SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTIONS 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
(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, 2006
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
ANNALY CAPITAL MANAGEMENT, INC.
(Exact Name of Registrant as Specified in its Charter)
MARYLAND 22-3479661
(State or other jurisdiction of incorporation (I.R.S. Employer
of organization) Identification Number)
1211 Avenue of the Americas, Suite 2902
New York, New York 10036
(Address of Principal Executive Offices) (Zip Code)
(212) 696-0100
(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
7.875% Series A Cumulative Redeemable
Preferred Stock 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, or a non-accelerated filer. See definition of "accelerated
filer and large accelerated filer" in Rule 12b-2 of the Exchange Act. (Check
one):
Large accelerated filer X Accelerated filer Non-accelerated filer
--- --- ---
Indicate by check mark whether the Registrant is a shell company (as
defined in Rule 12b-2 of the Act). Yes No X .
-- ---
At June 30, 2006, the aggregate market value of the voting stock held by
non-affiliates of the Registrant was $2,066,444,356.
The number of shares of the Registrant's Common Stock outstanding on
February 26, 2007 was 205,350,591
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,
2006. Portions of such proxy statement are incorporated by reference into Part
III of this Form 10-K.
ANNALY CAPITAL MANAGEMENT, INC.
--------------------------------------------------------------------------------
2006 FORM 10-K ANNUAL REPORT
TABLE OF CONTENTS
PART I
PAGE
ITEM 1. BUSINESS 5
ITEM 1A. RISK FACTORS 21
ITEM 1B. UNRESOLVED STAFF COMMENTS 30
ITEM 2. PROPERTIES 30
ITEM 3. LEGAL PROCEEDINGS 30
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 30
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED
STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES 31
ITEM 6. SELECTED FINANCIAL DATA 33
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS 35
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 51
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA 53
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE 53
ITEM 9A. CONTROLS AND PROCEDURES 53
ITEM 9B. OTHER INFORMATION 54
PART III
ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE 54
ITEM 11. EXECUTIVE COMPENSATION 54
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS 54
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS AND DIRECTOR
INDEPENDENCE 54
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES 54
PART IV
ITEM 15. EXHIBITS AND FINANCIAL STATEMENT SCHEDULES 55
FINANCIAL STATEMENTS F-1
SIGNATURES II-1
EXHIBIT INDEX II-2
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
Certain statements contained in this annual report, and certain
statements contained in our future filings with the Securities and Exchange
Commission (the "SEC" or the "Commission"), in our press releases or in our
other public or shareholder communications may not be based on historical facts
and are "forward-looking statements" within the meaning of the Private
Securities Litigation Reform Act of 1995. Forward-looking statements, which are
based on various assumptions (some of which are beyond our control), may be
identified by reference to a future period or periods or by the use of
forward-looking terminology, such as "may," "will," "believe," "expect,"
"anticipate," "continue," or similar terms or variations on those terms or the
negative of those terms. Actual results could differ materially from those set
forth in forward-looking statements due to a variety of factors, including, but
not limited to:
o changes in interest rates,
o changes in the yield curve,
o changes in prepayment rates,
o the availability of mortgage-backed securities and other securities
for purchase,
o the availability of financing,
o changes in the market value of our assets,
o changes in business conditions and the general economy,
o risks associated with the investment advisory business of our wholly
owned subsidiary, Fixed Income Discount Advisory Company (which we
refer to as FIDAC), including:
o the removal by FIDAC's clients of assets FIDAC manages,
o FIDAC's regulatory requirements, and
o competition in the investment advisory business,
o changes in government regulations affecting our business, and
o our ability to maintain our qualification as a REIT for federal income
tax purposes.
For a discussion of the risks and uncertainties which could cause actual results
to differ from those contained in the forward-looking statements, please see the
information under the caption "Risk Factors" described in this Form 10-K. We do
not undertake, and specifically disclaim any obligation, to publicly release the
result of any revisions which may be made to any forward-looking statements to
reflect the occurrence of anticipated or unanticipated events or circumstances
after the date of such statements.
(i)
PART I
ITEM 1. BUSINESS
-----------------
THE COMPANY
Background
Annaly Capital Management, Inc. owns, manages, and finances a portfolio
of investment securities, including mortgage pass-through certificates,
collateralized mortgage obligations (or CMOs), agency callable debentures, and
other securities representing interests in or obligations backed by pools of
mortgage loans. Our principal business objective is to generate net income for
distribution to our stockholders from the spread between the interest income on
our investment securities and the cost of borrowings to finance our acquisition
of investment securities. We are a Maryland corporation that commenced
operations on February 18, 1997. We are self-advised and self-managed. We
acquired Fixed Income Discount Advisory Company (or FIDAC) on June 4, 2004.
FIDAC is a registered investment advisor and is our taxable REIT subsidiary. We
also own a majority interest in an investment fund.
We have financed our purchases of investment securities with the net
proceeds of equity offerings and borrowings under repurchase agreements whose
interest rates adjust based on changes in short-term market interest rates.
We have elected and believe that we are organized and have operated in
a manner that qualifies us to be taxed as a real estate investment trust (or
REIT) under the Internal Revenue Code of 1986, as amended (or the Code). If we
qualify for taxation as a REIT, we generally will not be subject to federal
income tax on our taxable income that is distributed to our stockholders.
Therefore, substantially all of our assets, other than FIDAC, our taxable REIT
subsidiary, consist of qualified REIT real estate assets (of the type described
in Section 856(c)(5)(B) of the Code). We have financed our purchases of
investment securities with the net proceeds of equity offerings and borrowings
under repurchase agreements whose interest rates adjust based on changes in
short-term market interest rates.
As used herein, "Annaly," the "Company," "we," "our" and similar terms
refer to Annaly Capital Management, Inc., unless the context indicates
otherwise. We changed our name to Annaly Capital Management, Inc. from Annaly
Mortgage Management, Inc. on August 2, 2006.
Assets
Under our capital investment policy, at least 75% of our total assets
must be comprised of high-quality mortgage-backed securities and short-term
investments. High quality securities means securities that (1) are rated within
one of the two highest rating categories by at least one of the nationally
recognized rating agencies, (2) are unrated but are guaranteed by the United
States government or an agency of the United States government, or (3) are
unrated but we determine them to be of comparable quality to rated high-quality
mortgage-backed securities.
The remainder of our assets, comprising not more than 25% of our total
assets, may consist of other qualified REIT real estate assets which are unrated
or rated less than high quality, but which are at least "investment grade"
(rated "BBB" or better by Standard & Poor's Corporation ("S&P") or the
equivalent by another nationally recognized rating agency) or, if not rated, we
determine them to be of comparable credit quality to an investment which is
rated "BBB" or better. In addition, we may directly or indirectly invest part of
this remaining 25% of our assets in other types of securities, including without
limitation, unrated debt, equity or derivative securities, to the extent
consistent with our REIT qualification requirements. The derivative securities
in which we invest may include securities representing the right to receive
interest only or a disproportionately large amount of interest, as well as
inverse floaters, which may have imbedded leverage as part of their structural
characteristics.
We may acquire mortgage-backed securities backed by single-family
residential mortgage loans as well as securities backed by loans on
multi-family, commercial or other real estate-related properties. To date, all
of the mortgage-backed securities that we have acquired have been backed by
single-family residential mortgage loans.
To date, all of the mortgage-backed securities that we have acquired
have been agency mortgage-backed securities which, although not rated, carry an
implied "AAA" rating. Agency mortgage-backed securities are mortgage-backed
securities for which a government agency or federally chartered corporation,
such as the Federal Home Loan Mortgage Corporation ("FHLMC"), the Federal
National Mortgage Association ("FNMA"), or the Government National Mortgage
Association ("GNMA"), guarantees payments of principal or interest on the
securities. Agency mortgage-backed securities consist of agency pass-through
certificates and CMOs issued or guaranteed by an agency. Pass-through
certificates provide for a pass-through of the monthly interest and principal
payments made by the borrowers on the underlying mortgage loans. CMOs divide a
pool of mortgage loans into multiple tranches with different principal and
interest payment characteristics.
5
At December 31, 2006, approximately 20% of our investment securities
were adjustable-rate pass-though certificates, approximately 72% of our
investment securities were fixed-rate pass-through certificates or CMOs, and
approximately 8% of our investment securities were CMO floaters. Our
adjustable-rate pass-through certificates are backed by adjustable-rate mortgage
loans and have coupon rates which adjust over time, subject to interest rate
caps and lag periods, in conjunction with changes in short-term interest rates.
Our fixed-rate pass-through certificates are backed by fixed-rate mortgage loans
and have coupon rates which do not adjust over time. CMO floaters are tranches
of mortgage-backed securities where the interest rate adjusts in conjunction
with changes in short-term interest rates. CMO floaters may be backed by
fixed-rate mortgage loans or, less often, by adjustable-rate mortgage loans. In
this Form 10-K, except where the context indicates otherwise, we use the term
"adjustable-rate securities" or "adjustable-rate investment securities" to refer
to adjustable-rate pass-through certificates, CMO floaters, and Agency
debentures. At December 31, 2006, the weighted average yield on our portfolio of
earning assets was 5.63% and the weighted average term to next rate adjustment
on adjustable rate securities was 19 months.
We may also invest in Federal Home Loan Bank ("FHLB"), FHLMC, and FNMA
debentures. We refer to the mortgage-backed securities and agency debentures
collectively as "Investment Securities." We intend to continue to invest in
adjustable-rate pass-through certificates, fixed-rate mortgage-backed
securities, CMO floaters, and Agency debentures. We may also invest on a limited
basis in mortgage derivative securities such as interest rate swaps, and other
derivative securities which include securities representing the right to receive
interest only or a disproportionately large amount of interest as well as
inverse floaters, which may have imbedded leverage as part of their structural
characteristics. We have not and will not invest in real estate mortgage
investment conduit ("REMIC") residuals and other CMO residuals
Borrowings
We attempt to structure our borrowings to have interest rate adjustment
indices and interest rate adjustment periods that, on an aggregate basis,
correspond generally to the interest rate adjustment indices and periods of our
adjustable-rate investment securities. However, periodic rate adjustments on our
borrowings are generally more frequent than rate adjustments on our investment
securities. At December 31, 2006, the weighted average cost of funds for all of
our borrowings was 5.14%, the weighted average original term to maturity was 194
days, and the weighted average term to next rate adjustment of these borrowings
was 125 days.
We generally expect to maintain a ratio of debt-to-equity of between
8:1 and 12:1, although the ratio may vary from time to time depending upon
market conditions and other factors that our management deems relevant. For
purposes of calculating this ratio, our equity is equal to the value of our
investment portfolio on a mark-to-market basis, less the book value of our
obligations under repurchase agreements and other collateralized borrowings. At
December 31, 2006, our ratio of debt-to-equity was 10.4:1.
Hedging
To the extent consistent with our election to qualify as a REIT, we
enter into hedging transactions to attempt to protect our investment securities
and related borrowings against the effects of major interest rate changes. This
hedging would be used to mitigate declines in the market value of our investment
securities during periods of increasing or decreasing interest rates and to
limit or cap the interest rates on our borrowings. These transactions would be
entered into solely for the purpose of hedging interest rate or prepayment risk
and not for speculative purposes.
6
Compliance with REIT and Investment Company Requirements
We constantly 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.
Executive Officers of the Company
The following table sets forth certain information as of February 23,
2007 concerning our executive officers:
Name Age Position held with the Company
---- --- ------------------------------
Michael A.J. Farrell 55 Chairman of the Board, Chief Executive Officer and President
Wellington J. Denahan-Norris 43 Vice Chairman of the Board, Chief Investment Officer and Chief
Operating Officer
Kathryn F. Fagan 40 Chief Financial Officer and Treasurer
R. Nicholas Singh 48 Executive Vice President, General Counsel, Secretary and Chief
Compliance Officer
James P. Fortescue 33 Executive Vice President and Head of Liabilities
Kristopher Konrad 32 Executive Vice President and Co-Head Portfolio Management
Rose-Marie Lyght 33 Executive Vice-President and Co-Head Portfolio Management
Jeremy Diamond 43 Managing Director
Ronald Kazel 39 Managing Director
Mr. Farrell and Ms. Denahan-Norris have an average of 25 years
experience in the investment banking and investment management industries where,
in various capacities, they have each managed portfolios of mortgage-backed
securities, arranged collateralized borrowings and utilized hedging techniques
to mitigate interest rate and other risk within fixed-income portfolios. Ms.
Fagan is a certified public accountant and, prior to becoming our Chief
Financial Officer and Treasurer, served as Chief Financial Officer and
Controller of a publicly owned savings and loan association. Mr. Singh joined
Annaly in February 2005. Prior to that, he was a partner in the law firm of
McKee Nelson LLP, and prior to that, a partner in Sidley Austin Brown & Wood
LLP. Mr. Fortescue joined Annaly in 1997. Mr. Konrad joined Annaly in 1997. Ms.
Lyght joined Annaly in April 1999. Mr. Diamond joined Annaly in March 2002. From
1990 to 2002 he was President of Grant's Financial Publishing. Mr. Kazel joined
Annaly in December 2001. Prior to that he was a Senior Vice-President in
Friedman Billings Ramsey's financial services investment banking group. We had
34 full-time employees at December 31, 2006.
Distributions
To maintain our qualification as a REIT, we must distribute substantially
all of our taxable income to our stockholders for each year. We have done this
in the past and intend to continue to do so in the future. We also have declared
and paid regular quarterly dividends in the past and intend to do so in the
future. We have adopted a dividend reinvestment plan to enable holders of common
stock to reinvest dividends automatically in additional shares of common stock.
BUSINESS STRATEGY
General
Our principal business objective is to generate income for distribution
to our stockholders, primarily from the net cash flows on our investment
securities. Our net cash flows result primarily from the difference between the
interest income on our investment securities and borrowing costs of our
repurchase agreements and from dividends we receive from FIDAC. To achieve our
business objective and generate dividend yields, our strategy is:
|X| to purchase mortgage-backed securities, the majority of which we
expect to have adjustable interest rates based on changes in
short-term market interest rates;
7
|X| to acquire mortgage-backed securities that we believe:
- we have the necessary expertise to evaluate and manage;
- we can readily finance;
- are consistent with our balance sheet guidelines and risk
management objectives; and
- provide attractive investment returns in a range of scenarios;
|X| to finance purchases of mortgage-backed securities with the proceeds
of equity offerings and, to the extent permitted by our capital
investment policy, to utilize leverage to increase potential returns
to stockholders through borrowings;
|X| to attempt to structure our borrowings to have interest rate
adjustment indices and interest rate adjustment periods that, on an
aggregate basis, generally correspond to the interest rate adjustment
indices and interest rate adjustment periods of our adjustable-rate
mortgage-backed securities;
|X| to seek to minimize prepayment risk by structuring a diversified
portfolio with a variety of prepayment characteristics and through
other means; and
|X| to issue new equity or debt and increase the size of our balance sheet
when opportunities in the market for mortgage-backed securities are
likely to allow growth in earnings per share.
We believe we are able to obtain cost efficiencies through our
facilities-sharing arrangement with FIDAC and by virtue of our management's
experience in managing portfolios of mortgage-backed securities and arranging
collateralized borrowings. We will strive to become even more cost-efficient
over time by:
|X| seeking to raise additional capital from time to time in order to
increase our ability to invest in mortgage-backed securities;
|X| striving to lower our effective borrowing costs by seeking direct
funding with collateralized lenders, rather than using financial
intermediaries, and investigating the possibility of using commercial
paper and medium term note programs;
|X| improving the efficiency of our balance sheet structure by
investigating the issuance of uncollateralized subordinated debt,
preferred stock and other forms of capital; and
|X| utilizing information technology in our business, including improving
our ability to monitor the performance of our investment securities
and to lower our operating costs.
8
Mortgage-Backed Securities
General
To date, all of the mortgage-backed securities that we have acquired
have been agency mortgage-backed securities which, although not rated, carry an
implied "AAA" rating. Agency mortgage-backed securities are mortgage-backed
securities where a government agency or federally chartered corporation, such as
FHLMC, FNMA or GNMA, guarantees payments of principal or interest on the
securities. Agency mortgage-backed securities consist of agency pass-through
certificates and CMOs issued or guaranteed by an agency.
Even though to date we have only acquired mortgage backed securities
with an implied "AAA" rating, under our capital investment policy, we have the
ability to acquire securities of lower quality. Under our policy, at least 75%
of our total assets must be high quality mortgage-backed securities and
short-term investments. High quality securities are securities (1) that are
rated within one of the two highest rating categories by at least one of the
nationally recognized rating agencies, (2) that are unrated but are guaranteed
by the United States government or an agency of the United States government, or
(3) that are unrated or whose ratings have not been updated but that our
management determines are of comparable quality to rated high quality
mortgage-backed securities.
Under our capital investment policy, the remainder of our assets,
comprising not more than 25% of total assets, may consist of mortgage-backed
securities and other qualified REIT real estate assets which are unrated or
rated less than high quality, but which are at least "investment grade" (rated
"BBB" or better by S&P or the equivalent by another nationally recognized rating
organization) or, if not rated, we determine them to be of comparable credit
quality to an investment which is rated "BBB" or better. In addition, we may
directly or indirectly invest part of this remaining 25% of our assets in other
types of securities, including without limitation, unrated debt, equity or
derivative securities, to the extent consistent with our REIT qualification
requirements. The derivative securities in which we invest may include
securities representing the right to receive interest only or a
disproportionately large amount of interest, as well as inverse floaters, which
may have imbedded leverage as part of their structural characteristics. We
intend to structure our portfolio to maintain a minimum weighted average rating
(including our deemed comparable ratings for unrated mortgage-backed securities)
of our mortgage-backed securities of at least single "A" under the S&P rating
system and at the comparable level under the other rating systems.
Our allocation of investments among the permitted investment types may
vary from time-to-time based on the evaluation by our board of directors of
economic and market trends and our perception of the relative values available
from these types of investments, except that in no event will our investments
that are not high quality exceed 25% of our total assets.
We intend to acquire only those mortgage-backed securities that we
believe we have the necessary expertise to evaluate and manage, that are
consistent with our balance sheet guidelines and risk management objectives and
that we believe we can readily finance. Since we generally hold the
mortgage-backed securities we acquire until maturity, we generally do not seek
to acquire assets whose investment returns are attractive in only a limited
range of scenarios. We believe that future interest rates and mortgage
prepayment rates are very difficult to predict. Therefore, we seek to acquire
mortgage-backed securities which we believe will provide acceptable returns over
a broad range of interest rate and prepayment scenarios.
At December 31, 2006, our mortgage-backed securities consist of
pass-through certificates and collateralized mortgage obligations issued or
guaranteed by FHLMC, FNMA or GNMA. We have not, and will not, invest in REMIC
residuals and other CMO residuals.
Description of Mortgage-Backed Securities
The mortgage-backed securities that we acquire provide funds for
mortgage loans made primarily to residential homeowners. Our securities
generally represent interests in pools of mortgage loans made by savings and
loan institutions, mortgage bankers, commercial banks and other mortgage
lenders. These pools of mortgage loans are assembled for sale to investors (like
us) by various government, government-related and private organizations.
9
Mortgage-backed securities differ from other forms of traditional debt
securities, which normally provide for periodic payments of interest in fixed
amounts with principal payments at maturity or on specified call dates. Instead,
mortgage-backed securities provide for a monthly payment, which consists of both
interest and principal. In effect, these payments are a "pass-through" of the
monthly interest and principal payments made by the individual borrower on the
mortgage loans, net of any fees paid to the issuer or guarantor of the
securities. Additional payments result from prepayments of principal upon the
sale, refinancing or foreclosure of the underlying residential property, net of
fees or costs which may be incurred. Some mortgage-backed securities, such as
securities issued by GNMA, are described as "modified pass-through." These
securities entitle the holder to receive all interest and principal payments
owed on the mortgage pool, net of certain fees, regardless of whether the
mortgagors actually make mortgage payments when due.
The investment characteristics of pass-through mortgage-backed
securities differ from those of traditional fixed-income securities. The major
differences include the payment of interest and principal on the mortgage-backed
securities on a more frequent schedule, as described above, and the possibility
that principal may be prepaid at any time due to prepayments on the underlying
mortgage loans or other assets. These differences can result in significantly
greater price and yield volatility than is the case with traditional
fixed-income securities.
Various factors affect the rate at which mortgage prepayments occur,
including changes in interest rates, general economic conditions, the age of the
mortgage loan, the location of the property and other social and demographic
conditions. Generally prepayments on mortgage-backed securities increase during
periods of falling mortgage interest rates and decrease during periods of rising
mortgage interest rates. We may reinvest prepayments at a yield that is higher
or lower than the yield on the prepaid investment, thus affecting the weighted
average yield of our investments.
To the extent mortgage-backed securities are purchased at a premium,
faster than expected prepayments result in a faster than expected amortization
of the premium paid. Conversely, if these securities were purchased at a
discount, faster than expected prepayments accelerate our recognition of income.
CMOs may allow for shifting of prepayment risk from slower-paying
tranches to faster-paying tranches. This is in contrast to mortgage pass-through
certificates where all investors share equally in all payments, including all
prepayments, on the underlying mortgages.
FHLMC Certificates
FHLMC is a privately-owned government-sponsored enterprise created
pursuant to an Act of Congress on July 24, 1970. The principal activity of FHLMC
currently consists of the purchase of mortgage loans or participation interests
in mortgage loans and the resale of the loans and participations in the form of
guaranteed mortgage-backed securities. FHLMC guarantees to each holder of FHLMC
certificates the timely payment of interest at the applicable pass-through rate
and ultimate collection of all principal on the holder's pro rata share of the
unpaid principal balance of the related mortgage loans, but does not guarantee
the timely payment of scheduled principal of the underlying mortgage loans. The
obligations of FHLMC under its guarantees are solely those of FHLMC and are not
backed by the full faith and credit of the United States. If FHLMC were unable
to satisfy these obligations, distributions to holders of FHLMC certificates
would consist solely of payments and other recoveries on the underlying mortgage
loans and, accordingly, defaults and delinquencies on the underlying mortgage
loans would adversely affect monthly distributions to holders of FHLMC
certificates.
FHLMC certificates may be backed by pools of single-family mortgage
loans or multi-family mortgage loans. These underlying mortgage loans may have
original terms to maturity of up to 40 years. FHLMC certificates may be issued
under cash programs (composed of mortgage loans purchased from a number of
sellers) or guarantor programs (composed of mortgage loans acquired from one
seller in exchange for certificates representing interests in the mortgage loans
purchased).
FHLMC certificates may pay interest at a fixed rate or an adjustable
rate. The interest rate paid on adjustable-rate FHLMC certificates ("FHLMC
ARMs") adjusts periodically within 60 days prior to the month in which the
interest rates on the underlying mortgage loans adjust. The interest rates paid
on certificates issued under FHLMC's standard ARM programs adjust in relation to
the Treasury index. Other specified indices used in FHLMC ARM programs include
the 11th District Cost of Funds Index published by the Federal Home Loan Bank of
San Francisco, LIBOR and other indices. Interest rates paid on fully-indexed
FHLMC ARM certificates equal the applicable index rate plus a specified number
of basis points. The majority of series of FHLMC ARM certificates issued to date
have evidenced pools of mortgage loans with monthly, semi-annual or annual
interest adjustments. Adjustments in the interest rates paid are generally
limited to an annual increase or decrease of either 100 or 200 basis points and
to a lifetime cap of 500 or 600 basis points over the initial interest rate.
Certain FHLMC programs include mortgage loans which allow the borrower to
convert the adjustable mortgage interest rate to a fixed rate. Adjustable-rate
mortgages which are converted into fixed-rate mortgage loans are repurchased by
FHLMC or by the seller of the loan to FHLMC at the unpaid principal balance of
the loan plus accrued interest to the due date of the last adjustable rate
interest payment.
10
FNMA Certificates
FNMA is a privately-owned, federally-chartered corporation organized
and existing under the Federal National Mortgage Association Charter Act. FNMA
provides funds to the mortgage market primarily by purchasing home mortgage
loans from local lenders, thereby replenishing their funds for additional
lending. FNMA guarantees to the registered holder of a FNMA certificate that it
will distribute amounts representing scheduled principal and interest on the
mortgage loans in the pool underlying the FNMA certificate, whether or not
received, and the full principal amount of any such mortgage loan foreclosed or
otherwise finally liquidated, whether or not the principal amount is actually
received. The obligations of FNMA under its guarantees are solely those of FNMA
and are not backed by the full faith and credit of the United States. If FNMA
were unable to satisfy its obligations, distributions to holders of FNMA
certificates would consist solely of payments and other recoveries on the
underlying mortgage loans and, accordingly, defaults and delinquencies on the
underlying mortgage loans would adversely affect monthly distributions to
holders of FNMA.
FNMA certificates may be backed by pools of single-family or
multi-family mortgage loans. The original term to maturity of any such mortgage
loan generally does not exceed 40 years. FNMA certificates may pay interest at a
fixed rate or an adjustable rate. Each series of FNMA ARM certificates bears an
initial interest rate and margin tied to an index based on all loans in the
related pool, less a fixed percentage representing servicing compensation and
FNMA's guarantee fee. The specified index used in different series has included
the Treasury Index, the 11th District Cost of Funds Index published by the
Federal Home Loan Bank of San Francisco, LIBOR and other indices. Interest rates
paid on fully-indexed FNMA ARM certificates equal the applicable index rate plus
a specified number of basis points. The majority of series of FNMA ARM
certificates issued to date have evidenced pools of mortgage loans with monthly,
semi-annual or annual interest rate adjustments. Adjustments in the interest
rates paid are generally limited to an annual increase or decrease of either 100
or 200 basis points and to a lifetime cap of 500 or 600 basis points over the
initial interest rate. Certain FNMA programs include mortgage loans which allow
the borrower to convert the adjustable mortgage interest rate of the ARM to a
fixed rate. Adjustable-rate mortgages which are converted into fixed-rate
mortgage loans are repurchased by FNMA or by the seller of the loans to FNMA at
the unpaid principal of the loan plus accrued interest to the due date of the
last adjustable rate interest payment. Adjustments to the interest rates on FNMA
ARM certificates are typically subject to lifetime caps and periodic rate or
payment caps.
GNMA Certificates
GNMA is a wholly owned corporate instrumentality of the United States
within the Department of Housing and Urban Development ("HUD"). The National
Housing Act of 1934 authorizes GNMA to guarantee the timely payment of the
principal of and interest on certificates which represent an interest in a pool
of mortgages insured by the Federal Housing Administration ("FHA") or partially
guaranteed by the Department of Veterans Affairs and other loans eligible for
inclusion in mortgage pools underlying GNMA certificates. Section 306(g) of the
Housing Act provides that the full faith and credit of the United States is
pledged to the payment of all amounts which may be required to be paid under any
guaranty by GNMA.
At present, most GNMA certificates are backed by single-family mortgage
loans. The interest rate paid on GNMA certificates may be a fixed rate or an
adjustable rate. The interest rate on GNMA certificates issued under GNMA's
standard ARM program adjusts annually in relation to the Treasury index.
Adjustments in the interest rate are generally limited to an annual increase or
decrease of 100 basis points and to a lifetime cap of 500 basis points over the
initial coupon rate.
11
Single-Family and Multi-Family Privately-Issued Certificates
Single-family and multi-family privately-issued certificates are
pass-through certificates that are not issued by one of the agencies and that
are backed by a pool of conventional single-family or multi-family mortgage
loans. These certificates are issued by originators of, investors in, and other
owners of mortgage loans, including savings and loan associations, savings
banks, commercial banks, mortgage banks, investment banks and special purpose
"conduit" subsidiaries of these institutions.
While agency pass-through certificates are backed by the express
obligation or guarantee of one of the agencies, as described above,
privately-issued certificates are generally covered by one or more forms of
private (i.e., non-governmental) credit enhancements. These credit enhancements
provide an extra layer of loss coverage in the event that losses are incurred
upon foreclosure sales or other liquidations of underlying mortgaged properties
in amounts that exceed the equity holder's equity interest in the property.
Forms of credit enhancements include limited issuer guarantees, reserve funds,
private mortgage guaranty pool insurance, over-collateralization and
subordination.
Subordination is a form of credit enhancement frequently used and
involves the issuance of classes of senior and subordinated mortgage-backed
securities. These classes are structured into a hierarchy to allocate losses on
the underlying mortgage loans and also for defining priority of rights to
payment of principal and interest. Typically, one or more classes of senior
securities are created which are rated in one of the two highest rating levels
by one or more nationally recognized rating agencies and which are supported by
one or more classes of mezzanine securities and subordinated securities that
bear losses on the underlying loans prior to the classes of senior securities.
Mezzanine securities, as used in this Form 10-K, refers to classes that are
rated below the two highest levels, but no lower than a single "B" rating under
the S&P rating system (or comparable level under other rating systems) and are
supported by one or more classes of subordinated securities which bear realized
losses prior to the classes of mezzanine securities. Subordinated securities, as
used in this Form 10-K, refers to any class that bears the "first loss" from
losses from underlying mortgage loans or that is rated below a single "B" level
(or, if unrated, we deem it to be below that level). In some cases, only classes
of senior securities and subordinated securities are issued. By adjusting the
priority of interest and principal payments on each class of a given series of
senior-subordinated mortgage-backed securities, issuers are able to create
classes of mortgage-backed securities with varying degrees of credit exposure,
prepayment exposure and potential total return, tailored to meet the needs of
sophisticated institutional investors.
Collateralized Mortgage Obligations and Multi-Class Pass-Through
Securities
We may also invest in CMOs and multi-class pass-through securities.
CMOs are debt obligations issued by special purpose entities that are secured by
mortgage loans or mortgage-backed certificates, including, in many cases,
certificates issued by government and government-related guarantors, including,
GNMA, FNMA and FHLMC, together with certain funds and other collateral.
Multi-class pass-through securities are equity interests in a trust composed of
mortgage loans or other mortgage-backed securities. Payments of principal and
interest on underlying collateral provide the funds to pay debt service on the
CMO or make scheduled distributions on the multi-class pass-through securities.
CMOs and multi-class pass-through securities may be issued by agencies or
instrumentalities of the U.S. Government or by private organizations. The
discussion of CMOs in the following paragraphs is similarly applicable to
multi-class pass-through securities.
In a CMO, a series of bonds or certificates is issued in multiple
classes. Each class of CMOs, often referred to as a "tranche," is issued at a
specific coupon rate (which, as discussed below, may be an adjustable rate
subject to a cap) and has a stated maturity or final distribution date.
Principal prepayments on collateral underlying a CMO may cause it to be retired
substantially earlier than the stated maturity or final distribution date.
Interest is paid or accrues on all classes of a CMO on a monthly, quarterly or
semi-annual basis. The principal and interest on underlying mortgages may be
allocated among the several classes of a series of a CMO in many ways. In a
common structure, payments of principal, including any principal prepayments, on
the underlying mortgages are applied to the classes of the series of a CMO in
the order of their respective stated maturities or final distribution dates, so
that no payment of principal will be made on any class of a CMO until all other
classes having an earlier stated maturity or final distribution date have been
paid in full.
12
Other types of CMO issues include classes such as parallel pay CMOs,
some of which, such as planned amortization class CMOs ("PAC bonds"), provide
protection against prepayment uncertainty. Parallel pay CMOs are structured to
provide payments of principal on certain payment dates to more than one class.
These simultaneous payments are taken into account in calculating the stated
maturity date or final distribution date of each class which, as with other CMO
structures, must be retired by its stated maturity date or final distribution
date but may be retired earlier. PAC bonds generally require payment of a
specified amount of principal on each payment date so long as prepayment speeds
on the underlying collateral fall within a specified range.
Other types of CMO issues include targeted amortization class CMOs (or
TAC bonds), which are similar to PAC bonds. While PAC bonds maintain their
amortization schedule within a specified range of prepayment speeds, TAC bonds
are generally targeted to a narrow range of prepayment speeds or a specified
prepayment speed. TAC bonds can provide protection against prepayment
uncertainty since cash flows generated from higher prepayments of the underlying
mortgage-related assets are applied to the various other pass-through tranches
so as to allow the TAC bonds to maintain their amortization schedule.
A CMO may be subject to the issuer's right to redeem the CMO prior to
its stated maturity date, which may diminish the anticipated return on our
investment. Privately-issued CMOs are supported by private credit enhancements
similar to those used for privately-issued certificates and are often issued as
senior-subordinated mortgage-backed securities. We will only acquire CMOs or
multi-class pass-through certificates that constitute debt obligations or
beneficial ownership in grantor trusts holding mortgage loans, or regular
interests in REMICs, or that otherwise constitute qualified REIT real estate
assets under the Internal Revenue Code (provided that we have obtained a
favorable opinion of our tax advisor or a ruling from the IRS to that effect).
Adjustable-Rate Mortgage Pass-Through Certificates and Floating Rate
Mortgage-Backed Securities
Most of the mortgage pass-through certificates we acquire are
adjustable-rate mortgage pass-through certificates. This means that their
interest rates may vary over time based upon changes in an objective index, such
as:
o LIBOR or the London Interbank Offered Rate. The interest rate that
banks in London offer for deposits in London of U.S. dollars.
o Treasury Index. A monthly or weekly average yield of benchmark U.S.
Treasury securities, as published by the Federal Reserve Board.
o CD Rate. The weekly average of secondary market interest rates on
six-month negotiable certificates of deposit, as published by the
Federal Reserve Board.
These indices generally reflect short-term interest rates. The underlying
mortgages for adjustable-rate mortgage pass-through certificates are
adjustable-rate mortgage loans ("ARMs").
We also acquire CMO floaters. One or more tranches of a CMO may have
coupon rates that reset periodically at a specified increment over an index such
as LIBOR. These adjustable-rate tranches are sometime known as CMO floaters and
may be backed by fixed or adjustable-rate mortgages.
There are two main categories of indices for adjustable-rate mortgage
pass-through certificates and floaters: (1) those based on U.S. Treasury
securities, and (2) those derived from calculated measures such as a cost of
funds index or a moving average of mortgage rates. Commonly utilized indices
include the one-year Treasury note rate, the three-month Treasury bill rate, the
six-month Treasury bill rate, rates on long-term Treasury securities, the 11th
District Federal Home Loan Bank Costs of Funds Index, the National Median Cost
of Funds Index, one-month or three-month LIBOR, the prime rate of a specific
bank, or commercial paper rates. Some indices, such as the one-year Treasury
rate, closely mirror changes in market interest rate levels. Others, such as the
11th District Home Loan Bank Cost of Funds Index, tend to lag changes in market
interest rate levels. We seek to diversify our investments in adjustable-rate
mortgage pass-through certificates and floaters among a variety of indices and
reset periods so that we are not at any one time unduly exposed to the risk of
interest rate fluctuations. In selecting adjustable-rate mortgage pass-through
certificates and floaters for investment, we will also consider the liquidity of
the market for the different mortgage-backed securities.
13
We believe that adjustable-rate mortgage pass-through certificates and
floaters are particularly well-suited to our investment objective of high
current income, consistent with modest volatility of net asset value, because
the value of adjustable-rate mortgage pass-through certificates and floaters
generally remains relatively stable as compared to traditional fixed-rate debt
securities paying comparable rates of interest. While the value of
adjustable-rate mortgage pass-through certificates and floaters, like other debt
securities, generally varies inversely with changes in market interest rates
(increasing in value during periods of declining interest rates and decreasing
in value during periods of increasing interest rates), the value of
adjustable-rate mortgage pass-through certificates and floaters should generally
be more resistant to price swings than other debt securities because the
interest rates on these securities move with market interest rates.
Accordingly, as interest rates change, the value of our shares should be
more stable than the value of funds which invest primarily in securities backed
by fixed-rate mortgages or in other non-mortgage-backed debt securities, which
do not provide for adjustment in the interest rates in response to changes in
market interest rates.
Adjustable-rate mortgage pass-through certificates and floaters typically
have caps, which limit the maximum amount by which the interest rate may be
increased or decreased at periodic intervals or over the life of the security.
To the extent that interest rates rise faster than the allowable caps on the
adjustable-rate mortgage pass-through certificates and floaters, these
securities will behave more like fixed-rate securities. Consequently, interest
rate increases in excess of caps can be expected to cause these securities to
behave more like traditional debt securities than adjustable-rate securities
and, accordingly, to decline in value to a greater extent than would be the case
in the absence of these caps.
Adjustable-rate mortgage pass-through certificates and floaters, like
other mortgage-backed securities, differ from conventional bonds in that
principal is to be paid back over the life of the security rather than at
maturity. As a result, we receive monthly scheduled payments of principal and
interest on these securities and may receive unscheduled principal payments
representing prepayments on the underlying mortgages. When we reinvest the
payments and any unscheduled prepayments we receive, we may receive a rate of
interest on the reinvestment which is lower than the rate on the existing
security. For this reason, adjustable-rate mortgage pass-through certificates
and floaters are less effective than longer-term debt securities as a means of
"locking in" longer-term interest rates. Accordingly, adjustable-rate mortgage
pass-through certificates and floaters, while generally having less risk of
price decline during periods of rapidly rising interest rates than fixed-rate
mortgage-backed securities of comparable maturities, have less potential for
capital appreciation than fixed-rate securities during periods of declining
interest rates.
As in the case of fixed-rate mortgage-backed securities, to the extent
these securities are purchased at a premium, faster than expected prepayments
would accelerate our amortization of the premium. Conversely, if these
securities were purchased at a discount, faster than expected prepayments would
accelerate our recognition of income.
As in the case of fixed-rate CMOs, floating-rate CMOs may allow for
shifting of prepayment risk from slower-paying tranches to faster-paying
tranches. This is in contrast to mortgage pass-through certificates where all
investors share equally in all payments, including all prepayments, on the
underlying mortgages.
Other Floating Rate Instruments
We may also invest in structured floating-rate notes issued or guaranteed
by government agencies, such as FNMA and FHLMC. These instruments are typically
structured to reflect an interest rate arbitrage (i.e., the difference between
the agency's cost of funds and the income stream from specified assets of the
agency) and their reset formulas may provide more attractive returns than other
floating rate instruments. The indices used to determine resets are the same as
those described above.
Mortgage Loans
As of December 31, 2006, we have not invested directly in mortgage
loans, but we may from time-to-time invest a small percentage of our assets
directly in single-family, multi-family or commercial mortgage loans. We expect
that the majority of these mortgage loans would be ARM pass-through
certificates. The interest rate on an ARM pass-through certificate is typically
tied to an index (such as LIBOR or the interest rate on Treasury bills), and is
adjustable periodically at specified intervals. These mortgage loans are
typically subject to lifetime interest rate caps and periodic interest rate or
payment caps. The acquisition of mortgage loans generally involves credit risk.
We may obtain credit enhancement to mitigate this risk; however, there can be no
assurances that we will able to obtain credit enhancement or that credit
enhancement would mitigate the credit risk of the underlying mortgage loans.
14
Capital Investment Policy
Asset Acquisitions
Our capital investment policy provides that at least 75% of our total
assets will be comprised of high quality mortgage-backed securities and
short-term investments. The remainder of our assets (comprising not more than
25% of total assets), may consist of mortgage-backed securities and other
qualified REIT real estate assets which are unrated or rated less than high
quality but which are at least "investment grade" (rated "BBB" or better) or, if
not rated, are determined by us to be of comparable credit quality to an
investment which is rated "BBB" or better. In addition, we may directly or
indirectly invest part of this remaining 25% of our assets in other types of
securities, including without limitation, unrated debt, equity or derivative
securities, to the extent consistent with our REIT qualification requirements.
The derivative securities in which we invest may include securities representing
the right to receive interest only or a disproportionately large amount of
interest, as well as inverse floaters, which may have imbedded leverage as part
of their structural characteristics.
Our capital investment policy requires that we structure our portfolio
to maintain a minimum weighted average rating (including our deemed comparable
ratings for unrated mortgage-backed securities) of our mortgage-backed
securities of at least single "A" under the S&P rating system and at the
comparable level under the other rating systems. To date, all of the
mortgage-backed securities we have acquired have been pass-through certificates
or CMOs issued or guaranteed by FHLMC, FNMA or GNMA which, although not rated,
have an implied "AAA" rating.
We intend to acquire only those mortgage-backed securities that we
believe we have the necessary expertise to evaluate and manage, that we can
readily finance and that are consistent with our balance sheet guidelines and
risk management objectives. Since we expect to hold our mortgage-backed
securities until maturity, we generally do not seek to acquire assets whose
investment returns are only attractive in a limited range of scenarios. We
believe that future interest rates and mortgage prepayment rates are very
difficult to predict and, as a result, we seek to acquire mortgage-backed
securities which we believe provide acceptable returns over a broad range of
interest rate and prepayment scenarios.
Among the asset choices available to us, our policy is to acquire those
mortgage-backed securities which we believe generate the highest returns on
capital invested, after consideration of the following:
|X| the amount and nature of anticipated cash flows from the asset;
|X| our ability to pledge the asset to secure collateralized borrowings;
|X| the increase in our capital requirement determined by our capital
investment policy resulting from the purchase and financing of the
asset; and
|X| the costs of financing, hedging and managing the asset.
Prior to acquisition, we assess potential returns on capital employed over the
life of the asset and in a variety of interest rate, yield spread, financing
cost, credit loss and prepayment scenarios.
We also give consideration to balance sheet management and risk
diversification issues. We deem a specific asset which we are evaluating for
potential acquisition as more or less valuable to the extent it serves to
increase or decrease certain interest rate or prepayment risks which may exist
in the balance sheet, to diversify or concentrate credit risk, and to meet the
cash flow and liquidity objectives our management may establish for our balance
sheet from time-to-time. Accordingly, an important part of the asset evaluation
process is a simulation, using risk management models, of the addition of a
potential asset and our associated borrowings and hedges to the balance sheet
and an assessment of the impact this potential asset acquisition would have on
the risks in and returns generated by our balance sheet as a whole over a
variety of scenarios.
15
We focus primarily on the acquisition of adjustable-rate
mortgage-backed securities, including floaters. We have, however, purchased a
significant amount of fixed-rate mortgage-backed securities and may continue to
do so in the future if, in our view, the potential returns on capital invested,
after hedging and all other costs, would exceed the returns available from other
assets or if the purchase of these assets would serve to reduce or diversify the
risks of our balance sheet.
Although we have not yet done so, we may purchase the stock of mortgage
REITs or similar companies when we believe that these purchases would yield
attractive returns on capital employed. When the stock market valuations of
these companies are low in relation to the market value of their assets, these
stock purchases can be a way for us to acquire an interest in a pool of
mortgage-backed securities at an attractive price. We do not, however, presently
intend to invest in the securities of other issuers for the purpose of
exercising control or to underwrite securities of other issuers.
We may acquire newly issued mortgage-backed securities, and also may
seek to expand our capital base in order to further increase our ability to
acquire new assets, when the potential returns from new investments appears
attractive relative to the return expectations of stockholders. We may in the
future acquire mortgage-backed securities by offering our debt or equity
securities in exchange for the mortgage-backed securities.
We generally intend to hold mortgage-backed securities for extended
periods. In addition, the REIT provisions of the Internal Revenue Code limit in
certain respects our ability to sell mortgage-backed securities. We may decide
however to sell assets from time to time, for a number of reasons, including our
desire to dispose of an asset as to which credit risk concerns have arisen, to
reduce interest rate risk, to substitute one type of mortgage-backed security
for another, to improve yield or to maintain compliance with the 55% requirement
under the Investment Company Act, or generally to re-structure the balance sheet
when we deem advisable. Our board of directors has not adopted any policy that
would restrict management's authority to determine the timing of sales or the
selection of mortgage-backed securities to be sold.
We do not invest in REMIC residuals or other CMO residuals.
As a requirement for maintaining REIT status, we will distribute to
stockholders aggregate dividends equaling at least 90% of our REIT taxable
income (determined without regard to the deduction for dividends paid and by
excluding any net capital gain) for each taxable year. We will make additional
distributions of capital when the return expectations of the stockholders appear
to exceed returns potentially available to us through making new investments in
mortgage-backed securities. Subject to the limitations of applicable securities
and state corporation laws, we can distribute capital by making purchases of our
own capital stock or through paying down or repurchasing any outstanding
uncollateralized debt obligations.
Our asset acquisition strategy may change over time as market
conditions change and as we evolve.
Credit Risk Management
We have not taken on credit risk to date, but may do so in the future.
In that event, we will review credit risk and other risk of loss associated with
each investment and determine the appropriate allocation of capital to apply to
the investment under our capital investment policy. Our board of directors will
monitor the overall portfolio risk and determine appropriate levels of provision
for loss.
Capital and Leverage
We expect generally to maintain a debt-to-equity ratio of between 8:1
and 12:1, although the ratio may vary from time-to-time depending upon market
conditions and other factors our management deems relevant, including the
composition of our balance sheet, haircut levels required by lenders, the market
value of the mortgage-backed securities in our portfolio and "excess capital
cushion" percentages (as described below) set by our board of directors from
time to time. For purposes of calculating this ratio, our equity (or capital
base) is equal to the value of our investment portfolio on a mark-to-market
basis less the book value of our obligations under repurchase agreements and
other collateralized borrowings. For the calculation of this ratio, equity
includes the Series B Cumulative Convertible Preferred Stock, which is not
included in equity under Generally Accepted Accounting Principles.
16
Our goal is to strike a balance between the under-utilization of
leverage, which reduces potential returns to stockholders, and the
over-utilization of leverage, which could reduce our ability to meet our
obligations during adverse market conditions. Our capital investment policy
limits our ability to acquire additional assets during times when our
debt-to-equity ratio exceeds 12:1. At December 31, 2006, our ratio of
debt-to-equity was 10.4:1. Our capital base represents the approximate
liquidation value of our investments and approximates the market value of assets
that we can pledge or sell to meet over-collateralization requirements for our
borrowings. The unpledged portion of our capital base is available for us to
pledge or sell as necessary to maintain over-collateralization levels for our
borrowings.
We are prohibited from acquiring additional assets during periods when
our capital base is less than the minimum amount required under our capital
investment policy, except as may be necessary to maintain REIT status or our
exemption from the Investment Company Act of 1940, as amended (the "Investment
Company Act"). In addition, when our capital base falls below our risk-managed
capital requirement, our management is required to submit to our board of
directors a plan for bringing our capital base into compliance with our capital
investment policy guidelines. We anticipate that in most circumstances we can
achieve this goal without overt management action through the natural process of
mortgage principal repayments. We anticipate that our capital base is likely to
exceed our risk-managed capital requirement during periods following new equity
offerings and during periods of falling interest rates and that our capital base
could fall below the risk-managed capital requirement during periods of rising
interest rates.
The first component of our capital requirements is the current
aggregate over-collateralization amount or "haircut" the lenders require us to
hold as capital. The haircut for each mortgage-backed security is determined by
our lenders based on the risk characteristics and liquidity of the asset.
Haircut levels on individual borrowings generally range from 3% or less for
certain FHLMC, FNMA or GNMA mortgage-backed securities to 20% for certain
privately-issued mortgage-backed securities. At December 31, 2006, the weighted
average haircut level on our securities was 3.0%. Should the market value of our
pledged assets decline, we will be required to deliver additional collateral to
our lenders to maintain a constant over-collateralization level on our
borrowings.
The second component of our capital requirement is the "excess capital
cushion." This is an amount of capital in excess of the haircuts required by our
lenders. We maintain the excess capital cushion to meet the demands of our
lenders for additional collateral should the market value of our mortgage-backed
securities decline. The aggregate excess capital cushion equals the sum of
liquidity cushion amounts assigned under our capital investment policy to each
of our mortgage-backed securities. We assign excess capital cushions to each
mortgage-backed security based on our assessment of the mortgage-backed
security's market price volatility, credit risk, liquidity and attractiveness
for use as collateral by lenders. The process of assigning excess capital
cushions relies on our management's ability to identify and weigh the relative
importance of these and other factors. In assigning excess capital cushions, we
also give consideration to hedges associated with the mortgage-backed security
and any effect such hedges may have on reducing net market price volatility,
concentration or diversification of credit and other risks in the balance sheet
as a whole and the net cash flows that we can expect from the interaction of the
various components of our balance sheet.
Our capital investment policy stipulates that at least 25% of the
capital base maintained to satisfy the excess capital cushion must be invested
in AAA-rated adjustable-rate mortgage-backed securities or assets with similar
or better liquidity characteristics.
A substantial portion of our borrowings are short-term or variable-rate
borrowings. Our borrowings are implemented primarily through repurchase
agreements, but in the future may also be obtained through loan agreements,
lines of credit, dollar-roll agreements (an agreement to sell a security for
delivery on a specified future date and a simultaneous agreement to repurchase
the same or a substantially similar security on a specified future date) and
other credit facilities with institutional lenders and issuance of debt
securities such as commercial paper, medium-term notes, CMOs and senior or
subordinated notes. We enter into financing transactions only with institutions
that we believe are sound credit risks and follow other internal policies
designed to limit our credit and other exposure to financing institutions.
We expect to continue to use repurchase agreements as our principal
financing device to leverage our mortgage-backed securities portfolio. We
anticipate that, upon repayment of each borrowing under a repurchase agreement,
we will use the collateral immediately for borrowing under a new repurchase
agreement. At present, we have entered into uncommitted facilities with 30
lenders for borrowings in the form of repurchase agreements. We have not at the
present time entered into any commitment agreements under which the lender would
be required to enter into new repurchase agreements during a specified period of
time, nor do we presently plan to have liquidity facilities with commercial
banks. We may, however, enter into such commitment agreements in the future. We
enter into repurchase agreements primarily with national broker-dealers,
commercial banks and other lenders which typically offer this type of financing.
We enter into collateralized borrowings only with financial institutions meeting
credit standards approved by our board of directors, and we monitor the
financial condition of these institutions on a regular basis.
17
A repurchase agreement, although structured as a sale and repurchase
obligation, acts as a financing under which we effectively pledge our
mortgage-backed securities as collateral to secure a short-term loan. Generally,
the other party to the agreement makes the loan in an amount equal to a
percentage of the market value of the pledged collateral. At the maturity of the
repurchase agreement, we are required to repay the loan and correspondingly
receive back our collateral. While used as collateral, the mortgage-backed
securities continue to pay principal and interest which are for our benefit. In
the event of our insolvency or bankruptcy, certain repurchase agreements may
qualify for special treatment under the Bankruptcy Code, the effect of which,
among other things, would be to allow the creditor under the agreement to avoid
the automatic stay provisions of the Bankruptcy Code and to foreclose on the
collateral agreement without delay. In the event of the insolvency or bankruptcy
of a lender during the term of a repurchase agreement, the lender may be
permitted, under applicable insolvency laws, to repudiate the contract, and our
claim against the lender for damages may be treated simply as an unsecured
creditor. In addition, if the lender is a broker or dealer subject to the
Securities Investor Protection Act of 1970, or an insured depository institution
subject to the Federal Deposit Insurance Act, our ability to exercise our rights
to recover our securities under a repurchase agreement or to be compensated for
any damages resulting from the lender's insolvency may be further limited by
those statutes. These claims would be subject to significant delay and, if and
when received, may be substantially less than the damages we actually incur.
Substantially all of our borrowing agreements require us to deposit
additional collateral in the event the market value of existing collateral
declines, which may require us to sell assets to reduce our borrowings. We have
designed our liquidity management policy to maintain a cushion of equity
sufficient to provide required liquidity to respond to the effects under our
borrowing arrangements of interest rate movements and changes in market value of
our mortgage-backed securities, as described above. However, a major disruption
of the repurchase or other market that we rely on for short-term borrowings
would have a material adverse effect on us unless we were able to arrange
alternative sources of financing on comparable terms.
Our articles of incorporation and bylaws do not limit our ability to
incur borrowings, whether secured or unsecured.
Interest Rate Risk Management
To the extent consistent with our election to qualify as a REIT, we
follow an interest rate risk management program intended to protect our
portfolio of mortgage-backed securities and related debt against the effects of
major interest rate changes. Specifically, our interest rate risk management
program is formulated with the intent to offset the potential adverse effects
resulting from rate adjustment limitations on our mortgage-backed securities and
the differences between interest rate adjustment indices and interest rate
adjustment periods of our adjustable-rate mortgage-backed securities and related
borrowings.
Our interest rate risk management program encompasses a number of
procedures, including the following:
|X| we attempt to structure our borrowings to have interest rate
adjustment indices and interest rate adjustment periods that, on an
aggregate basis, generally correspond to the interest rate adjustment
indices and interest rate adjustment periods of our adjustable-rate
mortgage-backed securities; and
|X| we attempt to structure our borrowing agreements relating to
adjustable-rate mortgage-backed securities to have a range of
different maturities and interest rate adjustment periods (although
substantially all will be less than one year).
We adjust the average maturity adjustment periods of our borrowings on
an ongoing basis by changing the mix of maturities and interest rate adjustment
periods as borrowings come due and are renewed. Through use of these procedures,
we attempt to minimize the differences between the interest rate adjustment
periods of our mortgage-backed securities and related borrowings that may occur.
18
We purchase from time-to-time interest rate swaps. We may enter into
interest rate collars, interest rate caps or floors, and purchase interest-only
mortgage-backed securities and similar instruments to attempt to mitigate the
risk of the cost of our variable rate liabilities increasing at a faster rate
than the earnings on our assets during a period of rising interest rates or to
mitigate prepayment risk. We may hedge as much of the interest rate risk as our
management determines is in our best interests, given the cost of the hedging
transactions and the need to maintain our status as a REIT. This determination
may result in our electing to bear a level of interest rate or prepayment risk
that could otherwise be hedged when management believes, based on all relevant
facts, that bearing the risk is advisable.
We seek to build a balance sheet and undertake an interest rate risk
management program which is likely to generate positive earnings and maintain an
equity liquidation value sufficient to maintain operations given a variety of
potentially adverse circumstances. Accordingly, our interest rate risk
management program addresses both income preservation, as discussed above, and
capital preservation concerns. For capital preservation, we monitor our
"duration." This is the expected percentage change in market value of our assets
that would be caused by a 1% change in short and long-term interest rates. To
monitor weighted average duration and the related risks of fluctuations in the
liquidation value of our equity, we model the impact of various economic
scenarios on the market value of our mortgage-backed securities and liabilities.
At December 31, 2006, we estimate that the duration of our assets was 3.26, and
giving effect to the swap transactions, our weighted average duration was 1.93.
We believe that our interest rate risk management program will allow us to
maintain operations throughout a wide variety of potentially adverse
circumstances. Nevertheless, in order to further preserve our capital base (and
lower our duration) during periods when we believe a trend of rapidly rising
interest rates has been established, we may decide to increase hedging
activities or to sell assets. Each of these actions may lower our earnings and
dividends in the short term to further our objective of maintaining attractive
levels of earnings and dividends over the long term.
We may elect to conduct a portion of our hedging operations through one
or more subsidiary corporations, each of which we would elect to treat as a
"taxable REIT subsidiary." To comply with the asset tests applicable to us as a
REIT, we could own 100% of the voting stock of such subsidiary, provided that
the value of the stock that we own in all such taxable REIT subsidiaries does
not exceed 20% of the value of our total assets at the close of any calendar
quarter. A taxable subsidiary, such as FIDAC, would not elect REIT status and
would distribute any net profit after taxes to us and its other stockholders.
Any dividend income we receive from the taxable subsidiary (combined with all
other income generated from our assets, other than qualified REIT real estate
assets) must not exceed 25% of our gross income.
We believe that we have developed a cost-effective asset/liability
management program to provide a level of protection against interest rate and
prepayment risks. However, no strategy can completely insulate us from interest
rate changes and prepayment risks. Further, as noted above, the federal income
tax requirements that we must satisfy to qualify as a REIT limit our ability to
hedge our interest rate and prepayment risks. We monitor carefully, and may have
to limit, our asset/liability management program to assure that we do not
realize excessive hedging income, or hold hedging assets having excess value in
relation to total assets, which could result in our disqualification as a REIT,
the payment of a penalty tax for failure to satisfy certain REIT tests under the
Internal Revenue Code, provided the failure was for reasonable cause. In
addition, asset/liability management involves transaction costs which increase
dramatically as the period covered by the hedging protection increases.
Therefore, we may be unable to hedge effectively our interest rate and
prepayment risks.
Prepayment Risk Management
We seek to minimize the effects of faster or slower than anticipated
prepayment rates through structuring a diversified portfolio with a variety of
prepayment characteristics, investing in mortgage-backed securities with
prepayment prohibitions and penalties, investing in certain mortgage-backed
security structures which have prepayment protections, and balancing assets
purchased at a premium with assets purchased at a discount. We monitor
prepayment risk through periodic review of the impact of a variety of prepayment
scenarios on our revenues, net earnings, dividends, cash flow and net balance
sheet market value.
19
Future Revisions in Policies and Strategies
Our board of directors has established the investment policies and
operating policies and strategies set forth in this Form 10-K. The board of
directors has the power to modify or waive these policies and strategies without
the consent of the stockholders to the extent that the board of directors
determines that the modification or waiver is in the best interests of our
stockholders. Among other factors, developments in the market which affect our
policies and strategies or which change our assessment of the market may cause
our board of directors to revise our policies and strategies.
Potential Acquisitions, Strategic Alliances and Other Investments
From time-to-time we have had discussions with other parties regarding
possible transactions including acquisitions of other businesses or assets,
investments in other entities, joint venture arrangements, or strategic
alliances. To date, except for the acquisition of FIDAC, none of these
discussions have gone beyond the preliminary stage. We have also considered from
time-to-time entering into related businesses, although to date we have not
entered into such businesses. In addition, during 2006 FIDAC expanded its line
of business to include the management of equity securities, initially for us and
an affiliated person, and the management of collateralized debt obligations.
We may, from time-to- time, continue to explore possible acquisitions,
investments, joint venture arrangements and strategic alliances.
Dividend Reinvestment and Share Purchase Plan
We have adopted a dividend reinvestment and share purchase plan. Under
the dividend reinvestment feature of the plan, existing shareholders can
reinvest their dividends in additional shares of our common stock. Under the
share purchase feature of the plan, new and existing shareholders can purchase
shares of our common stock. We have an effective shelf registration statement on
Form S-3 which initially registered 2,000,000 shares that could be issued under
the plan. We still sell shares covered by this registration statement under the
plan.
At the Market Sales Programs
We have entered into an ATM Equity Offering(sm) Sales Agreement with
Merrill Lynch & Co. and Merrill Lynch, Pierce, Fenner & Smith Incorporated (or
Merrill Lynch), relating to the sale of shares of our common stock from time to
time through Merrill Lynch. We have also entered into a ATM Equity Sales
Agreement with UBS Securities LLC (or UBS Securities), relating to the sale of
shares of our common stock from time to time through UBS Securities. Under these
agreements, sales of the shares, if any, will be made by means of ordinary
brokers' transaction of the New York Stock Exchange at market prices.
Legal Proceedings
From time-to-time, we are involved in various claims and legal actions
arising in the ordinary course of business. In the opinion of management, the
ultimate disposition of these matters will not have a material adverse effect on
our consolidated financial statements.
Employees
As of December 31, 2006, we had 34 full time employees. None of our
employees are subject to any collective bargaining agreements. We believe we
have good relations with our employees.
Available Information
Our investor relations website is www.annaly.com. We make available on
this website under "Financial Reports and SEC filings," free of charge, our
annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on
Form 8-K and amendments to those reports as soon as reasonably practicable after
we electronically file or furnish such materials to the SEC.
20
COMPETITION
We believe that our principal competition in the acquisition and holding
of the types of mortgage-backed securities we purchase are financial
institutions such as banks, savings and loans, life insurance companies,
institutional investors such as mutual funds and pension funds, and certain
other mortgage REITs. Some of our competitors have greater financial resources
and access to capital than we do. Our competitors, as well as additional
competitors which may emerge in the future, may increase the competition for the
acquisition of mortgage-backed securities, which in turn may result in higher
prices and lower yields on assets.
ITEM 1A. RISK FACTORS
-----------------------
An investment in our stock involves a number of risks. Before making an
investment decision, you should carefully consider all of the risks described in
this Form 10-K. If any of the risks discussed in this Form 10-K actually occur,
our business, financial condition and results of operations could be materially
adversely affected. If this were to occur, the trading price of our stock could
decline significantly and you may lose all or part of your investment.
Risks Related to Our Business
An increase in the interest payments on our borrowings relative to the interest
we earn on our investment securities may adversely affect our profitability
We earn money based upon the spread between the interest payments we
earn on our investment securities and the interest payments we must make on our
borrowings. If the interest payments on our borrowings increase relative to the
interest we earn on our investment securities, our profitability may be
adversely affected.
The interest payments on our borrowings may increase relative to the
interest we earn on our adjustable-rate investment securities for various
reasons discussed in this section.
o Differences in timing of interest rate adjustments on our investment
securities and our borrowings may adversely affect our profitability
We rely primarily on short-term borrowings to acquire investment
securities with long-term maturities. Accordingly, if short-term interest rates
increase, this may adversely affect our profitability.
Most of the investment securities we acquire are adjustable-rate
securities. This means that their interest rates may vary over time based upon
changes in an objective index, such as:
- LIBOR. The interest rate that banks in London offer for deposits
in London of U.S. dollars.
- Treasury Rate. A monthly or weekly average yield of benchmark
U.S. Treasury securities, as published by the Federal Reserve
Board.
- CD Rate. The weekly average of secondary market interest rates on
six-month negotiable certificates of deposit, as published by the
Federal Reserve Board.
These indices generally reflect short-term interest rates. On December
31, 2006, approximately 28% of our investment securities were adjustable-rate
securities.
The interest rates on our borrowings similarly vary with changes in an
objective index. Nevertheless, the interest rates on our borrowings generally
adjust more frequently than the interest rates on our adjustable-rate investment
securities. For example, on December 31, 2006, our adjustable-rate investment
securities had a weighted average term to next rate adjustment of 19 months,
while our borrowings had a weighted average term to next rate adjustment of 125
days. Accordingly, in a period of rising interest rates, we could experience a
decrease in net income or a net loss because the interest rates on our
borrowings adjust faster than the interest rates on our adjustable-rate
investment securities.
21
o Interest rate caps on our investment securities may adversely affect
our profitability
Our adjustable-rate investment securities are typically subject to
periodic and lifetime interest rate caps. Periodic interest rate caps limit the
amount an interest rate can increase during any given period. Lifetime interest
rate caps limit the amount an interest rate can increase through maturity of an
investment security. Our borrowings are not subject to similar restrictions.
Accordingly, in a period of rapidly increasing interest rates, we could
experience a decrease in net income or experience a net loss because the
interest rates on our borrowings could increase without limitation while the
interest rates on our adjustable-rate investment securities would be limited by
caps.
o Because we acquire fixed-rate securities, an increase in interest
rates may adversely affect our profitability
While the majority of our investments consist of adjustable-rate
investment securities, we also invest in fixed-rate mortgage-backed securities.
In a period of rising interest rates, our interest payments could increase while
the interest we earn on our fixed-rate mortgage-backed securities would not
change. This would adversely affect our profitability. On December 31, 2006,
approximately 72% of our investment securities were fixed-rate securities.
An increase in prepayment rates may adversely affect our profitability
The mortgage-backed securities we acquire are backed by pools of
mortgage loans. We receive payments, generally, from the payments that are made
on these underlying mortgage loans. When borrowers prepay their mortgage loans
at rates that are faster than expected, this results in prepayments that are
faster than expected on the mortgage-backed securities. These faster than
expected prepayments may adversely affect our profitability.
We often purchase mortgage-backed securities that have a higher
interest rate than the market interest rate at the time. In exchange for this
higher interest rate, we must pay a premium over the market value to acquire the
security. In accordance with accounting rules, we amortize this premium over the
term of the mortgage-backed security. If the mortgage-backed security is prepaid
in whole or in part prior to its maturity date, however, we must expense all or
a part of the remaining unamortized portion of the premium that was prepaid at
the time of the prepayment. This adversely affects our profitability.
Prepayment rates generally increase when interest rates fall and
decrease when interest rates rise, but changes in prepayment rates are difficult
to predict. Prepayment rates also may be affected by conditions in the housing
and financial markets, general economic conditions and the relative interest
rates on fixed-rate and adjustable-rate mortgage loans.
We may seek to reduce prepayment risk by acquiring mortgage-backed
securities at a discount. If a discounted security is prepaid in whole or in
part prior to its maturity date, we will earn income equal to the amount of the
remaining discount. This will improve our profitability if the discounted
securities are prepaid faster than expected.
We also can acquire mortgage-backed securities that are less affected
by prepayments. For example, we can acquire CMOs, a type of mortgage-backed
security. CMOs divide a pool of mortgage loans into multiple tranches that allow
for shifting of prepayment risks from slower-paying tranches to faster-paying
tranches. This is in contrast to pass-through or pay-through mortgage-backed
securities, where all investors share equally in all payments, including all
prepayments. As discussed below, the Investment Company Act imposes restrictions
on our purchase of CMOs. On December 31, 2006, approximately 37% of our
mortgage-backed securities were CMOs and approximately 63% of our
mortgage-backed securities were pass-through or pay-through securities.
While we seek to minimize prepayment risk to the extent practical, in
selecting investments we must balance prepayment risk against other risks and
the potential returns of each investment. No strategy can completely insulate us
from prepayment risk.
22
An increase in interest rates may adversely affect our book value
Increases in interest rates may negatively affect the market value of
our investment securities. Our fixed-rate securities, generally, are more
negatively affected by these increases. In accordance with accounting rules, we
reduce our book value by the amount of any decrease in the market value of our
investment securities.
Our strategy involves significant leverage
We seek to maintain a ratio of debt-to-equity of between 8:1 and 12:1,
although our ratio may at times be above or below this amount. We incur this
leverage by borrowing against a substantial portion of the market value of our
investment securities. By incurring this leverage, we can enhance our returns.
Nevertheless, this leverage, which is fundamental to our investment strategy,
also creates significant risks.
o Our leverage may cause substantial losses
Because of our significant leverage, we may incur substantial losses if
our borrowing costs increase. Our borrowing costs may increase for any of the
following reasons:
- short-term interest rates increase;
- the market value of our investment securities decreases;
- interest rate volatility increases; or
- the availability of financing in the market decreases.
o Our leverage may cause margin calls and defaults and force us to sell
assets under adverse market conditions
Because of our leverage, a decline in the value of our investment
securities may result in our lenders initiating margin calls. A margin call
means that the lender requires us to pledge additional collateral to
re-establish the ratio of the value of the collateral to the amount of the
borrowing. Our fixed-rate mortgage-backed securities generally are more
susceptible to margin calls as increases in interest rates tend to more
negatively affect the market value of fixed-rate securities.
If we are unable to satisfy margin calls, our lenders may foreclose on
our collateral. This could force us to sell our investment securities under
adverse market conditions. Additionally, in the event of our bankruptcy, our
borrowings, which are generally made under repurchase agreements, may qualify
for special treatment under the Bankruptcy Code. This special treatment would
allow the lenders under these agreements to avoid the automatic stay provisions
of the Bankruptcy Code and to liquidate the collateral under these agreements
without delay.
o Liquidation of collateral may jeopardize our REIT status
To continue 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 investment securities, we may be unable to comply with these requirements,
ultimately jeopardizing our status as a REIT and our failure to qualify as a
REIT will have adverse tax consequences.
o We may exceed our target leverage ratios
We seek to maintain a ratio of debt-to-equity of between 8:1 and 12:1.
However, we are not required to stay within this leverage ratio. If we exceed
this ratio, the adverse impact on our financial condition and results of
operations from the types of risks described in this section would likely be
more severe.
23
o We may not be able to achieve our optimal leverage
We use leverage as a strategy to increase the return to our investors.
However, we may not be able to achieve our desired leverage for any of the
following reasons:
- we determine that the leverage would expose us to excessive risk;
- our lenders do not make funding available to us at acceptable
rates; or
- our lenders require that we provide additional collateral to
cover our borrowings.
o We may incur increased borrowing costs which would adversely affect
our profitability
Currently, all of our borrowings are collateralized borrowings in the
form of repurchase agreements. If the interest rates on these repurchase
agreements increase, it would adversely affect our profitability.
Our borrowing costs under repurchase agreements generally correspond to
short-term interest rates such as LIBOR or a short-term Treasury index, plus or
minus a margin. The margins on these borrowings over or under short-term
interest rates may vary depending upon:
- the movement of interest rates;
- the availability of financing in the market; or
- the value and liquidity of our investment securities.
If we are unable to renew our borrowings at favorable rates, our profitability
may be adversely affected
Since we rely primarily on short-term borrowings, our ability to
achieve our investment objectives depends not only on our ability to borrow
money in sufficient amounts and on favorable terms, but also on our ability to
renew or replace on a continuous basis our maturing short-term borrowings. If we
are not able to renew or replace maturing borrowings, we would have to sell our
assets under possibly adverse market conditions.
Our hedging strategies expose us to risks
Our policies permit us to enter into interest rate swaps, caps and
floors and other derivative transactions to help us mitigate our interest rate
and prepayment risks described above. We have used interest rate swaps and
interest rate caps to provide a level of protection against interest rate risks,
but no hedging strategy can protect us completely.
o Out hedging strategies may not be successful in mitigating the risks
associated with interest rates
We cannot assure you that our use of derivatives will offset the risks
related to changes in interest rates. It is likely that there will be periods in
the future during which we will incur losses on our derivative financial
instruments that will not be fully offset by gains on our portfolio. The
derivative financial instruments we select may not have the effect of reducing
our interest rate risk. In addition, the nature and timing of hedging
transactions may influence the effectiveness of these strategies. Poorly
designed strategies or improperly executed transactions could significantly
increase our risk and lead to material losses. In addition, hedging strategies
involve transaction and other costs. Our hedging strategy and the derivatives
that we use may not adequately offset the risk of interest rate volatility or
that our hedging transactions may not result in losses.
o Our use of derivatives may expose us to counterparty risks
We enter into interest rate swap and cap agreements to hedge risks
associated with movements in interest rates. If a swap counterparty cannot
perform under the terms of an interest rate swap, we would not receiving
payments due under that agreement, we may lose any unrealized gain associated
with the interest rate swap, and the hedged liability would cease to be hedged
by the interest rate swap. We may also be at risk for any collateral we have
pledged to secure our obligations under the interest rate swap if the
counterparty become insolvent or file for bankruptcy. Similarly, if a cap
counterparty fails to perform under the terms of the cap agreement, in addition
to not receiving payments due under that agreement that would off-sets our
interest expense, we would also incur a loss for all remaining unamortized
premium paid for that agreement.
24
We may face risks of investing in inverse floating rate securities
We may invest in inverse floaters. The returns on inverse floaters are
inversely related to changes in an interest rate. Generally, income on inverse
floaters will decrease when interest rates increase and increase when interest
rates decrease. Investments in inverse floaters may subject us to the risks of
reduced or eliminated interest payments and losses of principal. In addition,
certain indexed securities and inverse floaters may increase or decrease in
value at a greater rate than the underlying interest rate, which effectively
leverages our investment in such securities. As a result, the market value of
such securities will generally be more volatile than that of fixed rate
securities.
Our investment strategy may involve credit risk
We may incur losses if there are payment defaults under our investment
securities.
To date, all of our mortgage-backed securities have been agency
certificates and agency debentures which, although not rated, carry an implied
"AAA" rating. Agency certificates are mortgage pass-through certificates where
Freddie Mac, Fannie Mae or Ginnie Mae guarantees payments of principal or
interest on the certificates. Agency debentures are debt instruments issued by
Freddie Mac, Fannie Mae, or the FHLB.
Even though we have only acquired "AAA" securities so far, pursuant to
our capital investment policy, we have the ability to acquire securities of
lower credit quality. Under our policy:
- 75% of our investments must have a "AA" or higher rating by S&P,
an equivalent rating by a similar nationally recognized rating
organization or our management must determine that the
investments are of comparable credit quality to investments with
these ratings;
- the remaining 25% of our total assets, may consist of other
qualified REIT real estate assets which are unrated or rated less
than high quality, but which are at least "investment grade"
(rated "BBB" or better by Standard & Poor's Corporation ("S&P")
or the equivalent by another nationally recognized rating agency)
or, if not rated, we determine them to be of comparable credit
quality to an investment which is rated "BBB" or better. In
addition, we may directly or indirectly invest part of this
remaining 25% of our assets in other types of securities,
including without limitation, unrated debt, equity or derivate
securities, to the extent consistent with our REIT qualification
requirements. The derivative securities in which we invest may
include securities representing the right to receive interest
only or a disproportionately large amount of interest, as well as
inverse floaters, which may have imbedded leverage as part of
their structural characteristics; and
- we seek to have a minimum weighted average rating for our
portfolio of at least "A" by S&P.
If we acquire securities of lower credit quality, we may incur losses
if there are defaults under those securities or if the rating agencies downgrade
the credit quality of those securities.
We have not established a minimum dividend payment level
We intend to pay quarterly dividends and to make distributions to our
stockholders in amounts such that all or substantially all of our taxable income
in each year (subject to certain adjustments) is distributed. This enables 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 in this section. 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.
25
Because of competition, we may not be able to acquire mortgage-backed securities
at favorable yields
Our net income depends, in large part, on our ability to acquire
mortgage-backed securities at favorable spreads over our borrowing costs. In
acquiring mortgage-backed securities, we compete with other REITs, investment
banking firms, savings and loan associations, banks, insurance companies, mutual
funds, other lenders and other entities that purchase mortgage-backed
securities, many of which have greater financial resources than us. As a result,
in the future, we may not be able to acquire sufficient mortgage-backed
securities at favorable spreads over our borrowing costs.
We are dependent on our key personnel
We are dependent on the efforts of our key officers and employees,
including Michael A. J. Farrell, our Chairman of the board of directors, Chief
Executive Officer and President, Wellington J. Denahan-Norris, our Vice
Chairman, Chief Operating Officer and Chief Investment Officer, and Kathryn F.
Fagan, our Chief Financial Officer and Treasurer. The loss of any of their
services could have an adverse effect on our operations. Although we have
employment agreements with each of them, we cannot assure you they will remain
employed with us.
We and our shareholders are subject to certain tax risks
o Our failure to qualify as a REIT would have adverse tax consequences
We believe that since 1997 we have qualified for taxation as a REIT for
federal income tax purposes. We plan to continue to meet the requirements for
taxation as a REIT. The determination that we are a REIT requires an analysis of
various factual matters and circumstances that may not be totally within our
control. For example, to qualify as a REIT, at least 75% of our gross income
must come from real estate sources and 95% of our gross income must come from
real estate sources and certain other sources that are itemized in the REIT tax
laws. We are also required to distribute to stockholders at least 90% of our
REIT taxable income (determined without regard to the deduction for dividends
paid and by excluding any net capital gain). Even a technical or inadvertent
mistake could jeopardize our REIT status. Furthermore, Congress and the Internal
Revenue Service (or IRS) might make changes to the tax laws and regulations, and
the courts might issue new rulings that make it more difficult or impossible for
us to remain qualified as a REIT.
If we fail to qualify as a REIT, we would be subject to federal income
tax at regular corporate rates. Also, unless the IRS granted us relief under
certain statutory provisions, we would remain disqualified as a REIT for four
years following the year we first fail to qualify. If we fail to qualify as a
REIT, we would have to pay significant income taxes and would therefore have
less money available for investments or for distributions to our stockholders.
This would likely have a significant adverse effect on the value of our
securities. In addition, the tax law would no longer require us to make
distributions to our stockholders.
A REIT that fails the quarterly asset tests for one or more quarters
will not lose its REIT status as a result of such failure if either (i) the
failure is regarded as a de minimis failure under standards set out in the
Internal Revenue Code, or (ii) the failure is greater than a de minimis failure
but is attributable to reasonable cause and not willful neglect. In the case of
a greater than de minimis failure, however, the REIT must pay a tax and must
remedy the failure within 6 months of the close of the quarter in which the
failure was identified. In addition, the Internal Revenue Code provides relief
for failures of other tests imposed as a condition of REIT qualification, as
long as the failures are attributable to reasonable cause and not willful
neglect. A REIT would be required to pay a penalty of $50,000, however, in the
case of each failure.
o We have certain distribution requirements
As a REIT, we must distribute at least 90% of our REIT taxable income
(determined without regard to the deduction for dividends paid and by excluding
any net capital gain). The required distribution limits the amount we have
available for other business purposes, including amounts to fund our growth.
Also, it is possible that because of the differences between the time we
actually receive revenue or pay expenses and the period we report those items
for distribution purposes, we may have to borrow funds on a short-term basis to
meet the 90% distribution requirement.
26
o We are also subject to other tax liabilities
Even if we qualify as a REIT, we may be subject to certain federal,
state and local taxes on our income and property. Any of these taxes would
reduce our operating cash flow.
o Limits on ownership of our common stock could have adverse
consequences to you and could limit your opportunity to receive a
premium on our stock
To maintain our qualification as a REIT for federal income tax
purposes, not more than 50% in value of the outstanding shares of our capital
stock may be owned, directly or indirectly, by five or fewer individuals (as
defined in the federal tax laws to include certain entities). Primarily to
facilitate maintenance of our qualification as a REIT for federal income tax
purposes, our charter will prohibit ownership, directly or by the attribution
provisions of the federal tax laws, by any person of more than 9.8% of the
lesser of the number or value of the issued and outstanding shares of our common
stock and will prohibit ownership, directly or by the attribution provisions of
the federal tax laws, by any person of more than 9.8% of the lesser of the
number or value of the issued and outstanding shares of any class or series of
our preferred stock. Our board of directors, in its sole and absolute
discretion, may waive or modify the ownership limit with respect to one or more
persons who would not be treated as "individuals" for purposes of the federal
tax laws if it is satisfied, based upon information required to be provided by
the party seeking the waiver and upon an opinion of counsel satisfactory to the
board of directors, that ownership in excess of this limit will not otherwise
jeopardize our status as a REIT for federal income tax purposes.
The ownership limit may have the effect of delaying, deferring or
preventing a change in control and, therefore, could adversely affect our
shareholders' ability to realize a premium over the then-prevailing market price
for our common stock in connection with a change in control.
o A REIT cannot invest more than 20% of its total assets in the stock or
securities of one or more taxable REIT subsidiaries; therefore, FIDAC
cannot constitute more than 20% of our total assets
A taxable REIT subsidiary is a corporation, other than a REIT or a
qualified REIT subsidiary, in which a REIT owns stock and which elects taxable
REIT subsidiary status. The term also includes a corporate subsidiary in which
the taxable REIT subsidiary owns more than a 35% interest. A REIT may own up to
100% of the stock of one or more taxable REIT subsidiaries. A taxable REIT
subsidiary may earn income that would not be qualifying income if earned
directly by the parent REIT. Overall, at the close of any calendar quarter, no
more than 20% of the value of a REIT's assets may consist of stock or securities
of one or more taxable REIT subsidiaries.
The stock and securities of FIDAC, our only taxable REIT subsidiary,
are expected to represent less than 20% of the value of our total assets.
Furthermore, we intend to monitor the value of our investments in the stock and
securities of FIDAC (and any other taxable REIT subsidiary in which we may
invest) to ensure compliance with the above-described 20% limitation. We cannot
assure you, however, that we will always be able to comply with the 20%
limitation so as to maintain REIT status.
o Taxable REIT subsidiaries are subject to tax at the regular corporate
rates, are not required to distribute dividends, and the amount of
dividends a taxable REIT subsidiary can pay to its parent REIT may be
limited by REIT gross income tests
A taxable REIT subsidiary must pay income tax at regular corporate
rates on any income that it earns. FIDAC will pay corporate income tax on its
taxable income, and its after-tax net income will be available for distribution
to us. Such income, however, is not required to be distributed.
Moreover, the annual gross income tests that must be satisfied to
ensure REIT qualification may limit the amount of dividends that we can receive
from FIDAC and still maintain our REIT status. Generally, not more than 25% of
our gross income can be derived from non-real estate related sources, such as
dividends from a taxable REIT subsidiary. If, for any taxable year, the
dividends we received from FIDAC, when added to our other items of non-real
estate related income, represented more than 25% of our total gross income for
the year, we could be denied REIT status, unless we were able to demonstrate,
among other things, that our failure of the gross income test was due to
reasonable cause and not willful neglect.
27
The limitations imposed by the REIT gross income tests may impede our
ability to distribute assets from FIDAC to us in the form of dividends. Certain
asset transfers may, therefore, have to be structured as purchase and sale
transactions upon which FIDAC recognizes taxable gain.
o If interest accrues on indebtedness owed by a taxable REIT subsidiary
to its parent REIT at a rate in excess of a commercially reasonable
rate, or if transactions between a REIT and a taxable REIT subsidiary
are entered into on other than arm's-length terms, the REIT may be
subject to a penalty tax
If interest accrues on an indebtedness owed by a taxable REIT
subsidiary to its parent REIT at a rate in excess of a commercially reasonable
rate, the REIT is subject to tax at a rate of 100% on the excess of (i) interest
payments made by a taxable REIT subsidiary to its parent REIT over (ii) the
amount of interest that would have been payable had interest accrued on the
indebtedness at a commercially reasonable rate. A tax at a rate of 100% is also
imposed on any transaction between a taxable REIT subsidiary and its parent REIT
to the extent the transaction gives rise to deductions to the taxable REIT
subsidiary that are in excess of the deductions that would have been allowable
had the transaction been entered into on arm's-length terms. We will scrutinize
all of our transactions with FIDAC in an effort to ensure that we do not become
subject to these taxes. We may not be able to avoid application of these taxes.
Risks of Ownership of Our Common Stock
o Issuances of large amounts of our stock could cause the market price
of our common stock to decline
As of February 26, 2007, 205,350,591 shares of our common stock were
outstanding. If we issue a significant number of shares of common stock or
securities convertible into common stock in a short period of time, there could
be a dilution of the existing common stock and a decrease in the market price of
the common stock.
o We may change our policies without stockholder approval
Our board of directors and management determine all of our policies,
including our investment, financing and distribution policies. They may amend or
revise these policies at any time without a vote of our stockholders. Policy
changes could adversely affect our financial condition, results of operations,
the market price of our common stock or our ability to pay dividends or
distributions.
o Our governing documents and Maryland law impose limitations on the
acquisition of our common stock and changes in control that could make
it more difficult for a third party to acquire us
Maryland Business Combination Act
---------------------------------
The Maryland General Corporation Law establishes special requirements
for "business combinations" between a Maryland corporation and "interested
stockholders" unless exemptions are applicable. An interested stockholder is any
person who beneficially owns 10% or more of the voting power of our
then-outstanding voting stock. Among other things, the law prohibits for a
period of five years a merger and other similar transactions between us and an
interested stockholder unless the board of directors approved the transaction
prior to the party's becoming an interested stockholder. The five-year period
runs from the most recent date on which the interested stockholder became an
interested stockholder. The law also requires a super majority stockholder vote
for such transactions after the end of the five-year period. This means that the
transaction must be approved by at least:
o 80% of the votes entitled to be cast by holders of outstanding voting
shares; and
28
o two-thirds of the votes entitled to be cast by holders of outstanding
voting shares other than shares held by the interested stockholder or
an affiliate of the interested stockholder with whom the business
combination is to be effected.
As permitted by the Maryland General Corporation Law, we have elected
not to be governed by the Maryland business combination statute. We made this
election by opting out of this statute in our articles of incorporation. If,
however, we amend our articles of incorporation to opt back in to the statute,
the business combination statute could have the effect of discouraging offers to
acquire us and of increasing the difficulty of consummating any such offers,
even if our acquisition would be in our stockholders' best interests.
Maryland Control Share Acquisition Act
--------------------------------------
Maryland law provides that "control shares" of a Maryland corporation
acquired in a "control share acquisition" have no voting rights except to the
extent approved by a vote of the stockholders. Two-thirds of the shares eligible
to vote must vote in favor of granting the "control shares" voting rights.
"Control shares" are shares of stock that, taken together with all other shares
of stock the acquirer previously acquired, would entitle the acquirer to
exercise voting power in electing directors within one of the following ranges
of voting power:
o One-tenth or more but less than one third of all voting power;
o One-third or more but less than a majority of all voting power; or
o A majority or more of all voting power.
Control shares do not include shares of stock the acquiring person is
entitled to vote as a result of having previously obtained stockholder approval.
A "control share acquisition" means the acquisition of control shares, subject
to certain exceptions.
If a person who has made (or proposes to make) a control share
acquisition satisfies certain conditions (including agreeing to pay expenses),
he may compel our board of directors to call a special meeting of stockholders
to consider the voting rights of the shares. If such a person makes no request
for a meeting, we have the option to present the question at any stockholders'
meeting.
If voting rights are not approved at a meeting of stockholders then,
subject to certain conditions and limitations, we may redeem any or all of the
control shares (except those for which voting rights have previously been
approved) for fair value. We will determine the fair value of the shares,
without regard to voting rights, as of the date of either:
o the last control share acquisition; or
o the meeting where stockholders considered and did not approve voting
rights of the control shares.
If voting rights for 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 obtain rights as objecting
stockholders and, there under, exercise appraisal rights. This means that you
would be able to force us to redeem your stock for fair value. Under Maryland
law, the fair value may not be less than the highest price per share paid in the
control share acquisition. Furthermore, certain limitations otherwise applicable
to the exercise of dissenters' rights would not apply in the context of a
control share acquisition. The control share acquisition statute would not apply
to shares acquired in a merger, consolidation or share exchange if we were a
party to the transaction. The control share acquisition statute could have the
effect of discouraging offers to acquire us and of increasing the difficulty of
consummating any such offers, even if our acquisition would be in our
stockholders' best interests.
Regulatory Risks
o Loss of Investment Company Act exemption would adversely affect us
29
We intend to conduct our business so as not to become regulated as an
investment company under the Investment Company Act. If we fail to qualify for
this exemption, our ability to use leverage would be substantially reduced, and
we would be unable to conduct our business as described in this Form 10-K.
We rely on the exclusion provided by Section 3(c)(5)(C) of the
Investment Company Act. Section 3(c)(5)(C) as interpreted by the staff of the
SEC, requires us to invest at least 55% of our assets in "mortgages and other
liens on and interest in real estate" (or Qualifying Real Estate Assets) and a
least 80% of our assets in Qualifying Real Estate Assets plus real estate
related assets. The assets that we acquire, therefore, are limited by the
provisions of the Investment Company Act and the rules and regulations
promulgated under the Investment Company Act. If the SEC determines that any of
these securities are not qualifying interests in real estate or real estate
related assets, adopts a contrary interpretation with respect to these
securities or otherwise believes we do not satisfy the above exceptions, we
could be required to restructure our activities or sell certain of our assets.
We may be required at times to adopt less efficient methods of financing certain
of our mortgage assets and we may be precluded from acquiring certain types of
higher yielding mortgage assets. The net effect of these factors will be to
lower our net interest income. If we fail to qualify for exemption from
registration as an investment company, our ability to use leverage would be
substantially reduced, and we would not be able to conduct our business as
described. Our business will be materially and adversely affected if we fail to
qualify for this exemption.
o Compliance with proposed and recently enacted changes in securities
laws and regulations increase our costs
The Sarbanes-Oxley Act of 2002 and rules and regulations promulgated by
the SEC and the New York Stock Exchange have increased the scope, complexity and
cost of corporate governance, reporting and disclosure practices. We believe
that these rules and regulations will make it more costly for us to obtain
director and officer liability insurance, and we may be required to accept
reduced coverage or incur substantially higher costs to obtain coverage. These
rules and regulations could also make it more difficult for us to attract and
retain qualified members of management and our board of directors, particularly
to serve on our audit committee.
ITEM 1B. UNRESOLVED STAFF COMMENTS
------------------------------------
None.
ITEM 2. PROPERTIES
---------------------
Our executive and administrative office is located at 1211 Avenue of
the Americas, Suite 2902 New York, New York 10036, telephone 212-696-0100. This
office is leased under a non-cancelable lease expiring December 31, 2009.
ITEM 3. LEGAL PROCEEDINGS
----------------------------
From time to time, we are involved in various claims and legal actions
arising in the ordinary course of business. In the opinion of management, the
ultimate disposition of these matters will not have a material effect on our
consolidated financial statements.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
--------------------------------------------------------------
We did not submit any matters to a vote of our stockholders during the
fourth quarter of 2006.
30
PART II
-------
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY, RELATED STOCKHOLDER MATTERS
-----------------------------------------------------------------------------
AND ISSUER PURCHASES OF EQUITY SECURITIES
-----------------------------------------
Our common stock began trading publicly on October 8, 1997 and is traded on
the New York Stock Exchange under the trading symbol "NLY". As of February 26,
2007, we had 205,350,591 shares of common stock issued and outstanding which
were held by approximately 114,000 holders of record.
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.
Stock Prices
High Low Close
First Quarter ended March 31, 2006 $12.82 $11.34 $12.14
Second Quarter ended June 30, 2006 $14.04 $11.57 $12.81
Third Quarter ended September 30, 2006 $13.25 $12.17 $13.14
Fourth Quarter ended December 31, 2006 $14.42 $13.01 $13.91
High Low Close
First Quarter ended March 31, 2005 $20.01 $17.34 $18.76
Second Quarter ended June 30, 2005 $20.01 $17.68 $17.93
Third Quarter ended September 30, 2005 $18.05 $12.49 $12.95
Fourth Quarter ended December 31, 2005 $12.90 $10.90 $10.94
Common Dividends
Declared Per Share
First Quarter ended March 31, 2006 $0.11
Second Quarter ended June 30, 2006 $0.13
Third Quarter ended September 30, 2006 $0.14
Fourth Quarter ended December 31, 2006 $0.19
First Quarter ended March 31, 2005 $0.45
Second Quarter ended June 30, 2005 $0.36
Third Quarter ended September 30, 2005 $0.13
Fourth Quarter ended December 31, 2005 $0.10
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. No dividends can be paid on our common stock unless we have paid full
cumulative dividends on our preferred stock. From the date of issuance of our
preferred stock through December 31, 2006, we have paid full cumulative
dividends on our preferred stock.
31
EQUITY COMPENSATION PLAN INFORMATION
We have adopted a long term stock incentive plan for executive
officers, key employees and nonemployee directors (the "Incentive Plan"). 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 ("ISOs") and options not so qualified ("NQSOs"). The Incentive Plan
authorizes the granting of options or other awards for an aggregate of the
greater of 500,000 shares or 9.5% of the outstanding shares of our common stock
up to a ceiling of 8,932,921 shares. For a description of our Incentive Plan,
see Note 9 to the Financial Statements.
The following table provides information as of December 31, 2006
concerning shares of our common stock authorized for issuance under our existing
Incentive Plan.
Number of securities
Number of securities to be Weighted-average exercise remaining available for
issued upon exercise of price of outstanding future issuance under
Plan Category outstanding options, options, warrants and Incentive Plan (excluding
warrants and rights rights previously issued)
----------------------------------------------------------------------------------------------------------------------
Equity compensation plans
approved by security holders 2,984,995 $15.10 5,239,500(1)
Equity compensation plans not
approved by security holders - - -
--------------------------------------------------------------------------------------
Total 2,984,995 $15.10 5,239,500
======================================================================================
(1) The Incentive Plan authorizes the granting of options or other awards for an
aggregate of the greater of 500,000 or 9.5% of the outstanding shares on a fully
diluted basis of our common stock up to a ceiling of 8,932,921 shares.
32
ITEM 6. SELECTED FINANCIAL DATA
----------------------------------
The following selected financial data are derived from our audited
financial statements for the years ended December 31, 2006, 2005, 2004, 2003,
and 2002. 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.
SELECTED FINANCIAL DATA
(dollars in thousands, except for per share data)
For the Year For the Year For the Year For the Year For the Year
Ended Ended Ended Ended Ended
December 31, December 31, December 31, December 31, December 31,
2006 2005 2004 2003 2002
---------------------------------------------------------------------------
Statement of Operations Data
Interest income $1,221,882 $705,046 $532,328 $337,433 $404,165
Interest expense 1,055,013 568,560 270,116 182,004 191,758
--------------------------------------------------------------------------
Net interest income 166,869 136,486 262,212 155,429 212,407
--------------------------------------------------------------------------
Other (loss) income:
Investment advisory and service fees 22,351 35,625 12,512 - -
(Loss) gain on sale of investment securities (3,862) (53,238) 5,215 40,907 21,063
Gain on termination of interest rate swaps 10,674 - - - -
Income from trading securities 3,994 - - - -
Loss on other-than-temporarily impaired securities (52,348) (83,098) - - -
--------------------------------------------------------------------------
Total other (loss) income (19,191) (100,711) 17,727 40,907 21,063
--------------------------------------------------------------------------
Expenses:
Distribution fees 3,444 8,000 2,860 - -
General and administrative expenses 40,063 26,278 24,029 16,233 13,963
--------------------------------------------------------------------------
Total Expenses 43,507 34,278 26,889 16,233 13,963
--------------------------------------------------------------------------
Impairment of intangible for customer relationships 2,493 - - - -
--------------------------------------------------------------------------
Income before income taxes 101,678 1,497 253,050 180,103 219,507
Income taxes 7,538 10,744 4,458 - -
--------------------------------------------------------------------------
Income (loss) before minority interest 94,140 (9,247) 248,592 180,103 219,507
Minority interest 324 - - - -
--------------------------------------------------------------------------
Net income (loss) 93,816 (9,247) 248,592 180,103 219,507
Dividends on preferred stock 19,557 14,593 7,745 - -
--------------------------------------------------------------------------
--------------------------------------------------------------------------
Net income available (loss related) to common $74,259 ($23,840) $240,847 $180,103 $219,507
shareholders
==========================================================================
Basic net income (loss) per average common share $0.44 ($0.19) $2.04 $1.95 $2.68
Diluted net income (loss) per average common share $0.44 ($0.19) $2.03 $1.94 $2.67
Dividends declared per common share $0.57 $1.04 $1.98 $1.95 $2.67
Dividends declared per preferred Series A share $1.97 $1.97 $1.45 - -
Dividends declared per preferred Series B share $1.08 - - - -
33
December 31, December 31, December 31, December 31, December 31,
Balance Sheet Data 2006 2005 2004 2003 2002
-----------------------------------------------------------------------------
Mortgage-Backed Securities, at fair value $30,167,509 $15,929,864 $19,038,386 $11,956,512 $11,551,857
Agency Debentures, at fair value 49,500 - 390,509 978,167 -
Total assets 30,715,980 16,063,422 19,560,299 12,990,286 11,659,084
Repurchase agreements 27,514,020 13,576,301 16,707,879 11,012,903 10,163,174
Total liabilities 28,056,149 14,559,399 17,859,829 11,841,066 10,579,018
Stockholders' equity 2,543,041 1,504,023 1,700,470 1,149,220 1,080,066
Number of common shares outstanding 205,345,591 123,684,931 121,263,000 96,074,096 84,569,206
For the Year For the Year For the Year For the Year For the Year
Ended Ended Ended Ended Ended
December 31, December 31, December 31, December 31, December 31,
Other Data 2006 2005 2004 2003 2002
------------------------------------------------------------------------------
Average total assets $23,130,057 $18,724,075 $17,293,174 $12,975,039 $10,486,423
Average investment securities 23,029,195 18,543,749 16,399,184 12,007,333 9,575,365
Average borrowings 21,399,130 17,408,828 15,483,118 11,549,368 9,128,933
Average equity 2,006,206 1,614,743 1,550,076 1,122,633 978,107
Yield on average interest earning assets 5.31% 3.80% 3.25% 2.81% 4.22%
Cost of funds on average interest bearing
liabilities 4.93% 3.27% 1.74% 1.58% 2.10%
Interest rate spread 0.38% 0.53% 1.51% 1.23% 2.12%
Financial Ratios
Net interest margin (net interest
income/average total assets) 0.72% 0.73% 1.52% 1.20% 2.03%
G&A expense as a percentage of average
total assets 0.17% 0.14% 0.14% 0.13% 0.13%
G&A expense as a percentage of average
equity 2.00% 1.63% 1.55% 1.45% 1.43%
Return on average total assets 0.41% (0.05%) 1.44% 1.39% 2.09%
Return on average equity 4.68% (0.57%) 16.04% 16.04% 22.44%
34
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
--------------------------------------------------------------------------
RESULTS OF OPERATIONS
---------------------
Overview
We are a self-managed real estate investment trust ("REIT") that owns
and manages a portfolio of mortgage-backed securities and agency debentures. Our
principal business objective is to generate net income for distribution to our
stockholders from the spread between the interest income on our investment
securities and the costs of borrowing to finance our acquisition of investment
securities.
We are primarily engaged in the business of investing, on a leveraged
basis, in mortgage pass-through certificates, collateralized mortgage
obligations and other mortgage-backed securities representing interests in or
obligations backed by pools of mortgage loans (collectively, "Mortgage-Backed
Securities"). We also invest in Federal Home Loan Bank ("FHLB"), Federal Home
Loan Mortgage Corporation ("FHLMC"), and Federal National Mortgage Association
("FNMA") debentures. The Mortgage-Backed Securities and agency debentures are
collectively referred to herein as "Investment Securities."
Under our capital investment policy, at least 75% of our total assets
must be comprised of high-quality mortgage-backed securities and short-term
investments. High quality securities means securities that (1) are rated within
one of the two highest rating categories by at least one of the nationally
recognized rating agencies, (2) are unrated but are guaranteed by the United
States government or an agency of the United States government, or (3) are
unrated but we determine them to be of comparable quality to rated high-quality
mortgage-backed securities.
The remainder of our assets, comprising not more than 25% of our total
assets, may consist of other qualified REIT real estate assets which are unrated
or rated less than high quality, but which are at least "investment grade"
(rated "BBB" or better by Standard & Poor's Corporation ("S&P") or the
equivalent by another nationally recognized rating agency) or, if not rated, we
determine them to be of comparable credit quality to an investment which is
rated "BBB" or better. In addition, we may directly or indirectly invest part of
this remaining 25% of our assets in other types of securities, including without
limitation, unrated debt, equity or derivate securities, to the extent
consistent with our REIT qualification requirements. The derivate securities in
which we invest may include securities representing the right to receive
interest only or a disproportionately large amount of interest, as well as
inverse floaters, which may have imbedded leverage as part of their structural
characteristics.
We may acquire mortgage-backed securities backed by single-family
residential mortgage loans as well as securities backed by loans on
multi-family, commercial or other real estate-related properties. To date, all
of the mortgage-backed securities that we have acquired have been backed by
single-family residential mortgage loans.
We have elected to be taxed as a REIT for federal income tax purposes.
Pursuant to the current federal tax regulations, one of the requirements of
maintaining our status as a REIT is that we must distribute at least 90% of our
REIT taxable income (determined without regard to the deduction for dividends
paid and by excluding any net capital gain) to our stockholders, subject to
certain adjustments.
The results of our operations are affected by various factors, many of
which are beyond our control. Our results of operations 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, the behavior of which involves various risks and
uncertainties. Prepayment speeds, as reflected by the Constant Prepayment Rate,
or CPR, and interest rates vary according to the type of investment, conditions
in financial markets, competition and other factors, none of which can be
predicted with any certainty. In general, as prepayment speeds on our
Mortgage-Backed Securities portfolio increase, related purchase premium
amortization increases, thereby reducing the net yield on such assets. The CPR
on our Mortgage Backed Securities portfolio averaged 17% and 27% for the years
ended December 31, 2006 and 2005, respectively. 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.
35
The table below provides quarterly information regarding our average
balances, interest income, interest expense, yield on assets, cost of funds and
net interest income for the quarterly periods presented.
Yield on
Average Average Average
Investment Total Interest Balance of Average
Securities Interest Earning Repurchase Interest Cost of Net Interest Net Interest
Held (1) Income Assets Agreements Expense Funds Income Rate Spread
----------------------------------------------------------------------------------------------------------------------
(ratios for the quarters have been annualized, dollars in thousands)
Quarter Ended
December 31, 2006 $28,888,956 $407,092 5.64% $27,118,402 $349,302 5.15% $57,790 0.49%
Quarter Ended
September 30, 2006 $24,976,876 $339,737 5.44% $23,120,247 $295,726 5.12% $44,011 0.32%
Quarter Ended
June 30, 2006 $21,660,089 $280,171 5.17% $20,060,978 $242,473 4.83% $37,698 0.34%
Quarter Ended
March 31, 2006 $16,590,859 $194,882 4.70% $15,296,893 $167,512 4.38% $27,370 0.32%
(1) Does not reflect unrealized gains/(losses).
The following table presents the CPR experienced on our Mortgage-Backed
Securities portfolio, on an annualized basis, for the quarterly periods
presented.
Quarter Ended CPR
------------- ---
December 31, 2006 15%
September 30, 2006 16%
June 30, 2006 19%
March 31, 2006 18%
December 31, 2005 28%
September 30, 2005 28%
June 30, 2005 27%
March 31, 2005 25%
We believe that the CPR in future periods will depend, in part, on
changes in and the level of market interest rates across the yield curve, with
higher CPRs expected during periods of declining interest rates and lower CPRs
expected during periods of rising interest rates.
We continue to explore alternative business strategies, alternative
investments and other strategic initiatives to complement our core business
strategy of investing, on a leveraged basis, in high quality Investment
Securities. No assurance, however, can be provided that any such strategic
initiative will or will not be implemented in the future.
For the purposes of computing ratios relating to equity measures,
throughout this report, equity includes Series B Cumulative Convertible
Preferred Stock, which has been treated under GAAP as temporary equity.
Critical Accounting Policies
Management's discussion and analysis of financial condition and results
of operations is based on the amounts reported in our financial statements.
These financial statements are prepared in conformity with accounting principles
generally accepted in the United States of America. In preparing the financial
statements, management is required to make various judgments, estimates and
assumptions that affect the reported amounts. Changes in these estimates and
assumptions could have a material effect on our financial statements. The
following is a summary of our policies most affected by management's judgments,
estimates and assumptions.
Market Valuation of Investment Securities: All assets classified as
available-for-sale are reported at fair value, based on market prices. Although
we generally intend to hold most of our Investment Securities until maturity, we
may, from time to time, sell any of our Investment Securities as part our
overall management of our portfolio. Accordingly, we are required to classify
36
all of our Investment Securities as available-for-sale. Our policy is to obtain
market values from independent sources. 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. The
determination of whether a security is other-than-temporarily impaired involves
judgements and assumptions based on subjective and objective factors.
Consideration is given to (1) the length of time and the extent to which the
fair value has been less than cost, (2) the financial condition and near-term
prospects of the issuer, and (3) 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. Investments with unrealized losses are not
considered other-than-temporarily impaired if the Company has the ability and
intent to hold the investments for a period of time, to maturity if necessary,
sufficient for a forecasted market price recovery up to or beyond the cost of
the investments. Unrealized losses on Investment Securities that are considered
other than temporary, as measured by the amount of decline in fair value
attributable to factors other than temporary, are recognized in income and the
cost basis of the Investment Securities is adjusted. Other-than-temporary
impaired losses on securities totaled $52.3 million for the year ended December
31, 2006 and $83.1 million for the year ended December 31, 2005. There were no
such adjustments for the year ended December 31, 2004 .
Interest income: Interest income is accrued based on the outstanding
principal amount of the Investment Securities and their contractual terms.
Premiums and discounts associated with the purchase of the Investment Securities
are amortized or accreted into interest income over the projected lives of the
securities using the interest method. Our policy for estimating prepayment
speeds for calculating the effective yield is to evaluate historical
performance, street consensus prepayment speeds, and current market conditions.
If our estimate of prepayments is incorrect, we may be required to make an
adjustment to the amortization or accretion of premiums and discounts that would
have an impact on future income.
Repurchase Agreements: We finance the acquisition of our Investment
Securities through the use of repurchase agreements. Repurchase agreements are
treated as collateralized financing transactions and are carried at their
contractual amounts, including accrued interest, as specified in the respective
agreements.
Income Taxes: We have elected to be taxed as a Real Estate Investment
Trust (or REIT) and intend to comply with the provisions of the Internal Revenue
Code of 1986, as amended (or the Code), with respect thereto. Accordingly, the
Company will not be subjected to federal income tax to the extent of its
distributions to shareholders and as long as certain asset, income and stock
ownership tests are met. The Company and FIDAC have made a joint election to
treat FIDAC as a taxable REIT subsidiary. As such, FIDAC is taxable as a
domestic C corporation and subject to federal and state and local income taxes
based upon its taxable income.
Impairment of Intangibles: The Company's acquisition of FIDAC was
accounted for using the purchase method. The cost of FIDAC was allocated to the
assets acquired, including identifiable intangible assets, and the liabilities
assumed based on their estimated fair values at the date of acquisition. The
excess of cost over the fair value of the net assets acquired was recognized as
goodwill. Intangible assets are periodically reviewed for potential impairment.
This evaluation requires significant judgment. During 2006, we recognized
impairment charges totaling $2.5 million on intangible assets relating to
customer relationships.
Results of Operations
Net Income Summary
For the year ended December 31, 2006, our net income was $93.8 million
or $0.44 basic income per average share related to common shareholders, as
compared to $9.2 million net loss or $0.19 basic loss per average share for the
year ended December 31, 2005. For the year ended December 31, 2004, our net
income was $248.6 million or $2.04 basic income per average share related to
common shareholders. Net income per average share increased by $0.63 per average
share available to common shareholders and total net income increased $103.0
million for the year ended December 31, 2006, when compared to the year ended
December 31, 2005. We attribute the increase in total net income for the year
ended December 31, 2006 compared to the year ended December 31, 2005 to the
increase in net interest income, reduction in losses on sales of securities and
losses on other-than-temporarily impaired securities, and gains on termination
of interest rate swaps. Net interest income increased by $30.4 million for the
year ended December 31, 2006, as compared to the year ended December 31, 2005,
due to the increase in interest earning assets from the deployment of additional
37
capital we raised in 2006. For the year ended December 31, 2006, net loss on
sale of Mortgage-Backed Securities was $3.9 million, as compared to a net loss
of $53.2 million in 2005. The loss on other-than-temporary impaired securities
totaled $52.3 million for the year ended December 31, 2006, as compared to $83.1
million for the year ended December 31, 2005. During the year ended December 31,
2006, the Company realized a gain on the termination of interest rate swaps of
$10.7 million. There was no gain on termination of swaps for the year ended
December 31, 2005. We attribute the decrease in total net income for the year
ended December 31, 2005 compared to the year ended December 31, 2004 to the
decline in interest rate spread, losses on sales of securities, and losses on
other-than-temporarily impaired securities. The interest rate spread decreased
from 1.51% for the year ended December 31, 2004 to 0.53% for the year ended
December 31, 2005. The total amortization for the year ended December 31, 2005
was $154.3 million and for the year ended December 31, 2004 was $179.6 million.
For the year ended December 31, 2005, net loss on sale of Mortgage-Backed
Securities was $53.2 million, as compared to a net gain of $5.2 million in 2004.
The table below presents the net income (loss) summary for the years ended
December 31, 2006, 2005, and 2004.
Net Income (Loss) Summary
(dollars in thousands, except for per share data)
-------------------------------------------------
Year Ended Year Ended Year Ended
December 31, December 31, December 31,
2006 2005 2004
---------------------------------------------------------
Interest income $1,221,882 $705,046 $532,328
Interest expense 1,055,013 568,560 270,116
---------------------------------------------------------
Net interest income 166,869 136,486 262,212
---------------------------------------------------------
Other (loss) income:
Investment advisory and service fees 22,351 35,625 12,512
(Loss) gain on sale of investment securities (3,862) (53,238) 5,215
Gain on termination of interest rate swaps 10,674 - -
Income from trading securities 3,994 - -
Loss on other-than-temporarily impaired securities (52,348) (83,098) -
---------------------------------------------------------
Total other (loss) income (19,191) (100,711) 17,727
---------------------------------------------------------
Expenses:
Distribution fees 3,444 8,000 2,860
General and administrative expenses 40,063 26,278 24,029
---------------------------------------------------------
Total expenses 43,507 34,278 26,889
---------------------------------------------------------
Impairment of intangible for customer relationships 2,493 - -
---------------------------------------------------------
Income before income taxes 101,678 1,497 253,050
Income taxes 7,538 10,744 4,458
---------------------------------------------------------
Income (loss) before minority interest 94,140 ($9,247) 248,592
Minority interest 324 - -
---------------------------------------------------------
Net Income (loss) 93,816 (9,247) 248,592
Dividends on preferred stock 19,557 14,593 7,745
---------------------------------------------------------
---------------------------------------------------------
Net income available (loss related) to
common shareholders $74,259 ($23,840) $240,847
=========================================================
Weighted average number of basic common shares
outstanding 167,666,631 122,475,032 118,223,330
Weighted average number of diluted common shares
outstanding 167,746,387 122,475,032 118,459,145
Basic net income (loss) per average common share $0.44 ($0.19) $2.04
Diluted net income (loss) per average common share $0.44 ($0.19) $2.03
Average total assets $23,130,057 $18,724,075 $17,293,174
Average equity 2,006,206 1,614,743 1,550,076
Return on average total assets 0.41% (0.05%) 1.44%
Return on average equity 4.68% (0.57%) 16.04%
38
Interest Income and Average Earning Asset Yield
We had average earning assets of $23.0 billion for the year ended
December 31, 2006. We had average earning assets of $18.5 billion for the year
ended December 31, 2005. We had average earning assets of $16.4 billion for the
year ended December 31, 2004. Our primary source of income is interest income.
Our interest income was $1.2 billion for the year ended December 31, 2006,
$705.0 million for the year ended December 31, 2005, and $532.3 million for the
year ended December 31, 2004. The yield on average investment securities was
5.31%, 3.80%, and 3.25% for the respective periods.
Interest Expense and the Cost of Funds
Our largest expense is the cost of borrowed funds. We had average
borrowed funds of $21.4 billion and total interest expense of $1.1 billion for
the year ended December 31, 2006. We had average borrowed funds of $17.4 billion
and total interest expense of $568.6 million for the year ended December 31,
2005. We had average borrowed funds of $15.5 billion and total interest expense
of $270.1 million for the year ended December 31, 2004. Our average cost of
funds was 4.93% for the year ended December 31, 2006 and 3.27 % for the year
ended December 31, 2005 and 1.74% for the year December 31, 2004. The cost of
funds rate increased by 166 basis points and the average borrowed funds
increased by $4.0 billion for the year ended December 31, 2006 when compared to
the year ended December 31, 2005. Interest expense for the year 2006 increased
by $486.5 million over the prior year due to the substantial increase in the
average repurchase balance and the increase in the cost of funds rate. The cost
of funds rate increased by 153 basis points and the average borrowed funds
increased by $1.9 billion for the year ended December 31, 2005, when compared to
the year ended December 31, 2004. Interest expense for the year ended December
31, 2005 increased by $298.5 million over the previous year due to the increase
in the average repurchase balance and substantial increase in the cost of funds
rate. Since a substantial portion of our repurchase agreements are short term,
changes in market rates are directly reflected in our interest expense. Our
average cost of funds was 0.10% below average one-month LIBOR and 0.28% below
average six-month LIBOR for the year ended December 31, 2006. Our average cost
of funds was 0.06% below average one-month LIBOR and 0.45% below average
six-month LIBOR for the year ended December 31, 2005. Our average cost of funds
was 0.24% above average one-month LIBOR and 0.06% below average six-month LIBOR
for the year ended December 31, 2004. Since the Federal Reserve continued to
raise the federal funds rate after December 31, 2005, we experienced an increase
in our funding costs.
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, 2006, 2005, 2004, 2003, and 2002 and the four quarters in
2006.
39
Average Cost of Funds
---------------------
(Ratios for the four quarters in 2006 have been annualized,
dollars in thousands)
Average Average
One-Month Average Cost Cost of
LIBOR of Funds Funds
Relative to Relative to Relative to
Average Average Average Average Average Average Average
Borrowed Interest Cost of One-Month Six-Month Six-Month One-Month Six-Month
Funds Expense Funds LIBOR LIBOR LIBOR LIBOR LIBOR
----------- ---------- ------ --------- --------- ----------- ----------- ---------
For the Year Ended
December 31, 2006 $21,399,130 $1,055,013 4.93% 5.03% 5.21% (0.18%) (0.10%) (0.28%)
For the Year Ended
December 31, 2005 $17,408,828 $568,560 3.27% 3.33% 3.72% (0.39%) (0.06%) (0.45%)
For the Year Ended
December 31, 2004 $15,483,118 $270,116 1.74% 1.50% 1.80% (0.30%) 0.24% (0.06%)
For the Year Ended
December 31, 2003 $11,549,368 $182,004 1.58% 1.21% 1.23% (0.02%) 0.37% 0.35%
For the Year Ended
December 31, 2002 $9,128,933 $191,758 2.10% 1.77% 1.88% (0.11%) 0.33% 0.22%
----------------------------------------------------------------------------------------------------------------------
For the Quarter Ended
December 31, 2006 $27,118,402 $349,302 5.15% 5.27% 5.31% (0.04%) (0.12%) (0.16%)
For the Quarter Ended
September 30, 2006 $23,120,247 $295,726 5.12% 5.29% 5.43% (0.14%) (0.17%) (0.31%)
For the Quarter Ended
June 30, 2006 $20,060,978 $242,473 4.83% 5.03% 5.27% (0.24%) (0.20%) (0.44%)
For the Quarter Ended
March 31, 2006 $15,296,893 $167,512 4.38% 4.55% 4.84% (0.29%) (0.17%) (0.46%)
Net Interest Income
Our net interest income which equals interest income less interest
expense, totaled $166.9 million for the year ended December 31, 2006, $136.5
million for the year ended December 31, 2005 and $262.2 million for the year
ended December 31, 2004. Our net interest income increased for the year ended
December 31, 2006, as compared to the year ended December 31, 2005, because of
the increased average asset base in 2006. In 2006 average assets increased
because of the deployment of additional capital. 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 0.38% for the year ended December 31, 2006 as compared
to 0.53% for the year ended December 31, 2005 and 1.51% for the year ended
December 31, 2004. This 15 basis point decrease was the result in the increased
funding cost of 166 basis points, offset by the increase in yield of 151 basis
points. Our net interest income increased for the year ended December 31, 2006
as compared to the year ended December 31, 2005 by $30.4 million because of the
increased average asset base for 2006. The net interest income for the year
ended December 31, 2005 decreased by $125.7 million, when compared to the year
ended December 31, 2004. This reduction was the result of the interest rate
spread decreasing by 98 basis points.
40
The table below shows our interest income by earning asset type,
average earning assets by type, total interest income, interest expense, average
repurchase agreements, average cost of funds, and net interest income for the
years ended December 31, 2006, 2005, 2004, 2003 and 2002 and the four quarters
in 2006.
Net Interest Income
(Ratios for the four quarters in 2006 have been annualized, dollars in thousands)
Yield
Average Average Average Net
Investment Total Interest Balance of Average Net Interest
Securities Interest Earning Repurchase Interest Cost of Interest Rate
Held Income Assets Agreements Expense Funds Income Spread
------------- --------- ----------- ------------ ---------- ------- --------- --------
For the Year Ended
December 31, 2006 $23,029,195 $1,221,882 5.31% $21,399,130 $1,055,013 4.93% $166,869 0.38%
For the Year Ended
December 31, 2005 $18,543,749 $705,046 3.80% $17,408,827 $568,560 3.27% $136,486 0.53%
For the Year Ended
December 31, 2004 $16,399,184 $532,328 3.25% $15,483,118 $270,116 1.74% $262,212 1.51%
For the Year Ended
December 31, 2003 $12,007,333 $337,433 2.81% $11,549,368 $182,004 1.58% $155,429 1.23%
For the Year Ended
December 31, 2002 $9,575,365 $404,165 4.22% $9,128,933 $191,758 2.10% $212,407 2.12%
-------------------------------------------------------------------------------------------------------------------
For the Quarter Ended
December 31, 2006 $28,888,956 $407,092 5.64% $27,118,402 349,302 5.15% $57,790 0.49%
For the Quarter Ended
September 30, 2006 $24,976,876 $339,737 5.44% $23,120,247 $295,726 5.12% $44,011 0.32%
For the Quarter Ended
June 30, 2006 $21,660,089 $280,171 5.17% $20,060,978 $242,473 4.83% $37,698 0.34%
For the Quarter Ended
March 31, 2006 $16,590,859 $194,882 4.70% $15,296,893 $167,512 4.38% $27,370 0.32%
Investment Advisory and Service Fees
FIDAC is a registered investment advisor which specializes in managing
fixed income securities. FIDAC expanded its line of business in 2006 to include
the management of equity securities, initially for us and an affiliated person
and collateralized debt obligations. FIDAC generally receives annual net
investment advisory fees of approximately 10 to 20 basis points of the gross
assets it manages, assists in managing or supervises. At December 31, 2006,
FIDAC had under management approximately $2.6 billion in net assets and $15.1
billion in gross assets, compared to $2.3 billion in net assets and $18.7
billion in gross assets at December 31, 2005. Net investment advisory and
service fees for the years ended December 31, 2006, 2005, and 2004 totaled $18.9
million, $27.6 million, and $9.7 million, respectively, net of fees paid to
third parties pursuant to distribution service agreements for facilitating and
promoting distribution of shares or units to FIDAC's clients. Gross assets under
management will vary from time to time because of changes in the amount of net
assets FIDAC manages as well as changes in the amount of leverage used by the
various funds and accounts FIDAC manages. Although net assets under management
increased by approximately $300 million from December 31, 2005 to December 31,
2006, gross assets under management declined during the same time period, as
leverage declined on the assets under management.
Gains and Losses on Sales of Investment Securities and Interest Rate
Swaps
For the year ended December 31, 2006, we sold investment securities
with an aggregate historical amortized cost of $3.2 billion for an aggregate
loss of $3.9 million. In addition, the Company had a $10.7 million gain on the
termination of interest rate swaps with a notional value of $1.2 billion. For
the year ended December 31, 2005, we sold investment securities with an
aggregate historical amortized cost of $3.4 billion for an aggregate loss of
$53.2 million. For the year ended December 31, 2004, we sold mortgage-backed
securities with an aggregate historical amortized cost of $591.7 million for an
aggregate gain of $5.2 million. The loss on sale of assets for the year ended
December 31, 2005 was due to portfolio rebalancing that was initiated in the
fourth quarter of 2005. We determined that certain assets purchased in a much
lower interest rate environment of 2003 and 2004 were unlikely to receive their
amortized cost basis, and commenced selling these assets. The rebalancing was
done with the objective of improving future financial performance. A positive
difference between the sale price and the historical amortized cost of our
41
Mortgage-Backed Securities is a realized gain and increases income accordingly.
We do not expect to sell assets on a frequent basis, but may from time to time
sell existing assets to move into new assets, which our management believes
might have higher risk-adjusted returns, or to manage our balance sheet as part
of our asset/liability management strategy.
Income from Trading Securities
Income from trading securities totaled $4.0 million for the year ended
December 31, 2006. FIDAC expanded its line of business in 2006 to include the
management of equity securities, initially for us and an affiliated person.
During the year ended December 31, 2005 and 2004, we did not earn income from
trading securities.
Impairment of intangible for Customer Relationships
During the year ended December 31, 2006, intangibles were evaluated for
possible impairment. It was determined that an impairment charge of $1.4 million
was necessary based on the decline in expected future cash flows on one customer
relationship. We also terminated an investment advisory agreement during the
year ended December 31, 2006. The expected cash flows from the contract were
valued as a component of the intangible for customer relationships on June 4,
2004, the date of the acquisition of FIDAC. The value of $1.1 million was deemed
to be impaired . The total impairment of intangible assets relating to customer
relationships is $2.5 million for the year ended December 31, 2006. There were
no impairment charges during the years ended December 31, 2005 and 2004.
Loss on other-than-temporarily impaired securities
At each quarter end, the Company reviewed each of its securities to
determine if an other-than-temporary impairment charge would be necessary. It
was determined that certain securities that were in an unrealized loss position,
the Company did not intend to hold them for a period of time, to maturity if
necessary, sufficient for a forecasted market price recovery up to or beyond the
cost of the investments. For the years ended December 31, 2006 and 2005, the
loss on other-than temporarily impaired securities totaled $52.3 million and
$83.1 million, respectively
General and Administrative Expenses
General and administrative (or G&A) expenses were $40.1 million for the
year ended December 31, 2006, $26.3 million for the year ended December 31,
2005, $24.0 million for the year ended December 31, 2004. G&A expenses as a
percentage of average total assets was 0.17%, 0.14%, and 0.14% for the years
ended December 31, 2006, 2005, and 2004, respectively. The increase in G&A
expenses of $13.8 million for the year December 31, 2006, was primarily the
result of increased salaries, directors and officers insurance and additional
costs related to FIDAC. Staff increased from 30 at the end of 2004 to 31 at the
end of 2005 and 34 at the end of 2006. Salaries and bonuses for the years ended
December 31, 2006, 2005, and 2004 were $28.7 million, $18.8 million and $17.2
million, respectively. The table below shows our total G&A expenses as compared
to average total assets and average equity for the years ended December 31,
2006, 2005, 2004, 2003 and 2002 and the four quarters in 2006.
G&A Expenses and Operating Expense Ratios
-----------------------------------------
(Ratios for the four quarters in 2006 have been annualized,
dollars in thousands)
Total G&A Total G&A
Expenses/Average Expenses/Average
Total G&A Expenses Assets Equity
------------------- ------------------- ------------------
For the Year Ended December 31, 2006 $40,063 0.17% 2.00%
For the Year Ended December 31, 2005 $26,278 0.14% 1.63%
For the Year Ended December 31, 2004 $24,029 0.14% 1.55%
For the Year Ended December 31, 2003 $16,233 0.13% 1.45%
For the Year Ended December 31, 2002 $13,963 0.13% 1.43%
------------------------------------------------------------------------------------------------------
For the Quarter Ended December 31, 2006 $12,219 0.16% 1.86%
For the Quarter Ended September 30, 2006 $11,542 0.18% 2.08%
For the Quarter Ended June 30, 2006 $8,985 0.18% 2.19%
For the Quarter Ended March 31, 2006 $7,177 0.18% 1.95%
42
Net Income and Return on Average Equity
Our net income was $93.8 million for the year ended December 31, 2006,
our net loss was $9.2 million for the year ended December 31, 2005, and our net
income was $248.6 million for the year ended December 31, 2004. Our return on
average equity was 4.68% for the year ended December 31, 2006, (0.57%) for the
year ended December 31, 2005, and 16.04% for the year ended December 31, 2004.
Even with the increase in G&A expenses and the reduction of net investment
advisory and service fees, net income for the year increase by $103.0 million.
We attribute the increase in total net income for the year ended December 31,
2006 over the year ended December 31, 2005 to the increase in net interest
income, the reduction in losses realized on sale of assets and the loss on
other-than-temporarily impaired securities, and the gains realized on the
termination of interest rate swaps. We attribute the decrease in total net
income for the year ended December 31, 2005 over the year ended December 31,
2004 to the decrease in interest rate spread, the loss realized on sale of
assets during the repositioning and the loss on other-than-temporarily impaired
securities
The table below shows our net interest income, net investment advisory
and service fees, gain on sale of investment securities and termination of
interest rate swaps, G&A expenses, loss on other-than-temporarily impaired
securities income from equity investment and income taxes each as a percentage
of average equity, and the return on average equity for the years ended December
31, 2006, 2005, 2004, 2003, and 2002 and for the four quarters in 2006.
Components of Return on Average Equity
(Ratios for the four quarters in 2006 have been annualized)
Gain/Loss
on Sale of
Mortgage-
Backed
Securities Loss on
Net and other-than- Impairment of
Net Investment Interest temporarily Income from intangible
Interest Advisory and Rate impaired equity G&A Income for customer Return
Income/ Service Swaps/ securities/ investment/ Expenses/ Taxes/ relationships/ on
Average Fees/Average Average Average Average Average Average Average Minority Average
Equity Equity Equity Equity Equity Equity Equity Equity interest Equity
--------- ------------ ----------- ------------ ----------- ---------- -------- -------------- -------- -------
For the Year Ended
December 31, 2006 8.32% 0.94% 0.34% (2.61%) 0.20% (2.00%) (0.38%) (0.12%) (0.01%) 4.68%
For the Year Ended
December 31, 2005 8.45% 1.71% (3.30%) (5.15%) - 1.63% 0.67% - - (0.57%)
For the Year Ended
December 31, 2004 16.92% 0.62% 0.34% - - 1.55% 0.29% - - 16.04%
For the Year Ended
December 31, 2003 13.85% - 3.64% - - 1.45% - - - 16.04%
For the Year Ended
December 31, 2002 21.72% - 2.15% - - 1.43% - - - 22.44%
----------------------------------------------------------------------------------------------------------------------------------
For the Quarter Ended
December 31, 2006 8.81% 0.67% 1.08% (0.84%) 0.52% (1.86%) (0.20%) - (0.05%) 8.13%
For the Quarter Ended
September 30, 2006 7.93% 0.76% 1.44% - 0.08% (2.08%) (0.41%) - - 7.72%
For the Quarter Ended
June 30, 2006 9.20% 1.08% (0.30%) (4.91%) - (2.19%) (0.33%) (0.46%) - 2.09%
For the Quarter Ended
March 31, 2006 7.45% 1.59% (1.91%) (7.28%) - (1.95%) (0.57%) (0.31%) - (2.98%)
Financial Condition
Investment Securities, Available for Sale
All of our Mortgage-Backed Securities at December 31, 2006, 2005, and
2004 were adjustable-rate or fixed-rate mortgage-backed securities backed by
single-family mortgage loans. All of the mortgage assets underlying these
mortgage-backed securities were secured with a first lien position on the
underlying single-family properties. All of our mortgage-backed securities were
FHLMC, FNMA or GNMA mortgage pass-through certificates or CMOs, which carry an
implied "AAA" rating. We mark-to-market all of our earning assets to fair value.
All of our agency debentures are callable and carry an implied "AAA"
rating. We mark-to-market all of our agency debentures to fair value.
43
We accrete discount balances as an increase in interest income over the
life of discount investment securities and we amortize premium balances as a
decrease in interest income over the life of premium investment securities. At
December 31, 2006, 2005, and 2004 we had on our balance sheet a total of $78.4
million, $21.5 million and $1.1 million, respectively, of unamortized discount
(which is the difference between the remaining principal value and current
historical amortized cost of our investment securities acquired at a price below
principal value) and a total of $219.1 million, $242.1 million and $427.0
million, respectively, of unamortized premium (which is the difference between
the remaining principal value and the current historical amortized cost of our
investment securities acquired at a price above principal value).
We received mortgage principal repayments of $5.1 billion for the year
ended December 31, 2006, $7.1 billion for the year ended December 31, 2005, and
$6.5 billion for the year ended December 31, 2004. The overall prepayment speed
for the year ended December 31, 2006, 2005 and 2004 was 17%, 27%, and 29%
respectively. During the year ended December 31, 2006, the CPR declined to 17%,
from 27%, due to a decline in refinancing activity. During the year ended
December 31, 2004, the annual prepayment speed was the highest in our history at
29%. Given our current portfolio composition, if mortgage principal prepayment
rates were to increase over the life of our mortgage-backed securities, all
other factors being equal, our net interest income would decrease during the
life of these mortgage-backed securities as we would be required to amortize our
net premium balance into income over a shorter time period. Similarly, if
mortgage principal prepayment rates were to decrease over the life of our
mortgage-backed securities, all other factors being equal, our net interest
income would increase during the life of these mortgage-backed securities as we
would amortize our net premium balance over a longer time period.
The table below summarizes our Investment Securities at December 31,
2006, 2005, 2004, 2003, and 2002 and September 30, 2006, June 30, 2006, and
March 31, 2006.
Investment Securities
---------------------
(dollars in thousands)
Amortized Fair Weighted
Principal Net Amortized Cost/Principal Value/Principal Average
Amount Premium Cost Amount Fair Value Amount Yield
----------- -------- ----------- ------------- ----------- --------------- ---------
At December 31, 2006 $30,134,791 $140,709 $30,275,500 100.47% $30,217,009 100.27% 5.63%
At December 31, 2005 $15,915,801 $220,637 $16,136,438 101.39% $15,929,864 100.09% 4.68%
At December 31, 2004 $19,123,902 $425,792 $19,549,694 102.23% $19,428,895 101.59% 3.43%
At December 31, 2003 $12,682,130 $299,810 $12,981,940 102.36% $12,934,679 101.99% 2.96%
At December 31, 2002 $11,202,384 $273,963 $11,476,347 102.45% $11,551,857 103.12% 3.25%
---------------------------------------------------------------------------------------------------------------------------
At September 30, 2006 $28,297,950 $139,717 $28,437,667 100.49% $28,348,027 100.18% 5.58%
At June 30, 2006 $23,822,683 $141,671 $23,964,354 100.59% $23,474,006 98.54% 5.42%
At March 31, 2006 $16,288,848 $173,428 $16,462,276 101.06% $16,176,348 99.31% 5.03%
The tables below set forth certain characteristics of our investment
securities. The index level for adjustable-rate Investment Securities is the
weighted average rate of the various short-term interest rate indices, which
determine the coupon rate.
Adjustable-Rate Investment Security Characteristics
---------------------------------------------------
(dollars in thousands)
Principal Amount
Weighted Weighted Weighted at Period End as
Average Average Term Weighted Average % of Total
Principal Coupon to Next Average Asset Investment
Amount Rate Adjustment Lifetime Cap Yield Securities
---------- -------- ------------ ------------ -------- ----------------
At December 31, 2006 $8,493,242 5.72% 19 months 9.76% 5.57% 28.18%
At December 31, 2005 $9,699,133 4.76% 22 months 10.26% 4.74% 60.94%
At December 31, 2004 $13,544,872 4.23% 24 months 10.12% 3.24% 70.83%
At December 31, 2003 $9,294,934 3.85% 23 months 9.86% 2.47% 73.29%
At December 31, 2002 $7,007,062 4.10% 11 months 10.37% 2.33% 62.55%
---------------------------------------------------------------------------------------------------------------
At September 30, 2006 $8,291,239 5.57% 17 months 9.64% 5.47% 29.30%
At June 30, 2006 $7,964,221 5.36% 16 months 9.75% 5.26% 33.43%
At March 31, 2006 $7,785,082 4.99% 20 months 10.27% 5.07% 47.79%
44
Fixed-Rate Investment Security Characteristics
----------------------------------------------
(dollars in thousands)
Principal Amount at
Weighted Average Weighted Average Period End as % of Total
Principal Amount Coupon Rate Asset Yield Investment Securities
---------------- ---------------- ----------------- ------------------------
At December 31, 2006 $21,641,549 5.83% 5.65% 71.82%
At December 31, 2005 $6,216,668 5.37% 4.60% 39.06%
At December 31, 2004 $5,579,030 5.24% 3.89% 29.17%
At December 31, 2003 $3,387,196 5.77% 4.29% 26.71%
At December 31, 2002 $4,195,322 6.76% 4.78% 37.45%
-----------------------------------------------------------------------------------------------------------------
At September 30, 2006 $20,006,711 5.82% 5.62% 70.70%
At June 30, 2006 $15,858,461 5.73% 5.50% 66.57%
At March 31, 2006 $8,503,766 5.43% 4.99% 52.21%
At December 31, 2006 and 2005, we held investment securities with
coupons linked to various indices. The following tables detail the portfolio
characteristics by index.
Adjustable-Rate Investment Securities by Index
----------------------------------------------
December 31, 2006
-----------------
National
Six- 11th Financial Six- Monthly
One- Six- Twelve Month 12-Month District Average Month 1-Year 2-Year 3-Year 5-Year Federal
Month Month Month Auction Moving Cost of Mortgage CD Treasury Treasury Treasury Treasury Cost of
Libor Libor Libor Average Average Funds Rate Rate Index Index Index Index Funds
------ ------ ------ -------- -------- --------- ---------- ------ --------- --------- --------- -------- --------
Weighted Average
Term to Next
Adjustment 1 mo. 35 mo. 36 mo. 2 mo. 1 mo. 1 mo. 5 mo. 3 mo. 13 mo. 9 mo. 17 mo. 31 mo. 1 mo.
Weighted Average
Annual Period Cap 6.70% 1.88% 2.00% 1.00% 0.16% 0.00% 2.00% 1.75% 1.00% 2.00% 2.03% 1.97% 0.00%
Weighted Average
Lifetime Cap at
December 31, 2006 7.32% 10.39% 10.70% 12.95% 10.53% 12.07% 10.90% 9.75% 10.81% 11.91% 13.17% 12.56% 13.41%
Investment
Principal Value
as Percentage
of Investment
Securities at
December 31, 2006 8.29% 2.71% 9.89% 0.00% 0.07% 0.41% 0.00% 0.06% 6.34% 0.00% 0.10% 0.03% 0.28%
Adjustable-Rate Investment Securities by Index
----------------------------------------------
December 31, 2005
-----------------
National
Six- 11th Financial Six- Monthly
One- Six- Twelve Month 12-Month District Average Month 1-Year 2-Year 3-Year 5-Year Federal
Month Month Month Auction Moving Cost of Mortgage CD Treasury Treasury Treasury Treasury Cost of
Libor Libor Libor Average Average Funds Rate Rate Index Index Index Index Funds
------ ------ ------ -------- -------- --------- ---------- ------ --------- --------- --------- -------- --------
Weighted Average
Term to Next
Adjustment 1 mo. 42 mo. 22 mo. 2 mo. 2 mo. 1 mo. 17mo. 3 mo. 18 mo. 14 mo. 21 mo. 34 mo. 1 mo.
Weighted Average
Annual Period Cap 7.29% 2.00% 2.00% 1.00% 0.16% 0.00% 2.00% 1.00% 1.90% 2.00% 2.03% 1.96% 0.00%
Weighted Average
Lifetime Cap at
December 31, 2005 7.98% 10.78% 10.33% 13.03% 10.61% 12.07% 10.90% 11.74% 10.54% 11.93% 13.12% 12.51% 13.40%
Investment
Principal Value
as Percentage
of Investment
Securities at
December 31, 2005 6.33% 6.42% 24.46% 0.01% 0.19% 0.94% 0.01% 0.03% 21.55% 0.01% 0.25% 0.06% 0.68%
45
Trading Securities and Trading Securities Sold, Not Yet Purchased
Trading securities and trading securities sold, not yet purchased are
included in the balance sheet as a result of consolidating the financial
statements, of an affiliated investment fund. Trading securities owned and
trading account securities sold, but not yet purchased consisted of securities
at fair values as of December 31, 2006. The resulting realized and unrealized
gains and losses are reflected in the statements of operations. The fair value
of the trading securities was $18.4 million and the trading securities sold, not
yet purchased was $41.9 million at December 31, 2006.
Borrowings
To date, our debt has consisted entirely of borrowings collateralized
by a pledge of our investment securities. These borrowings appear on our balance
sheet as repurchase agreements. At December 31, 2006, we had established
uncommitted borrowing facilities in this market with 30 lenders in amounts which
we believe are in excess of our needs. All of our investment securities are
currently accepted as collateral for these borrowings. However, we limit our
borrowings, and thus our potential asset growth, in order to maintain unused
borrowing capacity and thus increase the liquidity and strength of our balance
sheet.
For the year ended December 31, 2006, the term to maturity of our
borrowings ranged from one day to three years, with a weighted average original
term to maturity of 194 days at December 31, 2006. For the year ended December
31, 2005, the term to maturity of our borrowings ranged from one day to three
years, with a weighted average original term to maturity of 163 days at December
31, 2005. For the year ended December 31, 2004, the term to maturity of our
borrowings ranged from one day to three years, with a weighted average original
term to maturity of 211 days at December 31, 2004.
At December 31, 2006, the weighted average cost of funds for all of our
borrowings 5.14% and the weighted average term to next rate adjustment was 125
days. At December 31, 2005, the weighted average cost of funds for all of our
borrowings was 4.16% and the weighted average term to next rate adjustment was
79 days. At December 31, 2004, the weighted average cost of funds for all of our
borrowings was 2.46% and the weighted average term to next rate adjustment was
111 days.
Liquidity
Liquidity, which is our ability to turn non-cash assets into cash,
allows us to purchase additional investment securities and to pledge additional
assets to secure existing borrowings should the value of our pledged assets
decline. Potential immediate sources of liquidity for us include cash balances
and unused borrowing capacity. Unused borrowing capacity will vary over time as
the market value of our investment securities varies. Our balance sheet also
generates liquidity on an on-going basis through mortgage principal repayments
and net earnings held prior to payment as dividends. Should our needs ever
exceed these on-going sources of liquidity plus the immediate sources of
liquidity discussed above, we believe that in most circumstances our investment
securities could be sold to raise cash. The maintenance of liquidity is one of
the goals of our capital investment policy. Under this policy, we limit asset
growth in order to preserve unused borrowing capacity for liquidity management
purposes.
Borrowings under our repurchase agreements increased by $13.9 billion
to $27.5 billion at December 31, 2006, from $13.6 billion at December 31, 2005.
The increase in borrowings was the result of our deployment of additional
capital raised during 2006, which permitted us to increase our borrowings.
We anticipate that, upon repayment of each borrowing under a repurchase
agreement, we will use the collateral immediately for borrowing under a new
repurchase agreement. We have not at the present time entered into any
commitment agreements under which the lender would be required to enter into new
repurchase agreements during a specified period of time, nor do we presently
plan to have liquidity facilities with commercial banks.
Under our repurchase agreements, we may be required to pledge
additional assets to our repurchase agreement counterparties (i.e., lenders) in
the event the estimated fair value of the existing pledged collateral under such
agreements declines and such lenders demand additional collateral (a "margin
call"), which may take the form of additional securities or cash. Similarly, if
the estimated fair value of investment securities increase due to changes in
46
market interest rates of market factors, lenders may release collateral back to
us. Specifically, margin calls result from a decline in the value of the our
Mortgage-Backed Securities securing our repurchase agreements, prepayments on
the mortgages securing such Mortgage-Backed Securities and to changes in the
estimated fair value of such Mortgage-Backed Securities generally due to
principal reduction of such Mortgage-Backed Securities from scheduled
amortization and resulting from changes in market interest rates and other
market factors. Through December 31, 2006, we did not have any margin calls on
our repurchase agreements that we were not able to satisfy with either cash or
additional pledged collateral. However, should prepayment speeds on the
mortgages underlying our Mortgage-Backed Securities and/or market interest rates
suddenly increase, margin calls on our repurchase agreements could result,
causing an adverse change in our liquidity position.
The following table summarizes the effect on our liquidity and cash
flows from contractual obligations for repurchase agreements, the non-cancelable
office lease and employment agreements at December 31, 2006.
(dollars in thousands)
Within One One to Three Three to More than
Contractual Obligations Year Years Five Years Five Years Total
-----------------------------------------------------------------------------------------------------------------
Repurchase agreements $26,114,020 - $1,200,000 $200,000 $27,514,020
Interest expense on repurchase
agreements 148,416 122,532 113,272 38,299 422,519
Long-term operating lease obligations
532 1,064 - - 1,596
Employment contracts 13,432 - - - 13,432
--------------------------------------------------------------------------
Total $26,276,400 $123,596 $1,313,272 $238,299 $27,951,567
==========================================================================
Stockholders' Equity
During the year ended December 31, 2006, we declared dividends to
common shareholders totaling $102.6 million or $0.57 per share, of which $39.0
million was paid on January 26, 2007. During the year ended December 31, 2006,
we declared and paid dividends to Series A Preferred shareholders totaling $14.6
million or $1.97 per share, and Series B Preferred shareholders totaling $5.0
million or $1.08. During the year ended December 31, 2005, we declared and paid
dividends to common shareholders totaling $127.1 million or $1.04 per share, of
which $12.4 million was paid on January 27, 2006. During the year ended December
31, 2005 we declared and paid dividends to Series A Preferred shareholders
totaling $14.6 million or $1.97 per share.
On August 16, 2006, the Company entered into an underwriting agreement
pursuant to which it sold 40,825,000 shares of its common stock for net proceeds
before expenses of approximately $476.7 million. This transaction settled on
August 22, 2006.
On April 6, 2006, the Company entered into an underwriting agreement
pursuant to which it sold 39,215,000 shares of its common stock for net proceeds
before expenses of approximately $437.7 million. On April 6, 2006, the Company
entered into a second underwriting agreement pursuant to which it sold 4,600,000
shares of its 6% Series B Cumulative Convertible Preferred Stock for net
proceeds before expenses of approximately $111.5 million. Each of these
transactions settled on April 12, 2006. The 6% Series B Cumulative Preferred
Stock has been treated under GAAP as temporary equity. For the purpose of
computing ratios relating to equity measures, the Series B Preferred Stock has
been included in equity.
On August 3, 2006 we entered into an ATM Equity Offering(sm) Sales
Agreement with Merrill Lynch & Co. and Merrill Lynch, Pierce, Fenner & Smith
Incorporated (or Merrill Lynch), relating to the sale of shares of our common
stock from time to time through Merrill Lynch. Sales of the shares, if any, will
be made by means of ordinary brokers' transaction on the New York Stock
Exchange. During the quarter ended December 31, 2006 we sold 500,000 shares of
our common stock under this program. On August 3, 2006, we also entered into an
ATM Equity Sales Agreement with UBS Securities LLC (or UBS Securities), relating
to the sale of shares of our common stock from time to time through UBS
Securities. Sales of the shares, if any, will be made by means of ordinary
brokers' transaction on the New York Stock Exchange. During the quarter ended
December 31, 2006, we did not sell any shares of our common stock under this
program. We refer to share issuance programs under these two agreements as the
ATM Programs.
47
During the year ended December 31, 2006, 1,598,500 shares of the
Company's common stock were issued through the ATM Programs and Equity Shelf
Program, totaling net proceeds of $20.9 million. During the year ended December
31, 2006, 22,160 options were exercised under the long-term compensation plan
for an aggregate exercise price of $183,000.
During the year ended December 31, 2005, 2,381,550 shares of the
Company's common stock were issued through the ESP, totaling net proceeds of
$40.1 million. During the year ended December 31, 2005, 16,128 options were
exercised under the long-term compensation plan for an aggregate exercise price
of $253,000. In addition, 24,253 common shares were sold through the dividend
reinvestment and direct purchase program for $440,000 during the year ended
December 31, 2005.
During the year ended December 31, 2004, 2,103,525 shares were issued
through the Equity Shelf Program totaling net proceeds of $37.5 million. During
the year ended December 31, 2004, 57,000 options were exercised under the
long-term compensation plan for an aggregate exercise price of $856,000. In
addition, 127,020 shares were purchased in the dividend reinvestment and direct
purchase program at $2.3 million.
On January 21, 2004, the Company entered into an underwriting
agreement pursuant to which the Company raised net proceeds of approximately
$363.6 million in an offering of 20,700,000 shares of common stock. On March 31,
2004, the Company entered into an underwriting agreement pursuant to which the
Company raised net proceeds of approximately $102.9 million through an offering
of 4,250,000 shares of 7.875% Series A Cumulative Redeemable Preferred Stock,
which settled on April 5, 2004. On October 14, 2004, the Company entered into an
underwriting agreement pursuant to which the Company raised net proceeds of
approximately $74.5 million through an offering of 3,162,500 shares of 7.875%
Series A Cumulative Redeemable Preferred Stock, which settled on October 19,
2004.
The FIDAC acquisition was completed on June 4, 2004. We issued
2,201,080 common shares to the shareholders of FIDAC, based on the December 31,
2003 closing price of $18.40. We continue to operate as a self-managed and
self-advised real estate investment trust, with FIDAC operating as our
wholly-owned taxable REIT subsidiary. We will not pay any consideration under
the cash out provisions contained in the merger agreement pursuant to which we
acquired FIDAC.
With our "available-for-sale" accounting treatment, unrealized
fluctuations in market values of assets do not impact our GAAP or taxable income
but rather are reflected on our balance sheet by changing the carrying value of
the asset and stockholders' equity under "Accumulated Other Comprehensive Income
(Loss)." By accounting for our assets in this manner, we hope to provide useful
information to stockholders and creditors and to preserve flexibility to sell
assets in the future without having to change accounting methods.
As a result of this mark-to-market accounting treatment, our book value
and book value per share are likely to fluctuate far more than if we used
historical amortized cost accounting. As a result, comparisons with companies
that use historical cost accounting for some or all of their balance sheet may
not be meaningful.
The table below shows unrealized gains and losses on the Investment
Securities and interest rate swaps in our portfolio.
Unrealized Gains and Losses
---------------------------
(dollars in thousands)
At December 31,
-------------------------------------------------------------------------
2006 2005 2004 2003 2002
-------------------------------------------------------------------------
Unrealized gain $112,596 $ 5,027 $ 23,021 $24,886 $90,507
Unrealized loss (188,708) (211,601) (143,821) (72,147) (14,996)
-------------------------------------------------------------------------
Net Unrealized (loss) gain ($76,112) ($206,574) ($120,800) ($47,261) $ 75,511
=========================================================================
Net unrealized losses as % of investment
securities principal amount (0.25%) (1.30%) (0.63%) (0.37%) 0.67%
Net unrealized losses as % of investment
securities amortized cost (0.25%) (1.28%) (0.62%) (0.37%) 0.67%
48
Unrealized changes in the estimated net market value of investment
securities have one direct effect on our potential earnings and dividends:
positive mark-to-market changes increase our equity base and allow us to
increase our borrowing capacity while negative changes tend to limit borrowing
capacity under our capital investment policy. A very large negative change in
the net market value of our investment securities might impair our liquidity
position, requiring us to sell assets with the likely result of realized losses
upon sale. The net unrealized loss on available for sale securities and interest
rate swaps was $76.1 million, or 0.25% of the amortized cost of our investment
securities as of December 31, 2006, $206.6 million, or 1.28% of the amortized
cost of our investment securities as of December 31, 2005 and $120.8 million, or
0.62% of the amortized cost of our investment securities as of December 31,
2004.
Mortgage-Backed Securities with a carrying value of $7.0 billion were
in a continuous unrealized loss position over 12 months at December 31, 2006 in
the amount of $138.2 million. Mortgage-Backed Securities with a carrying value
of $6.4 billion were in a continuous unrealized loss position for less than 12
months at December 31, 2006 in the amount of $30.2 million. Mortgage-Backed
Securities with a carrying value of $4.6 billion were in a continuous unrealized
loss position over 12 months at December 31, 2005 in the amount of $111.1
million. Mortgage-Backed Securities with a carrying value of $8.4 billion were
in a continuous unrealized loss position for less than 12 months at December 31,
2005 in the amount of $100.5 million. The decline in value of these securities
is solely due to increases in interest rates. All of the Mortgage-Backed
Securities are "AAA" rated or carry an implied "AAA" rating. During the years
ended December 31, 2006 and 2005, the Company recorded an impairment loss of
$52.3 million and $83.1 million. The remaining investments are not considered
other-than-temporarily impaired since the Company currently has the ability and
intent to hold the investments for a period of time or to maturity, if
necessary, sufficient for a forecasted market price recovery up to or beyond the
cost of the investments. Also, the Company is guaranteed payment on the par
value of the securities.
Leverage
Our debt-to-equity ratio at December 31, 2006, 2005, and 2004 was
10.4:1, 9.0:1, and 9.8:1, respectively. We generally expect to maintain a ratio
of debt-to-equity of between 8:1 and 12:1, although the ratio may vary from this
range from time to time based upon various factors, including our management's
opinion of the level of risk of our assets and liabilities, our liquidity
position, our level of unused borrowing capacity and over-collateralization
levels required by lenders when we pledge assets to secure borrowings.
Our target debt-to-equity ratio is determined under our capital
investment policy. Should our actual debt-to-equity ratio increase above the
target level due to asset acquisition or market value fluctuations in assets, we
will cease to acquire new assets. Our management will, at that time, present a
plan to our board of directors to bring us back to our target debt-to-equity
ratio; in many circumstances, this would be accomplished over time by the
monthly reduction of the balance of our Mortgage-Backed Securities through
principal repayments.
Asset/Liability Management and Effect of Changes in Interest Rates
We continually review our asset/liability management strategy with
respect to interest rate risk, mortgage prepayment risk, credit risk and the
related issues of capital adequacy and liquidity. Our goal is to provide
attractive risk-adjusted stockholder returns while maintaining what we believe
is a strong balance sheet.
We seek to manage the extent to which our net income changes as a
function of changes in interest rates by matching adjustable-rate assets with
variable-rate borrowings. In addition, we have attempted to mitigate the
potential impact on net income of periodic and lifetime coupon adjustment
restrictions in our portfolio of investment securities by entering into interest
rate swaps. At December 31, 2006, we entered into swap agreements with a total
notional amount of $9.3 billion. We agreed to pay a weighted average pay rate of
5.17% and receive a floating rate based on one month LIBOR. At December 31,
2005, we entered into swap agreements with a total notional amount of $479.0
million. We agreed to pay a weighted average pay rate of 4.88% and receive a
floating rate based on one month LIBOR. The interest rate swap had not settled
as of December 31, 2005. We may enter into similar derivative transactions in
the future by entering into interest rate collars, caps or floors or purchasing
interest only securities.
49
Changes in interest rates may also affect the rate of mortgage
principal prepayments and, as a result, prepayments on mortgage-backed
securities. We will seek to mitigate the effect of changes in the mortgage
principal repayment rate by balancing assets we purchase at a premium with
assets we purchase at a discount. To date, the aggregate premium exceeds the
aggregate discount on our mortgage-backed securities. As a result, prepayments,
which result in the expensing of unamortized premium, will reduce our net income
compared to what net income would be absent such prepayments.
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.
Capital Resources
At December 31, 2006, we had no material commitments for capital
expenditures.
Inflation
Virtually all of our assets and liabilities are financial in nature. As
a result, interest rates and other factors drive our performance far more 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 dividends based upon our net income as
calculated for tax purposes; in each case, our activities and balance sheet are
measured with reference to historical cost or fair market value without
considering inflation.
Other Matters
We calculate that our qualified REIT assets, as defined in the Internal
Revenue Code, are 100% of our total assets at December 31, 2006 and 2005 as
compared to the Internal Revenue Code requirement that at least 75% of our total
assets be qualified REIT assets. We also calculate that 99.3% and 93.3%,
respectively, of our revenue qualifies for the 75% source of income test, and
100% of our revenue qualifies for the 95% source of income test, under the REIT
rules for the years ended December 31, 2006 and 2005. We also met all REIT
requirements regarding the ownership of our common stock and the distribution of
our net income. Therefore, as of December 31, 2006, 2005 and 2004, we believe
that we qualified as a REIT under the Internal Revenue Code.
We at all times intend to conduct our business so as not to become
regulated as an investment company under the Investment Company Act of 1940, as
amended (the "Investment Company Act"). We rely on the exclusion provided by
Section 3(c)(5)(C) of the Investment Company Act. Section 3 ( c)(5)( C), as
interpreted by the staff of the SEC, requires us to invest at least 55% of our
assets in "mortgages and other liens on and interests in real estate" (or
Qualifying Real Estate Assets) and a least 80% or our assets in Qualifying Real
Estate Assets plus real estate related assets. The assets that we acquire,
therefore, are limited by the provisions of the Investment Company Act and the
rules and regulations promulgated under the Investment Company Act. We calculate
that as of December 31, 2006, 2005 and 2004, we were in compliance with this
requirement.
50
ITEM 7A QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
---------------------------------------------------------------------
MARKET RISK
Market risk is the exposure to loss resulting from changes in interest
rates, foreign currency exchange rates, commodity prices and equity prices. The
primary market risk to which we are exposed is interest rate risk, which 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. Changes in the general level of interest rates
can affect our net interest income, which is the difference between the interest
income earned on interest-earning assets and the interest expense incurred in
connection with our interest-bearing liabilities, by affecting the spread
between our interest-earning assets and interest-bearing liabilities. Changes in
the level of interest rates also can affect the value of our Mortgage-Backed
Securities and our ability to realize gains from the sale of these assets. We
may utilize a variety of financial instruments, including interest rate swaps,
caps, floors, inverse floaters and other interest rate exchange contracts, in
order to limit the effects of interest rates on our operations. When we use
these types of derivatives to hedge the risk of interest-earning assets or
interest-bearing liabilities, we may be subject to certain risks, including the
risk that losses on a hedge position will reduce the funds available for
payments to holders of securities and that the losses may exceed the amount we
invested in the instruments.
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 and 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, 2006 and various estimates
regarding prepayment and all activities are made at each level of rate shock.
Actual results could differ significantly from these estimates.
Change in Projected Percentage Projected Percentage
Interest Rate Change in Net Interest Income Change in Portfolio Value
--------------------------------------------------------------------------------
-75 Basis Points 30.92% 1.81%
-50 Basis Points 20.92% 1.41%
-25 Basis Points 10.57% 0.90%
Base Interest Rate - -
+25 Basis Points (10.71%) (0.39%)
+50 Basis Points (21.53%) (1.18%)
+75 Basis Points (32.44%) (2.07%)
ASSET AND LIABILITY MANAGEMENT
Asset and liability management is 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.
51
The following table sets forth the estimated maturity or repricing of
our interest-earning assets and interest-bearing liabilities at December 31,
2006. 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.
Within 3 More than 1 3 Years and
Months 4-12 Months Year to 3 Over Total
Years
(dollars in thousands)
---------------------------------------------------------------
Rate Sensitive Assets:
Investment Securities
(Principal) $3,039,168 $1,690,693 $7,443,539 $17,961,391 $30,134,791
Rate Sensitive Liabilities:
Repurchase Agreements,
with the effect of swaps 16,207,620 2,119,100 3,980,300 5,207,000 27,514,020
---------------------------------------------------------------
Interest rate sensitivity gap (13,168,452) (428,407) 3,463,239 12,754,391 2,620,771
===============================================================
Cumulative rate sensitivity gap (13,168,452) (13,596,859)(10,133,620) 2,620,771
==================================================
Cumulative interest rate
sensitivity gap as a
percentage of total rate-
sensitive assets (44%) (45%) (34%) 9%
==================================================
Our analysis of risks is based on management'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 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."
52
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-19 ] 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 (the "CEO") and Chief
Financial Officer (the "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, by our employees, 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 Report On Internal Control Over Financial Reporting
Dated: February 26, 2007
Management of the Company is responsible for establishing and
maintaining adequate internal control over financial reporting. Internal control
over financial reporting is defined in Rule 13a-15(f) under the Securities
Exchange Act as a process designed by, or under the supervision of, the
Company's principal executive and principal financial officers and effected by
the Company's Board of Directors, management and other personnel to provide
reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance with
generally accepted accounting principles and includes those policies and
procedures that:
o pertain to the maintenance of records that in reasonable detail
accurately and fairly reflect the transactions and dispositions of the
assets of the Company;
o provide reasonable assurance that transactions are recorded as necessary
to permit preparation of financial statements in accordance with
generally accepted accounting principles, and that receipts and
expenditures of the Company are being made only in accordance with
authorizations of management and directors of the Company; and
o provide reasonable assurance regarding prevention or timely detection of
unauthorized acquisition, use or disposition of the Company's assets
that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial
reporting may not prevent or detect misstatements. As a result, even systems
determined to be effective can provide only reasonable assurance regarding the
preparation and presentation of financial statements. Moreover, projections of
any evaluation of effectiveness to future periods are subject to the risks that
controls may become inadequate because of changes in conditions or that the
degree of compliance with the policies or procedures may deteriorate.
The Company's management assessed the effectiveness of the Company's
internal control over financial reporting as of December 31, 2006. In making
this assessment, the Company's management used criteria set forth by the
Committee of Sponsoring Organizations of the Treadway Commission (COSO) in
Internal Control-Integrated Framework.
53
Based on management's assessment, the Company's management believes
that, as of December 31, 2006, the Company's internal control over financial
reporting was effective based on those criteria. There have been no changes in
the Company's internal controls over financial reporting that occurred during
the quarter ended December 31, 2006 that have materially affected, or are
reasonably likely to affect its internal control over financial reporting.
The Company's independent registered public accounting firm, Deloitte &
Touche LLP, have issued an audit report on management's assessment of the
Company's internal control over financial reporting. This report appears on page
F-1 of this annual report on Form 10-K.
ITEM 9B. OTHER INFORMATION
----------------------------
None.
PART III
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, 2006. The information regarding our executive officers
required by Item 10 appears in Part I of this 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, 2006.
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.annaly.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, 2006.
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, 2006.
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, 2006.
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, 2006.
54
PART IV
ITEM 15 EXHIBITS, FINANCIAL STATEMENT SCHEDULES.
---------------------------------------------------
(a) Documents filed as part of this report:
1. Financial Statements.
2. Schedules to Financial Statements:
All financial statement schedules not included 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 Exhibit Description
Number
3.1 Articles of Amendment and Restatement of the Articles of
Incorporation of the Registrant (incorporated by reference to Exhibit
3.2 to the Registrant's Registration Statement on Form S-11
(Registration No. 333-32913) filed with the Securities and Exchange
Commission on August 5, 1997).
3.2 Articles of Amendment of the Articles of Incorporation of the
Registrant (incorporated by reference to Exhibit 3.1 of the
Registrant's Registration Statement on Form S-3 (Registration
Statement 333-74618) filed with the Securities and Exchange
Commission on June 12, 2002).
3.3 Articles of Amendment of the Articles of Incorporation of the
Registrant (incorporated by reference to Exhibit 3.1 of the
Registrant's Form 8-K (filed with the Securities and Exchange
Commission on August 3, 2006).
3.4 Form of Articles Supplementary designating the Registrant's 7.875%
Series A Cumulative Redeemable Preferred Stock, liquidation
preference $25.00 per share (incorporated by reference to Exhibit
3.3 to the Registrant's 8-A filed April 1, 2004).
3.5 Articles Supplementary of the Registrant's designating an additional
2,750,000 shares of the Company's 7.875% Series A Cumulative
Redeemable Preferred Stock, as filed with the State Department of
Assessments and Taxation of Maryland on October 15, 2004
(incorporated by reference to Exhibit 3.2 to the Registrant's 8-K
filed October 4, 2004).
3.6 Articles Supplementary designating the Registrant's 6% Series B
Cumulative Convertible Preferred Stock, liquidation preference
$25.00 per share (incorporated by reference to Exhibit 3.1 to the
Registrant's 8-K filed April 10, 2006).
3.7 Bylaws of the Registrant, as amended (incorporated by reference to
Exhibit 3.3 to the Registrant's Registration Statement on Form S-11
(Registration No. 333-32913) filed with the Securities and Exchange
Commission on August 5, 1997).
4.1 Specimen Common Stock Certificate (incorporated by reference to
Exhibit 4.1 to Amendment No. 1 to the Registrant's Registration
Statement on Form S-11 (Registration No. 333-32913) filed with the
Securities and Exchange Commission on September 17, 1997).
4.2 Specimen Preferred Stock Certificate (incorporated by reference to
Exhibit 4.2 to the Registrant's Registration Statement on Form S-3
(Registration No. 333-74618) filed with the Securities and Exchange
Commission on December 5, 2001).
4.3 Specimen Series A Preferred Stock Certificate (incorporated by
reference to Exhibit 4.1 of the Registrant's Registration
Statement on Form 8-A filed with the SEC on April 1, 2004).
4.4 Specimen Series B Preferred Stock Certificate (incorporated by
reference to Exhibit 4.1 to the Registrant's Form 8K filed with
the Securities and Exchange Commission on April 10, 2006).
55
10.1 Long-Term Stock Incentive Plan (incorporated by reference to
Exhibit 10.3 to the Registrant's Registration Statement on Form
S-11 (Registration No. 333-32913) filed with the Securities and
Exchange Commission on August 5, 1997).*
10.2 Form of Master Repurchase Agreement (incorporated by reference to
Exhibit 10.7 to the Registrant's Registration Statement on Form S-11
(Registration No. 333-32913) filed with the Securities and Exchange
Commission on August 5, 1997).
10.3 Amended and Restated Employment Agreement, effective as of June 4,
2004, between the Registrant and Michael A.J. Farrell (incorporated
by reference to Exhibit 10.3 of the Registrant's Form 10-K filed with
the Securities and Exchange Commission on March 10, 2005).*
10.4 Amended and Restated Employment Agreement, effective as of June 4,
2004, between the Registrant and Wellington J. Denahan
(incorporated by reference to Exhibit 10.4 of the Registrant's
Form 10-K filed with the Securities and Exchange Commission on
March 10, 2005).*
10.5 Amended and Restated Employment Agreement, effective as of June 4,
2004,between the Registrant and Kathryn F. Fagan (incorporated by
reference to Exhibit 10.5 of the Registrant's Form 10-K filed with
the Securities and Exchange Commission on March 10, 2005).*
10.6 Amended and Restated Employment Agreement, effective as of June 4,
2004, between the Registrant and James P. Fortescue (incorporated by
reference to Exhibit 10.7 of the Registrant's Form 10-K filed with
the Securities and Exchange Commission on March 10, 2005).*
10.7 Amended and Restated Employment Agreement, dated as of January 23,
2006, between the Registrant and Jeremy Diamond.*
10.8 Amended and Restated Employment Agreement, dated as of January 23,
2006, between the Registrant and Ronald D. Kazel.*
10.9 Amended and Restated Employment Agreement, dated as of April 21,
2006, between the Registrant and Rose-Marie Lyght (incorporated by
reference to Exhibit 10.9 of the Registrant's Form 10-Q filed with
the Securities and Exchange Commission on May 9, 2006).*
10.10 Amended and Restated Employment Agreement, effective as of June 4,
2004, between the Registrant and Kristopher R. Konrad
(incorporated by reference to Exhibit 10.11 of the Registrant's
Form 10-K filed with the Securities and Exchange Commission on
March 10, 2005).*
10.11 Amended and Restated Employment Agreement, dated January 23, 2006,
between the Registrant and R. Nicholas Singh.*
10.12 Agreement and Plan of Merger, dated as of December 31, 2003, by and
among the Registrant, Fixed Income Discount Advisory Company, FDC
MergerSub, Inc., Michael A.J. Farrell, Wellington J. Denahan,
Jennifer S. Karve, Kathryn F. Fagan, Jeremy Diamond, Ronald D. Kazel,
Rose-Marie Lyght, Kristopher R. Konrad, and James P. Fortescue
(incorporated by reference to Exhibit 99.2 to the Registrant's Form
8-K filed with the Securities and Exchange Commission on January 2,
2004).
12.1 Computation of ratio of earnings to combined fixed charges and
preferred stock dividends.
23.1 Consent of Independent Registered Public Accounting Firm.
31.1 Certification of Michael A.J. Farrell, Chairman, Chief Executive
Officer, and President of the Registrant, pursuant to 18 U.S.C.
Section 1350 as adopted pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002.
31.2 Certification of Kathryn F. Fagan, Chief Financial Officer and
Treasurer of the Registrant, pursuant to 18 U.S.C. Section 1350 as
adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of Michael A.J. Farrell, Chairman, 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.
32.2 Certification of Kathryn F. Fagan, Chief Financial Officer and
Treasurer of the Registrant, pursuant to 18 U.S.C. Section 1350 as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
* Exhibit Numbers 10.1 and 10.3-10.11 are management contracts or compensatory
plans required to be filed as Exhibits to this Form 10-K.
56
ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
FINANCIAL STATEMENTS
--------------------------------------------------------------------------------
Page
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM F-1
CONSOLIDATED FINANCIAL STATEMENTS FOR THE YEARS ENDED
DECEMBER 31, 2006, 2005,and 2004:
Consolidated Statements of Financial Condition F-3
Consolidated Statements of Operations and Comprehensive Income (Loss) F-4
Consolidated Statements of Stockholders' Equity F-5
Consolidated Statements of Cash Flows F-6
Notes to Consolidated Financial Statements F-7
57
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
Annaly Capital Management, Inc.
New York, New York
We have audited the accompanying consolidated statements of financial
condition of Annaly Capital Management, Inc. and subsidiaries (the "Company") as
of December 31, 2006 and 2005, and the related consolidated statements of
operations and comprehensive income (loss), stockholders' equity, and cash flows
for each of the three years in the period ended December 31, 2006. We also have
audited management's assessment, included in the accompanying Management Report
On Internal Control Over Financial Reporting included at Item 9A, that the
Company maintained effective internal control over financial reporting as of
December 31, 2006, based on criteria established in Internal Control--Integrated
Framework issued by the Committee of Sponsoring Organizations of the Treadway
Commission. The Company's management is responsible for these financial
statements, for maintaining effective internal control over financial reporting,
and for its assessment of the effectiveness of internal control over financial
reporting. Our responsibility is to express an opinion on these financial
statements, an opinion on management's assessment, and an opinion on the
effectiveness of the Company's internal control over financial reporting based
on our audits.
We conducted our audits 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 and whether effective
internal control over financial reporting was maintained in all material
respects. Our audit of financial statements included 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, and evaluating the overall financial statement presentation. Our
audit of internal control over financial reporting included obtaining an
understanding of internal control over financial reporting, evaluating
management's assessment, testing and evaluating the design and operating
effectiveness of internal control, and performing such other procedures as we
considered necessary in the circumstances. We believe that our audits provide a
reasonable basis for our opinions.
A company's internal control over financial reporting is a process designed
by, or under the supervision of, the company's principal executive and principal
financial officers, or persons performing similar functions, and effected by the
company's board of directors, management, and other personnel to provide
reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance with
generally accepted accounting principles. A company's internal control over
financial reporting includes those policies and procedures that (1) pertain to
the maintenance of records that, in reasonable detail, accurately and fairly
reflect the transactions and dispositions of the assets of the company; (2)
provide reasonable assurance that transactions are recorded as necessary to
permit preparation of financial statements in accordance with generally accepted
accounting principles, and that receipts and expenditures of the company are
being made only in accordance with authorizations of management and directors of
the company; and (3) provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use, or disposition of the company's
assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial
reporting, including the possibility of collusion or improper management
override of controls, material misstatements due to error or fraud may not be
prevented or detected on a timely basis. Also, projections of any evaluation of
the effectiveness of the internal control over financial reporting to future
periods are subject to the risk that the controls may become inadequate because
of changes in conditions, or that the degree of compliance with the policies or
procedures may deteriorate.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Annaly
Capital Management, Inc. and subsidiaries, as of December 31, 2006 and 2005, and
the results of their operations and their cash flows for each of the three years
in the period ended December 31, 2006, in conformity with accounting principles
generally accepted in the United States of America. Also in our opinion,
management's assessment that the Company maintained effective internal control
F-1
over financial reporting as of December 31, 2006, is fairly stated, in all
material respects, based on the criteria established in Internal
Control--Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission. Furthermore, in our opinion, the
Company maintained, in all material respects, effective internal control over
financial reporting as of December 31, 2006, based on the criteria established
in Internal Control--Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission.
/s/ Deloitte & Touche LLP
New York, New York
February 26, 2007
F-2
ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
DECEMBER 31, 2006 AND 2005
(dollars in thousands, except for share data)
DECEMBER 31, 2006 DECEMBER 31, 2005
--------------------------------------
ASSETS
------------------------------------------
Cash and cash equivalents $91,782 $4,808
Mortgage-Backed Securities, at fair value 30,167,509 15,929,864
Agency debentures, at fair value 49,500 -
Trading securities, at fair value 18,365 -
Receivable for Mortgage-Backed Securities
sold 200,535 13,449
Accrued interest receivable 146,089 71,340
Receivable for advisory and service fees 3,178 3,497
Intangible for customer relationships, net 11,184 15,183
Goodwill 22,966 23,122
Interest rate swaps, at fair value 2,558 -
Other assets 2,314 2,159
--------------------------------------
Total assets $30,715,980 $16,063,422
======================================
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------------
Liabilities:
Repurchase agreements $27,514,020 $13,576,301
Payable for Mortgage-Backed Securities
purchased 338,172 933,051
Trading securities sold, not yet
purchased, at fair value 41,948 -
Accrued interest payable 83,998 27,994
Dividends payable 39,016 12,368
Other liabilities - 305
Accounts payable 18,816 8,837
Interest rate swaps, at fair value 20,179 543
--------------------------------------
Total liabilities 28,056,149 14,559,399
--------------------------------------
Minority interest in equity of
consolidated affiliate 5,324 -
--------------------------------------
6.00% Series B Cumulative Convertible
Preferred Stock:
4,600,000 and 0 authorized, issued and
outstanding, respectively 111,466 -
--------------------------------------
Stockholders' Equity:
7.875% Series A Cumulative Redeemable
Preferred Stock:
7,637,500 authorized 7,412,500 shares
issued and outstanding 177,088 177,088
Common stock: par value $.01 per share;
500,000,000 authorized,
205,345,591 and 123,684,931 shares
issued and outstanding,
respectively 2,053 1,237
Additional paid-in capital 2,615,016 1,679,452
Accumulated other comprehensive loss (76,112) (207,117)
Accumulated deficit (175,004) (146,637)
--------------------------------------
Total stockholders' equity 2,543,041 1,504,023
--------------------------------------
Total liabilities, minority interest,
Series B Preferred Stock and
stockholders' equity $30,715,980 $16,063,422
======================================
See notes to consolidated financial statements.
F-3
ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME (LOSS)
YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004
(dollars in thousands, except per share amounts)
For the Year For the Year For the Year
Ended December Ended December Ended December
31, 2006 31, 2005 31, 2004
------------------------------------------------
Interest income $1,221,882 $705,046 $532,328
Interest expense 1,055,013 568,560 270,116
------------------------------------------------
Net interest income 166,869 136,486 262,212
Other (loss) income:
Investment advisory and
service fees 22,351 35,625 12,512
(Loss) gain on sale of
Investment Securities (3,862) (53,238) 5,215
Gain on termination of
interest rate swaps 10,674 - -
Income from trading
securities 3,994 - -
Loss on other-than-
temporarily impaired
securities (52,348) (83,098) -
------------------------------------------------
Total other (loss) income (19,191) (100,711) 17,727
------------------------------------------------
Expenses:
Distribution fees 3,444 8,000 2,860
General and administrative
expenses 40,063 26,278 24,029
------------------------------------------------
Total expenses 43,507 34,278 26,889
------------------------------------------------
Impairment of intangible for
customer relationships 2,493 - -
Income before income taxes and
minority interest 101,678 1,497 253,050
Income taxes 7,538 10,744 4,458
------------------------------------------------
Income (loss) before
minority interest 94,140 (9,247) 248,592
Minority interest 324 - -
------------------------------------------------
Net Income (loss) 93,816 (9,247) 248,592
Dividends on preferred stock 19,557 14,593 7,745
------------------------------------------------
Net income available (loss
related) to common shareholders $74,259 ($23,840) $240,847
================================================
Net income available (loss
related) to common shareholders
per average common share:
Basic $0.44 ($0.19) $2.04
================================================
Diluted $0.44 ($0.19) $2.03
================================================
Weighted average number of
common shares outstanding:
Basic 167,666,631 122,475,032 118,223,330
================================================
Diluted 167,746,387 122,475,032 118,459,145
================================================
Net income (loss) $93,816 ($9,247) $248,592
------------------------------------------------
Comprehensive income (loss):
Unrealized gain (loss) on
available-for sale securities 91,873 (222,110) (68,324)
Unrealized loss on interest
rate swaps (6,404) (543) -
Reclassification adjustment
for net losses (gains)
included in net income or
loss 45,536 136,336 (5,215)
------------------------------------------------
Other comprehensive income
(loss) 131,005 (86,317) (73,539)
------------------------------------------------
Comprehensive income (loss) $224,821 ($95,564) $175,053
================================================
See notes to consolidated financial statements.
F-4
ANNALY CAPITAL MANAGEMENT, INC.AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004
(dollars in thousands, except per share data)
Common Additional Other Accumulated Retained
Preferred Stock Paid-In Comprehensive (Deficit)
Stock Par Value Capital Income (Loss) Earnings Total
----------------------------------------------------------------------------
BALANCE, DECEMBER 31, 2003 $961 $1,194,159 ($47,261) $1,361 $1,149,220
Net Income 248,592
Other comprehensive loss (73,539)
Comprehensive income 175,053
Exercise of stock options 1 855 856
Net proceeds from direct purchase and
dividend reinvestment 1 2,285 2,286
Net proceeds from follow-on offering 207 363,385 363,592
Common shares issued in FIDAC transaction 22 40,478 40,500
Net proceeds from preferred offering $177,077 177,077
Net proceeds from equity shelf program 21 37,473 37,494
Preferred dividends declared, $1.45 per share (7,745) (7,745)
Common dividends declared, $1.98 per share (237,863) (237,863)
----------------------------------------------------------------------------
BALANCE, DECEMBER 31, 2004 $177,077 $1,213 $1,638,635 ($120,800) $4,345 $1,700,470
Net loss (9,247)
Other comprehensive Loss (86,317)
Comprehensive loss (95,564)
Reduction in estimated legal cost of
preferred offering 11 11
Exercise of stock options 253 253
Net proceeds from direct purchase and
dividend reinvestment 440 440
Net proceeds from equity shelf program 24 40,124 40,148
Preferred dividends declared, $1.97 per share (14,593) (14,593)
Common dividends declared, $1.04 per share (127,142) (127,142)
----------------------------------------------------------------------------
BALANCE, DECEMBER 31, 2005 $177,088 $1,237 $1,679,452 ($207,117) ($146,637) $1,504,023
Net income 93,816
Other comprehensive income 131,005
Comprehensive income 224,821
Exercise of stock options 183 183
Option expense 1,285 1,285
Net proceeds from follow-on offerings 800 913,200 914,000
Net proceeds from equity shelf program 16 20,896 20,912
Preferred Series A dividends declared $1.97
per share (14,594) (14,594)
Preferred Series B dividends declared $1.08
per share (4,966) (4,966)
Common dividends declared, $0.57 per share (102,623) (102,623)
----------------------------------------------------------------------------
BALANCE, DECEMBER 31, 2006 $177,088 $2,053 $2,615,016 ($76,112) ($175,004) $2,543,041
============================================================================
See notes to consolidated financial statements.
F-5
ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 2006, 2005, AND 2004
(dollars in thousands)
For the Year For the Year For the Year
Ended Ended Ended
December 31, December 31, December 31,
2006 2005 2004
---------------------------------------------
Cash flows from operating activities:
Net income (loss) $93,816 ($9,247) $248,592
Adjustments to reconcile net income (loss) to net
cash provided by operating activities:
Amortization of Mortgage Backed Securities
premiums and discounts, net 63,625 154,309 179,602
Amortization of intangibles 1,589 571 130
Loss (gain) on sale of Investment Securities 3,862 53,238 (5,215)
Gain on termination of interest rate swaps (10,674) - -
Stock option expense 1,285 56 317
Net realized gain on trading investments (1,200) - -
Unrealized depreciation on trading investments 1,180 - -
Market value adjustment on long-term repurchase
agreements (149) (2,514) (1,133)
Loss on other-than-temporarily impaired
securities 52,348 83,098 -
Impairment of intangibles 2,493 - -
(Increase) decrease in accrued interest
receivable (76,224) 10,555 (27,964)
Increase in other assets (238) (425) (1,749)
Purchase of trading investments (44,200) - -
Proceeds from sale of trading securities 28,838 - -
Purchase of trading securities sold, not yet
purchased (16,096) - -
Proceeds for securities sold, not yet purchased 55,073 - -
(Decrease) increase in advisory and service
fees receivable 319 (1,138) (795)
Increase (decrease) in interest payable 56,004 (7,727) 20,732
Increase in accrued expenses and other
liabilities 9,978 753 4,400
---------------------------------------------
Net cash provided by operating activities 221,629 281,529 416,917
---------------------------------------------
Cash flows from investing activities:
Purchase of Mortgage-Backed Securities (23,196,076) (7,416,869) (14,147,323)
Proceeds from sale of Investment Securities 3,040,984 3,231,219 596,962
Principal payments of Mortgage-Backed Securities 5,115,693 7,053,867 6,495,911
Purchase of agency debentures - - (250,000)
Proceeds from called agency debentures - 130,000 845,000
Cash from FIDAC acquisition - - 2,526
---------------------------------------------
Net cash (used in) provided by investing
activities (15,039,399) 2,998,217 (6,456,924)
---------------------------------------------
Cash flows from financing activities:
Proceeds from repurchase agreements 292,418,807 245,514,548 152,739,827
Principal payments on repurchase agreements (278,481,088) (248,646,126) (147,045,071)
Proceeds from exercise of stock options 183 197 539
Proceeds from termination of interest rate swaps 10,674 - -
Proceeds from direct purchase and dividend
reinvestment - 440 2,286
Net proceeds from follow-on offerings 914,000 - 363,592
Net proceeds from preferred stock offering 111,466 - 177,077
Net proceeds from equity shelf program and ATM
Equity Sales Agreement 20,912 40,148 37,494
Minority interest 5,324
Dividends paid (95,534) (189,998) (230,131)
---------------------------------------------
Net cash provided by (used in) financing
activities 14,904,744 (3,280,791) 6,045,613
---------------------------------------------
Net increase (decrease) in cash and cash
equivalents 86,974 (1,045) 5,606
Cash and cash equivalents, beginning of year 4,808 5,853 247
---------------------------------------------
Cash and cash equivalents, end of year $91,782 $4,808 $5,853
=============================================
Supplemental disclosure of cash flow information:
Interest paid $999,009 $576,287 $249,384
=============================================
Taxes paid $7,242 $11,740 $3,462
=============================================
Noncash financing activities:
Net change in unrealized loss on available-for-
sale securities and interest rate swaps, net of
reclassification adjustment $131,005 ($86,317) ($73,539)
=============================================
Dividends declared, not yet paid $39,016 $12,368 $60,632
=============================================
Noncash investing and financing activities:
Noncash acquisition of FIDAC - - $40,500
=============================================
See notes to consolidated financial statements.
F-6
ANNALY CAPITAL MANAGEMENT, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004
--------------------------------------------------------------------------------
1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES
Annaly Capital Management, Inc. (the "Company") was incorporated in
Maryland on November 25, 1996. The Company changed its name from Annaly Mortgage
Management, Inc. to Annaly Capital Management, Inc. effective August 2, 2006.
The Company commenced its operations of purchasing and managing an investment
portfolio of mortgage-backed securities on February 18, 1997, upon receipt of
the net proceeds from the private placement of equity capital. An initial public
offering was completed on October 14, 1997. The Company is a real estate
investment trust (REIT) under the Internal Revenue Code of 1986, as amended. The
Company acquired Fixed Income Discount Advisory Company ("FIDAC") on June 4,
2004. FIDAC is a registered investment advisor and is a taxable REIT subsidiary
of the Company. On June 27, 2006, the Company made a majority equity investment
of 90% in an affiliated investment fund (the "Fund"). At December 31, 2006, the
Fund was invested 100% in equity investments.
A summary of the Company's significant accounting policies follows:
The consolidated financial statements include the accounts of the
Company, FIDAC and the Fund. All intercompany balances and transactions have
been eliminated. The minority shareholder in the Fund is reflected as minority
interest in the consolidated financial statements.
Cash and Cash Equivalents - Cash and cash equivalents include cash on
hand and money market funds.
Mortgage-Backed Securities and Agency Debentures - The Company invests
primarily in mortgage pass-through certificates, collateralized mortgage
obligations and other mortgage-backed securities representing interests in or
obligations backed by pools of mortgage loans (collectively, "Mortgage-Backed
Securities"). The Company also invests in agency debentures issued by Federal
Home Loan Bank ("FHLB"), Federal Home Loan Mortgage Corporation ("FHLMC"), and
Federal National Mortgage Association ("FNMA"). The Mortgage-Backed Securities
and agency debentures are collectively referred to herein as "Investment
Securities."
Statement of Financial Accounting Standards ("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. Although the
Company generally intends to hold most of its Investment Securities until
maturity, it may, from time to time, sell any of its Investment Securities as
part of its overall management of its portfolio. Accordingly, SFAS No. 115
requires the Company to classify all of its Investment Securities as
available-for-sale. 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 excluded from earnings and reported as a separate
component of stockholders' equity.
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, and (3) 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. The loss on other-than-temporarily impaired
securities was $52.3 million during the year ended December 31, 2006 and $83.1
million during the year ended December 31, 2005. There were no impairment losses
recognized in 2004.
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 fair value of Mortgage-Backed Securities
and agency debentures available-for-sale and interest rate swaps is equal to
their carrying value presented in the consolidated statements of financial
condition. The fair value of trading securities and trading securities sold, not
yet purchased is equal to their estimated fair value presented in the
consolidated statements of financial condition. The fair value of cash and cash
equivalents, accrued interest receivable, receivable for securities sold,
receivable for advisory and service fees, repurchase agreements, with less than
a one year maturity date, and payable for mortgage-backed securities purchased,
dividends payable, accounts payable, and accrued interest payable, generally
approximates cost as of December 31, 2006 due to the short term nature of these
financial instruments.
F-7
Interest income is accrued based on the outstanding principal amount of
the Investment Securities and their contractual terms. Premiums and discounts
associated with the purchase of the Investment Securities are amortized into
interest income over the projected lives of the securities using the interest
method. The Company's policy for estimating prepayment speeds for calculating
the effective yield is to evaluate historical performance, consensus prepayment
speeds, and current market conditions.
Investment Securities transactions are recorded on the trade date.
Purchases of newly-issued securities are recorded when all significant
uncertainties regarding the characteristics of the securities are removed,
generally shortly before settlement date. Realized gain and losses on sale of
Investment Securities are determined on the specific identification basis.
Derivative Financial Instruments/Hedging Activity-- The Company hedges
interest rate risk through the use of derivative financial instruments,
comprised of interest rate caps and interest rate swaps (collectively, "Hedging
Instruments"). The Company accounts for Hedging Instruments in accordance with
SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities,
("SFAS 133") as amended and interpreted. The Company carries all Hedging
Instruments at their fair value, as assets, if their fair value is positive, or
as liabilities, if their fair value is negative. As the Company's interest rate
swaps are designated as cash flow hedges under SFAS No. 133, the change in the
fair value of any such derivative is recorded in other comprehensive income or
loss for hedges that qualify as effective. At December 31, 2006 the Company did
not have any interest rate caps. The ineffective amount of all Hedging
Instruments, if any, is recognized in earnings each year. To date, the Company
has not recognized any change in the value of its interest rate swaps in
earnings as a result of the hedge or a portion thereof being ineffective.
Upon entering into hedging transactions, the Company documents the
relationship between the Hedging Instruments and the hedged liability. The
Company also documents its risk-management policies, including objectives and
strategies, as they relate to its hedging activities. The Company assesses, both
at inception of a hedge and on an on-going basis, whether or not the hedge is
"highly effective," as defined by SFAS 133. The Company discontinues hedge
accounting on a prospective basis with changes in the estimated fair value
reflected in earnings when (i) it is determined that the derivative is no longer
effective in offsetting cash flows of a hedged item (including hedged items such
as forecasted transactions); (ii) it is no longer probable that the forecasted
transaction will occur; or (iii) it is determined that designating the
derivative as a Hedging Instrument is no longer appropriate.
When the Company enters into an interest rate swap, it agrees to pay a
fixed rate of interest and to receive a variable interest rate, generally based
on the London Interbank Offered Rate ("LIBOR"). The Company's interest rate
swaps are designated as cash flow hedges against the benchmark interest rate
risk associated with the Company's borrowings.
All changes in the unrealized gains/losses on any interest rate swap are
recorded in accumulated other comprehensive income or loss and are reclassified
to earnings as interest expense is recognized on the Company's hedged
borrowings. If it becomes probable that the forecasted transaction, which in
this case refers to interest payments to be made under the Company's short-term
borrowing agreements, will not occur by the end of the originally specified time
period, as documented at the inception of the hedging relationship, then the
related gain or loss in accumulated other comprehensive income or loss would be
reclassified to income or loss.
Realized gains and losses resulting from the termination of an interest
rate swap are initially recorded in accumulated other comprehensive income or
loss as a separate component of stockholders' equity. The gain or loss from a
terminated interest rate swap remains in accumulated other comprehensive income
or loss until the forecasted interest payments affect earnings. If it becomes
probable that the forecasted interest payments will not occur, then the entire
gain or loss would be recognized in earnings.
Credit Risk - The Company has limited its exposure to credit losses on
its portfolio of Mortgage-Backed Securities by only purchasing securities issued
by FHLMC, FNMA, or GNMA. The payment of principal and interest on the FHLMC and
FNMA Mortgage-Backed Securities are guaranteed by those respective agencies, and
the payment of principal and interest on the GNMA Mortgage-Backed Securities are
backed by the full faith and credit of the U.S. government. All of the Company's
Investment Securities have an actual or implied "AAA" rating.
F-8
Trading Securities and Trading Securities sold, not yet purchased -
Trading securities and trading securities sold, not yet purchased, are included
in the balance sheet as a result of consolidating the financial statements of
the Fund, and are carried at fair value at December 31, 2006. The realized and
unrealized gains and losses from trading securities are recorded in the income
from trading securities balance in the accompanying consolidated statements of
operations.
Trading account securities sold, not yet purchased represent
obligations of the Fund to deliver the specified security at the contracted
price, and thereby create a liability to purchase the security in the market at
prevailing prices.
Repurchase Agreements - The Company finances the acquisition of its
Investment Securities through the use of repurchase agreements. Repurchase
agreements are treated as collateralized financing transactions and are carried
at their contractual amounts, including accrued interest, as specified in the
respective agreements.
Cumulative Convertible Preferred Stock- The Company classifies its Series
B Cumulative Convertible Preferred Stock on the consolidated statements of
financial condition using the guidance in SEC Accounting Series Release No. 268,
Presentation in Financial Statements of "Redeemable Preferred Stocks," and
Emerging Issues Task Force ("EITF") Topic D-98, Classification and Measurement
of Redeemable Securities. The Series B Cumulative Convertible Preferred Stock
contains fundamental change provisions that allow the holder to redeem the
preferred stock for cash if certain events occur. As redemption under these
provisions is not solely within the Company's control, the Company has
classified the Series B Cumulative Convertible Preferred Stock as temporary
equity in the accompanying consolidated statement of financial condition.
The Company has analyzed whether the embedded conversion option should be
bifurcated under the guidance in SFAS No. 133 and EITF Issue No. 00-19,
Accounting for Derivative Financial Instruments Indexed to, and Potentially
Settled in, a Company's Own Stock, and has determined that bifurcation is not
necessary.
Income Taxes - The Company has elected to be taxed as a REIT and intends
to comply with the provisions of the Internal Revenue Code of 1986, as amended
(the "Code"), with respect thereto. Accordingly, the Company will not be
subjected to federal income tax to the extent of its distributions to
shareholders and as long as certain asset, income and stock ownership tests are
met. The Company and FIDAC have made a joint election to treat FIDAC as a
taxable REIT subsidiary. As such, FIDAC is taxable as a domestic C corporation
and subject to federal and state and local income taxes based upon its taxable
income.
Use of Estimates - The preparation of the consolidated 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.
Intangible assets - The Company's acquisition of FIDAC was accounted for
using the purchase method. Under the purchase method, net assets and results of
operations of acquired companies are included in the consolidated financial
statements from the date of acquisition. In addition, the cost of FIDAC was
allocated to the assets acquired, including identifiable intangible assets, and
the liabilities assumed based on their estimated fair values at the date of
acquisition. The excess of purchase price over the fair value of the net assets
acquired was recognized as goodwill. Intangible assets are periodically (but not
less frequently than annually) reviewed for potential impairment. Intangible
assets with an estimated useful life are expected to amortize over a 8.7 year
weighted average time period. During the year ended December 31, 2006, the
Company recognized $2.5 million in impairment losses on intangible assets
relating to customer relationships. During the years ended December 31, 2005 and
2004, the Company did not have impairment losses.
Stock-Based Compensation - On December 16, 2004, the Financial Accounting
Standards Board (FASB) issued SFAS No. 123 (Revised 2004) - Share-Based Recent
Payment ("SFAS No. 123R"). SFAS No. 123R, which replaces SFAS No. 123, requires
the Company to measure and recognize in the financial statements the
compensation cost relating to share-based payment transactions. The compensation
cost should be reassessed based on the fair value of the equity instruments
issued. We adopted SFAS No. 123R effective January 1, 2006 under the modified
prospective transition method. Accordingly, prior period amounts have not been
restated. Under this application, the Company is required to record compensation
expense for all awards granted or modified on or after January 1, 2006 and for
the unvested portion of all outstanding awards that remain outstanding at the
date of adoption. The adoption of SFAS No. 123R resulted in total stock-based
compensation expense of approximately $1.3 million for the year ended December
31, 2006.
F-9
The Company elected to recognize compensation expense on a
straight-line basis over the requisite service period for the entire award (that
is, over the requisite service period of the last separately vesting portion of
the award). We estimate fair value using the Black-Scholes valuation model. The
assumptions used to value the options granted during the year ended December 31,
2006 are as follows: Expected volatility of 26.50%, expected dividends of 5.57%,
expected term in years of 6.8 and risk-free rate of 4.6%. Assumptions used to
estimate the compensation expense are determined as follows:
o Expected term (estimated time of outstanding) is estimated using the
historical exercise behavior of employees
o Expected volatility is measured using the weighted average of historical
daily changes in the market price of our common stock over the expected
term of the award
o Expected dividend yield is based on projected dividend yield over the
expected term of the award
o Risk-free interest rate is equivalent to the implied yield on zero-coupon
U.S. Treasury bonds with a remaining maturity equal to the expected term of
the awards; and,
o Forfeitures are based substantially on the history of cancellations of
similar awards granted by the Company in prior years.
Prior to the adoption of SFAS No. 123R, we used the intrinsic
value method prescribed in APB 25 and also followed the disclosure requirements
of SFAS No. 123, as amended by SFAS No. 148, Accounting for Stock-Based
Compensation - Transition and Disclosure ("SFAS No. 148") which required certain
disclosures on a pro forma basis as if the fair value method had been followed
for accounting for such compensation.
For the For the
Year Ended Year Ended
December 31, 2005 December 31, 2004
Net (loss) income available to common
shareholders, as reported ($23,840) $240,847
Deduct: Total stock-based employee
compensation expense determined under
fair value based method (357) (149)
----------------------------------------
Pro-forma net (loss) income available to
common shareholers ($24,197) $240,698
========================================
Net (loss) income per share available to
common shareholders, as reported:
Basic ($0.19) $2.04
========================================
Diluted ($0.19) $2.03
========================================
Pro-forma net income per share available
to common shareholders:
Basic ($0.20) $2.03
========================================
Diluted ($0.20) $2.03
========================================
Recent Accounting Pronouncements - SEC Staff Accounting Bulletin No. 108
-- In September 2006 the SEC issued Staff Accounting Bulletin (SAB) No. 108
"Considering the effects of Prior Year Misstatements When Quantifying
Misstatements in Current Year Financial Statements" (SAB 108), which expresses
the Staff's views regarding the process of quantifying financial statement
misstatements. SAB 108 is effective for annual financial statements covering the
fiscal year ending after November 15, 2006. Registrants are required to quantify
the impact of correcting all misstatements, including both the carryover and
reversing effects of prior year misstatements, on the current year financial
statements. The techniques most commonly used in practice to accumulate and
quantify misstatements are generally referred to as the "rollover" (current year
income statement perspective) and "iron curtain" (year-end balance perspective)
approaches. The financial statements would require adjustment when either
approach results in quantifying a misstatement that is material, after
considering all relevant quantitative and qualitative factors. The adoption of
SAB 108 on December 31, 2006 has no effect on the Company's consolidated
financial statements.
In April 2006, the FASB issued FSP FIN 46(R)-6, Determining the
Variability to be Considered When Applying FASB Interpretation No. 46(R)("FIN
46(R)-6"). FIN 46(R)-6 addresses the approach to determine the variability to
consider when applying FIN 46(R). The variability that is considered in applying
Interpretation 46(R) may affect (i) the determination as to whether an entity is
a variable interest entity ("VIE"), (ii) the determination of which interests
F-10
are variable in the entity, (iii) if necessary, the calculation of expected
losses and residual returns on the entity, and (iv) the determination of which
party is the primary beneficiary of the VIE. Thus, determining the variability
to be considered is necessary to apply the provisions of Interpretation 46(R).
FIN 46(R)-6 is required to be prospectively applied to entities in which the
Company first become involved after July 1, 2006 and would be applied to all
existing entities with which the Company is involved if and when a
"reconsideration event" (as described in FIN 46) occurs. The adoption did not
have a material impact on the consolidated financial statements of the Company.
In February 2006, the FASB issued FAS No. 155, Accounting for Certain
Hybrid Instruments ("FAS 155"), an amendment of FASB Statements No. 133 and 140.
Among other things, FAS 155: (i) permits fair value re-measurement for any
hybrid financial instrument that contains an embedded derivative that otherwise
would require bifurcation; (ii) clarifies which interest-only strips and
principal-only strips are not subject to the requirements of FAS 133; (iii)
establishes a requirement to evaluate interests in securitized financial assets
to identify interests that are freestanding derivatives or that are hybrid
financial instruments that contain an embedded derivative requiring bifurcation;
(iv) clarifies that concentrations of credit risk in the form of subordination
are not embedded derivatives; and (v) amends FAS 140 to eliminate the
prohibition on a qualifying special-purpose entity from holding a derivative
financial instrument that pertains to a beneficial interest other than another
derivative financial instrument. FAS 155 is effective for all financial
instruments acquired or issued by the Company after December 31, 2006.
On September 25, 2006, the FASB met and proposed a scope exception under
FAS 155 for securitized interests that only contain an embedded derivative that
is tied to the prepayment risk of the underlying pre-payable financial assets,
and for which the investor does not control the right to accelerate the
settlement. If a securitized interest contains any other embedded derivative
(for example, an inverse floater), then it would be subject to the bifurcation
tests in FAS 133, as would securities purchased at a significant premium. The
FASB plans to issue their final position in early 2007.
In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for
Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109 ("FIN
48"), and related implementation issues. FIN 48 clarifies the accounting for
uncertainty in income taxes recognized in the Company's financial statements in
accordance with FASB Statement No. 109, Accounting for Income Taxes. FIN 48
prescribes a threshold and measurement attribute for recognition in the
financial statements of an asset or liability resulting from a tax position
taken or expected to be taken in a tax return. FIN 48 also provides guidance on
derecognition, classification, interest and penalties, accounting in interim
periods, disclosure and transition. FIN 48 is effective as of the beginning of
fiscal years that begin after December 15, 2006. The implement of FIN 48 is not
expected to have a material impact on the Company's consolidated financial
statements.
In September 2006, the FASB issued SFAS No. 157, Fair Value Measurements.
SFAS No. 157 defines fair value, establishes a framework for measuring fair
value and requires enhanced disclosures about fair value measurements. SFAS No.
157 requires companies to disclose the fair value of its 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. SFAS No. 157 is
effective for the Company on January 1, 2008. The Company is currently
evaluating the impact adoption of SFAS No. 157 may have on its consolidated
financial statements.
Proposed Accounting Pronouncements- The FASB has added an item to its
current proposed amendment relating to the accounting treatment under SFAS No.
140, Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities of transactions where assets purchased from a
particular counterparty are financed via a repurchase agreement with the same
counterparty. Currently, the Company records such assets and the related
financing in the consolidated statement of financial condition, and the
corresponding interest income and interest expense in the Company's consolidated
statement of operations and comprehensive (loss) income. For assets representing
available-for-sale investment securities, as in the Company's case, any change
in fair value is reported through other comprehensive income under SFAS No. 115,
with the exception of impairment losses, which are recorded in the consolidated
statement of operations and comprehensive (loss) income as realized losses.
However, a transaction where assets are acquired from and financed under
a repurchase agreement with the same counterparty may not qualify for a sale
treatment by a seller under an interpretation of SFAS No. 140, which would
require the seller to continue to carry such sold assets on their books based on
their "continuing involvement" with such assets. Depending on the ultimate
outcome of the FASB deliberations, the result may be that the Company would be
precluded from recording the assets purchased in the transaction described above
as well as the related financing in the Company's consolidated statement of
financial condition and would instead be treating the Company's net investment
in such assets as a derivative.
F-11
This potential change in accounting treatment would not affect the
economic substance of the transactions but would affect how the transactions
would be reported in the Company's financial statements. The Company's cash
flows, liquidity and ability to pay a dividend would be unchanged, and the
Company does not believe the Company's taxable income or net equity would be
affected.
F-12
2. MORTGAGE-BACKED SECURITIES
The following tables present the Company's available-for-sale
Mortgage-Backed Securities portfolio as of December 31, 2006 and 2005:
Government
Federal Home Loan Federal National National
Mortgage Mortgage Mortgage Total Mortgage-
December 31, 2006 Corporation Association Association Backed Securities
-----------------------------------------------------------------------
(dollars in thousands)
Mortgage-Backed
Securities, gross $10,675,235 $19,085,218 $324,338 $30,084,791
Unamortized discount (21,332) (56,517) (204) (78,053)
Unamortized premium 82,707 133,164 3,271 219,142
-----------------------------------------------------------------------
Amortized cost 10,736,610 19,161,865 327,405 30,225,880
Gross unrealized gains 35,174 74,498 366 110,038
Gross unrealized losses (73,125) (92,548) (2,736) (168,409)
-----------------------------------------------------------------------
Estimated fair value $10,698,659 $19,143,815 $325,035 $30,167,509
=======================================================================
Gross Unrealized Gross Unrealized Estimated Fair
Amortized Cost Gain Loss Value
-----------------------------------------------------------------------
(dollars in thousands)
Adjustable rate $8,546,363 $12,764 ($61,483) $8,497,644
Fixed rate 21,679,517 97,274 (106,926) 21,669,865
-----------------------------------------------------------------------
Total $30,225,880 $110,038 ($168,409) $30,167,509
=======================================================================
Government
Federal Home Loan Federal National National
Mortgage Mortgage Mortgage Total Mortgage-
December 31, 2005 Corporation Association Association Backed Securities
-----------------------------------------------------------------------
(dollars in thousands)
Mortgage-Backed
Securities, gross $5,689,898 $9,881,672 $344,231 $15,915,801
Unamortized discount (4,043) (17,345) (62) (21,450)
Unamortized premium 92,228 144,726 5,133 242,087
-----------------------------------------------------------------------
Amortized cost 5,778,083 10,009,053 349,302 16,136,438
Gross unrealized gains 3,174 1,853 - 5,027
Gross unrealized losses (80,733) (124,330) (6,538) (211,601)
-----------------------------------------------------------------------
Estimated fair value $5,700,524 $9,886,576 $342,764 $15,929,864
=======================================================================
Gross Unrealized Gross Unrealized Estimated Fair
Amortized Cost Gain Loss Value
-----------------------------------------------------------------------
(dollars in thousands)
Adjustable rate $9,844,261 $3,973 ($120,480) 9,727,754
Fixed rate 6,292,177 1,054 (91,121) 6,202,110
-----------------------------------------------------------------------
Total $16,136,438 $5,027 ($211,601) $15,929,864
=======================================================================
F-13
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 on December 31, 2006 and 2005 according to their estimated
weighted-average life classifications:
December 31, 2006 December 31, 2005
Weighted-Average Life Fair Value Amortized Cost Fair Value Amortized Cost
(dollars in thousands)
--------------------------------------------------------------------------------------------
Less than one year $379,967 $382,268 $508,851 $514,560
Greater than one year and less
than five years 21,788,975 21,851,659 12,648,106 12,824,736
Greater than or equal to five
years 7,998,567 7,991,953 2,772,907 2,797,142
------------------------------------------------------------
Total $30,167,509 $30,225,880 $15,929,864 $16,136,438
============================================================
The weighted-average lives of the mortgage-backed securities at
December 31, 2006 and 2005 in the table above are based upon data provided
through subscription-based financial information services, assuming constant
principal prepayment rates to the reset date of each security. The prepayment
model considers current yield, forward yield, steepness of the yield curve,
current mortgage rates, mortgage rate of the outstanding loans, loan age, margin
and volatility.
Mortgage-Backed Securities with a carrying value of $7.0 billion were
in a continuous unrealized loss position over 12 months at December 31, 2006 in
the amount of $138.2 million. Mortgage-Backed Securities with a carrying value
of $6.4 billion were in a continuous unrealized loss position for less than 12
months at December 31, 2006 in the amount of $30.2 million. Mortgage-Backed
Securities with a carrying value of $4.6 billion were in a continuous unrealized
loss position over 12 months at December 31, 2005 in the amount of $111.1
million. Mortgage-Backed Securities with a carrying value of $8.4 billion were
in a continuous unrealized loss position for less than 12 months at December 31,
2005 in the amount of $100.5 million. The decline in value of these securities
is solely due to increases in interest rates. All of the Mortgage-Backed
Securities are "AAA" rated or carry an implied "AAA" rating. During the years
ended December 31, 2006 and 2005, the Company recorded impairment losses of
$52.3 million and $83.1 million, respectively. The remaining investments are not
considered other-than-temporarily impaired since the Company currently has the
ability and intent to hold the investments for a period of time or to maturity,
if necessary, sufficient for a forecasted market price recovery up to or beyond
the cost of the investments. Also, the Company is guaranteed payment on the par
value of the securities.
The adjustable rate Mortgage-Backed Securities are limited by periodic
caps (generally interest rate adjustments are limited to no more than 1% every
nine months) and lifetime caps. The weighted average lifetime cap was 9.8% at
December 31, 2006 and 10.3% at December 31, 2005.
During the year ended December 31, 2006, the Company realized $3.9
million in net losses from sales of Investment Securities. During year ended
December 31, 2005, the Company realized $53.2 million in net gains from sales of
Mortgage-Backed Securities.
3. AGENCY DEBENTURES
At December 31, 2006, the Company owned agency debentures with a
carrying value of $49.6 million, including the unrealized loss of $120,000. At
December 31, 2005, the Company did not own agency debentures.
4. REPURCHASE AGREEMENTS
The Company had outstanding $27.5 billion and $13.6 billion of
repurchase agreements with weighted average borrowing rates of 5.14% and 4.16%,
and weighted average remaining maturities of 125 days and 79 days as of December
31, 2006 and December 31, 2005, respectively. Investment Securities pledged as
collateral under these repurchase agreements had an estimated fair value of
$28.6 billion at December 31, 2006 and $14.3 billion at December 31, 2005.
F-14
At December 31, 2006 and December 31, 2005, the repurchase agreements
had the following remaining maturities:
December 31, 2006 December 31, 2005
(dollars in thousands)
---------------------------------------------------------
Within 30 days $22,778,703 $10,575,945
30 to 59 days 2,285,317 1,250,356
60 to 89 days 200,000 -
90 to 119 days - -
Over 120 days 2,250,000 1,750,000
--------------------------- -----------------------------
Total $27,514,020 $13,576,301
=========================== =============================
The Company did not have an amount at risk greater than 10% of the equity
of the Company with any counterparties as of December 31, 2006.
The Company had an amount at risk greater than 10% of the equity of the
Company with the following counterparty at December 31, 2005.
Amount at risk(1) Weighted average days
(dollars in thousands) to maturity
---------------------------------------------------
UBS Securities LLC $179,959 121
(1) Equal to the sum of fair value of securities sold plus accrued interest
income minus the sum of repurchase agreements plus
accrued interest expense.
The Company has entered into repurchase agreements which provide the
counterparty with the right to call the balance prior to maturity date. The
repurchase agreements totaled $1.4 billion and the market value of the option to
call is $1.4 million. Management has determined that the call option is not
required to be bifurcated under the provisions of FASB No. 133 as it is deemed
clearly and closely related to the debt instrument, therefore the option value
is not recorded in the consolidated financial statements.
5. INTEREST RATE SWAPS
In connection with the Company's interest rate risk management
strategy, the Company hedges a portion of its interest rate risk by entering
into derivative financial instrument contracts. As of December 31, 2006, 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 Mortgage-Backed Securities 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 table below presents information about the Company's swaps outstanding at
December 31, 2006.
Notional Amount Weighted Average Weighted Average Net Estimated Fair
(dollars in thousands) Pay Rate Receive Rate Value/Carrying Value
(dollars in thousands)
-------------------------------------------------------------------------------------
$9,328,000 5.17% 5.35% ($17,621)
In 2006, the Company had a $10.7 million realized gain on the
termination of interest rate swaps with a notional value of $1.2 billion. At
December 31, 2005, there were no swap contracts that had settled.
6. PREFERRED STOCK AND COMMON STOCK
(A) Stock Issuances
On August 16, 2006, the Company entered into an underwriting agreement
pursuant to which it sold 40,825,000 shares of its common stock for net proceeds
before expenses of approximately $476.7 million. This transaction settled on
August 22, 2006.
F-15
On April 6, 2006, the Company entered into an underwriting agreement
pursuant to which it sold 39,215,000 shares of its common stock for net proceeds
before expenses of approximately $437.7 million. On April 6, 2006, the Company
entered into a second underwriting agreement pursuant to which if sold 4,600,000
shares of its 6% Series B Cumulative Convertible Preferred Stock for net
proceeds before expenses of approximately $111.5 million. Both of these
transactions settled on April 12, 2006.
On August 3, 2006, the Company entered into an ATM Equity Offering(sm)
Sales Agreement with Merrill Lynch & Co. and Merrill Lynch, Pierce, Fenner &
Smith Incorporated ("Merrill Lynch"), relating to the sale of shares of its
common stock from time to time through Merrill Lynch. Sales of the shares, if
any, are made by means of ordinary brokers' transaction on the New York Stock
Exchange. During the year ended December 31, 2006, 500,000 shares of the
Company's common stock were issued pursuant to this program, totaling $6.7
million in net proceeds.
On August 3, 2006, the Company entered into an ATM Equity Sales
Agreement with UBS Securities LLC ("UBS Securities"), relating to the sale of
shares of its common stock from time to time through UBS Securities. Sales of
the shares, if any, are made by means of ordinary brokers' transaction on the
New York Stock Exchange. During the year ended December 31, 2006, no shares of
the Company's common stock were issued pursuant to this program.
During the year ended December 31, 2006, the Company declared dividends
to common shareholders totaling $102.6 million or $.57 per share, of which $39.0
million were paid on January 26, 2007. During the year ended December 31, 2006,
the Company declared and paid dividends to Series A preferred shareholders
totaling $14.6 million or $1.97 per share and Series B Preferred shareholders
totaling $5.0 million or $1.08 per share. During the year ended December 31,
2006, 1,098,500 shares of the Company's common stock were issued through the
Equity Shelf Program, totaling net proceeds of $14.2 million. During the year
ended December 31, 2006, 22,160 options were exercised under the long-term
compensation plan for an aggregate exercise price of $183,000.
During the year ended December 31, 2005, the Company declared dividends
to common shareholders totaling $127.1 million, the Company declared and paid
dividends to preferred shareholders totaling $14.6 million or $1.97 per share.
During the twelve months ended December 31, 2005, 2,381,550 shares of the
Company's common stock were issued through the Equity Shelf Program, totaling
net proceeds of $40.1 million. During the year ended December 31, 2005, 16,128
options were exercised under the long-term compensation plan for an aggregate
exercise price of $253,000. In addition, 24,253 common shares were sold through
the dividend reinvestment and direct purchase program for $440,000 during the
year ended December 31, 2005.
During the year ended December 31, 2004, 2,103,525 shares were issued
through the Equity Shelf Program, totaling net proceeds of $37.5 million. During
the year ended December 31, 2004, 57,000 options were exercised under the
long-term compensation plan for an aggregate exercise price of $856,000. In
addition, 127,020 shares were purchased in the dividend reinvestment and direct
purchase program at $2.3 million.
(B) Preferred Stock
At December 31, 2006, the Company had issued and outstanding 7,412,500
shares of Series A Cumulative Redeemable Preferred Stock, with a par value $0.01
per share and a liquidation preference of $25.00 per share plus accrued and
unpaid dividends (whether or not declared). The Series A preferred stock must be
paid a dividend at a rate of 7.875% per year on the $25.00 liquidation
preference before the common stock is entitled to receive any dividends. The
Series A preferred stock is redeemable at $25.00 per share plus accrued and
unpaid dividends (whether or not declared) exclusively at the Company's option
commencing on April 5, 2009 (subject to the Company's right under limited
circumstances to redeem the Series A preferred stock earlier in order to
preserve its qualification as a REIT). The Series A preferred stock is senior to
the Company's common stock and is on parity with the Series B preferred stock
with respect to dividends and distributions, including distributions upon
liquidation, dissolution or winding up. The Series A preferred stock generally
does not have any voting rights, except if the Company fails to pay dividends on
the Series A preferred stock for six or more quarterly periods (whether or not
consecutive). Under such circumstances, the Series A preferred stock, together
with the Series B preferred stock, will be entitled to vote to elect two
additional directors to the Board, until all unpaid dividends have been paid or
declared and set apart for payment. In addition, certain material and adverse
changes to the terms of the Series A preferred stock cannot be made without the
affirmative vote of holders of at least two-thirds of the outstanding shares of
Series A preferred stock and Series B preferred stock. Through December 31,
2006, the Company had declared and paid all required quarterly dividends on the
Series A preferred stock.
F-16
At December 31, 2006, the Company had issued and outstanding 4,600,000
shares of Series B Cumulative Convertible Preferred Stock, with a par value
$0.01 per share and a liquidation preference of $25.00 per share plus accrued
and unpaid dividends (whether or not declared). The Series B preferred stock
must be paid a dividend at a rate of 6% per year on the $25.00 liquidation
preference before the common stock is entitled to receive any dividends.
The Series B preferred stock is not redeemable. The Series B preferred
stock is convertible into shares of common stock at a conversion rate that
adjusts from time to time upon the occurrence of certain events, including if
the Company distributes to its common shareholders in any calendar quarter cash
dividends in excess of $0.11 per share. Initially, the conversion rate was
1.7730 shares of common shares per $25 liquidation preference. Commencing April
5, 2011, the Company has a right in certain circumstances to convert each
Series B preferred stock into a number of common shares based upon the then
prevailing conversion rate. The Series B preferred stock is also convertible
into common shares at the option of the Series B preferred shareholder at any
time at the then prevailing conversion rate. The Series B preferred stock is
senior to the Company's common stock and is on parity with the Series A
preferred stock with respect to dividends and distributions, including
distributions upon liquidation, dissolution or winding up. The Series B
preferred stock generally does not have any voting rights, except if the Company
fails to pay dividends on the Series B preferred stock for six or more quarterly
periods (whether or not consecutive). Under such circumstances, the Series B
preferred stock, together with the Series A preferred stock, will be entitled to
vote to elect two additional directors to the Board, until all unpaid dividends
have been paid or declared and set apart for payment. In addition, certain
material and adverse changes to the terms of the Series B preferred stock cannot
be made without the affirmative vote of holders of at least two-thirds of the
outstanding shares of Series B preferred stock and Series A preferred stock.
Through December 31, 2006, the Company had declared and paid all required
quarterly dividends on the Series B preferred stock.
7. NET INCOME (LOSS) PER COMMON SHARE
The following table presents a reconciliation of the net income (loss)
and shares used in calculating basic and diluted earnings per share for the
years ended December 31, 2006, 2005 and 2004.
For the year ended
December 31, December 31, December 31,
2006 2005 2004
----------------------------------------
Net income (loss) $93,816 ($9,247) $248,592
Less: Preferred stock dividends 19,557 14,593 7,745
----------------------------------------
Net income available (loss related) to
common shareholders $74,259 ($23,840) $240,847
========================================
Weighted average shares of common stock
outstanding-basic 167,667 122,475 118,223
Add: Effect of dilutive stock options 79 - 236
----------------------------------------
Weighted average shares of common stock
outstanding-diluted 167,746 122,475 118,459
========================================
The Series B Cumulative Convertible Preferred Stock was anti-dilutive
for the year ended December 31, 2006. Because the Company had a net loss related
to common shareholders for the year ended December 31, 2005, options to purchase
2,333,593 shares of common stock were considered anti-dilutive for the year
ended December 31, 2005. Options to purchase 12,500 of common stock were
outstanding and considered anti-dilutive as their exercise price exceeded the
average stock price for the year ended December 31, 2004.
8. LONG-TERM STOCK INCENTIVE PLAN
The Company has adopted a long term stock incentive plan for executive
officers, key employees and non-employee directors (the "Incentive Plan"). The
Incentive Plan authorizes the Compensation Committee of the board of directors
to grant awards, including non-qualified options as well as incentive stock
options as defined under Section 422 of the Code. The Incentive Plan authorizes
the granting of options or other awards for an aggregate of the greater of
500,000 shares or 9.5% of the diluted outstanding shares of the Company's common
stock, up to ceiling of 8,932,921 shares. Stock options are issued at the
current market price on the date of grant, subject to an immediate or four year
vesting in four equal installments with a contractual term of 5 or 10 years. The
grant date fair value is calculated using the Black-Scholes option valuation
model.
F-17
For the years ended
December 31, 2006 December 31, 2005 December 31, 2004
------------------------------------------------------------------
Weighted Weighted Weighted
Average Average Average
Number of Exercise Number of Exercise Number of Exercise
Shares Price Shares Price Shares Price
------------------------------------------------------------------
Options outstanding at the
beginning of year 2,333,593 $16.10 1,645,721 $15.66 1,063,259 $14.28
Granted 737,250 11.72 737,750 17.08 639,750 17.39
Exercised (22,160) 8.25 (16,128) 12.21 (57,288) 9.40
Forfeited (60,000) 15.39 - - - -
Expired (3,688) 13.69 (33,750) 17.87 - -
------------------------------------------------------------------
Options outstanding at the
end of year 2,984,995 $15.10 2,333,593 $16.10 1,645,721 $15.66
==================================================================
Options exercisable at the
end of the year 1,298,496 $15.28 831,906 $13.84 540,721 $11.62
The weighted average remaining contractual term was approximately 7.3
years for stock options outstanding and approximately 5.9 years for stock
options exercisable as of December 31, 2006. As of December 31, 2006, there was
approximately $2.8 million of total unrecognized compensation cost related to
nonvested share-based compensation awards. That cost is expected to be
recognized over a weighted average period of 2.6 years.
The following table summarizes information about stock options outstanding at
December 31, 2006:
Weighted Weighted Average Weighted Weighted Average
Average Remaining Average Remaining
Total Exercise Price Contractual Life Total Exercise Contractual Life
Range of Exercise Options on Total (Years) on Total Options Price on (Years) on
Prices Outstanding Outstanding Outstanding Exercisable Exercisable Exercisable
----------------------------------------------------------------------------------------------------------------------------
$7.94-$19.99 2,974,995 $15.08 7.34 1,288,496 $15.24 5.97
$20.00-$29.99 10,000 20.53 0.99 10,000 20.53 0.99
----------------- ---------------- ------------------- ------------ ------------- ---------------------
2,984,995 $15.10 7.32 1,298,496 $15.28 5.93
================= ================ =================== ============ ============= =====================
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 difference between book and taxable income arising from
Section 162(m) of the Code pertaining to employee remuneration.
During the year ended December 31, 2006, the Company recorded $3.1
million of income tax expense for income attributable to FIDAC, its taxable REIT
subsidiary, and the portion of earnings retained based on Code Section 162(m)
limitations. During the year ended December 31, 2006, the Company recorded $4.5
million of income tax expense for a portion of earnings retained based on
Section 162(m) limitations. The statutory combined federal, state, and city
corporate tax rate is 45%. 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) and to taxable income earned at the
taxable subsidiaries. Thus, as a REIT, our effective tax rate is significantly
less as we are allowed to deduct dividend distributions.
During the year ended December 31, 2005, the Company recorded $8.7
million of income tax expense for income attributable to FIDAC, its taxable REIT
subsidiary, and the portion of earnings retained based on Code Section 162(m)
limitations. During the year ended December 31, 2005, the Company recorded $2.0
million of income tax expense for a portion of earnings retained based on
Section 162(m) limitations.
During the year ended December 31, 2004, the Company recorded $4.5
million of income tax expense for income attributable to FIDAC and the portion
of earnings retained based on Code Section 162(m) limitations.
F-18
10. LEASE COMMITMENTS
The Company has a noncancelable lease for office space, which commenced
in May 2002 and expires in December 2009. Office rent expense was $618,000,
$573,000, and $591,000 for the years ended December 31, 2006, 2005 and 2004,
respectively. The expense was net of sub-lease payments received of $91,000,
$84,000, and $7,000 for the years ended December 31, 2006, 2005 and 2004,
respectively.
The Company's aggregate future minimum lease payments are as follows:
Total per Year
(dollars in thousands)
2007 $532
2008 532
2009 532
------------------------
Total remaining lease payments $1,596
========================
11. INTEREST RATE RISK
The primary market risk to the Company is interest rate risk. Interest rates
are highly sensitive to many factors, including governmental monetary and tax
policies, domestic and international economic and political considerations and
other factors beyond the Company's control. Changes in the general level of
interest rates can affect net interest income, which is the difference between
the interest income earned on interest-earning assets and the interest expense
incurred in connection with the interest-bearing liabilities, by affecting the
spread between the interest-earning assets and interest-bearing liabilities.
Changes in the level of interest rates also can affect the value of the
Investment Securities and the Company's ability to realize gains from the sale
of these assets. A decline in the value of the Investment Securities pledged as
collateral for borrowings under repurchase agreements could result in the
counterparties demanding additional collateral pledges or liquidation of some of
the existing collateral to reduce borrowing levels. Liquidation of collateral at
losses could have an adverse accounting impact, as discussed in Note 3.
The Company seeks to manage the extent to which net income changes as a
function of changes in interest rates by matching adjustable-rate assets with
variable-rate borrowings. The Company may seek to mitigate the potential impact
on net income of periodic and lifetime coupon adjustment restrictions in the
portfolio of Investment Securities by entering into interest rate agreements
such as interest rate caps and interest rate swaps. As of December 31, 2006, the
Company entered into interest rate swaps to pay a fixed rate and receive a
floating rate of interest, with total notional amount of $9.3 billion.
Changes in interest rates may also have an effect on the rate of
mortgage principal prepayments and, as a result, prepayments on Mortgage-Backed
Securities. The Company will seek to mitigate the effect of changes in the
mortgage principal repayment rate by balancing assets purchased at a premium
with assets purchased at a discount. To date, the aggregate premium exceeds the
aggregate discount on the Mortgage-Backed Securities. As a result, prepayments,
which result in the expensing of unamortized premium, will reduce net income
compared to what net income would be absent such prepayments.
12. CONTINGENCIES
From time to time, the Company is involved in various claims and legal
actions arising in the ordinary course of business. In the opinion of
management, the ultimate disposition of these matters will not have a material
effect on the Company's consolidated financial statements.
F-19
13. SUMMARIZED QUARTERLY RESULTS (UNAUDITED)
The following is a presentation of the quarterly results of operations
for the year ended December 31, 2006.
March 31, June 30, September 30, December 31,
2006 2006 2006 2006
(dollars in thousands, except per share data)
------------------------------------------------------
Interest income $194,882 $280,171 $339,737 $407,092
------------------------------------------------------
Interest expense 167,512 242,473 295,726 349,302
------------------------------------------------------
------------------------------------------------------
Net interest income 27,370 37,698 44,011 57,790
------------------------------------------------------
Other (loss) income:
Investment advisory and service fees 6,997 5,210 4,966 5,178
(Loss) gain on sale of Investment
Securities (7,006) (1,239) (446) 4,829
Gain on termination of interest rate swaps - - 8,414 2,260
Income from trading securities - - 612 3,382
Loss on other-than-temporarily impaired
securities (26,730) (20,114) - (5,504)
------------------------------------------------------
Total other (loss) income (26,739) (16,143) 13,546 10,145
------------------------------------------------------
Expenses:
Distribution fees 1,170 755 724 795
General and administrative expenses 7,177 8,985 11,682 12,219
------------------------------------------------------
Total expenses 8,347 9,740 12,406 13,014
------------------------------------------------------
Impairment of intangible for customer
relationships 1,148 1,345 - -
------------------------------------------------------
(Loss) income before income taxes and
minority interest (8,864) 10,470 45,151 54,921
Income taxes 2,085 1,892 2,273 1,288
------------------------------------------------------
(Loss) income before minority interest (10,949) 8,578 42,878 53,633
Minority interest - - 28 296
------------------------------------------------------
Net (loss) income (10,949) 8,578 42,850 53,337
Dividends on preferred stock 3,648 5,163 5,373 5,373
------------------------------------------------------
======================================================
Net (loss related) income available to
common
shareholders ($14,597) $3,415 $37,477 $47,964
======================================================
Weighted average number of basic common
shares outstanding 123,693,851 158,632,865 181,767,106 205,092,330
======================================================
Weighted average number of diluted common
shares outstanding 123,693,851 158,703,614 189,952,159 213,455,555
======================================================
Net (loss related) income available to common
shareholders per average common share:
Basic ($0.12) $0.02 $0.21 $0.23
======================================================
Diluted ($0.12) $0.02 $0.20 $0.23
======================================================
F-20
The following is a presentation of the quarterly results of operations
for the year ended December 31, 2005.
March 31, June 30, September 30, December 31,
2005 2005 2005 2005
(dollars in thousands, except per share data)
-------------------------------------------------------
Interest income $176,289 $171,595 $177,474 $179,688
-------------------------------------------------------
Interest expense 113,993 133,758 155,043 165,766
-------------------------------------------------------
-------------------------------------------------------
Net interest income 62,296 37,837 22,431 13,922
-------------------------------------------------------
Other income (loss):
Investment advisory and service fees 6,309 9,669 10,945 8,702
Gain (loss) on sale of Investment
Securities 580 11,435 32 (65,285)
Loss on other-than-temporarily impaired
securities - - - (83,098)
Total other income (loss) 6,889 21,104 10,977 (139,681)
-------------------------------------------------------
Expenses:
Distribution Fees 1,610 2,126 2,414 1,850
General and administrative expenses 6,664 6,800 6,455 6,359
-------------------------------------------------------
Total expenses 8,274 8,926 8,869 8,209
-------------------------------------------------------
Income (loss) before income taxes 60,911 50,015 24,539 (133,968)
Income taxes 1,578 3,022 3,353 2,791
-------------------------------------------------------
Net income (loss) 59,333 46,993 21,186 (136,759)
Dividends on preferred stock 3,648 3,648 3,648 3,649
-------------------------------------------------------
=======================================================
Net income available (loss related) to
common shareholders $55,685 $43,345 $17,538 ($140,408)
=======================================================
Weighted average number of basic common
shares outstanding 121,270,867 121,740,256 123,169,910 123,684,931
=======================================================
Weighted average number of diluted common
shares outstanding 121,564,320 122,013,050 123,330,645 123,684,931
=======================================================
Net income available (loss related) to common
shareholders per average common share:
Basic $0.46 $0.36 $0.14 ($1.14)
=========================================================
Diluted $0.46 $0.36 $0.14 ($1.14)
=========================================================
******
F-21
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.
ANNALY CAPITAL MANAGEMENT, INC.
Date: February 26, 2007 By: /s/ Michael A. J. Farrell
-------------------------
Michael A. J. Farrell
Chairman, Chief Executive Officer,
and President
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.
Signature Title Date
/s/ KEVIN P. BRADY Director February 26, 2007
------------------
Kevin P. Brady
/s/ KATHRYN F. FAGAN Chief Financial Officer and Treasurer February 26, 2007
--------------------- (principal financial and accounting
Kathryn F. Fagan officer)
/s/ MICHAEL A.J. FARRELL Chairman of the Board, Chief Executive February 26, 2007
------------------------ Officer, President and Director
Michael A. J. Farrell (principal executive officer)
/s/ JONATHAN D. GREEN Director February 26, 2007
----------------------
Jonathan D. Green
/s/ JOHN A. LAMBIASE Director February 26, 2007
-------------------
John A. Lambiase
/s/ E. WAYNE NORDBERG Director February 26, 2007
---------------------
E. Wayne Nordberg
/s/ DONNELL A. SEGALAS Director February 26, 2007
----------------------
Donnell A. Segalas
/s/ WELLINGTON DENAHAN-NORRIS Vice Chairman of the Board, Chief February 26, 2007
----------------------------- Investment Officer, Chief Operating
Wellington Denahan-Norris Officer and Director
II-1
EXHIBIT INDEX
Exhibit Exhibit Description
Number
3.1 Articles of Amendment and Restatement of the Articles of
Incorporation of the Registrant (incorporated by reference to
Exhibit 3.2 to the Registrant's Registration Statement on Form
S-11 (Registration No. 333-32913) filed with the Securities and
Exchange Commission on August 5, 1997).
3.2 Articles of Amendment of the Articles of Incorporation of the
Registrant (incorporated by reference to Exhibit 3.1 of the
Registrant's Registration Statement on Form S-3 (Registration
Statement 333-74618) filed with the Securities and Exchange
Commission on June 12, 2002).
3.3 Bylaws of the Registrant, as amended (incorporated by reference to
Exhibit 3.3 to the Registrant's Registration Statement on Form
S-11 (Registration No. 333-32913) filed with the Securities and
Exchange Commission on August 5, 1997).
4.1 Specimen Common Stock Certificate (incorporated by reference to
Exhibit 4.1 to Amendment No. 1 to the Registrant's Registration
Statement on Form S-11 (Registration No. 333-32913) filed with the
Securities and Exchange Commission on September 17, 1997).
4.2 Specimen Preferred Stock Certificate (incorporated by reference to
Exhibit 4.2 to the Registrant's Registration Statement on Form S-3
(Registration No. 333-74618) filed with the Securities and
Exchange Commission on December 5, 2001).
4.3 Specimen Series A Preferred Stock Certificate (incorporated by
reference to Exhibit 4.1 of the Registrant's Registration
Statement on Form 8-A filed with the SEC on April 1, 2004).
4.4 Specimen Series B Preferred Stock Certificate (incorporated by
reference to Exhibit 4.1 to the Registrant's Form 8K filed with
the Securities and Exchange Commission on April 10, 2006).
10.1 Long-Term Stock Incentive Plan (incorporated by reference to
Exhibit 10.3 to the Registrant's Registration Statement on Form
S-11 (Registration No. 333-32913) filed with the Securities and
Exchange Commission on August 5, 1997).*
10.2 Form of Master Repurchase Agreement (incorporated by reference to
Exhibit 10.7 to the Registrant's Registration Statement on Form
S-11 (Registration No. 333-32913) filed with the Securities and
Exchange Commission on August 5, 1997).
10.3 Amended and Restated Employment Agreement, effective as of June 4,
2004, between the Registrant and Michael A.J. Farrell
(incorporated by reference to Exhibit 10.3 of the Registrant's
Form 10-K filed with the Securities and Exchange Commission on
March 10, 2005).*
10.4 Amended and Restated Employment Agreement, effective as of June
4, 2004, between the Registrant and Wellington J. Denahan
(incorporated by reference to Exhibit 10.4 of the Registrant's
Form 10-K filed with the Securities and Exchange Commission on
March 10, 2005).*
10.5 Amended and Restated Employment Agreement, effective as of June 4,
2004,between the Registrant and Kathryn F. Fagan (incorporated by
reference to Exhibit 10.5 of the Registrant's Form 10-K filed with
the Securities and Exchange Commission on March 10, 2005).*
10.6 Amended and Restated Employment Agreement, effective as of June 4,
2004, between the Registrant and James P. Fortescue (incorporated
by reference to Exhibit 10.7 of the Registrant's Form 10-K filed
with the Securities and Exchange Commission on March 10, 2005).*
10.7 Amended and Restated Employment Agreement, dated as of January 23,
2006, between the Registrant and Jeremy Diamond.*
10.8 Amended and Restated Employment Agreement, dated as of January 23,
2006, between the Registrant and Ronald D. Kazel.*
10.9 Amended and Restated Employment Agreement, dated as of April 21,
2006, between the Registrant and Rose-Marie Lyght (incorporated by
reference to Exhibit 10.9 of the Registrant's Form 10-Q filed with
the Securities and Exchange Commission on May 9, 2006).*
II-2
10.10 Amended and Restated Employment Agreement, effective as of June 4,
2004, between the Registrant and Kristopher R. Konrad
(incorporated by reference to Exhibit 10.11 of the Registrant's
Form 10-K filed with the Securities and Exchange Commission on
March 10, 2005).*
10.11 Amended and Restated Employment Agreement, dated January 23, 2006,
between the Registrant and R. Nicholas Singh.*
10.12 Agreement and Plan of Merger, dated as of December 31, 2003, by
and among the Registrant, Fixed Income Discount Advisory Company,
FDC MergerSub, Inc., Michael A.J. Farrell, Wellington J. Denahan,
Jennifer S. Karve, Kathryn F. Fagan, Jeremy Diamond, Ronald D.
Kazel, Rose-Marie Lyght, Kristopher R. Konrad, and James P.
Fortescue (incorporated by reference to Exhibit 99.2 to the
Registrant's Form 8-K filed with the Securities and Exchange
Commission on January 2, 2004).
12.1 Computation of ratio of earnings to combined fixed charges and
preferred stock dividends.
23.1 Consent of Independent Registered Public Accounting Firm.
31.1 Certification of Michael A.J. Farrell, Chairman, Chief Executive
Officer, and President of the Registrant, pursuant to 18 U.S.C.
Section 1350 as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
31.2 Certification of Kathryn F. Fagan, Chief Financial Officer and
Treasurer of the Registrant, pursuant to 18 U.S.C. Section 1350 as
adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certification of Michael A.J. Farrell, Chairman, 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.
32.2 Certification of Kathryn F. Fagan, Chief Financial Officer and
Treasurer of the Registrant, pursuant to 18 U.S.C. Section 1350 as
adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
* Exhibit Numbers 10.1 and 10.3-10.11 are management contracts or compensatory
plans required to be filed as Exhibits to this Form 10-K.
II-3