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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: JUNE 30, 1996
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 common stock, as of the last practicable date.
Common Stock ($.01 par value) 8,783,601 as of August 7, 1996
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REDWOOD TRUST, INC.
FORM 10-Q
INDEX
Page
----
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Balance Sheets at June 30, 1996 and December 31, 1995 ............ 3
Statements of Operations for the three and six months
ended June 30, 1996 and June 30, 1995 ............................ 4
Statements of Stockholders' Equity for the three and six months
ended June 30, 1996 and June 30, 1995 ............................ 5
Statements of Cash Flows for the three and six months
ended June 30, 1996 and June 30, 1995 ............................ 6
Notes to Financial Statements .................................... 7
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations ......................... 17
PART II. OTHER INFORMATION
Item 1. Legal Proceedings ..................................................... 44
Item 2. Changes in Securities ................................................. 44
Item 3. Defaults Upon Senior Securities ....................................... 44
Item 4. Submission of Matters to a Vote of Security Holders ................... 44
Item 5. Other Information ..................................................... 45
Item 6. Exhibits and Reports on Form 8-K ...................................... 45
SIGNATURES ..................................................................... 46
2
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
REDWOOD TRUST, INC.
BALANCE SHEETS
(In thousands, except share data)
June 30, 1996 December 31, 1995
------------- -----------------
ASSETS
Cash and cash equivalents $ 10,407 $ 4,825
Mortgage assets 1,007,480 432,244
Interest rate agreements 1,351 547
Accrued interest receivable 7,292 3,270
Other assets 1,800 671
---------- --------
$1,028,330 $441,557
========== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
LIABILITIES
Reverse repurchase agreements $ 858,772 $346,335
Notes payable 37,442 23,981
Accrued interest payable 4,052 1,290
Accrued expenses and other liabilities 361 227
Dividends payable 3,408 1,434
---------- --------
904,035 373,267
---------- --------
Commitments and contingencies (See Note 10)
STOCKHOLDERS' EQUITY
Common stock, par value $.01 per share;
Authorized 50,000,000 shares, issued and
outstanding 8,520,116 and 5,517,299 shares 85 55
Additional paid-in capital 130,441 73,895
Net unrealized loss on assets available for sale (4,553) (5,476)
Undistributed income (deficit) (1,678) (184)
---------- --------
124,295 68,290
---------- --------
$1,028,330 $441,557
========== ========
The accompanying notes are an integral part of these financial statements
3
REDWOOD TRUST, INC.
STATEMENTS OF OPERATIONS
(In thousands, except share data)
Three Months Ended Six Months Ended
June 30, June 30,
1996 1995 1996 1995
---- ---- ---- ----
INTEREST INCOME
Mortgage assets $ 12,699 $ 2,941 $ 21,613 $ 5,095
Cash and investments 202 20 419 36
---------- ---------- ---------- ----------
12,901 2,961 22,032 5,131
INTEREST EXPENSE 9,075 2,191 15,277 3,724
INTEREST RATE AGREEMENTS
Interest rate agreement expense 255 82 407 98
---------- ---------- ---------- ----------
NET INTEREST INCOME 3,571 688 6,348 1,309
Provision for credit losses 477 40 808 59
---------- ---------- ---------- ----------
Net interest income after provision for credit losses 3,094 648 5,540 1,250
General and administrative expenses 594 198 1,086 399
---------- ---------- ---------- ----------
NET INCOME $ 2,500 $ 450 $ 4,454 $ 851
========== ========== ========== ==========
NET INCOME PER SHARE
Primary $ 0.29 $ 0.22 $ 0.60 $ 0.41
Fully diluted $ 0.28 $ 0.22 $ 0.58 $ 0.41
Weighted average shares of common stock and
common stock equivalents:
Primary 8,600,232 2,063,094 7,453,969 2,061,148
Fully diluted 8,789,968 2,063,094 7,643,586 2,061,148
Dividends declared per Class A preferred share $ -- $ 0.30 $ -- $ 0.50
Dividends declared per common share $ 0.40 $ -- $ 0.86 $ --
The accompanying notes are an integral part of these financial statements
4
REDWOOD TRUST, INC.
STATEMENTS OF STOCKHOLDERS' EQUITY
For the Six Months Ended June 30, 1996
(In thousands, except share data)
Net Unrealized
Common Stock Additional Loss on Assets
------------ Paid-in Available Undistributed
Shares Amount Capital for Sale Income (Deficit) Total
------ ------ ------- -------- ---------------- -----
Balance, December 31, 1995 5,517,299 $55 $ 73,895 $(5,476) $ (184) $ 68,290
Shares issued pursuant to
dividend reinvestment plan 4,077 -- 79 -- -- $ 79
Offering costs -- -- (48) -- -- $ (48)
Net income -- -- -- -- 1,954 $ 1,954
Common stock
dividends declared -- -- -- -- (2,540) $ (2,540)
Fair value adjustment on
assets available for sale -- -- -- 411 -- $ 411
--------- --- -------- ------- ------- --------
Balance, March 31, 1996 5,521,376 $55 $ 73,926 $(5,065) $ (770) $ 68,146
Shares issued pursuant to
dividend reinvestment plan 22,569 -- 448 -- -- $ 448
April 19, 1996 public offering
issuance of new shares 2,875,000 29 54,855 -- -- $ 54,884
Conversion of stock
warrants 101,171 1 1,516 -- -- $ 1,517
Offering costs -- -- (304) -- -- $ (304)
Net income -- -- -- -- 2,500 $ 2,500
Common stock
dividends declared -- -- -- -- (3,408) $ (3,408)
Fair value adjustment on
assets available for sale -- -- -- 512 -- $ 512
--------- --- -------- ------- ------- --------
Balance, June 30, 1996 8,520,116 $85 $130,441 $(4,553) $(1,678) $124,295
========= === ======== ======= ======= ========
The accompanying notes are an integral part of these financial statements
5
REDWOOD TRUST, INC.
STATEMENTS OF CASH FLOWS
(In thousands, except share data)
Three Months Ended Six Months Ended
June 30, June 30,
1996 1995 1996 1995
---- ---- ---- ----
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 2,500 $ 450 $ 4,454 $ 851
Adjustments to reconcile net income to net cash
provided by operating activities:
Amortization of mortgage asset premium and discount, net 1,023 (202) 1,554 (418)
Depreciation and amortization 18 13 35 25
Provision for credit losses on mortgage assets 477 40 808 59
Amortization of interest rate cap agreements 189 82 340 98
(Increase) in accrued interest receivable (2,796) (401) (4,022) (512)
(Increase) in other assets (1,098) (52) (1,164) (15)
Increase (decrease) in accrued interest payable 2,436 (347) 2,762 (358)
Increase (decrease) in accrued expenses and other 71 (3) 134 60
--------- -------- --------- --------
Net cash provided by (used in) operating activities 2,820 (420) 4,901 (210)
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of mortgage assets (496,184) (35,355) (663,036) (59,471)
Principal payments on mortgage assets 53,058 2,934 85,872 5,608
Purchase of interest rate cap agreements (489) (37) (654) (331)
--------- -------- --------- --------
Net cash used in investing activities (443,615) (32,458) (577,818) (54,194)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net borrowings from reverse repurchase agreements 387,400 29,246 512,437 44,898
Net borrowings from notes payable 93 4,637 13,461 10,607
Private placement issuance costs -- (5) -- (8)
Proceeds from stock issued pursuant to dividend reinvestment plan 448 -- 527 --
Proceeds from common stock issued 56,400 -- 56,400 --
Stock issuance costs (304) -- (352) --
Dividends paid (2,540) (333) (3,974) (500)
--------- -------- --------- --------
Net cash provided by financing activities 441,497 33,545 578,499 54,997
Net increase in cash and cash equivalents 702 667 5,582 593
Cash and cash equivalents at beginning of period 9,705 953 4,825 1,027
--------- -------- --------- --------
Cash and cash equivalents at end of period $ 10,407 $ 1,620 $ 10,407 $ 1,620
========= ======== ========= ========
Supplemental disclosure of cash flow information:
Cash paid for interest $ 6,639 $ 2,538 $ 12,515 $ 4,082
========= ======== ========= ========
The accompanying notes are an integral part of these financial statements
6
REDWOOD TRUST, INC.
NOTES TO FINANCIAL STATEMENTS
JUNE 30, 1996
NOTE 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
Redwood Trust, Inc. (the "Company") was incorporated in Maryland on
April 11, 1994. At incorporation 208,332 shares of the Company's common
stock, par value $.01 per share ("Common Stock") were issued to various
officers and employees of the Company.
On August 19, 1994, upon receipt of the net proceeds from the first
closing of its private placement of Units, the Company commenced its
operations of acquiring and managing mortgage assets. Each Unit
consisted of one share of Class A Convertible Preferred Stock, par
value $.01 per share ("Preferred Stock") and one Stock Purchase Warrant
("Warrant"). In this first closing, the Company issued 1,226,465 Units
at a price of $15 per Unit. The Company received proceeds of $17
million, net of an underwriting discount of $1.05 per share and other
offering costs.
In October 1994, the Company completed a second closing of its private
placement of Units. The Company issued an additional 439,598 Units at a
price of $15 per Unit. The Company received proceeds of $6 million, net
of an underwriting discount of $1.05 per share and other offering
costs.
On August 9, 1995, the Company completed its initial public offering of
3,593,750 shares of common stock at $15.50 per share (the "Initial
Public Offering"). The Company received proceeds of $51 million, net of
an underwriting discount of $1.085 per share and other offering costs.
Concurrent with the completion of the Initial Public Offering, all
1,666,063 outstanding shares of Class A Convertible Preferred Stock
converted into 1,667,134 shares of Common Stock.
On April 19, 1996, the Company completed its second public offering of
2,875,000 shares of common stock at $20.25 per share. The Company
received proceeds of $55 million, net of an underwriting discount of
$1.164 per share and other offering costs.
The Company's primary source of revenue is from the acquisition and
management of real estate mortgage loans and mortgage securities
(together "Mortgage Assets"). The Company acquires Mortgage Assets that
are secured by single-family, multifamily and commercial real estate
properties throughout the Untied States, with a special emphasis on
properties located in the State of California.
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.
7
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 Strips").
Statement of Financial Accounting Standards No. 115,
Accounting for Certain Investments in Debt and Equity
Securities ("SFAS 115"), requires the Company to classify its
investments as either trading investments, available-for-sale
investments or held-to-maturity investments. Although the
Company generally intends to hold most of its Mortgage Assets
until maturity, it may, from time to time, sell any of its
Mortgage Assets as part of its overall management of its
balance sheet. Accordingly, this flexibility requires the
Company to classify all of its Mortgage Assets 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.
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
Mortgage Assets; primarily, a deterioration of the credit
quality of the underlying mortgages, or a deterioration of the
credit protection available related to the mortgage loan pool.
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 Strips 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 Strip could be
zero or negative. In the event that the projected return on an
investment in an IO Strip 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. Interest Rate Agreements,
which include interest rate cap agreements (the "Cap
Agreements") and interest rate swap agreements (the "Swap
Agreements"), entered into by the Company are intended to
provide income throughout their effective period 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.
8
The Company accounts for the Interest Rate Agreements as
hedges. Because the 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 is amortized over the effective
period of that Cap 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.
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; primarily, a 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 $175,932 at June 30,
1996 and $113,515 at December 31, 1995. Depreciation expense
and leasehold improvements amortization for the three and six
months ended June 30, 1996 totaled $9,657 and $18,552,
respectively. Depreciation expense and leasehold improvements
amortization for the three and six months ended June 30, 1995
totaled $4,059 and $8,118, respectively. Accumulated
depreciation and leasehold improvement amortization totaled
$49,919 at June 30, 1996 and $31,367 at December 31, 1995.
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 arising
from the effect of convertible preferred stock, using the
if-converted method, and dilutive stock options and warrants,
using the treasury stock method. The treasury stock method
calculation assumes all dilutive stock options and warrants
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.
9
Credit Risk
Most 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 June 30, 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+. At December 31, 1995, the privately issued Mortgage
Assets held by the Company had rating equivalents ranging from
AAA to unrated, with a weighted average of A+; 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 allowance is
increased by provisions charged to operations. When a loan or
portions of a loan is 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 and six months ended June 30, 1996
the Company provided for $476,669 and $808,185 in credit
losses, respectively. During the three and six months ended
June 30, 1995 the Company provided for $40,599 and $59,035 in
credit losses, respectively. During the three and six months
ended June 30, 1996 and June 30, 1995 the Company incurred no
charge-offs. The reserve balance at June 30, 1996 and December
31, 1995 was $1,297,899 and $489,713, respectively.
NOTE 2. MORTGAGE ASSETS
Mortgage Assets Excluding IO Strip
At June 30, 1996, Mortgage Assets, excluding IO Strips, consisted of
the following:
FEDERAL HOME LOAN FEDERAL NATIONAL PRIVATELY ISSUED
MORTGAGE MORTGAGE MORTGAGE
(IN THOUSANDS) CORPORATION ASSOCIATION ASSETS TOTAL
-------------- ----------- ----------- ------ -----
Mortgage Assets, Gross $219,124 $385,592 $401,049 $1,005,765
Unamortized Discount 0 (266) (16,342) (16,608)
Unamortized Premium 5,561 9,209 4,957 19,727
-------- -------- -------- ----------
Amortized Cost 224,685 394,535 389,664 1,008,884
Allowance for Credit Losses 0 0 (1,298) (1,298)
Gross Unrealized Gains 299 1,088 1,928 3,315
Gross Unrealized Losses (494) (834) (4,094) (5,422)
-------- -------- -------- ----------
Estimated Fair Value $224,490 $394,789 $386,200 $1,005,479
======== ======== ======== ==========
10
At December 31, 1995, Mortgage Assets, excluding IO Strips, consisted of the
following:
FEDERAL HOME LOAN FEDERAL NATIONAL PRIVATELY ISSUED
MORTGAGE MORTGAGE MORTGAGE
(IN THOUSANDS) CORPORATION ASSOCIATION ASSETS TOTAL
- -------------- ----------- ----------- ------ -----
Mortgage Assets, Gross $46,160 $190,061 $207,404 $443,625
Unamortized Discount 0 (313) (16,719) (17,032)
Unamortized Premium 907 3,608 1,535 6,050
------- -------- -------- --------
Amortized Cost 47,067 193,356 192,220 432,643
Allowance for Credit Losses 0 0 (490) (490)
Gross Unrealized Gains 334 1,033 874 2,241
Gross Unrealized Losses (110) (458) (4,345) (4,913)
------- -------- -------- --------
Estimated Fair Value $47,291 $193,931 $188,259 $429,481
======= ======== ======== ========
At June 30, 1996 and December 31, 1995, all investments in Mortgage Assets
consisted of interests in adjustable rate mortgages on residential properties. A
majority of such 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 over a period
of thirty years; the actual maturity is subject to change based on the
prepayments of the underlying mortgage loans.
At June 30, 1996, the average annualized effective yield was 6.92% based on the
amortized cost of the assets and 6.98% based on the fair value of the assets. At
December 31, 1995, the average annualized effective yield on the Mortgage Assets
was 7.66% based on the amortized cost of the assets and 7.74% based on the fair
value of the assets.
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) and lifetime caps. At June 30, 1996 and December 31, 1995
the weighted average lifetime cap was 11.71% and 11.54%, respectively.
IO Strips
The amortized cost and fair value of the Company's IO Strips are summarized as
follows:
(IN THOUSANDS) JUNE 30, 1996 DECEMBER 31, 1995
------------- -----------------
Amortized Cost $2,963 $3,593
Gross Unrealized Gains 0 0
Gross Unrealized Losses (962) (830)
---------------------------- ------ ------
Estimated Fair Value $2,001 $2,763
====== ======
The average annualized effective yield at June 30, 1996 on the IO Strips was
7.84% based on the amortized cost of the assets and 12.12% based on the fair
value of the assets. The average annualized effective yield at December 31, 1995
on the IO Strips was 9.99% based on the amortized cost of the assets and 13.61%
based on the fair value of the assets.
11
NOTE 3. INTEREST RATE AGREEMENTS
The amortized cost and fair value of the Company's Interest Rate
Agreements are summarized as follows:
(IN THOUSANDS) JUNE 30, 1996 DECEMBER 31, 1995
------------- -----------------
Amortized Cost $ 2,835 $ 2,521
Gross Unrealized Gains 108 0
Gross Unrealized Losses (1,592) (1,974)
----------------------- ------- -------
Estimated Fair Value $ 1,351 $ 547
======= =======
Cap Agreements
The Company had thirty-two outstanding Cap Agreements at June 30, 1996
and twenty-three outstanding Cap Agreements at December 31, 1995.
Potential future earnings from each of these Cap Agreements are based
on variations in the London Interbank Offered Rate ("LIBOR"). Three of
the Cap Agreements at June 30, 1996 and December 31, 1995 had
contractually stated notional amounts which vary over the life of the
Cap Agreement. The sum of the notional amounts of the Company's Cap
Agreements in effect was $464,000,000 and $302,000,000 at June 30, 1996
and December 31, 1995, respectively. The weighted average cap strike
rate during the three and six months ended June 30, 1996 was 7.12% and
7.22%. The weighted average cap strike rate during the three and six
months ended June 30, 1995 was 7.62% and 7.44%. 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.
Cap Agreements outstanding at June 30, 1996 are as follows:
(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
---- ------ ----------- ----------- ----------- ------------
1996 (last 6 months) $432,446 7.25% 5.50% 12.00% $ 385
1997 321,875 7.94% 5.50% 12.00% 613
1998 185,657 8.74% 6.94% 12.00% 533
1999 110,277 9.30% 6.94% 12.00% 372
2000 52,889 8.95% 7.50% 10.00% 255
2001 33,082 8.55% 7.50% 9.00% 220
2002 24,616 8.68% 8.00% 9.00% 157
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 $2,835
======
12
Swap Agreements
The Company had seven outstanding Swap Agreements at June 30, 1996 and
one outstanding Swap Agreement at December 31, 1995. The Swap
Agreements outstanding at June 30, 1996 and December 31, 1995 are as
follows:
INTEREST RATE
NOTIONAL FACE -------------
EFFECTIVE PERIODS: AMT (IN THOUSANDS) COMPANY PAYS COMPANY RECEIVES
------------------ ------------------ ------------ ----------------
April 1996 to April 1997 and $10,000 6.97% 3 Month LIBOR
April 1997 to April 1998 7.18% 3 Month LIBOR
May 1996 to May 1997 $20,000 6.01% 3 Month LIBOR
May 1996 to May 1998 $20,000 6.40% 3 Month LIBOR
June 1996 to June 1997 $20,000 6.06% 3 Month LIBOR
October 1996 to October 1997 $15,000 6.49% 3 Month LIBOR
June 1996 to June 1998 $30,000 3 mo. T Bills + .44% 3 Month LIBOR
June 1996 to June 1999 $30,000 3 mo. T Bills + .46% 3 Month LIBOR
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 both Cap and Swap 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 eight different
counter-parties in order to reduce the risk of credit exposure to any
one counter-party.
There have been no terminations of Interest Rate Agreements as of June
30, 1996 or December 31, 1995.
NOTE 4. REVERSE REPURCHASE AGREEMENTS AND NOTES PAYABLE
The Company has entered into both reverse repurchase agreements and
notes payable (together "Borrowings") to finance acquisitions of a
portion of its Mortgage Assets. These Borrowings are collateralized by
a portion of the Company's Mortgage Assets. At no time are more than
34% of the Borrowings with any one investment banking firm. At June 30,
1996, Mortgage Assets actually pledged had an estimated fair value of
$947,321,364. At December 31, 1995, Mortgage Assets actually pledged
had an estimated fair value of $386,321,449.
At June 30, 1996 the Company had $896,214,000 of Borrowings outstanding
with a weighted average borrowing rate of 5.70% and a weighted average
maturity of 72 days. At December 31, 1995, the Company had $370,316,047
of Borrowings outstanding with a weighted average borrowing rate of
6.01% and a weighted average remaining maturity of 74 days. At June 30,
1996 and December 31, 1995, the Borrowings had the following remaining
maturities:
(IN THOUSANDS) JUNE 30, 1996 DECEMBER 31, 1995
------------- -----------------
Within 30 days $340,496 $ 75,808
30 to 90 days 187,541 175,921
Over 90 days 368,177 118,587
------------ -------- --------
Total Borrowings $896,214 $370,316
======== ========
For the three and six months ended June 30, 1996, the average balance
of Borrowings was $651,643,000 and $543,811,000, respectively with a
weighted average interest cost of 5.60% and 5.65%. For the three and
six months ended June 30, 1995 the average balance of Borrowings was
$139,978,725 and $121,571,884, respectively with a weighted average
interest cost of 6.28% and 6.18%. The maximum balance outstanding
during the six months ended June 30, 1996 was $897,271,000. The maximum
balance outstanding during the year ended December 31, 1995 was
$370,316,000.
13
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 June 30, 1996 and
December 31, 1995 . 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.
JUNE 30, 1996 DECEMBER 31, 1995
------------- -----------------
CARRYING FAIR CARRYING FAIR
(IN THOUSANDS) AMOUNT VALUE AMOUNT VALUE
-------------- ------ ----- ------ -----
Assets
Mortgage Assets $1,005,479 $1,005,479 $429,481 $429,481
IO Strips 2,001 2,001 2,763 2,763
Interest Rate Agreements 1,351 1,351 547 547
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, reverse repurchase
agreements and accrued liabilities are reflected in the financial
statements at their amortized costs, which approximates their fair
value because of the short-term nature of these instruments.
NOTE 6. CLASS A CONVERTIBLE PREFERRED STOCK
Prior to the Initial Public Offering the Company was authorized to
issue up to 12,000,000 shares of Preferred Stock, $.01 par value, in
one or more series and to fix the powers, designations, preferences and
rights of each series. The Preferred Stock ranked senior to the
Company's Common Stock as to dividends and liquidation rights.
Following the closing of the Initial Public Offering, the Company filed
Articles Supplementary to reclassify all authorized and unissued shares
of Preferred Stock and all shares of Class A Preferred Stock received
upon conversion of Class A Preferred Stock into Common Stock as
authorized and unissued shares of Common Stock.
NOTE 7. STOCK PURCHASE WARRANTS
At June 30, 1996 and December 31, 1995 there were 1,563,957 and
1,665,063 Warrants outstanding, respectively. Each Warrant entitles the
holder to purchase 1.000667 share 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, key
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 dividend equivalent rights ("DERs") to such eligible
recipients other than non-employee directors. Non-employee directors
are automatically provided annual grants of NQSOs with 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, provided that no more than 500,000 shares of Common Stock shall
be cumulatively available for grant as ISOs. At June 30, 1996, there
were 1,278,017 shares of Common Stock available for grant. 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. In June, 1996 each of the four non-employee directors was
automatically granted an additional 2,500 NQSOs at an exercise price of
$24.63 per share. No options were granted to employees during the three
14
and six months ended June 30, 1996. During the year ended December 31,
1995 each of the four non-employee directors was automatically granted
an additional 2,500 NQSOs at an exercise price of $7.18 per share and
employees were granted 156,972 NQSOs at exercise prices ranging from
$17.38 to $21.50 per share. On July 19, 1995, 47,083 options were
exercised at prices ranging from $0.10 to $0.11 per share resulting in
proceeds to the Company of $5,079. During the year ended December 31,
1994 the Company granted 40,000 options at an exercise price of $0.10
per share, 20,000 of which were NQSOs and 20,000 of which were ISOs,
and 148,333 ISOs at an exercise price of $0.11 per share. 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 NQSOs granted under the plan to
accrue DERs. The first and second quarter 1996 dividends resulted in
non-cash charges to general and administrative expenses of $84,919 and
$79,405, respectively, for DERs accruing on NQSOs outstanding on the
record date of the dividend. The 1995 dividends on common stock
resulted in non-cash charges to general and administrative expenses of
$54,513 for DERs accruing on NQSOs outstanding on the record date of
the dividend. DERs represent shares of stock which are issuable to
holders of NQSOs when the holders exercise the underlying NQSOs based
on the price of the stock on the dividend payment date. A total of
9,508 shares have been granted as DERs as of June 30, 1996. At June 30,
1996 a total of 374,813 of the 1,278,017 available options had been
granted as options or DERs (47,083 of which had been exercised) leaving
903,204 of the options available for grant.
In October 1995, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 123 "Accounting for
Stock-Based Compensation." Under the provisions of SFAS No. 123,
compensation cost is measured at the grant date based on the fair value
of the award and is recognized over the service period, which is
usually the vesting period. The Company is required to either recognize
compensation expense under this method or to disclose the pro forma net
income and earnings per share effects based on the SFAS No. 123 fair
value methodology. SFAS No. 123 applies to financial statements for
fiscal years beginning after December 15, 1995. The Company will
implement the requirements of SFAS No. 123 in 1996 and will only adopt
the disclosure provisions of this statement; accordingly, this
statement will have no impact on the financial position and the results
of operations when adopted.
NOTE 9. DIVIDENDS
On March 11, 1996 the Company declared a dividend of $2,539,833, or
$0.46 per common share. This dividend was paid on April 19, 1996 to
shareholders of record as of March 29, 1996. On June 14, 1996 the
Company declared a dividend of $3,408,046, or $0.40 per common share.
This dividend was paid on July 18, 1996 to shareholders of record as of
June 28, 1996.
On March 17, 1995, the Company declared a dividend of $333,213, or
$0.20 per preferred share. This dividend was paid on April 21, 1995 to
preferred shareholders of record as of March 31, 1995. On June 19,
1995, the Company declared a dividend of $499,819, or $0.30 per
preferred share. This dividend was paid on July 21, 1995 to preferred
shareholders of record as of June 30, 1995. On September 15, 1995, the
Company declared a dividend of $1,103,264, or $0.20 per common share.
This dividend was paid on October 20, 1995 to common shareholders of
record as of September 29, 1995. On December 13, 1995, the Company
declared a dividend of $1,434,500, or $0.26 per common share. This
fourth quarter 1995 dividend was paid on January 19, 1996 to common
shareholders of record as of December 29, 1995
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 1995 which was paid
in January 1996 is considered taxable income to shareholders in the
year declared. The Company's dividends are not eligible for the
dividends received deduction for corporations.
15
NOTE 10. COMMITMENTS AND CONTINGENCIES
As of June 30, 1996 the Company had entered into a commitment to
purchase a Federal National Mortgage Association Asset for
approximately $2,300,000. At June 30, 1996 and December 31, 1995, 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 and six months ended June 30, 1996 was $26,399 and $50,461,
respectively. Rental expense for office properties under operating
leases for the three and six months ended June 30, 1995 was $16,098 and
$31,822, respectively. Future minimum rental commitments as of June 30,
1996 under noncancelable operating leases with initial or remaining
terms of more than one year, are as follows:
MINIMUM RENTAL
COMMITMENT
YEAR ENDING AS OF JUNE 30, 1996
DECEMBER 31, (IN THOUSANDS)
------------ --------------
1996 60
1997 121
1998 121
1999 121
2000 121
2001 40
---- ----
Total $584
Because the lease is in the Company's name, the above amounts represent
100% of the minimum future rental commitments. However, the Company
shares certain office expenses, such as lease payments and utilities,
on a pro rata basis with GB Capital. GB Capital is owned by certain
officers of the Company. This arrangement is covered by an
Administrative Services and Facilities Sharing Agreement. For the three
and six months ended June 30, 1996, the Company was bearing 95% of the
lease expenses and GB Capital was bearing 5%. For the three and six
months ended June 30, 1995, the Company was bearing 70% of the lease
expenses and GB Capital was bearing 30%.
16
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
OVERVIEW
Redwood Trust, Inc. (the "Company") is a mortgage finance company which
acquires and holds mortgage assets using its equity and borrowed funds.
The Company's source of earnings is net interest income, or the
interest income earned on mortgages less the interest expense paid on
borrowed funds. The Company's primary competitors are other financial
institutions, such as banks and savings and loan institutions, which
seek to earn spread income from owning 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 Federal taxes so
long as the Company pays out as dividends an amount equal to at least
95% of its taxable income.
The Company's strategy is to focus solely on being a highly efficient
spread lender. Instead of maintaining an in-house mortgage origination
staff, the Company acquires mortgage assets from mortgage origination
companies and from the secondary mortgage market. The Company
out-sources mortgage servicing functions. Rather than build a retail
branch banking system, the Company accesses borrowed funds in the
capital markets. In the second quarter of 1996, the Company's operating
expenses to assets ratio was 0.31% and its ratio of operating expenses
to net interest income was 17%.
As of June 30, 1996, all of the Company's mortgage assets were
adjustable-rate, first-lien mortgages on single-family properties. 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 acquires individual whole mortgage loans (7% of total
mortgage assets as of June 30, 1996), pools of mortgage loans which
have been fully insured against credit losses by one of the Federal
government mortgage agencies (61%), pools of mortgage loans which have
been securitized and 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 (29%), and securitized
mortgage interests which are subordinated and have higher levels of
credit risk such that they have received a rating below BBB (3%). The
average credit rating equivalent of the Company's mortgage assets is
AA+.
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.
In general, the Company seeks to acquire "A" quality single-family
mortgage assets consisting of mortgages with loan balances between
$207,000 and $500,000, with a target average loan balance of $250,000
to $300,000. Because of their size, these "jumbo" loans are not
eligible to be acquired or guaranteed by the Federal government
mortgage agencies (FNMA, FHLMC). The Company also acquires FNMA and
FHLMC mortgage securities.
As of June 30, 1996, over two-thirds of the non-FNMA, non-FHLMC
mortgage assets owned by the Company were secured by single-family
residential properties located in California. Management believes that
the economy and the trend of residential housing values in California
was generally stable to improving during the second quarter of 1996.
The Company believes that a majority of the jumbo adjustable-rate
mortgages in the United States are secured by California properties.
The rate the Company earns on its mortgage assets increases or falls in
conjunction with 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; the average
term-to-next-adjustment for all of the Company's mortgage assets was 4
months as of June 30, 1996. Borrowings have maturities ranging from one
to twelve months; the average term-to-next-adjustment for borrowings
was 2.4 months as of June 30, 1996. Coupon rate adjustments on the
Company's mortgages are limited by periodic and lifetime caps; the
Company's hedging program seeks to mitigate the negative
17
effects such 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.
To date, 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 otherwise.
The Company intends to continue to pursue growth when management
believes that such growth is likely to be additive to earnings per
share potential.
RESULTS OF OPERATIONS: THREE MONTHS ENDING JUNE 30, 1996 VERSUS THREE
MONTHS ENDING JUNE 30, 1995 AND FIRST SIX MONTHS OF 1996 VERSUS FIRST
SIX MONTHS OF 1995
REPORTING PERIODS
The 1994 fiscal year ("fiscal 1994") commenced with the start of
Company operations on August 19, 1994 and finished December 31, 1994.
All subsequent reporting periods correspond to their calendar
equivalents.
NET INCOME SUMMARY
Net earnings for the second quarter of 1996 were $2.5 million. These
earnings were five times the $0.5 million the Company earned in the
second quarter of 1995. The primary reason total earnings increased was
that average assets increased by 369%. For similar reasons, net
earnings in the first half of 1996 of $4.5 million represent an
increase of 423% over net earnings of $0.9 million in the first half of
1995.
TABLE 1
NET INCOME
INTEREST
RATE NET CREDIT
INTEREST INTEREST AGREEMENT INTEREST PROVISION OPERATING NET
INCOME EXPENSE EXPENSE INCOME EXPENSE EXPENSES INCOME
------ ------- ------- ------ ------- -------- ------
(DOLLARS IN THOUSANDS)
1995, 1st Half $ 5,131 $ 3,724 $ 98 $1,309 $ 59 $ 399 $ 851
1996, 1st Half 22,032 15,277 407 6,348 808 1,086 4,454
Fiscal 1994 $ 1,296 $ 760 $ 8 $ 528 $ 0 $ 146 $ 382
1995, Quarter 1 2,170 1,533 16 621 19 201 401
1995, Quarter 2 2,961 2,191 82 688 40 198 450
1995, Quarter 3 3,985 2,432 112 1,441 84 364 993
1995, Quarter 4 6,610 4,452 129 2,029 350 368 1,311
1996, Quarter 1 9,131 6,202 152 2,777 331 492 1,954
1996, Quarter 2 12,901 9,075 255 3,571 477 594 2,500
18
Earnings per share in the second quarter of 1996 were $0.29,
representing an increase of 33% over the $0.22 per share earned in the
second quarter of 1995. Earnings per share increased both due to an
increase in return on equity from 8.00% to 8.93% and an increase in the
equity per share the Company had available with which to generate
earnings. Equity capital (book value) per share increased from $12.02
to $14.59 due to accretive stock offerings at prices in excess of book
value in August 1995 and April 1996. The increase in return on equity
of 12% and the increase in book value per share of 21% led directly to
an earnings per share increase of 33%.
Second quarter 1996 earnings per share were lower than the $0.32
reported in the first quarter of 1996. Although book value per share on
a subsequent quarter basis increased from $12.34 to $14.59 due to the
Company's April 1996 stock offering, return on equity dropped from
11.43% to 8.93%. The stock offering had two temporary dilutive effects
on return on equity and earnings per share: the Company was
under-invested in mortgage assets relative to its equity base on
average in the second quarter (the Company's capital was 74% employed
in the second quarter versus 87% in the first quarter) and the new
mortgage assets acquired in the second quarter had lower initial
coupons than the average mortgage in portfolio. By the end of the
second quarter, however, 89% of the Company's capital was employed in
earning assets. In addition, the lower initial coupons on newly
acquired mortgages should adjust upwards towards their full potential
rates over time, with most of the adjustment available to the Company
within six months.
For the first half of 1996, earnings per share were $0.60, an increase
of 45% versus the comparable period in 1995. Return on equity increased
from 7.73% to 9.88% and book value per share increased from $12.02 to
$14.59.
Reported earnings per share is based on primary shares. The number of
primary shares equals the average number of shares outstanding during
the quarter plus shares added due to the potential dilutive effects of
future warrant and option exercises.
TABLE 2
EARNINGS PER SHARE, BOOK VALUE PER SHARE
AND RETURN ON EQUITY
POTENTIAL BOOK EARNINGS
AVERAGE DILUTION VALUE RETURN PER
NUMBER OF DUE TO TOTAL PER SHARE ON PRIMARY
SHARES WARRANTS PRIMARY OUTSTANDING AT AVERAGE SHARE
OUTSTANDING AND OPTIONS SHARES END OF PERIOD EQUITY (EPS)
----------- ----------- ------ ------------- ------ -----
1995, 1st Half 1,874,395 186,753 2,061,148 $12.02 7.73% $0.41
1996, 1st Half 6,667,675 786,294 7,453,969 14.59 9.88% 0.60
Fiscal 1994 1,676,080 240,766 1,916,846 $10.82 5.35% $0.20
1995, Quarter 1 1,874,395 240,766 2,115,161 11.93 7.46% 0.19
1995, Quarter 2 1,874,395 188,699 2,063,094 12.02 8.00% 0.22
1995, Quarter 3 3,944,129 239,009 4,183,138 13.14 7.59% 0.23
1995, Quarter 4 5,516,310 563,197 6,079,507 12.38 7.22% 0.22
1996, Quarter 1 5,521,376 608,211 6,129,587 12.34 11.43% 0.32
1996, Quarter 2 7,813,974 786,258 8,600,232 14.59 8.93% 0.29
DIVIDEND SUMMARY
Dividends in the second quarter of 1996 were $0.40 per share, an
increase of 33% over the $0.30 dividend paid in the same quarter one
year earlier. Total dividends paid for the second quarter of 1996 were
$3.4 million versus $0.5 million paid for the same time period one year
earlier. Dividends in the first half of 1996 were $0.86 per share, an
increase of 72% over the $0.50 per share dividend paid in the first
half of 1995. Total dividends paid for the first half of 1996 were $5.9
million; total dividends paid for the same period the prior
19
year were $0.8 million. The Company was able to increase its total
dividends and dividend per share over these periods due to the increase
in earnings discussed above.
The Company's policy is to pay out over time as dividends 100% of its
earnings as calculated for tax purposes. To date, taxable income has
exceeded dividends paid by $0.2 million; this excess taxable income
will be distributed as part of the Company's regular quarterly dividend
in the future.
Taxable income currently exceeds income as calculated according to
generally accepted accounting principles (GAAP income) because (i)
taxable income credit expense equals actual credit losses rather than
credit provisions, and actual credit losses 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)
dividend equivalent rights which accrue on stock options are deducted
from GAAP income as an operating expense but are not deducted from
taxable income, and (iv) operating expenses differ in certain other
aspects. Taxable income is a closer approximation of current cash flow
generation than is GAAP income.
Dividends per share has exceeded earnings per share because taxable
income has exceeded GAAP income and because the number of shares
eligible at quarter end to receive a dividend has generally been
smaller than the number of primary shares used to calculate earnings
per share.
TABLE 3
TAXABLE INCOME AND DIVIDENDS
TAXABLE
OPERATING
EXPENSES TAXABLE
TAXABLE AND INCOME SHARES
CREDIT MORTGAGE RETURN OUTSTANDING
NET EXPENSE AMORTIZATION TAXABLE ON EARNING DIVIDEND TOTAL
INCOME DIFFERENCES DIFFERENCES INCOME EQUITY DIVIDEND DECLARED DIVIDEND
------ ----------- ----------- ------ ------ -------- -------- --------
(DOLLARS IN THOUSANDS)
1995, 1st Half $ 851 $ 59 26 $ 936 8.51% 1,666,064 $0.50 $ 833
1996, 1st Half 4,454 808 429 5,691 12.62% 6,916,139 0.86 5,948
Fiscal 1994 $ 382 $ 0 (28) $ 354 4.95% 1,401,904 $0.25 $ 350
1995, Quarter 1 401 19 (12) 408 7.58% 1,666,063 0.20 333
1995, Quarter 2 450 40 38 528 9.40% 1,666,063 0.30 500
1995, Quarter 3 993 84 5 1,082 8.27% 5,516,313 0.20 1,103
1995, Quarter 4 1,311 347 156 1,814 9.99% 5,517,299 0.26 1,435
1996, Quarter 1 1,954 331 264 2,549 14.92% 5,521,376 0.46 2,540
1996, Quarter 2 2,500 477 165 3,142 11.23% 8,520,116 0.40 3,408
COUPON INCOME ON MORTGAGE ASSETS
The average coupon on the Company's mortgage assets was 7.37% during
the second quarter of 1996, a decrease from the 7.64% earned in the
first quarter of 1996. The coupon rate in the second quarter was lower
because (i) the short-term interest rate indices which determine
coupons on mortgage assets had declined (as approximated in the table
below by the decline in the six month average of six-month LIBOR) and
(ii) the Company acquired a substantial volume of new mortgage assets
during the quarter which had lower-than-fully-indexed initial coupon
rates. On average, coupons were 0.37% below their fully-indexed rates
during the quarter. Coupons were 0.51% below their fully-indexed rates
at the end of the quarter due to interest rate increases in June 1996.
This suggests that coupons on existing mortgage assets should be
increasing in the third and fourth quarters of 1996, given stable
interest rates and all other factors being equal.
In the second quarter of 1995, the coupon rate was 6.79%, or 1.71%
lower than the fully-indexed rate at the time. This gap between the
coupon rate and the fully-indexed rate was due primarily to the
acquisition of mortgages in late 1994 and early 1995 that had low
initial coupon rates. Since many of these mortgage
20
acquisitions were made at a discount price, the yield on the mortgages
was higher than the low coupons would suggest due to discount
amortization.
TABLE 4
COUPON INCOME ON MORTGAGE ASSETS
COUPON AVERAGE AVERAGE
AVERAGE VERSUS FULLY- COUPON
AVERAGE COUPON SIX MONTH SIX MONTH INDEXED VERSUS
PRINCIPAL RATE AVERAGE OF AVERAGE OF RATE FULLY AVERAGE AVERAGE
COUPON VALUE OF DURING SIX-MONTH SIX-MONTH DURING INDEXED BOOK COUPON
INCOME MORTGAGES PERIOD LIBOR LIBOR PERIOD RATE PRICE YIELD
------ --------- ------ ----- ----- ------ ---- ----- -----
(DOLLARS IN THOUSANDS)
1995, 1st Half $ 4,678 $143,252 6.58% 6.36% 0.22% 8.71% (2.13%) 99.01% 6.65%
1996, 1st Half 23,167 623,124 7.48% 5.56% 1.92% 7.59% (0.11%) 99.52% 7.51%
Fiscal 1994 $ 1,102 $ 50,306 6.01% 5.07% 0.94% 8.35% (2.34%) 100.02% 6.01%
1995, Quarter 1 1,940 124,673 6.31% 6.25% 0.06% 8.93% (2.62%) 99.61% 6.33%
1995, Quarter 2 2,738 161,628 6.79% 6.48% 0.31% 8.50% (1.71%) 98.54% 6.90%
1995, Quarter 3 3,779 210,051 7.14% 6.10% 1.04% 8.10% (0.96%) 98.73% 7.23%
1995, Quarter 4 6,682 359,693 7.37% 5.82% 1.55% 7.92% (0.55%) 99.28% 7.42%
1996, Quarter 1 9,445 497,227 7.64% 5.62% 2.02% 7.43% 0.21% 98.87% 7.73%
1996, Quarter 2 13,722 749,021 7.37% 5.49% 1.88% 7.74% (0.37%) 99.95% 7.37%
AMORTIZATION OF PREMIUM AND DISCOUNT AND EFFECT OF CHANGES IN PRINCIPAL
REPAYMENT RATES
In calculating its interest income for the second quarter of 1996, the
Company added $0.25 million in discount amortization to its coupon
income and then deducted $1.27 million in premium amortization. As
shown in Table 6, the net effect was a reduction in mortgage yield of
0.50%. Although the average total balance of discount and premium on
the Company's books was approximately equal during the quarter, the
rate at which the Company wrote off its premium balance during the
quarter (31% annual rate) was far higher than the rate at which the
Company took discount amortization into income (6% annual rate).
The Company writes off premium at a rate equal to the mortgage
principal repayment rate of the associated mortgage assets. The rate of
principal repayment for these assets was 31% in the second quarter of
1996 versus 12% in the same quarter a year earlier. The increased rate
of principal repayment was caused by lower long-term interest rates, a
narrowed spread between short and long-term interest rates and other
factors. The faster rate of principal repayment decreased earnings in
the quarter relative to what they otherwise would have been.
When the Company is able to acquire high-credit-quality mortgage assets
at a discount due to very low initial coupon rates, the Company
amortizes the associated discount into income in the short-term to
offset the effect of the low coupon. As a result, in early 1995 the
Company took its discount balances into income at a rapid rate.
Virtually all of this type of discount had been taken into income by
the end of the third quarter of 1995.
When the Company acquires mortgage assets that have some credit risk at
a discount, the Company uses what management believes to be
conservative assumptions regarding the future cash flows of such
mortgages to determine a discount amortization schedule for that asset.
The result is that such discount is amortized into income at a
relatively slow rate, regardless of the actual rate of mortgage
principal repayment experienced. As shown in the table below, the
discount amortization rate in the first half of 1996 was 5% per year.
The Company anticipates that the rate of discount amortization on these
mortgage assets will increase as the mortgages season, thus potentially
benefiting net income in the future.
As the rate of mortgage principal repayment increases, the Company's
earnings are decreased in the short-term because the rate of premium
write-off is highly sensitive to such changes while the rate of
discount amortization is not. This earnings sensitivity to changes in
the mortgage principal repayment rate has been increasing as the
Company acquires more mortgage assets at premium prices. With an
unamortized premium balance of $22.7
21
million as of June 30, 1996, the sensitivity of earnings to a 5
percentage point change in the mortgage principal repayment rate was
estimated to be $0.03 per share per quarter.
TABLE 5
AMORTIZATION ON MORTGAGE ASSETS
NET
ANNUAL ANNUAL AVERAGE NET
AVERAGE RATE OF AVERAGE RATE OF PREMIUM/ AMORTIZATION
DISCOUNT DISCOUNT DISCOUNT PREMIUM PREMIUM PREMIUM (DISCOUNT) INCOME/
BALANCE AMORTIZATION AMORTIZATION BALANCE AMORTIZATION AMORTIZATION BALANCE (EXPENSE)
------- ------------ ------------ ------- ------------ ------------ ------- ---------
(DOLLARS IN THOUSANDS)
1995, 1st Half $ 2,489 $471 38% $ 1,067 $ 53 10% $(1,422) $ 418
1996, 1st Half 16,840 422 5% 13,850 1,975 29% (2,990) (1,553)
Fiscal 1994 $ 440 $101 63% $ 450 $ 19 11% $ 10 $ 82
1995, Quarter 1 1,440 234 66% 960 19 8% (480) 215
1995, Quarter 2 3,528 237 27% 1,175 34 12% (2,353) 203
1995, Quarter 3 6,017 280 19% 3,351 123 15% (2,666) 157
1995, Quarter 4 10,889 210 8% 8,314 429 21% 2,575) (219)
1996, Quarter 1 16,941 177 4% 11,299 707 25% (5,642) (530)
1996, Quarter 2 6,739 245 6% 16,402 1,268 31% (337) (1,023)
EARNING ASSET YIELD
The Company's earning assets consist of its mortgage assets and its
cash balances. The mortgage asset yield is a function of coupon income
and amortization of premium and discount. The cash yield is a function
of short-term interest rates and other factors. The earning asset yield
in the second quarter of 1996 was 6.84%, or 1.35% over the six month
average of six-month LIBOR. This was lower than the 7.32% yield in the
first quarter of 1996 and the 7.37% yield in the second quarter of 1995
for reasons discussed above.
TABLE 6
EARNING ASSET YIELD
EFFECT OF YIELD VS.
NET SIX-MONTH SIX-MONTH
DISCOUNT/ EARNING AVERAGE OF AVERAGE OF
COUPON (PREMIUM) MORTGAGE CASH ASSET SIX-MONTH SIX-MONTH
YIELD AMORTIZATION YIELD YIELD YIELD LIBOR LIBOR
----- ------------ ----- ----- ----- ----- -----
(DOLLARS IN THOUSANDS)
1995, 1st Half 6.65% 0.64% 7.29% 5.34% 7.27% 6.36% 0.91%
1996, 1st Half 7.51% (0.45%) 7.06% 5.80% 7.03% 5.56% 1.47%
Fiscal 1994 6.01% 0.52% 6.53% 4.68% 6.31% 5.07% 1.24%
1995, Quarter 1 6.33% 0.83% 7.16% 5.03% 7.14% 6.25% 0.89%
1995, Quarter 2 6.90% 0.49% 7.39% 5.59% 7.37% 6.48% 0.89%
1995, Quarter 3 7.23% 0.29% 7.52% 5.49% 7.48% 6.10% 1.38%
1995, Quarter 4 7.42% (0.23%) 7.19% 5.43% 7.14% 5.82% 1.32%
1996, Quarter 1 7.73% (0.37%) 7.36% 5.96% 7.32% 5.62% 1.70%
1996, Quarter 2 7.37% (0.50%) 6.87% 5.64% 6.84% 5.49% 1.35%
COST OF BORROWED FUNDS AND HEDGING AND THE INTEREST RATE SPREAD
The cost of borrowed funds in the second quarter of 1996 was 5.60%,
which was a decrease of 0.12% from the prior quarter. The Company's
financing efficiency and asset/liability strategy can be evaluated, in
part, by comparing the Company's cost of funds to the six month average
of six-month LIBOR. Throughout the first half of 1996, the Company's
cost of funds approximated 9 to 11 basis points over this average.
22
In the second quarter of 1995 the cost of funds was 6.28%, or 20 basis
points lower than the six month average of six-month LIBOR. In the
first half of 1995 the cost of funds averaged 6.36%, or 18 basis points
lower than average LIBOR. The cost of funds was relatively lower in the
first half of 1995 as compared to average LIBOR than it was in the
first half of 1996 because (i) the Company extended liabilities in late
1994 prior to and during a period of rapidly rising interest rates and
(ii) starting in mid-1995 the Company started acquiring whole mortgage
loans and lower-rated mortgage securities which, when pledged to secure
borrowings, result in a higher cost of borrowing relative to LIBOR.
Hedging costs, or interest rate agreement expenses, consist of the
amortization of premium paid for interest rate cap agreements, net of
any income received, plus the net on-going expense or income from
interest rate swaps. In an interest rate cap agreement, the Company
pays an up-front premium to a counter-party; the counter-party will
make payments to the Company if LIBOR rises above a certain level. In
an interest rate swap agreement, the Company typically does not make an
up-front payment. The Company agrees to pay a fixed rate of interest to
a counter-party on a certain notional amount; the counter-party in turn
pays to the Company a floating rate of interest on the same notional
amount. In addition, the Company has entered into Treasury versus LIBOR
"basis" swaps to reduce potential risks arising from Treasury-based
mortgage assets funded with LIBOR-based borrowings. These basis swaps
will provide increased income to the Company should short-term LIBOR
rates increase relative to short-term Treasury rates and but will
increase hedging expense for the Company should that spread narrow. See
Footnote 3 to the Financial Statements for further details.
In the second quarter of 1996, hedging costs added 0.16% to the
Company's cost of funds, or, alternatively, reduced the yield of the
Company's assets which were funded with borrowings by the same amount.
Hedging costs in the second quarter of 1996 were relatively lower than
in the second quarter of 1995 due to a flatter yield curve and lower
levels of interest rate volatility in 1996. In addition, the Company
reduced its hedging activities somewhat in the second quarter of 1996
in conjunction with an extension of the maturities of its borrowings.
Relative to the size of the balance sheet, hedging costs in the first
half of 1996 were approximately equal to hedging costs in the first
half of 1995.
The interest rate spread is the difference between the earning asset
yield and the cost of funds and hedging; it measures the profitability
of that portion of the balance sheet wherein earning assets are funded
with borrowings. The interest rate spread for the second quarter of
1996 was 1.08%. This was lower than the 1.46% earned in the first
quarter of 1996 due primarily to the relative decline in coupon income
and increased premium amortization discussed above.
The second quarter of 1996 spread of 1.08% was higher than the 0.86%
earned in the second quarter of 1995. Although the cost of funds was
higher (relative to prevailing LIBOR rates) in the second quarter of
1996, the earning asset yield was significantly higher and the cost of
hedging was lower. For similar reasons, the spread in the first half of
1996 of 1.23% was wider than the spread in the first half of 1995 of
0.93%.
23
TABLE 7
COST OF BORROWED FUNDS
COST OF
FUNDS VS. COST
SIX-MONTH SIX-MONTH OF
AVERAGE OF AVERAGE OF FUNDS EARNING INTEREST
COST OF SIX-MONTH SIX-MONTH COST OF AND ASSET RATE
FUNDS LIBOR LIBOR HEDGING HEDGING YIELD SPREAD
----- ----- ----- ------- ------- ----- ------
1995, 1st Half 6.18% 6.36% (0.18%) 0.16% 6.34% 7.27% 0.93%
1996, 1st Half 5.65% 5.56% 0.09% 0.15% 5.80% 7.03% 1.23%
Fiscal 1994 5.50% 5.07% 0.43% 0.06% 5.56% 6.31% 0.92%
1995, Quarter 1 6.04% 6.25% (0.21%) 0.06% 6.10% 7.14% 1.04%
1995, Quarter 2 6.28% 6.48% (0.20%) 0.23% 6.51% 7.37% 0.86%
1995, Quarter 3 6.04% 6.10% (0.06%) 0.28% 6.32% 7.48% 1.16%
1995, Quarter 4 5.99% 5.82% 0.17% 0.17% 6.16% 7.14% 0.98%
1996, Quarter 1 5.72% 5.62% 0.10% 0.14% 5.86% 7.32% 1.46%
1996, Quarter 2 5.60% 5.49% 0.11% 0.16% 5.76% 6.84% 1.08%
CREDIT PROVISIONS
Credit provisions for the second quarter of 1996 were $0.48 million, or
0.25% of average assets and 1.70% of average equity during the quarter.
Credit provisions were significantly lower in the second quarter of
1995 ($0.04 million, 0.10% of assets, 0.72% of equity) as the Company
had not yet acquired its whole loans or most of the mortgage securities
rated below BBB which it currently owns. These credit expenses
represent provisions only; there were no actual credit losses in either
of these periods.
For the first half of 1996, credit provisions were $0.81 million, or
0.26% of average assets and 1.79% of average equity. Due to smaller
balances of mortgages with credit risk in the first half of 1995,
credit provisions were lower: $0.06 million, or 0.08% of assets and
0.54% of equity. There were no actual credit losses in either of these
periods.
The Company takes on-going quarterly credit provisions to build a
credit reserve for possible future losses from its mortgage securities,
particularly for the 3% of the portfolio which was rated below BBB.
Such credit provisions were taken at a rate of approximately $112,000
per month during the second quarter of 1996. In addition, each quarter
the Company takes a provision of 0.30% of the balance of whole loans
acquired during that quarter, net of whole loan principal repayments.
The rate at which the Company takes credit provisions may be adjusted
based on the Company's review of the performance of the Company's
mortgage assets.
The table below summarizes the Company's credit provisions and actual
credit losses. Please also see "Financial Condition -- Credit Reserves"
below.
24
TABLE 8
CREDIT PROVISIONS AND ACTUAL CREDIT LOSSES
CREDIT CREDIT ACTUAL ACTUAL ANNUALIZED ANNUALIZED
PROVISIONS PROVISIONS CREDIT CREDIT TOTAL CREDIT CREDIT
ON ON TOTAL LOSSES ON LOSSES ON ACTUAL PROVISIONS PROVISIONS
WHOLE SECURITIZED CREDIT WHOLE SECURITIZED CREDIT TO AVERAGE TO AVERAGE
LOANS ASSETS PROVISIONS LOANS ASSETS LOSSES ASSETS EQUITY
----- ------ ---------- ----- ------ ------ ------ ------
(DOLLARS IN THOUSANDS)
1995, 1st Half $ 0 $ 59 $ 59 $0 $0 $0 0.08% 0.54%
1996, 1st Half 135 673 808 0 0 0 0.26% 1.79%
Fiscal 1994 $ 0 $ 0 $ 0 $0 $0 $0 0.00% 0.00%
1995, Quarter 1 0 19 19 0 0 0 0.06% 0.34%
1995, Quarter 2 0 40 40 0 0 0 0.10% 0.72%
1995, Quarter 3 0 84 84 0 0 0 0.16% 0.64%
1995, Quarter 4 79 271 350 0 4 4 0.37% 1.93%
1996, Quarter 1 (5) 336 331 0 0 0 0.26% 1.94%
1996, Quarter 2 140 337 477 0 0 0 0.25% 1.70%
OPERATING EXPENSES
Operating expenses (or general and administrative expenses) were $0.59
million in the second quarter of 1996. This was an increase over the
$0.20 million of operating expenses from the same quarter in 1995.
Nevertheless, the Company was significantly more productive in 1996, as
measured by the operating expenses to net interest income ratio
dropping from 29% to 17%, the operating expenses to average assets
ratio dropping from 0.49% to 0.31% and the operating expenses to
average equity ratio dropping from 3.52% to 2.12%. Average assets per
employee increased from $33 million to $84 million over this time
period.
Operating expenses also increased from $0.40 million to $1.09 million
from the first half of 1995 to the first half of 1996. Nevertheless,
measures of operating expense productivity improved over that time
period as well.
The salaries of the Company's officers have increased over the life of
the Company as the equity base has increased. When the Company's equity
base reached $100 million in April of 1996, however, all officer's
salaries became capped under the terms of their employment agreements.
Under the current compensation system, future salary increases for
officers are anticipated to be limited to adjustments in the Consumer
Price Index.
TABLE 9
OPERATING EXPENSES
OPERATING AVERAGE
CASH STOCK EXPENSE/ OPERATING OPERATING ASSETS PER
COMP AND OPTION OTHER TOTAL NET EXPENSE/ EXPENSE/ AVE. # OF
BENEFITS AND DER OPERATING OPERATING INTEREST AVERAGE AVERAGE EMPLOYEES
EXPENSE EXPENSE EXPENSE EXPENSE INCOME ASSETS EQUITY ($MM)
------- ------- ------- ------- ------ ------ ------ -----
(DOLLARS IN THOUSANDS)
1995, 1st Half $162 $ 0 $237 $ 399 30% 0.56% 3.63% $29
1996, 1st Half 538 164 384 1,086 17% 0.34% 2.41% 77
Fiscal 1994 $ 63 $ 0 $ 83 $ 146 28% 0.69% 2.05% $12
1995, Quarter 1 81 0 120 201 32% 0.65% 3.74% 25
1995, Quarter 2 81 0 117 198 29% 0.49% 3.52% 33
1995, Quarter 3 197 7 160 364 25% 0.67% 2.79% 39
1995, Quarter 4 103 47 218 368 18% 0.39% 2.03% 53
1996, Quarter 1 233 85 174 492 18% 0.39% 2.88% 69
1996, Quarter 2 305 79 210 594 17% 0.31% 2.12% 84
25
COMPONENTS OF RETURN ON EQUITY
Table 10 shows elements of the Company's income statement expressed as
a percentage of average equity.
The spread times the debt/equity ratio equals the contribution of
spread lending to the Company's return on equity (ROE). The wider the
spread, and the more spread lending undertaken by the Company relative
to the size of its equity base, the greater the ROE from this sector of
the balance sheet. Spread lending ROE in the second quarter of 1996 was
reduced from the first quarter of 1996 (6.28% versus 9.25%) as the
spread was smaller and the Company has employed less of its capital on
average during the second quarter. As compared to the second quarter of
1995, when the contribution to ROE from spread lending was 5.32%, the
Company had a wider spread but utilized less leverage in the second
quarter of 1996. For the first half of 1996 the spread lending ROE was
7.41%, which was greater than the 5.12% earned in the first half of
1995 due to both a wider spread and increased use of leverage.
Given the Company's target equity-to-assets ratio (see "Capital
Adequacy/Risk-Adjusted Capital Policy" below), the target
debt-to-equity ratio for the Company was 8.29 as of June 30, 1996
versus an average debt-to-equity during the second quarter of 5.78. The
Company intends to increase the size of its balance sheet relative to
its equity base in the third and fourth quarter of 1996 while seeking
to maintain an attractive spread.
The second component of return on equity is the net interest income
generated from the equity-funded portion of the Company's balance
sheet. Equity is used to fund earning assets plus a small amount of
fixed assets and net working capital. There is no cost of funds for
this section of the balance sheet. At 6.47%, the contribution of
equity-funded lending to ROE in the second quarter of 1996 was greater
than that of spread lending. The equity-funded ROE of 6.47% represents
the earning asset yield during the quarter of 6.84% adjusted for the
fact that less than 100% of equity was invested in earning assets. The
equity-funded lending ROE was lower in the second quarter of 1996
versus the second quarter of 1995 (and was lower in the first half of
1996 versus the first half of 1995) as the earning asset yield was
lower.
Combining spread lending and equity-funded lending, the net interest
income ROE in the second quarter of 1996 was 12.75%. After credit
provisions of 1.70% of equity and operating expenses of 2.12% of
equity, the net ROE for the Company was 8.93%. Compared to the second
quarter of 1995 when return on equity was 8.00%, net interest income
ROE was higher, credit provisions were higher and operating expenses
were lower in the second quarter of 1996. The net ROE in the first half
of 1996 of 9.88% was higher than the net ROE in the first half of 1995
of 7.73% for similar reasons.
26
TABLE 10
COMPONENTS OF RETURN ON EQUITY
(EQUITY-BASED METHOD)
EQUITY- NET
SPREAD FUNDED INTEREST CREDIT OPERATING NET
DEBT/ LENDING LENDING INCOME PROVISIONS/ EXPENSE/ RETURN
EQUITY RETURN ON RETURN ON RETURN ON AVERAGE AVERAGE ON
SPREAD RATIO EQUITY EQUITY EQUITY EQUITY EQUITY EQUITY
------ ----- ------ ------ ------ ------ ------ ------
1995, 1st Half 0.93% 5.48x 5.12% 6.78% 11.90% 0.54% 3.63% 7.73%
1996, 1st Half 1.23% 6.00x 7.41% 6.67% 14.08% 1.79% 2.41% 9.88%
Fiscal 1994 0.92% 1.94x 1.78% 5.62% 7.40% 0.00% 2.05% 5.35%
1995, Quarter 1 1.04% 4.72x 4.92% 6.62% 11.54% 0.34% 3.74% 7.46%
1995, Quarter 2 0.86% 6.20x 5.32% 6.92% 12.24% 0.72% 3.52% 8.00%
1995, Quarter 3 1.16% 3.08x 3.59% 7.43% 11.02% 0.64% 2.79% 7.59%
1995, Quarter 4 0.98% 4.10x 4.01% 7.17% 11.18% 1.93% 2.03% 7.22%
1996, Quarter 1 1.46% 6.34x 9.25% 7.00% 16.25% 1.94% 2.88% 11.43%
1996, Quarter 2 1.08% 5.78x 6.28% 6.47% 12.75% 1.70% 2.12% 8.93%
Table 11 shows the components of the Company's income statement
expressed as a percentage of assets. Return on assets of 1.31% in the
second quarter of 1996 consisted of the net interest margin of 1.87%
less the credit expenses to assets ratio of 0.25% and the operating
expenses to assets ratio of 0.31%. Return on assets times a leverage
ratio (assets/equity) yields return on equity. As of June 30, 1996, the
Company's target leverage ratio expressed in this manner was 9.28,
which was higher than the average assets-to-equity ratio in the second
quarter of 6.81.
TABLE 11
COMPONENTS OF RETURN ON EQUITY
(ASSET-BASED METHOD)
COST OF
FUNDS
AND
INTEREST HEDGING CREDIT G&A RETURN AVERAGE
INCOME/ EXPENSE/ NET PROVISION/ EXP./ ON ASSETS RETURN
AVERAGE AVERAGE INTEREST AVERAGE AVERAGE AVERAGE TO ON
ASSETS ASSETS MARGIN ASSETS ASSETS ASSETS EQUITY EQUITY
------ ------ ------ ------ ------ ------ ------ ------
1995, 1st Half 7.15% 5.33% 1.82% 0.07% 0.56% 1.19% 6.52x 7.73%
1996, 1st Half 6.96% 4.96% 2.00% 0.25% 0.34% 1.41% 7.02x 9.88%
Fiscal 1994 6.15% 3.64% 2.51% 0.00% 0.69% 1.82% 2.95x 5.35%
1995, Quarter 1 7.00% 5.00% 2.00% 0.05% 0.65% 1.30% 5.76x 7.46%
1995, Quarter 2 7.26% 5.57% 1.69% 0.10% 0.49% 1.10% 7.25x 8.00%
1995, Quarter 3 7.38% 4.71% 2.67% 0.16% 0.67% 1.84% 4.13x 7.59%
1995, Quarter 4 7.05% 4.89% 2.16% 0.37% 0.39% 1.40% 5.16x 7.22%
1996, Quarter 1 7.24% 5.04% 2.20% 0.26% 0.39% 1.55% 7.38x 11.43%
1996, Quarter 2 6.77% 4.90% 1.87% 0.25% 0.31% 1.31% 6.81x 8.93%
27
FINANCIAL CONDITION
SUMMARY
Management believes the Company is well capitalized for the level of
risk undertaken. The Company's assets are single-family mortgages. A
substantial 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 substantial 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 closely matched; all of the mortgages are
adjustable-rate mortgages financed with equity and 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 and, based on the quality of its assets, believes
it will continue to be able to access borrowed funds without
difficulty. 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: all of the Company's
earning assets and interest rate agreements are marked-to-market at
liquidation value. The Company has no intangible assets or goodwill.
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 table below shows the principal components of the Company's balance
sheet over time.
TABLE 12
END OF PERIOD BALANCE SHEET
RECEIVABLES
INTEREST AND
MORTGAGE RATE OTHER TOTAL STOCKHOLDERS'
END OF PERIOD CASH ASSETS AGREEMENTS ASSETS ASSETS BORROWINGS PAYABLES EQUITY
------------- ---- ------ ---------- ------ ------ ---------- -------- ------
(DOLLARS IN THOUSANDS)
1995, 1st Half $ 1,620 $ 175,242 $ 825 $1,634 $ 179,321 $155,881 $ 907 $ 22,533
1996, 1st Half 10,407 1,007,480 1,351 9,092 1,028,330 896,214 7,821 124,295
Fiscal 1994 $ 1,027 $ 117,477 $1,892 $1,132 $ 121,528 $100,376 $ 871 $ 20,281
1995, Quarter 1 953 141,860 1,434 1,193 145,440 121,998 1,090 22,352
1995, Quarter 2 1,620 175,242 825 1,634 179,321 155,881 907 22,533
1995, Quarter 3 1,150 298,785 809 2,650 303,394 228,826 2,095 72,473
1995, Quarter 4 4,825 432,244 547 3,941 441,557 370,316 2,951 68,290
1996, Quarter 1 9,705 565,159 1,233 5,216 581,313 508,721 4,447 68,145
1996, Quarter 2 10,407 1,007,480 1,351 9,092 1,028,330 896,214 7,821 124,295
28
AVERAGE DAILY BALANCE SHEET
The table below shows the estimated average daily balance during each
period of the principal components of the Company's balance sheet.
TABLE 13
AVERAGE DAILY BALANCE SHEET
RECEIVABLES
INTEREST AND
MORTGAGE RATE OTHER TOTAL STOCKHOLDERS'
CASH ASSETS AGREEMENTS ASSETS ASSETS BORROWINGS PAYABLES EQUITY
---- ------ ---------- ------ ------ ---------- -------- ------
(DOLLARS IN THOUSANDS)
1995, 1st Half $ 1,342 $140,943 $1,209 $1,282 $144,776 $121,572 $1,012 $ 22,192
1996, 1st Half 14,520 615,463 1,162 5,762 636,907 543,811 2,398 90,698
Fiscal 1994 $ 6,627 $ 49,734 $ 790 $ 711 $ 57,862 $ 37,910 $ 368 $ 19,584
1995, Quarter 1 1,217 121,979 1,399 1,096 125,691 102,961 910 21,820
1995, Quarter 2 1,466 159,697 1,020 1,468 163,651 139,979 1,111 22,561
1995, Quarter 3 3,597 207,712 831 2,107 214,247 159,794 2,585 51,868
1995, Quarter 4 10,709 356,739 730 3,556 371,734 295,089 4,653 71,991
1996, Quarter 1 14,639 487,110 667 4,630 507,046 435,979 2,324 68,743
1996, Quarter 2 14,402 743,816 1,658 6,892 766,768 651,643 2,472 112,653
MORTGAGE ASSET ACQUISITIONS
The two principal criteria the Company uses when acquiring mortgage
assets are (i) the mortgages must be "A" quality and (ii) the
risk-adjusted returns on equity the Company anticipates earning on such
assets across a variety of economic scenarios must be attractive
relative to the Company's cost of capital and relative to other
available mortgage assets.
During the second quarter of 1996 the Company acquired mortgage assets
of $496 million, thereby increasing the Company's total mortgage
balance by 78%. Whole mortgage loans represented 10% of the
acquisitions in the second quarter of 1996. FHLMC and FNMA guaranteed
mortgages represented 71% and private-label mortgage securities
represented 19% of the quarter's acquisitions. The average price paid
for mortgage assets acquired during the quarter was 102.36% of
principal value. The premium pricing for these assets as compared to
past acquisitions reflects, on average, the higher credit ratings,
higher net margins, and higher life caps of these recently acquired
assets. The average initial coupon of the acquired mortgages was 7.30%;
this was lower than the fully-indexed coupon rate toward which these
coupons will adjust over time. The table below summarizes the
characteristics of the Company's mortgage asset acquisitions.
29
TABLE 14
MORTGAGE ASSET ACQUISITIONS
AVERAGE AAA A & BELOW
ASSET PRICE "A" FHLMC &AA BBB BBB
ACQUISITIONS VERSUS 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)
1995, 1st Half $ 59,471 93.79% 6.57% 0.0% 45.2% 27.7% 10.4% 16.7%
1996, 1st Half 663,036 102.42% 7.38% 7.4% 65.5% 27.1% 0.0% 0.0%
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%
SUMMARY OF MORTGAGE ASSET CHARACTERISTICS
As of June 30, 1996 all the Company's mortgage assets were single-family,
adjustable-rate, first-lien mortgages or securitized interests in pools of such
loans. The average historical amortized cost of these assets was 100.60% of
principal value at that time. The estimated bid-side market value of these
assets (which the Company uses as the carrying value of mortgages on its balance
sheet) was 100.17% of principal value. The average credit rating equivalent at
June 30, 1996 was AA+. For all the mortgage assets owned by the Company, 51% of
the underlying properties were located in California. Excluding the FHLMC and
FNMA guaranteed mortgages, 67% of the properties underlying the Company's whole
loans and private-label securities were located in California. The table below
summarizes the Company's mortgage asset balances.
TABLE 15
MORTGAGE ASSET SUMMARY
ESTIMATED PERCENT IN
BID-SIDE CALIFORNIA
AMORTIZED ESTIMATED MARKET AVERAGE EXCLUDING
MORTGAGE COST TO BID-SIDE VALUE TO CREDIT FHLMC
PRINCIPAL AMORTIZED PRINCIPAL MARKET PRINCIPAL RATING PERCENT IN & FNMA
END OF PERIOD VALUE COST VALUE VALUE VALUE EQUIV. CALIFORNIA MORTGAGES
- ------------- ----- ---- ----- ----- ----- ------ ---------- ---------
(DOLLARS IN THOUSANDS)
1995, 1st Half $ 178,429 $ 174,415 97.75% $ 175,242 98.21% AA+ 72% 80%
1996, 1st Half 1,005,765 1,011,847 100.60% 1,007,480 100.17% AA+ 51% 67%
Fiscal 1994 $ 120,627 $ 120,135 99.59% $ 117,477 97.39% AA+ 72% 82%
1995, Quarter 1 143,393 141,792 98.88% 141,860 98.93% AA+ 73% 80%
1995, Quarter 2 178,429 174,415 97.75% 175,242 98.21% AA+ 72% 80%
1995, Quarter 3 298,718 298,894 100.06% 298,785 100.02% AA+ 65% 77%
1995, Quarter 4 443,625 436,236 98.33% 432,244 97.43% AA+ 65% 71%
1996, Quarter 1 573,807 569,744 99.29% 565,159 98.49% AA+ 64% 69%
1996, Quarter 2 1,005,765 1,011,847 100.60% 1,007,480 100.17% AA+ 51% 67%
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 by the end of each adjustment period to the level of the index
plus the net margin. The fully-indexed rate is the current index plus the net
margin: this is the maximum level to which the coupon could adjust should
interest rates remain unchanged. The rate of adjustment of the current coupon to
the fully-indexed rate is determined by the adjustment
30
periods and the periodic caps of the mortgage loans. As of June 30, 1996,
assuming no changes in the balance sheet or the underlying indices, the coupon
rates on the Company's mortgages would increase from 7.42% to 7.93% over time,
with most of the adjustment taking place over the next six months.
TABLE 16
AVERAGE MORTGAGE ASSET CHARACTERISTICS
COUPON AVERAGE
INTEREST MORTGAGE RATE VS. NUMBER
MORTGAGE RATE MORTGAGE FULLY- FULLY- OF MONTHS MORTGAGE
COUPON INDEX NET INDEXED INDEXED TO NEXT LIFETIME ASSET
END OF PERIOD RATE LEVEL MARGIN RATE RATE ADJSTMNT CAP YIELD
- ------------- ---- ----- ------ ---- ---- -------- --- -----
1995, 1st Half 6.94% 5.99% 2.21% 8.20% (1.26%) 3 11.54% 7.74%
1996, 1st Half 7.42% 5.72% 2.21% 7.93% (0.51%) 4 11.71% 6.98%
Fiscal 1994 6.00% 6.94% 2.25% 9.19% (3.19%) 3 11.48% 6.60%
1995, Quarter 1 6.53% 6.47% 2.24% 8.71% (2.18%) 3 11.57% 7.23%
1995, Quarter 2 6.94% 5.99% 2.21% 8.20% (1.26%) 3 11.54% 7.74%
1995, Quarter 3 7.35% 5.86% 2.20% 8.06% (0.71%) 4 11.56% 7.81%
1995, Quarter 4 7.50% 5.44% 2.08% 7.52% (0.02%) 3 11.54% 7.74%
1996, Quarter 1 7.59% 5.47% 2.11% 7.58% 0.01% 3 11.53% 7.67%
1996, Quarter 2 7.42% 5.72% 2.21% 7.93% (0.51%) 4 11.71% 6.98%
The table below segments the Company's mortgage assets by adjustment index,
coupon adjustment frequency and periodic cap adjustment. As of the end of the
second quarter of 1996, 60% of the Company's mortgage assets had coupon rates
which adjusted as a function of changes in the wholesale cost of funds of
money-center banks (the LIBOR and CD indices), 38% adjusted as a function of
short-term U.S. Treasury interest rates, and 2% adjusted off other indices. The
coupon adjustment cycle is every six months for 62% of total mortgages, every
twelve months for 33% of the total and monthly for 3% of the total;
approximately 2% of mortgages have other re-pricing terms. The periodic caps for
95% of the mortgage assets were either 1% per six months or 2% per year; 3% of
the mortgages had no periodic caps and 2% had other cap structures.
TABLE 17
MORTGAGE ASSETS BY INDEX
SIX- SIX-
SIX- ONE- MONTH ONE- SIX- MONTH
MONTH MONTH BANK YEAR MONTH AVERAGE
LIBOR LIBOR CD TREASURY TREASURY DISCOUNT
INDEX INDEX INDEX INDEX INDEX RATE OTHER
----- ----- ----- ----- ----- ---- -----
Adjustment Frequency/Loan 6 months 1 month 6 months 12 months 6 months 6 months various
Average Adjustment/Pool 3 months 1 month 3 months 6 months 3 months 3 months various
Annualized Periodic Cap 2% none 2% 2% 2% 2% various
% OF TOTAL MORTGAGE ASSETS AT PERIOD END
----------------------------------------
1995, 1st Half 83.0% 2.5% 13.8% 0.7% 0.0% 0.0% 0.0%
1996, 1st Half 54.1% 3.2% 3.4% 33.3% 1.9% 2.5% 1.6%
Fiscal 1994 78.2% 3.9% 17.9% 0.0% 0.0% 0.0% 0.0%
1995, Quarter 1 78.7% 3.1% 17.3% 0.9% 0.0% 0.0% 0.0%
1995, Quarter 2 83.0% 2.5% 13.8% 0.7% 0.0% 0.0% 0.0%
1995, Quarter 3 66.8% 1.4% 11.6% 11.5% 7.6% 0.0% 1.1%
1995, Quarter 4 59.7% 7.7% 12.8% 12.5% 5.0% 0.0% 2.3%
1996, Quarter 1 63.1% 6.5% 8.9% 14.9% 3.6% 0.0% 3.0%
1996, Quarter 2 54.1% 3.2% 3.4% 33.3% 1.9% 2.5% 1.6%
31
The average credit rating equivalent of the Company's mortgage assets at the end
of the second quarter of 1996 was AA+. Whole mortgage loans were $69.7 million,
or 6.9% of total mortgage assets. Due to the "A" quality underwriting and
documentation standards the Company requires for these 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. Securitized loans with a
credit rating equivalent of BBB or better were $912.7 million, or 90.6% of the
Company's total mortgage assets. Securitized loans with a credit rating
equivalent of below BBB represented 2.5% of the total as of June 30, 1996. The
table below shows the balance of the Company's whole mortgage loans and the
Company's securitized mortgage assets segregated by credit rating. Unrated
securitized assets have been assigned a credit rating equivalent by management.
TABLE 18
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
LOAN EQUIV. EQUIV. EQUIV. LOAN EQUIV. EQUIV. EQUIV.
CARRYING CARRYING CARRYING CARRYING PERCENT PERCENT PERCENT PERCENT
END OF PERIOD VALUE VALUE VALUE VALUE OF TOTAL OF TOTAL OF TOTAL OF TOTAL
- ------------- ----- ----- ----- ----- -------- -------- -------- --------
(DOLLARS IN THOUSANDS)
1995, 1st Half $ 0 $150,846 $11,306 $13,092 0.0% 86.0% 6.5% 7.5%
1996, 1st Half 69,666 886,990 25,753 25,070 6.9% 88.0% 2.6% 2.5%
Fiscal 1994 $ 0 $109,548 $ 4,761 $ 3,168 0.0% 93.2% 4.1% 2.7%
1995, Quarter 1 0 125,237 10,988 5,635 0.0% 88.3% 7.7% 4.0%
1995, Quarter 2 0 150,846 11,306 13,092 0.0% 86.0% 6.5% 7.5%
1995, Quarter 3 0 263,344 16,338 19,103 0.0% 88.1% 5.5% 6.4%
1995, Quarter 4 26,450 355,784 25,171 24,839 6.1% 82.4% 5.8% 5.7%
1996, Quarter 1 24,861 490,189 25,838 24,272 4.4% 86.8% 4.6% 4.2%
1996, Quarter 2 69,666 886,990 25,753 25,070 6.9% 88.0% 2.6% 2.5%
WHOLE MORTGAGE LOANS
As of June 30, 1996, the Company owned 257 whole loans with a total loan balance
of $69.2 million. All of these loans are adjustable-rate, single-family loans
underwritten to "A" quality standards. The average loan size was $269,080.
California loans represent 73% of the total outstanding balance. Loans with
original loan-to-value ratios in excess of 80% represent 23% of the total
outstanding balance; each of these loans is credit-enhanced with primary
mortgage insurance which serves to bring the effective loan-to-value ratio to
75% or less. After giving effect to this mortgage insurance, the average
original loan-to-value ratio of the Company's whole loans was 73%.
32
TABLE 19
WHOLE MORTGAGE LOAN SUMMARY
AT JUNE 30, 1996 AT DECEMBER 31, 1995
---------------- --------------------
(ALL RATIOS BASED ON % OF TOTAL LOAN PORTFOLIO BALANCES UNLESS NOTED)
Face Value $69,153,598 $26,411,412
Amortized Cost 69,666,163 26,450,045
Adjustable-Rate 100% 100%
Single-Family 100% 100%
"A" Quality Underwriting 100% 100%
First Lien 100% 100%
Owner-Occupied 100% 100%
Property Located in Northern California 30% 30%
Property Located in Southern California 43% 44%
Number of Loans 257 109
Average Loan Size $ 269,080 $ 242,307
Original Loan Balance in Excess of $500,000 13% 25%
Average Original Loan to Value Ratio (LTV) 76% 76%
Original LTV greater than 80% 23% 26%
Percent of Original LTV greater than 80% with Mortgage Insurance 100% 100%
Effective Original LTV including Primary Mortgage Insurance 73% 73%
1993 Origination 1% 0%
1994 Origination 2% 2%
1995 Origination 63% 98%
1996 Origination 34% 0%
Non-Performing Assets (90+ days delinquent) $ 278,637 $ 0
Number of Non-Performing Loans (90+ days delinquent) 2 0
Non-Performing Assets as % of Total Loan Balances 0.4% 0.0%
The Company defines non-performing assets ("NPAs") as whole loans which are
delinquent more than 90 days. As of June 30, 1996, the Company's NPAs were
$278,637, reflecting two loans in foreclosure. At December 31, 1995 the Company
had no non-performing assets. The Company has experienced no actual whole loan
credit losses to date.
SECURITIZED MORTGAGES RATED AAA TO BBB
At June 30, 1996, 91% 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, 1995, these types of mortgage securities represented
88% of the Company's mortgage assets.
Each of these securitized interests in mortgage pools has credit-enhancement
from a third-party which provides the Company with 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 this 91% portion of the Company's 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. The Company has
experienced no actual credit losses from these mortgage assets.
SECURITIZED MORTGAGES RATED BELOW BBB
The Company acquires limited amounts of securitized mortgage assets with a
credit rating equivalent of less than BBB when management believes that the cash
flow and return on equity, net of expected credit losses, over the life of the
asset will be attractive. Such assets had a bid-side market value at June 30,
1996 of $25.1 million, or 2.5%
33
of the Company's total mortgage assets. At December 31, 1995, the balance of
such assets was $24.8 million. 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.
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) and the eventual
return of principal (net of credit losses) which was purchased at a discount
(thus increasing the rate at which the Company's amortizes its discount balance
into income).
The bulk of the Company's securitized assets with a credit rating equivalent
below BBB are credit-enhanced, although 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 may be
significant as these interests are subordinated to and provide
credit-enhancement for other, more senior, interests issued from the same
mortgage pool.
For several of these interests owned by the Company, the underlying pools
currently have levels of mortgage delinquencies in excess of management's
original expectations. Mortgage servicing issues rather than poor mortgage
credit may be responsible for some of the increase in reported delinquencies.
The Company is monitoring the efforts of the mortgage servicing companies
responsible for these pools. Delinquency rates in these pools appeared to
stabilize in the second quarter of 1996.
For all the Company's securitized mortgage assets rated below BBB that have
credit-enhancement, actual pool credit losses (which would serve to reduce the
credit-enhancement protection to the Company's interests) have been minimal to
date. The Company has experienced no credit losses from these assets.
At June 30, 1996 and December 31, 1995, the Company also owned $0.2 million of
"first loss" assets. These are subordinated interests with no
credit-enhancement. All credit losses in the related pools of mortgages will
reduce the principal value of the Company's "first loss" asset and will be
recognized as an actual credit loss by the Company. The limit of the Company's
potential credit losses on these assets is equal to the amortized cost of $0.2
million. As the Company's cost basis in "first loss" assets is low relative to
the mortgage principal value, the Company's realized credit loss will equal only
10-15% of the principal value of any mortgage credit losses in the pools. Total
credit losses realized by the Company to date on first loss assets have been
$3,997.
CREDIT RESERVES
Through its quarterly credit provisions, the Company is building a credit
reserve for credit losses which could occur in the future, particularly in its
portfolio of whole mortgage loans and securitized mortgage interests with
ratings below BBB. As of June 30, 1996, the historical amortized cost of such
"higher-risk" mortgage assets was $98.5 million, or 9.7% of total mortgage
assets. Assets which have an immediate potential threat of credit loss were the
Company's first loss assets and its non-performing whole loans. The historical
amortized cost of such assets at June 30, 1996 was $0.5 million. The credit
reserve at June 30, 1996 was $1.3 million.
34
TABLE 20
CREDIT RESERVES
CREDIT
RESERVES/
AMORTIZED AMORTIZED HIGHER- FIRST FIRST
COST OF COST OF RISK CREDIT LOSS LOSS
AMORTIZED SECURITIZED TOTAL ASSETS TO RESERVE/ ASSETS ASSETS
COST OF ASSETS HIGHER- TOTAL HIGHER- AND NON- AND NON-
WHOLE RATED RISK MORTGAGE CREDIT RISK PERFORMING PERFORMING
END OF PERIOD LOANS BELOW BBB ASSETS ASSETS RESERVES ASSETS LOANS LOANS
- ------------- ----- --------- ------ ------ -------- ------ ----- -----
(DOLLARS IN THOUSANDS)
1995, 1st Half $ 0 $13,351 $13,351 7.7% $ 59 0.44% $ 0 n/a
1996, 1st Half 69,680 28,858 98,538 9.7% 1,298 1.32% 514 252%
Fiscal 1994 $ 0 $ 3,377 $ 3,377 2.8% $ 0 0.00% $ 0 n/a
1995, Quarter 1 0 5,836 5,836 4.1% 19 0.32% 0 n/a
1995, Quarter 2 0 13,351 13,351 7.7% 59 0.44% 0 n/a
1995, Quarter 3 0 19,964 19,964 6.7% 143 0.72% 0 n/a
1995, Quarter 4 26,449 28,857 55,306 12.7% 490 0.89% 228 215%
1996, Quarter 1 24,851 28,051 52,902 9.3% 821 1.55% 422 194%
1996, Quarter 2 69,680 28,858 98,538 9.7% 1,298 1.32% 514 252%
As one step in determining the adequacy of its level of credit reserves, the
Company reviews the level of 90+ day delinquencies in its whole loan portfolio
and in the pools underlying all its securitized mortgage interests. The Company
estimates the likely percentage of such delinquencies that may result in a
default and then estimates the likely aggregate loss severity (percentage of
principal loss per defaulted loan). After taking into consideration the benefit
of any third-party credit enhancements and the level of the Company's historical
amortized cost for the asset, the Company makes an estimate of possible future
realized credit losses based on current delinquencies. In order to complete the
evaluation of the adequacy of its reserve levels, the Company then considers
additional credit losses that may arise from future delinquencies.
The table below shows the Company's historical loss severity experience. The
table shows the cumulative percentage principal loss (loss severity) for loans
that both defaulted and resulted in a loss as estimated by the Company for the
loans in the mortgage pools underlying the Company's securities. These defaults
have generally not resulted in credit losses to the Company due to
credit-enhancement protection.
The table below also shows the estimated future credit losses that would be
incurred by the Company if 100% of the 90+ day delinquent loans which are in the
pools underlying its securitized mortgage interests or are owned directly by the
Company defaulted and resulted in a loss. Estimated losses for a variety of loss
severities are shown. This gives one measure of the adequacy of the Company's
credit reserve based on current delinquencies, although the table most likely
over-estimates potential future losses as the Company does not expect 100% of
such delinquent loans to default or nor does the Company expect all defaults to
result in a loss. Any such defaults may take up to a year or longer to occur;
continued quarterly credit provisions will add to the reserve over this time.
This table addresses the risk arising from current delinquencies only; it does
not purport to reflect potential losses that may occur over the life of these
assets.
35
TABLE 21
POTENTIAL FUTURE CREDIT LOSSES ESTIMATED BASED ON
CURRENT 90+ DAY DELINQUENCIES ONLY
POTENTIAL POTENTIAL POTENTIAL POTENTIAL POTENTIAL POTENTIAL
CUMULATIVE FUTURE FUTURE FUTURE FUTURE FUTURE FUTURE
ESTIMATED LOSSES LOSSES LOSSES LOSSES LOSSES LOSSES
ACTUAL ASSUMING ASSUMING ASSUMING ASSUMING ASSUMING ASSUMING
CREDIT REALIZED LOSS LOSS LOSS LOSS LOSS LOSS
LOSS LOSS SEVERITY SEVERITY SEVERITY SEVERITY SEVERITY SEVERITY
END OF PERIOD RESERVE SEVERITY OF 10% OF 15% OF 20% OF 25% OF 30% OF 35%
- ------------- ------- -------- ------ ------ ------ ------ ------ ------
(DOLLARS IN THOUSANDS)
1995, 1st Half $ 59 0% $ 0 $ 0 $ 0 $ 0 $ 0 $ 0
1996, 1st Half 1,298 18% 68 102 147 715 1,449 2,215
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 18% 68 102 147 715 1,449 2,215
INTEREST RATE AGREEMENTS
The Company's interest rate agreements are assets carried on the balance sheet
at estimated liquidation value. There is a risk that the counter-parties to the
interest rate agreements will not be able to perform under these contracts. All
of the counter-parties to the Company's interest rate agreements have a credit
rating of at least "A". Potential accounting income losses from counter-party
risk are limited to the Company's amortized cost basis in these agreements,
which was $2.8 million at June 30, 1996 and $2.5 million at December 31, 1995.
The Company has experienced no credit losses on interest rate agreements.
BORROWINGS
To date, the Company's debt has consisted entirely of borrowings collateralized
by a pledge of the Company's mortgage assets. These borrowings appear on the
balance sheet as reverse repurchase agreements and notes payable. The size of
the market for borrowings of this type is measured in the trillions of dollars;
institutions with high-quality pledgable assets such as banks, savings and
loans, brokerage firms, federal agencies and the Federal Reserve Bank are the
largest U.S. borrowers in this market. The Company has established uncommitted
borrowing facilities in this market in amounts in excess of its current
requirements.
All of the Company's mortgage assets are currently accepted as collateral for
such borrowings. On average, the Company could borrow 94% to 96% of the market
value of its mortgage assets. The Company, however, limits 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 interest rate has adjusted to market levels on a
regular schedule during the term of the borrowing, so the
term-to-next-rate-adjustment may be shorter than the term-to-maturity. The
weighted average term-to-maturity and weighted average
term-to-next-rate-adjustment were both 72 days at June 30, 1996. At December 31,
1995 the average term-to-maturity was 74 days and the average
term-to-next-rate-adjustment was 26 days. The Company lengthened the
term-to-next-rate-adjustment for its borrowings in the second quarter of 1996
and correspondingly reduced its level of short-term interest rate hedging. These
longer-term borrowings better match the adjustment frequency of the Company's
assets. As long as the Company maintains this
36
strategy, the Company believes the result, as compared to using shorter-term
borrowings, is likely to be reduced short-term earnings volatility but also
reduced long-term total earnings.
TABLE 22
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)
1995, 1st Half $ 175,242 95.4% $167,192 $155,881 64 days 28 days 6.23%
1996, 1st Half 1,007,480 95.9% 965,735 896,214 72 days 72 days 5.70%
Fiscal 1994 $ 117,477 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% 282,432 228,826 38 days 31 days 5.95%
1995, Quarter 4 432,244 94.6% 408,998 370,316 74 days 26 days 6.01%
1996, Quarter 1 565,159 95.2% 537,783 508,721 48 days 19 days 5.62%
1996, Quarter 2 1,007,480 95.9% 965,735 896,214 72 days 72 days 5.70%
LIQUIDITY
A financial institution has ample liquidity when it is able 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 will vary over time as the market value of the Company's
mortgage assets fluctuate and due to other factors. Potential immediate sources
of liquidity as a percent of total borrowings equaled 9% at June 30, 1996 and
12% at December 31, 1995. 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. 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. The table below shows the potential
immediate sources of liquidity available to the Company.
37
TABLE 23
POTENTIAL IMMEDIATE SOURCES OF LIQUIDITY
POTENTIAL
IMMEDIATE POTENTIAL
SOURCES OF IMMEDIATE
LIQUIDITY SOURCES
ESTIMATED (CASH + OF
UNUSED EST. UNUSED LIQUIDITY
CASH BORROWING BORROWING AS % OF
END OF PERIOD BALANCE CAPACITY CAPACITY) BORROWINGS
------------- ------- -------- --------- ----------
(DOLLARS IN THOUSANDS)
1995, 1st Half $ 1,620 $11,311 $12,931 8%
1996, 1st Half 10,407 69,521 79,928 9%
Fiscal 1994 $ 1,027 $11,907 $12,934 13%
1995, Quarter 1 953 11,721 12,674 10%
1995, Quarter 2 1,620 11,311 12,931 8%
1995, Quarter 3 1,150 53,606 54,756 24%
1995, Quarter 4 4,825 38,682 43,507 12%
1996, Quarter 1 9,705 29,062 38,767 8%
1996, Quarter 2 10,407 69,521 79,928 9%
STOCKHOLDERS' EQUITY
During the first half of 1996 the Company's equity base grew from $68.3 million
to $124.3 million as a result of the Company's April 1996 stock offering, a
positive mark-to-market adjustment on the Company's assets, proceeds from the
exercise of warrants, and stock sold pursuant to the Company's Dividend
Reinvestment Plan.
Book value per share grew 18% in the first half of 1996, from $12.38 to $14.59.
This increase was due primarily to the accretive nature of the Company's April
1996 offering of stock, which was completed at a price of $20.25 per share.
Management believes that book value per share growth is one important indicator
of potential future earnings per share growth; as book value per share rises,
the Company has more equity capital per share to invest in its business.
For balance sheet purposes the Company values all of its mortgage assets and
interest rate agreements at their estimated bid-side liquidation market value.
As a result, the Company's equity base and book value per share will fluctuate.
The difference between market value and historical amortized cost, or "Net
Unrealized Loss on Assets Available for Sale", was $4.6 million, or 0.4% of
assets, as of June 30, 1996. The net unrealized loss at December 31, 1995 was
$5.5 million, or 1.2% of assets. Net unrealized loss includes both mark-downs on
assets taken immediately upon acquisition (as liquidation values are generally
estimated to be lower than acquisition prices) and the effect of subsequent
market value fluctuations.
38
TABLE 24
STOCKHOLDERS' EQUITY
NET NET NET HISTORICAL
UNREALIZED UNREALIZED UNREALIZED HISTORICAL AMORTIZED GAAP
LOSSES LOSSES ON TOTAL LOSSES AMORTIZED GAAP COST REPORTED
ON INTEREST NET AS % OF COST REPORTED EQUITY EQUITY
MORTGAGE RATE UNREALIZED TOTAL EQUITY EQUITY PER PER
END OF PERIOD ASSETS AGREEMENTS LOSSES ASSETS BASE BASE SHARE SHARE
- ------------- ------ ---------- ------ ------ ---- ---- ----- -----
(DOLLARS IN THOUSANDS)
1995, 1st Half $ 886 $(1,200) $ (314) (0.2%) $ 22,847 $ 22,533 $12.19 $12.02
1996, 1st Half (3,068) (1,485) (4,553) (0.4%) 128,847 124,295 15.12 14.59
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
CAPITAL ADEQUACY/RISK-ADJUSTED CAPITAL POLICY
Stockholders' equity as a percent of total assets was 12.1% at June 30, 1996 and
15.5% at December 31, 1995. The Company's target equity-to-assets ratio at June
30, 1996 was 10.8%. This level of equity capitalization is higher than that of
many banks, savings and loans, Federal government mortgage agencies, insurance
companies, and REITs that act as mortgage portfolio lenders.
The Company's target equity-to-assets ratio varies over time as a function of
the Company's asset mix, the Company's liquidity position, the level of unused
borrowing capacity, and the over-collateralization levels required by lenders
when the Company pledges assets to secure borrowings. The Company currently
seeks to maintain an equity-to-assets ratio of 7% to 10% for assets 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, the Company currently seeks to maintain an equity-to-assets ratio of 40%
to 100%. Thus the overall target equity-to-assets ratio will vary over time as a
function of the asset mix and other factors. As shown in the table below, the
target equity-to-assets ratio has been declining since mid-1995 due primarily to
a change in asset mix. In aggregate, the Company's per-asset capital
requirements have not changed significantly over the life of the Company.
The target equity-to-assets ratio is determined through a Board-level process
called for in the Company's Risk-Adjusted Capital ("RAC") Policy. Should the
actual equity-to-assets ratio of the Company fall below the target level due to
asset acquisitions and/or asset market value fluctuations, management will cease
the acquisition of new assets. Management will, at that time, present a plan to
the Board to bring the Company back to its target equity-to-assets ratio; in
many circumstances, this would be accomplished over time by waiting for the
balance of mortgage assets to reduce through principal repayments.
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 RAC Policy.
Management anticipates that the target equity-to-assets ratio may continue to
drop in the future as the Company shifts its asset mix with an increased
emphasis on high-quality whole mortgage loans and securitized mortgage assets
rated AAA and AA.
With excess capital of $13.6 million as compared to its risk-adjusted capital
guideline at June 30, 1996, the Company had asset growth potential of
approximately $126 million assuming acquired mortgage assets have the same mix
as existing mortgage assets. The Company employed approximately 74% of its
capital base on average during the second quarter of 1996.
39
TABLE 25
EXCESS CAPITAL AND ASSET GROWTH POTENTIAL
POTENTIAL ASSET ESTIMATED
ASSET GROWTH PERCENT
TARGET ACTUAL SIZE POTENTIAL OF
EQUITY EQUITY WITH WITH CAPITAL
TO TO SAME ACTUAL SAME EMPLOYED
EQUITY ASSETS ASSETS EXCESS ASSET ASSET ASSET DURING
END OF PERIOD CAPITAL RATIO RATIO CAPITAL MIX SIZE MIX PERIOD
- ------------- ------- ----- ----- ------- --- ---- --- ------
(DOLLARS IN THOUSANDS)
1995, 1st Half $ 22,533 12.95% 12.57% $ (1,069) $ 173,989 $ 179,321 $ (5,332) 82%
1996, 1st Half 124,295 10.77% 12.09% 13,566 1,154,303 1,028,330 125,973 79%
Fiscal 1994 $ 20,280 10.84% 16.69% $ 6,716 $ 187,048 $ 121,528 $ 65,520 30%
1995, Quarter 1 22,352 12.41% 15.37% 3,970 180,173 145,440 34,733 70%
1995, Quarter 2 22,533 12.95% 12.57% (1,069) 173,989 179,321 (5,332) 94%
1995, Quarter 3 72,473 13.08% 23.89% 32,155 554,183 303,394 250,789 55%
1995, Quarter 4 68,290 12.59% 15.47% 12,028 542,431 441,557 100,874 69%
1996, Quarter 1 68,146 11.72% 11.72% 26 581,540 581,313 227 87%
1996, Quarter 2 124,295 10.77% 12.09% 13,566 1,154,303 1,028,330 125,973 74%
WARRANTS
At June 30, 1996 the Company had 1,563,957 warrants outstanding; at December 31,
1995 the Company had 1,665,063 warrants outstanding. In the first six months of
1996, 101,106 warrants were exercised. These warrants currently trade on NASDAQ
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.
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 sometime on or prior to
December 31, 1997. If all these warrants are exercised, the Company will receive
new equity capital of approximately $23.5 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 pattern of net income which is stable and growing over time
relative to its competitors in the banking and savings and loan industries.
The Company seeks 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.
Another goal of the Company's asset/liability strategy is to preserve liquidity
by managing the volatility of the net market value of the Company's balance
sheet as shown in the stockholders' equity account. In the event of an increase
in short-term interest rates, the market value of the Company's mortgage assets
would likely fall, particularly in the short-term. The Company anticipates that
the market value of its interest rate agreements would likely rise and partially
offset decreases in mortgage values. See "Equity Duration" below.
Changes in interest rates also may have an effect on the rate of mortgage
principal repayment; the Company seeks to mitigate the effect of changes in the
mortgage principal repayment rate from an economic point of view by balancing
assets purchased at a premium with assets purchased at a discount. However, due
to the Company's GAAP accounting practices, changes in the rate of mortgage
principal repayment have differing
40
effects on premium and discount amortization schedules. When the rate of
mortgage principal repayments has increased above expected levels, the Company
records premium amortization at a faster rate than discount amortization. This
accounting practice leads to a lower level of GAAP accounting income, compared
to what it otherwise would have been, during periods of rapid mortgage principal
repayments. See "Amortization of Premium and Discount and Effect of Changes in
Principal Repayment Rates" above.
Although the net effects of changes in interest rates, mortgage prepayment
rates, and other factors cannot be determined in advance, management believes
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) the Company may have reduced hedging expenses on
existing interest rate agreements or may have positive hedging income due to the
rate increases, (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 each 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 could be an initial increase in earnings followed by decreased earnings
after a lag period.
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 achieves this goal, the Company's return on equity, earnings and
dividends would maintain a constant or widening spread to the level of
short-term interest rates over time.
INTEREST RATE SENSITIVITY GAP
The table below shows the Company's cumulative interest rate sensitivity gap, or
maturity gap, for periods of one month to one year 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
during that particular time frame, while a positive gap implies that rising
interest rates will lead to higher earnings. Lower interest rates would have the
opposite effect.
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 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 table below shows that the Company's two-month cumulative gap as a
percentage of total assets was negative 10% at June 30, 1996. 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 nine-month gap of positive 5% at June 30, 1996.
This implies that the impact on net interest income of increasing interest rates
may be positive within nine months even though the initial impact may have been
negative. Falling interest rates would have the opposite effect.
Although the Company's balance sheet does have these 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
41
basis what the actual impact of such interest rate changes on the Company's net
income would be, especially over shorter time periods.
Since virtually all of the Company's assets and liabilities have income or
expense rates which adjust to market conditions within one year, the Company's
cumulative twelve-month interest rate sensitivity gap, which was positive 12% at
June 30, 1996, applies to time periods longer than one year as well. The Company
has a positive twelve-month interest rate sensitivity gap even though virtually
all assets and liabilities adjust within one year because the Company has more
earning assets than interest-bearing liabilities.
The negative short-term interest rate sensitivity gap was much reduced at June
30, 1996 compared to earlier periods because the Company extended the maturity
of its liabilities during the second quarter.
TABLE 26
INTEREST RATE SENSITIVITY GAP EXCLUDING INTEREST RATE AGREEMENTS
CUMULATIVE CUMULATIVE CUMULATIVE CUMULATIVE CUMULATIVE CUMULATIVE CUMULATIVE CUMULATIVE
1-MONTH 2-MONTH 3-MONTH 4-MONTH 5-MONTH 6-MONTH 9-MONTH 12-MONTH
GAP GAP GAP GAP GAP GAP GAP GAP
AS A % OF AS A % OF AS A % OF AS A % OF AS A % OF AS A % OF AS A % OF AS A % OF
TOTAL TOTAL TOTAL TOTAL TOTAL TOTAL TOTAL TOTAL
END OF PERIOD ASSETS ASSETS ASSETS ASSETS ASSETS ASSETS ASSETS ASSETS
- ------------- ------ ------ ------ ------ ------ ------ ------ ------
1995, 1st Half (39%) (49%) (33%) (17%) (3%) 11% 12% 12%
1996, 1st Half (13%) (10%) (3%) (6%) (6%) (2%) 5% 12%
Fiscal 1994 (3%) (0%) 5% (1%) 1% 15% 15% 15%
1995, Quarter 1 (46%) (41%) (27%) (12%) 0% 14% 14% 14%
1995, Quarter 2 (39%) (49%) (33%) (17%) (3%) 11% 12% 12%
1995, Quarter 3 (51%) (34%) (19%) (6%) 4% 18% 20% 23%
1995, Quarter 4 (48%) (36%) (26%) (16%) (3%) 9% 12% 15%
1996, Quarter 1 (62%) (47%) (34%) (21%) (8%) 4% 8% 11%
1996, Quarter 2 (13%) (10%) (3%) (6%) (6%) (2%) 5% 12%
INTEREST RATE AGREEMENTS
The Company's interest rate agreements alter the interest rate risk profile
suggested by the interest rate sensitivity gap analysis. See "Cost of Borrowed
Funds and Hedging and the Interest Rate Spread" above and Footnote 3 of the
Financial Statements.
The interest rate agreements are designed to produce income for the Company as
short-term interest rates rise. 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. The table below shows that, as of June 30,
1996, 59% of the Company's borrowings (or 59% of its assets that are funded with
borrowings) were protected with interest rate agreements. This is a lower amount
than in previous periods; the Company had a reduced need for hedging because it
extended the maturities of its borrowings in the second quarter. In addition, as
of June 30, 1996, the Company had entered into a variety of interest rate cap
and swap agreements which would only become effective after that date and
therefore were not shown in this table.
42
TABLE 27
NOTIONAL AMOUNT OF INTEREST RATE AGREEMENTS EFFECTIVE AS A % OF TOTAL BORROWINGS
(OR OF ASSETS FUNDED WITH BORROWINGS)
ASSUMING AN IMMEDIATE SHIFT IN INTEREST RATES
IMMEDIATE INCREASE IN ONE-MONTH OR THREE-MONTH LIBOR OF:
--------------------------------------------------------
END OF PERIOD 0BPS 50BPS 100BPS 150BPS 200BPS 300BPS 400BPS 500BPS 600BPS 700BPS
- ------------- ---- ----- ------ ------ ------ ------ ------ ------ ------ ------
1995, 1st Half 0% 0% 44% 47% 47% 60% 66% 66% 73% 73%
1996, 1st Half 8% 22% 35% 39% 42% 52% 55% 58% 58% 59%
Fiscal 1994 0% 0% 5% 5% 5% 5% 5% 5% 5% 5%
1995, Quarter 1 0% 30% 30% 34% 34% 34% 34% 34% 34% 34%
1995, Quarter 2 0% 0% 44% 47% 47% 60% 66% 66% 73% 73%
1995, Quarter 3 0% 0% 0% 47% 49% 57% 60% 64% 64% 68%
1995, Quarter 4 0% 24% 24% 40% 59% 70% 70% 78% 78% 81%
1996, Quarter 1 0% 19% 35% 43% 48% 66% 70% 76% 76% 78%
1996, Quarter 2 8% 22% 35% 39% 42% 52% 55% 58% 58% 59%
INTEREST RATE FUTURES AND OPTIONS
In the second half of 1996, the Company intends to commence the limited use of
interest rate futures and 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 currently in use by the Company;
the Company intends to use them in a similar manner and for hedging purposes
only. The Company currently plans to limit 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. Unless federal
legislation changing REIT hedging restrictions with respect to futures and
options is enacted, the Company currently plans to limit its use of futures and
listed options so that its net profits from such instruments will be limited to
5% or less of the Company's gross taxable income on an annual basis.
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 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.
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
financial statements are prepared in accordance with generally accepted
accounting principals (GAAP) 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.
43
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
At June 30, 1996, 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
Not applicable
Item 3. Defaults Upon Senior Securities
Not applicable
Item 4. Submission of Matters to a Vote of Security Holders
(a)The Annual Meeting of Shareholders of the Company
was held on June 14, 1996.
(b)The following matters were voted on at the Annual
Meeting:
(1) Election of Directors
Votes
------------------------------
Nominee For Against Abstain
-------------------------- ---------- -------- -------
Douglas B. Hansen 4,011,336 300 0
Thomas F. Farb 4,011,336 300 0
Charles J. Toeniskoetter 4,011,336 300 0
The following Directors' terms of office continue
after the meeting:
George E. Bull
Nello Gonfiantini
Dan A. Emmett
Frederick H. Borden
(2) Ratification of Coopers & Lybrand as the
Company's independent public accountants for the
fiscal year ending December 31, 1996.
Votes
--------------------------------
For Against Abstain
------------ ------- --------
3,999,516 7,220 4,900
(3) Ratification of the amendments to the Stock
Option Plan.
Votes
--------------------------------
For Against Abstain
------------ ------- --------
2,510,240 542,456 24,800
44
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit 11 to Part I - Computation of Earnings Per
Share for the three and six months ended June 30,
1996 and June 30, 1995.
Exhibit 27 - Financial Data Schedule
(b) Reports
None
45
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: August 7, 1996 By:/s/ Douglas B. Hansen
---------------------
Douglas B. Hansen
President and Chief Financial Officer
(authorized officer of registrant)
Dated: August 7, 1996 By:/s/ Vickie L. Rath
------------------
Vickie L. Rath
Vice President, Treasurer and Controller
(principal accounting officer)
46
REDWOOD TRUST, INC.
INDEX TO EXHIBIT
Sequentially
Exhibit Numbered
Number Page
- ------- ------------
11 Computation of Earnings per Share......... 48
27 Financial Data Schedule................... 50
47