-----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, ERBsqUDvyB6WjvYyDJ5j07pdfa9qjlbFQ8pLVTb+9iNf5IEMdaFb0H4vO7tTIwpI Yw1J0b2cskMtcwSP3sO3ig== 0000950172-03-001616.txt : 20030515 0000950172-03-001616.hdr.sgml : 20030515 20030515165238 ACCESSION NUMBER: 0000950172-03-001616 CONFORMED SUBMISSION TYPE: 10-Q PUBLIC DOCUMENT COUNT: 3 CONFORMED PERIOD OF REPORT: 20030331 FILED AS OF DATE: 20030515 FILER: COMPANY DATA: COMPANY CONFORMED NAME: ANTHRACITE CAPITAL INC CENTRAL INDEX KEY: 0001050112 STANDARD INDUSTRIAL CLASSIFICATION: REAL ESTATE INVESTMENT TRUSTS [6798] IRS NUMBER: 133978906 STATE OF INCORPORATION: MD FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-Q SEC ACT: 1934 Act SEC FILE NUMBER: 001-13937 FILM NUMBER: 03705812 BUSINESS ADDRESS: STREET 1: 40 EAST 52ND STREET CITY: NEW YORK STATE: NY ZIP: 10022 BUSINESS PHONE: 2127545560 MAIL ADDRESS: STREET 1: 40 EAST 52ND STREET CITY: NEW YORK STATE: NY ZIP: 10022 FORMER COMPANY: FORMER CONFORMED NAME: ANTHRACITE MORTGAGE CAPITAL INC DATE OF NAME CHANGE: 19971121 10-Q 1 ahr10q331.txt QUARTERLY REPORT SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-Q (X) QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended March 31, 2003 OR ( ) TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from: ________ to ________ Commission File Number 001-13937 ANTHRACITE CAPITAL, INC. (Exact name of registrant as specified in its charter) Maryland 13-3978906 (State or other jurisdiction of (I.R.S. Employer incorporation or organization) Identification No.) 40 East 52nd Street, New York, New York 10022 (Address of principal executive offices) (Zip Code) (Registrant's telephone number including area code): (212) 409-3333 NOT APPLICABLE (Former name, former address, and for new fiscal year; if changed since last report) 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. (1) Yes _X_ No ___ (2) Yes _X_ No ___ Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). (1) Yes _X_ No ___ As of May 13, 2003, 47,813,550 shares of common stock ($.001 par value per share) were outstanding. 1 ANTHRACITE CAPITAL, INC., FORM 10-Q INDEX
PART I - FINANCIAL INFORMATION Page Item 1. Interim Financial Statements........................................................................4 Consolidated Statements of Financial Condition At March 31, 2003 (Unaudited) and December 31, 2002.................................................4 Consolidated Statements of Operations (Unaudited) For the Three Months Ended March 31, 2003 and 2002..................................................5 Consolidated Statement of Changes in Stockholders' Equity (Unaudited) For the Three Months Ended March 31, 2003...........................................................6 Consolidated Statements of Cash Flows (Unaudited) For the Three Months Ended March 31, 2003 and 2002..................................................7 Notes to Consolidated Financial Statements (Unaudited)..............................................8 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations..............................................................................17 Item 3. Quantitative and Qualitative Disclosures about Market Risk.........................................34 Item 4. Controls and Procedures............................................................................39 Part II - OTHER INFORMATION Item 1. Legal Proceedings..................................................................................40 Item 2. Changes in Securities and Use of Proceeds..........................................................40 Item 3. Defaults Upon Senior Securities....................................................................40 Item 4. Submission of Matters to a Vote of Security Holders................................................40 Item 5. Other Information..................................................................................40 Item 6. Exhibits and Reports on Form 8-K...................................................................40 SIGNATURES ...................................................................................................41
2 CAUTIONARY STATEMENT REGARDING FORWARD-WORKING STATEMENTS Certain statements contained herein are not, and certain statements contained in future filings by Anthracite Capital, Inc. (the "Company") with the Securities and Exchange Commission (the "SEC") in the Company's press releases or in the Company's other public or stockholder communications may not be, based on historical facts and are "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements which are based on various assumptions (some of which are beyond the Company's control) may be identified by reference to a future period or periods, or by the use of forward-looking terminology, such as "believe," "expect," "anticipate," "intend," "estimate," "position," "target," "mission," "assume," "achievable," "potential," "strategy," "goal," "objective," "plan," "aspiration," "outlook," "outcome," "continue," "remain," "maintain," "strive," "trend," and variations of such words and similar expressions, or future or conditional verbs such as "will," "would," "should," "could," "may," or similar terms or variations on those terms, or the negative of those terms. Actual results could differ materially from those set forth in forward-looking statements and future results could differ materially from historical performance due to a variety of factors, including, but not limited to: (1) the introduction, withdrawal, success and timing of business initiatives and strategies; (2) changes in political, economic or industry conditions, the interest rate environment or financial and capital markets, which could result in deterioration in credit performance; (3) the performance and operations of the Manager; (4) the impact of increased competition; (5) the impact of capital improvement projects; (6) the impact of future acquisitions; (7) the unfavorable resolution of legal proceedings; (8) the extent and timing of any share repurchases; (9) the impact, extent and timing of technological changes and the adequacy of intellectual property protection; (10) the impact of legislative and regulatory actions and reforms; (11) terrorist activities, which may adversely affect the general economy, financial and capital markets, the real estate industry and the Company; and (12) the ability of the Manager to attract and retain highly talented professionals. Forward-looking statements speak only as of the date they are made. The Company does not undertake, and specifically disclaims any obligation, to publicly release the result of any revisions which may be made to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements. 3 Part I - FINANCIAL INFORMATION Item 1. Consolidated Financial Statements
Anthracite Capital, Inc. and Subsidiaries Consolidated Statements of Financial Condition (in thousands, except per share data) - --------------------------------------------------------------------------------------------------------------------------------- March 31, 2003 December 31, 2002 (Unaudited) ASSETS Cash and cash equivalents $ 21,210 $ 24,698 Restricted cash equivalents 62,661 84,485 Securities available for sale, at fair value Subordinated commercial mortgage-backed securities (CMBS) $ 661,515 $ 602,706 Investment grade securities 1,400,377 370,356 -------------- -------------- Total securities available for sale 2,061,892 973,062 Securities held for trading, at fair value 461,386 1,427,733 Commercial mortgage loans, net 57,742 65,664 Investments in real estate joint ventures 7,778 8,265 Equity investment in Carbon Capital, Inc. 17,755 14,997 Receivable for investments sold 252,241 - Other assets 39,323 40,447 -------------- --------------- Total Assets $2,981,988 $2,639,351 ============== =============== LIABILITIES AND STOCKHOLDERS' EQUITY Liabilities: Borrowings: Collateralized debt obligations $684,684 $ 684,590 Secured by pledge of subordinated CMBS 54,565 7,295 Secured by pledge of other securities available for sale and restricted cash equivalents 1,050,020 98,439 Secured by pledge of securities held for trading 348,319 1,355,333 Secured by pledge of investments in real estate joint ventures 937 1,337 Secured by pledge of commercial mortgage loans 14,667 14,667 -------------- -------------- Total borrowings $2,153,192 $2,161,661 Payable for investments purchased 356,859 524 Distributions payable 16,706 16,589 Other liabilities 57,191 54,361 -------------- --------------- Total Liabilities $2,583,948 $2,233,135 -------------- --------------- Commitments and Contingencies Stockholders' Equity: Common stock, par value $0.001 per share; 400,000 shares authorized; 47,731 shares issued and outstanding in March 31, 2003; and 47,398 shares issued and outstanding in December 31, 2002 48 47 10% Series B preferred stock, liquidation preference $47,817 36,379 36,379 Additional paid-in capital 518,597 515,180 Distributions in excess of earnings (32,366) (24,161) Accumulated other comprehensive loss (124,618) (121,229) -------------- --------------- Total Stockholders' Equity 398,040 406,216 -------------- --------------- Total Liabilities and Stockholders' Equity $2,981,988 $2,639,351 ============== ===============
The accompanying notes are an integral part of these financial statements. 4
Anthracite Capital, Inc. Consolidated Statements of Operations (Unaudited) (in thousands, except per share data) For the Three For the Three Months Ended Months Ended March 31, 2003 March 31, 2002 ------------------------------------ Income: Interest from securities $24,652 $28,679 Interest from commercial mortgage loans 1,185 3,619 Interest from trading securities 15,831 6,288 Earnings from real estate joint ventures 236 261 Earnings from equity investment 743 185 Interest from cash and cash equivalents 176 319 ------------------------------------ Total income 42,823 39,351 ------------------------------------ Expenses: Interest 15,504 8,032 Interest-trading securities 4,201 3,608 Management and incentive fee 2,577 5,407 Other expenses - net 582 576 ------------------------------------ Total expenses 22,864 17,623 ------------------------------------ Other gain (losses): Gain (loss) on sale of securities available for sale 142 (4,079) Gain (loss) on securities held for trading (10,404) 4,014 Foreign currency gain (loss) - (247) ------------------------------------ Total other gain (loss) (10,262) (312) ------------------------------------ Income before cumulative transition adjustment 9,697 21,416 ------------------------------------ Cumulative transition adjustment - SFAS 142 - 6,327 ------------------------------------ Net Income 9,697 27,743 ------------------------------------ Dividends on preferred stock 1,195 1,389 ------------------------------------ Net Income available to common stockholders $8,502 $26,354 ==================================== Net income per common share, basic: Income before cumulative transition adjustment $0.18 $0.44 Cumulative transition adjustment - SFAS 142 - 0.14 ------------------------------------ Net income $0.18 $0.58 ==================================== Net income per common share, diluted: Income before cumulative transition adjustment $0.18 $0.44 Cumulative transition adjustment - SFAS 142 - 0.14 ------------------------------------ Net income $0.18 $0.58 ==================================== Weighted average number of shares outstanding: Basic 47,592 45,654 Diluted 47,622 45,731 The accompanying notes are an integral part of these financial statements.
5 Anthracite Capital, Inc. and Subsidiaries Consolidated Statement of Changes in Stockholders' Equity (Unaudited) For the Three Months Ended March 31, 2003 (in thousands)
- ----------------------------------------------------------------------------------------------------------------------------------- Series Accumulated Common B Additional Distributions Other Total Stock, Preferred Paid-In In Excess Comprehensive Comprehensive Stockholders' Par Value Stock Capital Of Earnings Loss Income Equity Balance at January 1, 2003 $47 $36,379 $515,180 $(24,161) $(121,229) $406,216 Net income 9,697 $9,697 9,697 Unrealized loss on cash flow hedges (2,306) (2,306) (2,306) Reclassification adjustments from cash flow hedges included in net income 1,869 1,869 1,869 Change in net unrealized gain (loss) on (2,952) (2,952) (2,952) securities available for sale, net of reclassification adjustment ---------------- Other Comprehensive loss (3,389) Comprehensive Income $6,308 ================ Dividends declared-common stock (16,707) (16,707) Dividends on preferred stock (1,195) (1,195) Issuance of common stock 1 3,417 3,418 - ----------------------------------------------------------------------------------------------------------------------------------- Balance at March 31, 2003 $48 $36,379 $518,597 $(32,366) $(124,618) $398,040 ============================================================================================ Disclosure of reclassification adjustment: Unrealized holding loss $(3,094) Reclassification for realized gains previously recorded as unrealized 142 ---------------- $(2,952) ================
The accompanying notes are an integral part of these financial statements. 6 Anthracite Capital, Inc. and Subsidiaries Consolidated Statements of Cash Flows (Unaudited) (in thousands)
- ------------------------------------------------------------------------------------------------------------------------------- For the Three For the Three Months Ended Months Ended March March 31, 2003 31, 2002 Cash flows from operating activities: Net income $9,697 $27,743 Adjustments to reconcile net income to net cash provided by operating activities: Net sale (purchase) of trading securities 387,278 (13,170) Net loss on sale of securities 10,262 65 Cumulative transition adjustment - (6,327) (Discount accretion), premium amortization, net (8,758) 3,932 Non-cash portion of net foreign currency loss - 82 Distributions from joint ventures in excess of earnings 487 87 Decrease (Increase) in other assets 1,578 (3,251) Increase (Decrease) in other liabilities 2,830 (8,947) ----------------------- --------------------- Net cash provided by operating activities 403,374 214 ----------------------- --------------------- Cash flows from investing activities: Purchase of securities available for sale (447,774) (224,144) Repayments received from commercial mortgage loans 7,923 865 Decrease in restricted cash equivalents 21,824 2,261 Principal payments received on securities available for sale 37,212 62,491 Investment in Carbon Capital, Inc. (2,950) - Proceeds from sales of securities available for sale - 354,187 Net payments from hedging securities (262) (2,069) ----------------------- --------------------- Net cash (used in) provided by investing activities (384,027) 193,591 ----------------------- --------------------- Cash flows from financing activities: Net decrease in borrowings (8,469) (207,396) Proceeds from issuance of common stock, net of offering costs 3,418 7,351 Dividends paid on common stock (16,589) (15,859) Interest paid on preferred stock (1,195) (1,389) ----------------------- --------------------- Net cash used in financing activities (22,835) (217,293) ----------------------- --------------------- Net decrease in cash and cash equivalents (3,488) (23,488) Cash and cash equivalents, beginning of period 24,698 43,071 ----------------------- --------------------- Cash and cash equivalents, end of period $21,210 $19,583 ======================= ===================== Supplemental disclosure of cash flow information: Interest paid $15,231 $19,449 ======================= ===================== Investments purchased not settled $252,241 $451,976 ======================= ===================== Investments sold not settled $356,859 $297,129 ======================= =====================
The accompanying notes are an integral part of these financial statements. 7 Anthracite Capital, Inc. and Subsidiaries Notes to Consolidated Financial Statements (Unaudited) (In thousands, except per shares and share data) Note 1 ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES Anthracite Capital, Inc. (the "Company"), a Maryland corporation, is a real estate finance company that generates income based on the spread between the interest income on its mortgage loans and securities investments and the interest expense from borrowings used to finance its investments. The Company seeks to earn high returns on a risk-adjusted basis to support a consistent quarterly dividend. The Company has elected to be taxed as a Real Estate Investment Trust ("REIT") under the Internal Revenue Code of 1986 and, therefore, its income is largely exempt from corporate taxation. The Company commenced operations on March 24, 1998. The Company's business focuses on (i) originating high yield commercial real estate loans, (ii) investing in below investment grade commercial mortgage backed securities ("CMBS") where the Company has the right to control the foreclosure/workout process on the underlying loans, and (iii) acquiring investment grade real estate related securities as a liquidity diversification. The accompanying unaudited financial statements have been prepared in conformity with the instructions to Form 10-Q and Article 10, Rule 10-01 of Regulation S-X for interim financial statements. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America ("GAAP") for complete financial statements. These financial statements should be read in conjunction with the annual financial statements and notes thereto included in the Company's annual report on Form 10-K for 2002 filed with the Securities and Exchange Commission. In the opinion of the Company's management, the accompanying financial statements contain all adjustments, consisting of normal and recurring accruals (except for the cumulative transition adjustment for SFAS 142 in the first quarter of 2002 - see Note 2 to the consolidated financial statements), necessary for a fair presentation of the results for the interim periods. Operating results for interim periods are not necessarily indicative of the results that may be expected for the entire year. In preparing the financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the dates of the statements of financial condition and revenues and expenses for the periods covered. Actual results could differ from those estimates and assumptions. Significant estimates in the financial statements include the valuation of certain of the Company's mortgage-backed securities and certain other investments. Note 2 ACCOUNTING CHANGE - BUSINESS COMBINATIONS In July 2001, the Financial Accounting Standards Board issued Statements of Financial Accounting Standards No. 141, ''Business Combinations,'' and No. 142, ''Goodwill and Other Intangible Assets'' (''SFAS 142''). These standards changed the accounting for business combinations by, among other things, prohibiting 8 the prospective use of pooling-of-interests accounting and requiring companies to stop amortizing goodwill and certain intangible assets with an indefinite useful life. Instead, goodwill and intangible assets deemed to have an indefinite useful life will be subject to an annual review for impairment. The new standards generally were effective for the Company in the first quarter of 2002. Upon adoption of SFAS 142 in the first quarter of 2002, the Company recorded a one-time, noncash adjustment of approximately $6,327 to write off the unamortized balance of its negative goodwill. Such charge is non-operational in nature and is reflected as a cumulative effect of an accounting change in the accompanying consolidated statement of operations. Note 3 NET INCOME PER SHARE Net income per share is computed in accordance with Statement of Financial Accounting Standards No. 128, "Earnings Per Share". Basic income per share is calculated by dividing net income available to common stockholders by the weighted average number of common shares outstanding during the period. Diluted income per share is calculated using the weighted average number of common shares outstanding during the period plus the additional dilutive effect of common stock equivalents. The dilutive effect of outstanding stock options is calculated using the treasury stock method, and the dilutive effect of preferred stock is calculated using the "if converted" method.
For the Three For the Three Months Ended Months Ended March 31, 2003 March 31, 2002 Numerator: Net Income available to common stockholders before cumulative transition adjustment $8,502 $20,027 Cumulative transition adjustment - 6,327 -------------------- ------------------- Numerator for basic earnings per share 8,502 26,354 Effect of 10.5% series A senior cumulative redeemable preferred stock - - -------------------- ------------------- Numerator for diluted earnings per share $8,052 $26,354 ==================== =================== Denominator: Denominator for basic earnings per share--weighted average common shares outstanding 47,592 45,654 Effect of 10.5% series A senior cumulative redeemable preferred stock - 30 Dilutive effect of stock options 30 47 -------------------- ------------------- Denominator for diluted earnings per share--weighted average common shares outstanding and common share equivalents outstanding 47,622 45,731 ==================== =================== Basic net income per weighted average common share: Income before cumulative transition adjustment $0.18 $0.44 Cumulative transition adjustment - SFAS 142 - 0.14 -------------------- ------------------- Net income $0.18 $0.58 ==================== =================== Diluted net income per weighted average common share and common share equivalents: Income before cumulative transition adjustment $0.18 $0.44 Cumulative transition adjustment - SFAS 142 - 0.14 -------------------- ------------------- Net income $0.18 $0.58 ==================== ===================
9 Note 4 SECURITIES AVAILABLE FOR SALE The Company's securities available for sale are carried at estimated fair value. The amortized cost and estimated fair value of securities available for sale as of March 31, 2003 are summarized as follows:
Gross Gross Estimated Amortized Unrealized Unrealized Fair Security Description Cost Gain Loss Value ----------------------------------------------------------- --------------- ---------------- --------------- ----------------- Commercial mortgage-backed securities ("CMBS"): CMBS IOs $ 40,858 $ 1,377 $ (484) $ 41,751 Investment grade CMBS 49,895 5,364 - 55,259 Non-investment grade rated subordinated securities 688,685 18,576 (72,342) 634,919 Non-rated subordinated securities 39,783 2,584 (15,771) 26,596 Credit tenant lease 9,025 - (69) 8,956 Investment grade REIT debt 174,431 13,696 (20) 188,107 --------------- ---------------- --------------- ----------------- Total CMBS 1,002,677 41,597 (88,686) 955,588 --------------- ---------------- --------------- ----------------- Single-family residential mortgage-backed securities ("RMBS"): Agency adjustable rate securities 38,021 450 (160) 38,311 Agency fixed rate securities 1,034,436 10,468 (184) 1,044,720 Residential CMOs 10,404 254 - 10,658 Hybrid Arms 12,485 130 - 12,615 --------------- ---------------- --------------- ----------------- Total RMBS 1,095,346 11,302 (344) 1,106,304 --------------- ---------------- --------------- ----------------- Total securities available for sale $ 2,098,023 $ 52,899 $ (89,030) $ 2,061,892 =============== ================ =============== =================
On March 31, 2003, $1,037,519 of RMBS securities classified as trading securities were reclassified as available for sale securities. The reclassification was based on the Company's intent with respect to these securities with the principle objective of generating returns from other than short-term pricing differences. As of March 31, 2003, an aggregate of $1,906,391 in estimated fair value of the Company's securities available for sale was pledged to secure its collateralized borrowings. As of March 31, 2003, the anticipated weighted average yield to maturity based upon the amortized cost of the subordinated CMBS ("reported yield") was 9.8% per annum. The anticipated reported yield of the Company's investment grade securities available for sale was 5.1%. The Company's reported yields on its subordinated CMBS and investment grade securities available for sale are based upon a number of assumptions that are subject to certain business and economic uncertainties and contingencies. Examples of these include, among other things, the rate and timing of principal payments (including prepayments, repurchases, defaults, and liquidations), the pass-through or coupon rate, and interest rate fluctuations. Additional factors that may affect the Company's anticipated yields to maturity on its subordinated CMBS include interest payment shortfalls due to 10 delinquencies on the underlying mortgage loans, and the timing and magnitude of credit losses on the mortgage loans underlying the subordinated CMBS that are a result of the general condition of the real estate market (including competition for tenants and their related credit quality) and changes in market rental rates. As these uncertainties and contingencies are difficult to predict and are subject to future events which may alter these assumptions, no assurance can be given that the anticipated yields to maturity, discussed above and elsewhere, will be achieved. The following table sets forth certain information relating to the aggregate principal balance and payment status of delinquent mortgage loans underlying the subordinated CMBS held by the Company as of March 31, 2003: ----------------------------------------------------------------- ---------------------------------------------- March 31, 2003 ----------------------------------------------------------------- ---------------------------------------------- Number % of Principal of Loans Collateral ------------------------------------------ ---------------------- ---------------------- ----------------------- Past due 30 days to 60 days $ 31,540 5 0.30% ------------------------------------------ ---------------------- ---------------------- ----------------------- Past due 60 days to 90 days 31,994 4 0.30 ------------------------------------------ ---------------------- ---------------------- ----------------------- Past due 90 days or more 124,811 21 1.19 ------------------------------------------ ---------------------- ---------------------- ----------------------- Real estate owned ("REO") 23,530 6 0.22 ------------------------------------------ ---------------------- ---------------------- ----------------------- Total delinquent 211,875 36 2.01 ------------------------------------------ ---------------------- ---------------------- ----------------------- Total principal balance $10,529,266 2,043 ------------------------------------------ ---------------------- ---------------------- -----------------------
To the extent that the Company's expectation of realized losses on individual loans supporting the CMBS, if any, or such resolutions differ significantly from the Company's original loss estimates, it may be necessary to reduce the projected reported yield on the applicable CMBS investment to better reflect such investment's expected earnings net of expected losses, and write the investment down to its fair value. While realized losses on individual loans may be higher or lower than original estimates, the Company currently believes its aggregate loss estimates and reported yields are appropriate on all investments. Note 5 SECURITIES HELD FOR TRADING Securities held for trading reflect short-term trading strategies, which the Company employs from time to time, designed to generate economic and taxable gains based on short-term difference in pricing. As part of its trading strategies, the Company may acquire long or short positions in U.S. Treasury or agency securities, forward commitments to purchase such securities, financial futures contracts and other fixed income or fixed income derivative securities. The Company's securities held for trading are carried at estimated fair value. At March 31, 2003, the Company's securities held for trading consisted of FNMA Mortgage Pools with an estimated fair value of $358,976, and a forward commitment with an estimated fair value of $102,410. The FNMA Mortgage Pools, and the underlying mortgages, bear interest at fixed rates for specified periods, generally three to seven years, after which the rates are periodically reset to market. For the three months ended March 31, 2003, losses on securities held for trading in the consolidated statements of operations of $10,404 are largely attributable to hedging the Company's sensitivity to long- 11 term interest rates. The Company's longstanding policy has been to maintain limits on the exposure of the Company's equity to changes in long-term rates as well as the exposure of earnings to changes in short-term funding rates. The sale of five-year futures on U.S. Treasury notes to reduce the Company's exposure to intermediate rates resulted in realized losses since market value changes in those hedging investments must be marked-to-market though the income statement. The value of these investments was negatively affected as the five-year US Treasury went up in price (therefore reducing the value of the hedged position) during the quarter. The Company's trading strategies are subject to the risk of unanticipated changes in the relative prices of long and short positions in trading securities, but are designed to be relatively unaffected by changes in the overall level of interest rates. Note 6 COMMON STOCK On March 6, 2003, the Company declared dividends to its common stockholders of $0.35 per share, which were paid on April 30, 2003 to stockholders of record on March 31, 2003. For U.S. Federal income tax purposes, the dividends are expected to be ordinary income to the Company's stockholders. For the three months ended March 31, 2003, the Company issued 333,328 shares of Common Stock under its Dividend Reinvestment Plan. Net proceeds to the Company were approximately $3,517. For the three months ended March 31, 2002, the Company issued 519,303 shares of Common Stock under its Dividend Reinvestment Plan. Net proceeds to the Company were approximately $5,661. In March 2002, the remaining 10,000 shares of Series A Preferred Stock were converted to 34,427 shares of Common Stock at a price of $7.26 per share in accordance with the terms of the Series A Preferred Stock. Note 7 TRANSACTIONS WITH AFFILIATES The Company has a Management Agreement with BlackRock Financial Management, Inc. (the "Manager"), a majority owned indirect subsidiary of The PNC Financial Services Group, Inc. ("PNC Bank") and the employer of certain directors and officers of the Company, under which the Manager manages the Company's day-to-day operations, subject to the direction and oversight of the Company's Board of Directors. On March 25, 2002, the Management Agreement was extended for one year through March 27, 2003, with the approval of the unaffiliated directors, on terms similar to the prior agreement with the following changes: (i) the incentive fee calculation would be based on GAAP earnings instead of funds from operations, (ii) the removal of the four-year period to value the Management Agreement in the event of termination and (iii) subsequent renewal periods of the Management Agreement would be for one year instead of two years. The Board was advised by Houlihan Lokey Howard & Zukin Financial Advisors, Inc., a national investment banking and financial advisory firm, in the renewal process. 12 On March 6, 2003, the unaffiliated directors approved an extension of the Management Agreement from its expiration of March 27, 2003 for one year through March 31, 2004. The terms of the renewed agreement are similar to the prior agreement except for the incentive fee calculation which would provide for a rolling four-quarter high watermark rather than a quarterly calculation. In determining the rolling four-quarter high watermark, the Company would calculate the incentive fee based upon the current and prior three quarters' net income. The Manager would be paid an incentive fee in the current quarter if the Yearly Incentive Fee, as defined, is greater than what was paid to the Manager in the prior three quarters cumulatively. The Company will phase in the rolling four-quarter high watermark commencing with the second quarter of 2003. Calculation of the incentive fee will be based on GAAP and adjusted to exclude special one-time events pursuant to changes in GAAP accounting pronouncements after discussion between the Manager and the unaffiliated directors. The incentive fee threshold did not change. The high watermark will be based on the existing incentive fee hurdle, which provides for the Manager to be paid 25% of the amount of earnings (calculated in accordance with GAAP) per share that exceeds the product of the adjusted issue price of the Company's common stock per share ($11.39 as of March 31, 2003) and the greater of 9.5% or 350 basis points over the ten-year Treasury note. The Company pays the Manager an annual base management fee equal to a percentage of the average invested assets of the Company as defined in the Management Agreement. The base management fee is equal to 1% per annum of the average invested assets rated less than BB- or not rated, 0.75% of average invested assets rated BB- to BB+, and 0.20% of average invested assets rated above BB+. In order to coincide with the increased size of the Company, effective July 1, 2001, the Manager reduced the base management fee from 0.35% of average invested assets rated above BB+. The Company incurred $2,577 and $2,219 in base management fees in accordance with the terms of the Management Agreement for the three months ended March 31, 2003 and 2002, respectively. In accordance with the provisions of the Management Agreement, the Company recorded reimbursements to the Manager of $6 and $5 for certain expenses incurred on behalf of the Company during the three months ended March 31, 2003 and 2002, respectively. Pursuant to the March 25, 2002 one-year Management Agreement extension, the incentive fee paid to the Manager was based on 25% of earnings (calculated in accordance with GAAP) of the Company. For purposes of calculating the incentive fee during 2002, the cumulative transition adjustment of $6,327 resulting from the Company's adoption of SFAS 142 was excluded from earnings in its entirety and included using an amortization period of three years. This revision saved the Company $1,448 of incentive fee for the three months ended March 31, 2002. The Company incurred $3,188 in incentive fees for the three months ended March 31, 2002. There was no incentive fee due to the Manager for the three months ended March 31, 2003. On March 17, 1999, the Company's Board of Directors approved an administration agreement with the Manager and the termination of a previous agreement with an unaffiliated third party. Under the terms of the administration agreement, the Manager provides financial reporting, audit coordination and accounting oversight services to the Company. The Company pays the Manager a monthly administrative fee at an annual rate of 0.06% of the first $125 million of average net assets, 0.04% of the next $125 million of average net assets and 0.03% of average net assets in excess of $250 million 13 subject to a minimum annual fee of $120. For the three months ended March 31, 2003 and 2002, the Company paid administration fees of $43 and $43, respectively. On July 20, 2001, the Company entered into a $50 million commitment to acquire shares in Carbon Capital, Inc. ("Carbon"), a private commercial real estate income opportunity fund managed by the Manager. The period during which the Company may be required to purchase shares under the commitment expires in July 2004. On March 31, 2003, the Company owned 18.8% of the outstanding shares in Carbon. The Company's remaining commitment at March 31, 2003 and December 31, 2002 was $32,436 and $35,116, respectively. On February 6, 2003, the Company funded a capital call notice in the amount of $2,680, which was used by Carbon to acquire a mezzanine loan secured by ownership interests in an entity that owns a mixed-use development. On May 15, 2000, the Company completed the acquisition of CORE Cap, Inc. The merger was a stock for stock acquisition where the Company issued 4,180,552 shares of its common stock and 2,261,000 shares of its series B preferred stock. At the time of the CORE Cap acquisition, the Manager agreed to pay GMAC (CORE Cap, Inc.'s external advisor) $12,500 over a ten-year period ("Installment Payment") to purchase the right to manage the assets under the existing management contract ("GMAC Contract"). The GMAC Contract had to be terminated in order to allow for the Company to complete the merger, as the Company's management agreement with the Manager did not provide for multiple managers. As a result the Manager offered to buy-out the GMAC Contract as the Manager estimated it would receive incremental fees above and beyond the Installment Payment, and thus was willing to pay for, and separately negotiate, the termination of the GMAC Contract. Accordingly, the value of the Installment Payment was not considered in the Company's allocation of its purchase price to the net assets acquired in the acquisition of CORE Cap, Inc. The Company agreed that should the Management Agreement with its Manager be terminated, not renewed or not extended for any reason other than for cause, the Company would pay to the Manager an amount equal to the Installment Payment less the sum of all payments made by the Manager to GMAC. As of March 31, 2003, the Installment Payment would be $9,500 payable over eight years. The Company does not accrue for this contingent liability. Note 8 BORROWINGS Certain information with respect to the Company's collateralized borrowings at March 31, 2003 is summarized as follows:
Lines of Reverse Total Credit and Repurchase Collateralized Collateralized Term Loans Agreements Debt Obligations Borrowings ------------------ --------------------- ---------------------- --------------------------- Outstanding borrowings $18,789 $1,449,719 $684,684 $2,153,192 Weighted average borrowing rate 2.99% 1.31% 6.60% 3.01% Weighted average remaining maturity 441 days 21 days 3,308 days 1,070 days Estimated fair value of assets pledged $50,438 $1,587,499 $754,514 $2,392,451
14 As of March 31, 2003, the Company's collateralized borrowings had the following remaining maturities:
Lines of Reverse Total Credit and Term Repurchase Collateralized Debt Collateralized Loans Agreements Obligations Borrowings ------------------ --------------------- --------------------------- ---------------------- Within 30 days $ - $1,449,719 $ - $1,449,719 31 to 59 days - - - - Over 60 days 18,789 - 684,684 703,473 ================== ===================== =========================== ====================== $18,789 $1,449,719 $684,684 $2,153,192 ================== ===================== =========================== ======================
Under the lines of credit and the reverse repurchase agreements, the respective lender retains the right to mark the underlying collateral to estimated market value. A reduction in the value of its pledged assets will require the Company to provide additional collateral or fund margin calls. From time to time, the Company expects that it will be required to provide such additional collateral or fund margin calls. Note 9 DERIVATIVE INSTRUMENTS Effective January 1, 2001, the Company adopted SFAS No. 133, "Accounting for Derivative Instruments and Hedging Activities", as amended, which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts and for hedging activities. All derivatives, whether designated in hedging relationships or not, are required to be recorded on the balance sheet at fair value. If the derivative is designated as a fair value hedge, the changes in the fair value of the derivative and of the hedged item attributable to the hedged risk are recognized in earnings. If the derivative is designated as a cash flow hedge, the effective portions of change in the fair value of the derivative are recorded in other comprehensive income ("OCI") and are recognized in the income statement when the hedged item affects earnings. Ineffective portions of changes in the fair value of cash flow hedges are recognized in earnings. The Company uses interest rate swaps to manage exposure to variable cash flows on portions of its borrowings under reverse repurchase agreements and as trading derivatives intended to offset changes in fair value related to securities held as trading assets. On the date in which the derivative contract is entered, the Company designates the derivative as either a cash flow hedge or a trading derivative. As of March 31, 2003, the Company had interest rate swaps with notional amounts aggregating $1,177,826 that were designated as cash flow hedges of borrowings under reverse repurchase agreements. Their aggregate fair value was a $45,235 asset included in other assets on the consolidated statements of financial condition. For the three months ended March 31, 2003, the net change in the fair value of the interest rate swaps was a decrease of $2,568, of which $262 was deemed ineffective and is included as an increase of interest expense and $2,306 was recorded as a reduction of OCI. As of March 31, 2003, the $1,177,826 notional of swaps which were designated as cash flow hedges had a weighted average remaining term of 5.31 years. As of March 31, 2003, the Company had interest rate swaps with notional amounts aggregating $651,545 designated as trading derivatives. Their aggregate fair value at March 31, 2003 of $4,408 is included in 15 trading securities on the consolidated statements of financial condition. For the three months ended March 31, 2003, the change in fair value for these trading derivatives was a decrease of $1,473 and is included as an addition to loss on securities held for trading in the consolidated statements of operations. As of March 31, 2003, the $651,545 notional of swaps which were designated as trading derivatives had a weighted average remaining term of 3.68 years. Occasionally, counterparties will require the Company or the Company will require counterparties to provide collateral for the interest rate swap agreements in the form of margin deposits. Net deposits are recorded as a component of either accounts receivable or other liabilities. Should the counterparty fail to return deposits paid, the Company would be at risk for the fair market value of that asset. At March 31, 2003 and 2002, the balance of such net margin deposits owed to counterparties as collateral under these agreements totaled $15,610 and $680, respectively. The contracts identified in the remaining portion of this note have been entered into to limit the Company's mark to market exposure to long-term interest rates. At March 31, 2003, the Company had outstanding short positions of 137 ten-year U.S. Treasury Note future contracts and 3,059 five-year U.S. Treasury Note future contracts expiring in June 2003, which represented $13,700 and $305,900 in face amount of U.S. Treasury Notes, respectively. The estimated fair value of these contracts was approximately $(362,834) at March 31, 2003, and the change in fair value related to these contracts is included as a component of loss on securities held for trading in the consolidated statements of operations. 16 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS All dollar figures expressed herein are expressed in thousands, except share or per share amounts. I. General The Company's primary long-term objective is to distribute consistent dividends supported by GAAP earnings. Over the long term, earnings are primarily maintained by consistent credit performance on the Company's investments, stability of the Company's liability structure and reinvestment rates. In 2002, the Company established a strong long-term secured debt issuance platform through two collateralized debt obligation ("CDO") offerings. These transactions effectively match funded a significant part of the Company's long-term credit sensitive CMBS and REIT portfolios at attractive terms. In 2003, the Company expects to redeploy capital raised from these transactions combined with additional equity capital raised from the Company's common stock issuance program. The current low interest rate environment adds a significant challenge to accreting per share earnings, since portfolio cash flows must be reinvested at lower than historical rates. However, issuing stock at a premium and locking in attractive spreads with additional CDO offerings can lead to the accretion of both earnings and book value per share as well as to increase diversification of credit exposure. Economic activity in the United States continues to point towards slow recovery at best. During the first quarter, low interest rates and rallying stock markets triggered a massive demand for high yield corporate credits causing the high yield market to return 7.6% for the three months ended March 31, 2003. This phenomenon was not replicated in the high yield commercial real estate markets. Management attributes this to high barriers to entry in these markets and believes this represents an opportunity for the Company to continue deploying capital in this sector. The Company continues to maintain a positive, though controlled exposure to both long and short-term rates through its active hedging strategies. The Company also will continue to seek out the best long-term matched financing solutions to lock in attractive spreads on the Company's commercial real estate securities portfolio. The Company establishes its dividend by analyzing the long-term sustainability of net income given existing market conditions and the current composition of its portfolio. This includes an analysis of the Company's credit loss assumptions, general level of interest rates, realized gains and losses and projected hedging costs. These factors are generally beyond the Company's control so there is no certainty that dividends will remain at current levels. During the first quarter of 2003, the Board of Directors declared a dividend of $0.35 per share to stockholders of record on March 31,2003, which was paid on April 30, 2003. This represents the sixth consecutive quarterly $0.35 dividend distribution. Since inception in March 1998, the Company has paid $200,229 in dividends. For the quarter ended March 31, 2003, the Company recorded $0.18 of GAAP earnings per share. For the quarter ended March 31, 2002, the Company recorded $0.58 of GAAP earnings per share, which included $0.14 per share as a cumulative transition adjustment under the implementation of SFAS 142. The Company's investment activities encompass three distinct lines of business: 1) Commercial Real Estate Securities 17 2) Commercial Real Estate Loans 3) Residential Mortgage Backed Securities The Company believes that these three investment activities represent an integrated strategy where each line of business supports the others and creates value over and above operating each line in isolation. The commercial real estate securities portfolio represents broad exposure to commercial real estate lending and provides diversification and high yields that are adjusted for anticipated losses over a long period of time (typically, a ten year weighted average life). These securities can be financed through the issuance of secured debt that matches the life of the investment. Commercial real estate loans provide attractive risk adjusted returns over shorter periods of time (typically, a three to five year weighted average life) through investments in loans secured by specific property types in specific regions. The RMBS portfolio is a highly liquid portfolio that supports the liquidity needs of the Company while typically earning attractive returns after hedging costs relative to other liquid investments. The Company believes the risks of these portfolios are not always highly correlated and thus can serve to provide stable earnings over long periods of time. The following table illustrates the change in the mix of the Company's three investment activities:
Carrying Value as of March 31, 2003 December 31, 2002 Amount % Amount % --------------------------------------------- Commercial real estate securities $ 955,588 37.0% $ 894,345 36.1% Commercial real estate loans(1) 65,520 2.5 73,929 3.0 Residential mortgage backed securities 1,567,690 60.5 1,506,450 60.9 --------------------------------------------- Total $2,588,798 100.0% $2,474,724 100.0% ---------------------------------------------
(1) Includes real estate joint ventures Commercial Real Estate Securities Portfolio Activity The Company continues to increase its investments in commercial real estate securities. Commercial real estate securities include CMBS and investment grade REIT debt. During the quarter ended March 31, 2003, the Company increased total assets in this sector by 7% from $894,345 to $955,588. Included in the Company's December 10, 2002 collateralized debt obligation ("CDO II") was a ramp facility that will be utilized to fund the purchase of $50,000 of par of below investment grade CMBS by September 30, 2003. The increase in commercial real estate securities for the quarter includes $30,000 of par of CMBS that was contributed to the ramp facility. At March 31, 2003, the balance of the ramp facility permits another $20,000 of par to be contributed to CDO II. The CMBS added includes $47,804 par of 2003 vintage CMBS rated BB- thru a nonrated tranche where the Company has the right to direct foreclosure on $1,006,389 of underlying loans. The loss adjusted yield of the controlling class (CMBS rated BB- and lower) CMBS acquired during the first quarter is estimated to be 11.23%. In computing the loss adjusted yields the Company assumed 2.30% of the principal of the underlying loans would result in losses over a weighted average of 8.6 years. The yield 18 of these CMBS assuming there would not be any losses is 16.44%. This is the eighth controlling class trust the Company acquired since its inception. The following table details the par, fair market value, adjusted purchase price and loss adjusted yield of the Company's commercial real estate securities included in the two CDOs as of March 31, 2003:
Par Fair Market Dollar Price Adjusted Dollar Price Loss Adjusted Value Purchase Price Yield ---------------------------------------------------------------------------------------- Investment grade CMBS $47,730 $51,914 108.77 $46,674 97.79 7.6% Investment grade REIT debt 171,545 188,107 109.65 174,431 101.68 6.5% CMBS rated BB+ to B 610,264 483,739 79.27 495,625 81.21 9.2% Whole Loans 9,032 8,956 99.16 9,025 99.92 6.1% ---------------------------------------------------------------------------------------- Total $838,571 $732,716 87.38 $725,755 86.55 8.43%
The following table details the par, fair market value, adjusted purchase price and loss adjusted yield of the Company's commercial real estate securities outside of the two CDOs as of March 31, 2003:
Fair Market Adjusted Loss Adjusted Par Value Dollar Price Purchase Price Dollar Price Yield ----------------------------------------------------------------------------------------- CMBS rated BB+ to B $ 126,567 $89,994 71.10 $104,653 82.69 8.7% CMBS rated B- or lower 298,456 87,783 29.41 128,190 42.95 12.6% CMBS IOs 915,068 41,750 4.56 40,858 4.47 9.5% Whole Loans 4,000 3,345 83.62 3,221 80.53 7.0% ----------------------------------------------------------------------------------------- Total $1,344,091 $222,872 16.58 $276,922 20.60 10.60%
Below Investment Grade CMBS and Underlying Loan Performance The Company divides its below investment grade CMBS investment activity into two portfolios: the eight trusts ("Controlling Class CMBS"), in which the Company is in the first loss position, and other below investment grade CMBS. The distinction between the two is in the controlling class rights. Controlling class rights allow the Company to control the workout and/or disposition of defaults that occur in the underlying loans. These securities absorb the first losses realized in the underlying loan pools. Other below investment grade CMBS have no rights to control the workout and/or disposition of underlying loan defaults, however they are not the first to absorb losses in the underlying pools. At March 31, 2003, the total par of the Company's other below investment grade CMBS was $261,157; the total credit protection, or subordination level, of this portfolio is 6.33%. The total par of the Company's Controlling Class CMBS at March 31, 2003 was $774,130 and the total par of the loans underlying these securities was $10,529,266. The non-rated security is the first to absorb underlying loan losses until its par is completely written off. The coupon payment on the non-rated security can also be reduced for special servicer fees charged to the trust. The next highest rated security in the structure will then generally be downgraded to non-rated and becomes the first to absorb losses and expenses from that point on. 19 The Company's investment in its Controlling Class CMBS by credit rating category at March 31, 2003 is as follows:
Fair Market Dollar Adjusted Dollar Subordination Par Value Price Purchase Price Price Level ---------------------------------------------------------------------------------- BB+ $80,286 $69,341 86.37 $68,518 85.34 7.90% BB 88,266 74,133 83.99 74,730 84.66 6.22% BB- 92,520 65,863 71.19 73,947 79.92 5.35% B+ 39,877 26,216 65.74 27,818 69.76 3.59% B 174,725 104,194 59.63 129,331 74.02 3.31% B- 92,263 42,024 45.55 56,671 61.42 2.25% CCC 79,212 19,163 24.19 31,736 40.06 1.41% NR 126,981 26,560 20.92 39,783 31.33 n/a ---------------------------------------------------------------------------------- Total $774,130 $427,494 55.22 $502,534 64.92
The Company's investment in its Controlling Class CMBS by credit rating category at December 31, 2002 is as follows:
Fair Market Dollar Adjusted Dollar Subordination Par Value Price Purchase Price Price Level ---------------------------------------------------------------------------------- BB+ $65,159 $56,543 86.78 $56,181 86.22 8.26% BB 58,170 48,674 83.68 48,560 83.48 6.73% BB- 84,972 59,415 69.92 68,623 80.76 5.48% B+ 32,329 21,533 66.61 23,173 71.68 3.72% B 168,435 99,815 59.26 125,197 74.33 3.35% B- 87,231 40,335 46.24 53,415 61.23 2.32% CCC 70,407 17,715 25.16 28,942 41.11 1.46% NR 123,349 25,335 20.54 34,171 27.70 n/a ---------------------------------------------------------------------------------- Total $690,052 $369,365 53.53 $438,262 63.51
During the first quarter of 2003, total par writedowns in the CMBS Controlling Class portfolio were $10,469. This reduces the total par of the non-rated securities by 2% and permanently reduces future cashflows. When the principal of loans is written off, the trust must also pay the expense of loan workouts and foreclosures, including special servicer fees. The effect of these cashflow reductions is reflected in the market value of these securities which declined by $4,302 during the quarter causing a reduction in Company book value. Further delinquencies and losses in the underlying loan portfolios may cause shortfalls to continue and cause the Company to conclude that a change in loss adjusted yield is required along with a significant write down of the adjusted purchase price through the income statement in accordance with accounting standard EITF 99-20. During the first quarter of 2003, the underlying loans were paid down by $39,363. Pay down proceeds are distributed to the highest rated CMBS class first and reduce the percent of total underlying collateral represented by each rating category. For all of the Company's Controlling Class securities, the Company assumes that 1.95% of the remaining current aggregate loan balance will not be recoverable. This represents an increase from 1.88% as of December 31, 2002 to include the new Controlling Class CMBS transaction acquired on 20 March 14, 2003. This estimate was developed based on an analysis of individual loan characteristics and prevailing market conditions at the time of origination. This loss estimate equates to cumulative expected defaults of approximately 5% over the life of the portfolio and an average assumed loss severity of 39.0% of the defaulted loan balance. All estimated workout expenses including special servicer fees are included in these assumptions. Actual results could differ materially from these estimated results. The following table shows the total amount of collateral outstanding on March 31, 2003 for each vintage year of Controlling Class securities owned by the Company along with losses assumed.
Weighted Avg. Losses Remaining Life of Recognized as % Total Collateral Losses Assumed Losses of Total ----------------------------------------------------------------------------- 1998 $ 7,870,911 $ 137,891 6.93 17.8% 1999 733,347 18,950 5.04 -0.2% 2001 918,619 23,797 6.54 0.0% 2003 1,006,389 24,348 7.89 0.0% ----------------------------------------------------------------------------- Total $ 10,529,266 $ 204,986 6.85 11.9% =============================================================================
As additional Controlling Class CMBS are added, the Company has been increasing the loss assumptions to take into account slower economic activity. Additionally, the Company plans to perform a detailed re-underwriting for a significant amount of the collateral from its 1998 vintage CMBS over the next 18 months. Upon completion, the Company may determine that its reported yields and book values need to be adjusted. The result of assuming greater losses, if that were the conclusion, would be an other than temporary writedown of CMBS to their market value which would include the realization of the amounts currently carried as unrealized losses on the Company's consolidated statements of financial condition. The Company feels this approach provides the appropriate discipline to maintain steady earnings over the long-term from this portfolio. See Item 3 -"Quantitative and Qualitative Disclosures About Market Risk" for a discussion of how differences between estimated and actual losses could affect Company earnings. The Company monitors credit performance on a monthly basis and debt service coverage ratios on a quarterly basis. Using these and other statistics, the Company maintains watch lists for loans that are delinquent thirty days or more and for loans that are not delinquent but have issues that the Company feels require close monitoring. The Company considers delinquency information from the Lehman Brothers Conduit Guide to be the most relevant measure of credit performance and market conditions applicable to its Controlling Class CMBS holdings. The year of issuance, or vintage year, is important, as older loan pools will tend to have more delinquencies than newly underwritten loans. The Company owns Controlling Class CMBS issued in 1998, 1999, 2001 and 2003. Comparable delinquency statistics referenced by vintage year as a percentage of par outstanding as of March 31, 2003 are shown in the table below: Vintage Year Underlying Delinquencies Lehman Conduit Guide Collateral Outstanding ---------------------------------------------------------------------------- 1998 $7,870,911 2.55% 2.21% 1999 733,347 1.51% 1.67% 2001 918,619 0.00% 0.76% 2003 1,006,389 0.00% 0.00% ---------------------------------------------------------------- Total $10,529,266 2.01% * 1.44% * * Weighted average based on respective collateral 21 Morgan Stanley also tracks CMBS loan delinquencies for specific CMBS transactions with more than $200,000 of collateral and that have been seasoned for at least one year. This seasoning criterion will generally adjust for the lower delinquencies that occur in newly originated collateral. As of March 31, 2003, the Morgan Stanley index indicated that delinquencies on 210 securitizations was 2.12%, and as of December 31, 2002, this same index indicated that delinquencies on 204 securitizations was 2.01%. See Item 3 - "Quantitative and Qualitative Disclosures About Market Risks" for a detailed discussion of how delinquencies and loan losses affect the Company. Delinquencies on the Company's CMBS collateral as a percent of principal increased in line with expectations. The Company's aggregate delinquency experience is consistent with comparable data provided in the Lehman Brothers Conduit Guide. Of the 36 delinquent loans shown on the chart in Note 4 of the consolidated financial statements, one was delinquent due to technical reasons, six were REO and being marketed for sale, four were in foreclosure, and the remaining 25 loans were in some form of workout negotiations. Aggregate realized losses of $14,277 were realized in the first quarter of 2003. This brings cumulative net losses realized to $23,426, which is 11.4% of total estimated losses. These losses include special servicer and other workout expenses. This experience to date is in line with the Company's loss expectations. Realized losses are expected to increase on the underlying loans as the portfolio ages. Special servicer expenses are also expected to increase as portfolios mature and US economic activity remains weak. The five transactions acquired in 1998 contributed 35 of the 36 delinquent loans. Of those five, the CMAC 1998 C2 transaction represents eleven delinquent loans with total par of $103,440. At March 31, 2003, this transaction incurred principal reductions of $6,700 which reduces the par and the future cash flows of the non rated class M security. The reduction represents 15% of the original class M principal balance. Furthermore, prior cash flow interruptions due to losses and delinquencies resulted in schedule payment shortfalls to the classes senior to the class M security in the amount of $2,437. This prevents the class M from receiving further cash flows until this shortfall has been paid in full. The Company has determined that cash flows may not resume for a significant period of time depending on future performance on the underlying loans. The fair market value of this security is currently carried at a dollar price of 33.1 to reflect the uncertainty of the cash flows. If underlying loan performance deteriorates, the Company may have to write this security down to its market value through the income statement in accordance with accounting standard EITF 99-20. The current unrealized loss on this security is $8,476. The Company manages its credit risk through disciplined underwriting, diversification, active monitoring of loan performance and exercise of its right to control the workout process as early as possible. The Company maintains diversification of credit exposures through its underwriting process and can shift its focus in future investments by adjusting the mix of loans in subsequent acquisitions. The comparative profiles of the loans underlying the Company's CMBS by property type as of March 31, 2003 and December 31, 2002 is as follows: 22 3/31/03 Exposure 12/31/02 Exposure ------------------------------------------------------------------------- Property Type Loan Balance % of Total Loan Balance % of Total ------------------------------------------------------------------------- Multifamily $3,577,849 34.0% $3,302,387 34.4% Retail 3,021,956 28.7 2,704,952 28.1 Office 2,145,019 20.4 1,809,519 18.8 Lodging 819,927 7.8 834,854 8.7 Industrial 594,293 5.6 589,044 6.1 Healthcare 344,305 3.3 346,298 3.6 Parking 25,917 0.2 29,743 0.3 ----------------------------------------------------- Total $10,529,266 100% $9,616,797 100% ===================================================== As of March 31, 2003, the fair market value of the Company's holdings of CMBS is $66,953 lower than the adjusted cost for these securities. This decline in the value of the investment portfolio represents market valuation changes and is not due to actual credit experience or credit expectations. The adjusted purchase price of the Company's Controlling Class CMBS portfolio as of March 31, 2003 represents approximately 65% of its par amount. The market value of the Company's Controlling Class CMBS portfolio as of March 31, 2003 represents approximately 55% of its par amount. As the portfolio matures, the Company expects to recoup the unrealized loss, provided that the credit losses experienced for each class of security in a transaction are not greater than the credit losses assumed in the purchase analysis of those individual securities. As of March 31, 2003, the Company believes there has been no material deterioration in the credit quality of its portfolio below original expectations. As the portfolio matures and expected losses occur, subordination levels of the lower rated classes of a CMBS investment will be reduced. This may cause the lower rated classes to be downgraded, which would negatively affect their market value and therefore the Company's net asset value. Reduced market value will negatively affect the Company's ability to finance any such securities that are not financed through a CDO or similar matched funding vehicle. In some cases, securities held by the Company may be upgraded to reflect seasoning of the underlying collateral and thus would increase the market value of the securities. The Company's GAAP income for its CMBS securities is computed based upon a yield which assumes credit losses. The yield to compute the Company's taxable income does not assume the occurrence of credit losses, as a loss can only be deducted for tax purposes when it has occurred. As a result, for the years ended December 31, 1998 through the three months ended March 31, 2003, the Company's GAAP income accrued on its CMBS assets was approximately $21,634 lower than the taxable income accrued on the CMBS assets. Commercial Real Estate Loan Activity The Company's commercial real estate loan portfolio generally emphasizes larger transactions located in metropolitan markets, as compared to the typical loan in the CMBS portfolio. There are no delinquencies in the Company's commercial real estate loan portfolio which is relatively small and heterogeneous. The Company has determined it is not necessary to establish a loan loss reserve for this portfolio. 23 The following table summarizes the Company's commercial real estate loan portfolio by property type as of March 31, 2003 and December 31, 2002:
March 31, 2003 December 31, 2002 --------------------------------- --------------------------------- Weighted Weighted Average Average Property Type Loan Outstanding Coupon Loan Outstanding Coupon ---------------- -------------------- ------------ -------------------- ------------ Amount % Amount % ---------------- ---------- --------- ------------ ---------- --------- ------------ Office $64,425 95.6% 9.3% $69,431 91.4% 9.5% Multifamily 2,965 4.4 3.7 3,013 4.0 3.6 Retail - - - 3,500 4.6 4.6 ---------- --------- ------------ ---------- --------- ------------ Total $67,390 100.0% 9.0% $75,944 100.0% 9.2% ---------- --------- ------------ ---------- --------- ------------
Residential Mortgage Backed Securities The RMBS market was extremely volatile in the first quarter as prepayments spiked to record levels and the ten-year Treasury rate increased as high as 4.15% and as low as 3.58%. However, the steep yield curve continues to provide a significant amount of income which offsets some of the volatility. The mark to market of this portfolio with its hedges is reflected in realized and unrealized gain/loss on the Company's consolidated statement of operations, and the net income is reported in the interest income and expense section of the same statements. The Company continues its policy of hedging this portfolio to maintain long-term stability of the portfolio, though short-term volatility can and does occur. The realized losses were substantially from rolling Treasury futures hedges; the Company did not liquidate any RMBS assets at a loss. The Company has significant liquidity to maintain its position over the longer term. At the end of the third quarter in 2002, the Company reevaluated its RMBS strategy. The Company relies on hedging to protect the value of the RMBS portfolio and maintain stable levels of leverage. The Company determined it would be more favorable to rely less on futures as a hedge, which is required to be marked to market through the consolidated statement of operations, and rely more on swaps which are marked to market on the consolidated statement of financial condition. Reducing the effect of income statement volatility caused by the RMBS portfolio that is not actively traded is important to the Company. At March 31, 2003, the Company reclassified $1,037,519 market value of RMBS from held for trading to available for sale, leaving $461,386 market value of RMBS in held for trading. The securities left in held for trading are 6.0% coupon agency passthroughs hedged to a zero duration with five year futures. These securities will be sold in the short-term with the capital redeployed into commercial real estate assets. The securities reclassified as available for sale are 4% - 5.5% Agency RMBS hedged with interest rate swaps of up to ten year maturities. A breakdown of the RMBS portfolio income performance for the quarter is as follows: Interest Income $20,285 Interest Expense 7,940 -------------- Net Interest Income 12,345 -------------- Realized loss (8,672) Unrealized loss in value (1,731) Net Income from RMBS $1,942 ============== 24 II. Results of Operations Net income for the three months ended March 31, 2003 was $9,697 or $0.18 per share ($0.18 diluted). Net income for the three months ended March 31, 2002 was $27,743 or $0.58 per share ($0.58 diluted). The decrease in income from 2002 to 2003 is primarily due to the cumulative transition adjustment for SFAS 142 in 2002 and losses on securities classified as held for trading in 2003. Interest Income: The following tables sets forth information regarding the total amount of income from certain of the Company's interest-earning assets.
For the Three Months Ended March 31, 2003 2002 ----------------------- ------------------------ Interest Interest Income Income ----------------------- ------------------------ CMBS $13,154 $13,279 Other securities 11,498 15,400 Commercial mortgage loans 1,185 3,619 Cash and cash equivalents 176 319 ----------------------- ------------------------ Total $26,013 $32,617 ======================= ========================
In addition, the Company earned $15,831 and $6,288 in interest income from securities held for trading during the three months ended March 31, 2003 and 2002, respectively, $236 and $261 in earnings from real estate joint ventures during the three months ended March 31, 2003 and 2002, respectively, and $743 and $185 in earnings from an equity investment during the three months ended March 31, 2003, and 2002, respectively. 25 Interest Expense: The following table sets forth information regarding the total amount of interest expense from certain of the Company's collateralized borrowings. Information is based on daily average balances during the period.
For the Three Months Ended March 31, 2003 2002 ------------------------- ------------------------ Interest Interest Expense Expense ------------------------- ------------------------ Reverse repurchase agreements $ 5,852 $ 8,147 Lines of credit and term loan 136 695 CDO liabilities 6,405 - ========================= ======================== Total $12,393 $ 8,842 ========================= ========================
The foregoing interest expense amounts for the three months ended March 31, 2003 do not include a $262 addition to interest expense related to hedge ineffectiveness, as well as a $7,050 addition to interest expense related to swaps. The foregoing interest expense amounts for the three months ended March 31, 2002 do not include a $1,175 reduction of interest expense related to hedge ineffectiveness, as well as a $3,973 addition to interest expense related to swaps. See Note 9 in the consolidated financial statements, Derivative Instruments, for a further description of the Company's hedge ineffectiveness. Net Interest Margin and Net Interest Spread from the Portfolio: The Company considers its portfolio to consist of its securities available for sale, mortgage loan pools, commercial mortgage loans and cash and cash equivalents because these assets relate to its core strategy of acquiring and originating high yield loans and securities backed by commercial real estate, while at the same time maintaining a portfolio of investment grade securities to enhance the Company's liquidity. Net interest margin from the portfolio is annualized net interest income from the portfolio divided by the average market value of interest-earning assets in the portfolio. Net interest income from the portfolio is total interest income from the portfolio less interest expense relating to collateralized borrowings. Net interest spread from the portfolio equals the yield on average assets for the period less the average cost of funds for the period. The yield on average assets is interest income from the portfolio divided by average amortized cost of interest earning assets in the portfolio. The average cost of funds is interest expense from the portfolio divided by average outstanding collateralized borrowings. The following chart describes the interest income, interest expense, net interest margin and net interest spread for the Company's portfolio. The following interest income and interest expense amounts exclude income and expense related to real estate joint ventures, equity investment and hedge ineffectiveness.
For the Three Months Ended March 31, 2003 2002 --------------------------------- --------------------------------- Interest income $41,844 $39,090 Interest expense $19,433 $12,803 Net interest margin 3.62% 5.01% Net interest spread 3.30% 4.56%
26 Other Expenses: Expenses other than interest expense consist primarily of management fees and general and administrative expenses. Management fees paid to the Manager of $2,577 for the three months ended March 31, 2003 and were solely base management fees. Management fees paid to the Manager of $5,407 for the three months ended March 31, 2002 were comprised of base management fees of $2,219 and incentive fees of $3,188. Other expenses/income-net of $582 and $576 for the three months ended March 31, 2003, and 2002, respectively, were comprised of accounting agent fees, custodial agent fees, directors' fees, fees for professional services, insurance premiums and due diligence costs. Other Gains (Losses): During the three months ended March 31, 2003 and 2002, the Company sold a portion of its securities available for sale for total proceeds of $0 and $354,187, respectively, resulting in a realized gain/(loss) of $142 and $(4,079), respectively. The (losses)/gains on securities held for trading were $(10,389) and $4,014 for the three months ended March 31, 2003 and 2002, respectively. The foreign currency loss of $(247) for the three months ended March 31, 2002 relates to the Company's net investment in a commercial mortgage loan denominated in pounds sterling and associated hedging, which was subsequently paid off in December 2002. Dividends Declared: On March 6, 2003, the Company declared distributions to its stockholders of $.35 per share, which was paid on April 30, 2003 to stockholders of record on March 31, 2003. 27 Changes in Financial Condition Securities Available for Sale: The Company's securities available for sale, which are carried at estimated fair value, included the following at March 31, 2003 and December 31, 2002:
March 31, 2003 December 31, Estimated 2002 Estimated Fair Fair Security Description Value Percentage Value Percentage -------------------------------------------------- ---------------- --------------- ----------------- ---------------- Commercial mortgage-backed securities: CMBS IOs $ 41,751 2.0% $ 43,634 4.5% Investment grade CMBS 55,259 2.7 55,120 5.7 Non-investment grade rated subordinated 634,919 30.8 577,371 59.3 securities Non-rated subordinated securities 26,596 1.3 25,335 2.7 Credit tenant lease 8,956 0.4 9,063 0.9 Investment grade REIT debt 188,107 9.1 183,822 18.9 ---------------- --------------- ----------------- ---------------- Total CMBS 955,588 46.3 894,345 92.0 ---------------- --------------- ----------------- ---------------- Single-family residential mortgage-backed securities: Agency adjustable rate securities 38,311 1.9 41,299 4.2 Agency fixed rate securities 1,044,720 50.7 8,833 0.9 Residential CMOs 10,658 0.5 13,834 1.4 Hybrid arms 12,615 0.6 14,751 1.5 ---------------- --------------- ----------------- ---------------- Total RMBS 1,106,304 53.7 78,717 8.0 ---------------- --------------- ----------------- ---------------- ---------------- --------------- ----------------- ---------------- Total securities available for sale $2,061,892 100.0% $973,062 100.0% ================ =============== ================= ================
The increase in the CMBS and investment grade REIT debt is attributable to the attractive opportunities available to the Company to match fund these assets in its two CDOs. Borrowings: As of March 31, 2003, the Company's debt consisted of collateralized debt obligations, line-of-credit borrowings, and reverse repurchase agreements, collateralized by a pledge of most of the Company's securities available for sale, securities held for trading, and its commercial mortgage loans. The Company's financial flexibility is affected by its ability to renew or replace on a continuous basis its maturing short-term borrowings. As of March 31, 2003, the Company has obtained financing in amounts and at interest rates consistent with the Company's short-term financing objectives. Under the collateralized debt obligations, lines of credit, and the reverse repurchase agreements, the lender retains the right to mark the underlying collateral to market value. A reduction in the value of its pledged assets would require the Company to provide additional collateral or fund margin calls. From time to time, the Company expects that it will be required to provide such additional collateral or fund margin calls. 28 The following table sets forth information regarding the Company's collateralized borrowings:
For the Three Months Ended March 31, 2003 ----------------------------------------------------------------- March 31, 2003 Maximum Range of Balance Balance Maturities --------------------- ---------------- -------------------------- Collateralized debt obligations $684,684 $684,684 8.7 to 10.4 years Reverse repurchase agreements 1,449,719 1,858,434 3 to 24 days Line of credit and term loan borrowings 18,789 22,057 121 to 837 days --------------------- ---------------- --------------------------
Hedging Instruments: From time to time, the Company may reduce its exposure to market interest rates by entering into various financial instruments that adjust portfolio duration. These financial instruments are intended to mitigate the effect of changes in interest rates on the value of certain assets in the Company's portfolio. At March 31, 2003, the Company had outstanding short positions of 3,059 five-year and 137 ten-year U.S. Treasury Note future contracts. At December 31, 2002, the Company had outstanding short positions of 3,166 five-year and 1,126 ten-year U.S. Treasury Note future contracts. Interest rate swap agreements as of March 31, 2003 and December 31, 2002 consisted of the following:
March 31, 2003 Weighted Notional Estimated Unamortized Average Value Fair Value Cost Remaining Term -------------------------------------------------------- Interest rate swaps $1,179,000 $(15,580) $0 2.18 years Interest rate swaps - CDO 650,371 (34,063) 0 9.36 years -------------------------------------------------------- Total $1,829,371 $(49,643) $0 4.73 years ======================================================== December 31, 2002 Weighted Notional Estimated Unamortized Average Value Fair Value Cost Remaining Term -------------------------------------------------------- Interest rate swaps $489,000 $(11,948) $0 1.79 years Interest rate swaps - CDO 673,832 (33,654) 0 9.60 years -------------------------------------------------------- Total $1,162,832 $(45,602) $0 6.31 years ========================================================
As of March 31, 2003, the Company had designated $1,177,826 notional of the interest rate swap agreements as cash flow hedges. As of December 31, 2002, the Company had designated $791,287 notional of the interest rate swap agreements as cash flow hedges. Capital Resources and Liquidity Liquidity is a measurement of the Company's ability to meet potential cash requirements, including 29 ongoing commitments to repay borrowings, fund investments, loan acquisition and lending activities and for other general business purposes. The primary sources of funds for liquidity consist of collateralized borrowings, principal and interest payments on and maturities of securities available for sale, securities held for trading and commercial mortgage loans, and proceeds from the maturity or sales thereof. To the extent that the Company may become unable to maintain its borrowings at their current level due to changes in the financing markets for the Company's assets, the Company may be required to sell assets in order to achieve lower borrowing levels. In this event, the Company's level of net income would decline. The Company's principal strategies for mitigating this risk are to maintain portfolio leverage at levels it believes are sustainable and to diversify the sources and types of available borrowing and capital. The Company has utilized committed bank facilities and preferred stock offerings, and will consider resecuritization or other achievable term funding of existing assets. In March 2002, the Series A Preferred stockholder converted its remaining 10,000 shares of the Series A Preferred Stock into 34,427 shares of Common Stock at a price of $7.26 per share pursuant to the terms of such preferred stock, which is $0.09 lower than the original conversion price due to the effects of anti-dilution provisions in the Series A Preferred Stock. For the quarter ended March 31, 2003, the Company issued 333,328 shares of Common Stock under its Dividend Reinvestment Plan. Net proceeds to the Company were approximately $3,517. As of March 31, 2003, $166,211 of the Company's $185,000 committed credit facility with Deutsche Bank, AG was available for future borrowings. The Company's operating activities provided cash flows of $403,374 and $214 during the three months ended March 31, 2003 and 2002, respectively, primarily through sales of trading securities and net income and purchases of trading securities, respectively. The Company's investing activities (used) provided cash flows of $(384,027) and $193,591 during the three months ended March 31, 2003 and 2002, respectively, primarily to purchase securities available for sale and to fund commercial mortgage loans, offset by significant sales of securities. The Company's financing activities used $(22,835) and $(217,293) during the three months ended March 31, 2003 and 2002, respectively, primarily from distributions on Common Stock in 2003 and reductions of the level of short-term borrowings in 2002. Although the Company's portfolio of securities available for sale was acquired at a net discount to the face amount of such securities, the Company has received to date, and expects to continue to have, sufficient cash flows from its portfolio to fund distributions to stockholders. The Company is subject to various covenants in its lines of credit, including maintaining a minimum GAAP net worth of $305,000, a debt-to-equity ratio not to exceed 5.5 to 1, a minimum cash requirement based upon certain debt to equity ratios, a minimum debt service coverage ratio of 1.5, and a minimum liquidity reserve of $10,000. As of March 31, 2003, the Company was in compliance with all such covenants. 30 The Company's ability to execute its business strategy depends to a significant degree on its ability to obtain additional capital. Factors which could affect the Company's access to the capital markets, or the costs of such capital, include changes in interest rates, general economic conditions and perception in the capital markets of the Company's business, covenants under the Company's current and future credit facilities, results of operations, leverage, financial conditions and business prospects. Current conditions in the capital markets for REITs such as the Company have made permanent financing transactions difficult and more expensive than at the time of the Company's initial public offering. Consequently, there can be no assurance that the Company will be able to effectively fund future growth. Except as discussed herein, management is not aware of any other trends, events, commitments or uncertainties that may have a significant effect on liquidity. Contingent Liability On May 15, 2000, the Company completed the acquisition of CORE Cap, Inc. The merger was a stock for stock acquisition where the Company issued 4,180,552 shares of its common stock and 2,261,000 shares of its series B preferred stock. At the time of the CORE Cap acquisition, the Manager agreed to pay GMAC (CORE Cap, Inc.'s external advisor) $12,500 over a ten-year period ("Installment Payment") to purchase the right to manage the assets under the existing management contract ("GMAC Contract"). The GMAC Contract had to be terminated in order to allow for the Company to complete the merger, as the Company's management agreement with the Manager did not provide for multiple managers. As a result the Manager offered to buy-out the GMAC Contract as the Manager estimated it would receive incremental fees above and beyond the Installment Payment, and thus was willing to pay for, and separately negotiate, the termination of the GMAC Contract. Accordingly, the value of the Installment Payment was not considered in the Company's allocation of its purchase price to the net assets acquired in the acquisition of CORE Cap, Inc. The Company agreed that should the Management Agreement with its Manager be terminated, not renewed or not extended for any reason other than for cause, the Company would pay to the Manager an amount equal to the Installment Payment less the sum of all payments made by the Manager to GMAC. As of March 31, 2003, the Installment Payment would be $9,500 payable over eight years. The Company does not accrue for this contingent liability. Transactions with Affiliates The Company has a Management Agreement with the Manager, a majority owned indirect subsidiary of The PNC Financial Services Group, Inc. ("PNC Bank") and the employer of certain directors and officers of the Company, under which the Manager manages the Company's day-to-day operations, subject to the direction and oversight of the Company's Board of Directors. On March 25, 2002, the Management Agreement was extended for one year through March 27, 2003, with the approval of the unaffiliated directors, on terms similar to the prior agreement with the following changes: (i) the incentive fee calculation would be based on GAAP earnings instead of funds from operations, (ii) the removal of the four-year period to value the Management Agreement in the event of termination and (iii) subsequent renewal periods of the Management Agreement would be for one year instead of two years. The Board was advised by Houlihan Lokey Howard & Zukin Financial Advisors, Inc., a national investment banking and financial advisory firm, in the renewal process. On March 6, 2003, the unaffiliated directors approved an extension of the Management Agreement from its expiration of March 27, 2003 for one year through March 31, 2004. The terms of the renewed 31 agreement are similar to the prior agreement except for the incentive fee calculation which would provide for a rolling four-quarter high watermark rather than a quarterly calculation. In determining the rolling four-quarter high watermark, the Company would calculate the incentive fee based upon the current and prior three quarters' net income. The Manager would be paid an incentive fee in the current quarter if the Yearly Incentive Fee is greater than what was paid to the Manager in the prior three quarters cumulatively. The Company will phase in the rolling four-quarter high watermark commencing with the second quarter of 2003. Calculation of the incentive fee will be based on GAAP and adjusted to exclude special one-time events pursuant to changes in GAAP accounting pronouncements after discussion between the Manager and the unaffiliated directors. The incentive fee threshold did not change. The high watermark will be based on the existing incentive fee hurdle, which provides for the Manager to be paid 25% of the amount of earnings (calculated in accordance with GAAP) per share that exceeds the product of the adjusted issue price of the Company's common stock per share ($11.39 as of March 31, 2003) and the greater of 9.5% or 350 basis points over the ten-year Treasury note. The Company pays the Manager an annual base management fee equal to a percentage of the average invested assets of the Company as defined in the Management Agreement. The base management fee is equal to 1% per annum of the average invested assets rated less than BB- or not rated, 0.75% of average invested assets rated BB- to BB+, and 0.20% of average invested assets rated above BB+. The Company incurred $2,577 and $2,219 in base management fees in accordance with the terms of the Management Agreement for the three months ended March 31, 2003 and 2002, respectively. In accordance with the provisions of the Management Agreement, the Company recorded reimbursements to the Manager of $6 and $5 for certain expenses incurred on behalf of the Company for the three months ended March 31, 2003 and 2002, respectively. Pursuant to the March 25, 2002 one-year Management Agreement extension, the incentive fee was based on 25% of earnings (calculated in accordance with GAAP) of the Company. For purposes of calculating the incentive fee during 2002, the cumulative transition adjustment of $6,327 resulting from the Company's adoption of SFAS 142 was excluded from earnings in its entirety and included using an amortization period of three years. This revision saved the Company $1,448 of incentive fee for the three months ended March 31, 2002. The Company incurred $3,188 in incentive compensation for the three months ended March 31, 2002. The Company did not incur incentive compensation fees for the three months ended March 31, 2003. On March 17, 1999, the Company's Board of Directors approved an administration agreement with the Manager and the termination of a previous agreement with an unaffiliated third party. Under the terms of the administration agreement, the Manager provides financial reporting, audit coordination and accounting oversight services to the Company. The Company pays the Manager a monthly administrative fee at an annual rate of 0.06% of the first $125 million of average net assets, 0.04% of the next $125 million of average net assets and 0.03% of average net assets in excess of $250 million subject to a minimum annual fee of $120. For the three months ended March 31, 2003 and 2002, the Company paid administration fees of $43 and $43, respectively. On July 20, 2001, the Company entered into a $50 million commitment to acquire shares in Carbon. The period during which the Company may be required to purchase shares under the commitment, expires in July 2004. On March 31, 2003, the Company owned 18.8% of the outstanding shares in 32 Carbon. The Company's remaining commitment at March 31, 2003 and December 31, 2002 was $32,436 and $35,116, respectively. On February 6, 2003, the Company funded a capital call notice in the amount of $2,680, which was used by Carbon to acquire a mezzanine loan secured by ownership interests in an entity that owns a mixed-use development. REIT Status: The Company has elected to be taxed as a REIT and therefore must comply with the provisions of the Internal Revenue Code with respect thereto. Accordingly, the Company generally will not be subject to Federal income tax to the extent of its distributions to stockholders and as long as certain asset, income and stock ownership tests are met. The Company may, however, be subject to tax at corporate rates or at excise tax rates on net income or capital gains not distributed. 33 ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK Market Risk: Market risk is the exposure to loss resulting from changes in interest rates, credit curve spreads, foreign currency exchange rates, commodity prices and equity prices. The primary market risks to which the Company is exposed are interest rate risk and credit curve risk. Interest rate risk is highly sensitive to many factors, including governmental, monetary and tax policies, domestic and international economic and political considerations and other factors beyond the control of the Company. Credit risk is highly sensitive to dynamics of the markets for commercial mortgage securities and other loans and securities held by the Company. Excessive supply of these assets combined with reduced demand will cause the market to require a higher yield. This demand for higher yield will cause the market to use a higher spread over the U.S. Treasury securities yield curve, or other benchmark interest rates, to value these assets. Changes in the general level of the U.S. Treasury yield curve can have significant effects on the market value of the Company's portfolio. The majority of the Company's assets are fixed rate securities valued based on a market credit spread to U.S. Treasuries. As U.S. Treasury securities are priced to a higher yield and/or the spread to U.S. Treasuries used to price the Company's assets is increased, the market value of the Company's portfolio may decline. Conversely, as U.S. Treasury securities are priced to a lower yield and/or the spread to U.S. Treasuries used to price the Company's assets is decreased, the market value of the Company's portfolio may increase. Changes in the market value of the Company's portfolio may affect the Company's net income or cash flow directly through their impact on unrealized gains or losses on securities held for trading or indirectly through their impact on the Company's ability to borrow. Changes in the level of the U.S. Treasury yield curve can also affect, among other things, the prepayment assumptions used to value certain of the Company's securities and the Company's ability to realize gains from the sale of such assets. In addition, changes in the general level of the LIBOR money market rates can affect the Company's net interest income. The majority of the Company's liabilities are floating rate based on a market spread to U.S. LIBOR. As the level of LIBOR increases or decreases, the Company's interest expense will move in the same direction. The Company may utilize a variety of financial instruments, including interest rate swaps, caps, floors and other interest rate exchange contracts, in order to limit the effects of fluctuations in interest rates on its operations. The use of these types of derivatives to hedge interest-earning assets and/or interest-bearing liabilities carries certain risks, including the risk that losses on a hedge position will reduce the funds available for payments to holders of securities and, that such losses may exceed the amount invested in such instruments. A hedge may not perform its intended purpose of offsetting losses or increased costs. Moreover, with respect to certain of the instruments used as hedges, the Company is exposed to the risk that the counterparties with which the Company trades may cease making markets and quoting prices in such instruments, which may render the Company unable to enter into an offsetting transaction with respect to an open position. If the Company anticipates that the income from any such hedging transaction will not be qualifying income for REIT income test purposes, the Company may conduct part or all of its hedging activities through a to-be-formed corporate subsidiary that is fully subject to federal corporate income taxation. The profitability of the Company may be adversely affected during any period as a result of changing interest rates. The following tables quantify the potential changes in the Company's net portfolio value and net interest income under various interest rates and credit-spread scenarios. The Company views the probability of 34 interest rate changes in terms of standard deviation units. Based on historical data, there is a 68% and 95% statistical probability that rates remained in a range of one and two standard deviation units, respectively. This statistical computation provides an historical context for analyzing changes in interest rates. Net portfolio value is defined as the value of interest-earning assets net of the value of interest-bearing liabilities. It is evaluated using an assumption that interest rates, as defined by the U.S. Treasury yield curve, increase or decrease and the assumption that the yield curves of the rate shocks will be parallel to each other. Net interest income is defined as interest income earned from interest-earning assets net of the interest expense incurred by the interest bearing liabilities. It is evaluated using the assumptions that interest rates, as defined by the U.S. LIBOR curve, increase or decrease and the assumption that the yield curves of the LIBOR rate shocks will be parallel to each other. Market value in this scenario is calculated using the assumption that the U.S. Treasury yield curve remains constant. All changes in income and value are measured as percentage changes from the respective values calculated in the scenario labeled as "Base Case." The base interest rate scenario assumes interest rates as of March 31, 2003. Actual results could differ significantly from these estimates. Projected Percentage Change In Portfolio Net Market Value Given U.S. Treasury Yield Curve Movements Change in Projected Change in Treasury Yield Curve, Portfolio +/- Basis Points Net Market Value - ------------------------------- ------------------------ -200 8.1% -100 6.3% -50 3.7% Base Case 0 +50 (4.8)% +100 (10.8)% +200 (26.0)% Projected Percentage Change In Portfolio Net Market Value Given Credit Spread Movements Change in Projected Change in Credit Spreads, Portfolio +/- Basis Points Net Market Value - ------------------------------- -------------------------- -200 27.1% -100 15.8% -50 8.4% Base Case 0 +50 (9.6)% +100 (20.2)% +200 (44.9)% 35
Projected Percentage Change In Portfolio Net Interest Income Given LIBOR Movements Projected Change in Projected Change in Change in LIBOR, Portfolio Portfoilo Net Ineterest +/- Basis Points Net Interest Income Income per Share - ------------------------------- ------------------------- -------------------------- -100 2.3% $0.04 -50 1.2% $0.02 Base Case 0 0 +50 (1.2)% $(0.02) +100 (2.3)% $(0.04) +200 (4.6)% $(0.09)
After changes to RMBS hedging were fully implemented early in the second quarter of 2003, the Company's exposure to changes in short-term interest rates would result in a $0.045 change in net income for every 50 basis point change in LIBOR. The aggregate sensitivity to short-term rates has not changed year over year. However, as detailed above, a significant portion of the Company's illiquid credit sensitive CMBS was match funded in 2002 with no short-term rate risk. As of March 31, 2003 the majority of the Company's short-term rate exposure was concentrated in the highly liquid RMBS portfolio which can be adjusted quickly to react to changes in short-term rates. Credit Risk: The Company's portfolios of commercial real estate assets are subject to a high degree of credit risk. Credit risk is the exposure to loss from loan defaults. Default rates are subject to a wide variety of factors, including, but not limited to, property performance, property management, supply/demand factors, construction trends, consumer behavior, regional economics, interest rates, the strength of the American economy and other factors beyond the control of the Company. All loans are subject to a certain probability of default. The Company underwrites its CMBS investments assuming the underlying loans will suffer a certain dollar amount of defaults and these defaults will lead to some level of realized losses. Loss adjusted yields are computed based on these assumptions and applied to each class of security supported by the cash flow on the underlying loans. The most significant variables affecting loss adjusted yields include, but are not limited to, the number of defaults, the severity of loss that occurs subsequent to a default and the timing of the actual loss. The different rating levels of CMBS will react differently to changes in these assumptions. The lowest rated securities (B- or lower) are generally more sensitive to changes in timing of actual losses. The higher rated securities (B or higher) are more sensitive to the severity of losses. The Company generally assumes that all of the principal of a non-rated security and a significant portion, if not all, of CCC and a portion of B- rated securities will not be recoverable over time. The loss adjusted yields of these classes reflect that assumption; therefore, the timing of when the total loss of principal occurs is the key assumption. The interest coupon generated by a security will cease when there is a total loss of its principal regardless of whether that principal is paid. Therefore, timing is of paramount importance because the longer the principal balance remains outstanding the more interest coupon the holder receives to support a greater economic return. Alternatively, if principal is lost faster than originally assumed there is less opportunity to receive interest coupon therefore a lower or possibly negative return may result. Additional losses occurring due to greater severity will not have a 36 significant effect as all principal is already assumed to be non-recoverable. If actual principal losses on the underlying loans exceed assumptions, the higher rated securities will be affected more significantly as a loss of principal may not have been assumed. The Company generally assumes that most if not all principal will be recovered by classes rated B or higher. The Company manages credit risk through the underwriting process, establishing loss assumptions and careful monitoring of loan performance. Before acquiring a Controlling Class security that represents a proposed pool of loans, the Company will perform a rigorous analysis of the quality of all of the loans proposed. As a result of this analysis, loans with unacceptable risk profiles will be removed from the proposed pool. Information from this review is then used to establish loss assumptions. The Company will assume that a certain portion of the loans will default and calculate an expected or loss adjusted yield based on that assumption. After the securities have been acquired, the Company monitors the performance of the loans, as well as external factors that may affect their value. Factors that indicate a higher loss severity or acceleration of the timing of an expected loss will cause a reduction in the expected yield and therefore reduce the earnings of the Company. Furthermore, the Company may be required to write down a portion of the adjusted purchase price of the affected assets through its income statement. For purposes of illustration, a doubling of the losses in the Company's Controlling Class CMBS, without a significant acceleration of those losses would reduce GAAP income going forward by approximately $0.21 per share of common stock per annum and cause a significant write down at the time the loss assumption is changed The amount of the write down depends on several factors, including which securities are most affected at the time of the write down, but is estimated to be in the range of $0.60 to $0.80 per share based on a doubling of expected losses. A significant acceleration of the timing of these losses would cause the Company's net income to decrease. The total adjusted purchase price of Controlling Class CMBS at March 31, 2003 was $10.53 per share. The amount of adjusted purchase price that is not match funded in a CDO is $4.84 per share. The Company's exposure to a write down is mitigated by the fact that most of these assets are financed on a non-recourse basis in the Company's CDOs, where a significant portion of the risk of loss is transferred to the CDO bondholders. Asset and Liability Management: Asset and liability management is concerned with the timing and magnitude of the repricing and/or maturing of assets and liabilities. It is the objective of the Company to attempt to control risks associated with interest rate movements. In general, management's strategy is to match the term of the Company's liabilities as closely as possible with the expected holding period of the Company's assets. This is less important for those assets in the Company's portfolio considered liquid as there is a very stable market for the financing of these securities. Other methods for evaluating interest rate risk, such as interest rate sensitivity "gap" (defined as the difference between interest-earning assets and interest-bearing liabilities maturing or repricing within a given time period), are used but are considered of lesser significance in the daily management of the Company's portfolio. Management considers this relationship when reviewing the Company's hedging strategies. Because different types of assets and liabilities with the same or similar maturities react differently to changes in overall market rates or conditions, changes in interest rates may affect the 37 Company's net interest income positively or negatively even if the Company were to be perfectly matched in each maturity category. The Company currently has positions in forward currency exchange contracts to hedge currency exposure in connection with its commercial mortgage loan denominated in pounds sterling. The purpose of the Company's foreign currency-hedging activities is to protect the Company from the risk that the eventual U.S. dollar net cash inflows from the commercial mortgage loan will be adversely affected by changes in exchange rates. The Company's current strategy is to roll these contracts from time to time to hedge the expected cash flows from the loan. Fluctuations in foreign exchange rates are not expected to have a material impact on the Company's net portfolio value or net interest income. 38 ITEM 4. CONTROLS AND PROCEDURES (a) Evaluation of Disclosure Controls and Procedures. The Company's Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the Company's disclosure controls and procedures (as such term is defined in Rules 13a-14(c) and 15d-14(c) under the Securities Exchange Act of 1934, as amended (the "Exchange Act")) as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"). Based on such evaluation, such officers have concluded that, as of the Evaluation Date, the Company's disclosure controls and procedures are effective in alerting them on a timely basis to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company's reports filed or submitted under the Exchange Act. (b) Changes in Internal Controls. Since the Evaluation Date, there have not been any significant changes in the Company's internal controls or in other factors that could significantly affect such controls. 39 Part II - OTHER INFORMATION Item 1. Legal Proceedings At March 31, 2003 there were no pending legal proceedings to which the Company was a party or of which any of its property was subject. Item 2. Changes in Securities and Use of Proceeds None. Item 3. Defaults Upon Senior Securities Not applicable. Item 4. Submission of Matters to a Vote of Security Holders None. Item 5. Other Information None. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits 10.1 Amended and Restated Investment Advisory Agreement, dated as of March 27, 2003, between the Registrant and BlackRock Financial Management, Inc. 99.1 Certification of CEO and CFO pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (b) Reports on Form 8-K On February 25, 2003, the Company filed a Current Report on Form 8-K to report under Item 5 the Company's earnings for the quarter and full year ended December 31, 2002. 40 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. ANTHRACITE CAPITAL, INC. Dated: May 15, 2003 By: /s/ Hugh R. Frater ____________________ Name: Hugh R. Frater Title: President and Chief Executive Officer (authorized officer of registrant) Dated: May 15, 2003 By: /s/ Richard M. Shea _________________________ Name: Richard M. Shea Title: Chief Operating Officer and Chief Financial Officer 41 CERTIFICATIONS I, Hugh R. Frater, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Anthracite Capital, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) Designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) Presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) All significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 42 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Dated: May 15, 2003 By: /s/ Hugh R. Frater ____________________ Name: Hugh R. Frater Title: President and Chief Executive Officer (authorized officer of registrant) 43 I, Richard M. Shea, certify that: 1. I have reviewed this quarterly report on Form 10-Q of Anthracite Capital, Inc.; 2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report; 3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this quarterly report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and we have: a) Designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this quarterly report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this quarterly report (the "Evaluation Date"); and c) Presented in this quarterly report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent function): a) All significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 44 6. The registrant's other certifying officers and I have indicated in this quarterly report whether or not there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Dated: May 15, 2003 By: /s/ Richard M. Shea _________________________ Name: Richard M. Shea Title: Chief Operating Officer and Chief Financial Officer 45 EX-10 3 s761576.txt EXHIBIT 10.1 Exhibit 10.1 ------------ AMENDED AND RESTATED INVESTMENT ADVISORY AGREEMENT -------------------------------------------------- AGREEMENT, dated as of March 27, 2003, between Anthracite Capital, Inc. (the "Company"), a Maryland corporation, and BlackRock Financial Management, Inc. (the "Manager"), a Delaware corporation. WHEREAS, the Company intends to invest in a diversified portfolio of multifamily, commercial and residential mortgage loans, mortgage-backed securities and other real estate related assets in U.S. and non-U.S. markets and expects to qualify for the tax benefits accorded by Sections 856 through 860 of the Internal Revenue Code of 1986, as amended (the "Code"); WHEREAS, the Company desires to retain the Manager to acquire, sell and otherwise manage the investments of the Company and to perform certain supervisory services for the Company in the manner and on the terms set forth herein; WHEREAS, the Company and the Manager entered into that certain Investment Advisory Agreement, dated as of March 27, 1998 (the "Investment Advisory Agreement"), as amended by that certain (i) First Amendment to the Investment Advisory Agreement, dated as of January 1, 1999, (ii) Second Amendment to the Investment Advisory Agreement, dated as of July 1, 2001, (iii) Third Amendment to the Investment Advisory Agreement, dated as of March 27, 2002 and (iv) Fourth Amendment to the Investment Advisory Agreement, dated as of May 13, 2002 and as extended by that certain (a) letter agreement dated May 5, 2000 between the Company and the Manager and (b) letter agreement dated March 25, 2002 between the Company and the Manager. All such amendments and extensions are referred to herein collectively as the "Prior Agreement." WHEREAS, the Manager and the Company desire to amend and restate the Prior Agreement in its entirety as set forth below; and WHEREAS, this Agreement amends and restates the Prior Agreement in all respects. NOW THEREFORE, in consideration of the mutual promises and agreements herein contained and other good and valuable consideration, the receipt of which is hereby acknowledged, it is agreed by and between the parties hereto as follows: 1 1. Definitions ----------- Capitalized terms used but not defined herein shall have the respective meanings assigned them in the Prospectus of the Company, dated March 24, 1998. In addition, the following terms have the meanings assigned them. (a) "Affiliate" means, when used with reference to a specified person, (i) any person that directly or indirectly controls or is controlled by or is under common control with the specified person, (ii) any person that is an officer of, partner in or trustee of, or serves in a similar capacity with respect to, the specified person or of which the specified person is an officer, partner or trustee, or with respect to which the specified person serves in a similar capacity and (iii) any person that, directly or indirectly, is the beneficial owner of 5% or more of any class of equity securities of the specified person or of which the specified person is directly or indirectly the owner of 5% or more of any class of equity securities; provided, however, that neither the Company nor any of its controlled Affiliates will be treated as an Affiliate of the Manager or any of its Affiliates. (b) "Agreement" means this Amended and Restated Investment Advisory Agreement, as amended from time to time. (c) "Average Invested Assets" for any period means the average of the aggregate book value of the assets of the Company (other than cash or cash equivalents), including all of the assets of all of its direct and indirect subsidiaries, before reserves for depreciation or bad debts or other similar noncash reserves, computed by taking the monthly average of such values during such period, and shall be determined as follows: (i) Average Invested Assets with a rating of less than BB- or not rated means, for any quarter, the Average Invested Assets in such quarter that have received a credit rating of less than BB- from Standard & Poor's Corporation ("S&P") or less than Ba3 from Moody's Investors Service, Inc. ("Moody's") or have received an equivalent rating from a nationally recognized securities rating organization ("NRSRO") or that have not been rated by any of Moody's, S&P or a NRSRO and are not guaranteed by the U.S. government or any agency or instrumentality thereof, (ii) Average Invested Assets with a rating of BB- to BB+ means, for any quarter, the Average Invested Assets in such quarter that have received a credit rating of BB- to BB+ from S&P or Ba3 to Ba1 from Moody's or have received an equivalent rating from a NRSRO and that are not covered by clause 2 (i) above, and (iii) Average Invested Assets with a credit rating above BB+ means, for any quarter, the Average Invested Assets in such quarter that have received a credit rating above BB+ from S&P or above Ba1 from Moody's or have received an equivalent rating from a NRSRO and that are not covered by clause (i) or (ii) above or that are not rated but are guaranteed by the U.S. government or any agency or instrumentality thereof. (d) "Board of Directors" means the Board of Directors of the Company. (e) "Closing Date" means the date of closing of the Company's initial public offering of Common Stock. (f) "Code" means the Internal Revenue Code of 1986, as amended. (g) "GAAP" means accounting principles generally accepted in the United States of America. (h) "Mortgage-Backed Securities" means debt obligations (bonds) that are secured by Mortgage Loans or mortgage certificates. (i) "Mortgage Loans" means multifamily, residential and commercial term loans secured by real property. (j) "REIT Provisions of the Code" means Sections 856 through 860 of the Code. (k) "Ten-Year 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 constant maturities 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. 3 (l) "Unaffiliated Directors" shall mean those directors who (a) do not own greater than a de minimis interest in the Manager or any of its Affiliates or (b) within the last two years, have not directly or indirectly (i) been an officer of or employed by the Company or the Manager or any of their respective Affiliates, (ii) been a director of the Manager or any of its Affiliates, (iii) performed more than a de minimis amount of services for the Manager or any of its Affiliates or (iv) had any material business or professional relationship with the Manager or any of its Affiliates. 2. In General ---------- The Manager agrees, as more fully set forth herein, to act as investment adviser to the Company with respect to the investment of the Company's assets and to supervise and arrange the purchase of securities and loans for and the sale of securities and loans held in the investment portfolio of the Company. The Manager shall 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 shall prepare regular reports for the Company's Board of Directors that will review the Company's acquisitions of assets, portfolio composition and characteristics, credit quality, performance and compliance with the policies approved by the Company's Board of Directors. The Manager shall allocate investment and disposition opportunities in accordance with policies and procedures the Manager considers fair and equitable, including, without limitation, such considerations as investment objectives, restrictions and time horizons, availability of cash and the amount of existing holdings. 3. Duties and Obligations of the Manager with Respect to ----------------------------------------------------- Investment of Assets of the Company - ----------------------------------- (a) Subject to the succeeding provisions of this Section and subject to the direction and control of the Company's Board of Directors, the Manager will be responsible for the day-to-day operations of the Company and will perform (or cause to be performed) such services and activities relating to the assets and operations of the Company as may be appropriate, including, but not limited to: (i) providing a complete program of investing and reinvesting the capital and assets of the Company in pursuit of the Company's investment objectives and in accordance with the policies adopted by the Company's Board of Directors from time to time; 4 (ii) serving as the Company's consultant with respect to formulation of investment criteria and preparation of policy guidelines by the Company's Board of Directors; (iii) assisting the Company in developing criteria for mortgage asset purchase commitments that are specifically tailored to the Company's investment objectives and making available to the Company the Company's knowledge and experience with respect to mortgage assets and other real estate related assets; (iv) counseling the Company in connection with policy decisions made by the Board of Directors; (v) evaluating and recommending hedging strategies to the Company's Board of Directors in accordance with hedging guidelines and policies adopted by the Board of Directors, and engaging in hedging activities on behalf of the Company, consistent with the Company's status as a REIT; (vi) maintaining the Company's exemption from regulation as an investment company under the Investment Company Act of 1940, as amended (the "Investment Company Act"); (vii) representing the Company in connection with the purchase and commitment to purchase or sell mortgage assets, including the accumulation of Mortgage Loans for securitization and the incurrence of debt; (viii) arranging for the issuance of Mortgage-Backed Securities from pools of Mortgage Loans owned by the Company; (ix) furnishing reports and statistical and economic research to the Company regarding the Company's activities and the services performed for the Company by the Manager; (x) monitoring and providing to the Company's Board of Directors on an ongoing basis price information and other data, obtained from certain nationally recognized dealers that maintain markets in mortgage assets identified by the Board of Directors from time to time, and providing data and advice to the Board of Directors in connection with the identification of such dealers; 5 (xi) administering the day-to-day operations of the Company and performing and supervising the performance of such other administrative functions necessary in the management of the Company as may be agreed upon by the Manager and the Company's Board of Directors; (xii) contracting, as necessary, with third parties for master servicing and special servicing of assets acquired by the Company; (xiii) communicating on behalf of the Company with the holders of the equity and debt securities of the Company as required to satisfy the reporting and other requirements of any governmental bodies or agencies and to maintain effective relations with such holders; (xiv) causing the Company to qualify to do business in all applicable jurisdictions; (xv) causing the Company to retain qualified accountants and legal counsel to assist in developing appropriate accounting procedures, compliance procedures and testing systems and to conduct quarterly compliance reviews; (xvi) assisting the Company in complying with all regulatory requirements applicable to the Company in respect of its business activities, including preparing or causing to be prepared all financial statements required under applicable regulations and contractual undertakings and all reports and documents, if any, required under the Securities Exchange Act of 1934, as amended (the "Exchange Act"); (xvii) assisting the Company in making all required tax filings and reports and maintaining its status as a REIT, including soliciting stockholders for required information to the extent provided in the REIT Provisions of the Code; (xviii) performing such other services as may be required from time to time for management and other activities relating to the assets of the Company as the Board of Directors shall reasonably request or the Manager shall deem appropriate under the particular circumstances; and (xix) using all reasonable efforts to cause the Company to comply with all applicable laws. 6 (b) In the performance of its duties under this Agreement, the Manager shall at all times use all reasonable efforts to conform to and act in accordance with any requirements imposed by (i) the status of the Company as a REIT as defined in the REIT Provisions of the Code; (ii) the Company's status as an entity exempt from regulation under the Investment Company Act; (iii) any other applicable provision of law; (iv) the provisions of the Articles of Incorporation and By-Laws of the Company, as such documents are amended from time to time; (v) the investment objectives and policies of the Company as set forth in its Registration Statement on Form S-11; and (vi) any policies and determinations of the Board of Directors of the Company. (c) The Manager will bear all costs and expenses of the Manager's officers and employees and any overhead incurred in connection with the Manager's duties hereunder, the cost of office space and equipment required for performance of the Manager's duties and shall bear the costs of any salaries or directors' fees of any officers or directors of the Company who are Affiliates of the Manager, except that the Board of Directors of the Company may approve reimbursement to the Manager of the Company's pro rata portion of the salaries, bonuses, health insurance, retirement benefits and all similar employment costs for the time spent on Company operations and administration (other than the provision of services covered by Section 3(a) above) of all personnel employed by the Manager who devote substantial time to Company operations and administration or the operations and administration of other companies advised by the Manager; provided that the Manager shall not be expected to bear the following expenses: issuance and transaction costs incident to the acquisition, disposition and financing of investments, legal, accounting and auditing fees and expenses, the compensation and expenses of the Company's Unaffiliated Directors, the costs of printing and mailing proxies and reports to stockholders, costs incurred by employees of the Manager for travel on behalf of the Company, costs associated with any computer software or hardware that is used solely for the Company, costs to obtain liability insurance to indemnify the Company's directors and officers, the Manager and its employees and directors and the Underwriters, and the compensation and expenses of the Company's custodian and transfer agent, if any. The Company will also be required to pay all expenses incurred in connection with due diligence, the accumulation of Mortgage Loans, the master and special servicing of Mortgage Loans, the issuance and administration of Mortgage-Backed Securities from pools of Mortgage Loans or otherwise, the raising of capital, the incurrence of debt, the acquisition of assets, interest expenses, taxes and license fees, non-cash costs, litigation, the base and incentive management fee and extraordinary or non-recurring expenses. (d) The Manager shall give the Company the benefit of its best judgment and effort in rendering services hereunder. 7 (e) Nothing in this Agreement shall prevent the Manager or any partner, officer, employee or other Affiliate of the Manager from acting as investment adviser for any other person, firm or corporation, or from engaging in any other lawful activity, and shall not in any way limit or restrict the Manager or any of its shareholders, officers, employees or agents from buying, selling or trading any securities for its or their own accounts or for the accounts of others for whom it or they may be acting; provided, however that the Manager will not undertake activities which, in its judgment, will substantially and adversely affect the performance of its obligations under this Agreement. (f) The Manager shall maintain an appropriate books of accounts and records relating to services performed under this Agreement, and such books of accounts and records shall be accessible for inspection by representatives of the Company or any of its subsidiaries at any time during normal business hours. The Manager shall keep confidential any and all information obtained in connection with the services rendered under this Agreement and shall not disclose any such information to nonaffiliated third parties except with the prior written consent of the Board of Directors or as may be required by law or order of a court or other tribunal having requisite jurisdiction. (g) The Manager shall require each seller or transferor of assets to be acquired by the Company to make such representations and warranties regarding such assets as may be directed by the Board of Directors, or, if no such directions are given, as may, in the judgment of the Manager, be necessary and appropriate. In addition, the Manager shall take such other action as may be directed by the Board of Directors, or, if no such directions are given, as it deems necessary or appropriate with regard to the protection of the Company's assets. 4. Portfolio Transactions and Brokerage ------------------------------------ The Manager is authorized, for the purchase and sale of the Company's assets, to employ such securities dealers as may, in the judgment of the Manager, implement the policy of the Company to obtain the best net results taking into account such factors as price, including dealer spread, the size, type and difficulty of the transaction involved, the firm's general execution and operational facilities and the firm's risk in positioning the securities involved. Consistent with this policy, the Manager is authorized to direct the execution of the Company's portfolio transactions to dealers and brokers furnishing statistical information or research deemed by the Manager to be 8 useful or valuable to the performance of the Manager's investment advisory functions for the Company. 5. Compensation of the Manager --------------------------- (a) Commencing with the first fiscal quarter after the Closing Date, the Company agrees to pay to the Manager and the Manager agrees to accept as full compensation for all services rendered by the Manager as such, (i) a quarterly base management fee calculated as a percentage of the Average Invested Assets of the Company on the last business day for which market quotations are available of each calendar quarter and equal to 1% per annum of such Average Invested Assets rated lower than BB- or not rated, 0.75% of such Average Invested Assets rated BB- through BB+ and 0.20% of such Average Invested Assets that are rated above BB+ and (ii) incentive compensation in an amount equal to the product of 25% of the dollar amount by which: (1) net income of the Company (before incentive fee) determined in accordance with GAAP plus $534,623.47 (the "Fixed Amount") for each fiscal quarter for which a calculation is made under this Section (provided, that, if this Agreement is not renewed pursuant to Section 7 hereof or, in the event this Agreement is so renewed, if the terms of this Section 5(a)(ii)(1) are amended to modify the Fixed Amount, then the Fixed Amounts which would have been payable through and including the quarter ended December 31, 2005 shall be included in the final calculation made pursuant to this Section 5(a)(ii)(1) prior to giving effect to any such non-renewal or modification; provided, further, that the Fixed Amount for the quarter ended December 31, 2005 shall be deemed to be $446,141.80) exceeds ------- (2) an amount equal to (a) the weighted average of the price per share of the Common Stock in the initial public offering and the prices per share of Common Stock in any secondary offerings of Common Stock by the Company, including, without limitation, issuances of Common Stock pursuant to the Company's Dividend Reinvestment and Stock Purchase Plan, private placements, public offerings and exercises of options granted under the Company's 1998 Stock Option Plan, multiplied by (b) the greater of: (i) 9.5% or (ii) the Ten-Year U.S. Treasury Rate plus 3.5% per annum (expressed as a quarterly percentage) multiplied by (c) the weighted average number of shares of Common Stock outstanding during such quarter 9 ; provided, however, that, beginning with the fiscal quarter ending June 30, 2003, calculation of such incentive fee payable to the Manager shall be calculated using a rolling four-quarter high watermark (the "Watermark"). Except as described below, in determining the Watermark, the Manager shall calculate the incentive fee based upon the current and prior three quarters' net income (the "Yearly Incentive Fee"). The Company shall pay the Manager an incentive fee in the current quarter if the Yearly Incentive Fee is greater than the amount the Company paid to the Manager in the prior three quarters cumulatively (except as described below); and provided, further, that calculation of the incentive fee shall be based on GAAP and adjusted to exclude special one-time events pursuant to changes in GAAP accounting pronouncements, or other one-time events, after discussion between the Manager and the Unaffiliated Directors. For the avoidance of doubt, calculations pursuant to this paragraph, including with respect to the Yearly Incentive Fee, for the quarter ending June 30, 2003 shall be made with respect to the quarter ending June 30, 2003, for the quarter ending September 30, 2003 shall be made with respect to the two quarters ending September 30, 2003 and for the quarter ending December 31, 2003 shall be made with respect to the three quarters ending December 31, 2003. For any period less than a fiscal quarter during which this Agreement is in effect, the fee shall be prorated according to the proportion which such period bears to a full quarter of 90, 91 or 92 days, as the case may be. (b) The management fees earned under Section 5(a)(i) will be payable in arrears. The Manager shall compute the compensation payable under Section 5(a) of this Agreement within 45 days after the end of each calendar quarter. A copy of the computations made by the Manager to calculate its compensation shall thereafter promptly be delivered to the Board of Directors and, upon such delivery, payment of the compensation earned under Section 5(a) of this Agreement shown therein shall be due and payable within 60 days after the end of such fiscal quarter. If requested by the Manager, the Company will make advance payments of the base management fee in Section 5(a)(i) above as often as semi-monthly at the rate of 75% of such fee estimated by the Manager. (c) The base management fee is intended to compensate the Manager for its costs in providing management services to the Company. The Board of Directors may adjust the base management fee with the consent of the Manager in the future if necessary to align the fee more closely with the costs of such services. 10 6. Indemnity --------- (a) The Company hereby agrees to indemnify the Manager and each of the Manager's shareholders, officers, employees, agents, associates and controlling persons and the shareholders, officers, employees and agents thereof (including any individual who serves at the Manager's request as director, officer, partner, trustee or the like of another corporation) (each such person being an "indemnitee") against any liabilities and expenses, including amounts paid in satisfaction of judgments, in compromise or as fines and penalties, and counsel fees (all as provided in accordance with applicable corporate law) reasonably incurred by such indemnitee in connection with the defense or disposition of any action, suit or other proceeding, whether civil or criminal, before any court or administrative or investigative body in which he may be or may have been involved as a party or otherwise or with which he may be or may have been threatened, while acting in any capacity set forth above in this Section 6 or thereafter by reason of his having acted in any such capacity, except with respect to any matter as to which he shall have been adjudicated not to have acted in good faith in the reasonable belief that his action was in the best interests of the Company and furthermore, in the case of any criminal proceeding, so long as he had no reasonable cause to believe that the conduct was unlawful; provided, however, that (1) no indemnitee shall be indemnified hereunder against any liability to the Company or its stockholders or any expense of such indemnitee arising by reason of (i) willful misfeasance, (ii) bad faith, (iii) gross negligence or (iv) reckless disregard of the duties involved in the conduct of his position (the conduct referred to in such clauses (i) through (iv) being sometimes referred to herein as "disabling conduct"), (2) as to any matter disposed of by settlement or a compromise payment by such indemnitee, pursuant to a consent decree or otherwise, no indemnification either for such payment or for any other expenses shall be provided unless there has been a determination that such settlement or compromise is in the best interests of the Company and that such indemnitee appears to have acted in good faith in the reasonable belief that his action was in the best interests of the Company and did not involve disabling conduct by such indemnitee and (3) with respect to any action, suit or other proceeding voluntarily prosecuted by any indemnitee as plaintiff, indemnification shall be mandatory only if the prosecution of such action, suit or other proceeding by such indemnitee was authorized by a majority of the Board of Directors of the Company. (b) The Company shall make advance payments in connection with the expenses of defending any action with respect to which indemnification might be sought hereunder if the Company receives a written affirmation of the indemnitee's good faith belief that the standard of conduct necessary for indemnification has been met and a 11 written undertaking to reimburse the Company unless it is subsequently determined that he is entitled to such indemnification and if a majority of the Board of Directors of the Company determine that the facts then known to them would not preclude indemnification. In addition, at least one of the following conditions must be met: (A) the indemnitee shall provide a security for his undertaking, (B) the Company shall be insured against losses arising by reason of any lawful advances or (C) a majority of a quorum consisting of directors of the Company who are neither affiliated persons of the Company nor parties to the proceeding ("Disinterested Non-Party Directors") or an independent legal counsel in a written opinion, shall determine, based on a review of readily available facts (as opposed to a full trial-type inquiry), that there is reason to believe that the indemnitee ultimately will be found entitled to indemnification. (c) All determinations with respect to indemnification hereunder shall be made (1) by a final decision on the merits by a court or other body before whom the proceeding was brought that such indemnitee is not liable by reason of disabling conduct or (2) in the absence of such a decision, by (i) a majority vote of a quorum of the Disinterested Non-Party Directors of the Company or (ii) if a majority vote of such quorum so directs, independent legal counsel in a written opinion. All determinations that advance payments in connection with the expense of defending any proceeding shall be authorized shall be made in accordance with the immediately preceding clause (2). (d) The rights accruing to any indemnitee under these provisions shall not exclude any other right to which he may be lawfully entitled. 7. Duration and Termination ------------------------ This Agreement shall commence on the date hereof for an initial term expiring on March 31, 2004. Thereafter, successive extensions, each for a period not to exceed one year, may be made by agreement between the Company and the Manager, with the approval of a majority of the Unaffiliated Directors until terminated or assigned under the provisions of this Section 7 or Section 9, as the case may be, of this Agreement. Upon termination of this Agreement by the Company, the Company is obligated to pay the Manager a termination fee that will be determined by independent appraisal other than in the case of termination by the Company for cause (as described below). The Company may terminate, or decline to renew the term of, this Agreement without cause at any time after the first two years upon 60 days' written notice by a majority vote of the Unaffiliated Directors; provided that the Company shall pay the 12 Manager a termination fee determined by independent appraisal of the value of this Agreement. Such appraisal is to be conducted by a nationally recognized appraisal firm mutually agreed upon by the Company and the Manager. If the Company and the Manager are unable to agree upon an appraisal firm, then each of the Company and the Manager is to choose an independent appraisal firm to conduct an appraisal. In such event, (i) if the appraisals prepared by the two appraisers so selected are the same or differ by an amount that does not exceed 20% of the higher of the two appraisals, the termination fee is to be deemed to be the average of the appraisals as prepared by each party's chosen appraiser and (ii) if these two appraisals differ by more than 20% of such higher amount, the two appraisers together are to select a third appraisal firm to conduct an appraisal. If the two appraisers are unable to agree as to the identity of such third appraiser, either of the Manager and the Company may request that the American Arbitration Association ("AAA") select the third appraiser. The termination fee then is to be the amount determined by such third appraiser, but in no event shall the termination fee be less than the lower of the two initial appraisals or more than the higher of such two initial appraisals. Each party shall pay the costs of the appraisers chosen by it, and each party shall pay one half of the costs of the third appraiser. Any appraisal hereunder shall be performed no later than 45 days following selection of the appraiser or appraisers. At the option of the Company, this Agreement, or any extension hereof, shall be and become terminated with cause upon 60 days' prior written notice of termination from the Board of Directors to the Manager, without payment of any termination fee, if any of the following events occur: (i) if the Manager commits a material breach of any provision of this Agreement (including any material breach of the provisions contained in Section 3(a) and (b) herein) and, after notice of such violation, shall not cure such violation within 30 days; or (ii) there is entered an order for relief or similar decree or order with respect to the Manager by a court having competent jurisdiction in an involuntary case under the federal bankruptcy laws as now or hereafter constituted or under any applicable federal or state bankruptcy, insolvency or other similar laws; or the Manager (A) ceases, or admits in writing its inability, to pay its debts as they become due and payable, or makes a general assignment for the benefit of, or enters into any composition or arrangement with, creditors; (B) applies for, or consents (by admission of material allegations of a petition or otherwise) to the appointment of a receiver, trustee, assignee, custodian, liquidator or sequestrator (or other similar official) of the Manager or of any substantial part of its properties or assets, or authorizes such an application or consent, or proceedings seeking such appointment are commenced without such authorization, consent or application against the Manager and continue undismissed for 30 days; or (C) authorizes or files a voluntary petition in bankruptcy, or applies for or consents (by admission of material allegations of a petition or otherwise) to the application of any bankruptcy, 13 reorganization, arrangement, readjustment of debt, insolvency, dissolution, liquidation or other similar law of any jurisdiction, or authorizes such application or consent, of proceedings to such end are instituted against application or consent, or proceedings to such end are instituted against the Manager without such authorization, application or consent and are approved as properly instituted and remain undismissed for 30 days or result in adjudication of bankruptcy or insolvency; or (D) permits or suffers all or any substantial part of its properties or assets to be sequestered or attached by court order and the order remains undismissed for 30 days. The Manager agrees that if any of the events specified above occur, it will give prompt written notice thereof to the Company's Board of Directors after the occurrence of such event. Upon written request from the Company, the Manager shall prepare, execute and deliver to a successor manager any and all documents and other instruments, place in such successor manager's possession all files and do or cause to be done all other acts or things necessary or appropriate to effect the purposes of such notice of termination, to the successor manager at the Manager's sole expense; provided, however, that the Manager shall be entitled to retain copies of all such documents and other instruments as it may be required by federal or state law. The Manager agrees to cooperate with Company and such successor manager in effecting the termination of the Manager's responsibilities and rights under this Agreement. 8. Action Upon Termination ----------------------- From and after the effective date of termination of this Agreement pursuant to Section 7 hereof, the Manager shall not be entitled to compensation for further services under this Agreement, but shall be paid all compensation accruing to the date of termination and, if such termination is not for cause, the termination fee determined pursuant to Section 7. The Manager shall forthwith upon such termination deliver to the Board of Directors all funds and property, documents, corporate records, reports and software of the Company or any subsidiary of the Company then in the custody of Manager; provided, however, that the Manager shall be entitled to retain copies of all such documents and other instruments as it may be required by federal or state law. 14 9. Assignment ------------- This Agreement may not be assigned without the prior written consent of all the parties to this Agreement. For the foregoing purposes, "assigned" shall have the meaning ascribed to it under the Investment Advisers Act of 1940, as amended and the rules promulgated thereunder. 10. Notices ------- Any notice under this Agreement shall be in writing to the other party at such address as the other party may designate from time to time for the receipt of such notice and shall be deemed to be received on the earlier of the date actually received or on the fourth day after the postmark if such notice is mailed first class postage prepaid. 11. Governing Law ------------- This Agreement shall be construed in accordance with the laws of the State of New York for contracts to be performed entirely therein without reference to choice of law principles thereof. 12. Amendments ----------- This Agreement shall not be amended, changed, modified, terminated or discharged in whole or in part except by an instrument in writing signed by all parties hereto, or their respective successors or assigns, or otherwise as provided herein. 13. Severability ------------ The invalidity or unenforceability of any provision of this Agreement shall not affect the validity of any other provision, and all other provisions shall remain in full force and effect. 15 14. Entire Agreement ---------------- This instrument contains the entire agreement between the parties as to the rights granted and the obligations assumed in this instrument. 15. Counterparts ------------ This Agreement may be signed by the parties in counterparts which together shall constitute one and the same agreement among the parties. 16 16. Manager Brochure ---------------- The Company hereby acknowledges that it has received from the Manager a copy of the Manager's Form ADV, Part II, at least forty-eight hours prior to entering into this Agreement. 17 IN WITNESS WHEREOF, the parties hereto have caused the foregoing instrument to be executed by their duly authorized officers, all as of the date and the year first above written. ANTHRACITE CAPITAL, INC. By: /s/ Hugh R. Frater --------------------------------------- Name: Hugh R. Frater Title: President and Chief Executive Officer BLACKROCK FINANCIAL MANAGEMENT, INC. By: /s/ Laurence D. Fink ---------------------------------------- Name: Laurence D. Fink Title: Chairman and Chief Executive Officer 18 EX-99 4 ahr991.txt EXHIBIT 99.1 Exhibit 99.1 Certification of CEO and CFO Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 In connection with the Quarterly Report on Form 10-Q of Anthracite Capital, Inc. (the "Company") for the quarter ending March 31, 2003 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), Hugh R. Frater, as Chief Executive Officer of the Company, and Richard M. Shea, as Chief Financial Officer of the Company, each hereby certifies, pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002, that, to the best of his knowledge: (1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Hugh R. Frater _________________________________ Name: Hugh R. Frater Title: Chief Executive Officer Date: May 15, 2003 /s/ Richard M. Shea ________________________________ Name: Richard M. Shea Title: Chief Financial Officer Date: May 15, 2003 This certification accompanies the Report pursuant to ss. 906 of the Sarbanes-Oxley Act of 2002 and shall not, except to the extent required by the Sarbanes-Oxley Act of 2002, be deemed filed by the Company for purposes of ss. 18 of the Securities Exchange Act of 1934, as amended. A signed original of this certification required by ss. 906 has been provided to the Company and will be retained by the Company and furnished to the Securities and Exchange Commission or its staff upon request. -----END PRIVACY-ENHANCED MESSAGE-----