SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE FISCAL YEAR ENDED: DECEMBER 31, 2007
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: 1-13447
CHIMERA INVESTMENT CORPORATION
(Exact Name of Registrant as Specified in its Charter)
MARYLAND 26-0630461
(State or other jurisdiction (I.R.S. Employer Identification Number)
of incorporation of organization)
1211 Avenue of the Americas, Suite 2902
New York, New York 10036
(Address of Principal Executive Offices) (Zip Code)
(646) 454-3759
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class Name of Each Exchange on Which Registered
Common Stock, par value $.01 per share New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act:
None.
Indicate by check mark whether the Registrant is a well-known seasoned issuer,
as defined in Rule 405 of the Securities Act. Yes X No
-- --
Indicate by check mark if the Registrant is not required to file reports
pursuant to Section 13 or Section 15(d) of the Act. Yes No X
-- --
Indicate by check mark whether the Registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months (or for such shorter period that the Registrant was
required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days:
Yes X No
-- --
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. __
Indicate by check mark whether the registrant is a large accelerated filer,
an accelerated filer, a non-accelerated filer or a smaller reporting company.
See the definitions of "accelerated filer, large accelerated filer and smaller
reporting company" in Rule 12b-2 of the Exchange Act. (Check one): Large
accelerated filer __ Accelerated filer __ Non-accelerated filer _X _ Smaller
reporting company __
Indicate by check mark whether the Registrant is a shell company (as
defined in Rule 12b-2 of the Act). Yes __ No _X_. -
At November 16, 2007 (the day that trading in the registrant's common stock
commenced on the New York Stock Exchange), the aggregate market value of
the voting stock held by non-affiliates of the Registrant was $496,666,677
based on the closing sale price on the New York Stock Exchange on that
date.
The number of shares of the Registrant's Common Stock outstanding on
February 29, 2008 was 37,744,918.
Documents Incorporated by Reference
The registrant intends to file a definitive proxy statement pursuant to
Regulation 14A within 120 days of the end of the fiscal year ended December
31, 2007. Portions of such proxy statement are incorporated by reference
into Part III of this Form 10-K.
ii
CHIMERA INVESTMENT CORPORATION
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2007 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
PAGE
PART I
ITEM 1. BUSINESS 2
ITEM 1A. RISK FACTORS 11
ITEM 1B. UNRESOLVED STAFF COMMENTS 33
ITEM 2. PROPERTIES 33
ITEM 3. LEGAL PROCEEDINGS 33
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 33
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED
STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES 33
ITEM 6. SELECTED FINANCIAL DATA 35
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS 36
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 52
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA 56
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE 56
ITEM 9A. CONTROLS AND PROCEDURES 56
ITEM 9B. OTHER INFORMATION 57
PART III
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE 57
ITEM 11. EXECUTIVE COMPENSATION 57
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS 57
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR
INDEPENDENCE 57
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES 57
PART IV
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES 57
FINANCIAL STATEMENTS F-1
iii
SIGNATURES S-1
EXHIBITS II-1
iv
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
We make forward-looking statements in this annual report that are subject
to risks and uncertainties. These forward-looking statements include information
about possible or assumed future results of our business, financial condition,
liquidity, results of operations, plans and objectives. When we use the words
"believe," "expect," "anticipate," "estimate," "plan," "continue," "intend,"
"should," "may," "would," "will" or similar expressions, we intend to identify
forward-looking statements. Statements regarding the following subjects, among
others, are forward-looking by their nature:
o our business and investment strategy;
o our projected operating results;
o our ability to obtain future financing arrangements;
o general volatility of the securities markets in which we invest;
o our expected investments;
o interest rate mismatches between our mortgage-backed securities and our
borrowings used to fund such purchases;
o changes in interest rates and mortgage prepayment rates;
o effects of interest rate caps on our adjustable-rate mortgage-backed
securities;
o rates of default or decreased recovery rates on our investments;
o prepayments of the mortgage and other loans underlying our mortgage-backed
or other asset-backed securities;
o the degree to which our hedging strategies may or may not protect us from
interest rate volatility;
o changes in governmental regulations, tax law and rates and similar matters;
o availability of investment opportunities in real estate-related and other
securities;
o availability of qualified personnel;
o estimates relating to our ability to make distributions to our stockholders
in the future;
o our understanding of our competition; and
o market trends in our industry, interest rates, the debt securities markets
or the general economy.
The forward-looking statements are based on our beliefs, assumptions and
expectations of our future performance, taking into account all information
currently available to us. You should not place undue reliance on these
forward-looking statements. These beliefs, assumptions and expectations can
change as a result of many possible events or factors, not all of which are
known to us. Some of these factors are described under the caption "Risk
Factors" in this Form 10-K. If a change occurs, our business, financial
condition, liquidity and results of operations may vary materially from those
expressed in our forward-looking statements. Any forward-looking statement
speaks only as of the date on which it is made. New risks and uncertainties
arise from time to time, and it is impossible for us to predict those events or
how they may affect us. Except as required by law, we are not obligated to, and
do not intend to, update or revise any forward-looking statements, whether as a
result of new information, future events or otherwise.
1
PART I
Item 1. Business
The Company
We are a real estate investment trust, or REIT, that invests in
residential mortgage loans, residential mortgage-backed securities, or RMBS,
real estate-related securities and various other asset classes. We are
externally managed by Fixed Income Discount Advisory Company, which we refer to
as our Manager or FIDAC. Our Manager is a wholly-owned subsidiary of Annaly
Capital Management, Inc., or Annaly, a New York Stock Exchange-listed REIT,
which has a long track record of managing investments in U.S. government agency
mortgage-backed securities. FIDAC is an investment advisor registered with the
Securities and Exchange Commission, or SEC.
Our objective is to provide attractive risk-adjusted returns to our
investors over the long-term, primarily through dividends and secondarily
through capital appreciation. We intend to achieve this objective by investing
in a broad class of financial assets to construct an investment portfolio that
is designed to achieve attractive risk-adjusted returns and that is structured
to comply with the various federal income tax requirements for REIT status and
to maintain our exclusion from regulation under the Investment Company Act of
1940, or 1940 Act.
We were organized in Maryland on June 1, 2007, and commenced operations on
November 21, 2007 following the completion of our initial public offering. In
our initial public offering, including the exercise of the underwriters'
overallotment option, we sold approximately 34.1 million shares of our common
stock at $15.00 per share, and raised proceeds of $479.3 million before offering
expenses. Concurrent with our initial public offering, in a private offering we
sold Annaly approximately 3.6 million shares of our common stock at $15.00 per
share for aggregate net proceeds of approximately $54.3 million.
Our Manager
We are externally managed and advised by FIDAC pursuant to a management
agreement. All of our officers are employees of our Manager or one of its
affiliates. Our Manager is a fixed-income investment management company
specializing in managing investments in U.S. government agency residential
mortgage-backed securities, or Agency RMBS, which are mortgage pass-through
certificates, collateralized mortgage obligations, or CMOs, and other
mortgage-backed securities representing interests in or obligations backed by
pools of mortgage loans issued or guaranteed by the Federal National Mortgage
Association, or Fannie Mae, the Federal Home Loan Mortgage Corporation, or
Freddie Mac, and the Government National Mortgage Association, or Ginnie Mae.
Our Manager also has experience in managing investments in non-Agency RMBS and
collateralized debt obligations, or CDOs; real estate-related securities; and
managing interest rate-sensitive investment strategies. Our Manager commenced
active investment management operations in 1994. At December 31, 2007, our
Manager was the adviser or sub-adviser for funds with approximately $3.1 billion
in net assets and $15.4 billion in gross assets, predominantly Agency RMBS.
Our Manager is responsible for administering our business activities and
day-to-day operations. We have no employees other than our officers. Pursuant to
the terms of the management agreement, our Manager provides us with our
management team, including our officers, along with appropriate support
personnel. Our Manager is at all times subject to the supervision and oversight
of our board of directors and has only such functions and authority as we
delegate to it.
Our Manager has well-respected and established portfolio management
resources for each of our targeted asset classes and a sophisticated
infrastructure supporting those resources, including investment professionals
focusing on residential mortgage loans, Agency and non-Agency RMBS and other
asset-backed securities. We also expect to benefit from our Manager's finance
and administration functions, which address legal, compliance, investor
relations and operational matters, including portfolio management, trade
allocation and execution, securities valuation, risk management and information
technologies in connection with the performance of its duties.
We do not pay any of our officers any cash compensation. Rather, we pay
our Manager a base management fee and incentive compensation based on
performance pursuant to the terms of the management agreement.
Our Investment Strategy
Our objective is to provide attractive risk-adjusted returns to our
investors over the long-term, primarily through dividends and secondarily
through capital appreciation. We intend to seek to achieve this objective by
investing in a diversified investment portfolio of residential mortgage loans,
real estate-related securities and real estate loans, as well as various other
asset classes, subject to maintaining our REIT status and exemption from
registration under the 1940 Act. The residential mortgage backed securities, or
RMBS, asset backed securities, or ABS, commercial mortgage backed securities, or
CMBS, and CDOs we purchase may include investment-grade and non-investment grade
classes, including the BB-rated, B-rated and non-rated classes.
2
We will rely on our Manager's expertise in identifying assets within our
target asset classes. We expect that our Manager will make investment decisions
based on various factors, including expected cash yield, relative value,
risk-adjusted returns, current and projected credit fundamentals, current and
projected macroeconomic considerations, current and projected supply and demand,
credit and market risk concentration limits, liquidity, cost of financing and
financing availability, as well as maintaining our REIT qualification and our
exemption from registration under the 1940 Act.
Over time, we will modify our investment allocation strategy as market
conditions change to seek to maximize the returns from our investment portfolio.
We believe this strategy, combined with our Manager's experience, will enable us
to pay dividends and achieve capital appreciation throughout changing interest
rate and credit cycles and provide attractive long-term returns to investors.
Our targeted asset classes and the principal investments we expect to make
in each are as follows:
Asset Class Principal Investments
----------- ---------------------
Residential Mortgage Loans o Prime mortgage loans, which
are mortgage loans that conform to
the underwriting guidelines of
Fannie Mae and Freddie Mac, which
we refer to as Agency Guidelines;
and jumbo prime mortgage loans,
which are mortgage loans that
conform to the Agency Guidelines
except as to loan size.
o Alt-A mortgage loans, which are
mortgage loans that may have been
originated using documentation
standards that are less stringent
than the documentation standards
applied by certain other first
lien mortgage loan purchase
programs, such as the Agency
Guidelines, but have one or more
compensating factors such as a
borrower with a strong credit or
mortgage history or significant
assets.
Residential Mortgage-Backed o Non-Agency RMBS, including
Securities investment-grade and
non-investment grade classes,
including the BB-rated, B-rated
and non-rated classes.
o Agency RMBS.
Other Asset-Backed Securities o Debt and equity tranches of
CDOs.
o Commercial mortgage-backed
securities, or CMBS.
o Consumer and non-consumer ABS,
including investment-grade and
non-investment grade classes,
including the BB-rated, B-rated
and non-rated classes.
Since we commenced operations in November 2007, we have focused our
investment activities on purchasing residential mortgage loans that have been
originated by select high-quality originators, including the retail lending
operations of leading commercial banks, and non-Agency RMBS. As the diligence
and acquisition lead times for residential mortgage loans are longer than for
non-Agency RMBS purchases, our investment portfolio at December 31, 2007 was
weighted toward non-Agency RMBS. We expect, however, our investment portfolio to
become weighted toward residential mortgage loans over the next three to six
months. Our investment decisions, however, will depend on prevailing market
conditions and will change over time. As a result, we cannot predict the
percentage of our assets that will be invested in each asset class or whether we
will invest in other classes of investments. We may change our investment
strategy and policies without a vote of our stockholders.
3
We intend to elect and qualify to be taxed as a REIT and to operate our
business so as to be exempt from registration under the 1940 Act, and therefore
we will be required to invest a substantial majority of our assets in loans
secured by mortgages on real estate and real estate-related assets. Subject to
maintaining our REIT qualification and our 1940 Act exemption, we do not have
any limitations on the amounts we may invest in any of our targeted asset
classes.
Investment Portfolio
The following briefly discusses the principal types of investments that we
expect to make:
Residential Mortgage Loans
We intend to invest in residential mortgage loans (mortgage loans secured
by residential real property) primarily through direct purchases from selected
high-quality originators. We intend to enter into mortgage loan purchase
agreements with a number of primary mortgage loan originators, including
mortgage bankers, commercial banks, savings and loan associations, home
builders, credit unions and mortgage conduits. We may also purchase mortgage
loans on the secondary market. We expect these loans to be secured primarily by
residential properties in the United States.
We intend to invest primarily in residential mortgage loans underwritten
to our specifications. The originators will perform the credit review of the
borrowers, the appraisal of the properties securing the loan, and maintain other
quality control procedures. We expect to generally consider the purchase of
loans when the originators have verified the borrowers' income and assets,
verified their credit history and obtained appraisals of the properties. We or a
third party will perform an independent underwriting review of the processing,
underwriting and loan closing methodologies that the originators used in
qualifying a borrower for a loan. Depending on the size of the loans, we may not
review all of the loans in a pool, but rather select loans for underwriting
review based upon specific risk-based criteria such as property location, loan
size, effective loan-to-value ratio, borrower's credit score and other criteria
we believe to be important indicators of credit risk. Additionally, before the
purchase of loans, we will obtain representations and warranties from each
originator stating that each loan is underwritten to our requirements or, in the
event underwriting exceptions have been made, we are informed so that we may
evaluate whether to accept or reject the loans. An originator who breaches these
representations and warranties in making a loan that we purchase may be
obligated to repurchase the loan from us. As added security, we will use the
services of a third-party document custodian to insure the quality and accuracy
of all individual mortgage loan closing documents and to hold the documents in
safekeeping. As a result, all of the original loan collateral documents that are
signed by the borrower, other than the original credit verification documents,
are examined, verified and held by the third-party document custodian.
We currently do not intend to originate mortgage loans or provide other
types of financing to the owners of real estate. We currently do not intend to
establish a loan servicing platform, but expect to retain highly-rated servicers
to service our mortgage loan portfolio. We may also purchase certain residential
mortgage loans on a servicing-retained basis. In the future, however, we may
decide to originate mortgage loans or other types of financing, and we may elect
to service mortgage loans and other types of assets.
We expect that all servicers servicing our loans will be highly rated by
the rating agencies. We will also conduct a due diligence review of each
servicer before executing a servicing agreement. Servicing procedures will
typically follow Fannie Mae guidelines but will be specified in each servicing
agreement. All servicing agreements will meet standards for inclusion in highly
rated mortgage-backed or asset-backed securitizations. We have entered into a
master servicing agreement to assist us with management, servicing oversight,
and other administrative duties associated with managing our mortgage loans.
We expect that the loans we acquire will be first lien, single-family
residential traditional fixed-rate, adjustable-rate and hybrid adjustable-rate
loans with original terms to maturity of not more than 40 years and are either
fully amortizing or are interest-only for up to 10 years, and fully amortizing
thereafter. Fixed-rate mortgage loans bear an interest rate that is fixed for
the life of the loan. All adjustable-rate and hybrid adjustable-rate residential
mortgage loans will bear an interest rate tied to an interest rate index. Most
loans have periodic and lifetime constraints on how much the loan interest rate
can change on any predetermined interest rate reset date. The interest rate on
each adjustable-rate mortgage loan resets monthly, semi-annually or annually and
generally adjusts to a margin over a U.S. Treasury index or the London Interbank
Offering Rate, or LIBOR, index. Hybrid adjustable-rate loans have a fixed rate
for an initial period, generally 3 to 10 years, and then convert to
adjustable-rate loans for their remaining term to maturity.
4
We will acquire residential mortgage loans for our portfolio with the
intention of either securitizing them and retaining them in our portfolio as
securitized mortgage loans, or holding them in our residential mortgage loan
portfolio. To facilitate the securitization or financing of our loans, we expect
to generally create subordinate certificates, which provide a specified amount
of credit enhancement. We expect to issue securities through securities
underwriters and either retain these securities or finance them in the
repurchase agreement market. There is no limit on the amount we may retain of
these below-investment-grade subordinate certificates. Until we securitize our
residential mortgage loans, we expect to finance our residential mortgage loan
portfolio through the use of warehouse facilities and repurchase agreements.
Residential Mortgage-Backed Securities
We intend to invest in RMBS which are typically pass-through certificates
created by the securitization of a pool of mortgage loans that are
collateralized by residential real estate properties.
The securitization process is governed by one or more of the rating
agencies, including Fitch Ratings, Moody's Investors Service and Standard &
Poor's, which determine the respective bond class sizes, generally based on a
sequential payment structure. Bonds that are rated from AAA to BBB by the rating
agencies are considered "investment grade." Bond classes that are subordinate to
the BBB class are considered "below-investment grade" or "non-investment grade."
The respective bond class sizes are determined based on the review of the
underlying collateral by the rating agencies. The payments received from the
underlying loans are used to make the payments on the RMBS. Based on the
sequential payment priority, the risk of nonpayment for the investment grade
RMBS is lower than the risk of nonpayment for the non-investment grade bonds.
Accordingly, the investment grade class is typically sold at a lower yield
compared to the non-investment grade classes which are sold at higher yields.
We may invest in investment grade and non-investment grade RMBS. We expect
to evaluate the credit characteristics of these types of securities, including,
but not limited to, loan balance distribution, geographic concentration,
property type, occupancy, periodic and lifetime cap, weighted-average
loan-to-value and weighted-average FICO score. Qualifying securities will then
be analyzed using base line expectations of expected prepayments and losses from
given sectors, issuers and the current state of the fixed-income market. Losses
and prepayments are stressed simultaneously based on a credit risk-based model.
Securities in this portfolio are monitored for variance from expected
prepayments, frequencies, severities, losses and cash flow. The due diligence
process is particularly important and costly with respect to newly formed
originators or issuers because there may be little or no information publicly
available about these entities and investments.
We may invest in net interest margin securities, or NIMs, which are notes
that are payable from and secured by excess cash flow that is generated by RMBS
or home equity line of credit-backed securities, or HELOCs, after paying the
debt service, expenses and fees on such securities. The excess cash flow
represents all or a portion of a residual that is generally retained by the
originator of the RMBS or HELOCs. The residual is illiquid, thus the originator
will monetize the position by securitizing the residual and issuing a NIM,
usually in the form of a note that is backed by the excess cash flow generated
in the underlying securitization.
We may invest in mortgage pass-through certificates issued or guaranteed
by Ginnie Mae, Fannie Mae or Freddie Mac. We refer to these U.S. government
agencies as Agencies, and to the mortgage pass-through certificates they issue
or guarantee as Agency Mortgage Pass-through Certificates. We may invest in
collateralized mortgage obligations issued by the Agencies. We refer to these
types of securities as Agency CMOs, and we refer to Agency Mortgage Pass-through
Certificates and Agency CMOs as Agency RMBS.
Other Asset-Backed Securities
5
We intend to invest in securities issued in various CDO offerings to gain
exposure to bank loans, corporate bonds, ABS, mortgages, RMBS and CMBS and other
instruments. To avoid any actual or perceived conflicts of interest with our
Manager, an investment in any such security structured or managed by our Manager
will be approved by a majority of our independent directors. To the extent such
securities are treated as debt of the CDO issuer for federal income tax
purposes, we will hold the securities directly, subject to the requirements of
our continued qualification as a REIT. To the extent the securities represent
equity interests in a CDO issuer for federal income tax purposes, we may be
required to hold such securities through a taxable REIT subsidiary, or TRS,
which would cause the income recognized with respect to such securities to be
subject to federal (and applicable state and local) corporate income tax. See
"Risk Factors - Tax Risks." We could fail to qualify as a REIT or we could
become subject to a penalty tax if the income we recognize from certain
investments that are treated or could be treated as equity interests in a
foreign corporation exceed 5% of our gross income in a taxable year.
In general, CDO issuers are special purpose vehicles that hold a portfolio
of income-producing assets financed through the issuance of rated debt
securities of different seniority and equity. The debt tranches are typically
rated based on cash flow structure, portfolio quality, diversification and
credit enhancement. The equity securities issued by the CDO vehicle are the
"first loss" piece of the CDO vehicle's capital structure, but they are also
generally entitled to all residual amounts available for payment after the CDO
vehicle's senior obligations have been satisfied. Some CDO vehicles are
"synthetic," in which the credit risk to the collateral pool is transferred to
the CDO vehicle by a credit derivative such as a credit default swap.
We also intend to invest in CMBS, which are secured by, or evidence
ownership interests in, a single commercial mortgage loan or a pool of mortgage
loans secured by commercial properties. These securities may be senior,
subordinated, investment grade or non-investment grade. We intend to invest in
CMBS that will yield current interest income and where we consider the return of
principal to be likely. We intend to acquire CMBS from private originators of,
or investors in, mortgage loans, including savings and loan associations,
mortgage bankers, commercial banks, finance companies, investment banks and
other entities.
We also intend to invest in consumer ABS. These securities are generally
securities for which the underlying collateral consists of assets such as home
equity loans, credit card receivables and auto loans. We also expect to invest
in non-consumer ABS. These securities are generally secured by loans to
businesses and consist of assets such as equipment loans, truck loans and
agricultural equipment loans. Issuers of consumer and non-consumer ABS generally
are special purpose entities owned or sponsored by banks and finance companies,
captive finance subsidiaries of non-financial corporations or specialized
originators such as credit card lenders. We may purchase RMBS and ABS which are
denominated in foreign currencies or are collateralized by non-U.S.assets.
Investment Guidelines
We have adopted a set of investment guidelines that set out the asset
classes, risk tolerance levels, diversification requirements and other criteria
used to evaluate the merits of specific investments as well as the overall
portfolio composition. Our Manager's Investment Committee reviews our compliance
with the investment guidelines periodically and our board of directors receives
an investment report at each quarter-end in conjunction with its review of our
quarterly results. Our board also reviews our investment portfolio and related
compliance with our investment policies and procedures and investment guidelines
at each regularly scheduled board of directors meeting.
Our board of directors and our Manager's Investment Committee have adopted
the following guidelines for our investments and borrowings:
o No investment shall be made that would cause us to fail to qualify as a
REIT for federal income tax purposes;
o No investment shall be made that would cause us to be regulated as an
investment company under the 1940 Act;
o With the exception of real estate and housing, no single industry shall
represent greater than 20% of the securities or aggregate risk exposure in
our portfolio; and
6
o Investments in non-rated or deeply subordinated ABS or other securities
that are non-qualifying assets for purposes of the 75% REIT asset test will
be limited to an amount not to exceed 50% of our stockholders' equity.
These investment guidelines may be changed by a majority of our board of
directors without the approval of our stockholders.
Our board of directors has also adopted a separate set of investment
guidelines and procedures to govern our relationships with FIDAC. We have also
adopted detailed compliance policies to govern our interaction with FIDAC,
including when FIDAC is in receipt of material non-public information.
Our Financing Strategy
We use leverage to increase potential returns to our stockholders. We are
not required to maintain any specific debt-to-equity ratio as we believe the
appropriate leverage for the particular assets we are financing depends on the
credit quality and risk of those assets.
Subject to our maintaining our qualification as a REIT, we expect to use a
number of sources to finance our investments, including the following:
o Repurchase Agreements. We intend to finance certain of our assets through
the use of repurchase agreements. We anticipate that repurchase agreements
will be one of the sources we will use to achieve our desired amount of
leverage for our residential real estate assets. We intend to maintain
formal relationships with multiple counterparties to obtain financing on
favorable terms.
o Warehouse Facilities. We intend to utilize credit facilities for capital
needed to fund our assets. We intend to maintain formal relationships with
multiple counterparties to maintain warehouse lines on favorable terms.
o Securitization. We will acquire residential mortgage loans for our
portfolio with the intention of securitizing them and retaining the
securitized mortgage loans in our portfolio. To facilitate the
securitization or financing of our loans, we will generally create
subordinate certificates, providing a specified amount of credit
enhancement, which we intend to retain in our portfolio.
o Asset-Backed Commercial Paper. We may finance certain of our assets using
asset-backed commercial paper, or ABCP, conduits, which are
bankruptcy-remote special purpose vehicles that issue commercial paper and
the proceeds of which are used to fund assets, either through repurchase or
secured lending programs. We may utilize ABCP conduits of third parties or
create our own conduit.
o Term Financing CDOs. We may finance certain of our assets using term
financing strategies, including CDOs and other match-funded financing
structures. CDOs are multiple class debt securities, or bonds, secured by
pools of assets, such as mortgage-backed securities and corporate debt.
Like typical securitization structures, in a CDO:
o the assets are pledged to a trustee for the benefit of the holders of the
bonds;
o one or more classes of the bonds are rated by one or more rating agencies;
and
o one or more classes of the bonds are marketed to a wide variety of
fixed-income investors, which enables the CDO sponsor to achieve a
relatively low cost of long-term financing.
Unlike typical securitization structures, the underlying assets may be
sold, subject to certain limitations, without a corresponding pay-down of
the CDO, provided the proceeds are reinvested in qualifying assets. As a
result, CDOs enable the sponsor to actively manage, subject to certain
limitations, the pool of assets. We believe CDO financing structures may
be an appropriate financing vehicle for our target asset classes because
they will enable us to obtain relatively low, long-term cost of funds and
minimize the risk that we may have to refinance our liabilities before the
maturities of our investments, while giving us the flexibility to manage
credit risk and, subject to certain limitations, to take advantage of
profit opportunities.
7
Our Interest Rate Hedging and Risk Management Strategy
We may, from time to time, utilize derivative financial instruments to
hedge all or a portion of the interest rate risk associated with our borrowings.
Under the federal income tax laws applicable to REITs, we generally will be able
to enter into certain transactions to hedge indebtedness that we may incur, or
plan to incur, to acquire or carry real estate assets, although our total gross
income from such hedges and other non-qualifying sources must not exceed 25% of
our gross income.
We intend to engage in a variety of interest rate management techniques
that seek to mitigate changes in interest rates or other potential influences on
the values of our assets. The federal income tax rules applicable to REITs may
require us to implement certain of these techniques through a TRS that is fully
subject to corporate income taxation. Our interest rate management techniques
may include:
o puts and calls on securities or indices of securities;
o Eurodollar futures contracts and options on such contracts;
o interest rate caps, swaps and swaptions;
o U.S. treasury securities and options on U.S. treasury securities; and
o other similar transactions.
We expect to attempt to reduce interest rate risks and to minimize
exposure to interest rate fluctuations through the use of match funded financing
structures, when appropriate, whereby we seek (i) to match the maturities of our
debt obligations with the maturities of our assets and (ii) to match the
interest rates on our investments with like-kind debt (i.e., floating rate
assets are financed with floating rate debt and fixed-rate assets are financed
with fixed-rate debt), directly or through the use of interest rate swaps, caps
or other financial instruments, or through a combination of these strategies. We
expect this to allow us to minimize the risk that we have to refinance our
liabilities before the maturities of our assets and to reduce the impact of
changing interest rates on our earnings.
Compliance with REIT and Investment Company Requirements
We monitor our investment securities and the income from these securities
and, to the extent we enter into hedging transactions, we monitor income from
our hedging transactions as well, so as to ensure at all times that we maintain
our qualification as a REIT and our exempt status under the Investment Company
Act of 1940, as amended.
Employees
We are externally managed and advised by our Manager pursuant to a
management agreement as discussed below. We have no employees other than our
officers, each of whom is also an employee of our Manager or one of its
affiliates. Our Manager is not obligated to dedicate certain of its employees
exclusively to us, nor is it or its employees obligated to dedicate any specific
portion of its time to our business. Our Manager uses the proceeds from its
management fee in part to pay compensation to its officers and employees who,
notwithstanding that certain of them also are our officers, receive no cash
compensation directly from us.
The Management Agreement
We have entered into a management agreement with our Manager with an
initial term ending December 31, 2010, with automatic, one-year renewals at the
end of each calendar year following the initial term, subject to approval by our
independent directors. Under the management agreement, our Manager implements
our business strategy and performs certain services for us, subject to oversight
by our board of directors. Our Manager is responsible for, among other things,
performing all of our day-to-day functions; determining investment criteria in
conjunction with our board of directors; sourcing, analyzing and executing
investments; asset sales and financings; and performing asset management duties.
8
Our independent directors review our Manager's performance annually, and
following the initial term, the management agreement may be terminated by us
without cause upon the affirmative vote of at least two-thirds of our
independent directors, or by a vote of the holders of at least a majority of the
outstanding shares of our common stock (other than shares held by Annaly or its
affiliates), based upon: (i) our Manager's unsatisfactory performance that is
materially detrimental to us, or (ii) our determination that the management fees
payable to our Manager are not fair, subject to our Manager's right to prevent
termination based on unfair fees by accepting a reduction of management fees
agreed to by at least two-thirds of our independent directors. We will provide
our Manager with 180-days' prior notice of such termination. Upon termination
without cause, we will pay our Manager a substantial termination fee. We may
also terminate the management agreement with 30 days' prior notice from our
board of directors, without payment of a termination fee, for cause or upon a
change of control of Annaly or our Manager, each as defined in the management
agreement. Our Manager may terminate the management agreement if we become
required to register as an investment company under the 1940 Act, with such
termination deemed to occur immediately before such event, in which case we
would not be required to pay a termination fee. Our Manager may also decline to
renew the management agreement by providing us with 180-days' written notice, in
which case we would not be required to pay a termination fee.
We pay our Manager a base management fee quarterly in arrears in an amount
equal to 1.75% per annum, calculated quarterly, of our stockholders' equity. For
purposes of calculating the base management fee, our stockholders' equity means
the sum of the net proceeds from any issuances of our equity securities since
inception (allocated on a pro rata daily basis for such issuances during the
fiscal quarter of any such issuance), plus our retained earnings at the end of
such quarter (without taking into account any non-cash equity compensation
expense incurred in current or prior periods), less any amount that we pay for
repurchases of our common stock, and less any unrealized gains, losses or other
items that do not affect realized net income (regardless of whether such items
are included in other comprehensive income or loss, or in net income). This
amount is adjusted to exclude one-time events pursuant to changes in generally
accepted accounting principles, or GAAP, and certain non-cash charges after
discussions between our Manager and our independent directors and approved by a
majority of our independent directors. The base management fee will be reduced,
but not below zero, by our proportionate share of any CDO base management fees
FIDAC receives in connection with the CDOs in which we invest, based on the
percentage of equity we hold in such CDOs. The base management fee is payable
independent of the performance of our investment portfolio.
In addition to the base management fee, our Manager is entitled to receive
quarterly incentive compensation in an amount equal to 20% of the dollar amount
by which Core Earnings, on a rolling four-quarter basis and before the incentive
management fee, exceeds the product of (1) the weighted average of the issue
price per share of all of our public offerings multiplied by the weighted
average number of shares of common stock outstanding in such quarter and (2)
0.50% plus one-fourth of the average of the one month LIBOR rate for such
quarter and the previous three quarters. For the initial four quarters following
this offering, Core Earnings and the LIBOR rate will be calculated on the basis
of each of the previously completed quarters on an annualized basis. Core
Earnings and LIBOR rate for the initial quarter will each be calculated from the
settlement date of this offering on an annualized basis. Core Earnings is a
non-GAAP measure and is defined as GAAP net income (loss) excluding non-cash
equity compensation expense, excluding any unrealized gains, losses or other
items that do not affect realized net income (regardless of whether such items
are included in other comprehensive income or loss, or in net income). The
amount is adjusted to exclude one-time events pursuant to changes in GAAP and
certain non-cash charges after discussions between our Manager and our
independent directors and approved by a majority of our independent directors.
The incentive management fee is reduced, but not below zero, by our
proportionate share of any CDO incentive management fees that FIDAC receives in
connection with the CDOs in which we invest, based on the percentage of equity
we hold in such CDOs.
In addition, we also reimburse our Manager for expenses it incurs related
us, including legal, accounting, due diligence and other services, but excluding
the salaries and other compensation of our Manager's employees.
Competition
Our net income depends, in large part, on our ability to acquire assets at
favorable spreads over our borrowing costs. In acquiring real estate-related
assets, we will compete with other mortgage REITs, specialty finance companies,
savings and loan associations, banks, mortgage bankers, insurance companies,
mutual funds, institutional investors, investment banking firms, financial
institutions, governmental bodies and other entities. In addition, there are
numerous mortgage REITs with similar asset acquisition objectives, including a
number that have been recently formed, and others that may be organized in the
future. These other REITs will increase competition for the available supply of
mortgage assets suitable for purchase. Many of our competitors are significantly
larger than we are, have access to greater capital and other resources and may
have other advantages over us. In addition, some of our competitors may have
higher risk tolerances or different risk assessments, which could allow them to
consider a wider variety of investments and establish more favorable
relationships than we can. Current market conditions may attract more
competitors, which may increase the competition for sources of financing. An
increase in the competition for sources of funding could adversely affect the
availability and cost of financing, and thereby adversely affect the market
price of our common stock.
9
Distributions
To maintain our qualification as a REIT, we must distribute substantially
all of our taxable income to our stockholders for each year. We declared our
first quarterly dividend for the period commencing November 21, 2007 and ending
December 31, 2007.
Available Information
Our investor relations website is www.chimerareit.com. We make available
on the website under "Financial Information /SEC filings," free of charge, our
annual report on Form 10-K and any other reports as soon as reasonably
practicable after we electronically file or furnish such materials to the SEC.
Information on our website, however, is not part of this Annual Report on Form
10-K.
10
Item 1A. Risk Factors
The risks and uncertainties described below are not the only ones facing
us. Additional risks and uncertainties that we are unaware of, or that we
currently deem immaterial, also may become important factors that affect us.
If any of the following risks occur, our business, financial condition or
results of operations could be materially and adversely affected. In that case,
the trading price of our common stock could decline, and stockholders may lose
some or all of their investment.
Risks Associated With Our Management and Relationship With Our Manager
We are dependent on our Manager and its key personnel for our success. We
have no separate facilities and are completely reliant on our Manager. We have
no employees other than our officers. Our officers are also employees of our
Manager, which has significant discretion as to the implementation of our
investment and operating policies and strategies. Accordingly, we depend on the
diligence, skill and network of business contacts of the senior management of
our Manager. Our Manager's employees evaluate, negotiate, structure, close and
monitor our investments; therefore, our success will depend on their continued
service. The departure of any of the senior managers of our Manager could have a
material adverse effect on our performance. In addition, we can offer no
assurance that our Manager will remain our investment manager or that we will
continue to have access to our Manager's principals and professionals. Our
management agreement with our Manager only extends until December 31, 2010. If
the management agreement is terminated and no suitable replacement is found to
manage us, we may not be able to execute our business plan. Moreover, our
Manager is not obligated to dedicate certain of its employees exclusively to us
nor is it obligated to dedicate any specific portion of its time to our
business, and none of our Manager's employees are contractually dedicated to us
under our management agreement with our Manager. The only employees of our
Manager who are primarily dedicated to our operations are Christian J.
Woschenko, our Head of Investments, and William B. Dyer, our Head of
Underwriting. There are conflicts of interest in our relationship with our
Manager and Annaly, which could result in decisions that are not in the best
interests of our stockholders. We are subject to potential conflicts of interest
arising out of our relationship with Annaly and our Manager. An Annaly executive
officer is our Manager's sole director and two of Annaly's employees are our
directors. Specifically, each of our officers also serves as an employee of our
Manager or Annaly. As a result, our Manager and our officers may have conflicts
between their duties to us and their duties to, and interests in, Annaly or our
Manager. There may also be conflicts in allocating investments which are
suitable both for us and Annaly as well as other FIDAC managed funds. Annaly may
compete with us with respect to certain investments which we may want to
acquire, and as a result we may either not be presented with the opportunity or
have to compete with Annaly to acquire these investments. Our Manager and our
officers may choose to allocate favorable investments to Annaly instead of to
us. The ability of our Manager and its officers and employees to engage in other
business activities may reduce the time our Manager spends managing us. Further,
during turbulent conditions in the mortgage industry, distress in the credit
markets or other times when we will need focused support and assistance from our
Manager, other entities for which our Manager also acts as an investment manager
will likewise require greater focus and attention, placing our Manager's
resources in high demand. In such situations, we may not receive the necessary
support and assistance we require or would otherwise receive if we were
internally managed or if our Manager did not act as a manager for other
entities.
We pay our Manager substantial management fees regardless of the
performance of our portfolio. Our Manager's entitlement to substantial
nonperformance-based compensation might reduce its incentive to devote its time
and effort to seeking investments that provide attractive risk-adjusted returns
for our portfolio. This in turn could hurt both our ability to make
distributions to our stockholders and the market price of our common stock.
Annaly owns approximately 9.6% of our common stock which entitles them to
receive quarterly distributions based on financial performance. In evaluating
investments and other management strategies, this may lead our Manager to place
emphasis on the maximization of revenues at the expense of other criteria, such
as preservation of capital. Investments with higher yield potential are
generally riskier or more speculative. This could result in increased risk to
the value of our invested portfolio. Annaly may sell the shares in us at any
time after the earlier of (i) November 15, 2010 or (ii) the termination of the
management agreement. To the extent Annaly sells some of its shares, its
interests may be less aligned with our interests.
Our incentive fee may induce our Manager to make certain investments, including
speculative investments.
11
In addition to its management fee, our Manager is entitled to receive
incentive compensation based, in part, upon our achievement of targeted levels
of Core Earnings. In evaluating investments and other management strategies, the
opportunity to earn incentive compensation based on net income may lead our
Manager to place undue emphasis on the maximization of net income at the expense
of other criteria, such as preservation of capital, to achieve higher incentive
compensation. Investments with higher yield potential are generally riskier or
more speculative. This could result in increased risk to the value of our
invested portfolio.
The management agreement with our Manager was not negotiated on an arm's-length
basis and may not be as favorable to us as if it had been negotiated with an
unaffiliated third party and may be costly and difficult to terminate.
Our president, chief financial officer, head of investments, treasurer,
controller, secretary and head of underwriting also serve as employees of our
Manager. In addition, certain of our directors are employees of our Manager. Our
management agreement with our Manager was negotiated between related parties,
and its terms, including fees payable, may not be as favorable to us as if it
had been negotiated with an unaffiliated third party. Termination of the
management agreement with our Manager without cause is difficult and costly. Our
independent directors will review our Manager's performance and the management
fees annually, and following the initial term, the management agreement may be
terminated annually by us without cause upon the affirmative vote of at least
two-thirds of our independent directors, or by a vote of the holders of at least
a majority of the outstanding shares of our common stock (other than those
shares held by Annaly or its affiliates), based upon: (i) our Manager's
unsatisfactory performance that is materially detrimental to us, or (ii) a
determination that the management fees payable to our Manager are not fair,
subject to our Manager's right to prevent termination based on unfair fees by
accepting a reduction of management fees agreed to by at least two-thirds of our
independent directors. Our Manager must be provided 180-days' prior notice of
any such termination. Additionally, upon such termination, the management
agreement provides that we will pay our Manager a termination fee equal to three
times the sum of (a) the average annual base management fee and (b) the average
annual incentive compensation earned by our Manager during the prior 24-month
period before such termination, calculated as of the end of the most recently
completed fiscal quarter. These provisions may adversely affect our ability to
terminate our Manager without cause. Our Manager is only contractually committed
to serve us until December 31, 2010. Thereafter, the management agreement is
renewable on an annual basis, however, our Manager may terminate the management
agreement annually upon 180-days' prior notice. If the management agreement is
terminated and no suitable replacement is found to manage us, we may not be able
to execute our business plan.
Our board of directors approved very broad investment guidelines for our Manager
and will not approve each investment decision made by our Manager.
Our Manager is authorized to follow very broad investment guidelines. Our
board of directors periodically reviews our investment guidelines and our
investment portfolio, but does not, and is not required to, review all of our
proposed investments or any type or category of investment, except that an
investment in a security structured or managed by our Manager must be approved
by a majority of our independent directors. In addition, in conducting periodic
reviews, our board of directors relies primarily on information provided to them
by our Manager. Furthermore, our Manager uses complex strategies, and
transactions entered into by our Manager may be difficult or impossible to
unwind by the time they are reviewed by our board of directors. Our Manager has
great latitude within the broad investment guidelines in determining the types
of assets it may decide are proper investments for us, which could result in
investment returns that are substantially below expectations or that result in
losses, which would materially and adversely affect our business operations and
results. Further, decisions made and investments entered into by our Manager may
not be in the best interests of our stockholders.
We may change our investment strategy and asset allocation without stockholder
consent, which may result in riskier investments.
We may change our investment strategy or asset allocation at any time
without the consent of our stockholders, which could result in our making
investments that are different from, and possibly riskier than, the investments
described in this Form 10-K. A change in our investment strategy may increase
our exposure to interest rate and default risk and real estate market
fluctuations. Furthermore, a change in our asset allocation could result in our
making investments in asset categories different from those described in this
Form 10-K. These changes could adversely affect the market price of our common
stock and our ability to make distributions to you. Our Manager has an incentive
to invest our funds in investment vehicles managed by our Manager because of the
possibility of generating an additional incremental management fee, which may
reduce other investment opportunities available to us.
12
We may invest in CDOs managed by our Manager, including the purchase or sale of
all or a portion of the equity of such CDOs, which may result in an immediate
loss in book value and present a conflict of interest between us and our
Manager.
We may invest in securities of CDOs managed by our Manager. If all of the
securities of a CDO managed by our Manager were not fully placed as a result of
our not investing, our Manager could experience losses due to changes in the
value of the underlying investments accumulated in anticipation of the launch of
such investment vehicle. The accumulated investments in a CDO transaction are
generally sold at the price at which they were purchased and not the prevailing
market price at closing. Accordingly, to the extent we invest in a portion of
the equity securities for which there has been a deterioration of value since
the securities were purchased, we would experience an immediate loss equal to
the decrease in the market value of the underlying investment. As a result, the
interests of our Manager in our investing in such a CDO may conflict with our
interests and that of our stockholders.
Our investment focus is different from those of other entities that are or have
been managed by our Manager.
Our investment focus is different from those of other entities that are or
have been managed by our Manager. In particular, entities managed by our Manager
have not purchased whole mortgage loans or structured whole loan
securitizations. In addition, our Manager has limited experience in managing
CDOs and investing in CDOs, non-Agency RMBS, CMBS and other ABS which we may
pursue as part of our investment strategy. Accordingly, our Manager's historical
returns are not indicative of its performance for our investment strategy and we
can offer no assurance that our Manager will replicate the historical
performance of the Manager's investment professionals in their previous
endeavors. Our investment returns could be substantially lower than the returns
achieved by our Manager's investment professionals' previous endeavors.
We compete with investment vehicles of our Manager for access to our Manager's
resources and investment opportunities.
Our Manager provides investment and financial advice to a number of
investment vehicles and some of our Manager's personnel are also employees of
Annaly and in that capacity are involved in Annaly's investment process.
Accordingly, we will compete with our Manager's other investment vehicles and
with Annaly for our Manager's resources. Our Manager may sponsor and manage
other investment vehicles with an investment focus that overlaps with ours,
which could result in us competing for access to the benefits that we expect our
relationship with our Manager will provide to us.
Risks Related To Our Business
We have little operating history and may not operate successfully or generate
sufficient revenue to make or sustain distributions to our stockholders.
We were organized in June 2007 and commenced operations in November 2007
and have little operating history. The results of our operations depend on many
factors, including the availability of opportunities for the acquisition of
assets, the level and volatility of interest rates, readily accessible short and
long-term financing, conditions in the financial markets and economic
conditions.
Failure to procure adequate capital and funding on favorable terms, or at all,
would adversely affect our results and may, in turn, negatively affect the
market price of shares of our common stock and our ability to distribute
dividends to our stockholders.
We depend upon the availability of adequate funding and capital for our
operations. We intend to finance our assets over the long-term through a variety
of means, including repurchase agreements, credit facilities, securitizations,
commercial paper and CDOs. Our access to capital depends upon a number of
factors over which we have little or no control, including:
13
o general market conditions;
o the market's perception of our growth potential;
o our current and potential future earnings and cash distributions; o the
market price of the shares of our capital stock; and
o the market's view of the quality of our assets.
The current situation in the sub-prime mortgage sector, and the current
weakness in the broader mortgage market, could adversely affect one or more of
our potential lenders and could cause one or more of our potential lenders to be
unwilling or unable to provide us with financing. In general, this could
potentially increase our financing costs and reduce our liquidity.
We will use a number of sources to finance our investments, including
repurchase agreements, warehouse facilities, securitizations, asset-backed
commercial paper and term CDOs. Current market conditions have affected the cost
and availability of financing from each of these sources -- and their individual
providers -- to different degrees; some sources generally are unavailable, some
are available but at a high cost, and some are largely unaffected. For example,
in the repurchase agreement market, borrowers have been affected differently
depending on the type of security they are financing. Non-Agency RMBS have been
harder to finance, depending on the type of assets collateralizing the RMBS. The
amount, term and margin requirements associated with these types of financings
have been impacted.
Currently, warehouse facilities to finance whole loan prime residential
mortgages are generally available from major banks, but at significantly higher
cost and greater margin requirements than previously offered. Many major banks
that offer warehouse facilities have also reduced the amount of capital
available to new entrants and consequently the size of those facilities offered
now are smaller than those previously available.
It is currently a challenging market to term finance whole loans through
securitization or bonds issued by a CDO structure. The highly rated senior bonds
in these securitizations and CDO structures currently have liquidity, but at
much wider spreads than issues priced earlier this year. The junior subordinate
tranches of these structures currently have few buyers and current market
conditions have forced issuers to retain these lower rated bonds rather than
sell them.
Certain issuers of asset-backed commercial paper (or ABCP) have been
unable to place (or roll) their securities, which has resulted, in some
instances, in forced sales of mortgage-backed securities, or MBS, and other
securities which has further negatively impacted the market value of these
assets. These market conditions are fluid and likely to change over time.
As a result, the execution of our investment strategy may be dictated by
the cost and availability of financing from these different sources.
If one or more major market participants goes out of business, it could
adversely affect the marketability of all fixed income securities and this could
negatively impact the value of the securities we acquire, thus reducing our net
book value.
Furthermore, if many of our potential lenders are unwilling or unable to
provide us with financing, we could be forced to sell our securities or
residential mortgage loans at an inopportune time when prices are depressed.
We cannot assure you that these markets will remain an efficient source of
long-term financing for our assets. If our strategy is not viable, we will have
to find alternative forms of financing for our assets which may not be
available. Further, as a REIT, we are required to distribute annually at least
90% of our REIT taxable income, determined without regard to the deduction for
dividends paid and excluding net capital gain, to our stockholders and are
therefore not able to retain significant amounts of our earnings for new
investments. We cannot assure you that any, or sufficient, funding or capital
will be available to us in the future on terms that are acceptable to us. If we
cannot obtain sufficient funding on acceptable terms, there may be a negative
impact on the market price of our common stock and our ability to make
distributions to our stockholders. Moreover, our ability to grow will be
dependent on our ability to procure additional funding. To the extent we are not
able to raise additional funds through the issuance of additional equity or
borrowings, our growth will be constrained.
We operate in a highly competitive market for investment opportunities and more
established competitors may be able to compete more effectively for investment
opportunities than we can.
14
A number of entities compete with us to make the types of investments that
we plan to make. We compete with other REITs, public and private funds,
commercial and investment banks and commercial finance companies. Many of our
competitors are substantially larger and have considerably greater financial,
technical and marketing resources than we do. Several other REITs have recently
raised, or are expected to raise, significant amounts of capital, and may have
investment objectives that overlap with ours, which may create competition for
investment opportunities. Some competitors may have a lower cost of funds and
access to funding sources that are not available to us. In addition, some of our
competitors may have higher risk tolerances or different risk assessments, which
could allow them to consider a wider variety of investments and establish more
favorable relationships than us. We cannot assure you that the competitive
pressures we face will not have a material adverse effect on our business,
financial condition and results of operations. Also, as a result of this
competition, we may not be able to take advantage of attractive investment
opportunities from time to time, and we can offer no assurance that we will be
able to identify and make investments that are consistent with our investment
objectives.
Loss of our 1940 Act exemption would adversely affect us and negatively affect
the market price of shares of our common stock and our ability to distribute
dividends and could result in the termination of the management agreement with
our Manager.
We operate our company so that we will not be required to register as an
investment company under the 1940 Act because we are "primarily engaged in the
business of purchasing or otherwise acquiring mortgages and other liens on and
interests in real estate." Specifically, our investment strategy is to invest at
least 55% of our assets in mortgage loans, RMBS that represent the entire
ownership in a pool of mortgage loans and other qualifying interests in real
estate and approximately an additional 25% of our assets in other types of
mortgages, RMBS, securities of REITs and other real estate-related assets. As a
result, we are limited in our ability to make certain investments. If we fail to
qualify for this exemption in the future, we could be required to restructure
our activities in a manner that or at a time when we would not otherwise choose
to do so, which could negatively affect the value of shares of our common stock,
the sustainability of our business model, and our ability to make distributions.
For example, if the market value of our investments in securities were to
increase by an amount that resulted in less than 55% of our assets being
invested in mortgage loans or RMBS that represent the entire ownership in a pool
of mortgage loans or less than 80% of our assets being invested in real
estate-related assets, we might have to sell securities to qualify for exemption
under the 1940 Act. The sale could occur during adverse market conditions, and
we could be forced to accept a price below that which we believe is acceptable.
In addition, there can be no assurance that the laws and regulations governing
REITs, including regulations issued by the Division of Investment Management of
the SEC, providing more specific or different guidance regarding the treatment
of assets as qualifying real estate assets or real estate-related assets, will
not change in a manner that adversely affects our operations. A loss of our 1940
Act exemption would allow our Manager to terminate the management agreement with
us, which would materially adversely affect our business and operations.
Rapid changes in the values of our residential mortgage loans, RMBS, and other
real estate-related investments may make it more difficult for us to maintain
our qualification as a REIT or our exemption from the 1940 Act.
If the market value or income potential of our residential mortgage loans,
RMBS, and other real estate-related investments declines as a result of
increased interest rates, prepayment rates or other factors, we may need to
increase our real estate investments and income or liquidate our non-qualifying
assets to maintain our REIT qualification or our exemption from the 1940 Act. If
the decline in real estate asset values or income occurs quickly, this may be
especially difficult to accomplish. This difficulty may be exacerbated by the
illiquid nature of any non-real estate assets we may own. We may have to make
investment decisions that we otherwise would not make absent the REIT and 1940
Act considerations.
We leverage our investments, which may adversely affect our return on our
investments and may reduce cash available for distribution to our stockholders.
We leverage our investments through borrowings, generally through the use
of repurchase agreements, warehouse facilities, credit facilities,
securitizations, commercial paper and CDOs. We are not required to maintain any
specific debt-to-equity ratio. The amount of leverage we use varies depending on
our ability to obtain credit facilities, the lenders' and rating agencies'
estimates of the stability of the investments' cash flow, and our assessment of
the appropriate amount of leverage for the particular assets we are funding. We
are required to maintain minimum average cash balances in connection with
borrowings under credit facilities. Our return on our investments and cash
available for distribution to our stockholders may be reduced to the extent that
changes in market conditions prevent us from leveraging our investments or
increase the cost of our financing relative to the income that can be derived
from the assets acquired. Our debt service payments will reduce cash flow
available for distributions to stockholders, which could adversely affect the
price of our common stock. We may not be able to meet our debt service
obligations, and, to the extent that we cannot, we risk the loss of some or all
of our assets to foreclosure or sale to satisfy the obligations. We leverage
certain of our assets through repurchase agreements. A decrease in the value of
these assets may lead to margin calls which we will have to satisfy. We may not
have the funds available to satisfy any such margin calls and we may be forced
to sell assets at significantly depressed prices due to market conditions or
otherwise. The satisfaction of such margin calls may reduce cash flow available
for distribution to our stockholders. Any reduction in distributions to our
stockholders may cause the value of our common stock to decline, in some cases,
precipitously.
15
We depend on warehouse and repurchase facilities, credit facilities and
commercial paper to execute our business plan, and our inability to access
funding could have a material adverse effect on our results of operations,
financial condition and business.
Our ability to fund our investments depends to a large extent upon our
ability to secure warehouse, repurchase, credit, and commercial paper financing
on acceptable terms. Pending the securitization of a pool of mortgage loans, if
any, we will fund the acquisition of mortgage loans through borrowings from
warehouse, repurchase, and credit facilities and commercial paper. We can
provide no assurance that we will be successful in establishing sufficient
warehouse, repurchase, and credit facilities and issuing commercial paper. In
addition, because warehouse, repurchase, and credit facilities and commercial
paper are short-term commitments of capital, the lenders may respond to market
conditions, which may favor an alternative investment strategy for them, making
it more difficult for us to secure continued financing. During certain periods
of the credit cycle, lenders may curtail their willingness to provide financing.
If we are not able to renew our then existing warehouse, repurchase, and credit
facilities and issue commercial paper or arrange for new financing on terms
acceptable to us, or if we default on our covenants or are otherwise unable to
access funds under any of these facilities, we will have to curtail our asset
acquisition activities.
It is possible that the lenders that provide us with financing could
experience changes in their ability to advance funds to us, independent of our
performance or the performance of our investments, including our mortgage loans.
In addition, if the regulatory capital requirements imposed on our lenders
change, they may be required to significantly increase the cost of the warehouse
facilities that they provide to us. Our lenders also may revise their
eligibility requirements for the types of residential mortgage loans they are
willing to finance or the terms of such financings, based on, among other
factors, the regulatory environment and their management of perceived risk,
particularly with respect to assignee liability. Financing of equity-based
lending, for example, may become more difficult in the future. Moreover, the
amount of financing we will receive under our warehouse and repurchase
facilities will be directly related to the lenders' valuation of the assets that
secure the outstanding borrowings. Typically warehouse, repurchase, and credit
facilities grant the respective lender the absolute right to reevaluate the
market value of the assets that secure outstanding borrowings at any time. If a
lender determines in its sole discretion that the value of the assets has
decreased, it has the right to initiate a margin call. A margin call would
require us to transfer additional assets to such lender without any advance of
funds from the lender for such transfer or to repay a portion of the outstanding
borrowings. Any such margin call could have a material adverse effect on our
results of operations, financial condition, business, liquidity and ability to
make distributions to our stockholders, and could cause the value of our common
stock to decline. We may be forced to sell assets at significantly depressed
prices to meet such margin calls and to maintain adequate liquidity, which could
cause us to incur losses. Moreover, to the extent we are forced to sell assets
at such time, given market conditions, we may be forced to sell assets at the
same time as others facing similar pressures to sell similar assets, which could
greatly exacerbate a difficult market environment and which could result in our
incurring significantly greater losses on our sale of such assets. In an extreme
case of market duress, a market may not even be present for certain of our
assets at any price.
The current dislocation in the sub-prime mortgage sector, and the current
weakness in the broader mortgage market, could adversely affect one or more of
our potential lenders and could cause one or more of our potential lenders to be
unwilling or unable to provide us with financing. This could potentially
increase our financing costs and reduce our liquidity. If one or more major
market participants fails, it could negatively impact the marketability of all
fixed income securities, including Agency and non-Agency RMBS, residential
mortgage loans and real estate related securities, and this could negatively
impact the value of the securities we acquire, thus reducing our net book value.
Furthermore, if many of our potential lenders are unwilling or unable to provide
us with financing, we could be forced to sell our assets at an inopportune time
when prices are depressed.
16
Certain of our financing facilities contain covenants that restrict our
operations and may inhibit our ability to grow our business and increase
revenues.
Certain of our financing facilities contain extensive restrictions,
covenants, and representations and warranties that, among other things, require
us to satisfy specified financial, asset quality, loan eligibility and loan
performance tests. If we fail to meet or satisfy any of these covenants or
representations and warranties, we would be in default under these agreements
and our lenders could elect to declare all amounts outstanding under the
agreements to be immediately due and payable, enforce their respective interests
against collateral pledged under such agreements and restrict our ability to
make additional borrowings. Certain of our financing agreements contain
cross-default provisions, so that if a default occurs under any one agreement,
the lenders under our other agreements could also declare a default. The
covenants and restrictions we expect in our financing facilities may restrict
our ability to, among other things:
o incur or guarantee additional debt;
o make certain investments or acquisitions;
o make distributions on or repurchase or redeem capital stock;
o engage in mergers or consolidations;
o finance mortgage loans with certain attributes;
o reduce liquidity below certain levels;
o grant liens;
o incur operating losses for more than a specified period;
o enter into transactions with affiliates; and
o hold mortgage loans for longer than established time periods.
These restrictions may interfere with our ability to obtain financing,
including the financing needed to qualify as a REIT, or to engage in other
business activities, which may significantly harm our business, financial
condition, liquidity and results of operations. A default and resulting
repayment acceleration could significantly reduce our liquidity, which could
require us to sell our assets to repay amounts due and outstanding. This could
also significantly harm our business, financial condition, results of
operations, and our ability to make distributions, which could cause the value
of our common stock to decline. A default will also significantly limit our
financing alternatives such that we will be unable to pursue our leverage
strategy, which could curtail our investment returns.
The repurchase agreements, warehouse facilities and credit facilities and
commercial paper that we use to finance our investments may require us to
provide additional collateral and may restrict us from leveraging our assets as
fully as desired.
We will use repurchase agreements, warehouse facilities, credit facilities
and commercial paper to finance our investments. If the market value of the
loans or securities pledged or sold by us to a funding source decline in value,
we may be required by the lending institution to provide additional collateral
or pay down a portion of the funds advanced, but we may not have the funds
available to do so. Posting additional collateral will reduce our liquidity and
limit our ability to leverage our assets, which could adversely affect our
business. In the event we do not have sufficient liquidity to meet such
requirements, lending institutions can accelerate repayment of our indebtedness,
increase our borrowing rates, liquidate our collateral or terminate our ability
to borrow. Such a situation would likely result in a rapid deterioration of our
financial condition and possibly necessitate a filing for protection under the
U.S. Bankruptcy Code. Further, financial institutions may require us to maintain
a certain amount of cash that is not invested or to set aside non-levered assets
sufficient to maintain a specified liquidity position which would allow us to
satisfy our collateral obligations. As a result, we may not be able to leverage
our assets as fully as we would choose, which could reduce our return on equity.
If we are unable to meet these collateral obligations, then, as described above,
our financial condition could deteriorate rapidly.
If the counterparty to our repurchase transactions defaults on its obligation to
resell the underlying security back to us at the end of the transaction term, or
if the value of the underlying security has declined as of the end of that term
or if we default on our obligations under the repurchase agreement, we will lose
money on our repurchase transactions.
17
When we engage in a repurchase transaction, we generally sell securities
to the transaction counterparty and receive cash from the counterparty. The
counterparty is obligated to resell the securities back to us at the end of the
term of the transaction, which is typically 30-90 days. Because the cash we
receive from the counterparty when we initially sell the securities to the
counterparty is less than the value of those securities (this difference is
referred to as the haircut), if the counterparty defaults on its obligation to
resell the securities back to us we would incur a loss on the transaction equal
to the amount of the haircut (assuming there was no change in the value of the
securities). We would also lose money on a repurchase transaction if the value
of the underlying securities has declined as of the end of the transaction term,
as we would have to repurchase the securities for their initial value but would
receive securities worth less than that amount. Any losses we incur on our
repurchase transactions could adversely affect our earnings, and thus our cash
available for distribution to our stockholders. If we default on one of our
obligations under a repurchase transaction, the counterparty can terminate the
transaction and cease entering into any other repurchase transactions with us.
In that case, we would likely need to establish a replacement repurchase
facility with another repurchase dealer in order to continue to leverage our
portfolio and carry out our investment strategy. There is no assurance we would
be able to establish a suitable replacement facility.
An increase in our borrowing costs relative to the interest we receive on our
assets may adversely affect our profitability, and thus our cash available for
distribution to our stockholders.
As our repurchase agreements and other short-term borrowings mature, we
will be required either to enter into new borrowings or to sell certain of our
investments. An increase in short-term interest rates at the time that we seek
to enter into new borrowings would reduce the spread between our returns on our
assets and the cost of our borrowings. This would adversely affect our returns
on our assets that are subject to prepayment risk, including our mortgage-backed
securities, which might reduce earnings and, in turn, cash available for
distribution to our stockholders.
If we issue senior securities we will be exposed to additional risks.
If we decide to issue senior securities in the future, it is likely that
they will be governed by an indenture or other instrument containing covenants
restricting our operating flexibility. Additionally, any convertible or
exchangeable securities that we issue in the future may have rights, preferences
and privileges more favorable than those of our common stock and may result in
dilution to owners of our common stock. We and, indirectly, our stockholders,
will bear the cost of issuing and servicing such securities.
Our securitizations will expose us to additional risks.
We expect to securitize certain of our portfolio investments to generate
cash for funding new investments. We expect to structure these transactions so
that they are treated as financing transactions, and not as sales, for federal
income tax purposes. In each such transaction, we would convey a pool of assets
to a special purpose vehicle, the issuing entity, and the issuing entity would
issue one or more classes of non-recourse notes pursuant to the terms of an
indenture. The notes would be secured by the pool of assets. In exchange for the
transfer of assets to the issuing entity, we would receive the cash proceeds of
the sale of non-recourse notes and a 100% interest in the equity of the issuing
entity. The securitization of our portfolio investments might magnify our
exposure to losses on those portfolio investments because any equity interest we
retain in the issuing entity would be subordinate to the notes issued to
investors and we would, therefore, absorb all of the losses sustained with
respect to a securitized pool of assets before the owners of the notes
experience any losses. Moreover, we cannot be assured that we will be able to
access the securitization market, or be able to do so at favorable rates. The
inability to securitize our portfolio could hurt our performance and our ability
to grow our business.
The use of CDO financings with over-collateralization requirements may have a
negative impact on our cash flow.
We expect that the terms of CDOs we may sponsor will generally provide
that the principal amount of assets must exceed the principal balance of the
related bonds by a certain amount, commonly referred to as
"over-collateralization." We anticipate that the CDO terms will provide that, if
certain delinquencies or losses exceed the specified levels based on the
analysis by the rating agencies (or any financial guaranty insurer) of the
characteristics of the assets collateralizing the bonds, the required level of
over-collateralization may be increased or may be prevented from decreasing as
would otherwise be permitted if losses or delinquencies did not exceed those
levels. Other tests (based on delinquency levels or other criteria) may restrict
our ability to receive net income from assets collateralizing the obligations.
We cannot assure you that the performance tests will be satisfied. In advance of
completing negotiations with the rating agencies or other key transaction
parties on our future CDO financings, we cannot assure you of the actual terms
of the CDO delinquency tests, over-collateralization terms, cash flow release
mechanisms or other significant factors regarding the calculation of net income
to us. Given recent volatility in the CDO market, rating agencies may depart
from historic practices for CDO financings, making them more costly for us.
Failure to obtain favorable terms with regard to these matters may materially
and adversely affect the availability of net income to us. If our assets fail to
perform as anticipated, our over-collateralization or other credit enhancement
expense associated with our CDO financings will increase.
18
Hedging against interest rate exposure may adversely affect our earnings, which
could reduce our cash available for distribution to our stockholders.
Subject to maintaining our qualification as a REIT, we pursue various
hedging strategies to seek to reduce our exposure to losses from adverse changes
in interest rates. Our hedging activity varies in scope based on the level and
volatility of interest rates, the type of assets held and other changing market
conditions. Interest rate hedging may fail to protect or could adversely affect
us because, among other things:
o interest rate hedging can be expensive, particularly during periods of
rising and volatile interest rates;
o available interest rate hedges may not correspond directly with the
interest rate risk for which protection is sought;
o the duration of the hedge may not match the duration of the related
liability;
o the amount of income that a REIT may earn from hedging transactions (other
than through TRSs) to offset interest rate losses is limited by federal tax
provisions governing REITs;
o the credit quality of the party owing money on the hedge may be downgraded
to such an extent that it impairs our ability to sell or assign our side of
the hedging transaction; and
o the party owing money in the hedging transaction may default on its
obligation to pay.
Our hedging transactions, which are intended to limit losses, may actually
limit gains and increase our exposure to losses. As a result, our hedging
activity may adversely affect our earnings, which could reduce our cash
available for distribution to our stockholders. In addition, hedging instruments
involve risk since they often are not traded on regulated exchanges, guaranteed
by an exchange or its clearing house, or regulated by any U.S. or foreign
governmental authorities. Consequently, there are no requirements with respect
to record keeping, financial responsibility or segregation of customer funds and
positions. Furthermore, the enforceability of agreements underlying derivative
transactions may depend on compliance with applicable statutory and commodity
and other regulatory requirements and, depending on the identity of the
counterparty, applicable international requirements. The business failure of a
hedging counterparty with whom we enter into a hedging transaction will most
likely result in its default. Default by a party with whom we enter into a
hedging transaction may result in the loss of unrealized profits and force us to
cover our commitments, if any, at the then current market price. Although
generally we will seek to reserve the right to terminate our hedging positions,
it may not always be possible to dispose of or close out a hedging position
without the consent of the hedging counterparty, and we may not be able to enter
into an offsetting contract in order to cover our risk. We cannot assure you
that a liquid secondary market will exist for hedging instruments purchased or
sold, and we may be required to maintain a position until exercise or
expiration, which could result in losses.
Declines in the market values of our investments may adversely affect periodic
reported results and credit availability, which may reduce earnings and, in
turn, cash available for distribution to our stockholders.
A substantial portion of our assets are classified for accounting purposes
as "available-for-sale" and carried at fair value. Changes in the market values
of those assets will be directly charged or credited to other comprehensive
income. In addition, a decline in values will reduce the book value of our
assets. A decline in the market value of our assets may adversely affect us,
particularly in instances where we have borrowed money based on the market value
of those assets. If the market value of those assets declines, the lender may
require us to post additional collateral to support the loan. If we were unable
to post the additional collateral, we would have to sell the assets at a time
when we might not otherwise choose to do so. A reduction in credit available may
reduce our earnings and, in turn, cash available for distribution to
stockholders.
The lack of liquidity in our investments may adversely affect our business.
19
We may invest in securities or other instruments that are not liquid. It
may be difficult or impossible to obtain third party pricing on the investments
we purchase. Illiquid investments typically experience greater price volatility
as a ready market does not exist. In addition, validating third party pricing
for illiquid investments may be more subjective than more liquid investments.
The illiquidity of our investments may make it difficult for us to sell such
investments if the need or desire arises. In addition, if we are required to
liquidate all or a portion of our portfolio quickly, we may realize
significantly less than the value at which we have previously recorded our
investments. As a result, our ability to vary our portfolio in response to
changes in economic and other conditions may be relatively limited, which could
adversely affect our results of operations and financial condition.
We are highly dependent on information systems and third parties, and systems
failures could significantly disrupt our business, which may, in turn,
negatively affect the market price of our common stock and our ability to pay
dividends to our stockholders.
Our business is highly dependent on communications and information
systems. Any failure or interruption of our systems could cause delays or other
problems in our securities trading activities, including mortgage-backed
securities trading activities, which could have a material adverse effect on our
operating results and negatively affect the market price of our common stock and
our ability to pay dividends to our stockholders.
We are required to obtain various state licenses in order to purchase mortgage
loans in the secondary market and there is no assurance we will be able to
obtain or maintain those licenses.
While we are not required to obtain licenses to purchase mortgage-backed
securities, we are required to obtain various state licenses to purchase
mortgage loans in the secondary market. We have applied for these licenses and
expect this process could take several months. There is no assurance that we
will obtain all of the licenses that we desire or that we will not experience
significant delays in seeking these licenses. Furthermore, we will be subject to
various information and other requirements to maintain these licenses, and there
is no assurance that we will satisfy those requirements. Our failure to obtain
or maintain licenses will restrict our investment options and could harm our
business.
We are subject to liability for potential violations of predatory lending laws,
which could adversely impact our results of operations, financial condition and
business.
Various federal, state and local laws have been enacted that are designed
to discourage predatory lending practices. The federal Home Ownership and Equity
Protection Act of 1994, or HOEPA, prohibits inclusion of certain provisions in
residential mortgage loans that have mortgage rates or origination costs in
excess of prescribed levels and requires that borrowers be given certain
disclosures prior to origination. Some states have enacted, or may enact,
similar laws or regulations, which in some cases impose restrictions and
requirements greater than those in HOEPA. In addition, under the anti-predatory
lending laws of some states, the origination of certain residential mortgage
loans, including loans that are not classified as "high cost" loans under
applicable law, must satisfy a net tangible benefits test with respect to the
related borrower. This test may be highly subjective and open to interpretation.
As a result, a court may determine that a residential mortgage loan, for
example, does not meet the test even if the related originator reasonably
believed that the test was satisfied. Failure of residential mortgage loan
originators or servicers to comply with these laws, to the extent any of their
residential mortgage loans become part of our mortgaged-related assets, could
subject us, as an assignee or purchaser to the related residential mortgage
loans, to monetary penalties and could result in the borrowers rescinding the
affected residential mortgage loans. Lawsuits have been brought in various
states making claims against assignees or purchasers of high cost loans for
violations of state law. Named defendants in these cases have included numerous
participants within the secondary mortgage market. If the loans are found to
have been originated in violation of predatory or abusive lending laws, we could
incur losses, which could adversely impact our results of operations, financial
condition and business.
Terrorist attacks and other acts of violence or war may affect the market for
our common stock, the industry in which we conduct our operations and our
profitability.
Terrorist attacks may harm our results of operations and your investment.
We cannot assure you that there will not be further terrorist attacks against
the United States or U.S. businesses. These attacks or armed conflicts may
directly impact the property underlying our asset-based securities or the
securities markets in general. Losses resulting from these types of events are
uninsurable. More generally, any of these events could cause consumer confidence
and spending to decrease or result in increased volatility in the United States
and worldwide financial markets and economies. Adverse economic conditions could
harm the value of the property underlying our asset-backed securities or the
securities markets in general which could harm our operating results and
revenues and may result in the volatility of the value of our securities.
20
We are subject to the requirements of the Sarbanes-Oxley Act of 2002.
As we are a public company, our management is required to deliver a report
that assesses the effectiveness of our internal controls over financial
reporting, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002, or
Sarbanes-Oxley Act. Section 404 of the Sarbanes-Oxley Act requires an
independent registered public accounting firm to deliver an attestation report
on the operating effectiveness of our internal controls over financial reporting
in conjunction with their opinion on our audited financial statements beginning
with the year ending December 31, 2008. Substantial work on our part is required
to implement appropriate processes, document the system of internal control over
key processes, assess their design, remediate any deficiencies identified and
test their operation. This process is expected to be both costly and
challenging. We cannot give any assurances that material weaknesses will not be
identified in the future in connection with our compliance with the provisions
of Sections 302 and 404 of the Sarbanes-Oxley Act. The existence of any material
weakness described above would preclude a conclusion by management and our
independent auditors that we maintained effective internal control over
financial reporting. Our management may be required to devote significant time
and expense to remediate any material weaknesses that may be discovered and may
not be able to remediate all material weaknesses in a timely manner. The
existence of any material weaknesses in our internal control over financial
reporting could also result in errors in our financial statements that could
require us to restate our financial statements, cause us to fail to meet our
reporting obligations and cause investors to lose confidence in our reported
financial information, all of which could lead to a decline in the trading price
of our stock.
Risks Related to Our Investments
We might not be able to purchase residential mortgage loans, mortgage-backed
securities and other investments that meet our investment criteria or at
favorable spreads over our borrowing costs.
Our net income depends on our ability to acquire residential mortgage
loans, mortgage-backed securities and other investments at favorable spreads
over our borrowing costs. Our investments are selected by our Manager, and our
stockholders will not have input into such investment decisions. Our Manager has
conducted due diligence with respect to each investment purchased. However,
there can be no assurance that our Manager's due diligence processes will
uncover all relevant facts or that any investment will be successful.
We may not realize income or gains from our investments.
We invest to generate both current income and capital appreciation. The
investments we invest in may, however, not appreciate in value and, in fact, may
decline in value, and the debt securities we invest in may default on interest
or principal payments. Accordingly, we may not be able to realize income or
gains from our investments. Any gains that we do realize may not be sufficient
to offset any other losses we experience. Any income that we realize may not be
sufficient to offset our expenses.
Our investments may be concentrated and will be subject to risk of default.
While we intend to diversify our portfolio of investments, we are not
required to observe specific diversification criteria. To the extent that our
portfolio is concentrated in any one region or type of security, downturns
relating generally to such region or type of security may result in defaults on
a number of our investments within a short time period, which may reduce our net
income and the value of our shares and accordingly may reduce our ability to pay
dividends to our stockholders.
21
Increases in interest rates could negatively affect the value of our
investments, which could result in reduced earnings or losses and negatively
affect the cash available for distribution to our stockholders.
We have and will continue to invest in real estate-related assets by
investing directly in residential mortgage loans and indirectly by purchasing
RMBS, CMBS and CDOs backed by real estate-related assets. Under a normal yield
curve, an investment in these assets will decline in value if long-term interest
rates increase. Declines in market value may ultimately reduce earnings or
result in losses to us, which may negatively affect cash available for
distribution to our stockholders. A significant risk associated with these
investments is the risk that both long-term and short-term interest rates will
increase significantly. If long-term rates were to increase significantly, the
market value of these investments would decline, and the duration and weighted
average life of the investments would increase. We could realize a loss if these
assets were sold. At the same time, an increase in short-term interest rates
would increase the amount of interest owed on the repurchase agreements or other
adjustable rate financings we may enter into to finance the purchase of these
assets. Market values of our investments may decline without any general
increase in interest rates for a number of reasons, such as increases in
defaults, increases in voluntary prepayments for those investments that are
subject to prepayment risk and widening of credit spreads.
In a period of rising interest rates, our interest expense could increase while
the interest we earn on our fixed-rate assets would not change, which would
adversely affect our profitability.
Our operating results will depend in large part on the differences between
the income from our assets, net of credit losses and financing costs. We
anticipate that, in most cases, the income from such assets will respond more
slowly to interest rate fluctuations than the cost of our borrowings.
Consequently, changes in interest rates, particularly short-term interest rates,
may significantly influence our net income. Increases in these rates will tend
to decrease our net income and market value of our assets. Interest rate
fluctuations resulting in our interest expense exceeding our interest income
would result in operating losses for us and may limit or eliminate our ability
to make distributions to our stockholders.
A significant portion of our portfolio investments will be recorded at fair
value, as determined in accordance with our pricing policy as approved by our
board of directors and, as a result, there will be uncertainty as to the value
of these investments.
A significant portion of our portfolio of investments is in the form of
securities that are not publicly traded. The fair value of securities and other
investments that are not publicly traded may not be readily determinable. It may
be difficult or impossible to obtain third party pricing on the investments we
purchase. We value these investments quarterly at fair value, as determined in
accordance with our pricing policy as approved by our board of directors.
Because such valuations are inherently uncertain, may fluctuate over short
periods of time and may be based on estimates, our determinations of fair value
may differ materially from the values that would have been used if a ready
market for these securities existed. The value of our common stock could be
adversely affected if our determinations regarding the fair value of these
investments were materially higher than the values that we ultimately realize
upon their disposal.
A prolonged economic slowdown, a recession or declining real estate values could
impair our investments and harm our operating results.
Many of our investments are susceptible to economic slowdowns or
recessions, which could lead to financial losses in our investments and a
decrease in revenues, net income and assets. Unfavorable economic conditions
also could increase our funding costs, limit our access to the capital markets
or result in a decision by lenders not to extend credit to us. These events
could prevent us from increasing investments and have an adverse effect on our
operating results.
Changes in prepayment rates could negatively affect the value of our investment
portfolio, which could result in reduced earnings or losses and negatively
affect the cash available for distribution to our stockholders.
There are seldom any restrictions on borrowers' abilities to prepay their
residential mortgage loans. Homeowners tend to prepay mortgage loans faster when
interest rates decline. Consequently, owners of the loans have to reinvest the
money received from the prepayments at the lower prevailing interest rates.
Conversely, homeowners tend not to prepay mortgage loans when interest rates
increase. Consequently, owners of the loans are unable to reinvest money that
would have otherwise been received from prepayments at the higher prevailing
interest rates. This volatility in prepayment rates may affect our ability to
maintain targeted amounts of leverage on our portfolio of residential mortgage
loans, RMBS, and CDOs backed by real estate-related assets and may result in
reduced earnings or losses for us and negatively affect the cash available for
distribution to our stockholders.
22
To the extent our investments are purchased at a premium, faster than
expected prepayments result in a faster than expected amortization of the
premium paid, which would adversely affect our earnings. Conversely, if these
investments were purchased at a discount, faster than expected prepayments
accelerate our recognition of income.
The mortgage loans we invest in and the mortgage loans underlying the mortgage
and asset-backed securities we invest in are subject to delinquency, foreclosure
and loss, which could result in losses to us.
Residential mortgage loans are typically secured by single-family
residential property and are subject to risks of delinquency and foreclosure and
risks of loss. The ability of a borrower to repay a loan secured by a
residential property is dependent upon the income or assets of the borrower. A
number of factors, including a general economic downturn, acts of God,
terrorism, social unrest and civil disturbances, may impair borrowers' abilities
to repay their loans. In addition, we invest in non-Agency RMBS, which are
backed by residential real property but, in contrast to Agency RMBS, their
principal and interest is not guaranteed by federally chartered entities such as
Fannie Mae and Freddie Mac and, in the case of Ginnie Mae, the U.S. government.
Asset-backed securities are bonds or notes backed by loans or other financial
assets. The ability of a borrower to repay these loans or other financial assets
is dependent upon the income or assets of these borrowers. Commercial mortgage
loans are secured by multifamily or commercial property and are subject to risks
of delinquency and foreclosure, and risks of loss that are greater than similar
risks associated with loans made on the security of single-family residential
property. The ability of a borrower to repay a loan secured by an
income-producing property typically is dependent primarily upon the successful
operation of such property rather than upon the existence of independent income
or assets of the borrower. If the net operating income of the property is
reduced, the borrower's ability to repay the loan may be impaired. Net operating
income of an income producing property can be affected by, among other things,
tenant mix, success of tenant businesses, property management decisions,
property location and condition, competition from comparable types of
properties, changes in laws that increase operating expense or limit rents that
may be charged, any need to address environmental contamination at the property,
the occurrence of any uninsured casualty at the property, changes in national,
regional or local economic conditions or specific industry segments, declines in
regional or local real estate values, declines in regional or local rental or
occupancy rates, increases in interest rates, real estate tax rates and other
operating expenses, changes in governmental rules, regulations and fiscal
policies, including environmental legislation, acts of God, terrorism, social
unrest and civil disturbances. In the event of any default under a mortgage loan
held directly by us, we will bear a risk of loss of principal to the extent of
any deficiency between the value of the collateral and the principal and accrued
interest of the mortgage loan, which could have a material adverse effect on our
cash flow from operations. In the event of the bankruptcy of a mortgage loan
borrower, the mortgage loan to such borrower will be deemed to be secured only
to the extent of the value of the underlying collateral at the time of
bankruptcy (as determined by the bankruptcy court), and the lien securing the
mortgage loan will be subject to the avoidance powers of the bankruptcy trustee
or debtor-in-possession to the extent the lien is unenforceable under state law.
Foreclosure of a mortgage loan can be an expensive and lengthy process which
could have a substantial negative effect on our anticipated return on the
foreclosed mortgage loan. RMBS evidence interests in or are secured by pools of
residential mortgage loans and CMBS evidence interests in or are secured by a
single commercial mortgage loan or a pool of commercial mortgage loans.
Accordingly, the RMBS and CMBS we invest in are subject to all of the risks of
the respective underlying mortgage loans.
We may be required to repurchase mortgage loans or indemnify investors if we
breach representations and warranties, which could harm our earnings.
If we sell loans, we would be required to make customary representations
and warranties about such loans to the loan purchaser. Our residential mortgage
loan sale agreements will require us to repurchase or substitute loans in the
event we breach a representation or warranty given to the loan purchaser. In
addition, we may be required to repurchase loans as a result of borrower fraud
or in the event of early payment default on a mortgage loan. Likewise, we are
required to repurchase or substitute loans if we breach a representation or
warranty in connection with our securitizations. The remedies available to a
purchaser of mortgage loans are generally broader than those available to us
against the originating broker or correspondent. Further, if a purchaser
enforces its remedies against us, we may not be able to enforce the remedies we
have against the sellers. The repurchased loans typically can only be financed
at a steep discount to their repurchase price, if at all. They are also
typically sold at a significant discount to the unpaid principal balance.
Significant repurchase activity could harm our cash flow, results of operations,
financial condition and business prospects.
23
We may enter into derivative contracts that could expose us to contingent
liabilities in the future.
Subject to maintaining our qualification as a REIT, part of our investment
strategy will involve entering into derivative contracts that could require us
to fund cash payments in certain circumstances. These potential payments will be
contingent liabilities and therefore may not appear on our statement of
financial condition. Our ability to fund these contingent liabilities will
depend on the liquidity of our assets and access to capital at the time, and the
need to fund these contingent liabilities could adversely impact our financial
condition.
Our Manager's due diligence of potential investments may not reveal all of the
liabilities associated with such investments and may not reveal other weaknesses
in such investments, which could lead to investment losses.
Before making an investment, our Manager assesses the strengths and
weaknesses of the originator or issuer of the asset as well as other factors and
characteristics that are material to the performance of the investment. In
making the assessment and otherwise conducting customary due diligence, our
Manager relies on resources available to it and, in some cases, an investigation
by third parties. This process is particularly important with respect to newly
formed originators or issuers with unrated and other subordinated tranches of
MBS and ABS because there may be little or no information publicly available
about these entities and investments. There can be no assurance that our
Manager's due diligence process will uncover all relevant facts or that any
investment will be successful.
Our real estate investments are subject to risks particular to real property.
We own assets secured by real estate and may own real estate directly in
the future, either through direct investments or upon a default of mortgage
loans. Real estate investments are subject to various risks, including:
o acts of God, including earthquakes, floods and other natural disasters,
which may result in uninsured losses;
o acts of war or terrorism, including the consequences of terrorist attacks,
such as those that occurred on September 11, 2001;
o adverse changes in national and local economic and market conditions;
o changes in governmental laws and regulations, fiscal policies and zoning
ordinances and the related costs of compliance with laws and regulations,
fiscal policies and ordinances;
o costs of remediation and liabilities associated with environmental
conditions such as indoor mold; and
o the potential for uninsured or under-insured property losses.
If any of these or similar events occurs, it may reduce our return from an
affected property or investment and reduce or eliminate our ability to make
distributions to stockholders.
We may be exposed to environmental liabilities with respect to properties to
which we take title.
In the course of our business, we may take title to real estate, and, if
we do take title, we could be subject to environmental liabilities with respect
to these properties. In such a circumstance, we may be held liable to a
governmental entity or to third parties for property damage, personal injury,
investigation, and clean-up costs incurred by these parties in connection with
environmental contamination, or may be required to investigate or clean up
hazardous or toxic substances, or chemical releases at a property. The costs
associated with investigation or remediation activities could be substantial. If
we ever become subject to significant environmental liabilities, our business,
financial condition, liquidity, and results of operations could be materially
and adversely affected.
We may in the future invest in RMBS collateralized by subprime mortgage loans,
which are subject to increased risks.
We may in the future invest in RMBS backed by collateral pools of subprime
residential mortgage loans. "Subprime" mortgage loans refer to mortgage loans
that have been originated using underwriting standards that are less restrictive
than the underwriting requirements used as standards for other first and junior
lien mortgage loan purchase programs, such as the programs of Fannie Mae and
Freddie Mac. These lower standards include mortgage loans made to borrowers
having imperfect or impaired credit histories (including outstanding judgments
or prior bankruptcies), mortgage loans where the amount of the loan at
origination is 80% or more of the value of the mortgage property, mortgage loans
made to borrowers with low credit scores, mortgage loans made to borrowers who
have other debt that represents a large portion of their income and mortgage
loans made to borrowers whose income is not required to be disclosed or
verified. Due to economic conditions, including increased interest rates and
lower home prices, as well as aggressive lending practices, subprime mortgage
loans have in recent periods experienced increased rates of delinquency,
foreclosure, bankruptcy and loss, and they are likely to continue to experience
delinquency, foreclosure, bankruptcy and loss rates that are higher, and that
may be substantially higher, than those experienced by mortgage loans
underwritten in a more traditional manner. Thus, because of the higher
delinquency rates and losses associated with subprime mortgage loans, the
performance of RMBS backed by subprime mortgage loans in which we may invest
could be correspondingly adversely affected, which could adversely impact our
results of operations, financial condition and business.
24
Exchange rate fluctuations may limit gains or result in losses.
If we directly or indirectly hold assets denominated in currencies other
than U.S. dollars, we will be exposed to currency risk that may adversely affect
performance. Changes in the U.S. dollar's rate of exchange with other currencies
may affect the value of investments in our portfolio and the income that we
receive in respect of such investments. In addition, we may incur costs in
connection with conversion between various currencies, which may reduce our net
income and accordingly may reduce our ability to pay distributions to our
stockholders.
Risks Related To Our Common Stock
We issued common stock on the New York Stock Exchange on November 16, 2007.
Our shares of common stock are newly issued securities for which there was
no trading market prior to November 2007. The market price of our common stock
may be highly volatile and could be subject to wide fluctuations.
Some of the factors that could negatively affect our share price include:
o actual or anticipated variations in our quarterly operating results;
o changes in our earnings estimates or publication of research reports about
us or the real estate industry;
o increases in market interest rates that may lead purchasers of our shares
to demand a higher yield;
o changes in market valuations of similar companies;
o adverse market reaction to any increased indebtedness we incur in the
future;
o additions or departures of our Manager's key personnel;
o actions by stockholders;
o speculation in the press or investment community; and
o general market and economic conditions.
Common stock eligible for future sale may have adverse effects on our share
price.
We cannot predict the effect, if any, of future sales of common stock, or
the availability of shares for future sales, on the market price of the common
stock. Sales of substantial amounts of common stock, or the perception that such
sales could occur, may adversely affect prevailing market prices for the common
stock. At December 31, 2007, we have 37,705,563 shares of common stock issued
and outstanding. In addition, Annaly holds 9.6% of our outstanding shares of
common stock as of December 31, 2007. Our equity incentive plan provides for
grants of restricted common stock and other equity-based awards up to an
aggregate of 8% of the issued and outstanding shares of our common stock (on a
fully diluted basis and including shares sold to Annaly concurrently with the
initial public offering and shares sold pursuant to the underwriters' exercise
of their overallotment option) at the time of the award, subject to a ceiling of
shares available for issuance under the plan. We, Annaly, and our officers and
directors have agreed with the underwriters to a 180-day lock-up period (subject
to extensions), meaning that, until the end of the 180-day lock-up period, we
and they will not, subject to certain exceptions, sell or transfer any shares of
common stock without the prior consent of Merrill Lynch. Merrill Lynch may, in
its sole discretion, at any time from time to time and without notice, waive the
terms and conditions of the lock-up agreements to which it is a party.
Additionally, Annaly has agreed with us to a further lock-up period that will
expire at the earlier of (i) November 15, 2010 or (ii) the termination of the
management agreement. When the lock-up periods expire, these common shares will
become eligible for sale, in some cases subject to the requirements of Rule 144
under the Securities Act of 1933, or the Securities Act. The market price of our
common stock may decline significantly when the restrictions on resale by
certain of our stockholders lapse. Sales of substantial amounts of common stock
or the perception that such sales could occur may adversely affect the
prevailing market price for our common stock.
25
There is a risk that our stockholders may not receive distributions or that
distributions may not grow over time.
We intend to make distributions on a quarterly basis out of assets legally
available to our stockholders in amounts such that all or substantially all of
our REIT taxable income in each year is distributed. We have not established a
minimum distribution payment level and our ability to pay distributions may be
adversely affected by a number of factors, including the risk factors described
herein. All distributions will be made at the discretion of our board of
directors and will depend on our earnings, our financial condition, maintenance
of our REIT status and other factors as our board of directors may deem relevant
from time to time. Among the factors that could adversely affect our results of
operations and impair our ability to pay distributions to our stockholders are:
o the profitability of the investment of the net proceeds of the initial
public offering:
o our ability to make profitable investments;
o margin calls or other expenses that reduce our cash flow;
o defaults in our asset portfolio or decreases in the value of our portfolio;
and
o the fact that anticipated operating expense levels may not provide
accurate, as actual results may vary from estimates.
A change in any one of these factors could affect our ability to make
distributions. We cannot assure you that we will achieve investment results that
will allow us to make a specified level of cash distributions or year-to-year
increases in cash distributions.
Market interest rates may have an effect on the trading value of our shares.
One of the factors that investors may consider in deciding whether to buy
or sell our shares is our distribution rate as a percentage of our share price
relative to market interest rates. If market interest rates increase,
prospective investors may demand a higher distribution rate or seek alternative
investments paying higher dividends or interest. As a result, interest rate
fluctuations and capital market conditions can affect the market value of our
shares. For instance, if interest rates rise, it is likely that the market price
of our shares will decrease as market rates on interest-bearing securities, such
as bonds, increase.
Investing in our shares may involve a high degree of risk.
The investments we make in accordance with our investment objectives may
result in a high amount of risk when compared to alternative investment options
and volatility or loss of principal. Our investments may be highly speculative
and aggressive, are subject to credit risk, interest rate risk, and market value
risks, among others, and therefore an investment in our shares may not be
suitable for someone with lower risk tolerance.
Broad market fluctuations could negatively impact the market price of our common
stock.
The stock market has experienced extreme price and volume fluctuations
that have affected the market price of many companies in industries similar or
related to ours and that have been unrelated to these companies' operating
performances. These broad market fluctuations could reduce the market price of
our common stock. Furthermore, our operating results and prospects may be below
the expectations of public market analysts and investors or may be lower than
those of companies with comparable market capitalizations, which could lead to a
material decline in the market price of our common stock.
Future sales of shares may have adverse consequences for investors.
26
We may issue additional shares in subsequent public offerings or private
placements to make new investments or for other purposes. We are not required to
offer any such shares to existing shareholders on a pre-emptive basis.
Therefore, it may not be possible for existing shareholders to participate in
such future share issues, which may dilute the existing shareholders' interests
in us. Annaly owns 9.6% of our outstanding shares of common stock as of December
31, 2007 and will be permitted, subject to the requirements of Rule 144 under
the Securities Act, to sell such shares upon the earlier of (i) November 15,
2010 or (ii) the termination of the management agreement.
Our charter and bylaws contain provisions that may inhibit potential acquisition
bids that stockholders may consider favorable, and the market price of our
common stock may be lower as a result.
Our charter and bylaws contain provisions that have an anti-takeover
effect and inhibit a change in our board of directors. These provisions include
the following:
o There are ownership limits and restrictions on transferability and
ownership in our charter. To qualify as a REIT for each taxable year after
2007, not more than 50% of the value of our outstanding stock may be owned,
directly or constructively, by five or fewer individuals during the second
half of any calendar year. In addition, our shares must be beneficially
owned by 100 or more persons during at least 335 days of a taxable year of
12 months or during a proportionate part of a shorter taxable year for each
taxable year after 2007. To assist us in satisfying these tests, our
charter generally prohibits any person from beneficially or constructively
owning more than 9.8% in value or number of shares, whichever is more
restrictive, of any class or series of our outstanding capital stock. These
restrictions may discourage a tender offer or other transactions or a
change in the composition of our board of directors or control that might
involve a premium price for our shares or otherwise be in the best
interests of our stockholders and any shares issued or transferred in
violation of such restrictions being automatically transferred to a trust
for a charitable beneficiary, thereby resulting in a forfeiture of the
additional shares.
o Our charter permits our board of directors to issue stock with terms that
may discourage a third party from acquiring us. Our charter permits our
board of directors to amend the charter without stockholder approval to
increase the total number of authorized shares of stock or the number of
shares of any class or series and to issue common or preferred stock,
having preferences, conversion or other rights, voting powers,
restrictions, limitations as to dividends or other distributions,
qualifications, or terms or conditions of redemption as determined by our
board. Thus, our board could authorize the issuance of stock with terms and
conditions that could have the effect of discouraging a takeover or other
transaction in which holders of some or a majority of our shares might
receive a premium for their shares over the then-prevailing market price of
our shares.
o Maryland Control Share Acquisition Act. Maryland law provides that "control
shares" of a corporation acquired in a "control share acquisition" will
have no voting rights except to the extent approved by a vote of two-thirds
of the votes eligible to be cast on the matter under the Maryland Control
Share Acquisition Act. "Control shares" means voting shares of stock that,
if aggregated with all other shares of stock owned by the acquirer or in
respect of which the acquirer is able to exercise or direct the exercise of
voting power (except solely by a revocable proxy), would entitle the
acquirer to exercise voting power in electing directors within one of the
following ranges of voting power: one-tenth or more but less than
one-third, one-third or more but less than a majority, or a majority or
more of all voting power. A "control share acquisition" means the
acquisition of control shares, subject to certain exceptions.
If voting rights or control shares acquired in a control share acquisition
are not approved at a stockholders' meeting, or if the acquiring person
does not deliver an acquiring person statement as required by the Maryland
Control Share Acquisition Act, then, subject to certain conditions and
limitations, the issuer may redeem any or all of the control shares for
fair value. If voting rights of such control shares are approved at a
stockholders' meeting and the acquirer becomes entitled to vote a majority
of the shares of stock entitled to vote, all other stockholders may
exercise appraisal rights. Our bylaws contain a provision exempting
acquisitions of our shares from the Maryland Control Share Acquisition Act.
However, our board of directors may amend our bylaws in the future to
repeal or modify this exemption, in which case any control shares of our
company acquired in a control share acquisition will be subject to the
Maryland Control Share Acquisition Act.
27
o Business Combinations. Under Maryland law, "business combinations" between
a Maryland corporation and an interested stockholder or an affiliate of an
interested stockholder are prohibited for five years after the most recent
date on which the interested stockholder becomes an interested stockholder.
These business combinations include a merger, consolidation, share exchange
or, in circumstances specified in the statute, an asset transfer or
issuance or reclassification of equity securities. An interested
stockholder is defined as:
o any person who beneficially owns 10% or more of the voting power of
the corporation's shares; or
o an affiliate or associate of the corporation who, at any time within
the two-year period before the date in question, was the beneficial
owner of 10% or more of the voting power of the then outstanding
voting stock of the corporation.
A person is not an interested stockholder under the statute if the board of
directors approved in advance the transaction by which such person
otherwise would have become an interested stockholder. However, in
approving a transaction, the board of directors may provide that its
approval is subject to compliance, at or after the time of approval, with
any terms and conditions determined by the board. After the five-year
prohibition, any business combination between the Maryland corporation and
an interested stockholder generally must be recommended by the board of
directors of the corporation and approved by the affirmative vote of at
least:
o 80% of the votes entitled to be cast by holders of outstanding shares
of voting stock of the corporation; and
o two-thirds of the votes entitled to be cast by holders of voting stock
of the corporation, other than shares held by the interested
stockholder with whom or with whose affiliate the business combination
is to be effected or held by an affiliate or associate of the
interested stockholder.
These super-majority vote requirements do not apply if the corporation's
common stockholders receive a minimum price, as defined under Maryland law,
for their shares in the form of cash or other consideration in the same
form as previously paid by the interested stockholder for its shares. The
statute permits various exemptions from its provisions, including business
combinations that are exempted by the board of directors before the time
that the interested stockholder becomes an interested stockholder. Our
board of directors has adopted a resolution which provides that any
business combination between us and any other person is exempted from the
provisions of the Maryland Control Share Acquisition Act, provided that the
business combination is first approved by the board of directors. This
resolution, however, may be altered or repealed in whole or in part at any
time. If this resolution is repealed, or the board of directors does not
otherwise approve a business combination, this statute may discourage
others from trying to acquire control of us and increase the difficulty of
consummating any offer.
o Staggered board. Our board of directors is divided into three classes
of directors. The current terms of the directors expire in 2008, 2009
and 2010, respectively. Directors of each class are chosen for
three-year terms upon the expiration of their current terms, and each
year one class of directors is elected by the stockholders. The
staggered terms of our directors may reduce the possibility of a
tender offer or an attempt at a change in control, even though a
tender offer or change in control might be in the best interests of
our stockholders.
o Our charter and bylaws contain other possible anti-takeover
provisions. Our charter and bylaws contains other provisions that may
have the effect of delaying, deferring or preventing a change in
control of us or the removal of existing directors and, as a result,
could prevent our stockholders from being paid a premium for their
common stock over the then- prevailing market price.
Our rights and the rights of our stockholders to take action against our
directors and officers are limited, which could limit stockholder's recourse in
the event of actions not in their best interests.
Our charter limits the liability of our directors and officers to us and
our stockholders for money damages, except for liability resulting from:
o actual receipt of an improper benefit or profit in money, property or
services; or
28
o a final judgment based upon a finding of active and deliberate dishonesty
by the director or officer that was material to the cause of action
adjudicated
for which Maryland law prohibits such exemption from liability.
In addition, our charter authorizes us to obligate our company to
indemnify our present and former directors and officers for actions taken by
them in those capacities to the maximum extent permitted by Maryland law. Our
bylaws require us to indemnify each present or former director or officer, to
the maximum extent permitted by Maryland law, in the defense of any proceeding
to which he or she is made, or threatened to be made, a party because of his or
her service to us. In addition, we may be obligated to fund the defense costs
incurred by our directors and officers.
Tax Risks
Your investment has various federal income tax risks.
This summary of certain tax risks is limited to the federal tax risks
addressed below. Additional risks or issues may exist that are not addressed in
this 10-K and that could affect the federal tax treatment of us or our
stockholders. This is not intended to be used and cannot be used by any
stockholder to avoid penalties that may be imposed on stockholders under the
Internal Revenue Code, or the Code. We strongly urge you to seek advice based on
your particular circumstances from an independent tax advisor concerning the
effects of federal, state and local income tax law on an investment in common
stock and on your individual tax situation.
Complying with REIT requirements may cause us to forego otherwise attractive
opportunities.
To qualify as a REIT for federal income tax purposes, we must continually
satisfy various tests regarding the sources of our income, the nature and
diversification of our assets, the amounts we distribute to our stockholders and
the ownership of our stock. To meet these tests, we may be required to forego
investments we might otherwise make. We may be required to make distributions to
stockholders at disadvantageous times or when we do not have funds readily
available for distribution. Thus, compliance with the REIT requirements may
hinder our investment performance.
Complying with REIT requirements may force us to liquidate otherwise attractive
investments.
To qualify as a REIT, we generally must ensure that at the end of each
calendar quarter at least 75% of the value of our total assets consists of cash,
cash items, government securities and qualified REIT real estate assets,
including certain mortgage loans and mortgage-backed securities. The remainder
of our investment in securities (other than government securities and qualifying
real estate assets) generally cannot include more than 10% of the outstanding
voting securities of any one issuer or more than 10% of the total value of the
outstanding securities of any one issuer. In addition, in general, no more than
5% of the value of our assets (other than government securities and qualifying
real estate assets) can consist of the securities of any one issuer, and no more
than 20% of the value of our total securities can be represented by securities
of one or more TRSs. If we fail to comply with these requirements at the end of
any quarter, we must correct the failure within 30 days after the end of such
calendar quarter or qualify for certain statutory relief provisions to avoid
losing our REIT status and suffering adverse tax consequences. As a result, we
may be required to liquidate from our portfolio otherwise attractive
investments. These actions could have the effect of reducing our income and
amounts available for distribution to our stockholders.
Potential characterization of distributions or gain on sale may be treated as
unrelated business taxable income to tax-exempt investors.
If (1) all or a portion of our assets are subject to the rules relating to
taxable mortgage pools, (2) we are a "pension-held REIT," (3) a tax-exempt
stockholder has incurred debt to purchase or hold our common stock, or (4) the
residual Real Estate Mortgage Investment Conduit interests, or REMICs, we buy
generate "excess inclusion income," then a portion of the distributions to and,
in the case of a stockholder described in clause (3), gains realized on the sale
of common stock by such tax-exempt stockholder may be subject to federal income
tax as unrelated business taxable income under the Internal Revenue Code.
29
Classification of a securitization or financing arrangement we enter into as a
taxable mortgage pool could subject us or certain of our stockholders to
increased taxation.
We intend to structure our securitization and financing arrangements as to
not create a taxable mortgage pool. However, if we have borrowings with two or
more maturities and, (1) those borrowings are secured by mortgages or
mortgage-backed securities and (2) the payments made on the borrowings are
related to the payments received on the underlying assets, then the borrowings
and the pool of mortgages or mortgage-backed securities to which such borrowings
relate may be classified as a taxable mortgage pool under the Internal Revenue
Code. If any part of our investments were to be treated as a taxable mortgage
pool, then our REIT status would not be impaired, but a portion of the taxable
income we recognize may, under regulations to be issued by the Treasury
Department, be characterized as "excess inclusion" income and allocated among
our stockholders to the extent of and generally in proportion to the
distributions we make to each stockholder. Any excess inclusion income would:
o not be allowed to be offset by a stockholder's net operating losses;
o be subject to a tax as unrelated business income if a stockholder were a
tax-exempt stockholder;
o be subject to the application of federal income tax withholding at the
maximum rate (without reduction for any otherwise applicable income tax
treaty) with respect to amounts allocable to foreign stockholders; and
o be taxable (at the highest corporate tax rate) to us, rather than to our
stockholders, to the extent the excess inclusion income relates to stock
held by disqualified organizations (generally, tax-exempt companies not
subject to tax on unrelated business income, including governmental
organizations).
Failure to qualify as a REIT would subject us to federal income tax, which would
reduce the cash available for distribution to our stockholders.
We intend to operate in a manner that is intended to cause us to qualify
as a REIT for federal income tax purposes commencing with our taxable year
ending on December 31, 2007. However, the federal income tax laws governing
REITs are extremely complex, and interpretations of the federal income tax laws
governing qualification as a REIT are limited. Qualifying as a REIT requires us
to meet various tests regarding the nature of our assets and our income, the
ownership of our outstanding stock, and the amount of our distributions on an
ongoing basis. While we intend to operate so that we will qualify as a REIT,
given the highly complex nature of the rules governing REITs, the ongoing
importance of factual determinations, including the tax treatment of certain
investments we may make, and the possibility of future changes in our
circumstances, no assurance can be given that we will so qualify for any
particular year. If we fail to qualify as a REIT in any calendar year and we do
not qualify for certain statutory relief provisions, we would be required to pay
federal income tax on our taxable income. We might need to borrow money or sell
assets to pay that tax. Our payment of income tax would decrease the amount of
our income available for distribution to our stockholders. Furthermore, if we
fail to maintain our qualification as a REIT and we do not qualify for certain
statutory relief provisions, we no longer would be required to distribute
substantially all of our REIT taxable income to our stockholders. Unless our
failure to qualify as a REIT were excused under federal tax laws, we would be
disqualified from taxation as a REIT for the four taxable years following the
year during which qualification was lost.
Failure to make required distributions would subject us to tax, which would
reduce the cash available for distribution to our stockholders.
To qualify as a REIT, we must distribute to our stockholders each calendar
year at least 90% of our REIT taxable income (including certain items of
non-cash income), determined without regard to the deduction for dividends paid
and excluding net capital gain. To the extent that we satisfy the 90%
distribution requirement, but distribute less than 100% of our taxable income,
we will be subject to federal corporate income tax on our undistributed income.
In addition, we will incur a 4% nondeductible excise tax on the amount, if any,
by which our distributions in any calendar year are less than the sum of:
o 85% of our REIT ordinary income for that year;
o 95% of our REIT capital gain net income for that year; and
o any undistributed taxable income from prior years.
We intend to distribute our REIT taxable income to our stockholders in a
manner intended to satisfy the 90% distribution requirement and to avoid both
corporate income tax and the 4% nondeductible excise tax. However, there is no
requirement that TRSs distribute their after-tax net income to their parent REIT
or their stockholders. Our taxable income may substantially exceed our net
income as determined based on generally accepted accounting principles, or GAAP,
because, for example, realized capital losses will be deducted in determining
our GAAP net income, but may not be deductible in computing our taxable income.
In addition, we may invest in assets that generate taxable income in excess of
economic income or in advance of the corresponding cash flow from the assets. To
the extent that we generate such non-cash taxable income in a taxable year, we
may incur corporate income tax and the 4% nondeductible excise tax on that
income if we do not distribute such income to stockholders in that year. As a
result of the foregoing, we may generate less cash flow than taxable income in a
particular year. In that event, we may be required to use cash reserves, incur
debt, or liquidate non-cash assets at rates or at times that we regard as
unfavorable to satisfy the distribution requirement and to avoid corporate
income tax and the 4% nondeductible excise tax in that year.
30
Ownership limitations may restrict change of control or business combination
opportunities in which our stockholders might receive a premium for their
shares.
In order for us to qualify as a REIT for each taxable year after 2007, no
more than 50% in value of our outstanding capital stock may be owned, directly
or indirectly, by five or fewer individuals during the last half of any calendar
year. "Individuals" for this purpose include natural persons, private
foundations, some employee benefit plans and trusts, and some charitable trusts.
To preserve our REIT qualification, our charter generally prohibits any person
from directly or indirectly owning more than 9.8% in value or in number of
shares, whichever is more restrictive, of any class or series of the outstanding
shares of our capital stock. This ownership limitation could have the effect of
discouraging a takeover or other transaction in which holders of our common
stock might receive a premium for their shares over the then prevailing market
price or which holders might believe to be otherwise in their best interests.
Our ownership of and relationship with any TRS which we may form or acquire will
be limited, and a failure to comply with the limits would jeopardize our REIT
status and may result in the application of a 100% excise tax.
A REIT may own up to 100% of the stock of one or more TRSs. A TRS may earn
income that would not be qualifying income if earned directly by the parent
REIT. Both the subsidiary and the REIT must jointly elect to treat the
subsidiary as a TRS. Overall, no more than 20% of the value of a REIT's assets
may consist of stock or securities of one or more TRSs. A TRS will pay federal,
state and local income tax at regular corporate rates on any income that it
earns. In addition, the TRS rules impose a 100% excise tax on certain
transactions between a TRS and its parent REIT that are not conducted on an
arm's-length basis. The TRS that we may form following the completion of this
offering would pay federal, state and local income tax on its taxable income,
and its after-tax net income would be available for distribution to us but would
not be required to be distributed to us. We anticipate that the aggregate value
of the TRS stock and securities owned by us will be less than 20% of the value
of our total assets (including the TRS stock and securities). Furthermore, we
will monitor the value of our investments in our TRSs to ensure compliance with
the rule that no more than 20% of the value of our assets may consist of TRS
stock and securities (which is applied at the end of each calendar quarter). In
addition, we will scrutinize all of our transactions with taxable REIT
subsidiaries to ensure that they are entered into on arm's-length terms to avoid
incurring the 100% excise tax described above. There can be no assurance,
however, that we will be able to comply with the 20% limitation discussed above
or to avoid application of the 100% excise tax discussed above.
We could fail to qualify as a REIT or we could become subject to a penalty tax
if income we recognize from certain investments that are treated or could be
treated as equity interests in a foreign corporation exceeds 5% of our gross
income in a taxable year.
We may invest in securities, such as subordinated interests in certain CDO
offerings, that are treated or could be treated for federal (and applicable
state and local) corporate income tax purposes as equity interests in foreign
corporations. Categories of income that qualify for the 95% gross income test
include dividends, interest and certain other enumerated classes of passive
income. Under certain circumstances, the federal income tax rules concerning
controlled foreign corporations and passive foreign investment companies require
that the owner of an equity interest in a foreign corporation include amounts in
income without regard to the owner's receipt of any distributions from the
foreign corporation. Amounts required to be included in income under those rules
are technically neither actual dividends nor any of the other enumerated
categories of passive income specified in the 95% gross income test.
Furthermore, there is no clear precedent with respect to the qualification of
such income under the 95% gross income test. Due to this uncertainty, we intend
to limit our direct investment in securities that are or could be treated as
equity interests in a foreign corporation such that the sum of the amounts we
are required to include in income with respect to such securities and other
amounts of non-qualifying income do not exceed 5% of our gross income. We cannot
assure you that we will be successful in this regard. To avoid any risk of
failing the 95% gross income test, we may be required to invest only indirectly,
through a domestic TRS, in any securities that are or could be considered to be
equity interests in a foreign corporation. This, of course, will result in any
income recognized from any such investment to be subject to federal income tax
in the hands of the TRS, which may, in turn, reduce our yield on the investment.
31
Liquidation of our assets may jeopardize our REIT qualification.
To qualify as a REIT, we must comply with requirements regarding our
assets and our sources of income. If we are compelled to liquidate our
investments to repay obligations to our lenders, we may be unable to comply with
these requirements, ultimately jeopardizing our qualification as a REIT, or we
may be subject to a 100% tax on any resultant gain if we sell assets in
transactions that are considered to be prohibited transactions.
The tax on prohibited transactions will limit our ability to engage in
transactions, including certain methods of securitizing mortgage loans that
would be treated as sales for federal income tax purposes.
A REIT's net income from prohibited transactions is subject to a 100% tax.
In general, prohibited transactions are sales or other dispositions of property,
other than foreclosure property, but including mortgage loans, held primarily
for sale to customers in the ordinary course of business. We might be subject to
this tax if we sold or securitized our assets in a manner that was treated as a
sale for federal income tax purposes. Therefore, to avoid the prohibited
transactions tax, we may choose not to engage in certain sales of assets at the
REIT level and may securitize assets only in transactions that are treated as
financing transactions and not as sales for tax purposes even though such
transactions may not be the optimal execution on a pre-tax basis. We could avoid
any prohibited tax concerns by engaging in securitization transactions through a
TRS, subject to certain limitations described above. To the extent that we
engage in such activities through domestic TRSs, the income associated with such
activities will be subject to federal (and applicable state and local) corporate
income tax.
Characterization of the repurchase agreements we enter into to finance our
investments as sales for tax purposes rather than as secured lending
transactions would adversely affect our ability to qualify as a REIT.
We will enter into repurchase agreements with a variety of counterparties
to achieve our desired amount of leverage for the assets in which we invest.
When we enter into a repurchase agreement, we generally sell assets to our
counterparty to the agreement and receive cash from the counterparty. The
counterparty is obligated to resell the assets back to us at the end of the term
of the transaction, which is typically 30-90 days. We believe that for federal
income tax purposes we will be treated as the owner of the assets that are the
subject of repurchase agreements and that the repurchase agreements will be
treated as secured lending transactions notwithstanding that such agreement may
transfer record ownership of the assets to the counterparty during the term of
the agreement. It is possible, however, that the IRS could successfully assert
that we did not own these assets during the term of the repurchase agreements,
in which case we could fail to qualify as a REIT.
Complying with REIT requirements may limit our ability to hedge effectively.
The REIT provisions of the Internal Revenue Code substantially limit our
ability to hedge mortgage-backed securities and related borrowings. Under these
provisions, our annual gross income from qualifying and non-qualifying hedges,
together with any other income not generated from qualifying real estate assets,
cannot exceed 25% of our gross income. In addition, our aggregate gross income
from non-qualifying hedges, fees, and certain other non-qualifying sources
cannot exceed 5% of our annual gross income. As a result, we might have to limit
our use of advantageous hedging techniques or implement those hedges through a
TRS, which we intend to form in the future. This could increase the cost of our
hedging activities or expose us to greater risks associated with changes in
interest rates than we would otherwise want to bear.
We may be subject to adverse legislative or regulatory tax changes that could
reduce the market price of our common stock.
At any time, the federal income tax laws or regulations governing REITs or
the administrative interpretations of those laws or regulations may be amended.
We cannot predict when or if any new federal income tax law, regulation or
administrative interpretation, or any amendment to any existing federal income
tax law, regulation or administrative interpretation, will be adopted,
promulgated or become effective and any such law, regulation or interpretation
may take effect retroactively. We and our stockholders could be adversely
affected by any such change in, or any new, federal income tax law, regulation
or administrative interpretation.
32
Dividends payable by REITs do not qualify for the reduced tax rates.
Legislation enacted in 2003 generally reduces the maximum tax rate for
dividends payable to domestic stockholders that are individuals, trusts and
estates from 38.6% to 15% (through 2010). Dividends payable by REITs, however,
are generally not eligible for the reduced rates. Although this legislation does
not adversely affect the taxation of REITs or dividends paid by REITs, the more
favorable rates applicable to regular corporate dividends could cause investors
who are individuals, trusts and estates to perceive investments in REITs to be
relatively less attractive than investments in stock of non-REIT corporations
that pay dividends, which could adversely affect the value of the stock of
REITs, including our common stock.
Item 1B. Unresolved Staff Comments
None.
Item 2. Properties
We do not own any property. Our executive and administrative office is
located at 1211 Avenue of the Americas, Suite 2902, New York, New York 10036,
telephone (646) 454-3759. We share this office space with Annaly and FIDAC.
Item 3. Legal Proceedings
We are not party to any material litigation or legal proceedings, or to
the best of our knowledge, any threatened litigation or legal proceedings,
which, in our opinion, individually or in the aggregate, would have a material
adverse effect on our results of operations or financial condition.
Item 4. Submission of Matters to a Vote of Security Holders
None.
Part II
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and
Issuer Purchases of Equity Securities
On November 15, 2007, the Securities and Exchange Commission declared
effective our Registration Statement on Form S-11 (File No. 333-145525) relating
to our initial public offering. The offering date was November 15, 2007. The
initial public offering was underwritten by Merrill Lynch, Pierce, Fenner &
Smith Incorporated, Credit Suisse Securities (USA) LLC, and Deutsche Bank
Securities Inc. acting as the representatives of J.P. Morgan Securities Inc.,
Keefe, Bruyette & Woods, Inc. and Bear, Stearns & Co. Inc. We registered
38,333,334 shares of our common stock, par value $0.01 per share. On November
21, 2007, we sold 34,083,334 of common stock in our initial public offering at a
price to the public of $15.00 per share for an aggregate offering price of
approximately $51.1 million. In connection with the offering, we paid
approximately $31.9 million in underwriting discounts and commissions and
incurred approximately $1 million of other offering expenses. None of the
underwriting discounts and commissions or offering expenses were incurred or
paid, directly or indirectly, to directors or officers of ours or their
associates or to persons owning 10% or more of our common stock or to any
affiliates of ours. After deducting the underwriting discounts and commissions
and these other offering expenses, we estimate that the net proceeds from the
offering equaled approximately $ 534.3 million.
In a concurrent private offering, we sold Annaly 3,621,581 shares of our
common stock at a price of $15 per share, for aggregate proceeds of
approximately $54.3 million. We did not pay any underwriting fees, commissions
or discounts with respect to the shares we sold Annaly. We relied on the
exemption from registration provided by Section 4(2) of the Securities Act for
the sale of the shares to Annaly.
33
We are investing the net proceeds of these offerings in accordance with
our investment objectives and strategies as described in the prospectus
comprising a part of the Registration Statement referenced above. There has been
no material change in our planned use of proceeds from our initial public
offering as described in our final prospectus filed with the Securities and
Exchange Commission pursuant to Rule 424(b).
Our common stock began trading publicly on November 16, 2007 and is traded
on the New York Stock Exchange under the trading symbol "CIM". As of February
19, 2008, we had 37,744,918 shares of common stock issued and outstanding which
were held by approximately 5,239 beneficial holders.The following table sets
forth, for the periods indicated, the high, low, and closing sales prices per
share of our common stock as reported on the New York Stock Exchange composite
tape and the cash dividends declared per share of our common stock for the
period commencing November 16, 2007 and ending December 31, 2007.
Stock Prices
High Low Close
November 16, 2007 to December 31, 2007 17.88 14.10 17.88
Common Dividends
Declared Per Share
Period commencing November 21, 2007 and ending
December 31, 2007 $0.025
We intend to pay quarterly dividends and to distribute to our stockholders
all or substantially all of our taxable income in each year (subject to certain
adjustments). This will enable us to qualify for the tax benefits accorded to a
REIT under the Code. We have not established a minimum dividend payment level
and our ability to pay dividends may be adversely affected for the reasons
described under the caption "Risk Factors." All distributions will be made at
the discretion of our board of directors and will depend on our earnings, our
financial condition, maintenance of our REIT status and such other factors as
our board of directors may deem relevant from time to time.
EQUITY COMPENSATION PLAN INFORMATION
We have adopted a long term stock incentive plan, or Incentive Plan, to
provide incentives to our independent directors, employees of our Manager and
its affiliates to stimulate their efforts towards our continued success
long-term growth and profitability and to attract, reward and retain personnel
and other service providers. The Incentive Plan authorizes the Compensation
Committee of the board of directors to grant awards, including incentive stock
options as defined under Section 422 of the Code, or ISOs, non-qualified stock
options, or NQSOs, restricted shares and other types of incentive awards. The
Incentive Plan authorizes the granting of options or other awards for an
aggregate of the greater of 8.0% of the outstanding shares of our common stock,
or 3,016,445 shares, up to a ceiling of 40,000,000 shares. For a description of
our Incentive Plan, see Note 8 to the Financial Statements.
The following table provides information as of December 31, 2007
concerning shares of our common stock authorized for issuance under our existing
Incentive Plan.
34
Number of Securities Weighted Average Number of Securities
to be Issued upon Exercise Price of Available for Future
Plan Category Exercise of Outstanding Issuance Under
Outstanding Options, Options, Warrants Equity Compensation
Warrants and and Rights Plans
Rights(1)
------------------------------- --------------------- ------------------- ---------------------
Equity Compensation Plans
Approved by Stockholders - - 3,016,445
Equity Compensation Plans Not
Approved by Stockholders(2) - - -
------------------------------- --------------------- ------------------- ---------------------
Total - - 3,016,445
=============================== ===================== =================== =====================
(1) The amount does not give effect to the 1,301,000 shares of restricted
common stock issued subsequent to December 31, 2007 to our Manager's
employees and to our independent directors under our equity incentive plan.
Each independent director was granted 3,000 shares of our restricted common
stock which fully vested on January 2, 2008. The restricted common stock
approved as grants to our officers and other employees of our Manager will
vest in equal installments on the first business day of each fiscal quarter
over a period of ten years beginning on January 2, 2008, or all outstanding
unvested shares will fully vest on the death of the individual.
(2) We do not have any equity plans that have not been approved by our
stockholders.
Item 6. Selected Financial Data
The following selected financial data are derived from our audited
financial statements for the period from November 21, 2007 (commencement of
operations) through December 31, 2007. The selected financial data should be
read in conjunction with the more detailed information contained in the
Financial Statements and Notes thereto and "Management's Discussion and Analysis
of Financial Condition and Results of Operations" included elsewhere in this
Form 10-K.
Statement of Financial Condition Highlights
(dollars in thousands, except per share data)
As of December 31, 2007
------------------------------------- --------------------------------
Mortgage-backed securities $1,124,290
Loans held for investment $162,371
Total assets $1,565,636
Repurchase agreements $270,584
Total liabilities $1,026,747
Shareholders' equity $538,889
Book value per share $14.29
Number of shares outstanding 37,705,563
Statement of Operations Highlights
(dollars in thousands, except per share data)
For the period November 21, 2007
to December 31, 2007
------------------------------------ ---------------------------------
Net interest income $3,077
Net loss ($2,906)
EPS (basic) ($0.08)
EPS (diluted) ($0.08)
Average shares - basic 37,401,737
Average shares - diluted 37,401,737
Taxable income per share (1) $0.03
Dividend declared per share (2) $0.025
35
Other Data
(dollars in thousands, except percentages)
For the period November 21,
2007 to December 31, 2007
------------------------------------------ ---------------------------
Average total assets $1,044,355
Average investment securities $399,736
Average borrowings $270,584
Average equity $530,982
Annualized yield on average interest
earning assets 7.02%
Annualized cost of funds on average
interest bearing
liabilities 5.08%
Annualized interest rate spread 1.94%
Annualized net interest margin (net
interest
income/average interest earning assets) 6.85%
Annualized G&A and management fee expense
as
percentage of average total assets 1.55%
Annualized G&A and management fee expense
as
percentage of average equity 3.05%
Return on average interest earning assets (6.47%)
Return on average equity (4.87%)
(1) See reconciliation of non-GAAP financial measurements to GAAP financial
measurements.
(2) For the applicable period as reported in our earnings announcements.
Reconciliation of non-GAAP financial measurements to GAAP financial measurements
Taxable income per share
As a REIT, we are required to distribute to our shareholders substantially
all of our REIT taxable earnings in the form of dividends. Taxable earnings per
share is a meaningful financial measurement for investors and management in
assessing our performance. A reconciliation of REIT taxable income per share to
GAAP EPS (basic) follows:
Reconciliation of REIT Taxable Income Per Share to GAAP EP
----------------------------------------------------------
For the period November
21, 2007 to December 31,
2007
-------------------------------------------- -------------------------
GAAP EPS ($0.08)
Unrealized loss on interest rate swaps $0.11
-------------------------
REIT taxable income per share $0.03
=========================
Item 7. Management's Discussion and Analysis of Financial Condition and Result
of Operations
The following discussion of our financial condition and results of
operations should be read in conjunction with the financial statements and notes
to those statements included in Item 8 of this Form 10-K. The discussion may
contain certain forward-looking statements that involve risks and uncertainties.
Forward-looking statements are those that are not historical in nature. As a
result of many factors, such as those set forth under "Risk Factors" in this
10-K, our actual results may differ materially from those anticipated in such
forward-looking statements.
Executive Summary
We are a newly-formed specialty finance company that will invest in
residential mortgage loans, residential mortgage-backed securities, real estate
related securities and various other asset classes. We are externally managed by
FIDAC. We intend to elect and qualify to be taxed as a REIT for federal income
tax purposes. Our targeted asset classes and the principal investments we expect
to make in each are as follows:
o Whole mortgage loans, consisting of:
36
o Prime mortgage loans
o Jumbo prime mortgage loans
o Alt-A mortgage loans
o RMBS, consisting of:
o Non-Agency RMBS, including investment-grade and non-investment grade
classes, including the BB-rated, B-rated and non-rated classes
o Agency RMBS
o ABS, consisting of:
o Debt and equity tranches of CDOs
o CMBS
o Consumer and non-consumer ABS, including investment-grade and
non-investment grade classes, including the BB-rated, B-rated and non-rated
classes
We completed our initial public offering on November 21, 2007. In that
offering and in a concurrent private offering we raised net proceeds before
offering expenses of approximately $533.6 million. We have commenced investing
these proceeds, and as of December 31, 2007, have a portfolio of RMBS and whole
mortgage loans of approximately $1.3 billion.
Our objective is to provide attractive risk-adjusted returns to our
investors over the long-term, primarily through dividends and secondarily
through capital appreciation. We intend to achieve this objective by investing
in a broad class of financial assets to construct an investment portfolio that
is designed to achieve attractive risk-adjusted returns and that is structured
to comply with the various federal income tax requirements for REIT status.
Our investment strategy is intended to take advantage of opportunities in
the current interest rate and credit environment. We will adjust our strategy to
changing market conditions by shifting our asset allocations across these
various asset classes as interest rate and credit cycles change over time. We
believe that our strategy, combined with our Manager's experience, will enable
us to pay dividends and achieve capital appreciation throughout changing market
cycles. We expect to take a long-term view of assets and liabilities, and our
reported earnings and mark-to-market valuations at the end of a financial
reporting period will not significantly impact our objective of providing
attractive risk-adjusted returns to our stockholders over the long-term.
We use leverage to seek to increase our potential returns and to fund the
acquisition of our assets. Our income is generated primarily by the difference,
or net spread, between the income we earn on our assets and the cost of our
borrowings. We expect to finance our investments using a variety of financing
sources including repurchase agreements, warehouse facilities, securitizations,
commercial paper and term financing CDOs. We expect to manage our debt by
utilizing interest rate hedges, such as interest rate swaps, to reduce the
effect of interest rate fluctuations related to our debt.
We expect the results of our operations to be affected by various factors,
many of which are beyond our control. Our results of operations will primarily
depend on, among other things, the level of our net interest income, the market
value of our assets, and the supply of and demand for such assets. Our net
interest income, which reflects the amortization of purchase premiums and
accretion of discounts, varies primarily as a result of changes in interest
rates, borrowing costs, and prepayment speeds, which is a measurement of how
quickly borrowers pay down the unpaid principal balance on their mortgage loans.
Prepayment Speeds. Prepayment speeds, as reflected by the Constant
Prepayment Rate, or CPR, vary according to interest rates, the type of
investment, conditions in financial markets, competition and other factors, none
of which can be predicted with any certainty. In general, when interest rates
rise, it is relatively less attractive for borrowers to refinance their mortgage
loans, and as a result, prepayment speeds tend to decrease. When interest rates
fall, prepayment speeds tend to increase. For mortgage loan and RMBS investments
purchased at a premium, as prepayment speeds increase, the amount of income we
earn decreases because the purchase premium we paid for the bonds amortizes
faster than expected. Conversely, decreases in prepayment speeds result in
increased income and can extend the period over which we amortize the purchase
premium. For mortgage loan and RMBS investments purchased at a discount, as
prepayment speeds increase, the amount of income we earn increases because of
the acceleration of the accretion of the discount into interest income.
Conversely, decreases in prepayment speeds result in decreased income and can
extend the period over which we accrete the purchase discount into interest
income.
37
Rising Interest Rate Environment. As indicated above, as interest rates
rise, prepayment speeds generally decrease, increasing our interest income.
Rising interest rates, however, increase our financing costs which may result in
a net negative impact on our net interest income. In addition, if we acquire
Agency and non-Agency RMBS collateralized by monthly reset adjustable-rate
mortgages, or ARMs, and three- and five-year hybrid ARMs, such interest rate
increases should result in decreases in our net investment income, as there
could be a timing mismatch between the interest rate reset dates on our RMBS
portfolio and the financing costs of these investments. Monthly reset ARMs are
ARMs on which coupon rates reset monthly based on indices such as one-month
LIBOR. Hybrid ARMs are mortgages that have interest rates that are fixed for an
initial period (typically three, five, seven or 10 years) and thereafter reset
at regular intervals subject to interest rate caps.
With respect to our floating rate investments such as CDO securities, such
interest rate increases should result in increases in our net investment income
because our floating rate assets are greater in amount than the related floating
rate liabilities. Similarly, such an increase in interest rates should generally
result in an increase in our net investment income on fixed-rate investments
made by us because our fixed-rate assets would be greater in amount than our
fixed-rate liabilities. We expect, however, that our fixed-rate assets would
decline in value in a rising interest rate environment and that our net interest
spreads on fixed rate assets could decline in a rising interest rate environment
to the extent such assets are financed with floating rate debt.
Credit Risk. One of our strategic focuses is on acquiring assets which we
believe to be of high credit quality. We believe this strategy will keep our
credit losses and financing costs low. We retain the risk of potential credit
losses on all of the residential mortgage loans we hold in our portfolio.
Additionally, some of our investments in RMBS may be qualifying interests for
purposes of maintaining our exemption from the 1940 Act because we retain a 100%
ownership interest in the underlying loans. If we purchase all classes of these
securitizations, we have the credit exposure on the underlying loans. Prior to
the purchase of these securities, we conduct a due diligence process that allows
us to remove loans that do not meet our credit standards based on loan-to-value
ratios, borrower's credit scores, income and asset documentation and other
criteria that we believe to be important indications of credit risk.
Size of Investment Portfolio. The size of our investment portfolio, as
measured by the aggregate unpaid principal balance of our mortgage loans and
aggregate principal balance of our mortgage related securities and the other
assets we own is also a key revenue driver. Generally, as the size of our
investment portfolio grows, the amount of interest income we receive increases.
The larger investment portfolio, however, drives increased expenses as we incur
additional interest expense to finance the purchase of our assets.
Since changes in interest rates may significantly affect our activities,
our operating results depend, in large part, upon our ability to effectively
manage interest rate risks and prepayment risks while maintaining our status as
a REIT.
Current Environment. While the current situation in the sub-prime mortgage
sector may provide us opportunities, the current weakness in the broader
mortgage market could adversely affect one or more of our potential lenders and
could cause one or more of our potential lenders to be unwilling or unable to
provide us with financing. In general, this could potentially increase our
financing costs and reduce our liquidity. We expect to use a number of sources
to finance our investments, including repurchase agreements, warehouse
facilities, securitizations, asset-backed commercial paper and term CDOs.
Current market conditions have affected the cost and availability of financing
from each of these sources--and their individual providers--to different
degrees; some sources generally are unavailable, some are available but at a
high cost, and some are largely unaffected. For example, in the repurchase
agreement market, borrowers have been affected differently depending on the type
of security they are financing. Non-Agency RMBS have been harder to finance,
depending on the type of assets collateralizing the RMBS. The amount, term and
margin requirements associated with these types of financings have been
impacted.
Currently, warehouse facilities to finance whole loan prime residential
mortgages are generally available from major banks, but at significantly higher
cost and greater margin requirements than previously offered. Many major banks
that offer warehouse facilities have also reduced the amount of capital
available to new entrants and consequently the size of those facilities offered
now are smaller than those previously available.
38
It is currently a challenging market to term finance whole loans through
securitization or bonds issued by a CDO structure. The highly rated senior bonds
in these securitizations and CDO structures currently have liquidity, but at
much wider spreads than issues priced in recent history. The junior subordinate
tranches of these structures currently have few buyers and current market
conditions have forced issuers to retain these lower rated bonds rather than
sell them.
Certain issuers of ABCP have been unable to place (or roll) their
securities, which has resulted, in some instances, in forced sales of MBS and
other securities which has further negatively impacted the market value of these
assets. These market conditions are fluid and likely to change over time. As a
result, the execution of our investment strategy may be dictated by the cost and
availability of financing from these different sources.
If one or more major market participants fails, it could negatively impact
the marketability of all fixed income securities and this could negatively
impact the value of the securities we acquire, thus reducing our net book value.
Furthermore, if many of our potential lenders are unwilling or unable to provide
us with financing, we could be forced to sell our securities or residential
mortgage loans at an inopportune time when prices are depressed.
In the current market, it may be difficult or impossible to obtain third
party pricing on the investments we purchase. In addition, validating third
party pricing for our investments may be more subjective as fewer participants
may be willing to provide this service to us. Moreover, the current market is
more illiquid than in recent history for some of the investments we purchase.
Illiquid investments typically experience greater price volatility as a ready
market does not exist. As volatility increases or liquidity decreases we may
have greater difficulty financing our investments which may negatively impact
our earnings and the execution of our investment strategy.
Critical Accounting Policies
Our financial statements are prepared in accordance with accounting
principles generally accepted in the United States of America. These accounting
principles may require us to make some complex and subjective decisions and
assessments. Our most critical accounting policies will involve decisions and
assessments that could affect our reported assets and liabilities, as well as
our reported revenues and expenses. We believe that all of the decisions and
assessments upon which our financial statements will be based will be reasonable
at the time made and based upon information available to us at that time. At
each quarter end, we obtain independent pricing on all of our assets and perform
a verification of those sources to our own internal estimate of fair market
value. We have identified what we believe will be our most critical accounting
policies to be the following:
Loans Held for Investment
We purchase residential mortgage loans and classify them as loans held for
investment on the statement of financial condition. Loans held for investment
are intended to be held to maturity and, accordingly, will be reported at the
principal amount outstanding, net of provisions for loan losses.
Loan loss provisions will be examined quarterly and updated to reflect
expectations of future probable credit losses based on factors such as
originator historical losses, geographic concentration, individual loan
characteristics, experienced losses, and expectations of future loan pool
behavior. As credit losses occur, the provision for loan losses will reflect
that realization.
When determine that it is probable that contractually due specific amounts
are deemed uncollectable, the loan is considered impaired. To measure our
impairment, we determine the fair value of the impaired loan the end of each
quarter by using estimates provided by independent dealers in the loans and/or
third party pricing services, which use information with respect to transactions
in such assets, quotations from dealers, market transactions for comparable
assets, various relationships between assets and yield to maturity in
determining value. If dealers or the independent pricing services are unable to
provide a price for an asset, or if the price provided by them is deemed
unreliable by our Manager, then the asset will be valued at its fair value as
determined in good faith by our Manager based on its model, utilizing observable
inputs. If upon completion of the valuation, the fair value of the loan is less
than its net carrying value, an allowance will be created with a corresponding
charge to the provision for losses. An allowance for mortgage loans would be
maintained at a level believed adequate by management to absorb probable losses.
We may elect to sell a loan held for investment due to adverse changes in credit
fundamentals. Once the determination has been made by us that we will no longer
hold the loan for investment, we will account for the loan at the lower of
amortized cost or estimated fair value. The reclassification of the loan and
recognition of impairments could adversely affect our reported earnings.
39
Valuations of Available-for-Sale Securities
We expect our investments in RMBS will be primarily classified as
available-for-sale securities that are carried on the statement of financial
condition at their fair value. This classification will result in changes in
fair values being recorded as statement of financial condition adjustments to
accumulated other comprehensive income or loss, which is a component of
stockholders' equity.
We expect our available-for-sale securities will have fair values as
determined with reference to price estimates provided by independent pricing
services and dealers in the securities. We will perform a validation of the
estimates provided by third parties to our internal model. If dealers or the
independent pricing services are unable to provide a price for an asset, or if
the price provided by them is deemed unreliable by our Manager, then the asset
will be valued at its fair value as determined in good faith by our Manager. The
pricing is subject to various assumptions which could result in different
presentations of value.
When the fair value of an available-for-sale security is less than its
amortized cost for an extended period, we will consider whether there is an
other-than-temporary impairment in the value of the security. If, based on our
analysis, an other-than-temporary impairment exists, the cost basis of the
security is written down to the then-current fair value, and the unrealized loss
is transferred from accumulated other comprehensive loss as an immediate
reduction of current earnings (as if the loss had been realized in the period of
other-than-temporary impairment). The determination of other-than-temporary
impairment is a subjective process, and different judgments and assumptions
could affect the timing of loss realization.
We will consider the following factors when determining an
other-than-temporary impairment for a security:
o The length of time and the extent to which the market value has been less
than the amortized cost;
o Whether the security has been downgraded by a rating agency; and
o Our intent to hold the security for a period of time sufficient to allow
for any anticipated recovery in market value.
The determination of other-than-temporary impairment is made at least
quarterly. If we determine an impairment to be other than temporary we will
realize a loss which will negatively impact current income.
Investment Consolidation
For each investment we make, we will evaluate the underlying entity that
issued the securities we will acquire or to which we will make a loan to
determine the appropriate accounting. We will refer to guidance in Statement of
Financial Accounting Standards (SFAS) No. 140, Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities, and FASB
Interpretation No. (FIN) 46R, Consolidation of Variable Interest Entities, in
performing our analysis. FIN 46R addresses the application of Accounting
Research Bulletin No. 51, Consolidated Financial Statements, to certain entities
in which voting rights are not effective in identifying an investor with a
controlling financial interest. In variable interest entities, or VIEs, an
entity is subject to consolidation under FIN 46R if the investors either do not
have sufficient equity at risk for the entity to finance its activities without
additional subordinated financial support, are unable to direct the entity's
activities, or are not exposed to the entity's losses or entitled to its
residual returns. VIEs within the scope of FIN 46R are required to be
consolidated by their primary beneficiary. The primary beneficiary of a VIE is
determined to be the party that absorbs a majority of the entity's expected
losses, its expected returns, or both. This determination can sometimes involve
complex and subjective analysis.
Interest Income Recognition
Interest income on available-for-sale securities and loans held for
investment are recognized over the life of the investment using the effective
interest method. Interest income on mortgage-backed securities is recognized
using the effective interest method as described by SFAS No. 91, Accounting for
Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and
Initial Direct Costs of Leases, for securities of high credit quality and
Emerging Issues Task Force No. 99-20, Recognition of Interest Income and
Impairment on Purchased and Retained Beneficial Interests in Securitized
Financial Assets, for all other securities. Interest income on loans held for
investment is recognized based on the contractual terms of the loan instruments.
Income recognition will be suspended for loans when, in the opinion of
management, a full recovery of income and principal becomes doubtful. Income
recognition will be resumed when the loan becomes contractually current and
performance is demonstrated to be resumed. Any loan fees or acquisition costs on
originated loans or securities will be capitalized and recognized as a component
of interest income over the life of the investment using the effective interest
method.
40
Under SFAS No. 91 and Emerging Issues Task Force No. 99-20, management
will estimate, at the time of purchase, the future expected cash flows and
determine the effective interest rate based on these estimated cash flows and
our purchase price. As needed, these estimated cash flows will be updated and a
revised yield computed based on the current amortized cost of the investment. In
estimating these cash flows, there will be a number of assumptions that will be
subject to uncertainties and contingencies. These include the rate and timing of
principal payments (including prepayments, repurchases, defaults and
liquidations), the pass-through or coupon rate and interest rate fluctuations.
In addition, interest payment shortfalls due to delinquencies on the underlying
mortgage loans, and the timing of the magnitude of credit losses on the mortgage
loans underlying the securities have to be judgmentally estimated. These
uncertainties and contingencies are difficult to predict and are subject to
future events that may impact management's estimates and our interest income.
Accounting For Derivative Financial Instruments
Our policies permit us to enter into derivative contracts, including
interest rate swaps and interest rate caps, as a means of mitigating our
interest rate risk. We intend to use interest rate derivative instruments to
mitigate interest rate risk rather than to enhance returns.
We account for derivative financial instruments in accordance with SFAS
No. 133, Accounting for Derivative Instruments and Hedging Activities, as
amended and interpreted. SFAS No. 133 requires an entity to recognize all
derivatives as either assets or liabilities in the statement of financial
condition and to measure those instruments at fair value. Additionally, the fair
value adjustments will affect either other comprehensive income in stockholders'
equity until the hedged item is recognized in earnings or net income depending
on whether the derivative instrument qualifies as a hedge for accounting
purposes and, if so, the nature of the hedging activity.
In the normal course of business, we may use a variety of derivative
financial instruments to manage, or hedge, interest rate risk. These derivative
financial instruments must be effective in reducing our interest rate risk
exposure in order to qualify for hedge accounting. When the terms of an
underlying transaction are modified, or when the underlying hedged item ceases
to exist, all changes in the fair value of the instrument are marked-to-market
with changes in value included in net income for each period until the
derivative instrument matures or is settled. Any derivative instrument used for
risk management that does not meet the hedging criteria is marked-to-market with
the changes in value included in net income.
Derivatives will be used for hedging purposes rather than speculation. We
will rely on quotations from a third parties to determine fair values. If our
hedging activities do not achieve our desired results, our reported earnings may
be adversely affected.
Reserve for Possible Credit Losses
The expense for possible credit losses in connection with debt investments
is the charge to earnings to increase the allowance for possible credit losses
to the level that management estimates to be adequate considering delinquencies,
loss experience and collateral quality. Other factors considered relate to
geographic trends and product diversification, the size of the portfolio and
current economic conditions. Based upon these factors, we will establish the
provision for possible credit losses by category of asset. When it is probable
that we will be unable to collect all amounts contractually due, the account is
considered impaired.
Where impairment is indicated, a valuation write-down or write-off is
measured based upon the excess of the recorded investment amount over the net
fair value of the collateral, as reduced by selling costs. Any deficiency
between the carrying amount of an asset and the net sales price of repossessed
collateral is charged to the allowance for credit losses.
Income Taxes
We intend to elect and qualify to be taxed as a REIT. Accordingly, we will
generally not be subject to corporate federal or state income tax to the extent
that we make qualifying distributions to our stockholders, and provided we
satisfy on a continuing basis, through actual investment and operating results,
the REIT requirements including certain asset, income, distribution and stock
ownership tests. If we fail to qualify as a REIT, and do not qualify for certain
statutory relief provisions, we will be subject to federal, state and local
income taxes and may be precluded from qualifying as a REIT for the subsequent
four taxable years following the year in which we lost our REIT qualification.
Accordingly, our failure to qualify as a REIT could have a material adverse
impact on our results of operations and amounts available for distribution to
our stockholders.
41
The dividends paid deduction of a REIT for qualifying dividends to its
stockholders is computed using our taxable income as opposed to net income
reported on the financial statements. Taxable income, generally, will differ
from net income reported on the financial statements because the determination
of taxable income is based on tax provisions and not financial accounting
principles.
We may elect to treat certain of our subsidiaries as TRSs. In general, a
TRS of ours may hold assets and engage in activities that we cannot hold or
engage in directly and generally may engage in any real estate or non-real
estate-related business. A TRS is subject to federal, state and local corporate
income taxes.
While our TRS will generate net income, our TRS can declare dividends to
us which will be included in our taxable income and necessitate a distribution
to our stockholders. Conversely, if we retain earnings at the TRS level, no
distribution is required and we can increase book equity of the consolidated
entity.
Recent Accounting Pronouncements
In September 2006, the Financial Accounting Standards Board, or FASB,
issued SFAS No. 157, Fair Value Measurements, or SFAS 157. SFAS 157 defines fair
value, establishes a framework for measuring fair value and requires enhanced
disclosures about fair value measurements. SFAS 157 requires companies to
disclose the fair value of their financial instruments according to a fair value
hierarchy (i.e., levels 1, 2, and 3, as defined). Additionally, companies are
required to provide enhanced disclosure regarding instruments in the level 3
category (which require significant management judgment), including a
reconciliation of the beginning and ending balances separately for each major
category of assets and liabilities. We do not believe that the adoption of SFAS
157 will have a significant impact on the manner in which we estimate fair
value, but expect that adoption will increase footnote disclosure to comply with
SFAS 157 disclosure requirements for financial statements issued after January
1, 2008.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for
Financial Assets and Financial Liabilities, or SFAS 159 Including an amendment
of FASB Statement No. 115. SFAS 159 permits entities to choose to measure many
financial instruments and certain other items at fair value. Unrealized gains
and losses on items for which the fair value option has been elected will be
recognized in earnings at each subsequent reporting date. SFAS 159 became
effective for the Company January 1, 2008. The Company did not elect the fair
value option for any existing eligible financial instruments.
In February 2008, FASB issued FASB Staff Position No. FAS 140-3 Accounting
for Transfers of Financial Assets and Repurchase Financing Transactions, or FSP
FAS 140-3. FSP FAS 140-3 addresses whether transactions where assets purchased
from a particular counterparty and financed through a repurchase agreement with
the same counterparty can be considered and accounted for as separate
transactions, or are required to be considered "linked" transactions and may be
considered derivatives under SFAS No. 133, Accounting for Derivative Instruments
and Hedging Activities, or SFAS 133. FSP FAS 140-3 requires purchases and
subsequent financing through repurchase agreements be considered linked
transactions unless all of the following conditions apply: (1) the initial
purchase and the use of repurchase agreements to finance the purchase are not
contractually contingent upon each other; (2) the repurchase financing entered
into between the parties provides full recourse to the transferee and the
repurchase price is fixed; (3) the financial assets is readily obtainable in the
market; and (4) the financial instrument and the repurchase agreement are not
coterminous. This FSP is effective for fiscal years beginning after November 15,
2008. We are currently evaluating FSP FAS 140-3 but does not expect its
application to have a significant impact on its financial reporting.
Financial Condition
All of our assets at December 31, 2007 were acquired with the net proceeds
of our initial public offering and concurrent private offering which were
consummated in November 2007, and our use of leverage. At December 31, 2007, our
portfolio consisted of $1.1 billion of RMBS and of approximately $162 million of
whole mortgage loans.
42
The following table summarizes certain characteristics of our portfolio at
December 31, 2007.
December 31,
2007
------------------------------------------------------------------ -------------
Leverage at period-end 0.5:1
Adjustable-rate mortgage-backed securities as % of portfolio 81.8%
Fixed-rate mortgage-backed securities as % of portfolio 5.7%
Adjustable-rate residential mortgage loans as % of portfolio 3.8%
Fixed-rate residential mortgage loans as % of portfolio 8.7%
Notional amount of interest rate swaps as % of portfolio 95.8%
Annualized yield on average earning assets during the period 7.02%
Annualized cost of funds on average repurchase balance during the
period 5.08%
Weighted average yield on assets at period-end 6.62%
Weighted average cost of funds at period-end 5.02%
Residential Mortgage-Backed Securities
The table below summarizes our RMBS investments at December 31, 2007:
Residential Mortgage-
Backed Securities
(dollars in thousands)
------------------------------- ------------------------
Amortized cost $1,114,137
Unrealized gains 10,675
Unrealized losses (522)
------------------------
Fair value $1,124,290
========================
As of December 31, 2007, the RMBS in our portfolio were purchased at a net
discount to their par value and our RMBS had a weighted average amortized cost
of 98.8.
The following table summarizes certain characteristics of our RMBS
portfolio at December 31, 2007. The estimated weighted average months to
maturity of the RMBS in the tables below are based upon our prepayment
expectations, which are based on both proprietary and subscription-based
financial models. Our prepayment projections consider current and expected
trends in interest rates, interest rate volatility, steepness of the yield
curve, the mortgage rate of the outstanding loan, time to reset and the spread
margin of the reset.
Weighted Averages
------------------------------------------
Estimated
Value Percent of
(dollars in Total Constant
thousands) RMBS Yield to Prepayment
(1) Portfolio Coupon Maturity Rate(2)
RMBS:
Non-Agency Prime $1,124,290 100.00% 6.32% 6.87% 10.13%
Investment grade - - - - -
Below investment
grade - - - - -
-------------- ---------- -------- ---------- -----------
Total RMBS $1,124,290 100.00% 6.32% 6.87% 10.13%
(1) All assets listed in this chart are carried at their fair value.
(2) Represents the estimated percentage of principal that will be prepaid over
the next 12 months based on historical principal paydowns.
43
The table below summarizes the credit ratings of our RMBS investments at
December 31, 2007:
Residential Mortgage-
Backed Securities
--------------------------
AAA 100.00%
AA -
A -
BBB -
BB -
B -
Not rated -
--------------------------
Total 100.00%
==========================
Actual maturities of RMBS are generally shorter than stated contractual
maturities, as they are affected by the contractual lives of the underlying
mortgages, periodic payments of principal, and prepayments of principal. The
stated contractual final maturity of the mortgage loans underlying our portfolio
of RMBS ranges up to 30 years, but the expected maturity is subject to change
based on the prepayments of the underlying loans. As of December 31, 2007, the
average final contractual maturity of the RMBS portfolio is 29 years.
The constant prepayment rate, or CPR, attempts to predict the percentage
of principal that will be prepaid over the next 12 months based on historical
principal paydowns. As interest rates rise, the rate of refinancings typically
declines, which we expect may result in lower rates of prepayment and, as a
result, a lower portfolio CPR. Conversely, as interest rates fall, the rate of
refinancings typically increases, which we expect may result in higher rates of
prepayment and, as a result, a higher portfolio CPR.
After the reset date, interest rates on our hybrid adjustable rate RMBS
securities adjust annually based on spreads over various LIBOR and Treasury
indices. These interest rates are subject to caps that limit the amount the
applicable interest rate can increase during any year, known as periodic cap,
and through the maturity of the applicable security, known as a lifetime cap.
The weighted average periodic cap for the portfolio is an increase of 1.86% the
weighted average maximum increases and decreases for the portfolio are 12.26%.
The following table summarizes our RMBS according to their estimated
weighted average life classifications as of December 31, 2007:
Weighted Average Life of Residential
------------------------------------
Mortgage-Backed Securities Portfolio
------------------------------------
Weighted Average Life of Residential Mortgage-Backed Securities
Portfolio
---------------------------------------------------------------
Fair Value
(dollars in thousands)
Less than one year $45,868
Greater than one year and less than
five years 1,078,422
Greater than or equal to five years -
-----------------------
Total $1,124,290
=======================
44
Whole Mortgage Loan Portfolio Characteristics
The following tables present certain characteristics of our whole mortgage
loan portfolio as of December 31, 2007.
Whole Mortgage Loan Portfolio Characteristics
---------------------------------------------------------------
(dollars in thousands)
---------------------------------------------------------------
Original loan balance $164,436
Unpaid principal balance $161,489
Weighted average coupon rate on loans 6.33%
Weighted average original term (years) 29.9
Weighted average remaining term (years) 29.5
Remaining Balance
Geographic Distribution (dollars in
Top 5 States thousands) % of Loan Portfolio Loan Count
----------------------- -------------------- ------------------- ---------------
California $36,593 22.66% 52
New Jersey $14,368 8.90% 25
New York $12,061 7.47% 18
Illinois $11,330 7.02% 15
Virginia $10,517 6.51% 20
-------------------- ------------------- ---------------
Total $84,869 52.56% 130
==================== =================== ===============
Remaining
Balance
(dollars in % of Loan % of Loan
Occupancy Status thousands) Portfolio Loan Count Loan Purpose Portfolio
---------------- ------------ ----------- --------------- -------------------------------------------
Owner occupied $148,685 92.07% 236 Purchase 70.96%
Second home $10,401 6.44% 17 Cash out refinance 14.76%
Investor $2,403 1.49% 5 Rate and term refinance 14.28%
------------ ----------- --------------- ---------------
Total $161,489 100.00% 258 Total 100.00%
============ =========== =============== ===============
% of Loan
Documentation Type Portfolio ARM Loan Type % of ARM Loans
----------------------------- ----------- -------------------------------------------
Full/alternative 86.43% Traditional ARM loans -
Stated income/no ratio 13.57% Hybrid ARM loans 100.00%
----------- ---------------
Total 100.00% Total 100.00%
=========== ===============
Dollars in % of Loan
Unpaid Principal Balance Thousands FICO Score Portfolio
------------------------- ---------- -------------------------------------------
$417,000 or less $3,177 740 and above 59.26%
$417,001 to $650,000 $84,386 700 to 739 25.10%
$650,001 to $1,000,000 $58,613 660 to 699 11.87%
$1,000,001 to $2,000,000 $15,313 620 to 659 3.13%
$2,000,001 to $3,000,000 - Below 620 0.64%
Over $3,000,001 - Total 100.00%
--------- ===============
Total $161,489
========== Weighted Average FICO Score 744
45
Original Loan to Value Dollars in % of Loan
Ratio Thousands Property Type Portfolio
------------------------- ---------- ----------------------------------------------------------
80.01% and above $16,990 Single-family detached 61.29%
70.01% to 80.00% $104,248 Planned urban development-detached 29.28%
60.01% to 70.00% $21,553 Condominium 5.80%
60.00% or less $18,698 Other residential 3.63%
---------- ---------------
Total $161,489 Total 100.00%
========== ===============
Weighted Average Original
Loan to Value Ratio 74.59%
Periodic Cap on Hybrid ARM Loans % of ARM Loans
----------------------------------- ------------------
3.00% or less 100.00%
3.01% to 4.00% -
4.01% to 5.00% -
------------------
Total 100.00%
==================
We purchase our whole mortgage loans on a servicing retained basis. As a
result, we do not service any loans, or receive any servicing income.
Results of Operations for the Year Ended December 31, 2007
We commenced operations on November 21, 2007, and therefore do not have
any comparable results for prior periods.
46
Net Loss Summary
Our net loss for the period commencing November 21, 2007 and ending
December 31, 2007 was $2.9 million, or $0.08 per average share. Our income for
this period consisted of interest income. The table below presents the net loss
summary for the period ended December 31, 2007:
Net Loss Summary
(dollars in thousands, except for per share data)
-------------------------------------------------
For the Period November 21, 2007
through December 31, 2007
----------------------------------------- -----------------------------------
Interest income $3,492
Interest expense 415
-----------------------------------
Net interest income 3,077
-----------------------------------
Unrealized losses on interest rate swaps (4,156)
-----------------------------------
Net investment income (expense) (1,079)
-----------------------------------
Expenses
Management fee 1,217
General and administrative expenses 605
-----------------------------------
Total expenses 1,822
Loss before income tax (2,901)
Income tax 5
-----------------------------------
Net loss ($2,906)
===================================
Net loss per share - basic and diluted ($0.08)
===================================
Weighted average number of shares
outstanding - basic and diluted 37,401,737
-----------------------------------
Comprehensive Income:
Net loss ($2,906)
-----------------------------------
Prepayment Risk
Other comprehensive income:
Unrealized gain on available-for-sale
securities 10,153
-----------------------------------
Comprehensive income $7,247
===================================
Interest Income and Average Earning Asset Yield
We had average earning assets of $399.7 million for the period commencing
November 21, 2007 and ending December 31, 2007. Our interest income was $3.5
million for the period commencing November 21, 2007 and ending December 31,
2007. The yield on our portfolio was 7.02% for the period.
Interest Expense and the Cost of Funds
We had average borrowed funds of $270.6 million and total interest expense
of $415,000 for the period commencing November 21, 2007 and ending December 31,
2007. Our average cost of funds was 5.08% for the period commencing November 21,
2007 and ending December 31, 2007.
47
The table below shows our average borrowed funds and average cost of funds
as compared to average one-month and average six-month LIBOR for the years ended
December 31, 2007.
Average Cost of Funds
---------------------
(Ratios for the period commencing November 21, 2007
and ending December 31, 2007 have been annualized, dollars in thousands)
Average
One-Month Average Average
LIBOR Cost of Cost of
Relative Funds Funds
Average to Relative Relative to
Average Average Six- Average to Average Average
Borrowed Interest Average Cost One-Month Month Six-Month One-Month Six-Month
Funds Expense of Funds LIBOR LIBOR LIBOR LIBOR LIBOR
------------- -------------- ------------- ---------- -------- ---------- ----------- -------------
For the Period Commencing
November 21, 2007 and Ending
December 31, 2007 $270,584 $415 5.08% 4.98% 4.84% 0.14% 0.10% 0.24%
Net Interest Income
Our net interest income, which equals interest income less interest
expense, totaled $3.1 million for the period commencing November 21, 2007 and
ending December 31, 2007. Our net interest spread, which equals the yield on our
average assets for the period less the average cost of funds for the period, was
1.94 % for the period commencing November 21, 2007 and ending December 31, 2007.
The table below shows our average assets held, total interest income,
yield on average interest earning assets, average balance of repurchase
agreements, interest expense, average cost of funds, net interest income, and
net interest rate spread for the period commencing November 21, 2007 and ending
December 31, 2007.
Net Interest Income
-------------------
(Ratios for the period commencing November 21, 2007
and ending December 31, 2007 have been annualized, dollars in thousands)
Yield on
Average
Interest Average Balance Average
Average Earning Total Interest Earning of Repurchase Interest Cost of Net Interest Net Interest
Assets Held Income Assets Agreements Expense Funds Income Rate Spread
--------------- -------------- -------------- --------------- ---------- --------- -------------- -------------
For the Period
Commencing November 21,
2007 and Ending
December 31, 2007 $399,736 $3,492 7.02% $270,584 $415 5.08% $3,077 1.94%
Gains and Losses on Sales of Assets and Interest Rate Swaps
We did not sell any assets or realize any gain or loss on interest rate
swaps during 2007.
Management Fee and General and Administrative Expenses
We paid FIDAC a base management fee of $1.2 million for the period
commencing November 21, 2007 and ending December 31, 2007. We did not pay an
incentive fee for this period.
General and administrative (or G&A) expenses were $605,218 for the period
commencing November 21, 2007 and ending December 31, 2007.
Total expenses as a percentage of average total assets were 1.55% for the
period commencing November 21, 2007 and ending December 31, 2007.
48
Currently, our Manager has waived its right to require us to pay our pro
rata portion of rent, telephone, utilities, office furniture, equipment,
machinery and other office, internal and overhead expenses of our Manager and
its affiliates required for our operations.
The table below shows our total management fee and G&A expenses as
compared to average total assets and average equity for the period commencing
November 21, 2007 and ending December 31, 2007.
Management Fee and G&A Expenses and Operating Expense Ratios
------------------------------------------------------------
(ratios for the quarters have been annualized, dollars in thousands)
Total Management Total Management Fee
Total Management Fee and G&A and G&A
Fee and G&A Expenses/Average Expenses/Average
Expenses Total Assets Equity
----------------- ------------------ --------------------
For the Period Commencing
November 21, 2007 and Ending
December 31, 2007 $1,822 1.55% 3.05%
Net Loss and Return on Average Equity
Our net loss was $2.9 million for the period commencing November 21, 2007
and ending December 31, 2007. The table below shows our net interest income,
gain (loss) on sale of RMBS and whole mortgage loans and termination of interest
rate swaps, unrealized gains (loss) on interest rate swaps, total expenses,
income tax, each as a percentage of average equity, and the return on average
equity for the period commencing November 21, 2007 and ending December 31, 2007.
Components of Return on Average Equity
--------------------------------------
(Ratios for the period commencing November 21, 2007 and ending December 31, 2007
have been annualized)
Gain/(Loss) on Unrealized
Sale of Asset Gain/(Loss)
and Interest on Interest Return
Net Interest Rate Rate Total Income on
Income/Average Swaps/Average Swaps/Average Expenses/Average Tax/Average Average
Equity Equity Equity Equity Equity Equity
--------------- -------------- -------------- ----------------- ------------ --------
For the Period Commencing November
21, 2007 and Ending
December 31, 2007 5.16% - (6.97%) (3.05%) (0.01%) (4.87%)
Liquidity and Capital Resources
We held cash and cash equivalents of approximately $6.0 million at
December 31, 2007.
Our operating activities used net cash of approximately $0.58 million for
the period commencing November 21, 2007 and ending December 31, 2007.
Our investing activities used net cash of $795.6 million for the period
commencing November 21, 2007 and ending December 31, 2007 primarily from the
purchase of RMBS and reverse repurchase agreements.
Our financing activities as of December 31, 2007 consisted of our initial
public offering and concurrent private offering, from which we received net
proceeds of $533.6 million, and proceeds from repurchase agreements totaling
approximately $270.6 million which we used to finance the acquisition of RMBS.
We expect to continue to borrow funds in the form of repurchase agreements as
well as other types of financing. As of December 31, 2007 we had established
seven borrowing arrangements with various investment banking firms, one of which
was in use on December 31, 2007. Increases in short-term interest rates could
negatively affect the valuation of our mortgage-related assets, which could
limit our borrowing ability or cause our lenders to initiate margin calls.
Amounts due upon maturity of our repurchase agreements will be funded primarily
through the rollover/reissuance of repurchase agreements and monthly principal
and interest payments received on our mortgage-backed securities.
49
For our short-term (one year or less) and long-term liquidity, which
include investing and compliance with collateralization requirements under our
repurchase agreements (if the pledged collateral decreases in value or in the
event of margin calls created by prepayments of the pledged collateral), we also
rely on the cash flow from investments, primarily monthly principal and interest
payments to be received on our RMBS and whole mortgage loans, cash flow from the
sale of securities as well as any primary securities offerings authorized by our
board of directors.
Based on our current portfolio, leverage rate and available borrowing
arrangements, we believe our assets will be sufficient to enable us to meet
anticipated short-term (one year or less) liquidity requirements such as to fund
our investment activities, pay fees under our management agreement, fund our
distributions to stockholders and pay general corporate expenses. However, an
increase in prepayment rates substantially above our expectations could cause a
temporary liquidity shortfall due to the timing of the necessary margin calls on
the financing arrangements and the actual receipt of the cash related to
principal paydowns. If our cash resources are at any time insufficient to
satisfy our liquidity requirements, we may have to sell debt or additional
equity securities in a common stock offering. If required, the sale of RMBS or
whole mortgage loans at prices lower than their carrying value would result in
losses and reduced income.
Our ability to meet our long-term (greater than one year) liquidity and
capital resource requirements will be subject to obtaining additional debt
financing and equity capital. Subject to our maintaining our qualification as a
REIT, we expect to use a number of sources to finance our investments, including
repurchase agreements, warehouse facilities, securitization, commercial paper
and term financing CDOs. Such financing will depend on market conditions for
capital raises and for the investment of any proceeds. If we are unable to
renew, replace or expand our sources of financing on substantially similar
terms, it may have an adverse effect on our business and results of operations.
Upon liquidation, holders of our debt securities and shares of preferred stock
and lenders with respect to other borrowings will receive a distribution of our
available assets prior to the holders of our common stock.
We are not required to maintain any specific debt-to-equity ratio as we
believe the appropriate leverage for the particular assets we are financing
depends on the credit quality and risk of those assets. At December 31, 2007,
our total debt was approximately $270.6 million which represented a
debt-to-equity ratio of approximately 0.5:1.
Stockholders' Equity
During the period ended December 31, 2007, we declared dividends to common
shareholders totaling $942,639 or $0.025 per share, all of which was paid on
January 25, 2008.
Contractual Obligations and Commitments
On November 15, 2007 we entered into a management agreement with FIDAC,
pursuant to which FIDAC is entitled to receive a base management fee, incentive
compensation and, in certain circumstances, a termination fee and reimbursement
of certain expenses as described in the management agreement. Such fees and
expenses do not have fixed and determinable payments. The base management fee is
payable quarterly in arrears in an amount equal to 1.75% per annum, calculated
quarterly, of our stockholders' equity (as defined in the management agreement).
Our Manager uses the proceeds from its management fee in part to pay
compensation to its officers and employees who, notwithstanding that certain of
them also are our officers, receive no cash compensation directly from us. The
base management fee will be reduced, but not below zero, by our proportionate
share of any CDO base management fees FIDAC receives in connection with the CDOs
in which we invest, based on the percentage of equity we hold in such CDOs. Our
Manager will receive quarterly incentive compensation in an amount equal to 20%
of the dollar amount by which Core Earnings, on a rolling four-quarter basis and
before the incentive management fee, exceeds the product of (1) the weighted
average of the issue price per share of all of our public offerings multiplied
by the weighted average number of shares of common stock outstanding in such
quarter and (2) 0.50% plus one-fourth of the average of the one month LIBOR rate
for such quarter and the previous three quarters. For the initial four quarters
following this offering, Core Earnings and the LIBOR rate will be calculated on
the basis of each of the previously completed quarters on an annualized basis.
Core Earnings and LIBOR rate for the initial quarter will each be calculated
from the settlement date of our initial public offering on an annualized basis.
Core Earnings is a non-GAAP measure and is defined as GAAP net income (loss)
excluding non-cash equity compensation expense, excluding any unrealized gains,
losses or other items that do not affect realized net income (regardless of
whether such items are included in other comprehensive income or loss, or in net
income). The amount will be adjusted to exclude one-time events pursuant to
changes in GAAP and certain non-cash charges after discussions between our
Manager and our independent directors and approval by a majority of our
independent directors. The incentive management fee will be reduced, but not
below zero, by our proportionate share of any CDO incentive management fees
FIDAC receives in connection with the CDOs in which we invest, based on the
percentage of equity we hold in such CDOs. We expect to enter into certain
contracts that contain a variety of indemnification obligations, principally
with our Manager, brokers and counterparties to repurchase agreements. The
maximum potential future payment amount we could be required to pay under these
indemnification obligations is unlimited.
50
The following table summarizes our contractual obligations at December 31,
2007.
(dollars in thousands)
----------------------------------------------------------------
Greater
One to Three to Than or
Within One Three Five Equal to
Contractual Obligations Year Years Years Five Years Total
-------------------------- ------------- ----------- ---------- ----------- ---------------
Repurchase agreements $270,584 - - - $270,584
Interest expense on
repurchase agreements(1) 1,206 - - - 1,206
------------- ----------- ---------- ----------- ---------------
Total $271,790 - - - $271,790
============= =========== ========== =========== ===============
(1) Interest is based on rates in effect as of December 31, 2007.
The repurchase agreements for our repurchase facilities generally do not
include substantive provisions other than those contained in the standard master
repurchase agreement as published by the Bond Market Association. Repurchase
agreements for whole mortgage loans that we entered into subsequent to December
31, 2007 contain negative covenants requiring us to maintain certain levels of
net asset value, tangible net worth and available funds and comply with interest
coverage ratios, leverage ratios and distribution limitations.
Off-Balance Sheet Arrangements
We do not have any relationships with unconsolidated entities or financial
partnerships, such as entities often referred to as structured finance or
special purpose entities, which would have been established for the purpose of
facilitating off-balance sheet arrangements or other contractually narrow or
limited purposes. Further, we have not guaranteed any obligations of
unconsolidated entities nor do we have any commitment or intent to provide
funding to any such entities. As such, we are not materially exposed to any
market, credit, liquidity or financing risk that could arise if we had engaged
in such relationships.
Dividends
To qualify as a REIT, we must pay annual dividends to our stockholders of
at least 90% of our taxable income, determined without regard to the deduction
for dividends paid and excluding any net capital gains. We intend to pay regular
quarterly dividends to our stockholders. Before we pay any dividend, whether for
U.S. federal income tax purposes or otherwise, which would only be paid out of
available cash to the extent permitted under our warehouse and repurchase
facilities and commercial paper, we must first meet both our operating
requirements and scheduled debt service on our warehouse lines and other debt
payable.
Inflation
Virtually all of our assets and liabilities are interest rate sensitive in
nature. As a result, interest rates and other factors influence our performance
far more so than does inflation. Changes in interest rates do not necessarily
correlate with inflation rates or changes in inflation rates. Our financial
statements are prepared in accordance with GAAP and our distributions will be
determined by our board of directors consistent with our obligation to
distribute to our stockholders at least 90% of our REIT taxable income on an
annual basis in order to maintain our REIT qualification; in each case, our
activities and balance sheet are measured with reference to historical cost
and/or fair market value without considering inflation.
51
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The primary components of our market risk are related to credit risk,
interest rate risk, prepayment risk, market value risk and real estate risk.
While we do not seek to avoid risk completely, we believe the risk can be
quantified from historical experience and we seek to actively manage that risk,
to earn sufficient compensation to justify taking those risks and to maintain
capital levels consistent with the risks we undertake.
Credit Risk
We are subject to credit risk in connection with our investments and face
more credit risk on assets we own which are rated below "AAA". The credit risk
related to these investments pertains to the ability and willingness of the
borrowers to pay, which is assessed before credit is granted or renewed and
periodically reviewed throughout the loan or security term. We believe that
residual loan credit quality is primarily determined by the borrowers' credit
profiles and loan characteristics. Our Manager will use a comprehensive credit
review process. Our Manager's analysis of loans includes borrower profiles, as
well as valuation and appraisal data. Our Manager uses compensating factors such
as liquid assets, low loan to value ratios and job stability in evaluating
loans. Our Manager's resources include a proprietary portfolio management
system, as well as third party software systems. Our Manager will utilize a
third party due diligence firm to perform an independent underwriting review to
insure compliance with existing guidelines. Our Manager will select loans for
review predicated on risk-based criteria such as loan-to-value, borrower's
credit score(s) and loan size. Our Manager will also outsource underwriting
services to review higher risk loans, either due to borrower credit profiles or
collateral valuation issues. In addition to statistical sampling techniques, our
Manager will create adverse credit and valuation samples, which we individually
review. Our Manager will reject loans that fail to conform to our standards. Our
Manager will accept only those loans which meet our underwriting criteria. Once
we own a loan, our Manager's surveillance process includes ongoing analysis
through our proprietary data warehouse and servicer files. Additionally, the
non-Agency RMBS and other ABS which we will acquire for our portfolio will be
reviewed by our Manager to ensure that they satisfy our risk based criteria. Our
Manager's review of non-Agency RMBS and other ABS will include utilizing its
proprietary portfolio management system. Our Manager's review of non-Agency RMBS
and other ABS will be based on quantitative and qualitative analysis of the
risk-adjusted returns on non-Agency RMBS and other ABS present.
Interest Rate 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 our control. We are subject to
interest rate risk in connection with our investments and our related debt
obligations, which are generally repurchase agreements, warehouse facilities,
securitization, commercial paper and term financing CDOs. Our repurchase
agreements and warehouse facilities may be of limited duration that are
periodically refinanced at current market rates. We intend to mitigate this risk
through utilization of derivative contracts, primarily interest rate swap
agreements.
Interest Rate Effect on Net Interest Income
Our operating results depend, in large part, on differences between the
income from our investments and our borrowing costs. Most of our warehouse
facilities and repurchase agreements provide financing based on a floating rate
of interest calculated on a fixed spread over LIBOR. The fixed spread varies
depending on the type of underlying asset which collateralizes the financing.
Accordingly, the portion of our portfolio which consists of floating interest
rate assets will be match-funded utilizing our expected sources of short-term
financing, while our fixed interest rate assets will not be match-funded. During
periods of rising interest rates, the borrowing costs associated with our
investments tend to increase while the income earned on our fixed interest rate
investments may remain substantially unchanged. This will result in a narrowing
of the net interest spread between the related assets and borrowings and may
even result in losses. Further, during this portion of the interest rate and
credit cycles, defaults could increase and result in credit losses to us, which
could adversely affect our liquidity and operating results. Such delinquencies
or defaults could also have an adverse effect on the spread between
interest-earning assets and interest-bearing liabilities. Hedging techniques are
partly based on assumed levels of prepayments of our fixed-rate and hybrid
adjustable-rate mortgage loans and RMBS. If prepayments are slower or faster
than assumed, the life of the mortgage loans and RMBS will be longer or shorter,
which would reduce the effectiveness of any hedging strategies we may use and
may cause losses on such transactions. Hedging strategies involving the use of
derivative securities are highly complex and may produce volatile returns.
52
Interest Rate Effects on Fair Value
Another component of interest rate risk is the effect changes in interest
rates will have on the fair value of the assets we acquire. We face the risk
that the fair value of our assets will increase or decrease at different rates
than that of our liabilities, including our hedging instruments. We primarily
assess our interest rate risk by estimating the duration of our assets and the
duration of our liabilities. Duration essentially measures the market price
volatility of financial instruments as interest rates change. We generally
calculate duration using various financial models and empirical data. Different
models and methodologies can produce different duration numbers for the same
securities.
It is important to note that the impact of changing interest rates on fair
value can change significantly when interest rates change beyond 100 basis
points from current levels. Therefore, the volatility in the fair value of our
assets could increase significantly when interest rates change beyond 100 basis
points. In addition, other factors impact the fair value of our interest
rate-sensitive investments and hedging instruments, such as the shape of the
yield curve, market expectations as to future interest rate changes and other
market conditions. Accordingly, in the event of changes in actual interest
rates, the change in the fair value of our assets would likely differ from that
shown above, and such difference might be material and adverse to our
stockholders.
Interest Rate Cap Risk
We also invest in adjustable-rate mortgage loans and RMBS. These are
mortgages or RMBS in which the underlying mortgages are typically subject to
periodic and lifetime interest rate caps and floors, which limit the amount by
which the security's interest yield may change during any given period. However,
our borrowing costs pursuant to our financing agreements will not be subject to
similar restrictions. Therefore, in a period of increasing interest rates,
interest rate costs on our borrowings could increase without limitation by caps,
while the interest-rate yields on our adjustable-rate mortgage loans and RMBS
would effectively be limited. This problem will be magnified to the extent we
acquire adjustable-rate RMBS that are not based on mortgages which are fully
indexed. In addition, the mortgages or the underlying mortgages in an RMBS may
be subject to periodic payment caps that result in some portion of the interest
being deferred and added to the principal outstanding. This could result in our
receipt of less cash income on our adjustable-rate mortgages or RMBS than we
need in order to pay the interest cost on our related borrowings. These factors
could lower our net interest income or cause a net loss during periods of rising
interest rates, which would harm our financial condition, cash flows and results
of operations.
Interest Rate Mismatch Risk
We intend to fund a substantial portion of our acquisitions of hybrid
adjustable-rate mortgages and RMBS with borrowings that, after the effect of
hedging, have interest rates based on indices and repricing terms similar to,
but of somewhat shorter maturities than, the interest rate indices and repricing
terms of the mortgages and RMBS. Thus, we anticipate that in most cases the
interest rate indices and repricing terms of our mortgage assets and our funding
sources will not be identical, thereby creating an interest rate mismatch
between assets and liabilities. Therefore, our cost of funds would likely rise
or fall more quickly than would our earnings rate on assets. During periods of
changing interest rates, such interest rate mismatches could negatively impact
our financial condition, cash flows and results of operations. To mitigate
interest rate mismatches, we may utilize the hedging strategies discussed above.
Our analysis of risks is based on our Manager's experience, estimates, models
and assumptions. These analyses rely on models which utilize estimates of fair
value and interest rate sensitivity. Actual economic conditions or
implementation of investment decisions by our management may produce results
that differ significantly from the estimates and assumptions used in our models
and the projected results shown in this Form 10-K.
Our profitability and the value of our portfolio (including interest rate
swaps) may be adversely affected during any period as a result of changing
interest rates. The following table quantifies the potential changes in net
interest income, portfolio value should interest rates go up or down 25, 50, and
75 basis points, assuming the yield curves of the rate shocks will be parallel
to each other and the current yield curve. All changes in income and value are
measured as percentage changes from the projected net interest income and
portfolio value at the base interest rate scenario. The base interest rate
scenario assumes interest rates at December 31, 2007 and various estimates
regarding prepayment and all activities are made at each level of rate shock.
Actual results could differ significantly from these estimates.
53
Projected Percentage Projected Percentage
Change in Interest Rate Change in Change in
Net Interest Income Portfolio Value
--------------------------------------------------------------------------------
-75 Basis Points (9.23%) 0.72%
-50 Basis Points (6.26%) 0.14%
-25 Basis Points (3.06%) (0.44%)
Base Interest Rate - -
+25 Basis Points 3.54% (1.60%)
+50 Basis Points 7.15% (2.18%)
+75 Basis Points 10.76% (2.76%)
Prepayment Risk
As we receive prepayments of principal on these investments, premiums paid
on such investments will be amortized against interest income. In general, an
increase in prepayment rates will accelerate the amortization of purchase
premiums, thereby reducing the interest income earned on the investments.
Conversely, discounts on such investments are accreted into interest income. In
general, an increase in prepayment rates will accelerate the accretion of
purchase discounts, thereby increasing the interest income earned on the
investments.
Extension Risk
Our Manager will compute the projected weighted-average life of our
investments based on assumptions regarding the rate at which the borrowers will
prepay the underlying mortgages. In general, when a fixed-rate or hybrid
adjustable-rate mortgage loans or RMBS are acquired with borrowings, we may, but
are not required to, enter into an interest rate swap agreement or other hedging
instrument that effectively fixes our borrowing costs for a period close to the
anticipated average life of the fixed-rate portion of the related assets. This
strategy is designed to protect us from rising interest rates because the
borrowing costs are fixed for the duration of the fixed-rate portion of the
related residential mortgage-backed security. However, if prepayment rates
decrease in a rising interest rate environment, the life of the fixed-rate
portion of the related assets could extend beyond the term of the swap agreement
or other hedging instrument. This could have a negative impact on our results
from operations, as borrowing costs would no longer be fixed after the end of
the hedging instrument while the income earned on the hybrid adjustable-rate
assets would remain fixed. This situation may also cause the market value of our
hybrid adjustable-rate assets to decline, with little or no offsetting gain from
the related hedging transactions. In extreme situations, we may be forced to
sell assets to maintain adequate liquidity, which could cause us to incur
losses.
Market Risk
Market Value Risk
Our available-for-sale securities will be reflected at their estimated
fair value with unrealized gains and losses excluded from earnings and reported
in other comprehensive income pursuant to SFAS No. 115, Accounting for Certain
Investments in Debt and Equity Securities. The estimated fair value of these
securities fluctuates primarily due to changes in interest rates and other
factors. Generally, in a rising interest rate environment, the estimated fair
value of these securities would be expected to decrease; conversely, in a
decreasing interest rate environment, the estimated fair value of these
securities would be expected to increase. As market volatility increases or
liquidity decreases, the fair value of our investments may be adversely
impacted. If we are unable to readily obtain independent pricing to validate our
estimated fair value of securities in the portfolio, the fair value gains or
losses recorded in other comprehensive income may be adversely affected.
Real Estate Risk
We own assets secured by real property and may own real property directly
in the future. Residential property values are subject to volatility and may be
affected adversely by a number of factors, including, but not limited to,
national, regional and local economic conditions (which may be adversely
affected by industry slowdowns and other factors); local real estate conditions
(such as an oversupply of housing); changes or continued weakness in specific
industry segments; construction quality, age and design; demographic factors;
and retroactive changes to building or similar codes. In addition, decreases in
property values reduce the value of the collateral and the potential proceeds
available to a borrower to repay our loans, which could also cause us to suffer
losses.
54
Risk Management
To the extent consistent with maintaining our REIT status, we will seek to
manage risk exposure to protect our portfolio of residential mortgage loans,
RMBS, and other assets and related debt against the effects of major
interest rate changes. We generally seek to manage our risk by:
o monitoring and adjusting, if necessary, the reset index and interest rate
related to our RMBS and our financings;
o attempting to structure our financings agreements to have a range of
different maturities, terms, amortizations and interest rate adjustment
periods;
o using derivatives, financial futures, swaps, options, caps, floors and
forward sales to adjust the interest rate sensitivity of our MBS and our
borrowings;
o using securitization financing to lower average cost of funds relative to
short-term financing vehicles further allowing us to receive the benefit of
attractive terms for an extended period of time in contrast to short term
financing and maturity dates of the investments included in the
securitization; and
o actively managing, on an aggregate basis, the interest rate indices,
interest rate adjustment periods, and gross reset margins of our MBS and
the interest rate indices and adjustment periods of our financings.
Our efforts to manage our assets and liabilities are concerned with the
timing and magnitude of the repricing of assets and liabilities. We attempt to
control risks associated with interest rate movements. Methods for evaluating
interest rate risk include an analysis of our interest rate sensitivity "gap",
which is the difference between interest-earning assets and interest-bearing
liabilities maturing or repricing within a given time period. A gap is
considered positive when the amount of interest-rate sensitive assets exceeds
the amount of interest-rate sensitive liabilities. A gap is considered negative
when the amount of interest-rate sensitive liabilities exceeds interest-rate
sensitive assets. During a period of rising interest rates, a negative gap would
tend to adversely affect net interest income, while a positive gap would tend to
result in an increase in net interest income. During a period of falling
interest rates, a negative gap would tend to result in an increase in net
interest income, while a positive gap would tend to affect net interest income
adversely. Because different types of assets and liabilities with the same or
similar maturities may react differently to changes in overall market rates or
conditions, changes in interest rates may affect net interest income positively
or negatively even if an institution were perfectly matched in each maturity
category.
The following table sets forth the estimated maturity or repricing of our
interest-earning assets and interest-bearing liabilities at December 31, 2007.
The amounts of assets and liabilities shown within a particular period were
determined in accordance with the contractual terms of the assets and
liabilities, except adjustable-rate loans, and securities are included in the
period in which their interest rates are first scheduled to adjust and not in
the period in which they mature and does include the effect of the interest rate
swaps. The interest rate sensitivity of our assets and liabilities in the table
could vary substantially if based on actual prepayment experience.
55
Within 3 1 Year to 3 Greater than
Months 3-12 Months Years 3 Years Total
----------------------------------------------- ------------ ------------ ------------ --------------
(dollars in thousands)
Rate Sensitive Assets:
Whole Mortgage Loans $- $- $- $161,489 $161,489
RMBS - - 169,929 958,293 $1,128,222
Rate Sensitive Liabilities:
Repurchase Agreements, with the
effect of swaps (896,296) 256,869 693,211 216,800 $270,584
------------ ------------ ------------ ------------ --------------
Interest rate sensitivity gap $896,296 ($256,869) ($523,282) $902,982 $1,019,127
============ ============ ============ ============ ==============
Cumulative rate sensitivity gap $896,296 $639,427 $116,145 $1,019,127
============ ============ ============ ============
Cumulative interest rate
sensitivity gap as
a percentage of total rate-
sensitive
assets 69% 50% 9% 79%
============ ============ ============ ============
Our analysis of risks is based on our manager's experience, estimates,
models and assumptions. These analyses rely on models which utilize estimates of
fair value and interest rate sensitivity. Actual economic conditions or
implementation of investment decisions by our manager may produce results that
differ significantly from the estimates and assumptions used in our models and
the projected results shown in the above tables and in this report. These
analyses contain certain forward-looking statements and are subject to the safe
harbor statement set forth under the heading, "Special Note Regarding
Forward-Looking Statements."
Item 8. Financial Statements and Supplementary Data
Our financial statements and the related notes, together with the Report
of Independent Registered Public Accounting Firm thereon, are set forth on pages
F-1 through F-13 of this Form 10-K.
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure
None.
Item 9A. Controls and Procedures
Our management, including our Chief Executive Officer, or CEO and Chief
Financial Officer, or CFO, reviewed and evaluated the effectiveness of the
design and operation of our disclosure controls and procedures (as defined in
Rule 13a-15(e) and 15d-15(e) of the Securities Exchange Act) as of the end of
the period covered by this annual report. Based on that review and evaluation,
the CEO and CFO have concluded that our current disclosure controls and
procedures, as designed and implemented, (1) were effective in ensuring that
information regarding the Company and its subsidiaries is made known to our
management, including our CEO and CFO, as appropriate to allow timely decisions
regarding required disclosure and (2) were effective in providing reasonable
assurance that information the Company must disclose in its periodic reports
under the Securities Exchange Act is recorded, processed, summarized and
reported within the time periods prescribed by the SEC's rules and forms.
Management's Annual Report on Internal Control over Financial Reporting
This Annual Report on Form 10-K does not include a report of management's
assessment regarding internal control over financial reporting due to a
transition period established by rules of the Securities and Exchange Commission
for newly public companies.
56
Attestation Report of Registered Public Accounting Firm
This Annual Report on Form 10-K does not include an attestation report of
the company's registered public accounting firm due to a transition period
established by rules of the Securities and Exchange Commission for newly public
companies.
Changes in Internal Controls
There have been no changes in our "internal control over financial
reporting" (as defined in rule 13a-15(f) of the Exchange Act) that occurred
during the period commencing November 21, 2007 and ending December 31, 2007 that
have materially affected, or are reasonably likely to materially affect, our
internal control over financial reporting.
Item 9A(T). Controls and Procedures.
Not applicable.
Item 9B. Other Information
None.
Item 10. Directors, Executive Officers and Corporate Governance
The information required by Item 10 as to our directors is incorporated
herein by reference to the proxy statement to be filed with the SEC within 120
days after December 31, 2007. The information regarding our executive officers
required by Item 10 appears in Part I of the Form 10-K. The information required
by Item 10 as to our compliance with Section 16 (a) of the Securities Exchange
Act of 1934 is incorporated by reference to the proxy statement to be filed with
the SEC within 120 days after December 31, 2007.
We have adopted a Code of Business Conduct and Ethics within the meaning
of Item 406(b) of Regulation S-K. This Code of Business Conduct and Ethics
applies to our principal executive officer, principal financial officer and
principal accounting officer. This Code of Business Conduct and Ethics is
publicly available on our website at www.chimerareit.com. If we make substantive
amendments to this Code of Business Conduct and Ethics or grant any waiver,
including any implicit waiver, we intend to disclose these events on our
website.
Item 11. Executive Compensation
The information required by Item 11 is incorporated herein by reference to
the proxy statement to be filed with the SEC within 120 days after December 31,
2007.
Item 12. Security Ownership of Certain Beneficial Owners and Management and
Related Stockholder Matters
The information required by Item 12 is incorporated herein by reference to
the proxy statement to be filed with the SEC within 120 days after December 31,
2007.
Item 13. Certain Relationships and Related Transactions, and Director
Independence
The information required by Item 13 is incorporated herein by reference to
the proxy statement to be filed with the SEC within 120 days after December 31,
2007.
Item 14. Principal Accountant Fees and Services
The information required by Item 14 is incorporated herein by reference to
the proxy statement to be filed with the SEC within 120 days after December 31,
2007.
Item 15. Exhibits, Financial Statement Schedules
57
(a) Documents filed as part of this report:
1. Financial Statements.
2. Schedules to Financial Statements.
All financial statement schedules have been omitted because they are
either inapplicable or the information required is provided in our Financial
Statements and Notes thereto, included in Part II, Item 8, of this Annual Report
on Form 10-K.
3. Exhibits:
EXHIBIT INDEX
Exhibit Description
Number
3.1 Articles of Amendment and Restatement of Chimera Investment
Corporation (filed as Exhibit 3.1 to the Company's
Registration Statement on Amendment No. 1 to Form S-11 (File
No. 333-145525) filed on September 27, 2007 and incorporated
herein by reference)
3.2 Amended and Restated Bylaws of Chimera Investment Corporation
(filed as Exhibit 3.2 to the Company's Registration Statement
on Amendment No. 2 to Form S-11 (File No. 333-145525) filed on
November 5, 2007 and incorporated herein by reference)
4.1 Specimen Common Stock Certificate of Chimera Investment
Corporation (filed as Exhibit 4.1 to the Company's
Registration Statement on Amendment No. 1 to Form S-11 (File
No. 333-145525) filed on September 27, 2007 and incorporated
herein by reference)
10.1 Form of Management Agreement between Chimera Investment
Corporation and Fixed Income Discount Advisory Company (filed
as Exhibit 10.1 to the Company's Registration Statement on
Amendment No. 1 to Form S-11 (File No. 333-145525) filed on
September 27, 2007 and incorporated herein by reference)
10.2+ Form of Equity Incentive Plan (filed as Exhibit 10.2 to the
Company's Registration Statement on Amendment No. 1 to Form
S-11 (File No. 333-145525) filed on September 27, 2007 and
incorporated herein by reference)
10.3+ Form of Restricted Common Stock Award (filed as Exhibit 10.3
to the Company's Registration Statement on Amendment No. 1 to
Form S-11 (File No. 333-145525) filed on September 27, 2007
and incorporated herein by reference)
10.4+ Form of Stock Option Grant (filed as Exhibit 10.4 to the
Company's Registration Statement on Amendment No. 1 to Form
S-11 (File No. 333-145525) filed on September 27, 2007 and
incorporated herein by reference)
10.5 Form of Master Securities Repurchase Agreement (filed as
Exhibit 10.5 to the Company's Registration Statement on
Amendment No. 3 to Form S-11 (File No. 333-145525) filed on
November 13, 2007 and incorporated herein by reference)
23.1 Master Repurchase Agreement, dated as of January 18, 2008, between
Credit Suisse First Boston Mortgage Capital LLC and Chimera Investment
Corporation (filed as Exhibit 10.1 to the Company's Current Report on
Form 8-K filed on January 24, 2008 and incorporated herein by
reference)
23.2 Master Repurchase Agreement, dated as of January 31, 2008,
among DB Structured Products, Inc., Deutsche Bank Securities
Inc., and Chimera Investment Corp. (filed as Exhibit 10.1 to
the Company's Current Report on Form 8-K filed on February 4,
2008 and incorporated herein by reference)
31.1 Certification of Matthew Lambiase, Chief Executive Officer and
President of the Registrant, pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
31.2 Certification of A. Alexandra Denahan, Chief Financial Officer of the
Registrant, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of Matthew Lambiase, Chief Executive Officer and
President of the Registrant, pursuant to 18 U.S.C. Section 1350 as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
58
32.2 Certification of A. Alexandra Denahan, Chief Financial Officer of the
Registrant, pursuant to 18 U.S.C. Section 1350 as adopted pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002.
+ Represents a management contract or compensatory plan or
arrangement.
59
CHIMERA INVESTMENT CORPORATION
FINANCIAL STATEMENTS
Report of Independent Registered Public Accounting Firm F-2
Financial Statements for the period ended December 31, 2007
Statement of Financial Condition F-3
Statement of Operations and Comprehensive Income (Loss) F-4
Statement of Stockholders' Equity F-5
Statement of Cash Flows F-6
Notes to Financial Statements F-7
F-1
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
Chimera Investment Corporation
New York, New York
We have audited the accompanying statement of financial condition of Chimera
Investment Corporation (the "Company") as of December 31, 2007 and the related
statements of operations and comprehensive income, stockholders' equity, and
cash flows for the period from November 21, 2007 (date operations commenced) to
December 31, 2007. These financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements based on our audit.
We conducted our audit in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. The Company is not required to
have, nor were we engaged to perform, an audit of its internal control over
financial reporting. Our audit included consideration of internal control over
financial reporting as a basis for designing audit procedures that are
appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the Company's internal control over financial
reporting. Accordingly, we express no such opinion. An audit also includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements, assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audit provides a
reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material
respects, the financial position of Chimera Investment Corporation as of
December 31, 2007, and the results of its operations and its cash flows for the
period from November 21, 2007 (date operations commenced) to December 31, 2007,
in conformity with accounting principles generally accepted in the United States
of America.
DELOITTE & TOUCHE LLP
New York, New York
March 3, 2008
F-2
CHIMERA INVESTMENT CORPORATION
STATEMENT OF FINANCIAL CONDITION
(dollars in thousands)
December 31, 2007
-------------------
ASSETS
------
Cash and cash equivalents $ 6,026
Restricted cash 1,350
Mortgage-Backed Securities, at fair value 1,124,290
Loans held for investment, net of allowance for loan losses
of $81 162,371
Reverse repurchase agreements 265,000
Accrued interest receivable 6,036
Other assets 563
-------------------
Total assets $ 1,565,636
===================
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Liabilities:
Repurchase agreements $ 270,584
Payable for Mortgage-Backed Securities purchased 748,920
Accrued interest payable 415
Dividends payable 943
Accounts payable and other liabilities 1,729
Interest rate swaps, at fair value 4,156
-------------------
Total liabilities 1,026,747
-------------------
Commitments and Contingencies (Note 12)
Stockholders' Equity:
Common stock: par value $.01 per share; 500,000,000 shares
authorized, 37,705,563 shares issued and outstanding 377
Additional paid-in capital 532,208
Accumulated other comprehensive income 10,153
Accumulated deficit (3,849)
-------------------
Total stockholders' equity 538,889
-------------------
Total liabilities and stockholders' equity $ 1,565,636
===================
See notes to financial statements.
F-3
CHIMERA INVESTMENT CORPORATION
STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
(dollars in thousands, except per share data)
For the Period
November 21, 2007
(date operations
commenced) through
December 31, 2007
-------------------
Interest income $ 3,492
Interest expense 415
-------------------
Net interest income 3,077
-------------------
Unrealized losses on interest rate swaps (4,156)
-------------------
Net Investment Income (Expense) (1,079)
-------------------
Expenses
Management fee 1,217
General and administrative expenses 605
-------------------
Total expenses 1,822
-------------------
Loss before income taxes (2,901)
Income tax 5
-------------------
Net loss ($2,906)
===================
Net loss per share - basic and diluted ($0.08)
===================
Weighted average number of shares outstanding - basic and
diluted 37,401,737
===================
Comprehensive Income:
Net loss ($2,906)
-------------------
Other comprehensive income:
Unrealized gain on available-for-sale securities 10,153
-------------------
Comprehensive income $ 7,247
===================
See notes to financial statements.
F-4
CHIMERA INVESTMENT CORPORATION
STATEMENT OF STOCKHOLDERS' EQUITY
(dollars in thousands)
Accumulated
Common Additional Other
Stock Par Paid-in Comprehensive Accumulated
Value Capital Income Deficit Total
-------------------------------------------------------------------------------------------
Balance, November 21, 2007 $ - $ - $ - $ - $ -
(date operations commenced)
Proceeds from common stock
offerings 377 532,197 - - 532,574
Net income - - - (2,906) (2,906)
Other comprehensive income - - 10,153 - 10,153
Proceeds from direct
purchases - 11 - - 11
Common dividends declared,
$0.025 per share - - - (943) (943)
-------------------------------------------------------------
Balance, December 31, 2007 $ 377 $ 532,208 $ 10,153 ($3,849) $ 538,889
=============================================================
See notes to financial statements.
F-5
CHIMERA INVESTMENT CORPORATION
STATEMENT OF CASH FLOWS
(dollars in thousands)
For the period
November 21
(date operations
commenced)
through
December 31,
2007
----------------
Cash Flows From Operating Activities:
Net loss ($2,906)
Adjustments to reconcile net loss to net cash used in operating
activities:
Amortization of investments (98)
Unrealized loss on interest rate swaps 4,156
Allowance for loan losses 81
Changes in operating assets
Increase in accrued interest receivable (4,337)
Increase in other assets (563)
Changes in operating liabilities
Increase in accounts payable 1,437
Increase in accrued interest payable 415
Increase in other liabilities 292
----------------
Net cash used in operating activities (1,523)
----------------
Cash Flows From Investing Activities:
Mortgage-backed securities portfolio:
Purchases (368,593)
Principal payments 1,788
Loans held for investment portfolio:
Purchases (162,465)
Reverse repurchase agreements (265,000)
Restricted cash (1,350)
----------------
Net cash used in investing activities (795,620)
----------------
Cash Flows From Financing Activities:
Net proceeds from repurchase agreements 270,584
Net proceeds from common stock offerings 532,574
Net proceeds from direct purchases of common stock 11
----------------
Net cash provided by financing activities 803,169
----------------
Net increase in cash and cash equivalents 6,026
Cash and cash equivalents at beginning of period -
----------------
Cash and cash equivalents at end of period $6,026
================
Non cash investing activities
Payable for securities purchased $748,920
================
Net change in unrealized gain on available for sale
securities $10,153
================
Non cash financing activities
Dividends declared, not yet paid $943
================
See notes to financial statements
F-6
CHIMERA INVESTMENT CORPORATION
NOTES TO FINANCIAL STATEMENTS
For the Period Ended December 31, 2007
1. Organization and Significant Accounting Policies
Chimera Investment Corporation, or the Company, was organized in Maryland on
June 1, 2007. The Company commenced operations on November 21, 2007 when it
completed its initial public offering. The Company has elected to be taxed as a
real estate investment trust or REIT under the Internal Revenue Code of 1986, as
amended. As such, the Company is required to distribute substantially all of the
income generated from its operations to its stockholders. As long as the Company
qualifies as a REIT, the Company will generally not be subject to U.S. federal
or state corporate taxes on its income to the extent that the Company
distributes at least 90% of its net income to its stockholders. Annaly Capital
Management, Inc., or Annaly, purchased 3,621,581 shares of the Company's common
shares in a private offering concurrent with the Company's initial public
offering. The Company is managed by Fixed Income Discount Advisory Company, or
FIDAC, an investment advisor registered with the Securities and Exchange
Commission and a wholly-owned subsidiary of Annaly.
A summary of the Company's significant accounting policies follows:
Cash and Cash Equivalents
Cash and cash equivalents include cash on hand and money market funds.
Restricted Cash
Restricted cash includes cash held by counterparties as collateral for
repurchase agreements and interest rate swaps.
Reverse Repurchase Agreements
The Company may invest its daily available cash balances via reverse repurchase
agreements to provide additional yield on its assets. These investments will
typically be recorded as short term investments, will mature daily, and are
referred to as receivables for reverse repurchase agreements in the statement of
financial condition. Reverse repurchase agreements are recorded at cost and are
collateralized by RMBS.
Mortgage-Backed Securities
The Company invests in mortgage-backed securities representing interests in
obligations backed by pools of mortgage loans and carries those securities at
fair value which is determined by obtaining independent pricing on the Company's
investments and perform a verification of those sources to the Company's own
internal estimate of fair market value. In the current market, it may be
difficult or impossible to obtain third party pricing on the investments the
Company purchases. In addition, validating third party pricing for the Company's
investments may be more subjective as fewer participants may be willing to
provide this service to the Company. Moreover, the current market is more
illiquid than in recent history for some of the investments the Company
purchases. Illiquid investments typically experience greater price volatility as
a ready market does not exist. As volatility increases or liquidity decreases,
the Company may have greater difficulty financing its investments which may
negatively impact its earnings and the execution of its investment strategy.
Statement of Financial Accounting Standards, or SFAS, No. 115, Accounting for
Certain Investments in Debt and Equity Securities, requires the Company to
classify its investment securities as either trading investments,
available-for-sale investments or held-to-maturity investments. The Company
intends to hold most of its residential mortgage-backed securities, or
RMBS, as available-for-sale and as such may sell any of its RMBS as part of its
overall management of its portfolio. All assets classified as available-for-sale
are reported at estimated fair value, based on market prices from independent
sources, with unrealized gains and losses included in other comprehensive
income.
Management evaluates securities for other-than-temporary impairment at least on
a quarterly basis, and more frequently when economic or market concerns warrant
such evaluation. Consideration is given to (1) the length of time and the extent
to which the fair value has been lower than carrying value, (2) the financial
condition and near-term prospects of the issuer, (3) credit quality and cash
flow performance of the security, and (4) the intent and ability of the Company
to retain its investment in the issuer for a period of time sufficient to allow
for any anticipated recovery in fair value. Unrealized losses on investment
securities that are considered other than temporary, as measured by the amount
of decline in fair value attributable to other-than-temporary factors, are
recognized in income and the cost basis of the investment securities is
adjusted.
Security transactions are recorded on the trade date. Realized gains and losses
from security transactions are determined based on the specific identification
method and recorded as a gain (loss) on sale of available for sale securities in
the statement of operations. Accretion of discounts or amortization of premiums
on available-for-sale securities and mortgage loans is computed using the
effective interest yield method and is included as a component of interest
income in the statement of operations.
F-7
Residential Mortgage Loans
The Company's residential mortgage loans are comprised of fixed-rate and
variable-rate loans. The Company purchases pools of residential mortgage loans
through a select group of originators. Mortgage loans are designated as held for
investment, recorded on trade date, and are carried at their principal balance
outstanding, plus any premiums or discounts which are amortized or accreted over
the estimated life of the loan, less allowances for loan losses. Loans are
evaluated for credit losses. The Company has created an unallocated provision
for loan losses estimated as a percentage of the remaining principal on the
loans as of December 31, 2007. Management's estimate is based on historical
experience of similarly underwritten loan pools. There were no specific losses
as of that date.
Fair Value Disclosure
SFAS No. 107, Disclosure About Fair Value of Financial Instruments, requires
disclosure of the fair value of financial instruments for which it is
practicable to estimate that value. The estimated fair value of investment
securities and interest rate swaps is equal to their carrying value presented in
the consolidated statements of financial condition. The estimated fair value of
cash and cash equivalents, accrued interest receivable, reverse
repurchase agreements, repurchase agreements with maturities shorter than one
year, payables for mortgage-backed securities purchased, dividends payable,
accounts payable, and accrued interest payable, generally approximates cost as
of December 31, 2007 due to the short term nature of these financial
instruments.
Interest Income
Interest income on available-for-sale securities and loans is recognized over
the life of the investment using the effective interest method. Interest income
on mortgage-backed securities is recognized using the effective interest method
as described by SFAS No. 91, Accounting for Nonrefundable Fees and Costs
Associated with Originating or Acquiring Loans and Initial Direct Costs of
Leases, for securities of high credit quality and Emerging Issues Task Force No.
99-20, Recognition of Interest Income and Impairment on Purchased and Retained
Beneficial Interests in Securitized Financial Assets, for all other securities.
Income recognition is suspended for loans when, in the opinion of management, a
full recovery of income and principal becomes doubtful. Income recognition is
resumed when the loan becomes contractually current and performance is
demonstrated to be resumed.
Allowance for Loan Losses
The Company has established an allowance for loan losses at a level that
management believes is adequate based on an evaluation of known and inherent
risks related to the Company's loan portfolio. The estimate is based on a
variety of factors including, but not limited to, current economic conditions,
industry loss experience, credit quality trends, loan portfolio composition,
delinquency trends, national and local economic trends, national unemployment
data, changes in housing appreciation and whether specific geographic areas
where the Company has significant loan concentrations are experiencing adverse
economic conditions and events such as natural disasters that may affect the
local economy or property values. Upon purchase of the pools of loans, the
Company obtained written representations and warranties from the sellers that
the Company could be reimbursed for the value of the loan if the loan fails to
meet the agreed upon origination standards. While the Company has little history
of its own to establish loan trends, delinquency trends of the originators and
the current market conditions aided in determining the allowance for loan
losses. The Company also performed due diligence procedures on a sample of loans
that met its criteria during the purchase process. As of December 31, 2007, the
allowance for loan losses was $80,745. The allowance consisted of unallocated
loan losses with no provision for specific loans. Management periodically
reviews the portfolio of loans for credit worthiness. When it is probable that
contractually due specific amounts are deemed uncollectible, the account is
considered impaired. Where impairment is indicated, a valuation write-off is
measured based upon the excess of the recorded investment over the net fair
value of the collateral, reduced by selling costs. Any deficiency between the
carrying amount of an asset and the net sales price of repossessed collateral is
charged to the allowance for loan losses.
Derivative Financial Instruments/Hedging Activity
The Company economically hedges interest rate risk through the use of derivative
financial instruments, currently limited to interest rate swaps. Realized and
unrealized gains and losses on interest rate swaps are recognized in earnings.
Credit Risk
The Company retains the risk of potential credit losses on all of the
residential mortgage loans it holds in its portfolio. Additionally, some of its
investments in RMBS may be qualifying interests for purposes of maintaining its
exemption from the 1940 Act if it retains a 100% ownership interest in the
underlying loans. If the Company purchases all classes of these securitizations,
it has the credit exposure on the underlying loans. It intends to mitigate the
risk of potential credit losses through its diligence in the asset selection
process.
Income Taxes
The Company qualifies to be taxed as a REIT for the taxable period ended
December 31, 2007. Therefore, the Company generally will not be subject to
corporate federal or state income tax to the extent that qualifying
distributions are made to stockholders and the REIT requirements are met
including certain asset, income, distribution and stock ownership tests. If the
Company failed to qualify as a REIT and did not qualify for certain statutory
relief provisions, the Company would be subject to federal, state and local
income taxes and may be precluded from qualifying as a REIT for the subsequent
four taxable years following the year in which the REIT qualification was lost.
F-8
Net Income Per Share
The Company calculates basic net income per share by dividing net income for the
period by weighted-average shares of its common stock outstanding for that
period. Diluted net income per share takes into account the effect of dilutive
instruments, such as stock options and unvested restricted common stock, but
uses the average share price for the period in determining the number of
incremental shares that are to be added to the weighted -average number of
shares outstanding. The Company had no potentially dilutive securities
outstanding during the period presented.
Stock Based Compensation
The Company did not have any stock based compensation for the period ended
December 31, 2007.
Use of Estimates
The preparation of the financial statements in conformity with accounting
principles generally accepted in the United States, or GAAP, requires management
to make estimates and assumptions that affect the reported amounts of assets and
liabilities and disclosure of contingent assets and liabilities at the date of
the financial statements and the reported amounts of revenues and expenses
during the reporting period. Actual results could differ from those estimates.
Recent Accounting Pronouncements
In September 2006, the Financial Accounting Standards Board, or FASB, issued
SFAS No. 157, Fair Value Measurements, or SFAS 157. SFAS 157 defines fair value,
establishes a framework for measuring fair value and requires enhanced
disclosures about fair value measurements. SFAS 157 requires companies to
disclose the fair value of their financial instruments according to a fair value
hierarchy (i.e., levels 1, 2, and 3, as defined). Additionally, companies are
required to provide enhanced disclosure regarding instruments in the level 3
category (which require significant management judgment), including a
reconciliation of the beginning and ending balances separately for each major
category of assets and liabilities. The Company does not believe that the
adoption of SFAS 157 will have a significant impact on the manner in which it
estimates fair value, but expects that adoption will increase footnote
disclosure to comply with SFAS 157 disclosure requirements for financial
statements issued after January 1, 2008.
In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for
Financial Assets and Financial Liabilities, or SFAS 159. SFAS 159 permits
entities to choose to measure many financial instruments and certain other items
at fair value. Unrealized gains and losses on items for which the fair value
option has been elected will be recognized in earnings at each subsequent
reporting date. SFAS 159 became effective for the Company January 1, 2008. The
Company did not elect the fair value option for any existing eligible financial
instruments.
In February 2008, FASB issued FASB Staff Position No. FAS 140-3 Accounting for
Transfers of Financial Assets and Repurchase Financing Transactions, or FSP FAS
140-3. FSP FAS 140-3 addresses whether transactions where assets purchased from
a particular counterparty and financed through a repurchase agreement with the
same counterparty can be considered and accounted for as separate transactions,
or are required to be considered "linked" transactions and may be considered
derivatives under SFAS No. 133, Accounting for Derivative Instruments and
Hedging Activities, or SFAS 133. FSP FAS 140-3 requires purchases and subsequent
financing through repurchase agreements be considered linked transactions unless
all of the following conditions apply: (1) the initial purchase and the use of
repurchase agreements to finance the purchase are not contractually contingent
upon each other; (2) the repurchase financing entered into between the parties
provides full recourse to the transferee and the repurchase price is fixed; (3)
the financial assets is readily obtainable in the market; and (4) the financial
instrument and the repurchase agreement are not coterminous. This FSP is
effective for fiscal years beginning after November 15, 2008. The Company is
currently evaluating FSP FAS 140-3 but does not expect its application to have a
significant impact on its financial reporting.
2. Mortgage-Backed Securities
The following table represents the Company's available for sale Mortgage-Backed
Securities portfolio as of December 31, 2007 at fair value. All unrealized
losses recorded are the result of changes in market conditions and are not the
result of any impairment of securities due to credit quality. All
Mortgage-Backed Securities are rated AAA at December 31, 2007.
F-9
(dollars in thousands)
Mortgage-backed securities, gross $1,114,137
Gross unrealized gain 10,675
Gross unrealized loss (522)
---------------
Fair value $1,124,290
===============
Actual maturities of mortgage-backed securities are generally shorter than
stated contractual maturities. Actual maturities of the Company's
mortgage-backed securities are affected by the contractual lives of the
underlying mortgages, periodic payments of principal and prepayments of
principal.
The following table summarizes the Company's mortgage-backed securities at
December 31, 2007 according to their estimated weighted-average life
classifications:
(dollars in thousands)
Weighted Average
Weighted Average Life Fair Value Amortized Cost Coupon
------------------------ ---------------- ----------------- ------------------
Less than one year $45,868 $46,102 6.31%
Greater than one year
and less than five
years 1,078,422 1,068,035 6.32%
Greater than five years - - -
---------------- ----------------- ------------------
Total $1,124,290 $1,114,137 6.32%
================ ================= ==================
The weighted-average lives of the mortgage-backed securities as December 31,
2007 in the tables above are based on data provided through dealer quotes,
assuming constant prepayment rates to the balloon or reset date for each
security. The prepayment model considers current yield, forward yield, steepness
of the curve, current mortgage rates, mortgage rate of the outstanding loan,
loan age, margin and volatility.
The Company did not sell any mortgage-backed securities during the period ended
December 31, 2007.
3. Loans Held For Investment
The following table represents the Company's residential mortgage loans
classified as held for investment at December 31, 2007, which are carried at
their principal balance outstanding less an allowance for loan losses:
(dollars in thousands)
Mortgage loans, at principal balance outstanding $162,452
Less: allowance for loan losses (81)
------------
Mortgage loans held for investment $162,371
============
The following table summarizes the changes in the allowance for loan losses for
the mortgage loan portfolio during the period ended December 31, 2007:
(dollars in thousands)
Balance, beginning of period $-
Provision for loan losses 81
Charge-offs -
--------
Balance, end of period $81
========
On a quarterly basis, the Company evaluates the adequacy of its allowance for
loan losses. Based on this analysis, the Company recorded a provision for loan
losses of $80,745 for the period ended December 31, 2007, representing 5 basis
points of the Company's mortgage loan portfolio. At December 31, 2007, there
were no loans 90 days or more past due and all loans were accruing interest.
The geographic distribution of the Company's loans held for investment was as
follows:
F-10
(dollars in thousands)
State Number of Loans Balance
--------------------------------------------------
CA 52 $36,593
NJ 25 14,368
NY 18 12,061
IL 15 11,330
VA 20 10,517
WA 13 7,111
TX 12 6,723
MA 11 6,623
FL 11 5,795
MD 7 5,011
GA 7 4,665
CO 5 3,686
CT 4 3,601
AZ 5 3,303
MI 4 3,121
UT 4 2,783
DC 4 2,628
PA 6 2,576
NC 4 2,487
NH 4 2,402
Other states,
individually less
than 1% of
aggregate current 27 14,105
balance
Unamortized
premium 963
Provision for
loan losses (81)
---------------
Total $162,371
===============
4. Repurchase Agreements
The Company had outstanding $270.6 million of repurchase agreements with
weighted average borrowing rates of 5.02% and weighted average remaining
maturities of 22 days as of December 31, 2007. Investment securities pledged as
collateral under these repurchase agreements had an estimated fair value of
$271.7 million at December 31, 2007.
At December 31, 2007, the repurchase agreements all had the following remaining
maturities:
(dollars in thousands)
Within 30 days $270,584
30 to 59 days -
60 to 89 days -
90 to 119 days -
Greater than or equal to 120 days -
----------------
Total $270,584
================
The Company did not have an amount at risk greater than 10% of the equity of the
Company with any counterparty as of December 31, 2007.
Currently the sub-prime mortgage sector is experiencing unprecedented losses and
there is a weakness in the broader mortgage market that has increased volatility
in market valuation of investments and the availability of credit which may
adversely affect one or more of the Company's lenders and could cause one or
more of the Company's lenders to be unwilling or unable to provide it with
additional financing. This could potentially increase the Company's financing
costs and reduce liquidity. If one or more major market participants fail, it
could negatively impact the marketability of all fixed income securities and
this could negatively impact the value of the securities in the Company's
portfolio, thus reducing its net book value. Furthermore, if many of the
Company's lenders are unwilling or unable to provide it with additional
financing, the Company could be forced to sell its investments at an inopportune
time when prices are depressed.
F-11
5. Interest Rate Swaps
In connection with the Company's interest rate risk management strategy, the
Company economically hedges a portion of its interest rate risk by entering into
derivative financial instrument contracts. As of December 31, 2007, such
instruments are comprised of interest rate swaps, which in effect modify the
cash flows on repurchase agreements. The use of interest rate swaps creates
exposure to credit risk relating to potential losses that could be recognized if
the counterparties to these instruments fail to perform their obligations under
the contracts. In the event of a default by the counterparty, the Company could
have difficulty obtaining its RMBS pledged as collateral for swaps. The Company
does not anticipate any defaults by its counterparties. The Company's swaps are
used to lock-in the fixed rate related to a portion of its current and
anticipated future 30-day term repurchase agreements. The Company accounts for
interest rate swaps as freestanding derivatives with changes in fair value
recorded in earnings.
The table below represents the Company's swaps outstanding at December 31, 2007:
(dollars in thousands)
Notional Amount Weighted Average Pay Weighted Average Net Estimated Fair
Rate Receive Rate Value/Carrying Value
--------------------- --------------------- --------------------- ----------------------
$1,235,000 4.04% 4.94% ($4,156)
6. Common Stock
The Company commenced operations on November 21, 2007 following the completion
of its initial public in which it sold approximately 34.1 million shares of its
common stock and raised proceeds of $479.3 million before offering expenses.
Concurrent with its initial public offering, in a private offering the Company
sold Annaly approximately 3.6 million shares of its common stock for aggregate
net proceeds of approximately $54.3 million. The Company had 37,705,363 shares
of common stock outstanding as of December 31, 2007.
7. Net Loss per Common Share
The following table presents a reconciliation of the net loss and shares used in
calculating basic and diluted earnings per share for the period ended December
31, 2007:
(dollars in thousands)
Net Loss ($2,906)
Net loss per weighted average shares of common stock outstanding -
basic
and diluted ($0.08)
Weighted average number of shares of common stock outstanding 37,401,737
8. Long Term Incentive Plan
On November 1, 2007, the Company adopted a long term stock incentive plan to
provide incentives to its independent directors, employees of FIDAC and its
affiliates, to stimulate their efforts towards our continued success, long-term
growth and profitability and to attract, reward and retain personnel and other
service providers. The Incentive Plan authorizes the Compensation Committee of
the board of directors to grant awards, including incentive stock options,
non-qualified stock options, restricted shares and other types of incentive
awards. The Incentive Plan authorizes the granting of options or other awards
for an aggregate of the greater of 8.0% of the outstanding shares of its common
stock, or 3,016,445 shares, up to a ceiling of 40,000,000 shares. No awards had
been made as of December 31, 2007 (see note 12).
9. Income Taxes
As a REIT, the Company is not subject to Federal income tax on earnings
distributed to its shareholders. Most states recognize REIT status as well. The
Company has decided to distribute the majority of its income and retain a
portion of the permanent differences between book and taxable income. During the
period ended December 31, 2007, the Company recorded $4,960 of income tax
expense for excise tax. The statutory combined federal, state, and city
corporate tax rate is 49.3%. This amount is applied to the amount of estimated
REIT taxable income retained (if any, and only up to 10% of ordinary income as
all capital gain income is distributed). Thus, as a REIT, the Company's
effective tax rate is significantly less as it is allowed to deduct dividend
distributions.
F-12
10. Credit Risk and Interest Rate Risk
The Company's primary components of market risk are credit risk and interest
rate risk. The Company is subject to credit risk in connection with its
investments in residential mortgage loans and credit sensitive mortgage-backed
securities rated below AAA. When the Company assumes credit risk, it attempts to
minimize interest rate risk through asset selection, hedging and matching the
income earned on mortgage assets with the cost of related liabilities. The
Company is subject to interest rate risk, primarily in connection with its
investments in fixed-rate and adjustable-rate mortgage backed securities and
residential mortgage loans. When the Company assumes interest rate risk, it
minimizes credit risk through asset selection. The Company's strategy is to
purchase loans underwritten to agreed-upon specifications of selected
originators in an effort to mitigate credit risk. The Company has established a
whole loan target market including prime borrowers with FICO scores generally
greater than 650, Alt-A documentation, geographic diversification,
owner-occupied property, moderate loan size and moderate loan to value ratio.
These factors are considered to be important indicators of credit risk.
11. Management Agreement and Related Party Transactions
The Company has entered into a management agreement with FIDAC, which provides
for an initial term through December 31, 2010 with automatic one-year extension
options and subject to certain termination rights. The Company pays FIDAC a
quarterly management fee equal to 1.75% per annum of the gross Stockholders'
Equity (as defined in the management agreement) of the Company. FIDAC is also
entitled to a quarterly incentive fee equal to 20% of the dollar amount by which
Core Earnings (as defined in the management agreement) on a rolling four-quarter
basis and before the incentive management fee, exceeds the product of (1) the
weighted average of the issue price per share of all of our public offerings
multiplied by the weighted average number of shares of common stock outstanding
in such quarter and (2) 0.50% plus one-fourth of the average of the one month
LIBOR rate for such quarter and the previous three quarters. For the initial
four quarters following the Company's initial public offering, Core Earnings and
the LIBOR rate will be calculated on the basis of each of the previously
completed quarters on an annualized basis. Core Earnings and LIBOR rate for the
initial quarter will each be calculated from the settlement date of this
offering on an annualized basis.
The Company is obligated to reimburse FIDAC for its costs incurred under the
management agreement. In addition, the Company is required to pay its pro rata
portion of rent, telephone, utilities, office furniture, equipment, machinery
and other office, internal and overhead expenses of FIDAC required for the
Company's operations. These expenses are allocated between FIDAC and the Company
based on the ratio of the Company's proportion of gross assets compared to all
remaining gross assets managed by FIDAC as calculated at each quarter end. FIDAC
and the Company will modify this allocation methodology, subject to the
Company's board of directors' approval if the allocation becomes inequitable
(i.e., if the Company becomes very highly leveraged compared to FIDAC's other
funds and accounts). FIDAC has waived its right to request reimbursement from
the Company of these expenses until such time as it determines to rescind that
waiver. The Company was required to reimburse FIDAC for all costs FIDAC paid on
behalf of the Company incurred in connection with the formation, organization
and initial public offering of the Company, which amounted to $697,947.
12. Commitments and Contingencies
From time to time, the Company may become involved in various claims and legal
actions arising in the ordinary course of business. Management is not aware of
any reported or unreported contingencies at December 31, 2007.
13. Subsequent Events
On January 2, 2008, the Company granted restricted stock awards in the amount of
1,301,000 shares to FIDAC's employees and the Company's independent directors.
The awards to the independent directors vested on the date of grant, and the
awards to FIDAC's employees vest quarterly over a period of 10 years.
On January 18, 2008, the Company entered into a master repurchase agreement with
Credit Suisse First Boston Mortgage Capital LLC. The agreement is a $500 million
lending facility of which $200 million is on an uncommitted basis. The agreement
terminates January 16, 2009.
On January 31, 2008, the Company entered into a master repurchase agreement with
DB Structured Products, Inc. and Deutsche Bank Securities, Inc. The agreement is
a $350 million committed lending facility. The agreement terminates January 29,
2010.
F-13
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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, in the city of New
York, State of New York.
CHIMERA INVESTMENT CORPORATION
By: /s/ Matthew Lambiase
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Matthew Lambiase
Chief Executive Officer and President
February 29, 2008
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the date indicated.
Signatures Title Date
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Chief Executive Officer, President, and
/s/ Matthew Lambiase Director (Principal Executive Officer) February 29, 2008
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Matthew Lambiase
Chief Financial Officer (Principal
/s/ A. Alexandra Denahan Financial and Accounting Officer) February 29, 2008
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A. Alexandra Denahan
/s/ Jeremy Diamond Director February 29, 2008
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Jeremy Diamond
/s/ Mark Abrams Director February 29, 2008
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Mark Abrams
/s/ Paul A. Keenan Director February 29, 2008
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Paul A. Keenan
/s/ Paul Donlin Director February 29, 2008
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Paul Donlin
S-1