Item 1A. RISK FACTORS
Holding our shares involves various risks and uncertainties. The risks described in this section are among those that have had or could in the future have a material adverse effect on our business, financial condition or results of operations, as well as on the value of our common shares.
Risks Related to Our Business
We need to make new investments that generate returns sufficient to cover operating costs and grow shareholder value over the long term.
During the third quarter of 2013, the Company sold its common shares in TEB. TEB owned the majority of the Company’s bonds, which were financed primarily with variable rate debt and preferred stock with periodic distribution rate resets. TEB generated a significant portion of the Company’s net income; however, the net income generated by TEB was at risk in light of its fixed rate bonds and the variable rate nature of TEB’s debt. TEB’s operating agreement also presented constraints, making it difficult to manage. For example, TEB could not enter into interest rate hedging instruments nor could it freely distribute cash to the Company. As a result of the TEB sale, the Company generated $19.2 million of unrestricted cash and was able to convert $44.8 million of cash held within TEB subject to distribution constraints, to cash that could be freely managed by the Company. At December 31, 2013, the Company had $66.8 million of unrestricted cash on its balance sheet. There is a risk that the Company will not be able to make new investments that will allow it to cover operating costs and grow shareholder value. There is also the risk that any new investments made by the Company will not generate returns sufficient to cover operating costs and grow shareholder value. Furthermore, because the Company has no restrictions as to the nature of its investments, it could deploy its cash into investments that have risk factors that we do not face today.
Changes in interest rates and credit spreads may adversely affect the value of our bonds.
The fair value of our bonds as reported on our balance sheet is impacted by changes in interest rates and credit spreads. As long-term rates rise or credit spreads increase, the value of our bonds will generally decline and these declines could be significant. Because most of our bonds are secured primarily by multifamily rental properties, increasing interest rates leading to higher mortgage rates may make it more difficult for buyers to obtain mortgage financing and may depress the prices buyers are willing to pay, thereby decreasing the value of our collateral and thus our bonds.
Changes in capitalization rates and interest rates may adversely affect the value of our real estate and our tax-credit-equity related contingent asset management fees.
The carrying value of our real estate is at fair value when initially recorded and is then evaluated for impairment or carried at the lower of cost or fair value depending on its balance sheet classification. The fair value of our real estate will generally decline if regional-specific capitalization and discount rates rise. Furthermore, the value of our contingent asset management fees (for which there is no current book basis) is dependent on the residual value of the LIHTC Funds’ underlying multifamily rental properties. The residual value of these rental properties will generally decline if regional-specific capitalization and discount rates rise.
Changes in interest rates may increase our borrowing costs and decrease our net interest income.
As short-term rates rise, our borrowing costs will increase and our net interest income will decline as our bond income is fixed and a significant portion of our bond debt is variable and tied to short-term rates. At December 31, 2013 we had $102.2 million of bond related debt of which approximately 76% was tied to the Securities Industry and Financial Markets Association (“SIFMA”) 7-day municipal swap index. We also had $111.9 million of subordinate debt at December 31, 2013 with a pay rate of 75 basis points (“bps”) that will reset to a variable rate during 2015. The variable rate on this debt will be tied to the London Interbank Offer Rate (“LIBOR”) 3-month index plus a spread of 330 basis points. Once the debt resets during 2015, our borrowing costs will be higher and will be subject to fluctuations of the LIBOR 3-month index.
At December 31, 2013, none of the variable rate debt was hedged; however, during the first quarter of 2014, the Company entered into an interest rate cap with a notional amount of $45.0 million to protect spread income when the SIFMA 7-day municipal swap index rises to 250 bps or higher. Such arrangements are inherently subject to counterparty risk and we therefore cannot provide assurance that our interest rate cap will be effective to hedge our exposure to rising interest rates.
The cash flows and value from our bond portfolio and real estate investments are dependent upon the quality of the related real estate collateral and can be impacted by the risks related to real estate.
Because a substantial portion of our assets are secured by real estate, or consist of investments in entities that own real estate, the value of our assets is subject to the risks associated with investments in real estate. Most of these investments are directly or indirectly secured by multifamily rental properties, and therefore the value of these investments may be adversely affected by macroeconomic conditions or other factors that adversely affect the real estate market generally, or the market for multifamily real estate and bonds secured by these properties in particular. These possible negative factors include, among others: (i) increasing levels of unemployment and other adverse economic conditions, regionally or nationally; (ii) decreased occupancy and rent levels due to supply and demand imbalances; (iii) changes in interest rates that affect the cost of our capital, the value of our bonds or the value of the real estate that secures the bonds; and (iv) lack of or reduced availability of mortgage financing.
Most of our investments derive their value from the cash flows generated by tenant leases. Many of the properties our investments finance have rent limitations that could adversely affect the ability to increase rents, as well as tenant income restrictions that may reduce the number of eligible tenants and, thus, occupancy rates at such properties. If, because of general economic conditions, local market conditions or property specific conditions, the tenants move out or cannot pay the rents charged on the specific units they lease, the owners (our borrowers) may not be able to lease the units to replacement tenants at full rent (or at all), in which case the cash flows from the properties may not be sufficient to pay interest on our bonds or loans and the value of our investments may decline. Real estate may also decline in value because of market conditions, environmental problems, casualty losses for which insurance proceeds are not sufficient to cover the loss, or condemnation proceedings.
The value of our assets and our ability to conduct business may be adversely affected by changes in local or national laws or regulatory conditions that affect significant segments of the real estate market, especially the multifamily housing market, including environmental, land use and other laws and regulations that affect the cost of maintaining and operating the properties that secure our investments.
We have been, and may continue to be, directly and indirectly affected by disruptions in credit markets.
Our business was significantly affected by the disruptions in the credit markets during the “Great Recession.” Disruptions in credit markets may cause significant deterioration in the market for tax-exempt mortgage revenue bonds and other instruments that are a major part of our assets and likely to play a significant role in our reinvestment strategy. This has in the past and may in the future result in our having to reduce the carrying value of our bonds and other assets.
Virtually all of our non-cash assets are illiquid and may be difficult to sell at their reported carrying values.
Our bonds and our direct and indirect investments in real estate are illiquid and difficult to value. As to our bonds in particular they are generally unenhanced and unrated and, as a consequence, the purchasers of the Company’s bonds are generally limited to accredited investors and qualified institutional buyers, which results in a limited trading market. This lack of liquidity complicates how the Company determines the fair value of its bonds as there is limited information on trades of comparable bonds. Therefore, there is a risk that if the Company needed to sell any of these assets, the price it is able to realize may be lower than the carrying value.
Over 50% of our bonds are 30 or more days past due in principal and/or interest and others are at risk of becoming 30 or more days past due in principal and/or interest.
As part of our sale of TEB, we retained our non-performing bonds so they now constitute the majority of our bond portfolio. The aggregate unpaid principal balance (“UPB”) of bonds that were 30 or more days past due in either principal and/or interest at December 31, 2013 was $149.7 million, or 51.4% of our total bond portfolio UPB (based on all bonds - see Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations - “Bond Portfolio”). We report our defaulted bonds at an estimated fair value which accounts for the default, but the values realized could be even less if foreclosures were pursued or if our borrowers filed for bankruptcy protection. Additionally, properties collateralizing certain performing bonds have net operating income (as represented in operating statements provided by the borrowing partnerships), which is less than the debt service owed to us. These bonds are at risk of default if the partners of the borrowing partnerships are unable or unwilling to continue to cover the shortfall in order to pay the full debt service.
The value of our tax-exempt investments could be adversely affected by changes in tax laws.
There can be no assurance that the government will not pass legislation that could adversely affect the value of our tax-exempt bonds. The government could make changes in tax or other laws, such as affordable housing incentive programs that while not directly affecting our tax-exempt bonds, could make them less valuable to investors. For example, if the federal government were to lower marginal federal income tax rates, or phase out the tax-exempt nature of the interest income for all or higher income taxpayers, our bonds would likely decline in value. Congress could also pass laws that make competing investments more attractive than tax-exempt bonds, which would also make our bonds less valuable.
Our bonds may not retain their tax-exempt status.
On the date of initial issuance of any tax-exempt bond that we hold, bond counsel or special tax counsel has rendered its opinion to the effect that interest on the bond is excludable from gross income for federal income tax purposes. However, under certain circumstances, our bonds could lose their tax-exempt status subsequent to issuance including, but not limited to: 1) borrower non-compliance with certain requirements that must be met subsequent to issuance in order for the bond to retain its tax-exempt status; 2) events that cause a technical bond reissuance; and 3) the Company being considered a substantial user of the underlying real estate. While we take steps to ensure that these circumstances do not occur, there can be no guarantees that the tax-exempt status will be maintained. If our bonds were to lose their tax-exempt status, then the fair value of those bonds would decline and the costs related to any financing tied to those bonds (e.g., our total return swaps (“TRS”)) would increase.
A signification portion of our debt is executed through total return swaps which subject us to certain risk.
The cash flows from our total return swaps are subject to the risks associated with the referenced asset (e.g., in most cases real estate related risks) and to credit risk of the obligor on the referenced asset. Also, to the extent the associated referenced assets lose value, we are at risk of having to provide additional collateral.
Executing total return swaps are important to our US business.
Currently, our total return swaps are with one financial institution. At least in the near term, entering into additional total return swaps is a significant part of our US business. To the extent, we are unable to execute these types of arrangements in the future we may not be able to achieve our near term goals and our financial position could suffer significantly.
Proposals pending in Congress could adversely affect the value of our investments in preferred stock or result in us having to post additional cash collateral for our TRS.
Our investments in preferred stock are comprised of stock investments in a private national mortgage lender and servicer. At December 31, 2013, these investments were carried at $31.4 million and the unpaid principal balance and estimated fair value was $36.6 million. This lender originates and services multifamily loans for both the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corp (“Freddie Mac”). There have been discussions and proposals in Congress to limit or eliminate the roles of Fannie Mae and Freddie Mac in the US mortgage market. If these or similar proposals were to pass, the business of the mortgage lender in which we hold these investments, and therefore the value of our investments, could be materially adversely affected. In addition, this investment is the reference asset in one of our TRS transactions. The counterparty to the transaction has the right to determine the value of the reference asset and to require us to post additional cash collateral if the value declines. We would be unable to invest such cash at more than nominal interest rates while it serves as collateral.
If we were subject to the Investment Company Act of 1940, we could be required to sell substantial portions of our assets at a time when we might not otherwise want to do so, and we could incur significant losses as a result.
We continuously monitor our activities to be sure we do not become subject to regulation as an investment company under the Investment Company Act of 1940. We are exempt from the Investment Company Act because of an exemption for companies that are “primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.” Because of changes in the nature and number of companies relying on this exemption and because most of the guidance surrounding this exemption comes from “no action” letters issued by the SEC staff, the SEC on August 31, 2011 issued a request for comment directed to the scope and use of this exemption. We do not know what action the SEC may take in response to the comments it receives. If we were regulated as an investment company under the Investment Company Act, we would be subject to extensive regulation and restrictions relating to capital structure, dividends and a number of other matters. Among other things, we would not be able to incur borrowings. Therefore, if due to a change in our assets, a change in the value of particular assets, or a change in the statute or the SEC’s interpretation of the statute, we were to become subject to the Investment Company Act, either we would have to restructure our assets so we would not be subject to that Act or we would have to change materially the way we do business. Any of those changes could require us to sell substantial portions of our assets at a time when we might not otherwise want to do so, and we could incur significant losses of value as a result.
We have provided guarantees with respect to certain of the tax credit equity funds that we sponsored, and if we were to become obligated to perform on those guarantees our financial condition and results of operation could suffer.
We have GP interests in certain LIHTC Funds for which we have guaranteed the availability of tax benefits and minimum returns on investment to certain LIHTC Funds’ investors. In some cases we sold our interest in LIHTC Funds where we made other types of guarantees and we have indemnified the purchaser from investor claims related to those guarantees. We continue to be obligated on our guarantees to the investors (or purchasers) in these funds and we could be required to make substantial payments with regard to these guarantees. In order for the investors in the LIHTC Funds to benefit from low-income housing tax credits, the partnerships in which the LIHTC Funds invest must operate affordable housing properties in compliance with a number of requirements in the Code and the regulations under it. Failure to comply continuously with these requirements throughout a 15-year recapture period could result in loss of the right to those low-income housing tax credits, including recapture of credits that were already taken, potentially creating liability under our guarantees. If we were to become obligated to perform on these guarantees our financial condition and results of operation would suffer.
For tax reasons, we may be limited in our ability to take optimal actions in workout situations.
In a workout situation, it is often useful for us to take control of the underlying real estate serving as collateral to our bonds. However, the tax benefits and return on investment guaranteed to certain LIHTC Funds’ investors may be negatively impacted if we directly acquire the GP interest in a LIHTC Fund’s lower tier property partnership (“LTPP”). If we were to become the GP in a LIHTC Fund’s LTPP, then the investors in the LIHTC Fund may be required to recognize taxable gains or forego future tax credits. If that were to happen, the Company may become obligated to perform under its guarantee in order to maintain the guaranteed yield. As a result, we may facilitate the transfer of the GP interest to an unrelated entity for tax purposes, rather than acquire the interest directly, in which case we might not be able to control the LTPP.
The value of our investment in and cash flow from our International Operations could fluctuate with changes in the relative value of the dollar, euro and South African rand.
The net assets and operations of IHS are denominated in euro and rand. In addition, our co-investments in the SA Fund and the SA Partnership are denominated in rand. We do not hedge these exposures and may experience losses as the value of our holdings in IHS, the SA Fund and the SA Partnership fluctuates with changes in foreign exchange rates of both the euro and the rand relative to the dollar. In addition, our SA Fund borrows money in US dollars from the Overseas Private Investment Corporation and the SA Fund itself therefore has dollar to rand currency risk and even though this risk is currently being hedged by the SA Fund with foreign currency derivatives, these borrowings or hedges could adversely impact the SA Fund’s results and the value of our investment. See “Notes to Consolidated Financial Statements - Note 1, Description of Business and Basis of Presentation” for more information regarding our interests in IHS and the funds.
Our International Operations have foreign government risk and stability risk.
Foreign governments have different laws and policies than the US government. They may change their laws and policies in ways that harm or limit our operations. They may compete directly with us. They may nationalize our operations without fair compensation to us. They may enact laws that make it more difficult for foreign companies to do business, thereby giving local competitors an advantage. South Africa and other countries impose exchange controls that regulate how money enters and leaves the country. These laws could be changed in ways that are adverse to us. Our ability to anticipate, control or counteract these risks is very limited.
Foreign countries have social and economic stability risks that are different than the US. South Africa has experienced some social unrest in the past year and if that were to continue our operations and investments there could be adversely affected.
The application of international tax regimes could substantially affect our after tax results of operations from International Operations.
Income we earn abroad is subject to an entirely different set of tax risks than income we earn domestically. We are subject to the laws of the various jurisdictions in which we earn income, or through which our income must move in order for us to receive it in the US. International treaties also govern these tax consequences. If any of these laws or treaties changes, it could impact our projected after tax results and the impact could be substantial.
Our International Operations are subject to additional real estate risks as compared to our US Operations, including laws and customs related to real estate ownership and finance.
The SA Fund and the SA Partnership invest in real estate in South Africa. While many of the risks are similar to investing in US real estate, there are legal differences and market differences that may result in higher risks, which may adversely impact our operations and our results.
Our International Operations include investments in for-sale units, meaning adverse conditions in the mortgage market could affect the value of those units.
The SA Fund investments include for-sale units. If purchasers have difficulty obtaining mortgages or other financing, unit sales and, therefore, the value of our interests in these ventures could be adversely affected.
Risks Relating to Ownership of Our Shares
Our Board of Directors (“Board”) can issue an unlimited number of common or preferred shares, which could reduce our book value per common share and earnings per common share and the cash or other assets available for distribution per common share upon liquidation or otherwise.
Under our Operating Agreement, our Board can authorize, without any requirement of shareholder approval, the issuance of an unlimited number of common shares. Although New York Stock Exchange (“NYSE”) rules previously imposed some limitations on our ability to issue shares without shareholder approval, our shares are not currently listed on the NYSE. Issuances of common shares could dilute the book value or the net income per common share or the cash per share available for distribution to common shareholders. Our Board can also authorize, without any requirement of shareholder approval, the issuance of an unlimited number of shares with preferences over the common shares as to dividends, distributions on liquidation and other matters, other than voting. This could reduce the book value and net earnings that would be allocable to our common shares and the cash or other assets that are available for distribution to our common shareholders either periodically or upon our liquidation.
Our shares are traded on the over-the-counter (“OTC”) market and may be less liquid than shares traded on a national exchange.
Our shares currently trade on the OTC market specifically through the OTCQB marketplace. Our shares are thinly-traded resulting in less liquidity than may be experienced when trading in shares listed on one of the major exchanges, such as the New York Stock Exchange. In an effort to enhance liquidity and improve shareholder returns, we are currently engaged in a share buyback program. Should we discontinue that buyback program, or should the current trading price exceed the Board approved price limit for any period of time, shareholders may continue to experience liquidity constraints in the trading of our shares.
Provisions of our Operating Agreement may discourage attempts to acquire us.
Our Operating Agreement contains at least three groups of provisions that could have the effect of discouraging people from trying to acquire control of us. Those provisions are:
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If any person or group acquires 10% or more of our shares, that person or group cannot, with a very limited exception, (1) engage in a business combination with us (including an acquisition from us of more than 10% of our assets or more than 5% of our shares) within five years after the person or group acquires the 10% or greater interest, unless our Board approved the business combination or approved the acquisition of a 10% or greater interest in us before it took place, or the business combination is approved by two-thirds of the members of our Board and holders of two-thirds of the shares that are not owned by the person or group that owns the 10% or greater interest; or (2) engage in a business combination with us until more than five years after the person or group acquires the 10% or greater interest, unless the business combination is recommended by our Board and approved by holders of 80% of our shares or of two-thirds of the shares that are not owned by the person or group that owns the 10% or greater interest.
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If any person or group makes an acquisition of our shares that causes the person or group to be able to exercise one-fifth or more but less than one-third of all voting power of our shares, one-third or more but less than a majority of all voting power of our shares, or a majority or more of all voting power of our shares, the acquired shares will lose their voting power, except to the extent approved at a meeting by the vote of two-thirds of the shares not owned by the person or group, and we will have the right to redeem, for their fair market value, any of the acquired shares for which the shareholders do not approve voting rights.
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One third of our directors are elected each year to three-year terms. That could delay the time when someone who acquires voting control of us could elect a majority of our directors.
The above provisions could deprive our shareholders of opportunities that might be attractive to many of them.
Item 1B.
Item 1B. UNRESOLVED STAFF COMMENTS
Not applicable.
Item 2.
Item 2. PROPERTIES
We do not own any of the real property where we conduct our business. Our corporate headquarters is located in Baltimore, Maryland, where we occupy approximately 9,000 square feet of office space pursuant to a lease that expires in January 2017. As of December 31, 2013, we had a second Baltimore lease for approximately 21,000 square feet which was subleased to a third party tenant at market rates. This lease and sublease expired in the first quarter 2014. We also had an office in Tampa, Florida where we leased approximately 24,000 square feet of office space pursuant to a lease that was terminated in the first quarter of 2014.
The majority of our IHS employees are located in Johannesburg, South Africa where we occupy 4,000 square feet of office space pursuant to a lease that expires in June 2018.
We believe our facilities are suitable for our requirements and are adequate for our contemplated future operations.
Item 3.
Item 3. LEGAL PROCEEDINGS
Except as described below, we are not, nor are any of our subsidiaries, a party to any material pending litigation or other legal proceedings, or to the best of our knowledge, any threatened litigation or legal proceedings, which, in the opinion of management, individually or in the aggregate, would be likely to have a material adverse effect on our results of operations or financial condition.
On September 27, 2013, the Company entered into a settlement agreement with the SEC intended to resolve claims as to filing deficiencies of the Company from 2006 through 2010. Pursuant to the settlement, the SEC issued an order revoking registration of our common shares (“Deregistration Order”) effective September 30, 2013. Once the Deregistration Order was effective, the Company was eligible to re-register its common shares with the SEC and immediately filed a Registration Statement on Form 8-A to re-register its common shares under Section 12(g) of the Exchange Act. This filing took effect immediately upon filing which resulted in the Company’s common shares once again being registered under the Exchange Act. As a result of the deregistration, and subsequent re-registration, of the Company’s common shares, the Company believes it has resolved the historical filing deficiencies.
The Company is a defendant in a purported class action lawsuit and two derivative suits originally filed in 2008. The plaintiffs in the class action lawsuit claim to represent a class of investors in the Company’s shares who allegedly were injured by misstatements in press releases and SEC filings between May 3, 2004, and January 28, 2008. The plaintiffs seek unspecified damages for themselves and the shareholders of the class they purport to represent. In the derivative suits, the plaintiffs claim, among other things, that the Company was injured because its directors and certain named officers did not fulfill duties regarding the accuracy of its financial disclosures. Both the class action and the derivative cases are pending in the United States District Court for the District of Maryland. The Company filed a motion to dismiss the class action and in June 2012, the Court issued a ruling dismissing all of the counts alleging any knowing or intentional wrongdoing by the Company or its affiliates, directors and officers. The plaintiffs appealed the Court’s ruling and on March 7, 2014, the United States Court of Appeals for the Fourth Circuit unanimously affirmed the lower Court’s ruling. As a result of these rulings, the only counts remaining in the case relate to the Company’s dividend reinvestment plan. As of December 31, 2013 and before this ruling on March 7, 2014, the Company deemed it probable that it would settle this case for at least $0.5 million and as such the Company had a contingent liability for $0.5 million at December 31, 2013. As a result of the subsequent ruling, the Company’s litigation exposure was significantly reduced. The Company will evaluate the impact of this ruling to its contingent liability as part of its first quarter 2014 financial reporting process.
Item 4.
Item 4. MINE SAFETY DISCLOSURES
Not applicable.
PART II Item 5.
Item 6. SELECTED FINANCIAL DATA
Not applicable.
Item 7.
Item 7. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
General Overview
We own and manage a portfolio of real estate related assets. Our primary holdings include a portfolio of bonds, a substantial portion of which are tax-exempt and backed by affordable multifamily rental properties. We also manage tax credit equity funds for third party investors that invest in similar affordable multifamily rental properties. Finally, we own a variety of direct investments in multifamily rental properties and land. Outside of the US, we are in the business of raising, investing in and asset managing private real estate funds that invest primarily in affordable for-sale and rental housing primarily in South Africa.
The Company operates through two reportable segments: US Operations and International Operations.
US Operations
The Company’s bond portfolio consisted of 36 bonds totaling $245.6 million (based on fair value and including $50.3 million of bonds eliminated due to consolidation), collateralized by 23 real estate properties at December 31, 2013. This bond portfolio is comprised primarily of multifamily tax-exempt bonds as well as community development district CDD bonds.
MuniMae is also the GP and manager of 13 LIHTC Funds which had $852.5 million of capital invested at December 31, 2013. These funds hold limited partnership interests in 117 affordable multifamily rental properties in the US. The Company’s ownership interest in the LIHTC Funds is nominal (ranging from 0.01% to 0.04%); however, the Company is entitled to asset management fees as well as contingent asset management fees based on several factors including the residual value of the LIHTC Funds’ underlying multifamily rental properties.
International Operations
All of the Company’s International Operations take place through a subsidiary, IHS which is in the business of raising, investing in and asset managing private real estate funds that invest in affordable for-sale and rental housing primarily in South Africa. At December 31, 2013, the Company’s ownership interest in IHS is approximately 83%. In addition to earning asset management fees, IHS, as the managing member is entitled to special distributions based on returns generated by the funds it sponsors. IHS currently manages one multi-investor fund (SA Fund), and a real estate partnership for a single-investor (SA Partnership), and is in the process of raising capital for a second multi-investor fund.
Critical Accounting Policies and Estimates
The preparation of our consolidated financial statements is based on the selection and application of US generally accepted accounting principles (“GAAP”), which requires us to make certain estimates and assumptions that affect the reported amounts and classification of the amounts in our consolidated financial statements. These estimates and assumptions require us to make difficult, complex and subjective judgments involving matters that are inherently uncertain. We base our accounting estimates and assumptions on historical experience and on judgments that are believed to be reasonable under the circumstances available to us at the time. Actual results could materially differ from these estimates. We applied our critical accounting policies and estimation methods consistently in all material respects and for all periods presented, and have discussed those policies with our Audit Committee.
We believe the following accounting policies involve a higher degree of judgment and complexity and represent the critical accounting policies and estimates used in the preparation of our consolidated financial statements.
Valuation of Bonds
Bonds available-for-sale include mortgage revenue bonds and other municipal bonds. We account for investments in bonds as available-for-sale debt securities under the provisions of ASC No. 320, “Investments - Debt and Equity Securities.” Accordingly, these investments in bonds are carried at fair value with changes in fair value (excluding other-than-temporary impairments) recognized in other comprehensive income. For most of our performing bonds, we estimate fair value using a discounted cash flow methodology; specifically, the Company discounts contractual principal and interest payments, adjusted for expected prepayments. The discount rate for each bond is based on expected investor yield requirements adjusted for bond attributes such as the expected term of the bond, debt service coverage ratio, geographic location and bond size. If observable market quotes are available, we will estimate the fair value based on such quoted prices. For non-performing bonds (i.e., defaulted bonds as well as certain non-defaulted bonds that we deem at risk of default in the near term), we estimate the fair value by discounting the property’s expected cash flows and residual proceeds using estimated discount and capitalization rates, less estimated selling costs. However, to the extent available, the Company may estimate fair value based on a sale agreement, a letter of intent to purchase, an appraisal or other indications of fair value as available. There are significant judgments and estimates associated with forecasting the estimated cash flows related to the bonds or the underlying collateral for non-performing bonds, including macroeconomic conditions, interest rates, local and regional real estate market conditions and individual property performance. In addition, the determination of the discount rates applied to these cash flow forecasts involves significant judgments as to current credit spreads and investor return expectations. The bonds reflected on the Consolidated Balance Sheets at December 31, 2013 were priced on average at approximately 87% of the portfolio’s unpaid principal balance. Given the size of our portfolio, different judgments as to credit spreads and investor return expectations could result in materially different valuations.
Consolidated Funds and Ventures (“CFVs”)
We have numerous investments in partnerships and other entities that primarily hold or develop real estate. In most cases our direct or indirect legal interest in these entities is minimal; however, we apply ASC No. 810 “Consolidation” in order to determine if we need to consolidate any of these entities. There is considerable judgment in assessing whether to consolidate an entity under these accounting principles. Some of the criteria we are required to consider include:
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The determination as to whether an entity is a variable interest entity (“VIE”).
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If the entity is considered a VIE, then the determination of whether we are the primary beneficiary of the VIE is needed and requires us to make judgments regarding: (1) our power to direct the activities of the VIE that most significantly impact the VIE’s economic performance, and (2) our obligation to absorb losses of the VIE that could potentially be significant to the VIE or our right to receive benefits from the VIE that could potentially be significant to the VIE. These assessments require a significant analysis of all of the variable interests in an entity, any related party considerations and other features that make such an analysis difficult and highly judgmental.
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If the entity is required to be consolidated, then upon initial consolidation, we record the assets, liabilities and noncontrolling interests at fair value. Substantially all of our consolidated entities are investment entities that own real estate or real estate related investments and, as such, there are judgments related to the forecasted cash flows to be generated from the investments such as rental revenue and operating expenses, vacancy, replacement reserves and tax benefits (if any). In addition, we must make judgments about discount rates and capitalization rates.
Income Taxes
Through July 9, 2013, the Company was a partnership for income tax purposes. Effective July 10, 2013, the Company converted from a partnership to a corporation for federal and state income tax purposes by making a check-the-box election with the IRS. As a result of the conversion, the Company will (i) be a direct corporate tax payer, (ii) no longer pass through its income and loss to its shareholders for tax purposes, and (iii) no longer issue each shareholder an annual tax statement on Schedule K-1. This change will also eliminate the ongoing costs of operating as a partnership and is consistent with changes in the nature of the Company’s activities.
As a result of the partnership treatment prior to the check-the-box election, all activity of the Company’s pass-through entities prior to July 10, 2013 was passed-through directly to the Company’s shareholders. During February 2014, those shareholders that held shares as of July 9, 2013 received a final Schedule K-1 for the partial year January 1, 2013 through July 9, 2013, including potential capital gains from the sale of the Company’s common shares in TEB. Effective July 10, 2013, all activity of the Company’s pass-through entities will be included on the Company’s corporate tax return. However, we have significant NOLs related to our corporate entities that we expect will be sufficient to offset federal taxable income and gains for the foreseeable future. Any basis differences in assets that were previously held by the pass-through entity were transferred to the corporation following the election, including any basis differences that were the result of the Company’s Section 754 election.
ASC No. 740, “Income Taxes,” establishes financial accounting and reporting standards for the effect of income taxes. The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current period and deferred tax assets and liabilities for future tax consequences of events that have been recognized in an entity's financial statements or tax returns. Significant judgment is required in determining and evaluating income tax positions, including assessing the relative merits and risks of various tax treatments considering statutory, judicial and regulatory guidance available regarding the tax position. We establish additional provisions for income taxes when there are certain tax positions that could be challenged and it is more likely than not these positions will not be sustained upon review by taxing authorities. Judgment is also required in assessing the future tax consequences of events that have been recognized in our consolidated financial statements or tax returns as well as the recoverability of our deferred tax assets. In assessing our ability to realize the benefit of our deferred tax assets we consider information such as forecasted earnings, future taxable income and tax planning strategies in measuring the required valuation allowance.
Results of Operations
The following discussion of our consolidated results of operations should be read in conjunction with our financial statements, including the accompanying notes. See “Critical Accounting Policies and Estimates” for more information concerning the most significant accounting policies and estimates applied in determining our results of operations.
The table below summarizes our consolidated financial performance for the years ended December 31, 2013 and 2012:
Net interest income
The following table summarizes our net interest income for the years ended December 31, 2013 and 2012:
Total net interest income decreased by 65.1% or $25.5 million, for the year ended December 31, 2013 as compared to 2012.
Interest on bonds decreased by $27.6 million for the year ended December 31, 2013 as compared to 2012. This decline was mainly due to a $449.8 million decline in the weighted average bond UPB (from $1,038.7 million for the year ended December 31, 2012 to $588.9 million for the year ended December 31, 2013) due primarily to the sale of our common shares in TEB. Partially offsetting this decline was an increase in the weighted average effective interest rate of 8 bps to 6.33%, which was primarily driven by an increase in cash collected on non-accrual bonds.
Asset related interest expense decreased 9.0% or $2.4 million for the year ended December 31, 2013 as compared to 2012. This decrease was mainly due to the transfer of our senior interests in and debt owed to securitization trusts and mandatorily redeemable preferred shares to the purchaser of TEB, as well as a $16.3 million decline in the weighted average balance of our non-bond related notes payable and other debt. These declines were partially offset by the acceleration of unamortized debt issuance costs and discounts in the second quarter of 2013 related to senior interests in and debt owed to securitization trusts ($4.6 million) and mandatorily redeemable preferred shares ($3.2 million) that were transferred to the purchaser of TEB. Also partially offsetting these declines was an increase in bond related notes payable and other debt interest expense as a result of certain bond transfers to the purchaser of TEB that did not qualify for sale accounting; therefore, secured borrowings and the associated interest expense increased.
Other interest expense
The following table summarizes our other interest expense for the years ended December 31, 2013 and 2012:
Other interest expense (which represents interest expense associated with debt which does not finance interest-bearing assets) decreased $3.6 million for the year ended December 31, 2013 as compared to 2012. This decline was mainly driven by repurchases of outstanding subordinate debentures during 2012 and first quarter 2013 of $42.7 million and $45.5 million, respectively.
Fee and Other Income
The following table summarizes our fee and other income for the years ended December 31, 2013 and 2012:
Fee and other income decreased by 4.40%, or $0.4 million, for the year ended December 31, 2013 as compared to 2012 mainly due to declines in income on preferred stock as a result of $5.0 million of par share redemptions in July 2012 that carried an average annual dividend rate of 17.5%.
Operating Expenses
The following table summarizes our operating expenses for the years ended December 31, 2013 and 2012:
Total operating expenses increased 10.8%, or $3.1 million, mainly due to increases in salaries and benefits and professional fees.
Salaries and benefits increased by $1.9 million year over year to $12.3 million for the year ended December 31, 2013 mainly due to increased expenses related to employee stock awards as well as severance expense. During 2013, the Company recognized $1.7 million of salaries and benefits expense related to employee stock option awards as compared to $0.2 million during 2012. Employee stock options are accounted for as liabilities and as the Company’s common share price increased during 2013 the related liability increased as well. The Company recognized $0.2 million in severance expense during 2013, but did not recognize any severance expense during 2012.
Professional fees increased $1.7 million for the year ended December 31, 2013 as compared to 2012. This increase was mainly due to $1.5 million of legal and other professional fees incurred during the second quarter of 2013 associated with the TEB sale.
Net Gains (Losses) on Assets, Derivatives and Extinguishment of Liabilities
The following table summarizes our net gains on assets, derivatives and early extinguishment of liabilities for the years ended December 31, 2013 and 2012:
Net gains on bonds increased $75.8 million for the year ended December 31, 2013 as compared to 2012. Substantially all of this increase was due to realized gains of $75.7 million associated with bonds transferred as part of the TEB sale. These gains had been previously recorded as "Accumulated other comprehensive income" ("AOCI"). As a result of the bonds being transferred to the purchaser of TEB, the Company reduced AOCI by $75.7 million and increased earnings by $75.7 million having no impact on overall common shareholders' equity.
For the year ended December 31, 2013, net gains on early extinguishment of liabilities were $36.6 million as compared to net losses of $1.8 million for 2012. During 2013, we recognized a $37.9 million gain on the repurchase of $45.5 million of subordinate debt UPB for $17.4 million, plus accrued interest. The gain represents the difference between the cash payment of $17.4 million and the carrying value of the debt of $56.9 million, reduced by the acceleration of $1.6 million of debt issuance costs. Partially offsetting this gain was a $1.5 million loss on the redemption of all of the outstanding Series A mandatorily redeemable preferred shares. During 2012, we recognized losses of $2.0 million in the fourth quarter associated with the replacement of our securitization debt that had credit enhancement and liquidity facilities expiring on March 31, 2013 as well as losses of $0.3 million associated with the early termination of five securitization trusts. These losses were partially offset by gains of $0.5 million on repurchases of mandatorily redeemable preferred shares.
During 2013 the Company had $0.8 million of mark-to-market gains on derivatives resulting from rising interest rates during the period, offset by $0.8 million of interest paid. The net losses of $1.6 million for 2012 were comprised of $4.3 million of interest paid, partially offset by $2.7 million of mark-to-market gains. The $2.7 million of mark-to-market gains were primarily related to interest rate swaps that were terminated in the first quarter and fourth quarter of 2012, and a TRS that was terminated in the second quarter of 2012.
Net gains on loans increased $1.2 million for the year ended December 31, 2013 as compared to 2012. The $1.5 million of gains recorded during 2013 were comprised of $1.2 million of cash proceeds received on loans which had no carrying value and lower of cost or market ("LOCOM") gains of $0.3 million. The $0.3 million of gains recorded during 2012 were all related to cash proceeds received on loans which had no carrying value.
Net Gains Due to Real Estate Consolidation and Foreclosure
The following table summarizes our net gains due to real estate consolidation and foreclosure for the years ended December 31, 2013 and 2012:
Net gains due to real estate consolidation and foreclosure were $10.9 million and $5.4 million for the years ended December 31, 2013 and 2012, respectively.
On April 30, 2013, a non-profit entity consolidated by the Company was assigned the GP interest in three properties for which the Company provided debt financing. On April 30, 2013, we estimated the fair value of our bonds secured by these three properties to be $28.1 million. The UPB of our bonds was $34.4 million and cumulative impairments and cumulative unrealized gains were $6.5 million and $4.5 million, respectively, at the date of consolidation. Upon assignment of the GP interests, the properties were consolidated and our bonds were eliminated against the corresponding mortgage payables of the properties. As a result, the unrealized gains of $4.5 million which were recorded within AOCI were transferred into the consolidated statements of operations and recorded as “Net gains due to real estate and foreclosure” having no impact on common shareholders’ equity.
On May 1, 2013, the non-profit entity referred to above was assigned the GP interest in two properties for which the Company provided debt financing. On May 1, 2013, we estimated the fair value of our bonds secured by these two properties to be $9.9 million, of which $0.8 million was recorded as an increase to AOCI at the date of consolidation. The UPB of our bonds was $10.9 million and cumulative impairments and cumulative unrealized gains were $3.7 million and $2.7 million, respectively (including the $0.8 million increase discussed above), at the date of consolidation. Upon assignment of the GP interests, the properties were consolidated and our bonds were eliminated against the corresponding mortgage payables of the properties. As a result, unrealized gains of $2.7 million were transferred out of AOCI and into the consolidated statements of operations and recorded as “Net gains due to real estate and foreclosure.” Common shareholders’ equity increased $0.8 million as a result of the bond valuation increase recorded on May 1, 2013 just prior to the property consolidation.
On May 31, 2013, the Company took a deed-in-lieu of foreclosure on a property serving as collateral for one of the Company's bonds with an estimated fair value of $7.3 million. The UPB of the bond was $7.3 million and cumulative impairments and cumulative unrealized gains were $0.7 million and $1.3 million, respectively, at the date of consolidation. Upon real estate acquisition, the property was consolidated and the bond was derecognized. As a result, the unrealized gains of $1.3 million which were recorded through AOCI were transferred into the consolidated statements of operations and recorded as “Net gains due to real estate and foreclosure” having no impact on overall equity. On May 31, 2013, immediately after taking the deed-in-lieu of foreclosure, the Company sold the property to a third party for its carrying value.
On August 6, 2013, the Company foreclosed on a property serving as collateral for one of the Company's bonds with an estimated fair value of $10.2 million. The UPB of the bond was $10.2 million and cumulative impairments and cumulative unrealized gains were each $2.4 million at the date of consolidation. Upon foreclosure, the property was consolidated and the bond was derecognized. As a result, the unrealized gains of $2.4 million which were recorded through AOCI were transferred into the consolidated statements of operations and recorded as "Net gains due to real estate and foreclosure" having no impact on overall equity. On August 14, 2013, the Company sold the property to a third party for $10.7 million.
On April 30, 2012, the non-profit entity referred to above was assigned the GP interest in a property for which the Company provided debt financing. On April 30, 2012, we estimated the fair value of our bond interest to be $12.5 million, of which $2.0 million was recorded as an increase to AOCI at the date of consolidation. The UPB of our bond interest was $12.8 million and cumulative impairments and cumulative unrealized gains were $2.9 million and $2.6 million, respectively (including the $2.0 million increase discussed above), at the date of consolidation. Upon assignment of the GP interest, the property was consolidated and our bonds were eliminated against the corresponding mortgage payable of the property. As a result, unrealized gains of $2.6 million were transferred out of AOCI and into the consolidated statements of operations and recorded as “Net gains due to real estate and foreclosure.” Common shareholders’ equity increased by $2.0 million as a result of bond valuation increase recorded on April 30, 2012 just prior to the property consolidation.
On August 8, 2012, the non-profit entity referred above was assigned the GP interest in three properties for which the Company provided debt financing. On August 8, 2012, we estimated the fair value of our bond interests to be $19.0 million, of which $1.0 million was recorded as an increase to AOCI at the date of consolidation. The UPB of our bond interests was $27.0 million and cumulative impairments and cumulative unrealized gains were $9.8 million and $1.8 million, respectively (including the $1.0 million increase discussed above), at the date of consolidation. Upon assignment of the GP interest, the properties were consolidated and our bond interests were eliminated against the corresponding mortgage payables of the properties. As a result, the unrealized gains of $1.8 million which were recorded within AOCI were transferred into the consolidated statement of operations. Common shareholders’ equity increased $1.0 million as a result of the bond valuation increase recorded on August 8, 2012 just prior to the property consolidation.
Also on August 8, 2012, the Company acquired three parcels of land serving as collateral to two bonds. On August 8, 2012, the carrying value of the Company's bonds was $2.6 million, with a UPB of $5.9 million, cumulative impairments of $4.3 million previously recognized through the consolidated statement of operations and cumulative unrealized gains of $1.0 million previously reported through AOCI. As a result, unrealized gains of $1.0 million were transferred out of AOCI and into the consolidated statement of operations having no impact on common shareholders’ equity.
Income Tax Benefit (Expense)
The table below summarizes our income tax benefit (expense) for the years ended December 31, 2013 and 2012.
On March 20, 2013, the Company and certain of its subsidiaries entered into a closing agreement with the Commonwealth of Massachusetts for amended returns for the calendar years ending December 31, 2004 through 2006. Pursuant to the closing agreement, the Commonwealth of Massachusetts agreed to issue a refund of $1.8 million to the Company. The Company received the refund on April 8, 2013. This agreement also resulted in a favorable resolution of $1.6 million of the Company's uncertain tax positions recorded at December 31, 2012. The release of the uncertain tax position resulted in a $1.6 million tax benefit in the first quarter of 2013.
Income Allocable to Perpetual Preferred Shareholders of a Subsidiary Company
The table below summarizes our income allocable to perpetual preferred shareholders of a subsidiary company for the years ended December 31, 2013 and 2012.
Income allocable to perpetual preferred shareholders of a subsidiary company decreased $5.7 million for the year ended December 31, 2013 as compared to 2012 mainly due to a decline in the weighted average balance of our perpetual preferred shares. During February 2013 and April 2013, $27.0 million and $11.0 million, respectively, of preferred share liquidation preference were redeemed and retired. On July 3, 2013, the remaining $121.0 million of preferred share liquidation preference was assumed by the purchaser of our common shares in TEB.
Net Income Allocable to the Common Shareholders Related to CFVs
The table below summarizes our net income related to funds and ventures that were consolidated for the years ended December 31, 2013 and 2012:
The details of Net income allocable to the common shareholders for the years ended December 31, 2013 and 2012 are as follows:
The Company’s interest income, asset management fees and guarantee fees are eliminated in consolidation, but are allocated to the Company due to the Company’s contractual right to this income. Interest income is primarily related to bonds that were eliminated when we consolidated the properties that collateralize the bonds. Asset management fees are from managing the SA Fund and LIHTC Funds. Guarantee fees are related to certain LIHTC Funds where the Company has guaranteed the investors’ yield. Equity in losses from Lower Tier Property Partnerships are losses that the Company records in the event that a LIHTC Fund’s investment in a Lower Tier Property Partnership has been reduced to zero, but because the Company has a bond or loan interest in the property, the Company will continue to record losses from the Lower Tier Property Partnership to the extent of the bond or loan carrying amount. Equity in income from SA Fund is our share of the SA Fund’s net income based on our 2.7% equity interest in the SA Fund.
Net income allocable to the common shareholders related to CFVs increased by $0.7 million for the year ended December 31, 2013 as compared to 2012 mainly due to a $1.2 million decline in equity in losses from the Lower Tier Property Partnerships, as well as a $1.1 million decline in other expenses relating to a fourth quarter 2012 impairment on a loan made from a LIHTC Fund to a Lower Tier Property Partnership that was not repeated during 2013.
Partially offsetting these increases were a $0.9 million decrease in interest income and a $0.9 million decrease in asset management fees. The Company has bond interest income that is recorded as an allocation of income because certain bonds were eliminated upon consolidation of the properties serving as collateral for those bonds. The decline in interest income was mainly due to the TEB sale, whereby we sold several of the eliminated bonds to Merrill Lynch Portfolio Management, Inc. (together with its affiliates, the “Purchaser”), an affiliate of Bank of America Merrill Lynch. Asset management fees declined mainly due to a decline in fees (asset management fees as well as expense reimbursements) from the SA Fund. Asset management fees from the SA Fund declined by $0.6 million as the payment structure transitioned in the second quarter 2012 from fees based on committed capital to fees based on invested capital. Reimbursement revenue for services provided to the SA Fund, the cost of which is included in salaries and benefits and general and administrative expense, also declined by $0.2 million.
Net Income to Common Shareholders from Discontinued Operations
The table below summarizes our net income from discontinued operations for the years ended December 31, 2013 and 2012:
The details of net income to common shareholders from discontinued operations for the years ended December 31, 2013 and 2012 are as follows:
At September 30, 2013, a non-profit entity that the Company consolidates owned four multifamily properties that were classified as held-for-sale on the consolidated balance sheets. The Company provided bond financing to these multifamily properties. Because we reflect the four multifamily properties on our balance sheet, the Company’s bonds were eliminated against the mortgage payable of the properties. During the fourth quarter of 2013, the Company assumed the general partner and limited partner interests in these four real estate partnerships from the non-profit. As a result of this transfer, the Company reclassified the real estate from real estate related to Consolidated Funds and Ventures to real estate related to MuniMae.
Subsequent to the transfer during the fourth quarter of 2013, the Company sold two of the four real estate properties for $47.2 million which resulted in a gain on sale of real estate of $19.1 million. The sales proceeds covered the Company’s related unpaid bond principal in full and a portion of the interest due on these bonds.
At September 30, 2012, the non-profit entity discussed above classified two of its multifamily property partnerships as held-for-sale. The Company provided bond financing to these multifamily properties. Because we reflect the two multifamily properties on our balance sheet, the Company’s bonds were eliminated against the mortgage payable of the properties. During the fourth quarter of 2012, one of the properties was sold for a net gain of $3.3 million to the common shareholders, and, during the first quarter of 2013, the other property was sold for a net gain of $3.6 million to the common shareholders. During the remainder of 2013, an additional $0.5 million of contingent proceeds relating to these properties were received. These gains are reflected as Net gains on redemption of bonds in the table above.
Bond Portfolio
The table below provides key metrics related to all of our bonds including those bonds that have been eliminated due to consolidation accounting as of December 31, 2013. Because as a legal matter we own the bonds that have been eliminated in consolidation, the asset management of our bond portfolio includes the asset management of these eliminated bonds. The table below reflects the portfolio from an asset management perspective. See “Notes to Consolidated Financial Statements - Note 17, Consolidated Funds and Ventures.”
(1)
Included in this amount were senior interests in bonds of $36.1 million that were financed by TRSs with a carrying amount of $36.3 million at December 31, 2013.
(2)
Non-performing is defined as bonds that are 30+ days past due in either principal and/or interest.
(3)
Included in this amount were senior interests in bonds of $30.7 million that were financed by TRSs with a carrying amount of $31.3 million at December 31, 2013. Also included in this amount were subordinate bonds with must pay coupons and $0.8 million fair value.
(4)
Included in this amount were subordinate cash flow bonds that do not have must pay coupons and are payable out of available cash flow only. No debt service has been collected on these bonds over the preceding twelve months and debt service is not calculated on these bonds as non-payment of debt service is not a default. Included in this amount were participating cash flow bonds with $8.5 million UPB and $6.1 million fair value.
(5)
The Company transferred interests in two of these bonds together with a guarantee to the buyer for timely principal and interest payment and therefore the cash received on the transfers was treated as a borrowing. Also, one of these bonds was financed through a TRS. On a combined basis, the Company had debt associated with these bonds with a carrying amount of $44.1 million at December 31, 2013.
(6)
These bonds were financed by two total returns swaps with a carrying amount of $21.3 million at December 31, 2013.
(7)
The weighted average pay rate represents the cash interest payments collected on the bonds as a percentage of the bonds’ average UPB for the preceding twelve months weighted by the bonds’ average UPB over the period for the population of bonds at December 31, 2013.
(8)
Debt service coverage is calculated on a rolling twelve-month basis using property level information as of the prior quarter-end for those bonds with must pay coupons.
(9)
The weighted average coupon and pay rate of the multifamily tax-exempt bonds and total bond portfolio excludes the population of subordinate cash flow bonds whereby non-payment of debt service is not a default.
(10)
Includes nine bonds that the Company eliminated as a result of consolidation accounting (one of which was a performing multifamily tax-exempt bond, five of which were non-performing multifamily tax-exempt bonds and three of which were subordinate cash flow and participating multifamily tax-exempt bonds). At December 31, 2013, these nine bonds had an UPB of $68.0 million and a fair value of $50.3 million, including $2.5 million of net unrealized mark-to-market gains occurring after consolidation that have not been reflected in the Company’s common equity given that the Company is required to consolidate and account for the real estate, which prohibits an increase in fair value from its original cost basis until the real estate is sold. See “Notes to Consolidated Financial Statements - Note 17, Consolidated Funds and Ventures” for more information.
Multifamily tax-exempt bonds
Multifamily tax-exempt bonds are issued by state and local governments or their agencies or authorities to finance affordable multifamily rental housing; typically however, the only source of recourse on these bonds is the collateral, which is the first mortgage or a subordinate mortgage on the underlying properties. The 23 properties serving as collateral are located across 15 different Metropolitan Statistical Areas (“MSA”). The highest concentration is in the Atlanta MSA and as of December 31, 2013, 30.6% and 28.7% (based on UPB and fair value, respectively) was located in Atlanta. Approximately 76% of our UPB is collateralized by properties that are affordable low-income housing and serve the general population while four properties or approximately 22% of our UPB serve the senior population and one property or 2% of our UPB serves students.
All of the properties are considered stabilized which means none of the properties have construction or lease-up risk and there is sufficient operating information to calculate rolling twelve month debt service coverage for those with must pay coupons.
As of December 31, 2013, the Company had 25 multifamily tax-exempt bonds with must pay coupons.
·
10 of the 25 bonds were performing bonds with $77.0 million UPB and $75.4 million fair value and average debt service coverage ratio of 0.84x. The potential for defaults exist within this population, but because these are low-income housing tax credit bonds, despite the fact that they have generally less than 0.9x debt service coverage, shortfalls to date have been supported by developers and tax credit syndicators.
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15 of the 25 bonds were non-performing bonds with $119.9 million UPB and $86.2 million fair value and an average debt service coverage ratio of 0.51x.
Additionally, as of December 31, 2013, five of the 25 must pay bonds were subordinate bonds with $9.5 million UPB and $1.8 million fair value. While these bonds do have must pay coupons, the debt service is paid only after payment is made on senior obligations that have a priority to the cash flow of the underlying collateral. The Company owns three of the related senior bonds with $16.7 million UPB and $16.0 million fair value. All but two of the must pay subordinate bonds with $0.9 million UPB and $1.0 million fair value were in default as of December 31, 2013.
As of December 31, 2013, the Company had three bonds with $14.7 million UPB and $10.1 million fair value that were subordinate and do not have must pay coupons. Debt service on these bonds is paid to the extent there is available cash flow and only after payment is made on senior obligations that have a priority to the cash flow of the underlying collateral. The Company owns one of the related senior bonds with a $7.9 million UPB and fair value. These cash flow bonds were excluded from the calculation of debt service coverage ratios as non-payment is not a default.
Community Development District Bonds
As of December 31, 2013, there were six CDD bonds with $58.3 million UPB and $52.3 million fair value that were issued by community development districts to finance infrastructure improvements for two large residential or commercial development projects. These bonds are commonly referred to as CDD bonds in Florida and as Community Development Authority (“CDA”) or Capital Improvement Cooperative District (“CID”) bonds in other states. The payment of debt service, and the ultimate repayment of the Company’s financing, generally rely upon the ability of the development, as improved, to generate tax revenues or special assessments. The collapse of the for-sale housing market beginning in 2006, and the sharp decline in the commercial market shortly thereafter, has put stress on this portfolio. As of December 31, 2013, one Alabama development, financed by four bonds, was 30 days or more past due. The Company’s prospects for recovery are closely tied to its ability to structure effective workouts, the ability of other parties to the transaction to pay the assessments, and cyclical improvement in residential and commercial markets.
Other Bonds
As of December 31, 2013, there were two bonds with $21.7 million UPB and fair value in rated municipal bonds. Specifically, these investments are senior certificate interests in a triple A enhanced trust collateralized by a pool of tax-exempt municipal bonds.
Valuation Results for the year ended 2013 as compared to the year ended 2012
During the year ended December 31, 2013, we recorded net unrealized losses of $16.1 million on our bond portfolio excluding bonds eliminated due to consolidation accounting (“Reported Bonds”) through other comprehensive income. Approximately two thirds of the net unrealized losses were due to an increase in market yields on performing bonds, much of which was recognized during second quarter 2013 on bonds sold as part of the TEB sale in third quarter 2013. The remaining net losses were primarily driven by increases in the weighted average discount rate as well as a reduction in expected cash flows from certain properties. During the year ended December 31, 2012, we recorded net unrealized gains of $34.3 million on our Reported Bonds through other comprehensive income largely due to declining market yields on our performing bonds still held in the portfolio at December 31, 2012.
Determination of Fair Value
The Company carries its Reported Bonds on a fair value basis at the end of each reporting period. Our bonds are not traded on an established exchange nor is there an active private trading market; therefore, our bonds are illiquid. This lack of liquidity inherently requires the Company’s management to apply a higher degree of judgment in determining the fair value of its bonds than would be required if there were a sufficient volume of trades of comparable bonds in the market place. For most of our performing bonds (i.e., bonds that are current in their payment of principal and interest), we estimate fair value using a discounted cash flow methodology; specifically, the Company discounts contractual principal and interest payments, adjusted for expected prepayments. The discount rate for each bond is based on expected investor yield requirements adjusted for bond attributes such as the expected term of the bond, debt service coverage, geographic location and bond size. The Company routinely validates its performing bond valuation model by comparing actual bond sale prices to the bond model valuation. The weighted average discount rate (i.e., market yield) on the performing bond portfolio was 6.48% and 7.02% at December 31, 2013 and 2012, respectively, for performing bonds still held in the portfolio at December 31, 2013.
For bonds that are past due in either principal or interest and for certain currently performing bonds where payment of full principal and interest is uncertain, the Company’s valuations are based on an estimate of the collateral value which is derived from a number of sources, including an internally prepared estimate derived by discounting the property’s expected cash flows and residual proceeds using estimated market discount and capitalization rates, less estimated selling costs. The discount rate for the bonds that are past due in either principal or interest averaged 8.5% and 8.2% at December 31, 2103 and 2012, respectively for bonds still in our portfolio at December 31, 2013. The capitalization rate averaged 6.7% and 6.9% at December 31, 2013 and 2012, respectively for bonds still in the portfolio at December 31, 2013.
To the extent available, the Company may estimate fair value based on a sale agreement, a letter of intent to purchase, an appraisal or other indications of fair value.
The lack of liquidity in the bond markets in which the Company transacts, coupled with the significant judgments that are inherent in our valuation methodologies, results in a risk that if the Company needed to sell bonds, the price it is able to realize may be lower than the carrying value (i.e., the fair value) of such bonds.
Liquidity and Capital Resources
During 2013 and the first quarter of 2014, the Company completed several transactions that improved its liquidity position. These transactions are summarized as follows:
During the first quarter of 2013, the Company sold 100% of its preferred stock investments for $36.6 million plus accrued interest. Separately, the Company entered into three TRS agreements with an affiliate of the purchaser of the preferred stock investments. During the first quarter, the primary uses of the sales proceeds were to:
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repurchase subordinate debt ($17.4 million in cash was used to repurchase $45.5 million of unpaid principal);
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pledge cash collateral of $14.0 million which replaced a letter of credit posted on the Company’s behalf to secure a guarantee obligation; and
·
pledge collateral of $3.7 million against the three TRS agreements referenced above.
During the second quarter of 2013, the Company sold its common shares in TEB for net proceeds of $19.2 million (representing $78.7 million of gross cash proceeds received, less $43.2 million of TEB cash and cash equivalents transferred to the Purchaser and $16.3 million that was used to collateralize borrowings with the Purchaser). In addition to generating $19.2 million of net cash proceeds, the Company was able to convert $44.8 million of cash held within TEB and subject to distribution constraints to cash that could be freely managed by the Company.
During the fourth quarter of 2013, the Company sold two real estate properties for $47.2 million and during the first quarter of 2014, the Company sold two additional real estate properties for $35.8 million. The proceeds from these sales have not been reinvested by the Company as of March 14, 2014.
Sources of Liquidity
Our principal sources of liquidity include cash and cash equivalents and cash flows from investing activities. At December 31, 2013 and 2012 we had cash and cash equivalents of $66.8 million and $50.9 million, respectively and we believe we have sufficient liquidity to meet our obligations as they become due.
We consolidate certain funds and ventures in which we have no (or nominal) equity interest, therefore we reflect the cash flow activities for those funds and ventures as part of our consolidated statements of cash flows. As reflected on our consolidated balance sheets, the cash held by these CFVs was reported in “Restricted cash,” outside of the Company’s cash and cash equivalents given that the Company does not have legal title to this cash. Therefore, the net increase to cash and cash equivalents is representative of the change only to MuniMae’s cash (i.e., without the cash of CFVs); however, the individual operating, investing and financing categories include cash flow activity for MuniMae and the CFVs. The tables below provide the cash activity related to MuniMae and the CFVs.
Operating activities
Cash flows provided by operations for MuniMae were $0.9 million and $7.8 million for the years ended December 31, 2013 and 2012, respectively. The $6.9 million decrease in cash provided by operating activities was primarily due to:
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a decrease in interest income of $30.1 million primarily as a result of the TEB sale, a $1.7 million increase in operating expenses ($1.5 million related to legal and other professional fees paid related to the TEB sale) and a $0.8 million decrease in asset management fees received, partially offset by:
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a $12.8 million reduction in interest expense primarily as a result of the TEB sale, an $8.5 million decrease in derivative terminations, a $3.5 million increase in other income received ($2.1 million related to income tax refunds) and a $1.2 million increase in principal payments received on loans held-for-sale.
Investing activities
Cash flows provided by investing activities for MuniMae were $81.1 million and $78.9 million for the years ended December 31, 2013 and 2012, respectively. The $2.2 million increase in cash provided by investing activities was primarily due to:
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a $67.0 million increase in net proceeds received from the sale of real estate, $19.2 million in net proceeds from the sale of TEB (net of $16.3 million of cash received from the TEB sale that was restricted for the purpose of providing collateral for borrowings with the Purchaser) and a $6.2 million decrease in advances on bonds, partially offset by:
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a $54.8 million decrease in principal payments and sales proceeds received on bonds, a $20.5 million increase in restricted cash (primarily a result of cash used to replace a letter of credit posted on the Company’s behalf to secure a guarantee obligation and excluding the increase in restricted cash that was funded with proceeds received from the TEB sale), a $7.5 million decrease in principal payments received on loans held for investment, a $5.0 million decrease in proceeds received from the redemption of preferred stock, a $1.3 million increase in investments in real estate and a $0.8 million decrease in insurance proceeds received related to real estate we own.
Financing activities
Cash flows used in financing activities for MuniMae were $66.1 million and $78.0 million for the years ended December 31, 2013 and 2012, respectively. The $11.9 million decrease in cash used in financing activities was primarily due to:
·
a $553.2 million net decrease in cash used to repay senior interests and other debt primarily resulting from a transaction that the Company completed during the fourth quarter of 2012 whereby all of the Company’s securitization debt that had credit enhancement and liquidity facilities expiring on March 31, 2013 was refinanced, a $4.7 million decrease in distributions paid to perpetual preferred shareholders and a $4.1 million decrease in payment of debt issue costs, partially offset by:
·
a $437.4 million net decrease in proceeds from borrowings primarily resulting from the refinancing completed during the fourth quarter of 2012 discussed above that generated $540.1 million of proceeds, partially offset by $73.3 million in proceeds generated from the issuance of TEB preferred shares during the first quarter of 2013 and $36.6 million in proceeds from a TRS financing entered into in connection with the transfer of our preferred stock investments during the first quarter of 2013. There was also a $70.9 million increase in the cash used to repurchase TEB preferred shares, $33.2 million of cash used to repurchase bonds, but treated as repayment of borrowings because we consolidate the related borrowing partnerships, a $5.9 million increase in the repayment of subordinate debentures and a $2.7 million increase in purchases of treasury stock.
Debt
The following table summarizes the outstanding balances and weighted-average interest rates at December 31, 2013. See “Notes to Consolidated Financial Statements - Note 6, Debt” for more information on our debt.
(1)
Asset related debt is debt which finances interest-bearing assets and the interest expense from this debt is included in “Net interest income” on the consolidated statements of operations. Other debt is debt which does not finance interest-bearing assets and the interest expense from this debt is included in “Interest expense” under” Operating and other expenses” on the consolidated statements of operations.
(2)
Included in notes payable and other debt were unamortized discounts of $1.6 and $1.7 million at December 31, 2013 and 2012, respectively.
(3)
Included in the subordinate debt balance were $3.0 million and $7.1 million of net premiums and effective interest rate payable (i.e., the difference between the current pay rate and the effective interest rate) at December 31, 2013 and 2012, respectively.
(4)
This amount includes $3.2 million of debt that has come due and remains payable; however, the Company has a forbearance agreement with the lender such that it is not pursuing any remedies.
Asset Related Debt Notes Payable and Other Debt - Bond Related
This debt is primarily comprised of TRS financing agreements on bonds available-for-sale ($102.3 million at December 31, 2013). This amount also includes secured borrowings of $30.7 million related to two bonds transferred with a performance guarantee that failed to receive accounting sale treatment.
Other Debt
Subordinate debt At December 31, 2013, the Company had $141.4 million of subordinate debt (principal) with a carrying value of $144.4 million and a weighted average effective interest rate of 7.2%.
During March of 2013, the Company repurchased the remaining unpaid principal balance ($45.5 million) of MMA Financial Holdings, Inc. (“MFH”) subordinate debt due May 2034 for a cash payment of $17.4 million plus accrued interest. As a result of this transaction, the Company recognized a gain on debt extinguishment of $37.9 million, comprised of the difference between the cash payment of $17.4 million and the carrying value of the debt of $56.9 million, reduced by the acceleration of $1.6 million of debt issuance costs. The gain on debt extinguishment is recorded in “Net gains on early extinguishment of liabilities” on the consolidated statements of operations for the year ended December 31, 2013.
See “Notes to Consolidated Financial Statements - Note 6, Debt” for further information.
Notes payable and other debt At December 31, 2013, this debt includes $36.6 million related to the TRS entered into during March of 2013 in connection with the Company’s sale of its preferred stock investment. See “Notes to Consolidated Financial Statements - Note 3, Investment in Preferred Stock” for more information. The debt is non-amortizing, matures on March 31, 2015 and bears an interest rate of 3-month LIBOR plus 400 bps (4.24% at December 31, 2013) and resets quarterly. The Company recorded debt issuance costs of $0.8 million associated with the transaction, of which $0.4 million was paid at inception and $0.4 million is payable at termination.
See “Notes to Consolidated Financial Statements - Note 6, Debt” for further information.
Covenant Compliance and Debt Maturities At December 31, 2013, the Company had $3.2 million of debt that had come due that continues to be governed by a forbearance agreement that expires April 30, 2015. The Company is complying with the terms of the agreement such that the lender is not pursuing any remedies.
Letters of Credit
On July 1, 2013, $0.1 million in a letter of credit expired unused and $2.9 million was canceled unused on July 31, 2013. As a result, the Company had no letters of credit outstanding at December 31, 2013.
Guarantees
The following table summarizes guarantees by type at December 31, 2013:
The indemnification contracts are with the purchaser of the tax credit equity (“TCE”) business and are related to the guarantees of investor yields on their investment in certain LIHTC Funds and indemnifications related to property performance on certain Lower Tier Property Partnerships. We made no cash payments under these indemnification agreements for the year ended December 31, 2013.
Our maximum exposure under the indemnification contracts represents the maximum loss the Company could incur under its guarantee agreements and is not indicative of the likelihood of the expected loss under the guarantees. The carrying amount represents the amount of unamortized fees received related to these guarantees with no additional amounts recognized as management does not believe it is probable that it will have to make payments under these indemnifications.
In addition to the above guarantees, the Company has guaranteed the investor yields on certain LIHTC Funds in which the Company continues to hold general partner interests and as a result, the Company consolidates these funds. The maximum exposure under these guarantees is estimated to be approximately $614.4 million at December 31, 2013. The Company does not expect to have any payouts related to these guarantees as the funds are now meeting and are expected in the future to meet investor yield requirements. See “Notes to Consolidated Financial Statements - Note 17, Consolidated Funds and Ventures.”
Debt Related to CFVs
The creditors of CFVs do not have recourse to the assets or general credit of MuniMae. At December 31, 2013, the debt related to CFVs had the following terms:
SA Fund
The SA Fund has an agreement with the Overseas Private Investment Corporation, an agency of the US, to provide loan financing not to exceed $80.0 million. The SA Fund has drawn a total of $49.1 million of debt against this financing arrangement as of December 31, 2013. This debt is an obligation of the SA Fund and there is no recourse to the Company.
This debt is denominated in US dollars; however, the SA Fund’s functional currency is the South African rand. Therefore, the SA Fund is exposed to foreign currency risk. In order to hedge this risk, from an economic standpoint, the SA Fund has entered into certain foreign exchange derivative contracts. As required, these derivative instruments are carried at fair value. The SA Fund does not designate these derivatives as accounting hedges and therefore, changes in fair value are recognized through “Net gains related to CFVs” on the consolidated statements of operations. The change of value in the debt obligation due to currency fluctuation is recognized through “Expenses from CFVs” on the consolidated statements of operations.
Consolidated Lower Tier Property Partnerships
During the third quarter of 2013, the Company sold 10 bonds that were not on our balance sheet at the time of sale because a non-profit entity that we consolidate is deemed to be the primary beneficiary of the associated Lower Tier Property Partnerships (“Consolidated Lower Tier Property Partnerships”). This non-profit held the real estate serving as collateral to these bonds. Therefore, upon the sale of TEB, the cash proceeds received on these 10 bonds were recorded as debt owed by the Consolidated Lower Tier Property Partnerships of $75.2 million. Subsequent to the TEB sale and during the third and fourth quarters of 2013, we repurchased five of these bonds thereby causing the outstanding debt obligation to decline by $33.6 million.
Company Capital
Common Shares
During 2013, through a series of actions, our Board of Directors authorized a stock repurchase program of up to 5 million shares at a price of up to 100% of the Company’s reported common shareholders’ equity per share as shown on the Company’s most current filed periodic report at the time of repurchase. During the year ended December 31, 2013, the Company repurchased 2,066,305 shares at an average price of $1.29. On March 12, 2014, the Board of Directors authorized an amendment to the stock repurchase program whereby the maximum repurchase price was set to a price of up to 95% of the Company’s last reported common shareholders’ equity per share. The Company’s common equity at December 31, 2013 was $65.3 million resulting in an equity per common share of $1.61. As a result the maximum price the Company may pay to repurchase stock upon the filing of this Report until the maximum price is reset upon the filing of its 2014 first quarter filing, or the plan is amended, is $1.53.
Dividend Policy
Our Board makes determinations regarding dividends based on management’s recommendation, which is based on an evaluation of a number of factors, including our common shareholders’ equity, business prospects and available cash. Our Board has not declared a dividend since the fourth quarter of 2007. In the future our Board will determine whether and in what amounts to declare dividends based on our earnings and cash flows, cash needs and any other factors our Board deems appropriate. It is unlikely that we will pay a dividend for the foreseeable future.
Item 7A.
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not applicable.
Item 8.
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The consolidated financial statements of MuniMae, together with the report thereon of KPMG LLP dated March 21, 2014, are in Item 15. Exhibits and Financial Statement Schedules at the end of this Report and are incorporated by reference herein.
Item 9.
Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
Item 9A.
Item 9A. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in our filings and submissions to the SEC under the Exchange Act is recorded, processed, and reported within the time periods specified in the SEC’s rules and forms. Such controls include those designed to ensure that information is accumulated and communicated to management, including our CEO and CFO, as appropriate, to allow timely decisions regarding required disclosures.
An evaluation was conducted under the supervision and with the participation of management, including the CEO and CFO, on the effectiveness of our disclosure controls and procedures, as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act. Based on this evaluation, the CEO and CFO concluded that our disclosure controls and procedures were effective as of December 31, 2013.
Management’s Report on Internal Control Over Financial Reporting
Management is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rule 13a-15(f) under the Exchange Act. Internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP and includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (2) provide reasonable assurance that transactions are recorded as necessary to permit the preparation of financial statements in accordance with GAAP; (3) provide reasonable assurance that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (4) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the Company’s assets that could have a material effect on the financial statements.
Because of inherent limitations, internal control over financial reporting may not prevent or detect misstatements. It is a process that involves human diligence and compliance and is therefore subject to human error and misjudgment. In general, evaluations of effectiveness for future periods are subject to risk as controls may become inadequate due to changes in conditions or the degree of compliance with key processes or procedures could deteriorate.
A “material weakness” as defined by Public Accounting Oversight Board (“PCAOB”) Auditing Standard No. 5, “An Audit of Internal Control over Financial Reporting That is Integrated with an Audit of Financial Statements” (“Auditing Standard No. 5”) is “a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the annual or interim financial statements will not be prevented or detected on a timely basis.” A “deficiency” in internal control over financial reporting as defined by Auditing Standard No. 5 “exists when the design or operation of a control does not allow management or employees, in the normal course of performing their assigned functions, to prevent or detect misstatements on a timely basis.” As a result of management’s internal control evaluation conducted as of December 31, 2013, management concluded that a material weakness existed within its consolidation accounting and reporting processes and because of this material weakness management concluded that we did not maintain effective internal control over financial reporting as of December 31, 2013, based on criteria described in the original Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission in 1992. Based on additional procedures and controls performed and put into place after December 31, 2013, but before the filing of this Report, management believes that the financial statements presented in this Report are presented fairly, in all material respects, in accordance with US GAAP. Management believes that the additional controls procedures should result in effective internal control over financial reporting going forward, but plans to evaluate the effectiveness of such control procedures for several quarters before concluding that the material weakness has been remediated.
Item 9B.
Item 9B. OTHER INFORMATION
None
PART III Item 10.
Item 11. EXECUTIVE COMPENSATION
The information required to be furnished by this Item 11 is contained in the Company’s Proxy Statement for its 2014 Annual Shareholders’ Meeting under the heading “Executive Compensation” and is incorporated herein by reference.
Item 12.
Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED SHAREHOLDER MATTERS
The information required to be furnished by this Item 12 is contained in the Company’s Proxy Statement for its 2014 Annual Shareholders’ Meeting under “Security Ownership of Certain Beneficial Owners and Management” and is incorporated herein by reference.
Item 13.
Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
The information required to be furnished by this Item 13 is contained in the Company’s Proxy Statement for its 2014 Annual Shareholders’ Meeting under “Related Party and Affiliate Transactions” and is incorporated herein by reference.
Item 14.
Item 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
The information required to be furnished by this Item 14 is contained in the Company’s Proxy Statement for its 2014 Annual Shareholders’ Meeting under “Independent Registered Public Accounting Firm” and is incorporated herein by reference.
PART IV Item 15.