CCPCN Capital Crossing Preferred (MM)

 

UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

 

 

 

FORM 10-K

 

 

Commission File Number 000-25193

 

 

 

 

 

Registrant’s telephone number, including area code:

(617) 880-1000

 

Securities registered pursuant to Section 12(b) of the Act:

8.50% Non-Cumulative Exchangeable Preferred Stock, Series D

(Title of Class)

 

Securities registered pursuant to Section 12(g) of the Act:

None

 

 

 

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.  Yes  o      No  þ

 

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  Yes  o      No  þ

 

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  þ      No  o

 

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statement incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.   o

 

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

 

 

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 outstanding of the registrant’s sole class of common stock was 100 shares, $.01 par value per share, as of March 24, 2008. No common stock was held by non-affiliates of the registrant.

 

TABLE OF CONTENTS

 

preference of $10 per share, which raised net proceeds of $16.9 million, after related offering costs of $1.5 million.

 

On May 11, 2004, Capital Crossing Preferred completed a public offering of 1,500,000 shares of Non-cumulative Exchangeable Preferred Stock, Series D, with a dividend rate of 8.50% and a liquidation preference of $25 per share, which raised net proceeds of $35.3 million, after related offering costs of $2.2 million. Series D preferred stock is exchangeable for preferred shares of Lehman Bank if the Office of Thrift Supervision (“OTS”) so directs, when or if Lehman Bank becomes or may in the near term become undercapitalized or Lehman Bank is placed into conservatorship or receivership. Series D preferred stock is redeemable at the option of Capital Crossing Preferred on or after July 15, 2009, with the prior consent of the OTS.

 

On February 14, 2007, Capital Crossing was acquired by Lehman Bank through a two step merger transaction. An interim thrift subsidiary of Lehman Bank was merged into Capital Crossing. Immediately following such merger, Capital Crossing was merged into Lehman Bank. Under the terms of the agreement, Lehman Brothers paid $30.00 per share in cash in exchange for each outstanding share of Capital Crossing.

 

Upon completion of the merger, Capital Crossing Preferred’s Board of Directors amended Capital Crossing Preferred’s charter. The exchange of the Series A, Series C and Series D preferred shares into preferred shares of Capital Crossing are now exchangeable into preferred shares of Lehman Bank. This amendment was approved by Capital Crossing Preferred’s common stockholder. On January 29, 2007, Capital Crossing Preferred’s Board of Directors voted to redeem the Series A preferred shares and Series C preferred shares. On March 23, 2007, Capital Crossing Preferred redeemed the Series A and C preferred shares. The Series B preferred shares and Series D preferred shares remain outstanding and remain subject to their existing terms and conditions, including their respective call features.

 

Capital Crossing Preferred’s principal business objective is to acquire and hold mortgage assets that will generate net income for distribution to stockholders. All of the mortgage assets in Capital Crossing Preferred’s loan portfolio at December 31, 2007 were acquired from Capital Crossing (previously, the sole common shareholder) and it is anticipated that substantially all additional mortgage assets will be acquired from Lehman Bank (currently, the sole common shareholder). As of December 31, 2007, Capital Crossing Preferred held loans acquired from Capital Crossing with net investment balances of $66.7 million. Capital Crossing Preferred’s loan portfolio at December 31, 2007 consisted primarily of mortgage assets secured by commercial and multi-family properties.

 

Lehman Bank administers the day-to-day activities of Capital Crossing Preferred in its roles as servicer under a master service agreement entered into between Lehman Bank and Capital Crossing Preferred and as advisor under an advisory agreement. Capital Crossing Preferred pays Lehman Bank an annual servicing fee equal to 0.20%, payable monthly, and an annual advisory fee equal to 0.05%, also payable monthly, of the gross average outstanding principal balances of loans in the loan portfolio for the immediately preceding month. Lehman Bank and its affiliates have interests that are not identical to those of Capital Crossing Preferred. Consequently, conflicts of interest may arise with respect to transactions, including, without limitation:

 

 

It is the intention of Capital Crossing Preferred that any agreements and transactions between Capital Crossing Preferred and Lehman Bank are fair to all parties and consistent with market terms, including the price paid and received for mortgage assets on their acquisition or disposition by Capital Crossing Preferred or in connection with the servicing of such mortgage assets. However, there can be no assurance that such agreements or transactions will be on terms as favorable to Capital Crossing Preferred as those that could have been obtained from unaffiliated third parties.

Lehman Bank

 

As noted above, on February 14, 2007, Capital Crossing was acquired by Lehman Bank and is now a division of Lehman Bank. Lehman Bank is a wholly owned subsidiary of Lehman Brothers. As a subsidiary of Lehman Brothers, a top-tier investment bank and market leader in mortgage and consumer loan securitization, Lehman Bank is uniquely positioned to offer products and pricing expertise that leverages a strong institutional background. Lehman Bank is headquartered in Wilmington, Delaware and is a member of the Federal Home Loan Bank System. Lehman Bank’s deposits are insured by the Deposit Insurance Fund, which is administered by the Federal Deposit Insurance Corporation (“FDIC”). At December 31, 2007, Lehman Bank had total assets of $16.1 billion, deposits of $12.0 billion and stockholders’ equity of $2.1 billion. At December 31, 2007, under the regulatory capital ratios developed and monitored by the federal bank regulatory agencies and applicable to banks, Lehman Bank’s capital was sufficient to enable it to be qualified as “well capitalized.”

 

As a majority-owned subsidiary of Lehman Bank, the assets and liabilities and results of operations of Capital Crossing Preferred are consolidated with those of Lehman Bank for Lehman Bank’s financial reporting and regulatory capital purposes. As such, loans acquired by Capital Crossing Preferred from Lehman Bank will nevertheless be treated as assets of Lehman Bank for purposes of compliance by Lehman Bank with the Office of Thrift Supervision’s regulatory capital requirements and in Lehman Bank’s consolidated financial statements. Interest income on those loans will be treated as interest income of Lehman Bank in Lehman Bank’s consolidated financial statements.

 

Acquisition of Loan Portfolio

 

Pursuant to the terms of a master mortgage loan purchase agreement entered into by and between Capital Crossing Preferred and Lehman Bank, Lehman Bank assigns, from time to time, certain loans to Capital Crossing Preferred. In connection with said assignment, Lehman Bank delivers or causes to be delivered to Capital Crossing Preferred the mortgage note with respect to each mortgage endorsed to the order of Capital Crossing Preferred, the original or certified copy of the mortgage with evidence of recording indicated thereon, if available, and an original or certified copy of an assignment of the mortgage in recordable form. Such documents are initially held by Lehman Bank, acting as custodian for Capital Crossing Preferred pursuant to the terms of a master service agreement entered into by and between Lehman Bank and Capital Crossing Preferred.

 

Under the terms of the master mortgage loan purchase agreement, Lehman Bank makes certain representations and warranties with respect to the mortgage assets for the benefit of Capital Crossing Preferred regarding information provided with respect to mortgage assets, liens, validity of the mortgage documents, and compliance with applicable laws. Lehman Bank is obligated to repurchase any mortgage asset sold by it to Capital Crossing Preferred as to which there is a material breach of any such representation or warranty, unless Capital Crossing Preferred permits Lehman Bank to substitute other qualified mortgage assets for such mortgage asset. Lehman Bank also indemnifies Capital Crossing Preferred for damages or costs resulting from any such breach. The repurchase price for any such mortgage asset is such asset’s net carrying value plus accrued and unpaid interest on the date of repurchase.

 

From time to time, mortgage assets may be returned to Lehman Bank in the form of dividends or returns of capital. Lehman Bank will consider the amounts of such returns when assessing the adequacy of the size and composition of Capital Crossing Preferred’s loan portfolio and may, from time to time, contribute additional mortgage assets to Capital Crossing Preferred. Lehman Bank will seek to ensure that the mortgage assets it contributes to Capital Crossing Preferred are generally of similar quality and characteristics as those returned to it.

 

Future decisions regarding mortgage asset acquisitions by Capital Crossing Preferred from Lehman Bank will be based on the level of Capital Crossing Preferred’s preferred stock dividends at the time and Capital Crossing Preferred’s required level of income necessary to generate adequate dividend coverage.

Management Policies and Programs

 

In administering Capital Crossing Preferred’s mortgage assets, Lehman Bank has a high degree of autonomy. Capital Crossing Preferred’s Board of Directors, however, has adopted certain policies to guide the acquisition and disposition of assets, use of capital and leverage, credit risk management and certain other activities. These policies, which are discussed below, may be amended or revised from time to time at the discretion of Capital Crossing Preferred’s Board of Directors without a vote of Capital Crossing Preferred’s stockholders, including Series D preferred shares, or without a vote of Capital Crossing Preferred’s only common stockholder, Lehman Bank.

 

Asset Acquisition and Disposition Policies.   Capital Crossing Preferred anticipates that it will, from time to time, purchase additional mortgage assets. Capital Crossing Preferred intends to acquire all or substantially all of such mortgage assets from Lehman Bank on terms that are comparable to those that could be obtained by Capital Crossing Preferred if such mortgage assets were purchased from unrelated third parties. Capital Crossing Preferred and Lehman Bank do not currently have specific policies with respect to the purchase by Capital Crossing Preferred from Lehman Bank of particular loans or pools of loans, other than that such assets must be eligible to be held by a REIT. Capital Crossing Preferred intends generally to acquire only performing loans from Lehman Bank. Capital Crossing Preferred may also from time to time acquire mortgage assets from unrelated third parties. To date, Capital Crossing Preferred has not adopted any arrangements or procedures by which it would purchase mortgage assets from unrelated third parties, and it has not entered into any agreements with any third parties with respect to the purchase of mortgage assets. Capital Crossing Preferred anticipates that it would purchase mortgage assets from unrelated third parties only if neither Lehman Bank nor any of its affiliates had an amount or type of mortgage asset sufficient to meet the requirements of Capital Crossing Preferred. Capital Crossing Preferred currently anticipates that the mortgage assets that it purchases will primarily include commercial and multi-family mortgage loans, although if Lehman Bank develops an expertise in additional mortgage asset products, Capital Crossing Preferred may purchase such additional types of mortgage assets. In addition, Capital Crossing Preferred may also from time to time acquire limited amounts of other assets eligible to be held by REITs.

 

In order to preserve its status as a REIT under the Internal Revenue Code, substantially all of the assets of Capital Crossing Preferred must consist of mortgage loans and other qualified assets of the type set forth in Section 856(c)(4)(A) of the Internal Revenue Code. Such other qualifying assets include cash, cash equivalents and securities, including shares or interests in other REITs, although Capital Crossing Preferred does not currently intend to invest in shares or interests in other REITs.

 

Capital and Leverage Policies.   To the extent that the Board of Directors determines that additional funding is required, Capital Crossing Preferred may raise such funds through additional equity offerings, debt financing or retention of cash flow (after consideration of provisions of the Internal Revenue Code requiring the distribution by a REIT of not less than 90% of its REIT taxable income and taking into account taxes that would be imposed on undistributed taxable income), or a combination of these methods.

 

Capital Crossing Preferred has no debt outstanding, and it currently does not intend to incur any indebtedness. The organizational documents of Capital Crossing Preferred limit the amount of indebtedness which it is permitted to incur without approval of the Series D preferred stockholders to no more than 100% of its total stockholders’ equity. Any such debt incurred may include intercompany advances made by Lehman Bank to Capital Crossing Preferred.

 

On May 18, 2007, Lehman Bank paid off all of its outstanding Federal Home Loan Bank of Boston (“FHLBB”) advances. Prior to that, Capital Crossing Preferred had guaranteed all of the obligations of Lehman Bank under the advances Lehman Bank had received from FHLBB. As a result, Capital Crossing Preferred had agreed to pledge a significant amount of its assets. These FHLBB guarantee obligations were assumed by Lehman Bank pursuant to the merger. As a result of the repayment, the guarantee was released. Capital Crossing Preferred received an annual fee of $80,000 under this agreement.

 

Capital Crossing Preferred may also issue additional series of preferred stock. However, it may not issue additional shares of preferred stock ranking senior to the Series D preferred shares without consent of holders

of at least two-thirds of the outstanding Series D preferred shares. Although Capital Crossing Preferred’s charter does not prohibit or otherwise restrict Lehman Bank or its affiliates from holding and voting shares of Series D preferred stock, to Capital Crossing Preferred’s knowledge the amount of shares of Series D preferred stock held by Lehman Bank or its affiliates is insignificant (less than 1%). Similarly, Capital Crossing Preferred may not issue additional shares of preferred stock ranking on parity with the Series D preferred shares without the approval of a majority of its independent directors. Prior to any future issuance of additional shares of preferred stock, Capital Crossing Preferred will take into consideration Lehman Bank’s regulatory capital requirements and the cost of raising and maintaining that capital at the time.

 

Conflicts of Interest Policies.   Because of the nature of Capital Crossing Preferred’s relationship with Lehman Bank and its affiliates, conflicts of interest have arisen and may arise with respect to certain transactions, including without limitation, Capital Crossing Preferred’s acquisition of mortgage assets from, or return of mortgage assets to Lehman Bank, or disposition of mortgage assets or foreclosed property to, Lehman Bank or its affiliates and the modification of the master service agreement. It is Capital Crossing Preferred’s policy that the terms of any financial dealings with Lehman Bank and its affiliates will be consistent with those available from unaffiliated third parties in the mortgage lending industry. In addition, Capital Crossing Preferred maintains an audit committee of its Board of Directors, which is comprised solely of three independent directors who satisfy the standards for independence promulgated by the Nasdaq Stock Market, Inc. Among other functions, the audit committee will review transactions between Capital Crossing Preferred and Lehman Bank and its affiliates. Under the terms of the advisory agreement, Lehman Bank may not subcontract its duties under the advisory agreement to an unaffiliated third party without the approval of Capital Crossing Preferred’s Board of Directors, including the approval of a majority of its independent directors. Furthermore, under the terms of the advisory agreement, Lehman Bank provides advice and recommendations with respect to all aspects of Capital Crossing Preferred’s business and operations, subject to the control and discretion of Capital Crossing Preferred’s Board of Directors.

 

Conflicts of interest between Capital Crossing Preferred and Lehman Bank and its affiliates may also arise in connection with decisions bearing upon the credit arrangements that Lehman Bank or one of its affiliates may have with a borrower. Conflicts could also arise in connection with actions taken by Lehman Bank as a controlling person of Capital Crossing Preferred. It is the intention of Capital Crossing Preferred and Lehman Bank that any agreements and transactions between Capital Crossing Preferred and Lehman Bank or its affiliates, including, without limitation, the master mortgage loan purchase agreement, are fair to all parties and are consistent with market terms for such types of transactions. The master service agreement provides that foreclosures and dispositions of the mortgage assets are to be performed in a manner substantially the same as for similar work performed by Lehman Bank for transactions on its own behalf. However, there can be no assurance that any such agreement or transaction will be on terms as favorable to Capital Crossing Preferred as would have been obtained from unaffiliated third parties.

 

There are no provisions in Capital Crossing Preferred’s charter limiting any officer, director, security holder or affiliate of Capital Crossing Preferred from having any direct or indirect pecuniary interest in any mortgage asset to be acquired or disposed of by Capital Crossing Preferred or in any transaction in which Capital Crossing Preferred has an interest or from engaging in acquiring and holding mortgage assets. As described herein, it is expected that Lehman Bank and its affiliates will have direct interests in transactions with Capital Crossing Preferred (including, without limitation, the sale of mortgage assets to Capital Crossing Preferred). It is not currently anticipated, however, that any of the officers or directors of Capital Crossing Preferred will have any interests in such mortgage assets.

 

Other Policies.   Capital Crossing Preferred intends to operate in a manner that will not subject it to regulation under the Investment Company Act of 1940, as amended. Capital Crossing Preferred does not intend to:

 

 

 

Capital Crossing Preferred may, under certain circumstances, and subject to applicable federal and state laws and the requirements for qualifying as a REIT, purchase Series D preferred shares in the open market or otherwise, for redemption by Capital Crossing Preferred. Any such redemption may generally only be effected with the prior approval of the OTS.

 

Capital Crossing Preferred currently intends to make investments and operate its business at all times in such a manner as to be consistent with the requirements of the Internal Revenue Code to qualify as a REIT. However, future economic, market, legal, tax or other considerations may cause the Board of Directors to determine that it is in the best interests of Capital Crossing Preferred and its stockholders to revoke its REIT status which would have the immediate result of subjecting Capital Crossing Preferred to federal income tax at regular corporate rates.

 

Under the advisory agreement, Lehman Bank monitors and reviews Capital Crossing Preferred’s compliance with the requirements of the Internal Revenue Code regarding Capital Crossing Preferred’s qualification as a REIT on a quarterly basis and has an independent public accounting firm, selected by the Board of Directors of Capital Crossing Preferred, periodically review the results of Lehman Bank’s analysis.

 

Servicing

 

The loans in Capital Crossing Preferred’s portfolio are serviced by Lehman Bank pursuant to the terms of the master service agreement. Lehman Bank in its role as servicer under the terms of the master service agreement receives an annual servicing fee equal to 0.20%, payable monthly, on the gross average outstanding principal balances of loans serviced for the immediately preceding month. Additionally, servicing fees include third party expenses associated with the collection of certain non-performing loans. For the years ended December 31, 2007, 2006 and 2005, Capital Crossing Preferred incurred $199,000, $239,000 and $273,000, respectively, in servicing fees. In 2007, loan servicing fees were offset by the recovery of third party servicing fees, previously expensed by Capital Crossing Prefered, of $54,000 due to the resolution of a loan.

 

The master service agreement requires Lehman Bank to service the loan portfolio in a manner substantially the same as for similar work performed by Lehman Bank for transactions on its own behalf. Lehman Bank collects and remits principal and interest payments, maintains perfected collateral positions, submits and pursues insurance claims and initiates and supervises foreclosure proceedings on the loan portfolio it services. Lehman Bank also provides accounting and reporting services required by Capital Crossing Preferred for such loans. Capital Crossing Preferred may also direct Lehman Bank to dispose of any loans which become classified, placed on non-performing status, or are renegotiated due to financial deterioration of the borrower. Lehman Bank is required to pay all expenses related to the performance of its duties under the master service agreement. Lehman Bank may institute foreclosure proceedings and foreclose, manage and protect the mortgaged premises, including exercising any power of sale contained in any mortgage or deed of trust, obtaining a deed-in-lieu-of-foreclosure or otherwise acquiring title to a mortgaged property underlying a mortgage loan by operation of law or otherwise in accordance with the terms of the master service agreement.

 

The master service agreement may be terminated at any time by written agreement between the parties or at any time by either party upon 30 days prior written notice to the other party and appointment of a successor servicer. The master service agreement will automatically terminate if Capital Crossing Preferred ceases to be an affiliate of Lehman Bank.

 

Lehman Bank remits daily to Capital Crossing Preferred all principal and interest collected on loans serviced by Lehman Bank for Capital Crossing Preferred.

 

When any mortgaged property underlying a mortgage loan is conveyed by a mortgagor, Lehman Bank generally, upon notice of the conveyance, will enforce any due-on-sale clause contained in the mortgage loan, to the extent permitted under applicable law and governmental regulations. The terms of a particular mortgage

loan or applicable law, however, may prohibit Lehman Bank from exercising the due-on-sale clause under certain circumstances related to the security underlying the mortgage loan and the buyer’s ability to fulfill the obligations under the related mortgage note.

 

Advisory Services

 

Capital Crossing Preferred has entered into an advisory agreement with Lehman Bank to administer the day-to-day operations of Capital Crossing Preferred. Lehman Bank is paid an annual advisory fee equal to 0.05%, payable monthly, of the gross average outstanding principal balances of Capital Crossing Preferred’s loans for the immediately preceding month, plus reimbursement for certain expenses incurred by Lehman Bank as advisor. For the years ended December 31, 2007, 2006 and 2005, Capital Crossing Preferred incurred $45,000, $60,000, and $70,000, respectively, in advisory fees. As advisor, Lehman Bank is responsible for:

 

 

Lehman Bank may, from time to time, subcontract all or a portion of its obligations under the advisory agreement to one or more of its affiliates involved in the business of managing mortgage assets or, with the approval of a majority of Capital Crossing Preferred’s Board of Directors as well as a majority of its independent directors, subcontract all or a portion of its obligations under the advisory agreement to unrelated third parties. Lehman Bank will not, in connection with the subcontracting of any of its obligations under the advisory agreement, be discharged or relieved in any respect from its obligations under the advisory agreement.

 

The advisory agreement had an initial term of five years, and currently is renewed each year for an additional one-year period unless Capital Crossing Preferred delivers notice of nonrenewal to Lehman Bank. Capital Crossing Preferred may terminate the advisory agreement at any time upon 90 days’ prior notice. As long as any Series D preferred shares remain outstanding, any decision by Capital Crossing Preferred either not to renew the advisory agreement or to terminate the advisory agreement must be approved by a majority of its Board of Directors, as well as by a majority of its independent directors. Other than the servicing fee and the advisory fee, Lehman Bank will not be entitled to any fee for providing advisory and management services to Capital Crossing Preferred.

 

Description of Loan Portfolio

 

To date, all of Capital Crossing Preferred’s loans have been acquired or were contributed from Capital Crossing, previously, the sole common shareholder. It is anticipated that substantially all additional mortgage assets will be acquired or contributed from Lehman Bank, currently, the sole common shareholder. Capital Crossing Preferred’s loan portfolio may or may not have the characteristics described below at future dates.

The following table sets forth information regarding the composition of the loan portfolio at the dates indicated:

 

 

The following table sets forth certain information regarding the geographic location of properties securing the mortgage loans in the loan portfolio at December 31, 2007:

 

The following tables set forth information regarding maturity, contractual interest rate and principal balance of all loans in the loan portfolio at December 31, 2007:

 

 

 

Loan Purchasing Activities.   A substantial portion of Capital Crossing Preferred’s loan portfolio consists of loans which were purchased by Capital Crossing, previously, the sole common shareholder, from third parties. It is anticipated that substantially all additional loans will be purchased from Lehman Bank, currently, the sole common shareholder. These loans primarily are secured by commercial real estate, multi-family or one-to-four family residential real estate or land located throughout the United States. These loans generally were purchased from sellers in the financial services industry or government agencies. Lehman Bank does not utilize any specific threshold underwriting criteria in evaluating individual loans or pools of loans for purchase, but rather evaluates each individual loan, if it is purchasing an individual loan, or pool of loans, if it is purchasing a pool of loans, on a case by case basis in making a purchase decision as described in more detail below.

 

Prior to acquiring a loan or portfolio of loans, Lehman Bank’s loan acquisition group conducts a comprehensive review and evaluation of the loan or loans to be acquired in accordance with its credit policy for purchased loans. This review includes an analysis of information provided by the seller, including credit and collateral files, a review and valuation of the underlying collateral and a review, where applicable, of the adequacy of the income generated by the property to repay the loan. This review is conducted by Lehman Bank’s in-house loan acquisition group, which includes credit analysts, real estate appraisers, environmental specialists and legal counsel.

 

The estimated value of the real property collateralizing the loan is determined by Lehman Bank’s in-house appraisal group which considers, among other factors, the type of property, its condition and location and its highest and best use in its marketplace. In many cases, real estate brokers and/or appraisers with specific knowledge of the local real estate market are also consulted. For larger loans, members of Lehman Bank’s in-house loan acquisition group typically visit the real property collateralizing the loan, conduct a site inspection and conduct an internal rental analysis of similar commercial properties in the local area. Lehman Bank analyzes the current and likely future cash flows generated by the collateral to repay the loan. Lehman Bank also considers minimum debt service coverage ratios, consisting of the ratio of net operating income to total principal and interest payments. New tax and title searches may also be obtained to verify the status of any prior liens on the collateral. Lehman Bank’s in-house environmental specialists review available information with respect to each property collateralizing a loan to assess potential environmental risk.

 

In order to determine the amount that Lehman Bank is willing to bid to acquire individual loans or loan pools, Lehman Bank considers, among other factors:

 

 

In addition to the factors listed above, Lehman Bank also considers the amount it may realize through collection efforts or foreclosure and sale of the collateral, net of expenses, and the length of time and costs required to complete the collection or foreclosure process in the event a loan becomes non-performing or is non-performing at the purchase date. All bids submitted by the Capital Crossing division are subject to the approval of the Division’s President, Chief Investment Officer, or Chief Operating Officer.

 

Loan Servicing and Asset Resolution.   Lehman Bank has a number of asset managers that are divided into management teams. Loans are assigned to asset managers based on their size and performance status. In the event that a purchased loan becomes delinquent, or if it is delinquent at the time of purchase, Lehman

Bank promptly initiates collection activities. If a delinquent loan becomes non-performing, Lehman Bank may pursue a number of alternatives with the goal of maximizing the overall return on each loan in a timely manner. During this period, Capital Crossing Preferred does not recognize interest income on such loans unless regular payments are being made. In instances when a loan is not returned to performing status, Lehman Bank may seek resolution through negotiating a discounted pay-off with borrowers, which may be accomplished through refinancing by the borrower with another lender, restructuring the loan to a level that is supported by existing collateral and debt service capabilities, or foreclosure and sale of the collateral.

 

 

Capital Crossing Preferred’s determination that a purchased loan is delinquent is made prospectively based upon the repayment schedule of the loan following the date of purchase by Lehman Bank and not from the origination date of the loan. Thus, if a borrower was previously in default under the loan (and the loan was not initially purchased as a “non-performing” loan), such default is disregarded by Capital Crossing Preferred in making a determination as to whether or not the purchased loan is delinquent. For example, if Lehman Bank acquires a loan that is past due at the time of acquisition, that loan would not be considered delinquent until it was 90 days past due from Lehman Bank’s purchase date. If Lehman Bank acquires a loan which is contractually delinquent, management evaluates the collectibility of principal and interest and interest would not be accrued when the collectibility of principal and interest is not probable or estimable. Interest income on purchased non-performing loans is accounted for using either the cash basis or the cost recovery method, whereby any amounts received are applied against the recorded amount of the loan. A determination as to which method is used is made on a case-by-case basis.

 

As servicing agent for Capital Crossing Preferred’s loan portfolio, Lehman Bank will continue to monitor Capital Crossing Preferred’s loans through its review procedures and updated appraisals. Additionally, in order to monitor the adequacy of cash flows on income-producing properties, Lehman Bank generally obtains financial statements and other information from the borrower and the guarantor, including, but not limited to, information relating to rental rates and income, maintenance costs and an update of real estate property tax payments.

 

Non-Performing Assets

 

The performance of Capital Crossing Preferred’s loan portfolio is evaluated regularly by management. Management generally classifies a loan as non-performing when the collectibility of principal and interest is ninety days or more past due or the collection of principal and interest is not probable or estimable.

 

The accrual of interest on loans and the accretion of discount is discontinued when loan payments are ninety days or more past due or the collectibility of principal and interest is not probable or estimable. Interest income previously accrued on such loans is reversed against current period interest income, and the loan is accounted for using either the cash basis or the cost recovery method whereby any amounts received are applied against the recorded amount of the loan. This determination is made on a case-by-case basis. Loans accounted for on the cost recovery method, in general, consist of non-performing loans.

Loans are returned to accrual status when the loan is brought current in accordance with management’s anticipated cash flows at the time of loan acquisition or origination and collection of principal and interest is probable and estimable.

 

When Capital Crossing Preferred classifies problem assets, it may establish specific allowances for loan losses or specific nonaccretable discount allocations in amounts deemed prudent by management. When Capital Crossing Preferred identifies problem loans or a portion thereof, as a loss, it will charge-off such amounts or set aside specific allowances or nonaccretable discount equal to the total loss. All of Capital Crossing Preferred’s loans are reviewed monthly to determine which loans are to be placed on non-performing status. In addition, Capital Crossing Preferred’s determination as to the classification of its assets and the amount of its valuation allowances is reviewed by the OTS during their examinations of Lehman Bank, which may result in the establishment of additional general or specific loss allowances.

 

The following table sets forth the amount of non-performing assets by category at the dates indicated:

 

 

Discount and Allowance for Loan Losses

 

Discounts on Acquired Loans.   In accordance with Statement of Position (“SOP”) No. 03-3 “Accounting for Certain Loans or Debt Securities Acquired in a Transfer”, Capital Crossing Preferred reviews acquired loans for differences between contractual cash flows and cash flows expected to be collected from Capital Crossing Preferred’s initial investment in the acquired loans to determine if those differences are attributable, at least in part, to credit quality. If those differences are attributable to credit quality, the loan’s contractually required payments receivable in excess of the amount of its cash flows expected at acquisition, or nonaccretable discount, is not accreted into income. SOP No. 03-3 requires that Capital Crossing Preferred recognize the excess of all cash flows expected at acquisition over Capital Crossing Preferred’s initial investment in the loan as interest income using the interest method over the term of the loan. This excess is referred to as accretable discount.

 

No loans acquired since the adoption of SOP No. 03-3 were within the scope of the SOP.

 

Loans which, at acquisition, do not have evidence of deterioration of credit quality since origination are outside the scope of SOP No. 03-3. For such loans, the discount, representing the excess of the amount of reasonably estimable and probable discounted future cash collections over the purchase price, is accreted into interest income using the interest method over the term of the loan. Prepayments are not considered in the calculation of accretion income. Additionally, discount is not accreted on non-performing loans.

 

There is judgment involved in estimating the amount of Capital Crossing Preferred’s future cash flows on acquired loans. The amount and timing of actual cash flows could differ materially from management’s estimates, which could materially affect Capital Crossing Preferred’s financial condition and results of operations. Depending on the timing of an acquisition of loans, a preliminary allocation may be utilized until a final allocation is established. Generally, the allocation will be finalized no later than ninety days from the date of purchase.

If cash flows cannot be reasonably estimated for any loan, and collection is not probable, the cost recovery method of accounting is used. Under the cost recovery method, any amounts received are applied against the recorded amount of the loan. Nonaccretable discount is generally offset against the related principal balance when the amount at which a loan is resolved or restructured is determined. There is no effect on the income statement as a result of these reductions.

 

Subsequent to acquisition, if cash flow projections improve, and it is determined that the amount and timing of the cash flows related to the nonaccretable discount are reasonably estimable and collection is probable, the corresponding decrease in the nonaccretable discount is transferred to the accretable discount and is accreted into interest income over the remaining life of the loan on the interest method. If cash flow projections deteriorate subsequent to acquisition, the decline is accounted for through a provision for loan losses included in earnings.

 

The following table sets forth certain information relating to the activity in the nonaccretable discount for the years indicated:

 

 

The predominant portion of the $155,000 and $215,000 of nonaccretable discount at December 31, 2007 and 2006, respectively relates to two loans and four loans (of which none are non-performing) with net investment balances of $202,000 and $299,000 at December 31, 2007 and 2006, respectively.

 

Allowance for Loan Losses.   Capital Crossing Preferred’s allowance for loan losses at December 31, 2007 was $1.2 million. The determination of this allowance requires the use of estimates and assumptions regarding the risks inherent in individual loans and the loan portfolio in its entirety. In addition, regulatory agencies periodically review the adequacy of the allowance for loan losses and may require Capital Crossing Preferred to make additions to its allowance for loan losses. While management believes its estimates and assumptions are reasonable, there can be no assurance that they will be proven to be correct in the future. The actual amount of future provisions that may be required cannot be determined, and such provisions may exceed the amounts of past provisions. Management believes that the allowance for loan losses is adequate to absorb the known and inherent risks in Capital Crossing Preferred’s loan portfolio at each date based on the facts known to management as of such date. Management continues to monitor and modify the allowances for general and specific loan losses as economic conditions dictate.

The following table sets forth management’s allocation of the allowance for loan losses by loan category and the percentage of the loans in each category to total loans in each category with respect to the loan portfolio at the dates indicated:

 

 

Employees

 

Capital Crossing Preferred has thirteen officers, including three executive officers. Each officer of Capital Crossing Preferred currently is also an officer and/or director of Lehman Bank or its affiliates. Capital Crossing Preferred will maintain corporate records and audited financial statements that are separate from those of Lehman Bank. Capital Crossing Preferred does not have any employees because it has retained Lehman Bank to perform all necessary functions pursuant to the advisory agreement and the master service agreement. There are no provisions in Capital Crossing Preferred’s charter limiting any of the officers or directors from having any direct or indirect pecuniary interest in any mortgage asset to be acquired or disposed of by Capital Crossing Preferred or in any transaction in which Capital Crossing Preferred has an interest or from engaging in acquiring and holding mortgage assets. None of the officers or directors currently has, nor is it anticipated that they will have, any such interest in Capital Crossing Preferred’s mortgage assets.

 

Competition

 

Capital Crossing Preferred does not anticipate that it will engage in the business of originating mortgage loans. It does anticipate that it may acquire mortgage assets in addition to those in the loan portfolio and that substantially all these mortgage assets will be acquired from Lehman Bank. The amount of future acquisitions of mortgage assets will be determined based upon the preferred dividend required to be paid by Capital Crossing Preferred and the level of assets required to produce an adequate dividend coverage ratio. Accordingly, Capital Crossing Preferred does not expect to compete with mortgage conduit programs, investment banking firms, savings and loan associations, banks, thrift and loan associations, finance companies, mortgage bankers or insurance companies in acquiring its mortgage assets from Lehman Bank. Lehman Bank, however, faces significant competition in the purchase of mortgage loans, which could have an adverse effect on the ability of Capital Crossing Preferred to acquire mortgage loans. If Lehman Bank does not successfully compete in the purchase of mortgage loans, there could be an adverse effect on Capital Crossing Preferred’s business, financial condition and results of operations.

 

The banking industry in the United States is part of the broader financial services industry which also includes insurance companies, mutual funds, consumer finance companies and securities brokerage firms. In recent years, intense market demands, technological and regulatory changes and economic pressures have eroded industry classifications which were once clearly defined. More specifically, in 1999, the U.S. Congress enacted the “Gramm-Leach-Bliley Act of 1999” (the “1999 Act”), under which banks are no longer prohibited from associating with, or having management interlocks with, a business organization engaged principally in securities activities. The 1999 Act permits bank holding companies that elect to become financial holding companies to engage in defined securities and insurance activities as well as to affiliate with securities and insurance companies. The 1999 Act also permits banks to have financial subsidiaries that may engage in certain activities not otherwise permissible for banks.

Numerous banks and non-bank financial institutions compete with Lehman Bank for deposit accounts and the acquisition of loans. With respect to deposits, additional significant competition arises from corporate and government debt securities, as well as money market mutual funds. The primary factors in competing for deposit accounts include interest rates, the quality and range of financial services offered and the convenience of office and automated teller machine locations and office hours. Lehman Bank’s competition for acquiring loans includes non-bank financial institutions which may or may not be subject to the same restrictions or regulations as Lehman Bank is. The primary factor in competing for purchased loans is price.

 

Lehman Bank faces substantial competition both from other more established banks and from non-bank financial institutions. Most of these competitors offer products and services similar to those offered by Lehman Bank, have facilities and financial resources greater than those of Lehman Bank and have other competitive advantages over Lehman Bank.

 

Environmental Matters

 

In the course of its business, Capital Crossing Preferred has acquired, and may in the future acquire through foreclosure, properties securing loans it has purchased which are in default and involve environmental matters. With respect to other real estate owned, there is a risk that hazardous substances or wastes, contaminants or pollutants could be discovered on such properties after acquisition. In such event, Capital Crossing Preferred may be required to remove such substances from the affected properties at its sole cost and expense and may not be able to recoup any of such costs from any third party.

 

 

 

Because of Capital Crossing Preferred’s obligations to creditors, it may not be able to make dividend or liquidation payments to holders of the Series D preferred shares

 

The Series D preferred shares rank:

 

 

If Capital Crossing Preferred incurs significant indebtedness, it may not have sufficient funds to make dividend or liquidation payments on the Series D preferred shares. Upon Capital Crossing Preferred’s liquidation, its obligations to its creditors would rank senior to the Series D preferred shares. At December 31, 2007, Capital Crossing Preferred had approximately $191,000 in accounts payable and other liabilities which, upon its liquidation, would be required to be paid before any payments could be made to holders of the Series D preferred shares. In addition, upon Capital Crossing Preferred’s liquidation, dissolution or winding up, if it does not have sufficient funds to pay the full liquidation amount, to the holders of the Series D preferred shares, will share ratably in any distribution in proportion to the full liquidation amount which they otherwise would be entitled and such holders may receive less than the per share liquidation amount.

 

The terms of the Series D preferred shares limit Capital Crossing Preferred’s ability to incur debt in excess of 100% of its stockholders’ equity without the approval of the holders of at least two-thirds of the outstanding Series D preferred shares, but do not require that Capital Crossing Preferred obtain the approval of the holders of the Series D preferred shares to issue additional series of preferred shares which rank equal to the Series D preferred shares as to payment of dividends or amount upon liquidation. As a result, subject to these limitations, Capital Crossing Preferred may incur obligations which may further limit its ability to make dividend or liquidation payments in the future.

 

Bank regulators may limit the ability of Capital Crossing Preferred to implement its business plan and may restrict its ability to pay dividends

 

Because Capital Crossing Preferred is a subsidiary of Lehman Bank, federal and state regulatory authorities have the right to examine it and its activities and under certain circumstances, to impose restrictions on Lehman Bank or Capital Crossing Preferred which could impact Capital Crossing Preferred’s ability to conduct its business according to its business objectives, which could materially adversely affect the financial condition and results of operations of Capital Crossing Preferred.

 

If Lehman Bank’s regulators determine that Lehman Bank’s relationship to Capital Crossing Preferred results in an unsafe and unsound banking practice, the regulators could restrict Capital Crossing Preferred’s ability to transfer assets, to make distributions to its stockholders, including dividends on its Series D preferred shares, or to redeem shares of Series D preferred stock or even require Lehman Bank to sever its relationship with or divest its ownership interest in Capital Crossing Preferred. Such actions could potentially result in Capital Crossing Preferred’s failure to qualify as a REIT.

 

Payment of dividends on the Series D preferred shares could also be subject to regulatory limitations if Lehman Bank becomes undercapitalized. Lehman Bank will be deemed undercapitalized if its total risk-based capital ratio is less than 8.0%, its Tier 1 risk-based capital ratio is less than 4.0% or its Tier 1 leverage ratio is

less than 4.0%. At December 31, 2007, Lehman Bank had a total risk-based capital ratio of 13.52%, a Tier 1 risk-based capital ratio of 11.66% and a Tier 1 leverage ratio of 11.99%, per the Thrift Financial Report filed with the OTS, which is sufficient for Lehman Bank to be considered well-capitalized. If Lehman Bank becomes undercapitalized or the OTS anticipates that it will become undercapitalized, the OTS may direct the automatic exchange of the preferred shares of Capital Crossing Preferred for preferred shares of Lehman Bank. For purposes of calculating these capital ratios as a percentage of Lehman Bank’s risk-weighted assets, as opposed to its total assets, Lehman Bank’s assets are assigned to risk categories based on the relative credit risk of the asset in question. These risk weights consist of 0% for assets deemed least risky such as cash, claims backed by the full faith and credit of the U.S. government, and balances due from Federal Reserve banks; 20% for assets deemed slightly more risky such as portions of obligations conditionally guaranteed by the U.S. government or federal funds sold; 50% for assets deemed still more risky such as government issued-revenue bonds, one-to-four family residential first mortgage loans and well-collateralized multi-family residential first mortgage loans; and 100% for all other assets, including private sector loans such as commercial mortgage loans as well as bank-owned real estate.

 

While Capital Crossing Preferred believes that dividends on the Series D preferred shares should not be considered distributions by Lehman Bank, the OTS may not agree with this position. Under OTS regulations on capital distributions, the ability of Lehman Bank to make a capital distribution varies depending primarily on Lehman Bank’s earnings and regulatory capital levels. Capital distributions are defined to include payment of dividends, stock repurchases, cash-out mergers and other distributions charged against the capital accounts of an institution. The OTS could limit or prohibit the payment of dividends on the Series D preferred shares if it determines that the payment of those dividends is a capital distribution by Lehman Bank and that Lehman Bank’s earnings and regulatory capital levels are below specified levels.

 

Capital Crossing Preferred’s results will be affected by factors beyond its control

 

Capital Crossing Preferred’s mortgage loan portfolio is subject to local economic conditions which could affect the value of the real estate assets underlying its loans and therefore, its results of operations will be affected by various conditions in the real estate market, all of which are beyond its control, such as:

 

 

Capital Crossing Preferred’s loans are concentrated in California and New England and adverse conditions in those markets could adversely affect its operations

 

Properties underlying Capital Crossing Preferred’s current mortgage assets are concentrated primarily in California, particularly Southern California, and New England. As of December 31, 2007, approximately 59.0% of the net balances of its mortgage loans were secured by properties located in California and 6.8% in New England. Adverse economic, political or business developments or natural hazards may affect these areas and the ability of property owners in these areas to make payments of principal and interest on the underlying mortgages. If either region experienced adverse economic, political or business conditions, or natural hazards, Capital Crossing Preferred would likely experience higher rates of loss and delinquency on its mortgage loans than if its loans were more geographically diverse.

A substantial majority of Capital Crossing Preferred’s loans were originated by other parties

 

At December 31, 2007, substantially all of Capital Crossing Preferred’s net loans consisted of loans originated by third parties that were purchased by Capital Crossing (previously the sole common shareholder) and subsequently acquired by Capital Crossing Preferred from Capital Crossing. It is anticipated that substantially all additional mortgage assets will be acquired from Lehman Bank, currently, the sole common shareholder. When Lehman Bank purchases loans originated by third parties, it generally cannot conduct the same level of due diligence that it would have conducted had it originated the loans. In addition, loans originated by third parties may lack current financial information and may have incomplete legal documentation and outdated appraisals. Although Lehman Bank conducts a comprehensive acquisition review, it also may rely on certain information provided by the parties that originated the loans, whose underwriting standards may be substantially different than Lehman Bank’s. These differences may include less rigorous appraisal requirements and debt service coverage ratios, and less rigorous analysis of property location and environmental factors, building condition and age, tenant quality, compliance with zoning regulations, any use restrictions, easements or rights of ways that may impact the property value and the borrower’s ability to manage the property and service the mortgage. As a result, Lehman Bank may not have information with respect to an acquired loan which, if known at the time of acquisition, would have caused it to reduce its bid price or not bid for the loan at all. This may adversely affect Capital Crossing Preferred’s yield on loans or cause it to increase its provision for loan losses. In addition, Lehman Bank may acquire loans as part of a pool that, given the opportunity to review and underwrite at the outset, it would not have originated. Loans such as these could have a higher risk of becoming non-performing in the future and adversely affect Capital Crossing Preferred’s results of operations.

 

More than half of Capital Crossing Preferred’s loan portfolio is made up of commercial mortgage loans which are generally riskier than other types of loans

 

Commercial mortgage loans constituted approximately 62.1% of the total loans, net of discounts, in Capital Crossing Preferred’s loan portfolio at December 31, 2007. Commercial mortgage loans are generally subject to greater risks than other types of loans. Capital Crossing Preferred’s commercial mortgage loans, like most commercial mortgage loans, generally lack standardized terms, may have shorter maturities than other mortgage loans and may not be fully amortizing, meaning that they have a principal balance or “balloon” payment due on maturity. The commercial real estate properties underlying Capital Crossing Preferred’s commercial mortgage loans also tend to be unique and are more difficult to value than other real estate properties. They are also subject to relatively greater environmental risks than other types of loans and to the corresponding burdens and costs of compliance with environmental laws and regulations. Because of these risks related to commercial mortgage loans, Capital Crossing Preferred may experience higher rates of default on its mortgage loans than it would if its loan portfolio was more diversified and included a greater number of owner-occupied residential or other mortgage loans. Higher rates of default will cause Capital Crossing Preferred’s level of impaired loans to increase, which may have a material adverse affect on its results of operation.

 

Capital Crossing Preferred may not be able to purchase loans at the same volumes or with the same yields as it has historically purchased

 

To date Capital Crossing Preferred has purchased all of the loans in its portfolio from Capital Crossing, previously its sole common shareholder. Historically, Capital Crossing has acquired such loans

 

 

Future loan purchases will depend on the availability of pools of loans offered for sale and Lehman Bank’s ability to submit successful bids or negotiate satisfactory purchase prices. The acquisition of loans is highly

competitive. Capital Crossing Preferred cannot provide assurance that Lehman Bank will be able to purchase loans at the same volumes or with the same yields as it has historically purchased. This may interfere with Capital Crossing Preferred’s ability to maintain the requisite level of mortgage assets to maintain its qualification as a REIT. If volumes of loans purchased decline or the yields on these loans decline further, Capital Crossing Preferred would experience a material adverse effect on its financial condition.

 

Capital Crossing Preferred could be held responsible for environmental liabilities of properties it acquires through foreclosure

 

If Capital Crossing Preferred chooses to foreclose on a defaulted mortgage loan to recover its investment it may be subject to environmental liabilities related to the underlying real property. Approximately 62.1% of the total loans, net of discounts, in Capital Crossing Preferred’s portfolio at December 31, 2007 were commercial mortgage loans, which generally are subject to relatively greater environmental risks than other types of loans. Hazardous substances or wastes, contaminants, pollutants or sources thereof may be discovered on properties during Capital Crossing Preferred’s ownership or after a sale to a third party. The amount of environmental liability could exceed the value of the real property. There can be no assurance that Capital Crossing Preferred would not be fully liable for the entire cost of any removal and clean-up on an acquired property, that the cost of removal and clean-up would not exceed the value of the property or that Capital Crossing Preferred could recoup any of the costs from any third party. In addition, Capital Crossing Preferred may find it difficult or impossible to sell the property prior to or following any such remediation. The incurrence of any significant environmental liabilities with respect to a property securing a mortgage loan could have a material adverse effect on Capital Crossing Preferred’s financial condition.

 

Capital Crossing Preferred is dependent in virtually every phase of its operations on the diligence and skill of the management of Lehman Bank

 

Lehman Bank, which holds all of Capital Crossing Preferred’s common stock, is involved in virtually every aspect of Capital Crossing Preferred’s operations. Capital Crossing Preferred has thirteen officers, including three executive officers, and no other employees and does not have any independent corporate infrastructure. All of Capital Crossing Preferred’s officers are also officers of Lehman Bank or its affiliates. Capital Crossing Preferred does not have any employees because it has retained Lehman Bank to perform all necessary functions pursuant to the advisory agreement and the master service agreement.

 

Under an advisory agreement between Capital Crossing Preferred and Lehman Bank, Lehman Bank administers day-to-day activities, including monitoring of Capital Crossing Preferred’s credit quality and advising it with respect to the acquisition, management, financing and disposition of mortgage assets and its operations generally. Under a master service agreement between Capital Crossing Preferred and Lehman Bank, Lehman Bank services Capital Crossing Preferred’s loan portfolio. The advisory agreement has an initial term of five years with an automatic renewal feature and the master service agreement has a one-year term with an automatic renewal feature. Both the master service agreement and the advisory agreement are subject to earlier termination upon 30 days and 90 days notice, respectively. Lehman Bank may subcontract all or a portion of its obligations under the advisory agreement to its affiliates or, with the approval of a majority of Capital Crossing Preferred’s Board of Directors including a majority of Capital Crossing Preferred’s independent directors, subcontract its obligations under the advisory agreement to unrelated third parties. Lehman Bank will not, in connection with the subcontracting of any of its obligations under the advisory agreement, be discharged or relieved from its obligations under the advisory agreement.

 

The loss of the services of Lehman Bank, or the inability of Lehman Bank to effectively provide such services whether as a result of the loss of key members of Lehman Bank’s management, early termination of the agreements or otherwise, and Capital Crossing Preferred’s inability to replace such services on favorable terms, or at all, could adversely affect Capital Crossing Preferred’s ability to conduct its operations.

Capital Crossing Preferred’s relationship with Lehman Bank may create conflicts of interest

 

Lehman Bank and its affiliates may have interests which are not identical to Capital Crossing Preferred’s and therefore conflicts of interest have arisen and may arise in the future with respect to transactions between Capital Crossing Preferred and Lehman Bank such as:

 

Acquisition of mortgage assets.   Capital Crossing Preferred anticipates that it will from time to time continue to purchase additional mortgage assets. Capital Crossing Preferred intends to acquire all or substantially all of such mortgage assets from Lehman Bank, on terms that are comparable to those that could be obtained by Capital Crossing Preferred if such mortgage assets were purchased from unrelated third parties. Neither Capital Crossing Preferred nor Lehman Bank currently have specific policies with respect to the purchase by Capital Crossing Preferred from Lehman Bank of particular loans or pools of loans, other than that such assets must be eligible to be held by a REIT. Although these purchases are structured to take advantage of the underwriting procedures of Lehman Bank, and while Capital Crossing Preferred believes that any agreements and transactions between it, on the one hand, and Lehman Bank and/or its affiliates on the other hand, are fair to all parties and consistent with market terms, neither Capital Crossing Preferred nor Lehman Bank have obtained any third-party valuation to confirm that Capital Crossing Preferred is paying fair market value for these loans, nor does Capital Crossing Preferred anticipate obtaining a third-party valuation in the future. Additionally, through limiting Capital Crossing Preferred’s source of purchased mortgage assets solely to those originated or purchased by Lehman Bank, Capital Crossing Preferred’s portfolio will generally reflect the nature, scope and risk of Lehman Bank’s portfolio rather than a more diverse portfolio composed of mortgage loans also purchased from other lenders.

 

Servicing of Capital Crossing Preferred mortgage assets by Lehman Bank.   Capital Crossing Preferred’s loans are serviced by Lehman Bank pursuant to the terms of the master service agreement. Lehman Bank in its role as servicer under the terms of the master service agreement receives an annual servicing fee equal to 0.20%, payable monthly, on the gross average outstanding principal balances of loans serviced for the immediately preceding month. The master service agreement requires Lehman Bank to service the loan portfolio in a manner substantially the same as for similar work performed by Lehman Bank for transactions on its own behalf. This will become especially important as Lehman Bank services any loans which become classified or are placed on non-performing status, or are renegotiated due to the financial deterioration of the borrower. While Capital Crossing Preferred believes that Lehman Bank will diligently pursue collection of any non-performing loans, Capital Crossing Preferred cannot provide assurance that this will be the case. Capital Crossing Preferred’s ability to make timely payments of dividends will depend in part upon Lehman Bank’s prompt collection efforts on behalf of Capital Crossing Preferred.

 

Future dispositions by Capital Crossing Preferred of mortgage assets to Lehman Bank or its affiliates.   The master service agreement provides that foreclosures and dispositions of the mortgage assets are to be performed in a manner substantially the same as for similar work performed by Lehman Bank on its own behalf. However, Capital Crossing Preferred cannot provide assurance that any such agreement or transaction will be on terms as favorable to it as would have been obtained from unaffiliated third parties. Lehman Bank may seek to exercise its influence over Capital Crossing Preferred’s affairs so as to cause the sale of the mortgage assets owned by Capital Crossing Preferred and their replacement by lesser quality loans purchased from Lehman Bank or elsewhere which could adversely affect Capital Crossing Preferred’s business and its ability to make timely payments of dividends.

 

Future modifications of the advisory agreement or master service agreement.   Should Capital Crossing Preferred seek to modify either the advisory agreement or the master service agreement, it would rely upon its officers, all of whom are also officers of Lehman Bank or its affiliates, and/or its directors, three of whom are also officers of Lehman Bank. Thus, Capital Crossing Preferred’s officers and/or directors would be responsible for taking positions with respect to such agreements that, while in Capital Crossing Preferred’s best interests, may not be in the best interests of Lehman Bank. In such instance, Lehman Bank has the ability to block any modification that is not in its best interests. Although the termination, modification or decision not to renew the advisory agreement and/or the master service agreement requires the approval of a majority of Capital Crossing Preferred’s independent directors, Lehman Bank, as holder of all of Capital Crossing

Preferred’s outstanding common stock, controls the election of all Capital Crossing Preferred directors, including the independent directors. Capital Crossing Preferred cannot provide assurance that such modifications, if available to it, will be on terms as favorable to it as those that could have been obtained from unaffiliated third parties.

 

The master loan purchase agreement was not the result of arm’s-length negotiations.   Capital Crossing Preferred acquires loans pursuant to the master mortgage loan purchase agreement between Capital Crossing Preferred and Lehman Bank, at an amount equal to Lehman Bank’s net carrying value for those mortgage assets. While Capital Crossing Preferred believes that the master mortgage loan purchase agreement, when entered into, was fair to all parties and consistent with market terms, all of its officers and three of its directors were at the time the master service mortgage loan purchase agreement was entered into officers of Capital Crossing and currently, Capital Crossing Preferred’s officers and three of the company’s current directors are officers of Lehman Bank and/or affiliates of Lehman Bank. Lehman Bank, as holder of all of Capital Crossing Preferred’s outstanding common stock, controls the election of all Capital Crossing Preferred directors, including the independent directors. Capital Crossing Preferred cannot provide assurance that the master mortgage loan purchase agreement was entered into on terms as favorable to Capital Crossing Preferred as those that could have been obtained from unaffiliated third parties.

 

Neither Capital Crossing Preferred nor Lehman Bank have specific policies with respect to the purchase by Capital Crossing Preferred from Lehman Bank of particular loans or pools of loans

 

The lack of specific policies with respect to the purchase by Capital Crossing Preferred of loans from Lehman Bank could result in Capital Crossing Preferred acquiring lower quality mortgage assets from Lehman Bank than if such policies were otherwise in place. Neither Capital Crossing Preferred nor Lehman Bank currently have specific policies with respect to the purchase by Capital Crossing Preferred from Lehman Bank of particular loans or pools of loans, other than that such assets must be eligible to be held by a REIT. Capital Crossing Preferred’s Board of Directors has adopted certain policies to guide the acquisition and disposition of assets but these policies may be revised from time to time at the discretion of the Board of Directors without a vote of Capital Crossing Preferred’s stockholders. Capital Crossing Preferred intends to acquire all or substantially all of the additional mortgage assets it may acquire in the future from Lehman Bank on terms that are comparable to those that could be obtained by Capital Crossing Preferred if such mortgage assets were purchased from unrelated third parties, but Capital Crossing Preferred cannot provide assurance that this will always be the case.

 

Capital Crossing Preferred’s Board of Directors has broad discretion to revise Capital Crossing Preferred’s strategies

 

Capital Crossing Preferred’s Board of Directors has established Capital Crossing Preferred’s investment and operating strategies. These strategies may be revised from time to time at the discretion of the Board of Directors without a vote of Capital Crossing Preferred’s stockholders. Changes in Capital Crossing Preferred’s strategies could have a negative effect on shareholders.

 

Capital Crossing Preferred does not obtain third-party valuations and therefore it may pay more or receive less than fair market value for its mortgage assets

 

To date, Capital Crossing Preferred has not obtained third-party valuations as part of its loan acquisitions or dispositions and does not anticipate obtaining third-party valuations for future acquisitions and dispositions of mortgage assets. Capital Crossing Preferred does not intend to obtain third-party valuations even where it is acquiring mortgage assets from, or disposing mortgage assets to, one of its affiliates, including Lehman Bank. Accordingly, Capital Crossing Preferred may pay its affiliates, including Lehman Bank, more than the fair market value of mortgage assets it acquires and may receive less than the fair market value of the mortgage assets it sells based on a third-party valuation.

Capital Crossing Preferred may pay more than fair market value for mortgages it purchases from Lehman Bank because it does not engage in arm’s-length negotiations with Lehman Bank

 

Capital Crossing Preferred acquires mortgage assets from Lehman Bank under a master mortgage loan purchase agreement between it and Lehman Bank, at an amount equal to Lehman Bank’s net carrying value for those mortgage assets. Because Lehman Bank is an affiliate of Capital Crossing Preferred’s, Capital Crossing Preferred does not engage in any arm’s-length negotiations regarding the consideration to be paid. Accordingly, if Lehman Bank’s net carrying value exceeds the fair market value of the mortgage assets, Capital Crossing Preferred would pay Lehman Bank more than the fair market value for those mortgaged assets.

 

Fluctuations in interest rates could reduce Capital Crossing Preferred earnings and affect its ability to pay dividends

 

Capital Crossing Preferred’s income consists primarily of interest earned on its mortgage assets and short-term investments. A significant portion of Capital Crossing Preferred’s mortgage assets bears interest at adjustable rates. If there is a decline in interest rates, then Capital Crossing Preferred will experience a decrease in income available to be distributed to its stockholders. If interest rates decline, Capital Crossing Preferred may also experience an increase in prepayments on its mortgage assets and may find it difficult to purchase additional mortgage assets bearing rates sufficient to support payment of dividends on the Series D preferred shares. Conversely, an increase in mortgage rates could result in decreased interest income and increased non-interest expense related to workouts and other collection efforts. An increase in interest rates that adversely affects the ability of borrowers to pay the principal or interest on Capital Crossing Preferred’s loans may lead to an increase in non-performing assets and a reduction of discount accreted into income, which could have a material adverse affect on Capital Crossing Preferred’s results of operation. Because the dividend rates on the Series D preferred shares are fixed, a significant decline or increase in interest rates, either of which result in lower net income, could materially adversely affect Capital Crossing Preferred’s ability to pay dividends on the Series D preferred shares.

 

Tax Risks Related to REITs

 

If Capital Crossing Preferred fails to qualify as a REIT, it will be subject to federal income tax at regular corporate rates

 

If Capital Crossing Preferred fails to qualify as a REIT for any taxable year, it would be subject to federal income tax, including any applicable alternative minimum tax, on its taxable income at regular corporate rates. As a result, the amount available for distribution to Capital Crossing Preferred’s stockholders would be reduced for the year or years involved. In addition, unless entitled to relief under statutory provisions, Capital Crossing Preferred would be disqualified from treatment as a REIT for the four taxable years following the year which qualification was lost. The failure to qualify as a REIT would reduce Capital Crossing Preferred’s net earnings available for distribution to its stockholders because of the additional tax liability for the year or years involved. Capital Crossing Preferred’s failure to qualify as a REIT would not by itself give it the right to redeem the Series D preferred shares, nor would it give the holders of the Series D preferred shares the right to have their shares redeemed.

 

Although Capital Crossing Preferred currently intends to operate in a manner designed to qualify as a REIT, future economic, market, legal, tax or other considerations may cause it to determine that it is in its best interest and in the best interest of holders of its common stock and preferred stock to revoke its REIT election. The tax law prohibits Capital Crossing Preferred from electing treatment as a REIT for the four taxable years following the year of any such revocation.

 

If Capital Crossing Preferred does not distribute 90% of its net taxable income, it may not qualify as a REIT

 

In order to qualify as a REIT, Capital Crossing Preferred generally is required each year to distribute to its stockholders at least 90% of its net taxable income, excluding net capital gains. Capital Crossing Preferred

may retain the remainder of REIT taxable income or all or part of its net capital gain, but will be subject to tax at regular corporate rates on such income. In addition, Capital Crossing Preferred is subject to a 4% nondeductible excise tax on the amount, if any, by which certain distributions considered as paid by Capital Crossing Preferred with respect to any calendar year are less than the sum of (1) 85% of its ordinary income for the calendar year, (2) 95% of its capital gains net income for the calendar year and (3) 100% of any undistributed income from prior periods. Under certain circumstances, federal or state regulatory authorities may restrict Capital Crossing Preferred’s ability, as a subsidiary of Lehman Bank, to make distributions to its stockholders in an amount necessary to retain its REIT qualification. Such a restriction could result in Capital Crossing Preferred failing to qualify as a REIT. To the extent Capital Crossing Preferred’s REIT taxable income may exceed the actual cash received for a particular period, Capital Crossing Preferred may not have sufficient liquidity to make distributions necessary to retain its REIT qualification.

 

Capital Crossing Preferred may redeem the Series D preferred shares at any time upon the occurrence of a tax event

 

At any time following the occurrence of certain changes in the tax laws or regulations concerning REITs, Capital Crossing Preferred will have the right to redeem the Series D preferred shares in whole, subject to the prior written approval of the OTS. Capital Crossing Preferred would have the right to redeem the Series D preferred shares if it received an opinion of counsel to the effect that, as a result of changes to the tax laws or regulations:

 

 

The occurrence of such changes in the tax laws or regulations will not, however, give the holders of the Series D preferred shares any right to have their shares redeemed.

 

Capital Crossing Preferred has imposed ownership limitations to protect its ability to qualify as a REIT, however, if ownership of the common stock of Lehman Bank becomes concentrated in a small number of individuals Capital Crossing Preferred may fail to qualify as a REIT

 

To maintain Capital Crossing Preferred’s status as a REIT, not more than 50% in value of Capital Crossing Preferred’s outstanding shares may be owned, directly or indirectly, by five or fewer individuals, as defined in the Internal Revenue Code to include certain entities, during the last half of each taxable year. Capital Crossing Preferred currently satisfies this requirement because for this purpose Capital Crossing Preferred’s common stock held by Lehman Bank is treated as held by Lehman Bank’s stockholders. However, it is possible that the ownership of Lehman Bank might become sufficiently concentrated in the future such that five or fewer individuals would be treated as having constructive ownership of more than 50% of the value of Capital Crossing Preferred’s stock. Capital Crossing Preferred may have difficulty monitoring the daily ownership and constructive ownership of its outstanding shares and, therefore, Capital Crossing Preferred cannot provide assurance that it will continue to meet the share ownership requirement. This risk may be increased in the future as Lehman Bank implements common stock repurchase programs because repurchases may cause ownership in Lehman Bank to become more concentrated. In addition, while the fact that the Series D preferred shares may be redeemed or exchanged will not affect Capital Crossing Preferred’s REIT status prior to any such redemption or exchange, the redemption or exchange of all or a part of the Series D preferred shares could adversely affect Capital Crossing Preferred’s ability to satisfy the share ownership requirements in the future.

 

 

 

 

 

PART II

 

Dividend Policy

 

Capital Crossing Preferred currently expects to pay an aggregate amount of dividends with respect to its outstanding shares of capital stock equal to substantially all of its REIT taxable income. In order to remain qualified as a REIT, Capital Crossing Preferred must distribute annually at least 90% of its REIT taxable income, excluding capital gains, to stockholders. Because in general it will be in Capital Crossing Preferred’s interest, and in the interests of its stockholders, to remain qualified as a REIT, this tax requirement creates a significant incentive to declare and pay dividends when Capital Crossing Preferred has sufficient resources to do so. Lehman Bank, as holder of all of Capital Crossing Preferred’s common stock, controls the election of all of its directors and also has a significant interest in having full dividends paid on its preferred shares. Capital Crossing Preferred anticipates that none of the dividends on outstanding preferred shares will constitute non-taxable returns of capital.

 

Dividends will be declared at the discretion of the Board of Directors after considering Capital Crossing Preferred’s distributable funds, financial requirements, tax considerations and other factors. Capital Crossing Preferred’s distributable funds will consist primarily of interest and principal payments on the mortgage assets, and Capital Crossing Preferred anticipates that a significant portion of such assets will earn interest at adjustable rates. Accordingly, if there is a decline in interest rates, Capital Crossing Preferred will experience a decrease in income available to be distributed to its stockholders. In a period of declining interest rates, Capital Crossing Preferred also may find it difficult to purchase additional mortgage assets bearing rates sufficient for it to be able to pay dividends on the Series D preferred shares.

 

The OTS’s prompt corrective action regulations prohibit entities such as Lehman Bank from making “capital distributions,” which include a transaction that the OTS determines, by order or regulation, to be “in substance a distribution of capital,” unless the institution is at least adequately capitalized after the distribution. There can be no assurances that the OTS would not seek to restrict Capital Crossing Preferred’s payment of dividends on the Series D preferred shares under these regulations if Lehman Bank were to fail to maintain a status of at least adequately capitalized. Currently, an institution is considered adequately capitalized if it has a total risk-based capital ratio of at least 8.0%, a Tier 1 risk-based capital ratio of at least 4.0% and a Tier 1 leverage ratio of at least 4.0%. At December 31, 2007, Lehman Bank’s total risk-based capital ratio was 13.52%, Tier 1 risk-based capital ratio was 11.66% and Tier 1 leverage ratio was 11.99%, per the Thrift Financial Report filed with the OTS.

 

In addition, the automatic exchange of shares of Lehman Bank preferred stock for shares of Capital Crossing Preferred Series D preferred shares may take place under circumstances in which Lehman Bank will be considered less than adequately capitalized for purposes of the OTS’s prompt corrective action regulations. Thus, at the time of the automatic exchange, Lehman Bank would likely be prohibited from paying dividends on its preferred shares, including its preferred shares issued in exchange for Capital Crossing Preferred’s Series D preferred shares. Further, Lehman Bank’s ability to pay dividends on its preferred shares following the automatic exchange also would be subject to various restrictions under OTS regulations and a resolution of Lehman Bank’s Board of Directors. If Lehman Bank did pay dividends on its preferred shares, such dividends would be paid out of its capital surplus.

 

Under certain circumstances, including a determination that Lehman Bank’s relationship with Capital Crossing Preferred results in an unsafe and unsound banking practice, federal and state regulatory authorities will have additional authority to restrict Capital Crossing Preferred’s ability to make dividend payments to its stockholders.

 

 

 

 

This Annual Report on Form 10-K contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, and Section 27A of the Securities Act of 1933, as amended. For purposes of these Acts, any statement that is not a statement of historical fact may be deemed a forward-looking statement. For example, statements containing the words “believes,” “anticipates,” “plans,” “expects,” “estimates,” “intends,” “may,” “projects,” “will,” “would,” and similar expressions may be forward-looking statements. Capital Crossing Preferred cautions investors not to place undue reliance on any forward-looking statements in this Annual Report on Form 10-K. Capital Crossing Preferred undertakes no obligation to publicly update any forward-looking statements, whether as a result of new information, future events or otherwise. There are a number of factors that could cause Capital Crossing Preferred’s actual results to differ materially from those indicated by these forward-looking statements, including without limitation the factors set forth below under “Item 1A. RISK FACTORS”. These factors and the other cautionary statements made in this annual report should be read as being applicable to all related forward-looking statements wherever they appear in this annual report. If one or more of these factors materialize, or if any underlying assumptions prove incorrect, Capital Crossing Preferred’s actual results, performance, or achievements may vary materially from any future results, performance, or achievements expressed or implied by these forward-looking statements.

 

Executive Level Overview

 

On February 14, 2007 the merger of Capital Crossing into Lehman Bank was completed. As a result, Lehman Bank owns all of Capital Crossing Preferred’s common stock. On January 29, 2007, Capital Crossing Preferred’s Board of Directors voted to redeem the Series A preferred shares and Series C preferred shares and on March 23, 2007, Capital Crossing Preferred redeemed the Series A and Series C preferred shares. The Series B preferred shares and Series D preferred shares remain outstanding and remain subject to their existing terms and conditions, including their respective call features.

 

Net income available to common shareholder decreased $1.3 million, or 24.1%, to $4.2 million in 2007 compared to $5.6 million in 2006 and decreased $339,000 or 5.7%, in 2006 compared to $5.9 million for 2005. The decrease from 2006 to 2007 is primarily the result of a decline in interest income and a decrease in gains on sales of loans. This decrease was partially offset by a decrease in preferred stock dividends due to the redemption of the Series A and Series C preferred shares on March 23, 2007. The decrease from 2005 to 2006 is primarily the result of declines in interest income offset by an increase in gain on sale of loans. The decreases in interest income for both 2007 and 2006 are primarily due to a smaller loan portfolio as a result of loan amortization and repayments.

 

All of the mortgage assets in Capital Crossing Preferred’s loan portfolio at December 31, 2007 were acquired from Capital Crossing, previously the sole common shareholder, and it is anticipated that substantially all additional mortgage assets will be acquired from Lehman Bank, currently the sole common shareholder. As of December 31, 2007, Capital Crossing Preferred held loans acquired from Capital Crossing with net investment balances of $66.7 million.

 

Commercial mortgage loans constituted approximately 62.1% of the total loans in Capital Crossing Preferred’s loan portfolio at December 31, 2007. Commercial mortgage loans are generally subject to greater risks than other types of loans. Capital Crossing Preferred’s commercial mortgage loans, like most commercial mortgage loans, generally lack standardized terms, tend to have shorter maturities than other mortgage loans and may not be fully amortizing. For these reasons, Capital Crossing Preferred may experience higher rates of default on its mortgage loans than it would if its loan portfolio was more diversified and included a greater number of owner-occupied residential or other mortgage loans.

 

Properties underlying Capital Crossing Preferred’s current mortgage assets are also concentrated primarily in California and New England. As of December 31, 2007, approximately 59.0% of the balances of its mortgage loans were secured by properties located in California and 6.8% in New England. In the instance

where either region experienced adverse economic, political or business conditions or natural disasters, Capital Crossing Preferred would likely experience higher rates of loss and delinquency on its mortgage loans.

 

Since Capital Crossing Preferred is a subsidiary of Lehman Bank, federal and state regulatory authorities will have the right to examine it and its activities and under certain circumstances, to impose restrictions on Lehman Bank or Capital Crossing Preferred which could impact Capital Crossing Preferred’s ability to conduct its business according to its business objectives. For instance, if Lehman Bank’s regulators determine that Lehman Bank’s relationship to Capital Crossing Preferred results in an unsafe and unsound banking practice, the regulators could restrict Capital Crossing Preferred’s ability to transfer assets, to make distributions to its stockholders or even require Lehman Bank to sever its relationship with or divest its ownership interest in Capital Crossing Preferred.

 

Decisions regarding the utilization of Capital Crossing Preferred’s cash are based, in large part, on its future commitments to pay preferred stock dividends. During 2007, the loan portfolio was large enough to generate income resulting in net income, which was 2.06 times preferred stock dividends. Future decisions regarding mortgage asset acquisitions and returns of capital will be based on the level of preferred stock dividends at the time and the required level of income necessary to generate adequate dividend coverage.

 

Application of Critical Accounting Policies and Estimates

 

The SEC requested that all registrants discuss their most “critical accounting policies” in management’s discussion and analysis of financial condition and results of operations. The SEC indicated that a “critical accounting policy” is one which is both important to the portrayal of the company’s financial condition and results and requires management’s most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain. While Capital Crossing Preferred’s significant accounting policies are more fully described in Note 1 to the Financial Statements, the following is a summary of the accounting policies believed by management to be most critical in their potential effect on Capital Crossing Preferred’s financial position or results of operations:

 

Discounts on Acquired Loans.   In accordance with SOP No. 03-3, Capital Crossing Preferred reviews acquired loans for differences between contractual cash flows and cash flows expected to be collected from Capital Crossing Preferred’s initial investment in the acquired loans to determine if those differences are attributable, at least in part, to credit quality. If those differences are attributable to credit quality, the loan’s contractually required payments receivable in excess of the amount of its cash flows expected at acquisition, or nonaccretable discount, is not accreted into income. SOP No. 03-3 requires that Capital Crossing Preferred recognize the excess of all cash flows expected at acquisition over Capital Crossing Preferred’s initial investment in the loan as interest income using the interest method over the term of the loan. This excess is referred to as accretable discount.

 

No loans acquired since the adoption of SOP No. 03-3 were within the scope of the SOP.

 

Loans which, at acquisition, do not have evidence of deterioration of credit quality since origination are outside the scope of SOP No. 03-3. For such loans, the discount, representing the excess of the amount of reasonably estimable and probable discounted future cash collections over the purchase price, is accreted into interest income using the interest method over the term of the loan. Prepayments are not considered in the calculation of accretion income. Additionally, discount is not accreted on non-performing loans.

 

There is judgment involved in estimating the amount of Capital Crossing Preferred’s future cash flows on acquired loans. The amount and timing of actual cash flows could differ materially from management’s estimates, which could materially affect Capital Crossing Preferred’s financial condition and results of operations. Depending on the timing of an acquisition of loans, a preliminary allocation may be utilized until a final allocation is established. Generally, the allocation will be finalized no later than ninety days from the date of purchase.

 

If cash flows cannot be reasonably estimated for any loan, and collection is not probable, the cost recovery method of accounting is used. Under the cost recovery method, any amounts received are applied against the recorded amount of the loan. Nonaccretable discount is generally offset against the related principal

balance when the amount at which a loan is resolved or restructured is determined. There is no effect on the income statement as a result of these reductions.

 

Subsequent to acquisition, if cash flow projections improve, and it is determined that the amount and timing of the cash flows related to the nonaccretable discount are reasonably estimable and collection is probable, the corresponding decrease in the nonaccretable discount is transferred to the accretable discount and is accreted into interest income over the remaining life of the loan on the interest method. If cash flow projections deteriorate subsequent to acquisition, the decline is accounted for through a provision for loan losses included in earnings.

 

Allowance for Loan Losses.   Arriving at an appropriate level of allowance for loan losses requires a high degree of judgment. Capital Crossing Preferred maintains an allowance for probable loan losses that are inherent in its loan portfolio. The allowance for loan losses is increased or decreased through a provision for loan losses or a reduction in the allowance for loan losses included in earnings.

 

In determining the adequacy of the allowance for loan losses, management makes significant judgments. Management initially reviews its loan portfolio to identify loans for which specific allocations are considered prudent. Specific allocations include the results of measuring impaired loans under Statement of Financial Accounting Standards (“SFAS”) No. 114 “Accounting by Creditors for Impairment of a Loan”. Next, management considers the level of loan allowances deemed appropriate for loans determined not to be impaired under SFAS No. 114. The allowance for these loans is determined by a formula whereby the portfolio is stratified by type and internal risk rating categories. Loss factors are then applied to each strata based on various considerations including collateral type, loss experience, delinquency trends, current economic conditions, industry standards, and regulatory guidelines. The allowance for loan losses is management’s estimate of the probable loan losses incurred as of the balance sheet date. There can be no assurance that Capital Crossing Preferred’s actual losses with respect to loans will not exceed its allowance for loan losses.

 

The allowance for loan losses is increased through a provision for loan losses included in earnings when evidence indicates that there has been a decrease in estimated cash flows expected to be collected. The allowance for loan losses is decreased upon sales or payoffs of loans for which a related allowance remains unused. Reductions in connection with sales are included in the calculation of the gain or loss, and reductions related to payoffs are recorded as a reduction in the allowance for loan losses included in earnings. Loan losses are charged against the allowance when management believes the net investment of the loan, or a portion thereof, is uncollectible. Subsequent recoveries, if any, are credited to the allowance when cash payments are received. It is anticipated that the allowance will continue to decline as reductions in the allowance for loan losses may continue to be recorded if loans pay off and allowance allocations related to these loans are not required or if additions due to loan impairment are not required.

 

 

 

 

The decline in interest income from 2006 to 2007 is a result of a decrease in the average balance of loans and by a decrease in the yield on loans. Average loans, net for 2007 totaled $79.8 million compared to $105.0 million for 2006. This decrease is primarily attributable to pay-offs, sales and amortization of loans. For 2007, the yield on the loan portfolio decreased to 9.11% compared to 9.35% for 2006. During 2007, the yield related to interest and fee income recognized on loan payoffs decreased to 1.11% compared to 1.25% for 2006. The level of interest and fee income recognized on loan payoffs varies for numerous reasons, as further discussed below. The yield from regularly scheduled interest and accretion income decreased to 8.00% for 2007 from 8.10% for 2006 primarily as a result of decreases in market interest rates. The interest rate on interest-bearing deposits increased to 1.23% for 2007 compared to 1.10% for 2006 as a result of an increased rate paid by Lehman Bank compared to the rate paid by Capital Crossing.

 

The decline in interest income from 2005 to 2006 is a result of a decrease in the average balance of loans offset, in part, by an increase in the yield on loans. Average loans, net for 2006 totaled $105.0 million compared to $123.4 million for 2005. This decrease is primarily attributable to pay-offs, sales and amortization of loans. For 2006, the yield on the loan portfolio increased to 9.35% compared to 9.16% for 2005. During 2006, the yield related to interest and fee income recognized on loan payoffs decreased to 1.25% compared to 1.33% for 2005. The level of interest and fee income recognized on loan payoffs varies for numerous reasons, as further discussed below. The yield from regularly scheduled interest and accretion income increased to 8.10% for 2006 from 7.83% for 2005 primarily as a result of increases in market interest rates. The interest rate on interest-bearing deposits remained unchanged from 2005 to 2006.

 

Income on loans includes the portion of the purchase discount that is accreted into income over the remaining lives of the related loans using the interest method. Because the carrying value of the loan portfolio is net of purchase discount, the related yield on this portfolio generally is higher than the aggregate contractual rate paid on the loans. The total yield includes the excess of a loan’s expected discounted future cash flows over its net investment, recognized using the interest method.

 

When a loan is paid-off, the excess of any cash received over the net investment is recorded as interest income. In addition to the amount of purchase discount that is recognized at that time, income may also include interest owed by the borrower prior to Capital Crossing’s acquisition of the loan, interest collected if on non-performing status and other loan fees (“other interest and fee income”). The following table sets forth, for the years indicated, the components of interest and fees on loans. There can be no assurance regarding future interest income, including the yields and related level of such income, or the relative portion attributable to loan pay-offs as compared to other sources.

 

 

The amount of loan pay-offs and related discount income is influenced by several factors, including the interest rate environment, the real estate market in particular areas, the timing of transactions, and circumstances related to individual borrowers and loans. The amount of individual loan payoffs is often a result of negotiations between Capital Crossing Preferred and the borrower. Based upon credit risk analysis and other factors, Capital Crossing Preferred will, in certain instances, accept less than the full amount contractually due in accordance with the loan terms.

The average balance of interest-bearing deposits decreased $29.8 million to $70.5 million for 2007 compared to $100.2 million for 2006 and increased $3.3 million to $100.2 million for 2006 compared to $96.9 million for 2005. The changes in the average balances of interest-bearing deposits are the result of periodic dividend payments, and returns of capital, offset by cash flows from loan repayments and proceeds from sales of loans.

 

Reductions in allowance for loan losses

 

Capital Crossing Preferred recorded reductions in the allowance for loan losses of $339,000, $406,000 and $516,000 for the years ended December 31, 2007, 2006 and 2005, respectively, to reverse unused loss reserves related to loans that have been paid off. The reduction in the allowance for loan losses is based on the volume and types of loan payoffs. As loans pay off, a reduction in the allowance for loan losses is recorded to reduce allowance allocations related to the loans that have paid-off for which a related allowance remains unused. The allowance for loan losses is based on the size of the portfolio and its historical performance. The determination of this allowance requires management’s use of estimates and assumptions regarding the risks inherent in individual loans and the loan portfolio in its entirety. Should the loan portfolio continue to decline without utilization of the allowance for loan losses, future reductions in the allowance for loans losses may be necessary.

 

Other income

 

During 2007, there was one loan sale to an unaffiliated third party comprised of two loans with carrying values of $333,000, resulting in a total gain of $46,000. During 2006, there were three loan sales to unaffiliated third parties comprised of a total of six loans, with carrying values of $1.6 million, resulting in a total gain of $1.0 million. There were no loan sales during 2005.

 

On May 18, 2007, Lehman Bank paid off all its remaining outstanding FHLBB advances. Prior to that, Capital Crossing Preferred had guaranteed all of the obligations of Lehman Bank under advances Lehman Bank had received from the FHLBB. These FHLBB obligations were assumed by Lehman Bank pursuant to the merger. As a result of the repayment, the guarantee was released. Capital Crossing Preferred received an annual fee of $80,000 under this agreement. Guarantee fee income for the years ended December 31, 2007, 2006 and 2005 was $30,000, $80,000 and $80,000, respectively.

 

Operating expenses

 

Loan servicing and advisory expenses decreased $109,000, or 36.5%, to $190,000 in 2007 from $299,000 in 2006 and decreased by $44,000, or 12.8%, from $343,000 in 2005. The decrease in 2007 is primarily the result of a reimbursement of $54,000 in loan expenses collected from a borrower at the time of payoff that were previously expensed by Capital Crossing Preferred as well as a decrease in the average balance of the loan portfolio. The decrease in 2006 is primarily the result of a decrease in the average balance of the loan portfolio.

 

Other general and administrative expenses increased $82,000, or 303.7%, to $109,000 from $27,000 in 2006 and decreased $141,000, or 83.9%, from $168,000 in 2005. The increase in 2007 is attributable to an increase in external audit expenses, a decrease in legal fee reimbursements collected from borrowers previously expensed by Capital Crossing Preferred related to certain loan collection matters, partially offset by a decrease in legal fees related to loan collection matters. The decrease in 2006 is primarily attributable to an increase in legal fee reimbursements collected from borrowers previously expensed by Capital Crossing Preferred related to certain loan collection matters.

 

Preferred stock dividends

 

Preferred stock dividends decreased in 2007 due to the redemption of the Series A and Series C preferred shares on March 23, 2007. Capital Crossing Preferred intends to pay dividends on its preferred stock and common stock in amounts necessary to continue to preserve its status as a REIT under the Internal Revenue Code.

Financial Condition

 

Interest-bearing Deposits with Parent

 

Interest-bearing deposits with parent consist entirely of money market accounts. The balance of interest-bearing deposits decreased $33.3 million to $50.4 million at December 31, 2007 compared to $83.7 million at December 31, 2006. The decrease in the balance of interest-bearing deposits is the result of the redemption of the Series A and Series C preferred shares, periodic dividend payments and returns of capital, offset by cash flows from loan repayments and loan sales.

 

 

Capital Crossing Preferred acquires primarily performing commercial real estate and multifamily residential mortgage loans. During 2006 and 2007, Capital Crossing Preferred did not acquire any loans from Capital Crossing or Lehman Bank.

 

Capital Crossing Preferred intends that each loan acquired from Lehman Bank in the future will be a whole loan, and will be originated or acquired by Lehman Bank in the ordinary course of its business. Capital Crossing Preferred also intends that all loans held by it will be serviced pursuant to the master service agreement with Lehman Bank.

 

There were no non-performing loans at December 31, 2007. Non-performing loans, net of discount, totaled $416,000 at December 31, 2006. Loans generally are placed on non-performing status and the accrual of interest and accretion of discount are generally discontinued when the collectibility of principal and interest is not probable or estimable. Unpaid interest income previously accrued on such loans is reversed against current period interest income. A loan is returned to accrual status when it is brought current in accordance with management’s anticipated cash flows at the time of acquisition and collection of principal and interest is probable and estimable.

 

Interest Rate Risk

 

Capital Crossing Preferred’s income consists primarily of interest income. If there is a decline in market interest rates, Capital Crossing Preferred may experience a reduction in interest income and a corresponding decrease in funds available to be distributed to its shareholders. The reduction in interest income may result from downward adjustments of the indices upon which the interest rates on loans are based and from prepayments of mortgage loans with fixed interest rates, resulting in reinvestment of the proceeds in lower yielding mortgage loans. Capital Crossing Preferred does not intend to use any derivative products to manage its interest rate risk.

Significant Concentration of Credit Risk

 

Concentration of credit risk generally arises with respect to Capital Crossing Preferred’s loan portfolio when a number of borrowers engage in similar business activities, or activities in the same geographical region. Concentration of credit risk indicates the relative sensitivity of Capital Crossing Preferred’s performance to both positive and negative developments affecting a particular industry. Capital Crossing Preferred’s balance sheet exposure to geographic concentrations directly affects the credit risk of the loans within its loan portfolio.

 

At December 31, 2007, 59.0% and 6.8% of Capital Crossing Preferred’s net real estate loan portfolio consisted of loans located in California and New England, respectively. At December 31, 2006, 54.3% and 12.0% of Capital Crossing Preferred’s net loan portfolio consisted of loans in California and New England, respectively. Consequently, the portfolio may experience a higher default rate in the event of adverse economic, political or business developments or natural hazards in California or New England that may affect the ability of property owners to make payments of principal and interest on the underlying mortgages.

 

Liquidity Risk Management

 

The objective of liquidity management is to ensure the availability of sufficient cash flows to meet all of Capital Crossing Preferred’s financial commitments and to capitalize on opportunities for Capital Crossing Preferred’s business expansion. In managing liquidity risk, Capital Crossing Preferred takes into account various legal limitations placed on a REIT.

 

Capital Crossing Preferred’s principal liquidity needs are:

 

 

The acquisition of additional mortgage assets is intended to be funded primarily through repayment of principal balances of mortgage assets by individual borrowers. Capital Crossing Preferred does not have and does not anticipate having any material capital expenditures. To the extent that the Board of Directors determines that additional funding is required, Capital Crossing Preferred may raise such funds through additional equity offerings, debt financing or retention of cash flow (after consideration of provisions of the Internal Revenue Code requiring the distribution by a REIT of at least 90% of its REIT taxable income and taking into account taxes that would be imposed on undistributed income), or a combination of these methods. Capital Crossing Preferred does not currently intend to incur any indebtedness. The organizational documents of Capital Crossing Preferred limit the amount of indebtedness which it is permitted to incur without the approval of the Series D preferred stockholders to no more than 100% of the total stockholders’ equity of Capital Crossing Preferred. Any such debt may include intercompany advances made by Lehman Bank to Capital Crossing Preferred.

 

Capital Crossing Preferred may also issue additional series of preferred stock. However, Capital Crossing Preferred may not issue additional shares of preferred stock ranking senior to the Series D preferred shares without the consent of holders of at least two-thirds of the Series D preferred shares, each voting as a separate class, outstanding at that time. Although Capital Crossing Preferred’s charter does not prohibit or otherwise restrict Lehman Bank or its affiliates from holding and voting shares of Series D preferred stock, to Capital Crossing Preferred’s knowledge the amount of shares of Series D preferred shares held by Lehman Bank or its affiliates is insignificant (less than 1%). Additional shares of preferred stock ranking on a parity with the Series D preferred shares may not be issued without the approval of a majority of Capital Crossing Preferred’s independent directors.

 

Impact of Inflation and Changing Prices

 

Capital Crossing Preferred’s asset and liability structure is substantially different from that of an industrial company in that virtually all assets of Capital Crossing Preferred are monetary in nature. Management believes

the impact of inflation on financial results depends upon Capital Crossing Preferred’s ability to react to changes in interest rates and by such reaction, reduce the inflationary impact on performance. Interest rates do not necessarily move in the same direction, or at the same magnitude, as the prices of other goods and services.

 

Various information shown elsewhere in this annual report will assist the reader in understanding how Capital Crossing Preferred is positioned to react to changing interest rates and inflationary trends. In particular, the discussion of market risk and other maturity and repricing information of Capital Crossing Preferred’s assets is contained in Item 7A, Quantitative and Qualitative Disclosure About Market Risk, of this annual report.

 

 

 

 

REPORT OF INDEPENDENT REGISTERED ACCOUNTING FIRM

 

The Board of Directors and Stockholders of

Capital Crossing Preferred Corporation:

 

We have audited the accompanying balance sheet of Capital Crossing Preferred Corporation, as of December 31, 2007 and the related statements of income, changes in stockholders’ equity and cash flows for the year then ended. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audit. The financial statements of Capital Crossing Preferred Corporation for the year ended December 31, 2006, were audited by other auditors whose report dated January 30, 2007, expressed an unqualified opinion on those statements.

 

We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. We were not engaged to perform an audit of the Company’s internal control over financial reporting. Our audit included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.

 

In our opinion, the 2007 financial statements referred to above present fairly, in all material respects, the financial position of Capital Crossing Preferred Corporation as of December 31, 2007, and the results of its operations and its cash flows for the year ended December 31, 2007 in conformity with United States generally accepted accounting principles.

 

As discussed in note 1 to the financial statements, in 2007 the Company has adopted Financial Accounting Standards Board Interpretation No. 48, “Accounting for Uncertainty in Income Taxes — an Interpretation of FASB Statement No. 109.”

 

 

Boston, Massachusetts

March 21, 2008

 

See accompanying notes to financial statements.