The risks
and uncertainties described below are not the only ones facing us. Additional
risks and uncertainties that we are unaware of, or that we currently deem
immaterial, also may become important factors that affect us.
If any of
the following risks occur, our business, financial condition or results of
operations could be materially and adversely affected. In that case, the trading
price of our common stock could decline, and stockholders may lose some or all
of their investment.
Risks
Associated With Recent Adverse Developments in the Mortgage Finance and Credit
Markets
Difficult
conditions in the financial markets and the economy generally have caused us and
may continue to cause us market value losses related to our holdings, and we do
not expect these conditions to improve in the near future.
Our
results of operations are materially affected by conditions in the mortgage
market, the financial markets and the economy generally. Recently, concerns over
inflation, energy costs, geopolitical issues, the availability and cost of
credit, the mortgage market and a declining real estate market have contributed
to increased volatility and diminished expectations for the economy and markets
going forward. The mortgage market, including the market for prime and Alt-A
loans, has been severely affected by changes in the lending landscape and there
is no assurance that these conditions have stabilized or that they will not
worsen. The severity of the liquidity limitation was largely unanticipated by
the markets. For now (and for the foreseeable future), access to mortgages has
been substantially limited. This has an impact on new demand for homes, which
will compress the home ownership rates and weigh heavily on future home price
performance. There is a strong correlation between home price growth rates and
mortgage loan delinquencies. The market deterioration has caused us to expect
increased losses related to our holdings and, during 2008, to sell assets at a
loss. Continued market deterioration may once again force us to sell
assets at a loss.
A
substantial portion of our assets are classified for accounting purposes as
“available-for-sale” and carried at fair value. Changes in the fair values of
those assets are directly charged or credited to OCI. As a result, a decline in
values may reduce the book value of our assets. Moreover, if the decline in
value of an available-for-sale security is other than temporary, such decline
will reduce earnings.
All of
our repurchase agreements and interest rate swap agreements are subject to
bilateral margin calls in the event that the collateral securing our obligations
under those facilities exceeds or does not meet our collateralization
requirements. For example, during 2008, due to the
deterioration in the market value of our assets, we received and met margin
calls under our repurchase agreements, which required us to obtain additional
funding from third parties, including from Annaly, and taking other steps to
increase our liquidity. Additionally, the disruptions during 2008 resulted in us
not being in compliance with the net income covenant in one of our whole loan
repurchase agreements and the liquidity covenants in our other whole loan
repurchase agreement at a time during which we had no amounts outstanding under
those facilities. We amended these covenants, and on July 29, 2008, we
terminated those facilities to avoid paying non-usage fees. We can
provide no assurances that such events will not occur again and at a time when
we cannot find additional funding which may result in us having to dispose of
assets at an inopportune time when prices are depressed.
Dramatic
declines in the housing market, with falling home prices and increasing
foreclosures and unemployment, have resulted in significant asset write-downs by
financial institutions, which have caused many financial institutions to seek
additional capital, to merge with other institutions and, in some cases, to
fail. In addition, we rely on the availability of financing to acquire
residential mortgage loans, real estate-related securities and real estate loans
on a leveraged basis. Institutions from which we will seek to obtain financing
may have owned or financed residential mortgage loans, real estate-related
securities and real estate loans, which have declined in value and caused them
to suffer losses as a result of the recent downturn in the residential mortgage
market. Many lenders and institutional investors have reduced and, in some
cases, ceased to provide funding to borrowers, including other financial
institutions. If these conditions persist, these institutions may become
insolvent or tighten their lending standards, which could make it more difficult
for us to obtain financing on favorable terms or at all. Our profitability may
be adversely affected if we are unable to obtain cost-effective financing for
our investments.
Mortgage
loan modification programs, future legislative action and changes in the
requirements necessary to qualify for refinancing a mortgage may adversely
affect the value of, and the returns on, the assets in which we
invest.
During
the second half of 2008, in 2009, and so far in 2010, the U.S. government,
through the Federal Housing Administration, or FHA, and the FDIC, implemented
programs designed to provide homeowners with assistance in avoiding residential
mortgage loan foreclosures including the Hope for Homeowners Act of 2008, which
allows certain distressed borrowers to refinance their mortgages into
FHA-insured loans and the Home Affordable Modification Program, or HAMP, which
provides a detailed, uniform model for one-time modification of eligible
residential mortgage loans. The programs may also involve, among other
things, the modification of mortgage loans to reduce the principal amount of the
loans or the rate of interest payable on the loans, or to extend the payment
terms of the loans. Members of the U.S. Congress have indicated support
for additional legislative relief for homeowners, including an amendment of the
bankruptcy laws to permit the modification of mortgage loans in bankruptcy
proceedings. These loan modification programs, including future
legislative or regulatory actions and amendments to the bankruptcy laws, that
result in the modification of outstanding mortgage loans, as well as changes in
the requirements necessary to qualify for refinancing a mortgage may adversely
affect the value of, and the returns on, our non-Agency RMBS and Agency
RMBS. Depending on whether or not we purchased an instrument at a
premium or discount, the yield we receive may be positively or negatively
impacted by any modification.
The
U.S. Government's pressing for refinancing of certain loans may affect
prepayment rates for mortgage loans in mortgage-backed securities.
In
addition to the increased pressure upon residential mortgage loan investors and
servicers to engage in loss mitigation activities, the U.S. Government is
pressing for refinancing of certain loans, and this encouragement may affect
prepayment rates for mortgage loans in mortgage-backed securities. In
connection with government-related securities, in February 2009 President Obama
unveiled the Homeowner Affordability and Stability Plan, which, in part, calls
upon Fannie Mae and Freddie Mac to loosen their eligibility criteria for the
purchase of loans in order to provide access to low-cost refinancing for
borrowers who are current on their mortgage payments but who cannot otherwise
qualify to refinance at a lower market rate. The major change was to
permit an increase in the loan-to-value, or LTV, ratio of a refinancing loan
eligible for sale up to 105%. In July 2009, the FHFA authorized Fannie Mae
and Freddie Mac to raise the present LTV ratio ceiling of 105% to 125%.
The charters governing the operations of Fannie Mae and Freddie Mac prohibit
purchases of loans with loan to value ratios in excess of 80% unless the loans
have mortgage insurance (or unless other types of credit enhancement are
provided in accordance with the statutory requirements). The FHFA, which
regulates Fannie Mae and Freddie Mac, determined that new mortgage insurance
will not be required on the refinancing if the applicable entity already owns
the loan or guarantees the related mortgage-backed securities.
Additionally, the Treasury reports that in some cases a new appraisal will not
be necessary upon refinancing. The Treasury estimates that up to 5,000,000
homeowners with loans owned or guaranteed by Fannie Mae or Freddie Mac may be
eligible for this refinancing program, which is scheduled to terminate in June
2010.
The HERA
authorized a voluntary FHA mortgage insurance program called HOPE for
Homeowners, or H4H Program, designed to refinance certain delinquent borrowers
into new FHA-insured loans. The H4H Program targets delinquent borrowers
under conventional mortgage loans, as well as under government-insured or
-guaranteed mortgage loans, that were originated on or before January 1,
2008. Holders of existing mortgage loans being refinanced under the H4H
Program must accept a write-down of principal and waive all prepayment
fees. While the use of the program has been extremely limited to date,
Congress continues to amend the program to encourage its use. The H4H
Program is effective through September 30, 2011.
To the
extent these and other economic stabilization or stimulus efforts are successful
in increasing prepayment speeds for residential mortgage loans, such as those in
mortgage-backed securities, that could potentially harm our income and operating
results, particularly in connection with loans or mortgage-backed securities
purchased at a premium or our interest-only securities.
The
actions of the U.S. government, Federal Reserve and Treasury, including the
establishment of the TALF and the PPIP, may adversely affect our
business.
The TALF
was first announced by the Treasury on November 25, 2008, and has been expanded
in size and scope since its initial announcement. Under the TALF, the
Federal Reserve Bank of New York makes non-recourse loans to borrowers to fund
their purchase of eligible assets, currently certain asset backed securities but
not RMBS. The nature of the eligible assets has been expanded several
times. The Treasury has stated that through its expansion of the TALF,
non-recourse loans will be made available to investors to certain fund purchases
of legacy securitization assets. On March 23, 2009, the Treasury in
conjunction with the FDIC, and the Federal Reserve, announced the PPIP. The PPIP
aims to recreate a market for specific illiquid residential and commercial loans
and securities through a number of joint public and private investment
funds. The PPIP is designed to draw new private capital into the market
for these securities and loans by providing government equity co-investment and
attractive public financing.
It is not
possible to predict how the TALF, the PPIP, or other recent U.S. Government
actions will impact the financial markets, including current significant levels
of volatility, or our current or future investments. To the extent the
market does not respond favorably to these initiatives or they do not function
as intended, our business may not receive any benefits from this
legislation. In addition, the U.S. government, Federal Reserve, Treasury
and other governmental and regulatory bodies have taken or are considering
taking other actions to address the financial crisis. We cannot predict
whether or when such actions may occur, and such actions could have a dramatic
impact on our business, results of operations and financial
condition.
There
can be no assurance that the actions of the U.S. Government, the Federal
Reserve, the Treasury and other governmental and regulatory bodies for the
purpose of stabilizing the financial markets, including the establishment of the
TALF and the PPIP, or market response to those actions, will achieve the
intended effect, that our business will benefit from these actions or that
further government or market developments will not adversely impact
us.
In
response to the financial issues affecting the banking system and the financial
markets and going concern threats to investment banks and other financial
institutions, the U.S. Government, the Federal Reserve, the Treasury and other
governmental and regulatory bodies have taken action to attempt to stabilize the
financial markets. Significant measures include the enactment of the
Economic Stabilization Act of 2008, or the EESA, to, among other things,
establish the Troubled Asset Relief Program, or the TARP; the enactment of the
HERA, which established a new regulator for Fannie Mae and Freddie Mac; the
establishment of the TALF; and the establishment of the PPIP.
There can
be no assurance that the EESA, HERA, TALF, PPIP or other recent U.S. Government
actions will have a beneficial impact on the financial markets, including on
current levels of volatility. To the extent the market does not respond
favorably to these initiatives or these initiatives do not function as intended,
our business may not receive the anticipated positive impact from the
legislation. There can also be no assurance that we will be eligible to
participate in any programs established by the U.S. Government such as the TALF
or the PPIP or, if we are eligible, that we will be able to utilize them
successfully or at all. In addition, because the programs are designed, in
part, to provide liquidity to restart the market for certain of our targeted
assets, the establishment of these programs may result in increased competition
for attractive opportunities in our targeted assets. It is also possible
that our competitors may utilize the programs which would provide them with
attractive debt and equity capital funding from the U.S. Government. In
addition, the U.S. Government, the Federal Reserve, the Treasury and other
governmental and regulatory bodies have taken or are considering taking other
actions to address the financial crisis. We cannot predict whether or when
such actions may occur, and such actions could have a dramatic impact on our
business, results of operations and financial condition.
The
conservatorship of Fannie Mae and Freddie Mac and related efforts, along with
any changes in laws and regulations affecting the relationship between Fannie
Mae and Freddie Mac and the U.S. Government, may adversely affect our
business.
Due to
increased market concerns about Fannie Mae and Freddie Mac’s ability to
withstand future credit losses associated with securities held in their
investment portfolios, and on which they provide guarantees, without the direct
support of the U.S. Government, on July 30, 2008, Congress passed the Housing
and Economic Recovery Act of 2008, or the HERA. Among other things, the
HERA established the Federal Housing Finance Agency, or FHFA, which has broad
regulatory powers over Fannie Mae and Freddie Mac. On September 6, 2008,
the FHFA placed Fannie Mae and Freddie Mac into conservatorship and, together
with the Treasury, established a program designed to boost investor confidence
in Fannie Mae’s and Freddie Mac’s debt and Agency RMBS. As the conservator
of Fannie Mae and Freddie Mac, the FHFA controls and directs the operations of
Fannie Mae and Freddie Mac and may (1) take over the assets of and operate
Fannie Mae and Freddie Mac with all the powers of the shareholders, the
directors and the officers of Fannie Mae and Freddie Mac and conduct all
business of Fannie Mae and Freddie Mac; (2) collect all obligations and money
due to Fannie Mae and Freddie Mac; (3) perform all functions of Fannie Mae and
Freddie Mac which are consistent with the conservator’s appointment; (4)
preserve and conserve the assets and property of Fannie Mae and Freddie Mac; and
(5) contract for assistance in fulfilling any function, activity, action or duty
of the conservator. A primary focus of this new legislation is to increase the
availability of mortgage financing by allowing Fannie Mae and Freddie Mac to
continue to grow their guarantee business without limit, while limiting net
purchases of mortgage-backed securities to a modest amount through the end of
2009. It is currently planned for Fannie Mae and Freddie Mac to reduce gradually
their mortgage-backed securities portfolios beginning in 2010.
In
addition to FHFA becoming the conservator of Fannie Mae and Freddie Mac, the
Treasury and FHFA have entered into Preferred Stock Purchase Agreements (PSPAs)
between the Treasury and Fannie Mae and Freddie Mac pursuant to which the
Treasury will ensure that each of Fannie Mae and Freddie Mac maintains a
positive net worth. On December 24, 2009, the U.S. Treasury amended the terms of
the U.S. Treasury’s PSPAs with Fannie Mae and Freddie Mac to remove the
$200 billion per institution limit established under the PSPAs until the end of
2012. The U.S. Treasury also amended the PSPAs with respect to the
requirements for Fannie Mae and Freddie Mac to reduce their
portfolios.
Although
the Treasury has committed capital to Fannie Mae and Freddie Mac, there can be
no assurance that these actions will be adequate for their needs. If these
actions are inadequate, Fannie Mae and Freddie Mac could continue to suffer
losses and could fail to honor their guarantees and other obligations. The
future roles of Fannie Mae and Freddie Mac could be significantly reduced and
the nature of their guarantees could be considerably diminished. Any changes to
the nature of the guarantees provided by Fannie Mae and Freddie Mac could
redefine what constitutes Agency RMBS and could have broad adverse market
implications and severe adverse consequences to our business.
Such
consequences to us may include an inability to use Agency RMBS as collateral for
our financings under our repurchase agreements since any decline in their value,
or perceived market uncertainty about their value, would make it more difficult
for us to obtain financing on acceptable terms or at all, or to maintain our
compliance with the terms of any financing transactions, or to maintain our
exemption under the 1940 Act. Further, the current credit support provided
by the Treasury to Fannie Mae and Freddie Mac, and any additional credit support
it may provide in the future, could have the effect of lowering the interest
rates we expect to receive from Agency RMBS, thereby tightening the spread
between the interest we earn on these securities and the cost of financing
them. All of the foregoing as well as unforeseen consequences resulting
from the foregoing could materially and adversely affect our business,
operations and financial condition.
A
significant portion of our financing is from Annaly which is a significant
shareholder of ours and which owns our Manager.
Our
ability to fund our investments on a leveraged basis depends to a large extent
upon our ability to secure warehouse, repurchase, credit, and/or commercial
paper financing on acceptable terms. The current dislocation in the non-Agency
mortgage sector has made it difficult for us to obtain short-term financing on
favorable terms. As a result, we have completed loan securitizations in order to
obtain long-term financing and terminated our un-utilized whole loan repurchase
agreements in order to avoid paying non-usage fees under those agreements. In
addition, commencing in 2008, we entered into a RMBS repurchase agreement with
Annaly, which owns approximately 6.7% of our outstanding shares of common stock.
This agreement contains customary representations, warranties and covenants
contained in such agreements including Annaly having the right to make margin
calls if the value of our RMBS collateralizing the agreement
falls. As of December 31, 2009, we had $259.0 million outstanding
under this agreement which consists of approximately 13% of our total
financing. Our RMBS repurchase agreement with Annaly is at market
rates and is secured by the RMBS pledged under the agreement and is callable by
Annaly on a weekly basis. We do not expect to increase significantly the amount
of securities pledged to Annaly or significantly increase or decrease the funds
we borrow from Annaly. We cannot assure you that Annaly will continue to provide
us with such financing. If Annaly does not provide us with financing, we cannot
assure you that we will be able to replace such financing. If we are
not able to replace this financing, we could be forced to sell our assets at an
inopportune time when prices are depressed.
Risks
Associated With Our Management and Relationship With Our Manager
We
are dependent on our Manager and its key personnel for our success.
We have
no separate facilities and are completely reliant on our Manager. We have no
employees other than our officers. Our officers are also employees of
our Manager, which has significant discretion as to the implementation of our
investment and operating policies and strategies. Accordingly,
we depend on the diligence, skill and network of business contacts of the senior
management of our Manager. Our Manager’s employees evaluate,
negotiate, structure, close and monitor our investments; therefore, our success
will depend on their continued service. The departure of any of the
senior managers of our Manager could have a material adverse effect on our
performance. In addition, we can offer no assurance that our Manager
will remain our investment manager or that we will continue to have access to
our Manager’s senior managers. Our management agreement with our
Manager only extends until December 31, 2010. If the management
agreement is terminated and no suitable replacement is found to manage us, we
may not be able to execute our business plan. Moreover, our Manager
is not obligated to dedicate certain of its employees exclusively to us nor is
it obligated to dedicate any specific portion of its time to our business, and
none of our Manager’s employees are contractually dedicated to us under our
management agreement with our Manager. The only employees of our
Manager who are primarily dedicated to our operations are Christian J.
Woschenko, our Head of Investments, and William B. Dyer, our Head of
Underwriting.
There
are conflicts of interest in our relationship with our Manager and Annaly, which
could result in decisions that are not in the best interests of our
stockholders.
We are
subject to conflicts of interest arising out of our relationship with Annaly and
our Manager. An Annaly executive officer is our Manager’s sole
director, two of Annaly’s employees are our directors and several of Annaly’s
employees are officers of our Manager and us. Specifically,
each of our officers also serves as an employee of our Manager or its
affiliates. As a result, our Manager and our officers may have
conflicts between their duties to us and their duties to, and interests in,
Annaly or our Manager. There may also be conflicts in
allocating investments which are suitable both for us and Annaly as well as
other FIDAC managed investment vehicles, including CreXus Investment Corp., or
CreXus, a public specialty finance company that acquires, manages, and finances,
directly or through its subsidiaries, commercial mortgage loans and other
commercial real estate debt, CMBS, and other commercial real estate-related
assets. Annaly owns approximately 4.5 million shares of common stock
of CreXus. Annaly and CreXus may compete with
us with respect to certain investments which we may want to acquire, and as a
result we may either not be presented with the opportunity or have to compete
with Annaly to acquire these investments. Our Manager and our
officers may choose to allocate favorable investments to Annaly or CreXus
instead of to us. The ability of our Manager and its officers
and employees to engage in other business activities may reduce the time our
Manager spends managing us. Further, during turbulent
conditions in the mortgage industry, distress in the credit markets or other
times when we will need focused support and assistance from our Manager, other
entities for which our Manager also acts as an investment manager will likewise
require greater focus and attention, placing our Manager’s resources in high
demand. In such situations, we may not receive the necessary
support and assistance we require or would otherwise receive if we were
internally managed or if our Manager did not act as a manager for other
entities. There is no assurance that the allocation policy that
addresses some of the conflicts relating to our investments will be adequate to
address all of the conflicts that may arise. In addition, we have
entered into a repurchase agreement with Annaly, our Manager’s parent, to
finance our RMBS. This financing arrangement may make us less likely
to terminate our Manager. It could also give rise to further
conflicts because Annaly may be a creditor of ours. As one of our
creditors, Annaly’s interests may diverge from the interests of our
stockholders.
We pay
our Manager substantial management fees regardless of the performance of our
portfolio. Our Manager’s entitlement to substantial
nonperformance-based compensation might reduce its incentive to devote its time
and effort to seeking investments that provide attractive risk-adjusted returns
for our portfolio. This in turn could hurt both our ability to
make distributions to our stockholders and the market price of our common
stock. Annaly owns approximately 6.7% of our outstanding shares of
common stock which entitles them to receive quarterly
distributions. In evaluating investments and other management
strategies, this may lead our Manager to place emphasis on the maximization of
revenues at the expense of other criteria, such as preservation of
capital. Investments with higher yield potential are generally
riskier or more speculative. This could result in increased risk to the value of
our invested portfolio. Annaly may sell the shares in us purchased
concurrently with our initial public offering at any time after the earlier of
(i) November 15, 2010 or (ii) the termination of the management
agreement. Annaly may sell the shares in us purchased immediately
after our 2008 secondary offering at any time after the earlier of (i) October
24, 2011 or (ii) the termination of the management agreement. Annaly
may sell the shares in us that it purchased immediately after our April 15, 2009
secondary offering at any time after the earlier of (i) April 15, 2012 or (ii)
the termination of the management agreement. Annaly may sell the shares in us
that it purchased immediately after our May 27, 2009 secondary offering at any
time after the earlier of (i) May 27, 2012 or (ii) the termination of the
management agreement. To the extent Annaly sells some of its shares,
its interests may be less aligned with our interests.
The
management agreement with our Manager was not negotiated on an arm’s-length
basis and may not be as favorable to us as if it had been negotiated with an
unaffiliated third party and may be costly and difficult to
terminate.
Our
president, chief financial officer, head of investments, treasurer, controller,
secretary and head of underwriting also serve as employees of our
Manager. In addition, certain of our directors are employees of
our Manager or its affiliates. Our management agreement with
our Manager was negotiated between related parties, and its terms, including
fees payable, may not be as favorable to us as if it had been negotiated with an
unaffiliated third party. Termination of the management agreement with our
Manager without cause is difficult and costly. Our independent directors will
review our Manager’s performance and the management fees annually, and following
the initial term, the management agreement may be terminated annually by us
without cause upon the affirmative vote of at least two-thirds of our
independent directors, or by a vote of the holders of at least a majority of the
outstanding shares of our common stock (other than those shares held by Annaly
or its affiliates), based upon: (i) our Manager’s unsatisfactory performance
that is materially detrimental to us, or (ii) a determination that the
management fees payable to our Manager are not fair, subject to our Manager’s
right to prevent termination based on unfair fees by accepting a reduction of
management fees agreed to by at least two-thirds of our independent directors.
Our Manager must be provided 180-days’ prior notice of any such termination.
Additionally, upon such termination, the management agreement provides that we
will pay our Manager a termination fee equal to three times the average annual
base management fee calculated as of the end of the most recently completed
fiscal quarter. These provisions may adversely affect our
ability to terminate our Manager without cause. Our Manager is only
contractually committed to serve us until December 31,
2010. Thereafter, the management agreement is renewable on an
annual basis, however, our Manager may terminate the management agreement
annually upon 180-days’ prior notice. If the management
agreement is terminated and no suitable replacement is found to manage us, we
may not be able to execute our business plan.
Our
board of directors approved very broad investment guidelines for our Manager and
will not approve each investment decision made by our Manager.
Our
Manager is authorized to follow very broad investment
guidelines. Our board of directors periodically reviews our
investment guidelines and our investment portfolio, but does not, and is not
required to review all of our proposed investments or any type or category of
investment, except that an investment in a security structured or managed by our
Manager must be approved by a majority of our independent
directors. In addition, in conducting periodic reviews, our
board of directors relies primarily on information provided to them by our
Manager. Furthermore, our Manager uses complex strategies, and
transactions entered into by our Manager may be difficult or impossible to
unwind by the time they are reviewed by our board of
directors. Our Manager has great latitude within the broad
investment guidelines in determining the types of assets it may decide are
proper investments for us, which could result in investment returns that are
substantially below expectations or that result in losses, which would
materially and adversely affect our business operations and
results. Further, decisions made and investments entered into
by our Manager may not be in the best interests of our
stockholders.
We
may change our investment strategy, asset allocation, or financing plans without
stockholder consent, which may result in riskier investments.
We may
change our investment strategy, asset allocation, or financing plans at any time
without the consent of our stockholders, which could result in our making
investments that are different from, and possibly riskier than, the investments
described in this Form 10-K. A change in our investment strategy or
financing plans may increase our exposure to interest rate and default risk and
real estate market fluctuations. Furthermore, a change in our asset allocation
could result in our making investments in asset categories different from those
described in this Form 10-K. These changes could adversely affect the market
price of our common stock and our ability to make distributions to our
stockholders.
While
investments in investment vehicles managed by our Manager require approval by a
majority of our independent directors, our Manager has an incentive to invest
our funds in investment vehicles managed by our Manager because of the
possibility of generating an additional incremental management fee, which may
reduce other investment opportunities available to us. In addition,
we cannot assure you that investments in investment vehicles managed by our
Manager will prove beneficial to us.
We
may invest in CDOs managed by our Manager, including the purchase or sale of all
or a portion of the equity of such CDOs, which may result in an immediate loss
in book value and present a conflict of interest between us and our
Manager.
We may
invest in securities of CDOs managed by our Manager. If all of the securities of
a CDO managed by our Manager were not fully placed as a result of our not
investing, our Manager could experience losses due to changes in the value of
the underlying investments accumulated in anticipation of the launch of such
investment vehicle. The accumulated investments in a CDO transaction are
generally sold at the price at which they were purchased and not the prevailing
market price at closing. Accordingly, to the extent we invest in a portion of
the equity securities for which there has been a deterioration of value since
the securities were purchased, we would experience an immediate loss equal to
the decrease in the market value of the underlying investment. As a result, the
interests of our Manager in our investing in such a CDO may conflict with our
interests and that of our stockholders.
Our
investment focus is different from those of other entities that are or have been
managed by our Manager.
Our
investment focus is different from those of other entities that are or have been
managed by our Manager. In particular, entities managed by our Manager have not
purchased whole mortgage loans or structured whole loan securitizations. In
addition, our Manager has limited experience in managing CDOs and investing in
CDOs, non-Agency RMBS, CMBS and other ABS which we may pursue as part of our
investment strategy. Accordingly, our Manager’s historical returns are not
indicative of its performance for our investment strategy and we can offer no
assurance that our Manager will replicate the historical performance of the
Manager’s investment professionals in their previous endeavors. Our investment
returns could be substantially lower than the returns achieved by our Manager’s
investment professionals’ previous endeavors.
We
compete with investment vehicles of our Manager for access to our Manager’s
resources and investment opportunities.
Our
Manager provides investment and financial advice to a number of investment
vehicles, including CreXus, and some of our Manager’s personnel are also
employees of Annaly and in that capacity are involved in Annaly’s investment
process. Accordingly, we will compete with our Manager’s other investment
vehicles and with Annaly for our Manager’s resources. Our Manager may sponsor
and manage other investment vehicles with an investment focus that overlaps with
ours, which could result in us competing for access to the benefits that we
expect our relationship with our Manager will provide to us.
Risks
Related To Our Business
We
have a limited operating history and may not continue to operate successfully or
generate sufficient revenue to make or sustain distributions to our
stockholders.
We were
organized in June 2007, commenced operations in November 2007, and have a
limited operating history. We cannot assure you that we will be able
to operate our business successfully or implement our operating policies and
strategies described in this Form 10-K. The results of our operations
depend on many factors, including the availability of opportunities for the
acquisition of assets, the valuation of our assets, the level and volatility of
interest rates, readily accessible short and long-term financing and the terms
of the financing, conditions in the financial markets and economic
conditions.
Failure
to procure adequate capital and funding on favorable terms, or at all, would
adversely affect our results and may, in turn, negatively affect the market
price of shares of our common stock and our ability to distribute dividends to
our stockholders.
The
capital and credit markets have been experiencing extreme volatility and
disruption for more than a year. The volatility and disruption have
reached unprecedented levels. In some cases, the markets have exerted downward
pressure on stock prices and credit capacity for certain lenders. We
depend upon the availability of adequate funding and capital for our
operations. We intend to finance our assets over the long-term
through a variety of means, including repurchase agreements, credit facilities,
securitizations, commercial paper and CDOs. Our access to capital
depends upon a number of factors over which we have little or no control,
including:
·
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general
market conditions;
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·
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the
market’s perception of our growth
potential;
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·
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our
current and potential future earnings and cash
distributions;
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·
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the
market price of the shares of our capital stock;
and
|
·
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the
market’s view of the quality of our
assets.
|
The current situation in the mortgage
sector and the current weakness in the broader credit markets could adversely
affect one or more of our potential lenders and could cause one or more of our
lenders or potential lenders to be unwilling or unable to provide us with
financing. In general, this could potentially increase our financing costs and
reduce our liquidity or require us to sell assets at an inopportune time or
price.
We have
and expect to use a number of sources to finance our investments, including
repurchase agreements, warehouse facilities, securitizations, asset-backed
commercial paper and term CDOs. Current market conditions have affected the cost
and availability of financing from each of these sources — and their individual
providers — to different degrees; some sources generally are unavailable, some
are available but at a high cost, and some are largely unaffected. For example,
in the repurchase agreement market, borrowers have been affected differently
depending on the type of security they are financing. Non-Agency RMBS have been
harder to finance, depending on the type of assets collateralizing the RMBS. The
amount, term and margin requirements associated with these types of financings
have been negatively impacted.
Currently,
warehouse facilities to finance whole loan prime residential mortgages are
generally available from major banks, but at significantly higher cost and
greater margin requirements than previously offered. Many major banks that offer
warehouse facilities have also reduced the amount of capital available to new
entrants and consequently the size of those facilities offered now are smaller
than those previously available.
It is
currently a challenging market to term finance whole loans through
securitization or bonds issued by a CDO structure. The highly rated senior bonds
in these securitizations and CDO structures currently have liquidity, but at
much wider spreads than issues priced earlier this year. The junior subordinate
tranches of these structures currently have few buyers and current market
conditions have forced issuers to retain these lower rated bonds rather than
sell them.
Certain
issuers of ABCP, have been unable to place (or roll) their securities, which has
resulted, in some instances, in forced sales of MBS, and other securities which
has further negatively impacted the market value of these
assets. These market conditions are fluid and likely to change over
time.
As a
result, the execution of our investment strategy may be dictated by the cost and
availability of financing from these different sources.
In
addition, the impairment of other financial institutions could negatively affect
us. If one or more major market participants fails or otherwise
experience a major liquidity crisis, as was the case for Bear Stearns & Co.
in March 2008, and Lehman Brothers Holdings Inc. in September 2008, it could
adversely affect the marketability of all fixed income securities and this could
negatively impact the value of the securities we acquire, thus reducing our net
book value.
Furthermore,
if any of our potential lenders or any of our lenders are unwilling or unable to
provide us with financing, we could be forced to sell our securities or
residential mortgage loans at an inopportune time when prices are
depressed.
Our
business, results of operations and financial condition may be materially
adversely affected by disruptions in the financial markets. We cannot
assure you, under such extreme conditions, that these markets will remain an
efficient source of long-term financing for our assets. If our
strategy is not viable, we will have to find alternative forms of financing for
our assets, which may not be available. Further, as a REIT, we are
required to distribute annually at least 90% of our REIT taxable income,
determined without regard to the deduction for dividends paid and excluding net
capital gain, to our stockholders and are therefore not able to retain
significant amounts of our earnings for new investments. We cannot
assure you that any, or sufficient, funding or capital will be available to us
in the future on terms that are acceptable to us. If we cannot obtain
sufficient funding on acceptable terms, there may be a negative impact on the
market price of our common stock and our ability to make distributions to our
stockholders. Moreover, our ability to grow will be dependent on our
ability to procure additional funding. To the extent we are not able
to raise additional funds through the issuance of additional equity or
borrowings, our growth will be constrained.
We
operate in a highly competitive market for investment opportunities and more
established competitors may be able to compete more effectively for investment
opportunities than we can.
A number
of entities compete with us to make the types of investments that we plan to
make. We compete with other REITs, public and private funds, commercial and
investment banks and commercial finance companies. Many of our competitors are
substantially larger and have considerably greater financial, technical and
marketing resources than we do. Several other REITs have recently raised, or are
expected to raise, significant amounts of capital, and may have investment
objectives that overlap with ours, which may create competition for investment
opportunities. Some competitors may have a lower cost of funds and access to
funding sources that are not available to us. In addition, some of our
competitors may have higher risk tolerances or different risk assessments, which
could allow them to consider a wider variety of investments and establish more
favorable relationships than us. We cannot assure you that the competitive
pressures we face will not have a material adverse effect on our business,
financial condition and results of operations. Also, as a result of this
competition, we may not be able to take advantage of attractive investment
opportunities from time to time, and we can offer no assurance that we will be
able to identify and make investments that are consistent with our investment
objectives.
Loss
of our 1940 Act exemption would adversely affect us and negatively affect the
market price of shares of our common stock and our ability to distribute
dividends and could result in the termination of the management agreement with
our Manager.
We intend
to conduct our operations so that neither we nor any of our subsidiaries are
required to register as an investment company under the 1940 Act. Because we are
a holding company that will conduct its businesses primarily through
wholly-owned subsidiaries, the securities issued by these subsidiaries that are
excepted from the definition of “investment company” under Section 3(c)(1) or
Section 3(c)(7) of the 1940 Act, together with any other investment securities
we may own, may not have a combined value in excess of 40% of the value of our
adjusted total assets on an unconsolidated basis. This requirement limits the
types of businesses in which we may engage through our subsidiaries. In
addition, the assets we and our subsidiaries may acquire are limited by the
provisions of the 1940 Act, the rules and regulations promulgated under the 1940
Act and SEC staff interpretative guidance, which may adversely affect our
performance.
If the
value of securities issued by our subsidiaries that are excepted from the
definition of “investment company” by Section 3(c)(1) or 3(c)(7) of the 1940
Act, together with any other investment securities we own, exceeds 40% of our
adjusted total assets on an unconsolidated basis, or if one or more of such
subsidiaries fail to maintain an exception or exemption from the 1940 Act, we
could, among other things, be required either (a) to substantially change the
manner in which we conduct our operations to avoid being required to register as
an investment company or (b) to register as an investment company under the 1940
Act, either of which could have an adverse effect on us and the market price of
our securities. If we were required to register as an investment company under
the 1940 Act, we would become subject to substantial regulation with respect to
our capital structure (including our ability to use leverage), management,
operations, transactions with affiliated persons (as defined in the 1940 Act),
portfolio composition, including restrictions with respect to diversification
and industry concentration, and other matters.
We expect
Chimera Asset Holding LLC and certain subsidiaries that we may form in the
future to rely upon the exemption from registration as an investment company
under the 1940 Act pursuant to Section 3(c)(5)(C) of the 1940 Act, which is
available for entities “primarily engaged in the business of purchasing or
otherwise acquiring mortgages and other liens on and interests in real estate.”
This exemption generally requires that at least 55% of these subsidiaries’
assets must be comprised of qualifying real estate assets and at least 80% of
each of their portfolios must be comprised of qualifying real estate assets and
real estate-related assets under the 1940 Act. We expect each of our
subsidiaries relying on Section 3(c)(5)(C) to rely on guidance published by the
SEC staff or on our analyses of guidance published with respect to other types
of assets to determine which assets are qualifying real estate assets and real
estate-related assets. If the SEC staff publishes new or different guidance with
respect to these matters, we may be required to adjust our strategy accordingly.
In addition, we may be limited in our ability to make certain investments and
these limitations could result in the subsidiary holding assets we might wish to
sell or selling assets we might wish to hold.
Certain
of our subsidiaries may rely on the exemption provided by Section 3(c)(6) which
excludes from the definition of “investment company” any company primarily
engaged, directly or through majority-owned subsidiaries, in a business, among
others, described in Section 3(c)(5)(C) of the 1940 Act (from which not less
than 25% of such company's gross income during its last fiscal year was derived)
together with an additional business or additional businesses other than
investing, reinvesting, owning, holding or trading in securities. The SEC staff
has issued little interpretive guidance with respect to Section 3(c)(6) and any
guidance published by the staff could require us to adjust our strategy
accordingly.
We expect
certain of our subsidiaries we may form in the future, including subsidiaries we
may form for the purpose of borrowing under TALF, to rely on Section 3(c)(7) for
their 1940 Act exemption and, therefore our interest in each of these
subsidiaries would constitute an “investment security” for purposes of
determining whether we pass the 40% test.
We may in
the future, however, organize one or more subsidiaries, including subsidiaries
we may form for the purpose of borrowing under TALF, that seek to rely on the
1940 Act exemption provided to certain structured financing vehicles by Rule
3a-7. If we organize subsidiaries that rely on Rule 3a-7 for an
exemption from the 1940 Act, these subsidiaries will also need to comply with
the restrictions described in “Business—Operating and Regulatory Structure—1940
Act Exemption.” In general, Rule 3a-7 exempts from the 1940 Act issuers that
limit their activities as follows:
• the
issuer issues securities the payment of which depends primarily on the cash flow
from “eligible assets” that by their terms convert into cash within a finite
time period;
• the
securities sold are fixed income securities rated investment grade by at least
one rating agency (fixed income securities which are unrated or rated below
investment grade may be sold to institutional accredited investors and any
securities may be sold to “qualified institutional buyers” and to persons
involved in the organization or operation of the issuer);
• the
issuer acquires and disposes of eligible assets (1) only in accordance with the
agreements pursuant to which the securities are issued, (2) so that the
acquisition or disposition does not result in a downgrading of the issuer’s
fixed income securities and (3) the eligible assets are not acquired or disposed
of for the primary purpose of recognizing gains or decreasing losses resulting
from market value changes; and
• unless
the issuer is issuing only commercial paper, the issuer appoints an independent
trustee, takes reasonable steps to transfer to the trustee an ownership or
perfected security interest in the eligible assets, and meets rating agency
requirements for commingling of cash flows.
Any
subsidiary also would need to be structured to comply with any guidance that may
be issued by the Division of Investment Management of the SEC on how the
subsidiary must be organized to comply with the restrictions contained in Rule
3a-7. Compliance with Rule 3a-7 may require that the indenture governing the
subsidiary include additional limitations on the types of assets the subsidiary
may sell or acquire out of the proceeds of assets that mature, are refinanced or
otherwise sold, on the period of time during which such transactions may occur,
and on the amount of transactions that may occur. In light of the requirements
of Rule 3a-7, our ability to manage assets held in a special purpose subsidiary
that complies with Rule 3a-7 will be limited and we may not be able to purchase
or sell assets owned by that subsidiary when we would otherwise desire to do so,
which could lead to losses. Initially, we will limit the aggregate value of our
interests in our subsidiaries that may in the future seek to rely on Rule 3a-7
to 20% or less of our total assets on an unconsolidated basis, as we continue to
discuss with the SEC staff the use of subsidiaries that rely on Rule 3a-7 to
finance our operations.
The
determination of whether an entity is a majority-owned subsidiary of our company
is made by us. The 1940 Act defines a majority-owned subsidiary of a person as a
company of which 50% or more of the outstanding voting securities are owned by
such person, or by another company which is a majority-owned subsidiary of such
person. The 1940 Act further defines voting securities as any security presently
entitling the owner or holder thereof to vote for the election of directors of a
company. We treat companies in which we own at least a majority of the
outstanding voting securities as majority-owned subsidiaries for purposes of the
40% test. We have not requested the SEC to approve our treatment of any company
as a majority-owned subsidiary and the SEC has not done so. If the SEC were to
disagree with our treatment of one or more companies as majority-owned
subsidiaries, we would need to adjust our strategy and our assets in order to
continue to pass the 40% test. Any such adjustment in our strategy could have a
material adverse effect on us.
There can
be no assurance that the laws and regulations governing the 1940 Act status of
REITs, including the Division of Investment Management of the SEC providing more
specific or different guidance regarding these exemptions, will not change in a
manner that adversely affects our operations. If we or our subsidiaries fail to
maintain an exception or exemption from the 1940 Act, we could, among other
things, be required either to (a) change the manner in which we conduct our
operations to avoid being required to register as an investment company, (b)
effect sales of our assets in a manner that, or at a time when, we would not
otherwise choose to do so, or (c) register as an investment company, any of
which could negatively affect the value of our common stock, the sustainability
of our business model, and our ability to make distributions which could have an
adverse effect on our business and the market price for our shares of common
stock.
Rapid
changes in the values of our RMBS, residential mortgage loans, and other real
estate-related investments may make it more difficult for us to maintain our
qualification as a REIT or our exemption from the 1940 Act.
If the
market value or income potential of our RMBS, residential mortgage loans, and
other real estate-related investments declines as a result of increased interest
rates, prepayment rates or other factors, we may need to increase our real
estate investments and income or liquidate our non-qualifying assets to maintain
our REIT qualification or our exemption from the 1940 Act. If the decline in
real estate asset values or income occurs quickly, this may be especially
difficult to accomplish. This difficulty may be exacerbated by the illiquid
nature of any non-real estate assets we may own. We may have to make investment
decisions that we otherwise would not make absent the REIT and 1940 Act
considerations.
We
leverage our investments, which may adversely affect our return on our
investments and may reduce cash available for distribution to our
stockholders.
We
leverage our investments through borrowings, generally through the use of
repurchase agreements, warehouse facilities, credit facilities, securitizations,
commercial paper and CDOs. We are not required to maintain any specific
debt-to-equity ratio. The amount of leverage we use varies depending on our
ability to obtain credit facilities, the lenders’ and rating agencies’ estimates
of the stability of the investments’ cash flow, and our assessment of the
appropriate amount of leverage for the particular assets we are funding. Under
some credit facilities, we expect to be required to maintain minimum average
cash balances in connection with borrowings. Our return on our investments and
cash available for distribution to our stockholders may be reduced to the extent
that changes in market conditions prevent us from leveraging our investments,
require us to decrease our rate of leverage, increase the amount of collateral
we post, or increase the cost of our financing relative to the income that can
be derived from the assets acquired. Our debt service payments will reduce cash
flow available for distributions to stockholders, which could adversely affect
the price of our common stock. We may not be able to meet our debt service
obligations, and, to the extent that we cannot, we risk the loss of some or all
of our assets to foreclosure or sale to satisfy the obligations. We leverage
certain of our assets through repurchase agreements. A decrease in the value of
these assets may lead to margin calls which we will have to satisfy. We may not
have the funds available to satisfy any such margin calls and we may be forced
to sell assets at significantly depressed prices due to market conditions or
otherwise. The satisfaction of such margin calls may reduce cash flow available
for distribution to our stockholders. Any reduction in distributions to our
stockholders or sales of assets at inopportune times or prices may cause the
value of our common stock to decline, in some cases, precipitously.
We
depend on warehouse and repurchase facilities, credit facilities and commercial
paper to execute our business plan, and our inability to access funding could
have a material adverse effect on our results of operations, financial condition
and business.
Our
ability to fund our investments depends to a large extent upon our ability to
secure warehouse, repurchase, credit, and commercial paper financing on
acceptable terms. We can provide no assurance that we will be successful in
establishing sufficient warehouse, repurchase, and credit facilities and issuing
commercial paper. In addition, because warehouse, repurchase, and credit
facilities and commercial paper are short-term commitments of capital, the
lenders may respond to market conditions, which may favor an alternative
investment strategy for them, making it more difficult for us to secure
continued financing. During certain periods of the credit cycle, such as
recently, lenders may curtail their willingness to provide financing. If we are
not able to renew our then existing warehouse, repurchase, and credit facilities
and issue commercial paper or arrange for new financing on terms acceptable to
us, or if we default on our covenants or are otherwise unable to access funds
under any of these facilities, we will have to curtail our asset acquisition
activities.
It
is possible that the lenders that provide us with financing could experience
changes in their ability to advance funds to us, independent of our performance
or the performance of our investments, including our mortgage loans. In
addition, if the regulatory capital requirements imposed on our lenders change,
they may be required to significantly increase the cost of the warehouse
facilities that they provide to us. Our lenders also may revise their
eligibility requirements for the types of residential mortgage loans they are
willing to finance or the terms of such financings, based on, among other
factors, the regulatory environment and their management of perceived risk,
particularly with respect to assignee liability. Financing of equity-based
lending, for example, may become more difficult in the future. Moreover, the
amount of financing we will receive under our warehouse and repurchase
facilities will be directly related to the lenders’ valuation of the assets that
secure the outstanding borrowings. Typically warehouse, repurchase, and credit
facilities grant the respective lender the absolute right to reevaluate the
market value of the assets that secure outstanding borrowings at any time. If a
lender determines in its sole discretion that the value of the assets has
decreased, it has the right to initiate a margin call. A margin call would
require us to transfer additional assets to such lender without any advance of
funds from the lender for such transfer or to repay a portion of the outstanding
borrowings. Any such margin call could have a material adverse effect on our
results of operations, financial condition, business, liquidity and ability to
make distributions to our stockholders, and could cause the value of our common
stock to decline. We may be forced to sell assets at significantly depressed
prices to meet such margin calls and to maintain adequate liquidity, which could
cause us to incur losses. Moreover, to the extent we are forced to sell assets
at such time, given market conditions, we may be forced to sell assets at the
same time as others facing similar pressures to sell similar assets, which could
greatly exacerbate a difficult market environment and which could result in our
incurring significantly greater losses on our sale of such assets. In an extreme
case of market duress, a market may not even be present for certain of our
assets at any price.
The
current dislocation and weakness in the broader mortgage markets could adversely
affect one or more of our potential lenders and could cause one or more of our
potential lenders to be unwilling or unable to provide us with
financing. This could potentially increase our financing costs and
reduce our liquidity. If one or more major market participants fails
or otherwise experiences a major liquidity crisis, as was the case for Bear
Stearns & Co. in March 2008 and Lehman Brothers Holdings Inc. in September
2008, it could negatively impact the marketability of all fixed income
securities, including Agency and non-Agency RMBS, residential mortgage loans and
real estate related securities, and this could negatively impact the value of
the securities we acquire, thus reducing our net book
value. Furthermore, if any of our potential lenders or any of our
lenders, including Annaly, are unwilling or unable to provide us with financing,
we could be forced to sell our assets at an inopportune time when prices are
depressed.
Beginning
in mid-February 2008, credit markets experienced a dramatic and sudden adverse
change. The severity of the limitation on liquidity was largely
unanticipated by the markets. Credit once again froze, and in
the mortgage market, valuations of non-Agency RMBS and whole mortgage loans came
under severe pressure. This credit crisis began in early February
2008, when a heavily leveraged investor announced that it had to de-lever and
liquidate a portfolio of approximately $30 billion of non-Agency
RMBS. Prices of these types of securities dropped dramatically, and
lenders started lowering the prices on non-Agency RMBS that they held as
collateral to secure the loans they had extended. The subsequent
failure in March 2008 of Bear Stearns & Co. worsened the
crisis. As the year progressed, deterioration in the fair value of
our assets continued, we received and met margin calls under our repurchase
agreements, which resulted in our obtaining additional funding from third
parties, including from Annaly, an affiliate, and taking other steps to increase
our liquidity.
The
challenges of 2008 and 2009 have continued as financing difficulties have
severely pressured liquidity and asset values. In September 2008,
Lehman Brothers Holdings, Inc., a major investment bank, experienced a major
liquidity crisis and failed. Securities trading remains limited and
mortgage securities financing markets remain challenging as the industry
continues to report negative news. This dislocation in the non-Agency
mortgage sector has made it difficult for us to obtain short-term financing on
favorable terms. As a result, we have completed loan
securitizations in order to obtain long-term financing and terminated our
un-utilized whole loan repurchase agreements in order to avoid paying non-usage
fees under those agreements. In addition, we have continued to seek
funding from Annaly. Under these circumstances, we expect to take
actions intended to protect our liquidity, which may include reducing borrowings
and disposing of assets as well as raising capital.
During
this period of market dislocation, fiscal and monetary policymakers have
established new liquidity facilities for primary dealers and commercial banks,
reduced short-term interest rates, and passed legislation that is intended to
address the challenges of mortgage borrowers and lenders. It is not
possible for us to predict how these actions will impact our
business. Although these aggressive steps are intended to protect and
support the US housing and mortgage market, we continue to operate under very
difficult market conditions. As a result, there can be no assurance
that the EESA, the TARP, the TALF, PPIP or other policy initiatives will have a
beneficial impact on the financial markets, including current extreme levels of
volatility. We cannot predict whether or when such actions may occur
or what impact, if any, such actions could have on our business, results of
operations and financial condition.
Certain
financing facilities may contain covenants that restrict our operations and may
inhibit our ability to grow our business and increase revenues.
Certain
financing facilities we may enter into may contain extensive restrictions,
covenants, and representations and warranties that, among other things, require
us to satisfy specified financial, asset quality, loan eligibility and loan
performance tests. If we fail to meet or satisfy any of these covenants or
representations and warranties, we would be in default under these agreements
and our lenders could elect to declare all amounts outstanding under the
agreements to be immediately due and payable, enforce their respective interests
against collateral pledged under such agreements and restrict our ability to
make additional borrowings. Certain financing agreements may contain
cross-default provisions, so that if a default occurs under any one agreement,
the lenders under our other agreements could also declare a default. The
covenants and restrictions we expect in our financing facilities may restrict
our ability to, among other things:
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incur
or guarantee additional debt;
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make
certain investments or
acquisitions;
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make
distributions on or repurchase or redeem capital
stock;
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engage
in mergers or consolidations;
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finance
mortgage loans with certain
attributes;
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·
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reduce
liquidity below certain levels;
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·
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incur
operating losses for more than a specified
period;
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enter
into transactions with affiliates;
and
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hold
mortgage loans for longer than established time
periods.
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These
restrictions may interfere with our ability to obtain financing, including the
financing needed to qualify as a REIT, or to engage in other business
activities, which may significantly harm our business, financial condition,
liquidity and results of operations. A default and resulting repayment
acceleration could significantly reduce our liquidity, which could require us to
sell our assets to repay amounts due and outstanding. This could also
significantly harm our business, financial condition, results of operations, and
our ability to make distributions, which could cause the value of our common
stock to decline. A default will also significantly limit our financing
alternatives such that we will be unable to pursue our leverage strategy, which
could curtail our investment returns.
The
repurchase agreements, warehouse facilities and credit facilities and commercial
paper that we use to finance our investments may require us to provide
additional collateral and may restrict us from leveraging our assets as fully as
desired.
We will
use repurchase agreements, warehouse facilities, credit facilities and
commercial paper to finance our investments. We currently have uncommitted
repurchase agreements with 18 counterparties, including Annaly, for financing
our RMBS. Our repurchase agreements are uncommitted and the
counterparty may refuse to advance funds under the agreements to
us. If the market value of the loans or securities pledged or sold by
us to a funding source decline in value, we may be required by the lending
institution to provide additional collateral or pay down a portion of the funds
advanced, but we may not have the funds available to do so. Posting additional
collateral will reduce our liquidity and limit our ability to leverage our
assets, which could adversely affect our business. In the event we do not have
sufficient liquidity to meet such requirements, lending institutions can
accelerate repayment of our indebtedness, increase our borrowing rates,
liquidate our collateral or terminate our ability to borrow. Such a situation
would likely result in a rapid deterioration of our financial condition and
possibly necessitate a filing for protection under the U.S. Bankruptcy Code.
Further, financial institutions may require us to maintain a certain amount of
cash that is not invested or to set aside non-levered assets sufficient to
maintain a specified liquidity position which would allow us to satisfy our
collateral obligations. As a result, we may not be able to leverage our assets
as fully as we would choose which could reduce our return on equity. If we are
unable to meet these collateral obligations, then, as described above, our
financial condition could deteriorate rapidly.
If
the counterparty to our repurchase transactions defaults on its obligation to
resell the underlying security back to us at the end of the transaction term, or
if the value of the underlying security has declined as of the end of that term
or if we default on our obligations under the repurchase agreement, we will lose
money on our repurchase transactions.
When we
engage in a repurchase transaction, we generally sell securities to the
transaction counterparty and receive cash from the counterparty. The
counterparty is obligated to resell the securities back to us at the end of the
term of the transaction, which is typically 30-90 days. Because the cash we
receive from the counterparty when we initially sell the securities to the
counterparty is less than the value of those securities (this difference is
referred to as the haircut), if the counterparty defaults on its obligation to
resell the securities back to us we would incur a loss on the transaction equal
to the amount of the haircut (assuming there was no change in the value of the
securities). We would also lose money on a repurchase transaction if the value
of the underlying securities has declined as of the end of the transaction term,
as we would have to repurchase the securities for their initial value but would
receive securities worth less than that amount. Any losses we incur on our
repurchase transactions could adversely affect our earnings, and thus our cash
available for distribution to our stockholders. If we default on one of our
obligations under a repurchase transaction, the counterparty can terminate the
transaction and cease entering into any other repurchase transactions with us.
In that case, we would likely need to establish a replacement repurchase
facility with another repurchase dealer in order to continue to leverage our
portfolio and carry out our investment strategy. There is no assurance we would
be able to establish a suitable replacement facility.
Our
rights under our repurchase agreements are subject to the effects of the
bankruptcy laws in the event of the bankruptcy or insolvency of us or our
lenders under the repurchase agreements.
In the
event of our insolvency or bankruptcy, certain repurchase agreements may qualify
for special treatment under the U.S. Bankruptcy Code, the effect of which, among
other things, would be to allow the lender under the applicable repurchase
agreement to avoid the automatic stay provisions of the U.S. 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.
An
increase in our borrowing costs relative to the interest we receive on our
assets may adversely affect our profitability, and thus our cash available for
distribution to our stockholders.
As our
repurchase agreements and other short-term borrowings mature, we will be
required either to enter into new borrowings or to sell certain of our
investments. An increase in short-term interest rates at the time that we seek
to enter into new borrowings would reduce the spread between our returns on our
assets and the cost of our borrowings. This would adversely affect our returns
on our assets that are subject to prepayment risk, including our mortgage-backed
securities, which might reduce earnings and, in turn, cash available for
distribution to our stockholders.
If
we issue senior securities we will be exposed to additional risks.
If we
decide to issue senior securities in the future, it is likely that they will be
governed by an indenture or other instrument containing covenants restricting
our operating flexibility. Additionally, any convertible or exchangeable
securities that we issue in the future may have rights, preferences and
privileges more favorable than those of our common stock and may result in
dilution to owners of our common stock. We and, indirectly, our stockholders,
will bear the cost of issuing and servicing such securities.
Our
securitizations will expose us to additional risks.
We have
and expect to continue to securitize certain of our portfolio investments to
generate cash for funding new investments. We expect to structure these
transactions either as financing transactions or as sales for
GAAP. In each such transaction, we convey a pool of assets to a
special purpose vehicle, the issuing entity, and the issuing entity issues one
or more classes of non-recourse notes pursuant to the terms of an indenture. The
notes are secured by the pool of assets. In exchange for the transfer of assets
to the issuing entity, we receive the cash proceeds of the sale of non-recourse
notes and a 100% interest in the equity of the issuing entity. The
securitization of our portfolio investments might magnify our exposure to losses
on those portfolio investments because any equity interest we retain in the
issuing entity would be subordinate to the notes issued to investors and we
would, therefore, absorb all of the losses sustained with respect to a
securitized pool of assets before the owners of the notes experience any losses.
Moreover, we cannot be assured that we will be able to access the securitization
market, or be able to do so at favorable rates. The inability to securitize our
portfolio could hurt our performance and our ability to grow our
business.
The
use of CDO financings with over-collateralization requirements may have a
negative impact on our cash flow.
We expect
that the terms of CDOs we may sponsor will generally provide that the principal
amount of assets must exceed the principal balance of the related bonds by a
certain amount, commonly referred to as ‘‘over-collateralization.’’ We
anticipate that the CDO terms will provide that, if certain delinquencies or
losses exceed the specified levels based on the analysis by the rating agencies
(or any financial guaranty insurer) of the characteristics of the assets
collateralizing the bonds, the required level of over-collateralization may be
increased or may be prevented from decreasing as would otherwise be permitted if
losses or delinquencies did not exceed those levels. Other tests (based on
delinquency levels or other criteria) may restrict our ability to receive net
income from assets collateralizing the obligations. We cannot assure you that
the performance tests will be satisfied. In advance of completing negotiations
with the rating agencies or other key transaction parties on our future CDO
financings, we cannot assure you of the actual terms of the CDO delinquency
tests, over-collateralization terms, cash flow release mechanisms or other
significant factors regarding the calculation of net income to us. Given recent
volatility in the CDO market, rating agencies may depart from historic practices
for CDO financings, making them more costly for us. Failure to obtain favorable
terms with regard to these matters may materially and adversely affect the
availability of net income to us. If our assets fail to perform as anticipated,
our over-collateralization or other credit enhancement expense associated with
our CDO financings will increase.
Hedging
against interest rate exposure may adversely affect our earnings, which could
reduce our cash available for distribution to our stockholders.
Subject
to maintaining our qualification as a REIT, we pursue various hedging strategies
to seek to reduce our exposure to losses from adverse changes in interest rates.
Our hedging activity varies in scope based on the level and volatility of
interest rates, the type of assets held and other changing market conditions.
Interest rate hedging may fail to protect or could adversely affect us because,
among other things:
·
|
interest
rate hedging can be expensive, particularly during periods of rising and
volatile interest rates;
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·
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available
interest rate hedges may not correspond directly with the interest rate
risk for which protection is
sought;
|
·
|
the
duration of the hedge may not match the duration of the related
liability;
|
·
|
the
amount of income that a REIT may earn from hedging transactions (other
than through TRSs) to offset interest rate losses is limited by federal
tax provisions governing REITs;
|
·
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the
credit quality of the party owing money on the hedge may be downgraded to
such an extent that it impairs our ability to sell or assign our side of
the hedging transaction; and
|
·
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the
party owing money in the hedging transaction may default on its obligation
to pay.
|
Our
hedging transactions, which are intended to limit losses, may actually limit
gains and increase our exposure to losses. As a result, our hedging activity may
adversely affect our earnings, which could reduce our cash available for
distribution to our stockholders. In addition, hedging instruments involve risk
since they often are not traded on regulated exchanges, guaranteed by an
exchange or its clearing house, or regulated by any U.S. or foreign governmental
authorities. Consequently, there are no requirements with respect to record
keeping, financial responsibility or segregation of customer funds and
positions. Furthermore, the enforceability of agreements underlying derivative
transactions may depend on compliance with applicable statutory and commodity
and other regulatory requirements and, depending on the identity of the
counterparty, applicable international requirements. The business failure of a
hedging counterparty with whom we enter into a hedging transaction will most
likely result in its default. Default by a party with whom we enter into a
hedging transaction may result in the loss of unrealized profits and force us to
cover our commitments, if any, at the then current market price. Although
generally we will seek to reserve the right to terminate our hedging positions,
it may not always be possible to dispose of or close out a hedging position
without the consent of the hedging counterparty, and we may not be able to enter
into an offsetting contract in order to cover our risk. We cannot assure you
that a liquid secondary market will exist for hedging instruments purchased or
sold, and we may be required to maintain a position until exercise or
expiration, which could result in losses.
Our
hedging strategies may not be successful in mitigating the risks associated with
interest rates.
Subject
to complying with REIT tax requirements, we have employed and intend to continue
to employ techniques that limit, or hedge, the adverse effects of rising
interest rates on our short-term repurchase agreements. In general,
our hedging strategy depends on our view of our entire portfolio, consisting of
assets, liabilities and derivative instruments, in light of prevailing market
conditions. We could misjudge the condition of our investment portfolio or the
market.
Our
hedging activity will vary in scope based on the level and volatility of
interest rates and principal repayments, the type of securities held and other
changing market conditions. Our actual hedging decisions will be determined in
light of the facts and circumstances existing at the time and may differ from
our currently anticipated hedging strategy. These techniques may include
entering into interest rate caps, collars, floors, forward contracts, futures or
swap agreements. We may conduct certain hedging transactions through a TRS,
which will be subject to federal, state and, if applicable, local income
tax.
There are
no perfect hedging strategies, and interest rate hedging may fail to protect us
from loss. Alternatively, we may fail to properly assess a risk to our
investment portfolio or may fail to recognize a risk entirely, leaving us
exposed to losses without the benefit of any offsetting hedging activities. The
derivative financial instruments we select may not have the effect of reducing
our interest rate risk. The nature and timing of hedging transactions may
influence the effectiveness of these strategies. Poorly designed strategies or
improperly executed transactions could actually increase our risk and losses. In
addition, hedging activities could result in losses if the event against which
we hedge does not occur. For example, interest rate hedging could fail to
protect us or adversely affect us because, among other things:
·
|
available
interest rate hedging may not correspond directly with the interest rate
risk for which protection is
sought;
|
·
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the
duration of the hedge may not match the duration of the related
liability;
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·
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as
explained in further detail in the risk factor immediately below, the
party owing money in the hedging transaction may default on its obligation
to pay;
|
·
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the
credit quality of the party owing money on the hedge may be downgraded to
such an extent that it impairs our ability to sell or assign our side of
the hedging transaction; and
|
·
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the
value of derivatives used for hedging may be adjusted from time to time in
accordance with accounting rules to reflect changes in fair value.
Downward adjustments, or “mark-to-market losses,” would reduce our
stockholders’ equity.
|
Whether
the derivatives we acquire achieve hedge accounting treatment or not, hedging
generally involves costs and risks. Our hedging strategies may adversely affect
us because hedging activities involve costs that we will incur regardless of the
effectiveness of the hedging activity. Those costs may be higher in periods of
market volatility, both because the counterparties to our derivative agreements
may demand a higher payment for taking risks, and because repeated adjustments
of our hedges during periods of interest rate changes also may increase costs.
Especially if our hedging strategies are not effective, we could incur
significant hedging-related costs without any corresponding economic
benefits.
We
have elected not to qualify for hedge accounting treatment.
We record
derivative and hedge transactions in accordance with GAAP. We have
elected not to qualify for hedge accounting treatment. As a result,
our operating results may suffer because losses on the derivatives that we enter
into may not be offset by a change in the fair value of the related hedged
transaction.
Declines
in the fair values of our investments may adversely affect periodic reported
results and credit availability, which may reduce earnings and, in turn, cash
available for distribution to our stockholders.
A
substantial portion of our assets are classified for accounting purposes as
“available-for-sale” and carried at fair value. Changes in the fair
values of those assets will be directly charged or credited to
OCI. In addition, a decline in values will reduce the book value of
our assets. A decline in the fair value of our assets may adversely affect us,
particularly in instances where we have borrowed money based on the fair value
of those assets. If the fair value of those assets declines, the lender may
require us to post additional collateral to support the loan. If we were unable
to post the additional collateral, we would have to sell the assets at a time
when we might not otherwise choose to do so. A reduction in credit available may
reduce our earnings and, in turn, cash available for distribution to
stockholders.
The
lack of liquidity in our investments may adversely affect our
business.
We may
invest in securities or other instruments that are not liquid. It may be
difficult or impossible to obtain third party pricing on the investments we
purchase. Illiquid investments typically experience greater
price volatility as a ready market does not exist. In addition,
validating third party pricing for illiquid investments may be more subjective
than more liquid investments. The illiquidity of our investments may
make it difficult for us to sell such investments if the need or desire arises.
In addition, if we are required to liquidate all or a portion of our portfolio
quickly, we may realize significantly less than the value at which we have
previously recorded our investments. As a result, our ability to vary our
portfolio in response to changes in economic and other conditions may be
relatively limited, which could adversely affect our results of operations and
financial condition.
We
are highly dependent on information systems and third parties, and systems
failures could significantly disrupt our business, which may, in turn,
negatively affect the market price of our common stock and our ability to pay
dividends to our stockholders.
Our
business is highly dependent on communications and information systems. Any
failure or interruption of our systems could cause delays or other problems in
our securities trading activities, including mortgage-backed securities trading
activities, which could have a material adverse effect on our operating results
and negatively affect the market price of our common stock and our ability to
pay dividends to our stockholders.
Terrorist
attacks and other acts of violence or war may affect the market for our common
stock, the industry in which we conduct our operations and our
profitability.
Terrorist
attacks may harm our results of operations and your investment. We cannot assure
you that there will not be further terrorist attacks against the United States
or U.S. businesses. These attacks or armed conflicts may directly impact the
property underlying our asset-based securities or the securities markets in
general. Losses resulting from these types of events are uninsurable. More
generally, any of these events could cause consumer confidence and spending to
decrease or result in increased volatility in the United States and worldwide
financial markets and economies. Adverse economic conditions could harm the
value of the property underlying our asset-backed securities or the securities
markets in general which could harm our operating results and revenues and may
result in the volatility of the value of our securities.
We
are subject to the requirements of the Sarbanes-Oxley Act of 2002.
As we are
a public company, our management is required to deliver a report that assesses
the effectiveness of our internal controls over financial reporting, pursuant to
Section 302 of the Sarbanes-Oxley Act of 2002, or Sarbanes-Oxley Act. Section
404 of the Sarbanes-Oxley Act requires an independent registered public
accounting firm to deliver an attestation report on management’s assessment of,
and the operating effectiveness of our internal controls over financial
reporting in conjunction with their opinion on our audited financial statements
beginning with the year ending December 31, 2008. Substantial work on our part
is required to implement appropriate processes, document the system of internal
control over key processes, assess their design, remediate any deficiencies
identified and test their operation. This process is expected to be both costly
and challenging. We cannot give any assurances that material
weaknesses will not be identified in the future in connection with our
compliance with the provisions of Sections 302 and 404 of the Sarbanes-Oxley
Act. The existence of any material weakness described above would
preclude a conclusion by management and our independent auditors that we
maintained effective internal control over financial reporting. Our
management may be required to devote significant time and expense to remediate
any material weaknesses that may be discovered and may not be able to remediate
all material weaknesses in a timely manner. The existence of any
material weaknesses in our internal control over financial reporting could also
result in errors in our financial statements that could require us to restate
our financial statements, cause us to fail to meet our reporting obligations and
cause investors to lose confidence in our reported financial information, all of
which could lead to a decline in the trading price of our stock.
The
increasing number of proposed federal, state and local laws may increase our
risk of liability with respect to certain mortgage loans, may include judicial
modification provisions and could increase our cost of doing
business.
The
United States Congress and various state and local legislatures are considering
legislation, which, among other provisions, would permit limited assignee
liability for certain violations in the mortgage loan origination process, and
would allow judicial modification of loan principal in the event of personal
bankruptcy. We cannot predict whether or in what form Congress or the
various state and local legislatures may enact legislation affecting our
business. We are evaluating the potential impact of these
initiatives, if enacted, on our practices and results of
operations. As a result of these and other initiatives, we are unable
to predict whether federal, state or local authorities will require changes in
our practices in the future or in our portfolio. These changes, if
required, could adversely affect our profitability, particularly if we make such
changes in response to new or amended laws, regulations or ordinances in any
state where we acquire a significant portion of our mortgage loans, or if such
changes result in us being held responsible for any violations in the mortgage
loan origination process, or if the principal amount of loans we own or are in
RMBS pools we own are modified in the personal bankruptcy process.
Risks
Related to Our Investments
We
might not be able to purchase residential mortgage loans, mortgage-backed
securities and other investments that meet our investment criteria or at
favorable spreads over our borrowing costs.
To the
extent we purchase assets using leverage, our net income depends on our ability
to acquire residential mortgage loans, mortgage-backed securities and other
investments at favorable spreads over our borrowing costs. Our
investments are selected by our Manager, and our stockholders will not have
input into such investment decisions. Our Manager has conducted due diligence
with respect to each investment purchased. However, there can be no
assurance that our Manager's due diligence processes will uncover all relevant
facts or that any investment will be successful.
We
may not realize income or gains from our investments.
We invest
to generate both current income and capital appreciation. The investments we
invest in may, however, not appreciate in value and, in fact, may decline in
value, and the debt securities we invest in may default on interest or principal
payments. Accordingly, we may not be able to realize income or gains from our
investments. Any gains that we do realize may not be sufficient to offset any
other losses we experience. Any income that we realize may not be sufficient to
offset our expenses.
Our
investments may be concentrated and will be subject to risk of
default.
While we
intend to diversify our portfolio of investments, we are not required to observe
specific diversification criteria. To the extent that our portfolio is
concentrated in any one region or type of security, downturns relating generally
to such region or type of security may result in defaults on a number of our
investments within a short time period, which may reduce our net income and the
value of our shares and accordingly may reduce our ability to pay dividends to
our stockholders.
Our
investments in subordinated RMBS are generally in the “first loss” position and
our investments in the mezzanine RMBS are generally in the “second loss”
position and therefore subject to losses.
In
general, losses on a mortgage loan included in a securitization will be borne
first by the equity holder of the issuing trust, and then by the “first loss”
subordinated security holder and then by the “second loss” mezzanine
holder. In the event of default and the exhaustion of any classes of
securities junior to those in which we invest and there is any further loss, we
will not be able to recover all of our investment in the securities we
purchase. In addition, if the underlying mortgage portfolio has been
overvalued by the originator, or if the values subsequently decline and, as a
result, less collateral is available to satisfy interest and principal payments
due on the related RMBS, the securities in which we invest may effectively
become the “first loss” position behind the more senior securities, which may
result in significant losses to us. The prices of lower credit
quality securities are generally less sensitive to interest rate changes than
more highly rated investments, but more sensitive to adverse economic downturns
or individual issuer developments. A projection of an economic
downturn, for example, could cause a decline in the price of lower credit
quality securities because the ability of obligors of mortgages underlying RMBS
to make principal and interest payments may be impaired. In such
event, existing credit support in the securitization structure may be
insufficient to protect us against loss of our principal on these
securities.
Increases
in interest rates could negatively affect the value of our investments, which
could result in reduced earnings or losses and negatively affect the cash
available for distribution to our stockholders.
We have
and will continue to invest in real estate-related assets by acquiring RMBS,
residential mortgage loans, CMBS and CDOs backed by real estate-related
assets. Under a normal yield curve, an investment in these assets
will decline in value if long-term interest rates increase. Declines in market
value may ultimately reduce earnings or result in losses to us, which may
negatively affect cash available for distribution to our stockholders. A
significant risk associated with these investments is the risk that both
long-term and short-term interest rates will increase significantly. If
long-term rates were to increase significantly, the market value of these
investments would decline, and the duration and weighted average life of the
investments would increase. We could realize a loss if these assets were sold.
At the same time, an increase in short-term interest rates would increase the
amount of interest owed on the repurchase agreements or other adjustable rate
financings we may enter into to finance the purchase of these
assets. Market values of our investments may decline without any
general increase in interest rates for a number of reasons, such as increases in
defaults, increases in voluntary prepayments for those investments that are
subject to prepayment risk and widening of credit spreads.
In
a period of rising interest rates, our interest expense could increase while the
interest we earn on our fixed-rate assets would not change, which would
adversely affect our profitability.
Our
operating results will depend in large part on the differences between the
income from our assets, net of credit losses and financing costs. We anticipate
that, in most cases, the income from such assets will respond more slowly to
interest rate fluctuations than the cost of our borrowings. Consequently,
changes in interest rates, particularly short-term interest rates, may
significantly influence our net income. Increases in these rates will tend to
decrease our net income and market value of our assets. Interest rate
fluctuations resulting in our interest expense exceeding our interest income
would result in operating losses for us and may limit or eliminate our ability
to make distributions to our stockholders.
Interest
rate mismatches between our investments and any borrowings used to fund
purchases of these assets may reduce our income during periods of changing
interest rates.
We intend
to fund some of our acquisitions of residential mortgage loans, real
estate-related securities and real estate loans with borrowings that have
interest rates based on indices and repricing terms with shorter maturities than
the interest rate indices and repricing terms of our adjustable-rate
assets. Accordingly, if short-term interest rates increase, this may
harm our profitability.
Some of
the residential mortgage loans, real estate-related securities and real estate
loans we acquire are and will be fixed-rate securities. This means
that their interest rates will not vary over time based upon changes in a
short-term interest rate index. Therefore, the interest rate indices
and repricing terms of the assets that we acquire and their funding sources will
create an interest rate mismatch between our assets and
liabilities. During periods of changing interest rates, these
mismatches could reduce our net income, dividend yield and the market price of
our stock.
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 whereas
the interest rates on our fixed-rate assets remain unchanged.
Interest
rate caps on our adjustable rate RMBS may adversely affect our
profitability.
Adjustable-rate
RMBS 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 over the life of the security. Our borrowings typically will not be
subject to similar restrictions. Accordingly, in a period of rapidly increasing
interest rates, the interest rates paid on our borrowings could increase without
limitation while caps could limit the interest rates on our adjustable-rate
RMBS. This problem is magnified for hybrid adjustable-rate and adjustable-rate
RMBS that are not fully indexed. Further, some hybrid adjustable-rate and
adjustable-rate RMBS may be subject to periodic payment caps that result in a
portion of the interest being deferred and added to the principal outstanding.
As a result, we may receive less cash income on hybrid adjustable-rate and
adjustable-rate RMBS than we need to pay interest on our related borrowings.
These factors could reduce our net interest income and cause us to suffer a
loss.
A
significant portion of our portfolio investments will be recorded at fair value,
as determined in accordance with our pricing policy as approved by our board of
directors and, as a result, there will be uncertainty as to the value of these
investments.
A
significant portion of our portfolio of investments is in the form of securities
that are not publicly traded. The fair value of securities and other investments
that are not publicly traded may not be readily determinable. It may
be difficult or impossible to obtain third party pricing on the investments we
purchase. We value these investments quarterly at fair value, as
determined in accordance with our pricing policy as approved by our board of
directors. Because such valuations are inherently uncertain, may fluctuate over
short periods of time and may be based on estimates, our determinations of fair
value may differ materially from the values that would have been used if a ready
market for these securities existed. The value of our common stock could be
adversely affected if our determinations regarding the fair value of these
investments were materially higher than the values that we ultimately realize
upon their disposal.
A
prolonged economic slowdown, a recession or declining real estate values could
impair our investments and harm our operating results.
Many of
our investments are susceptible to economic slowdowns or recessions, which could
lead to financial losses in our investments and a decrease in revenues, net
income and assets. Unfavorable economic conditions also could increase our
funding costs, limit our access to the capital markets or result in a decision
by lenders not to extend credit to us. These events could prevent us from
increasing investments and have an adverse effect on our operating
results.
Changes
in prepayment rates could negatively affect the value of our investment
portfolio, which could result in reduced earnings or losses and negatively
affect the cash available for distribution to our stockholders.
There are
seldom any restrictions on borrowers’ abilities to prepay their residential
mortgage loans. Homeowners tend to prepay mortgage loans faster when interest
rates decline. Consequently, owners of the loans have to reinvest the money
received from the prepayments at the lower prevailing interest rates.
Conversely, homeowners tend not to prepay mortgage loans when interest rates
increase. Consequently, owners of the loans are unable to reinvest money that
would have otherwise been received from prepayments at the higher prevailing
interest rates. This volatility in prepayment rates may affect our ability to
maintain targeted amounts of leverage on our portfolio of residential mortgage
loans, RMBS, and CDOs backed by real estate-related assets and may result in
reduced earnings or losses for us and negatively affect the cash available for
distribution to our stockholders.
To the
extent our investments are purchased at a premium, faster than expected
prepayments result in a faster than expected amortization of the premium paid,
which would adversely affect our earnings. Conversely, if these
investments were purchased at a discount, faster than expected prepayments
accelerate our recognition of income. On February 10, 2010, Fannie
Mae and Freddie Mac announced their intention to significantly increase their
purchases of delinquent loans from the pools of mortgages collateralizing their
Agency MBS beginning in March 2010, which could materially impact the rate of
principal prepayments on our Agency MBS guaranteed by these two government
sponsored enterprises or GSEs.
The
mortgage loans we invest in and the mortgage loans underlying the mortgage and
asset-backed securities we invest in are subject to delinquency, foreclosure and
loss, which could result in losses to us.
Residential
mortgage loans are typically secured by single-family residential property and
are subject to risks of delinquency and foreclosure and risks of loss. The
ability of a borrower to repay a loan secured by a residential property is
dependent upon the income or assets of the borrower. A number of factors,
including a general economic downturn, acts of God, terrorism, social unrest and
civil disturbances, may impair borrowers’ abilities to repay their loans. In
addition, we invest in non-Agency RMBS, which are backed by residential real
property but, in contrast to Agency RMBS, their principal and interest is not
guaranteed by federally chartered entities such as Fannie Mae and Freddie Mac
and, in the case of Ginnie Mae, the U.S. government. The U.S. Department of
Treasury and FHFA have also entered into preferred stock purchase agreements
between the U.S. Department of Treasury and Fannie Mae and Freddie Mac pursuant
to which the U.S. Department of Treasury will ensure that each of Fannie Mae and
Freddie Mac maintains a positive net worth. Asset-backed securities
are bonds or notes backed by loans or other financial assets. The ability of a
borrower to repay these loans or other financial assets is dependent upon the
income or assets of these borrowers. Commercial mortgage loans are secured by
multifamily or commercial property and are subject to risks of delinquency and
foreclosure, and risks of loss that are greater than similar risks associated
with loans made on the security of single-family residential property. The
ability of a borrower to repay a loan secured by an income-producing property
typically is dependent primarily upon the successful operation of such property
rather than upon the existence of independent income or assets of the borrower.
If the net operating income of the property is reduced, the borrower’s ability
to repay the loan may be impaired. Net operating income of an income producing
property can be affected by, among other things, tenant mix, success of tenant
businesses, property management decisions, property location and condition,
competition from comparable types of properties, changes in laws that increase
operating expense or limit rents that may be charged, any need to address
environmental contamination at the property, the occurrence of any uninsured
casualty at the property, changes in national, regional or local economic
conditions or specific industry segments, declines in regional or local real
estate values, declines in regional or local rental or occupancy rates,
increases in interest rates, real estate tax rates and other operating expenses,
changes in governmental rules, regulations and fiscal policies, including
environmental legislation, acts of God, terrorism, social unrest and civil
disturbances. In the event of any default under a mortgage loan held directly by
us, we will bear a risk of loss of principal to the extent of any deficiency
between the value of the collateral and the principal and accrued interest of
the mortgage loan, which could have a material adverse effect on our cash flow
from operations. In the event of the bankruptcy of a mortgage loan borrower, the
mortgage loan to such borrower will be deemed to be secured only to the extent
of the value of the underlying collateral at the time of bankruptcy (as
determined by the bankruptcy court), and the lien securing the mortgage loan
will be subject to the avoidance powers of the bankruptcy trustee or
debtor-in-possession to the extent the lien is unenforceable under state law.
Foreclosure of a mortgage loan can be an expensive and lengthy process which
could have a substantial negative effect on our anticipated return on the
foreclosed mortgage loan. RMBS evidence interests in or are secured by pools of
residential mortgage loans and CMBS evidence interests in or are secured by a
single commercial mortgage loan or a pool of commercial mortgage loans.
Accordingly, the RMBS and CMBS we invest in are subject to all of the risks of
the respective underlying mortgage loans.
We
may be required to repurchase mortgage loans or indemnify investors if we breach
representations and warranties, which could harm our earnings.
If we
sell loans, we would be required to make customary representations and
warranties about such loans to the loan purchaser. Our residential mortgage loan
sale agreements will require us to repurchase or substitute loans in the event
we breach a representation or warranty given to the loan purchaser. In addition,
we may be required to repurchase loans as a result of borrower fraud or in the
event of early payment default on a mortgage loan. Likewise, we are required to
repurchase or substitute loans if we breach a representation or warranty in
connection with our securitizations. The remedies available to a purchaser of
mortgage loans are generally broader than those available to us against the
originating broker or correspondent. Further, if a purchaser enforces its
remedies against us, we may not be able to enforce the remedies we have against
the sellers. The repurchased loans typically can only be financed at a steep
discount to their repurchase price, if at all. They are also typically sold at a
significant discount to the unpaid principal balance. Significant repurchase
activity could harm our cash flow, results of operations, financial condition
and business prospects.
We
may enter into derivative contracts that could expose us to contingent
liabilities in the future.
Subject
to maintaining our qualification as a REIT, part of our investment strategy
involves entering into derivative contracts that could require us to fund cash
payments in certain circumstances. These potential payments will be contingent
liabilities and therefore may not appear on our consolidated statement of
financial condition. Our ability to fund these contingent liabilities will
depend on the liquidity of our assets and access to capital at the time, and the
need to fund these contingent liabilities could adversely impact our financial
condition.
Our
Manager’s due diligence of potential investments may not reveal all of the
liabilities associated with such investments and may not reveal other weaknesses
in such investments, which could lead to investment losses.
Before
making an investment, our Manager assesses the strengths and weaknesses of the
originator or issuer of the asset as well as other factors and characteristics
that are material to the performance of the investment. In making the assessment
and otherwise conducting customary due diligence, our Manager relies on
resources available to it and, in some cases, an investigation by third parties.
This process is particularly important with respect to newly formed originators
or issuers with unrated and other subordinated tranches of MBS and ABS because
there may be little or no information publicly available about these entities
and investments. There can be no assurance that our Manager’s due diligence
process will uncover all relevant facts or that any investment will be
successful.
Our
real estate investments are subject to risks particular to real
property.
We own
assets secured by real estate and may own real estate directly in the future,
either through direct investments or upon a default of mortgage loans. Real
estate investments are subject to various risks, including:
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acts
of God, including earthquakes, floods and other natural disasters, which
may result in uninsured losses;
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acts
of war or terrorism, including the consequences of terrorist attacks, such
as those that occurred on September 11,
2001;
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adverse
changes in national and local economic and market
conditions;
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changes
in governmental laws and regulations, fiscal policies and zoning
ordinances and the related costs of compliance with laws and regulations,
fiscal policies and ordinances;
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costs
of remediation and liabilities associated with environmental conditions
such as indoor mold; and
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the
potential for uninsured or under-insured property
losses.
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If any of
these or similar events occurs, it may reduce our return from an affected
property or investment and reduce or eliminate our ability to make distributions
to stockholders.
We
may be exposed to environmental liabilities with respect to properties to which
we take title.
In the
course of our business, we may take title to real estate, and, if we do take
title, we could be subject to environmental liabilities with respect to these
properties. In such a circumstance, we may be held liable to a governmental
entity or to third parties for property damage, personal injury, investigation,
and clean-up costs incurred by these parties in connection with environmental
contamination, or may be required to investigate or clean up hazardous or toxic
substances, or chemical releases at a property. The costs associated with
investigation or remediation activities could be substantial. If we ever become
subject to significant environmental liabilities, our business, financial
condition, liquidity, and results of operations could be materially and
adversely affected.
We
may in the future invest in RMBS collateralized by subprime mortgage loans,
which are subject to increased risks.
We may in
the future invest in RMBS backed by collateral pools of subprime residential
mortgage loans. ‘‘Subprime’’ mortgage loans refer to mortgage loans that have
been originated using underwriting standards that are less restrictive than the
underwriting requirements used as standards for other first and junior lien
mortgage loan purchase programs, such as the programs of Fannie Mae and Freddie
Mac. These lower standards include mortgage loans made to borrowers having
imperfect or impaired credit histories (including outstanding judgments or prior
bankruptcies), mortgage loans where the amount of the loan at origination is 80%
or more of the value of the mortgage property, mortgage loans made to borrowers
with low credit scores, mortgage loans made to borrowers who have other debt
that represents a large portion of their income and mortgage loans made to
borrowers whose income is not required to be disclosed or verified. Due to
economic conditions, including increased interest rates and lower home prices,
as well as aggressive lending practices, subprime mortgage loans have in recent
periods experienced increased rates of delinquency, foreclosure, bankruptcy and
loss, and they are likely to continue to experience delinquency, foreclosure,
bankruptcy and loss rates that are higher, and that may be substantially higher,
than those experienced by mortgage loans underwritten in a more traditional
manner. Thus, because of the higher delinquency rates and losses associated with
subprime mortgage loans, the performance of RMBS backed by subprime mortgage
loans in which we may invest could be correspondingly adversely affected, which
could adversely impact our results of operations, financial condition and
business.
Our
Manager will utilize analytical models and data in connection with the valuation
of our investments, and any incorrect, misleading or incomplete information used
in connection therewith would subject us to potential risks.
Given the
complexity of our investments and strategies, our Manager must rely heavily on
analytical models (both net present value based loss mitigation models and those
supplied by third-parties) and information and data supplied by third-parties,
or Models and Data. Models and Data will be used to value investments
or potential investments and also in connection with hedging our
investments. When Models and Data prove to be incorrect, misleading
or incomplete, any decisions made in reliance thereon expose us to potential
risks. For example, by relying on Models and Data, especially valuation models,
our Manager may be induced to buy certain investments at prices that are too
high, to sell certain other investments at prices that are too low or to miss
favorable opportunities altogether. Similarly, any hedging based on
faulty Models and Data may prove to be unsuccessful. Furthermore, any
valuations of our investments that are based on valuation models may prove to be
incorrect.
Some of
the risks of relying on analytical models and third-party data are particular to
analyzing tranches from securitizations, such as MBS. These risks include, but
are not limited to, the following: (i) collateral cash flows and/or liability
structures may be incorrectly modeled in all or only certain scenarios, or may
be modeled based on simplifying assumptions that lead to errors; (ii)
information about collateral may be incorrect, incomplete, or misleading; (iii)
collateral or bond historical performance (such as historical prepayments,
defaults, cash flows, etc.) may be incorrectly reported, or subject to
interpretation (e.g., different issuers may report delinquency statistics based
on different definitions of what constitutes a delinquent loan); or (iv)
collateral or bond information may be outdated, in which case the models may
contain incorrect assumptions as to what has occurred since the date information
was last updated.
Some of
the analytical models used by our Manager, such as mortgage prepayment models or
mortgage default models, are predictive in nature. The use of
predictive models has inherent risks. For example, such models may
incorrectly forecast future behavior, leading to potential losses on a cash flow
and/or a mark-to-market basis. In addition, the predictive models used by our
Manager may differ substantially from those models used by other market
participants, with the result that valuations based on these predictive models
may be substantially higher or lower for certain investments than actual market
prices. Furthermore, since predictive models are usually constructed
based on historical data supplied by third-parties, the success of relying on
such models may depend heavily on the accuracy and reliability of the supplied
historical data and the ability of these historical models to accurately reflect
future periods.
All
valuation models rely on correct market data inputs. If incorrect market data is
entered into even a well-founded valuation model, the resulting valuations will
be incorrect. However, even if market data is inputted correctly, “model prices”
will often differ substantially from market prices, especially for securities
with complex characteristics, such as derivative securities.
Exchange
rate fluctuations may limit gains or result in losses.
If we
directly or indirectly hold assets denominated in currencies other than U.S.
dollars, we will be exposed to currency risk that may adversely affect
performance. Changes in the U.S. dollar’s rate of exchange with other currencies
may affect the value of investments in our portfolio and the income that we
receive in respect of such investments. In addition, we may incur costs in
connection with conversion between various currencies, which may reduce our net
income and accordingly may reduce our ability to pay distributions to our
stockholders.
Regulatory
and Legal Risks
Violations
of federal, state and local laws by the originator, the servicer, or may result
in rescission of the loans or penalties that may adversely impact our
income.
Violations
of certain provisions of federal, state and local laws by the originator, the
servicer or us, as well as actions by governmental agencies, authorities and
attorneys general, may limit our or the servicer’s ability to collect all or
part of the principal of, or interest on, the residential mortgage loans we
purchase and hold, and loans that serve as security for the MBS we purchase and
hold. Violations could also subject the entity that made or modified
the loans to damages and administrative enforcement (including disgorgement of
prior interest and fees paid). In particular, a loan seller’s failure
to comply with certain requirements of federal and state laws could subject the
seller (and other assignees of the mortgage loans) to monetary penalties and
result in the obligors’ rescinding the mortgage loans against the seller and any
subsequent holders of the mortgage loans, even if the assignee was not
responsible for and was unaware of those violations. These adverse
consequences vary depending on the applicable law and may vary depending on the
type or severity of the violation, but they typically include:
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the
ability of the homeowner to rescind, or cancel, the
loan;
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the
inability of the holder of the loan to collect all of the principal and
interest otherwise due on the loan;
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the
right of the homeowner to a refund of amounts previously paid (which may
include amounts financed by the loan), or to set off those amounts against
his or her future loan obligations;
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the
liability of the servicer and the owner of the loan for actual damages,
statutory damages and punitive damages, civil or criminal penalties, costs
and attorneys’ fees.
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The terms
of the documents under which we intend to purchase loans, and the terms of the
documents used to create the MBS we intend to purchase, may entitle the holders
of the loans and the special purpose vehicles that hold loans in MBS to
contractual indemnification against these liabilities. For example,
the sellers of loans placed in an MBS typically represent that each mortgage
loan was made in compliance with applicable federal and state laws and
regulations at the time it was made. If there is a material breach of
that representation, the seller may be contractually obligated to cure the
breach or repurchase or replace the affected mortgage loan. If the
seller is unable or otherwise fails to satisfy these obligations, the yield on
the loans and MBS might be materially and adversely affected. Due to
the well publicized recent deterioration in the housing and commercial property
markets, many of the sellers that issued these indemnifications are no longer in
business or are unable to financially respond to their indemnification
obligations. Consequently, holders of interests in the loans and MBS
may ultimately have to absorb the losses arising from the sellers’
violations. While we attempt to take these factors into account in
the prices we pay for loans and MBS, we can offer no assurances concerning the
validity of the assumptions we use in our pricing decisions.
Furthermore,
the volume of new and modified laws and regulations at both the federal and
state levels has increased in recent years. For example, H.R. 1105,
which was signed into law in March 2009, gives the Federal Trade Commission, or
FTC, authority to issue rules under which it will define what constitutes unfair
and deceptive practices relating to mortgage lending and loan servicing and
which gives enforcement authority to state attorneys general. There
is also an increased risk that the both we and the servicer of loans we purchase
or that are held in MBS we purchase may be involved in litigation over
violations or alleged violations of recently enacted and proposed
laws. It is possible that these laws might result in additional
significant costs and liabilities, which could further adversely affect the
results of our operations. Any litigation would increase our expenses
and reduce funds available for distribution to our stockholders.
Some
local municipalities also have enacted laws that impose potentially significant
penalties on loan servicing activities related to abandoned properties or real
estate owned properties.
Any of
these preceding could result in delays and/or reductions in receipts of amounts
due on the loans we intend to purchase or on the loans held in MBS we intend to
purchase, harming our income and operating results.
We
may be subject to liability for potential violations of predatory lending and
other laws, which could adversely impact our results of operations, financial
condition and business.
Various
federal, state and local laws have been enacted that are designed to discourage
predatory lending practices and more are currently proposed. The federal Home
Ownership and Equity Protection Act of 1994, commonly known as HOEPA, prohibits
inclusion of certain provisions in residential mortgage loans that have mortgage
rates or origination costs in excess of prescribed levels and requires that
borrowers be given certain disclosures before origination. Some
states have enacted, or may enact, similar laws or regulations, which in some
cases impose restrictions and requirements greater than those in
HOEPA. In addition, under the anti-predatory lending laws of some
states, the origination of certain residential mortgage loans, including loans
that are not classified as “high cost” loans under applicable law, must satisfy
a net tangible benefits test with respect to the related
borrower. This test may be highly subjective and open to
interpretation. As a result, a court may determine that a residential mortgage
loan we hold, for example, does not meet the test even if the related originator
reasonably believed that the test was satisfied.
Failure
of residential mortgage loan originators or servicers to comply with these laws,
to the extent any of their residential mortgage loans become part of our
mortgage-related assets, could subject us, as an assignee or purchaser of the
related residential mortgage loans or RMBS, to monetary penalties and could
result in the borrowers rescinding the affected residential mortgage
loans. Lawsuits have been brought in various states making claims
against assignees or purchasers of high cost loans for violations of state
law. Named defendants in these cases have included numerous
participants in the secondary mortgage market. If the loans are found
to have been originated in violation of predatory or abusive lending laws, we
could incur losses, which could adversely impact our results of operations,
financial condition and business.
There
is the potential for limitations on our ability to finance purchases of loans
and MBS, and for losses on the loans and MBS we purchase, as a result of
violations of law by the originating lenders.
In June
2003, a California jury found a warehouse lender and securitization underwriter
liable in part for fraud on consumers committed by a lender to whom it provided
financing and underwriting services. The jury found that the
investment bank was aware of the fraud and substantially assisted the lender in
perpetrating the fraud by providing financing and underwriting services that
allowed the lender to continue to operate, and held it liable for 10% of the
plaintiff’s damages. This instance of liability is the first case we
know of in which an investment bank was held partly responsible for violations
committed by a mortgage lender customer. Shortly after the
announcement of the jury verdict in the California case, the Florida Attorney
General filed suit against the same financial institution, seeking an injunction
to prevent it from financing mortgage loans within Florida, as well as damages
and civil penalties, based on theories of unfair and deceptive trade practices
and fraud. The suit claimed that this financial institution aided and
abetted the same lender involved in the California case in its commission of
fraudulent representations in Florida.
In
December of 2008, the Massachusetts Supreme Judicial Court upheld a lower
court’s order entered against a lender that enjoined the lender from
foreclosing, without court approval, on certain mortgage loans secured by the
borrower’s principal dwelling that the court considered “presumptively
unfair.”
In May of
2009, another securitizer of residential mortgage loans entered into a
settlement agreement with the Commonwealth of Massachusetts stemming from its
investigation of subprime lending and securitization markets. The
securitizer agreed to provide loan restructuring (including significant
principal write-downs) valued at approximately $50 million to Massachusetts
subprime borrowers and to make a $10 million payment to the
Commonwealth.
If other
courts or regulators take similar actions, investment banks and investors in
residential and commercial mortgage loans and MBS (such as us) might face
increased litigation as they are named as defendants in lawsuits and regulatory
actions against the mortgage companies or securitizers with which they do
business or they might be prohibited from foreclosing on loans they
purchased. Some investment banks may charge more for warehouse
lending and reduce the prices they pay for loans to build in the costs of this
potential litigation or exit the business entirely, thereby increasing our cost
of borrowing. Any such actions by courts and regulators, and any such
increases in our costs of borrowing, could, in turn, have a material adverse
effect on our results of operations, financial condition, and business
prospects.
We
are required to obtain various state licenses in order to purchase mortgage
loans in the secondary market and there is no assurance we will be able to
obtain or maintain those licenses.
While we
are not required to obtain licenses to purchase mortgage-backed securities, we
are required to obtain various state licenses to purchase mortgage loans in the
secondary market. There is no assurance that we will obtain all of the licenses
that we desire or that we will not experience significant delays in seeking
these licenses. Furthermore, we will be subject to various information reporting
requirements to maintain these licenses, and there is no assurance that we will
satisfy those requirements. Our failure to obtain or maintain licenses will
restrict our investment options and could harm our business.
The
federal government’s pressing for refinancing of certain loans may affect
prepayment rates for mortgage loans in MBS.
In
addition to the increased pressure upon residential mortgage loan investors and
servicers to engage in loss mitigation activities, the federal government is
pressing for refinancing of certain loans, and this encouragement may affect
prepayment rates for mortgage loans in MBS. In connection with
government-related securities, in February 2009 President Obama unveiled the
Homeowner Affordability and Stability Plan, which, in part, calls upon Fannie
Mae and Freddie Mac to loosen their eligibility criteria for the purchase of
loans in order to provide access to low-cost refinancing for borrowers who are
current on their mortgage payments but who cannot otherwise qualify to refinance
at a lower market rate. The major change is to permit an increase in
the LTV ratio of a refinancing loan eligible for sale up to 105%. The
charters governing the operations of Fannie Mae and Freddie Mac prohibit
purchases of loans with loan to value ratios in excess of 80% unless the loans
have mortgage insurance (or unless other types of credit enhancement are
provided in accordance with the statutory requirements). The FHFA,
which regulates Fannie Mae and Freddie Mac, determined that new mortgage
insurance will not be required on the refinancing if the applicable entity
already owns the loan or guarantees the related MBS. Additionally,
the U.S. Treasury reports that in some cases a new appraisal will not be
necessary upon refinancing. The U.S. Treasury estimates that up to
5,000,000 homeowners with loans owned or guaranteed by Fannie Mae or Freddie Mac
may be eligible for this refinancing program, which is scheduled to terminate in
June 2010.
In
connection with all RMBS, the HERA authorized a voluntary FHA mortgage insurance
program called HOPE for Homeowners, or H4H Program, designed to refinance
certain delinquent borrowers into new FHA-insured loans. The H4H
Program targets delinquent borrowers under conventional mortgage loans, as well
as under government-insured or -guaranteed mortgage loans, that were originated
on or before January 1, 2008. Holders of existing mortgage loans
being refinanced under the H4H Program must accept a write-down of principal and
waive all prepayment fees. While the use of the program has been
extremely limited to date, Congress continues to amend the program to encourage
its use. The H4H Program is effective through September 30,
2011.
To the
extent these and other economic stabilization or stimulus efforts are successful
in increasing prepayment speeds for residential mortgage loans, such as those in
RMBS, that could potentially harm our income and operating results, particularly
in connection with loans or MBS purchased at a premium or our interest-only
securities.
Federal
and state agencies have taken enforcement actions and enacted regulations and
government programs that require government sponsored enterprises
(such as Fannie Mae and Freddie Mac), insured depository institutions, and state
regulated loan servicers to engage in loss mitigation activities relating to
residential mortgage loans.
Federal
and state agencies have taken enforcement actions and enacted regulations that
require government sponsored enterprises (such as Fannie Mae and Freddie Mac),
insured depository institutions, and state regulated loan servicers to engage in
loss mitigation activities relating to residential mortgage
loans. Other agencies have published policies that strongly recommend
these entities to engage in loss mitigation activities. These loss
mitigation activities may include, for example, loan modifications that
significantly reduce interest and payments, deferrals of payments, and
reductions of principal balances.
On March
4, 2009, the U.S. Treasury announced HAMP, which is intended to enable borrowers
to retain their homes when feasible. Eligibility for relief initially
is limited to owner occupant borrowers with loans of less than $729,000 that
were in existence as of January 1, 2009. HAMP requires eligibility
criteria and modification terms that may be more favorable to the borrower than
an investor or the servicer may otherwise choose to use. As the
modification plan applies to owner occupied residential mortgage loans in
default or imminent default, absent a modification the loans may be subject to
foreclosure. Nevertheless, an increase in loans that take advantage
of the modification opportunities may result in the repurchase of pooled loans
in RMBS, thereby terminating our rights to earn interest on those
loans.
There is
litigation currently pending that challenges prior loss mitigation activities on
the premise that they are contrary to the terms of the agreements under which
established residential mortgage securities were formed. Nevertheless, the
recent enactment of the HFSTH Act provides a safe harbor in some circumstances
from these types of lawsuits for servicers entering into “qualified loss
mitigation plans” with respect to residential mortgages originated before the
act was enacted. A servicer’s duty to any investor or other party to
maximize the net present value of any mortgage being modified will be construed
to apply to all investors and other parties and will be deemed satisfied when
the following criteria are met: (a) a default on the payment of the
mortgage has occurred, is imminent, or is reasonably foreseeable, (b) the
mortgagor occupies the property securing the mortgage as his or her principal
residence and (c) the servicer reasonably determined that the application of
such qualified loss mitigation plan will likely provide an anticipated recovery
on the outstanding principal mortgage debt that will exceed the anticipated
recovery through foreclosure. Any servicer that is deemed to be
acting in the best interests of all investors and parties is relieved of
liability to any party owed a duty as discussed above and shall not be subject
to any injunction, stay or other equitable relief to such party based solely
upon the implementation by the servicer of a qualified loss mitigation
plan. The act further provides that any person, including a trustee,
issuer and loan originator, shall not be liable for monetary damages or subject
to an injunction, stay or other equitable relief based solely upon that person’s
cooperation with a servicer in implementing a qualified loss mitigation program
that meets the criteria set forth above. By protecting
servicers from such liabilities, this safe harbor may encourage loan
modifications and servicers may not be able to service the mortgage loans in
accordance with their prior practices. As a result of the enactment
of the HFSTH Act, loss mitigation activities may result in even more significant
reductions in the returns on loans and RMBS we purchase, potentially harming our
income and operating results.
Proposed
Congressional legislation (H.R. 3126) supported by President Obama would, if
passed, create a Consumer Financial Protection Agency (“CFPA”). The
bill has undergone numerous changes since its introduction, and there are
reports about broad revisions to the bill. The bill would establish a
new federal agency whose principal purpose would be to regulate the provision of
financial services and products. As proposed, the bill would grant
the CFPA sweeping and broad powers and provide the CFPA authority to both
mandate and limit the financial products offered to consumers. It is
possible the CFPA could significantly limit our ability to offer products and
services, and impose requirements on us as to what financial services and
products we offer and the manner in which we market our services and
products. Because of the uncertainty concerning whether the bill will
be passed, and its coverage, it is difficult to predict the impact it will have
on our operations, income and expenses.
We
will likely be subject to civil liability if we fail to make required
disclosures to consumers.
Purchasers
of consumer purpose, residential mortgage loans have affirmative disclosure
obligations to consumers under the HFSTH Act, which Congress enacted in May 2009
with an immediate effective date. This new statutory obligation will
subject purchasers of mortgage loans to civil liability if they fail to make the
required disclosures. Specifically, section 404 of the HFSTH Act amends the
Truth in Lending Act to provide that a creditor that purchases or is assigned a
mortgage loan must notify the borrower in writing of a sale or transfer of his
or her mortgage loan, not later than 30 days after the transaction’s
completion. The notice must include how to reach an agent or party
having authority to act on behalf of the new creditor, the location of the place
where the transfer of ownership is recorded and any other relevant information
about the new creditor. This disclosure would be in addition to any
transfer of servicing notice required under the Real Estate Settlement
Procedures Act. Federal consumer credit law does not typically impose
responsibility on assignees to communicate directly with mortgagors, and the
statutory language is ambiguous.
Litigation
alleging inability to foreclose may limit our ability to recover on some of the
loans we purchase or that are held in RMBS.
In
October 2007, a judge in the U.S. District Court for the Northern District of
Ohio dismissed 14 cases in which plaintiffs sought to foreclose mortgages held
in securitization trusts by ruling that those plaintiffs lacked standing to
sue. In each case, the judge found that the plaintiff was not the
owner of the note and mortgage on the date the foreclosure complaint was filed
in court. Similar actions have been initiated in other
states. These actions arise as a result of the common practice in the
mortgage industry of mortgage loan sellers providing the loan purchasers
unrecorded assignments of the mortgage in blank (i.e., the assignments do not
name the assignee). Some courts have held that before a note holder
may initiate a foreclosure, the note holder must show proof to the court that
the mortgage itself has been properly assigned to the purchaser each time the
mortgage loan has been sold. It is sometimes difficult to obtain and
then record originals of each successive assignment. It is still
unclear whether higher courts will uphold the requirements imposed by these
lower courts.
Until the
issue is settled, investors in mortgage loans are at risk of being unable to
foreclose on defaulted loans, or at a minimum will be subject to delays until
all assignments in the chain of the loan’s title are properly
recorded. Thus, we may not be able to recover on some of the loans we
purchase or that are held in the RMBS we purchase, or we may suffer delays in
foreclosure, all of which could result in a lower return on our loans and
RMBS.
In
addition, some legislatures are also instituting stringent proof of ownership
requirements that a servicer must satisfy before commencing a foreclosure
action. By way of example, the New York State Assembly earlier this year amended
state law to require that any foreclosure complaint contain an affirmative
allegation that the plaintiff is the owner and holder of the note and mortgage
at issue or has been delegated the authority to institute the foreclosure action
by the owner and holder of the subject mortgage and note. Again, laws
of this type may limit our ability to recover on some of the loans we purchase
or that are held in the RMBS we purchase, and may result in delays in the
foreclosure process, all of which could result in a lower return on our loans
and RMBS.
Legislative
action to provide mortgage relief and foreclosure moratoriums may negatively
impact our business.
As
delinquencies and defaults in residential mortgages have recently increased,
there has been an increasing amount of legislative action that might restrict
our ability to foreclose and resell the property of a customer in
default. For example, some recently enacted state laws may require
the lender to deliver a notice of intent to foreclose, provide borrowers
additional time to cure or reinstate their loans, impose mandatory settlement
conference and mediation requirements, require lenders to offer loan
modifications, and prohibit initiation of foreclosure until the borrower has
been provided time to consult with foreclosure counselors.
Alternatively,
new federal legislation and some legislatures provide a subsidy to a customer to
permit the customer to continue to make payments during a period of
hardship. In the case of a subsidy, it is possible that we might be
required to forego a portion of the amount otherwise due on the loan for a
temporary period.
Finally,
some state legislatures are requiring foreclosing lenders to give special
notices to tenants in properties that the lenders are foreclosing on, or to
permit the tenants to remain in the property for a period of time following the
foreclosure.
These
laws delay the initiation or completion of foreclosure proceedings on specified
types of residential mortgage loans, or otherwise limit the ability of
residential loan servicers to take actions that may be essential to preserve the
value of the mortgage loans on behalf of the holders of
MBS. Any such limitations are likely to cause delayed or
reduced collections from mortgagors and generally increased servicing
costs. Any restriction on our ability to foreclose on a loan, any
requirement that we forego a portion of the amount otherwise due on a loan or
any requirement that we modify any original loan terms is likely to negatively
impact our business, financial condition, liquidity and results of
operations.
United
States military operations may increase risk of Servicemembers Civil Relief Act
shortfalls.
Under the
federal Service members Civil Relief Act, a borrower who enters active military
service after the origination of his or her mortgage loan generally may not be
required to pay interest above an annual rate of 6%, and the note holder is
restricted from exercising certain enforcement remedies, during the period of
the borrower’s active duty status. Several states also have enacted
or are considering similar laws with varying applicability and
effect. As a result of military operations in Afghanistan and Iraq,
the United States has placed a substantial number of armed forces reservists and
members of the National Guard on active duty status. It is possible
that the number of reservists and members of the National Guard placed on active
duty status may remain at high levels for an extended time. To the
extent that a member of the military, or a member of the armed forces reserves
or National Guard who is called to active duty, is a mortgagor on a loan
underlying RMBS we may purchase, the interest rate limitation of the
Servicemembers Civil Relief Act, and any comparable state law, will
apply. An increase in the number of borrowers taking advantage of
those laws may increase servicing expenses for loans underlying RMBS we may
purchase, and may also reduce cash flow and the interest payments collected from
those borrowers. In the event of default, the laws may result in
delaying or preventing the loan servicer from exercising otherwise available
remedies for default. If these events occur, they may result in
interest shortfalls on the loans in underlying RMBS we may purchase that will be
borne by holders of those RMBS.
Risks
Related To Our Common Stock
The
market price and trading volume of our shares of common stock may be
volatile.
At
December 31, 2009, we had 670,371,587 shares of common stock issued and
outstanding. The market price of shares of our common stock may be
highly volatile and could be subject to wide fluctuations. In
addition, the trading volume in our shares of common stock may fluctuate and
cause significant price variations to occur. We cannot assure you that the
market price of our shares of common stock will not fluctuate or decline
significantly in the future. Some of the factors that could negatively affect
our share price or result in fluctuations in the price or trading volume of our
shares of common stock include those set forth under “Risk Factors” and “A
Warning About Forward-Looking Statements” and in the information incorporated
and deemed to be incorporated by reference herein, as well as:
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actual
or anticipated variations in our quarterly operating results or business
prospects;
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changes
in our earnings estimates or publication of research reports about us or
the real estate industry;
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an
inability to meet or exceed securities analysts' estimates or
expectations;
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increases
in market interest rates;
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hedging
or arbitrage trading activity in our shares of common
stock;
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changes
in market valuations of similar
companies;
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changes
in valuations of our assets;
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adverse
market reaction to any increased indebtedness we incur in the
future;
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additions
or departures of management
personnel;
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actions
by institutional shareholders;
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speculation
in the press or investment
community;
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changes
in our distribution policy;
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regulatory
changes affecting our industry generally or our
business;
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general
market and economic conditions; and
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future
sales of our shares of common stock or securities convertible into, or
exchangeable or exercisable for, our shares of common
stock.
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Common
stock eligible for future sale may have adverse effects on our share
price.
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.
We cannot
predict the effect, if any, of future sales of common stock, or the availability
of shares for future sales, on the market price of the common
stock. Sales of substantial amounts of common stock, or the
perception that such sales could occur, may adversely affect prevailing market
prices for the common stock. At December 31, 2009, we had 670,371,587
shares of common stock issued and outstanding. Annaly owned
approximately 6.7% of our outstanding shares of common stock as of December 31,
2009. Our equity incentive plan provides for grants of restricted
common stock and other equity-based awards up to an aggregate of 8% of the
issued and outstanding shares of our common stock (on a fully diluted basis) at
the time of the award, subject to a ceiling of 40,000,000 shares available for
issuance under the plan. On January 2, 2008, our executive officers
and other employees of our Manager and our independent directors were granted,
as a group, 1,301,000 shares of our restricted common stock. The
restricted common stock granted to our executive officers and other employees of
our Manager or its affiliates vests in equal installments on the first business
day of each fiscal quarter over a period of 10 years beginning on January 2,
2008, of which 269,800 shares vested and 21,955 shares were forfeited as of
December 31, 2009. The restricted common stock granted to our
executive officers and other employees of our Manager or its affiliates that
remain outstanding and are unvested will fully vest on the death of the
individual. The 1,031,200 shares of our restricted common stock
granted to our executive officers and other employees of our Manager or its
affiliates and to our independent directors that remains unvested as of December
31, 2009 represents approximately 0.15% of the issued and outstanding shares of
our common stock (on a fully diluted basis). We will not make
distributions on shares of restricted stock that have not vested.
Annaly
has agreed with us to a further lock-up period in connection with the shares
purchased by Annaly concurrently with our initial public offering that will
expire at the earlier of (i) November 15, 2010 or (ii) the termination of the
management agreement. Annaly has agreed with us to a further lock-up
period in connection with the shares purchased by Annaly immediately after our
2008 secondary offering that will expire at the earlier of (i) October 24, 2011
or (ii) the termination of the management agreement. Annaly has
agreed with us to a further lock-up period in connection with the shares
purchased by Annaly immediately after our April 15, 2009 secondary offering that
will expire at the earlier of (i) April 15, 2012 or (ii) the termination of the
management agreement. Annaly has agreed with us to a further lock-up period in
connection with the shares purchased by Annaly immediately after our May 27,
2009 secondary offering that will expire at the earlier of (i) May 27, 2012 or
(ii) the termination of the management agreement. When the lock-up periods
expire, these common shares will become eligible for sale, in some cases subject
to the requirements of Rule 144 under the Securities Act of 1933, as amended, or
the Securities Act. The market price of our common stock may
decline significantly when the restrictions on resale by certain of our
stockholders lapse. Sales of substantial amounts of common stock or
the perception that such sales could occur may adversely affect the prevailing
market price for our common stock.
There
is a risk that our stockholders may not receive distributions or that
distributions may not grow over time.
We intend
to make distributions on a quarterly basis out of assets legally available to
our stockholders in amounts such that all or substantially all of our REIT
taxable income in each year is distributed. We have not established a minimum
distribution payment level and our ability to pay distributions may be adversely
affected by a number of factors, including the risk factors described
herein. All distributions will be made at the discretion of our board
of directors and will depend on our earnings, our financial condition,
maintenance of our REIT status and other factors as our board of directors may
deem relevant from time to time. Among the factors that could adversely affect
our results of operations and impair our ability to pay distributions to our
stockholders are:
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the
profitability of the investments of net proceeds from our equity
raises;
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our
ability to make profitable
investments;
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margin
calls or other expenses that reduce our cash
flow;
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defaults
in our asset portfolio or decreases in the value of our portfolio;
and
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the
fact that anticipated operating expense levels may not prove accurate, as
actual results may vary from
estimates.
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A change
in any one of these factors could affect our ability to make distributions. We
cannot assure you that we will achieve investment results that will allow us to
make a specified level of cash distributions or year-to-year increases in cash
distributions.
Market
interest rates may have an effect on the trading value of our
shares.
One of
the factors that investors may consider in deciding whether to buy or sell our
shares is our distribution rate as a percentage of our share price relative to
market interest rates. If market interest rates increase, prospective investors
may demand a higher distribution rate or seek alternative investments paying
higher dividends or interest. As a result, interest rate fluctuations and
capital market conditions can affect the market value of our shares. For
instance, if interest rates rise, it is likely that the market price of our
shares will decrease as market rates on interest-bearing securities, such as
bonds, increase.
Investing
in our shares may involve a high degree of risk.
The
investments we make in accordance with our investment objectives may result in a
high amount of risk when compared to alternative investment options and
volatility or loss of principal. Our investments may be highly speculative and
aggressive, are subject to credit risk, interest rate, and market value risks,
among others, and therefore an investment in our shares may not be suitable for
someone with lower risk tolerance.
Broad
market fluctuations could negatively impact the market price of our common
stock.
The stock
market has experienced extreme price and volume fluctuations that have affected
the market price of many companies in industries similar or related to ours and
that have been unrelated to these companies’ operating performances. These broad
market fluctuations could reduce the market price of our common stock.
Furthermore, our operating results and prospects may be below the expectations
of public market analysts and investors or may be lower than those of companies
with comparable market capitalizations, which could lead to a material decline
in the market price of our common stock.
Future
sales of shares may have adverse consequences for investors.
We may
issue additional shares in subsequent public offerings or private placements to
make new investments or for other purposes. We are not required to offer any
such shares to existing shareholders on a pre-emptive basis. Therefore, it may
not be possible for existing shareholders to participate in such future share
issues, which may dilute the existing shareholders’ interests in us. Annaly owns
approximately 6.7% of our shares of common stock excluding unvested shares of
restricted stock granted to our executive officers and employees of our Manager
or its affiliates. Annaly will be permitted, subject to the
requirements of Rule 144 under the Securities Act, to sell such shares upon the
earlier of (i) (a) November 15, 2010 with respect to shares acquired
concurrently with our initial public offering and (b) October 24, 2011 with
respect to shares Annaly acquired immediately after our 2008 secondary offering
(c) April 15, 2012 with respect to shares Annaly acquired immediately after our
April 2009 secondary offering (d) May 27, 2012 with respect to shares Annaly
acquired immediately after our May 2009 secondary offering or (ii) the
termination of the management agreement.
Our
charter and bylaws contain provisions that may inhibit potential acquisition
bids that stockholders may consider favorable, and the market price of our
common stock may be lower as a result.
Our
charter and bylaws contain provisions that have an anti-takeover effect and
inhibit a change in our board of directors. These provisions include the
following:
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There are ownership limits and
restrictions on transferability and ownership in our charter. To
qualify as a REIT for each taxable year after 2007, not more than 50% of
the value of our outstanding stock may be owned, directly or
constructively, by five or fewer individuals during the second half of any
calendar year. In addition, our shares must be beneficially owned by 100
or more persons during at least 335 days of a taxable year of 12 months or
during a proportionate part of a shorter taxable year for each taxable
year after 2007. To assist us in satisfying these tests, our charter
generally prohibits any person from beneficially or constructively owning
more than 9.8% in value or number of shares, whichever is more
restrictive, of any class or series of our outstanding capital stock.
These restrictions may discourage a tender offer or other transactions or
a change in the composition of our board of directors or control that
might involve a premium price for our shares or otherwise be in the best
interests of our stockholders and any shares issued or transferred in
violation of such restrictions being automatically transferred to a trust
for a charitable beneficiary, thereby resulting in a forfeiture of the
additional shares.
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Our charter permits our board
of directors to issue stock with terms that may discourage a third party
from acquiring us. Our charter permits our board of directors to
amend the charter without stockholder approval to increase the total
number of authorized shares of stock or the number of shares of any class
or series and to issue common or preferred stock, having preferences,
conversion or other rights, voting powers, restrictions, limitations as to
dividends or other distributions, qualifications, or terms or conditions
of redemption as determined by our board. Thus, our board could
authorize the issuance of stock with terms and conditions that could have
the effect of discouraging a takeover or other transaction in which
holders of some or a majority of our shares might receive a premium for
their shares over the then-prevailing market price of our
shares.
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Maryland Control Share
Acquisition Act. Maryland law provides that ‘‘control shares’’ of a
corporation acquired in a ‘‘control share acquisition’’ will have no
voting rights except to the extent approved by a vote of two-thirds of the
votes eligible to be cast on the matter under the Maryland Control Share
Acquisition Act. ‘‘Control shares’’ means voting shares of stock that, if
aggregated with all other shares of stock owned by the acquirer or in
respect of which the acquirer is able to exercise or direct the exercise
of voting power (except solely by a revocable proxy), would entitle the
acquirer to exercise voting power in electing directors within one of the
following ranges of voting power: one-tenth or more but less than
one-third, one-third or more but less than a majority, or a majority or
more of all voting power. A ‘‘control share acquisition’’ means the
acquisition of control shares, subject to certain
exceptions.
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If voting
rights or control shares acquired in a control share acquisition are not
approved at a stockholders’ meeting, or if the acquiring person does not deliver
an acquiring person statement as required by the Maryland Control Share
Acquisition Act, then, subject to certain conditions and limitations, the issuer
may redeem any or all of the control shares for fair value. If voting rights of
such control shares are approved at a stockholders’ meeting and the acquirer
becomes entitled to vote a majority of the shares of stock entitled to vote, all
other stockholders may exercise appraisal rights. Our bylaws contain a provision
exempting acquisitions of our shares from the Maryland Control Share Acquisition
Act. However, our board of directors may amend our bylaws in the future to
repeal or modify this exemption, in which case any control shares of our company
acquired in a control share acquisition will be subject to the Maryland Control
Share Acquisition Act.
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Business Combinations.
Under Maryland law, ‘‘business combinations’’ between a Maryland
corporation and an interested stockholder or an affiliate of an interested
stockholder are prohibited for five years after the most recent date on
which the interested stockholder becomes an interested stockholder. These
business combinations include a merger, consolidation, share exchange or,
in circumstances specified in the statute, an asset transfer or issuance
or reclassification of equity securities. An interested stockholder is
defined as:
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any
person who beneficially owns 10% or more of the voting power of the
corporation’s shares; or
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an
affiliate or associate of the corporation who, at any time within the
two-year period before the date in question, was the beneficial owner of
10% or more of the voting power of the then outstanding voting stock of
the corporation.
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A person
is not an interested stockholder under the statute if the board of directors
approved in advance the transaction by which such person otherwise would have
become an interested stockholder. However, in approving a transaction, the board
of directors may provide that its approval is subject to compliance, at or after
the time of approval, with any terms and conditions determined by the
board. After the five-year prohibition, any business combination
between the Maryland corporation and an interested stockholder generally must be
recommended by the board of directors of the corporation and approved by the
affirmative vote of at least:
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80%
of the votes entitled to be cast by holders of outstanding shares of
voting stock of the corporation;
and
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two-thirds
of the votes entitled to be cast by holders of voting stock of the
corporation, other than shares held by the interested stockholder with
whom or with whose affiliate the business combination is to be effected or
held by an affiliate or associate of the interested
stockholder.
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These
super-majority vote requirements do not apply if the corporation’s common
stockholders receive a minimum price, as defined under Maryland law, for their
shares in the form of cash or other consideration in the same form as previously
paid by the interested stockholder for its shares. The statute
permits various exemptions from its provisions, including business combinations
that are exempted by the board of directors before the time that the interested
stockholder becomes an interested stockholder. Our board of directors
has adopted a resolution which provides that any business combination between us
and any other person is exempted from the provisions of the Maryland Control
Share Acquisition Act, provided that the business combination is first approved
by the board of directors. This resolution, however, may be altered
or repealed in whole or in part at any time. If this resolution is
repealed, or the board of directors does not otherwise approve a business
combination, this statute may discourage others from trying to acquire control
of us and increase the difficulty of consummating any offer.
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Staggered board. Our
board of directors is divided into three classes of directors. The current
terms of the directors expire in 2010, 2011 and 2012 respectively.
Directors of each class are chosen for three-year terms upon the
expiration of their current terms, and each year one class of directors is
elected by the stockholders. The staggered terms of our directors may
reduce the possibility of a tender offer or an attempt at a change in
control, even though a tender offer or change in control might be in the
best interests of our stockholders.
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Our charter and bylaws contain
other possible anti-takeover provisions. Our charter and
bylaws contains other provisions that may have the effect of delaying,
deferring or preventing a change in control of us or the removal of
existing directors and, as a result, could prevent our stockholders from
being paid a premium for their common stock over the then-prevailing
market price.
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Our
rights and the rights of our stockholders to take action against our directors
and officers are limited, which could limit stockholder's recourse in the event
of actions not in their best interests.
Our
charter limits the liability of our directors and officers to us and our
stockholders for money damages, except for liability resulting
from:
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actual
receipt of an improper benefit or profit in money, property or services;
or
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a
final judgment based upon a finding of active and deliberate dishonesty by
the director or officer that was material to the cause of action
adjudicated
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for which
Maryland law prohibits such exemption from liability.
In
addition, our charter authorizes us to obligate our company to indemnify our
present and former directors and officers for actions taken by them in those
capacities to the maximum extent permitted by Maryland law. Our bylaws require
us to indemnify each present or former director or officer, to the maximum
extent permitted by Maryland law, in the defense of any proceeding to which he
or she is made, or threatened to be made, a party because of his or her service
to us. In addition, we may be obligated to fund the defense costs incurred by
our directors and officers.
Tax
Risks
Your
investment has various federal income tax risks.
This
summary of certain tax risks is limited to the federal tax risks addressed
below. Additional risks or issues may exist that are not addressed in this Form
10-K and that could affect the federal tax treatment of us or our
stockholders. This is not intended to be used and cannot be used by
any stockholder to avoid penalties that may be imposed on stockholders under the
Internal Revenue Code, or the Code. We strongly urge you to seek advice based on
your particular circumstances from an independent tax advisor concerning the
effects of federal, state and local income tax law on an investment in common
stock and on your individual tax situation.
Complying
with REIT requirements may cause us to forego otherwise attractive
opportunities.
To
qualify as a REIT for federal income tax purposes, we must continually satisfy
various tests regarding the sources of our income, the nature and
diversification of our assets, the amounts we distribute to our stockholders and
the ownership of our stock. To meet these tests, we may be required to forego
investments we might otherwise make. We may be required to make distributions to
stockholders at disadvantageous times or when we do not have funds readily
available for distribution. Thus, compliance with the REIT requirements may
hinder our investment performance.
Complying
with REIT requirements may force us to liquidate otherwise attractive
investments.
To
qualify as a REIT, we generally must ensure that at the end of each calendar
quarter at least 75% of the value of our total assets consists of cash, cash
items, government securities and qualified REIT real estate assets, including
certain mortgage loans and mortgage-backed securities. The remainder of our
investment in securities (other than government securities and qualifying real
estate assets) generally cannot include more than 10% of the outstanding voting
securities of any one issuer or more than 10% of the total value of the
outstanding securities of any one issuer. In addition, in general, no more than
5% of the value of our assets (other than government securities, qualifying real
estate assets, and stock in one or more TRSs) can consist of the securities of
any one issuer, and no more than 25% of the value of our total securities can be
represented by securities of one or more TRSs. If we fail to comply
with these requirements at the end of any quarter, we must correct the failure
within 30 days after the end of such calendar quarter or qualify for certain
statutory relief provisions to avoid losing our REIT status and suffering
adverse tax consequences. As a result, we may be required to liquidate from our
portfolio otherwise attractive investments. These actions could have the effect
of reducing our income and amounts available for distribution to our
stockholders.
Potential
characterization of distributions or gain on sale may be treated as unrelated
business taxable income to tax-exempt investors.
If (1)
all or a portion of our assets are subject to the rules relating to taxable
mortgage pools, (2) we are a ‘‘pension-held REIT,’’ or (3) a tax-exempt
stockholder has incurred debt to purchase or hold our common stock, then a
portion of the distributions to and, in the case of a stockholder described in
clause (3), gains realized on the sale of common stock by such tax-exempt
stockholder may be subject to federal income tax as unrelated business taxable
income under the Internal Revenue Code.
Classification
of a securitization or financing arrangement we enter into as a taxable mortgage
pool could subject us or certain of our stockholders to increased
taxation.
We intend
to structure our securitization and financing arrangements as to not create a
taxable mortgage pool. However, if we have borrowings with two or more
maturities and, (1) those borrowings are secured by mortgages or mortgage-backed
securities and (2) the payments made on the borrowings are related to the
payments received on the underlying assets, then the borrowings and the pool of
mortgages or mortgage-backed securities to which such borrowings relate may be
classified as a taxable mortgage pool under the Internal Revenue Code. If any
part of our investments were to be treated as a taxable mortgage pool, then our
REIT status would not be impaired, but a portion of the taxable income we
recognize may, under regulations to be issued by the Treasury Department, be
characterized as ‘‘excess inclusion’’ income and allocated among our
stockholders to the extent of and generally in proportion to the distributions
we make to each stockholder. Any excess inclusion income would:
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not
be allowed to be offset by a stockholder’s net operating
losses;
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be
subject to a tax as unrelated business income if a stockholder were a
tax-exempt stockholder;
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be
subject to the application of federal income tax withholding at the
maximum rate (without reduction for any otherwise applicable income tax
treaty) with respect to amounts allocable to foreign stockholders;
and
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be
taxable (at the highest corporate tax rate) to us, rather than to our
stockholders, to the extent the excess inclusion income relates to stock
held by disqualified organizations (generally, tax-exempt organizations
not subject to tax on unrelated business income, including governmental
organizations).
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Failure
to qualify as a REIT would subject us to federal income tax, which would reduce
the cash available for distribution to our stockholders.
We
qualify as a REIT for federal income tax purposes commencing with our taxable
year ending on December 31, 2007. However, the federal income tax laws governing
REITs are extremely complex, and interpretations of the federal income tax laws
governing qualification as a REIT are limited. Qualifying as a REIT requires us
to meet various tests regarding the nature of our assets and our income, the
ownership of our outstanding stock, and the amount of our distributions on an
ongoing basis. While we intend to operate so that we will qualify as a REIT,
given the highly complex nature of the rules governing REITs, the ongoing
importance of factual determinations, including the tax treatment of certain
investments we may make, and the possibility of future changes in our
circumstances, no assurance can be given that we will so qualify for any
particular year. If we fail to qualify as a REIT in any calendar year and we do
not qualify for certain statutory relief provisions, we would be required to pay
federal income tax on our taxable income. We might need to borrow money or sell
assets to pay that tax. Our payment of income tax would decrease the amount of
our income available for distribution to our stockholders. Furthermore, if we
fail to maintain our qualification as a REIT and we do not qualify for certain
statutory relief provisions, we no longer would be required to distribute
substantially all of our REIT taxable income to our stockholders. Unless our
failure to qualify as a REIT were excused under federal tax laws, we would be
disqualified from taxation as a REIT for the four taxable years following the
year during which qualification was lost.
Failure
to make required distributions would subject us to tax, which would reduce the
cash available for distribution to our stockholders.
To
qualify as a REIT, we must distribute to our stockholders each calendar year at
least 90% of our REIT taxable income (excluding certain items of non-cash income
in excess of a specified threshold), determined without regard to the deduction
for dividends paid and excluding net capital gain. To the extent that we satisfy
the 90% distribution requirement, but distribute less than 100% of our taxable
income, we will be subject to federal corporate income tax on our undistributed
income. In addition, we will incur a 4% nondeductible excise tax on the amount,
if any, by which our distributions in any calendar year are less than the sum
of:
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85%
of our REIT ordinary income for that
year;
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95%
of our REIT capital gain net income for that year;
and
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any
undistributed taxable income from prior
years.
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We intend
to distribute our REIT taxable income to our stockholders in a manner intended
to satisfy the 90% distribution requirement and to avoid both corporate income
tax and the 4% nondeductible excise tax. However, there is no requirement that
TRSs distribute their after-tax net income to their parent REIT or their
stockholders. Our taxable income may substantially exceed our net income as
determined by GAAP, because, for example, realized capital losses will be
deducted in determining our GAAP net income, but may not be deductible in
computing our taxable income. In addition, we may invest in assets that generate
taxable income in excess of economic income or in advance of the corresponding
cash flow from the assets. To the extent that we generate such non-cash taxable
income in a taxable year, we may incur corporate income tax and the 4%
nondeductible excise tax on that income if we do not distribute such income to
stockholders in that year. As a result of the foregoing, we may generate less
cash flow than taxable income in a particular year. In that event, we may be
required to use cash reserves, incur debt, or liquidate non-cash assets at rates
or at times that we regard as unfavorable to satisfy the distribution
requirement and to avoid corporate income tax and the 4% nondeductible excise
tax in that year. Moreover, our ability to distribute cash may be
limited by financing facilities we may enter into.
Ownership
limitations may restrict change of control or business combination opportunities
in which our stockholders might receive a premium for their shares.
In order
for us to qualify as a REIT for each taxable year after 2007, no more than 50%
in value of our outstanding capital stock may be owned, directly or indirectly,
by five or fewer individuals during the last half of any calendar year.
‘‘Individuals’’ for this purpose include natural persons, private foundations,
some employee benefit plans and trusts, and some charitable trusts. To preserve
our REIT qualification, our charter generally prohibits any person from directly
or indirectly owning more than 9.8% in value or in number of shares, whichever
is more restrictive, of any class or series of the outstanding shares of our
capital stock. This ownership limitation could have the effect of discouraging a
takeover or other transaction in which holders of our common stock might receive
a premium for their shares over the then prevailing market price or which
holders might believe to be otherwise in their best interests.
Our
ownership of and relationship with any TRS which we may form or acquire will be
limited, and a failure to comply with the limits would jeopardize our REIT
status and may result in the application of a 100% excise tax.
A REIT
may own up to 100% of the stock of one or more TRSs. A TRS may earn income that
would not be qualifying income if earned directly by the parent REIT. Both the
subsidiary and the REIT must jointly elect to treat the subsidiary as a TRS.
Overall, no more than 25% of the value of a REIT’s assets may consist of stock
or securities of one or more TRSs. A TRS will pay federal, state and local
income tax at regular corporate rates on any income that it earns. In addition,
the TRS rules impose a 100% excise tax on certain transactions between a TRS and
its parent REIT that are not conducted on an arm’s-length basis. Any TRS that we
may form would pay federal, state and local income tax on its taxable income,
and its after-tax net income would be available for distribution to us but would
not be required to be distributed to us. We anticipate that the aggregate value
of the TRS stock and securities owned by us will be less than 25% of the value
of our total assets (including the TRS stock and securities). Furthermore, we
will monitor the value of our investments in our TRSs to ensure compliance with
the rule that no more than 25% of the value of our assets may consist of TRS
stock and securities (which is applied at the end of each calendar quarter). In
addition, we will scrutinize all of our transactions with taxable REIT
subsidiaries to ensure that they are entered into on arm’s-length terms to avoid
incurring the 100% excise tax described above. There can be no assurance,
however, that we will be able to comply with the 25% limitation discussed above
or to avoid application of the 100% excise tax discussed above.
We
could fail to qualify as a REIT or we could become subject to a penalty tax if
income we recognize from certain investments that are treated or could be
treated as equity interests in a foreign corporation exceeds 5% of our gross
income in a taxable year.
We may
invest in securities, such as subordinated interests in certain CDO offerings,
that are treated or could be treated for federal (and applicable state and
local) corporate income tax purposes as equity interests in foreign
corporations. Categories of income that qualify for the 95% gross income test
include dividends, interest and certain other enumerated classes of passive
income. Under certain circumstances, the federal income tax rules concerning
controlled foreign corporations and passive foreign investment companies require
that the owner of an equity interest in a foreign corporation include amounts in
income without regard to the owner’s receipt of any distributions from the
foreign corporation. Amounts required to be included in income under those rules
are technically neither actual dividends nor any of the other enumerated
categories of passive income specified in the 95% gross income test.
Furthermore, there is no clear precedent with respect to the qualification of
such income under the 95% gross income test. Due to this uncertainty, we intend
to limit our direct investment in securities that are or could be treated as
equity interests in a foreign corporation such that the sum of the amounts we
are required to include in income with respect to such securities and other
amounts of non-qualifying income do not exceed 5% of our gross income. We cannot
assure you that we will be successful in this regard. To avoid any risk of
failing the 95% gross income test, we may be required to invest only indirectly,
through a domestic TRS, in any securities that are or could be considered to be
equity interests in a foreign corporation. This, of course, will result in any
income recognized from any such investment to be subject to federal income tax
in the hands of the TRS, which may, in turn, reduce our yield on the
investment.
Liquidation
of our assets may jeopardize our REIT qualification.
To
qualify as a REIT, we must comply with requirements regarding our assets and our
sources of income. If we are compelled to liquidate our investments to repay
obligations to our lenders, we may be unable to comply with these requirements,
ultimately jeopardizing our qualification as a REIT, or we may be subject to a
100% tax on any resultant gain if we sell assets in transactions that are
considered to be prohibited transactions.
The
tax on prohibited transactions will limit our ability to engage in transactions,
including certain methods of securitizing mortgage loans that would be treated
as sales for federal income tax purposes.
A REIT’s
net income from prohibited transactions is subject to a 100% tax. In general,
prohibited transactions are sales or other dispositions of property, other than
foreclosure property, but including mortgage loans, held primarily for sale to
customers in the ordinary course of business. We might be subject to this tax if
we sold or securitized our assets in a manner that was treated as a sale for
federal income tax purposes. Therefore, to avoid the prohibited transactions
tax, we may choose not to engage in certain sales of assets at the REIT level
and may securitize assets only in transactions that are treated as financing
transactions and not as sales for tax purposes even though such transactions may
not be the optimal execution on a pre-tax basis. We could avoid any
prohibited transactions tax concerns by engaging in securitization transactions
through a TRS, subject to certain limitations described above. To the extent
that we engage in such activities through domestic TRSs, the income associated
with such activities will be subject to federal (and applicable state and local)
corporate income tax.
Characterization
of the repurchase agreements we enter into to finance our investments as sales
for tax purposes rather than as secured lending transactions would adversely
affect our ability to qualify as a REIT.
We have
entered into and will enter into repurchase agreements with a variety of
counterparties to achieve our desired amount of leverage for the assets in which
we invest. When we enter into a repurchase agreement, we generally sell assets
to our counterparty to the agreement and receive cash from the counterparty. The
counterparty is obligated to resell the assets back to us at the end of the term
of the transaction, which is typically 30 to 90 days. We believe that for
federal income tax purposes we will be treated as the owner of the assets that
are the subject of repurchase agreements and that the repurchase agreements will
be treated as secured lending transactions notwithstanding that such agreement
may transfer record ownership of the assets to the counterparty during the term
of the agreement. It is possible, however, that the IRS could successfully
assert that we did not own these assets during the term of the repurchase
agreements, in which case we could fail to qualify as a REIT.
Complying
with REIT requirements may limit our ability to hedge effectively.
The REIT
provisions of the Internal Revenue Code substantially limit our ability to hedge
mortgage-backed securities and related borrowings. Under these provisions, our
annual gross income from non-qualifying hedges, together with any other income
not generated from qualifying real estate assets, cannot exceed 25% of our
annual gross income. In addition, our aggregate gross income from non-qualifying
hedges, fees, and certain other non-qualifying sources cannot exceed 5% of our
annual gross income. As a result, we might have to limit our use of advantageous
hedging techniques or implement those hedges through a TRS, which we may form in
the future. This could increase the cost of our hedging activities or expose us
to greater risks associated with changes in interest rates than we would
otherwise want to bear.
We
may be subject to adverse legislative or regulatory tax changes that could
reduce the market price of our common stock.
At any
time, the federal income tax laws or regulations governing REITs or the
administrative interpretations of those laws or regulations may be amended. We
cannot predict when or if any new federal income tax law, regulation or
administrative interpretation, or any amendment to any existing federal income
tax law, regulation or administrative interpretation, will be adopted,
promulgated or become effective and any such law, regulation or interpretation
may take effect retroactively. We and our stockholders could be adversely
affected by any such change in, or any new, federal income tax law, regulation
or administrative interpretation.
Dividends
payable by REITs do not qualify for the reduced tax rates.
Legislation
enacted in 2003 generally reduces the maximum tax rate for dividends payable to
domestic stockholders that are individuals, trusts and estates from 38.6% to 15%
(through 2010). Dividends payable by REITs, however, are generally not eligible
for the reduced rates. Although this legislation does not adversely affect the
taxation of REITs or dividends paid by REITs, the more favorable rates
applicable to regular corporate dividends could cause investors who are
individuals, trusts and estates to perceive investments in REITs to be
relatively less attractive than investments in stock of non-REIT corporations
that pay dividends, which could adversely affect the value of the stock of
REITs, including our common stock.
None.
We do not
own any property. Our executive and administrative office is located
at 1211 Avenue of the Americas, Suite 2902, New York, New York 10036, telephone
(646) 454-3759. We share this office space with Annaly and
FIDAC.
We are
not party to any material litigation or legal proceedings, or to the best of our
knowledge, any threatened litigation or legal proceedings, which, in our
opinion, individually or in the aggregate, would have a material adverse effect
on our results of operations or financial condition.
None.