-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, QpalNhstBQj/TH+4DhIoz57qNKQWeAbkQxKT1bADCkzbcdQ63Akbrt8kxftj89fW lIOGAqr5C5CBo9bPES5aKg== 0000912057-01-506129.txt : 20010409 0000912057-01-506129.hdr.sgml : 20010409 ACCESSION NUMBER: 0000912057-01-506129 CONFORMED SUBMISSION TYPE: 10-K405 PUBLIC DOCUMENT COUNT: 2 CONFORMED PERIOD OF REPORT: 20001231 FILED AS OF DATE: 20010402 FILER: COMPANY DATA: COMPANY CONFORMED NAME: APEX MORTGAGE CAPITAL INC CENTRAL INDEX KEY: 0001045956 STANDARD INDUSTRIAL CLASSIFICATION: REAL ESTATE INVESTMENT TRUSTS [6798] IRS NUMBER: 954650863 STATE OF INCORPORATION: MD FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K405 SEC ACT: SEC FILE NUMBER: 001-13637 FILM NUMBER: 1589482 BUSINESS ADDRESS: STREET 1: 865 FIGUEROA STREET STREET 2: STE 1800 CITY: LOS ANGELES STATE: CA ZIP: 90017 BUSINESS PHONE: 2132440461 10-K405 1 a2042106z10-k405.txt FORM 10-K405 =============================================================================== UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D. C. 20549 FORM 10-K (MARK ONE) X ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES - -------- EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED: DECEMBER 31, 2000 OR - ------- TRANSITION REPORT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _____ TO _____ COMMISSION FILE NUMBER: 001-13637 APEX MORTGAGE CAPITAL, INC. (Exact name of Registrant as specified in its Charter) MARYLAND 95-4650863 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification Number) 865 SOUTH FIGUEROA STREET LOS ANGELES, CALIFORNIA 90017 (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code (213) 244-0440 Securities registered pursuant to Section 12(b) of the Act: TITLE OF EACH CLASS NAME OF EXCHANGE WHICH REGISTERED ------------------- --------------------------------- Common Stock ($.01 par value) American Stock Exchange Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes X No ------- ------- Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 Regulation S-K is not contained herein, and will not be contained, to the best of the Registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ X ] At March 16, 2001, the aggregate market value of the voting stock held by non-affiliates was $49,001,173 based on the closing price of the Common Stock on the New York Stock Exchange. Number of shares of Common Stock outstanding at March 16, 2001: 5,753,000 DOCUMENTS INCORPORATED BY REFERENCE: Portions of the Registrant's definitive Proxy Statement to be filed pursuant to Regulation 14A within 120 days from December 31, 2000, are incorporated by reference into Part III. =============================================================================== SAFE HARBOR STATEMENT UNDER THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 CERTAIN INFORMATION CONTAINED IN THIS REPORT CONSTITUTES "FORWARD-LOOKING STATEMENTS" WHICH CAN BE IDENTIFIED BY THE USE OF FORWARD-LOOKING TERMINOLOGY SUCH AS "MAY," "WILL," "SHOULD," "EXPECT," "ANTICIPATE," "ESTIMATE," "INTEND," "CONTINUE," OR "BELIEVES" OR THE NEGATIVES THEREOF OR OTHER VARIATIONS THEREON OR COMPARABLE TERMINOLOGY. SOME IMPORTANT FACTORS THAT WOULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE IN ANY FORWARD-LOOKING STATEMENTS INCLUDE CHANGES IN INTEREST RATES; DOMESTIC AND FOREIGN BUSINESS, MARKET, FINANCIAL OR LEGAL CONDITIONS; DIFFERENCES IN THE ACTUAL ALLOCATION OF THE ASSETS OF THE COMPANY FROM THOSE ASSUMED; AND THE DEGREE TO WHICH ASSETS ARE HEDGED AND THE EFFECTIVENESS OF THE HEDGE, AMONG OTHERS. IN ADDITION, THE DEGREE OF RISK IS INCREASED BY THE COMPANY'S LEVERAGING OF ITS ASSETS. 2 APEX MORTGAGE CAPITAL, INC. 2000 FORM 10-K ANNUAL REPORT TABLE OF CONTENTS
PAGE ---- ITEM 1. BUSINESS 4 ITEM 2. PROPERTIES 20 ITEM 3. LEGAL PROCEEDINGS 20 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 20 ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS 20 ITEM 6. SELECTED FINANCIAL DATA 22 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 23 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 31 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA 34 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE 34 ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT 34 ITEM 11. EXECUTIVE COMPENSATION 34 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT 34 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS 34 ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K 35
3 CERTAIN CAPITALIZED AND OTHER TERMS USED HEREIN SHALL HAVE THE MEANINGS ASSIGNED TO THEM IN THE GLOSSARY AT THE END OF THIS REPORT. PART I ITEM 1. BUSINESS GENERAL Apex Mortgage Capital, Inc. (the "Company"), a Maryland corporation, was formed on September 15, 1997, primarily to acquire United States agency and other highly rated, single-family real estate adjustable and fixed rate Mortgage Related Assets. The Company commenced operations on December 9, 1997 following the initial public offering of the Company's Common Stock. The Company's principal executive offices are located at 865 South Figueroa Street, Suite 1800, Los Angeles, California 90017, and its telephone number is (213) 244-0440. The Company uses its equity capital and borrowed funds to seek to generate income based on the difference between the yield on its Mortgage Related Assets and the cost of its borrowings. The Company has elected to be taxed as a real estate investment trust ("REIT") under the Internal Revenue Code of 1986, as amended (the "Code"). The Company will not generally be subject to federal taxes on its income to the extent that it distributes its net income to its stockholders and maintains its qualification as a REIT. The day-to-day operations of the Company are managed by an external management company, TCW Investment Management Company (the "Manager"), subject to the direction and oversight of the Company's Board of Directors. A majority of the Board of Directors are unaffiliated with The TCW Group, Inc. ("TCW" and, together with its subsidiaries and Affiliates, the "TCW Group") or the Manager. The Manager is a wholly-owned subsidiary of TCW. The Manager was established in 1992 and the TCW Group began operations in 1971 through one of its affiliates. The Company's investment management team are selected members of the TCW Group's Mortgage-Backed Securities Group (the "MBS Group"), all of whom have over twelve years of experience in raising and managing mortgage capital. The Company has elected to be externally managed by the Manager to take advantage of the existing operational systems, expertise and economies of scale associated with the Manager's current business operations, among other reasons. The Manager's key officers have experience in raising and managing mortgage capital, mortgage finance and the purchase and administration of Mortgage Related Assets. RECENT EVENTS DIVIDEND DECLARATION. On March 20, 2001, the Company's Board of Directors declared a dividend distribution of $0.35 per share. The dividend is payable on April 20, 2001, to shareholders of record on March 30, 2001. REPORTING PERIOD. Unless otherwise noted, this report describes the Company's operations and developments through the date hereof. EXCHANGE LISTING. Effective February 8, 2001, the Company was listed on the American Stock Exchange and began trading its common stock under the symbol AXM. STRATEGY To achieve its business objective and generate dividend yields that provide a competitive rate of return for its stockholders, the Company's strategy is to: - - purchase primarily single-family fixed and adjustable rate Mortgage Related Assets; 4 - - manage the credit risk of its Mortgage Related Assets through, among other activities (i) carefully selecting Mortgage Related Assets to be acquired, (ii) complying with the Company's investment policy, (iii) actively monitoring the ongoing credit quality and servicing of its Mortgage Related Assets, and (iv) maintaining appropriate capital levels and allowances for possible credit losses; - - finance purchases of Mortgage Related Assets with the net proceeds of equity offerings and, to the extent permitted by the Company's leverage policy, to utilize leverage to increase potential returns to stockholders through borrowings (primarily reverse repurchase agreements) with interest rates that will also reflect changes in short-term market interest rates; - - seek to structure its borrowings in accordance with its interest rate risk management policy; - - utilize interest rate swaps, forward contracts on U.S. Treasury notes, interest rate caps and similar financial instruments to mitigate interest rate risks; and - - seek to minimize prepayment risk primarily by structuring a diversified portfolio with a variety of prepayment characteristics. There can be no assurance that the Company will be able to generate competitive earnings and dividends while holding primarily High Quality Mortgage Related Assets and maintaining a disciplined risk-control profile. The Company may attempt to increase the return to stockholders over time by: (i) raising additional capital in order to increase its ability to invest in additional Mortgage Related Assets; (ii) lowering its effective borrowing costs through direct funding with collateralized lenders, in addition to using Wall Street intermediaries, and investigating the possibility of using collateralized commercial paper and medium-term note programs; and (iii) improving the efficiency of its balance sheet structure by issuing uncollateralized subordinated debt and other forms of capital. MANAGEMENT POLICIES AND PROGRAMS The Company is a financial company that uses its equity capital and borrowed funds to seek to generate net income based on the difference between the interest income on its assets and the cost of its borrowings. The Company has elected to be taxed as a REIT under the Code. The Company intends to operate in accordance with its operating policies as approved by the Company's Board of Directors at least annually. The Company has established the following four primary operating policies to implement its business strategy of acquiring assets consisting primarily of United States agency and other high rated single-family real estate mortgage securities and mortgage loans in order to generate dividend yields that provide a competitive rate of return for its stockholders. - - Investment Policy - - Leverage Policy - - Interest Rate Risk Management Policy - - REIT Compliance Policy Compliance with the policy guidelines shall be determined at the time of purchase of the Mortgage Related Assets (based on the most recent valuation used by the Company) and will not be affected by events subsequent to such purchase. Such events include, without limitation, changes in characterization, value or rating of any specific Mortgage Related Assets or economic conditions or other events generally affecting any Mortgage Related Assets of the type held by the Company. 5 INVESTMENT POLICY The Company intends to acquire investments that it believes will maximize returns on capital invested, after considering (i) the amount and nature of the anticipated returns from the investment, (ii) the Company's ability to pledge the investment to secure collateralized borrowings, and (iii) the costs associated with financing, hedging, managing, securitizing and reserving for such investments. The Company generally expects to primarily invest in Mortgage Related Assets that may include Short-Term Investments, Mortgage-Backed Securities, High Credit Quality Mortgage Loans, Mortgage Derivative Securities and Other Investments. The Company's investment policy is intended to provide guidelines for the acquisition of its investments. Specifically, the investment policy states that the Company intends to acquire a portfolio of investments that can be segregated into specific categories. Each category and its respective investment limitations are as follows: 50% CATEGORY At least 50% of the Company's total assets are expected to consist of (i) Short-Term Investments, (ii) Mortgage-Backed Securities that are either issued or guaranteed by an agency of the U.S. government, (iii) Mortgage-Backed Securities that are rated AAA by at least one nationally recognized rating agency or (iv) High Credit Quality Mortgage Loans that are funded with Committed Secured Borrowings. 75% CATEGORY At least 75% of the Company's total assets are expected to consist of investments that qualify for the 50% Category or other Mortgage-Backed Securities that have received an investment grade rating by at least one nationally recognized rating agency. 90% CATEGORY At least 90% of the Company's total assets are expected to consist of investments that qualify for the 75% Category or High Credit Quality Mortgage Loans that are not funded by Committed Secured Borrowings. 10% CATEGORY Not more than 10% of the Company's total assets are expected to consist of (i) Mortgage-Backed Securities rated below investment grade, (ii) Mortgage Derivative Securities or (iii) Other Investments. LEVERAGE POLICY The Company generally anticipates utilizing leverage to increase returns to its shareholders. The Company's goal is to strike a balance between the under-utilization of leverage, which reduces potential returns to stockholders, and the over-utilization of leverage, which could reduce the Company's ability to meet its obligations during periods of adverse market conditions. The Company has established a leverage policy to control the type and amount of leverage used to fund the acquisition of its Mortgage Related Assets. The Company's leverage policy is intended to provide guidelines for utilizing secured borrowings in the form of Uncommitted Secured Borrowings and Committed Secured Borrowings. UNCOMMITTED SECURED BORROWINGS The Company expects a substantial portion of its borrowings may consist of Uncommitted Secured Borrowings, including reverse repurchase agreements, lines of credit, Dollar-Roll Agreements and other financing transactions. Such funding sources generally do not commit the lender to continue to provide financing to the Company. The Company intends to limit the amount of Uncommitted Secured Borrowings to 92% of its total assets, less any assets that are funded with Committed Secured Borrowings, plus the market value of any related hedging transactions. If the amount of such borrowings exceeds 92%, the Manager will be required to submit to the Company's Board of Directors a plan designed to bring the total amount of Uncommitted Secured Borrowings below the 92% limitation. It is anticipated that in many circumstances this goal will be achieved over time without active management through the natural process of mortgage principal repayments and increases in the market value of the Company's total assets. The Company anticipates that it will 6 only enter into repurchase agreements and other financing transactions with counter-parties rated investment grade by a Rating Agency. COMMITTED SECURED BORROWINGS The Company's borrowings may consist of Committed Secured Borrowings, including the issuance of CMOs, structured commercial paper programs, secured term notes and other financing transactions. Such funding sources generally commit the lender to provide financing to the Company for a specified period of time or to provide financing to the Company to fund specific assets until they mature. The Company intends to limit the amount of Committed Secured Borrowings to 97% of the assets funded with such borrowings at the time any corresponding transaction is entered into. INTEREST RATE RISK MANAGEMENT POLICY The Company has established an interest rate risk management policy that is intended to mitigate the negative impact of changing interest rates. The Company generally intends to mitigate interest rate risk by targeting the difference between the market weighted average duration on its Mortgage Related Assets funded with secured borrowings to the market weighted average duration of such borrowings to one year or less, taking into account all hedging transactions. The Company generally does not intend to have any specific duration target for the portion of its Mortgage Related Assets that are not funded by secured borrowings. There can be no assurance that the Company will be able to limit such duration differences and there may be periods of time when the duration difference will be greater than one year. The Company may implement its interest rate risk management policy by utilizing various hedging transactions, including interest rate swaps, interest rate swaptions, interest rate caps, interest rate floors, financial futures contracts, options on financial futures contracts and other structured transactions. The Company does not intend to enter into such transactions for speculative purposes. REIT COMPLIANCE POLICY The Company intends to operate its business in compliance with the REIT Provisions of the Code. Accordingly, all of the provisions outlined in the Company's investment, leverage and interest rate risk management policies are subordinate to the REIT Provisions of the Code if any conflicts arise. To qualify for tax treatment as a REIT, the Company must meet certain tests as fully described in sections 856 and 857 of the Code. A summary of the requirements for qualification as a REIT is described immediately below. STOCK OWNERSHIP TESTS. The capital stock of the Company must be held by at least 100 persons and no more than 50% of the value of such capital stock may be owned, directly or indirectly, by five or fewer individuals at all times during the last half of the taxable year. Tax-Exempt Entities, other than private foundations and certain unemployment compensation trusts, are generally not treated as individuals for these purposes. The stock ownership requirements must be satisfied in the Company's second taxable year and in each subsequent taxable year. ASSET TESTS. The Company must generally meet the following asset tests at the close of each quarter of each taxable year. At least 75% of the value of the Company's total assets must consist of Qualified REIT Real Estate Assets, U.S. Government securities, cash and cash items (the "75% Asset Test"). The value of securities held by the Company but not taken into account for purposes of the 75% Asset Test must not exceed (i) 5% of the value of the Company's total assets in the case of securities of any one non-government issuer, or (ii) 10% of the outstanding voting securities of any such issuer. INCOME TESTS. The Company must generally meet certain gross income tests for each taxable year. At least 75% of the Company's gross income must be derived from certain specified real estate sources, including interest income and gain from the disposition of Qualified REIT Real Estate Assets or Qualified Temporary Investment Income (the "75% Gross Income Test"). At least 95% of the Company's gross income for each taxable year must be derived from sources of income qualifying for the 75% Gross Income Test, dividends, interest unrelated to real estate, and gains from the sale of stock or other securities (including certain interest rate swap and cap agreements entered into to hedge variable rate debt incurred to acquire Qualified REIT Real Estate Assets) not held for sale in the ordinary course of business (the "95% Gross Income Test"). 7 DIVIDEND DISTRIBUTION REQUIREMENTS. The Company must generally distribute to its stockholders an amount equal to at least 95% of the Company's taxable income before deductions of dividends paid and excluding net capital gains. The Company has until January 31 following the end of the fiscal year to pay the dividends out to shareholders and is permitted to offer a special dividend in order to meet the 95% requirement. OTHER POLICIES The Company intends to operate in a manner that will not subject it to regulation under the Investment Company Act. The Company does not currently intend to (i) originate Mortgage Loans or (ii) offer securities in exchange for real property. The Company will not purchase any Mortgage Related Assets from its Affiliates other than mortgage securities that may be purchased from a taxable subsidiary of the Company that may be formed in connection with the securitization of Mortgage Loans. FUTURE REVISIONS IN POLICIES AND STRATEGIES The Company's Board of Directors has established the policies and strategies set forth in this report. The Board of Directors (subject to approval by a majority of Unaffiliated Directors) has the power to modify or waive such policies and strategies without the consent of the stockholders. The Company's Board of Directors will at least annually establish and approve (including approval by a majority of Unaffiliated Directors) the policies and strategies of the Company. DESCRIPTION OF MORTGAGE RELATED ASSETS The Company invests principally in the following types of Mortgage Related Assets subject to the operating restrictions described in "Management Policies and Programs" below. PRIMARY MORTGAGE SECURITIES PASS-THROUGH CERTIFICATES. Pass-Through Certificates are securities representing interests in "pools" of mortgage loans secured by residential real property in which payments of both interest and principal on the securities are generally made monthly, in effect "passing through" monthly payments made by the individual borrowers on the mortgage loans which underlie the securities (net of fees paid to the issuer or guarantor of the securities). Early repayment of principal on some Mortgage Related Assets (arising from prepayments of principal due to sale of the underlying property, refinancing, or foreclosure, net of fees and costs which may be incurred) may expose the Company to a lower rate of return upon reinvestment of principal. This is known as prepayment risk. Also, if a security subject to prepayment has been purchased at a premium, the value of the premium would be lost in the event of prepayment. Like other fixed income securities, when interest rates rise, the value of a Mortgage Related Asset generally will decline; however, when interest rates are declining, the value of Mortgage Related Assets with prepayment features may not increase as much as other fixed income securities. The rate of prepayments on underlying mortgages will affect the price and volatility of a Mortgage Related Asset, and may have the effect of shortening or extending the effective maturity of the security beyond what was anticipated at the time of purchase. When interest rates rise, the holdings of Mortgage Related Assets by the Company can reduce returns if the owners of the underlying mortgages pay off their mortgages later than anticipated. This is known as extension risk. Payment of principal and interest on some mortgage pass-through securities (but not the market value of the securities themselves) may be guaranteed by the full faith and credit of the U.S. Government (in the case of securities guaranteed by the Government National Mortgage Association ("GNMA")) or guaranteed by agencies or instrumentalities of the U.S. Government (in the case of securities guaranteed by the federally chartered and privately owned corporation organized and existing under the Federal National Mortgage Association Charter Act (12 U.S.C., Section 1716 et seq.), formerly known as the Federal National Mortgage Association ("Fannie Mae"), or the Federal Home Loan Mortgage Corporation ("FHLMC")) which are supported only by the discretionary authority of the U.S. Government to purchase the agency's obligations. Mortgage Related Assets created by non-governmental issuers (such as commercial banks, savings and loan institutions, private mortgage insurance companies, mortgage bankers and other secondary market issuers) may be supported by various forms of insurance or guarantees, including individual loan, title, pool and hazard insurance and letters of credit, which may be issued by governmental entities, private insurers or the mortgage poolers. 8 COLLATERALIZED MORTGAGE OBLIGATIONS. Collateralized Mortgage Obligations ("CMOs") are hybrid mortgage related instruments. Interest and pre-paid principal on a CMO are paid, in most cases, on a monthly basis. CMOs may be collateralized by whole mortgage loans but are more typically collateralized by portfolios of mortgage pass-through securities guaranteed by GNMA, FHLMC, or Fannie Mae. CMOs are structured into multiple classes, with each class bearing a different stated maturity. Monthly payments of principal, including prepayments, are first returned to investors holding the shortest maturity class; investors holding the longer maturity classes receive principal only after the first class has been retired. CMOs that are issued or guaranteed by the U.S. Government or by any of its agencies or instrumentalities will be considered U.S. Government securities by the Company. OTHER MORTGAGE SECURITIES GENERAL. The Company may acquire other mortgage securities such as non-High Quality Mortgage Related Assets and other mortgage securities collateralized by single-family Mortgage Loans, mortgage warehouse participations, Mortgage Derivative Securities, subordinated interests and other mortgage-backed and mortgage-collateralized obligations, other than pass-through certificates and CMOs. MORTGAGE DERIVATIVE SECURITIES. The Company may acquire Mortgage Derivative Securities not to exceed 10% of its total assets. Mortgage Derivative Securities provide for the holder to receive interest only, principal only, or interest and principal in amounts that are disproportionate to those payable on the underlying Mortgage Loans. Payments on Mortgage Derivative Securities are highly sensitive to the rate of prepayments on the underlying Mortgage Loans. In the event of more rapid (slower) than anticipated prepayments on such Mortgage Loans, the rates of return on interests in Mortgage Derivative Securities representing the right to receive interest only or a disproportionately large amount of interest ("Interest Only Derivatives") would be likely to decline (increase). Conversely, the rates of return on Mortgage Derivative Securities representing the right to receive principal only or a disproportionate amount of principal ("Principal Only Derivatives") would be likely to increase (decrease) in the event of rapid (slow) prepayments. The Company may also invest in Inverse Floaters, a class of CMOs with a coupon rate that resets in the opposite direction from the market rate of interest to which it is indexed such as the London Inter-Bank Offered Rate ("LIBOR") or the 11th District Cost of Funds Index ("COFI"). Any rise in the index rate (as a consequence of an increase in interest rates) causes a drop in the coupon rate of an Inverse Floater while any drop in the index rate causes an increase in the coupon of an Inverse Floater. An Inverse Floater may behave like a security that is leveraged since its interest rate usually varies by a magnitude much greater than the magnitude of the index rate of interest. The "leverage-like" characteristics inherent in Inverse Floaters are associated with greater volatility in their market prices. The Company also may invest in other Mortgage Derivative Securities that may in the future be developed. SUBORDINATED INTERESTS. The Company also may acquire subordinated interests, which are classes of mortgage securities that are junior to other classes of such series of mortgage securities in the right to receive payments from the underlying Mortgage Loans. The subordination may be for all payment failures on the Mortgage Loans securing or underlying such series of mortgage securities. The subordination will not be limited to those resulting from certain types of risks, such as those resulting from war, earthquake or flood, or the bankruptcy of a borrower. The subordination may be for the entire amount of the series of mortgage securities or may be limited in amount. MORTGAGE WAREHOUSE PARTICIPATIONS. The Company also may from time to time acquire mortgage warehouse participations as an additional means of diversifying its sources of income. The Company anticipates that such investments, together with its investments in Other Mortgage Assets, will not in the aggregate exceed 10% of its total Mortgage Related Assets. These investments are participations in lines of credit to Mortgage Loan originators that are secured by recently originated Mortgage Loans that are in the process of being sold to investors. Mortgage warehouse participations do not qualify as Qualified REIT Real Estate Assets. Accordingly, this activity is limited by the REIT Provisions of the Code. MORTGAGE LOANS GENERAL. The Company may acquire and accumulate Mortgage Loans as part of its investment strategy until a sufficient quantity has been accumulated for securitization into High Credit Quality Mortgage Loans. The Company anticipates that the Mortgage Loans acquired by it and not yet securitized will not constitute more than 25% of the Company's total Mortgage Related Assets at any time. All Mortgage Loans will be acquired with the intention of securitizing them into High Credit Quality Mortgage Loans. However, there can be no assurance that the Company will be 9 successful in securitizing the Mortgage Loans. To meet the Company's investment criteria, the Mortgage Loans to be acquired by the Company will generally conform to the underwriting guidelines established by Fannie Mae, FHLMC or other credit insurers. Applicable banking laws generally require that an appraisal be obtained in connection with the original issuance of Mortgage Loans by the lending institution. The Company does not intend to obtain additional appraisals at the time of acquiring Mortgage Loans. The Mortgage Loans may be originated by or purchased from various suppliers of Mortgage Related Assets throughout the United States, such as savings and loan associations, banks, mortgage bankers, home-builders, insurance companies and other mortgage lenders. The Company may acquire Mortgage Loans directly from originators and from entities holding Mortgage Loans originated by others. The Board of Directors of the Company has not established any limits upon the geographic concentration of Mortgage Loans to be acquired by the Company or the credit quality of suppliers of Mortgage Related Assets. CONFORMING AND NONCONFORMING MORTGAGE LOANS. The Company may acquire both Conforming and Nonconforming Mortgage Loans for securitization. Conforming Mortgage Loans comply with the requirements for inclusion in a loan guarantee program sponsored by Fannie Mae, FHLMC or GNMA. Nonconforming Mortgage Loans are Mortgage Loans that do not qualify in one or more respects for purchase by Fannie Mae or FHLMC under their standard programs. The Company expects that a majority of Nonconforming Mortgage Loans it purchases will be nonconforming primarily because they have original principal balances which exceed the requirements for FHLMC or Fannie Mae programs. COMMITMENTS TO MORTGAGE LOAN SELLERS. The Company may issue commitments to originators and other sellers of Mortgage Loans who follow policies and procedures that generally comply with Fannie Mae and FHLMC regulations and guidelines and that comply with all applicable federal and state laws and regulations for Mortgage Loans secured by single-family (one-to-four units) residential properties. In addition, commitments may be issued for agency certificates as well as privately issued pass-through certificates and Mortgage Loans. Although the Company may commit to acquire Mortgage Loans prior to funding, all Mortgage Loans are to be fully funded prior to their acquisition by the Company. Following the issuance of commitments, the Company will be exposed to risks of interest rate fluctuations similar to those risks on Mortgage Related Assets. SECURITIZATION OF MORTGAGE LOANS. The Mortgage Loans will be acquired by the Company and held until a sufficient quantity has been accumulated for securitization. During the accumulation period, the Company will be subject to risks of borrower defaults and bankruptcies, fraud losses and special hazard losses (such as those occurring from earthquakes or floods) that are not covered by standard hazard insurance. In the event of a default on any Mortgage Loan held by the Company, the Company will bear the risk of loss of principal to the extent of any deficiency between the value of the collateral underlying the Mortgage Loan and the principal amount of the Mortgage Loan. No assurance can be given that any such mortgage, fraud or hazard insurance will adequately cover a loss suffered by the Company. Also during the accumulation period, the costs of financing the Mortgage Loans through reverse repurchase agreements and other borrowings and lines of credit with warehouse lenders could exceed the interest income on the Mortgage Loans. It may not be possible or economical for the Company to complete the securitization for all Mortgage Loans that the Company acquires, in which case the Company will continue to bear the risks of borrower defaults and special hazard losses. PROTECTION AGAINST MORTGAGE LOAN RISKS. It is anticipated that each Mortgage Loan purchased will have a commitment for mortgage pool insurance from a mortgage insurance company with a claims-paying ability rated investment grade by either of the Rating Agencies. Mortgage pool insurance insures the payment of certain portions of the principal and interest on Mortgage Loans. In lieu of mortgage pool insurance, the Company may arrange for other forms of credit enhancement such as letters of credit, subordination of cash flows, corporate guaranties, establishment of reserve accounts or over-collateralization. It is expected that when the Company acquires Mortgage Loans, the seller will generally represent and warrant to the Company that there has been no fraud or misrepresentation during the origination of the Mortgage Loans and generally agree to repurchase any Mortgage Loan with respect to which there is fraud or misrepresentation. The Company will provide similar representations and warranties when the Company sells or pledges the Mortgage Loans as collateral for mortgage securities. If a Mortgage Loan becomes delinquent and the pool insurer is able to prove that there was a fraud or misrepresentation in connection with the origination of the Mortgage Loan, the pool insurer will not be liable for the portion of the loss attributable to such fraud or misrepresentation. Although the Company will generally have recourse to the seller based on the seller's representations and warranties to the Company, the Company will generally be at risk for loss to the extent the seller does not perform its repurchase obligations. 10 OTHER INVESTMENTS. The Company may acquire Other Investments that include (i) equity and debt securities issued by other primarily mortgage related finance companies, (ii) interests in mortgage related collateralized bond obligations, (iii) other subordinated interests in pools of mortgage related assets, (iv) commercial mortgage loans and securities, and (v) residential mortgage loans other than High Credit Quality Mortgage Loans. Although the Company expects that its Other Investments will be limited to less than 10% of total assets, there is no limit to how much of the Company's shareholders' equity will be allocated to Other Investments. There may be periods in which Other Investments represent a large portion of the Company's shareholders' equity. PRINCIPAL RISKS AND SPECIAL CONSIDERATIONS LEVERAGE RISK. The Company employs a leveraging strategy of generally borrowing up to 92% of its total assets to finance the acquisition of additional Mortgage Related Assets. The Company's borrowing may, at times, exceed 92% of its total assets. In the event borrowing costs exceed the income on its Mortgage Related Assets, the Company will experience negative cash flow and incur losses. Another risk of leverage is the possibility that the value of the collateral securing the borrowings will decline. In such event, additional collateral or repayment of borrowings would be required. The Company could be required to sell Mortgage Related Assets under adverse market conditions in order to maintain liquidity. If these sales were made at prices lower than the carrying value of the Mortgage Related Assets, the Company would experience losses. INTEREST RATE RISK. There is the possibility that the value of the Company's Mortgage Related Assets may fall since fixed income securities generally fall when interest rates rise. The longer the term of a fixed income instrument, the more sensitive it will be to fluctuations in value from interest rate changes. Changes in interest rates may have a significant effect on the Company's operations, because it may hold Mortgage Related Assets with long terms to maturity. Rising interest rates will negatively impact the Company's borrowings since the value of the collateral securing the borrowing will decline in value, requiring additional collateral or repayments of borrowing. This could reduce the level of borrowings and reduce returns. Also, when interest rates rise, the Company's holding of Mortgage Related Assets can reduce returns if the owners of the underlying mortgages pay-off their mortgages later than anticipated. This is known as EXTENSION RISK. When interest rates drop, the Company's holdings of the Mortgage Related Assets can reduce returns if the owners of the underlying mortgages pay off their mortgages sooner than anticipated since the funds prepaid will have to be invested at the then lower prevailing rate. This is known as PREPAYMENT RISK. In addition, when interest rates drop, not only can the value of Mortgage Related Assets drop, but the yield can drop, particularly where the yield on the security is tied to interest rates, such as adjustable mortgages. LIQUIDITY RISK. There is the possibility that the Company may lose money or be prevented from earning capital gains if it cannot sell a Mortgage Related Asset at a time and price that is most beneficial to the Company. The Company is subject to liquidity risk because it invests in mortgage securities which have experienced periods of illiquidity. CREDIT RISK. Credit risk is the possibility that the Company could lose money if an issuer is unable to meet its financial obligations, such as the payment of principal and/or interest on an instrument, or goes bankrupt. The Company may invest a portion of its assets in Mortgage Related Assets which are not guaranteed by the U.S. Government or investment grade, which may make the Company subject to substantial credit risk. This is especially true during periods of economic uncertainty or during economic down-turns. EQUITY RISK. Equity risk is the possibility that the Company could lose money if its equity investments decline in value. Such a decline could be caused by a number of factors, including but not limited to, overall market conditions, suspension or omission of dividends, bankruptcies and litigation. This is especially true during periods of economic uncertainties and economic downturns. FAILURE TO MAINTAIN REIT STATUS RISK. Failure to maintain REIT status risk refers to the possibility that the Company may become subject to federal income tax as a regular corporation. The Company intends at all times to maintain substantially all of its investments in, and otherwise conduct its business in a manner consistent with, the REIT Provisions of the Code. If the Company fails to qualify as a REIT, it would be treated as a regular corporation for federal tax purposes. This would result in the Company being subject to federal income tax that would further result in a substantial reduction of cash available for distribution to shareholders. FAILURE TO MAINTAIN INVESTMENT COMPANY ACT EXEMPTION RISK. The Company intends to conduct its business so as not to become a "regulated investment company" under the Investment Company Act. As a result, the Company's 11 ownership of certain Mortgage Related Assets may be limited by the Investment Company Act. This could have the effect of adversely affecting the Company's operations and returns to shareholders. In addition, if the Company fails to qualify for the exemption from registration as an investment company, its ability to use leverage would be substantially reduced. This could reduce income to the Company and returns to shareholders. FEDERAL INCOME TAX CONSEQUENCES The following discussion summarizes certain federal income tax consequences for the Company. This discussion is based on current law. The following discussion is not exhaustive of all possible tax considerations. It does not give a detailed discussion of any state, local or foreign tax considerations, nor does it discuss all of the aspects of federal, state, local or foreign income taxation that may be relevant to a stockholder of the Company in light of such stockholder's particular circumstances. Prospective investors in the Company are urged to consult with their own tax advisors regarding the specific consequences to each of them of the purchase, ownership and sale of stock in an entity electing to be taxed as a REIT, including the federal, state, local, foreign and other tax considerations of such purchase, ownership, sale and election and the potential changes in applicable tax laws. GENERAL The Code provides special tax treatment for organizations that qualify and elect to be taxed as REITs. In brief, if certain specific conditions imposed by the Code are met, entities that invest primarily in real estate assets, including Mortgage Loans, that otherwise would be taxed as corporations are generally not taxed at the corporate level on their taxable income that is distributed to their stockholders. This treatment eliminates most of the "double taxation" (at the corporate level and then again at the stockholder level when the income is distributed) that typically results from the use of corporate investment vehicles. A qualifying REIT, however, may be subject to certain excise and other taxes, as well as income taxes, on Taxable Income that is not currently distributed to its stockholders. The Company has made an election to be taxed as a REIT under the Code commencing with its taxable year ended December 31, 1997. There can be no assurance, however, that all qualification requirements for such treatment will be met. In the event that the Company does not qualify as a REIT in any taxable year, it will be subject to federal income tax as a domestic corporation and its stockholders will be taxed in the same manner as stockholders of ordinary corporations. To the extent that the Company would, as a consequence, be subject to potentially significant tax liabilities, the amount of earnings and cash available for distribution to its stockholders would be reduced. REQUIREMENTS FOR QUALIFICATION AS A REIT To qualify for tax treatment as a REIT under the Code, the Company must meet certain tests. The Company has adopted a policy to comply with the REIT Provisions of the Code. TERMINATION OR REVOCATION OF REIT STATUS The Company's status as a REIT will be terminated automatically if it fails to meet the Code's requirements for qualification as a REIT, unless certain relief provisions apply with respect to the Company's failure to meet the Code's requirements. If the Company's REIT status were to be terminated, the Company will not be eligible again to elect REIT status until the fifth taxable year that begins after the year for which its status as a REIT was terminated. The Company may also voluntarily revoke its election, in which case it would be prohibited, without exception, from electing REIT status for the year to which the revocation relates and the following four taxable years. The Company has no intention to voluntarily revoke its REIT election. If the Company fails to qualify for taxation as a REIT in any taxable year, and the relief provisions do not apply, the Company would be subject to tax (including any applicable alternative minimum tax) on its taxable income at regular corporate income tax rates. Distributions to stockholders of the Company with respect to any year in which it fails to qualify as a REIT would not be deductible by the Company nor would they be required to be made. Failure to qualify as a REIT would result in the Company's reduction of its distributions to stockholders in order to pay the resulting taxes. If, after terminating its REIT status, the Company later qualifies and elects to be taxed as a REIT again, the Company could face significant adverse tax consequences. 12 TAXATION OF THE COMPANY In any year in which the Company qualifies as a REIT, it generally will not be subject to federal income tax on that portion of its Taxable Income or net capital gain which is distributed to its stockholders. The Company generally will, however, be subject to federal income tax (at the rates applicable to corporations) on any net income or net capital gain that is not distributed to its stockholders. The Company intends to distribute substantially all of its Taxable Income to its stockholders on a pro rata basis in each year. In addition, the Company will also be subject to a tax of 100% of net income from any "prohibited transaction" under the Code and will be subject to a 100% tax on the greater of the amount by which it fails either the 75% or 95% Gross Income Tests, multiplied by a fraction intended to reflect the Company's profitability, if the failure to satisfy such tests is due to reasonable cause and not willful neglect and if certain other requirements are met. The Company may also be subject to the alternative minimum tax on certain items of tax preference with respect to undistributed income. The Company may securitize Mortgage Loans and sell such mortgage securities through a taxable subsidiary. However, if the Company itself were to sell such mortgage securities on a regular basis, there is a substantial risk that they would be deemed dealer property and that all of the profits from such sales would be subject to tax at the rate of 100% as income from "prohibited transactions" under the Code. The Company therefore intends to make any such sales through a taxable subsidiary. The taxable subsidiary will not be subject to this 100% tax on income from prohibited transactions under the Code, which is only applicable to REITs. However, the taxable subsidiary will be subject to federal income, tax on its taxable income at the tax rates applicable to corporations. The Company may elect to retain and pay income tax on all or a portion of its net long-term capital gains for any taxable year, in which case the Company's stockholders would include in their income as long-term capital gains their proportionate share of such undistributed capital gains. The stockholders would be treated as having paid their proportionate share of the income taxes paid by the Company on the undistributed capital gains, which amounts would be credited or refunded to the stockholders. The Company will also be subject to a nondeductible 4% excise tax if it fails to make timely dividend distributions in certain amounts for each calendar year. The Company intends to declare its fourth regular annual dividend during the final quarter of the year and to make such dividend distribution no later than 31 days after the end of the year in order to avoid imposition of the excise tax. Such a distribution would be taxed to the stockholders in the year that the distribution was declared, not in the year paid. Imposition of the excise tax on the Company would reduce the amount of cash available for distribution to its stockholders. TAXABLE SUBSIDIARIES The Company may, in the future, cause the creation and sale of mortgage securities through a taxable corporation or corporations. The Company may own interests in such corporations, known as "taxable REIT subsidiaries," so long as no more than 20% of the value of the Company's gross assets consist of securities of taxable REIT subsidiaries. In addition, the dividends received by the Company from any taxable REIT subsidiaries will not qualify as income from Qualified REIT Real Estate Assets for purposes of the 75% Gross Income Test, and will have to be limited, along with the Company's other interest, dividends, gains on the sale of securities, hedging income and other income not derived from Qualified REIT Real Estate Assets to less than 25% of the Company's gross revenues in each taxable year. If the taxable subsidiary creates a taxable mortgage pool, such pool itself will constitute a separate taxable subsidiary of the taxable subsidiary. The taxable subsidiary would be unable to offset the income derived from such a taxable mortgage pool with losses derived from any other activities. 13 TAXATION OF STOCKHOLDERS For any taxable year in which the Company is treated as a REIT for federal income tax purposes, amounts distributed by the Company to its stockholders out of current or accumulated earnings and profits will be includable by the stockholders as ordinary income for federal income tax purposes unless properly designated by the Company as capital gain dividends. In the latter case, the distributions will be taxable to the stockholders as long-term capital gains. Distributions of the Company will not be eligible for the dividends received deduction for corporate shareholders. Stockholders may not deduct any net operating losses or capital losses of the Company. Any loss on the sale or exchange of shares of the Common Stock held by a stockholder for six months or less will be treated as a long-term capital loss to the extent of any capital gain dividend received on the Common Stock held by such stockholders during the six-month period. If the Company makes distributions to its stockholders in excess of its current and accumulated earnings and profits, those distributions will be considered first a tax-free return of capital, reducing the tax basis of a stockholder's shares until the tax basis is zero. Such distributions in excess of the tax basis will be taxable as a gain realized from the sale of the Company's Common Stock. The Company will notify stockholders after the close of the Company's taxable year as to the portions of the distributions which constitute ordinary income, return of capital and capital gain. Dividends and distributions declared in the last quarter of any year payable to stockholders of record on a specified date in such month may be deemed to have been received by the stockholders and paid by the Company on December 31 of the record year, provided that such dividends are paid before February 1 of the following year. TAXATION OF TAX-EXEMPT ENTITIES In general, a Tax-Exempt Entity that is a stockholder of the Company is not subject to tax on distributions. The IRS has ruled that amounts distributed by a REIT to an exempt employees' pension trust do not constitute UBTI and thus should be nontaxable to such a Tax-Exempt Entity. However, if a Tax-Exempt Entity has financed the acquisition of any of its stock in the Company with "acquisition indebtedness" within the meaning of the Code, distributions on such stock could be treated as UBTI. Under certain conditions, if a tax-exempt employee pension or profit sharing trust were to acquire more than 10% of the Company's Common Stock, a portion of the dividends on such Common Stock could be treated as UBTI. For social clubs, voluntary employee benefit associations, supplemental unemployment benefit trusts, and qualified group legal services plans exempt from federal income taxation under Code Sections 501(c)(7), (c)(9), (c)(17) and (c)(20), respectively, income from an investment in the Company will constitute UBTI unless the organization is able to properly deduct amounts set aside or placed in reserve for certain purposes so as to offset the UBTI generated by its investment in the Company. Such entities should review Code Section 512(a)(3) and should consult their own tax advisors concerning these "set aside" and reserve requirements. STATE AND LOCAL TAXES The Company and its stockholders may be subject to state or local taxation in various jurisdictions, including those in which it or they transact business or reside. The state and local tax treatment of the Company and its stockholders may not conform to the federal income tax consequences discussed above. Consequently, prospective stockholders should consult their own tax advisors regarding the effect of state and local tax laws on an investment in the Common Stock. CERTAIN UNITED STATES FEDERAL INCOME TAX CONSEQUENCES APPLICABLE TO FOREIGN HOLDERS The following discussion summarizes certain United States tax consequences of the acquisition, ownership and disposition of the Common Stock by a purchaser of the Common Stock that, for United States income tax purposes, is not a "United States Holder" (a "Foreign Holder"). For purposes of discussion, a United States Holder means: a citizen or resident of the United States; a corporation, partnership, or other entity created or organized in the United States or under the laws of the United States or of any political subdivision thereof (unless, in the case of a partnership, the IRS provides otherwise by regulations); an estate whose income is includable in gross income for United States income tax purposes regardless of its 14 source; or, a trust if a court within the United States is able to exercise primary supervision over the administration of the trust and one or more United States persons have the authority to control all substantial decisions of the trust. This discussion does not consider any specific facts or circumstances that may apply to a particular Foreign Holder. Prospective investors are urged to consult their tax advisors regarding the United States tax consequences of acquiring, holding and disposing of Common Stock, as well as any tax consequences that may arise under the laws of any foreign, state, local or other taxing jurisdiction. DIVIDENDS. Dividends paid by the Company out of earnings and profits to a Foreign Holder will generally be subject to federal income tax withholding at the rate of 30%, unless reduced or eliminated by an applicable tax treaty or unless such dividends are treated as effectively connected with a United States trade or business conducted by the Foreign Holder. A Foreign Holder eligible for a reduction in withholding under an applicable treaty must so notify the Company by completing the appropriate IRS form. Distributions paid by the Company in excess of its earnings and profits will be treated as a tax-free return of capital to the extent of the holder's adjusted basis in his Common Stock, and thereafter as gain from the sale or exchange of a capital asset as described below. If it cannot be determined at the time a distribution is made whether such distribution will exceed the Company's earnings and profits (which, under most circumstances, will correspond to the Company's net income before the deduction for dividends paid), the distribution will be subject to withholding at the same rate as dividends. However, any amounts withheld will be refundable or creditable against the Foreign Holder's United States tax liability if the Company subsequently determines that such distribution was, in fact, in excess of the earnings and profits of the Company. If the receipt of the dividend is treated as being effectively connected with the conduct of a trade or business within the United States by a Foreign Holder, the dividend received will be subject to the United States federal income tax on net income that applies to United States persons generally (and, in addition with respect to foreign corporate holders and under certain circumstances, the 30% branch profits tax). For any year in which the Company qualifies as a REIT, distributions to a Foreign Holder that are attributable to gain from the sales or exchanges by the Company of "United States real property interests" will be treated as if such gain were effectively connected with a United States business and will thus be subject to tax at the normal capital gain rates applicable to United States stockholders (subject to applicable alternative minimum tax) under the provisions of the Foreign Investment in Real Property Tax Act of 1980 ("FIRPTA"). Also, distributions subject to FIRPTA may be subject to a 30% branch profits tax in the hands of a foreign corporate stockholder not entitled to a treaty exemption. The Company is required to withhold 35% of any distribution that could be designated by the Company as a capital gains dividend. This amount may be credited against the Foreign Holder's FIRPTA tax liability. GAIN ON DISPOSITION. A Foreign Holder will generally not be subject to United States federal income tax on a gain recognized on a sale or other disposition of the Common Stock unless (i) the gain is effectively connected with the conduct of a trade or business within the United States by the Foreign Holder, (ii) in the case of a Foreign Holder who is a nonresident alien individual and holds the Common Stock as a capital asset, such holder is present in the United States for 183 or more days (computed in part by reference to days present in the two prior years) in the taxable year and certain other requirements are met, or (iii) the Foreign Holder is subject to tax under the FIRPTA rules discussed below. Gain that is effectively connected with the conduct of a United States Holder will be subject to the United States federal income tax on net income that applies to United States persons generally (and, with respect to corporate holders and under certain circumstances, the branch profits tax) but will not be subject to withholding. Foreign Holders should consult applicable treaties, which may provide for different rules. Gain recognized by a Foreign Holder upon a sale of its Common Stock will generally not be subject to tax under FIRPTA if the Company is a "domestically controlled REIT," which is defined generally as a REIT in which at all times during a specified testing period less than 50% in value of its shares were held directly or indirectly by non-U.S. persons. Because only a minority of the Company's stockholders are expected to be Foreign Holders, the Company anticipates that it will qualify as a domestically controlled REIT. Accordingly, a Foreign Holder should not be subject to U.S. tax from gains recognized upon disposition of the Common Stock. However, because the Common Stock is publicly traded, no assurance can be given that the Company will continue to be a domestically controlled REIT. INFORMATION REPORTING AND BACKUP WITHHOLDING. United States information reporting requirements and backup withholding tax will generally not apply to dividends paid on the Common Stock to a Foreign Holder at an address outside the United States. Payments by a United States office of a broker of the proceeds of a sale of the Common Stock is subject to both backup withholding at a rate of 31% and information reporting unless the holder certifies its Foreign Holder status under penalties of perjury or otherwise establishes an exemption. Information reporting requirements (but not backup withholding) will also apply to payments of the proceeds of sales of the Common Stock by foreign offices of United States brokers, or foreign brokers with certain types of relationships to the United States, unless the broker has documentary 15 evidence in its records that the holder is a Foreign Holder and certain other conditions are met, or the holder otherwise establishes an exemption. Backup withholding is not an additional tax. Any amounts withheld under the backup withholding rules will be refunded or credited against the Foreign Holder's United States federal income tax liability, provided that the required information is furnished to the IRS. ERISA CONSIDERATIONS In considering an investment in the Common Stock, a fiduciary of a profit-sharing, pension stock bonus plan or individual retirement account ("IRA"), including a plan for self-employed individuals and their employees or any other employee benefit plan subject to prohibited transaction provisions of the Code or the fiduciary responsibility provisions of ERISA (an "ERISA Plan") should consider (a) whether the ownership of Common Stock is in accordance with the documents and instruments governing such ERISA Plan, (b) whether the ownership of Common Stock is consistent with the fiduciary's responsibilities and satisfies the requirements of Part 4 of Subtitle B of Title I of ERISA (where applicable) and, in particular, the diversification, prudence and liquidity requirements of Section 404 of ERISA, (c) ERISA's prohibitions in improper delegation of control over, or responsibility for, "plan assets" and ERISA's imposition of co-fiduciary liability on a fiduciary who participates in, permits (by action or inaction) the occurrence of, or fails to remedy a known breach of duty by another fiduciary and (d) the need to value the assets of the ERISA Plan annually. In regard to the "plan assets" issue noted in clause (c) above, O'Melveny & Myers LLP, the Company's counsel, at the time of the Company's public offering was of the opinion that the Common Stock should qualify as a "publicly offered security," and, therefore, the acquisition of such Common Stock by ERISA Plans should not cause the Company's assets to be treated as assets of such investing ERISA Plans for purposes of the fiduciary responsibility provisions of ERISA or the prohibited transaction provisions of the Code. Fiduciaries of ERISA Plans and IRAs should consult with and rely upon their own advisors in evaluating the consequences under the fiduciary provisions of ERISA and the Code of an investment in Common Stock in light of their own circumstances. COMPETITION The Company believes that the principal competition in the business of acquiring and holding Mortgage Related Assets are financial institutions such as banks, savings and loans, life insurance companies, institutional investors such as mutual funds and pension funds, and certain other mortgage REITs. The Company anticipates that it will be able to compete effectively and generate competitive rates of return for stockholders due to the Manager's experience in managing mortgage capital, access to and experience in secondary mortgage markets, relative freedom to securitize its Mortgage Related Assets, relatively low level of operating costs, ability to utilize prudent amounts of leverage through accessing the wholesale market for collateralized borrowings, freedom from certain forms of regulation and the tax advantages of its REIT status. EMPLOYEES As of December 31, 2000, the Company had no employees. The Manager manages the day to day operations of the Company, subject to the direction and oversight of the Company's Board of Directors and under the terms of a Management Agreement discussed below. THE MANAGEMENT AGREEMENT The Company has entered into a Management Agreement with the Manager for a one year term ending on December 31, 2001. The Manager is primarily involved in two activities: (i) asset/liability management--acquisition, financing, hedging, management and disposition of Mortgage Related Assets, including credit and prepayment risk management; and (ii) capital management--oversight of the Company's structuring, analysis, capital raising and investor relations activities. In conducting these activities, the Manager formulates operating strategies for the Company, arranges for the acquisition of Mortgage Related Assets by the Company, arranges for various types of financing for the Company, monitors the 16 performance of the Company's Mortgage Related Assets and provides certain administrative and managerial services in connection with the operation of the Company. The Manager is required to manage the business affairs of the Company in conformity with the policies that are approved and monitored by the Company's Board of Directors. The Manager is required to prepare regular reports for the Company's Board of Directors that will review the Company's acquisitions of Mortgage Related Assets, portfolio composition and characteristics, credit quality, performance and compliance with the policies approved by the Company's Board of Directors. At all times, the Manager is subject to the direction and oversight of the Company's Board of Directors and will have only such functions and authority as the Company may delegate to it. The Manager is responsible for the day-to-day operations of the Company. The Management Agreement may be renewed for additional one-year terms at the discretion of the Unaffiliated Directors, unless previously terminated by the Company or the Manager upon written notice. Except in the case of a termination or non-renewal by the Company for cause, upon termination or non-renewal of the Management Agreement by the Company, the Company is obligated to pay the Manager a termination or non-renewal fee, which may be significant. The termination or non-renewal fee shall be equal to the fair market value of the Management Agreement without regard to the Company's termination right, as determined by an independent appraisal. The selection of the independent appraiser shall be subject to the approval of the Unaffiliated Directors. Neither the fair market value of the Management Agreement nor the various factors which the appraiser may find relevant in its determination of the fair market value can be determined at this time. The fair market value of the Management Agreement will be affected by significant variables, including (i) the historical management fees paid to the Manager, (ii) any projections of future management fees to be paid to the Manager determined by the independent appraiser, (iii) the relative valuations of agreements similar to the Management Agreement and (iv) other factors, all of which may be unrelated to the performance of the Manager. The Management Agreement may be assigned by the Manager to an Affiliate of TCW without the consent of the Company. The Management Agreement may be assigned to a non-Affiliate of TCW only with the approval of a majority of the Unaffiliated Directors. MANAGER COMPENSATION The Manager will receive annual base management compensation based on the Average Net Invested Capital of the Company, payable monthly in arrears, equal to 3/4 of 1% of Average Net Invested Capital. The term "Average Net Invested Capital" means the month end sum of (1) the Company's total shareholders' equity computed in accordance with generally accepted accounting principles plus (2) any unsecured debt that has been approved for inclusion by the Unaffiliated Directors at issuance plus or minus (3) an adjustment to exclude the impact of any unrealized gains, losses or other items that do not affect realized net income. Accordingly, incurring collateralized debt to finance specific investment purchases does not ordinarily increase Average Net Invested Capital. The Manager shall also be entitled to receive as incentive compensation for each fiscal quarter, an amount equal to 30% of the Net Income of the Company, before incentive compensation, in excess of the amount that would produce an annualized Return on Equity equal to the Ten-Year U.S. Treasury Rate plus 1%. The incentive compensation calculation and payment will be made quarterly in arrears. The term "Return on Equity" is calculated for any quarter by dividing the Company's Net Income for the quarter by its Average Net Worth for the quarter. For purposes of calculating the incentive compensation payable, the definition "Return on Equity" is not related to the actual distributions received by stockholders or to an individual investor's actual return on investment. For such calculations, the "Net Income" of the Company means the taxable income of the Company (including net capital gains, if any) before the Manager's incentive compensation, net operating loss deductions arising from losses in prior periods and deductions permitted by the Code in calculating taxable income for a REIT plus the effects of adjustments, if any, necessary to record hedging and interest transactions in accordance with generally accepted accounting principles. A deduction for all of the Company's interest expenses for borrowed funds is taken into account in calculating Net Income. "Average Net Worth" for any period means the arithmetic average of the sum of the gross proceeds from any offering of its equity securities by the Company, before deducting any underwriting discounts and commissions and other expenses and costs relating to the offerings, plus the Company's retained earnings (without taking into account any losses incurred in prior periods) computed by taking the average of such values at the end of each month during such period, minus the cumulative amounts paid by the Company to repurchase its shares. 17 The ability of the Company to achieve an annualized Return on Equity in excess of the Ten-Year U.S. Treasury Rate plus 1%, and of the Manager to earn the incentive compensation described in the preceding paragraph, is dependent upon the level and volatility of interest rates, the Company's ability to react to changes in interest rates and to utilize successfully the operating strategies described herein, and other factors, many of which are not within the Company's or the Manager's control. The Manager's base compensation shall be calculated by the Manager within 15 days after the end of each month, and such calculation shall be promptly delivered to the Company. The Company is obligated to pay the base compensation within 30 days after the end of each month. The Manager shall compute the quarterly incentive compensation within 45 days after the end of each fiscal quarter, and the Company shall pay the incentive compensation with respect to each fiscal quarter within 15 days following the delivery to the Company of the Manager's written statement setting forth the computation of the incentive compensation for such quarter. The Company's Board of Directors shall review and approve the calculation of base and incentive compensations paid to the Manager quarterly, one quarter in arrears, during each scheduled quarterly Board of Directors meeting. Quarterly incentive compensation is subject to an annual adjustment so that the incentive compensation is based on earnings for the entire year. The Company believes that this compensation arrangement benefits its stockholders because it ties the Manager's compensation to Return on Equity and, in periods of low earnings, the Manager's incentive compensation is reduced or eliminated, thereby lowering the Company's operating expenses. EXPENSES Subject to the limitations set forth below, the Company will generally pay all its operating expenses, except those specifically required to be borne by the Manager under the Management Agreement. The operating expenses required to be borne by the Manager include the compensation of the Company's officers and the cost of office space, equipment and other personnel required for the Company's day-to-day operations. The expenses that are paid by the Company will include (but not necessarily be limited to) the cost of money borrowed by the Company (including interest), taxes and license fees, issuance and transaction costs incident to the acquisition, disposition and financing of investments, costs related to hedging transactions, legal, investigatory, accounting and auditing fees and expenses, consultants' advisory services with respect to REIT and other compliance matters, the compensation and expenses of the Company's Unaffiliated Directors, the costs of making distributions and printing and mailing proxies and reports to stockholders, costs incurred by employees of the Manager for travel on behalf of the Company, costs incident to the issuance of mortgage securities, costs incident to the accumulation and servicing of Mortgage Loans, costs associated with any computer software or hardware that is used solely for the Company, costs to obtain liability insurance to indemnify the Manager, the Company's directors and officers, and the Company's underwriters, the compensations and expenses of the Company's custodian, transfer agent and registrar, and any extraordinary or non-recurring costs or charges incurred by the Company, if any. Certain Company operating expenses shall be limited to an amount per year equal to the greater of 2% of the Average Net Invested Capital of the Company or 25% of its Net Income for that year. The operating expenses that are subject to this limitation are: (i) all insurance costs incurred by the Company or any subsidiary of the Company, including any costs to obtain liability or other insurance to indemnify the Manager and underwriters of any securities of the Company; (ii) expenses connected with payments of dividends or interest or distributions in any other form made or caused to be made by the Board of Directors to holders of the securities of the Company or any subsidiary of the Company; (iii) all expenses of third parties pertaining to communications to holders of equity securities or debt securities of the Company or any subsidiary of the Company and the other bookkeeping and clerical work necessary to maintain relations with holders of such securities and in complying with the continuous reporting and other requirements of governmental bodies or agencies (these expenses include any costs of computer services utilized in connection with these communications and reporting requirements, the cost of printing and mailing certificates for such securities and proxy solicitation materials and reports to holders of the Company's or any subsidiary's securities and reports to third parties required under any indenture to which the Company or any subsidiary of the Company is a party); (iv) custodian's, transfer agent's and registrar's fees and charges; (v) compensation, fees and expenses paid to Unaffiliated Directors of the Company or any subsidiary of the Company, the cost of director and officer liability insurance and premiums for fidelity and errors and omissions insurance; (vi) legal, accounting and auditing fees and expenses relating to the Company's or any subsidiary's operations (excluding litigation-related fees and expenses); 18 (vii) expenses relating to any office or office facilities maintained by the Company or any subsidiary of the Company, exclusive of the office of the Manager; (viii) travel and related expenses of directors, officers and employees of the Manager and of directors, officers and employees of the Company or any subsidiary of the Company who are also directors, officers or employees of the Manager, incurred in connection with attending meetings of the Board of Directors or holders of securities of the Company or any subsidiary of the Company or performing other business activities that relate to the Company or any subsidiary of the Company, including expenses allocable to such meetings or business activities; (ix) costs associated with computer hardware and software, third party information services and office expenses that relate solely to the business activities of the Company; and (x) all other expenses regarded as ordinary operating expenses in accordance with generally accepted accounting principles, exclusive of certain specifically excluded expenses as described below. Expenses excluded from the expense limitation and wholly payable by the Company are (but are not limited to) those incurred in connection with the accumulation and servicing of Mortgage Loans, the issuance and administration of mortgage securities from pools of Mortgage Loans, the raising of capital, the acquisition of Mortgage Related Assets, interest and hedging expenses, taxes and license fees, non-cash costs, litigation, investigations in connection with litigation or threatened litigation, base and incentive management compensation and extraordinary and non-recurring expenses. The determination of Net Income for purposes of calculating the expense limitation will be the same as for calculating the Manager's incentive compensation except that it will include any incentive compensation payable for such period. Expenses in excess of the expense limitation will be paid and shall not be recoverable (by reclassification as compensation or otherwise) by the Manager, unless the Unaffiliated Directors determine that, based upon unusual or non-recurring factors, a higher level of expenses is justified for such fiscal year. In that event, such expenses may be recovered by the Manager in succeeding years to the extent that expenses in succeeding quarters are below the limitation of expenses. Expense reimbursement will be made monthly, subject to adjustment at the end of each year. CERTAIN RELATIONSHIPS; CONFLICTS OF INTEREST In addition to its base management compensation under the Management Agreement, the Manager has the opportunity to earn incentive compensation for each fiscal quarter, subject to an annual reconciliation so that the incentive compensation is based on earnings for the entire calendar year, in an amount equal to 30% of the Net Income of the Company (before payment of such incentive compensation) in excess of the amount that would produce on annualized Return on Equity equal to the Ten-Year U.S. Treasury Rate plus 1%. In evaluating Mortgage Related Assets for investment and in other operating strategies, an undue emphasis on the maximization of income at the expense of other criteria, such as preservation of capital, in order to achieve a higher incentive fee could result in increased risk to the value of the Company's Mortgage Related Asset portfolio. The Company, on the one hand, and the Manager and its Affiliates, on the other hand, do not presently expect to, but may in the future, enter into a number of relationships other than those governed by the Management Agreement, some of which may give rise to conflicts of interest between the Manager and its Affiliates and the Company. The market in which the Company will seek to purchase Mortgage Related Assets is characterized by rapid evolution of products and services and, thus, there may in the future be relationships between the Company and the Manager and its Affiliates in addition to those described herein. Any such relationships or transactions will require the approval of the Company's Board of Directors, including a majority of the Unaffiliated Directors. The Manager and its Affiliates may act as investment adviser or manager for other entities, which may or may not include services similar to those it renders to the Company. Pursuant to the terms of the Management Agreement, the Manager and its Affiliates will agree on the allocation of mortgage securities between the Company and other accounts over which the Manager and its Affiliates have control. The Manager will base allocation decisions on the procedures the Manager considers fair and equitable, including, without limitation, such considerations as investment objectives, restrictions and time horizon, availability of cash and the amount of existing holdings. 19 LIMITS OF RESPONSIBILITY Pursuant to the Management Agreement, the Manager does not assume any responsibility other than to undertake the services called for thereunder and is not responsible for any action of the Company's Board of Directors in following or declining to follow its advice or recommendations. The Manager, its directors and its officers will not be liable to the Company, any issuer of mortgage securities, any subsidiary of the Company, the Unaffiliated Directors, the Company's stockholders or any subsidiary's stockholders for acts performed in accordance with and pursuant to the Management Agreement, except by reason of acts constituting bad faith, willful misconduct, gross negligence or reckless disregard of their duties under the Management Agreement. The Company has agreed to indemnify the Manager, its directors and its officers with respect to all expenses, losses, damages, liabilities, demands, charges and claims arising from any acts or omissions of the Manager made in good faith in the performance of its duties under the Management Agreement. The Management Agreement does not limit or restrict the right of the Manager or any of its officers, directors, employees or Affiliates from engaging in any business or rendering services of any kind to any other person, including the purchase of, or rendering advice to others purchasing Mortgage Related Assets that meet the Company's policies and criteria. The Manager may also advise or manage other mortgage related entities subject to certain limitations, including REITs, that invest in residential and commercial mortgages and other residential and non-residential mortgage securities. The ability of the Manager and its officers and employees to engage in other business activities could reduce the time and effort spent on the Company. The Management Agreement does not specify a minimum amount of time or attention that the Manager or its officers or employees must devote to the Company's business. ITEM 2. PROPERTIES The Company does not own or lease any real property. The Company's principal executive offices are located at 865 South Figueroa Street, Los Angeles, California 90017, telephone (213) 244-0440. Such offices are provided by the Manager in accordance with the Management Agreement. ITEM 3. LEGAL PROCEEDINGS There are no legal proceedings pending against the Company. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS At the 2000 Annual Meeting of Shareholders held June 20, 2000, shareholders of record as of April 28, 2000 were asked to vote to ratify the selection of Deloitte & Touche LLP as the Company's independent auditors. 5,594,139 shares were voted for the proposal, 7,472 shares were voted against the proposal, no shares were withheld, 14,797 shares abstained and no votes were broker non-votes. In addition, the above-described shareholders were asked to vote on the two Class II Directors of the Company's Board of Directors to hold office until the Annual Meeting of Shareholders in 2003. 5,586,315 shares were voted for Peter G. Allen and 30,093 shares were voted against or were withheld. 5,584,715 shares were voted for Philip A. Barach and 31,693 shares were voted against or were withheld. PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS EQUITY MARKET ACTIVITY The Company's Common Stock began trading on December 4, 1997 and is traded on the American Stock Exchange under the trading symbol AXM. The Company previously traded on the New York Stock Exchange. As of March 16, 2001, the Company had 5,753,000 shares of Common Stock issued and outstanding. 20 The following table sets forth the high, low and closing sales prices per share of Common Stock as reported on the New York Stock Exchange composite tape and the cash dividend declared per share of Common Stock.
CASH STOCK PRICE DIVIDENDS ------------------------------- DECLARED 2000 HIGH LOW CLOSE PER SHARE - ---- ---- --- ----- --------- Fourth Quarter ended December 31, 2000 $7.35 $6.80 $6.89 $0.35 Third Quarter ended September 30, 2000 $9.00 $7.06 $7.30 $0.35 Second Quarter ended June 30, 2000 $10.19 $8.50 $8.50 $0.35 First Quarter ended March 31, 2000 $10.56 $8.75 $8.75 $0.46 1999 Fourth Quarter ended December 31, 1999 $12.69 $10.06 $10.19 $0.46 Third Quarter ended September 30, 1999 $13.56 $11.50 $12.38 $0.46 Second Quarter ended June 30, 1999 $13.94 $12.13 $13.31 $0.42 First Quarter ended March 31, 1999 $13.50 $9.86 $13.50 $0.38 1998 Fourth Quarter ended December 31, 1998 $11.13 $7.25 $9.63 $0.30 Third Quarter ended September 30, 1998 $12.06 $9.06 $9.56 $0.27 Second Quarter ended June 30, 1998 $12.75 $10.44 $10.50 $0.25 First Quarter ended March 31, 1998 $14.06 $11.50 $12.38 $0.25
On March 20, 20001 the Company's Board of Directors declared a dividend distribution of $0.35 per share. The dividend is payable on April 20, 2001, to shareholders of record on March 30, 2001. The Company intends to pay quarterly dividends and to make distributions to its stockholders of all or substantially all of its taxable income each year (subject to certain adjustments) so as to qualify for the tax benefits accorded to a REIT under the Code. All distributions will be made by the Company at the discretion of the Board of Directors and will depend on the taxable earnings of the Company, financial condition of the Company, maintenance of REIT status and such other factors as the Board of Directors may deem relevant from time to time. SHARE REPURCHASE PROGRAM On January 13, 1998, the Company's board of directors authorized a program to repurchase up to 750,000 shares of the Company's Common Stock. On September 16, 1998, the Company's board of directors authorized a program to repurchase up to an additional 750,000 shares of the Company's Common Stock having completed the original repurchase program of 750,000 shares. The Company repurchased 947,100 shares of common stock during the year ended December 31, 1998. The average price per share repurchased during the year ended December 31, 1998 was $11.16. The repurchased shares are held in treasury at cost in the financial statements herein. No shares were repurchased during the years ended December 31, 2000 and 1999. An additional 552,900 shares of common stock are currently authorized for potential repurchase in the future. The Company may continue to repurchase shares of common stock in the future when market conditions warrant. 21 ITEM 6. SELECTED FINANCIAL DATA The following selected financial data are derived from audited financial statements for the years ended December 31, 2000, 1999, 1998, and the period from commencement of operations on December 9, 1997 to December 31, 1997. The selected financial data should be read in conjunction with the more detailed information contained in the financial statements and notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations" included elsewhere in this report.
PERIOD FROM YEAR ENDED YEAR ENDED YEAR ENDED DECEMBER 9, 1997 DECEMBER 31, 2000 DECEMBER 31, 1999 DECEMBER 31, 1998 TO DECEMBER 31, 1997 ---------------------------------------------------------------------------- STATEMENT OF OPERATIONS DATA: Days in period 366 365 365 22 Interest income $42,834,000 $52,517,000 $41,975,000 $428,000 Interest expense $33,779,000 $42,345,000 $36,007,000 $111,000 Net interest income $9,055,000 $10,172,000 $5,968,000 $317,000 Net (loss) gain on investment transactions ($36,703,000) $1,938,000 $1,047,000 - General and administrative expenses $1,734,000 $3,385,000 $2,104,000 $167,000 Net (loss) income ($28,243,000) $11,112,000 $5,547,000 $150,000 Average number of shares outstanding 6,190,000 6,700,100 5,753,000 5,753,000 Basic net income per share ($4.91) $1.93 $0.90 $0.02 Diluted net income per share ($4.91) $1.92 $0.90 $0.02 Dividends declared per share $1.51 $1.72 $1.07 $0.04 AT DECEMBER 31, AT DECEMBER 31, AT DECEMBER 31, AT DECEMBER 31, 2000 1999 1998 1997 ---------------------------------------------------------------------------- BALANCE SHEET DATA: Mortgage-backed securities $600,131,000 $701,143,000 $829,713,000 $265,880,000 Other investments $9,068,000 $17,481,000 $16,422,000 - Total assets $614,073,000 $735,745,000 $865,478,000 $271,307,000 Reverse repurchase agreements $545,434,000 $672,660,000 $767,908,000 $87,818,000 Total liabilities $569,690,000 $679,704,000 $777,448,000 $178,310,000 Stockholders' equity $44,383,000 $56,041,000 $88,030,000 $92,997,000 Book value per share $7.71 $9.74 $15.30 $13.88 Fair value of off balance sheet hedging instruments - $3,815,000 ($9,994,000) - Impact of terminated interest rate swap contracts on equity value $2,546,000 - - - Adjusted book value per share $8.16 $10.40 $13.56 $13.88
22 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS GENERAL The Company uses its equity capital and borrowed funds to seek to generate income based on the difference between the yield on its Mortgage Related Assets and the cost of its borrowings. The Company will elect to be taxed as a REIT under the Code. The Company will not generally be subject to federal taxes on its income to the extent that it distributes its net income to its stockholders and maintains its qualification as a REIT. The Company has reviewed its financial instruments to identify those to which SFAS No. 133 and related amendments apply. Management believes that the only instruments for which the accounting will be affected by SFAS No. 133 are the forward contracts used to hedge fixed income securities. The transition adjustment that will be recorded on January 1, 2001 will result in the reclassification of $2,173,000 net losses of unrealized and deferred gains and losses on investment securities and forward contracts from accumulated other comprehensive income to current income. Also, deferred gains on interest rate swaps previously designated as hedges will be reclassified from other liabilities to accumulated other comprehensive income. In conjunction with the adoption of SFAS No. 133 on January 1, 2001, the Company will reclassify $594,469,000 of its mortgage securities from the available-for-sale category to the trading category for investments accounted for under SFAS No. 115. This change will result in the reclassification of $1,742,000 net unrealized gains from accumulated other comprehensive income to current income, in addition to net unrealized gains included in the SFAS No. 133 transition adjustment discussed above. FINANCIAL CONDITION FIXED INCOME SECURITIES At December 31, 2000 and 1999 the Company held $600,131,000 and $701,143,000 of Fixed Income Securities, respectively. The original maturity of a significant portion of the Fixed Income Securities ranges from fifteen to thirty years; the actual maturity is subject to change based on the prepayments of the underlying mortgage loans. The following table is a schedule of Fixed Income Securities held listed by security type (dollars in thousands):
December 31, 2000 December 31, 1999 --------------------------------- ----------------------------------- Fixed Income Securities Carrying Value Percent of Carrying Value Percent of Portfolio Portfolio - ---------------------------------------------------------------------------------------------------------- Mortgage Securities: Adjustable Rate (1) $40,253 6.71% $32,256 4.50% Fixed Rate $554,216 92.35% 662,348 94.50% Other Fixed Income Securities $5,662 0.94% 6,539 1.00% --------------- --------------- --------------- ---------------- Totals $600,131 100.00% $701,143 100.00% =============== =============== =============== ================
(1) At December 31, 2000 and 1999, the interest rate indices for 97% and 3% of the adjustable rate mortgage securities were based on the one-year U.S. Treasury rate and the six-month London Inter-Bank Offered Rate, respectively. 23 The following table shows various weighted average characteristics of the Fixed Income Securities held by the Company at December 31, 2000 (dollars in thousands):
Percent of Weighted Total Par Adjusted Market Current Average Security Type Par Amount Amount Cost Basis Price Coupon Life (1) - ------------------------------------------------------------------------------------------------------------------------ 15 Year Agency/AAA Pass-throughs $145,251 23.90% 98.00% 99.90% 6.50% 4.5 20 Year Agency Pass-throughs 230,193 37.90% 97.00% 99.30% 6.50% 5.6 30 Year Agency Pass-throughs 54,759 9.00% 99.65% 101.23% 7.41% 5.0 AAA CMOs 127,759 21.00% 95.68% 97.92% 6.80% 6.4 ------------------ ------------ ------------- ---------- --------- ------------ Total Fixed Rate Holdings $557,962 91.80% 97.22% 99.33% 6.80% 5.4 Other Fixed Income Securities 10,400 1.70% 64.31% 54.44% 15.89% 1.8 Adjustable Rate Holdings 39,253 6.50% 102.49% 102.55% 8.00% 0.6 ------------------ ------------ ------------- ---------- --------- ------------ Total Portfolio $607,615 100.00% 96.99% 98.77% 6.90% 5.1 ================== ============ ============= ========== ========= ============
The following table shows various weighted average characteristics of the Fixed Income Securities held by the Company at December 31, 1999 (dollars in thousands):
Percent of Weighted Total Par Amortized Market Current Average Security Type Par Amount Amount Cost Basis Price Coupon Life (1) - --------------------------------------------------------------------------------------------------------------------------- 15 Year Agency/AAA Pass-throughs $167,717 23.00% 100.49% 97.30% 6.50% 5.1 20 Year Agency Pass-throughs 251,819 34.50% 100.46% 96.26% 6.50% 6.4 30 Year Agency Pass-throughs 31,424 4.30% 101.36% 95.98% 6.99% 7.7 AAA CMOs 237,202 32.40% 99.76% 95.53% 6.82% 7.2 --------------- ------------ ------------- ----------- ---------- ----------- Total Fixed Rate Holdings $688,162 94.20% 100.26% 96.25% 6.63% 6.4 Other Fixed Income Securities 10,400 1.40% 69.38% 62.88% 15.53% 2.1 Adjustable Rate Holdings 31,923 4.40% 101.73% 101.04% 6.62% 1.0 --------------- ------------ ------------- ----------- ---------- ----------- Total Portfolio $730,485 100.00% 99.89% 95.88% 6.76% 6.1 =============== ============ ============= =========== ========== ===========
(1) The weighted average life of the fixed rate mortgage securities is based upon market prepayment expectations as of the dates shown. The actual weighted average life could be longer or shorter depending on the actual prepayment rates experienced over the life of the securities. The weighted average life shown for the adjustable rate mortgage assets represents the average time until the next coupon reset date. All averages are shown in years. EQUITY SECURITIES At December 31, 2000 and 1999 the Company held $9,068,000 and $17,481,000 of equity securities, respectively. Equity securities consist primarily of investment in equities issued by other real estate investment trusts. 24 At December 31, 2000, equity securities consisted of the following:
(In thousands) Shares Held Adjusted Cost Fair Value -------------------------------------------------- COMMON STOCK: American Residential Investment Trust, Inc. 109 $611 $238 Anworth Mortgage Asset Corporation 222 994 900 Dynex Capital, Inc. 75 122 75 ------------------------------------- Total Common Stock 1,727 1,213 ------------------------------------- CONVERTIBLE PREFERRED STOCK: Capstead Mortgage Corporation, Series B 520 4,408 5,492 Dynex Capital, Inc., Series A 53 420 427 Dynex Capital, Inc., Series B 150 1,167 1,088 Dynex Capital, Inc., Series C 108 968 848 ------------------------------------- Total Convertible Preferred Stock 6,963 7,855 ------------------------------------- Total Equity Securities $8,690 $9,068 =====================================
At December 31, 1999, equity securities consisted of the following:
(In thousands) Shares Held Cost Fair Value -------------------------------------------------- COMMON STOCK: American Residential Investment Trust, Inc. 109 $611 $748 Anthracite Capital, Inc. 500 3,071 3,188 Anworth Mortgage Asset Corporation 222 994 997 Dynex Capital, Inc. 75 1,080 483 Hanover Capital Mortgage Holdings, Inc. 385 1,842 1,396 Impac Commercial Holdings, Inc. 249 1,441 1,307 ------------------------------------- Total Common Stock 9,039 8,119 ------------------------------------- CONVERTIBLE PREFERRED STOCK: Capstead Mortgage Corporation, Series B 520 4,408 4,940 Dynex Capital, Inc., Series A 53 920 715 Dynex Capital, Inc., Series B 150 2,711 1,987 Dynex Capital, Inc., Series C 108 2,292 1,720 ------------------------------------- Total Convertible Preferred Stock 10,331 9,362 ------------------------------------- Total Equity Securities $19,370 $17,481 =====================================
HEDGING INSTRUMENTS The Company utilizes interest rate caps, swaps and similar financial instruments to mitigate the risk of the cost of its variable-rate liabilities exceeding the earnings on its mortgage assets during a period of rising interest rates. Under these agreements, the Company received cash payments to the extent of the excess of three-month LIBOR over the agreements' contract rate times the notional amount. During the year ended December 31, 1999, the Company terminated all outstanding interest rate caps with a notional amount of $900,000,000 which resulted in a realized gain of $172,000 which is included in net gain on investment transactions in the 1999 statement of operations. 25 During the year ended December 31, 1999, the expiration of put options on ten-year U.S. Treasury futures contracts with a notional amount of $50,000,000 resulted in a realized loss of $334,000 which is included in net gain on investment transactions in the 1999 statement of operations. During the year ended December 31, 2000, the Company terminated all outstanding interest rate swap agreements with a combined notional amount of $386,213,000 which resulted in a deferred gain of $5,554,000 that will be amortized over the remaining life of the original swap agreements. The deferred gain is included in liabilities on the balance sheet and the amortization expense is included in interest expense in the statement of operations. During the year ended December 31, 2000, $3,008,000 of the deferred gain was amortized. Approximately 92% of the deferred gain will be amortized by June 30, 2001. The remaining deferred gain will be fully amortized by May 31, 2002. At December 31, 1999, the Company had entered into interest rate swap agreements with the total current notional amount as stated below. Under these agreements, the Company receives a floating rate and pays a fixed rate.
Current Average Unrealized Notional Amount Weighted Average Termination Gains (000) Average Life Fixed Rate Floating Rate Date (000) ---------------------- ------------------ -------------------- ------------------- ------------------- ----------------- $400,129 1.6 years 5.869% 1Mo LIBOR 8/9/2001 $3,815
During the year ended December 31, 1999, the Company terminated interest rate swap agreements with a combined notional amount of $255,530,000 which resulted in a net deferred loss of $66,000, which was fully amortized at August 31, 2000. The deferred loss is included in other comprehensive income on the balance sheet and the amortization expense is included in interest expense in the statement of operations. During years ended December 31, 2000 and 1999, $23,000 and $42,000 of the net deferred loss was amortized, respectively. The Company is generally required to deposit collateral with the swap agreement counter-parties in an amount at least equal to the amount of any unrealized losses. At December 31, 1999 the Company had securities with a fair market value of $2,592,000 on deposit with its counter-parties. At December 31, 1999 the Company received fixed income securities with a fair market value of $1,600,000 as a deposit from a swap agreement counter-party. There can be no assurance that the Company will enter into hedging activities or that, if entered into, such activities will have the desired beneficial impact on the Company's results of operations or financial condition. Moreover, no hedging activity can completely insulate the Company from the risks associated with changes in interest rates and prepayment rates. Hedging involves risk and typically involves costs, including transaction costs. Such costs increase dramatically as the period covered by the hedging increases and during periods of rising and volatile interest rates. The Company may increase its hedging activity and, thus, increase its hedging costs during such periods when interest rates are volatile or rising and hedging costs have increased. The Company intends generally to hedge as much of the interest rate risk as the Manager determines is in the best interest of the shareholders of the Company given the cost of such hedging transactions and the Company's desire to maintain its status as a REIT. The Company's policies do not contain specific requirements as to the percentages or amount of interest rate risk that the Manager is required to hedge. At December 31, 2000, the Company had open forward contracts to sell U.S. Treasury notes with terms stated below.
Current Fair value of Average Unrealized Notional Amount Average Contract contracts Termination Gains (Losses) (000) Price (000) Date (000) ------------------------ --- -------------------- ---------------------- ---------------------- ------------------------ $575,000 101.099 $585,048 1/19/2001 ($3,731)
26 At December 31, 1999, the Company had entered into forward contracts to sell U.S. Treasury notes with terms stated below.
Fair value of Average Unrealized Current Average Contract contracts Termination Gains (Losses) Notional Amount (000) Price (000) Date (000) ------------------------ --- -------------------- ---------------------- ---------------------- ------------------------ $335,000 99.278 $336,492 2/12/2000 $3,909
The contracts were entered into to mitigate the negative impact of rising interest rates on fixed income securities available-for-sale that generally have a market weighted average duration approximately equal to the contracts shown above. The following is a presentation of forward contracts closed during the year ended December 31, 2000:
Deferral Amount (000) --------------------------- Deferred (Losses) $(22,902) Deferred Gains 6,042 --------------------------- Total Deferral $(16,860) ===========================
During the year ended December 31, 2000, forward contracts to sell U.S. Treasury notes with a notional amount of $5,670,000,000 were closed resulting in a net deferred loss of $16,860,000. $8,425,000 of the deferred loss incurred was reclassified from other comprehensive income into net loss on investment transactions in the statement of operations during the year ended December 31, 2000 as part an impairment charge recorded on the underlying assets being hedged. The Company anticipates reclassifying the remaining deferred and unrealized losses from other comprehensive income into a net loss line item in the statement of operations on January 1, 2001 in connection with the adoption of Statement of Financial Accounting Standards ("SFAS") No. 133. During the year ended December 31, 1999, two forward contracts to sell U.S. Treasury notes with a notional amount of $135,000,000 and $100,000,000 were closed resulting in a deferred loss of $390,000 and deferred gain of $51,000, respectively. LIABILITIES The Company has entered into reverse repurchase agreements to finance certain of its mortgage-backed securities. These agreements are secured by a portion of the Company's mortgage-backed securities and bear interest rates that have historically moved in close relationship to LIBOR. At December 31, 2000, the Company had outstanding $545,434,000 of reverse repurchase agreements with a weighted average current borrowing rate of 6.61% and a maturity of 1.1 months. The reverse repurchase agreements were collateralized by mortgage-backed securities with an estimated fair value of $564,274,000. At December 31, 1999, the Company had outstanding $672,660,000 of reverse repurchase agreements with a weighted average current borrowing rate of 5.98% and a maturity of 2.0 months. The reverse repurchase agreements were collateralized by mortgage-backed securities with an estimated fair value of $689,396,000. The Company had $24,256,000 and $7,044,000 of other liabilities at December 31, 2000 and 1999, respectively, consisting primarily of deferred gain on interest rate swaps, accrued interest payable and payables for unsettled securities at December 31, 2000 and accrued interest payable and payables for unsettled securities at December 31, 1999. The Company anticipates settling all other liabilities within one year. 27 OTHER MATTERS At December 31, 2000, the Company held equity securities and senior unsecured notes issued by Dynex Capital, Inc. ("Dynex") with fair market values of $2,437,000 and $3,750,000, respectively. During the year ended December 31, 1999, Dynex suspended the payment of dividends on its preferred stock. Accordingly, the Company is no longer recognizing dividend income on its equity investments in Dynex. Dynex is currently paying interest on its senior notes. Accordingly, the Company is recognizing interest income on the senior note investments issued by Dynex. If Dynex were to suspend payment of interest on its senior notes, interest income recognized by the Company would be negatively impacted. During the year ended December 31, 2000, the Company recorded an impairment reserve of $3,368,000 on its Dynex preferred stock holdings which is included in net loss on investment transactions in the statement of operations. The Company could also incur additional losses if the remaining Dynex investments are sold or written-down further. During the year ended December 31, 2000, the Company recorded an impairment reserve on its Dynex common stock holdings of $958,000 which is included in net loss on investment transactions in the statement of operations. The Company could also incur additional losses if the remaining Dynex investments are sold or written-down further. RESULTS OF OPERATIONS - 2000 COMPARED TO 1999 For the year ended December 31, 2000, the Company's net loss was $28,243,000, or $4.91 per share on a basic and diluted basis, based on a weighted average of 5,753,000 shares outstanding. That compares to net income of $11,112,000, or $1.93 per share on a basic basis and $1.92 on a diluted basis, based on a weighted average of 5,753,000 and 5,779,000 shares outstanding, respectively, for the year ended December 31, 1999. Net interest income for the year ended December 31, 2000 was $9,055,000 consisting of interest income on mortgage assets and cash balances less interest expense on reverse repurchase agreements compared to $10,172,000 for the year ended December 31, 1999. The Company reported dividend income of $1,139,000 from dividends on equity investments for the year ended December 31, 2000 compared to $2,387,000 for the year ended December 31, 1999. The Company reported net losses on investment transactions of $36,703,000 consisting primarily of an impairment charge of $18,284,000 on certain fixed-rate mortgage securities that may be sold prior to maturity, an impairment charge of $4,326,000 on certain equity securities, the recognition of the associated unrealized loss and deferred hedging losses on the impaired assets of $8,425,000, a loss of $5,795,000 on the sale of $193,953,000 of fixed income securities and a gain of $126,000 on the sale of equity securities during the year ended December 31, 2000. The Company realized a net gain of $1,938,000 primarily from the sale of equity investments for the year ended December 31, 1999. The Company incurred operating expenses of $1,734,000 for the year ended December 31, 2000 consisting of incentive fees, management fees, audit, tax, legal, printing, insurance and other expenses compared to $3,385,000 for the year ended December 31, 1999. The following table reflects the average balances for each category of the Company's interest earning assets as well as the Company's interest bearing liabilities, with the corresponding effective rate of interest annualized (dollars in thousands): 28 AVERAGE BALANCE AND RATE TABLE (Dollars in thousands)
For the Year Ended For the Year Ended December 31, 2000 December 31, 1999 ----------------------------- --------------------------- Average Effective Average Effective Balance Rate Balance Rate ------------ ------------ ------------ ----------- Interest Earning Assets: Mortgage Securities $622,350 6.67% $772,464 6.65% Other Fixed Income Assets 6,945 16.09% 5,822 14.40% Cash and Cash Equivalents 3,588 4.96% 6,322 4.76% ------------ ------------ ------------ ----------- Total Interest Earning Assets 632,883 6.76% 784,608 6.69% ------------ ------------ ------------ ----------- Interest Bearing Liabilities: Reverse Repurchase Agreements 576,190 5.86% 732,960 5.78% ------------ ------------ ------------ ----------- Net Interest Earning Assets and Spread $56,693 0.91% $51,648 0.91% ============ ============ ============ ===========
The effective yield data is computed by dividing the annualized net interest income or expense including hedging transactions into the average daily balance shown. The following table reflects the average balances for the Company's equity securities (dollars in thousands): AVERAGE BALANCE AND RATE TABLE (Dollars in thousands)
For the Year Ended For the Year Ended December 31, 2000 December 31, 1999 ---------------------------- --------------------------- Effective Effective Average Dividend Average Dividend Balance Yield Balance Yield ------------ ------------ ------------ ----------- Equity securities $15,578 7.31% $18,763 12.73%
RESULTS OF OPERATIONS - 1999 COMPARED TO 1998 For the year ended December 31, 1999, the Company's net income was $11,112,000, or $1.93 per share on a basic basis and $1.92 on a diluted basis, based on a weighted average of 5,753,000 and 5,779,000 shares outstanding, respectively. That compares to $5,547,000, or $0.90 per share on both a basic and diluted basis, based on a weighted average of 6,190,000 shares outstanding for the year ended December 31, 1998. Net interest income for the year ended December 31, 1999 was $10,172,000 consisting of interest income on mortgage assets and cash balances less interest expense on reverse repurchase agreements compared to $5,968,000 for the year ended December 31, 1998. The Company reported dividend income of $2,387,000 from dividends on equity investments for the year ended December 31, 1999 compared to $636,000 for the year ended December 31, 1998. The Company reported net gains on investment transactions of $1,938,000 primarily from the sale of equity securities during the year ended December 31, 1999. The Company realized a net gain of $1,047,000 primarily from the sale of mortgage-backed securities and other investments for the year ending December 31, 1998. The Company incurred operating expenses of $3,385,000 for the year ended December 31, 1999 consisting of incentive fees, management fees, audit, tax, legal, printing, insurance and other expenses compared to $2,104,000 for the year ended December 31, 1998. The following table reflects the average balances for each category of the Company's interest earning assets as well as the Company's interest bearing liabilities, with the corresponding effective rate of interest annualized (dollars in thousands): 29 AVERAGE BALANCE AND RATE TABLE (Dollars in thousands)
For the Year Ended For the Year Ended December 31, 1999 December 31, 1998 ---------------------------- --------------------------- Average Effective Average Effective Balance Rate Balance Rate ------------ ------------ ------------ ----------- Interest Earning Assets: Mortgage Securities $772,464 6.65% $670,559 6.13% Other Fixed Income Assets 5,822 14.40% 1,324 14.37% Cash and Cash Equivalents 6,322 4.76% 13,923 5.10% ------------ ------------ ------------ ----------- Total Interest Earning Assets 784,608 6.69% 685,806 6.12% ------------ ------------ ------------ ----------- Interest Bearing Liabilities: Reverse Repurchase Agreements 732,960 5.78% 624,865 5.76% ------------ ------------ ------------ ----------- Net Interest Earning Assets and Spread $51,648 0.91% $60,941 0.36% ============ ============ ============ ===========
The effective yield data is computed by dividing the annualized net interest income or expense including hedging transactions into the average daily balance shown. The following table reflects the average balances for the Company's equity securities (dollars in thousands): AVERAGE BALANCE AND RATE TABLE (Dollars in thousands)
For the Year Ended For the Year Ended December 31, 1999 December 31, 1998 ----------------------------- --------------------------- Effective Effective Average Dividend Average Dividend Balance Yield Balance Yield ------------ ------------ ------------ ----------- Equity securities $18,763 12.73% $3,718 17.10%
The effective yield data is computed by dividing the annualized net interest income or expense into the average daily balance shown. LIQUIDITY AND CAPITAL RESOURCES The Company's primary sources of funds as of December 31, 2000 consisted of reverse repurchase agreements totaling $545,434,000. The Company expects to continue to borrow funds in the form of reverse repurchase agreements. At December 31, 2000, the Company had borrowing arrangements with over twenty different investment banking firms. Increases in short-term interest rates could negatively impact the valuation of the Company's mortgage assets which could limit the Company's borrowing ability or cause its lenders to initiate margin calls. The Company will also rely on the cash flow from operations, primarily monthly principal and interest payments to be received on the mortgage assets, for liquidity. The Company believes that equity capital, combined with the cash flow from operations and the utilization of borrowings, will be sufficient to enable the Company to meet anticipated liquidity requirements. If the Company's cash resources are at any time insufficient to satisfy the Company's liquidity requirements, the Company may be required to liquidate mortgage assets or sell debt or additional equity securities. If required, the sale of mortgage assets at prices lower than the carrying value of such assets would result in losses. 30 The Company may in the future increase its capital resources by making additional offerings of equity and debt securities, including classes of preferred stock, common stock, commercial paper, medium-term notes, CMOs and senior or subordinated notes. All debt securities, other borrowings, and classes of preferred stock will be senior to the Common Stock in a liquidation of the Company. The effect of additional equity offerings may be the dilution of stockholders' equity of the Company or the reduction of the price of shares of the Common Stock, or both. The Company is unable to estimate the amount, timing or nature of additional offerings as they will depend upon market conditions and other factors. 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 principles 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 and or fair market value without considering inflation. ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company's two primary components of market risk are interest rate risk and equity price risk as discussed below. INTEREST RATE RISK EFFECT ON NET INCOME. The Company invests in fixed-rate mortgage assets that are expected to be funded with short-term borrowings. During periods of rising interest rates, the borrowing costs associated with funding such fixed-rate assets are subject to increase while the income earned on such assets may remain substantially unchanged. This would result in a narrowing of the net interest spread between the related assets and borrowings and may even result in losses. The Company may enter into derivative transactions seeking to mitigate the negative impact of a rising interest rate environment. Hedging techniques will be based, in part, on assumed levels of prepayments of the Company's mortgage assets. If prepayments are slower or faster than assumed, the life of the mortgage assets will be longer or shorter which would reduce the effectiveness of the Company's hedging techniques and may result in losses on such transactions. Hedging techniques involving the use of derivative securities are highly complex and may produce volatile returns. The hedging activity of the Company will also be limited by the asset and sources of income requirements applicable to the Company as a REIT. EXTENSION RISK. Fixed-rate assets are generally acquired with a projected weighted average life based on certain assumptions regarding prepayments. In general, when a fixed-rate mortgage asset is acquired with borrowings, the Company may, but is not required to, enter into an interest rate swap agreement or other hedging instrument that effectively fixes the Company's borrowing costs for a period close to the anticipated average life of the related asset. This strategy is designed to protect the Company from rising interest rates because the borrowing costs are fixed for the duration of the asset. However, if prepayment rates decrease in a rising interest rate environment, the life of the mortgage asset could extend beyond the term of the swap agreement or other hedging instrument. This situation could negatively impact the Company as borrowing costs would no longer be fixed after the end of the hedging instrument while the income earned on the asset would remain fixed. This situation may also cause the market value of the Company's mortgage assets to decline with little or no offsetting gain from the related hedging transactions. In certain situations, the Company may be forced to sell assets and incur losses to maintain adequate liquidity. PREPAYMENT RISK. Fixed-rate assets in combination with hedging instruments are also subject to prepayment risk. In falling interest rate scenarios, the fixed-rate mortgage assets may prepay faster such that the average life becomes shorter than its related hedging instrument. If this were to happen, the Company would potentially need to reinvest at rates lower than that of the related hedging instrument. This situation may result in the narrowing of interest rate spreads or may cause losses. FORWARD CONTRACT RISK. The Company may also enter in forward contracts to sell U.S. Treasury notes in addition to or instead of interest rate swap agreements. These forward contracts are generally expected to mitigate the impact of rising interest rates on the fair value of the Company's fixed income securities. However, if the interest rate spread between mortgage securities and U.S. Treasury notes were to widen, the fair value of the Company's portfolio would generally be 31 expected to decline. In addition, the use of forward contracts to sell U.S. Treasury notes generally does not directly impact borrowing costs in the same manner as interest rate swap agreements. Therefore, the use of such forward contracts could result in net income volatility during periods of interest rate volatility. The Company also invests in adjustable-rate mortgage assets that are typically subject to periodic and lifetime interest rate caps that limit the amount an adjustable-rate mortgage asset's interest rate can change during any given period, as well as the minimum rate payable. The Company's borrowings will not be subject to similar restrictions. Hence, in a period of increasing interest rates, interest rates on its borrowings could increase without limitation by caps, while the interest rates on its mortgage assets are generally limited by caps. This problem will be magnified to the extent the Company acquires mortgage assets that are not fully indexed. Further, some adjustable-rate mortgage assets may be subject to periodic payment caps that result in some portion of the interest being deferred and added to the principal outstanding. This could result in receipt by the Company of less cash income on its adjustable-rate mortgage assets than is required to pay interest on the related borrowings. These factors could lower the Company's net interest income or cause a net loss during periods of rising interest rates, which would negatively impact the Company's financial condition, cash flows and results of operations. The Company intends to fund a substantial portion of its acquisitions of adjustable-rate mortgage assets with borrowings that have interest rates based on indices and repricing terms similar to, but of somewhat shorter maturities than, the interest rate indices and repricing terms of the mortgage assets. Thus, the Company anticipates that in most cases the interest rate indices and repricing terms of its mortgage assets and its funding sources will not be identical, thereby creating an interest rate mismatch between assets and liabilities. While the historical spread between relevant short-term interest rate indices has been relatively stable, there have been periods, especially during the 1979-1982 and 1994 interest rate environments, when the spread between such indices was volatile. During periods of changing interest rates, such interest rate mismatches could negatively impact the Company's financial condition, cash flows and results of operations. Prepayment rates generally increase when prevailing interest rates fall below the interest rates on existing mortgage assets. In addition, prepayment rates generally increase when the difference between long-term and short-term interest rates declines. Prepayments of mortgage assets could adversely affect the Company's results of operations in several ways. The Company anticipates that a substantial portion of its adjustable-rate mortgage assets may bear initial "teaser" interest rates that are lower than their "fully indexed" rates (the applicable index plus a margin). In the event that such an adjustable-rate mortgage asset is prepaid prior to or soon after the time of adjustment to a fully indexed rate, the Company will have held the mortgage asset while it was less profitable and lost the opportunity to receive interest at the fully indexed rate over the expected life of the adjustable-rate mortgage asset. In addition, the prepayment of any mortgage asset that had been purchased at a premium by the Company would result in the immediate write-off of any remaining capitalized premium amount and consequent reduction of the Company's net interest income by such amount. Finally, in the event that the Company is unable to acquire new mortgage assets to replace the prepaid mortgage assets, its financial condition, cash flow and results of operations could be materially adversely affected. EFFECT ON FAIR VALUE. Another component of interest rate risk is the effect changes in interest rates will have on the market value of the Company's assets. This is the risk that the market value of the Company's assets will increase or decrease at different rates than that of the Company's liabilities including its hedging instruments. The Company primarily assesses its interest rate risk by estimating the duration of its assets and the duration of its liabilities including all hedging instruments. Duration essentially measures the market price volatility of financial instruments as interest rates change. The Company generally calculates duration using various financial models and empirical data. 32 The following sensitivity analysis table shows the estimated impact on the fair value of the Company's interest rate sensitive investments net of its hedging instruments and reverse repurchase agreement liabilities assuming rates instantaneously fall one hundred basis points and rise one hundred basis points. (Dollars are in thousands except per share amounts.)
- ------------------------------------------------------------------------------------------------------- Fair Value for Scenario Shown Interest Interest Rates Fall Rates Rise 100 Basis 100 Basis Points Unchanged Points - ------------------------------------------------------------------------------------------------------- Interest Rate Sensitive Instruments $34,842 $36,130 $32,896 Change in Fair Value ($1,288) - ($3,234) Change as a Percent of Fair Value (0.21%) - (0.54%) Change as a Percent of Stockholders' Equity (2.90%) - (7.29%) Change on a Per Share Basis ($0.22) - ($0.56)
It is important to note that the impact of changing interest rates on fair value can change significantly when interest rates change beyond one hundred basis points from current levels. Therefore, the volatility in fair value for the Company could increase significantly when interest rates change beyond one hundred basis points. In addition, there are other factors that impact the fair value of the Company's interest rate sensitive investments and hedging instruments such as the shape of the yield curve, market expectations as to future interest rate changes and other market conditions. Accordingly, there may be differences between the fair value changes shown above and actual changes in fair value as interest rates change and those differences may be material. The Company has established an interest rate risk management policy that is intended to mitigate the negative impact of changing interest rates. The Company generally intends to mitigate interest rate risk by targeting the difference between the market weighted average duration on its mortgage related assets funded with secured borrowings to the market weighted average duration of such borrowings to one year or less, taking into account all hedging transactions. The Company generally does not intend to have any specific duration target for the portion its mortgage related assets that are not funded by secured borrowings. There can be no assurance that the Company will be able to limit such duration differences and there may be periods of time when the duration difference will be greater than one year. EQUITY PRICE RISK Another component of market risk for the Company is equity price risk. This is the risk that the market value of the Company's equity investments will decrease. The following table shows the impact on the Company's fair value as the price of its equity securities change assuming price decreases of 10% and increases of 10%. Actual price decreases or increases may be greater or smaller. (Dollars are in thousands except per share amounts.)
- ------------------------------------------------------------------------------------------------------- Fair Value for Scenario Shown Prices Prices Decrease Increase 10% Unchanged 10% - ------------------------------------------------------------------------------------------------------- Equity Investments $8,161 $9,068 $9,975 Change in Fair Value (907) - 907 Change as a Percent of Fair Value (10%) - 10% Change as a Percent of Stockholders' Equity (2.0%) - 2.0% Change on a Per Share Basis (0.16) - 0.16
33 Although there is no direct link between changes in fair value and changes in earnings in many cases, a decline in fair value for the Company may translate into decreased earnings over the remaining life of the investment portfolio. If the fair market value of the Company's portfolio were to decline significantly, the Company's overall liquidity may be impaired which could result in the Company being required to sell assets at losses. THE COMPANY'S ANALYSIS OF RISKS IS BASED ON MANAGEMENT'S EXPERIENCE, ESTIMATES, MODELS AND ASSUMPTIONS. THESE ANALYSES RELY ON MODELS OF FINANCIAL INFORMATION WHICH UTILIZE ESTIMATES OF FAIR VALUE AND INTEREST RATE SENSITIVITY. ACTUAL ECONOMIC CONDITIONS OR IMPLEMENTATION OF INVESTMENT DECISIONS BY THE MANAGER MAY PRODUCE RESULTS THAT DIFFER SIGNIFICANTLY FROM THE ESTIMATES AND ASSUMPTIONS USED IN THE COMPANY'S MODELS AND THE PROJECTED RESULTS SHOWN IN THE ABOVE TABLES AND IN THIS REPORT. THESE ANALYSES CONTAIN CERTAIN "FORWARD-LOOKING STATEMENTS" AND ARE SUBJECT TO THE SAFE HARBOR CONTAINED IN THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA The financial statements of the Company and the related notes, together with the Independent Auditors' Report thereon, are set forth on pages F-3 through F-20 on this Form 10-K. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by Item 10 is incorporated herein by reference to the definitive Proxy Statement to be filed within 120 days from December 31, 2000 pursuant to general instruction G(3). ITEM 11. EXECUTIVE COMPENSATION The information required by Item 11 is incorporated herein by reference to the definitive Proxy Statement to be filed within 120 days from December 31, 2000 pursuant to general instruction G(3). ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT The information required by Item 12 is incorporated herein by reference to the definitive Proxy Statement to be filed within 120 days from December 31, 2000 pursuant to general instruction G(3). ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by Item 13 is incorporated herein by reference to the definitive Proxy Statement to be filed within 120 days from December 31, 2000 pursuant to general instruction G(3). 34 PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K (a) Documents filed as part of this report: 1. The following financial statements of the Company are included in Part II, Item 8 of this Annual Report on Form 10-K: - Independent Auditors' Report; - Balance Sheets as of December 31, 2000 and December 31, 1999; - Statements of Operations: Years Ended December 31, 2000, December 31, 1999 and December 31, 1998; - Statements of Stockholders' Equity: Years Ended December 31, 2000, December 31, 1999 and December 31, 1998; - Statements of Cash Flows: Years Ended December 31, 2000, December 31, 1999 and December 31, 1998; - Notes to Financial Statements. 2. Schedules to financial statements: All financial statement schedules have been omitted because they are either inapplicable or the information required is provided in the Company's Financial Statements and Notes thereto, included in Part II, Item 8 of this Annual Report on Form 10-K. 3. Exhibits:
Exhibit Number Exhibit -------- ------- 24.1.1 Powers of Attorney.
(b) Reports on Form 8-K. None. 35 GLOSSARY As used in this Annual Report on Form 10-K, the capitalized and other terms listed below have the meanings indicated. "Affiliate" means, when used with reference to a specified person, any person that directly, or indirectly through one or more intermediaries, controls or is controlled by, or is under common control with the specified person. "Average Net Invested Capital" means the month end sum of (1) the Company's total shareholders' equity computed in accordance with generally accepted accounting principles plus (2) any unsecured debt that has been approved for inclusion by the Unaffiliated Directors at issuance plus or minus (3) an adjustment to exclude the impact of any unrealized gains, losses or other items that do not affect realized net income. "Average Net Worth" means for any period the arithmetic average of the sum of the gross proceeds from the offerings of its equity securities by the Company, before deducting any underwriting discounts and commissions and other expenses and costs relating to the offerings, plus the Company's retained earnings (without taking into account any losses incurred in prior periods) computed by taking the average of such values at the end of each month during such period, minus the cumulative amounts paid by the Company to repurchase its shares. "Bankruptcy Code" means Title 11 of the United States Code, as amended "CMOs" means debt obligations (bonds) that are collateralized by mortgage loans or mortgage certificates other than Mortgage Derivative Securities and subordinated interests. CMOs are structured so that principal and interest payments received on the collateral are sufficient to make principal and interest payments on the bonds. Such bonds may be issued by United States government agencies or private issuers in one or more classes with fixed or variable interest rates, maturities and degrees of subordination that are characteristics designed for the investment objectives of different bond purchasers. "Code" means the Internal Revenue Code of 1986, as amended. "COFI" is the 11th District Cost of Funds Index, the index made available monthly by the Federal Home Loan Bank Board of the cost of funds to members of the Federal Home Loan Bank 11th District. "Committed Secured Borrowings" means (i) CMOs, (ii) structured commercial paper programs, (iii) secured term notes and (iv) other secured financing transactions that generally commit the lender to provide financing to the Company for a specified period of time or to provide financing to the Company to fund specific assets until they mature. "Common Stock" means the Company's shares of Common Stock, $0.01 par value per share. "Company" means Apex Mortgage Capital, Inc., a Maryland corporation. "Conforming Mortgage Loans" means conventional Mortgage Loans that either comply with requirements for inclusion in credit support programs sponsored by Fannie Mae, FHLMC, or GNMA or are FHA or VA Loans, all of which are secured by first mortgages or deeds of trust on single-family (one to four unit) residences. "Dollar-Roll Agreement" means an agreement to sell a security for delivery on a specified future date and a simultaneous agreement to repurchase the same or substantially similar security on a specified future date. "ERISA" means the Employee Retirement Income Security Act of 1974, as amended. "ERISA Plan" means a pension, profit-sharing, retirement or other employee benefit plan that is subject to ERISA. "Fannie Mae" means the federally chartered and privately owned corporation organized and existing under the Federal National Mortgage Association Charter Act (12 U.S.C., ss. 1716 et seq.), formerly known as the Federal National Mortgage Association. "FHA" means the United States Federal Housing Administration. "FHA Loans" means Mortgage Loans insured by the FHA. "FHLMC" means the Federal Home Loan Mortgage Corporation. 36 "FIRPTA" means the Foreign Investment in Real Property Tax Act of 1980, as amended. "Foreign Holder" means a purchaser of the Common Stock that, for United States income tax purposes, is not a United States person. "GNMA" means the Government National Mortgage Association. "High Credit Quality Mortgage Loans" means individual loans secured by residential real property that are either underwritten to credit standards that generally comply with the credit standards approved by Fannie, Freddie Mac or GNMA or pools of loans that have other credit support features that generally reduce the associated credit risk to that of investment grade securities. "High Quality" means either (i) securities that are rated investment grade or above by at least one of the Rating Agencies, or (ii) securities that are unrated but are obligations of the United States or obligations guaranteed by the United States government or an agency or instrumentality thereof. "Interest Only Derivatives" means Mortgage Derivative Securities representing the right to receive interest only or a disproportionately large amount of interest. "Inverse Floaters" means a class of CMOs with a coupon rate that moves inversely to a designated index, such as LIBOR or COFI. Income floaters have coupon rates that typically change at a multiple of the changes at the relevant index rate. Any rise in the index rate (as a consequence of an increase in interest rates) causes a drop in the coupon rate of an Inverse Floater while any drop in the index rate causes an increase in the coupon of an Inverse Floater. "Investment Company Act" means the Investment Company Act of 1940, as amended. "IRAs" means Individual Retirement Accounts. "IRS" means the Internal Revenue Service. "Keogh Plans" means H.R. 10 Plans. "LIBOR" means the London-Inter-Bank Offered Rate. "Management Agreement" means the agreement by and between the Company and the Manager whereby the Manager agrees to perform certain services to the Company in exchange for certain compensation. "Manager" means TCW Investment Management Company, a California corporation. "MBS Group" means the TCW Group's Mortgage-Backed Securities Group. "Mortgage-Backed Securities" means securities representing interests in, or secured by mortgages on residential real property that are not Mortgage Derivative Securities. "Mortgage Derivative Securities" means mortgage backed securities that are (i) Interest Only Derivatives, (ii) Principal Only Derivatives, (iii) inverse interest only derivatives, (iv) Inverse Floaters and (v) other mortgage related derivative instruments. "Mortgage Loans" means Conforming and Nonconforming Mortgage Loans, FHA Loans and VA Loans. "Mortgage Related Assets" means (i) Short-Term Investments, (ii) Mortgage-Backed Securities, (iii) High Credit Quality Mortgage Loans, (iv) Mortgage Derivative Securities and (v) Other Investments. "Net Income" means the taxable income of the Company before the Manager's incentive compensation, net operating loss deductions arising from losses in prior periods and deductions permitted by the Code in calculating taxable income for a REIT, including a deduction for the Company's interest expenses for borrowed funds, plus the effects of adjustments, if any, necessary to record hedging and interest transactions in accordance with generally accepted accounting principles. 37 "Nonconforming Mortgage Loans" means conventional Mortgage Loans that do not conform to one or more requirements of Fannie Mae, FHA, FHLMC, GNMA or VA for participation in one or more of such agencies' mortgage loan credit support programs, such as the principal amounts financed or the underwriting guidelines used in making the loan. "Other Investments" means (i) equity and debt securities issued by other primarily mortgage related finance companies, (ii) interests in mortgage related collateralized bond obligations, (iii) other subordinated interests in pools of Mortgage Related Assets, (iv) commercial mortgage loans and securities, and (v) residential mortgage loans other than High Credit Quality Mortgage Loans. "Principal Only Derivatives" means Mortgage Derivative Securities representing the right to receive principal only or a disproportionate amount of principal. "Qualified REIT Real Estate Assets" means pass-through certificates, Mortgage Loans, agency certificates, and other assets of the type described in Section 856(c)(6)(B) of the Code. "Qualified Temporary Investment Income" means income attributable to stock or debt instruments acquired with new capital of the Company received during the one-year period beginning on the day such proceeds were received. "Rating Agencies" means any nationally recognized rating agency. "REIT" means a real estate investment trust as defined under Section 856 of the Code. "REIT Provisions of the Code" means Sections 856 through 860 of the Code. "Return on Equity" means an amount calculated for any quarter by dividing the Company's Net Income for the quarter by its Average Net Worth for the quarter. "Short-Term Investments" means short-term bank certificates of deposit, short-term United States Treasury securities, short-term United States government agency securities, commercial paper, repurchase agreements, short-term CMOs, short-term asset-backed securities, and other similar types of short-term investment instruments. "Tax-Exempt Entity" means a qualified pension, profit-sharing or other employee retirement benefit plans, Keogh plans, bank commingled trust funds for such plans, and IRAs, and other similar entities intended to be exempt from federal income taxation. "Taxable Income" means for any year the taxable income of the Company for such year (excluding any net income derived either from property held primarily for sale to customers or from foreclosure property) subject to certain adjustments provided in the REIT Provisions of the Code. "TCW" means The TCW Group, Inc. "TCW Group" means TCW and its subsidiaries and Affiliates. "Ten-Year U.S. Treasury Rate" means the arithmetic average of the weekly average yield to maturity for actively traded current coupon U.S. Treasury fixed interest rate securities (adjusted to a constant maturity of ten years) published by the Federal Reserve Board during a quarter, or, if such rate is not published by the Federal Reserve Board, any Federal Reserve Bank or agency or department of the federal government selected by the Company. If the Company determines in good faith that the Ten-Year U.S. Treasury Rate cannot be calculated as provided above, then the rate shall be the arithmetic average of the per annum average yields to maturities, based upon closing asked prices on each business day during a quarter, for each actively traded marketable U.S. Treasury fixed interest rate security with a final maturity date not less than eight nor more than twelve years from the date of the closing asked prices as chosen and quoted for each business day in each such quarter in New York City by at least three recognized dealers in U.S. government securities selected by the Company. "UBTI" means "unrelated trade or business income" as defined in Section 512 of the Code. "Unaffiliated Directors" means those directors that are not affiliated, directly or indirectly, with the Manager or the TCW Group, whether by ownership of, ownership interest in, employment by, any material business or professional 38 relationship with, or serving as an officer or director of the Manager or the TCW Group, and are not employed by or officers of the Company. "Uncommitted Secured Borrowings" means (i) reverse repurchase agreements, (ii) lines of credit, (iii) Dollar-Roll Agreements, and (iv) other secured financing transactions that generally do not commit the lender to continue to provide financing to the Company. "United States Holder" means a purchaser of the Common Stock that, for United States income tax purposes, is a United States person (i.e., is not a Foreign Holder). "VA" means the United States Veterans Administration. "VA Loans" means Mortgage Loans partially guaranteed by the VA under the Serviceman's Readjustment Act of 1944, as amended. 39 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities and Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. Apex Mortgage Capital, Inc. (Registrant) Dated: March 30, 2001 /s/ Philip A. Barach -------------------------------------- Philip A. Barach President and Chief Executive Officer (Principal Executive Officer) Dated: March 30, 2001 /s/ Daniel K. Osborne -------------------------------------- Daniel K. Osborne Executive Vice President Chief Operating Officer and Chief Financial Officer (Principal Accounting Officer) Pursuant to the requirements of the Securities and Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Signature Capacity Date - --------- -------- ---- /s/ Marc I. Stern Chairman of the Board March 30, 2001 - ------------------------------------- Marc I. Stern /s/ Jeffrey E. Gundlach Vice Chairman of the Board March 30, 2001 - ------------------------------------- Chief Investment Officer Jeffrey E. Gundlach /s/ Philip A. Barach President and March 30, 2001 - ------------------------------------- Chief Executive Officer Philip A. Barach (Principal Executive Officer) /s/ Peter G. Allen* Director March 30, 2001 - ------------------------------------- Peter G. Allen /s/ John C. Argue* Director March 30, 2001 - ------------------------------------- John C. Argue /s/ John A. Gavin* Director March 30, 2001 - ------------------------------------- John A. Gavin /s/ Carl C. Gregory III* Director March 30, 2001 - ------------------------------------- Carl C. Gregory III *By: /s/Daniel K. Osborne -------------------------------- Daniel K. Osborne Attorney-in-Fact
40 APEX MORTGAGE CAPITAL, INC. FINANCIAL STATEMENTS AND INDEPENDENT AUDITORS' REPORT FOR INCLUSION IN FORM 10-K FILED WITH SECURITIES AND EXCHANGE COMMISSION DECEMBER 31, 2000 F-1 APEX MORTGAGE CAPITAL, INC. INDEX TO FINANCIAL STATEMENTS
PAGE ---- Independent Auditors' Report F-3 Balance Sheets F-4 Statements of Operations F-5 Statements of Stockholders' Equity F-6 Statements of Cash Flows F-7 Notes to Financial Statements F-8
F-2 INDEPENDENT AUDITORS' REPORT To the Stockholders of Apex Mortgage Capital, Inc. We have audited the accompanying balance sheets of Apex Mortgage Capital, Inc. (the "Company") as of December 31, 2000 and 1999 and the related statements of operations, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2000. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements referred to above present fairly, in all material respects, the financial position of Apex Mortgage Capital, Inc. as of December 31, 2000 and 1999 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2000, in conformity with accounting principles generally accepted in the United States of America. DELOITTE & TOUCHE LLP Los Angeles, California February 9, 2001 F-3 APEX MORTGAGE CAPITAL, INC. BALANCE SHEETS
DECEMBER 31, 2000 DECEMBER 31, 1999 ASSETS Cash and cash equivalents $ 140,000 $ 2,605,000 Fixed income securities available-for-sale, at fair value (Note 3) 600,131,000 701,143,000 Equity securities available-for-sale, at fair value (Note 3) 9,068,000 17,481,000 Accrued interest receivable 3,734,000 6,254,000 Principal payments receivable 288,000 3,537,000 Unrealized gain on forward contracts (Note 11) - 3,909,000 Other assets 712,000 816,000 ---------------- ---------------- $ 614,073,000 $ 735,745,000 ================ ================ LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities Reverse repurchase agreements (Note 5) $ 545,434,000 $ 672,660,000 Payable for unsettled securities 14,514,000 - Accrued interest payable 569,000 3,660,000 Dividend payable 2,073,000 2,724,000 Unrealized loss on forward contracts (Note 11) 3,731,000 - Deferred gain on interest rate swap contracts 2,546,000 - Accrued expenses and other liabilities 823,000 660,000 ---------------- ---------------- 569,690,000 679,704,000 ================ ================ Commitments and contingencies (Notes 3,4,10, and 11) Stockholders' Equity Preferred stock, par value $0.01 per share; 50,000,000 shares authorized; no shares outstanding Common stock, par value $0.01 per share; 100,000,000 shares authorized; 6,700,100 shares outstanding (Notes 7 and 9) 67,000 67,000 Additional paid-in-capital 93,360,000 93,265,000 Accumulated other comprehensive income (loss) (1,079,000) (26,513,000) Accumulated dividend distributions in excess of net income (37,396,000) (209,000) Treasury stock, at cost (947,100 shares) (Note 7) (10,569,000) (10,569,000) ---------------- ---------------- 44,383,000 56,041,000 ---------------- ---------------- $ 614,073,000 $ 735,745,000 ================ ================
See accompanying notes to financial statements F-4 APEX MORTGAGE CAPITAL, INC. STATEMENTS OF OPERATIONS
YEAR ENDED DECEMBER 31, ----------------------------------------------------------------------- 2000 1999 1998 INTEREST INCOME: Fixed income securities $ 42,618,000 $ 52,216,000 $ 41,265,000 Cash and cash equivalents 216,000 301,000 710,000 ---------------------- ---------------------- ---------------------- 42,834,000 52,517,000 41,975,000 INTEREST EXPENSE 33,779,000 42,345,000 36,007,000 ---------------------- ---------------------- ---------------------- NET INTEREST INCOME 9,055,000 10,172,000 5,968,000 ---------------------- ---------------------- ---------------------- NET GAIN (LOSS) ON INVESTMENT TRANSACTIONS (36,703,000) 1,938,000 1,047,000 DIVIDEND INCOME 1,139,000 2,387,000 636,000 GENERAL AND ADMINISTRATIVE EXPENSES: Management fee (Note 8) 512,000 629,000 644,000 Incentive fee (Note 8) - 1,714,000 619,000 Professional fees 382,000 73,000 75,000 Insurance expense 272,000 267,000 267,000 Directors' fees 76,000 60,000 70,000 Stock option expense (Note 9) 95,000 287,000 118,000 Other 397,000 355,000 311,000 ---------------------- ---------------------- ---------------------- 1,734,000 3,385,000 2,104,000 ---------------------- ---------------------- ---------------------- NET INCOME (LOSS) $ (28,243,000) $ 11,112,000 $ 5,547,000 ====================== ====================== ====================== Net Income (Loss) Per Share: Basic $ (4.91) $ 1.93 $ 0.90 ====================== ====================== ====================== Diluted $ (4.91) $ 1.92 $ 0.90 ====================== ====================== ====================== Weighted Average Number of Shares Outstanding: Basic 5,753,000 5,753,000 6,190,000 ====================== ====================== ====================== Diluted 5,753,000 5,779,000 6,190,000 ====================== ====================== ====================== Dividends Declared Per Share $ 1.51 $ 1.72 $ 1.07 ====================== ====================== ======================
See accompanying notes to financial statements F-5 APEX MORTGAGE CAPITAL, INC. STATEMENTS OF STOCKHOLDERS' EQUITY YEAR ENDED DECEMBER 31, 2000
ACCUMULATED ACCUMULATED DIVIDEND COMMON STOCK ADDITIONAL OTHER DISTRIBUTIONS ---------------------- PAID-IN COMPREHENSIVE IN EXCESS OF SHARES AMOUNT CAPITAL INCOME (LOSS) NET INCOME --------- ----------- ----------- -------------- ------------ Balance, January 1, 1998 6,700,100 $ 67,000 $92,860,000 $ 188,000 $ (118,000) Repurchases of common stock -- -- -- -- Issuance of stock options to non-employees (Note 9) -- -- 118,000 -- Net income -- -- -- -- 5,547,000 Other comprehensive income: Net unrealized gain on investments available-for-sale, net of reclassification adjustment (Note 13) -- -- -- 6,501,000 Comprehensive income Dividends declared -- -- -- -- (6,564,000) --------- --------- --------- ------------ ---------- Balance, December 31, 1998 6,700,100 67,000 92,978,000 6,689,000 (1,135,000) Issuance of stock options to non-employees (Note 9) -- -- 287,000 -- -- Net income -- -- -- -- 11,112,000 Other comprehensive income: Net unrealized (loss) on investments available-for-sale, net of reclassification adjustment (Note 13) -- -- -- (37,111,000) -- Unrealized gain on forward contracts -- -- -- 3,909,000 Dividends declared -- -- -- -- (10,186,000) --------- --------- --------- ------------ ---------- Balance, December 31, 1999 6,700,100 67,000 93,265,000 (26,513,000) (209,000) Issuance of stock options to non-employees (Note 9) 95,000 Net loss ($28,243,000) Other comprehensive income: Net unrealized gain on investments available-for-sale, net of reclassification adjustment (Note 13) 32,860,0000 Unrealized (loss) and net deferred losses on forward contracts, net of reclassification adjustment (Note 13) (7,426,000) Comprehensive income (loss) Dividends declared (8,944,000) --------- --------- --------- ------------ ---------- Balance, December 31, 2000 6,700,100 $ 67,000 $93,360,000 $ (1,079,000) ($37,396,000) ========= ========= ========= ============ ========== TREASURY COMPREHENSIVE STOCK, AT INCOME/(LOSS) COST TOTAL -------------- ---------- ---------- Balance, January 1, 1998 $92,997,000 Repurchases of common stock $(10,569,000) (10,569,000) Issuance of stock options to non-employees (Note 9) 118,000 Net income $ 5,547,000 -- 5,547,000 Other comprehensive income: Net unrealized gain on investments available-for-sale, net of reclassification adjustment (Note 13) 6,501,000 -- 6,501,000 ------------ Comprehensive income $ 12,048,000 ============ Dividends declared -- (6,564,000) ---------- ---------- Balance, December 31, 1998 (10,569,000) 88,030,000 Issuance of stock options to non-employees (Note 9) -- 287,000 Net income $ 11,112,000 -- 11,112,000 Other comprehensive income: Net unrealized (loss) on investments available-for-sale, net of reclassification adjustment (Note 13) (37,111,000) -- (37,111,000) Unrealized gain on forward contracts 3,909,000 -- 3,909,000 Comprehensive) income (loss) $(22,090,000) -- ============ Dividends declared -- (10,186,000) ---------- ---------- Balance, December 31, 1999 (10,569,000) 56,041,000 Issuance of stock options to non-employees (Note 9) 95,000 Net loss (28,243,000) (28,243,000) Other comprehensive income: Net unrealized gain on investments available-for-sale, net of reclassification adjustment (Note 13) 32,860,000 32,860,000 Unrealized (loss) and net deferred losses on forward contracts, net of reclassification adjustment (Note 13) (7,426,000) (7,426,000) ------------ Comprehensive income (loss) $ (2,809,000) ============ Dividends declared (8,944,000) ---------- ---------- Balance, December 31, 2000 $(10,569,000) $44,383,000 ========== ==========
F-6 APEX MORTGAGE CAPITAL, INC. STATEMENTS OF CASH FLOWS
YEAR ENDED DECEMBER 31, ------------------------------------------------------------- 2000 1999 1998 OPERATING ACTIVITIES: Net Income (Loss) $ (28,243,000) $ 11,112,000 $ 5,547,000 Adjustments to reconcile net income to net cash provided by operating activities: Amortization (2,559,000) 668,000 3,533,000 Net (gain) loss on investment transactions 36,703,000 (1,938,000) (1,047,000) Change in assets and liabilities: Accrued interest receivable 2,520,000 (1,103,000) (3,835,000) Other assets 104,000 (239,000) 275,000 Accrued interest payable (3,091,000) (2,513,000) 6,063,000 Accrued expenses and other liabilities 163,000 (92,000) (724,000) ------------------ ------------------- ------------------- Net cash provided by operating activities 5,597,000 5,895,000 9,812,000 ------------------ ------------------- ------------------- INVESTING ACTIVITIES: Purchase of equity securities - (12,946,000) (19,716,000) Purchase of fixed income securities (133,930,000) (117,094,000) (1,511,359,000) Purchase of interest rate caps - - (80,000) Payments on closed forward contracts (23,283,000) - - Proceeds from sales of equity securities 6,481,000 9,636,000 1,662,000 Proceeds from sales of fixed income securities 193,953,000 40,406,000 594,201,000 Proceeds from closed forward contracts 6,091,000 - - Proceeds from sales of interest rate caps - 172,000 - Proceeds from terminating interest rate swaps 5,554,000 - - Principal payments on fixed income securities 73,893,000 168,344,000 270,608,000 ------------------ ------------------- ------------------- Net cash provided by (used in) investing activities 128,759,000 88,518,000 (664,684,000) ------------------ ------------------- ------------------- FINANCING ACTIVITIES: Net proceeds from reverse repurchase agreements (127,226,000) (95,248,000) 680,090,000 Dividend distributions (9,595,000) (9,239,000) (5,055,000) Purchase of treasury stock - - (10,569,000) ------------------ ------------------- ------------------- Net cash used in financing activities (136,821,000) (104,487,000) 664,466,000 ------------------ ------------------- ------------------- NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS (2,465,000) (10,074,000) 9,594,000 CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 2,605,000 12,679,000 3,085,000 ------------------ ------------------- ------------------- CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 140,000 $ 2,605,000 $ 12,679,000 ================== =================== =================== SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Cash paid for interest $ 39,711,000 $ 44,970,000 $ 29,944,000 ================== =================== =================== NONCASH INVESTING AND FINANCING ACTIVITIES: Net unrealized loss on securities available-for-sale and forward contracts $ 25,434,000 $ (33,202,000) $ 6,501,000 ================== =================== =================== Principal payments, not yet received $ 3,249,000 $ 2,600,000 $ 937,000 ================== =================== =================== Securities purchased, not yet settled $ 14,514,000 $ 838,000 $ 87,800,000 ================== =================== =================== Dividends declared, not yet paid $ 2,073,000 $ 2,724,000 $ 1,777,000 ================== =================== ===================
See accompanying notes to financial statements F-7 APEX MORTGAGE CAPITAL, INC. NOTES TO FINANCIAL STATEMENTS NOTE 1 - THE COMPANY Apex Mortgage Capital, Inc. (the "Company") was incorporated in Maryland on September 15, 1997. The Company commenced its operations of acquiring and managing a portfolio of mortgage assets on December 9, 1997, upon receipt of the net proceeds from the initial public offering of the Company's common stock. The Company uses its equity capital and borrowed funds to seek to generate income based on the difference between the yield on its investments and the cost of its borrowings. The Company is structured for tax purposes as a real estate investment trust ("REIT") under the Internal Revenue Code of 1986, as amended (the "Code"). NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES CASH AND CASH EQUIVALENTS Cash and cash equivalents include cash and highly liquid investments with original maturities of three months or less. The carrying amount of cash equivalents approximates their fair value. FIXED INCOME SECURITIES The Company's fixed income securities consist primarily of residential mortgage securities and other fixed income securities. All fixed income securities are recorded at cost on the date the assets are purchased. Realized gains and losses on sales of the securities are determined on an average cost basis. A majority of the Company's fixed income securities are expected to qualify as real estate assets under the REIT Provisions of the Code. Interest income on the Company's mortgage securities is accrued based on the actual coupon rate and the outstanding principal amount. Premiums and discounts are amortized into interest income over the lives of the securities using the effective yield method adjusted for the effects of estimated prepayments. Interest income on the Company's other fixed income securities is accrued using the effective interest method applied prospectively based on current market assumptions. When securities are deemed to be impaired, an impairment reserve is recorded. Such reserve is accounted for as an adjustment to the cost of the securities and is accreted into income on the same basis as the original discount. The Company's policy is to generally classify its fixed income securities as available-for-sale. The fixed income securities are reported at fair value with unrealized gains and losses excluded from earnings and reported in accumulated other comprehensive income. EQUITY SECURITIES The Company's equity securities consist primarily of equity securities issued by other real estate investment trusts. Dividend income on equity securities is recorded on the declaration date. Realized gains and losses on sales of the securities are determined on an average cost basis. A majority of the Company's equity securities are expected to qualify as real estate assets under the REIT Provisions of the Code. The Company's policy is to generally classify its equity securities as available-for-sale. Equity securities are reported at fair value with unrealized gains and losses excluded from earnings and reported in accumulated other comprehensive income. INTEREST RATE HEDGING TRANSACTIONS The Company enters into interest rate swap and interest rate cap agreements in order to mitigate the impact of rising interest rates on the cost of its short-term borrowings. Amounts payable or receivable from such agreements are accounted for on an accrual basis and recognized as a net adjustment to interest expense. Premiums paid for cap agreements accounted for as hedges are recorded as other assets and amortized over the lives of such agreements as an adjustment to interest expense. Realized gains and losses on terminated swaps F-8 accounted for as hedges are recorded as other assets or other liabilities and amortized over the original lives of the agreements as an adjustment to interest expense. The Company also enters into forward contracts to sell U.S. Treasury notes in order to mitigate the negative impact of rising interest rates on the fair value of its fixed income securities available-for-sale. Unrealized gains and losses on open forwards are shown as assets and liabilities, respectively, and as accumulated other comprehensive income in the balance sheets. Realized gains and losses on terminated forwards are recorded as deferred gains and losses and included in accumulated other comprehensive income in the balance sheets, and are amortized over the remaining lives of the fixed income securities being hedged as an adjustment to income in the statements of operations. STOCK BASED COMPENSATION The Company grants stock options to its directors and officers and to certain directors, officers and employees of its investment manager and the investment manager itself, as discussed in Note 9. Options granted to directors of the Company are accounted for using the intrinsic value method, and generally no compensation expense is recognized in the statements of operations for such options. Other options are accounted for using the fair value method; such options are measured at their fair value when they are granted and are recognized as a general and administrative expense during the periods when the options vest and the related services are performed. FEDERAL AND STATE INCOME TAXES The Company has elected to be taxed as a REIT and generally is not subject to federal and state taxes on its income to the extent it distributes annually 95% of its predistribution taxable income to stockholders and meets certain other asset, income and stock ownership tests. As such, no accrual for income taxes has been included in the financial statements. NET INCOME PER SHARE Basic net income per share is calculated on the basis of the weighted average number of common shares outstanding during each period. Diluted net income per share includes the additional dilutive effect of common stock equivalents and outstanding stock options, and is calculated using the treasury stock method. Stock options that could potentially dilute net income per share in the future were not included in the computation of diluted net income per share in 2000 and 1998 because they would have been antidilutive for the period presented. INCOME RECOGNITION Income and expenses are recorded on the accrual basis of accounting. CREDIT RISK The Company has limited its exposure to credit losses on its portfolio of fixed income securities by purchasing securities that are either rated "AAA" by at least one nationally recognized rating agency or are issued by the Federal Home Loan Mortgage Corporation ("FHLMC"), Fannie Mae (formerly known as the Federal National Mortgage Corporation) or the Government National Mortgage Association ("GNMA"). The payment of principal and interest on the FHLMC, Fannie Mae and GNMA securities are guaranteed by those respective agencies. In addition, the Company has the ability to purchase up to 10% of the portfolio in below investment grade securities. USE OF ESTIMATES The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. F-9 RECENTLY ISSUED ACCOUNTING STANDARDS In June 1998, the Financial Accounting Standards Board issued SFAS No. 133, ACCOUNTING FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES. The Statement and subsequent amendments establish accounting and reporting standards requiring that every derivative instrument (including certain derivative instruments embedded in other contracts) be recorded in the balance sheet as either an asset or liability measured at its fair value. The Statement requires that changes in the derivative's fair value be recognized currently in earnings unless specific hedge accounting criteria are met. Special accounting for qualifying hedges allows a derivative's gains and losses to offset related results on the hedged item in the income statement, and requires that a company must formally document, designate, and assess the effectiveness of transactions that receive hedge accounting. SFAS No. 133, as amended, is effective for the Company's fiscal year beginning January 1, 2001. The Company has reviewed its financial instruments to identify those to which SFAS No. 133 and related amendments apply. Management believes that the only instruments for which the accounting will be affected by SFAS No. 133 are the forward contracts used to hedge fixed income securities. The transition adjustment that will be recorded on January 1, 2001 will result in the reclassification of $2,173,000 net losses of unrealized and deferred gains and losses on investment securities and forward contracts from accumulated other comprehensive income to current income. Also, deferred gains on interest rate swaps previously designated as hedges will be reclassified from other liabilities to accumulated other comprehensive income. In conjunction with the adoption of SFAS No. 133 on January 1, 2001, the Company will reclassify $594,469,000 of its mortgage securities from the available-for-sale category to the trading category for investments accounted for under SFAS No. 115. This change will result in the reclassification of $1,742,000 net unrealized gains from accumulated other comprehensive income to current income, in addition to net unrealized gains included in the SFAS No. 133 transition adjustment discussed above. During the year ended December 31, 1999, the Company wrote off $64,000 of unamortized organization costs in accordance with the adoption of SOP 98-5, REPORTING ON THE COST OF START-UP ACTIVITIES. NOTE 3 - FIXED INCOME AND EQUITY SECURITIES At December 31, 2000, fixed income securities consisted of the following:
Adjustable Rate Fixed Rate Other Fixed (in thousands) Mortgage Mortgage Income Securities Securities Securities Total --------------------------------------------------------------- Principal Amount $39,253 $557,962 $10,400 $607,615 Unamortized Premium (Discount) 978 (2,154) (3,712) (4,888) Impairment Reserve - (13,375) (13,375) --------------------------------------------------------------- Adjusted Cost 40,231 542,433 6,688 589,352 Unrealized Gains 46 11,783 - 11,829 Unrealized Losses (24) - (1,026) (1,050) --------------------------------------------------------------- Fair Value $40,253 $554,216 $5,662 $600,131 ===============================================================
F-10 At December 31, 1999, fixed income securities consisted of the following:
(in thousands) Adjustable Rate Fixed Rate Other Fixed Mortgage Mortgage Income Securities Securities Securities Total --------------------------------------------------------------- Principal Amount $31,923 $688,162 $10,400 $730,485 Unamortized Premium (Discount) 553 1,823 (3,185) (809) --------------------------------------------------------------- Amortized Cost 32,476 689,985 7,215 729,676 Unrealized Gains 33 - - 33 Unrealized Losses (253) (27,637) (676) (28,566) --------------------------------------------------------------- Fair Value $32,256 $662,348 $6,539 $701,143 ===============================================================
The contractual final maturity of the mortgage loans supporting the mortgage securities is generally between 15 and 30 years at origination. Because of prepayments on the underlying mortgage loans, the actual weighted-average maturity is expected to be less. A portion of the other fixed income securities generally have an original maturity of five years subject to certain acceleration provisions. The expected average remaining maturity at December 31, 2000 and 1999 was approximately 2.0 and 3.0 years, respectively. The remaining portion has a fixed remaining maturity of approximately 1.5 years as of December 31, 2000. A portion of the adjustable rate mortgage securities are typically subject to periodic and lifetime caps that limit the amount an adjustable rate mortgage-backed security's interest rate can change during any given period and over the life of the asset. At December 31, 2000, the portion of adjustable rate mortgage securities that were subject to periodic and lifetime caps had an average periodic cap equal to 2.0% per annum and an average lifetime cap equal to 11.3%. At December 31, 1999, the average periodic cap on the adjustable rate mortgage assets was 2.0% per annum and the average lifetime cap was equal to 11.3%. During the year ended December 31, 2000 the Company realized $741,000 and $6,536,000 in gains and losses, respectively, on the sale of $97,440,000 and $96,513,000 of fixed income securities, respectively, which were classified as available-for-sale. During the year ended December 31, 1999 the Company realized $219,000 and $25,000 in gains and losses, respectively, on the sale of $5,684,000 and $34,722,000 of fixed income securities, respectively, which were classified as available-for-sale. During the year ended December 31, 1998 the Company realized $972,000 in gains on the sale of $594,201,000 of fixed income securities which were classified as available-for-sale. During the year ended December 31, 2000, the Company recorded an impairment reserve of $18,284,000 on its fixed-rate mortgage securities, which is included in net loss on investment transactions in the statements of operations. The impairment reserve represents an other-than-temporary decline in the fair value, as of September 30, 2000, of investments held that the Company no longer intends to hold until maturity. A portion of these investments were sold in the fourth quarter of 2000. The Company could also incur additional losses (or recapture losses already recognized) depending on the actual proceeds of future investment sales or if further impairment charges are required. F-11 The net deferred loss and unrealized loss of $7,345,000 and $1,079,000, respectively, on forward contracts were reclassified from other comprehensive income into net loss on investment transactions in the statement of operations during the year ended December 31, 2000 as part of the impairment charge recorded on the underlying assets being hedged. At December 31, 2000 and 1999, equity securities consisted of the following:
(in thousands) December 31, 2000 December 31, 1999 ------------------------ ----------------------- Cost $13,016 $19,370 Unrealized Gains 1,091 789 Unrealized Losses (713) (2,678) Impairment Reserve (4,326) - ------------------------ ----------------------- Fair Value $9,068 $17,481 ======================== =======================
During the year ended December 31, 2000 the Company realized $348,000 and $222,000 in gains and losses, respectively, on the sale of $3,419,000 and $3,062,000 of equity securities, respectively, which were classified as available-for-sale. During the year ended December 31, 1999 the Company realized $1,916,000 and $10,000 in gains and losses, respectively, on the sale of $9,495,000 and $141,000 of equity securities, respectively, which were classified as available-for-sale. During the year ended December 31, 1998, the Company realized $303,000 in gains on the sale of $1,662,000 of equity securities, which were classified as available-for-sale. At December 31, 2000, the Company held equity securities and senior unsecured notes issued by Dynex Capital, Inc. ("Dynex") with fair market values of $2,437,000 and $3,750,000, respectively. During the year ended December 31, 1999, Dynex suspended the payment of dividends on its preferred stock. Accordingly, the Company is no longer recognizing dividend income on its equity investments in Dynex. Dynex is currently paying interest on its senior notes. Accordingly, the Company is recognizing interest income on the senior note investments issued by Dynex. If Dynex were to suspend payment of interest on its senior notes, interest income recognized by the Company would be negatively impacted. During the year ended December 31, 2000, the Company recorded an impairment reserve of $3,368,000 on its Dynex preferred stock holdings which is included in net loss on investment transactions in the statement of operations. The Company could also incur additional losses if the remaining Dynex investments are sold or written down further. During the year ended December 31, 2000, the Company recorded an impairment reserve on its Dynex common stock holdings of $958,000 which is included in net loss on investment transactions in the statement of operations. The Company could also incur additional losses if the remaining Dynex investments are sold or written down further. NOTE 4 - INTEREST RATE CAP AGREEMENTS AND TREASURY PUT OPTIONS Interest rate cap agreements include the carrying value of interest rate caps purchased by the Company to mitigate the impact of rising interest rates on the cost of its short-term borrowings. As discussed in Note 10, the Company has entered into certain interest rate swap transactions. The execution of these swaps eliminated the need for the cap protection previously purchased. Accordingly, the interest rate cap agreements no longer qualified for hedge accounting and were written down to zero during the year ended December 31, 1998. During the year ended December 31, 1999, the interest rate caps were sold, resulting in a realized gain of $172,000, which is included in net gain on investment transactions in the 1999 statement of operations. There were no outstanding interest rate cap agreements as of December 31, 2000 and 1999. Under these agreements, the Company received cash payments to the extent of the excess of the three-month London Interbank Offered Rate ("LIBOR") over the agreements' contract rate times the notional amount. During the year ended December 31, 1999, the Company purchased put options on ten-year U.S. Treasury futures contracts with a notional amount of $50,000,000. The options did not qualify for hedge accounting under SFAS No. 80 and were therefore accounted for as trading securities under SFAS No. 115. The options F-12 expired during 1999, which resulted in a realized loss of $334,000, which is included in net gain on investment transactions in the 1999 statement of operations. NOTE 5 - REVERSE REPURCHASE AGREEMENTS The Company has entered into reverse repurchase agreements to finance certain of its investments. These agreements are secured by a portion of the Company's investments and bear interest rates that have historically moved in close relationship to LIBOR. At December 31, 2000, the Company had outstanding $545,434,000 of reverse repurchase agreements with a weighted average current borrowing rate of 6.61% and a maturity of 1.1 months. The reverse repurchase agreements were collateralized by securities with an estimated fair value of $564,274,000. At December 31, 1999, the Company had outstanding $672,660,000 of reverse repurchase agreements with a weighted average current borrowing rate of 5.98% and a maturity of 2.0 months. The reverse repurchase agreements were collateralized by securities with an estimated fair value of $689,396,000. For the year ended December 31, 2000, the average reverse repurchase agreement balance was $576,190,000 with a weighted average interest cost of 6.33%. The maximum reverse repurchase agreement balance outstanding during the year ended December 31, 2000 was $672,660,000. For the year ended December 31, 1999, the average reverse repurchase agreement balance was $732,960,000 with a weighted average interest cost of 5.28%. The maximum reverse repurchase agreement balance outstanding during the year ended December 31, 1999 was $812,019,000. NOTE 6 - FAIR VALUE OF FINANCIAL INSTRUMENTS The following table presents the amortized cost and estimated fair values of the Company's financial instruments. SFAS 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 or liquidation sale (dollars in thousands):
At December 31, 2000 At December 31, 1999 ----------------------- ------------------------ Adjusted Fair Adjusted Fair Cost Value Cost Value ------------------------ ------------------------ Mortgage related securities $582,664 $594,469 $722,461 $694,604 Equity securities 8,690 9,068 19,360 17,481 Other fixed income securities 6,688 5,662 7,215 6,539 Interest rate swaps - - - 3,815 Forward contracts - (3,731) - 3,909
Adjusted cost in the table above includes the net effect of unamortized impairment reserves. The Company bases its fair value estimates for mortgage related securities, equity securities, other fixed income securities, interest rate swaps, and forward contracts primarily on third party price indications provided by dealers who make markets in these financial instruments 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 and reverse repurchase agreements are reflected in the financial statements at their costs, which approximates their fair value because of the short-term nature of these instruments. F-13 NOTE 7 - STOCK REPURCHASE PROGRAM The Company's Board of Directors has authorized a program to repurchase shares of the Company's common stock. At December 31, 2000 and 1999, the Company was authorized to repurchase an additional 552,900 shares of the Company's common stock pursuant to the repurchase program. At December 31, 2000 and 1999, the Company held 947,100 shares of treasury stock repurchased in 1998. During the years ended December 31, 2000 and 1999, the Company did not repurchase any treasury shares. NOTE 8 - TRANSACTIONS WITH AFFILIATES The Company has entered into a Management Agreement (the "Management Agreement"), as amended, with TCW Investment Management Company (the "Manager"), a wholly owned subsidiary of The TCW Group, Inc., under which the Manager will manage its day-to-day operations, subject to the direction and oversight of the Company's Board of Directors. The Company will pay the Manager annual base management compensation, payable monthly in arrears, equal to 3/4 of 1% of the average net invested capital as further defined in the Management Agreement. The Company recorded expense of $512,000, $629,000, and $644,000 in base management compensation to the Manager during the years ended December 31, 2000, 1999 and 1998, respectively. The accrued liability for base management compensation was $85,000 and $157,000 at December 31, 2000 and 1999, respectively. The Company also pays the Manager, as incentive compensation, an amount equal to 30% of the Net Income of the Company, before incentive compensation, in excess of the amount that would produce an annualized return on equity equal to the ten-year US Treasury rate plus 1% as further defined in the Management Agreement. The Company recorded expense of $1,714,000 and $619,000 for incentive compensation to the Manager for the years ended December 31, 1999 and 1998, respectively. No incentive compensation was incurred for the year ended December 31, 2000. There was no accrued liability for incentive compensation at December 31, 2000. The accrued liability for incentive compensation was $216,000 at December 31, 1999. The Company may also grant stock options to directors, officers and key employees of the Company, the Manager, its directors, officers and key employees (see Note 9). The Management Agreement may be renewed each year at the discretion of the Company's Board of Directors, unless previously terminated by the Company or the Manager upon written notice. Except in the case of a termination or non-renewal by the Company for cause, upon termination or non-renewal of the Management Agreement by the Company, the Company is obligated to pay the Manager a termination or non-renewal fee, which may be significant. The termination or non-renewal fee shall be equal to the fair market value of the Management Agreement without regard to the Company's termination right, as determined by an independent appraisal. Neither the fair market value of the Management Agreement nor the various factors that an appraiser may find relevant in its determination of the fair market value can be determined at this time. The fair market value of the Management Agreement will be affected by significant variables, including (i) the historical management fees paid to the Manager, (ii) any projections of future management fees to be paid to the Manager determined by the independent appraiser, (iii) the relative valuations of agreements similar to the Management Agreement and (iv) other factors, all of which may be unrelated to the performance of the Manager. Similar management agreements have been valued at as much as eight times the historical annual fees paid under such agreements. Any termination or non-renewal fee paid may be materially greater than eight times historical fees and the Company can provide no assurance at this time as to the amount of any such fee. The Company's other fixed income investments include securities that are issued by special purpose companies that invest primarily in mortgage-related assets. The Manager serves as the investment manager to these companies and is paid fees in connection with such services. The Company does not anticipate paying any management fees directly to the Manager in connection with these investments. F-14 NOTE 9 - STOCK OPTIONS The Company has adopted a stock option plan (the "Amended and Restated 1997 Stock Option Plan") that provides for the grant of both qualified incentive stock options that meet the requirements of Section 422 of the Code, and non-qualified stock options, stock appreciation rights and dividend equivalent rights. Stock options may be granted to directors of the Company ("employees"), and to the Manager and the directors, officers and key employees of the Manager ("non-employees"). The exercise price for any stock option granted under the Amended and Restated 1997 Stock Option Plan may not be less than 100% of the fair market value of the shares of common stock at the time the option is granted. Each option must terminate no more than ten years from the date it is granted. Subject to anti-dilution provisions for stock splits, stock dividends and similar events, the Amended and Restated 1997 Stock Option Plan authorizes the grant of options to purchase an aggregate of 1,000,000 shares of common stock. The Company recognized stock option expense relating to the options granted to the non-employees of $95,000, $287,000 and $118,000 during the years ended December 31, 2000, 1999 and 1998, respectively. For stock options outstanding at December 31, 2000, the range of exercise prices is $6.98 to $15.00 per share and the weighted-average remaining contractual life is 8.19 years. For the year ended December 31, 2000, options to purchase 183,000 shares of the Company's common stock were granted to directors of the Company and options to purchase 125,000 shares were granted to officers of the Company and officers and key employees of the Manager. The exercise price of the options granted during 2000 was $6.98 per share. None of the options granted during 2000 include dividend equivalent rights. The fair value of each option granted during 2000 was estimated to be $0.04 as of the grant date using the Black-Scholes option pricing model with the following assumptions: dividend yield of 20% per annum; expected volatility of 30%; risk free interest rate of 5.22% per annum; and an expected life of 10 years. The options granted during 2000 expire in December 2010 and vested in two equal installments during the month of December in 2001 and 2002. For the year ended December 31, 1998, options to purchase 112,000 shares of the Company's common stock were granted to directors of the Company and options to purchase 58,000 shares were granted to officers of the Company and officers and key employees of the Manager. The exercise price of the options granted during 1998 was $10.38 per share. All of the options granted during 1998 include dividend equivalent rights that entitle the option holder to receive a cash payment equal to the dividends declared on the Company's common stock multiplied by the number of options held until the options are exercised or expire. The fair value of each option granted during 1998 was estimated to be $5.32 as of the grant date using the Black-Scholes option pricing model with the following assumptions: dividend yield of 0% per annum (to account for the dividend equivalent rights); expected volatility of 30%; risk free interest rate of 4.57% per annum; and an expected life of 10 years. The options granted during 1998 expire in December 2008 and vested in two equal installments during the month of December in 1999 and 2000. For the year ended December 31, 1997, options to purchase 210,000 shares of the Company's common stock were granted to directors of the Company and options to purchase 190,000 shares were granted to officers of the Company and officers and key employees of the Manager. The exercise price of the options granted during 1997 was $15 per share. The fair value of each option granted during 1997 was estimated to be $1.05 as of the grant date using the Black-Scholes option pricing model with the following assumptions: dividend yield of 11% per annum; expected volatility of 30%; risk free interest rate of 5.82% per annum; and an expected life of 10 years. F-15 The options granted during 1997 expire in December 2007 and vest in three equal installments during the month of February in 1999, 2000 and 2001. If the Company had recorded stock option grants to Company directors at fair value and related compensation expense, the pro forma effect on the Company's net income and earnings per share would have been as follows:
Year Ended Year Ended Year Ended December 31, December 31, December 31, 2000 1999 1998 --------------------------------------------------- Net (loss) income - as reported ($28,243,000) $11,112,000 $5,547,000 Net (loss) income - pro forma ($28,409,000) 10,611,000 5,411,000 Basic earnings per share - as reported ($4.91) $1.93 $0.90 Diluted earnings per share - as reported ($4.91) $1.92 $0.90 Basic earnings per share - pro forma ($4.94) $1.84 $0.87 Diluted earnings per share - pro forma ($4.94) $1.84 $0.87
Information regarding stock option activity during the years ended December 31, 2000, 1999, and 1998 is as follows:
Weighted Average Shares Exercise Price ------------------ ------------------ Options Outstanding at January 1, 1998 400,000 $15.00 Options Granted During 1998 170,000 10.38 Exercised - - Expired - - ------------------ Options Outstanding at December 31, 1998 and 1999 570,000 13.62 Options Granted During 2000 308,000 6.98 Exercised - - Expired - - ------------------ Options Outstanding at December 31, 2000 878,000 $11.29 ==================
F-16 NOTE 10 - CONTRACTUAL COMMITMENTS There were no interest rate swap agreements at December 31, 2000. During the year ended December 31, 1999 the Company entered into interest rate swap agreements as summarized below. Under these agreements, the Company received a floating rate and paid a fixed rate. December 31, 1999:
Current Average Unrealized Notional Amount Average Termination Gains (000) Fixed Rate Floating Rate Date (000) ---------------------------------------------------------------------------------------------------------------------- $400,129 5.869% 1Mo LIBOR 8/9/2001 $3,815
The Company received $334,000 from the swap counter-parties during the year ended December 31, 2000, which is netted against interest expense in the statements of operations. The Company paid $3,614,000 and $414,000 to the swap counter-parties during the years ended December 31, 1999 and 1998, respectively, which is included in interest expense in the statements of operations. During the year ended December 31, 2000, the Company terminated all outstanding interest rate swap agreements with a combined notional amount of $386,213,000 which resulted in a deferred gain of $5,554,000 that is being amortized over the remaining life of the original swap agreements. The deferred gain is included in other liabilities on the balance sheet and the amortization expense is included in interest expense in the statements of operations. During the year ended December 31, 2000, $3,008,000 of the deferred gain was amortized. Approximately 92% of the deferred gain will be amortized by August 31, 2001. The remaining deferred gain will be fully amortized by May 31, 2002. During the year ended December 31, 1999, the Company terminated interest rate swap agreements with a combined notional amount of $255,530,000 which resulted in a net deferred loss of $66,000 that is being amortized over the remaining life of the original swap agreements. The net deferred loss is included in other assets on the balance sheet and the amortization expense is included in interest expense on the statements of operations. During years ended December 31, 2000 and 1999, $23,000 and $42,000 of the net deferred loss was amortized, respectively. The Company is generally required to deposit collateral with the swap agreement counter-parties in an amount at least equal to the amount of any unrealized losses. At December 31, 1999 the Company had securities with a fair market value of $2,592,000 on deposit with its counter-parties. At December 31, 1999 the Company received fixed income securities with a fair market value of $1,600,000 as a deposit from a swap agreement counter-party. NOTE 11 - FORWARD CONTRACTS At December 31, 2000, the Company had open forward contracts to sell U.S. Treasury notes with terms stated below.
Current Average Net Unrealized Notional Amount Termination Losses Average Maturity of (000) Date (000) Underlying Securities -------------------------------------------------------------------------------------------------------------------- $575,000 1/19/2001 ($3,731) 2.99 Years
F-17 At December 31, 1999, the Company had open forward contracts to sell U.S. Treasury notes with terms stated below.
Current Average Unrealized Notional Amount Termination Gains Average Maturity of (000) Date (000) Underlying Securities -------------------------------------------------------------------------------------------------------------------- $335,000 2/12/2000 $3,909 3.36 Years
During the year ended December 31, 2000, forward contracts to sell U.S. Treasury notes with a notional amount of $5,670,000,000 were closed resulting in a net deferred loss of $16,860,000. $8,425,000 of the deferred loss incurred was reclassified from other comprehensive income into net loss on investment transactions in the statement of operations during the year ended December 31, 2000 as part an impairment charge recorded on the underlying assets being hedged. The Company anticipates reclassifying the remaining deferred and unrealized losses from other comprehensive income into a net loss line item in the statement of operations on January 1, 2001 in connection with the adoption of Statement of Financial Accounting Standards ("SFAS") No. 133. During the year ended December 31, 1999, two forward contracts to sell U.S. Treasury notes with a notional amount of $135,000,000 and $100,000,000 were closed resulting in a deferred loss of $390,000 and deferred gain of $51,000, respectively. The deferred loss and gain are being amortized as an adjustment to interest income over the remaining weighted average lives of the fixed income securities being hedged, which was 4.8 years at December 31, 1999. The contracts were entered into to mitigate the negative impact of rising interest rates on fixed income securities available-for-sale that generally have a market-weighted average duration approximately equal to the contracts shown above. NOTE 12 - ADOPTION OF SHAREHOLDER RIGHTS PLAN On June 30, 1999, the Board of Directors of Apex Mortgage Capital, Inc. (the "Company") declared a dividend distribution of one Right for each outstanding share of Company Common Stock to stockholders of record at the close of business on July 30, 1999 (the "Record Date"). Each Right entitles the registered holder to purchase from the Company one one-hundredth of a share of Series A Junior Participating Preferred Stock, par value $0.01 per share (the "Preferred Stock"), at a Purchase Price of $50, subject to adjustment. The description and terms of the Rights are set forth in a Shareholder Rights Agreement (the "Rights Agreement") between the Company and The Bank of New York, as Rights Agent. Initially, the Rights will be attached to all Common Stock certificates representing shares then outstanding, and no separate Rights Certificates will be distributed. Subject to certain exceptions specified in the Rights Agreement, the Rights will separate from the Common Stock and a Distribution Date will occur upon the earlier of (i) 10 business days following a public announcement that a person or group of affiliated or associated persons (an "Acquiring Person") has acquired, or obtained the right to acquire, beneficial ownership of 15% or more of the outstanding shares of Common Stock (the "Stock Acquisition Date"), other than as a result of repurchases of stock by the Company or certain inadvertent actions by institutional or certain other stockholders or (ii) 10 business days (or such later date as the Board shall determine) following the commencement of a tender offer or exchange offer that would result in a person or group becoming an Acquiring Person. Until the Distribution Date, (i) the Rights will be evidenced by the Common Stock certificates and will be transferred with and only with such Common Stock certificates, (ii) new Common Stock certificates issued after the Record Date will contain a notation incorporating the Rights Agreement by reference and (iii) the surrender for transfer of any certificates for Common Stock outstanding will also constitute the transfer of the Rights associated with the Common Stock represented by such certificate. Pursuant to the Rights Agreement, the Company reserves the right to require that, prior to the occurrence of a triggering event, upon any exercise of Rights, a number of Rights be exercised so that only whole shares of Preferred Stock will be issued. The Rights are not exercisable until the Distribution Date and will expire on July 30, 2009, unless earlier redeemed or exchanged by the Company. F-18 NOTE 13 - RECLASSIFICATION ADJUSTMENTS OF COMPREHENSIVE INCOME The following is a presentation of the reclassification amounts to comprehensive income for the years ended December 31, 2000, 1999 and 1998:
For the Year Ended For the Year Ended For the Year Ended December 31, 2000 December 31, 1999 December 31, 1998 ------------------ ------------------ ------------------ Unrealized gains (losses) arising during the year $ 1,315,000 $ (36,212,000) $ 6,689,000 Less: reclassification of net losses to impairment reserve 22,610,000 - - Less: reclassification adjustment for net losses (gains) resulting from asset sales 8,935,000 (899,000) (188,000) ------------------ ------------------ ------------------ Net unrealized gains (losses) on investments available-for-sale $ 32,860,000 $ (37,111,000) $ 6,501,000 ================== ================== ================== Net deferred (losses) from forward contracts closed during the year $ (16,860,000) $ - $ - Less: reclassification of net deferred and unrealized losses to impairment reserve 8,424,000 - - Less: reclassification adjustment for net losses included in net income 346,000 - - Less: reclassification adjustment for net losses resulting from asset sales 664,000 - - ------------------ ------------------ ------------------ Net unrealized (loss) and deferred losses on forward contracts $ (7,426,000) $ - $ - ================== ================== ==================
F-19 NOTE 14 - SUMMARIZED QUARTERLY RESULTS (UNAUDITED) The following is a presentation of the quarterly results of operations (amounts are in thousands except per share amounts):
Year Ended December 31, 2000 ----------------------------------------------------- Fourth Third Second First Quarter Quarter Quarter Quarter ------------ ------------ ------------ ----------- Interest Income $10,224 $9,580 $10,893 $12,137 Interest Expense 7,901 7,600 8,590 9,688 ------------ ------------ ------------ ----------- Net Interest Income 2,323 1,980 2,303 2,449 ------------ ------------ ------------ ----------- Net Gain (Loss) on Investment Transactions 741 (29,912) (7,532) - Dividend Income 230 185 354 370 General and Administrative Expenses (290) (680) (241) (523) ------------ ------------ ------------ ----------- Net (Loss) Income $3,004 ($28,427) ($5,116) $2,296 ============ ============ ============ =========== Basic EPS $0.52 ($4.94) ($0.89) $0.40 ============ ============ ============ =========== Diluted EPS $0.52 ($4.94) ($0.89) $0.40 ============ ============ ============ =========== Average Number of Shares Outstanding - Basic (net of treasury shares) 5,753 5,753 5,753 5,753 ============ ============ ============ =========== Average Number of Shares Outstanding - Diluted (net of treasury shares) 5,753 5,753 5,753 5,753 ============ ============ ============ =========== Dividend Declared Per Share $0.35 $0.35 $0.35 $0.46 ============ ============ ============ ===========
F-20
Year Ended December 31, 1999 ----------------------------------------------------- Fourth Third Second First Quarter Quarter Quarter Quarter ------------ ----------- ------------ ------------ Interest Income $12,375 $13,124 $13,081 $13,937 Interest Expense 10,093 10,231 10,760 11,261 ------------ ----------- ------------ ------------ Net Interest Income 2,282 2,893 2,321 2,676 ------------ ----------- ------------ ------------ Net Gain on Investment Transactions 225 437 662 614 Dividend Income 489 503 684 711 General and Administrative Expenses (665) (868) (813) (1,039) ------------ ----------- ------------ ------------ Net Income $2,331 $2,965 $2,854 $2,962 ============ =========== ============ ============ Basic EPS $0.41 $0.52 $0.50 $0.51 ============ =========== ============ ============ Diluted EPS $0.40 $0.51 $0.49 $0.51 ============ =========== ============ ============ Average Number of Shares Outstanding - Basic (net of treasury shares) 5,753 5,753 5,753 5,753 ============ =========== ============ ============ Average Number of Shares Outstanding - Diluted 5,771 5,784 5,787 5,773 (net of treasury shares) Dividend Declared Per Share $0.46 $0.46 $0.42 $0.38 ============ =========== ============ ============
F-21 EX-24.1-1 2 a2042106zex-24_11.txt EXHIBIT 24.1.1 EXHIBIT 24.1.1 POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that I, Carl C. Gregory III, constitute and appoint Philip A. Barach and Daniel K. Osborne, and each of them, as my true and lawful attorneys-in-fact and agents with full power of substitution and resubstitution, for me and in my name, place and stead, in any and all capacities, to sign any Form 10-K or Form 10-Q of Apex Mortgage Capital, Inc., and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing in as I might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact or agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. /s/ CARL C. GREGORY - -------------------------------- Carl C. Gregory III POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that I, John C. Argue, constitute and appoint Philip A. Barach and Daniel K. Osborne, and each of them, as my true and lawful attorneys-in-fact and agents with full power of substitution and resubstitution, for me and in my name, place and stead, in any and all capacities, to sign any Form 10-K or Form 10-Q of Apex Mortgage Capital, Inc., and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing in as I might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact or agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. /s/ JOHN C. ARGUE - -------------------------------- John C. Argue POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that I, John A. Gavin, constitute and appoint Philip A. Barach and Daniel K. Osborne, and each of them, as my true and lawful attorneys-in-fact and agents with full power of substitution and resubstitution, for me and in my name, place and stead, in any and all capacities, to sign any Form 10-K or Form 10-Q of Apex Mortgage Capital, Inc., and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing in as I might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact or agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. /s/ JOHN A. GAVIN - -------------------------------- John A. Gavin POWER OF ATTORNEY KNOW ALL MEN BY THESE PRESENTS, that I, Peter G. Allen, constitute and appoint Philip A. Barach and Daniel K. Osborne, and each of them, as my true and lawful attorneys-in-fact and agents with full power of substitution and resubstitution, for me and in my name, place and stead, in any and all capacities, to sign any Form 10-K or Form 10-Q of Apex Mortgage Capital, Inc., and to file the same, with all exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, granting unto said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing in as I might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact or agents or any of them, or their or his substitute or substitutes, may lawfully do or cause to be done by virtue hereof. /s/ PETER G. ALLEN - -------------------------------- Peter G. Allen -----END PRIVACY-ENHANCED MESSAGE-----