================================================================================ UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED: SEPTEMBER 30, 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 stock, as of the last practicable date. Class B Preferred Stock ($.01 par value) 1,006,250 as of November 8,1996 Common Stock ($.01 par value) 9,138,872 as of November 8,1996 ================================================================================ REDWOOD TRUST, INC. FORM 10-Q INDEX
Page ---- PART I. FINANCIAL INFORMATION Item 1. Financial Statements Balance Sheets at September 30, 1996 and December 31, 1995 ....... 3 Statements of Operations for the three and nine months ended September 30, 1996 and September 30, 1995 .................. 4 Statements of Stockholders' Equity for the three and nine months ended September 30, 1996 and September 30, 1995 .................. 5 Statements of Cash Flows for the three and nine months ended September 30, 1996 and September 30, 1995 .................. 6 Notes to Financial Statements .................................... 7 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations .................... 19 PART II. OTHER INFORMATION Item 1. Legal Proceedings ................................................ 46 Item 2. Changes in Securities ............................................ 46 Item 3. Defaults Upon Senior Securities .................................. 46 Item 4. Submission of Matters to a Vote of Security Holders .............. 46 Item 5. Other Information ................................................ 46 Item 6. Exhibits and Reports on Form 8-K ................................. 46 SIGNATURES ................................................................ 47
2 PART I. FINANCIAL INFORMATION ITEM 1. FINANCIAL STATEMENTS REDWOOD TRUST, INC. BALANCE SHEETS (In thousands, except share data)
September 30, 1996 December 31, 1995 ------------------ ----------------- ASSETS Cash and cash equivalents $ 14,599 $ 4,825 Mortgage assets 1,375,870 432,244 Interest rate agreements 873 547 Accrued interest receivable 10,781 3,270 Other assets 1,355 671 ----------- ----------- $ 1,403,478 $ 441,557 =========== =========== LIABILITIES AND STOCKHOLDERS' EQUITY LIABILITIES Short-term borrowings $ 1,225,094 $ 370,316 Accrued interest payable 10,379 1,290 Accrued expenses and other liabilities 472 227 Dividends payable 4,016 1,434 ----------- ----------- 1,239,961 373,267 ----------- ----------- Commitments and contingencies (See Note 11) STOCKHOLDERS' EQUITY Preferred stock, par value $0.01 per share: Class B 9.74% Cumulative Convertible 1,006,250 and 0 shares authorized; 1,006,250 and 0 shares issued and outstanding ($31,582 aggregate liquidation preference) 29,712 0 Common stock, par value $0.01 per share; 48,993,750 and 50,000,000 shares authorized; 9,069,653 and 5,517,299 shares issued and outstanding 91 55 Additional paid-in capital 138,081 73,895 Net unrealized loss on assets available for sale (2,060) (5,476) Dividends in excess of net income (2,307) (184) ----------- ----------- 163,517 68,290 ----------- ----------- $ 1,403,478 $ 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 Nine Months Ended September 30, September 30, 1996 1995 1996 1995 ----------- ----------- ----------- ----------- INTEREST INCOME Mortgage assets $ 19,121 $ 3,936 $ 40,734 $ 9,031 Cash and investments 250 50 669 85 ----------- ----------- ----------- ----------- 19,371 3,986 41,403 9,116 INTEREST EXPENSE 14,447 2,432 29,724 6,155 INTEREST RATE AGREEMENTS Interest rate agreement expense 349 112 756 210 ----------- ----------- ----------- ----------- NET INTEREST INCOME 4,575 1,442 10,923 2,751 Provision for credit losses 516 84 1,324 143 ----------- ----------- ----------- ----------- Net interest income after provision for credit losses 4,059 1,358 9,599 2,608 Operating expenses 672 364 1,758 763 ----------- ----------- ----------- ----------- NET INCOME $ 3,387 $ 994 $ 7,841 $ 1,845 =========== =========== =========== =========== Net income 3,387 994 7,841 1,845 Less cash dividends on Class B preferred stock (388) -- (388) -- ----------- ----------- ----------- ----------- Net income available to common stockholders 2,999 994 7,453 1,845 =========== =========== =========== =========== NET INCOME PER SHARE Primary $ 0.32 $ 0.24 $ 0.90 $ 0.67 Fully diluted $ 0.31 $ 0.24 $ 0.89 $ 0.67 Weighted average shares of common stock and common stock equivalents: Primary 9,516,174 4,183,138 8,246,815 2,747,642 Fully diluted 9,657,395 4,183,138 8,402,542 2,747,642 Dividends declared per Class A preferred share $ -- $ -- $ -- $ 0.50 Dividends declared per Class B preferred share $ 0.386 $ -- $ 0.386 $ -- Dividends declared per common share $ 0.40 $ 0.20 $ 1.26 $ 0.20
The accompanying notes are an integral part of these financial statements 4 REDWOOD TRUST, INC. STATEMENTS OF STOCKHOLDERS' EQUITY For the Nine Months Ended September 30, 1996 (In thousands, except share data)
Net Unrealized Class B Additional Loss on Assets Undistributed Preferred Common Paid-in Available Income / Stock Stock Capital for Sale (Deficit) Total ---------------------------------------------------------------------------------------- Balance, December 31, 1995 -- $ 55 $ 73,895 ($ 5,476) ($ 184) $ 68,290 Net income -- -- -- -- 1,954 1,954 Issuance of common stock -- -- 79 -- -- 79 Offering costs -- -- (48) -- -- (48) Dividends declared -- -- -- -- (2,540) (2,540) Fair value adjustment on assets available for sale -- -- -- 411 -- 411 --------- ------ --------- --------- --------- --------- Balance, March 31, 1996 -- 55 73,926 (5,065) (770) 68,146 Net income -- -- -- -- 2,500 2,500 Issuance of common stock -- 29 55,303 -- -- 55,332 Offering costs -- -- (304) -- -- (304) Conversion of stock warrants -- 1 1,516 -- -- 1,517 Dividends declared -- -- -- -- (3,408) (3,408) Fair value adjustment on assets available for sale -- -- -- 512 -- 512 --------- ------ --------- --------- --------- --------- Balance, June 30, 1996 -- 85 130,441 (4,553) (1,678) 124,295 Net income -- -- -- -- 3,387 3,387 Issuance of common stock -- 1 495 -- -- 496 Issuance of Class B preferred stock 29,868 -- -- -- -- 29,868 Offering costs (156) -- (163) -- -- (319) Conversion of stock warrants -- 5 7,308 -- -- 7,313 Dividends declared: Common -- -- -- -- (3,628) (3,628) Class B Preferred -- -- -- -- (388) (388) Fair value adjustment on assets available for sale -- -- -- 2,493 -- 2,493 --------- ------ --------- --------- --------- --------- Balance, September 30, 1996 $ 29,712 $ 91 $ 138,081 ($ 2,060) ($ 2,307) $ 163,517
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 Nine Months Ended September 30, September 30, 1996 1995 1996 1995 ----------- ----------- ----------- ----------- CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 3,387 $ 994 $ 7,841 $ 1,845 Adjustments to reconcile net income to net cash provided by operating activities: Amortization of mortgage asset premium and discount, net 1,435 (157) 2,989 (575) Depreciation and amortization 25 18 60 43 Provision for credit losses on mortgage assets 516 84 1,324 143 Amortization of interest rate cap agreements 208 112 548 210 (Increase) in accrued interest receivable (3,489) (753) (7,511) (1,265) (Increase) decrease in other assets 420 (282) (744) (296) Increase in accrued interest payable 6,327 493 9,089 135 Increase in accrued expenses and other 111 92 245 152 ----------- ----------- ----------- ----------- Net cash provided by operating activities 8,940 601 13,841 392 CASH FLOWS FROM INVESTING ACTIVITIES: Purchases of mortgage assets (443,860) (132,640) (1,106,896) (192,111) Principal payments on mortgage assets 76,942 8,319 162,814 13,927 Purchases of interest rate cap agreements (660) (481) (1,314) (813) ----------- ----------- ----------- ----------- Net cash used in investing activities (367,578) (124,802) (945,396) (178,997) CASH FLOWS FROM FINANCING ACTIVITIES: Net borrowings from reverse repurchase agreements 328,880 72,945 854,778 128,450 Net proceeds from issuance of Class B preferred stock 29,712 -- 29,712 -- Net proceeds from issuance of common stock 7,646 51,286 64,221 51,278 Dividends paid (3,408) (500) (7,382) (1,000) ----------- ----------- ----------- ----------- Net cash provided by financing activities 362,830 123,731 941,329 178,728 Net increase (decrease) in cash and cash equivalents 4,192 (470) 9,774 123 Cash and cash equivalents at beginning of period 10,407 1,620 4,825 1,027 ----------- ----------- ----------- ----------- Cash and cash equivalents at end of period $ 14,599 $ 1,150 $ 14,599 $ 1,150 =========== =========== =========== =========== Supplemental disclosure of cash flow information: Cash paid for interest $ 8,120 $ 2,432 $ 20,635 $ 6,514 =========== =========== =========== ===========
The accompanying notes are an integral part of these financial statements 6 REDWOOD TRUST, INC. NOTES TO FINANCIAL STATEMENTS SEPTEMBER 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. On August 8, 1996, the Company completed its public offering of 1,006,250 shares of Class B 9.74% Cumulative Convertible Preferred stock ("Class B preferred stock") at $31.00 per share. The Company received proceeds of $30 million, net of an underwriting discount of $1.317 per share and other offering costs. During September, 1996, the Company completed a Universal Shelf Registration. With this Registration Statement, the Company may offer Common Stock, Preferred Stock, Warrants and Shareholder Rights from time to time. The aggregate maximum offering price of all securities to be issued pursuant to this Registration Statement is $200,000,000. 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 real estate properties throughout the United 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. 7 A summary of the Company's significant accounting policies follows: Cash and cash equivalents Cash and cash equivalents include cash on hand and highly liquid investments with original maturities of three months or less. The carrying amount of cash equivalents approximates their fair value. Mortgage Assets The Company's mortgage assets ("Mortgage Assets") may consist of mortgage loans, mortgage loans which have been securitized by the Company following acquisition, mortgage loans which have been securitized by others prior to acquisition by the Company and interest only strips ("IO 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 expected cash flow from the Mortgage Assets, including an other-than-temporary deterioration of the credit quality of the underlying mortgages and/or the credit protection available to the related mortgage pool. 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 8 Agreements, which include interest rate cap agreements (the "Cap Agreements"), interest rate swap agreements (the "Swap Agreements") and interest rate collar agreements (the "Collar Agreements"), entered into by the Company are intended to provide income to offset potential reduced net interest income under certain rising interest rate scenarios. The Company periodically evaluates the effectiveness of these hedges under various interest rate scenarios. The Company accounts for the Interest Rate Agreements as hedges. Because the Mortgage Assets are carried at fair value, the Company's Interest Rate Agreements are carried at fair value, with unrealized gains and losses reported as a separate component of equity. The cost of each Cap Agreement and the net cost or payment received on each Collar Agreement is amortized over the effective period of that Cap or Collar Agreement using the effective interest method. The income and expense related to each Swap Agreement is recognized on an accrual basis. Gains and losses on early termination of Interest Rate Agreements are amortized as a component of net interest income over the remaining term of the original Interest Rate Agreement, or, if shorter, over the remaining term of associated Mortgage Assets as adjusted for estimated future principal prepayments. 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 serious deterioration of the ability of the counterparty to perform under the terms of the Interest Rate Agreement. Premises, Furniture and Equipment Leasehold improvements are stated at cost and are amortized on a straight-line basis over the life of the lease. Furniture and equipment is stated at cost and depreciated on an accelerated basis over its estimated useful life. Expenditures for repairs and maintenance are charged to expense when incurred. Premises and equipment totaled $233,244 at September 30, 1996 and $113,515 at December 31, 1995. Depreciation expense and leasehold improvements amortization for the three and nine months ended September 30, 1996 totaled $16,514 and $35,066, respectively. Depreciation expense and leasehold improvements amortization for the three and nine months ended September 30, 1995 totaled $9,879 and $17,995, respectively. Accumulated depreciation and leasehold improvement amortization totaled $66,433 at September 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 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 September 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 nine months ended September 30, 1996 the Company provided for $515,895 and $1,324,080 in credit losses, respectively. During the three and nine months ended September 30, 1995 the Company provided for $84,044 and $143,079 in credit losses, respectively. During the three and nine months ended September 30, 1996 and September 30, 1995 the Company incurred no charge-offs. The reserve balance at September 30, 1996 and December 31, 1995 was $1,813,794 and $489,713, respectively. NOTE 2. MORTGAGE ASSETS Mortgage Assets Excluding IO Strip At September 30, 1996, Mortgage Assets, excluding IO Strips, consisted of the following:
FEDERAL HOME LOAN FEDERAL NATIONAL NON-AGENCY MORTGAGE MORTGAGE MORTGAGE (IN THOUSANDS) CORPORATION ASSOCIATION ASSETS TOTAL ----------------- ---------------- ---------- ----------- Mortgage Assets, Gross $ 259,831 $ 595,497 $ 505,734 $ 1,361,062 Unamortized Discount 0 (243) (16,095) (16,338) Unamortized Premium 7,243 15,650 6,980 29,873 ----------- ----------- ----------- ----------- Amortized Cost 267,074 610,904 496,619 1,374,597 Allowance for Credit Losses 0 0 (1,814) (1,814) Gross Unrealized Gains 752 1,683 2,679 5,114 Gross Unrealized Losses (212) (691) (3,397) (4,300) ----------- ----------- ----------- ----------- Estimated Fair Value $ 267,614 $ 611,896 $ 494,087 $ 1,373,597 =========== =========== =========== ===========
10 At December 31, 1995, Mortgage Assets, excluding IO Strips, consisted of the following:
FEDERAL HOME FEDERAL NATIONAL NON-AGENCY LOAN 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 September 30, 1996 and December 31, 1995, all investments in Mortgage Assets consisted of interests in adjustable rate mortgages on residential properties. A majority of the Non-Agency Mortgage Asset properties are located in the State of California. The securitized interests in pools of adjustable rate mortgages from the Federal Home Loan Mortgage Corporation and the Federal National Mortgage Association are guaranteed as to principal and interest by those US government agencies. The original maturity of the vast majority of the Mortgage Assets is over a period of thirty years; the actual maturity is subject to change based on the prepayments of the underlying mortgage loans. At September 30, 1996, the average annualized effective yield was 6.97% based on the amortized cost of the assets and 6.97% 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 September 30, 1996 and December 31, 1995 the weighted average lifetime cap was 11.69% and 11.54%, respectively. IO Strips The amortized cost and fair value of the Company's IO Strips are summarized as follows:
(IN THOUSANDS) SEPTEMBER 30, 1996 DECEMBER 31, 1995 ------------------ ----------------- Amortized Cost $ 2,734 $ 3,593 Gross Unrealized Gains 42 0 Gross Unrealized Losses (503) (830) ------- ------- Estimated Fair Value $ 2,273 $ 2,763 ======= =======
The average annualized effective yield at September 30, 1996 on the IO Strips was 11.10% based on the amortized cost of the assets and 13.35% 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) SEPTEMBER 30, 1996 DECEMBER 31, 1995 ------------------ ----------------- Amortized Cost $ 3,286 $ 2,521 Gross Unrealized Gains 54 0 Gross Unrealized Losses (2,467) (1,974) ------- ------- Estimated Fair Value $ 873 $ 547 ======= =======
Cap Agreements The Company had forty outstanding Cap Agreements at September 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 September 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 $482,500,000 and $302,000,000 at September 30, 1996 and December 31, 1995, respectively. The weighted average cap strike rate during the three and nine months ended September 30, 1996 was 7.11% and 7.18%. The weighted average cap strike rate during the three and nine months ended September 30, 1995 was 7.86% and 7.64%. 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 September 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 3 months) $421,571 7.29% 5.50% 12.00% $ 193 1997 547,392 8.04% 5.50% 12.00% 822 1998 269,657 8.73% 6.94% 12.00% 703 1999 176,197 9.32% 6.94% 12.00% 529 2000 97,889 9.06% 7.50% 10.00% 362 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 $ 3,286 ========
Collar Agreement At September 30, 1996, the Company had entered into one outstanding collar agreement, consisting of the purchase of a cap agreement subsidized by the sale of a floor agreement. On the cap portion, the Company will receive net hedge income to the extent that three month LIBOR exceeds 7.50%. On the floor portion, the Company will incur a net hedge expense to the extent that three month LIBOR falls below 5.91% 12 The Collar Agreement outstanding at September 30, 1996 is as follows:
NOTIONAL FACE EXPECTED AMOUNT CAP STRIKE FLOOR COLLAR EXPENSE EFFECTIVE PERIOD: (IN THOUSANDS) INDEX RATE STRIKE RATE AMORTIZATION ----------------- -------------- ----- ---- ----------- ------------ October 1996 to July 1999 $20,000 3 mo LIBOR 7.50% 5.91% $0
Swap Agreements The Company has entered into three types of Interest Rate Swap Agreements summarized as follows: Fixed vs. Floating Rate Swap Agreements: The Company had six outstanding Fixed vs. Floating Rate Swap Agreements ("Fixed Pay Rate Swaps") at September 30, 1996 and one outstanding Fixed Pay Rate Swap at December 31, 1995. The sum of the notional amounts of the Company's Fixed Pay Rate Swaps in effect was $70,000,000 and $10,000,000 at September 30, 1996 and December 31, 1995, respectively. Under these swap agreements, the Company receives the 3 month LIBOR rate and pays the fixed rate shown below.
(DOLLARS IN THOUSANDS) AVERAGE SWAP NOTIONAL FACE AVERAGE LOW HIGH YEAR AMOUNT PAY RATE PAY RATE PAY RATE ---- ------ -------- -------- -------- 1996 (last 3 months) $ 82,554 6.30% 6.01% 6.97% 1997 109,699 6.27% 6.01% 7.18% 1998 (first 5 months) 25,828 6.59% 6.40% 7.18%
Periodic Swap Agreements: As of September 30, 1996, the Company had entered into three Periodic Swap Agreements designed to produce income to the Company in the event that the three month LIBOR rate rises sharply. In each of these swaps, the Company receives income on the notional face at a rate equal to three month LIBOR less 0.230% to 0.265% and pays income on the notional face on the lesser of (a) three month LIBOR or (b) the prior period's LIBOR plus 0.50%. The average notional face of these swaps is $110 million, with $90 million maturing in August 1999 and $20 million maturing in September 1999.
(DOLLARS IN THOUSANDS) AVERAGE SWAP NOTIONAL FACE AVERAGE SPREAD LOW SPREAD HIGH SPREAD YEAR AMOUNT RECEIVED RECEIVED RECEIVED ---- ------ -------- -------- -------- 1996 (last 3 months) $110,000 -0.255% -0.265% -0.230% 1997 110,000 -0.255% -0.265% -0.230% 1998 110,000 -0.255% -0.265% -0.230% 1999 (first 9 months) 98,242 -0.257% -0.265% -0.230%
Basis Swap Agreements: As of September 30, 1996, the Company had entered into five LIBOR/Treasury bill Basis Swap Agreements totaling $160 million. These Basis Swap Agreements, in conjunction with the Company's other swap and cap agreements, are designed to reduce the potential risks in that portion of the Company's balance sheet wherein Treasury-based assets are funded with LIBOR-based liabilities. The Basis Swap Agreements will produce net hedge income for the Company to the extent that three month LIBOR exceeds the average three month Treasury bill rate by 0.440% to 0.465% and will produce a net hedge expense for the Company to the extent that the spread between these two indices is narrower than 0.440% to 0.465%. Half of the Company's $160 million in Basis Swap Agreements were effective at the end of the third quarter of 1996; the remainder will be effective by 13 December 31, 1996. The maturities of these Basis Swap Agreements are as follows: $30 million in June 1998, $50 million in December 1998, $30 million in June 1999 and $50 million in December 1999.
(DOLLARS IN THOUSANDS) AVERAGE SWAP NOTIONAL FACE AVERAGE SPREAD LOW SPREAD HIGH SPREAD YEAR AMOUNT PAID PAID PAID ---- ------ ---- ---- ---- 1996 (last 3 months) $ 61,087 0.450% 0.440% 0.465% 1997 160,000 0.453% 0.440% 0.465% 1998 144,877 0.455% 0.440% 0.465% 1999 64,712 0.464% 0.460% 0.465%
The Company has incurred credit risk to the extent that the counter-parties to the Interest Rate Agreements do not perform their obligations under the Interest Rate Agreements. Potential credit write offs are limited to the amortized cost of the Cap Agreements. In addition, for Cap, Swap and Collar Agreements, if one of the counter-parties does not perform, the Company would not receive the cash to which it would otherwise be entitled under the Interest Rate Agreement. In order to mitigate this risk, the Company has entered into Interest Rate Agreements only with counter-parties rated A or better and has entered into Interest Rate Agreements with twelve 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 September 30, 1996 or December 31, 1995. NOTE 4. SHORT-TERM BORROWINGS The Company has entered into reverse repurchase agreements, notes payable and a revolving line of credit (together "Short-Term Borrowings") to finance acquisitions of a portion of its Mortgage Assets. These Short-Term Borrowings are collateralized by a portion of the Company's Mortgage Assets. In September 1996, the Company entered into a $20 million, one-year revolving line of credit agreement with a financial institution. The agreement requires that the Company maintain certain financial ratios. The Company is in compliance with all requirements. Interest rates on borrowings under this facility are based on LIBOR. At September 30, 1996, borrowings under this facility totaled $19,943,000 and were committed through October 15, 1996. At September 30, 1996 the Company had $1,225,094,000 of Short-Term Borrowings outstanding with a weighted average borrowing rate of 5.782% and a weighted average maturity of 102 days. These borrowings were collateralized with $1,289,471,000 of Mortgage Assets. At December 31, 1995, the Company had $370,316,047 of Short-Term Borrowings outstanding with a weighted average borrowing rate of 6.01% and a weighted average remaining maturity of 74 days. These borrowing were collateralized with $386,321,000 of Mortgage Assets. At September 30, 1996 and December 31, 1995, the Short-Term Borrowings had the following remaining maturities:
(IN THOUSANDS) SEPTEMBER 30, 1996 DECEMBER 31, 1995 ------------------ ----------------- Within 30 days $ 221,265 $ 75,808 30 to 90 days 253,477 175,921 Over 90 days 750,352 118,587 ---------- ---------- Total Borrowings $1,225,094 $ 370,316 ========== ==========
14 For the three and nine months ended September 30, 1996, the average balance of Short-Term Borrowings was $999,229,000 and $696,725,000, respectively with a weighted average interest cost of 5.78% and 5.69%. For the three and nine months ended September 30, 1995 the average balance of Short-Term Borrowings was $159,794,000 and $134,431,000, respectively with a weighted average interest cost of 6.09% and 6.10%. The maximum balance outstanding during the nine months ended September 30, 1996 was $1,225,094,000. The maximum balance outstanding during the year ended December 31, 1995 was $370,316,000. 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 September 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.
SEPTEMBER 30, 1996 DECEMBER 31, 1995 ------------------------- ------------------------- CARRYING FAIR CARRYING FAIR (IN THOUSANDS) AMOUNT VALUE AMOUNT VALUE ---------- ---------- ---------- ---------- Assets Mortgage Assets $1,373,597 $1,373,597 $ 429,481 $ 429,481 IO Strips 2,273 2,273 2,763 2,763 Interest Rate Agreements 873 873 547 547
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 In 1994 the Company issued 1,666,063 shares of Class A Convertible Preferred Stock. The Class A Preferred Stock ranked senior to the Company's Common Stock as to dividends and liquidation rights. Concurrent with the completion of the Initial Public Offering on August 9, 1995, all 1,666,063 outstanding shares of Class A Convertible Preferred Stock converted into 1,667,134 shares of Common Stock. NOTE 7. CLASS B CONVERTIBLE PREFERRED STOCK On August 8, 1996, the Company issued 1,006,250 shares of Class B 9.74% Cumulative Convertible Preferred Stock. Each share of the Class B Preferred Stock is convertible at the option of the holder at any time into one share of Common Stock. The Class B Preferred Stock will be redeemable by the Company after September 30, 1999. The Class B Preferred Stock pays a dividend equal to the greater of (i) $0.755 per quarter or (ii) an amount equal to the quarterly dividend declared on the number of shares of the Common Stock into which the Class B Preferred Stock is convertible. The Class B Preferred Stock ranks senior to the Company's Common Stock as to the payment of dividends and liquidation rights. NOTE 8. STOCK PURCHASE WARRANTS At September 30, 1996 and December 31, 1995 there were 1,076,431 and 1,665,063 Warrants outstanding, respectively. Each Warrant entitles the holder to purchase 1.000667 shares of the Company's common stock at an exercise price of $15.00 per share. The Warrants remain exercisable until December 31, 1997. 15 NOTE 9. 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. At September 30, 1996 and December 31, 1995, 983,097 and 142,060 shares of Common Stock, respectively, were available for grant. Of the shares of Common Stock available for grant, no more than 500,000 shares of Common Stock shall be cumulatively available for grant as ISOs. At September 30, 1996 and December 31, 1995, 168,333 ISOs had been granted. The exercise price for ISOs granted under the Stock Option Plan may not be less than the fair market value of shares of Common Stock at the time the ISO is granted. All stock options granted under the Stock Option Plan vest no earlier than ratably over a four year period from the date of grant and expire within ten years after the date of grant. The Company's Stock Option Plan permits stock options granted under the plan to accrue DERs. For the three and nine months ended September 30, 1996, the DERs accrued on NQSOs resulted in non-cash charges to general and administrative expenses of $80,592 and $244,916, respectively. These non-cash charges were $7,200 for both the three and nine months ended September 30, 1995. DERs represent shares of stock which are issuable to holders of stock options when the holders exercise the underlying stock options. The number of DER shares accrued are based on the level of the Company's dividends and on the price of the stock on the related dividend payment date. Information with respect to stock option and DER activity is as follows:
NINE MONTHS ENDED YEAR ENDED SEPTEMBER 30, 1996 DECEMBER 31, 1995 ------------------ ----------------- Outstanding options at beginning of period: 310,857 188,333 Options granted 10,000 166,972 Options exercised (42,083) (47,083) Dividend equivalent rights earned 9,411 2,635 ------- ------- Outstanding options at end of period 288,185 310,857 ======= ======= Exercise price per share: For options exercised during period $0.10 - $0.11 $0.10 - $0.11 For options outstanding end of period $0.10 - $24.63 $0.10 - $21.50
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. 16 NOTE 10. 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 September 16, 1996 the Company declared a dividend of $388,413 and $3,627,861, or $0.386 per Class B preferred share and $0.40 per common share, respectively. These dividends were paid on October 21, 1996 to shareholders of record as of September 30, 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. NOTE 11. COMMITMENTS AND CONTINGENCIES As of September 30, 1996 the Company had entered into a commitment to purchase $23 million of Mortgage Assets for settlement in October 1996. At September 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 nine months ended September 30, 1996 was $28,647 and $79,108, respectively. Rental expense for office properties under operating leases for the three and nine months ended September 30, 1995 was $16,098 and $47,920, respectively. Future minimum rental commitments as of September 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 SEPTEMBER 30, 1996 DECEMBER 31, (IN THOUSANDS) ------------ -------------- 1996 30 1997 121 1998 121 1999 121 2000 121 2001 40 ---- ---- Total $554 ====
17 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 nine months ended September 30, 1996, the Company was bearing 95% of the lease expenses and GB Capital was bearing 5%. For the three and nine months ended September 30, 1995, the Company was bearing 70% of the lease expenses and GB Capital was bearing 30%. 18 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS The following discussion should be read in conjunction with the Financial Statements and Notes. SAFE HARBOR STATEMENT "Safe Harbor" Statement under the Private Securities Litigation Reform Act of 1995: Statements in this discussion regarding Redwood Trust, Inc. (the "Company") and its business which are not historical facts are "forward-looking statements" that involve risks and uncertainties. For a discussion of such risks and uncertainties, which could cause actual results to differ from those contained in the forward-looking statements, see "Risk Factors" commencing on Page 18 of the Company's preferred stock offering prospectus, dated August 8, 1996 (Registration Statement No. 333-08363). OVERVIEW Redwood Trust, Inc. is a mortgage finance company which acquires and manages 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 believes its primary competitors are other financial institutions, such as banks and savings and loan institutions, which seek to earn spread income from managing mortgage assets. Compared to most of its competitors, the Company believes it benefits from a lower cost of operations and from its status as a Real Estate Investment Trust ("REIT"). As a REIT, the Company does not pay corporate Federal income taxes so long as the Company pays out as dividends an amount equal to at least 95% of its taxable income and satisfies certain other conditions. 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 to gather deposits, the Company accesses borrowed funds in the capital markets. This strategy enables the Company to keep its operating costs low. In the third quarter of 1996, the Company's operating expenses to assets ratio was 0.23% and its efficiency ratio (operating expenses to net interest income) was 15%. As of September 30, 1996, all of the Company's mortgage assets consisted of adjustable-rate, first-lien mortgages on single-family properties or mortgage securities evidencing an interest in such mortgages. In the future, the Company may acquire fixed-rate single-family mortgage loans as well as mortgage loans on multi-family or commercial properties. The Company acquires individual whole mortgage loans (9% of total mortgage assets as of September 30, 1996), mortgage securities evidencing an interest in pools of mortgage loans which have been fully insured against credit losses by one of the Federal government mortgage agencies (64%), mortgage securities which have partial private-sector credit-enhancement through insurance, subordination, or other means sufficient to warrant an investment-grade credit rating from one of the nationally-recognized credit rating firms (25%), and mortgage securities which are subordinated and have higher levels of credit risk such that they have received a rating below BBB (2%). 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. 19 As of September 30, 1996, 69% 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 have been generally stable to improving in the first nine months of 1996. The coupon rate the Company earns on its mortgage assets increases or falls in conjunction with changes in short-term interest rates, as does the rate the Company pays on its borrowings. The coupon rate on each mortgage generally adjusts on a one, six or twelve month cycle; the average term-to-next-adjustment for all of the Company's mortgage assets was 4 months as of September 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 September 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 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 without such growth. The Company intends to continue to pursue growth when management believes that such growth is likely to be additive to earnings per share potential. In the third quarter of 1996, the Company issued 1,006,250 shares of Class B 9.74% Cumulative Convertible Preferred Stock. For purposes of calculating net income available to common shareholders, the dividends payable on these preferred shares is deducted. Given the characteristics of this preferred stock, the Company includes it in its equity base for determining selected performance ratios. RESULTS OF OPERATIONS: THREE MONTHS ENDING SEPTEMBER 30, 1996 VERSUS THREE MONTHS ENDING SEPTEMBER 30, 1995 AND FIRST NINE MONTHS OF 1996 VERSUS FIRST NINE 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. CHANGE IN CALCULATION METHOD FOR CERTAIN PREVIOUSLY REPORTED YIELDS AND RATIOS Certain previously reported yields and ratios have been changed for this report due to a number of changes in calculation methods, including a change in the "day-count" convention used by the Company and an adjustment to average daily balance figures. These changes are not material, however, management has made these changes in an effort to make the presentation of these figures more useful and consistent. 20 NET INCOME SUMMARY Net earnings in the third quarter of 1996 were $3.0 million, an increase of 200% over the $1.0 million the Company earned in the third quarter of 1995. The primary reason total earnings increased was that average assets increased by nearly $1 billion, or 438%, from the 1995 period to the 1996 period. For a similar reason, net earnings in the first nine months of 1996 of $7.5 million represent a more than fourfold increase over net earnings of $1.8 million in the first nine months of 1995. The table below presents the Company's quarterly net income by major income and expense category. TABLE 1 NET INCOME
Interest Rate Net Credit Interest Interest Agreement Interest Provision Operating Income Expense Expense Income Expense Expenses ------ ------- ------- ------ ------- -------- (dollars in thousands) 1995, 1st Nine Months $ 9,116 $ 6,155 $ 210 $ 2,751 $ 143 $ 763 1996, 1st Nine Months 41,403 29,724 756 10,923 1,324 1,758 Fiscal 1994 $ 1,296 $ 760 $ 8 $ 528 $ 0 $ 146 1995, Quarter 1 2,170 1,533 16 621 19 201 1995, Quarter 2 2,961 2,191 82 688 40 198 1995, Quarter 3 3,986 2,432 112 1,442 84 364 1995, Quarter 4 6,610 4,453 129 2,029 350 368 1996, Quarter 1 9,131 6,202 151 2,777 331 492 1996, Quarter 2 12,901 9,075 255 3,571 477 594 1996, Quarter 3 19,371 14,447 349 4,575 516 672
Net Income Net Income Before After Preferred Preferred Preferred Dividends Dividends Dividends --------- --------- --------- (dollars in thousands) 1995, 1st Nine Months $ 1,845 $ 0 $ 1,845 1996, 1st Nine Months 7,841 388 7,453 Fiscal 1994 $ 382 $ 0 $ 382 1995, Quarter 1 401 0 401 1995, Quarter 2 450 0 450 1995, Quarter 3 994 0 994 1995, Quarter 4 1,311 0 1,311 1996, Quarter 1 1,954 0 1,954 1996, Quarter 2 2,500 0 2,500 1996, Quarter 3 3,387 388 2,999
Earnings per share in the third quarter of 1996 were $0.32, representing an increase of 33% over the $0.24 per share earned in the third quarter of 1995. Earnings per share increased due to an increase in return on average equity from 7.66% to 9.41% and an increase in the equity per share the Company had available with which to generate earnings from $13.14 to $16.23. Equity (or book value) per share increased due to accretive stock offerings at prices in excess of book value in April 1996 (common stock) and August 1996 (preferred stock). Third quarter 1996 earnings per share were 10% higher than the $0.29 reported in the second quarter of 1996. This quarterly EPS increase also resulted from an increase in return on average equity and an increase in the book value per share. Two factors served to limit the Company's return on average equity during the third quarter of 1996. The Company was under-invested in mortgage assets relative to its equity base and capital policy guidelines, with 84% of the Company's capital base employed in earning assets on average during the quarter. In addition, the Company estimates that the average coupon during the period of 7.52% was 0.47% below the average fully-indexed coupon level for this period. This lower-than-full-potential coupon was primarily a result of the rapid pace of acquisitions of mortgages during the second and third quarter. The newly acquired mortgages had coupons which were less than fully-indexed. As of September 30, 1996, the average coupon rate on the Company's assets was 0.36% below the fully-indexed level. For the first nine months of 1996, earnings per share were $0.90, an increase of 34% versus the comparable period in 1995. Return on average equity for the two nine month periods increased from 7.64% to 9.63% and book value per share increased from $13.14 to $16.23. The table below presents information on shares outstanding, earnings per share, book value per share and return on average equity (ROE). 21 TABLE 2 EARNINGS PER SHARE, BOOK VALUE PER SHARE AND RETURN ON AVERAGE EQUITY
BOOK VALUE RETURN BOOK VALUE PER COMMON ON AVERAGE POTENTIAL PER COMMON AND PREFERRED RETURN AVERAGE EARNINGS NUMBER OF DILUTION TOTAL SHARE SHARE ON COMMON PER COMMON DUE TO NUMBER OF OUTSTANDING OUTSTANDING AVERAGE AND PRIMARY SHARES WARRANTS PRIMARY AT AT COMMON PREFERRED SHARE OUTSTANDING AND OPTIONS SHARES END OF PERIOD END OF PERIOD EQUITY EQUITY ("EPS") ----------- ----------- ------ ------------- ------------- ------ ------ ------- 1995, 1st Nine Months 2,571,888 175,754 2,747,642 $13.14 $ 13.14 7.64% 7.64% $ 0.67 1996, 1st Nine Months 7,360,916 885,899 8,246,815 14.75 16.23 9.60% 9.63% 0.90 Fiscal 1994 1,676,080 240,766 1,916,846 $10.82 $ 10.82 5.40% 5.40% $ 0.20 1995, Quarter 1 1,874,395 240,766 2,115,161 11.93 11.93 7.36% 7.36% 0.19 1995, Quarter 2 1,874,395 188,699 2,063,094 12.02 12.02 7.97% 7.97% 0.22 1995, Quarter 3 3,944,129 239,009 4,183,138 13.14 13.14 7.66% 7.66% 0.24 1995, Quarter 4 5,516,310 563,197 6,079,507 12.38 12.38 7.28% 7.28% 0.22 1996, Quarter 1 5,521,376 608,211 6,129,587 12.34 12.34 11.37% 11.37% 0.32 1996, Quarter 2 7,813,974 786,258 8,600,232 14.59 14.59 8.88% 8.88% 0.29 1996, Quarter 3 8,732,326 783,848 9,516,174 14.75 16.23 9.32% 9.41% 0.32
DIVIDEND SUMMARY Dividends paid to common shareholders for the third quarter of 1996 were $0.40 per share, which was twice the $0.20 dividend paid in the same quarter one year earlier. Dividends paid to preferred shareholders were $0.386 per share, reflecting the minimum quarterly preferred dividend of $0.755 pro-rated for the partial period from the preferred stock issuance date to the end of the quarter. No such preferred stock was outstanding a year earlier. Total dividends (common plus preferred) paid for the third quarter of 1996 were $4.0 million versus $1.1 million paid for the same time period in 1995. Dividends in the first nine months of 1996 were $1.26 per share, an increase of 80% over the $0.70 per share dividend paid in the first nine months of 1995. Total dividends paid for the first nine months of 1996 were $10.0 million; total dividends paid for the same period the prior year were $1.9 million. 22 TABLE 3 DIVIDENDS
TAXABLE INCOME AFTER PREFERRED TOTAL COMMON DIVIDENDS PREFERRED COMMON SHARES PER COMMON SHARES PREFERRED AND OUTSTANDING COMMON DIVIDEND TOTAL OUTSTANDING DIVIDEND TOTAL PREFERRED EARNING SHARE DECLARED COMMON EARNING DECLARED PREFERRED DIVIDENDS DIVIDEND OUTSTANDING PER SHARE DIVIDEND DIVIDEND PER SHARE DIVIDEND DECLARED -------- ----------- --------- -------- -------- --------- -------- -------- (DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA) 1995, 1st Nine Months 2,766,134 $0.73 $0.70 $1,936 0 $0.000 $ 0 $1,936 1996, 1st Nine Months 7,599,794 1.28 1.26 9,576 1,006,250 0.386 388 9,964 Fiscal 1994 1,401,904 $0.25 $0.25 $ 350 0 $0.000 $ 0 $ 350 1995, Quarter 1 1,666,063 0.25 0.20 333 0 0.000 0 333 1995, Quarter 2 1,666,063 0.32 0.30 500 0 0.000 0 500 1995, Quarter 3 5,516,313 0.20 0.20 1,103 0 0.000 0 1,103 1995, Quarter 4 5,517,299 0.33 0.26 1,435 0 0.000 0 1,435 1996, Quarter 1 5,521,376 0.46 0.46 2,540 0 0.000 0 2,540 1996, Quarter 2 8,520,116 0.37 0.40 3,408 0 0.000 0 3,408 1996, Quarter 3 9,069,653 0.40 0.40 3,628 1,006,250 0.386 388 4,016
The Company's policy is to distribute over time as dividends 100% of its earnings as calculated for tax purposes. Through September 30, 1996, cumulative taxable income has exceeded cumulative dividends paid or declared by $0.2 million; the Company intends to distribute this excess taxable income 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 (actual credit losses through September 30, 1996 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. Management believes taxable income is a closer approximation of current cash flow generation than is GAAP income. Dividends per share have 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. The table below presents the major differences between GAAP and taxable income. 23 TABLE 4 TAXABLE INCOME
TAXABLE OPERATING GAAP EXPENSES TAXABLE TAXABLE TAXABLE TAXABLE NET INCOME TAXABLE AND INCOME INCOME INCOME INCOME BEFORE CREDIT MORTGAGE BEFORE AFTER RETURN RETURN PREFERRED EXPENSE AMORTIZATION PREFERRED PREFERRED ON COMMON ON TOTAL DIVIDENDS DIFFERENCES DIFFERENCES DIVIDENDS DIVIDENDS EQUITY EQUITY --------- ----------- ----------- --------- --------- ------ ------ (DOLLARS IN THOUSANDS) 1995, 1st Nine Months $ 1,845 $ 143 $ 31 $ 2,019 $ 2,019 8.36% 8.36% 1996, 1st Nine Months 7,841 1,324 574 9,739 9,351 12.05% 11.96% Fiscal 1994 $382 $ 0 $ (28) $ 354 $ 354 4.99% 4.99% 1995, Quarter 1 401 19 (12) 408 408 7.48% 7.48% 1995, Quarter 2 450 40 38 528 528 9.37% 9.37% 1995, Quarter 3 994 84 5 1,082 1,082 8.35% 8.35% 1995, Quarter 4 1,311 347 156 1,814 1,814 10.08% 10.08% 1996, Quarter 1 1,954 331 264 2,549 2,549 14.83% 14.83% 1996, Quarter 2 2,500 477 165 3,142 3,142 11.16% 11.16% 1996, Quarter 3 3,387 516 145 4,048 3,660 11.37% 11.25%
COUPON INCOME ON MORTGAGE ASSETS The average coupon on the Company's mortgage assets was 7.52% during the third quarter of 1996, an increase from the 7.47% average coupon rate in the second quarter of 1996. The coupon rate in the third quarter rose because (i) the short-term interest rate indices which determine coupons on mortgage assets increased (as approximated in the table below by the increase in the six month average of the six-month LIBOR rate) and (ii) towards the end of the third quarter, coupons on the mortgage assets which the Company acquired in the second and third quarters began to adjust towards their fully-indexed levels. In the second and third quarter of 1996, the Company acquired $940 million in mortgage assets; these new assets represented a substantial portion of the Company's total mortgage assets as of September 30, 1996. These assets were generally acquired with initial coupon rates below their fully-indexed rate and, as of the end of the third quarter, many of these new mortgage assets had not yet had a coupon adjustment since being acquired by the Company. In the last few quarters the Company has generally been acquiring mortgages at a premium price to the face value of the mortgages. In the third quarter of 1996, the average historical amortized cost of the mortgages on the Company's books moved above par. As a result, the average coupon yield (coupon income divided by the adjusted average mortgage acquisition price) in the third quarter of 1996 of 7.44% was lower than the average coupon rate of 7.52%. In the third quarter of 1995, the coupon rate was 7.29%, or 0.77% lower than the estimated average fully-indexed rate during the quarter. 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 acquisitions were made at a discount price, the yield on the mortgages was higher than the low coupon would suggest due to the Company's low basis in the assets and the boost to income from discount amortization. The table below presents the Company's average coupon rates and coupon yields on its mortgage assets as compared to the fully-indexed rates and a benchmark of the six month average of the six-month LIBOR rate. 24 TABLE 5 COUPON INCOME ON MORTGAGE ASSETS
AVERAGE 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 Nine Months $ 8,457 $ 163,880 6.88% 6.28% 0.60% 8.32% (1.44%) 98.84% 6.96% 1996, 1st Nine Months 43,724 773,571 7.54% 5.59% 1.95% 7.82% (0.28%) 100.21% 7.52% Fiscal 1994 $ 1,102 $ 50,070 6.09% 5.07% 1.02% 8.68% (2.59%) 100.02% 6.09% 1995, Quarter 1 1,940 122,835 6.32% 6.25% 0.07% 8.75% (2.44%) 99.47% 6.35% 1995, Quarter 2 2,738 160,537 6.82% 6.48% 0.34% 8.33% (1.51%) 98.53% 6.92% 1995, Quarter 3 3,779 207,338 7.29% 6.10% 1.19% 8.06% (0.77%) 98.71% 7.39% 1995, Quarter 4 6,682 352,251 7.59% 5.82% 1.77% 7.74% (0.16%) 99.27% 7.64% 1996, Quarter 1 9,445 488,762 7.73% 5.62% 2.11% 7.43% 0.30% 98.85% 7.82% 1996, Quarter 2 13,722 734,347 7.47% 5.49% 1.98% 7.82% (0.35%) 99.95% 7.48% 1996, Quarter 3 20,557 1,094,081 7.52% 5.65% 1.87% 7.99% (0.47%) 100.98% 7.44%
AMORTIZATION OF PREMIUM AND DISCOUNT AND EFFECTS OF CHANGES IN MORTGAGE PRINCIPAL REPAYMENT RATES The average annualized principal repayment rate of the Company's mortgage assets in the third quarter was 28%. The comparable rate was 16% for the third quarter of 1995. Annualized mortgage principal repayments averaged 28% for the first nine months of 1996 and 11% for the first nine months of 1995. The primary direct earnings impact of changes in the rate of mortgage principal repayment is the effect on the rate at which the Company amortizes (as an expense) premium balances paid on the acquisition of mortgage assets. The Company writes off premium at a rate equal to the actual monthly mortgage principal repayment rate of the associated mortgage assets. Due to the increase in mortgage principal repayment speeds, the average annualized rate of premium amortization was 25% of the premium balance in the third quarter of 1996 versus 15% in the same quarter a year earlier. The amortization of discount into income serves to partially offset the effects of premium amortization. The rate at which the Company amortizes discount balances into income, however, is far less sensitive to short-term changes in the rate of mortgage principal repayment. The Company recognizes two types of discount. 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. In early 1995, most of the Company's discount balances were of this type. Accordingly, 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 discount mortgage assets that have a material amount of credit risk, 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 which does not fluctuate significantly with short-term changes in the actual rate of mortgage principal repayment even though more rapid principal repayments may benefit the long-term economics of owning these discount mortgages. As shown in the table below, despite rapid principal repayment rates, the annualized discount amortization rate was 7% of the discount balance in third quarter and was 6% for the first nine months of 1996. 25 As a result of the Company's methods of amortizing premium and discount, faster mortgage principal repayment speeds have led to lower earnings in 1996 than would otherwise have been reported. In calculating its interest income for the third quarter of 1996, the Company added $0.27 million in discount amortization to its coupon income and then deducted $1.71 million in premium amortization. As shown in Table 7, the net effect in the third quarter of premium and discount amortization was a reduction in net mortgage yield of 0.49%. In the third quarter of 1995, the net effect of amortization was to add 0.30% to the net mortgage yield. For the first nine months of 1996, the reduction in net mortgage yield due to amortization was 0.47%; for the same period in 1995, amortization added 0.48% to the net mortgage yield. The Company's earnings sensitivity to changes in the mortgage principal repayment rate has been increasing as the Company continues to acquire mortgage assets at premium prices. Management believes that the sensitivity of earnings to a one percentage point change in the mortgage principal repayment rate, all other factors being equal, was approximately $0.01 per share per quarter as of September 30, 1996. TABLE 6 AMORTIZATION ON MORTGAGE ASSETS
NET NET NET ANNUAL ANNUAL AVERAGE NET MORTGAGE MORTGAGE AVERAGE RATE OF AVERAGE RATE OF PREMIUM/ AMORT PRINCIPAL PRINCIPAL DISCOUNT DISCOUNT DISCOUNT PREMIUM PREMIUM PREMIUM (DISC) INCOME/ REPAYMTS REPAYMT BALANCE AMORT AMORT BALANCE AMORT AMORT BALANCE (EXPENSE) RECEIVED RATE ------- ----- ----- ------- ----- ----- ------- --------- -------- ---- (DOLLARS IN THOUSANDS) 1995, 1st Nine Months $ 3,678 $751 27% $ 1,779 $ 176 13% $ (1,899) $ 575 $ 13,927 11% 1996, 1st Nine Months 16,716 693 6% 18,344 3,682 27% 1,628 (2,989) 162,814 28% Fiscal 1994 $440 $101 63% $ 450 $ 19 12% $ 10 $ 82 $ 1,244 7% 1995, Quarter 1 1,440 234 65% 785 19 10% (655) 215 2,673 9% 1995, Quarter 2 3,528 237 27% 1,175 34 12% (2,353) 203 2,934 7% 1995, Quarter 3 6,017 280 19% 3,351 123 15% (2,666) 157 8,319 16% 1995, Quarter 4 10,889 210 8% 8,314 429 21% (2,575) (219) 24,898 28% 1996, Quarter 1 16,941 177 4% 11,299 707 25% (5,642) (530) 32,814 27% 1996, Quarter 2 16,739 245 6% 16,402 1,268 31% (337) (1,023) 53,058 29% 1996, Quarter 3 16,471 271 7% 27,233 1,706 25% 10,762 (1,435) 76,942 28%
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 the coupon yield and the 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 third quarter of 1996 was 6.92%, or 1.27% over the six month average of six-month LIBOR. The margin between the earning asset yield and the level of short-term interest rates narrowed in this quarter, for the most part due to the Company's rapid growth. The earning asset yield was 7.64%, or 1.54% over the six month average of six-month LIBOR, in the third quarter of 1995. For the first nine months of 1996, the earning asset yield was 7.02% (1.43% over average LIBOR) and in the first nine months of 1995 the earning asset yield was 7.41% (1.13% over average LIBOR). 26 TABLE 7 EARNING ASSET YIELD
EFFECT OF YIELD VS. NET SIX-MONTH SIX-MONTH DISCOUNT/ NET EARNING AVERAGE OF AVERAGE OF COUPON (PREMIUM) MORTGAGE CASH ASSET SIX-MONTH SIX-MONTH YIELD AMORTIZATION YIELD YIELD YIELD LIBOR LIBOR ----- ------------ ----- ----- ----- ----- ----- 1995, 1st Nine Months 6.96% 0.48% 7.44% 5.41% 7.41% 6.28% 1.13% 1996, 1st Nine Months 7.52% (0.47%) 7.05% 5.58% 7.02% 5.59% 1.43% Fiscal 1994 6.09% 0.53% 6.62% 4.73% 6.40% 5.07% 1.33% 1995, Quarter 1 6.35% 0.77% 7.12% 4.96% 7.09% 6.25% 0.84% 1995, Quarter 2 6.92% 0.49% 7.42% 5.57% 7.40% 6.48% 0.92% 1995, Quarter 3 7.39% 0.30% 7.68% 5.53% 7.64% 6.10% 1.54% 1995, Quarter 4 7.64% (0.24%) 7.40% 5.48% 7.34% 5.82% 1.52% 1996, Quarter 1 7.82% (0.37%) 7.45% 5.93% 7.40% 5.62% 1.78% 1996, Quarter 2 7.48% (0.51%) 6.97% 5.61% 6.94% 5.49% 1.45% 1996, Quarter 3 7.44% (0.49%) 6.95% 5.30% 6.92% 5.65% 1.27%
COST OF BORROWED FUNDS AND HEDGING AND THE INTEREST RATE SPREAD From the second to the third quarter of 1996, the cost of borrowed funds increased from 5.57% to 5.78%. This increase was due primarily to an increase in short-term interest rates (as shown in Table 8 by an increase in the six month average of six-month LIBOR) and to an increase in the percentage of the balance sheet consisting of whole loans (which, on average, are more costly to fund than securitized mortgage assets). The cost of hedging declined slightly, from 0.16% of average borrowed funds in the second quarter to 0.14% in the third quarter. The all-in cost of funds and hedging was 5.92% for the third quarter of 1996. The all-in cost of funds and hedging in the third quarter of 1995 was 6.37%. In the third quarter of both of these years, the all-in cost of funds and hedging was 0.27% over the average LIBOR rate. For the first nine months of 1995 and 1996, the all-in cost of funds and hedging was 6.31% and 5.83%, respectively. The all-in cost of funds for these periods was 0.03% and 0.24% over the six month average of six-month 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 swap and collar agreements. 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 a collar agreement, the Company generally does not make an initial payment, will incur a hedge expense if the index falls below the floor strike rate and will have hedge income if the index exceeds the cap strike rate. The Company has also entered into a periodic cap designed to serve as a hedge against short-term interest rates rising faster than 0.50% per quarter. 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 will increase hedging expense for the Company should that spread narrow. See "Note 3. Interest Rate Agreements" to the Notes to Financial Statements for further details. Hedging costs in the third quarter of 1996 and the first nine months of 1996 were lower relative to the size of the balance sheet than in the same time periods 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 and third quarters of 1996 in conjunction with the extension of the maturities of its borrowings. 27 The interest rate spread is the difference between the earning asset yield and the all-in 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 third quarter of 1996 was 1.00%. This was lower than the 1.21% earned in the second quarter of 1996 and the 1.27% earned in the third quarter of 1995. As discussed above, the compression of the spread in the third quarter is primarily a product of the Company's rapid growth in the second and third quarters. The interest rate spread in the first nine months of 1996 of 1.19% was slightly wider than the spread in the first nine months of 1995 of 1.10%. Relative to 1995, increased asset yields (relative to short-term interest rates) and lower hedging costs in 1996 offset a higher cost of funds (relative to short-term interest rates). TABLE 8 COST OF BORROWED FUNDS AND HEDGING
COST OF COST OF FUNDS AND FUNDS VS. COST HEDGING VS. SIX MONTH SIX-MONTH OF SIX-MONTH AVERAGE OF AVERAGE OF FUNDS AVERAGE OF EARNING INTEREST COST OF SIX-MONTH SIX-MONTH COST OF AND SIX-MONTH ASSET RATE FUNDS LIBOR LIBOR HEDGING HEDGING LIBOR YIELD SPREAD ----- ----- ----- ------- ------- ----- ----- ------ 1995, 1st Nine Months 6.10% 6.28% (0.17%) 0.21% 6.31% 0.03% 7.41% 1.10% 1996, 1st Nine Months 5.69% 5.59% 0.10% 0.14% 5.83% 0.24% 7.02% 1.19% Fiscal 1994 5.55% 5.07% 0.48% 0.06% 5.61% 0.54% 6.40% 0.79% 1995, Quarter 1 5.96% 6.25% (0.29%) 0.06% 6.02% (0.23%) 7.09% 1.07% 1995, Quarter 2 6.26% 6.48% (0.22%) 0.23% 6.49% 0.01% 7.40% 0.91% 1995, Quarter 3 6.09% 6.10% (0.01%) 0.28% 6.37% 0.27% 7.64% 1.27% 1995, Quarter 4 6.04% 5.82% 0.22% 0.18% 6.22% 0.40% 7.34% 1.12% 1996, Quarter 1 5.69% 5.62% 0.07% 0.14% 5.83% 0.21% 7.40% 1.57% 1996, Quarter 2 5.57% 5.49% 0.08% 0.16% 5.73% 0.24% 6.94% 1.21% 1996, Quarter 3 5.78% 5.65% 0.13% 0.14% 5.92% 0.27% 6.92% 1.00%
CREDIT PROVISIONS Credit provisions for the third quarter of 1996 were $0.52 million, or 0.18% of average assets and 1.43% of average equity during the quarter. In the third quarter of 1995, credit provisions were $0.08 million, or 0.16% of average assets and 0.65% of average equity. Credit provisions were lower in the third quarter of 1995 as the Company had not yet acquired its whole loans or many 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 similar reasons, the credit provisions for the first nine months of 1996 of $1.32 million (equaling 0.22% of average assets and 1.63% of average equity) were higher than the credit provisions for the same time period in 1995 of $0.14 million (which equaled 0.11% of average assets and 0.59% of average 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 assets. Such credit provisions were taken at a rate of approximately $113,000 per month during the third 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 plus the amount of any interest accrued on non-performing assets. In the third quarter, this portion of the provision totaled $178,000. The rate at which the Company takes credit provisions may be adjusted in the future based on the Company's review of credit reserve adequacy. 28 The table below summarizes the Company's credit provisions and actual credit losses. Please also see "Financial Condition -- Credit Reserves" below. TABLE 9 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 Nine months $ 0 $ 143 $ 143 $ 0 $ 0 $ 0 0.11% 0.59% 1996, 1st Nine months 313 1,011 1,324 0 0 0 0.22% 1.63% 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% 0.65% 1995, Quarter 4 79 271 350 0 4 4 0.38% 1.95% 1996, Quarter 1 (5) 336 331 0 0 0 0.26% 1.93% 1996, Quarter 2 140 337 477 0 0 0 0.25% 1.69% 1996, Quarter 3 178 338 516 0 0 0 0.18% 1.43%
OPERATING EXPENSES Operating expenses were $0.67 million in the third quarter of 1996. This was an increase from the $0.36 million of operating expenses incurred in the same quarter in 1995. Nevertheless, the Company was significantly more productive in the third quarter of 1996 as compared to the third quarter of 1995, as measured by the efficiency ratio (operating expenses to net interest income) dropping from 25% to 15%, the operating-expenses-to-average-assets ratio dropping from 0.68% to 0.23% and the operating-expenses-to-average-equity ratio dropping from 2.81% to 1.87%. Average assets per employee increased from $39 million to $115 million. For the first nine months of 1995 to the first nine months of 1996, operating expenses increased from $0.76 million to $1.76 million. Nevertheless, measures of operating expense productivity improved over that time period as well. The table below presents the Company's operating expenses and selected ratios measuring the Company's operating efficiency. 29 TABLE 10 OPERATING EXPENSES
NON-CASH OPERATING AVERAGE CASH STOCK OTHER OTHER EXPENSE/ OPERATING OPERATING ASSETS PER COMP AND OPTION NON-CASH CASH TOTAL NET EXPENSE/ EXPENSE/ AVE. # OF BENEFITS AND DER OPERATING OPERATING OPERATING INTEREST AVERAGE AVERAGE EMPLOYEES EXPENSE EXPENSE EXPENSE EXPENSE EXPENSE INCOME ASSETS EQUITY ($MM) ------- ------- ------- ------- ------- ------ ------ ------ ----- (DOLLARS IN THOUSANDS) 1995, 1st Nine Months $359 $ 7 $ 43 $354 $ 763 28% 0.61% 3.16% $ 33 1996, 1st Nine Months 848 245 17 648 1,758 16% 0.29% 2.16% 92 Fiscal 1994 $ 63 $ 0 $ 42 $ 41 $ 146 28% 0.70% 2.07% $ 12 1995, Quarter 1 81 0 37 83 201 32% 0.64% 3.69% 25 1995, Quarter 2 81 0 (20) 137 198 29% 0.48% 3.51% 33 1995, Quarter 3 197 7 26 134 364 25% 0.68% 2.81% 39 1995, Quarter 4 103 48 96 120 368 18% 0.40% 2.04% 53 1996, Quarter 1 233 85 (3) 177 492 18% 0.39% 2.86% 69 1996, Quarter 2 305 79 (5) 214 594 17% 0.31% 2.11% 84 1996, Quarter 3 310 81 25 256 672 15% 0.23% 1.87% 115
COMPONENTS OF RETURN ON AVERAGE EQUITY Table 11 below shows elements of the Company's income statement expressed as a percentage of average equity. TABLE 11 COMPONENTS OF RETURN ON AVERAGE EQUITY (EQUITY-BASED METHOD)
EQUITY- NET RETURN ON SPREAD FUNDED INTEREST AVERAGE LENDING LENDING INCOME CREDIT OPERATING COMMON RETURN ON INTEREST DEBT/ RETURN ON RETURN ON RETURN ON PROVISIONS/ EXPENSE/ AND AVERAGE RATE EQUITY AVERAGE AVERAGE AVERAGE AVERAGE AVERAGE PREFERRED COMMON SPREAD RATIO EQUITY EQUITY EQUITY EQUITY EQUITY EQUITY EQUITY ------ ----- ------ ------ ------ ------ ------ ------ ------ 1995, 1st Nine months 1.10% 4.18x 4.56% 6.83% 11.39% 0.59% 3.16% 7.64% 7.64% 1996, 1st Nine months 1.19% 6.42x 7.59% 5.83% 13.42% 1.63% 2.16% 9.63% 9.60% Fiscal 1994 0.79% 1.94x 1.82% 5.65% 7.47% 0.00% 2.07% 5.40% 5.40% 1995, Quarter 1 1.07% 4.72x 5.07% 6.32% 11.39% 0.34% 3.69% 7.36% 7.36% 1995, Quarter 2 0.91% 6.20x 5.61% 6.59% 12.20% 0.72% 3.51% 7.97% 7.97% 1995, Quarter 3 1.27% 3.08x 3.92% 7.20% 11.12% 0.65% 2.81% 7.66% 7.66% 1995, Quarter 4 1.12% 4.10x 4.61% 6.66% 11.27% 1.95% 2.04% 7.28% 7.28% 1996, Quarter 1 1.57% 6.34x 9.99% 6.17% 16.16% 1.93% 2.86% 11.37% 11.37% 1996, Quarter 2 1.21% 5.78x 7.02% 5.66% 12.68% 1.69% 2.11% 8.88% 8.88% 1996, Quarter 3 1.00% 6.94x 6.94% 5.77% 12.71% 1.43% 1.87% 9.41% 9.32%
Net interest income as a percentage of equity of 12.71% in the third quarter of 1996 was similar to the 12.68% earned in the second quarter of 1996. The Company earned a narrower spread but maintained its net interest income earnings rate through better capital utilization. The overall return on equity (ROE) rose as a result of decreased credit provisions and operating expenses as a percentage of equity. As compared to the third quarter of 1995, ROE in the third quarter of 1996 was higher due to greater net interest income earnings as a percentage of equity and a significantly improved operating expense ratio. For similar reasons, the ROE for the first nine months of 1996 exceeded that earned in the same period the year before. 30 The table below shows the components of the Company's income statement expressed as a percentage of average assets. TABLE 12 COMPONENTS OF RETURN ON AVERAGE EQUITY (ASSET-BASED METHOD)
COST OF AVERAGE FUNDS ASSETS TO RETURN ON AND AVERAGE AVERAGE INTEREST HEDGING CREDIT OPERATING RETURN COMMON COMMON RETURN ON INCOME/ EXPENSE/ NET PROVISION/ EXPENSE/ ON AND AND AVERAGE AVERAGE AVERAGE INTEREST AVERAGE AVERAGE AVERAGE PREFERRED PREFERRED COMMON ASSETS ASSETS MARGIN ASSETS ASSETS ASSETS EQUITY EQUITY EQUITY ------ ------ ------ ------ ------ ------ ------ ------ ------ 1995, 1st Nine Months 7.23% 5.05% 2.18% 0.11% 0.61% 1.46% 5.22x 7.64% 7.64% 1996, 1st Nine Months 6.82% 5.02% 1.80% 0.22% 0.29% 1.29% 7.46x 9.63% 9.60% Fiscal 1994 6.20% 3.68% 2.53% 0.00% 0.70% 1.83% 2.95x 5.40% 5.40% 1995, Quarter 1 6.91% 4.93% 1.98% 0.06% 0.64% 1.28% 5.76x 7.36% 7.36% 1995, Quarter 2 7.24% 5.55% 1.69% 0.10% 0.48% 1.10% 7.25x 7.97% 7.97% 1995, Quarter 3 7.44% 4.75% 2.69% 0.16% 0.68% 1.86% 4.13x 7.66% 7.66% 1995, Quarter 4 7.11% 4.93% 2.18% 0.38% 0.40% 1.41% 5.16x 7.28% 7.28% 1996, Quarter 1 7.20% 5.01% 2.19% 0.26% 0.39% 1.54% 7.38x 11.37% 11.37% 1996, Quarter 2 6.73% 4.87% 1.86% 0.25% 0.31% 1.30% 6.81x 8.88% 8.88% 1996, Quarter 3 6.73% 5.14% 1.59% 0.18% 0.23% 1.18% 8.00x 9.41% 9.32%
As compared to the second quarter of 1996, the net interest margin and the return on average assets in the third quarter of 1996 narrowed due to the compression of the interest rate spread (as discussed above) and the greater utilization of leverage. Partially offsetting the effects of spread compression were improved credit provision and operating expense ratios. With the greater utilization of the Company's capital, ROE increased despite a lower return on assets (ROA). Similarly, the ROA was lower and the ROE was higher in the third quarter and first nine months of 1996 as compared to the same periods in 1995. 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. 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 estimated 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. 31 END OF PERIOD BALANCE SHEET The table below shows the components of the Company's balance sheet over time. TABLE 13 END OF PERIOD BALANCE SHEET
RECEIVABLES COMMON INTEREST AND AND MORTGAGE RATE OTHER TOTAL PREFERRED PREFERRED COMMON END OF PERIOD CASH ASSETS AGREEMENTS ASSETS ASSETS BORROWINGS PAYABLES EQUITY EQUITY EQUITY - ------------- ---- ------ ---------- ------ ------ ---------- -------- ------ ------ ------ (DOLLARS IN THOUSANDS) Fiscal 1994 $ 1,027 $ 117,477 $1,892 $ 1,132 $ 121,528 $ 100,376 $ 871 $ 20,281 $ 0 $ 20,281 1995, Quarter 1 953 141,860 1,434 1,193 145,440 121,998 1,090 22,352 0 22,352 1995, Quarter 2 1,620 175,242 825 1,634 179,321 155,881 907 22,533 0 22,533 1995, Quarter 3 1,150 298,785 809 2,650 303,394 228,826 2,095 72,473 0 72,473 1995, Quarter 4 4,825 432,244 547 3,941 441,557 370,316 2,951 68,290 0 68,290 1996, Quarter 1 9,705 565,159 1,233 5,216 581,313 508,721 4,447 68,145 0 68,145 1996, Quarter 2 10,407 1,007,480 1,351 9,092 1,028,330 896,214 7,821 124,295 0 124,295 1996, Quarter 3 14,599 1,375,870 873 12,136 1,403,478 1,225,094 14,867 163,517 29,712 133,805
AVERAGE DAILY BALANCE SHEET The table below shows the estimated average daily balances over time of the components of the Company's balance sheet. TABLE 14 AVERAGE DAILY BALANCE SHEET
RECEIVABLES COMMON INTEREST AND AND MORTGAGE RATE OTHER TOTAL PREFERRED PREFERRED COMMON END OF PERIOD CASH ASSETS AGREEMENTS ASSETS ASSETS BORROWINGS PAYABLES EQUITY EQUITY EQUITY - ------------- ---- ------ ---------- ------ ------ ---------- -------- ------ ------ ------ (DOLLARS IN THOUSANDS) 1995, 1st Nine Months $ 2,102 $ 161,881 $1,082 $ 3,123 $ 168,188 $134,431 $ 1,564 $ 32,193 $ 0 $ 32,193 1996, 1st Nine Months 15,975 770,830 1,388 21,628 809,821 696,725 4,523 108,572 5,097 103,475 Fiscal 1994 $ 6,627 $ 49,498 $ 790 $ 948 $ 57,862 $ 37,910 $ 368 $ 19,584 $ 0 $ 19,584 1995, Quarter 1 1,217 121,116 1,399 1,958 125,691 102,894 977 21,820 0 21,820 1995, Quarter 2 1,466 158,606 1,020 2,559 163,651 139,979 1,111 22,561 0 22,561 1995, Quarter 3 3,597 204,999 831 4,819 214,247 159,794 2,585 51,868 0 51,868 1995, Quarter 4 10,709 349,296 730 10,999 371,734 295,089 4,653 71,991 0 71,991 1996, Quarter 1 14,639 478,645 667 13,095 507,046 435,979 2,324 68,743 0 68,743 1996, Quarter 2 14,402 729,143 1,658 21,566 766,768 651,643 2,472 112,653 0 112,653 1996, Quarter 3 18,854 1,101,074 1,833 30,129 1,151,890 999,229 8,728 143,933 15,179 128,754
MORTGAGE ASSET ACQUISITIONS The two principal criteria the Company uses when acquiring mortgage assets are: (i) the mortgages must be "A" quality in terms of underwriting and documentation standards, or must be credit-enhanced to the AAA or AA credit-rating level, and (ii) the risk-adjusted returns on equity the Company anticipates earning on such assets must be attractive across a variety of economic scenarios relative to the Company's cost of capital and relative to other available mortgage assets. During the third quarter of 1996, the Company acquired mortgage assets of $444 million, thereby increasing the Company's net total mortgage balance by 37%. Whole mortgage loans represented 14% of the acquisitions in the third quarter of 1996. FHLMC- and FNMA-guaranteed mortgages represented 70% and private-label 32 mortgage securities represented 16% of the quarter's acquisitions. The average price paid for mortgage assets acquired during the quarter was 102.74% of principal value. The pricing in excess of face value for these assets as compared to past acquisitions reflects, on average, the higher credit ratings, higher initial coupons and higher net margins of these recently acquired assets. The average initial coupon of the acquired mortgages was 7.53%, which was 0.49% lower than the fully-indexed coupon rate toward which these coupons will adjust over time based on the index levels at the time of acquisition. The table below summarizes the characteristics of the Company's mortgage asset acquisitions. TABLE 15 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 Nine Months $ 192,111 100.05% 7.14% 0.0% 54.7% 30.8% 5.9% 8.6% 1996, 1st Nine Months 1,106,896 102.55% 7.44% 10.2% 67.3% 22.5% 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% 1996, Quarter 3 443,860 102.74% 7.53% 14.4% 69.9% 15.7% 0.0% 0.0%
SUMMARY OF MORTGAGE ASSET CHARACTERISTICS As of September 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 (before credit provision write-downs) was 101.20% of principal value. The estimated bid-side market value of these assets (which the Company uses as the carrying value of mortgages on its balance sheet) was 101.09% of principal value. The average credit rating equivalent at September 30, 1996 was AA+. For all the mortgage assets owned by the Company, 45% of the underlying properties were located in California. Excluding the FHLMC- and FNMA-guaranteed mortgages, 69% of the properties underlying the Company's mortgage assets were located in California. The table below summarizes the Company's mortgage asset balances. 33 TABLE 16 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) 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% 1996, Quarter 3 1,361,062 1,377,331 101.20% 1,375,870 101.09% AA+ 45% 69%
The following table shows the average characteristics of the Company's mortgage assets at the end of each reporting period. The index level is the weighted average rate of the various short-term interest rate indices which determine coupon adjustments. Unless limited by periodic or lifetime caps, the mortgage coupons adjust at the end of each adjustment period to the level of the index plus the net margin. The fully-indexed rate is the current index plus the net margin: this is the maximum level to which the coupon could adjust over time should interest rates remain unchanged. The rate of adjustment of the current coupon to the fully-indexed rate is determined by the length of the adjustment periods and the periodic caps of the mortgage loans. TABLE 17 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 ADJUSTMENT CAP YIELD - ------------- ---- ----- ------ ---- ---- ---------- --- ----- 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% 1996, Quarter 3 7.55% 5.70% 2.21% 7.91% (0.36%) 4 11.69% 6.99%
As of the end of the third quarter of 1996, 50% 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), 49% adjusted as a function of short-term U.S. Treasury interest rates and 1% adjusted off other indices. The coupon adjustment cycle is every six months for 51% of total mortgages, every twelve months for 46% of total mortgages and monthly for 2% of total mortgages. Approximately 1% of mortgages have other re-pricing terms. The periodic caps for 97% of the mortgage assets were either 1% per six months or 2% per year; 2% of the mortgages had no periodic caps and 1% had other cap structures. The table below segments the Company's mortgage assets by adjustment index, coupon adjustment frequency and periodic cap adjustment 34 TABLE 18 MORTGAGE ASSETS BY INDEX
SIX- SIX- ONE- MONTH ONE- SIX- MONTH MONTH BANK YEAR MONTH LIBOR LIBOR CD TREASURY TREASURY INDEX INDEX INDEX INDEX INDEX OTHER ----- ----- ----- ----- ----- ----- Adjustment Frequency/Loan 6 months 1 month 6 months 12 months 6 months various Average Adjustment/Pool 3 months 1 month 3 months 6 months 3 months various Annualized Periodic Cap 2% none 2% 2% 2% various
% OF TOTAL MORTGAGE ASSETS AT PERIOD END ---------------------------------------- Fiscal 1994 78.2% 3.9% 17.9% 0.0% 0.0% 0.0% 1995, Quarter 1 78.7% 3.1% 17.3% 0.9% 0.0% 0.0% 1995, Quarter 2 83.0% 2.5% 13.8% 0.7% 0.0% 0.0% 1995, Quarter 3 66.8% 1.4% 11.6% 11.5% 7.6% 1.1% 1995, Quarter 4 59.7% 7.7% 12.8% 12.5% 5.0% 2.3% 1996, Quarter 1 63.1% 6.5% 8.9% 14.9% 3.6% 3.0% 1996, Quarter 2 54.1% 3.2% 3.4% 33.3% 4.4% 1.6% 1996, Quarter 3 45.5% 2.2% 2.4% 45.7% 3.0% 1.2%
At the end of the third quarter of 1996, whole mortgage loans were $127.7 million, or 9.3% 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 $1.2 billion, or 88.8% of the Company's total mortgage assets and securitized mortgage loans with a credit rating equivalent of below BBB represented 1.9% of the total as of September 30, 1996. Unrated securitized assets have been assigned a credit rating equivalent by management. The table below shows the balance of the Company's whole mortgage loans and the Company's securitized mortgage assets segregated by credit rating. TABLE 19 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) 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% 1996, Quarter 3 127,695 1,196,887 25,748 25,540 9.3% 86.9% 1.9% 1.9%
WHOLE MORTGAGE LOANS As of September 30, 1996, the Company owned 478 whole loans with a total loan balance of $126.4 million. All of these loans were adjustable-rate, single-family loans underwritten to "A" quality standards. The average loan size was $264,490. California loans represent 85% of the total outstanding balance. Loans with original loan-to- 35 value ratios in excess of 80% represent 32% of the total outstanding balance; each of these loans is credit-enhanced with primary mortgage insurance which served to bring the effective original 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%. In addition, for $11.7 million of these loans the Company has recourse to an "A"-rated third party for any losses which may occur prior to August 2001. The table below presents selected characteristics of the Company's whole loan mortgage assets. TABLE 20 WHOLE MORTGAGE LOAN SUMMARY
AT SEPTEMBER 30, 1996 AT DECEMBER 31,1995 --------------------- ------------------- (ALL RATIOS BASED ON % OF TOTAL LOAN PORTFOLIO BALANCES (ALL DOLLARS IN THOUSANDS) UNLESS NOTED) Face Value $126,426 $26,411 Amortized Cost 127,809 26,449 Adjustable-Rate 100% 100% Single-Family 100% 100% "A" Quality Underwriting 100% 100% First Lien 100% 100% Primary Residence 99% 100% Property Located in Northern California 34% 30% Property Located in Southern California 51% 44% Top Ten States as of 9/30/96 California 84.8% 74.5% Minnesota 2.5% 0.0% Colorado 1.5% 3.2% Oregon 1.3% 2.3% Ohio 1.3% 0.7% Michigan 1.3% 0.0% Utah 1.1% 0.5% Washington 1.0% 3.8% Texas 1.0% 3.9% Connecticut 0.6% 1.3% Number of Loans 478 109 Average Loan Size $ 264 $ 242 Loan Balance in Excess of $500,000 12% 23% Average Original Loan to Value Ratio (LTV) 78% 76% Original LTV greater than 80% 32% 26% Percent of Original LTV greater than 80% with Mortgage Insurance 100% 100% Effective Original LTV including Primary Mortgage 73% 72% Insurance 1993 Origination 7% 0% 1994 Origination 43% 2% 1995 Origination 32% 98% 1996 Origination 18% 0% Non-Performing Assets (90+ days delinquent) $ 404 $ 0 Number of Non-Performing Loans (90+ days delinquent) 3 0 Non-Performing Assets as % of Total Loan Balances 0.3% 0.0%
The Company defines non-performing assets ("NPAs") as whole loans which are delinquent more than 90 days. As of September 30, 1996, the Company's NPAs were $403,606, reflecting three loans in foreclosure. At December 31, 1995 the Company had no non-performing assets. The Company has experienced no actual whole loan credit losses through September 30, 1996. SECURITIZED MORTGAGES RATED AAA TO BBB At September 30, 1996, 89% 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 36 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 these mortgage assets is low. In the event, however, that credit losses in these pools exhaust the credit-enhancement or in the event of default of FNMA, FHLMC or another third party guarantor, credit losses to the Company could result. To date, 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 average equity, net of expected credit losses, over the life of the asset will be attractive. Such assets had an estimated bid-side market value at September 30, 1996 of $25.5 million, or 1.9% of the Company's total mortgage assets. At December 31, 1995, the estimated market value 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. Another potential benefit is the eventual return of principal (net of credit losses) which was purchased at a discount, 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. Delinquency levels in these pools appeared to have stabilized in the second and third quarters of 1996. Actual pool credit losses which serve to reduce the credit-enhancement protection to the Company's below BBB-rated interests have occurred as of September 30, 1996, but a substantial majority of the aggregate original credit enhancement in these pools is still intact. The Company has experienced no credit losses from these assets. At September 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 10-20% of the principal value of any mortgage credit losses in the pools. Total credit losses realized by the Company on "first loss" assets have been $3,997 through September 30, 1996. 37 CREDIT RESERVES Through its quarterly credit provisions, the Company is building a credit reserve for future credit losses. The first step the Company takes in its on-going review of the adequacy of its credit reserve is to assess potential credit risk arising from seriously delinquent (90+ days) whole loans and seriously delinquent loans in the mortgage pools underlying the Company's securitized mortgage assets. Future credit losses from these loans will depend on the number of these loans actually defaulting, the loss severity experienced on default of the loan, the level of credit-enhancement at the pool level, and the Company's amortized cost basis in that asset. The table below shows the credit losses that could be incurred by the Company if all the seriously delinquent mortgage loans in which the Company owned an interest at September 30, 1996 were to default and result in a loss. For example, if all these loans were to default and the loss severity experienced was 25% of the loan balance, credit losses to the Company would be $703,000 (39% of the current credit reserve.) The amount of actual credit losses that will be incurred from these loans is unknown; management expects that some losses will be realized in the near future. This table addresses the potential credit risk arising from current serious delinquencies only; it does not purport to reflect potential losses that may occur over the life of these assets. 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) Fiscal 1994 $ 0 0% $ 0 $ 0 $ 0 $ 0 $ 0 $ 0 1995, Quarter 1 19 0% 0 0 0 0 0 0 1995, Quarter 2 59 0% 0 0 0 0 0 0 1995, Quarter 3 143 0% 0 0 0 0 0 0 1995, Quarter 4 490 9% 15 22 29 37 103 435 1996, Quarter 1 821 10% 39 58 78 227 655 1,280 1996, Quarter 2 1,298 16% 68 102 147 715 1,449 2,215 1996, Quarter 3 1,814 22% 102 154 205 703 1,254 2,196
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. INTEREST RATE AGREEMENTS The Company's interest rate agreements are 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 $3.3 million at September 30, 1996 and $2.5 million at December 31, 1995. The Company has experienced no credit losses on interest rate agreements. See "Note 3: Interest Rate Agreements" in the Notes to Financial Statements for additional information. BORROWINGS Through the end of the third quarter of 1996, the Company's debt has consisted entirely of borrowings collateralized by a pledge of the Company's mortgage assets. 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 38 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 believes that total borrowing capacity has been 94% to 97% of the market value of its mortgage assets. The Company, however, has limited its borrowings, and thus its potential asset growth, in order to maintain unused borrowing capacity and thus increase the liquidity and strength of its balance sheet. The term-to-maturity of the Company's borrowings have ranged from one day to one year. For some borrowings, the cost of funds adjusts to 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 was 102 days and the weighted average term-to-next-rate-adjustment was 71 days at September 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 beginning in the second quarter of 1996 and correspondingly reduced its level of short-term interest rate hedging. 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) 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% 1996, Quarter 3 1,375,870 96.1% 1,322,091 1,225,094 102 days 71 days 5.78%
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 is defined as estimated borrowing capacity (as shown in Table 22) less total borrowings and is based on the market value of the Company's assets at period-end. 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 September 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 39 (although such sales could cause realized losses). The table below shows the potential immediate sources of liquidity available to the Company. 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) 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% 1996, Quarter 3 14,599 96,997 111,596 9%
STOCKHOLDERS' EQUITY During the first nine months of 1996 the Company's equity base grew $95.2 million, from $68.3 million to $163.5 million. This growth was the result of the Company's April 1996 common stock offering ($54.5 million), the August 1996 preferred stock offering ($29.6 million), proceeds from the issuance of common stock upon the exercise of warrants ($8.8 million), positive mark-to-market adjustments on the Company's assets ($3.4 million), common stock sold pursuant to the Company's Dividend Reinvestment Plan ($1.0 million) and a negative adjustment (- $2.1 million) because dividends have exceeded GAAP income. Dividends generally track income as calculated for tax purposes. Over this nine month period, book value per share grew from $12.38 to $16.23, an increase of 31%. Management believes that book value per share growth helps the Company in its efforts to generate future earnings per share growth; as book value per share increases, 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 $2.1 million, or 0.1% of assets, as of September 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. 40 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) Fiscal 1994 $(2,657) $ 101 $(2,556) (2.1%) $ 22,837 $ 20,280 $12.18 $10.82 1995, Quarter 1 86 (635) (549) (0.4%) 22,901 22,352 12.22 11.93 1995, Quarter 2 886 (1,200) (314) (0.2%) 22,847 22,533 12.19 12.02 1995, Quarter 3 34 (1,585) (1,551) (0.5%) 74,024 72,473 13.42 13.14 1995, Quarter 4 (3,502) (1,974) (5,476) (1.2%) 73,766 68,290 13.37 12.38 1996, Quarter 1 (3,763) (1,302) (5,065) (0.9%) 73,211 68,146 13.26 12.34 1996, Quarter 2 (3,068) (1,485) (4,553) (0.4%) 128,847 124,295 15.12 14.59 1996, Quarter 3 353 (2,413) (2,060) (0.1%) 165,578 163,517 16.43 16.23
CAPITAL ADEQUACY/RISK-ADJUSTED CAPITAL POLICY Stockholders' equity as a percent of total assets was 11.7% at September 30, 1996 and 15.5% at December 31, 1995. The Company's target equity-to-assets ratio at September 30, 1996 was 10.3%. This target 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, liquidity position, the level of unused borrowing capacity, the level of interest rates as compared to the periodic and life caps in the Company's assets, and the over-collateralization levels required by the Company's lenders. The Company has sought 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 has sought to maintain an equity-to-assets ratio of 40% to 100%. Through September 30, 1996, the Company's per-asset capital requirements have not changed significantly since the founding of the Company, although the overall target equity-to-assets ratio has varied 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 as the Company has increased its focus on the acquisition of mortgage assets with relatively low credit risk and relatively good liquidity. 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 most circumstances, this would be accomplished over time by waiting for the balance of mortgage assets to reduce through mortgage 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 a continued emphasis on the acquisition of high-quality whole mortgage loans and securitized mortgage assets rated AAA and AA. With excess capital of $18.7 million as compared to its risk-adjusted capital guideline at September 30, 1996, the Company had asset growth potential of approximately $181 million assuming acquired mortgage assets have the same mix as existing mortgage assets. The Company estimates it employed approximately 84% of its capital base on average during the third quarter of 1996. 41 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) 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% 1996, Quarter 3 163,517 10.32% 11.65% 18,664 1,584,315 1,403,478 180,837 84%
WARRANTS At September 30, 1996, the Company had 1,076,431 warrants outstanding; at December 31, 1995 the Company had 1,665,063 warrants outstanding. In the first nine months of 1996, 588,632 warrants were exercised, thus generating additional equity proceeds to the Company of $8.8 million. 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 additional new equity capital of approximately $16.1 million. ASSET/LIABILITY MANAGEMENT AND EFFECT OF CHANGES IN INTEREST RATES Management continually reviews the Company's asset/liability strategy with respect to interest rate risk, mortgage principal repayment risk, credit risk and the related issues of capital adequacy and liquidity. The Company seeks attractive risk-adjusted shareholder returns while seeking to maintain a strong balance sheet and 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. A primary 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, in such an event, the market value of its interest rate agreements would likely rise and partially offset decreases in mortgage values. See "Asset/Liability Management and Effect of Changes in Interest Rates -- Equity Duration" below. Changes in interest rates also may have an effect on the rate of mortgage principal repayment; the Company generally 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. Such balancing may not always be possible, however. As discussed earlier, the Company has purchased assets in 1996 at prices 42 in excess of par value, and thus has significantly increased the net unamortized premium balance. In addition, due to the Company's accounting practices, changes in the rate of mortgage principal repayment have differing effects on premium and discount amortization schedules. When the rate of mortgage principal repayment increases, the Company accelerates premium amortization at a faster rate than discount amortization. This accounting practice leads to a lower level of accounting income, compared to what it otherwise would have been, during periods of rapid mortgage principal repayments. See "Results of Operations -- Amortization of Premium and Discount and Effect of Changes in Principal Repayment Rates" above. Although the net effects on earnings of changes in interest rates, mortgage prepayment rates, and other factors cannot be determined in advance, management believes, given the balance sheet as of September 30, 1996, that some of the following effects may occur in an environment of rising short-interest rates: (i) earnings on that portion of the balance sheet funded with equity may rise over time as the coupons on adjustable rate mortgages adjust upwards, (ii) earnings on that portion of the balance sheet funded with borrowings (spread lending) may be initially reduced as borrowing costs rise more quickly than the coupons on adjustable rate mortgages, although most or all of the spread might be restored over time as the mortgage coupons fully adjust to the rate change, (iii) earnings may benefit from net hedge income or reduced net hedge expense from interest rate agreements, (iv) premium amortization expenses may be reduced if the rate of mortgage principal repayment diminishes. All other factors being equal, the net effect of an increase in short-term interest rates may be an initial drop in earnings followed by increased earnings after a lag period. The length of any such lag period would likely be determined by the speed and extent of the change in interest rates. Management believes 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 average 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 BEFORE HEDGING 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, while a positive gap implies that rising interest rates will lead to higher earnings. Lower interest rates would have the opposite effect. In each case, these effects are limited to the particular time period for which the gap is calculated. As applied to the Company, this gap analysis ignores the effect of the Company's hedging activities (interest rate agreements), the effect of the periodic and lifetime caps in the Company's assets, the effect of changes in mortgage principal repayment rates and other factors. Nevertheless, the gap analysis can provide some useful information on the Company's interest rate risk profile. The Company's two-month cumulative gap as a percentage of total assets was negative 16% at September 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 3% at September 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 could have been negative. Falling interest rates would likely 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 43 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 September 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 (a portion of the Company's earning assets are funded with equity). The negative short-term interest rate sensitivity gap was reduced at the end of the second and third quarter of 1996 compared to earlier periods because the Company extended the average maturity of its liabilities beginning in the second quarter of 1996. 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 - ------------- ------ ------ ------ ------ ------ ------ ------ ------ 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% 1996, Quarter 3 (21%) (16%) (9%) (10%) (8%) (4%) 3% 12%
INTEREST RATE AGREEMENTS The Company's interest rate agreements materially alter the interest rate risk profile suggested by the interest rate sensitivity gap analysis. See "Results of Operations -- Cost of Borrowed Funds and Hedging and the Interest Rate Spread" above and "Note 3. Interest Rate Agreements" of the Notes to Financial Statements for further detail and information. The interest rate agreements are designed to produce income for the Company as short-term interest rates rise to partially or fully offset possible losses of net interest income from the spread lending portion of the Company's balance sheet. These agreements can be thought of as serving to limit potential increases in the costs of the Company's borrowings or, alternatively, as serving to remove some of the periodic and lifetime caps imbedded in the Company's assets. In addition, the interest rate agreements are designed to appreciate in market value in most circumstances in which short-term interest rates rise sharply, thereby partially offsetting likely concurrent declines in the market value of the Company's mortgage assets. The Company has also entered into Treasury/LIBOR basis swaps designed, in conjunction with the Company's other interest rate agreements, to partially offset potential negative effects on the Company's earnings and mark-to-market equity balances should LIBOR interest rates materially increase as compared to U.S. Treasury interest rates. A portion of the Company's balance sheet consists of mortgages with coupons set as a function of short-term U.S. Treasury interest rates; these assets are funded with borrowings with a cost of funds more closely linked to short-term LIBOR rates. 44 INTEREST RATE FUTURES AND OPTIONS 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. The Company currently plans to seek 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. 45 PART II OTHER INFORMATION Item 1. Legal Proceedings At September 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 On August 8, 1996, the Company issued its Class B 9.74% Cumulative Convertible Preferred Stock (the "Preferred Stock"). Under the terms of the Preferred Stock, no dividends may be paid on shares of Common Stock unless full cumulative dividends have been paid on the Preferred Stock. Item 3. Defaults Upon Senior Securities Not applicable Item 4. Submission of Matters to a Vote of Security Holders Not applicable Item 5. Other Information None Item 6. Exhibits and Reports on Form 8-K (a) Exhibits Exhibit 3.4* - Articles Supplementary of the Registration relating to the Preferred Stock, filed August 9, 1996. Exhibit 4.3* - Preferred Stock Certificate. Exhibit 11 to Part I - Computation of Earnings Per Share for the three and six months ended September 30, 1996 and September 30, 1995. Exhibit 27 - Financial Data Schedule * Incorporated by reference to the correspondingly numbered exhibit to the Registration Statement on Form S-11 (333-08363) filed by the Registrant on July 18, 1996. (b) Reports No filings on Form 8-K were made. 46 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: November 8, 1996 By: /s/ Douglas B. Hansen ----------------------------------------- Douglas B. Hansen President and Chief Financial Officer (authorized officer of registrant) Dated: November 8, 1996 By: /s/ Vickie L. Rath ---------------------------------------- Vickie L. Rath Vice President, Treasurer and Controller (principal accounting officer) 47 REDWOOD TRUST, INC. INDEX TO EXHIBIT Sequentially Exhibit Numbered Number Page - ------ -------- 11 Computation of Earnings per Share...... 49 27 Financial Data Schedule................ 51 48 EXHIBIT 11.1 REDWOOD TRUST, INC. STATEMENT RE: COMPUTATION OF PER SHARE EARNINGS
Three Months Nine Months Ended Ended September 30, 1996 September 30, 1996 ------------------ ------------------ PRIMARY: Average common shares outstanding ........................... 8,732,326 7,360,916 Net effect of dilutive stock options outstanding during the period -- based on the treasury stock method.. 162,393 186,576 Net effect of dilutive stock warrants outstanding during the period -- based on the treasury stock method.. 621,455 699,324 ---------- ---------- Total 9,516,174 8,246,815 ========== ========== Net Income $2,999,205 $7,453,284 ========== ========== Per Share Amount $ 0.32 $ 0.90 ========== ========== FULLY DILUTED: Average common shares outstanding ........................... 8,732,326 7,360,916 Net effect of dilutive stock options outstanding during the period -- based on the treasury stock method.. 180,891 204,202 Net effect of dilutive stock warrants outstanding during the period -- based on the treasury stock method.. 744,178 837,425 ---------- ---------- Total 9,657,395 8,402,542 ========== ========== Net Income $2,999,205 $7,453,284 ========== ========== Per Share Amount $ 0.31 $ 0.89 ========== ==========
49 EXHIBIT 11.1 REDWOOD TRUST, INC. STATEMENT RE: COMPUTATION OF PER SHARE EARNINGS
Three Months Nine Months Ended Ended September 30, 1995 September 30, 1995 ------------------ ------------------ Primary: Average common shares outstanding .............................. 3,219,754 1,223,170 Average preferred shares outstanding (A) ....................... 724,375 1,348,718 Net effect of dilutive stock options outstanding during the period -- based on the treasury stock method .... 154,886 175,754 Net effect of dilutive stock warrants outstanding during the period -- based on the treasury stock method .... 84,123 N/A ---------- ---------- Total 4,183,138 2,747,642 ========== ========== Net Income $ 993,815 $1,845,134 ========== ========== Per Share Amount $ 0.24 $ 0.67 ========== ========== Fully Diluted: Average common shares outstanding .............................. 3,219,754 1,223,170 Average preferred shares outstanding (A) ....................... 724,375 1,348,718 Net effect of dilutive stock options outstanding during the period -- based on the treasury stock method .... 154,886 175,754 Net effect of dilutive stock warrants outstanding during the period -- based on the treasury stock method .... 84,123 N/A ---------- ---------- Total 4,183,138 2,747,642 ========== ========== Net Income $ 993,815 $1,845,134 ========== ========== Per Share Amount $ 0.24 $ 0.67 ========== ==========
(A) Preferred shares considered common stock equivalents for all periods as there is no stated yield and there is an automatic conversion feature to convert the preferred to common with no additional proceeds to the company. 50