ITEM 1. BUSINESS
The statements contained in this Form 10-K that are not purely historical are forward looking statements, including statements regarding the Company's expectations, hopes, beliefs, intentions, or strategies regarding the future. Statements which use the words "expects", "will", "may", "anticipates", "goal", "intends", "seeks", "strategy" and derivatives of such words are forward looking statements. These forward looking statements, including statements regarding changes in the Company's future income, Mortgage Asset portfolio, financings, plans to create origination capability, ways the Company may seek to grow income, management expectations regarding future provisions for loan losses, and the Company's belief in the adequacy of loan losses, are based on information available to the Company on the date hereof, and the Company assumes no obligation to update any such forward looking statement. It is important to note that the Company's actual results could differ materially from those in such forward looking statements. Among the factors that could cause actual results to differ materially are the factors set forth below under the heading "Business Risks". In particular, the Company's future income could be affected by interest rate increases, high levels of prepayments, Mortgage Loan defaults, reductions in the value of retained interest in securitizations, and inability to acquire or finance new Mortgage assets.
GENERAL
American Residential Investment Trust, Inc. (the "Company") was incorporated in the State of Maryland on February 6, 1997, and is a real estate investment trust ("REIT"). The Company acquires non-conforming adjustable-rate and fixed-rate, single-family whole loans (collectively, "Mortgage Loans") through bulk purchases in the capital markets and through purchases from originators. The Company has in the past, and may in the future, acquire Mortgage Securities. It finances its acquisitions with equity and secured borrowings. The Company generally earns interest on the portion of its portfolio financed with equity and earns a net interest spread on the portion of its portfolio financed with secured borrowings. The Company is structured as a real estate investment trust, thereby generally eliminating federal taxes at the corporate level on income it distributes to stockholders.
The Company has entered into an agreement with Home Asset Management Corporation (the "Manager") to manage the day-to-day operations of the Company (the "Management Agreement"). Accordingly, the Company's success depends significantly on the Manager. Pursuant to the terms of the Management Agreement, the Manager advises the Company's Board of Directors with respect to the formulation of investment criteria and preparation of policy guidelines, and is compensated based upon the principal amount and type of Mortgage Securities and Mortgage Loans, (collectively, "Mortgage Assets") held by the Company. The Manager may also earn incentive fees based on the level of net income of the Company. See "The Management Agreement."
INVESTMENTS
Mortgage Loans
The Company acquires non-conforming, adjustable-rate and fixed-rate residential Mortgage Loans primarily through bulk purchases from the capital markets and from other financial institutions. The Company also invests in Mortgage Loans which it acquires directly from originators. Although the Company invested in agency mortgage-backed securities and privately issued mortgage-backed securities (collectively, "Mortgage Securities") backed by conforming loans in the past, the Company believes that it can enhance the overall yield of its Mortgage Asset portfolio by investing primarily in non-conforming Mortgage Loans, which generally are relatively higher yielding (adjusted for risk) than conforming Mortgage Loans and Mortgage Securities.
The Company only acquires those Mortgage Loans which the Company believes it has the expertise (with the advice of the Manager) to evaluate and manage and which are consistent with the Company's balance sheet guidelines and risk management objectives. The Company also considers (i) the amount and nature of anticipated cash flows from the Mortgage Assets, (ii) the Company's ability to pledge the Mortgage
Loans to secure collateralized borrowings, (iii) the increase in the Company's capital requirements resulting from the purchase and financing of the Mortgage Loans, as determined pursuant to the Company's capital policies, and (iv) the costs of financing, hedging, managing, servicing, securitizing and providing for credit losses on the Mortgage Assets. Prior to the acquisition of Mortgage Loans, potential returns on capital employed are assessed over the life of the Mortgage Loans and in a variety of interest rates, yield spread, financing cost, credit loss, and prepayment scenarios. The Board of Directors of the Company can revise the Company's investment policies at its sole discretion, subject to approval by a majority of the Company's directors who are not employees or officers of the Company.
The Company initially finances acquisitions of Mortgage Loans with short term borrowings which generally mature in one year or less. The Company's objective is to permanently finance its Mortgage Loans ("Bond Collateral") with long-term non-recourse securitizations. Mortgage Loans are financed with borrowings that will bear interest at rates which periodically adjust to the applicable market rate. See "Funding."
All of the Mortgage Loans held by the Company as of December 31, 1999 are non-conforming Mortgage Loans. The Mortgage Loans are non-conforming primarily as a result of credit rating of the borrower and consist predominantly of "A-" and "B" grade, non-conforming Mortgage Loans and to a lesser extent, "C" and "D" grade Mortgage Loans. The Company grades each Mortgage Loan based predominantly on the mortgage credit rating of the borrower. See "Underwriting." Non-conforming Mortgage Loans generally are subject to greater frequency of delinquency and loss than conforming Mortgage Loans. See "Business Risks -- Borrower Credit May Decrease Value of Mortgage Loans." Accordingly, lower credit grade Mortgage Loans normally bear a higher rate of interest and are subject to higher fees (including prepayment fees and late payment penalties) than conforming Mortgage Loans.
For the year 1999, the Company acquired Mortgage Loans with an aggregate carrying value of approximately $990.6 million. The majority of these Mortgage Loans were subsequently pledged as Bond Collateral for securitizations. At December 31, 1999, the Company had approximately $1.2 billion of Bond Collateral.
REMIC Certificates
The Company diversified its residential Mortgage Loan sales activities in 1998 to include the securitization of Mortgage Loans through a Real Estate Mortgage Investment Conduit ("REMIC"). The REMIC, which consisted of pooled adjustable-rate first-lien mortgages, was issued by American Residential Holdings, Inc. ("Holdings"), a non-REIT, taxable affiliate of the Company, to the public through the registration statement of the related underwriter. The retained interest in securitization consists of assets generated by the Company's loan securitization. These assets, REMIC subordinate certificates, were valued at approximately $6.6 million at December 31, 1999.
While the Company does not currently intend to acquire additional residual interests issued by REMICs, subordinate interests in Mortgage Securities or interest-only Mortgage Securities, it is not prohibited from doing so under the terms of its Capital Policy. Residual interests, if acquired by a REIT, would generate excess inclusion income. See "Federal Income Tax Consequences -- Taxation of Stockholders."
MORTGAGE LOAN ACQUISITIONS
Acquisitions
The Company has acquired the majority of its Mortgage Loans to date on a bulk basis. In some cases, the Mortgage Loans are purchased directly from large originators and in other cases through a Wall Street investment bank. Bulk packages are usually greater than $50 million in size and can be as much as $400 to $500 million.
In addition to acquiring Mortgage Loans through bulk purchases in the capital markets, the Manager has leveraged the expertise of its executive officers in the residential Mortgage Loan industry and continues to purchase Mortgage Loans on behalf of the Company directly from the originators. Under this program, the
Manager has (i) identified segments of the residential Mortgage Loan market that meet its general criteria for potential originations, (ii) arranges for the acquisition by the Company of Mortgage Loans originated, hence avoiding certain loan broker or other intermediary fees, and (iii) arranges for the servicing of the Mortgage Loans by originators or by entities experienced in servicing the particular types of Mortgage Loans involved.
Mortgage Loan Origination
Having established a base portfolio through the use of large bulk acquisitions of loans, the Company's business plan for 2000 includes the origination of non-conforming and subprime, residential mortgage loans. Creating an origination capability would enable the Company to replenish the existing portfolio as natural runoff occurs. Under the Company's plan, the consumer (or broker working on behalf of a consumer) will submit, via the internet or telephone, mortgage applications that are then underwritten by a qualified underwriter in accordance with the Company's underwriting guidelines prior to funding. The Company is establishing controls which seek to ensure the loans comply with regulatory requirements and meet the Company's credit guidelines. The Company will offer both fixed-rate and adjustable-rate mortgage loans. In order to be competitive in the market place, the Company plans to offer competitive pricing, and a well-trained staff to provide frequent and effective responses during the origination process. The Company is in the process of obtaining the required licenses in several targeted states.
The origination plan is designed to lower the Company's cost of acquiring loans (and, as a result, reduce loan level premium amortization expense on new loans) as well as enable more favorable loan characteristics. The Company expects to begin originating loans in the 2nd quarter of 2000. The positive impacts (of lower premium amortization and more favorable loan characteristics) on the Company's results of operations are not expected to be material until 2001. There can be no assurance that the new origination program will be successful.
Pricing
Mortgage Loans acquired on a bulk basis have been priced on either a negotiated basis with the sellers or pursuant to a bidding process. The Company sets investment criteria for the Manager to use in developing bids. The criteria includes risk-adjusted yield requirements. In each case, different prices will be established for the various types of Mortgage Loans to be acquired or originated based on current market conditions, the expected financing costs, prepayment assumptions and loan loss expectations.
Underwriting
The Company reviews the aggregate attributes of a package of Mortgage Loans, as specified by the seller of the Mortgage Loans, to determine if the package conforms to the Company's acquisition criteria. If the Company then elects to purchase a package of Mortgage Loans, the Company reviews the Mortgage Loan documentation for conformance to the seller's specifications. In evaluating a package of Mortgage Loans to be acquired on a bulk basis, the Company reviews the loan documentation for a large sample, sometimes up to 100%, of the Mortgage Loans to be acquired. To date, all of the Company's underwriting reviews have been performed by a nationally recognized third party underwriting review firm or in-house personnel. The Company also obtains representations and warranties from the seller with respect to the quality and terms of the Mortgage Loans being acquired.
The Company considers a variety of factors in determining whether to acquire a package of Mortgage Loans. These factors generally include the credit grade and income history of each borrower, the loan-to-value ratio for each property, the prepayment penalties for the Mortgage Loans, the weighted average coupon of the Mortgage Loans and the documentation required for approval of the Mortgage Loans. The Company may also consider other factors with respect to any individual package under consideration.
Underwriting standards are applied by or on behalf of a lender to evaluate the borrower's credit standing and repayment ability, and the value and adequacy of the related mortgaged property as collateral. In general, a prospective borrower applying for a Mortgage Loan is required to fill out a detailed application designed to provide to the underwriting officer pertinent credit information. As part of the description of the borrower's
financial condition, the borrower generally is required to provide a current list of assets and liabilities and a statement of income and expenses, as well as an authorization to apply for a credit report which summarizes the borrower's credit history with local merchants and lenders and any record of bankruptcy. In most cases, an employment verification is obtained from an independent source (typically the borrower's employer) which verifies among other things, the length of employment with that organization, the current salary, and whether it is expected that the borrower will continue such employment in the future. If a prospective borrower is self-employed, the borrower may be required to submit copies of signed tax returns. The borrower may also be required to authorize verification of deposits at financial institutions where the borrower has demand or savings accounts.
In most cases, the lender's analysis of the borrower's credit report includes review of a credit score produced by an independent credit-scoring firm, such as Fair, Issac and Company ("FICO"). Credit scores estimate, on a relative basis, which borrowers are most likely to default on Mortgage Loans. Lower scores imply higher default risks relative to higher scores. FICO scores are empirically derived from historical credit bureau data and represent a numerical weighing of a borrower's credit characteristics over a two year period. A FICO score is generated through the statistical analysis of a number of credit-related characteristics and variables. Common characteristics include the following: the number of credit lines (trade lines), payment history, past delinquencies, severity of delinquencies, current levels of indebtedness, types of credit and length of credit history. Attributes are the specific values of each characteristic. A scorecard (the model) is created with weights or points assigned to each attribute. An individual loan applicant's credit score is derived by summing together the attribute weights for that applicant.
Substantially all of the Company's Mortgage Assets as of December 31, 1999 are residential Mortgage Loans made to borrowers with credit ratings below the conforming Mortgage Loan underwriting guidelines. The following matrix generally describes the underwriting criteria employed by the originators of the Mortgage Loans in evaluating the credit quality of non-conforming Mortgage Loans.
The borrowers credit level usually impacts the maximum loan to (property) value ratio as well as the interest rate on the mortgage. Typically, at the time of origination, "A-" loans do not exceed 90% loan to value; "B" loans do not exceed 85% loan to value; "C" loans do not exceed 75% loan to value and "C-/D" loans do not exceed 65% loan to value.
As of December 31, 1999 more than 70% of the Company's Mortgage Assets were grade "A/A-" at the time of origination and approximately 20% of the Mortgage Loans were graded "B". At December 31, 1999
the weighted average original loan to property value ratio for the Company's Mortgage Assets was approximately 79%.
In determining the adequacy of the mortgaged property as collateral, an appraisal is made of each property considered for financing. The appraiser is required to inspect the property and verify that it is in good condition and that construction, if new, has been completed. The appraisal is based on the market value of comparable homes, the estimated rental income (if considered applicable by the appraiser) and the cost of replacing the home. The value of the property being financed, as indicated by the appraisal, must be such that it currently supports, and is anticipated to support in the future, the outstanding Mortgage Loan balance.
Once all applicable employment, credit and property information is received, a determination generally is made as to whether the prospective borrower has sufficient monthly income available to meet (i) the borrower's monthly obligations on the proposed Mortgage Loan (determined on the basis of the monthly payments due in the year of origination) and other expenses related to the mortgaged property (such as property taxes and hazard insurance), and (ii) monthly housing expenses and other financial obligations and monthly living expenses. The underwriting standards may be permitted to vary in appropriate cases where factors such as low loan-to-value ratios or other compensating factors exist.
SERVICING
The Company has acquired Mortgage Loans on both a "servicing released" basis (i.e., the Company acquired both the Mortgage Loans and the rights to service them) and on a "servicing retained" basis (i.e., the Company acquired the Mortgage Loans but not the rights to service the Mortgage Loans). Generally, whether the Mortgage Loans are acquired on a servicing released or servicing retained basis is determined pursuant to negotiations with the seller.
The Company has contracted with subservicers to provide servicing at a cost of a fixed percentage of the outstanding mortgage balance and the right to hold escrow account balances and retain certain ancillary charges. In addition, for a small portion of the Mortgage Loans, the Company will pay the subservicer a fixed dollar fee plus a percentage of the outstanding Mortgage Loan balance and a percentage of all amounts collected. The Company believes that the selection of third party sub-servicers was more cost effective than establishing a servicing department within the Company. However, part of the Company's responsibility is to continually monitor the performance of the sub-servicers through monthly performance reviews. Depending on these sub-servicer reviews, the Company may in the future form a separate collection group to assist the sub-servicer in the servicing of these loans. The Company has arranged for the servicing of the Mortgage Loans with servicing entities that have particular expertise and experience in the types of Mortgage Loans being acquired. See "Business Risks -- Loans Serviced by Third Parties."
FUNDING
The Company employs a debt financing strategy to increase its investment in Mortgage Assets. By using the Company's Mortgage Assets as collateral to borrow funds, the Company is able to purchase Mortgage Assets with significantly greater value than its equity. The Company has a targeted leverage ratio of between 10% and 12%, which is generally greater than the levels of many other companies that invest in Mortgage Assets, including many commercial banks, savings and loans, and government agencies. See "Capital Guidelines".
The Company's financing strategy is designed to maintain a cushion of equity sufficient to provide required liquidity to respond to the effects under its borrowing arrangements of interest rate movements and changes in the market value of its Mortgage Assets. However, a major disruption of the reverse repurchase or other markets relied on by the Company for short-term borrowings could have a material adverse effect on the Company unless the Company was able to arrange alternative sources of financing. The Company continues to finance its acquisition of Mortgage Assets primarily through reverse repurchase agreements and uses securitizations (for permanent long-term financings) and, to a lesser extent, uses lines of credit and other financings.
Reverse Repurchase Agreements (short-term borrowings)
The Company currently finances a portion of Mortgage Assets through a form of borrowing known as reverse repurchase agreements. In a reverse repurchase agreement transaction, the Company agrees to sell a Mortgage Asset and simultaneously agrees to repurchase the same Mortgage Asset one day to six months later at a higher price with the price differential representing the interest expense. These transactions constitute collateralized borrowings for the Company, based on the market value of the Company's Mortgage Assets. The Company generally will retain beneficial ownership of the Mortgage Security, including the right to distributions on the collateral and the right to vote. Upon a payment default under any such reverse repurchase agreement, the lending party may liquidate the collateral.
The Company's reverse repurchase agreements generally require the Company to pledge cash or additional Mortgage Assets in the event the market value of existing collateral declines. To the extent that cash reserves are insufficient to cover such deficiencies in collateral, the Company may be required to sell Mortgage Assets to reduce the borrowings. The Company currently uses one facility that can be used to finance the acquisition of Mortgage Loans. The Company intends to enter into additional committed reverse repurchase agreements.
At December 31, 1999, short-term total borrowings outstanding were $119.0 million, with Mortgage Loans with a par value of $122.0 million pledged to secure such borrowings. The short-term borrowings were undertaken pursuant to reverse repurchase agreements. At December 31, 1999, the weighted average borrowing rate for short-term debt was 6.05% per annum. Upon the expiration of each reverse repurchase agreement, the Company refinances the debt on a daily basis at the new market rate. Accordingly, in a period of increasing interest rates, the Company's interest expense could increase substantially prior to the time that the Company's interest income with respect to such Mortgage Loans increase. See "Business Risks -- Interest Rate Increases May Reduce Income From Operations." The Company has entered into reverse repurchase agreements primarily with national broker/dealers, commercial banks and other lenders who typically offer such financing. The Manager and the Company will monitor the need for such commitment agreements and may enter into such commitment agreements in the future if deemed favorable to the Company. See "Business Risks -- Failure to Renew Or Obtain Adequate Funding May Adversely Affect Results of Operations." There can be no assurance that the Company will be able to continue to borrow funds using reverse repurchase agreements or otherwise finance its Mortgage Loans.
In the event of the insolvency or bankruptcy of the Company, the creditor under reverse repurchase agreements may be allowed to avoid the automatic stay provisions of the Bankruptcy Code and to foreclose on the collateral agreements without delay. In the event of insolvency or bankruptcy of a lender during the term of a reverse repurchase agreement, the lender may be permitted to repudiate the contract, and the Company's claim against the lender for damages therefrom may be treated simply as one of the unsecured creditors. Should this occur, the Company's claims would be subject to significant delay and, if received, may be substantially less than the damages actually suffered by the Company.
Securitizations (long-term borrowings)
The Company intends to continue to securitize Mortgage Loans as part of its overall financing strategy. Securitization is the process of pooling Mortgage Loans and issuing equity securities, such as mortgage pass-through certificates, or debt securities, such as Collateralized Mortgage Obligations ("CMOs"). The Company intends to securitize its Mortgage Loans primarily by issuing structured debt. Under this approach, for accounting purposes, the Mortgage Loans so securitized remain on the balance sheet as assets and the debt obligations (i.e., the CMOs) appear as liabilities. A structured debt securitization is generally expected to result in substituting one type of debt financing for another, as proceeds from the structured debt issuance are applied against preexisting borrowings (i.e., borrowings under reverse repurchase agreements). The structured debt securities issued will constitute limited recourse, long term financing, the payments on which generally correspond to the payments on the Mortgage Loans serving as collateral for the debt. Such financings are not subject to a margin call if a rapid increase in rates would reduce the value of the underlying Mortgage Loans and, hence, reduce the liquidity risk to the Company for the Mortgage Loans so financed.
The decision to issue CMOs will be based on the Company's current and future investment needs, market conditions and other factors. Each issue of CMOs is fully payable from the principal and interest payments on the underlying Mortgage Loans collateralizing such debt, any cash or other collateral required to be pledged as a condition to receiving the desired rating on the debt, and any investment income on such collateral. The Company earns the net interest spread between the interest income on the Mortgage Loans securing the CMOs and the interest and other expenses associated with the CMO financing. The net interest spread may be directly impacted by the levels of prepayment of the underlying Mortgage Loans and, to the extent each CMO class has variable rates of interest, may be affected by changes in short-term interest rates.
If the Company issues CMOs for financing purposes, it will seek an investment grade rating for such CMOs by a nationally recognized rating agency. To secure such a rating, it is often necessary to pledge collateral in excess of the principal amount of the CMOs to be issued, or to obtain other forms of credit enhancements such as additional mortgage loan insurance. The need for additional collateral or other credit enhancements depends upon factors such as the type of collateral provided and the interest rates paid thereon, the geographic concentration of the mortgaged property securing the collateral and other criteria established by the rating agency. The pledge of additional collateral would reduce the capacity of the Company to raise additional funds through short-term secured borrowings or additional CMOs and diminish the potential expansion of its investment portfolio. As a result, the Company's objective is to pledge additional collateral for CMOs only in the amount required to obtain an investment grade rating for the CMOs by a nationally recognized rating agency. Total credit loss exposure to the Company is limited to the equity invested in the CMOs at any point in time.
The Company believes that under prevailing market conditions, an issuance of CMOs receiving other than an investment grade rating would require payment of an excessive yield to attract investors. No assurance can be given that the Company will achieve the ratings it plans to seek for the CMOs.
In connection with the securitization of "B" and "C" Mortgage Loans, the levels of subordination required as credit enhancement for the more senior classes of securities issued in connection therewith would be higher than those with respect to its "A" grade non-conforming Mortgage Loans. Thus, to the extent that the Company retains any of the subordinated securities created in connection with such securitizations and losses with respect to such pools of "B" and "C" grade Mortgage Loans or Mortgage Loans secured by second liens are higher than expected, the Company's future operations could be adversely affected.
During 1998, the Company securitized Mortgage Loans in a CMO through its wholly owned subsidiary, American Residential Eagle, Inc. ("Eagle"), by issuing collateralized mortgage bonds "Long-Term Debt" through a Financial Asset Securitization Investment Trust ("FASIT"). The bonds were assigned to a FASIT trust and trust certificates evidencing the assets of the trust were sold to investors. The trust certificates were issued in classes representing senior, mezzanine, and subordinate payment priorities. Payments received on single-family mortgage loans ("Bond Collateral") are used to make payments on the Long-Term Debt. The obligations under the Long Term Debt are payable solely from the Bond Collateral and are otherwise non-recourse to the Company. The maturity of each class of trust certificates is directly affected by the rate of principal repayments on the related Bond Collateral. The Long-Term Debt is also subject to redemption according to the specific terms of the indenture pursuant to which the bonds were issued and the FASIT trust. As a result, the actual maturity of the Long-Term Debt is likely to occur earlier than its stated maturity.
Also, during 1998, the Company securitized Mortgage Loans in a "REMIC" through an affiliate, Holdings. The Company accounted for the REMIC securitization as a sale of Mortgage Loans and recorded a gain on the transaction. The Company, through Holdings, retained an interest in this securitization having a fair value of $6.6 million as of December 31, 1999. The value of this residual interest is subject to all of the same risks impacting the Company relative to the level of prepayments, increasing interest rates, credit exposure and liquidity. A decline in the value of this investment could adversely impact book equity and the Company's financial condition and results of operation.
During 1999, the Company issued, through Eagle and its wholly owned subsidiary, American Residential Eagle 2 ("Eagle 2"), three new series of mortgage backed bonds (Long-Term Debt). Two series of the bonds were non-recourse obligations of a trust formed and wholly-owned by Eagle. All series of bonds were secured
by the assets of the trust, which consist of both adjustable rate and fixed rate mortgage loans secured by first liens on one- to four-family residential properties. Payments received on Bond Collateral are used to make payments on the Long-Term Debt. Payments received on the mortgage loans in excess of obligations due under the Long-Term Debt are remitted to the Company on a monthly basis by the an independent trustee. The obligations under the Long-Term Debt are payable solely from the Bond Collateral and are otherwise non-recourse to the Company. The maturity of the bonds is directly affected by the rate of principal repayments on the related Bond Collateral. The Long-Term Debt is also subject to redemption by the Company according to the specific terms of the indenture pursuant to which the bonds were issued. As a result, the actual maturity of the Long-Term Debt is likely to occur earlier than its stated maturity.
At December 31, 1999, total long-term borrowings outstanding were approximately $1.1 billion with Mortgage Loans valued at approximately $1.2 billion pledged to secure such borrowings. These borrowings are carried on the balance sheet at historical cost, which approximates market value.
CAPITAL GUIDELINES
The Company's capital management goal is to strike a balance between the under-utilization of leverage, which could reduce potential returns to stockholders, and the over-utilization of leverage, which could reduce the Company's ability to meet its obligations during period of adverse market conditions. For this purpose, the Company has established various risk management policies and processes. For example, the Company and its Board of Directors regularly review the Company's leverage and exposure to liquidity risks to determine leverage ranges and the level of new Mortgage Asset acquisition activity. For limited periods, the Company may exceed its desired leverage range, but it is anticipated that in most circumstances the desired leverage will be achieved over time without specific action by the Company or the Manager through the natural process of mortgage principal repayments and increases in Mortgage Loan acquisition activities. The Company anticipates that the actual leverage is likely to be the lowest during periods following new equity offerings and during periods of falling interest rates and that the actual leverage is likely to be the highest during periods after the acquisition of large bulk Mortgage Loan packages. The Board of Directors has the discretion to modify the Company's policies and restrictions without stockholder consent. There are no restrictions on the Company's ability to incur debt and there can be no assurance the level of debt that the Company is authorized to incur will not be increased by the Board of Directors. See "Business Risks -- Policies and Strategies May Be Revised at the Discretion of the Board of Directors."
The Company, with the advice of the Manager, assigns to each Mortgage Asset a specified amount of capital to be maintained against it by aggregating three key components. The first component of the Company's capital allocation process is the current aggregate over-collateralization amount or "haircut" the lenders require the Company to hold as capital. The Company is required to pledge as collateral Mortgage Assets with a market value that exceeds the amount it borrows. The haircut for each Mortgage Asset is determined by the lender based on the risk characteristics and liquidity of that Mortgage Asset. For example, haircut levels on individual borrowings could range from 3% to 5% for Mortgage Securities and Mortgage Loans.
The second component of the Company's capital Allocation process is the "liquidity capital cushion." The Company expects that substantially all of its reverse repurchase agreements will require the Company to deposit additional collateral in the event the market value of existing collateral declines. The liquidity cushion is an additional amount of capital in excess of the haircut maintained by the Company designed to assist the Company in meeting the demands of the lenders for additional collateral should the market value of the Company's Mortgage Assets decline. Alternatively, the Company might sell Mortgage Assets to reduce the borrowings. See "Business Risks -- Investments in Mortgage Assets May Be Illiquid."
The third component of the Company's capital allocation process is the "capital cushion" assigned to each Mortgage Asset based on the Manager's assessment of the Mortgage Asset's credit risk. This represents an assessment of the risk of delinquency, default or loss on individual Mortgage Assets.
Finally, the Board of Directors establishes, subject to revision from time to time, leverage and cash reserve guidelines based on the composition of assets and liabilities and assessments of capital call risks. The
Board of Directors reviews on a periodic basis various analyses prepared by the Manager of the risks inherent in the Company's balance sheet, including an analysis of the effects of various scenarios on the Company's net cash flow, net income, dividends, liquidity and net market value. Should the Board of Directors determine, in its discretion, that leverage or the minimum required cash reserves are either too low or too high, the Board of Directors will raise or lower capital guidelines accordingly.
At December 31, 1999, book equity capital to total fair value of the Company's Assets was approximately 6.67%. This ratio is lower than the ratio the Company has traditionally maintained, principally because of the premium write-down of approximately $12.3 million taken in the fourth quarter of 1999 related to the CMO/ FASIT portfolio. See ("Item 7. Management's Discussion and Analysis of Financial Conditions and Results of Operations"). This percentage may fluctuate from time to time, as the composition of the balance sheet changes, haircut levels required by lenders change, the value of the Mortgage Assets change and as the capital cushion percentages are adjusted over time. The Company will actively monitor and adjust, if necessary, its policies and processes, both on an aggregate portfolio level as well as on an individual pool or Mortgage Loan basis. The Company expects to take into consideration current market conditions and a variety of interest rate scenarios, performance of hedges, performance of Mortgage Assets, credit risk, prepayments of Mortgage Assets, the restructuring of Mortgage Assets, general economic conditions, potential issuance of additional equity, pending acquisitions or sales of Mortgage Assets, Mortgage Loan securitizations and the general availability of financing.
RISK MANAGEMENT
Prior to arranging the acquisition of Mortgage Assets by the Company, the Manager gives consideration to balance sheet management and risk diversification issues. A specific Mortgage Asset which is being evaluated for potential acquisition is deemed more or less valuable to the Company to the extent it serves to increase or decrease certain interest rate or prepayment risks which may exist in the balance sheet, to diversify or concentrate credit risk, and to meet the cash flow and liquidity objectives the Company may establish for its balance sheet from time to time. Accordingly, an important part of the Mortgage Assets evaluation process is a simulation, using the Manager's risk management model, of the addition of proposed Mortgage Assets and its associated borrowings and hedgings to the balance sheet and an assessment of the impact any proposed acquisition of Mortgage Assets would have on the risks in, and returns generated by, the Company's balance sheet as a whole over a variety of scenarios.
Interest Rate Risk Management
To the extent consistent with its election to qualify as a REIT, the Company has implemented certain processes and utilizes interest rate agreements and other hedging instruments intended to protect the Company against significant changes in interest rates.
The Manager hedges the Company's Mortgage Asset portfolio to offset the potential adverse effects from (i) the differences between the interest rate adjustment period of its Mortgage Assets and related borrowings (gap risk) See "ITEM 7a. Quantitative and Qualitative Disclosure About Market Risk", (ii) lifetime and periodic rate adjustment caps on its Mortgage Assets, and (iii) the differences between interest rate adjustment indices of its Mortgage Assets and related borrowings (basis risk). The gap risk (mismatch of assets and liabilities) is especially acute with fixed rate Mortgage Loans and intermediate adjustable Mortgage Loans. Intermediate adjustable Mortgage Loans are fixed for a set period and then convert to a six-month adjustable rate. The fixed period is usually two to five years. The Manager monitors and evaluates the results of its hedging strategy and adjusts its hedging strategy as it deems is in the best interest of the Company.
The Company recognizes the need to hedge these specific interest rate risks associated with its Mortgage Asset portfolio and has sought the hedging instrument most appropriate for the specific risk. The Company may enter into additional types of hedging transactions in the future if Management believes there exists a significant risk to operations.
Hedging involves transaction and other costs, and such costs increase as the period covered by the hedging protection increases and also increase in periods of rising and fluctuating interest rates. For example,
in a typical interest rate cap agreement, the cap purchaser makes an initial lump sum cash payment to the cap seller in exchange for the sellers' promise to make cash payments to the purchaser on fixed dates during the contract term if prevailing interest rates exceed the rate specified in the interest rate cap agreement. Because of the cost involved, the Company may be prevented from effectively hedging its interest rate risks without significantly reducing the Company's return on equity.
The un-amortized cost of the interest rate cap agreements, ("cap") at December 31, 1999 was approximately $1.6 million. Cap premiums are amortized from the effective date of the cap through the termination date on a straight-line basis. For the year ended December 31, 1999, the interest rate cap agreement amortization expense was approximately $797,000. There was $104,000 in income from the cap agreements during this period. There was approximately $1.1 million of floor expense during this period. There were two expirations of cap and floor agreements during 1999 with a combined notional amount of approximately $750 million. For the year ended December 31, 1999, cap expense equaled approximately 0.13% of the average balance of the Company's Mortgage Assets and 0.12% of the average balance of the Company's interest bearing liabilities. For such period, the cap expense was approximately 2.30% of net interest income from Mortgage Assets. At December 31, 1999, the cap range of strike rates was 6.3% to 8.1% and the weighted average strike rate was approximately 6.9%. At December 31, 1999 cap agreements had a combined notional amount of $650 million. Some of the Company's interest rate cap agreements have strike rates and/or notional face amounts which vary over time. All of the interest rate caps reference the one month LIBOR.
Mortgage derivative securities can also be effective hedging instruments in certain situations as the value and yields of some of these securities tend to increase as interest rates rise and tend to decrease in value and yields as interest rates decline, while the experience for others is the converse. As part of the Company's hedging program, the Manager will monitor on an ongoing basis the interest rate risks which arise as asset and liability characteristics change and or in fluctuating interest rate environments. The Manager will consider alternative methods and costs of hedging such risks, which may include the use of mortgage derivative securities. The Company intends to limit its purchases of mortgage derivative securities to investments that qualify as Qualified REIT Assets, as defined below, so that income from such securities will constitute qualifying income for purposes of the 95% and 75% of income tests, as defined below. The Company does not currently intend to, but may in the future, enter into interest rate swap agreements, buy and sell financial futures contracts and options on financial futures contracts and trade forward contracts as a hedge against future interest rate changes; however, the Company will not invest in these instruments unless the Company and the Manager are exempt from the registration requirements of the Commodities Exchange Act or otherwise comply with the provisions of that act. The REIT provisions of the Code may restrict the Company's ability to purchase hedges and may severely restrict the Company's ability to employ other strategies. In all its hedging transactions, the Company will contract only with counterparties that the Company believes are sound credit risks. See "Requirements for Qualification as a REIT -- Gross Income Tests."
Certain of the federal income tax requirements that the Company must satisfy to qualify as a REIT limit the Company's ability to fully hedge its interest rate and prepayment risks. The Manager monitors carefully, and may have to limit, the Company's asset/liability management program to assure that it does not realize excessive hedging income, or hold hedging assets having excess value in relation to total assets, which would result in the Company's disqualification as a REIT or, in the case of excess hedging income, the payment of a penalty tax for failure to satisfy certain REIT income tests under the Code, provided such failure was for reasonable cause. In addition, asset/liability management involves transaction costs which increase dramatically as the period covered by the hedging protection increases. Therefore, the Company may be prevented from effectively hedging its interest rate and prepayment risks. See "Federal Income Tax Consequences -- Requirements for Qualification as a REIT."
In particular, income from hedging the Company's variable rate borrowings (other than with hedging instruments that are Qualified REIT Assets) qualifies for the 95% of income test, but not for the 75% of income test, for REIT qualification. The Company must limit its income from such hedging or the sale of hedging contracts, along with other types of income that qualifies for the 95% of income test, but not for the
75% of income test, to less than 25% of the Company's gross revenues. In addition, hedging instruments, such as swaps, caps, floors, collars, and financial futures contracts, are securities for purposes of the quarterly asset tests for REIT qualification. The Company must ascertain that securities, including the hedging instruments (other than hedging instruments that are Qualified REIT Assets), issued by a single issuer do not account for 5% or more of the value of the Company's assets as of the last day of each calendar quarter. The Company does not expect to encounter material problems complying with these tests.
Although the Company believes that, with the advice of the Manager, it has developed a cost effective interest rate risk management program to provide a level of protection against interest rate risks, developing an effective program is complex and no program can insulate the Company from the effects of interest rate changes. Further, the cost of hedging transactions and the federal tax laws applicable to REITs may limit the Company's ability to fully hedge its interest rate risks.
Prepayment Risk Management Process
The Company has sought to minimize the effects on operations caused by faster than anticipated prepayment rates by lowering premiums paid to acquire mortgages and by purchasing Mortgage Loans with prepayment penalties. Prepayment penalties typically expire 2 to 5 years from origination and the penalty (subject to state-by-state laws) can range from approximately $800 to $4,000 on a $100,000 loan. There can be no assurance that the Company's efforts to reduce prepayment rates will be successful.
The borrowers' prepayment of principal included only the principal repaid which was not part of the normal amortization of the loan. The borrowers repayment of principal is the total payment of principal for the period.
The amortized cost of the Company's total Mortgage Assets at December 31, 1999 was equal to 103.7% of the face value of the Mortgage Assets. The amortized cost of Mortgage Loans at December 31, 1999 was equal to 103.6% of the face value of the Mortgage Loan, and the amortized cost of the Company's Bond Collateral at December 31, 1999 was equal to 103.7% of the face value of the Bond Collateral.
Credit Risk Management
The Company reviews with the Manager credit risks and other risks of loss associated with each investment and determines the appropriate allocation of capital to apply to such investment. In addition, the Company attempts to diversify its Mortgage Asset portfolio to avoid undue geographic, issuer, industry and certain other types of concentrations. The Company has obtained protection against some risks from sellers and servicers through representations and warranties and other appropriate documentation. The Board of Directors monitors the overall portfolio risk and will increase the allowance for Mortgage Loan losses when it believes appropriate.
In order to reduce the credit risks associated with acquisitions of Mortgage Loans, the Company, with the advice of the Manager (i) employs a quality control program, (ii) acquires Mortgage Loans that represent a broad range of moderate risks as opposed to a concentrated risk, (iii) monitors the credit quality of newly acquired and existing Mortgage Assets, and (iv) periodically adjusts the Mortgage Loan loss allowances. See "Management's Discussion and Analysis of Financial Conditions and Results of Operations". The Company also has arranged for servicing of its Mortgage Loans with servicing entities that have particular expertise and experience in the types of Mortgage Loans acquired and monitor the performance of these servicers monthly. See "Business Risks -- Borrower Credit May Decrease Value of Mortgage Loans," "Characteristics of Underlying Property May Decrease Value of Mortgage Loans," and "Loans Serviced by Third Parties."
The Company may sell Mortgage Assets from time to time for a number of reasons, including, without limitation, to dispose of Mortgage Assets as to which credit risk concerns have arisen, to seek to reduce interest rate risk, to substitute one type of Mortgage Asset for another to seek to improve yield or to maintain compliance with the 55% requirement under the Investment Company Act, and generally to restructure the balance sheet when Management deems such action advisable. The REIT Provisions of the Code limit in certain respects the ability of the Company to sell Mortgage Assets.
FEDERAL INCOME TAX CONSEQUENCES
The Company intends to maintain its status as a REIT for federal income tax purposes. A corporation qualifying as a REIT may avoid corporate income taxation by distributing dividends equal to its taxable income to its stockholders annually. The Company is organized in conformity with the requirements for qualification and taxation as a REIT under the Internal Revenue Code of 1986, as amended (the "Code").
The provisions of the Code are highly technical and complex. This summary is not intended to be a detailed discussion of all applicable provisions of the Code, the rules and regulations promulgated thereunder, or the administrative and judicial interpretations thereof. The Company has not obtained a ruling from the Internal Revenue Service (the "Service") with respect to tax considerations relevant to its organization or operation, or to an acquisition of its common stock. This summary is not intended to be a substitute for prudent tax planning, and each shareholder of the Company is urged to consult its own tax advisor with respect to these and other federal, state and local tax consequences of the acquisition, ownership and disposition of shares of the common stock of the Company and any potential changes in applicable law.
REQUIREMENTS FOR QUALIFICATION AS A REIT
To qualify for tax treatment as a REIT under the Code, the Company must meet certain tests which are described in brief below.
Stock Ownership Tests
For all taxable years after the first taxable year for which a REIT election is made, the Company's shares of stock must be transferable and must be held by a minimum of 100 persons for at least 335 days of a 12 month year (or a proportionate part of a short tax year). The Company must also use the calendar year as its taxable year. In addition, at all times during the second half of each taxable year, no more than 50% in value of the shares of any class of the stock of the Company may be owned directly or indirectly by five or fewer individuals. The Company intends to satisfy both the 100 stockholder and 50%/5 stockholder individual ownership limitations described above for as long as it seeks qualification as a REIT. The Company uses the calendar year as its taxable year for income tax purposes.
Asset Tests
On the last day of each calendar quarter, at least 75% of the value of the Company's assets must consist of Qualified REIT Assets, government securities, cash and cash items (the "75% of assets test"). The Company believes that substantially all of its assets are and will continue to be Qualified REIT Assets. Qualified REIT Assets include interests in real property, interests in Mortgage Loans secured by real property and interests in REMICs.
On the last day of each calendar quarter, of the investments in securities not included in the 75% of assets test, the value of any one issuer's securities may not exceed 5% by value of the Company's total assets, and the Company may not own more than 10% of any one issuer's outstanding voting securities. See "Proposed Tax Legislation" below. If such limits are ever exceeded, the Company intends to take appropriate remedial action to dispose of such excess assets within the 30 day period after the end of the calendar quarter, as permitted under the Code.
Gross Income Tests
The Company must satisfy the following income-based tests for each year in order to qualify as a REIT.
1. The 75% Test. At least 75% of the Company's gross income (the "75% of income test") for the taxable year must be derived from qualified REIT assets. The investments that the Company has made and intends to make will give rise primarily to mortgage interest qualifying under the 75% of income test.
2. The 95% Test. In addition to deriving 75% of its gross income from the sources listed above, at least an additional 20% of the Company's gross income for the taxable year must be derived from those
sources, or from dividends, interest or gains from the sale of disposition of stock or other securities that are not dealer property (the "95% of income test"). In order to help ensure compliance with the 95% of income test and the 75% of income test, the Company intends to limit substantially all of the assets that it acquires to Qualified REIT Assets. The policy of the Company to maintain REIT status may limit the type of assets, including hedging contracts, that the Company otherwise might acquire.
If the Company fails to satisfy one or both of the 75% or 95% of income tests for any year, it may face either (a) assuming such failure was for reasonable cause and not willful neglect, a 100% tax on the greater of the amounts of income by which it failed to comply with the 75% test of income or the 95% of income test, reduced by estimated related expenses or (b) loss of REIT status.
Distribution Requirement
The Company must distribute to its stockholders on a pro rata basis an amount equal to (i) 95% of its taxable income before deduction of dividends paid and excluding net capital gain, plus (ii) 95% of the excess of the net income from foreclosure property over the tax imposed on such income by the Code less (iii) any "excess noncash income" (the "95% distribution test"). The Company intends to make distributions to its stockholders in amounts sufficient to meet the 95% distribution test.
A nondeductible excise tax, equal to 4% of the excess of such required distributions over the amounts actually distributed will be imposed on the Company for each calendar year to the extent that dividends paid during the year (or declared during the last quarter of the year and paid during January of the succeeding year) are less than the sum of (i) 85% of the Company's "ordinary income," (ii) 95% of the Company's capital gain net income plus, and (iii) income not distributed in earlier years.
Recordkeeping Requirements
As a REIT, the Company is required to maintain records regarding the actual and constructive ownership of its shares, and other information, and within 30 days after the end of its taxable year, to demand statements from persons owning above specified level of the Company's shares (generally shareholders owning more than 1% of the Company's outstanding stock). The Company must maintain, as part of the Company's records, a list of those persons failing or refusing to comply with this demand. Stockholders who fail or refuse to comply with the demand must submit a statement with their tax returns setting forth the actual stock ownership and other information. The Company also is required to maintain permanent records of its assets as of the last day of each calendar quarter. The Company intends to maintain the records and demand statements as required by these regulations.
TAXATION OF STOCKHOLDERS
For any taxable year in which the Company is treated as a REIT for federal income purposes, amounts distributed by the Company to its stockholders will be included by the stockholders as ordinary income for federal income tax purposes unless properly designated by the Company as capital gain dividends. In the latter case, the distributions will be taxable to the stockholders as long-term capital gains. Any loss on the sale or exchange of shares of the stock of the Company held by a stockholder for six months or less will be treated as a long-term capital loss to the extent of any capital gain dividend received on the stock held by such stockholders. If the Company makes distributions to its stockholders in excess of its current and accumulated operations and profits, those distributions will be considered first a tax-free return of capital, reducing the tax basis of a stockholder's share until the tax basis is zero. Such distributions in excess of the tax basis will be taxable as gain realized from the sale of the Company's shares.
Distributions by the Company will not be eligible for the dividends received deduction for corporations. Stockholders may not deduct any net operating losses or capital losses of the Company.
The Company does not expect to acquire or retain residual interests issued by REMICs. Such residual interests, if acquired by a REIT, would generate excess inclusion income that, among other things, is fully
taxable as unrelated business taxable income ("UBTI") to Tax Exempt Entities. Potential investors, and in particular Tax Exempt Entities, are urged to consult with their tax advisors concerning this issue.
The Company will notify stockholders after the close of the Company's taxable year as to the portions of the distributions which constitute ordinary income, return of capital and capital gain. Dividends and distributions declared in the last quarter of any year payable to stockholders of record on a specified date in such month will be deemed to have been received by the stockholders and paid by the Company on December 31 of the record year, provided that such dividends are paid before February 1 of the following year.
RECENT TAX LEGISLATION
Recently adopted legislation, H.R. 1180, contains several provisions affecting REITs. After the effective date of the bill, December 31, 2000 (i.e., beginning with the 2001 tax year), REITs will be able to own directly the stock of taxable subsidiaries. At present, REITs are generally limited to holding non-voting preferred stock in taxable affiliates. The value of all taxable subsidiaries of a REIT will be limited to 20% of the total value of the REIT's assets. Existing taxable subsidiaries will have to be converted to qualified taxable REIT subsidiaries after December 31, 2000, unless the existing taxable subsidiary has been in place since July 12, 1999 and there has been no material change in the taxable subsidiary's assets or business since that time. In addition, a REIT will be subject to a 100% penalty tax equal to any rents or charges that the REIT imposed on the taxable subsidiary in excess of the arm's length price for comparable services.
The minimum dividend distributions of a REIT will have to equal 90% of taxable income, down from 95% of taxable income under current law. This provision will also first be effective beginning with the 2001 tax year. Under this provision, the Company will be able to retain a greater percentage of its after-tax earnings if desired.
In its year 2001 budget the Clinton Administration has included a proposal that would increase the amount of a REIT's taxable income that must be distributed during the year in order to avoid imposition of the 4% excise tax from the current 85% to 98%. The Administration also proposed a provision that would bar an entity from electing REIT status if 50% or more of its stock was owned by another corporation.
Management does not believe that these proposals will have a material effect on the Company's business and operations.
INVESTMENT COMPANY ACT
The Company at all times intends to conduct its business so as not to become regulated as an investment company under the Investment Company Act of 1940. If the Company were to become regulated as an investment company, then the Company's use of leverage would be substantially reduced. The Investment Company Act of 1940 exempts entities that are "primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interest in real estate" ("Qualifying Interests"). Under current interpretation of the staff of the Securities and Exchange Commission, in order to qualify for this exemption, the Company must maintain at least 55% of its assets directly in Qualifying Interests. In addition, unless certain mortgage securities represent all the certificates issued with respect to an underlying pool of mortgages, such mortgage securities may be treated as securities separate from the underlying mortgage loans and, thus, may not be considered Qualifying Interests for purposes of the 55% requirement.
COMPETITION
The Company's net interest income will depend, in large part, on the Company's ability to acquire Mortgage Assets on acceptable terms and at favorable spreads over the Company's borrowing costs. There can be no assurance that the Company will be able to acquire sufficient Mortgage Assets at spreads above the Company's cost of funds. In acquiring Mortgage Assets, the Company will compete with investment banking firms, savings and loan associations, banks, mortgage bankers, insurance companies, mutual funds, other lenders, FHLMC, FNMA, GNMA and other entities purchasing Mortgage Assets, many of which have greater financial resources than the Company. In addition, there are several REITs similar to the Company,
and others may be organized in the future. The effect of the existence of additional REITs may be to increase competition for the available supply of Mortgage Assets suitable for purchase by the Company. The Company will face competition from companies already established in these markets. There can be no assurance that the Company will be able to successfully compete with its competition.
EMPLOYEES
Currently, the Company and the Manager each employ five executive officers and ten additional employees. Each of the executive officers has between 11 and 25 years, and collectively, they have an average of 24 years of experience in the residential mortgage industry. Four executive officers worked together previously as a management team.
THE MANAGEMENT AGREEMENT
Term of the Management Agreement and Termination Fee
The Company entered into a Management Agreement with the Manager for an initial term of two years beginning February 11, 1997. The Management Agreement will be renewed automatically for successive one year periods unless a notice of non-renewal is timely delivered by the Company. The Company may elect to prevent the automatic renewal of the Management Agreement only by vote of both a majority of the Board of Directors and a majority of the directors who are not executive officers or employees of the Company followed by delivery of a written notice of non-renewal to the Manager at least 60 days prior to the end of the then-current period of the Management Agreement. At the December 1999 Board meeting, the Board of Directors did not bring the Management Agreement up for discussion, therefore; the next opportunity for the Board to terminate the contract will be February 11, 2001. The Management Agreement will terminate at the expiration of the then-current period in which such notice of non-renewal is delivered. Upon non-renewal of the Management Agreement without cause, a termination fee will be payable to the Manager. See "Management Fees." In addition, the Company has the right to terminate the Management Agreement at any time upon the happening of certain specified events, after notice and an opportunity to cure, including a material breach by the Manager of any provision contained in the Management Agreement. Upon such a termination for cause, no termination fee will be payable to the Manager.
Administrative Services Provided by the Manager
The Manager is responsible for the day-to-day operations of the Company and performs such services and activities relating to the assets and operations of the Company as may be appropriate, including:
(i) serving as the Company's consultant with respect to the formulation of investment criteria and the preparation of policy guidelines;
(ii) assisting the Company in developing criteria for Mortgage Asset purchase commitments that are specifically tailored to the Company's long term investment objectives and making available to the Company its knowledge and experience with respect to Mortgage Loan underwriting criteria;
(iii) representing the Company in connection with the purchase of, and commitment to purchase, Mortgage Assets, including the formation of Mortgage Asset purchase commitment criteria;
(iv) arranging for the issuance of Mortgage Securities from pools of Mortgage Loans and providing the Company with supporting services in connection with the creation of Mortgage Securities;
(v) furnishing reports and statistical and economic research to the Company regarding the Company's activities and the performance of the Manager;
(vi) monitoring and providing to the Board of Directors on an ongoing basis price information and other data, which price information and other data shall be obtained from certain nationally recognized dealers and other entities that maintain markets in Mortgage Assets as selected by the Board of Directors
from time to time, and providing advice to the Board of Directors to aid the Board of Directors in the selection of such dealers and other entities;
(vii) administering the day-to-day operations of the Company and performing and supervising the performance of such other administrative functions necessary in the management of the Company as may be agreed upon by the Manager and the Board of Directors, including the collection of revenues and the payment of the Company's expenses, debts and obligations and maintenance of appropriate computer services to perform such administrative functions;
(viii) designating a servicer and/or subservicer for those Mortgage Loans sold to the Company by originators that have elected not to service such Mortgage Loans and arranging for the monitoring and administering of such servicer and subservicer;
(ix) counseling the Company in connection with policy decisions to be made by the Board of Directors;
(x) evaluating and recommending hedging strategies to the Board of Directors and, upon approval by the Board of Directors, facilitating the implementation and monitoring the performance of these strategies;
(xi) supervising compliance with the REIT Provisions of the Code and Investment Company Act of 1940 status, including setting up a system to monitor hedging activities on a periodic basis for such compliance;
(xii) establishing quality control procedures for the Mortgage Assets of the Company, including audits of Mortgage Loan underwriting files and the hiring of any agents with such particular knowledge and expertise as may be appropriate to perform any such quality control procedures, and administering, performing and supervising the performance of the quality control procedures of the Company and performing and supervising the performance of such other functions related thereto necessary or advisable to assist in the performance of such procedures and the attainment of the purposes thereof;
(xiii) upon request by and in accordance with the directions of the Board of Directors, investing or reinvesting any money of the Company;
(xiv) conducting, or causing to be conducted, a legal document review of each Mortgage Loan acquired to verify the accuracy and completeness of the information contained in the Mortgage Loans, security instruments and other pertinent documents in the mortgage file;
(xv) providing the Company with data processing, legal and administrative services to the extent required to implement the business strategy of the Company;
(xvi) providing all actions necessary for compliance by the Company with all federal, state and local regulatory requirements applicable to the Company in respect of its business activities, including preparing or causing to be prepared all financial statements required under applicable regulations and contractual undertakings and all reports and documents, if any, required under the Securities Exchange Act of 1934, as amended;
(xvii) providing all actions necessary to enable the Company to make required federal, state and local tax filings and reports and to generally enable the Company to maintain its status as a REIT, including soliciting stockholders for required information to the extent provided in the REIT Provisions of the Code;
(xviii) communicating on behalf of the Company with the holders of the equity and debt securities of the Company as required to satisfy the reporting and other requirements of any governmental bodies or agencies and to maintain effective relations with such holders; and
(xix) performing such other services as may be required from time to time for management and other activities relating to the assets of the Company as the Board of Directors shall reasonably request or the Manager shall deem appropriate under the particular circumstances.
Except in certain circumstances, the Manager may not assign its rights and duties under the Management Agreement, in whole or in part, without the written consent of the Company and the consent of a majority of the Company's independent directors who are not affiliated with the Manager.
Servicing of the Mortgage Loans
The Company has acquired certain of its Mortgage Loans on a servicing released basis. The Manager has entered into contracts with other parties to provide sub-servicing for the Company. The Manager will monitor the sub-servicing of the Mortgage Loans. Such monitoring includes, but not be limited to, the following: (i) serving as the Company's consultant with respect to the servicing of Mortgage Loans; (ii) collection of information and submission of reports pertaining to the Mortgage Loans and to moneys remitted to the Manager or the Company by any servicer; (iii) periodic review and evaluation of the performance of each servicer to determine its compliance with the terms and conditions of the applicable subservicing or servicing agreement and, if deemed appropriate, recommending to the Company the termination of such agreement; (iv) acting as a liaison between servicers and the Company and working with servicers to the extent necessary to improve their servicing performance; (v) review of and recommendations as to fire losses, easement problems and condemnation, delinquency and foreclosure procedures with regard to the Mortgage Loans; (vi) review of servicer's delinquency, foreclosure and other reports on Mortgage Loans; (vii) supervising claims filed under any mortgage insurance policies; and (viii) enforcing the obligation of any servicer to repurchase Mortgage Loans from the Company.
Limits of Responsibility
Pursuant to the Management Agreement, the Manager will not assume any responsibility other than to render the services called for thereunder and will not be responsible for any action of the Company's Board of Directors in following or declining to follow its advice or recommendations. The Manager, its directors, officers, stockholders and employees will not be liable to the Company, any issuer of Mortgage Securities, any subsidiary of the Company, the Company's independent directors, the Company's stockholders or any subsidiary's stockholders for acts performed in accordance with and pursuant to the Management Agreement, except by reason of acts or omissions constituting bad faith, willful misconduct, gross negligence or reckless disregard of their duties under the Management Agreement. The Manager does not have significant assets other than its interest in the Management Agreement. Consequently, there can be no assurance that the Company would be able to recover any damages for claims it may have against the Manager. The Company has agreed to indemnify the Manager, and its respective directors, officers, stockholders and employees with respect to all expenses, losses, damages, liabilities, demands, charges and claims arising from any acts or omissions of the Manager made in good faith in the performance of its duties under the Management Agreement and not constituting bad faith, willful misconduct, gross negligence or reckless disregard of its duties. The Management Agreement does not limit or restrict the right of the Manager or any of its officers, directors, employees or affiliates to engage in any business or to render services of any kind to any other person, including the purchase of, or rendering advice to others purchasing Mortgage Assets which meet the Company's policies and criteria, except that the Manager and its officers, directors or employees will not be permitted to provide for any such services to any residential mortgage REIT, other than the Company or another REIT sponsored by the Manager or its affiliates, which has operating policies and strategies different in one or more material respects from those of the Company, as confirmed by a majority of the independent directors of the Company
Relationship between the Manager and the Company
In addition to the Management Agreement between the Manager and the Company, the Manager also has limited rights in the shares of the Company's common stock held by MDC REIT Holdings, LLC ("MDC-REIT") an intermediate holding company. The Manager contributed $20 million in 1997 to MDC-REIT which used the funds to acquire the shares of the Company's common stock. In exchange for its contribution to MDC-REIT, the Manager received a senior right to receive distributions from MDC-REIT equal to 5% per quarter of the capital contributed by the Manager, compounded quarterly to the extent unpaid.
After payment of the preference amount in full, the Manager has a right to receive approximately 50% of any remaining distributions in repayment of its capital contribution. The Manager has also been appointed to oversee the day-to-day operations of MDC-REIT. However, after payment in full of its preference amount and return of its capital contribution, the Manager will have no further rights to distributions from MDC-REIT. MDC-REIT's sole asset is its shares of the Company's common stock and its sole source of income is dividends declared by the Company.
Management Fees
The Manager receives an annual base management fee payable monthly in arrears of an amount representing the monthly portion of the per annum percentage of "gross mortgage assets" of the Company and its subsidiaries. These fees shall be applicable during the entire operational stage of the Company's business. The Company pays to the Manager the following management fees and incentive compensation:
- 1/8 of 1% per year, paid monthly (the "Agency Percentage"), of the principal amount of Agency Securities;
- 3/8 of 1% per year, paid monthly (the "Non-Agency Percentage"), of the principal amount of all other Mortgage Assets; and
- 25% of the amount by which the Company's net income (calculated prior to deduction of this incentive compensation fee) exceeds the annualized return on equity equal to the average Ten Year U.S. Treasury Rate plus 2%.
The term "gross mortgage assets" means for any month the aggregate book value of the consolidated Mortgage Assets of the Company and its subsidiaries, before allowances for depreciation or bad debts or other similar noncash allowances, computed at the end of such month prior to any dividend distribution made during each month.
The incentive compensation calculation and payment are made quarterly in arrears. The term "Return on Equity" is calculated for any quarter by dividing the Company's Net Income for the quarter by its Average Net Worth for the quarter. For such calculations, the "Net Income" of the Company means the net income of the Company determined in accordance with GAAP before the Manager's incentive compensation, the deduction for dividends paid and net operating loss deductions arising from losses in prior periods. A deduction for the Company's interest expenses for borrowed money is taken when calculating Net Income. "Average Net Worth" for any period means (i) $20,165,000 plus (ii) the arithmetic average of the sum of the gross proceeds from any offering of its equity securities by the Company, before deducting any underwriting discount and commissions and other expenses and costs relating to the offering, plus the Company's retained earnings (without taking into account any losses incurred in prior periods and excluding amounts reflecting taxable income to be distributed as dividends and amounts reflecting valuation allowance adjustments) computed by taking the daily average of such values during such period. The definition "Return on Equity" is used only for purposes of calculating the incentive compensation payable, and is not related to the actual distributions received by stockholders. The incentive compensation payments to the Manager are made before any income distributions are made to the stockholders of the Company.
The Manager's base management fee is calculated by the Manager within 15 days after the end of each month, and such calculation is promptly delivered to the Company. The Company is obligated to pay the amount of the final base management fee in excess of the amount paid to the Manager at the beginning of the month pursuant to the Manager's good faith estimate within 30 days after the end of each month. The Company pays the incentive fee with respect to each fiscal quarter within 15 days following the delivery to the Company of the Manager's written statement setting forth the computation of the incentive fee for such quarter. The Manager computes the annual incentive fee within 45 days after the end of each fiscal year, and any required adjustments are paid by the Company or the Manager within 15 days after the delivery of the Manager's written computation to the Company.
Termination Fees
The Company may elect to prevent the automatic renewal of the Management Agreement by vote of both a majority of the Board of Directors and a majority of the directors who are not executive officers or employees of the Company followed by delivery of a written notice of non-renewal to the Manager at least 60 days prior to the end of the then-current period of the Management Agreement. The Management Agreement shall terminate at the expiration of the then-current period in which such notice of non-renewal is delivered. Upon non-renewal of the Management Agreement without cause, a termination fee will be payable to the Manager, in an amount equal to the greater of (i) the fair value of the Management Agreement as established by an independent appraiser, or (ii) three times the total of the base and incentive compensation fees paid to the Manager for the four most recently completed calendar quarters ending on or prior to the date of termination. In addition, the Company has the right to terminate the Management Agreement at any time upon the occurrence of certain specified events, after notice and an opportunity to cure, including a material breach by the Manager of any provision contained in the Management Agreement. Upon such a termination for cause, no termination fee will be payable to the Manager. In December 1999, the Board of Directors unanimously agreed to extend the management contract for one additional year. The next opportunity for the Board to terminate the contract will be February 11, 2001. The Management Agreement will terminate at the expiration of the then-current period in which such notice of non-renewal is delivered.
Expenses
The Company pays all operating expenses, except those specifically required to be borne by the Manager under the Management Agreement. The operating expenses required to be borne by the Manager include the compensation and other employment costs of the Manager's officers in their capacities as such and the cost of office space and out-of-pocket costs, equipment and other personnel required for performance of the Company's day-to-day operations. The expenses that are paid by the Company will include issuance and transaction costs incident to the acquisition, disposition and financing of investments, regular legal and auditing fees and expenses, the fees and expenses of the Company's directors, premiums for directors' and officers' liability insurance, premiums for fidelity and errors and omissions insurance, subservicing expenses, the costs of printing and mailing proxies and reports to stockholders, and the fees and expenses of the Company's custodian and transfer agent, if any. The Company, rather than the Manager, is also required to pay expenses associated with litigation and other extraordinary or non-recurring expenses. Expense reimbursements are made monthly.
Salary Reimbursements
The Company employs certain employees of the Manager involved in the day-to-day operations of the Company, including the Company's executive officers, so that such employees may maintain certain benefits that are available only to employees of the Company under the Code. These benefits include the ability to receive incentive stock options under the 1997 Stock Option Plan and to participate in the Company's Employee Stock Purchase Plan. In order to receive the aggregate benefits of the Management Agreement originally negotiated between the Company and the Manager, the Company pays the base salaries of such employees and is reimbursed quarterly by the Manager for all costs incurred with respect to such payments. At December 31, 1999 the Company had advanced approximately $273,000 to the Manager for payroll advances.
BUSINESS RISKS
Interest Rate Increases May Reduce Income From Operations
The majority of the Company's Mortgage Loans have a repricing frequency of two years or less, while substantially all of the Company's borrowings have a repricing frequency of one month or less. Accordingly, the interest rates on the Company's borrowings may be based on interest rate indices which are different from, and adjust more rapidly than, the interest rate indices of its related Mortgage Loans. Consequently, increases in (short term) interest rates may significantly influence the Company's net interest income. While increases in short term interest rates will increase the yields on a portion of the Company's adjustable-rate Mortgage
Loans, rising short term rates will also increase the cost of borrowings by the Company. To the extent such costs rise more than the yields on such Mortgage Loans, the Company's net interest income will be reduced or a net interest loss may result. The Company mitigates some of its "gap" risk by purchasing interest rate hedges (referred to as "caps"), however potential income from these hedges may only partially offset the adverse impact of rising borrowing costs.
The value of retained interest in securitization could be adversely impacted by increases in short term interest rates which may negatively impact the Company's financial condition and results of operations.
High Levels of Mortgage Asset Prepayments Will Reduce Operating Income
The level of prepayments of mortgage assets purchased with a premium by the Company directly impacts the level of amortization of capitalized premiums.
Mortgage Asset prepayment rates generally increase when new Mortgage Loan interest rates fall below the current interest rates on Mortgage Loans. Prepayment experience also may be affected by the expiration of prepayment penalty clauses, the ability of the borrower to obtain a more favorable Mortgage Loan, geographic location of the property securing the adjustable-rate Mortgage Loans, the assumability of a Mortgage Loan, conditions in the housing and financial markets and general economic conditions. The level of prepayments is also subject to the same seasonal influences as the residential real estate industry with prepayment rates generally being highest in the summer months and lowest in the winter months. The Company experienced high levels of prepayments during 1999 on its CMO/FASIT segment of its Mortgage Loan portfolio due principally to the fact that the underlying adjustable rate loans were subject to their first initial interest rate adjustment (after being fixed for the first two years), prepayment penalty clauses were expired and borrowers were able to secure more favorable rates by refinancing. The Company anticipates that overall prepayment rates are likely to continue at relatively high levels for an indefinite period on the CMO/FASIT segment of the portfolio, and that prepayment rates will increase on the other segments of the Mortgage Loan portfolio as the underlying loans are subject to rate increases and prepayment penalties expire. There can be no assurance that the Company will be able to achieve or maintain lower prepayment rates or that prepayment penalty income will offset premium amortization expense. Accordingly, the Company's financial condition and results of operations could be materially adversely affected.
As of December 31, 1999 approximately 76% of the Mortgage Loan portfolio had prepayment penalty clauses, with a weighted average of 20 months remaining before prepayment penalties expire. Prepayment penalty clauses serve as a deterrent to early prepayments and the penalties collected help to offset the premium amortization expense. However, prepayment penalty fees may be in an amount which is less than the figure which would fully compensate the Company for its remaining capitalized premiums, and prepayment penalty provisions may expire before the prepayment occurs.
Borrower Credit May Decrease Value of Mortgage Assets
During the time the Company holds Mortgage Loans Held-for-Investment, Bond Collateral or Retained Interest in Securitizations it is subject to credit risks, including risks of borrower defaults, bankruptcies and special hazard losses that are not covered by standard hazard insurance (such as those occurring from earthquakes or floods). In the event of a default on any Mortgage Loan held by the Company or mortgage underlying Retained Interest in Securitization, the Company will bear the risk of loss of principal to the extent of any deficiency between the value of the secured property and the amount owing on the Mortgage Loan, less any payments from an insurer or guarantor. Although the Company has established an allowance for Mortgage Loan losses, in view of its limited operating history and lack of experience with the Company's current Mortgage Loans, and Mortgage Loans that it may acquire, there can be no assurance that any allowance for Mortgage Loan losses which is established will be sufficient to offset losses on Mortgage Loans in the future.
Credit risks associated with non-conforming Mortgage Loans, especially sub-prime Mortgage Loans, may be greater than those associated with Mortgage Loans that conform to Fannie Mae ("FNMA") and Freddie Mac ("FHLMC") guidelines. The principal difference between sub-prime Mortgage Loans and conforming Mortgage Loans typically include one or more of the following: worse credit and income histories of the
mortgagors, higher loan-to-value ratios, reduced or alternative documentation required for approval of the mortgagors, different types of properties securing the Mortgage Loans, higher loan sizes and the mortgagor's non-owner occupancy status with respect to the mortgaged property. As a result of these and other factors, the interest rates charged on non-conforming Mortgage Loans are often higher than those charged for conforming Mortgage Loans. The combination of different underwriting criteria and higher rates of interest may lead to higher delinquency rates and/or credit losses for non-conforming as compared to conforming Mortgage Loans and thus require high loan loss allowances. All of the Company's Mortgage Loans at December 31, 1999 were originated as sub-prime Mortgage Loans.
Even assuming that properties secured by the Mortgage Loans held by the Company provide adequate security for such Mortgage Loans, substantial delays could be encountered in connection with the foreclosure of defaulted Mortgage Loans, with corresponding delays in the receipt of related proceeds by the Company. State and local statutes and rules may delay or prevent the Company's foreclosure on or sale of the mortgaged property and typically prevent the Company from receiving net proceeds sufficient to repay all amounts due on the related Mortgage Loan.
Defaulted Mortgage Loans also cease to be eligible collateral for reverse repurchase borrowings, and therefore have to be financed by the Company from other funds until ultimately liquidated. The Company attempts to mitigate this risk by utilizing long-term financing vehicles. At December 31, 1999, 10.9% of the Company's borrowings for Mortgage Assets were in the form reverse repurchase borrowings
Accumulation Risk Associated with Mortgage Loans Held-for-Investment
At various points in time, the Company purchases and holds Mortgage Loans which are primarily financed with short-term reverse repurchase agreements. Typically mortgages are accumulated for one to six months and then securitized and transferred into Bond Collateral. During the accumulation period the loans are financed with short-term reverse repurchase agreements. Although the reverse repurchase agreements are committed, lenders have the right to mark the mortgage collateral to market and potentially increase the Company's cash equity investment in the mortgage collateral. During periods of rising interest rates or turbulent market conditions, the market value of these loans may be adversely impacted. At December 31, 1999 there were 1,006 Mortgage Loans with a principal balance of $122.0 million being financed by short-term reverse repurchase agreements.
Inability to Acquire Mortgage Assets
The Company's net interest income will depend, in large part, on the Company's ability to acquire Mortgage Assets on acceptable terms and at favorable spreads over the Company's borrowing costs. There can be no assurance that the Company will be able to replenish the Mortgage Asset portfolio as prepayments occur. In acquiring Mortgage Assets, the Company will compete with numerous other financial institutions. The effect of the existence of these competitors may be to increase competition for the available supply or price of Mortgage Assets suitable for purchase by the Company. There can be no assurance that the Company will be able to successfully compete with its competition.
To the extent that the Company is unable to fully invest in a sufficient amount of Mortgage Loans meeting its criteria, the Company's results of operations will be materially adversely affected.
The Company may acquire Mortgage Assets with geographic, originators, insurer and other types of concentrations. Accordingly, a significant portion of the Company's Mortgage Assets may be subject to the risks associated with a single type of occurrence. In the event of such an occurrence, the adverse effects on the Company's results of operations will be significantly greater than if the Company's Mortgage Assets were diversified with respect to such factors.
The Company's ability to acquire Mortgage Assets is also dependent on the availability of financing to fund these acquisitions. See "Failure to Renew or Obtain Adequate Funding May Adversely Affect Results of Operations.
Prepayments, Credit Losses and Increases in Short term Interest May Adversely Affect the Value of Retained Interest in Securitization
In 1998, the Company diversified its residential Mortgage Loan sales activities to include the securitization of such loans through a Real Estate Mortgage Investment Conduit ("REMIC"). The REMIC consisted of pooled, first-lien mortgages and was issued by Holdings to the public through a registration statement of an underwriter. The interest-only strip referred to as the Class "X" Certificate was created in the process of the securitization and transferred from Holdings to Eagle. The value of this investment is impacted by the level of future prepayments, credit loss and net interest spread on the underlying mortgages. A decline in the value of this investment could adversely affect the Company's financial condition and results of operations.
Failure to Successfully Manage Interest Rate Risks May Adversely Affect Results of Operations
The Company will follow a program intended to protect against interest rate changes. However, developing an effective interest rate risk management strategy is complex and no management strategy can completely insulate the Company from risks associated with interest rate changes. In addition, hedging involves transaction costs. In the event the Company hedges against interest rate risks, the Company may substantially reduce its net income. Further, the federal tax laws applicable to REITs may limit the Company's ability to fully hedge its interest rate risks. Such federal tax laws may prevent the Company from effectively implementing hedging strategies that, absent such restrictions, would best insulate the Company from the risks associated with changing interest rates. See "Business -- Risk Management -- Interest Rate Risk Management."
Currently, the Company has entered into hedging transactions which seek to protect only against gap risk associated with significant increases in interest rates Accordingly, the Company may not be adequately protected against risks associated with interest rate increases and such increases could adversely affect the Company's financial condition and results of operations.
In the event that the Company purchases interest rate caps or other interest rate derivatives to hedge against gap risk, basis risk or lifetime, periodic rate or payment caps, and the provider of such caps on interest rate derivatives becomes financially unsound or insolvent, the Company may be forced to unwind such caps on its interest rate derivatives with such provider and may take a loss thereon. The Company intends to purchases interest rate caps and derivatives only from financially sound institutions and monitors the financial strength of such institutions on a periodic basis, but no assurance can be given that the Company can avoid such third party risks.
Failure to Renew or Obtain Adequate Funding May Adversely Affect Results of Operations
The Company currently relies on short term borrowings to fund the initial acquisitions of Mortgage Loans. Accordingly, the ability of the Company to achieve its investment objectives depends on its ability (i) to borrow money in sufficient amounts and on favorable terms, (ii) to renew or replace on a continuous basis its maturing short term borrowings and (iii) to successfully leverage its Mortgage Assets. In addition, the Company is dependent upon a few lenders to provide the primary credit facilities for its purchases of Mortgage Assets. Any failure to obtain or renew adequate funding under these facilities or other financings on favorable terms, could reduce the Company's net interest income and have a material adverse effect on the Company's operations. The Company's reverse repurchase financing facility expires within one year. The Company expects to renew this facility and obtain additional financing from other sources. There can be no assurances that this facility will be renewed.
In the event the Company is not able to renew or replace maturing short-term borrowings, the Company could be required to sell Mortgage Loans Held-for-Investment under adverse market conditions and could incur losses as a result. Any event or development, such as a sharp rise in interest rates or increasing market concern about the value or liquidity of a type or types of Mortgage Assets in which the Company's Mortgage Asset portfolio is concentrated, will reduce the market value of the Mortgage Assets, which would likely cause lenders to require additional collateral.
Due to the underlying loan to collateral values established by the Company's lenders, the Company may be subject to calls for additional capital in the event of adverse market conditions. Such conditions include (i) higher than expected levels of prepayments on Mortgage Loans and (ii) sudden increases in interest rates. Although its long-term financing agreements are non-recourse, net interest income from the Bond Collateral can be "trapped" to pay down debt in order for the Company to maintain its collateral value requirements. As such, the Company would not be able to use this income to purchase loans or pay dividends. There can be no assurances that the Company will not be required to reduce or cease new loan purchases activity or dividends should it be required to divert cash flow to maintain collateral requirements. See "Business -- Funding," and "-- Capital Guidelines."
The Company is not subject to statutory, regulatory or third party limitations on incurring debt. Accordingly, there are no restrictions on the Company's ability to incur debt and there can be no assurance that the level of debt that the Company incurs will not be increased by the Board of Directors. See "Policies and Strategies May Be Revised at the Discretion of the Board of Directors."
The Company has historically relied upon securitization as a means of securing long-term debt. There can be no assurances that this asset-backed securitization vehicle will be available to the Company in the future.
Investments in Mortgage Assets May Be Illiquid
Although the Company expects that a majority of the Company's investments will be in Mortgage Assets for which a resale market exists, certain of the Company's investments may lack a regular trading market and may be illiquid. In addition, during turbulent market conditions, the liquidity of all of the Company's Mortgage Assets may be adversely impacted. There is no limit to the percentage of the Company's investments that may be invested in illiquid Mortgage Assets. In the event the Company requires additional cash as a result of a margin call pursuant to its financing agreements or otherwise, the Company may be required to liquidate Mortgage Assets on unfavorable terms. The Company's inability to liquidate Mortgage Assets could render it insolvent.
Loans Serviced by Third Parties
All of the Company's Mortgage Loans are serviced by subservicers. The Company continually monitors the performance of the subservicers through performance reviews, comparable statistics for delinquencies and on-site visits. The Company has on occasion determined that subservicers have not followed standard collection and servicing practices related to the Company's Mortgage Loans which the Company believes have lead to increased delinquencies and higher loan losses on selected defaulted Mortgage Loans segments. The Company and the Manager continue to monitor these servicers, have put these entities on notice of such deficiencies, and has instituted other mitigating processes. The Company has arranged for servicing with entities that have particular expertise in non-conforming Mortgage Loans. Although the Company has established these relationships and procedures, there can be no assurance that these subservicers will service the Company's Mortgage Loans in such a way as to minimize delinquency rates and/or credit losses and not cause an adverse effect on the Company's results of operations.
The Direct Origination of Residential Mortgages is Subject to A Variety of Business Risks Including Overhead Exposure, Regulatory Oversight, Competition and Possible Interest Rate Exposure Associated With Commitments to Fund Mortgages
The Company intends to begin originating Mortgage Loans during 2001. The business of originating Mortgage Loans is subject to various risks such as overhead costs that may not be offset by origination fees and revenues, risks associated with non-compliance with various sate and federal laws covering mortgage lending practices, disclosures and loan documentation, pressure on profit margins caused by a very competitive mortgage marketplace, and potential exposure to interest rate risk in the event that the Company makes commitments to borrowers to fund loans at a certain interest rate and prevailing interest rates increase. The Company and the Manager intend to use the extensive experience and skill of its executive team and
employees, and to hire additional highly experienced staff, to manage all of the risks inherent in originating mortgages, but there can be no such assurances that all of these risks will be fully mitigated..
The Management Agreement does not limit or restrict the right of the Manager or any of its officers, directors, employees or affiliates to engage in any business or to render services of any kind to any other person, including purchasing, or rendering advice to others purchasing, Mortgage Assets which meet the Company's policies and criteria, except that the Manager and its officers, directors, or employees will not be permitted to provide any such services to any REIT which invests primarily in residential Mortgage Assets, other than the Company.
Characteristics of Underlying Property May Decrease Value of Mortgage Loans
Although the Company intends to seek geographic diversification of the properties which are collateral for the Company's Mortgage Loans, it does not intend to set specific diversification requirements (whether by state, zip code or other geographic measure). Concentration in any one geographic area will increase the exposure of the Company's Mortgage Assets to the economic and natural hazard risks associated with that area.
Certain properties securing Mortgage Loans may be contaminated by hazardous substances resulting in reduced property values. If the Company forecloses on a defaulted Mortgage Loan collateralized by such property, the Company may be subject to environmental liabilities regardless of whether the Company was responsible for the contamination. The results of the Company's Mortgage Loan acquisition program may also be affected by various factors, many of which are beyond the control of the Company, such as (i) local and other economic conditions affecting real estate values, (ii) interest rate levels and the availability of credit to refinance such Mortgage Loans at or prior to maturity, and (iii) increased operating costs, including energy costs, real estate taxes and costs of compliance with regulations.
Default of Manager under Securities Purchase Agreement; Restrictive Covenants
In connection with the private financing of the Manager and the Company, the Company, the Manager and MDC-REIT entered into a Securities Purchase Agreement dated as of February 11, 1997 (the "Securities Purchase Agreement") with the institutional investors therein (the "Investors") providing for, among other things, the purchase by the Investors of senior secured notes of the Manager due February 11, 2002 (the "Notes"). Pursuant to the Securities Purchase Agreement, the Company must comply with various covenants, including covenants restricting the Company's investment, hedging and leverage policies, leverage ratio and indebtedness levels, and business and tax status. These restrictions may limit the Company's ability to adequately respond to changing market conditions, even when such changes may be in the best interest of the Company, which could have a material adverse effect on the Company's financial condition and results of operations.
The Manager's default on its obligations with respect to the Notes, could result in a default and termination of the Management Agreement, in which case the operations of the Company could be materially and adversely affected pending either the engagement of a new manager or the development internally of the resources necessary to manage the operation of the Company. The Manager is currently in default of its covenants. The senior note holders have not issued waivers, however the parties continue to operate under the terms of the Management Agreement. In addition, MDC-REIT has pledged 1.6 million shares of its common stock of the Company to secure the Manager's obligations under the Securities Purchase Agreement. As a result of the defaults under the Securities Purchase Agreement, the pledged shares could be transferred to the holders of the Notes, who will then have certain demand registration rights.
EXECUTIVE OFFICERS OF THE COMPANY
The following table presents certain information concerning the executive officers of the Company:
- --------------- (1) Each executive officer holds the same position with the Manager.
(2) Mr. Robbins and Mr. Fuller are founders of the Company.
JOHN M. ROBBINS has served as Chairman of the Board of Directors and Chief Executive Officer and Director of the Company since its formation in February 1997. Prior to joining the Company, Mr. Robbins was Chairman of the Board of American Residential Mortgage Corporation from 1990 until 1994 and President of American Residential Mortgage Corporation from the time he co-founded it in 1983 until 1994. He also served as Executive Vice President of Imperial Savings Association from 1983 to 1987. Mr. Robbins has worked in the mortgage banking industry since 1973. Mr. Robbins has served two terms on the Board of Governors and the Executive Committee of the Mortgage Association of America and was appointed to its first Board of Directors. He has also served on FNMA's National Advisory Board. Mr. Robbins is currently a director of Garden Fresh Restaurant Corporation, Accredited Home Lenders and is a trustee of the University of San Diego.
JAY M. FULLER has served as President, Chief Operating Officer and Director of the Company since its formation in February 1997. Prior to joining the Company Mr. Fuller served as President of Victoria Mortgage from 1995 to 1996. Mr. Fuller was an Executive Vice President and Chief Administration Officer of American Residential Mortgage Corporation from 1985 to 1994 and Senior Vice President from 1983 to 1985. In these capacities, at various times, Mr. Fuller was responsible for, among other things, Mortgage Loan originations and servicing for American Residential Mortgage Corporation. Mr. Fuller has worked in the mortgage banking industry continuously since 1975. Mr. Fuller currently serves on the Board of Directors of Friends of Santa Fe Christian Schools.
JUDITH A. BERRY has served as Executive Vice President and Chief Financial Officer of the Company since June, 1999. From 1996 to 1999 Ms. Berry was President of Directors Acceptance, the Subprime Mortgage Division of Norwest Mortgage, Inc. Ms. Berry was Executive Vice President and Chief Financial Officer of American Residential Mortgage Corporation from 1989 to 1994. Between 1984 and 1989, she was Senior Vice President of Acquisitions and New Business Development for American Residential Mortgage Corporation. Ms. Berry was an audit manager for Arthur Young, now Ernst & Young from 1978 to 1984. Ms. Berry received a BS in Business Administration from San Diego State University in 1977 and is a Certified Public Accountant in California.
ROLLIE O. LYNN has served as Senior Vice President, Capital Markets, responsible for the areas of portfolio management for the Company since its formation in February 1997. Prior to joining the Company, Mr. Lynn served as Vice President, Capital Markets, of Long Beach Mortgage Company responsible for managing, hedging and trading the firm's non-conforming residential Mortgage Loans. Prior to joining Long Beach Mortgage, Mr. Lynn served as Vice President, Secondary Marketing, of American Residential Mortgage Corporation from 1991 to 1994, as Vice President, Capital Markets, of Imperial Savings from 1988 to 1992, and as Vice President of Great American First Savings Bank of San Diego from 1985 to 1988. Mr. Lynn has worked in the mortgage banking business continuously since 1977. Mr. Lynn received two Bachelor of Arts degrees in 1976 from California State University at Chico. Mr. Lynn is a licensed real estate broker in California.
LISA S. FAULK has served as Senior Vice President, Operations, of the Company since October 1997. Prior to joining the Company, Ms. Faulk served as Vice President, Conduit Underwriting, for Advanta Mortgage Corporation where she managed the Conduit Division's underwriting, funding and processing functions in the non-conforming credit markets. Ms. Faulk was Vice President, Manager Credit Risk Review, for Homefed Bank, Federal Savings Bank from 1984 to 1993.
GLOSSARY
AS USED IN THIS FORM 10-K, THE CAPITALIZED AND OTHER TERMS LISTED BELOW HAVE THE MEANINGS INDICATED.
"AGENCY SECURITIES" means mortgage participation certificates issued by FHLMC, FNMA or GNMA. These securities entitle the holder to receive a pass-through of principal and interest payments on the underlying pool of Mortgage Loans and are issued or guaranteed by federal government sponsored agencies.
"BASIS RISK" is the difference and timing of the index used to adjust the interest rate (yield) on assets, and the index used to adjust the interest rate on liabilities.
"CMO" means Collateralized Mortgage Obligation.
"CODE" means the Internal Revenue Code of 1986, as amended.
"COUPON RATE" means, with respect to Mortgage Assets, the annualized cash interest income annually received from the asset, expressed as a percentage of the face value of the asset.
"EARNING ASSETS" means, with respect to Mortgage Assets, the annualized cash interest income actually received from the asset, expressed as a percentage of the face value of the asset.
"EQUITY-FUNDED LENDING" means the portion of the Company's earning assets acquired using the Company's equity capital.
"FASIT" means Financial Asset Securitization Investment Trust.
"FHLMC" means the Federal Home Loan Mortgage Corporation.
"FNMA" means the Federal National Mortgage Association.
"FULLY-INDEXED RATE" means, with respect to adjustable-rate Mortgage Assets, the rate that would be paid by the borrower ("gross") or received by the Company as owner of the Mortgage Assets ("net") if the coupon rate on the adjustable-rate Mortgage Assets were able to adjust immediately to a market rate without being subject to adjustment periods, periodic caps, or life caps. It is equal to the current yield of the adjustable-rate Mortgage Assets index plus the gross or net margin.
"GAP RISK" means the timing difference (mis-match) between the repricing of interest rate sensitive assets and interest rate sensitive liabilities.
"GNMA" means the Government National Mortgage Association.
"INTEREST RATE ADJUSTMENT INDICES" means, in the case of Mortgage Assets, any of the objective indices based on the market interest rates of a specified debt instrument (such as United States Treasury Bills in the case of the Treasury Index and United States dollar deposits in London in the case of LIBOR) or based on the average interest rate of a combination of debt instruments (such as the 11th District Cost of Funds Index), used as a reference base to reset the interest rate for each adjustment period on the Mortgage Asset, and in the case of borrowings, is used herein to mean the market interest rates of a specified debt instrument (such as reverse repurchase agreements for Mortgage Securities) as well as any of the objective indices described above that are used as a reference base to reset the interest rate for each adjustable period under the related borrowing instrument.
"INTEREST RATE ADJUSTMENT PERIOD" means, in the case of Mortgage Assets, the period of time set forth in the debt instrument that determines when the interest rate is adjusted and, with respect to borrowings, is used to mean the term to maturity of a short term, fixed-rate debt instrument (such as a 30-day reverse repurchase
agreement) as well as the period of time set forth in a long term, adjustable-rate debt instrument that determines when the interest rate is adjusted.
"LIFETIME INTEREST RATE CAP" or "LIFE CAP" means the maximum coupon rate that may accrue during any period over the term of an adjustable-rate Mortgage Loan or, in the case of a Mortgage Security, the maximum weighted average coupon rate that may accrue during any period over the term of such Mortgage Security.
"LIQUIDITY CAPITAL CUSHION" is a term defined in the Company's Capital Policy. It represents a portion of the capital the Company is required to maintain as part of this policy in order to continue to make asset acquisitions. The liquidity capital cushion is that part of the required capital base which is in excess of the Company's haircut requirements.
"MORTGAGE ASSETS" means Mortgage Securities, Mortgage Loans Held-for-Investment and Bond Collateral.
"MORTGAGE LOANS" means Mortgage Loans secured by residential or mixed use properties.
"MORTGAGE SECURITIES" means Agency Mortgage-Backed Securities and Privately Issued Mortgage-Backed Securities.
"NONCONFORMING MORTGAGE LOANS" means conventional single-family and multifamily Mortgage Loans that do not conform to one or more requirements of CHLMC or FNMA for participation in one or more of such agencies' mortgage loss credit support programs.
"PERIODIC INTEREST RATE CAP" or "PERIODIC CAP" means the maximum change in the coupon rate permissible under the terms of the loan at each coupon adjustable date. Periodic caps limit both the speed by which the coupon rate can adjust upwards in a rising interests rate environment and the speed by which the coupon rate can adjust downwards in a falling rate environment.
"PRIVATELY ISSUED SECURITIES" means mortgage participation certificates issued by certain private institutions. These securities entitle the holder to receive a pass-through of principal and interest payments on the underlying pool of Mortgage Loans and are issued or guaranteed by the private institution.
"REIT PROVISIONS OF THE CODE" means sections 856 through 860 of the Code.
"REMIC" means Real Estate Mortgage Investment Conduit.
"SPREAD LENDING" means the portion of the Company's earning assets acquired using borrowed funds.
"TEN YEAR U.S. TREASURY RATE" for a quarterly period shall mean the arithmetic average of the weekly per annum Ten Year Average Yields published by the Federal Reserve Board during such quarter. In the event that the Federal Reserve Board does not publish a weekly per annum ten Year Average Yield during any week in a quarter, then the Ten Year U.S. Treasury Rate for such week shall be the weekly per annum Ten Year Average Yield published by any Federal Reserve Bank or by any U.S. Government department or agency selected by the Company for such week. In the event that the Company determines in good faith that for any reason the Company cannot determine the Ten Year U.S. Treasury Rate for any quarter as provided above, then the Ten Year U.S. Treasury Rate for such quarter shall be the arithmetic average of the Per Annum average yields to maturity based upon the daily closing bids during such quarter for each of the issues of actively traded marketable U.S. treasury fixed interest rate securities (other than securities which can, at the option of the holder, be surrendered at face value in payment of any federal estate tax) with a final maturity date not less than eight nor more than twelve years from the date of each such quotation, as chosen and for each business day or less frequently if daily quotations shall not be generally available in each such quarterly period in New York City and quoted to the Company by at least three recognized dealers in U.S. Government securities selected by the Company.
ITEM 2.
ITEM 2. PROPERTIES
The Company's and the Manager's executive offices are located at 445 Marine View Avenue, Suite 230, Del Mar, California. The Company and the Manager currently occupy approximately 7,000 square feet of space. The Manager leases facilities pursuant to a lease expiring in April 1, 2000. The cost for this space for the year ended December 31, 1999, was approximately $166,000. Management believes that these facilities are adequate for the Company's and the Manager's foreseeable needs.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
At December 31, 1999, there were no material pending legal proceedings to which the Company was a party or of which any of its property was subject.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
The Company's common stock began trading on October 29, 1997 and is traded on the New York Stock Exchange under the trading symbol INV. As of December 31, 1999, the Company had 8,055,500 shares of common stock issued and outstanding which was held by 53 holders of record.
The following table sets forth, for the periods indicated, the high, low and closing sales prices per share of common stock as reported on the New York Stock Exchange composite tape common stock.
The Company intends to pay quarterly dividends and to make such distributions to its stockholders in amounts such that all or substantially all of its taxable income (subject to certain adjustments) is distributed so as to qualify for the tax benefits accorded to a REIT under the Code. However, net earnings on a GAAP basis differs from taxable income primarily due to net earnings on a GAAP basis being based on the accrual method of accounting while taxable income more closely resembles cash flow. All distributions will be made by the Company at the discretion of the Board of Directors and will depend on the operations of the Company, financial condition of the Company, maintenance of REIT status and such other factors as the Board of Directors may deem relevant from time to time.
The following table sets forth, for the periods indicated, the dividends paid in 1997, 1998, 1999 and 2000:
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following selected Statement of Operations and Balance Sheet data as of December 31, 1999, 1998 and 1997, and for the years ended December 31, 1999 and 1998 and for the period from February 11, 1997 (commencement of operations) through December 31, 1997, has been derived from the Company's consolidated financial statements audited by KPMG LLP, independent auditors, whose report with respect thereto appears on page. Such selected financial data should be read in conjunction with those consolidated financial statements and the accompanying notes thereto and with "Management's Discussion and Analysis of Financial Conditions and Results of Operations" also included elsewhere herein.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The statements contained in this Form 10-K that are not purely historical are forward looking statements, including statements regarding the Company's expectations, hopes, beliefs, intentions, or strategies regarding the future. Statements which use the words "expects", "will", "may", "anticipates", "goal", "intends", "seeks", "strategy" and derivatives of such words are forward looking statements. These forward looking statements, including statements regarding changes in the Company's future income, Mortgage Asset portfolio, financings, plans to create origination capability, ways the Company may seek to grow income, management expectations regarding future provisions for loan losses, and the Company's belief in the adequacy of loan losses, are based on information available to the Company on the date hereof, and the Company assumes no obligation to update any such forward looking statement. It is important to note that the Company's actual results could differ materially from those in such forward looking statements. Among the factors that could cause actual results to differ materially are the factors set forth under item 1 under the heading "Business Risks". In particular, the Company's future income could be affected by interest rate increases, high levels of prepayments, Mortgage Loan defaults, reductions in the value of retained interest in securitizations, and inability to acquire or finance new Mortgage assets.
OVERVIEW
The Company's revenue primarily consists of interest income generated from its Mortgage Assets and its cash and investment balances (collectively, "earning assets"), income generated by equity in income of American Residential Holdings, Inc., management fees, and prepayment penalty income.
The Company funds its acquisitions of earning assets with both its equity capital and with borrowings. For that portion of the Company's earning assets funded with equity capital ("equity-funded lending"), net interest income is derived from the average yield on earning assets. Due to the adjustable-rate nature of the majority of its earning assets, the Company expects that income from this source will tend to increase as interest rates rise and will tend to decrease as interest rates fall, but only after the expiration of any initial fixed teaser periods and then only periodically once or twice each year.
For that portion of the Company's earning assets funded with borrowings ("spread lending"), the resulting net interest income is a function of the volume of spread lending and the difference between the Company's average yield on earning assets and the cost of borrowed funds. Income from spread lending will generally decrease following an increase in short term interest rates due to increases in borrowing costs but a lag in adjustments to the earning asset yields. Yields on adjustable rate loans generally adjust based on a short term interest rate index, but the majority of the Company's earning assets are adjustable rate loans which are subject to an initial fixed teaser period of 2 years, and then adjust periodically every six months. Income from spread lending will generally increase following a fall in short term interest rates as borrowing costs decline and downward adjustments to earning asset yields lag behind. The Company purchases interest rate cap agreements to partially offset the impacts of significant increases in short term interest rates and the loss of spread income which occurs when borrowing rates (which generally adjust monthly) increase more than earning asset yields (which generally adjust only after the expiration of any fixed teaser periods and then only periodically, once or twice a year).
The Company's primary expenses, beside its borrowing costs, are amortization of loan purchase premiums, provision for loan losses, management and administrative expenses and hedging costs. Premiums are amortized in relation to actual portfolio repayments on each segment of the portfolio, so the level of premium amortization expense is linked to the amount of capitalized loan purchase premiums for each portfolio and the level of repayments in each portfolio group. Management fees and administrative costs are generally based on the size of the earning asset portfolio, and to a lesser degree, the level of loan purchase activity. Hedging costs are based on size of the portfolio subject to gap risk and the market prices for interest rate cap agreements.
During the fourth quarter of 1999 the Company recorded approximately $12.3 million write-down of its Bond Collateral, Mortgage Loans. The write-down was related to a particular segment of the portfolio that had been purchased at a significant premium and subsequently experienced high prepayments. This write-down
generated a net loss for 1999 of approximately $3.9 million but served to reduce the un-amortized premiums on the portfolio from 7.17% at December 31, 1998 to 3.69% at December 31, 1999.
The Company may seek to generate growth in net income in a variety of ways, including through (i) improving productivity by increasing the size of the earning assets, (ii) changing the mix of Mortgage Asset types among the earning assets and lowering premiums paid in an effort to improve returns and reduce the Company's sensitivity to prepayments, (issuing new common stock and increasing the size of the earning assets, and (iii) increasing the efficiency with which the Company uses its equity capital over time by maintaining the Company's use of debt when prudent and by issuing subordinated debt, preferred stock or other forms of debt and equity. There can be no assurance, however, that the Company's efforts will be successful or that the Company will increase or maintain its income level.
Results of Operations
For the year ended December 31, 1999 the Company generated a net loss of approximately $3.9 million and net loss per share of common stock diluted of $0.48 compared to the year ended December 31, 1998 when the Company generated a net loss of approximately $1.2 million and net loss per share of common stock-diluted of $0.15. For the period February 11, 1997 (commencement of operations) through December 31, 1997 the Company generated net income of approximately $2.4 million and diluted net income per share of $0.82. The net loss in 1999 was directly attributable to the write-down of premium on Bond Collateral, Mortgage Loans in the amount of approximately $12.3 million. These loans were purchased in 1997 when non-conforming loans were selling significantly above par. The net loss in 1998 was directly attributable to the loss on sale of Mortgage Securities available-for-sale and the provision for loan losses. Due to market conditions in 1998, i.e. high prepayments, fueled by declining interest rates and the need to lower leverage, the majority of the Company's Mortgage Securities available-for-sale were sold during the fourth quarter of 1998. This sale resulted in a loss of approximately $5.9 million.
The growth in Mortgage Asset interest income of $9.7 million and net interest spread of $6.3 million between the years ended December 31, 1999 and 1998 was primarily due to an increase in the Company's Mortgage Assets held during the year, higher asset yields due to a change in the composition of Mortgage Assets, and, relative to net interest spread, offset by higher interest expense associated with an increase in borrowings and an increase in borrowing rates during the second half of 1999. The growth in Mortgage Asset interest income of $53.7 million and net interest spread of 18.6 million between the year ended December 31, 1998 and the period February 11, 1997 (commencement of operations) through December 31, 1997, was also due to an increase in the Company's Mortgage Assets held during the period and higher asset yields due to a change in the composition of Mortgage Assets.
Net interest income decreased $9.4 million between the years ended December 31, 1999 and 1998 due to higher premium amortization and premium write-downs, offset by the increase in net interest spread. Net interest income increased $7.1 million between the year ended December 31, 1998 and the period February 11, 1997 (commencement of operations) through December 31, 1997. This increase was due to an increase in the Company's Mortgage Assets held during the year.
Premium amortization expense represents the amortization of purchase premiums paid for Mortgage Loans acquired in excess of the par value of the loans. Actual repayment rates (the amount of principal repayments during a period compared to the beginning principal balance) are applied to the remaining unamortized premium to calculate amortization expense. Premium amortization expense was approximately $16.6 million for the year ended December 31, 1999, approximately $13.3 million for the year ended December 31, 1998, and approximately $1.8 million for the period from February 11, 1997 (commencement of operations) through December 31, 1997. Higher premium amortization expense is due to growth in Bond Collateral and associated amortization of related purchase premiums and higher levels of repayments in the CMO/FASIT segment of the Bond Collateral portfolio, the oldest and most expensive portion of Mortgage Loans. Additionally, increased levels of prepayments in the fourth quarter of 1999 on the CMO/FASIT
segment of Bond Collateral, Mortgage Loans lead to a premium write-down of $12.3 million in the fourth quarter of 1999. The following chart represents constant repayment rates ("CPRs"):
At December 31, 1999, unamortized premiums as a percentage of the remaining principal amount of Bond Collateral, Mortgage Loans were 3.71%, as compared to 8.16% at December 31, 1998, primarily due to the writedown of premium on the CMO/FASIT portfolio. The chart below provides a breakdown of prepayment coverage and the weighted average months remaining until the next interest rate adjustment for each segment of the Mortgage Loan portfolio:
- --------------- * Prepayment coverage is the number of months remaining before the prepayment clause in the mortgage loan contracts expire and borrowers may prepay the loan without prepayment penalty charges.
Most of the intermediate adjustable rate mortgages in the CMO/FASIT segment of the Bond Collateral portfolio have reached their first contractual interest rate adjustment (increase) and prepayment penalties on these loans have expired, resulting in a higher probability of refinancing and principal prepayments. The Company anticipates that prepayment rates on the newer Mortgage Loans will increase as these predominately adjustable rate loans reach their initial adjustments or when prepayment penalty clauses expire. There can be no assurance that the Company will be able to achieve or maintain lower prepayment rates or that prepayment rates will not increase. The Company's financial condition and results of operations could be materially adversely affected if prepayments continue at high levels. Net interest income, after premium amortization, premium write-down and provision for loan losses, decreased 148.1% from approximately $6.4 million in income for the year ended December 31, 1998 to a loss of approximately $3.1 million for the year ended December 31, 1999 due primarily to higher premium amortization and the premium write-down of approximately $12.3 million, offset by higher net interest spread discussed above. Net interest income, after premium amortization and provision for loan losses, increased 131.3% from $2.8 million for the period February 11, 1997 (commencement of operations) through December 31, 1997, to $6.4 million for the year
ended December 31, 1998, offset by higher premium amortization and provision for loan loss, due to increases in net interest spread.
During 1999, other operating income increased approximately $2.1 million over the year ended December 31, 1998 primarily due to an increase of approximately $3.0 million in prepayment penalty income, and an increase in the size of the Mortgage Loan portfolio and the proportion of loans with prepayment penalties. This increase was offset by a decrease in equity in income of American Residential Holdings, Inc. of approximately $945,000. This decrease is due to the fact that no loan sales occurred in 1999 compared to a sale and REMIC securitization in 1998 by American Residential Holdings, Inc. During 1998, the Company generated prepayment penalty income of approximately $806,000 and management fee income of approximately $420,000. There was no income from prepayment penalty or management fees for the period February 11, 1997 (commencement of operations) through December 31, 1997.
For the year ended December 31, 1999, other expenses increased approximately $1.1 million (excluding the loss on sale of Mortgage Securities available-for-sale of approximately $5.9 million in 1998) over the year ended December 31, 1998. During 1999 there was a loss on the sale of real estate owned of $349,000 and management fees increased approximately $1.1 million as a result of the Company's increase in Mortgage Loans. General and administrative expenses decreased approximately $317,000 from the year ended December 31, 1998 to the year ended December 31, 1999. Other expenses increased from $379,000 for the period February 11, 1997 (commencement of operations) through December 31, 1997 to approximately $4.1 million for the year ended December 31, 1998 (excluding the loss on sale of Mortgage Securities available-for-sale of approximately $5.9 million in 1998). The increase in general and administrative expenses between the period February 11, 1997 (commencement of operations) through December 31, 1997, and the year ended December 31, 1998 is primarily the result of the Company's increased management fees which resulted from the increase in the Company's Mortgage Assets.
The Company held Mortgage Assets of approximately $1.3 billion as of December 31, 1999, comprised of Mortgage Loans held-for-investment, net pledged, of approximately $126.2 million and Bond Collateral, of approximately $1.2 billion. The Company held Mortgage Assets of approximately $603.4 million as of December 31, 1998. Mortgage Assets at December 31, 1998 were comprised of Mortgage Securities available-for-sale, of approximately $6.6 million, Mortgage Loans held-for-investment, pledged, of approximately $179.0 million and Bond Collateral, of approximately $417.8 million. This compares to Mortgage Assets with a carrying value of approximately $549.9 million at December 31, 1997, comprised of Mortgage Securities available-for-sale, of approximately $387.1 million, including approximately $3.3 million net unrealized loss recorded as of the year end, and Mortgage Loans held-for-investment, pledged of approximately $162.8 million.
Liquidity and Capital Resources
During the year ended December 31, 1999, net cash provided by operating activities was approximately $27.7 million. The difference between net cash provided by operating activities and the net loss of approximately $3.9 million was primarily the result of amortization and write down of mortgage asset premiums and provision for loan losses. During the year ended December 31, 1998, net cash provided by operating activities was approximately $10.7 million. The difference between net cash provided by operating activities and the net loss of approximately $1.2 million was primarily the result of amortization of mortgage asset premiums and provisions for loan losses. Both amortization of mortgage premium and provisions for loan losses are non-cash charges. During the period from February 11, 1997 (commencement of operations) through December 31, 1997, net cash provided by operating activities was approximately $1.3 million. Net cash provided by operating activities was negatively impacted by an increase in accrued interest receivable, offset by an increase in accrued interest payable. There were no Mortgage Assets held at February 11, 1997 and, therefore, the total accrued interest receivables at December 31, 1997 negatively affected cash. Net cash for the period was positively affected by an increase in accrued interest payable, premium amortization, other accrued expenses, and management fees payable.
Net cash used in investing activities for the year ended December 31, 1999 was approximately $717.2 million. Net cash used for the year was negatively affected by the purchase of Mortgage Loans in the amount of approximately $990.6 million, and the purchase of interest rate cap agreements of approximately $1.7 million. Net cash used in investing activities for the year ended December 31, 1999 was positively affected by principal payments of approximately $266.2 million, sale of mortgage securities of approximately $3.2 million and proceeds from the sale of real estate owned of approximately $5.6 million. Net cash used in investing activities for the year ended December 31, 1998 was approximately $74.9 million. Net cash used for the year was negatively affected by the purchase of Mortgage Loans in the amount of approximately $649.6 million, the purchase of the retained interest in securitization of approximately $6.7 million, and the purchase of interest rate cap agreements of approximately $1.0 million. Net cash used in investing activities for the year ended December 31, 1998 was positively affected by principal payments of approximately $250.8 million and sale of Mortgage Assets of approximately $331.3 million. Net cash used in investing activities for the period from February 11, 1997 (commencement of operations) through December 31, 1997 was approximately $555.5 million. Net cash used for the period was negatively affected by the purchase of Mortgage Assets in the amount of approximately $593.8 and positively affected by principal prepayments of approximately $38,800.
For the year ended December 31, 1999, net cash provided by financing activities was approximately $663.5 million offset by the payment of dividends totaling $7 million. Net cash provided by financing activities was positively affected by the issuance of long-term debt in the amount of approximately $958.3 million and an increase in net borrowings from long-term debt of approximately $7.1 million. Net cash provided by financing activities was negatively impacted by a decrease in net borrowings from reverse repurchase agreements of approximately $47.2 million, payments on long-term debt of approximately $244.3 million and dividends paid of approximately $7.0 million. For the year ended December 31, 1998, net cash provided by financing activities was approximately $93.0 million offset by the payment of dividends totaling $6.8 million. Net cash provided by financing activities was positively affected by the issuance of long-term debt in the amount of approximately $457.0 million. Net cash provided by financing activities was negatively impacted by a decrease in net borrowings from reverse repurchase agreements of approximately $285.1 million, payments on long-term debt of approximately $71.6 million, dividends paid of approximately $6.8 million and purchase of the common stock of $492,000. For the period from February 11, 1997 (commencement of operations) through December 31, 1997, net cash provided by financing activities was $560.1 million offset by the payment of dividends totaling $1.1 million. Net cash provided was primarily from borrowings under reverse repurchase agreements and net proceeds received from the issuance of common stock in the Company's private placement of common stock in February 1997 and the Company's initial public offering (the "Offering") of 6,500,000 shares of its common stock par value $0.01 per share. The Offering was completed in November 3, 1997 at an initial offering price of $15.00 per share. The Company raised $89.7 million in the Offering, net of $6.3 million underwriting discount and $1.5 million in other offering expenses.
Although the 1998 U.S. economy was one of the healthiest in decades, much of the world was experiencing financial crisis. Economic woes of Russia, Japan, China, Brazil and others shook the confidence of the U.S. markets. Concurrently, failures at Crimmie Mae, a Commercial Mortgage REIT, and hedge funds, such as Long Term Capital, as well as sizeable losses arising from some residential sub-prime originators caused volatility in the price of U.S. financial assets and eventually led to a liquidity crisis in the fall of 1998. The liquidity crisis had a negative effect on the Mortgage REIT industry. Financial lines utilized to accumulate Mortgage assets were reduced or made unavailable by Wall Street firms and banks.
Financial turmoil in world economics, and a domestic liquidity crisis may return. The Company intends to renew its existing reverse repurchase financing facility when it expires in July, 2000 and to secure commitments from additional firms for similar financing. There can be no assurance that the Company will be able to secure new short or long-term financing or that financing will be available at favorable terms. See "Business Risks -- Failure to Renew or Obtain Adequate Funding May Adversely Affect Results of Operations."
ITEM 7a.
ITEM 7a. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISKS
Repricing of Interest-Earning Assets and Interest-Bearing Liabilities
The following table sets forth the amounts of interest-earning assets and interest-bearing liabilities outstanding at December 31, 1999, which are anticipated by the Company to reprice in each of the future time periods shown. The amount of assets and liabilities shown which reprice during a particular period were determined based on contractual maturity. Asset balances have not been adjusted for expected prepayments. All principal prepayments on Bond Collateral, Mortgage Loans are used to reduce long-term debt. For fair value of financial instruments as of December 31, 1999, see Note 10. Fair Value of Financial Instruments" (dollars in thousands):
- --------------- (1) Retained Interest in Securitization represents a residual interest only strip acquired in a REMIC securitization and sale completed by Holdings. The majority of the underlying mortgages have a contractual re-pricing average of more than 6 months to one year, while the undelying financing costs adjust monthly.
(2) Interest rate sensitivity gap represents the difference between net interest-earning assets and interest-bearing liabilities.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The consolidated financial statements of the Company and the related notes, together with the Independent Auditor's Report thereon are set forth on pages through on this Form 10-K.
ITEM 9.
ITEM 9.CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information required by Item 10 with respect to directors is incorporated herein by reference to the information contained under the headings "Election of Directors" and "Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's definitive Proxy Statement for the Company's annual meeting of stockholders to be held May 24, 2000 (the "Proxy Statement"). The information required with respect to executive officers is set forth in Item 1 of this report under the caption "Executive Officers of the Company."
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by Item 11 is incorporated herein by reference to the information contained under the heading "Executive Compensation and Other Matters" in the Company's Proxy Statement.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by Item 12 is incorporated herein by reference to the information contained under the heading "Stock Ownership of Certain Beneficial Owners and Management" in the Company's Proxy Statement.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by Item 13 is incorporated herein by reference to the information contained under the headings "Compensation Committee Interlocks and Insider Participation" and "Certain Transactions" in the Company's Proxy Statement.
PART IV
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT, SCHEDULES AND REPORTS ON FORM 8-K
(a) Documents filed as part of this report:
1. The following Financial Statements of the Company are included in Part II, Item 8 of this Annual Report on Form 10K:
Independent Auditors' Report;
Consolidated Balance Sheets as of December 31, 1999 and 1998;
Consolidated Statements of Operations and Comprehensive Income (Loss) for the years ended December 31, 1999 and December 31, 1998 and for the period from February 11, 1997 (commencement of operations) through December 31, 1997;
Consolidated Statements of Stockholders' Equity for the years ended December 31, 1999 and December 31, 1998 and for the period from February 11, 1997 (commencement of operations) through December 31, 1997;
Consolidated Statements of Cash Flows for the years ended December 31, 1999 and December 31, 1998 and for the period from February 11, 1997 (commencement of operations) through December 31, 1997;
Notes to Consolidated Financial Statements
2. Financial Statement Schedules.
All financial statement schedules have been omitted because they are either inapplicable or the information required is provided in the Company's Financial Statements and Notes thereto, included in Part II, Item 8 of this Annual Report on Form 10-K.
3. Exhibits:
EXHIBIT INDEX
- --------------- * Incorporated by reference to Registration Statement on Form S-11 (File No. 333-33679)
+ Management Contract or Compensatory Plan
** Incorporated by reference to Current Reports on Form 8-K (File No. 001-13485)
*** Incorporated by reference to the Company's Annual Report on Form 10-K for the Fiscal year ended 1997
**** Incorporated by reference to Current Reports on Form 8-K (File No. 333-47311)
***** Incorporated by reference to Current Reports on Form 8-K (File No. 333-5932)
****** Incorporated by reference to Current Reports on Form 8-K (File No. 333-70189-01)
(b) Reports on Form 8-K:
Current Report (File No. 001-13485)
FINANCIAL STATEMENTS AND INDEPENDENT AUDITORS' REPORT
FOR INCLUSION IN FORM 10-K FILED WITH SECURITIES AND EXCHANGE COMMISSION DECEMBER 31, 1999
REPORT OF INDEPENDENT AUDITORS
The Board of Directors American Residential Investment Trust, Inc. Del Mar, California:
We have audited the accompanying consolidated balance sheets of American Residential Investment Trust, Inc. and subsidiaries (the Company) as of December 31, 1999 and 1998, and the related consolidated statements of operations and comprehensive income (loss), stockholders' equity and cash flows for the years ended December 31, 1999 and 1998 and for the period from February 11, 1997 (commencement of operations) through December 31, 1997. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 1999 and 1998, and the results of their operations and their cash flows for the years ended December 31, 1999 and 1998, and for the period from February 11, 1997 (commencement of operations) through December 31, 1997 in conformity with generally accepted accounting principles.
KPMG LLP
San Diego, California January 28, 2000
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
ASSETS
See accompanying notes to consolidated financial statements.
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS) (IN THOUSANDS, EXCEPT PER SHARE DATA)
See accompanying notes to consolidated financial statements.
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (IN THOUSANDS, EXCEPT SHARE DATA)
See accompanying notes to consolidated financial statements.
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS)
See accompanying notes to consolidated financial statements.
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC., AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND PRACTICES
Basis of Financial Statement Presentation
The consolidated financial statements include the accounts of American Residential Investment Trust, Inc. ("AmRES"), a Maryland corporation, American Residential Eagle, Inc., ("Eagle"), a Delaware special purpose corporation and wholly-owned subsidiary of AmRES and American Residential Eagle 2, Inc. ("Eagle 2"), a Delaware limited purpose corporation and wholly-owned subsidiary of Eagle (collectively "AmRIT"). Substantially all of the assets of Eagle and Eagle 2 are pledged or subordinated to support long-term debt in the form of collateralized mortgage bonds ("Long-Term Debt") and are not available for the satisfaction of general claims of AmRIT. American Residential Holdings, Inc. ("Holdings"), is an affiliate of AmRES and accounted for under the equity method. AmRIT and Holdings are together referred to as (the "Company"). The Company's exposure to loss on the assets pledged as collateral is limited to its net investment, as the Long-Term Debt is non-recourse to the Company. All significant intercompany balances and transactions with Eagle and Eagle 2 have been eliminated in the consolidation of AmRIT. Certain amounts for prior periods have been reclassified to conform with the current year's presentation.
During the first half of 1998, the Company formed Holdings, through which a portion of the Company's non-conforming adjustable-rate and fixed-rate, single-family whole loans (collectively, "Mortgage Loans"), acquisition and finance activities are conducted. AmRIT owns all of the preferred stock and has a non-voting 95% economic interest in Holdings. Because AmRIT does not control Holdings, its investment in Holdings is accounted for under the equity method. Under this method, original equity investments in Holdings are recorded at cost and adjusted by AmRIT's share of earnings or losses and decreased by dividends received.
The preparation of consolidated financial statements in conformity with generally accepted accounting principles requires management of the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenue and expenses during the reported period. Actual results could differ from those estimates.
Organization
AmRES commenced operations on February 11, 1997. AmRES was financed through a private equity funding from its manager, Home Asset Management Corporation (the "Manager"). AmRES operates as a mortgage real estate investment trust ("REIT") which has elected to be taxed as a REIT for Federal income tax purposes, which generally will allow AmRES to pass its income through to its stockholders without payment of corporate level Federal income tax, provided that the Company distributes at least 95% of its taxable income to stockholders. During 1998, AmRES formed Eagle, a special-purpose finance subsidiary. Holdings, a non-REIT, taxable affiliate of the Company, was established during the first half of 1998. During 1999, AmRES formed Eagle 2, a limited-purpose corporation and wholly-owned subsidiary of Eagle. The Company acquires residential mortgage loans ("Mortgage Loans"). These Mortgage Loans are typically secured by single-family real estate properties throughout the United States. The Company utilizes both debt and equity to finance its acquisitions. The Company may also use securitization techniques to enhance the value and liquidity of the Company's Mortgage Loans and may sell Mortgage Loans from time to time.
The Company sold residential mortgage loans in the second quarter of 1998 through the use of a Real Estate Mortgage Investment Conduit ("REMIC"). The REMIC, which consisted of pooled adjustable-rate first-lien mortgages, was issued by Holdings to the public through the registration statement of the related underwriter.
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC., AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Cash and Cash Equivalents
For purposes of the statement of cash flows, cash and cash equivalents include cash on hand and highly liquid investments with original maturities of three months or less.
Mortgage Assets
The Company's Mortgage Assets consist of interests in mortgage securities which have been securitized by others prior to acquisition by the Company (Mortgage Securities) and Mortgage Loans secured by residential properties (Mortgage Loans).
Mortgage Securities
AmRIT classifies its investments as either trading investments, available-for-sale investments or held-to-maturity investments. Although AmRIT generally intends to hold most of its Mortgage Securities until maturity, it may, from time to time, sell any of its Mortgage Securities as part of its overall management of its balance sheet. Accordingly, this flexibility requires AmRIT to classify all of its Mortgage Securities as available-for-sale. All Mortgage Securities classified as available-for-sale are reported at fair value, with unrealized gains and losses excluded from operations and reported as a separate component of stockholders' equity, as accumulated other comprehensive income (loss). A decline in the market value of any available-for-sale security below cost that is deemed to be other than temporary results in an impairment which is charged to operations and a new basis for the security is established.
Interest income is accrued based on the outstanding principal amount of the Mortgage Securities and their contractual terms. Premiums relating to Mortgage Securities are amortized into interest income over the lives of the Mortgage Securities using the interest method. Gains or losses on the sale of Mortgage Securities are based on the specific identification method.
Mortgage Loans Held-For-Investment and Bond Collateral
Mortgage loans held-for-investment and Bond Collateral include various types of adjustable-rate and fixed-rate loans secured by mortgages on single-family residential real estate properties. Premiums related to these loans are amortized over their estimated lives using the interest method. Loans are continually evaluated for collectibility and, if appropriate, the loan may be placed on non-accrual status. Generally, loans are placed in non-accrual status that are in foreclosure or non-performing bankruptcy, i.e. loans in bankruptcy and not performing according to the bankruptcy plan that is established with the trustee. When loans are placed on non-accrual status, all interest previously accrued but not collected is reversed against current period interest income. Income on non-accrual loans is subsequently recognized only to the extent that cash is received and the loans principal balance is deemed collectible. Loans are restored to accrual status when loans become well secured and are in the process of collection.
The Company considers a loan to be impaired when, based upon current information and events, it believes it will be unable to collect all amounts due according to the contractual terms of the loan agreement. Given the homogeneous nature of the loan portfolio, loan are evaluated for impairment collectively. Many factors are considered in the determination of impairment. The measurement of collateral dependent loans is based on the fair value of the loan's collateral.
Allowance for Loan Losses
The Company maintains an allowance for losses on Mortgage Loans Held-for-Investment and Bond Collateral, Mortgage Loans at an amount which it believes is sufficient to provide adequate protection against losses in the mortgage loan portfolio. The allowance for losses is determined primarily on the basis of management's judgment of net loss potential including specific allowances for known impaired loans, changes
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC., AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
in the nature and volume of the portfolio, value of the collateral and current economic conditions that may affect the borrower's ability to pay. A provision is recorded for all loans or portions thereof deemed to be uncollectible thereby increasing the allowance for loan losses. Subsequent recoveries on mortgage loans previously charged off are credited to the allowance.
Interest Rate Cap Agreements
The Company uses interest rate cap agreements (the "Cap Agreements") for interest rate risk protection. The Cap Agreements are purchased primarily to reduce the Company's gap risk (the timing difference or mis-match between the repricing of interest rate sensitive assets and interest rate sensitive liabilities). The Company periodically evaluates the effectiveness of these Cap Agreements under various interest rate scenarios.
The cost of the Cap Agreements are amortized over the life of the Cap Agreements using the straight-line method. The Company has credit risk to the extent counterparties to the Cap Agreements do not perform their obligations under the Cap Agreements. In order to lessen this risk and to achieve competitive pricing, the Company has entered into Cap Agreements only with counterparties which are investment grade rated.
Income Taxes
AmREIT has elected to be taxed as a REIT and complies with REIT provisions of the Internal Revenue Code (the "Code") and the corresponding provisions of State law. Accordingly, AmREIT will not be subject to federal or state income tax to the extent of its distributions to stockholders. In order to maintain its status as a REIT, AmREIT is required, among other requirements, to distribute at least 95% of its taxable income.
Income (Loss) per Share
The following table illustrates the computation of basic and diluted income (loss) per share (in thousands, except share and per share data):
At December 31, 1999, 1998 and 1997 there were 791,400, 695,900 and 414,200, respectively, of options that were antidilutive and, therefore, not included in the calculation above.
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC., AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Comprehensive Income (Loss)
The Company recognizes comprehensive income (loss) as part of the Statement of Operations and Comprehensive Income (Loss) and is disclosed as part of stockholders' equity in accumulated other comprehensive income (loss). Comprehensive income (loss) consists of net income (loss) and net unrealized gains (losses) on retained interest in securitization.
Segments
The Company adopted the provisions of SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," in 1998. This statement establishes standards for the way companies report information about operating segments in annual financial statements. It also establishes standards for related disclosures about products and services, geographic areas and major customers. The Company has determined that it does not have any separately reportable business segments as of December 31, 1999.
Recent Accounting Developments
In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities." SFAS No. 133 establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts, (collectively referred to as derivatives) and for hedging activities. It requires that an entity recognize all derivatives as either assets or liabilities in the balance sheet and measure those instruments at fair value. If certain conditions are met, a derivative may be specifically designated as (a) a hedge of the exposure to changes in the fair value of a recognized asset or liability or an unrecognized firm commitment, (b) a hedge of the exposure to variable cash flows of a forecasted transaction, or (c) a hedge of the foreign currency exposure of a net investment in a foreign operation, an unrecognized firm commitment, an available-for-sale security, or a foreign-currency-denominated forecasted transaction.
Under SFAS No. 133, an entity that elects to apply hedge accounting is required to establish at the inception of the hedge the method it will use for assessing the effectiveness of the hedging derivative and the measurement approach for determining the ineffective aspect of the hedge. Those methods must be consistent with the entity's approach to managing risk.
SFAS No. 133 amends SFAS No. 32, "Foreign Currency Translation," to permit special accounting for a hedge of a foreign currency forecasted transaction with a derivative. It supersedes SFAS No. 80, "Accounting for Futures Contracts," SFAS No. 105, "Disclosure of Information about Financial Instruments with Off- Balance-Sheet Risk and Financial Instruments with Concentrations of Credit Risk," and SFAS No. 119, "Disclosure about Derivative Financial Instruments and Fair Value of Financial Instruments." It amends SFAS No. 107, "Disclosures about Fair Value of Financial Instruments," to include in SFAS No. 107 the disclosure provisions about concentrations of credit risk from SFAS No. 105. This Statement also nullifies or modifies the consensus reached in a number of issues addressed by the Emerging Issues Task Force.
In June, 1999, the FASB issued SFAS No. 137, "Accounting for Derivative Instruments and Hedging Activities -- Deferral of the Effective Date of FASB Statement No. 133, an Amendment of FASB Statement No. 133". SFAS No. 137 defers the effective date of SFAS No. 133 for one year. SFAS No. 133, as amended, is now effective for all fiscal quarters of all fiscal years beginning after June 15, 2000. The Company is in the process of determining the impact of adopting SFAS No. 133.
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC., AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 2. MORTGAGE SECURITIES AVAILABLE FOR SALE, NET
AmREIT's mortgage participation certificates issued by FHLMC, FNMA or GNMA ("Agency Securities") and mortgage participation certificates issued by certain private institutions ("Privately Issued Securities") (collectively, "Mortgage Securities") consisted of the following (dollars in thousands):
On July 26, 1999, AmREIT sold the remaining Mortgage Securities available-for-sale. The book value of these assets at the time of sale was approximately $3.2 million and there was a gain on sale of approximately $30,000.
NOTE 3. MORTGAGE LOANS HELD-FOR-INVESTMENT, NET, PLEDGED
AmREIT purchases certain non-conforming Mortgage Loans to be held as long-term investments. At December 31, 1999 and 1998, Mortgage Loans held for investment consist of the following (dollars in thousands):
A summary of the activity in the allowance for loan losses is as follows (dollars in thousands):
At December 31, 1999 and 1998, the weighted average net coupon on the Mortgage Loans was 9.17% and 9.31%, respectively, per annum. All Mortgage Loans have a repricing frequency of five years or less. At December 31, 1999 and 1998, approximately 29% and 46%, respectively, of the collateral was located in California with no other state representing more than 6% and 7%, respectively.
As of December 31, 1999 and 1997, there were no Mortgage Loans on non-accrual status. There were $2.3 million Mortgage Loans on non accrual status as of December 31, 1998. Interest income of $981,000 would have been recorded for the year ended December 31, 1998 on Mortgage Loans Held-for-Investment, net, pledged, and Bond Collateral, Mortgage Loans (See Note 4) if non-accrual loans had been on a current basis, in accordance with their original terms.
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC., AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 4. BOND COLLATERAL, MORTGAGE LOANS
AmRIT has pledged collateral in order to secure the Long-Term Debt issued in the form of CMOs. Bond Collateral consists primarily of adjustable-rate, conventional, 30-year mortgage loans secured by first liens on one- to four-family residential properties. All Bond Collateral is pledged to secure repayment of the related Long-Term Debt obligation. All principal and interest (less servicing and related fees) on the Bond Collateral is remitted to a trustee and is available for payment on the Long-Term Debt obligation. The obligations under the Long-Term Debt are payable solely from the Bond Collateral and are otherwise non-recourse to AmRIT.
The components of the Bond Collateral at December 31, 1999 and 1998 are summarized as follows (dollars in thousands):
At December 31, 1999 and 1998, approximately 38% and 39%, respectively of the collateral was located in California for the CMO/FASIT 1998-1 and no other state represented more than 8% and 7%, respectively. At December 31, 1999, approximately 38% of the collateral was located in California for the CMO 1999-1 and no other state represented more than 7%. At December 31, 1999, approximately 21% of the collateral was located in California for the CMO 1999-2 and no other state represented more than 7%. At December 31, 1999, approximately 13% of the collateral was located in Michigan for the CMO/REMIC 1999-A and no other state represented more than 10%.
Impaired loans included in the Company's Bond Collateral, Mortgage Loans as of December 31, 1999 and 1998 were approximately $37.5 and $11.8 million, respectively At December 31, 1998, impaired loans had an aggregate specific related allowance amount of approximately $2.6 million. There was no specific related allowance for 1999.
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC., AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
A summary of the activity in the allowance for loan losses is as follows (dollars in thousands):
NOTE 5. BOND COLLATERAL, REAL ESTATE OWNED
The Company owned 68 properties and 7 properties as of December 31, 1999 and 1998. respectively. Upon transfer of the loans to real estate owned, the Company recorded a corresponding charge against the allowance for loan losses to write-down the real estate owned to fair value less estimated cost of disposal. At December 31, 1999 and 1998, real estate owned totaled approximately $5.2 million and $490,000, respectively.
NOTE 6. RETAINED INTEREST IN SECURITIZATION
Retained interest in securitization consists of assets generated and retained in conjunction with the Company's 1998-1 REMIC securitization. A summary of these assets at December 31, 1999 and 1998 were as follows (dollars in thousands):
The Company classified the 1998-1 REMIC securities as available-for-sale securities and carries them at market value. The fair value of the retained interest is determined by computing the present value of the excess of the weighted-average coupon of the residential mortgages sold (9.32%) over the sum of: (1) the coupon on the senior interest (5.95%), and (2) a servicing fee paid to the servicer of the residential mortgages (0.50%) and other fees, and taking into account expected estimated losses to be incurred on the portfolio of residential mortgages sold over the estimated lives of the residential mortgages and using an estimated future average prepayment assumption of 35% per year for 1999 and 25% per year for 1998. The prepayment assumption used in estimating the cash flows is based on recent evaluations of the actual prepayments of the related portfolio and on market prepayment rates on new portfolios of similar residential mortgages, taking into consideration the current interest rate environment and its expected impact on the estimated future prepayment rate. The estimated cash flows expected to be received by the Company are discounted at an interest rate that the Company believes is commensurate with the risk of holding such a financial instrument. The rate used to discount the cash flows coming out of the trust was approximately 12%. To the extent that actual future excess cash flows are different from estimated excess cash flows, the fair value of the Company's retained interest could change.
Under the terms of the securitization, the retained interest is required to build over-collateralization to specified levels using the excess cash flows described above until set percentages of the securitized portfolio are attained. Future cash flows to the retained interest holder are all held by the REMIC trust until a specific percentage of either the original or current certificate balance is attained which percentage can be raised if
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC., AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
certain charge-offs and delinquency ratios are exceeded. The certificate holders' recourse for credit losses is limited to the amount of over-collateralization held in the REMIC trust. Upon maturity of the certificates or upon exercise of an option ("clean up call") to repurchase all the remaining residential mortgages once the balance of the residential mortgages in the trust are reduced to 10% of the original balance of the residential mortgages in the trust, any remaining amounts in the trust are distributed. The current amount of any over-collateralization balance held by the trust is recorded as part of the retained interest.
In future periods, the Company will recognize additional revenue from the retained interest if the actual performance of the mortgage loans is higher than the original estimate or the Company may increase the estimated fair value of the retained interest. If the actual performance of the mortgage loans is lower than the original estimate, then an adjustment to the carrying value of the retained interest may be required if the estimated fair value of the retained interest is less than its carrying value.
NOTE 7. INTEREST RATE CAP AGREEMENTS
The amortized cost of the Company's interest rate cap agreements was $1.6 million net of accumulated amortization of $1.1 million and $674,000 net of accumulated amortization of $368,000 at December 31, 1999 and 1998, respectively.
Cap Agreements
The Company had four outstanding Cap Agreements at December 31, 1999 and 1998. Potential future earnings from each of these Cap Agreements are based on variations in the one month London Interbank Offered Rate ("LIBOR"). The Cap Agreements at December 31, 1999 and 1998 have contractually stated notional amounts which vary over the life of the Cap Agreements. Under these Cap Agreements the Company will receive cash payments should the agreed-upon reference rate, one month LIBOR, increase above the strike rates of the Cap Agreements. There was approximately $104 thousand in income for the year ended December 31, 1999 for Cap Agreements, offset by $797,000 in Cap Agreement amortization. No earnings were recognized in 1998 or 1997 for Cap Agreements.
All of the adjustable-rate mortgage securities and mortgage loans are limited by periodic caps (generally interest rate adjustments are limited to no more than 1% every six months) and lifetime interest rate caps.
Floor Agreements
The Company had no outstanding floor agreements at December 31, 1999. The Company had two outstanding floor agreements at December 31, 1998. Each of the floor agreements at December 31, 1998 have contractually stated notional amounts which vary over the life of the floor agreements. Under these floor agreements the Company will make cash payments should the agreed-upon reference rate, one month LIBOR, decrease below the strike rates of the floor agreements. Approximately $1.1 million floor agreement expense was included in hedge expense in 1999 and approximately $300,000 was recognized in 1998. No expense was recorded in 1997 for floor agreements.
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC., AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Interest rate agreements outstanding at December 31, 1999 and 1998 are as follows (dollars in thousands):
NOTE 8. SHORT-TERM DEBT
The Company has entered into reverse repurchase agreements with two lenders to finance the acquisition of Mortgage Loans. The Company has a $100 million committed and $100 million uncommitted agreement with Bear Stearns, expiring on July 31, 2000, and a $100 million committed agreement with Morgan Stanley Mortgage Corporation, Inc. which expires March 10, 2000. When the reverse repurchase agreements are in use, they are collateralized by a portion of the Company's Mortgage Loans.
At December 31, 1999 and 1998, the Company had approximately $119.0 million and $166.2 million, respectively of Mortgage Loans reverse repurchase agreements outstanding with a weighted average borrowing rate of 6.05% and 5.68%, respectively. The maximum month end balance and the average balance outstanding for the twelve months ended December 31, 1999 were approximately $406.0 million and $141.3 million, respectively. The maximum month end balance and the average balance outstanding for the twelve months ended December 31, 1998 were approximately $942.0 million and $499.2 million, respectively. The weighted average remaining maturity was one day for both 1999 and 1998.
At December 31, 1999 and 1998, the Mortgage Loans reverse repurchase agreements had the following characteristics (dollars in thousands):
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC., AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 9. LONG-TERM DEBT, NET
During the second quarter of 1998, AmRIT, through its wholly owned subsidiary, Eagle, issued approximately $457.0 million of collateralized mortgage bonds (Long-Term Debt) through a Financial Asset Securitization Investment Trust (FASIT). The bonds were assigned to a FASIT trust and trust certificates evidencing the assets of the trust were sold to investors. The trust certificates were issued in classes representing senior, mezzanine, and subordinate payment priorities. Payments received on single-family mortgage loans ("Bond Collateral") are used to make payments on the Long-Term Debt. The obligations under the Long Term Debt are payable solely from the Bond Collateral and are otherwise non-recourse to AmRIT. The maturity of each class of trust certificates is directly affected by the rate of principal repayments on the related Bond Collateral. The Long-Term Debt is also subject to redemption according to the specific terms of the indenture pursuant to which the bonds were issued and the FASIT trust. As a result, the actual maturity of the Long-Term Debt is likely to occur earlier than its stated maturity.
During the second quarter of 1999, AmRIT, through its wholly owned subsidiary, Eagle, issued approximately $229.0 million of a single class of mortgage backed notes (Long-Term Debt). The notes are principally secured by the assets of the trust, which consist primarily of fixed and adjustable rate mortgage loans secured by first liens on one- to four-family residential properties. Payments received on the mortgage loans ("Bond Collateral") are used to make payments on the Long-Term Debt. The obligations under the Long-Term Debt are payable solely from the Bond Collateral and are otherwise non-recourse to AmRIT. The maturity of the notes is directly affected by the rate of principal repayments on the related Bond Collateral. The Long-Term Debt is also subject to redemption according to the specific terms of the indenture pursuant to which the notes were issued. As a result, the actual maturity of the Long-Term Debt is likely to occur earlier than its stated maturity.
During the third quarter of 1999, AmRIT, through its wholly owned subsidiary, Eagle, issued approximately $394.1 million of Series 1999-2 mortgage backed bonds (Long-Term Debt) in two classes. The bonds are non-recourse obligations of a trust formed and wholly-owned by Eagle. The Class A-1 Bonds of approximately $332.4 million are secured by the assets of the trust, which consist of approximately $339.8 million in adjustable-rate mortgage loans secured by first liens on one- to four-family residential properties. The interest rate for the Class A-1 Bonds is variable based on one-month LIBOR. The Class A-2 Bonds of approximately $61.7 million are secured by approximately $63 million in fixed-rate mortgage loans secured by first liens on one- to four-family residential properties. The interest rate on the Class A-2 Bonds is 7.09%. Payments received on the mortgage loans securing the bonds ("Bond Collateral") are used to make payments on the Long-Term Debt. Payments received on the mortgage loans in excess of obligations due under the Long-Term Debt agreement are remitted to the Company on a monthly basis by the Bond Trustee. The obligations under the Long-Term Debt are payable solely from the Bond Collateral and are otherwise non-recourse to AmRIT. While the stated maturity of the bonds is July 25, 2029, the actual maturity of the bonds is directly affected by the rate of principal repayments on the related Bond Collateral. The Long-Term Debt is also subject to redemption by the Company according to the specific terms of the indenture pursuant to which the bonds were issued. As a result, the actual maturity of the Long-Term Debt is likely to occur earlier than its stated maturity.
During the third quarter of 1999, Greenwich Capital Financial Products, Inc. ("GCFP") conveyed to AmRIT, Mortgage Loans consisting of first lien, fully-amortizing, residential mortgage loans ("Mortgage Loans") with original terms to maturity of 30 years and an aggregate scheduled principal balance as of the close of business on August 1, 1999 of $335.2 million. AmRIT then conveyed an interest in the Mortgage Loans to Greenwich Financial Asset Securities Corp. in exchange for a specified cash sum and certain REMIC securities. Under generally accepted accounting principles, the transaction was treated as an issuance of Long Term Debt, Series 1999-A, secured by the Mortgage Loans. The Series 1999-A Long-Term Debt consists of two classes: Class A-1 which had an initial principal amount of approximately $335.2 million and
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC., AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Class S-1 which is an interest only class. The interest rate for the Class A-1 is variable based on the one-month LIBOR. The interest rate for the Class S-1 begins at 3.5%, declines by 0.5% each year for two years and then declines to 0.00% at the end of year three. The stated maturity for the Class A-1 is August, 2029, however, since the maturity of the debt is directly affected by the rate of principal repayments of the related Mortgage Loans, the actual maturity of the Class A-1 is likely to occur earlier than its stated maturity.
AmRIT conveyed to Eagle, which in turn conveyed to Eagle 2, AmRIT's remaining interest in the Mortgage Loans (subject to the Series 1999-A Long Term Debt) and received as payment a combination of cash and credit for an additional capital contribution. Pursuant to a Financing Agreement with GCFP, Eagle 2 pledged its interest in the Mortgage Loans as collateral to secure a term loan made to it by GCFP, and directed the Trustee to remit all collections, distributions or other income with respect to the Mortgage Loans (net of amounts due on the Series 1999-A Long Term Debt) directly to GCFP to prepay outstanding principal and interest.
The initial principal amount of the loan under the Financing Agreement was equal to 55% of the market value (as defined therein) of the Mortgage Loans (or approximately $7.1 million). To maintain a substantial level of over collateralization during the term of the loan, the Financing Agreement requires Eagle 2 to maintain a specified level of collateral (including the mortgage Loans and any additional collateral pledged by Eagle 2). In the event that the collateral value of the Mortgage Loans and other pledged collateral is determined to be less than required, GCFP may require Eagle 2 to deliver additional cash, securities or additional collateral or to repay principal in the amount of such deficiency; the failure to do so would constitute an event of default. The loan matures on February 26, 2001.
The components of the Long-Term Debt at December 31, 1999 and December 31, 1998, along with selected other information are summarized below (dollars in thousands):
Additionally, in conjunction with the 1999-A Securitization, the Company received additional financing from GCFP. At December 31, 1999, the balance of Long-Term-Debt was approximately $6.1 million. AmRIT has guaranteed the payment and performance when due (whether at stated maturity, by acceleration or otherwise) of all obligations of Eagle 2 to GCFP under the Financing Agreement.
NOTE 10. FAIR VALUE OF FINANCIAL INSTRUMENTS
The estimated fair value of financial instruments amounts have been determined by the Company's management using available market information and appropriate valuation methodologies; however, consider-
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC., AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
able judgement is necessarily required to interpret market data to develop estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. The fair value as of December 31, 1999 and 1998 is as follows (dollars in thousands):
The following describes the methods and assumptions used by the Company in estimating fair values.
Cash and Cash Equivalents
The carrying amount for cash and cash equivalents approximates fair value because these instruments are demand deposits and money market mutual funds and do not present unanticipated interest rate or credit concerns.
Retained Interest in Securitization
This security is classified as available-for-sale and as such is carried at fair value. See "Notes to the Consolidated Financial Statements -- Note 6. Retained Interest in Securitization" for a description of the valuation methodology.
Mortgage Securities available-for-sale and Mortgage Loans Held-for-Investment
The fair value for Mortgage Securities available-for-sale and Mortgage Loans and held-for-investment is estimated based on quoted market prices from dealers and brokers for similar types of Mortgage Assets.
The fair value for Bond Collateral is estimated based on quoted market prices from dealers and brokers for similar types of mortgage loans.
Interest Rate Cap Agreements
The fair value of interest rate cap agreements is estimated based on quoted market prices from dealers and brokers.
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC., AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Due from Affiliate
The fair value of due from affiliate approximates the carrying amount because of the short-term nature of the asset.
Short-Term Debt
The fair value of reverse repurchase agreements approximates the carrying amounts because of the short term nature of the liabilities.
Long-Term Debt
The fair value of long-term debt is estimated based upon comparable rates on similar debt instruments.
Due to Affiliate
The fair value of due to affiliate approximates the carrying amount because of the short-term nature of the liability.
NOTE 11. STOCK OPTION PLANS
The Company has adopted the 1997 Stock Incentive Plan (the "Incentive Plan") and the 1997 Stock Option Plan (the "Option Plan") for executive officers and key employees and has adopted the 1997 Outside Directors Option Plan (the "Directors Plan") for directors who are not employees of the Company.
The Incentive Plan, the Option Plan and the Directors Plan authorize the Board of Directors (or a committee appointed by the Board of Directors) to grant incentive stock options ("ISOs"), as defined under section 422 of the Code, options not so qualified ("NQSOs"), and stock appreciation rights ("SAR's") to such eligible recipients.
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC., AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
During the period from February 11, 1997 (commencement of operations) through December 31, 1999, the Company granted 1,021,100 options as follows:
The Incentive Plan was adopted on February 11, 1997 (the "Effective Date"), and a total 315,200 shares of common stock have been reserved for issuance. All stock options granted under the Incentive Plan vest at the earlier of a four-year period from the date of grant or once the Company issues an aggregate of $150 million of new equity, and will expire within ten years after the date of grant.
The Company also has adopted the 1997 Employee Stock Purchase Plan (the "Purchase Plan") which permits eligible employees to purchase common stock at a discount through accumulated payroll deductions. No shares were issued under the Purchase Plan as of December 31, 1999.
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC., AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
As of December 31, 1999, The following options were reserved for issuance under the Company's option plans:
In November 1995, the FASB issued Statement of Financial Accounting Standards No. 123 (SFAS 123), "Accounting for Stock Based Compensation." This statement establishes financial accounting standards for stock-based employee compensation plans. SFAS 123 permits the Company to choose either a new fair value based method or the current APB Opinion 25 Intrinsic value based method of accounting for its stock-based compensation arrangements. SFAS 123 requires pro forma disclosures of net income (loss) computed as if the fair value based method had been applied for in financial statements of companies that continue to follow current practice in accounting for such arrangements under Opinion 25. SFAS 123 applies to all stock-based employee compensation plans in which an employer grants shares of its stock or other equity instruments to employees except for employees stock ownership plans. SFAS 123 also applies to plans in which the employer incurs liabilities to employees in amounts based on the price of the employer's stock, i.e., stock option plans, stock purchase plans, restricted stock plans, and stock appreciation rights. The statement also specifies the accounting for transactions in which a company issues stock options or other equity instruments for services provided by non employees or to acquire goods or services from the outside supplies or vendors.
The Company elected to apply the APB Opinion 25 in accounting for its plans: the 1997 Stock Incentive Plan, 1997 Stock Option Plan, 1997 Employee Stock Purchase Plan and 1997 Outside Directors Stock Option Plan and, accordingly, no compensation cost has been recognized in the financial statements. Had the Company determined compensation cost based on the fair value at the grant date for its stock options exercisable under SFAS No. 123, the Company's net income (loss) and income (loss) per share for the years ended December 31, 1999 and 1998 and for the period from February 11, 1997 (commencement of operations) through December 31, 1997 would have decreased to the pro forma amounts indicated below (dollars in thousands except per share data):
The derived fair value of the options granted during the years ended December 31, 1999 and 1998 and the period from February 11, 1997 (commencement of operations) through December 31, 1997 was approximately $606,000, $46,000 and $1.1 million respectively, or a per option fair value of $1.52, $5.11 and $1.77 respectively, using the Black-Scholes option pricing model with the following assumptions for 1999;
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC., AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
a weighted average expected dividend yield of 13.63%, a weighted average risk-free interest rate of 5.53%, expected life of 5 years, and expected volatility of 60.89%, for 1998; a weighted average expected dividend yield of 7.46%, a weighted average risk-free interest rate of 5.52%, expected life of 5 years for employees and 4 years for board members, and expected volatility of 62%, and for 1997; a weighted average expected dividend yield of 7.36%, a weighted average risk-free interest rate of 5.59%, expected life of 5 years, and expected volatility of 20%.
NOTE 12. STOCKHOLDERS' EQUITY
On February 11, 1997, the Company issued 1,614,000 shares of common stock at a price of $12.50 per share of common stock. The Company received proceeds of approximately $20.2 million, net of issuance costs of $10,000. On November 3, 1997, the Company issued 6,500,000 shares of common stock at a price of $15.00 per share of common stock. The Company received proceeds of approximately $89.7 million, net of issuance costs of approximately $7.8 million. During 1998, the Company repurchased 58,500 shares of common stock. The Company paid approximately $492,000 for the repurchased shares.
On December 19, 1997, the Company declared a dividend of $1.3 million or $0.16 per share. The dividend was paid on January 21, 1998 to holders of record of common stock as of December 31, 1997. On October 21, 1997, the Company declared a dividend of $519,000 or $0.32 per share of common stock. This dividend was paid on October 29, 1997 to holders of record of common stock as of September 30, 1997. On July 17, 1997, the Company declared a dividend of $438,000 or $0.27 per share of common stock. This dividend was paid on July 17, 1997 to holders of record of common stock as of June 30, 1997. On May 1, 1997, the Company declared a dividend of $146,000 or $0.09 per share of common stock. This dividend was paid on May 1, 1997 to holders of record of common stock as of March 31, 1997.
On December 17, 1998, the Company declared a dividend of $1.2 million or $0.15 per share. The dividend was paid on January 28, 1999 to holders of record of common stock as of December 31, 1998. On October 15, 1998, the Company declared a dividend of $967,000 or $0.12 per share. This dividend was paid on November 2, 1998 to holders of record of common stock as of October 26, 1998. On July 13, 1998, the Company declared a dividend of $2.3 million or $0.28 per share. This dividend was paid on July 31, 1998 to holders of record of common stock as of July 24, 1998. On April 14, 1998, the Company declared a dividend of $2.3 million or $0.28 per share. This dividend was paid on April 30, 1998 to holders of record of common stock as of April 24, 1998.
On December 16, 1999, the Company declared a dividend of $2.4 million or $0.30 per share. The dividend was paid on January 31, 2000 to holders of record of common stock as of December 31, 1999. On October 21, 1999, the Company declared a dividend of $2.2 million or $0.27 per share dividend payable on November 8, 1999 to stockholders of record as of November 1, 1999. On July 21, 1999, the Company declared dividend of $2.0 million or $0.25 per share. The dividend was paid on August 6, 1999 to stockholders of record as of July 30, 1999. On April 22, 1999 the Company declared a dividend of $1.6 million or $0.20 per share. The dividend was paid on May 10, 1999 to stockholders of record as of May 3, 1999.
On February 8, 1999, the Company adopted a Stockholder Rights Plan ("the Plan") designed to enable all Company stockholders to realize the full value of their investment and to provide for fair and equal treatment for all stockholders in the event that an unsolicited attempt is made to acquire the Company. The adoption of the Plan is intended as a means to guard against any potential use of takeover tactics designed to gain control of the Company without paying all stockholders full and fair value for their stock. The distribution of the Rights is not in response to any proposal to acquire the Company and the Board is not aware of any such effort.
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC., AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
Under the Plan, stockholders will receive one Right to purchase one one-hundredth of a share of a new series of preferred stock for each outstanding share of the Company's common stock held of record at the close of business on February 26, 1999, or thereafter.
The Rights, which will trade with the common stock, become exercisable to purchase one one-hundredth of a share of the new preferred stock, at $30.00 per Right, when someone acquires 15% or more of the Company's common stock or announces a tender offer which could result in such person owning 15% or more of the common stock. Each one one-hundredth of a share of the new preferred stock has terms designed to make it substantially the economic equivalent of one share of common stock. The Rights can be redeemed by the Board for $0.01. Under certain circumstances, if someone acquires 15% or more of the common stock, the Rights permit stockholders other than the acquiror to purchase common stock having a market value of twice the exercise price of the Rights, in lieu of the preferred stock. In addition, in the event of certain business combinations, the Rights permit purchase of the common stock of an acquiror at a 50% discount. Rights held by the acquiror will become null and void in both cases. The rights expire on February 2, 2009. The Rights distribution will not be taxable to stockholders and will be issued to stockholders of record on February 26, 1999.
NOTE 13. STOCK SPLIT AND AUTHORIZED SHARES
On August 6, 1997, the Company authorized a 0.8-for-one reverse stock split of all of the outstanding shares of common stock. All references in the financial statements to the number of shares, per share amounts and prices of the Company's common stock have been retroactively restated to reflect the decreased number of shares of common stock outstanding. On October 20, 1997, the Company increased the number of total authorized shares of common stock to 25,000,000 from 4,000,000. Under the articles of incorporation, as amended on October 20, 1997, the Company is authorized to issue any class of capital stock, common stock or preferred stock, up to the aggregate authorized amount of 25,001,000 shares, all of which has been initially designated as common stock. All unissued shares may be reclassified by the Company's Board of Directors as one or more series of preferred stock.
NOTE 14. MANAGEMENT AGREEMENT
Effective February 11, 1997, the Company entered into a Management Agreement with the Manager for an initial term of two years, to provide management services to the Company. The agreement automatically renews unless terminated by AmRES.
The Manager receives management fees and incentive compensation as follows:
- 1/8 of 1% per year, to be paid monthly, of the principal amount of agency securities;
- 3/8 of 1% per year, to be paid monthly, of the principal amount of all Mortgage Loans other than agency securities; and
- 25% of the amount by which the Company's net income (before deducting the amount to be paid as incentive compensation) exceeds the annualized return on equity equal to the average ten year U.S. Treasury Rate plus 2%.
Management fees of approximately $3.5 million, $2.4 million and $249,000 were recorded for the years ended December 31, 1999, 1998 and for the period from February 11, 1997 (commencement of operations) through December 31, 1997, respectively. The incentive compensation is calculated for each fiscal quarter, and paid to the Manager quarterly in arrears before any income distributions are made to stockholders. There was no incentive compensation for the year ended December 31, 1999. For the year ended December 31, 1998, and for the period from February 11, 1997 (commencement of operations) through December 31, 1997 incentive compensation was approximately $24,000 and $34,000, incentive compensation, respectively.
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC., AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
The Company will employ certain employees of the Manager involved in the day-to-day operations of the Company, including the Company's executive officers, so that such employees may maintain certain benefits that are available only to employees of the Company under the Code. These benefits include the ability to receive incentive stock options under the 1997 Stock Option Plan and to participate in the Company's Employee Stock Purchase Plan. In order to receive the aggregate benefits of the Management Agreement originally negotiated between the Company and the Manager, the Company will pay the base salaries of such employees and will be reimbursed by the Manager for all costs incurred with respect to such payments.
The Manager's default on certain debt, could result in a default and termination of the Management Agreement, in which case the operations of the Company could be materially and adversely affected pending either the engagement of a new manager or the development internally of the resources necessary to manage the operation of the Company. The Manager is currently in default of certain debt covenants. The senior note holders have not issued waivers, however the parties continue to operate under the original terms of the Management Agreement. In addition, MDC Reit Holdings, LLC ("MDC-REIT") has pledged 1.6 million shares of its common stock of the Company to secure the Manager's obligations under the Securities Purchase Agreement. As a result of the defaults under the Securities Purchase Agreement, the pledged shares could be transferred to the holders of the Notes, who will then have certain demand registration rights.
NOTE 15. RELATED PARTY TRANSACTIONS
During the year ended December 31, 1998, the Company purchased approximately $24 million of Mortgage Loans from an affiliated entity of one of its directors. These purchases were made in the normal course of business at terms consistent with the Company's general purchasing policies.
On June 1, 1998, the Company sold approximately $98.2 million par value Mortgage Loans to Holdings for total consideration of $103.5 million. Management believes the loans were sold at fair value at the time of the transaction.
On June 30, 1998, Holdings transferred the Class "X" Certificate to the Company as part of the purchase price of Mortgage Loans purchased from the Company on June 1, 1998. The Class "X" Certificate had a fair value of $6.6 million at the time of the transfer.
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC., AND SUBSIDIARIES
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)
NOTE 16. SELECTED QUARTERLY FINANCIAL DATA
Selected quarterly financial data for 1999 and 1998 is as follows (dollars in thousands, except per share data):
NOTE 17. COMMITMENTS AND CONTINGENCIES
On January 28, 2000, the Company sold $66.0 million in Mortgage Loans Held-for-Investment back to the originator that sold these loans to the Company during the fourth quarter of 1999. Certain irregularities were discovered during the Company's routine post-funding quality control review related to underwriting compliance and loan documents. The buyback was pursuant to certain representations and warranty obligations of the originator related to underwriting criteria and regulatory compliance.
SIGNATURES
Pursuant to the requirements of the Securities Act of 1933, the Registrant certifies that it has reasonable grounds to believe that it meets all of the requirements for filing on Form 10-K and has duly caused this Form 10-K to be signed on its behalf by the undersigned, thereto duly authorized, in the City of San Diego, State of California, on the 30th day of March, 2000.
AMERICAN RESIDENTIAL INVESTMENT TRUST, INC.
By: /s/ JOHN M. ROBBINS ------------------------------------------- John M. Robbins Chief Executive Officer
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