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

 

 

 

 

Form 10-K

 

 

Commission file number 001-11981

 

MUNICIPAL MORTGAGE & EQUITY, LLC

(Exact name of registrant as specified in its charter)

 

 

Registrant’s telephone number, including area code

(443) 263-2900

 

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

 

 

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

Common Shares

 

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 o     No þ

 

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 statements 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):

(Do not check if a smaller reporting company)

 

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 aggregate market value of our common shares held by non-affiliates was $112,130,694 based on the last sale price as reported in the over the counter market on June 30, 2008.

 

Number of shares of Common Shares outstanding as of December 31, 2008: 39,382,641.

 

DOCUMENTS INCORPORATED BY REFERENCE

 

The following documents have been incorporated by reference into this Form 10-K as indicated: None.

 

 

Municipal Mortgage & Equity, LLC

 

TABLE OF CONTENTS

 

Index to Financial Statements

 

 

This Report contains forward-looking statements intended to qualify for the safe harbor contained in Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Forward-looking statements often include words such as “may,” “will,” “should,” “anticipate,” “estimate,” “expect,” “project,” “intend,” “plan,” “believe,” “seek,” “would,” “could,” and similar words or are made in connection with discussions of future operating or financial performance.

 

Forward-looking statements reflect our management’s expectations at the date of this Report regarding future conditions, events or results. They are not guarantees of future performance. By their nature, forward-looking statements are subject to risks and uncertainties. Our actual results and financial condition may differ materially from what is anticipated in the forward-looking statements. There are many factors that could cause actual conditions, events or results to differ from those anticipated by the forward-looking statements contained in this Report. They include the factors discussed in Item 1A. Risk Factors.

 

Readers are cautioned not to place undue reliance on forward-looking statements in this Report or that we make from time to time, and to consider carefully the factors discussed in Item 1A. Risk Factors in evaluating these forward-looking statements. We have not undertaken to update any forward-looking statements.

 

The 2004 and 2005 consolidated financial statements included in this Annual Report (“Report”) on Form 10-K have been restated from the consolidated financial statements for those years included in our Report on Form 10-K for the year ended December 31, 2005. Further, the 2004 consolidated financial statements have been restated from the 2004 consolidated financial statements included in our Report on Form 10-K for the year ended December 31, 2004.

 

The consolidated financial statements included in this Report, including the restated 2004 and 2005 consolidated financial statements, were audited by KPMG LLP (“KPMG”). The 2004 and 2005 consolidated financial statements included in our Report on Form 10-K for the year ended December 31, 2005 were audited by PricewaterhouseCoopers, LLP (“PwC”).

 

The principal changes resulting from the restatement of our 2004 and 2005 consolidated financial statements, include the following (see “Notes to Consolidated Financial Statements-Note 2, Restatement of Previously Issued Financial Statements” for more information):

 

 

Item 6.  Selected Financial Data included in this Report presents consolidated income statement data for years ended December 31, 2006, 2005 and 2004 and consolidated balance sheet data at December 31, 2006, 2005, 2004, and 2003. Preparing restated standalone consolidated income statement data for years ended December 31, 2002 and 2003 (as well as consolidated balance sheet data at December 2002) would have been very costly and would have significantly delayed the filing of this Report. Because it has been more than five years since December 31, 2003, we believe that restated financial data related to 2003 and years prior would be only marginally beneficial and would not have justified either the cost or the delay that would have been required to prepare it. Accordingly, we did not deem it practical to include selected financial data for those years; however, as part of the restatement, we have properly reflected the cumulative effect of the restatement in our beginning balance of shareholders’ equity at December 31, 2003.

 

This Report does not contain quarterly information for years ended December 31, 2006 and 2005 nor do we plan to provide this information through subsequent Securities and Exchange Commission (“SEC”) filings. Preparing and providing this information would be costly, would be only marginally beneficial to our investors and would serve only to delay the filing of this Report as well as future filings which will provide our 2007 and 2008 financial position and results of operations.

 

Item 9A.  Controls and Procedures includes our Management’s Report on Internal Control Over Financial Reporting. SEC rules require that management evaluate the effectiveness, as of the end of each fiscal year, of the Company’s internal control over financial reporting on a suitable, recognized framework that is established by a body or group that has followed due process procedures, including broad distribution of the framework for public comments. Our management began its evaluation based on such a framework, but when, at a relatively early stage of the evaluation, it became clear that there were material weaknesses in our internal control over financial reporting at December 31, 2006 (which are described in Item 9A. Controls and Procedures) that made them not effective at that date, we terminated the process without completing the evaluation and focused our time and attention on the restatement effort. This allowed us the ability to more fully devote our accounting resources to restating our 2005 and 2004 financial statements and preparing our 2006 financial statements. However, as a result, our management did not complete its assessment of the effectiveness of our internal control over financial reporting at December 31, 2006 and our independent registered public accounting firm has not been able to render an opinion on the effectiveness of our internal control over financial reporting.

 

Although this Report relates to the year ended December 31, 2006, certain information is presented as of the time this Report is being filed, rather than as of December 31, 2006. In particular, except as expressly stated, the information in Item 1. Business, Item 1A. Risk Factors, Item 2. Properties and Item 3. Litigation, as well as information about prices of our common shares and dividends in Item 5. Market for Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of Equity Securities, is presented as of the time this Report is being filed or as close to the time this Report is filed as is practical. Our business and financial condition at the date this Report is being filed are very different from what they were at December 31, 2006.

 

 

Except as expressly indicated or unless the context otherwise requires, “the Company,” “MuniMae,” “we,” “our” or “us” means Municipal Mortgage & Equity, LLC, a Delaware limited liability company, and its majority owned subsidiaries.

 

Although this Report is for the year ended December 31, 2006, unless otherwise noted, the description below is of our business as it exists on the date of this Report.

 

Overview

 

We were organized in 1996 as a Delaware limited liability company and are classified as a partnership for federal income tax purposes. We have essentially the same limited liability, governance and management structures as a corporation, but we are treated as a pass-through entity for federal income tax purposes. Thus, our shareholders include their distributive shares of our income, deductions and credits on their tax returns. Among other things, this allows us to pass-through tax-exempt interest income to our shareholders. Many of our subsidiaries also are pass-through entities, and our taxable income, deductions and credits that are reflected on our shareholders’ tax returns include the income, deductions and credits of those subsidiaries. However, other of our subsidiaries are corporations that pay taxes on their own taxable income. Our income, deductions and credits that are reflected on our shareholders’ tax returns do not include the income of those subsidiaries, but include any taxable dividends or other taxable distributions we receive from them. Tax information is provided to our shareholders on Schedule K-1 rather than on Form 1099.

 

We have been severely affected by market conditions since late 2007. Because of these market conditions, many of the entities that in the past have been principal investors in funds we form were not interested in investing in 2008 (and continue not to be interested in investing in early 2009). That forced us to curtail many of our activities. It also deprived us of access to funds we had expected would be used to meet investment commitments we had made. Our access to funds was also reduced when markets for securitized financial assets essentially shut down beginning in the fall of 2007. Then, because of a sharp decline in the market value of both our tax-exempt debt securities and our interest rate hedges in February 2008 and subsequent months, we were required to post substantial amounts of additional collateral, including cash, to meet our collateral requirements. The combination of these factors led us to have serious liquidity problems during most of the second, third and fourth quarters of 2008, which continues into 2009. That, in turn, led us to curtail many of our operations, to engage in the sale of certain of our business segments and to sell assets at distressed prices, in many instances, for less than the amounts of the borrowings they secured. Because of our failure to provide consolidated financial statements to our lenders when required by applicable loan documents or to make periodic filings with the SEC when they are due, many of our lenders have the right to exercise default remedies which would allow them to demand repayment of our indebtedness or that we post additional collateral. We have little or no available funds or assets to post as collateral or with which to repay borrowings. These circumstances have led our independent registered public accounting firm to include in its February 11, 2009 auditors’ report, an explanatory paragraph stating that there is substantial doubt relating to our ability to continue as a going concern. Although we have been selling assets in order to meet our liquidity needs, (see “Recent and Proposed Transactions and Termination of a Business” and “Notes to Consolidated Financial Statements-Note 21, Liquidity and Going Concern Uncertainty”), we continue to have liquidity problems. The description of our business in this Report must be read with that in mind.

 

Our business consists primarily of activities involving investments and financings secured by, or otherwise related to, multifamily or commercial real estate, the majority of which generates tax-exempt income, tax credits or other tax benefits for investors. We have also been engaged in the financing of renewable energy generation projects, which also generates tax credits and other tax benefits for investors. In addition, we have, until very recently, provided investment management services to a limited number of institutional investors. Generally we invest for our own account by acquiring tax-exempt bonds secured by low income housing projects, in which we may have a very small equity investment through funds we sponsor and manage on

behalf of institutional investors (“Low Income Housing Tax Credit Equity Funds” or “LIHTC Funds”). We also originate loans for our own account and for sale to others. The majority of our loan business is related to construction loans on multifamily projects that we hold until construction completion and then we provide permanent financing on these projects. Generally these permanent loans are sold to government sponsored enterprises (“GSEs”), primarily Federal National Mortgage Association (“Fannie Mae”) and Federal Home Loan Mortgage Corporation (“Freddie Mac”), or are insured by the U.S. Department of Housing and Urban Development (“HUD”) and sold to investors as securitized mortgage backed securities after they are guaranteed by the government agency Government National Mortgage Association (“Ginnie Mae”). After the sale we continue to service these loans, earning loan servicing fees over the life of the loan. At December 31, 2008 total loans that we serviced related to these GSEs and agencies was $6.9 billion. We also distribute and place commercial real estate loans into funds we manage for institutional investors, although we may hold these loans for short periods of time until they are placed in a fund. At December 31, 2008 we had approximately $2.5 billion in investments we directly owned, although some of these were to be held by us only for a short period of time until they were placed into a fund or sold. However, most of our activities have involved investments by funds we sponsor and manage. These funds are normally limited partnerships of which one of our subsidiaries is the general partner or limited liability companies of which one of our subsidiaries is the managing member. At December 31, 2008, funds or other entities we managed owned investment assets with unpaid principal balances and outstanding equity totaling $10.8 billion, the majority of which is related to the LIHTC Funds. Normally, we have taken small ownership interests in funds we manage and we have received fees for forming and managing the funds, as well as for finding, arranging and servicing investments for the funds. Typically, a small number of financial institutions or large companies have invested in funds we formed. However, in some instances a single investor has acquired the entire interest in a fund, other than our small interest as the general partner or manager. In addition, we have been managing investment pools for a number of pension funds and insurance companies. However, outside of our LIHTC Funds, most of our arrangements to manage assets for unrelated institutional investors have been, or are in the process of being, terminated.

 

There is a significant difference between the assets and liabilities reflected on our consolidated balance sheet prepared under U.S. generally accepted accounting principals (“GAAP”) and those assets that we view as legally owned by us or liabilities we are directly obligated on. Our December 31, 2006 consolidated balance sheet reflected consolidated total assets of $8.5 billion and consolidated shareholders’ equity of $667.9 million. However, our December 31, 2006 consolidated balance sheet included $4.9 billion of assets and $2.0 billion of liabilities of over 200 funds and partnerships in which we (MuniMae and its majority owned subsidiaries) had little or no ownership interest, but the assets and liabilities of which are required to be consolidated primarily due to FIN 46(R). Although it would not be in accordance with GAAP to exclude the impact of these consolidated funds and ventures from our consolidated financial statements, information that excludes these funds and ventures helps our management, and we believe will help investors, to understand which assets MuniMae has a direct or indirect economic interest in, and the liabilities that MuniMae or entities it owns could be required to pay. Without the assets and liabilities of these consolidated funds and ventures, (but including assets that were eliminated as part of the consolidation) MuniMae and its owned subsidiaries had at December 31, 2006, total assets of $3.9 billion and $3.2 billion in total liabilities, including perpetual preferred stock of a subsidiary. See Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations — “Results of Operations — Summary of GAAP-adjusted Results.”

 

The consolidation of these entities also affects our reported revenues, because certain fees and other payments received from such consolidated entities are not reflected as revenues but are reflected as income allocated to us in the consolidated statement of operations. We must also record losses related to these entities even though the Company itself has no expectation to fund those losses, other than possible losses related to the actual investments we may already have in those entities. We have recorded cumulative pre-tax losses related to these entities totaling approximately $90.0 million through December 31, 2006. The majority of these losses would be reversed upon a qualifying sale of our interests that would allow us to deconsolidate these entities. However, that may not occur for a substantial period of time, if at all, because some of the interests are held to protect tax-exempt bonds we hold or to protect the LIHTC Funds’ investments in these entities, and, indirectly, our guarantee of the yields of some LIHTC Funds.

Our principal offices are located at 621 E. Pratt Street, Suite 300, Baltimore, MD 21202. Our telephone number at those offices is (443) 263-2900. Our corporate website is located at http://www.munimae.com, and our filings under the Securities Exchange Act of 1934 are available through that site, as well as on the SEC’s website http://www.sec.gov. The information contained on our corporate website is not a part of this Report.

 

Effect of Current Market Conditions on Us

 

Beginning early in 2008, there was a major deterioration in the market for low income housing tax credits, tax-exempt bonds and other assets that are a major part of our business. This, combined with the factors that have affected credit markets and financial institutions throughout the nation, had a severe effect upon us during 2008, causing us to have to curtail significant aspects of our business and to sell assets at substantial losses to obtain funds to meet our commitments or to satisfy lenders. The values at which our assets are reflected in the financial statements at December 31, 2006 and prior years does not reflect these losses or reductions in the market values of those assets due to the deterioration in credit markets and other changes in market conditions in late 2007 and 2008. As a result of these on-going market conditions, we anticipate that our 2007 and 2008 financial statements will include substantial losses related to the deterioration in the market value of our bond portfolio and impairments to the value of loans and other assets, including goodwill and other intangibles related to acquisitions of businesses in prior years. The 2007 and 2008 financial statements will also include the impact of reduced revenues due to market conditions in 2007 and 2008, and additional costs related to the development and application of our accounting policies, the preparation and audit of our financial statements and on-going maintenance of our accounting and finance functions. Therefore there will be a substantial reduction in our net worth from what is presented in our December 31, 2006 consolidated balance sheet.

 

Some of the specific ways in which we were affected by conditions in credit markets generally and in our businesses specifically were as follows:

 

 

 

Currently, we are facing a significant shortage of liquid assets. The risks caused by this shortage are described under Item 1A. Risk Factors — “We have been forced to sell assets to raise funds we need to meet our cash needs” and Risk Factors — “If we were forced to sell all our pledged assets, the total sales price might not be sufficient to enable us to repay all our borrowings.” In addition, the fact that we do not have financial statements for any periods after December 31, 2006 is a default under many of our borrowing facilities and, in the absence of forbearance agreements, gives the lenders the right to require us to repay the sums we have borrowed, and if all of these loan amounts were currently declared due and payable, we would not have available resources sufficient to satisfy all of such loan amounts. This led our registered public accounting firm, KPMG, to include in its February 11, 2009 opinion regarding our financial statements an explanatory paragraph regarding substantial doubt about our ability to continue as a going concern.

 

The Evolution of Our Business

 

When we became a public company in 1996, we were primarily engaged in originating, investing in and servicing tax-exempt mortgage revenue bonds issued by state and local government authorities to finance affordable multifamily housing developments. Since becoming a public company, the following acquisitions have significantly expanded our business; however, in 2008, due to current market conditions, we began contracting our business (see “Recent and Proposed Transactions and Termination of a Business” for further details):

 

 

 

 

 

Historically, a significant portion of our income distributed to our shareholders has been tax-exempt. That is because we and many of our subsidiaries are treated as pass-through entities for federal income tax purposes, and therefore, our shareholders include their distributive shares of our income, deductions and credits, including our tax-exempt interest income and our tax credits, on their tax returns. However, certain aspects of our business are intended to generate taxable income through corporations that are themselves taxpayers, so only proceeds of dividends and interest we receive from them are taxable to our shareholders. During recent years, our business had increasingly involved activities that generated taxable income, and therefore the percentage of the distributions we made that was taxable to our shareholders was increasing. Then, in 2008, we incurred (and we passed onto our shareholders) capital losses for tax purposes due to bond sales and closing-out many of our derivative positions, income from tax-exempt interest and some taxable interest income. In May 2008, we suspended our long practice of paying quarterly dividends. However, despite the fact that we have suspended paying dividends, to the extent the activities we conduct through entities that are pass-through entities for federal income tax purposes generate taxable income, our shareholders will have to pay taxes on the portions of that taxable income that are allocable to their shareholdings. However, based on the share price paid by each investor, certain investors may have capital gains allocated to them.

 

Recent and Proposed Transactions and Termination of a Business

 

Agreement to sell Agency loan origination and servicing business

 

In December 2008, we agreed to sell our business of originating loans for sale to GSEs and servicing those loans to a newly formed subsidiary of Mud Duck Equities, LLC (“Mud Duck”). At the same time, we borrowed $10.0 million from the Mud Duck subsidiary for one year, at an interest rate of 20% per annum. In February 2009, we amended the transaction terms, and increased the sum we borrowed to $15.0 million. The total sale price will be $70.5 million, of which $23.5 million will be paid partly by return of the note evidencing the $15.0 million loan and the balance in cash, and the remaining $47.0 million will be treated as a contribution to the purchaser in exchange for which we will receive $15.0 million of Series A Preferred units, which will entitle us to cumulative quarterly cash distributions at the rate of 17.5% per year, $15.0 million of Series B Preferred units, which will entitle us to cumulative quarterly cash distributions at the rate of 14.5% per year, and $17.0 million of Series C Preferred units, which will entitle us to cumulative quarterly cash distributions at the rate of 11.5% per year. All three series of Preferred units are redeemable at the option of the purchaser (but not

at our option) for their liquidation preference plus any unpaid distributions. We have agreed to reimburse the purchaser, up to a maximum of $30.0 million, for payments the purchaser may be required to make under loss sharing arrangements with Fannie Mae and other government sponsored enterprises or agencies with regard to loans we sold them. During the first four years after the closing, this reimbursement obligation (and some other possible indemnifications) will be satisfied by cancellation of Series C Preferred units and then Series B Preferred units. We will have the right to sell or pledge the Preferred units, but for four years any sale of the Series B or Series C Preferred units will be subject to the possibility that they will be cancelled to satisfy our reimbursement obligations. The transaction is subject to, among other things, approval by the government sponsored enterprises or agencies to which we sell loans we originate or which insure loans we originate.

 

Sale of renewable energy business

 

On April 1, 2009, we sold substantially all the assets of our Renewable Energy business to a subsidiary of Fotowatio S.L. for $19.7 million (subject to possible adjustment), of which $1.5 million was paid when the Purchase Agreement was signed, $13.6 million was paid at the April 1, 2009 closing, and the remainder, net of a reduction because we elected to retain a biomass facility was paid at a second closing on April 15, 2009. The sale did not include our interests in two solar energy investment funds we had sponsored.

 

Possible sale of tax credit equity business

 

We have engaged in discussions with a possible purchaser of our tax credit equity business. However, no transaction has been agreed upon.

 

Sale of recently acquired businesses

 

We disposed of our Sustainable Land Fund and our George Elkins Mortgage Banking businesses in late 2008 for essentially no consideration.

 

Termination of asset management business

 

In late 2008 and early 2009, we terminated substantially all of our Real Estate division’s business of providing asset management services to institutional investors.

 

What will remain

 

If we complete the sales of our Agency Lending business and our Tax Credit Equity business, our only significant remaining activities will be owning and managing portfolios of tax-exempt and market rate bonds and loans. This will enable us to reduce significantly the number of people we employ (in addition to the personnel of the businesses we sell who become employees of the buyers or whose services are no longer required because we do not operate those businesses).

 

Our Business

 

As described under “Recent and Proposed Transactions,” we are in the process of selling two, and possibly three, aspects of our Business. If those transactions all take place, they will significantly alter the nature of our Business and substantially reduce both our assets and our revenues. The description below is of our business as it exists in April 2009, without giving effect to those transactions.

 

Until 2008, we and our subsidiaries were primarily involved in arranging and providing debt and equity financing for developers and owners of multifamily and commercial real estate and clean energy projects. Prior to 2008, we would find what we believed were attractive investment opportunities and investors (including ourselves) who were interested in those opportunities. During 2008 and the first part of 2009, we have been unable to form new funds, and in good part our business activities have been limited to providing multifamily loans in our business of originating mortgage loans for sale to, and servicing loans for, government sponsored enterprises and agencies, and new solar projects in our renewable ventures business (although even this aspect of our business was substantially reduced during 2008). We also have provided

investment management and advisory services for institutional investors, but this activity is in the process of being discontinued.

 

We generate income primarily through returns on financing we provide, and through fees and distributions from funds and other investment entities we manage.

 

We operate through three primary divisions. They are:

 

 

 

 

 

 

Beginning at the end of 2007, there was a major reduction in the willingness of the institutions that in the past had been investors in the funds we manage or lenders to those funds to invest in new investment funds or to provide financing to new investment funds. In addition, we, like many companies, were encountering increasing efforts by banks and other credit providers to reduce their outstanding loans, loan commitments and credit exposure to us. Further, since the fall of 2007, there have been fewer and fewer buyers of newly securitized bonds, and what buyers there are have been requiring yields that made it unprofitable for us to securitize the bonds we originate. Therefore, we have had to stop using securitization as a source of financing. Then, beginning early in 2008, there was a major deterioration in the market for tax-exempt bonds and other instruments that are a major part of our assets.

 

In response to these conditions, during the first quarter of 2008, we substantially reduced all our new business activities other than origination of mortgage loans for sale to Fannie Mae and Freddie Mac or to purchasers of government guaranteed loans, activities related to renewable energy generation and the start up of an international housing fund. Subsequently, we reduced the rate at which we were investing in renewable energy projects, partly because of the lack of adequate capital to invest and partly because of a delay by Congress in finalizing legislation extending various energy related tax credits that were scheduled to reduce at the end of 2008 (but were finally extended late in 2008). In addition, as the market prices of the bonds we owned and hedges we held against certain bonds declined, our creditors began to require us to post additional collateral.

The effects of current market conditions on us and the steps we have taken or have been forced to take as a result of them is discussed in greater detail under the caption “Effects of Current Market Conditions on Us.”

 

Affordable Housing Division

 

Affordable housing typically refers to multifamily apartment developments with below market rents that are intended to be affordable to lower income families (typically families earning 60% or less of the area median income). In most instances, the owners of the affordable housing projects are entitled to special federal income tax benefits, and in some instances state and local tax benefits, to help defray development and operating costs and therefore make possible below market rents. In order to qualify for special federal income tax benefits, at least a specified portion of the units in a project must be set aside to be rented to lower income families. While most of our affordable housing related activities involve investments that entitle the holders to special tax benefits, we also are involved with some investments in affordable housing that do not provide special tax benefits. A significant portion of our revenues from our affordable housing division comes from interest on debt instruments we hold (including interests in tax-exempt bonds) or proceeds of sales of debt instruments or of equity interests in affordable housing related entities. However, a large portion of our revenues related to affordable housing projects comes from fees, including:

 

 

Asset management and guarantee fees paid by funds that are consolidated are eliminated in consolidation, as they represent an expense to the LIHTC Funds, and revenue to us. However, these amounts are included as a component of the GAAP net income (loss) that results from the consolidation of these funds.

 

Tax Credit Equity Segment

 

Normally, the developer of an affordable housing development prefers to sell the tax credits related to the development rather than using them itself. To make this possible, the developer usually forms a limited partnership (“Lower Tier Property Partnership”) to develop or hold and operate the affordable housing project and then sells the limited partnership interests in the Lower Tier Property Partnership to investors who want to benefit from the partnership’s low income housing tax credits. We “syndicate” tax credits by forming LIHTC Funds that purchase directly or indirectly the limited partnership interests in multiple Lower Tier Property Partnerships. We attract capital from institutional investors which will comprise virtually all of the equity of the LIHTC Funds, and the LIHTC Funds use this capital, and sometimes interim debt financing (that we provided in some cases), to purchase the limited partner interests in the Lower Tier Property Partnerships. Because both the Lower Tier Property Partnerships and the LIHTC Funds (as well as any intermediate entities) are pass-through entities for federal income tax purposes, the equity owners of the LIHTC Funds receive the tax benefit of the credits generated by the Lower Tier Property Partnerships. We are the general partner of, and manage, the LIHTC Funds, and usually have an interest of between 0.01% and 1.0% in each of them. Investors in the LIHTC Funds typically have been large financial institutions, including certain GSEs, as well as banks and insurance companies. At December 31, 2008, we were managing 129 LIHTC Funds that held limited partner interests in 1,673 Lower Tier Property Partnerships.

 

In almost all instances, when a Lower Tier Property Partnership is formed, the developer is the general partner of the limited partnership. However, in some instances in which the Lower Tier Property Partnership is suffering from financial or operating challenges, we form a subsidiary which takes over the general partner role (“GP Take Backs”). Generally, when this occurs we consolidate these entities under FIN 46(R).

Within the Tax Credit Equity segment, we provided two general types of guarantees: (1) either single investor or multi-investor LIHTC Fund level guarantees where MuniMae, directly and indirectly, guaranteed the investor’s return on investment (“guaranteed funds”); and (2) individual indemnifications to specific investors in non-guaranteed LIHTC Funds related to the performance of specific Lower Tier Property Partnerships.

 

In late 2007 and early 2008, several of the entities that historically had been the principal investors in the LIHTC Funds we form indicated that during all or most of 2008, they would not be making investments in order to obtain the benefit of low income housing tax credits. This made it impracticable for us to try to form new LIHTC Funds, and therefore early in 2008 we suspended our efforts to form new LIHTC Funds or to invest in Lower Tier Property Partnerships for LIHTC Funds until we see an improvement in this market. In addition, because we frequently committed to purchase equity interests in Lower Tier Property Partnerships so those interests would be available for new LIHTC Funds we expected to form, the inability to form LIHTC Funds left us with equity purchase commitments we had to fund ourselves. We have had difficulty obtaining the capital needed to meet those commitments, and in some instances have not been timely in meeting them, which could put us in breach of our commitments.

 

In late 2008, we began to actively seek a purchaser of our Tax Credit Equity business.

 

Affordable Bond Segment

 

We originate and purchase private placement tax-exempt bonds issued by agencies of state or local governments to finance affordable housing projects. Typically, these bonds are secured by mortgages on the real estate to which they relate, but are not supported by governmental taxing power.

 

Until the fall of 2007, we financed our investments in these bonds by selling them individually or as portfolios into securitization trusts from which senior and junior interests were issued. The senior interests were sold to investors, and we retained the junior interests. To increase the creditworthiness of the interests in these trusts, we, in most instances, caused the bonds held in the trusts to be guaranteed by entities with very high credit ratings, including, in some instances, the GSEs. The junior interests we retained entitle us to the residual payments after all fees and expenses, and all principal and interest due with regard to the senior interests, have been paid. Since the fall of 2007, the market for interests in these types of bond pools has dried up and therefore, we have been unable to finance our investments in this manner. Early in 2008, we suspended until markets return to normal acquiring bonds of this type or entering into new funding commitments.

 

In April 2006, we began investing in highly rated state housing agency tax-exempt bonds. Due to a decrease in demand as a result of adverse capital market conditions, we stopped all acquisition activity related to these types of bonds in the fall of 2007 and during 2008 we liquidated nearly all of our positions in them, usually at a loss and frequently for less than the amounts we had borrowed to acquire the bonds.

 

Affordable Debt Segment

 

We provide construction and permanent financing to developers of affordable housing projects. We convert our construction loans into permanent mortgage loans, which we either retain or sell. Frequently we arrange for Fannie Mae or Freddie Mac to purchase the permanent debt financing.

 

As of December 31, 2008, we had an outstanding balance of loans to developers of affordable housing totaling $143.0 million.

 

Real Estate Division

 

We have originated mortgage loans secured by market rate multifamily apartment properties and other commercial properties built by a wide variety of developers. A small portion of these loans have been in the form of purchases of tax-exempt debt instruments issued by state or local government agencies to finance infrastructure or other projects. However, in most instances, we have made taxable mortgage loans to entities formed by developers of conventional multifamily or commercial properties, which have been secured by the real estate and sometimes, but not always, were guaranteed by the developers. Usually, we have retained construction period loans until projects are completed, at which time we have arranged funds to provide the

permanent financing or we originate and sell the permanent loans to GSEs (i.e., Fannie Mae and Freddie Mac) or programs created by them. At December 31, 2008, we owned market rate commercial mortgage loans with an unpaid principal balance of approximately $383.3 million, of which approximately 75.5% were senior mortgage loans and approximately 24.5% were subordinated mortgage loans.

 

The sources of our revenues from real estate finance not involving affordable housing are:

 

 

A more detailed description of our market rate commercial real estate finance activities is as follows:

 

Agency Lending Segment

 

We originate multifamily housing loans with the intention of selling them to GSEs. We are an approved seller and servicer of Ginnie Mae mortgage-backed securities, an approved seller and servicer of Fannie Mae Delegated Underwriting and Servicing (“DUS”) Loans, and an approved seller and servicer of Freddie Mac mortgage loans. We are also a Federal Housing Administration (“FHA”)/HUD Multifamily Accelerated Processing approved lender, and a FHA Traditional Application Processing Lender.

 

Loans we originate in connection with these programs must be underwritten and structured in accordance with financial requirements established by the GSEs to which we expect to sell particular loans or the government agencies which we expect will credit enhance the loans. In addition, we are required to maintain minimum net worth, liquidity and insurance coverage. Because the GSEs are secondary market purchasers, we cannot sell loans to the GSEs until we have held them for a period of time. Typically, we hold loans for less than 60 days before selling them to the GSEs. In addition Fannie Mae requires us to bear up to 20% (and in some instances an even higher percentage) of the losses on loans we sell to it, based on various loss sharing formulae. We also have loss sharing arrangements with Freddie Mac. When we sell loans to the GSEs, we retain the right to service them, for which we receive fees.

 

Although we curtailed many of our activities during 2008, we did not curtail this aspect of our businesses. However, in December 2008, due to liquidity needs, we agreed to sell this aspect of our business, and we expect to complete that sale during the second quarter of 2009. See Item 1. Business — “Recent and Proposed Transactions.”

 

Merchant Banking Segment

 

Prior to 2008, we made construction, interim and permanent loans to developers of multifamily and commercial real estate projects that do not entitle holders to any special tax benefits. The loans were typically secured by mortgages on the properties to which they relate and sometimes were guaranteed by the developers. Sometimes we retained these loans as investments and sometimes we securitized them or we sold them to investment funds we sponsored and managed. When we retain loans, we typically borrow most of the funds we loan to the developers, and make most of our profit from the amount by which the interest on our loans to the developers exceeds the interest we pay for the sums we borrow.

 

We also have provided loan origination, asset management, investment advisory, loan servicing and other services to institutional investors and funds that we do not originate. In particular,

 

 

 

During December 2008, we notified some of the investors we were advising that we intended to stop providing investment advisory services to institutional investors, and other of our investment advisory clients notified us that they were changing advisors.

 

We have in the past invested in tax-exempt bonds issued by community development districts to finance the development of community infrastructure in areas of commercial or single family home development. These bonds are secured by pledges of specific payments or assessments by the local improvement districts that issue the bonds. They are without recourse to the general taxing power of any government agencies. Because of liquidity needs and other factors resulting from current market conditions, we sold many of these bonds during 2008 and we are no longer acquiring any new bonds.

 

In addition, we have invested in debt secured by student housing or assisted living developments. Early in 2008, we substantially curtailed this aspect of our business until market conditions return to normal and we are able to securitize or otherwise finance loans we originate or purchase.

 

Renewable Energy and Other Developing Businesses Division

 

Renewable Energy Related Investments

 

We entered the field of financing and developing renewable energy projects (i.e., solar power, wind power, bio-power and similar energy sources) in May 2006, by acquiring Reventures Management Company, LLC, for cash and stock, and renaming it MMA Renewable Ventures (“ReVen”). By December 31, 2008, we had formed four funds through which we and institutional investors had made equity commitments of $249.4 million primarily related to 26 solar projects that have a total capacity to produce approximately 35 megawatts of electric power per year. This production was sold to customers under long-term power supply contracts of varying terms. At December 31, 2008, the funds’ investments in these projects totaled $193.9 million.

 

In April 2009, we sold our renewable energy finance and development business, but we kept our interests in two of the funds we had formed and an interest in a biomass facility. See Item 1. Business — “Recent and Proposed Transactions.”

 

While we operated the renewable energy finance and development business, we received fees for arranging investments in funds we organized, for developing power generation projects, for arranging financing for construction of facilities in connection with projects, and for guaranteeing obligations to third party investors. We also receive fees for managing the projects and funds. In most cases, we retained a general partnership or managing member interest in each fund we sponsored and normally we were entitled to an increased distribution of income (“promote income”) after investors received specified returns on their investments.

 

We had remained actively engaged through the first quarter of 2008 in our renewable energy finance and development activities. However, beginning in the second quarter of 2008, we reduced the pace at which we were investing in renewable energy projects, partly because of a slowdown in our ability to obtain funds for investments, and partly because of investor uncertainty caused by Congress’ delay in finalizing legislation extending tax credits that were scheduled to reduce significantly at the end of 2008 (but now have been extended).

Developing Businesses

 

Through a joint venture in which we had a 49% economic interest, and in which we now have an 85% economic interest, we have invested in South Africa Workforce Housing Fund, LP, (“SA Fund”) a fund that invests in moderately priced workforce housing in South Africa. We have committed to make an investment in the SA Fund equal to 2.82% of the total equity capital raised for investment in the fund. A portion of the funding of SA Fund is participating debt provided by the United States Overseas Private Investment Corporation, a federal government entity, and the remainder is equity invested by institutional and large private investors. We are currently trying to sell our interest in this venture.

 

In February 2007, we acquired a mortgage brokerage business known as George Elkins Mortgage Banking for $10.2 million. In September 2007, we acquired Sustainable Land Fund, a company that was formed to structure and manage investments in land with environmental attributes such as wetlands, for $0.8 million. We disposed of both of these businesses in late 2008 for essentially no consideration.

 

For financial accounting purposes, we treated renewable ventures and other developing businesses as a single reportable segment in 2006.

 

Federal Income Tax Considerations

 

Treatment as a Partnership

 

We own interests in various entities, some of which are subject to federal and state income taxes and other entities that are pass-through entities for tax purposes (meaning the partners or owners of the partnership interests are allocated the taxable income). We are a publicly traded partnership (“PTP”) and as such, all of our pass-through entity income is allocated to our common shareholders. Therefore, we do not have a liability for federal and state income taxes related to the PTP income. As a publicly traded partnership, we will be taxed as a corporation for any taxable year in which less than 90% of our gross income consists of “qualifying income.” Qualifying income includes interest, dividends, real property rents, gains from the sale or other disposition of real property or other capital assets held for the production of interest or dividends, and certain other items. Our outside counsel has advised us that, although the issue is not free from doubt, tax-exempt interest income constitutes qualifying income for this purpose.

 

If, for any reason, we were treated as a corporation for federal income tax purposes, our income, deductions, credits and other tax items would not pass-through to shareholders, and shareholders would be treated as shareholders in a corporation for federal income tax purposes. If that occurred, we would be required to pay federal income tax at regular corporate rates on our net income, except to the extent we would benefit from receiving tax-exempt income on our bond investments. In addition, any distributions we make to our shareholders would constitute dividend income that is taxable to our shareholders to the extent of our earnings and profits, without regard to the fact that we receive tax-exempt income. Under current law, dividends paid to our shareholders from income on which we paid taxes would likely be taxable at the 15% rate applicable to qualifying dividends.

 

Tax-exempt Status of Bonds We Hold

 

On the date of initial issuance of any tax-exempt bond that we hold or have held, bond counsel or special tax counsel has rendered its opinion to the effect that interest on the bond is excludable from gross income for federal income tax purposes. These opinions are subject to customary exceptions, including an exception for any tax-exempt bond during any period when it is held by a “substantial user” of the property to which it relates or a person “related” to a “substantial user” (unless the proceeds of the bond are loaned to a charitable organization described in Section 501(c)(3) of the Internal Revenue Code (“the Code”)).

 

In order to exercise remedies with regard to defaulted bonds without becoming a substantial user of the properties securing the bonds, our predecessor, SCA Tax-Exempt Fund Limited Partnership (“predecessor”) sometimes arranged for partnerships controlled by Mark K. Joseph, the Chairman of our Board of Directors, and other of our predecessor’s officers to acquire the properties and become the borrowers on the bonds. At December 31, 2006, a partnership controlled by Mr. Joseph was the sole limited partner of the borrower on

13 bonds that we owned, and on December 31, 2008 it was the sole limited partner of the borrower on 7 bonds that we owned.

 

Similarly, MuniMae Foundation, Inc., (“Foundation”) a charitable entity of the type described in Section 501(c)(3) of the Code, or entities owned by it, are the owners of the properties securing three defaulted bonds we own that would not be tax-exempt unless the properties securing them were owned by 501(c)(3) organizations. The Foundation applies net revenues from the respective properties to pay interest and principal on the bonds we hold until such, if any, time as the bonds are paid in full.

 

We have received legal advice that, based on certain assumptions, ownership or control of borrowers by the partnership Mr. Joseph controls or ownership by the Foundation of properties securing bonds we own, would not cause us to be a person related to a substantial user of the underlying properties, and therefore would not adversely effect the tax-exempt status of the bonds.

 

The Code establishes certain requirements which must be met subsequent to the issuance of a tax-exempt bond for interest on that bond to continue to be excluded from gross income for federal income tax purposes. Each issuer of the bonds we hold, as well as each of the underlying borrowers, has covenanted to comply with these continuing requirements. Failure to comply with any of the continuing requirements of the Code could cause the interest on a bond to be includable in our shareholders’ gross income for federal income tax purposes and such inclusion could be retroactive.

 

Certain events subsequent to the issuance of a bond may be treated for federal income tax purposes as a reissuance of the bond, which could adversely affect the tax-exempt status of the bond. From time to time tax-exempt mortgage bonds we hold go into default. We exercise what we believe to be prudent business practices to enforce our creditor’s rights with regard to defaulted bonds, including in some instances initiating foreclosure proceedings. It is possible that the Internal Revenue Service (“IRS”) may treat our actions to exercise or not to exercise rights with regard to defaulted mortgage bonds as constituting significant modifications and, therefore, conclude that for federal income tax purposes, the bonds were reissued. If the IRS were successful in maintaining this position, interest on the bonds probably would be taxable for federal income tax purposes. We consult counsel and take other steps to try to ensure that our actions (or failures to act) with regard to defaulted bonds will not constitute reissuance of the bonds. In addition, tax-exempt bonds we hold may need to be restructured and remarketed. We could recognize taxable income, gain or loss upon a restructuring and remarketing of tax-exempt bonds we hold even though the restructuring does not result in any cash proceeds to us. In addition, unless various conditions are met, the restructuring and remarketing of tax-exempt bonds could cause the interest on the bonds to lose their tax-exempt status. Sometimes we enter into interest rate swaps or other transactions in order to hedge exposures with regard to tax-exempt bonds we hold. These investments may produce income that is subject to federal income tax.

 

Tax Matters relating to Securitizations

 

Many of the senior interests in our securitization programs are held by tax-exempt money market funds. Tax-exempt money market funds generally have required that these securitization trusts, which are structured as partnerships for federal income tax purposes, make an election under Section 761 of the Code to opt out of the provisions of subchapter K of the Code. As a result, each holder of an interest in these securitization partnerships separately reports its share of income and deductions of the partnership using the holder’s own accounting method and tax year rather than its distributive share of income and deductions calculated at the partnership level.

 

In 2002 and 2003 the IRS issued a series of revenue procedures which stated, among other things, that partnerships, such as the ones used to securitize our bonds, do not meet the requirements of Section 761 of the Code. However, the IRS will not challenge a partnership’s or a partner’s tax treatment for partnerships with start-up dates prior to January 1, 2004 that made Section 761 elections (“Pre-2004 Partnerships”) if that treatment has been consistent with the Section 761 election and certain other requirements are met. We have been advised by counsel that each Pre-2004 Partnership in which we own an interest has met the requirements set forth in the IRS guidance and none of those Pre-2004 Partnerships has acquired any new assets that would cause it no longer to be eligible for the grandfathering rule described above.

If any of the Pre-2004 Partnerships failed to meet any of the requirements of the IRS guidance described above, and therefore were required to comply with the requirements of subchapter K of the Code, it is likely that all of the tax-exempt money market funds which hold senior interests in those securitizations and have tender options would tender their positions and the remarketing agent would have to sell the tendered interests to purchasers which are not tax-exempt money market funds. This would probably result in an increase in the distributions that have to be made to the holders of the senior interests, which would reduce, dollar for dollar, the distributions on the residual interests in the Pre-2004 Partnerships that we own. The senior interest holders have tender option rights with regard to all of the floating rate securitization trusts into which we have deposited bonds.

 

Beginning in January 1, 2004, we have complied with the revenue procedures described above in creating securitization partnerships.

 

Tax Effects on our Shareholders Resulting from our Taxable Income and Deductions

 

Although we were formed in a way that enables us to pass-through the benefit of tax-exempt income to our shareholders, currently, we have investments and operations that generate income that is not exempt from federal income tax. Among other things, our fees related to the Tax Credit Equity segment, our fees related to servicing and administering the bonds in our Affordable Bond segment, and our fees and interest income related to the Affordable Agency, Agency Lending, Real Estate and the Renewable Energy segments are earned through subsidiaries that are taxable corporations, and distributions by those subsidiaries generate income to us that is taxable to our shareholders. In addition, sales of our assets may result in gains that are taxable to our shareholders. Similarly, our shareholders are entitled to deduct their respective portions of our interest expense that is incurred in connection with our investment and operating activities. They are not, however, entitled to deduct interest on indebtedness we incur to purchase or carry tax-exempt bonds. In 2008, we incurred (and we passed on to our shareholders) capital losses due to bond sales and closing out of derivative positions, income from tax-exempt interest and some taxable interest income. However, based on the share price paid by each investor, certain investors may have capital gains allocated to them.

 

Further, as described above, the IRS could seek to recharacterize the income on one or more of our tax-exempt bonds as taxable income. We may also have taxable income, such as income from market discounts that does not generate cash for us. Therefore, it is possible that shareholders could at times be treated as receiving taxable income in excess of the amounts we distribute to them.

 

We use various tax accounting and reporting conventions to determine each shareholder’s allocable share of our ordinary income, gain, loss and deductions. These allocations are respected for federal income tax purposes only if they are considered to have “substantial economic effect” or are in accordance with each shareholder’s “interest in the partnership.” Because we allocate our tax attributes to our shareholders on the basis of the respective numbers of shares they own, we believe that if our allocation were ever challenged, they would be upheld. However, there is no assurance that would be the case. There can be no assurance that we will continue to be a pass-through entity for income tax purposes. In addition to the reasons discussed above by which we might involuntarily become subject to tax as a corporation, we have the right to voluntarily elect such status.

 

Risk Management

 

The Board of Directors delegates authority for investment risk management to the Company’s Real Estate Investment Committee and balance sheet risk management to the Capital Committee.

 

Investment Risk Management — Real Estate Investment Committee (“REIC”).  The REIC is chaired by the Company’s Chief Credit Officer and membership includes the Chief Executive Officer and other senior managers. Except for specific transaction types, the REIC delegates authority to investment committees within each business group to review and approve investments by that business group. The Company’s Chief Credit Officer is responsible for administration and compliance of the REIC and the business group investment committees. Each business group investment committee has formal policies and procedures, and a majority of its members are from the management staff and include the head of credit for the applicable business group,

the business group head and other senior business group staff. In some business groups, there is a single investment committee that reviews and approves both new investments as well as restructurings and workouts while in other business groups there are separate committees for new investments and restructurings and workouts. In addition to approval by the business group investment committee, restructurings and workouts that involve balance sheet assets must be approved by REIC.

 

The Company’s Affordable Housing Division (“MMA Financial”), has three investment committees: (1) The Developer Loan Committee, which approves predevelopment and bridge loans; (2) The Investment Committee which approves all new investments and loans (except those approved by the Developer Loan Committee); and (3) the Sale, Refinancing and Workout Committee which approves all material post-investment transactions including workouts, restructurings, refinancing, dispositions and sales. The Company’s Real Estate Division, (“MMA Realty Capital” or “MRC”), has a single investment committee, the MRC Committee, which approves all new investments and loans as well as restructurings and workouts. The Renewable Ventures group has a single investment committee, the Energy Project Investment Committee, for approving both new investments as well as restructurings and workouts.

 

Each business group has formal roles, policies and procedures for managing potential conflicts of interest arising between the business group and its clients or between multiple clients involved in the same transaction. The interests of the Company’s clients are represented internally by relationship managers or in some cases by independent directors (i.e. directors not related to the Company) for certain entities who are responsible for ensuring that the Company satisfies its fiduciary duties and are involved throughout the decision making process regarding transactions affecting their clients and have the ultimate authority to approve or disapprove of such transactions. Within MMA Financial, this process is managed within the Sale, Refinancing and Workout Committee. Within MMA Realty Capital, a subcommittee of the MRC Committee, the Allocation, Conflicts and Compliance Committee, is responsible for administering the business group’s allocation policy, compliance and suitability issues, conflicts of interest and principal transactions. In addition to the relationship managers, internal or external legal counsel is involved in transactions where conflicts of interest may be present.

 

Balance Sheet Risk Management — Capital Committee (“CC”).  The CC is chaired by the Company’s Chief Credit Officer and membership includes the Chief Executive Officer and other senior managers. The CC exists to review and approve transactions that have a material impact on the Company’s balance sheet, excluding transactions approved by REIC and its subcommittees. Transactions requiring CC review and approval include new (or modifications to existing) indebtedness, guarantees, indemnifications, and contingent liabilities; capital for new programs and initiatives and the use of derivatives. The CC delegates authority for a limited number of transaction types to business groups or corporate departments (for example, Corporate Treasury has been delegated the authority for approving certain ordinary course cash management transactions). All CC transactions go through a formal review and approval process which includes sign-offs by key functions including accounting, tax, legal, treasury, compliance, servicing, and asset management. The CC operates within annual capacity limits for different types of transactions established by the Board of Directors.

 

Day to Day Risk Management.  In addition to its formal committee structure, the Company views risk management as a key on-going process which is staffed both corporately (within the office of the Chief Credit Officer) and within the business groups. Within the business groups, the Company has policies and procedures related to its risk management activities including credit policy, underwriting, asset management, servicing and workouts. Additionally, each business group has a head of credit and risk management who reports to both the business group head and the Chief Credit Officer. Corporately, the Chief Credit Officer reports to the Chief Executive Officer and is a member of the Company’s Senior Staff committee.

 

Competition

 

In seeking attractive tax credit, clean energy, multifamily and other housing and commercial property related investment opportunities, we have competed directly against a large number of syndicators, direct investors and lenders, including banks, finance companies and other financial intermediaries and providers of related services (such as portfolio loan servicing). While we historically were able to compete effectively against

these competitors on the basis of service, access to investor capital, longstanding relationships with developers and a broad array of product offerings, many of our competitors benefited from substantial economies of scale in their businesses and a lower cost of capital.

 

We competed directly with other syndicators in raising investor capital for tax credit investments. While we historically were able to compete effectively against those competitors on the basis of service, track record, and access to high-quality investments, several of our competitors benefited from the ability to (1) warehouse credit more efficiently; (2) use large amounts of tax credits themselves; and (3) more effectively guarantee tax credit investments because of their credit ratings.

 

Employees

 

As of December 31, 2008, we had approximately 435 employees, none of whom were parties to any collective bargaining agreements. This was a reduction from the approximately 575 employees we had at December 31, 2007. In addition, at December 31, 2008, we were engaging approximately 70 people provided by outside financial and accounting firms on a substantially full time basis to supplement the employees in our finance and accounting departments in connection with the development and application of our accounting policies, the restatement of our 2004 and 2005 financial statements and preparation of our 2006 financial statements. At March 31, 2009, we had approximately 333 employees.

 

 

Holding our shares involves various risks and uncertainties. The risks described in this section are among those that have had or could in the future have a material adverse effect on our business, financial condition or results of operations, as well as the value of our common shares.

 

Risks Related to Current Market Conditions

 

We have been directly and indirectly affected by the recent disruptions in credit markets.

 

Many aspects of our businesses have been affected by the recent disruptions in the credit markets, in some cases significantly. Some of these have been direct effects on us or our assets, and some have been effects on financial institutions and other entities with which we deal that have affected their ability or willingness to participate or continue to participate in our activities as equity investors, lenders or otherwise. The principal effects of the credit market disruption on us are described in Item 1. Business — “Effects of Current Market Conditions on Us.”

 

We have been severely affected by deterioration in the market for tax-exempt bonds and other instruments of the type we own.

 

Beginning early in 2008, there was a major deterioration in the market for tax-exempt bonds and other instruments that are a major part of our assets. This, combined with the factors that have affected credit markets and financial institutions throughout the nation, had a severe effect upon us during 2008, causing us to have to curtail significant aspects of our business and to sell assets at substantial losses to obtain funds we needed to meet our commitments or to satisfy lenders.

 

We have been forced to sell assets and business segments in order to raise funds we need to meet our cash needs.

 

Currently, we are facing a significant shortage of liquid assets. During 2008, we sold investment assets to generate cash or to minimize our obligation related to future funding requirements and in most instances we sold these assets for less than the amounts for which we had purchased them. In some instances the sales prices were less than the borrowings secured by the assets we sold, so that, instead of generating cash, the sales consumed additional cash or collateral we had posted with the lenders (we carried out the sales anyway in order to reduce our market risk). In order to raise cash, we have sold or agreed to sell two segments of our

business and are attempting to sell a third segment. If we complete all those transactions, our only significant remaining activities will be owning and managing portfolios of tax-exempt bonds and market rate loans.

 

As a result of reductions in revenues and substantial realized and unrealized losses in the carrying value of our municipal bonds and other investments due to severely adverse current market conditions, and to the high costs of preparing and auditing our financial statements, we are incurring significant operating losses.

 

We were billed approximately $142 million in third party consulting costs and costs related to our audit as well as the audits of certain wholly-owned subsidiaries between January 1, 2007 and December 31, 2008. These costs were primarily related to the review and finalization of our accounting policies for all aspects of our business, the development and execution of procedures for the measurement of our transactions under these polices, the preparation of the financial statements that appear in this Report, the audit of these financial statements (including costs related to separate wholly-owned subsidiary company audits, some of which are performed by a firm other than KPMG), internal audit related costs and income tax advice and preparation costs. These costs do not include audit costs incurred related to the funds that we manage, a portion which are allocated and paid for by the funds and a portion of which we bear.

 

While we have not completed our 2007 and 2008 financial statements, it is clear that the impacts of reductions in revenues in multiple business lines and in the value of municipal bonds and other investments we hold or have sold, and the costs of developing and applying our accounting policies and preparing and auditing our 2006 and restated 2005 and 2004 financial statements, when added to our 2007 and 2008 on-going operating expenses, resulted in significant operating losses in both 2007 and 2008.

 

Most of our lenders have the right to require us to repay what we have borrowed or could require us to post additional collateral.

 

Although we are current with respect to our contractual interest payments, many of our debt agreements require us to provide timely GAAP basis financial statements and as a result most of our lenders have the right (absent forbearance agreements) to require us to repay what we have borrowed from them (our lenders have not done that to date and many of them have entered into short term forbearance agreements). This, along with our need to sell assets and in some cases business segments, has led our independent registered public accounting firm to include in its auditor’s report an explanatory paragraph regarding substantial doubt as to our ability to continue as a going concern, Also, we are subject to the constant possibility that one or more of our lenders will assert that the current market value of the assets that secure their loans (which in most instances our lenders determine) has fallen below required levels and that we must either post additional collateral or reduce the amount of our borrowings. We have little or no available funds to post as additional collateral or with which to repay borrowings.

 

If we were forced to sell all our pledged assets, the total sales price might not be sufficient to enable us to repay all our borrowings.

 

We believe that under normal market conditions, we could in at least most instances sell the assets that secure our borrowings for more than the amounts of the borrowings they secure. However, there is a significant possibility that if our lenders forced us to sell those assets into the current inactive market, the total sale proceeds would not equal our total borrowings.

 

We are facing defaults and delinquencies with respect to many of the debt instruments we hold.

 

We hold various types of debt instruments. Our largest holding is of tax-exempt bonds relating to affordable housing developments, as well as other types of tax-exempt bonds. The delinquency rate at December 31, 2008, with regard to those bonds is lower than it historically has been. However, the delinquency rate with regard to most of the other types of debt instruments we hold increased significantly during 2008. Even in instances in which developers guaranteed loans secured by projects they developed, many of the developers appear to be having financial problems that cast doubt on their ability to fulfill their guarantees if they are called upon to do so.

General Risks Related to Our Business

 

Economic conditions adversely affecting the real estate market have had a material adverse effect on us.

 

Because we, the funds we manage and the investors we have advised, own and finance investments directly or indirectly secured by multifamily residential properties and other commercial real estate, the value of our and the funds’ and investors’ investments are subject to being (and recently have been) materially adversely affected by macroeconomic conditions or other factors that adversely affect the real estate market generally, or the market for multifamily real estate in particular, either nationally or in regions in which we, the funds we manage or our other clients have significant investments. These possible negative factors (many of which have recently occurred) include, among others:

 

 

We might not be able to meet our funding commitments.

 

Due to market conditions and their effect on our business and liquidity we might not be able to meet funding commitments. The failure to meet such commitments could put us in breach of those commitments.

 

We are exposed to the normal risks that affect construction lenders which could adversely affect our or our funds’ return on investment.

 

Some of the investments owned by us or by funds we manage, and from which we or the funds derive interest income, are mortgage loans secured by multifamily residential rental housing properties or renewable energy projects that are still under construction or are undergoing substantial rehabilitation, and we make construction loans with regard to commercial real estate. Thus, we often provide construction financing and take other construction period risks with the expectation of being repaid, or converting our construction loans into permanent mortgage loans, when the developments or projects are completed. During the construction phase of a development or project for which we are a lender, which often lasts 12 to 24 months, our investment is subject to all the risks that normally apply to construction projects, including the possibility of:

 

 

If a developer cannot complete the development that is collateral for a construction loan we made, we may have to arrange and finance the completion of the project in order to protect our ability to recover the construction loan.

 

In addition, some of our investments and those of the funds we manage are secured by mortgages on properties that are in a lease-up phase. Developers’ failures to complete lease-up of these properties on

schedule or at anticipated rent levels could adversely affect the ability of the developers to make mortgage payments on schedule and therefore could adversely affect the return on the investment we or the funds we manage have made.

 

We are exposed to risks specific to real estate.

 

Because many of our assets are secured by real estate, or consist of investments in entities that own real estate, the value of our assets is subject to the risks associated with investments in real estate. Among other things, real estate may decline in value because of market conditions, an inability to obtain key permits, a change in, or failure to obtain a change in, zoning, environmental problems, casualty losses for which insurance proceeds are not sufficient to cover the loss, and condemnation proceedings. We conduct extensive due diligence prior to making investments but problems may arise subsequent to our investment. Negative changes in the value of our assets could have a material adverse effect on us.

 

We are sometimes subject to collateral calls and if we cannot meet the calls we may be deemed in default.

 

Many of our borrowings and other financial obligations are secured by loans or bonds we own. If the value of the loans or bonds securing particular obligations falls below specified percentages of the obligations, we must either reduce the amount of the obligations or provide additional collateral. Under current market conditions, we may have difficulty doing either of those things and if we cannot do either of them, we may be deemed to have defaulted on the borrowings or other financial obligations, and our creditors may have the right to liquidate our collateral to satisfy their claims.

 

The market value, availability or cost of our investments and investment opportunities could be adversely affected by changes in prevailing interest rates.

 

Most of the investments we hold, or that are made by funds or entities we created and manage, are debt instruments or similar to debt instruments. The value of those investments can be severely affected by changes in prevailing interest rates. In particular, a significant increase in prevailing interest rates for taxable or tax-exempt debt instruments substantially reduces the market value of investments we hold. In addition, it could reduce the availability of new investment opportunities and increase the competition for those investments.

 

We do not, and cannot, fully hedge against interest rate risks.

 

Significant portions of the money we and our funds use to make investments are borrowed under credit lines that bear interest at floating rates. Therefore, an increase in prevailing interest rates could make it substantially more expensive for us or our funds to continue to hold investments, while at the same time reducing the prices at which we could dispose of those investments. We do not fully hedge our exposure to changes in interest rates and so we are exposed to the risks of unfavorable changes in interest rates beyond our hedging activities.

 

We hedge our exposure to interest rate changes in a variety of ways. However, our hedges normally have significantly shorter lives than the interest rate sensitive instruments in which we invest. Further, we do not, and frequently cannot, hedge against all the interest rate risks that may affect us. Also, hedges do not always work as we expect them to. See Item 1. Business — “Effects of Current Market Conditions Upon Us.” Therefore, we are to an extent exposed to risks that changes in interest rates will negatively affect the value of our assets.

 

We can lose money on the transactions we undertake to hedge against losses due to interest rate movements.

 

Sometimes we hedge against interest rate movements by purchasing options, but in many instances, we have hedged against increases in interest rates, which generally cause declines in the value of our debt instruments, by entering into transactions that are expected to increase in value as interest rates rise. The risk of a loss in value if interest rates fall is the cost of the protection we receive by entering into these transactions. Further, as is described under Item 1. Business — “Effect of Current Market Conditions on Us,” there was a period in early 2008 when, due to a market anomaly, the value of swaps we had purchased to hedge against a decline in

the value of a portfolio of tax-exempt bonds we held, fell at the same time the value of the tax-exempt bonds declined. While this was a very unusual situation, it reflects the fact that many hedges involve a degree of risk themselves.

 

Our ability to find investors or make tax-exempt investments could be adversely affected by changes in government tax incentive programs.

 

A significant aspect of our business has consisted of selling to investors securities or interests that enable them to realize tax benefits the government provides as incentives to make certain types of investments. We did this primarily by creating entities through which investors could obtain tax credits for investing in affordable housing or in renewable source power generation facilities. We also purchased tax-exempt bonds issued to fund affordable housing and other types of projects. There is no guarantee that the government will continue to provide the types of tax credits that have been available or that it will not change current tax-exempt bond legislation. If the federal government were to reduce, eliminate or not renew the tax credits for investments in affordable housing or renewable energy, or were to change the tax-exempt bond legislation, our ability to find investors for the funds we create or to make tax-exempt bond investments could, even in times of normal market conditions, be materially impaired. Even uncertainty as to a possible imminent reduction or elimination of tax benefits can make investors reluctant to invest in the types of investments we market. Further, the government could make other changes in the tax laws that, while not directly affecting tax credits or tax-exempt bond legislation could make them less valuable to investors. A discussion of U.S. federal tax considerations that affect us and our shareholders appears in Item 1. Business — “Federal Income Tax Considerations.”

 

Substantial reduction or increased costs in the activities of GSEs that provide liquidity to the market for real estate related investments could adversely affect our business.

 

Fannie Mae and Freddie Mac are important to many aspects of our business. They have historically been among the largest corporate buyers of low income housing related tax credits of the type we syndicate. We also have generated substantial revenues by originating loans and selling them to Fannie Mae and Freddie Mac. In addition, Fannie Mae and Freddie Mac have provided credit enhancement that we used in connection with sales or securitizations of some of our assets, as well as credit enhancement for some of the tax-exempt bonds that we originated. We are in the process of selling both the aspect of our business that syndicates low income housing related tax credits and the aspect of our business that originates loans for sale to Fannie Mae and Freddie Mac and other government sponsored agencies.

 

In 2008, Fannie Mae and Freddie Mac were placed under government conservatorship, and according to news reports each of them suffered major losses during 2008. There have been numerous proposals that would significantly change their activities. To date, we have not experienced a significant change in the operations or strategies of Fannie Mae or Freddie Mac that affect us. However, it is possible that, as a result of the conservatorship or in reaction to the losses, there will be changes in the way one or both of them operate, or in their funding that will adversely affect our on-going business.

 

Most of our assets are pledged as collateral for borrowings that could go into default causing us to suffer significant losses.

 

All of our businesses require significant access to borrowed funds and as such we have almost no assets that are unencumbered at December 31, 2008. Because we were not able to deliver financial statements in a timely manner, most of our debt that is not part of a bond securitization transaction was in default, and most of our lenders could have required us to repay the indebtedness. If our lenders had required us to repay the indebtedness and we had been unable to do so (which, in view of current market conditions, probably would have been the case with regard to many of our borrowings), the lenders would have been able to liquidate the assets that secure the indebtedness. If lenders liquidated our assets under current market conditions, we would suffer significant losses of value.

We must be careful not to become subject to the Investment Company Act of 1940 because if we were subject to that Act, we could be required to sell substantial portions of our assets at a time when we might not otherwise want to do so, and we could incur significant losses as a result.

 

We continuously monitor our activities to be sure we do not become subject to regulation as an investment company under the Investment Company Act of 1940, as amended. We are exempt from the Investment Company Act because of an exemption for companies that are “primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.” If we were regulated as an investment company under the Investment Company Act, we would be subject to extensive regulation and restrictions relating to capital structure, dividends and a number of other matters. Among other things, we would not be able to borrow money. Therefore, if due to a change in our assets or in the value of particular assets, we were to become subject to the Investment Company Act, either we would have to restructure our assets so we would not be subject to that Act or we would have to change materially the way we do business. Either of those changes could require us to sell substantial portions of our assets at a time when we might not otherwise want to do so, and we could incur significant losses of value as a result.

 

Risks Related to Our Financial Reporting

 

There have been material weaknesses in our internal controls over financial reporting that have required us on three occasions to restate our financial statements with the assistance of outside accounting consultants, and until we have sufficient internal resources we may need continued substantial assistance from outside accounting consultants at considerable cost.

 

For the last several years, there have been (and there continue to be) material weaknesses in our internal control over financial reporting. Because of this, we have on three occasions had to restate our financial statements. The first restatement was to adjust our unaudited financial statements for the first and second quarters of 2004 to record deferred compensation expense related to one employment contract. Then, in the spring of 2006, we restated our audited financial statements for 2004 and prior years. Subsequently, in September 2006, we determined that we had to restate our audited 2005 financial statements and further restate our audited restated financial statements for 2004 and prior years. The need for the restatements resulted primarily from the factors discussed in Item 9A. Controls and Procedures.

 

The problems caused by these deficiencies delayed the filing of this Report until two years after it was due and will cause us to be late in making SEC filings relating to 2007, 2008 and at least some subsequent periods. While we have completed our 2006 financial statements and the restated 2005 and 2004 financial statements that appear in this Report, we were able to do that only by using a large number of outside consultants to supplement our own accounting personnel and systems. During 2007, we brought in a new chief financial officer, a new business unit financial officer, a new head of internal audit, and other new senior accounting and financial reporting personnel. However, we still do not have sufficient internal resources to enable us to generate reliable financial statements without substantial assistance from outside accounting consultants at considerable cost.

 

The material weaknesses in our internal control over financial reporting substantially increase the cost of ensuring that there will not be misstatements in our financial statements.

 

A material weakness in internal control over financial reporting means that there are deficiencies that present a more than remote possibility (or, under a 2007 revision to the standard, a reasonable possibility) that a material misstatement of a company’s annual or interim financial statements will not be prevented or detected on a timely basis. Because there have been, and continue to be, material weaknesses in our internal control over financial reporting, we have had to use means other than reliance on our internal control over financial reporting to ensure that there are not material misstatements in our financial statements. These alternative means have been very labor intensive and have contributed significantly to the high costs we have incurred in preparing our financial statements. Further, while we believe these alternative means have been effective in allowing us to prepare the GAAP compliant financial statements contained in this Report, going forward there continues to be a risk that there may be a material misstatement in our financial statements.

We will continue to incur major costs in the preparation and audit of our financial statements, which could adversely affect our financial results.

 

We are trying to develop sufficient accounting and finance capability and systems to be able to prepare our financial statements and do a significant portion of our tax return preparation work ourselves instead of using outside consultants. However, we are likely to incur unusually high financial statement preparation and audit costs at least during 2009 and possibly 2010. The high financial statement preparation and audit costs have materially adversely affected our financial results and are likely to continue to do so at least through 2009 and possibly longer.

 

Our 2007 and 2008 financial statements will not be filed with the SEC or provided to lenders when they are due, which means we will not meet a requirement of many of our loan agreements and unless we obtain waivers or forbearances, our lenders could terminate our lending agreements and require us to repay the sums we have borrowed, and if all of these loan amounts were currently declared due and payable, we would not have available resources sufficient to satisfy all of such loan amounts.

 

Because of the delay in completing our 2006 annual financial statements and the continuing material weaknesses in our financial reporting and accounting systems, our 2007 and 2008 annual financial statements will not be filed with the SEC until at least many months after they are due.

 

Most of our loan agreements require that we provide timely financial statements or file reports with the SEC when they are due and give the lenders copies of those reports. Most of our lenders waived, or otherwise did not enforce, these requirements in 2007 and 2008. While we will continue to seek waivers or forbearances with regard to these financial reporting requirements, most of our lenders could, if they wished to do so, use our inability to provide financial statements when they are due as a basis for terminating their lending arrangements with us and requiring us to repay the sums we have borrowed from them. Under current market conditions, if all of these loan amounts were currently declared due and payable, we would not have available resources sufficient to satisfy all of such loan amounts.

 

The SEC Staff has inquired into the reasons for our restatements and if they decide to take any substantial action against us it could adversely affect our business.

 

After we announced in September 2006, that we would be restating our financial statements for 2005 and prior years, the Philadelphia regional office of the SEC informed us that it was conducting an informal inquiry concerning us and requested the voluntary production of documents and information concerning, among other things, the reasons for that restatement and for our prior restatement. We provided the requested documents and information and are cooperating fully with the informal inquiry. The SEC staff has been monitoring the progress of the restatement and the preparation of our 2006 financial statements. We do not know what, if anything, the SEC staff may do now that the restatement and the preparation of our 2006 financial statements have been completed. Any substantial action against us by the SEC could adversely affect our business.

 

The book value of our assets is not necessarily the amount for which they could be sold at any point in time, and if we currently were forced to sell significant assets, we probably would not realize their full book value.

 

Our assets include a variety of bonds, loans and other debt instruments. Under GAAP, in some instances these bonds, loans and other debt instruments are recorded at their fair value on each balance sheet date. In other instances, they are carried at amortized cost (i.e., unpaid principal balances less any deferred costs or fees) unless we determine that they are impaired or there has been an other-than-temporary impairment in the value of particular assets, in which case the book values of those assets are reserved against or written down to their estimated fair values. The estimated fair values of the assets are determined using quoted market prices, if available, or with discounted cash flow models considering expected cash flows and market yields. The prices for which we can sell particular bonds, loans or other debt instruments at a point in time are affected by current market conditions at that time. As is discussed under Item 1A. Risk Factors — “Risks Related to Current Market Conditions,” under current market conditions, the prices for which we can sell the bonds,

loans and other debt investments we own are significantly lower than the prices for which they could be sold under normal market conditions.

 

Risk Related to our Affordable Housing Division

 

Affordable housing partnerships may not be able to repay their borrowings from us and that could adversely affect the return on the investment to us or to the funds we manage.

 

We advance substantial funds as loans (including our investments in bonds) to partnerships engaged in the development of affordable housing projects. While these projects are under construction, they are subject to the normal risks that affect construction lenders, as discussed above under the caption “General Risks Related to our Business — We are exposed to the normal risks that affect construction lenders that could adversely affect our or our funds’ return on investment.” Because substantially all the units in most of those projects are rented to individuals or families with incomes no greater than 60% of area median incomes, there is a risk that tenants will not be able to pay their rent, and therefore the partnerships that own the projects will not be able to make required payments on the mortgage debt we hold and that could adversely affect the return on the investment to us or to the funds we manage.

 

As a sponsor of tax credit equity funds, we have exposure to risk of loss if we are unable to place partnership interests at sufficiently high prices.

 

In connection with our sponsorship of tax credit equity funds as described in Item 1. Business — “Our Tax Credit Equity Segment,” we have often advanced funds by acquiring interests in partnerships or other entities that own affordable housing projects with the intention of selling those interests to tax credit equity funds we sponsor. At any point in time, the amount of these advances can be material. Generally, we have recovered our advances by selling the interests to tax credit equity funds we have sponsored. At December 31, 2008 we were holding interests for which we had paid $30.5 million, and were committed to pay an additional $82.1 million to purchase interests, which we expected to sell to tax credit equity funds. However, currently we are not able to form new tax credit equity funds, and therefore we can only sell partnership interests we are holding or are committed to purchase to existing LIHTC Funds, and only to the extent those funds have access to capital with which to make additional investments, or to third party purchasers. Further, the yield investors in tax equity funds are requiring has risen to a level that has caused us to lose money on many of the sales we do make. In 2008, we expect to recognize significant losses from selling interests we had acquired in tax credit generating partnerships.

 

Economic conditions have substantially reduced demand for investments that generate tax credits, and therefore we have curtailed our efforts to identify investments that generate tax credits or to form LIHTC Funds.

 

Late in 2007 and early in 2008, several of the entities that historically had been the principal investors in LIHTC finds we sponsor indicated that during all or most of 2008, they would not be making investments in order to benefit from low income tax credits. Those entities have announced significant net losses from their own activities, and therefore, may not have taxable income for a substantial period. If they do not have taxable income, they probably will have no need for tax credits. As a result of this, during 2008, we suspended our efforts to form new LIHTC Funds or to identify potential investments for new LIHTC Funds. We are currently attempting to sell our Tax Credit Equity business.

 

Substantially all of our investments are illiquid, which could prevent us from consummating sales on favorable terms and makes it difficult for us accurately to value our investment portfolio.

 

There is no regular trading market for most of the tax-exempt and taxable real estate related debt and equity interests in which we and the funds we manage have invested. This results in a serious lack of liquidity, particularly during weak markets, such as those that have prevailed since the summer of 2007 and are discussed in the portion of this Risk Factors section captioned “Risks Related to Current Credit Market

Conditions” and “General Risks Related to Our Business.” The lack of liquidity could seriously adversely affect the price for which we, or the funds we manage, could sell debt or equity securities if necessary.

 

In addition, the absence of liquid markets for the interests we hold makes them difficult to value, and could require us to write down the carrying value of the interests because of market conditions that do not actually affect the performance of assets that support the securities that we hold.

 

We have provided guarantees with respect to certain of the tax credit equity funds that we sponsored, and if we were to become obligated to perform on those guarantees our financial condition and results of operation could suffer.

 

We have guaranteed availability of tax benefits and minimum returns on investment to investors in some of the tax credit equity funds that we sponsored. We could be required to make substantial payments with regard to these guarantees. If we were to become obligated to perform on those guarantees our financial condition and results of operation could suffer.

 

Noncompliance with various legal requirements by the affordable housing partnerships could impair our investors’ right to low income housing tax credits and have a negative impact on our business.

 

The ability of investors in tax credit equity funds we sponsor to benefit from low income housing tax credits requires that the partnerships in which those funds invest operate affordable housing projects in compliance with a number of requirements in the Code and the Regulations under it. Failure to comply continuously with these requirements throughout a 15-year recapture period could result in loss of the right to those low income housing tax credits, including recapture of credits that were already taken. While we are not legally required to assure availability of tax credits (except in limited instances in which we have guaranteed availability of tax benefits and minimum returns to fund investors), in order to maintain relationships with investors, we might decide to cure delinquent mortgage payments or do other things to protect investors’ access to low income housing tax credits. These events could have a negative impact on our business.

 

A significant portion of our interests in tax-exempt bonds and our residual interests in securitized asset pools have been pledged as collateral to support securitization programs.

 

A significant group of our assets are residual interests in securitization vehicles to which we sold tax-exempt bonds. Those residual interests are only entitled to interest after all senior interests have received specified interest payments and generally are not entitled to principal payments until all senior interests have been paid in full. In addition, we pledged investments as collateral with respect to these securitization programs. Among other things, in a typical securitization facility, the payment of the interest and principal on senior floating rate interests is guaranteed by a third-party credit enhancement provider, we are required to reimburse the credit enhancer for any payments it may be required to make as a result of its guarantee and we have pledged assets to secure that reimbursement obligation. If the credit enhancer is required to repay the senior floating rate certificates, both the securities in the securitization pool and the additional assets we have pledged may be sold to reimburse the credit enhancer for the sums it had to pay. This may result in our incurring significant losses.

 

In addition, if the value of the tax-exempt bonds we have securitized or pledged as collateral for a securitization program decreases significantly, we may be required to post cash or additional investments as additional collateral for the program. If we do not post the additional collateral, the securitization program may be terminated and the securitized bonds and additional collateral we pledged may be liquidated to satisfy the obligations to the holders of the securitization program certificates. This could result in the sale of the collateral at an inopportune time (such as the current time) on unfavorable terms.

Risks Related to Our Real Estate Division

 

Substantially all of our investments are illiquid, which could prevent us from consummating sales on favorable terms and makes it difficult for us accurately to value our investment portfolio.

 

There is no regular trading market for most of the market rate commercial real estate related debt and equity interests in which we and funds we manage have invested. This could result in a serious lack of liquidity, particularly during weak markets, such as those that have prevailed since the summer of 2007 and are discussed in the portion of this Risk Factors section captioned “Risks Related to Current Credit Market Conditions” and “General Risks Related to Our Business.” The lack of liquidity could seriously adversely affect the price for which we, or the funds we manage, could sell debt or equity securities if necessary.

 

The assets in which we invest may not realize the value forecasted at acquisition.

 

Although market conditions are a substantial factor in our ability to sell assets in which we have invested, the underlying value of those assets affects both our ability to sell them and their value to us as long-term investments. We have devoted substantial attention to analyzing investments before we make them. However, these analyses were made at a time when real estate markets were significantly different from those that currently prevail. Because of that, several market rate commercial loans we made are in arrears and there may be defaults with regard to other loans we have made.

 

A portion of our market rate investments are subordinated bonds or are junior in right of payment to other obligations and if the borrowers are unable to make all required payments, we may suffer losses.

 

When we hold junior or subordinated debt instruments or bond interests, if the borrower is unable or fails to make all of its required payments, we will not be paid until all the senior securities or senior bond interests have been paid in full. Further, in most instances we cannot, without the consent of the senior holders, take actions that might protect our interests. That can further reduce the likelihood of our receiving the full sum due to us if a borrower becomes insolvent. At December 31, 2008, we had market rate bond and loan investments in our Real Estate division totaling $78.2 million and $94.1 million, respectively, which were subordinate to more senior interests.

 

As a delegated underwriter and servicer in the Fannie Mae DUS program and Freddie Mac Program Plus program, we have agreed to share losses (up to specified levels) on loans that we underwrite and sell to Fannie Mae and Freddie Mac.

 

As discussed in Item 1. Business, we participate in the Fannie Mae DUS and Freddie Mac Program Plus programs. The terms of our participation require that we assume responsibility for a portion of any loss that may result from borrower defaults including foreclosure, based on Fannie Mae’s and Freddie Mac’s loss sharing formulas. Under the Fannie Mae DUS program, we are generally responsible for the first 5% of the unpaid principal balance and 25% of any additional losses with a maximum cap of 20% of the original principal balance. Certain loans have a maximum cap of 30% and 40% and different loss sharing percentages. Under the Freddie Mac Program Plus program, we are generally responsible for the first 8% of the unpaid principal balance. Although our losses to date under these guarantees have been minimal, that may not always be the case and a material increase in these losses could have a negative impact on our financial condition or results of operations.

 

We have agreed to sell the business that participates in these programs. The agreement entitles the purchaser to reduce the liquidation preference of preferred shares received as compensation for the sale by up to $30.0 million for losses under these programs.

Our agency loan origination business is particularly dependent on maintaining our relationships with the GSEs that participate in the multifamily housing market and adverse changes to those relationships could cause our business and results of operations to suffer.

 

We have agreed to sell the portion of our business that participates in the DUS program and in Freddie Mac’s Program Plus and other programs. Completion of that transaction is conditioned upon the purchaser being licensed to participate in those programs. We expect the transaction to be completed during the second quarter of 2009. If the transaction is not completed, we would continue to be subject to risks related to our relationships with GSEs.

 

The maintenance of our DUS license with Fannie Mae and our participation in Freddie Mac’s Program Plus and other programs have been important to the continued productivity of our debt sector operations. As a DUS lender, we have been subject to periodic reviews by Fannie Mae, and we have had to comply with a variety of underwriting and servicing guidelines imposed by Fannie Mae. Fannie Mae and Freddie Mac could revoke our program licenses if we did not comply with the program guidelines.

 

Also, the value of our DUS license could be adversely impacted if Fannie Mae were to change the delegated authority of its DUS lenders or otherwise make it more costly or difficult for DUS lenders to underwrite and service loans on Fannie Mae’s behalf.

 

If Fannie Mae or Freddie Mac were to admit more financial services firms into their programs, our competitive advantage would decline. We have no control over whether Fannie Mae or Freddie Mac expands the size of its programs. The value of our DUS license and our participation in Freddie Mac’s Program Plus could be adversely impacted if either of those GSEs were to invite a significant number of new participants into its program. If more financial services firms compete for business in this marketplace, the profit margins on our debt business would likely decline and our results of operations could suffer.

 

Risks Relating to Ownership of Our Shares

 

Our Board can issue an unlimited number of common or preferred shares, which could reduce our book value per common share and earnings per common share and the cash or other assets available for distribution per common share upon liquidation or otherwise.

 

Under our Operating Agreement, our Board of Directors can authorize, without any requirement of shareholder approval, the issuance of an unlimited number of common shares. Although New York Stock Exchange (“NYSE”) rules imposed some limitations on our ability to issue shares without shareholder approval, our shares are not currently listed on the NYSE. Issuances of common shares could dilute the book value or the net income per common share or the cash per share available for distribution to common shareholders. Our Board can also authorize, without any requirement of shareholder approval, the issuance of an unlimited number of shares with preferences over the common shares as to dividends, distributions on liquidation and other matters, other than voting. This could reduce the book value and net earnings that would be allocable to our common shares and the cash or other assets that are available for distribution to our common shareholders either periodically or upon our liquidation.

 

We have stopped paying dividends and it is unlikely we will resume paying them in the near future.

 

Prior to the fourth quarter of 2007, we paid increasing dividends to our shareholders for 43 consecutive quarters. In January 2008 in response to deteriorating market conditions and our increasing costs, our Board reduced the dividend for the fourth quarter of 2007 by 37% from what we had paid for the prior quarter. The following quarter, our Board did not declare any dividend and our Board has not declared any dividend since then. Our Board considers a number of factors in deciding whether we should pay a dividend for a quarter. However, in view of the difficulty we are having generating the cash we need for our operations and to satisfy our lenders, it is unlikely that we will pay a dividend in the near future.

Our shareholders may be taxed on their respective shares of our taxable income, even if we do not make distributions to them.

 

We are a limited liability company, not a corporation, and we have elected to be taxed as though we were a partnership. Because of that, our taxable income and loss, and our other tax attributes (including the tax-exempt nature of some of the interest we receive) are treated, at least for U.S. federal income tax purposes, as the taxable income or loss and other tax attributes, of our shareholders. That avoids the double tax to which corporations and their shareholders usually are subject, and enables our shareholders to benefit from the fact that a portion of our income is exempt from federal income tax. However, if we have taxable income in excess of the sums we are able to distribute to our shareholders, our shareholders will be taxed on sums they do not receive, since under the rules of partnership taxation our shareholders are taxed based on taxable income and not on our distributions. In addition, much of our tax-exempt income is subject to the alternative minimum tax (“AMT”) for federal income tax purposes and shareholders who are subject to the AMT could be subject to tax on such income even if we do not distribute it. In 2008, although we had substantial losses for financial accounting purposes and we passed through to our shareholders for tax purposes capital losses due to bond sales and closing out of derivative positions, we also passed through to our shareholders tax-exempt interest income and some taxable interest income. Some shareholders may have capital gains as a result of the share price they paid for our common shares.

 

We could have additional federal income tax obligations which would reduce the sums available for distribution to shareholders.

 

Because we and a number of our subsidiaries are taxed as though we were partnerships, we and those subsidiaries do not have to pay federal income taxes on a significant portion of our income. As is discussed in Item 1. Business — “Material U.S. Federal Tax Considerations,” it is possible that because of changes in the tax laws or changes in the way the tax laws are applied, or by our own election, we may at some time become subject to federal income tax, which would reduce the sums we would have available to distribute to our shareholders. Also, it is possible that the dividends we pay, including the portions derived from our tax-exempt income, could become fully taxable to our shareholders in the same manner, and at the same rates, as dividends paid by taxable corporations.

 

One of our shareholders has the right to designate one, and in some circumstances two, of our directors, which is a right that is not available to any other of our shareholders.

 

Under our organizational documents (since our inception), Shelter Development Holdings, Inc., which is controlled by Mark Joseph, the Chairman of our Board, or its successor has the right to appoint one of our directors, or, if we have more than ten directors, it has the right to appoint two of our directors. This right is not available to any other of our shareholders.

 

Provisions of our Operating Agreement may discourage attempts to acquire us.

 

Our Operating Agreement contains at least three groups of provisions that could have the effect of discouraging people from trying to acquire control of us. Those provisions are:

 

 

 

The above provisions could deprive our shareholders of opportunities that might be attractive to many of them.

 

 

None.

 

 

We do not own any of the real property where we conduct our business. Our corporate headquarters is located in Baltimore, Maryland, where we lease approximately 35,000 sq. feet of office space pursuant to a lease that expires in 2014. Our two other principal offices are located in Tampa, Florida (where we lease approximately 35,000 sq. feet of office space pursuant to a lease that expires in 2016) and Boston, Massachusetts (where we lease approximately 55,000 sq. feet of office space pursuant to a lease that expires in 2015).

 

Our debt, structured finance and fund management segments predominantly use the Baltimore and Tampa offices. Our tax credit equity sector primarily uses our Boston office.

 

As of the date of this Report, we also lease office space for regional offices in the following locations: Chicago, Illinois; Grapevine, Texas; Detroit, Michigan; Atlanta, Georgia; Roswell, Georgia; San Diego, California; San Francisco, California; Irvine, California; St. Paul, Minnesota; Denver, Colorado; New York, New York; and El Segundo, California. We will be disposing of some of these offices as we sell aspects of our business and we expect to close others due to current market conditions. We believe our facilities are suitable for our requirements and are adequate for our current and contemplated future operations.

 

 

Except as described below, we are not a party to any material litigation or other legal proceedings, or to the best of our knowledge, any threatened litigation or legal proceedings, which, in the opinion of management, individually or in the aggregate, would be likely to have a material adverse effect on our results of operations or financial condition.

 

In September 2006, we were named as a nominal defendant in a suit in the Delaware Chancery Court entitled Paddy Wood v. Charles C. Baum, et.al, C.A. No. 2404-VCL, a derivative suit in which the plaintiff sought recovery on our behalf for damages we allegedly suffered because, among other things, we allegedly failed to record impairments to various assets as required by GAAP. The action was dismissed in November 2007 because the plaintiff had failed to ask our Board to investigate the allegations. The plaintiff appealed and in June 2008 the Delaware Supreme Court affirmed the dismissal.

 

After we announced in September 2006, that we would be restating our financial statements for 2005 and prior years, the Philadelphia regional office of the SEC informed us that it was conducting an informal inquiry concerning us and requested the voluntary production of documents and information concerning, among other things, the reasons for that and a prior restatement. We provided the requested documents and information and are cooperating fully with the informal inquiry. The SEC staff has been advised by us on the progress of the

restatement and the preparation of our 2006 financial statements. We do not know what, if anything, the SEC staff may do now that the restatement and our 2006 financial statements are filed.

 

In the first half of 2008, we were named as a defendant in eleven (subsequently reduced to ten) purported class action lawsuits and five derivative suits. In each of these class action lawsuits, the plaintiff purports to represent a class of investors in the Company’s shares who allegedly were injured by claimed misstatements in press releases issued and SEC filings made between May 3, 2004, and January 28, 2008. The plaintiffs seek unspecified damages for themselves and the shareholders of the class they purport to represent. The class action lawsuits have been consolidated into a single legal proceeding pending in the United States District Court for the District of Maryland. The derivative cases have also been consolidated before the United States District Court for the District of Maryland. Both cases will proceed under the name In Re Municipal Mortgage & Equity, LLC Securities and Derivative Litigation, Case No. 80-MDL-1961. By Court order, a single consolidated amended complaint was filed in the class actions on December 5, 2008. Similarly, a single consolidated amended complaint was filed in the derivative cases on December 12, 2008. In the derivative suits, the plaintiffs claim, among other things, that the Company was injured because its directors and certain named officers did not fulfill their duties. A derivative suit is a lawsuit brought by a holder of shares or other equity interests in a company, not on the holder’s own behalf, but on behalf of the company, and against the parties who allegedly caused harm to the company. Any proceeds of a successful derivative action are awarded to the company, except to the extent they are used to pay fees to the plaintiffs’ counsel and other costs. On March 12, 2009, we filed a motion to dismiss the class action. We and the plaintiffs agreed not to take any further action regarding the derivative cases at least until the motion to dismiss the class actions is decided. Due to the inherent uncertainties of litigation, and because these specific actions are still in a preliminary stage, the Company cannot reasonably predict the outcome of these matters at this time.

 

In October 2008, Navigant Consulting, Inc. (“Navigant”) filed suit against the Company for $7.8 million in consulting fees billed to the Company related to Navigant’s services in connection with the restatement, development of accounting policies and business unit services. The Company disputes the claims and expects to defend the case vigorously. The Company has filed an answer and counterclaims. Because the case is at an early stage, the Company cannot reasonably predict the outcome at this time.

 

In July 2007, we received a letter from the U.S. Securities and Exchange Commission (SEC) informing us of a routine examination of our subsidiary that is registered under the Investment Advisers Act of 1940 and bringing matters to our attention for consideration and corrective action related to record keeping and other matters. We designated a new chief compliance officer of the subsidiary and remediated most of the issues identified in the letter, and we informed the SEC staff of the steps we had taken to do that. While we have taken steps to correct all the deficiencies that were identified, it is possible that the SEC could seek to penalize us because of our prior failures to meet applicable requirements; however, because we no longer provide investment management services to institutional investors, our subsidiary is no longer registered under the Investment Advisors Act.

 

 

None.

 

 

Until February 5, 2008, our common stock was listed on the New York Stock Exchange under the symbol “MMA.” Since then, it has been traded in the over the counter market under the symbol “MMAB.PK.” The following table shows the high and low sales prices for our common stock during the periods of 2008, 2007 and 2006 indicated in consolidated trading reported by the NYSE for 2006 and 2007, and the over the counter market known as the pink sheets for 2008, and the cash dividends we declared per share:

 

 

Prior to the fourth quarter of 2007, we paid increasing dividends to our shareholders for 43 consecutive quarters. In January 2008 in response to deteriorating market conditions and our increasing costs, our Board reduced the dividend for the fourth quarter of 2007 by 37% from what we had paid for the prior quarter. Nonetheless, the total dividends for 2007 exceeded the operating cash we generated in that year. In May 2008, our Board did not declare any dividend and our Board has not declared any dividend since then. Our Board considers a number of factors in deciding whether we should pay a dividend for a quarter. However, in view of the difficulty we are having generating the cash we need for our operations and to satisfy our lenders, it is unlikely that we will pay a dividend in the near future.

 

On December 31, 2008, the last sale price of our common shares reported in the over the counter market was $0.27. On that day, there were approximately 2,157 holders of record of our common shares. We issued Schedule K-1s to approximately 45,844 persons who were beneficial owners of our shares during 2008. However, those persons were not necessarily all beneficial owners at the same time.

 

Performance Graph

 

The following table compares total shareholder return for MuniMae at December 31, 2008 to the Standard and Poor’s 500 Index, the FTSE National Association of Real Estate Investment Trusts (“NAREIT”) Equity Index, and a peer group (“Peer Group”) Index consisting of American Home Mortgage Investment Corp., Annaly Capital Management Inc., Capital Trust Inc., Capitalsource Inc., Charter Mac (now known as Centerline Holding Co.), Fieldstone Investment Corporation, Impac Mortgage Holdings Inc., Istar Financial Inc., MFA Mortgage Investments, Inc. (now known as MFA Financial Inc.), Mortgage IT Holdings, Inc., Northstar realty Finance Corp., Novastar Financial Inc., Rait Financial Trust, and Redwood Trust Inc., assuming a $100 investment made on December 31, 2001 and assuming reinvestment of all dividends. MuniMae selected the NAREIT index because the NAREIT index consists of real estate investment trusts which, like MuniMae, pass-through the majority of their income to their shareholders, albeit not tax-exempt income. MuniMae selected the Peer Group companies because those companies operate within the same general industry as MuniMae.

 

COMPARISON OF 7 YEAR CUMULATIVE TOTAL RETURN*
Among Municipal Mortgage And Equity, LLC, The S&P 500 Index,
The FTSE NAREIT Equity Index And A Peer Group

 

 

Fiscal year ending December 31.

Copyright^© 2009 S&P, a division of The McGraw-Hill Companies Inc. All rights reserved.

 

Comparative Total Return Analysis

 

 

Unregistered Sales of Equity Securities

 

During the years ended December 31, 2006 and 2005, we issued equity securities in two transactions that were not registered under the Securities Act of 1933, as amended. In July 2005, we entered into a stock purchase agreement to acquire all outstanding capital stock of Glaser Financial Group, Inc. for an initial cash purchase price of $50.0 million plus deferred payments of approximately $12.0 million over the three year period subsequent to the closing along with contingent consideration to be paid if certain specified levels of operating performance were achieved. Deferred payments were made to the sellers in 2006 and 2007 in the form of common shares. In May 2006, we acquired Renewable Ventures LLC, a third-party financer and operator of renewable energy generation facilities for approximately $3.0 million, including approximately $0.6 million of common shares. We issued shares in these transactions without registration in reliance on the exemption in Section 4(2) of the Securities Act for transactions by an issuer not involving any public offering.

 

Issuer Purchases of Equity Securities

 

None.

 

The following table contains selected financial data that are derived from our audited consolidated financial statements included in this Report and should be read in conjunction with those financial statements. The 2004 and 2005 consolidated financial statements included in this Report on Form 10-K have been restated from the consolidated financial statements for those years included in our Report on Form 10-K for the year ended December 31, 2005. Further, the 2004 consolidated financial statements have been restated from the 2004 consolidated financial statements included in our Report on Form 10-K for the year ended December 31, 2004. See “Notes to Consolidated Financial Statements-Note 2, Restatement of Previously Reported Results” included in this Report for additional detail on the accounting corrections.

 

The selected financial data included in this Report relate only to the years ended December 31, 2006, 2005 and 2004. Preparing restated standalone financial data regarding the years ended December 31, 2002 and 2003 would have been very costly and would have significantly delayed the filing of this Report. Because it has been more than five years since December 31, 2003, we believe that restated financial data related to the years ended December 31, 2003 and 2002 would only be marginally beneficial and would not have justified either the cost or the delay that would have been required to prepare it. Accordingly, we did not deem it practical to include selected financial data for those years; however, as part of the restatement, we have reflected the cumulative effect of the restatement in our beginning balance of shareholders’ equity at December 31, 2003.

 

 

 

 

 

Except as otherwise noted, this Management’s Discussion and Analysis of Financial Condition and Results of Operations describes us as we existed on December 31, 2006 and the factors that affected our operating results during 2006, 2005 and 2004. It does not take account of things that have happened since December 31, 2006, which have materially changed us and our businesses. See Item 1. Business.

 

General Overview

 

Our business activities consist primarily of making, providing and arranging investments and financing secured by, or otherwise related to, multifamily or commercial real estate, the majority of which generates tax-exempt income, tax credits or other tax benefits for investors. We have also been engaged in the financing of renewable energy projects, which also generates tax credits and other tax benefits for investors. In addition, we have provided investment management services to a limited number of institutional investors.

 

MuniMae was organized in 1996 as a Delaware limited liability company and became a public company in 1996. We are classified as a partnership for federal income tax purposes. We have the same limited liability, governance and management structures as a corporation, but we are treated as a pass-through entity for federal income tax purposes. Thus, our shareholders include their distributive shares of our income, deductions and credits on their tax returns. Among other things, this allows us to pass-through tax-exempt interest income to our shareholders.

 

Many of our subsidiaries also are pass-through entities, and our taxable income, deductions and credits that are reflected on our shareholders’ tax returns include the income, deductions and credits of those subsidiaries. However, other of our subsidiaries are corporations that pay taxes on their own taxable income. Our income, deductions and credits that are reflected on our shareholders’ tax returns do not include the income of those subsidiaries, but include any taxable dividends or other taxable payments we receive from them. Tax information is provided to our shareholders on Schedule K-1 rather than on Form 1099.

 

We generate income primarily through returns on financing we provide, and through fees and distributions from funds and other investment entities we manage.

 

We operate through three primary divisions as described below:

 

 

 

 

 

 

There is a significant difference between the assets and liabilities reflected on our consolidated balance sheet prepared under GAAP and those assets that are legally owned by us or liabilities we are directly obligated on. Our December 31, 2006 consolidated balance sheet reflected consolidated total assets of $8.5 billion and consolidated shareholders’ equity of $667.9 million. However, our December 31, 2006 consolidated balance sheet included $4.9 billion of assets and $2.0 billion of liabilities of over 200 funds and partnerships in which we (MuniMae and its majority owned subsidiaries) had little or no ownership interest, but the assets and liabilities of which are required to be consolidated primarily due to FIN 46(R). Although it would not be in accordance with GAAP to exclude the impact of these consolidated funds and ventures from our consolidated financial statements, we believe that explaining the effect of including these entities helps the public to understand which assets MuniMae has a direct or indirect economic interest in, and the liabilities that MuniMae or entities it owns could be required to pay. Without the assets and liabilities of these consolidated funds and ventures (but including assets that were eliminated as part of the consolidation) MuniMae had at December 31, 2006, total assets of $3.9 billion and $3.2 billion in total liabilities, including perpetual preferred stock of a subsidiary.

 

The consolidation of these entities also affects our reported revenues because certain fees and other payments received from the consolidated entities are not reflected as revenues but are reflected as income allocated to us in the consolidated statement of operations. We must also record losses related to these entities even though MuniMae itself has no expectation to fund those losses, other than possible losses related to the investments we actually have in those entities. We have recorded cumulative pre-tax losses related to these entities totaling approximately $90.0 million through December 31, 2006. The majority of these losses would be reversed upon a qualifying sale of our interest or other event that would allow us to deconsolidate these entities.

 

Critical Accounting Policies and Estimates

 

The preparation of our consolidated financial statements is based on the selection and application of GAAP, which requires us to make certain estimates and assumptions that affect the reported amounts and classification of the amounts in our consolidated financial statements. These estimates and assumptions require us to make difficult, complex and subjective judgments involving matters that are inherently uncertain. We base our accounting estimates and assumptions on historical experience and on judgments that are believed to be reasonable under the circumstances available to us at the time. Actual results could materially differ from these estimates. We applied our critical accounting policies and estimation methods consistently in all material respects and for all periods presented, and have discussed those policies with our Audit Committee.

 

We believe the following accounting policies involve a higher degree of judgment and complexity and represent the critical accounting policies and estimates used in the preparation of our consolidated financial statements.

 

Consolidated Funds and Ventures

 

We are associated with numerous investments in partnerships and other entities that primarily hold or develop real estate, although some of these investments are related to the development of renewable energy projects. In most cases our direct or indirect legal interest is minimal in these entities; however, we apply Accounting Research Bulletin No. 51, “Consolidated Financial Statements” (“ARB 51”), FIN 46(R) or Emerging Issues Task Force Issue No. 04-5, “Determining Whether a General Partner, or the General Partners as a Group, Controls a Limited Partnership or Similar Entity When the Limited Partners have Certain Rights” (“EITF 04-5”) in order to determine if we need to consolidate any of these entities. There is considerable judgment in assessing whether to consolidate an entity under these accounting principles. Some of the criteria we are required to consider include:

 

 

 

We or funds we manage have investments in over 2,000 entities, the majority of which are considered to be VIEs and therefore are subject to the application of FIN 46(R). Based on the application of FIN 46(R) or similar accounting pronouncements, we have consolidated over 200 of these entities, which resulted in assets of $4.9 billion being added to our balance sheet at December 31, 2006. In addition, we recorded cumulative pre-tax losses related to these entities totaling approximately $90.0 million through December 31, 2006. The majority of these losses would be reversed upon a qualifying sale of our interest or other event that would allow us to deconsolidate these entities.

 

Valuation of Bonds and Retained Interests in Securitized Bonds

 

Bonds available-for-sale include mortgage revenue bonds, other municipal bonds and retained interests in securitized bonds. We account for investments in bonds as available-for-sale debt securities under the provisions of Statement of Financial Accounting Standards (“FASB”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities” (“SFAS 115”).

 

Accordingly, these investments in bonds are carried at fair value with changes in fair value (excluding other-than-temporary impairments) recognized in other comprehensive income. We estimate the fair value of our bonds using quoted prices, where available; however, most of our bonds do not have observable market quotes. For these bonds, we estimate the fair value of the bonds by discounting the cash flows that we expect to receive using current estimates of appropriate discount rates. For non-performing bonds, given that we have the right to foreclose on the underlying real estate property which is the collateral for the bonds, we estimate the fair value by discounting the underlying properties’ expected cash flows using estimated discount and capitalization rates less estimated selling costs. There are significant judgments and estimates associated with forecasting the estimated cash flows related to the bonds or the underlying collateral for defaulted bonds, including macroeconomic conditions, interest rates, local and regional real estate market conditions and individual property performance. In addition, the discount rates applied to these cash flow forecasts involves significant judgments as to current credit spreads and investor return expectations. We had $100.9 million of net unrealized gains reflected in our bond portfolio reported at a fair value of $1.8 billion at December 31, 2006. Given the size of our portfolio, different judgments as to credit spreads and investor return expectations could result in materially different valuations.

 

In addition, we have to make a determination as to whether there is an other-than-temporary impairment in bonds in our bond portfolio. As such, we follow the guidance in FASB Staff Position FAS 115-1 and FAS 124-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments” (“FSP FAS 115-1/124-1”). Retained interests in securitized bonds are periodically reviewed for potential impairment in accordance with Emerging Issues Task Force Issue No. 99-20, ”Recognition of Interest Income and Impairment on Purchased Beneficial Interests and Beneficial Interests that Continue to be Held by a Transferor in Securitized Financial Assets” (“EITF 99-20”).

 

We evaluate our bond portfolio for other-than-temporary impairment throughout the year. Each bond with an estimated fair value less than amortized cost is reviewed on a quarterly basis by management. At a minimum,

management considers the following factors that, either individually or in combination, could indicate that the decline is other-than-temporary:

 

 

Among the other factors that are considered in determining intent and ability is a review of our capital adequacy, interest rate risk profile and liquidity position. Declines in the fair value of the bonds below their amortized cost that are deemed to be other-than-temporary are recognized in earnings as “Impairment on bonds.” The fair value of an other-than-temporarily impaired bond becomes the new cost basis of the bond and it is not adjusted for subsequent recoveries in fair value. We have recorded cumulative impairment of $43.0 million on bonds that we owned at December 31, 2006.

 

Allowance for Loan Losses

 

The allowance for loan losses represents management’s best estimate of probable incurred losses attributable to loans held for investment. The allowance for loan losses is composed of two different components, including a loan-specific allowance based on the provisions of Statement of Financial Accounting Standards No. 114, “Accounting by Creditors for Impairment of a Loan, an amendment of FASB Statements No. 5 and 15” (“SFAS 114”) and an unallocated allowance attributable to the remaining portfolio based on the provisions of Statement of Financial Accounting Standards No. 5, “Accounting for Contingencies” (“SFAS 5”).

 

We perform systematic reviews of our loan portfolio throughout the year to identify credit risk and to assess overall collectability. The Company’s credit risk rating process (see Item 7A. Quantitative and Qualitative Disclosures about Market Risk — “Credit and Liquidity Risk”) is inherently subjective and is based on judgments related to the borrower’s past performance, the current status of the loan, the performance of the underlying collateral and the current condition of the loan as compared to our original underwriting. The credit risk rating process is integral to our determination of which loans are considered impaired and it also has a significant impact on the determination of our unallocated loan loss as we apply our loss experience based on our credit ratings.

 

For impaired loans, we determine if a specific loan loss is required. Specific impairment losses are measured based upon:

 

 

This measurement process is judgmental and in most cases the impairment measure is based on the fair value of the underlying collateral, which is primarily real estate related assets. Real estate valuations require significant estimates and assumptions such as rental or lease revenue, operating expenses, vacancy considerations and investor discount and capitalization rates. In addition, many of our properties are low income housing apartment projects that have tax credits associated with them that we value for purposes of determining impairment. The values of these tax credits is based on the performance and compliance of the property with guidelines established to qualify for the tax credits. Future non-compliance can impact the tax credit value through loss of credits or tax credit recapture.

Valuation of Mortgage Servicing Rights

 

We account for purchased MSRs initially at fair value. MSRs that are retained from the sale of loans are initially recorded through an allocation of the cost of the loan between the loan sold and the retained MSR, based on their relative fair value.

 

As observable market prices for commercial multifamily MSRs are not available, we estimate the fair value of mortgage servicing rights by utilizing an internally developed discounted cash flow model to calculate the present value of expected future cash flows associated with servicing the loans when mortgage servicing rights are initially recorded and at each balance sheet date. This calculation uses a number of inputs and assumptions that are based on historical experience as well as external market information such as industry surveys and published market data. The assumptions used in the valuation model include borrower prepayment speeds, discount rates that are commensurate with the risk profile of the serviced assets, servicing costs, allowable fees, ancillary income, foreclosure rate, float earnings rate, escrow earning rate, and tax and insurance inflation rate.

 

Models used to value mortgage servicing rights are highly sensitive to changes in certain assumptions such as prepayment speeds and discount rates. Loan level prepayment curves are created for each loan to project expected prepayment behavior. Loan prepayment speeds are determined by both voluntary and involuntary factors, adjusted for market conditions. Voluntary prepayments are influenced by the call protection period, lockout period, yield maintenance, prepayment penalties and the interest rate environment. Involuntary prepayment (defaults) rates are estimated based on loan type and loan age. The discount rate represents the required rate of return that investors would expect for an asset with similar risk. The discount rates are calculated incrementally, and include a risk free rate, a base market pricing spread and additional risk premiums depending on mortgage servicing characteristics.

 

Impairment on Equity Method Investments and Impairment on Real Estate in Lower Tier Property Partnerships

 

Equity Method Investments

 

Our consolidated LIHTC Funds hold investments in unconsolidated Lower Tier Property Partnerships. In addition, we directly hold investments in unconsolidated Lower Tier Property Partnerships prior to placing these partnerships into LIHTC Funds. We also hold investments in other unconsolidated real estate. These investments are accounted for under the equity method and we assess our equity method investments for other-than-temporary impairment in accordance with Accounting Principles Board Opinion No. 18, “The Equity Method of Accounting for Investments in Common Stock” (“APB 18”) and Emerging Issues Task Force Issue No. 94-1, “Accounting for Tax Benefits Resulting from Investments in Affordable Housing Projects” (“EITF 94-1”). Depending on whether these investments are in affordable housing projects, the pertinent accounting literature will differ.

 

Equity method investments in affordable housing projects

 

In accordance with EITF 94-1, we use an undiscounted cash flow approach to identify other-than-temporary impairment related to our equity method investments in affordable housing projects. The undiscounted cash flow projections provide an estimate of:

 

 

If the cash flow projection provides an estimate that is less than the carrying value of the equity investment, then the investment is written down through a current period reduction to net income, a majority of which is allocated to non-controlling interest holders.

 

Equity method investments that are not affordable housing projects

 

In accordance with APB 18, we use an undiscounted cash flow approach to identify other-than-temporary impairment. The undiscounted cash flow projection provides an estimate of the cash flows associated with the long-lived asset held by the unconsolidated real estate entity. If our equity share of the total undiscounted cash flows is less than the carrying value of the equity investment, then our investment is written down through a current period reduction to net income. However, the impairment charge is based on our equity share of the fair value of the unconsolidated entity based on discounted cash flows.

 

Real Estate in Lower Tier Property Partnerships

 

In some cases we hold real estate because we have consolidated certain Lower Tier Property Partnerships in light of the fact that we have taken back the general partner interest in such partnerships. In other cases (but more infrequent), we hold real estate through a foreclosure or deed-in-lieu of foreclosure. Generally, the real estate is low income housing assets financed with tax credit equity or tax-exempt bonds. We assess the appropriateness of the carrying value of the real estate based on the identification of triggering events as prescribed by Statement of Financial Accounting Standards No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets” (“SFAS 144”). The Company uses an undiscounted cash flow approach to assess recoverability of the asset and where undiscounted cash flows are less than the carrying value of property, we measure impairment based on the fair value of the property.

 

In addition, with regard to the Lower Tier Property Partnerships in which we hold an equity investment, as discussed above, we also apply SFAS 144 in order to assess impairment of the real estate asset held by these entities. Given that we are recording a share of income or loss through our equity investment in these entities, we assess whether the impairment taken by the Lower Tier Property Partnership is adequate and adjust our equity in losses from these entities as needed.

 

The application of our accounting policies related to impairment on equity method investments and impairment on real estate in Lower Tier Property Partnerships requires judgments and estimates that are primarily related to forecasting cash flows associated with the real estate asset(s) held by these entities. In addition, fair valuing these assets is dependent on key assumptions related to discount rates and capitalization rates.

 

Income taxes

 

Municipal Mortgage & Equity, LLC is the parent entity that owns interests in various entities, some of which are corporations subject to federal and state income taxes (“C corporations”) and others of which are pass-through entities for tax purposes (meaning the owners of the partnership or other equity interests are allocated the taxable income). Municipal Mortgage & Equity, LLC is itself a pass-through entity, and therefore, all the income (and loss) of our pass-through entity subsidiaries is allocated to our common shareholders. We do not have a liability for federal and state income taxes related to our income. However, we do have several business segments that operate their business through taxable C corporations; and as such a portion of our income is subject to federal and state income taxes.

 

Statement of Financial Accounting Standards No. 109, “Accounting for Income Taxes” (“SFAS 109”), establishes financial accounting and reporting standards for the effect of income taxes. The objectives of accounting for income taxes are to recognize the amount of taxes payable or refundable for the current period and deferred tax assets and liabilities for future tax consequences of events that have been recognized in an entity’s financial statements or tax returns. Significant judgment is required in determining and evaluating income tax positions, including assessing the relative merits and risks of various tax treatments considering statutory, judicial and regulatory guidance available regarding the tax position. We establish additional

provisions for income taxes when there are certain tax positions that could be challenged and that may not be sustained upon review by taxing authorities.

 

Judgment is also required in assessing the future tax consequences of events that have been recognized in our consolidated financial statements or tax returns as well as the recoverability of our deferred tax assets. In assessing the realizability of our deferred tax assets we consider information such as forecasted earnings, future taxable income and tax planning strategies in measuring the required valuation allowance.

 

Restatement Changes

 

In September 2006, we determined that we had to restate our financial statements for 2005 and 2004. The restatement results changed our previous accounting results across many areas of our activities. However, it has not resulted in any significant adjustments to our corporate cash accounts.

 

The following table provides the cumulative impact of the restatement on shareholders’ equity at December 31, 2005. Management has classified the accounting changes, which have all been determined to be corrections of errors, into broad categories as out lined below. The manner in which the restatement impact is attributed to the ten categories is subjective and certain changes may relate to more than one category. While such classifications are not required under GAAP, management believes these classifications may assist users in understanding the nature and impact of the changes made as part of the restatement. See “Notes to Consolidated Financial Statements-Note 2, Restatement of Previously Reported Results” included in this Report for a more detailed discussion of the accounting corrections.

 

 

Consolidation of Funds and Ventures

 

As part of the restatement process, we re-evaluated our direct or indirect relationship with over 2,000 potential variable interest entities in which we have little or no ownership interest, but for which we may be deemed to be the primary beneficiary or to have control. Our re-evaluation of the application of FIN 46(R), EITF 04-5 and ARB 51 resulted in the consolidation of funds and ventures that were previously not consolidated or were consolidated incorrectly. As a result, upon restatement, we have consolidated all assets, liabilities and non-controlling interests, as well as income and expenses of over 200 additional entities.

 

The following summarizes the re-evaluation considerations related to our different funds and ventures.

 

LIHTC Funds

 

There are two primary changes related to the consolidation of the LIHTC Funds:

 

 

 

Historically, we ceased recognizing losses when our general partner capital accounts in LIHTC Funds reached zero. Because we are the general partner, we should have continued to record our general partner portion of a LIHTC Fund’s losses, even if our capital account was reduced below zero. In addition, as the general partner, we should have recorded losses attributable to the limited partners when the limited partners’ capital accounts in the LIHTC Funds reached zero. As part of the restatement, we recorded the losses of LIHTC Funds in excess of our general partner capital accounts and the losses of LIHTC Funds related to the limited partners’ capital accounts after their capital accounts reached zero. In addition, we have extended loan and bond financing to certain unconsolidated Lower Tier Property Partnerships. In consolidation, these are considered additional interests that should absorb losses of the unconsolidated Lower Tier Property Partnerships. These losses are generally non-cash losses caused by depreciation and thus we generally do not expect to advance cash related to these losses. The cumulative impact on shareholders’ equity related to these items was a decrease of $23.5 million (before income taxes) at December 31, 2005.

 

Consolidated Lower Tier Property Partnerships

 

The Consolidated Lower Tier Property Partnerships primarily represent the consolidation of partnerships as to which we took over the general partner interest because of issues with the property or developers (GP Take Backs). Generally, at the time of a GP Take Back transaction the developer general partner has little or no equity in the project, and in many cases there is no third party limited partner equity to absorb losses. As a result, as the new general partner, we must record for financial reporting purposes all of the losses (which are primarily due to non-cash depreciation) in those cases where the limited partners’ capital accounts have reached zero. Sale of our general partner interest or of the property that results in the deconsolidation of the Lower Tier Property Partnerships will result in us reversing the previously recorded losses into income. The cumulative impact on shareholders’ equity related to these items was a decrease of $77.3 million (before income taxes) at December 31, 2005.

 

Tax Credit Equity Accounting

 

We restated several items related to the accounting for our Tax Credit Equity segment. Previously, we deferred certain organizational costs, did not properly capitalize acquisition costs in Lower Tier Property Partnerships and did not consider the portion of the investment funded by us in the measurement of capitalized interest.

 

We also historically applied the lease accounting approach under SFAS 66 to guaranteed funds, which resulted in us recording the total limited partners’ invested capital in the fund as a guarantee liability. This guarantee liability was being relieved and recognized as income over the life of the fund on a straight-line basis. In addition, we recorded all of the net losses associated with these funds (as there was no non-controlling interest to which to allocate these losses). As part of the restatement, we are no longer applying lease accounting to these entities. We are consolidating the guaranteed LIHTC Funds consistent with the consolidation accounting for the non-guaranteed funds. The guarantee obligation is eliminated in consolidation and is measured as a possible cost that is considered for purposes of syndication fee revenue recognition.

 

We corrected the calculation for determining the portion of syndication income to recognize when the LIHTC Funds invested in Lower Tier Property Partnerships. In addition, we changed the way we measure and reduce income by our future expected costs and losses associated with the syndication of new funds. Lastly, our recognition of asset management fees had been based on whether the amounts were determinable and collection was reasonably assured within one year, but did not consider the Funds’ ability to pay in subsequent periods.

 

The cumulative impact to shareholders’ equity resulting from Tax Credit Equity restatement adjustments was a decrease of $41.3 million (before income taxes) at December 31, 2005. In addition, historically we did not

record a liability for unfunded equity commitments while interests in Lower Tier Property Partnerships were warehoused, nor did we record a liability for unfunded equity commitments once these investments were syndicated and placed into LIHTC Funds. As part of the restatement we recorded a $903.8 million increase in our “Investments in unconsolidated Lower Tier Property Partnerships” and a $232.4 million increase in our “Investments in unconsolidated ventures” with a corresponding increase of $903.8 million in “Unfunded equity commitments to unconsolidated Lower Tier Property Partnerships” and a $232.4 million increase in “Unfunded equity commitments to investments in unconsolidated ventures” at December 31, 2005, in the consolidated balance sheets.

 

Bond Accounting

 

As part of the restatement, our bond portfolio was valued higher by $61.0 million at December 31, 2005. We had been reporting bond values based on informal quotes from a broker, which were not supported by independently observable market inputs or cash flow models. In the restatement, we created an internal discounted cash flow model using market-based assumptions. These amounts do not include the impact of consolidation, which eliminated a portion of these changes in the consolidation process.

 

Tax Valuation Allowance

 

As a result of the restatement, we substantially increased our deferred tax assets, primarily due to the significant deferral of income related to the Tax Credit Equity accounting changes. As part of the restatement, we re-evaluated the realizability of our deferred tax assets. After considering all available evidence, both positive and negative, we concluded that it was more likely than not that the deferred tax assets would not be realized. As a result, we concluded that a valuation allowance was required against our deferred tax assets. At December 31, 2005, the cumulative impact of providing a valuation allowance related to our deferred tax assets was $41.3 million.

 

Other Restatement Adjustments

 

The restatement also resulted in various changes to our loan accounting, equity investment accounting, derivative accounting, MSR accounting, as well as other changes, as more fully described in “Notes to Consolidated Financial Statements-Note 2, Restatement of Previously Reported Results” included in this Report.

 

Results of Operations

 

We are now consolidating all of our LIHTC Funds and certain Lower Tier Property Partnerships in situations where we have assumed the general partner role through a transfer of the general partner interest or where we have acquired the property through foreclosure. One effect of consolidating these entities is the elimination of the revenues we receive when these entities pay us fees and the recording of net losses in those cases where the limited partnership capital account has reached zero (although this revenue is allocated to us through “Net losses allocable to non-controlling interests from consolidated funds and ventures”). See “Notes to Consolidated Financial Statements-Note 20, Consolidated Funds and Ventures.” Consolidating these entities makes the year over year comparisons difficult and the net impact is not necessarily reflective of the economics to us based on our true legal ownership or contractual interest in these entities. Although it is not in accordance with GAAP to exclude the impact of these consolidated funds and ventures from our financial statements, information that excludes these funds and ventures helps our management, and we believe will help investors, to understand the revenue and expenses (and gains and losses) that more directly depicts MuniMae’s activities and economics without the activities and economics associated with the non-controlling interest holders of these consolidated funds and ventures.

 

Therefore, the following results of operations discussion is provided in two sections: Section I — Summary of Consolidated Results which provides a results of operations discussion that is reflective of our GAAP consolidated income statement, and Section II — Summary of GAAP-adjusted Results which provides a results of operations discussion that excludes certain revenues/gains and expenses/losses related to our legal

interests in these entities and presents differently certain income and expense components related to our contractual interests in these entities. Management also provides segment results on a segment adjusted earnings basis, which can be found in “Notes to Consolidated Financial Statements-Note 18, Segment Information.” This metric includes all adjustments made to arrive at our GAAP-adjusted results and also incorporates further adjustments to remove the impact of additional significant non-cash items (See “Notes to Consolidated Financial Statements-Note 18, Segment Information” for more details).

 

Section I. Summary of Consolidated Results

 

The table below summarizes our consolidated financial performance for the years ended December 31, 2006, 2005 and 2004:

 

 

 

 

Interest Income

 

The following table summarizes our interest income for the years ended December 31, 2006, 2005 and 2004:

 

 

Interest income is our primary source of revenue and is affected by changes in the interest rate environment as well as the size of the underlying bond and loan portfolios.

 

Year Ended 2006 Compared to Year Ended 2005

 

Total Interest income increased 28.4% or $41.7 million for the year ended December 31, 2006 as compared to 2005 and is due to the following:

 

Interest on bonds increased 13.1% or $11.6 million for the year ended December 31, 2006 as compared to 2005 primarily due to the growth of the bond portfolio, partially offset by declines due to lower interest rates. The weighted average bond portfolio increased by $201.8 million in 2006 to approximately $1.5 billion compared to $1.3 billion at year end 2005. This increase was primarily driven by new investments in our mortgage revenue bonds and other municipal bonds as we strategically continued to expand our bond portfolio given the positive pricing spreads we were achieving through our securitizations, partially offset by sale and redemption activity. Consistent with the interest rate environment, new bonds were issued during 2006 at lower interest rates, which resulted in a 16 basis point (“bp”) reduction to the average interest rate earned on the bond portfolio during 2006.

 

Interest income on loans increased 52.6% or $28.6 million for the year ended December 31, 2006 as compared to 2005. The primary driver of the increase was the expansion of the weighted average loan portfolio from $725.8 million for 2005 to $986.4 million for 2006. This expansion of the loan portfolio was driven primarily by increased investments in bridge loans as a result of the acquisition of MONY in February 2005. Our bridge loan balance was $136.9 million at year end December 31, 2005 and increased to $458.6 million at year end December 31, 2006. This increase was partially offset by transfers of loans from our balance sheet to MRC Mortgage Investment Trust (a non-consolidated investment company we manage).

 

Interest on short-term investments increased $1.5 million for the year ended December 31, 2006 as compared to 2005. This increase is due mainly to the acquisition of Glaser in July 2005. The Glaser acquisition significantly expanded the Fannie Mae and Freddie Mac servicing portfolio in 2006, which required us to maintain short-term investments as a collateral requirement related to our Fannie Mae servicing status.

 

Year Ended 2005 Compared to Year Ended 2004

 

Interest income increased 19.2% or $23.7 million for the year ended December 31, 2005 as compared to 2004 and is due to the following:

 

Interest on bonds increased 11.6% for the year ended December 31, 2006 as compared to 2005 primarily due to the growth of the bond portfolio, partially offset by declines in the average interest rate on the bond portfolio. The weighted average bond portfolio increased approximately $165.4 million to $1.3 billion in 2005 from $1.1 billion in 2004 mainly due to increased investments in our mortgage revenue bonds and other municipal bonds, partially offset by sale and redemption activity. Due to the competitive nature of the marketplace and consistent with the interest rate environment, new bonds were issued during 2005 at lower interest rates, which resulted in a 21 bp reduction in the average interest rate earned on the bond portfolio.

Interest income on loans increased 29.4% or $12.4 million for the year ended December 31, 2005 as compared to 2004 primarily due to an increase in the average interest rate earned on the loan portfolio and an increase in the loan portfolio. The average interest rate earned on the loan portfolio increased by 66 basis points (“bps”) during 2005 primarily a result of higher interest rates charged on existing construction loans (the prime rate, which is the base rate for these loans, continued to increase in 2005). The average loan portfolio grew by $115.4 million, or 18.9% during 2005 due to new investments in construction loans, primarily as the result of our acquisition of Glaser in July 2005.

 

Interest on short-term investments increased $2.2 million for the year ended December 31, 2005 as compared to 2004. This increase is mainly due to the Fannie Mae collateral requirement as a result of the Glaser acquisition in July 2005.

 

Fee and Other Income

 

The following table summarizes our fee and other income for the years ended December 31, 2006, 2005 and 2004:

 

 

Year Ended 2006 Compared to Year Ended 2005

 

Total fee and other income increased 32.2% or $17.8 million for the year ended December 31, 2006 as compared to 2005 due mainly to an increase in syndication fees and promote income, partially offset by declines in other income components as outlined below.

 

Syndication fees increased $13.2 million or 41.0% for the year ended December 31, 2006 as compared to 2005 mainly due to an increase in capital contributed from the LIHTC Funds to the Lower Tier Property Partnerships, partially offset by a decline in the average syndication fee rate. We generally receive our syndication fee revenue at or near the time a LIHTC Fund is syndicated; however, syndication fees are recognized ratably in our consolidated statements of operations as capital contributions are made by the LIHTC Funds to the Lower Tier Property Partnerships. Capital contributed to the Lower Tier Property Partnerships increased $325.0 million in 2006 as compared to 2005. The average net syndication fee rate (net syndication fees generated for fund syndication as a percentage of fund capital) for funds syndicated in 2006 decreased by 101 bps.

 

Asset management and advisory fees are earned based on specific percentages of invested or committed capital in funds for which we provide asset management, advisory and portfolio management services. Asset management and advisory fees decreased $1.6 million for the year ended December 31, 2006 as compared to 2005 primarily due to the sale of our general partner interest in the Transwestern Mezzanine Realty Partners II, LLC fund (“Mezz II”) in March 2006. Beginning in April 2006, the new general partner was entitled to the asset management fees and therefore we only received three months of asset management fees in 2006 as compared to approximately eleven months of fees on the $300 million of committed capital in 2005. Additionally, advisory fees related to our Transwestern Mezzanine Realty Partners, LP fund (“Mezz I”) decreased due to a return of capital to its investors as a result of loan sales and loan maturities.

We earn debt placement fees for providing services in relation to assets originated and placed with our advisory clients. Debt placement fees decreased by $3.2 million for the year ended December 31, 2006 as compared to 2005. This decrease was due to several items including: (1) the sale of our general partner interest in the Mezz II fund in March 2006, removing the opportunity for us to source additional assets for this fund throughout 2006; (2) the decline in loan originations in the B-Note Value Fund L.P. (“B-Note Value Fund”) in 2006; and (3) in 2005, we served as a conduit and broker for four deals in which we earned debt placement fees in 2005, but this activity was not repeated in 2006.

 

Guarantee fees decreased $0.6 million for the year ended December 31, 2006 as compared to 2005 mainly due to the expiration of certain guarantees that we assumed through the 2003 acquisition of the HCI business of Lend Lease Real Estate Investments, Inc.

 

Servicing fees are earned for performing mortgage servicing activities, including collection of payments from individual borrowers, distribution of these payments to investors, maintenance of escrow funds and other administrative duties. The majority of these fees are associated with mortgage loans that we owned and then sold to investors, retaining the related mortgage servicing rights. We also earn fees for servicing activities performed for institutional investors. Our fees are generally based on a percentage of the unpaid principal balance of the mortgage being serviced. During the years 2004, 2005, and 2006, the weighted average servicing fee on the portfolio ranged between 29 bps and 38 bps. Our servicing fee income is offset by the amortization of the mortgage servicing rights that are established when we sell loans with servicing retained and the amortization of purchased mortgage servicing rights (purchased primarily from business combinations). Servicing fee income increased $3.1 million for the year ended December 31, 2006 as compared to 2005 mainly due to a $2.1 billion increase in the average serviced portfolio as a result of the full year impact of the Glaser acquisition in 2005, partially offset by declines in the average servicing fee rate of 31 bps in 2005 to 29 bps in 2006. Cash payments received for servicing activities increased $8.2 million to $19.3 million in 2006 as compared to $11.1 million in 2005. Amortization of mortgage servicing rights also increased by $5.1 million to $11.9 million for the year ended December 31, 2006 as compared to $6.8 million for 2005.

 

Other fees are composed of promote income, revenue from the sale/transfer of general partner interests in certain of our managed funds, collateral fees, and other miscellaneous fess such as extension fees, late fees, application fees, disposition fees, cancellation fees and administrative servicing fees. Other fees increased $7.0 million for the year ended December 31, 2006 as compared to 2005 mainly due to an increase in promote income. We receive promote income under arrangements where the investors in funds we manage achieve a targeted return and then we are entitled to share in the income above that targeted return. In 2006, we earned $5.5 million of promote income from Mezz I. The other significant driver of the increase in other fees in 2006 over 2005 was $2.0 million of income from the sale of the Mezz II general partner interest to Transwestern Investment Company, LLC in March 2006.

 

Year Ended 2005 Compared to Year Ended 2004

 

Total fee and other income increased $6.4 million for the year ended December 31, 2005 as compared to the year ended December 31, 2004 due mainly to increases in asset management fees and debt placement fees, partially offset by a decline in guarantee fees as discussed below.

 

Syndication fee revenue remained flat between the years ended December 31, 2005 and 2004. Capital contributed by the LIHTC Funds into the Lower Tier Property Partnerships increased $101.3 million in 2005 as compared to the year ended December 31, 2004; however, syndication fees did not increase due to a 24 bp decline in the average net syndication fee rate for the funds syndicated in 2005.

 

Asset management and advisory fees increased $3.4 million for the year ended December 31, 2005 as compared to 2004 and Debt placement fees increased $2.4 million for the year ended December 31, 2005 as compared to 2004, both of these increases were mainly due to the MONY acquisition in February 2005.

 

Guarantee fees decreased $2.0 million for the year ended December 31, 2005 as compared to 2004 due primarily to the recognition of $1.8 million in fees in 2004 on a yield guarantee that expired in 2004.

Servicing fee income increased $0.8 million for the year ended December 31, 2005 as compared to 2004 mainly due to a $1.9 billion increase in the average servicing portfolio as a result of the 2005 Glaser acquisition, offset by declines in the average servicing fee rate from 38 bps in 2004 to 31 bps in 2005. Cash payments received for servicing activities increased $6.1 million to $11.1 million in 2005 as compared to $5.0 million in 2004. Servicing fees are reduced by the amortization of mortgage servicing rights which increased by $5.3 million to $6.8 million for the year ended December 31, 2005 as compared to $1.5 million for 2004.

 

Other fees increased $2.3 million for the year ended December 31, 2005 as compared to 2004 due mainly to increases in disposition fee income and miscellaneous fee income. We are entitled to disposition fee income when we are involved in brokering the sale of assets to a third party. We typically have minimal involvement in these transactions and only participate at the request of an investor. In 2004, we brokered no transactions of this type but were involved in two transactions in 2005 that resulted in disposition fee income of approximately $1.4 million. The increase in miscellaneous fee income was due to the expansion of our loan portfolio in 2005, which provides us the opportunity to earn loan fees related to extensions, cancellations and other loan activities. As the servicing portfolio expanded in 2005 we earned additional fees of this nature.

 

Revenue from Consolidated Funds and Ventures

 

The following table summarizes our revenue from consolidated funds and ventures for the years ended December 31, 2006, 2005 and 2004:

 

 

Revenue from consolidated funds and ventures is comprised of rental income from consolidated Lower Tier Property Partnerships as well as interest income from LIHTC Funds and the B-Note Value Fund.

 

Year Ended 2006 Compared to Year Ended 2005

 

Revenue from consolidated funds and ventures increased $6.3 million for the year ended December 31, 2006 as compared to 2005 due to increases in interest and other income, partially offset by declines in rental income as described below.

 

Revenue from rental and other income from real estate decreased $4.6 million for the year ended December 31, 2006 as compared to 2005 primarily due to a decline in the number of income producing real estate properties during 2006 from 2005.

 

Interest and other income increased $10.9 million for the year ended December 31, 2006 as compared to 2005 due almost entirely to an increase in interest income on loans held by the B-Note Value Fund. Interest income for 2006 was higher than 2005 as the general partner interest in the B-Note Value Fund was acquired in February 2005 and held for all of 2006.

 

Year Ended 2005 Compared to Year Ended 2004

 

Revenue from consolidated funds and ventures increased $22.9 million for the year ended December 31, 2005 as compared to 2004 due mainly to increases in interest and other income and also due to increases in rental income as outlined below.

 

Revenue from rental and other income from real estate increased $6.2 million for the year ended December 31, 2005 as compared to 2004 due primarily to the increase in the number of income producing real estate properties during 2005 from 2004.

Interest and other income increased $16.7 million for the year ended December 31, 2005 as compared to 2004 due mainly to interest income from the B-Note Value Fund acquired in early 2005. The LIHTC Funds and Lower Tier Property Partnerships also reported net increases in interest and other income of $5.1 million during 2005 primarily attributable to increases in interest income on short-term investment accounts.

 

Interest Expense

 

The following table summarizes our interest expense for the years ended December 31, 2006, 2005 and 2004:

 

 

Year Ended 2006 Compared to Year Ended 2005

 

Interest expense increased $30.9 million for the year ended December 31, 2006 as compared to 2005. This increase can be attributed to three main factors: (1) the weighted average debt balance associated with senior interest in securitization trusts related to our bond business increased from $661.7 million in 2005 to $927.5 million in 2006. This volume increase combined with a 43 bp increase in the average interest rate on theses trusts accounted for close to half of the of the year-over-year increase in interest expense; (2) our average notes payable and other debt balances increased $85.5 million between 2006 and 2005. This volume increase also coupled with a 120 bp increase in the average interest rate on these debt instruments accounted for $9.9 million of the year-over-year increase in interest expense; and (3) in 2006, we entered into a new repurchase facility resulting in an $80.5 million increase in the average debt balance which contributed $4.9 million of interest expense during 2006 that was not incurred in 2005. The overall increase in our debt balances can be attributed to the expansion of our business as a result of the continued favorable pricing spreads in the bond securitization markets and due to our expansion through business acquisitions.

 

Year Ended 2005 Compared to Year Ended 2004

 

Interest expense increased $21.7 million for the year ended December 31, 2005 as compared to 2004. This increase was primarily due to the issuance of $91.5 million of subordinate debentures in 2005. This contributed an additional $8.1 million of interest expense as compared to 2004 and accounted for 37.1% of the year-over-year increase. Other drivers of the increase in interest expense from 2004 to 2005 were increases in the senior interest of securitization trusts and an increase in interest rates on our lines of credit used to fund loans held for investment. The average debt balance for senior interest of securitization trusts increased $101.5 million to $661.7 million in 2005 from $560.2 million in 2004. Also, the average interest rate on these trusts increased 43 bps between 2005 and 2004. The average debt balance for our line of credit facilities remained flat, but the average interest rate on the facilities increased 153 bps in 2005 to 4.71% from 3.18% in 2004.

Operating Expenses

 

The following table summarizes our operating expenses for the years ended December 31, 2006, 2005 and 2004:

 

 

Year Ended 2006 Compared to Year Ended 2005

 

Total operating expenses increased $9.0 million for the year ended December 31, 2006 as compared to 2005 due mainly to an increase in professional fees and miscellaneous expenses as discussed below.

 

Salary and benefit expenses decreased $1.8 million for the year ended December 31, 2006 as compared to 2005. In 2005, we executed a business unit restructuring effort resulting in $4.8 million of severance costs in 2005. This one time cost in 2005 resulted in the decline of Salaries and benefits costs between 2005 and 2006, but was partially offset by an increase in Salaries and benefits expenses related to the remaining work force. Salary and benefits growth, absent the severance costs incurred in 2005, was approximately 3.8%.

 

General and administrative costs increased $1.4 million the year ended December 31, 2006 as compared to 2005. Our general and administrative expenses have two primary components: (1) specific expenses that are incurred during LIHTC Fund formation and in some cases, LIHTC Fund liquidations and (2) non-fund specific costs that are related to our normal operations. In 2006, non-fund specific costs increased $3.6 million. These non-fund specific costs increased primarily due to the Glaser and MONY acquisitions in 2005 which increased our general and administration spending, especially in rent, travel and technology. The increase in general and administrative expenses was partially offset by declines in our LIHTC Fund formation specific expenses during the year ended December 31, 2006 as compared to the year ended December 31, 2005. In 2006, fund specific costs were $11.7 million, down from $13.9 million in 2005. This decrease is attributable to a decrease in broker fees. In 2005, broker fees were paid by us; however, in 2006 broker fees were paid out of investor capital contributions based on changes in the partnership agreements.

 

Professional fees which include accounting fees, consulting fees and legal fees increased $3.6 million for the year ended December 31, 2006 as compared to 2005 mainly due to increases in consulting fees. Consulting fees increased $2.3 million in 2006 over 2005 due to increased expenses related to the development and application of accounting policies, and finance function process and financial reporting improvement efforts. These two initiatives added approximately $0.9 million and $1.3 million to our consulting fees in 2006, respectively.

 

Depreciation and amortization increased $0.9 million for the year ended December 31, 2006 as compared to 2005 due mainly to increases in standard depreciable items, such as furniture and fixtures, office equipment, computer hardware and software, as well as leasehold improvements. In 2005, we relocated one of our offices and we expanded one of our offices. These office changes resulted in increased purchases of the standard depreciable items outlined above which had a significant impact on depreciation and amortization, increasing the costs by approximately $0.6 million. Most of these purchases were made in 2005 but the full year impact of these additions was not realized until 2006.

 

Other expenses increased $4.8 million for the year ended December 31, 2006 as compared to 2005. The primary driver of the year-over-year increase was due to remediation interest of $6.0 million paid to the

LIHTC Funds in 2007 of which $2.5 million was recognized in 2006 (see “ Notes to Consolidated Financial Statements-Note 14 Commitments and Contingencies” for further details).

 

Year Ended 2005 Compared to Year Ended 2004

 

Total operating expenses increased $26.8 million for the year ended December 31, 2005 as compared to 2004 primarily as a result of higher salary and benefit expenses as well as higher general and administrative costs as discussed below.

 

Salaries and benefits expenses increased $17.0 million for the year ended December 31, 2005 as compared to the year ended December 31, 2006. We executed a business unit restructuring effort resulting in the addition of approximately $4.8 million in severance costs in 2005. The remainder of the increase was predominantly due to the increase in employees (and related costs) due to the Glaser and MONY acquisitions that occurred in 2005.

 

General and administrative costs increased $6.1 million for the year ended December 31, 2005 as compared to 2004 primarily due to an increase in non-fund specific costs of $4.0 million. These non-fund specific costs increased due to the Glaser and MONY acquisitions in 2005 which increased our spending levels in the areas of rent, travel, technology and office supplies. In addition, fund specific costs increased $2.0 million to $13.9 million for the year ended December 31, 2005 as compared to $11.9 million in 2004. This increase in fund specific costs was due to higher acquisition costs for Lower Tier Property Partnerships placed into LIHTC Funds during 2005.

 

Professional fees increased $2.8 million for the year ended December 31, 2005 as compared to 2004 due to an increase in consulting fees of $1.6 million as well as an increase in legal expenses of $0.6 million. Higher consulting fees were attributable to increased internal audit spending and costs related to Sarbanes-Oxley projects. The increase in legal costs was driven by additional legal services required due to the expansion of our business.

 

Depreciation and amortization increased $1.3 million for the year ended December 31, 2005 as compared to 2004 due to an increase in office related purchases of equipment and depreciable assets as we continued to grow our business through acquisitions and internal growth.

 

Impairment on Bonds and Provision for Credit Losses

 

The following table summarizes our bond impairment and our provision for credit losses for the years ended December 31, 2006, 2005 and 2004:

 

 

Year Ended 2006 Compared to Year Ended 2005

 

Total bond impairments and provision for credit losses decreased $3.5 million for year ended December 31, 2006 as compared to 2005.

 

Impairment on bonds decreased $10.9 million for the year ended December 31, 2006 as compared to 2005. During 2005, we recorded impairments of $12.7 million on four bonds based on broker prices obtained on anticipated sales of these bonds. During 2006, there were three bonds impaired based on discounted cash flows of the underlying property and no individual impairment exceeded $1.0 million.

The provision for credit losses includes provisions related to estimated losses for individual loans deemed to be impaired as well as for estimated losses on non-specified loans for our loans held for investment. The provision for credit losses also includes estimated losses on unfunded loan commitments as well as estimated losses for inherent loss exposure related to certain recourse provisions related to loans sold to Fannie Mae or guaranteed by Ginnie Mae. The provision for credit losses increased $7.4 million for year ended December 31, 2006 as compared to 2005 primarily due to several loans related to one property with additional impairment recorded in 2006 for $7.9 million.

 

Year Ended 2005 Compared to Year Ended 2004

 

Total bond impairments and provision for credit losses increased $12.5 million for year ended December 31, 2005 as compared to 2004 due primarily to the increase in bond impairments of $12.3 million taken in 2005, as discussed above.

 

Expenses from Consolidated Funds and Ventures

 

The following table summarizes our expenses from consolidated funds and ventures for the years ended December 31, 2006, 2005 and 2004:

 

 

Expenses of consolidated funds and ventures are primarily the result of activities and charges related to our LIHTC Funds, consolidated Lower Tier Property Partnerships and the B-Note Value Fund.

 

Year Ended 2006 Compared to Year Ended 2005

 

Expenses from consolidated funds and ventures increased $13.2 million for the year ended December 31, 2006 as compared to 2005.

 

Depreciation and amortization decreased $3.9 million for the year ended December 31, 2006 as compared to the year ended December 31, 2005 mainly due to the transfer of several properties from a held for use classification to held for sale classification. Properties, once classified as held for sale, are no longer subject to depreciation expense.

 

Interest expense from consolidated funds and ventures increased $6.4 million for the year ended December 31, 2006 as compared to 2005. Interest expense increased in 2006 primarily due to increased usage of lines of credit to finance LIHTC Fund operations as well as additional debt related to the consolidation of the B-Note Value Fund in 2005. LIHTC Funds were utilizing approximately eight lines of credit at year end 2005 with a total outstanding balance at year end of $74.6 million and in 2006 approximately 12 additional lines were added resulting in a total outstanding balance at year end of $374.0 million. The consolidation of the B-Note Value Fund in 2005 had a significant impact on interest expense growth in 2006 as the fund further financed the growth of its loan portfolio in 2006.

 

Impairment on investments in unconsolidated Lower Tier Property Partnerships increased $18.1 million for the year ended December 31, 2006 as compared to 2005. During 2005, 197 properties recorded impairment as compared to 253 properties in 2006 without any one property comprising the majority of the balance. The increase cannot be attributed to any single factor, but is due to property specific and sub-market factors that are unique to each individual property.

Other operating expenses related to consolidated funds and ventures are primarily management fees, maintenance and utilities related to consolidated Lower Tier Property Partnerships and accounting fees, legal expenses and bad debt reserves. Other operating expenses decreased by $7.5 million for the year ended December 31, 2006 as compared to 2005 mainly due to reduced expenses associated with the LIHTC Funds. Other operating expenses of the LIHTC Funds decreased $6.3 million primarily due to a $5.2 million decrease related to bad debt reserves for advances made to Lower Tier Property Partnerships and a $1.9 million decrease in LIHTC Fund legal and accounting costs.

 

Year Ended 2005 Compared to Year Ended 2004

 

Expenses from consolidated funds and ventures increased $11.9 million for the year ended December 31, 2005 as compared to 2004.

 

Depreciation and amortization decreased $2.1 million for the year ended December 31, 2005 as compared to 2004. The decrease in Depreciation and amortization expense was not due to any single factor, but is the result of more assets becoming fully depreciated in 2005 than 2004 and fewer property additions in 2005.

 

Interest expense from consolidated funds and ventures increased $7.5 million for the year ended December 31, 2005 as compared to 2004. Interest expense increased in 2005 primarily due to increased usage of lines of credit to finance LIHTC Fund operations as well as the first time consolidation of the B-Note Value Fund in 2005.

 

Impairment on investments in unconsolidated Lower Tier Property Partnerships decreased $5.3 million for the year ended December 31, 2005 as compared to 2004. The decrease cannot be attributed to any single factor, but is due to property specific and sub-market factors that are unique to each individual property.

 

Other operating expenses increased $11.8 million for the year ended December 31, 2005 as compared to 2004. Other operating expenses of the LIHTC Funds increased $8.1 million due to a $2.8 million increase related to bad debt reserves for advances made to Lower Tier Property Partnerships and a $4.2 million increase in LIHTC Fund legal and accounting costs.

 

Net Gains on Asset Sales and Derivatives

 

The following table summarizes our net gains on asset sales for the years ended December 31, 2006, 2005 and 2004:

 

 

Year Ended 2006 Compared to Year Ended 2005

 

Net gains on asset sales and derivatives increased $9.8 million for the year ended December 31, 2006 as compared to 2005 mainly due to gains on sale of loans as described below.

 

Net gains on the sale of bonds increased $2.0 million for the year ended December 31, 2006 as compared to 2005. In 2006, 70.8%, or approximately $5.9 million of the gains on bond sales were attributable to two bonds; 81.6% of the gains can be explained with the addition of two other bonds with gains of under $0.6 million per bond. Generally, we do not actively sell our bonds and therefore these bond sale gains in 2006 and 2005 are primarily due to bond redemptions (pay-offs) on bonds we have previously impaired.

Net gains on the sale of loans increased $9.0 million for the year ended December 31, 2006 as compared to 2005 due to increased loan sales to Fannie Mae and Freddie Mac. This increase is largely due to the expansion of our Agency Lending business segment as a result of the Glaser acquisition in 2005.

 

We recorded net losses on derivatives of $3.6 million during 2006 as compared to net gains of $4.4 million during 2005 for an overall decline in income of $8.0 million. The net loss in 2006 was primarily due to mark-to-market losses on our derivative positions due to a decreasing interest rate environment in 2006. During 2005, our gains were primarily due to the sale of net pay fixed swaps during a rising rate environment, partially offset by net interest expense on our interest rate swaps.

 

Net gains on sale of real estate increased $6.8 million for the year ended December 31, 2006 as compared to 2005. From time to time the Company may protect its loan or bond position by taking legal ownership of a property through a deed-in-lieu of foreclosure, or directly through a foreclosure, and we may later sell our interest, at which time a gain or loss on sale of real estate will be recognized. In addition, we may sell certain limited or general partnership interests in partnerships that own real estate. In 2006, the Company recognized $6.8 million of gains on the sale of real estate. A gain of $5.6 million was related to a sale of our limited partner interest in an unconsolidated partnership and $1.2 million represents a gain on the sale of our general partnership interest in a partnership related to a GP Take Back property.

 

Year Ended 2005 Compared to Year Ended 2004

 

Net gains on asset sales increased $22.3 million in the year ended December 31, 2005 as compared to the year ended December 31, 2004.

 

Net gains (losses) on the sale of bonds increased $6.5 million for the year ended December 31, 2005 as compared to 2004. In 2005, 78.3%, or approximately $5.0 million of the gains on bond sales were attributable to two bonds with gains of $3.8 million and $1.2 million.

 

Net gains on the sale of loans increased $7.0 million for the year ended December 31, 2005 as compared to 2004 due to increased loan sales to Fannie Mae and Freddie Mac. This increase is largely due to the expansion of our Agency Lending business segment as a result of the Glaser acquisition in 2005.

 

We recorded net losses on derivatives of $4.4 million during 2004 as compared to net gains of $4.4 million during 2005 for an overall decline in income of $8.8 million. The net loss in 2004 was primarily due to net interest expense incurred on our derivative positions.

 

Net Gains on Sale of Real Estate from Consolidated Funds and Ventures

 

The following table summarizes our net gains on asset sales from consolidated funds and ventures for the years ended December 31, 2006, 2005 and 2004:

 

 

Year Ended 2006 Compared to Year Ended 2005

 

Net gains on the sale of real estate from consolidated funds and ventures increased $32.8 million for the year ended December 31, 2006 as compared to 2005. The increase in 2006 is attributable to increased proceeds from sales of real estate held by Lower Tier Property Partnerships. These sales were primarily comprised of properties reaching the end of their tax credit compliance period, at which time, the LIHTC Funds have limited economic benefits from continuing to hold these properties and therefore they begin marketing their limited partners interests for sale. The gain recognized from a GAAP standpoint is the difference between the carrying value as measured on the equity method of accounting (typically zero at the end of the tax credit compliance period) and the net proceeds received at the time of sale. In 2006, the LIHTC Funds received

$66.6 million in proceeds on sales of properties as compared to $33.3 million in 2005, resulting in an increased gain on sale of real estate.

 

Year Ended 2005 Compared to Year Ended 2004

 

Net gains on the sale of real estate from consolidated funds and ventures increased $13.9 million for the year ended December 31, 2005 as compared to 2004. In 2005, the LIHTC Funds received $33.3 million in cash proceeds on sales of properties as compared to $24.4 million in 2004. The increased cash combined with lower basis in the sold properties, resulted in a larger gain in 2005.

 

Equity in Earnings from Unconsolidated Ventures

 

The following table summarizes our equity in earnings from unconsolidated ventures for the years ended December 31, 2006, 2005 and 2004:

 

 

Year Ended 2006 Compared to Year Ended 2005

 

Equity in earnings from unconsolidated ventures decreased $21.1 million for the year ended December 31, 2006 as compared to 2005. These unconsolidated ventures principally acquire, develop and sell real estate properties. The decrease in 2006 can be attributed to lower average gains on property sales from our CAPREIT 3M Venture that invests in and manages numerous multifamily apartment projects. Even though the number of properties sold increased from three to six in 2006, there were lower gains associated with these sales in 2006 compared to 2005 as a result of transaction pricing and our basis in these properties.

 

Year Ended 2005 Compared to Year Ended 2004

 

Equity in earnings from unconsolidated ventures increased $25.9 million for the year ended December 31, 2005 as compared to 2004. The significant increase in 2005 can be attributed to an increase in sales volume over 2004; in 2005, three properties were sold compared with one in 2004. Furthermore, the proceeds of these sales were significantly greater.

 

Equity in Losses from Unconsolidated Lower Tier Property Partnerships held by Consolidated Funds and Ventures

 

The table below summarizes the equity in losses from unconsolidated Lower Tier Property Partnerships held by consolidated funds and ventures for the periods ending December 31, 2006, 2005 and 2004:

 

 

Year Ended 2006 Compared to Year Ended 2005

 

Equity in losses from unconsolidated Lower Tier Property Partnerships held by consolidated funds and ventures increased $38.3 million for the year ended December 31, 2006 as compared to 2005. Generally, the Lower Tier Property Partnerships generate GAAP net losses because they are low income housing projects that are designed to be “subsidized” by investment tax credits; therefore, the properties’ operations conceptually breakeven on a cash basis, but will have significant GAAP net losses due to deprecation expense. The increase

in the number and size of syndicated LIHTC Funds contributed to an increase in investments in Lower Tier Property Partnerships that resulted in increased equity losses. Also contributing to the increase was the fact that many more projects moved from the construction phase to operations, which triggers the property recording depreciation on the building. The $51.4 million increase in LIHTC Funds losses was offset by $12.4 million due to profits on sale of investment properties held by entities we have an equity investment in through our Real Estate division.

 

Year Ended 2005 Compared to Year Ended 2004

 

Equity in losses from unconsolidated Lower Tier Property Partnerships held by consolidated funds and ventures increased $42.5 million for the year ended December 31, 2005 as compared to 2004. The increase in the number and size of syndicated LIHTC Funds contributed to an increase in investments in Lower Tier Property Partnerships that resulted in equity losses as projects moved from their construction phase into operations. The LIHTC Funds losses increased $42.6 million for the year ended December 31, 2005.

 

Income Tax Expense

 

The table below summarizes the consolidated income tax expense for the periods ending December 31, 2006, 2005 and 2004:

 

 

We are a publicly traded partnership (“PTP”) for tax purposes, and as such, our entire pass-through entity income and loss is allocated to our common shareholders. Therefore, we do not have income tax expense related to our pass-through entity income. We do own C corporation entities, which are subject to federal and state income taxes. The income tax expense shown here is related to our C corporation entities. Our income tax expense is comprised of federal and state income tax expense. State income tax expense remained relatively the same each year for a variety of reasons, such as the nature and originating location of the income, the attribution of expenses to such income, etc. The federal income tax expense has remained relatively constant as we are generating C corporation GAAP net operating losses and we are in an overall net deferred tax asset position for all years. Because of this, we are dependent on the generation of future income in order to support our ability to record an income tax benefit related to our C corporation net losses. Based on an evaluation of all of the available evidence, both positive and negative, we concluded that our deferred tax assets would not be realized and as such we are providing a valuation allowance on virtually all of our originating deferred tax assets in all years. Thus, the federal portion of our income tax expense has not materially changed in these years.

 

Distributions Declared to Perpetual Preferred Shareholders of Subsidiary

 

The table below summarizes the distributions declared to perpetual preferred shareholders of subsidiary for the periods ending December 31, 2006, 2005 and 2004:

 

 

Year Ended 2006 Compared to Year Ended 2005

 

Distributions declared to perpetual preferred shareholders of a subsidiary increased for the year ended December 31, 2006 as compared to 2005 due to new share issuances on November 4, 2005 of $100.0 million.

The increase in distributions declared to perpetual preferred shareholders of subsidiary in 2006 can be attributed to the full year impact of the $100.0 million November 2005 issuance. The corresponding annual distribution rates for 2006 and 2005 were 5.3% and 5.6%, respectively.

 

Year Ended 2005 Compared to Year Ended 2004

 

Distributions declared to perpetual preferred shareholders of a subsidiary increased for the year ended December 31, 2005 as compared to 2004 due to new share issuances on November 4, 2005 and October 19, 2004 of $100.0 million and $73.0 million, respectively. The full year impact of the October 2004 issuance combined with the partial year impact of the $100.0 million issuance in November 2005 were the primary drivers of the $4.2 million increase in 2005. The corresponding annual distribution rates for 2005 and 2004 were 5.6% and 5.0%, respectively.

 

Net Loss Allocable to Non-Controlling Interests from Consolidated Funds and Ventures

 

The table below summarizes the net loss allocable to non-controlling interests from consolidated funds and ventures for the periods ending December 31, 2006, 2005 and 2004:

 

 

Year Ended 2006 Compared to Year Ended 2005

 

Losses allocable to non-controlling interests from consolidated funds and ventures increased $32.3 million for the year ended December 31, 2006 as compared to 2005. Losses allocable to non-controlling interests in consolidated funds and ventures are primarily attributable to the LIHTC Funds. The Company holds a 0.1% to 1.0% interest in these Funds; therefore, the majority (i.e., 99%) of the activity related to these entities is allocated to the non-controlling interest holders. In addition, other income statement activities, such as asset management and guarantee fees, are reclassified (when we consolidate these entities) from revenue to net loss allocable to non-controlling interests from consolidated funds and ventures. The increase from 2005 to 2006 is attributable to an overall increase in net losses of consolidated funds and ventures of $12.4 million and an increase in our allocation of income attributable to asset management and other fees, gains on sale of real estate and allocations of income due to the Company’s general partner interests of $21.9 million.

 

Year Ended 2005 Compared to Year Ended 2004

 

Losses allocable to non-controlling interests from consolidated funds and ventures increased $32.9 million for the year ended December 31, 2005 as compared to 2004. The increase from 2004 to 2005 is attributable to increase in net losses of consolidated funds and ventures of $17.6 million and an increase in our allocation of income of $14.8 million.

Discontinued Operations

 

The table below summarizes our income from discontinued operations related to consolidated funds and ventures for the periods ending December 31, 2006, 2005 and 2004:

 

 

Years Ended 2006, 2005 and 2004 Compared

 

In 2006, we generated net income from discontinued operations of $9.6 million, an increase of $2.0 million over 2005. The $9.6 million was primarily attributable to two properties we disposed of in 2006, generating net income of $9.4 million, which for the most part represents the reversal of cumulative non-cash losses we recorded on these properties during our holding period. In 2005, our $7.6 million of net income from discontinued operations is primarily related to a $10.0 million gain on sale of real estate related to a property we foreclosed on and immediately sold. In 2004, we had a similar foreclosure and immediate sale of a property generating a $11.3 million gain.

 

Section II. Summary of GAAP-adjusted Results

 

We consolidate all of our LIHTC Funds, certain Lower Tier Property Partnerships in situations where we executed a GP Take Back of a Lower Tier Property Partnership, and certain other funds and ventures that the Company manages through its Real Estate Division (see “Notes to Consolidated Financial Statements-Note 20, Consolidated Funds and Ventures”). The effects of consolidating these entities is to include in our financial statements the assets, liabilities, non-controlling interests, income and expenses of these entities, even though we have little or no legal or economic ownership interest in them. Management believes that explaining the effect of excluding these consolidated funds and ventures from our financial results is useful for investors.

 

GAAP-adjusted net income is a view of the Company’s financial results without the effects of the consolidated funds and ventures. In addition, GAAP-adjusted net income excludes the allocations of losses in those cases where the Company’s capital account has reached zero. Also, discontinued operations (after removing the impact of the consolidated funds and ventures) are reclassified to the financial statement line items where they would have been recorded if we did not account for them as discontinued operations. GAAP-adjusted net income is a non-GAAP financial measure and is used in addition to, and in conjunction with, results presented in accordance with GAAP. This non-GAAP financial measure should not be relied upon to the exclusion of the GAAP net income. The following discussion is intended to provide the reader with an example of the amounts that would be presented on a GAAP-adjusted results basis and we have limited our discussion to the year ended December 31, 2006.

The table below summarizes our GAAP-adjusted financial performance for the year ended December 31, 2006:

 

Summary of GAAP-adjusted Results