|
|
|
March
31, 2007
|
|
|
|
|
Notional
Amount
|
|
Carrying
Amount
|
|
Estimated
Fair
Value
|
|
|
|
|
|
|
|
|
|
|
|
Continuing
Operations:
|
|
|
|
|
|
|
|
|
Investment
securities available for sale
|
|
$
|
449,349
|
|
$
|
447,063
|
|
$
|
447,063
|
|
|
Mortgage
loans held in the securitization trusts
|
|
|
540,549
|
|
|
544,046
|
|
|
542,290
|
|
|
Commitments
and contingencies:
|
|
|
|
|
|
|
|
|
|
|
|
Interest
rate swaps
|
|
|
285,000
|
|
|
(183
|
)
|
|
(183
|
)
|
|
Interest
rate caps
|
|
$
|
1,469,636
|
|
$
|
1,300
|
|
$
|
1,300
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Discontinued
Operations:
|
|
|
|
|
|
|
|
|
|
|
|
Mortgage
loans held for sale
|
|
$
|
60,872
|
|
$
|
60,883
|
|
$
|
61,422
|
|
|
Commitments
and contingencies:
|
|
|
|
|
|
|
|
|
|
|
|
Interest
rate lock commitments - loan commitments
|
|
|
4,843
|
|
|
(7
|
)
|
|
(7
|
)
|
|
Interest
rate lock commitments - mortgage loans held for sale
|
|
|
54,571
|
|
|
37
|
|
|
37
|
|
|
Forward
loan sales contracts -mortage loans held for sale
|
|
|
531
|
|
|
(11
|
)
|
|
(11
|
)
|
|
Forward
loan sales contracts - loan commitments
|
|
$
|
4,843
|
|
$
|
1
|
|
$
|
1
|
|
|
|
|
December
31, 2006
|
|
|
|
|
Notional
Amount
|
|
Carrying
Amount
|
|
Estimated
Fair
Value
|
|
|
|
|
|
|
|
|
|
|
|
Continuing
Operations:
|
|
|
|
|
|
|
|
|
|
|
|
Investment
securities available for sale
|
|
$
|
491,293
|
|
$
|
488,962
|
|
$
|
488,962
|
|
|
Mortgage
loans held in the securitization trusts
|
|
|
584,358
|
|
|
588,160
|
|
|
582,504
|
|
|
Commitments
and contingencies:
|
|
|
|
|
|
|
|
|
|
|
|
Interest
rate swaps
|
|
|
285,000
|
|
|
621
|
|
|
621
|
|
|
Interest
rate caps
|
|
$
|
1,540,518
|
|
$
|
2,011
|
|
$
|
2,011
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Discontinued
Operations:
|
|
|
|
|
|
|
|
|
|
|
|
Mortgage
loans held for sale
|
|
$
|
110,804
|
|
$
|
106,900
|
|
$
|
107,810
|
|
|
Commitments
and contingencies:
|
|
|
|
|
|
|
|
|
|
|
|
Interest
rate lock commitments - loan commitments
|
|
|
104,334
|
|
|
(118
|
)
|
|
(118
|
)
|
|
Interest
rate lock commitments - mortgage loans held for sale
|
|
|
106,312
|
|
|
(98
|
)
|
|
(98
|
)
|
|
Forward
loan sales contracts
|
|
$
|
142,110
|
|
$
|
171
|
|
$
|
171
|
|
The
impact of changing interest rates may be mitigated by portfolio prepayment
activity that we closely monitor and the portfolio funding strategies we employ.
First, our floating rate borrowings may react to changes in interest rates
before our adjustable rate assets because the weighted average next repricing
dates on the related borrowings may have shorter time periods than that of
the
adjustable rate assets. Second, interest rates on adjustable rate assets may
be
limited to a “periodic cap” or an increase of typically 1% or 2% per adjustment
period, while our borrowings do not have comparable limitations. Third, our
adjustable rate assets typically lag changes in the applicable interest rate
indices by 45 days, due to the notice period provided to adjustable rate
borrowers when the interest rates on their loans are scheduled to
change.
In
a
period of declining interest rates or nominal differences between long-term
and
short-term interest rates, the rate of prepayment on our mortgage assets may
increase. Increased prepayments would cause us to amortize any premiums paid
for
our mortgage assets faster, thus resulting in a reduced net yield on our
mortgage assets. Additionally, to the extent proceeds of prepayments cannot
be
reinvested at a rate of interest at least equal to the rate previously earned
on
such mortgage assets, our earnings may be adversely affected.
Conversely,
if interest rates rise or if the differences between long-term and short-term
interest rates increase the rate of prepayment on our mortgage assets may
decrease. Decreased prepayments would cause us to amortize the premiums paid
for
our ARM assets over a longer time period, thus resulting in an increased net
yield on our mortgage assets. Therefore, in rising interest rate environments
where prepayments are declining, not only would the interest rate on the ARM
Assets portfolio increase to re-establish a spread over the higher interest
rates, but the yield also would rise due to slower prepayments. The combined
effect could mitigate other negative effects that rising short-term interest
rates might have on earnings.
Interest
rates can also affect our net return on hybrid adjustable rate (“hybrid ARM”)
securities and loans net of the cost of financing hybrid ARMs. We
continually monitor and estimate the duration of our hybrid ARMs and have a
policy to hedge the financing of the hybrid ARMs such that the net duration
of
the hybrid ARMs, our borrowed funds related to such assets, and related hedging
instruments are less than one year. During a declining interest rate
environment, the prepayment of hybrid ARMs may accelerate (as borrowers may
opt
to refinance at a lower rate) causing the amount of liabilities that have been
extended by the use of interest rate swaps to increase relative to the amount
of
hybrid ARMs, possibly resulting in a decline in our net return on hybrid ARMs
as
replacement hybrid ARMs may have a lower yield than those being prepaid.
Conversely, during an increasing interest rate environment, hybrid ARMs may
prepay slower than expected, requiring us to finance a higher amount of hybrid
ARMs than originally forecast and at a time when interest rates may be higher,
resulting in a decline in our net return on hybrid ARMs. Our exposure to
changes in the prepayment speed of hybrid ARMs is mitigated by regular
monitoring of the outstanding balance of hybrid ARMs and adjusting the amounts
anticipated to be outstanding in future periods and, on a regular basis, making
adjustments to the amount of our fixed-rate borrowing obligations for future
periods.
Interest
rate changes may also impact our net book value as our securities, certain
mortgage loans and related hedge derivatives are marked-to-market each quarter.
Generally, as interest rates increase, the value of our fixed income
investments, such as mortgage loans and mortgage-backed securities, decreases
and as interest rates decrease, the value of such investments will increase.
We
seek to hedge to some degree changes in value attributable to changes in
interest rates by entering into interest rate swaps and other derivative
instruments. In general, we would expect that, over time, decreases in value
of
our portfolio attributable to interest rate changes will be offset to some
degree by increases in value of our interest rate swaps, and vice versa.
However, the relationship between spreads on securities and spreads on swaps
may
vary from time to time, resulting in a net aggregate book value increase or
decline. However, unless there is a material impairment in value that would
result in a payment not being received on a security or loan, changes in the
book value of our portfolio will not directly affect our recurring earnings
or
our ability to make a distribution to our stockholders.
In
order
to minimize the negative impacts of changes in interest rates on earnings and
capital, we closely monitor our asset and liability mix and utilize interest
rate swaps and caps, subject to the limitations imposed by the REIT
qualification tests.
Movements
in interest rates can pose a major risk to us in either a rising or declining
interest rate environment. We depend on substantial borrowings to conduct our
business. These borrowings are all made at variable interest rate terms that
will increase as short term interest rates rise. Additionally, when interest
rates rise, mortgage loans held for sale and any applications in process with
interest rate lock commitments, or IRLCs, decrease in value. To preserve the
value of such loans or applications in process with IRLCs, we may enter into
forward sale loan contracts, or FSLCs, to be settled at future dates with fixed
prices.
Our
hedging transactions using derivative instruments also involve certain
additional risks such as counterparty credit risk, the enforceability of hedging
contracts and the risk that unanticipated and significant changes in interest
rates will cause a significant loss of basis in the contract. The counterparties
to our derivative arrangements are major financial institutions and securities
dealers that are well capitalized with high credit ratings and with which we
may
also have other financial relationships. While we do not anticipate
nonperformance by any counterparty, we are exposed to potential credit losses
in
the event the counterparty fails to perform. Our exposure to credit risk in
the
event of default by a counterparty is the difference between the value of the
contract and the current market price. There can be no assurance that we will
be
able to adequately protect against the forgoing risks and will ultimately
realize an economic benefit that exceeds the related expenses incurred in
connection with engaging in such hedging strategies.
Credit
Spread Exposure
The
mortgage-backed securities we currently, and will in the future, own are also
subject to spread risk. The majority of these securities will be adjustable-rate
securities that are valued based on a market credit spread to U.S. Treasury
security yields. In other words, their value is dependent on the yield demanded
on such securities by the market based on their credit relative to U.S. Treasury
securities. Excessive supply of such securities combined with reduced demand
will generally cause the market to require a higher yield on such securities,
resulting in the use of a higher or wider spread over the benchmark rate
(usually the applicable U.S. Treasury security yield) to value such securities.
Under such conditions, the value of our securities portfolio would tend to
decline. Conversely, if the spread used to value such securities were to
decrease or tighten, the value of our securities portfolio would tend to
increase. Such changes in the market value of our portfolio may affect our
net
equity, net income or cash flow directly through their impact on unrealized
gains or losses on available-for-sale securities, and therefore our ability
to
realize gains on such securities, or indirectly through their impact on our
ability to borrow and access capital.
Furthermore,
shifts in the U.S. Treasury yield curve, which represents the market’s
expectations of future interest rates, would also affect the yield required
on
our securities and therefore their value. These shifts, or a change in spreads,
would have a similar effect on our portfolio, financial position and results
of
operations.
Market
(Fair Value) Risk
For
certain of the financial instruments that we own, fair values will not be
readily available since there are no active trading markets for these
instruments as characterized by current exchanges between willing parties.
Accordingly, fair values can only be derived or estimated for these investments
using various valuation techniques, such as computing the present value of
estimated future cash flows using discount rates commensurate with the risks
involved. However, the determination of estimated future cash flows is
inherently subjective and imprecise. Minor changes in assumptions or estimation
methodologies can have a material effect on these derived or estimated fair
values. These estimates and assumptions are indicative of the interest rate
environments as of March 31, 2007 and do not take into consideration the effects
of subsequent interest rate fluctuations.
We
note
that the values of our investments in mortgage-backed securities, and in
derivative instruments, primarily interest rate hedges on our debt, will be
sensitive to changes in market interest rates, interest rate spreads, credit
spreads and other market factors. The value of these investments can vary and
has varied materially from period to period. Historically, the values of our
mortgage loan portfolio have tended to vary inversely with those of its
derivative instruments.
The
following describes the methods and assumptions we use in estimating fair values
of our financial instruments:
Fair
value estimates are made as of a specific point in time based on estimates
using
present value or other valuation techniques. These techniques involve
uncertainties and are significantly affected by the assumptions used and the
judgments made regarding risk characteristics of various financial instruments,
discount rates, estimates of future cash flows, future expected loss experience
and other factors.
Changes
in assumptions could significantly affect these estimates and the resulting
fair
values. Derived fair value estimates cannot be substantiated by comparison
to
independent markets and, in many cases, could not be realized in an immediate
sale of the instrument. Also, because of differences in methodologies and
assumptions used to estimate fair values, the fair values used by us should
not
be compared to those of other companies.
The
fair
values of the Company’s residential mortgage-backed securities are generally
based on market prices provided by five to seven dealers who make markets in
these financial instruments. If the fair value of a security is not reasonably
available from a dealer, management estimates the fair value based on
characteristics of the security that the Company receives from the issuer and
on
available market information.
The
fair
value of loans held for investment are determined by the loan pricing sheet
which is based on internal management pricing and third party competitors in
similar products and markets.
The
fair
value of loan commitments to fund with agreed upon rates are estimated using
the
fees and rates currently charged to enter into similar agreements, taking into
account the remaining terms of the agreements and the present creditworthiness
of the counterparties. For fixed rate loan commitments, fair value also
considers the difference between current market interest rates and the existing
committed rates.
The
fair
value of commitments to deliver mortgages is estimated using current market
prices for dealer or investor commitments relative to our existing
positions.
The
market risk management discussion and the amounts estimated from the analysis
that follows are forward-looking statements that assume that certain market
conditions occur. Actual results may differ materially from these projected
results due to changes in our ARM portfolio and borrowings mix and due to
developments in the domestic and global financial and real estate markets.
Developments in the financial markets include the likelihood of changing
interest rates and the relationship of various interest rates and their impact
on our ARM portfolio yield, cost of funds and cash flows. The analytical methods
that we use to assess and mitigate these market risks should not be considered
projections of future events or operating performance.
As
a
financial institution that has only invested in U.S.-dollar denominated
instruments, primarily residential mortgage instruments, and has only borrowed
money in the domestic market, we are not subject to foreign currency exchange
or
commodity price risk. Rather, our market risk exposure is largely due to
interest rate risk. Interest rate risk impacts our interest income, interest
expense and the market value on a large portion of our assets and liabilities.
The management of interest rate risk attempts to maximize earnings and to
preserve capital by minimizing the negative impacts of changing market rates,
asset and liability mix, and prepayment activity.
The
table
below presents the sensitivity of the market value of our portfolio using a
discounted cash flow simulation model. Application of this method results in
an
estimation of the percentage change in the market value of our assets,
liabilities and hedging instruments per 100 basis point (“bp”) shift in interest
rates expressed in years - a measure commonly referred to as duration. Positive
portfolio duration indicates that the market value of the total portfolio will
decline if interest rates rise and increase if interest rates decline. The
closer duration is to zero, the less interest rate changes are expected to
affect earnings. Included in the table is a “Base Case” duration calculation for
an interest rate scenario that assumes future rates are those implied by the
yield curve as of March 31, 2007. The other two scenarios assume interest rates
are instantaneously 100 and 200 bps higher that those implied by market rates
as
of March 31, 2007.
The
use
of hedging instruments is a critical part of our interest rate risk management
strategies, and the effects of these hedging instruments on the market value
of
the portfolio are reflected in the model’s output. This analysis also takes into
consideration the value of options embedded in our mortgage assets including
constraints on the repricing of the interest rate of ARM Assets resulting from
periodic and lifetime cap features, as well as prepayment options. Assets and
liabilities that are not interest rate-sensitive such as cash, payment
receivables, prepaid expenses, payables and accrued expenses are excluded.
The
duration calculated from this model is a key measure of the effectiveness of
our
interest rate risk management strategies.
Changes
in assumptions including, but not limited to, volatility, mortgage and financing
spreads, prepayment behavior, defaults, as well as the timing and level of
interest rate changes will affect the results of the model. Therefore, actual
results are likely to vary from modeled results.
Net
Portfolio Duration
March
31, 2007
|
|
|
|
|
|
Basis
point increase
|
|
|
|
|
|
Base
|
|
|
+100
|
|
|
+200
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Mortgage
Portfolio
|
|
|
0.86
years
|
|
|
1.25
years
|
|
|
1.38
years
|
|
|
Borrowings
(including hedges)
|
|
|
0.42
years
|
|
|
0.42
years
|
|
|
0.42
years
|
|
|
Net
|
|
|
0.44
years
|
|
|
0.83
years
|
|
|
0.96
years
|
|
It
should
be noted that the model is used as a tool to identify potential risk in a
changing interest rate environment but does not include any changes in portfolio
composition, financing strategies, market spreads or changes in overall market
liquidity.
Based
on
the assumptions used, the model output suggests a very low degree of portfolio
price change given increases in interest rates, which implies that our cash
flow
and earning characteristics should be relatively stable for comparable changes
in interest rates.
Although
market value sensitivity analysis is widely accepted in identifying interest
rate risk, it does not take into consideration changes that may occur such
as,
but not limited to, changes in investment and financing strategies, changes
in
market spreads, and changes in business volumes. Accordingly, we make extensive
use of an earnings simulation model to further analyze our level of interest
rate risk.
There
are
a number of key assumptions in our earnings simulation model. These key
assumptions include changes in market conditions that affect interest rates,
the
pricing of ARM products, the availability of ARM products, and the availability
and the cost of financing for ARM products. Other key assumptions made in using
the simulation model include prepayment speeds and management’s investment,
financing and hedging strategies, and the issuance of new equity. We typically
run the simulation model under a variety of hypothetical business scenarios
that
may include different interest rate scenarios, different investment strategies,
different prepayment possibilities and other scenarios that provide us with
a
range of possible earnings outcomes in order to assess potential interest rate
risk. The assumptions used represent our estimate of the likely effect of
changes in interest rates and do not necessarily reflect actual results. The
earnings simulation model takes into account periodic and lifetime caps embedded
in our ARM Assets in determining the earnings at risk.
Liquidity
and Funding Risk
Liquidity
is a measure of our ability to meet potential cash requirements, including
ongoing commitments to repay borrowings, fund and maintain investments, pay
dividends to our stockholders and other general business needs. We recognize
the
need to have funds available for our operating. It is our policy to have
adequate liquidity at all times. We plan to meet liquidity through normal
operations with the goal of avoiding unplanned sales of assets or emergency
borrowing of funds.
Our
ability to hold mortgage loans held for sale require cash. Generally, we are
required to have a balance of between zero and 4% of the loan’s balance funded
by the Company with cash, the balance being drawn from the warehouse facility.
Our operating cash inflows are predominately from cash flows from mortgage
securities, principal and interest on mortgage loans, and sales of originated
loans.
Loans
financed on our warehouse facility are subject to changing market valuations
and
margin calls. The market value of our loans is dependent on a variety of
economic conditions, including interest rates (and borrower demand) and end
investor desire and capacity. These values can also be affected by general
tightening of credit standards across the industry recently. There is no
certainty that market values will remain constant going forward. To the extent
the value of the loans declines significantly, we would be required to repay
portions of the amounts we have borrowed.
As
it
relates to our investment portfolio, derivative financial instruments we use
also subject us to “margin call” risk based on their market values. Under our
interest rate swaps, we pay a fixed rate to the counterparties while they pay
us
a floating rate. When floating rates are low, on a net basis we pay the
counterparty and visa-versa. In a declining interest rate environment, we would
be subject to additional exposure for cash margin calls due to accelerating
prepayments of mortgage assets. However, the asset side of the balance sheet
should increase in value in a further declining interest rate scenario. Most
of
our interest rate swap agreements provide for a bi-lateral posting of margin,
the effect being that either swap party must post margin, depending on the
change in value of the swap over time. Unlike typical unilateral posting of
margin only in the direction of the swap counterparty, this provides us with
additional flexibility in meeting our liquidity requirements as we can call
margin on our counterparty as swap values increase.
Incoming
cash on our mortgage loans and securities is a principal source of cash. The
volume of cash depends on, among other things, interest rates. The volume and
quality of such incoming cash flows can be impacted by severe and immediate
changes in interest rates. If rates increase dramatically, our short-term
funding costs will increase quickly. While many of our investment portfolio
loans are hybrid ARMs, they typically will not reset as quickly as our funding
costs creating a reduction in incoming cash flow. Our derivative financial
instruments are used to mitigate the effect of interest rate
volatility.
We
manage
liquidity to ensure that we have the continuing ability to maintain cash flows
that are adequate to meet commitments on a timely and cost-effective basis.
Our
principal sources of liquidity are the repurchase agreement market, the issuance
of CDOs, loan warehouse facilities as well as principal and interest payments
from portfolio Assets. We believe our existing cash balances and cash flows
from
operations will be sufficient for our liquidity requirements for at least the
next 12 months.
Prepayment
Risk
When
borrowers repay the principal on their mortgage loans before maturity or faster
than their scheduled amortization, the effect is to shorten the period over
which interest is earned, and therefore, reduce the cash flow and yield on
our
ARM Assets. Furthermore, prepayment speeds exceeding or lower than our
reasonable estimates for similar assets, impact the effectiveness of any hedges
we have in place to mitigate financing and/or fair value risk. Generally, when
market interest rates decline, borrowers have a tendency to refinance their
mortgages. The higher the interest rate a borrower currently has on his or
her
mortgage the more incentive he or she has to refinance the mortgage when rates
decline. Additionally, when a borrower has a low loan-to-value ratio, he or
she
is more likely to do a “cash-out” refinance. Each of these factors increases the
chance for higher prepayment speeds during the term of the loan.
We
mitigate prepayment risk by constantly evaluating our ARM portfolio at a range
of reasonable market prepayment speeds observed at the time for assets with
a
similar structure, quality and characteristics. Furthermore, we stress-test
the
portfolio as to prepayment speeds and interest rate risk in order to develop
an
effective hedging strategy.
For
the
three months ended March 31, 2007, our mortgage assets paid down at an
approximate average annualized Constant Paydown Rate (“CPR”) of 19%, compared to
17% for the three months ended December 31, 2006, 21% for the three months
ended
September 30, 2006, 20% for the three months ended June 30, 2006 and 18% for
the
three months ended March 31, 2006. When prepayment experience increases, we
have
to amortize our premiums over a shorter time period, resulting in a reduced
yield to maturity on our ARM Assets. Conversely, if actual prepayment experience
decreases, we would amortize the premium over a longer time period, resulting
in
a higher yield to maturity. We monitor our prepayment experience on a monthly
basis and adjust the amortization of the net premium, as
appropriate.
Credit
Risk
Credit
risk is the risk that we will not fully collect the principal we have invested
in mortgage loans or securities. As previously noted, we are predominately
a
high-quality loan originator and our underwriting guidelines are intended to
evaluate the credit history of the potential borrower, the capacity and
willingness of the borrower to repay the loan, and the adequacy of the
collateral securing the loan. Along with this however, is a growing percentage
of loans underwritten with stated income and/or stated assets. These loan types
make credit risk assessment more difficult.
We
mitigate credit risk by establishing and applying criteria that identifies
high-credit quality borrowers. With regard to the purchased mortgage security
portfolio, we rely on the guaranties of FNMA, FHLMC, GNMA or the AAA/Aaa rating
established by the Rating Agencies.
With
regard to loans included in our securitization, factors such as FICO score,
LTV,
debt-to-income ratio, and other borrower and collateral factors are evaluated.
Credit enhancement features, such as mortgage insurance may also be factored
into the credit decision. In some instances, when the borrower exhibits strong
compensating factors, exceptions to the underwriting guidelines may be
approved.
Our
loans
held in securitization are concentrated in geographic markets that are generally
supply constrained. We believe that these markets have less exposure to sudden
declines in housing values than those markets which have an oversupply of
housing. In addition, in the supply constrained housing markets we focus on,
housing values tend to be high and, generally, underwriting standards for higher
value homes require lower LTVs and thus more owner equity further mitigating
credit risk. For our mortgage securities that are purchased, we rely on the
Fannie Mae, Freddie Mac, Ginnie Mae and AAA-rating of the securities
supplemented with additional due diligence.
