even if we do enter into derivative transactions in the future, these transactions could mitigate our interest rate and prepayment risks but could not insulate us from these risks.
Our investment strategy may involve credit risk
We may incur losses if there are payment defaults under our mortgage-backed securities.
To date, all of our mortgage-backed securities have been agency certificates which, although not rated, carry an implied "AAA" rating. Agency certificates are mortgage-backed securities where Freddie Mac, Fannie Mae or Ginnie Mae guarantees payments of principal or interest on the certificates.
o Fannie Mae is a common abbreviation that refers to the Federal National Mortgage Association, a privately owned, federally chartered corporation organized under an act of Congress.
o Ginnie Mae is a common abbreviation that refers to the Government National Mortgage Association, a wholly-owned instrumentality of the United States within the Department of Housing and Urban Development.
Even though we have only acquired AAA securities so far, under our capital investment policy we have the ability to acquire securities of lower credit quality. Under our policy:
o 75% of our investments must have a AA or higher rating by Standard & Poor's Corporation (or S&P), or an equivalent rating by another nationally recognized rating organization, or our management must determine that the investments are of comparable credit quality to investments with these ratings;
o the remaining 25% of our investments must have a BBB or higher rating by S&P, or an equivalent rating by another nationally recognized rating organization, or our management must determine that the investments
are of comparable credit quality to investments with these ratings; securities with ratings of BBB or higher are commonly referred to as "investment grade" securities; and
o we seek to have a minimum weighted average rating for our portfolio of at least A by S&P.
If we acquire mortgage-backed securities of lower credit quality, we may incur losses if there are defaults under those mortgage-backed securities or if the rating agencies downgrade the credit quality of those mortgage-backed securities.
Because of competition, we may not be able to acquire mortgage-backed securities at favorable yields
Our net income depends, in large part, on our ability to acquire mortgage-backed securities at favorable spreads over our borrowing costs. In acquiring mortgage-backed securities, we compete with other REITs, investment banking firms, savings and loan associations, banks, insurance companies, mutual funds, other lenders and other entities that purchase mortgage-backed securities, many of which have greater financial resources than us. As a result, in the future, we may not be able to acquire sufficient mortgage-backed securities at favorable spreads over our borrowing costs.
We are dependent on our key personnel
We are dependent on the efforts of our key officers and employees, including Michael A. J. Farrell, Chairman of the Board and Chief Executive Officer, Timothy J. Guba, President and Chief Operating Officer, Wellington J. St. Claire, Vice Chairman and Portfolio Manager and Kathryn F. Fagan, Chief Financial Officer. The loss of any of their services could have an adverse effect on our operations. Although we have employment agreements with each of them, we cannot assure you they will remain employed with us.
Some of our officers and employees have potential conflicts of interest
Some of our officers and employees have potential conflicts of interest with us. The material potential conflicts are as follows:
Our officers and employees manage assets for other clients
Messrs. Farrell and Guba, Ms. St. Claire and other officers and employees are actively involved in managing mortgage-backed securities and other fixed income assets for institutional clients through Fixed Income Discount Advisory Company. FIDAC is a registered investment adviser which on December 31, 2000 managed, assisted in managing or supervised approximately $1.2 billion in gross assets for a wide array of clients. Of that amount, FIDAC managed approximately $850 million of those gross assets on a discretionary basis. The U.S. Dollar Floating Rate Fund is a fund managed by FIDAC. Mr. Farrell is a Director of the Floating Rate Fund. These officers will continue to perform services for FIDAC, the institutional clients and the Floating Rate Fund. Mr. Farrell is also the sole shareholder of FIDAC.
These responsibilities may create conflicts of interest for these officers and employees if they are presented with corporate opportunities that may benefit us and the institutional clients and the Floating Rate Fund. Our officers allocate investments among Annaly, the institutional clients and the Floating Rate Fund by determining the entity or account for which the investment is most suitable. In making this determination, our officers consider the investment strategy and guidelines of each entity or account with respect to acquisition of assets, leverage, liquidity and other factors that our officers determine appropriate.
Some or our directors and officers have ownership interests in our affiliates that create potential conflicts of interest
Mr. Farrell, our Chairman and Chief Executive Officer, and other directors and officers of Annaly, have direct and indirect ownership interests in our affiliates that create potential conflicts of interest.
During 1998, we made an initial investment of $49,980 in Annaly International Mortgage Management, Inc. Annaly International explores business opportunities overseas, including the origination of mortgages. Annaly International has not commenced operations beyond this exploratory state. We own 33% of the equity of Annaly International in the form of non-voting securities. The remaining equity of Annaly International is owned by FIDAC, Michael A.J. Farrell, our Chairman and Chief Executive Officer, Timothy J. Guba, our President and Chief Operating Officer, Wellington J. St. Claire, our Vice Chairman and Portfolio Manager, Kathryn F. Fagan, our Chief Financial Officer, John S. Grace, one of our directors, and other persons. Mr. Farrell, our Chairman and Chief Executive Officer, is the sole shareholder of FIDAC.
During 1998, Annaly International made an initial investment of $20,400 in Annaly.com, Inc. Annaly.com explores opportunities to acquire or originate mortgages in the United States. Annaly.com has established a Web site at http://www.annaly.com but has not commenced the acquisition or origination of mortgages. Annaly International owns 51% of the equity of Annaly.com. The remaining equity of Annaly.com is owned by FIDAC.
Our management allocates rent and other office expenses between our affiliates and us. These allocations may create conflicts of interest. In addition, we intend to enter into agreements with our affiliates in the future. These agreements will present potential conflicts of interest. Our management currently allocates rent and other expenses 90% to Annaly and 10% to FIDAC. Our audit committee must approve any change in these allocation percentages. In addition, our management will obtain prior approval of our audit committee prior to entering into any agreements with our affiliates.
We and our shareholders are subject to certain tax risks
Our failure to qualify as a REIT would have adverse tax consequences
We believe that since 1997 we have qualified for taxation as a REIT for federal income tax purposes. We plan to continue to meet the requirements for taxation as a REIT. Many of these requirements, however, are highly technical and complex. The determination that we are a REIT requires an analysis of various factual matters and circumstances that may not be totally within our control. For example, to qualify as a REIT, as least 95% of our gross income must come from certain sources that are itemized in the REIT tax laws. We are also required to distribute to shareholders at least 95% of our REIT taxable income (excluding capital gains) for the taxable year ending December 31, 2000, and at least 90% of our taxable income (excluding capital gains) for subsequent taxable years. Even a technical or inadvertent mistake could jeopardize our REIT status. Furthermore, Congress and the IRS might make changes to the tax laws and regulations, and the courts might issue new rulings that make it more difficult or impossible for us to remain qualified as a REIT.
If we fail to qualify as a REIT, we would be subject to federal income tax at regular corporate rates. Also, unless the IRS granted us relief under certain statutory provisions, we would remain disqualified as a REIT for four years following the year we first fail to qualify. If we fail to qualify as a REIT, we would have to pay significant income taxes and would therefore have less money available for investments or for distributions to our shareholders. This would likely have a significant adverse effect on the value of our securities. In addition, we would no longer be required to make any distributions to our shareholders.
We have certain distribution requirements
As a REIT, we must distribute 95% of our annual taxable income for the taxable year ending December 31, 2000 and 90% of our annual taxable income for subsequent years. The required distribution limits the amount we have available for other business purposes, including amounts to fund our growth. Also, it is possible that because of the differences between the time we actually receive revenue or pay expenses and the period we report those items for distribution purposes, we may have to borrow funds on a short-term basis to meet these requirements.
We are also subject to other tax liabilities
Even if we qualify as a REIT, we may be subject to certain federal, state and local taxes on our income and property. Any of these taxes would reduce our operating cash flow.
Loss of Investment Company Act exemption would adversely affect us
We intend to conduct our business so as not to become regulated as an investment company under the Investment Company Act. If we fail to qualify for this exemption, our ability to use leverage would be substantially reduced and we would be unable to conduct our business as described in this Form 10-K.
The Investment Company Act exempts entities that are primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate. Under the current interpretation of the staff of the SEC, in order to qualify for this exemption, we must maintain at least 55% of our assets directly in these qualifying real estate interests. Mortgage-backed securities that do not represent all the certificates issued with respect to an underlying pool of mortgages may be treated as securities separate from the underlying mortgage loans and, thus, may not qualify for purposes of the 55% requirement. Therefore, our ownership of these mortgage-backed securities is limited by the provisions of the Investment Company Act. In addition, in meeting the 55% requirement under the Investment Company Act, we treat as qualifying interests mortgage-backed securities issued with respect to an underlying pool as to which we hold all issued certificates. If the SEC or its staff adopts a contrary interpretation, we could be required to sell a substantial amount of our mortgage-backed securities, under potentially adverse market conditions. Further, in order to insure that we at all times qualify for the exemption from the Investment Company Act, we may be precluded from acquiring mortgage-backed securities whose yield is somewhat higher than the yield on mortgage-backed securities that could be purchased in a manner consistent with the exemption. The net effect of these factors may be to lower our net income.
We may change our policies without stockholder approval
Our Board of Directors and management determine all of our policies, including our investment, financing and distribution policies. Although they have no current plans to do so, they may amend or revise these policies at any time without a vote of our stockholders. Policy changes could adversely affect our financial condition, results of operations, the market price of our common stock or our ability to pay dividends or distributions.
Maryland Business Combination Statute
The Maryland General Corporation Law establishes special requirements for "business combinations" between a Maryland corporation and "interested stockholders" unless exemptions are applicable. An interested stockholder is any person who beneficially owns 10% or more of the voting power of our then-outstanding voting stock. Among other things, the law prohibits for a period of five years a merger and other similar transactions between our company and an interested stockholder unless the board of directors approved the transaction prior to the party becoming an interested stockholder. The five-year period runs from the most recent date on which the interested stockholder became an interested stockholder. The law also requires a supermajority stockholder vote for such transactions after the end of the five-year period. This means that the transaction must be approved by at least:
o 80% of the votes entitled to be cast by holders of outstanding voting shares; and
o 66% of the votes entitled to be cast by holders of outstanding voting shares other than shares held by the interested stockholder with whom the business combination is to be effected.
As permitted under Maryland General Corporation Law, we have elected not to be governed by the business combination statute by opting out of this statute in our articles of incorporation. If, however, we amend our articles of incorporation to opt back in to this statute, the business combination statute could have the effect of discouraging offers to acquire us and of increasing the difficulty of consummating any such offers, even if our acquisition would be in our stockholders' best interests.
Maryland Control Share Acquisition Statute
Maryland law provides that "control shares" of a Maryland corporation acquired in a "control share acquisition" have no voting rights except to the extent approved by a stockholder vote. Two-thirds of the shares eligible to vote must vote in favor of granting the "control shares" voting rights. "Control shares" are shares of stock that, taken together with all other shares of stock the acquirer previously acquired, would entitle the acquirer to exercise at least 10% of the voting power in electing directors. Control shares do not include shares of stock the acquiring person is entitled to vote as a result of having previously obtained stockholder approval. A "control share acquisition" means the acquisition of control shares, subject to certain exceptions.
If a person who has made (or proposes to make) a control share acquisition satisfies certain conditions (including agreeing to pay expenses), he may compel our board of directors to call a special meeting of stockholders to be held within 50 days to consider the voting rights of the shares. If such a person makes no request for a meeting, we have the option to present the question at any stockholders' meeting.
If voting rights are not approved at a meeting of stockholders then we may redeem any or all of the control shares (except those for which voting rights have previously been approved) for fair value. We will determine the fair value of the shares, without regard to voting rights, as of the date of either:
o the last control share acquisition, or
o any meeting where stockholders considered and did not approve voting rights of the control shares.
If voting rights for control shares are approved at a stockholders' meeting and the acquirer becomes entitled to vote a majority of the shares of stock entitled to vote, all other stockholders may exercise appraisal rights. This means that you would be able to force us to redeem your stock for fair value. Under Maryland law, the fair value may not be less than the highest price per share paid in the control share acquisition. Furthermore, certain limitations otherwise applicable to the exercise of dissenters' rights would not apply in the context of a control share acquisition. The control share acquisition statute would not apply to shares acquired in a merger, consolidation or share exchange if we were a party to the transaction. The control share acquisition statute could have the effect of discouraging offers to acquire us and of increasing the difficulty of consummating any such offers, even if our acquisition would be in our stockholders' best interests.
ITEM 2.
ITEM 2. PROPERTIES
Our executive and administrative office is located at 12 East 41st Street, Suite 700, New York, New York 10017, telephone 212-696-0100. This office is leased under a lease expiring December 2007.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
At December 31, 2000, there were no pending legal proceedings to which we were a party, or to which any of our property was subject.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
We did not submit any matters to a vote of the Company's stockholders during the fourth quarter of 2000.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our common stock began trading publicly on October 8, 1997 and is traded on the New York Stock Exchange under the trading symbol "NLY". As of March 20, 2001, we had 25,696,459 shares of common stock issued and outstanding which were held by 6,841 holders of record.
The following table sets forth, for the periods indicated, the high, low, and closing sales prices per share of common stock as reported on the New York Stock Exchange composite tape and the cash dividends declared per share of our common stock. Stock Prices
High Low Close
First Quarter ended March 31, 2000 $ 9.25 $ 7.19 $ 8.88 Second Quarter ended June 30, 2000 $ 9.38 $ 8.19 $ 8.88 Third Quarter ended September 30, 2000 $ 9.50 $ 8.06 $ 9.13 Fourth Quarter ended December 31, 2000 $ 9.50 $ 7.88 $ 9.06
First Quarter ended March 31, 1999 $10.25 $ 7.94 $10.25 Second Quarter ended June 30, 1999 $11.38 $ 9.31 $11.25 Third Quarter ended September 30, 1999 $11.50 $ 9.19 $ 9.31 Fourth Quarter ended December 31, 1999 $ 9.44 $ 8.06 $ 8.75
Cash Dividends Declared Per Share
First Quarter ended March 31, 2000 $0.35 Second Quarter ended June 30, 2000 $0.30 Third Quarter ended September 30, 2000 $0.25 Fourth Quarter ended December 31, 2000 $0.25
First Quarter ended March 31, 1999 $0.33 Second Quarter ended June 30, 1999 $0.35 Third Quarter ended September 30, 1999 $0.35 Fourth Quarter ended December 31, 1999 $0.35
We intend to pay quarterly dividends and to make distributions to our stockholders in amounts that all or substantially all of our taxable income in each year (subject to certain adjustments) is distributed. This will enable us to qualify for the tax benefits accorded to a REIT under the Code. We have not established a minimum dividend payment level and our ability to pay dividends may be adversely affected for the reasons described under the caption "Risk Factors." All distributions will be made at the discretion of our Board and will depend on our earnings, our financial condition , maintenance of our REIT status and such other factors as our Board of Directors may deem relevant from time to time.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data are derived from our audited financial statements for the years ended December 31, 2000, 1999 and 1998, and the period ended December 31, 1997. The selected financial data should be read in conjunction with the more detailed information contained in the Financial Statements and Notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations" included elsewhere in this Form 10-K.
SELECTED FINANCIAL DATA (dollars in thousands, except for per share data)
(1) Ratios for the 317-day period ended December 31, 1997 have been annualized.
ITEM 7.
ITEM 7.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Overview
We are a real estate investment trust that owns and manages a portfolio of mortgage-backed securities. Our principal business objective is to generate net income for distribution to our stockholders from the spread between the interest income on our mortgage-backed securities and the costs of borrowing to finance our acquisition of mortgage-backed securities.
We commenced operations on February 18, 1997 upon the consummation of a private placement. We completed our initial public offering on October 14, 1997. The 317-day period ended December 31, 1997 was a short operating period and not a full twelve months.
Results of Operations
Net Income Summary
For the year ended December 31, 2000, our GAAP net income was $16.6 million, or $1.18 basic earnings per average share, as compared to $18.1 million, or $1.41 basic earnings per average share for the year ended December 31, 1999. For the year ended December 31, 1998, our GAAP net income was $15.5 million, or $1.22 basic earnings per average share. We compute our GAAP net income per share by dividing net income by the weighted average number of shares of outstanding common stock during the period, which was 14,089,436 for the year ended December 31, 2000, 12,889,510 for the year ended December 31, 1999, and 12,709,116 for the year ended December 31, 1998. Dividends per weighted average number of shares outstanding for the year ended December 31, 2000 was $1.15 per share, or $16.3 million in total. Dividends per weighted average number of shares outstanding for the year ended December 31, 1999 was $1.38 per share, or $18.0 million in total. Dividends per weighted average number of shares outstanding for the year ended December 31, 1998 was $1.22 per share, or $15.4 million in total. Our return on average equity was 14.09% for the year ended December 31, 2000, 15.41% for the year ended December 31, 1999, and 11.80% year ended December 31, 1998. The table below presents the net income summary for the years ended December 31, 2000, 1999, 1998, the period ended December 31, 1997.
Net Income Summary
Taxable Income and GAAP Income
For the years ended December 31, 2000, 1999, and 1998 our income as calculated for tax purposes (taxable income) differed from income as calculated according to GAAP (GAAP income). Our taxable income for the year ended December 31, 2000 was approximately $15.7 million, or $1.11 per share, as compared to taxable income of $18.4 million, or $1.43 per share, for the year ended December 31, 1999. The differences were in the calculations of premium and discount amortization, gains on sale of mortgage-backed securities, and general and administrative expenses.
The distinction between taxable income and GAAP income is important to our stockholders because dividends are declared on the basis of taxable income. While we do not pay taxes so long as we satisfy the requirements for exemption from taxation pursuant to the REIT provisions of the Internal Revenue Code, each year we complete a corporate tax form on which taxable income is calculated as if we were to be taxed. This taxable income level determines the amount of dividends we can pay out over time. The table below presents the major differences between our GAAP and taxable income for the years ended December 31, 2000, 1999, and 1998, the period ended December 31, 1997, and the four quarters in 2000.
Taxable Income
Interest Income and Average Earning Asset Yield
We had average earning assets of $1.6 billion for the year ended December 31, 2000. We had average earning assets of $1.5 billion for both years ended December 31, 1999 and 1998. Our primary source of income for the years ended December 31, 2000, 1999, and 1998 was interest income. A portion of our income was generated by gains on the sales of our mortgage-backed securities. Our interest income was $109.8 million for the year ended December 31, 2000, $89.8 million for the year ended December 31, 1999, and $90.0 million for the year ended December 31, 1998. Our yield on average earning assets was 7.02%, 6.15%, and 6.16% for the same respective periods. Our yield on average earning assets increased by 0.87% and our average earning asset balance increased by $11.0 million for the year ended December 31, 2000 as compared to the year ended December 31, 1999. Interest income increased to $19.9 million for the year ended December 31, 2000 over prior year, due to the increase in average earning asset balance and yield. Our average earning asset balance decreased by $756,000 for the year ended December 31, 1999 as compared to the year ended December 31, 1998. Interest income decreased by $174,000 for the year ended December 31, 1999 over prior year, due to the slight decline in the average earning asset balance and yield. The table below shows our average balance of cash equivalents and mortgage-backed securities, the yields we earned on each type of earning assets, our yield on average earning assets and our interest income for the years ended December 31, 2000, 1999 and 1998, and the period ended December 31, 1997, and the four quarters in 2000.
Average Earning Asset Yield
The constant prepayment rate (or CPR) on our mortgage-backed securities for the year ended December 31, 2000 was 11%, for the year ended December 31, 1999 was 18%, and for the year ended December 31, 1998 was 23%. CPR is an assumed rate of prepayment for our mortgage-backed securities, expressed as an annual rate of prepayment relative to the outstanding principal balance of our mortgage-backed securities. CPR does not purport to be either a historical description of the prepayment experience of our mortgage-backed securities or a prediction of the anticipated rate of prepayment of our mortgage-backed securities.
Principal prepayments had a negative effect on our earning asset yield for the years ended December 31, 2000, 1999 and 1998 because we adjust our rates of premium amortization and discount accretion monthly based upon the effective yield method, which takes into consideration changes in prepayment speeds.
Interest Expense and the Cost of Funds
We anticipate that our largest expense will be the cost of borrowed funds. We had average borrowed funds of $1.4 billion for the years ended December 31, 2000, 1999 and 1998. Interest expense totaled of $92.9 million, $69.8 million and $75.7 million for the years ended December 31, 2000, 1999 and 1998. Our average
cost of funds was 6.41% for the year ended December 31, 2000, 5.17% for the year ended December 31, 1999 and 5.57% for the year ended December 31, 1998. The cost of funds rate increased by 1.24% and the average borrowed funds increased by $99.8 million for the year ended December 31, 2000 when compared to the year ended December 31, 1999; consequently, interest expense increased by 33%. Our average cost of funds was 5.17% for the year ended December 31, 1999 and 5.57% for the year ended December 31, 1998. The cost of funds rate declined 0.40% and the average borrowed funds declined by $9.8 million for the year ended December 31, 1999 when compared to the year ended December 31, 1998; consequently, interest expense decreased by 8%.
With our current asset/liability management strategy, changes in our cost of funds are expected to be closely correlated with changes in short-term LIBOR, although we may choose to extend the maturity of our liabilities at any time. Our average cost of funds was equal to average one-month LIBOR for the year ended December 31, 2000, 0.08% below average one-month LIBOR for the year ended December 31, 1999 and equal to average one-month LIBOR for the year ended December 31, 1998. We generally have structured our borrowings to adjust with one-month LIBOR because we believe that one-month LIBOR may continue to be lower than six-month LIBOR in the present interest rate environment. During the year ended December 31, 2000, average one-month LIBOR, which was 6.41%, was 0.25% lower than average six-month LIBOR, which was 6.66%. During the year ended December 31, 1999, average one-month LIBOR, which was 5.25%, was 0.28% lower than average six-month LIBOR, which was 5.53%. During the year ended December 31, 1998, average one-month LIBOR, which was 5.57%, was 0.03% higher than average six-month LIBOR, which was 5.54%. The table below shows our average borrowed funds and average cost of funds as compared to average one-month and average six-month LIBOR for the years ended December 31, 2000, 1999 and 1998, the period ended December 31, 1997 and the four quarters in 2000.
Average Cost of Funds
Net Interest Rate Agreement Expense
We have not entered into any interest rate agreements to date. As part of our asset/liability management process, we may enter into interest rate agreements such as interest rate caps, floors or swaps. These agreements would be entered into with the intent to reduce interest rate or prepayment risk and would be designed to provide us income and capital appreciation in the event of certain changes in interest rates. However, even after entering into these agreements, we would still be exposed to interest rate and prepayment risks. We review the need for
interest rate agreements on a regular basis consistent with our capital investment policy.
Net Interest Income
Our net interest income, which equals interest income less interest expense, totaled $16.8 million for the year ended December 31, 2000, $20.0 million for the year ended December 31, 1999, and $14.3 million for the year ended December 31, 1998. Our net interest income decreased for the year ended December 31, 2000 because of higher funding costs for the year. The substantial increase in interest expense for the year ended December 31, 2000 was only partially offset by the increase in interest income. Our net interest income increased because of lower funding costs for the year for the year ended December 31, 1999, when compared to the year ended December 31, 1998. 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 0.61% for the year ended December 31, 2000 as compared to 0.98% for the year ended December 31, 1999. This 0.37% decrease in spread income is reflected in the $3.2 million decrease in net interest income. Our net interest spread was 0.98% for the year ended December 31, 1999 as compared to 0.59% for the year ended December 31, 1998. This 0.39% increase in spread income is reflected in the $5.7 million increase in net interest income. Net interest margin, which equals net interest income divided by average interest earning assets, was 1.02% for the year ended December 31, 2000, 1.35% for the year ended December 31, 1999, and 0.95% for the year ended December 31, 1998. The principal reason that net interest margin exceeded net interest spread is that average interest earning assets exceeded average interest bearing liabilities. A portion of our assets is funded with equity rather than borrowings. We did not have any interest rate agreement expenses to date.
The table below shows our interest income by earning asset type, average earning assets by type, total interest income, interest expense, average repurchase agreements, average cost of funds, and net interest income for the years ended December 31, 2000, 1999 and 1998, the period ended December 31, 1997, and the four quarters in 2000.
GAAP Net Interest Income
Gains and Losses on Sales of Mortgage-Backed Securities
For the year ended December 31, 2000, we sold mortgage-backed securities with an aggregate historical amortized cost of $487.8 million for an aggregate gain of $2.0 million. For the year ended December 31, 1999, we sold mortgage-backed securities with an aggregate historical amortized cost of $122.1 million for an aggregate gain of $455,000. For the year ended December 31, 1998, we sold mortgage-backed securities with an aggregate historical amortized cost of $565.2 million for an aggregate gain of $3.3 million. As stated above, our gain on the sale of assets increased substantially for the year ended December 31, 2000. For the year ended December 31, 1999, there was a greater emphasis on spread income and not gains. The difference between the sale price and the historical amortized cost of our mortgage-backed securities is a realized gain and increases income accordingly. We do not expect to sell assets on a frequent basis, but may from time to time sell existing assets to move into new assets, which our management believes might have higher risk-adjusted returns, or to manage our balance sheet as part of our asset/liability management strategy.
Credit Losses
We have not experienced credit losses on our mortgage-backed securities to date. We have limited our exposure to credit losses on our mortgage-backed securities by purchasing only securities, issued or guaranteed by FNMA, FHLMC or GNMA, which, although not rated, carry an implied "AAA" rating.
General and Administrative Expenses
General and administrative expenses ("G&A") were $2.3 million for the years ended December 31, 2000 and 1999. G&A expenses were $2.1 million for the year ended December 31, 1998. G&A expenses as a percentage of average assets was 0.14%, 0.15%, and 0.14% for the years ended December 31, 2000, 1999, and 1998 respectively. G&A expenses in total were materially unchanged for the three year period. The table below shows our total G&A expenses as compared to average assets and average equity for the years ended December 31, 2000, 1999 and 1998, the period ended December 31, 1997, and the four quarters in 2000.
GAAP G&A Expenses and Operating Expense Ratios
Total G&A Total G&A Expenses/Average Expenses/Average Total G&A Assets Equity Expenses (annualized) (annualized) ---------------- ---------------- ----------------- (dollars in the thousands) For the Year Ended December 31, 2000 $2,286 0.14% 1.94% For the Year Ended December 31, 1999 $2,281 0.15% 1.94% For the Year Ended December 31, 1998 $2,106 0.14% 1.60% For the Period Ended December 31, 1997 $852 0.21% 1.61% For the Quarter Ended December 31, 2000 $670 0.14% 2.11% For the Quarter Ended September 30, 2000 $527 0.13% 1.84% For the Quarter Ended June 30, 2000 $507 0.15% 1.85% For the Quarter Ended March 31, 2000 $582 0.16% 2.19%
Net Income and Return on Average Equity
Our net income was $16.6 million for the year ended December 31, 2000, $18.1 million for the year ended December 31, 1999, and $15.5 million for the year ended December 31, 1998. Our return on average equity was 14.1% for the year ended December 31, 2000, 15.4% for the year ended December 31, 1999, and 11.8% for the year ended December 31, 1998. The decrease in net income for the year ended December 2000, as compared to the year ended December 31, 1999, is a direct result of a decrease in spread income. As previously mentioned, the substantial increase in interest expense for the year ended December 31, 2000 was the primary reason that our earnings decreased. The Company was able to take advantage of appreciation in asset value. The gain on sale of securities increased by $1.6 million for the year ended December 31, 2000, as compared to the prior year. The increase in net income for the year ended December 31, 1999, as compared to the year ended December 31, 1998, is a direct result of an increase in spread income. The substantial decline in interest expense for the year ended December 31, 1999 was the primary reason that our earnings increased. The G&A expenses remained relatively constant during the three year period. The table below shows our net interest income, gain on sale of mortgage-backed securities and G&A expenses each as a percentage of average equity, and the return on average equity for the years ended December 31, 2000, 1999, 1998, and 1997, and for the four quarters in 2000.
Components of Return on Average Equity
(Ratios for the Quarters Ended December 31, 2000, September 30, 2000, June 30, 2000, March 31, 2000 and the Period ended December 31, 1997 are annualized)
Dividends and Taxable Income
We have elected to be taxed as a REIT under the Internal Revenue Code. Accordingly, we have distributed substantially all of our taxable income for each year since inception to our stockholders, including income resulting from gains on sales of our mortgage-backed securities. From inception through December 31, 2000, approximate taxable income exceeded dividend declarations by $810,000, or $0.05 per share, based on the number of shares of common stock outstanding at period end. The table below shows taxable income as compared to dividends paid for the years ended December 31, 2000, 1999 and 1998, the period ended December 31, 1997, and the four quarters in 2000.
Dividend Summary
Financial Condition
Mortgage-Backed Securities
All of our mortgage-backed securities at December 31, 2000, 1999, and 1998 were adjustable-rate or fixed-rate mortgage-backed securities backed by single-family mortgage loans. All of the mortgage assets underlying these mortgage-backed securities were secured with a first lien position on the underlying single-family properties. All our mortgage-backed securities were FHLMC, FNMA or GNMA mortgage pass-through certificates or CMOs, which carry an implied "AAA" rating. We mark-to-market all of our earning assets at liquidation value.
We accrete discount balances as an increase in interest income over the life of discount mortgage-backed securities and we amortize premium balances as a decrease in interest income over the life of premium mortgage-backed securities. At December 31, 2000, 1999, and 1998 we had on our balance sheet a total of $989,000, $1.1 million and $609,000, respectively, of unamortized discount (which is the difference between the remaining
principal value and current historical amortized cost of our mortgage-backed securities acquired at a price below principal value) and a total of $24.3 million, $23.6 million and $24.9 million, respectively, of unamortized premium (which is the difference between the remaining principal value and the current historical amortized cost of our mortgage-backed securities acquired at a price above principal value).
We received mortgage principal repayments of $168.5 million for the year ended December 31, 2000, $362.7 million for the year ended December 31, 1999, and $486.3 million for the year ended December 31, 1998. Given our current portfolio composition, if mortgage principal prepayment rates were to increase over the life of our mortgage-backed securities, all other factors being equal, our net interest income would decrease during the life of these mortgage-backed securities as we would be required to amortize our net premium balance into income over a shorter time period. Similarly, if mortgage principal prepayment rates were to decrease over the life of our mortgage-backed securities, all other factors being equal, our net interest income would increase during the life of these mortgage-backed securities as we would amortize our net premium balance over a longer time period.
The table below summarizes our mortgage-backed securities at December 31, 2000, 1999, 1998 and 1997, September 30, 2000, June 30, 2000, and March 31, 2000.
Mortgage-Backed Securities
The tables below set forth certain characteristics of our mortgage-backed securities. The index level for adjustable-rate mortgage-backed securities is the weighted average rate of the various short-term interest rate indices, which determine the coupon rate.
Adjustable-Rate Mortgage-Backed Security Characteristics
Fixed-Rate Mortgage-Backed Security Characteristics
At December 31, 2000, 1999, and 2000 we held mortgage-backed securities with coupons linked to the one-year, three-year, and five-year Treasury indices, one-month LIBOR and the six-month CD rate.
Adjustable-Rate Mortgage-Backed Securities by Index December 31, 2000
Adjustable-Rate Mortgage-Backed Securities by Index December 31, 1999
Adjustable-Rate Mortgage-Backed Securities by Index December 31, 1998
Interest Rate Agreements
Interest rate agreements are assets that are carried on a balance sheet at estimated liquidation value. We have not entered into any interest rate agreements since our inception.
Borrowings
To date, our debt has consisted entirely of borrowings collateralized by a pledge of our mortgage-backed securities. These borrowings appear on our balance sheet as repurchase agreements. At December 31, 2000, we had established uncommitted borrowing facilities in this market with twenty-three lenders in amounts, which we believe, are in excess of our needs. All of our mortgage-backed securities are currently accepted as collateral for these borrowings. However, we limit our borrowings, and thus our potential asset growth, in order to maintain unused borrowing capacity and thus increase the liquidity and strength of our balance sheet.
For the years ended December 31, 2000, 1999 and 1998, the term to maturity of our borrowings ranged from one day to six months, with a weighted average original term to maturity of 56 days at December 31, 2000, 50 days at December 31, 1999, and 49 days at December 31, 1998. At December 31, 2000, the weighted average cost of funds for all of our borrowings was 6.55% and the weighted average term to next rate adjustment was 29 days. At December 31, 1999, the weighted average cost of funds for all of our borrowings was 5.26% and the weighted average term to next rate adjustment was 20 days. At December 31, 1998, the weighted average cost of funds for all of our borrowings was 5.21% and the weighted average term to next rate adjustment was 29 days.
Liquidity
Liquidity, which is our ability to turn non-cash assets into cash, allows us to purchase additional mortgage-backed securities and to pledge additional assets to secure existing borrowings should the value of our pledged assets decline. Potential immediate sources of liquidity for us include cash balances and unused borrowing capacity. Unused borrowing capacity will vary over time as the market value of our mortgage-backed securities varies. Our balance sheet also generates liquidity on an on-going basis through mortgage principal repayments and net earnings held prior to payment as dividends. Should our needs ever exceed these on-going sources of liquidity plus the immediate sources of liquidity discussed above, we believe that our mortgage-backed securities could in most circumstances be sold to raise cash. The maintenance of liquidity is one of the goals of our capital
investment policy. Under this policy, we limit asset growth in order to preserve unused borrowing capacity for liquidity management purposes.
Stockholders' Equity
We use "available-for-sale" treatment for our mortgage-backed securities; we carry these assets on our balance sheet at estimated market value rather than historical amortized cost. Based upon this "available-for-sale" treatment, our equity base at December 31, 2000 was $135.6 million, or $9.34 per share. If we had used historical amortized cost accounting, our equity base at December 31, 2000 would have been $148.6 million, or $10.24 per share. Our equity base at December 31, 1999 was $103.3 million, or $7.60 per share. If we had used historical amortized cost accounting, our equity base at December 31, 1998 would have been $140.8 million, or $10.37 per share. Our equity base at December 31, 1998 was $125.9 million, or $9.95 per share. If we had used historical amortized cost accounting, our equity base at December 31, 1998 would have been $132.3 million, or $10.46 per share. During the years ended December 31, 2000 and 1999, the Company raised additional capital in the amount of $7.4 million and $8.2 million through its direct purchase program. The Company completed secondary offerings of 9,800,000 shares of common stock on January 29, 2001. The aggregate net proceeds to the company (after deducting estimated expenses) are estimated to be $87.4 million. The underwriters exercised an option to purchase 1,350,000 additional shares of common stock to cover over-allotments on February 22, 2001, providing the company with net proceeds of $12.1 million.
With our "available-for-sale" accounting treatment, unrealized fluctuations in market values of assets do not impact our GAAP or taxable income but rather are reflected on our balance sheet by changing the carrying value of the asset and stockholders' equity under "Accumulated Other Comprehensive Income (Loss)." By accounting for our assets in this manner, we hope to provide useful information to stockholders and creditors and to preserve flexibility to sell assets in the future without having to change accounting methods.
As a result of this mark-to-market accounting treatment, our book value and book value per share are likely to fluctuate far more than if we used historical amortized cost accounting. As a result, comparisons with companies that use historical cost accounting for some or all of their balance sheet may not be meaningful.
The table below shows unrealized gains and losses on the mortgage-backed securities in our portfolio.
Unrealized Gains and Losses
Unrealized changes in the estimated net market value of mortgage-backed securities have one direct effect on our potential earnings and dividends: positive market-to-market changes increase our equity base and allow us to increase our borrowing capacity while negative changes tend to limit borrowing capacity under our capital investment policy. A very large negative change in the net market value of our mortgage-backed securities might impair our liquidity position, requiring us to sell assets with the likely result of realized losses upon sale. "Unrealized Losses on Available for Sale Securities" was $13.0 million, or 0.66% of the amortized cost of our mortgage-backed securities at December 31, 2000. "Unrealized Losses on Available for Sale Securities" was $37.6 million or 2.54% of the amortized cost of our mortgage-backed securities at December 31, 1999. "Unrealized Losses on Available for Sale Securities" was $6.4 million or 0.42% of the amortized cost of our mortgage-backed securities at December 31, 1998.
The table below shows our equity capital base as reported and on a historical amortized cost basis at December 31, 2000, 1999, 1998, and 1997, and September 30, 2000, June 30, 2000 and March 31,2000. Issuances of common stock, the level of GAAP earnings as compared to dividends declared, and other factors influence our historical cost equity capital base. The GAAP reported equity capital base is influenced by these factors plus changes in the "Net Unrealized Losses on Assets Available for Sale" account.
Stockholders' Equity
Leverage
Our debt-to-GAAP reported equity ratio at December 31, 2000, 1999, and 1998 was 12.0:1, 12.9:1, 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-GAAP reported 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 in 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, although we have not done so to date, we may seek to mitigate the potential impact on net income of periodic and lifetime coupon adjustment restrictions in our portfolio of mortgage-backed securities by entering into interest rate agreements such as interest rate caps and interest rate swaps.
Changes in interest rates may also 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.
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 Internal Revenue Code, are 99.9% of our total assets at December 31, 2000 and 1999 and 99.5% at December 31, 1998, as compared to the Internal Revenue Code requirement that at least 75% of our total assets be qualified REIT assets. We also calculate that 98.1%, 99.5% and 96.4% of our revenue qualifies for the 75% source of income test, and 100% of its revenue qualifies for the 95% source of income test, under the REIT rules for the years ended December 31, 2000, 1999, and 1998, respectively. We also met all REIT requirements regarding the ownership of our common stock and the distribution of our net income. Therefore, as of December 31, 2000, 1999 and 1998 we believe that we qualified as a REIT under the Internal Revenue Code.
We at all times intend to conduct our business so as not to become regulated as an investment company under the Investment Company Act. If we were to become regulated as an investment company, then our use of leverage would be substantially reduced. The Investment Company Act exempts entities that are "primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate" (qualifying interests). Under current interpretation of the staff of the SEC, in order to qualify for this exemption, we must maintain at least 55% of our assets directly in qualifying interests. In addition, unless certain mortgage securitites represent all the certificates issued with respect to an underlying pool of mortgages, the mortgage-backed securities may be treated as securities separate from the underlying mortgage loans and, thus, may not be considered qualifying interests for purposes of the 55% requirement. We calculate that as of December 31, 2000, 1999 and 1998 we were in compliance with this requirement.
ITEM 7A
ITEM 7A QUANTITATIVE AND QUALITIATIVE DISCLOSURES ABOUT MARKET RISK
MARKET RISK
Market risk is the exposure to loss resulting from changes in interest rates, foreign currency exchange rates, commodity prices and equity prices. The primary market risk to which we are exposed is interest rate risk. Interest rates are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond our control. Changes in the general level of interest rates can affect our net interest income, which is the difference between the interest income earned on interest-earning assets and the interest expense incurred in connection with our interest-bearing liabilities, by affecting the spread between our interest-earning assets and interest-bearing liabilities. Changes in the level of interest rates also can affect the value of our mortgage-backed securities and our ability to realize gains from the sale of these assets. We may utilize a variety of financial instruments, including interest rate swaps, caps, floors and other interest rate exchange contracts, in order to limit the effects of interest rates on our operations. If we use these types of derivatives to hedge the risk of interest-earning assets or interest-bearing liabilities, we may be subject to certain risks, including the risk that losses on a hedge position will reduce the funds available for payments to holders of securities and that the losses may exceed the amount we invested in the instruments. To date, we have not purchased any hedging instruments.
Our profitability and the value of our portfolio may be adversely affected during any period as a result of changing interest rates. The following table quantifies the potential changes in net interest income and portfolio value should interest rates go up or down 200 basis points, assuming the yield curves of the rate shocks will be parallel to each other and the current yield curve. All changes in income and value are measured as percentage changes from the projected net interest income and portfolio value at the base interest rate scenario. The base interest rate scenario assumes interest rates at December 31, 2000 and various estimates regarding prepayment and all activities are made at each level of rate shock. Actual results could differ significantly from these estimates.
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. The following table sets forth the estimated maturity or repricing of our interest-earning assets and interest-bearing liabilities at December 31, 2000. The amounts of assets and liabilities shown within a particular period were determined in accordance with the contractual terms of the assets and liabilities, except adjustable-rate loans, and securities are included in the period in which their interest rates are first scheduled to adjust and not in the period in which they mature. Mortgage-backed securities reflect estimated prepayments that were estimated based on analyses of broker estimates, the results of a prepayment model that we utilized and empirical data. Our management believes that these assumptions approximate actual experience and considers them reasonable; however, the interest rate sensitivity of our assets and liabilities in the table could vary substantially if different assumptions were used or actual experience differs from the historical experience on which the assumptions are based.
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 8
ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Our financial statements and the related notes, together with the Independent Auditors' Report thereon, are set forth on pages through of this Form 10-K.
ITEM 9
ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10
ITEM 10 DIRECTORS AND OFFICERS OF THE REGISTRANT
The information required by Item 10 is incorporated herein by reference to the definitive proxy statement we are filing pursuant to Regulation 14A under the headings "Election of Directors," "Directors," "Management," and "Section 16(a) Beneficial Ownership Reporting Compliance."
ITEM 11
ITEM 11 EXECUTIVE COMPENSATION
The information required by Item 11 is incorporated herein by reference to the definitive proxy statement we are filing pursuant to Regulation 14A under the heading "Executive Compensation."
ITEM 12
ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by Item 12 is incorporated herein by reference to the definitive proxy statement we are filing pursuant to Regulation 14A under the heading "Security Ownership of Certain Beneficial Owners and Management."
ITEM 13
ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by Item 13 is incorporated herein by reference to the definitive proxy statement we are filing pursuant to Regulation 14A under the heading "Executive Compensation."
PART IV
ITEM 14
ITEM 14 EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) Documents filed as part of this report:
1. Financial Statements.
2. Schedules to Financial Statements:
All financial statement schedules not included have been omitted because they are either inapplicable or the information required is provided in our Financial Statements and Notes thereto, included in Part II, Item 8, of this Annual Report on Form 10-K.
3. Exhibits:
3.1 Articles of Incorporation of the Registrant (incorporated by reference to Exhibit 3.1 to our Registration Statement on Form S-11 (Registration No. 333-32913) filed with the Securities and Exchange Commission on August 5, 1997).
3.2 Articles of Amendment and Restatement of the Articles of Incorporation of the Registrant (incorporated by reference to Exhibit 3.2 to our Registration Statement on Form S-11 (Registration No. 333-32913) filed with the Securities and Exchange Commission on August 5, 1997).
3.3 Bylaws of the Registrant, as amended (incorporated by reference to Exhibit 3.3 to our Registration Statement on Form S-11 (Registration No. 333-32913) filed with the Securities and Exchange Commission on August 5, 1997).
4.1 Specimen Common Stock Certificate (incorporated by reference to Exhibit 4.1 to Amendment No. 1 to our Registration Statement on Form S-11(Registration No. 333-32913) filed with the Securities and Exchange Commission on September 17, 1997.
10.1 Purchase Agreement, dated February 12, 1997, between the Registrant and Freedman, Billings, Ramsey & Co., Inc. ("FBR") (incorporated by reference to Exhibit 10.1 to our Registration Statement on Form S-11 (Registration No. 333-32913) filed with the Securities and Exchange Commission on August 5, 1997).
10.2 Registration Rights Agreement, dated February 12, 1997, between the Registrant and FBR (incorporated by reference to Exhibit 10.2 to our Registration Statement on Form S-11 (Registration No. 333-32913) filed with the Securities and Exchange Commission on August 5, 1997).
10.3 Long-Term Stock Incentive Plan (incorporated by reference to Exhibit 10.3 to our Registration Statement on Form S-11 (Registration No. 333-32913) filed with the Securities and Exchange Commission on August 5, 1997).
10.4 Employment Agreement, effective as of January 27, 1997, between the Company and Michael A.J. Farrell (incorporated by reference to Exhibit 10.4 to our Registration Statement on Form S-11 (Registration No. 333-32913) filed with the Securities and Exchange Commission on August 5, 1997).
10.5 Employment Agreement, effective as of January 27, 1997, between the Company and Timothy J. Guba (incorporated by reference to Exhibit 10.5 to our Registration Statement on Form S-11 (Registration No. 333-32913) filed with the Securities and Exchange Commission on August 5, 1997).
10.6 Employment Agreement, effective as of January 27, 1997, between the Company and Wellington J. St. Claire (incorporated by reference to Exhibit 10.6 to our Registration Statement on Form S-11 (Registration No. 333-32913) filed with the Securities and Exchange Commission on August 5, 1997).
10.7 Form of Master Repurchase Agreement (incorporated by reference to Exhibit 10.7 to our Registration Statement on Form S-11 (Registration No. 333-32913) filed with the Securities and Exchange Commission on August 5, 1997).
10.8 Form of Purchase Agreement between the Company and the purchasers in the Direct Offering (incorporated by reference to Exhibit 10.8 to our Registration Statement on Form S-11 (Registration No. 333-32913) filed with the Securities and Exchange Commission on August 5, 1997).
10.9 Employment Agreement, effective as of November 1, 1997, between the Company and Kathryn F. Fagan (incorporated by reference to Exhibit 10.9 to our Form 10-K for the fiscal year ended December 31, 1997).
10.10 Employment Agreement, effective as of January 1, 2001, between the Company and Jennifer A. Stephens*
23.1 Consent of Independent Accountants.*
* Filed herewith.
Exhibit Numbers 10.3-10.6, 10.9 and 10.10 are management contracts or compensatory plans required to be filed as Exhibits to this Form 10-K.
(b) Reports on Form 8-K
We have not filed any reports on Form 8-K during the last quarter of the period covered by this report.
Annaly Mortgage Management, Inc. Independent Auditors' Report
Financial Statements Years Ended December 31, 2000, 1999 and 1998
Annaly Mortgage Management, Inc.
NOTES TO FINANCIAL STATEMENTS - --------------------------------------------------------------------------------
Page
INDEPENDENT AUDITORS' REPORT 1
FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2000, 1999 AND 1998:
Balance Sheets 2
Statements of Operations 3
Statements of Stockholders' Equity 4
Statement of Cash Flows 5
Notes to Financial Statements 6-14
INDEPENDENT AUDITORS' REPORT
To the Board of Directors and Stockholders of Annaly Mortgage Management, Inc.
We have audited the accompanying statements of financial condition of Annaly Mortgage Management, Inc. (the "Company") at of December 31, 2000, 1999 and 1998, and the related statements of operations, changes in stockholders' equity, and cash flows for the years then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2000, 1999 and 1998, and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America.
New York, New York February 5, 2000
ANNALY MORTGAGE MANAGEMENT, INC.
STATEMENTS OF FINANCIAL CONDITION DECEMBER 31, 2000 AND 1999 - --------------------------------------------------------------------------------
See notes to financial statements.
ANNALY MORTGAGE MANAGEMENT, INC.
STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 2000, 1999 AND 1998 - --------------------------------------------------------------------------------
See notes to financial statements.
ANNALY MORTGAGE MANAGEMENT, INC.
STATEMENT OF STOCKHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 2000, 1999 AND 1998 - --------------------------------------------------------------------------------
See notes to financial statements.
ANNALY MORTGAGE MANAGEMENT, INC.
STATEMENT OF CASH FLOWS YEARS ENDED DECEMBER 31, 2000, 1999 AND 1998 - --------------------------------------------------------------------------------
See notes to financial statements
ANNALY MORTGAGE MANAGEMENT, INC.
NOTES TO FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2000, 1999 AND 1998 - --------------------------------------------------------------------------------
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
Annaly Mortgage Management, Inc. (the "Company") was incorporated in Maryland on November 25, 1996. The Company commenced its operations of purchasing and managing an investment portfolio of Mortgage-Backed Securities on February 18, 1997, upon receipt of the net proceeds from the private placement of equity capital. An initial public offering was completed on October 14, 1997.
A summary of the Company's significant accounting policies follows:
Cash and Cash Equivalents - Cash and cash equivalents includes cash on hand and money market funds. The carrying amounts of cash equivalents approximates their value.
Mortgage-Backed Securities - The Company invests primarily in mortgage pass-through certificates, collateralized mortgage obligations and other mortgage-backed securities representing interests in or obligations backed by pools of mortgage loans (collectively, "Mortgage-Backed Securities").
Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities, requires the Company to classify its investments as either trading investments, available-for-sale investments or held-to-maturity investments. Although the Company generally intends to hold most of its Mortgage-Backed Securities until maturity, it may, from time to time, sell any of its Mortgage-Backed Securities as part of its overall management of its balance sheet. Accordingly, this flexibility requires the Company to classify all of its Mortgage-Backed Securities as available-for-sale. All assets classified as available-for-sale are reported at fair value, based on market prices provided by certain dealers who make markets in these financial instruments, with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders' equity.
Unrealized losses on Mortgage-Backed Securities that are considered other than temporary, as measured by the amount of decline in fair value attributable to factors other than temporary, are recognized in income and the cost basis of the Mortgage-Backed Securities is adjusted. There were no such adjustments for the years ended December 31, 2000, 1999, and 1998.
Interest income is accrued based on the outstanding principal amount of the Mortgage-Backed Securities and their contractual terms. Premiums and discounts associated with the purchase of the Mortgage-Backed Securities are amortized into interest income over the lives of the securities using the interest method.
Mortgage-Backed Securities transactions are recorded on the trade date. Purchases of newly issued securities are recorded when all significant uncertainties regarding the characteristics of the securities are removed, generally shortly before settlement date. Realized gains and losses on Mortgage-Backed Securities transactions are determined on the specific identification basis.
Credit Risk - At December 31, 2000 and 1999, the Company has limited its exposure to credit losses on its portfolio of Mortgage-Backed Securities by only purchasing securities issued by Federal Home Loan Mortgage Corporation ("FHLMC"), Federal National Mortgage Association ("FNMA"), or Government National Mortgage Association ("GNMA"). The payment of principal and interest on the FHLMC and FNMA Mortgage-Backed Securities are guaranteed by those respective agencies and the payment of principal and interest on the GNMA Mortgage-Backed Securities are backed by the full-faith-and-credit of the U.S. government. At December 31, 2000 and 1999, all of the Company's Mortgage-Backed Securities have an implied "AAA" rating.
Income Taxes - The Company has elected to be taxed as a Real Estate Investment Trust ("REIT") and intends to comply with the provisions of the Internal Revenue Code of 1986, as amended (the "Code") with respect thereto. Accordingly, the Company will not be subjected to Federal income tax to the extent of its distributions to shareholders and as long as certain asset, income and stock ownership tests are met.
Use of Estimates - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Recent Accounting Pronouncements - The Company adopted the provisions of Statement of Financial Accounting Standards ("SFAS") No. 133, Accounting for Derivative Instruments and Hedging Activities, as mended by SFAS No. 137, Accounting for Derivative Instruments and Hedging Activities - Deferral of the Effective Date for FASB Statement No. 133, and No. 138, Accounting for Certain Derivative Instruments and Certain Hedging Activities, and as interpreted by the FASB and the Derivatives Implementation Group through Statement No. 133, Implementation Issues, as of January 1, 2000. The Company has no derivative instruments or any embedded derivative instruments that require bifurcation. Management has determined that the adoption of SFAS No. 133 has no material effect on the Company's financial statements.
2. MORTGAGE-BACKED SECURITIES
The following table pertains to the Company's Mortgage-Backed Securities classified as available-for-sale as of December 31, 2000, which are carried at their fair value:
The following table pertains to the Company's Mortgage-Backed Securities classified as available-for-sale as of December 31, 1999, which are carried at their fair value:
The adjustable rate Mortgage-Backed Securities are limited by periodic caps (generally interest rate adjustments are limited to no more than 1% every six months) and lifetime caps. The weighted average lifetime cap was 11.5% and 10.6% at December 31, 2000 and 1999.
During the year ended December 31, 2000, the Company realized $2,025,205 in gains from sales of Mortgage-Backed Securities. During the year ended December 31, 1999, the Company realized $563,259 in gains from sales of Mortgage-Backed Securities. Losses totaled $108,477 for the year ended December 31, 1999. During the year ended December 31, 1998, the Company realized $3,344,070 in gains from sales of Mortgage-Backed Securities. Losses totaled $9,964 for the year ended December 31, 1998
3. REPURCHASE AGREEMENTS
The Company had outstanding $1,628,359,000 and $1,338,295,750 of repurchase agreements with a weighted average borrowing rate of 6.55% and 5.26% and a weighted average remaining maturity of 29 days and 20 days as of December 31, 2000 and 1999, respectively. At December 31, 2000 and 1999, Mortgage-Backed Securities actually pledged had an estimated fair value of $1,668,161,860 and $1,376,684,559, respectively.
At December 31, 2000 and 1999, the repurchase agreements had the following remaining maturities:
2000 1999
Within 30 days $ 1,135,886,000 $ 1,197,416,250 30 to 59 days 363,810,000 25,767,000 60 to 89 days 48,845,000 -- 90 to 119 days -- 115,112,500 Over 120 days 79,818,000 -- --------------- --------------- $ 1,628,359,000 $ 1,338,295,750 =============== ===============
4. COMMON STOCK
During the year ended December 31, 2000, 47,499 options were exercised at $198,762. Also, 894,163 shares were purchased in direct offerings, totaling $7,392,859. During the year ended December 31, 1999, 57,204 options were exercised at $233,276. Also, 875,688 shares were purchased in the dividend reinvestment and share purchase plan, totaling $8,170,602.
During the Company's year ending December 31, 2000, the Company declared dividends to shareholders totaling $16,333,252, or $1.15 per share, of which $12,702,507 was paid during the year and $3,630,745 was paid on January 30, 2001.
During the Company's year ending December 31, 1999, the Company declared dividends to shareholders totaling $17,977,754, or $1.38 per share, of which $13,224,293 was paid during the year and $4,753,461 was paid on January 27, 2000.
5. EARNINGS PER SHARE (EPS)
In February 1997, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting No. 128, Earnings Per Share (SFAS No. 128), which requires dual presentation of basic EPS and diluted EPS on the face of the income statement for all entities with complex capital structures. SFAS No. 128 also requires a reconciliation of the numerator and denominator of basic EPS and diluted EPS computation. For the year ended December 31, 2000, the reconciliation is as follows:
Year Ended December 31, 2000 --------------------------------------- Income Shares Per-Share (Numerator) (Denominator) Amount
Net income $16,587,288 ----------- Basic EPS 16,587,288 14,089,436 $ 1.18 ======
Effect of dilutive securities: Dilutive stock options -- 288,023 ----------- ---------- Diluted EPS $16,587,288 14,377,459 $ 1.15 =========== ========== ======
Options to purchase 334,881 shares were outstanding during the year and were dilutive as the exercise price of between $4.00 and $8.13 was less than the average stock price for the year of $8.51. Options to
purchase 568,926 shares of stock were outstanding and not considered dilutive. The exercise price of between $8.63 and $11.25 was greater than the average stock price for the year of $8.51.
For the year ended December 31, 1999, the reconciliation is as follows:
Year Ended December 31, 1999 --------------------------------------- Income Shares Per-Share (Numerator) (Denominator) Amount
Net income $18,139,280 ----------- Basic EPS 18,139,280 12,889,510 $ 1.41 ====== Effect of dilutive securities: Dilutive stock options -- 564,497 ----------- ---------- Diluted EPS $18,139,280 13,454,007 $ 1.35 =========== ========== ======
Options to purchase 708,380 shares were outstanding during the year and were dilutive as the exercise price (between $4.00 and $8.94) was less than the average stock price for the year for the Company of $9.58. Options to purchase 135,676 shares of stock were outstanding and not considered dilutive. The exercise price (between $10.00 and $11.25) was greater than the average stock price for the year of $9.58.
For the year ended December 31, 1998, the reconciliation is as follows:
For the Year Ended December 31, 1998 --------------------------------------- Income Shares Per-Share (Numerator) (Denominator) Amount
Net income $15,488,923 ----------- Basic EPS 15,488,923 12,709,116 $ 1.22 ====== Effect of dilutive securities: Dilutive stock options 311,532 ----------- ---------- Diluted EPS $15,488,923 13,020,648 $ 1.19 =========== ========== ======
Options to purchase 446,084 shares were outstanding during the period (Note 6) and were dilutive as the exercise price (between $4.00 and $8.13) was less than the average stock price for the year for the Company of $9.36. Options to purchase 147,676 shares of stock were outstanding and not considered dilutive. The exercise price (between $10.00 and $11.28) was greater than the average stock price for the year of $9.36.
6. LONG TERM STOCK INCENTIVE PLAN
The Company has adopted a long term stock incentive plan for executive officers, key employees and nonemployee directors (the "Incentive Plan"). The Incentive Plan authorizes the Compensation
Committee of the Board of Directors to grant awards, including incentive stock options as defined under section 422 of the Code ("ISOs") and options not so qualified ("NQSOs"). The Incentive Plan authorizes the granting of options or other awards for an aggregate of the greater of 500,000 shares or 9.95% of the outstanding shares of the Company's common stock.
The Company adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation. Accordingly, no compensation cost for the Incentive Plan has been determined based on the fair value at the grant date for awards consistent with the provisions of SFAS No. 123. For the Company's pro forma net earnings, the compensation cost will be amortized over the vesting period of the options. The Company's net earnings per share would have been reduced to the pro forma amounts indicated below:
December 31, --------------------------------------- 2000 1999 1998
Net earnings - as reported $16,587,288 $18,139,280 $15,488,925 Net earnings - pro forma 16,468,550 18,010,908 15,280,631 Earnings per share - as reported $1.18 $1.41 $1.22 Earnings per share - pro forma $1.17 $1.40 $1.20
The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted average assumptions used for grants in the year ended December 31, 2000: dividend yield of 12.69%; expected volatility of 28.33%; risk-free interest rate of 5.16%; and the weighted average expected lives of nine years. For the year ended December 31, 1999, dividend yield of 15%; expected volatility of 32%; risk-free interest rate of 5.61%; and the weighted average expected lives of seven years. For the year ended December 31, 1998, dividend yield of 10%; expected volatility of 33%; risk-free interest rate of 5.56%; and expected lives of seven years.
Information regarding options at December 31, 2000 is as follows:
Information regarding options at December 31, 1999 is as follows:
The following table summarizes information about stock options outstanding at December 31, 2000:
Weighted Average Options Remaining Contractual Exercise Price Outstanding Life (Yrs.)
$ 4.00 65,128 1 7.94 116,250 10 8.13 269,753 8 8.63 300,000 9 8.94 6,250 2 9.06 6,250 3 10.00 131,500 1 10.75 6,250 2 11.25 2,426 2 ------- --- 903,807 6.9 ======= ===
At December 31, 2000 and 1999, 341,013 and 162,389 options were vested and not exercised, respectively.
7. COMPREHENSIVE INCOME
The Company adopted Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income. Statement No. 130 requires the reporting of comprehensive income in addition to net income from operations. Comprehensive income is a more inclusive financial reporting methodology that includes disclosure of certain financial information that historically has not been recognized in the calculation of net income. The Company at December 31, 2000 and 1999 held securities classified as available-for-sale. At December 31, 2000, the net unrealized losses totaled $13,044,259 and at December 31, 1999, the net unrealized losses totaled $37,568,510.
8. LEASE COMMITMENTS
The Corporation has a noncancelable lease for office space, which commenced in April 1998 and expires in December 2007.
The Corporation's aggregate future minimum lease payments are as follows:
2001 $ 97,868 2002 100,515 2003 110,261 2004 113,279 2005 116,388 2006 119,590 2007 122,888 --------- Total remaining lease payments $ 780,789 =========
9. RELATED PARTY TRANSACTION
Included in "Other Assets" on the Balance sheet is an investment in Annaly International Money Management, Inc. On June 24, 1998, the Company acquired 99,960 nonvoting shares, at a cost of $49,980. The officers and directors of Annaly International Money Management Inc. are also officers and directors of the Company.
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 mortgage-backed securities and the Company's ability to realize gains from the sale of these assets.
The Company seeks to manage the extent to which net income changes as a function of changes in interest rates by matching adjustable-rate assets with variable-rate borrowings. In addition, although the Company has not done so to date, the Company may seek to mitigate the potential impact on net income of periodic and lifetime coupon adjustment restrictions in the portfolio of mortgage-backed securities by entering into interest rate agreements such as interest rate caps and interest rate swaps.
Changes in interest rates may also have an effect on the rate of mortgage principal prepayments and, as a result, prepayments on mortgage-backed securities. The Company will seek to mitigate the effect of changes in the mortgage principal repayment rate by balancing assets purchased at a premium with assets purchased at a discount. To date, the aggregate premium exceeds the aggregate discount on the mortgage-backed securities. As a result, prepayments, which result in the expensing of unamortized premium, will reduce net income compared to what net income would be absent such prepayments.
11. SUBSEQUENT EVENT
The Company completed a secondary offerings of 9,800,000 shares of company common stock on January 29, 2001. The aggregate net proceeds to the Company after deducting expenses are estimated to be $87.4 million. The underwriters exercised an option to purchase 1,350,000 additional shares of common stock to cover over-allotments on February 22, 2001, providing the Company with additional net proceeds of $12.1 million.
12. SUMMARIZED QUARTERLY RESULTS (UNAUDITED)
The following is a presentation of the quarterly results of operations for the year ended December 31, 2000.
The following is a presentation of the quarterly results of operations for the year ended December 31, 1999.
The following is a presentation of the quarterly results of operations for the year ended December 31, 1998.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
ANNALY MORTGAGE MANAGEMENT, INC.
Date: March 26, 2001 By: /s/ Michael A. J. Farrell
Michael A. J. Farrell Chairman and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated.
EXHIBIT INDEX
* Filed herewith.