SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED: DECEMBER 31, 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 (I.R.S. Employer
of incorporation of organization) Identification Number)
1211 Avenue of the Americas, Suite 2902
New York, New York 10036
(Address of Principal Executive Offices) (Zip Code)
(646) 454-3759
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class Name of Each Exchange on Which Registered
Common Stock, par value $.01 per share New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act:
None.
Indicate by check mark whether the Registrant is a well-known seasoned issuer,
as defined in Rule 405 of the Securities Act. Yes [X] No [_]
Indicate by check mark if the Registrant is not required to file reports
pursuant to Section 13 or Section 15(d) of the Act. Yes [_] No [X]
Indicate by check mark whether the Registrant (1) has filed all 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 if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [_]
Indicate by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer or a smaller reporting company. See
the definitions of "accelerated filer, large accelerated filer and smaller
reporting company" in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer [_] Accelerated filer [X]
Non-accelerated filer [_] Smaller reporting company [_]
Indicate by check mark whether the Registrant is a shell company (as defined in
Rule 12b-2 of the Act). Yes [_] No [X].
At June 30, 2008, the aggregate market value of the voting stock held by
non-affiliates of the Registrant was $307,090,839 based on the closing sale
price on the New York Stock Exchange on that date.
The number of shares of the Registrant's Common Stock outstanding on February
27, 2009 was 177,196,945.
Documents Incorporated by Reference
The registrant intends to file a definitive proxy statement pursuant to
Regulation 14A within 120 days of the end of the fiscal year ended December 31,
2008. Portions of such proxy statement are incorporated by reference into Part
III of this Form 10-K.
ii
CHIMERA INVESTMENT CORPORATION
--------------------------------------------------------------------------------
2008 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
PAGE
PART I
ITEM 1. BUSINESS 3
ITEM 1A. RISK FACTORS 13
ITEM 1B. UNRESOLVED STAFF COMMENTS 41
ITEM 2. PROPERTIES 41
ITEM 3. LEGAL PROCEEDINGS 41
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 41
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED
STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES 41
ITEM 6. SELECTED FINANCIAL DATA 42
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS 44
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 67
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA 71
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE 71
ITEM 9A. CONTROLS AND PROCEDURES 71
ITEM 9B. OTHER INFORMATION 72
PART III
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE 73
ITEM 11. EXECUTIVE COMPENSATION 73
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS 73
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR
INDEPENDENCE 73
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES 73
PART IV
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES 73
FINANCIAL STATEMENTS F-1
SIGNATURES S-1
EXHIBITS II-1
iii
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
We make forward-looking statements in this annual 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 investments 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 investments;
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
o market trends in our industry, interest rates, the debt securities
markets or the general economy.
1
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 this 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.
2
PART I
Item 1. Business
The Company
We are a specialty finance company that invests in residential mortgage
backed securities, or RMBS, residential mortgage loans, real estate-related
securities and various other asset classes. We elected to be taxed as a real
estate investment trust, or REIT, for federal income tax purposes commencing
with our taxable year ending on December 31, 2007. Therefore, we generally will
not be subject to federal income tax on our taxable income that is distributed
to our stockholders. We commenced operations in November 2007.
We are externally managed by Fixed Income Discount Advisory Company, which
we refer to as our Manager or FIDAC. Our Manager is an investment advisor
registered with the Securities and Exchange Commission, or SEC. Additionally,
our Manager is a wholly-owned subsidiary of Annaly Capital Management, Inc., or
Annaly, a New York Stock Exchange-listed REIT, which has a long track record of
managing investments in U.S. government agency mortgage-backed securities.
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 and
to maintain our exclusion from regulation under the Investment Company Act of
1940, or 1940 Act.
Our Manager
We are externally managed and advised by FIDAC pursuant to a management
agreement. All of our officers are employees of our Manager or one of its
affiliates. Our Manager is a fixed-income investment management company
specializing in managing investments in U.S. government agency residential
mortgage-backed securities, or Agency RMBS, which are mortgage pass-through
certificates, collateralized mortgage obligations, or CMOs, and other
mortgage-backed securities representing interests in or obligations backed by
pools of mortgage loans issued or guaranteed by the Federal National Mortgage
Association, or Fannie Mae, the Federal Home Loan Mortgage Corporation, or
Freddie Mac, and the Government National Mortgage Association, or Ginnie Mae.
Our Manager also has experience in managing investments in non-Agency RMBS and
collateralized debt obligations, or CDOs; real estate-related securities; and
managing credit and interest rate-sensitive investment strategies. Our Manager
commenced active investment management operations in 1994. At December 31, 2008
our Manager was the adviser or sub-adviser for funds with approximately $2.5
billion in net assets and $10.7 billion in gross assets, predominantly Agency
RMBS.
Our Manager is responsible for administering our business activities and
day-to-day operations. We have no employees other than our officers. Pursuant to
the terms of the management agreement, our Manager provides us with our
management team, including our officers, along with appropriate support
personnel. Our Manager is at all times subject to the supervision and oversight
of our board of directors and has only such functions and authority as we
delegate to it.
Our Manager has well-respected and established portfolio management
resources for each of our targeted asset classes and a sophisticated
infrastructure supporting those resources, including investment professionals
focusing on residential mortgage loans, Agency and non-Agency RMBS and other
asset-backed securities, or ABS. Additionally, we have benefitted and expect to
continue to benefit from our Manager's finance and administration functions,
which address legal, compliance, investor relations and operational matters,
including portfolio management, trade allocation and execution, securities
valuation, risk management and information technologies in connection with the
performance of its duties.
We do not pay any of our officers any cash compensation. Rather, we pay our
Manager a base management fee pursuant to the terms of the management agreement.
3
Our Investment Strategy
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 diversified investment portfolio of RMBS, residential mortgage loans, real
estate-related securities and various other asset classes, subject to
maintaining our REIT status and exemption from registration under the 1940 Act.
The RMBS, ABS, commercial mortgage backed securities, or CMBS, and CDOs we
purchase may include investment-grade and non-investment grade classes,
including the BB-rated, B-rated and non-rated classes.
We rely on our Manager's expertise in identifying assets within our target
asset classes. Our Manager makes investment decisions based on various factors,
including expected cash yield, relative value, risk-adjusted returns, current
and projected credit fundamentals, current and projected macroeconomic
considerations, current and projected supply and demand, credit and market risk
concentration limits, liquidity, cost of financing and financing availability,
as well as maintaining our REIT qualification and our exemption from
registration under the 1940 Act.
Over time, we will modify our investment allocation strategy as market
conditions change to seek to maximize the returns from our investment portfolio.
We believe this strategy, combined with our Manager's experience, will enable us
to pay dividends and achieve capital appreciation throughout changing interest
rate and credit cycles and provide attractive long-term returns to investors.
Our targeted asset classes and the principal investments we expect to make
in each are as follows:
Asset Class Principal Investments
----------- ---------------------
Residential Mortgage-Backed Securities 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.
Residential Mortgage Loans o Prime mortgage loans, which are
mortgage loans that conform to the
underwriting guidelines of Fannie
Mae and Freddie Mac, which we refer
to as Agency Guidelines; and jumbo
prime mortgage loans, which are
mortgage loans that conform to the
Agency Guidelines except as to loan
size.
o Alt-A mortgage loans, which are
mortgage loans that may have been
originated using documentation
standards that are less stringent
than the documentation standards
applied by certain other first lien
mortgage loan purchase programs,
such as the Agency Guidelines, but
have one or more compensating
factors such as a borrower with a
strong credit or mortgage history or
significant assets.
Other Asset-Backed Securities 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.
4
Since we commenced operations in November 2007, we have focused our
investment activities on acquiring non-Agency RMBS and on purchasing residential
mortgage loans that have been originated by select high-quality originators,
including the retail lending operations of leading commercial banks. Our
investment portfolio at December 31, 2008 was weighted toward non-Agency RMBS.
We expect that over the near term, our investment portfolio will continue to be
weighted toward RMBS, subject to maintaining our REIT qualification and our 1940
Act exemption.
In addition, we have engaged in and anticipate continuing to engage in
transactions with residential mortgage lending operations of leading commercial
banks and other high-quality originators which we identify and re-underwrite
residential mortgage loans owned by such entities, and rather than purchasing
and securitizing such residential mortgage loans ourselves, we and the
originator would structure the securitization and we would purchase the
resulting mezzanine and subordinate non-Agency RMBS. We may also engage in
similar transactions with non-Agency RMBS in which we acquire AAA-rated
non-Agency RMBS and immediately re-securitize those securities. We would sell
the resulting AAA-rated super senior RMBS and retain the AAA-rated mezzanine
RMBS. Our investment decisions, however, will depend on prevailing market
conditions and will change over time. As a result, we cannot predict the
percentage of our assets that will be invested in each asset class or whether we
will invest in other classes of investments. We may change our investment
strategy and policies without a vote of our stockholders.
We have elected to be taxed as a REIT commencing with our taxable year
ended December 31, 2007 and operate our business to be exempt from registration
under the 1940 Act, and therefore we are required to invest a substantial
majority of our assets in loans secured by mortgages on real estate and real
estate-related assets. Subject to maintaining our REIT qualification and our
1940 Act exemption, we do not have any limitations on the amounts we may invest
in any of our targeted asset classes.
Investment Portfolio
The following briefly discusses the principal types of investments that we
have made and expect to make:
Residential Mortgage-Backed Securities
We have invested in and intend to continue to invest in RMBS which are
typically pass-through certificates created by the securitization of a pool of
mortgage loans that are collateralized by residential real estate properties.
The securitization process is governed by one or more of the rating
agencies, including Fitch Ratings, Moody's Investors Service and Standard &
Poor's, which determine the respective bond class sizes, generally based on a
sequential payment structure. Bonds that are rated from AAA to BBB by the rating
agencies are considered "investment grade." Bond classes that are subordinate to
the BBB class are considered "below-investment grade" or "non-investment grade."
The respective bond class sizes are determined based on the review of the
underlying collateral by the rating agencies. The payments received from the
underlying loans are used to make the payments on the RMBS. Based on the
sequential payment priority, the risk of nonpayment for the investment grade
RMBS is lower than the risk of nonpayment for the non-investment grade bonds.
Accordingly, the investment grade class is typically sold at a lower yield
compared to the non-investment grade classes which are sold at higher yields.
We invest in investment grade and non-investment grade RMBS. We evaluate
the credit characteristics of these types of securities, including, but not
limited to, loan balance distribution, geographic concentration, property type,
occupancy, periodic and lifetime cap, weighted-average loan-to-value and
weighted-average FICO score. Qualifying securities are then analyzed using base
line expectations of expected prepayments and losses from given sectors, issuers
and the current state of the fixed-income market. Losses and prepayments are
stressed simultaneously based on a credit risk-based model. Securities in this
portfolio are monitored for variance from expected prepayments, frequencies,
severities, losses and cash flow. The due diligence process is particularly
important and costly with respect to newly formed originators or issuers because
there may be little or no information publicly available about these entities
and investments.
We may invest in net interest margin securities, or NIMs, which are notes
that are payable from and secured by excess cash flow that is generated by RMBS
or home equity line of credit-backed securities, or HELOCs, after paying the
debt service, expenses and fees on such securities. The excess cash flow
represents all or a portion of a residual that is generally retained by the
originator of the RMBS or HELOCs. The residual is illiquid, thus the originator
will monetize the position by securitizing the residual and issuing a NIM,
usually in the form of a note that is backed by the excess cash flow generated
in the underlying securitization.
5
We may invest in mortgage pass-through certificates issued or guaranteed by
Ginnie Mae, Fannie Mae or Freddie Mac. We refer to these U.S. government
agencies as Agencies, and to the mortgage pass-through certificates they issue
or guarantee as Agency Mortgage Pass-through Certificates. More specifically,
Agency Mortgage Pass-through Certificates are securities representing interests
in "pools" of mortgage loans secured by residential real property where payments
of both interest and principal, plus pre-paid principal, on the securities are
made monthly to holders of the security, in effect "passing through" monthly
payments made by the individual borrowers on the mortgage loans that underlie
the securities, net of fees paid to the issuer/guarantor and servicers of the
securities. We may also invest in CMOs issued by the Agencies. CMOs consist of
multiple classes of securities, with each class bearing different stated
maturity dates. Monthly payments of principal, including prepayments, are first
returned to investors holding the shortest maturity class; investors holding the
longer maturity classes receive principal only after the first class has been
retired. We refer to these types of securities as Agency CMOs, and we refer to
Agency Mortgage Pass-through Certificates and Agency CMOs as Agency RMBS.
Agency RMBS are collateralized by either fixed-rate mortgage loans, or
FRMs, adjustable-rate mortgage loans, or ARMs, or hybrid ARMs. Hybrid ARMs are
mortgage loans 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. Our allocation between securities
collateralized by FRMs, ARMs or hybrid ARMs will depend on various factors
including, but not limited to, relative value, expected future prepayment
trends, supply and demand, costs of financing, costs of hedging, expected future
interest rate volatility and the overall shape of the U.S. Treasury and interest
rate swap yield curves. We take these factors into account when we make these
types of investments.
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.
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 equity and preferred securities and
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.
6
We anticipate engaging in transactions with residential mortgage lending
operations of leading commercial banks and other high-quality originators in
which we identify and re-underwrite residential mortgage loans owned by such
entities, and rather than purchasing and securitizing such residential mortgage
loans ourselves, we and the originator would structure the securitization and we
would purchase the resulting mezzanine and subordinate non-Agency RMBS. We may
also engage in similar transactions with non-Agency RMBS in which we would
acquire AAA-rated non-Agency RMBS and immediately re-securitize those
securities. We would sell the resulting AAA-rated super senior RMBS and retain
the AAA-rated mezzanine RMBS.
Residential Mortgage Loans
We have invested and intend to continue to invest in residential mortgage
loans (mortgage loans secured by residential real property) primarily through
direct purchases from selected high-quality originators. We intend to enter into
additional mortgage loan purchase agreements with a number of primary mortgage
loan originators, including mortgage bankers, commercial banks, savings and loan
associations, home builders, credit unions and mortgage conduits. We may also
purchase mortgage loans on the secondary market. We expect these loans to be
secured primarily by residential properties in the United States.
We invest primarily in residential mortgage loans underwritten to our
specifications. The originators perform the credit review of the borrowers, the
appraisal of the properties securing the loan, and maintain other quality
control procedures. We generally consider the purchase of loans when the
originators have verified the borrowers' income and assets, verified their
credit history and obtained appraisals of the properties. We or a third party
perform an independent underwriting review of the processing, underwriting and
loan closing methodologies that the originators used in qualifying a borrower
for a loan. Depending on the size of the loans, we may not review all of the
loans in a pool, but rather select loans for underwriting review based upon
specific risk-based criteria such as property location, loan size, effective
loan-to-value ratio, borrower's credit score and other criteria we believe to be
important indicators of credit risk. Additionally, before the purchase of loans,
we obtain representations and warranties from each originator stating that each
loan is underwritten to our requirements or, in the event underwriting
exceptions have been made, we are informed so that we may evaluate whether to
accept or reject the loans. An originator who breaches these representations and
warranties in making a loan that we purchase may be obligated to repurchase the
loan from us. As added security, we use the services of a third-party document
custodian to insure the quality and accuracy of all individual mortgage loan
closing documents and to hold the documents in safekeeping. As a result, all of
the original loan collateral documents that are signed by the borrower, other
than the original credit verification documents, are examined, verified and held
by the third-party document custodian.
We currently do not intend to originate mortgage loans or provide other
types of financing to the owners of real estate. We currently do not intend to
establish a loan servicing platform, but expect to retain highly-rated servicers
to service our mortgage loan portfolio. We purchase certain residential mortgage
loans on a servicing-retained basis. In the future, however, we may decide to
originate mortgage loans or other types of financing, and we may elect to
service mortgage loans and other types of assets.
We expect that all servicers servicing our loans will be highly rated by
the rating agencies. We also conduct a due diligence review of each servicer
before executing a servicing agreement. Servicing procedures will typically
follow Fannie Mae guidelines but will be specified in each servicing agreement.
All servicing agreements will meet standards for inclusion in highly rated
mortgage-backed or asset-backed securitizations. We have entered into a master
servicing agreement with Wells Fargo, N.A. to assist us with management,
servicing oversight, and other administrative duties associated with managing
our mortgage loans.
We expect that the loans we acquire will be first lien, single-family
residential traditional fixed-rate, adjustable-rate and hybrid adjustable-rate
loans with original terms to maturity of not more than 40 years and are either
fully amortizing or are interest-only for up to ten years, and fully amortizing
thereafter. Fixed-rate mortgage loans bear an interest rate that is fixed for
the life of the loan. All adjustable-rate and hybrid adjustable-rate residential
mortgage loans will bear an interest rate tied to an interest rate index. Most
loans have periodic and lifetime constraints on how much the loan interest rate
can change on any predetermined interest rate reset date. The interest rate on
each adjustable-rate mortgage loan resets monthly, semi-annually or annually and
generally adjusts to a margin over a U.S. Treasury index or the LIBOR index.
Hybrid adjustable-rate loans have a fixed rate for an initial period, generally
three to ten years, and then convert to adjustable-rate loans for their
remaining term to maturity.
7
We acquire residential mortgage loans for our portfolio with the intention
of either securitizing them and retaining them in our portfolio as securitized
mortgage loans, or holding them in our residential mortgage loan portfolio. To
facilitate the securitization or financing of our loans, we expect to generally
create subordinate certificates, which provide a specified amount of credit
enhancement. We expect to issue securities through securities underwriters and
either retain these securities or finance them in the repurchase agreement
market. There is no limit on the amount we may retain of these
below-investment-grade subordinate certificates. Until we securitize our
residential mortgage loans, we expect to finance our residential mortgage loan
portfolio through the use of warehouse facilities and repurchase agreements.
Other Asset-Backed Securities
We may invest in securities issued in various CDO offerings to gain
exposure to bank loans, corporate bonds, ABS, mortgages, RMBS and CMBS and other
instruments. To avoid any actual or perceived conflicts of interest with our
Manager, an investment in any such security structured or managed by our Manager
will be approved by a majority of our independent directors. To the extent such
securities are treated as debt of the CDO issuer for federal income tax
purposes, we will hold the securities directly, subject to the requirements of
our continued qualification as a REIT. To the extent the securities represent
equity interests in a CDO issuer for federal income tax purposes, we may be
required to hold such securities through a taxable REIT subsidiary, or TRS,
which would cause the income recognized with respect to such securities to be
subject to federal (and applicable state and local) corporate income tax. See
"Risk Factors - Tax Risks." We could fail to qualify as a REIT or we could
become subject to a penalty tax if the income we recognize from certain
investments that are treated or could be treated as equity interests in a
foreign corporation exceed 5% of our gross income in a taxable year.
We may invest in CMBS, which are secured by, or evidence ownership
interests in, a single commercial mortgage loan or a pool of mortgage loans
secured by commercial properties. These securities may be senior, subordinated,
investment grade or non-investment grade. We intend to invest in CMBS that will
yield current interest income and where we consider the return of principal to
be likely. We intend to acquire CMBS from private originators of, or investors
in, mortgage loans, including savings and loan associations, mortgage bankers,
commercial banks, finance companies, investment banks and other entities.
In general, CDO issuers are special purpose vehicles that hold a portfolio
of income-producing assets financed through the issuance of rated debt
securities of different seniority and equity. The debt tranches are typically
rated based on cash flow structure, portfolio quality, diversification and
credit enhancement. The equity securities issued by the CDO vehicle are the
"first loss" piece of the CDO vehicle's capital structure, but they are also
generally entitled to all residual amounts available for payment after the CDO
vehicle's senior obligations have been satisfied. Some CDO vehicles are
"synthetic," in which the credit risk to the collateral pool is transferred to
the CDO vehicle by a credit derivative such as a credit default swap.
We also intend to invest in consumer ABS. These securities are generally
securities for which the underlying collateral consists of assets such as home
equity loans, credit card receivables and auto loans. We also expect to invest
in non-consumer ABS. These securities are generally secured by loans to
businesses and consist of assets such as equipment loans, truck loans and
agricultural equipment loans. Issuers of consumer and non-consumer ABS generally
are special purpose entities owned or sponsored by banks and finance companies,
captive finance subsidiaries of non-financial corporations or specialized
originators such as credit card lenders. We may purchase RMBS and ABS which are
denominated in foreign currencies or are collateralized by non-U.S. assets.
Investment Guidelines
We have adopted a set of investment guidelines that set out the asset
classes, risk tolerance levels, diversification requirements and other criteria
used to evaluate the merits of specific investments as well as the overall
portfolio composition. Our Manager's Investment Committee reviews our compliance
with the investment guidelines periodically and our board of directors receives
an investment report at each quarter-end in conjunction with its review of our
quarterly results. Our board also reviews our investment portfolio and related
compliance with our investment policies and procedures and investment guidelines
at each regularly scheduled board of directors meeting.
Our board of directors and our Manager's Investment Committee have adopted
the following guidelines for our investments and borrowings:
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o No investment shall be made that would cause us to fail to qualify as
a REIT for federal income tax purposes;
o No investment shall be made that would cause us to be regulated as an
investment company under the 1940 Act;
o With the exception of real estate and housing, no single industry
shall represent greater than 20% of the securities or aggregate risk
exposure in our portfolio; and
o Investments in non-rated or deeply subordinated ABS or other
securities that are non-qualifying assets for purposes of the 75% REIT
asset test will be limited to an amount not to exceed 50% of our
stockholders' equity.
These investment guidelines may be changed by a majority of our board of
directors without the approval of our stockholders.
Our board of directors has also adopted a separate set of investment
guidelines and procedures to govern our relationships with FIDAC. We have also
adopted detailed compliance policies to govern our interaction with FIDAC,
including when FIDAC is in receipt of material non-public information.
Our Financing Strategy
We use leverage to increase potential returns to our stockholders. We are
not required 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.
Subject to our maintaining our qualification as a REIT, we may use a number
of sources to finance our investments, including the following:
o Repurchase Agreements. We finance certain of our assets through the
use of repurchase agreements. We anticipate that repurchase agreements
will be one of the sources we will use to achieve our desired amount
of leverage for our residential real estate assets. We maintain formal
relationships with multiple counterparties to obtain financing on
favorable terms.
o Warehouse Facilities. We may utilize credit facilities for capital
needed to fund our assets. We intend to maintain formal relationships
with multiple counterparties to maintain warehouse lines on favorable
terms.
o Securitization. We have and may continue to acquire residential
mortgage loans for our portfolio with the intention of securitizing
them and retaining the securitized mortgage loans in our portfolio. To
facilitate the securitization or financing of our loans, we generally
create subordinate certificates, providing a specified amount of
credit enhancement, which we intend to retain in our portfolio.
o Asset-Backed Commercial Paper. We may finance certain of our assets
using asset-backed commercial paper, or ABCP, conduits, which are
bankruptcy-remote special purpose vehicles that issue commercial paper
and the proceeds of which are used to fund assets, either through
repurchase or secured lending programs. We may utilize ABCP conduits
of third parties or create our own conduit.
o Term Financing CDOs. We may finance certain of our assets using term
financing strategies, including CDOs and other match-funded financing
structures. CDOs are multiple class debt securities, or bonds, secured
by pools of assets, such as mortgage-backed securities and corporate
debt. Like typical securitization structures, in a CDO:
o the assets are pledged to a trustee for the benefit of the
holders of the bonds;
o one or more classes of the bonds are rated by one or more rating
agencies; and
o one or more classes of the bonds are marketed to a wide variety
of fixed-income investors, which enables the CDO sponsor to
achieve a relatively low cost of long-term financing.
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Unlike typical securitization structures, the underlying assets may be
sold, subject to certain limitations, without a corresponding pay-down of
the CDO, provided the proceeds are reinvested in qualifying assets. As a
result, CDOs enable the sponsor to actively manage, subject to certain
limitations, the pool of assets. We believe CDO financing structures may be
an appropriate financing vehicle for our target asset classes because they
will enable us to obtain relatively low, long-term cost of funds and
minimize the risk that we may have to refinance our liabilities before the
maturities of our investments, while giving us the flexibility to manage
credit risk and, subject to certain limitations, to take advantage of
profit opportunities.
Our Interest Rate Hedging and Risk Management Strategy
We may, from time to time, utilize derivative financial instruments to
hedge all or a portion of the interest rate risk associated with our borrowings.
Under the federal income tax laws applicable to REITs, we generally enter into
certain transactions to hedge indebtedness that we incur, or plan to incur, to
acquire or carry real estate assets, although our total gross income from such
hedges and other non-qualifying sources must not exceed 25% of our gross income.
We engage in a variety of interest rate management techniques that seek to
mitigate changes in interest rates or other potential influences on the values
of our assets. The federal income tax rules applicable to REITs require us to
implement certain of these techniques through a taxable REIT subsidiary or "TRS"
that is fully subject to corporate income taxation. Our interest rate management
techniques may include:
o puts and calls on securities or indices of securities;
o Eurodollar futures contracts and options on such contracts;
o interest rate caps, swaps and swaptions;
o U.S. treasury securities and options on U.S. treasury securities; and
o other similar transactions.
We attempt to reduce interest rate risks and to minimize exposure to
interest rate fluctuations through the use of match funded financing structures,
when appropriate, whereby we seek (i) to match the maturities of our debt
obligations with the maturities of our assets and (ii) to match the interest
rates on our investments with like-kind debt (i.e., floating rate assets are
financed with floating rate debt and fixed-rate assets are financed with
fixed-rate debt), directly or through the use of interest rate swaps, caps or
other financial instruments, or through a combination of these strategies. This
will allow us to minimize the risk that we have to refinance our liabilities
before the maturities of our assets and to reduce the impact of changing
interest rates on our earnings.
Compliance with REIT and Investment Company Requirements
We monitor our investment securities and the income from these securities
and, to the extent we enter into hedging transactions, we monitor income from
our hedging transactions as well, so as to ensure at all times that we maintain
our qualification as a REIT and our exempt status under the 1940 Act.
Employees
We are externally managed and advised by our Manager pursuant to a
management agreement as discussed below. We have no employees other than our
officers, each of whom is also an employee of our Manager or one of its
affiliates. Our Manager is not obligated to dedicate certain of its employees
exclusively to us, nor is it or its employees obligated to dedicate any specific
portion of its time to our business. Our Manager 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.
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The Management Agreement
We entered into a management agreement with our Manager with an initial
term ending December 31, 2010, with automatic, one-year renewals at the end of
each calendar year following the initial term, subject to approval by our
independent directors. Under the management agreement, our Manager implements
our business strategy and performs certain services for us, subject to oversight
by our board of directors. Our Manager is responsible for, among other things,
performing all of our day-to-day functions; determining investment criteria in
conjunction with our board of directors; sourcing, analyzing and executing
investments; asset sales and financings; and performing asset management duties.
Our independent directors review our Manager's performance annually, and
following the initial term, the management agreement may be terminated by us
without cause upon the affirmative vote of at least two-thirds of our
independent directors, or by a vote of the holders of at least a majority of the
outstanding shares of our common stock (other than shares held by Annaly or its
affiliates), based upon: (i) our Manager's unsatisfactory performance that is
materially detrimental to us, or (ii) our determination that the management fees
payable to our Manager are not fair, subject to our Manager's right to prevent
termination based on unfair fees by accepting a reduction of management fees
agreed to by at least two-thirds of our independent directors. We will provide
our Manager with 180-days' prior notice of such termination. Upon termination
without cause, we will pay our Manager a substantial termination fee. We may
also terminate the management agreement with 30 days' prior notice from our
board of directors, without payment of a termination fee, for cause or upon a
change of control of Annaly or our Manager, each as defined in the management
agreement. Our Manager may terminate the management agreement if we become
required to register as an investment company under the 1940 Act, with such
termination deemed to occur immediately before such event, in which case we
would not be required to pay a termination fee. Our Manager may also decline to
renew the management agreement by providing us with 180-days' written notice, in
which case we would not be required to pay a termination fee.
We pay our Manager a base management fee quarterly in arrears in an amount
equal to 1.50% per annum, calculated quarterly, of our stockholders' equity. For
purposes of calculating the base management fee, our stockholders' equity means
the sum of the net proceeds from any issuances of our equity securities since
inception (allocated on a pro rata daily basis for such issuances during the
fiscal quarter of any such issuance), plus our retained earnings at the end of
such quarter (without taking into account any non-cash equity compensation
expense incurred in current or prior periods), less any amount that we pay for
repurchases of our common stock, and less any unrealized gains, losses or other
items that do not affect realized net income (regardless of whether such items
are included in other comprehensive income or loss, or in net income). This
amount is adjusted to exclude one-time events pursuant to changes in generally
accepted accounting principles, or GAAP, and certain non-cash charges after
discussions between our Manager and our independent directors and approved by a
majority of our independent directors. 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. The base management fee is payable
independent of the performance of our investment portfolio.
For the year ended December 31, 2008 and the period November 21, 2007 to
December 31, 2007, our Manager earned base management fees of $8.4 million and
$1.2 million, respectively and received expense reimbursement of $0 and $698
thousand, respectively. Currently, our Manager 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 our
Manager and its affiliates required for our operations. 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.
Competition
Our net income depends, in large part, on our ability to acquire assets at
favorable spreads over our borrowing costs. In acquiring real estate-related
assets, we will compete with other mortgage REITs, specialty finance companies,
savings and loan associations, banks, mortgage bankers, insurance companies,
mutual funds, institutional investors, investment banking firms, financial
institutions, governmental bodies and other entities. In addition, there are
numerous mortgage REITs with similar asset acquisition objectives, including a
number that have been recently formed, and others that may be organized in the
future. These other REITs will increase competition for the available supply of
mortgage assets suitable for purchase. Many of our competitors are significantly
larger than we are, have access to greater capital and other resources and may
have other advantages over us. In addition, some of our competitors may have
higher risk tolerances or different risk assessments, which could allow them to
consider a wider variety of investments and establish more favorable
relationships than we can. Current market conditions may attract more
competitors, which may increase the competition for sources of financing. An
increase in the competition for sources of funding could adversely affect the
availability and cost of financing, and thereby adversely affect the market
price of our common stock.
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Distributions
To maintain our qualification as a REIT, we must distribute substantially
all of our taxable income to our stockholders for each year. We have declared
and paid regular quarterly dividends in the past and intend to do so in the
future.
Available Information
Our investor relations website is www.chimerareit.com. We make available on
the website under "Financial Information /SEC filings," free of charge, our
annual report on Form 10-K and any other reports as soon as reasonably
practicable after we electronically file or furnish such materials to the SEC.
Information on our website, however, is not part of this Annual Report on Form
10-K.
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Item 1A. Risk Factors
The risks and uncertainties described below are not the only ones facing
us. Additional risks and uncertainties that we are unaware of, or that we
currently deem immaterial, also may become important factors that affect us.
If any of the following risks occur, our business, financial condition or
results of operations could be materially and adversely affected. In that case,
the trading price of our common stock could decline, and stockholders may lose
some or all of their investment.
Risks Associated With Recent Adverse Developments in the Mortgage
Finance and Credit Markets
Difficult conditions in the financial markets and the economy generally have
caused us and may continue to cause us market value 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.
During the year ended December 31, 2008, in order to reduce our leverage to
protect our portfolio from increased market volatility, we sold assets with a
carrying value of $802.5 million in non-Agency RMBS and unsecured loans for a
loss of approximately $144.3 million and terminated $1.5 billion in notional
interest rate swaps for a loss of approximately $10.3 million, which together
resulted in a net realized loss of approximately $154.6 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.
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. During 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 (see "Certain Relationships and Related
Transactions"), and taking other steps to increase our liquidity. Additionally,
the disruptions during the year ended December 31, 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. A reduction in credit available
may reduce our earnings and, in turn, cash available to us for distribution to
stockholders.
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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, which owns approximately 8.6% of our outstanding shares
of common stock. This agreement contains customary representations, warranties
and covenants contained in such agreements including Annaly having the right to
make margin calls if the value of our RMBS collateralizing the agreement falls.
As of December 31, 2008, we had $562.1 million outstanding under this agreement
which consists of approximately 53% of our total financing. Our RMBS repurchase
agreement with Annaly is rolled daily at market rates 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. 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.
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.
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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.
Risks Associated With Our Management and Relationship With Our Manager
We are dependent on our Manager and its key personnel for our success.
We have no separate facilities and are completely reliant on our Manager.
We have no employees other than our officers. Our officers are also employees of
our Manager, which has significant discretion as to the implementation of our
investment and operating policies and strategies. Accordingly, we depend on the
diligence, skill and network of business contacts of the senior management of
our Manager. Our Manager's employees evaluate, negotiate, structure, close and
monitor our investments; therefore, our success will depend on their continued
service. The departure of any of the senior managers of our Manager could have a
material adverse effect on our performance. In addition, we can offer no
assurance that our Manager will remain our investment manager or that we will
continue to have access to our Manager's senior managers. Our management
agreement with our Manager only extends until December 31, 2010. If the
management agreement is terminated and no suitable replacement is found to
manage us, we may not be able to execute our business plan. Moreover, our
Manager is not obligated to dedicate certain of its employees exclusively to us
nor is it obligated to dedicate any specific portion of its time to our
business, and none of our Manager's employees are contractually dedicated to us
under our management agreement with our Manager. The only employees of our
Manager who are primarily dedicated to our operations are Christian J.
Woschenko, our Head of Investments, and William B. Dyer, our Head of
Underwriting.
There are conflicts of interest in our relationship with our Manager and Annaly,
which could result in decisions that are not in the best interests of our
stockholders.
We are subject to conflicts of interest arising out of our relationship
with Annaly and our Manager. An Annaly executive officer is our Manager's sole
director, two of Annaly's employees are our directors and several of Annaly's
employees are officers of our Manager and us. Specifically, each of our officers
also serves as an employee of our Manager or its affiliates. As a result, our
Manager and our officers may have conflicts between their duties to us and their
duties to, and interests in, Annaly or our Manager. There may also be conflicts
in allocating investments which are suitable both for us and Annaly as well as
other FIDAC managed funds. Annaly may compete with us with respect to certain
investments which we may want to acquire, and as a result we may either not be
presented with the opportunity or have to compete with Annaly to acquire these
investments. Our Manager and our officers may choose to allocate favorable
investments to Annaly instead of to us. The ability of our Manager and its
officers and employees to engage in other business activities may reduce the
time our Manager spends managing us. Further, during turbulent conditions in the
mortgage industry, distress in the credit markets or other times when we will
need focused support and assistance from our Manager, other entities for which
our Manager also acts as an investment manager will likewise require greater
focus and attention, placing our Manager's resources in high demand. In such
situations, we may not receive the necessary support and assistance we require
or would otherwise receive if we were internally managed or if our Manager did
not act as a manager for other entities. There is no assurance that the
allocation policy that addresses some of the conflicts relating to our
investments, which is described under "Business-Conflicts of Interest," will be
adequate to address all of the conflicts that may arise. In addition, we have
entered into a repurchase agreement with Annaly, our Manager's parent, to
finance our RMBS. This financing arrangement may make us less likely to
terminate our Manager, It could also give rise to further conflicts because
Annaly may be a creditor of ours. As one of our creditors, Annaly's interests
may diverge from the interests of our stockholders.
15
We pay our Manager substantial management fees regardless of the
performance of our portfolio. Our Manager's entitlement to substantial
nonperformance-based compensation might reduce its incentive to devote its time
and effort to seeking investments that provide attractive risk-adjusted returns
for our portfolio. This in turn could hurt both our ability to make
distributions to our stockholders and the market price of our common stock.
Annaly owns approximately 8.6% of our outstanding shares of common stock which
entitles them to receive quarterly distributions. In evaluating investments and
other management strategies, this may lead our Manager to place emphasis on the
maximization of revenues at the expense of other criteria, such as preservation
of capital. Investments with higher yield potential are generally riskier or
more speculative. This could result in increased risk to the value of our
invested portfolio. Annaly may sell the shares in us purchased concurrently with
our initial public offering at any time after the earlier of (i) November 15,
2010 or (ii) the termination of the management agreement. Annaly may sell the
shares in us purchased immediately after our 2008 secondary offering at any time
after the earlier of (i) October 24, 2011 or (ii) the termination of the
management agreement. To the extent Annaly sells some of its shares, its
interests may be less aligned with our interests.
The management agreement with our Manager was not negotiated on an arm's-length
basis and may not be as favorable to us as if it had been negotiated with an
unaffiliated third party and may be costly and difficult to terminate.
Our president, chief financial officer, head of investments, treasurer,
controller, secretary and head of underwriting also serve as employees of our
Manager. In addition, certain of our directors are employees of our Manager or
its affiliates. Our management agreement with our Manager was negotiated between
related parties, and its terms, including fees payable, may not be as favorable
to us as if it had been negotiated with an unaffiliated third party. Termination
of the management agreement with our Manager without cause is difficult and
costly. Our independent directors will review our Manager's performance and the
management fees annually, and following the initial term, the management
agreement may be terminated annually by us without cause upon the affirmative
vote of at least two-thirds of our independent directors, or by a vote of the
holders of at least a majority of the outstanding shares of our common stock
(other than those shares held by Annaly or its affiliates), based upon: (i) our
Manager's unsatisfactory performance that is materially detrimental to us, or
(ii) a determination that the management fees payable to our Manager are not
fair, subject to our Manager's right to prevent termination based on unfair fees
by accepting a reduction of management fees agreed to by at least two-thirds of
our independent directors. Our Manager must be provided 180-days' prior notice
of any such termination. Additionally, upon such termination, the management
agreement provides that we will pay our Manager a termination fee equal to three
times the average annual base management fee calculated as of the end of the
most recently completed fiscal quarter. These provisions may adversely affect
our ability to terminate our Manager without cause. Our Manager is only
contractually committed to serve us until December 31, 2010. Thereafter, the
management agreement is renewable on an annual basis, however, our Manager may
terminate the management agreement annually upon 180-days' prior notice. If the
management agreement is terminated and no suitable replacement is found to
manage us, we may not be able to execute our business plan.
Our board of directors approved very broad investment guidelines for our Manager
and will not approve each investment decision made by our Manager.
Our Manager is authorized to follow very broad investment guidelines. Our
board of directors periodically reviews our investment guidelines and our
investment portfolio, but does not, and is not required to review all of our
proposed investments or any type or category of investment, except that an
investment in a security structured or managed by our Manager must be approved
by a majority of our independent directors. In addition, in conducting periodic
reviews, our board of directors relies primarily on information provided to them
by our Manager. Furthermore, our Manager uses complex strategies, and
transactions entered into by our Manager may be difficult or impossible to
unwind by the time they are reviewed by our board of directors. Our Manager has
great latitude within the broad investment guidelines in determining the types
of assets it may decide are proper investments for us, which could result in
investment returns that are substantially below expectations or that result in
losses, which would materially and adversely affect our business operations and
results. Further, decisions made and investments entered into by our Manager may
not be in the best interests of our stockholders.
We may change our investment strategy, asset allocation, or financing plans
without stockholder consent, which may result in riskier investments.
We may change our investment strategy, asset allocation, or financing plans
at any time without the consent of our stockholders, which could result in our
making investments that are different from, and possibly riskier than, the
investments described in this Form 10-K. A change in our investment strategy or
financing plans may increase our exposure to interest rate and default risk and
real estate market fluctuations. Furthermore, a change in our asset allocation
could result in our making investments in asset categories different from those
described in this Form 10-K. These changes could adversely affect the market
price of our common stock and our ability to make distributions to our
stockholders.
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While investments in investment vehicles managed by our Manager require
approval by a majority of our independent directors, our Manager has an
incentive to invest our funds in investment vehicles managed by our Manager
because of the possibility of generating an additional incremental management
fee, which may reduce other investment opportunities available to us. In
addition, we cannot assure you that investments in investment vehicles managed
by our Manager will prove beneficial to us.
We may invest in CDOs managed by our Manager, including the purchase or sale of
all or a portion of the equity of such CDOs, which may result in an immediate
loss in book value and present a conflict of interest between us and our
Manager.
We may invest in securities of CDOs managed by our Manager. If all of the
securities of a CDO managed by our Manager were not fully placed as a result of
our not investing, our Manager could experience losses due to changes in the
value of the underlying investments accumulated in anticipation of the launch of
such investment vehicle. The accumulated investments in a CDO transaction are
generally sold at the price at which they were purchased and not the prevailing
market price at closing. Accordingly, to the extent we invest in a portion of
the equity securities for which there has been a deterioration of value since
the securities were purchased, we would experience an immediate loss equal to
the decrease in the market value of the underlying investment. As a result, the
interests of our Manager in our investing in such a CDO may conflict with our
interests and that of our stockholders.
Our investment focus is different from those of other entities that are or have
been managed by our Manager.
Our investment focus is different from those of other entities that are or
have been managed by our Manager. In particular, entities managed by our Manager
have not purchased whole mortgage loans or structured whole loan
securitizations. In addition, our Manager has limited experience in managing
CDOs and investing in CDOs, non-Agency RMBS, CMBS and other ABS which we may
pursue as part of our investment strategy. Accordingly, our Manager's historical
returns are not indicative of its performance for our investment strategy and we
can offer no assurance that our Manager will replicate the historical
performance of the Manager's investment professionals in their previous
endeavors. Our investment returns could be substantially lower than the returns
achieved by our Manager's investment professionals' previous endeavors.
We compete with investment vehicles of our Manager for access to our Manager's
resources and investment opportunities.
Our Manager provides investment and financial advice to a number of
investment vehicles and some of our Manager's personnel are also employees of
Annaly and in that capacity are involved in Annaly's investment process.
Accordingly, we will compete with our Manager's other investment vehicles and
with Annaly for our Manager's resources. Our Manager may sponsor and manage
other investment vehicles with an investment focus that overlaps with ours,
which could result in us competing for access to the benefits that we expect our
relationship with our Manager will provide to us.
Risks Related To Our Business
We have a limited operating history and may not continue to operate successfully
or generate sufficient revenue to make or sustain distributions to our
stockholders.
We were organized in June 2007, commenced operations in November 2007, and
have a limited operating history. We cannot assure you that we will be able to
operate our business successfully or implement our operating policies and
strategies described in this Form 10-K. The results of our operations depend on
many factors, including the availability of opportunities for the acquisition of
assets, the valuation of our assets, the level and volatility of interest rates,
readily accessible short and long-term financing and the terms of the financing,
conditions in the financial markets and economic conditions.
17
Failure to procure adequate capital and funding on favorable terms, or at all,
would adversely affect our results and may, in turn, negatively affect the
market price of shares of our common stock and our ability to distribute
dividends to our stockholders.
The capital and credit markets have been experiencing extreme volatility
and disruption for more than a year. The volatility and disruption have reached
unprecedented levels. In some cases, the markets have exerted downward pressure
on stock prices and credit capacity for certain lenders. We depend upon the
availability of adequate funding and capital for our operations. We intend to
finance our assets over the long-term through a variety of means, including
repurchase agreements, credit facilities, securitizations, commercial paper and
CDOs. Our access to capital depends upon a number of factors over which we have
little or no control, including:
o general market conditions;
o the market's perception of our growth potential;
o our current and potential future earnings and cash distributions;
o the market price of the shares of our capital stock; and
o the market's view of the quality of our assets.
The current situation in the mortgage sector and the current weakness in
the broader credit markets could adversely affect one or more of our potential
lenders and could cause one or more of our lenders or potential lenders to be
unwilling or unable to provide us with financing. In general, this could
potentially increase our financing costs and reduce our liquidity or require us
to sell assets at an inopportune time or price.
We have and 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.
Currently, warehouse facilities to finance whole loan prime residential
mortgages are generally available from major banks, but at significantly higher
cost and 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.
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 earlier this year. 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 asset-backed commercial paper, or ABCP, have been unable
to place (or roll) their securities, which has resulted, in some instances, in
forced sales of mortgage-backed securities, or 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.
In addition, the impairment of other financial institutions could
negatively affect us. If one or more major market participants fails or
otherwise experience 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 adversely affect 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 any 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.
18
Our business, results of operations and financial condition may be
materially adversely affected by recent disruptions in the financial markets. We
cannot assure you, under such extreme conditions, that these markets will remain
an efficient source of long-term financing for our assets. If our strategy is
not viable, we will have to find alternative forms of financing for our assets,
which may not be available. Further, as a REIT, we are required to distribute
annually at least 90% of our REIT taxable income, determined without regard to
the deduction for dividends paid and excluding net capital gain, to our
stockholders and are therefore not able to retain significant amounts of our
earnings for new investments. We cannot assure you that any, or sufficient,
funding or capital will be available to us in the future on terms that are
acceptable to us. If we cannot obtain sufficient funding on acceptable terms,
there may be a negative impact on the market price of our common stock and our
ability to make distributions to our stockholders. Moreover, our ability to grow
will be dependent on our ability to procure additional funding. To the extent we
are not able to raise additional funds through the issuance of additional equity
or borrowings, our growth will be constrained.
We operate in a highly competitive market for investment opportunities and more
established competitors may be able to compete more effectively for investment
opportunities than we can.
A number of entities compete with us to make the types of investments that
we plan to make. We compete with other REITs, public and private funds,
commercial and investment banks and commercial finance companies. Many of our
competitors are substantially larger and have considerably greater financial,
technical and marketing resources than we do. Several other REITs have recently
raised, or are expected to raise, significant amounts of capital, and may have
investment objectives that overlap with ours, which may create competition for
investment opportunities. Some competitors may have a lower cost of funds and
access to funding sources that are not available to us. In addition, some of our
competitors may have higher risk tolerances or different risk assessments, which
could allow them to consider a wider variety of investments and establish more
favorable relationships than us. We cannot assure you that the competitive
pressures we face will not have a material adverse effect on our business,
financial condition and results of operations. Also, as a result of this
competition, we may not be able to take advantage of attractive investment
opportunities from time to time, and we can offer no assurance that we will be
able to identify and make investments that are consistent with our investment
objectives.
Loss of our 1940 Act exemption would adversely affect us and negatively affect
the market price of shares of our common stock and our ability to distribute
dividends and could result in the termination of the management agreement with
our Manager.
We operate our company so that we will not be required to register as an
investment company under the 1940 Act because we are "primarily engaged in the
business of purchasing or otherwise acquiring mortgages and other liens on and
interests in real estate." Specifically, our investment strategy is to invest at
least 55% of our assets in mortgage loans, RMBS that represent the entire
ownership in a pool of mortgage loans and other qualifying interests in real
estate and approximately 25% of our assets in other types of mortgages, RMBS,
securities of REITs and other real estate-related assets. As a result of the
1940 Act, we are limited in our ability to make certain investments. In the
absence of specific guidance on the subject from the Division of Investment
Management of the SEC, we have determined that accounting principles generally
accepted in the United States, or GAAP, is an appropriate method to value our
qualifying real estate assets under the 1940 Act. Accordingly, as long as we own
all of the equity of an owner trust and the underlying mortgage loans and whole
pools held by an owner trust remain our assets under GAAP, we classify each of
the whole mortgage loans and all of the whole pools held by such owner trusts as
qualifying real estate assets under the 1940 Act.
If we fail to qualify for this exemption in the future, we could be
required to restructure our activities in a manner that or at a time when we
would not otherwise choose to do so, which could negatively affect the value of
shares of our capital stock, the sustainability of our business model, and our
ability to make distributions. For example, if the market value of our
investments in securities were to increase by an amount that resulted in less
than 55% of our assets being invested in mortgage loans or RMBS that represent
the entire ownership in a pool of mortgage loans or less than 80% of our assets
being invested in real estate-related assets, we might have to sell securities
to qualify for exemption under the 1940 Act. The sale could occur during adverse
market conditions, and we could be forced to accept a price below that which we
believe is acceptable. In addition, there can be no assurance that the laws and
regulations governing REITs, including regulations issued by the Division of
Investment Management of the SEC, providing more specific or different guidance
regarding the treatment of assets as qualifying real estate assets or real
estate-related assets, will not change in a manner that adversely affects our
operations. A loss of our 1940 Act exemption would allow our Manager to
terminate the management agreement with us, which would materially adversely
affect our business and operations.
19
Rapid changes in the values of our RMBS, residential mortgage loans, and other
real estate-related investments may make it more difficult for us to maintain
our qualification as a REIT or our exemption from the 1940 Act.
If the market value or income potential of our RMBS, residential mortgage
loans, and other real estate-related investments declines as a result of
increased interest rates, prepayment rates or other factors, we may need to
increase our real estate investments and income or liquidate our non-qualifying
assets to maintain our REIT qualification or our exemption from the 1940 Act. If
the decline in real estate asset values or income occurs quickly, this may be
especially difficult to accomplish. This difficulty may be exacerbated by the
illiquid nature of any non-real estate assets we may own. We may have to make
investment decisions that we otherwise would not make absent the REIT and 1940
Act considerations.
We leverage our investments, which may adversely affect our return on our
investments and may reduce cash available for distribution to our stockholders.
We leverage our investments through borrowings, generally through the use
of repurchase agreements, warehouse facilities, credit facilities,
securitizations, commercial paper and CDOs. We are not required to maintain any
specific debt-to-equity ratio. The amount of leverage we use varies depending on
our ability to obtain credit facilities, the lenders' and rating agencies'
estimates of the stability of the investments' cash flow, and our assessment of
the appropriate amount of leverage for the particular assets we are funding.
Under some credit facilities, we expect to be required to maintain minimum
average cash balances in connection with borrowings. Our return on our
investments and cash available for distribution to our stockholders may be
reduced to the extent that changes in market conditions prevent us from
leveraging our investments, require us to decrease our rate of leverage,
increase the amount of collateral we post, or increase the cost of our financing
relative to the income that can be derived from the assets acquired. Our debt
service payments will reduce cash flow available for distributions to
stockholders, which could adversely affect the price of our common stock. We may
not be able to meet our debt service obligations, and, to the extent that we
cannot, we risk the loss of some or all of our assets to foreclosure or sale to
satisfy the obligations. We leverage certain of our assets through repurchase
agreements. A decrease in the value of these assets may lead to margin calls
which we will have to satisfy. We may not have the funds available to satisfy
any such margin calls and we may be forced to sell assets at significantly
depressed prices due to market conditions or otherwise. The satisfaction of such
margin calls may reduce cash flow available for distribution to our
stockholders. Any reduction in distributions to our stockholders or sales of
assets at inopportune times or prices may cause the value of our common stock to
decline, in some cases, precipitously.
We depend on warehouse and repurchase facilities, credit facilities and
commercial paper to execute our business plan, and our inability to access
funding could have a material adverse effect on our results of operations,
financial condition and business.
Our ability to fund our investments depends to a large extent upon our
ability to secure warehouse, repurchase, credit, and commercial paper financing
on acceptable terms. We can provide no assurance that we will be successful in
establishing sufficient warehouse, repurchase, and credit facilities and issuing
commercial paper. In addition, because warehouse, repurchase, and credit
facilities and commercial paper are short-term commitments of capital, the
lenders may respond to market conditions, which may favor an alternative
investment strategy for them, making it more difficult for us to secure
continued financing. During certain periods of the credit cycle, such as
recently, lenders may curtail their willingness to provide financing. If we are
not able to renew our then existing warehouse, repurchase, and credit facilities
and issue commercial paper or arrange for new financing on terms acceptable to
us, or if we default on our covenants or are otherwise unable to access funds
under any of these facilities, we will have to curtail our asset acquisition
activities.
20
It is possible that the lenders that provide us with financing could
experience changes in their ability to advance funds to us, independent of our
performance or the performance of our investments, including our mortgage loans.
In addition, if the regulatory capital requirements imposed on our lenders
change, they may be required to significantly increase the cost of the warehouse
facilities that they provide to us. Our lenders also may revise their
eligibility requirements for the types of residential mortgage loans they are
willing to finance or the terms of such financings, based on, among other
factors, the regulatory environment and their management of perceived risk,
particularly with respect to assignee liability. Financing of equity-based
lending, for example, may become more difficult in the future. Moreover, the
amount of financing we will receive under our warehouse and repurchase
facilities will be directly related to the lenders' valuation of the assets that
secure the outstanding borrowings. Typically warehouse, repurchase, and credit
facilities grant the respective lender the absolute right to reevaluate the
market value of the assets that secure outstanding borrowings at any time. If a
lender determines in its sole discretion that the value of the assets has
decreased, it has the right to initiate a margin call. A margin call would
require us to transfer additional assets to such lender without any advance of
funds from the lender for such transfer or to repay a portion of the outstanding
borrowings. Any such margin call could have a material adverse effect on our
results of operations, financial condition, business, liquidity and ability to
make distributions to our stockholders, and could cause the value of our common
stock to decline. We may be forced to sell assets at significantly depressed
prices to meet such margin calls and to maintain adequate liquidity, which could
cause us to incur losses. Moreover, to the extent we are forced to sell assets
at such time, given market conditions, we may be forced to sell assets at the
same time as others facing similar pressures to sell similar assets, which could
greatly exacerbate a difficult market environment and which could result in our
incurring significantly greater losses on our sale of such assets. In an extreme
case of market duress, a market may not even be present for certain of our
assets at any price.
The current dislocation and weakness in the broader mortgage markets could
adversely affect one or more of our potential lenders and could cause one or
more of our potential lenders to be unwilling or unable to provide us with
financing. This could potentially increase our financing costs and reduce our
liquidity. 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, including
Agency and non-Agency RMBS, residential mortgage loans and real estate related
securities, and this could negatively impact the value of the securities we
acquire, thus reducing our net book value. Furthermore, if any of our potential
lenders or any of our lenders, including Annaly, are unwilling or unable to
provide us with financing, we could be forced to sell our assets at an
inopportune time when prices are depressed.
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. Recently, the government passed the Housing and
Economic Recovery Act of 2008. Fannie Mae and Freddie Mac have 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
Certain financing facilities may contain covenants that restrict our operations
and may inhibit our ability to grow our business and increase revenues.
Certain financing facilities we may enter into may contain extensive
restrictions, covenants, and representations and warranties that, among other
things, require us to satisfy specified financial, asset quality, loan
eligibility and loan performance tests. If we fail to meet or satisfy any of
these covenants or representations and warranties, we would be in default under
these agreements and our lenders could elect to declare all amounts outstanding
under the agreements to be immediately due and payable, enforce their respective
interests against collateral pledged under such agreements and restrict our
ability to make additional borrowings. Certain financing agreements may contain
cross-default provisions, so that if a default occurs under any one agreement,
the lenders under our other agreements could also declare a default. The
covenants and restrictions we expect in our financing facilities may restrict
our ability to, among other things:
o incur or guarantee additional debt;
o make certain investments or acquisitions;
o make distributions on or repurchase or redeem capital stock;
o engage in mergers or consolidations;
o finance mortgage loans with certain attributes;
o reduce liquidity below certain levels;
o grant liens;
o incur operating losses for more than a specified period;
o enter into transactions with affiliates; and
o hold mortgage loans for longer than established time periods.
These restrictions may interfere with our ability to obtain financing,
including the financing needed to qualify as a REIT, or to engage in other
business activities, which may significantly harm our business, financial
condition, liquidity and results of operations. A default and resulting
repayment acceleration could significantly reduce our liquidity, which could
require us to sell our assets to repay amounts due and outstanding. This could
also significantly harm our business, financial condition, results of
operations, and our ability to make distributions, which could cause the value
of our common stock to decline. A default will also significantly limit our
financing alternatives such that we will be unable to pursue our leverage
strategy, which could curtail our investment returns.
The repurchase agreements, warehouse facilities and credit facilities and
commercial paper that we use to finance our investments may require us to
provide additional collateral and may restrict us from leveraging our assets as
fully as desired.
We will use repurchase agreements, warehouse facilities, credit facilities
and commercial paper to finance our investments. We currently have uncommitted
repurchase agreements with 13 counterparties, including Annaly, for financing
our RMBS. Our repurchase agreements are uncommitted and the counterparty may
refuse to advance funds under the agreements to us. If the market value of the
loans or securities pledged or sold by us to a funding source decline in value,
we may be required by the lending institution to provide additional collateral
or pay down a portion of the funds advanced, but we may not have the funds
available to do so. Posting additional collateral will reduce our liquidity and
limit our ability to leverage our assets, which could adversely affect our
business. In the event we do not have sufficient liquidity to meet such
requirements, lending institutions can accelerate repayment of our indebtedness,
increase our borrowing rates, liquidate our collateral or terminate our ability
to borrow. Such a situation would likely result in a rapid deterioration of our
financial condition and possibly necessitate a filing for protection under the
U.S. Bankruptcy Code. Further, financial institutions may require us to maintain
a certain amount of cash that is not invested or to set aside non-levered assets
sufficient to maintain a specified liquidity position which would allow us to
satisfy our collateral obligations. As a result, we may not be able to leverage
our assets as fully as we would choose which could reduce our return on equity.
If we are unable to meet these collateral obligations, then, as described above,
our financial condition could deteriorate rapidly.
22
If the counterparty to our repurchase transactions defaults on its obligation to
resell the underlying security back to us at the end of the transaction term, or
if the value of the underlying security has declined as of the end of that term
or if we default on our obligations under the repurchase agreement, we will lose
money on our repurchase transactions.
When we engage in a repurchase transaction, we generally sell securities to
the transaction counterparty and receive cash from the counterparty. The
counterparty is obligated to resell the securities back to us at the end of the
term of the transaction, which is typically 30-90 days. Because the cash we
receive from the counterparty when we initially sell the securities to the
counterparty is less than the value of those securities (this difference is
referred to as the haircut), if the counterparty defaults on its obligation to
resell the securities back to us we would incur a loss on the transaction equal
to the amount of the haircut (assuming there was no change in the value of the
securities). We would also lose money on a repurchase transaction if the value
of the underlying securities has declined as of the end of the transaction term,
as we would have to repurchase the securities for their initial value but would
receive securities worth less than that amount. Any losses we incur on our
repurchase transactions could adversely affect our earnings, and thus our cash
available for distribution to our stockholders. If we default on one of our
obligations under a repurchase transaction, the counterparty can terminate the
transaction and cease entering into any other repurchase transactions with us.
In that case, we would likely need to establish a replacement repurchase
facility with another repurchase dealer in order to continue to leverage our
portfolio and carry out our investment strategy. There is no assurance we would
be able to establish a suitable replacement facility.
Our rights under our repurchase agreements are subject to the effects of the
bankruptcy laws in the event of the bankruptcy or insolvency of us or our
lenders under the repurchase agreements.
In the event of our insolvency or bankruptcy, certain repurchase agreements
may qualify for special treatment under the U.S. Bankruptcy Code, the effect of
which, among other things, would be to allow the lender under the applicable
repurchase agreement to avoid the automatic stay provisions of the U.S.
Bankruptcy Code and to foreclose on the collateral agreement without delay. In
the event of the insolvency or bankruptcy of a lender during the term of a
repurchase agreement, the lender may be permitted, under applicable insolvency
laws, to repudiate the contract, and our claim against the lender for damages
may be treated simply as an unsecured creditor. In addition, if the lender is a
broker or dealer subject to the Securities Investor Protection Act of 1970, or
an insured depository institution subject to the Federal Deposit Insurance Act,
our ability to exercise our rights to recover our securities under a repurchase
agreement or to be compensated for any damages resulting from the lender's
insolvency may be further limited by those statutes. These claims would be
subject to significant delay and, if and when received, may be substantially
less than the damages we actually incur.
An increase in our borrowing costs relative to the interest we receive on our
assets may adversely affect our profitability, and thus our cash available for
distribution to our stockholders.
As our repurchase agreements and other short-term borrowings mature, we
will be required either to enter into new borrowings or to sell certain of our
investments. An increase in short-term interest rates at the time that we seek
to enter into new borrowings would reduce the spread between our returns on our
assets and the cost of our borrowings. This would adversely affect our returns
on our assets that are subject to prepayment risk, including our mortgage-backed
securities, which might reduce earnings and, in turn, cash available for
distribution to our stockholders.
If we issue senior securities we will be exposed to additional risks.
If we decide to issue senior securities in the future, it is likely that
they will be governed by an indenture or other instrument containing covenants
restricting our operating flexibility. Additionally, any convertible or
exchangeable securities that we issue in the future may have rights, preferences
and privileges more favorable than those of our common stock and may result in
dilution to owners of our common stock. We and, indirectly, our stockholders,
will bear the cost of issuing and servicing such securities.
Our securitizations will expose us to additional risks.
We have and expect to continue to securitize certain of our portfolio
investments to generate cash for funding new investments. We expect to structure
these transactions either as financing transactions or as sales for GAAP
pursuant to Statement of Financial Accounting Standards (SFAS) No. 140,
Accounting for Transfers and Servicing of Financial Assets and Extinguishments
of Liabilities. In each such transaction, we convey a pool of assets to a
special purpose vehicle, the issuing entity, and the issuing entity issues one
or more classes of non-recourse notes pursuant to the terms of an indenture. The
notes are secured by the pool of assets. In exchange for the transfer of assets
to the issuing entity, we receive the cash proceeds of the sale of non-recourse
notes and a 100% interest in the equity of the issuing entity. The
securitization of our portfolio investments might magnify our exposure to losses
on those portfolio investments because any equity interest we retain in the
issuing entity would be subordinate to the notes issued to investors and we
would, therefore, absorb all of the losses sustained with respect to a
securitized pool of assets before the owners of the notes experience any losses.
Moreover, we cannot be assured that we will be able to access the securitization
market, or be able to do so at favorable rates. The inability to securitize our
portfolio could hurt our performance and our ability to grow our business.
23
The use of CDO financings with over-collateralization requirements may have a
negative impact on our cash flow.
We expect that the terms of CDOs we may sponsor will generally provide that
the principal amount of assets must exceed the principal balance of the related
bonds by a certain amount, commonly referred to as "over-collateralization." We
anticipate that the CDO terms will provide that, if certain delinquencies or
losses exceed the specified levels based on the analysis by the rating agencies
(or any financial guaranty insurer) of the characteristics of the assets
collateralizing the bonds, the required level of over-collateralization may be
increased or may be prevented from decreasing as would otherwise be permitted if
losses or delinquencies did not exceed those levels. Other tests (based on
delinquency levels or other criteria) may restrict our ability to receive net
income from assets collateralizing the obligations. We cannot assure you that
the performance tests will be satisfied. In advance of completing negotiations
with the rating agencies or other key transaction parties on our future CDO
financings, we cannot assure you of the actual terms of the CDO delinquency
tests, over-collateralization terms, cash flow release mechanisms or other
significant factors regarding the calculation of net income to us. Given recent
volatility in the CDO market, rating agencies may depart from historic practices
for CDO financings, making them more costly for us. Failure to obtain favorable
terms with regard to these matters may materially and adversely affect the
availability of net income to us. If our assets fail to perform as anticipated,
our over-collateralization or other credit enhancement expense associated with
our CDO financings will increase.
Hedging against interest rate exposure may adversely affect our earnings, which
could reduce our cash available for distribution to our stockholders.
Subject to maintaining our qualification as a REIT, we pursue various
hedging strategies to seek to reduce our exposure to losses from adverse changes
in interest rates. Our hedging activity varies in scope based on the level and
volatility of interest rates, the type of assets held and other changing market
conditions. Interest rate hedging may fail to protect or could adversely affect
us because, among other things:
o interest rate hedging can be expensive, particularly during periods of
rising and volatile interest rates;
o available interest rate hedges may not correspond directly with the
interest rate risk for which protection is sought;
o the duration of the hedge may not match the duration of the related
liability;
o the amount of income that a REIT may earn from hedging transactions
(other than through TRSs) to offset interest rate losses is limited by
federal tax provisions governing REITs;
o the credit quality of the party owing money on the hedge may be
downgraded to such an extent that it impairs our ability to sell or
assign our side of the hedging transaction; and
o the party owing money in the hedging transaction may default on its
obligation to pay.
Our hedging transactions, which are intended to limit losses, may actually
limit gains and increase our exposure to losses. As a result, our hedging
activity may adversely affect our earnings, which could reduce our cash
available for distribution to our stockholders. In addition, hedging instruments
involve risk since they often are not traded on regulated exchanges, guaranteed
by an exchange or its clearing house, or regulated by any U.S. or foreign
governmental authorities. Consequently, there are no requirements with respect
to record keeping, financial responsibility or segregation of customer funds and
positions. Furthermore, the enforceability of agreements underlying derivative
transactions may depend on compliance with applicable statutory and commodity
and other regulatory requirements and, depending on the identity of the
counterparty, applicable international requirements. The business failure of a
hedging counterparty with whom we enter into a hedging transaction will most
likely result in its default. Default by a party with whom we enter into a
hedging transaction may result in the loss of unrealized profits and force us to
cover our commitments, if any, at the then current market price. Although
generally we will seek to reserve the right to terminate our hedging positions,
it may not always be possible to dispose of or close out a hedging position
without the consent of the hedging counterparty, and we may not be able to enter
into an offsetting contract in order to cover our risk. We cannot assure you
that a liquid secondary market will exist for hedging instruments purchased or
sold, and we may be required to maintain a position until exercise or
expiration, which could result in losses.
Our hedging strategies may not be successful in mitigating the risks associated
with interest rates.
Subject to complying with REIT tax requirements, we have employed and intend to
continue to employ techniques that limit, or hedge, the adverse effects of
rising interest rates on our short-term repurchase agreements. In general, our
hedging strategy depends on our view of our entire portfolio, consisting of
assets, liabilities and derivative instruments, in light of prevailing market
conditions. We could misjudge the condition of our investment portfolio or the
market.
24
Our hedging activity will vary in scope based on the level and volatility
of interest rates and principal repayments, the type of securities held and
other changing market conditions. Our actual hedging decisions will be
determined in light of the facts and circumstances existing at the time and may
differ from our currently anticipated hedging strategy. These techniques may
include entering into interest rate caps, collars, floors, forward contracts,
futures or swap agreements. We may conduct certain hedging transactions through
a TRS, which will be subject to federal, state and, if applicable, local income
tax.
There are no perfect hedging strategies, and interest rate hedging may fail
to protect us from loss. Alternatively, we may fail to properly assess a risk to
our investment portfolio or may fail to recognize a risk entirely, leaving us
exposed to losses without the benefit of any offsetting hedging activities. The
derivative financial instruments we select may not have the effect of reducing
our interest rate risk. The nature and timing of hedging transactions may
influence the effectiveness of these strategies. Poorly designed strategies or
improperly executed transactions could actually increase our risk and losses. In
addition, hedging activities could result in losses if the event against which
we hedge does not occur. For example, interest rate hedging could fail to
protect us or adversely affect us because, among other things:
o available interest rate hedging may not correspond directly with the
interest rate risk for which protection is sought;
o the duration of the hedge may not match the duration of the related
liability;
o as explained in further detail in the risk factor immediately below,
the party owing money in the hedging transaction may default on its
obligation to pay;
o the credit quality of the party owing money on the hedge may be
downgraded to such an extent that it impairs our ability to sell or
assign our side of the hedging transaction; and
o the value of derivatives used for hedging may be adjusted from time to
time in accordance with accounting rules to reflect changes in fair
value. Downward adjustments, or "mark-to-market losses," would reduce
our stockholders' equity.
Whether the derivatives we acquire achieve hedge accounting treatment under
the Financial Accounting Standards Board, or FASB, Statement of Financial
Accounting Standards No. 133, Accounting for Derivative Instruments and Hedging
Activities, or SFAS 133, or not, hedging generally involves costs and risks. Our
hedging strategies may adversely affect us because hedging activities involve
costs that we will incur regardless of the effectiveness of the hedging
activity. Those costs may be higher in periods of market volatility, both
because the counterparties to our derivative agreements may demand a higher
payment for taking risks, and because repeated adjustments of our hedges during
periods of interest rate changes also may increase costs. Especially if our
hedging strategies are not effective, we could incur significant hedging-related
costs without any corresponding economic benefits.
We have elected not to qualify for hedge accounting treatment.
We record derivative and hedge transactions in accordance with SFAS 133. 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.
Declines in the fair 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 will be directly charged or credited to other comprehensive income.
In addition, a decline in values will reduce the book value of our assets. A
decline in the fair value of our assets may adversely affect us, particularly in
instances where we have borrowed money based on the fair value of those assets.
If the fair value of those assets declines, the lender may require us to post
additional collateral to support the loan. If we were unable to post the
additional collateral, we would have to sell the assets at a time when we might
not otherwise choose to do so. A reduction in credit available may reduce our
earnings and, in turn, cash available for distribution to stockholders.
25
The lack of liquidity in our investments may adversely affect our business.
We may invest in securities or other instruments that are not liquid. 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. 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.
We are highly dependent on information systems and third parties, and systems
failures could significantly disrupt our business, which may, in turn,
negatively affect the market price of our common stock and our ability to pay
dividends to our stockholders.
Our business is highly dependent on communications and information systems.
Any failure or interruption of our systems could cause delays or other problems
in our securities trading activities, including mortgage-backed securities
trading activities, which could have a material adverse effect on our operating
results and negatively affect the market price of our common stock and our
ability to pay dividends to our stockholders.
We are required to obtain various state licenses in order to purchase mortgage
loans in the secondary market and there is no assurance we will be able to
obtain or maintain those licenses.
While we are not required to obtain licenses to purchase mortgage-backed
securities, we are required to obtain various state licenses to purchase
mortgage loans in the secondary market. There is no assurance that we will
obtain all of the licenses that we desire or that we will not experience
significant delays in seeking these licenses. Furthermore, we will be subject to
various information reporting requirements to maintain these licenses, and there
is no assurance that we will satisfy those requirements. Our failure to obtain
or maintain licenses will restrict our investment options and could harm our
business.
We are subject to liability for potential violations of predatory lending laws,
which could adversely impact our results of operations, financial condition and
business.
Various federal, state and local laws have been enacted that are designed
to discourage predatory lending practices. The federal Home Ownership and Equity
Protection Act of 1994, or HOEPA, prohibits inclusion of certain provisions in
residential mortgage loans that have mortgage rates or origination costs in
excess of prescribed levels and requires that borrowers be given certain
disclosures prior to origination. Some states have enacted, or may enact,
similar laws or regulations, which in some cases impose restrictions and
requirements greater than those in HOEPA. In addition, under the anti-predatory
lending laws of some states, the origination of certain residential mortgage
loans, including loans that are not classified as "high cost" loans under
applicable law, must satisfy a net tangible benefits test with respect to the
related borrower. This test may be highly subjective and open to interpretation.
As a result, a court may determine that a residential mortgage loan, for
example, does not meet the test even if the related originator reasonably
believed that the test was satisfied. Failure of residential mortgage loan
originators or servicers to comply with these laws, to the extent any of their
residential mortgage loans become part of our mortgaged-related assets, could
subject us, as an assignee or purchaser to the related residential mortgage
loans, to monetary penalties and could result in the borrowers rescinding the
affected residential mortgage loans. Lawsuits have been brought in various
states making claims against assignees or purchasers of high cost loans for
violations of state law. Named defendants in these cases have included numerous
participants within the secondary mortgage market. If the loans are found to
have been originated in violation of predatory or abusive lending laws, we could
incur losses, which could adversely impact our results of operations, financial
condition and business.
26
Terrorist attacks and other acts of violence or war may affect the market for
our common stock, the industry in which we conduct our operations and our
profitability.
Terrorist attacks may harm our results of operations and your investment.
We cannot assure you that there will not be further terrorist attacks against
the United States or U.S. businesses. These attacks or armed conflicts may
directly impact the property underlying our asset-based securities or the
securities markets in general. Losses resulting from these types of events are
uninsurable. More generally, any of these events could cause consumer confidence
and spending to decrease or result in increased volatility in the United States
and worldwide financial markets and economies. Adverse economic conditions could
harm the value of the property underlying our asset-backed securities or the
securities markets in general which could harm our operating results and
revenues and may result in the volatility of the value of our securities.
We are subject to the requirements of the Sarbanes-Oxley Act of 2002.
As we are a public company, our management is required to deliver a report
that assesses the effectiveness of our internal controls over financial
reporting, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, or
Sarbanes-Oxley Act. Section 404 of the Sarbanes-Oxley Act requires an
independent registered public accounting firm to deliver an attestation report
on management's assessment of, and the operating effectiveness of our internal
controls over financial reporting in conjunction with their opinion on our
audited financial statements beginning with the year ending December 31, 2008.
Substantial work on our part is required to implement appropriate processes,
document the system of internal control over key processes, assess their design,
remediate any deficiencies identified and test their operation. This process is
expected to be both costly and challenging. We cannot give any assurances that
material weaknesses will not be identified in the future in connection with our
compliance with the provisions of Sections 302 and 404 of the Sarbanes-Oxley
Act. The existence of any material weakness described above would preclude a
conclusion by management and our independent auditors that we maintained
effective internal control over financial reporting. Our management may be
required to devote significant time and expense to remediate any material
weaknesses that may be discovered and may not be able to remediate all material
weaknesses in a timely manner. The existence of any material weaknesses in our
internal control over financial reporting could also result in errors in our
financial statements that could require us to restate our financial statements,
cause us to fail to meet our reporting obligations and cause investors to lose
confidence in our reported financial information, all of which could lead to a
decline in the trading price of our stock.
The increasing number of proposed federal, state and local laws may increase our
risk of liability with respect to certain mortgage loans, may include judicial
modification provisions and could increase our cost of doing business.
The United States Congress and various state and local legislatures are
considering legislation, which, among other provisions, would permit limited
assignee liability for certain violations in the mortgage loan origination
process, and would allow judicial modification of loan principal in the event of
personal bankruptcy. We cannot predict whether or in what form Congress or the
various state and local legislatures may enact legislation affecting our
business. We are evaluating the potential impact of these initiatives, if
enacted, on our practices and results of operations. As a result of these and
other initiatives, we are unable to predict whether federal, state or local
authorities will require changes in our practices in the future or in our
portfolio. These changes, if required, could adversely affect our profitability,
particularly if we make such changes in response to new or amended laws,
regulations or ordinances in any state where we acquire a significant portion of
our mortgage loans, or if such changes result in us being held responsible for
any violations in the mortgage loan origination process, or if the principal
amount of loans we own or are in RMBS pools we own are modified in the personal
bankruptcy process.
Risks Related to Our Investments
We might not be able to purchase residential mortgage loans, mortgage-backed
securities and other investments that meet our investment criteria or at
favorable spreads over our borrowing costs.
To the extent we purchase assets using leverage, our net income depends on
our ability to acquire residential mortgage loans, mortgage-backed securities
and other investments at favorable spreads over our borrowing costs. Our
investments are selected by our Manager, and our stockholders will not have
input into such investment decisions. Our Manager has conducted due diligence
with respect to each investment purchased. However, there can be no assurance
that our Manager's due diligence processes will uncover all relevant facts or
that any investment will be successful.
27
We may not realize income or gains from our investments.
We invest to generate both current income and capital appreciation. The
investments we invest in may, however, not appreciate in value and, in fact, may
decline in value, and the debt securities we invest in may default on interest
or principal payments. Accordingly, we may not be able to realize income or
gains from our investments. Any gains that we do realize may not be sufficient
to offset any other losses we experience. Any income that we realize may not be
sufficient to offset our expenses.
Our investments may be concentrated and will be subject to risk of default.
While we intend to diversify our portfolio of investments, we are not
required to observe specific diversification criteria. To the extent that our
portfolio is concentrated in any one region or type of security, downturns
relating generally to such region or type of security may result in defaults on
a number of our investments within a short time period, which may reduce our net
income and the value of our shares and accordingly may reduce our ability to pay
dividends to our stockholders.
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.
Increases in interest rates could negatively affect the value of our
investments, which could result in reduced earnings or losses and negatively
affect the cash available for distribution to our stockholders.
We have and will continue to invest in real estate-related assets by
acquiring RMBS, residential mortgage loans, CMBS and CDOs backed by real
estate-related assets. Under a normal yield curve, an investment in these assets
will decline in value if long-term interest rates increase. Declines in market
value may ultimately reduce earnings or result in losses to us, which may
negatively affect cash available for distribution to our stockholders. A
significant risk associated with these investments is the risk that both
long-term and short-term interest rates will increase significantly. If
long-term rates were to increase significantly, the market value of these
investments would decline, and the duration and weighted average life of the
investments would increase. We could realize a loss if these assets were sold.
At the same time, an increase in short-term interest rates would increase the
amount of interest owed on the repurchase agreements or other adjustable rate
financings we may enter into to finance the purchase of these assets. Market
values of our investments may decline without any general increase in interest
rates for a number of reasons, such as increases in defaults, increases in
voluntary prepayments for those investments that are subject to prepayment risk
and widening of credit spreads.
In a period of rising interest rates, our interest expense could increase while
the interest we earn on our fixed-rate assets would not change, which would
adversely affect our profitability.
Our operating results will depend in large part on the differences between
the income from our assets, net of credit losses and financing costs. We
anticipate that, in most cases, the income from such assets will respond more
slowly to interest rate fluctuations than the cost of our borrowings.
Consequently, changes in interest rates, particularly short-term interest rates,
may significantly influence our net income. Increases in these rates will tend
to decrease our net income and market value of our assets. Interest rate
fluctuations resulting in our interest expense exceeding our interest income
would result in operating losses for us and may limit or eliminate our ability
to make distributions to our stockholders.
28
Interest rate mismatches between our investments and any borrowings used to fund
purchases of these assets may reduce our income during periods of changing
interest rates.
We intend to fund some of our acquisitions of residential mortgage loans,
real estate-related securities and real estate loans with borrowings that have
interest rates based on indices and repricing terms with shorter maturities than
the interest rate indices and repricing terms of our adjustable-rate assets.
Accordingly, if short-term interest rates increase, this may harm our
profitability.
Some of the residential mortgage loans, real estate-related securities and
real estate loans we acquire are and will be fixed-rate securities. This means
that their interest rates will not vary over time based upon changes in a
short-term interest rate index. Therefore, the interest rate indices and
repricing terms of the assets that we acquire and their funding sources will
create an interest rate mismatch between our assets and liabilities. During
periods of changing interest rates, these mismatches could reduce our net
income, dividend yield and the market price of our stock.
Accordingly, in a period of rising interest rates, we could experience a
decrease in net income or a net loss because the interest rates on our
borrowings adjust whereas the interest rates on our fixed-rate assets remain
unchanged.
Interest rate caps on our adjustable rate RMBS may adversely affect our
profitability.
Adjustable-rate RMBS are typically subject to periodic and lifetime
interest rate caps. Periodic interest rate caps limit the amount an interest
rate can increase during any given period. Lifetime interest rate caps limit the
amount an interest rate can increase over the life of the security. Our
borrowings typically will not be subject to similar restrictions. Accordingly,
in a period of rapidly increasing interest rates, the interest rates paid on our
borrowings could increase without limitation while caps could limit the interest
rates on our adjustable-rate RMBS. This problem is magnified for hybrid
adjustable-rate and adjustable-rate RMBS that are not fully indexed. Further,
some hybrid adjustable-rate and adjustable-rate RMBS may be subject to periodic
payment caps that result in a portion of the interest being deferred and added
to the principal outstanding. As a result, we may receive less cash income on
hybrid adjustable-rate and adjustable-rate RMBS than we need to pay interest on
our related borrowings. These factors could reduce our net interest income and
cause us to suffer a loss.
A significant portion of our portfolio investments will be recorded at fair
value, as determined in accordance with our pricing policy as approved by our
board of directors and, as a result, there will be uncertainty as to the value
of these investments.
A significant portion of our portfolio of investments is in the form of
securities that are not publicly traded. The fair value of securities and other
investments that are not publicly traded may not be readily determinable. It may
be difficult or impossible to obtain third party pricing on the investments we
purchase. We value these investments quarterly at fair value, as determined in
accordance with our pricing policy as approved by our board of directors.
Because such valuations are inherently uncertain, may fluctuate over short
periods of time and may be based on estimates, our determinations of fair value
may differ materially from the values that would have been used if a ready
market for these securities existed. The value of our common stock could be
adversely affected if our determinations regarding the fair value of these
investments were materially higher than the values that we ultimately realize
upon their disposal.
A prolonged economic slowdown, a recession or declining real estate values could
impair our investments and harm our operating results.
Many of our investments are susceptible to economic slowdowns or
recessions, which could lead to financial losses in our investments and a
decrease in revenues, net income and assets. Unfavorable economic conditions
also could increase our funding costs, limit our access to the capital markets
or result in a decision by lenders not to extend credit to us. These events
could prevent us from increasing investments and have an adverse effect on our
operating results.
29
Changes in prepayment rates could negatively affect the value of our investment
portfolio, which could result in reduced earnings or losses and negatively
affect the cash available for distribution to our stockholders.
There are seldom any restrictions on borrowers' abilities to prepay their
residential mortgage loans. Homeowners tend to prepay mortgage loans faster when
interest rates decline. Consequently, owners of the loans have to reinvest the
money received from the prepayments at the lower prevailing interest rates.
Conversely, homeowners tend not to prepay mortgage loans when interest rates
increase. Consequently, owners of the loans are unable to reinvest money that
would have otherwise been received from prepayments at the higher prevailing
interest rates. This volatility in prepayment rates may affect our ability to
maintain targeted amounts of leverage on our portfolio of residential mortgage
loans, RMBS, and CDOs backed by real estate-related assets and may result in
reduced earnings or losses for us and negatively affect the cash available for
distribution to our stockholders.
To the extent our investments are purchased at a premium, faster than
expected prepayments result in a faster than expected amortization of the
premium paid, which would adversely affect our earnings. Conversely, if these
investments were purchased at a discount, faster than expected prepayments
accelerate our recognition of income.
The mortgage loans we invest in and the mortgage loans underlying the mortgage
and asset-backed securities we invest in are subject to delinquency, foreclosure
and loss, which could result in losses to us.
Residential mortgage loans are typically secured by single-family
residential property and are subject to risks of delinquency and foreclosure and
risks of loss. The ability of a borrower to repay a loan secured by a
residential property is dependent upon the income or assets of the borrower. A
number of factors, including a general economic downturn, acts of God,
terrorism, social unrest and civil disturbances, may impair borrowers' abilities
to repay their loans. In addition, we invest in non-Agency RMBS, which are
backed by residential real property but, in contrast to Agency RMBS, their
principal and interest is not guaranteed by federally chartered entities such as
Fannie Mae and Freddie Mac and, in the case of Ginnie Mae, the U.S. government.
The U.S. Department of Treasury and FHFA have also 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. Asset-backed
securities are bonds or notes backed by loans or other financial assets. The
ability of a borrower to repay these loans or other financial assets is
dependent upon the income or assets of these borrowers. Commercial mortgage
loans are secured by multifamily or commercial property and are subject to risks
of delinquency and foreclosure, and risks of loss that are greater than similar
risks associated with loans made on the security of single-family residential
property. The ability of a borrower to repay a loan secured by an
income-producing property typically is dependent primarily upon the successful
operation of such property rather than upon the existence of independent income
or assets of the borrower. If the net operating income of the property is
reduced, the borrower's ability to repay the loan may be impaired. Net operating
income of an income producing property can be affected by, among other things,
tenant mix, success of tenant businesses, property management decisions,
property location and condition, competition from comparable types of
properties, changes in laws that increase operating expense or limit rents that
may be charged, any need to address environmental contamination at the property,
the occurrence of any uninsured casualty at the property, changes in national,
regional or local economic conditions or specific industry segments, declines in
regional or local real estate values, declines in regional or local rental or
occupancy rates, increases in interest rates, real estate tax rates and other
operating expenses, changes in governmental rules, regulations and fiscal
policies, including environmental legislation, acts of God, terrorism, social
unrest and civil disturbances. In the event of any default under a mortgage loan
held directly by us, we will bear a risk of loss of principal to the extent of
any deficiency between the value of the collateral and the principal and accrued
interest of the mortgage loan, which could have a material adverse effect on our
cash flow from operations. In the event of the bankruptcy of a mortgage loan
borrower, the mortgage loan to such borrower will be deemed to be secured only
to the extent of the value of the underlying collateral at the time of
bankruptcy (as determined by the bankruptcy court), and the lien securing the
mortgage loan will be subject to the avoidance powers of the bankruptcy trustee
or debtor-in-possession to the extent the lien is unenforceable under state law.
Foreclosure of a mortgage loan can be an expensive and lengthy process which
could have a substantial negative effect on our anticipated return on the
foreclosed mortgage loan. RMBS evidence interests in or are secured by pools of
residential mortgage loans and CMBS evidence interests in or are secured by a
single commercial mortgage loan or a pool of commercial mortgage loans.
Accordingly, the RMBS and CMBS we invest in are subject to all of the risks of
the respective underlying mortgage loans.
30
We may be required to repurchase mortgage loans or indemnify investors if we
breach representations and warranties, which could harm our earnings.
If we sell loans, we would be required to make customary representations
and warranties about such loans to the loan purchaser. Our residential mortgage
loan sale agreements will require us to repurchase or substitute loans in the
event we breach a representation or warranty given to the loan purchaser. In
addition, we may be required to repurchase loans as a result of borrower fraud
or in the event of early payment default on a mortgage loan. Likewise, we are
required to repurchase or substitute loans if we breach a representation or
warranty in connection with our securitizations. The remedies available to a
purchaser of mortgage loans are generally broader than those available to us
against the originating broker or correspondent. Further, if a purchaser
enforces its remedies against us, we may not be able to enforce the remedies we
have against the sellers. The repurchased loans typically can only be financed
at a steep discount to their repurchase price, if at all. They are also
typically sold at a significant discount to the unpaid principal balance.
Significant repurchase activity could harm our cash flow, results of operations,
financial condition and business prospects.
We may enter into derivative contracts that could expose us to contingent
liabilities in the future.
Subject to maintaining our qualification as a REIT, part of our investment
strategy involves entering into derivative contracts that could require us to
fund cash payments in certain circumstances. These potential payments will be
contingent liabilities and therefore may not appear on our consolidated
statement of financial condition. Our ability to fund these contingent
liabilities will depend on the liquidity of our assets and access to capital at
the time, and the need to fund these contingent liabilities could adversely
impact our financial condition.
Our Manager's due diligence of potential investments may not reveal all of the
liabilities associated with such investments and may not reveal other weaknesses
in such investments, which could lead to investment losses.
Before making an investment, our Manager assesses the strengths and
weaknesses of the originator or issuer of the asset as well as other factors and
characteristics that are material to the performance of the investment. In
making the assessment and otherwise conducting customary due diligence, our
Manager relies on resources available to it and, in some cases, an investigation
by third parties. This process is particularly important with respect to newly
formed originators or issuers with unrated and other subordinated tranches of
MBS and ABS because there may be little or no information publicly available
about these entities and investments. There can be no assurance that our
Manager's due diligence process will uncover all relevant facts or that any
investment will be successful.
Our real estate investments are subject to risks particular to real property.
We own assets secured by real estate and may own real estate directly in
the future, either through direct investments or upon a default of mortgage
loans. Real estate investments are subject to various risks, including:
o acts of God, including earthquakes, floods and other natural
disasters, which may result in uninsured losses;
o acts of war or terrorism, including the consequences of terrorist
attacks, such as those that occurred on September 11, 2001;
o adverse changes in national and local economic and market conditions;
o changes in governmental laws and regulations, fiscal policies and
zoning ordinances and the related costs of compliance with laws and
regulations, fiscal policies and ordinances;
o costs of remediation and liabilities associated with environmental
conditions such as indoor mold; and
o the potential for uninsured or under-insured property losses.
If any of these or similar events occurs, it may reduce our return from an
affected property or investment and reduce or eliminate our ability to make
distributions to stockholders.
We may be exposed to environmental liabilities with respect to properties to
which we take title.
In the course of our business, we may take title to real estate, and, if we
do take title, we could be subject to environmental liabilities with respect to
these properties. In such a circumstance, we may be held liable to a
governmental entity or to third parties for property damage, personal injury,
investigation, and clean-up costs incurred by these parties in connection with
environmental contamination, or may be required to investigate or clean up
hazardous or toxic substances, or chemical releases at a property. The costs
associated with investigation or remediation activities could be substantial. If
we ever become subject to significant environmental liabilities, our business,
financial condition, liquidity, and results of operations could be materially
and adversely affected.
31
We may in the future invest in RMBS collateralized by subprime mortgage loans,
which are subject to increased risks.
We may in the future invest in RMBS backed by collateral pools of subprime
residential mortgage loans. "Subprime" mortgage loans refer to mortgage loans
that have been originated using underwriting standards that are less restrictive
than the underwriting requirements used as standards for other first and junior
lien mortgage loan purchase programs, such as the programs of Fannie Mae and
Freddie Mac. These lower standards include mortgage loans made to borrowers
having imperfect or impaired credit histories (including outstanding judgments
or prior bankruptcies), mortgage loans where the amount of the loan at
origination is 80% or more of the value of the mortgage property, mortgage loans
made to borrowers with low credit scores, mortgage loans made to borrowers who
have other debt that represents a large portion of their income and mortgage
loans made to borrowers whose income is not required to be disclosed or
verified. Due to economic conditions, including increased interest rates and
lower home prices, as well as aggressive lending practices, subprime mortgage
loans have in recent periods experienced increased rates of delinquency,
foreclosure, bankruptcy and loss, and they are likely to continue to experience
delinquency, foreclosure, bankruptcy and loss rates that are higher, and that
may be substantially higher, than those experienced by mortgage loans
underwritten in a more traditional manner. Thus, because of the higher
delinquency rates and losses associated with subprime mortgage loans, the
performance of RMBS backed by subprime mortgage loans in which we may invest
could be correspondingly adversely affected, which could adversely impact our
results of operations, financial condition and business.
Fannie Mae and Freddie Mac, which guarantee the Agency RMBS in which we may
invest, were recently placed into the conservatorship of the Federal Housing
Finance Agency.
The interest and principal payments we expect to receive on some of the
mortgage-backed securities in which we intend to invest will be guaranteed by
Fannie Mae, Freddie Mac, or Ginnie Mae. The recent economic challenges in the
residential mortgage market have affected the financial results and stock values
of Fannie Mae and Freddie Mac. In 2008, both Fannie Mae and Freddie Mac reported
substantial losses.
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. Recently, the government passed the Housing and
Economic Recovery Act of 2008. Fannie Mae and Freddie Mac have 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.
32
Exchange rate fluctuations may limit gains or result in losses.
If we directly or indirectly hold assets denominated in currencies other
than U.S. dollars, we will be exposed to currency risk that may adversely affect
performance. Changes in the U.S. dollar's rate of exchange with other currencies
may affect the value of investments in our portfolio and the income that we
receive in respect of such investments. In addition, we may incur costs in
connection with conversion between various currencies, which may reduce our net
income and accordingly may reduce our ability to pay distributions to our
stockholders.
Risks Related To Our Common Stock
We issued common stock on the New York Stock Exchange on November 16, 2007.
Our shares of common stock are newly issued securities for which there was
no trading market prior to November 2007. The market price of our common stock
may be highly volatile and could be subject to wide fluctuations.
Some of the factors that could negatively affect our share price include:
o actual or anticipated variations in our quarterly operating results;
o changes in our earnings estimates or publication of research reports
about us or the real estate industry;
o increases in market interest rates that may lead purchasers of our
shares to demand a higher yield;
o changes in market valuations of similar companies;
o changes in valuations of our assets;
o adverse market reaction to any increased indebtedness we incur in the
future;
o additions or departures of our Manager's key personnel;
o actions by stockholders;
o speculation in the press or investment community; and
o general market and economic conditions.
Common stock eligible for future sale may have adverse effects on our share
price.
We cannot predict the effect, if any, of future sales of common stock, or
the availability of shares for future sales, on the market price of the common
stock. Sales of substantial amounts of common stock, or the perception that such
sales could occur, may adversely affect prevailing market prices for the common
stock. At December 31, 2008, we had 177,198,212 shares of common stock issued
and outstanding. In addition, Annaly owned approximately 8.6% of our outstanding
shares of common stock as of December 31, 2008. Our equity incentive plan
provides for grants of restricted common stock and other equity-based awards up
to an aggregate of 8% of the issued and outstanding shares of our common stock
(on a fully diluted basis) at the time of the award, subject to a ceiling of
40,000,000 shares available for issuance under the plan. On January 2, 2008, our
executive officers and other employees of our Manager and our independent
directors were granted, as a group, 1,301,000 shares of our restricted common
stock. The restricted common stock granted to our executive officers and other
employees of our Manager or its affiliates vests in equal installments on the
first business day of each fiscal quarter over a period of 10 years beginning on
January 2, 2008, of which 140,900 shares vested and 17,880 shares were forfeited
during the year ended December 31, 2008. The restricted common stock granted to
our executive officers and other employees of our Manager or its affiliates that
remain outstanding and are unvested will fully vest on the death of the
individual. The 1,160,100 shares of our restricted common stock granted to our
executive officers and other employees of our Manager or its affiliates and to
our independent directors that remains unvested as of December 31, 2008
represents approximately 0.65% of the issued and outstanding shares of our
common stock (on a fully diluted basis). We will not make distributions on
shares of restricted stock that have not vested. We, Annaly, and our executive
officers and our directors have agreed with the underwriters to a 90-day lock-up
period (subject to extensions), meaning that, until the end of the 90-day
lock-up period, we and they will not, subject to certain exceptions, sell or
transfer any shares of common stock without the prior consent of Merrill Lynch &
Co, which we refer to as Merrill Lynch. Merrill Lynch may, in its sole
discretion, at any time from time to time and without notice, waive the terms
and conditions of the lock-up agreements to which it is a party. Additionally,
Annaly has agreed with us to a further lock-up period in connection with the
shares purchased by Annaly concurrently with our initial public offering that
will expire at the earlier of (i) November 15, 2010 or (ii) the termination of
the management agreement. Annaly has further agreed with us to a further lock-up
period in connection with the shares purchased by Annaly immediately after our
2008 secondary offering that will expire at the earlier of (i) October 24, 2011
or (ii) the termination of the management agreement. When the lock-up periods
expire, these common shares will become eligible for sale, in some cases subject
to the requirements of Rule 144 under the Securities Act of 1933, as amended, or
the Securities Act. The market price of our common stock may decline
significantly when the restrictions on resale by certain of our stockholders
lapse. Sales of substantial amounts of common stock or the perception that such
sales could occur may adversely affect the prevailing market price for our
common stock.
33
There is a risk that our stockholders may not receive distributions or that
distributions may not grow over time.
We intend to make distributions on a quarterly basis out of assets legally
available to our stockholders in amounts such that all or substantially all of
our REIT taxable income in each year is distributed. We have not established a
minimum distribution payment level and our ability to pay distributions may be
adversely affected by a number of factors, including the risk factors described
herein. All distributions will be made at the discretion of our board of
directors and will depend on our earnings, our financial condition, maintenance
of our REIT status and other factors as our board of directors may deem relevant
from time to time. Among the factors that could adversely affect our results of
operations and impair our ability to pay distributions to our stockholders are:
o the profitability of the investments of net proceeds from our equity
raises;
o our ability to make profitable investments;
o margin calls or other expenses that reduce our cash flow;
o defaults in our asset portfolio or decreases in the value of our
portfolio; and
o the fact that anticipated operating expense levels may not prove
accurate, as actual results may vary from estimates.
A change in any one of these factors could affect our ability to make
distributions. We cannot assure you that we will achieve investment results that
will allow us to make a specified level of cash distributions or year-to-year
increases in cash distributions.
Market interest rates may have an effect on the trading value of our shares.
One of the factors that investors may consider in deciding whether to buy
or sell our shares is our distribution rate as a percentage of our share price
relative to market interest rates. If market interest rates increase,
prospective investors may demand a higher distribution rate or seek alternative
investments paying higher dividends or interest. As a result, interest rate
fluctuations and capital market conditions can affect the market value of our
shares. For instance, if interest rates rise, it is likely that the market price
of our shares will decrease as market rates on interest-bearing securities, such
as bonds, increase.
Investing in our shares may involve a high degree of risk.
The investments we make in accordance with our investment objectives may
result in a high amount of risk when compared to alternative investment options
and volatility or loss of principal. Our investments may be highly speculative
and aggressive, are subject to credit risk, interest rate, and market value
risks, among others, and therefore an investment in our shares may not be
suitable for someone with lower risk tolerance.
Broad market fluctuations could negatively impact the market price of our common
stock.
The stock market has experienced extreme price and volume fluctuations that
have affected the market price of many companies in industries similar or
related to ours and that have been unrelated to these companies' operating
performances. These broad market fluctuations could reduce the market price of
our common stock. Furthermore, our operating results and prospects may be below
the expectations of public market analysts and investors or may be lower than
those of companies with comparable market capitalizations, which could lead to a
material decline in the market price of our common stock.
Future sales of shares may have adverse consequences for investors.
We may issue additional shares in subsequent public offerings or private
placements to make new investments or for other purposes. We are not required to
offer any such shares to existing shareholders on a pre-emptive basis.
Therefore, it may not be possible for existing shareholders to participate in
such future share issues, which may dilute the existing shareholders' interests
in us. Annaly owns approximately 8.6% of our shares of common stock excluding
unvested shares of restricted stock granted to our executive officers and
employees of our Manager or its affiliates. Annaly will be permitted, subject to
the requirements of Rule 144 under the Securities Act, to sell such shares upon
the earlier of (i) (a) November 15, 2010 with respect to shares acquired
concurrently with our initial public offering and (b) October 24, 2011 with
respect to shares Annaly acquired immediately after our 2008 secondary offering
or (ii) the termination of the management agreement.
34
Our charter and bylaws contain provisions that may inhibit potential acquisition
bids that stockholders may consider favorable, and the market price of our
common stock may be lower as a result.
Our charter and bylaws contain provisions that have an anti-takeover effect
and inhibit a change in our board of directors. These provisions include the
following:
o There are ownership limits and restrictions on transferability and
ownership in our charter. To qualify as a REIT for each taxable year
after 2007, not more than 50% of the value of our outstanding stock
may be owned, directly or constructively, by five or fewer individuals
during the second half of any calendar year. In addition, our shares
must be beneficially owned by 100 or more persons during at least 335
days of a taxable year of 12 months or during a proportionate part of
a shorter taxable year for each taxable year after 2007. To assist us
in satisfying these tests, our charter generally prohibits any person
from beneficially or constructively owning more than 9.8% in value or
number of shares, whichever is more restrictive, of any class or
series of our outstanding capital stock. These restrictions may
discourage a tender offer or other transactions or a change in the
composition of our board of directors or control that might involve a
premium price for our shares or otherwise be in the best interests of
our stockholders and any shares issued or transferred in violation of
such restrictions being automatically transferred to a trust for a
charitable beneficiary, thereby resulting in a forfeiture of the
additional shares.
o Our charter permits our board of directors to issue stock with terms
that may discourage a third party from acquiring us. Our charter
permits our board of directors to amend the charter without
stockholder approval to increase the total number of authorized shares
of stock or the number of shares of any class or series and to issue
common or preferred stock, having preferences, conversion or other
rights, voting powers, restrictions, limitations as to dividends or
other distributions, qualifications, or terms or conditions of
redemption as determined by our board. Thus, our board could authorize
the issuance of stock with terms and conditions that could have the
effect of discouraging a takeover or other transaction in which
holders of some or a majority of our shares might receive a premium
for their shares over the then-prevailing market price of our shares.
o Maryland Control Share Acquisition Act. Maryland law provides that
"control shares" of a corporation acquired in a "control share
acquisition" will have no voting rights except to the extent approved
by a vote of two-thirds of the votes eligible to be cast on the matter
under the Maryland Control Share Acquisition Act. "Control shares"
means voting shares of stock that, if aggregated with all other shares
of stock owned by the acquirer or in respect of which the acquirer is
able to exercise or direct the exercise of voting power (except solely
by a revocable proxy), would entitle the acquirer to exercise voting
power in electing directors within one of the following ranges of
voting power: one-tenth or more but less than one-third, one-third or
more but less than a majority, or a majority or more of all voting
power. A "control share acquisition" means the acquisition of control
shares, subject to certain exceptions.
If voting rights or control shares acquired in a control share
acquisition are not approved at a stockholders' meeting, or if the
acquiring person does not deliver an acquiring person statement as
required by the Maryland Control Share Acquisition Act, then, subject
to certain conditions and limitations, the issuer may redeem any or
all of the control shares for fair value. If voting rights of such
control shares are approved at a stockholders' meeting and the
acquirer becomes entitled to vote a majority of the shares of stock
entitled to vote, all other stockholders may exercise appraisal
rights. Our bylaws contain a provision exempting acquisitions of our
shares from the Maryland Control Share Acquisition Act. However, our
board of directors may amend our bylaws in the future to repeal or
modify this exemption, in which case any control shares of our company
acquired in a control share acquisition will be subject to the
Maryland Control Share Acquisition Act.
35
o Business Combinations. Under Maryland law, "business combinations"
between a Maryland corporation and an interested stockholder or an
affiliate of an interested stockholder are prohibited for five years
after the most recent date on which the interested stockholder becomes
an interested stockholder. These business combinations include a
merger, consolidation, share exchange or, in circumstances specified
in the statute, an asset transfer or issuance or reclassification of
equity securities. An interested stockholder is defined as:
o any person who beneficially owns 10% or more of the voting
power of the corporation's shares; or
o an affiliate or associate of the corporation who, at any
time within the two-year period before the date in question,
was the beneficial owner of 10% or more of the voting power
of the then outstanding voting stock of the corporation.
A person is not an interested stockholder under the statute if the
board of directors approved in advance the transaction by which such
person otherwise would have become an interested stockholder. However,
in approving a transaction, the board of directors may provide that
its approval is subject to compliance, at or after the time of
approval, with any terms and conditions determined by the board. After
the five-year prohibition, any business combination between the
Maryland corporation and an interested stockholder generally must be
recommended by the board of directors of the corporation and approved
by the affirmative vote of at least:
o 80% of the votes entitled to be cast by holders of
outstanding shares of voting stock of the corporation; and
o two-thirds of the votes entitled to be cast by holders of
voting stock of the corporation, other than shares held by
the interested stockholder with whom or with whose affiliate
the business combination is to be effected or held by an
affiliate or associate of the interested stockholder.
These super-majority vote requirements do not apply if the
corporation's common stockholders receive a minimum price, as defined
under Maryland law, for their shares in the form of cash or other
consideration in the same form as previously paid by the interested
stockholder for its shares. The statute permits various exemptions
from its provisions, including business combinations that are exempted
by the board of directors before the time that the interested
stockholder becomes an interested stockholder. Our board of directors
has adopted a resolution which provides that any business combination
between us and any other person is exempted from the provisions of the
Maryland Control Share Acquisition Act, provided that the business
combination is first approved by the board of directors. This
resolution, however, may be altered or repealed in whole or in part at
any time. If this resolution is repealed, or the board of directors
does not otherwise approve a business combination, this statute may
discourage others from trying to acquire control of us and increase
the difficulty of consummating any offer.
o Staggered board. Our board of directors is divided into three classes
of directors. The current terms of the directors expire in 2009, 2010
and 2011, respectively. Directors of each class are chosen for
three-year terms upon the expiration of their current terms, and each
year one class of directors is elected by the stockholders. The
staggered terms of our directors may reduce the possibility of a
tender offer or an attempt at a change in control, even though a
tender offer or change in control might be in the best interests of
our stockholders.
o Our charter and bylaws contain other possible anti-takeover
provisions. Our charter and bylaws contains other provisions that may
have the effect of delaying, deferring or preventing a change in
control of us or the removal of existing directors and, as a result,
could prevent our stockholders from being paid a premium for their
common stock over the then-prevailing market price.
Our rights and the rights of our stockholders to take action against our
directors and officers are limited, which could limit stockholder's recourse in
the event of actions not in their best interests.
Our charter limits the liability of our directors and officers to us and
our stockholders for money damages, except for liability resulting from:
o actual receipt of an improper benefit or profit in money, property or
services; or
36
o a final judgment based upon a finding of active and deliberate
dishonesty by the director or officer that was material to the cause
of action adjudicated
for which Maryland law prohibits such exemption from liability.
In addition, our charter authorizes us to obligate our company to indemnify
our present and former directors and officers for actions taken by them in those
capacities to the maximum extent permitted by Maryland law. Our bylaws require
us to indemnify each present or former director or officer, to the maximum
extent permitted by Maryland law, in the defense of any proceeding to which he
or she is made, or threatened to be made, a party because of his or her service
to us. In addition, we may be obligated to fund the defense costs incurred by
our directors and officers.
Tax Risks
Your investment has various federal income tax risks.
This summary of certain tax risks is limited to the federal tax risks
addressed below. Additional risks or issues may exist that are not addressed in
this Form 10-K and that could affect the federal tax treatment of us or our
stockholders. This is not intended to be used and cannot be used by any
stockholder to avoid penalties that may be imposed on stockholders under the
Internal Revenue Code, or the Code. We strongly urge you to seek advice based on
your particular circumstances from an independent tax advisor concerning the
effects of federal, state and local income tax law on an investment in common
stock and on your individual tax situation.
Complying with REIT requirements may cause us to forego otherwise attractive
opportunities.
To qualify as a REIT for federal income tax purposes, we must continually
satisfy various tests regarding the sources of our income, the nature and
diversification of our assets, the amounts we distribute to our stockholders and
the ownership of our stock. To meet these tests, we may be required to forego
investments we might otherwise make. We may be required to make distributions to
stockholders at disadvantageous times or when we do not have funds readily
available for distribution. Thus, compliance with the REIT requirements may
hinder our investment performance.
Complying with REIT requirements may force us to liquidate otherwise attractive
investments.
To qualify as a REIT, we generally must ensure that at the end of each
calendar quarter at least 75% of the value of our total assets consists of cash,
cash items, government securities and qualified REIT real estate assets,
including certain mortgage loans and mortgage-backed securities. The remainder
of our investment in securities (other than government securities and qualifying
real estate assets) generally cannot include more than 10% of the outstanding
voting securities of any one issuer or more than 10% of the total value of the
outstanding securities of any one issuer. In addition, in general, no more than
5% of the value of our assets (other than government securities and qualifying
real estate assets) can consist of the securities of any one issuer, and no more
than 25% of the value of our total securities can be represented by securities
of one or more TRSs. If we fail to comply with these requirements at the end of
any quarter, we must correct the failure within 30 days after the end of such
calendar quarter or qualify for certain statutory relief provisions to avoid
losing our REIT status and suffering adverse tax consequences. As a result, we
may be required to liquidate from our portfolio otherwise attractive
investments. These actions could have the effect of reducing our income and
amounts available for distribution to our stockholders.
Potential characterization of distributions or gain on sale may be treated as
unrelated business taxable income to tax-exempt investors.
If (1) all or a portion of our assets are subject to the rules relating to
taxable mortgage pools, (2) we are a "pension-held REIT," (3) a tax-exempt
stockholder has incurred debt to purchase or hold our common stock, or (4) the
residual Real Estate Mortgage Investment Conduit interests, or REMICs, we buy
generate "excess inclusion income," then a portion of the distributions to and,
in the case of a stockholder described in clause (3), gains realized on the sale
of common stock by such tax-exempt stockholder may be subject to federal income
tax as unrelated business taxable income under the Internal Revenue Code.
37
Classification of a securitization or financing arrangement we enter into as a
taxable mortgage pool could subject us or certain of our stockholders to
increased taxation.
We intend to structure our securitization and financing arrangements as to
not create a taxable mortgage pool. However, if we have borrowings with two or
more maturities and, (1) those borrowings are secured by mortgages or
mortgage-backed securities and (2) the payments made on the borrowings are
related to the payments received on the underlying assets, then the borrowings
and the pool of mortgages or mortgage-backed securities to which such borrowings
relate may be classified as a taxable mortgage pool under the Internal Revenue
Code. If any part of our investments were to be treated as a taxable mortgage
pool, then our REIT status would not be impaired, but a portion of the taxable
income we recognize may, under regulations to be issued by the Treasury
Department, be characterized as "excess inclusion" income and allocated among
our stockholders to the extent of and generally in proportion to the
distributions we make to each stockholder. Any excess inclusion income would:
o not be allowed to be offset by a stockholder's net operating losses; o
be subject to a tax as unrelated business income if a stockholder were
a tax-exempt stockholder;
o be subject to the application of federal income tax withholding at the
maximum rate (without reduction for any otherwise applicable income
tax treaty) with respect to amounts allocable to foreign stockholders;
and
o be taxable (at the highest corporate tax rate) to us, rather than to
our stockholders, to the extent the excess inclusion income relates to
stock held by disqualified organizations (generally, tax-exempt
companies not subject to tax on unrelated business income, including
governmental organizations).
Failure to qualify as a REIT would subject us to federal income tax, which would
reduce the cash available for distribution to our stockholders.
We qualify as a REIT for federal income tax purposes commencing with our
taxable year ending on December 31, 2007. However, the federal income tax laws
governing REITs are extremely complex, and interpretations of the federal income
tax laws governing qualification as a REIT are limited. Qualifying as a REIT
requires us to meet various tests regarding the nature of our assets and our
income, the ownership of our outstanding stock, and the amount of our
distributions on an ongoing basis. While we intend to operate so that we will
qualify as a REIT, given the highly complex nature of the rules governing REITs,
the ongoing importance of factual determinations, including the tax treatment of
certain investments we may make, and the possibility of future changes in our
circumstances, no assurance can be given that we will so qualify for any
particular year. If we fail to qualify as a REIT in any calendar year and we do
not qualify for certain statutory relief provisions, we would be required to pay
federal income tax on our taxable income. We might need to borrow money or sell
assets to pay that tax. Our payment of income tax would decrease the amount of
our income available for distribution to our stockholders. Furthermore, if we
fail to maintain our qualification as a REIT and we do not qualify for certain
statutory relief provisions, we no longer would be required to distribute
substantially all of our REIT taxable income to our stockholders. Unless our
failure to qualify as a REIT were excused under federal tax laws, we would be
disqualified from taxation as a REIT for the four taxable years following the
year during which qualification was lost.
Failure to make required distributions would subject us to tax, which would
reduce the cash available for distribution to our stockholders.
To qualify as a REIT, we must distribute to our stockholders each calendar
year at least 90% of our REIT taxable income (including certain items of
non-cash income), determined without regard to the deduction for dividends paid
and excluding net capital gain. To the extent that we satisfy the 90%
distribution requirement, but distribute less than 100% of our taxable income,
we will be subject to federal corporate income tax on our undistributed income.
In addition, we will incur a 4% nondeductible excise tax on the amount, if any,
by which our distributions in any calendar year are less than the sum of:
o 85% of our REIT ordinary income for that year;
o 95% of our REIT capital gain net income for that year; and
o any undistributed taxable income from prior years.
38
We intend to distribute our REIT taxable income to our stockholders in a
manner intended to satisfy the 90% distribution requirement and to avoid both
corporate income tax and the 4% nondeductible excise tax. However, there is no
requirement that TRSs distribute their after-tax net income to their parent REIT
or their stockholders. Our taxable income may substantially exceed our net
income as determined by GAAP, because, for example, realized capital losses will
be deducted in determining our GAAP net income, but may not be deductible in
computing our taxable income. In addition, we may invest in assets that generate
taxable income in excess of economic income or in advance of the corresponding
cash flow from the assets. To the extent that we generate such non-cash taxable
income in a taxable year, we may incur corporate income tax and the 4%
nondeductible excise tax on that income if we do not distribute such income to
stockholders in that year. As a result of the foregoing, we may generate less
cash flow than taxable income in a particular year. In that event, we may be
required to use cash reserves, incur debt, or liquidate non-cash assets at rates
or at times that we regard as unfavorable to satisfy the distribution
requirement and to avoid corporate income tax and the 4% nondeductible excise
tax in that year. Moreover, our ability to distribute cash may be limited by
financing facilities we may enter into.
Ownership limitations may restrict change of control or business combination
opportunities in which our stockholders might receive a premium for their
shares.
In order for us to qualify as a REIT for each taxable year after 2007, no
more than 50% in value of our outstanding capital stock may be owned, directly
or indirectly, by five or fewer individuals during the last half of any calendar
year. "Individuals" for this purpose include natural persons, private
foundations, some employee benefit plans and trusts, and some charitable trusts.
To preserve our REIT qualification, our charter generally prohibits any person
from directly or indirectly owning more than 9.8% in value or in number of
shares, whichever is more restrictive, of any class or series of the outstanding
shares of our capital stock. This ownership limitation could have the effect of
discouraging a takeover or other transaction in which holders of our common
stock might receive a premium for their shares over the then prevailing market
price or which holders might believe to be otherwise in their best interests.
Our ownership of and relationship with any TRS which we may form or acquire will
be limited, and a failure to comply with the limits would jeopardize our REIT
status and may result in the application of a 100% excise tax.
A REIT may own up to 100% of the stock of one or more TRSs. A TRS may earn
income that would not be qualifying income if earned directly by the parent
REIT. Both the subsidiary and the REIT must jointly elect to treat the
subsidiary as a TRS. Overall, no more than 25% of the value of a REIT's assets
may consist of stock or securities of one or more TRSs. A TRS will pay federal,
state and local income tax at regular corporate rates on any income that it
earns. In addition, the TRS rules impose a 100% excise tax on certain
transactions between a TRS and its parent REIT that are not conducted on an
arm's-length basis. The TRS that we may form would pay federal, state and local
income tax on its taxable income, and its after-tax net income would be
available for distribution to us but would not be required to be distributed to
us. We anticipate that the aggregate value of the TRS stock and securities owned
by us will be less than 25% of the value of our total assets (including the TRS
stock and securities). Furthermore, we will monitor the value of our investments
in our TRSs to ensure compliance with the rule that no more than 25% of the
value of our assets may consist of TRS stock and securities (which is applied at
the end of each calendar quarter). In addition, we will scrutinize all of our
transactions with taxable REIT subsidiaries to ensure that they are entered into
on arm's-length terms to avoid incurring the 100% excise tax described above.
There can be no assurance, however, that we will be able to comply with the 25%
limitation discussed above or to avoid application of the 100% excise tax
discussed above.
We could fail to qualify as a REIT or we could become subject to a penalty tax
if income we recognize from certain investments that are treated or could be
treated as equity interests in a foreign corporation exceeds 5% of our gross
income in a taxable year.
We may invest in securities, such as subordinated interests in certain CDO
offerings, that are treated or could be treated for federal (and applicable
state and local) corporate income tax purposes as equity interests in foreign
corporations. Categories of income that qualify for the 95% gross income test
include dividends, interest and certain other enumerated classes of passive
income. Under certain circumstances, the federal income tax rules concerning
controlled foreign corporations and passive foreign investment companies require
that the owner of an equity interest in a foreign corporation include amounts in
income without regard to the owner's receipt of any distributions from the
foreign corporation. Amounts required to be included in income under those rules
are technically neither actual dividends nor any of the other enumerated
categories of passive income specified in the 95% gross income test.
Furthermore, there is no clear precedent with respect to the qualification of
such income under the 95% gross income test. Due to this uncertainty, we intend
to limit our direct investment in securities that are or could be treated as
equity interests in a foreign corporation such that the sum of the amounts we
are required to include in income with respect to such securities and other
amounts of non-qualifying income do not exceed 5% of our gross income. We cannot
assure you that we will be successful in this regard. To avoid any risk of
failing the 95% gross income test, we may be required to invest only indirectly,
through a domestic TRS, in any securities that are or could be considered to be
equity interests in a foreign corporation. This, of course, will result in any
income recognized from any such investment to be subject to federal income tax
in the hands of the TRS, which may, in turn, reduce our yield on the investment.
39
Liquidation of our assets may jeopardize our REIT qualification.
To qualify as a REIT, we must comply with requirements regarding our assets
and our sources of income. If we are compelled to liquidate our investments to
repay obligations to our lenders, we may be unable to comply with these
requirements, ultimately jeopardizing our qualification as a REIT, or we may be
subject to a 100% tax on any resultant gain if we sell assets in transactions
that are considered to be prohibited transactions.
The tax on prohibited transactions will limit our ability to engage in
transactions, including certain methods of securitizing mortgage loans that
would be treated as sales for federal income tax purposes.
A REIT's net income from prohibited transactions is subject to a 100% tax.
In general, prohibited transactions are sales or other dispositions of property,
other than foreclosure property, but including mortgage loans, held primarily
for sale to customers in the ordinary course of business. We might be subject to
this tax if we sold or securitized our assets in a manner that was treated as a
sale for federal income tax purposes. Therefore, to avoid the prohibited
transactions tax, we may choose not to engage in certain sales of assets at the
REIT level and may securitize assets only in transactions that are treated as
financing transactions and not as sales for tax purposes even though such
transactions may not be the optimal execution on a pre-tax basis. We could avoid
any prohibited transactions tax concerns by engaging in securitization
transactions through a TRS, subject to certain limitations described above. To
the extent that we engage in such activities through domestic TRSs, the income
associated with such activities will be subject to federal (and applicable state
and local) corporate income tax.
Characterization of the repurchase agreements we enter into to finance our
investments as sales for tax purposes rather than as secured lending
transactions would adversely affect our ability to qualify as a REIT.
We have entered into and will enter into repurchase agreements with a
variety of counterparties to achieve our desired amount of leverage for the
assets in which we invest. When we enter into a repurchase agreement, we
generally sell assets to our counterparty to the agreement and receive cash from
the counterparty. The counterparty is obligated to resell the assets back to us
at the end of the term of the transaction, which is typically 30 to 90 days. We
believe that for federal income tax purposes we will be treated as the owner of
the assets that are the subject of repurchase agreements and that the repurchase
agreements will be treated as secured lending transactions notwithstanding that
such agreement may transfer record ownership of the assets to the counterparty
during the term of the agreement. It is possible, however, that the IRS could
successfully assert that we did not own these assets during the term of the
repurchase agreements, in which case we could fail to qualify as a REIT.
Complying with REIT requirements may limit our ability to hedge effectively.
The REIT provisions of the Internal Revenue Code substantially limit our
ability to hedge mortgage-backed securities and related borrowings. Under these
provisions, our annual gross income from non-qualifying hedges, together with
any other income not generated from qualifying real estate assets, cannot exceed
25% of our annual gross income. In addition, our aggregate gross income from
non-qualifying hedges, fees, and certain other non-qualifying sources cannot
exceed 5% of our annual gross income. As a result, we might have to limit our
use of advantageous hedging techniques or implement those hedges through a TRS,
which we may form in the future. This could increase the cost of our hedging
activities or expose us to greater risks associated with changes in interest
rates than we would otherwise want to bear.
We may be subject to adverse legislative or regulatory tax changes that could
reduce the market price of our common stock.
At any time, the federal income tax laws or regulations governing REITs or
the administrative interpretations of those laws or regulations may be amended.
We cannot predict when or if any new federal income tax law, regulation or
administrative interpretation, or any amendment to any existing federal income
tax law, regulation or administrative interpretation, will be adopted,
promulgated or become effective and any such law, regulation or interpretation
may take effect retroactively. We and our stockholders could be adversely
affected by any such change in, or any new, federal income tax law, regulation
or administrative interpretation.
40
Dividends payable by REITs do not qualify for the reduced tax rates.
Legislation enacted in 2003 generally reduces the maximum tax rate for
dividends payable to domestic stockholders that are individuals, trusts and
estates from 38.6% to 15% (through 2010). Dividends payable by REITs, however,
are generally not eligible for the reduced rates. Although this legislation does
not adversely affect the taxation of REITs or dividends paid by REITs, the more
favorable rates applicable to regular corporate dividends could cause investors
who are individuals, trusts and estates to perceive investments in REITs to be
relatively less attractive than investments in stock of non-REIT corporations
that pay dividends, which could adversely affect the value of the stock of
REITs, including our common stock.
Item 1B. Unresolved Staff Comments
None.
Item 2. Properties
We do not own any property. Our executive and administrative office is
located at 1211 Avenue of the Americas, Suite 2902, New York, New York 10036,
telephone (646) 454-3759. We share this office space with Annaly and FIDAC.
Item 3. Legal Proceedings
We are not party to any material litigation or legal proceedings, or to the
best of our knowledge, any threatened litigation or legal proceedings, which, in
our opinion, individually or in the aggregate, would have a material adverse
effect on our results of operations or financial condition.
Item 4. Submission of Matters to a Vote of Security Holders
None.
Part II
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and
Issuer Purchases of Equity Securities
Our common stock began trading publicly on the New York Stock Exchange
under the trading symbol "CIM" on November 16, 2007. As of February 27, 2009, we
had 177,196,945 shares of common stock issued and outstanding which were held by
approximately 5,702 beneficial holders. The following table sets forth, for the
periods indicated, the high, low, and closing sales prices per share of our
common stock as reported on the New York Stock Exchange composite tape and the
cash dividends declared per share of our common stock for the year ended
December 31, 2008 and the period commencing November 16, 2007 and ending
December 31, 2007.
Stock Prices
High Low Close
--------- --------- ---------
Quarter Ended December 31, 2008 $ 6.10 $ 1.90 $ 3.45
Quarter Ended September 30, 2008 $ 9.05 $ 4.73 $ 6.21
Quarter Ended June 30, 2008 $ 14.17 $ 9.01 $ 9.01
Quarter Ended March 31, 2008 $ 19.59 $ 12.00 $ 12.30
November 16, 2007 to December 31, 2007 $ 17.88 $ 14.10 $ 17.88
41
Common Dividends
Declared Per Share
------------------
Quarter Ended December 31, 2008 $0.04
Quarter Ended September 30, 2008 $0.16
Quarter Ended June 30, 2008 $0.16
Quarter Ended March 31, 2008 $0.26
Period commencing November 21, 2007 and ending
December 31, 2007 $0.025
We pay quarterly dividends and distribute to our stockholders all or
substantially all of our taxable income in each year (subject to certain
adjustments). This enables us to qualify for the tax benefits accorded to a REIT
under the Code. We have not established a minimum dividend payment level and our
ability to pay dividends may be adversely affected for the reasons described
under the caption "Risk Factors." All distributions will be made at the
discretion of our board of directors and will depend on our earnings, our
financial condition, maintenance of our REIT status and such other factors as
our board of directors may deem relevant from time to time.
Sale of Unregistered Securities
On November 21, 2007, in a private offering we sold Annaly 3,621,581 shares
of our common stock at a price of $15 per share, for aggregate proceeds of
approximately $54.3 million. We did not pay any underwriting fees, commissions
or discounts with respect to the shares we sold Annaly. We relied on the
exemption from registration provided by Section 4(2) of the Securities Act for
the sale of the shares to Annaly. This sale occurred concurrently with our
initial public offering which was consummated on the same date.
On October 29, 2008, in a private offering we sold Annaly 11,681,415
million shares of common stock at a price of $2.25 per share for aggregate
proceeds of approximately $26.3 million. We did not pay any underwriting fees,
commissions or discounts with respect to the shares we sold Annaly. We relied on
the exemption from registration provided by Section 4(2) of the Securities Act
for the sale of the shares to Annaly. This sale occurred immediately subsequent
to our secondary offering which was consummated on the same date.
EQUITY COMPENSATION PLAN INFORMATION
We have adopted a long term stock incentive plan, or Incentive Plan, to
provide incentives to our independent directors, employees of our Manager and
its affiliates to stimulate their efforts towards our 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 as defined under Section 422 of the Code, or ISOs, non-qualified stock
options, or NQSOs, 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 our common stock,
or 14,175,857 shares, up to a ceiling of 40,000,000 shares. For a description of
our Incentive Plan, see Note 10 to the Financial Statements.
The following table provides information as of December 31, 2008 concerning
shares of our common stock authorized for issuance under our existing Incentive
Plan.
Number of
Securities to be Number of
Issued upon Weighted Average Securities
Exercise of Exercise Price of Available for
Outstanding Outstanding Future Issuance
Options, Warrants Options, Warrants Under Equity
Plan Category and Rights(1) and Rights Compensation Plans
--------------------------------- --------------------- ------------------- --------------------
Equity Compensation Plans 1,283,120 - 12,892,737
Approved by Stockholders
Equity Compensation Plans Not - - -
Approved by Stockholders(1)
--------------------------------- --------------------- ------------------- --------------------
Total 1,283,120 - 12,892,737
================================= ===================== =================== ====================
(1) We do not have any equity plans that have not been approved by our
stockholders.
42
Item 6. Selected Financial Data
The following selected financial data are derived from our audited
financial statements for the year ended December 31, 2008 and the period from
November 21, 2007 (commencement of operations) through December 31, 2007. The
selected financial data should be read in conjunction with the more detailed
information contained in the Financial Statements and Notes thereto and
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" included elsewhere in this Form 10-K.
Consolidated Statement of Financial Condition Highlights
(dollars in thousands, except per share data)
As of December 31, As of December 31,
2008 2007
------------------------------------------------------------ ------------------
Mortgage-backed securities $ 855,467 $ 1,124,290
Loans held for investment -- $ 162,371
Securitized loans held for investment $ 583,346 --
Total assets $ 1,477,501 $ 1,565,636
Repurchase agreements $ 562,119 $ 270,584
Securitized debt $ 488,743 --
Total liabilities $ 1,063,046 $ 1,026,747
Shareholders' equity $ 414,455 $ 538,889
Book value per share $ 2.34 $ 14.29
Number of shares outstanding 177,198,212 37,705,563
Consolidated Statement of Operations Highlights
(dollars in thousands, except per share data)
For the period
For the year November 21, 2007
ended December to December 31,
31, 2008 2007
------------------------------------------------------------ ----------------
Net interest income $44,715 $3,077
Net loss ($119,809) ($2,906)
Loss per share - basic and diluted ($1.90) ($0.08)
Average shares - basic and diluted 63,155,878 37,401,737
Taxable income per share (1) $0.62 $0.03
Dividends declared per share (2) $0.62 $0.025
(1) See reconciliation of non-GAAP financial measurements to GAAP
financial measurements.
(2) For applicable period as reported in our earnings announcement.
43
Other Data
(dollars in thousands, except percentages)
For the period
November 21,
For the year 2007 to
ended December December 31,
31, 2008 2007
--------------------------------------------------------------------------------
Average total assets $ 1,659,313 $ 1,044,355
Average investment securities $ 1,711,705 $ 399,736
Average borrowings $ 1,304,873 $ 270,584
Average equity $ 400,256 $ 530,982
Annualized yield on average interest 5.96%
earning assets 7.02%
Annualized cost of funds on average interest
bearing liabilities 4.64% 5.08%
Annualized interest rate spread 1.32% 1.94%
Annualized net interest margin (net interest
income/average interest earning assets) 2.61% 6.85%
Annualized G&A and management fee expense as
percentage of average total assets 0.85% 1.55%
Annualized G&A and management fee expense as
percentage of average equity 3.50% 3.05%
Return on average interest earning assets (7.00%) (6.47%)
Return on average equity (29.93%) (4.87%)
(1) See reconciliation of non-GAAP financial measurements to GAAP
financial measurements.
(2) For the applicable period as reported in our earnings announcements.
Reconciliation of non-GAAP financial measurements to GAAP financial measurements
Taxable income per share
As a REIT, we are required to distribute to our shareholders substantially
all of our REIT taxable earnings in the form of dividends. Taxable earnings per
share is a meaningful financial measurement for investors and management in
assessing our performance. A reconciliation of REIT taxable income per share to
GAAP EPS (basic) follows:
Reconciliation of REIT Taxable Income Per Share to GAAP Loss per Share
----------------------------------------------------------------------
For the
period
For the year November 21,
ended 2007 to
December 31, December 31,
2008 2007
--------------------------------------------------------------------------------
GAAP loss per share ($1.90) ($0.08)
Realized loss on sale of investments $2.45 -
Unrealized loss on interest rate swaps $0.07 $0.11
--------------- --------------
REIT taxable income per share $0.62 $0.03
=============== ==============
Item 7. Management's Discussion and Analysis of Financial Condition and Result
of Operations
The following discussion of our financial condition and results of
operations should be read in conjunction with the financial statements and notes
to those statements included in Item 8 of this Form 10-K. The discussion may
contain certain forward-looking statements that involve risks and uncertainties.
Forward-looking statements are those that are not historical in nature. As a
result of many factors, such as those set forth under "Risk Factors" in this
Form 10-K, our actual results may differ materially from those anticipated in
such forward-looking statements.
44
Executive Summary
We are a specialty finance company that invests in residential
mortgage-backed securities, residential mortgage loans, 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 have made and expect to
continue 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 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 to Annaly, we raised proceeds
before offering expenses of approximately $533.6 million. We completed a
secondary offering on October 29, 2008. In that offering and in an immediately
subsequent private offering to Annaly, we raised proceeds before offering
expenses of approximately $301.0 million. We have invested the proceeds of our
initial public offering and concurrent private offering, and have commenced
investing proceeds of our October 2008 offerings. As of December 31, 2008, we
had a portfolio of approximately $855.5 million of RMBS and approximately $583.3
million in securitized loans.
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.
Since we commenced operations in November 2007, we have focused our
investment activities on acquiring non-Agency RMBS and on purchasing residential
mortgage loans that have been originated by select high-quality originators,
including the retail lending operations of leading commercial banks. Our
investment portfolio at December 31, 2008 was weighted toward non-Agency RMBS.
We expect that over the near term our investment portfolio will continue to be
weighted toward RMBS, subject to maintaining our REIT qualification and our 1940
Act exemption. In addition, we have engaged in and anticipate continuing to
engage in transactions with residential mortgage lending operations of leading
commercial banks and other high-quality originators in which we identify and
re-underwrite residential mortgage loans owned by such entities, and rather than
purchasing and securitizing such residential mortgage loans ourselves, we and
the originator would structure the securitization and we would purchase the
resulting mezzanine and subordinate non-Agency RMBS. We may also engage in
similar transactions with non-Agency RMBS in which we would acquire AAA-rated
non-Agency RMBS and immediately re-securitize those securities. We would sell
the resulting AAA-rated super senior RMBS and retain the AAA-rated mezzanine
RMBS.
45
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 our Manager'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 have financed and expect to continue to finance our investments
using a variety of financing sources including repurchase agreements, warehouse
facilities, securitizations, commercial paper and term financing CDOs. We have
managed and expect to continue to 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. As of December 31, 2008, we had outstanding
indebtedness of approximately $1.1 billion, which consists of recourse leverage
of approximately $562.1 million and non-recourse securitized financing of
approximately $488.7 million.
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 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 Bear Stearns & Co. worsened
the crisis. As the year progressed deterioration in the fair value of our assets
continued, 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. To reduce
leverage and protect the portfolio from increased market volatility, we sold
assets with a carrying value of $802.5 million in non-Agency RMBS and unsecured
loans for a loss of approximately $144.3 million and terminated $1.5 billion in
notional interest rate swaps for a loss of approximately $10.3 million, which
together resulted in a net realized loss of approximately $154.6 million.
Additionally, the disruptions during the period 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.
46
The challenges of the first quarter of 2008 continued throughout the year
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. As a result, we expect to operate
with a low level of leverage and to continue to take actions that would support
available cash. 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.
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.
Subsequent to June 30, 2008, there were 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. Recently, the government passed the "Housing and
Economic Recovery Act of 2008." Fannie Mae and Freddie Mac have 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.
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.
47
On April 24, 2008 we transferred $619.7 million of our residential mortgage
loans held for investment to the PHHMC 2008-CIM1 Trust in a securitization
transaction. In this transaction, we 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. We incurred approximately $1.3
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 Extinguishment of Liabilities, or SFAS
140.
On July 25, 2008, we transferred $151.2 million of our residential mortgage
loans held for investment to the PHHMC 2008-CIM2 Trust in a securitization
transaction. In this transaction, we initially 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 and
classified them as mortgage-backed securities, available for sale on its
consolidated statement of financial condition. There was no value assigned to
the residual interest. 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.
This transaction was accounted for as a sale pursuant to SFAS 140, and the
related loans held for investment were derecognized from the consolidated
statements of financial condition. We have no other continuing interests with
the trust.
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 to eliminate the incentive fees previously provided for
in the management agreement.
We completed a secondary offering on October 29, 2008. In that offering and
in an immediately subsequent private offering to Annaly, we raised proceeds
before offering expenses of approximately $301.0 million.
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.
Rising Interest Rate Environment. As indicated above, as interest rates
rise, prepayment speeds generally decrease, increasing our 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.
48
With respect to our floating rate investments, such interest rate increases
should result in increases in our net investment income if 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 a 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 credit 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.
49
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
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.
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 GAAP. These
accounting principles may require us to make some complex and subjective
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 will be 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 perform 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:
Mortgage Loan Sales and Securitizations
We periodically enter into transactions in which we sell financial assets,
such as RMBS, mortgage loans and other assets. Upon a transfer of financial
assets, we sometimes retain or acquire senior or subordinated interests in the
related assets. In addition, we generally do not acquire servicing rights for
mortgage loans we purchase. Gains and losses on such transactions are recognized
using the guidance in SFAS No. 140, Accounting for Transfers and Servicing of
Financial Assets and Extinguishments of Liabilities, a replacement of FASB
Statement No. 125, or SFAS No 140 which is based on a financial components
approach that focuses on control. Under this approach, after a transfer of
financial assets, an entity recognizes the financial and servicing assets it
controls and the liabilities it has incurred, derecognizes financial assets when
control has been surrendered, and derecognizes liabilities when extinguished.
We determine the gain or loss on sale of mortgage loans by allocating the
carrying value of the underlying mortgage between securities or loans sold and
the interests retained based on their fair values. The gain or loss on sale is
the difference between the cash proceeds from the sale and the amount allocated
to the securities or loans sold.
50
From time to time, we may securitize loans held for investment. These
transactions are recorded in accordance with SFAS 140 Accounting for Transfers
and Servicing of Financial Assets and Extinguishment of Liabilities (SFAS 140)
and are accounted for as either a "sale" and the loans held for investment are
removed from the consolidated statements of financial condition or as a
"financing" and are classified as "Securitized loans held for investment" on the
Company's consolidated statements of financial condition, depending upon the
structure of the securitization transaction.
Valuation of Investments
On January 1, 2008, we adopted FASB Statement of Financial Accounting
Standards No. 157, Fair Value Measurements, or SFAS 157, which defines fair
value, establishes a framework for measuring fair value in accordance with GAAP
and expands disclosures about 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 follows:
Level 1 - inputs to the valuation methodology are quoted prices
(unadjusted) for identical assets and liabilities in active markets.
Level 2 - inputs to the valuation methodology include quoted prices for
similar assets and liabilities in active markets, and inputs that are observable
for the asset or liability, either directly or indirectly, for substantially the
full term of the financial instrument.
Level 3 - inputs to the valuation methodology are unobservable and
significant to 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.
Any changes to the valuation methodology are reviewed by management to
ensure the changes are appropriate. As markets and products develop and the
pricing for certain products becomes more transparent, we continue to refine our
valuation methodologies. The methods used by us may produce a fair value
calculation that may not be indicative of net realizable value or reflective of
future fair values. Furthermore, while we believe our valuation methods are
appropriate and consistent with other market participants, the use of different
methodologies, or assumptions, to determine the fair value of certain financial
instruments could result in a different estimate of fair value at the reporting
date. We use inputs that are current as of the measurement date, which may
include periods of market dislocation, during which price transparency may be
reduced. This condition could cause our financial instruments to be reclassified
from Level 2 to Level 3.
As of December 31, 2008, we have classified the valuation of our RMBS as "Level
2" as described above.
Loans Held for Investment
We purchase residential mortgage loans and classify them as loans held for
investment on the consolidated statement of financial condition. Loans held for
investment 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
estimated 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.
51
When we determine that it is probable that contractually due specific
amounts are deemed uncollectable, the loan is considered impaired. To estimate
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.
An allowance for mortgage loans would be maintained at an estimated 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.
Available-for-Sale Securities
Our investments in RMBS are classified as available-for-sale securities
that are carried on the consolidated statement of financial condition at their
fair value. This classification results in changes in fair values being recorded
as adjustments to accumulated other comprehensive income or loss, which is a
component of stockholders' equity.
When the fair value of an available-for-sale security is less than its
amortized cost for an extended period, 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 The financial condition and near-term prospects of the issuer;
o The credit quality and cash flow performance of the security; 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 evaluate the underlying entity that issued
the securities we acquired or to which we 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, in performing our analysis. 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.
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, as amended by FSP
Emerging Issues Task Force No. 99-20-1, 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 will be
resumed when the loan becomes contractually current and performance is
demonstrated to be resumed.
52
Under SFAS No. 91 and Emerging Issues Task Force No. 99-20, as amended,
management estimates, at the time of purchase, the future expected cash flows
and determines the effective interest rate based on these estimated cash flows
and our purchase price. As needed, these estimated cash flows are updated and a
revised yield computed based on the current amortized cost of the investment. In
estimating these cash flows, there are a number of assumptions that are 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 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 consolidated statement of financial
condition and to measure those instruments at fair value. Additionally, the fair
value adjustments 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.
In the normal course of business, we use a variety of derivative financial
instruments to 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 marked-to-market with
changes in value 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 marked-to-market with the
changes in value included in net income.
Derivatives are used for hedging purposes rather than speculation. We 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.
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
We intend to elect and 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.
53
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.
We may elect to treat certain of our subsidiaries as 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.
Recent Accounting Pronouncements
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for
Financial Assets and Financial Liabilities - including an amendment of FASB
Statement No. 115 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 was
effective for the Company commencing January 1, 2008. The Company did not elect
the fair value option for any of its financial instruments.
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.
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 or 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.
On December 11, 2008 the Financial Accounting Standard Board (FASB) issued
a staff position entitled FSP SFAS 140-4 and Fin 46(R)-8 (FSP). The FSP amends
both FASB Statement 140, Accounting for Transfers and Servicing of Financial
Assets and Extinguishments of Liabilities and FASB Interpretation No. 46
(revised December 2003), Consolidation of Variable Interest Entities, to require
public entities to provide additional disclosures about the transfer of
financial assets and involvement with variable interest entities (including
qualifying special purpose entities or QSPE), respectively. The intent of the
disclosure requirements is to provide greater transparency to financial
statement users about an enterprises continuing involvement with financial
assets after they have been transferred in a securitization or asset-backed
financing arrangement (SFAS 140); and to demonstrate how an enterprise's
involvement with a variable interest entity (VIE) affects their financial
position, financial performance and cash flows (FIN 46(R)). We sponsored two
securitizations during 2008. One was a transfer of financial assets accounted
for as a financing. The other was a transfer of assets which was accounted for
as a sale utilizing a QSPE. The implementation of this FSP will require
additional disclosures regarding our assets and liabilities. This FSP is
effective for the first reporting period ending after December 15, 2008 which,
for us is December 31, 2008.
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Financial Condition
At December 31, 2008 our portfolio consisted of $1.4 billion of RMBS and
securitized loans. At December 31, 2007 our portfolio consisted of $1.1 billion
of RMBS and loans held for investment.
The following table summarizes certain characteristics of our portfolio at
December 31, 2008 and 2007:
December 31, December 31,
2008 2007
--------------------------------------------------------------------------------------------------
Leverage at period-end 2.5:1 0.5:1
Residential mortgage-backed securities as % of portfolio 66.2% 87.5%
Residential mortgage loans as % of portfolio - 12.5%
Loans collateralizing secured debt as % of portfolio 33.8% -
Fixed-rate investments as % of portfolio 29.9% 14.4%
Adjustable-rate investments as % of portfolio 70.1% 85.6%
Fixed rate investments
Residential mortgage-backed securities as % of fixed-rate assets 49.9% 39.5%
Residential mortgage loans as % of fixed-rate assets - 60.5%
Loans collateralizing secured debt as a % of fixed-rate assets 50.1% -
Adjustable-rate investments
Residential mortgage-backed securities as a % of adjustable-rate
assets 73.1% 95.5%
Residential mortgage loans as a % of adjustable-rate assets - 4.5%
Loans collateralizing secured debt as a % of adjustable-rate
assets 26.9% -
Annualized yield on average earning assets during the period 5.96% 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 1.32% 1.94%
Weighted average yield on assets at period-end 5.93% 6.62%
Weighted average cost of funds at period-end 3.39% 5.02%
Residential Mortgage-Backed Securities
The table below summarizes our RMBS investments at December 31, 2008 and
2007:
For the period
November 21,
For the year ended 2007 to
December 31, December 31,
2008 2007
(dollars in thousands)
Amortized cost $ 1,122,135 $ 1,114,137
Unrealized gains 7,700 10,675
Unrealized losses (274,368) (522)
----------- -----------
Fair value $ 855,467 $ 1,124,290
=========== ===========
As of December 31, 2008 and 2007, the RMBS in our portfolio were purchased
at a net discount to their par value and our RMBS had a weighted average
amortized cost of 99.0 and 98.8, respectively.
55
The following tables summarize certain characteristics of our RMBS
portfolio at December 31, 2008 and 2007. 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.
December 31, 2008
------------------------------------------
Weighted Averages
------------------------------------------
Estimated
Value (1) Percent of Constant
(dollars in Total RMBS Yield to Prepayment
thousands) Portfolio Coupon Maturity Rate (2)
Non-Agency
Prime $125,640 14.69% 5.57% 8.32% 9.45%
Alt-A 487,465 56.98% 6.07% 6.28% 11.93%
Subprime -- -- -- -- --
Agency 242,362 28.33% 6.69% 6.00% 23.79%
-------- ------ ---- ---- -----
Total RMBS $855,467 100.00% 6.12% 6.55% 14.00%
======== ====== ==== ==== =====
(1) All assets listed in this table are carried at their fair value.
(2) Represents the estimated percentage of principal that will be prepaid over
the next 12 months based on historical principal paydowns.
December 31, 2007
------------------------------------------
Weighted Averages
------------------------------------------
Estimated
Value (1) Percent of Constant
(dollars in Total RMBS Yield to Prepayment
thousands) Portfolio Coupon Maturity Rate (2)
Non-Agency
Prime $1,124,290 100.00% 6.32% 6.87% 10.13%
Alt-A -- -- -- -- --
Subprime -- -- -- -- --
Agency -- -- -- -- --
---------- ------ ---- ---- -----
Total RMBS $1,124,290 100.00% 6.32% 6.87% 10.13%
========== ====== ==== ==== =====
(1) All assets listed in this table are carried at their fair value.
(2) Represents the estimated percentage of principal that will be prepaid over
the next 12 months based on historical principal paydowns.
The table below summarizes the credit ratings of our RMBS investments at
December 31, 2008 and 2007:
December 31, December 31,
2008 2007
------ ------
AAA 97.28% 100.00%
AA 0.40% --
A 0.04% --
BBB 0.02% --
BB 0.03% --
B 0.01% --
Not rated 2.22% --
------ ------
Total 100.00% 100.00%
====== ======
56
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 December 31, 2008 and
2007, the average final contractual maturity of the RMBS portfolio was 30 and 29
years, respectively.
The constant prepayment rate, or CPR, attempts to predict the percentage of
principal that will be prepaid over the next 12 months 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 RMBS portfolio is an increase of 1.46%
and the weighted average maximum increases for the RMBS portfolio is 10.9%.
The following table summarizes our RMBS according to their estimated
weighted average life classifications as of December 31, 2008 and 2007:
December 31, December 31,
2008 2007
---------- ----------
(dollars in thousands)
Less than one year $ -- $ 45,868
Greater than one year and less than five years 768,163 1,078,422
Greater than or equal to five years 87,304 --
---------- ----------
Total $ 855,467 $1,124,290
========== ==========
Mortgage Loans Held for Investment Portfolio Characteristics
The following tables present certain characteristics of our whole mortgage
loan portfolio as of December 31, 2007. We did not hold whole mortgage loans as
of December 31, 2008.
December 31, 2007
-----------------
(dollars in thousands)
Original loan balance $164,436
Unpaid principal balance $161,489
Weighted average coupon rate on loans 6.33%
Weighted average original term (years) 29.9
Weighted average remaining term (years) 29.5
Remaining Balance
Geographic Distribution (dollars in % of Loan
Top 5 States thousands) Portfolio Loan Count
------------------------- -------------------- --------------- ----------
California $36,593 22.66% 52
New Jersey $14,368 8.90% 25
New York $12,061 7.47% 18
Illinois $11,330 7.02% 15
Virginia $10,517 6.51% 20
------- ------ -------
Total $84,869 52.56% 130
======= ====== =======
57
Occupancy Status Remaining
Balance
(dollars % of Loan Loan Purpose % of
in Loan Loan
thousands) Portfolio Count Portfolio
------------------- ---------- --------- ------- ---------------------- ---------
Owner occupied $148,685 92.07% 236 Purchase 70.96%
Second home $10,401 6.44% 17 Cash out refinance 14.76%
Investor $2,403 1.49% 5 Rate and term 14.28%
refinance
---------- --------- ------- --------
Total $161,489 100.00% 258 Total 100.00%
========== ========= ======= ========
% of
Loan % of ARM
Documentation Type Portfolio ARM Loan Type Loans
------------------------------ ---------- ------------------------- ----------
Full/alternative 86.43% Traditional ARM loans -
Stated income/no ratio 13.57% Hybrid ARM loans 100.00%
---------- ----------
Total 100.00% Total 100.00%
========== ==========
Unpaid Principal Balance Dollars FICO Score % of
in Loan
Thousands Portfolio
--------------------------- ---------- ---------------------------- --------
$417,000 or less $3,177 740 and above 59.26%
$417,001 to $650,000 $84,386 700 to 739 25.10%
$650,001 to $1,000,000 $58,613 660 to 699 11.87%
$1,000,001 to $2,000,000 $15,313 620 to 659 3.13%
$2,000,001 to $3,000,000 - Below 620 0.64%
--------
Over $3,000,001 - Total 100.00%
---------- ========
Total $161,489
==========
Weighted Average FICO Score 744
Dollars % of
Original Loan to Value in Loan
Ratio Thousands Property Type Portfolio
--------------------------- ---------- --------------------------------- --------
80.01% and above $16,990 Single-family detached 61.29%
70.01% to 80.00% $104,248 Planned urban 29.28%
development-detached
60.01% to 70.00% $21,553 Condominium 5.80%
60.00% or less $18,698 Other residential 3.63%
---------- --------
Total $161,489 Total 100.00%
========== ========
Weighted Average Original 74.59%
Loan to Value Ratio
% of ARM
Periodic Cap on Hybrid ARM Loans Loans
-------------------------------------- ------------
3.00% or less 100.00%
3.01% to 4.00% -
4.01% to 5.00% -
------------
Total 100.00%
============
58
We purchase our whole mortgage loans on a servicing retained basis. As a
result, we do not service any loans, or receive any servicing income.
Securitized Debt Portfolio Characteristics
The following tables present certain characteristics of our loans
collateralizing debt portfolio as of December 31, 2008. We did not hold loans
collateralizing debt as of December 31, 2007.
December 31, 2008
-------------------
(dollars in
thousands)
Original loan balance $598,403
Unpaid principal balance $578,996
Weighted average coupon rate on loans 5.95%
Weighted average original term (years) 29
Weighted average remaining term (years) 28
Remaining Balance
Geographic Distribution (dollars in % of Loan
Top 5 States thousands) Portfolio Loan Count
------------------------- -------------------- ----------------- ---------------
California $190,004 32.82% 254
New Jersey $38,576 6.66% 57
Florida $34,208 5.91% 46
Illinois $34,027 5.88% 45
New York $26,643 4.60% 42
-------------------- ----------------- ---------------
Total $323,458 55.87% 444
==================== ================= ===============
Occupancy Status Remaining
Balance
(dollars % of Loan Loan Purpose % of
in Loan Loan
thousands) Portfolio Count Portfolio
------------------- ---------- --------- ------- ------------------------ --------
Owner occupied $521,212 90.02% 740 Purchase 62.96%
Second home $47,784 8.25% 65 Cash out refinance 14.95%
Investor $10,000 1.73% 17 Rate and term 22.09%
refinance
---------- --------- ------- --------
Total $578,996 100.00% 822 Total 100.00%
========== ========= ======= ========
% of ARM
ARM Loan Type Loans
------------------------------ ----------
Traditional ARM loans -
Hybrid ARM loans 100.00%
----------
Total 100.00%
==========
Unpaid Principal Balance Dollars FICO Score % of
in Loan
Thousands Portfolio
--------------------------- ---------- ---------------------------- --------
$417,000 or less $5,486 740 and above 69.82%
$417,001 to $650,000 $225,927 700 to 739 18.33%
$650,001 to $1,000,000 $237,625 660 to 699 9.28%
$1,000,001 to $2,000,000 $104,359 620 to 659 1.74%
$2,000,001 to $3,000,000 $5,599 Below 620 0.83%
--------
Over $3,000,001 - Total 100.00%
---------- ========
Total $578,996
==========
Weighted Average FICO Score 758
59
Dollars % of
Original Loan to Value in Loan
Ratio Thousands Property Type Portfolio
--------------------------- ---------- --------------------------------- --------
80.01% and above $65,320 Single-family detached 59.60%
70.01% to 80.00% $321,150 Planned urban 31.72%
development-detached
60.01% to 70.00% $89,542 Condominium 6.60%
60.00% or less $102,984 Other residential 2.08%
---------- --------
Total $578,996 Total 100.00%
========== ========
Weighted Average Original 72.51%
Loan to Value Ratio
% of ARM
Periodic Cap on Hybrid ARM Loans Loans
-------------------------------------- ------------
3.00% or less 100.00%
3.01% to 4.00% -
4.01% to 5.00% -
------------
Total 100.00%
============
We purchase our whole mortgage loans on a servicing retained basis. As a
result, we do not service any loans, or receive any servicing income.
Results of Operations for the Year Ended December 31, 2008 and the Period Ended
December 31, 2007
We commenced operations on November 21, 2007, and therefore do not have any
comparable results for prior periods.
Net Loss Summary
Our net loss for the year ended December 31, 2008 was $119.8 million, or
$1.90 per share. Our net loss for the period commencing November 21, 2007 and
ending December 31, 2007 was $2.9 million, or $0.08 per average share,
respectively. The table below presents the net loss summary for the year ended
December 31, 2008 and the period commencing November 21, 2007 and ending
December 31, 2007:
60
Net Loss Summary
(dollars in thousands, except for per share data)
For the
Period
November
For the Year 21, 2007
Ended through
December 31, December
2008 31, 2007
------------ ------------
Interest income $ 105,259 $ 3,492
Interest expense 60,544 415
------------ ------------
Net interest income 44,715 3,077
------------ ------------
Unrealized gains (losses) on interest rate
swaps 4,156 (4,156)
Realized losses on sales of investments (144,304) --
Realized losses on terminations of
interest rate swaps (10,337) --
------------ ------------
Net investment expense (105,770) (1,079)
------------ ------------
Expenses
Management fee 8,428 1,217
General and administrative expenses 5,599 605
------------ ------------
Total expenses 14,027 1,822
Loss before income taxes (119,797) (2,901)
Income tax 12 5
------------ ------------
Net loss ($ 119,809) ($ 2,906)
============ ============
Net loss per share - basic and diluted ($ 1.90) ($ 0.08)
============ ============
Weighted average number of shares
outstanding - basic and diluted 63,155,878 37,401,737
------------ ------------
Comprehensive (loss) income:
Net loss ($ 119,809) ($ 2,906)
------------ ------------
Other comprehensive (loss) income:
Unrealized (loss) gain on
available-for-sale securities (421,125) 10,153
Reclassification adjustment for realized
losses included in income 144,304 --
------------ ------------
Other comprehensive (loss) income (276,821) 10,153
============ ============
Comprehensive (loss) income ($ 396,630) $ 7,247
============ ============
Interest Income and Average Earning Asset Yield
We had average earning assets of $1.7 billion and $399.7 million for the
year ended December 31, 2008 and the period November 21, 2007 to December 31,
2007, respectively. Our interest income was $105.3 million and $3.5 million for
the year ended December 31, 2008 and the period November 21, 2007 to December
31, 2007, respectively. The yield on our portfolio was 5.96% and 7.02% for the
year ended December 31, 2008 and the period November 21, 2007 to December 31,
2007, respectively.
Interest Expense and the Cost of Funds
We had average borrowed funds of $1.3 billion and $270.6 million and total
interest expense of $60.5 million and $415,000 for the year ended December 31,
2008 and the period November 21, 2007 to December 31, 2007, respectively. Our
average cost of funds was 4.64% and 5.08% for the year ended December 31, 2008
and the period November 21, 2007 to December 31, 2007, respectively.
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 year ended
December 31, 2008 and the period ended December 31, 2007.
61
Average Cost of Funds
(Ratios for the quarters in 2008 and the period November 21, 2007
to December 31, 2007 have been annualized, dollars in thousands)
Average
Average Cost of Average
One-Month Funds Cost of
LIBOR Relative Funds
Relative to Relative to
Average Average Average Average to Average Average Average
Borrowed Interest Cost of One-Month Six-Month Six-Month One-Month Six-Month
Funds Expense Funds LIBOR LIBOR LIBOR LIBOR LIBOR
----------- ---------- --------- --------- --------- ------------ ----------- ------------
For the Year Ended December
31, 2008 $1,304,873 $60,544 4.64% 2.68% 3.06% (0.38%) 1.96% 1.58%
----------------------------- ----------- ---------- --------- --------- --------- ------------ ----------- ------------
For the quarter ended
December 31, 2008 $1,105,239 $10,954 3.96% 2.23% 2.94% (0.71%) 1.73% 1.02%
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 November
21, 2007 to 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 $44.7 million and $3.1 million for the year ended December 31,
2008 and the period November 21, 2007 to December 31, 2007, respectively. 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 1.32% and 1.94% for the year
ended December 31, 2008 and the period November 21, 2007 to December 31, 2007,
respectively.
The table below shows our average assets held, total interest income, 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 year ended December 31, 2008 and the period November 21,
2007 to December 31, 2007.
Net Interest Income
(Ratios for quarters in 2008 and the period November 21, 2007 to
December 31, 2007 have been annualized, dollars in thousands)
Yield
on
Average Interest Average Average Net
Earning Earned Interest Average Cost Net Interest
Assets on Earning Debt Interest of Interest Rate
Held Assets Assets Balance Expense Funds Income Spread
---------- -------- --------- ---------- -------- -------- -------- ------
For the Year Ended
December 31, 2008 $1,711,705 $102,093 5.96% $1,304,873 $60,544 4.64% $44,715 1.32%
----------------------- ---------- -------- --------- ---------- -------- -------- -------- ------
For the Quarter ended
December 31, 2008 $1,621,205 $23,254 5.74% $1,105,239 $10,954 3.96% $12,702 1.78%
For the Quarter ended
September 30, 2008 $1,751,748 $23,419 5.35% $1,339,531 $15,543 4.64% $7,915 0.71%
For the Quarter ended
June 30, 2008 $1,917,969 $29,630 6.18% $1,449,567 $20,025 5.53% $9,926 0.65%
For the Quarter ended
March 31, 2008 $1,555,896 $25,790 6.63% $1,325,156 $14,022 4.23% $14,172 2.40%
For the Period
November 21, 2007 to
December 31,
2007 $399,736 $3,492 7.02% $270,584 $415 5.08% $3,077 1.94%
Management Fee and General and Administrative Expenses
We paid FIDAC a base management fee of $8.4 million and $1.2 million for
the year ended December 31, 2008 and the period November 21, 2007 to December
31, 2007, respectively.
62
General and administrative (or G&A) expenses were $5.6 million and $605
thousand for the year ended December 31, 2008 and the period November 21, 2007
to December 31, 2007, respectively.
Total expenses as a percentage of average total assets were 0.85% and 1.55%
for the year ended December 31, 2008 and the period November 21, 2007 to
December 31, 2007, respectively.
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 year ended December 31, 2008
and the period November 21, 2007 to December 31, 2007.
Management Fee and G&A Expenses and Operating Expense Ratios
(Ratios for the quarters in 2008 and the period November 31, 2007 to
December 31, 2007
have been annualized, dollars in thousands)
Total Total
Total Management Fee Management Fee
Management and G&A and G&A
Fee and G&A Expenses/Average Expenses/Average
Expenses Total Assets Equity
------------- ----------------- -----------------
For the Year Ended December 31, 2008 $14,027 0.85% 3.50%
--------------------------------------- ------------- ----------------- -----------------
For the Quarter ended December 31,
2008 $3,918 1.10% 4.78%
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 November 21, 2007 to
December 31, 2007 $1,822 1.55% 3.05%
Net Loss and Return on Average Equity
Our net loss was $119.8 million and $2.9 million for the year ended
December 31, 2008 and for the period November 21, 2007 to December 31, 2007,
respectively. The table below shows our net interest income, loss on sale of
assets and termination of interest rate swaps, 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 year ended December 31, 2008
and the period November 21, 2007 to December 31, 2007, respectively.
Components of Return on Average Equity
(Ratios for the quarters in 2008 and the period November 21, 2007 to
December 31, 2007 have been annualized)
Unrealized
Net Loss on Sale of Gain/(Loss) on
Interest Asset and Interest Interest Rate Total Income Return on
Income/Average Rate Swaps/Average Swaps/Average Expenses/Average Tax/Average Average
Equity Equity Equity Equity Equity Equity
------------- -------------------- ----------------- -------------- --------------- --------------
For the Year Ended
December 31, 2008 11.17% (38.64%) 1.04% (3.50%) -- (29.93%)
------------------------------------------------------------------------------------------------------------------------------
For the Quarter ended
December 31, 2008 15.50% -- -- (4.78%) -- 10.72%
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
November 21, 2007 to
December 31, 2007 5.16% -- (6.97%) (3.05%) (0.01%) (4.87%)
63
Liquidity and Capital Resources
Liquidity measures our ability to meet cash requirements, including ongoing
commitments to repay our borrowings, fund and maintain RMBS, mortgage loans and
other assets, pay dividends and other general business needs. Our principal
sources of capital and funds for additional investments primarily include
earnings from our investments, borrowings under securitizations, repurchase
agreements and other financing facilities, and proceeds from equity offerings.
We expect these sources of financing will be sufficient to meet our short-term
liquidity needs.
We expect to continue to borrow funds in the form of repurchase agreements
as well as other types of financing. 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.
For our short-term (one year or less) and long-term liquidity, which
include 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, a
decline in the value of our collateral or 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 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, securitization, 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 and shares of preferred stock
and lenders with respect to other borrowings will receive a distribution of our
available assets prior to the holders of our common stock.
We held cash and cash equivalents of approximately $27.5 million and $6.0
million at December 31, 2008 and 2007, respectively.
Our operating activities provided net cash of approximately $30.7 million
and used cash of approximately $1.5 million for the year ended December 31, 2008
and the period November 21, 2007 to December 31, 2007, respectively.
Our investing activities provided net cash of $1.0 billion and $795.6
million for the year ended December 31, 2008 and the period November 21, 2007 to
December 31, 2007, respectively, primarily for the purchases of investments and
the $151.2 million securitization which was accounted for as a sale.
Our financing activities as of December 31, 2008 consisted of net proceeds
from our October 2008 secondary offerings in which we raised approximately
$299.6 million, repurchase agreements, as well as the debt obligations of a
$619.7 million securitization which was accounted for as a financing. We
currently have established uncommitted repurchase agreements for RMBS with 13
counterparties, including Annaly. As of December 31, 2008, we had $562.1 million
outstanding under our repurchase agreement with Annaly, which constitutes
approximately 53% of our total financing. Our repurchase agreement with Annaly
has weighted average borrowing rates of 1.43% and weighted average remaining
maturities of 2 days. This agreement is collateralized by our RMBS which had an
estimated fair value of $680.8 million at December 31, 2008. The interest rates
of these repurchase agreements are generally indexed to the one-month LIBOR rate
and reprice accordingly.
64
At December 31, 2008, the repurchase agreements for RMBS had the following
remaining maturities:
December 31, 2008
(dollars in
thousands)
-------------------------------- ---------------------
Within 30 days $562,119
30 to 59 days -
60 to 89 days -
90 to 119 days -
Greater than or equal to 120 days -
---------------------
Total $562,119
=====================
We are not required 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. At December 31, 2008 and
2007, our total debt was approximately $1.1 billion and $270.6 million, which
represented a debt-to-equity ratio of approximately 2.5:1 and 0.5:1,
respectively.
Stockholders' Equity
Our charter provides that we may issue up to 550,000,000 shares of stock,
consisting of up to 500,000,000 shares of common stock having a par value of
$0.01 per share and up to 50,000,000 shares of preferred stock having a par
value of $0.01 per share.
We consummated a public offering and private offering of our common stock
on October 29, 2008. In these offerings we raised proceeds before the
underwriter's discount but before offering expenses of approximately $301.0
million.
Management Agreement and Related Party Transactions
Management Agreement
On November 15, 2007 we entered into a management agreement with FIDAC,
pursuant to which FIDAC is entitled to receive a base management fee 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 1.50% per annum, calculated quarterly, of our
stockholders' equity (as defined in the management agreement). 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.
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 December 31, 2008, we had $562.1 million
outstanding under the agreement with a weighted average borrowing rate of 1.43%.
Restricted Stock Grants
We granted 1,301,000 shares of restricted stock to our Manager's employees
and members of our board of directors during the year ended December 31, 2008.
During the year ended December 31, 2008, 140,900 shares of restricted stock we
had awarded to FIDAC's employees and our board members vested and 17,880 shares
were forfeited or cancelled. At December 31, 2008 there are approximately 1.2
million unvested shares of restricted stock issued to employees of FIDAC. For
the year ended December 31, 2008, compensation expense less general and
administrative costs associated with the amortization of the fair value of the
restricted stock totaled $1.7 million.
65
Contractual Obligations and Commitments
The following table summarizes our contractual obligations at December 31,
2008.
Greater
One to Three to Than or
Within One Three Five Equal to
Year Years Years Five Years Total
---------- ---------- ---------- ---------- ----------
(dollars in thousands)
Repurchase agreements $ 562,119 $ -- $ -- $ -- $ 562,119
Securitized debt (1) 65,561 112,745 85,955 246,535 510,796
Interest expense on
repurchase agreements (2) 22 -- -- -- 22
Interest expense on
securitized debt 26,469 42,694 31,965 92,125 193,253
---------- ---------- ---------- ---------- ----------
Total $ 654,171 $ 155,439 $ 117,920 $ 338,660 $1,266,190
========== ========== ========== ========== ==========
(1) Securitized debt is non-recourse.
(2) Interest rates are variable and based on rates in effect as of December 31,
2008.
The following table summarizes our contractual obligations at December 31,
2007.
(dollars in thousands)
Greater
One to Than or
Within One Three Three to Equal to
Contractual Obligations Year Years Five Years Five Years Total
------------------------------- -------------- ----------- ----------- ----------- -------------
Repurchase agreements $270,584 -- -- -- $270,584
Interest expense on
repurchase agreements(1) 1,206 -- -- -- 1,206
-------------- ----------- ----------- ----------- -------------
Total $271,790 -- -- -- $271,790
============== =========== =========== =========== =============
(1) Interest is based on rates in effect as of December 31, 2007.
The repurchase agreements for our repurchase facilities generally do not
include substantive provisions other than those contained in the standard master
repurchase agreement as published by the Securities Industry and Financial
Markets Association.
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.
66
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 financing facilities, we must
first meet any operating requirements and scheduled debt service on our
financing facilities 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 7A. 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 market
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.
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. Our Manager uses a comprehensive credit
review process. Our Manager's analysis of loans includes borrower profiles, as
well as valuation and appraisal data. Our Manager uses compensating factors such
as liquid assets, low loan to value ratios and job stability in evaluating
loans. Our Manager's resources include a proprietary portfolio management
system, as well as third party software systems. Our Manager utilizes a third
party due diligence firm to perform an independent underwriting review to insure
compliance with existing guidelines. Our Manager selects loans for review
predicated on risk-based criteria such as loan-to-value, borrower's credit
score(s) and loan size. Our Manager 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, our Manager
creates adverse credit and valuation samples, which we individually review. Our
Manager rejects loans that fail to conform to our standards. Our Manager will
accept only those loans which meet our underwriting criteria. Once we own a
loan, our Manager's surveillance process includes ongoing analysis through our
proprietary data warehouse and servicer files. Additionally, the non-Agency RMBS
and other ABS which we acquire for our portfolio are reviewed by our Manager to
ensure that they satisfy our risk based criteria. Our Manager's review of
non-Agency RMBS and other ABS includes utilizing its proprietary portfolio
management system. Our Manager's review of non-Agency RMBS and other ABS are
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.
67
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.
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 intend to 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, we anticipate that 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 our Manager'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-K.
68
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 December 31, 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 Projected Percentage Change
Change in Interest Rate in Net Interest Income in Portfolio Value
------------------------ --------------------------- ---------------------------
-75 Basis Points (2.10%) 0.70%
-50 Basis Points (1.47%) 0.36%
-25 Basis Points (0.84%) 0.03%
Base Interest Rate - -
+25 Basis Points 0.55% (0.62%)
+50 Basis Points 1.07% (0.94%)
+75 Basis Points 1.58% (1.25%)
Prepayment Risk
As we receive prepayments of principal on these investments, premiums paid
on such investments are 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.
Extension Risk
Our Manager 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.
69
Real Estate 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 financings 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 MBS
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.
The following table sets forth the estimated maturity or repricing of our
interest-earning assets and interest-bearing liabilities at December 31, 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.
70
1 Year to 3 Greater than 3
Within 3 Months 3-12 Months Years Years Total
------------------------------------- ----------------- ----------------- ----------------- ------------------ -----------------
(dollars in thousands)
Rate sensitive assets $ 833,175 $ 4,620 $ 467,724 $ 406,910 $1,712,429
Cash equivalents 27,480 - - - 27,480
----------------- ----------------- ----------------- ------------------ -----------------
Total rate sensitive assets 860,655 4,620 467,724 406,910 1,739,909
----------------- ----------------- ----------------- ------------------ -----------------
Rate sensitive liabilities,
with the effect
of swaps 562,119 - - 510,796 1,072,915
----------------- ----------------- ----------------- ------------------ -----------------
Interest rate sensitivity gap $ 298,536 $ 4,620 $ 467,724 ($ 103,886) $ 666,994
================= ================= ================= ================== =================
Cumulative rate sensitivity gap
$ 298,536 $ 303,156 $ 770,880 $ 666,994
================= ================= ================= ==================
Cumulative interest rate sensitivity
gap as a percentage of total
rate-sensitive assets 17% 17% 44% 38%
================= ================= ================= ==================
Our analysis of risks is based on our manager'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 manager 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 Form 10-K. These
analyses contain certain forward-looking statements and are subject to the safe
harbor statement set forth under the heading, "Special Note Regarding
Forward-Looking Statements."
Item 8. Financial Statements and Supplementary Data
Our financial statements and the related notes, together with the Report of
Independent Registered Public Accounting Firm thereon, are set forth on pages
F-1 through F-24 of this Form 10-K.
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
None.
Item 9A. 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 annual 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.
71
Management's Annual Report on Internal Control over Financial Reporting
Dated: February 27, 2009
Management of the Company is responsible for establishing and maintaining
adequate internal control over financial reporting. Internal control over
financial reporting is defined in Rules 13a-15(f) under the Securities Exchange
Act as a process designed by, or under the supervision of, the Company's
principal executive and principal financial officers and effected by the
Company's Board of Directors, management and other personnel to provide
reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance with
generally accepted accounting principles and includes those policies and
procedures that:
o pertain to the maintenance of records that in reasonable detail
accurately and fairly reflect the transactions and dispositions
of the assets of the Company;
o provide reasonable assurance that transactions are recorded as
necessary to permit preparation of financial statements in
accordance with generally accepted accounting principles, and
that receipts and expenditures of the Company are being made only
in accordance with authorizations of management and directors of
the Company; and
o provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use or disposition of the
Company's assets that could have a material effect on the
financial statements.
Because of its inherent limitations, internal control over financial
reporting may not prevent or detect misstatements. As a result, even systems
determined to be effective can provide only reasonable assurance regarding the
preparation and presentation of financial statements. Moreover, projections of
any evaluation of effectiveness to future periods are subject to the risks that
controls may become inadequate because of changes in conditions or that the
degree of compliance with the policies or procedures may deteriorate.
The Company's management assessed the effectiveness of the Company's
internal control over financial reporting as of December 31, 2008. In making
this assessment, the Company's management used criteria set forth by the
Committee of Sponsoring Organizations of the Treadway Commission (COSO) in
Internal Control-Integrated Framework.
Based on management's assessment, the Company's management believes that,
as of December 31, 2008, the Company's internal control over financial reporting
was effective based on those criteria.
The Company's independent registered public accounting firm, Deloitte &
Touche LLP, has issued an attestation report on the Company's internal control
over financial reporting. This report appears on page F-2 of this annual report
on Form 10-K.
Changes in Internal Controls
There have been no changes in our "internal control over financial
reporting" (as defined in rule 13(a)-15(f) of the Exchange Act) that occurred
during the year ended December 31, 2008 that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.
Item 9A(T). Controls and Procedures.
Not applicable.
Item 9B. Other Information
None.
72
Item 10. Directors, Executive Officers and Corporate Governance
The information required by Item 10 as to our directors is incorporated
herein by reference to the proxy statement to be filed with the SEC within 120
days after December 31, 2008.
The information regarding our executive officers required by Item 10 is
incorporated by reference to the proxy statement to be filed with the SEC within
120 days after December 31, 2008.
The information required by Item 10 as to our compliance with Section 16(a)
of the Securities Exchange Act of 1934 is incorporated by reference to the proxy
statement to be filed with the SEC within 120 days after December 31, 2008.
We have adopted a Code of Business Conduct and Ethics within the meaning of
Item 406(b) of Regulation S-K. This Code of Business Conduct and Ethics applies
to our principal executive officer, principal financial officer and principal
accounting officer. This Code of Business Conduct and Ethics is publicly
available on our website at www.chimerareit.com. If we make substantive
amendments to this Code of Business Conduct and Ethics or grant any waiver,
including any implicit waiver, we intend to disclose these events on our
website.
The information regarding certain matters pertaining to our corporate
governance required by Item 407(c)(3), (d)(4) and (d)(5) of Regulation S-K is
incorporated by reference to the Proxy Statement to be filed with the SEC within
120 days after December 31, 2008.
Item 11. Executive Compensation
The information required by Item 11 is incorporated herein by reference to
the proxy statement to be filed with the SEC within 120 days after December 31,
2008.
Item 12. Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters
The information required by Item 12 is incorporated herein by reference to
the proxy statement to be filed with the SEC within 120 days after December 31,
2008.
Item 13. Certain Relationships and Related Transactions, and Director
Independence
The information required by Item 13 is incorporated herein by reference to
the proxy statement to be filed with the SEC within 120 days after December 31,
2008.
Item 14. Principal Accountant Fees and Services
The information required by Item 14 is incorporated herein by reference to
the proxy statement to be filed with the SEC within 120 days after December 31,
2008.
Item 15. Exhibits, Financial Statement Schedules
(a) Documents filed as part of this report:
1. Financial Statements.
2. Schedules to Financial Statements.
All financial statement schedules have been omitted because they are either
inapplicable or the information required is provided in our Financial Statements
and Notes thereto, included in Part II, Item 8, of this Annual Report on Form
10-K.
73
3. Exhibits:
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)
10.8 Master Repurchase Agreement, dated as of January 18, 2008, between
Credit Suisse First Boston Mortgage Capital LLC and Chimera Investment
Corporation (filed as Exhibit 10.1 to the Company's Current Report on
Form 8-K filed on January 24, 2008 and incorporated herein by
reference)
10.9 Master Repurchase Agreement, dated as of January 31, 2008, among DB
Structured Products, Inc., Deutsche Bank Securities Inc., and Chimera
Investment Corp. (filed as Exhibit 10.1 to the Company's Current
Report on Form 8-K filed on February 4, 2008 and incorporated herein
by reference)
10.10 Amendment No. 1, dated as of March 14, 2008, to the Master Repurchase
Agreement, dated as of January 31, 2008, among DB Structured Products,
Inc., Deutsche Bank Securities Inc., and Chimera Investment Corp.
(filed as Exhibit 10.1 to the Company's Current Report on Form 8-K
filed on March 19, 2008 and incorporated herein by reference)
10.11 Amendment No. 2, dated as of March 26, 2008, to the Master Repurchase
Agreement, dated as of January 31, 2008, among DB Structured Products,
Inc., Deutsche Bank Securities Inc., and Chimera Investment Corp.
(filed as Exhibit 10.1 to the Company's Current Report on Form 8-K
filed on March 26, 2008 and incorporated herein by reference)
23.3 Consent of Independent Registered Public Accounting Firm.
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.
74
Exhibit Description
Number
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.
75
CHIMERA INVESTMENT CORPORATION
FINANCIAL STATEMENTS
Report of Independent Registered Public Accounting Firm F-2
Consolidated Financial Statements for the year ended December 31, 2008
and the period ended December 31, 2007
Consolidated Statements of Financial Condition F-3
Consolidated Statements of Operations and Comprehensive Loss F-4
Consolidated Statements of Stockholders' Equity F-5
Consolidated Statements of Cash Flows F-6
Notes to Consolidated Financial Statements F-7
F-1
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
Chimera Investment Corporation
New York, New York
We have audited the accompanying consolidated statements of financial condition
of Chimera Investment Corporation and its subsidiary (the "Company") as of
December 31, 2008 and 2007, and the related consolidated statements of
operations and comprehensive income (loss), stockholders' equity, and cash flows
for the year ended December 31, 2008 and the period from November 21, 2007 (date
operations commenced) to December 31, 2007. We also have audited the Company's
internal control over financial reporting as of December 31, 2008, based on
criteria established in Internal Control -- Integrated Framework issued by the
Committee of Sponsoring Organizations of the Treadway Commission. The Company's
management is responsible for these financial statements, for maintaining
effective internal control over financial reporting, and for its assessment of
the effectiveness of internal control over financial reporting, included in the
accompanying Management's Annual Report On Internal Control Over Financial
Reporting at Item 9A. Our responsibility is to express an opinion on these
financial statements and an opinion on the Company's internal control over
financial reporting based on our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement and whether effective internal
control over financial reporting was maintained in all material respects. Our
audits of the financial statements included examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements, assessing
the accounting principles used and significant estimates made by management, and
evaluating the overall financial statement presentation. Our audit of internal
control over financial reporting included obtaining an understanding of internal
control over financial reporting, assessing the risk that a material weakness
exists, and testing and evaluating the design and operating effectiveness of
internal control based on the assessed risk. Our audits also included performing
such other procedures as we considered necessary in the circumstances. We
believe that our audits provide a reasonable basis for our opinions.
A company's internal control over financial reporting is a process designed by,
or under the supervision of, the company's principal executive and principal
financial officers, or persons performing similar functions, and effected by the
company's board of directors, management, and other personnel to provide
reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance with
generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that (1) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company's
assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial
reporting, including the possibility of collusion or improper management
override of controls, material misstatements due to error or fraud may not be
prevented or detected on a timely basis. Also, projections of any evaluation of
the effectiveness of the internal control over financial reporting to future
periods are subject to the risk that the controls may become inadequate because
of changes in conditions, or that the degree of compliance with the policies or
procedures may deteriorate.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Chimera Investment
Corporation and its subsidiary as of December 31, 2008 and 2007, and the results
of their operations and their cash flows for the year ended December 31, 2008
and the period from November 21, 2007 (date operations commenced) to December
31, 2007, in conformity with accounting principles generally accepted in the
United States of America. Also, in our opinion, the Company maintained, in all
material respects, effective internal control over financial reporting as of
December 31, 2008, based on the criteria established in Internal Control --
Integrated Framework issued by the Committee of Sponsoring Organizations of the
Treadway Commission.
/s/ DELOITTE & TOUCHE LLP
New York, New York
February 27, 2009
F-2
CHIMERA INVESTMENT CORPORATION
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(dollars in thousands)
December 31, December 31,
2008 2007
----------- -----------
ASSETS
Cash and cash equivalents $ 27,480 $ 6,026
Restricted cash -- 1,350
Residential Mortgage-Backed Securities, at fair value 855,467 1,124,290
Mortgage loans held for investment, net of allowance for loan
losses of $0 and $81
thousand, respectively -- 162,371
Securitized loans held for investment, net of allowance for
loan losses of
$1.6 million and $0, respectively 583,346 --
Reverse repurchase agreements -- 265,000
Accrued interest receivable 9,951 6,036
Other assets 1,257 563
----------- -----------
Total assets $ 1,477,501 $ 1,565,636
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Repurchase agreements $ 562,119 $ 270,584
Securitized debt 488,743 --
Payable for investments purchased -- 748,920
Accrued interest payable 2,465 415
Dividends payable 7,040 943
Accounts payable and other liabilities 2,679 1,729
Interest rate swaps, at fair value -- 4,156
----------- -----------
Total liabilities 1,063,046 1,026,747
----------- -----------
Commitments and Contingencies (Note 14)
Stockholders' Equity:
Common stock: par value $.01 per share; 500,000,000 shares
authorized, 177,198,212 and 37,705,563 shares issued and
outstanding 1,760 377
Additional paid-in capital 831,966 532,208
Accumulated other comprehensive (loss) income (266,668) 10,153
Accumulated deficit (152,603) (3,849)
----------- -----------
Total stockholders' equity 414,455 538,889
----------- -----------
Total liabilities and stockholders' equity $ 1,477,501 $ 1,565,636
=========== ===========
See notes to consolidated financial statements.
F-3
CHIMERA INVESTMENT CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)
(dollars in thousands, except per share data)
For the Period
November 21,
For the Year 2007 to
Ended December December 31,
31, 2008 2007
------------ ------------
Interest income $ 105,259 $ 3,492
Interest expense 60,544 415
------------ ------------
Net interest income 44,715 3,077
------------ ------------
Unrealized gains (losses) on interest rate swaps 4,156 (4,156)
Realized losses on sales of investments (144,304) --
Realized losses on terminations of interest rate swaps (10,337) --
------------ ------------
Net investment expense (105,770) (1,079)
------------ ------------
Expenses
Management fee 8,428 1,217
General and administrative expenses 5,599 605
------------ ------------
Total expenses 14,027 1,822
------------ ------------
Loss before income taxes (119,797) (2,901)
Income tax expense 12 5
------------ ------------
Net loss ($ 119,809) ($ 2,906)
============ ============
Net loss per share - basic and diluted ($ 1.90) ($ 0.08)
============ ============
Weighted average number of shares outstanding - basic and
diluted 63,155,878 37,401,737
============ ============
Comprehensive (loss) income:
Net loss ($ 119,809) ($ 2,906)
------------ ------------
Other comprehensive (loss) income:
Unrealized (loss) gain on available-for-sale securities (421,125) 10,153
Reclassification adjustment for realized losses included in
income 144,304 --
------------ ------------
Other comprehensive (loss) income ($ 276,821) $ 10,153
------------ ------------
Comprehensive (loss) income ($ 396,630) $ 7,247
============ ============
See notes to consolidated financial statements.
F-4
CHIMERA INVESTMENT CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(dollars in thousands)
Accumulated
Common Additional Other
Stock Par Paid-in Comprehensive Accumulated
Value Capital Income Deficit Total
--------- --------- --------- --------- ---------
Balance, November 21, 2007
(date operations commenced) $ -- $ -- $ -- $ -- $ --
Net loss -- -- -- (2,906) (2,906)
Other comprehensive income -- -- 10,153 -- 10,153
Net proceeds from common
stock offerings 377 532,197 -- -- 532,574
Net proceeds from direct
purchases -- 11 -- -- 11
Common dividends declared,
$0.025 per share -- -- -- (943) (943)
----------------------------- --------- --------- --------- --------- ---------
Balance, December 31, 2007 $ 377 $ 532,208 $ 10,153 ($ 3,849) $ 538,889
----------------------------- --------- --------- --------- --------- ---------
Net loss -- -- -- (119,809) (119,809)
Other comprehensive loss -- -- (276,821) -- (276,821)
Net proceeds from common
stock offerings 1,382 298,202 -- -- 299,584
Net proceeds from direct
purchases -- 97 -- -- 97
Restricted stock grants 1 1,459 -- -- 1,460
Common dividends declared,
$0.62 per share -- -- (28,945) (28,945)
----------------------------- --------- --------- --------- --------- ---------
Balance, December 31, 2008 $ 1,760 $ 831,966 ($266,668) ($152,603) $ 414,455
============================= ========= ========= ========= ========= =========
See notes to consolidated financial statements.
F-5
CHIMERA INVESTMENT CORPORATION
CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands)
For the
Period
For the Year November 21,
Ended December to December
31, 2008 31, 2007
------------ ------------
Cash Flows From Operating Activities:
Net loss ($ 119,809) ($ 2,906)
Adjustments to reconcile net loss to net cash provided by
(used in) operating activities:
Amortization of investments 294 (98)
Unrealized (gains) losses on interest rate swaps (4,156) 4,156
Realized loss on sale of investments 144,304 --
Realized loss on termination of interest rate swaps (10,337) --
Allowance for loan losses 1,540 81
Restricted stock grants 1,460 --
Changes in operating assets
Increase in accrued interest receivable (5,613) (4,337)
Increase in other assets (694) (563)
Changes in operating liabilities
(Decrease) increase in accounts payable and other liabilities 950 1,729
Increase in accrued interest payable 2,050 415
------------ ------------
Net cash provided by (used in) operating activities 30,663 (1,523)
------------ ------------
Cash Flows From Investing Activities:
Residential mortgage-backed securities portfolio:
Purchases (1,483,416) (368,593)
Sales 567,455 --
Principal payments 174,449 1,788
Loans held for investment portfolio:
Purchases (735,271) (162,465)
Sales 90,732 --
Principal payments 23,115 --
Loans collateralizing debt
Purchases (111) --
Principal payments 40,714 --
Reverse repurchase agreements 265,000 (265,000)
Restricted cash 1,350 (1,350)
------------ ------------
Net cash used in investing activities (1,055,983) (795,620)
------------ ------------
Cash Flows From Financing Activities:
Net proceeds from reverse repurchase agreements 85,585,116 270,584
Net payments on reverse repurchase agreements (85,293,581) --
Net proceeds from common stock offerings 299,584 532,574
Net proceeds from securitized debt borrowing 526,716 --
Net payments on securitized debt borrowing (37,973) --
Net proceeds from direct purchases of common stock 97 11
Net payments on termination of interest rate swaps (10,337) --
Dividends paid (22,848) --
------------ ------------
Net cash provided by financing activities 1,046,774 803,169
------------ ------------
Net increase in cash and cash equivalents 21,454 6,026
Cash and cash equivalents at beginning of period 6,026 --
------------ ------------
Cash and cash equivalents at end of period $ 27,480 $ 6,026
============ ============
Supplemental disclosure of cash flow information
Interest paid $ 58,493 $ --
============ ============
Taxes paid $ 33 $ --
============ ============
Non cash investing activities
Payable for securities purchased $ -- $ 748,920
============ ============
Transfer from loans held for investment to securitization
trust $ 735,271 $ --
============ ============
Net change in unrealized (loss) gain on available for sale
securities ($ 276,821) $ 10,153
============ ============
Non cash financing activities
Dividends declared, not yet paid $ 7,040 $ 943
============ ============
See notes to consolidated financial statements
F-6
CHIMERA INVESTMENT CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS For the
Year Ended December 31, 2008 and the Period Ended December 31, 2007
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 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. During July 2008, the Company formed Chimera Securities
Holding, LLC, a wholly owned subsidiary. Chimera Securities Holding, LLC is a
qualified REIT subsidiary used to hold residential mortgage-backed securities
("RMBS") for certain of the Company's securitizations. Annaly Capital
Management, Inc., or Annaly, currently owns 8.6% of the Company's common shares.
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.
A summary of the Company's significant accounting policies follows:
Basis of Presentation
The consolidated financial statements include the accounts of the Company and
its wholly owned subsidiary, Chimera Securities Holding, LLC. All intercompany
balances and transactions have been eliminated.
Cash and Cash Equivalents
Cash and cash equivalents include cash in bank 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 via 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 consolidated statement of
financial condition. Reverse repurchase agreements are recorded at cost and are
collateralized by residential mortgage-backed securities, or RMBS.
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 by this
model to determine that prices are reflective of the current market. Management
performs a validation of the fair value calculated by this model 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 certain of 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. See
Note 5.
F-7
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. The Company
intends to hold 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 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 issuer 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
RMBS transactions are determined based on the specific identification method and
recorded as a gain (loss) on sale of available for sale securities in the
consolidated 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 consolidated statement of operations.
The current situation in the mortgage sector and the current weakness in the
broader credit markets 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 fail, 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.
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, but not limited to, 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 obtains 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 aided 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. The Company has created an
unallocated provision for possible loan losses estimated as a percentage of the
remaining principal on the loans. Management's estimate is based on historical
experience of similar underwritten pools.
When it is probable that contractually due specific amounts are deemed
uncollectible, the account 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. There were no losses specifically allocated to loans as of December 31,
2008 and 2007.
F-8
Securitized Debt
The Company has securitized debt to finance a portion of its residential
mortgage loan portfolio. The securitizations are 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
securitizations which are accounted for as financings under SFAS 140 are
recorded as an asset called "Securitized loans" and the corresponding debt as
"Securitized debt" in the consolidated statement of financial condition.
Fair Value Disclosure
SFAS No. 107, Disclosure About Fair Value of Financial Instruments, requires
disclosure of the fair value of financial instruments for which it is
practicable to estimate that value. The estimated fair value of mortgage backed
securities and interest rate swaps is equal to their carrying value presented in
the consolidated statements of financial condition. Securitized loans are
carried at amortized cost. The estimated fair value of cash and cash
equivalents, accrued interest receivable, reverse repurchase agreements,
repurchase agreements with maturities shorter than one year, payables for
mortgage-backed securities purchased, dividends payable, accounts payable, and
accrued interest payable, generally approximates cost as of December 31, 2008
and 2007 due to the short term nature of these financial instruments.
Interest Income
Interest income on RMBS 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, as amended by FSP Emerging Issues Task Force No.
99-20-1, 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 hedges interest rate risk through the use of derivative financial
instruments, currently interest rate swaps. The Company 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.
The Company accounts 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 consolidated statement of
financial condition and to measure those instruments at fair value.
Additionally, the fair value adjustments 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.
Credit Risk
The Company retains the risk of potential credit losses on all of the
residential mortgage loans it holds in its portfolio. Additionally, some of its
investments in RMBS may be qualifying interests for purposes of maintaining its
exemption from the 1940 Act if it retains a 100% ownership interest in the
underlying loans. If the Company purchases all classes of these securitizations,
it has the credit exposure on the underlying loans. It intends to mitigate the
risk of potential credit losses through its diligence in the asset selection
process.
Mortgage Loan Sales and Securitizations
The Company periodically enters into transactions in which it sells
financial assets such as RMBS, mortgage loans and other assets. Upon a transfer,
the Company sometimes retains or acquires senior or subordinated interests in
the related assets. In addition, the Company generally does not acquire
servicing rights for mortgage loans it purchases. Gains and losses on such
transactions are recognized using the guidance in SFAS No. 140," Accounting for
Transfers and Servicing of Financial Assets and Extinguishments of Liabilities-a
Replacement of FASB Statement No. 125" or SFAS No. 140, which is based on a
financial components approach that focuses on control. Under this approach,
after a transfer of financial assets, an entity recognizes the financial and
servicing assets it controls and the liabilities it has incurred, derecognizes
financial assets when control has been surrendered, and derecognizes liabilities
when extinguished. The gain or loss on sale is determined by allocating the
carrying value of the underlying mortgage loans between securities or loans sold
and the interests retained based on their fair values.
F-9
The Company determines the gain or loss on sale of mortgage loans by allocating
the carrying value of the underlying mortgage loans between securities or loans
sold and the interests retained based on their fair values. The gain or loss on
sale is the difference between the cash proceeds from the sale and the amount
allocated to the securities or loans sold.
From time to time, the Company may securitize loans held for investment. These
transactions are recorded in accordance with SFAS 140 Accounting for Transfers
and Servicing of Financial Assets and Extinguishment of Liabilities (SFAS 140)
and are accounted for as either a "sale" and the loans held for investment are
removed from the consolidated statements of financial condition or as a
"financing" and are classified as "Securitized loans held for investment" on the
Company's consolidated statements of financial condition, depending upon the
structure of the securitization transaction.
Income Taxes
The Company qualifies 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 consequences 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 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.
F-10
Use of Estimates
The preparation of the financial statements in conformity with generally
accepted accounting principles or (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.
Recent Accounting Pronouncements
In September 2006, the Financial Accounting Standards Board, or FASB, issued
SFAS No. 157, Fair Value Measurements, or 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 their financial instruments according to a fair value
hierarchy (i.e., levels 1, 2, and 3, as defined). Additionally, companies are
required to provide enhanced disclosure regarding instruments in the level 3
category (which require significant management judgment), including a
reconciliation of the beginning and ending balances separately for each major
category of assets and liabilities. SFAS 157 was adopted by the Company on
January 1, 2008. SFAS 157 did not significantly impact the manner in which
management estimates fair value, but it required additional disclosures, which
are included in Note 5.
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 its 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 February 2008, FASB issued FASB Staff Position No. SFAS 140-3 Accounting for
Transfers of Financial Assets and Repurchase Financing Transactions, ("FSP SFAS
140-3"). FSP SFAS 140-3 addresses whether transactions where assets purchased
from a particular counterparty and financed through a repurchase agreement with
the same counterparty can be considered and accounted for as separate
transactions, or are required to be considered "linked" transactions and may be
considered derivatives under SFAS 133 Accounting for Derivative Instruments and
Hedging Activities. FSP SFAS 140-3 requires purchases and subsequent financing
through repurchase agreements be considered linked transactions unless all of
the following conditions apply: (1) the initial purchase and the use of
repurchase agreements to finance the purchase are not contractually contingent
upon each other; (2) the repurchase financing entered into between the parties
provides full recourse to the transferee and the repurchase price is fixed; (3)
the financial assets are readily obtainable in the market; and (4) the financial
instrument and the repurchase agreement are not coterminous. This FSP is
effective for the Company on January 1, 2009. The Company is currently
evaluating FSP SFAS 140-3 but does not expect its application to have a
significant impact on its financial reporting.
In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative
Instruments and Hedging Activities, or SFAS 161, 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 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 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.
F-11
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. 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. The Company does not have any QSPEs at December 31, 2008 or December
31, 2007.
On December 11, 2008 the Financial Accounting Standard Board (FASB) issued a
staff position entitled FSP SFAS 140-4 and Fin 46(R)-8 (FSP). The FSP amends
both FASB Statement 140, Accounting for Transfers and Servicing of Financial
Assets and Extinguishments of Liabilities and FASB Interpretation No. 46
(revised December 2003), Consolidation of Variable Interest Entities, to require
public entities to provide additional disclosures about the transfer of
financial assets and involvement with variable interest entities (including
qualifying special purpose entities or QSPE), respectively. The intent of the
disclosure requirements is to provide greater transparency to financial
statement users about an enterprises continuing involvement with financial
assets after they have been transferred in a securitization or asset-backed
financing arrangement (SFAS 140); and to demonstrate how an enterprise's
involvement with a variable interest entity (VIE) affects its financial
position, financial performance and cash flows (FIN 46(R)). The Company
sponsored two securitizations during 2008. One was a transfer of financial
assets accounted for as a financing. The other was a transfer of assets which
was accounted for as a sale utilizing a QSPE. Additionally, the Company is
involved in asset-backed financing arrangements in the form of repurchase
agreements and reverse repurchase agreements; therefore it is directly affected
by the FSP. The implementation of this FSP will require additional disclosures
regarding the Company's assets and liabilities. This FSP is effective for the
first reporting period ending after December 15, 2008. Required disclosures
under FSP SFAS 140-4 and FIN 46(R)-8 have been incorporated into this Form 10-K.
In January, 2009, the FASB issued Emerging Issues Task Force (EITF) Staff
Position No EITF 99-20-01, "Amendments to the Impairment Guidance of EITF Issue
99-20". EITF 99-20-01 was issued in an effort to provide a more consistent
determination on whether an other-than-temporary impairment has occurred for
certain beneficial interests in securitized financial assets.
Other-than-temporary impairment has occurred if there has been an adverse change
in future estimated cash flow and its impact reflected in current earnings. The
determination cannot be overcome by management judgment of the probability of
collecting all cash flows previously projected. For debt securities that are not
within the scope of EITF 99-20-01, Statement 115 continues to apply. The
objective of other-than-temporary impairment analysis is to determine whether it
is probable that the holder will realize some portion of the unrealized loss on
an impaired security. Factors to consider when making an other-than-temporary
impairment decision include information about past events, current conditions,
reasonable and supportable forecasts, remaining payment terms, financial
condition of the issuer, expected defaults, value of underlying collateral,
industry analysis, sector credit rating, credit enhancement, and financial
condition of guarantor. This EITF became effective for the Company for December
31, 2008.
2. Mortgage-Backed Securities
The following table represents the Company's available for sale RMBS portfolio
as of December 31, 2008 and December 31, 2007 at fair value.
F-12
(dollars in thousands)
December 31, December 31,
2008 2007
----------- -----------
Mortgage-backed securities, $ 1,122,135 $ 1,114,137
gross
Gross unrealized gain 7,700 10,675
Gross unrealized loss (274,368) (522)
----------- -----------
Fair value $ 855,467 $ 1,124,290
=========== ===========
During the year ended December 31, 2008, the Company completed sales of RMBS
with a carrying value of $704.9 million which resulted in net realized losses of
approximately $137.4 million. The Company did not sell any RMBS during the
period from November 21, 2007 to December 31, 2007.
The following table presents the gross unrealized losses, and estimated fair
value of the Company's RMBS by length of time that such securities have been in
a continuous unrealized loss position at December 31, 2008 and December 31,
2007.
Unrealized Loss Position For:
-----------------------------------------------------------------------------------------------------
Less than 12 Months 12 Months or More Total
Estimated Unrealized Estimated Unrealized Estimated Unrealized
Fair Value Losses Fair Value Losses Fair Value Losses
-----------------------------------------------------------------------------------------------------
(dollars in thousands)
December 31, 2008 $ 855,467 ($274,368) $ - $ - $ 855,467 ($274,368)
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 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
mortgage-backed securities 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 mortgage-backed securities at
December 31, 2008 according to their weighted-average life classifications:
(dollars in thousands)
Weighted
Weighted Average Life Fair Value Amortized Cost Average Coupon
--------------------------- ---------------- ----------------- ----------------
Less than one year $ - $ - -
Greater than one year and
less than five years 768,163 975,835 6.05%
Greater than five years 87,304 146,300 6.56%
---------------- ----------------- ----------------
Total $855,467 $1,122,135 6.12%
================ ================= ================
The following table summarizes the Company's mortgage-backed securities at
December 31, 2007 according to their estimated weighted-average life
classifications:
(dollars in thousands)
Weighted
Weighted Average Life Fair Value Amortized Cost Average 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%
================ ================ =================
F-13
The weighted-average lives of the mortgage-backed securities as of December 31,
2008 and December 31, 2007 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 rate of
the outstanding loan, loan age, margin and volatility.
3. Loans Held for Investment
The Company did not have any loans held for investment as of December 31, 2008.
The following table represents the Company's residential mortgage loans
classified as held for investment at December 31, 2008 and December 31, 2007,
which are carried at their principal balance outstanding less an allowance for
loan losses:
December 31, 2008 December 31, 2007
------------------- -------------------
(dollars in thousands)
Mortgage loans, at principal balance $ - $162,452
outstanding
Less: allowance for loan losses - (81)
------------------- -------------------
Mortgage loans held for investment $ - $162,371
=================== ===================
During the year ended December 31, 2008, the Company completed sales of
residential mortgage loans with a carrying value of $97.7 million which resulted
in net realized losses of approximately $6.9 million. The Company did not sell
any residential mortgage loans during the period ended December 31, 2007.
The following table summarizes the changes in the allowance for loan losses for
the mortgage loan portfolio during the year ended December 31, 2008 and the
period ended December 31, 2007:
For the
Period
For the Year November
Ended 21, 2007 to
December 31, December
2008 31, 2007
--------------- -------------
(dollars in thousands)
Balance, beginning of period $ 81 $ -
Provision for loan losses (81) 81
Charge-offs - -
--------------- -------------
Balance, end of period $ - $81
=============== =============
On a quarterly basis, the Company evaluates the adequacy of its allowance for
loan losses. Based on this analysis, the Company recorded a provision for loan
losses of $80,745 for the period ended December 31, 2007, representing 5 basis
points of the Company's mortgage loan portfolio. At December 31, 2007, there
were no loans 90 days or more past due and all loans were accruing interest. The
Company did not have any loans held for investment as of December 31, 2008.
4. Securitized Loans Held for Investment
The following table represents the Company's securitized residential mortgage
loans classified as held for investment at December 31, 2008. The Company did
not hold any securitized loans at December 31, 2007. At December 31, 2008,
approximately 55.7% of the Company's securitized loans are adjustable rate
mortgage loans and 44.3% 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 ten years) and thereafter reset at regular intervals subject to
interest rate caps. The estimated fair value of the securitized loans held for
investment is $585.0 million at December 31, 2008. The loans held for investment
are carried at their principal balance outstanding less an allowance for loan
losses:
F-14
December 31, December 31,
2008 2007
-------- -----
(dollars in thousands)
Securitized mortgage loans, at principal balance $584,967 $ --
Less: allowance for loan losses 1,621 --
-------- -----
Securitized mortgage loans held for investment $583,346 $ --
======== =====
The following table summarizes the changes in the allowance for loan losses for
the securitized mortgage loan portfolio during the year ended December 31, 2008
and the period ended December 31, 2007:
December 31, December 31,
2008 2007
------ ----
(dollars in thousands)
Balance, beginning of period $ -- $ --
Provision for loan losses 1,621 --
Charge-offs -- --
------ ----
Balance, end of period $1,621 $ --
====== ====
On a quarterly basis, the Company evaluates the adequacy of its allowance for
loan losses. The Company recorded an allowance for loan losses of $1.6 million
for the year ended December 31, 2008, representing 28 basis points of the
principal balance of the Company's securitized mortgage loan portfolio. At
December 31, 2008, there were no loans more than 60 days past due and all loans
were accruing interest.
During the year ended December 31, 2008 the Company completed two
securitizations of loans held for investment in its residential mortgage loan
portfolio.
In the first transaction, 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 $1.3 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,
and the related loans held for investment were reclassified as securitized loans
held for investment on the consolidated statements of financial condition.
In the second transaction, the Company transferred $151.2 million of its
residential mortgage loans held for investment to the PHHMC 2008-CIM2 Trust in a
securitization transaction. In this transaction, the Company initially 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 and classified them as mortgage-backed securities, available
for sale on its consolidated statement of financial condition. There was no
value assigned to the residual interest. On August 28, 2008, the Company 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. This transaction was accounted for as a sale
pursuant to SFAS 140 and the related loans held for investment were derecognized
from the consolidated statements of financial condition. The Company has no
other continuing interests with the trust.
5. Fair Value Measurement
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 defines as follows:
Level 1- inputs to the valuation methodology are quoted prices (unadjusted)
for identical assets and liabilities in active markets.
Level 2- inputs to the valuation methodology include quoted prices for
similar assets and liabilities in active markets, and inputs that are
observable for the asset or liability, either directly or indirectly, for
substantially the full term of the financial instrument.
F-15
Level 3- inputs to the valuation methodology are unobservable and
significant to 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 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.
Any changes to the valuation methodology are reviewed by management to ensure
the changes are appropriate. As markets and products develop and the pricing for
certain products becomes more transparent, we continue to refine our valuation
methodologies. The methods used may produce a fair value calculation that may
not be indicative of net realizable value or reflective of future fair values.
Furthermore, while the Company believes its valuation methods are appropriate
and consistent with other market participants, the use of different
methodologies, or assumptions, to determine the fair value of certain financial
instruments could result in a different estimate of fair value at the reporting
date. The Company uses inputs that are current as of the measurement date, which
may include periods of market dislocation, during which price transparency may
be reduced.
As of December 31, 2008, the Company has classified its RMBS as "Level 2".
The Company's financial assets and liabilities carried at fair value on a
recurring basis are valued at December 31, 2008 as follows:
Level 1 Level 2 Level 3
---------------- -------------------- --------------------
(dollars in thousands)
Assets:
Mortgage-Backed $ - $855,467 $ -
Securities
The following is a summary of changes in balance sheet line items measured using
Level 3 inputs:
Year Ended December 31, 2008
--------------------------------------------------------------------------------
RMBS
----------------
(dollars in
thousands)
Assets:
Balance December 31, 2007 $ -
Total (losses) gains
Included in earnings -
Included in other comprehensive income ($ 3,920)
Purchase, issuances and settlements Transfers to RMBS:
Level 2 $ 5,167
Level 3 ($ 5,167)
----------------
Balance December 31, 2008 $ -
================
Changes in unrealized (losses) gains relating to assets
still held at December 31, 2008 $ -
================
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 to level 3 when the
Company is unable to obtain third party pricing verification. The Company had
classified certain securities that are subordinate pieces of its non-agency
portfolio initially as level 3 assets. However, due to the subsequent
availability of market prices and quotes for these assets, the assets were
transferred to level 2.
F-16
6. Repurchase Agreements
Residential Mortgage-Backed Securities
--------------------------------------
The Company had outstanding $562.1 million and $270.6 million of RMBS repurchase
agreements with weighted average borrowing rates of 1.43% and 5.02% and weighted
average remaining maturities of 2 days and 22 days as of December 31, 2008 and
December 31, 2007, respectively. Investment securities pledged as collateral
under these repurchase agreements had an estimated fair value of $680.8 million
and $271.7 million at December 31, 2008 and December 31, 2007, respectively. The
interest rates of these repurchase agreements are generally indexed to the
one-month LIBOR rate and reprice accordingly.
At December 31, 2008 and 2007, the repurchase agreements all had the following
remaining maturities:
December 31, December 31,
2008 2007
------------- -------------
(dollars in thousands)
Within 30 days $562,119 $270,584
30 to 59 days - -
60 to 89 days - -
90 to 119 days - -
Greater than or equal to 120 days - -
------------- -------------
Total $562,119 $270,584
============= =============
At December 31, 2008 the Company had an amount at risk of approximately 29% of
its equity with Annaly Capital Management, Inc., an affiliate. At December 31,
2007 the Company did not have an amount at risk of greater than 10% of the
equity of the Company with any counterparty.
Loans Held for Investment
-------------------------
The Company entered into two master repurchase agreements pursuant under which
it financed mortgage loans. One agreement was a $500 million lending facility of
which $200 million is on an uncommitted basis. This agreement was due to
terminate January 16, 2009. The second agreement was a $350 million committed
lending facility. This agreement was due to terminate January 29, 2010. On July
29, 2008, the Company terminated both lending facilities. On December 31, 2008
and December 31, 2007, the Company did not have any amounts borrowed against
these facilities.
Market Risk
-----------
Currently the mortgage sector is experiencing unprecedented losses and there is
weakness in the broader mortgage market that has increased volatility in market
valuation of investments and the availability of credit which may 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 it with additional
financing. This could potentially increase the Company's financing costs and
reduce liquidity. If one or more major market participants fail, it could
negatively impact the marketability of all fixed income securities and 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 it with additional financing, the Company
could be forced to sell its investments at an inopportune time when prices are
depressed.
F-17
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 consolidated statement of financial condition.
The following table presents the estimated principal repayment schedule
of the securitized debt held in bankruptcy remote entities outstanding at
December 31, 2008.
Greater
One to Three to Than or
Within One Three Five Equal to
Year Years Years Five Years Total
-------------- ----------- ---------- ------------ ------------
(dollars in thousands)
Securitized debt $ 65,561 $112,745 $ 85,955 $246,534 $ 510,795
-------------- ----------- ---------- ------------ ------------
Total $654,171 $155,439 $117,920 $338,659 $1,266,189
============== =========== ========== ============ ============
Maturities of the Company's securitized debt are dependent upon cash flows
received from the underlying loans receivable. The estimate of their repayment
is based on scheduled principal payments on the underlying loans receivable.
This estimate will differ from actual amounts to the extent prepayments and/or
loan losses are experienced.
The following table presents the carrying amount and estimated fair value of the
Company's securitized debt at December 31, 2008.
Carrying Amount Estimated Fair
Value
------------------------------------ ----------------- ----------------
Securitized debt $488,743 $510,796
----------------- ----------------
Total $488,743 $510,796
================= ================
As of December 31, 2008 the Company had no off balance sheet credit risk.
At December 31, 2008, securitized debt collateralized by residential mortgage
loans had a principal balance of $488.7 million. The debt matures between the
years 2023 and 2038. At December 31, 2008, the debt carried a weighted average
cost of financing equal to 5.55% of which approximately 44% of the remaining
principal balance is a fixed rate at 5.65% and 66% of the remaining principal
balance is a variable rate of 6.33%. 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 may hedge a portion of its interest rate risk by entering into
derivative financial instrument contracts. Typically such instruments are
comprised of interest rate swaps, which in effect modify the cash flows on
repurchase agreements. The use of interest rate swaps creates exposure to credit
risk relating to potential losses that could be recognized if the counterparties
to these instruments fail to perform their obligations under the contracts. In
the event of a default by the counterparty, the Company could have difficulty
obtaining its RMBS pledged as collateral for swaps. The Company's swaps are used
to lock-in the fixed rate related to a portion of its current and anticipated
future 30-day term repurchase agreements. The Company accounts for interest rate
swaps as freestanding derivatives with changes in fair value recorded in
earnings. During the year, the Company terminated all of its interest rate swaps
for a net realized loss of $10.3 million. As of December 31, 2008, the Company
had no interest rate swaps outstanding. As of December 31, 2007, the Company had
$1.2 million in notional interest rate swaps which paid a fixed rate and
received a floating rate indexed to one month LIBOR.
The table below represents the Company's interest rate swaps outstanding:
F-18
Notional Amount Weighted Average Weighted Average Net Estimated Fair
Pay Rate Receive Rate Value/Carrying Value
------------------- ----------------- ------------------- ------------------- ---------------------
(dollars in thousands)
December 31, 2008 $ - - - -
December 31, 2007 $1,235,000 4.04% 4.94% ($4,156)
9. Common Stock
The Company's charter provides that it may issue up to 550,000,000 shares of
stock, consisting of up to 500,000,000 shares of common stock having a par value
of $0.01 per share and up to 50,000,000 shares of preferred stock having a par
value of $0.01 per share.
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 gross proceeds of
approximately $247.5 million. Immediately following the sale of these shares,
Annaly 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 $37.1 million. The Company's total net proceeds from
these offerings to be approximately $299.6 million.
During the year ended December 31, 2008, the Company declared dividends to
common shareholders totaling $28.9 million or $0.62 per share.
10. Long Term Incentive Plan
The Company has adopted a long term stock incentive plan to provide incentives
to its independent directors, 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 14,175,857 shares, up to a ceiling of 40,000,000
shares.
As of December 31, 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, 140,900 shares vested and 17,880 shares were
forfeited or cancelled during the year ended December 31, 2008. At December 31,
2008, the Company had outstanding 1,160,100 shares of unvested restricted common
stock. 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.
A summary of the status of the Company's non-vested shares as of December
31, 2008, and changes during the year ended December 31, 2008, is presented
below:
Weighted Average
Non-vested Shares Grant Date Fair Value
---------------------------------- --------------------- -----------------------
Non-vested at January 1, 2008 - $ -
Granted 1,301,000 $17.72
Vested 140,900 $11.65
Forfeited 17,880 $10.15
---------------------
Non-vested at December 31, 2008 1,160,100 $17.72
=====================
As of December 31, 2008, there was $20.6 million of total unrecognized
compensation cost related to non-vested share-based compensation arrangements
granted under the long term incentive plan. That cost is expected to be
recognized over a weighted-average period of 9 years. The total fair value of
shares vested during the year ended December 31, 2008 was $1.6 million. There
were no shares that vested during the period November 21, 2007 to December 31,
2007.
F-19
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 year
ended December 31, 2008 and the period November 21, 2007 to December 31, 2007,
the Company recorded $12,431 and $4,960 of income tax expense related to state
and federal tax liabilities on undistributed income, respectively for an
effective tax rate of 0%.
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 borrowings under 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 pays 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. Management fees
paid to FIDAC for the year ended December 31, 2008 and period ended December 31,
2007 were $8.4 million and $1.2 million, respectively.
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 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). FIDAC has waived its
right to request reimbursement from the Company of these expenses until such
time as it determines to rescind that waiver. The Company was required to
reimburse FIDAC for all costs FIDAC paid on behalf of the Company incurred in
connection with the formation, organization and initial public offering of the
Company, which amounted to $697,947.
During the year ended December 31, 2008, 140,900 shares of restricted stock
issued by the Company to FIDAC's employees vested, as discussed in Note 10.
F-20
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 December 31, 2008, the Company
was borrowing $562.1 million under this repurchase 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 December 31, 2008.
15. Summarized Quarterly Results (Unaudited)
The following is a presentation of the results of operations for the year ended
December 31, 2008 and the period November 21, 2007 (commencement of operations)
to December 31, 2007.
For the Period
For the Quarter November 21, 2007
For the Quarter Ended September For the Quarter For the Quarter (date operations
Ended December 31, 30, 2008 Ended June 30, Ended March 31, commenced) through
2008 (unaudited) (unaudited) 2008 (unaudited) 2008 (unaudited) December 31, 2007 (1)
--------------- --------------- -------------- -------------- ---------------
Interest income $ 23,656 $ 23,458 $ 29,951 $ 28,194 $ 3,492
Interest expense 10,954 15,543 20,025 14,022 415
--------------- --------------- -------------- -------------- ---------------
Net interest income 12,702 7,915 9,926 14,172 3,077
--------------- --------------- -------------- -------------- ---------------
Unrealized gains (losses) on
Interest rate swaps -- 10,065 25,584 (31,493) (4,156)
Realized gains (losses) on
sales of investments -- (113,130) 1,644 (32,819) --
Realized gains (losses) on
terminations of interest rate
swaps -- (10,460) 123 -- --
--------------- --------------- -------------- -------------- ---------------
Net investment income
(expense) 12,702 (105,610) 37,277 (50,140) (1,079)
--------------- --------------- -------------- -------------- ---------------
Expenses
Management fee 2,292 1,681 2,228 2,227 1,217
General and administrative
expenses 1,626 253 1,152 2,565 605
--------------- --------------- -------------- -------------- ---------------
Total expenses 3,918 1,934 3,380 4,792 1,822
--------------- --------------- -------------- -------------- ---------------
Income (loss) before
income taxes 8,784 (107,544) 33,897 (54,932) (2,901)
--------------- --------------- -------------- -------------- ---------------
Income tax (3) 12 -- 3 5
--------------- --------------- -------------- -------------- ---------------
Net income (loss) $ 8,787 ($ 107,556) $ 33,897 ($ 54,935) ($ 2,906)
=============== =============== ============== ============== ===============
Net income (loss) per share
- basic and diluted $ 0.07 ($ 2.76) $ 0.87 ($ 1.46) ($ 0.08)
=============== =============== ============== ============== ===============
Weighted average number
of shares outstanding -
basic and diluted 135,115,190 38,992,893 38,999,850 37,744,486 37,401,737
=============== =============== ============== ============== ===============
Net income (loss) $ 8,787 ($ 107,556) $ 33,897 ($ 54,935) ($ 2,906)
--------------- --------------- -------------- -------------- ---------------
Other comprehensive (loss) income:
Unrealized (loss) gain on
available-for-sale securities (128,361) (146,456) (58,051) (88,257) 10,153
Reclassification adjustment
for realized (gains) losses
included in income -- 113,130 (1,644) 32,819 --
--------------- --------------- -------------- -------------- ---------------
Other comprehensive (loss) (128,361) (33,326) (59,695) (55,438) 10,153
income
--------------- --------------- -------------- -------------- ---------------
Comprehensive (loss) income ($ 119,574) ($ 140,882) ($ 25,798) ($ 110,373) $ 7,247
=============== =============== ============== ============== ===============
(1) Derived from the audited financial statements at December 31, 2007.
F-21
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
February 27, 2009
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the date indicated.
Signatures Title Date
---------- ----- ----
Chief Executive Officer, President,
and Director (Principal Executive
/s/ Matthew Lambiase Officer) February 27, 2009
-------------------------
Matthew Lambiase
Chief Financial Officer (Principal
/s/ A. Alexandra Denahan Financial and Accounting Officer) February 27, 2009
-------------------------
A. Alexandra Denahan
/s/ Jeremy Diamond Director February 27, 2009
-------------------------
Jeremy Diamond
/s/ Mark Abrams Director February 27, 2009
-------------------------
Mark Abrams
/s/ Paul A. Keenan Director February 27, 2009
-------------------------
Paul A. Keenan
/s/ Paul Donlin Director February 27, 2009
-------------------------
Paul Donlin
S-1