10-Q: Quarterly report pursuant to Section 13 or 15(d)
Published on November 14, 1996
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
|X| Quarterly Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the quarter ended September 30, 1996
|_| Transition Report Pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
Commission file number 1-9819
RESOURCE MORTGAGE CAPITAL, INC.
(Exact name of registrant as specified in its charter)
Virginia 52-1549373
(State or other jurisdiction of I.R.S. Employer
incorporation or organization) Identification No.)
4880 Cox Road, Glen Allen, Virginia 23060
(Address of principal executive offices) (Zip Code)
(804) 967-5800
(Registrant's telephone number, including area code)
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 ninety days. |X| Yes [] No
On October 31, 1996, the registrant had 20,653,593 shares of common stock of
$.01 value outstanding, which is the registrant's only class of common stock.
RESOURCE MORTGAGE CAPITAL, INC.
FORM 10-Q
INDEX
PAGE
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
RESOURCE MORTGAGE CAPITAL, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(amounts in thousands except share data)
RESOURCE MORTGAGE CAPITAL, INC.
CONSOLIDATED STATEMENT OF SHAREHOLDERS' EQUITY
(amounts in thousands except share data)
RESOURCE MORTGAGE CAPITAL, INC.
NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS September 30, 1996 (amounts
in thousands except share data)
NOTE 1--BASIS OF PRESENTATION
The accompanying consolidated financial statements have been prepared in
accordance with the instructions to Form 10-Q and do not include all of the
information and notes required by generally accepted accounting principles for
complete financial statements. The consolidated financial statements include the
accounts of Resource Mortgage Capital, Inc., its wholly-owned subsidiaries, and
certain other entities. As used herein, the "Company" refers to Resource
Mortgage Capital, Inc. (RMC) and each of the entities that is consolidated with
RMC for financial reporting purposes. A portion of the Company's operations are
operated by taxable corporations that are consolidated with RMC for financial
reporting purposes, but are not consolidated for income tax purposes. All
significant intercompany balances and transactions have been eliminated in
consolidation.
In the opinion of management, all material adjustments, consisting of normal
recurring adjustments, considered necessary for a fair presentation of the
consolidated financial statements have been included. The Consolidated Balance
Sheet at September 30, 1996, the Consolidated Statements of Operations for the
three and nine months ended September 30, 1996 and 1995, the Consolidated
Statement of Shareholders' Equity for the nine months ended September 30, 1996,
the Consolidated Statements of Cash Flows for the nine months ended September
30, 1996 and 1995 and related notes to consolidated financial statements are
unaudited. Operating results for the nine months ended September 30, 1996 are
not necessarily indicative of the results that may be expected for the year
ending December 31, 1996. For further information, refer to the audited
consolidated financial statements and footnotes included in the Company's Form
10-K for the year ended December 31, 1995.
Certain amounts for 1995 have been reclassified to conform with the presentation
for 1996.
NOTE 2--NET INCOME PER COMMON SHARE
Net income per common share as shown on the consolidated statements of
operations for the three and nine months ended September 30, 1996 and 1995 is
presented on both a primary net income per common share and fully diluted net
income per common share basis. Fully diluted net income per common share is
computed by dividing net income applicable to common stock by the average number
of shares of common stock and common stock equivalents outstanding for items
that are dilutive. The average number of shares is increased by the assumed
conversion of convertible items, but only if dilutive. For the three and nine
months ended September 30, 1996, the Company's Series A and B Cumulative
Convertible Preferred Stocks were dilutive. Series A and Series B Preferred
Stock are convertible to shares of common stock on a one-for-one basis. The
following table summarizes the average number of shares of common stock and
equivalents used to compute primary and fully diluted net income per common
share for the three and nine months ended September 30, 1996 and 1995:
NOTE 3--AVAILABLE FOR SALE MORTGAGE INVESTMENTS
The following table summarizes the Company's amortized cost basis of collateral
for CMOs and mortgage securities held at September 30, 1996 and December 31,
1995, and the related average effective interest rates (calculated excluding
unrealized gains and losses) for the month ended September 30, 1996 and December
31, 1995:
The Company has classified collateral for CMOs and all mortgage securities as
available-for-sale. Other mortgage securities with an aggregate principal
balance of $27,087 were sold during the three and nine months ended September
30, 1996 for an aggregate net loss of $1,975. The specific identification method
is used to calculate the basis of mortgage investments sold. In addition, the
Company reduced the basis in certain other mortgage securities as expectations
of future prepayment rates would result in the Company receiving less cash than
its current basis in those investments. The adjustment recorded was $1,143 and
is included in loss on sale of mortgage investments in the accompanying
financial statements.
The following table presents the fair value of the Company's collateral for CMOs
and mortgage securities held at September 30, 1996 and December 31, 1995:
NOTE 4--SALE OF SINGLE-FAMILY OPERATIONS
On May 13, 1996, the Company sold its single-family correspondent, wholesale,
and servicing operations (collectively, the single-family mortgage operations)
to Dominion Mortgage Services, Inc. (Dominion), a wholly-owned subsidiary of
Dominion Resources, Inc. (NYSE: D) The purchase price was $68 million for the
stock and assets of the single-family mortgage operations. The terms of the
purchase included an initial cash payment of $20.4 million, with the remainder
of the purchase price paid in five annual installments of $9.5 million beginning
January 2, 1997, pursuant to a note agreement. The note bears interest at a rate
of 6.50%. The terms of the sale generally prohibit the Company from acquiring
single-family, residential mortgages through either correspondents or a
wholesale network for a period of five years. As a result of the sale, the
Company recorded a net gain of $17.5 million. Such amount is net of various
reserves for contingent liabilities related to the sale of the operations and
includes a provision of $31.0 million for possible losses on single-family loans
where the Company, which performed the servicing of such loans prior to the
sale, has retained a portion of the credit risk on these loans.
NOTE 5--ADOPTION OF FINANCIAL ACCOUNTING STANDARDS
In January 1996, the Company adopted Financial Accounting Standards Board
Statement No. 123, "Accounting for Stock-Based Compensation" (FAS No. 123). FAS
No. 123 establishes a fair value based method of accounting for stock-based
compensation plans. FAS No. 123 permits entities to expense an estimated fair
value of employee stock options or to continue to measure compensation cost for
these plans using the intrinsic value accounting method contained in APB Opinion
No. 25. As the Company issues only stock appreciation rights pursuant to various
stock incentive plans which are currently paid in cash, the impact of adopting
FAS No. 123 did not result in a material change to the Company's financial
position or results of operations.
In June 1996, the Financial Accounting Standards Board (FASB) issued FAS No.
125, "Accounting for Transfers and Servicing of Financial Assets and
Extinguishments of Liabilities". FAS No. 125 provides accounting and reporting
standards for transfers and servicing of financial assets and extinguishments of
liabilities based on consistent application of a financial components approach
that focuses on control of the respective assets and liabilities. It
distinguishes transfers of financial assets that are sales from transfers that
are secured borrowings. FAS No. 125 is effective for transfers and servicing of
financial assets and extinguishments of liabilities occurring after December 31,
1996. The impact of this statement on the Company's financial position and
results of operations has not been determined, but is not expected to be
material.
NOTE 6--ACQUISITION OF MULTI-FAMILY CAPITAL MARKETS, INC.
On August 30, 1996, the Company acquired Multi-Family Capital Markets, Inc.
(MCM), which specializes in the sourcing, underwriting and closing of
multi-family loans secured by first liens on apartment properties that have
qualified for low income housing tax credits. The Company acquired all of the
outstanding stock and assets of MCM for $4 million. Of this amount, $2.8 million
was paid in cash with the remaining $1.2 million paid through the issuance of
notes to the sellers, due in installments through September 1, 1999 and
September 1, 2001. The acquisition was accounted for as a purchase, and
accordingly, the purchase price was allocated to the assets and liabilities
acquired based on their estimated fair values as of the date of acquisition.
MCM's results of operations are not material to the Company's consolidated
financial statements and proforma financial information has therefore not been
presented.
NOTE 7--SUBSEQUENT EVENT
On October 9, 1996, the Company issued 1,840,000 shares of Series C 9.73%
Cumulative Convertible Preferred Stock at a price of $30 per share. Net proceeds
from this issuance totaled $52.9 million.
Item 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
Summary
Resource Mortgage Capital, Inc. (the Company) is a mortgage and consumer finance
company which uses its production operations to create investments for its
portfolio. Currently, the Company's primary production operations include the
origination of loans secured by manufactured housing and the origination of
mortgage loans secured by multi-family properties. The Company will generally
securitize loans funded as collateral for collateralized mortgage obligations
(CMOs) or pass-through securities to limit its credit risk and provide long-term
financing for its portfolio. The majority of the Company's current investment
portfolio is comprised of loans or securities ("ARM loans" or "ARM securities")
that have coupon rates which adjust over time (subject to certain limitations)
in conjunction with changes in short-term interest rates. The Company intends to
expand its production sources in the future to include other financial products,
such as commercial real estate loans. The Company has elected to be treated as a
real estate investment trust (REIT) for federal income tax purposes and as such
must distribute substantially all of its taxable income to shareholders and will
generally not be subject to federal income tax.
On May 13, 1996, the Company completed the sale of its single-family mortgage
operations to Dominion Mortgage Services, Inc. (Dominion), a wholly-owned
subsidiary of Dominion Resources, Inc., for approximately $68 million. Included
in the single-family mortgage operations were the Company's single-family
correspondent, wholesale, and servicing operations. The sale resulted in a gain
of $17.5 million, which was net of various reserves for contingent liabilities
related to the single-family mortgage operations including a provision of $31.0
million for possible losses on single-family loans where the Company has
retained a portion of the credit risk and where, prior to the sale, the Company
had serviced such single-family loans.
The Company's principle sources of earnings are net interest income on its
investment portfolio and loans in warehouse. The Company's investment portfolio
consists principally of collateral for CMOs and adjustable-rate mortgage (ARM)
securities. The Company funds its production and its portfolio investments with
both borrowings and cash raised from the issuance of equity capital. For the
portion of loans in warehouse and portfolio investments funded with borrowings,
the Company generates net interest income to the extent that there is a positive
spread between the yield on the earning assets and the cost of borrowed funds.
For that portion of the balance sheet that is funded with equity capital, net
interest income is primarily a function of the yield generated from the interest
earning asset. The cost of the Company's borrowings may be increased or
decreased by interest rate swap, cap or floor agreements.
Approximately $3.7 billion of the Company's investment portfolio as of September
30, 1996, is comprised of ARM loans or ARM securities. Generally, during a
period of rising interest rates, the Company's net interest spread earned on its
investment portfolio will decrease. The decrease of the net interest spread
results from (i) the lag in resets of the ARM loans underlying the ARM
securities and collateral for CMOs and (ii) rate resets on the ARM loans which
are generally limited to 1% every six months, while the associated borrowings
have no such limitation. As interest rates stabilize and the ARM loans reset,
the net interest margin may be restored to its former level as the yields on the
ARM loans adjust to market conditions. Conversely, net interest margin may
increase following a fall in short-term interest rates; this increase may be
temporary as the yields on the ARM loans adjust to the new market conditions
after a lag period. In each case, however, the Company expects that the increase
or decrease in the net interest spread due to changes in the short-term interest
rates is temporary. The net interest spread may also be increased or decreased
by the cost or proceeds of the interest rate swap, cap or floor agreements.
The Company strives to create a diversified portfolio of investments that in the
aggregate generates stable income for the Company in a variety of interest rate
environments and preserves the capital base of the Company. The Company seeks to
generate growth in earnings and dividends per share in a variety of ways,
including (i) adding investments to its portfolio when opportunities in the
market are favorable; (ii) developing production capabilities to originate and
acquire financial assets in order to create attractively priced investments for
its portfolio, as well as control the underwriting and servicing of such
financial assets; and (iii) increasing the efficiency with which the Company
utilizes its equity capital over time. To increase potential returns to
shareholders, the Company also employs leverage through the use of secured
borrowings and repurchase agreements to fund a portion of its production and
portfolio investments. Currently, the Company's production operations are
comprised of multi-family and manufactured housing lending. The Company's
strategy is to expand these existing production sources as well as to diversify
into other financial products such as commercial real estate loans. The Company
also intends to selectively purchase single-family loans in bulk with the intent
to securitize such loans as collateral for CMOs. By pursuing these strategies,
the Company believes it can create investments for the portfolio at a lower
effective cost than if such assets were purchased in the market, although there
can be no assurance that the Company will be successful in accomplishing this
strategy.
In order to grow its equity base, the Company may issue additional preferred or
common stock. Management strives to issue such additional shares when it
believes existing shareholders are likely to benefit from such offerings through
higher earnings and dividends per share than as compared to the level of
earnings and dividends the Company would likely generate without such offerings.
On August 30, 1996, the Company acquired Multi-Family Capital Markets, Inc.
(MCM), which specializes in the sourcing, underwriting and closing of
multi-family loans secured by first liens on apartment properties that have
qualified for low income housing tax credits. The Company acquired all of the
outstanding stock and assets of MCM for $4.0 million. The Company believes this
acquisition will complement its current strategy of expanding its multi-family
lending business and will improve its competitive position in the marketplace
for such loans.
Three Months and Nine Months Ended September 30, 1996 Compared to Three Months
and Nine Months Ended September 30, 1995. The increase in the Company's earnings
during the nine months ended September 30, 1996 as compared to the same period
in 1995 is primarily the result of the increase in net interest margin and the
gain on the sale of the single-family operations offset partially by a decline
in the gain on sale of mortgage investments and an increase in general and
administrative expenses. The increase in the Company's earnings during the three
months ended September 30, 1996 as compared with the same period in 1995 can be
attributed primarily to an increase in net interest margin.
Net interest margin for the nine months ended September 30, 1996 increased to
$55.1 million, or 93%, over the $28.5 million for the same period for 1995. This
increase was a result of an overall increase in the net interest spread on all
interest-earning assets, as well as the increased contribution from CMOs issued.
The net interest spread on all investments increased to 160 basis points for the
nine months ended September 30, 1996 versus 92 basis points for the nine months
ended September 30, 1995. The increase in the net interest spreads is generally
attributable to the ARM securities continued upward rate resets, such that these
securities were generally fully-indexed for the first nine months of 1996, and
the more favorable interest rate environment on borrowings related to the ARM
securities and CMOs.
Gain on sale of the Company's single-family operations and mortgage investments
increased to a net $14.6 million for the nine months ended September 30, 1996,
from $7.2 million for the nine months ended September 30, 1995. The increase of
the net gain is due to a one-time gain related to the sale of the Company's
single-family correspondent, wholesale and servicing business. The sale of the
Company's single-family operations was completed in May 1996, at a recorded gain
of $18.9 million. Additional adjustments related to the sale were made in the
third quarter, reducing the gain recorded by $1.4 million to $17.5 million. The
gain generated from the sale of single-family operations is offset by a $7.5
million loss during the second quarter from the sale of certain underperforming
securities in the Company's investment portfolio. Additional adjustments related
to the sale of these underperforming investments were made in the third quarter,
reducing the loss by $2.2 million to $5.3 million. The net gain on sale for the
nine months ended September 30, 1996, was further reduced by a reduction in the
carrying value of certain other mortgage securities as expectations of future
prepayment rates will result in the Company receiving less cash than its current
basis in those investments. For the nine months ended September 30, 1995, the
gain on sale of mortgage investments includes gains of $3.6 million related to
securitizations and whole loan sales of single-family loans, $1.2 million from
the sale of servicing and $2.3 million related to the sale of investments.
General and administrative expenses increased $2.5 million, or 19.4%, to $15.7
million for the nine months ended September 30, 1996, as the Company continues
to build its infrastructure for its manufactured housing operations. General and
administrative expenses also increased from 1995 as a result of the Company's
continued expansion of its wholesale origination capabilities for its
single-family operations prior to the sale.
The following table summarizes the average balances of the Company's
interest-earning assets and their average effective yields, along with the
Company's average interest-bearing liabilities and the related average effective
interest rates, for each of the periods presented.
Average Balances and Effective Interest Rates
The increase in net interest spread for both the three and nine months ended
September 30, 1996 relative to the same periods in 1995 is primarily the result
of the increase in the spread on ARM securities and an increase in CMOs, which
for the three months ended September 30, 1996, constituted the largest portion
of the Company's investment portfolio on a weighted average basis. The net
interest spread on ARM securities increased 72 basis points, from 43 basis
points for the nine months ended September 30, 1995 to 115 basis points for the
nine months ended September 30, 1996. ARM securities during the first nine
months of 1996 were generally fully-indexed relative to their respective
indices. At September 30, 1995, the ARM securities were "teased" approximately
33 basis points on a weighted average basis. The ARM securities have become
fully-indexed as short-term interest rates stabilized and then declined during
the latter half of 1995 and through the first quarter of 1996. The net interest
spread also temporarily benefited as a result of the declining short-term
interest rate environment during the first part of 1996, which had the impact of
reducing the Company's borrowing costs faster than it reduced the yields on the
Company's interest earning assets. The Company's overall weighted average
borrowing costs decreased to 6.03% for the nine months ended September 30, 1996
from 6.57% for the nine months ended September 30, 1995, while the overall yield
on interest-earning assets increased to 7.63% from 7.49%. CMOs increased to $2.9
billion at September 30, 1996, or 248%, from $0.8 billion at September 30, 1995.
The net interest spread on CMOs increased 43 basis points, from 127 basis points
for the nine months ended September 30, 1995, to 170 basis points for the nine
months ended September 30, 1996.
PORTFOLIO RESULTS
The Company's investment strategy is to create a diversified portfolio of
securities that in the aggregate generate stable income in a variety of interest
rate and prepayment rate environments and preserve the capital base of the
Company. The Company has pursued its strategy of concentrating on its production
activities to create investments with attractive yields. In many instances, the
Company's investment strategy has involved not only the creation or acquisition
of the asset, but also the related long-term, non-recourse borrowings such as
through the issuance of CMOs.
Interest Income and Interest Earning Assets
The Company's average interest earning assets were $4.0 billion during the nine
months ended September 30, 1996, an increase of 20% from $3.3 billion of average
interest earning assets during the same period of 1995. Total interest income
rose 21%, from $188.6 million during the nine months ended September 30, 1995 to
$228.9 million during the same period of 1996. Overall, the yield on interest
earning assets rose to 7.63% for the nine months ended September 30, 1996 from
7.49% for the nine months ended September 30, 1995, as the investment in higher
yielding collateral for CMOs continued to grow. On a quarter to quarter basis,
average interest earning assets for the quarter ended June 30, 1996 were $4.2
billion versus $4.1 billion for the quarter ended September 30, 1996. Total
interest income for the quarter ended June 30, 1996 was $78.3 million versus
$78.4 million for the quarter ended September 30, 1996. As indicated in the
table below, average yields for these periods were 7.52% and 7.64%,
respectively, which were 1.88 % and 1.84% higher than the average daily
six-month LIBOR interest rate during those periods. The majority of the ARM
loans underlying the Company's ARM securities and collateral for CMOs are
indexed to and reset based upon the level of the London InterBank Offered Rate
(LIBOR) for six-month deposits (six-month LIBOR). As a result of the six-month
LIBOR daily average increasing during the second and third quarters of 1996, the
Company expects that the yield on the ARM loans underlying the ARM securities
and collateral for CMOs will trend upward during the fourth quarter since the
majority of the ARM loans underlying the Company's ARM securities and CMO
securities reset generally every six months and on a one-to-two month lag
The net yield on average interest earning assets increased to 2.21% for the
three months ended September 30, 1996, compared to 2.11% for the three months
ended June 30, 1996 and 1.74% for the three months ended September 30, 1995. The
increase from the three months ended June 30, 1996 and September 30, 1995 is
principally due to the increase in the spread earned on the interest-earning
assets, despite an increase in average interest-earning assets to $4.1 billion
for the three months ended September 30, 1996. Average interest earning assets
will continue to increase as the Company retains loans funded through its
production operations as collateral for CMOs. Net yield on average
interest-earning assets is expected to decrease as a result. Net yield as a
percentage of net average assets (defined as interest earning assets less
non-recourse CMOs issued), was 6.84% for the three months ended September 30,
1996, versus 5.62% for the three months ended June 30, 1996 and 3.01% for the
three months ended September 30, 1995. Net yield as a percentage of net average
assets is expected to increase due to the continued use of non-recourse CMOs.
The net yield percentages presented below exclude non-interest CMO expenses such
as provision for credit losses, and interest on senior notes payable. For the
three months ended September 30, 1996, if these expenses were included, the net
yield on average interest-earning assets would be 1.85%, and the net yield on
net average assets would be 6.30%, respectively.
The average asset yield is reduced for the amortization of premium on the
Company's investment portfolio. By creating its investments through its
production operations, the Company believes that premium amounts are less than
if the investments were acquired in the market. As indicated in the table below,
premiums on the Company's ARM securities, fixed-rate securities and collateral
for CMOs at September 30, 1996 was $60.8 million, or approximate by 1.60% of the
aggregate investment portfolio balance. The mortgage principal repayment rate
for the Company (indicated in the table below as "CPR Annualized Rate") was 19%
for the three months ended September 30, 1996. The Company expects that the
long-term prepayment speeds will range between 18% and 21%. The CPR for the
third quarter of 1996 is currently within this range and the Company expects it
will remain within this range for the fourth quarter of 1996. CPR stands for
"constant prepayment rate" and is a measure of the annual prepayment rate on a
pool of loans.
Interest Expense and Cost of Funds
The Company's largest expense is the interest cost on borrowed funds. Funds to
finance the investment portfolio are borrowed in the form of CMOs or repurchase
agreements, both of which are primarily indexed to LIBOR, principally one-month
LIBOR. For the nine month period ended September 30, 1996 as compared to the
same period in 1995, interest expense increased to $163.4 million from $149.8
million while the average cost of funds decreased to 6.07% for the nine month
period ended September 30, 1996 compared to 6.57% for the nine month period
ended September 30, 1995. The Company's cost of funds rose in conjunction with
the increase in the one-month LIBOR rate through the second quarter of 1995, and
then began to decline correspondingly with the decline in interest rates since
that time. The Company may use interest rate swaps, caps and financial futures
to manage its interest rate risk. The net costs during the related period of
these instruments are included in the cost of funds table below.
Interest Rate Agreements
As part of its asset/liability management process, the Company enters into
interest rate agreements such as interest rate caps and swaps and financial
futures contracts ("hedges"). These agreements are used to reduce interest rate
risk which arise from the lifetime yield caps on the ARM securities, the
mismatched repricing of portfolio investments versus borrowed funds, and
finally, assets repricing on indices such as the prime rate which are different
than the related borrowing indices. The agreements are designed to protect the
portfolio's cash flow, and to provide income and capital appreciation to the
Company in the event that short-term interest rates rise quickly.
The following table includes all interest rate agreements in effect as of the
various quarter ends. This table excludes hedge amounts for the Company's
production operations. Generally, interest rate swaps and caps are used to
manage the interest rate risk associated with assets that have periodic and
annual reset limitations financed with borrowings that have no such limitations.
Financial futures contracts and options on futures are used to lengthen the
terms of repurchase agreement financing, generally from one month to three and
six months. Amounts presented are aggregate notional amounts. To the extent any
of these agreements are terminated, gains and losses are generally amortized
over the remaining period of the original hedge.
Net Interest Rate Agreement Expense
The net interest rate agreement expense, or hedging expense, equals the
expenses, net of any benefits received, from these agreements. For the quarter
ended September 30, 1996, net hedging expense amounted to $1.20 million versus
$1.02 million and $0.86 million for the quarters ended June 30, 1996 and
September 30, 1995, respectively. For the nine months ended September 30, 1996,
net hedging expense was $3.94 million versus $3.54 million for the nine months
ended September 30, 1995. Such amounts exclude the hedging costs and benefits
associated with the Company's production activities as these amounts are
deferred as additional premium or discount on the loan funded and amortized over
the life of the loan as an adjustment to its yield.
Fair value
The fair value of the Company's investment portfolio as of September 30, 1996,
as measured by the net unrealized gain on mortgage investments, has improved
relative to September 30, 1995. The net unrealized gain on mortgage investments
improved by $74.4 million from September 30, 1995 to September 30, 1996. This
increase in the portfolio's value is primarily attributable to the increase in
the value of the collateral for CMOs relative to the CMOs issued during the last
twelve months, as well as an increase in value of the Company's ARM securities
due principally to the ARM securities being fully-indexed, and the stabilization
of interest rates.
Credit Exposures
The Company has historically securitized its loan production in pass-through or
CMO securitization structures. With either structure, the Company may use
overcollateralization, subordination, reserve funds, bond insurance, mortgage
pool insurance or any combination of the foregoing for credit enhancement.
Regardless of the form of credit enhancement, the Company may retain a limited
portion of the direct credit risk after securitization. This risk can include
risk of loss related to hazards not covered under standard hazard insurance
policies and credit risks on loans not covered by standard borrower mortgage
insurance, or pool insurance.
Beginning in 1994, the Company issued pass-through securities which used
subordination structures as their form of credit enhancement. The credit risk of
subordinated pass-through securities is concentrated in the subordinated classes
(which may themselves partially be credit enhanced with reserve funds or pool
insurance) of the securities, thus allowing the senior classes of the securities
to receive the higher credit rating. To the extent credit losses are greater
than expected (or exceed the protection provided by any reserve funds or pool
insurance), the holders of the subordinated securities will experience a lower
yield (which may be negative) than expected on their investments. At September
30, 1996, the Company retained $21.2 million in aggregate principal amount of
subordinated securities, which are carried at a book value of $3.8 million,
reflecting such potential credit loss exposure.
With CMO structures, the Company also retains credit risk relative to the amount
of overcollateralization required in conjunction with the bond insurance. Losses
are generally first applied to the overcollateralization amount, and any losses
in excess of that amount would be borne by the bond insurer or the holders of
the CMOs. The Company only incurs credit losses to the extent that losses are
incurred in the repossession, foreclosure and sale of the underlying collateral.
Such losses generally equal the excess of the principal amount outstanding, less
any proceeds from mortgage or hazard insurance, over the liquidation value of
the collateral. To compensate the Company for retaining this loss exposure, the
Company generally receives an excess yield on the mortgage loans relative to the
yield on the CMOs. At September 30, 1996, the Company retained $88.3 million in
aggregate principal amount of overcollateralization, and had reserves or
otherwise had provided coverage on $62.1 million of the potential credit loss
exposure.
The Company principally used pool insurance as its means of credit enhancement
for years prior to 1994. Pool insurance has generally been unavailable as a
means of credit enhancement since the beginning of 1994. Pool insurance covered
substantially all credit risk for the security with the exception of fraud in
the origination or certain special hazard risks. Loss exposure due to special
hazards is generally limited to an amount equal to a fixed percentage of the
principal balance of the pool of mortgage loans at the time of securitization.
Fraud in the origination exposure is generally limited to those loans which
default within one year of origination. The reserve for potential losses on
these risks was $7.9 million at September 30, 1996, which the Company believes
represents its maximum exposure from these risks.
The following table summarizes the aggregate principal amount of collateral for
CMOs and pass-through securities outstanding which are subject to credit
exposure, the maximum credit exposure held by the Company represented by the
amount of overcollateralization and first loss securities owned by the Company,
the credit reserves established by the Company for such exposure and the actual
credit losses incurred. The table excludes reserves and losses due to fraud and
special hazard exposure.
The following table summarizes the single-family mortgage loan delinquencies as
a percentage of the outstanding loan balance for the total collateral for CMOs
and pass-through securities outstanding where the Company has retained a portion
of the credit risk either through holding a subordinated security or through
overcollateralization. There were no delinquencies on any multi-family loans
where the Company has retained a portion of the credit risk either through
holding a subordinated security or through overcollateralization.
The following table summarizes the credit rating for investment held in the
Company's portfolio. This table excludes the Company's other mortgage
securities. (The risk on such securities is prepayment related, not credit
related) In preparing the table, the carrying balances of the investments rated
below A are net of credit reserves and discounts. The average credit rating of
the Company's mortgage investments at the end of the third quarter of 1996 was
AAA. Securitized loans with a credit rating of A or better were $4,142.9
million, or 99.88% of the Company's total mortgage investments. Securitized
loans with a credit rating below A represented 0.12% of the total as of
September 30, 1996. At the end of the third quarter 1996, $339.1 million of all
mortgage investments were split rated between rating agencies. Where investments
were split-rated, for purposes of this table, the Company classified such
investments based on the higher credit rating.
PRODUCTION ACTIVITIES
Until May 1996, the Company's production operations were comprised mainly of its
single-family mortgage operations that concentrated on the "non-conforming"
segment of the residential loan market. The Company funded its single-family
loans directly through mortgage brokers (wholesale) and purchased loans through
a network of mortgage companies (correspondents). Loans originated through the
Company's former single-family mortgage operations constitute the majority of
loans underlying the securities that comprise the Company's current investment
portfolio. On May 13, 1996, the Company sold its single-family mortgage
operations to Dominion Mortgage Services, Inc. (Dominion) for approximately $68
million. Included in the sale of the single-family mortgage operations were the
Company's single-family correspondent, wholesale, and servicing operations.
Since the sale, the Company's primary production operations have been focused on
multi-family lending and manufactured housing lending. The Company is in the
process of broadening its multi-family lending capabilities to include other
types of commercial real estate loans and to expand its manufactured housing
lending to include inventory financing to manufactured housing dealers. The
Company may also purchase single-family loans on a "bulk" basis from time to
time, and may originate such loans on a retail basis.
The purpose of the Company's production operations is to enhance the return on
shareholders' equity (ROE) by earning a favorable net interest spread while
loans are in warehouse being accumulated for securitization or sale and creating
investments for its portfolio at a lower cost than if such investments were
purchased from third parties. The creation of such investments generally
involves the issuance of pass-through securities or CMOs collateralized by the
loans generated from the Company's production activities, and the retention of
one or more classes of the securities or CMOs relating to such issuance. The
issuance of pass-through securities and CMOs generally limits the Company's
credit and interest rate risk relating to loans generated by the Company's
production operations.
When a sufficient volume of loans is accumulated, the Company generally
securitizes the loans through the issuance of CMOs or pass-through securities.
The Company believes that securitization is an efficient and cost effective way
for the Company to (i) reduce capital otherwise required to own the loans in
whole loan form; (ii) limit the Company's exposure to credit risk on the loans;
(iii) lower the overall cost of financing the loans; and (iv) depending on the
securitization structure, limit the Company's exposure to interest rate and/or
valuation risk. As a result of the reduction in the availability of mortgage
pool insurance, and the Company's desire to both reduce its recourse borrowings
as a percentage of its overall borrowings and the variability of its earnings,
the Company has utilized the CMO structure for securitizing substantially all of
its loan production since the beginning of 1995.
The following table summarizes the production activity for the three and nine
month periods ended September 30, 1996 and 1995.
Manufactured housing lending commenced during the second quarter of 1996. Since
commencement, the Company has opened region offices in North Carolina, Georgia,
Texas and Michigan. The Company is planning to establish a fifth regional office
on the West coast during the first quarter of 1997. Principally all funding
volume has been obtained through relationships with manufactured housing
dealers. As of September 30, 1996, the Company had $16 million in principal
balance of manufactured housing loans in inventory, and had commitments
outstanding of approximately $9 million. The Company's current sources of
originations are its dealer network and direct marketing to consumers. In the
future, the Company plans to expand its sources of origination to nearly all
sources for manufactured housing loans by establishing relationships with park
owners, developers of manufactured housing communities, manufacturers of
manufactured homes, brokers and correspondents. In addition, the Company also
expects to offer dealer inventory financing beginning in the fourth quarter
1996. Once certain volume levels are achieved at a particular region, district
offices may be opened in an effort to further market penetration. The first
district office is expected to be opened in the first quarter of 1997.
As of September 30, 1996, the Company had $148.1 million in principal balance of
multi-family loans in warehouse. The Company funded $57.4 million in
multi-family loans during the three months ended September 30, 1996 compared to
$72.6 million for the three months ended June 30, 1996 and none for the three
months ended September 30, 1995. Principally all fundings are under the
Company's lending programs for properties that have been allocated low income
housing tax credits. As of September 30, 1996 commitments to fund multi-family
loans over the next 20 months were approximately $532.6 million. The Company
expects that it will have funded volume sufficient enough to securitize a
portion of its multifamily mortgage loans held in warehouse in the first half of
1997 through the issuance of CMOs. The Company will retain a portion of the
credit risk after securitization and intends to service the loans.
On August 30, 1996, the Company acquired Multi-Family Capital Markets, Inc.
(MCM). MCM sources, underwrites and closes multi-family loans secured by first
liens on apartment properties that have qualified for low income housing tax
credits. With the acquisition of MCM, the multi-family mortgage loans originated
by the Company are now sourced through the Company's direct relationships with
developers and syndicators. There are no correspondent or broker relationships.
Through MCM, the Company has funded over $301 million of multi-family mortgage
loans since 1992.
The Company anticipates that it will continue to expand its production
operations into new product types, such as commercial mortgages, in the future.
Such commercial mortgages would be securitized with the Company's multi-family
productions.
OTHER ITEMS
General and Administrative Expenses
General and administrative expenses (G&A expense) consist of expense incurred in
conducting the Company's production activities, managing the investment
portfolio, and various corporate expenses. G&A expense increased for the nine
month period ended September 30, 1996 as compared to the same period in 1995
primarily due to the expansion of the single-family wholesale operations and the
start up costs related to the manufactured housing lending operations. As a
result of the sale, G&A expense related to the production operations decreased
for the three months ended September 30, 1996. This decrease, however, was
offset by an increase in the accrual for outstanding stock appreciation rights
granted pursuant to the Company's Stock Incentive Plan as a result of the
increase in the Company's stock price since June 30, 1996. G&A related to the
production operations will increase over time as the Company expands its
production activities with current and new product types.
The following table summarizes the Company's efficiency, the ratio of G&A
expense to average interest earning assets, and the ratio of G&A expense to
average total equity.
Net Income and Return on Equity
Net income increased from $24.8 million for the nine months ended September 30,
1995 to $55.1 million for the nine months ended September 30, 1996. Return on
common equity (excluding the impact of the unrealized gain on mortgage
investments) also increased from 11.67% for the nine months ended September 30,
1995 to 22.34% for the nine months ended September 30, 1996. The majority of the
increase in both the net income and the return on common equity is due to (i)
the gain recognized on the sale of the single-family operations in the second
quarter of 1996, (ii) the increased net margin related to increased levels of
interest-earning assets, and (iii) the increase in the net interest spread on
interest-earning assets.
Dividends and Taxable Income
The Company and its qualified REIT subsidiaries (collectively "Resource REIT")
have elected to be treated as a real estate investment trust for federal income
tax purposes. The REIT provisions of the Internal Revenue Code require Resource
REIT to distribute to shareholders substantially all of its taxable income,
thereby restricting its ability to retain earnings. The Company may issue
additional common stock, preferred stock or other securities in the future in
order to fund growth in its operations, growth in its portfolio of mortgage
investments, or for other purposes.
The Company intends to declare and pay out as dividends 100% of its taxable
income over time. The Company's current practice is to declare quarterly
dividends per share. Generally, the Company strives to declare a quarterly
dividend per share which will result in the distribution of most or all of the
taxable income earned during the quarter. At the time of the dividend
announcement, however, the total level of taxable income for the quarter is
unknown. Additionally, the Company has considerations other than the desire to
pay out most of the taxable earnings for the quarter, which may take precedence
when determining the level of dividends.
Taxable income differs from the financial statement net income which is
determined in accordance with generally accepted accounting principles (GAAP).
For the nine months ended September 30, 1996, the Company's taxable earnings per
share of $1.96 were higher than the Company's declared dividend per share of
$1.645. The majority of the difference was caused by GAAP and tax differences
related to the sale of the single-family operations. For tax purposes, the sale
will be accounted for on an installment sale basis with annual taxable income of
approximately $10 million. Additionally, the Company has a capital loss
carryforward available from prior years of $9 million which will offset a
portion of the tax gain from the sale of the single-family operations that would
be recognized in 1996. Cumulative undistributed taxable income represents timing
differences in the amounts earned for tax purposes versus the amounts
distributed. Such amounts can be distributed for tax purposes in the subsequent
year as a portion of the normal quarterly dividend.
LIQUIDITY AND CAPITAL RESOURCES
The Company has various sources of cash flow upon which it relies for its
working capital needs. Sources of cash flow from operations include primarily
the return of principal on its portfolio of mortgage investments and the
issuance of CMOs. Other borrowings provide the Company with additional cash flow
in the event that it is necessary. Historically, these sources have provided
sufficient liquidity for the conduct of the Company's operations. However, if a
significant decline in the market value of the Company's mortgage investments
should occur, the Company's available liquidity from these other borrowings may
be reduced. As a result of such a reduction in liquidity, the Company may be
forced to sell certain mortgage assets in order to maintain liquidity. If
required, these sales could be made at prices lower than the carrying value of
such assets, which could result in losses.
The Company borrows funds on a short-term basis to support the accumulation of
loans prior to the sale of such loans or the issuance of mortgage- or
asset-backed securities. These borrowings may bear fixed or variable interest
rates, may require additional collateral in the event that the value of the
existing collateral declines, and may be due on demand or upon the occurrence of
certain events. If borrowing costs are higher than the yields on the assets
financed with such funds, the Company's ability to acquire or fund additional
assets may be substantially reduced and it may experience losses. These
short-term borrowings consist of the Company's warehouse lines of credit and
repurchase agreements and are paid down as the Company securitizes or sells
loans.
A substantial portion of the assets of the Company are pledged to secure
indebtedness incurred by the Company. Accordingly, those assets would not be
available for distribution to any general creditors or the stockholders of the
Company in the event of the Company's liquidation, except to the extent that the
value of such assets exceeds the amount of the indebtedness they secure.
Warehouse Lines of Credit
The Company has various credit facilities aggregating $350 million to finance
loan fundings and for working capital purposes which expire in November 1996,
December 1996 and April 1998. One of these facilities includes several sublines
aggregating $250 million to serve various purposes, such as multi-family loan
fundings, working capital, and manufactured housing loan fundings, which may
not, in the aggregate, exceed the overall facility commitment of $150 million at
any time. Working capital borrowings are limited to $30 million. The Company
expects that these credit facilities will be renewed, if necessary, at their
respective expiration dates, although there can be no assurance of such renewal.
The lines of credit contain certain financial covenants which the Company met as
of September 30, 1996. However, changes in asset levels or results of operations
could result in the violation of one or more covenants in the future.
Repurchase Agreements
The Company also may finance a portion of its loans in warehouse with repurchase
agreements on an uncommitted basis. As of September 30, 1996, the Company had no
outstanding obligations under such repurchase agreements.
The Company finances its mortgage securities through repurchase agreements.
Repurchase agreements allow the Company to sell the mortgage securities for cash
together with a simultaneous agreement to repurchase the same mortgage
securities on a specified date for a price which is equal to the original sales
price plus an interest component. At September 30, 1996, the Company had
outstanding obligations of $1.23 billion under such repurchase agreements, of
which $1.2 billion, $19.9 million and $8.7 million were secured by ARM
securities, fixed-rate mortgage securities and other mortgage securities,
respectively. Increases in either short-term interest rates or long-term
interest rates could negatively impact the valuation of these mortgage
securities and may limit the Company's borrowing ability or cause various
lenders to initiate margin calls. Additionally, certain of the Company's ARM
securities are AAA or AA rated classes that are subordinate to related AAA rated
classes from the same series of securities. Such AAA or AA rated classes have
less liquidity than securities that are not subordinated, and the value of such
classes is more dependent on the credit rating of the related insurer or the
credit performance of the underlying mortgage loans. In instances of a downgrade
of an insurer, or the deterioration of the credit quality of the underlying
mortgage collateral, the Company may be required to sell certain mortgage assets
in order to maintain liquidity. If required, these sales could be made at prices
lower than the carrying value of the assets, which could result in losses.
The Company may lengthen the duration of its repurchase agreements secured by
mortgage securities by entering into certain futures and/or option contracts. As
of September 30, 1996, the Company had lengthened the duration of $1.0 billion
of its repurchase agreements to three months by entering into certain futures
and option contracts. The Company also has entered into approximately $0.5
billion of futures for repurchase agreements which have a duration of one month.
Additionally, the Company owns approximately $370 million of its CMOs and has
financed such CMOs with $370 million of short-term debt. For financial statement
presentation purposes, the Company has classified the $370 million of short-term
debt as CMOs outstanding.
Potential immediate sources of liquidity for the Company include cash balances
and unused availability on the credit facilities described above.
The increase in sources of liquidity as a percentage of borrowings from the
second quarter 1996 to the third quarter 1996 is primarily the result of the
issuance of a CMOs during the third quarter. The collateral for the CMOs was
comprised mainly of mortgage securities owned by the Company which were financed
with repurchase agreements. These repurchase agreements were paid off as a
result of the issuance of the CMO.
Unsecured Borrowings
The Company issued two series of unsecured notes totaling $50 million in 1994.
The proceeds from this issuance were used for general corporate purposes. The
notes have an outstanding balance at September 30, 1996 of $47 million. The
first principal repayment of one of the notes was due October 1995 and annually
thereafter, with quarterly interest payments due. Principal repayment on the
second note is contracted to begin in October 1998. The notes mature between
1999 and 2001 and bear interest at 9.56% and 10.03%. The note agreements contain
certain financial covenants which the Company met as of September 30, 1996.
However, changes in asset levels or results of operations could result in the
violation of one or more covenants in the future.
Forward-Looking Statements
Certain written statements in this Form 10-Q made by the Company, that are not
historical fact constitute "forward-looking statements" within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. Such forward-looking statements may
involve factors that could cause the actual results of the Company to differ
materially from historical results or from any results expressed or implied by
such forward-looking statements. The Company cautions the public not to place
undue reliance on forward-looking statements, which may be based on assumptions
and anticipated events that do not materialize. The Company does not undertake,
and the Securities Litigation Reform Act specifically relieves the Company from,
any obligation to update any forward-looking statements.
Factors that may causes actual results to differ from historical results or from
any results expressed or implied by forward-looking statements include the
following:
Economic Conditions. The Company is affected by consumer demand for manufactured
housing, multi-family housing and other products which it finances. A material
decline in demand for these goods and services would result in a reduction in
the volume of loans originated by the Company. The risk of defaults and credit
losses could increase during an economic slowdown or recession. This could have
and adverse effect on the Company's financial performance and the performance on
the Company's securitized loan pools.
Capital Resources. The Company relies on various credit facilities and
repurchase agreements with certain investment banking firms to help meet the
Company's short-term funding needs. The Company believes that as these
agreements expire, they will continue to be available or will be able to be
replaced; however no assurance can be given as to such availability or the
prospective terms and conditions of such agreements or replacements.
Interest Rate Fluctuations. The Company's income depends on its ability to earn
greater interest on its investments than the interest cost to finance these
investments. Interest rates in the markets served by the Company generally rise
or fall with interest rates as a whole. A majority of the loans currently
originated by the Company are fixed-rate. The profitability of a particular
securitization may be reduced if interest rates increase substantially before
these loans are securitized. In addition, the majority of the investments held
by the Company are variable rate CMOs and adjustable-rate investments. These
investments are financed through short-term repurchase agreements. The net
interest spread for these investments could decrease during a period of rapidly
rising interest rates, since the investments have interest rate caps and the
related borrowing have no such interest rate caps.
Defaults. Defaults may have an adverse impact on the Company's financial
performance, if actual credit losses differ materially from estimates made by
the Company at the time of securitization. The allowance for losses is
calculated on the basis of historical experience and management's best
estimates. Actual defaults may differ from the Company's estimate as a result of
economic conditions. Actual defaults on ARM loans may increase during a rising
interest rate environment. The Company believes that its reserves are adequate
for such risks.
Prepayments. Prepayments may have an adverse impact on the Company's financial
performance, if prepayments differ materially from estimates made by the
Company. The prepayment rate is calculated on the basis of historical experience
and management's best estimates. Actual rates of prepayment may vary as a result
of the prevailing interest rate. Prepayments are expected to increase during a
declining interest rate environment. The Company's exposure to more rapid
prepayments is (i) the faster amortization of premium on the investments and
(ii) the replacement of investments in its portfolio with lower yield
securities.
Competition. The financial services industry is a highly competitive
market. Increased competition in the market could adversely affect the
Company's market share within the industry.
Regulatory Changes. The Company's business is subject to federal and state
regulation which, among other things require the Company to maintain various
licenses and qualifications and require specific disclosures to borrowers.
Changes in existing laws and regulations or in the interpretation thereof, or
the introduction of new laws and regulations, could adversely affect the
Company's operation and the performance of the Company's securitized loan pools.
New Production Sources. The Company has recently begun originating manufactured
housing loans, and anticipates entering other lending businesses that are
complementary to its current multi-family mortgage lending strategy. The Company
is incurring or will incur expenditures related to the start-up of these
businesses, with no guarantee that production targets set by the Company will be
met or that these businesses will be profitable. Various factors such as
economic conditions, interest rates, competition and the lack of the Company's
prior experience in originating manufactured housing or other loans could all
impact these new production sources.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
None
Item 2. Changes in Securities
Not applicable
Item 3. Defaults Upon Senior Securities
Not applicable
Item 4. Submission of Matters to a Vote of Security Holders
None
Item 5. Other Information
None
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
3.1Form of Amendment to Articles of Incorporation regarding par
value of the Preferred Stock (Incorporated herein by reference
to the Exhibit to the Registrant's Current Report on Form 8-K,
filed October 15, 1996).
(b) Reports on Form 8-K
Current Report on Form 8-K filed with the Commission on October
15, 1996, regarding the issuance of Series C 9.73% Cumulative
Convertible preferred Stock)
SIGNATURES
Pursuant to the requirements 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.
ESOURCE MORTGAGE CAPITAL, INC.
By: /s/ Thomas H. Potts
Thomas H. Potts, President
authorized officer of registrant)
/s/ Lynn K. Geurin
Lynn K. Geurin, Executive Vice
President and Chief Financial Officer
(principal accounting officer)
Dated: November 14, 1996