FBR - Understanding Prime Active MREIT's

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R E S E A R

C H

F R I E D M A N B I L L I N G S R A M S E Y

Financial Institutions

Important disclosures can be found on the last page of this report.

Paul J. Miller, CFA ** • 703.469.1252 • [email protected] Friedman, Billings, Ramsey & Co., Inc. Steve Stelmach • 703.312.1848 • [email protected] 1001 Nineteenth Street North • Arlington, Virginia 22209

Annett Franke • 703.469.1280 • [email protected]

July 13, 2005 Industry Update

Understanding Prime Active Mortgage REITS

Summary and Recommendation

Active mortgage REITs have become one of the more dynamic segments of the mortgage and financial servicesindustry in recent years. These companies originate loans in a taxable subsidiary and then earn tax-free interestincome from holding those loans on their balance sheets. The strategy is akin to a traditional thrift, althoughactive mortgage REITs benefit from a more dynamic capital structure and greater use of capital market solutions.We continue to see unique investment opportunities within the active mortgage REIT segment, and this report isintended to provide the necessary background information to evaluate the space.

Key Points

• What is an active mortgage REIT? Active mortgage REITs (mREIT) couple the origination capabilities of a mortgage bank with the portfolio investment strategy of a passive mortgage REIT. Active mortgage REITsoriginate mortgage loans for the purpose of holding the asset on balance sheet and earning a spread betweenthe asset’s yield and the company’s cost of funding, much like a traditional thrift. Secondarily, the mortgageorigination capabilities of active mortgage REITs provide for gain-on-sale income. Passive mortgage REITs, by comparison, purchase rather than self-generate the assets held in portfolio.

• The REIT structure presents a unique set of opportunities and challenges. When compared totraditional thrifts, active mortgage REITs benefit from a more streamlined expense structure, a reducedregulatory burden, and (generally) lower capital requirements. Active REITs are designed to createinvestments with higher returns than passive REITs, because the self-generated asset tends to garner higher yields than purchased assets due to Wall Street disintermediation. However, unlike thrifts, whose depositfunding is relatively stable, some forms of funding used by mortgage REITs are subject to marketconditions. Whether one is dealing with thrifts, active REITs, or passive REITs, other challenges include the

management of credit, interest rate, and prepayment risks that are amplified by the use of leverage.• Future value creation is compelling. We continue to view the active mortgage REITs in the context of

their future value, not just the value that can be created off of current investment balances. We believe thatthe ability of active mortgage REITs to produce investable assets provides unique investment opportunitiesthat are limited only by the companies’ abilities to originate new loans and access to additional capital.Ultimately, we believe, the Street should value these companies based on the potential size of the investment portfolio, which is the result of origination capabilities and available capital.

• Mortgage origination outlook still strong. The ability of an active mortgage REIT to profitably addinvestments to its balance sheet depends largely on the origination environment as well as the company’sability to originate attractive loans within that environment. As mortgage REITs tend to favor high-quality,adjustable rate mortgages, active mortgage REITs can influence the loan production process so that more of the attractive loans are originated. We continue to expect a mortgage origination environment that is

beneficial to active mortgage REITs. In particular, ARM loans are expected to increase as a percentage of total loan originations as interest rates move higher and product acceptance grows.

• Valuations remain on the lower end of our expectations. Given our expectations for strong growthopportunities, we believe that the mREIT group as a whole remains attractively valued. When evaluating thegroup, investors tend to focus myopically on the current and near-term dividend capabilities of the company.However, this near-sighted view ignores the longer-term growth prospects that are attainable, consideringtheir generally robust origination capabilities compared to the current sizes of their investment portfolios.



FRIEDMAN, BILLINGS, RAMSEY & CO., INC.

Institutional Brokerage, Research and Investment Banking

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Table of Contents

The Basics of Active Mortgage REITs................................................................................................................3 The Economics of an Active Mortgage REIT .............................................................................................. 3 A Look toward Valuation.............................................................................................................................4 Active versus Passive Mortgage REITs ...................................................................................................... 4 REITs – A Brief Historical Perspective........................................................................................................5

The Bigger Issues .............................................................................................................................................. 6 Creating Value As an Active Mortgage REIT Grows................................................................................... 6 Earnings Drivers and Dividend Power ........................................................................................................ 7 1. Portfolio Size...........................................................................................................................................7 2. Spreads: A Risk/Return Trade-Off ......................................................................................................... 8 3. Taxable REIT Subsidiary (TRS) Profitability ........................................................................................... 8 Funding.......................................................................................................................................................8 The Challenges......................................................................................................................................... 11

Accounting Issues ............................................................................................................................................ 14 GAAP versus Tax Accounting...................................................................................................................14

Securitizations: Financing or Sale? Does it Really Matter?....................................................................... 16 Classification of Mortgage Assets .............................................................................................................17

Appendix .......................................................................................................................................................... 18 REIT Requirements .................................................................................................................................. 18 Mortgage Originations............................................................................................................................... 18

Risks ................................................................................................................................................................ 20





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The Basics of Active Mortgage REITs

The Economics of an Active Mortgage REIT

The active mortgage REIT combines the operations of a traditional mortgage bank, which creates revenuefrom the cash gain-on-sale of mortgage loans, and a passive mortgage REIT, which creates revenue frominvesting in mortgage assets and earning the spread between the asset yield and the company’s cost of funds.Additionally, coupling these two operations creates the opportunity for increased returns on capital, as thecombined entity can enjoy greater efficiencies. An example illustrating the economics of an active mortgageREIT follows. The ROEs (returns on equity) provided are illustrative and can certainly differ betweencompanies and throughout business cycles.

Mortgage banking (assumed ROE range of 10% to 80%, volatile earnings, minimal capital)

The traditional mortgage bank generates revenues by originating a loan and selling it to third parties, earningcash gain-on-sale income in the process. Relative to thrifts or passive REITs, mortgage banks need to commitvery little capital to their operations; therefore, returns on equity can at times have a wide range of 10% to80% or wider. However, profitability depends largely on the overall mortgage origination market, whichtends to be volatile and highly dependent on mortgage refinance volume.

On a single loan, mortgage banks can earn roughly 1% to 2% on the sale of the loan in cash upfront. Due tothe short-term nature of the company’s warehouse line, mortgage banks assume very little interest rate or credit risk. As a rough example, the mortgage bank will originate a 6% coupon mortgage and sell the loan toa third party for 75 basis points, while maintaining the servicing component with a present value of 125 basis points.

Passive mortgage REIT (ROE from 10% to 15%, more stable earnings, higher capital requirements)

The passive mortgage REIT generates revenue by using its capital as well as borrowed funds to invest inmortgage-related assets (generally mortgage-backed securities or loans). Depending on a variety of factors,such as borrowing and hedging costs, the average life of the security, and credit performance, the passivemortgage REIT can, for example, earn 1% to 3% over time on a mortgage loan, with ROEs in the 10%-15%range. Passive REITs have minimal fixed infrastructure costs and are essentially capital market plays, which

are dependent on financial markets staying open, because the companies cannot internally generate capitaldue to their payout requirements. Unlike mortgage banks, the earnings streams of passive REITs tend to beless volatile and not dependent on fluctuations in the in-mortgage production.

Active mortgage REIT (ROE from 15% to 25%, more stable earnings than mortgage bank)

The active mortgage REIT combines the operations of the mortgage bank with the investment portfolio of the passive REIT to realize a smoother earnings stream than a pure-play mortgage bank and a higher ROE than a passive REIT. Under the active REIT structure, the mortgage bank originates the loan and either sells theasset for cash gain-on-sale income or passes the loan to the REIT portfolio if the asset meets the company’sinvestment criteria, namely high-quality adjustable rate mortgages, predominately 5-1 ARMs or 3-1 ARMs.We believe that passive REITs tend to earn lower ROEs than active REITs because the self-generated assetsheld by the active REITs tend to have higher yields, as investment intermediaries are disintermediated.

As the TRS moves large amounts of assets to the REIT portfolio, we believe that it will be a drag on

earnings, because it absorbs the cost of origination but realizes very little benefit from the transfer of the loanto the REIT.

Traditional thrift model

Joining the operations of a mortgage bank with the investment capabilities of a mortgage REIT creates anorganization that is functionally similar to a thrift. Just as a thrift creates a loan and holds it on its balancesheet, so does an active mortgage REIT. While a thrift enjoys what we believe to be a more-stable fundingsource (namely, its deposit franchise), active mortgage REITs have a cost advantage (including lower capitalrequirements, the absence of a large branch network, and a significantly lower tax obligation)





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Additionally, thrifts tend to have high G&A costs and lower growth potential compared to the ramp-up phaseof active mREITs. Both thrifts and active mortgage REITs (through their taxable REIT subsidiaries [TRS])can self-generate capital, whereas passive REITs cannot. We tend to think of the active mREIT as a moredynamic business model, due to the more-flexible cost structure and more-efficient (but less permanent)source of funding. Both the thrift and active mREITs have the ability to recognize income upfront by sellingoriginated loans that are not intended for the investment portfolio. An important distinction between a thrift

and active mortgage REIT is that a thrift can retain earnings generated from the portfolio, whereas the activemortgage REIT will pay out at least 90% of its portfolio earnings in the form of a dividend.

A Look toward Valuation

In looking at valuation for active mortgage REITs, we generally evaluate the company’s ability to produceand maintain a dividend as well as traditional valuation multiples. The group currently trades at 11.1 times2006 earnings, 1.7 times tangible book value, and an expected 2006 dividend yield of 11.2%. Althoughvaluation multiples do prove to be useful, we believe that the dividend will be the main driver of stock appreciation, especially for the newly formed REITs. As these newer REITs fully lever their balance sheets,net interest income should grow much faster than more mature companies. Therefore, we believe it is particularly important to consider expected dividend payments as well as current dividend payments whensizing return potential.

Active versus Passive Mortgage REITs

ROE. We believe that active mortgage REITs can realize higher returns over time because the structurecombines the earnings power of a mortgage bank (which is typically linked to the economics of originatingmortgage loans and selling them into the secondary market) and the earnings stream captured over time in a portfolio.

Disintermediation. By originating mortgage loans and securitizing them in the same corporate entity, theactive mortgage REIT disintermediates those firms that specialize in accumulating loans and warehousingthem until they are securitized and the residential mortgage-backed securities (RMBS) are sold. Thatintermediation comes at a price, which we estimate to be approximately 30 basis points to 50 basis points,allowing the active mortgage REIT to have a lower cost basis in the securities than passive mortgage REITs.As a result, this increases returns to the active mortgage REITs, compared to passive REITs, which purchasesecurities in the secondary market.

Income diversification. An active mortgage REIT has two primary revenue drivers: mortgage bank earnings, which peak during periods of high origination activity, and portfolio earnings, which tend to benefitfrom periods of low refinancing activity as portfolio prepayments slow and the originated asset earns incomefrom a longer period of time. Although these two earnings streams tend to peak at different points in theeconomic cycle, they will both be depressed if the yield curve is flat or inverted.

Amortization. Passive mortgage REITs depend on the capital market for acquiring the assets that theyeventually place in their investment portfolios. These market-acquired assets are typically purchased at a premium, which will need to be amortized over the life of the asset. Excessive premium amortization,especially in high mortgage-refinance environments, will pressure earnings for passive REITs. On the other hand, active mortgage REITs manage their exposure to high-premium assets by investing in the productoriginated by the TRS. By owning self-originated assets, the REIT avoids the high premiums associated withmarket-acquired assets.

Capital generation. Unlike a REIT that does not operate a profitable TRS, active mortgage REITs cangenerate after-tax cash flows that can support portfolio growth or dividend payments or be retained in theTRS to support business expansion. We believe that a stabilized active REIT can achieve a higher valuationthan a passive REIT because the active REIT has a source of internally generated capital to support growth.Aside from valuation, the self-generated capital attainable under an active structure provides for greater management flexibility. By retaining capital, the company is not completely dependent on the capitalmarkets for future growth. However, we believe that the capital-generation function will not be immediate, aswe first thought, but will play out over time. As the TRS absorbs much of the operation costs but realizesvery little revenue while the portfolio is building out, we expect the TRS will run breakeven at best.





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Operational risks. Passive mortgage REITs have an operational advantage over active mortgage REITs. Tooperate a passive mortgage REIT, management needs little more than an MBS trading desk, portfoliomanager, and legal council. By comparison, active mortgage REITs tend to require additional personnel,namely a small army of mortgage originators and underwriters, and in many cases, a loan servicing center.

Exhibit 1: ROE Illustration

Source: FBR

REITs – A Brief Historical Perspective

Before moving further, it would be helpful to put the active mortgage REIT industry into its historicalcontext. Real Estate Investment Trusts were created to facilitate broader ownership in real estate and realestate-related assets. Any qualified income generated by the REIT and passed on to investors through adividend is not subject to corporate income tax. Originally intended to encourage ownership in physical properties (qualified asset), the definition of “qualified asset” has expanded to include assets that help financereal estate properties, namely mortgage backed securities (MBS). REITs that invest in properties are

generally referred to as “Equity REITs,” while REITs that invest in real estate-related securities, or MBS, arereferred to as “Mortgage REITs.”

Mortgage REITs come in two flavors, passive REITs and active REITs. Historically, mortgage REITs weresolely engaged in the business of purchasing mortgage backed securities on a leveraged basis and earning thespread between the yield on the MBS and the REITs funding costs. We refer to these businesses as passiveREITs, because they are not engaged in the creation of the asset in which they invest. Instead, their portfolioacquisitions are limited only to the securities offered in the market place.

Effective in 2001, the REIT Modernization Act allows REITs to own and operate taxable subsidiaries.Intended to allow equity REITs to own and operate related ‘noncustomary” businesses such as concierge

MORTGAGE BANKS

Business

Originates & Services Loansfor Cash Gain on Sale

Servicing Income Over TimeVolatile Earnings Stream

Profitability

Earns approximately 2 pts per loan

ROE range from 10% - 70%

PASSIVE MORTGAGE REITS

Business

Invests In Mortgage Backed Securities (MBS)Earns spread between asset yld. and funding cost

Interest Rate RiskPossible Credit Risk

Profitability

Earns Approx. 1 to 3 points per loan(Depending on life)


ACTIVE MORTGAGE REITS

Business

Self-generates mortgage assets held on B/S

Earns spread between asset yld. and funding costSell less attractive product for cash gain on sale

Profitability

Earns Approx. 3 to 5 points per






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services to its tenants, the act is sufficiently broad to allow for mortgage REITs to operate mortgage bankingand brokerage subsidiaries as well.

In the past few years, mortgage REITs have adopted TRSs for the purpose of self-generating the asset thatthey hold on their balance sheets. The TRSs are mortgage origination and brokerage operations that sourceloans and allocate the asset to REITs’ portfolios. We refer to mortgage REITs that create the asset and also

hold the asset in their portfolios as active REITs.While the income generated by the portfolio is exempt from corporate income tax, the earnings of the TRSare not. The TRS is a fully taxable entity, and any earnings derived from the TRS’ sale of goods or servicesto the parent REIT are taxable.

(See the appendix of this document for a summation of REIT requirements as well as a brief overview of rules governing the TRS.)

An active mortgage REIT can be formed in several ways. A REIT can develop origination capabilities, likeThornburg Mortgage (TMA), or a mortgage bank can merge with a REIT, like American Home Mortgage(AHM), or adopt REIT tax status, such as HomeBanc (HMB) and MortgageIt (MHL).

Due to the complexities of the corporate structure and accounting regime, companies converting frommortgage banks to REITs do face some operational risks through the transition period. Assuming asuccessful transition, however, we view the near-term operational challenges involved with REIT conversionas worthwhile for many mortgage banks, as future income should be more stable than mortgage bankingincome, which ebbs and flows with industrywide mortgage originations.

The Bigger Issues

Creating Value As an Active Mortgage REIT Grows

An important approach to evaluating active mortgage REITs is determining the company’s longer-termvalue. We define terminal value as the value of the shares based on the earnings stream of the company after the REIT portfolio has grown to its maximum, or equilibrium, size.

We believe that the market too often ignores the growth prospects of these institutions, opting to focuswrongfully, we believe, on the current and near-term dividend capacity of the underlying portfolios. Whilethe sustainability of the current dividend is a relevant gauge of value created today, we believe activemortgage REITs should be judged more heavily on the value they can create in the future. We believe thatthis future value creation is a direct result of the portfolio’s eventual size, which is a function of ARMorigination capabilities.

In calculating the maximum size of the portfolio, we assume that the portfolio will grow only as large as themortgage bank’s ability to replenish the investment runoff. Runoff of mortgage backed securities, also calledliquidation, occurs through mortgage refinancings and natural maturation of the underlying mortgage loans.

We also evaluate the amount of equity required to support the portfolio given the company’s targetedleverage ratio. If the current equity level is not sufficient to support the portfolio’s potential size, further capital raises would be required. Therefore, the portfolio will grow to the extent that the company can retaincapital or raise it in the equity market.

Assuming that the portfolio has reached its equilibrium size, future value can be estimated by applying a netinterest margin to arrive at the portfolio’s earnings capability. This simplified analysis assumes that themortgage bank is a break-even proposition. Assuming 100% of earnings are paid out in the form of adividend, investors can assign a potential dividend yield and then surmise the value where the stock couldtrade (the lower the assumed dividend yield, the higher the future value). We believe that this analysis isreflective of the potential growth embedded in the REIT structure and can be used as an illustration of potential share value, given a maximum portfolio size that the company’s ARM origination level can sustain.In other words, the market should value these company’s on the potential dividend payout, which isdetermined by origination size and origination mix of the TRS (the mortgage bank), which determines thesize of the REIT portfolio.





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Earnings Drivers and Dividend Power

The earnings drivers of an active mortgage REIT include:

1. The size of the company’s investment portfolio.

2. The net spread on that portfolio.

3. The profitability of the TRS as determined by the mortgage origination market and mix of product.

1. Portfolio Size

As active mREITs transition from gain-on-sale income toward spread income, the size of the portfolio becomes critically important. The larger the portfolio, the higher the potential dividend payout can become,ultimately driving valuation. For active mREITs, the most efficient portfolio size is the point in which the portfolio’s runoff equals originations of REIT-eligible assets. At that point, the TRS subsidiary can replacethe prepaying assets with the more-profitable self-generated assets without relying on purchasing MBS in theopen market. We believe that this strategy maximizes the efficiency and dividend power of the activeMortgage REIT. As an example, a TRS that produces $10 billion in mortgage loans, with 50% of thosemortgages eligible for the portfolio (based on credit and interest rate risk characteristics), can produce $5 billion in assets for the portfolio. Assuming an average life of three years on the loans, the TRS can sustain a

$15 billion portfolio. A three-year life roughly equates to a 33% conditional prepayment rate. So 33% of $15 billion in assets equals runoff of $5 billion a year. Put another way, $5 billion in originations of REIT-eligible assets are needed to sustain the portfolio’s size of $15 billion, given a 33% prepayment rate.

Exhibit 2: Maximum Portfolio Size

Total TRS Originations (in mil) $10,000

x Production Eligible for Portfolio (%) 50%

= Production Eligible for Portfolio ($) $5,000

÷ Assumed Prepayment Rate of Portfoio 33%

REIT Portfolio Size (in mil) $15,152

Source: FBR

What are REIT-eligible assets? ARMs! Adjustable-rate mortgages (ARMs) are among the most desirableassets for a REIT, bank, or any other portfolio lender. The shorter the adjustment period, the easier it is for portfolio lenders to hedge against changes in interest rates. ARM loans come in a variety of product types:traditional ARMs with monthly adjustment rates, hybrid ARMs that allow for fixed payments for a set periodof time, interest-only ARMs, where borrowers pay the interest portion only for a fixed period of time, andoption ARMs, where borrowers have a variety of payment options each month. Some industry observers fear that borrowers who take out ARMs are exposing themselves to greater risks to payment shocks in a rising-rate environment. Should home buyers practice prudent borrowing practices, we believe that the ARM canactually be a consumer-friendly loan.

Outlook for ARMs. Given the attractiveness of the product for portfolio lenders and the product’s increasingconsumer acceptance, it is prudent to discuss our outlook for the product in a rising mortgage rateenvironment. Rising mortgage rates, coupled with increased borrower sophistication, leads to higher adjustable-rate mortgage production. In addition, strong home price appreciation exacerbates the move to

adjustable-rate mortgages, as home buyers look for alternative products to meet affordability hurdles.

U.S. production of ARMs, which rose from 22% of its total production at the end of December 2003 to 32%in the first quarter of 2005, could remain at these strong levels or even increase slightly as borrowers hunt for affordability options and are more than willing to offer the product. The lender will benefit from ARMs heldin the investment portfolio, which are easier to match-fund; therefore, rising rates present less of a challengethan holding fixed-rate mortgages. Secondly, prepayments slow in rising-rate environments; therefore, whilerates on the ARM products adjust higher, the likelihood of the borrower to refinance declines. Higher interest rates and lower mortgage prepayment activities translate into higher asset yields on the company’s portfolio.





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2. Spreads: A Risk/Return Trade-Off

The spread that the company can earn between the asset yields and borrowing costs play a crucial role in profitability. Many investors will focus on the yield curve as a proxy of profitability in the active mortgageREIT space. We believe that this is somewhat misguided, as the active mortgage REITs do not earn the entirespread between asset and liabilities by borrowing short term and lending long term. Rather, they earn the

spread between their funding costs and asset yields at nearly the same point in the yield curve. As the creator of the asset held in the portfolio, an active mortgage REIT can extract higher yields than if it purchasedsecurities in the marketplace. The higher-yielding assets create a profit opportunity between the cost of funds,despite the fact that the asset and liability have the same duration. Active and passive REITs tend to havedifferent spreads between the yield on assets held on balance sheet and the funding costs of the associatedliabilities. The difference in spread is primarily attributable to the asset side of the balance sheet, as activeand passive REITs tend to have similar funding strategies.

Active mortgage REITs have greater flexibility to source attractive loans. While investment purchases at passive mortgage REITs are subject to the availability of securities in the market, active mortgage REITs canoriginate the loans that best meet their investment criteria. However, an active mortgage REITs’ originationcapabilities will depend greatly on the overall origination market and the company’s separate originationchannels, which will dictate the quantity of preferred assets that are originated.

Active REITs garner more favorable asset yields (between 30 basis points to 50 basis points) relative to their passive brethren as a result of their self-origination capabilities. By originating and holding the asset, activeREITs retain more of the asset’s yield that would otherwise be given to intermediaries, namely the WallStreet firms that assist in the securitization process. In addition, some REITs hold a residual interest piece of the self-originated assets. The residual is a small portion of a securitization that absorbs much of the creditand prepayment risk associated with a pool of loans. For the assumption of this risk, the residual will pay anextremely high yield relative to the other tranches of a securitization. Holding this residual will help boostasset yields in the near term but will normalize as credit and prepayment expense tick higher. Further clouding the differences between the yields of active and passive REITs are the differences between GAAP-reported net income and taxable net income, which determines the dividend. We go into further detailregarding GAAP/Tax differences later in this report.

3. Taxable REIT Subsidiary (TRS) Profitability

The TRS’ profitability is determined by the demand for mortgage products and the gain-on-sale of that product. Changes in the interest rate environment and resulting changes to the origination mix will have bothadvantages and disadvantages for mortgage-originating REITs’ profitability. When active mortgage REITsare ramping up their portfolios, the TRS’ profitability comes under pressure, as the mortgages that wouldhave been sold for cash are instead diverted to the portfolio. However, in times when the portfolio is notgrowing, the TRS’ profitability can be measured by the volume of loans produced and eventually soldmultiplied by the basis points of margin garnered from the sale after backing out direct origination costs andG&A expenses. The TRS faces a profitability hurdle when the portfolio is being filled, because loans thatwould have otherwise been sold for cash are instead transferred to the REIT portfolio. However, as the portfolio hits its full leverage, the TRS can profitably sell excess production.

Funding

The cost of capital is a significant determinant of an active REITs growth and profitability. The higher the price-to-book multiple (a lower cost of capital), the more accretive any capital raise will be to currentshareholders. Should an active mortgage REIT own a TRS that operates at a loss or breakeven, accessingcapital markets becomes critical for growth. The price-to-book multiple at which the deal gets completedaffects accretion to current shareholders. REITs can use a variety of funding sources, namely equity, reverserepurchase agreements, securitizations, commercial paper, and even corporate debt, although this option hasyet to be widely used in the active mortgage REIT sector.

Equity. Of course, the most basic form of funding, the active Mortgage REIT’s portfolio, is the company’sown equity. However, as the companies actively utilize leverage, the equity component of the portfolio’s





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funding generally amounts to only 5% to 10% of the portfolio’s assets, equating to leverage of roughly 10times to 20 times. Borrowings take the form of reverse repurchase agreements (repo), commercial paper (CP), collateralized debt obligations (CDOs), and whole loan financings. The amount of leverage is largelydetermined by the type of funding used with 10 to 13 times leverage for repo funding and 15 to 20 timesleverage for CDO financing.

Reverse repurchase agreements. The traditional form of borrowing for mortgage REITs has been reverserepurchase agreements. Repos are collateralized borrowings with relatively short terms of anywhere betweenone to 12 months. They provide a relatively straightforward form of borrowing and therefore are commonlyused. Interest rate risk is generally mitigated by the use of hedging strategies such as swaps or caps.

However, repos do pose some challenges; a company can run the risk of a liquidity crunch because repos are based on secured lending. Should the counterparties that are extending the Repo lines become nervous, theycan pull their funding lines and force the REIT to liquidate assets – an event that would negatively affectearnings and distributions. Additionally, the reverse repurchase facilities are based on the fair value of thecollateral backing the borrowings. Should that collateral lose value, the Repo funding available to the REITwould decline.

Utilizing Repo funding does expose the REIT to higher degrees of interest rate risk, as the life of the asset isgenerally longer than the life of the reverse repurchase agreement. Should short-term rates increase, the

change in rates would be reflected in the company’s cost of funds sooner than it would be reflected in assetyields. For this reason, Repo financing requires higher levels of capital than other forms of financing,although hedging strategies help to mitigate this risk. Under a repo facility, the company is required to hold4% to 5% of equity against the borrowings but generally holds anywhere from 8% to 10%, which serves asan extra layer of protection against interest rate moves.

Collateralized debt obligations. A more recent form of funding has been the use of collateralized debtobligations (CDOs). The funding source is particularly attractive to active mortgage REITs, as they self-generate the assets that back the CDO transaction, which provide incremental yield above purchasedsecurities. In a CDO transaction, the capital requirements are much lower than in repo financing. CDOsgenerally require capital of around 2% depending on the makeup of the underlying collateral, versus 8% to10% collateral held against repos. The lower capital requirements reflect the more permanent nature of CDOfinancing.

Once a securitization is done, the REIT must decide how to finance it. The securitization process createshighly liquid assets that can be readily financed through repos or CDOs. The portions, or tranches, of thesecuritization that are retained by the company are usually financed through the repo market. The tranchesthat are sold into the markets to investors are considered collateralized debt obligations (CDOs). Below, wecompare repo financing with CDO financing.

Exhibit 3: Repo versus CDO Financing

Repo Financing CDO Financing

- subject to margin calls if asset value declines - permanent financing - terms do not change

- 8% to 10% capital requirement - lower capital requirements with 2%

- higher capital requirement results - allows for 16x to 18x leverage

in lower leverage - 10x to 12x - cost of financing higher

- typically limited to 30 days

- roll-over risk as interest rate resets

- term Repo: 60, 90, or more days

Source: FBR

Example of a securitization. In a securitization, the active REIT forms a pool of loans that are depositedinto a trust. The trust then issues debt to fund the assets. The created securities provide liquidity, as they can be bought or sold quickly, as any commonly traded bond, whereas trading a portfolio of loans is moreexpensive and time consuming. Also, mortgage-backed securities can be financed at lower costs relative to





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financing whole loans on a warehouse line. While the actual securitization process is the same with eachcompany, the debt structuring can vary depending on different investment objectives.

In our example below, we describe how a securitization can be structured to obtain different leverage and netinterest margin. Assume that Company A and Company B both deposit $900 million of mortgage loans intothe trust and the trust issues $895 million debt against the loans. The remaining balance of $5 million is

financed through equity, also known as over-collateralization. We assume both companies obtain the samecredit rating and the same spread on the tranches. Company A decides to retain the BBB and A- ratedtranches, or a total of 6%, which are usually financed through equity or repos. The higher-rated tranches aresold to investors and considered collateralized debt financing.

Under a second scenario, Company B decides to keep only the BBB rated tranches, or 2% of the deal, andsell all remaining tranches to third parties. The retained tranches are financed in the Repo market, whichrequires a higher capital. Company B achieves a higher leverage in the deal than Company A as the equitystake is lower. On the other hand, Company A will obtain a higher net interest margin on the deal, as theRepo-ed tranches have a lower funding cost. A company would chose to retain a higher percentage of thedeal if spreads on the tranches are wide, and therefore, the debt-funding cost to the company would increase.While this would result in lower leverage as more equity is put up, net interest margin on the deal will benefit.

In some cases, mortgage REITs might decide to retain all the tranches instead of selling them to third partiesand finance the entire securitization deal in the repo market.

Exhibit 4: Securitization Examples

Company A Company B

AAA AAA

AA AA

A A

BBB BBB

OC OC

97.5% tranches sold

CDO - financed

2% tranches retained

repo-financed

0.5% capital

93.5% tranches sold

CDO - financed

6% tranches retained

repo-financed

0.5% capital

Source: FBR

Commercial paper: higher costs, but unsecured and more permanent. In an attempt to broaden fundingsources, many companies are tapping commercial paper facilities that possess similar characteristics as Repofacilities but help diversify the counter-party risk and the potential of funding being pulled. Typically,companies issue asset-backed commercial paper through an on-balance bankruptcy remote vehicle and investthe proceeds in mortgage-related assets.

Trust preferred offerings. As the equity capital markets have become less attractive for some mortgageREITs to raise capital in today’s interest rate environment, some have recently turned to trust preferredsecurities issuance.

Because trust preferred stocks are not classified as common equity, the instruments are not included in thecalculation of return on equity, meaning that they can be used to boost capital without diluting commonshareholders’ stock. Additionally, unlike preferred stock, their dividends, which are considered to be aninterest payment, are tax deductible. As a result, trust preferred securities may enable the companies to meet





11

their capital needs while increasing both ROE and earnings per share. Preferred stock also provides a sourceof financing that is unsecured, meaning that no assets are pledged against the funds.

Trust preferreds may have more uses than a Swiss army knife. They can be used to payoff debt, financeacquisitions, and fund a stock buyback program. The proceeds can also be used to support a REITs assetgrowth. The entire trust preferred market has become very mature, which is to say both efficient and liquid;

that is good news for mortgage REITs, because one never knows when a little trust preferred capital mightcome in handy.

In some cases, smaller companies will issue pooled trust preferred stock, which is a new twist on the concept.The market for trust preferred generally tightens for issues of less than $25 million, and the issuance costsmay be prohibitive. Pooled trust preferred stock would allow smaller issues to be pooled, alleviating both of those concerns while retaining the advantages found in the trust preferred structure.

The Challenges

Understanding Interest Rate Risk

When analyzing interest rate risk, it is worth reviewing a few key concepts, such as maturity, average life,duration, and convexity.

1) Maturity: A loan’s maturity is the length of the loan’s possible life in years. As an example, a 30-year amortizing adjustable-rate mortgage will mature in 30 years, assuming no prepayments.

2) Average life: Prepayments will reduce the time a loan is in existence. This shorter time period is knownas a loan’s average life. As an example, a pool of 5/1 Hybrid ARMs that has a 30-year amortization period (a 30-year maturity) may exist for only four years.

3) Duration: Duration is a measure of price changes given a change in interest rates. The higher theduration, the more susceptible a loan is to changes in valuation. Using our example of a 5/1 HybridARM, the duration may only be 3.5 years. The valuation of this 3.5-year duration asset is lesssusceptible to changes in interest rates than a five-year duration asset.

4) Convexity: A bond’s convexity reflects the degree of change in price given changes in duration. Putanother way, convexity is the change in duration due to changes in interest rates. Two bonds with the

same duration but different convexity will experience different price movements, with the more convex bond experiencing greater price swings.

Maturity. While the first three concepts appear synonymous to causal observers, there are importantdistinctions. To illustrate the differences, we use a hypothetical example of a $1 billion portfolio of 5/1Hybrid ARMs with a 30-year amortization schedule. The underlying loans have a set interest rate for the firstfive years and then are adjusted annually based on prevailing rates every year thereafter until the loan is paidoff (in 30 years, which is the loans’ maturity).

Average life. The option for borrowers to prepay mortgage debt adds the element of average life to theabove scenario. While the original loan has a maturity of 30 years, the likelihood that a borrower will prepaythat loan is relatively high. Borrowers will repay loans for a variety of reasons, including moving residences,refinancing to taking advantage of favorable interest rates, or refinancing to avoid the reset period of theadjustable rate mortgage. Because of these reasons, the loans in this example will exist for only a few years,

representing an average life of maybe only four years for the entire pool.Duration, in the case of mortgage assets, is actually a measure of price sensitivity, given changes in interestrates measured in years. This is not to be confused with either maturity or average life. Duration helpscompare changes in price given different coupon levels and maturities. Active mortgage REITs will attemptto match the duration (match the changes in valuation) of their assets and the liabilities to help mitigateschanges in valuation due to interest rate moves. The exhibit below is an illustrative example of changes induration given changes in interest rates. A portfolio of loans with an average duration of 3.5 years will bematch-funded, with debt having a duration of 3.5 years as well.





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Exhibit 5 below highlights projected changes in duration given changes in interest rates. In this hypotheticalexample, assume that an MBS has a duration of 3.5 years. Assuming a 100-basis-point increase in interestrates, the duration would increase to just over five years. Given a 100-basis-point decline in interest rates, theeffective duration would decline to one year. Beyond a 100-basis-point change in interest rates, changes induration are relatively muted.

Exhibit 5: Projected Durations of Hypothetical MBS

0

1

2

3

4

5

6

7

-300 -200 -100 0 +100 +200 +300

Interest Rate Change

E f f e c t i v e D u r a t i o n

3-4 yrs. duraton

1 yr duration

5 yr duration

Source: FBR

Convexity: positive versus negative. Convexity adds a layer of difficulty to a company’s portfolio strategy.Simplistically, convexity can be viewed as the volatility of changes in duration. While a portfolio’s assetsand liabilities may be duration matched at any point in time, due to different levels of convexity between theassets and liabilities, a change in interest rates may have a greater impact on one side of the balance sheetthan the other.

For MBS, convexity is negative, because rising prepayment rates dampen the price increase in declining ratescenarios. The MBS’s life extends in a rising-rate environment – the polar opposite of the scenario that bondinvestors would want in such an environment. Noncallable bonds, by comparison, have positive convexity,

meaning that the percentage price increase in a declining rate environment is greater than the percentage price decline if rates increase by the same amount.

For an MBS portfolio, the pricing reaction to changes in interest rates will differ between the asset side of the balance sheet and the liability side, due to differing convexities. With varying degrees of success, companiesemploy hedging strategies to try to manage duration and convexity risk. The latter is accomplished by purchasing noncallable bonds that mirror the negative convexity of the MBS asset; however, this tends to becostly and is therefore not widely employed.

Exhibit 6 below illustrates two bonds; one is positively convex and the other is negatively convex. The chartillustrates the differences in price changes between the two bonds given a change in yield. In a declining rateenvironment, you will notice that the price of the negatively convex bond will cap out as expectations for prepayments increase. In a rising-rate environment, the negatively convex bond price also declines as theexpected life of the bond extends at the moment investors would prefer the security to prepay.





13

Exhibit 6: Illustration of Positive and Negative Convexity

Yield

P r i c e

Positive Convexity

Negative Convexity

y 0

100

y 1

101

103

102

+1

-1

Source: FBR

Managing Interest Rate Risk – REIT’s Hedging Options

Companies generally hedge against changes in interest rates by employing either a swap transaction, a captransaction, or both.

Swap. Many times, companies will employ a swapping strategy to hedge the portfolio. In a swappingstrategy, the company attempts to lock in a level yield regardless of the movement of interest rates,essentially flattening out the yield curve. As this strategy aims to lock-in a margin irregardless of the interestrate environment, it tends to be more expensive than a capping strategy, which allows funding costs to floatwith interest rates up until a preset level. A swap is akin to issuing noncallable bullet debt. In either a

swapping strategy or capping strategy, companies will often be exposed to convexity risk.Interest rate caps. When interest rate caps are employed, a company essentially allows funding costs to floatuntil a preset level is reached. Because coupons on a loan pool are generally fixed for a period, the portfoliowill witness spread compression in a rising-rate environment until the caps are triggered, after which thespread between assets and liabilities will stabilize.

This compression is generally expected and offset by new securitizations added to the portfolio as it grows.Over time, the actual spread for any given securitization should range somewhere between the initial spreadand the spread at the time the cap is triggered. The precise spread for the company’s entire portfolio isdependent upon the weighted average of the spreads of all securitizations.

Asset Quality

While an active REIT’s taxable subsidiary has the flexibility to originate a wide spectrum of loan products,

the portfolios tend to hold only the originated loans that meet favorable term, credit, and interest ratecharacteristics. With respect to asset quality, REITs have the incentive to hold high-quality mortgages toavoid unnecessary credit exposure. As a result, many active mortgage REITs hold Fannie Mae- and FreddieMac-eligible assets. Otherwise, portfolio holdings consist of high FICO loans as well as AAA or AA ratedmortgage backed securities (MBS). Average loan-to-value ratios tend to be lower than 70% with averageFICO scores of 700 or higher. Active mortgage REITs also have the ability to sift through the TRS production for the best-quality loans, while lower-credit-quality loans are sold off.

The newer companies with limited operating histories as REITs have less credit experience; therefore, theytend to apply conservative assumptions when gauging the impact of the credit cycle. Mortgageit, for





14

example, reserves 7 basis points on all loans sold to third parties and 12 basis points on loans held on balancesheet. Strict asset quality criteria is important, as excessive defaults would negatively affect income as wellas investment valuations.

Valuation of MBS – Option Adjusted Spreads (OAS)

As investors in mortgage-backed securities, mortgage REITs value their holdings using option-adjustedspreads (OAS). Prepayment uncertainty in mortgage cash flows makes it difficult to price MBS usingtraditional valuation approaches such as yield to maturity. To overcome the many of the shortcomings of static cash flow analysis, investors price mortgage securities on an OAS basis.

What does OAS measure and how is it determined? The OAS measures the value of a mortgage securityincluding the prepayment option. In technical terms, the OAS measures the average spread over the Treasuryspot rate curve that is adjusted for the average exercise of the prepayment option. The OAS analysis uses probabilistic methods (Monte Carlo Simulation) to evaluate the security over a wide range of interest rate paths that may occur over its term. The OAS is found by averaging the spreads over the interest rate paths for the possible spot rate curves.

The OAS for MBS is also dependent on interest rate volatility. Volatility measures the variability of yieldsover a given time period. If the range of yields is large, volatility will be high, and there will be a greater chance that a wider range of rate environments will occur. The result is that there will be greater uncertaintyto cash flows and a lower value for the bond.

The OAS is particularly important in turning interest rate cycles when spreads and volatility are especiallyerratic. High interest rate uncertainty leads to higher interest rate volatility and lower OAS in turn. In a morestable interest rate environment, interest rate volatility declines, and as a result, OAS widens.

The market-implied volatility, which affects the OAS on MBS, can be represented by swaption volatility.For mortgage REITs with portfolio composition of short-term ARMs, the volatility of these securities can berepresented by two-year and three-year swaption volatility. Over the last 12 months, we have observed highswaption volatility, which has led to a decline in OAS on the mortgage securities.

For holders of mortgage securities, the performance of the portfolio is closely related to the OAS spreads of the MBS at the time of purchase or transfer to REIT. Mortgage with high OAS at the beginning of theinvestment horizon are more likely to generate a lower return. In addition, the relative performance of MBS

is affected by how the OAS changes over the investment horizon. If the OAS on MBS declines by 10 basis points over the investment period, the security becomes richer. Therefore, the larger the OAS declines duringthe period, the higher the return on the MBS relative to Treasuries. If the OAS goes up, the security becomescheaper.

To summarize, OAS valuation is a method of comparing MBS with different cash flow characteristics on amore equal basis. The wider the OAS, the cheaper the security. In recent periods, OAS has been relativelytight.

Accounting Issues

GAAP versus Tax Accounting

While REITs do not pay corporate income tax on REIT earnings, the companies do calculate net income for Uncle Sam on a taxable basis and report earnings to investors on a consolidated GAAP basis, just as anyother company domiciled in the U.S would. Under a REIT structure, differences in GAAP and taxable netincome are significant. Exacerbating the issue are the inter-company transfers between a taxable subsidiaryand non-taxable REIT parent.

For GAAP financial reporting purposes, a mortgage REIT that houses a taxable REIT subsidiary isconsidered one entity. For tax-reporting purposes, the operations conducted in the REIT and the operationsconducted in the taxable subsidiary (the mortgage bank) are treated as two separate entities. Because of thistax treatment, differences in taxable and GAAP-reported income occur. While these differences are often





15

complex, the main difference between tax and GAAP earnings is the accounting for financial asset transfer and allowance for loan losses, which at times is reflected in the company’s net interest margin.

Asset transfer. Transfer of mortgage loans (assets) between the mortgage bank (TRS) and the REIT createsa major difference between GAAP and tax accounting. Tax rules require that the mortgage loans aretransferred to the REIT at fair market value, which creates normally a markup to the origination cost of the

asset. Under tax accounting, this transfer at a markup generates a taxable gain for the TRS and higher cost tothe REIT, as the REIT pays a premium on the transfer of loans. On a GAAP basis, this intra-companytransfer of assets, the gain to the TRS, and the cost to the REIT are eliminated.

However, the TRS is treated as a separate company and not consolidated with the REIT for income and assettesting or for other tax purposes. The TRS is subject to corporate income taxes on the fair market valuetransfer pricing from TRS to REIT. The effects of transfer pricing are especially pronounced during theinitial periods after the conversion to mortgage REIT, when the mortgage bank transfers a large volume of mortgage loans into the REIT to build up its portfolio quickly. During this period, gain-on-sale of loans intothe capital markets is reduced and the fair value transfer of the loans to the REIT is eliminated under GAAP.At the same time, the REIT portfolio is not large enough to generate net interest income to offset the lower earnings from the mortgage bank.

Allowance for loan losses. To a lesser extent, allowance for loan losses also creates a GAAP-tax difference.

Since the mortgage REITs are maintaining a portfolio of mortgage loans on its balance sheet, they mustmaintain a contra asset account, or a provisioning/allowance for loan losses. The provisioning account is based upon management’s estimate for future loan losses. Typically, statistical analysis of historic andcurrent loan performance and current economic conditions are used when estimating the proper level of theallowance account. Under GAAP accounting, the income is reduced by the provision for loan losses, whereasactual losses alone are deducted as expenses under tax accounting. Because of the nature of mortgage loan performance, taxable income is usually higher in the earlier years of a mortgage loan and lower in futureyears when compared to GAAP accounting as losses slightly increase as mortgage loans season.

Taxable NIM versus GAAP NIM. Differences exist between a company’s reported GAAP net interestmargin and its taxable net interest margin. As REITs pay dividends based on taxable earnings, it is thetaxable NIM that should be the focus of attention. The primary differences between the two numbers are the provision for loan losses and amortization of origination expenses, which are not recognized from a tax perspective. Therefore, taxable net interest income will generally be higher than reported GAAP numbers.

Exhibit 7 illustrates the differences between the two numbers.

Exhibit 7: GAAP versus Taxable Spread: a Simplified Illustration

Passive Active

MBS Prime

REITs REITs

Yield 3.00% 3.50%

Funding 2.00% 2.00%

ROA 1.00% 1.50%

Leverage 10x 10x

Return On Levered Portion of Portfolio 10.0% 15.0%

Return on Free Equity 3.00% 3.50%Combined Return 13.00% 18.50%

G&A 1.50% 1.50%

ROE 11.50% 17.00%

Source: FBR

Active mortgage REITs also tend to report different GAAP net interest margins. As an example, onecompany may include provision expense within the interest expense line (thus reducing net interest margin),while others may run their provisions through operating expenses (thus excluding provisioning expense fromthe margin calculation). It is important that investors are aware of these differences, as one company’s





16

reported net interest margin may be significantly different than another’s, but the economic difference could be minimal.

Securitizations: Financing or Sale? Does it Really Matter?

Instead of holding whole mortgage loans, mortgage REITs will bundle adjustable rate and hybrid mortgage

loans into a security and retain the securitized asset in REIT portfolio. These securities provide liquidity asthey can be bought or sold more easily than mortgage loans, which tend to be more expensive and labor intensive to sell.

Securitizations can be structured as either financing or sale for accounting purposes, which determines thetiming of revenue recognition. Most mortgage REITs classify the securitization as a financing, which allowsthe company to carry the loans on the balance sheet as assets. In certain instances, mortgage REITs willstructure securitizations as sale to third parties, allowing them to book a noncash gain on sale with the fair value of the retained residual carried on the balance sheet. The value of the residual is based on assumptionssuch as prepayment and life of loans and is reevaluated quarterly. Under a sale transaction, the mortgageassets and liabilities are not recorded on the balance sheet and referred to as an off-balance-sheetsecuritization.

Exhibit 8: Accounting for Securitizations

Financing (On Balance Sheet) Gain on Sale (Off Balance Sheet)

- book the loans as assets on balance sheet - book noncash gain on sale at time of securitization

with corresponding debt as liabilities - remove mortgage assets and liabilities from

- carry mortgage loans at LOCOM balance sheet

- mark to market securities in trading or AFS - record fair value of retained residual interest as asset

affecting earnings (trading) or book value (AFS) - mark to market residuals on regular basis

- current quarter earnings affected as no gain - higher income when securitization occurs

on sale is booked - creates more volatility when securitizations

- future earnings more stable with recurring do not occur on regular schedule

spread income from assets - no spread income over life of loan

Source: FBR

Whether classified as a financing or a sale, pros and cons exist for each. A sale transaction generates a gain(or loss) at the time of securitization and results in higher income in the period in which the securitizationoccurs. But it also creates more volatile earnings in certain environments, particularly when loansecuritizations are not completed on a consistent schedule. A financing transaction usually results in higher income recognition in future periods, as the interest income is recognized over the life of the loan. Whilefuture REIT earnings will be more stable, current quarter earnings could be affected, especially when a largevolume of loans is transferred to the REIT.

When a pool of loans is securitized, the resulting asset is separated into tranches. Each tranche can carry itsown credit rating, interest rate, and term. Companies usually retain ownership of the equity tranche (residual)and the subordinated tranches that represent the company’s maximum exposure to credit losses on the loans.The equity tranche is the riskiest, as it absorbs credit losses first. The highest tranches are less risky, as theyget affected only when losses become excessive. The amount of the subordinated tranches retained depends

on a company’s risk-return objectives. Retaining more of the subordinated tranches results in a higher spread,however, it exposes the company to increased credit risk, as these tranches absorb losses first.

Evaluating the merits of individual securitizations is a difficult task. In fact, it likely takes a certain amount of time after the securitization has matured for investors to get a clearer picture of prepayment speeds and creditquality of a particular deal. However, we do look at the credit quality and characteristics of the mortgageloans in the pool, the coupons on the loans and the yield on the notes, and the resulting net spread (ROA) onthe securitization. Portfolio holdings with FICO loans of 700 or higher and average loan-to-value ratios in the70% range reflect a high-quality mortgage loan pool. Higher ROAs are preferable but need to be consideredalong with the type of mortgage loan.





17

Classification of Mortgage Assets

Once the mortgage loans are securitized, the companies can classify the mortgage loans under FAS 140 asmortgage-backed securities (MBS). If the technical requirements under FAS 140 are not met, then thecompany will have to classify the assets under FAS 65 as mortgage loan held for investment on the balancesheet. These loans are held on the balance sheet at lower of cost or market value (LOCOM).

Now the Tricky Part – Classification of Mortgage Securities (SFAS 115)

If the company meets the FAS 140 criteria and the assets are carried on the books as securities, it becomesnecessary to designate the assets among three portfolio categories, according to FAS 115: held-to-maturity(HTM), available-for-sale (AFS), or held for trading. The classification decision has different implicationsfor income statement and balance sheet.

If mortgage REITs classify their holdings as HTM, they cannot sell the securities prior to maturity, except inexceptional circumstances. These securities are carried on the balance sheet at their original cost and with the premium amortized over the life of the loan. We feel this is the most conservative method, as changes inmarket value of the securities are not reflected on the income statement or balance sheet. Typically, thriftsuse this method of accounting for the loans that they hold on balance sheet.

Most often though, mortgage REITs will classify the securities as AFS, under which the securities are carriedon the balance sheet at fair market value. AFS gives the company more flexibility to manage their portfolioholdings. However, market value changes in the securities flows through other comprehensive income(AOCI) in the shareholders’ equity, introducing volatility to book value.

Most mortgage REITs in our universe will use either AFS or trading. In certain instances, however,companies will move mortgage securities into the trading portfolio to generate profit on short-termdifferences in prices. These are reported at fair value on the balance sheet and marked to market, with theunrealized gains on losses flowing through earnings. The overall cash flows for the company are unchanged,

but earnings become more volatile.

While the recordation and classification of securities may differ from company to company, it is important tonote that the economics of the business is unchanged. Some companies believe it is prudent to record thesecurities’ value lower and let the economics be reflected over a longer period of time. Others believe thatmarketing to market the securities on the balance sheet every quarter provides a more up-to-date financial

picture. In either case, book value remains unchanged. Generally, we are unsure of the accounting methodused, as long as management provides sufficient clarity as to the components affecting the company’sfinancial statements.





18

Appendix

REIT Requirements

Tax laws for REIT qualification are fairly complex. If a company fails to meet any of the tests, income will be taxed and the company may not qualify for REIT treatment for the four taxable years after it failed toqualify. Asset tests, income tests, and ownership tests are the major requirements. Here we only want totouch on the big issues. On a quarterly basis, 75% of a REIT’s assets must consist of real estate assets such asreal property or loans secured by real property. In addition, although a REIT can own up to 100% of a TRS, aREIT cannot own more than 10% of the voting securities of any corporation other than another REIT or TRS.REITs also need to meet several income tests. One of the major tests is that 75% of the REIT’s gross incomemust be from real estate-related income, which would consist entirely of interest income on loan assets heldat the REIT level for mortgage REITs. While this definition just scratches the surface, it shows that tax lawsfor REITs are very detailed and complex.

Mortgage Originations

The Mortgage Bankers Association estimates that $3.8 trillion of mortgages were originated in 2003, a record

that will likely prove to be hard to break in coming years. The MBA estimates that originations topped $2.5trillion in 2004 and are on track to do the same in 2005. It also projects that purchase volume was $1.4trillion, or 56% of total originations, in 2004, and will be $1.5 trillion, or 60%, in 2005, versus 34%, or $1.28trillion, in 2003. Although the refinancing market is expected to slow significantly in both 2004 and 2005,the purchase market is anticipated to remain strong.

Adjustable-rate mortgages are also expected to remain strong, as more borrowers are willing to take oninterest rate risk on their individual balance sheets. As a percentage of total production, ARMs are expectedto be approximately 35% in 2004 and 37% in 2005.

Recall, that active mortgage REITs originate much of the product that they hold on their balance sheets.However, the TRSs also originate a sizable amount of loans that are not eligible for the portfolio because theloan does not meet either credit or term characteristics needed by the portfolio. In that case, the TRS will sellthe loan for cash gain on sale.

Nearly as important as the mix of product is the channel through which the asset was created, because weview some production channels as more resilient to fluctuations in overall originations than other avenues of production. Generally, we view the retail channel as a more stable production engine over time, although thefixed costs associated with a branch network can impact profitability in a declining origination market.

Mortgages can be originated through three separate channels: retail, wholesale, and correspondent.

Retail Channel

Through the retail channel, employees of the originating institution source loans directly from consumers.Under the traditional retail model, loans are originated through a network of branch offices. More recently,direct retail originations have been sourced through home builders’ and real estate agent offices. Internetoriginations tend to be lumped into the retail category.

Mortgage loans originated through retail channels traditionally produce a higher margin than loans sourcedthrough the wholesale or correspondent channels. Retail branch establishments provide the company with alocal presence, but fixed costs associated with maintaining physical branches are high. Loan officers aregenerally commission based and can be offered incentives to source purchase-mortgage volume and high-quality ARM products that can be transferred into the REIT portfolio or sold at a profit in the secondarymarket.

As mortgage companies have greater control over the type of product originated through the retail channel,companies with a large retail presence will have greater flexibility to originate loans that the REIT portfoliofinds attractive.





19

Wholesale Channel

Wholesale originations refer to the practice of a mortgage bank originating loans from mortgage brokers,with the loan funded and closed in the name of the mortgage bank. In a wholesale arrangement, the broker will have relationships with many mortgage banks and will direct an incoming loan to the mortgage bank thatoffers the most favorable terms. The wholesale channel provides the mortgage banks with an origination

network that is relatively low cost, although margins tend to be less robust compared to the retail channel.The wholesale channel is also subject to greater price competition for loan applications, as the originating broker can sell the loan application to any mortgage bank with which the broker has a relationship. As longas the loan meets the required underwriting criteria for several mortgage banks, the broker will sell theapplication to the bank that offers the best price.

Correspondent Channel

In a correspondent relationship, mortgage banks purchase closed loans from an originating institution, suchas a bank or credit union. Similar to wholesale, the correspondent channel tends to have lower margins thanretail production. However, unlike the wholesale channel, where the loan is underwritten to comply with themortgage bank’s specific origination criteria, loans purchased through the correspondent channel aregenerally underwritten based on the originating institution’s criteria.





20

Risks

Economic slowdown. A significant decline in the overall economy could lead to declining real estatevalues, which would likely reduce the level of new mortgage loan originations. Furthermore, declining realestate values significantly increase the likelihood that the companies will incur losses on loans in the event of

defaults. Any sustained period of increased payment delinquencies, foreclosures, or losses could adverselyaffect earnings.

Interest rate risk. Rising interest rates generally reduce the demand for mortgage loans. Interest rates have been favorably low in the last several years, but there can be no assurance that rates will stay at these levels.A sudden shift in Federal Reserve policy to a less accommodative stance would compress spreads and couldresult in lower earnings.

Changes in the level of interest rates also can affect the companies’ ability to originate or acquire mortgageloans or mortgage-backed securities and the value of assets. In addition, the companies may not be able toduration-match borrowings and mortgage loan holdings accurately in periods of interest rate volatility.

Leverage of equity. Active mortgage REITs lever the REIT portfolio through the use of repurchaseagreements, bank credit facilities, securitizations, including the issuance of collateralized debt securities, andother borrowings. The amount of leverage incurred will vary depending on its ability to obtain creditfacilities and lenders’ estimates of the value of its portfolio's cash flow.

Funding needs. The companies rely, in part, on warehouse and repurchase facilities in order to fundmortgage loans. These facilities are provided by financial institutions that may cancel the facilities with littleor no notice, and the facilities are subject to periodic renewal. If the companies are unable to renew thefacilities, or if a providing financial institution cancels a facility, the company would be forced to reduce itsoriginations, which could negatively affect earnings.

REIT qualification. The portion of the tax code defining REIT status is complex and could be subject tointerpretation; penalties for fraudulent claims can exceed 100% of income and could have a negative effecton the business. If the companies fail to comply with all of the REIT qualification rules, they could be subjectto corporate-level taxes or penalties.



*Closing price of last business day immediately prior to the date of this publication.

IMPORTANT INFORMATION CONCERNING FRIEDMAN, BILLINGS, RAMSEY & CO., INC.

Company Specific DisclosuresSpecific disclosures are applicable to tickers indicated.

General DisclosuresInformation about the research analyst responsible for this report:The analyst(s) whose name(s) appear with an ** on the front page of this report certifies that the views expressed herein accurately reflect the analyst's

personal views as to the subject securities and issuers, and further certifies that no part of such analyst's compensation was, is, or will be, directly orindirectly, related to the specific recommendations or views expressed by the analyst in the report. The analyst(s) responsible for this research report hasreceived and is eligible to receive compensation, including bonus compensation, based on Friedman, Billings, Ramsey & Co. Inc.'s ("FBRC") overalloperating revenues, including revenues generated by FBRC's investment banking department.

Information about our investment banking department:In the normal course of its business, FBRC seeks to perform investment banking and other services for various companies and to receive compensation inconnection with such services. As such, investors should assume that FBRC intends to seek investment banking or other business relationships with thecompanies.

Information about our recommendations, holdings and investment decisions:Our brokers and analysts may make recommendations to their clients, and our affil iates may make investment decisions that are contrary to therecommendations contained in a research report. Such recommendations or investment decisions are based on the particular investment strategies, risktolerances, and other investment factors of that particular client or affiliate. From time to time, FBRC, its affiliated entities, and their respective directors,officers, employees, or members of their immediate families may have a long or short position in the securities mentioned in this report.

Information about our rating system:FBRC instituted the following three-tiered rating system on October 11, 2002 for securities it covers:

Outperform — FBRC expects that the subject company will outperform similar companies within its industry over the next 12–18 months. We

recommend that investors buy the securities at the current valuation.

Market Perform — FBRC expects that the subject company will perform in line with similar companies within its industry. We recommend that

investors maintain their current positions and add on weakness as the valuation or fundamentals become more favorable.

Underperform — FBRC expects that the subject company will underperform similar companies within its industry. We recommend that investors

reduce their positions until the valuation or fundamentals become more compelling.

(1)As of midnight on the business day immediately prior to the date of this publication.A description of the five-tiered rating system used prior to October 11, 2002, can be found at http://www.fbrcorp.com/disclosurespre10702.asp.

General information about this research report:Additional information on the securities mentioned in this report is available upon request. This report is based on data obtained from sources we believe tobe reliable, but is not guaranteed as to accuracy and does not purport to be complete. This report should not be construed as advice designed to meet theparticular investment needs of any investor, nor as an offer or solicitation to buy or sell the securities mentioned herein, and any opinions expressed hereinare subject to change.

These securities may be sold to or purchased from customers or others by FBRC acting as principal or agent. This publication has been issued and approvedby FBRC under a compliance routine approved by Friedman, Billings, Ramsey, International Ltd., its U.K. FSA Regulated affiliate, for distribution to U.K. andEuropean non-private clients.

Commentary regarding the future direction of financial markets is illustrative and is not intended to predict actual results, which may differ substantially from

the opinions expressed herein. References to "median," "consensus," "Street," etc., estimates of economic data refer to the median estimate of economistspolled by Bloomberg L.P.

If any hyperlink is inaccessible, call 800.846.5050 and ask for Editorial.Copyright 2005 Friedman, Billings, Ramsey & Co., Inc.

Rating FBRC Research Distribution1 FBRC Banking Services in the past 12 months1

Buy (Outperform) 49.8 % 20.2 %

Hold (Market Perform) 44.0 % 5.5 %

Sell (Underperform) 6.2 % 0.0 %

FBR - Understanding Prime Active MREIT's

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