LUM Luminent Mtg Cap

 

 

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

FORM 10-Q

(Mark One)

þ		Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

for the quarterly period ended June 30, 2007

OR

o		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: 000-31828

(Former name, former address and former fiscal year, if changed since last report)

     Indicate by check mark whether 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 þ No o .

     Indicate by check mark whether registrant is a large accelerated filer, an accelerated filer, or a non- accelerated filer. See definition of “accelerated filer and large accelerated filer” as defined in Rule 12b-2 of the Exchange Act. (Check one)

Large accelerated filer o Accelerated filer þ Non-accelerated filer o

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

     The number of shares of common stock outstanding on August 31, 2007 was 43,303,004.

 

 

INDEX

				PAGE
INTRODUCTORY NOTE				ii
CAUTIONARY NOTE				iii
PART I		FINANCIAL INFORMATION
ITEM 1.		FINANCIAL STATEMENTS			1
ITEM 2.		MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS			25
ITEM 3.		QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK			46
ITEM 4.		CONTROLS AND PROCEDURES			50
PART II		OTHER INFORMATION
ITEM 1.		LEGAL PROCEEDINGS			51
ITEM 1A.		RISK FACTORS			51
ITEM 2.		UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS			54
ITEM 3.		DEFAULTS UPON SENIOR SECURITIES			54
ITEM 4.		SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS			54
ITEM 5.		OTHER INFORMATION			55
ITEM 6.		EXHIBITS			54
SIGNATURES					55
EXHIBIT INDEX					56
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

INTRODUCTORY NOTE

     The consolidated financial statements of Luminent Mortgage Capital, Inc. (“our”, “we” or “us”) as of June 30, 2007 and for the three and six months ended June 30, 2007, have been prepared in conformity with the instructions to Form 10-Q and Article 10, Rule 10-01, of Regulation S-X for interim financial statements.

     Subsequent to June 30, 2007, a number of material and adverse changes in the availability of financing for prime quality mortgage-related securities occurred. These changes accelerated in an unprecedented manner in early August 2007, when traditional lenders to the mortgage industry substantially reduced and, in some cases, eliminated debt financing to the industry. These changes also included a significant reduction in the availability of various types of short-term financing, including repurchase agreements and asset-backed commercial paper. Lenders have also increased their margin requirements, which has resulted in numerous margin calls and distressed prices for mortgage-backed securities. These market conditions have created a liquidity crisis that has materially adversely affected many companies in the mortgage business, including us.

     As reported in greater detail in Note 1 and Note 12 to our consolidated financial statements, subsequent to June 30, 2007 we have incurred significant losses from the sale of assets at distressed prices to meet margin calls, seizure of certain assets by creditors and defaults under our financing agreements, among other events. As a result, our current consolidated financial condition and results of operations are materially different from our consolidated financial condition and results of operations at June 30, 2007 and for the three and six months then ended as presented in the accompanying consolidated financial statements.

     We caution you to bear these developments in mind when reading this Form 10-Q Report and to await further financial and strategic information that we will publish when we have completed the analysis of our current financial condition.

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

     This Form 10-Q contains or incorporates by reference certain forward-looking statements under the Private Securities Litigation Reform Act of 1995. Forward-looking statements convey our current expectations or forecasts of future events. All statements contained in this Form 10-Q other than statements of historical fact are forward-looking statements. Words such as “anticipates,” “estimates,” “expects,” “projects,” “intends,” “plans,” “believes” and words and terms of similar substance used in connection with any discussion of future operating or financial performance identify forward-looking statements.

     We claim the protection of the safe harbor for forward-looking statements provided in the Private Securities Litigation Reform Act of 1995. These statements may be made directly in this Form 10-Q and they may also be incorporated by reference in this Form 10-Q to other documents we file with the SEC. We base our forward-looking statements upon the current beliefs and expectations of our management and they are inherently subject to significant business, economic and competitive uncertainties and contingencies, many of which are difficult to predict and generally beyond our control. In addition, these forward-looking statements are subject to assumptions with respect to future business strategies and decisions that are subject to change. Actual results may differ materially from the anticipated results discussed in these forward-looking statements. These forward-looking statements include, among other things, statements about:

	•		continued creditworthiness of the holders of mortgages underlying our mortgage-related assets;
	•		our ability to purchase sufficient mortgages for our securitization business;
	•		the effect of the flattening of, or other changes in, the yield curve on our investment strategies;
	•		changes in interest rates and mortgage prepayment rates;
	•		our ability to obtain or renew sufficient funding to maintain our leverage strategies and support our liquidity position;
	•		the possible effect of negative amortization of mortgages on our financial condition and REIT qualification;
	•		the possible impact of our failure to maintain exemptions under the 1940 Act;
	•		potential impacts of our leveraging policies on our net income and cash available for distribution;
	•		the power of our board of directors to change our operating policies and strategies without stockholder approval;
	•		effects of interest rate caps on our adjustable-rate and hybrid adjustable-rate loans and mortgage-backed securities;
	•		the degree to which our hedging strategies may or may not protect us from interest rate volatility;
	•		our ability to invest up to 10% of our investment portfolio in residuals, leveraged mortgage derivative securities and shares of other REITs as well as other investments;
	•		volatility in the timing and amount of our cash distributions; and
	•		the other factors described in this Form 10-Q, including those under the captions “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Risk Factors” and “Quantitative and Qualitative Disclosures about Market Risk.”

     We caution you not to place undue reliance on these forward-looking statements, which speak only as of the date of this Form 10-Q or the date of any document incorporated by reference in this Form 10-Q. All subsequent written and oral forward-looking statements attributable to us or any person acting on our behalf are expressly qualified in their entirety by the cautionary statements contained or referred to in this section. Except to the extent required by applicable law or regulation, we undertake no obligation to update these forward-looking statements to reflect events or circumstances after the date of this Form 10-Q or to reflect the occurrence of unanticipated events.

PART I

FINANCIAL INFORMATION

See notes to condensed consolidated financial statements

See notes to condensed consolidated financial statements

See notes to condensed consolidated financial statements

See notes to condensed consolidated financial statements

LUMINENT MORTGAGE CAPITAL, INC.

•       On August 16, 2007, the Company entered into a letter of intent with Arco, which included the arrangement of repurchase agreement financing in the amount of $64.9 million at an interest rate of one-month LIBOR plus 4.00%, and a revolving liquidity line of credit of $60.0 million to be used in the stabilization of existing repurchase agreements, to meet financing maturities and to provide working capital for the Company. See Note 12 for further information about the terms of this agreement.

•       On August 21, 2007, the Company entered into an interim agreement with Arco, whereby the Company received a secured loan of $18.25 million for one month, at an interest rate of one-month LIBOR plus 4.00%. The agreement was amended on September 12, 2007 and September 21, 2007 to increase the amount of the loan to $33.25 million and extended the maturity of the loan pending completion of the agreement described above. It is Arco’s intent that the loan will be included in the revolving liquidity line described above upon finalization of the agreement.

•       Between July 1, 2007 and August 31, 2007, the Company and our repo lenders have liquidated mortgage-backed securities with an amortized cost of approximately $1.9 billion subject to repurchase agreements in order to repay them. Management is working with repo lenders to liquidate additional assets in order to repay additional debt, meet required margin calls or obtain alternate financing.

•       The Company has repaid all of its warehouse lines of credit that were used to finance whole loan purchases. One warehouse line for $1.0 billion has been terminated, and no balances are currently outstanding on two warehouse lines totaling $1.5 billion.

•       The Company has sold all but five unsecuritized loans. The Company does not finance these five loans and is seeking recoveries where it has the contractual right to require repurchase by the originator.

•       The Company has maintained an interest in its ten whole loan securitizations.

•       The Company’s management has implemented an expense reduction plan that includes reductions in headcount as well as operating expense reductions.

          The Company’s management is currently focused on stabilizing the investment portfolio in the short-term and returning to profitability once the existing portfolio has been stabilized. There can be no assurance that further market disruption will not occur or that the Company will be able to successfully execute its business or liquidity plans discussed herein.

          The information furnished in these unaudited condensed consolidated interim statements reflects all adjustments that are, in the opinion of management, necessary for a fair statement of the results for the periods presented. These adjustments are of a normal recurring nature, unless otherwise disclosed in this Form 10-Q. The results of operations in the interim periods do not necessarily indicate the results that may be expected for the full year. The interim financial information should be read in conjunction with the Company’s Form 10-K for the year ended December 31, 2006.

NOTE 2 —SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

          Note 2 to the consolidated financial statements in the Company’s 2006 Form 10-K describes the Company’s significant accounting policies. There have been no significant changes to these policies during 2007 with the exception of the required adoption of SFAS No. 155, Accounting for Certain Hybrid Financial Instruments – an Amendment of FASB Statement No. 133 and 140 . See the description of recent accounting pronouncements below.

           Recent Accounting Pronouncements

          In July 2007, the Financial Accounting Standards Board, or FASB, authorized a proposed FASB Staff Position, or FSP, that, if approved for issuance by the FASB, will significantly affect the accounting for our convertible senior debentures. The proposed FSP will require that the initial debt proceeds be allocated between a liability component and an equity component. The resulting debt discount would be amortized over the period the debt is expected to be outstanding as additional interest expense. The proposed FSP is expected to be effective for fiscal years beginning after December 15, 2007 and to require retrospective application.

          In July 2007, the FASB issued proposed FSP FAS 140-d, Accounting for Transfers of Financial Assets and Repurchase Financing Transactions . The Board currently seeks written comments on the proposed FSP, which addresses the accounting for the transfer of financial assets and a subsequent repurchase financing.

          The FSP focuses on the circumstances that would permit a transferor and a transferee to separately evaluate the accounting for a transfer of a financial asset and a repurchase financing under FASB Statement No. 140, Transfers and Servicing of Financial Assets and Extinguishments of Liabilities.

          The proposed FSP states that a transfer of a financial asset and a repurchase agreement involving the transferred financial asset should be considered part of the same arrangement when the counterparties to the two transactions are the same unless certain criteria are met. The criteria in the proposed FSP are intended to identify whether (1) there is a valid and distinct business or economic purpose for entering separately into the two transactions and (2) the repurchase financing does not result in the initial transferor regaining control over the previously transferred financial assets. Its purpose is to limit diversity of practice in accounting for these situations, resulting in more consistent financial reporting. Consequently, it is the FASB’s desire to have the proposed FSP effective as soon as practicable.

          Currently, the Company records such assets and the related financing gross on its consolidated balance sheet, and the corresponding interest income and interest expense gross on its consolidated statement of operations. Any change in fair value of the security is reported through other comprehensive income or current period income, depending on its classification under SFAS No. 115, Accounting for Investments in Certain Debt and Equity Securities . This potential change in accounting treatment does not affect the economics of the transactions but does affect how the transactions would be reported in the Company’s consolidated financial statements. The Company’s cash flows, liquidity and ability to pay a dividend would be unchanged, and it is expected that its REIT taxable income and its qualification as a REIT would not be affected. Also, net equity would not be materially affected.

          In June 2007, the American Institute of Certified Public Accountants, or AICPA, issued Statement of Position, or SOP, 07-1, Clarification of the Scope of the Audit and Accounting Guide Investment Companies and Accounting for Parent Companies and Equity Method Investors for Investments in Investment Companies. This SOP provides guidance for determining whether an entity is within the scope of the AICPA Audit and Accounting Guide Investment Companies , or the Guide. Entities that are within the scope of the Guide are required, among other things, to carry their investments at fair value, with changes in fair value included in earnings. The provisions of this SOP are effective January 1, 2008. The Company is currently evaluating this new guidance and has not yet determined whether it will be required to apply the provisions of the Guide in presenting its consolidated financial statements.

          In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. This Statement allows entities to make an election to record financial assets and liabilities, with limited exceptions, at fair value on the balance sheet, with changes in fair value recorded in earnings. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. The Company elected not to adopt the Statement early as permitted and is still evaluating the impact of this Statement on its consolidated financial statements.

          In February 2006, the FASB issued SFAS No. 155 . This Statement provides entities with relief from having to separately determine the fair value of an embedded derivative that would otherwise be required to be bifurcated from its host contract in accordance with SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities . The Statement allows an entity to make an irrevocable election to measure such a hybrid financial instrument at fair value in its entirety, with changes in fair value recognized in earnings. Once the fair value election has been made, that hybrid financial instrument may not be designated as a hedging instrument pursuant to SFAS No. 133. The Statement is effective for all financial instruments acquired, issued or subject to a remeasurement event occurring after the beginning of an entity’s first fiscal year that begins after September 15, 2006. In January 2007, the FASB released Statement 133 Implementation Issue No. B40 , Embedded Derivatives: Application of Paragraph 13(b) to Securitized Interests in Prepayable Financial Assets (B40). B40 provides a narrow scope exception for certain securitized interests from the tests required under SFAS No. 133. The Company reviewed all securities that were purchased subsequent to January 1, 2007 and identified certain hybrid securities

which require bifurcation. The Company has elected to carry these securities at fair value as trading securities, although these securities were not acquired for resale. The Company will recognize changes in the fair value of these securities in other income.

          In June 2006, the FASB issued Interpretation, or FIN, No. 48, Accounting for Uncertainty in Income Taxes. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in an enterprise’s financial statements in accordance with SFAS No. 109, Accounting for Income Taxes. FIN 48 prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. This interpretation also provides guidance on derecognition, classification, interest and penalties, accounting in interim periods, disclosure and transition. FIN 48 became effective for fiscal years beginning after December 15, 2006. The Company’s adoption of this interpretation did not have a material impact on its consolidated financial statements.

          At June 30, 2007 and December 31, 2006, mortgage-backed securities had a weighted-average amortized cost, excluding residual interests, of 98.5% and 99.0% of face amount, respectively.

          The following table shows the Company’s available-for-sale mortgage-backed securities’ fair value and gross unrealized losses on temporarily impaired securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at December 31, 2006. The Company had no unrealized losses on available-for-sale securities at June 30, 2007.

Holding Period of Gross Unrealized Losses on Available-for-Sale Securities
(in thousands)

          The Company evaluates securities for other-than-temporary impairment on a quarterly basis, and more frequently when conditions warrant such evaluation. An impairment loss of $14.1 million for the three and six months ended June 30, 2007 was due to assumption changes on certain Residential Mortgage Credit securities due to increased loss expectations on certain securities. At June 30, 2007, the Company had $1.4 billion of securities held as available-for-sale with an impairment as of the balance sheet date of $4.6 million. As of the balance sheet date, the Company evaluated the impairment on these securities as temporary given the facts and circumstances on that date because it had the intent and believed it had the ability to hold the securities for a period of time sufficient to recover all unrealized losses. Due to the significance of the mortgage industry deterioration discussed in Note 1, which occurred after the balance sheet date, the Company has reclassified $4.6 million of impairment losses, representing all unrealized holding losses on securities, from other comprehensive income, which is a component of equity, to the consolidated statement of operations for the three and six month periods ended June 30, 2007. This reclassification does not change the Company’s book value at June 30, 2007 or taxable income for the three and six months ended June 30, 2007.

          Subsequent to June 30, 2007, certain rating agencies announced the downgrade or expected down grade in the rating of certain mortgage-backed securities due to higher than expected delinquencies and the potential for higher than expected losses. All of the mortgage-backed securities that the Company holds which were on the rating agencies downgrade list were already identified by the Company as having higher than expected delinquencies and the loss expectations used to determine the fair value of those securities were adjusted accordingly as an other-than-temporary impairment and impairment losses were recognized in the statement of operations prior to June 30, 2007.

          Impairment losses for the three and six months ended June 30, 2006 of $0.4 million and $2.2 million, respectively, related to Spread securities that the Company did not intend to hold until their maturity.

          The temporary impairment of securities at December 31, 2006 resulted from the fair value of the mortgage-backed securities falling below their amortized cost basis and was solely attributable to changes in interest rates. At December 31, 2006, none of the securities held had been downgraded by a credit rating agency since their purchase and the Company had the ability and intent to hold these securities for a period of time that is sufficient to recover all unrealized losses. As such, the Company does not believe any of these securities were other-than-temporarily impaired at December 31, 2006.

          The Company accounts for certain of the mortgage-backed securities in its Residential Mortgage Credit portfolio in accordance with the Emerging Issues Task Force, or EITF 99-20, Recognition of interest Income and Impairment on Purchased and Retained Beneficial Interests in Securitized Financial Assets . Under EITF 99-20, the