UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED: MARCH 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 (IRS Employer Identification No.)
of incorporation or organization)
1211 AVENUE OF THE AMERICAS, SUITE 2902
NEW YORK, NEW YORK
(Address of principal executive offices)
10036
(Zip Code)
(212) 696-0100
(Registrant's telephone number, including area code)
Indicate by check mark whether the Registrant (1) has filed all documents and
reports required to be filed by Section 13 or 15(d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days:
Yes X No
--- ---
Indicate by check mark whether the Registrant is a large accelerated filer, an
accelerated filer, non-accelerated filer, or a smaller reporting company. See
definition of "accelerated filer," "large accelerated filer," and "smaller
reporting company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer | | Accelerated filer | | Non-accelerated filer |X| Smaller reporting company | |
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). Yes | | No |X|
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the last practicable date:
Class Outstanding at May 14, 2008
Common Stock, $.01 par value 37,772,450
CHIMERA INVESTMENT CORPORATION
FORM 10-Q
TABLE OF CONTENTS
Part I. FINANCIAL INFORMATION
Item 1. Financial Statements:
Statements of Financial Condition at March 31, 2008 1
(Unaudited) and December 31, 2007 (Derived from the
audited financial statements at December 31, 2007)
Statements of Operations and Comprehensive Income (Loss) 2
(Unaudited) for the Quarter Ended March 31, 2008 and the
period from November 21, 2007 to December 31, 2007 (Derived
from the audited financial statements at December, 31,
2007)
Statement of Stockholders' Equity for the Quarter Ended 3
March 31, 2008 (Unaudited)
Statements of Cash Flows for the Quarter Ended March 31, 4
2008 (Unaudited) and the period from November 21, 2007 to
December 31, 2007 (Derived from the audited financial
statements at December 31, 2007)
Notes to Financial Statements (Unaudited) 6
Item 2. Management's Discussion and Analysis of Financial Condition 17
and Results of Operations
Item 3. Quantitative and Qualitative Disclosures about Market Risk 35
Item 4. Controls and Procedures 39
Part II. OTHER INFORMATION
Item 1. Legal Proceedings 40
Item 1A. Risk Factors 40
Item 6. Exhibits 41
SIGNATURES 42
CERTIFICATIONS 43
i
PART I.
ITEM 1. FINANCIAL STATEMENTS
CHIMERA INVESTMENT CORPORATION
STATEMENTS OF FINANCIAL CONDITION
(dollars in thousands, except per share data)
March 31, 2008 December 31,
(unaudited) 2007(1)
------------------ ----------------
ASSETS
------
Cash and cash equivalents $ 91,370 $ 6,026
Restricted cash 102,834 1,350
Reverse repurchase agreements - 265,000
Mortgage-Backed Securities, at fair value 1,229,780 1,124,290
Loans held for investment, net of allowance for loan losses of $1.3
million and $81 thousand, respectively 361,594 162,371
Receivable for investments sold 113,581 -
Accrued interest receivable 9,993 6,036
Other assets 892 563
------------------ ----------------
Total assets $ 1,910,044 $ 1,565,636
================== ================
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Liabilities:
Repurchase agreements $ 1,439,534 $ 270,584
Payable for investments purchased - 748,920
Accrued interest payable 3,207 415
Dividends payable 9,814 943
Accounts payable and other liabilities 2,528 1,729
Interest rate swaps 35,649 4,156
------------------ ----------------
Total liabilities 1,490,732 1,026,747
------------------ ----------------
Commitments and Contingencies (Note 12)
Stockholders' Equity:
Common stock: par value $.01 per share; 500,000,000 shares
authorized, 37,744,918 and 37,705,563 shares issued and outstanding,
respectively 377 377
Additional paid-in capital 532,818 532,208
Accumulated other comprehensive (loss) income (45,285) 10,153
Accumulated deficit (68,598) (3,849)
------------------ ----------------
Total stockholders' equity 419,312 538,889
------------------ ----------------
Total liabilities and stockholders' equity $ 1,910,044 $ 1,565,636
================== ================
(1) Derived from the audited financial statements at December 31, 2007.
See notes to financial statements.
1
CHIMERA INVESTMENT CORPORATION
STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)
(dollars in thousands, except per share data)
For the Period
For the Quarter November 21,
Ended March 2007 through
31, 2008 December 31,
(unaudited) 2007(1)
----------------- -----------------
Interest income $ 28,194 $ 3,492
Interest expense 14,022 415
----------------- -----------------
Net interest income 14,172 3,077
----------------- -----------------
Unrealized losses on interest rate swaps (31,493) (4,156)
Realized losses on sales of investments (32,819) -
----------------- -----------------
Net investment expense (50,140) (1,079)
----------------- -----------------
Other expenses
Management fee 2,227 1,217
General and administrative expenses 2,565 605
----------------- -----------------
Total expenses 4,792 1,822
----------------- -----------------
Loss before income taxes (54,932) (2,901)
Income taxes 3 5
----------------- -----------------
Net loss $ (54,935) $ (2,906)
================= =================
Net loss per share - basic and diluted $ (1.46) $ (0.08)
================= =================
Weighted average number of shares outstanding - basic and
diluted 37,744,486 37,401,737
================= =================
Comprehensive Income (Loss):
Net loss $ (54,935) $ (2,906)
Other comprehensive (loss) income:
Unrealized (loss) gain on available-for-sale securities (88,257) 10,153
Reclassification adjustment for realized losses included
in net income 32,819 -
----------------- -----------------
Other comprehensive (loss) income (55,438) 10,153
----------------- -----------------
Comprehensive (loss) income $ (110,373) $ 7,247
================= =================
(1) Derived from the audited financial statements at December 31, 2007.
See notes to financial statements.
2
CHIMERA INVESTMENT CORPORATION
STATEMENT OF STOCKHOLDERS' EQUITY
(dollars in thousands, except per share data)
(unaudited)
Accumulated
Common Other
Stock Par Additional Comprehensive Accumulated
Value Paid-in Capital Income (Loss) Deficit Total
--------------------------------------------------------------------------------------------------------------------------
Balance, January 1, 2008 $ 377 $ 532,208 $ 10,153 $ (3,849) $ 538,889
Net loss - - - (54,935) (54,935)
Other comprehensive (loss) income - - (55,438) - (55,438)
Costs associated with common
stock offering - (87) - - (87)
Restricted stock grants - 697 - - 697
Common dividends declared, $0.26
per share - - - (9,814) (9,814)
---------------------------------------------------------------------------------
Balance, March 31, 2008 $ 377 $ 532,818 $ (45,285) $ (68,598) $ 419,312
=================================================================================
See notes to financial statements.
3
CHIMERA INVESTMENT CORPORATION
STATEMENTS OF CASH FLOWS
(dollars in thousands)
For the For the Period
Quarter Ended November 21,
March 31, 2007 Through
2008 December 31,
(unaudited) 2007(1)
-------------------------------------
Cash Flows From Operating Activities:
Net loss $ (54,935) $ (2,906)
Adjustments to reconcile net loss to net cash provided by operating
activities:
Amortization of investment premiums and discounts (615) (98)
Unrealized losses on interest rate swaps 31,493 4,156
Realized losses on sale of investments 32,819 -
Allowance for loan losses 1,179 81
Restricted stock grants 697 -
Changes in operating assets
Increase in accrued interest receivable (5,871) (4,337)
Increase in other assets (329) (563)
Changes in operating liabilities
Increase in accounts payable 837 1,437
Increase in accrued interest payable 2,792 415
(Decrease)/increase in other liabilities (38) 292
----------------- ----------------
Net cash provided by/(used in) operating activities 8,029 (1,523)
----------------- ----------------
Cash Flows From Investing Activities:
Mortgage-Backed securities portfolio:
Purchases (1,228,572) (368,593)
Sales 248,014 -
Principal payments 49,190 1,788
Loans held for investment portfolio:
Purchases (329,610) (162,465)
Principal payments 6,857 -
Reverse repurchase agreements 265,000 (265,000)
Restricted cash (101,484) (1,350)
----------------- ----------------
Net cash used in investing activities (1,090,605) (795,620)
----------------- ----------------
Cash Flows From Financing Activities:
Net proceeds from repurchase agreements 5,448,193 270,584
Net payments on repurchase agreements (4,279,243) -
Costs associated with/net proceeds from common stock offerings (87) 532,574
Net proceeds from direct purchases of common stock - 11
Dividends paid (943) -
----------------- ----------------
Net cash provided by financing activities 1,167,920 803,169
----------------- ----------------
Net increase in cash and cash equivalents 85,344 6,026
Cash and cash equivalents at beginning of period 6,026 -
----------------- ----------------
Cash and cash equivalents at end of period $ 91,370 $ 6,026
================= ================
Supplemental disclosure of cash flow information
Interest paid $ 11,230 $ -
================= ================
Taxes paid $ 45 $ -
4
Non cash investing activities
Receivable for investments sold $ 113,581 $ -
================= ================
Payable for investments purchased $ - $ 748,920
================= ================
Net change in unrealized gain on available for sale securities $ (55,438) $ 10,153
================= ================
Non cash financing activities
Dividends declared, not yet paid $ 9,814 $ 943
================= ================
(1) Derived from the audited financial statements at December 31, 2007.
See notes to financial statements.
5
CHIMERA INVESTMENT CORPORATION
NOTES TO FINANCIAL STATEMENTS
FOR THE QUARTER ENDED MARCH 31, 2008
(unaudited)
--------------------------------------------------------------------------------
1. Organization and Significant Accounting Policies
Chimera Investment Corporation, or the Company, was organized in Maryland on
June 1, 2007. The Company commenced operations on November 21, 2007 when it
completed its initial public offering. The Company has elected to be taxed as a
real estate investment trust, or REIT, under the Internal Revenue Code of 1986,
as amended. As such, the Company is required to distribute substantially all of
the income generated from its operations to its stockholders. As long as the
Company qualifies as a REIT, the Company will generally not be subject to U.S.
federal or state corporate taxes on its income to the extent that the Company
distributes at least 90% of its taxable net income to its stockholders. The
Company is managed by Fixed Income Discount Advisory Company, or FIDAC, an
investment advisor registered with the Securities and Exchange Commission. FIDAC
is a wholly-owned subsidiary of Annaly Capital Management, Inc., or Annaly.
A summary of the Company's significant accounting policies follows:
Cash and Cash Equivalents
Cash and cash equivalents include cash on hand and money market funds.
Restricted Cash
Restricted cash includes cash held by counterparties as collateral for
repurchase agreements and interest rate swaps.
Reverse Repurchase Agreements
The Company may invest its daily available cash balances 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 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 calculated
using a pricing model. Management will review the fair values generated to
determine prices are reflective of the current market. Management performs a
validation of the fair value calculated by the pricing model by comparing its
results to independent prices provided by dealers in the securities and/or third
party pricing services. If dealers or independent pricing services are unable to
provide a price for an asset, or if the price provided by them is deemed
unreliable by FIDAC, then the asset will be valued at its fair value as
determined in good faith by FIDAC. In the current market, it may be difficult or
impossible to obtain third party pricing on the investments the Company
purchases. In addition, validating third party pricing for the Company's
investments may be more subjective as fewer participants may be willing to
provide this service to the Company. Moreover, the current market is more
illiquid than in recent history for some of the investments the Company
purchases. Illiquid investments typically experience greater price volatility as
a ready market does not exist. As volatility increases or liquidity decreases,
the Company may have greater difficulty financing its investments which may
negatively impact its earnings and the execution of its investment strategy.
Please see Note 4 for a discussion of fair value measurement.
Statement of Financial Accounting Standards, or SFAS, No. 115, Accounting for
Certain Investments in Debt and Equity Securities, requires the Company to
classify its investment securities as either trading investments,
available-for-sale investments or held-to-maturity investments. 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.
6
Management evaluates investment securities for other-than-temporary impairment
at least on a quarterly basis, and more frequently when economic or market
concerns warrant such evaluation. Consideration is given to (1) the length of
time and the extent to which the fair value has been lower than carrying value,
(2) the financial condition and near-term prospects of the issuer, (3) credit
quality and cash flow performance of the security, and (4) the intent and
ability of the Company to retain its investment in the security for a period of
time sufficient to allow for any anticipated recovery in fair value. Unrealized
losses on investment securities that are considered other than temporary, as
measured by the amount of decline in fair value attributable to
other-than-temporary factors, are recognized in income and the cost basis of the
investment securities is adjusted.
RMBS transactions are recorded on the trade date. Realized gains and losses from
sales of RMBS are determined based on the specific identification method and
recorded as a gain (loss) on sale of investments in the statement of operations.
Accretion of discounts or amortization of premiums on available-for-sale
securities and mortgage loans is computed using the effective interest yield
method and is included as a component of interest income in the statement of
operations.
Loans Held for Investment
The Company's residential mortgage loans are comprised of fixed-rate and
variable-rate loans. The Company purchases pools of residential mortgage loans
through a select group of originators. Mortgage loans are designated as held for
investment, recorded on trade date, and are carried at their principal balance
outstanding, plus any premiums or discounts which are amortized or accreted over
the estimated life of the loan, less allowances for loan losses. Loans are
evaluated for possible credit losses. The Company has created an unallocated
provision for loan losses estimated as a percentage of the remaining principal
on the loans. Management's estimate is based on historical experience of
similarly underwritten loan pools. There were no allocated losses as of March
31, 2008 or December 31, 2007.
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 obtained written representations and warranties from the sellers that
the Company could be reimbursed for the value of the loan if the loan fails to
meet the agreed upon origination standards. While the Company has little history
of its own to establish loan trends, delinquency trends of the originators and
the current market conditions aid in determining the allowance for loan losses.
The Company also performed due diligence procedures on a sample of loans that
met its criteria during the purchase process.
When it is probable that 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.
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 investment
securities and interest rate swaps is equal to their carrying value presented in
the consolidated statements of financial condition. 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 the
dates presented due to the short term nature of these financial instruments. The
estimated fair value of residential mortgage loans approximates carrying value
less an allowance for loan losses. The fair value of repurchase agreements with
longer dated maturities is generally approximated by cost as the loans reprice
frequently to market rates.
7
Interest Income
Interest income on available-for-sale securities and loans held for investment
is recognized over the life of the investment using the effective interest
method. Interest income on available for sale securities and loans held for
investment is recognized using the effective interest method as described by
SFAS No. 91, Accounting for Nonrefundable Fees and Costs Associated with
Originating or Acquiring Loans and Initial Direct Costs of Leases, for
securities of high credit quality and Emerging Issues Task Force No. 99-20,
Recognition of Interest Income and Impairment on Purchased and Retained
Beneficial Interests in Securitized Financial Assets, for all other securities.
Income recognition is suspended for loans when, in the opinion of management, a
full recovery of income and principal becomes doubtful. Income recognition is
resumed when the loan becomes contractually current and performance is
demonstrated to be resumed.
Derivative Financial Instruments/Hedging Activity
The Company economically hedges interest rate risk through the use of derivative
financial instruments, currently limited to interest rate swaps. The Company
accounts for these interest rate swaps as free-standing derivatives.
Accordingly, they are carried at fair value with realized and unrealized gains
and losses recognized in earnings.
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 consequence for those differences, which will either be taxable
or deductible when the assets and liabilities are recovered or settled. Deferred
taxes are also recognized for operating losses that are available to offset
future taxable income. Valuation allowances are established when necessary to
reduce deferred tax assets to the amount expected to be realized. In July 2006,
the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income
Taxes, an interpretation of FASB Statement No. 109 ("FIN 48"). FIN 48 clarifies
the accounting for uncertainty in income taxes recognized in a company's
financial statements and prescribes a recognition threshold and measurement
attribute for the financial statement recognition and measurement of a tax
position taken or expected to be taken in an income tax return. FIN 48 also
provides guidance on de-recognition, classification, interest and penalties,
accounting in interim periods, disclosure and transition. FIN 48 was effective
for the Company upon inception and its effect was not material for the quarter
ended March 31, 2008.
Net Income per Share
The Company calculates basic net income per share by dividing net income for the
period by weighted-average shares of its common stock outstanding for that
period. Diluted net income 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 are recognized over the vesting
period of such grants based on the estimated fair value on the grant date.
8
Stock compensation awards granted to the employees of FIDAC are accounted for in
accordance with EITF 96-18, Accounting For Equity Instruments That Are Issued to
Other Than Employees for Acquiring, or in Conjunction with Selling, Goods and
Services, which requires the Company to measure the fair value of the equity
instrument using the stock prices and other measurement assumptions as of the
earlier of either the date at which a performance commitment by the counterparty
is reached or the date at which the counterparty's performance is complete.
Use of Estimates
The preparation of the financial statements in conformity with accounting
principles generally accepted in the United States, 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 requires additional disclosures, which
are included in Note 4.
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. FAS 140-3 Accounting for
Transfers of Financial Assets and Repurchase Financing Transactions, or FSP FAS
140-3. FSP FAS 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 No. 133, Accounting for Derivative Instruments and
Hedging Activities, or SFAS 133. FSP FAS 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 is 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 FAS 140-3 but does not expect its application to have a
significant impact on its financial reporting.
2. Residential Mortgage-Backed Securities
The following table represents the Company's available for sale RMBS portfolio
as of March 31, 2008 and December 31, 2007 at fair value.
March 31, December 31,
2008 2007
--------------------------------------------------------------------------------
(dollars in thousands)
Mortgage-Backed securities, at amortized cost $1,275,065 $1,114,137
Gross unrealized gain - 10,675
Gross unrealized loss (45,285) (522)
-------------------------------
Fair value $1,229,780 $1,124,290
===============================
9
The following table presents the gross unrealized losses, and estimated fair
value of the Company's Mortgage-Backed Securities by length of time that such
securities have been in a continuous unrealized loss position at March 31, 2008.
Unrealized Loss Position For:
-------------------------------------------------------------------------------------------------------------------
Less than 12 Months 12 Months or More Total
-------------------------------------------------------------------------------------------------------------------
Estimated Fair Unrealized Estimated Fair Unrealized Estimated Fair Unrealized
Value Losses Value Losses Value Losses
-------------------------------------------------------------------------------------------------------------------
(dollars in thousands)
$1,229,780 ($45,285) $ - $ - $1,229,780 ($45,285)
The decline in value of these securities is solely due to market conditions and
not the quality of the assets. All of the Mortgage-Backed Securities are "AAA"
rated or carry an implied "AAA" rating. The investments are not considered
other-than-temporarily impaired because the Company currently has the ability
and intent to hold the investments to maturity or for a period of time
sufficient for a forecasted market price recovery up to or beyond the cost of
the investments.
Actual maturities of mortgage-backed securities are generally shorter than
stated contractual maturities. Actual maturities of the Company's RMBS are
affected by the contractual lives of the underlying mortgages, periodic payments
of principal and prepayments of principal.
The following table summarizes the Company's RMBS at March 31, 2008 and December
31, 2007 according to their estimated weighted-average life classifications:
March 31, 2008
(dollars in thousands)
Weighted Average
Weighted Average Life Fair Value Amortized Cost Coupon
-----------------------------------------------------------------------------------------------
Less than one year - - -
Greater than one year and
less than five years $1,229,780 $1,275,065 6.27%
Greater than five years - - -
--------------------------------------------------------------
Total $1,229,780 $1,275,065 6.27%
==============================================================
December 31, 2007
(dollars in thousands)
Weighted Average
Weighted Average Life Fair Value Amortized Cost Coupon
-----------------------------------------------------------------------------------------------
Less than one year $45,868 $46,102 6.31%
Greater than one year and
less than five years 1,078,422 1,068,035 6.32%
Greater than five years - - -
--------------------------------------------------------------
Total $1,124,290 $1,114,137 6.32%
==============================================================
The weighted-average lives of the mortgage-backed securities in the tables above
are based on data provided through dealer quotes, assuming constant prepayment
rates to the balloon or reset date for each security. The prepayment model
considers current yield, forward yield, steepness of the curve, current mortgage
rates, mortgage rates of the outstanding loan, loan age, margin and volatility.
10
During the three months ended March 31, 2008, the Company sold RMBS with a
carrying value of $272.3 million for proceeds of $248.0 million realizing a loss
of $24.3 million. The Company did not sell any RMBS during the period ended
December 31, 2007.
3. Loans Held for Investment
The following table represents the Company's residential mortgage loans
classified as held for investment at March 31, 2008 and December 31, 2007. At
March 31, 2008 approximately 10.7% of the Company's investments are adjustable
rate mortgage loans and 11.2% are fixed rate mortgage loans. All of the
adjustable rate loans held for investment are hybrid ARMs. Hybrid ARMs are
mortgages that have interest rates that are fixed for an initial period
(typically three, five, seven or 10 years) and thereafter reset at regular
intervals subject to interest rate caps. The loans held for investment are
carried at their principal balance outstanding less an allowance for loan
losses:
March 31, December 31,
2008 2007
---------------------------------------------------------------------------------------
(dollars in thousands)
Mortgage loans, at principal balance $362,854 $162,452
Less: allowance for loan losses (1,260) (81)
--------------------------------
Mortgage loans held for investment $361,594 $162,371
================================
The following table summarizes the changes in the allowance for loan losses for
the mortgage loan portfolio during the periods ended March 31, 2008 and December
31, 2007:
March 31, December 31,
2008 2007
--------------------------------------------------------------------
(dollars in thousands)
Balance, beginning of period $ 81 $ -
Provision for loan losses 1,179 81
Charge-offs - -
---------------------------------
Balance, end of period $1,260 $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 $1.2 million for the quarter ended March 31, 2008, representing 33
basis points of the Company's mortgage loan portfolio. For the period ended
December 31, 2007, the Company recorded a provision for loan losses of $81
thousand representing 5 basis points of the Company's mortgage loan portfolio.
At March 31, 2008, there were no loans 60 days or more past due and all loans
were accruing interest.
The geographic distribution of the Company's loans held for investment at March
31, 2008 was as follows:
(dollars in thousands)
------------------------------------------------------------------------------
Unpaid Principal
State Number of Loans Balance
------------------------------------------------------------------------------
CA 172 $124,804
NJ 42 26,121
NY 31 21,215
FL 30 19,671
IL 21 17,587
WA 24 14,888
AZ 19 12,901
VA 23 12,632
TX 21 12,218
CO 15 10,714
GA 13 9,266
11
MD 15 8,773
MA 14 8,703
CT 9 7,521
MI 7 6,576
NC 7 4,225
DC 6 4,124
Other states, individually
less than 1% of
aggregate current
balance 58 36,589
Unamortized premium 3,393
Provision for loan losses (1,260)
----------------------
Total* $360,661
======================
*Total varies from Statements of Financial Position due to repayment of
residential mortgage loans sold.
During the three months ended March 31, 2008, the Company sold residential
mortgage loans with a carrying value of $121.9 million for proceeds of $113.4
million realizing a loss of $8.6 million. The Company did not sell any mortgage
loans during the period ended December 31, 2007.
4. 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 defined as follow:
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 pay 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 reasonableness. The dealer quotes will incorporate common
market pricing methods, including a spread measurement to the Treasury curve or
interest rate swap curve as well as underlying characteristics of the particular
security including coupon, periodic and life caps, rate reset period, issuer,
additional credit support and expected life of the security. The Company's
financial assets and liabilities carried at fair value on a recurring basis are
valued as follows:
Level 1 Level 2 Level 3
(dollars in thousands)
-------------------------------------------------------------------------------------------------------
Assets:
Mortgage-Backed Securities $ - $ 1,229,780 $ -
Liabilities:
Interest Rate Swaps $ - $ 35,649 $ -
12
5. Repurchase Agreements
(A) Mortgage-Backed Securities
The Company had outstanding $1.0 billion and $270.6 million of repurchase
agreements with weighted average borrowing rates of 4.78% and 5.02% and weighted
average remaining maturities of 54 and 22 days as of March 31, 2008 and December
31, 2007 respectively. At March 31, 2008, RMBS pledged as collateral under these
repurchase agreements had an estimated fair value of $1.1 billion, carrying
value of $1.0 billion, including accrued interest, and cash totaling $67.7
million. At December 31, 2007, RMBS pledged as collateral had an estimated fair
value of $271.7 million. The interest rates of these repurchase agreements are
generally indexed to the one-month LIBOR rate and reprice accordingly.
At March 31, 2008 and December 31, 2007, the repurchase agreements
collateralized by RMBS had the following remaining maturities:
March 31, December 31,
2008 2007
--------------------------------
(dollars in thousands)
Within 30 days $598,168 $270,584
30 to 59 days 384,964 -
60 to 89 days - -
90 to 119 days - -
Greater than or equal to 120 days 24,514 -
--------------------------------
Total $1,007,646 $270,584
================================
(B) Loans Held for Investment
The Company has entered into two master repurchase agreements pursuant to which
it finances mortgage loans. One agreement is a $500 million lending facility of
which $200 million is on an uncommitted basis. This agreement terminates January
16, 2009. The second agreement is a $350 million committed lending facility.
This agreement terminates January 29, 2010. Repurchase agreements for whole
mortgage loans contain negative covenants requiring the Company to maintain
certain levels of net asset value, tangible net worth and available funds and
comply with interest coverage ratios, leverage ratios and distribution
limitations. As of March 31, 2008, the Company had $487.0 million borrowed
against these facilities which included $55.2 million of RMBS at an effective
rate of 4.41%. The amount borrowed on the loans held for investment at March 31,
2008 was collateralized by mortgage loans with a carrying value of $433.3
million, including accrued interest, and cash totaling $35.2 million. During the
quarter, the Company amended one of its financing agreements twice. These
facilities have covenants that are standard for industry practice and the
Company was in compliance with all such covenants at March 31, 2008.
At March 31, 2008, the repurchase agreements collateralized by mortgage loans
had the following remaining maturities:
March 31, 2008
------------------------
(dollars in thousands)
Within 30 days $ -
30 to 59 days -
60 to 89 days -
90 to 119 days -
Greater than or equal to 120 days 431,888
------------------------
Total $431,888
------------------------
The average days to maturity on the Company's mortgage loans held for investment
is 399 days. At December 31, 2007 there were no borrowings outstanding.
13
The Company had an amount at risk equal to 15% of our equity of with Bear
Stearns and 11% of our equity with Credit Suisse as of March 31, 2008. At
December 31, 2007 we did not have an amount at risk greater than 10% of equity
with any counterparty.
Currently the sub-prime 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.
6. Interest Rate Swaps
In connection with the Company's interest rate risk management strategy, the
Company economically hedges a portion of its interest rate risk by entering into
derivative financial instrument contracts. As of March 31, 2008, such
instruments are comprised of interest rate swaps, which in effect modify the
cash flows on repurchase agreements. 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.
The table below represents the Company's swaps outstanding at March 31, 2008:
(dollars in thousands)
Weighted Average Pay Weighted Average Receive Net Estimated Fair
Notional Amount Rate Rate Value/Carrying Value
--------------------------------------------------------------------------------------------------------------------------
$1,626,377 3.78% 2.66% ($35,649)
7. Common Stock
During the quarter ended March 31, 2008, the Company declared dividends to
common shareholders totaling $9.8 million or $0.26 per share, which were paid on
April 30, 2008.
8. 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 its common
stock, or 3,019,593 shares, up to a ceiling of 40,000,000 shares.
During the quarter ended March 31, 2008, the Company granted restricted stock
awards in the amount of 1,301,000 shares to FIDAC's employees and the Company's
independent directors. 39,355 shares of restricted stock vested during the
quarter ended March 31, 2008. 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. The Company did not grant any incentive awards during the
period ending December 31, 2007.
At March 31, 2008 there are approximately 1.3 million unvested shares of
restricted stock issued to employees of FIDAC. For the three months ended March
31, 2008, compensation expense less general and administrative costs associated
with the amortization of the fair value of the restricted stock totaled $697
thousand.
14
9. Income Taxes
As a REIT, the Company is not subject to Federal income tax on earnings
distributed to its shareholders. Most states recognize REIT status as well. The
Company has decided to distribute the majority of its income. During the quarter
ended March 31, 2008, the Company recorded $2,813 of income tax expense related
to state and federal tax liabilities on undistributed income for an effective
tax rate of .01%.
10. 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 and residential
mortgage loans. 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.
11. 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. FIDAC is also
entitled to a quarterly incentive fee equal to 20% of the dollar amount by which
Core Earnings (as defined in the management agreement) on a rolling four-quarter
basis and before the incentive management fee, exceeds the product of (1) the
weighted average of the issue price per share of all of our public offerings
multiplied by the weighted average number of shares of common stock outstanding
in such quarter and (2) 0.50% plus one-fourth of the average of the one month
LIBOR rate for such quarter and the previous three quarters. For the initial
four quarters following the Company's initial public offering, Core Earnings and
the LIBOR rate will be calculated on the basis of each of the previously
completed quarters on an annualized basis. Core Earnings and LIBOR rate for the
initial quarter will each be calculated from the settlement date of the offering
on an annualized basis. At March 31, 2008 quarterly management fees in the
amount of $2.2 million were accrued and $2.3 million was payable to FIDAC. At
December 31, 2007 quarterly management fees in the amount of $1.2 million were
accrued and payable to FIDAC.
The Company is obligated to reimburse FIDAC for its costs incurred under the
management agreement. In addition, the management agreement permits FIDAC to
require the Company to pay for its pro rata portion of rent, telephone,
utilities, office furniture, equipment, machinery and other office, internal and
overhead expenses of FIDAC incurred in the operation of the Company. These
expenses are allocated between FIDAC and the Company based on the ratio of the
Company's proportion of gross assets compared to all remaining gross assets
managed by FIDAC as calculated at each quarter end. FIDAC and the Company will
modify this allocation methodology, subject to the Company's board of directors'
approval if the allocation becomes inequitable (i.e., if the Company becomes
very highly leveraged compared to FIDAC's other funds and accounts). For the
quarter ending March 31, 2008, FIDAC has waived its right to request
reimbursement from the Company for these expenses.
During the quarter ended March 31, 2008, the Company issued shares of restricted
stock to FIDAC's employees, as discussed in Note 8.
15
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 contained in such agreements. As of
March 31, 2008, the Company did not have any outstanding obligations under
either agreement.
12. 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 March 31, 2008.
13. Subsequent Events
On April 24, 2008 the Company completed a $619.7 million securitization, a
long-term financing transaction whereby it securitized its then-current
inventory of mortgage loans. In this transaction, the Company sold approximately
$536.9 million of AAA-rated fixed and floating rate bonds to third party
investors, and retained approximately $46.3 million of AAA-rated mezzanine bonds
and $36.5 million in subordinated bonds. This transaction will be accounted for
as a financing transaction pursuant to SFAS 140, Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities.
16
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
-------------------------------------------------------------------------
RESULTS OF OPERATIONS
---------------------
Special Note Regarding Forward-Looking Statements
We make forward-looking statements in this report that are subject to
risks and uncertainties. These forward-looking statements include information
about possible or assumed future results of our business, financial condition,
liquidity, results of operations, plans and objectives. When we use the words
"believe," "expect," "anticipate," "estimate," "plan," "continue," "intend,"
"should," "may," "would," "will" or similar expressions, we intend to identify
forward-looking statements. Statements regarding the following subjects, among
others, are forward-looking by their nature:
o our business and investment strategy;
o our projected operating results;
o our ability to obtain future financing arrangements;
o general volatility of the securities markets in which we invest;
o our expected 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 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 changes in governmental regulations, tax law and rates 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.
The forward-looking statements are based on our beliefs, assumptions
and expectations of our future performance, taking into account all information
currently available to us. You should not place undue reliance on these
forward-looking statements. These beliefs, assumptions and expectations can
change as a result of many possible events or factors, not all of which are
known to us. Some of these factors are described under the caption "Risk
Factors" in our most recent Annual Report on Form 10-K and any subsequent
Quarterly Reports on Form 10-Q. If a change occurs, our business, financial
condition, liquidity and results of operations may vary materially from those
expressed in our forward-looking statements. Any forward-looking statement
speaks only as of the date on which it is made. New risks and uncertainties
arise from time to time, and it is impossible for us to predict those events or
how they may affect us. Except as required by law, we are not obligated to, and
do not intend to, update or revise any forward-looking statements, whether as a
result of new information, future events or otherwise.
17
Executive Summary
We are a specialty finance company that invests in residential mortgage
loans, residential mortgage-backed securities, real estate related securities
and various other asset classes. We are externally managed by FIDAC. We intend
to elect and qualify to be taxed as a REIT for federal income tax purposes. Our
targeted asset classes and the principal investments we expect to make in each
are as follows:
o Whole mortgage loans, consisting of:
o Prime mortgage loans
o Jumbo prime mortgage loans
o Alt-A mortgage loans
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 Asset Backed Securities, or ABS, consisting of:
o Debt and equity tranches of CDOs
o CMBS
o Consumer and non-consumer ABS, including investment-grade and
non-investment grade classes, including the BB-rated, B-rated and
non-rated classes
We completed our initial public offering on November 21, 2007. In that
offering and in a concurrent private offering we raised net proceeds before
offering expenses of approximately $533.6 million. We have commenced investing
these proceeds, and as of March 31, 2008, have a portfolio of RMBS and whole
mortgage loans of approximately $1.6 billion.
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.
Our investment strategy is intended to take advantage of opportunities
in the current interest rate and credit environment. We will adjust our strategy
to changing market conditions by shifting our asset allocations across these
various asset classes as interest rate and credit cycles change over time. We
believe that our strategy, combined with FIDAC's experience, will enable us to
pay dividends and achieve capital appreciation throughout changing market
cycles. We expect to take a long-term view of assets and liabilities, and our
reported earnings and mark-to-market valuations at the end of a financial
reporting period will not significantly impact our objective of providing
attractive risk-adjusted returns to our stockholders over the long-term.
We use leverage to seek to increase our potential returns and to fund
the acquisition of our assets. Our income is generated primarily by the
difference, or net spread, between the income we earn on our assets and the cost
of our borrowings. We expect to finance our investments using a variety of
financing sources including repurchase agreements, warehouse facilities,
securitizations, commercial paper and term financing CDOs. We expect 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.
18
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 we expected to finance our investments. These instruments included
repurchase agreements, warehouse facilities, securitizations, asset-backed
commercial paper 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 available but
at a high cost, and some are 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 greater margin requirements than previously offered. It was also an
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 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.
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 as well as entered into agreements to purchase whole mortgage loans. We
believed we were purchasing high credit quality assets which we were readily
able to finance.
Beginning mid-February 2008, credit markets experienced a dramatic and
sudden adverse change. The severity of the liquidity limitation 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 non-Agency RMBS. Prices of these types of
securities dropped dramatically, and lenders started lowering the prices on
non-agency mortgage bonds that they held as collateral versus their loans. The
subsequent failure of a major investment bank worsened the crisis.
Like every other participant in the financial markets, we have not been
immune to these problems. We have met all margin calls we have received. Sudden
declines in the valuation of investments can impair liquidity and make it more
difficult to meet future margin calls. To provide flexibility during this market
disruption we have amended one of our financing agreements twice to ease
liquidity covenants. We are currently and to date have been in compliance with
all provisions of our financing agreements.
Subsequent to March 31, 2008, non-Agency RMBS and whole mortgage loan
valuations remain volatile and under severe pressure. 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 protect
our liquidity.
On April 24, 2008 the we completed a $619.7 million securitization, a
long-term financing transaction whereby we securitized its then-current
inventory of mortgage loans. In this transaction, we sold approximately $536.9
million of AAA-rated fixed and floating rate bonds to third party investors, and
retained approximately $46.3 million of AAA-rated mezzanine bonds and $36.5
million in subordinated bonds.
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.
19
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 one-month LIBOR.
Hybrid ARMs are mortgages that have interest rates that are fixed for an initial
period (typically three, five, seven or 10 years) and thereafter reset at
regular intervals subject to interest rate caps.
With respect to our floating rate investments, such interest rate
increases should result in increases in our net investment income because our
floating rate assets are greater in amount than the related floating rate
liabilities. Similarly, such an increase in interest rates should generally
result in an increase in our net investment income on fixed-rate investments
made by us because our fixed-rate assets would be greater in amount than our
fixed-rate liabilities. We expect, however, that our fixed-rate assets would
decline in value in a rising interest rate environment and that our net interest
spreads on fixed rate assets could decline in a rising interest rate environment
to the extent such assets are financed with floating rate debt.
Credit Risk. One of our strategic focuses is on 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, borrower's 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. While the current situation in the sub-prime
mortgage sector may provide us opportunities, the current weakness in the
broader mortgage market 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. In general, this could potentially increase
our financing costs and reduce our liquidity. 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.
20
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
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 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 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 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, 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 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 accounting
principles generally accepted in the United States of America. These accounting
principles may require us to make some complex and subjective decisions and
assessments. Our most critical accounting policies will involve decisions and
assessments that could affect our reported assets and liabilities, as well as
our reported revenues and expenses. We believe that all of the decisions and
assessments upon which our financial statements 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 market value using a pricing
model. We validate our pricing model by obtaining independent pricing on all of
our assets and performing a verification of those sources to our own internal
estimate of fair market value. We have identified what we believe will be our
most critical accounting policies to be the following:
Recent Accounting Pronouncements
On January 1, 2008, we adopted 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 follow:
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 reasonableness. 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 in the future.
Loans Held for Investment
We purchase residential mortgage loans and classify them as loans held
for investment on the 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
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.
21
When we determine that it is probable that contractually due specific
amounts are deemed uncollectable, the loan is considered impaired. To measure
our impairment we determine the excess of the recorded investment amount over
the net fair value of the collateral, as reduced by selling costs. Any
deficiency between the carrying amount of an asset and the net sales price of
repossessed collateral is charged to the allowance for loan losses.
An allowance for mortgage loans is maintained at a level believed
adequate by management to absorb probable losses. We may elect to sell a loan
held for investment due to adverse changes in credit fundamentals. Once the
determination has been made by us that we will no longer hold the loan for
investment, we will account for the loan at the lower of amortized cost or
estimated fair value. The reclassification of the loan and recognition of
impairments could adversely affect our reported earnings.
Valuations of Available-for-Sale Securities
We expect our investments in RMBS will be primarily classified as
available-for-sale securities that are carried on the statement of financial
condition at their fair value. This classification will result in changes in
fair values being recorded as adjustments to accumulated other comprehensive
income or loss, which is a component of stockholders' equity.
Our available-for-sale securities have fair values as determined with
reference to fair values calculated using a pricing model. Management reviews
the fair values generated to insure prices are reflective of the current market.
We perform a validation of the fair value calculated by the pricing model by
comparing its results to independent prices provided by dealers in the
securities and/or third party pricing services. If dealers or independent
pricing services are unable to provide a price for an asset, or if the price
provided by them is deemed unreliable by FIDAC, then the asset will be valued at
its fair value as determined in good faith by FIDAC. The pricing is subject to
various assumptions which could result in different presentations of value.
When the fair value of an available-for-sale security is less than its
amortized cost for an extended period, we consider whether there is an
other-than-temporary impairment in the value of the security. If, based on our
analysis, an other-than-temporary impairment exists, the cost basis of the
security is written down to the then-current fair value, and the unrealized loss
is transferred from accumulated other comprehensive loss as an immediate
reduction of current earnings (as if the loss had been realized in the period of
other-than-temporary impairment). The determination of other-than-temporary
impairment is a subjective process, and different judgments and assumptions
could affect the timing of loss realization.
We consider the following factors when determining an
other-than-temporary impairment for a security:
o The length of time and the extent to which the market value has been less
than the amortized cost;
o Whether the security has been downgraded by a rating agency; and
o Our intent to hold the security for a period of time sufficient to allow
for any anticipated recovery in market value.
The determination of other-than-temporary impairment is made at least
quarterly. If we determine an impairment to be other than temporary we will
realize a loss which will negatively impact current income.
Investment Consolidation
For each investment we make, we will evaluate the underlying entity
that issued the securities we will acquire or to which we will make a loan to
determine the appropriate accounting. We will 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.
22
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. Interest income on available for sale securities and loans held
for investment is recognized using the effective interest method as described by
SFAS No. 91, Accounting for Nonrefundable Fees and Costs Associated with
Originating or Acquiring Loans and Initial Direct Costs of Leases, for
securities of high credit quality and Emerging Issues Task Force No. 99-20,
Recognition of Interest Income and Impairment on Purchased and Retained
Beneficial Interests in Securitized Financial Assets, for all other securities.
Income recognition is suspended for loans when, in the opinion of management, a
full recovery of income and principal becomes doubtful. Income recognition is
resumed when the loan becomes contractually current and performance is
demonstrated to be resumed.
Under SFAS No. 91 and Emerging Issues Task Force No. 99-20, management
will estimate, at the time of purchase, the future expected cash flows and
determine the effective interest rate based on these estimated cash flows and
our purchase price. As needed, these estimated cash flows will be updated and a
revised yield computed based on the current amortized cost of the investment. In
estimating these cash flows, there will be a number of assumptions that will be
subject to uncertainties and contingencies. These include the rate and timing of
principal payments (including prepayments, repurchases, defaults and
liquidations), the pass-through or coupon rate and interest rate fluctuations.
In addition, interest payment shortfalls due to delinquencies on the underlying
mortgage loans, and the timing of the magnitude of credit losses on the mortgage
loans underlying the securities have to be judgmentally estimated. These
uncertainties and contingencies are difficult to predict and are subject to
future events that may impact management's estimates and our interest income.
Accounting For Derivative Financial Instruments
Our policies permit us to enter into derivative contracts, including
interest rate swaps and interest rate caps, as a means of mitigating our
interest rate risk. We intend to use interest rate derivative instruments to
mitigate interest rate risk rather than to enhance returns.
We account for derivative financial instruments in accordance with SFAS
No. 133, Accounting for Derivative Instruments and Hedging Activities, as
amended and interpreted. SFAS No. 133 requires an entity to recognize all
derivatives as either assets or liabilities in the statement of financial
condition and to measure those instruments at fair value. Additionally, the fair
value adjustments will affect either other comprehensive income in stockholders'
equity until the hedged item is recognized in earnings or net income depending
on whether the derivative instrument qualifies as a hedge for accounting
purposes and, if so, the nature of the hedging activity.
In the normal course of business, we may 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 included in net
income for each period until the derivative instrument matures or is settled.
Any derivative instrument used for risk management that does not meet the
hedging criteria is carried at fair value with the changes in value included in
net income.
Derivatives will be used for hedging purposes rather than speculation.
We will rely on quotations from third parties to determine fair values. If our
hedging activities do not achieve our desired results, our reported earnings may
be adversely affected.
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.
23
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.
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.
Financial Condition
At March 31, 2008, our portfolio consisted of $1.2 billion of RMBS and of
approximately $361.6 million of whole mortgage loans.
The following table summarizes certain characteristics of our portfolio at March
31, 2008 and December 31, 2007.
March 31, December 31,
2008 2007
------------------------------------------------------------------------------------------------------------------
Leverage at period-end 3.4:1 0.5:1
Adjustable-rate mortgage-backed securities as % of portfolio 74.0% 81.8%
Fixed-rate mortgage-backed securities as % of portfolio 4.1% 5.7%
Adjustable-rate residential mortgage loans as % of portfolio 10.7% 3.8%
Fixed-rate residential mortgage loans as % of portfolio 11.2% 8.7%
Annualized yield on average earning assets during the period 6.63% 7.02%
Annualized cost of funds on average repurchase balance during the period 4.23% 5.08%
Annualized interest rate spread during the period 2.40% 1.94%
Weighted average yield on assets at period-end 6.32% 6.62%
Weighted average cost of funds at period-end 4.67% 5.02%
Residential Mortgage-Backed Securities Characteristics
24
The table below summarizes our RMBS investments at March 31, 2008 and
December 31, 2007:
March 31, December 31,
2008 2007
(dollars in thousands)
--------------------------------------------------------------------------------
Amortized cost $1,275,065 $1,114,137
Unrealized gains - 10,675
Unrealized losses (45,285) (522)
---------------------------------------
Fair value $1,229,780 $1,124,290
=======================================
As of March 31, 2008, the RMBS in our portfolio were purchased at a net
discount to their par value. Our RMBS had a weighted average amortized cost of
99.4 and 98.8 at March 31, 2008 and December 31, 2007, respectively.
The following tables summarize certain characteristics of our RMBS
portfolio at March 31, 2008 and December 31, 2007.
Weighted Averages
Estimated Value Constant
(dollars in Yield to Prepayment
thousands) (1) Coupon Maturity Rate(2)
-------------------------------------------------------------------------------------------
March 31, 2008 $1,229,780 6.27% 6.53% 11%
December 31, 2007 $1,124,290 6.32% 6.87% 10%
(1) All assets listed in this chart are carried at their fair value.
(2) Represents the estimated percentage of principal that will be prepaid over
the next three months based on historical principal paydowns.
The table below summarizes the credit ratings of our RMBS investments at March
31, 2008 and December 31, 2007:
March 31, December 31,
2008 2007
----------------------------------
AAA 100.00% 100.00%
AA - -
A - -
BBB - -
BB - -
B - -
Not rated - -
----------------------------------
Total 100.00% 100.00%
==================================
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 40 years, but the expected maturity is subject to change
based on the prepayments of the underlying loans. As of March 31, 2008, the
average final contractual maturity of the RMBS portfolio is 31 years, and as of
December 31, 2007, it was 29 years. The estimated weighted average months to
maturity of the RMBS in the tables below are based upon our prepayment
expectations, which are based on both proprietary and subscription-based
financial models. Our prepayment projections consider current and expected
trends in interest rates, interest rate volatility, steepness of the yield
curve, the mortgage rate of the outstanding loan, time to reset and the spread
margin of the reset.
The constant prepayment rate, or CPR, reflects the percentage of
principal that was prepaid over the prior 3 months. 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.
25
After the reset date, interest rates on our hybrid adjustable rate RMBS
securities adjust annually based on spreads over various LIBOR and Treasury
indices. These interest rates are subject to caps that limit the amount the
applicable interest rate can increase during any year, known as periodic cap,
and through the maturity of the applicable security, known as a lifetime cap.
The weighted average periodic cap for the portfolio is an increase of 1.93% and
the weighted average maximum lifetime increases and decreases for the portfolio
are 12.18%.
The following table summarizes our RMBS according to their estimated
weighted average life classifications as of March 31, 2008 and December 31,
2007:
Fair Value
March 31, December 31,
2008 2007
(dollars in thousands)
----------------------------------
Less than one year $ - $ 45,868
Greater than one year and less than five years 1,229,780 1,078,422
Greater than or equal to five years - -
----------------------------------
Total $1,229,780 $1,124,290
==================================
Whole Mortgage Loan Portfolio Characteristics
The following tables present certain characteristics of our whole
mortgage loan portfolio as of March 31, 2008.
(dollars in thousands)
------------------------------------------------------------------
Original loan balance $367,640
Unpaid principal balance $358,528
Weighted average coupon rate on loans 6.11%
Weighted average original term (years) 29.1
Weighted average remaining term (years) 28.8
Geographic Distribution Remaining Balance
Top 5 States (dollars in thousands) % of Loan Portfolio Loan Count
---------------------------------------------------------------------------------------------------
CA $124,804 34.81% 172
NJ 26,121 7.29% 42
NY 21,215 5.92% 31
FL 19,671 5.49% 30
IL 17,587 4.91% 21
--------------------------------------------------------------------
Total $209,398 58.42% 296
====================================================================
Remaining
Balance % of % of
(dollars in Loan Loan Loan
Occupancy Status thousands) Portfolio Count Loan Purpose Portfolio
---------------------------------------------------------- ------------------------------------------
Owner occupied $321,064 89.55% 471 Purchase 72.53%
Second home 31,467 8.78% 42 Cash out refinance 15.47%
Investor 5,997 1.67% 14 Rate and term refinance 12.00%
---------------------------------- ----------
Total $358,528 100.00% 527 100.00%
================================== ==========
26
% of
% of Loan ARM
Documentation Type Portfolio ARM Loan Type Loans
-------------------------------------------------- --------------------------------------------
Full/alternative 83.16% Traditional ARM loans -
Stated income/no ratio 16.84% Hybrid ARM loans 100.00%
------------ ------------
Total 100.00% Total 100.00%
============ ============
Dollars in % of Loan
Unpaid Principal Balance Thousands FICO Score Portfolio
-------------------------------------------------- -----------------------------------------------
$417,000 or less $ 3,950 740 and above 64.10%
$417,001 to $650,000 154,704 700 to 739 23.02%
$650,001 to $1,000,000 131,208 660 to 699 9.61%
$1,000,001 to $2,000,000 66,235 620 to 659 2.15%
$2,000,001 to $3,000,000 2,431 Below 620 or not available 1.12%
---------------
Over $3,000,001 - Total 100.00%
------------------ ===============
Total $358,528
==================
Weighted Average FICO Score 752
Original Loan to Value Dollars in % of Loan
Ratio Thousands Property Type Portfolio
-------------------------------------------------- ----------------------------------------------------
80.01% and above $ 49,775 Single-family 57.33%
70.01% to 80.00% 210,594 Planned urban development 29.72%
60.01% to 70.00% 45,692 Condominium 7.69%
60.00% or less 52,467 Other residential 5.26%
------------------ ---------------
Total $358,528 Total 100.00%
================== ===============
Weighted Average Original 73.83%
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 Quarter Ended March 31, 2008.
Net Loss Summary
Our net loss for the quarter ended March 31, 2008 was $54.9 million, or
$1.46 per average 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.
Our income for each of these periods consisted of interest income. The table
below presents the net loss summary for the quarter ended March 31, 2008 and for
the period ended December 31, 2007:
27
Net Loss Summary
(dollars in thousands, except for per share data)
-------------------------------------------------
For the
Period
November
For the 21, 2007
Quarter through
Ended March December
31, 2008 31, 2007
--------------------------------------------------------------------------------------------------------
Interest income $ 28,194 $ 3,492
Interest expense 14,022 415
---------------- ---------------
Net interest income 14,172 3,077
---------------- ---------------
Unrealized losses on interest rate swaps (31,493) (4,156)
Realized losses on sales of investments (32,819) -
---------------- ---------------
Net investment expense (50,140) (1,079)
---------------- ---------------
Expenses
Management fee 2,227 1,217
General and administrative expenses 2,565 605
---------------- ---------------
Total expenses 4,792 1,822
---------------- ---------------
Loss before income taxes (54,932) (2,901)
Income taxes 3 5
---------------- ---------------
Net loss $ (54,935) $ (2,906)
================ ===============
Net loss per share - basic and diluted $ (1.46) $ (0.08)
================ ===============
Weighted average number of shares outstanding - basic
and diluted 37,744,486 37,401,737
================ ===============
Comprehensive Income (Loss):
Net loss $ (54,935) $ (2,906)
---------------- ---------------
Other comprehensive (loss) income:
Unrealized (loss) gain on available-for-sale securities (88,257) 10,153
Other comprehensive income:
Reclassification adjustment for realized losses included
in net income 32,819 -
---------------- ---------------
Other comprehensive (loss) income (55,438) 10,153
---------------- ---------------
Comprehensive (loss) income $ (110,373) $ 7,247
================ ===============
We attribute the net loss primarily to unrealized losses on our
interest rate swaps due to fair value adjustments and realized losses on sales
of investments during the quarter ended March 31, 2008.
Interest Income and Average Earning Asset Yield
We had average earning assets of $1.6 billion for the quarter ended
March 31, 2008. Our interest income was $28.2 million for the quarter ended
March 31, 2008. The yield on our portfolio was 6.63% for the quarter ended March
31, 2008. We had average earning assets of $399.7 million for the period
commencing November 21, 2007 and ending December 31, 2007. Our interest income
was $3.5 million for the period commencing November 21, 2007 and ending December
31, 2007. The yield on our portfolio was 7.02% for the period ending December
31, 2007. We attribute the increase in interest income to the increase in
interest earning assets during the quarter.
28
Interest Expense and the Cost of Funds
We had average borrowed funds of $1.3 billion and total interest
expense of $14.0 million for the quarter ended March 31, 2008. Our average cost
of funds was 4.23% for the quarter ended March 31, 2008. We had average borrowed
funds of $270.6 million and total interest expense of $415 thousand for the
period commencing November 21, 2007 and ending December 31, 2007. Our average
cost of funds was 5.08% for the period commencing November 21, 2007 and ending
December 31, 2007. We attribute the increase in interest expense to the increase
in assets we were financing. The average cost of funds declined during the
quarter in response to the cuts in the Federal Funds target rate during the
period.
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
quarter ended March 31, 2008 and for the period ending December 31, 2007.
Average Cost of Funds
(Ratios for the quarter ended March 31, 2008 and for the period ending December 31, 2007
have been annualized, dollars in thousands)
Average
Average Average Cost Cost of
One-Month of Funds Funds
Average LIBOR Relative to Relative to
Average Average One- Average Relative to Average Average
Borrowed Interest Cost of Month Six-Month Average Six- One-Month Six-Month
Funds Expense Funds LIBOR LIBOR Month LIBOR LIBOR LIBOR
------------ ----------- ------- -------- --------- ------------- ------------- --------------
For the quarter ended $1,325,156 $14,022 4.23% 3.31% 3.18% 0.13% 0.92% 1.05%
March 31, 2008
------------------------------------------------------------------------------------------------------------------------
For the period $270,584 $415 5.08% 4.98% 4.84% 0.14% 0.10% 0.24%
commencing November
21, 2007 and ending
December 31, 2007
Net Interest Income
Our net interest income, which equals interest income less interest
expense, totaled $14.2 million for the quarter ended March 31, 2008. Our net
interest spread, which equals the yield on our average assets for the period
less the average cost of funds for the period, was 2.40% for the quarter ended
March 31, 2008. Our net interest income totaled $3.1 million for the period
commencing November 21, 2007 and ending December 31, 2007. Our net interest
spread was 1.94% for the period commencing November 21, 2007 and ending December
31, 2007. We attribute the increase to the increase in interest earning assets
in the portfolio and the decrease in our cost of funds.
The table below shows our average assets held, total interest earned on
assets, yield on average interest earning assets, average balance of repurchase
agreements, interest expense, average cost of funds, net interest income, and
net interest rate spread for the quarter ended March 31, 2008 and for the period
commencing November 21, 2007 and ending December 31, 2007.
29
Net Interest Income
(Ratios for the quarter ended March 31, 2008 and for the period ending December 31, 2007
have been annualized, dollars in thousands)
Yield on
Average Average Net
Average Interest Interest Balance of Average Net Interest
Earning Earned on Earning Repurchase Interest Cost of Interest Rate
Assets Held Assets Assets Agreements Expense Funds Income Spread
----------------------------------------------------------------------------------------------
For the Quarter Ended $1,555,896 $25,790 6.63% $1,325,156 $14,022 4.23% $14,172 2.40%
March 31, 2008
------------------------------------------------------------------------------------------------------------------------
For the Period $399,736 $3,492 7.02% $270,584 $415 5.08% $3,077 1.94%
Commencing November
21, 2007 and Ending
December 31, 2007
Gains and Losses on Sales of Assets and Interest Rate Swaps
For the quarter ended March 31, 2008, we sold assets with a carrying
value of $394.2 million for an aggregate loss of $32.8 million. We did not sell
any assets or realize any gain or loss on interest rate swaps during 2007.
Management Fee and General and Administrative Expenses
We paid FIDAC a base management fee of $2.2 million for the quarter
ended March 31, 2008. We did not pay an incentive fee for the quarter ended
March 31, 2008. We paid FIDAC a base management fee of $1.2 million for the
period commencing November 21, 2007 and ending December 31, 2007. We did not pay
an incentive fee for this period.
General and administrative (or G&A) expenses were $2.6 million for the
quarter ended March 31, 2008 compared to G&A expenses of $605 thousand for the
period commencing November 21, 2007 and ending December 31, 2007. We attribute
the increase to a full quarter of expenses being accrued and the additional
expense associated with the vesting of restricted stock grants.
Total expenses as a percentage of average total assets were 1.10% for
the quarter ended March 31, 2008 compared to 1.55% for the period commencing
November 21, 2007 and ending December 31, 2007. We attribute the decrease to the
increase in total assets held in the portfolio.
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 quarter ended March
31, 2008 and the period commencing November 21, 2007 and ending December 31,
2007.
Management Fee and G&A Expenses and Operating Expense Ratios
(Ratios for the quarter ended March 31, 2008 and for the period ending December 31, 2007
have been annualized, dollars in thousands)
Total Total Management Total Management
Management Fee and G&A Fee and G&A
Fee and G&A Expenses/Average Expenses/Average
Expenses Total Assets Equity
-----------------------------------------------------------
For the Quarter ended March 31, 2008 $4,792 1.10% 4.00%
------------------------------------------------------------------------------------------------------------
For the Period Commencing November 21, 2007 $1,822 1.55% 3.05%
and Ending December 31, 2007
30
Net Loss and Return on Average Equity
Our net loss was $54.9 million for the quarter ended March 31, 2008 compared to
a net loss of $2.9 million for the period commencing November 21, 2007 and
ending December 31, 2007. We attribute the increased losses to realized losses
on sales of investments and unrealized losses on interest rate swaps. The table
below shows our net interest income, gain (loss) on sale of assets, unrealized
gains (loss) on interest rate swaps, total expenses, income tax, each as a
percentage of average equity, and the return on average equity for the quarter
ended March 31, 2008 and the period commencing November 21, 2007 and ending
December 31, 2007.
Components of Return on Average Equity
(Ratios for the quarter ended March 31, 2008 and for the period ending December 31, 2007
have been annualized)
Gain/(Loss) on Unrealized
Sale of Gain/(Loss) on Total
Net Interest Investments Interest Rate Expenses/ Income Return on
Income/Average /Average Swaps/Average Average Tax/Average Average
Equity Equity Equity Equity Equity Equity
---------------------------------------------------------------------------------
For the Quarter ended March 11.83% (27.40%) (26.29%) (4.00%) - (45.86%)
31, 2008
--------------------------------------------------------------------------------------------------------------
For the Period Commencing 5.16% - (6.97%) (3.05%) (0.01%) (4.87%)
November 21, 2007 and
Ending December 31, 2007
Liquidity and Capital Resources
We held cash and cash equivalents of approximately $91.4 million at
March 31, 2008 compared to cash and cash equivalents of approximately $6.0
million at December 31, 2007. We attribute the increase to a reduction in
leverage by the Company and the termination of short term investments in reverse
repurchase agreements.
Our operating activities provided net cash of approximately $8.0
million for the quarter ended March 31, 2008 compared to net cash used by
operating activities of approximately $1.5 million for the period commencing
November 21, 2007 and ending December 31, 2007. We attribute this increase to
the longer operating period during the quarter ended March 31, 2008 and larger
portfolio we owned during that quarter.
Our investing activities used net cash of $1.1 billion for the quarter
ended March 31, 2008 primarily from the purchase of investments. For the period
commencing November 21, 2007 and ending December 31, 2007, our investing
activities used net cash of $795.6 million.
Our financing activities as of March 31, 2008 consisted of proceeds
from repurchase agreements. We expect to continue to borrow funds in the form of
repurchase agreements as well as other types of financing. As of March 31, 2008
we had established repurchase agreements for RMBS with 12 investment banking
firms and an affiliate of ours. We had also established two repurchase
agreements for whole mortgage loans as of March 31, 2008.
To collateralize our RMBS, we had outstanding $1.0 billion in
repurchase agreements with weighted average borrowing rates of 4.78% and
weighted average remaining maturities of 54 days as of March 31, 2008. The RMBS
pledged as collateral under these repurchase agreements had an estimated fair
value of $1.1 billion at March 31, 2008. At December 31, 2007, we collateralized
our RMBS with $270.6 million in repurchase agreements with weighted average
borrowing rates of 5.02% and weighted average remaining maturities of 22 days.
The interest rates of these repurchase agreements are generally indexed to the
one-month LIBOR rate and reprice accordingly.
At March 31, 2008 and December 31, 2007, the repurchase agreements for
RMBS had the following remaining maturities:
March 31, 2008 December 31, 2007
(dollars in thousands)
--------------------------------------------------------------------------------
Within 30 days $598,168 $270,584
30 to 59 days 384,964 -
60 to 89 days - -
90 to 119 days - -
Greater than or equal to 120 days 24,514 -
-----------------------------------------
Total $1,007,646 $270,584
=========================================
31
During the quarter ended March 31, 2008, we entered into two master
repurchase agreements pursuant to which we finance whole mortgage loans. One
agreement is a $500 million lending facility of which $200 million is on an
uncommitted basis. This agreement terminates January 16, 2009. The second
agreement is a $350 million committed lending facility. This agreement
terminates January 29, 2010. Repurchase agreements for whole mortgage loans
contain negative covenants requiring us to maintain certain levels of net asset
value, tangible net worth and available funds and comply with interest rate
coverage ratios, leverage ratios and distribution limitations. As of March 31,
2008, we had $487.0 million borrowed against these facilities, which included
$55.2 million of RMBS, at an effective rate of 4.41%. The amount borrowed on the
loans held for investment at March 31, 2008 was collateralized by mortgage loans
with a carrying value of $433.3 million, including accrued interest, and cash
totaling $35.2 million. During the quarter, the Company amended one of its
financing agreements twice. These facilities have covenants that are standard
for industry practice and the Company was in compliance with all such covenants
at March 31, 2008.
At March 31, 2008, the repurchase agreements for mortgage loans had the
following remaining maturities:
March 31, 2008
(dollars in
thousands)
------------------------------------------------------------
Within 30 days $ -
30 to 59 days -
60 to 89 days -
90 to 119 days -
Greater than or equal to 120 days 431,888
---------------------
Total $431,888
=====================
Increases in short-term interest rates could negatively affect the
valuation of our mortgage-related assets, which could limit our borrowing
ability or cause our lenders to initiate margin calls. Amounts due upon maturity
of our repurchase agreements will be funded primarily through the
rollover/reissuance of repurchase agreements and monthly principal and interest
payments received on our mortgage-backed securities.
For our short-term (one year or less) and long-term liquidity, which
includes investing and compliance with collateralization requirements under our
repurchase agreements (if the pledged collateral decreases in value or in the
event of margin calls created by prepayments of the pledged collateral), we also
rely on the cash flow from investments, primarily monthly principal and interest
payments to be received on our RMBS and whole mortgage loans, cash flow from the
sale of securities as well as any primary securities offerings authorized by our
board of directors.
Based on our current portfolio, leverage ratio and available borrowing
arrangements, we believe our assets will be sufficient to enable us to meet
anticipated short-term (one year or less) liquidity requirements such as to fund
our investment activities, pay fees under our management agreement, fund our
distributions to stockholders and pay general corporate expenses. However, an
increase in prepayment rates substantially above our expectations could cause a
temporary liquidity shortfall due to the timing of the necessary margin calls on
the financing arrangements and the actual receipt of the cash related to
principal paydowns. If our cash resources are at any time insufficient to
satisfy our liquidity requirements, we may have to sell investments or issue
debt or additional equity securities in a common stock offering. If required,
the sale of RMBS or whole mortgage loans at prices lower than their carrying
value would result in losses and reduced income.
Our ability to meet our long-term (greater than one year) liquidity and
capital resource requirements will be subject to obtaining additional debt
financing and equity capital. Subject to our maintaining our qualification as a
REIT, we expect to use a number of sources to finance our investments, including
repurchase agreements, warehouse facilities, 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.
32
We are not required by our investment guidelines to maintain any
specific debt-to-equity ratio as we believe the appropriate leverage for the
particular assets we are financing depends on the credit quality and risk of
those assets. However, our repurchase agreements for whole loans require us to
maintain certain debt-to-equity ratios. At March 31, 2008, our total debt was
approximately $1.4 billion which represented a debt-to-equity ratio of
approximately 3.4:1.
Stockholders' Equity
During the quarter ended March 31, 2008, we declared dividends to
common shareholders totaling $9.8 million, or $0.26 per share, all of which was
paid on April 30, 2008. During the period ended December 31, 2007, we declared
dividends to common shareholders totaling $943 thousand or $0.025 per share, all
of which was paid on January 25, 2008.
Management Agreement and Related Party Transactions
We have entered into a management agreement with FIDAC, pursuant to
which FIDAC is entitled to receive a base management fee, incentive compensation
and, in certain circumstances, a termination fee and reimbursement of certain
expenses as described in the management agreement. Such fees and expenses do not
have fixed and determinable payments. The base management fee is payable
quarterly in arrears in an amount equal to 1.75% per annum, calculated
quarterly, of our stockholders' equity (as defined in the management agreement).
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. FIDAC will
receive quarterly incentive compensation in an amount equal to 20% of the dollar
amount by which Core Earnings, on a rolling four-quarter basis and before the
incentive management fee, exceeds the product of (1) the weighted average of the
issue price per share of all of our public offerings multiplied by the weighted
average number of shares of common stock outstanding in such quarter and (2)
0.50% plus one-fourth of the average of the one month LIBOR rate for such
quarter and the previous three quarters. For the initial four quarters following
this offering, Core Earnings and the LIBOR rate will be calculated on the basis
of each of the previously completed quarters on an annualized basis. Core
Earnings and the LIBOR rate for the initial quarter will each be calculated from
the settlement date of our initial public offering on an annualized basis. Core
Earnings is a non-GAAP measure and is defined as GAAP net income (loss)
excluding non-cash equity compensation expense, excluding 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). The amount will be adjusted to exclude one-time events pursuant to
changes in GAAP and certain non-cash charges after discussions between FIDAC and
our independent directors and approval by a majority of our independent
directors. The incentive management fee will be reduced, but not below zero, by
our proportionate share of any CDO incentive management fees FIDAC receives in
connection with the CDOs in which we invest, based on the percentage of equity
we hold in such CDOs. We expect to enter into certain contracts that contain a
variety of indemnification obligations, principally with FIDAC, brokers and
counterparties to repurchase agreements. The maximum potential future payment
amount we could be required to pay under these indemnification obligations is
unlimited.
In March 2008, we entered into a RMBS repurchase agreement and a
receivables sales agreement with Annaly. These agreements contain customary
representations, warranties and covenants contained in such agreements. As of
March 31, 2008, we did not have any outstanding obligations under either
agreement.
During the quarter ended March 31, 2008, we granted restricted stock
awards in the amount of 1,301,000 shares to FIDAC's employees and the Company's
independent directors. 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. We did not grant any incentive awards during the period ended
December 31, 2007.
33
At March 31, 2008 there are approximately 1.3 million unvested shares
of restricted stock issued to employees of FIDAC. For the three months ended
March 31, 2008, compensation expense less general and administrative costs
associated with the amortization of the fair value of the restricted stock
totaled $697 thousand.
Contractual Obligations and Commitments
The following table summarizes our contractual obligations at March 31,
2008.
(dollars in thousands)
--------------------
Greater
Than or
One to Three to Equal to
Contractual Obligations Within One Year Three Years Five Years Five Years Total
------------------------------------------------------------------------------------------------------------------------
Repurchase agreements for RMBS $ 952,490 $ 55,156 $ - $ - $ 1,007,646
Repurchase agreements for mortgage
loans 309,062 122,826 - - 431,888
Interest expense on RMBS repurchase
agreements(1) 2,359 1,964 - - 4,323
Interest expense on mortgage loan
repurchase agreements(1) 4,257 3,485 - - 7,742
-----------------------------------------------------------------------------
Total $ 1,268,168 $ 183,431 $ - $ - $ 1,451,599
=============================================================================
(1) Interest is based on rates in effect as of March 31, 2008.
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. Repurchase agreements for whole mortgage loans
contain negative covenants requiring us to maintain certain levels of net asset
value, tangible net worth and available funds and comply with interest coverage
ratios, leverage ratios and distribution limitations. The Company is in
compliance with all such provisions.
Off-Balance Sheet Arrangements
We do not have any relationships with unconsolidated entities or
financial partnerships, such as entities often referred to as structured finance
or special purpose entities, which would have been established for the purpose
of facilitating off-balance sheet arrangements or other contractually narrow or
limited purposes. Further, we have not guaranteed any obligations of
unconsolidated entities nor do we have any commitment or intent to provide
funding to any such entities. As such, we are not materially exposed to any
market, credit, liquidity or financing risk that could arise if we had engaged
in such relationships.
Dividends
To qualify as a REIT, we must pay annual dividends to our stockholders
of at least 90% of our taxable income, determined without regard to the
deduction for dividends paid and excluding any net capital gains. We intend to
pay regular quarterly dividends to our stockholders. Before we pay any dividend,
whether for U.S. federal income tax purposes or otherwise, which would only be
paid out of available cash to the extent permitted under our warehouse and
repurchase facilities and commercial paper, we must first meet both our
operating requirements and scheduled debt service on our warehouse lines and
other debt payable.
Inflation
Virtually all of our assets and liabilities are interest rate sensitive
in nature. As a result, interest rates and other factors influence our
performance far more so than does inflation. Changes in interest rates do not
necessarily correlate with inflation rates or changes in inflation rates. Our
financial statements are prepared in accordance with GAAP and our distributions
will be determined by our board of directors consistent with our obligation to
distribute to our stockholders at least 90% of our REIT taxable income on an
annual basis in order to maintain our REIT qualification; in each case, our
activities and balance sheet are measured with reference to historical cost
and/or fair market value without considering inflation.
34
Item 3. Quantitative and Qualitative Disclosures About Market Risk
The primary components of our market risk are related to credit risk,
interest rate risk, prepayment risk, market value risk and real estate risk.
While we do not seek to avoid risk completely, we believe the risk can be
quantified from historical experience and we seek to actively manage that risk,
to earn sufficient compensation to justify taking those risks and to maintain
capital levels consistent with the risks we undertake.
Credit Risk
We are subject to credit risk in connection with our investments and
face more credit risk on assets we own which are rated below "AAA". The credit
risk related to these investments pertains to the ability and willingness of the
borrowers to pay, which is assessed before credit is granted or renewed and
periodically reviewed throughout the loan or security term. We believe that
residual loan credit quality is primarily determined by the borrowers' credit
profiles and loan characteristics. FIDAC will use a comprehensive credit review
process. FIDAC's analysis of loans includes borrower profiles, as well as
valuation and appraisal data. FIDAC uses compensating factors such as liquid
assets, low loan to value ratios and job stability in evaluating loans. FIDAC's
resources include a proprietary portfolio management system, as well as third
party software systems. FIDAC utilizes third party due diligence firms to
perform an independent underwriting review to insure compliance with existing
guidelines. FIDAC selects loans for review predicated on risk-based criteria
such as loan-to-value, borrower's credit score(s) and loan size. FIDAC also
outsources underwriting services to review higher risk loans, either due to
borrower credit profiles or collateral valuation issues. In addition to
statistical sampling techniques, FIDAC creates adverse credit and valuation
samples, which we individually review. FIDAC rejects loans that fail to conform
to our standards. FIDAC accepts only those loans which meet our underwriting
criteria. Once we own a loan, FIDAC's surveillance process includes ongoing
analysis through our proprietary data warehouse and servicer files.
Additionally, the non-Agency RMBS and other ABS which we will acquire for our
portfolio are reviewed by FIDAC to ensure that they satisfy our risk based
criteria. FIDAC's review of non-Agency RMBS and other ABS includes utilizing its
proprietary portfolio management system. FIDAC's review of non-Agency RMBS and
other ABS is based on quantitative and qualitative analysis of the risk-adjusted
returns on non-Agency RMBS and other ABS present.
Interest Rate Risk
Interest rate risk is highly sensitive to many factors, including
governmental monetary and tax policies, domestic and international economic and
political considerations and other factors beyond our control. We are subject to
interest rate risk in connection with our investments and our related debt
obligations, which are generally repurchase agreements, warehouse facilities,
securitization, commercial paper and term financing CDOs. Our repurchase
agreements and warehouse facilities may be of limited duration that are
periodically refinanced at current market rates. We intend to mitigate this risk
through utilization of derivative contracts, primarily interest rate swap
agreements.
Interest Rate Effect on Net Interest Income
Our operating results depend, in large part, on differences between the
income from our investments and our borrowing costs. Most of our warehouse
facilities and repurchase agreements provide financing based on a floating rate
of interest calculated on a fixed spread over LIBOR. The fixed spread varies
depending on the type of underlying asset which collateralizes the financing.
Accordingly, the portion of our portfolio which consists of floating interest
rate assets will be match-funded utilizing our expected sources of short-term
financing, while our fixed interest rate assets will not be match-funded. During
periods of rising interest rates, the borrowing costs associated with our
investments tend to increase while the income earned on our fixed interest rate
investments may remain substantially unchanged. This will result in a narrowing
of the net interest spread between the related assets and borrowings and may
even result in losses. Further, during this portion of the interest rate and
credit cycles, defaults could increase and result in credit losses to us, which
could adversely affect our liquidity and operating results. Such delinquencies
or defaults could also have an adverse effect on the spread between
interest-earning assets and interest-bearing liabilities. Hedging techniques are
partly based on assumed levels of prepayments of our fixed-rate and hybrid
adjustable-rate mortgage loans and RMBS. If prepayments are slower or faster
than assumed, the life of the mortgage loans and RMBS will be longer or shorter,
which would reduce the effectiveness of any hedging strategies we may use and
may cause losses on such transactions. Hedging strategies involving the use of
derivative securities are highly complex and may produce volatile returns.
35
Interest Rate Effects on Fair Value
Another component of interest rate risk is the effect changes in
interest rates will have on the fair value of the assets we acquire. We face the
risk that the fair value of our assets will increase or decrease at different
rates than that of our liabilities, including our hedging instruments. We
primarily assess our interest rate risk by estimating the duration of our assets
and the duration of our liabilities. Duration essentially measures the market
price volatility of financial instruments as interest rates change. We generally
calculate duration using various financial models and empirical data. Different
models and methodologies can produce different duration numbers for the same
securities.
It is important to note that the impact of changing interest rates on
fair value can change significantly when interest rates change beyond 100 basis
points from current levels. Therefore, the volatility in the fair value of our
assets could increase significantly when interest rates change beyond 100 basis
points. In addition, other factors impact the fair value of our interest
rate-sensitive investments and hedging instruments, such as the shape of the
yield curve, market expectations as to future interest rate changes and other
market conditions. Accordingly, in the event of changes in actual interest
rates, the change in the fair value of our assets would likely differ from that
shown above and such difference might be material and adverse to our
stockholders.
Interest Rate Cap Risk
We also invest in adjustable-rate mortgage loans and RMBS. These are
mortgages or RMBS in which the underlying mortgages are typically subject to
periodic and lifetime interest rate caps and floors, which limit the amount by
which the security's interest yield may change during any given period. However,
our borrowing costs pursuant to our financing agreements will not be subject to
similar restrictions. Therefore, in a period of increasing interest rates,
interest rate costs on our borrowings could increase without limitation by caps,
while the interest-rate yields on our adjustable-rate mortgage loans and RMBS
would effectively be limited. This problem will be magnified to the extent we
acquire adjustable-rate RMBS that are not based on mortgages which are fully
indexed. In addition, the mortgages or the underlying mortgages in an RMBS may
be subject to periodic payment caps that result in some portion of the interest
being deferred and added to the principal outstanding. This could result in our
receipt of less cash income on our adjustable-rate mortgages or RMBS than we
need in order to pay the interest cost on our related borrowings. These factors
could lower our net interest income or cause a net loss during periods of rising
interest rates, which would harm our financial condition, cash flows and results
of operations.
Interest Rate Mismatch Risk
We fund a substantial portion of our acquisitions of hybrid
adjustable-rate mortgages and RMBS with borrowings that, after the effect of
hedging, have interest rates based on indices and repricing terms similar to,
but of somewhat shorter maturities than, the interest rate indices and repricing
terms of the mortgages and RMBS. Thus, in most cases the interest rate indices
and repricing terms of our mortgage assets and our funding sources will not be
identical, thereby creating an interest rate mismatch between assets and
liabilities. Therefore, our cost of funds would likely rise or fall more quickly
than would our earnings rate on assets. During periods of changing interest
rates, such interest rate mismatches could negatively impact our financial
condition, cash flows and results of operations. To mitigate interest rate
mismatches, we may utilize the hedging strategies discussed above. Our analysis
of risks is based on FIDAC's experience, estimates, models and assumptions.
These analyses rely on models which utilize estimates of fair value and interest
rate sensitivity. Actual economic conditions or implementation of investment
decisions by our management may produce results that differ significantly from
the estimates and assumptions used in our models and the projected results shown
in this Form 10-Q.
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.
36
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 March 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 in Projected Percentage Change in
Change in Interest Rate Net Interest Income Portfolio Value
----------------------------------------------------------------------------------------------------------------------
-75 Basis Points (16.77%) .24%
-50 Basis Points (11.81%) .05%
-25 Basis Points (6.23%) (0.12%)
Base Interest Rate
+25 Basis Points 6.35% (0.47%)
+50 Basis Points 12.73% (0.64%)
+75 Basis Points 19.09% (0.81%)
Prepayment Risk
As we receive prepayments of principal on these investments, premiums
paid on such investments will be amortized against interest income. In general,
an increase in prepayment rates will accelerate the amortization of purchase
premiums, thereby reducing the interest income earned on the investments.
Conversely, discounts on such investments are accreted into interest income. In
general, an increase in prepayment rates will accelerate the accretion of
purchase discounts, thereby increasing the interest income earned on the
investments.
Extension Risk
FIDAC will compute 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 will be 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.
37
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.
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 will seek
to manage risk exposure to protect our portfolio of residential mortgage loans,
RMBS, and other assets and related debt against the effects of major interest
rate changes. We generally seek to manage our risk by:
o monitoring and adjusting, if necessary, the reset index and interest
rate related to our RMBS and our financings;
o attempting to structure our financing agreements to have a range of
different maturities, terms, amortizations and interest rate
adjustment periods;
o using derivatives, financial futures, swaps, options, caps, floors and
forward sales to adjust the interest rate sensitivity of our MBS and
our borrowings;
o using securitization financing to lower average cost of funds relative
to short-term financing vehicles further allowing us to receive the
benefit of attractive terms for an extended period of time in contrast
to short term financing and maturity dates of the investments included
in the securitization; and
o actively managing, on an aggregate basis, the interest rate indices,
interest rate adjustment periods, and gross reset margins of our
investments and the interest rate indices and adjustment periods of
our financings.
Our efforts to manage our assets and liabilities are concerned with the
timing and magnitude of the repricing of assets and liabilities. We attempt to
control risks associated with interest rate movements. Methods for evaluating
interest rate risk include an analysis of our interest rate sensitivity "gap",
which is the difference between interest-earning assets and interest-bearing
liabilities maturing or repricing within a given time period. A gap is
considered positive when the amount of interest-rate sensitive assets exceeds
the amount of interest-rate sensitive liabilities. A gap is considered negative
when the amount of interest-rate sensitive liabilities exceeds interest-rate
sensitive assets. During a period of rising interest rates, a negative gap would
tend to adversely affect net interest income, while a positive gap would tend to
result in an increase in net interest income. During a period of falling
interest rates, a negative gap would tend to result in an increase in net
interest income, while a positive gap would tend to affect net interest income
adversely. Because different types of assets and liabilities with the same or
similar maturities may react differently to changes in overall market rates or
conditions, changes in interest rates may affect net interest income positively
or negatively even if an institution were perfectly matched in each maturity
category.
The following table sets forth the estimated maturity or repricing of
our interest-earning assets and interest-bearing liabilities at March 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.
38
Within 3 1 Year to 3 Greater than
Months 3-12 Months Years 3 Years Total
---------------------------------------------------------------------------------------------------------------------------
(dollars in thousands)
Rate Sensitive Assets:
Investment securities $ - $ - $ 530,415 $ 1,111,627 $ 1,642,042
Cash equivalents 91,370 - - - 91,370
Rate Sensitive Liabilities:
Repurchase Agreements, with the effect of
swaps (100,394) 345,623 1,067,805 126,500 1,439,534
-----------------------------------------------------------------------------
Interest rate sensitivity gap $ 191,764 $ (345,623) $ (537,390) $ 985,127 $ 293,878
=============================================================================
Cumulative rate sensitivity gap $ 191,764 $ (153,859) $ (691,249) $ 293,878
==============================================================
Cumulative interest rate sensitivity gap as
a percentage of total rate-sensitive
assets 11% (9%) (40%) 17%
==============================================================
Our analysis of risks is based on FIDAC's experience, estimates, models
and assumptions. These analyses rely on models which utilize estimates of fair
value and interest rate sensitivity. Actual economic conditions or
implementation of investment decisions by FIDAC may produce results that differ
significantly from the estimates and assumptions used in our models and the
projected results shown in the above tables and in this report. These analyses
contain certain forward-looking statements and are subject to the safe harbor
statement set forth under the heading, "Special Note Regarding Forward-Looking
Statements."
ITEM 4. CONTROLS AND PROCEDURES
Evaluation of Disclosure Controls and Procedures
Our management, including our Chief Executive Officer, or CEO, and
Chief Financial Officer, or CFO, reviewed and evaluated the effectiveness of the
design and operation of our disclosure controls and procedures (as defined in
Rule 13a-15(e) and 15d-15(e) of the Securities Exchange Act) as of the end of
the period covered by this quarterly report. Based on that review and
evaluation, the CEO and CFO have concluded that our current disclosure controls
and procedures, as designed and implemented, (1) were effective in ensuring that
information regarding the Company and its subsidiaries is made known to our
management, including our CEO and CFO, as appropriate to allow timely decisions
regarding required disclosure and (2) were effective in providing reasonable
assurance that information the Company must disclose in its periodic reports
under the Securities Exchange Act is recorded, processed, summarized and
reported within the time periods prescribed by the SEC's rules and forms.
Changes in Internal Controls
There have been no changes in our "internal control over financial
reporting" (as defined in Rule 13a-15(f) under the Securities Exchange Act) that
occurred during the period covered by this quarterly report that has materially
affected, or is reasonably likely to materially affect, our internal control
over financial reporting.
PART II. OTHER INFORMATION
39
Item. 1. LEGAL PROCEEDINGS
From time to time, we may be involved in various claims and legal
actions arising in the ordinary course of business. In the opinion of
management, the ultimate disposition of these matters will not have a material
adverse effect on our consolidated financial statements.
Item 1A. RISK FACTORS
In addition to the other information set forth in this report, you
should carefully consider the factors discussed in Part I, "Item 1A. Risk
Factors" in our Annual Report on Form 10-K for the year ended December 31, 2007,
which could materially affect our business, financial condition or future
results. The information presented below updates and should be read in
conjunction with the risk factors and information disclosed in that Form 10-K.
The weakness in the mortgage market has caused us to expect increased market
losses related to our holdings.
The mortgage market, including the market for prime and alt-A loans,
has been severely affected by changes in the lending landscape. 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 and many product types being
severely curtailed. At the margin, 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.
For the quarter ended March 31, 2008, we had no impairments on RMBS or
whole mortgage loans. 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." Changes in the market values of those assets
are directly charged or credited to stockholders' equity. 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. For the quarter ended March 31, 2008, we had no impairment
charges on our RMBS and whole mortgage loans.
All of our repurchase agreements and interest rate swaps are subject to
bilateral margin calls in the event that the collateral securing our obligations
under those facilities exceeds or does not meet our collateralization
requirements. We analyze the sufficiency of our collateralization daily, and as
of March 31, 2008, on a net basis, the fair value of the collateral, including
restricted cash, securing our obligations under repurchase agreements and
interest rate swaps, exceeded the amount of such obligations by approximately
$202.5 million. During the quarter ended March 31, 2008, due to the
deterioration in the market value of our assets, we received margin calls under
our repurchase agreements, which resulted in our having to amend our liquidity
covenants. Should we receive additional margin calls, we may not be able to
amend the liquidity covenants or obtain other funding. 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.
40
Item 6. EXHIBITS
Exhibits:
The exhibits required by this item are set forth on the Exhibit
Index attached hereto
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 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)
10.3+ 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)
10.4+ 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)
10.5 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)
23.1 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)
23.2 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)
31.1 Certification of Matthew Lambiase, Chief Executive Officer and
President of the Registrant, pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
31.2 Certification of A. Alexandra Denahan, Chief Financial Officer of
the Registrant, pursuant to Section 302 of the Sarbanes-Oxley Act
of 2002.
32.1 Certification of Matthew Lambiase, Chief Executive Officer and
President of the Registrant, pursuant to 18 U.S.C. Section 1350
as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.
32.2 Certification of A. Alexandra Denahan, Chief Financial Officer of
the Registrant, pursuant to 18 U.S.C. Section 1350 as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
+ Represents a management contract or compensatory plan or arrangement.
41
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
May 14, 2008
By: /s/ A. Alexandra Denahan
------------------------
A. Alexandra Denahan
Chief Financial Officer (Principal Financial Officer)
May 14, 2008
42