| LUMINENT MORTGAGE CAPITAL INC ITEM 1A RISK FACTORS As used in this report, “Luminent,” “Company,” “we,” “our,” and “us,” refer to Luminent Mortgage Capital, Inc |
| and its subsidiaries, except where the context otherwise requires |
| The occurrence of one or more of these risk factors could adversely impact our results of operations or financial condition |
| General Risks Related to our Business We might not be able to find mortgage loans or mortgage-backed securities that meet our investment criteria or at favorable spreads over our borrowing costs, which would adversely impact our results of operations or financial condition |
| Our net income depends on our ability to acquire residential mortgage loans and mortgage-backed securities at favorable spreads over our borrowing costs |
| In acquiring mortgage loans and mortgage-backed securities, we compete with many other purchasers, including REITs, investment banking firms, savings and loan associations, banks, insurance companies and mutual funds, many of which have greater financial resources than we do |
| As a result, we may not be able to acquire a sufficient amount of mortgage loans or mortgage-backed securities at favorable spreads over our borrowing costs, which would adversely impact our results of operations or financial condition |
| We have limited experience in the business of acquiring and securitizing mortgage loans and we may not be successful, which would adversely impact our results of operations or financial condition |
| Loan acquisition and securitization activity within our Residential Mortgage Credit portfolio strategy is inherently complex and involves risks related to the types of mortgage loans we seek to acquire, interest rate changes, funding sources, delinquency rates, borrower bankruptcies and other factors that we may not be able to manage successfully |
| It may take years to determine whether we can manage these risks successfully |
| Our failure to manage these and other risks would adversely impact our results of operations or financial condition |
| Our mortgage loans and mortgage-backed securities are subject to prepayments, and increased prepayment rates could adversely impact our results of operations or financial condition |
| The principal and interest payments that we receive from our mortgage loans and mortgage-backed securities are generally funded by the payments that borrowers make on the related mortgage loans pursuant to amortization schedules |
| When borrowers prepay their mortgage loans sooner than expected, we correspondingly receive principal cash flows from our investments earlier than anticipated |
| Prepayment rates generally increase when interest rates decline and decrease when interest rates rise |
| Changes in prepayment rates, however, tend to lag a few months behind changes in interest rates and are difficult to predict |
| Prepayment rates may also be affected by other factors, including the strength of the housing and financial markets, the overall economy, mortgage loan interest rates currently available to borrowers in the market and the ability of borrowers to refinance their mortgages |
| We seek to purchase mortgage loans and mortgage-backed securities that we believe have favorable risk-adjusted expected returns relative to market interest rates at the time of purchase |
| If the coupon interest rate for a mortgage loan or mortgage-backed security is higher than the market interest rate at the time it is purchased, then it will be acquired at a premium to its par value |
| Correspondingly, if the coupon interest rate for a mortgage loan or mortgage-backed security is lower than the market interest rate at the time it is purchased, then it will be acquired at a discount to its par value |
| We are required to amortize any premiums or accrete discounts related to our mortgage loans and mortgage-backed securities over their expected terms |
| The amortization of a premium reduces our interest income, while the accretion of a discount increases our interest income |
| The expected terms for mortgage loans and mortgage-backed securities are a function of the prepayment rates for the mortgage loans purchased or underlying the mortgage-backed securities purchased |
| If mortgage loans and mortgage-backed securities purchased at a premium subsequently are prepaid in whole or in part more quickly than anticipated, then we are required to amortize their respective premiums more quickly, which would decrease our net interest income and adversely impact our results of operations |
| Conversely, if mortgage loans and mortgage-backed securities purchased at a discount subsequently are prepaid in whole or in part more slowly than anticipated, then we are required to accrete their respective 12 _________________________________________________________________ [69]Table of Contents discounts more slowly, which would decrease our net interest income and adversely impact our results of operations or financial condition |
| Our stockholders’ equity or book value is volatile and is subject to changes in interest rates |
| The fair values of the mortgage loans and mortgage-backed securities that we purchase are subject to daily fluctuations in market pricing resulting from changes in interest rates |
| For example, when interest rates increase, the fair value of our assets generally declines, and, when interest rates decrease, the fair value of our assets generally increases |
| For our mortgage-backed securities that are classified as “available for sale,” we are required to carry these assets at fair value and to flow any changes in their fair value through the “other comprehensive income or loss” portion of stockholders’ equity on our balance sheet |
| The daily fluctuations in market pricing of these mortgage-backed securities, and their corresponding flow through our stockholders’ equity, creates volatility in our stockholders’ equity, or book value |
| Our mortgage loans and mortgage-backed securities are subject to defaults, which could adversely impact our results of operations or financial condition |
| Each of our two mortgage investment strategies bears the risk of loss resulting from defaults |
| Our risk of loss is dependent upon the credit quality and performance of the mortgage loans that we purchase directly, as well as upon the credit quality and performance of the mortgage loans underlying the mortgage-backed securities that we purchase or securitize |
| In our Spread strategy, the mortgage-backed securities that we purchase are generally backed by federal government agencies, such as Ginnie Mae, or by federally-chartered corporations, including Fannie Mae and Freddie Mac, or are rated AAA and are guaranteed by corporate guarantors |
| Ginnie Mae’s obligations are backed by the full faith and credit of the United States |
| The obligations of Fannie Mae and Freddie Mac and other corporate guarantors are solely their own |
| A substantial deterioration in the financial strength of Fannie Mae, Freddie Mac or other corporate guarantors could increase our exposure to future delinquencies, defaults or credit losses on our holdings of mortgage-backed securities issued by these entities |
| If the mortgage-backed securities we purchase under our Spread strategy experience defaults, it could adversely impact our results of operations or financial condition |
| In our Residential Mortgage Credit portfolio strategy, we purchase mortgage loans that are not credit-enhanced and that do not have the backing of Ginnie Mae, Fannie Mae or Freddie Mac |
| Although we generally seek to purchase high-quality mortgage loans, we bear the risk of loss from borrower default, bankruptcy and special hazard losses on any loans that we purchase and subsequently securitize |
| In the event of a default on any mortgage loan that we hold, we would bear the net loss of principal that would adversely impact our results of operations or financial condition |
| As part of our Residential Mortgage Credit portfolio strategy, we also purchase subordinated mortgage-backed securities that have credit ratings below AAA These subordinated mortgage-backed securities are structured to absorb a disproportionate share of losses from their underlying mortgage loans |
| In the event of a default on any of the mortgage loans underlying the mortgage-backed securities that we hold pursuant to our Residential Mortgage Credit portfolio strategy, we would bear the net loss of principal and it would adversely impact our results of operations |
| Finally, all of our mortgage loans and mortgage-backed securities are secured by underlying real property interests |
| To the extent that the value of the property underlying our mortgage loans or mortgage-backed securities decreases, our security might be impaired, which might decrease the value of our assets, and might adversely impact our results of operations |
| The representations and warranties that we will make in our securitizations may subject us to liability, which could adversely impact our results of operations or financial condition |
| We will make representations and warranties regarding the mortgage loans that we transfer into securitization trusts |
| Each securitization’s trustee has recourse to us with respect to the breach of the standard representations and warranties regarding the loans made at the time such mortgages are transferred |
| While we generally have recourse to our loan originators for any such breaches, there can be no assurance of the originators’ abilities to honor their 13 _________________________________________________________________ [70]Table of Contents respective obligations |
| We attempt to limit generally the potential remedies of the trustee to the potential remedies we receive from the originators from whom we acquire our mortgage loans |
| However, in some cases, the remedies available to the trustee may be broader than those available to us against the originators of the mortgages, and should the trustee enforce its remedies against us, we may not always be able to enforce whatever remedies we have against our originators |
| Furthermore, if we discover, prior to the securitization of a loan, that there is any fraud or misrepresentation with respect to a mortgage loan and the originator fails to repurchase the loan, then we may not be able to sell the mortgage loan or may have to sell the loan at a discount |
| Our mortgage loans and mortgage-backed securities are subject to interest rate caps and resets that could adversely impact our results of operations or financial condition |
| The mortgage loans we purchase directly and the mortgage loans collateralized for the mortgage-backed securities that we purchase may be subject to periodic and lifetime interest rate caps |
| Periodic interest rate caps limit the amount that the interest rate on a mortgage loan can increase during any given period |
| Lifetime interest rate caps limit the amount that the interest rate of a mortgage loan can increase throughout the life of the loan |
| The periodic adjustments to the interest rates of the mortgage loans we purchase directly and that underlie our mortgage-backed securities, known as resets, are based on changes in an objective benchmark interest rate index, such as the US Treasury index or LIBOR During a period of rapidly increasing interest rates, the interest rates paid on our borrowings could increase without limitation while interest rate caps and delayed resets could limit the increases in the yields on our mortgage loans and mortgage-backed securities |
| This problem is magnified for mortgage loans and mortgage-backed securities that are not fully indexed |
| Further, some of the mortgage loans and mortgages underlying our mortgage-backed securities may be subject to periodic payment caps that result in a portion of the interest being deferred and added to the principal outstanding |
| As a result, we may receive less cash income on our mortgage loans and mortgage-backed securities than we need to pay interest on our related borrowings |
| These factors might adversely impact our results of operations or financial condition |
| The use of securitizations with over-collateralization requirements could restrict our cash flow and adversely impact our results of operations or financial condition |
| If we use over-collateralization as a credit enhancement for our securitizations, such over-collateralization will restrict our cash flow if loan delinquencies exceed certain levels |
| The terms of our securitizations generally will provide that, if certain delinquencies and/or losses exceed specified levels based on rating agencies’ (or the financial guaranty insurer’s, if applicable) analysis of the characteristics of the loans pledged to collateralize the securities, the required level of over-collateralization may be increased or may be prevented from decreasing as would otherwise be permitted if losses and/or delinquencies did not exceed those levels |
| Other tests, based on delinquency levels or other criteria, may restrict our ability to receive net interest income from a securitization transaction |
| Failure to satisfy performance tests could adversely impact our results of operations |
| We purchase subordinated mortgage-backed securities that are structured to absorb a disproportionate amount of any losses on the underlying mortgage loans |
| These purchases could adversely impact our results of operations or financial condition |
| These subordinated mortgage-backed securities are structured to absorb a disproportionate share of the losses from their underlying mortgage loans, and expose us to high levels of volatility in net interest income, interest rate risk, prepayment risk, credit risk and market pricing volatility, any one of which might adversely impact our results of operations or financial condition |
| 14 _________________________________________________________________ [71]Table of Contents Our mortgage loans and mortgage-backed securities are subject to potential illiquidity, which might prevent us from selling them at reasonable prices when we find it necessary to sell them |
| This factor could adversely impact our results of operations or financial condition |
| From time to time, mortgage loans and mortgage-backed securities experience periods of illiquidity |
| A period of illiquidity might result from the absence of a willing buyer or an established market for these assets, as well as legal or contractual restrictions on resale |
| We bear the risk of being unable to dispose of our mortgage loans and our mortgage-backed securities at advantageous times and prices during periods of illiquidity, which could adversely impact our results of operations or financial condition |
| Our mortgage loans and mortgage-backed securities are subject to the overall health of the US economy, and a national or regional economic slowdown could adversely impact our results of operations or financial condition |
| The health of the US residential mortgage market is correlated with the overall health of the US economy |
| An overall decline in the US economy could cause a significant decrease in the values of mortgaged properties throughout the US This decrease, in turn, could increase the risk of delinquency, default or foreclosure on our mortgage loans and on the mortgage loans underlying our mortgage-backed securities, and could adversely impact our results of operations or financial condition |
| We might not be able to obtain financing for our mortgage loans or mortgage-backed securities, which would adversely impact our results of operations or financial condition |
| The success of our business strategies depends upon our ability to obtain various types of financing for our mortgage loans and mortgage-backed securities, including repurchase agreements, warehouse financing, the issuance of debt securities and other types of long-term financing, including the issuance of preferred and common equity securities |
| Our inability to obtain a significant amount of financing through these sources would adversely impact our results of operations or financial condition |
| Our investment strategies employ a significant amount of leverage, and are subject to daily fluctuations in market pricing and margin calls, which could adversely impact our results of operations or financial condition |
| Both of our investment strategies employ leverage |
| In our Spread strategy, we generally seek to borrow between eight and 12 times the amount of our equity allocated to this strategy |
| Within our Residential Mortgage Credit portfolio strategy, in our loan origination and securitization portfolio we generally seek to borrow between 15 and 25 times the amount of our equity allocated to this strategy |
| In our credit sensitive portfolio, we generally seek to borrow between zero and five times the amount of our equity allocated to this strategy |
| In both investment strategies, however, at any one time our actual borrowings may be above or below the leverage ranges stated above |
| We achieve our leverage primarily by borrowing against the market value of our mortgage loans and mortgage-backed securities through a combination of repurchase agreements, warehouse financing, debt securities and other types of borrowings |
| Some of our sources of borrowings are from “committed” sources, such as warehouse facilities and debt securities, and some are from “uncommitted” sources, such as repurchase agreement lines |
| At any given time, our total indebtedness depends significantly upon our lenders’ estimates of our pledged assets’ market value, credit quality, liquidity and expected cash flows as well as upon our lenders’ applicable asset advance rates, also known as “haircuts |
| ” In addition, uncommitted borrowing sources have the right to stop lending to us at any time |
| The mortgage loans and mortgage-backed securities that we purchase are subject to daily fluctuations in market pricing resulting from changes in interest rates |
| As market prices change, our mortgage loans and mortgage-backed securities that are financed through repurchase agreements and warehouse financing may be subject to margin calls by our financing counterparties |
| A margin call requires us to post more collateral or cash with our counterparties in support of our financing |
| We face the risk that we might not be able to meet our debt service obligations or margin calls and, to the extent that we cannot, we might be forced to liquidate some or all of our assets at disadvantageous prices that would adversely impact our results of operations |
| A default on a collateralized borrowing could also result in an involuntary liquidation of the pledged asset, which would adversely impact our 15 _________________________________________________________________ [72]Table of Contents results of operations |
| Furthermore, if our lenders do not allow us to renew our borrowings or we cannot replace maturing borrowings on favorable terms or at all, we might be forced to liquidate some or all of our assets at disadvantageous prices which would adversely impact our results of operations or financial condition |
| Our use of leverage also amplifies the risks associated with other risk factors detailed in this discussion of risk factors, which might adversely impact our results of operations or financial condition |
| Interest rate mismatches between our mortgage loans and mortgage-backed securities and our borrowings could adversely impact our results of operations or financial condition |
| The interest rate repricing terms of the borrowings that we use are shorter than the interest rate repricing terms of our assets |
| As a result, during a period of rising interest rates, we could experience a decrease in, or elimination of, our net income or generate a net loss because the interest rates on our borrowings could increase faster than our asset yields |
| Conversely, during a period of declining interest rates and accompanying higher prepayment activity, we could experience a decrease in, or elimination of, our net income or generate a net loss as a result of higher premium amortization expense |
| Our use of certain types of financing may give our lenders greater rights in the event that either we or any of our lenders file for bankruptcy |
| Our borrowings under repurchase agreements and warehouse financing may qualify for special treatment under the bankruptcy code, giving our lenders the ability to avoid the automatic stay provisions of the bankruptcy code and to take possession of and liquidate our collateral under the repurchase agreements without delay if we file for bankruptcy |
| Furthermore, the special treatment of repurchase agreements and warehouse financing under the bankruptcy code may make it difficult for us to recover our pledged assets in the event that any of our lenders files for bankruptcy |
| Thus, the use of repurchase agreements and warehouse financing exposes our pledged assets to risk in the event of a bankruptcy filing by any of our lenders or us |
| Our hedging activities might be unsuccessful and adversely impact our results of operations and book value |
| We can use Eurodollar futures, interest rate swaps, caps and floors and other derivative instruments in order to reduce, or “hedge,” our interest rate risks |
| The amount of hedging activities that we utilize will vary over time |
| Our hedging activities might mitigate our interest rate risks, but cannot eliminate these risks |
| The effectiveness of our hedging activities will depend significantly upon whether we correctly quantify the interest rate risks being hedged, as well as our execution of and ongoing monitoring of our hedging activities |
| Our hedging activities could adversely impact our results of operations, our book value and our status as a REIT and, therefore, such activities could be limited |
| In some situations, we may sell hedging instruments at a loss in order to maintain adequate liquidity |
| For some of our hedging activities, we may elect hedge accounting treatment under Statement of Financial Accounting Standards (“SFAS”) Nodtta 133, Accounting for Derivative Instruments and Hedging Activities, as amended and interpreted |
| The ongoing monitoring requirements of SFAS Nodtta 133 are complex and rigorous |
| If we fail to meet these requirements, or if certain hedging activities do not qualify for hedge accounting under SFAS Nodtta 133, we could not designate our hedging activities as hedges under SFAS Nodtta 133 and would be required to utilize mark-to-market accounting through our consolidated statements of operations, which would adversely impact our results of operations or financial condition |
| Effective December 31, 2005, we discontinued the use of hedge accounting as defined in SFAS Nodtta 133 |
| As a result, beginning in the first quarter of 2006, all changes in the value of our portfolio of hedges, including interest rate swaps and Eurodollar futures contracts, will be reflected in our consolidated statement of operations rather than primarily through accumulated other comprehensive income and loss on our consolidated balance sheet |
| We expect this change to introduce some volatility into our results of operations, as the market value of our hedge positions changes |
| 16 _________________________________________________________________ [73]Table of Contents Our mortgage loans may not be serviced effectively, which might adversely impact our results of operations or financial condition |
| The success of our loan originations and securitizations within our Residential Mortgage Credit portfolio strategy will depend upon our ability to ensure that our mortgage loans are serviced effectively |
| We do not intend to service our mortgage loans ourselves, and intend to transfer the servicing of our loans to a third party with whom we have established a sub-servicing relationship |
| Our failure to service our mortgage loans properly could adversely impact our results of operations or financial condition |
| If we are unable to securitize our mortgage loans successfully, we may be unable to grow or fully execute our business strategies and our earnings may decrease |
| We intend to structure our securitization transactions so that we must account for them as secured borrowings in accordance with SFAS Nodtta 140, Accounting for Transfers and Servicing of Financial Assets and Extinguishments of Liabilities, and, as a result, we are precluded from using sale accounting to recognize any gain or loss |
| To securitize our mortgage loans, we have created a wholly owned subsidiary and we contribute a pool of mortgage loans to the subsidiary in connection with each securitization |
| An inability to securitize our mortgage loans successfully could limit our ability to grow our business or fully execute our business strategies and could decrease our earnings |
| In addition, the successful securitization of our mortgage loans might expose us to losses as the portions of the securitizations that we choose to keep will tend to be those that are riskier and more likely to generate credit losses |
| Risks Related to Seneca Seneca might fail to comply with the terms of the Amended Agreement, manage our Spread portfolio poorly or lose key personnel that are important to our Spread portfolio, which could adversely impact our results of operations or financial condition |
| In March 2005, we executed an Amended Agreement with Seneca |
| Seneca has dedicated key personnel to our Spread portfolio business, including the investment and financing decisions related to that portfolio |
| Pursuant to the Amended Agreement, Seneca is responsible for providing us with the data to enable us to calculate the financial results of the Spread portfolio and its related liabilities |
| If Seneca fails to comply with the terms of the Amended Agreement, Seneca can be terminated for cause, which could adversely impact our results of operations |
| If Seneca manages our Spread portfolio poorly, or loses key personnel that are important to the ongoing management of our Spread portfolio, it could adversely impact our results of operations or financial condition |
| Seneca also might be subject to business continuity risk, due to the change in its ownership announced in 2005 |
| This could adversely affect the management of our Spread Portfolio |
| Because Seneca is entitled to a fee that may be significant if we terminate the Amended Agreement without cause, economic considerations might preclude us from terminating the Amended Agreement in the event that Seneca’s performance fails to meet our expectations but does not constitute cause |
| If we terminate the Amended Agreement without cause or because we decide to manage our Spread Portfolio, then we have to pay a fee to Seneca that may be significant |
| Under the amended agreement, the amount of the termination fee is an amount equal to two times the amount of the highest annual base management compensation and the highest annual incentive management compensation, for a particular year, earned by Seneca during any of the three years (or on an annualized basis if a lesser period) preceding the effective date of the termination, multiplied by a fraction, where the numerator is the positive difference, resulting from 36 minus the number of months between the effective date of the Amended Agreement and the termination date, and the denominator is 36 |
| After March 2008, there would be no termination fee |
| At December 31, 2005, the termination fee, if we elected to terminate the Amended Agreement without cause as of that date, was approximately dlra15dtta7 million |
| The actual amount of such fee cannot be known at this time |
| Paying this fee would reduce significantly the cash available for distribution to our stockholders and might cause us to suffer a net operating loss |
| Consequently, terminating the Amended Agreement might not be advisable even if we determine that it would be more efficient to operate with an internal management structure or if we are otherwise dissatisfied with Seneca’s performance |
| 17 _________________________________________________________________ [74]Table of Contents Seneca’s liability is limited under the Amended Agreement and we have agreed to indemnify Seneca against certain liabilities |
| Seneca has not assumed any responsibility to us other than to render the services described in the Amended Agreement, and Seneca is not responsible for any action of our Board of Directors in declining to follow Seneca’s advice or recommendations |
| Seneca and its directors, officers and employees are not liable to us for acts performed by its officers, directors or employees in accordance with and pursuant to the Amended Agreement, except for acts constituting gross negligence, recklessness, willful misconduct or active fraud in connection with their duties under the Amended Agreement |
| We have agreed to indemnify Seneca and its directors, officers and employees with respect to all expenses, losses, damages, liabilities, demands, charges and claims arising from acts of Seneca not constituting gross negligence, recklessness, willful misconduct or active fraud |
| Legal and Tax Risks If we are disqualified as a REIT, we will be subject to tax as a regular corporation and face substantial tax liability |
| Qualification as a REIT involves the application of highly technical and complex US federal income tax code provisions for which only a limited number of judicial or administrative interpretations exist |
| Accordingly, there can be no assurances that we will be able to remain qualified as a REIT for US federal income tax purposes |
| Even a technical or inadvertent mistake could jeopardize our REIT status |
| Furthermore, Congress or the IRS might change tax laws or regulations and the courts might issue new rulings, in each case potentially having retroactive effect that could make it more difficult or impossible for us to qualify as a REIT in a particular tax year |
| If we fail to qualify as a REIT in any tax year, then: • we would be taxed as a regular domestic corporation, which, among other things, means that we would be unable to deduct distributions to our stockholders in computing taxable income and we would be subject to US federal income tax on our taxable income at regular corporate rates; • any resulting tax liability could be substantial, would reduce the amount of cash available for distribution to our stockholders and could force us to liquidate assets at inopportune times, causing lower income or higher losses than would result if these assets were not liquidated; and • unless we were entitled to relief under applicable statutory provisions, we would be disqualified from treatment as a REIT for the subsequent four taxable years following the year during which we lost our qualification and, thus, our cash available for distribution to our stockholders would be reduced for each of the years during which we did not qualify as a REIT Even if we remain qualified as a REIT, we might face other tax liabilities that reduce our cash flow |
| Any of these taxes would decrease cash available for distribution to our stockholders |
| Complying with REIT requirements might cause us to forego otherwise attractive opportunities |
| In order to qualify as a REIT for US federal income tax purposes, we must satisfy tests concerning, among other things, our sources of income, the nature and diversification of our assets, the amounts we distribute to our stockholders and the ownership of our stock |
| To satisfy the distribution requirements of 90prca of taxable REIT net income, we may also be required to make distributions to our stockholders at disadvantageous times or when we do not have funds readily available for distribution |
| Thus, compliance with REIT requirements may cause us to forego opportunities we would otherwise pursue |
| In addition, the REIT provisions of the Internal Revenue Code, or Code, impose a 100prca tax on income from “prohibited transactions |
| ” Prohibited transactions generally include sales of assets that constitute inventory or other property held for sale in the ordinary course of a business, other than foreclosure property |
| This 100prca tax could impact our desire to sell mortgage-backed securities at otherwise opportune times if we believe such sales could be considered prohibited transactions |
| 18 _________________________________________________________________ [75]Table of Contents Complying with REIT requirements may limit our ability to hedge effectively |
| The REIT provisions of the Code substantially limit our ability to hedge mortgage-backed securities and related borrowings |
| Under these provisions, our annual income from qualified hedges, together with any other income not generated from qualified REIT real estate assets, is limited to less than 25prca of our gross income |
| In addition, we must limit our aggregate income from hedging and services from all sources, other than from qualified REIT real estate assets or qualified hedges, to less than 5prca of our annual gross income |
| As a result, we might in the future have to limit our use of advantageous hedging techniques, which could leave us exposed to greater risks associated with changes in interest rates than we would otherwise want to bear |
| If we fail to satisfy the 25prca or 5prca limitations, unless our failure was due to reasonable cause and we meet certain other technical requirements, we could lose our REIT status for federal income tax purposes |
| Even if our failure were due to reasonable cause, we might have to pay a penalty tax equal to the amount of our income in excess of certain thresholds, multiplied by a fraction intended to reflect our profitability |
| Complying with the REIT requirements may force us to borrow to make distributions to our stockholders |
| As a REIT, we must distribute at least 90prca of our annual taxable income, subject to certain adjustments, to our stockholders |
| From time to time, we might generate taxable income greater than our net income for financial reporting purposes from, among other things, amortization of capitalized purchase premiums, or our taxable income might be greater than our cash flow available for distribution to our stockholders |
| If we do not have other funds available in these situations, we might be unable to distribute 90prca of our taxable income as required by the REIT rules |
| In that case, we would need to borrow funds, sell a portion of our mortgage loans or mortgage-backed securities potentially at disadvantageous prices or find another alternative source of funds |
| These alternatives could increase our costs or reduce our equity and reduce amounts available to invest in mortgage loans or mortgage-backed securities |
| Recognition of excess inclusion income by us could have adverse tax consequences to us or our stockholders |
| We may recognize excess inclusion income and our stockholders may be required to treat a portion of the distribution they receive as excess inclusion income |
| Excess inclusion income may not be offset with net operating losses otherwise available to stockholders, represents unrelated business taxable income in the hands of an otherwise tax-exempt stockholder and is subject to withholding tax at the maximum rate of 30prca, without regard to otherwise applicable exemptions or rate reductions, to the extent such income is allocable to a stockholder who is not a US person |
| Although the law is not entirely clear, excess inclusion income may be taxable (at the highest corporate tax rates) to us, rather than our stockholders, to the extent allocable to our stock held in record name by disqualified organizations (generally, tax-exempt entities not subject to unrelated business income tax, including governmental organizations) |
| Nominees who hold our stock on behalf of disqualified organizations also potentially may be subject to this tax |
| Generally, excess inclusion income is the income allocable to a REMIC residual interest in excess of the income that would have been allocable to such interest if it were a bond having a yield to maturity equal to 120prca of the long-term applicable rate based on the weighted-average yields of treasury securities and is published monthly by the IRS for use in various tax calculations |
| Although we plan to structure our securitization transactions to qualify as non-REMIC financing transactions for federal income tax purposes, we may recognize excess inclusion income attributable to the equity interests we retain in those securitization transactions |
| In short, if a REIT holds 100prca of the sole class of equity interest in a non-REMIC multi-class mortgage-backed securities offering that qualifies as a borrowing for federal income tax purposes, the equity interests retained by the REIT, under regulations that have not yet been issued, will be subject to rules similar to those applicable to a REMIC residual interest |
| Thus, because we intend to undertake non-REMIC multi-class mortgage-backed securities transactions, we may recognize excess inclusion income |
| If we recognize excess inclusion income, we may, under regulations that have not yet been issued, have to allocate the excess inclusion income to the distributions we distribute to our stockholders to the extent our REIT 19 _________________________________________________________________ [76]Table of Contents taxable income (taking into account the dividends paid deduction) is less than the sum of our excess inclusions for the taxable year |
| Generally, to maintain our REIT status, we must distribute at least 90prca of our taxable income (determined without regard to the dividends paid deduction and by excluding any net capital gains) in each year |
| To the extent the sum of our excess inclusion income is less than 10prca of our total taxable income, we may elect to pay tax on such excess inclusion income rather than treating a portion of our distributions as comprising excess inclusion income |
| Complying with the REIT requirements may force us to liquidate otherwise attractive investments |
| In order to qualify as a REIT, we must ensure that at the end of each calendar quarter at least 75prca of the value of our assets consists of cash, cash items, government securities, certain temporary investments and qualified REIT real estate assets |
| The remainder of our investment in securities generally cannot include more than 10prca of the outstanding voting securities of any one issuer or more than 10prca of the total value of the outstanding securities of any one issuer |
| In addition, generally, no more than 5prca of the value of our assets can consist of the securities of any one issuer |
| If we fail to comply with these requirements, we could lose our REIT status unless we are able to avail ourselves of certain relief provisions |
| Under certain relief provisions, we would be subject to penalty taxes |
| Failure to maintain an exemption from the Investment Company Act would harm our results of operations |
| We seek to conduct our business so as not to become regulated as an investment company under the Investment Company Act of 1940, as amended |
| Because we conduct some of our business through wholly owned subsidiaries, we must ensure not only that we qualify for an exclusion or exemption from regulation under the Investment Company Act, but also that each of our subsidiaries so qualifies |
| 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, based on a series of no-action letters issued by the SEC’s Division of Investment Management (Division), in order to qualify for this exemption, at least 55prca of our assets must consist of mortgage loans and other assets that are considered the functional equivalent of mortgage loans for purposes of the Investment Company Act (collectively, “qualifying real estate assets”), and an additional 25prca of our assets must consist of real estate-related assets |
| Based on the no-action letters issued by the Division, we classify our investment in residential mortgage loans as qualifying real estate assets, provided the loans are “fully secured” by an interest in real estate |
| That is, if the loan-to-value ratio of the loan is equal to or less than 100prca, then we consider the mortgage loan a qualifying real estate asset |
| We do not consider loans with loan-to-value ratios in excess of 100prca to be qualifying real estate assets for the 55prca test, but only real estate-related assets for the 25prca test |
| We also consider agency whole pool certificates to be qualifying real estate assets |
| Most non-agency mortgage-backed securities do not constitute qualifying real estate assets for purposes of the 55prca test, because they represent less than the entire beneficial interest in the related pool of mortgage loans |
| If we acquire securities that, collectively, are expected to receive all of the principal and interest paid on the related pool of underlying loans (less fees, such as servicing and trustee fees, and expenses of the securitization), then we will consider those securities, collectively, to be qualifying real estate assets |
| Mortgage-backed securities that do not represent all of the certificates issued with respect to an underlying pool of mortgages may be treated as separate from the underlying mortgage loans and, thus, may not qualify for purposes of the 55prca requirement |
| Therefore, our ownership of these mortgage-backed securities is limited by the provisions of the Investment Company Act |
| One exception relates to the most subordinate class of securities issued in a securitization if the holder has the right to decide whether to foreclose upon defaulted loans |
| In addition to monitoring our assets to qualify for exclusion from regulation as an investment company, we also must ensure that each of our subsidiaries qualifies for its own exclusion or exemption |
| To the extent that we form subsidiaries in the future, we must ensure that they qualify for their own separate exclusion from regulation as an investment company |
| 20 _________________________________________________________________ [77]Table of Contents We have not received, nor have we sought, a no-action letter from the Division regarding how our investment strategy fits within the exclusion from regulation under the Investment Company Act that we are using |
| In satisfying the 55prca requirement under the Investment Company Act, we treat as qualifying real estate assets mortgage loans that we own and mortgage-backed securities issued with respect to an underlying pool as to which we hold all issued certificates, or subordinate classes with foreclosure rights with respect to the underlying mortgage loans |
| If the SEC adopts a contrary interpretation of such treatment, we could be required to sell a substantial amount of our mortgage-backed securities under potentially adverse market conditions |
| Further, we might be precluded from acquiring higher-yielding mortgage-backed securities and instead buy a lower yielding security in our attempts to ensure that we at all times qualify for the exemption under the Investment Company Act |
| These factors may lower or eliminate our net income |
| We plan to continue to satisfy the tests with respect to our assets, measured on an unconsolidated basis |
| It is not completely settled, however, that the tests are to be measured on an unconsolidated basis |
| To the extent the SEC provides further guidance on how to measure assets for these tests, we will adjust our measurement techniques |
| 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 our operating policies and programs |
| Misplaced reliance on legal opinions or statements by issuers of mortgage-backed securities could result in a failure to comply with REIT income or assets tests |
| When purchasing mortgage-backed securities, we may rely on opinions of counsel for the issuer or sponsor of such securities, or statements made in related offering documents, for purposes of determining whether and to what extent those securities constitute REIT real estate assets for purposes of the REIT asset tests and produce income that qualifies under the REIT gross income tests |
| The inaccuracy of any such opinions or statements may adversely affect our REIT qualification and could result in significant corporate-level tax |
| One-action rules may harm the value of the underlying property |
| Several states have laws that prohibit more than one action to enforce a mortgage obligation, and some courts have construed the term “action” broadly |
| In such jurisdictions, if the judicial action is not conducted according to law, there may be no other recourse in enforcing a mortgage obligation, thereby decreasing the value of the underlying property |
| We may be harmed by changes in various laws and regulations |
| Changes in the laws or regulations governing Seneca may impair Seneca’s ability to perform services in accordance with the Amended Agreement |
| Our business may be harmed by changes to the laws and regulations affecting our manager, Seneca, or us, including changes to securities laws and changes to the Code applicable to the taxation of REITs |
| New legislation may be enacted into law or new interpretations, rulings or regulations could be adopted, any of which could harm us, Seneca and our stockholders, potentially with retroactive effect |
| Risks Related to Investing in Our Securities The timing and amount of our cash distributions may be volatile over time |
| Our policy is to make quarterly distributions to our stockholders in amounts such that we distribute all or substantially all of our REIT taxable net income in each year, subject to certain adjustments, which, along with other factors, should enable us to qualify for the tax benefits accorded to a REIT under the Code |
| We do not intend to establish a minimum distribution payment level for the foreseeable future |
| Our ability to make distributions might be harmed by the risk factors described herein |
| All distributions will be made at the discretion of our Board of Directors and will depend on our earnings, our financial condition, maintenance of our REIT status and such other factors as our Board of Directors may deem relevant from time to time |
| We cannot assure you that we will have the ability to make distributions to our stockholders in the future |
| 21 _________________________________________________________________ [78]Table of Contents Our declared cash distributions may force us to liquidate mortgage loans or mortgage-backed securities or borrow additional funds |
| From time to time, our Board of Directors will declare cash distributions |
| These distribution declarations are irrevocable |
| If we do not have sufficient cash to fund distributions, we will need to liquidate mortgage loans or mortgage-backed securities or borrow funds by entering into repurchase agreements or otherwise borrowing funds under our margin lending facility to pay the distribution |
| If required, the sale of mortgage loans or mortgage-backed securities at prices lower than the carrying value of such assets would result in losses |
| Also, if we were to borrow funds on a regular basis to make distributions, it is likely that our results of operations and our stock price would be harmed |
| Future offerings of debt securities by us, which would be senior to our common stock upon liquidation, or equity securities, which would dilute our existing stockholders and may be senior to our common stock for the purposes of distributions, may harm the value of our common stock |
| In the future, we may attempt to increase our capital resources by making additional offerings of debt or equity securities, including commercial paper, medium-term notes, senior or subordinated notes and classes of preferred stock or common stock |
| Upon our liquidation, holders of our debt securities and shares of preferred stock and lenders with respect to other borrowings will receive a distribution of our available assets prior to the holders of our common stock |
| Additional equity offerings by us may dilute the holdings of our existing stockholders or reduce the value of our common stock, or both |
| Our preferred stock, if issued, would have a preference on distributions that could limit our ability to make distributions to the holders of our common stock |
| Because our decision to issue securities in any future offering will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings |
| Thus, our stockholders bear the risk of our future offerings reducing the market price of our common stock and diluting their stock holdings in us |
| Our earnings are derived from the expected positive spread between the yield on our assets and the cost of our borrowings |
| This spread will not necessarily be larger in high interest rate environments than in low interest rate environments and may also be negative |
| In addition, during periods of high interest rates, our net income and, therefore, the amount of any distributions on our common stock, might be less attractive compared to alternative investments of equal or lower risk |
| The market price and trading volume of our common stock may be volatile; broad market fluctuations could harm the market price of our common stock |
| The market price of our common stock may be volatile and be subject to wide fluctuations |
| In addition, the trading volume in our common stock may fluctuate and cause significant price variations to occur |
| If the market price of our common stock declines significantly, you may be unable to resell your shares at or above your purchase price |
| The stock market has experienced price and volume fluctuations that have affected the market price of many companies in industries similar or related to ours and that have been unrelated to these companies’ operating performances |
| These broad market fluctuations could reduce the market price of our common stock |
| Furthermore, our operating results and prospects may be below the expectations of public market analysts and investors or may be lower than those of companies with comparable market capitalizations, which could harm the market price of our common stock |
| The market price of our common stock may be adversely affected by future sales of a substantial number of shares of our common stock in the public market or the availability of such shares for sale |
| We cannot predict the effect, if any, of future sales of our common stock, or the availability of shares for future sales, on the market price of our common stock |
| Sales of substantial amounts of shares of our common stock, or the perception that these sales could occur, may harm prevailing market prices for our common stock |
| 22 _________________________________________________________________ [79]Table of Contents Subject to Rule 144 volume limitations applicable to our officers and directors, substantially all of our shares of common stock outstanding are eligible for immediate resale by their holders |
| If any of our stockholders were to sell a large number of shares in the public market, the sale could reduce the market price of our common stock and could impede our ability to raise future capital through a sale of additional equity securities |
| We may issue additional shares of common stock or shares of preferred stock that are convertible into common stock |
| If we were to issue a significant number of shares of our common stock or convertible preferred stock in a short period of time, our outstanding shares of common stock could be diluted and the market price of our common stock could decline |
| Restrictions on ownership of a controlling percentage of our capital stock might limit your opportunity to receive a premium on our stock |
| For the purpose of preserving our REIT qualification and for other reasons, our charter prohibits direct or constructive ownership by any person of more than 9dtta8prca of the lesser of the total number or value of the outstanding shares of our common stock or more than 9dtta8prca of the outstanding shares of our preferred stock |
| The constructive ownership rules in our charter are complex and may cause our outstanding stock owned by a group of related individuals or entities to be deemed to be constructively owned by one individual or entity |
| As a result, the acquisition of less than 9dtta8prca of our outstanding stock by an individual or entity could cause that individual or entity to own constructively in excess of 9dtta8prca of our outstanding stock, and thus be subject to the ownership limit in our charter |
| Any attempt to own or transfer shares of our common or preferred stock in excess of the ownership limit without the consent of our Board of Directors is void, and will result in the shares being transferred by operation of law to a charitable trust |
| These provisions might inhibit market activity and the resulting opportunity for our stockholders to receive a premium for their shares that might otherwise exist if any person were to attempt to assemble a block of our stock in excess of the number of shares permitted under our charter and that may be in the best interests of our stockholders |
| Certain provisions of Maryland law and our charter and bylaws could hinder, delay or prevent a change in control of our company |
| Certain provisions of the Maryland Business General Corporate Law, our charter and our bylaws have the effect of discouraging, delaying or preventing transactions that involve an actual or threatened change in control of our company |
| These provisions include the following: • Classified Board of Directors |
| Our Board of Directors is divided into three classes with staggered terms of office of three years each |
| The classification and staggered terms of office of our directors make it more difficult for a third party to gain control of our Board of Directors |
| At least two annual meetings of stockholders, instead of one, generally would be required to effect a change in a majority of our Board of Directors |
| • Removal of Directors |
| Under our charter, subject to the rights of one or more classes or series of preferred stock to elect one or more directors, a director may be removed only for cause and only by the affirmative vote of at least two-thirds of all votes entitled to be cast by our stockholders generally in the election of directors |
| • Number of Directors, Board Vacancies, Term of Office |
| We have elected to be subject to certain provisions of Maryland law that vest in our Board of Directors the exclusive power to determine the number of directors and the exclusive power, by the affirmative vote of a majority of the remaining directors, to fill vacancies on the board even if the remaining directors do not constitute a quorum |
| These provisions of Maryland law, which are applicable even if other provisions of Maryland law or our charter or bylaws provide to the contrary, also provide that any director elected to fill a vacancy shall hold office for the remainder of the full term of the class of directors in which the vacancy occurred, rather than the next annual meeting of stockholders as would otherwise be the case, and until his or her successor is elected and qualifies |
| Under our charter, our Board of Directors has the power to issue preferred stock from time to time in one or more series and to establish the terms, preferences and rights of any such series of preferred stock, all without approval of our stockholders |
| • Duties of Directors with Respect to Unsolicited Takeovers |
| Maryland law provides protection for Maryland corporations against unsolicited takeovers by limiting, among other things, the duties of the directors in unsolicited takeover situations |
| The duties of directors of Maryland corporations do not require them to (1) accept, recommend or respond to any proposal by a person seeking to acquire control of the corporation, (2) authorize the corporation to redeem any rights under, or modify or render inapplicable, any stockholder rights plan, (3) make a determination under the Maryland Business Combination Act or the Maryland Control Share Acquisition Act or (4) act or fail to act solely because of the effect the act or failure to act may have on an acquisition or potential acquisition of control of the corporation or the amount or type of consideration that may be offered or paid to the stockholders in an acquisition |
| Moreover, under Maryland law, the act of the directors of a Maryland corporation relating to or affecting an acquisition or potential acquisition of control is not subject to any higher duty or greater scrutiny than is applied to any other act of a director |
| Maryland law also contains a statutory presumption that an act of a director of a Maryland corporation satisfies the applicable standards of conduct for directors under Maryland law |
| • Ownership Limit |
| In order to preserve our status as a REIT under the Code, our charter generally prohibits any single stockholder, or any group of affiliated stockholders, from beneficially owning more than 9dtta8prca of our outstanding common and preferred stock unless our Board of Directors waives or modifies this ownership limit |
| • Maryland Business Combination Act |
| The Maryland Business Combination Act provides that, unless exempted, a Maryland corporation may not engage in business combinations, including mergers, dispositions of 10prca or more of its assets, certain issuances of shares of stock and other specified transactions, with an “interested stockholder” or an affiliate of an interested stockholder for five years after the most recent date on which the interested stockholder became an interested stockholder, and thereafter unless specified criteria are met |
| An interested stockholder is generally a person owning or controlling, directly or indirectly, 10prca or more of the voting power of the outstanding stock of a Maryland corporation |
| Our Board of Directors has adopted a resolution exempting us from this statute |
| However, our Board of Directors may repeal or modify this resolution in the future, in which case the provisions of the Maryland Business Combination Act would be applicable to business combinations between us and interested stockholders |
| • Maryland Control Share Acquisition Act |
| Maryland law provides that “control shares” of a corporation acquired in a “control share acquisition” shall have no voting rights except to the extent approved by a vote of two-thirds of the votes eligible to be cast on the matter under the Maryland Control Share Acquisition Act |
| “Control shares” means shares of stock that, if aggregated with all other shares of stock previously acquired by the acquirer, would entitle the acquirer to exercise voting power in electing directors within one of the following ranges of the voting power: one-tenth or more but less than one-third, one-third or more but less than a majority or a majority or more of all voting power |
| A “control share acquisition” means the acquisition of control shares, subject to certain exceptions |
| If voting rights of control shares acquired in a control share acquisition are not approved at a stockholders’ meeting, then, subject to certain conditions and limitations, the corporation may redeem any or all of the control shares for fair value |
| If voting rights of such control shares are approved at a stockholders’ meeting and the acquirer becomes entitled to vote a majority of the shares of stock entitled to vote, all other stockholders may exercise appraisal rights |
| Our bylaws contain a provision exempting acquisitions of our shares from the Maryland Control Share Acquisition Act |
| However, our Board of Directors may amend our bylaws in the future to repeal or modify this exemption, in which case any control shares of our company acquired in a control share acquisition will be subject to the Maryland Control Share Acquisition Act |