sUB pRIME bABY
On July 25, 2007, OITRS entered into a binding agreement to sell a majority of its remaining private-label and agency mortgage servicing portfolio, which had an aggregate unpaid principal balance of approximately $3.0 billion as of June 30, 2007. The aggregate sales proceeds will be used to repay debt that is currently secured by OITRS’s mortgage servicing portfolio. The transaction, which is subject to various closing conditions, is expected to be completed by September 4, 2007. The transaction is not expected to result in a material gain or loss.
On April 18, 2007, the Board of Managers of OITRS, at the recommendation of the Board of Directors of the Company, approved the closure of the wholesale and conduit mortgage loan origination channels. Both channels ceased accepting new applications for mortgage loans on April 20, 2007. On May 7, 2007, OITRS signed a binding agreement to sell its retail mortgage loan origination channel to a third party as well. On June 30, 2007, OITRS entered into an amendment to this agreement. The proceeds of the transactions were approximately $1.5 million plus the assumption of certain liabilities of OITRS. The transaction, coupled with the disposal of the conduit and wholesale origination channels, resulted in a loss of approximately $10.5 million. Going forward, OITRS will not operate a mortgage loan origination business and the results of the mortgage origination business are reported as discontinued operations for the three and six months ended June 30, 2007.
OITRS was acquired by the Company in November 2005. As a result of the merger, OITRS became a wholly-owned taxable REIT subsidiary of Opteum. On December 21, 2006, Opteum sold to Citigroup Global Markets Realty Corp. (“Citigroup Realty”) a Class B non-voting limited liability company membership interest in OITRS, representing 7.5% of all of OITRS’s outstanding limited liability company membership interests, for $4.1 million. OITRS is subject to corporate income taxes and files separate federal and state income tax returns.
Dividends to Stockholders
In order to maintain its qualification as a REIT, Opteum is required (among other provisions) to annually distribute dividends to its stockholders in an amount at least equal to, generally, 90% of Opteum’s REIT taxable income. REIT taxable income is a term that describes Opteum’s operating results calculated in accordance with rules and regulations promulgated pursuant to the Internal Revenue Code.
Opteum’s REIT taxable income is computed differently from net income as computed in accordance with generally accepted accounting principles ("GAAP net income"), as reported in the Company’s accompanying consolidated financial statements. Depending on the number and size of the various items or transactions being accounted for differently, the differences between REIT taxable income and GAAP net income can be substantial and each item can affect several reporting periods. Generally, these items are timing or temporary differences between years; for example, an item that may be a deduction for GAAP net income in the current year may not be a deduction for REIT taxable income until a later year.
As a REIT, Opteum may be subject to a federal excise tax if Opteum distributes less than 85% of its taxable income by the end of the calendar year. Accordingly, Opteum’s dividends are based on its taxable income, as determined for federal income tax purposes, as opposed to its net income computed in accordance with GAAP (as reported in the accompanying consolidated financial statements).
Results of Operations
PERFORMANCE OVERVIEW
Described below are the Company’s results of operations for the six and three months ended June 30, 2007, as compared to the Company’s results of operations for the six and three months ended June 30, 2006. During the three month period ended June 30, 2007, the Company ceased all mortgage origination business at OITRS. As stated above, result of those operations are reported in the financial statements as discontinued operations. As a result of these actions, the Company’s financial statements are not comparable to prior reports filed since the acquisition of OITRS.
Consolidated net loss for the six and three months ended June 30, 2007, was $240.5 million and $162.5 million, respectively, compared to a consolidated net loss of $9.4 million and $1.4 million, respectively, for the six and three months ended June 30, 2006. Consolidated net loss per basic and diluted share of Class A Common Stock was $9.67 and $6.53, respectively, for the six and three months ended June 30, 2007, compared to a consolidated net loss per basic and diluted share of Class A Common Stock of $0.38 and $0.06, respectively, for the comparable prior period. The decline in consolidated net loss was driven primarily by a permanent impairment taken on MBS securities in the Company’s MBS portfolio, continued poor operating results of OITRS and declines in the value of the retained interest in securitization, also at OITRS.
For the three months ended June 30, 2007, the Company no longer has the ability and intent to hold until recovery MBS securities whose values are impaired as of June 30, 2007. Accordingly, due to liquidity and working capital needs brought about by the turmoil in the mortgage market, the Company no longer had the ability to hold such assets until their amortized cost could be fully recovered. During the three months ended June 30, 2007, the Company sold securities with a market value at the time of sale of approximately $782.0 million that were impaired at the time of sale, realizing losses on sale of $18.6 million. The Company recorded $55.3 million of permanent impairments on the remaining $1.8 billion of MBS securities held as available-for-sale at June 30, 2007. As a result of these actions the Company’s net interest margin (or NIM) on it’s portfolio of MBS securities increased to 86 basis points as of June 30, 2007. The NIM measures the spread, in basis points, between the weighted average yield on the MBS portfolio and the weighted average borrowing costs on the repo liabilities. This figure does not incorporate the effect of other sources of interest income or expense nor overhead expenses.
For the six and three months ended June 30, 2007, comprehensive (loss) was ($163.8) million and ($89.7) million, respectively, including the net unrealized gain/(loss) on available-for-sale securities of $2.1 million and ($1.0) million and the reclassification at June 30, 2007 of the other-than-temporary loss on MBS of $55.3 million. For the six and three months ended June 30, 2007, reclassification of realized loss on mortgage-backed securities sales of $19.4 million and $18.6 million were made to reflect the realized loss on sales of assets previously reflected in comprehensive loss as unrealized losses on available for sale securities. For the six and three months ended June 30, 2006, comprehensive (loss) was ($43.3) million and ($23.9) million, respectively, including the net unrealized loss on available-for-sale securities of ($33.9) million and ($22.5) million, respectively. The factors resulting in the unrealized loss on available-for-sale securities are described below.
Comprehensive (loss) is as follows:
(in thousands)
Six Month Ended Three Months Ended
June 30, 2007 June 30, 2006 June 30, 2007 June 30, 2006
Net (loss) $ (240,537) $ (9,367) $ (162,467) $ (1,395)
Reclassify net realized loss on MBS 19,388 - 18,568 -
Reclassify other-than-temporary loss on MBS 55,250 - 55,250 -
Unrealized gain (loss) on available-for-sale securities, net 2,135 (33,897) (1,043) (22,472)
Comprehensive (loss) $ (163,764) $ (43,264) $ (89,692) $ (23,867)
Unrealized gains/(losses) on available-for-sale securities is a component of accumulated other comprehensive loss, which is included in stockholders’ equity on the consolidated balance sheet. Accumulated other comprehensive loss is the difference between the fair market value of the portfolio of MBS securities and their cost basis. The unrealized gain on available-for-sale securities for the six months ended June 30, 2007 was driven by a combination of a decrease in short term rates for the period, which tends to increase the fair market value of the Company’s portfolio of MBS securities, and increased amortization of net premium for the period, which lowers the cost basis in the portfolio of MBS securities. The increased amortization for the period was the result of the continued upward resetting of ARM securities in the portfolio, which results in higher coupons on the securities relative to their booked yields, and therefore greater amortization.
The Company has negative retained earnings (titled “Accumulated deficit” in the stockholders’ equity section of the accompanying consolidated financial statements) as of June 30, 2007, partially because of the consequences of Opteum’s tax qualification as a REIT. As is more fully described in the “Dividends to Stockholders” section above, Opteum’s dividends are based on its REIT taxable income, as determined for federal income tax purposes, and not on its net income computed in accordance with GAAP (as reported in the accompanying consolidated financial statements).
For the six months ended June 30, 2007, Opteum's REIT taxable loss was approximately $76.1 million less than Opteum's net loss from REIT activities computed in accordance with GAAP. The most significant difference was the impairment taken on available-for-sale securities which is reflected in GAAP earnings but not for REIT tax purposes. If such securities are eventually sold and realized loses incurred, a substantial portion of this difference would be eliminated. Another contributor is attributable to interest on inter-company loans with OITRS as well as timing differences in the recognition of compensation expense attributable to phantom stock awards. In April of 2007, the Board of Directors of the Company approved the forgiveness of up to $108.3 million of inter-company debt with OITRS. Such action will reduce future interest income associated with the inter-company debt. With respect to the phantom stock awards, the future deduction of this temporary difference is uncertain as to the amount (the amount of the tax impact is measured at the fair value of the shares as of a future date and this amount may be greater than or less than the financial statement deduction already taken by Opteum). Since inception through June 30, 2007, Opteum's taxable income is approximately $91.0 million greater than Opteum's financial statement net income as computed in accordance with GAAP. For the six months ended June 30, 2007, tax capital losses of approximately $29.4 million were realized; these capital losses are only available to the REIT to offset future capital gains and therefore they do not reduce REIT taxable income.
PERFORMANCE OF OPTEUM’S MBS PORTFOLIO
For the six and three months ended June 30, 2007, the REIT generated ($9.5) million and ($8.2) million of net interest income (loss). Included in these results were $65.8 million and $27.5 million of interest income, offset by $75.3 million and $35.7 million of interest expense. Inclusive in these results is the quarterly retrospective adjustment of ($4.4) million and ($6.2) million for the six and three month period ended June 30, 2007. The retrospective adjustment is described below under Critical Accounting Policies/Income Recognition. Net interest income is down approximately $21.6 million and $19.2 million, respectively, compared to the six and three months ended June 30, 2006. The decline is mostly the result of the approximately 46.6% reduction in the MBS investment portfolio.
For the six and three months ended June 30, 2007, the REIT’s general and administrative costs were $3.7 million and $1.9 million, respectively. For the six and three months ended June 30, 2006, the REIT’s general and administrative costs were $5.2 million and $3.0 million, respectively. The decrease in general and administrative expenses was primarily the result of a reduction in employee bonus accruals. Operating expenses, which incorporate trading costs, fees and other direct costs, were $0.5 million and $0.2 million, for the six and three months ended June 30, 2007 and $0.5 million and $0.2 million for the six and three months ended June 30, 2006, respectively.
As stated above, the REIT recorded permanent impairment charges to various MBS securities at June 30, 2007. In addition, certain securities were sold that were impaired at the time of sale. As a result, the REIT had $19.4 million and $18.6 million, respectively, in losses from the sale of securities in the MBS portfolio during the six and three months ended June 30, 2007. For the six and three months ended June 30, 2006, Opteum reported no gains/loss from the sale of MBS.
As of June 30, 2007, Opteum’s MBS portfolio consisted of $1.8 billion of agency or government MBS at fair value and had a weighted average yield on assets of 6.10% and a net weighted average borrowing cost of 5.24%. The following tables summarize Opteum’s agency and government mortgage related securities as of June 30, 2007:
Asset Category Market Value
(in thousands) Percentage
of
Entire Portfolio Weighted
Average
Coupon Weighted
Average
Maturity
in Months Longest
Maturity Weighted
Average Coupon Reset in Months Weighted
Average
Lifetime Cap Weighted
Average Periodic Cap
Adjustable-Rate MBS $ 1,171,277 64.40% 5.42% 318 1-Apr-44 4.95 9.85% 1.74%
Fixed-Rate MBS $ 433,500 23.84% 6.64% 241 1-Jan-37 n/a n/a n/a
Hybrid Adjustable-Rate MBS $ 213,859 11.76% 4.40% 336 1-May-36 13.87 9.91% 2.04%
Total Portfolio $ 1,818,636 100.00% 5.59% 302 1-Apr-44 6.32 9.86% 1.79%
Agency Market Value
(in thousands) Percentage of
Entire Portfolio
Fannie Mae $ 1,413,319 77.71%
Freddie Mac 107,250 5.90%
Ginnie Mae 298,067 16.39%
Total Portfolio $ 1,818,636 100.00%
Entire Portfolio
Effective Duration (1) 1.36
Weighted Average Purchase Price $ 102.31
Weighted Average Current Price $ 100.95
(1) Effective duration of 1.36 indicates that an interest rate increase of 1% would be expected to cause a 1.36% decline in the value of the MBS in the Company’s investment portfolio.
In evaluating Opteum’s MBS portfolio assets and their performance, Opteum’s management team primarily evaluates these critical factors: asset performance in differing interest rate environments, duration of the security, yield to maturity, potential for prepayment of principal and the market price of the investment.
Opteum’s portfolio of MBS will typically be comprised of adjustable-rate MBS, fixed-rate MBS, hybrid adjustable-rate MBS and balloon maturity MBS. Opteum seeks to acquire low duration assets that offer high levels of protection from mortgage prepayments. Although the duration of an individual asset can change as a result of changes in interest rates, Opteum strives to maintain a portfolio with an effective duration of less than 2.0. The stated contractual final maturity of the mortgage loans underlying Opteum’s portfolio of MBS generally ranges up to 30 years. However, the effect of prepayments of the underlying mortgage loans tends to shorten the resulting cash flows from Opteum’s investments substantially. Prepayments occur for various reasons, including refinancing of underlying mortgages and loan payoffs in connection with home sales.
Prepayments on the loans underlying Opteum’s MBS can alter the timing of the cash flows from the underlying loans to the Company. As a result, Opteum gauges the interest rate sensitivity of its assets by measuring their effective duration. While modified duration measures the price sensitivity of a bond to movements in interest rates, effective duration captures both the movement in interest rates and the fact that cash flows to a mortgage related security are altered when interest rates move. Accordingly, when the contract interest rate on a mortgage loan is substantially above prevailing interest rates in the market, the effective duration of securities collateralized by such loans can be quite low because of expected prepayments. Although some of the fixed-rate MBS in Opteum’s portfolio are collateralized by loans with a lower propensity to prepay when the contract rate is above prevailing rates, their price movements track securities with like contract rates and therefore exhibit similar effective duration.
As of June 30, 2007, approximately 64.4% of the REIT portfolio is comprised of short duration ARM securities. The REIT favors such securities since they offer attractive yields relative to alternative securities in an inverted yield curve environment such as the one the Company has been operating in recently. Going forward, to the extent the shape of the yield curve is less or not inverted, the composition of the portfolio may be changed to better take advantage of opportunities in the market at that time.
The value of the REIT’s MBS portfolio changes as interest rates rise or fall. Opteum faces the risk that the market value of its assets will increase or decrease at different rates than that of its liabilities, including its hedging instruments. Opteum primarily assesses its interest rate risk by estimating the duration of its assets and the duration of its liabilities. Duration essentially measures the market price volatility of financial instruments as interest rates change. Opteum generally calculates duration using various financial models and empirical data and different models and methodologies can produce different duration numbers for the same securities.
The following sensitivity analysis shows the estimated impact on the fair value of Opteum's interest rate-sensitive investments as of June 30, 2007, assuming rates instantaneously fall 100 basis points, rise 100 basis points and rise 200 basis points:
(in thousands)
Interest Rates Fall
100 Basis Points Interest Rates Rise
100 Basis Points Interest Rates Rise
200 Basis Points
Adjustable-Rate MBS
(Fair Value $1,171,277)
Change in fair value $ 8,610 $ (8,610) $ (17,220)
Change as a percent of fair value 0.74% (0.74%) (1.47%)
Fixed-Rate MBS
(Fair Value $433,500)
Change in fair value $ 12,721 $ (12,721) $ (25,442)
Change as a percent of fair value 2.93% (2.93%) (5.87%)
Hybrid Adjustable-Rate MBS
(Fair Value $213,859)
Change in fair value $ 3,386 $ (3,386) $ (6,772)
Change as a percent of fair value 1.58% (1.58) (3.17%)
Cash
(Fair Value $ 41,903)
Portfolio Total
(Fair Value $1,818,636)
Change in fair value $ 24,717 $ (24,717) $ (49,434)
Change as a percent of fair value 1.36% (1.36%) (2.72%)
The table below reflects the same analysis presented above but with the figures in the columns that indicate the estimated impact of a 100 basis point fall or rise adjusted to reflect the impact of convexity.
(in thousands)
Interest Rates Fall
100 Basis Points Interest Rates Rise
100 Basis Points Interest Rates Rise
200 Basis Points
Adjustable-Rate MBS
(Fair Value $1,171,277)
Change in fair value $ 4,929 $ (12,238) $ (32,091)
Change as a percent of fair value 0.42% (1.04%) (2.74%)
Fixed-Rate MBS
(Fair Value $433,500)
Change in fair value $ 9,782 $ (14,854) $ (31,881)
Change as a percent of fair value 2.26% (3.43%) (7.35%)
Hybrid Adjustable-Rate MBS
(Fair Value $213,859)
Change in fair value $ 2,552 $ (4,092) $ (9,413)
Change as a percent of fair value 1.19% (1.91%) (4.40%)
Cash
(Fair Value $41,903)
Portfolio Total
(Fair Value $1,818,636)
Change in fair value $ 17,263 $ (31,184) $ (73,385)
Change as a percent of fair value 0.95% (1.71%) (4.04%)
In addition to changes in interest rates, other factors impact the fair value of Opteum's interest rate-sensitive investments and hedging instruments, such as the shape of the yield curve, market expectations as to future interest rate changes and other market conditions. Accordingly, in the event of changes in actual interest rates, the change in the fair value of Opteum's assets would likely differ from that shown above and such difference might be material and adverse to Opteum's stockholders.
For reference, the table below shows the principal balance of Opteum’s investment securities, the net unamortized premium, amortized cost of securities held, average cost expressed as a price, the fair market value of investments and the fair market value expressed as a price for the current quarter and each of the previous nine quarters for the portfolio of MBS securities only. The data in the table below does not include information pertaining to discontinued operations at OITRS.
(in thousands)
Quarter Ended Principal
Balance of
Investment
Securities Held Unamortized
Premium (Net) Amortized Cost of
Securities Held Amortized
Cost/Principal
Balance Held Fair Market
Value of
Investment
Securities Held Fair Market
Value/Principal
Balance Held
At June 30, 2007 $ 1,801,492 $ 17,144 $ 1,818,636 100.95 $ 1,818,636 100.95
At March 31, 2007 2,893,761 109,445 3,003,206 103.78 2,931,796 101.31
At December 31, 2006 2,779,867 115,612 2,895,479 104.16 2,808,734 101.04
At September 30, 2006 3,055,791 122,300 3,178,091 104.00 3,080,060 100.79
At June 30, 2006 3,396,910 120,769 3,517,679 103.56 3,407,288 100.31
At March 31,2006 3,515,113 111,361 3,626,473 103.17 3,538,554 100.67
At December 31, 2005 3,457,891 112,636 3,570,527 103.26 3,494,029 101.05
At September 30, 2005 3,797,401 113,393 3,910,793 102.99 3,858,320 101.60
At June 30, 2005 3,784,668 114,673 3,899,341 103.03 3,876,206 102.42
At March 31, 2005 3,212,517 109,390 3,321,907 103.41 3,299,052 102.69
The table below shows Opteum’s average investments held, total interest income, yield on average earning assets, average repurchase obligations outstanding, interest expense, average cost of funds, net interest income and net interest spread for the quarter ended June 30, 2007, and the nine previous quarters for Opteum’s portfolio of MBS securities only. The data in the table below does not include information pertaining to discontinued operations at OITRS. Indicated in the table below, net interest spread declined during the second quarter of 2007 to (1.04%) from 0.36% in the first quarter of 2007. Excluding the quarterly retrospective adjustment, the net interest margin declined from 0.11% in the first quarter of 2007 to 0.00% in the second quarter of 2007.
RATIOS FOR THE QUARTERS HAVE BEEN ANNUALIZED
(in thousands)
Quarter Ended Average
Investment
Securities Held Total Interest Income Yield on
Average Interest
Earning Assets Average
Balance of
Repurchase
Obligations
Outstanding Interest
Expense Average
Cost of
Funds Net
Interest
Income Net
Interest
Spread
June 30, 2007 $ 2,375,216 $ 29,009 4.89% $ 2,322,727 $ 34,396 5.92% $ (5,387) (1.04%)
March 31, 2007 2,870,265 41,856 5.83% 2,801,901 38,357 5.48% 3,500 0.36%
December 31, 2006 2,944,397 35,162 4.78% 2,869,210 40,400 5.63% (5,238) (0.86%)
September 30, 2006 3,243,674 45,850 5.65% 3,151,813 42,710 5.42% 3,140 0.23%
June 30, 2006 3,472,921 57,027 6.57% 3,360,421 42,829 5.10% 14,198 1.47%
March 31, 2006 3,516,292 42,345 4.82% 3,375,777 37,661 4.46% 4,684 0.35%
December 31, 2005 3,676,175 43,140 4.69 % 3,533,486 35,913 4.07 % 7,227 0.63 %
September 30, 2005 3,867,263 43,574 4.51 % 3,723,603 33,102 3.56 % 10,472 0.95 %
June 30, 2005 3,587,629 36,749 4.10 % 3,449,744 26,703 3.10 % 10,045 1.00 %
March 31, 2005 3,136,142 31,070 3.96 % 2,976,409 19,842 2.67 % 11,228 1.30 %
For the three months ended June 30, 2007, ($6.2) million of the $29.0 million of interest income was attributable to the quarterly retrospective adjustment. As a result of the retrospective adjustment, the yield on average interest earning assets for the period was reduced by 104.1 basis points to 488.5 basis points. For the three months ended June 30, 2006, $13.4 million of the $57.0 million of interest income was derived from the quarterly retrospective adjustment. The adjustment represented 154.3 basis points of the 656.8 basis points of the yield on average interest earning assets.
PERFORMANCE OF DISCONTINUED OPERATIONS OF OITRS
As stated above, the Company has sold or discontinued all residential mortgage origination activities at OITRS. Going forward, all reported financial results will reflect this decision. The principal business activities of OITRS were the origination and sale of mortgage loans. In addition, as part of the securitization of loans sold, OITRS retained an interest in the resulting residual interest cash flows more fully described below. Finally, OITRS serviced the loans securitized as well as some loans sold on a whole loan basis.
As of June 30, 2007, OITRS owned $93.5 million of mortgage loans net of deferred origination costs, mark to market and other adjustments which were classified as mortgage loans held for sale. Gains/(losses) realized on the mortgage banking activities for the six and three months ended June 30, 2007, were ($61.8) million and ($43.9) million, respectively, and for the six and three months ended June 30, 2006, were ($2.9) million and ($5.9) million, respectively. These gains/(losses) reflect the effects of the mark to market of IRLCs and loans held for sale prior to the sale date of ($9.3) million and $4.8 million, respectively, for the six and three months ended June 30, 2007, and were ($4.9) million and ($0.8) million, respectively, for the six and three months ended June 30, 2006. OITRS’s gains/(losses) from mortgage banking activities were the result of a sharp deterioration in the secondary market for the loans OITRS originates and sells. Owing to fears related to the credit performance of certain types of loans OITRS originated, namely high combined loan to value (“CLTV”) and second lien mortgages, prices obtained upon sale were depressed and OITRS also experienced elevated levels of early payment defaults (EPDs), resulting in OITRS recording high loan loss reserves.
Gains/(losses) from mortgage banking activities include changes in the fair value of retained interests in securitizations and the associated hedge gains or losses. Excluding changes in fair value of retained interests in securitizations net of hedge gains and losses, OITRS had gains/(losses) from sales of mortgages held for sale of ($29.6) million and ($17.6) million, respectively, for the six and three months ended June 30, 2007, and $19.1 million and $15.2 million, respectively, for the six and three months ended June 30, 2006.
The retained interests in securitizations represent residual interests in loans originated or purchased by OITRS prior to securitization. The total fair market value of these retained interests was approximately $73.8 million as of June 30, 2007. Fluctuations in value of retained interests are primarily driven by projections of future interest rates (the forward LIBOR curve), the discount rate used to determine the present value of the residual cash flows and prepayment and loss estimates on the underlying mortgage loans. Due to higher forward LIBOR rates, the market value of the retained interests decreased by $27.5 million and $26.2 million, respectively, for the six and three months ended June 30, 2007 and decreased by $24.5 million and $20.2 million, respectively, for the six and three months ended June 30, 2006.
The table below provides details of OITRS’s (loss) on mortgage banking activities for the six and three months ended June 30, 2007 and 2006. OITRS recognizes a gain or loss on sale of mortgages held for sale only when the loans are actually sold.
(LOSSES) ON MORTGAGE BANKING ACTIVITIES
(in thousands)
Six Months Ended Three Months Ended
June 30, 2007 June 30, 2006 June 30, 2007 June 30, 2006
Fair Value adjustment of retained interests, trading $ (27,492) $ (24,472) $ (26,168) $ (20,246)
Gain/ (loss) on sales of mortgage loans 4,942 49,567 (9,571) 28,738
Fees on brokered loans 1,749 3,135 892 1,586
Gain/(loss) on derivatives (4,719) 2,521 (83) (881)
Direct loan origination expenses, deferred (5,495) 689 (4,003) (549)
Fees earned, brokering 705 1,306 270 535
Write off purchased pipeline (Purchase Accounting Adjustment) - (534) - -
$ (30,310) $ 32,212 $ (38,663) $ 9,183
Direct loan origination expenses, reclassified (22,181) (30,204) (9,942) (14,252)
Net gain/(loss) on sale of mortgage loans $ (52,491) $ 2,008 $ (48,605) $ (5,069)
Change in market value of IRLCs $ 14 $ (809) $ (190) $ 2,935
Change in market value mortgage loans for held for sale $ (9,338) $ (4,080) $ 4,940 $ (3,744)
(Loss) on mortgage banking activities $ (61,815) $ (2,881) $ (43,855) $ (5,878)
For the six and three months ended June 30, 2007 and 2006, OITRS originated mortgage loans of $1.5 billion and $0.4 billion, and $2.8 billion and $1.5 billion, respectively. For the six and three months ended June 30, 2007, OITRS sold $2.0 billion and $0.7 billion of originated mortgage loans. For the six and three months ended June 30, 2006, OITRS sold $2.7 billion and $1.3 billion of originated mortgage loans. Of the originated mortgage loans sold during the six and three months ended June 30, 2007, $0.8 billion of the $2.0 billion and $0.3 billion of the $0.7 billion, respectively, were sold on a servicing retained basis. Of the originated mortgage loans sold during the six and three months ended June 30, 2006, $1.7 billion of the $2.7 billion and $0.6 billion of the $1.3 billion, respectively, were sold on a servicing retained basis.
For the six and three months ended June 30, 2007 and 2006, OITRS had net servicing income/ (loss) of ($10.6) million and ($6.0) million, and $1.8 million and $3.6 million, respectively. The results for the six and three month periods were driven primarily by negative fair value adjustments to the MSRs (inclusive of run-off of the servicing portfolio) for the six and three months ended June 30, 2007 and the Company’s early adoption of SFAS 156 on January 1, 2006 (for the six and three months ended June 30, 2006).
As of June 30, 2007, OITRS held originated MSRs on approximately $3.6 billion in mortgages with a fair market value of approximately $32.1 million. For the six and three months ended June 30, 2007 and 2006, additions to the MSRs were $7.7 million and $2.4 million, and $17.1 million and $6.1 million, respectively. In turn, the net fair value adjustments for the six and three months ended June 30, 2007, reflect declines in fair value due to run-off of ($6.0) million and ($1.4) million and adjustments due to (decreases)/increases in fair value of ($6.3) million and ($1.3) million, respectively. The net fair value adjustments for the six and three months ended June 30, 2006, reflect declines in fair value due to run-off of ($10.4) million and ($4.9) million and adjustments due to (decreases)/increases in fair value of ($0.4) million and $2.1 million, respectively. Changes in valuation assumptions for the six and three months ended June 30, 2007, reduced the fair market value by $4.6 million and $2.1 million, respectively. Changes in valuation assumptions and early adoption of SFAS 156 in January of 2006 increased fair market value for the six months ended June 30, 2006, by $3.2 million. There were no such changes for the three months ended June 30, 2006.
Liquidity and Capital Resources
As of June 30, 2007, Opteum had master repurchase agreements in place with 19 counterparties and had outstanding balances under 10 of these agreements. None of the counterparties to these agreements are affiliates of Opteum. These agreements are secured by Opteum’s MBS and bear interest rates that are based on a spread to LIBOR.
As of June 30, 2007, Opteum had obligations outstanding under its repurchase agreements totaling $1.8 billion with a net weighted average borrowing cost of 5.24%. All of Opteum’s outstanding repurchase agreement obligations are due in less than 15 months with $0.8 billion maturing between two and 30 days, $0.5 billion maturing between 31 and 90 days and $0.5 billion maturing in more than 90 days. Securing these repurchase agreement obligations as of June 30, 2007, were MBS with an estimated fair value of $1.8 billion and a weighted average maturity of 302 months.
As of June 30, 2007, Opteum’s repurchase agreements had the following counterparties, amounts outstanding, amounts-at-risk and weighted average remaining maturities:
(in thousands)
Repurchase Agreement Counterparties Amount
Outstanding Amount
at Risk(1) Weighted Average
Maturity of
Repurchase
Agreements
in Days Percent
of Total
Amount
Outstanding
Deutsche Bank Securities, Inc. $ 785,347 $ 10,232 118 44.04 %
JP Morgan Securities Inc. 646,699 16,211 183 36.26
ING Financial Markets, LLC 81,790 969 93 4.59
HSBC Securities (USA) Inc. 78,232 1,599 13 4.39
UBS Securities LLC 52,821 1,452 26 2.96
Lehman Brothers Inc. 44,564 1,279 256 2.50
Nomura Securities International, Inc. 40,857 1,531 10 2.29
Citigroup Goldman Sachs & Co. 24,814 502 6 1.39
Goldman Sachs 23,570 456 60 1.32
Bear, Stearns & Co. Inc. 4,637 154 6 0.26
Total $ 1,783,331 $ 34,385 100.00 %
(1) Equal to the fair value of securities sold, plus accrued interest income, minus the sum of repurchase agreement liabilities, plus accrued interest expense.
Opteum’s master repurchase agreements have no stated expiration, but can be terminated at any time at Opteum’s option or at the option of the counterparty. However, once a definitive repurchase agreement under a master repurchase agreement has been entered into, it generally may not be terminated by either party. A negotiated termination can occur, but may involve a fee to be paid by the party seeking to terminate the repurchase agreement transaction.
Opteum has entered into contracts and paid commitment fees to three counterparties providing for an aggregate of $0.75 billion in committed repurchase agreement facilities at pre-determined borrowing rates and haircuts for a 364 day period following the commencement date of each contract. The facilities capacity and expiration dates are as follows: $450.0 million on October 17, 2007 and $300 million on April 23, 2008. Opteum has no obligation to utilize these repurchase agreement facilities.
In addition, two of the agreements described above are available to provide financing for up to $150 million to cover margin requirements associated with monthly principal payments on the MBS portfolio.
It is the Company’s present intention to seek to renew its various committed and uncommitted repurchase agreements as they become due or expire. However, market conditions could change making the renewal of these contractual arrangements more expensive or unattainable. Further, as discussed above, increases in short-term interest rates could negatively impact the valuation of Opteum’s MBS portfolio. Should this occur, Opteum’s ability to enter into new repurchase agreements or extend its existing repurchase agreements could be limited and may cause Opteum’s repurchase agreement counterparties to initiate margin calls. Under this scenario, Opteum would likely seek alternative sources of financing which could include additional debt or equity financing or sales of assets.
Given the current turmoil in the mortgage market, such alternative sources of financing are not readily available to the Company. Further, as a result of the turmoil in the mortgage market, cash needs of OITRS were increased. The increased needs stemmed from margin calls on the various warehouse lines and depressed levels on loan sales. The Company, as guarantor, is potentially exposed to cash needs connected to OITRS’s warehouse lines to the extent OITRS has insufficient funds to meet margin calls or repay borrowings. Accordingly, during the three month period ended June 30, 2007, the Company undertook a series of assets sales intended to raise funds necessary to support the operations of OITRS and maintain adequate liquidity during the disruptions in the mortgage market that occurred and are continuing.
The Company has obtained committed funding arrangements that provide specified advance rates and funding levels and are available to finance our MBS portfolio. Should our financing be withdrawn and our committed funding agreements not be sufficient to finance all of our MBS investments, we may be forced to sell such assets, which may result in losses upon such sales. While the financing in place for our retained interests, trading held by OITRS is committed through December 20, 2007, the lender on the financing facility has and may continue to request additional margin be posted in connection with the facility. If we are unable to meet such requests in the future, we may be forced to sell the assets or seek alternative financing. At present, such alternative financing arrangements for the residual interests, trading may not be available or only available at substantially higher cost to OITRS. If cash resources are, at any time, insufficient to satisfy the Company’s liquidity requirements, such as when cash flow from operations were materially negative, the Company may be required to pledge additional assets to meet margin calls, liquidate assets, sell additional debt or equity securities or pursue other financing alternatives. Any sale of mortgage-related securities or other assets held for sale at prices lower than the carrying value of such assets would reduce our income. The Company presently believes that its equity and junior subordinated debt capital, combined with the cash flow from operations and the utilization of borrowings, will be sufficient to enable the Company to meet its anticipated liquidity requirements. Continued disruptions in market conditions could, however, adversely affect the Company’s liquidity, including the lack of available financing for our MBS assets beyond the capacity of our committed facilities (currently $0.75 billion), increases in interest rates, increases in prepayment rates substantially above expectations and decreases in value of assets held for sale. Therefore, no assurances can be made regarding the Company's ability to satisfy its liquidity and working capital requirements.
In May 2005, Opteum completed a private offering of $51.6 million of trust preferred securities of Bimini Capital Trust I (“BCTI”) resulting in the issuance by Opteum of $51.6 million of junior subordinated notes. The interest rate payable by Opteum on the BCTI junior subordinated notes is fixed for the first five years at 7.61% and then floats at a spread of 3.30% over three-month LIBOR for the remaining 25 years. However, the BCTI junior subordinated notes and the corresponding BCTI trust preferred securities are redeemable at Opteum’s option at the end of the first five year period and at any subsequent date that Opteum chooses.
In addition, in October 2005, Opteum completed a private offering of an additional $51.5 million of trust preferred securities of Bimini Capital Trust II (“BCTII”) resulting in the issuance by Opteum of an additional $51.5 million of junior subordinated notes. The interest rate on the BCTII junior subordinated notes and the corresponding BCTII trust preferred securities is fixed for the first five years at 7.8575% and then floats at a spread of 3.50% over three-month LIBOR for the remaining 25 years. However, the BCTII junior subordinated notes and the corresponding BCTII trust preferred securities are redeemable at Opteum’s option at the end of the first five year period and at any subsequent date that Opteum chooses.
Opteum attempts to ensure that the income generated from available investment opportunities, when the use of leverage is employed for the purchase of assets, exceeds the cost of its borrowings. However, the issuance of debt at a fixed rate for any long-term period, considering the use of leverage, could create an interest rate mismatch if Opteum is not able to invest at yields that exceed the interest rates of the Company’s junior subordinated notes and other borrowings.
LIQUIDITY AND CAPITAL RESOURCES OF THE DISCONTINUED OPERATIONS OF OITRS
In order to facilitate the sale of the remaining residential mortgage loans held for sale at June 30, 2007, OITRS has various warehouse and aggregation lines of credit available, some of which are committed facilities while others are uncommitted. As of July 1, 2007 OITRS had an aggregation line of $300 million, an uncommitted warehouse line of $30 million and a committed warehouse line of $50 million. In addition, OITRS had a $80 million committed line of credit secured by OITRS’s retained interests in securitizations and the ability to utilize $20 million of the committed warehouse line mentioned above to finance originated mortgage servicing rights. The ability to utilize the committed warehouse line to finance originated mortgage servicing rights matures September 28, 2007. The balance of the $50 million committed warehouse line and the $30 million uncommitted warehouse line matured July 31, 2007. On August 9, 2007, the $300 million aggregation line was further amended and the limit was reduced to $40 million. At the time the capacity of the facility was reduced, the outstanding balance was $12.6 million.
The committed and uncommitted warehouse and aggregation facilities are secured by mortgage loans and other assets of OITRS. The facilities generally contain various covenants pertaining to tangible net worth, available cash and liquidity, leverage ratio, and servicing delinquency. As of June 30, 2007, OITRS was not in compliance with respect to four covenants pertaining to tangible net worth, available cash and liquidity, debt to tangible net worth and profitability with one lender and the Company was not in compliance pertaining to tangible net worth with the same lender and one other lender. OITRS has obtained waivers from each lender for the covenant violations. In the event waivers are not obtained, OITRS would be in default under the terms of the agreements. In the event OITRS defaulted under the terms of the agreement, the lenders could force OITRS to liquidate the mortgage loans collateralizing the loan, seek payment from the Company as guarantor, or force OITRS into an involuntary bankruptcy. In the event the Company were required to perform under its duties as guarantor, the Company’s liquidity would be constrained or it may not be able to satisfy such obligations. In such event, this would also constitute an event of default under the terms of the agreement and the lenders would have the same remedies available to them as above.
As of June 30, 2007, OITRS had outstanding balances of approximately $89.3 million under their various warehouse and aggregation lines and approximately $59.8 million outstanding on other lines of credit with various lenders. The rates on these borrowings generally are based on a spread to LIBOR.
The Company believes that its committed and uncommitted warehouse and aggregation lines are sufficient to support the liquidation of OITRS’s remaining residential mortgage loans held for sale.
OITRS has commitments to sell mortgage loans to third parties. As of June 30, 2007, OITRS had outstanding commitments to sell loans of approximately $50.8 million.
Outlook
As discussed above, the Company's results of operations for the six and three months ended June 30, 2007 continue to be impacted by the prior monetary policy actions of the Federal Reserve whereby their target for the federal funds rate was raised by 425 basis points over a two year period. Initially, the Company repositioned its portfolio of MBS securities in response to the steps taken by the Federal Reserve by significantly increasing the allocation to short resetting ARMs. However, while this protected the portfolio from rising funding costs to some extent, such ARM securities reset upward in coupon less frequently than funding costs and the NIM of the portfolio became negative in late 2006. The NIM of the portfolio was negative for the three month period ended June 30, 2007 as well. As a consequence of the impairment charges taken on available-for-sale securities during the period ended June 30, 2007, the NIM on the Company’s portfolio is now positive on a GAAP basis. To the extent the Federal Reserve resumed their tightening policy in the future, there can be no assurance the Company would be able to maintain its positive NIM. In the event the NIM on the Company’s portfolio of MBS securities were no longer positive, the results of operations would be negatively impacted.
The funding costs of the MBS portfolio have stabilized and the yield on the MBS assets now exceeds the funding costs through a combination of ARM resetting and as a result of the impairment charge taken. The need to fund negative cash flow operations at OITRS precluded the Company from reinvesting monthly pay-downs throughout much of 2006 and 2007 and thus exacerbated the erosion of the NIM. Going forward, the combination of the ability to reinvest pay-downs on a regular basis, the continued appreciation in yield resulting from ARM resets and the absence of cash flow needs for OITRS should allow the NIM of the MBS portfolio to remain positive. However, the reduced size of the portfolio in relation to our operating expenses will constrain the earnings potential of the Company in the near term.
Developments in the secondary market for Alt-A and, specifically, loans with additional second lien mortgages, had a material negative impact on the results of operations of OITRS. Owing primarily to poor credit performance of such high CLTV residential mortgage loans, especially those originated in late 2006 and early 2007, the secondary market for such loans deteriorated. The poor credit performance of such loans manifested itself in elevated levels of EPDs and significantly depressed prices in the secondary market. As a result, OITRS recorded reserves for loan losses in excess of amounts recorded in earlier periods related to EPDs.
On April 18, 2007, the Board of Managers of OITRS approved the closure of its warehouse and conduit loan origination channels. On June 30, 2007, OITRS sold its retail loan origination channel to a third party. Accordingly, as a result of the closing of the sale of the retail origination channel and the closure of OITRS conduit and wholesale origination channel, OITRS no longer operates a mortgage loan origination business.
During the wind down of the mortgage loan origination operations, OITRS will still need access to a sufficient capacity of warehouse lines of credit to fund the remaining unsold loans in its inventory. In the event such borrowing capacity is reduced or withdrawn before the inventory can be fully liquidated, OITRS may need to seek alternative sources of funding or hold such loans until sold. Further, OITRS has exposure to early payment default claims that have been received from buyers of mortgage loans sold in the past. The settlement of such claims will also need to be funded. The Company believes that adequate reserves have been recorded for such exposure.
Critical Accounting Policies
The Company’s financial statements are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). The Company’s significant accounting policies are described in Note 1 to the Company’s accompanying Consolidated Financial Statements.
GAAP requires the Company’s management to make some complex and subjective decisions and assessments. The Company’s most critical accounting policies involve decisions and assessments which could significantly affect reported assets and liabilities, as well as reported revenues and expenses. The Company believes that all of the decisions and assessments upon which its financial statements are based were reasonable at the time made based upon information available to it at that time. Management has identified its most critical accounting policies to be the following:
LONG-LIVED ASSETS
Long-lived assets, including property, plant and equipment and goodwill comprise a significant amount of the Company’s total assets. The Company makes judgments and estimates about the carrying value of these assets, including amounts to be capitalized, depreciation methods and useful lives. The Company also reviews these assets for impairment on a periodic basis or whenever events or changes in circumstances indicate that the carrying amounts may not be recoverable. The impairment test consists of a comparison of an asset’s fair value with its carrying value; if the carrying value of the asset exceeds its fair value, an impairment loss is recognized in the Consolidated Statement of Operations in an amount equal to that excess. When an asset’s fair value is not readily apparent from other sources, management’s determination of an asset’s fair value requires it to make long-term forecasts of future net cash flows related to the asset. These forecasts require assumptions about future demand, future market conditions and regulatory developments. Significant and unanticipated changes to these assumptions could require a provision for impairment in a future period.
In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long Lived Assets (“SFAS 144”), the closure and/or sale of mortgage loan origination channels (discussed in Note 12) required management to test the associated long lived assets for recoverability. In connection with the testing of recoverability of the long lived assets, OITRS recorded an impairment charge of $8.9 million and $3.0 million, respectively, for the six and three months ended June 30, 2007. Further, in accordance with SFAS 144, such long lived assets were reported by OITRS as held for use as of March 31, 2007, but these assets are now included in discontinued operations for the remainder of 2007.
GOODWILL AND OTHER INTANGIBLE ASSETS
In accordance with SFAS No. 142, Goodwill and Other Intangible Assets, goodwill of a reporting unit (OITRS) and other intangible assets (the “Opteum” trade name) not subject to amortization shall be tested for impairment on an annual basis and between annual tests if an event occurs or circumstances change that indicate the intangible asset might be impaired, which, in the case of goodwill of a reporting unit, is when such event or circumstances would more likely than not reduce the fair value of that reporting unit below its carrying amount. The closure and or sale of the mortgage loan origination channels constituted such an event that would require impairment analyses on the goodwill and other intangibles not subject to amortization. Accordingly, OITRS recorded impairment charges of both goodwill and other intangible assets not subject to amortization of approximately $3.4 million and $0.6 million, respectively, for the six and three months ended June 30, 2007.
MORTGAGE BACKED SECURITIES
The Company’s investments in MBS are classified as available-for-sale securities. As a result, changes in fair value are recorded as a balance sheet adjustment to accumulated other comprehensive income (loss), which is a component of stockholders' equity, rather than through the statement of operations. The Company’s MBS have fair values determined by management based on the average of third-party broker quotes received and/or by independent pricing sources when available. Because the price estimates may vary to some degree between sources, management must make certain judgments and assumptions about the appropriate price to use to calculate the fair values for financial reporting purposes. Alternatively, management could opt to have the value of all of its positions in MBS determined by either an independent third-party pricing source or do so internally based on managements own estimates. Management believes pricing on the basis of third-party broker quotes is the most consistent with the definition of fair value described in SFAS No. 107, Disclosures about the Fair Value of Financial Instruments.
When the fair value of an available-for-sale security is less than amortized cost, management considers whether there is an other-than-temporary impairment in the value of the security. The decision is based on the credit quality of the issue (agency versus non-agency and for non-agency, the credit performance of the underlying collateral), the security prepayment speeds, the length of time the security has been in an unrealized loss position and the Company's ability and intent to hold securities. As of June 30, 2007, the Company did not hold any non-agency securities in its portfolio. If, in management's judgment, an other-than-temporary impairment exists, the cost basis of the security is written down in the period to fair value and the unrealized loss is recognized in current period earnings. Such an event occurred in the period ended June 30, 2007 and as a consequence the cost basis of all MBS securities have been written down to fair value and the previously unrealized loss recognized in current period earnings.
RETAINED INTEREST, TRADING
Retained interest, trading is the subordinated interests retained by the Company from the Company’s various securitizations and includes the over-collateralization and residual net interest spread remaining after payments to the Public Certificates and NIM Notes (see Note 12). Retained interest, trading represents the present value of estimated cash flows to be received from these subordinated interests in the future. The subordinated interests retained are classified as “trading securities” and are reported at fair value with unrealized gains or losses reported in earnings. In order to value these unrated and unquoted retained interests, the Company utilizes either pricing available directly from dealers or calculates their present value by projecting their future cash flows on a publicly-available analytical system. When a publicly-available analytical system is employed, the Company uses the following variable factors in estimating the fair value of these assets:
Interest Rate Forecast. LIBOR interest rate curve.
Discount Rate. The present value of all future cash flows utilizing a discount rate assumption established at the discretion of the Company to represent market conditions and value.
Prepayment Forecast. The prepayment forecast may be expressed by the Company in accordance with one of the following standard market conventions: Constant Prepayment Rate (“CPR”) or Percentage of a Prepayment Vector. Prepayment forecasts are made utilizing Citigroup Global Markets Yield Book and/or management estimates based on historical experience. Conversely, prepayment speed forecasts could have been based on other market conventions or third-party analytical systems. Prepayment forecasts may be changed as OITRS observes trends in the underlying collateral as delineated in the Statement to Certificate Holders generated by the securitization trust’s Trustee for each underlying security.
Credit Performance Forecast. A forecast of future credit performance of the underlying collateral pool will include an assumption of default frequency, loss severity and a recovery lag. In general, the Company will utilize the combination of default frequency and loss severity in conjunction with a collateral prepayment assumption to arrive at a target cumulative loss to the collateral pool over the life of the pool based on historical performance of similar collateral by the originator. The target cumulative loss forecast will be developed and noted at the pricing date of the individual security but may be updated by the Company consistent with observations of the actual collateral pool performance.
As of June 30, 2007, and December 31, 2006, key economic assumptions and the sensitivity of the current fair value of retained interests to the immediate 10% and 20% adverse change in those assumptions are as follows:
(in thousands)
June 30, 2007 December 31, 2006
Carrying value of retained interests – fair value $ 73,798 $ 104,199
Weighted average life (in years) 4.65 4.26
Prepayment assumption (annual rate) 33.78% 37.88%
Impact on fair value of 10% adverse change $ (4,821) $ (8,235)
Impact on fair value of 20% adverse change $ (8,873) $ (14,939)
Expected Credit losses (annual rate) 0.55% 0.56%
Impact on fair value of 10% adverse change $ (2,642) $ (3,052)
Impact on fair value of 20% adverse change $ (5,365) $ (6,098)
Residual Cash-Flow Discount Rate 17.35% 16.03%
Impact on fair value of 10% adverse change $ (3,542) $ (4,575)
Impact on fair value of 20% adverse change $ (6,767) $ (8,771)
Interest rates on variable and adjustable loans and bonds Forward LIBOR Yield Curve Forward LIBOR Yield Curve
Impact on fair value of 10% adverse change $ (24,550) $ (18,554)
Impact on fair value of 20% adverse change $ (43,031) $ (39,292)
These sensitivities are entirely hypothetical and should be used with caution. As the figures indicate, changes in fair value based upon 10% and 20% variations in assumptions generally cannot be extrapolated to greater or lesser percentage variations because the relationship of the change in assumption to the change in fair value may not be linear. Also, in this table, the effect of the variation in a particular assumption on the fair value of the subordinated interest is calculated without changing any other assumption. In reality, changes in one factor may result in changes in another that may magnify or counteract the sensitivities. To estimate the impact of a 10% and 20% adverse change of the forward LIBOR curve, a parallel shift in the forward LIBOR curve was assumed based on the forward LIBOR curve as of June 30, 2007 and December 31, 2006.
MORTGAGE SERVICING RIGHTS
The Company recognizes mortgage servicing rights (“MSRs”) as assets when separated from the underlying mortgage loans in connection with the sale of such loans. Upon sale of a loan, the Company measures the retained MSRs by allocating the total cost of originating a mortgage loan between the loan and the servicing right based on their relative fair values. Gains or losses on the sale of MSRs are recognized when title and all risks and rewards have irrevocably passed to the purchaser of such MSRs and there are no significant unresolved contingencies.
In March 2006, the FASB issued SFAS No. 156, Accounting for Servicing of Financial Assets. The Company elected to early adopt SFAS 156 as of January 1, 2006, and to measure all mortgage servicing assets at fair value (and as one class).
To facilitate hedging of the MSRs, management has elected to utilize an internal model for valuation purposes. Accordingly, fair value is estimated based on internally generated expected cash flows considering market prepayment estimates, historical prepayment rates, portfolio characteristics, interest rates and other economic factors.
As of June 30, 2007, and December 31, 2006, key economic assumptions and the sensitivity of the current fair value of MSR cash flows to the immediate 10% and 20% adverse change in those assumptions are as follows:
(in thousands)
June 30, 2007 December 31, 2006
Prepayment assumption (annual rate) (PSA) 387.9 424.6
Impact on fair value of 10% adverse change $ (1,311) $ (3,923)
Impact on fair value of 20% adverse change $ (2,494) $ (7,557)
MSR Cash-Flow Discount Rate 14.50% 14.50%
Impact on fair value of 10% adverse change $ (1,194) $ (3,505)
Impact on fair value of 20% adverse change $ (2,296) $ (6,727)
These sensitivities are entirely hypothetical and should be used with caution. As the figures indicate, changes in fair value based upon 10% and 20% variations in assumptions generally cannot be extrapolated to greater or lesser percentage variations because the relationship of the change in assumption to the change in fair value may not be linear. Also, in this table, the effect of the variation in a particular assumption on the fair value of the MSRs is calculated without changing any other assumption. In reality, changes in one factor may result in changes in another which may magnify or counteract the sensitivities.
INCOME RECOGNITION
Interest income on MBS is accrued based on the actual coupon rate and the outstanding principal amount of the underlying mortgages. Premiums and discounts are amortized or accreted into interest income over the estimated lives of the MBS using the effective yield method adjusted for the effects of estimated prepayments based on SFAS No. 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases; an amendment of FASB Statements No. 13, 60 and 65 and a rescission of FASB Statement No. 17. Adjustments are made using the retrospective method to the effective interest computation each reporting period based on the actual prepayment experiences to date and the present expectation of future prepayments of the underlying mortgages. To make assumptions as to future estimated rates of prepayments, the Company currently uses actual market prepayment history for the securities it owns and for similar securities that the Company does not own and current market conditions. If the estimate of prepayments is incorrect, the Company is required to make an adjustment to the amortization or accretion of premiums and discounts that would have an impact on future income.
With respect to mortgage loans held for sale, interest income and interest expense are recognized as earned or incurred. Loans are placed on a non-accrual status when concern exists as to the ultimate collectability of principal or interest. Loans return to accrual status when principal and interest become current and are anticipated to be fully collectible. The Company recognizes gain (or loss) on the sale of these loans. Gains or losses on such sales are recognized at the time legal title transfers to the purchaser of such loans based upon the difference between the sales proceeds from the purchaser and the allocated basis of the loan sold, adjusted for net deferred loan fees and certain direct costs and selling costs. The Company defers net loan origination costs and fees as a component of the loan balance on the balance sheet. Such costs are not amortized and are recognized into income as a component of the gain or loss upon sale. Accordingly, salaries, commissions, benefits and other operating expenses of $22.2 million and $9.9 million, respectively, during the six and three months ended June 30, 2007 were capitalized as direct loan origination costs.
Servicing fee income is generally a fee based on a percentage of the outstanding principal balances of the mortgage loans serviced by the Company (or by a sub-servicer where the Company is the master servicer) and is recorded as income as the installment payments on the mortgages are received by the Company or the sub-servicer.
INCOME TAXES
Opteum has elected to be taxed as a REIT under the Code. As further described below, Opteum’s subsidiary, OITRS a taxpaying entity for income tax purposes and is taxed separately from Opteum. Opteum will generally not be subject to federal income tax on its REIT taxable income to the extent that Opteum distributes its REIT taxable income to its stockholders and satisfies the ongoing REIT requirements, including meeting certain asset, income and stock ownership tests. A REIT must generally distribute at least 90% of its REIT taxable income to its stockholders, of which 85% generally must be distributed within the taxable year, in order to avoid the imposition of an excise tax. The remaining balance may be distributed up to the end of the following taxable year, provided the REIT elects to treat such amount as a prior year distribution and meets certain other requirements.
OITRS and its activities are subject to corporate income taxes and the applicable provisions of SFAS No. 109, Accounting for Income Taxes. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. In assessing the realizability of deferred tax assets, management considers whether it is more likely than not that some portion or all of the deferred tax assets will not be realized. To the extent management believes deferred tax assets will not be fully realized in future periods, a provision is recorded so as to reflect the net portion, if any, of the deferred tax asset management expects to realize.
Off-Balance Sheet Arrangements
As previously discussed OITRS pools loans originated or purchased and then sells them or securitizes them to obtain long-term financing for its assets. Securitized loans are transferred to a trust where they serve as collateral for asset-backed bonds, which the trust primarily issues to the public. During the second quarter of 2007, OITRS did not execute a securitization, and is not expected to do so in the future. However, OITRS held approximately $73.8 million of retained interests from securitizations as of June 30, 2007.
The cash flows associated with OITRS’s securitization activities over the six months ended June 30, 2007, were as follows:
(in thousands)
Six Months Ended June 30, 2007 Six Months Ended June 30, 2006
Proceeds from securitizations $ - $ 1,436,838
Servicing fees received 9,691 9,252
Servicing advances net of repayments 1,433 1,550
Cash flows received on retained interests 2,909 2,009
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
There have been no material changes to the Company’s exposure to market risk since December 31, 2006. The information set forth under Item 7A – Quantitative and Qualitative Disclosures About Market Risk in the Company’s Annual Report on Form 10-K for the period ended December 31, 2006, is incorporated herein by reference.
ITEM 4. CONTROLS AND PROCEDURES.
Evaluation of Disclosure Controls and Procedures
The Company maintains disclosure controls and procedures that are designed to ensure that information required to be disclosed in the Company’s reports under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and that such information is accumulated and communicated to the Company’s management, including its Chief Executive Officer and Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
As of the end of the period covered by this report, the Company’s management carried out an evaluation, under the supervision and with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures. Based on such evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were ineffective to accomplish their intended objectives as of June 30, 2007, for the following reasons:
On June 30, 2007, the Company’s majority-owned subsidiary, Orchid Island TRS, LLC (then known as Opteum Financial Services, LLC) (“OITRS”), completed the sale of substantially all of the assets related to OITRS’s retail mortgage loan origination business (the “Business”), and certain other assets associated with OITRS’s corporate staff functions. In connection with the consummation of this transaction, the employment by OITRS of substantially all of OITRS’s employees was terminated and a majority of these employees were hired by the purchaser of the Business. Owing to a substantial reduction in OITRS’s personnel in connection with the sale of the Business, the preparation of estimates necessary for the completion of the Company’s Quarterly Report on Form 10-Q for the period ended June 30, 2007, delayed the completion and timely filing of such report, which delay could not have been avoided without unreasonable effort or expense.
Changes in Internal Controls over Financial Reporting
The substantial reduction in OITRS’s personnel in connection with the sale of the Business as described above has necessitated the re-allocation of responsibility for certain controls and procedures to the remaining staff of OITRS and the staff of Opteum. As a result, the extent of segregation of duties has been reduced. Except for the foregoing, there was no change in the Company’s internal control over financial reporting that occurred during the Company’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
PART II. OTHER INFORMATION.
ITEM 1. LEGAL PROCEEDINGS.
The Company is involved in various lawsuits and claims, both actual and potential, including some that it has asserted against others, in which monetary and other damages are sought. These lawsuits and claims relate primarily to contractual disputes arising out of the ordinary course of the Company’s business. The outcome of such lawsuits and claims is inherently unpredictable. However, management believes that, in the aggregate, the outcome of all lawsuits and claims involving the Company will not have a material effect on the Company’s consolidated financial position or liquidity; however, any such outcome may be material to the results of operations of any particular period in which costs, if any, are recognized. See also Notes 9 and 12 to the Company’s accompanying consolidated financial statements.
ITEM 1A. RISK FACTORS.
During the period covered by this report, there were no material changes from the risk factors previously disclosed under Item 1A – Risk Factors in the Company’s Annual Report on Form 10-K for the period December 31, 2006 as filed on March 14, 2007. The information set forth under Item 1A – Risk Factors in the Company’s Annual Report on Form 10-K for the period ended December 31, 2006, is incorporated herein by reference.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
The Annual Meeting of Stockholders of the Company was held on April 30, 2007.
1. Election of Directors. At the meeting, Kevin L. Bespolka and W. Christopher Mortenson were each re-elected as Class I directors to serve until the 2010 Annual Meeting of Stockholders. For each nominee, the number of votes cast for and withheld were as follows:
NOMINEE FOR WITHHELD
Kevin L Bespolka 20,517,313 464,990
W. Christopher Mortenson 20,518,020 464,283
The following directors continued in office after the meeting:
Jeffrey J. Zimmer, Robert E. Cauley, Peter R. Norden, Maureen A. Hendricks and Buford H. Ortale.
On June 12, 2007, Robert J. Dwyer was appointed as a member of the Board of Directors and as Chair of the Audit Committee of the Board of Directors following the resignation from the Board of Directors of Maureen A. Hendricks. On June 29, 2007, in conjunction with the sale by the Company of its Retail mortgage origination business, Peter R. Norden resigned his positions with the Company and as a member of the Board of Directors.
2. Ratification of Appointment of Independent Registered Public Accounting Firm. At the meeting, the appointment of Ernst & Young LLP as the Company’s independent registered public accounting firm for the year ending December 31, 2007 was ratified by the Company’s stockholders. The number of votes cast for and against the ratification of Ernst & Young LLP and the number of abstentions and broker non-votes were as follows:
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