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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, 1997
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: 0-26436
REDWOOD TRUST, INC.
(Exact name of Registrant as specified in its Charter)
MARYLAND 68-0329422
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
591 REDWOOD HIGHWAY, SUITE 3100
MILL VALLEY, CALIFORNIA 94941
(Address of principal executive offices) (Zip Code)
(415) 389-7373
(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
----- -----
APPLICABLE ONLY TO CORPORATE ISSUERS:
Indicate the number of shares outstanding of each of the issuer's
classes of stock, as of the last practicable date.
Class B Preferred Stock ($.01 par value) 999,638 as of May 9, 1997
Common Stock ($.01 par value) 13,021,846 as of May 9, 1997
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REDWOOD TRUST, INC.
FORM 10-Q
INDEX
Page
----
PART I. FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements
Consolidated Balance Sheets at March 31, 1997 and December 31, 1996.......... 3
Consolidated Statements of Operations for the three months
ended March 31, 1997 and March 31, 1996...................................... 4
Consolidated Statements of Stockholders' Equity for the three months
ended March 31, 1997 and March 31, 1996...................................... 5
Consolidated Statements of Cash Flows for the three months
ended March 31, 1997 and March 31, 1996...................................... 6
Notes to Consolidated Financial Statements................................... 7
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations.................................... 18
PART II. OTHER INFORMATION
Item 1. Legal Proceedings................................................................ 50
Item 2. Changes in Securities............................................................ 50
Item 3. Defaults Upon Senior Securities.................................................. 50
Item 4. Submission of Matters to a Vote of Security Holders.............................. 50
Item 5. Other Information................................................................ 50
Item 6. Exhibits and Reports on Form 8-K................................................. 50
SIGNATURES ............................................................................... 51
2
PART I. FINANCIAL INFORMATION
ITEM 1. CONSOLIDATED FINANCIAL STATEMENTS
REDWOOD TRUST, INC. AND SUBSIDIARY
CONSOLIDATED BALANCE SHEETS
(In thousands, except share data)
March 31, 1997 December 31, 1996
-------------- -----------------
ASSETS
Cash and cash equivalents $ 12,985 $ 11,068
Mortgage assets 2,604,714 2,153,428
Interest rate agreements 5,773 2,601
Accrued interest receivable 19,251 15,537
Other assets 341 1,563
----------- -----------
$ 2,643,064 $ 2,184,197
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Short-term borrowings $ 2,373,279 $ 1,953,103
Accrued interest payable 14,962 14,060
Accrued expenses and other liabilities 1,262 761
Dividends payable 7,899 5,268
----------- -----------
2,397,402 1,973,192
----------- -----------
Commitments and contingencies (See Note 10)
STOCKHOLDERS' EQUITY
Preferred stock, par value $0.01 per share; Class B 9.74% Cumulative
Convertible 999,638 and 1,006,250 shares authorized; 999,638 and
1,006,250 shares issued and outstanding
($31,744 aggregate liquidation preference) 29,383 29,579
Common stock, par value $0.01 per share;
49,000,362 and 48,993,750 shares authorized;
11,905,957 and 10,996,572 issued and outstanding 119 110
Additional paid-in capital 219,461 187,507
Net unrealized gain/(loss) on assets available for sale 118 (3,460)
Dividends in excess of net income (3,419) (2,731)
----------- -----------
245,662 211,005
----------- -----------
$ 2,643,064 $ 2,184,197
=========== ===========
The accompanying notes are an integral part of these consolidated financial
statements.
3
REDWOOD TRUST, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except share data)
Three Months Ended
March 31,
1997 1996
----------- ----------
INTEREST INCOME
Mortgage assets $ 38,406 $ 8,914
Cash and investments 162 217
----------- ----------
38,568 9,131
INTEREST EXPENSE 28,900 6,202
INTEREST RATE AGREEMENTS
Interest rate agreements expense 595 151
----------- ----------
NET INTEREST INCOME 9,073 2,778
Provision for credit losses 695 332
----------- ----------
Net interest income after provision for credit losses 8,378 2,446
Operating expenses 1,167 492
----------- ----------
NET INCOME 7,211 1,954
----------- ----------
Less cash dividends on Class B preferred stock 755 --
----------- ----------
NET INCOME AVAILABLE TO COMMON STOCKHOLDERS $ 6,456 $ 1,954
=========== ==========
NET INCOME PER SHARE
Primary $ 0.53 $ 0.32
Fully diluted $ 0.53 $ 0.32
Weighted average shares of common stock and common stock equivalents:
Primary 12,116,867 6,129,587
Fully diluted 12,133,742 6,132,648
Dividends declared per Class B preferred share $ 0.755 $ --
Dividends declared per common share $ 0.600 $ 0.460
The accompanying notes are an integral part of these consolidated financial
statements.
4
REDWOOD TRUST, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
For the three months ended March 31, 1997
(In thousands, except share data)
Net
Unrealized
Gain/(Loss)
Class B Preferred Stock Common Stock Additional on Assets Dividends in
---------------------------------------------- Paid-in Available Excess of
Shares Amount Shares Amount Capital for Sale Net Income Total
- ---------------------------------------------------------------------------------------------------------------------------------
Balance, December 31, 1996 1,006,250 $ 29,579 10,996,572 $110 $187,507 ($3,460) ($2,731) $211,005
- ---------------------------------------------------------------------------------------------------------------------------------
Net income -- -- -- -- -- -- 7,211 7,211
Conversion of Class B
preferred stock
into common stock (6,612) (196) 6,612 1 195 -- -- 0
Issuance of common stock -- -- 902,773 8 31,759 -- -- 31,767
Dividends declared:
Class B Preferred -- -- -- -- -- -- (755) (755)
Common -- -- -- -- -- -- (7,144) (7,144)
Fair value adjustment on
assets available for sale -- -- -- -- -- 3,578 -- 3,578
- ---------------------------------------------------------------------------------------------------------------------------------
Balance, March 31, 1997 999,638 $ 29,383 11,905,957 $119 $219,461 $ 118 ($3,419) $245,662
=================================================================================================================================
The accompanying notes are an integral part of these consolidated financial
statements.
5
REDWOOD TRUST, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands, except share data)
Three Months Ended
March 31,
1997 1996
--------- ---------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 7,211 $ 1,954
Adjustments to reconcile net income to net cash
provided by operating activities:
Amortization of mortgage asset premium and discount, net 3,818 530
Depreciation and amortization 26 17
Provision for credit losses on mortgage assets 695 332
Amortization of interest rate cap agreements 311 151
Increase in accrued interest receivable (3,714) (1,226)
(Increase) decrease in other assets 1,196 (66)
Increase in accrued interest payable 902 326
Increase in accrued expenses and other 501 63
--------- ---------
Net cash provided by operating activities 10,946 2,081
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of mortgage assets (627,075) (166,852)
Principal payments on mortgage assets 173,362 32,814
Purchases of interest rate cap agreements (1,991) (165)
--------- ---------
Net cash used in investing activities (455,704) (134,203)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net borrowings from reverse repurchase agreements 420,176 138,405
Net proceeds from issuance of common stock 31,767 31
Dividends paid (5,268) (1,434)
--------- ---------
Net cash provided by financing activities 446,675 137,002
Net increase in cash and cash equivalents 1,917 4,880
Cash and cash equivalents at beginning of period 11,068 4,825
--------- ---------
Cash and cash equivalents at end of period $ 12,985 $ 9,705
========= =========
Supplemental disclosure of cash flow information:
Cash paid for interest $ 28,068 $ 5,876
========= =========
The accompanying notes are an integral part of these consolidated financial
statements.
6
REDWOOD TRUST, INC. AND SUBSIDIARY
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
MARCH 31, 1997
NOTE 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
Redwood Trust, Inc. ("Redwood Trust" or the "Company") was incorporated
in Maryland on April 11, 1994 and commenced operations on August 19,
1994. The Company completed its initial public offering of 3,593,750
shares of Common Stock on August 4, 1995 at a price of $15.50 per
share. On April 19, 1996 the Company completed its second public
offering of 2,875,000 shares of Common Stock at a price of $20.25 per
share. On August 8, 1996 the Company completed its public offering of
1,006,250 shares of Class B 9.74% Cumulative Convertible Preferred
Stock ("Class B Preferred Stock") at a price of $31.00 per share. On
November 19, 1996 the Company completed its third public offering of
1,250,000 shares of Common Stock at a price of $31.75 per share. On
January 24, 1997 the Company completed its fourth public offering of
750,000 shares of Common Stock at a price of $39.50 per share.
The Company's principal source of earnings is net interest income, or
interest income generated from its Mortgage Assets less the cost of
borrowed funds and hedging. The Company acquires Mortgage Assets that
are secured by single-family real estate properties throughout the
United States, with a special emphasis on properties located in the
State of California.
The consolidated financial statements include the accounts of Redwood
Trust, Inc. and its special-purpose finance subsidiary, Sequoia
Mortgage Funding Corporation. Inter-company balances have been
eliminated.
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the
date of the financial statements and the reported amounts of revenue
and expenses during the reported period. Actual results could differ
from those estimates.
A summary of the Company's significant accounting policies follows:
Cash and Cash Equivalents
Cash and cash equivalents include cash on hand and highly
liquid investments with original maturities of three months or
less. The carrying amount of cash equivalents approximates
their fair value.
Mortgage Assets
The Company's mortgage assets ("Mortgage Assets") may consist
of mortgage loans, mortgage loans which have been securitized
by the Company following acquisition, mortgage loans which
have been securitized by others prior to acquisition by the
Company and interest only strips ("IO's").
Statement of Financial Accounting Standards No. 115,
Accounting for Certain Investments in Debt and Equity
Securities ("SFAS 115"), requires the Company to classify its
mortgage loans which have been securitized and IO's as either
trading investments, available-for-sale investments or
held-to-maturity investments. Although the Company generally
intends to hold most of these Mortgage Assets until maturity,
it may, from time to time, sell any of these Mortgage Assets
as part of its overall management of its balance sheet.
Accordingly, to maintain flexibility, the Company currently
classifies all of its Mortgage Assets which have been
securitized and its IO's as available-for-sale. All assets
classified as available-for-sale are reported at fair value,
with unrealized gains and losses excluded from earnings and
reported as a separate component of stockholders' equity.
7
Unrealized losses on Mortgage Assets that are considered
other-than-temporary, as measured by the amount of decline in
fair value attributable to factors other than temporary, are
recognized in income and the cost basis of the Mortgage Asset
is adjusted. Other-than-temporary unrealized losses are based
on management's assessment of various factors affecting the
expected cash flow from the Mortgage Assets, including an
other-than-temporary deterioration of the credit quality of
the underlying mortgages and/or the credit protection
available to the related mortgage pool.
Mortgage Assets held in the form of mortgage loans are carried
at their unpaid principal balance, net of unamortized discount
or premium.
Interest income is accrued based on the outstanding principal
amount of the Mortgage Assets and their contractual terms.
Discounts and premiums relating to Mortgage Assets are
amortized into interest income over the lives of the Mortgage
Assets using methods that approximate the effective yield
method. Gains or losses on the sale of Mortgage Assets are
based on the specific identification method.
IO's are accounted for under the prospective method. Under
this method, income is amortized over the asset's estimated
life based on a method which provides a constant yield. At the
end of each quarter, the yield over the remaining life of the
asset is recalculated based on expected future cash flows.
This new yield is then used to calculate the subsequent
quarter's financial statement income.
Under certain extended high interest rate periods, or in the
event of extremely high prepayment rates on the collateral,
the return on the Company's investment in an IO could be zero
or negative. In the event that the projected return on an
investment in an IO falls below a risk free rate, the Company
would record a write down of such investment to its fair
value.
Interest Rate Agreements
The rate the Company pays on its short-term and variable
borrowings will rise and fall without limit as short-term
market interest rates fluctuate. The rate the Company earns on
its adjustable rate assets, however, is limited by periodic
and lifetime caps.
Under the Company's hedging policy the Company does not hedge
specific assets or liabilities, but rather the Company hedges
the risk of overall limitations to its interest income. To
utilize hedge accounting, the policy requires risk reduction
and that there be at least a 50% correlation between changes
in the estimated fair value of the assets or liabilities
hedged and the hedge instruments. Currently, the Company
invests in "Interest Rate Agreements." Interest Rate
Agreements, which include interest rate cap agreements (the
"Cap Agreements"), interest rate swap agreements (the "Swap
Agreements"), interest rate collar agreements (the "Collar
Agreements") and interest rate futures agreements (the
"Futures Agreements"), entered into by the Company are
intended to provide income to offset potential reduced net
interest income under certain rising interest rate scenarios.
The Company periodically evaluates the effectiveness of these
hedges under various interest rate scenarios.
The Company accounts for the Interest Rate Agreements as
hedges. Because the hedged Mortgage Assets are carried at fair
value, the Company's Interest Rate Agreements are carried at
fair value, with unrealized gains and losses reported as a
separate component of equity.
The cost of each Cap Agreement and the net cost or payment
received on each Collar Agreement is amortized over the
effective period of that Cap or Collar Agreement using the
effective interest method. The income and expense related to
each Swap Agreement is recognized on an accrual basis. Gains
and losses on early termination of Interest Rate Agreements
are amortized as a component of net interest income over the
remaining term of the original Interest Rate Agreement, or, if
shorter, over the remaining term of associated Mortgage Assets
as adjusted for estimated future principal prepayments.
8
Unrealized losses on Interest Rate Agreements that are
considered other-than-temporary are recognized in income and
the cost basis of the Interest Rate Agreement is adjusted. The
other-than-temporary decline is measured as the amount of the
decline in fair value attributable to factors that are
other-than-temporary. Other-than-temporary unrealized losses
are based on management's assessment of various factors
affecting the Interest Rate Agreements, for example, a serious
deterioration of the ability of the counterparty to perform
under the terms of the Interest Rate Agreement.
Premises, Furniture and Equipment
Leasehold improvements are stated at cost and are amortized on
a straight-line basis over the life of the lease. Furniture
and equipment is stated at cost and depreciated on an
accelerated basis over its estimated useful life. Expenditures
for repairs and maintenance are charged to expense when
incurred. Premises and equipment totaled $285,197 at March 31,
1997 and $257,493 at December 31, 1996. Depreciation expense
and leasehold improvements amortization for the three months
ended March 31, 1997 and March 31, 1996 totaled $17,111 and
$4,059, respectively. Accumulated depreciation and leasehold
improvement amortization totaled $107,165 at March 31, 1997
and $90,053 at December 31, 1996.
Income Taxes
The Company has elected to be taxed as a Real Estate
Investment Trust ("REIT") and intends to comply with the REIT
provisions of the Internal Revenue Code (the "Code") and the
corresponding provisions of State law. Accordingly, the
Company will not be subject to Federal or state income tax to
the extent of its distributions to stockholders. In order to
maintain its status as a REIT, the Company is required, among
other requirements, to distribute at least 95% of its taxable
income.
Earnings Per Share
Earnings per share are based on the weighted average shares of
common stock outstanding plus common equivalent shares using
the treasury stock method. The treasury stock method
calculation assumes all dilutive common stock equivalents are
exercised and the funds generated by the exercise are used to
buy back outstanding common stock at the average market price
during the reporting period, for primary earnings per share,
or at the end of period market price if higher, for fully
diluted earnings per share.
In February 1997, the Financial Accounting Standards Board
issued Statement of Financial Accounting Standards No. 128,
"Earning Per Share" ("SFAS 128"). SFAS 128 is designed to
improve the earnings per share ("EPS") information provided in
the financial statements by simplifying the existing
computational guidelines, revising the disclosure
requirements, and increasing the comparability of EPS data on
an international basis. SFAS 128 is effective for financial
statements issued for periods ending after December 15, 1997,
including interim periods. The Company will implement SFAS 128
in its December 31, 1997 financial statements. The following
table reflects the impact that SFAS 128 would have had on the
current financial statements.
Three Months Ended
March 31,
1997 1996
----- -----
As Reported:
Primary Earnings Per Share $0.53 $0.32
Fully Diluted Earnings Per Share $0.53 $0.32
Under SFAS No. 128:
Basic Earnings Per Share $0.56 $0.35
Fully Diluted Earnings Per Share $0.53 $0.32
9
Credit Risk
The majority of the Company's Mortgage Assets have protection
from some degree of credit loss either through subordination,
insurance, third party guarantees, or other means. Many of the
Company's Privately-Issued Mortgage Assets have received
ratings from one or more of the four nationally recognized
credit rating agencies. Based on these ratings, and on credit
criteria similar to those used by rating agencies, the Company
assigns a "rating equivalent" to each Mortgage Asset. For
purposes of assigning a rating equivalent to unrated pools of
whole loans or unrated securitized pools of mortgage loans,
the Company assigns a series of ratings to different portions
of the pool according to the Company's estimation of how the
pool would currently be structured and rated if it were newly
securitized. At March 31, 1997, the Privately-Issued Mortgage
Assets held by the Company had rating equivalents ranging from
AAA to unrated, with a weighted average of AA+; the weighted
average rating equivalent of all the Company's Mortgage Assets
was AA+. At December 31, 1996, the Privately-Issued Mortgage
Assets held by the Company had rating equivalents ranging from
AAA to unrated, with a weighted average of AA+; the weighted
average rating equivalent of all the Company's Mortgage Assets
was AA+.
An allowance for credit losses is maintained at a level deemed
appropriate by management to provide for known losses as well
as unidentified potential losses in its Mortgage Asset
portfolio. The allowance is based upon management's assessment
of various factors affecting its Privately-Issued Mortgage
Assets, including current and projected economic conditions,
delinquency status and credit protection. In determining the
allowance for credit losses, the Company's credit exposure is
considered based on its credit risk position in the mortgage
pool. These estimates are reviewed periodically and, as
adjustments become necessary, they are reported in earnings in
the periods in which they become known. The reserve is
increased by provisions charged to income from operations.
When a loan or portions of a loan are determined to be
uncollectible, the portion deemed uncollectible is charged
against the allowance and subsequent recoveries, if any, are
credited to the allowance. During the three months ended March
31, 1997 the Company provided for $695,469 in credit losses
and incurred $42,236 in charge-offs, resulting in a reserve
balance of $2,832,783 at March 31, 1997. During the three
months ended March 31, 1996 the Company provided for $331,516
in credit losses and incurred no charge-offs, resulting in a
reserve balance of $821,229 at March 31, 1996. The reserve
balance at December 31, 1996 was $2,179,550.
Reclassifications
Certain amounts for prior years have been reclassified to
conform with the 1997 presentation.
Recent Accounting Pronouncements
In June 1996 the Financial Accounting Standards Board issued
Statement of Financial Accounting Standards No. 125,
"Accounting for Transfers and Servicing of Financial Assets
and Extinguishments of Liabilities" ("SFAS 125"). SFAS 125
provides accounting and reporting standards for all types of
securitization transactions involving the transfer of
financial assets including repurchase agreements and
collateralized borrowing arrangements. The Company has adopted
this pronouncement effective January 1, 1997. The adoption of
SFAS 125 does not have a material impact on the Company's
financial statements.
10
NOTE 2. MORTGAGE ASSETS
Mortgage Assets Excluding IO's
At March 31, 1997, Mortgage Assets, excluding IO's, consisted of the
following:
FEDERAL HOME LOAN FEDERAL NATIONAL NON-AGENCY
MORTGAGE MORTGAGE MORTGAGE
(IN THOUSANDS) CORPORATION ASSOCIATION ASSETS TOTAL
----------------- ---------------- ---------- -----------
Mortgage Assets, Gross $ 321,354 $ 660,388 $ 1,574,115 $ 2,555,857
Unamortized Discount 0 (214) (15,427) (15,641)
Unamortized Premium 10,381 20,611 31,714 62,706
--------- --------- ----------- -----------
Amortized Cost 331,735 680,785 1,590,402 2,602,922
Allowance for Credit Losses 0 0 (2,833) (2,833)
Gross Unrealized Gains 1,476 3,592 2,637 7,705
Gross Unrealized Losses (200) (274) (4,633) (5,107)
--------- --------- ----------- -----------
Carrying Value $ 333,011 $ 684,103 $ 1,585,573 $ 2,602,687
========= ========= =========== ===========
At December 31, 1996, Mortgage Assets, excluding IO's, consisted of the
following:
FEDERAL HOME LOAN FEDERAL NATIONAL NON-AGENCY
MORTGAGE MORTGAGE MORTGAGE
(IN THOUSANDS) CORPORATION ASSOCIATION ASSETS TOTAL
----------------- ---------------- ---------- -----------
Mortgage Assets, Gross $ 304,668 $ 635,268 $ 1,177,309 $ 2,117,245
Unamortized Discount 0 (234) (15,859) (16,093)
Unamortized Premium 9,287 17,652 24,839 51,778
--------- --------- ----------- -----------
Amortized Cost 313,955 652,686 1,186,289 2,152,930
Allowance for Credit Losses 0 0 (2,180) (2,180)
Gross Unrealized Gains 1,091 2,082 2,746 5,919
Gross Unrealized Losses (185) (688) (4,477) (5,350)
--------- --------- ----------- -----------
Carrying Value $ 314,861 $ 654,080 $ 1,182,378 $ 2,151,319
========= ========= =========== ===========
At March 31, 1997 and December 31, 1996, all investments in Mortgage
Assets consisted of interests in adjustable-rate mortgages on
residential properties. A majority of the Non-Agency Mortgage Asset
properties are located in the State of California. The securitized
interests in pools of adjustable-rate mortgages from the Federal Home
Loan Mortgage Corporation and the Federal National Mortgage Association
are guaranteed as to principal and interest by those US government
agencies. The original maturity of the vast majority of the Mortgage
Assets is thirty years; the actual maturity is subject to change based
on the prepayments of the underlying mortgage loans.
At March 31, 1997, the average annualized effective yield on the
Mortgage Assets was 6.85% based on the amortized cost of the assets and
6.85% based on the fair value of the assets. At December 31, 1996, the
average annualized effective yield was 7.10% based on the amortized
cost of the assets and 7.11% based on the fair value of the assets.
11
Most of the adjustable-rate mortgage securities and loans are limited
by periodic caps (generally interest rate adjustments are limited to no
more than 1% every six months or 2% every year) and lifetime caps. At
March 31, 1997 and December 31, 1996, the weighted average lifetime cap
was 11.91% and 11.73%, respectively.
IO's
The amortized cost and fair value of the Company's IO's are summarized
as follows:
(IN THOUSANDS) MARCH 31, 1997 DECEMBER 31, 1996
-------------- -----------------
Amortized Cost $ 2,400 $ 2,539
Gross Unrealized Gains 49 45
Gross Unrealized Losses (422) (475)
------- -------
Estimated Fair Value $ 2,027 $ 2,109
======= =======
The average annualized effective yield at March 31, 1997 on the IO's
was 11.47% based on the amortized cost of the assets and 13.58% based
on the fair value of the assets. The average annualized effective yield
at December 31, 1996 on the IO's was 11.24% based on the amortized cost
of the assets and 13.53% based on the fair value of the assets.
NOTE 3. INTEREST RATE AGREEMENTS
The amortized cost and fair value of the Company's Interest Rate
Agreements are summarized as follows:
(IN THOUSANDS) MARCH 31, 1997 DECEMBER 31, 1996
-------------- -----------------
Amortized Cost $ 7,879 $ 6,200
Gross Unrealized Gains 734 156
Gross Unrealized Losses (2,840) (3,755)
------- -------
Carrying Value $ 5,773 $ 2,601
======= =======
The sum of the notional amounts of all of the Company's Interest Rate
Agreements in effect was $2,192,200,000 at March 31, 1997 and
$1,128,000,000 at December 31, 1996, respectively.
Cap Agreements
The Company had seventy-one outstanding Cap Agreements at March 31,
1997 and fifty-seven outstanding Cap Agreements at December 31, 1996.
Potential future earnings from each of these Cap Agreements are based
on variations in the London Inter-Bank Offered Rate ("LIBOR"). The sum
of the notional amounts of the Company's Cap Agreements in effect was
$1,767,200,000 and $703,000,000 at March 31, 1997 and December 31,
1996, respectively. The weighted average cap strike rate during the
three months ended March 31, 1997 and March 31, 1996 was 7.63% and
7.35%, respectively. Under these Cap Agreements the Company will
receive cash payments should an agreed-upon reference rate, either
one-month or three-month LIBOR, increase above the strike rates of the
Cap Agreements.
12
Information on Cap Agreements outstanding at March 31, 1997 is
summarized below.
(DOLLARS IN THOUSANDS) AVERAGE CAP EXPECTED
NOTIONAL FACE AVERAGE CAP LOW CAP HIGH CAP CAP EXPENSE
YEAR AMOUNT STRIKE RATE STRIKE RATE STRIKE RATE AMORTIZATION
---- ------ ----------- ----------- ----------- ------------
1997 (last 9 months) 1,719,796 7.37% 5.50% 12.00% 1,985
1998 983,191 8.47% 5.50% 12.00% 1,753
1999 1,022,088 9.47% 6.30% 12.00% 1,727
2000 739,720 9.95% 7.50% 12.00% 1,231
2001 441,164 10.11% 7.50% 11.00% 714
2002 49,274 8.39% 8.00% 11.00% 169
2003 22,634 8.67% 8.00% 9.00% 145
2004 21,834 8.67% 8.00% 9.00% 135
2005 5,216 8.53% 8.50% 9.00% 20
------
Total $7,879
======
Collar Agreement
At March 31, 1997, the Company had entered into one outstanding collar
agreement, consisting of the purchase of a cap agreement subsidized by
the sale of a floor agreement. On the cap portion, the Company will
receive net hedge income to the extent that three month LIBOR exceeds
7.50%. On the floor portion, the Company will incur a net hedge expense
to the extent that three month LIBOR falls below 5.91%
Information on the Collar Agreement outstanding at March 31, 1997 is
summarized below.
NOTIONAL FACE EXPECTED
AMOUNT CAP STRIKE FLOOR COLLAR EXPENSE
EFFECTIVE PERIOD: (IN THOUSANDS) INDEX RATE STRIKE RATE AMORTIZATION
----------------- -------------- ----- ---- ----------- ------------
April 1997 to July 1999 $20,000 3 mo LIBOR 7.50% 5.91% $0
Swap Agreements
The Company has entered into three types of Interest Rate Swap
Agreements summarized as follows:
Fixed vs. Floating Rate Swap Agreements:
The Company had six outstanding fixed vs. floating rate Swap Agreements
("Fixed Pay Rate Swaps") at March 31, 1997 and December 31, 1996. The
sum of the notional amounts of the Company's Fixed Pay Rate Swaps in
effect was $135,000,000 at March 31, 1997 and December 31, 1996. Under
these Swap Agreements, the Company receives the 3 month LIBOR rate and
pays the agreed upon fixed rate.
Information on Fixed Pay Rate Swaps outstanding at March 31, 1997 is
summarized below.
(DOLLARS IN THOUSANDS) AVERAGE SWAP
NOTIONAL FACE AVERAGE LOW HIGH
YEAR AMOUNT PAY RATE PAY RATE PAY RATE
---- ------ -------- -------- --------
1997 (last 9 months) 101,418 6.29% 6.01% 7.18%
1998 (first 5 months) 25,828 6.59% 6.40% 7.18%
Periodic Swap Agreements:
As of March 31, 1997, the Company had entered into three Periodic Swap
Agreements designed to produce income to the Company in the event that
the three month LIBOR rate rises sharply. In each of these swaps, the
Company receives income on the notional face at a rate equal to three
month LIBOR less 0.230% to 0.265% and
13
pays income on the notional face on the lesser of (a) three month LIBOR
or (b) the prior period's LIBOR plus 0.50%. The average notional face
of these swaps is $110,000,000, with $90,000,000 maturing in August
1999 and $20,000,000 maturing in September 1999.
Information on the Periodic Swap Agreements outstanding at March 31,
1997 is summarized below.
(DOLLARS IN THOUSANDS) AVERAGE SWAP
NOTIONAL FACE AVERAGE SPREAD LOW SPREAD HIGH SPREAD
YEAR AMOUNT RECEIVED RECEIVED RECEIVED
---- ------ -------- -------- --------
1997 (last 9 months) 110,000 -0.255% -0.265% -0.230%
1998 110,000 -0.255% -0.265% -0.230%
1999 (first 9 months) 98,242 -0.257% -0.265% -0.230%
Basis Swap Agreements:
As of March 31, 1997, the Company had entered into five LIBOR/Treasury
bill Basis Swap Agreements totaling $160 million in notional value.
These Basis Swap Agreements, in conjunction with the Company's other
Swap and Cap Agreements, are designed to reduce the potential risks in
that portion of the Company's balance sheet wherein Treasury-based
assets are funded with LIBOR-based liabilities. The Basis Swap
Agreements will produce net hedge income for the Company to the extent
that three month LIBOR exceeds the average three month Treasury bill
rate by 0.440% to 0.465% and will produce a net hedge expense for the
Company to the extent that the spread between these two indices is
narrower than 0.440% to 0.465%. The maturities of these Basis Swap
Agreements are as follows: $30,000,000 in June 1998, $50,000,000 in
December 1998, $30,000,000 in June 1999 and $50,000,000 in December
1999. Information on Basis Swap Agreements outstanding at December 31,
1996 is summarized below.
(DOLLARS IN THOUSANDS) AVERAGE SWAP
NOTIONAL FACE AVERAGE SPREAD LOW SPREAD HIGH SPREAD
YEAR AMOUNT PAID PAID PAID
---- ------ ---- ---- ----
1997 (last 9 months) 160,000 0.453% 0.440% 0.465%
1998 144,877 0.455% 0.440% 0.465%
1999 64,712 0.464% 0.460% 0.465%
The Company has incurred credit risk to the extent that the
counter-parties to the Interest Rate Agreements do not perform their
obligations under the Interest Rate Agreements. Potential credit
write-offs are limited to the amortized cost of the Cap Agreements. In
addition, for Cap, Swap and Collar Agreements, if one of the
counter-parties does not perform, the Company would not receive the
cash to which it would otherwise be entitled under the Interest Rate
Agreement. In order to mitigate this risk, the Company has entered into
Interest Rate Agreements only with counter-parties rated A or better
and has entered into Interest Rate Agreements with fifteen different
counter-parties in order to reduce the risk of credit exposure to any
one counter-party.
NOTE 4. SHORT-TERM BORROWINGS
The Company has entered into reverse repurchase agreements, notes
payable and a revolving line of credit (together "Short-Term
Borrowings") to finance acquisitions of a portion of its Mortgage
Assets. These Short-Term Borrowings are collateralized by a portion of
the Company's Mortgage Assets.
At March 31, 1997, the Company had $2,373,279,000 of Short-Term
Borrowings outstanding with a weighted average borrowing rate of 5.82%
and a weighted average maturity of 79 days. These borrowings were
collateralized with $2,478,190,951 of Mortgage Assets. At December 31,
1996, the Company had $1,953,103,000 of Short-Term Borrowings
outstanding with a weighted average borrowing rate of 5.83% and a
weighted average remaining maturity of 98 days. These borrowing were
collateralized with $2,050,813,000 of Mortgage Assets.
14
In September 1996, the Company entered into a $20,000,000, one-year
revolving line of credit agreement with a financial institution. The
agreement requires that the Company maintain certain financial ratios.
The Company is in compliance with all requirements. Interest rates on
borrowings under this facility are based on LIBOR. At March 31, 1997,
borrowings under this facility totaled $19,191,000 and were committed
through April 16, 1997. At December 31, 1996, borrowings under this
facility totaled $19,302,000. These borrowings are reflected in the
$2,373,279,000 and $1,953,103,000 of Short-Term Borrowings outstanding
at March 31, 1997 and December 31, 1996.
At March 31, 1997 and December 31, 1996, the Short-Term Borrowings had
the following remaining maturities:
(IN THOUSANDS) MARCH 31, 1997 DECEMBER 31, 1996
-------------- -----------------
Within 30 days $ 588,937 $ 268,042
30 to 90 days 622,985 667,567
Over 90 days 1,161,357 1,017,494
---------- ----------
Total Borrowings $2,373,279 $1,953,103
========== ==========
For the three months ended March 31, 1997 and March 31, 1996, the
average balance of Short-Term Borrowings was $2,056,051,000 and
$435,978,990 with a weighted average interest cost of 5.62% and 5.69%,
respectively. The maximum balances outstanding during the three months
ended March 31, 1997 and March 31, 1996 were $2,373,279,000 and
$508,721,000, respectively.
NOTE 5. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following table presents the carrying amounts and estimated fair
values of the Company's financial instruments at March 31, 1997 and
December 31, 1996. FASB Statement No. 107, Disclosures about Fair Value
of Financial Instruments, defines the fair value of a financial
instrument as the amount at which the instrument could be exchanged in
a current transaction between willing parties, other than in a forced
liquidation sale.
MARCH 31, 1997 DECEMBER 31, 1996
-------------- -----------------
CARRYING FAIR CARRYING FAIR
(IN THOUSANDS) AMOUNT VALUE AMOUNT VALUE
------ ----- -------- -----
Assets
Mortgage Assets $2,602,687 $2,602,212 $2,151,319 $2,151,319
IO's 2,027 2,027 2,109 2,109
Interest Rate Agreements 5,773 5,773 2,601 2,601
Management bases its fair value estimates primarily on third party bid
price indications, such as bid indications provided by dealers who make
markets in these assets and asset valuations made by collateralized
lenders, when such indications are available. However, the fair value
reported reflects estimates and may not necessarily be indicative of
the amounts the Company could realize in a current market exchange.
Cash and cash equivalents, interest receivable, short-term borrowings,
accrued interest payable, accrued expenses and other liabilities are
reflected in the financial statements at their costs, which
approximates their fair value because of the short-term nature of these
instruments.
NOTE 6. CLASS B 9.74% CUMULATIVE CONVERTIBLE PREFERRED STOCK
On August 8, 1996, the Company issued 1,006,250 shares of Class B
Preferred Stock. Each share of the Class B Preferred Stock is
convertible at the option of the holder at any time into one share of
Common Stock. After September 30, 1999, the Company can either redeem
or cause a conversion of the Class B Preferred Stock. The Class B
Preferred Stock pays a dividend equal to the greater of (i) $0.755 per
quarter or (ii) an amount equal to the quarterly dividend declared on
the number of shares of the Common Stock into which the Class B
Preferred Stock is convertible. The Class B Preferred Stock ranks
senior to the Company's Common Stock as to the
15
payment of dividends and liquidation rights. The liquidation preference
entitles the holders of the Class B Preferred Stock to receive $31 per
share plus any accrued dividends before any distribution is made on the
Common Stock.
As of March 31, 1997, a total of 6,612 shares of the Class B Preferred
Stock has been converted into 6,612 shares of the Company's Common
Stock. At March 31, 1997 and December 31, 1996, there were 999,638 and
1,006,250 shares of the Class B Preferred Stock outstanding,
respectively.
NOTE 7. STOCK PURCHASE WARRANTS
At March 31, 1997 and December 31, 1996, there were 272,304 and 412,894
Warrants outstanding, respectively. Each Warrant entitles the holder to
purchase 1.000667 shares of the Company's common stock at an exercise
price of $15.00 per share. The Warrants remain exercisable until
December 31, 1997.
NOTE 8. STOCK OPTION PLAN
The Company has adopted a Stock Option Plan for executive officers,
employees and non-employee directors (the "Stock Option Plan"). The
Stock Option Plan authorizes the Board of Directors (or a committee
appointed by the Board of Directors) to grant "incentive stock options"
as defined under section 422 of the Code ("ISOs"), options not so
qualified ("NQSOs"), deferred stock, restricted stock, performance
shares, stock appreciation rights and limited stock appreciation rights
("Awards") and stock dividend equivalent rights ("stock DERs") to such
eligible recipients other than non-employee directors. Non-employee
directors are automatically provided annual grants of NQSOs with stock
DERs pursuant to a formula under the Stock Option Plan.
The number of shares of Common Stock available under the Stock Option
Plan for options and Awards, subject to certain anti-dilution
provisions, is 15% of the Company's total outstanding shares of Common
Stock. At March 31, 1997 and December 31, 1996, 1,022,241 and 1,138,743
shares of Common Stock, respectively, were available for grant. Of the
shares of Common Stock available for grant, no more than 500,000 shares
of Common Stock shall be cumulatively available for grant as ISOs. At
March 31, 1997 and December 31, 1996, 299,633 ISOs had been granted.
The exercise price for ISOs granted under the Stock Option Plan may not
be less than the fair market value of shares of Common Stock at the
time the ISO is granted. All stock options granted under the Stock
Option Plan vest no earlier than ratably over a four year period from
the date of grant and expire within ten years after the date of grant.
The Company's Stock Option Plan permits stock options granted under the
plan to accrue stock DERs. For the three months ended March 31, 1997
and March 31, 1996, the stock DERs accrued on NQSOs that had a stock
DER feature resulted in non-cash charges to operating expenses of
$123,859 and $84,919, respectively. Stock DERs represent shares of
stock which are issuable to holders of stock options when the holders
exercise the underlying stock options. The number of stock DER shares
accrued are based on the level of the Company's dividends and on the
price of the stock on the related dividend payment date.
Information with respect to stock option and DER activity is as
follows:
THREE MONTHS ENDED YEAR ENDED
MARCH 31, 1997 DECEMBER 31, 1996
-------------- -----------------
Outstanding options at beginning of period: 421,577 310,857
Options granted 250,000 141,300
Options exercised -- (42,083)
Dividend equivalent rights earned 2,910 11,503
------- -------
Outstanding options at end of period 674,487 421,577
======= =======
Exercise price per share:
For options exercised during period -- $0.10 - $0.11
For options outstanding end of period $0.10 - $42.50 $0.10 - $36.88
16
NOTE 9. DIVIDENDS
The Company declared and paid the following dividends for the three
months ended March 31, 1997 and for the year ended December 31, 1996:
Dividends Per Share
------------------------
Declaration Record Payable Total Class B Common
Date Date Date Dividends Preferred Stock Stock
---- ---- ---- --------- --------------- ------
3/5/97 3/31/97 4/21/97 $7,898,301 $0.755 $0.600
12/16/96 12/31/96 1/21/97 $5,268,314 $0.755 $0.410
9/16/96 9/30/96 10/21/96 $4,016,274 $0.386 $0.400
6/14/96 6/28/96 7/18/96 $3,408,046 -- $0.400
3/11/96 3/29/96 4/19/96 $2,539,833 -- $0.460
Under the Internal Revenue Code of 1986, a dividend declared by a REIT
in December of a calendar year, payable to shareholders of record as of
a specified date in December, will be deemed to have been paid by the
Company and received by the shareholders on that record date if the
dividend is actually paid before February 1st of the following calendar
year. Therefore, the dividend declared in December 1996 which was paid
in January 1997 is considered taxable income to shareholders in the
year declared. The Company's dividends are not eligible for the
dividends received deduction for corporations.
NOTE 10. COMMITMENTS AND CONTINGENCIES
As of March 31, 1997, the Company had entered into a commitment to
purchase $4.9 million of Mortgage Assets for settlement in April 1997.
The Company had also entered into a commitment to purchase one Interest
Rate Agreement for a premium of $25,125. At March 31, 1997, the Company
had no other outstanding commitments to purchase or sell Mortgage
Assets or to purchase, sell or terminate Interest Rate Agreements. The
Company also had no commitments to enter into additional reverse
repurchase agreements or other borrowings.
Rental expense for office properties under operating leases for the
three months ended March 31, 1997 and March 31, 1996, was $30,813 and
$24,062, respectively.
Future minimum rental commitments as of March 31, 1997 under
non-cancelable operating leases with initial or remaining terms of more
than one year, are as follows:
MINIMUM RENTAL
COMMITMENT
YEAR ENDING AS OF MARCH 31, 1997
DECEMBER 31, (IN THOUSANDS)
------------ -------------
1997 143
1998 191
1999 191
2000 191
2001 64
----
Total $524
Effective January 1, 1997, the Company is bearing 100% of all expenses.
Prior to 1997, the Company shared certain office expenses, such as
lease payments and utilities, on a pro rata basis with GB Capital. GB
Capital was owned by certain officers of the Company and ceased
operations effective March 31, 1997. For the year ended December 31,
1996, the Company was bearing 95% of the lease expenses and GB Capital
was bearing 5%.
17
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following discussion should be read in conjunction with the
Consolidated Financial Statements and Notes.
SAFE HARBOR STATEMENT
"Safe Harbor" Statement under the Private Securities Litigation Reform
Act of 1995: Statements in this discussion regarding Redwood Trust,
Inc. (the "Company") and its business which are not historical facts
are "forward-looking statements" that involve risks and uncertainties.
For a discussion of such risks and uncertainties, which could cause
actual results to differ from those contained in the forward-looking
statements, see "Risk Factors" commencing on Page 26 of the Company's
1996 Form 10-K.
OVERVIEW
Redwood Trust, Inc. is a mortgage finance company which acquires
mortgages and seeks to earn spread income while holding and managing
the mortgages to maturity. The Company uses both its equity and
borrowed funds to acquire mortgages. The Company's source of earnings
is net interest income, or the interest income earned on mortgages less
interest expense paid on borrowed funds and hedging costs. The Company
believes its primary competitors are other financial institutions, such
as banks and savings and loan institutions, which seek to earn spread
income from managing mortgage assets. Compared to most of its
competitors, the Company believes it benefits from a lower cost of
operations and from its status as a Real Estate Investment Trust
("REIT"). As a REIT, the Company does not pay corporate Federal income
taxes on its taxable income it pays out as dividends.
The Company has sought to structure its business to achieve operational
efficiencies and to minimize fixed costs. Instead of maintaining an
in-house mortgage origination staff, the Company acquires mortgage
assets from mortgage origination companies, savings and loans, banks
and from the secondary mortgage market. The Company out-sources
mortgage servicing functions. Rather than build a retail branch banking
system to gather deposits (which would require the Company to obtain a
bank or savings and loan charter, pay taxes and be regulated), the
Company accesses borrowed funds in the capital markets. This strategy
enables the Company to keep its operating costs low. In the first
quarter of 1997, the Company's operating expenses to assets ratio was
0.20% and its efficiency ratio (operating expenses to net interest
income) was 13%.
As of March 31, 1997, all of the Company's mortgage assets consisted of
adjustable-rate, first-lien mortgages on single-family properties or
mortgage securities evidencing an interest in such mortgages. In the
future the Company may acquire fixed-rate single-family mortgage loans
as well as mortgage loans on multi-family or commercial properties.
The Company is an "A" quality mortgage lending company: the Company
does not own mortgages originated to "B", "C", or "D" quality
origination or documentation standards except in limited circumstances
when the Company has a degree of credit protection sufficient to
eliminate most of the potential credit risk from such loans.
The Company acquires high quality individual whole mortgage loans (28%
of total mortgage assets as of March 31, 1997), mortgage securities
evidencing an interest in pools of mortgage loans which have been fully
insured against credit losses by one of the government-sponsored
mortgage entities such as GNMA, FHLMC and FNMA (39% of total), mortgage
securities which have partial private-sector credit-enhancement through
insurance, subordination, or other means sufficient to warrant an
investment-grade credit rating from one of the nationally-recognized
credit rating firms (32% of total), and mortgage securities which are
subordinated and have higher levels of credit risk such that they have
received a rating below BBB (1% of total). The average credit rating
equivalent of the Company's mortgage assets is AA+.
The Company seeks to acquire "A" quality single-family mortgage assets
consisting of "jumbo" mortgages which, in general, have loan balances
greater than $214,600. Because of their size, these jumbo loans are not
eligible to be acquired or guaranteed by the government-sponsored
mortgage entities. The Company also acquires FNMA and
18
FHLMC mortgage securities and smaller balance "A" quality whole loans
when such acquisitions are deemed attractive by management.
As of March 31, 1997, 41% of the whole mortgage loans owned by the
Company were secured by single-family residential properties located in
California. In addition, 70% of the properties underlying the mortgage
pools in which the Company owned an interest that was rated less than
AA were located in California. Management believes that the economy and
the trend of residential housing values in California were generally
stable to improving in 1996 and the first quarter of 1997.
The coupon rate the Company earns on its adjustable-rate mortgage
assets (100% of all mortgage assets as of March 31, 1997) increases or
falls in conjunction with changes in short-term interest rates, as does
the rate the Company pays on its borrowings. The coupon rate on each
mortgage generally adjusts on a one, six or twelve month cycle;
approximately 2% of the Company's assets are "hybrid" adjustable rate
mortgages that have an extended period to the first coupon change
(averaging 30 months from March 31, 1997) and thereafter adjust on a
regular 12 month schedule. The average term-to-next-adjustment for all
of the Company's mortgage assets was five months as of March 31, 1997.
Borrowings have maturities ranging from one to twelve months; the
average maturity at March 31, 1997 was 79 days. Some of these
borrowings have adjustable rates; the
term-to-next-interest-rate-adjustment for these borrowings was 43 days
as of March 31, 1997. The Company's interest rate agreement hedging
program is designed to reduce the impact of negative effects that could
occur in a rising interest rate environment as a result of mismatches
between the adjustment dates of the Company's assets and liabilities.
Such mismatches, before hedging, averaged 3.5 months at March 31, 1997.
Changes in the coupon rates earned on the Company's mortgages are
limited by periodic and lifetime caps; the Company's hedging program
also seeks to mitigate the negative effects such mortgage coupon caps
may have on spread income should short-term interest rates increase
rapidly. Because the Company's adjustable-rate earning assets exceed
its liabilities, the Company believes that rising short-term interest
rates may lead to higher net earnings after a lag period, all other
factors being equal. Similarly, falling short-term interest rates may
lead to reduced net earnings after a lag period.
The Company seeks to generate secular growth in earnings and dividends
per share in a variety of ways, including through (i) issuing new
equity and increasing the size of the balance sheet when opportunities
in the mortgage market are likely to allow growth in earnings per
share, (ii) seeking to improve productivity by increasing the size of
the balance sheet at a rate faster than operating expenses increase,
(iii) changing the mix of mortgage asset types on the balance sheet in
an effort to improve risk-adjusted returns, (iv) seeking to benefit by
an increased market value of assets and lower borrowing costs should
mortgage asset quality improve with seasoning, mortgage principal
repayments, and improvements in real estate markets and the general
economy, and (v) increasing the efficiency with which the Company
utilizes its equity capital over time by increasing the Company's use
of debt when prudent and by issuing subordinated debt, preferred stock
or other forms of debt and equity.
The Company has grown rapidly by issuing new capital and acquiring new
mortgage assets. While the Company believes such growth has
significantly increased its long-term earnings per share potential, the
near-term effect has been a reduction in reported earnings per share as
compared to what earnings likely would have been without such growth.
The Company intends to continue to pursue additional growth in the
future when management believes that growth is likely to be additive to
earnings per share potential.
RESULTS OF OPERATIONS: FIRST QUARTER 1997 VS. FIRST QUARTER 1996
CHANGE IN CLASSIFICATION FOR CERTAIN ASSETS AND CHANGE IN CALCULATION
METHOD FOR CERTAIN PREVIOUSLY REPORTED YIELDS AND RATIOS
Through December 31, 1996, the Company classified all of its mortgage
assets and interest rate agreements as "available-for-sale" and, as a
result, carried these assets on its balance sheet at fair market value
(estimated liquidation value). Starting in 1997, the Company has
reclassified certain assets as "held-to-maturity". Accordingly, such
assets are now carried on the Company's balance sheet at a carrying
value that will be adjusted over time from the market value at the time
of reclassification towards historical amortized cost. Neither the use
of this different type of balance
19
sheet classification nor the change from one type of balance sheet
classification to the other will effect in any way the manner in which
the Company manages its business or calculates its net income.
As a result of this change, the stockholders' equity numbers reported
by the Company on its balance sheet have become, in the opinion of
management, more difficult to interpret as stockholders' equity
includes a valuation account which incorporates mark-to-market
adjustments on some mortgage assets and interest rate agreements, but
not on other assets or on any liabilities. In addition, the valuation
account includes the adjustment factor described above designed to move
the carrying value of reclassified assets towards historical amortized
cost over time. Thus stockholders' equity and the valuation account
will not represent a full mark-to-market presentation nor will it
reflect a historical amortized cost presentation.
Since information regarding market values of assets and liabilities is
a very important input into the management of the operations of the
Company, and because management believes that these market values are a
source of potentially valuable information for its shareholders, the
Company will continue to fully disclose mark-to-market figures for all
of its earning assets, interest rate agreements and liabilities in this
"Management's Discussion and Analysis" section of its financial
reports. See "Financial Condition -- Stockholders' Equity" below.
In accordance with these changes, the Company has changed its method of
calculating certain previously reported yields and ratios. Unless
indicated otherwise, all such measures have now been calculated using
historical amortized cost figures for all assets and liabilities;
mark-to-market effects are excluded. For example, historical return on
equity ("ROE") figures have been adjusted downwards slightly from
previously reported ROE numbers as the Company's equity base on a
historical amortized cost basis has, in the past, exceeded its equity
base as calculated including unrealized market value losses on assets.
These changes effect certain balance sheet and yield calculations, but
do not effect the calculation of income. These changes are not
material. Management has made these changes in an effort to make the
presentation of these figures more useful and consistent.
TOTAL NET INCOME
Total net income to common and preferred shareholders, as calculated
according to Generally Accepted Accounting Principles ("GAAP"),
increased by 269%, from $2.0 million in the first quarter of 1996 to
$7.2 million in the first quarter of 1997. Total net income available
to common shareholders after preferred dividends increased by 230%,
from $2.0 million in the first quarter of 1996 to $6.5 million in the
first quarter of 1997. Growth in total net income was driven primarily
by growth in average assets. From the first quarter of 1996 to the
first quarter of 1997, average assets grew by 350% to $2.3 billion,
interest income revenue grew by 322% to $38.6 million, net interest
income grew by 227% to $9.1 million, credit provision expenses rose by
110% to $0.7 million and operating expenses grew by 137% to $1.2
million. Average total equity grew by 219% to $237.2 million.
Growth in revenues and net interest income have lagged average asset
growth somewhat as the Company has changed its asset mix towards lower
credit risk assets with narrower spreads and as the Company has
utilized a higher percentage of debt rather than equity to fund its
mortgage assets. Credit provision expenses have not increased pro-rata
with growth in average assets as the Company has not added to its
portfolio of securitized mortgages rated less than AA since 1995. On
average, the Company has moved towards an asset mix that, through March
31, 1997, has required a lower average level of credit provisions.
Growth in operating expenses has lagged asset growth as the Company has
become more efficient in its operations.
The Company's primary income and expense categories are shown in
Table 1.
20
TABLE 1
NET INCOME
REVENUES INTEREST NET INCOME INCOME
OR RATE NET CREDIT BEFORE AFTER
INTEREST INTEREST AGREEMENT INTEREST PROVISION OPERATING PREFERRED PREFERRED PREFERRED
INCOME EXPENSE EXPENSE INCOME EXPENSE EXPENSES DIVIDENDS DIVIDENDS DIVIDENDS
------ ------- ------- ------ ------- -------- --------- --------- ---------
(DOLLARS IN THOUSANDS)
Fiscal 1994 $ 1,296 $ 760 $ 8 $ 528 $ 0 $ 146 $ 382 $ 0 $ 382
1995, Quarter 1 2,170 1,533 16 621 19 201 401 0 401
1995, Quarter 2 2,960 2,190 82 688 40 198 450 0 450
1995, Quarter 3 3,986 2,432 112 1,442 84 364 994 0 994
1995, Quarter 4 6,610 4,453 129 2,028 350 368 1,310 0 1,310
1996, Quarter 1 9,131 6,202 151 2,778 331 493 1,954 0 1,954
1996, Quarter 2 12,901 9,075 255 3,571 477 594 2,500 0 2,500
1996, Quarter 3 19,371 14,447 350 4,574 516 671 3,387 388 2,999
1996, Quarter 4 25,881 19,467 402 6,012 372 796 4,844 760 4,084
1997, Quarter 1 38,568 28,900 595 9,073 695 1,167 7,211 755 6,456
SHARES OUTSTANDING
Table 2 below shows the number of common shares (which includes Class A
preferred shares which were converted into common shares in 1995), preferred
shares, and warrants outstanding at the end of each reporting period. The table
also shows the average number of primary common shares (common shares
outstanding increased by an amount based on potential future dilution due to
warrants and options) used to calculate the Company's reported earnings per
share. From the first quarter of 1996 to the first quarter of 1997, the average
number of primary common shares outstanding increased by 98%.
TABLE 2
NUMBER OF SHARES
AVERAGE
COMMON PREFERRED NUMBER OF
SHARES SHARES WARRANTS AVERAGE POTENTIAL AVERAGE COMMON
OUTSTANDING OUTSTANDING OUTSTANDING NUMBER OF DILUTION NUMBER OF AND
AT AT AT COMMON DUE TO PRIMARY PREFERRED
PERIOD PERIOD PERIOD SHARES WARRANTS COMMON SHARES
END END END OUTSTANDING AND OPTIONS SHARES OUTSTANDING
--- --- --- ----------- ----------- ------ -----------
Fiscal 1994 1,874,395 0 1,666,063 1,676,080 240,766 1,916,846 1,676,080
1995, Quarter 1 1,874,395 0 1,666,063 1,874,395 240,766 2,115,161 1,874,395
1995, Quarter 2 1,874,395 0 1,666,063 1,874,395 188,699 2,063,094 1,874,395
1995, Quarter 3 5,516,313 0 1,666,063 3,944,129 239,009 4,183,138 3,944,129
1995, Quarter 4 5,517,299 0 1,665,063 5,516,310 563,197 6,079,507 5,516,310
1996, Quarter 1 5,521,376 0 1,665,063 5,521,376 608,211 6,129,587 5,521,376
1996, Quarter 2 8,520,116 0 1,563,957 7,813,974 786,258 8,600,232 7,813,974
1996, Quarter 3 9,069,653 1,006,250 1,076,431 8,732,326 783,848 9,516,174 9,246,389
1996, Quarter 4 10,996,572 1,006,250 412,894 9,705,138 747,334 10,452,472 10,711,388
1997, Quarter 1 11,905,957 999,638 272,304 11,605,171 511,696 12,116,867 12,610,686
EARNINGS PER PRIMARY SHARE (EPS)
Reported earnings per primary common share (EPS) in the first quarter of 1997
were $0.53. This was an increase of 66% from the $0.32 earned in the first
quarter of 1996. As shown in Table 3, the two primary components of this
increase in EPS were an 18% increase in the return on equity earned by the
Company and a 33% increase in book value per share (the amount of equity per
share the Company has available with which to generate earnings).
21
TABLE 3
PRIMARY COMPONENTS OF EARNINGS PER SHARE
(HISTORICAL AMORTIZED COST BASIS)
EARNINGS EARNINGS
RETURN PER ADJUSTMENT PER
AVERAGE ON AVERAGE FOR PRIMARY
COMMON AVERAGE COMMON POTENTIAL COMMON
EQUITY PER COMMON SHARE FUTURE SHARE
SHARE EQUITY OUTSTANDING DILUTION ("EPS")
----- ------ ----------- -------- -------
Fiscal 1994 $12.01 5.25% $0.23 $0.03 $0.20
1995, Quarter 1 12.36 6.94% 0.21 0.02 0.19
1995, Quarter 2 12.27 7.82% 0.24 0.02 0.22
1995, Quarter 3 13.37 7.54% 0.25 0.01 0.24
1995, Quarter 4 13.38 7.10% 0.24 0.02 0.22
1996, Quarter 1 13.49 10.50% 0.35 0.03 0.32
1996, Quarter 2 15.05 8.50% 0.32 0.03 0.29
1996, Quarter 3 15.16 9.06% 0.34 0.02 0.32
1996, Quarter 4 15.99 10.53% 0.42 0.03 0.39
1997, Quarter 1 17.89 12.44% 0.56 0.03 0.53
Return on equity increased as a result of increasing operational and capital
efficiencies at the Company. As shown in Table 4, the return on total equity
(including common and preferred equity) earned by the Company rose from 10.50%
in the first quarter of 1996 to 12.16% in the first quarter of 1997 Net interest
income per dollar of total equity increased from 14.92% to 15.30% as the Company
increased its capital utilization efficiency. Credit expenses as a percentage of
total equity dropped from 1.78% to 1.17% as the result of the shift the Company
has been making since mid-1995 towards the acquisition of lower-credit-risk
assets. Operating expenses as a percentage of total equity dropped from 2.64% to
1.97% as the Company became more productive. See "Earning Asset Yield and
Interest Rate Spread", "Net Interest Income", "Credit Expenses" and "Operating
Expenses" below.
TABLE 4
PRIMARY COMPONENTS OF RETURN ON TOTAL EQUITY
(HISTORICAL AMORTIZED COST BASIS)
NET
INTEREST RATIO OF
INCOME CREDIT OPERATING AVERAGE
RETURN ON PROVISIONS/ EXPENSE/ RETURN ON RETURN ON ASSETS
AVERAGE AVERAGE AVERAGE AVERAGE AVERAGE RETURN ON TO
TOTAL TOTAL TOTAL TOTAL COMMON AVERAGE TOTAL
EQUITY EQUITY EQUITY EQUITY EQUITY ASSETS EQUITY
------ ------ ------ ------ ------ ------ ------
Fiscal 1994 7.27% 0.00% 2.01% 5.25% 5.25% 1.81% 2.90x
1995, Quarter 1 10.73% 0.32% 3.48% 6.94% 6.94% 1.26% 5.48x
1995, Quarter 2 11.96% 0.70% 3.44% 7.82% 7.82% 1.10% 7.13x
1995, Quarter 3 10.94% 0.64% 2.76% 7.54% 7.54% 1.85% 4.08x
1995, Quarter 4 10.99% 1.90% 1.99% 7.10% 7.10% 1.40% 5.06x
1996, Quarter 1 14.92% 1.78% 2.64% 10.50% 10.50% 1.52% 6.89x
1996, Quarter 2 12.14% 1.62% 2.02% 8.50% 8.50% 1.30% 6.56x
1996, Quarter 3 12.40% 1.40% 1.82% 9.18% 9.06% 1.17% 7.83x
1996, Quarter 4 13.01% 0.81% 1.72% 10.48% 10.53% 1.25% 8.39x
1997, Quarter 1 15.30% 1.17% 1.97% 12.16% 12.44% 1.25% 9.74x
The Company's equity per share (on a historical amortized cost basis excluding
the mark-to-market valuation adjustments that have been made on a portion of the
Company's assets) has increased due to accretive stock offerings priced at
levels in excess of book value per share. In addition, in the first quarter of
1997, the Company's equity per share as reported increased due to market value
appreciation of Company assets. Equity
22
per share growth has been offset to some degree by the exercise of warrants and
options, the payment of dividends (which are based on taxable income) in excess
of GAAP income, and other factors. As shown in Table 24, total equity per share
(excluding mark-to-market valuation adjustments) increased by 44% from $13.26 at
March 31, 1996 to $19.03 at March 31, 1997. Table 5 shows how each of the
Company's public stock offerings increased the Company's total equity per share
(and thus its earnings per share potential).
TABLE 5
ACCRETIVE STOCK OFFERINGS
(HISTORICAL AMORTIZED COST BASIS)
% % %
INCREASE INCREASE INCREASE
IN IN IN
NUMBER PRICE PER NET NUMBER TOTAL EQUITY PER
SECURITY DATE OF SHARES SHARE PROCEEDS OF SHARES EQUITY SHARE
- -------- ---- --------- ----- -------- --------- ------ -----
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Common Stock - IPO 08/04/95 3,593,750 $ 15.50 $ 51,281 187% 224% 13%
Common Stock 04/19/96 2,875,000 20.25 54,730 52% 74% 15%
Class B Preferred Stock 08/17/96 1,006,250 31.00 29,712 12% 23% 10%
Common Stock 11/19/96 1,250,000 31.75 39,171 12% 23% 10%
Common Stock 01/24/97 750,000 39.50 29,223 6% 14% 7%
TAXABLE INCOME
In order to determine its dividend levels, the Company must first determine its
pre-tax, or taxable, income as calculated according to IRS guidelines. As a
REIT, the Company deducts its dividend distributions from taxable income and is
required to pay Federal taxes on any remaining undistributed taxable income.
Since the Company intends to distribute 100% of its taxable income as dividends
(and as a REIT is required to distribute at least 95%), the Company is not
generally subject to Federal income tax. As a result of these REIT issues, the
Company's total dividends will reflect its taxable income rather than its total
net GAAP income.
Taxable income differs from GAAP because (i) taxable income credit expense
equals actual credit losses rather than credit provisions (actual credit losses
through March 31, 1997 have been minor), (ii) amortization methods differ for
discount that has been created when mortgages have been acquired at a price
below principal value, (iii) stock dividend equivalent rights which accrue on
some stock options are deducted from GAAP income as an operating expense but are
not deducted from taxable income until the stock is issued, and (iv) operating
expenses differ in certain other aspects. Management believes taxable income is
a closer approximation of current cash flow generation than is GAAP income.
Taxable income (before preferred dividends) in the first quarter of 1997 was
$7.9 million and was 10% higher than GAAP net income (before preferred
dividends) of $7.2 million during the same period. The table below presents the
major differences between GAAP and taxable income for the Company.
23
TABLE 6
TAXABLE INCOME
GAAP TAXABLE
CREDIT OPERATING
GAAP PROVISIONS EXPENSES TAXABLE TAXABLE TAXABLE TAXABLE
NET INCOME IN EXCESS OF AND INCOME INCOME RETURN ON RETURN ON
BEFORE REALIZED MORTGAGE BEFORE AFTER AVERAGE AVERAGE
PREFERRED CREDIT AMORTIZATION PREFERRED PREFERRED COMMON TOTAL
DIVIDENDS LOSSES DIFFERENCES DIVIDENDS DIVIDENDS EQUITY EQUITY
--------- ------ ----------- --------- --------- ------ ------
(DOLLARS IN THOUSANDS)
Fiscal 1994 $ 382 $ 0 $ (28) $ 354 $ 354 4.86% 4.86%
1995, Quarter 1 401 19 (12) 408 408 7.05% 7.05%
1995, Quarter 2 450 40 38 528 528 9.19% 9.19%
1995, Quarter 3 994 84 5 1,083 1,083 8.21% 8.21%
1995, Quarter 4 1,310 347 156 1,813 1,813 9.83% 9.83%
1996, Quarter 1 1,954 331 264 2,549 2,549 13.69% 13.69%
1996, Quarter 2 2,500 477 165 3,142 3,142 10.69% 10.69%
1996, Quarter 3 3,387 516 145 4,048 3,660 11.06% 10.97%
1996, Quarter 4 4,844 365 220 5,429 4,669 12.03% 11.75%
1997, Quarter 1 7,211 653 48 7,912 7,157 13.79% 13.34%
DIVIDENDS
The Company declared a dividend of $0.60 per common share in the first quarter
of 1997 resulting in a total dividend distribution (including preferred
dividends) of $7.9 million, or 99.8% of taxable income earned during the
quarter. Through March 31, 1997, cumulative taxable income exceeded cumulative
dividends paid or declared by $0.4 million; the Company intends to distribute
this excess taxable income as part of the Company's future dividends.
The first quarter common stock dividend of $0.60 per share represented a 46%
increase over the $0.41 per common share declared in the fourth quarter of 1996
and an increase of 30% over the $0.46 declared for the first quarter of 1996.
The Company's Class B Preferred stock outstanding at period end receives a
quarterly dividend of $0.755 per share or, if greater, the common stock
dividend. There were 999,638 shares of Class B Preferred stock outstanding at
March 31, 1997. Dividends for the first quarter of 1997 equaled the minimum
level of $0.755 per share.
24
TABLE 7
DIVIDENDS
TAXABLE
INCOME
AFTER
PREFERRED TOTAL
COMMON DIVIDENDS PREFERRED COMMON
SHARES PER COMMON SHARES PREFERRED AND
OUTSTANDING COMMON DIVIDEND TOTAL OUTSTANDING DIVIDEND TOTAL PREFERRED
EARNING SHARE DECLARED COMMON EARNING DECLARED PREFERRED DIVIDENDS
DIVIDEND OUTSTANDING PER SHARE DIVIDEND DIVIDEND PER SHARE DIVIDEND DECLARED
-------- ----------- --------- -------- --------- --------- -------- --------
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
Fiscal 1994 1,401,904 $ 0.25 $ 0.25 $ 350 0 $ 0.000 $ 0 $ 350
1995, Quarter 1 1,666,063 0.25 0.20 333 0 0.000 0 333
1995, Quarter 2 1,666,063 0.32 0.30 500 0 0.000 0 500
1995, Quarter 3 5,516,313 0.20 0.20 1,103 0 0.000 0 1,103
1995, Quarter 4 5,517,299 0.33 0.26 1,434 0 0.000 0 1,434
1996, Quarter 1 5,521,376 0.46 0.46 2,540 0 0.000 0 2,540
1996, Quarter 2 8,520,116 0.37 0.40 3,408 0 0.000 0 3,408
1996, Quarter 3 9,069,653 0.40 0.40 3,628 1,006,250 0.386 388 4,016
1996, Quarter 4 10,996,572 0.42 0.41 4,508 1,006,250 0.755 760 5,268
1997, Quarter 1 11,905,957 0.60 0.60 7,144 999,638 0.755 755 7,899
EARNING ASSET YIELD AND INTEREST RATE SPREAD
The yield on the Company's earning assets (mortgages plus cash) declined from
7.34% in the first quarter of 1996 to 6.87% in the first quarter of 1997, a
decline of 47 basis points. Over the same period, the Company's cost of funds
declined by 7 basis points from 5.69% to 5.62% and the Company's cost of hedging
declined by 2 basis points from 0.14% to 0.12%. As a result of these changes,
the spread the Company earned between the yield on its assets and its cost of
borrowed funds and hedging declined from 1.51% in the first quarter of 1996 to
1.13% in the first quarter of 1997.
The asset mix of the Company, and therefore the earning asset yield and the
spread the Company earned, changed from the first quarter of 1996 to first
quarter of 1997. Beginning in 1995, the Company ceased the acquisition of
higher-yielding, wider-spread, higher-credit-risk assets such as mortgage
securities rated below AA and focused on the acquisition of lower-yielding,
narrower-spread, lower-credit-risk assets such as high-quality whole loans and
mortgage securities rated AAA and AA. A competitive return on equity can be
achieved by the Company on these new higher-quality assets, despite a lower
yield and a narrower interest rate spread, as the Company makes a smaller
internal capital allocation to these assets and expenses a lower level of credit
provisions.
Rapid asset growth has also led, on a temporary basis, to lower asset yields and
a narrower spread for the Company. Newly acquired adjustable-rate mortgages
typically have lower initial mortgage coupon rates than the Company earns on its
existing mortgage portfolio. Typically the coupon rates on newly acquired
mortgages are lower than average for six to twelve months. Thus the Company's
average spread has been narrower on a temporary basis during periods of rapid
balance sheet growth.
25
TABLE 8
EARNING ASSET YIELD AND INTEREST RATE SPREAD
AVERAGE EFFECT OF
COUPON NET
RATE AVERAGE AVERAGE DISCOUNT/ NET EARNING INTEREST
DURING COST COUPON (PREMIUM) MORTGAGE CASH ASSET COST OF COST OF RATE
PERIOD BASIS YIELD AMORTIZATION YIELD YIELD YIELD FUNDS HEDGING SPREAD
------ ----- ----- ------------ ----- ----- ----- ----- ------- ------
Fiscal 1994 6.09% 100.0% 6.09% 0.45% 6.54% 4.73% 6.33% 5.55% 0.06% 0.72%
1995, Quarter 1 6.32% 99.5% 6.35% 0.70% 7.05% 4.96% 7.03% 5.96% 0.06% 1.01%
1995, Quarter 2 6.82% 98.5% 6.92% 0.51% 7.43% 5.57% 7.41% 6.26% 0.23% 0.92%
1995, Quarter 3 7.29% 98.7% 7.39% 0.30% 7.69% 5.53% 7.66% 6.09% 0.28% 1.29%
1995, Quarter 4 7.59% 99.3% 7.64% (0.25%) 7.39% 5.48% 7.34% 6.04% 0.18% 1.12%
1996, Quarter 1 7.73% 98.8% 7.82% (0.44%) 7.38% 5.93% 7.34% 5.69% 0.14% 1.51%
1996, Quarter 2 7.47% 100.0% 7.48% (0.56%) 6.92% 5.61% 6.90% 5.57% 0.16% 1.17%
1996, Quarter 3 7.52% 101.0% 7.44% (0.52%) 6.92% 5.30% 6.90% 5.78% 0.14% 0.98%
1996, Quarter 4 7.58% 101.4% 7.48% (0.59%) 6.89% 5.31% 6.87% 5.76% 0.12% 0.99%
1997, Quarter 1 7.70% 101.8% 7.56% (0.68%) 6.88% 5.69% 6.87% 5.62% 0.12% 1.13%
The Company's earning asset yield and spread were also diminished in the first
quarter of 1997 due to an increase in the rate of mortgage principal repayments
on those assets for which the Company paid a premium price. As shown in Table 9,
the Company wrote off its premium balances at an annual rate of 25% in the first
quarter of 1996 and 29% in the first quarter of 1997. The Company writes off
premium as an amortization expense at a rate equal to or greater than the actual
monthly rate of principal repayment on those assets, so increases in principal
repayment rates cause an increase in amortization expense. The mortgages the
Company acquired at a discount also had rapid rates of mortgage principal
repayment; the Company does not amortize its discount balances into income at a
correspondingly rapid rate, however, as the discount balance acts as a form of
credit reserve for these assets. See "Credit Reserves" below.
The average annualized rate of principal repayment of the Company's mortgage
assets was 32% in the first quarter of 1997. This measure includes scheduled
principal payments, prepayments of principal, and the effects of returns of
principal caused by certain calls imbedded in securitized mortgage interests. It
represents the rate at which the Company must acquire new mortgage assets in
order to maintain its current size. A significant and increasing portion of the
Company's mortgage assets represent senior interests in pools of mortgage loans;
such senior interests typically receive principal repayments at an accelerated
rate relative to the rate of principal pay down of the underlying mortgage pool.
The Company's rate of mortgage principal repayment has increased, in part,
because of this change in asset mix. The weighted average Conditional Prepayment
Rate ("CPR") of the Company's mortgage loans and for the pools of mortgages
underlying the Company's securitized interests was 23% in the first quarter of
1997; CPR is a standard mortgage industry calculation which measures mortgage
prepayments but does not include scheduled mortgage principal repayments or the
effects of accelerated payments or calls. The adjustable-rate mortgages the
Company has acquired have generally been of a type that should be expected to
experience faster rates of principal repayment and higher CPRs than many other
types of adjustable-rate and fixed-rate mortgages. At acquisition, the Company
assumes that these mortgages will pay down at rapid rates; the Company adjusts
its bids for mortgage assets accordingly.
26
TABLE 9
AMORTIZATION ON MORTGAGE ASSETS
NET NET EST. AVE.
ANNUAL ANNUAL NET MORTGAGE MORTGAGE CONDITIONAL
AVERAGE RATE OF AVERAGE RATE OF AMORT. PRINCIPAL PRINCIPAL PREPYMNT
DISCOUNT DISCOUNT DISCOUNT PREMIUM PREMIUM PREMIUM INCOME/ REPAYMTS REPAYMT RATE
BALANCE AMORT. AMORT. BALANCE AMORT. AMORT. (EXPENSE) RECEIVED RATE "CPR"
------- ----- ------ ------- ------ ------ ------- -------- ---- -----
(DOLLARS IN THOUSANDS)
Fiscal 1994 $ 440 $ 101 63% $ 450 $ 19 12% $ 82 $ 1,244 7% 9%
1995, Quarter 1 1,440 234 65% 785 19 10% 215 2,673 9% 8%
1995, Quarter 2 3,528 237 27% 1,175 34 12% 203 2,934 7% 11%
1995, Quarter 3 6,017 280 19% 3,351 123 15% 157 8,319 16% 21%
1995, Quarter 4 10,889 210 8% 8,314 429 21% (219) 24,898 28% 25%
1996, Quarter 1 16,941 177 4% 11,299 707 25% (530) 32,814 27% 26%
1996, Quarter 2 16,739 245 6% 16,402 1,268 31% (1,023) 53,058 29% 29%
1996, Quarter 3 16,471 271 7% 27,233 1,707 25% (1,436) 76,942 28% 24%
1996, Quarter 4 16,236 217 5% 36,977 2,425 26% (2,208) 95,610 26% 23%
1997, Quarter 1 15,927 272 7% 56,374 4,090 29% (3,818) 173,362 32% 23%
The Company's earning asset yield and interest rate spread also declined during
the first quarter of 1997 as prospective yields and spreads available from newly
acquired mortgages declined throughout 1996 and thus far in 1997. Mortgage
prices have risen over the past year relative to expected future cash flows.
Management believes mortgage prices have risen due to strong demand from banks,
savings and loans, and other financial institutions (stemming from a continued
state of over-capitalization), an increase in the price of financial assets in
general, a decrease in interest rate volatility, and other factors. The effect
on the Company's earnings of this increase in mortgage prices for new assets was
offset to some degree by a reduced cost of hedging.
As noted, the Company's spread has narrowed over the past year for a variety of
reasons (some of which are temporary); at the same time, however, the Company
has significantly improved its operating and capital efficiencies. These
efficiencies have allowed the Company to increase return on equity over this
period despite lower yields and spreads.
As compared to the spread of 0.99% the Company earned in the fourth quarter of
1996, the 1.13% earned in the first quarter of 1997 was an improvement. The
Company's earning asset yield remained flat at 6.87% while the Company lowered
its cost of funds by 0.14%.
NET INTEREST INCOME
Net interest income, or interest income revenues less the cost of funds and
hedging, increased from $2.8 million in the first quarter of 1996 to $9.1
million in the first quarter of 1997.
As a percentage of average total equity, net interest income increased from
14.92% in the first quarter of 1996 to 15.30% in the first quarter of 1997.
There were three primary factors affecting profitability at the net interest
income level. First, the earning asset yield decreased from 7.34% to 6.87% over
this period, thus reducing the rate of net interest income the Company earned
from its mortgage assets funded directly with equity proceeds. In addition, as
discussed above, the spread the Company earned between its asset yield and its
cost of borrowed funds decreased from 1.51% to 1.13%. As an offsetting positive
factor, however, the Company was able to reduce risk on its balance sheet and
thereby lower its target equity-to-assets ratio. This combined with better
coordination of the timing of receipt of new equity and its employment in
earning assets allowed the Company to utilize more leverage and increase
returns. The target equity-to-assets ratio dropped from 12.8% to 10.1% and the
average actual equity-to-asset ratio dropped from 14.5% to 10.3%. (Balance sheet
capacity utilization increased from 88% to 98%).
From the fourth quarter of 1996 to the first quarter of 1997, net interest
income as a percentage of equity increased from 13.01% to 15.30%. The earning
asset yield in both quarters was 6.87%, so earnings from
27
equity-funded assets were similar. The interest rate spread earned increased
from 0.99% to 1.13%. In addition, the Company was able to make greater use of
leverage due to continued risk reduction (the target equity-to-assets ratio
dropped from 10.2% to 10.1%) and due to an increase in balance sheet capacity
utilization from 86% to 98% (the average actual equity-to-asset ratio dropped
from 11.9% to 10.3%).
TABLE 10
NET INTEREST INCOME
NET AVERAGE RATIO
INTEREST EQUITY AVERAGE PERCENT OF
INCOME TO TARGET OF SPREAD
RETURN ON ASSETS EQUITY CAPITAL FUNDED
AVERAGE EARNING INTEREST RATIO TO EMPLOYED ASSETS NET
TOTAL ASSET RATE DURING ASSETS DURING TO INTEREST
EQUITY YIELD SPREAD PERIOD RATIO PERIOD EQUITY MARGIN
------ ----- ------ ------ ----- ------ ------ ------
Fiscal 1994 7.27% 6.33% 0.72% 34.5% 10.6% 31% 1.88x 2.50%
1995, Quarter 1 10.73% 7.03% 1.01% 18.2% 12.9% 71% 4.44x 1.96%
1995, Quarter 2 11.96% 7.41% 0.92% 14.0% 13.2% 94% 6.09x 1.68%
1995, Quarter 3 10.94% 7.66% 1.29% 24.5% 13.6% 55% 3.03x 2.68%
1995, Quarter 4 10.99% 7.34% 1.12% 19.8% 13.6% 69% 4.00x 2.17%
1996, Quarter 1 14.92% 7.34% 1.51% 14.5% 12.8% 88% 5.86x 2.17%
1996, Quarter 2 12.14% 6.90% 1.17% 15.2% 11.4% 75% 5.54x 1.85%
1996, Quarter 3 12.40% 6.90% 0.98% 12.8% 10.7% 84% 6.77x 1.58%
1996, Quarter 4 13.01% 6.87% 0.99% 11.9% 10.2% 86% 7.31x 1.55%
1997, Quarter 1 15.30% 6.87% 1.13% 10.3% 10.1% 98% 8.67x 1.57%
The net interest margin is net interest income divided by assets. This ratio
changes as a function of the leverage ratio and other factors. As shown in Table
10, due to improving spreads and other efficiencies the net interest margin has
remained steady in a narrow range over the last three quarters even though the
Company has made greater use of leverage.
CREDIT LOSSES AND PROVISIONS
Realized actual credit losses were $0 in the first quarter of 1996 and were
$42,713 in the first quarter of 1997. The losses reduced taxable income and
dividends by the indicated amounts for those quarters, but did not impact
reported GAAP net income as they were previously provided for. The Company
expects to realize credit losses throughout 1997.
The Company reduced reported net income by $695,470 in the first quarter of 1997
to provide for possible future credit losses. As shown in Table 11, this
provision represented 0.12% of average assets and 1.17% of total average equity.
The credit provision in the first quarter of 1996 was $331,516, or 0.26% of
assets and 1.78% of equity. The Company has been able to reduce its credit
provision rate as its reduces the average level of credit risk on its balance
sheet (below-BBB-rated mortgage securities have declined from 4.9% of assets at
March 31, 1996 to 1.1% of assets at March 31, 1997).
The Company recently changed its policy regarding credit provisions for whole
mortgage loans. Formerly, the Company took a provision for "A" quality whole
loans at the time of acquisition equal to 0.30% of the principal value of the
mortgages. In the fourth quarter of 1996, the Company started taking whole loan
credit provisions on an on-going, rather than a one-time, basis in order to
avoid large unwarranted swings in reported income that could be caused by
acquisitions of bulk loan portfolios. Under the new policy, the Company takes
on-going credit provisions at an annual rate of 0.15% of the principal value of
"A" quality whole loans. The increase in credit provisions from the fourth
quarter of 1996 to the first quarter of 1997 is primarily the result of this
change in provision method and of a large bulk whole loan acquisition at the end
of 1996.
28
TABLE 11
CREDIT PROVISIONS AND ACTUAL CREDIT LOSSES
ANNUALIZED
ANNUALIZED CREDIT
TOTAL CREDIT PROVISIONS
TOTAL ACTUAL PROVISIONS TO AVERAGE
CREDIT CREDIT TO AVERAGE TOTAL
PROVISIONS LOSSES ASSETS EQUITY
---------- ------ ------ ------
(DOLLARS IN THOUSANDS)
Fiscal 1994 $ 0 $ 0 0.00% 0.00%
1995, Quarter 1 19 0 0.06% 0.32%
1995, Quarter 2 40 0 0.10% 0.70%
1995, Quarter 3 84 0 0.16% 0.64%
1995, Quarter 4 350 4 0.38% 1.90%
1996, Quarter 1 331 0 0.26% 1.78%
1996, Quarter 2 477 0 0.25% 1.62%
1996, Quarter 3 516 0 0.18% 1.40%
1996, Quarter 4 372 7 0.10% 0.81%
1997, Quarter 1 695 42 0.12% 1.17%
OPERATING EXPENSES
The Company has been able to improve its operating efficiency over time. As
shown in Table 12, total operating expenses rose from $0.5 million in the first
quarter of 1996 to $1.2 million in the first quarter of 1997. As a percentage of
average assets, however, annualized operating expenses dropped from 0.38% to
0.20% and as a percentage of total average equity annualized operating expenses
dropped from 2.64% to 1.97%. Thus, the improvement in return on equity over this
period due to increasing operational efficiencies was 0.67%.
From the fourth quarter of 1996 to the first quarter of 1997, operating expenses
rose by 47%, although most measures of operational efficiency remained the same
or improved. The Company significantly increased the accrual rates it uses for
cash compensation in anticipation of moving to a market-based salary and bonus
system for all employees except the Chairman/CEO and the President. Following a
third-party analysis of compensation practices at comparable companies, the
management and the Board of Directors decided that the Company and its
shareholders would best be served by increasing salaries and materially
increasing potential bonus awards for some employees in order to reflect market
rates of compensation. In order to maintain the current close alignment between
shareholders' interests and the compensation of the top employees, however, the
Board of Directors decided that the two senior executives will continue to be
compensated primarily with stock options and related dividend equivalent rights
and anticipates, given current information, that these two executives will
continue to receive salary and annual bonus awards which will be substantially
below market-based rates.
29
TABLE 12
OPERATING EXPENSES
EFFICIENCY
RATIO
(OPERATING OPERATING AVERAGE
COMPENSATION EXPENSE/ OPERATING EXPENSE/ ASSETS PER
AND OTHER TOTAL NET EXPENSE/ AVERAGE AVE. # OF
BENEFITS OPERATING OPERATING INTEREST AVERAGE TOTAL EMPLOYEES
EXPENSE EXPENSE EXPENSE INCOME) ASSETS EQUITY ($MM)
------- ------- ------- ------- ------ ------ -----
(DOLLARS IN THOUSANDS)
Fiscal 1994 $ 63 $ 83 $ 146 28% 0.69% 2.01% $ 12
1995, Quarter 1 81 120 201 32% 0.63% 3.48% 25
1995, Quarter 2 81 117 198 29% 0.48% 3.44% 33
1995, Quarter 3 204 160 364 25% 0.68% 2.76% 39
1995, Quarter 4 151 217 368 18% 0.39% 1.99% 53
1996, Quarter 1 319 174 493 18% 0.38% 2.64% 70
1996, Quarter 2 384 210 594 17% 0.31% 2.02% 84
1996, Quarter 3 390 281 671 15% 0.23% 1.82% 115
1996, Quarter 4 480 316 796 13% 0.21% 1.72% 155
1997, Quarter 1 732 435 1,167 13% 0.20% 1.97% 221
PER SHARE TRENDS
Table 13 below shows the Company's assets, equity, and income statement
components on a per average share outstanding basis (including both common and
preferred shares). From the first quarter of 1996 to the first quarter of 1997,
the Company was able to increase its average assets per average share by 97%,
from $93 to $183. This increase was due to reduced equity-to-assets ratio
targets attributable to risk reductions in the balance sheet, rising capital
efficiencies resulting in greater balance sheet capacity utilization, and
increasing equity per share values. Revenues per share increased by 85% and net
interest income per share increased by 44% over the one year period from first
quarter 1996 to first quarter 1997. Per share costs of credit expenses and
operating expenses remained stable. Total net income per share (including
preferred and common shares) rose 63% from $0.35 to $0.57.
TABLE 13
PER SHARE INFORMATION
AVERAGE AVERAGE NET INTEREST CREDIT OPERATING
ASSETS TOTAL EQUITY REVENUES INCOME PROVISIONS EXPENSES NET INCOME
PER AVERAGE PER AVERAGE PER AVERAGE PER AVERAGE PER AVERAGE PER AVERAGE PER AVERAGE
COMMON AND COMMON AND COMMON AND COMMON AND COMMON AND COMMON AND COMMON AND
PREFERRED PREFERRED PREFERRED PREFERRED PREFERRED PREFERRED PREFERRED
SHARE SHARE SHARE SHARE SHARE SHARE SHARE
----- ----- ----- ----- ----- ----- -----
Fiscal 1994 $ 34.85 $12.01 $0.77 $0.31 $0.00 $0.09 $0.22
1995, Quarter 1 67.77 12.36 1.16 0.33 0.01 0.11 0.21
1995, Quarter 2 87.54 12.27 1.58 0.37 0.02 0.11 0.24
1995, Quarter 3 54.54 13.37 1.01 0.37 0.02 0.09 0.26
1995, Quarter 4 67.72 13.38 1.20 0.37 0.06 0.07 0.24
1996, Quarter 1 92.87 13.49 1.65 0.50 0.06 0.09 0.35
1996, Quarter 2 98.76 15.05 1.65 0.45 0.06 0.07 0.32
1996, Quarter 3 124.97 15.96 2.10 0.50 0.06 0.07 0.37
1996, Quarter 4 144.83 17.26 2.42 0.55 0.03 0.07 0.45
1997, Quarter 1 183.09 18.81 3.06 0.72 0.06 0.09 0.57
30
FINANCIAL CONDITION
SUMMARY
Management believes the Company is well capitalized for the levels of risks
undertaken. The Company's assets are single-family mortgage assets. A majority
of these assets are further credit-enhanced beyond the inherent value of a
mortgage secured by a first lien on a residential property. The liquidity of a
majority of the Company's assets has been enhanced through the securitization
and credit rating process. The interest rate risks of the Company's assets and
liabilities are well matched; all mortgages have adjustable-rate coupons after
an initial period and are financed with equity and with variable-rate
borrowings. Interest rate risks which remain on the balance sheet after this
matching program are mitigated through the Company's interest rate hedging
program. The Company has uncommitted borrowing facilities in excess of its
needs. The Company only takes credit risk on mortgages underwritten to "A"
quality standards. The Company takes credit provisions to reserve for potential
future credit losses. The Company has low operating expenses and a high
percentage of its equity invested in earning assets. The Company's capital base
is tangible capital. Nevertheless, the Company maintains an equity-to-assets
ratio that is higher than that of many banks, savings and loans, insurance
companies, and REITs that act as mortgage portfolio lenders.
END OF PERIOD BALANCE SHEET
The Company's assets consist primarily of earning assets (mortgage assets and
cash). As shown in the table below, total assets increased by $0.5 billion, or
21%, from December 31, 1996 to March 31, 1997. The figures in the table below
present the balance sheet on a historical amortized cost basis and therefore
exclude the mark-to-market valuation account from balances shown for mortgage
assets, interest rate agreements, and stockholders' equity. This is the
presentation the Company would report if it had classified all of its assets as
"held-to-maturity".
TABLE 14
END OF PERIOD BALANCE SHEET
(HISTORICAL AMORTIZED COST BASIS)
RCVBLES
INTEREST AND
MORTGAGE CREDIT RATE OTHER TOTAL PREFERRED COMMON TOTAL
END OF PERIOD CASH ASSETS RESERVE AGRMNTS ASSETS ASSETS BORROWINGS PAYABLES EQUITY EQUITY EQUITY
- ------------- ---- ------ ------- ------- ------ ------ ---------- -------- ------ ------ ------
(DOLLARS IN THOUSANDS)
Fiscal 1994 $ 1,027 $ 120,135 $ (0) $ 1,791 $ 1,132 $ 124,085 $ 100,376 $ 872 $ 0 $ 22,837 $ 22,837
1995, Quarter 1 953 141,793 (19) 2,069 1,193 145,989 121,998 1,090 0 22,901 22,901
1995, Quarter 2 1,620 174,415 (59) 2,025 1,634 179,635 155,881 907 0 22,847 22,847
1995, Quarter 3 1,150 298,894 (143) 2,394 2,650 304,944 228,826 2,095 0 74,023 74,023
1995, Quarter 4 4,825 436,235 (490) 2,521 3,941 447,032 370,316 2,951 0 73,765 73,765
1996, Quarter 1 9,705 569,744 (821) 2,534 5,216 586,378 508,721 4,447 0 73,210 73,210
1996, Quarter 2 10,407 1,011,846 (1,298) 2,835 9,092 1,032,882 896,214 7,821 0 128,847 128,847
1996, Quarter 3 14,599 1,377,332 (1,814) 3,286 12,136 1,405,539 1,225,094 14,867 29,712 135,866 165,578
1996, Quarter 4 11,068 2,155,469 (2,180) 6,200 17,100 2,187,657 1,953,103 20,089 29,579 184,886 214,465
1997, Quarter 1 12,985 2,605,323 (2,833) 7,879 19,592 2,642,946 2,373,279 24,123 29,383 216,161 245,544
AVERAGE DAILY BALANCE SHEET
Table 15 presents the estimated average daily balances of the major components
of the Company's balance sheet as presented on a historical amortized cost
basis.
31
TABLE 15
AVERAGE DAILY BALANCE SHEET
(HISTORICAL AMORTIZED COST BASIS)
RCVBLES
INTEREST AND
MORTGAGE CREDIT RATE OTHER TOTAL PREFERRED COMMON TOTAL
END OF PERIOD CASH ASSETS RESERVE AGRMNTS ASSETS ASSETS BORROWINGS PAYABLES EQUITY EQUITY EQUITY
- ------------- ---- ------ ------- ------- ------ ------ ---------- -------- ------ ------ ------
(DOLLARS IN THOUSANDS)
Fiscal 1994 $ 6,627 $ 50,081 $ (0) $ 759 $ 947 $ 58,414 $ 37,910 $ 367 $ 0 $ 20,137 $ 20,137
1995, Quarter 1 1,217 122,181 (6) 1,684 1,958 127,034 102,894 978 0 23,162 23,162
1995, Quarter 2 1,466 158,183 (31) 1,916 2,559 164,093 139,979 1,111 0 23,003 23,003
1995, Quarter 3 3,597 204,672 (82) 2,120 4,819 215,126 159,794 2,585 0 52,747 52,747
1995, Quarter 4 10,709 349,676 (249) 2,428 11,000 373,564 295,089 4,654 0 73,821 73,821
1996, Quarter 1 14,639 483,102 (594) 2,503 12,094 512,762 435,979 2,324 0 74,459 74,459
1996, Quarter 2 14,402 734,010 (1,002) 2,737 21,566 771,713 651,643 2,472 0 117,598 117,598
1996, Quarter 3 18,854 1,104,844 (1,491) 3,185 30,129 1,155,521 999,229 8,728 15,179 132,385 147,564
1996, Quarter 4 16,137 1,490,985 (1,952) 4,681 41,430 1,551,281 1,351,510 14,898 29,671 155,202 184,873
1997, Quarter 1 12,147 2,233,410 (2,394) 6,899 58,856 2,308,918 2,056,051 15,691 29,545 207,631 237,176
MORTGAGE ASSET ACQUISITIONS
The two principal criteria the Company uses when acquiring mortgage assets are:
(i) the mortgages must be "A" quality in terms of underwriting and documentation
standards, or, if the loans in a securitized pool of mortgages have not been
underwritten to "A" quality standards, the interest in that pool acquired by the
Company must be credit-enhanced through insurance, subordination or other means
to such a degree that the interest has been rated AAA or AA by the credit rating
agencies, and (ii) the risk-adjusted returns on equity the Company anticipates
earning on such assets must be attractive across a variety of economic scenarios
relative to the Company's cost of capital and relative to other available
mortgage assets. Assets which are lower-risk, lower-yield, narrower-spread and
higher-priced may produce higher returns on equity across a variety of scenarios
for the Company than riskier assets due to a lower capital allocation to the
lower-risk asset.
The Company acquired $627 million of mortgage assets in the first quarter of
1997. A majority of these asset acquisitions did not close until late March, so
the income from these new assets will not have a significant effect on the
Company's income until the second quarter of 1997.
As shown in Table 16, an increasing percentage of the Company's acquisitions
have consisted of whole mortgage loans. The Company has also continued to
acquire adjustable-rate mortgage securities rated AAA and AA, but has not
acquired mortgage securities rated below AA since 1995.
32
TABLE 16
MORTGAGE ASSET ACQUISITIONS
AVERAGE AAA A & BELOW
ASSET PRICE "A" FHLMC &AA BBB BBB
ACQUISITIONS AS % OF AVERAGE QUALITY & FNMA RATED RATED RATED
AT PRINCIPAL INITIAL WHOLE GUARANTEED MORTGAGE MORTGAGE MORTGAGE
COST VALUE COUPON LOANS MORTGAGES SECURITIES SECURITIES SECURITIES
---- ----- ------ ----- --------- ---------- ---------- ----------
(DOLLARS IN THOUSANDS)
Fiscal 1994 $ 121,297 99.53% 5.87% 0.0% 64.8% 28.1% 4.3% 2.8%
1995, Quarter 1 24,116 94.80% 6.78% 0.0% 15.1% 49.1% 25.6% 10.2%
1995, Quarter 2 35,355 93.11% 6.42% 0.0% 65.8% 13.1% 0.0% 21.1%
1995, Quarter 3 132,640 103.14% 7.40% 0.0% 59.0% 32.3% 3.8% 4.9%
1995, Quarter 4 162,461 95.78% 7.39% 16.5% 52.4% 20.1% 5.5% 5.5%
1996, Quarter 1 166,852 102.60% 7.60% 0.0% 47.6% 52.4% 0.0% 0.0%
1996, Quarter 2 496,184 102.36% 7.30% 9.9% 71.5% 18.6% 0.0% 0.0%
1996, Quarter 3 443,860 102.74% 7.53% 14.4% 69.9% 15.7% 0.0% 0.0%
1996, Quarter 4 875,968 102.86% 7.81% 47.3% 17.5% 35.2% 0.0% 0.0%
1997, Quarter 1 627,075 102.46% 7.45% 40.0% 19.9% 40.1% 0.0% 0.0%
SUMMARY OF MORTGAGE ASSET CHARACTERISTICS
All the Company's mortgage assets acquired through March 31, 1997 were
single-family, adjustable-rate, first-lien mortgages or securitized interests in
pools of such loans. The average credit rating equivalent has been maintained at
AA+. At March 31, 1997, $1.8 billion principal value of the Company's mortgage
assets (72%) were classified as "available-for-sale" and were carried on its
balance sheet at estimated bid-side market value. The remaining $0.7 billion
principal value of the Company's mortgages (28%) were recently re-classified as
"held-to-maturity". Over time, the carrying value of these re-classified
mortgage assets will be adjusted towards historical amortized cost through
quarterly adjustments to the valuation account. At March 31, 1997, the estimated
liquidation value of all of the Company's mortgage assets was $2.604 billion;
net unrealized gains on all mortgage assets were 0.7% of the historical
amortized cost before credit reserve.
TABLE 17
MORTGAGE ASSET SUMMARY
UNREALIZED
GAINS/
(LOSSES)
AS % OF
AMORTIZED
MORTGAGE HISTORICAL GAAP ESTIMATED COST OF
PRINCIPAL UNAMORTIZED UNAMORTIZED AMORTIZED CREDIT VALUATION CARRYING LIQUIDATION MORTGAGE
END OF PERIOD VALUE PREMIUM DISCOUNT COST RESERVE ACCOUNT VALUE VALUE ASSETS
- ------------- ----- ------- -------- ---- ------- ------- ----- ----- ------
(DOLLARS IN THOUSANDS)
Fiscal 1994 $ 120,627 $ 827 $ 1,319 $ 120,135 $ (0) $(2,658) $ 117,477 $ 117,477 (2.21%)
1995, Quarter 1 143,393 914 2,515 141,792 (19) 87 141,860 141,860 0.06%
1995, Quarter 2 178,429 1,409 5,423 174,415 (59) 886 175,242 175,242 0.51%
1995, Quarter 3 298,718 7,498 7,322 298,894 (143) 34 298,785 175,242 0.01%
1995, Quarter 4 443,625 9,643 17,032 436,236 (490) (3,502) 432,244 432,244 (0.80%)
1996, Quarter 1 573,807 12,790 16,853 569,744 (821) (3,764) 565,159 565,159 (0.66%)
1996, Quarter 2 1,005,765 22,691 16,609 1,011,847 (1,298) (3,069) 1,007,480 1,007,480 (0.30%)
1996, Quarter 3 1,361,062 32,607 16,338 1,377,331 (1,814) 353 1,375,870 1,375,870 0.03%
1996, Quarter 4 2,117,245 54,317 16,039 2,155,469 (2,180) 139 2,153,428 2,153,428 0.01%
1997, Quarter 1 2,555,857 65,106 15,641 2,605,322 (2,833) 2,225 2,604,714 2,604,240 0.07%
The following table shows the average characteristics of the Company's mortgage
assets at the end of each reporting period. The index level is the weighted
average rate of the various short-term interest rate indices which determine
coupon adjustments. Unless limited by periodic or lifetime caps, the mortgage
coupons adjust at the end of each adjustment period to the level of the index
plus the net margin. The fully-indexed rate is the current index
33
plus the net margin: this is the maximum level to which the coupon could adjust
over time should interest rates remain unchanged. The rate of adjustment of the
current coupon to the fully-indexed rate is determined by the length of the
adjustment periods and the periodic caps of the mortgage loans. Due to increases
in short-term interest rates in March 1997, the Company's average mortgage
coupon of 7.70% was 0.49% below the full potential coupon rate of the mortgages
of 8.19% at March 31, 1997.
TABLE 18
AVERAGE MORTGAGE ASSET CHARACTERISTICS
COUPON AVERAGE
INTEREST MORTGAGE RATE VS. NUMBER
MORTGAGE RATE MORTGAGE FULLY- FULLY- OF MONTHS
COUPON INDEX NET INDEXED INDEXED TO NEXT LIFETIME
END OF PERIOD RATE LEVEL MARGIN RATE RATE ADJUSTMENT CAP
- ------------- ---- ----- ------ ---- ---- ---------- ---
Fiscal 1994 6.00% 6.94% 2.25% 9.19% (3.19%) 3 11.48%
1995, Quarter 1 6.53% 6.47% 2.24% 8.71% (2.18%) 3 11.57%
1995, Quarter 2 6.94% 5.99% 2.21% 8.20% (1.26%) 3 11.54%
1995, Quarter 3 7.35% 5.86% 2.20% 8.06% (0.71%) 4 11.56%
1995, Quarter 4 7.50% 5.44% 2.08% 7.52% (0.02%) 3 11.54%
1996, Quarter 1 7.59% 5.47% 2.11% 7.58% 0.01% 3 11.53%
1996, Quarter 2 7.42% 5.72% 2.21% 7.93% (0.51%) 4 11.71%
1996, Quarter 3 7.55% 5.70% 2.21% 7.91% (0.36%) 4 11.69%
1996, Quarter 4 7.75% 5.58% 2.24% 7.82% (0.07%) 5 11.73%
1997, Quarter 1 7.70% 5.98% 2.21% 8.19% (0.49%) 5 11.91%
As shown in Table 19, over the course of 1996 and through the first quarter of
1997, the Company increased its percentage of mortgage assets which had coupon
rates adjusting as a function of short-term U.S. Treasury interest rate indices.
Such assets represented 60% of all mortgage assets as of March 31, 1997 while
40% of Company assets adjusted off of LIBOR, CD, or other indices. Since changes
in the cost of the Company's liabilities are generally correlated with changes
in LIBOR rates, the Company's spread income will be diminished should LIBOR
rates rise relative to U.S. Treasury rates. Management expects that this effect,
should it occur, would be offset to some degree by the interest rate agreements
(caps, swaps, and basis swaps) owned by the Company.
TABLE 19
MORTGAGE ASSETS BY INDEX
SIX- HYBRID 3/1 STANDARD
SIX- ONE- MONTH ONE- ONE- SIX-
MONTH MONTH BANK YEAR YEAR MONTH
LIBOR LIBOR CD TREASURY TREASURY TREASURY
INDEX INDEX INDEX INDEX INDEX INDEX OTHER
----- ----- ----- ----- ----- ----- -----
Period of Initial Coupon Set 6 months 3 months 6 months 36 months 12 months 6 months various
Subsequent Adjust Frequency 6 months 1 month 6 months 12 months 12 months 6 months various
Average Next Adjustment 3 months 1 month 3 months 30 months 6 months 3 months various
Annualized Periodic Cap 2% none 2% 2% 2% 2% various
% OF TOTAL MORTGAGE ASSETS AT PERIOD END
Fiscal 1994 78.3% 3.8% 17.9% 0.0% 0.0% 0.0% 0.0%
1995, Quarter 1 78.7% 3.1% 17.3% 0.0% 0.9% 0.0% 0.0%
1995, Quarter 2 83.1% 2.5% 13.7% 0.0% 0.7% 0.0% 0.0%
1995, Quarter 3 66.9% 1.4% 11.5% 0.0% 11.5% 7.5% 1.2%
1995, Quarter 4 60.0% 7.5% 12.5% 0.0% 12.5% 5.0% 2.5%
1996, Quarter 1 63.1% 6.5% 8.8% 0.0% 14.8% 3.6% 3.2%
1996, Quarter 2 54.2% 3.2% 3.3% 0.0% 33.2% 4.4% 1.7%
1996, Quarter 3 45.6% 2.2% 2.4% 0.0% 45.6% 3.0% 1.2%
1996, Quarter 4 35.9% 1.4% 2.5% 0.0% 56.1% 2.0% 2.1%
1997, Quarter 1 34.0% 2.6% 1.9% 2.4% 55.8% 1.6% 1.7%
34
The table below shows the balance of the Company's whole mortgage loans and the
Company's securitized mortgage assets segregated by credit rating equivalent.
Due to the "A" quality underwriting and documentation standards of the Company's
whole loans, management believes that over 90% of the balance of these loans
would receive a credit rating of AAA or AA should the Company securitize these
loans and seek a credit rating from the credit rating agencies in the future. As
a result, management believes that percentage of the Company's balance sheet
which had the equivalent of a AAA or AA rating was 94% or greater at both
December 31, 1996 and March 31, 1997.
TABLE 20
MORTGAGE ASSETS BY CREDIT RATING EQUIVALENT
AAA/ A/ BB/ AAA/ A/ BB/
WHOLE AA BBB OTHER AA BBB OTHER
MORTGAGE RATING RATING RATING WHOLE RATING RATING RATING AVERAGE
LOAN EQUIV. EQUIV. EQUIV. LOAN EQUIV. EQUIV. EQUIV. CREDIT
AMORTIZED AMORTIZED AMORTIZED AMORTIZED PERCENT PERCENT PERCENT PERCENT RATING
END OF PERIOD COST COST COST COST OF TOTAL OF TOTAL OF TOTAL OF TOTAL EQUIVALENT
- ------------- ---- ---- ---- ---- -------- -------- -------- -------- ----------
(DOLLARS IN THOUSANDS)
Fiscal 1994 $ 0 $ 111,274 $ 5,208 $ 3,376 0.0% 92.9% 4.3% 2.8% AA+
1995, Quarter 1 0 124,556 11,398 5,839 0.0% 87.9% 8.0% 4.1% AA+
1995, Quarter 2 0 149,645 11,418 13,352 0.0% 85.8% 6.5% 7.7% AA+
1995, Quarter 3 0 262,418 16,505 19,971 0.0% 87.8% 5.5% 6.7% AA+
1995, Quarter 4 26,449 355,500 25,417 28,869 6.1% 81.5% 5.8% 6.6% AA+
1996, Quarter 1 24,851 490,611 26,231 28,051 4.4% 86.1% 4.6% 4.9% AA+
1996, Quarter 2 69,680 887,888 25,422 28,858 6.9% 87.7% 2.5% 2.9% AA+
1996, Quarter 3 127,809 1,195,188 25,429 28,906 9.3% 86.8% 1.8% 2.1% AA+
1996, Quarter 4 527,280 1,573,868 25,385 28,935 24.5% 73.0% 1.2% 1.3% AA+
1997, Quarter 1 731,957 1,819,100 25,311 28,955 28.1% 69.8% 1.0% 1.1% AA+
WHOLE MORTGAGE LOANS
The Company significantly increased the size of its whole mortgage loan
portfolio (mortgage loans which have not been securitized) in 1996 and in the
first quarter of 1997. The table below presents selected characteristics of the
Company's whole mortgage loans.
At March 31, 1997, the Company owned 2,795 whole mortgage loans with a total
principal balance of $716 million; these loans had an amortized cost before
credit reserve of $732 million, a balance sheet carrying value of $730 million,
and an estimated bid-side market value of $730 million. The whole loan credit
reserve was $0.6 million. At December 31, 1996 the Company owned 2,172 whole
mortgage loans with a total principal balance of $515 million; these loans had
an amortized cost before credit reserve of $527 million, a balance sheet
carrying value of $525 million, and an estimated bid-side market value of $525
million. The whole loan credit reserve at December 31, 1996 was $0.4 million.
All of these whole loans were adjustable-rate, single-family loans underwritten
to "A" quality standards. At March 31, 1997, the average whole loan size was
$256,221. California loans represent 41% of the total outstanding balance. Loans
with original loan-to-value ratios (LTV) in excess of 80% represent 24% of the
total outstanding balance; a substantial majority of these higher-LTV loans are
credit-enhanced with primary mortgage insurance or other forms of credit support
serving to bring the effective original LTV ratio on each of those loans to 75%
or less. After giving effect to this mortgage insurance, the average original
LTV ratio of the Company's whole loans was 68% at March 31, 1997. The ratio of
the current loan balance to original home value is lower than the original LTV
ratios detailed here due to pay downs of mortgage principal over time.
35
TABLE 21
WHOLE MORTGAGE LOAN SUMMARY
AT MARCH 31, 1997 AT DECEMBER 31,1996
----------------- -------------------
(ALL RATIOS BASED ON % OF TOTAL PRINCIPAL VALUE UNLESS NOTED) (ALL DOLLARS IN THOUSANDS)
Face or Principal Value $716,137 $515,033
Amortized Cost 731,957 527,280
Market Value 729,561 525,475
Adjustable-Rate 100% 100%
Single-Family 100% 100%
"A" Quality Underwriting 100% 100%
First Lien 100% 100%
Primary Residence (owner-occupied) 94% 94%
Second Home 4% 4%
Investment Property 2% 2%
Property Located in Northern California 17% 18%
Property Located in Southern California 24% 26%
Top Ten States as of 3/31/97
California 41.3% 43.5%
Maryland 6.4% 8.0%
Florida 4.6% 4.2%
Illinois 4.0% 3.8%
New York 3.8% 3.1%
Texas 3.4% 2.3%
Virginia 3.4% 4.3%
Connecticut 3.2% 3.0%
New Jersey 3.2% 2.8%
Massachusetts 2.7% 3.4%
Number of Loans 2,795 2,172
Average Loan Size $ 256 $ 237
Loan Balance less than $214,600 20% 23%
Loan Balance greater than $500,000 14% 8%
Average Original Loan-to-Value Ratio (LTV) 74% 77%
Original LTV > 80% 24% 25%
% of Original LTV > 80% with Primary Mortgage Insurance 94% 97%
Effective Original LTV including Primary Mortgage 68% 73%
Insurance
1989 and Prior Years Origination 6% 9%
1990 Origination 3% 4%
1991 Origination 1% 2%
1992 Origination 3% 4%
1993 Origination 9% 14%
1994 Origination 41% 52%
1995 Origination 4% 7%
1996 Origination 30% 8%
1997 Origination 2% 0%
Average Seasoning in Months 33 37
Non-Performing Assets (90+ days delinquent + f/c + REO) $ 1,220 $ 1,249
Number of Non-Performing Loans (NPAs) 6 7
Non-Performing Assets as % of Total Loan Balances 0.2% 0.2%
Non-Performing Assets as % of Total Assets 0.05% 0.06%
Real Estate Owned Assets (REO) $ 128 $ 196
Number of Real Estate Owned Assets 1 1
Real Estate Owned Assets as % of Total Loan Balances 0.02% 0.04%
The Company defines non-performing assets ("NPAs") as whole loans which are
delinquent more than 90 days, in foreclosure or real estate owned (REO). As of
March 31, 1997, the Company's NPAs were $1.2 million, with two loans 90+ days
delinquent, three loans in foreclosure and one real estate owned. At December
31, 1996, the Company had seven non-performing assets totaling $1.2 million.
Through March 31, 1997, the Company
36
experienced a credit loss on one whole loan. The loss severity on this loan
(total credit loss divided by the loan balance) was 7% for a total actual credit
loss of $12,995. Management eventually expects its whole loan credit losses to
mirror the experience of the "A" quality single-family residential mortgage
market as a whole. The Company is building a reserve for potential future credit
losses; see "Credit Reserves".
SECURITIZED MORTGAGES RATED AAA TO BBB
At March 31, 1997, 71% of the Company's mortgage assets were securitized
interests in pools of single-family mortgage loans which had an investment-grade
credit rating of AAA through BBB from one or more of the nationally-recognized
rating agencies, or, if not rated, had equivalent credit quality in the view of
management. At December 31, 1996, these types of mortgage securities represented
74% of the Company's mortgage assets.
Each of these investment-grade mortgage securities has credit-enhancement from a
third-party which provides the Company with full or partial protection from
credit losses in addition to the protection afforded by the value of the
properties underlying the individual mortgages and any primary mortgage
insurance on individual loans. Given the quality of the mortgage loans in these
pools and the levels of additional credit-enhancement, management believes the
level of credit risk for these mortgage assets is low. In the event, however,
that credit losses in these pools exhaust the credit-enhancement or in the event
of default of FNMA, FHLMC or another third party guarantor, credit losses to the
Company could result. Through March 31, 1997, the Company has experienced no
actual credit losses from these mortgage assets.
At March 31, 1997, the principal value of these mortgage assets was $1.80
billion, the historical amortized cost was $1.84 billion, the balance sheet
carrying value was $1.85 billion, and the estimated bid-side market value was
$1.85 billion. At December 31, 1996, the principal value of these mortgage
assets was $1.56 billion, the historical amortized cost was $1.60 billion, the
balance sheet carrying value was $1.60 billion, and the estimated bid-side
market value was $1.60 billion.
SECURITIZED MORTGAGES RATED BELOW BBB
In 1994 and 1995, the Company acquired a limited amount of securitized mortgage
assets with a credit rating equivalent of less than BBB. A majority of the
mortgages in the pools underlying these securities were underwritten to "A"
quality standards. The Company may acquire additional such assets when
management believes that the cash flow and return on average equity over the
life of the asset, net of expected credit losses, will be attractive. These
assets have high potential yields but also have higher levels of credit risk,
are costly to finance and require a large allocation of capital under the
Company's risk-adjusted capital system. Approximately 70% of the mortgage loans
in the pools underlying these securities at the time of issue of these
securities were located in California. As of March 31, 1997, these assets had a
principal, or face, value of $40.5 million, an amortized cost before credit
reserve of $29.0 million and an estimated bid-side market value (which equaled
carrying value) of $25.5 million. The credit reserve at March 31, 1997 was $2.2
million. At December 31, 1996, these assets had a principal value of $40.8
million, an amortized cost before credit reserve of $28.9 million and an
estimated bid-side market value (which equaled carrying value) of $25.6 million.
The credit reserve at December 31, 1996 was $1.8 million.
These assets may be highly beneficial to the Company over their life, although
any such benefits are likely to be realized chiefly in later years. Future
benefits may include possible credit rating upgrades and market value
improvements as the mortgage interests senior to the Company's position prepay.
This would lead to lower borrowing costs, an expanded equity base for the
Company and a lower internal risk-adjusted capital allocation. Another potential
benefit is the eventual return of principal (net of credit losses) which was
purchased at a discount. This would tend to increase the Company's earnings as
it amortizes these discount balances into income.
Approximately 98% of the Company's securitized assets with a credit rating
equivalent below BBB are credit-enhanced to some degree. These assets are
credit-enhanced to a lesser degree than higher-rated assets. Credit losses will
not be incurred by the Company on these assets until total credit losses in the
related mortgage pool exhaust the credit-enhancement. At that point, however,
the rate of loss to the Company's interest is likely to be
37
significant as these interests are subordinated to and provide
credit-enhancement for other, more senior, interests issued from the same
mortgage pool. In effect, the Company is providing a form of mortgage credit
insurance to the senior interests in each of these pools and therefore the
Company would bear the credit risk of the entire pool (which would be many times
the size of the Company's interest) in the event that the credit-enhancement
junior to the Company's interest is exhausted. Total potential credit losses to
the Company are limited to the Company's cost basis in these assets.
In some of the mortgage pools underlying these securities, delinquencies
currently exceed management's original expectations. Delinquency levels in most
of these pools appear to have stabilized during 1996 and thus far in 1997.
Actual pool credit losses which have reduced the credit-enhancement protection
to the Company's below BBB-rated interests have occurred, but most of the
aggregate credit enhancement in these pools that existed at the time of
acquisition was still intact at March 31, 1997. Through the first quarter of
1997, the Company has experienced no credit losses from these credit-enhanced,
below-BBB-rated assets.
In 1995, the Company acquired two "first loss" assets. These are subordinated
interests with no credit-enhancement and with leveraged credit risk. At both
December 31, 1996 and March 31, 1997, the estimated market value of these assets
was approximately $0.3 million; their historical amortized cost was $0.2
million. All credit losses in the related pools of mortgages will reduce the
principal value of these first loss assets and will be recognized as an actual
credit loss by the Company. As the Company's cost basis in its first loss assets
is low relative to the mortgage principal value, the Company's realized credit
loss will equal only 10-20% of the principal value of any mortgage credit losses
in the pools. The limit of the Company's potential credit losses on these assets
is equal to the amortized cost of $0.2 million. Total actual credit losses
realized by the Company on these first loss assets were $3,997 in 1995, $6,520
in 1996 and $29,718 in the first quarter of 1997.
CREDIT RESERVES
The Company has been building a credit reserve for future potential credit
losses through taking quarterly credit provisions. These credit provisions
reduce reported GAAP earnings (but only future actual credit losses will reduce
taxable earnings and dividends). The first step the Company takes in its
on-going review of the adequacy of its credit reserve is to assess potential
credit risk arising from whole loans and loans in the mortgage pools underlying
the Company's securitized mortgage assets which are seriously delinquent (90+
days delinquent, in foreclosure and real estate owned). Future credit losses
from these loans will depend on the number of these loans actually defaulting,
the loss severity experienced on default of the loan (net of recoveries from any
individual loan private mortgage insurance), the level of credit-enhancement at
the pool level, and the Company's amortized cost basis in that asset. The table
below shows the credit losses that could be incurred by the Company if all the
seriously delinquent mortgage loans in the Company's whole loan and mortgage
securities portfolios at the end of the respective quarter were to default and
result in a loss. For example, if 100% of the seriously delinquent loans as of
March 31, 1997 were to default and the loss severity experienced was 25% of the
loan balance, credit losses to the Company would be $2,014,000 (71% of the
current credit reserve). If such losses happen, most of them would likely occur
over the next twelve months (during which time the Company will continue to take
credit provisions and build its reserve). The amount of actual credit losses
that will be incurred from these loans is unknown. This table below addresses
the potential credit risk arising from serious delinquencies as the end of the
respective quarters only; it does not purport to reflect potential losses that
may occur over the life of these assets. In order to complete the evaluation of
the adequacy of its reserve levels, the Company also considers additional credit
losses that may arise from future delinquencies. See also "Results of Operations
- -- Credit Provisions".
38
TABLE 22
POTENTIAL FUTURE CREDIT LOSSES ESTIMATED BASED ON
CURRENT 90+ DAY DELINQUENCIES ONLY
POTENTIAL POTENTIAL POTENTIAL POTENTIAL POTENTIAL POTENTIAL
FUTURE FUTURE FUTURE FUTURE FUTURE FUTURE
LOSSES LOSSES LOSSES LOSSES LOSSES LOSSES
CUMULATIVE ASSUMING ASSUMING ASSUMING ASSUMING ASSUMING ASSUMING
CREDIT LOSS LOSS LOSS LOSS LOSS LOSS LOSS
LOSS SEVERITY SEVERITY SEVERITY SEVERITY SEVERITY SEVERITY SEVERITY
END OF PERIOD RESERVE EXPERIENCE OF 10% OF 15% OF 20% OF 25% OF 30% OF 35%
- ------------- ------- ---------- ------ ------ ------ ------ ------ ------
(DOLLARS IN THOUSANDS)
Fiscal 1994 $ 0 0% $ 0 $ 0 $ 0 $ 0 $ 0 $ 0
1995, Quarter 1 19 0% 0 0 0 0 0 0
1995, Quarter 2 59 0% 0 0 0 0 0 0
1995, Quarter 3 143 0% 0 0 0 0 0 0
1995, Quarter 4 490 9% 15 22 29 37 103 435
1996, Quarter 1 821 10% 39 58 78 227 655 1,280
1996, Quarter 2 1,298 16% 68 102 147 715 1,449 2,215
1996, Quarter 3 1,814 22% 102 154 205 703 1,254 2,196
1996, Quarter 4 2,180 27% 190 285 861 1,601 2,420 3,440
1997, Quarter 1 2,833 25% 204 370 1,040 2,014 3,217 4,486
As of March 31, 1997 the mortgage securities rated below BBB owned by the
Company had a historical amortized cost basis on the Company's books which was
$14.8 million below the principal value (or face value) of such mortgage
interests. While this $14.8 million is not a credit reserve per se, the discount
basis of these assets should serve to offset a portion of any actual losses of
principal due to credit that may occur in these assets in the future. To the
extent such losses are not incurred, this $14.8 million discount will be
amortized into the Company's reported income over time as the mortgage principal
of these assets pay down. Due to their subordinated status, many of these
below-BBB-rated assets are not currently receiving significant principal pay
downs; unless impacted by poor credit performance, the Company should start to
receive a reasonable flow of principal pay downs from these assets during the
next ten years and thus may be able to recognize an increased amortization of
its discount balances into income at that time.
INTEREST RATE AGREEMENTS
The Company's interest rate agreements are described in detail in "Note 3.
Interest Rate Agreements" in the Notes to Consolidated Financial Statements.
These assets had a historical amortized cost basis of $7.9 million at March 31,
1997, an estimated bid-side market value of $5.8 million and a balance sheet
carrying value of $5.8 million. There is no credit reserve for these assets. At
December 31, 1996, the Company's interest rate agreements had a historical
amortized cost basis of $6.4 million, an estimated bid-side market value of $2.6
million and a balance sheet carrying value of $2.6 million. There is a risk that
the counter-parties to the interest rate agreements will not be able to perform
to the terms of these contracts. If this were to happen, the Company's total
accounting exposure would be limited to its historical amortized cost basis in
these assets, although the true economic opportunity cost to the Company could
be higher. Each of the twelve counter-parties to the Company's interest rate
agreements had a credit rating of at least "A" as of March 31, 1997.
BORROWINGS
At March 31, 1997, the Company's debt consisted of collateralized borrowing
arrangements of various types (reverse repurchase agreements, notes payable,
revolving lines of credit). All such borrowings were short-term and their market
value approximated the historical cost and carrying value of $2.37 billion. To
date, the Company has borrowed from fifteen different collateralized lenders.
The Company's ability to roll over such borrowings when they mature depends on
the market value, liquidity and credit quality of its assets, the soundness of
the Company's balance sheet as a whole, the state of the collateralized lending
market, and other factors. See "Note 5. Short-Term Borrowings" in the Notes to
Consolidated Financial Statements for additional
39
information. The Company has established uncommitted borrowing facilities in
this market in amounts in excess of its current requirements.
On average, the Company believes that its average total borrowing capacity has
been 94% to 97% of the market value of its mortgage assets. The Company,
however, has limited its borrowings, and thus its potential asset growth, in
order to maintain unused borrowing capacity and thus increase the liquidity and
strength of its balance sheet.
The term-to-maturity of the Company's borrowings have ranged from one day to one
year. For some borrowings, the cost of funds adjusts to a market level on a
monthly basis during the term of the borrowing, so the
term-to-next-rate-adjustment may be shorter than the term-to-maturity. At March
31, 1997, the weighted average term-to-maturity was 79 days and the weighted
average term-to-next-rate-adjustment was 43 days; at December 31, 1996, the
average term-to-maturity was 98 days and the average
term-to-next-rate-adjustment was 55 days. The Company adjusts the maturities and
other terms of its borrowings over time based on the interest rate
characteristics of its balance sheet, the degree to which interest rate risk has
been reduced through the use of interest rate agreements and other factors.
Since late 1996, the Company has been reducing the term-to-next-rate adjustment
of its liabilities while increasing its interest rate agreement hedging
activities.
TABLE 23
BORROWING SUMMARY
ESTIMATED
MARKET BORROWING
VALUE OF CAPACITY AVERAGE RATE ON
PLEDGABLE AS A % OF ESTIMATED AVERAGE TERM TO BORROWINGS
MORTGAGE PLEDGABLE BORROWING TOTAL TERM TO RATE OUTSTANDING
END OF PERIOD ASSETS ASSETS CAPACITY BORROWINGS MATURITY ADJUSTMENT AT PERIOD-END
- ------------- ------ ------ -------- ---------- -------- ---------- -------------
(DOLLARS IN THOUSANDS)
Fiscal 1994 $ 117,447 95.6% $ 112,283 $ 100,376 112 days 70 days 5.80%
1995, Quarter 1 141,860 94.3% 133,719 121,998 97 days 27 days 6.25%
1995, Quarter 2 175,242 95.4% 167,192 155,881 64 days 28 days 6.23%
1995, Quarter 3 298,785 94.5% 282,442 228,826 38 days 31 days 5.95%
1995, Quarter 4 432,244 94.6% 409,014 370,316 74 days 26 days 6.01%
1996, Quarter 1 565,159 95.2% 537,874 508,721 48 days 19 days 5.62%
1996, Quarter 2 1,007,480 95.9% 965,795 896,214 72 days 72 days 5.70%
1996, Quarter 3 1,375,870 96.2% 1,324,220 1,225,094 102 days 71 days 5.78%
1996, Quarter 4 2,153,427 96.5% 2,077,098 1,953,103 98 days 55 days 5.83%
1997, Quarter 1 2,604,240 96.5% 2,513,840 2,373,279 79 days 43 days 5.82%
STOCKHOLDERS' EQUITY
From December 31, 1996 to March 31, 1997, the Company's equity base (exclusive
of the mark-to-market valuation account) grew from $214.4 million to $245.5
million. This growth was the result of the Company's January 1997 common stock
offering ($29.2 million), proceeds from the issuance of common stock upon the
exercise of warrants ($2.1 million) and common stock sold pursuant to the
Company's Dividend Reinvestment Plan ($0.5 million). Stockholders' equity was
decreased by $0.7 million in the first quarter as dividend distributions (which
are based on taxable income, see "Results of Operations - Taxable Income")
exceeded GAAP income.
Book value, or equity, per share (including common and preferred, excluding the
valuation account) increased by 6% from $17.87 to $19.03 from December 31, 1996
to March 31, 1997. See Table 24.
For balance sheet purposes, the Company carries some of its mortgage assets and
interest rate agreements on its balance sheet at their estimated bid-side
liquidation market value. As a result, the Company's equity base and book value
per share may fluctuate due to market conditions and other factors. Reported
GAAP net unrealized gain or loss includes both mark-downs on some assets taken
immediately upon acquisition (as liquidation values
40
are generally estimated to be lower than acquisition prices) and the effect of
subsequent market value fluctuations on a portion of the Company's assets. This
valuation account also includes balance sheet accounting entries being made over
time as a result of a re-classification of certain assets. The GAAP account does
not include the effect of market value changes of "held-to-maturity" assets or
of liabilities.
TABLE 24
STOCKHOLDERS' EQUITY
(GAAP REPORTING BASIS)
HISTORICAL
AMORTIZED
GAAP COST
TOTAL REPORTED EQUITY
VALUATION VALUATION HISTORICAL EQUITY PER GAAP
VALUATION ACCOUNT FOR ACCOUNT AMORTIZED BASE COMMON REPORTED
ACCOUNT FOR INTEREST TOTAL AS % OF COST INCLUDING AND EQUITY
MORTGAGE RATE VALUATION TOTAL EQUITY VALUATION PREFERRED PER
END OF PERIOD ASSETS AGREEMENTS ACCOUNT ASSETS BASE ACCOUNT SHARE SHARE
- ------------- ------ ---------- ------- ------ ---- ------- ----- -----
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Fiscal 1994 $ (2,657) $ 101 $(2,556) (2.1%) $ 22,837 $ 20,280 $12.18 $10.82
1995, Quarter 1 86 (635) (549) (0.4%) 22,901 22,352 12.22 11.93
1995, Quarter 2 886 (1,200) (314) (0.2%) 22,847 22,533 12.19 12.02
1995, Quarter 3 34 (1,585) (1,551) (0.5%) 74,024 72,473 13.42 13.14
1995, Quarter 4 (3,502) (1,974) (5,476) (1.2%) 73,766 68,290 13.37 12.38
1996, Quarter 1 (3,763) (1,302) (5,065) (0.9%) 73,211 68,146 13.26 12.34
1996, Quarter 2 (3,068) (1,485) (4,553) (0.4%) 128,847 124,295 15.12 14.59
1996, Quarter 3 353 (2,413) (2,060) (0.1%) 165,578 163,517 16.43 16.23
1996, Quarter 4 139 (3,599) (3,460) (0.2%) 214,465 211,005 17.87 17.58
1997, Quarter 1 2,225 (2,107) 118 0.0% 245,544 245,662 19.03 19.04
The table below presents the Company's estimated mark-to-market value of its
entire balance sheet. As such it represents an estimate of the theoretical
liquidation value of the Company if all assets and liabilities could be disposed
of at their current market values. The Company expects that these values will
fluctuate significantly over time, and that such fluctuations may or may not
imply changes in the Company's credit worthiness or its potential to generate
earnings and dividends in the future.
41
TABLE 25
STOCKHOLDERS' EQUITY
(ESTIMATED FULL MARK-TO-MARKET BASIS)
HISTORICAL
AMORTIZED MARK-TO-
COST MARKET
EQUITY EQUITY
PER CHANGES FROM HISTORICAL AMORTIZED COST BASIS PER
COMMON ---------------------------------------------- TOTAL COMMON
AND INTEREST OTHER MARK-TO- AND
PREFERRED MORTGAGE RATE ASSETS/ MARKET PREFERRED
END OF PERIOD SHARE ASSETS AGREEMENTS BORROWINGS LIABILITIES EQUITY SHARE
- ------------- ----- ------ ---------- ---------- ----------- ------ -----
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
Fiscal 1994 $12.18 $(2,381) $ 101 $ 0 $(244) $ 20,036 $10.69
1995, Quarter 1 12.22 86 (635) 0 (210) 22,142 11.81
1995, Quarter 2 12.19 886 (1,200) 0 (157) 22,376 11.94
1995, Quarter 3 13.42 34 (1,584) 0 (177) 72,296 13.11
1995, Quarter 4 13.37 (3,502) (1,974) 0 (151) 68,139 12.35
1996, Quarter 1 13.26 (3,764) (1,302) 0 (26) 68,119 12.34
1996, Quarter 2 15.12 (3,068) (1,484) 0 65 124,360 14.60
1996, Quarter 3 16.43 353 (2,414) 0 35 163,552 16.23
1996, Quarter 4 17.87 139 (3,598) 0 236 211,241 17.60
1997, Quarter 1 19.03 1,750 (2,106) 0 410 245,598 19.03
LIQUIDITY
A financial institution has ample liquidity when it is able, without seriously
disrupting its operations, to meet the demands made upon it for cash payments
with its cash reserves, operating cash flow, borrowing capacity, proceeds from
asset sales, or other sources of cash. Liquidity allows the Company to purchase
additional mortgage assets and allows the Company to pledge additional assets to
secure existing borrowings should the value of pledged assets decline. Potential
immediate sources of liquidity for the Company include cash balances and unused
borrowing capacity. Unused borrowing capacity is defined as estimated borrowing
capacity (as shown above in Table 23) less total borrowings and is based on the
market value of the Company's assets and market conditions in the collateralized
lending markets at period-end. Unused borrowing capacity will vary over time as
the market value of the Company's mortgage assets and market conditions
fluctuate and due to other factors. Potential immediate sources of liquidity
totaled $135 million at December 31, 1996 and $154 million at March 31, 1997.
The maintenance of liquidity is one of the goals of the Company's risk-adjusted
capital policy; under this policy, asset growth is limited in order to preserve
unused borrowing capacity for liquidity management purposes.
The Company's balance sheet generates liquidity on an on-going basis through
mortgage principal repayments and net earnings held prior to payment as
dividends. The Company's operations through March 31, 1997 have been cash flow
positive. Should the Company's needs ever exceed these on-going sources of
liquidity plus the immediate sources of liquidity discussed above, management
believes that the Company's mortgage assets and interest rate agreements could
be sold in most circumstances to raise cash (although such sales could cause
realized losses). The table below shows the potential immediate sources of
liquidity available to the Company.
42
TABLE 26
SOURCES OF LIQUIDITY
POTENTIAL ADJUSTMENTS
IMMEDIATE TO RECONCILE
SOURCES OF NET INCOME
LIQUIDITY NET TO NET CASH
ESTIMATED (CASH + INCOME (SEE STATEMENT NET CASH
UNUSED EST. UNUSED MORTGAGE BEFORE OF CASH FLOWS PROVIDED
CASH BORROWING BORROWING PRINCIPAL PREFERRED IN FINANCIAL BY OPERATING
BALANCE CAPACITY CAPACITY) REPAYMENTS DIVIDENDS STATEMENTS) ACTIVITIES
------- -------- --------- ---------- --------- ----------- ----------
(DOLLARS IN THOUSANDS)
Fiscal 1994 $ 1,027 $ 11,907 $ 12,934 $ 1,244 $ 382 $ (501) $ (119)
1995, Quarter 1 953 11,721 12,674 2,673 401 (191) 211
1995, Quarter 2 1,620 11,311 12,931 2,934 450 (870) (420)
1995, Quarter 3 1,150 53,616 54,766 8,319 994 (393) 601
1995, Quarter 4 4,825 38,698 43,523 24,898 1,310 (68) 1,242
1996, Quarter 1 9,705 29,153 38,858 32,814 1,954 127 2,081
1996, Quarter 2 10,407 69,581 79,988 53,058 2,500 320 2,820
1996, Quarter 3 14,599 99,126 113,725 76,942 3,387 5,553 8,940
1996, Quarter 4 11,068 123,995 135,063 95,610 4,844 1,790 6,634
1997, Quarter 1 12,985 140,561 153,546 173,362 7,211 3,735 10,946
CAPITAL ADEQUACY/RISK-ADJUSTED CAPITAL POLICY
The Company's target equity-to-assets ratio was 9.97% at December 31, 1996 and
10.09% at March 31, 1997 (These ratios are based on the Company's estimated
market values of the assets.) The Company's target equity-to-assets ratio varies
over time as a function of the Company's liquidity position, the maturity of the
Company's borrowings, the level of unused borrowing capacity, the level of
interest rates as compared to the periodic and life caps in the Company's
assets, the over-collateralization levels required by the Company's lenders and
the market value of the assets. The Company has sought to maintain an
equity-to-assets ratio of 7% to 10% for assets funded with short-term borrowings
which have low credit risk, relatively low interest rate risk, good liquidity,
and low lender over-collateralization requirements. For less liquid assets with
credit risk that are funded with short-term borrowings, the Company has sought
to maintain an equity-to-assets ratio of 40% to 100%. For assets funded to
maturity with long-term borrowings, the Company anticipates it would seek to
maintain an equity-to-assets ratio of 5% or less in most circumstances. The
Company's per-asset capital requirements have not changed significantly since
the founding of the Company; the decline in target equity-to-assets ratio during
1996 was a function of a change in asset mix. The increase in the target ratio
in the first quarter of 1997 was primarily due to the increase in market
interest rates late in the quarter. These target levels of equity capitalization
are higher than that of many banks, savings and loans, Federal government
mortgage agencies, insurance companies, and REITs that act as mortgage portfolio
lenders.
The target equity-to-assets ratio is determined through a Board-level process
determined by the Company's Risk-Adjusted Capital Policy. Since the factors on
which the guidelines and the actual capital levels of the Company are based do
fluctuate, the Company expects that its actual capital levels will fall below
its capital guidelines from time to time. For instance, if short-term interest
rates rose sharply, for assets funded with short-term borrowings the Company's
actual capital levels would decline at the same time that its capital
requirements would rise. When the capital guidelines exceed the actual available
capital, management will cease the acquisition of new mortgage assets and will
make plans to bring the Company's capital levels back into compliance with its
guidelines over time.
In certain limited circumstances and in limited amounts, the Company may, prior
to a planned equity offering, acquire or commit to acquire assets in excess of
the levels proscribed by its Risk-Adjusted Capital levels. For example, the
Company ended the first quarter of 1997 with assets of $213 million in excess of
what could have been supported by its capital base in the absence of this
special provision. The Company's capital ratios were brought back within its
standard Risk-Adjusted Capital guidelines through the Company's April 1997
common
43
stock offering. In a similar manner, the Company owned excess assets at the end
of the fourth quarter of 1996 in anticipation of its January 1997 common stock
offering.
The Company attempts to hold what it believes to be a reasonable amount of
capital given the risks in its balance sheet; target capital levels could rise
or fall over time. If the Company continues to move towards a lower- risk
balance sheet (through acquiring higher-quality more-liquid mortgage assets,
acquiring mortgages with no periodic caps, replacing short-term debt with
long-term debt, or other such means), the Company would seek to lower its target
equity-to-assets ratio in what it believes to be an appropriate manner.
In the past, the Company has operated with significantly fewer assets than would
have been allowed under its Risk-Adjusted Capital system. As shown in Table 10,
the average equity-to-assets ratio has exceeded the target equity-to-assets
ratio; that is, the Company's balance sheet capacity has been under-utilized.
Average balance sheet capacity utilization was 88% in the first quarter of 1996,
with an average equity-to-assets ratio of 14.5% as compared to an average target
equity-to-assets ratio of 12.8%. Average balance sheet capacity utilization was
98% during the first quarter of 1997, with an average balance sheet capacity
utilization of 10.3% as compared to an average target equity-to-assets ratio of
10.1%. The Company's rate of asset growth has made it difficult for the Company
to achieve optimum capital efficiency. In the past, the Company has raised
equity in advance of seeking to acquire new mortgages. As evidenced by the
improvement in the capacity utilization from the first quarter of 1996 to the
first quarter of 1997, the Company has succeeded in increasing its capital
efficiency through the use of its equity shelf registration and through
committing to acquire some assets in advance of planned equity offerings as
described above.
The table below shows the Company's actual and target equity-to-assets ratios
and the Company's actual asset size as compared to its full potential asset size
given its equity capital base and the guidelines of the Company's Risk-Adjusted
Capital Policy.
TABLE 27
EXCESS CAPITAL AND ASSET GROWTH POTENTIAL AT END OF QUARTER
ACTUAL POTENTIAL ASSET
END OF ASSET GROWTH
TARGET PERIOD SIZE POTENTIAL
EQUITY EQUITY WITH WITH
ACTUAL TO TO SAME ACTUAL SAME
"RISK-BASED" ASSETS ASSETS EXCESS ASSET ASSET ASSET
END OF PERIOD CAPITAL RATIO RATIO CAPITAL MIX SIZE MIX
- ------------- ------- ----- ----- ------- --- ---- ---
(DOLLARS IN THOUSANDS)
Fiscal 1994 $ 20,280 10.84% 16.69% $ 6,716 $ 187,048 $ 121,528 $ 65,520
1995, Quarter 1 22,352 12.41% 15.37% 3,970 180,173 145,440 34,733
1995, Quarter 2 22,533 12.95% 12.57% (1,069) 173,989 179,321 (5,332)
1995, Quarter 3 72,473 13.08% 23.89% 32,155 554,183 303,394 250,789
1995, Quarter 4 68,290 12.59% 15.47% 12,028 542,431 441,557 100,874
1996, Quarter 1 68,146 11.72% 11.72% 26 581,540 581,313 227
1996, Quarter 2 124,295 10.77% 12.09% 13,566 1,154,303 1,028,330 125,973
1996, Quarter 3 163,517 10.32% 11.65% 18,664 1,584,315 1,403,478 180,837
1996, Quarter 4 211,005 9.97% 9.66% (6,798) 2,116,028 2,184,197 (68,169)
1997, Quarter 1 245,188 10.09% 9.28% (21,504) 2,429,511 2,642,590 (213,079)
CLASS B PREFERRED STOCK
In August 1996, the Company issued 1,006,250 shares of Class B Preferred Stock;
these shares trade on the Nasdaq National Market under the symbol RWTIP. As of
March 31, 1997, there were 999,638 such shares outstanding; 6,612 shares of
Preferred Stock were converted into Common Shares in the first quarter of 1997.
The liquidation preference of each share of Class B Preferred is $31.00 plus any
accrued dividends. Preferred holders receive a quarterly dividend equal to the
greater of $0.755 or the common stock dividend. Each share of Class B Preferred
is convertible at any time at the option of the holder thereof into one share of
common
44
stock (subject to possible future adjustment in certain circumstances); the
Company has the right to force this conversion on or after October 1, 1999
providing that the market price of the common stock for a period of time prior
to such redemption exceeds the conversion price (initially equal to the issue
price of $31.00). The Company also has the right to call the Preferred for
$31.00 per share plus any accrued dividends in cash starting October 1, 1999.
See "Note 7. Class B 9.74% Cumulative Convertible Preferred Stock" in the Notes
to Consolidated Financial Statements for additional information.
WARRANTS
At March 31, 1997, the Company had 272,304 warrants outstanding; at December 31,
1996 the Company had 412,894 warrants outstanding. In the first quarter of 1997,
140,590 warrants were exercised generating additional equity proceeds to the
Company of $2.1 million. The remaining warrants trade on the Nasdaq National
Market under the symbol RWTIW. Each warrant gives the holder the right until
December 31, 1997 to buy 1.000667 shares of common stock at a price per share of
$15.00. See "Note 8. Stock Purchase Warrants" in the Notes to Consolidated
Financial Statements for additional information. If the Company's common stock
continues to trade at a price above $15.00 per share, the remaining warrants are
likely to be exercised on or prior to December 31, 1997. If all these warrants
are exercised, the Company will receive additional new equity capital of
approximately $4.1 million.
ASSET/LIABILITY MANAGEMENT AND EFFECT OF CHANGES IN INTEREST RATES
Management continually reviews the Company's asset/liability strategy with
respect to interest rate risk, mortgage principal repayment risk, credit risk
and the related issues of capital adequacy and liquidity. The Company seeks
attractive risk-adjusted shareholder returns while seeking to maintain a strong
balance sheet and long-term pattern of net income which grows over time relative
to its competitors in the banking and savings and loan industries.
Changes in interest rates, mortgage principal repayment rates, and other factors
are likely, however, to cause short-term volatility in the Company's reported
EPS results; the Company generally does not seek to hedge away or otherwise
significantly reduce this potential short-term earnings volatility.
The Company has sought to manage the extent to which net income changes as a
function of changes in interest rates by matching adjustable-rate assets with
variable-rate liabilities and by hedging through the use of interest rate
agreements to mitigate the potential impact on net income of periodic and
lifetime caps (coupon adjustment restrictions) in the assets. Should the Company
acquire other types of mortgages (including fixed rate mortgages) in the future,
the Company anticipates it will seek to reduce interest rate risks through
funding with appropriately matched debt, through hedging, or other means. In
general, the Company does not seek to anticipate future changes in interest
rates. The Company seeks to prepare itself for a variety of possible future
interest rate environments.
A primary goal of the Company's asset/liability strategy is to preserve
liquidity by preserving the market value of its mortgage assets and interest
rate agreements and thus preserving, in most conditions, the Company's ability
to maintain its level of borrowings. Through March 31, 1997, all of the
Company's borrowings were secured by the market value of its mortgage assets. In
seeking to preserve liquidity and the Company's ability to roll over short-term
borrowings, the Company allocates what it believes to be a sufficient amount of
capital to each mortgage asset which serves to act as a cushion preserving the
Company's ability to secure borrowings despite potential market value
fluctuations of its mortgage assets. The Company has also undertaken a hedging
program utilizing interest rate agreements. In the event of an increase in
short-term and/or long-term interest rates, the market value of the Company's
mortgage assets would likely fall, particularly in the short-term. The Company
anticipates that, in such an event, the market value of its interest rate
agreements would likely rise and partially offset decreases in mortgage values.
Management believes that the combined effect of the Company's equity allocations
and its hedging program are likely to preserve liquidity for the Company in most
interest rate environments. See "Asset/Liability Management and Effect of
Changes in Interest Rates -- Equity Duration"
45
below. The market value of the Company's mortgage assets can also fluctuate as a
function of changes in supply and demand, market volatility, and other factors
which may be difficult or impossible to hedge.
Changes in interest rates also may have an effect on the rate of mortgage
principal repayment; the Company has sought in the past to mitigate the economic
effect of changes in the mortgage principal repayment rate by balancing assets
purchased at a premium with assets purchased at a discount. The Company has not
been able to achieve such balancing in 1996 and in the first quarter of 1997,
however, as virtually all mortgage assets which were available for acquisition
from the secondary mortgage market and which were otherwise attractive to the
Company were priced at a premium. As a result, the Company has significantly
increased its net unamortized premium balance relative to the size of its
balance sheet. Potential short-term earnings volatility with respect to changes
in mortgage principal repayment rates has increased as a result. At March 31,
1997, the Company estimates that its quarterly EPS in the short-term would be
decreased by approximately $0.01 for each one percentage point increase in the
Company's rate of mortgage principal repayment, all other factors being equal;
EPS would increase in a similar manner should principal repayment rates slow.
Although the net effects on earnings of changes in interest rates, mortgage
prepayment rates, and other factors cannot be determined in advance, management
believes, given the balance sheet as of March 31, 1997, that some of the
following effects may occur in an environment of rising short-interest rates:
(i) earnings on that portion of the balance sheet funded with equity may rise
over time as the coupons on adjustable rate mortgages adjust upwards, (ii)
earnings on that portion of the balance sheet funded with borrowings (spread
lending) may be initially reduced as borrowing costs rise more quickly than the
coupons on adjustable rate mortgages, although most or all of the spread might
be restored over time as the mortgage coupons fully adjust to the rate change,
(iii) earnings may benefit from net hedge income or reduced net hedge expense
from interest rate agreements, (iv) premium amortization expenses may be reduced
if the rate of mortgage principal repayment diminishes. All other factors being
equal, the net effect of an increase in short-term interest rates may be an
initial drop in earnings followed by increased earnings after a lag period. The
length of any such lag period would likely be determined by the speed and extent
of the change in interest rates. Management believes that most of these effects
would likely be reversed in an environment of falling short-term interest rates.
All other factors being equal, therefore, the net effect of falling short-term
interest rates, given the balance sheet as of March 31, 1997, could be an
initial increase in earnings followed by decreased earnings after a lag period.
The Company's change in its mix of assets throughout 1996 and in the first
quarter of 1997 increased the Company's basis risk between LIBOR interest rates
and U.S. Treasury bill interest rates. The majority of the Company's assets at
March 31, 1997 had coupons which changed as a function of U.S. Treasury bill
rates while all the Company's borrowings had a cost of funds which tends to
change in conjunction with changes in LIBOR rates. The Company believes its
interest rate agreements mitigate to some degree the extent to which a reduced
spread for the Company would result from LIBOR rates rising relative to U.S.
Treasury interest rates. See "Note 3. Interest Rate Agreements" in the Notes to
Consolidated Financial Statements for additional information.
Should the Company continue its funding strategy in effect at March 31, 1997,
the Company's short-term earnings will also fluctuate to some extent with
changes in the relationship between six and twelve month interest rates (off of
which the coupons on Company's mortgage assets adjust) and one to six month
interest rates (on which the Company's cost of funds is based). All other
factors being equal, a flatter yield curve in the short end of the yield curve
(when six and twelve month rates are low relative to one to six month rates) may
have a negative effect on the Company's spread earnings.
In general, the Company's goal is to stabilize spread lending income over longer
periods of time and allow income from equity-funded lending to rise as
short-term interest rates rise and fall as short-term interest rates fall. If
the Company were to achieve this goal, the Company's return on average equity,
earnings and dividends would, over longer periods of time, rise as short-term
interest rates rise, fall as short-term interest rates fall, and thus maintain a
constant or widening spread to the level of short-term interest rates.
46
Should long-term interest rates rise while short-term interest rates remain
stable, management expects, based on the Company's balance sheet as of March 31,
1997, that mortgage principal repayment rates may slow (thus benefiting
earnings) but the market value of the Company's assets, net of hedges, would
likely fall (thus potentially reducing the amount of assets the Company could
carry on its balance sheet.)
INTEREST RATE SENSITIVITY GAP BEFORE HEDGING
The table below shows the Company's cumulative interest rate sensitivity gap, or
maturity gap, for periods of one month to five years as a percentage of total
assets. The interest rate sensitivity gap is a tool used by financial
institutions, such as banks and savings and loans, to analyze the possible
effects of interest rate changes on net income over time. The gap measures the
amount of assets that mature or have a coupon adjustment in a particular period
as compared to the amount of liabilities similarly adjusting during that time. A
negative gap implies that rising interest rates will lead to lower earnings,
while a positive gap implies that rising interest rates will lead to higher
earnings. Lower interest rates would have the opposite effect. In each case,
these effects are limited to the particular time period for which the gap is
calculated.
As applied to the Company, this gap analysis ignores the effect of the Company's
hedging activities (interest rate agreements), the effect of the periodic and
lifetime caps in the Company's assets, the effects of "lookbacks" whereby coupon
rates on Company assets are set based on interest rates one to three months
prior to the start of accrual of a new coupon rate, the effect of changes in
mortgage principal repayment rates and other factors. Nevertheless, the gap
analysis can provide some useful information on the Company's interest rate risk
profile.
The Company's three-month cumulative gap as a percentage of total assets was
negative 34% at March 31, 1997. This suggests that the initial impact on the
Company's earnings of rising interest rates would be negative. Falling interest
rates would have the opposite effect. The Company had a cumulative twelve-month
gap of positive 7% at March 31, 1997. This implies that the impact on net
interest income of increasing interest rates may be positive after several
quarters even though the initial impact could have been negative. Falling
interest rates would likely have the opposite effect.
Although the Company's balance sheet does have these underlying characteristics,
since a variety of factors (such as interest rate agreements) have not been
taken into account in the gap analysis, it is not possible to assess, solely on
this basis, what the actual impact of such interest rate changes on the
Company's net income would be, especially over shorter time periods.
The Company has a positive interest rate sensitivity gap for periods of one year
or longer even though most assets and liabilities adjust within one year because
the Company has more earning assets than interest-bearing liabilities (i.e., a
portion of the Company's earning assets are funded with equity).
47
TABLE 28
INTEREST RATE SENSITIVITY GAP EXCLUDING INTEREST RATE AGREEMENTS
CUMULATIVE CUMULATIVE CUMULATIVE CUMULATIVE CUMULATIVE CUMULATIVE
3-MONTH 6-MONTH 9-MONTH ONE YEAR THREE YEAR FIVE YEAR
GAP GAP GAP GAP GAP GAP
AS A % OF AS A % OF AS A % OF AS A % OF AS A % OF AS A % OF
TOTAL TOTAL TOTAL TOTAL TOTAL TOTAL
END OF PERIOD ASSETS ASSETS ASSETS ASSETS ASSETS ASSETS
- ------------- ------ ------ ------ ------ ------ ------
Fiscal 1994 5% 15% 15% 15% 15% 15%
1995, Quarter 1 (27%) 14% 14% 14% 14% 14%
1995, Quarter 2 (33%) 11% 12% 12% 12% 12%
1995, Quarter 3 (19%) 18% 20% 23% 23% 23%
1995, Quarter 4 (26%) 9% 12% 15% 15% 15%
1996, Quarter 1 (34%) 4% 8% 11% 11% 11%
1996, Quarter 2 (3%) (2%) 5% 12% 12% 12%
1996, Quarter 3 (9%) (4%) 3% 12% 12% 12%
1996, Quarter 4 (28%) (12%) (1%) 10% 10% 10%
1997, Quarter 1 (34%) (17%) (4%) 7% 9% 9%
INTEREST RATE AGREEMENTS
The Company's interest rate agreements materially alter the interest rate risk
profile suggested by the interest rate sensitivity gap analysis. See "Results of
Operations -- Cost of Borrowed Funds and Hedging and the Interest Rate Spread"
above and "Note 3. Interest Rate Agreements" of the Notes to Consolidated
Financial Statements for further detail and information.
The interest rate agreements are designed to produce income for the Company as
short-term interest rates rise to partially offset possible losses of net
interest income from the spread lending portion of the Company's balance sheet.
These agreements can be thought of as serving to limit potential increases in
the costs of the Company's borrowings or, alternatively, as serving to remove
some of the periodic and lifetime caps imbedded in the Company's assets. These
agreements also serve to remove some of the short-term risk arising from funding
assets that have fixed coupon adjustments for six to twelve months with
liabilities that are fixed, on average as of March 31, 1997, for a three month
shorter period of time. In addition, the interest rate agreements are designed
to appreciate in market value in most circumstances in which short-term and/or
long-term interest rates rise sharply, thereby partially offsetting likely
concurrent declines in the market value of the Company's mortgage assets.
INTEREST RATE FUTURES AND OPTIONS
The Company has used interest rate futures and may use listed options on
interest rate futures as part of its on-going interest rate risk management
process. These instruments are in some ways similar to the interest rate
agreements; the Company uses them in a similar manner and for hedging purposes
only. The Company currently limits the aggregate amount of funds that the
Company will deposit as original margin on futures plus premiums on listed
options to less than 1% of the Company's total assets, after taking into account
unrealized gains and unrealized losses on any such contracts. The Company
currently limits its use of futures and listed options so that its profits from
such instruments will be limited to 5% or less of the Company's gross taxable
income on an annual basis. The Company had no positions in futures or options on
futures at December 31, 1996 or March 31, 1997.
EQUITY DURATION
The Company uses "equity duration" to measure the stability of the market value
of its assets with respect to the size of its equity base as interest rates
fluctuate. Equity duration is a theoretical calculation of the projected
percentage change in the reported equity base of the Company that would occur if
short-term and long-term
48
interest rates moved up or down by 1% overnight. The Company's goal is to
maintain an equity duration of less than 15%. In practice, the Company believes
it has maintained an equity duration of less than 10%. Should interest rates
increase by more than 1%, the Company believes its equity duration would
increase from its current levels.
INFLATION
Virtually all of the Company's assets and liabilities are financial in nature.
As a result, interest rates and other factors drive the Company's performance
far more than does inflation. Changes in interest rates do not necessarily
correlate with inflation rates or changes in inflation rates. The Company's
Consolidated Financial Statements are prepared in accordance with Generally
Accepted Accounting Principals and the Company's dividends are determined by the
Company's net income as calculated for tax purposes; in each case, the Company's
activities and balance sheet are measured with reference to historical cost or
fair market value without considering inflation.
SEASONAL EFFECTS
There are three factors that management has identified which may have seasonal
effects on the Company's earnings. First, management believes that in many years
there may be more mortgage assets for sale by motivated sellers in the fourth
quarter of the year than at any other time. If this is true, in many years the
Company could grow at a faster rate in the fourth quarter than at other times of
the year. This would generally benefit earnings in the first quarter of the
following year. Secondly, mortgage principal repayment rates have a seasonal
pattern of slowing in the winter and accelerating in the summer. Since the
Company's premium amortization expenses are based on the Company's actual
monthly principal repayment experience, overall earnings may be higher, all
other things being equal, in the winter months. Finally, there is a mismatch in
the day-count method that is used each month to determine the Company's interest
income from mortgages and its interest expense from short-term borrowings. As a
result, given the characteristics of the Company's balance sheet as of March 31,
1997 and assuming all other factors are equal, net interest income should tend
to be higher in quarters, such as the first and second quarters of the year,
that have fewer days.
49
PART II OTHER INFORMATION
Item 1. Legal Proceedings
At March 31, 1997, there were no pending legal proceedings to which the
Company as a party or of which any of its property was subject.
Item 2. Changes in Securities
None
Item 3. Defaults Upon Senior Securities
Not applicable
Item 4. Submission of Matters to a Vote of Security Holders
Not applicable
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit 11.1 to Part I - Computation of Earnings Per Share for
the three months ended March 31, 1997.
Exhibit 27 - Financial Data Schedule.
(b) Reports
Form 8-K filed on January 7, 1997 containing the Company's
Amended and Restated Bylaws, amended December 13, 1996.
50
SIGNATURES
Pursuant to the requirements of the Securities Act of 1934, the registrant has
duly caused this report to be signed on its behalf by the undersigned thereunto
duly authorized.
REDWOOD TRUST, INC.
Dated: May 9, 1997 By: /s/ Douglas B. Hansen
------------------------------------------
Douglas B. Hansen
President and Chief Financial Officer
(authorized officer of registrant)
Dated: May 9, 1997 By: /s/ Vickie L. Rath
------------------------------------------
Vickie L. Rath
Vice President, Treasurer and Controller
(principal accounting officer)
51
REDWOOD TRUST, INC.
INDEX TO EXHIBIT
Sequentially
Exhibit Numbered
Number Page
- ------- ------------
11.1 Computation of Earnings per Share................. 53
27 Financial Data Schedule........................... 54
52