Annual Statements Open main menu

Arlington Asset Investment Corp. - Quarter Report: 2005 September (Form 10-Q)

FORM 10-Q DATED 09/30/05
Table of Contents

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 

(Mark One)

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2005

 

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                      to                     

 

Commission file number: 000-50230

 


 

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

(Exact name of Registrant as specified in its charter)

 

Virginia   54-1873198
(State or other jurisdiction of
incorporation or organization)
  (I.R.S. Employer
Identification No.)

 

1001 Nineteenth Street North

Arlington, VA 22209

(Address of principal executive offices)

(Zip code)

 

(703) 312-9500

(Registrant’s telephone number including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

 

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  x    No  ¨

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act.):    Yes  ¨    No  x

 

Indicate the number of shares outstanding of each of the registrant’s classes of common stock, as of the latest practicable date:

 

Title


  Outstanding

Class A Common Stock   159,056,784 shares as of October 28, 2005

Class B Common Stock

    13,480,249 shares as of October 28, 2005

 



Table of Contents

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

 

FORM 10-Q

 

FOR THE QUARTER ENDED SEPTEMBER 30, 2005

 

INDEX

 

         Page

Part I. FINANCIAL INFORMATION

    

Item 1.

 

Financial Statements — (unaudited)

    
   

Consolidated Balance Sheets — September 30, 2005 and December 31, 2004

   3
   

Consolidated Statements of Operations — Three Months Ended September 30, 2005 and 2004

   4
   

Consolidated Statements of Operations — Nine Months Ended September 30, 2005 and 2004

   5
    Consolidated Statements of Changes in Shareholders’ Equity — Nine Months Ended
September 30, 2005 and Year Ended December 31, 2004
   6
   

Consolidated Statements of Cash Flows — Nine Months Ended September 30, 2005 and 2004

   7
   

Notes to Consolidated Financial Statements

   8

Item 2.

 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

   30

Item 3.

 

Quantitative and Qualitative Disclosures about Market Risk

   44

Item 4.

 

Controls and Procedures

   47

Part II. OTHER INFORMATION

    

Item 1.

 

Legal Proceedings

   48

Item 6.

 

Exhibits

   50
   

Signatures

   51

 

2


Table of Contents

PART I — FINANCIAL INFORMATION

 

Item 1. Consolidated Financial Statements and Notes — (unaudited)

 

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

CONSOLIDATED BALANCE SHEETS

(Dollars in thousands, except per share data)

(Unaudited)

 

    September 30,
2005


    December 31,
2004


 

ASSETS

               

Cash and cash equivalents

  $ 181,534     $ 224,371  

Restricted cash

    21,576       7,156  

Receivables:

               

Interest

    91,164       46,324  

Due from servicer

    86,345       —    

Securities sold

    63,064       —    

Other

    46,615       28,556  

Investments:

               

Mortgage-backed securities, at fair value

    9,268,662       11,726,689  

Loans held for investment, net

    6,999,409       —    

Loans held for sale, net

    1,541,283       —    

Long-term investments

    361,131       441,499  

Reverse repurchase agreements

    488,113       183,375  

Trading securities, at fair value

    1,429,547       7,744  

Due from clearing broker

    162,759       95,247  

Goodwill

    160,525       108,013  

Intangible assets, net

    27,880       14,404  

Furniture, equipment, software and leasehold improvements, net of accumulated depreciation and amortization of $28,619 and $22,889, respectively

    40,602       18,733  

Prepaid expenses and other assets

    100,948       26,177  
   


 


Total assets

  $ 21,071,157     $ 12,928,288  
   


 


LIABILITIES AND SHAREHOLDERS’ EQUITY

               

Liabilities:

               

Trading account securities sold but not yet purchased, at fair value

  $ 156,428     $ 17,176  

Commercial paper

    8,214,835       7,294,949  

Repurchase agreements

    6,853,306       3,467,569  

Securities purchased

    —         144,430  

Dividends payable

    58,616       65,870  

Interest payable

    19,943       5,894  

Accrued compensation and benefits

    56,374       131,218  

Accounts payable, accrued expenses and other liabilities

    123,689       94,288  

Temporary subordinated loan payable

    100,000       —    

Securitization financing for loans held for investment, net

    3,809,901       —    

Long-term debt

    283,928       128,370  
   


 


Total liabilities

    19,677,020       11,349,764  
   


 


Commitments and Contingencies (Note 11)

               

Shareholders’ equity:

               

Preferred Stock

    —         —    

Class A Common Stock, $0.01 par value, 450,000,000 shares authorized, 157,400,117 and 143,967,205 shares issued and outstanding, respectively

    1,574       1,440  

Class B Common Stock, $0.01 par value, 100,000,000 shares authorized, 15,130,249 and 24,929,599 shares issued and outstanding, respectively

    151       249  

Additional paid-in capital

    1,544,661       1,483,640  

Employee stock loan receivable (591,342 and 711,343 shares)

    (4,242 )     (4,890 )

Deferred compensation

    (20,295 )     (16,863 )

Accumulated other comprehensive loss, net

    (209,168 )     (38,162 )

Retained earnings

    81,456       153,110  
   


 


Total shareholders’ equity

    1,394,137       1,578,524  
   


 


Total liabilities and shareholders’ equity

  $ 21,071,157     $ 12,928,288  
   


 


 

See notes to consolidated financial statements.

 

3


Table of Contents

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

 

CONSOLIDATED STATEMENTS OF OPERATIONS

(Dollars in thousands, except per share data)

(Unaudited)

 

     Three Months Ended
September 30,


     2005

    2004

Revenues:

              

Investment banking:

              

Capital raising

   $ 86,035     $ 130,019

Advisory

     3,026       11,602

Institutional brokerage:

              

Principal transactions

     4,348       4,241

Agency commissions

     20,445       18,505

Mortgage trading interest

     11,304       —  

Mortgage trading net investment loss

     (2,401 )     —  

Asset management:

              

Base management fees

     7,914       7,044

Incentive allocations and fees

     832       1,737

Principal investment:

              

Interest

     144,401       88,035

Net investment income

     4,866       19,090

Dividends

     8,772       5,820

Mortgage banking:

              

Interest

     29,383       —  

Gain on sale of loans, net

     17,600       —  

Other

     3,376       1,827
    


 

Total revenues

     339,901       287,920

Interest expense

     156,373       44,265

Provision for loan losses

     4,890       —  
    


 

Revenues, net of interest expense and provision for loan losses

     178,638       243,655
    


 

Non-Interest Expenses:

              

Compensation and benefits

     88,348       95,824

Professional services

     16,158       13,421

Business development

     8,815       8,284

Clearing and brokerage fees

     2,363       1,556

Occupancy and equipment

     9,397       3,898

Communications

     5,561       3,348

Other operating expenses

     16,861       4,846
    


 

Total non-interest expenses

     147,503       131,177
    


 

Net income before income taxes

     31,135       112,478

Income tax provision

     8,090       20,329
    


 

Net income

   $ 23,045     $ 92,149
    


 

Basic earnings per share

   $ 0.14     $ 0.55
    


 

Diluted earnings per share

   $ 0.14     $ 0.55
    


 

Dividends declared per share

   $ 0.34     $ 0.34
    


 

Weighted average shares outstanding:

              

Basic

     169,745       167,593
    


 

Diluted

     170,490       168,800
    


 

 

See notes to consolidated financial statements.

 

4


Table of Contents

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

 

CONSOLIDATED STATEMENTS OF OPERATIONS

(Dollars in thousands, except per share data)

(Unaudited)

 

     Nine Months Ended
September 30,


     2005

    2004

Revenues:

              

Investment banking:

              

Capital raising

   $ 267,887     $ 272,695

Advisory

     10,344       22,027

Institutional brokerage:

              

Principal transactions

     14,162       15,686

Agency commissions

     61,772       68,702

Mortgage trading interest

     11,304       —  

Mortgage trading net investment loss

     (2,401 )     —  

Asset management:

              

Base management fees

     24,195       19,963

Incentive allocations and fees

     1,187       2,958

Principal investment:

              

Interest

     360,021       264,141

Net investment income

     18,746       74,531

Dividends

     20,583       8,475

Mortgage banking:

              

Interest

     56,993       —  

Gain on sale of loans, net

     35,640       —  

Other

     9,327       4,824
    


 

Total revenues

     889,760       754,002

Interest expense

     334,920       111,188

Provision for loan losses

     6,028       —  
    


 

Revenues, net of interest expense and provision for loan losses

     548,812       642,814
    


 

Non-Interest Expenses:

              

Compensation and benefits

     244,162       228,411

Professional services

     49,994       38,635

Business development

     36,215       33,707

Clearing and brokerage fees

     6,435       6,937

Occupancy and equipment

     23,893       10,128

Communications

     14,893       9,732

Other operating expenses

     45,695       16,168
    


 

Total non-interest expenses

     421,287       343,718
    


 

Net income before income taxes

     127,525       299,096

Income tax provision

     26,825       36,129
    


 

Net income

   $ 100,700     $ 262,967
    


 

Basic earnings per share

   $ 0.60     $ 1.57
    


 

Diluted earnings per share

   $ 0.59     $ 1.56
    


 

Dividends declared per share

   $ 1.02     $ 1.14
    


 

Weighted average shares outstanding:

              

Basic

     169,166       166,975
    


 

Diluted

     170,122       168,500
    


 

 

See notes to consolidated financial statements.

 

5


Table of Contents

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

 

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY

(Dollars in thousands)

(Unaudited)

 

    Class A
Number of
Shares


  Class A
Amount


  Class B
Number of
Shares


    Class B
Amount


    Additional
Paid-In
Capital


  Employee
Stock
Loan
Receivable


    Deferred
Compen-
sation


    Accumulated
Other
Compre-
hensive
Income (loss)


    Retained
Earnings


    Total

   

Compre-

hensive
Income
(Loss)


 

Balances, December 31, 2003

  141,021,320   $ 1,410   25,872,099     $ 259     $ 1,443,228   $ (8,277 )   $ (2,203 )   $ 60,505     $ 59,417     $ 1,554,339          
   
 

 

 


 

 


 


 


 


 


       

Net Income

                                                          349,559       349,559     $ 349,559  

Conversion of Class B shares to Class A shares

  942,500     10   (942,500 )     (10 )                                           —            

Issuance of Class A common shares

  2,003,385     20                   40,003             (14,660 )                     25,363          

Repayment of employee stock purchase and loan plan receivable

                                  3,796                               3,796          

Interest on employee stock purchase and loan plan

                            409     (409 )                                        

Other comprehensive income:

                                                                             

Net change in unrealized gain (loss) on available-for-sale investment securities, (net of taxes of $1,978)

                                                  (76,392 )             (76,392 )     (76,392 )

Net change in unrealized gain (loss) on cash flow hedges

                                                  (22,275 )             (22,275 )     (22,275 )
                                                                         


Comprehensive income

                                                                        $ 250,892  
                                                                         


Dividends

                                                          (255,866 )     (255,866 )        
   
 

 

 


 

 


 


 


 


 


       

Balances, December 31, 2004

  143,967,205   $ 1,440   24,929,599     $ 249     $ 1,483,640   $ (4,890 )   $ (16,863 )   $ (38,162 )   $ 153,110     $ 1,578,524          
   
 

 

 


 

 


 


 


 


 


       

Net Income

                                                          100,700       100,700     $ 100,700  

Conversion of Class B shares to Class A shares

  9,799,350     98   (9,799,350 )     (98 )                                                      

Issuance of Class A common shares

  3,633,562     36                   60,821             (3,432 )                     57,425          

Repayment on employee stock purchase and loan plan receivable

                            11     837                               848          

Interest on employee stock purchase and loan plan

                            189     (189 )                                        

Other comprehensive income:

                                                                             

Net change in unrealized gain (loss) on available-for-sale investment securities, (net of taxes of $302)

                                                  (180,613 )             (180,613 )     (180,613 )

Net change in unrealized gain (loss) on cash flow hedges

                                                  9,607               9,607       9,607  
                                                                         


Comprehensive loss

                                                                        $ (70,306 )
                                                                         


Dividends

                                                          (172,354 )     (172,354 )        
   
 

 

 


 

 


 


 


 


 


       

Balances, September 30, 2005

  157,400,117   $ 1,574   15,130,249     $ 151     $ 1,544,661   $ (4,242 )   $ (20,295 )   $ (209,168 )   $ 81,456     $ 1,394,137          
   
 

 

 


 

 


 


 


 


 


       

 

See notes to consolidated financial statements.

 

6


Table of Contents

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

 

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Dollars in thousands)

(Unaudited)

 

    Nine Months Ended
September 30,


 
    2005

    2004

 

Cash flows from operating activities:

               

Net income

  $ 100,700     $ 262,967  

Non-cash items included in earnings:

               

Incentive allocations and fees and net investment income from long-term investments

    (20,391 )     (76,526 )

Premium amortization on mortgage-backed securities

    51,905       60,959  

Premium amortization on loans held for investment

    6,172       —    

Derivative contracts marked-to-market

    (2,026 )     4,316  

Depreciation and amortization

    9,678       4,241  

Other

    13,708       (490 )

Changes in operating assets:

               

Restricted cash

    (14,420 )     —    

Receivables:

               

Investment banking

    (6,014 )     (7,490 )

Asset management fees

    905       (260 )

Affiliates

    4,724       763  

Due from servicer

    (85,512 )     —    

Other

    (58,549 )     409  

Due from clearing broker

    (67,512 )     (137,342 )

Marketable and trading securities

    (1,421,803 )     (49,441 )

Originations and purchases of mortgage loans held for sale, net of fees

    (4,177,109 )     —    

Cost basis on sale and principal repayment of loans held for sale

    2,704,559       —    

Prepaid expenses and other assets

    (49,083 )     (14,103 )

Changes in operating liabilities:

               

Trading account securities sold but not yet purchased

    139,252       138,440  

Repurchase agreements related to trading securities, net

    1,477,987       —    

Accounts payable, accrued expenses and other liabilities

    16,382       9,869  

Accrued compensation and benefits

    (57,560 )     (7,393 )
   


 


Net cash (used in) provided by operating activities

    (1,434,007 )     188,919  
   


 


Cash flows from investment activities:

               

Purchases of mortgage-backed securities

    (1,912,947 )     (5,075,794 )

Receipt of principal payments on mortgage-backed securities

    3,024,039       3,227,861  

Proceeds from sales of mortgage-backed securities

    998,296       1,298,721  

Purchases of reverse repurchase agreements, net

    (137,363 )     (162,095 )

Purchases and origination of loans held for investment

    (6,851,467 )     —    

Receipt of principal repayment from loans held for investment

    279,458       —    

Purchases of long-term investments

    (67,258 )     (71,825 )

Proceeds from sales of long-term investments

    78,274       155,865  

Purchase of First NLC Financial Services, LCC, net cash

    (62,672 )     —    

Purchases of fixed assets

    (23,120 )     (7,274 )

Proceeds from disposals of fixed assets

    —         22  
   


 


Net cash used in investing activities

    (4,674,760 )     (634,519 )
   


 


Cash flows from financing activities:

               

Proceeds from issuance of long-term debt

    155,000       52,500  

Repayments of long-term debt

    (970 )     —    

Proceeds from (repayments of) repurchase agreements, net

    1,257,210       (310,709 )

Proceeds from issuances of commercial paper, net

    919,886       953,353  

Proceeds from temporary subordinated loan

    200,000       —    

Repayments of temporary subordinated loan

    (100,000 )     —    

Proceeds from securitization financing

    3,910,563       —    

Repayments of securitization financing

    (100,699 )     —    

Dividends paid

    (179,391 )     (191,056 )

Proceeds from issuance of common stock

    3,483       18,605  

Proceeds from repayments of employee stock loan receivable

    848       3,754  
   


 


Net cash provided by financing activities

    6,065,930       526,447  
   


 


Net increase in cash and cash equivalents

    (42,837 )     80,847  

Cash and cash equivalents, beginning of period

    224,371       92,688  
   


 


Cash and cash equivalents, end of period

  $ 181,534     $ 173,535  
   


 


Supplemental Cash Flow Information:

               

Cash payments for interest

  $ 312,128     $ 96,981  

Cash payments for taxes

  $ 26,670     $ 48,264  

Note: A portion of the Company’s acquisition of First NLC Financial Services, LLC was a non-cash transaction see Note 2.

 

See notes to consolidated financial statements.

 

7


Table of Contents

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Dollars in thousands)

(Unaudited)

 

1. Basis of Presentation:

 

The consolidated financial statements of Friedman, Billings, Ramsey Group, Inc. and subsidiaries (“FBR Group,” “FBR,” or the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and with the instructions to Form 10-Q. Therefore, they do not include all information required by accounting principles generally accepted in the United States of America for complete financial statements. The interim financial statements reflect all adjustments (consisting only of normal recurring adjustments) which are, in the opinion of management, necessary for a fair statement of the results for the periods presented. All significant intercompany accounts and transactions have been eliminated in consolidation. The results of operations for interim periods are not necessarily indicative of the results for the entire year. These financial statements should be read in conjunction with the consolidated financial statements and notes thereto for the year ended December 31, 2004 included on Form 10-K filed by the Company under the Securities Exchange Act of 1934.

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

 

Certain amounts in the consolidated financial statements and notes for prior periods have been reclassified to conform to the current period presentation.

 

2. First NLC Financial Services, LLC Acquisition:

 

On February 16, 2005, the Company completed the acquisition of First NLC Financial Services, LLC (First NLC), a non-conforming residential mortgage loan originator located in Florida for a purchase price of $98,563 paid in a combination of cash and stock. First NLC currently operates in 42 states and originates loans through both wholesale and retail channels. First NLC is part of the Company’s mortgage banking segment but operates as a wholly owned subsidiary. The Company expects that the acquisition of First NLC will assist in expanding and adding flexibility to the Company’s mortgage loan business by providing the ability to originate, price, portfolio and sell non-conforming mortgage loan assets based on market conditions.

 

The Company accounted for the acquisition of First NLC in accordance with Statement of Financial Accounting Standards (SFAS) No. 141, “Business Combinations” using the purchase method of accounting. Under the purchase method, net assets and results of operations of acquired companies are included in the consolidated financial statements from the date of acquisition. In addition, SFAS 141 provides that the cost of an acquired entity must be allocated to the assets acquired, including identifiable intangible assets, and the liabilities assumed based on their estimated fair values at the date of acquisition. The excess of cost over the fair value of the net assets acquired must be recognized as goodwill.

 

8


Table of Contents

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (Continued)

 

The $98,563 purchase price included cash of $72,085, issuance of 1,297,746 shares of FBR Class A common stock at a price of $18.82 per share for a total of $24,420, and estimated direct acquisition costs of $2,058. A summary of the fair values of the net assets acquired is as follows:

 

Cash

   $ 11,471  

Interest receivable

     1,107  

Loans held for sale, net

     508,443  

Intangible asset

     16,500  

Other assets

     10,029  

Warehouse finance facilities

     (483,164 )

Other liabilities

     (18,335 )

Goodwill

     52,512  
    


Total purchase price, including acquisition costs

   $ 98,563  
    


 

Identified intangible assets represent the fair value of First NLC’s broker relationships. Pursuant to SFAS No. 142, “Goodwill and Other Intangible Assets,” this intangible asset will be amortized over an estimated useful life of ten years based on the economic depletion of this asset. The expected pre-tax amortization expense for the years ended December 31, 2005, 2006, 2007, 2008, and 2009, are estimated to be $2,911, $2,764, $2,304, $1,925, and $1,612, respectively. The total amount of goodwill represents the purchase price of First NLC in excess of the fair value of the net assets acquired. Under SFAS No. 142, goodwill is not amortized. Instead, this asset is required to be tested at least annually for impairment. Both the identified broker relationship intangible asset and the goodwill are deductible for tax purposes.

 

As a result of the acquisition of First NLC, the Company adopted the following accounting policies:

 

Mortgage Loans

 

Mortgage loans originated by First NLC are classified as held for sale and are carried at the lower of cost or market value. When there is a definitive agreement to transfer loans to MHC I, Inc. (MHC I), a wholly owned qualified REIT subsidiary of the Company, the loans are reclassified as held for investment and are transferred to MHC I at the lower of cost or market value on the transfer date. Loans classified as held for investment are reported at amortized cost. Market value is determined by current investor yield commitments and/or requirements on the aggregate basis, or in the absence of such, current investor commitments and/or requirements for loans of similar terms and credit quality.

 

The cost basis of mortgage loans includes premiums paid on loans purchased and direct loan origination costs (net of loan fees collected from borrowers) on loans originated by the Company. The cost basis of loans transferred from held for sale to held for investment includes market value adjustments, if any, to record such transfers as the lower of cost or market value.

 

The Company maintains an allowance for loan losses on loans held for investment. Specific allowance for loan losses are established for impaired loans based on a comparison of the recorded carrying value of the loan to either the present value of the loan’s expected cash flow, the loan’s estimated market price or the estimated fair value of the underlying collateral. The allowance is increased by charges to operations and decreased by charge-offs (net of recoveries). Management’s periodic evaluation of the adequacy of the allowance is based upon known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of underlying collateral, and current and expected future economic conditions.

 

9


Table of Contents

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (Continued)

 

Interest Income on Loans

 

Interest income on loans is recorded as earned to the extent that such amounts are expected to be collected. Interest on loans from borrowers not expected to service the debt and interest on loans that are contractually past due 90 or more days is charged-off, or an allowance is established based upon management’s periodic evaluation. The allowance is established by a charge to interest income equal to all interest previously accrued and unpaid, and income is subsequently recognized only to the extent that cash payments are received until the borrower’s ability to make periodic interest and principal payments is adequate, in which case the loan is returned to accrual status.

 

Gain on Sale of Loans, Net

 

Gain on sale of loans is the difference between the sale proceeds and the net carrying amount of the loans less a provision for repurchase and premium recapture obligations. Gain on sale of loans is recognized when the Company transfers ownership of the loan to the purchaser and the funds are collected. Loan sales are on a servicing-released basis. The Company reduces its gain on sale of loans to record liabilities (1) for loans sold which may be required to be repurchased due to breaches of representations and warranties or if a borrower fails to make one or more of the first loan payments due on the loan and (2) for premium recapture in instances where the sold loan is paid in full by the borrower during the first year subsequent to the sale date.

 

Transfers of financial assets (mortgage loans) are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the loan has been isolated from the Company, (2) the transferee has the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred loan, and (3) the Company does not maintain effective control over the transferred loan through either (a) an agreement that both entitles and obligates the Company to repurchase or redeem them before their maturity or (b) the ability to unilaterally cause the holder to return the specific loan.

 

The following presents unaudited pro forma consolidated results for the three and nine months ended September 30, 2005 and 2004, as though the acquisition had occurred as of January 1, 2004.

 

    Three Months Ended
September 30,


    2005

  2004

Gross revenues, as reported

  $ 339,901   $ 287,920

Revenues, net of interest expense and provision for loan losses, as reported

    178,638     243,655

Net earnings, as reported

    23,045     92,149

Gross revenues, pro forma

    339,901     304,823

Revenues, net of interest expense and provision for loan losses, pro forma

    178,638     264,737

Net earnings, pro forma

    23,045     100,199

Earnings per common share:

           

Basic, as reported

  $ 0.14   $ 0.55
   

 

Diluted, as reported

  $ 0.14   $ 0.55
   

 

Basic, pro forma

  $ 0.14   $ 0.60
   

 

Diluted, pro forma

  $ 0.14   $ 0.59
   

 

 

10


Table of Contents

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (Continued)

 

   

Nine months Ended

September 30,


    2005

  2004

Gross revenues, as reported

  $ 889,760   $ 754,002

Revenues, net of interest expense and provision for loan losses, as reported

    548,812     642,814

Net earnings, as reported

    100,700     262,967

Gross revenues, pro forma

    902,518     817,586

Revenues, net of interest expense and provision for loan losses, pro forma

    558,868     706,594

Net earnings, pro forma

    99,441     286,447

Earnings per common share:

           

Basic, as reported

  $ 0.60   $ 1.57
   

 

Diluted, as reported

  $ 0.59   $ 1.56
   

 

Basic, pro forma

  $ 0.59   $ 1.72
   

 

Diluted, pro forma

  $ 0.58   $ 1.70
   

 

 

3. Stock Compensation:

 

The Company accounts for stock-based compensation in accordance with SFAS No. 123, “Accounting for Stock-Based Compensation,” as amended. Pursuant to SFAS 123, the Company continues to apply the provisions of Accounting Principles Board Opinion (APB) No. 25, “Accounting for Stock Issued to Employees.” Under APB 25, compensation expense is recorded for the difference, if any, between the fair market value of the common stock on the date of grant and the exercise price of the option. For certain option grants made during 2004, the exercise prices of options granted was below the market prices on the dates of grants. The following pro forma financial information reflects the application of SFAS 123’s fair value approach to recording stock compensation.

 

     Three Months Ended
September 30,


   Nine months Ended
September 30,


     2005

   2004

   2005

   2004

Net income, as reported

   $ 23,045    $ 92,149    $ 100,700    $ 262,967

Add: Stock based employee compensation expense included in reported net income, net of tax effects

     31      31      92      89

Deduct: Stock based employee compensation expense, net of tax effects

     200      143      1,557      198
    

  

  

  

Pro forma net income

   $ 22,876    $ 92,037    $ 99,235    $ 262,858
    

  

  

  

Basic earnings per share—as reported

   $ 0.14    $ 0.55    $ 0.60    $ 1.57
    

  

  

  

Basic earnings per share—pro forma

   $ 0.13    $ 0.55    $ 0.59    $ 1.57
    

  

  

  

Diluted earnings per share—as reported

   $ 0.14    $ 0.55    $ 0.59    $ 1.56
    

  

  

  

Diluted earnings per share—pro forma

   $ 0.13    $ 0.55    $ 0.58    $ 1.56
    

  

  

  

 

11


Table of Contents

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (Continued)

 

4. Investments:

 

Institutional Brokerage Trading Securities

 

Trading securities owned and trading account securities sold but not yet purchased consisted of securities at fair values as of September 30, 2005 and December 31, 2004:

 

     September 30, 2005

   December 31, 2004

     Owned

   Sold But
Not Yet
Purchased


   Owned

   Sold But
Not Yet
Purchased


Fixed income securities

   $ 1,395,729    $ 155,899    $ 2,658    $ 3,102

Corporate equity securities

     33,818      529      5,086      14,074
    

  

  

  

     $ 1,429,547    $ 156,428    $ 7,744    $ 17,176
    

  

  

  

 

In May 2005, the Company initiated certain fixed income trading activities primarily related to mortgage-backed, asset-backed and other structured securities, at its broker-dealer subsidiary Friedman, Billings, Ramsey and Co. (FBR & Co.). These activities include buying and selling mortgage-backed securities and other structured securities, in various financial transactions (which may include forward trades, dollar rolls and reverse repurchase transactions). The Company manages market risk associated with these securities positions primarily through forward purchases and sales of such securities. To accomplish this objective, the Company also may use U.S. Treasury securities, agency debt securities, Eurodollar futures and options to buy or sell agency debt and mortgage-related securities. To manage institutional credit risk, the Company analyzes and monitors the financial condition and trading positions of all counterparties and establishes trading limits consistent with these reviews.

 

Trading account securities sold but not yet purchased represent obligations of the Company to deliver the specified security at the contracted price, and thereby, create a liability to purchase the security in the market at prevailing prices. In general, the corporate equity obligations relate primarily to over-allotments associated with the Company’s underwriting activities. With respect to the securities sold but not yet purchased balance, the Company maintains an option to purchase additional shares from the issuer at the applicable offering price less the underwriter discount to cover these short positions for $-0- and $13,832, as of September 30, 2005 and December 31, 2004, respectively. Accordingly, these transactions when unrelated to over-allotments result in off-balance-sheet risk as the Company’s ultimate obligation to satisfy the sale of securities sold but not yet purchased may exceed the current value recorded in the consolidated balance sheets.

 

The weighted average coupon for fixed income trading securities owned and for fixed income securities sold but not yet purchased were 5.10% and 5.21%, respectively, as of September 30, 2005. The Company funds investments in such trading securities owned primarily with repurchase agreement borrowings (see Note 6). As of September 30, 2005, $1,313,587 of these securities were pledged as collateral for repurchase agreements.

 

12


Table of Contents

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (Continued)

 

Principal Investments

 

Mortgage-related and long-term investments consisted of the following as of the dates indicated:

 

     September 30,
2005


   December 31,
2004


Mortgage-Related Investments:

             

Agency mortgage backed securities:

             

Fannie Mae

   $ 6,596,851    $ 8,120,164

Freddie Mac

     1,885,086      2,673,234

Ginnie Mae

     370,710      525,236
    

  

       8,852,647      11,318,634

Private-label mortgage-backed securities (1)

     416,015      408,055
    

  

Total mortgage-backed securities (2)

     9,268,662      11,726,689
    

  

Mortgage Loans:

             

Loans held for investment, net

     6,999,409      —  

Loans held for sale, net

     1,541,283      —  
    

  

Total mortgage loans

     8,540,692      —  
    

  

Reverse repurchase agreements

     488,113      183,375
    

  

Total mortgage-related investments

     18,297,467      11,910,064
    

  

Long-term Investments

             

Merchant Banking:

             

Marketable equity securities

     217,866      188,074

Non-public equity securities

     76,550      158,478

Other

     1,314      1,389

Preferred equity debt investment

     5,000      5,000

Proprietary fund investments

     47,129      70,434

Other investments

     13,272      18,124
    

  

Total long-term investments

     361,131      441,499
    

  

Total mortgage-related and long-term investments

   $ 18,658,598    $ 12,351,563
    

  


(1) Private-label mortgage-backed securities held by the Company as of September 30, 2005 and December 31, 2004 were rated AAA by Standard & Poors.

 

(2) The Company’s mortgage-backed securities portfolio is comprised of adjustable-rate MBS, substantially all of which are Hybrid ARM securities in which the coupon is fixed for three or five years before adjusting. The weighted-average coupon of the portfolio at September 30, 2005 and December 31, 2004 was 4.02% and 3.98%, respectively.

 

13


Table of Contents

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (Continued)

 

Mortgage-Backed Securities and Long Term Investments

 

The Company’s investment securities consist primarily of mortgage-backed securities and equity investments in publicly traded companies. In accordance with SFAS 115, “Accounting for Certain Investments in Debt and Equity Securities,” the securities are classified as either available-for-sale (carried at fair value with resulting unrealized gains and losses reflected as other comprehensive income and loss) or trading (carried at fair value with unrealized gains and losses recorded to net investment income). Gross unrealized gains and losses on these securities as of September 30, 2005 and December 31, 2004 were:

 

     September 30, 2005

     Amortized
Cost/Cost Basis


   Unrealized

    Fair Value

      Gains

   Losses

   

Mortgage-backed securities(1) – Available-for-sale

   $ 9,438,406    $ 234    $ (169,978 )   $ 9,268,662

Marketable equity securities – Available-for-sale

     269,874      9,669      (61,677 )     217,866
    

  

  


 

     $ 9,708,280    $ 9,903    $ (231,655 )   $ 9,486,528
    

  

  


 


(1) The amortized cost of MBS includes unamortized net premium of $142,965 at September 30, 2005.

 

     December 31, 2004

    

Amortized

Cost/Cost Basis


   Unrealized

    Fair Value

      Gains

   Losses

   

Mortgage-backed securities – Available-for-sale

   $ 11,809,091    $ 3,478    $ (85,880 )   $ 11,726,689

Marketable equity securities – Available-for-sale

     154,639      33,940      (505 )     188,074
    

  

  


 

     $ 11,963,730    $ 37,418    $ (86,385 )   $ 11,914,763
    

  

  


 

 

The following table provides further information regarding the duration of unrealized losses on available-for-sale securities as of September 30, 2005:

 

    Continuous Unrealized Loss Position for

    Less Than 12 Months

  12 Months or More

    Amortized
Cost/Cost Basis


  Unrealized
Losses


    Fair Value

  Amortized
Cost


  Unrealized
Losses


    Fair Value

Mortgage-backed securities

  $ 6,169,992   $ (102,916 )   $ 6,067,076   $ 3,214,209   $ (67,062 )   $ 3,147,147

Marketable equity securities

    222,417     (61,677 )     160,740     —       —         —  
   

 


 

 

 


 

Total

  $ 6,392,409   $ (164,593 )   $ 6,227,816   $ 3,214,209   $ (67,062 )   $ 3,147,147
   

 


 

 

 


 

 

The unrealized losses on mortgage-backed securities are due to interest rate increases and are not related to credit quality. All of the mortgage-backed securities held by the Company with unrealized losses are either guaranteed as to principal and interest by Fannie Mae, Freddie Mac or Ginnie Mae or are rated AAA by Standard & Poors. The Company does not deem these investments to be other-than-temporarily impaired because the decline in market value is attributable to interest rate increases and because the Company has the intent and ability to hold these investments until a recovery of fair value occurs, which may be maturity. Additionally, there is a limited severity in the decline of value and substantially all of the Company’s mortgage-backed securities are adjustable rate Hybrid ARMs. These securities have interest reset dates, a substantial portion of which are within thirty-six months.

 

The Company has also evaluated its portfolio of marketable equity securities for impairment. For each of the securities in an unrealized loss position as of September 30, 2005, the Company reviewed the underlying causes for the impairments, as well as the severity and durations of the impairments. A significant portion of the

 

14


Table of Contents

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (Continued)

 

unrealized losses relate to equity securities in the nonprime mortgage industry. Companies in this sector have been negatively affected during the three-months ended September 30, 2005, by various factors including, rising short-term interest rates and lower whole-loan premiums. Unrealized loss positions relating to such investments had not been significant prior to this period. The Company evaluated the near term prospects for each of the investments in unrealized loss positions in relation to the severity and duration of the impairment. Based on that evaluation the Company’s ability and intent to hold these investments for a reasonable period of time sufficient for a forecasted recovery of fair value, the Company does not consider these investments to be other-than-temporarily impaired at September 30, 2005. We will continue to evaluate these investments at each reporting period end. If we determine at a future date that an impairment is other-than-temporary, the applicable unrealized loss will be reclassified from accumulated other comprehensive loss and recorded as a realized loss in the statement of operations at the time the determination is made.

 

During the three-months ended September 30, 2005, the Company received $218,237 from sales of mortgage-backed securities resulting in gross gains and losses of $-0- and $(812), respectively, and received $12,354 from sales of marketable equity securities resulting in gross gains and losses of $4,591 and $-0-, respectively. Included in mortgage-backed securities sold and the related gains and losses are $182,969 of mortgage-backed securities purchased and classified as trading during the three-months ended September 30, 2005. The Company recognized realized losses of $(722) on trading securities. During the three-months ended September 30, 2004, the Company received $1,419,986 from sales of mortgage-backed securities with gross gains and losses of $4,825 and $(2,983), respectively, and received $42,258 from sales of marketable equity securities with gross gains and losses of $13,194 and $-0-, respectively.

 

During the nine-months ended September 30, 2005, the Company received $1,061,360 from sales of mortgage-backed securities resulting in gross gains and losses of $704 and $(2,781), respectively, and received $52,970 from sales of marketable equity securities resulting in gross gains and losses of $19,523 and $(124), respectively. Included in MBS sold and the related gains and losses are $411,107 of MBS purchased and classified as trading during the nine-months ended September 30, 2005. The Company recognized realized losses of $(1,197) on trading securities. During the nine-months ended September 30, 2004, the Company received $1,673,765 from sales of mortgage-backed securities with gross gains and losses of $4,994 and $(3,820), respectively, and received $130,353 from sales of marketable equity securities with gross gains and losses of $66,785 and $-0-, respectively.

 

As of September 30, 2005, $9,032,263 of the mortgage-backed securities were pledged as collateral for repurchase agreements and commercial paper borrowings. In addition, $85,711 of principal and interest receivables related to the securities collateralizing commercial paper borrowings have also been pledged as collateral for those borrowings.

 

Mortgage Loans

 

Through First NLC and MHC I, the Company invests in non-conforming mortgage loans. Non-conforming mortgage loans include loans to borrowers who do not meet the conforming underwriting guidelines of Fannie Mae, Freddie Mac or Ginnie Mae because of higher loan-to-value ratios, the nature or absence of income documentation, limited credit histories, high levels of consumer debt, past credit difficulties or other factors. Non-conforming loans also include loans to more creditworthy borrowers where the size of the loan exceeds conforming underwriting guidelines.

 

15


Table of Contents

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (Continued)

 

Loans held for sale, net and loans held for investment, net were comprised of the following as of September 30, 2005:

 

     Held for
Sale


    Held for
Investment


 

Principal balance

   $ 1,515,715     $ 6,837,708  

Deferred origination costs, net and unamortized premiums

     26,169       167,729  

Allowance for lower of cost or market value/ loan losses

     (601 )     (6,028 )
    


 


Mortgage loans, net

   $ 1,541,283     $ 6,999,409  
    


 


 

The allowance for loan losses on loans held for investment is summarized as follows for the nine-months ended September 30, 2005:

 

Balance, beginning of period

   $ —  

Provision

     6,028

Charge-offs, net

     —  
    

Allowance for loan losses

   $ 6,028
    

 

Mortgage loans 90 or more days past due totaled $59,485 as of September 30, 2005.

 

As of September 30, 2005, the Company had purchased mortgage insurance on $708,903 in principal balance of mortgage loans held for investment. The mortgage insurance policy insures the Company against certain losses on the covered loans, and assists the Company in reducing its credit risk by lowering the effective loan-to-value ratios on the applicable mortgage loans. The Company also manages credit risk by purchasing or originating loans at favorable loan to value ratios. Excluding the effects of Mortgage insurance, the weighted average loan to value ratio of loans held for sale as of September 30, 2005 was less that 82%.

 

Properties securing the mortgage loans in the Company’s portfolio are geographically dispersed throughout the United States. As of September 30, 2005, approximately 31%, 13%, 8% and 6% of the properties were located in California, Florida, Illinois and New York, respectively. The remaining properties securing the Company’s mortgage loan portfolio did not exceed 5% of the total portfolio in any other state.

 

The Company finances its mortgage loan portfolio through repurchase agreements and securitization financing transactions, which are described in Note 6. Substantially all of the mortgage loans held by the Company were pledged under such borrowings as of September 30, 2005.

 

Reverse Repurchase Agreements

 

Through Arlington Funding, LLC (Arlington Funding), a commercial paper conduit managed by the Company (see Note 6), the Company provides warehouse financing to mortgage originators. As of September 30, 2005, the outstanding balance of such financings was $320,752 and the weighted average coupon was 4.23%. The Company funds its advances through commercial paper borrowings.

 

In addition, in conjunction with its fixed income trading activity, the Company enters into reverse repurchase agreements with mortgage originators and other third parties that hold mortgage loans and mortgage securities. The outstanding balance of these transactions was $167,376 and the weighted average coupon was 3.62% as of September 30, 2005.

 

16


Table of Contents

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (Continued)

 

5. Intangible Assets and Goodwill

 

The following table reflects the components of intangible assets as of the dates indicated:

 

     September 30,
2005


    December 31,
2004


 

Management contracts:

                

Cost

   $ 19,929     $ 19,929  

Accumulated amortization

     (6,469 )     (5,525 )
    


 


Net

   $ 13,460     $ 14,404  
    


 


Broker relationships:

                

Cost

   $ 16,500     $ —    

Accumulated amortization

     (2,080 )     —    
    


 


Net

   $ 14,420     $ —    
    


 


Intangible Assets, net

   $ 27,880     $ 14,404  
    


 


 

Estimated amortization expense for each of the next five years is as follows:

 

     Amount

Remaining 2005

   $ 1,146

2006

     4,023

2007

     3,563

2008

     3,184

2009

     2,871

2010

     2,613

 

The carrying value of goodwill is $160,525 as of September 30, 2005, with $108,013 of this balance attributable to the Company’s merger with FBR Asset in 2003 and its principal investing segment. The remaining goodwill balance relates to the Company’s first quarter 2005 acquisition of First NLC that resulted in $52,512 of goodwill that is attributable to the mortgage banking segment (see Note 2 for further information).

 

6. Borrowings:

 

Commercial Paper and Repurchase Agreements

 

The Company issues commercial paper and enters into repurchase agreements to fund its investments in mortgage-backed securities, as well as its warehouse lending and fixed income trading activities. Commercial paper issuances are conducted through Georgetown Funding Company, LLC (Georgetown Funding) and Arlington Funding.

 

Georgetown Funding, formed in August 2003, is a special purpose Delaware limited liability company organized for the purpose of issuing extendable commercial paper notes collateralized by mortgage-backed securities and entering into reverse repurchase agreements with the Company and its affiliates. The Company serves as administrator for Georgetown Funding’s commercial paper program and all of Georgetown Funding’s transactions are conducted with FBR. Through the Company’s administration agreement and repurchase agreements, the Company is the primary beneficiary of Georgetown Funding and consolidates this entity for financial reporting purposes. The commercial paper notes issued by Georgetown Funding are rated A1+/P1 by Standard & Poor’s and Moody’s Investors Service, respectively. The Company’s Master Repurchase Agreement with Georgetown Funding enables the Company to finance up to $12,000,000 of mortgage-backed securities.

 

Arlington Funding, formed in October 2004, is a special purpose Delaware limited liability company organized for the purpose of issuing extendable commercial paper notes collateralized by non-conforming

 

17


Table of Contents

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (Continued)

 

mortgages and providing warehouse financing in the form of reverse repurchase agreements to the Company and its affiliates and to mortgage originators with which the Company has a relationship. The Company serves as administrator for Arlington Funding’s commercial paper program and provides collateral as well as guarantees for commercial paper issuances. As part of those guarantees, the Company has pledged $29,555 in cash to collateralize its obligation. Through these arrangements, the Company is the primary beneficiary of Arlington Funding and consolidates this entity for financial reporting purposes. The extendable commercial paper notes issued by Arlington Funding are rated A1+/P1 by Standard & Poor’s and Moody’s Investors Service, respectively. Our financing capacity through Arlington Funding is $5,000,000.

 

The Company also has short-term financing facilities that are structured as repurchase agreements with various financial institutions to fund its portfolio of mortgage loans. The interest rates under these agreements are based on LIBOR plus a spread that ranges between 0.60% to 1.50% based on the nature of the mortgage collateral.

 

The following tables provide information regarding the Company’s outstanding commercial paper, repurchase agreement borrowings, and mortgage financing facilities.

 

    September 30, 2005

  December 31, 2004

        Commercial    
Paper


  Repurchase
    Agreements    


  Short-Term
Mortgage
Financing
Facilities (1)


      Commercial    
Paper


  Repurchase
    Agreements    


  Short-Term
Mortgage
Financing
Facilities


Outstanding balance

  $ 8,214,835   $ 2,791,905   $ 4,061,401   $ 7,294,949   $ 3,467,569   $ —  

Weighted-average rate

    3.79%     3.79%     4.57%     2.38%     2.34%     —  

Weighted-average term to maturity (1)

    24.3 days     18.5 days     NA     28.3 days     39.8 days     NA

(1) Under these mortgage financing agreements, which expire or may be terminated by the Company or the counterparty within one year, the Company may finance mortgage loans for up to 180 days. The interest rates on these borrowings reset daily.

 

    September 30, 2005

  September 30, 2004

        Commercial    
Paper


      Repurchase    
Agreements


  Short-Term
Mortgage
Financing
Facilities


      Commercial    
Paper


  Repurchase
    Agreements    


  Short-Term
Mortgage
Financing
Facilities


Weighted-average outstanding balance during the three months ended

  $ 8,300,373   $ 2,014,444   $ 3,661,232   $ 4,775,182   $ 6,310,166   $ —  

Weighted-average rate during the three months ended

    3.55%     3.50%     4.29%     1.56%     1.52%     —  

Weighted-average outstanding balance during the nine months ended

  $ 7,836,804   $ 2,997,247   $ 1,923,132   $ 4,659,973   $ 5,762,767   $ —  

Weighted-average rate during the nine months ended

    3.08%     2.93%     4.15%     1.27%     1.29%     —  

 

18


Table of Contents

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (Continued)

 

Securitization Financing

 

From time to time, the Company issues asset-backed securities through securitization trusts to finance a portion of the Company’s portfolio of loans held for investment. The asset-backed securities are secured solely by the mortgages transferred to the trust and are non-recourse to the Company. The principal and interest payments on the mortgages provide the funds to pay debt service on the securities. This securitization activity is accounted for as a financing since the securitization trusts do not meet the qualifying special purpose entity criteria under SFAS No. 140 and because the Company maintains continuing involvement in the securitized mortgages through its ownership of certain interests issued by the trust. As of September 30, 2005, the Company has issued $3,910,563 of asset-backed securities.

 

Interest rates on these securities reset monthly and are indexed to one-month LIBOR. The weighted average interest rate payable on the securities was 4.22% as of September 30, 2005. Although the stated maturities for each of these securities are 30 years, the Company expects the securities to be fully repaid prior due to borrower prepayments.

 

As of September 30, 2005, the outstanding balance of the securities was as follows:

 

Security balance

   $ 3,811,351  

Discount on bonds, net

     (1,450 )
    


Balance of securitization financing, net

   $ 3,809,901  
    


Current balance of loans collateralizing the securities

   $ 4,019,887  
    


 

In addition to the discount, which represents the difference between the sales price of the securities and the face amount, the Company has deferred the costs incurred to issue the securities. These costs totaled $8,648 as of September 30, 2005 and are included in prepaid expenses and other assets in the Consolidated Balance Sheets. The discount and deferred costs are amortized as a component of interest expense over the life of the debt.

 

See also Note 7 for information regarding the effects of derivative instruments on the Company’s borrowing costs.

 

Temporary Subordinated Loan

 

In September 2005, the Company through FBR & Co. obtained a $100,000 temporary subordinated loan from a subsidiary of its clearing broker. Proceeds of this borrowing are allowable for net capital purposes and were used by the Company in connection with regulatory capital requirements to support underwriting activity. Interest on this loan accrued at an annual rate of three-month LIBOR plus 4%. The loan was repaid in October 2005.

 

19


Table of Contents

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (Continued)

 

Long Term Debt

 

As of September 30, 2005, the Company had issued a total of $277,500 of long term debentures through TRS Holdings. The long-term debentures accrue and require payments of interest quarterly at an annual rate of three- month LIBOR plus 2.25% to 3.25%. The weighted average interest rate on these long term debentures was 6.14% as of September 30, 2005. During the nine months ended September 30, 2005, the Company had issued the following long-term debentures:

 

Issuance Date


   Amount

   Interest Rate

   Maturity Date

   Redemption
Date (1)


March 2005

   $ 25,000    3-month LIBOR plus 2.25%    March 30, 2035    March 30, 2010

April 2005

   $ 20,000    3-month LIBOR plus 2.25%    June 15, 2035    June 15, 2010

April 2005

   $ 20,000    3-month LIBOR plus 2.25%    July 7, 2035    July 7, 2010

May 2005

   $ 30,000    3-month LIBOR plus 2.50%    June 30, 2035    June 30, 2010

August 2005

   $ 35,000    3-month LIBOR plus 2.30%    August 15, 2035    August 15, 2010

August 2005

   $ 25,000    3-month LIBOR plus 2.50%    October 30, 2035    October 30, 2010

(1) Redemption Date represents the date after which the Company may redeem the securities in whole at any time or in part from time to time at a redemption amount equal to the principal amount thereof plus accrued interest.

 

7. Derivative Financial Instruments and Hedging Activities:

 

In the normal course of its operations, the Company is a party to financial instruments that are accounted for as derivative financial instruments in accordance with SFAS No. 133, “Accounting for Derivative Instruments and for Hedging Activities,” as amended. These instruments include interest rate swaps and caps, credit default swaps, Eurodollar futures contracts, borrower interest rate lock agreements, commitments to purchase and sell mortgage loans and mortgaged-backed securities, and warrants to purchase common stock.

 

Derivative Instruments

 

The Company utilizes derivative financial instruments to hedge the interest rate risk associated with its short- and long-term borrowings. The Company also uses derivatives to economically hedge certain positions in mortgage-backed securities and mortgage loans. The counterparties to these instruments are U.S. financial institutions. Under the interest rate swap agreements, the Company receives a floating rate based on three-month LIBOR and pays a fixed rate. With interest rate caps, in exchange for a fee paid at inception of the agreement, the Company receives a floating rate based on one-month LIBOR whenever one-month LIBOR exceeds a specified rate (the “strike” rate). Under its credit derivative agreements, the Company is required to make payments based on a fixed interest rate and receives payments that float based on specified credit events. Eurodollar futures contracts are a proxy for the forward AA/AAA LIBOR-based credit curve and allow the Company the ability to lock in three-month LIBOR forward rates for its short term borrowings based on the maturity dates of the contracts. The following table summarizes the Company’s derivative positions as of September 30, 2005 and December 31, 2004:

 

20


Table of Contents

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (Continued)

 

    September 30, 2005

    December 31, 2004

    Notional Amount

  Fair Value

    Notional Amount

  Fair Value

Cash flow hedges:

                         

Interest rate swap agreements (1)

  $ —     $ —       $ 1,000,000   $ 7,133

Interest rate cap agreements (2)

    1,819,021     149       —       —  

Eurodollar futures contracts (3)

    9,424,000     6,040       500,000     897

Eurodollar future put option contracts (4)

    22,350,000     20,004              

No hedge designation (5)

    1,000,000     (1,940 )     —       —  

(1) Interest rate swap expired July 28, 2005

 

(2) Comprised of two interest rate caps which mature on August 25, 2008 and October 28, 2005. The notional amounts of the caps amortize over the life of the agreements. The strike rates also vary over the life of the agreements between 6.30% and 10.50%.

 

(3) The $9,424,000 total notional amount of Eurodollar futures contracts as of September 30, 2005 represents the accumulation of Eurodollar futures contracts that mature on a quarterly basis between December 2005 and September 2008 and hedge short term borrowings of between $1,300,000 and $150,000.

 

(4) The $22,350,000 total notional amount of Eurodollar future put option contracts as of September 30, 2005, represents the accumulation of Eurodollar future put option contracts that mature on a quarterly basis between December 2005 and March 2007 and hedge short-term borrowings of between $5,240,000 and $750,000.

 

(5) Comprised of two credit default swaps with maturities in July 2034 and November 2035, two interest rate caps maturing September 2010, and Eurodollar futures contracts with varying maturities in 2005 and 2006. The total notional amounts associated with the credit defaults swaps, interest rate caps, and Eurodollar futures contracts are $895,000, $-0-, and $105,000, respectively. The fair values totaled $(2,095), $152, and $3, respectively.

 

When hedging the variability in interest payments associated with the Company’s borrowing activities, the notional amount of each interest rate swap, cap agreement, Eurodollar futures contract, and Eurodollar future put option contract is matched against a like amount of current and/or anticipated borrowings under repurchase agreements, commercial paper or the Company’s variable securitization financings. These instruments are highly effective hedges and qualify as cash flow hedges under SFAS 133. Accordingly, changes in the fair value of these derivatives are reported in other comprehensive income to the extent the hedge was effective, while changes in value attributable to hedge ineffectiveness are reported in earnings. The gains and losses on cash flow hedge transactions that are reported in other comprehensive income are reclassified to earnings in the periods in which the earnings are affected by the hedged cash flows.

 

The Company also uses various derivative instruments to economically hedge certain mortgage-backed security and mortgage loan positions. Eurodollar futures contracts are primarily used to hedge the fair value of certain mortgage-backed security positions, which are comprised of mortgage-backed securities classified as trading and commitments to purchase such mortgage-backed securities. Credit derivatives are used to hedge the risk of adverse changes to credit spreads on prospective securitization financing transactions. The Company does not designate these derivative instruments, as well as, certain interest rate caps as hedges under SFAS 133. The gains and losses on these derivatives are recorded to net investment income. For the three- and nine-months ended September 30, 2005, the Company recorded a net gain of $351 and $791 on these derivatives.

 

The net effect of the Company’s hedging of the variability in interest payments was to decrease interest expense by $1,133 and $8,474 for the three- and nine-months ended September 30, 2005. These hedging activities increased interest expense by $876 and $(6,187) during the same periods in 2004. The total net gain deferred in accumulated other comprehensive income relating to these derivatives was $11,777 at September 30, 2005. Of this amount, $6,199 is expected to flow through the Company’s statement of operations over the next twelve months.

 

21


Table of Contents

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (Continued)

 

Commitments

 

The Company enters into commitments to (i) originate mortgage loans (referred to as interest rate lock agreements), (ii) purchase and sell mortgage loans, and (iii) purchase and sell MBS. Interest rate locks related to the origination of loans held for sale and commitments to purchase and sell mortgage loans are accounted for as derivatives under SFAS 133. Outstanding interest rate locks totaled $448,136 as of September 30, 2005. There were no outstanding commitments to purchase mortgage loans, or purchase or sell mortgage-backed securities at September 30, 2005. There was a commitment to sell $410,000 of mortgage loans at September 30, 2005. The Company had no commitments to originate, purchase or sell loans prior to its acquisition of First NLC in the first quarter of 2005. Gains and losses on these derivatives were not material during the three months and nine months ended September 30, 2005.

 

Gains and losses on commitments that are net settled and optional commitments are recorded to income. During the three months and nine months ended September 30, 2004, net losses on these commitments totaled $(788) and $(638), respectively. There was no such commitment activity during the first nine months of 2005.

 

Stock Warrants

 

In connection with its capital raising activities, the Company may receive warrants to acquire equity securities. These instruments are accounted for as derivatives with changes in the fair value recorded to net investment income under SFAS 133. During the three and nine months ended September 30, 2005 the Company recorded a net gains of $727 and $467, respectively. During the same periods in 2004, the Company recorded net gains of $4,380 and $5,513 respectively, related to these instruments. As of September 30, 2005, the Company held stock warrants with a fair value of $2,484. Furthermore, during the three months and nine months ended September 30, 2005, the company exercised warrants and sold the resulting stock realizing a gain/(loss) of $(2) and $287, respectively.

 

8. Income Taxes:

 

In connection with the Company’s merger with FBR Asset effective March 31, 2003, the parent company, FBR Group elected REIT status under the Internal Revenue Code. As a REIT, FBR Group is not subject to Federal income tax on earnings distributed to its shareholders. Most states recognize REIT status as well. Since FBR Group intends to distribute 100% of its REIT taxable income to shareholders, the Company has recognized no income tax expense on its REIT income.

 

To maintain tax qualification as a REIT, FBR Group must meet certain income and asset tests and distribution requirements. The REIT must distribute to shareholders at least 90% of its (parent company) taxable income. A predominance of the REIT’s gross income must come from real estate sources and other portfolio-type income. A significant portion of the REIT’s assets must consist of real estate and similar portfolio investments, including mortgage-backed securities. Beginning in 2001, the tax law changed to allow REITs to hold a certain percentage of their assets in taxable REIT subsidiaries. The income generated from the Company’s taxable REIT subsidiaries is taxed at normal corporate rates and will generally not be distributed to the Company’s shareholders. Failure to maintain REIT qualification would subject FBR Group to Federal and state corporate income taxes at regular corporate rates.

 

During the three- and nine-months ended September 30, 2005, the Company recorded $8,090 and $26,825, respectively, of income tax expense for income attributable to taxable REIT subsidiaries. The Company’s effective tax rate at its taxable REIT subsidiaries for taxable income attributable these entities was 43% for the three and 46% for the nine months ended September 30, 2005. During the three- and nine-months ended September 30, 2004, the Company recorded $20,329 and $36,129, respectively, of income tax expense for

 

22


Table of Contents

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (Continued)

 

taxable income attributable to its taxable REIT subsidiaries. The Company’s effective tax rate applicable to this 2004 income was 39%. The increase in the effective tax rates in the three-months ended September 30, 2005 is due to an increase in the Company’s state taxes due to changes in state apportionment and the increase the effective tax rate for the nine months ended September 30, 2005 is due primarily to the to the non-deductible nature of the $7,500 charge recorded in the first quarter 2005 relating to the Company’s proposed settlements with the Securities and Exchange Commission (SEC) and the NASD’s Department of Market Regulation (see Note 11) and state taxes. The decrease in the dollar amounts of the tax provisions during the three- and nine-month periods ended September 30, 2005 is due to the decline in earnings attributable to the Company’s taxable REIT subsidiaries.

 

9. Net Capital Requirements:

 

The Company’s U.S. broker-dealer subsidiaries, FBR & Co. and FBR Investment Services, Inc. (FBRIS), are registered with the Securities and Exchange Commission (SEC) and are members of the National Association of Securities Dealers, Inc. Additionally, Friedman, Billings, Ramsey International Ltd. (FBRIL) is registered with the Financial Services Authority (FSA) of the United Kingdom. As such, they are subject to the minimum net capital requirements promulgated by the SEC and FSA. As of September 30, 2005, FBR & Co. had net capital of $90,664 that was $84,609 in excess of its required minimum net capital of $6,055. As of September 30, 2005, FBRIS and FBRIL had net capital in excess of required amounts.

 

10. Earnings Per Share:

 

The following tables present the computations of basic and diluted earnings per share for the three and nine months ended September 30, 2005 and 2004:

 

     Three Months Ended
September 30, 2005


   Three Months Ended
September 30, 2004


     Basic

   Diluted

   Basic

   Diluted

Weighted average shares outstanding:

                           

Common stock

     169,745      169,745      167,593      167,593

Stock options and restricted stock

     —        745      —        1,207
    

  

  

  

Weighted average common and common equivalent shares outstanding

     169,745      170,490      167,593      168,800
    

  

  

  

Net earnings applicable to common stock

   $ 23,045    $ 23,045    $ 92,149    $ 92,149
    

  

  

  

Earnings per common share

   $ 0.14    $ 0.14    $ 0.55    $ 0.55
    

  

  

  

 

     Nine months Ended
September 30, 2005


   Nine months Ended
September 30, 2004


     Basic

   Diluted

   Basic

   Diluted

Weighted average shares outstanding:

                           

Common stock

     169,166      169,166      166,975      166,975

Stock options and restricted stock

     —        956      —        1,525
    

  

  

  

Weighted average common and common equivalent shares outstanding

     169,166      170,122      166,975      168,500
    

  

  

  

Net earnings applicable to common stock

   $ 100,700    $ 100,700    $ 262,967    $ 262,967
    

  

  

  

Earnings per common share

   $ 0.60    $ 0.59    $ 1.57    $ 1.56
    

  

  

  

 

23


Table of Contents

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (Continued)

 

As of September 30, 2005 and 2004, respectively, 3,915,313 and 4,031,675 options to purchase shares of common stock were outstanding (both including shares associated with the Employee Stock Purchase and Loan Plan that are treated as options). As of September 30, 2005 and 2004, respectively, 2,428,133 and 3,174,175 of the total outstanding options were exercisable and 2,855,006 and 2,632,300 were anti-dilutive. In addition, the 2,047,930 restricted common shares granted to employees (see Note 12) are also included in the calculation of weighted average common equivalent diluted shares outstanding for the three- and nine-months ended September 30, 2005.

 

11. Commitments and Contingencies:

 

Contractual Obligations

 

The Company has contractual obligations to make future payments in connection with short and long-term debt, non-cancelable lease agreements and other contractual commitments as well as uncalled capital commitments to various investment partnerships that may be called over the next six years. The following table sets forth these contractual obligations by fiscal year:

 

    

Remaining

2005


   2006

   2007

   2008

   2009

   Thereafter

   Total

Long-term debt (1)

   $ —      $ 970    $ 970    $ 970    $ 970    $ 280,048    $ 283,928

Minimum rental and other contractual commitments

     3,955      17,303      12,812      12,662      11,999      54,921      113,652

Capital commitments (2)

     —        —        —        —        —        —        —  
    

  

  

  

  

  

  

Total Contractual Obligations

   $ 3,955    $ 18,273    $ 13,782    $ 13,632    $ 12,969    $ 334,969    $ 397,580
    

  

  

  

  

  

  


(1) This table excludes interest payments to be made on the Company’s long-term debt securities issued through TRS Holdings. The Company will incur $4,599 in interest related to these long-term debt securities in the fourth quarter of 2005. Based on the 3-month LIBOR of 4.07% as of September 30, 2005, plus a weighted average margin of 2.58%, estimated annualized interest on the current outstanding principal of $277,500 of long-term debt securities would be approximately $18,500 for the year ending December 31, 2006. These long-term debt securities mature in thirty years beginning in March 2033 through October 2035. Note that interest on this long-term debt floats based on 3-month LIBOR, therefore, actual coupon interest will differ from this estimate.

 

(2) The table above excludes $6,746 of uncalled capital commitments to various investment partnerships that may be called over the next ten years. This amount was excluded because the Company cannot determine when, if ever, the commitments will be called.

 

The Company also has short-term commercial paper and repurchase agreement liabilities of $8,214,835 and $6,853,306, respectively, as of September 30, 2005, as well as $3,809,901 of securitization financing that matures in 2035. See Note 6 for further information.

 

As of September 30, 2005, the Company had made interest rate lock agreements with mortgage borrowers and commitments to sell mortgage loans of $448,136 and $410,000, respectively.

 

24


Table of Contents

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (Continued)

 

Repurchase and Premium Recapture Obligations

 

The Company’s sales of mortgage loans are subject to standard mortgage industry representations and warranties that may require the Company to repurchase the mortgage loans due to breaches of these representations and warranties or if a borrower fails to make one or more of the first loan payments due on the loan. In addition, the Company is generally obligated to repay all or a portion of the original premium received on the sale of loans in the event that the loans are paid in full by the borrowers during the first year subsequent to the sale date. Generally, the gross contingent liability declines by one-twelfth each month over the twelve month period the contingency exists subsequent to the sale date. The Company maintains a liability reserve for its repurchase and premium recapture obligations. The reserve is increased through charges to the gain (or loss) recorded at the time of sale. The reserve is reduced by charge-offs when loans are repurchased or premiums are repaid. Activity for the reserve was as follows during the period since the Company’s acquisition of First NLC through September 30, 2005 (the Company did not maintain a reserve for repurchase and premium recapture obligations prior to the acquisition of First NLC):

 

    

Total

Reserve


 

Balance at acquisition of First NLC

   $ 8,238  

Provision

     6,724  

Charge-offs

     (5,484 )
    


Balance, at September 30, 2005

   $ 9,478  
    


 

The Company’s exposure to repurchase and premium recapture obligations relates primarily to mortgage loans sold over the last three months which totaled $1,331,801. The total gross premium received by First NLC on mortgage loan sales over the last 12 months totaled $117,159. As noted above, the Company’s exposure to premium recapture generally declines by one-twelfth each month after the sale date.

 

Litigation

 

As of September 30, 2005, except as described below, the Company was not a defendant or plaintiff in any lawsuits or arbitrations, nor involved in any governmental or self-regulatory organization (SRO) matters that are expected to have a material adverse effect on the Company’s financial condition or statements of operations. The Company is a defendant in a small number of civil lawsuits and arbitrations (together, litigation) relating to its various businesses. In addition, the Company is subject to various reviews, examinations, investigations and other inquiries by governmental agencies and SROs. There can be no assurance that these matters individually or in aggregate will not have a material adverse effect on the Company’s financial condition or results of operations in a future period. However, based on management’s review with counsel, resolution of these matters is not expected to have a material adverse effect on the Company’s financial condition or results of operations.

 

Many aspects of the Company’s business involve substantial risks of liability and litigation. Underwriters, broker-dealers and investment advisers are exposed to liability under Federal and state securities laws, other Federal and state laws and court decisions, including decisions with respect to underwriters’ liability and limitations on indemnification, as well as with respect to the handling of customer accounts. For example, underwriters may be held liable for material misstatements or omissions of fact in a prospectus used in connection with the securities being offered and broker-dealers may be held liable for statements made by their securities analysts or other personnel. In certain circumstances, broker-dealers and asset managers may also be held liable by customers and clients for losses sustained on investments. In recent years, there has been an increasing incidence of litigation and actions by government agencies and SROs involving the securities industry, including class actions that seek substantial damages. The Company is also subject to the risk of litigation, including litigation that may be without merit. As the Company intends to actively defend such

 

25


Table of Contents

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (Continued)

 

litigation, significant legal expenses could be incurred. An adverse resolution of any future litigation against the Company could materially affect the Company’s operating results and financial condition.

 

The Company’s business (through its recently acquired subsidiary First NLC and affiliated entities) includes the origination, acquisition, pooling, securitization and sale of non-conforming residential mortgage loans. Consequently, the Company is subject to additional federal and state laws in this area of operation, including laws relating to lending, consumer protection, privacy and unfair trade practices. Although the Company is not currently involved in any legal proceedings incidental to these operations, it may become so in the future in the normal course of business.

 

Putative Class Action Securities Lawsuits

 

The Company and certain current and former senior officers and directors have been named in a series of putative class action securities lawsuits filed in the second quarter of 2005, all of which are pending in the United States District Court for the Southern District of New York. The Company refers to these lawsuits as the Weiss et al. putative class action lawsuits. The complaints in these actions are brought under various sections of the Securities Exchange Act of 1934, as amended, and allege misstatements and omissions concerning (i) the SEC and NASD investigations described at page 48 relating to FBR & Co.’s involvement in the private investment in public equity on behalf of CompuDyne, Inc. in October 2001 and (ii) the Company’s expected earnings, including the potential adverse impact on the Company of changes in interest rates. The Company is contesting these lawsuits vigorously, but the Company cannot predict the likely outcome of these lawsuits or their likely impact on the Company at this time.

 

Shareholders’ Derivative Action

 

The Company and certain current and former senior officers and directors have been named in a shareholders’ derivative action that is presently pending in the United States District Court for the Southern District of New York. The Company, which is a nominal defendant in this action, refers to this derivative action as the Lemon Bay Partners derivative action. The complaint alleges conduct substantially similar to that alleged in the Weiss et al. putative class action lawsuits described above. The Company has not responded to the complaint and no discovery has commenced. The Company cannot predict the likely outcome of this action or its likely impact on the Company at this time. The Company’s Board of Directors has established a special committee comprised of two independent directors to evaluate shareholder demand letters which contain allegations similar to the Lemon Bay Partners derivative action and to recommend to the Board of Directors whether such a derivative action is in the best interests of the Company.

 

Regulatory Charges and Related Matters

 

On April 26, 2005, the Company announced that its broker-dealer subsidiary, FBR & Co. proposed settlement to the staffs of the SEC and the NASD’s Department of Market Regulation to resolve ongoing, previously disclosed investigations by the SEC and NASD staffs. The proposed settlement concerns insider trading, violations of antifraud provisions of the federal securities laws and applicable NASD rules and other charges concerning the Company’s trading in a company account and the offering of a private investment in public equity on behalf of a public company in October 2001.

 

In the settlement offers, without admitting or denying any wrongdoing, FBR & Co. proposed to pay $3,500 to the SEC and $4,000 to the NASD and consent to injunctions, censure and additional undertakings to improve its administrative and compliance procedures.

 

26


Table of Contents

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (Continued)

 

The proposed settlement is subject to review and approval by the SEC and the NASD, respectively, which may accept, reject or impose further conditions or other modifications to some or all of the terms of the proposed settlements. There are no assurances regarding the SEC’s and NASD’s consideration or determination of any offer of settlement, and no settlement is final unless and until approved by the SEC or NASD, as applicable. The Company has recorded a $7,500 charge, in March 2005, with respect to the proposed settlements with the SEC and NASD.

 

Incentive Fees

 

The Company recognizes incentive income from the partnerships based on what would be due to the Company if the partnership terminated on the balance sheet date. Incentive allocations may be based on unrealized gains and losses, and could vary significantly based on the ultimate realization of the gains or losses. We may therefore reverse previously recorded incentive allocations in future periods relating to the Company’s managed partnerships. As of September 30, 2005, $2,979 was subject to such potential future reversal.

 

12. Shareholders’ Equity:

 

Dividends

 

The Company declared the following distributions during the nine months ended September 30, 2005 and year ended December 31, 2004:

 

Declaration Date


  

Record Date


  

Payment Date


   Dividends
Per Share


 

2005

                  
September 13, 2005    September 30, 2005    October 31, 2005    $ 0.34  
June 9, 2005    June 30, 2005    July 29, 2005    $ 0.34  
March 17, 2005    March 31, 2005    April 29, 2005    $ 0.34  

2004

                  
December 9, 2004    December 31, 2004    January 28, 2005    $ 0.39 (1)
September 9, 2004    September 30, 2004    October 29, 2004    $ 0.34  
June 10, 2004    June 30, 2004    July 30, 2004    $ 0.46 (2)
March 10, 2004    March 31, 2004    April 30, 2004    $ 0.34  

(1) Includes a special dividend of $0.05 per share.

 

(2) Includes a special dividend of $0.12 per share.

 

Restricted Stock

 

During the nine-months ended September 30, 2005, the Company granted 684,156 shares of restricted Class A common stock to employees for incentive compensation earned during 2004 and 2005, and 1,349,263 additional shares of restricted Class A common stock under the Company’s Stock and Annual Incentive Plans, including 239,323 shares issued in connection with the acquisition of First NLC. As of September 30, 2005, a total of 2,047,930 shares of restricted Class A common stock with an unamortized value of $20,295 is included in deferred compensation in shareholders’ equity.

 

Employee Stock Purchase and Loan Plan

 

In connection with the Employee Stock Purchase and Loan Plan, in July and August 2001, the Company issued stock and received five-year, limited recourse promissory notes from employees with interest accruing at 6.5 percent accreting to principal for the remaining purchase price. The notes are collateralized by the shares of

 

27


Table of Contents

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (Continued)

 

stock purchased under the plan. As of September 30, 2005 and December 31, 2004, the balance outstanding on these loans was $4,242 and $4,890, respectively. During the three- and nine-months ended September 30, 2005, $132 and $417, respectively, of compensation expense was recorded for dividends paid on the shares purchased with proceeds from the notes.

 

13. Segment Information:

 

The Company considers its capital markets, asset management, principal investing, and mortgage banking operations to be four separately reportable segments. The capital markets segment includes the Company’s investment banking and institutional brokerage operations. Asset management includes the Company’s fee based asset management operations. The Company’s principal investing segment includes mortgage related investment activities, and substantially all of the Company’s equity security investing activities. The Company’s mortgage banking segment includes the origination and sale of mortgage loans for residential properties. The Company has developed systems and methodologies to allocate overhead costs to its business units and, accordingly, presents segment information consistent with internal management reporting. Revenue generating transactions between the individual segments have been included in the net revenue and pre-tax income of each segment. These transactions include investment banking activities provided by the capital markets segment to other segments and the sale of mortgage loans between the mortgage banking and principal investing segments. The following table illustrates the financial information for the Company’s segments for the periods presented:

 

   

Capital

Markets


 

Asset

Management


 

Principal

Investing


  Mortgage
Banking


  Intersegment
Eliminations(1)


   

Consolidated

Totals


Three Months Ended September 30, 2005

                                     

Net revenues

  $ 123,218   $ 9,625   $ 23,579   $ 28,873   $ (6,657 )   $ 178,638

Pre-tax income

    21,790     77     12,873     3,052     (6,657 )     31,135

Three Months Ended September 30, 2004

                                     

Net revenues

  $ 165,181   $ 10,482   $ 67,992   $ —     $ —       $ 243,655

Pre-tax income

    53,315     1,704     57,459     —       —         112,478

Nine months Ended September 30, 2005

                                     

Net revenues

  $ 371,152   $ 28,772   $ 100,546   $ 63,717   $ (15,375 )   $ 548,812

Pre-tax income

    62,017     192     76,109     4,582     (15,375 )     127,525

Nine months Ended September 30, 2004

                                     

Net revenues

  $ 381,729   $ 27,701   $ 233,384   $ —     $ —       $ 642,814

Pre-tax income

    93,081     2,644     203,371     —       —         299,096

(1) Intersegment Eliminations represent the elimination of intersegment transactions noted above.

 

14. Accounting Developments:

 

In December 2004, the Financial Accounting Standards Board (FASB) issued SFAS No. 123 (revised 2004), “Share-Based Payment” (SFAS 123R). SFAS 123R requires public companies to recognize expense in the income statement for the grant-date fair value of awards of equity instruments to employees. Expense is to be recognized over the period during which employees are required to provide service. SFAS 123R also clarifies and expands certain guidance in SFAS 123, including measuring fair value and attributing compensation cost to reporting periods. Under the modified prospective transition method the Company expects to apply, compensation cost is recognized after the date of adoption for the portion of outstanding awards granted prior to the adoption of SFAS 123 for which service has not yet been rendered. In April 2005, the SEC amended the effective date of SFAS 123R to be effective for annual periods that begin after September 15, 2005. We are currently evaluating the effect of adoption of SFAS 123R, but do not expect adoption to have a material effect on our results of operations and financial condition.

 

28


Table of Contents

FRIEDMAN, BILLINGS, RAMSEY GROUP, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (unaudited) — (Continued)

 

15. Subsequent Event:

 

Securitization Financing

 

In November 2005, the Company issued $1,000,000 of additional asset-backed securities through a securitization trust to finance loans held for investment. The asset-backed securities are secured solely by the mortgages transferred to the trust and are non-recourse to the Company. The principal and interest payments of the mortgages provide the funds to pay debt service on the securities. The securitization will be accounted for as a financing since the securitization trust does not meet the qualifying special purpose entity criteria under SFAS No. 140 and because the Company maintains continuing involvement in the securitized mortgages through its ownership of certain interests issued by the trust.

 

Interest rates on these securities reset monthly and are indexed to one-month LIBOR. The stated maturity date of the securities is November 2035, although the Company expects the securities to be fully repaid prior to that date due to borrower prepayments.

 

29


Table of Contents
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

The following analysis of the consolidated financial condition and results of operations of Friedman, Billings, Ramsey Group, Inc. (the “Company”) should be read in conjunction with the unaudited Consolidated Financial Statements as of September 30, 2005 and 2004, and the Notes thereto and the Company’s 2004 Annual Report on Form 10-K.

 

Business Environment

 

Our revenues consist primarily of capital raising revenue and advisory fees in investment banking; agency commissions, principal transactions, and mortgage trading income in institutional brokerage; base management fees and incentive allocations and fees in asset management; and net interest income, net investment income, including realized gains from merchant banking investments and mortgage loans, equity method earnings, and dividend income in principal investing and mortgage banking.

 

The majority of our principal investing is in mortgage related investments, particularly mortgage loans and mortgage-backed securities (MBS), but we also invest in merchant banking opportunities, including equity securities, mezzanine debt and senior loans, including non-real estate related assets, subject to maintaining our REIT status. As a result of our acquisition of First NLC in February 2005, we have initiated various mortgage-banking activities.

 

We constantly evaluate the rates of return that can be achieved in each investment category and for each individual investment in which we participate. Historically, our mortgage investments have provided us with higher risk adjusted rates of return than most other investment opportunities we have evaluated. Although increases in short-term rates over the past year have reduced the rate of return on our mortgage investments, we have continued to maintain a high allocation of our assets and capital in this sector. There is no assurance that our past experience will be indicative of future results and that mortgage investments will provide higher rates of return than other investment altrnatives. Consequently, we continue to evaluate investment opportunities against the returns available in each of our investment alternatives and endeavor to allocate our assets and capital with an emphasis toward the highest risk-adjusted returns available. This strategy will cause us to have different allocations of capital in different environments.

 

Our investment banking (capital raising, merger and acquisition, restructuring, and advisory services), institutional brokerage and asset management revenues are linked to the capital markets business activities. In addition, our business activities are focused in the financial services, real estate, energy, technology, healthcare, and diversified industries sectors. Historically, we have focused on small and mid-cap stocks, although our research coverage and associated brokerage activities increasingly involve larger-cap stocks. By their nature, our business activities are highly competitive and are not only subject to general market conditions, volatile trading markets, and fluctuations in the volume of market activity, but also to the conditions affecting the companies and markets in our areas of focus. As a result, revenues can be subject to significant volatility from period to period.

 

Our investment banking and asset management revenues and net income are subject to substantial positive and negative fluctuations due to a variety of factors that cannot be predicted with great certainty. These factors include the overall condition of the economy and the securities markets as a whole and the industry sectors on which we focus. For example, a significant portion of the performance-based or incentive revenues that we recognize from our venture capital, private equity, and other asset management activities is based on the value of securities held by the funds we manage. The value of these securities includes unrealized gains or losses that may change from one period to another. Although when market conditions permit, we may take steps to realize or lock-in gains on these securities, these securities are often illiquid, and therefore such steps may not be possible, and the value of these securities is subject to increased market risk. Similarly, investment banking activities and our market share are subject to significant market risk.

 

30


Table of Contents

In order to profit in this increasingly competitive environment, we continually evaluate each of our businesses across varying market conditions for competitiveness, profitability, and alignment with our long-term strategic objectives, including the diversification of revenue sources. We believe that it is important to diversify and strengthen our revenue base by increasing the segments of our business that offer a recurring and more predictable source of revenue.

 

Trends

 

The principal external factor affecting our mortgage investments is interest rates.

 

Short-term interest rates have been increasing and may continue to increase. Over the last twelve months, the Federal Reserve has increased the Federal Funds rate eight times, from 1.75% at September 30, 2004 to 3.75% at September 30, 2005, and it is unknown for how much longer and in what amount, if any, the Federal Reserve will continue to increase such rates. This increase in short-term interest rates has also caused LIBOR, the interest rate that is the basis for most of our funding costs, to increase by a similar amount. Because the financing arrangements we have for our mortgage assets, including securitization financing for loans held for investment, are floating-rate and adjust periodically, the interest expense on this funding increases directly as LIBOR increases. It is possible to mitigate some of the increase in short-term rates by hedging with derivative instruments such as interest-rate cap, swaps, or futures. As of September 30, 2005, we have entered into various derivative instruments to partially hedge the interest rate risk on our borrowings (see Note 7 to the financial statements for detail).

 

At the same time that short-term interest rates have risen, long-term interest rates have been relatively stable, with ten-year Treasury yields only increasing 0.20% from September 30, 2004 to September 30, 2005. This environment has led to the continuation of refinancing opportunities for mortgage borrowers and, thus, higher than historical prepayment speeds. Higher prepayment speeds cause us to amortize any premium (the amount paid in excess of par for the asset) we have in our mortgage portfolio at a faster rate thus reducing our reported net interest yield. These higher prepayment speeds may persist causing our yield in the mortgage portfolio to be lower than anticipated.

 

The increase in interest rates and, in particular, the increase in the two-year LIBOR swap rate from September 30, 2004 to September 30, 2005 of 1.63% has not been accompanied by a comparable increase in coupons for non-conforming mortgage loans. Coupons on newly originated non-conforming loans have, in general, increased by less than half of the increase in the two-year swap rate over this period. The resulting compression in spread between these assets and related liabilities has resulted in lower profitability for non-conforming mortgage assets that are either held in portfolio or that are sold for cash. It is not known when or if coupons will fully adjust to reflect the higher cost of funds for these mortgage assets.

 

Results of Operations

 

Three months ended September 30, 2005 compared to three months ended September 30, 2004

 

Net income decreased from $92.1 million during the third quarter of 2004 to $23.0 million during the third quarter of 2005. This decrease is primarily due to decreased investment banking revenues of $52.6 million and a decrease in net interest income in our principal investing activities as a result of increased borrowing costs and increased non-interest expenses of $16.3 million. These decreases and increases were offset, to some degree, by gains on sale of mortgage loans and net interest income resulting from the initiation of mortgage banking activities. Regarding non-interest expenses, the Company continues to make investments in its operations and technology infrastructure in order to address the increase in employees and support growth initiatives. During the first quarter 2005, the Company completed the acquisition of First NLC a non-conforming mortgage originator (see further detail regarding First NLC in the discussion of the Company’s results of operations for the nine months ended September 30, 2005). Third quarter 2005 results reflect increased professional services, occupancy and equipment, communication, and other expenses due to the increase in employees and related facilities as a result of the acquisition. Third quarter 2005 net income also includes $8.1 million of income tax expenses as compared to $20.3 million of income taxes recorded in the third quarter of 2004.

 

The Company’s net revenues decreased 26.7% from $243.7 million in 2004 to $178.6 million in 2005 due to the following changes in revenues and interest expense:

 

Capital raising revenue decreased 33.8% from $130.0 million in 2004 to $86.0 million in 2005. The decrease is attributable to fewer lead or co-managed transactions completed in 2005 as compared to 2004. During

 

31


Table of Contents

Results of Operations—(Continued)

 

the third quarter of 2005, the Company managed 11 public equity offerings raising $4.8 billion. During the third quarter of 2004, the Company managed 19 public equity/debt offerings raising $3.2 billion. The average size of underwritten equity/debt transactions for which we were a lead or co-manager increased from $168.4 million in 2004 to $436.4 million in 2005. The company also managed 9 asset-backed security offerings during the third quarter of 2005 totaling $7.6 billion in transaction volume. In addition, the Company completed four private equity placements in during the third quarter 2005 generating $56.8 million in revenues compared to two private equity placements in 2004 generating $64 million.

 

Advisory revenue decreased 74.1% from $11.6 million in 2004 to $3.0 million in 2005 due primarily to a decrease in the number of advisory engagements.

 

Institutional brokerage revenue from principal transactions increased 2.4% from $4.2 million in 2004 to $4.3 million in 2005 as a result of increases in both trading gains and trading volume. Institutional brokerage agency commissions increased 10.3% from $18.5 million in 2004 to $20.4 million in 2005 as a result of increases in trading volume. In addition, the Company’s mortgage trading operations contributed $11.3 million in interest income to institutional brokerage activity. The mortgage trading interest income was offset by a net investment loss of $2.4 million related to these securities and $8.2 million of interest expense related to repurchase agreements used to finance these trading activities.

 

Asset management base management fees increased 12.9% from $7.0 million in 2004 to $7.9 million in 2005. The increase is primarily attributable to the increase in average productive assets under management in 2005 as compared to 2004, as well as an increase in mutual fund administrative fees. Asset management incentive allocations and fees decreased 52.9% from $1.7 million in 2004 to $0.8 million in 2005 primarily as a result of fund performance during the period and the reversal of incentive allocations from certain investment partnerships.

 

Revenues from our principal investment and mortgage banking activities, net of related interest expense and provision for loan losses, totaled $57.7 million for the third quarter of 2005 compared to $71.7 million for the third quarter of 2004. A primary source of these revenues is net interest income from mortgage investments, the components of which are summarized in the following table (dollars in thousands).

 

    Three Months Ended
September 30, 2005


    Three Months Ended
September 30, 2004


 
   

Average

Balance


  Income /
(Expense)


   

Yield /

Cost


   

Average

Balance


  Income /
(Expense)


   

Yield /

Cost


 

Mortgage-backed securities

  $ 9,783,015   $ 77,102     3.15 %   $ 11,501,189   $ 86,116     3.00 %

Mortgage loans

    5,449,225     94,044     6.90 %     —       —       —    

Reverse repurchase agreements

    193,780     2,018     4.08 %     —       —       —    
   

 


       

 


     
    $ 15,426,020     173,164     4.49 %   $ 11,501,189     86,116     3.00 %
   

               

             

Other (1)

          620                   1,919        
         


             


     
            173,784                   88,035        

Repurchase agreements

  $ 1,567,729     (13,896 )   (3.47 )%   $ 6,059,695     (23,063 )   (1.49 )%

Commercial paper

    8,300,373     (75,299 )   (3.55 )%     4,775,181     (19,024 )   (1.56 )%

Mortgage financing credit facilities

    3,661,232     (40,174 )   (4.29 )%     —       —       —    

Securitization financing

    1,322,002     (14,224 )   (4.21 )%     —       —       —    

Derivative contracts (2)

          1,133                   876        
   

 


       

 


     
    $ 14,851,336     (142,460 )   (3.75 )%   $ 10,834,876     (41,211 )   (1.49 )%
   

 


       

 


     

Net interest income/spread

        $ 31,324     0.74 %         $ 46,824     1.51 %
         


 

       


 


(1) Includes interest income on cash and other miscellaneous interest-earning assets.

 

(2) Includes the effect of derivative instruments accounted for as cash flow hedges.

 

32


Table of Contents

Results of Operations—(Continued)

 

As shown in the table above, net interest income decreased by $15.5 million from third quarter 2004 to third quarter 2005 due to an increase in interest expense. This increase was due to eight increases in the federal funds rate over the last year. The increase in interest expense was partially offset by increases in the average balance of interest earning assets, particularly non-prime mortgage loans which have higher yields than those earned on our MBS portfolio. Premium amortization expense, a component of interest income, totaled $24.9 million in the third quarter of 2005 compared to $24.2 million in the third quarter of 2004.

 

Other sources of principal investing and mortgage banking revenues are dividends, gains on sale of loans and net investment income. The Company recorded $8.8 million in dividend income from its merchant banking equity investment portfolio for third quarter 2005, compared to $5.8 million during the third quarter 2004. The increase in dividend income was primarily due to an increase in investments making such distributions. Net investment income totaled $4.9 million during the three months ended September 30, 2005, compared to $19.1 million for the same period in 2004, as summarized in the following table (dollars in thousands).

 

     Three Months Ended
September 30,


 
     2005

    2004

 

Realized gains on sale of available for sale investments, net

   $ 4,502     $ 15,036  

Income/(loss) from equity method investments

     (404 )     1,425  

Gains/(losses) on investment securities—marked-to-market, net

     683       4,860  

Other, net

     85       (2,231 )
    


 


     $ 4,866     $ 19,090  
    


 


 

Income (loss) from equity method investments reflects the Company’s equity in earnings from investments in proprietary investment partnerships and other managed investments. Gains and losses on investment securities—marked-to-market relate to securities received in connection with capital raising activities. Other net investment income includes gains and losses from mortgage-backed securities classified as trading and derivatives not designated as hedges under SFAS No. 133. See Notes 4 and 7 to the financial statements for further information on these other gains and losses, as well as gains and losses on available-for-sale investments.

 

During the third quarter of 2005, the Company sold $1.3 billion of loans held for sale at a weighted average premium of 2.57%. Net of related direct costs and provision for repurchase and premium recapture obligations, the Company’s gain on sale of loans for the quarter was $17.6 million or 1.32% of principal sold.

 

Other interest expense, primarily relating to long term debt issued through FBR TRS Holdings, increased from $1.2 million in 2004 to $4.2 million in 2005 due to increased long term borrowing of $175.0 million since September of 2004.

 

In the third quarter of 2005, the Company recorded a $4.9 million provision for loan losses. The Company’s mortgage loan portfolio is comprised of 2005 originations and was acquired primarily during the second and third quarters of 2005. The provision recorded in the third quarter reflects management’s estimate of losses incurred during this period.

 

Total non-interest expenses increased 12.4% from $131.2 million in 2004 to $147.5 million in 2005. This increase is due to increased headcount at the Company, investments in facilities and technology and also costs associated First NLC’s non-conforming mortgage loan investment operations offset by the decrease in variable compensation as a result of decreased investment banking revenues.

 

Compensation and benefits expense decreased 7.8% from $95.8 million in 2004 to $88.3 million in 2005. This decrease was primarily due to decreased variable compensation associated with investment banking and executive compensation. These decreases were offset by increased headcount as a result of the acquisition of First NLC.

 

33


Table of Contents

Results of Operations—(Continued)

 

Professional services increased 20.9% from $13.4 million in 2004 to $16.2 million in 2005 primarily due to increases in consultant costs associated with technology infrastructure improvements as well as costs associated with the integration of First NLC operations.

 

Business development expenses increased 6.0% from $8.3 million in 2004 to $8.8 million in 2005. This increase is primarily due to an increase in travel costs and business promotions related to the mortgage origination services of the Company as a result of the acquisition of First NLC.

 

Clearing and brokerage fees increased 50.0% from $1.6 million in 2004 to $2.4 million in 2005. The increase is due to increased equity trading volumes as well as mortgage trading activity initiated in 2005.

 

Occupancy and equipment expense increased 141.0% from $3.9 million in 2004 to $9.4 million in 2005 primarily due to the investments made in the expanding of office space at the Arlington, New York, and Boston offices and upgrade of technology to accommodate the increase in headcount during 2004, as well as the increase in the Company’s headcount related to the acquisition of First NLC. Total employees as of September 30, 2005 were 2,455, including 1,654 First NLC employees, compared to 665 employees as of September 30, 2004.

 

Communications expense increased 69.7% from $3.3 million in 2004 to $5.6 million in 2005 primarily due to increased costs related to market data and customer trading services and the acquisition of First NLC.

 

Other operating expenses increased 252.1% from $4.8 million in 2004 to $16.9 million in 2005. This change reflects the addition of approximately $4.6 million in servicing fees and insurance related to the mortgage loan portfolio, costs related to First NLC’s operations of $4.8 million which includes $0.8 million of amortization for the identified broker relationship intangible asset, and increase in business registration fees of $0.5 million.

 

The total income tax provision decreased from $20.3 million in 2004 to $8.1 million in 2005 due to decreased taxable income related to the investment banking operations in 2005 as compared to 2004. The Company’s effective tax rate at its taxable REIT subsidiaries was 43.0% for the three months ended September 30, 2005 compared to 39.0% in 2004. The increase in the effective tax rate is due to an increase in the Company’s state income taxes due to the changes in state apportionment.

 

Nine months ended September 30, 2005 compared to nine months ended September 30, 2004

 

Net income decreased from $263.0 million in 2004 to $100.7 million in 2005. This decrease is primarily due to decreased net interest income in our principal investing activities as a result of increased borrowing costs and decreased realized gains in 2005 as compared to 2004, as well as increased non-interest expenses. These decreases and increases were offset, to some degree, by gains on the sale of mortgage loans and net interest income resulting from the initiation of mortgage banking activities. Regarding non-interest expenses, the Company recognized $7.5 million in expenses in the first quarter of 2005 related to proposed settlements with the Securities and Exchange Commission (SEC) and the NASD’s Department of Market Regulation relating to charges concerning the Company’s trading in a company account and the offering of a private investment in public equity on behalf of a public company in 2001. In addition, the Company continues to make investments in its operations and technology infrastructure in order to address the increase in employees and support growth initiatives. During the first quarter 2005, the Company completed the acquisition of First NLC a non-conforming mortgage originator (see below). The nine months ended September 2005 results reflect higher compensation, including certain non-recurring compensation payments related to the acquisition of First NLC, occupancy and equipment, and other expenses due to the increase in employees and related facilities as a result of the acquisition. Our 2005 net income also includes $26.8 million of income tax expenses as compared to $36.1 million of income tax expenses recorded in the first nine months of 2004.

 

On February 16, 2005, the Company completed the acquisition of First NLC, a non-conforming residential mortgage loan originator located in Florida for $98.6 million in a combination of cash and stock. First NLC currently operates in 42 states and originates loans through both wholesale and retail channels. First NLC is part

 

34


Table of Contents

Results of Operations—(Continued)

 

of the Company’s principal investing group but operates as a wholly owned subsidiary. The Company expects that the acquisition of First NLC will assist in expanding and adding flexibility to the Company’s mortgage loan business by providing the ability to originate, price, portfolio and sell non-conforming mortgage loan assets based on market conditions.

 

The Company accounted for the acquisition of First NLC in accordance with Statement of Financial Accounting Standards (SFAS) No. 141, “Business Combinations” using the purchase method of accounting. Under the purchase method, net assets and results of operations of acquired companies are included in the consolidated financial statements from the date of acquisition. In addition, SFAS 141 provides that the cost of an acquired entity must be allocated to the assets acquired, including identifiable intangible assets, and the liabilities assumed based on their estimated fair values at the date of acquisition. The excess of cost over the fair value of the net assets acquired must be recognized as goodwill.

 

The $98.6 million purchase price included cash of $72.1 million, issuance of 1,297,746 shares of FBR Class A common stock at a price of $18.82 per share for a total of $24.4 million, and estimated direct acquisition costs of $2.1 million.

 

The Company’s net revenues decreased 14.6% from $642.8 million in 2004 to $548.8 million in 2005 due to the following changes in revenues and interest expense:

 

Capital raising revenue decreased 1.8% from $272.7 million in 2004 to $267.9 million in 2005. The decrease is attributable to fewer lead or co-managed transactions completed in 2005 as compared to 2004. During the first nine months of 2005, the Company managed 42 public equity/debt offerings raising $12.1 billion. During the first nine months of 2004, the Company managed 60 public equity/debt offerings raising $9.0 billion. The average size of underwritten equity/debt transactions for which we were a lead or co-manager increased from $150.4 million in 2004 to $288.3 million in 2005. The company also managed 20 asset-backed security offerings during the first nine months of 2005 totaling $15.5 billion in transaction volume. In addition, the Company completed 10 private placements in 2005 generating $163.6 million in revenues compared to 7 in 2004 generating $112.7 million.

 

Advisory revenue decreased 53.2% from $22.0 million in 2004 to $10.3 million in 2005 due primarily to a decrease in advisory engagements.

 

Institutional brokerage revenue from principal transactions decreased 9.6% from $15.7 million in 2004 to $14.2 million in 2005 as a result of decreases in both trading gains and trading volume. Institutional brokerage agency commissions decreased 10.1% from $68.7 million in 2004 to $61.8 million in 2005 as a result of decreases in trading volume. In addition, the Company’s mortgage trading operations contributed $11.3 million in interest income to institutional brokerage activity. The mortgage trading interest income was offset by a net investment loss of $2.4 million related to these securities and $8.2 million of interest expense related to repurchase agreements used to finance these trading activities.

 

Asset management base management fees increased 21.0% from $20.0 million in 2004 to $24.2 million in 2005. The increase is primarily attributable to the increase in average productive assets under management in 2005 as compared to 2004, as well as an increase in mutual fund administrative fees. Asset management incentive allocations and fees decreased 60% from $3 million in 2004 to $1.2 million in 2005 primarily as a result of fund performance during the period and the reversal of incentive allocations from certain investment partnerships.

 

Revenues from our principal investment and mortgage banking activities, net of related interest expense, totaled $176.9 million for the first nine months of 2005 compared to $241.4 million for the first nine months of 2004. A primary source of these revenues is net interest income from mortgage investments, the components of which are summarized in the following table (dollars in thousands).

 

35


Table of Contents

Results of Operations—(Continued)

 

     Nine months Ended
September 30, 2005


   Nine months Ended
September 30, 2004


    

Average

Balance


   Income /
(Expense)


   

Yield /  

Cost


  

Average

Balance


   Income /
(Expense)


   

Yield /  

Cost


Mortgage-backed securities

   $ 10,749,189    $ 266,593     3.31%    $ 10,986,397    $ 259,417     3.15%

Mortgage loans

     2,714,293      141,946     6.97%      —        —        

Reverse repurchase agreements

     284,159      7,495     3.48%      —        —        
    

  


      

  


   
     $ 13,747,641      416,034     4.03%    $ 10,986,397      259,417     3.15%
    

               

            

Other (1)

            980                   4,724      
           


             


   
              417,014                   264,141      

Repurchase agreements

   $ 2,832,484      (62,031 )   (2.89)%    $ 5,643,850      (54,445 )   (1.27)%

Commercial paper

     7,836,804      (182,852 )   (3.08)%      4,659,972      (45,070 )   (1.27)%

Mortgage financing credit facilities

     1,923,132      (60,590 )   (4.15)%      —        —        

Securitization

     573,722      (18,101 )   (4.16)%      —        —        

Derivative contracts (2)

            8,474                   (6,187 )    
    

  


      

  


   
     $ 13,166,142      (315,100 )   (3.15)%    $ 10,303,822      (105,702 )   (1.35)%
    

  


      

  


   

Net interest income/spread

          $ 101,914     0.88%           $ 158,439     1.80%
           


 
         


 

(1) Includes interest income on cash and other miscellaneous interest-earning assets. Other interest income in the first nine months of 2004 includes $2.1 million of income related to bridge financing arrangements.

 

(2) Includes the effect of derivative instruments accounted for as cash flow hedges.

 

As shown in the table above, net interest income decreased by $56.5 million from the nine months ended September 30, 2004 to the nine months ended September 30, 2005 due to an increase in interest expense. This increase was due to eight increases in the federal funds rate over the last year. The increase in interest expense was partially offset by increases in the average balance of interest earning assets particularly non-prime mortgage loans which have higher yields than those earned on our MBS portfolio. Premium amortization expense totaled $58.0 million in the first nine months of 2005 compared to $60.9 million in the first nine months of 2004.

 

Other sources of principal investing and mortgage banking revenues are dividends, gain on sale of loans and net investment income. The Company recorded $20.6 million in dividend income from its merchant banking equity investment portfolio for the first nine months of 2005, compared to $8.5 million during the first nine months of 2004. The increase in dividend income was primarily due to an increase in investments making such distributions. Net investment income totaled $18.7 million during the nine months ended September 30, 2005, compared to a gain of $74.5 million for the same period in 2004. The following table summarizes the components of net investment income (dollars in thousands).

 

     Nine months Ended
September 30,


 
     2005

    2004

 

Realized gains on sale of available for sale investments, net

   $ 18,520     $ 67,961  

(Loss)/income from equity method investments

     (840 )     2,099  

Gains on investment securities—marked-to-market, net

     929       7,138  

Other, net

     137       (2,667 )
    


 


     $ 18,746     $ 74,531  
    


 


 

36


Table of Contents

Results of Operations—(Continued)

 

Income (loss) from equity method investments reflects the Company’s equity in earnings from investments in proprietary investment partnerships and other managed investments. Gains and losses on investment securities—marked-to-market relate to securities received in connection with capital raising activities. Other net investment income includes gains and losses from mortgage-backed securities classified as trading and derivatives not designated as hedges under SFAS No. 133. See Notes 4 and 7 to the financial statements for further information on these other gains and losses, as well as gains and losses on available-for-sale investments.

 

During the first nine months of 2005, the Company sold $2.7 billion of loans held for sale at a weighted average premium of 2.68%. Net of related direct costs and provision for repurchase and premium recapture obligations the Company’s gain on sale of loans for the period was $35.6 million or 1.33% of principal sold.

 

Other interest expense, primarily relating to long term debt issued through FBR TRS Holdings, increased from $2.5 million in 2004 to $9.3 million in 2005 due to increased long term borrowing of $175.0 million since September of 2004.

 

For the nine-months ended September 30, 2005, the Company recorded a $6.0 million provision for loan losses. The Company’s mortgage loan portfolio is comprised of 2005 origination and was acquired primarily during the second and third quarters of 2005. The provision recorded reflects management’s estimate of losses incurred during this period.

 

Total non-interest expenses increased 22.6% from $343.7 million in 2004 to $421.3 million in 2005 due primarily to increases in employees and the acquisition of First NLC. In addition, the Company recognized an expense of $7.5 million based on the estimated settlements with the SEC and the NASD’s Department of Market Regulation.

 

Compensation and benefits expense increased 6.9% from $228.4 million in 2004 to $244.2 million in 2005. This increase was primarily due to increased headcount as a result of the acquisition of First NLC offset by decreased variable compensation in 2005 as compared to 2004 as result of decreased investment banking revenues and a reduction in executive officer variable compensation. Certain executive officers elected to relinquish $7.3 million of their variable cash compensation associated with the Company’s earnings during the first two quarters of 2005. In conjunction with this relinquishment of variable cash compensation, in July 2005 the Board of Directors approved restricted stock grants totaling approximately $4.5 million to these executive officers. These grants were made in August 2005 and are subject to forfeiture restrictions that lapse ratably over the three year period after the date of grant. As a percentage of net revenues, compensation and benefits expense increased from 35.5% in 2004 to 44.5% in 2005 due to the effects of the acquisition of First NLC.

 

Professional services increased 29.5% from $38.6 million in 2004 to $50.0 million in 2005 primarily due to increases in accounting and consultants fees related to Sarbanes-Oxley compliance performed in the first quarter, consultant fees related to the integration of First NLC operations, legal costs associated with the proposed settlements with the SEC and NASD as discussed above, and sub-advisory fees related to the increase in assets under management.

 

Business development expenses increased 7.4% from $33.7 million in 2004 to $36.2 million in 2005. This increase is primarily due to an increase in travel costs and business promotions related to the mortgage origination services of the Company as a result of the acquisition of First NLC

 

Clearing and brokerage fees decreased 7.2% from $6.9 million in 2004 to $6.4 million in 2005 due to decreased institutional brokerage volume and related revenue.

 

Occupancy and equipment expense increased 136.6% from $10.1 million in 2004 to $23.9 million in 2005 primarily due to the investments made in the expanding of office space at the Arlington, New York, and Boston

 

37


Table of Contents

Results of Operations—(Continued)

 

offices, as well as the increase in the Company’s headcount related specifically to the acquisition of First NLC at September 30, 2005 as compared to September 30, 2004. Total employees as of September 30, 2005 were 2,455, including 1,654 First NLC employees, compared to 665 employees as of September 30, 2004.

 

Communications expense increased 53.6% from $9.7 million in 2004 to $14.9 million in 2005 primarily due to increased costs related to market data and customer trading services and the acquisition of First NLC.

 

Other operating expenses increased 182.1% from $16.2 million in 2004 to $45.7 million in 2005. This change reflects $7.5 million relating to the proposed settlements with the SEC and the NASD’s Department of Market Regulation as discussed above, loan servicing fees and insurance relating mortgage loan portfolio of $5.8 million, costs related to First NLC’s operations of $10.4 million which includes amortization of the identified broker relationship intangible of $2.1 million, and increase in business registration fees of $1.4 million, and increased 12b-1 fees of $0.6 million.

 

The total income tax provision decreased from $36.1 million in 2004 to $26.8 million in 2005 due to decreased taxable income in 2005 as compared to 2004. The Company’s effective tax rate at its taxable REIT subsidiaries was 46% for the nine months ended September 30, 2005 due primarily to the non-deductible nature of the $7.5 million charge recorded during the period relating to the Company’s proposed settlements with the SEC and the NASD’s Department of Market Regulation and state income taxes due to changes in state apportionment. The Company’s 2004 effective tax rate was 39%.

 

Liquidity and Capital Resources

 

Liquidity is a measurement of our ability to meet potential cash requirements including ongoing commitments to repay borrowings, fund investments, loan acquisition and lending activities, and for other general business purposes. In addition, regulatory requirements applicable to our broker-dealer and banking subsidiaries provide for minimum capital levels in these entities. The primary sources of funds for liquidity consist of repurchase agreements and commercial paper borrowings, securitization borrowings, principal and interest payments on mortgage loans and mortgage-backed securities, dividends on equity securities, proceeds from sales of mortgage loans and other investments, internally generated funds, equity capital contributions, and credit provided by banks, clearing brokers, and affiliates of our principal clearing broker. Potential future sources of liquidity for us include existing cash balances, internally generated funds, sales of investments, borrowing capacity through margin accounts and under lines of credit, and future issuances of common stock, preferred stock, or debt.

 

Sources of Funding

 

We believe that our existing cash balances, cash flows from operations, borrowing capacity, other sources of liquidity and execution of our financing strategies should be sufficient to meet our cash requirements. We have obtained, and believe we will be able to continue to obtain, short-term financing in amounts and at interest rates consistent with our financing objectives. We may, however, seek debt or equity financings, in public or private transactions, to provide capital for corporate purposes and/or strategic business opportunities, including possible acquisitions, joint ventures, alliances, or other business arrangements which could require substantial capital outlays. Our policy is to evaluate strategic business opportunities, including acquisitions and divestitures, as they arise. There can be no assurance that we will be able to generate sufficient funds from future operations, or raise sufficient debt or equity on acceptable terms, to take advantage of strategic business or investment opportunities that become available. Should our needs ever exceed these sources of liquidity, we believe that most of our investments could be sold, in most circumstances, to provide cash.

 

As of September 30, 2005, the Company’s indebtedness totaled $19.6 billion, which resulted in a leverage ratio of 14.1 to 1. In addition to trading account securities sold short and other payables and accrued expenses, our indebtedness consisted of repurchase agreements with several financial institutions, commercial paper issued through Georgetown Funding and Arlington Funding, securitization financings and long-term debentures issued through our taxable REIT subsidiary, FBR TRS Holdings. Such long-term debt issuances have totaled $277.5

 

38


Table of Contents

Liquidity and Capital Resources—(Continued)

 

million. These long term debt securities accrue and require payments of interest quarterly at annual rates of three-month LIBOR plus 2.25%-3.25%, mature in thirty years, and are redeemable, in whole or in part, without penalty after five years. As of September 30, 2005, we had $283.9 million of long-term corporate debt.

 

As of September 30, 2005, we have issued $3.9 billion of mortgage-backed bonds through securitization trusts to finance a portion of the Company’s portfolio of loans held for investment. Interest rates on these bonds reset monthly and are indexed to one-month LIBOR. The weighted average interest rate payable on the securities was 4.22% as of September 30, 2005.

 

In September 2005, the Company through FBR & Co. obtained a $100 million temporary subordinated loan from a subsidiary of its clearing broker. Proceeds of this borrowing are allowable for net capital purposes and were used by the Company in connection with regulatory capital requirements to support underwriting activity. Interest on this loan accrued at an annual rate of three-month LIBOR plus 4%. The loan was repaid in October 2005.

 

In July 2005, we renewed a $200 million, 364-day senior unsecured credit agreement with various financial institutions. This facility includes a one-year term-out option. The facility is available for general corporate purposes, working capital and other potential short-term liquidity needs.

 

Georgetown Funding is a special purpose Delaware limited liability company organized for the purpose of issuing extendable commercial paper notes collateralized by mortgage-backed securities and entering into reverse repurchase agreements with us and our affiliates. We serve as administrator for Georgetown Funding’s commercial paper program, and all of Georgetown Funding’s transactions are conducted with FBR. Through our administration agreement and repurchase agreements, we are the primary beneficiary of Georgetown Funding and consolidate this entity for financial reporting purposes. The extendable commercial paper notes issued by Georgetown Funding are rated A1+/P1 by Standard & Poor’s and Moody’s Investors Service, respectively. Our Master Repurchase Agreement with Georgetown Funding enables us to finance up to $12 billion of mortgage-backed securities.

 

Arlington Funding is a special purpose Delaware limited liability company organized for the purpose of issuing extendable commercial paper notes collateralized by non-conforming mortgage loans and providing warehouse financing in the form of reverse repurchase agreements to us and our affiliates, and with mortgage originators with which we have a relationship. We serve as administrator for Arlington Funding’s commercial paper program and provide collateral as well as guarantees for commercial paper issuances. Through these arrangements, we are the primary beneficiary of Arlington Funding and consolidate this entity for financial reporting purposes. The extendable commercial paper notes issued by Arlington Funding are rated A1+/P1 by Standard & Poor’s and Moody’s Investors Service, respectively. Our financing capacity through Arlington Funding is $5 billion.

 

The Company also has short-term financing facilities that are structured as repurchase agreements with various financial institutions to fund its portfolio of mortgage loans. The interest rates under these agreements are based on LIBOR plus a spread that ranges between 0.60% to 1.50% based on the nature of the mortgage collateral.

 

Our mortgage financing repurchase agreements include provisions contained in the standard master repurchase agreement as published by the Bond Market Association and may be amended and supplemented in accordance with industry standards for repurchase facilities. Our mortgage financing repurchase agreements include financial covenants, with which the failure to comply would represent an event of default under the applicable repurchase agreement. Similarly, each repurchase agreement includes events of default for failures to

 

39


Table of Contents

Liquidity and Capital Resources—(Continued)

 

qualify as a REIT, events of insolvency and events of default on other indebtedness. As provided in the standard master repurchase agreement as typically amended, upon the occurrence of an event of default or termination event the applicable counterparty has the option to terminate all repurchase transactions under such counterparty’s repurchase agreement and to demand immediate payment of any amount due from us to the counterparty.

 

Under our repurchase agreements, we may be required to pledge additional assets to our repurchase agreement counterparties in the event the estimated fair value of the existing pledged collateral under such agreements declines and such lenders demand additional collateral (i.e., margin call), which may take the form of additional securities or cash. Margin calls on repurchase agreements collateralized by our MBS investments primarily result from events such as declines in the value of the underlying mortgage collateral caused by factors such as rising interest rates or prepayments. Margin calls on repurchase agreements collateralized by our mortgage loans primarily result from events such as declines in the value of the underlying mortgage collateral caused by interest rates, prepayments, and/or the deterioration in the credit quality of the underlying loans.

 

To-date, we have not had any margin calls on our repurchase agreements that we were not able to satisfy with either cash or additional pledged collateral. However, should we encounter a surge in interest rates, prepayments, or delinquency levels, margin calls on our repurchase agreements could result in a manner that could cause an adverse change in our liquidity position.

 

The following table provides information regarding the Company’s outstanding commercial paper, repurchase agreement borrowings, and mortgage financing facilities (dollars in thousands).

 

    September 30, 2005

  December 31, 2004

        Commercial    
Paper


  Repurchase
    Agreements    


  Short-Term
Mortgage
Financing
Facilities(1)


      Commercial    
Paper


  Repurchase
    Agreements    


  Short-Term
Mortgage
Financing
Facilities


Outstanding balance

  $ 8,214,835   $ 2,791,905   $ 4,061,401   $ 7,294,949   $ 3,467,569   $ —  

Weighted-average rate

    3.79%     3.79%     4.57%     2.38%     2.34%     —  

Weighted-average term to maturity (1)

    24.3 days     18.5 days     NA     28.3 days     39.8 days     NA

(1) Under these mortgage financing agreements, which expire or may be terminated by the Company or the counterparty within one year, the Company may finance mortgage loans for up to 180 days. The interest rates on these borrowings reset daily.

 

Assets

 

Our principal assets consist of MBS, non-conforming mortgage loans, cash and cash equivalents, receivables, long-term investments and securities held for trading purposes. As of September 30, 2005, liquid assets consisted primarily of cash and cash equivalents of $181.5 million. Cash equivalents consist primarily of money market funds invested in debt obligations of the U.S. government. In addition, we held $9.3 billion in MBS, $8.5 billion in non-conforming mortgage loans, $361.1 million in long-term investments, $1.4 billion in marketable trading securities, and a receivable due from our clearing broker of $162.8 million at September 30, 2005.

 

As of September 30, 2005, our mortgage-backed securities portfolio was comprised primarily of agency mortgage-backed ARM and Hybrid ARM securities. Excluding principal receivable, which totaled $79.7 million, the total par value of the portfolio was $9.22 billion and the market value was $9.19 billion. As of September 30, 2005, the weighted average coupon of the portfolio was 4.02%. Our non-conforming mortgage loan portfolio is also comprised substantially of Hybrid ARMs. As of September 30, 2005, the principal balance of the mortgage loan portfolio was $8.4 billion and the weighted average coupon was 7.46%. The actual yield of the MBS and the

 

40


Table of Contents

Liquidity and Capital Resources—(Continued)

 

mortgage portfolio is affected by the price paid to acquire or the deferred net costs incurred to originate the investment. Our cost basis in MBS and mortgage loans is normally greater than the par value (i.e., a premium) resulting in the yield being less than the stated coupon. At September 30, 2005, the MBS portfolio had a net premium of $143 million (1.55% of the unpaid principal balance or par value) and the mortgage portfolio had a net premium of $194 million (2.32%), including deferred net origination costs and purchase loan price adjustments associated with the acquisition of First NLC. The weighted average yield on the mortgage portfolio was 6.92% as of September 30, 2005. Based on the amount of the premium and our estimates of future prepayments, the weighted average yield of the mortgage-backed securities portfolio was 3.10% as of September 30, 2005. Management’s estimate of prepayments, which was equivalent to a lifetime CPR of approximately 26%, is based on historical performance and estimates of future performance, including historical CPRs, interest rates and characteristics of the mortgage-backed securities portfolio, including Hybrid ARM type, age, and the weighted average coupon of the loans underlying the securities assessed in relation to current market data.

 

Long-term investments primarily consist of investments in marketable equity and non-public equity securities, managed partnerships (including hedge, private equity, and venture capital funds), in which we serve as managing partner, our investment in Capital Crossover Partners (a partnership we do not manage), and our investment in preferred equity of a privately held company. Although our investments in hedge, private equity and venture capital funds are mostly illiquid, the underlying investments of such entities are, in the aggregate, mostly publicly-traded, liquid equity and debt securities, some of which may be restricted due to contractual “lock-up” requirements.

 

The following table provides additional detail regarding the Company’s merchant banking investments as of September 30, 2005 (dollars in thousands).

 

     Shares

   Cost Basis

   Fair Value
/ Carrying
Value


Merchant Banking Investments

                  

Aames Investment Corporation

   4,707,900    $ 37,216    $ 29,566

Asset Capital Corporation, Inc. (1)

   943,766      7,500      7,500

Cmet Finance Holdings, Inc. (1)

   65,000      6,150      6,150

ECC Capital Corp. (1)

   3,940,110      25,000      12,845

Fieldstone Investment Corporation

   3,588,329      49,734      41,840

Government Properties Trust

   210,000      2,100      2,058

JER Investors Trust (1)

   377,350      5,264      6,815

KKR Financial Corp. (2)

   1,250,000      23,250      27,800

Lexington Strategic Asset Corp. (1)

   537,634      5,000      5,000

Medical Properties Trust, Inc. (2)

   1,795,571      16,180      17,596

New Century Financial Corporation

   636,885      35,050      23,100

New York Mortgage Trust, Inc.

   200,000      1,760      1,494

People’s Choice Financial Corporation (1)

   3,500,000      32,900      32,900

Quanta Capital Holdings Ltd.

   2,870,620      26,697      17,224

Saxon Capital, Inc.

   1,679,300      31,264      19,899

Specialty Underwriters Alliance, Inc. (1)

   1,242,410      10,977      10,163

Taberna Realty Finance Trust (1)

   985,663      10,000      10,000

Tower Group, Inc.

   325,000      2,763      4,914

Vintage Wine Trust, Inc. (1)

   1,075,269      10,000      10,000

Whittier Energy Corporation (convertible preferred) (1)

   89,606      5,000      5,000

Preferred equity investment (1)

   —        5,000      5,000

Other

   —        3,960      3,865
         

  

Total Merchant Banking Investments

        $ 352,765    $ 300,729
         

  


(1) As of September 30, 2005 these shares cannot be traded in a public market (e.g. NYSE or Nasdaq) but may be sold in private transactions.
(2) As of September 30, 2005, the Company is restricted from selling its shares.

 

41


Table of Contents

Liquidity and Capital Resources—(Continued)

 

Net unrealized gains and losses related to our MBS and merchant banking investments that are included in “accumulated other comprehensive loss” in our balance sheet totaled $(169) million and $(52) million, respectively, as of September 30, 2005. If we choose to liquidate these securities or we determine that a decline in value of these investments below our cost basis is “other than temporary,” a portion or all of the gains or losses will be recognized as realized gain (loss) in the statement of operations during the period in which the liquidation or determination is made. Our investment portfolio is exposed to potential future downturns in the markets and private debt and equity securities are exposed to deterioration of credit quality, defaults, and downward valuations.

 

Regulatory Capital

 

FBR & Co. and FBR Investment Services, Inc. (FBRIS), as U.S. broker-dealers, are registered with the SEC and are members of NASD. Additionally, Friedman, Billings, Ramsey International, Ltd. (FBRIL), our U.K. broker-dealer, is registered with the Financial Services Authority (FSA) of the United Kingdom. As such, they are subject to the minimum net capital requirements promulgated by the SEC and FSA, respectively. As of September 30, 2005, FBR & Co. had regulatory net capital as defined of $90.7 million, which exceeded its required net capital of $6.1 million by $84.6 million, FBRIS and FBRIL had regulatory net capital as defined in excess of the amounts required.

 

FBR National Trust (FBR Bank) is subject to various regulatory capital requirements administered by the federal banking agencies. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, FBR Bank’s assets, liabilities, and certain off-balance sheet items are calculated under regulatory accounting practices. FBR Bank’s capital levels and classification are also subject to qualitative judgments by the regulators with regard to components, risk weightings, and other factors.

 

Quantitative measures established by regulation to ensure capital adequacy require FBR Bank to maintain minimum capital levels and ratios of tangible and core capital (defined in the regulations) to total adjusted assets (as defined), and of total capital (as defined) to risk-weighted assets (as defined). Management believes, as of September 30, 2005, FBR Bank meets all capital adequacy requirements to which it is subject.

 

Dividends

 

The Company declared the following distributions during the nine months ended September 30, 2005 and year ended December 31, 2004:

 

Declaration Date


  

Record Date


  

Payment Date


   Dividends
Per Share


 
2005                   
September 13, 2005    September 30, 2005    October 31, 2005    $ 0.34  
June 9, 2005    June 30, 2005    July 29, 2005    $ 0.34  
March 17, 2005    March 31, 2005    April 29, 2005    $ 0.34  
2004                   
December 9, 2004    December 31, 2004    January 28, 2005    $ 0.39 (1)
September 9, 2004    September 30, 2004    October 29, 2004    $ 0.34  
June 10, 2004    June 30, 2004    July 30, 2004    $ 0.46 (2)
March 10, 2004    March 31, 2004    April 30, 2004    $ 0.34  

(1) Includes a special dividend of $0.05 per share.

 

(2) Includes a special dividend of $0.12 per share.

 

In October 2005, the Company announced its intention to reduce its quarterly dividend payment from $0.34 per share to $0.20 per share beginning in the fourth quarter 2005. This planned change in dividend policy is intended to enable the Company to maintain a stable dividend and maintain the integrity of our business model.

 

42


Table of Contents

Liquidity and Capital Resources—(Continued)

 

Contractual Obligations

 

We have contractual obligations to make future payments in connection with long-term debt and non-cancelable lease agreements and other contractual commitments as well as uncalled capital commitments to various investment partnerships that may be called over the next ten years. The following table sets forth these contractual obligations by fiscal year (dollars in thousands):

 

     Remaining
2005


   2006

   2007

   2008

   2009

   Thereafter

   Total

Long-term debt (1)

   $ —      $ 970    $ 970    $ 970    $ 970    $ 280,048    $ 283,928

Minimum rental and other contractual commitments

     3,955      17,303      12,812      12,662      11,999      54,921      113,652

Capital commitments (2)

     —        —        —        —        —        —        —  
    

  

  

  

  

  

  

Total Contractual Obligations

   $ 3,955    $ 18,273    $ 13,782    $ 13,632    $ 12,969    $ 334,969    $ 397,580
    

  

  

  

  

  

  


(1) This table excludes interest payments to be made on the Company’s long-term debt securities issued through TRS Holdings. The Company will incur $4.6 million in interest related to these long-term debt securities in the fourth quarter of 2005. Based on the 3-month LIBOR of 4.07% as of September 30, 2005, plus a weighted average margin of 2.58%, estimated annualized interest on the current outstanding principal of $277.5 million of long-term debt securities would be approximately $18.5 million for the year ending December 31, 2006. These long-term debt securities mature in thirty years beginning in March 2033 through October 2035. Note that interest on this long-term debt floats based on 3-month LIBOR, therefore, actual coupon interest will differ from this estimate.

 

(2) The table above excludes $6.7 million of uncalled capital commitments to various investment partnerships that may be called over the next ten years. This amount was excluded because the Company cannot determine when, if ever, the commitments will be called.

 

The Company also has short term commercial paper and repurchase agreement liabilities of $8.2 billion and $6.9 billion, respectively as of September 30, 2005, as well as $3.8 billion of securitization financing that matures in 2035. See Note 6 for further information.

 

As of September 30, 2005, the Company had made interest rate lock agreements with mortgage borrowers and commitments to sell mortgage loans of $448 million and $410 million, respectively.

 

43


Table of Contents
Item 3. Quantitative and Qualitative Disclosures about Market Risk

 

Market risk generally represents the risk of loss through a change in realizable value that can result from a change in the prices of equity securities, a change in the value of financial instruments as a result of changes in interest rates, a change in the volatility of interest rates or, a change in the credit rating of an issuer. The Company is exposed to the following market risks as a result of its investments in mortgage-backed securities, mortgage loans and equity investments. Except for trading securities held by FBR & Co. and certain mortgage-backed securities designated as trading, none of these investments is held for trading purposes.

 

Interest Rate Risk

 

Leveraged MBS and Mortgage Loans

 

The Company is subject to interest-rate risk as a result of its principal investment and mortgage banking activities. Through these activities, the Company invests in mortgage-backed securities and mortgage loans and finances those investments with repurchase agreement, commercial paper and securitization borrowings, all of which are interest rate sensitive financial instruments. The Company is exposed to interest rate risk that fluctuates based on changes in the level or volatility of interest rates and mortgage prepayments and in the shape and slope of the yield curve. The Company attempts to hedge a portion of its exposure to rising interest rates primarily through the use of paying fixed and receiving floating interest rate swaps, interest rate caps, and Eurodollar futures and put option contracts. The counterparty to the Company’s derivative agreements at September 30, 2005 are U.S. financial institutions.

 

The Company’s primary risk is related to changes in both short and long term interest rates, which affect the Company in several ways. As interest rates increase, the market value of the mortgage-backed securities and mortgage loans may be expected to decline, prepayment rates may be expected to go down, and duration may be expected to extend. An increase in interest rates is beneficial to the market value of the Company’s derivative instruments designated as hedges. For example, for interest rate swap positions, the cash flows from receiving the floating rate portion increase and the fixed rate paid remains the same under this scenario. If interest rates decline, the reverse is true for mortgage-backed securities and mortgage loans, paying fixed and receiving floating interest rate swaps, interest rate caps, and Eurodollar futures and put option contracts.

 

The Company records its derivatives at fair value. The differential between amounts paid and received for derivative instruments designated as hedges is recorded as an adjustment to interest expense. In addition, the Company records the ineffectiveness of its hedges, if any, in interest expense. In the event of early termination of these derivatives, the Company receives or makes a payment based on the fair value of the instrument, and the related deferred gain or loss recorded in other comprehensive income is amortized into income or expense over the original hedge period.

 

The table that follows shows the expected change in market value for the Company’s current mortgage-backed securities, mortgage loans, and derivatives related to the Company’s principal investment and mortgage banking activities under several hypothetical interest-rate scenarios. Interest rates are defined by the U.S. Treasury yield curve. The changes in rates are assumed to occur instantaneously. It is further assumed that the changes in rates occur uniformly across the yield curve and that the level of LIBOR changes by the same amount as the yield curve. Actual changes in market conditions are likely to be different from these assumptions.

 

Changes in value are measured as percentage changes from their respective values presented in the column labeled “Value at September 30, 2005.” Actual results could differ significantly from these estimates. The estimated change in value of the mortgages loans and mortgage-backed securities reflects an effective duration of 1.60 years and 1.01 years, respectively. The effective durations are based on observed market value changes, as well as management’s own estimate of the effect of interest rate changes on the fair value of the investments including assumptions regarding prepayments based, in part, on age of and interest rate on the mortgages and the mortgages underlying the mortgage-backed securities, prior exposure to refinancing opportunities, and an overall analysis of historical prepayment patterns under a variety of past interest rate conditions (dollars in thousands, except per share amounts).

 

44


Table of Contents

Interest Rate Risk—(Continued)

 

    

Value at
September 30,

2005


   Value at
September 30, 2005
with 100 basis
point increase in
interest rates


   Percent
Change


    Value at
September 30, 2005
with 100 basis
point decrease in
interest rates


   Percent
Change


 

Assets

                                 

Mortgage-backed securities

   $ 9,268,662    $ 9,159,755    (1.18 )%   $ 9,346,982    0.84 %

Mortgage loans

     8,540,692      8,372,014    (1.97 )%     8,645,316    1.23 %

Derivative assets

     54,583      101,290    85.57 %     7,522    (86.22 )%

Reverse repurchase agreements

     488,113      488,113            488,113       

Other

     2,719,107      2,719,107            2,719,107       
    

  

        

      

Total Assets

   $ 21,071,157    $ 20,840,279    (1.10 )%   $ 21,207,040    0.64 %
    

  

        

      

Liabilities

                                 

Repurchase agreements and commercial paper

   $ 15,068,141    $ 15,068,141          $ 15,068,141       

Securitization financing

     3,809,901      3,809,901            3,809,901       

Derivative liabilities

     30,331      53,356    75.91 %     4,272    (85.92 )%

Other

     768,647      768,647            768,647       
    

  

        

      

Total Liabilities

     19,677,020      19,700,045    0.12 %     19,650,961    (0.13 )%
    

  

        

      

Shareholders’ Equity

     1,394,137      1,140,234    (18.21 )%     1,556,079    11.62 %
    

  

        

      

Total Liabilities and Shareholders’ Equity

   $ 21,071,157    $ 20,840,279    (1.10 )%   $ 21,207,040    0.64 %
    

  

        

      

Book Value per Share

   $ 8.21    $ 6.71    (18.21 )%   $ 9.16    11.62 %
    

  

        

      

 

As shown above, the Company’s portfolio of mortgage loans and mortgage-backed securities generally will benefit less from a decline in interest rates than it will be adversely affected by a same scale increase in interest rates. This may effectively limit an investor’s upside potential in a market rally. The changes in the fair value of mortgage loans as presented in the table above will not necessarily affect the Company’s earnings or shareholders’ equity since mortgage loans held for investment are reported at amortized cost and mortgage loans held for sale are reported at fair value only when fair value is less than amortized cost. See also discussion of Trends that affect our business in Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

Other

 

The value of our direct investments in other companies is also likely to be affected by significant changes in interest rates. For example, many of the companies are exposed to risks similar to those identified above as being applicable to our own investments in mortgage-backed securities and mortgage loans. Additionally, changes in interest rates often affect market prices of equity securities. Because each of the companies in which we invest has its own interest rate risk management process, it is not feasible for us to quantify the potential impact that interest rate changes would have on the stock price or the future dividend payments by any of the companies in which we have invested.

 

Equity Price Risk

 

The Company is exposed to equity price risk as a result of its investments in marketable equity securities, investment partnerships, and trading securities. Equity price risk changes as the volatility of equity prices changes or the values of corresponding equity indices change.

 

While it is impossible to exactly project what factors may affect the prices of equity sectors and how much the effect might be, the table below illustrates the impact a ten percent increase and a ten percent decrease in the

 

45


Table of Contents

Equity Price Risk—(Continued)

 

price of the equities held by the Company would have on the value of the total assets and the book value of the Company as of September 30, 2005 (dollars in thousands, except per share amounts).

 

     Value at
September 30,
2005


    Value of
Equity at
September 30,
2005 with
10% Increase
in Price


    Percent
    Change    


   Value at
September 30,
2005 with
10% Decrease
in Price


    Percent
    Change    


Assets

                                 

Marketable equity securities

   $ 300,729     $ 330,802     10%    $ 270,656     (10)%

Equity method investments

     47,129       51,842     10%      42,416     (10)%

Investment securities-marked to market

     5,541       6,095     10%      4,987     (10)%

Other long-term investments

     7,732       7,732            7,732      

Trading securities—equities

     35,265       38,792     10%      31,739     (10)%

Other

     20,674,761       20,674,761            20,674,761      
    


 


      


   

Total Assets

   $ 21,071,157     $ 21,110,024     0.18%    $ 21,032,291     (0.18)%
    


 


      


   

Liabilities

   $ 19,677,020     $ 19,677,020          $ 19,677,020      
    


 


      


   

Shareholders’ Equity

                                 

Common stock

     1,725       1,725            1,725      

Paid-in-capital

     1,544,661       1,544,661            1,544,661      

Employee stock loan receivable

     (4,242 )     (4,242 )          (4,242 )    

Deferred compensation

     (20,295 )     (20,295 )          (20,295 )    

Accumulated comprehensive income

     (209,168 )     (179,095 )   14.38%      (239,241 )   (14.38)%

Retained earnings

     81,456       90,250     10.80%      72,663     (10.79)%
    


 


      


   

Total Shareholders’ Equity

     1,394,137       1,433,004     2.79%      1,355,271     (2.79)%
    


 


      


   

Total Liabilities and Shareholders’ Equity

   $ 21,071,157     $ 21,110,024     0.18%    $ 21,032,291     (0.18)%
    


 


      


   

Book Value per Share

   $ 8.21     $ 8.43     2.74%    $ 7.98     (2.83)%
    


 


      


   

 

Except to the extent that the Company sells its marketable equity securities or other long term investments, or a decrease in their market value is deemed to be other than temporary, an increase or decrease in the market value of those assets will not directly affect the Company’s earnings, however an increase or decrease in the value of equity method investments, investment securities-marked to market, as well as trading securities will directly effect the Company’s earnings.

 

46


Table of Contents
Item 4. Controls and Procedures

 

Pursuant to Rule 13a-15(b) under the Securities Exchange Act of 1934, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s principal executive officer Eric F. Billings, and principal financial officer, Kurt R. Harrington, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined under Rule 13a-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this report. Based upon that evaluation, Eric F. Billings and Kurt R. Harrington concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to material information relating to the Company (including its consolidated subsidiaries) required to be included in the Company’s periodic SEC filings.

 

Except as discussed below, there has been no change in the Company’s internal control over financial reporting during the quarter ended September 30, 2005 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

On February 16, 2005, the Company completed the acquisition of First NLC Financial Services, LLC (First NLC). As a result of this acquisition the Company adopted certain new accounting policies relative to mortgage loans, including policies relating to mortgage loans held for investment and mortgage loans held for sale (see Note 2 to the interim financial statements). Currently, the Company is in the process of assessing internal controls relative to First NLC and its operations.

 

Forward-Looking Statements

 

This Form 10-Q includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Some of the forward-looking statements can be identified by the use of forward-looking words such as “believes”, “expects,” “may,” “will,” “should,” “seeks,” “approximately,” “intends,” “plans,” “estimates” or “anticipates” or the negative of those words or other comparable terminology. Such statements include, but are not limited to, those relating to the effects of growth, our principal investment activities, levels of assets under management and our current equity capital levels. Forward-looking statements involve risks and uncertainties. You should be aware that a number of important factors could cause our actual results to differ materially from those in the forward-looking statements. These factors include, but are not limited to, the effect of demand for public offerings, activity in the secondary securities markets, interest rates, interest spreads, and mortgage prepayment speeds, the risks associated with merchant banking investments, available technologies, competition for business and personnel, and general economic, political, and market conditions. We will not necessarily update the information presented or incorporated by reference in this Form 10-Q if any of these forward-looking statements turn out to be inaccurate. For a more detailed discussion of the risks affecting our business see our Form 10-K for 2004 and especially the section “Risk Factors.”

 

47


Table of Contents

PART II – OTHER INFORMATION

 

Item 1. Legal Proceedings

 

Regulatory Investigations

 

As previously reported on Form 8-K and in the Company’s Quarterly Report on Form 10-Q for the quarter ended March 31, 2005, on April 26, 2005, the Company announced that its broker-dealer subsidiary, FBR & Co., has proposed a settlement to the staff of the Division of Enforcement (SEC staff) of the Securities and Exchange Commission (Commission) and the staff of the Department of Market Regulation of NASD (NASD staff) to resolve ongoing, previously disclosed investigations by the SEC and NASD staffs. The proposed settlement concerns insider trading and other charges related to the Company’s trading in a company account and the offering of a private investment in public equity on behalf of CompuDyne, Inc. in October 2001.

 

In the SEC proceeding, FBR & Co., without admitting or denying any wrongdoing, proposed to pay disgorgement, civil penalties and interest totaling approximately $3.5 million and to consent to the entry of a permanent injunction with respect to violations of the antifraud provisions of the federal securities laws, and agreed to consent to an administrative proceeding in which FBR & Co. would be subjected to a censure and agree to certain additional undertakings including engagement of an independent consultant to review its procedures and oversee the implementation of improvements. FBR & Co. has requested that the SEC staff recommend to the Commission that such an offer of settlement be approved, pending final negotiation of the settlement language. The offer of settlement is subject to approval by the Commission, and the Commission may accept, reject or impose further conditions or other modifications to some or all of the terms of the proposed settlement. Furthermore, there are no assurances regarding the Commission’s consideration or determination of any offer of settlement, and no settlement is final unless and until approved by the Commission.

 

In the parallel NASD proceeding, without admitting or denying any wrongdoing, FBR & Co. has proposed a settlement of alleged violations of the antifraud provisions of the federal securities laws and applicable NASD Rules. FBR & Co. would also agree to the same undertakings provided for in the proposed settlement with the SEC, and to pay a fine of $4 million to the NASD. The proposed settlement must be reviewed and accepted by the NASD.

 

The proposed SEC and NASD settlements are subject to FBR & Co. obtaining relief from certain statutory disqualifications, and the SEC staff can make no assurance that any or all of the requested relief will be granted by the Commission. The Company recorded a $7.5 million charge in its 2005 first quarter with respect to the proposed settlements with the SEC and NASD.

 

Putative Class Action Securities Lawsuits

 

The Company and certain current and former senior officers and directors have been named in a series of putative class action securities lawsuits filed in the third quarter of 2005, all of which are pending in the United States District Court for the Southern District of New York. The Company refers to these lawsuits as the Weiss et al. putative class action lawsuits. The complaints in these actions are brought under various sections of the Securities Exchange Act of 1934, as amended, and allege misstatements and omissions concerning (i) the SEC and NASD investigations described above relating to FBR & Co.’s involvement in the private investment in public equity on behalf of CompuDyne, Inc. in October 2001 and (ii) the Company’s expected earnings, including the potential adverse impact on the Company of changes in interest rates. The Company is contesting these lawsuits vigorously, but the Company cannot predict the likely outcome of these lawsuits or their likely impact on the Company at this time.

 

Shareholders’ Derivative Action

 

The Company and certain current and former senior officers and directors have been named in a shareholders’ derivative action that is presently pending in the United States District Court for the Southern

 

48


Table of Contents

District of New York. The Company, which is a nominal defendant in this action, refers to this derivative action as the Lemon Bay Partners derivative action. The complaint alleges conduct substantially similar to that alleged in the Weiss et al. putative class action lawsuits described above. The Company has not responded to the complaint and no discovery has commenced. The Company cannot predict the likely outcome of this action or its likely impact on the Company at this time. The Company’s Board of Directors has established a special committee comprised of two independent directors to evaluate shareholder demand letters which contain allegations similar to the Lemon Bay Partners derivative action and to recommend to the Board of Directors whether such a derivative action is in the best interests of the Company.

 

Other Legal Proceedings

 

As previously reported in the Company’s Annual Report on 10-K for the year ended December 31, 2004, one of the Company’s investment adviser subsidiaries, Money Management Associates, Inc. (MMA) and one of its now closed mutual funds are involved in an investigation by the SEC with regard to certain losses sustained by the fund in 2003. The Company continues to cooperate fully with the investigation, and to date the investigation is continuing. Since no proceedings have been initiated in this investigation, it is inherently difficult to predict its outcome or potential affect on MMA or the Company. It is possible that the SEC may initiate proceedings as a result of its investigations, and any such proceedings could result in adverse judgments, injunctions, fines, penalties or other relief against MMA or one or more of its officers or employees.

 

Except as described above, as of September 30, 2005, the Company was not a defendant or plaintiff in any lawsuits or arbitrations that are expected to have a material adverse effect on the Company’s financial condition or results of operations. The Company is a defendant in a small number of civil lawsuits and arbitrations relating to its various businesses, and is subject to various reviews, examinations, investigations and other inquiries by governmental agencies and SROs, none of which are expected to have a material adverse effect on the Company’s financial condition or results of operations.

 

49


Table of Contents
Item 6. Exhibits

 

The exhibits identified with (1) below are on file with the SEC as part of our Registration Statement on Form S-1, as amended, No. 333-39107, and are incorporated herein by reference.

 

The exhibit identified with (2) below is on file with the SEC as part of our 1999 annual report on Form 10-K and is incorporated by reference.

 

The exhibit identified with (3) below is on file with the SEC as part of our 1999 annual report on Form 10-K and is incorporated by reference. This exhibit was modified by an announcement filed with the SEC in a current report on Form 8-K, dated March 31, 2005 and is incorporated by reference.

 

3.01  (1)    Registrant’s Articles of Incorporation.
3.02  (1)    Registrant’s Bylaws.
4.01  (1)    Form of Specimen Certificate for Registrant’s Class A Common Stock.
10.02  (1)    The 1997 Employee Stock Purchase Plan.
10.03  (2)    FBR Stock and Annual Incentive Plan.
10.04  (1)    The Non-Employee Director Stock Compensation Plan.
10.05  (1)(3)    The Key Employee Incentive Plan.
12      Computation of Ratio of Earnings to Fixed Charges
31(a)      Certification of Eric F. Billings, Chief Executive Officer of Friedman, Billings, Ramsey Group, Inc. pursuant to Rule 13a-14(a)/15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31(b)      Certification of Kurt R. Harrington, Chief Financial Officer of Friedman, Billings, Ramsey Group, Inc. pursuant to Rule 13a-14(a)/15d-14(a), as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32(a)      Certification of Eric F. Billings, Chief Executive Officer of Friedman, Billings, Ramsey Group, Inc. pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32(b)      Certification of Kurt R. Harrington, Chief Financial Officer of Friedman, Billings, Ramsey Group, Inc. pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

 

50


Table of Contents

SIGNATURES

 

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

Friedman, Billings, Ramsey Group, Inc.
By:  

/s/    KURT R. HARRINGTON

    Kurt R. Harrington
    Senior Vice President and Chief Financial Officer
    (Principal Financial Officer)

 

Date: November 9, 2005

 

By:  

/s/    ROBERT J. KIERNAN

    Robert J. Kiernan
    Vice President, Controller and Chief Accounting Officer
    (Principal Accounting Officer)

 

Date: November 9, 2005

 

51