10-K 1 a4360904.txt ANNALY MORTGAGE MANAGEMENT, INC. 10-K SECURITIES AND EXCHANGE COMMISSION WASHINGTON, D.C. 20549 FORM 10-K FOR ANNUAL AND TRANSITION REPORTS PURSUANT TO SECTIONS 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 (MARK ONE) [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED: DECEMBER 31, 2002 OR [ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM TO COMMISSION FILE NUMBER: 1-13447 ANNALY MORTGAGE MANAGEMENT, INC. (Exact Name of Registrant as Specified in its Charter) MARYLAND 22-3479661 (State or other jurisdiction of incorporation of organization) (I.R.S. Employer Identification Number) 1211 Avenue of the Americas, Suite 2902 New York, New York 10036 (Address of Principal Executive Offices) (Zip Code) (212) 696-0100 (Registrant's telephone number, including area code) Securities registered pursuant to Section 12(b) of the Act: Title of Each Class Name of Each Exchange on Which Registered Common Stock, par value $.01 per share New York Stock Exchange Securities registered pursuant to Section 12(g) of the Act: None. Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: Yes X No -------------------------------------------------------------------------------- Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes X No --- --- At March 21, 2003 the aggregate market value of the voting stock held by non-affiliates of the Registrant was $1,471,163,839 The number of shares of the Registrant's Common Stock outstanding on March 21, 2003 was 84,646,859 DOCUMENTS INCORPORATED BY REFERENCE: Portions of the Registrant's definitive Proxy Statement issued in connection with the 2003 Annual Meeting of Stockholders of the Registrant to be held on May 15, 2003 are incorporated by reference into Part III. ANNALY MORTGAGE MANAGEMENT, INC. -------------------------------------------------------------------------------- 2002 FORM 10-K ANNUAL REPORT TABLE OF CONTENTS PART I
PAGE ITEM 1. BUSINESS 1 ITEM 2. PROPERTIES 26 ITEM 3. LEGAL PROCEEDINGS 26 ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS 26 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS 27 ITEM 6. SELECTED FINANCIAL DATA 29 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS 30 ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK 44 ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA 46 ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE 46 PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT 46 ITEM 11. EXECUTIVE COMPENSATION 46 ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS 46 ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS 46 ITEM 14. CONTROLS AND PROCEDURES PART IV ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K 47 FINANCIAL STATEMENTS F-1 SIGNATURES II-1 CERTIFICATIONS II-1 EXHIBIT INDEX II-4
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS Certain statements contained in this annual report, and certain statements contained in our future filings with the Securities and Exchange Commission (the "SEC" or the "Commission"), in our press releases or in our other public or shareholder communications may not be, based on historical facts and are "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements which are based on various assumptions, (some of which are beyond our control) may be identified by reference to a future period or periods, or by the use of forward-looking terminology, such as "may," "will," "believe," "expect," "anticipate," "continue," or similar terms or variations on those terms, or the negative of those terms. Actual results could differ materially from those set forth in forward-looking statements due to a variety of factors, including, but not limited to, changes in interest rates, changes in yield curve, changes in prepayment rates, the availability of mortgage backed securities for purchase, the availability of financing and, if available, the terms of any financing. For a discussion of the risks and uncertainties that could cause actual results to differ from those contained in the forward-looking statements, see "Risk Factors." We do not undertake, and specifically disclaim any obligation, to publicly release the result of any revisions that may be made to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements. PART I ITEM 1. BUSINESS THE COMPANY Background Annaly Mortgage Management, Inc owns and manages a portfolio of mortgage-backed securities, including mortgage pass-through certificates, collateralized mortgage obligations (" CMOs") and other securities representing interests in or obligations backed by pools of mortgage loans. Our principal business objective is to generate net income for distribution to our stockholders from the spread between the interest income on our mortgage-backed securities and the costs of borrowing to finance our acquisition of mortgage-backed securities. We have elected to be taxed as a real estate investment trust ("REIT") under the Internal Revenue Code. Therefore, substantially all of our assets consist of qualified REIT real estate assets (of the type described in Section 856(c)(5)(B) of the Internal Revenue Code). We commenced operations on February 18, 1997. We are self-advised and self-managed. We have financed our purchases of mortgage-backed securities with the net proceeds of equity offerings and borrowings under repurchase agreements whose interest rates adjust based on changes in short-term market interest rates. As used herein, "Annaly," "we," "our" and similar terms refer to Annaly Mortgage Management, Inc., unless the context indicates otherwise. Assets Under our capital investment policy, at least 75% of our total assets must be comprised of high-quality mortgage-backed securities and short-term investments. High quality securities means securities that (1) are rated within one of the two highest rating categories by at least one of the nationally recognized rating agencies, (2) are unrated but are guaranteed by the United States government or an agency of the United States government, or (3) are unrated but we determine them to be of comparable quality to rated high-quality mortgage-backed securities. The remainder of our assets, comprising not more than 25% of our total assets, may consist of other qualified REIT real estate assets which are unrated or rated less than high quality, but which are at least "investment grade" (rated "BBB" or better by Standard & Poor's Corporation (S&P) or the equivalent by another nationally recognized rating agency) or, if not rated, we determine them to be of comparable credit quality to an investment which is rated "BBB" or better. 1 We may acquire mortgage-backed securities backed by single-family residential mortgage loans as well as securities backed by loans on multi-family, commercial or other real estate-related properties. To date, all of the mortgage-backed securities that we have acquired have been backed by single-family residential mortgage loans. To date, all of the securities that we have acquired have been agency mortgage-backed securities which, although not rated, carry an implied "AAA" rating. Agency mortgage-backed securities are mortgage-backed securities for which a government agency or federally chartered corporation, such as the Federal Home Loan Mortgage Corporation ("FHLMC"), the Federal National Mortgage Association ("FNMA"), or the Government National Mortgage Association ("GNMA"), guarantees payments of principal or interest on the securities. Agency mortgage-backed securities consist of agency pass-through certificates and CMOs issued or guaranteed by an agency. Pass-through certificates provide for a pass-through of the monthly interest and principal payments made by the borrowers on the underlying mortgage loans. CMOs divide a pool of mortgage loans into multiple tranches with different principal and interest payment characteristics. At December 31, 2002, approximately 30% of our mortgage-backed securities were adjustable-rate pass-though certificates, approximately 37% of our mortgage-backed securities were fixed-rate pass-through certificates or CMOs, and approximately 33% of our mortgage-backed securities were CMO floaters. Our adjustable-rate pass-through certificates are backed by adjustable-rate mortgage loans and have coupon rates which adjust over time, subject to interest rate caps and lag periods, in conjunction with changes in short-term interest rates. CMO floaters are tranches of CMOs mortgage-backed securities where the interest rate adjusts in conjunction with changes in short-term interest rates. Our fixed-rate pass-through certificates are backed by fixed-rate mortgage rates which do not adjust over time. CMO floaters may be backed by fixed-rate mortgage loans or, less often, by adjustable-rate mortgage loans. In this Form 10-K, except where the context indicates otherwise, we use the term "adjustable-rate securities" or "adjustable-rate mortgage-backed securities" to refer to adjustable-rate pass-through certificates and CMO floaters. At December 31, 2002, the weighted average yield on our portfolio of earning assets was 3.25%, and the weighted average term to next rate adjustment on adjustable rate securities was 11 months. We intend to continue to invest in adjustable-rate pass-through certificates, fixed-rate mortgage-backed securities and CMO floaters. Although we have not done so to date, we may also invest on a limited basis in mortgage derivative securities representing the right to receive interest only or a disproportionately large amount of interest. We have not and will not invest in real estate mortgage investment conduit ("REMIC") residuals, other CMO residuals or any mortgage-backed securities, such as inverse floaters, which have imbedded leverage as part of their structural characteristics. Borrowings We attempt to structure our borrowings to have interest rate adjustment indices and interest rate adjustment periods that, on an aggregate basis, correspond generally to the interest rate adjustment indices and periods of our adjustable-rate mortgage-backed securities. However, periodic rate adjustments on our borrowings are generally more frequent than rate adjustments on our mortgage-backed securities. At December 31, 2002, the weighted average cost of funds for all of our borrowings was 1.72%, the weighted average original term to maturity was 166 days, and the weighted average term to next rate adjustment of these borrowings was 124 days. We generally expect to maintain a ratio of debt-to-equity of between 8:1 and 12:1, although the ratio may vary from time to time depending upon market conditions and other factors that our management deems relevant. For purposes of calculating this ratio, our equity is equal to the value of our investment portfolio on a mark-to-market basis, less the book value of our obligations under repurchase agreements and other collateralized borrowings. At December 31, 2002, our ratio of debt-to-equity was 9.4:1. Hedging To the extent consistent with our election to qualify as a REIT, we may enter into hedging transactions to attempt to protect our mortgage-backed securities and related borrowings against the effects of major interest rate changes. This hedging would be used to mitigate declines in the market value of our mortgage-backed securities during periods of increasing or decreasing interest rates and to limit or cap the interest rates on our borrowings. 2 These transactions would be entered into solely for the purpose of hedging interest rate or prepayment risk and not for speculative purposes. To date, we have not entered into any hedging transactions. Compliance With REIT and Investment Company Requirements We constantly monitor our mortgage-backed securities and the income from these securities and, to the extent we enter into hedging transactions in the future, will monitor income from our hedging transactions as well, so as to ensure at all times that we maintain our qualification as a REIT and our exempt status under the Investment Company Act. Management Our executive officers are: - Michael A.J. Farrell, Chairman of the Board, Chief Executive, Officer and President; - Wellington J. Denahan, Vice Chairman of the Board and Chief Investment Officer; - Kathryn F. Fagan, Chief Financial Officer and Treasurer; - Jennifer A. Stephens, Secretary and Investment Officer; and - James P. Fortescue, Senior Vice President and Repurchase Agreement Manager Mr. Farrell and Ms. Denahan have an average of 22 years experience in the investment banking and investment management industries where, in various capacities, they have each managed portfolios of mortgage-backed securities, arranged collateralized borrowings and utilized hedging techniques to mitigate interest rate and other risk within fixed-income portfolios. Mr. Farrell was appointed our President effective as of January 1, 2002. Ms. Fagan is a certified public accountant and, prior to becoming our Chief Financial Officer and Treasurer, served as Chief Financial Officer and Controller of a publicly owned savings and loan association. Ms. Stephens and Mr. Fortescue have worked for us since December 1996. Since 1994, Mr. Farrell and Ms. Denahan have managed Fixed Income Discount Advisory Company ("FIDAC"), a registered investment advisor which, at December 31, 2002, managed, assisted in managing or supervised approximately $8 billion in gross assets for a wide array of clients, all of which, assets on that date were managed on a discretionary basis. Mr. Farrell is the sole stockholder of FIDAC. Management's duties on behalf of FIDAC's clients may create conflicts of interest if members of management are presented with corporate opportunities that may benefit both us and clients for which FIDAC acts as investment advisor. In the event that an investment opportunity arises, the investment will be allocated to another entity or us by determining the entity or account for which the investment is most suitable. In making this determination, our management will consider the investment strategy and guidelines of each entity or account with respect to acquisition of assets, leverage, liquidity and other factors which management determines appropriate. Distributions To maintain our qualification as a REIT, we must distribute substantially all of our taxable income to our stockholders for each year. We have done this in the past and intend to continue to do so in the future. We also have declared and paid regular quarterly dividends in the past and intend to do so in the future. We have adopted a dividend reinvestment plan to enable holders of common stock to reinvest dividends automatically in additional shares of common stock. 3 BUSINESS STRATEGY General Our principal business objective is to generate income for distribution to our stockholders, primarily from the net cash flows on our mortgage-backed securities. Our net cash flows result primarily from the difference between the interest income on our mortgage-backed security investments and our borrowing costs on our mortgage-backed securities. To achieve our business objective and generate dividend yields, our strategy is: - to purchase mortgage-backed securities, the majority of which we expect to have adjustable interest rates based on changes in short-term market interest rates; - to acquire mortgage-backed securities that we believe: - we have the necessary expertise to evaluate and manage; - we can readily finance; - are consistent with our balance sheet guidelines and risk management objectives; and - provide attractive investment returns in a range of scenarios; - to finance purchases of mortgage-backed securities with the proceeds of equity offerings and, to the extent permitted by our capital investment policy, to utilize leverage to increase potential returns to stockholders through borrowings; - to attempt to structure our borrowings to have interest rate adjustment indices and interest rate adjustment periods that, on an aggregate basis, generally correspond to the interest rate adjustment indices and interest rate adjustment periods of our adjustable-rate mortgage-backed securities; - to seek to minimize prepayment risk by structuring a diversified portfolio with a variety of prepayment characteristics and through other means; and - to issue new equity or debt and increase the size of our balance sheet when opportunities in the market for mortgage-backed securities are likely to allow growth in earnings per share. We believe we are able to obtain cost efficiencies through our facilities-sharing arrangement with FIDAC and by virtue of our management's experience in managing portfolios of mortgage-backed securities and arranging collateralized borrowings. We will strive to become even more cost-efficient over time by: - seeking to raise additional capital from time to time in order to increase our ability to invest in mortgage-backed securities; - striving to lower our effective borrowing costs over time by seeking direct funding with collateralized lenders, rather than using financial intermediaries, and investigating the possibility of using commercial paper and medium term note programs; - improving the efficiency of our balance sheet structure by investigating the issuance of uncollateralized subordinated debt, preferred stock and other forms of capital; and - utilizing information technology in our business, including improving our ability to monitor the performance of our mortgage-backed securities and to lower our operating costs. 4 Mortgage-Backed Securities General To date, all of the mortgage-backed securities that we have acquired have been agency mortgage-backed securities which, although not rated, carry an implied "AAA" rating. Agency mortgage-backed securities are mortgage-backed securities where a government agency or federally chartered corporation, such as FHLMC, FNMA or GNMA, guarantees payments of principal or interest on the securities. Agency mortgage-backed securities consist of agency pass-through certificates and CMOs issued or guaranteed by an agency. Even though to date we have only acquired securities with an implied "AAA" rating, under our capital investment policy, we have the ability to acquire securities of lower quality. Under our policy, at least 75% of our total assets must be high quality mortgage-backed securities and short-term investments. High quality securities are securities (1) that are rated within one of the two highest rating categories by at least one of the nationally recognized rating agencies, (2) that are unrated but are guaranteed by the United States government or an agency of the United States government, or (3) that are unrated or whose ratings have not been updated but that our management determines are of comparable quality to rated high quality mortgage-backed securities. Under our capital investment policy, the remainder of our assets, comprising not more than 25% of total assets, may consist of mortgage-backed securities and other qualified REIT real estate assets which are unrated or rated less than high quality, but which are at least "investment grade" (rated "BBB" or better by S&P or the equivalent by another nationally recognized rating organization) or, if not rated, we determine them to be of comparable credit quality to an investment which is rated "BBB" or better. We intend to structure our portfolio to maintain a minimum weighted average rating (including our deemed comparable ratings for unrated mortgage-backed securities) of our mortgage-backed securities of at least single "A" under the S&P rating system and at the comparable level under the other rating systems. Our allocation of investments among the permitted investment types may vary from time-to-time based on the evaluation by our board of directors of economic and market trends and our perception of the relative values available from these types of investments, except that in no event will our investments that are not high quality exceed 25% of our total assets. We intend to acquire only those mortgage-backed securities that we believe we have the necessary expertise to evaluate and manage, that are consistent with our balance sheet guidelines and risk management objectives and that we believe we can readily finance. Since we generally hold the mortgage-backed securities we acquire until maturity, we generally do not seek to acquire assets whose investment returns are attractive in only a limited range of scenarios. We believe that future interest rates and mortgage prepayment rates are very difficult to predict. Therefore, we seek to acquire mortgage-backed securities which we believe will provide acceptable returns over a broad range of interest rate and prepayment scenarios. At December 31, 2002, our mortgage-backed securities consist of pass-through certificates and collateralized mortgage obligations issued or guaranteed by FHLMC, FNMA or GNMA. We have not, and will not, invest in REMIC residuals, other CMO residuals or mortgage-backed securities, such as inverse floaters, which have imbedded leverage as part of their structural characteristics. Description of Mortgage-Backed Securities The mortgage-backed securities that we acquire provide funds for mortgage loans made primarily to residential homeowners. Our securities generally represent interests in pools of mortgage loans made by savings and loan institutions, mortgage bankers, commercial banks and other mortgage lenders. These pools of mortgage loans are assembled for sale to investors (like us) by various government, government-related and private organizations. Mortgage-backed securities differ from other forms of traditional debt securities, which normally provide for periodic payments of interest in fixed amounts with principal payments at maturity or on specified call dates. Instead, mortgage-backed securities provide for a monthly payment, which consists of both interest and principal. In 5 effect, these payments are a "pass-through" of the monthly interest and principal payments made by the individual borrower on the mortgage loans, net of any fees paid to the issuer or guarantor of the securities. Additional payments result from prepayments of principal upon the sale, refinancing or foreclosure of the underlying residential property, net of fees or costs which may be incurred. Some mortgage-backed securities, such as securities issued by GNMA, are described as "modified pass-through." These securities entitle the holder to receive all interest and principal payments owed on the mortgage pool, net of certain fees, regardless of whether the mortgagors actually make mortgage payments when due. The investment characteristics of pass-through mortgage-backed securities differ from those of traditional fixed-income securities. The major differences include the payment of interest and principal on the mortgage-backed securities on a more frequent schedule, as described above, and the possibility that principal may be prepaid at any time due to prepayments on the underlying mortgage loans or other assets. These differences can result in significantly greater price and yield volatility than is the case with traditional fixed-income securities. Various factors affect the rate at which mortgage prepayments occur, including changes in interest rates, general economic conditions, the age of the mortgage loan, the location of the property and other social and demographic conditions. Generally prepayments on mortgage-backed securities increase during periods of falling mortgage interest rates and decrease during periods of rising mortgage interest rates. We may reinvest prepayments at a yield that is higher or lower than the yield on the prepaid investment, thus affecting the weighted average yield of our investments. To the extent mortgage-backed securities are purchased at a premium, faster than expected prepayments result in a faster than expected amortization of the premium paid. Conversely, if these securities were purchased at a discount, faster than expected prepayments accelerate our recognition of income. CMOs may allow for shifting of prepayment risk from slower-paying tranches to faster-paying tranches. This is in contrast to mortgage pass-through certificates where all investors share equally in all payments, including all prepayments, on the underlying mortgages. FHLMC Certificates FHLMC is a privately-owned government-sponsored enterprise created pursuant to an Act of Congress on July 24, 1970. The principal activity of FHLMC currently consists of the purchase of mortgage loans or participation interests in mortgage loans and the resale of the loans and participations in the form of guaranteed mortgage-backed securities. FHLMC guarantees to each holder of FHLMC certificates the timely payment of interest at the applicable pass-through rate and ultimate collection of all principal on the holder's pro rata share of the unpaid principal balance of the related mortgage loans, but does not guarantee the timely payment of scheduled principal of the underlying mortgage loans. The obligations of FHLMC under its guarantees are solely those of FHLMC and are not backed by the full faith and credit of the United States. If FHLMC were unable to satisfy these obligations, distributions to holders of FHLMC certificates would consist solely of payments and other recoveries on the underlying mortgage loans and, accordingly, defaults and delinquencies on the underlying mortgage loans would adversely affect monthly distributions to holders of FHLMC certificates. FHLMC certificates may be backed by pools of single-family mortgage loans or multi-family mortgage loans. These underlying mortgage loans may have original terms to maturity of up to 40 years. FHLMC certificates may be issued under cash programs (composed of mortgage loans purchased from a number of sellers) or guarantor programs (composed of mortgage loans acquired from one seller in exchange for certificates representing interests in the mortgage loans purchased). FHLMC certificates may pay interest at a fixed rate or an adjustable rate. The interest rate paid on adjustable-rate FHLMC certificates ("FHLMC ARMs") adjusts periodically within 60 days prior to the month in which the interest rates on the underlying mortgage loans adjust. The interest rates paid on certificates issued under FHLMC's standard ARM programs adjust in relation to the Treasury index. Other specified indices used in FHLMC ARM programs include the 11th District Cost of Funds Index published by the Federal Home Loan Bank of San Francisco, LIBOR and other indices. Interest rates paid on fully-indexed FHLMC ARM certificates equal 6 the applicable index rate plus a specified number of basis points. The majority of series of FHLMC ARM certificates issued to date have evidenced pools of mortgage loans with monthly, semi-annual or annual interest adjustments. Adjustments in the interest rates paid are generally limited to an annual increase or decrease of either 100 or 200 basis points and to a lifetime cap of 500 or 600 basis points over the initial interest rate. Certain FHLMC programs include mortgage loans which allow the borrower to convert the adjustable mortgage interest rate to a fixed rate. Adjustable-rate mortgages which are converted into fixed-rate mortgage loans are repurchased by FHLMC or by the seller of the loan to FHLMC at the unpaid principal balance of the loan plus accrued interest to the due date of the last adjustable rate interest payment. FNMA Certificates FNMA is a privately-owned, federally-chartered corporation organized and existing under the Federal National Mortgage Association Charter Act. FNMA provides funds to the mortgage market primarily by purchasing home mortgage loans from local lenders, thereby replenishing their funds for additional lending. FNMA guarantees to the registered holder of a FNMA certificate that it will distribute amounts representing scheduled principal and interest on the mortgage loans in the pool underlying the FNMA certificate, whether or not received, and the full principal amount of any such mortgage loan foreclosed or otherwise finally liquidated, whether or not the principal amount is actually received. The obligations of FNMA under its guarantees are solely those of FNMA and are not backed by the full faith and credit of the United States. If FNMA were unable to satisfy its obligations, distributions to holders of FNMA certificates would consist solely of payments and other recoveries on the underlying mortgage loans and, accordingly, defaults and delinquencies on the underlying mortgage loans would adversely affect monthly distributions to holders of FNMA. FNMA certificates may be backed by pools of single-family or multi-family mortgage loans. The original term to maturity of any such mortgage loan generally does not exceed 40 years. FNMA certificates may pay interest at a fixed rate or an adjustable rate. Each series of FNMA ARM certificates bears an initial interest rate and margin tied to an index based on all loans in the related pool, less a fixed percentage representing servicing compensation and FNMA's guarantee fee. The specified index used in different series has included the Treasury Index, the 11th District Cost of Funds Index published by the Federal Home Loan Bank of San Francisco, LIBOR and other indices. Interest rates paid on fully-indexed FNMA ARM certificates equal the applicable index rate plus a specified number of basis points. The majority of series of FNMA ARM certificates issued to date have evidenced pools of mortgage loans with monthly, semi-annual or annual interest rate adjustments. Adjustments in the interest rates paid are generally limited to an annual increase or decrease of either 100 or 200 basis points and to a lifetime cap of 500 or 600 basis points over the initial interest rate. Certain FNMA programs include mortgage loans which allow the borrower to convert the adjustable mortgage interest rate of the ARM to a fixed rate. Adjustable-rate mortgages which are converted into fixed-rate mortgage loans are repurchased by FNMA or by the seller of the loans to FNMA at the unpaid principal of the loan plus accrued interest to the due date of the last adjustable rate interest payment. Adjustments to the interest rates on FNMA ARM certificates are typically subject to lifetime caps and periodic rate or payment caps. GNMA Certificates GNMA is a wholly owned corporate instrumentality of the United States within the Department of Housing and Urban Development ("HUD"). The National Housing Act of 1934 authorizes GNMA to guarantee the timely payment of the principal of and interest on certificates which represent an interest in a pool of mortgages insured by the Federal Housing Administration ("FHA") or partially guaranteed by the Department of Veterans Affairs and other loans eligible for inclusion in mortgage pools underlying GNMA certificates. Section 306(g) of the Housing Act provides that the full faith and credit of the United States is pledged to the payment of all amounts which may be required to be paid under any guaranty by GNMA. At present, most GNMA certificates are backed by single-family mortgage loans. The interest rate paid on GNMA certificates may be a fixed rate or an adjustable rate. The interest rate on GNMA certificates issued under GNMA's standard ARM program adjusts annually in relation to the Treasury index. Adjustments in the interest rate are generally limited to an annual increase or decrease of 100 basis points and to a lifetime cap of 500 basis points over the initial coupon rate. 7 Single-Family and Multi-Family Privately-Issued Certificates Single-family and multi-family privately-issued certificates are pass-through certificates that are not issued by one of the agencies and that are backed by a pool of conventional single-family or multi-family mortgage loans. These certificates are issued by originators of, investors in, and other owners of mortgage loans, including savings and loan associations, savings banks, commercial banks, mortgage banks, investment banks and special purpose "conduit" subsidiaries of these institutions. While agency pass-through certificates are backed by the express obligation or guarantee of one of the agencies, as described above, privately-issued certificates are generally covered by one or more forms of private (i.e., non-governmental) credit enhancements. These credit enhancements provide an extra layer of loss coverage in the event that losses are incurred upon foreclosure sales or other liquidations of underlying mortgaged properties in amounts that exceed the equity holder's equity interest in the property. Forms of credit enhancements include limited issuer guarantees, reserve funds, private mortgage guaranty pool insurance, over-collateralization and subordination. Subordination is a form of credit enhancement frequently used and involves the issuance of classes of senior and subordinated mortgage-backed securities. These classes are structured into a hierarchy to allocate losses on the underlying mortgage loans and also for defining priority of rights to payment of principal and interest. Typically, one or more classes of senior securities are created which are rated in one of the two highest rating levels by one or more nationally recognized rating agencies and which are supported by one or more classes of mezzanine securities and subordinated securities that bear losses on the underlying loans prior to the classes of senior securities. Mezzanine securities, as used in this Form 10-K, refers to classes that are rated below the two highest levels, but no lower than a single "B" rating under the S&P rating system (or comparable level under other rating systems) and are supported by one or more classes of subordinated securities which bear realized losses prior to the classes of mezzanine securities. Subordinated securities, as used in this Form 10-K, refers to any class that bears the "first loss" from losses from underlying mortgage loans or that is rated below a single "B" level (or, if unrated, we deem it to be below that level). In some cases, only classes of senior securities and subordinated securities are issued. By adjusting the priority of interest and principal payments on each class of a given series of senior-subordinated mortgage-backed securities, issuers are able to create classes of mortgage-backed securities with varying degrees of credit exposure, prepayment exposure and potential total return, tailored to meet the needs of sophisticated institutional investors. Collateralized Mortgage Obligations and Multi-Class Pass-Through Securities We may also invest CMOs and multi-class pass-through securities. CMOs are debt obligations issued by special purpose entities that are secured by mortgage loans or mortgage-backed certificates, including, in many cases, certificates issued by government and government-related guarantors, including, GNMA, FNMA and FHLMC, together with certain funds and other collateral. Multi-class pass-through securities are equity interests in a trust composed of mortgage loans or other mortgage-backed securities. Payments of principal and interest on underlying collateral provide the funds to pay debt service on the CMO or make scheduled distributions on the multi-class pass-through securities. CMOs and multi-class pass-through securities may be issued by agencies or instrumentalities of the U.S. Government or by private organizations. The discussion of CMOs in the following paragraphs is similarly applicable to multi-class pass-through securities. 8 In a CMO, a series of bonds or certificates is issued in multiple classes. Each class of CMOs, often referred to as a "tranche," is issued at a specific coupon rate (which, as discussed below, may be an adjustable rate subject to a cap) and has a stated maturity or final distribution date. Principal prepayments on collateral underlying a CMO may cause it to be retired substantially earlier than the stated maturity or final distribution date. Interest is paid or accrues on all classes of a CMO on a monthly, quarterly or semi-annual basis. The principal and interest on underlying mortgages may be allocated among the several classes of a series of a CMO in many ways. In a common structure, payments of principal, including any principal prepayments, on the underlying mortgages are applied to the classes of the series of a CMO in the order of their respective stated maturities or final distribution dates, so that no payment of principal will be made on any class of a CMO until all other classes having an earlier stated maturity or final distribution date have been paid in full. Other types of CMO issues include classes such as parallel pay CMOs, some of which, such as planned amortization class CMOs ("PAC bonds"), provide protection against prepayment uncertainty. Parallel pay CMOs are structured to provide payments of principal on certain payment dates to more than one class. These simultaneous payments are taken into account in calculating the stated maturity date or final distribution date of each class which, as with other CMO structures, must be retired by its stated maturity date or final distribution date but may be retired earlier. PAC bonds generally require payment of a specified amount of principal on each payment date so long as prepayment speeds on the underlying collateral fall within a specified range. Other types of CMO issues include targeted amortization class CMOs (or TAC bonds), which are similar to PAC bonds. While PAC bonds maintain their amortization schedule within a specified range of prepayment speeds, TAC bonds are generally targeted to a narrow range of prepayment speeds or a specified prepayment speed. TAC bonds can provide protection against prepayment uncertainty since cash flows generated from higher prepayments of the underlying mortgage-related assets are applied to the various other pass-through tranches so as to allow the TAC bonds to maintain their amortization schedule. A CMO may be subject to the issuer's right to redeem the CMO prior to its stated maturity date, which may diminish the anticipated return on our investment. Privately-issued CMOs are supported by private credit enhancements similar to those used for privately-issued certificates and are often issued as senior-subordinated mortgage-backed securities. We will only acquire CMOs or multi-class pass-through certificates that constitute debt obligations or beneficial ownership in grantor trusts holding mortgage loans, or regular interests in REMICs, or that otherwise constitute qualified REIT real estate assets under the Internal Revenue Code (provided that we have obtained a favorable opinion of our tax advisor or a ruling from the IRS to that effect). Adjustable-Rate Mortgage Pass-Through Certificates and Floating Rate Mortgage-Backed Securities Most of the mortgage pass-through certificates we acquire are adjustable-rate mortgage pass-through certificates. This means that their interest rates may vary over time based upon changes in an objective index, such as: - LIBOR or the London Interbank Offered Rate. The interest rate that banks in London offer for deposits in London of U.S. dollars. - Treasury Index. A monthly or weekly average yield of benchmark U.S. Treasury securities, as published by the Federal Reserve Board. - CD Rate. The weekly average of secondary market interest rates on six-month negotiable certificates of deposit, as published by the Federal Reserve Board. These indices generally reflect short-term interest rates. The underlying mortgages for adjustable-rate mortgage pass-through certificates are adjustable-rate mortgage loans ("ARMs"). We also acquire "floating rate CMOs" or "floaters." One or more tranches of a CMO may have coupon rates that reset periodically at a specified increment over an index such as LIBOR. These adjustable-rate tranches are sometime known as "floating-rate CMOs" or "floaters" and may be backed by fixed or adjustable-rate mortgages. 9 There are two main categories of indices for adjustable-rate mortgage pass-through certificates and floaters: (1) those based on U.S. Treasury securities, and (2) those derived from calculated measures such as a cost of funds index or a moving average of mortgage rates. Commonly utilized indices include the one-year Treasury note rate, the three-month Treasury bill rate, the six-month Treasury bill rate, rates on long-term Treasury securities, the 11th District Federal Home Loan Bank Costs of Funds Index, the National Median Cost of Funds Index, one-month or three-month LIBOR, the prime rate of a specific bank, or commercial paper rates. Some indices, such as the one-year Treasury rate, closely mirror changes in market interest rate levels. Others, such as the 11th District Home Loan Bank Cost of Funds Index, tend to lag changes in market interest rate levels. We seek to diversify our investments in adjustable-rate mortgage pass-through certificates and floaters among a variety of indices and reset periods so that we are not at any one time unduly exposed to the risk of interest rate fluctuations. In selecting adjustable-rate mortgage pass-through certificates and floaters for investment, we will also consider the liquidity of the market for the different mortgage-backed securities. We believe that adjustable-rate mortgage pass-through certificates and floaters are particularly well-suited to our investment objective of high current income, consistent with modest volatility of net asset value, because the value of adjustable-rate mortgage pass-through certificates and floaters generally remains relatively stable as compared to traditional fixed-rate debt securities paying comparable rates of interest. While the value of adjustable-rate mortgage pass-through certificates and floaters, like other debt securities, generally varies inversely with changes in market interest rates (increasing in value during periods of declining interest rates and decreasing in value during periods of increasing interest rates), the value of adjustable-rate mortgage pass-through certificates and floaters should generally be more resistant to price swings than other debt securities because the interest rates on these securities move with market interest rates. Accordingly, as interest rates change, the value of our shares should be more stable than the value of funds which invest primarily in securities backed by fixed-rate mortgages or in other non-mortgage-backed debt securities, which do not provide for adjustment in the interest rates in response to changes in market interest rates. Adjustable-rate mortgage pass-through certificates and floaters typically have caps, which limit the maximum amount by which the interest rate may be increased or decreased at periodic intervals or over the life of the floater. To the extent that interest rates rise faster than the allowable caps on the adjustable-rate mortgage pass-through certificates and floaters, these securities will behave more like fixed-rate securities. Consequently, interest rate increases in excess of caps can be expected to cause these securities to behave more like traditional debt securities than adjustable-rate securities and, accordingly, to decline in value to a greater extent than would be the case in the absence of these caps. Adjustable-rate mortgage pass-through certificates and floaters, like other mortgage-backed securities, differ from conventional bonds in that principal is to be paid back over the life of the security rather than at maturity. As a result, we receive monthly scheduled payments of principal and interest on these securities and may receive unscheduled principal payments representing prepayments on the underlying mortgages. When we reinvest the payments and any unscheduled prepayments we receive, we may receive a rate of interest on the reinvestment which is lower than the rate on the existing security. For this reason, adjustable-rate mortgage pass-through certificates and floaters are less effective than longer-term debt securities as a means of "locking in" longer-term interest rates. Accordingly, adjustable-rate mortgage pass-through certificates and floaters, while generally having less risk of price decline during periods of rapidly rising interest rates than fixed-rate mortgage-backed securities of comparable maturities, have less potential for capital appreciation than fixed-rate securities during periods of declining interest rates. As in the case of fixed-rate mortgage-backed securities, to the extent these securities are purchased at a premium, faster than expected prepayments would accelerate our amortization of the premium. Conversely, if these securities were purchased at a discount, faster than expected prepayments would accelerate our recognition of income. 10 As in the case of fixed-rate CMOs, floating-rate CMOs may allow for shifting of prepayment risk from slower-paying tranches to faster-paying tranches. This is in contrast to mortgage pass-through certificates where all investors share equally in all payments, including all prepayments, on the underlying mortgages. Other Floating Rate Instruments We may also invest in structured floating-rate notes issued or guaranteed by government agencies, such as FNMA and FHLMC. These instruments are typically structured to reflect an interest rate arbitrage (i.e., the difference between the agency's cost of funds and the income stream from specified assets of the agency) and their reset formulas may provide more attractive returns than other floating rate instruments. The indices used to determine resets are the same as those described above. Mortgage Loans We have not as of December 31, 2002, but we may from time-to-time invest a small percentage of our assets directly in single-family, multi-family or commercial mortgage loans. We expect that the majority of these mortgage loans would be ARMs. The interest rate on an ARM is typically tied to an index (such as LIBOR or the interest rate on Treasury bills), and is adjustable periodically at specified intervals. These mortgage loans are typically subject to lifetime interest rate caps and periodic interest rate or payment caps. The acquisition of mortgage loans generally involves credit risk. We may obtain credit enhancement to mitigate this risk; however, there can be no assurances that we will able to obtain credit enhancement or that credit enhancement would mitigate the credit risk of the underlying mortgage loans. Capital Investment Policy Asset Acquisitions Our capital investment policy provides that at least 75% of our total assets will be comprised of high quality mortgage-backed securities and short-term investments. The remainder of our assets (comprising not more than 25% of total assets), may consist of mortgage-backed securities and other qualified REIT real estate assets which are unrated or rated less than high quality but which are at least "investment grade" (rated "BBB" or better) or, if not rated, are determined by us to be of comparable credit quality to an investment which is rated "BBB" or better. Our capital investment policy requires that we structure our portfolio to maintain a minimum weighted average rating (including our deemed comparable ratings for unrated mortgage-backed securities) of our mortgage-backed securities of at least single "A" under the S&P rating system and at the comparable level under the other rating systems. To date, all of the mortgage-backed securities we have acquired have been pass-through certificates or CMOs issued or guaranteed by FHLMC, FNMA or GNMA which, although not rated, have an implied "AAA" rating. We intend to acquire only those mortgage-backed securities which we believe we have the necessary expertise to evaluate and manage, which we can readily finance and which are consistent with our balance sheet guidelines and risk management objectives. Since we expect to hold our mortgage-backed securities until maturity, we generally do not seek to acquire assets whose investment returns are only attractive in a limited range of scenarios. We believe that future interest rates and mortgage prepayment rates are very difficult to predict and, as a result, we seek to acquire mortgage-backed securities which we believe provide acceptable returns over a broad range of interest rate and prepayment scenarios. Among the asset choices available to us, our policy is to acquire those mortgage-backed securities which we believe generate the highest returns on capital invested, after consideration of the following: - the amount and nature of anticipated cash flows from the asset; - our ability to pledge the asset to secure collateralized borrowings; 11 - the increase in our capital requirement determined by our capital investment policy resulting from the purchase and financing of the asset; and - the costs of financing, hedging, managing and reserving for the asset. Prior to acquisition, we assess potential returns on capital employed over the life of the asset and in a variety of interest rate, yield spread, financing cost, credit loss and prepayment scenarios. We also give consideration to balance sheet management and risk diversification issues. We deem a specific asset which we are evaluating for potential acquisition as more or less valuable to the extent it serves to increase or decrease certain interest rate or prepayment risks which may exist in the balance sheet, to diversify or concentrate credit risk, and to meet the cash flow and liquidity objectives our management may establish for our balance sheet from time-to-time. Accordingly, an important part of the asset evaluation process is a simulation, using our risk management model, of the addition of a potential asset and our associated borrowings and hedges to the balance sheet and an assessment of the impact this potential asset acquisition would have on the risks in and returns generated by our balance sheet as a whole over a variety of scenarios. We focus primarily on the acquisition of adjustable-rate mortgage-backed securities, including floaters. We have, however, purchased a significant amount of fixed-rate mortgage-backed securities and may continue to do so in the future if, in our view, the potential returns on capital invested, after hedging and all other costs, would exceed the returns available from other assets or if the purchase of these assets would serve to reduce or diversify the risks of our balance sheet. Although we have not yet done so, we may purchase the stock of mortgage REITs or similar companies when we believe that these purchases would yield attractive returns on capital employed. When the stock market valuations of these companies are low in relation to the market value of their assets, these stock purchases can be a way for us to acquire an interest in a pool of mortgage-backed securities at an attractive price. We do not, however, presently intend to invest in the securities of other issuers for the purpose of exercising control or to underwrite securities of other issuers. We may acquire newly issued mortgage-backed securities, and also will seek to expand our capital base in order to further increase our ability to acquire new assets, when the potential returns from new investments appears attractive relative to the return expectations of stockholders. We may in the future acquire mortgage-backed securities by offering our debt or equity securities in exchange for the mortgage-backed securities. We generally intend to hold mortgage-backed securities for extended periods. In addition, the REIT provisions of the Internal Revenue Code limit in certain respects our ability to sell mortgage-backed securities. We may decide however to sell assets from time-to-time, for a number of reason, including our desire to dispose of an asset as to which credit risk concerns have arisen, to reduce interest rate risk, to substitute one type of mortgage-backed security for another, to improve yield or to maintain compliance with the 55% requirement under the Investment Company Act, and generally to re-structure the balance sheet when we deem advisable. Our board of directors has not adopted any policy that would restrict management's authority to determine the timing of sales or the selection of mortgage-backed securities to be sold. We do not invest in principal-only interests in mortgage-backed securities, residual interests, accrual bonds, inverse-floaters, two-tiered index bonds, cash flow bonds, mortgage-backed securities with imbedded leverage or mortgage-backed securities that would be deemed unacceptable for collateralized borrowings, excluding shares in mortgage REITs. As a requirement for maintaining REIT status, we will distribute to stockholders aggregate dividends equaling at least 90% of our taxable income (excluding capital gains) for each taxable year. We will make additional distributions of capital when the return expectations of the stockholders appear to exceed returns potentially available to us through making new investments in mortgage-backed securities. Subject to the limitations of applicable securities and state corporation laws, we can distribute capital by making purchases of our own capital stock or through paying down or repurchasing any outstanding uncollateralized debt obligations. 12 Our asset acquisition strategy may change over time as market conditions change and as we evolve. Credit Risk Management We have not taken on credit risk to date, but may do so in the future. In that event, we will review credit risk and other risk of loss associated with each investment and determine the appropriate allocation of capital to apply to the investment under our capital investment policy. Our board of directors will monitor the overall portfolio risk and determine appropriate levels of provision for loss. Capital and Leverage We expect generally to maintain a debt-to-equity ratio of between 8:1 and 12:1, although the ratio may vary from time-to-time depending upon market conditions and other factors our management deems relevant, including the composition of our balance sheet, haircut levels required by lenders, the market value of the mortgage-backed securities in our portfolio and "excess capital cushion" percentages (as described below) set by our board of directors from time to time. For purposes of calculating this ratio, our equity (or capital base) is equal to the value of our investment portfolio on a mark-to-market basis less the book value of our obligations under repurchase agreements and other collateralized borrowings. At December 31, 2002, our ratio of debt-to-equity was 9.4:1. Our goal is to strike a balance between the under-utilization of leverage, which reduces potential returns to stockholders, and the over-utilization of leverage, which could reduce our ability to meet our obligations during adverse market conditions. Our capital investment policy limits our ability to acquire additional assets during times when our debt-to-equity ratio exceeds 12:1. Our capital base represents the approximate liquidation value of our investments and approximates the market value of assets that we can pledge or sell to meet over-collateralization requirements for our borrowings. The unpledged portion of our capital base is available for us to pledge or sell as necessary to maintain over-collateralization levels for our borrowings. We are prohibited from acquiring additional assets during periods when our capital base is less than the minimum amount required under our capital investment policy, except as may be necessary to maintain REIT status or our exemption from the Investment Company Act of 1940, as amended (the "Investment Company Act"). In addition, when our capital base falls below our risk-managed capital requirement, our management is required to submit to our board of directors a plan for bringing our capital base into compliance with our capital investment policy guidelines. We anticipate that in most circumstances we can achieve this goal without overt management action through the natural process of mortgage principal repayments. We anticipate that our capital base is likely to exceed our risk-managed capital requirement during periods following new equity offerings and during periods of falling interest rates and that our capital base could fall below the risk-managed capital requirement during periods of rising interest rates. The first component of our capital requirements is the current aggregate over-collateralization amount or "haircut" the lenders require us to hold as capital. The haircut for each mortgage-backed security is determined by our lenders based on the risk characteristics and liquidity of the asset. Haircut levels on individual borrowings generally range from 3% for certain FHLMC, FNMA or GNMA mortgage-backed securities to 20% for certain privately-issued mortgage-backed securities. At December 31, 2002, the weighted average haircut level on our securities was 3.96%. Should the market value of our pledged assets decline, we will be required to deliver additional collateral to our lenders to maintain a constant over-collateralization level on our borrowings. The second component of our capital requirement is the "excess capital cushion." This is an amount of capital in excess of the haircuts required by our lenders. We maintain the excess capital cushion to meet the demands of our lenders for additional collateral should the market value of our mortgage-backed securities decline. The aggregate excess capital cushion equals the sum of liquidity cushion amounts assigned under our capital investment policy to each of our mortgage-backed securities. We assign excess capital cushions to each mortgage-backed security based on our assessment of the mortgage-backed security's market price volatility, credit risk, liquidity and attractiveness for use as collateral by lenders. The process of assigning excess capital cushions relies on our management's ability to identify and weigh the relative importance of these and other factors. In assigning 13 excess capital cushions, we also give consideration to hedges associated with the mortgage-backed security and any effect such hedges may have on reducing net market price volatility, concentration or diversification of credit and other risks in the balance sheet as a whole and the net cash flows that we can expect from the interaction of the various components of our balance sheet. Our capital investment policy stipulates that at least 25% of the capital base maintained to satisfy the excess capital cushion must be invested in AAA-rated adjustable-rate mortgage-backed securities or assets with similar or better liquidity characteristics. A substantial portion of our borrowings are short-term or variable-rate borrowings. Our borrowings are implemented primarily through repurchase agreements, but in the future may also be obtained through loan agreements, lines of credit, dollar-roll agreements (an agreement to sell a security for delivery on a specified future date and a simultaneous agreement to repurchase the same or a substantially similar security on a specified future date) and other credit facilities with institutional lenders and issuance of debt securities such as commercial paper, medium-term notes, CMOs and senior or subordinated notes. We enter into financing transactions only with institutions that we believe are sound credit risks and follow other internal policies designed to limit our credit and other exposure to financing institutions. We expect to continue to use repurchase agreements as our principal financing device to leverage our mortgage-backed securities portfolio. We anticipate that, upon repayment of each borrowing under a repurchase agreement, we will use the collateral immediately for borrowing under a new repurchase agreement. At present, we have entered into uncommitted facilities with 25 lenders for borrowings in the form of repurchase agreements. We have not at the present time entered into any commitment agreements under which the lender would be required to enter into new repurchase agreements during a specified period of time, nor do we presently plan to have liquidity facilities with commercial banks. We may, however, enter into such commitment agreements in the future. We enter into repurchase agreements primarily with national broker-dealers, commercial banks and other lenders which typically offer this type of financing. We enter into collateralized borrowings only with financial institutions meeting credit standards approved by our board of directors, and we monitor the financial condition of these institutions on a regular basis. A repurchase agreement, although structured as a sale and repurchase obligation, acts as a financing under which we effectively pledge our mortgage-backed securities as collateral to secure a short-term loan. Generally, the other party to the agreement makes the loan in an amount equal to a percentage of the market value of the pledged collateral. At the maturity of the repurchase agreement, we are required to repay the loan and correspondingly receive back our collateral. While used as collateral, the mortgage-backed securities continue to pay principal and interest which are for our benefit. In the event of our insolvency or bankruptcy, certain repurchase agreements may qualify for special treatment under the Bankruptcy Code, the effect of which, among other things, would be to allow the creditor under the agreement to avoid the automatic stay provisions of the Bankruptcy Code and to foreclose on the collateral agreement without delay. In the event of the insolvency or bankruptcy of a lender during the term of a repurchase agreement, the lender may be permitted, under applicable insolvency laws, to repudiate the contract, and our claim against the lender for damages may be treated simply as an unsecured creditor. In addition, if the lender is a broker or dealer subject to the Securities Investor Protection Act of 1970, or an insured depository institution subject to the Federal Deposit Insurance Act, our ability to exercise our rights to recover our securities under a repurchase agreement or to be compensated for any damages resulting from the lender's insolvency may be further limited by those statutes. These claims would be subject to significant delay and, if and when received, may be substantially less than the damages we actually incur. Substantially all of our borrowing agreements require us to deposit additional collateral in the event the market value of existing collateral declines, which may require us to sell assets to reduce our borrowings. We have designed our liquidity management policy to maintain a cushion of equity sufficient to provide required liquidity to respond to the effects under our borrowing arrangements of interest rate movements and changes in market value of our mortgage-backed securities, as described above. However, a major disruption of the repurchase or other market that we rely on for short-term borrowings would have a material adverse effect on us unless we were able to arrange alternative sources of financing on comparable terms. 14 Our articles of incorporation and bylaws do not limit our ability to incur borrowings, whether secured or unsecured. Interest Rate Risk Management To the extent consistent with our election to qualify as a REIT, we follow an interest rate risk management program intended to protect our portfolio of mortgage-backed securities and related debt against the effects of major interest rate changes. Specifically, our interest rate risk management program is formulated with the intent to offset the potential adverse effects resulting from rate adjustment limitations on our mortgage-backed securities and the differences between interest rate adjustment indices and interest rate adjustment periods of our adjustable-rate mortgage-backed securities and related borrowings. Our interest rate risk management program encompasses a number of procedures, including the following: - we attempt to structure our borrowings to have interest rate adjustment indices and interest rate adjustment periods that, on an aggregate basis, generally correspond to the interest rate adjustment indices and interest rate adjustment periods of our adjustable-rate mortgage-backed securities; and - we attempt to structure our borrowing agreements relating to adjustable-rate mortgage-backed securities to have a range of different maturities and interest rate adjustment periods (although substantially all will be less than one year). We adjust the average maturity adjustment periods of our borrowings on an ongoing basis by changing the mix of maturities and interest rate adjustment periods as borrowings come due and are renewed. Through use of these procedures, we attempt to minimize the differences between the interest rate adjustment periods of our mortgage-backed securities and related borrowings that may occur. Although we have not done so to date, we may purchase from time-to-time interest rate caps, interest rate swaps, interest rate collars, interest rate caps or floors, "interest only" mortgage-backed securities and similar instruments to attempt to mitigate the risk of the cost of our variable rate liabilities increasing at a faster rate than the earnings on our assets during a period of rising interest rates or to mitigate prepayment risk. We may hedge as much of the interest rate risk as our management determines is in our best interests, given the cost of the hedging transactions and the need to maintain our status as a REIT. This determination may result in our electing to bear a level of interest rate or prepayment risk that could otherwise be hedged when management believes, based on all relevant facts, that bearing the risk is advisable. We seek to build a balance sheet and undertake an interest rate risk management program which is likely to generate positive earnings and maintain an equity liquidation value sufficient to maintain operations given a variety of potentially adverse circumstances. Accordingly, our interest rate risk management program addresses both income preservation, as discussed above, and capital preservation concerns. For capital preservation, we monitor our "duration." This is the expected percentage change in market value of our assets that would be caused by a 1% change in short and long-term interest rates. To monitor duration and the related risks of fluctuations in the liquidation value of our equity, we model the impact of various economic scenarios on the market value of our mortgage-backed securities and liabilities. At December 31, 2002, we estimate that the duration of our assets was .5%. We believe that our interest rate risk management program will allow us to maintain operations throughout a wide variety of potentially adverse circumstances. Nevertheless, in order to further preserve our capital base (and lower our duration) during periods when we believe a trend of rapidly rising interest rates has been established, we may decide to enter into or increase hedging activities or to sell assets. Each of these actions may lower our earnings and dividends in the short term to further our objective of maintaining attractive levels of earnings and dividends over the long term. We may elect to conduct a portion of our hedging operations through one or more subsidiary corporations which would not be a qualified REIT subsidiary and would be subject to federal and state income taxes. To comply with the asset tests applicable to us as a REIT, the value of the securities of the any taxable subsidiary we hold must be limited to less than 5% of the value of our total assets as of the end of each calendar quarter and we may not own 15 more than 10% of the voting securities of the taxable subsidiary. We could, however, elect to treat a subsidiary as a "taxable REIT subsidiary," in which case we could own 100% of the voting stock of such subsidiary, provided that the value of the stock that we own in all such taxable REIT subsidiaries does not exceed 20% of the value of our total assets at the close of any calendar quarter. A taxable subsidiary would not elect REIT status and would distribute any net profit after taxes to us and its other stockholders. Any dividend income we receive from the taxable subsidiary (combined with all other income generated from our assets, other than qualified REIT real estate assets) must not exceed 25% of our gross income. We believe that we have developed a cost-effective asset/liability management program to provide a level of protection against interest rate and prepayment risks. However, no strategy can completely insulate us from interest rate changes and prepayment risks. Further, as noted above, the federal income tax requirements that we must satisfy to qualify as a REIT limit our ability to hedge our interest rate and prepayment risks. We monitor carefully, and may have to limit, our asset/liability management program to assure that we do not realize excessive hedging income, or hold hedging assets having excess value in relation to total assets, which would result in our disqualification as a REIT or, in the case of excess hedging income, the payment of a penalty tax for failure to satisfy certain REIT income tests under the Internal Revenue Code, provided the failure was for reasonable cause. In addition, asset/liability management involves transaction costs which increase dramatically as the period covered by the hedging protection increases. Therefore, we may be unable to hedge effectively our interest rate and prepayment risks. Prepayment Risk Management We seek to minimize the effects of faster or slower than anticipated prepayment rates through structuring a diversified portfolio with a variety of prepayment characteristics, investing in mortgage-backed securities with prepayment prohibitions and penalties, investing in certain mortgage-backed security structures which have prepayment protections, and balancing assets purchased at a premium with assets purchased at a discount. We monitor prepayment risk through periodic review of the impact of a variety of prepayment scenarios on our revenues, net earnings, dividends, cash flow and net balance sheet market value. Future Revisions in Policies and Strategies Our board of directors has established the investment policies and operating policies and strategies set forth in this Form 10-K. The board of directors has the power to modify or waive these policies and strategies without the consent of the stockholders to the extent that the board of directors determines that the modification or waiver is in the best interests of our stockholders. Among other factors, developments in the market which affect our policies and strategies or which change our assessment of the market may cause our board of directors to revise our policies and strategies. Potential Acquisitions, Strategic Alliances and Other Investments From time-to-time we have had discussions with other parties regarding possible transactions including acquisitions of other businesses or assets, investments in other entities, joint venture arrangements, or strategic alliances. To date, none of these discussions have gone beyond the preliminary stage. We have also considered from time-to-time entering into related businesses, although to date we have not entered into such businesses. During 1998, we made an initial investment of $49,980 in Annaly International Money Management, Inc., ("Annaly International"). Annaly International was formed to explore business opportunities overseas, including the origination of mortgages. Annaly International did not commence operations beyond this exploratory stage. We owned 33% of the equity of Annaly International in the form of non-voting securities. The remaining equity of Annaly International was owned by FIDAC, Michael A.J. Farrell, our Chairman, Chief Executive Officer, and President, Wellington J. Denahan, our Vice Chairman, Chief Investment Officer, Kathryn F. Fagan, our Chief Financial Officer and Treasurer, Jennifer A. Stephens, our Secretary and Investment Officer and other persons. Annaly International Money Management, Inc. was liquidated on June 30, 2002, resulting in a $44,000 loss. 16 During 1998, Annaly International made an initial investment of $20,400 in Annaly.com, Inc, ("Annaly.com"). Annaly.com explores opportunities to acquire or originate mortgages in the United States. Annaly.com has established a website at http://www.annaly.com but did not commence the acquisition or origination of mortgages. Annaly International owned 51% of the equity of Annaly.com. The remaining equity of Annaly.com is owned by FIDAC I Partners, whose partners include FIDAC and our executive officers. Annaly.com, Inc. was dissolved on June 30, 2002. Prior to making our investment in Annaly International, we consulted with our tax advisors to ensure that the investment would not cause us to fail to satisfy the asset and source of income tests applicable to us as a REIT. Prior to making any other equity investment, we will similarly consult with our tax advisors. We may, from time-to- time, continue to explore possible acquisitions, investments, joint venture arrangements and strategic alliances. Dividend Reinvestment and Share Purchase Plan We have adopted a dividend reinvestment and share purchase plan. Under the dividend reinvestment feature of the plan, existing shareholders can reinvest their dividends in additional shares of our common stock. Under the share purchase feature of the plan, new and existing shareholders can purchase shares of our common stock. We have filed and the SEC has declared effective a Form S-3 registration statement registering 2,000,000 shares that may be issued under the plan. Legal Proceedings There are no material pending legal proceedings to which we are a party or to which any of our property is subject. Available Information Our investor relations website is www.annaly.com. We make available on this website under "Financials," free of charge, our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports as soon as reasonably practicable after we electronically file or furnish such materials to the SEC. COMPETITION We believe that our principal competition in the business of acquiring and holding mortgage-backed securities are financial institutions such as banks, savings and loans, life insurance companies, institutional investors such as mutual funds and pension funds, and certain other mortgage REITs. The existence of these competitive entities, as well as the possibility of additional entities forming in the future, may increase the competition for the acquisition of mortgage-backed securities resulting in higher prices and lower yields on assets. RISK FACTORS An investment in our stock involves a number of risks. Before making an investment decision, you should carefully consider all of the risks described in this Form 10-K. If any of the risks discussed in this Form 10-K actually occur, our business, financial condition and results of operations could be materially adversely affected. If this were to occur, the trading price of our common stock could decline significantly and you may lose all or part of your investment. If the interest payments on our borrowings increase relative to the interest we earn on our mortgage-backed securities, it may adversely affect our profitability 17 We earn money based upon the spread between the interest payments we earn on our mortgage-backed securities and the interest payments we must make on our borrowings. If the interest payments on our borrowings increase relative to the interest we earn on our mortgage-backed securities, our profitability may be adversely affected. The interest payments on our borrowings may increase relative to the interest we earn on our adjustable-rate mortgage-backed securities for various reasons discussed in this section. - Differences in timing of interest rate adjustments on our mortgage-backed securities and our borrowings may adversely affect our profitability We rely primarily on short-term borrowings to acquire mortgage-backed securities with long-term maturities. Accordingly, an increase in short-term interest rates may adversely affect our profitability. Most of the mortgage-backed securities we acquire are adjustable-rate securities. This means that their interest rates may vary over time based upon changes in an objective index, such as: - LIBOR or the London Interbank Offered Rate. The interest rate that banks in London offer for deposits in London of U.S. dollars. - Treasury Index. A monthly or weekly average yield of benchmark U.S. Treasury securities, as published by the Federal Reserve Board. - CD Rate. The weekly average of secondary market interest rates on six-month negotiable certificates of deposit, as published by the Federal Reserve Board. These indices generally reflect short-term interest rates. On December 31, 2002, approximately 63% of our mortgage-backed securities were adjustable-rate securities. The interest rates on our borrowings similarly vary with changes in an objective index. Nevertheless, the interest rates on our borrowings generally adjust more frequently than the interest rates on our adjustable-rate mortgage-backed securities. For example, on December 31, 2002, our adjustable-rate securities had a weighted average term to next rate adjustment of 11 months, while our borrowings had a weighted average term to next rate adjustment of 124 days. Accordingly, in a period of rising interest rates, we could experience a decrease in net income or a net loss because the interest rates on our borrowings adjust faster than the interest rates on our adjustable-rate mortgage-backed securities. - Interest rate caps on our mortgage-backed securities may adversely affect our profitability Our adjustable-rate mortgage-backed securities are typically subject to periodic and lifetime interest rate caps. Periodic interest rate caps limit the amount an interest rate can increase during any given period. Lifetime interest rate caps limit the amount an interest rate can increase through maturity of a mortgage-backed security. Our borrowings are not subject to similar restrictions. Accordingly, in a period of rapidly increasing interest rates, we could experience a decrease in net income or a net loss because the interest rates on our borrowings could increase without limitation while the interest rates on our adjustable-rate mortgage-backed securities would be limited by caps. - Because we acquire fixed rate securities, an increase in interest rates may adversely affect our profitability While the majority of our investments consist of adjustable-rate mortgage-backed securities, we also invest in fixed-rate mortgage-backed securities. In a period of rising interest rates, our interest payments could increase while the interest we earn on our fixed rate mortgage-backed securities would not change. This would adversely affect our profitability. On December 31, 2002, approximately 37% of our mortgage-backed securities were fixed rate securities. 18 An increase in prepayment rates may adversely affect our profitability The mortgage-backed securities we acquire are backed by pools of mortgage loans. We receive payments, generally, from the payments that are made on these underlying mortgage loans. When borrowers prepay their mortgage loans at rates that are faster than expected, this results in prepayments that are faster than expected on the mortgage-backed securities. These faster than expected prepayments may adversely affect our profitability. We often purchase mortgage-backed securities that have a higher interest rate than the market interest rate at the time. In exchange for this higher interest rate, we must pay a premium over the market value to acquire the security. In accordance with accounting rules, we amortize this premium over the term of the mortgage-backed security using the effective yield method. If the mortgage-backed security is prepaid in whole or in part prior to its expected maturity date, we must amortize the premium that was prepaid at the time of the prepayment. This adversely affects our profitability. On December 31, 2002, approximately 97% of the mortgage-backed securities we owned were acquired at a premium. Prepayment rates generally increase when interest rates fall and decrease when interest rates rise, but changes in prepayment rates are difficult to predict. Prepayment rates also may be affected by conditions in the housing and financial markets, general economic conditions and the relative interest rates on fixed-rate and adjustable-rate mortgage loans. We may seek to reduce prepayment risk by acquiring mortgage-backed securities at a discount. If a discounted security is prepaid in whole or in part prior to its expected maturity date, we will earn income equal to the amount of the remaining discount. This will improve our profitability if the discounted securities are prepaid faster than expected We can also acquire mortgage-backed securities that are less affected by prepayments. For example, we can acquire collateralized mortgage obligations or CMOs, a type of mortgage-backed security. CMOs divide a pool of mortgage loans into multiple tranches that allow for shifting of prepayment risks from slower-paying tranches to faster-paying tranches. This is in contrast to pass-through or pay-through mortgage-backed securities, where all investors share equally in all payments, including all prepayments. As discussed below, the Investment Company Act imposes restrictions on our purchase of CMOs. On December 31, 2002, approximately 33% of our mortgage-backed securities were CMOs and approximately 67% of our mortgage-backed securities were pass-through or pay-through securities. While we seek to minimize prepayment risk to the extent practical, in selecting investments we must balance prepayment risk against other risks and the potential returns of each investment. No strategy can completely insulate us from prepayment risk. An increase in interest rates may adversely affect our book value Increases in interest rates may negatively affect the market value of our mortgage-backed securities. Our fixed-rate securities, generally, are more negatively affected by these increases. In accordance with accounting rules, we reduce our book value by the amount of any decrease in the market value of our mortgage-backed securities. Our strategy involves significant leverage We seek to maintain a ratio of debt-to-equity of between 8:1 and 12:1, although our ratio may at times be above or below this amount. We incur this leverage by borrowing against a substantial portion of the market value of our mortgage-backed securities. By incurring this leverage, we can enhance our returns. Nevertheless, this leverage, which is fundamental to our investment strategy, also creates significant risks. - Our leverage may cause substantial losses 19 Because of our significant leverage, we may incur substantial losses if our borrowing costs increase. Our borrowing costs may increase for any of the following reasons: - short-term interest rates increase - the market value of our mortgage-backed securities decreases - interest rate volatility increases; or - the availability of financing in the market decreases Our leverage may cause margin calls and defaults and force us to sell assets under adverse market conditions Because of our leverage, a decline in the value of our mortgage-backed securities may result in our lenders initiating margin calls. A margin call means that the lender requires us to pledge additional collateral to re-establish the ratio of the value of the collateral to the amount of the borrowing. Our fixed-rate mortgage-backed securities generally are more susceptible to margin calls as increases in interest rates tend to more negatively affect the market value of fixed-rate securities. If we are unable to satisfy margin calls, our lenders may foreclose on our collateral. This could force us to sell our mortgage-backed securities under adverse market conditions. Additionally, in the event of our bankruptcy, our borrowings, which are generally made under repurchase agreements, may qualify for special treatment under the Bankruptcy Code. This special treatment would allow the lenders under these agreements to avoid the automatic stay provisions of the Bankruptcy Code and to liquidate the collateral under these agreements without delay. - Liquidation of collateral may jeopardize our REIT status To continue to qualify as a REIT, we must comply with requirements regarding our assets and our sources of income. If we are compelled to liquidate our mortgage-backed securities, we may be unable to comply with these requirements, ultimately jeopardizing our status as a REIT. - We may exceed our target leverage ratios We seek to maintain a ratio of debt-to-equity of between 8:1 and 12:1. However, we are not required to stay within this leverage ratio. If we exceed this ratio, the adverse impact on our financial condition and results of operations from the types of risks described in this section would likely be more severe. - We may not be able to achieve our optimal leverage We use leverage as a strategy to inhance the return to our investors. However, we may not be able to achieve our desired leverage for any of the following reasons: - we determine that the leverage would expose us to excessive risk; - our lenders do not make funding available to us at acceptable rates; or - our lenders require that we provide additional collateral to cover our borrowings - We may incur increased borrowing costs which would adversely affect our profitability Currently, all of our borrowings are collateralized borrowings in the form of repurchase agreements. If the interest rates on these repurchase agreements increase, it would adversely affect our profitability. 20 Our borrowing costs under repurchase agreements generally correspond to short-term interest rates such as LIBOR or a short-term Treasury index, plus or minus a margin. The margins on these borrowings over or under short-term interest rates may vary depending upon: - the movement of interest rates; - the availability of financing in the market; or - the value and liquidity of our mortgage-backed securities, If we are unable to renew our borrowings at favorable rates, our profitability may be adversely affected Since we rely primarily on short-term borrowings, our ability to achieve our investment objectives depends not only on our ability to borrow money in sufficient amounts and on favorable terms, but also on our ability to renew or replace on a continuous basis our maturing short-term borrowings. If we are not able to renew or replace maturing borrowings, we would have to sell assets under possibly adverse market conditions. We have not used derivatives to mitigate our interest rate and prepayment risks Our policies permit us to enter into interest rate swaps, caps and floors and other derivative transactions to help us mitigate our interest rate and prepayment risks described above. However, we have determined in the past that the cost of these transactions outweighs the benefits. In addition, we will not enter into derivative transactions if we believe they will jeopardize our status as a REIT. If we decide to enter into derivative transactions in the future, these transactions may mitigate our interest rate and prepayment risks but cannot insulate us from these risks. Our investment strategy may involve credit risk We may incur losses if there are payment defaults under our mortgage-backed securities. To date, all of our mortgage-backed securities have been agency certificates which, although not rated, carry an implied "AAA" rating. Agency certificates are mortgage-backed securities where FHLMC, FNMA, or GNMA guarantees payments of principal or interest on the certificates. Even though we have only acquired "AAA" securities so far, pursuant to our capital investment policy we have the ability to acquire securities of lower credit quality. Under our policy: - 75% of our investments must have a "AA" or higher rating by Standard & Poor's Corporation ("S&P"), or an equivalent rating by a similar nationally recognized rating organization, or our management must determine that the investments are of comparable credit quality to investments with these ratings; - the remaining 25% of our investments must have a "BBB" or higher rating by S&P, or an equivalent rating by a similar nationally recognized rating organization, or our management must determine that the investments are of comparable credit quality to investments with these ratings. Securities with ratings of "BBB" or higher are commonly referred to as "investment grade" securities; and - we seek to have a minimum weighted average rating for our portfolio of at least "A" by S&P. If we acquire mortgage-backed securities of lower credit quality, we may incur losses if there are defaults under those mortgage-backed securities or if the rating agencies downgrade the credit quality of those mortgage-backed securities. We have not established a minimum dividend payment level We intend to pay quarterly dividends and to make distributions to our stockholders in amounts such that all or substantially all of our taxable income in each year (subject to certain adjustments) is distributed. This will enable 21 us to qualify for the tax benefits accorded to a REIT under the Code. We have not established a minimum dividend payment level and our ability to pay dividends may be adversely affected for the reasons described in this section. All distributions will be made at the discretion of our board of directors and will depend on our earnings, our financial condition, maintenance of our REIT status and such other factors as our board of directors may deem relevant from time to time. Because of competition, we may not be able to acquire mortgage-backed securities at favorable yields Our net income depends, in large part, on our ability to acquire mortgage-backed securities at favorable spreads over our borrowing costs. In acquiring mortgage-backed securities, we compete with other REITs, investment banking firms, savings and loan associations, banks, insurance companies, mutual funds, other lenders and other entities that purchase mortgage-backed securities, many of which have greater financial resources than us. As a result, in the future, we may not be able to acquire sufficient mortgage-backed securities at favorable spreads over our borrowing costs. We are dependent on our key personnel We are dependent on the efforts of our key officers and employees, including Michael A. J. Farrell, Chairman of the board of directors, Chief Executive Officer, and President, Wellington J. Denahan, Vice Chairman and Chief Investment Officer, Kathryn F. Fagan, Chief Financial Officer and Treasurer, and Jennifer A Stephens, Secretary and Investment Officer. The loss of any of their services could have an adverse effect on our operations. Although we have employment agreements with each of them, we cannot assure you they will remain employed with us. Some of our directors, officers and employees have ownership interests and manage assets for other clients that create potential conflicts of interest. Mr. Farrell, Ms. Denahan and other officers and employees are actively involved in managing mortgage-backed securities and other fixed income assets for institutional clients through Fixed Income Discount Advisory Company. FIDAC is a registered investment adviser which on December 31, 2002 managed, assisted in managing or supervised approximately $8 billion in gross assets on a discretionary basis for a wide array of clients. The U.S. Dollar Floating Rate Fund is a fund managed by FIDAC. Mr. Farrell is a Director of the Floating Rate Fund. FIDAC may also manage other funds in the future. These officers will continue to perform services for FIDAC, the institutional clients, the Floating Rate Fund, and other funds managed by the FIDAC. FIDAC is currently owned 100% by Mr. Farrell, our Chairman of the Board, Chief Executive Officer, and President. These responsibilities may create conflicts of interest for these officers and employees if they are presented with corporate opportunities that may benefit us and the institutional clients, the Floating Rate Fund, and other funds managed by FIDAC. Our officers allocate investments among us, the institutional clients and the Floating Rate Fund, and other funds managed by FIDAC by determining the entity or account for which the investment is most suitable. In making this determination, our officers consider the investment strategy and guidelines of each entity or account with respect to acquisition of assets, leverage, liquidity, and other factors that our officers determine appropriate. Our management allocates rent and other office expenses between our affiliate and us. These allocations may create conflicts of interest. Our management currently allocates rent and other expenses 90% to Annaly and 10% to FIDAC. Our audit committee must approve any change in these allocation percentages. In addition, we may enter into agreements, such as technology sharing or research agreements, with our affiliates in the future. These agreements would present potential conflicts of interest. Our management will obtain prior approval of our audit committee prior to entering into any agreements with our affiliates. We and our shareholders are subject to certain tax risks |X| Our failure to qualify as a REIT would have adverse tax consequences 22 We believe that since 1997 we have qualified for taxation as a REIT for federal income tax purposes. We plan to continue to meet the requirements for taxation as a REIT. Many of these requirements, however, are highly technical and complex. The determination that we are a REIT requires an analysis of various factual matters and circumstances that may not be totally within our control. For example, to qualify as a REIT, at least 75% of our gross income must come from real estate sources and 95% of our gross income must come from real estate sources and certain other sources that are itemized in the REIT tax laws. We are also required to distribute to stockholders at least 90% (95% with respect to taxable years beginning before January 1, 2001) of our REIT taxable income (excluding capital gains). Even a technical or inadvertent mistake could jeopardize our REIT status. Furthermore, Congress and the Internal Revenue Service ("IRS") might make changes to the tax laws and regulations, and the courts might issue new rulings that make it more difficult or impossible for us to remain qualified as a REIT. If we fail to qualify as a REIT, we would be subject to federal income tax at regular corporate rates. Also, unless the IRS granted us relief under certain statutory provisions, we would remain disqualified as a REIT for four years following the year we first fail to qualify. If we fail to qualify as a REIT, we would have to pay significant income taxes and would therefore have less money available for investments or for distributions to our stockholders. This would likely have a significant adverse effect on the value of our securities. In addition, the tax law would no longer require us to make distributions to our stockholders. - We have certain distribution requirements As a REIT, we must distribute 90% (95% with respect to taxable years beginning before January 1, 2001) of our annual taxable income. The required distribution limits the amount we have available for other business purposes, including amounts to fund our growth. Also, it is possible that because of the differences between the time we actually receive revenue or pay expenses and the period we report those items for distribution purposes, we may have to borrow funds on a short-term basis to meet the 90% distribution requirement. - We are also subject to other tax liabilities Even if we qualify as a REIT, we may be subject to certain federal, state and local taxes on our income and property. Any of these taxes would reduce our operating cash flow. Proposed legislation for dividend exclusions could affect the value of our stock On January 7, 2003, the Bush Administration released a proposal intended to eliminate one level of the federal "double taxation" that is currently imposed on corporate income for regular C corporations. Under this proposal, dividends from a regular C corporation may be excluded, in whole or in part, from a stockholder's federal taxable income to the extent that corporate income tax has been paid on the earnings from which the dividends are paid. REITs currently are tax-advantaged relative to regular C corporations because they are not subject to corporate-level federal income tax on income that they distribute to stockholders. The Bush Administration's proposal, if enacted in its original form, could decrease the tax advantage of a REIT relative to a regular C corporation because part or all of the dividends received by a stockholder from a regular C corporation would be exempt, in whole or in part, from federal income tax and, as a result, could cause individual investors to view stocks of regular C corporations as more attractive relative to stocks of REITs than is the case currently. It is not possible to predict whether the Bush Administration's proposal ultimately will be enacted, the form which it might take, and, if enacted, the effects it may have on the value of our common stock. Loss of Investment Company Act exemption would adversely affect us We intend to conduct our business so as not to become regulated as an investment company under the Investment Company Act. If we fail to qualify for this exemption, our ability to use leverage would be substantially reduced and we would be unable to conduct our business as described in this Form 10-K. The Investment Company Act exempts entities that are primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate. Under the current interpretation of the SEC staff, in order to qualify for this exemption, we must maintain at least 55% of our assets directly in these qualifying real estate interests. Mortgage-backed securities that do not represent all of the certificates issued with respect to an underlying pool of mortgages may be treated as securities separate from the underlying mortgage loans and, thus, may not qualify for purposes of the 55% requirement. Our ownership of these mortgage-backed securities, therefore, is limited by the provisions of the Investment Company Act. In addition, in meeting the 55% requirement under the Investment Company Act, we treat as qualifying interests mortgage-backed securities issued with respect to an underlying pool as to which we hold all issued certificates. If the SEC or its staff adopts a contrary interpretation, we could be required to sell a substantial amount of our mortgage-backed securities, under potentially adverse market conditions. Further, in order to insure that we at all times qualify for the exemption from the Investment Company Act, we may be precluded from acquiring mortgage-backed securities whose yield is somewhat higher than the yield on mortgage-backed securities that could be purchased in a manner consistent with the exemption. The net effect of these factors may be to lower our net income. Issuances of large amounts of our stock could cause our price to decline 23 As of March 21, 2003 we had 84,646,859 shares of our common stock were outstanding. We may issue additional shares of common stock or shares of preferred stock that are convertible into common stock. If we issue a significant number of shares of common stock or convertible preferred 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 may change our policies without stockholder approval Our board of directors and management determine all of our policies, including our investment, financing and distribution policies. Although they have no current plans to do so, they may amend or revise these policies at any time without a vote of our stockholders. Policy changes could adversely affect our financial condition, results of operations, the market price of our common stock or our ability to pay dividends or distributions. Maryland Business Combination Act The Maryland General Corporation Law establishes special requirements for "business combinations" between a Maryland corporation and "interested stockholders" unless exemptions are applicable. An interested stockholder is any person who beneficially owns 10% or more of the voting power of our then-outstanding voting stock. Among other things, the law prohibits for a period of five years a merger and other similar transactions between us and an interested stockholder unless the board of directors approved the transaction prior to the party becoming an interested stockholder. The five-year period runs from the most recent date on which the interested stockholder became an interested stockholder. The law also requires a super majority stockholder vote for such transactions after the end of the five-year period. This means that the transaction must be approved by at least: - 80% of the votes entitled to be cast by holders of outstanding voting shares; and - two-thirds of the votes entitled to be cast by holders of outstanding voting shares other than shares held by the interested stockholder or an affiliate of the interested stockholder with whom the business combination is to be effected. As permitted by the Maryland General Corporation Law, we have elected not to be governed by the Maryland business combination statute. We made this election by opting out of this statute in our articles of incorporation. If, however, we amend our articles of incorporation to opt back in to the statute, the business combination statute could have the effect of discouraging offers to acquire us and of increasing the difficulty of consummating any such offers, even if our acquisition would be in our stockholders' best interests. Maryland Control Share Acquisition Act Maryland law provides that "control shares" of a Maryland corporation acquired in a "control share acquisition" have no voting rights except to the extent approved by a vote of the stockholders. Two-thirds of the shares eligible to vote must vote in favor of granting the "control shares" voting rights. "Control shares" are shares of stock that, taken together with all other shares of stock the acquirer previously acquired, would entitle the acquirer to exercise voting power in electing directors within one of the following ranges of voting power: - One-tenth or more but less than one third of all voting power; - One-third or more but less than a majority of all voting power; or - A majority or more of all voting power. Control shares do not include shares of stock the acquiring person is entitled to vote as a result of having previously obtained stockholder approval. A "control share acquisition" means the acquisition of control shares, subject to certain exceptions. 24 If a person who has made (or proposes to make) a control share acquisition satisfies certain conditions (including agreeing to pay expenses), he may compel our board of directors to call a special meeting of stockholders to consider the voting rights of the shares. If such a person makes no request for a meeting, we have the option to present the question at any stockholders' meeting. If voting rights are not approved at a meeting of stockholders then, subject to certain conditions and limitations, we may redeem any or all of the control shares (except those for which voting rights have previously been approved) for fair value. We will determine the fair value of the shares, without regard to voting rights, as of the date of either: - the last control share acquisition; or - the meeting where stockholders considered and did not approve voting rights of the control shares. If voting rights for control shares are approved at a stockholders' meeting and the acquirer becomes entitled to vote a majority of the shares of stock entitled to vote, all other stockholders may obtain rights as objecting stockholders and, thereunder, exercise appraisal rights. This means that you would be able to force us to redeem your stock for fair value. Under Maryland law, the fair value may not be less than the highest price per share paid in the control share acquisition. Furthermore, certain limitations otherwise applicable to the exercise of dissenters' rights would not apply in the context of a control share acquisition. The control share acquisition statute would not apply to shares acquired in a merger, consolidation or share exchange if we were a party to the transaction. The control share acquisition statute could have the effect of discouraging offers to acquire us and of increasing the difficulty of consummating any such offers, even if our acquisition would be in our stockholders' best interests. 25 ITEM 2. PROPERTIES Our executive and administrative office is located at 1211 Avenue of the Americas, Suite 2902 New York, New York 10036, telephone 212-696-0100. This office is leased under a noncancelable lease expiring December 31, 2009. ITEM 3. LEGAL PROCEEDINGS At December 31, 2002, there were no pending legal proceedings to which we were a party, or to which any of our property was subject. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS We did not submit any matters to a vote of our stockholders during the fourth quarter of 2002. 26 PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS Our common stock began trading publicly on October 8, 1997 and is traded on the New York Stock Exchange under the trading symbol "NLY". As of March 21, 2003, we had 84,646,859 shares of common stock issued and outstanding which were held by approximately 66,568 holders of record. The following table sets forth, for the periods indicated, the high, low, and closing sales prices per share of common stock as reported on the New York Stock Exchange composite tape and the cash dividends declared per share of our common stock.
Stock Prices High Low Close First Quarter ended March 31, 2002 $17.62 $15.30 $16.98 Second Quarter ended June 30, 2002 $21.50 $16.20 $19.40 Third Quarter ended September 30, 2002 $20.40 $14.00 $18.45 Fourth Quarter ended December 31, 2002 $19.95 $15.25 $18.80 High Low Close First Quarter ended March 31, 2001 $11.50 $8.75 $11.26 Second Quarter ended June 30, 2001 $13.76 $10.50 $13.71 Third Quarter ended September 30, 2001 $14.93 $12.70 $14.45 Fourth Quarter ended December 31, 2001 $17.01 $13.20 $16.00 Cash Dividends Declared Per Share First Quarter ended March 31, 2002 $0.63 Second Quarter ended June 30, 2002 $0.68 Third Quarter ended September 30, 2002 $0.68 Fourth Quarter ended December 31, 2002 $0.68 First Quarter ended March 31, 2001 $0.30 Second Quarter ended June 30, 2001 $0.40 Third Quarter ended September 30, 2001 $0.45 Fourth Quarter ended December 31, 2001 $0.60
We intend to pay quarterly dividends and to distribute to our stockholders all or substantially all of our taxable income in each year (subject to certain adjustments). This will enable us to qualify for the tax benefits accorded to a REIT under the Code. We have not established a minimum dividend payment level and our ability to pay dividends may be adversely affected for the reasons described under the caption "Risk Factors." All distributions will be made at the discretion of our board of directors and will depend on our earnings, our financial condition, maintenance of our REIT status and such other factors as our board of directors may deem relevant from time to time. EQUITY COMPENSATION PLAN INFORMATION The Company has adopted a long term stock incentive plan for executive officers, key employees and nonemployee directors (the "Incentive Plan"). The Incentive Plan authorizes the Compensation Committee of 27 the board of directors to grant awards, including incentive stock options as defined under Section 422 of the Code ("ISOs") and options not so qualified ("NQSOs"). The Incentive Plan authorizes the granting of options or other awards for an aggregate of the greater of 500,000 shares or 9.5% of the outstanding shares of the Company's common stock. For a description of the Company's Incentive Plan, see Note 7 to the Financial Statements. The following table provides information as of December 31, 2002, concerning shares of the Company's common stock authorized for issuance under Annaly Mortgage Management, Inc.'s existing Incentive Plan.
Number of securities remaining available for Number of securities to be Weighted-average exercise future issuance under issued upon exercise of price of outstanding Incentive Plan (excluding Plan Category outstanding options options previously issued) ------------------------------------------------------------------------------------------------------------------- Incentive Plan approved by shareholders 512,706 $8.59 7,570,074(1) Incentive Plan not approved by shareholders - - - ---------------------------- ---------------------------- ---------------------------- Total 512,706 $8.59 7,570,074 ============================ ============================ ============================ (1) The Incentive Plan authorizes the granting of options or other awards for an aggregate of the greater of 500,000 or 9.5% of the outstanding shares on a fully diluted basis of the Company's common stock. ((85,081,912*9.5%)-512,706)
28 ITEM 6. SELECTED FINANCIAL DATA The following selected financial data are derived from our audited financial statements for the years ended December 31, 2002, 2001, 2000, 1999 and 1998. The selected financial data should be read in conjunction with the more detailed information contained in the Financial Statements and Notes thereto and "Management's Discussion and Analysis of Financial Condition and Results of Operations" included elsewhere in this Form 10-K.
SELECTED FINANCIAL DATA (dollars in thousands, except for per share data) For the Year For the Year For the Year For the Year For the Year Ended Ended Ended Ended Ended December 31, December 31, December 31, December 31, December 31, 2002 2001 2000 1999 1998 ----------------------------------------------------------------------- Statement of Operations Data: Interest income $404,165 $263,058 $109,750 $89,812 $89,986 Interest expense 191,758 168,055 92,902 69,846 75,735 ----------------------------------------------------------------------- Net interest income $212,407 $95,003 $16,848 $19,966 $14,251 Gain on sale of mortgage-backed securities 21,063 4,586 2,025 454 3,344 General and administrative expenses (G&A expense) 13,963 7,311 2,286 2,281 2,106 ----------------------------------------------------------------------- Net income $219,507 $92,278 $16,587 $18,139 $15,489 ======================================================================= Basic net income per average share $2.68 $2.23 $1.18 $1.41 $1.22 Diluted net income per average share $2.67 $2.21 $1.15 $1.35 $1.19 Dividends declared per share $2.67 $1.75 $1.15 $1.38 $1.21 December 31, December 31 December 31, December 31, December 31, Balance Sheet Data: 2002 2001 2000 1999 1998 ----------------------------------------------------------------------- Mortgage-Backed Securities, net $11,551,857 $7,575,379 $1,978,219 $1,437,793 $1,520,289 Total assets 11,659,084 7,717,314 2,035,029 1,491,322 1,527,352 Repurchase agreements 10,163,174 6,367,710 1,628,359 1,338,296 1,280,510 Total liabilities 10,579,018 7,049,957 1,899,386 1,388,050 1,401,481 Stockholders' equity 1,080,066 667,357 135,642 103,272 125,871 Number of common shares outstanding 84,569,206 59,826,975 14,522,978 13,581,316 12,648,424 Other Data: Average total assets $10,486,423 $5,082,852 $1,652,459 $1,473,765 $1,499,875 Average earning assets 9,575,365 4,682,780 1,564,491 1,461,254 1,461,791 Average borrowings 9,128,933 4,388,900 1,449,999 1,350,230 1,360,040 Average equity 978,107 437,376 117,727 117,685 131,265 Yield on interest earning assets 4.22% 5.62% 7.02% 6.15% 6.16% Cost of funds on interest bearing liabilities 2.10% 3.83% 6.41% 5.17% 5.57% Interest rate spread 2.12% 1.79% 0.61% 0.98% 0.59% Annualized Financial Ratios: Net interest margin (net interest Income/average total assets) 2.03% 1.87% 1.02% 1.35% 0.95% G&A expense as a percentage of average assets 0.13% 0.14% 0.14% 0.15% 0.14% G&A expense as a percentage of average equity 1.43% 1.67% 1.94% 1.94% 1.60% Return on average assets 2.09% 1.82% 1.00% 1.23% 1.03% Return on average equity 22.44% 21.10% 14.09% 15.41% 11.80%
29 ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS Special Note Regarding Forward-Looking Statements Certain statements contained in this annual report, and certain statements contained in our future filings with the Securities and Exchange Commission (the "SEC" or the "Commission"), in our press releases or in our other public or shareholder communications may not be, based on historical facts and are "forward-looking statements" within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements which are based on various assumptions, (some of which are beyond our control) may be identified by reference to a future period or periods, or by the use of forward-looking terminology, such as "may," "will," "believe," "expect," "anticipate," "continue," or similar terms or variations on those terms, or the negative of those terms. Actual results could differ materially from those set forth in forward-looking statements due to a variety of factors, including, but not limited to, changes in interest rates, changes in yield curve, changes in prepayment rates, the availability of mortgage backed securities for purchase, the availability of financing and, if available, the terms of any financing. For a discussion of the risks and uncertainties that could cause actual results to differ from those contained in the forward-looking statements, see "Risk Factors." We do not undertake, and specifically disclaim any obligation, to publicly release the result of any revisions that may be made to any forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements. Overview We are a real estate investment trust that owns and manages a portfolio of mortgage-backed securities. Our principal business objective is to generate net income for distribution to our stockholders from the spread between the interest income on our mortgage-backed securities and the costs of borrowing to finance our acquisition of mortgage-backed securities. Critical Accounting Policies Management's discussion and analysis of financial condition and results of operations is based on the amounts reported in our financial statements. These financial statements are prepared in accordance with accounting principles generally accepted in the United States of America. In preparing the financial statements, management is required to make various judgments, estimates and assumptions that affect the reported amounts. Changes in these estimates and assumptions could have a material effect on our financial statements. The following is a summary of our policies that is the most affected by management's judgments, estimates and assumptions. Market Valuation of Securities: All assets classified as available-for-sale are reported at fair value, based on market prices. Our policy is to obtain market values from three independent sources and record the market value of the securities based on the average of the three. Amortization of premiums and accretion of discounts: Premiums and discounts associated with the purchase of the Mortgage-Backed Securities are amortized into interest income over the lives of the securities using the interest method. Our policy for estimating prepayment speeds for calculating the effective yield is to evaluate historical performance, street consensus prepayment speeds, and current market conditions. Results of Operations Net Income Summary For the year ended December 31, 2002, our net income was $219.5 million or $2.68 basic earnings per average share, as compared to $92.3 million or $2.23 30 basic earnings per average share for the year ended December 31, 2001. For the year ended December 31, 2000, our net income was $16.6 million, or $1.18 basic earnings per average share. Net income per average share increased by $0.45 and total net income increased by $127.2 million. The increase in 2002 net income over 2001 is attributable to our acquisition of additional mortgage-backed securities using proceeds raised from our January 2002 public offering and Equity Shelf Program during the year and the increase in the interest rate spread between our interest-earning assets and our interest-bearing liabilities. The same is true for the increase in net income for the year 2001, when compared to the year 2000. We consummated three public offerings in the year 2001 and the interest rate spread increased. We compute our net income per share by dividing net income by the weighted average number of shares of outstanding common stock during the period, which was 82,044,141 for the year ended December 31, 2002, 41,439,631 for the year ended December 31, 2001, and 14,089,436 for the year ended December 31, 2000. Dividends per share for the year ended December 31, 2002 were $2.67, or an aggregate of $223.6 million. Dividends per share for the year ended December 31, 2001 were $1.75 per share, or $88.4 million in total. Dividends per share for the year ended December 31, 2000 were $1.15 per share, or $16.3 million in total. Our return on average equity was 22.44% for the year ended December 31, 2002, 21.10% for the year ended December 31, 2001, and 14.09% for the year ended December 31, 2000. The increase in return on equity in 2002 compared to 2001 is primarily due to the favorable interest rate environment. The table below presents the net income summary for the years ended December 31, 2002, 2001, 2000, 1999, and 1998. 31
Net Income Summary (dollars in the thousands, except for per share data) Year Ended Year Ended Year Ended Year Ended Year Ended December 31, December 31, December December 31, December 31, 2002 2001 31, 2000 1999 1998 -------------- --------------- ------------- -------------- -------------- Interest Income $404,165 $263,058 $109,750 $89,812 $89,986 Interest Expense 191,758 168,055 92,902 69,846 75,735 -------------- --------------- ------------- -------------- -------------- Net Interest Income $212,407 $95,003 $16,802 $19,966 $14,251 Gain on Sale of Mortgage-Backed Securities 21,063 4,586 2,025 454 3,344 General and Administrative Expenses 13,963 7,311 2,286 2,281 2,106 -------------- --------------- ------------- -------------- -------------- Net Income $219,507 $92,278 $16,587 $18,139 $15,489 ============== =============== ============= ============== ============== Average Number of Basic Shares Outstanding 82,044,141 41,439,631 14,089,436 12,889,510 12,709,116 Average Number of Diluted Shares Outstanding 82,282,883 41,857,498 14,377,459 13,454,007 13,020,648 Basic Net Income Per Share $2.68 $2.23 $1.18 $1.41 $1.22 Diluted Net Income Per Share $2.67 $2.21 $1.15 $1.35 $1.19 Average Total Assets $10,486,423 $5,082,852 $1,652,459 $1,473,765 $1,499,875 Average Equity 978,107 437,376 117,727 117,685 131,265 Annualized Return on Average Assets 1.43% 1.82% 1.00% 1.23% 1.03% Annualized Return on Average Equity 22.44% 21.10% 14.09% 15.41% 11.80%
Interest Income and Average Earning Asset Yield We had average earning assets of $9.6 billion for the year ended December 31, 2002. We had average earning assets of $4.7 billion for the year ended December 31, 2001. We had average earning assets of $1.6 billion for the year ended December 31, 2000. Our primary source of income for the years ended December 31, 2002, 2001, and 2000 was interest income. A portion of our income was generated by gains on the sales of our mortgage-backed securities. Our interest income was $404.2 million for the year ended December 31, 2002, $263.1 million for the year ended December 31, 2001, and $109.8 million for the year ended December 31, 2000. Our yield on average earning assets was 4.22%, 5.62%, and 7.02% for the same respective periods. Our yield on average earning assets decreased by 1.40% and our average earning asset balance increased by $4.9 billion for the year ended December 31, 2002, when compared to the prior year. Due to the increase in the asset base resulting from the inflow of capital from our public offering and Equity Shelf Program during the year ended December 31, 2002, interest income increased by $141.1 million. Our yield on average earning assets decreased by 1.40% and our average earning asset balance increased by $3.1 billion for the year ended December 31, 2001, when compared to the prior year. Due to the increase in assets resulting from the three public offerings during the year ended December 31, 2001, interest income increased by $153.3 million. The table below shows our average balance of cash equivalents and mortgage-backed securities, the yields we earned on each type of earning assets, our yield on average earning assets and our interest income for the years ended December 31, 2002, 2001, 2000, and 1999, and 1998 the four quarters in 2002.
Average Earning Asset Yield (ratios for the four quarters in 2002 are annualized) Yield on Average Yield on Average Yield on Average Mortgage- Average Average Mortgage- Average Cash Backed Earning Cash Backed Earning Interest Equivalents Securities Assets Equivalents Securities Assets Income ----------- ---------- ------- ----------- ---------- ------- ------- (dollars in thousands) For the Year Ended December 31, 2002 $2 $9,575,365 $9,575,367 1.14% 4.22% 4.22% $404,165 For the Year Ended December 31, 2001 $2 $4,682,778 $4,682,780 3.25% 5.62% 5.62% $263,058
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Average Yield on Average Yield on Average Mortgage- Average Average Mortgage- Average Cash Backed Earning Cash Backed Earning Interest Equivalents Securities Assets Equivalents Securities Assets Income ----------- ---------- ------- ----------- ---------- ------- ------- (dollars in thousands) For the Year Ended December 31, 2000 $263 $1,564,228 $1,564,491 4.18% 7.02% 7.02% $109,750 For the Year Ended December 31, 1999 $221 $1,461,033 $1,461,254 4.10% 6.15% 6.15% $89,812 For the Year Ended December 31, 1998 $2 $1,461,789 $1,461,791 4.32% 6.16% 6.16% $89,986 ---------------------------------------------------------------------------------------------------------------------------- For the Quarter Ended December 31, 2002 $2 $10,400,894 $10,400,896 0.88% 3.56% 3.56% $92,641 For the Quarter Ended September 30, $2 $10,661,228 $10,661,230 1.14% 4.10% 4.10% $109,201 2002 For the Quarter Ended June 30, 2002 $2 $9,629,332 $9,629,334 1.23% 4.55% 4.55% $109,423 For the Quarter Ended March 31, 2002 $2 $7,610,006 $7,610,008 1.29% 4.88% 4.88% $92,900
The constant prepayment rate ("CPR") on our mortgage-backed securities for the year ended December 31, 2002 was 33%, for the year ended December 31, 2001 was 26%, and for the year ended December 31, 2000 was 11%. CPR is an assumed rate of prepayment for our mortgage-backed securities, expressed as an annual rate of prepayment relative to the outstanding principal balance of our mortgage-backed securities. CPR does not purport to be either a historical description of the prepayment experience of our mortgage-backed securities or a prediction of the anticipated rate of prepayment of our mortgage-backed securities. Principal prepayments had a negative effect on our earning asset yield for the years ended December 31, 2002, 2001, and 2000 because we adjust our rates of premium amortization and discount accretion monthly based upon the effective yield method, which takes into consideration changes in prepayment speeds. Interest Expense and the Cost of Funds Our largest expense is the cost of borrowed funds, primarily through repurchase agreements. We had average borrowed funds of $9.1 billion for the year ended December 31, 2002, $4.4 billion for the year ended December 31, 2001, and $1.4 billion for the year ended December 31, 2000. Interest expense totaled $191.8 million, $168.1 million, and $92.9 million for the years ended December 31, 2002, 2001, and 2000, respectively. Our average cost of funds was 2.10% for the year ended December 31, 2002, 3.83% for the year ended December 31, 2001, and 6.41% for the year ended December 31, 2000. The cost of funds rate decreased by 1.73% and the average borrowed funds increased by $4.7 billion for the year ended December 31, 2002. Interest expense for the year ended December 31, 2002 increased $23.7 million, from $168.1 million to $191.8 million. We increased our asset base by raising approximately $379.5 million of additional capital in 2002. As a result, we increased the amounts borrowed under repurchase agreements. Consequently, the increased interest expense for the year 2002 is the result of our growth. The cost of funds rate decreased by 2.58% and the average borrowed funds increased by $3.0 billion for the year ended December 31, 2001. Interest expense for the year ended December 31, 2001 increased $75.2 million. We increased our asset base by raising approximately $474.2 million of additional capital in 2001. Consequently, the increased interest expense for the year 2001 is the result of our growth. Changes in our short-term cost of funds are expected to be closely correlated with changes in short-term LIBOR, although we have chosen to extend the maturity on a portion of our liabilities to three years. Our average cost of funds was 0.33% greater than average one-month LIBOR for the year ended December 31, 2002, and 0.22% greater than average six-month LIBOR. Our average cost of funds was 0.05% less than average one-month LIBOR for the year ended December 31, 2001, and 0.10% greater than average six-month LIBOR. Our average cost of funds was equal to average one-month LIBOR for the year ended December 31, 2000, and 0.25% less than average six-month LIBOR. During the year ended December 31, 2002, average one-month LIBOR, which was 1.77%, was 0.11% less than average six-month LIBOR, which was 1.88%. During the year ended December 31, 2001, average one-month LIBOR, which was 3.88%, was 0.15% greater than average six-month LIBOR, which was 3.73%. During the year ended December 31, 2000, average one-month LIBOR, which was 6.41%, was 0.25% lower than average six-month LIBOR, which was 6.66%. The table below shows our average borrowed funds and average cost of funds as compared to average one-month and average six-month 33 LIBOR for the years ended December 31, 2002, 2001, 2000, 1999, 1998, and the four quarters in 2002.
Average Cost of Funds (Ratios for the four quarters in 2002 have been annualized) Average One-Month Average Cost Average Cost LIBOR of Funds of Funds Relative to Relative to Relative to Average Average Average Average Average Average Average Borrowed Interest Cost of One-Month Six-Month Six-Month One-Month Six-Month Funds Expense Funds LIBOR LIBOR LIBOR LIBOR LIBOR --------- -------- -------- -------- -------- ---------- ------------- ------------ (dollars in thousands) For the Year Ended December 31, 2002 $9,128,933 $191,758 2.10% 1.77% 1.88% (0.11%) 0.33% 0.22% For the Year Ended December 31, 2001 $4,388,900 $168,055 3.83% 3.88% 3.73% 0.15% (0.05%) 0.10% For the Year Ended December 31, 2000 $1,449,999 $92,902 6.41% 6.41% 6.66% (0.25%) - (0.25%) For the Year Ended December 31, 1999 $1,350,230 $69,846 5.17% 5.25% 5.53% (0.28%) (0.08%) (0.36%) For the Year Ended December 31, 1998 $1,360,040 $75,735 5.57% 5.57% 5.54% 0.03% - 0.03% ------------------------------------------------------------------------------------------------------------------------ For the Quarter Ended December 31, 2002 $10,097,676 $49,874 1.98% 1.57% 1.55% 0.02% 0.41% 0.43% For the Quarter Ended September 30, 2002 $10,122,840 $54,012 2.13% 1.82% 1.82% - 0.31% 0.31% For the Quarter Ended June 30, 2002 $9,102,992 $47,860 2.10% 1.85% 2.11% (0.26%) 0.25% (0.01%) For the Quarter Ended March 31, 2002 $7,192,222 $40,012 2.23% 1.85% 2.06% (0.21%) 0.38% 0.17%
Net Interest Income Our net interest income, which equals interest income less interest expense, totaled $212.4 million for the year ended December 31, 2002, $95.0 million for the year ended December 31, 2001, $16.8 million for the year ended December 31, 2000. Our net interest spread, which equals the yield on our average assets for the period less the average cost of funds for the period, was 2.12% for the year ended December 31, 2002, which is a 0.33% increase over the prior year. The net interest spread for the year ended December 31, 2001 was 1.79%, as compared to 0.61% for the year ended December 31, 2000. Our net interest income increased by $117.4 million for the year ended December 31, 2002 over the prior year. The increase in our balance sheet which resulted from our raising additional capital in 2002, along with the 0.33% increase in the interest rate spread. The substantial increase in our balance sheet in 2001 which resulted from our raising additional capital in that year, along with the 1.18% increase in the interest rate spread, caused the $78.2 million increase in net interest income. Net interest margin, which equals net interest income divided by average interest earning assets, was 2.03% for the year ended December 31, 2002, 1.87% for the year ended December 31, 2001, and 1.02% for the year ended December 31, 2000. The principal reason that net interest margin exceeded net interest spread is that average interest earning assets exceeded average interest bearing liabilities. A portion of our assets is funded with equity rather than borrowings. The table below shows our interest income by earning asset type, average earning assets by type, total interest income, interest expense, average repurchase agreements, average cost of funds, and net interest income for the years ended December 31, 2002, 2001, 2000, 1999, 1998, and the four quarters in 2002.
Net Interest Income (Ratios for the four quarters in 2002 have been annualized) Yield on Average Interest Average Average Mortgage Income on Average Total Interest Balance of Average Net -Backed Mortgage Cash Interest Earning Repurchase Interest Cost of Interest Securities -Backed Equivalents Income Assets Agreements Expense Funds Income Held Securities ------------ ---------- ----------- -------- -------- ----------- --------- ------- -------- (dollars in the thousands) For the Year Ended December 31, 2002 $9,575,365 $404,165 $2 $404,165 4.22% $9,128,933 $191,758 2.10% $212,407 For the Year Ended December 31, 2001 $4,682,778 $263,058 $2 $263,058 5.62% $4,388,900 $168,055 3.83% $95,003 For the Year Ended December 31, 2000 $1,564,228 $109,739 $263 $109,750 7.02% $1,449,999 $92,902 6.41% $16,848 For the Year Ended December 31, 1999 $1,461,033 $89,801 $221 $89,812 6.15% $1,350,230 $69,846 5.17% $19,966 For the Year Ended December 31, 1998 $1,461,789 $89,986 $2 $89,986 6.16% $1,360,040 $75,735 5.57% $14,251 ---------------------------------------------------------------------------------------------------------------------- For the Quarter Ended December 31, 2002 $10,400,894 $92,641 $2 $92,641 3.56% $10,097,676 $49,874 1.98% $42,767 For the Quarter Ended $10,661,228 $109,201 $2 $109,201 4.10% $10,122,840 $54,012 2.13% $55,189 September 30, 2002 For the Quarter Ended $9,629,332 $109,423 $2 $109,423 4.55% $9,102,992 $47,860 2.10% $61,563 June 30, 2002 For the Quarter Ended $7,610,006 $92,900 $2 $92,900 4.88% $7,192,222 $40,012 2.23% $52,888 March 31, 2002
Gains and Losses on Sales of Mortgage-Backed Securities For the year ended December 31, 2002, we sold mortgage-backed securities with an aggregate historical amortized cost of $2.1 billion for an aggregate gain of $21.1 million. For the year ended December 31, 2001, we sold mortgage-backed securities with an aggregate historical amortized cost of $1.2 billion for an aggregate gain of $4.6 million. For the year ended December 31, 2000, we sold mortgage-backed securities with an aggregate historical amortized cost of $487.8 million for an aggregate gain of $2.0 million. The gain on sale of assets for the year ended December 31, 2002 increased by $16.5 million over the prior year. We were able to take advantage to the appreciation in our portfolio, while maintaining a book value of $12.77. The gain on sale of assets for the year ended December 31, 2001 increased by $2.6 million over the prior year. Even though the gain for the year 2001 increased over the prior year, as a percentage of total income it declined. We do not expect to sell assets on a frequent basis, but may from time to time sell existing assets to move into new assets, which our management believes might have higher risk-adjusted returns, or to manage our balance sheet as part of our asset/liability management strategy. Credit Losses We have not experienced credit losses on our mortgage-backed securities to date. We have limited our exposure to credit losses on our mortgage-backed securities by purchasing only securities, issued or guaranteed by Federal Home Loan Mortgage Corporation, the Federal National Mortgage Association, or the Government National Mortgage Association, which, although not rated, carry an implied "AAA" rating. Under our capital investment policy, however, up to 25% of our securities could be rated "BBB" or better or if unrated, securities we deem to be of a quality "BBB" or better. General and Administrative Expenses General and administrative expenses ("G&A") were $14.0 million for the year ended December 31, 2002, $7.3 million for the year ended December 31, 2001, and $2.3 million for the year ended December 31, 2000. G&A expenses as a percentage of average assets was 0.13%, 0.14%, and 0.14% for the years ended December 31, 2002, 2001, and 2000, respectively. G&A expense has increase proportionately with our increased capital base. Increases in salaries were the primary reason for the overall increase in G&A. The staff increased to 15 employees by the end of 2002 from 10 employees at the end of 2001. In 2002, we paid aggregate salaries and bonuses of $10.8 million compared to $4.7 million in 2001. G&A expenses in total were materially unchanged for the years ended December 31, 2001, and 2000. The table below shows our total 35 G&A expenses as compared to average assets and average equity for the years ended December 31, 2002, 2001, 2000, 1999, 1998, and the four quarters in 2002.
G&A Expenses and Operating Expense Ratios (Ratios for the four quarters in 2002 have been annualized) Total G&A Total G&A Total G&A Expenses/Average Expenses/Average Expenses Assets Equity (dollars in the thousands) For the Year Ended December 31, 2002 $13,963 0.13% 1.43% For the Year Ended December 31, 2001 $7,311 0.14% 1.67% For the Year Ended December 31, 2000 $2,286 0.14% 1.94% For the Year Ended December 31, 1999 $2,281 0.15% 1.94% For the Year Ended December 31, 1998 $2,106 0.14% 1.60% ---------------------------- ---------------- ----------------- ------------------- For the Quarter Ended December 31, 2002 $3,904 0.13% 1.44% For the Quarter Ended September 30, 2002 $3,268 0.12% 1.22% For the Quarter Ended June 30, 2002 $3,536 0.13% 1.37% For the Quarter Ended March 31, 2002 $3,255 0.14% 1.55%
Net Income and Return on Average Equity Our net income was $219.5 million for the year ended December 31, 2002, $92.3 million for the year ended December 31, 2001, and $16.6 million for the year ended December 31, 2000. Our return on average equity was 22.44% for the year ended December 31, 2002, 21.1% for the year ended December 31, 2001, and 14.1% for the year ended December 31, 2000. Net income increased by $127.2 million in the year 2002 over the previous year, due to the increased asset base and the increase in the average interest rate spread. The increase in net income for the year ended December 2001, as compared to the year ended December 31, 2000, is a direct result of growth in our balance sheet following our three public offerings in 2001, as well as the favorable interest rate environment during the year 2001. We were able to take advantage of appreciation in asset value in 2001. The gain on sale of securities increased by $2.6 million for the year ended December 31, 2001, as compared to the prior year. The table below shows our net interest income, gain on sale of mortgage-backed securities and G&A expenses each as a percentage of average equity, and the return on average equity for the years ended December 31, 2002, 2001, 2000, 1999, and 1998, and for the four quarters in 2002.
Components of Return on Average Equity (Ratios for the four quarters in 2002 have been annualized) Gain on Sale of Net Interest Mortgage-Backed G&A Return on Income/Average Securities/Average Expenses/Average Average Equity Equity Equity Equity For the Year Ended December 31, 2002 21.72% 2.15% 1.43% 22.44% For the Year Ended December 31, 2001 21.72% 1.05% 1.67% 21.10% For the Year Ended December 31, 2000 14.31% 1.72% 1.94% 14.09% For the Year Ended December 31, 1999 16.97% 0.38% 1.94% 15.41%
36 For the Year Ended December 31, 1998 10.85% 2.55% 1.60% 11.80% ------------------------------------------------------------------------------------------------------- For the Quarter Ended December 31, 2002 15.80% 4.27% 1.44% 18.63% For the Quarter Ended September 30, 2002 20.68% 1.78% 1.22% 21.24% For the Quarter Ended June 30, 2002 23.93% 0.52% 1.37% 23.08% For the Quarter Ended March 31, 2002 25.24% 1.63% 1.55% 25.32% Financial Condition
Mortgage-Backed Securities All of our mortgage-backed securities at December 31, 2002, 2001, and 2000 were adjustable-rate or fixed-rate mortgage-backed securities backed by single-family mortgage loans. All of the mortgage assets underlying these mortgage-backed securities were secured with a first lien position on the underlying single-family properties. All our mortgage-backed securities were FHLMC, FNMA or GNMA mortgage pass-through certificates or CMOs, which carry an implied "AAA" rating. We mark-to-market all of our earning assets at liquidation value. We accrete discount balances as an increase in interest income over the life of discount mortgage-backed securities and we amortize premium balances as a decrease in interest income over the life of premium mortgage-backed securities. At December 31, 2002, 2001, and 2000, we had on our balance sheet a total of $664,000, $2.1 million, and $989,000, respectively, of unamortized discount (which is the difference between the remaining principal value and current historical amortized cost of our mortgage-backed securities acquired at a price below principal value) and a total of $274.6 million, $139.4 million, and $24.3 million, respectively, of unamortized premium (which is the difference between the remaining principal value and the current historical amortized cost of our mortgage-backed securities acquired at a price above principal value). We received mortgage principal repayments of $4.7 billion for the year ended December 31, 2002, $1.7 billion for the year ended December 31, 2001, and $168.5 million for the year ended December 31, 2000. The overall prepayment speed for the year ended December 31, 2002, 2001, 2000 was 33%, 27%, and 11%, respectively. During the quarter ended December 31, 2002, the prepayment speeds were the highest in our history at 43%. The result was record returns of principal for the year, relative to the asset size. The increase in prepayments in 2001 from 2000 was primarily because we acquired more mortgage-backed securities following our three public offerings. Given our current portfolio composition, if mortgage principal prepayment rates were to increase over the life of our mortgage-backed securities, all other factors being equal, our net interest income would decrease during the life of these mortgage-backed securities as we would be required to amortize our net premium balance into income over a shorter time period. Similarly, if mortgage principal prepayment rates were to decrease over the life of our mortgage-backed securities, all other factors being equal, our net interest income would increase during the life of these mortgage-backed securities as we would amortize our net premium balance over a longer time period. The table below summarizes certain characteristics of our mortgage-backed securities at December 31, 2002, 2001, 2000, 1999, and 1998, September 30, 2002, June 30, 2002, and March 31, 2002.
Mortgage-Backed Securities Estimated Amortized Fair Weighted Net Amortized Cost/Principal Estimated Value/PrincipaAverage Principal Value Premium Cost Value Fair Value Value l Yield (dollars in thousands) At December 31, 2002 $11,202,384 $273,963 $11,476,347 102.45% $11,551,857 103.12% 3.25% At December 31, 2001 $7,399,941 $137,269 $7,537,210 101.86% $7,575,379 102.37% 4.41% At December 31, 2000 $1,967,967 $23,296 $1,991,263 101.18% $1,978,219 100.52% 7.09% At December 31, 1999 $1,452,917 $22,444 $1,475,361 101.54% $1,437,793 98.96% 6.77% At December 31, 1998 $1,502,414 $24,278 $1,526,692 101.62% $1,520,289 101.19% 6.43% ----------------------------------------------------------------------------------------------------------------------- At September 30, 2002 $11,170,379 $244,777 $11,415,156 102.19% $11,489,538 102.86% 3.67%
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At June 30, 2002 $10,833,374 $224,114 $11,057,488 102.07% $11,124,771 102.69% 3.90% At March 31, 2002 $9,982,678 $193,048 $10,175,726 101.93% $10,206,228 102.24% 4.31%
The tables below set forth certain characteristics of our mortgage-backed securities. The index level for adjustable-rate mortgage-backed securities is the weighted average rate of the various short-term interest rate indices, which determine the coupon rate.
Adjustable-Rate Mortgage-Backed Security Characteristics Principal Value at Weighted Period End Weighted Weighted Average Weighted Weighted as % of Average Average Weighted Term to Average Average Total Principal Coupon Index Average Net Next Lifetime Asset Mortgage-Backed Value Rate Level Margin Adjustment Cap Yield Securities (dollars in thousands) At December 31, 2002 $7,007,062 4.10% 2.51% 1.59% 11 months 10.37% 2.33% 62.55% At December 31, 2001 $5,793,250 5.90% 3.95% 1.95% 24 months 11.49% 3.87% 78.29% At December 31, 2000 $1,454,356 7.61% 5.76% 1.85% 15 months 11.47% 7.24% 73.90% At December 31, 1999 $951,839 7.33% 5.84% 1.49% 11 months 10.30% 7.64% 65.51% At December 31, 1998 $1,030,654 6.84% 5.18% 1.66% 12 months 10.63% 6.42% 68.60% ------------------------------------------------------------------------------------------------------------------------ At September 30, 2002 $7,583,147 4.37% 2.80% 1.57% 10 months 10.36% 2.90% 67.89% At June 30, 2002 $7,939,126 4.57% 2.96% 1.61% 12 months 10.46% 3.17% 73.28% At March 31, 2002 $7,248,832 4.94% 3.25% 1.69% 16 months 10.73% 3.52% 72.61% -------------------------------------------------------------------------------------------------------------------------
Fixed-Rate Mortgage-Backed Security Characteristics Principal Value Weighted Weighted as % of Total Principal Average Coupon Average Mortgage-Backed Value Rate Asset Yield Securities (dollars in thousands) At December 31, 2002 $4,195,322 6.76% 4.78% 37.45% At December 31, 2001 $1,606,691 6.92% 6.33% 21.71% At December 31, 2000 $513,611 6.62% 6.68% 26.10% At December 31, 1999 $501,078 6.58% 7.01% 34.49% At December 31, 1998 $471,760 6.55% 6.47% 31.40% -------------------------- -------------- ---------------- -------------- ------------------ At September 30, 2002 $3,587,232 6.95% 5.29% 32.11% At June 30, 2002 $2,894,248 7.09% 5.91% 26.72% At March 31, 2002 $2,733,846 7.01% 6.40% 27.39%
At December 31, 2002 we held mortgage-backed securities with coupons linked to the one-year, two-year, three-year, and five-year Treasury indices, one-month and one-year LIBOR, six-month Auction Average, twelve-month moving average and the six-month CD rate. At December 31, 2001 we held mortgage-backed securities with coupons linked to the one-year, three-year, and five-year Treasury indices, one-month and six-month LIBOR, six-month Auction Average, twelve-month moving average and the six-month CD rate. 38
Adjustable-Rate Mortgage-Backed Securities by Index December 31, 2002 Six-Month 12-Month 2-Year ---------- Auction Moving 1-Year Treasury 3-Year 5-Year One-Month One-Year Average Average Six-Month Treasury Index Treasury Treasury LIBOR LIBOR CD Rate Index Index Index Weighted Average Adjustment Frequency 1mo. 12 mo. 6 mo. 1 mo. 6 mo. 12 mo. 24 mo. 36 mo. 60 mo. Weighted Average Term to Next Adjustment 1mo. 41 mo. 2 mo. 1 mo. 2 mo. 22 mo. 10 mo. 20 mo. 31 mo. Weighted Average Annual Period Cap None 2.00% 2.00% None 1.00% 1.93% 2.00% 2.00% 2.00% Weighted Average Lifetime Cap at December 31, 2002 9.01% 11.31% 13.00% 10.37% 11.60% 11.83% 11.93% 12.83% 12.57% Mortgage Principal Value as Percentage of Mortgage- Backed Securities at December 31, 2002 32.43% 0.33% 0.03% 0.58% 0.14% 27.67% 0.03% 0.92% 0.42%
Adjustable-Rate Mortgage-Backed Securities by Index December 31, 2001 Six-Month 12-Month ---------- Auction Moving 1-Year 3-Year 5-Year One-Month Six-Month Average Average Six-Month Treasury Treasury Treasury LIBOR LIBOR CD Rate Index Index Index ----------- ----------- Weighted Average Adjustment Frequency 1mo. 6 mo. 6 mo. 12 mo. 6 mo. 12 mo. 36 mo. 60 mo. Weighted Average Term to Next Adjustment 1mo. 55 mo. 2 mo. 11 mo. 2 mo. 33 mo. 16 mo. 33 mo. Weighted Average Annual Period Cap None 2.00% 0.50% None 1.00% 1.98% 2.00% 1.96% Weighted Average Lifetime Cap at December 31, 2001 9.09% 11.50% 12.53% 10.63% 11.40% 12.22% 13.08% 12.92% Mortgage Principal Value as Percentage of Mortgage- Backed Securities at December 31, 2001 18.32% 0.13% 0.12% 1.06% 0.22% 56.20% 1.35% 0.89%
Adjustable-Rate Mortgage-Backed Securities by Index December 31, 2000 3-Year One-Month Six-Month 1-Year Treasury 5-Year LIBOR CD Rate Treasury Index Index Treasury Index Weighted Average Adjustment Frequency 1 mo. 6 mo. 12 mo. 36 mo. 60 mo. Weighted Average Term to Next Adjustment 1 mo. 2 mo. 23 mo. 20 mo. 40 mo. Weighted Average Annual Period Cap None 1.00% 1.98% 2.00% 1.76% Weighted Average Lifetime Cap at December 31, 2000 9.11% 11.37% 12.61% 13.24% 12.42% Mortgage Principal Value as Percentage of Mortgage-Backed Securities at December 31, 2000 24.08% 1.21% 44.52% 2.97% 1.12%
39 Borrowings To date, our debt has consisted entirely of borrowings collateralized by a pledge of our mortgage-backed securities. These borrowings appear on our balance sheet as repurchase agreements. At December 31, 2002, we had established uncommitted borrowing facilities in this market with 25 lenders in amounts, which we believe, are in excess of our needs. We believe that we have used approximately 57% of our uncommitted borrowing line. All of our mortgage-backed securities are currently accepted as collateral for these borrowings. However, we limit our borrowings, and thus our potential asset growth, in order to maintain unused borrowing capacity and thus increase the liquidity and strength of our balance sheet. At December 31, 2002, we had collateral in excess of the required haircut on our repurchase agreements in the amount of $677.7 million. For the year ended December 31, 2002, the term to maturity of our borrowings ranged from one day to three years, with a weighted average original term to maturity of 166 days at December 31, 2002. For the years ended December 31, 2001 and 2000, the term to maturity of our borrowings ranged from one day to three years, with a weighted average original term to maturity of 119 days at December 31, 2001, and 56 days at December 31, 2000. At December 31, 2002, the weighted average cost of funds for all of our borrowings was 1.72% and the weighted average term to next rate adjustment was 124 days. At December 31, 2001, the weighted average cost of funds for all of our borrowings was 2.18% and the weighted average term to next rate adjustment was 85 days. At December 31, 2000, the weighted average cost of funds for all of our borrowings was 6.55% and the weighted average term to next rate adjustment was 29 days. At December 31, 2001, the weighted average original term increased because of the use of three year repurchase agreements. Liquidity Liquidity, which is our ability to turn non-cash assets into cash, allows us to purchase additional mortgage-backed securities and to pledge additional assets to secure existing borrowings should the value of our pledged assets decline. Potential immediate sources of liquidity for us include cash balances and unused borrowing capacity. Unused borrowing capacity will vary over time as the market value of our mortgage-backed securities varies. Our balance sheet also generates liquidity on an on-going basis through mortgage principal repayments and net earnings held prior to payment as dividends. Should our needs ever exceed these on-going sources of liquidity plus the immediate sources of liquidity discussed above, we believe that our mortgage-backed securities could in most circumstances be sold to raise cash. The maintenance of liquidity is one of the goals of our capital investment policy. Under this policy, we limit asset growth in order to preserve unused borrowing capacity for liquidity management purposes. Stockholders' Equity We use "available-for-sale" treatment for our mortgage-backed securities; we carry these assets on our balance sheet at estimated market value rather than historical amortized cost. Based upon this "available-for-sale" treatment, our equity base at December 31, 2002 was $1.1 billion, or $12.77 per share. If we had used historical amortized cost accounting, our equity base at December 31, 2002 would have been $1.0 billion, or $11.88 per share. Our equity base at December 31, 2001 was $667.4 million, or $11.15 per share. If we had used historical amortized cost accounting, our equity base at December 31, 2001 would have been $629.2 million, or $10.52 per share. Our equity base at December 31, 2000 was $135.6 million, or $9.34 per share. If we had used historical amortized cost accounting, our equity base at December 31, 2000 would have been $148.6 million, or $10.24 per share. Through the Equity Shelf Program, in which we sell shares from time-to-time at market prices, we raised approximately $28.1 million in net proceeds and issued 1,484,100 shares during 2002. Also in 2002, 165,480 shares were purchased through our dividend reinvestment and share purchase plan, totaling approximately $3.0 million. We also completed an offering of common stock in the first quarter issuing 23,000,000 shares, with aggregate net proceeds of approximately $347.4 million. We completed three public offerings during the year ended December 31, 2001 in which we issued a total of 45,060,100 shares of common stock, and received aggregate net proceeds of approximately $474.2 million. 40 With our "available-for-sale" accounting treatment, unrealized fluctuations in market values of assets do not impact our GAAP or taxable income but rather are reflected on our balance sheet by changing the carrying value of the asset and stockholders' equity under "Accumulated Other Comprehensive Income (Loss)." By accounting for our assets in this manner, we hope to provide useful information to stockholders and creditors and to preserve flexibility to sell assets in the future without having to change accounting methods. As a result of this mark-to-market accounting treatment, our book value and book value per share are likely to fluctuate far more than if we used historical amortized cost accounting. As a result, comparisons with companies that use historical cost accounting for some or all of their balance sheet may not be meaningful. The table below shows unrealized gains and losses on the mortgage-backed securities in our portfolio.
Unrealized Gains and Losses (dollars in thousands) At December 31, 2002 2001 2000 1999 1998 ------------ --------------- ----------- --------------- ------------- Unrealized Gain $90,507 $53,935 $ 3,020 $ 1,531 $3,302 Unrealized Loss (14,997) (15,766) (16,064) (39,100) (9,706) ------------ --------------- ----------- --------------- ------------- Net Unrealized Gain (Loss) $75,510 $38,169 ($13,044) ($37,569) ($6,404) ============ =============== =========== =============== ============= Net Unrealized Gain (Loss) as % of Mortgage- Backed Securities Principal Value 0.67% 0.52% (0.66%) (2.59%) (0.43%) Net Unrealized Gain (Loss) as % of Mortgage- Backed Securities Amortized Cost 0.67% 0.51% (0.66%) (2.54%) (0.42%)
Unrealized changes in the estimated net market value of mortgage-backed securities have one direct effect on our potential earnings and dividends: positive marked-to-market changes increase our equity base and allow us to increase our borrowing capacity while negative changes tend to limit borrowing capacity under our capital investment policy. A very large negative change in the net market value of our mortgage-backed securities might impair our liquidity position, requiring us to sell assets with the likely result of realized losses upon sale. The net unrealized gains (loss) on available for sale securities was $75.5 million, or 0.67% or the amortized cost of our mortgage-backed securities as of December 31, 2002, $38.2 million, or 0.51% or the amortized cost of our mortgage-backed securities as of December 31, 2001, and ($13.0) million, or (0.66%) of the amortized cost of our mortgage-backed securities at December 31, 2000. The table below shows our equity capital base as reported and on a historical amortized cost basis at December 31, 2002, 2001, 2000, 1999, and 1998, and September 30, 2002, June 30, 2002 and March 31,2002. Issuances of common stock, the level of earnings as compared to dividends declared, and other factors influence our historical cost equity capital base. The reported equity capital base is influenced by these factors plus changes in the "Net Unrealized Losses on Assets Available for Sale" account. 41
Stockholders' Equity Historical Historical Net Unrealized Reported Amortized Cost Reported Equity Amortized Cost Gains on Assets Equity Base Equity Per (Book Value) Per Equity Base Available for Sale (Book Value) Share Share (dollars in thousands, except per share data) At December 31, 2002 $1,004,555 $75,511 $1,080,066 $11.88 $12.77 At December 31, 2001 $629,188 $38,169 $667,357 $10.52 $11.15 At December 31, 2000 $148,686 ($13,044) $135,642 $10.24 $9.34 At December 31, 1999 $140,841 ($37,569) $103,272 $10.37 $7.60 At December 31, 1998 $132,275 ($6,404) $125,871 $10.46 $9.95 -------------------------------------------------------------------------------------------------------------- At September 30, 2002 $1,010,623 $74,382 $1,085,005 $11.96 $12.84 At June 30, 2002 $982,348 $67,283 $1,049,631 $11.84 $12.65 At March 31, 2002 $978,186 $30,502 $1,008,688 $11.80 $12.17
Leverage Our debt-to-equity ratio at December 31, 2002, 2001, and 2000 was 9.4:1, 9.5:1, and 12.0:1, respectively. We generally expect to maintain a ratio of debt-to-equity of between 8:1 and 12:1, although the ratio may vary from this range from time-to-time based upon various factors, including our management's opinion of the level of risk of our assets and liabilities, our liquidity position, our level of unused borrowing capacity and over-collateralization levels required by lenders when we pledge assets to secure borrowings. Our target debt-to-equity ratio is determined under our capital investment policy. Should our actual debt-to-equity ratio increase above the target level due to asset acquisition or market value fluctuations in assets, we will cease to acquire new assets. Our management will, at that time, present a plan to our board of directors to bring us back to our target debt-to-equity ratio; in many circumstances, this would be accomplished over time by the monthly reduction of the balance of our mortgage-backed securities through principal repayments. Asset/Liability Management and Effect of Changes in Interest Rates We continually review our asset/liability management strategy with respect to interest rate risk, mortgage prepayment risk, credit risk and the related issues of capital adequacy and liquidity. Our goal is to provide attractive risk-adjusted stockholder returns while maintaining what we believe is a strong balance sheet. We seek to manage the extent to which our net income changes as a function of changes in interest rates by matching adjustable-rate assets with variable-rate borrowings. In addition, although we have not done so to date, we may seek to mitigate the potential impact on net income of periodic and lifetime coupon adjustment restrictions in our portfolio of mortgage-backed securities by entering into interest rate agreements such as interest rate caps and interest rate swaps. Changes in interest rates may also affect the rate of mortgage principal prepayments and, as a result, prepayments on mortgage-backed securities. We will seek to mitigate the effect of changes in the mortgage principal repayment rate by balancing assets we purchase at a premium with assets we purchase at a discount. To date, the aggregate premium exceeds the aggregate discount on our mortgage-backed securities. As a result, prepayments, which result in the expensing of unamortized premium, will reduce our net income compared to what net income would be absent such prepayments. Inflation Virtually all of our assets and liabilities are financial in nature. As a result, interest rates and other factors drive our performance far more than does inflation. Changes in interest rates do not necessarily correlate with inflation rates or changes in inflation rates. Our financial statements are prepared in accordance with GAAP and our dividends based upon our net income as 42 calculated for tax purposes; in each case, our activities and balance sheet are measured with reference to historical cost or fair market value without considering inflation. Other Matters We calculate that our qualified Real Estate Investment Trust ("REIT") assets, as defined in the Internal Revenue Code, are 100.0% of our total assets at December 31, 2002, 2001, and 2000 as compared to the Internal Revenue Code requirement that at least 75% of our total assets be qualified REIT assets. We also calculate that 100% of our revenue qualifies for the 75% source of income test, and 100% of its revenue qualifies for the 95% source of income test, under the REIT rules for the years ended December 31, 2001, 2000, and 1999. We also met all REIT requirements regarding the ownership of our common stock and the distribution of our net income. Therefore, as of December 31, 2002, 2001, and 2000 we believe that we qualified as a REIT under the Internal Revenue Code. We at all times intend to conduct our business so as not to become regulated as an investment company under the Investment Company Act of 1940, as amended (the "Investment Company Act"). If we were to become regulated as an investment company, then our use of leverage would be substantially reduced. The Investment Company Act exempts entities that are "primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate" (qualifying interests). Under current interpretation of the staff of the SEC, in order to qualify for this exemption, we must maintain at least 55% of our assets directly in qualifying interests. In addition, unless certain mortgage securitites represent all the certificates issued with respect to an underlying pool of mortgages, the mortgage-backed securities may be treated as securities separate from the underlying mortgage loans and, thus, may not be considered qualifying interests for purposes of the 55% requirement. We calculate that as of December 31, 2002, 2001, and 2000 we were in compliance with this requirement. 43 ITEM 7A QUANTITATIVE AND QUALITIATIVE DISCLOSURES ABOUT MARKET RISK MARKET RISK Market risk is the exposure to loss resulting from changes in interest rates, foreign currency exchange rates, commodity prices and equity prices. The primary market risk to which we are exposed is interest rate risk. Interest rates are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond our control. Changes in the general level of interest rates can affect our net interest income, which is the difference between the interest income earned on interest-earning assets and the interest expense incurred in connection with our interest-bearing liabilities, by affecting the spread between our interest-earning assets and interest-bearing liabilities. Changes in the level of interest rates also can affect the value of our mortgage-backed securities and our ability to realize gains from the sale of these assets. We may utilize a variety of financial instruments; including interest rate swaps, caps, floors and other interest rate exchange contracts, in order to limit the effects of interest rates on our operations. If we use these types of derivatives to hedge the risk of interest-earning assets or interest-bearing liabilities, we may be subject to certain risks, including the risk that losses on a hedge position will reduce the funds available for payments to holders of securities and that the losses may exceed the amount we invested in the instruments. To date, we have not purchased any hedging instruments. Our profitability and the value of our portfolio may be adversely affected during any period as a result of changing interest rates. The following table quantifies the potential changes in net interest income and portfolio value should interest rates go up or down 100 basis points, assuming the yield curves of the rate shocks will be parallel to each other and the current yield curve. All changes in income and value are measured as percentage changes from the projected net interest income and portfolio value at the base interest rate scenario. The base interest rate scenario assumes interest rates at December 31, 2002, and various estimates regarding prepayment and all activities are made at each level of rate shock. Actual results could differ significantly from these estimates.
Projected Percentage Change in Projected Percentage Change in Change in Interest Rate Net Interest Income Portfolio Value ---------------------------------------- -------------------------------------- -------------------------------------- -100 Basis Points (5%) 2% -50 Basis Points (3%) 1% -25 Basis Points (1%) 1% Base Interest Rate +25 Basis Points 3% (1%) +50 Basis Points 3% (1%) +100 Basis Points 1% (2%)
ASSET AND LIABILITY MANAGEMENT Asset and liability management is concerned with the timing and magnitude of the repricing of assets and liabilities. We attempt to control risks associated with interest rate movements. Methods for evaluating interest rate risk include an analysis of our interest rate sensitivity "gap", which is the difference between interest-earning assets and interest-bearing liabilities maturing or repricing within a given time period. A gap is considered positive when the amount of interest-rate sensitive assets exceeds the amount of interest-rate sensitive liabilities. A gap is considered negative when the amount of interest-rate sensitive liabilities exceeds interest-rate sensitive assets. During a period of rising interest rates, a negative gap would tend to adversely affect net interest income, while a positive gap would tend to result in an increase in net interest income. During a period of falling interest rates, a negative gap would tend to result in an increase in net interest income, while a positive gap would tend to affect net interest income adversely. Because different types of assets and liabilities with the same or similar maturities may react differently to changes in overall market rates or conditions, changes in interest rates may affect net interest income positively 44 or negatively even if an institution were perfectly matched in each maturity category. The following table sets forth the estimated maturity or repricing of our interest-earning assets and interest-bearing liabilities at December 31, 2002. The amounts of assets and liabilities shown within a particular period were determined in accordance with the contractual terms of the assets and liabilities, except adjustable-rate loans, and securities are included in the period in which their interest rates are first scheduled to adjust and not in the period in which they mature. Mortgage-backed securities reflect estimated prepayments that were estimated based on analyses of broker estimates, the results of a prepayment model that we utilized and empirical data. Our management believes that these assumptions approximate actual experience and considers them reasonable; however, the interest rate sensitivity of our assets and liabilities in the table could vary substantially if different assumptions were used or actual experience differs from the historical experience on which the assumptions are based.
More than 1 Within 3 Months Year to 3 Years 3 Years and 4-12 Months Over Total (dollars in thousands) ------------------------------------------------------------------------------------- ---------------- ----------------- ---------------- ---------------- ---------------- Rate Sensitive Assets: Mortgage-Backed Securities $3,833,919 $847,137 $1,853,611 $4,667,717 $11,202,384 Rate Sensitive Liabilities: Repurchase Agreements 8,699,409 $1,463,765 10,163,174 ---------------- ----------------- ---------------- ---------------- ---------------- Interest rate sensitivity gap ($4,865,490) $847,137 $389,846 $4,667,717 $1,039,210 ================ ================= ================ ================ ================ Cumulative rate sensitivity gap ($4,864,990) ($4,018,353) ($3,628,507) $1,039,210 ================ ================= ================ ================ Cumulative interest rate sensitivity gap as a percentage of total rate-sensitive assets (43.43%) (35.87%) (32.39%) 9.28%
Our analysis of risks is based on management's experience, estimates, models and assumptions. These analyses rely on models which utilize estimates of fair value and interest rate sensitivity. Actual economic conditions or implementation of investment decisions by our management may produce results that differ significantly form the estimates and assumptions used in our models and the projected results shown in the above tables and in this report. These analyses contain certain forward-looking statements and are subject to the safe harbor statement set forth under the heading, "Special Note Regarding Forward-Looking Statements." 45 ITEM 8 FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA Our financial statements and the related notes, together with the Independent Auditors' Report thereon, are set forth on pages F-1 through F-17 of this Form 10-K. ITEM 9 CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE None. PART III ITEM 10 DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT The information required by Item 10 as to our directors is incorporated herein by reference to the definitive proxy statement we are filing pursuant to Regulation 14A. The information required by Item 10 as to our compliance with Section 16(a) of the Securities Exchange Act of 1934 is incorporated by reference to the definitive proxy statement we are filing pursuant to Regulation 14A. ITEM 11 EXECUTIVE COMPENSATION The information required by Item 11 is incorporated herein by reference to the definitive proxy statement we are filing pursuant to Regulation 14A. ITEM 12 SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS The information required by Item 12 is incorporated herein by reference to the definitive proxy statement we are filing pursuant to Regulation 14A. ITEM 13 CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS The information required by Item 13 is incorporated herein by reference to the definitive proxy statement we are filing pursuant to Regulation 14A. ITEM 14 CONTROLS AND PROCEDURES Within 90 days prior to the date of this report, we carried out an evaluation, under the supervision and with the participation of our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on this evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures are effective in timely alerting them to material information required to be included in our periodic SEC reports. It should be noted that the design of any system of controls is based in part upon certain assumptions, and there can be no assurance that any design will succeed in achieving its stated goals. In addition, we reviewed our internal controls, and there have been no significant changes in our internal controls or in other factors that could significantly affect those controls subsequent to the date of their last evaluation. 46 PART IV ITEM 15 EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Documents filed as part of this report: 1. Financial Statements. 2. Schedules to Financial Statements: All financial statement schedules not included have been omitted because they are either inapplicable or the information required is provided in our Financial Statements and Notes thereto, included in Part II, Item 8, of this Annual Report on Form 10-K. 3. Exhibits: EXHIBIT INDEX Exhibit Exhibit Description Number 3.1 Articles of Incorporation of the Registrant (incorporated by reference to Exhibit 3.1 to our Registration Statement on Form S-11 (Registration No. 333-32913) filed with the Securities and Exchange Commission on August 5, 1997). 3.2 Articles of Amendment and Restatement of the Articles of Incorporation of the Registrant (incorporated by reference to Exhibit 3.2 to our Registration Statement on Form S-11 (Registration No. 333-32913) filed with the Securities and Exchange Commission on August 5, 1997). 3.3 Articles of Amendment of the Articles of Incorporation of the Registrant (incorporated to Exhibit 3.1 of the Registrant's Registration Statement on Form S-3 (Registration Statement 333-74618) filed with the Securities and Exchange Commission on June 12, 2002). 3.4 Bylaws of the Registrant, as amended (incorporated by reference to Exhibit 3.3 to our Registration Statement on Form S-11 (Registration No. 333-32913) filed with the Securities and Exchange Commission on August 5, 1997). 4.1 Specimen Common Stock Certificate (incorporated by reference to Exhibit 4.1 to Amendment No. 1 to our Registration Statement on Form S-11 (Registration No. 333-32913) filed with the Securities and Exchange Commission on September 17, 1997). 4.2 Specimen Preferred Stock Certificate (incorporated by reference to Exhibit 4.2 to the Registrant's Registration Statement on Form S-3 (Registration No. 333-74618) filed with the Securities and Exchange Commission on December 5, 2001). 10.1 Purchase Agreement, dated February 12, 1997, between the Registrant and Friedman, Billings, Ramsey & Co., Inc. ("FBR") (incorporated by reference to Exhibit 10.1 to our Registration Statement on Form S-11 (Registration No. 333-32913), filed with the Securities and Exchange Commission on August 5, 1997). 10.2 Registration Rights Agreement, dated February 12, 1997, between the Registrant and FBR (incorporated by reference to Exhibit 10.2 to our Registration Statement on Form S-11 (Registration No. 333-32913) filed with the Securities and Exchange Commission on August 5, 1997). 10.3 Long-Term Stock Incentive Plan (incorporated by reference to Exhibit 10.3 to our Registration Statement on Form S-11 (Registration No. 333-32913) filed with the Securities and Exchange Commission on August 5, 1997).* 10.4 Form of Master Repurchase Agreement (incorporated by reference to Exhibit 10.7 to our Registration Statement on Form S-11 (Registration No. 333-32913) filed with the Securities and Exchange Commission on August 5, 1997). 10.5 Form of Purchase Agreement, between the Registrant and the purchasers in the Direct Offering (incorporated by reference to Exhibit 10.8 to our Registration Statement on Form S-11 (Registration No. 333-32913) filed with the Securities and Exchange Commission on August 5, 1997). 10.6 Amended and Restated Employment Agreement, effective as of May 1, 2001 between the Registrant and Michael A.J. Farrell (incorporated by reference to Exhibit 10.1 to our Form 10-Q/A for its quarterly period ended June 30, 2001 filed with the Securities and Exchange Commission on August 27, 2001).* 10.7 Amended and Restated Employment Agreement, effective as of May 1, 2001, between the Registrant and Wellington St. Claire (incorporated by reference to Exhibit 10.2 to our Form 10-Q/A for its quarterly period ended June 30, 2001 filed with the Securities and Exchange Commission on August 27, 2001).* 10.8 Amended and Restated Employment Agreement, effective as of May 1, 2001 between the Registrant and Kathryn F. Fagan (incorporated by reference to Exhibit 10.3 to our Form 10-Q/A for its quarterly period ended June 30, 2001 filed with the Securities and Exchange Commission on August 27, 2001).* 10.9 Amended and Restated Employment Agreement, effective as of May 1, 2001, between the Registrant and Jennifer A. Stephens (incorporated by reference to Exhibit 10.4 to our Form 10-Q/A for its quarterly period ended June 30, 2001 filed with the Securities and Exchange Commission on August 27, 2001).* 23.1 Consent of Independent Auditors. 99.1 Certification of Michael A.J. Farrell, Chairman, Chief Executive Officer, and President of the Registrant, pursuant to 18 U.S.C. Section 1350. 99.2 Certification of Kathryn F. Fagan, Chief Financial Officer and Treasurer of the Registrant, pursuant to 18 U.S.C. Section 1350. * Exhibit Numbers 10.3 and 10-6-10.9 are management contracts or compensatory plans required to be filed as Exhibits to this Form 10-K. II-4 (b) Reports on Form 8-K On January 25, 2002, we filed a Form 8-K with respect to our entering into an underwriting agreement with UBS Warburg LLC, Merrill Lynch, Pierce Fenner & Smith Incorporated, ABN AMRO Rothschild, LLC, Friedman, Billings, Ramsey & Co., Inc., RBC Dain Rauscher Inc., and U.S. Bancorp Piper Jaffray Inc., as representatives of the several underwriters. On July 8, 2002, we filed a Form 8-K with respect to our entering into a Sales Agency Agreement with UBS Warburg LLC. None Annaly Mortgage Management, Inc. Independent Auditors' Report Financial Statements Years Ended December 31, 2002, 2001, and 2000
Annaly Mortgage Management, Inc. NOTES TO FINANCIAL STATEMENTS -------------------------------------------------------------------------------------------------------------------------- Page INDEPENDENT AUDITORS' REPORT F-1 FINANCIAL STATEMENTS FOR THE YEARS ENDED DECEMBER 31, 2002, 2001, AND 2000: Statements of Financial Condition F-2 Statements of Operations F-3 Statements of Stockholders' Equity F-4 Statement of Cash Flows F-5 Notes to Financial Statements F-6-F-17
F-1 INDEPENDENT AUDITORS' REPORT To the board of directors and Stockholders of Annaly Mortgage Management, Inc. We have audited the accompanying statements of financial condition of Annaly Mortgage Management, Inc. (the "Company") as of December 31, 2002 and 2001, and the related statements of operations, changes in stockholders' equity, and cash flows for each of the three years in the period ended December 31, 2002. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2002 and 2001, and the results of its operations and its cash flows for each of the three years in the period ended December 31, 2002, in conformity with accounting principles generally accepted in the United States of America. /s/ Deloitte & Touche LLP ------------------------- New York, New York February 26, 2003 F-1
ANNALY MORTGAGE MANAGEMENT, INC. STATEMENTS OF FINANCIAL CONDITION DECEMBER 31, 2002 AND 2001 ------------------------------------------------------------------------------------------------------------------------ 2002 2001 ASSETS (dollars in thousands) --------------------------------------------- CASH AND CASH EQUIVALENTS $ 726 $ 429 MORTGAGE-BACKED SECURITIES - At fair value 11,551,857 7,575,379 RECEIVABLE FOR MORTGAGE-BACKED SECURITIES SOLD 55,954 94,503 ACCRUED INTEREST RECEIVABLE 49,707 46,804 OTHER ASSETS 840 199 ---- --- TOTAL ASSETS $ 11,659,084 $ 7,717,314 ============= =========== LIABILITIES AND STOCKHOLDERS' EQUITY LIABILITIES: Repurchase agreements $ 10,163,174 $ 6,367,710 Payable for Mortgage-Backed Securities purchased 338,691 627,064 Accrued interest payable 14,935 16,043 Dividends payable 57,499 35,896 Other liabilities 2,812 2,010 Accounts payable 1,907 1,234 ------ ----- Total liabilities 10,579,018 7,049,957 ----------- --------- STOCKHOLDERS' EQUITY: Common stock: par value $.01 per share; 500,000,000 authorized, 84,569,206 and 59,826,975 shares issued and outstanding, respectively 846 598 Additional paid-in capital 1,003,200 623,986 Accumulated other comprehensive income 75,511 38,169 Retained earnings 509 4,604 ---- ----- Total stockholders' equity 1,080,066 667,357 ---------- ------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 11,659,084 $ 7,717,314 ============= =========== See notes to financial statements
F-2
ANNALY MORTGAGE MANAGEMENT, INC. STATEMENTS OF OPERATIONS YEARS ENDED DECEMBER 31, 2002, 2001, AND 2000 ------------------------------------------------------------------------------------------------------------------------ 2002 2001 2000 (dollars in thousands, except for per share data) ------------------------------------------------------- INTEREST INCOME: Mortgage-Backed Securities and cash equivalents $ 404,165 $ 263,058 $ 109,751 INTEREST EXPENSE - Repurchase agreements 191,758 168,055 92,902 -------- -------- ------ NET INTEREST INCOME 212,407 95,003 16,849 GAIN ON SALE OF MORTGAGE-BACKED SECURITIES 21,063 4,586 2,025 GENERAL AND ADMINISTRATIVE EXPENSES 13,963 7,311 2,287 ------- ------ ----- NET INCOME 219,507 92,278 16,587 -------- ------- ------ OTHER COMPREHENSIVE GAIN: Unrealized gain on available-for-sale securities 58,405 55,800 26,549 Less reclassification adjustment for gains included in net income (21,063) (4,586) (2,025) --------- -------- ------- Other comprehensive gain 37,342 51,214 24,524 ------- ------- ------ TOTAL COMPREHENSIVE INCOME $ 256,849 $ 143,492 $ 41,111 ========== ========== ======== NET INCOME PER SHARE: Basic $ 2.68 $ 2.23 $ 1.18 ======= ======= ====== Diluted $ 2.67 $ 2.21 $ 1.15 ======= ======= ====== AVERAGE NUMBER OF SHARES OUTSTANDING: Basic 82,044,141 41,439,631 14,089,436 =========== =========== ========== Diluted 82,282,883 41,857,498 14,377,459 =========== =========== ========== See notes to financial statements.
F-3
ANNALY MORTGAGE MANAGEMENT, INC. STATEMENTS OF STOCKHOLDERS' EQUITY YEARS ENDED DECEMBER 31, 2002, 2001, AND 2000 (dollars in thousands) ------------------------------------------------------------------------------------------------------------------------------------ Accumulated Common Additional Other Stock Paid-in Comprehensive Retained Comprehensive Par Value Capital Income Earnings Income Total (Loss) BALANCE, DECEMBER 31, 1999 135 140,263 443 (37,569) 103,272 Other comprehensive income: Unrealized net gains on securities, net of reclassification adjustment - - 24,524 - 24,524 ------------- Comprehensive income - - $41,111 - - 41,111 ============= Exercise of stock options 198 - - 198 Proceeds from direct purchase 9 7,384 - - 7,393 Dividends declared for the year ended December 31, 2000, $1.15 per share - - (16,333) - (16,333) ----- -------- -------- -------- -------- BALANCE, DECEMBER 31, 2000 144 147,845 697 (13,045) 135,641 Net income $92,278 92,278 Other comprehensive income: Unrealized net gains on securities, net of reclassification adjustment - - 51,214 - 51,214 ------------- Comprehensive income - - $143,492 - - 143,492 ============= Exercise of stock options 3 2,972 - - 2,975 Shares exchanged upon exercise of stock options (587) (587) Proceeds from direct purchase 142 - - 142 Proceeds from secondary offerings 451 473,614 474,065 Dividends declared for the year ended December 31, 2001, $1.75 per share - - (88,371) - (88,371) ----- -------- -------- -------- -------- BALANCE, DECEMBER 31, 2001 $598 $623,986 4,604 38,169 667,357 Net income $219,507 219,507 Other comprehensive income: Unrealized net gains on securities, net of reclassification adjustment 37,342 - 37,342 ------------- Comprehensive income $256,849 - - 256,849 ============= Exercise of stock options 1 1,089 - - 1,090 Shares exchanged upon exercise of stock options (76) (76) Proceeds from direct purchase 2 3,007 - - 3,009 Proceeds from secondary offerings 230 347,106 347,336 Proceeds from equity shelf program 15 28,088 28,103 Dividends declared for the year ended December 31, 2002, $2.67 per share - - (223,602) - (223,602) ----- ---------- -------- -------- ------------ BALANCE, DECEMBER 31, 2002 $846 $1,003,200 $509 $75,511 $1,080,066 ===== ========== ======== ======== ============ See notes to financial statements
F-4
ANNALY MORTGAGE MANAGEMENT, INC. STATEMENT OF CASH FLOWS YEARS ENDED DECEMBER 31, 2002, 2001, AND 2000 ------------------------------------------------------------------------------------------------------------------------------------ 2002 2001 2000 (dollars in thousands) ------------------------------------------------------------------ CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 219,507 $ 92,278 $ 16,587 Adjustments to reconcile net income to net cash provided by operating activities: Amortization of mortgage premiums and discounts, net 106,198 36,865 2,647 Market value adjustment on long term repurchase agreement 1,204 986 Gain on sale of Mortgage-Backed Securities (21,063) (4,587) (2,025) Stock option expense 240 790 Increase in accrued interest receivable (2,903) (35,301) (4,645) (Increase) decrease in other assets (641) 61 (62) (Decrease) increase in accrued interest payable (1,109) 7,729 1,631 Increase in other liabilities and accounts payable 673 950 120 ---- ---- --- Net cash provided by operating activities 302,106 99,771 14,253 -------- ------- ------ CASH FLOWS FROM INVESTING ACTIVITIES: Purchase of Mortgage-Backed Securities (11,079,561) (8,194,215) (952,738) Proceeds from sale of Mortgage-Backed Securities 2,076,800 1,248,812 489,810 Principal payments on Mortgage-Backed Securities 4,728,666 1,685,874 168,517 ---------- ---------- ------- Net cash used in investing activities (4,274,095) (5,259,529) (294,411) ------------ ------------ --------- CASH FLOWS FROM FINANCING ACTIVITIES: Proceeds from repurchase agreements 87,463,924 49,773,650 14,196,953 Principal payments on repurchase agreements (83,668,862) (45,033,275) (13,906,890) Proceeds from exercise of stock options 774 1,597 199 Proceeds from direct equity offering 3,010 142 7,393 Proceeds from secondary offerings 375,439 474,065 - Dividends paid (201,999) (56,105) (17,456) ---------- --------- -------- Net cash provided by financing activities 3,972,286 5,160,074 280,199 ---------- ---------- ------- NET INCREASE IN CASH AND CASH EQUIVALENTS 297 316 41 CASH AND CASH EQUIVALENTS, BEGINNING OF YEAR 429 113 72 ---- ---- -- CASH AND CASH EQUIVALENTS, END OF YEAR $ 726 $ 429 $ 113 ====== ====== ===== SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Interest paid $ 190,650 $ 160,327 $ 91,270 ========== ========== ======== NONCASH FINANCING ACTIVITIES: Net change in unrealized loss on available-for-sale securities $ 37,342 $ 51,214 $ (24,524) ========= ========= ========== Dividends declared, not yet paid $ 57,499 $ 35,896 $ 3,631 ========= ========= ======= See notes to financial statements.
F-5 Annaly Mortgage Management, Inc. NOTES TO FINANCIAL STATEMENTS YEARS ENDED DECEMBER 31, 2002, 2001, AND 2000 -------------------------------------------------------------------------------- 1. ORGANIZATION AND SIGNIFICANT ACCOUNTING POLICIES Annaly Mortgage Management, Inc. (the "Company") was incorporated in Maryland on November 25, 1996. The Company commenced its operations of purchasing and managing an investment portfolio of Mortgage-Backed Securities on February 18, 1997, upon receipt of the net proceeds from the private placement of equity capital. An initial public offering was completed on October 14, 1997. A summary of the Company's significant accounting policies follows: Cash and Cash Equivalents - Cash and cash equivalents includes cash on hand and money market funds. The carrying amount of cash equivalents approximates their value. Mortgage-Backed Securities - The Company invests primarily in mortgage pass-through certificates, collateralized mortgage obligations and other mortgage-backed securities representing interests in or obligations backed by pools of mortgage loans (collectively, "Mortgage-Backed Securities"). Statement of Financial Accounting Standards No. 115, Accounting for Certain Investments in Debt and Equity Securities, requires the Company to classify its investments as either trading investments, available-for-sale investments or held-to-maturity investments. Although the Company generally intends to hold most of its Mortgage-Backed Securities until maturity, it may, from time to time, sell any of its Mortgage-Backed Securities as part of its overall management of its balance sheet. Accordingly, this flexibility requires the Company to classify all of its Mortgage-Backed Securities as available-for-sale. All assets classified as available-for-sale are reported at fair value, based on market prices provided by certain dealers who make markets in these financial instruments, with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders' equity. Unrealized losses on Mortgage-Backed Securities that are considered other than temporary, as measured by the amount of decline in fair value attributable to factors other than temporary, are recognized in income and the cost basis of the Mortgage-Backed Securities is adjusted. There were no such adjustments for the years ended December 31, 2002, 2001, and 2000. Interest income is accrued based on the outstanding principal amount of the Mortgage-Backed Securities and their contractual terms. Premiums and discounts associated with the purchase of the Mortgage-Backed Securities are amortized into interest income over the lives of the securities using the interest method. Mortgage-Backed Securities transactions are recorded on the trade date. Purchases of newly issued securities are recorded when all significant uncertainties regarding the characteristics of the securities are removed, generally shortly before settlement date. Realized gains and losses on Mortgage-Backed Securities transactions are determined on the specific identification basis. F-6 Credit Risk - At December 31, 2002 and 2001, the Company has limited its exposure to credit losses on its portfolio of Mortgage-Backed Securities by only purchasing securities issued by Federal Home Loan Mortgage Corporation ("FHLMC"), Federal National Mortgage Association ("FNMA"), or Government National Mortgage Association ("GNMA"). The payment of principal and interest on the FHLMC and FNMA Mortgage-Backed Securities are guaranteed by those respective agencies and the payment of principal and interest on the GNMA Mortgage-Backed Securities are backed by the full-faith-and-credit of the U.S. government. At December 31, 2002 and 2001, all of the Company's Mortgage-Backed Securities have an implied "AAA" rating. Repurchase Agreements - The Company finances the acquisition of its Mortgage-Backed Securities through the use of repurchase agreements. Repurchase agreements are treated as collateralized financing transactions and are carried at their contractual amounts, including accrued interest, as specified in the respective agreements. Accrued interest is recorded as a separate line item. Income Taxes - The Company has elected to be taxed as a Real Estate Investment Trust ("REIT") and intends to comply with the provisions of the Internal Revenue Code of 1986, as amended (the "Code") with respect thereto. Accordingly, the Company will not be subjected to federal income tax to the extent of its distributions to shareholders and as long as certain asset, income and stock ownership tests are met. Use of Estimates - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. New Accounting Pronouncement - In December 2002, the FASB issued Statement of Financial Accounting Standard (SFAS) No. 148, "Accounting for Stock-Based Compensation-Transition and Disclosures, an Amendment of FASB Statement No123." This Statement provides alternative methods of transition for companies who voluntarily change to the fair value-based method of accounting for stock-based employee compensation in accordance with SFAS NO. 123, "Accounting for Stock-Based Compensation." (SFAS 123). SFAS No. 148 does not permit the use of the original SFAS No. 123 prospective method of transition for changes to the fair value based method made in fiscal years beginning after December 15, 2003. The Statement also requires prominent disclosures in both annual and interim financial statements about the method of accounting for stock-based compensation and the effect of the method used on reported results. This Statement is effective upon issuance F-7 2. MORTGAGE-BACKED SECURITIES The following table pertains to the Company's Mortgage-Backed Securities classified as available-for-sale as of December 31, 2002, which are carried at their fair value:
Federal Federal Government Total Home Loan National National Mortgage- Mortgage Mortgage Mortgage Backed Corporation Association Association Securities (dollars in the thousands) ---------------------------------------------------------------------------------- Mortgage-Backed Securities, gross $ 5,120,929 $ 5,860,987 $ 220,468 $ 11,202,384 Unamortized discount (544) (120) - (664) Unamortized premium 105,872 164,071 4,684 274,627 -------- -------- ------ ------- Amortized cost 5,226,257 6,024,938 225,152 11,476,347 Gross unrealized gains 31,731 58,239 537 90,507 Gross unrealized losses (9,554) (5,318) (125) (14,997) -------- -------- ------ -------- Estimated fair value $ 5,248,434 $ 6,077,859 $ 225,564 $ 11,551,857 ============ ============ ========== ============ Amortized Cost Gross Unrealized Gain Gross Unrealized Loss Estimated Fair Value Adjustable Rate $ 7,144,741 $ 35,349 $ (12,424) $ 7,167,666 Fixed Rate 4,331,606 55,158 (2,573) 4,384,191 ---------- ------- -------- ---------- Total $ 11,476,347 $ 90,507 $ (14,997) $ 11,551,857 ============= ========= =========== ============
F-8 The following table pertains to the Company's Mortgage-Backed Securities classified as available-for-sale as of December 31, 2001, which are carried at their fair value:
Federal Federal Government Total Home Loan National National Mortgage- Mortgage Mortgage Mortgage Backed Corporation Association Association Securities (dollars in thousands) --------------------------------------------------------------------------------- Mortgage-Backed \ Securities, gross $ 4,426,195 $ 2,894,026 $ 79,720 $ 7,399,941 Unamortized discount (1,346) (755) - (2,101) Unamortized premium 83,775 54,118 1,477 139,370 ------- ------- ------ ------- Amortized cost 4,508,624 2,947,389 81,197 7,537,210 Gross unrealized gains 32,636 21,224 75 53,935 Gross unrealized losses (7,986) (7,314) (466) (15,766) -------- -------- ------ -------- Estimated fair value $ 4,533,274 $ 2,961,299 $ 80,806 $ 7,575,379 ============ ============ ========= =========== Amortized Cost Gross Unrealized Gain Gross Unrealized Loss Estimated Fair Value Adjustable Rate $ 5,908,236 $ 44,469 $ (10,049) $ 5,942,656 Fixed Rate 1,628,974 9,466 (5,717) 1,632,723 ---------- ------ -------- --------- Total $ 7,537,210 $ 53,935 $ (15,766) $ 7,575,379 ============ ========= =========== ===========
The adjustable rate Mortgage-Backed Securities are limited by periodic caps (generally interest rate adjustments are limited to no more than 1% every six months) and lifetime caps. The weighted average lifetime cap was 8.8% and 11.5% at December 31, 2002 and 2001, respectively. During the year ended December 31, 2002, the Company realized $21.1 million in gains from sales of Mortgage-Backed Securities. During the year ended December 31, 2001, the Company realized $6.8 million in gains from sales of Mortgage-Backed Securities. Losses totaled $2.2 million for the year ended December 31, 2001. During the year ended December 31, 2000, the Company realized $2.0 million in gains from sales of Mortgage-Backed Securities. 3. REPURCHASE AGREEMENTS The Company had outstanding $10,163,174,000 and $6,367,710,000 of repurchase agreements with a weighted average borrowing rate of 1.72% and 2.18% and a weighted average remaining maturity of 124 days and 85 days as of December 31, 2002 and 2001, respectively. At December 31, 2002 and 2001, Mortgage-Backed Securities pledged had an estimated fair value of $10,517,558,000 and $6,564,250,000, respectively. F-9 At December 31, 2002 and 2001 the repurchase agreements had the following remaining maturities:
2002 2001 --------------------------------------------- (dollars in thousands) Within 30 days $ 7,778,003 $ 5,380,006 30 to 59 days 816,906 206,947 60 to 89 days 104,500 66,202 90 to 119 days 65,037 Over 120 days 1,463,765 649,518 ---------------------- --------------------- $ 10,163,174 $ 6,367,710 ============= ===========
4. OTHER LIABILITIES In 2001, the Company entered into a repurchase agreement maturing in July 2004, at which time, the repurchase agreement gives the buyer the right to extend, in whole or in part, in three-month increments up to July 2006. The repurchase agreement has a principal value of $100,000,000. The Company accounts for the extension option as a separate interest rate floor liability carried at fair value. The initial fair value of $1,200,000 allocated to the extension option resulted in a similar discount on the repurchase agreement borrowings that is being amortized over the initial term of 3 years using the effective yield method. At December 31, 2002, the fair value of this interest rate floor was a $2,812,000 and was classified as other liabilities. The aggregate charge of $1,204,000 and $986,000 is included in interest expense for 2002 and 2001, respectively. 5. COMMON STOCK During the Company's year ending December 31, 2002, the Company declared dividends to shareholders totaling $223,602,000, or $2.67 per share, of which $166,102,000 was paid during the year and $57,499,000 was paid on January 29, 2003. During the year ended December 31, 2002, 97,095 options were exercised at $1,090,000. Total shares exchanged upon exercise of the stock options were 4,444 at a value of $76,000. Through the Equity Shelf Program, the Company raised $28,103,000 in net proceeds and issued 1,481,000 shares. Also, 165,480 shares were purchased in dividend reinvestment and share purchase plan, totaling $3,009,000. The Company completed an offering of common stock in the first quarter issuing 23,000,000 shares, with aggregate net proceeds of $347.3 million. During the Company's year ending December 31, 2001, the Company declared dividends to shareholders totaling $88,370,451, or $1.75 per share, of which $52,474,266 was paid during the year and $35,896,185 was paid on January 30, 2002. During the year ended December 31, 2001, 274,231 options were exercised at $2,974,666. Total shares exchanged upon exercise of the stock options were 41,620 at a value of $588,068. Also, 10,856 shares were purchased in dividend reinvestment and share purchase plan, totaling $142,456. The Company completed an offering of common stock in the third quarter issuing 14,991,600 shares, with aggregate net proceeds of $179.6 million. An offering of common stock during the second quarter of 2001 was completed issuing 18,918,500 shares, with aggregate net proceeds of $195.3 million. Additional offerings for 11,150,000 shares were completed during the first quarter for aggregate net proceeds of $99.3 million. During the Company's year ending December 31, 2000, the Company declared dividends to shareholders totaling $16,333,252, or $1.15 per share, of which $12,702,507 was paid during the year and $3,630,745 was paid on January 30, 2001. During the year ended December 31, 2000, 47,499 options were exercised at $198,762. Also, 894,163 shares were purchased in direct offerings, totaling $7,392,859. F-10 6. EARNINGS PER SHARE (EPS) For the year ended December 31, 2002, the reconciliation is as follows:
For the Year Ended December 31, 2002 (dollars in thousands, except for per share data) ---------------------------------------------------------- Income Shares Per-Share (Numerator) (Denominator) Amount ---------------------------------------------------------- Net income $ 219,507 ---------- Basic EPS 219,507 82,044,141 $ 2.68 ====== Effect of dilutive securities: Dilutive stock options - 238,742 -- ------- Diluted EPS $ 219,507 82,282,883 $ 2.67 ========== =========== ======
Options to purchase 6,250 shares of stock were outstanding and considered anti-dillutive as their exercise price exceeded the average stock price for the year. For the year ended December 31, 2001, the reconciliation is as follows:
For the Year Ended December 31, 2001 (dollars in thousands, except for per share data) ---------------------------------------------------- Average Income Shares Per-Share (Numerator) (Denominator) Amount ---------------------------------------------------- Net income $ 92,278 --------- Basic EPS 92,278 41,439,631 $ 2.23 ====== Effect of dilutive securities: Dilutive stock options - 417,867 -- ------- Diluted EPS $ 92,278 41,857,498 $ 2.21 ========= =========== ======
Options to purchase 6,250 shares of stock were outstanding and considered anti-dilutive as their exercise price exceeded the average stock price for the year. F-11 For the year ended December 31, 2000, the reconciliation is as follows:
For the Year Ended December 31, 2000 (dollars in the thousands, except per share data) ------------------------------------------------------ Average Income Shares Per-Share (Numerator) (Denominator) Amount ------------------------------------------------------ Net income $ 16,587 --------- Basic EPS 16,587 14,089,436 $ 1.18 ====== Effect of dilutive securities: Dilutive stock options - 288,023 -- ------- Diluted EPS $ 16,587 14,377,459 $ 1.15 ========= =========== ======
Options to purchase 568,926 shares of stock were outstanding and considered anti-dilutive. The exercise price exceeded the average stock price for the year. 7. LONG-TERM STOCK INCENTIVE PLAN The Company has adopted a long term stock incentive plan for executive officers, key employees and nonemployee directors (the "Incentive Plan"). The Incentive Plan authorizes the Compensation Committee of the board of directors to grant awards, including incentive stock options as defined under Section 422 of the Code ("ISOs") and options not so qualified ("NQSOs"). The Incentive Plan authorizes the granting of options or other awards for an aggregate of the greater of 500,000 shares or 9.5% of the fully diluted outstanding shares of the Company's common stock. The following table sets forth activity relating to the Company's stock options awards
2002 2001 2000 Weighted Weighted Weighted Number of Average Number of Average Number of Average Shares Exercise Shares Exercise Shares Exercise Price Price Price Options outstanding at the beginning of period 635,826 $8.48 903,807 $8.28 844,056 $8.03 Granted 6,250 20.35 6,250 13.69 122,500 8.00 Exercised (97,095) 8.75 (274,231) 7.95 (47,499) 4.18 Expired (32,275) 8.28 (15,250) 9.17 -------------- -------------- -------------- -------------- ------------- ------------- Options outstanding at the end of period 512,706 $8.59 635,826 $8.48 903,807 8.28 ============== ============== ============== ============== ============= ============= Options exercisable at end of period 393,076 $8.67 335,328 $8.63 341,226 $8.72
F-12 The following table summarizes information about stock options outstanding at December 31, 2002:
Weighted Average Options Weighted Average Remaining Contractual Range of Exercise Price Outstanding Exercise Price Life (Yrs.) ----------------------------------------------------------------------------------------------------- $7.94-$19.99 506,456 8.44 6.5 $20.00-$29.99 6,250 20.35 4.5 --------------------------------------------------------------- 512,706 8.59 6.5 ===============================================================
The Company accounts for the incentive plan under the intrinsic value method in accordance with APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. No stock-based employee compensation cost is reflected in net income, as all options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant. The following table illustrates the effect on net income and earnings per share if the company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, to stock-based employee compensation.
For the Year Ended December 31, 2002 2001 2000 (dollars in thousands, except per share data) ----------------- --------------- --------------- Net income, as reported $219,507 $92,278 $16,587 Deduct: Total stock-based employee compensation expense determined under fair value based method (33) (266) (118) ----------------- --------------- --------------- Pro-forma net income $219,474 $92,012 $16,469 ================= =============== =============== Net income per share, as reported Basic $2.68 $2.23 $1.18 Diluted $2.67 $2.21 $1.17 Pro-forma net income per share Basic $2.68 $2.22 $1.17 Diluted $2.67 $2.20 $1.15
The weighted average fair value at date of grant for stock options granted during the year ended December 31, 2002, 2001 and 2000 was $0.83, $0.89 and $0.43 per option, respectively. The fair value of stock options at date of grant was estimated using the Black-Scholes option pricing model utilizing the following weighted average assumptions:
For the Year Ended December 31, 2002 2001 2000 ---------------------------------------------- Risk-free interest rate 4.02% 4.21% 5.16% Expected option life in years 5 5 5 Expected stock price volatility 26% 28% 28% Expected dividend yield 13.57% 15.32% 12.69%
F-13 8. COMPREHENSIVE INCOME The Company adopted Statement of Financial Accounting Standards No. 130, Reporting Comprehensive Income. Statement No. 130 requires the reporting of comprehensive income in addition to net income from operations. Comprehensive income is a more inclusive financial reporting methodology that includes disclosure of certain financial information that historically has not been recognized in the calculation of net income. The Company at December 31, 2002 and 2001 held securities classified as available-for-sale. At December 31, 2002, the net unrealized gains totaled $75,511,000 and at December 31, 2001, the net unrealized losses totaled $38,169,000. 9. LEASE COMMITMENTS The Corporation has a noncancelable lease for office space, which commenced in May 2002 and expires in December 2009. The Corporation's aggregate future minimum lease payments are as follows:
Total per Year (dollars in thousands) 2003 500 2004 500 2005 500 2006 530 2007 532 thereafter 1,064 ------------------------ Total remaining lease payments $3,626 ========================
10. RELATED PARTY TRANSACTION Included in "Other Assets" on the Balance sheet as of December 31, 2001 is an investment in Annaly International Money Management, Inc. On June 24, 1998, the Company acquired 99,960 nonvoting shares, at a cost of $49,980. Annaly International Money Management, Inc. was liquidated during the year, resulting in a $44,000 loss, which is reflected in "Gain on Sale of Securities," in the Statement of Operations. The officers and directors of Annaly International Money Management Inc. are also officers and directors of the Company. Officers and employees of the Company are actively involved in managing Mortgage-Backed Securities and other fixed income assets for institutional clients through Fixed Income Discount Advisory Company ("FIDAC"). FIDAC is a registered investment adviser, which is owned 100% by the Chief Executive Officer of Annaly Mortgage Management, Inc. Our management currently allocates rent and other general and administrative expenses 90% to Annaly and 10% to FIDAC. 11. INTEREST RATE RISK The primary market risk to the Company is interest rate risk. Interest rates are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond the Company's control. Changes in the general level of interest rates can affect net interest income, which is the difference between the interest income earned on interest-earning assets and the interest expense incurred in connection with the interest-bearing liabilities, by affecting the spread between the interest-earning assets and interest-bearing liabilities. Changes in the level of interest rates also can affect the value of the mortgage-backed securities and the Company's ability to realize gains from the sale of these assets. The Company seeks to manage the extent to which net income changes as a function of changes in interest rates by matching adjustable-rate assets with variable-rate borrowings. In addition, although the Company has not done so to F-14 date, the Company may seek to mitigate the potential impact on net income of periodic and lifetime coupon adjustment restrictions in the portfolio of mortgage-backed securities by entering into interest rate agreements such as interest rate caps and interest rate swaps. Changes in interest rates may also have an effect on the rate of mortgage principal prepayments and, as a result, prepayments on mortgage-backed securities. The Company will seek to mitigate the effect of changes in the mortgage principal repayment rate by balancing assets purchased at a premium with assets purchased at a discount. To date, the aggregate premium exceeds the aggregate discount on the mortgage-backed securities. As a result, prepayments, which result in the expensing of unamortized premium, will reduce net income compared to what net income would be absent such prepayments. 12. SUMMARIZED QUARTERLY RESULTS (UNAUDITED) The following is a presentation of the quarterly results of operations for the year ended December 31, 2002.
Quarters Ending March 31, June 30, September 30, December 31, 2002 2002 2002 2002 (dollars in the thousands) ----------------------------------------------------------------------- Interest income from Mortgage- Backed Securities and cash $ 92,900 $ 109,423 $ 109,201 $ 92,641 Interest expense on repurchase agreements 40,012 47,860 54,012 49,874 ------- ------- ------- ------ Net interest income 52,888 61,563 55,189 42,767 Gain on sale of Mortgage-Backed Securities 3,410 1,343 4,747 11,563 General and administrative expenses 3,255 3,536 3,268 3,904 ------ ------ ------ ----- Net income $ 53,043 $ 59,370 $ 56,668 $ 50,426 ========= ========= ========= ======== Net income per share: Basic $0.69 $0.72 $0.68 $0.60 ====== ====== ====== ===== Diluted $0.69 $0.71 $0.68 $0.60 ====== ====== ====== ===== Average number of shares outstanding: Basic 76,709,836 82,910,206 83,668,422 84,525,171 =========== =========== =========== ========== Diluted 77,017,431 83,186,865 83,939,870 84,766,747 =========== =========== =========== ==========
F-15 The following is a presentation of the quarterly results of operations for the year ended December 31, 2001. Quarters Ending March 31, June 30, September 30, December 31, 2001 2001 2001 2001 (dollars in thousands) ----------------------------------------------------------------------- Interest income from Mortgage- Backed Securities and cash $ 42,434 $ 64,790 $ 75,775 $ 80,059 Interest expense on repurchase agreements 33,453 45,284 48,620 40,698 ------- ------- ------- ------ Net interest income 8,981 19,506 27,155 39,361 Gain on sale of Mortgage-Backed Securities 269 482 1,184 2,651 General and administrative expenses 921 1,393 1,993 3,004 ---- ------ ------ ----- Net income $ 8,329 $ 18,595 $ 26,346 $ 39,008 ======== ========= ========= ======== Net income per share: Basic $0.38 $0.48 $0.58 $0.65 ====== ====== ====== ===== Diluted $0.37 $0.48 $0.57 $0.65 ====== ====== ====== ===== Average number of shares outstanding: Basic 21,851,481 38,473,928 45,503,179 59,776,777 =========== =========== =========== ========== Diluted 22,535,210 39,054,488 45,959,693 60,155,994 =========== =========== =========== ==========
F-16 The following is a presentation of the quarterly results of operations for the year ended December 31, 2000.
Quarters Ending March 31, June 30, September 30, December 31, 2000 2000 2000 2000 (dollars in thousands) ----------------------------------------------------------------------- Interest income from Mortgage- Backed Securities and cash $ 24,617 $ 25,735 $ 28,239 $ 31,160 Interest expense on repurchase agreements 19,293 21,453 24,779 27,377 ------- ------- ------- ------ Net interest income 5,324 4,282 3,460 3,783 Gain on sale of Mortgage-Backed Securities 107 65 873 981 General and administrative expenses 582 507 527 670 ---- ---- ---- --- Net income $ 4,849 $ 3,840 $ 3,806 $ 4,094 ======== ======== ======== ======= Net income per share: Basic $0.35 $0.27 $0.27 $0.28 ====== ====== ====== ===== Diluted $0.35 $0.26 $0.26 $0.28 ====== ====== ====== ===== Average number of shares outstanding: Basic 13,660,539 14,039,741 14,238,680 14,413,578 =========== =========== =========== ========== Diluted 13,971,112 14,631,940 14,529,142 14,702,189 =========== =========== =========== ==========
****** F-17 SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, in the city of New York, State of New York. ANNALY MORTGAGE MANAGEMENT, INC. Date: March 24, 2003 By: /s/ Michael A. J. Farrell Michael A. J. Farrell Chairman, Chief Executive Officer, and President Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the date indicated.
Title Date Signature /s/ KEVIN P. BRADY Director March 24, 2003 Kevin P. Brady /s/ SPENCER I. BROWNE Director March 24, 2003 Spencer Browne /s/ KATHRYN F. FAGAN Chief Financial Officer and Treasurer March 24, 2003 (principal financial and accounting officer) Kathryn F. Fagan /s/ MICHAEL A.J. FARRELL Chairman of the Board, Chief Executive Officer, March 24, 2003 President and Director (principal executive Michael A. J. Farrell officer) /s/ JONATHAN D. GREEN Director March 24, 2003 Jonathan D. Green /s/ JOHN A. LAMBIASE Director March 24, 2003 John A. Lambiase /s/ DONNELL A. SEGALAS Director March 24, 2003 Donnell A. Segalas /s/ WELLINGTON DENAHAN Vice Chairman of the Board and Director March 24, 2003 Wellington Denahan
II-1 CERTIFICATIONS I, Michael A.J. Farrell, certify that: 1. I have reviewed this annual report on Form 10-K of Annaly Mortgage Management, Inc.; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 24, 2003 /s/ Michael A.J. Farrell ------------------------ Michael A.J. Farrell Chairman, Chief Executive Officer, and President (Principal Executive Officer) II-2 CERTIFICATIONS I, Kathryn F. Fagan, certify that: 1. I have reviewed this annual report on Form 10-K of Annaly Mortgage Management, Inc.; 2. Based on my knowledge, this annual report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this annual report; 3. Based on my knowledge, the financial statements, and other financial information included in this annual report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this annual report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14) for the registrant and have: a) designed such disclosure controls and procedures to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this annual report is being prepared; b) evaluated the effectiveness of the registrant's disclosure controls and procedures as of a date within 90 days prior to the filing date of this annual report (the "Evaluation Date"); and c) presented in this annual report our conclusions about the effectiveness of the disclosure controls and procedures based on our evaluation as of the Evaluation Date; 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): a) all significant deficiencies in the design or operation of internal controls which could adversely affect the registrant's ability to record, process, summarize and report financial data and have identified for the registrant's auditors any material weaknesses in internal controls; and b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal controls; and 6. The registrant's other certifying officers and I have indicated in this annual report whether there were significant changes in internal controls or in other factors that could significantly affect internal controls subsequent to the date of our most recent evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses. Date: March 24, 2003 /s/ Kathryn F. Fagan -------------------- Kathryn F. Fagan Chief Financial Officer and Treasurer (Principal Financial Officer) II-3 EXHIBIT INDEX Exhibit Exhibit Description Sequentially Number Numbered Page 3.1 Articles of Incorporation of the Registrant (incorporated by reference to Exhibit 3.1 to our Registration Statement on Form S-11 (Registration No. 333-32913) filed with the Securities and Exchange Commission on August 5, 1997). 3.2 Articles of Amendment and Restatement of the Articles of Incorporation of the Registrant (incorporated by reference to Exhibit 3.2 to our Registration Statement on Form S-11 (Registration No. 333-32913) filed with the Securities and Exchange Commission on August 5, 1997). 3.3 Bylaws of the Registrant, as amended (incorporated by reference to Exhibit 3.3 to our Registration Statement on Form S-11 (Registration No. 333-32913) filed with the Securities and Exchange Commission on August 5, 1997). 4.1 Specimen Common Stock Certificate (incorporated by reference to Exhibit 4.1 to Amendment No. 1 to our Registration Statement on Form S-11 (Registration No. 333-32913) filed with the Securities and Exchange Commission on September 17, 1997. 10.1 Purchase Agreement, dated February 12, 1997, between the Registrant and Friedman, Billings, Ramsey & Co., Inc. ("FBR") (incorporated by reference to Exhibit 10.1 to our Registration Statement on Form S-11 (Registration No. 333-32913), filed with the Securities and Exchange Commission on August 5, 1997). 10.2 Registration Rights Agreement, dated February 12, 1997, between the Registrant and FBR (incorporated by reference to Exhibit 10.2 to our Registration Statement on Form S-11 (Registration No. 333-32913) filed with the Securities and Exchange Commission on August 5, 1997). 10.3 Long-Term Stock Incentive Plan (incorporated by reference to Exhibit 10.3 to our Registration Statement on Form S-11 (Registration No. 333-32913) filed with the Securities and Exchange Commission on August 5, 1997).* 10.4 Form of Master Repurchase Agreement (incorporated by reference to Exhibit 10.7 to our Registration Statement on Form S-11 (Registration No. 333-32913) filed with the Securities and Exchange Commission on August 5, 1997). 10.5 Form of Purchase Agreement, between the Registrant and the purchasers in the Direct Offering (incorporated by reference to Exhibit 10.8 to our Registration Statement on Form S-11 (Registration No. 333-32913) filed with the Securities and Exchange Commission on August 5, 1997). 10.6 Amended and Restated Employment Agreement, effective as of May 1, 2001 between the Registrant and Michael A.J. Farrell (incorporated by reference to Exhibit 10.1 to our Form 10-Q/A for its quarterly period ended June 30, 2001 filed with the Securities and Exchange Commission on August 27, 2001).* 10.7 Amended and Restated Employment Agreement, effective as of May 1, 2001, between the Registrant and Wellington St. Claire (incorporated by reference to Exhibit 10.2 to our Form 10-Q/A for its quarterly period ended June 30, 2001 filed with the Securities and Exchange Commission on August 27, 2001).* 10.8 Amended and Restated Employment Agreement, effective as of May 1, 2001 between the Registrant and Kathryn F. Fagan (incorporated by reference to Exhibit 10.3 to our Form 10-Q/A for its quarterly period ended June 30, 2001 filed with the Securities and Exchange Commission on August 27, 2001).* 10.9 Amended and Restated Employment Agreement, effective as of May 1, 2001, between the Registrant and Jennifer A. Stephens (incorporated by reference to Exhibit 10.4 to our Form 10-Q/A for its quarterly period ended June 30, 2001 filed with the Securities and Exchange Commission on August 27, 2001).* 23.1 Consent of Independent Auditors. 99.1 Certification of Michael A.J. Farrell, Chairman, Chief Executive Officer, and President of the Registrant, pursuant to 18 U.S.C. Section 1350. 99.2 Certification of Kathryn F. Fagan, Chief Financial Officer and Treasurer of the Registrant, pursuant to 18 U.S.C. Section 1350. * Exhibit Numbers 10.3 and 10-6-10.9 are management contracts or compensatory plans required to be filed as Exhibits to this Form 10-K. Exhibit 23.1 INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in Registration Statements No. 333-74618 and No. 333-72985 of Annaly Mortgage Management, Inc. on Form S-3 of our report dated February 26, 2003, appearing in the Annual Report on Form 10-K of Annaly Mortgage Management, Inc. for the year ended December 31, 2002 and to the reference to us under the heading "Experts" in the Prospectus, which is part of these Registration Statements. /s/ Deloitte & Touche LLP New York, New York March 26, 2003 Exhibit 99.1 ANNALY MORTGAGE MANAGEMENT, INC. 1211 AVENUE OF THE AMERICAS SUITE 2902 NEW YORK, NEW YORK 10036 CERTIFICATION OF CHIEF EXECUTIVE OFFICER REGARDING PERIODIC REPORT CONTAINING FINANCIAL STATEMENTS I, Michael A.J. Farrell, the Chairman of the Board of Directors, Chief Executive Officer, and President of Annaly Mortgage Management, Inc. (the "Company") in compliance with 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, hereby certify that, the Company's Annual Report on Form 10-K for the period ended December 31, 2002 (the "Report") filed with the Securities and Exchange Commission: -- fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and -- the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Michael A.J. Farrell Michael A.J. Farrell Chairman of the Board of Directors Chief Executive Officer, and President March 24, 2003 Exhibit 99.2 ANNALY MORTGAGE MANAGEMENT, INC. 1211 AVENUE OF THE AMERICAS SUITE 2902 NEW YORK, NEW YORK 10036 CERTIFICATION OF CHIEF FINANCIAL OFFICER REGARDING PERIODIC REPORT CONTAINING FINANCIAL STATEMENTS I, Kathryn F. Fagan, the Chief Financial Officer and Treasurer of Annaly Mortgage Management, Inc. (the "Company") in compliance with 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, hereby certify that, the Company's Annual Report on Form 10-K for the period ended December 31, 2002 (the "Report") filed with the Securities and Exchange Commission: -- fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and -- the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. /s/ Kathryn F. Fagan Kathryn F. Fagan Chief Financial Officer and Treasurer March 24, 2003