UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED: SEPTEMBER 30, 2008
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM _______________ TO _________________
COMMISSION FILE NUMBER: 1-13447
CHIMERA INVESTMENT CORPORATION
(Exact name of Registrant as specified in its Charter)
MARYLAND 26-0630461
(State or other jurisdiction of incorporation (IRS Employer Identification No.)
or organization)
1211 AVENUE OF THE AMERICAS, SUITE 2902
NEW YORK, NEW YORK
(Address of principal executive offices)
10036
(Zip Code)
(646) 454-3759
(Registrant's telephone number, including area code)
Indicate by check mark whether the Registrant (1) has filed all documents
and reports required to be filed by Section 13 or 15(d) of the Securities
Exchange Act of 1934 during the preceding 12 months (or for such shorter period
that the Registrant was required to file such reports), and (2) has been subject
to such filing requirements for the past 90 days:
Yes X No
----- ------
Indicate by check mark whether the Registrant is a large accelerated filer,
an accelerated filer, non-accelerated filer, or a smaller reporting company. See
definition of "accelerated filer," "large accelerated filer," and "smaller
reporting company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer |_| Accelerated filer |_| Non-accelerated filer |X|
Smaller reporting company |_|
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). Yes |_| No |X|
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the last practicable date:
Class Outstanding at November 10, 2008
Common Stock, $.01 par value 177,170,098
CHIMERA INVESTMENT CORPORATION
FORM 10-Q
TABLE OF CONTENTS
Part I. FINANCIAL INFORMATION
Item 1. Financial Statements:
Consolidated Statements of Financial Condition at September 30, 2008 (Unaudited) and December 31, 2007
(Derived from the audited statement of financial condition at December 31, 2007) 1
Consolidated Statements of Operations and Comprehensive Loss for the Quarter and Nine Months ended
September 30, 2008 (Unaudited) 2
Consolidated Statement of Stockholders' Equity for the Quarters Ended March 31, 2008, June 30,
2008 and September 30, 2008 (Unaudited) 3
Consolidated Statements of Cash Flows for the Quarter and Nine Months ended September 30, 2008
(Unaudited) 4
Notes to Consolidated Financial Statements (Unaudited) 5
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 18
Item 3. Quantitative and Qualitative Disclosures about Market Risk 37
Item 4. Controls and Procedures 42
Part II. OTHER INFORMATION
Item 1. Legal Proceedings 43
Item 1A. Risk Factors 43
Item 6. Exhibits 45
SIGNATURES 47
CERTIFICATIONS 48
PART I.
ITEM 1. FINANCIAL STATEMENTS
i
CHIMERA INVESTMENT CORPORATION
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(dollars in thousands, except per share data)
September 30, December 31,
2008 2007(1)
(unaudited)
---------------- ------------------
ASSETS
------
Cash and cash equivalents $ 6,167 $ 6,026
Restricted cash - 1,350
Reverse repurchase agreements - 265,000
Mortgage-Backed Securities, at fair value 759,378 1,124,290
Loans held for investment, net of allowance for loan losses
of $0 and $81, respectively - 162,371
Securitized loans held for investment, net of allowance for
loan losses of $681 and $0, respectively 598,014 -
Accrued interest receivable 8,212 6,036
Other assets 456 563
---------------- ------------------
Total assets $ 1,372,227 $ 1,565,636
================ ==================
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Liabilities:
Repurchase agreements $ 619,657 $ 270,584
Securitized debt 500,688 -
Payable for investments purchased - 748,920
Accrued interest payable 2,579 415
Dividends payable 6,048 943
Accounts payable and other liabilities 2,313 1,729
Interest rate swaps, at fair value - 4,156
---------------- ------------------
Total liabilities 1,131,285 1,026,747
---------------- ------------------
Commitments and Contingencies (Note 14)
Stockholders' Equity:
Common stock: par value $.01 per share; 500,000,000 shares
authorized, 38,992,893 and 37,705,563 shares issued and
outstanding, respectively 378 377
Additional paid-in capital 533,220 532,208
Accumulated other comprehensive (loss) income (138,307) 10,153
Accumulated deficit (154,349) (3,849)
---------------- ------------------
Total stockholders' equity 240,942 538,889
---------------- ------------------
Total liabilities and stockholders' equity $ 1,372,227 $ 1,565,636
================ ==================
(1) Derived from the audited statement of financial condition at December 31, 2007.
See notes to consolidated financial statements.
1
CHIMERA INVESTMENT CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
(dollars in thousands, except per share data)
(unaudited)
For the Quarter For the Nine
Ended Months Ended
September 30, September 30,
2008 2008
---------------- ----------------
Interest income $ 23,458 $ 81,603
Interest expense 15,543 49,590
---------------- ----------------
Net interest income 7,915 32,013
---------------- ----------------
Unrealized gains on interest rate swaps 10,065 4,156
Realized losses on sales of investments (113,130) (144,304)
Realized losses on terminations of interest rate
swaps (10,460) (10,337)
---------------- ----------------
Net investment expense (105,610) (118,472)
---------------- ----------------
Other expenses
Management fee 1,681 6,136
General and administrative expenses 253 3,972
---------------- ----------------
Total expenses 1,934 10,108
---------------- ----------------
Loss before income taxes (107,544) (128,580)
Income tax 12 15
---------------- ----------------
Net loss $ (107,556) $ (128,595)
================ ================
Net loss per share - basic and diluted $ (2.76) $ (3.30)
================ ================
Weighted average number of shares outstanding - basic
and diluted 38,992,893 38,994,357
================ ================
Comprehensive Loss:
Net loss $ (107,556) $ (128,595)
---------------- ----------------
Other comprehensive loss:
Unrealized loss on available-for-sale securities (146,456) (282,611)
Reclassification adjustment for realized losses
included in net income 113,130 144,304
---------------- ----------------
Other comprehensive loss (33,326) (138,307)
---------------- ----------------
Comprehensive loss $ (140,882) $ (266,902)
================ ================
See notes to consolidated financial statements.
2
CHIMERA INVESTMENT CORPORATION
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(dollars in thousands, except per share data)
(unaudited)
Accumulated
Common Other
Stock Par Additional Comprehensive Accumulated
Value Paid-in Capital Loss Deficit Total
---------------------------------------------------------------------------------------------------------------------------
Balance, January 1, 2008 $ 377 $ 532,208 $ 10,153 $ (3,849) $ 538,889
Net loss - - - (128,594) (128,594)
Other comprehensive loss - - (148,460) - (148,460)
Costs associated with common
stock offering - (277) - - (277)
Restricted stock grants 1 1289 - - 1,290
Common dividends declared, $0.16
per share - - - (21,906) (21,906)
---------------------------------------------------------------------------
Balance, September 30, 2008 $ 378 $ 533,220 $ (138,307) $ (154,349) $ 240,942
===========================================================================
See notes to consolidated financial statements.
3
CHIMERA INVESTMENT CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands)
(unaudited)
For the Quarter For the Nine
Ended Months Ended
September 30, September 30,
2008 2008
--------------- ---------------
Cash Flows From Operating Activities:
Net loss $ (107,556) $ (128,595)
Adjustments to reconcile net loss to net cash provided by
(used in) operating activities:
Amortization of investment premiums and discounts 908 (25)
Unrealized gains on interest rate swaps (10,065) (4,156)
Realized losses on sale of investments 113,130 144,304
(Benefit) provision for loan losses (563) 600
Restricted stock grants expense 254 1,289
Changes in operating assets
Decrease (increase) in accrued interest receivable 1,651 (3,874)
Decrease in other assets 1,192 106
Changes in operating liabilities
(Decrease) increase in accounts payable (570) 434
(Decrease) increase in accrued interest payable (939) 2,165
(Decrease) increase in other liabilities (657) 150
--------------- ---------------
Net cash provided by (used in) operating
activities (3,215) 12,398
--------------- ---------------
Cash Flows From Investing Activities:
Mortgage-Backed securities portfolio:
Purchases (708) (1,229,280)
Sales 319,441 567,455
Principal payments 41,407 144,519
Loans held for investment portfolio:
Purchases (146,862) (735,271)
Sales - 90,733
Principal payments 1,172 23,115
Securitized loans
Principal payments 14,892 27,549
Purchases (111) (111)
Reverse repurchase agreements - 265,000
Decrease in restricted cash 29,507 1,350
--------------- ---------------
Net cash provided by (used in) investing
activities 258,738 (844,941)
--------------- ---------------
Cash Flows From Financing Activities:
Net proceeds from repurchase agreements 30,563,956 49,177,282
Net payments on repurchase agreements (30,853,387) (48,828,209)
Costs associated with common stock offerings (61) (277)
Net proceeds from securitized debt 10,314 526,217
Net payments on securitized debt (14,023) (25,529)
Dividends paid (6,044) (16,800)
--------------- ---------------
Net cash provided by financing activities (299,245) 832,685
--------------- ---------------
Net (decrease) increase in cash and cash equivalents (43,722) 141
Cash and cash equivalents at beginning of period 49,889 6,026
--------------- ---------------
Cash and cash equivalents at end of period $ 6,167 $ 6,167
=============== ===============
Supplemental disclosure of cash flow information
Interest paid $ 16,482 $ 47,425
=============== ===============
Taxes paid $ 12 $ 33
=============== ===============
Non cash investing activities
Payable for investments purchased $ (146,824) $ 146,824
=============== ===============
Transfer from loans held for investment
to Mortgage-backed securities $ 146,862 $ 146,862
=============== ===============
Net change in unrealized loss on available for sale
securities $ (33,326) $ (138,307)
=============== ===============
Non cash financing activities
Dividends declared, not yet paid $ 6,048 $ 6,048
=============== ===============
See notes to consolidated financial statements.
4
CHIMERA INVESTMENT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE QUARTER ENDED SEPTEMBER 30, 2008
(dollars in thousands, except per share data)
(unaudited)
--------------------------------------------------------------------------------
1. Organization and Significant Accounting Policies
Chimera Investment Corporation, or the Company, was organized in Maryland on
June 1, 2007. The Company commenced operations on November 21, 2007 when it
completed its initial public offering. The Company has elected to be taxed as a
real estate investment trust, or REIT, under the Internal Revenue Code of 1986,
as amended. As such, the Company is required to distribute substantially all of
the income generated from its operations to its stockholders. As long as the
Company qualifies as a REIT, the Company will generally not be subject to U.S.
federal or state corporate taxes on its income to the extent that the Company
distributes at least 90% of its taxable net income to its stockholders. The
Company is managed by Fixed Income Discount Advisory Company, or FIDAC, an
investment advisor registered with the Securities and Exchange Commission. FIDAC
is a wholly-owned subsidiary of Annaly Capital Management, Inc., or Annaly.
A summary of the Company's significant accounting policies follows:
Basis of Presentation
The accompanying unaudited consolidated financial statements have been prepared
in conformity with the instructions to Form 10-Q and Article 10, Rule 10-01 of
Regulation S-X for interim financial statements. Accordingly, they may not
include all of the information and footnotes required by accounting principles
generally accepted in the United States of America, or GAAP. The consolidated
interim financial statements are unaudited; however, in the opinion of the
Company's management, all adjustments, consisting only of normal recurring
accruals, necessary for a fair presentation of the financial position, results
of operations, and cash flows have been included. Comparative information for
the quarter and nine months ended September 30, 2007 is not provided because the
Company did not commence operations until November 21, 2007. These unaudited
consolidated financial statements should be read in conjunction with the audited
consolidated financial statements included in the Company's Annual Report on
Form 10-K for the year ended December 31, 2007. The nature of the Company's
business is such that the results of any interim period are not necessarily
indicative of results for a full year.
Cash and Cash Equivalents
Cash and cash equivalents include cash on hand and money market funds.
Restricted Cash
Restricted cash includes cash held by counterparties as collateral for
repurchase agreements and interest rate swaps.
Reverse Repurchase Agreements
The Company may invest its daily available cash balances in reverse repurchase
agreements to provide additional yield on its assets. These investments will
typically be recorded as short term investments, will mature daily, and are
referred to as reverse repurchase agreements in the statement of financial
condition. Reverse repurchase agreements are recorded at cost and are
collateralized by residential mortgage-backed securities, or RMBS.
5
Residential Mortgage-Backed Securities
The Company invests in RMBS representing interests in obligations backed by
pools of mortgage loans and carries those securities at fair value estimated
using a pricing model. Management reviews the fair values generated to
determine that prices are reflective of the current market. Management performs
a validation of the fair value calculated by the pricing model by comparing its
results to independent prices provided by dealers in the securities and/or third
party pricing services. If dealers or independent pricing services are unable to
provide a price for an asset, or if the price provided by them is deemed
unreliable by FIDAC, then the asset will be valued at its fair value as
determined in good faith by FIDAC. In the current market, it may be difficult or
impossible to obtain third party pricing on the investments the Company
purchases. In addition, validating third party pricing for the Company's
investments may be more subjective as fewer participants may be willing to
provide this service to the Company. Moreover, the current market is more
illiquid than in recent history for some of the investments the Company
purchases. Illiquid investments typically experience greater price volatility as
a ready market does not exist. As volatility increases or liquidity decreases,
the Company may have greater difficulty financing its investments which may
negatively impact its earnings and the execution of its investment strategy.
Please see Note 5 for a discussion of fair value measurement.
Statement of Financial Accounting Standards, or SFAS, No. 115, Accounting for
Certain Investments in Debt and Equity Securities, requires the Company to
classify its investment securities as either trading investments,
available-for-sale investments or held-to-maturity investments. Although the
Company generally intends to hold most of its RMBS until maturity, the Company
records its RMBS as available-for-sale and as such may sell any of its RMBS as
part of its overall management of its portfolio. All assets classified as
available-for-sale are reported at estimated fair value, with unrealized gains
and losses included in other comprehensive income.
Management evaluates investment securities for other-than-temporary impairment
at least on a quarterly basis, and more frequently when economic or market
concerns warrant such evaluation. Consideration is given to (1) the length of
time and the extent to which the fair value has been lower than carrying value,
(2) the financial condition and near-term prospects of the issuer, (3) credit
quality and cash flow performance of the security, and (4) the intent and
ability of the Company to retain its investment in the security for a period of
time sufficient to allow for any anticipated recovery in fair value. Unrealized
losses on investment securities that are considered other than temporary, as
measured by the amount of decline in fair value attributable to
other-than-temporary factors, are recognized in income and the cost basis of the
investment securities is adjusted.
RMBS transactions are recorded on the trade date. Realized gains and losses from
sales of RMBS are determined based on the specific identification method and
recorded as a gain (loss) on sale of investments in the statement of operations.
Accretion of discounts or amortization of premiums on available-for-sale
securities and mortgage loans is computed using the effective interest yield
method and is included as a component of interest income in the statement of
operations.
The current situation in the mortgage sector and the current weakness in the
broader mortgage market could adversely affect one or more of the Company's
lenders and could cause one or more of the Company's lenders to be unwilling or
unable to provide additional financing. This could potentially increase the
Company's financing costs and reduce liquidity. If one or more major market
participants fails, it could negatively impact the marketability of all fixed
income securities, including government mortgage securities. This could
negatively impact the value of the securities in the Company's portfolio, thus
reducing its net book value. Furthermore, if many of the Company's lenders are
unwilling or unable to provide additional financing, the Company could be forced
to sell its Investment Securities at an inopportune time when prices are
depressed.
Loans Held for Investment and Securitized Loans Held for Investment
The Company's securitized and un-securitized residential mortgage loans are
comprised of fixed-rate and variable-rate loans. The Company purchases pools of
residential mortgage loans through a select group of originators. Mortgage loans
are designated as held for investment, recorded on trade date, and are carried
at their principal balance outstanding, plus any premiums or discounts which are
amortized or accreted over the estimated life of the loan, less allowances for
loan losses. Loans are evaluated for possible credit losses. The Company has
created an unallocated provision for loan losses estimated as a percentage of
the remaining principal on the loans. Management's estimate is based on
historical experience of similarly underwritten loan pools. There were no losses
specifically allocated to loans as of September 30, 2008. From time to time, the
Company may securitize loans held for investment. These transactions are
recorded in accordance with FAS 140 Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities as either a "sale" and
classified as Mortgage-Backed Securities or as a "secured borrowing" and
classified as Securitized loans held for investment on the Company's
consolidated statement of financial condition.
6
Allowance for Loan Losses
The Company has established an allowance for loan losses at a level that
management believes is adequate based on an evaluation of known and inherent
risks related to the Company's loan portfolio. The estimate is based on a
variety of factors including, current economic conditions, industry loss
experience, credit quality trends, loan portfolio composition, delinquency
trends, national and local economic trends, national unemployment data, changes
in housing appreciation and whether specific geographic areas where the Company
has significant loan concentrations are experiencing adverse economic conditions
and events such as natural disasters that may affect the local economy or
property values. Upon purchase of the pools of loans, the Company obtained
written representations and warranties from the sellers that the Company could
be reimbursed for the value of the loan if the loan fails to meet the agreed
upon origination standards. While the Company has little history of its own to
establish loan trends, delinquency trends of the originators and the current
market conditions aid in determining the allowance for loan losses. The Company
also performed due diligence procedures on a sample of loans that met its
criteria during the purchase process.
When it is probable that specific contractually due amounts are uncollectible,
the loan is considered impaired. Where impairment is indicated, a valuation
write-off is measured based upon the excess of the recorded investment over the
net fair value of the collateral, reduced by selling costs. Any deficiency
between the carrying amount of an asset and the net sales price of repossessed
collateral is charged to the allowance for loan losses.
Securitized Debt
The Company has issued securitized debt to finance a portion of its residential
mortgage loan portfolio. The securitized debt is collateralized by residential
adjustable or fixed rate mortgage loans that have been placed in a trust and
bear interest and principal payments to the debt holders. The Company's
securitized debt is accounted for as borrowings and recorded as a liability on
the consolidated statement of financial condition.
Interest Income
Interest income on available-for-sale securities and loans held for investment
is recognized over the life of the investment using the effective interest
method as described by SFAS No. 91, Accounting for Nonrefundable Fees and Costs
Associated with Originating or Acquiring Loans and Initial Direct Costs of
Leases, for securities of high credit quality and Emerging Issues Task Force No.
99-20, Recognition of Interest Income and Impairment on Purchased and Retained
Beneficial Interests in Securitized Financial Assets, for all other securities.
Income recognition is suspended for loans when, in the opinion of management, a
full recovery of income and principal becomes doubtful. Income recognition is
resumed when the loan becomes contractually current and performance is
demonstrated to be resumed.
Derivative Financial Instruments/Hedging Activity
The Company economically hedges interest rate risk through the use of derivative
financial instruments. If the Company hedges using interest rate swaps it
accounts for these instruments as free-standing derivatives. Accordingly, they
are carried at fair value with realized and unrealized gains and losses
recognized in earnings.
7
Income Taxes
The Company intends to qualify to be taxed as a REIT, and therefore it generally
will not be subject to corporate federal or state income tax to the extent that
qualifying distributions are made to stockholders and the REIT requirements,
including certain asset, income, distribution and stock ownership tests are met.
If the Company failed to qualify as a REIT and did not qualify for certain
statutory relief provisions, the Company would be subject to federal, state and
local income taxes and may be precluded from qualifying as a REIT for the
subsequent four taxable years following the year in which the REIT qualification
was lost.
The Company accounts for income taxes in accordance with SFAS No. 109,
Accounting for Income Taxes, which requires the recognition of deferred income
taxes for differences between the basis of assets and liabilities for financial
statement and income tax purposes. Deferred tax assets and liabilities represent
the future tax consequence for those differences, which will either be taxable
or deductible when the assets and liabilities are recovered or settled. Deferred
taxes are also recognized for operating losses that are available to offset
future taxable income. Valuation allowances are established when necessary to
reduce deferred tax assets to the amount expected to be realized. In July 2006,
the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income
Taxes, an interpretation of FASB Statement No. 109 ("FIN 48"). FIN 48 clarifies
the accounting for uncertainty in income taxes recognized in a company's
financial statements and prescribes a recognition threshold and measurement
attribute for the financial statement recognition and measurement of a tax
position taken or expected to be taken in an income tax return. FIN 48 also
provides guidance on de-recognition, classification, interest and penalties,
accounting in interim periods, disclosure and transition. FIN 48 was effective
for the Company upon inception and its effect was not material.
Net Loss per Share
The Company calculates basic net loss per share by dividing net loss for the
period by the weighted-average shares of its common stock outstanding for that
period. Diluted net loss per share takes into account the effect of dilutive
instruments, such as stock options, but uses the average share price for the
period in determining the number of incremental shares that are to be added to
the weighted average number of shares outstanding. The Company had no
potentially dilutive securities outstanding during the periods presented.
Stock-Based Compensation
The Company accounts for stock-based compensation in accordance with the
provisions of SFAS No. 123R, Accounting for Stock-Based Compensation, which
establishes accounting and disclosure requirements using fair value based
methods of accounting for stock-based compensation plans. Compensation expense
related to grants of stock and stock options is recognized over the vesting
period of such grants based on the estimated fair value on the grant date.
Stock compensation awards granted to the employees of FIDAC are accounted for in
accordance with EITF 96-18, Accounting For Equity Instruments That Are Issued to
Other Than Employees for Acquiring, or in Conjunction with Selling, Goods and
Services, which requires the Company to measure the fair value of the equity
instrument using the stock prices and other measurement assumptions as of the
earlier of either the date at which a performance commitment by the counterparty
is reached or the date at which the counterparty's performance is complete.
Use of Estimates
The preparation of the financial statements in conformity with GAAP requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates.
8
Recent Accounting Pronouncements
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements ("SFAS
157"). SFAS 157 defines fair value, establishes a framework for measuring fair
value and requires enhanced disclosures about fair value measurements. SFAS 157
requires companies to disclose the fair value of its financial instruments
according to a fair value hierarchy (i.e., levels 1, 2, and 3, as defined) and
establishes that fair value is based on exit price as of the measurement date.
SFAS 157 was effective for the Company on January 1, 2008, see Note 5 for the
related disclosure.
Subsequently, on October 10, 2008, FASB issued FASB Staff Position (FSP) 157-3,
Determining the Fair Value of a Financial Asset When the Market for That Asset
Is Not Active ("FSP 157-3"), in response to the deterioration of the credit
markets. This FSP provides guidance clarifying how SFAS 157, should be applied
when valuing securities in markets that are not active. The guidance provides an
illustrative example that applies the objectives and framework of SFAS 157,
utilizing management's internal cash flow and discount rate assumptions when
relevant observable data do not exist. It further clarifies how observable
market information and market quotes should be considered when measuring fair
value in an inactive market. It reaffirms the notion of fair value as an exit
price as of the measurement date and that fair value analysis is a transactional
process and should not be broadly applied to a group of assets. FSP 157-3 is
effective upon issuance including prior periods for which financial statements
have not been issued. The Company does not believe the implementation of FSP
157-3 will have a material effect on the fair value of their assets as the
Company intends to continue the methodologies used in previous quarters to value
assets as defined under the original SFAS 157.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for
Financial Assets and Financial Liabilities, or SFAS 159. SFAS 159 permits
entities to choose to measure many financial instruments and certain other items
at fair value. Unrealized gains and losses on items for which the fair value
option has been elected will be recognized in earnings at each subsequent
reporting date. SFAS 159 became effective for the Company January 1, 2008. The
Company did not elect the fair value option for any existing eligible financial
instruments.
In June 2008, the FASB proposed amending SFAS 140 Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities and FIN 46(R),
Consolidation of Variable Interest Entities. This was due to increased
scrutiny of these accounting pronouncements by the SEC, Congress and financial
statement users in the wake of recent deterioration in the credit markets. The
proposed amendments would eliminate the Qualified Special Purpose Entity (QSPE)
in SFAS 140, and modify the consolidation model in FIN 46(R). QSPEs are utilized
extensively by many financial firms in securitizations for off-balance sheet
financing for "sale accounting" treatment in the transfer of financial assets.
Currently, QSPEs do not have to be consolidated on the issuing firm's financial
statements. Should the proposed changes to SFAS 140 become final, enterprises
involved with QSPEs will no longer be exempt from applying FIN 46(R), the FASB
Interpretation on consolidation; thus, previously unconsolidated entities may
have to be consolidated. The revisions will also eliminate the provision in
paragraph 9(b) of SFAS 140 that allowed entities to "look-through" to the rights
of beneficial interest holders when analyzing control. Further, the revisions
will address the derecognition of assets and amend the criteria for said
derecognition; and require that the beneficial interests received by a
transferor, in connection with a sale of an entire financial asset to an entity
that is not consolidated by the transferor, be considered proceeds of the sale
and initially measured at fair value.
Both financing and sale treatments have been used for GAAP reporting and tax
treatment by the Company. FASB has released their Exposure Draft on the proposed
amendments with comments due by November 14, 2008. The Company is currently
reviewing the effect of these amendments on the Company.
9
In March 2008, the FASB issued SFAS No. 161, or SFAS 161, Disclosures about
Derivative Instruments and Hedging Activities, an amendment of FASB Statement
No. 133. SFAS 161 attempts to improve the transparency of financial reporting by
providing additional information about how derivative and hedging activities
affect an entity's financial position, financial performance and cash flows.
This statement changes the disclosure requirements for derivative instruments
and hedging activities by requiring enhanced disclosure about (1) how and why an
entity uses derivative instruments, (2) how derivative instruments and related
hedged items are accounted for under SFAS Statement 133 and its related
interpretations, and (3) how derivative instruments and related hedged items
affect an entity's financial position, financial performance, and cash flows. To
meet these objectives, SFAS 161 requires qualitative disclosures about
objectives and strategies for using derivatives, quantitative disclosures about
fair value amounts and of gains and losses on derivative instruments, and
disclosures about credit-risk-related contingent features in derivative
agreements. This disclosure framework is intended to better convey the purpose
of derivative use in terms of the risks that an entity is intending to manage.
SFAS 161 is effective for the Company on January 1, 2009. The Company expects
that adoption of SFAS 161 will increase footnote disclosure to comply with the
disclosure requirements for financial statements issued after January 1, 2009.
2. Mortgage-Backed Securities
The following table represents the Company's available for sale RMBS portfolio
as of September 30, 2008 and December 31, 2007, at fair value.
September 30, 2008 December 31, 2007
-----------------------------------------------------------------------------
(dollars in thousands)
Mortgage-Backed securities, at
amortized cost $ 897,685 $ 1,114,137
Gross unrealized gain 1,858 10,675
Gross unrealized loss (140,165) (522)
--------------------------------------
Fair value $ 759,378 $ 1,124,290
======================================
During the quarter ended September 30, 2008, the Company had completed sales of
assets with a carrying value of $432.6 million in AAA-rated non-Agency RMBS
which resulted in net realized losses of approximately $113.1 million.
The following table presents the gross unrealized losses and estimated fair
value of the Company's Mortgage-Backed Securities by length of time that such
securities have been in a continuous unrealized loss position at September 30,
2008 and December 31, 2007.
Unrealized Loss Position
For:
-------------------------------------------------------------------------------------------------------
Less than 12 Months 12 Months or More Total
-------------------------------------------------------------------------------------------------------
Estimated Unrealized Estimated Unrealized Estimated Fair Unrealized
Fair Value Losses Fair Value Losses Value Losses
-------------------------------------------------------------------------------------------------------
(dollars in thousands)
September 30, 2008 $ 759,378 ($140,165) - - $ 759,378 ($140,165)
December 31, 2007 $1,124,290 ($522) - - $1,124,290 ($522)
The decline in value of these securities is solely due to market conditions and
not the credit quality of the assets. The investments are not considered
other-than-temporarily impaired because the Company currently has the ability
and intent to hold the investments to maturity or for a period of time
sufficient for a forecasted market price recovery up to or beyond the cost of
the investments.
Actual maturities of mortgage-backed securities are generally shorter than
stated contractual maturities. Actual maturities of the Company's RMBS are
affected by the contractual lives of the underlying mortgages, periodic payments
of principal and prepayments of principal.
The following table summarizes the Company's RMBS at September 30, 2008 and
December 31, 2007 according to their estimated weighted-average life
classifications:
10
September 30, 2008
(dollars in thousands)
Weighted Average
Weighted Average Life Fair Value Amortized Cost Coupon
--------------------------------------------------------------------------------------------------------------------------
Less than one year $ - $ - -
Greater than one year and less than five years 524,663 623,467 5.92%
Greater than five years 234,715 274,218 6.15%
------------------------------------------------------------------------
Total $759,378 $897,685 5.99%
========================================================================
December 31, 2007
(dollars in thousands)
Weighted Average
Weighted Average Life Fair Value Amortized Cost Coupon
--------------------------------------------------------------------------------------------------------------------------
Less than one year $ 45,868 $ 46,102 6.31%
Greater than one year and less than five years 1,078,422 1,068,035 6.32%
Greater than five years - - -
------------------------------------------------------------------------
Total $1,124,290 $1,114,137 6.32%
========================================================================
The weighted-average lives of the mortgage-backed securities in the tables above
are based on data provided through dealer quotes, assuming constant prepayment
rates to the balloon or reset date for each security. The prepayment model
considers current yield, forward yield, steepness of the curve, current mortgage
rates, mortgage rates of the outstanding loan, loan age, margin and volatility.
3. Loans Held for Investment
The following table represents the Company's residential mortgage loans
classified as held for investment at September 30, 2008 and December 31, 2007.
At December 31, 2007, all of the adjustable rate loans held for investment were
hybrid ARMs. Hybrid ARMs are mortgages that have interest rates that are fixed
for an initial period (typically three, five, seven or 10 years) and thereafter
reset at regular intervals subject to interest rate caps. The loans held for
investment were carried at their principal balance outstanding less an allowance
for loan losses:
September 30, 2008 December 31, 2007
-----------------------------------------------------------------------------------------------------
(dollars in thousands)
Mortgage loans, at principal balance $ - $ 162,452
Less: allowance for loan losses - (81)
----------------------------------------------
Mortgage loans held for investment $ - $ 162,371
==============================================
The following table summarizes the changes in the allowance for loan losses for
the mortgage loan portfolio during the nine months ended September 30, 2008:
September 30, 2008
------------------------------------------------------------------
(dollars in thousands)
Balance, beginning of period $ 81
Provision for loan losses 465
Reversal of provision for loan losses (546)
------------------------
Balance, end of period $ -
========================
11
On a quarterly basis, the Company evaluates the adequacy of its allowance for
loan losses. As of September 30, 2008, the Company had no residential mortgage
loans held for investment and reversed the allowance for loan losses of $546
thousand. As of December 31, 2007, the Company recorded an allowance for loan
losses of $81 thousand representing 5 basis points of the Company's mortgage
loan portfolio.
During the quarter ended September 30, 2008, the Company sponsored a $151.2
million securitization accounted for as a sale. In this transaction, the Company
retained all securities issued by the securitization trust including
approximately $142.4 million of AAA-rated fixed and floating rate senior bonds
and $8.8 million in subordinated bonds. On August 28, 2008, the Company sold
approximately $74.9 million of the AAA-rated fixed and floating rate bonds
related to this securitization to third-party investors, and realized a loss of
$11.6 million. The company retained the mezzanine tranche and various
subordinate tranches in this transaction and classifies them as mortgage-backed
securities, available for sale on its consolidated statement of financial
condition.
During the nine months ended September 30, 2008, the Company sold $97.7 million
of loans held for investment and realized losses of $6.9 million.
4. Securitized Loans Held for Investment
During the quarter ended June 30, 2008, the Company transferred $619.7 million
of its residential mortgage loans held for investment to the PHHMC 2008 CIM1
Trust in a securitization transaction. In this transaction, the Company sold
$536.9 million of AAA-rated fixed and floating rate bonds to third party
investors and retained $46.3 million of AAA-rated mezzanine bonds and $36.5
million in subordinated bonds which provide credit support to the certificates
issued to third parties. The certificates issued by the trust are collateralized
by loans held for investment that have been transferred to the PHHMC 2008-CIM1
Trust. The Company incurred approximately $1.4 million in issuance costs that
were deducted from the proceeds of the transaction and are being amortized over
the life of the bonds. This transaction was accounted for as a financing
pursuant to SFAS 140, Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities.
The following table represents the Company's securitized residential mortgage
loans classified as held for investment at September 30, 2008. The Company did
not hold any securitized loans at December 31, 2007. At September 30, 2008
approximately 55.5% of the Company's securitized loans are adjustable rate
mortgage loans and 44.5% are fixed rate mortgage loans. All of the adjustable
rate loans held for investment are hybrid ARMs. Hybrid ARMs are mortgages that
have interest rates that are fixed for an initial period (typically three, five,
seven or 10 years) and thereafter reset at regular intervals subject to interest
rate caps. The loans held for investment are carried at their principal balance
outstanding less an allowance for loan losses:
September 30, 2008
--------------------------------------------------------------------------------
(dollars in thousands)
Securitized mortgage loans, at principal balance $ 598,695
Less: allowance for loan losses (681)
-------------------------
Securitized mortgage loans held for investment $ 598,014
=========================
The following table summarizes the changes in the allowance for loan losses for
the mortgage loan portfolio during the nine months ended September 30, 2008:
September 30, 2008
----------------------------------------------------------
(dollars in thousands)
Balance, beginning of period $ -
Provision for loan losses 681
-----------------------
Balance, end of period $ 681
=======================
On a quarterly basis, the Company evaluates the adequacy of its allowance for
loan losses. The Company maintained its allowance for loan losses for the
quarter ended September 30, 2008 of $681 thousand, representing 12 basis points
of the principal balance of the Company's securitized mortgage loan portfolio.
At September 30, 2008, there were no loans 60 days or more past due and all
loans were accruing interest.
12
5. Fair Value Measurements
SFAS 157 defines fair value, establishes a framework for measuring fair value,
establishes a three-level valuation hierarchy for disclosure of fair value
measurement and enhances disclosure requirements for fair value measurements.
The valuation hierarchy is based upon the transparency of inputs to the
valuation of an asset or liability as of the measurement date. The three levels
are defined as follow:
Level 1 - valuation based on quoted prices for identical assets in
active markets.
Level 2 - valuation based on one or more quoted prices in markets that
are not active or for which all significant inputs are observable,
either directly or indirectly.
Level 3 - inputs to the valuation methodology are unobservable and
significant to the overall fair value.
Mortgage-Backed Securities and interest rate swaps are valued using a pricing
model. The MBS pricing model incorporates such factors as coupons, prepayment
speeds, spread to the Treasury and swap curves, convexity, duration, periodic
and life caps, and credit enhancement. Interest rate swaps are modeled by
incorporating such factors as the Treasury curve, LIBOR rates, and the receive
rate on the interest rate swaps. Management reviews the fair values determined
by the pricing model and compares its results to dealer quotes received on
investments to validate reasonableness of the valuations indicated by the
pricing model. The dealer quotes will incorporate common market pricing methods,
including a spread measurement to the Treasury curve or interest rate swap curve
as well as underlying characteristics of the particular security including
coupon, periodic and life caps, rate reset period, issuer, additional credit
support and expected life of the security. The Company's financial assets and
liabilities carried at fair value on a recurring basis are valued at September
30, 2008 as follows:
Level 1 Level 2 Level 3
(dollars in thousands)
------------------------------------------------------------------------------------------
Assets:
Mortgage-Backed Securities $ - $ 754,211 $ 5,167
For investments classified above as Level 3, the Company recorded costs
associated with the purchase of these assets in the amount of $8.7 million and
unrealized losses on the investments equal to $3.5 million during the quarter
ended September 30, 2008. Unrealized losses on the investments classified as
Level 3 by the Company are included in the consolidated statement of operations
as a component of other comprehensive income.
As fair value is not an entity specific measure and is a market based approach
which considers the value of an asset or liability from the perspective of a
market participant, observability of prices and inputs can vary significantly
from period to period. During times of market dislocation, as has been
experienced during the recent months, the observability of prices and inputs can
be reduced for certain instruments. A condition such as this can cause
instruments to be reclassified from level 1 to level 2 or level 2 to level 3.
6. Repurchase Agreements
13
(A) Mortgage-Backed Securities
The Company had outstanding $619.7 million and $270.6 million of repurchase
agreements with weighted average borrowing rates of 8.38% and 5.02% and weighted
average remaining maturities of 1 and 22 days as of September 30, 2008 and
December 31, 2007 respectively. At September 30, 2008, RMBS pledged as
collateral under these repurchase agreements had an estimated fair value of
$736.8 million and a carrying value of $619.8 million, including accrued
interest. At December 31, 2007, RMBS pledged as collateral had an estimated fair
value of $271.7 million. The interest rates of these repurchase agreements are
generally indexed to the one-month LIBOR rate and reprice accordingly.
At September 30, 2008 and December 31, 2007, the repurchase agreements
collateralized by RMBS had the following remaining maturities:
September 30, December 31,
2008 2007
-----------------------------------
(dollars in thousands)
Within 30 days $619,657 $270,584
30 to 59 days - -
60 to 89 days - -
90 to 119 days - -
Greater than or equal to 120 days - -
-----------------------------------
Total $619,657 $270,584
===================================
In March 2008, the Company entered into a RMBS repurchase agreement and a
receivables sales agreement with Annaly. These agreements contain customary
representations, warranties and covenants. As of September 30, 2008, the Company
was financing $619.7 million under the RMBS repurchase agreement.
At September 30, 2008, the Company had approximately 49% of equity at risk with
Annaly. At December 31, 2007, the Company did not have an amount at risk greater
than 10% of equity with any counterparty.
(B) Loans Held for Investment
The Company entered into two master repurchase agreements pursuant to which it
financed mortgage loans. One agreement was a $500 million lending facility of
which $200 million was on an uncommitted basis. This agreement was to be
terminated January 16, 2009. The second agreement was a $350 million committed
lending facility. This agreement was to be terminated January 29, 2010. On July
29, 2008, the Company terminated both lending facilities. As of September 30,
2008 and December 31, 2007, the Company did not have any amounts borrowed
against these facilities.
14
7. Securitized Debt
All of the Company's securitized debt is collateralized by residential mortgage
loans. For financial reporting purposes, the Company's securitized debt is
accounted for as a financing pursuant to SFAS 140, Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities. Thus, the
residential mortgage loans held as collateral are recorded in the assets of the
Company as securitized loans and the securitized debt is recorded as a liability
in the statement of financial condition.
At September 30, 2008, the securitized debt of the Company was collateralized by
$592.1 million of residential mortgage loans and has a principal balance of $501
million. The debt matures between the years 2023 and 2038. At September 30, 2008
the debt carried a weighted average interest rate equal to 5.58%. At December
31, 2007 the Company had no securitized debt.
8. Interest Rate Swaps
In connection with the Company's interest rate risk management strategy, the
Company economically hedged a portion of its interest rate risk by entering into
derivative financial instrument contracts. Generally, such instruments were
comprised of interest rate swaps, which in effect modify the cash flows on
repurchase agreements. The Company's swaps were used to lock-in a fixed rate
relative to a portion of its current and anticipated future 30-day term
repurchase agreements. The Company accounted for interest rate swaps as
freestanding derivatives with changes in fair value recorded in earnings. During
the quarter the Company terminated all of its interest rate swaps.
The table below represents the Company's swaps outstanding:
Notional Amount Weighted Average Weighted Average Net Estimated Fair
Pay Rate Receive Rate Value/Carrying Value
--------------------------------------------------------------------------------------------------------------------------
(dollars in thousands)
September 30, 2008 - - - -
December 31, 2007 $1,235,000 4.04% 4.94% ($4,156)
9. Common Stock
During the quarter ended September 30, 2008, the Company declared dividends to
common shareholders totaling $6.0 million or $0.16 per share, which were paid on
October 31, 2008.
On October 24, 2008 the Company announced the sale of 110,000,000 shares of
common stock in a public offering at $2.25 per share for estimated gross
proceeds of approximately $247.5 million. Immediately following the sale of
these shares, Annaly Capital Management, Inc. purchased 11,681,415 shares at the
same price per share as the public offering, for net proceeds of approximately
$26.3 million. In addition, on October 28, 2008 the underwriters exercised the
option to purchase up to an additional 16,500,000 shares of common stock to
cover overallotments for gross proceeds of approximately $35.8 million. The
Company estimates the total net proceeds from these offerings to be $300
million.
10. Long Term Incentive Plan
The Company has adopted a long term stock incentive plan to provide incentives
to its independent directors and employees of FIDAC and its affiliates, to
stimulate their efforts towards the Company's continued success, long-term
growth and profitability and to attract, reward and retain personnel and other
service providers. The incentive plan authorizes the Compensation Committee of
the board of directors to grant awards, including incentive stock options,
non-qualified stock options, restricted shares and other types of incentive
awards. The Incentive Plan authorizes the granting of options or other awards
for an aggregate of the greater of 8.0% of the outstanding shares of the
Company's common stock, or 3,119,431 shares, up to a ceiling of 40,000,000
shares.
As of September 30, 2008, the Company has granted restricted stock awards in the
amount of 1,301,000 shares to FIDAC's employees and the Company's independent
directors. Of these shares, 35,075 shares vested and 6,957 shares were forfeited
or cancelled during the quarter ended September 30, 2008. For the nine months
ended September 30, 2008, 108,675 shares vested and 13,670 shares were
forfeited. The awards to the independent directors vested on the date of grant,
and the awards to FIDAC's employees vest quarterly over a period of 10 years.
15
At September 30, 2008 there are approximately 1.2 million unvested shares of
restricted stock issued to employees of FIDAC. For the three months ended
September 30, 2008, compensation expense less general and administrative costs
associated with the amortization of the fair value of the restricted stock
totaled $254 thousand. For the nine months ended September 30, 2008 compensation
expense less general and administrative costs associated with the amortization
of the fair value of the restricted stock totaled $1.3 million.
11. Income Taxes
As a REIT, the Company is not subject to Federal income tax on earnings
distributed to its shareholders. Most states recognize REIT status as well. The
Company has decided to distribute the majority of its income. During the quarter
ended September 30, 2008, the Company recorded income tax expense of $11,906
related to state and federal tax liabilities on undistributed income. For the
nine months ended September 30, 2008, the Company recorded income tax expense of
$14,719.
12. Credit Risk and Interest Rate Risk
The Company's primary components of market risk are credit risk and interest
rate risk. The Company is subject to credit risk in connection with its
investments in residential mortgage loans and credit sensitive mortgage-backed
securities. When the Company assumes credit risk, it attempts to minimize
interest rate risk through asset selection, hedging and matching the income
earned on mortgage assets with the cost of related liabilities. The Company is
subject to interest rate risk, primarily in connection with its investments in
fixed-rate and adjustable-rate mortgage backed securities, residential mortgage
loans, and repurchase agreements. When the Company assumes interest rate risk,
it minimizes credit risk through asset selection. The Company's strategy is to
purchase loans underwritten to agreed-upon specifications of selected
originators in an effort to mitigate credit risk. The Company has established a
whole loan target market including prime borrowers with FICO scores generally
greater than 650, Alt-A documentation, geographic diversification,
owner-occupied property, moderate loan size and moderate loan to value ratio.
These factors are considered to be important indicators of credit risk.
13. Management Agreement and Related Party Transactions
The Company has entered into a management agreement with FIDAC, which provides
for an initial term through December 31, 2010 with automatic one-year extension
options and subject to certain termination rights. The Company paid FIDAC a
quarterly management fee equal to 1.75% per annum of the gross Stockholders'
Equity (as defined in the management agreement) of the Company for the quarter
ended September 30, 2008. Management fees accrued for the quarter ending
September 30, 2008 are $1.7 million. Management fees accrued for the nine months
ended September 30, 2008 were $6.1 million. At December 31, 2007 quarterly
management fees in the amount of $1.2 million were accrued and subsequently paid
to FIDAC.
On October 13, 2008, the Company and FIDAC amended the management agreement to
reduce the base management fee from 1.75% per annum to 1.50% per annum of the
Company's stockholders' equity and provide that the incentive fees may be in
cash or shares of the Company's common stock, at the election of the Company's
board of directors.
On October 19, 2008, the Company and FIDAC further amended the management
agreement to provide that the incentive fee be eliminated in its entirety and
FIDAC receive only the base management fee of 1.50% per annum of the Company's
stockholders' equity.
The Company is obligated to reimburse FIDAC for its costs incurred under the
management agreement. In addition, the management agreement permits FIDAC to
require the Company to pay for its pro rata portion of rent, telephone,
utilities, office furniture, equipment, machinery and other office, internal and
overhead expenses of FIDAC incurred in the operation of the Company. These
expenses are allocated between FIDAC and the Company based on the ratio of the
Company's proportion of gross assets compared to all remaining gross assets
managed by FIDAC as calculated at each quarter end. FIDAC and the Company will
modify this allocation methodology, subject to the Company's board of directors'
approval if the allocation becomes inequitable (i.e., if the Company becomes
very highly leveraged compared to FIDAC's other funds and accounts). For the
quarter ending September 30, 2008, FIDAC has waived its right to request
reimbursement from the Company for these expenses.
16
During the quarter ended September 30, 2008, 35,075 shares of restricted stock
issued by the Company to FIDAC's employees vested, as discussed in Note 10.
In March 2008, the Company entered into a RMBS repurchase agreement and a
receivables sales agreement with Annaly. These agreements contain customary
representations, warranties and covenants. As of September 30, 2008, the Company
was financing $619.7 million under this agreement.
14. Commitments and Contingencies
From time to time, the Company may become involved in various claims and legal
actions arising in the ordinary course of business. Management is not aware of
any reported or unreported contingencies at September 30, 2008.
15. Subsequent Events
On October 13, 2008, the Company and FIDAC amended the management agreement with
FIDAC to reduce the base management fee from 1.75% per annum to 1.50% per annum
of the Company's stockholders' equity and provide that the incentive fees may be
paid in cash or shares of the Company's common stock, at the election of the
Company's board of directors.
On October 19, 2008, the Company and FIDAC further amended the management
agreement to provide that the incentive fee be eliminated in its entirety and
the Manager receive only the base management fee of 1.50% per annum of the
Company's stockholders' equity.
On October 24, 2008 the Company announced the sale of 110,000,000 shares of
common stock in a public offering at $2.25 per share for estimated gross
proceeds of approximately $247.5 million. Immediately following the sale of
these shares, Annaly Capital Management, Inc. purchased 11,681,415 shares at the
same price per share as the public offering, for net proceeds of approximately
$26.3 million. In addition, on October 28, 2008 the underwriters exercised the
option to purchase up to an additional 16,500,000 shares of common stock to
cover overallotments for gross proceeds of approximately $35.8 million. The
Company estimates the total net proceeds from these offerings to be $300
million.
17
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
Special Note Regarding Forward-Looking Statements
We make forward-looking statements in this report that are subject to
risks and uncertainties. These forward-looking statements include information
about possible or assumed future results of our business, financial condition,
liquidity, results of operations, plans and objectives. When we use the words
"believe," "expect," "anticipate," "estimate," "plan," "continue," "intend,"
"should," "may," "would," "will" or similar expressions, we intend to identify
forward-looking statements. Statements regarding the following subjects, among
others, are forward-looking by their nature:
o our business and investment strategy;
o our projected financial and operating results;
o our ability to maintain existing financing arrangements, obtain future
financing arrangements and the terms of such arrangements;
o general volatility of the securities markets in which we invest;
o our expected investments;
o changes in the value of our investments;
o interest rate mismatches between our mortgage-backed securities and
our borrowings used to fund such purchases;
o changes in interest rates and mortgage prepayment rates;
o effects of interest rate caps on our adjustable-rate mortgage-backed
securities;
o rates of default or decreased recovery rates on our investments;
o prepayments of the mortgage and other loans underlying our
mortgage-backed or other asset-backed securities;
o the degree to which our hedging strategies may or may not protect us
from interest rate volatility;
o impact of and changes in governmental regulations, tax law and rates,
accounting guidance, and similar matters;
o availability of investment opportunities in real estate-related and
other securities;
o availability of qualified personnel;
o estimates relating to our ability to make distributions to our
stockholders in the future;
o our understanding of our competition; and
18
o market trends in our industry, interest rates, the debt securities
markets or the general economy.
The forward-looking statements are based on our beliefs, assumptions
and expectations of our future performance, taking into account all information
currently available to us. You should not place undue reliance on these
forward-looking statements. These beliefs, assumptions and expectations can
change as a result of many possible events or factors, not all of which are
known to us. Some of these factors are described under the caption "Risk
Factors" in our most recent Annual Report on Form 10-K and any subsequent
Quarterly Reports on Form 10-Q. If a change occurs, our business, financial
condition, liquidity and results of operations may vary materially from those
expressed in our forward-looking statements. Any forward-looking statement
speaks only as of the date on which it is made. New risks and uncertainties
arise from time to time, and it is impossible for us to predict those events or
how they may affect us. Except as required by law, we are not obligated to, and
do not intend to, update or revise any forward-looking statements, whether as a
result of new information, future events or otherwise.
Executive Summary
We are a specialty finance company that invests in residential mortgage
loans, residential mortgage-backed securities, real estate related securities
and various other asset classes. We are externally managed by FIDAC. We have
elected and intend to qualify to be taxed as a REIT for federal income tax
purposes commencing with our taxable year ending on December 31, 2007. Our
targeted asset classes and the principal investments we expect to make in each
are as follows:
o RMBS, consisting of:
o Non-Agency RMBS, including investment-grade and non-investment grade
classes, including the BB-rated, B-rated and non-rated classes
o Agency RMBS
o Whole mortgage loans, consisting of:
o Prime mortgage loans
o Jumbo prime mortgage loans
o Alt-A mortgage loans
o Asset Backed Securities, or ABS, consisting of:
o CMBS
o Debt and equity tranches of CDOs
o Consumer and non-consumer ABS, including investment-grade and
non-investment grade classes, including the BB-rated, B-rated and
non-rated classes
We completed our initial public offering on November 21, 2007. In that
offering and in a concurrent private offering we raised net proceeds before
offering expenses of approximately $533.6 million. We completed a second public
offering and second private offering on October 29, 2008. In these offerings we
raised proceeds before offering expenses of approximately $309.6 million and we
are commencing investing these proceeds.
Our objective is to provide attractive risk-adjusted returns to our
investors over the long-term, primarily through dividends and secondarily
through capital appreciation. We intend to achieve this objective by investing
in a broad class of financial assets to construct an investment portfolio that
is designed to achieve attractive risk-adjusted returns and that is structured
to comply with the various federal income tax requirements for REIT status. We
expect that over the near term our investment portfolio will continue to be
weighted toward non-Agency RMBS, subject to maintaining our REIT qualification
and our 1940 Act exemption, which may, depending on the composition of our
investment portfolio, require us to purchase Agency RMBS or other qualifying
assets. Over time we expect that our investment portfolio will become more
weighted toward residential mortgage loans.
19
Our investment strategy is intended to take advantage of opportunities
in the current interest rate and credit environment. We will adjust our strategy
to changing market conditions by shifting our asset allocations across these
various asset classes as interest rate and credit cycles change over time. We
believe that our strategy, combined with FIDAC's experience, will enable us to
pay dividends and achieve capital appreciation throughout changing market
cycles. We expect to take a long-term view of assets and liabilities, and our
reported earnings and mark-to-market valuations at the end of a financial
reporting period will not significantly impact our objective of providing
attractive risk-adjusted returns to our stockholders over the long-term.
We use leverage to seek to increase our potential returns and to fund
the acquisition of our assets. Our income is generated primarily by the
difference, or net spread, between the income we earn on our assets and the cost
of our borrowings. We expect to finance our investments using a variety of
financing sources including repurchase agreements, warehouse facilities,
securitizations, commercial paper and term financing CDOs. We may manage our
debt by utilizing interest rate hedges, such as interest rate swaps, to reduce
the effect of interest rate fluctuations related to our debt.
Recent Developments
We commenced operations in November 2007 in the midst of challenging
market conditions which affected the cost and availability of financing from the
facilities with which we expected to finance our investments. These instruments
included repurchase agreements, warehouse facilities, securitizations,
asset-backed commercial paper, or ABCP, and term CDOs. The liquidity crisis
which commenced in August 2007 affected each of these sources--and their
individual providers--to different degrees; some sources generally became
unavailable, some remained available but at a high cost, and some were largely
unaffected. For example, in the repurchase agreement market, non-Agency RMBS
became harder to finance, depending on the type of assets collateralizing the
RMBS. The amount, term and margin requirements associated with these types of
financings were also impacted. At that time, warehouse facilities to finance
whole loan prime residential mortgages were generally available from major
banks, but at significantly higher cost and had greater margin requirements than
previously offered. It was also extremely difficult to term finance whole loans
through securitization or bonds issued by a CDO structure. Financing using ABCP
froze as issuers became unable to place (or roll) their securities, which
resulted, in some instances, in forced sales of mortgage-backed securities, or
MBS, and other securities which further negatively impacted the market value of
these assets.
Although the credit markets had been undergoing much turbulence, as we
started ramping up our portfolio, we noted a slight easing. We entered into a
number of repurchase agreements we could use to finance RMBS. In January 2008,
we entered into two whole mortgage loan repurchase agreements. As we began to
see the availability of financing, we were also seeing better underwriting
standards used to originate new mortgages. We commenced buying and financing
RMBS and also entered into agreements to purchase whole mortgage loans. We
purchased high credit quality assets which we believed we would be readily able
to finance.
Beginning in mid-February 2008, credit markets experienced a dramatic
and sudden adverse change. The severity of the limitation on liquidity was
largely unanticipated by the markets. Credit once again froze, and in the
mortgage market, valuations of non-Agency RMBS and whole mortgage loans came
under severe pressure. This credit crisis began in early February 2008, when a
heavily leveraged investor announced that it had to de-lever and liquidate a
portfolio of approximately $30 billion of non-Agency RMBS. Prices of these types
of securities dropped dramatically, and lenders started lowering the prices on
non-Agency RMBS that they held as collateral to secure the loans they had
extended. The subsequent failure in March 2008 of a major investment bank
worsened the crisis. During the past nine months, due to the deterioration in
the market value of our assets, we received and met margin calls under our
repurchase agreements, which resulted in our obtaining additional funding from
third parties, including from Annaly, and taking other steps to increase our
liquidity. Additionally, the disruptions during the six months ended June 30,
2008 resulted in us not being in compliance with the net income covenant in one
of our whole loan repurchase agreements and the liquidity covenants in our other
whole loan repurchase agreement at a time during which we had no amounts
outstanding under those facilities. We amended these covenants, and on July 29,
2008, we terminated those facilities to avoid paying non-usage fees. Although we
made no asset sales during the quarter ended June 30, 2008, for the third
quarter of 2008, we sold assets with a carrying value of $432.6 million in
AAA-rated non-Agency RMBS for a loss of approximately $113.1 million, which
includes a realized loss of $11.6 million related to the August 28, 2008
transaction described below, and terminated $983.4 million in notional interest
rate swaps for a loss of approximately $10.5 million, which together resulted in
a net realized loss of approximately $123.6 million.
20
The challenges of the first quarter of 2008 have continued into the
second and third quarters, as financing difficulties have severely pressured
liquidity and asset values. In September 2008, Lehman Brothers Holdings, Inc., a
major investment bank, experienced a major liquidity crisis and failed.
Securities trading remains limited and mortgage securities financing markets
remain challenging as the industry continues to report negative news. This
dislocation in the non-Agency mortgage sector has made it difficult for us to
obtain short-term financing on favorable terms. As a result, we have completed
loan securitizations in order to obtain long-term financing and terminated our
un-utilized whole loan repurchase agreements in order to avoid paying non-usage
fees under those agreements. In addition, we have continued to seek funding from
Annaly. Under these circumstances, we expect to take actions intended to protect
our liquidity, which may include reducing borrowings and disposing of assets as
well as raising capital as we recently did. As a result, we expect to operate
with a low level of leverage and to continue to take actions that would support
available cash.
During this period of market dislocation, fiscal and monetary
policymakers have established new liquidity facilities for primary dealers and
commercial banks, reduced short-term interest rates, and passed legislation that
is intended to address the challenges of mortgage borrowers and lenders. This
legislation, the Housing and Economic Recovery Act of 2008, seeks to forestall
home foreclosures for distressed borrowers and assist communities with
foreclosure problems. Although these aggressive steps are intended to protect
and support the US housing and mortgage market, we continue to operate under
very difficult market conditions.
Since June 30, 2008, there have been increased market concerns about
Freddie Mac and Fannie Mae's ability to withstand future credit losses
associated with securities held in their investment portfolios, and on which
they provide guarantees, without the direct support of the federal government.
Recently, the government passed the "Housing and Economic Recovery Act of 2008."
Fannie Mae and Freddie Mac have recently been placed into the conservatorship of
the Federal Housing Finance Agency, or FHFA, their federal regulator, pursuant
to its powers under The Federal Housing Finance Regulatory Reform Act of 2008, a
part of the Housing and Economic Recovery Act of 2008. As the conservator of
Fannie Mae and Freddie Mac, the FHFA controls and directs the operations of
Fannie Mae and Freddie Mac and may (1) take over the assets of and operate
Fannie Mae and Freddie Mac with all the powers of the shareholders, the
directors, and the officers of Fannie Mae and Freddie Mac and conduct all
business of Fannie Mae and Freddie Mac; (2) collect all obligations and money
due to Fannie Mae and Freddie Mac; (3) perform all functions of Fannie Mae and
Freddie Mac which are consistent with the conservator's appointment; (4)
preserve and conserve the assets and property of Fannie Mae and Freddie Mac; and
(5) contract for assistance in fulfilling any function, activity, action or duty
of the conservator.
In addition to FHFA becoming the conservator of Fannie Mae and Freddie
Mac, (i) the U.S. Department of Treasury and FHFA have entered into preferred
stock purchase agreements between the U.S. Department of Treasury and Fannie Mae
and Freddie Mac pursuant to which the U.S. Department of Treasury will ensure
that each of Fannie Mae and Freddie Mac maintains a positive net worth; (ii) the
U.S. Department of Treasury has established a new secured lending credit
facility which will be available to Fannie Mae, Freddie Mac, and the Federal
Home Loan Banks, which is intended to serve as a liquidity backstop, which will
be available until December 2009; and (iii) the U.S. Department of Treasury has
initiated a temporary program to purchase RMBS issued by Fannie Mae and Freddie
Mac. Given the highly fluid and evolving nature of these events, it is unclear
how our business will be impacted. Based upon the further activity of the U.S.
government or market response to developments at Fannie Mae or Freddie Mac, our
business could be adversely impacted.
21
The Emergency Economic Stabilization Act of 2008, or EESA, was recently
enacted. The EESA provides the U.S. Secretary of the Treasury with the authority
to establish a Troubled Asset Relief Program, or TARP, to purchase from
financial institutions up to $700 billion of residential or commercial mortgages
and any securities, obligations, or other instruments that are based on or
related to such mortgages, that in each case was originated or issued on or
before March 14, 2008, as well as any other financial instrument that the U.S.
Secretary of the Treasury, after consultation with the Chairman of the Board of
Governors of the Federal Reserve System, determines the purchase of which is
necessary to promote financial market stability, upon transmittal of such
determination, in writing, to the appropriate committees of the U.S. Congress.
The EESA also provides for a program that would allow companies to insure their
troubled assets.
There can be no assurance that the EESA will have a beneficial impact
on the financial markets, including current extreme levels of volatility. To the
extent the market does not respond favorably to the TARP or the TARP does not
function as intended, our business may not receive the anticipated positive
impact from the legislation. In addition, the U.S. Government, Federal Reserve
and other governmental and regulatory bodies have taken or are considering
taking other actions to address the financial crisis. We cannot predict whether
or when such actions may occur or what impact, if any, such actions could have
on our business, results of operations and financial condition.
On July 25, 2008, we sponsored a $151.2 million securitization whereby
we securitized our then-current inventory of mortgage loans. In this
transaction, we retained all of the securities issued by the securitization
trust including approximately $142.4 million of AAA-rated fixed and floating
rate senior bonds and $8.8 million in subordinated bonds. This transaction will
be accounted for as a sale. On August 28, 2008, we sold approximately $74.9
million of the AAA-rated fixed and floating rate bonds related to the July 25,
2008 securitization to third-party investors and realized a loss of $11.6
million.
On September 9, 2008, we declared the third quarter 2008 common stock
cash dividend of $0.16 per share of our common stock. This dividend is payable
October 31, 2008 to common shareholders of record on September 18, 2008.
In October 2008, we and FIDAC amended our management agreement to
reduce the base management fee from 1.75% per annum to 1.50% per annum of our
stockholders' equity and eliminate the incentive fees previously provided for in
the management agreement.
Trends
We expect the results of our operations to be affected by various
factors, many of which are beyond our control. Our results of operations will
primarily depend on, among other things, the level of our net interest income,
the market value of our assets, and the supply of and demand for such assets.
Our net interest income, which reflects the amortization of purchase premiums
and accretion of discounts, varies primarily as a result of changes in interest
rates, borrowing costs, and prepayment speeds, which is a measurement of how
quickly borrowers pay down the unpaid principal balance on their mortgage loans.
Prepayment Speeds. Prepayment speeds, as reflected by the Constant
Prepayment Rate, or CPR, vary according to interest rates, the type of
investment, conditions in financial markets, competition and other factors, none
of which can be predicted with any certainty. In general, when interest rates
rise, it is relatively less attractive for borrowers to refinance their mortgage
loans, and as a result, prepayment speeds tend to decrease. When interest rates
fall, prepayment speeds tend to increase. For mortgage loan and RMBS investments
purchased at a premium, as prepayment speeds increase, the amount of income we
earn decreases because the purchase premium we paid for the bonds amortizes
faster than expected. Conversely, decreases in prepayment speeds result in
increased income and can extend the period over which we amortize the purchase
premium. For mortgage loan and RMBS investments purchased at a discount, as
prepayment speeds increase, the amount of income we earn increases because of
the acceleration of the accretion of the discount into interest income.
Conversely, decreases in prepayment speeds result in decreased income and can
extend the period over which we accrete the purchase discount into interest
income.
22
Rising Interest Rate Environment. As indicated above, as interest rates
rise, prepayment speeds generally decrease, increasing our net interest income.
Rising interest rates, however, increase our financing costs which may result in
a net negative impact on our net interest income. In addition, if we acquire
Agency and non-Agency RMBS collateralized by monthly reset adjustable-rate
mortgages, or ARMs, and three- and five-year hybrid ARMs, such interest rate
increases could result in decreases in our net investment income, as there could
be a timing mismatch between the interest rate reset dates on our RMBS portfolio
and the financing costs of these investments. Monthly reset ARMs are ARMs on
which coupon rates reset monthly based on indices such as the one-month London
Interbank Offering Rate, or LIBOR. Hybrid ARMs are mortgages that have interest
rates that are fixed for an initial period (typically three, five, seven or ten
years) and thereafter reset at regular intervals subject to interest rate caps.
With respect to our floating rate investments, such interest rate
increases should result in increases in our net investment income because our
floating rate assets are greater in amount than the related floating rate
liabilities. Similarly, such an increase in interest rates should generally
result in an increase in our net investment income on fixed-rate investments
made by us because our fixed-rate assets would be greater in amount than our
fixed-rate liabilities. We expect, however, that our fixed-rate assets would
decline in value in a rising interest rate environment and that our net interest
spreads on fixed rate assets could decline in a rising interest rate environment
to the extent such assets are financed with floating rate debt.
Falling Interest Rate Environment. As interest rates fall, prepayment
speeds generally increase, decreasing our net interest income. Falling interest
rates, however, decrease our financing costs which may result in a net positive
impact on our net interest income. In addition, if we acquire Agency and
non-Agency RMBS collateralized by monthly reset adjustable-rate mortgages, or
ARMs, and three- and five-year hybrid ARMs, such interest rate decreases could
result in increases in our net investment income, as there could be a timing
mismatch between the interest rate reset dates on our RMBS portfolio and the
financing costs of these investments. Monthly reset ARMs are ARMs on which
coupon rates reset monthly based on indices such as the one-month London
Interbank Offering Rate, or LIBOR. Hybrid ARMs are mortgages that have interest
rates that are fixed for an initial period (typically three, five, seven or ten
years) and thereafter reset at regular intervals subject to interest rate caps.
With respect to our floating rate investments, such interest rate
decreases may result in decreases in our net investment income because our
floating rate assets may be greater in amount than the related floating rate
liabilities. Similarly, such an decrease in interest rates should generally
result in an increase in our net investment income on fixed-rate investments
made by us because our fixed-rate assets would be greater in amount than our
fixed-rate liabilities. We expect, however, that our fixed-rate assets would
increase in value in a falling interest rate environment and that our net
interest spreads on fixed rate assets could increase in a falling interest rate
environment to the extent such assets are financed with floating rate debt.
Credit Risk. One of our strategic focuses is acquiring assets which we
believe to be of high credit quality. We believe this strategy will generally
keep our credit losses and financing costs low. We retain the risk of potential
credit losses on all of the residential mortgage loans we hold in our portfolio.
Additionally, some of our investments in RMBS may be qualifying interests for
purposes of maintaining our exemption from the 1940 Act because we retain a 100%
ownership interest in the underlying loans. If we purchase all classes of these
securitizations, we have the credit exposure on the underlying loans. Prior to
the purchase of these securities, we conduct a due diligence process that allows
us to remove loans that do not meet our credit standards based on loan-to-value
ratios, borrowers' credit scores, income and asset documentation and other
criteria that we believe to be important indications of credit risk.
Size of Investment Portfolio. The size of our investment portfolio, as
measured by the aggregate unpaid principal balance of our mortgage loans and
aggregate principal balance of our mortgage related securities and the other
assets we own is also a key revenue driver. Generally, as the size of our
investment portfolio grows, the amount of interest income we receive increases.
The larger investment portfolio, however, drives increased expenses as we incur
additional interest expense to finance the purchase of our assets.
Since changes in interest rates may significantly affect our
activities, our operating results depend, in large part, upon our ability to
effectively manage interest rate risks and prepayment risks while maintaining
our status as a REIT.
Current Environment. The current weakness in the broader mortgage
markets could adversely affect one or more of our potential lenders or any of
our lenders and could cause one or more of our potential lenders or any of our
lenders to be unwilling or unable to provide us with financing or require us to
post additional collateral. In general, this could potentially increase our
financing costs and reduce our liquidity or require us to sell assets at an
inopportune time. We expect to use a number of sources to finance our
investments, including repurchase agreements, warehouse facilities,
securitizations, asset-backed commercial paper and term CDOs. Current market
conditions have affected the cost and availability of financing from each of
these sources and their individual providers to different degrees; some sources
generally are unavailable, some are available but at a high cost, and some are
largely unaffected. For example, in the repurchase agreement market, borrowers
have been affected differently depending on the type of security they are
financing. Non-Agency RMBS have been harder to finance, depending on the type of
assets collateralizing the RMBS. The amount, term and margin requirements
associated with these types of financings have been negatively impacted.
23
Currently, warehouse facilities to finance whole loan prime residential
mortgages are generally available from major banks, but at significantly higher
cost and have greater margin requirements than previously offered. Many major
banks that offer warehouse facilities have also reduced the amount of capital
available to new entrants and consequently the size of those facilities offered
now are smaller than those previously available. We decided to terminate our two
whole loan repurchase agreements in order to avoid paying non-usage fees under
those agreements.
It is currently a challenging market to term finance whole loans
through securitization or bonds issued by a CDO structure. The highly rated
senior bonds in these securitizations and CDO structures currently have
liquidity, but at much wider spreads than issues priced in recent history. The
junior subordinate tranches of these structures currently have few buyers and
current market conditions have forced issuers to retain these lower rated bonds
rather than sell them.
Certain issuers of ABCP have been unable to place (or roll) their
securities, which has resulted, in some instances, in forced sales of MBS and
other securities which has further negatively impacted the market value of these
assets. These market conditions are fluid and likely to change over time. As a
result, the execution of our investment strategy may be dictated by the cost and
availability of financing from these different sources.
If one or more major market participants fails or otherwise experiences
a major liquidity crisis, as was the case for Bear Stearns & Co. in March 2008,
and Lehman Brothers Holdings Inc. in September 2008, it could negatively impact
the marketability of all fixed income securities and this could negatively
impact the value of the securities we acquire, thus reducing our net book value.
Furthermore, if many of our potential lenders or any of our lenders are
unwilling or unable to provide us with financing, we could be forced to sell our
securities or residential mortgage loans at an inopportune time when prices are
depressed. For example, for the quarter ended March 31, 2008, we sold assets
with a carrying value of $394.2 million for an aggregate loss of $32.8 million.
While we did not sell any assets during the quarter ended June 30, 2008, for the
third quarter of 2008, we sold assets with a carrying value of $432.6 million in
AAA-rated non-Agency RMBS for a loss of approximately $113.1 million and
terminated $983.4 million in notional interest rate swaps for a loss of
approximately $10.5 million, which together resulted in a net realized loss of
approximately $123.6 million.
As described above, there has been significant government action in the
capital markets. However, there can be no assurance that the government's
actions with respect to Freddie Mac and Fannie Mae, the EESA, or the TARP will
have a beneficial impact on the financial markets, including current extreme
levels of volatility. To the extent the market does not respond favorably to
these actions, or these actions do not function as intended, our business may
not receive the anticipated positive impact from them. In addition, the U.S.
Government, Federal Reserve and other governmental and regulatory bodies have
taken or are considering taking other actions to address the financial crisis.
We cannot predict whether or when such actions may occur or what impact, if any,
such actions could have on our business, results of operations and financial
condition.
In the current market, it may be difficult or impossible to obtain
third party pricing on the investments we purchase. In addition, validating
third party pricing for our investments may be more subjective as fewer
participants may be willing to provide this service to us. Moreover, the current
market is more illiquid than in recent history for some of the investments we
purchase. Illiquid investments typically experience greater price volatility as
a ready market does not exist. As volatility increases or liquidity decreases we
may have greater difficulty financing our investments which may negatively
impact our earnings and the execution of our investment strategy.
Critical Accounting Policies
Our financial statements are prepared in accordance with accounting
principles generally accepted in the United States of America. These accounting
principles may require us to make some complex and subjective decisions and
assessments. Our most critical accounting policies will involve decisions and
assessments that could affect our reported assets and liabilities, as well as
our reported revenues and expenses. We believe that all of the decisions and
assessments upon which our financial statements are based will be reasonable at
the time made and based upon information available to us at that time. At each
quarter end, we calculate estimated fair value using a pricing model. We
validate our pricing model by obtaining independent pricing on all of our assets
and performing a verification of those sources to our own internal estimate of
fair value. We have identified what we believe will be our most critical
accounting policies to be the following:
24
Valuation of Investments
On January 1, 2008, we adopted SFAS 157, which defines fair value,
establishes a framework for measuring fair value, and establishes a three-level
valuation hierarchy for disclosure of fair value measurement and enhances
disclosure requirements for fair value measurements. The valuation hierarchy is
based upon the transparency of inputs to the valuation of an asset or liability
as of the measurement date. The three levels are defined as follow:
Level 1 - valuation based on quoted prices for identical assets in
active markets.
Level 2 - valuation based on one or more quoted prices in markets that
are not active or for which all significant inputs are observable,
either directly or indirectly.
Level 3 - inputs to the valuation methodology are unobservable and
significant to overall fair value.
Mortgage-Backed Securities and interest rate swaps are valued using a
pricing model. The MBS pricing model incorporates such factors as coupons,
prepayment speeds, spread to the Treasury and swap curves, convexity, duration,
periodic and life caps, and credit enhancement. Interest rate swaps are modeled
by incorporating such factors as the Treasury curve, LIBOR rates, and the
receive rate on the interest rate swaps. Management reviews the fair values
determined by the pricing model and compares its results to dealer quotes
received on each investment to validate the reasonableness of the valuations
indicated by the pricing models. The dealer quotes will incorporate common
market pricing methods, including a spread measurement to the Treasury curve or
interest rate swap curve as well as underlying characteristics of the particular
security including coupon, periodic and life caps, rate reset period, issuer,
additional credit support and expected life of the security.
As fair value is not an entity specific measure and is a market based
approach which considers the value of an asset or liability from the perspective
of a market participant, observability of prices and inputs can vary
significantly from period to period. During times of market dislocation, as has
been experienced during the recent months, the observability of prices and
inputs can be reduced for certain instruments. A condition such as this can
cause instruments to be reclassified from level 1 to level 2 or level 2 to level
3. At September 30, 2008 we held $5.2 million of investments we classify as
Level 3; the remainder of our investments are classified as Level 2.
Loans Held for Investment and Securitized Loans Held to Maturity
We purchase residential mortgage loans and classify them as loans held
for investment or Securitized loans held to maturity on the statement of
financial condition. These investments are intended to be held to maturity and,
accordingly, are reported at the principal amount outstanding, net of provisions
for loan losses.
Loan loss provisions are examined quarterly and updated to reflect
expectations of future probable credit losses based on factors such as
originator historical losses, geographic concentration, individual loan
characteristics, experienced losses, and expectations of future loan pool
behavior. As credit losses occur, the provision for loan losses will reflect
that realization.
When we determine that it is probable that contractually due specific
amounts are deemed uncollectable, the loan is considered impaired. To measure
our impairment we determine the excess of the recorded investment amount over
the net fair value of the collateral, as reduced by selling costs. Any
deficiency between the carrying amount of an asset and the net sales price of
repossessed collateral is charged to the allowance for loan losses.
25
An allowance for mortgage loans is maintained at a level believed
adequate by management to absorb probable losses. We may elect to sell a loan
held for investment due to adverse changes in credit fundamentals. Once the
determination has been made by us that we will no longer hold the loan for
investment, we will account for the loan at the lower of amortized cost or
estimated fair value. The reclassification of the loan and recognition of
impairments could adversely affect our reported earnings.
Valuations of Available-for-Sale Securities
We expect our investments in RMBS will be primarily classified as
available-for-sale securities that are carried on the statement of financial
condition at their fair value. This classification will result in changes in
fair values being recorded as statement of financial condition adjustments to
accumulated other comprehensive income or loss, which is a component of
stockholders' equity.
Our available-for-sale securities have fair values as determined with
reference to fair values calculated using a pricing model. Management reviews
the fair values generated to insure prices are reflective of the current market.
We perform a validation of the fair value calculated by the pricing model by
comparing its results to independent prices provided by dealers in the
securities and/or third party pricing services. If dealers or independent
pricing services are unable to provide a price for an asset, or if the price
provided by them is deemed unreliable by FIDAC, then the asset will be valued at
its fair value as determined in good faith by FIDAC. The pricing is subject to
various assumptions which could result in different presentations of value.
When the fair value of an available-for-sale security is less than its
amortized cost for an extended period or there is a significant decline in
value, we consider whether there is an other-than-temporary impairment in the
value of the security. If, based on our analysis, an other-than-temporary
impairment exists, the cost basis of the security is written down to the
then-current fair value, and the unrealized loss is transferred from accumulated
other comprehensive loss as an immediate reduction of current earnings (as if
the loss had been realized in the period of other-than-temporary impairment).
The determination of other-than-temporary impairment is a subjective process,
and different judgments and assumptions could affect the timing of loss
realization.
We consider the following factors when determining an
other-than-temporary impairment for a security:
o The length of time and the extent to which the market value has been
less than the amortized cost;
o Whether the security has been downgraded by a rating agency; and
o Our intent to hold the security for a period of time sufficient to
allow for any anticipated recovery in market value.
The determination of other-than-temporary impairment is made at least
quarterly. If we determine an impairment to be other than temporary we will
realize a loss which will negatively impact current income.
Investment Consolidation
For each investment we make, we will evaluate the underlying entity
that issued the securities we will acquire or to which we will make a loan to
determine the appropriate accounting. In performing our analysis, we refer to
guidance in Statement of Financial Accounting Standards (SFAS) No. 140,
Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities, and FASB Interpretation No. (FIN) 46R, Consolidation of Variable
Interest Entities. FIN 46R addresses the application of Accounting Research
Bulletin No. 51, Consolidated Financial Statements, to certain entities in which
voting rights are not effective in identifying an investor with a controlling
financial interest. In variable interest entities, or VIEs, an entity is subject
to consolidation under FIN 46R if the investors either do not have sufficient
equity at risk for the entity to finance its activities without additional
subordinated financial support, are unable to direct the entity's activities, or
are not exposed to the entity's losses or entitled to its residual returns. VIEs
within the scope of FIN 46R are required to be consolidated by their primary
beneficiary. The primary beneficiary of a VIE is determined to be the party that
absorbs a majority of the entity's expected losses, its expected returns, or
both. This determination can sometimes involve complex and subjective analyses.
26
Interest Income Recognition
Interest income on available-for-sale securities and loans held for
investment is recognized over the life of the investment using the effective
interest method as described by SFAS No. 91, Accounting for Nonrefundable Fees
and Costs Associated with Originating or Acquiring Loans and Initial Direct
Costs of Leases, for securities of high credit quality and Emerging Issues Task
Force No. 99-20, Recognition of Interest Income and Impairment on Purchased and
Retained Beneficial Interests in Securitized Financial Assets, for all other
securities. Income recognition is suspended for loans when, in the opinion of
management, a full recovery of income and principal becomes doubtful. Income
recognition is resumed when the loan becomes contractually current and
performance is demonstrated to be resumed.
Under SFAS No. 91 and Emerging Issues Task Force No. 99-20, management
will estimate, at the time of purchase, the future expected cash flows and
determine the effective interest rate based on these estimated cash flows and
our purchase price. As needed, these estimated cash flows will be updated and a
revised yield computed based on the current amortized cost of the investment. In
estimating these cash flows, there will be a number of assumptions that will be
subject to uncertainties and contingencies. These include the rate and timing of
principal payments (including prepayments, repurchases, defaults and
liquidations), the pass-through or coupon rate and interest rate fluctuations.
In addition, interest payment shortfalls due to delinquencies on the underlying
mortgage loans, and the timing of the magnitude of credit losses on the mortgage
loans underlying the securities have to be judgmentally estimated. These
uncertainties and contingencies are difficult to predict and are subject to
future events that may impact management's estimates and our interest income.
Accounting For Derivative Financial Instruments
Our policies permit us to enter into derivative contracts, including
interest rate swaps and interest rate caps, as a means of mitigating our
interest rate risk. We intend to use interest rate derivative instruments to
mitigate interest rate risk rather than to enhance returns.
We account for derivative financial instruments in accordance with SFAS No.
133, Accounting for Derivative Instruments and Hedging Activities, as amended
and interpreted. SFAS No. 133 requires an entity to recognize all derivatives as
either assets or liabilities in the statement of financial condition and to
measure those instruments at fair value. Additionally, the fair value
adjustments will affect either other comprehensive income in stockholders'
equity until the hedged item is recognized in earnings or net income depending
on whether the derivative instrument qualifies as a hedge for accounting
purposes and, if so, the nature of the hedging activity. We have elected not to
qualify for hedge accounting treatment. As a result, our operating results may
suffer because losses on the derivatives that we enter into may not be offset by
a change in the fair value of the related hedged transaction.
In the normal course of business, we may use a variety of derivative
financial instruments to economically manage, or hedge, interest rate risk.
These derivative financial instruments must be effective in reducing our
interest rate risk exposure in order to qualify for hedge accounting. When the
terms of an underlying transaction are modified, or when the underlying hedged
item ceases to exist, all changes in the fair value of the instrument are
included in net income for each period until the derivative instrument matures
or is settled. Any derivative instrument used for risk management that does not
meet the hedging criteria is carried at fair value with the changes in value
included in net income.
Derivatives will be used for economic hedging purposes rather than
speculation. We will rely on quotations from third parties to determine fair
values. If our hedging activities do not achieve our desired results, our
reported earnings may be adversely affected. We hold no derivatives at September
30, 2008.
27
Reserve for Possible Credit Losses
The expense for possible credit losses in connection with debt
investments is the charge to earnings to increase the allowance for possible
credit losses to the level that management estimates to be adequate considering
delinquencies, loss experience and collateral quality. Other factors considered
relate to geographic trends and product diversification, the size of the
portfolio and current economic conditions. Based upon these factors, we
establish the provision for possible credit losses by category of asset. When it
is probable that we will be unable to collect all amounts contractually due, the
account is considered impaired.
Where impairment is indicated, a valuation write-down or write-off is
measured based upon the excess of the recorded investment amount over the net
fair value of the collateral, as reduced by selling costs. Any deficiency
between the carrying amount of an asset and the net sales price of repossessed
collateral is charged to the allowance for credit losses.
Income Taxes
The Company has elected and intends to qualify to be taxed as a REIT.
Accordingly, we will generally not be subject to corporate federal or state
income tax to the extent that we make qualifying distributions to our
stockholders, and provided we satisfy on a continuing basis, through actual
investment and operating results, the REIT requirements including certain asset,
income, distribution and stock ownership tests. If we fail to qualify as a REIT,
and do not qualify for certain statutory relief provisions, we will be subject
to federal, state and local income taxes and may be precluded from qualifying as
a REIT for the subsequent four taxable years following the year in which we lost
our REIT qualification. Accordingly, our failure to qualify as a REIT could have
a material adverse impact on our results of operations and amounts available for
distribution to our stockholders.
The dividends paid deduction of a REIT for qualifying dividends to its
stockholders is computed using our taxable income as opposed to net income
reported on the financial statements. Taxable income, generally, will differ
from net income reported on the financial statements because the determination
of taxable income is based on tax provisions and not financial accounting
principles.
In the future, we may create subsidiaries and treat them as taxable
REIT subsidiaries, or TRSs. In general, a TRS of ours may hold assets and engage
in activities that we cannot hold or engage in directly and generally may engage
in any real estate or non-real estate-related business. A TRS is subject to
federal, state and local corporate income taxes.
While our TRS will generate net income, our TRS can declare dividends
to us which will be included in our taxable income and necessitate a
distribution to our stockholders. Conversely, if we retain earnings at the TRS
level, no distribution is required and we can increase book equity of the
consolidated entity.
Financial Condition
At September 30, 2008, our portfolio consisted of $759.4 million of
RMBS and of approximately $598 million of securitized mortgage loans.
28
The following table summarizes certain characteristics of our portfolio at
September 30, 2008 and December 31, 2007.
September 30, December 31,
2008 2007
-----------------------------------------------------------------------------------------------------------------
Leverage at period-end 4.6:1 0.5:1
Residential mortgage-backed securities as a % of portfolio 60.4% 87.5%
Residential mortgage loans as a % of portfolio - 12.5%
Loans collateralizing secured debt as a % of portfolio 39.6% -
Fixed-rate investments as % of portfolio 18.4% 14.4%
Adjustable-rate investments as % of portfolio 81.6% 85.6%
Fixed-rate investments
Residential mortgage-backed securities as a % of fixed-rate assets 4.4% 39.5%
Residential mortgage loans as a % of fixed-rate assets - 60.5%
Loans collateralizing secured debt as a % of fixed-rate assets 95.6% -
Adjustable-rate investments
Residential mortgage-backed securities as a % of adjustable-rate assets 73.0% 95.5%
Residential mortgage loans as a % of adjustable-rate assets - 4.5%
Loans collateralizing secured debt as a % of adjustable-rate assets 27.0% -
Annualized yield on average earning assets during the period 5.35% 7.02%
Annualized cost of funds on average repurchase agreements balance during
the period 4.64% 5.08%
Annualized interest rate spread during the period 0.71% 1.94%
Weighted average yield on assets at period-end 5.63% 6.62%
Weighted average cost of funds at period-end 7.10% 5.02%
Residential Mortgage-Backed Securities
The table below summarizes our RMBS investments at September 30, 2008 and
December 31, 2007:
September 30, December 31,
2008 2007
(dollars in thousands)
--------------------------------------------------------------------------------
Amortized cost $897,685 $1,114,137
Unrealized gains 1,858 10,675
Unrealized losses (140,165) (522)
---------------------------------------
Fair value $759,378 $1,124,290
=======================================
As of September 30, 2008, the RMBS in our portfolio were purchased at a
net discount to their par value. Our RMBS had a weighted average amortized cost
of 99.4% and 98.8% at September 30, 2008 and December 31, 2007, respectively.
The following tables summarize certain characteristics of our RMBS
portfolio at September 30, 2008 and December 31, 2007.
Weighted Averages
Estimated Value Constant
(dollars in Yield to Prepayment
thousands) (1) Coupon Maturity Rate(2)
-------------------------------------------------------------------------------------------
September 30, 2008 $759,378 5.99% 6.23% 9%
December 31, 2007 $1,124,290 6.32% 6.87% 10%
(1) All assets listed in this chart are carried at their fair value.
(2) Represents the estimated percentage of principal that will be prepaid over
the next three months based on historical principal paydowns.
29
Actual maturities of RMBS are generally shorter than stated contractual
maturities, as they are affected by the contractual lives of the underlying
mortgages, periodic payments of principal, and prepayments of principal. The
stated contractual final maturity of the mortgage loans underlying our portfolio
of RMBS ranges up to 39 years, but the expected maturity is subject to change
based on the prepayments of the underlying loans. As of September 30, 2008, the
average final contractual maturity of the RMBS portfolio is 19 years, and as of
December 31, 2007, it was 29 years. The estimated weighted average months to
maturity of the RMBS in the tables below are based upon our prepayment
expectations, which are based on both proprietary and subscription-based
financial models. Our prepayment projections consider current and expected
trends in interest rates, interest rate volatility, steepness of the yield
curve, the mortgage rate of the outstanding loan, time to reset and the spread
margin of the reset.
The constant prepayment rate, or CPR, attempts to predict the
percentage of principal that will be prepaid over a period of time. We calculate
average CPR on a quarterly basis based on historical principal paydowns. As
interest rates rise, the rate of refinancings typically declines, which we
expect may result in lower rates of prepayment and, as a result, a lower
portfolio CPR. Conversely, as interest rates fall, the rate of refinancings
typically increases, which we expect may result in higher rates of prepayment
and, as a result, a higher portfolio CPR.
After the reset date, interest rates on our hybrid adjustable rate RMBS
securities adjust annually based on spreads over various LIBOR and Treasury
indices. These interest rates are subject to caps that limit the amount the
applicable interest rate can increase during any year, known as periodic cap,
and through the maturity of the applicable security, known as a lifetime cap.
The weighted average periodic cap for the portfolio is an increase of 2.01% and
the weighted average maximum lifetime increases and decreases for the portfolio
are 6.26%.
The following table summarizes our RMBS according to their estimated
weighted average life classifications as of September 30, 2008 and December 31,
2007:
Fair Value
September 30, December 31,
2008 2007
(dollars in thousands)
----------------------------------
Less than one year $ - $ 45,868
Greater than one year and less than five years 524,663 1,078,422
Greater than or equal to five years 234,715 -
----------------------------------
Total $759,378 $1,124,290
==================================
Results of Operations for the Quarter and Nine Months Ended September 30, 2008
(No Comparable Information for 2007)
Net Income/Loss Summary
Our net loss for the quarter ended September 30, 2008 was $107.6
million, or $2.76 per share. Our loss for this quarter consisted primarily of
realized losses on sales of assets.
For the nine months ended September 30, 2008, our net loss was $128.6
million or $3.30 per share. We attribute the net loss for the nine months ended
September 30, 2008 primarily to realized losses on sales of investments.
The table below presents the net income/loss summary for the quarter
and nine months ended September 30, 2008:
30
Net Income/Loss Summary
(dollars in thousands, except for per share data)
-------------------------------------------------------------------------------------------
For the For the Nine
Quarter Months
Ended Ended
September September
30, 2008 30, 2008
-------------------------------------------------------------------------------------------
Interest income $ 23,458 $ 81,603
Interest expense 15,543 49,590
------------------ ----------------
Net interest income 7,915 32,013
------------------ ----------------
Unrealized gains on interest rate swaps 10,065 4,156
Realized losses on sales of investments (113,130) (144,304)
Realized losses on terminations of interest
rate swaps (10,460) (10,337)
------------------ ----------------
Net investment expense (105,610) (118,472)
------------------ ----------------
Expenses
Management fee 1,681 6,136
General and administrative expenses 253 3,972
------------------ ----------------
Total expenses 1,934 10,108
------------------ ----------------
Loss before income taxes (107,544) (128,580)
Income taxes 12 15
------------------ ----------------
Net loss $ (107,556) $ (128,595)
================== ================
Net loss per share - basic and diluted $ (2.76) $ (3.30)
================== ================
Weighted average number of shares outstanding - basic
and diluted 38,992,893 38,994,357
================== ================
Comprehensive Loss:
Net loss $ (107,556) $ (128,595)
------------------ ----------------
Other comprehensive loss:
Unrealized loss on available-for-sale securities
Other comprehensive income: (146,456) (282,611)
Reclassification adjustment for realized
losses included
in net income 113,130 144,304
------------------ ----------------
Other comprehensive loss (33,326) (138,307)
------------------ ----------------
Comprehensive loss $ (140,882) $ (266,902)
================== ================
Interest Income and Average Earning Asset Yield
We had average earning assets of $1.8 billion for the quarter ended
September 30, 2008. Our interest income was $23.5 million for the quarter ended
September 30, 2008. The yield on our portfolio was 5.35% for the quarter ended
September 30, 2008. We had average earning assets of $1.7 billion for the nine
months ending September 30, 2008. Our interest income for this nine month period
was $81.6 million. The yield on our portfolio was 6.03% for this nine month
period.
31
Interest Expense and the Cost of Funds
Our largest expense is the cost of borrowed funds. We had average
borrowed funds of $1.3 billion and total interest expense of $15.5 million for
the quarter ended September 30, 2008. Our average cost of funds was 4.64% for
the quarter ended September 30, 2008. We had average borrowed funds of $1.4
billion, total interest expense of $49.6 million, and our average cost of funds
was 4.82% for the nine months ending September 30, 2008.
The table below shows our average borrowed funds and average cost of
funds as compared to average one-month and average six-month LIBOR for the
quarters ended September 30, 2008, June 30, 2008, March 31, 2008, and the period
commencing November 21, 2007 (inception) and ending December 31, 2007.
Average Cost of Funds
(Ratios have been annualized, dollars in thousands)
Average
One-Month
LIBOR Average Average
Relative Cost Cost of
to of Funds Funds
Average Average Average Relative to Relative to
Average Average One- Six- Six- Average Average
Borrowed Interest Cost of Month Month Month One-Month Six-Month
Funds Expense Funds LIBOR LIBOR LIBOR LIBOR LIBOR
-------------------------------------- ---------- --------- ------- ------- -------- ---------- ----------- ------------
For the quarter ended
September 30, 2008 $1,339,531 $15,543 4.64% 2.62% 3.19% (0.57%) 2.02% 1.45%
------------------------------------------------------------------------------------------------------------------------
For the quarter ended
June 30, 2008 $1,449,567 $20,025 5.53% 2.59% 2.93% (0.34%) 2.94% 2.60%
------------------------------------------------------------------------------------------------------------------------
For the quarter ended
March 31, 2008 $1,325,156 $14,022 4.23% 3.31% 3.18% 0.13% 0.92% 1.05%
------------------------------------------------------------------------------------------------------------------------
For the period ended
December 31, 2007 $270,584 $415 5.08% 4.98% 4.84% 0.14% 0.10% 0.24%
Net Interest Income
Our net interest income, which equals interest income less interest
expense, totaled $7.9 million for the quarter ended September 30, 2008. Our net
interest spread, which equals the yield on our average assets for the period
less the average cost of funds for the period, was 0.71% for the quarter ended
September 30, 2008. Our net interest income totaled $32.0 million for the nine
months ended September 30, 2008. Our net interest spread for this nine month
period was 1.21%.
The table below shows our average assets held, total interest earned on
assets, yield on average interest earning assets, average balance of repurchase
agreements, interest expense, average cost of funds, net interest income, and
net interest rate spread for the quarters ended September 30, 2008, June 30,
2008, March 31, 2008, and the period commencing November 21, 2007 and ending
December 31, 2007.
32
Net Interest Income
(Ratios have been annualized, dollars in thousands)
Yield on
Average Average Net
Average Interest Interest Balance of Average Net Interest
Earning Earned Earning Repurchase Interest Cost of Interest Rate
Assets Held on Assets Assets Agreements Expense Funds Income Spread
------------------------------------------------------------------------------------------------------------------------
For the Quarter ended $1,751,748 $23,419 5.35% $1,339,531 $15,543 4.64% $7,915 0.71%
September 30, 2008
------------------------------------------------------------------------------------------------------------------------
For the Quarter ended $1,917,969 $29,630 6.18% $1,449,567 $20,025 5.53% $9,926 0.65%
June 30, 2008
------------------------------------------------------------------------------------------------------------------------
For the Quarter ended $1,555,896 $25,790 6.63% $1,325,156 $14,022 4.23% $14,172 2.40%
March 31, 2008
------------------------------------------------------------------------------------------------------------------------
For the Period $399,736 $3,492 7.02% $270,584 $415 5.08% $3,077 1.94%
ended December 31,
2007
Gains and Losses on Sales of Assets and Interest Rate Swaps
During the quarter ended September 30, 2008, we sold assets with a
carrying value of $432.6 million in AAA-rated non-Agency RMBS and terminated
$983.4 million in interest rate swaps, which resulted in net realized losses of
approximately $113.1 million and $10.5 million, respectively.
Management Fee and General and Administrative Expenses
We paid FIDAC a base management fee of $1.7 million for the quarter
ended September 30, 2008. We did not pay an incentive fee for the quarter ended
September 30, 2008. We paid FIDAC a base management fee of $6.1 million for the
nine months ended September 30, 2008 and did not pay it an incentive fee for
this nine month period.
General and administrative (or G&A) expenses were $253 thousand for the
quarter ended September 30, 2008 and $4.0 million for the nine months ended
September 30, 2008.
Total expenses as a percentage of average total assets were 0.46% for
the quarter ended September 30, 2008 and were 0.75% for the nine months ended
September 30, 2008.
Currently, FIDAC has waived its right to require us to pay our pro rata
portion of rent, telephone, utilities, office furniture, equipment, machinery
and other office, internal and overhead expenses of FIDAC and its affiliates
required for our operations.
The table below shows our total management fee and G&A expenses as
compared to average total assets and average equity for the quarters ended
September 30, 2008, June 30, 2008, March 31, 2008, and the period commencing
November 21, 2007 and ending December 31, 2007.
Management Fee and G&A Expenses and Operating Expense
Ratios (Ratios have been annualized, dollars in thousands)
Total Total Management Total Management
Management Fee and G&A Fee and G&A
Fee and G&A Expenses/Average Expenses/Average
Expenses Total Assets Equity
------------------------------------------------------------------------------------------------------------
For the Quarter ended September 30, 2008 $1,934 0.46% 2.46%
------------------------------------------------------------------------------------------------------------
For the Quarter ended June 30, 2008 $3,380 0.70% 3.35%
------------------------------------------------------------------------------------------------------------
For the Quarter ended March 31, 2008 $4,792 1.10% 4.00%
------------------------------------------------------------------------------------------------------------
For the Period Commencing November 21, $1,822 1.55% 3.05%
2007 and Ending December 31, 2007
33
Net Income/Loss and Return on Average Equity
Our net loss was $107.6 million for the quarter ended September 30,
2008, and $128.6 million for the nine months ended September 30, 2008. We
attribute the losses incurred during the nine months ended September 30, 2008 to
realized losses on sales of investments and terminations of interest rate swaps.
The table below shows our net interest income, gain (loss) on sale of assets,
unrealized gains (loss) on interest rate swaps, total expenses, income tax, each
as a percentage of average equity, and the return on average equity for the
quarters ended September 30, 2008, June 30, 2008 and March 31, 2008, and the
period commencing November 21, 2007 and ending December 31, 2007.
Components of Return on Average Equity
(Ratios have been annualized)
Net Gain/(Loss) Unrealized
Interest on Sale of Gain/(Loss) on Total
Income/ Investments Interest Rate Expenses/ Income Return on
Average /Average Swaps/Average Average Tax/Average Average
Equity Equity Equity Equity Equity Equity
--------------------------------------------------------------------------------------------------------------------------------
For the Quarter ended September 30, 2008 10.07% (157.28%) 12.81% (2.46%) (0.02%) (136.88%)
--------------------------------------------------------------------------------------------------------------------------------
For the Quarter ended June 30, 2008 9.84% 1.75% 25.36% (3.35%) - 33.60%
--------------------------------------------------------------------------------------------------------------------------------
For the Quarter ended March 31, 2008 11.83% (27.40%) (26.29%) (4.00%) - (45.86%)
--------------------------------------------------------------------------------------------------------------------------------
For the Period Commencing November 21, 2007
and Ending December 31, 2007 5.16% - (6.97%) (3.05%) (0.01%) (4.87%)
Liquidity and Capital Resources
We held cash and cash equivalents of approximately $6.2 million at
September 30, 2008.
Our operating activities used net cash of approximately $3.2 million
for the quarter ended September 30, 2008. We generated net cash of approximately
$12.4 million from operations for the nine months ended September 30, 2008.
Our investing activities provided net cash of $258.7 million for the
quarter ended September 30, 2008, and used net cash of $845 million for the nine
months ended September 30, 2008. We used the cash provided by our repurchase
financing activities primarily for the purchase of investments.
Our financing activities as of September 30, 2008 consisted of proceeds
from repurchase agreements. We expect to continue to borrow funds in the form of
repurchase agreements as well as other types of financing. As of September 30,
2008, we had $619.7 million outstanding under our repurchase agreement with
Annaly collateralized by our RMBS with weighted average borrowing rates of 8.38%
and weighted average remaining maturities of 1 day. The RMBS pledged as
collateral under these repurchase agreements had an estimated fair value of
$736.8 million at September 30, 2008. The interest rates of these repurchase
agreements are generally indexed to the one-month LIBOR rate and reprice
accordingly. The terms of the repurchase transaction borrowings under our master
repurchase agreements generally conform to the terms in the standard master
repurchase agreement as published by the Securities Industry and Financial
Markets Association, or SIFMA, as to repayment, margin requirements and the
segregation of all securities we have initially sold under the repurchase
transaction. In addition, each lender typically requires that we include
supplemental terms and conditions to the standard master repurchase agreement.
Typical supplemental terms and conditions include changes to the margin
maintenance requirements, required haircuts, and purchase price maintenance
requirements, requirements that all controversies related to the repurchase
agreement be litigated in a particular jurisdiction and cross default
provisions. These provisions will differ for each of our lenders and will not be
determined until we engage in a specific repurchase transaction.
34
At September 30, 2008, June 30, 2008 and March 31, 2008, the repurchase
agreements for RMBS had the following remaining maturities:
September 30, 2008 June 30, 2008 March 31, 2008
(dollars in thousands)
----------------------------------------------------------------------------------------------------------
Within 30 days $619,657 $539,603 $598,168
30 to 59 days - 344,972 384,964
60 to 89 days - - -
90 to 119 days - 24,514 -
Greater than or equal to 120 days - - 24,514
-------------------------------------------------------------------
Total $619,657 $909,089 $1,007,646
===================================================================
We had entered into two master repurchase agreements pursuant to which
we financed mortgage loans. We terminated these agreements during the quarter in
order to avoid paying non-usage fees under those agreements. One agreement was a
$500 million lending facility of which $200 million was on an uncommitted basis.
The second agreement was a $350 million committed lending facility.
Increases in short-term interest rates could negatively affect the
valuation of our mortgage-related assets, which could limit our borrowing
ability or cause our lenders to initiate margin calls. Amounts due upon maturity
of our repurchase agreements will be funded primarily through the
rollover/reissuance of repurchase agreements and monthly principal and interest
payments received on our mortgage-backed securities.
For our short-term (one year or less) and long-term liquidity, which
includes investing and compliance with collateralization requirements under our
repurchase agreements (if the pledged collateral decreases in value or in the
event of margin calls created by prepayments of the pledged collateral), we also
rely on the cash flow from investments, primarily monthly principal and interest
payments to be received on our RMBS and whole mortgage loans, cash flow from the
sale of securities as well as any primary securities offerings authorized by our
board of directors.
Based on our current portfolio, leverage ratio and available borrowing
arrangements, we believe our assets will be sufficient to enable us to meet
anticipated short-term (one year or less) liquidity requirements such as to fund
our investment activities, pay fees under our management agreement, fund our
distributions to stockholders and pay general corporate expenses. However, an
increase in prepayment rates substantially above our expectations could cause a
temporary liquidity shortfall due to the timing of the necessary margin calls on
the financing arrangements and the actual receipt of the cash related to
principal paydowns. If our cash resources are at any time insufficient to
satisfy our liquidity requirements, we may have to sell investments or issue
debt or additional equity securities in a common stock offering. If required,
the sale of RMBS or whole mortgage loans at prices lower than their carrying
value would result in losses and reduced income.
Our ability to meet our long-term (greater than one year) liquidity and
capital resource requirements will be subject to obtaining additional debt
financing and equity capital. Subject to our maintaining our qualification as a
REIT, we expect to use a number of sources to finance our investments, including
repurchase agreements, warehouse facilities, securitizations, commercial paper
and term financing CDOs. Such financing will depend on market conditions for
capital raises and for the investment of any proceeds. If we are unable to
renew, replace or expand our sources of financing on substantially similar
terms, it may have an adverse effect on our business and results of operations.
Upon liquidation, holders of our debt securities, if any, and shares of
preferred stock, if any, and lenders with respect to other borrowings will
receive a distribution of our available assets prior to the holders of our
common stock.
35
We are not required by our investment guidelines to maintain any
specific debt-to-equity ratio as we believe the appropriate leverage for the
particular assets we are financing depends on the credit quality and risk of
those assets. However, our repurchase agreements for whole loans require us to
maintain certain debt-to-equity ratios. At September 30, 2008, our total debt
was approximately $1.1 billion which represented a debt-to-equity ratio of
approximately 4.6:1.
Stockholders' Equity
During the quarter ended September 30, 2008, we declared dividends to
common shareholders totaling $6.0 million, or $0.16 per share, all of which was
paid on October 31, 2008.
Management Agreement and Related Party Transactions
We have entered into a management agreement with FIDAC, pursuant to
which FIDAC is entitled to receive a base management fee, incentive compensation
and, in certain circumstances, a termination fee and reimbursement of certain
expenses as described in the management agreement. Such fees and expenses do not
have fixed and determinable payments. The base management fee is payable
quarterly in arrears in an amount equal to 1.75% per annum, calculated
quarterly, of our stockholders' equity (as defined in the management agreement).
On October 13, 2008, we and FIDAC amended the management agreement to reduce the
base management fee from 1.75% per annum to 1.50% per annum of our stockholders'
equity and provide that the incentive fees may be paid in cash or shares of the
Company's common stock, at the election of the Company's board of directors. On
October 19, 2008, we and FIDAC further amended the management agreement to
provide that the incentive fee be eliminated in its entirety and FIDAC receive
only the base management fee of 1.50% per annum of our stockholders' equity.
FIDAC uses the proceeds from its management fee in part to pay compensation to
its officers and employees who, notwithstanding that certain of them also are
our officers, receive no cash compensation directly from us. The base management
fee will be reduced, but not below zero, by our proportionate share of any CDO
base management fees FIDAC receives in connection with the CDOs in which we
invest, based on the percentage of equity we hold in such CDOs. We expect to
enter into certain contracts that contain a variety of indemnification
obligations, principally with FIDAC, brokers and counterparties to repurchase
agreements. The maximum potential future payment amount we could be required to
pay under these indemnification obligations is unlimited. Management fees
accrued and payable for the quarter ending September 30, 2008 are $1.7 million.
Management fees accrued for the nine months ended September 30, 2008 were $6.1
million.
Financing Arrangements with Annaly
In March 2008, we entered into a RMBS repurchase agreement with Annaly.
This agreement contains customary representations, warranties and covenants
contained in such agreements. As of September 30, 2008, we had $619.7 million
outstanding under the agreement with a weighted average borrowing rate of 8.38%.
Restricted Stock Grants
During the quarter ended September 30, 2008, 35,075 shares of
restricted stock we had awarded to our Manager's employees vested and 6,957
shares were forfeited or cancelled. We did not grant any incentive awards during
the quarter ended September 30, 2008. For the nine months ended September 30,
2008, 108,675 shares vested and 13,670 shares were forfeited.
At September 30, 2008 there are approximately $1.2 million unvested
shares of restricted stock issued to employees of FIDAC. For the three months
ended September 30, 2008, compensation expense less general and administrative
costs associated with the amortization of the fair value of the restricted stock
totaled $254 thousand. For the nine months ended September 30, 2008 compensation
expense less general and administrative costs associated with the amortization
of the fair value of the restricted stock totaled $1.3 million.
36
Contractual Obligations and Commitments
The following table summarizes our contractual obligations at September
30, 2008.
(dollars in thousands)
-------------------------------------------------------------------
Greater
Than or
Within One One to Three to Equal to
Contractual Obligations Year Three Years Five Years Five Years Total
---------------------------------------------------------------------------------------------------
Repurchase agreements for RMBS $619,657 $- $- $- $619,657
Securitized debt 78,185 142,964 118,807 183,284 523,240
Interest expense on RMBS
repurchase agreements(1) - - - - -
Interest expense on securitized
debt(1) 29,220 49,708 33,740 255,887 368,555
-------------------------------------------------------------------
Total $727,062 $192,672 $152,547 $439,171 $1,511,452
===================================================================
(1) Interest is based on variable rates in effect as of September 30, 2008.
Off-Balance Sheet Arrangements
We do not have any relationships with unconsolidated entities or
financial partnerships, such as entities often referred to as structured finance
or special purpose entities, which would have been established for the purpose
of facilitating off-balance sheet arrangements or other contractually narrow or
limited purposes. Further, we have not guaranteed any obligations of
unconsolidated entities nor do we have any commitment or intent to provide
funding to any such entities. As such, we are not materially exposed to any
market, credit, liquidity or financing risk that could arise if we had engaged
in such relationships.
Dividends
To qualify as a REIT, we must pay annual dividends to our stockholders
of at least 90% of our taxable income, determined without regard to the
deduction for dividends paid and excluding any net capital gains. We intend to
pay regular quarterly dividends to our stockholders. Before we pay any dividend,
whether for U.S. federal income tax purposes or otherwise, which would only be
paid out of available cash to the extent permitted under our warehouse and
repurchase facilities, we must first meet both our operating requirements and
scheduled debt service on our warehouse lines and other debt payable.
Inflation
Virtually all of our assets and liabilities are interest rate sensitive
in nature. As a result, interest rates and other factors influence our
performance far more so than does inflation. Changes in interest rates do not
necessarily correlate with inflation rates or changes in inflation rates. Our
financial statements are prepared in accordance with GAAP and our distributions
will be determined by our board of directors consistent with our obligation to
distribute to our stockholders at least 90% of our REIT taxable income on an
annual basis in order to maintain our REIT qualification; in each case, our
activities and balance sheet are measured with reference to historical cost
and/or fair market value without considering inflation.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
The primary components of our market risk are related to credit risk,
interest rate risk, prepayment risk, market value risk and real estate risk.
While we do not seek to avoid risk completely, we believe the risk can be
quantified from historical experience and we seek to actively manage that risk,
to earn sufficient compensation to justify taking those risks and to maintain
capital levels consistent with the risks we undertake.
37
Credit Risk
We are subject to credit risk in connection with our investments and
face more credit risk on assets we own which are rated below "AAA". The credit
risk related to these investments pertains to the ability and willingness of the
borrowers to pay, which is assessed before credit is granted or renewed and
periodically reviewed throughout the loan or security term. We believe that
residual loan credit quality is primarily determined by the borrowers' credit
profiles and loan characteristics. FIDAC will use a comprehensive credit review
process. FIDAC's analysis of loans includes borrower profiles, as well as
valuation and appraisal data. FIDAC uses compensating factors such as liquid
assets, low loan to value ratios and job stability in evaluating loans. FIDAC's
resources include a proprietary portfolio management system, as well as third
party software systems. FIDAC utilizes third party due diligence firms to
perform an independent underwriting review to insure compliance with existing
guidelines. FIDAC selects loans for review predicated on risk-based criteria
such as loan-to-value, borrower's credit score(s) and loan size. FIDAC also
outsources underwriting services to review higher risk loans, either due to
borrower credit profiles or collateral valuation issues. In addition to
statistical sampling techniques, FIDAC creates adverse credit and valuation
samples, which we individually review. FIDAC rejects loans that fail to conform
to our standards. FIDAC accepts only those loans which meet our underwriting
criteria. Once we own a loan, FIDAC's surveillance process includes ongoing
analysis through our proprietary data warehouse and servicer files.
Additionally, the non-Agency RMBS and other ABS which we will acquire for our
portfolio are reviewed by FIDAC to ensure that they satisfy our risk based
criteria. FIDAC's review of non-Agency RMBS and other ABS includes utilizing its
proprietary portfolio management system. FIDAC's review of non-Agency RMBS and
other ABS is based on quantitative and qualitative analysis of the risk-adjusted
returns on non-Agency RMBS and other ABS present.
Interest Rate Risk
Interest rate risk is highly sensitive to many factors, including
governmental monetary and tax policies, domestic and international economic and
political considerations and other factors beyond our control. We are subject to
interest rate risk in connection with our investments and our related debt
obligations, which are generally repurchase agreements, warehouse facilities,
securitization, commercial paper and term financing CDOs. Our repurchase
agreements and warehouse facilities may be of limited duration that are
periodically refinanced at current market rates. We intend to mitigate this risk
through utilization of derivative contracts, primarily interest rate swap
agreements.
Interest Rate Effect on Net Interest Income
Our operating results depend, in large part, on differences between the
income from our investments and our borrowing costs. Most of our warehouse
facilities and repurchase agreements provide financing based on a floating rate
of interest calculated on a fixed spread over LIBOR. The fixed spread varies
depending on the type of underlying asset which collateralizes the financing.
Accordingly, the portion of our portfolio which consists of floating interest
rate assets will be match-funded utilizing our expected sources of short-term
financing, while our fixed interest rate assets will not be match-funded. During
periods of rising interest rates, the borrowing costs associated with our
investments tend to increase while the income earned on our fixed interest rate
investments may remain substantially unchanged. This will result in a narrowing
of the net interest spread between the related assets and borrowings and may
even result in losses. Further, during this portion of the interest rate and
credit cycles, defaults could increase and result in credit losses to us, which
could adversely affect our liquidity and operating results. Such delinquencies
or defaults could also have an adverse effect on the spread between
interest-earning assets and interest-bearing liabilities. Hedging techniques are
partly based on assumed levels of prepayments of our fixed-rate and hybrid
adjustable-rate mortgage loans and RMBS. If prepayments are slower or faster
than assumed, the life of the mortgage loans and RMBS will be longer or shorter,
which would reduce the effectiveness of any hedging strategies we may use and
may cause losses on such transactions. Hedging strategies involving the use of
derivative securities are highly complex and may produce volatile returns.
38
Interest Rate Effects on Fair Value
Another component of interest rate risk is the effect changes in
interest rates will have on the fair value of the assets we acquire. We face the
risk that the fair value of our assets will increase or decrease at different
rates than that of our liabilities, including our hedging instruments. We
primarily assess our interest rate risk by estimating the duration of our assets
and the duration of our liabilities. Duration essentially measures the market
price volatility of financial instruments as interest rates change. We generally
calculate duration using various financial models and empirical data. Different
models and methodologies can produce different duration numbers for the same
securities.
It is important to note that the impact of changing interest rates on
fair value can change significantly when interest rates change beyond 100 basis
points from current levels. Therefore, the volatility in the fair value of our
assets could increase significantly when interest rates change beyond 100 basis
points. In addition, other factors impact the fair value of our interest
rate-sensitive investments and hedging instruments, such as the shape of the
yield curve, market expectations as to future interest rate changes and other
market conditions. Accordingly, in the event of changes in actual interest
rates, the change in the fair value of our assets would likely differ from that
shown above and such difference might be material and adverse to our
stockholders.
Interest Rate Cap Risk
We also invest in adjustable-rate mortgage loans and RMBS. These are
mortgages or RMBS in which the underlying mortgages are typically subject to
periodic and lifetime interest rate caps and floors, which limit the amount by
which the security's interest yield may change during any given period. However,
our borrowing costs pursuant to our financing agreements will not be subject to
similar restrictions. Therefore, in a period of increasing interest rates,
interest rate costs on our borrowings could increase without limitation by caps,
while the interest-rate yields on our adjustable-rate mortgage loans and RMBS
would effectively be limited. This problem will be magnified to the extent we
acquire adjustable-rate RMBS that are not based on mortgages which are fully
indexed. In addition, the mortgages or the underlying mortgages in an RMBS may
be subject to periodic payment caps that result in some portion of the interest
being deferred and added to the principal outstanding. This could result in our
receipt of less cash income on our adjustable-rate mortgages or RMBS than we
need in order to pay the interest cost on our related borrowings. These factors
could lower our net interest income or cause a net loss during periods of rising
interest rates, which would harm our financial condition, cash flows and results
of operations.
Interest Rate Mismatch Risk
We fund a substantial portion of our acquisitions of hybrid
adjustable-rate mortgages and RMBS with borrowings that, after the effect of
hedging, have interest rates based on indices and repricing terms similar to,
but of somewhat shorter maturities than, the interest rate indices and repricing
terms of the mortgages and RMBS. Thus, in most cases the interest rate indices
and repricing terms of our mortgage assets and our funding sources will not be
identical, thereby creating an interest rate mismatch between assets and
liabilities. Therefore, our cost of funds would likely rise or fall more quickly
than would our earnings rate on assets. During periods of changing interest
rates, such interest rate mismatches could negatively impact our financial
condition, cash flows and results of operations. To mitigate interest rate
mismatches, we may utilize the hedging strategies discussed above. Our analysis
of risks is based on FIDAC's experience, estimates, models and assumptions.
These analyses rely on models which utilize estimates of fair value and interest
rate sensitivity. Actual economic conditions or implementation of investment
decisions by our management may produce results that differ significantly from
the estimates and assumptions used in our models and the projected results shown
in this Form 10-Q.
39
Our profitability and the value of our portfolio (including interest
rate swaps) may be adversely affected during any period as a result of changing
interest rates. The following table quantifies the potential changes in net
interest income, portfolio value should interest rates go up or down 25, 50, and
75 basis points, assuming the yield curves of the rate shocks will be parallel
to each other and the current yield curve. All changes in income and value are
measured as percentage changes from the projected net interest income and
portfolio value at the base interest rate scenario. The base interest rate
scenario assumes interest rates at September 30, 2008 and various estimates
regarding prepayment and all activities are made at each level of rate shock.
Actual results could differ significantly from these estimates.
Projected Percentage Change in Projected Percentage Change in
Change in Interest Rate Net Interest Income Portfolio Value
----------------------------------------------------------------------------------------------------------------------
-75 Basis Points (6.88%) 0.70%
-50 Basis Points (5.02%) 0.52%
-25 Basis Points (3.14%) 0.32%
Base Interest Rate
+25 Basis Points 1.44% (0.14%)
+50 Basis Points 2.62% (0.40%)
+75 Basis Points 3.81% (0.68%)
Prepayment Risk
As we receive prepayments of principal on these investments, premiums
paid on such investments will be amortized against interest income. In general,
an increase in prepayment rates will accelerate the amortization of purchase
premiums, thereby reducing the interest income earned on the investments.
Conversely, discounts on such investments are accreted into interest income. In
general, an increase in prepayment rates will accelerate the accretion of
purchase discounts, thereby increasing the interest income earned on the
investments.
Extension Risk
FIDAC computes the projected weighted-average life of our investments
based on assumptions regarding the rate at which the borrowers will prepay the
underlying mortgages. In general, when fixed-rate or hybrid adjustable-rate
mortgage loans or RMBS are acquired with borrowings, we may, but are not
required to, enter into an interest rate swap agreement or other hedging
instrument that effectively fixes our borrowing costs for a period close to the
anticipated average life of the fixed-rate portion of the related assets. This
strategy is designed to protect us from rising interest rates because the
borrowing costs are fixed for the duration of the fixed-rate portion of the
related assets. However, if prepayment rates decrease in a rising interest rate
environment, the life of the fixed-rate portion of the related assets could
extend beyond the term of the swap agreement or other hedging instrument. This
could have a negative impact on our results from operations, as borrowing costs
would no longer be fixed after the end of the hedging instrument while the
income earned on the hybrid adjustable-rate assets would remain fixed. This
situation may also cause the market value of our hybrid adjustable-rate assets
to decline, with little or no offsetting gain from the related hedging
transactions. In extreme situations, we may be forced to sell assets to maintain
adequate liquidity, which could cause us to incur losses.
Market Risk
Market Value Risk
Our available-for-sale securities are reflected at their estimated fair
value with unrealized gains and losses excluded from earnings and reported in
other comprehensive income pursuant to SFAS No. 115, Accounting for Certain
Investments in Debt and Equity Securities. The estimated fair value of these
securities fluctuates primarily due to changes in interest rates and other
factors. Generally, in a rising interest rate environment, the estimated fair
value of these securities would be expected to decrease; conversely, in a
decreasing interest rate environment, the estimated fair value of these
securities would be expected to increase. As market volatility increases or
liquidity decreases, the fair value of our investments may be adversely
impacted. If we are unable to readily obtain independent pricing to validate our
estimated fair value of securities in the portfolio, the fair value gains or
losses recorded in other comprehensive income may be adversely affected.
40
Real Estate Market Risk
We own assets secured by real property and may own real property
directly in the future. Residential property values are subject to volatility
and may be affected adversely by a number of factors, including, but not limited
to, national, regional and local economic conditions (which may be adversely
affected by industry slowdowns and other factors); local real estate conditions
(such as an oversupply of housing); changes or continued weakness in specific
industry segments; construction quality, age and design; demographic factors;
and retroactive changes to building or similar codes. In addition, decreases in
property values reduce the value of the collateral and the potential proceeds
available to a borrower to repay our loans, which could also cause us to suffer
losses.
Risk Management
To the extent consistent with maintaining our REIT status, we seek to
manage risk exposure to protect our portfolio of residential mortgage loans,
RMBS, and other assets and related debt against the effects of major interest
rate changes. We generally seek to manage our risk by:
o monitoring and adjusting, if necessary, the reset index and interest
rate related to our RMBS and our financings;
o attempting to structure our financing agreements to have a range of
different maturities, terms, amortizations and interest rate
adjustment periods;
o using derivatives, financial futures, swaps, options, caps, floors and
forward sales to adjust the interest rate sensitivity of our MBS and
our borrowings;
o using securitization financing to lower average cost of funds relative
to short-term financing vehicles further allowing us to receive the
benefit of attractive terms for an extended period of time in contrast
to short term financing and maturity dates of the investments included
in the securitization; and
o actively managing, on an aggregate basis, the interest rate indices,
interest rate adjustment periods, and gross reset margins of our
investments and the interest rate indices and adjustment periods of
our financings.
Our efforts to manage our assets and liabilities are concerned with the
timing and magnitude of the repricing of assets and liabilities. We attempt to
control risks associated with interest rate movements. Methods for evaluating
interest rate risk include an analysis of our interest rate sensitivity "gap",
which is the difference between interest-earning assets and interest-bearing
liabilities maturing or repricing within a given time period. A gap is
considered positive when the amount of interest-rate sensitive assets exceeds
the amount of interest-rate sensitive liabilities. A gap is considered negative
when the amount of interest-rate sensitive liabilities exceeds interest-rate
sensitive assets. During a period of rising interest rates, a negative gap would
tend to adversely affect net interest income, while a positive gap would tend to
result in an increase in net interest income. During a period of falling
interest rates, a negative gap would tend to result in an increase in net
interest income, while a positive gap would tend to affect net interest income
adversely. Because different types of assets and liabilities with the same or
similar maturities may react differently to changes in overall market rates or
conditions, changes in interest rates may affect net interest income positively
or negatively even if an institution were perfectly matched in each maturity
category.
41
The following table sets forth the estimated maturity or repricing of
our interest-earning assets and interest-bearing liabilities at September 30,
2008. The amounts of assets and liabilities shown within a particular period
were determined in accordance with the contractual terms of the assets and
liabilities, except adjustable-rate loans, and securities are included in the
period in which their interest rates are first scheduled to adjust and not in
the period in which they mature and does include the effect of the interest rate
swaps. The interest rate sensitivity of our assets and liabilities in the table
could vary substantially if based on actual prepayment experience.
Within 3 1 Year to 3 Greater than
Months 3-12 Months Years 3 Years Total
---------------------------------------------------------------------------------------------------------------------------
(dollars in thousands)
Rate sensitive assets $ 47,191 $ - $ 139,737 $ 1,307,968 $ 1,494,896
Cash equivalents 6,167 - - - 6,167
-----------------------------------------------------------------------------
Total rate sensitive assets 53,358 - 139,737 1,307,968 1,501,063
-----------------------------------------------------------------------------
Rate sensitive liabilities, with the effect
of swaps 619,657 - - 523,241 1,142,898
-----------------------------------------------------------------------------
Interest rate sensitivity gap $ (566,299) $ - $ 139,737 $ 784,727 $ 358,165
=============================================================================
Cumulative rate sensitivity gap $ (566,299) $ (566,299) $ (426,562) $ 358,165
==============================================================
Cumulative interest rate sensitivity gap as
a percentage of total rate-sensitive
assets (38%) (38%) (28%) 24%
==============================================================
Our analysis of risks is based on FIDAC's experience, estimates, models
and assumptions. These analyses rely on models which utilize estimates of fair
value and interest rate sensitivity. Actual economic conditions or
implementation of investment decisions by FIDAC may produce results that differ
significantly from the estimates and assumptions used in our models and the
projected results shown in the above tables and in this report. These analyses
contain certain forward-looking statements and are subject to the safe harbor
statement set forth under the heading, "Special Note Regarding Forward-Looking
Statements."
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
Our management, including our Chief Executive Officer, or CEO, and
Chief Financial Officer, or CFO, reviewed and evaluated the effectiveness of the
design and operation of our disclosure controls and procedures (as defined in
Rule 13a-15(e) and 15d-15(e) of the Securities Exchange Act) as of the end of
the period covered by this quarterly report. Based on that review and
evaluation, the CEO and CFO have concluded that our current disclosure controls
and procedures, as designed and implemented, (1) were effective in ensuring that
information regarding the Company and its subsidiaries is made known to our
management, including our CEO and CFO, as appropriate to allow timely decisions
regarding required disclosure and (2) were effective in providing reasonable
assurance that information the Company must disclose in its periodic reports
under the Securities Exchange Act is recorded, processed, summarized and
reported within the time periods prescribed by the SEC's rules and forms.
42
Changes in Internal Controls
There have been no changes in our "internal control over financial
reporting" (as defined in Rule 13a-15(f) under the Securities Exchange Act) that
occurred during the period covered by this quarterly report that has materially
affected, or is reasonably likely to materially affect, our internal control
over financial reporting.
PART II. OTHER INFORMATION
Item. 1. LEGAL PROCEEDINGS
From time to time, we may be involved in various claims and legal
actions arising in the ordinary course of business. In the opinion of
management, the ultimate disposition of these matters will not have a material
adverse effect on our consolidated financial statements.
Item 1A. RISK FACTORS
In addition to the other information set forth in this report, you
should carefully consider the factors discussed in Part I, "Item 1A. Risk
Factors" in our Annual Report on Form 10-K for the year ended December 31, 2007,
which could materially affect our business, financial condition or future
results. The information presented below updates and should be read in
conjunction with the risk factors and information disclosed in that Form 10-K.
DIFFICULT CONDITIONS IN THE FINANCIAL MARKETS AND THE ECONOMY GENERALLY, HAVE
CAUSED US AND MAY CONTINUE TO CAUSE US MARKET LOSSES RELATED TO OUR HOLDINGS,
AND WE DO NOT EXPECT THESE CONDITIONS TO IMPROVE IN THE NEAR FUTURE.
Our results of operations are materially affected by conditions in the
mortgage market, the financial markets and the economy generally. Recently,
concerns over inflation, energy costs, geopolitical issues, the availability and
cost of credit, the mortgage market and a declining real estate market have
contributed to increased volatility and diminished expectations for the economy
and markets going forward. The mortgage market, including the market for prime
and Alt-A loans, has been severely affected by changes in the lending landscape
and there is no assurance that these conditions have stabilized or that they
will not worsen. The severity of the liquidity limitation was largely
unanticipated by the markets. For now (and for the foreseeable future), access
to mortgages has been substantially limited. While the limitation on financing
was initially in the sub-prime mortgage market, the liquidity issues have now
also affected prime and Alt-A non-Agency lending, with mortgage rates remaining
much higher than previously available in recent periods and many product types
being severely curtailed. This has an impact on new demand for homes, which will
compress the home ownership rates and weigh heavily on future home price
performance. There is a strong correlation between home price growth rates and
mortgage loan delinquencies. The market deterioration has caused us to expect
increased losses related to our holdings and to sell assets at a loss.
Although as of and for the quarter ended September 30, 2008 we sold
assets with a carrying value of $432.6 million in AAA-rated non-Agency RMBS for
a loss of approximately $113.1 million and terminated $983.4 million in notional
interest rate swaps for a loss of approximately $10.5 million, which together
resulted in a net realized loss of approximately $123.6 million. Further
declines in the market values of our investments may adversely affect periodic
reported results and credit availability, which may reduce earnings and, in
turn, cash available for distribution to our stockholders.
A substantial portion of our assets are classified for accounting
purposes as "available-for-sale" and carried at fair value. Changes in the fair
values of those assets are directly charged or credited to other comprehensive
income. As a result, a decline in values may reduce the book value of our
assets. Moreover, if the decline in value of an available-for-sale security is
other than temporary, such decline will reduce earnings.
43
All of our repurchase agreements and interest rate swap agreements are
subject to bilateral margin calls in the event that the collateral securing our
obligations under those facilities exceeds or does not meet our
collateralization requirements. We analyze the sufficiency of our
collateralization daily, and as of September 30, 2008, on a net basis, the fair
value of the collateral, including restricted cash, securing our obligations
under repurchase agreements and interest rate swaps, exceeded the amount of such
obligations by approximately $130.8 million. During the nine months ended June
30, 2008, due to the deterioration in the market value of our assets, we
received and met margin calls under our repurchase agreements, which resulted in
our obtaining additional funding from third parties, including from Annaly, and
taking other steps to increase our liquidity. Additionally, the disruptions
during the nine months ended September 30, 2008 resulted in us not being in
compliance with the net income covenant in one of our whole loan repurchase
agreements and the liquidity covenants in our other whole loan repurchase
agreement at a time during which we had no amounts outstanding under those
facilities. We amended these covenants, and on July 29, 2008, we terminated
those facilities to avoid paying non-usage fees. Should we receive additional
margin calls, we may not be able to amend the restrictive covenants or obtain
other funding. If we were unable to post additional collateral, we would have to
sell the assets at a time when we might not otherwise choose to do so and such
sales may be at a loss. A reduction in credit available may reduce our earnings
and, in turn, cash available to us for distribution to stockholders.
Dramatic declines in the housing market, with falling home prices and
increasing foreclosures and unemployment, have resulted in significant asset
write-downs by financial institutions, which have caused many financial
institutions to seek additional capital, to merge with other institutions and,
in some cases, to fail. In addition, we rely on the availability of financing to
acquire residential mortgage loans, real estate-related securities and real
estate loans on a leveraged basis. Institutions from which we will seek to
obtain financing may have owned or financed residential mortgage loans, real
estate-related securities and real estate loans, which have declined in value
and caused them to suffer losses as a result of the recent downturn in the
residential mortgage market. Many lenders and institutional investors have
reduced and, in some cases, ceased to provide funding to borrowers, including
other financial institutions. If these conditions persist, these institutions
may become insolvent or tighten their lending standards, which could make it
more difficult for us to obtain financing on favorable terms or at all. Our
profitability may be adversely affected if we are unable to obtain
cost-effective financing for our investments.
A SIGNIFICANT PORTION OF OUR FINANCING IS FROM ANNALY WHICH IS A SIGNIFICANT
SHAREHOLDER OF OURS AND WHICH OWNS OUR MANAGER.
Our ability to fund our investments on a leveraged basis depends to a
large extent upon our ability to secure warehouse, repurchase, credit, and/or
commercial paper financing on acceptable terms. The current dislocation in the
non-Agency mortgage sector has made it difficult for us to obtain short-term
financing on favorable terms. As a result, we have completed loan
securitizations in order to obtain long-term financing and terminated our
un-utilized whole loan repurchase agreements in order to avoid paying non-usage
fees under those agreements. In addition, we have entered into a RMBS repurchase
agreement with Annaly. This agreement contains customary representations,
warranties and covenants contained in such agreements. As of September 30, 2008,
we had approximately $620.0 million outstanding under this agreement, which
constitutes approximately 56% of our total financing. Our RMBS repurchase
agreement with Annaly is rolled daily at market rates, bears interest at LIBOR
plus 150 basis points, and is secured by the RMBS pledged under the agreement.
We do not expect to increase significantly the amount of securities pledged to
Annaly or significantly increase or decrease the funds we borrow from Annaly. We
cannot assure you that Annaly will continue to provide us with such financing.
If Annaly does not provide us with financing, we cannot assure you that we will
be able to replace such financing, and if we are not able to replace this
financing, we could be forced to sell our assets at an inopportune time when
prices are depressed.
THE LACK OF LIQUIDITY IN OUR INVESTMENTS MAY ADVERSELY AFFECT OUR BUSINESS,
INCLUDING OUR ABILITY TO VALUE AND SELL OUR ASSETS.
We have invested and may continue to invest in securities or other
instruments that are not liquid. Moreover, turbulent market conditions, such as
those currently in effect, could significantly and negatively impact the
liquidity of our assets. It may be difficult or impossible to obtain third party
pricing on the investments we purchase. Illiquid investments typically
experience greater price volatility, as a ready market does not exist, and can
be more difficult to value. In addition, validating third party pricing for
illiquid investments may be more subjective than more liquid investments. The
illiquidity of our investments may make it difficult for us to sell such
investments if the need or desire arises. In addition, if we are required to
liquidate all or a portion of our portfolio quickly, we may realize
significantly less than the value at which we have previously recorded our
investments. As a result, our ability to vary our portfolio in response to
changes in economic and other conditions may be relatively limited, which could
adversely affect our results of operations and financial condition.
44
THERE CAN BE NO ASSURANCE THAT THE ACTIONS OF THE U.S. GOVERNMENT, FEDERAL
RESERVE AND OTHER GOVERNMENTAL AND REGULATORY BODIES FOR THE PURPOSE OF
STABILIZING THE FINANCIAL MARKETS, OR MARKET RESPONSE TO THOSE ACTIONS, WILL
ACHIEVE THE INTENDED EFFECT, OUR BUSINESS MAY NOT BENEFIT FROM THESE ACTIONS AND
FURTHER GOVERNMENT OR MARKET DEVELOPMENTS COULD ADVERSELY IMPACT US.
In response to the financial issues affecting the banking system and
financial markets and going concern threats to investment banks and other
financial institutions, the Emergency Economic Stabilization Act of 2008, or
EESA, was recently enacted. The EESA provides the U.S. Secretary of the Treasury
with the authority to establish a Troubled Asset Relief Program, or TARP, to
purchase from financial institutions up to $700 billion of residential or
commercial mortgages and any securities, obligations, or other instruments that
are based on or related to such mortgages, that in each case was originated or
issued on or before March 14, 2008, as well as any other financial instrument
that the U.S. Secretary of the Treasury, after consultation with the Chairman of
the Board of Governors of the Federal Reserve System, determines the purchase of
which is necessary to promote financial market stability, upon transmittal of
such determination, in writing, to the appropriate committees of the U.S.
Congress. The EESA also provides for a program that would allow companies to
insure their troubled assets.
There can be no assurance that the EESA will have a beneficial impact
on the financial markets, including current extreme levels of volatility. To the
extent the market does not respond favorably to the TARP or the TARP does not
function as intended, our business may not receive the anticipated positive
impact from the legislation. In addition, the U.S. Government, Federal Reserve
and other governmental and regulatory bodies have taken or are considering
taking other actions to address the financial crisis. We cannot predict whether
or when such actions may occur or what impact, if any, such actions could have
on our business, results of operations and financial condition.
OUR INVESTMENTS IN SUBORDINATED RMBS ARE GENERALLY IN THE "FIRST LOSS" POSITION
AND OUR INVESTMENTS IN THE MEZZANINE RMBS ARE GENERALLY IN THE "SECOND LOSS"
POSITION AND THEREFORE SUBJECT TO LOSSES.
In general, losses on a mortgage loan included in a securitization will
be borne first by the equity holder of the issuing trust, and then by the "first
loss" subordinated security holder and then by the "second loss" mezzanine
holder. In the event of default and the exhaustion of any classes of securities
junior to those in which we invest and there is any further loss, we will not be
able to recover all of our investment in the securities we purchase. In
addition, if the underlying mortgage portfolio has been overvalued by the
originator, or if the values subsequently decline and, as a result, less
collateral is available to satisfy interest and principal payments due on the
related RMBS, the securities in which we invest may effectively become the
"first loss" position behind the more senior securities, which may result in
significant losses to us. The prices of lower credit quality securities are
generally less sensitive to interest rate changes than more highly rated
investments, but more sensitive to adverse economic downturns or individual
issuer developments. A projection of an economic downturn, for example, could
cause a decline in the price of lower credit quality securities because the
ability of obligors of mortgages underlying RMBS to make principal and interest
payments may be impaired. In such event, existing credit support in the
securitization structure may be insufficient to protect us against loss of our
principal on these securities.
Item 6. EXHIBITS
Exhibits:
The exhibits required by this item are set forth on the Exhibit Index
attached hereto
45
EXHIBIT INDEX
Exhibit Description
Number
3.1 Articles of Amendment and Restatement of Chimera Investment Corporation (filed as Exhibit
3.1 to the Company's Registration Statement on Amendment No. 1 to Form S-11 (File No.
333-145525) filed on September 27, 2007 and incorporated herein by reference)
3.2 Amended and Restated Bylaws of Chimera Investment Corporation (filed as Exhibit 3.2 to
the Company's Registration Statement on Amendment No. 2 to Form S-11 (File No. 333-145525)
filed on November 5, 2007 and incorporated herein by reference)
4.1 Specimen Common Stock Certificate of Chimera Investment Corporation (filed as Exhibit 4.1
to the Company's Registration Statement on Amendment No. 1 to Form S-11 (File No.
333-145525) filed on September 27, 2007 and incorporated herein by reference)
10.1 Form of Management Agreement between Chimera Investment Corporation and Fixed Income
Discount Advisory Company (filed as Exhibit 10.1 to the Company's Registration Statement
on Amendment No. 1 to Form S-11 (File No. 333-145525) filed on September 27, 2007 and
incorporated herein by reference)
10.2 Form of Amendment No. 1 to the Management Agreement between Chimera Investment Corporation
and Fixed Income Discount Advisory Company (filed as Exhibit 10.2 to the Company's
Registration Statement on Amendment No. 1 to Form S-11 (File No. 333-151403) filed on
October 14, 2008 and incorporated herein by reference)
10.3 Form of Amendment No. 2 to the Management Agreement between Chimera Investment Corporation
and Fixed Income Discount Advisory Company (filed as Exhibit 10.1 to the Company's
Current Report on Form 8-K filed on October 20, 2008 and incorporated herein by reference)
10.4+ Form of Equity Incentive Plan (filed as Exhibit 10.2 to the Company's Registration
Statement on Amendment No. 1 to Form S-11 (File No. 333-145525) filed on September 27,
2007 and incorporated herein by reference)
10.5+ Form of Restricted Common Stock Award (filed as Exhibit 10.3 to the Company's Registration
Statement on Amendment No. 1 to Form S-11 (File No. 333-145525) filed on September 27,
2007 and incorporated herein by reference)
10.6+ Form of Stock Option Grant (filed as Exhibit 10.4 to the Company's Registration Statement
on Amendment No. 1 to Form S-11 (File No. 333-145525) filed on September 27, 2007 and
incorporated herein by reference)
10.7 Form of Master Securities Repurchase Agreement (filed as Exhibit 10.5 to the Company's
Registration Statement on Amendment No. 3 to Form S-11 (File No. 333-145525) filed on
November 13, 2007 and incorporated herein by reference)
31.1 Certification of Matthew Lambiase, Chief Executive Officer and
President of the Registrant, pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
31.2 Certification of A. Alexandra Denahan, Chief Financial Officer of the Registrant, pursuant
to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of Matthew Lambiase, Chief Executive Officer and President of the
Registrant, pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
32.2 Certification of A. Alexandra Denahan, Chief Financial Officer of the Registrant, pursuant
to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.
+ Represents a management contract or compensatory plan or arrangement.
46
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized, in the city of New
York, State of New York.
CHIMERA INVESTMENT CORPORATION
By: /s/ Matthew Lambiase
------------------------
Matthew Lambiase
Chief Executive Officer and President
November 10, 2008
By: /s/ A. Alexandra Denahan
------------------------
A. Alexandra Denahan
Chief Financial Officer (Principal Financial Officer)
November 10, 2008
47