ITEM 1. BUSINESS
GENERAL
Thornburg Mortgage Asset Corporation and subsidiaries (the "Company") is a mortgage acquisition company that primarily invests in adjustable-rate mortgage ("ARM") assets comprised of ARM securities and ARM loans, thereby indirectly providing capital to the single family residential housing market. In 1998, the Company began investing in hybrid ARM assets ("Hybrid ARMs") which are included in the Company's references to ARM securities and ARM loans. Hybrid ARMs have a fixed rate of interest for an initial period, generally 3 to 5 years, and then convert to an adjustable-rate for the balance of the term of the Hybrid ARM and are funded with long-term debt obligations such that the debt obligations mature within one year of the first interest rate reset date of the Hybrid ARMs. ARM securities represent interests in pools of ARM loans, which often include guarantees or other credit enhancements against losses from loan defaults. While the Company is not a bank or savings and loan, its business purpose, strategy, method of operation and risk profile are best understood in comparison to such institutions. The Company leverages its equity capital using borrowed funds, invests in ARM assets and seeks to generate income based on the difference between the yield on its ARM assets portfolio and the cost of its borrowings. The corporate structure of the Company differs from most lending institutions in that the Company is organized for tax purposes as a real estate investment trust ("REIT") and therefore generally passes through substantially all of its earnings to shareholders without paying federal or state income tax at the corporate level. See "Federal Income Tax Considerations -- Requirements for Qualification as a REIT". During 1998, in connection with the Company's issuance of $1.1 billion of callable AAA notes, the Company formed two REIT qualified subsidiaries. These subsidiaries are consolidated in the Company's financial statements and federal and state tax returns.
OPERATING POLICIES AND STRATEGIES
Investment Strategies
The Company's investment strategy is to purchase ARM securities and ARM loans originated and serviced by other mortgage lending institutions. Increasingly, mortgage lending is being conducted by mortgage lenders who specialize in the origination and servicing of mortgage loans and then sell these loans to other mortgage investment institutions, such as the Company. The Company believes it has a competitive advantage in the acquisition and investment of these mortgage securities and mortgage loans because of the low cost of its operations relative to traditional mortgage investors like banks and savings and loans. Like traditional financial institutions, the Company seeks to generate income for distribution to its shareholders primarily from the difference between the interest income on its ARM assets and the financing costs associated with carrying its ARM assets.
The Company purchases ARM assets from broker-dealers and financial institutions that regularly make markets in these assets. The Company also purchases ARM assets from other mortgage suppliers, including mortgage bankers, banks, savings and loans, investment banking firms, home builders and other firms involved in originating, packaging and selling mortgage loans.
The Company's mortgage assets portfolio may consist of either agency or privately issued securities (generally publicly registered) mortgage pass-through securities, multiclass pass-through securities, collateralized mortgage obligations ("CMOs"), collateralized bond obligations ("CBOs"), generally backed by high quality mortgage backed securities, ARM loans, Hybrid ARMs or short-term investments that either mature within one year or have an interest rate that reprices within one year. The Company will not invest more than 30% of its ARM assets in Hybrid ARMs and will limit its interest rate repricing mismatch (the difference between the remaining fixed-rate period of a Hybrid ARM and the maturity of the fixed-rate liability funding a Hybrid ARM) to no more than one year.
The Company's investment policy is to invest at least 70% of total assets in High Quality adjustable and variable rate mortgage securities and short-term investments. High Quality means:
(1) securities that are unrated but are guaranteed by the U.S. Government or issued or guaranteed by an agency of the U.S. Government; (2) securities which are rated within one of the two highest rating categories by at least one of either Standard & Poor's or Moody's Investors Service, Inc. (the "Rating Agencies"); or (3) securities that are unrated or whose ratings have not been updated but are determined to be of comparable quality (by the rating standards of at least one of the Rating Agencies) to a High Quality rated mortgage security, as determined by the Manager (as defined below) and approved by the Company's Board of Directors; or (4) the portion of ARM or hybrid loans that have been deposited into a trust and have received a credit rating of AA or better from at least one Rating Agency.
The remainder of the Company's ARM portfolio, comprising not more than 30% of total assets, may consist of Other Investment assets, which may include:
(1) adjustable or variable rate pass-through certificates, multi-class pass-through certificates or CMOs backed by loans on single-family, multi-family, commercial or other real estate-related properties so long as they are rated at least Investment Grade at the time of purchase. "Investment Grade" generally means a security rating of BBB or Baa or better by at least one of the Rating Agencies; (2) ARM loans secured by first liens on single-family residential properties, generally underwritten to "A" quality standards, and acquired for the purpose of future securitization (see description of "A" quality in "Portfolio of Mortgage Assets - ARM and Hybrid ARM Loans"); or (3) a limited amount, currently $70 million as authorized by the Board of Directors, of less than investment grade classes of ARM securities that are created as a result of the Company's loan acquisition and securitization efforts.
Since inception, the Company has generally invested less than 15%, currently approximately 4%, of its total assets in Other Investment assets, excluding loans held for securitization. Despite the generally higher yield, the Company does not expect to significantly increase its investment in Other Investment securities. This is primarily due to the difficulty of financing such assets at reasonable financing terms and values through all economic cycles. Since the Company has never had a large investment in Other Investment securities and believes it has always been very selective and cautious regarding these investments, this adjustment to the Company's investment strategy is not expected to have a material impact on the Company's operating results.
The Company does not invest in REMIC residuals or other CMO residuals and, therefore does not create excess inclusion income or unrelated business taxable income for tax exempt investors. Therefore, the Company is a mortgage REIT eligible for purchase by tax exempt investors, such as pension plans, profit sharing plans, 401(k) plans, Keogh plans and Individual Retirement Accounts ("IRAs").
Acquisition of ARM and Hybrid ARM Loans
The Company acquires existing pools of ARM loans and intends to begin acquiring individual loans directly from loan originators for future securitization. Acquiring ARM loans for future securitization is expected to benefit the Company by providing: (i) greater control over the types of ARM loans originated; (ii) the ability to acquire ARM loans at lower prices so that the amount of the premium to be amortized will be reduced in the event of prepayment; (iii) additional sources of new whole-pool ARM assets; and (iv) potentially higher yielding investments in its portfolio.
The Company acquires residential ARM and Hybrid ARM whole loans utilizing two processes which the Company calls the Bulk Acquisition Method ("Bulk Method") and the Flow Acquisition Method ("Flow Method"). The Bulk Method, which the Company began utilizing in 1997, involves a number of the Company's established relationships with mortgage originators, or mortgage aggregators, who sell the Company pools of whole loans at market prices, with the servicing rights, generally, remaining with the originator or seller. In cases where the Company buys the servicing rights along with the loans, the Company contracts with a qualified loan servicer to perform the loan servicing function for a fee. In this Bulk Method, the loans are originated using the seller's loan products and programs, and the credit review of the borrower and the appraisal of the property and the quality control procedures are performed by the originators.
The Company only considers the purchase of loans when all of the borrowers have had their incomes verified, their credit checked, their assets verified and appraisals of the properties have been obtained. The Company then obtains an independent underwriter's review, performed by a third party for the benefit of the Company, which entails a review of the processes and closing method used by the originators in verifying the borrower credit as well as a review of the property valuation. In addition, the Company will, at the request of the third party credit review providers, utilize its own personnel to re-review some of the individual loans in order to insure the highest possible loan quality. The Company generally selects loans for underwriting review based upon specific criteria such as property location, loan size, effective loan-to-value ratios, borrowers' credit scoring and other criteria the Company believes to be important indicators of credit risk. Additionally, prior to the purchase of loans, the Company obtains representations and warranties from each seller stating that each loan meets the Company's underwriting standards and other requirements. The breach of such representations and warranties in regards to a loan can result in the seller having an obligation to repurchase the loan.
In the Flow Method, which the Company will begin utilizing in the first half of 1999, the Company acquires mortgage loans using the Company's specific loan programs and underwriting criteria. This means that the originator/seller originates the individual loans using the Company's established credit and program guidelines. All program participants, (originators/sellers), are screened by the Company as to their financial strength as well as to their own established in-house mortgage procedures. The credit of each borrower and the value of each property is underwritten by the originators and are subject to the quality control procedures of the originators. This is the same process used by originators/sellers in the Bulk Method except that all of the credit and appraisal guidelines have been developed and designed by the Company to meet the Company's own credit criteria and portfolio requirements. All of the loans are then subjected to further credit review by mortgage insurance companies that also use the Company's guidelines to insure product quality and compliance to the Company's guidelines. The three mortgage insurance companies chosen by the Company to perform this function use a two-step loan approval process. After the credit review and quality control review are performed by the originator/seller, but prior to the purchase of the loans by the Company, all of the loans are placed through an automated underwriting system created by the Federal National Mortgage Association ("Fannie Mae") called "Desktop Underwriter." This is the same system used by Fannie Mae in connection with all of their own loan purchases. Secondly, all loans that pass the Desktop Underwriter test are then screened by the mortgage insurance company personnel as to their compliance to the Company's guidelines. A select number of these loans are then subjected to an additional quality control procedure performed by a third party. Additionally, all of the loans acquired through the Flow Method are assigned a "Risk Evaluation Score" or "Mortgage Score" by each of the mortgage insurance companies. The risk score evaluates not only the borrower's credit but also the geographic location of the property, the economic viability of the area, the general market conditions and the loan product chosen by the borrower. The Company believes that obtaining risk scores will help in reducing the Company's securitization costs by insuring that the Company purchases the highest quality mortgage loans with the lowest risk possible. As in the Bulk Method, mortgage loans acquired through the Flow Method are acquired, generally, with the servicing rights remaining with the originator/seller. As with the Bulk Method, in cases where the Company buys the servicing rights along with the loans, the Company contracts with a qualified loan servicer to perform the loan servicing function for a fee. The Company obtains representations and warranties from each seller or program participant stating that each loan meets the Company's underwriting standards and other requirements. As in the Bulk Method, the breach of such representations and warranties in regards to a loan can result in the seller having an obligation to repurchase the loan.
In both methods the Company uses its in-house staff as well as third party due diligence providers to verify the credit quality of the borrowers as well as the soundness of the mortgage collateral securing the individual loans. As added security, the Company uses the services of a third party document custodian to insure the quality and accuracy of all individual mortgage loan documents which are then held in safekeeping with the third-party document custodian. As a result, all of the original individual loan documents that are signed by the borrower, other than the original credit verification documents, are examined and verified by the custodian.
Securitization of ARM and Hybrid ARM Loans
The Company acquires ARM and Hybrid ARM loans for its portfolio with the intention of securitizing them in such a way as to maximize the amount of high quality assets that can be created from an accumulation of the ARM and Hybrid ARM loans. In order to facilitate the securitization of its loans, the Company intends to create and retain a subordinate interest in the loans, to provide a limited amount of credit enhancement, and then to purchase an insurance policy from a third party financial guarantor that will "wrap" the remaining balance of the loans to a credit rating of AA or better. Upon securitization, the Company then plans to either own the high quality ARM certificates and the subordinate certificates in its portfolio and finance the high quality certificates in the repurchase agreement market, or to utilize such ARM assets to collateralize capital markets issued debt obligations with a credit rating of AA or better from a Rating Agency as an alternative financing source to the repurchase agreement market.
Financing Strategies
The Company employs a leveraging strategy to increase its assets by borrowing against its ARM assets and then using the proceeds to acquire additional ARM assets. By leveraging its portfolio in this manner, the Company expects to maintain an equity-to-assets ratio between 8% to 10%, when measured on a historical cost basis. The Company believes that this level of capital is sufficient to allow the Company to continue to operate in interest rate environments in which the Company's borrowing rates might exceed its portfolio yield. These conditions could occur when the interest rate adjustments on the ARM assets lag the interest rate increases in the Company's variable rate borrowings or when the interest rate of the Company's variable rate borrowings are mismatched with the interest rate indices of the Company's ARM assets. The Company also believes that this capital level is adequate to protect the Company from having to sell assets during periods when the value of its ARM assets are declining. During the fourth quarter of 1998, the Company did sell some assets in order to increase its equity ratio from approximately 8% to over 9%, which under the market conditions at the time was a more appropriate level. If the ratio of the Company's equity-to-total assets, measured on a historical cost basis, falls below 8%, the Company will take action to increase its equity-to-assets ratio to 8% of total assets or greater, when measured on a historical cost basis, through normal portfolio amortization, raising equity capital, sale of assets or other steps as necessary.
The Company's ARM assets are financed primarily at short-term borrowing rates and can be financed utilizing reverse repurchase agreements, dollar-roll agreements, borrowings under lines of credit and other secured or unsecured financings which the Company may establish with approved institutional lenders. Prior to 1998, reverse repurchase agreements had been the primary source of financing utilized by the Company to finance its ARM assets. In 1998, the Company issued $1.1 billion of callable AAA rated notes in addition to utilizing reverse repurchase agreements to finance its assets. Generally, upon repayment of each reverse repurchase agreement, the ARM assets used to collateralize the financing will immediately be pledged to secure a new reverse repurchase agreement. The Company has established lines of credit and collateralized financing agreements with twenty-four different financial institutions.
Reverse repurchase agreements take the form of a simultaneous sale of pledged assets to a lender at an agreed upon price in return for the lender's agreement to resell the same assets back to the borrower at a future date (the maturity of the borrowing) at a higher price. The price difference is the cost of borrowing under these agreements. In the event of the insolvency or bankruptcy of a lender during the term of a reverse repurchase agreement, provisions of the Federal Bankruptcy Code, if applicable, may permit the lender to consider the agreement to resell the assets to be an executory contract that, at the lender's option, may be either assumed or rejected by the lender. If a bankrupt lender rejects its obligation to resell pledged assets to the Company, the Company's claim against the lender for the damages resulting therefrom may be treated as one of many unsecured claims against the lender's assets. These claims would be subject to significant delay and, if and when payments are received, they may be substantially less than the damages actually suffered by the Company. To mitigate this risk the Company enters into collateralized borrowings with only financially sound institutions approved by the Board of Directors, including a majority of unaffiliated directors, and monitors the financial condition of such institutions on a regular, periodic basis.
The Company, commencing in 1998, also utilizes capital market transactions by issuing debt collateralized by specific pools of ARM assets that are placed in a trust. The financing of ARM assets in this way eliminates the risk of margin calls on the financing of those ARM assets and limits the Company's exposure to credit risk on the ARM and Hybrid ARM loans collateralizing such debt. The Company receives a credit rating on the debt based on the quality of the ARM assets, amount of any credit enhancement obtained and subordination levels of the debt proscribed by the rating agency(ies), all of which affects the interest rate at which the debt can be issued. The principal and interest payments on the debt are paid by the trust out of the cash flows received on the collateral. By utilizing such a structure, the Company can issue either floating rate debt indexed to various indices that more closely matches the characteristics of the collateralized ARM assets, depending upon market constraints and conditions, or fixed rate debt that corresponds to the characteristics of collateralized Hybrid ARM loans.
The Company also enters into financing facilities for whole loans. The Company uses these credit lines to finance its acquisition of whole loans while it is accumulating loans for securitization or until more permanent financing is arranged in a capital markets collateralized debt transaction. In 1998, the Company utilized two whole loan financing facilities that provided the Company with uncommitted lines of credit based on the market value of its whole loans. Uncommitted lines of credit are generally less expensive than a committed line of credit, but during periods of market turmoil, uncommitted lines of credit can be terminated by the counterparty with little notice to the Company and at a time when the Company would have difficulty in replacing the line of credit. Therefore, beginning in 1999, the Company has decided to negotiate and pay a fee for committed facilities as well as continue to utilize uncommitted facilities. During January 1999, the Company entered into one committed facility in the amount of $150,000,000, which the Company can increase to $300,000,000 for an additional fee, and is negotiating a number of other committed and uncommitted facilities.
The Company mitigates its interest-rate risk from borrowings by selecting maturities that approximately match the interest-rate adjustment periods on its ARM assets. Accordingly, borrowings bear variable or short-term fixed (one year or less) interest rates. Generally, the borrowing agreements require the Company to deposit additional collateral in the event the market value of existing collateral declines, which, in dramatically rising interest rate markets, could require the Company to sell assets to reduce the borrowings.
The Company's Bylaws limit borrowings, excluding the collateralized borrowings in the form of reverse repurchase agreements, dollar-roll agreements and other forms of collateralized borrowings discussed above, to no more than 300% of the Company's net assets, on a consolidated basis, unless approved by a majority of the unaffiliated directors. This limitation generally applies only to unsecured borrowings of the Company. For this purpose, the term "net assets" means the total assets (less intangibles) of the Company at cost, before deducting depreciation or other non-cash reserves, less total liabilities, as calculated at the end of each quarter in accordance with generally accepted accounting principles. Accordingly, the 300% limitation on unsecured borrowings does not affect the Company's ability to finance its total assets with collateralized borrowings.
Hedging Strategies
The Company makes use of hedging transactions to mitigate the impact of certain adverse changes in interest rates on its net interest income. In general, ARM assets have a maximum lifetime interest rate cap, or ceiling, meaning that each ARM asset contains a contractual maximum rate. The borrowings incurred by the Company to finance its ARM assets portfolio are not subject to equivalent interest rate caps. Accordingly, the Company purchases interest rate cap agreements ("Cap Agreements") to prevent the Company's borrowing costs from exceeding the lifetime maximum interest rate on its ARM assets. These Cap Agreements have the effect of offsetting a portion of the Company's borrowing costs if prevailing interest rates exceed the rate specified in the Cap Agreement. A Cap Agreement is a contractual agreement for which the Company pays a fee, which may at times be financed, typically to either a commercial bank or investment banking firm. Pursuant to the terms of the Cap Agreements owned as of December 31, 1998, the Company will receive cash payments if the one-month, three-month or six-month LIBOR index increases above certain specified levels, which range from 7.50% to 13.00% and average approximately 10.10%. The fair value of these Cap Agreements also tends to increase when general market interest rates increase and decrease when market interest rates decrease, helping to partially offset changes in the fair value of the Company's ARM assets.
In addition, ARM assets are generally subject to periodic caps. Periodic caps generally limit the maximum interest rate coupon change on any interest rate coupon adjustment date to either a maximum of 1% per semiannual adjustment or 2% per annual adjustment. The borrowings incurred by the Company do not have similar periodic caps. The Company generally does not hedge against the risk of its borrowing costs rising above the periodic interest rate cap level on the ARM assets because the contractual future interest rate adjustments on the ARM assets will cause their interest rates to increase over time and reestablish the ARM assets' interest rate to a spread over the then current index rate. The Company attempts to mitigate the effect of periodic caps in several ways. First, the yield on the Company's ARM assets can change by more that the 1% or 2% per periodic interest rate adjustment limitation depending upon how prepayment activity changes as interest rates change. Secondly, during 1998, the Company began to acquired variable rate CMOs and CBOs ("Floaters"), Hybrid ARMs and certain other ARM loans that do not have a periodic cap. As of December 31, 1998, approximately $622.9 million of the Company's ARM securities and $909.2 million of the Company's ARM loans did not have periodic caps or were Hybrid ARMs, representing approximately 36% of total ARM assets.
The Hybrid ARMs have an initial fixed rate period, generally 3 to 5 years. Since the Company's borrowings are generally short-term, the Company enters into interest rate swap agreements that hedge a portion of the fixed rate period, so that the unhedged fixed rate period is no more than one year. In accordance with the terms of these swap agreements, the Company pays a fixed rate of interest during the term of the agreements, and receives a payment that varies monthly with the one month LIBOR Index. Due to the longer term nature of these agreements and because the hedged Hybrid ARMs are amortizing based on homeowner scheduled payments and unscheduled prepayments, the Company generally enters into both a swap that amortizes at an agreed upon single prepayment rate and an additional swap that amortizes at a prepayment rate which the Company has the option to change monthly within a range of rates.
The Company also enters into interest rate swap agreements to manage the average interest rate reset period on its borrowings. In accordance with the terms of the swap agreements, the Company pays a fixed rate of interest during the term of the agreements and receives a payment that varies monthly with the one month LIBOR Index. These agreements have the effect of fixing the Company's borrowing costs on a similar amount of swaps owned by the Company and, as a result, the Company reduces the interest rate variability of its borrowings. The Company may also use interest rate swap agreements from time to time to change from one interest rate index to another interest rate index and thus decrease further the basis risk between the Company's interest yielding assets and the financing of such assets.
The ARM assets held by the Company were generally purchased at prices greater than par. The Company is amortizing the premiums paid for these assets over their expected lives using the level yield method of accounting. To the extent that the prepayment rate on the Company's ARM assets differs from expectations, the Company's net interest income will be affected. Prepayments generally increase when mortgage interest rates fall below the interest rates on ARM loans. To the extent there is an increase in prepayment rates, resulting in a shortening of the expected lives of the Company's ARM assets, the Company's net income and, therefore, the amount available for dividends could be adversely affected. To mitigate the adverse effect of an increase in prepayments on the Company's ARM assets, the Company has purchased ARM assets at prices at or below par, however the Company's portfolio of ARM assets is currently held at a net premium. The Company may also purchase limited amounts of "principal only" mortgage derivative assets backed by either fixed-rate mortgages or ARM assets as a hedge against the adverse effect of increased prepayments. To date, the Company has not purchased any "principal only" mortgage derivative assets.
The Company may enter into other hedging-type transactions designed to protect its borrowings costs or portfolio yields from interest rate changes. Such transactions may include the purchase or sale of interest rate futures contracts or options on interest rate futures contracts. The Company may also purchase "interest only" mortgage derivative assets or other derivative products for purposes of mitigating risk from interest rate changes. The Company has not, to date, entered into these types of transactions, but may do so in the future. The Company will not invest in any futures transactions unless the Company and Thornburg Mortgage Advisory Corporation (the "Manager") are exempt from the registration requirements of the Commodities Exchange Act or otherwise comply with the provisions of that Act.
Hedging transactions currently utilized by the Company generally are designed to protect the Company's net interest income during periods of rising market interest rates. The Company does not intend to hedge for speculative purposes. Further, no hedging strategy can completely insulate the Company from risk, and certain of the federal income tax requirements that the Company must satisfy to qualify as a REIT limit the Company's ability to hedge, particularly with respect to hedging against periodic cap risk. The Company carefully monitors and may have to limit its hedging strategies to ensure that it does not realize excessive hedging income, or hold hedging assets having excess value in relation to total assets. See "Federal Income Tax Considerations - Requirements for Qualification as a REIT".
Operating Restrictions
The Board of Directors has established the Company's operating policies and any revisions in the operating policies and strategies require the approval of the Board of Directors, including a majority of the unaffiliated directors. Except as otherwise restricted, the Board of Directors has the power to modify or alter the operating policies without the consent of shareholders. Developments in the market which affect the operating policies and strategies mentioned herein or which change the Company's assessment of the market may cause the Board of Directors (including a majority of the unaffiliated directors) to revise the Company's operating policies and financing strategies.
In the event the rating of an ARM security held by the Company is reduced by the Rating Agencies to below Investment Grade after acquisition by the Company, the asset may be retained in the Company's investment portfolio if the Manager recommends that it be retained and the recommendation is approved by the Board of Directors (including a majority of the unaffiliated directors).
The Company has elected to qualify as a REIT for tax purposes. The Company has adopted certain compliance guidelines which include restrictions on the acquisition, holding and sale of assets. Prior to the acquisition of any asset, the Company determines whether such asset will constitute a "Qualified REIT Asset" as defined by the Internal Revenue Code of 1986, as amended (the "Code"). Substantially all the assets that the Company has acquired and will acquire for investment are expected to be Qualified REIT Assets. This policy limits the investment strategies that the Company may employ.
The Company closely monitors its purchases of ARM assets and the income from such assets, including from its hedging strategies, so as to ensure at all times that it maintains its qualification as a REIT. The Company developed certain accounting systems and testing procedures with the help of qualified accountants and tax experts to facilitate its ongoing compliance with the REIT provisions of the Code. See "Federal Income Tax Considerations - Requirements for Qualification as a REIT". No changes in the Company's investment policies and operating policies and strategies, including credit criteria for mortgage asset investments, may be made without the approval of the Company's Board of Directors, including a majority of the unaffiliated directors.
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. The Investment Company Act exempts entities that are "primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate" ("Qualifying Interests"). Under current interpretation of the staff of the SEC, in order to qualify for this exemption, the Company must maintain at least 55% of its assets directly in Qualifying Interests. In addition, unless certain mortgage assets represent all the certificates issued with respect to an underlying pool of mortgages, such mortgage assets may be treated as assets separate from the underlying mortgage loans and, thus, may not be considered Qualifying Interests for purposes of the 55% requirement. The Company closely monitors its compliance with this requirement and intends to maintain its exempt status. Up to the present, the Company has been able to maintain its exemption through the purchase of whole pool government agency and privately issued ARM securities and loans that qualify for the exemption. See "Portfolio of Mortgage Assets - Pass-Through Certificates - Privately Issued ARM Pass-Through Certificates".
The Company does not purchase any assets from or enter into any servicing or administrative agreements (other than the Management Agreement) with any entities affiliated with the Manager. Any changes in this policy would be subject to approval by the Board of Directors, including a majority of the unaffiliated directors.
PORTFOLIO OF MORTGAGE ASSETS
As of December 31, 1998, ARM assets comprised approximately 98% of the Company's total assets. The Company has invested in the following types of mortgage assets in accordance with the operating policies established by the Board of Directors and described in "Business - Operating Policies and Strategies - Operating Restrictions".
PASS-THROUGH CERTIFICATES
The Company's investments in mortgage assets are concentrated in High Quality ARM pass-through certificates which account for approximately 90% of ARM assets held. These High Quality ARM pass-through certificates consist of Agency Certificates and privately issued ARM pass-through certificates that meet the High Quality credit criteria. These High Quality ARM pass-through certificates acquired by the Company represent interests in ARM loans which are secured primarily by first liens on single-family (one-to-four units) residential properties, although the Company may also acquire ARM pass-through certificates secured by liens on other types of real estate-related properties. The Company also includes in this category of assets a portion of the ARM and Hybrid ARM loans that have been deposited in a trust and held as collateral for its AAA notes payable in the amount equivalent to the AAA portion of the debt issued by the trust. The ARM pass-through certificates, including the ARM and Hybrid ARM loans collateralizing AAA notes payable, acquired by the Company are generally subject to periodic interest rate adjustments, as well as periodic and lifetime interest rate caps which limit the amount an ARM security's interest rate can change during any given period.
The following is a discussion of each type of pass-through certificate held by the Company as of December 31, 1998:
FHLMC ARM Programs
FHLMC is a shareholder-owned government sponsored enterprise created pursuant to an Act of Congress on July 24, 1970. The principal activity of FHLMC consists of the purchase of first lien, conventional residential mortgages, including both whole loans and participation interests in such mortgages and the resale of the loans and participations in the form of guaranteed mortgage assets. During 1998, FHLMC issued $7.2 billion of FHLMC ARM certificates and as of December 31, 1998, there was $37.5 billion of all types of FHLMC ARM certificates outstanding, of which FHLMC held $9.8 billion in its own portfolio.
Each FHLMC ARM Certificate issued to date has been issued in the form of a pass-through certificate representing an undivided interest in a pool of ARM loans purchased by FHLMC. The ARM loans included in each pool are fully amortizing, conventional mortgage loans with original terms to maturity of up to 40 years secured by first liens on one-to-four unit family residential properties or multi-family properties. The interest rate paid on FHLMC ARM Certificates adjust periodically on the first day of the month following the month in which the interest rates on the underlying mortgage loans adjust.
FHLMC guarantees to each holder of its ARM Certificates the timely payment of interest at the applicable pass-through rate and ultimate collection of all principal on the holder's pro rata share of the unpaid principal balance of the related ARM loans, but does not guarantee the timely payment of scheduled principal of the underlying mortgage loans. The obligations of FHLMC under its guarantees are solely those of FHLMC and are not backed by the full faith and credit of the U.S. Government. If FHLMC were unable to satisfy such obligations, distributions to holders of FHLMC ARM Certificates would consist solely of payments and other recoveries on the underlying mortgage loans and, accordingly, monthly distributions to holders of FHLMC ARM Certificates would be affected by delinquent payments and defaults on such mortgage loans.
FNMA ARM Programs
FNMA is a federally chartered and privately owned corporation organized and existing under the Federal National Mortgage Association Charter Act. FNMA provides funds to the mortgage market primarily by purchasing home mortgage loans from mortgage loan originators, thereby replenishing their funds for additional lending. FNMA established its first ARM programs in 1982 and currently has several ARM programs under which ARM certificates may be issued, including programs for the issuance of assets through REMICs under the Code. During 1998, FNMA issued $14.0 billion of FNMA ARM certificates and as of December 31, 1998, there was $59.0 billion of all types of FNMA ARM certificates outstanding, of which FNMA held $11.9 billion in its own portfolio.
Each FNMA ARM Certificate issued to date has been issued in the form of a pass-through certificate representing a fractional undivided interest in a pool of ARM loans formed by FNMA. The ARM loans included in each pool are fully amortizing conventional mortgage loans secured by a first lien on either one-to-four family residential properties or multi-family properties. The original terms to maturities of the mortgage loans generally do not exceed 40 years. FNMA has issued several different series of ARM Certificates. Each series bears an initial interest rate and margin tied to an index based on all loans in the related pool, less a fixed percentage representing servicing compensation and FNMA's guarantee fee.
FNMA guarantees to the registered holder of a FNMA ARM Certificate that it will distribute amounts representing scheduled principal and interest (at the rate provided by the FNMA ARM Certificate) on the mortgage loans in the pool underlying the FNMA ARM Certificate, whether or not received, and the full principal amount of any such mortgage loan foreclosed or otherwise finally liquidated, whether or not the principal amount is actually received. The obligations of FNMA under its guarantees are solely those of FNMA and are not backed by the full faith and credit of the U.S. Government. If FNMA were unable to satisfy such obligations, distributions to holders of FNMA ARM Certificates would consist solely of payments and other recoveries on the underlying mortgage loans and, accordingly, monthly distributions to holders of FNMA ARM Certificates would be affected by delinquent payments and defaults on such mortgage loans.
Privately Issued ARM Pass-Through Certificates
Privately issued ARM Pass-Through Certificates are structured similar to the Agency Certificates discussed above but are issued by originators of, and investors in, mortgage loans, including savings and loan associations, savings banks, commercial banks, mortgage banks, investment banks and special purpose subsidiaries of such institutions. Privately issued ARM pass-through certificates are usually backed by a pool of non-conforming conventional adjustable-rate mortgage loans and are generally structured with one or more types of credit enhancement, including pool insurance, guarantees, or subordination. Accordingly, the privately issued ARM pass-through certificates typically are not guaranteed by an entity having the credit status of FHLMC or FNMA.
Privately issued ARM pass-through certificates credit enhanced by mortgage pool insurance provide the Company with an alternative source of ARM assets (other than Agency ARM assets) that meet the Qualifying Interests test for purposes maintaining the Company's exemption under the Investment Company Act of 1940. Since the inception of the Company in 1993, most of the providers of mortgage pool insurance have stopped providing such insurance. Therefore, the Company has increased its investment in Agency ARM securities and in whole loans as its primary sources of Qualifying Interests in real estate.
COLLATERALIZED MORTGAGE OBLIGATIONS ("CMOS"), COLLATERALIZED BOND OBLIGATIONS ("CBOS") AND MULTICLASS PASS-THROUGH ASSETS
CMOs are debt obligations, ordinarily issued in series and most commonly backed by a pool of fixed rate mortgage loans or pass-through certificates, each of which consists of several serially maturing classes. The CBOs acquired by the Company, like CMOs, are debt obligations, but, in the case of CBOs, are secured by security interests in portfolios of high quality, low duration, mortgage-backed, asset-backed and other fixed and floating rate securities managed by third-parties. The Company only acquires CBO's that have portfolios that consist primarily of either real estate qualifying assets or high quality mortgage backed securities. Multiclass pass-through securities are equity interests in a trust composed of similar underlying mortgage assets. Generally, principal and interest payments received on the underlying mortgage-related assets securing a series of CMOs or multiclass pass-through securities are applied to principal and interest due on one or more classes of the CMOs of such series or to pay scheduled distributions of principal and interest on multiclass pass-throughs. In a CBO transaction, principal and interest payments are used to pay current period interest and any excess is reinvested into the portfolio. CBOs typically don't amortize monthly, rather they mature on a specific maturity date. Scheduled payments of principal and interest on the mortgage-related assets and other collateral securing a series of CMOs, CBOs or multiclass pass-throughs are intended to be sufficient to make timely payments of principal and interest on such issues or securities and to retire each class of such obligations at their stated maturity.
Multiclass pass-through securities backed by ARM assets or ARM loans owned by the Company are typically structured into classes designated as senior classes, mezzanine classes and subordinated classes. The Company also owns variable rate classes of CMOs and CBOs that are backed by both fixed- and adjustable-rate mortgages.
The senior classes in a multiclass pass-through security generally have first priority over all cash flows and consequently have the least amount of credit risk since principal losses are generally covered by mortgage pool insurance policies or are charged against the subordinated classes in order of subordination. As a result of these features, the senior classes receive the highest credit rating from Rating Agencies of the series of classes for each multiclass pass-through security.
The mezzanine classes of a multiclass pass-through security generally have a slightly greater risk of principal loss than the senior classes since they provide some credit enhancement to the senior classes. In most, but not all, instances, mezzanine classes participate on a pro-rata basis with senior classes in their right to receive cash flow and have expected lives similar to the senior classes. In other instances, mezzanine classes are subordinate in their right to receive cash flow and have average lives that are longer than the senior classes. However, in all cases, a mezzanine class has a similar or slightly lower credit rating than the senior class from the Rating Agencies. Generally, the mezzanine classes that the Company has acquired are rated High Quality.
Subordinated classes are junior in the right to receive payment from the underlying mortgages to other classes of a multiclass pass-through security. The subordination provides credit enhancement to the senior and mezzanine classes. Subordinated classes may be at risk for some payment failures on the mortgage loans securing or underlying such assets and generally represent a greater level of credit risk as they are responsible for bearing the risk of credit loss on all of the outstanding loans underlying a CMO, CBO or multi-class pass-through. As a result of being subject to more credit risk, subordinated classes generally have lower credit ratings relative to the senior and mezzanine classes.
The Subordinated classes which the Company has acquired were all rated at least Investment Grade at the time of purchase by one of the Rating Agencies, and in certain cases are High Quality, or were created as part of the Company's process of securitizing whole loans. The Subordinated classes acquired by the Company in the open market are limited in amount and bear yields which the Company believes are commensurate with the increased risks involved. In general, the Company acquires subordinated classes when they are seasoned and when the more senior classes of the multi-class security have been paid down to levels that mitigate the risk of non-payment on the subordinate classes.
The market for Subordinated classes is not extensive and at times may be illiquid. In addition, the Company's ability to sell Subordinated classes is limited by the REIT Provisions of the Code. The Company has not purchased any Subordinated classes that are not Qualified REIT Assets. The Subordinated classes acquired by the Company, which are not High Quality, together with the Company's other investments in Other Investment assets, may not, in the aggregate, comprise more than 30% of the Company's total assets, in accordance with the Company's investment policy.
The variable rate classes of CMOs and CBOs, or Floaters, owned by the Company generally float at a spread to the one-month LIBOR index and are backed by mortgages that are either fixed-rate or are adjustable-rate mortgages indexed to the one-year U. S. Treasury yield or a Cost of Funds index.
ARM AND HYBRID ARM LOANS
The ARM and Hybrid ARM loans the Company has acquired are all first mortgages on single-family residential properties. Some have additional collateral in the form of pledged financial assets that provides the Company with additional credit protection in exchange for a simpler application and approval process. The Company acquires loans are underwritten to "A" quality standards. The Company considers loans to be "A" quality when they are underwritten in such a way as to assure that the mortgages are protected by adequate borrower income to make the required loan payment, adequate verifiable equity in the underlying property, and by the borrower's willingness and ability to repay the mortgage as demonstrated by a good credit history. As a result, the loans are generally fully documented loans to borrowers with good credit histories, adequate income to support the monthly mortgage payment, adequate assets to close the loan, with 80% or lower effective loan-to-value ratios based on independently appraised property values or are seasoned loans with over five years or more of good payment history.
When acquiring ARM and Hybrid ARM loans, either originated specifically for the Company or when the Company acquires pools of loans in bulk, the Company focuses its attention on key aspects of a borrower's profile and the characteristics of a mortgage loan product that the Company believes are most important in insuring excellent loan performance and minimal credit exposure. The Company's loan programs focus on larger down payments, excellent borrower credit history (as measured by a credit report and a credit score) and a conservative appraisal process. If an ARM or Hybrid ARM loan acquired has a loan to property value that is above 80%, then the borrower is required to pay for private mortgage insurance providing additional protection to the Company against credit risk. The loans acquired have original maturities of forty years or less. The ARM and Hybrid ARM loans are either fully amortizing or are interest only for up to ten years and fully amortizing thereafter. All ARM loans acquired bear an interest rate that is tied to an interest rate index and some have periodic and lifetime constraints on how much the loan interest rate can change on any predetermined interest rate reset date. In general, the interest rate on each ARM loan resets at a frequency that is either monthly, semi-annually or annually. The indices the ARM loans are tied to are generally a U.S. Treasury Bill index, LIBOR, Certificate of Deposit, a Cost of Funds index or Prime. The Hybrid ARM loans have an initial fixed rate period, generally 3 to 5 years, and then they convert to an ARM loan with the features of an ARM loan described above.
RISK FACTORS
FORWARD-LOOKING STATEMENTS
In accordance with the Private Securities Litigation Reform Act of 1995 (the "1995 Act"), the Company can obtain a "Safe Harbor" for forward-looking statements by identifying those statements and by accompanying those statements with cautionary statements which identify factors that could cause actual results to differ from those in the forward-looking statements. Accordingly, the following information contains or may contain forward-looking statements: (1) information included in this Annual Report on Form 10-K, including, without limitation, statements made regarding investments in ARM securities and ARM loans, and Hybrid ARM loans, hedging, leverage, interest rates and statements in Item 7, Management's Discussion and Analysis of Financial Condition and Results of Operations, (2) information included in future filings by the Company with the Securities and Exchange Commission including, without limitation, statements with respect to growth, projected revenues, earnings, returns and yields on its portfolio of mortgage assets, the impact of interest rates, costs, and business strategies and plans, and (3) information contained in the Company's Annual Report or other written material, releases and oral statements issued by or on behalf of, the Company, including, without limitation, statements with respect to growth, projected revenues, net income, returns and yields on its portfolio of mortgage assets, the impact of interest rates, costs and business strategies and plans.
The following is a summary of the factors the Company believes important and that could cause actual results to differ from the Company's expectations. The Company is publishing these factors pursuant to the 1995 Act. Such factors should not be construed as exhaustive or as an admission regarding the adequacy of disclosure made by the Company prior to the effective date of the 1995 Act. Readers should understand that many factors govern whether any forward-looking statement will be or can be achieved. Any one of those factors could cause actual results to differ materially from those projected. No assurance is or can be given that any important factor set forth below will be realized in a manner so as to allow the Company to achieve the desired or projected results. The words "believe," "except," "anticipate," "intend," "aim," "will," and similar words identify forward-looking statements. The Company cautions readers that the following important factors, among others, could affect the Company's actual results and could cause the Company's actual consolidated results to differ materially from those expressed in any forward-looking statements made by or on behalf of the Company.
- - A Dramatic Increase in Short-term Interest Rates
- - The Effectiveness of Using Various Interest Rate Derivative Instruments for Hedging ARM Assets or Borrowing Costs
- - The Ability to Acquire Attractively Priced and Underwritten ARM and Hybrid ARM Loans and Securities
- - Interest Rate Repricing Mismatch Between Asset Yields and Borrowing Rates
- - A Decline in the Market Value of ARM Securities, Which Would Result in Margin Calls
- - Unanticipated Levels of Prepayment Rates
- - A Flattening or Inversion of the Yield Curve Between Short and Long-Term Interest Rates
- - The Use of Substantial Borrowed Funds to Enhance Returns
- - Risk of Credit Loss Associated with Acquiring, Accumulating and Securitizing ARM Loans
- - Interest Rate Risks Associated with any Future Unhedged Portion of the Fixed Term of Hybrid ARMs
- - The Loss of Key Personnel
- - Fundamental Changes in Investment Policies and Strategies
- - Fluctuations or Variability of Dividend Distributions
- - Capital Stock Price Volatility
COMPETITION
In acquiring ARM assets, the Company competes with other mortgage REITs, investment banking firms, savings and loan associations, banks, mortgage bankers, insurance companies, mutual funds, other lenders, FNMA, FHLMC and other entities purchasing ARM assets, many of which have greater financial resources than the Company. The existence of these competitive entities, as well as the possibility of additional entities forming in the future, may increase the competition for the acquisition of ARM assets resulting in higher prices and lower yields on such mortgage assets.
EMPLOYEES
As of December 31, 1998, the Company had no employees. Thornburg Mortgage Advisory Corporation (the "Manager") carries out the day to day operations of the Company, subject to the supervision of the Board of Directors and under the terms of a management agreement discussed below.
THE MANAGEMENT AGREEMENT
On June 17, 1994, the Company renewed its management agreement with Thornburg Mortgage Advisory Corporation (the "Management Agreement"), the Manager, for a term of five years, with an annual review required each year. On December 15, 1995, the Agreement was amended to provide that in the event a person or entity obtains more than 20% of the Company's common stock, if the Company is combined with another entity, or if the Company terminates the Agreement other than for cause, the Company is obligated to acquire substantially all of the assets of the Manager through an exchange of shares with a value based on a formula tied to the Manager's net profits. The Company has the right to terminate the Management Agreement upon the occurrence of certain specific events, including a material breach by the Manager of any provision contained in the Management Agreement.
The Manager at all times is subject to the supervision of the Company's Board of Directors and has only such functions and authority as the Company may delegate to it. 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.
The Manager receives a per annum base management fee on a declining scale based on average shareholders' equity, adjusted for liabilities that are not incurred to finance assets ("Average Shareholders' Equity" or "Average Net Invested Assets" as defined in the Agreement), payable monthly in arrears. The Manager is also entitled to receive, as incentive compensation for each fiscal quarter, an amount equal to 20% of the Net Income of the Company, before incentive compensation, in excess of the amount that would produce an annualized Return on Equity equal to 1% over the Ten Year U.S. Treasury Rate. For further information regarding the base management fee, incentive compensation and applicable definitions, see the Company's Proxy Statement dated March 29, 1999 under the caption "Certain Relationships and Related Transactions".
Subject to the limitations set forth below, the Company pays all operating expenses except those specifically required to be paid by the Manager under the Management Agreement. The operating expenses required to be paid by the Manager include the compensation of the Company's officers and the cost of office space, equipment and other personnel required for the Company's day-to-day operations. The expenses that will be 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, the costs of printing and mailing proxies and reports to shareholders, the fees and expenses of the Company's custodian and transfer agent, if any, and reimbursement of any obligation of the Manager for any New Mexico Gross Receipts Tax liability. The expenses required to be paid by the Company which are attributable to the operations of the Company shall be limited to an amount per year equal to the greater of 2% of the Average Net Invested Assets of the Company or 25% of the Company's Net Income for that year. The determination of Net Income for purposes of calculating the expense limitation will be the same as for calculating the Manager's incentive compensation except that it will include any incentive compensation payable for such period. Expenses in excess of such amount will be paid by the Manager, unless the unaffiliated directors determine that, based upon unusual or non-recurring factors, a higher level of expenses is justified for such fiscal year. In that event, such expenses may be recovered by the Manager in succeeding years to the extent that expenses in succeeding quarters are below the limitation of expenses. The Company, rather than the Manager, will also be required to pay expenses associated with litigation and other extraordinary or non-recurring expenses. Expense reimbursement will be made monthly, subject to adjustment at the end of each year.
The transaction costs incident to the acquisition and disposition of investments, the incentive compensation and the New Mexico Gross Receipts Tax liability will not be subject to the 2% limitation on operating expenses. Expenses excluded from the expense limitation are those incurred in connection with the servicing of mortgage loans, the raising of capital, the acquisition of assets, interest expenses, taxes and license fees, non-cash costs and the incentive management fee.
FEDERAL INCOME TAX CONSIDERATIONS
GENERAL
The Company has elected to be treated as a REIT for federal income tax purposes. In brief, if certain detailed conditions imposed by the REIT provisions of the Code are met, electing entities that invest primarily in real estate investments and mortgage loans, and that otherwise would be taxed as corporations are, with certain limited exceptions, not taxed at the corporate level on their taxable income that is currently distributed to their shareholders. This treatment eliminates most of the "double taxation" (at the corporate level and then again at the shareholder level when the income is distributed) that typically results from the use of corporate investment vehicles.
In the event that the Company does not qualify as a REIT in any year, it would be subject to federal income tax as a domestic corporation and the amount of the Company's after-tax cash available for distribution to its shareholders would be reduced. The Company believes it has satisfied the requirements for qualification as a REIT since commencement of its operations in June 1993. The Company intends at all times to continue to comply with the requirements for qualification as a REIT under the Code, as described below.
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 briefly below.
Ownership of Common Stock
For all taxable years after the first taxable year for which a REIT election is made, the Company's shares of capital stock 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). In addition, at all times during the second half of each taxable year, no more than 50% in value of the capital stock of the Company may be owned directly or indirectly by five or fewer individuals. The Company is required to maintain records regarding the actual and constructive ownership of its shares, and other information, and to demand statements from persons owning above a specified level of the REIT's shares (as long as the Company has over 200 or more shareholders, only persons holding 1% or more of the Company's outstanding shares of capital stock) regarding their ownership of shares. The Company must keep a list of those shareholders who fail to reply to such a demand.
The Company is required to use the calendar year as its taxable year for income purposes.
Nature of Assets
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 assets, cash and cash items. The Company expects that substantially all of its assets will continue to be Qualified REIT Assets. On the last day of each calendar quarter, of the investments in assets not included in the foregoing 75% assets test, the value of securities issued by any one issuer may not exceed 5% in value of the Company's total assets and the Company may not own more than 10% of any one issuer's outstanding voting securities. Pursuant to its compliance guidelines, the Company intends to monitor closely the purchase and holding of its assets in order to comply with the above assets tests.
Sources of Income
The Company must meet the following separate income-based tests each year:
1. THE 75% TEST. At least 75% of the Company's gross income for the taxable year must be derived from Qualified REIT Assets including interest (other than interest based in whole or in part on the income or profits of any person) on obligations secured by mortgages on real property or interests in real property. The investments that the Company has made and will continue to make will give rise primarily to mortgage interest qualifying under the 75% 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 or disposition of stock or other assets that are not dealer property. The Company intends to limit substantially all of the assets that it acquires (other than stock in certain affiliate corporations as discussed below) to Qualified REIT Assets. The policy of the Company to maintain REIT status may limit the type of assets, including hedging contracts and other assets, that the Company otherwise might acquire.
Distributions
The Company must distribute to its shareholders on a pro rata basis each year an amount equal to at least (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 Company intends to make distributions to its shareholders in sufficient amounts to meet this 95% distribution requirement.
The Service has ruled that if a REIT's dividend reinvestment plan (the "DRP") allows shareholders of the REIT to elect to have cash distributions reinvested in shares of the REIT at a purchase price equal to at least 95% of fair market value on the distribution date, then such cash distributions qualify under the 95% distribution test. The Company believes that its DRP complies with this ruling.
TAXATION OF THE COMPANY'S SHAREHOLDERS
For any taxable year in which the Company is treated as a REIT for federal income purposes, amounts distributed by the Company to its shareholders out of current or accumulated earnings and profits will be includable by the shareholders as ordinary income for federal income tax purposes unless properly designated by the Company as capital gain dividends. Distributions of the Company will not be eligible for the dividends received deduction for corporations. Shareholders may not deduct any net operating losses or capital losses of the Company.
If the Company makes distributions to its shareholders in excess of its current and accumulated earnings and profits, those distributions will be considered first a tax-free return of capital, reducing the tax basis of a shareholder's shares 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. The Company will withhold 30% of dividend distributions to shareholders that the Company knows to be foreign persons unless the shareholder provides the Company with a properly completed IRS form for claiming the reduced withholding rate under an applicable income tax treaty.
The Clinton Administration has introduced a proposal in the fiscal 2000 federal budget that would limit the aggregate value of businesses undertaken by a REIT through taxable subsidiaries to 5% or less of the REIT's total assets. The Company may from time to time hold, through one or more taxable subsidiaries, assets that, if held directly by the Company, could otherwise generate income that would have an adverse effect on the Company's qualification as a REIT or on certain classes of the Company's shareholders. The Company does not reasonably expect that the value of any such taxable subsidiaries, in the aggregate, ever to exceed 5% of the Company's assets and therefore the Company does not anticipate that the proposal, if enacted, would have a material effect on the Company's operations.
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 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 stock of the Company and any potential changes in applicable law.
ITEM 2.
ITEM 2. PROPERTIES
The Company's principal executive offices are located in Santa Fe, New Mexico and are provided by the Manager in accordance with the Management Agreement. The Company's two subsidiaries have their principal offices in Irvine, California.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
At December 31, 1998, there were no 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
No matters were submitted to a vote of the Company's shareholders during the fourth quarter of 1998.
PART II
ITEM 5.
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS
The Company's common stock is traded on the New York Stock Exchange under the trading symbol "TMA". As of January 31, 1999, the Company had 21,989,679 shares of common stock issued and 21,489,663 shares of common stock outstanding which were held by 1,161 holders of record and approximately 17,355 beneficial owners.
The following table sets forth, for the periods indicated, the high, low and closing sales prices per share of common stock as reported on the New York Stock Exchange composite tape and the cash dividends declared per share of common stock.
The Company intends to pay quarterly dividends and to make such distributions to its shareholders in such amounts that all or substantially all of its taxable income each year (subject to certain adjustments) is distributed, so as to qualify for the tax benefits accorded to a REIT under the Code. All distributions will be made by the Company at the discretion of the Board of Directors and will depend on the earnings and 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.
DIVIDEND REINVESTMENT PLAN
The Company has a Dividend Reinvestment and Stock Purchase Plan (the "DRP") that allows both common and preferred shareholders to have their dividends reinvested in additional shares of common stock and to purchase additional shares. The common stock to be acquired for distribution under the DRP may be purchased at the Company's discretion from the Company at a discount from the then prevailing market price or in the open market. Shareholders and non-shareholders also can make additional purchases of stock monthly, subject to a minimum of $100 ($500 for non-shareholders) and a maximum of $5,000 for each optional cash purchase. Continental Stock Transfer & Trust Company (the "Agent"), the Company's transfer agent, is the Trustee and administrator of the DRP. Additional information about the details of the DRP and a prospectus are available from the Agent or the Company. Shareholders who own stock that is registered in their own name and want to participate must deliver a completed enrollment form to the Agent. Forms are available from the Agent or the Company. Shareholders who own stock that is registered in a name other than their own (e.g., broker or bank nominee) and want to participate must either request the broker or nominee to participate on their behalf or request that the broker or nominee re-register the stock in the shareholder's name and deliver a completed enrollment form to the Agent.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
The following selected financial data are derived from audited financial statements of the Company for the years ended December 31, 1998, 1997, 1996, 1995 and 1994. The selected financial data should be read in conjunction with the more detailed information contained in the Financial Statements and Notes thereto and "Management's Discussion and Analysis of Financial Conditions and Results of Operations" included elsewhere in this Form 10-K (Amounts in thousands, except per share data).
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
OVERVIEW OF FOURTH QUARTER 1998 EVENTS IN THE MORTGAGE MARKET
Like most other mortgage finance companies, the Company was affected by turmoil in the global and domestic financial markets during the fourth quarter of 1998. Due to turbulent market conditions, the Company saw its portfolio asset values decline, its margin requirements for financing certain of its ARM assets increase, especially with respect to its non-agency portfolio, and the market value of its hedging instruments decline, which required the Company to post additional collateral and caused the Company difficulty in financing its less than AA rated assets at acceptable valuations. Additionally, due to the high level of prepayments on its agency securities, which the Company must fund out of its excess liquidity prior to receipt of payments from FNMA and FHLMC, and the heightened sense of risk aversion on the part of the Company's lenders, the Company's level of available excess cash and liquid securities diminished from levels maintained in prior periods. All of these factors combined to reduce the level of liquidity available to the Company during the fourth quarter of 1998. The Company undertook several measures to increase its liquidity during these difficult market conditions. First, the Company requested that its lenders not make margin calls on its loans backed by agency securities until the applicable payments had been received by the Company. Several lenders agreed to this request. Second, the Company undertook the sale of certain assets in order to reduce its asset portfolio. Accordingly, during the fourth quarter, the Company sold $421.2 million of ARM assets and recorded a loss on sale of $4.1 million. Of this loss amount, $3.4 million is related to $155 million of ARM securities that are indexed to the one-year U.S. Treasury index and which, as a group, prepaid at an annualized rate of 49% during October and had a yield below the Company's cost of funds. The Company believes that by selecting these specific ARM securities for sale, it not only increased its liquidity, but it improved the future return on its ARM securities portfolio. Lastly, the Company financed the majority of its whole loans and commitments to purchase whole loans by issuing $1.1 billion of AAA rated notes, callable monthly, in a securitized financing transaction in the fourth quarter of 1998. This financing benefited the Company by providing the Company with a capital efficient method to finance its whole loan assets over year end and allows the Company to call the transaction and refinance the loans at a lower interest rate in early 1999 if market conditions improve. However, the cost of this financing was greater than current financing rates available to the Company for whole loans and therefore adversely affected earnings in the fourth quarter of 1998 and possibly will continue to do so during the first half of 1999. All of these measures were successful in maintaining the Company's liquidity throughout the fourth quarter of 1998 and the Company entered 1999 with a much improved liquidity level.
FINANCIAL CONDITION
At December 31, 1998, the Company held total assets of $4.345 billion, $4.268 billion of which consisted of ARM assets. That compares to $4.691 billion in total assets and $4.639 billion of ARM assets at December 31, 1997. Since commencing operations, the Company has purchased either ARM securities (backed by agencies of the U.S. government or privately-issued, generally publicly registered, mortgage assets, most of which are rated AA or higher by at least one of the Rating Agencies) or ARM loans generally originated to "A" quality underwriting standards. At December 31, 1998, 95.9% of the assets held by the Company, including cash and cash equivalents, were High Quality assets, far exceeding the Company's investment policy minimum requirement of investing at least 70% of its total assets in High Quality ARM assets and cash and cash equivalents. Of the ARM assets currently owned by the Company, 90.0% are in the form of adjustable-rate pass-through certificates or ARM loans. The remainder are floating rate classes of CMOs (5.8%) or investments in floating rate classes of CBOs (4.2%) backed primarily by mortgaged-backed securities.
The following table presents a schedule of ARM assets owned at December 31, 1998 and December 31, 1997 classified by High Quality and Other Investment assets and further classified by type of issuer and by ratings categories.
As of December 31, 1998, the Company had reduced the cost basis of its ARM securities by a total of $1,242,000 due to potential future credit losses (other than temporary declines in fair value). The Company is providing for potential future credit losses on two securities that have an aggregate carrying value of $11.8 million, which represent less than 0.3% of the Company's total portfolio of ARM assets. Although both of these assets continue to perform, there is only minimal remaining credit support to mitigate the Company's exposure to potential future credit losses.
Additionally, during 1998, the Company recorded a $762,000 provision for potential credit losses on its loan portfolio, although no actual losses have been realized in the loan portfolio to date. As of December 31, 1998, the Company's ARM loan portfolio included eight loans that are considered seriously delinquent (60 days or more delinquent) with an aggregate balance of $5.0 million. The average original effective loan-to-value ratio on these eight delinquent loans is approximately 62%. The Company estimates that the realizable value of each of the single family homes backing these loans to be more than the value of the individual loans and, therefore, the Company does not expect to realize a loss on any of these delinquent loans. The Company's credit reserve policy regarding ARM loans is to record a monthly provision of 0.15% (annualized rate) on the outstanding principal balance of loans (including loans securitized by the Company for which the Company has retained first loss exposure), subject to adjustment on certain loans or pools of loans based upon factors such as, but not limited to, age of the loans, borrower payment history, low loan-to-value ratios and quality of underwriting standards applied by the originator.
The following table classifies the Company's portfolio of ARM assets by type of interest rate index.
The ARM portfolio had a current weighted average coupon of 7.28% at December 31, 1998. This consisted of an average coupon of 6.96% on the hybrid portion of the portfolio and an average coupon of 7.32% on the rest of the portfolio. If the non-hybrid portion of the portfolio had been "fully indexed," the weighted average coupon would have been approximately 6.79%, based upon the current composition of the portfolio and the applicable indices. As of December 31, 1997, the ARM portfolio had a weighted average coupon of 7.56%. If the ARM portfolio had been "fully indexed," the weighted average coupon would have been approximately 7.64%, based upon the composition of the portfolio and the applicable indices at that time. The Company did not own any hybrids as of December 31, 1997. The lower average coupon on the ARM portfolio as of the end of 1998 compared to 1997 is reflective of the overall lower interest rates in the U.S. economy during these respective periods.
At December 31, 1998, the current yield of the ARM assets portfolio was 5.86%, compared to 6.38% as of December 31, 1997, with an average term to the next repricing date of 253 days as of December 31, 1998, compared to 110 days as of December 31, 1997. The increase in the number of days until the next repricing of the ARMs is primarily due to the hybrid loans acquired by the Company during 1998, which, in general, do not reprice for three to five years from their origination date and have an average remaining fixed rate period of 4.3 years. The current yield includes the impact of the amortization of applicable premiums and discounts, the cost of hedging, the amortization of the deferred gains from hedging activity and the impact of principal payment receivables.
The reduction in the yield as of December 31, 1998, compared to December 31, 1997, is primarily because of a combination of a lower average interest coupon on the ARM portfolio by 0.28%, as stated above, and the higher rate of ARM portfolio prepayments as of the end of 1998 compared to the end of 1997. During the fourth quarter of 1998 the rate of prepayments had slowed to 29%, but this was higher than the 24% experienced during the fourth quarter of 1997. The higher level of prepayments increased the amount of premium amortization expense and increased the impact of non-interest earning assets in the form of principal payment receivables. Higher premium amortization and a higher balance of principal payment receivables decreased the ARM portfolio yield by 0.24% as of the end of 1998 compared to the end of 1997.
The following table presents various characteristics of the Company's ARM and Hybrid ARM loan portfolio as of December 31, 1998. This information pertains to both the loans held for securitization and the loans held as collateral for the callable AAA notes payable.
During the year ended December 31, 1998, the Company purchased $1.502 billion of ARM securities, 93.7% of which were High Quality assets, and $1.092 billion of ARM loans generally originated to "A" quality underwriting standards or seasoned loans with over five years of good payment history and/or low loan-to-value ratios. Of the ARM assets acquired during 1998, approximately 33% were Hybrid ARMs, 32% were indexed to LIBOR, 13% were indexed to U.S. Treasury bill rates, 12% were indexed to a Cost of Funds Index, 9% were indexed to a Certificate of Deposit Index and the remaining 1% to other indices. During 1998, the Company began the acquisition of Hybrid ARM assets that have an interest rate that is fixed for an initial period of time, generally 3 to 5 years, and then convert to an adjustable-rate for the balance of the term of the loan. The Company emphasized purchasing assets during 1998 at substantially lower prices relative to par in order to reduce the potential impact of future prepayments. As a result, the Company emphasized the acquisition of ARM and Hybrid ARM loans and high quality floating rate collateralized mortgage and bond obligations. In doing so, the average premium paid for ARM assets acquired in 1998 was 1.09% of par as compared to 3.29% of par in 1997 when the Company emphasized the purchase of seasoned ARM assets.
The Company sold ARM assets in the amount of $932.3 million at a net loss of $278,000 during 1998. As discussed earlier, a large portion of these sales occurred in the fourth quarter during a period of time when liquidity was a problem for the mortgage finance industry. During this period, the Company sold $421.2 million of ARM securities at a net loss of $4.1 million. During the prior nine months, the Company had sold $511.1 million of ARM assets at a net gain of $3.8 million. These sales during the first nine months of 1998 reflect the Company's desire to manage the portfolio with a view to enhancing the total return of the portfolio. The Company monitors the performance of its individual ARM assets and generally sells an asset when there is an opportunity to replace it with an ARM asset that has an expected higher long-term yield or more attractive interest rate characteristics. The Company is presented with investment opportunities in the ARM assets market on a daily basis and management evaluates such opportunities against the performance of its existing portfolio. At times, the Company is able to identify opportunities that it believes will improve the total return of its portfolio by replacing selected assets. In managing the portfolio, the Company may realize either gains or losses in the process of replacing selected assets.
For the quarter ended December 31, 1998, the Company's mortgage assets paid down at an approximate average annualized constant prepayment rate of 29% compared to 24% during the same period of 1997. The annualized constant prepayment rate averaged approximately 31% during the full year of 1998 compared to 22% during 1997. When prepayment experience exceeds expectations due to sustained increased prepayment activity, the Company has to amortize its premiums over a shorter time period, resulting in a reduced yield to maturity on the Company's ARM assets. Conversely, if actual prepayment experience is less than the assumed constant prepayment rate, the premium would be amortized over a longer time period, resulting in a higher yield to maturity. The Company monitors its prepayment experience on a monthly basis in order to adjust the amortization of the net premium, as appropriate.
The fair value of the Company's portfolio of ARM assets classified as available-for-sale declined by 2.10% from a negative adjustment of 0.52% of the portfolio as of December 31, 1997, to a negative adjustment of 2.62% as of December 31, 1998. This price decline was primarily because of a decline in the levels of liquidity in the mortgage market, the impact of market difficulties in financing mortgage assets, a widening of credit spreads relative to treasury yields due to uncertainties regarding future economic activity in the U.S. and global economies and because of increased future prepayment expectations which have the effect of shortening the average life of the Company's ARM assets and decreasing their fair value. The amount of the negative adjustment to fair value on the ARM assets classified as available-for-sale increased from $21.7 million as of December 31, 1997, to $83.2 million as of December 31, 1998. As of December 31, 1998, all of the Company's ARM securities are classified as available-for-sale and are carried at their fair value.
The Company has purchased Cap Agreements in order to limit its exposure to risks associated with the lifetime interest rate caps of its ARM assets should interest rates rise above specified levels. The Cap Agreements act to reduce the effect of the lifetime or maximum interest rate cap limitation. The Cap Agreements purchased by the Company will allow the yield on the ARM assets to continue to rise in a high interest rate environment just as the Company's cost of borrowings would continue to rise, since the borrowings do not have any interest rate cap limitation. At December 31, 1998, the Cap Agreements owned by the Company had a remaining notional balance of $4.026 billion with an average final maturity of 2.3 years, compared to a remaining notional balance of $4.156 billion with an average final maturity of 3.1 years at December 31, 1997. Pursuant to the terms of the Cap Agreements, the Company will receive cash payments if the one-month, three-month or six-month LIBOR index increases above certain specified levels, which range from 7.50% to 13.00% and average approximately 10.10%. The fair value of these Cap Agreements also tends to increase when general market interest rates increase and decrease when market interest rates decrease, helping to partially offset changes in the fair value of the Company's ARM assets. At December 31, 1998, the fair value of the Cap Agreements was $1.5 million, $6.8 million less than the amortized cost of the Cap Agreements.
The following table presents information about the Company's Cap Agreement portfolio as of December 31, 1998:
As of December 31, 1998, the Company was a counterparty to nineteen interest rate swap agreements ("Swaps") having an aggregate notional balance of $1.473 billion. As of year-end, these Swaps had a weighted average remaining term of 16.5 months. In accordance with these Swaps, the Company will pay a fixed rate of interest during the term of these Swaps and receive a payment that varies monthly with the one-month LIBOR rate. As a result of entering into these Swaps, the Company has reduced the interest rate variability of its cost to finance its ARM assets by increasing the average period until the next repricing of its borrowings from 26 days to 204 days. Fourteen of these Swaps were entered into in connection with the Company's acquisition of Hybrid ARM loans and commitments to purchase Hybrid ARM loans. These fourteen Swaps that hedge the fixed rate portion of the Company's Hybrid ARM loans (to within one year of the first interest rate reset) had a notional balance of $523 million at year-end and an average maturity of 44.0 months. The other five swaps with a notional balance of $950 million were entered into for the purpose of lengthening the average next re-pricing date of the Company's borrowings to more closely match the re-pricing characteristics of the Company's ARM assets. These five swaps mature during the first quarter of 1999.
RESULTS OF OPERATIONS - 1998 COMPARED TO 1997
For the year ended December 31, 1998, the Company's net income was $22,695,000, or $0.75 per share (Basic EPS), based on a weighted average of 21,488,000 shares outstanding. That compares to $41,402,000, or $1.95 per share (Basic EPS), based on a weighted average of 18,048,000 shares outstanding for the year ended December 31, 1997. Net interest income for the year totaled $31,040,000, compared to $49,064,000 for the same period in 1997. Net interest income is comprised of the interest income earned on portfolio assets less interest expense from borrowings. During 1998, the Company recorded a net loss on the sale of ARM securities of $278,000 as compared to a gain of $1,189,000 during 1997. Additionally, during 1998, the Company reduced its earnings and the carrying value of its ARM assets by reserving $2,032,000 for potential credit losses, compared to $886,000 during 1997. During 1998, the Company incurred operating expenses of $6,035,000, consisting of a base management fee of $4,142,000, a performance-based fee of $759,000 and other operating expenses of $1,134,000. During 1997, the Company incurred operating expenses of $7,965,000, consisting of a base management fee of $3,664,000, a performance-based fee of $3,363,000 and other operating expenses of $938,000. Total operating expenses decreased as a percentage of average assets to 0.13% for 1998, compared to 0.21% for 1997, primarily due to the elimination of the performance-based fee during the last three quarters of 1998.
The Company's return on average common equity was 4.80% for the year ended December 31, 1998 compared to 12.72% for the year ended December 31, 1997. The primary reasons for the lower return on average common equity are the Company's lower interest rate spread, discussed further below and the net loss recorded in 1998 on the sale of ARM securities, which were partially offset by lower operating expenses.
The table below highlights the historical trend and the components of return on average common equity (annualized) and the 10-year U. S. Treasury average yield during each respective quarter which is applicable to the computation of the performance fee:
The decline in the Company's return on common equity from the fourth quarter of 1997 to the fourth quarter of 1998 is primarily due to the decline in the net interest spread between the Company's interest-earning assets and interest-bearing liabilities, an increase in the Company's provision for losses and the impact of a net loss on ARM sales as compared to a net gain on ARM sales. This decline in net return on common equity was partially offset by the elimination of the performance-based fee. The decline in the Company's return on common equity from the third quarter of 1998 to the fourth quarter of 1998 is primarily due to the impact of a net loss on ARM sales as compared to a net gain on ARM sales and an increase in the Company's provision for losses. This decline was partially offset by an increase in the net interest spread between the Company's interest-earning assets and interest-bearing liabilities.
The following table presents the components of the Company's net interest income for the years ended December 31, 1998 and 1997:
As presented in the table above, the Company's net interest income decreased by $18.0 million in 1998 compared to 1997, primarily because the amortization of net premium increased by $24.8 million. In 1998 the amortization of net premium was 13.7% of coupon interest income on ARM assets as compared to 7.9% in 1997, reflecting, in part, the increased rate of ARM prepayments in 1998 as compared to 1997.
The following table reflects the average balances for each category of the Company's interest earning assets as well as the Company's interest bearing liabilities, with the corresponding effective rate of interest annualized for the years ended December 31, 1998 and 1997:
As a result of the yield on the Company's interest-earning assets declining to 5.96% during 1998 from 6.56% during 1997 and the Company's cost of funds increasing to 5.78% during 1998 from 5.76% during 1997, net interest income decreased by $18,024,000. This decrease in net interest income is a combination of rate and volume variances. There was a combined unfavorable rate variance of $23,332,000, which was almost entirely the result of a lower yield on the Company's ARM assets portfolio and other interest-earning assets. The increased average size of the Company's portfolio during 1998 compared to 1997 contributed to higher net interest income in the amount of $5,310,000. The average balance of the Company's interest-earning assets was $4.817 billion during 1998 compared to $3.777 billion during 1997 -- an increase of 28%.
The following table highlights the components of net interest spread and the annualized yield on net interest-earning assets as of each applicable quarter end:
As of December 31, 1998, the Company's yield on its ARM assets portfolio, including the impact of the amortization of premiums and discounts, the cost of hedging, the amortization of deferred gains from hedging activity and the impact of principal payment receivables, was 5.86%, compared to 6.38% as of December 31, 1997-- a decrease of 0.52%. The Company's cost of funds as of December 31, 1998, was 5.94%, compared to 5.91% as of December 31, 1997 -- an increase of 0.03%. As a result of these changes, the Company's net interest spread as of December 31, 1998 was -0.08%, compared to 0.47% as of December 31, 1997. The decline in the net interest spread is largely attributable to the decline in the ARM portfolio yield which is primarily the result of the lower average interest coupon and the higher level of premium amortization. The increase in the Company's cost of funds as of year end is generally the impact of the rate on the newly issued callable AAA notes payable. The notes were issued on December 18, 1998 at a time when finance rates are generally seasonably high, reflecting the mortgage finance market's reluctance to finance assets over year-end, and the notes were issued at a time when mortgage finance spreads were unusually wide due to the liquidity crises discussed earlier. Subsequent to year-end, the rate on the callable AAA notes, which floats with one-month LIBOR, decreased by 0.68%.
The Company's net interest spread declined from 0.47% as of December 31, 1997 to -0.08% as of December 31, 1998. The primary reasons for these declines continues to be the relationship between the one-year U. S. Treasury yield and LIBOR and the impact of the increased rate of ARM prepayments as well as the impact of issuing the callable AAA notes close to year-end. From December 31, 1997 to December 31, 1998, the one-year U.S. Treasury yield declined by approximately 0.98%, from 5.51% to 4.53%, while LIBOR rates applicable to the Company's borrowings decreased by only 0.70%, from 5.77% to 5.07%, creating a negative index spread as of December 31, 1998 of -0.54% compared to a negative index spread as of December 31, 1997 of -0.26%. As of December 31, 1998, approximately 35% of the Company's ARM assets were indexed to the one-year U. S. Treasury bill yield, down from approximately 49% as of December 31, 1997, and, therefore, the yield on such assets declined with the index. To put this in historical perspective, the one-year U.S. Treasury bill yield had a spread of - -0.26% to the average of the one- and three-month LIBOR rate as of December 31, 1997, compared to having a spread of -0.02% at December 31, 1996, -.06% on average during 1997, 0.04% on average during 1996 and -0.07% on average during 1995. For the five-year period from 1993 to 1997, the average spread was 0.15%. The average spread during the three month period ended December 31, 1998 was - -0.93%, which was substantially worse than the average spread during the previous quarter of -0.53% or in the second quarter of 1998 when the average spread was -0.27%. The Company does not know when or if the relationship between the one-year U. S. Treasury bill yield and LIBOR will return to historical norms, but the Company's spreads are expected to improve if that occurs. As of the middle of March 1999, the one-year U.S. Treasury bill yield and LIBOR spread had improved back to approximately -.25%. The Company is also continuing to decrease its exposure to the one-year U. S. Treasury/LIBOR relationship by reducing the portion of the portfolio indexed to the one-year U. S. Treasury rate and financed with LIBOR. The Company's ARM portfolio yield also was lower as of December 31, 1998 compared to December 31, 1997 because of an increase in the amortization of the net premium on ARM assets which reflects an increase in the average rate of prepayments on the ARM portfolio. During the fourth quarter of 1998, the average prepayment rate was 29%, compared to 24% during the comparable period in 1997. The impact of this was to increase the average amount of non-interest-earning assets in the form of principal payments receivable as well as to increase the amortization expense related to writing off the Company's premiums and discounts. The Company generally amortizes its premiums and discounts on a monthly basis based on the most recent three-month average of the prepayment rate of its ARM assets, thereby adjusting its amortization to current market conditions, which is reflected in the yield of the ARM portfolio. As of December 31, 1998, the yield adjustment related to premium amortization amounted to 1.18% compared to 0.94% as of December 31, 1997. As discussed above, the Company's net spread of -.08% also reflects the cost of the callable AAA notes which were issued on December 18, 1998 and had an interest rate of 6.32% as of year-end, which has subsequently declined to a rate of 5.64% in January and which will continue to float with one-month LIBOR.
The Company's provision for losses has increased with the acquisition of whole loans. The provision for loan losses is based on an annualized rate of 0.15% on the outstanding principal balance of loans as of each month-end, subject to certain adjustments as discussed above. As of December 31, 1998, the Company's whole loans, including those held as collateral for the AAA notes payable, accounted for 24.5% of the Company's portfolio of ARM assets compared to 2.6% as of December 31, 1997. To date, the Company has not experienced any actual losses in its whole loan portfolio, but based on industry standards, losses are expected and are being provided for as the portfolio ages.
During 1998, the Company realized a net loss from the sale of ARM securities in the amount of $278,000 compared to a gain of $1,189,000 during 1997. The 1998 sales generally fall into two categories. During the first nine months of 1998, the Company realized a net gain on the sale of ARM assets in the amount $3,780,000 as part of the Company's ongoing portfolio management. These sales reflect the Company's desire to manage the portfolio with a view to enhancing the total return of the portfolio over the long-term while generating current earnings during this period of fast prepayments and narrow interest spreads. The Company monitors the performance of its individual ARM assets and selectively sells an asset when there is an opportunity to replace it with an ARM asset that has an expected higher long-term yield or more attractive interest rate characteristics. The Company sold $511.8 million of ARM assets during the first nine months of 1998, most which were either indexed to a Cost of Funds index, the one-year U. S. Treasury index or were prepaying faster than expected. During the first nine months of 1998 when the Company sold selected assets, it was able to reinvest the proceeds in ARM assets that were indexed to indices preferred by the Company and at prices that reflected current market assumptions regarding prepayments speeds and interest rates and thus far, as a whole, they have been performing better than the portfolio acquired before 1998. During the fourth quarter of 1998, the Company sold assets for the primary purpose of maintaining adequate levels of liquidity at a time when the mortgage finance market experienced a sudden liquidity crises and, thus, was able to avoid the forced liquidation of any of its assets by mortgage finance counterparties. However, the Company realized a net loss of $4,059,000 on these sales. Although the Company is never pleased when it has to sell assets at a loss, the Company was very pleased with the response of its mortgage finance counterparties to the high credit quality and highly liquid characteristics of the Company's ARM portfolio in that all of the Company's counterparties, upon review of the company's ARM portfolio and investment policies, continued to provide financing at reasonable collateral values and reasonable requirements for over collateralization.
As a REIT, the Company is required to declare dividends amounting to 85% of each year's taxable income by the end of each calendar year and to have declared dividends amounting to 95% of its taxable income for each year by the time it files its applicable tax return and, therefore, generally passes through substantially all of its earnings to shareholders without paying federal income tax at the corporate level. As of December 31, 1998, the Company had distributed all of its cumulative taxable income to its shareholders. Since the Company, as a REIT, pays its dividends based on taxable earnings, the dividends may at times be more or less than reported earnings. The following table provides a reconciliation between the Company's earnings as reported based on generally accepted accounting principles and the Company's taxable income before its' common dividend deduction:
On August 17, 1998, the Company announced that its Board of Directors had approved a rescheduling of the Company's quarterly board meetings and the declaration, record and payment dates of its regular cash dividend on its common stock. Under the new schedule, the Board of Directors will meet after the close of each quarter end, so the Board can review actual quarterly financial results as they consider the declaration of common dividends. This action is also expected to provide a modest benefit to the financial results of the Company as the Company will be able to retain earnings over each quarter end and to leverage this additional capital for an extended period of time, generating additional income for shareholders when the additional assets are invested at a positive effective margin. This action does not effect the dividend dates in connection with the Company's Series A 9.68% Cumulative Convertible Preferred Shares.
For the year ended December 31, 1998, the Company's ratio of operating expenses to average assets was 0.13% compared to 0.21% for 1997. The Company's expense ratios are among the lowest of any company investing in mortgage assets, giving the Company what it believes to be a significant competitive advantage over more traditional mortgage portfolio lending institutions such as banks and savings and loans. This competitive advantage enables the Company to operate with less risk, such as credit and interest rate risk, and still generate an attractive long-term return on equity when compared to these more traditional mortgage portfolio lending institutions. The Company pays the Manager an annual base management fee, generally based on average shareholders' equity, not assets, as defined in the Management Agreement, payable monthly in arrears as follows: 1.1% of the first $300 million of Average Shareholders' Equity, plus 0.8% of Average Shareholders' Equity above $300 million. Since this management fee is based on shareholders' equity and not assets, this fee increases as the Company successfully accesses capital markets and raises additional equity capital and is, therefore, managing a larger amount of invested capital on behalf of its shareholders. In order for the Manager to earn a performance fee, the rate of return on the shareholders' investment, as defined in the Management Agreement, must exceed the average ten-year U.S. Treasury rate during the quarter plus 1%. During 1998, as the Company's return on shareholders' equity declined, compared to 1997, the performance fee also declined, to an annualized 0.02% of average assets compared to 0.09% during 1997. As presented in the following table, the performance fee is a variable expense that fluctuates with the Company's return on shareholders' equity relative to the average 10-year U.S. Treasury rate.
The following table highlights the quarterly trend of operating expenses as a percent of average assets:
RESULTS OF OPERATIONS - 1997 COMPARED TO 1996
For the year ended December 31, 1997, the Company's net income was $41,402,000, or $1.95 per share (Basic EPS), based on a weighted average of 18,047,955 shares outstanding. That compares to $25,737,000, or $1.73 per share (Basic EPS), based on a weighted average of 14,873,700 shares outstanding for the year ended December 31, 1996. This 61% increase in earnings -- a 13% increase on a per-share basis -- was achieved despite a 21% increase in the average number of shares outstanding during the two periods. Net interest income for the year totaled $49,064,000, compared to $30,345,000 for the same period in 1996, an increase of 62%. Net interest income is comprised of the interest income earned on mortgage investments less interest expense from borrowings. During 1997, the Company recorded a gain on the sale of ARM securities of $1,189,000 as compared to a gain of $1,362,000 during 1996. Additionally, during 1997, the Company reduced its earnings and the carrying value of its ARM assets by reserving $886,000 for potential credit losses, compared to $990,000 during 1996. During 1997, the Company incurred operating expenses of $7,965,000, consisting of a base management fee of $3,664,000, a performance-based fee of $3,363,000 and other operating expenses of $938,000. During 1996, the Company incurred operating expenses of $4,980,000, consisting of a base management fee of $1,872,000, a performance-based fee of $2,462,000 and other operating expenses of $646,000. Total operating expenses decreased as a percentage of net interest income to 16.2% for 1997, compared to 16.4% for 1996, thereby contributing to the Company's improved net earnings.
The Company's return on average common equity for the year ended December 31, 1997 was 12.72%, compared to 11.68% for the same period in 1996.
The following table presents the components of the Company's net interest income for the years ended December 31, 1997 and 1996:
Despite the fact that the Company's cost of funds increased from 5.67% in 1996 to 5.76% in 1997, its net interest income increased during this same time period, primarily due to the increased size of the Company's portfolio. Net interest income increased by $18,719,000, which is a combination of rate and volume variances. There was a combined favorable rate variance of $623,000, which consisted of a favorable variance of $2,691,000 resulting from the higher yield on the Company's ARM assets portfolio and other interest-earning assets and an unfavorable variance of $2,068,000 resulting from an increase in the Company's cost of funds. The increased average size of the Company's portfolio during 1997 compared to 1996 contributed to higher net interest income in the amount of $18,096,000. The average balance of the Company's interest-earning assets was $3.777 billion during 1997 compared to $2.351 billion during 1996 -- an increase of 61%.
The Company's ARM assets portfolio generated a yield of 6.56% during 1997, compared to 6.45% during 1996. The Company's cost of funds during 1997 was 5.76%, compared to 5.67% during 1996, primarily as a result of higher short-term interest rates available to the Company for financing purposes. Despite the fact that the Company's cost of funds increased, the Company's net spread increased to 0.80% for 1997 from a spread of 0.78% for 1996 -- an increase of 0.02%. The Company's yield on net interest-earning assets, which includes the impact of shareholders' equity, rose to 1.30% for 1997 from 1.29% for 1996.
The following table reflects the average balances for each category of the Company's interest-earning assets as well as the Company's interest-bearing liabilities with the corresponding effective rate of interest annualized for the years ended December 31, 1997, and December 31, 1996:
As of the end of 1997, the Company's yield on its ARM assets portfolio, including the impact of the amortization of premiums and discounts, the cost of hedging, the amortization of deferred gains from hedging activity and the impact of principal payment receivables, was 6.38%, compared to 6.64% as of the end of 1996 -- a decrease of 0.26%. The Company's cost of funds as of December 31, 1997, was 5.91%, compared to 5.72% as of December 31, 1996 -- an increase of 0.19%. This increase was primarily the result of financing a portion of the ARM portfolio over 1997 year-end at a time when LIBOR interest rates increased suddenly late in November due to year-end pressures. Fortunately the Company, expecting this to occur, already had financed most of its portfolio over year-end before the LIBOR increase and, thus, was able to avoid the full potential impact. Subsequent to year-end, LIBOR interest rates have generally returned to their previous level, which will be reflected in first quarter 1998 interest rate spreads. As a result of these changes, the Company's net interest spread as of the end of 1997 was 0.47%, compared to 0.92% as of the end of 1996 - -- a decrease of 0.45%.
During 1997, the Company realized a net gain from the sale of ARM securities in the amount of $1,189,000, compared to a gain of $1,362,000 during 1996. Additionally, the Company recorded a provision for credit losses in the amount of $886,000 during the year ended December 31, 1997, although the Company only incurred actual credit losses of $96,000 during the year, compared to a provision for credit losses in the amount of $990,000 during 1996 with no actual credit losses. The Company provided for additional credit losses because its review of underlying ARM collateral indicates potential for some loss on two ARM securities, which, at December 31, 1997 were being carried at a market value of $13.1 million, or 0.3% of the Company's ARM portfolio. The Company also has a policy to regularly record a provision for possible credit losses on its portfolio of ARM loans.
For both years ended December 31, 1997 and 1996, the Company's ratio of operating expenses to average assets was 0.21%. The Company's operating expense ratio is well below the average of other more traditional mortgage portfolio lending institutions such as banks and savings and loans. The Company pays the Manager an annual base management fee, generally based on average shareholders' equity, not assets, as defined in the Management Agreement, payable monthly in arrears as follows: 1.1% of the first $300 million of Average Shareholders' Equity, plus 0.8% of Average Shareholders' Equity above $300 million. Since this management fee is based on shareholders' equity and not assets, this fee increases as the Company successfully accesses capital markets and raises additional equity capital and is, therefore, managing a larger amount of invested capital on behalf of its shareholders. In order for the Manager to earn a performance fee, the rate of return on the shareholders' investment, as defined in the Management Agreement, must exceed the average ten-year U.S. Treasury rate during the quarter plus 1%. During 1997, the Manager earned a performance fee of $3,363,000. During 1997, after paying this performance fee, the Company's return on common equity was 12.72%. See Note 7 to the Financial Statements for a discussion of the management fee formulas.
MARKET RISKS
The market risk management discussion and the amounts estimated from the analysis that follows are forward-looking statements regarding market risk that assume that certain adverse market conditions occur. Actual results may differ materially from these projected results due to changes in the Company's ARM portfolio and borrowings mix and due to developments in the domestic and global financial and real estate markets. The analytical methods utilized by the Company to assess and mitigate these market risks should not be considered projections of future events or operating performance.
As a financial institution that has only invested in U.S. dollar denominated instruments, primarily residential mortgage instruments, and has only borrowed money in the domestic market, the Company is not subject to foreign currency exchange or commodity price risk, but rather the Company's market risk exposure is limited solely to interest rate risk. Interest rate risk is defined as the sensitivity of the Company's current and future earnings to interest rate volatility, variability of spread relationships and the difference in repricing intervals between the Company's assets and liabilities. Interest rate risk impacts the Company's interest income, interest expense and the market value on a large portion of the Company's assets and liabilities. The management of interest rate risk attempts to maximize earnings and to preserve capital by minimizing the negative impacts of changing market rates, asset and liability mix and prepayment activity.
The table below presents the Company's consolidated interest rate risk using the static gap methodology. This method reports the difference between interest rate sensitive assets and liabilities at specific points in time as of December 31, 1998, based on the earlier of term to repricing or the term to repayment of the of the asset or liability. The table does not include assets and liabilities that are not interest rate sensitive such as payment receivables, prepaid expenses, payables and accrued expenses. The table provides a projected repricing or maturity based on scheduled rate adjustments, scheduled payments, and estimated prepayments. For many of the Company's assets and certain of the Company's liabilities, the maturity date is not determinable with certainty. In general, the Company's ARM assets can be prepaid before contractual amortization and/or maturity. Likewise, the Company's callable AAA rated notes are paid down as the related ARM asset collateral pays down. The static gap report reflects the Company's investment policy that allows for only the acquisition of ARM assets that reprice within one year or Hybrids ARMs that are match funded to within one-year of their initial repricing.
The difference between assets and liabilities repricing or maturing in a given period is one approximate measure of interest rate sensitivity. More assets than liabilities repricing in a period (a positive gap) implies earnings will rise as interest rates rise and decline as interest rates decline. More liabilities repricing than assets (a negative gap) implies declining income as rates rise and increasing income as rates decline. The static gap analysis does not take into consideration constraints on the repricing of the interest rate of ARM assets in a given period resulting from periodic and lifetime cap features nor the behavior of various indexes applicable to the Company's assets and liabilities. Different interest rate indexes exhibit different degrees of volatility in the same interest rate environment due to other market factors such as, but not limited to, government fiscal policies, market concern regarding potential credit losses, changes in spread relationships among different indexes and global market disruptions.
The use of interest rate instruments such as Swaps and Cap Agreements are integrated into the Company's interest rate risk management. The notional amounts of these instruments are not reflected in the Company's balance sheet. The Swaps are included in the static gap report for purposes of analyzing interest rate risk because they have the affect of adjusting the repricing characteristics of the Company's liabilities. The Cap Agreements are not considered in a static gap report because they do not effect the timing of the repricing of the instruments they hedge, but rather they, in effect, remove the limit on the amount of interest rate change that can occur relative to the applicable hedged asset.
Although the static gap methodology is widely accepted in identifying interest rate risk, it does not take into consideration changes that may occur such as, but not limited to, changes in investment and financing strategies, changes in market spreads and relationships among different indexes, changes in hedging strategy, changes in prepayment speeds and changes in business volumes. Accordingly, the Company makes extensive usage of an earnings simulation model to analyze its level of interest rate risk. This analytical technique used to measure and manage interest rate risk includes the impact of all on-balance-sheet and off-balance-sheet financial instruments.
There are a number of key assumptions made in using the Company's earnings simulation model. These key assumptions include changes in market conditions that effect interest rates, the pricing of ARM products, the availability of ARM products, the availability and the cost of financing for ARM products. Other key assumptions made in using the simulation model include prepayment speeds, management's investment, financing and hedging strategies and the issuance of new equity. The Company typically runs the simulation model under a variety of hypothetical business scenarios that may include different interest rate scenarios, different investment strategies, different prepayment possibilities and other scenarios that provide the Company with a range of possible earnings outcomes in order to assess potential interest rate risk. The assumptions used represent the Company's estimate of the likely effect of changes in interest rates and do not necessarily reflect actual results. The earnings simulation model takes into account periodic and lifetime caps embedded in the Company's ARM assets in determining the earnings at risk.
At December 31, 1998, based on the earnings simulation model, the Company's potential earnings at risk to a gradual, parallel 100 basis point rise in market interest rates over the next twelve months was approximately 6.3% of projected 1998 net income. The assumptions used in the earnings simulation model are inherently uncertain and as a result, the analysis cannot precisely predict the impact of higher interest rates on net income. Actual results would differ from simulated results due to timing, magnitude and frequency of interest rate changes, changes in prepayment speed other than what was assumed in the model, changes in other market conditions and management strategies to offset its potential exposure, among other factors. This measure of risk represents the Company's exposure to higher interest rates at a particular point in time. The Company's actual risk is always changing. The Company continuously monitors the Company's risk profile as it changes and alters its strategies as appropriate in its view of the likely course of interest rates and other developments in the Company's business.
LIQUIDITY AND CAPITAL RESOURCES
The Company's primary source of funds for the year ended December 31, 1998 consisted of reverse repurchase agreements, which totaled $2.867 billion, and callable AAA notes, which had a balance of $1.127 billion. The Company's other significant sources of funds for the year ended December 31, 1998 consisted primarily of payments of principal and interest from its ARM assets in the amount of $2.1 billion and proceeds from the sale of ARM assets in the amounts of $932.0 million. In the future, the Company expects its primary sources of funds will consist of borrowed funds under reverse repurchase agreement transactions with one- to twelve-month maturities, capital market financing transactions collateralized by ARM and hybrid loans, proceeds from monthly payments of principal and interest on its ARM assets portfolio and occasional asset sales. The Company's liquid assets generally consist of unpledged ARM assets, cash and cash equivalents.
Total borrowings incurred at December 31, 1998, had a weighted average interest rate of 5.84%. The reverse repurchase agreements had a weighted average remaining term to maturity of 2.0 months and the callable AAA notes payable had a final maturity of January 25, 2029, but will be paid down as the ARM assets collateralizing the notes are paid down. As of December 31, 1998, $1.147 billion of the Company's borrowings were variable-rate term reverse repurchase agreements. Term reverse repurchase agreements are committed financings with original maturities that range from three months to two years. The interest rates on these term reverse repurchase agreements are indexed to either the one-, three- or six-month LIBOR rate and reprice accordingly. The interest rate on the callable AAA notes adjusts monthly based on changes in one-month LIBOR.
The Company has arrangements to enter into reverse repurchase agreements with 24 different financial institutions and on December 31, 1998, had borrowed funds with 16 of these firms. Because the Company borrows money under these agreements based on the fair value of its ARM assets and because changes in interest rates can negatively impact the valuation of ARM assets, the Company's borrowing ability under these agreements could be limited and lenders may initiate margin calls in the event interest rates change or the value of the Company's ARM assets decline for other reasons. Additionally, certain of the Company's ARM assets are rated less than AA by the Rating Agencies (approximately 4.0%) and have less liquidity than assets that are rated AA or higher. Other mortgage assets which are rated AA or higher by the Rating Agencies derive their credit rating based on a mortgage pool insurer's rating. As a result of either changes in interest rates, credit performance of a mortgage pool or a downgrade of a mortgage pool issuer, the Company may find it difficult to borrow against such assets and, therefore, may be required to sell certain mortgage assets in order to maintain liquidity. If required, these sales could be at prices lower than the carrying value of the assets, which would result in losses. During the fourth quarter of 1998, as discussed earlier, the Company maintained an adequate level of liquidity by selling certain ARM securities. The Company believes it will continue to have sufficient liquidity to meet its future cash requirements from its primary sources of funds for the foreseeable future without needing to sell assets.
The Company, by issuing the callable AAA notes, has financed $1.1 billion of its ARM assets in a structure that is not subject to margin calls. In this structure, the financing of these assets is not based on their market value or subject to subsequent changes in mortgage credit markets as is the case of the reverse repurchase agreement arrangements. The Company has retained a call on both the notes and the collateral in the event the Company should choose to refinance these ARM assets in a different manner.
As of December 31, 1998, the Company had one whole loan financing facility with an uncommitted borrowing capacity of $250,000,000. The Company had no balance borrowed against this facility as of year-end. This facility matured on January 8, 1999 and has been subsequently re-negotiated for an additional one year period. Under the new agreement in effect as of January 8, 1999, the whole loan financing facility is a committed facility in an amount of up to $150,000,000, with an option to increase the amount to $300,000,000. The Company is also negotiating to enter into one other committed whole loan financing facility and three uncommitted whole loan financing facilities in order to facilitate its acquisitions of whole loans in a prudent manner.
In December 1996, the Company's Registration Statement on Form S-3, registering the sale of up to $200 million of additional equity securities, was declared effective by the Securities and Exchange Commission. This registration statement includes the possible issuances of common stock, preferred stock, warrants or shareholder rights. As of December 31, 1998, the Company had $109 million of its securities registered for future sale under this Registration Statement.
On July 13, 1998, the Board of Directors approved a common stock repurchase program of up to 500,000 shares at prices below book value, subject to availability of shares and other market conditions. On September 18, 1998, the Board of Directors expanded this program by approving the repurchase of up to 1,000,000 shares at prices below book value. To date, the Company has repurchased 500,016 shares at an average price of $9.28 per share.
The Company has a Dividend Reinvestment and Stock Purchase Plan (the "DRP") designed to provide a convenient and economical way for existing shareholders to automatically reinvest their dividends in additional shares of common stock and for new and existing shareholders to purchase shares at a discount to the current market price of the common stock, as defined in the DRP. As a result of participation in the DRP during the first half of 1998, the Company issued 1,581,550 new shares of common stock and received $24.4 million of new equity capital. During the second half of 1998, the Company purchased shares in the open market on behalf of the participants in its DRP instead of issuing new shares below book value. In accordance with the terms and conditions of the DRP, the Company pays the brokerage commission in connection with these purchases.
EFFECTS OF INTEREST RATE CHANGES
Changes in interest rates impact the Company's earnings in various ways. While the Company only invests in ARM assets, rising short-term interest rates may temporarily negatively affect the Company's earnings and conversely falling short-term interest rates may temporarily increase the Company's earnings. This impact can occur for several reasons and may be mitigated by portfolio prepayment activity as discussed below. First, the Company's borrowings will react to changes in interest rates sooner than the Company's ARM assets because the weighted average next repricing date of the borrowings is usually a shorter time period. Second, interest rates on ARM loans are generally limited to an increase of either 1% or 2% per adjustment period (commonly referred to as the periodic cap) and the Company's borrowings do not have similar limitations. Third, the Company's ARM assets lag changes in the indices due to the notice period provided to ARM borrowers when the interest rates on their loans are scheduled to change. The periodic cap only affects the Company's earnings when interest rates move by more than 1% per six-month period or 2% per year.
Interest rate changes may also impact the Company's ARM assets and borrowings differently because the Company's ARM assets are indexed to various indices whereas the interest rate on the Company's borrowings generally move with changes in LIBOR. Although the Company has always favored acquiring LIBOR based ARM assets in order to reduce this risk, LIBOR based ARMs are not generally well accepted by home owners in the U.S. As a result, the Company has acquired ARM assets indexed to a mix of indices in order to diversify its exposure to changes in LIBOR in contrast to changes in other indices. During times of global economic instability, U.S. Treasury rates generally decline because foreign and domestic investors generally consider U.S. Treasury instruments to be a safe haven for investments. The Company's ARM assets indexed to U.S. Treasury rates then decline in yield as U.S. Treasury rates decline, whereas the Company's borrowings and other ARM assets may not be affected by the same pressures or to the same degree. As a result, the Company's income can improve or decrease depending on the relationship between the various indices that the Company's ARM assets are indexed to compared to changes in the Company's cost of funds.
The rate of prepayment on the Company's mortgage assets may increase if interest rates decline, or if the difference between long-term and short-term interest rates diminishes. Increased prepayments would cause the Company to amortize the premiums paid for its mortgage assets faster, resulting in a reduced yield on its mortgage assets. Additionally, to the extent proceeds of prepayments cannot be reinvested at a rate of interest at least equal to the rate previously earned on such mortgage assets, the Company's earnings may be adversely affected.
Conversely, the rate of prepayment on the Company's mortgage assets may decrease if interest rates rise, or if the difference between long-term and short-term interest rates increases. Decreased prepayments would cause the Company to amortize the premiums paid for its ARM assets over a longer time period, resulting in an increased yield on its mortgage assets. Therefore, in rising interest rate environments where prepayments are declining, not only would the interest rate on the ARM assets portfolio increase to re-establish a spread over the higher interest rates, but the yield also would rise due to slower prepayments. The combined effect could significantly mitigate other negative effects that rising short-term interest rates might have on earnings.
Lastly, because the Company only invests in ARM assets and approximately 8% to 10% of such mortgage assets are purchased with shareholders' equity, the Company's earnings over time will tend to increase following periods when short-term interest rates have risen and decrease following periods when short-term interest rates have declined. This is because the financed portion of the Company's portfolio of ARM assets will, over time, reprice to a spread over the Company's cost of funds, while the portion of the Company's portfolio of ARM assets that are purchased with shareholders' equity will generally have a higher yield in a higher interest rate environment and a lower yield in a lower interest rate environment.
YEAR 2000 ISSUES
The Year 2000 issues involve both hardware design flaws in which many computer systems, and machines that use computer chips, will not correctly recognize the date beginning in the Year 2000 and, additionally, software applications and compilers that do not use a four-digit reference to years which might not behave as intended once the Year 2000 is reached. Three general areas of concern are: 1) clocks built into computers and computer chips that will rollover to 1900 or 1980 instead of 2000, 2) purchased software that does not recognize the Year 2000 as a leap year or that does not use a four-digit reference to years, and 3) internally developed applications that do not store the year as a four-digit year. The Company invests in assets and enters into agreements that employ the use of dates and is, therefore, concerned about the ability of equipment and computer programs to interpret dates or recognize dates accurately.
In consideration of the Year 2000 issues, the Manager has reviewed the ability of its own computers and computer programs to properly recognize and handle dates in the Year 2000. Through the normal upgrading of computer equipment, the Manager has already replaced all computers that were not Year 2000 compliant. The software used by the Company has been internally developed using products that are Year 2000 compliant. The Manager has also reviewed all the date fields embedded in its internally developed spreadsheets, databases and other programs and has determined that all such programs are using four-digit years in references to dates. Therefore, the Company believes that all of its equipment and internal systems are ready for the Year 2000. To date, the Manager has incurred all costs in order for the Company to be Year 2000 compliant.
The Company believes that most of its exposure to Year 2000 issues involves the readiness of third parties such as, but not limited to, loan servicers, security master servicers, security paying agents and trustees, its stock transfer agent, its securities custodian, the counterparties on its various financing agreements and hedging contracts and vendors. The Manager, at its expense, is conducting a survey, which is expected to be completed during the first half of 1999, of all such third parties to try to determine the readiness of such third parties to handle Year 2000 dates and to try to determine the potential impact of Year 2000 issues. The Company cannot be certain that such a survey will fully identify all Year 2000 issues or to fully access the potential problems or loss associated with Year 2000 issues or that any failure by these other third parties to resolve Year 2000 issues would not have an adverse effect on the Company's operations and financial condition. The Company and the Manager believe that they are spending the appropriate and necessary resources to try to identify Year 2000 issues and to resolve them or to mitigate the impact of them to the best of their ability as they are identified. The Company has not developed likely worst case scenarios nor contingency plans for such scenarios.
OTHER MATTERS
The Company calculates its Qualified REIT Assets, as defined in the Internal Revenue Code of 1986, as amended (the "Code"), to be 99.1% of its total assets, compared to the Code requirement that at least 75% of its total assets must be Qualified REIT Assets. The Company also calculates that 99.8% of its 1998 revenue qualifies for the 75% source of income test and 100% of its 1998 revenue qualifies for the 95% source of income test under the REIT rules. The Company also met all REIT requirements regarding the ownership of its common stock and the distributions of its net income. Therefore, as of December 31, 1998, the Company believes that it will continue to qualify as a REIT under the provisions of the Code.
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, the Company's use of leverage would be substantially reduced. The Investment Company Act exempts entities that are "primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate" ("Qualifying Interests"). Under current interpretation of the staff of the SEC, in order to qualify for this exemption, the Company must maintain at least 55% of its assets directly in Qualifying Interests. In addition, unless certain mortgage assets represent all the certificates issued with respect to an underlying pool of mortgages, such mortgage assets may be treated as assets separate from the underlying mortgage loans and, thus, may not be considered Qualifying Interests for purposes of the 55% requirement. As of December 31, 1998, the Company calculates that it is in compliance with this requirement.
ITEM 7A.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information called for by Item 7A is incorporated by reference from the information in Item 7 under the caption "Market Risk" set forth on pages 34 through 36 in this Form 10-K
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements of the Company, the related notes and schedules to the financial statements, together with the Independent Auditor's Report thereon are set forth on pages through in 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 is incorporated herein by reference to the definitive Proxy Statement dated March 29, 1999 pursuant to General Instruction G(3).
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
The information required by Item 11 is incorporated herein by reference to the definitive Proxy Statement dated March 29, 1999 pursuant to General Instruction G(3).
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by Item 12 is incorporated herein by reference to the definitive Proxy Statement dated March 29, 1999 pursuant to General Instruction G(3).
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by Item 13 is incorporated herein by reference to the definitive Proxy Statement dated March 29, 1999 pursuant to General Instruction G(3).
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-K:
Independent Auditors' Report; Consolidated Balance Sheets as of December 31, 1998 and 1997; Consolidated Statements of Operations for the years ended December 31, 1998, 1997 and 1996; Consolidated Statements of Shareholders' Equity for the years ended December 31, 1998, 1997 and 1996; Consolidated Statements of Cash Flows for the years ended December 31, 1998, 1997 and 1996 and Notes to Consolidated Financial Statements.
2. Schedules to Consolidated Financial Statements:
All consolidated financial statement schedules are included in Part II, Item 8 of this Annual Report on Form-K.
3. Exhibits:
See "Exhibit Index".
(b) Reports on Form 8-K:
None
THORNBURG MORTGAGE ASSET CORPORATION AND SUBSIDIARIES
CONSOLIDATED FINANCIAL STATEMENTS
AND
INDEPENDENT AUDITOR'S REPORT
For Inclusion in Form 10-K
Filed with
Securities and Exchange Commission
December 31, 1998
INDEPENDENT AUDITOR'S REPORT
To the Board of Directors Thornburg Mortgage Asset Corporation Santa Fe, New Mexico
We have audited the accompanying consolidated balance sheets of Thornburg Mortgage Asset Corporation and subsidiaries as of December 31, 1998 and 1997 and the related consolidated statements of operations, shareholders' equity and cash flows for each of the three years in the period ended December 31, 1998. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with 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 Thornburg Mortgage Asset Corporation and subsidiaries as of December 31, 1998 and 1997, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 1998 in conformity with generally accepted accounting principles.
Our audits were made for the purpose of forming an opinion on the basic financial statements taken as a whole. The supplemental Schedule IV is presented for purposes of complying with the Securities and Exchange Commission's rules and is not a part of the basic financial statements. This schedule has been subjected to the auditing procedures applied in our audits of the basic financial statements and, in our opinion, is fairly stated in all material respects in relation to the basic financial statements taken as a whole.
/s/ McGLADREY & PULLEN, LLP
McGLADREY & PULLEN, LLP
New York, New York January 20 , 1999
See Notes to Consolidated Financial Statements.
See Notes to Consolidated Financial Statements.
See Notes to Consolidated Financial Statements.
THORNBURG MORTGAGE ASSET CORPORATION AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
Thornburg Mortgage Asset Corporation (the "Company") was incorporated in Maryland on July 28, 1992. The Company commenced its operations of purchasing and managing for investment a portfolio of adjustable-rate mortgage assets on June 25, 1993, upon receipt of the net proceeds from the initial public offering of the Company's common stock.
A summary of the Company's significant accounting policies follows:
CASH AND CASH EQUIVALENTS
Cash and cash equivalents includes cash on hand and highly liquid investments with original maturities of three months or less. The carrying amount of cash equivalents approximates their value.
BASIS OF PRESENTATION
The consolidated financial statements include the accounts of the Company and its wholly owned special purpose finance subsidiaries, Thornburg Mortgage Funding Corporation and Thornburg Mortgage Acceptance Corporation. The Company formed these entities in connection with the issuance of the callable collateralized notes discussed in Note 3. All material intercompany accounts and transactions are eliminated in consolidation.
ADJUSTABLE-RATE MORTGAGE ASSETS
The Company's adjustable-rate mortgage ("ARM") assets are comprised of ARM securities, ARM loans and collateral for callable AAA notes payable, which also consists of ARM securities and ARM loans.
In the second quarter of 1998, the Company decided to change its policy regarding its classification of ARM securities such that each ARM security is classified as available-for-sale. The Company changed its policy because the remaining amount of ARM securities classified as held-to-maturity had become a relatively small percentage of the portfolio, less than 8% of assets at March 31, 1998, and because it is apparent that as more mortgage REITs have been formed, that it is industry practice to carry all mortgage securities as available-for-sale. The Company had not classified any ARM securities purchased since 1994 as held-to-maturity and does not expect to do so in the future. Management has made the determination that all of its ARM securities should be designated as available-for-sale in order to be prepared to respond to potential future opportunities in the market, to sell ARM securities in order to optimize the portfolio's total return and to retain its ability to respond to economic conditions that might require the Company to sell assets in order to maintain an appropriate level of liquidity. Since all ARM securities are designated as available-for-sale, they are reported at fair value, with unrealized gains and losses excluded from earnings and reported in accumulated other comprehensive income as a separate component of shareholders' equity.
Management has the intent and ability to hold the Company's ARM loans for the foreseeable future and until maturity or payoff. Therefore, they are carried at their unpaid principal balances, net of unamortized premium or discount and allowance for loan losses.
The collateral for the callable AAA notes includes ARM securities and ARM loans which are accounted for in the same manner as the ARM securities and ARM loans that are not held as collateral.
Premiums and discounts associated with the purchase of the ARM assets are amortized into interest income over the lives of the assets using the effective yield method adjusted for the effects of estimated prepayments.
ARM asset transactions are recorded on the date the ARM assets are purchased or sold. Purchases of new issue ARM assets are recorded when all significant uncertainties regarding the characteristics of the assets are removed, generally shortly before settlement date. Realized gains and losses on ARM asset transactions are determined on the specific identification basis.
CREDIT RISK
The Company limits its exposure to credit losses on its portfolio of ARM securities by only purchasing ARM securities that have an investment grade rating at the time of purchase and have some form of credit enhancement or are guaranteed by an agency of the federal government. An investment grade security generally has a security rating of BBB or Baa or better by at least one of two nationally recognized rating agencies, Moody's Investor Services, Inc. or Standard & Poor's, Inc. (the "Rating Agencies"). Additionally, the Company has also purchased ARM loans and limits its exposure to credit losses by restricting its whole loan purchases to ARM loans generally originated to "A" quality underwriting standards or loans that have at least five years of pay history and/or low loan to property value ratios. The Company further limits its exposure to credit losses by limiting its investment in investment grade securities that are rated A, or equivalent, BBB, or equivalent, or ARM loans originated to "A" quality underwriting standards ("Other Investments") to no more than 30% of the portfolio.
The Company monitors the delinquencies and losses on the underlying mortgage loans backing its ARM assets. If the credit performance of the underlying mortgage loans is not as expected, the Company makes a provision for possible credit losses at a level deemed appropriate by management to provide for known losses as well as unidentified losses in its ARM assets portfolio. The provision is based on management's assessment of numerous factors affecting its portfolio of ARM assets including, but not limited to, current economic conditions, delinquency status, credit losses to date on underlying mortgages and remaining credit protection. The provision for ARM securities is made by reducing the cost basis of the individual security for the decline in fair value which is other than temporary, and the amount of such write-down is recorded as a realized loss, thereby reducing earnings. The Company also makes a monthly provision for possible credit losses on its portfolio of ARM loans which is an increase to the reserve for possible loan losses. The provision for possible credit losses on loans is based on loss statistics of the real estate industry for similar loans, taking into consideration factors including, but not limited to, underwriting characteristics, seasoning, geographic location and current economic conditions. When a loan or a portion of a loan is deemed to be uncollectible, the portion deemed to be uncollectible is charged against the reserve and subsequent recoveries, if any, are credited to the reserve.
Credit losses on pools of loans that are held as collateral for AAA notes payable are also covered by third party insurance policies that protect the Company from credit losses above a specified level, limiting the Company's exposure to credit losses on such loans. The Company makes a monthly provision for possible credit losses on these loans the same as it does for loans that are not held as collateral for AAA notes payable, except, taking into consideration its maximum exposure.
Provisions for credit losses do not reduce taxable income and thus do not affect the dividends paid by the Company to shareholders in the period the provisions are taken. Actual losses realized by the Company do reduce taxable income in the period the actual loss is realized and would affect the dividends paid to shareholders for that tax year.
DERIVATIVE FINANCIAL INSTRUMENTS
INTEREST RATE CAP AGREEMENTS
The Company purchases interest rate cap agreements (the "Cap Agreements") to limit the Company's risks associated with the lifetime or maximum interest rate caps of its ARM assets should interest rates rise above specified levels. The Cap Agreements reduce the effect of the lifetime cap feature so that the yield on the ARM assets will continue to rise in high interest rate environments as the Company's cost of borrowings also continue to rise.
Under policies in effect prior to the second quarter of 1998, Cap Agreements classified as a hedge against held-to-maturity assets were initially carried at their fair value as of the time the Cap Agreements and the related assets are designated as held-to-maturity with an adjustment to equity for any unrealized gains or losses at the time of the designation. Any adjustment to equity was thereafter amortized into interest income as a yield adjustment in a manner consistent with the amortization of any premium or discount. All Cap Agreements are now classified as a hedge against available-for-sale assets and are carried at their fair value with unrealized gains and losses reported as a separate component of equity, consistent with the reporting of such assets. The carrying value of the Cap Agreements are included in ARM securities on the balance sheet. The Company purchases Cap Agreements by incurring a one-time fee or premium. The amortization of the premium paid for the Cap Agreements is included in interest income as a contra item (i.e., expense) and, as such, reduces interest income over the lives of the Cap Agreements.
Realized gains and losses resulting from the termination of the Cap Agreements that were hedging assets classified as held-to-maturity were deferred as an adjustment to the carrying value of the related assets and are being amortized into interest income over the terms of the related assets. Realized gains and losses resulting from the termination of such agreements that are hedging assets classified as available-for-sale are initially reported in a separate component of equity, consistent with the reporting of those assets, and are thereafter amortized as a yield adjustment.
INTEREST RATE SWAP AGREEMENTS
The Company enters into interest rate swap agreements in order to manage its interest rate exposure when financing its ARM assets. In general, swap agreements have been utilized by the Company in two ways. One way has been to use swap agreements as a cost effective way to lengthen the average repricing period of its variable rate and short term borrowings. Additionally, as the Company acquires hybrid assets, it also enters into swap agreements in order to manage the interest rate repricing mismatch (the difference between the remaining fixed-rate period of a hybrid and the maturity of the fixed-rate liability funding a hybrid) to approximately one year. Revenues and expenses from the interest rate swap agreements are accounted for on an accrual basis and recognized as a net adjustment to interest expense.
INCOME TAXES
The Company has elected to be taxed as a Real Estate Investment Trust ("REIT") and complies with the provisions of the Internal Revenue Code of 1986, as amended (the "Code") with respect thereto. Accordingly, the Company will not be subject to Federal income tax on that portion of its income that is distributed to shareholders and as long as certain asset, income and stock ownership tests are met.
NET EARNINGS PER SHARE
Basic EPS amounts are computed by dividing net income (adjusted for dividends declared on preferred stock) by the weighted average number of common shares outstanding. Diluted EPS amounts assume the conversion, exercise or issuance of all potential common stock instruments unless the effect is to reduce a loss or increase the earnings per common share.
Following is information about the computation of the earnings per share data for the years ended December 31, 1998, 1997 and 1996 (Amounts in thousands except per share data):
The Company has granted options to directors and officers of the Company and employees of the Manager to purchase 59,784 in 1998, 240,320 in 1997 and 169,099 shares of common stock in 1996 at average prices of $14.82, $20.89 and $15.44 per share during the years ended December 31, 1998, 1997 and 1996, respectively. The conversion of preferred stock was not included in the computation of diluted EPS for any year because such conversion would increase the diluted EPS.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1997, the Financial Accounting Standards Board ("FASB") issued SFAS No. 130, Reporting Comprehensive Income. This statement requires companies to classify items of other comprehensive income, such as unrealized gains and losses on available-for-sale securities, by their nature in a financial statement and display the accumulated balance of other comprehensive income separately from retained earnings and additional paid-in capital in the equity section of a statement of financial position. The Company adopted this statement in the first quarter of 1998.
In June 1998, the FASB issued SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities. SFAS No. 133 established a framework of accounting rules that standardize accounting and reporting for all derivative instruments and is effective for financial statements issued for fiscal years beginning after June 15, 1999. The Statement requires that all derivative financial instruments be carried on the balance sheet at fair value. Currently the only derivative instruments that are not on the Company's balance sheet at fair value are interest rate swap agreements. The fair value of interest rate swap agreements is disclosed in Note 4, Fair Value of Financial Instruments. The Company believes that its use of interest rate swap agreements qualify as cash-flow hedges as defined in the statement. Therefore, the effective portion of the hedge's change in the fair value of these derivatives instruments will be recorded in other comprehensive income and the ineffective portion will be included in earnings when the Company adopts the statement in the first quarter of its fiscal 2000 year.
In October 1998, the FASB issued SFAS No. 134, Accounting for Mortgage-Backed Securities Retained after the Securitization of Mortgage Loans Held for Sale by a Mortgage Banking Enterprise. This Statement, which is effective for the first fiscal quarter beginning after December 15, 1998, provides guidance to mortgage banking entities who securitize mortgage loans such that their accounting for securitized loans will be the same as their accounting for marketable securities. The Company has already been accounting for its securitized loans in a manner consistent with the new statement and therefore expects no changes to its financial position or results of operations as a result of adopting SFAS No. 134.
NOTE 2. ADJUSTABLE-RATE MORTGAGE ASSETS AND INTEREST RATE CAP AND FLOOR AGREEMENTS
The following tables present the Company's ARM assets as of December 31, 1998 and December 31, 1997. The ARM securities classified as available-for-sale are carried at their fair value, while the ARM securities classified as held-to-maturity in 1997 and ARM loans are carried at their amortized cost basis (dollar amounts in thousands):
During 1998, the Company realized $4,634,000 in gains and $4,912,000 in losses on the sale of $932.3 million of ARM securities and ARM loans. During 1997, the Company realized $2,179,000 in gains and $990,000 in losses on the sale of $189.0 million of ARM securities, and during 1996, the Company realized $1,427,000 in gains and $65,000 in losses on the sale of $276.4 million of ARM securities. All of the ARM securities sold were classified as available-for-sale. During 1998, approximately $379 million securities previously classified as held-to-maturity were reclassified as available-for-sale.
As of December 31, 1998, the Company had reduced the cost basis of its ARM securities due to potential future credit losses (other than temporary declines in fair value) in the amount of $1,242,000. At December 31, 1998, the Company is providing for potential future credit losses on two assets that have an aggregate carrying value of $11.8 million, which represent less than 0.3% of the Company's total portfolio of ARM assets. Both of these assets are performing and one has some remaining credit support that mitigates the Company's exposure to potential future credit losses. Additionally, during 1998, the Company, in accordance with its credit policies, recorded a $762,000 provision for potential credit losses on its loan portfolio, although no actual losses have been realized in the loan portfolio to date.
The following tables summarize ARM loan delinquency information as of December 31, 1998 and 1997 (dollar amounts in thousands):
The following table summarizes the activity for the allowance for losses on ARM loans for the year ended December 31, 1998 and 1997 (dollar amounts in thousands):
As of December 31, 1998, the Company had commitments to purchase $102.1 million of ARM loans.
The average effective yield on the ARM assets owned was 5.86% as of December 31, 1998 and 6.38% as of December 31, 1997. The average effective yield is based on historical cost and includes the amortization of the net premium paid for the ARM assets and the Cap Agreements, the impact of ARM principal payment receivables and the amortization of deferred gains from hedging activity.
As of December 31, 1998 and December 31, 1997, the Company had purchased Cap Agreements with a remaining notional amount of $4.026 billion and $4.156 billion, respectively. The notional amount of the Cap Agreements purchased decline at a rate that is expected to approximate the amortization of the ARM assets. Under these Cap Agreements, the Company will receive cash payments should the one-month, three-month or six-month London InterBank Offer Rate ("LIBOR") increase above the contract rates of the Cap Agreements which range from 7.50% to 13.00% and average approximately 10.10%. The Company's ARM assets portfolio had an average lifetime interest rate cap of 11.70%. The Cap Agreements had an average maturity of 2.3 years as of December 31, 1998. The initial aggregate notional amount of the Cap Agreements declines to approximately $3.485 billion over the period of the agreements, which expire between 1999 and 2004. The Company purchased these Cap Agreements by incurring a one-time fee, or premium. The premium is amortized, or expensed, over the lives of the Cap Agreements and decreases interest income on the Company's ARM assets during the period of amortization. The Company has credit risk to the extent that the counterparties to the cap agreements do not perform their obligations under the Cap Agreements. If one of the counterparties does not perform, the Company would not receive the cash to which it would otherwise be entitled under the conditions of the Cap Agreement. In order to mitigate this risk and to achieve competitive pricing, the Company has entered into Cap Agreements with six different counterparties, five of which are rated AAA, and one is rated AA.
NOTE 3. REVERSE REPURCHASE AGREEMENTS, CALLABLE COLLATERALIZED NOTES PAYABLE AND OTHER BORROWINGS
The Company has entered into reverse repurchase agreements to finance most of its ARM assets. The reverse repurchase agreements are short-term borrowings that are secured by the market value of the Company's ARM assets and bear interest rates that have historically moved in close relationship to LIBOR.
As of December 31, 1998, the Company had outstanding $2.867 billion of reverse repurchase agreements with a weighted average borrowing rate of 5.62% and a weighted average remaining maturity of 2.0 months. As of December 31, 1998, $1.147 billion of the Company's borrowings were variable-rate term reverse repurchase agreements with original maturities that range from three months to two years. The interest rates of these term reverse repurchase agreements are indexed to either the one-, three- or six-month LIBOR rate and reprice accordingly. The reverse repurchase agreements at December 31, 1997 were collateralized by ARM assets with a carrying value of $3.005 billion, including accrued interest and cash in the amount of $22.4 million.
At December 31, 1998, the reverse repurchase agreements had the following remaining maturities (dollar amounts in thousands):
As of December 31, 1998, the Company had one whole loan financing facility with an uncommitted borrowing capacity of $250,000,000. The Company had no balance borrowed against this facility as of year-end. This facility matured on January 8, 1999 and has been subsequently re-negotiated for an additional one year period. Under the new agreement in effect as of January 8, 1999, the whole loan financing facility is a committed facility in an amount of up to $150,000,000, with an option to increase this amount to $300,000,000.
On December 18, 1998, the Company, through a special purpose finance subsidiary, issued $1.144 billion of callable AAA notes payable ("Notes") collateralized by ARM loans with a principal balance of $1.049 billion and ARM securities with a balance of $128.3 million. As part of this transaction, the Company retained ownership of a subordinated certificate in the amount of $32.4 million, which represents the Company's maximum exposure to credit losses on the loans collateralizing the Notes. As of December 31, 1998, the Notes had a balance of $1.127 billion and an interest rate of 6.32%. The interest rate adjusts monthly at one-month LIBOR plus 0.70% through November 1999 and at one-month LIBOR plus 1.40% thereafter. The Notes mature on January 25, 2029 and are callable by the Company or Bear Stearns, one of the underwriters, monthly, although Bear Stearns has indicated it does not intend to exercise its ability to call the collateral prior to May 1999. The Company may call either the collateral or the Notes, at its option. In connection with the issuance of the Notes, the Company incurred costs of $3.9 million which is being amortized over the expected life of the Notes. Since the Notes are paid down as the collateral pays down, the amortization of the issuance cost will be adjusted periodically based on actual payment experience. If the collateral pays down faster than currently estimated, then the amortization of the issuance cost will increase and the effective cost of the Notes will increase and, conversely, if the collateral pays down slower than currently estimated, then the amortization of issuance cost will be decreased and the effective cost of the Notes will also decrease.
As of December 31, 1998, the Company was a counterparty to nineteen interest rate swap agreements ("Swaps") having an aggregate notional balance of $1.473 billion. As of year-end, these Swaps had a weighted average remaining term of 16.5 months. In accordance with these Swaps, the Company will pay a fixed rate of interest during the term of these Swaps and receive a payment that varies monthly with the one-month LIBOR rate. As a result of entering into these Swaps, the Company has reduced the interest rate variability of its cost to finance its ARM securities by increasing the average period until the next repricing of its borrowings from 26 days to 204 days. Fourteen of these Swaps were entered into in connection with the Company's acquisition of hybrid loans and commitments to acquire hybrid loans. These fourteen Swaps that hedge the fixed rate portion of the Company's hybrid loans (to within one year of the first interest rate reset) had a notional balance of $523 million at year-end and an average maturity of 44.0 months. The Swaps at December 31, 1998 were collateralized by ARM assets with a carrying value of $0.9 million, including accrued interest.
As of December 31, 1998, the Company had financed a portion of its portfolio of interest rate cap agreements with $2.0 million of other borrowings which require quarterly or semi-annual payments until the year 2000. These borrowings have a weighted average fixed rate of interest of 7.87% and have a weighted average remaining maturity of 1.4 years. The other borrowings financing cap agreements at December 31, 1998 were collateralized by ARM securities with a carrying value of $3.1 million, including accrued interest. The aggregate maturities of these other borrowings are as follows (dollars in thousands):
1999 $ 1,397 2000 632 ------- $ 2,029 =======
The total cash paid for interest was $267.9 million, $177.9 million and $112.2 million for 1998, 1997 and 1996 respectively.
NOTE 4. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following table presents the carrying amounts and estimated fair values of the Company's financial instruments at December 31, 1998 and December 31, 1997. FASB Statement No. 107, Disclosures About Fair Value of Financial Instruments, defines the fair value of a financial instrument as the amount at which the instrument could be exchanged in a current transaction between willing parties, other than in a forced or liquidation sale (dollar amounts in thousands):
The above carrying amounts for assets are combined in the balance sheet under the caption adjustable-rate mortgage assets. The carrying amount for assets categorized as available-for-sale is their fair value whereas the carrying amount for assets held-to-maturity or held for the foreseeable future is their amortized cost.
The fair values of the Company's ARM securities and cap agreements are based on market prices provided by certain dealers who make markets in these financial instruments or third-party pricing services. The fair values for ARM loans is determined by the Company by using the same pricing models employed by the Company in the process of determining a price to bid for loans in the open market, taking into consideration the aggregated characteristics of groups of loans such as, but not limited to, collateral type, index, margin, life cap, periodic cap, underwriting standards, age and delinquency experience. The fair value of the Company's long-term debt and interest rate swap agreements, which are off-balance sheet financial instruments, are based on market values provided by dealers who are familiar with the terms of the long-term debt and swap agreements. The fair values reported reflect estimates and may not necessarily be indicative of the amounts the Company could realize in a current market exchange. Cash and cash equivalents, interest receivable, reverse repurchase agreements, callable collateralized notes and other liabilities are reflected in the financial statements at their amortized cost, which approximates their fair value because of the short-term nature of these instruments.
NOTE 5. COMMON AND PREFERRED STOCK
In January 1997, the Company issued 2,760,000 shares of Series A 9.68% Cumulative Convertible Preferred Stock at a price of $25 per share pursuant to its Registration Statement on Form S-3 declared effective in December 1996. Net proceeds from this issuance totaled $65.8 million. The dividends are cumulative commencing on the issue date and are payable quarterly, in arrears. The dividends per share are equal to the greater of (i) $0.605 per quarter, or (ii) the quarterly dividend declared on the Company's common stock. Each share is convertible at the option of the holder at any time into one share of common stock. The preferred shares are redeemable by the Company on and after December 31, 1999, in whole or in part, as follows: (i) for one share of common stock plus accumulated, accrued but unpaid dividends, provided that for 20 trading days within any period of 30 consecutive trading days the closing price of the common stock equals or exceeds the conversion price of $25, or (ii) for cash at the issue price of $25, plus any accumulated, accrued but unpaid dividends through the redemption date. In the event of liquidation, the holders of the preferred shares will be entitled to receive out of the assets of the Company, prior to any distribution to the common shareholders, the issue price of $25 per share in cash, plus any accumulated, accrued and unpaid dividends.
During 1998, the Company issued 1,581,550 shares of common stock under its Dividend Reinvestment and Stock Purchase Plan and received net proceeds of $24.4 million. During 1997, the Company issued 912,590 shares of common stock under this plan and received net proceeds of $18.0 million, and during 1996, the Company issued 347,434 shares of common stock under this plan and received net proceeds of $5.4 million.
During 1998, stock options for 128,377 shares of common stock were exercised at an average price of $15.23 and $2.0 million of notes receivable were executed in connection with the exercise of these options. During 1997, stock options for 186,071 shares of common stock were exercised at an average price of $15.71. The Company received net proceeds of $0.2 million, and $2.7 million of notes receivable were executed in connection with the exercise of certain options. During 1996, stock options for 23,595 shares of common stock were exercised at an average price of $15.41 that generated net proceeds of $0.4 million.
On July 13, 1998, the Board of Directors approved a common stock repurchase program of up to 500,000 shares at prices below book value, subject to availability of shares and other market conditions. On September 18, 1998, the Board of Directors expanded this program by approving the repurchase of up to an additional 500,000 shares. To date, the company has repurchased 500,016 at an average price of $9.28 per share.
During the Company's 1998 fiscal year, the Company declared dividends to shareholders totaling $0.905 per common share, all of which was paid during 1998, and $2.42 per preferred share, of which $1.815 was paid during 1998 and $0.605 was paid on January 11, 1999. During the Company's 1997 fiscal year, the Company declared dividends to shareholders totaling $1.97 per common share, of which $1.47 was paid during 1997 and $0.50 was paid on January 12, 1998, and $2.265 per preferred share, of which $1.66 was paid during 1997 and $0.605 was paid on January 12, 1998. During the Company's 1996 fiscal year, the Company declared dividends to shareholders totaling $1.65 per common share, of which $1.20 was paid during 1996 and $0.45 was paid on January 12, 1997. For federal income tax purposes, $0.0638 of the 1998 common stock dividends was return of capital and not taxable, $0.01 of the 1997 common stock dividend was capital gains subject to a maximum tax rate of 28%, and $0.05 of the 1997 common stock dividend was capital gains subject to a maximum tax rate of 20%, and $0.03 of the 1996 common stock dividend was long-term capital gains. In addition, the preferred dividend paid on January 11, 1999 will be taken as a dividend deduction on the Company's 1999 income tax return and is therefore not taxable income for preferred shareholders until 1999. The remainder of the dividends paid for fiscal years 1998, 1997 and 1996 was ordinary income to the Company's common and preferred shareholders.
NOTE 6. STOCK OPTION PLAN
The Company has a Stock Option and Incentive Plan (the "Plan") which authorizes the granting of options to purchase an aggregate of up to 1,800,000 shares, but not more than 5% of the outstanding shares of the Company's common stock. The Plan authorizes the Board of Directors, or a committee of the Board of Directors, to grant Incentive Stock Options ("ISOs") as defined under section 422 of the Internal Revenue Code of 1986, as amended, options not so qualified ("NQSOs"), Dividend Equivalent Rights ("DERs"), Stock Appreciation Rights ("SARs"), and Phantom Stock Rights ("PSRs").
The exercise price for any options granted under the Plan may not be less than 100% of the fair market value of the shares of the common stock at the time the option is granted. Options become exercisable six months after the date granted and will expire ten years after the date granted, except options granted in connection with an offering of convertible preferred stock, in which case such options become exercisable if and when the convertible preferred stock is converted into common stock.
The Company issued DERs at the same time as ISOs and NQSOs based upon a formula defined in the Plan. During 1998 the number of DERs issued was based on 35% of the ISOs and NQSOs granted during 1998. The number of PSRs issued are based on the level of the Company's dividends and on the price of the Company's stock on the related dividend payment date and is equivalent to the cash that otherwise would be paid on the outstanding DERs and previously issued PSRs. The Company recorded an expense associated with the DERs and the PSRs of $11,000 and $32,000 for the years ended December 31, 1998 and 1997, respectively.
Notes receivable from stock sales has resulted from the Company selling shares of common stock through the exercise of stock options. The notes have maturity terms ranging from 3 years to 9 years and accrue interest at rates that range from 5.40% to 6.00% per annum. In addition, the notes are full recourse promissory notes and are secured by a pledge of the shares of the Common Stock acquired. Interest, which is credited to paid-in-capital, is payable quarterly, with the balance due at the maturity of the notes. The payment of the notes will be accelerated only upon the sale of the shares of Common Stock pledged for the notes. The notes may be prepaid at any time at the option of each borrower. As of December 31, 1998, there were $4.6 million of notes receivable from stock sales outstanding.
The Company adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, "Accounting for Stock-Based Compensation." Accordingly, no compensation cost has been recognized for the Company's stock option plan. Had compensation cost for the Company's stock option plan been determined based on the fair value at the grant date for awards in 1998, 1997 and 1996 consistent with the provisions of SFAS No. 123, the Company's net earnings and earnings per share would have been reduced to the pro forma amounts indicated in the table below. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option-pricing model (dollar amounts in thousands, except per share data).
Information regarding options is as follows:
The following table summarizes information about stock options outstanding at December 31, 1998:
NOTE 7. TRANSACTIONS WITH AFFILIATES
The Company has a Management Agreement (the "Agreement") with Thornburg Mortgage Advisory Corporation ("the Manager"). Under the terms of this Agreement, the Manager, subject to the supervision of the Company's Board of Directors, is responsible for the management of the day-to-day operations of the Company and provides all personnel and office space. The Agreement provides for an annual review by the unaffiliated directors of the Board of Directors of the Manager's performance under the Agreement.
The Company pays the Manager an annual base management fee based on average shareholders' equity, adjusted for liabilities that are not incurred to finance assets ("Average Shareholders' Equity" or "Average Net Invested Assets" as defined in the Agreement) payable monthly in arrears as follows: 1.1% of the first $300 million of Average Shareholders' Equity, plus 0.8% of Average Shareholders' Equity above $300 million.
For the years ended December 31, 1998, 1997 and 1996, the Company paid the Manager $4,142,000, $3,664,000 and $1,872,000, respectively, in base management fees in accordance with the terms of the Agreement.
The Manager is also entitled to earn performance based compensation in an amount equal to 20% of the Company's annualized net income, before performance based compensation, above an annualized Return on Equity equal to the ten year U.S. Treasury Rate plus 1%. For purposes of the performance fee calculation, equity is generally defined as proceeds from issuance of common stock before underwriter's discount and other costs of issuance, plus retained earnings. For the years ended December 31, 1998, 1997 and 1996, the Company paid the Manager $759,000, $3,363,000 and $2,462,000, respectively, in performance based compensation in accordance with the terms of the Agreement.
NOTE 8. NET INTEREST INCOME ANALYSIS
The following table summarizes the amount of interest income and interest expense and the average effective interest rate for the periods ended December 31, 1998, 1997 and 1996 (dollar amounts in thousands):
The following table presents the total amount of change in interest income/expense from the table above and presents the amount of change due to changes in interest rates versus the amount of change due to changes in volume (dollar amounts in thousands):
NOTE 9. SUMMARIZED QUARTERLY RESULTS (UNAUDITED)
The following is a presentation of the quarterly results of operations (amounts in thousands, except per share amounts):
SCHEDULE IV - Mortgage Loans on Real Estate
Column A, Description: The Company's whole loan portfolio at December 31, 1998, which consists of only first mortgages on single-family residential housing, is stratified as follows (dollar amounts in thousands):
Notes: (1) Reconciliation of carrying amounts of mortgage loans:
Balance at December 31, 1997. . $ 118,987 Additions during 1998: Loan purchases. . . . . . . . 1,092,238
Deductions during 1998: Collections of principal. . 128,079 Cost of mortgage loans sold 2,043 Provision for losses. . . . 762 Amortization of premium . . 2,016 ---------- 132,900 ---------- Balance at December 31, 1998. . $1,078,325 ==========
(2) The provision for losses is based on management's assessment of various factors. (3) Cost for Federal income taxes is the same. (4) The geographic distribution of the Company's whole loan portfolio at December 31, 1998 is as follows:
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
THORNBURG MORTGAGE ASSET CORPORATION (Registrant)
Dated: March 26, 1999 /s/ Garrett Thornburg --------------------------------------- Garrett Thornburg Chairman of the Board of Directors and Chief Executive Officer (Principal Executive Officer)
Dated: March 26, 1999 /s/ Richard P. Story --------------------------------------- Richard P. Story Chief Financial Officer and Treasurer (Principal Accounting Officer)
Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.