SECURITIES AND EXCHANGE COMMISSION

 

Washington, DC  20549

 

FORM 10-Q

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended September 30, 2006

 

**Commission File Number: 001-12477**

 

**CHEVY CHASE PREFERRED CAPITAL CORPORATION**

(Exact name of registrant as specified in its charter)

 

|   | **Maryland** | **52-1998335** |
|--------|--------------|----------------|

|   | (State or other jurisdiction of | (I.R.S. Employer |
|--------|---------------------------------|------------------|

|   | incorporation or organization) | Identification No.) |
|--------|--------------------------------|---------------------|

 

**7501 Wisconsin Avenue**

**Bethesda, Maryland 20814**

(Address of principal executive offices) (Zip Code)

 

**(301) 987-2265**

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

| Yes[ X ] | No [ | ] |
|----------|------|---|

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.  (Check one):  Large accelerated filer[   ]                Accelerated filer[   ]Non-accelerated filer [ X ]

 

Indicate by check mark whether the registrant is a shell company (as defined in Exchange Act Rule 12b-2).

| Yes[ | ] | No [ X ] |
|------|---|----------|

 

The number of shares outstanding of the registrant’s sole class of common stock was 100 shares, $1.00 par value per share, as of October 15, 2006.  All of such shares were owned by Chevy Chase Bank, F.S.B.; therefore, no common stock was held by non-affiliates.

 

 

**CHEVY CHASE PREFERRED CAPITAL CORPORATION**

 

**TABLE OF CONTENTS**

 

**PART I - FINANCIAL INFORMATION**

**Page**

| **Item 1. Financial Statements:** | 1 |
|-----------------------------------|---|

|   | (a) | Statements of Financial Condition as of September 30, 2006 and |
|--------|-----|----------------------------------------------------------------|

|   | December 31, 2005 | 2 |
|--------|-------------------|---|

|   | (b) | Statements of Operations for the Three and Nine Months Ended |
|--------|-----|--------------------------------------------------------------|

|   | September 30, 2006 and 2005 | 3 |
|--------|-----------------------------|---|

|   | (c) | Statement of Stockholders’ Equity for the Nine Months |
|--------|-----|------------------------------------------------------------|

|   | Ended September 30, 2006 | 4 |
|--------|--------------------------|---|

|   | (d) | Statements of Cash Flows for the Nine Months Ended |
|--------|-----|----------------------------------------------------|

|   | September 30, 2006 and 2005 | 5 |
|--------|-----------------------------|---|

|   | (e) | Notes to Financial Statements | 6 |
|--------|-----|-------------------------------|---|

 

**Item 2.  Management’s Discussion and Analysis of Financial**

|   | **Condition and Results of Operations** | 8 |
|--------|-----------------------------------------|---|

 

| **Item 3.  Quantitative and Qualitative Disclosures about Market Risk** | 11 |
|-------------------------------------------------------------------------|----|

 

| **Item 4.  Controls and Procedures** | 11 |
|--------------------------------------|----|

 

**PART II – OTHER INFORMATION**

 

| **Item 1.  Legal Proceedings** | 13 |
|--------------------------------|----|

 

| **Item 1A. Risk Factors** | 13 |
|---------------------------|----|

 

| **Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds** | 13 |
|--------------------------------------------------------------------------|----|

 

| **Item 3.  Defaults Upon Senior Securities** | 13 |
|----------------------------------------------|----|

 

| **Item 4.  Submission of Matters to a Vote of Security Holders** | 13 |
|------------------------------------------------------------------|----|

 

| **Item 5.  Other Information** | 13 |
|--------------------------------|----|

 

| **Item 6.  Exhibits** | 13 |
|-----------------------|----|

 

 

**PART I**

 

**ITEM 1.  Financial Statements**

 

The following unaudited financial statements and notes of Chevy Chase Preferred Capital Corporation (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information.  In the opinion of management, all adjustments necessary for a fair presentation of the financial position and the results of operations for the interim period presented have been included.  These unaudited financial statements and notes should be read in conjunction with the Company’s financial statements and notes for the year ended December 31, 2005 included in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission on March 24, 2006 (the “2005 10-K”).

 

-1-

 

**CHEVY CHASE PREFERRED CAPITAL CORPORATION**

**STATEMENTS OF FINANCIAL CONDITION**

 

|                                             |   | September 30,            |   | December 31,             |
|--------------------------------------------------|--------|--------------------------|--------|--------------------------|
|                                             |   | 2006                     |   | 2005                     |
|                                             |   | (Unaudited)              |   |                     |
| **ASSETS**                                       |
|                                             |   |                     |   |                     |
| Cash and interest-bearing deposits               |   | $              3,179,303 |   | $              1,913,298 |
| Residential mortgage loans (net of allowance for |   |                     |   |                     |
| losses of $40,333 at both period ends)           |   | 366,320,365              |   | 376,814,496              |
| Accounts receivable from parent                  |   | 469,701                  |   | 1,458,559                |
| Accrued interest receivable                      |   | 1,584,440                |   | 1,543,716                |
| Prepaid expenses                                 |   | 18,575                   |   | 5,000                    |
| Total assets                                     |   | $          371,572,384   |   | $          381,735,069   |

 

                **LIABILITIES AND STOCKHOLDERS’ EQUITY**

| Liabilities:                                                                                                                                                                                                                              |                    |   |                    |
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-------------------------|--------|-------------------------|
| Loan payable to parent                                                                                                                                                                                                                    | $            65,300,000 |   | $            75,000,000 |
| Accrued interest payable to parent                                                                                                                                                                                                        | 345,919                 |   | 319,523                 |
| Accounts payable to others and accrued expenses                                                                                                                                                                                           | 32,927                  |   | 9,624                   |
| Dividends payable to parent                                                                                                                                                                                                               | -                       |   | 2,300,000               |
| Dividends payable to others                                                                                                                                                                                                               | 3,890,625               |   | 3,890,625               |
| Total liabilities                                                                                                                                                                                                                         | 69,569,471              |   | 81,519,772              |
|                                                                                                                                                                                                                                      |                    |   |                    |
| Stockholders’ Equity:                                                                                                                                                                                                                |                    |   |                    |
| Preferred Stock, 10,000,000 shares authorized:

10 3/8% Noncumulative Exchangeable Preferred Stock, Series A, $5 par value, 3,000,000 shares issued and outstanding (liquidation value of $150,000,000 plus accrued and unpaid dividends) | 15,000,000              |   | 15,000,000              |
| Common stock, $1 par value, 1,000 shares authorized, 100 shares issued and outstanding                                                                                                                                                    | 100                     |   | 100                     |
| Capital contributed in excess of par                                                                                                                                                                                                      | 284,999,900             |   | 284,999,900             |
| Retained earnings                                                                                                                                                                                                                         | 2,002,913               |   | 215,297                 |
| Total stockholders’ equity                                                                                                                                                                                                           | 302,002,913             |   | 300,215,297             |
|                                                                                                                                                                                                                                      |                    |   |                    |
| Total liabilities and stockholders’ equity                                                                                                                                                                                           | $          371,572,384  |   | $          381,735,069  |

 

 

 

 

 

 

 

See the accompanying Notes to Financial Statements.

 

-2-

 

**CHEVY CHASE PREFERRED CAPITAL CORPORATION**

**STATEMENTS OF OPERATIONS**

(Unaudited)

 

|                          | Three Months Ended

September 30, |   | Nine Months Ended

September 30, |
|-------------------------------|-----------------------------------|--------|----------------------------------|
|                          | 2006                              |   | 2005                             |   | 2006 |   | 2005 |
| **Net Interest Income**       |                              |   |                             |   |   |   |   |
| Residential mortgage loans    | $        6,062,952                |   | $        5,604,297               |   | $      17,918,388 |   | $      16,530,739 |
| Other                         | 3,579                             |   | 1,322                            |   | 17,367 |   | 7,470 |
| Total interest income         | 6,066,531                         |   | 5,605,619                        |   | 17,935,755 |   | 16,538,209 |
| Interest expense              | 1,147,388                         |   | 844,163                          |   | 3,262,001 |   | 2,217,723 |
| Net interest income           | 4,919,143                         |   | 4,761,456                        |   | 14,673,754 |   | 14,320,486 |
|                          |                              |   |                             |   |   |   |   |
| **Operating Expenses**        |                              |   |                             |   |   |   |   |
| Loan servicing fees - parent  | 226,070                           |   | 227,094                          |   | 681,992 |   | 695,356 |
| Advisory fees - parent        | 50,000                            |   | 50,000                           |   | 150,000 |   | 150,000 |
| Directors’ fees          | 8,000                             |   | 8,000                            |   | 24,000 |   | 24,000 |
| General and administrative    | 45,314                            |   | 15,995                           |   | 128,167 |   | 79,199 |
| Total operating expenses      | 329,384                           |   | 301,089                          |   | 984,159 |   | 948,555 |
|                          |                              |   |                             |   |   |   |   |
| **NET INCOME**                | $        4,589,759                |   | $        4,460,367               |   | $      13,689,595 |   | $      13,371,931 |
|                          |                              |   |                             |   |   |   |   |
| **PREFERRED STOCK DIVIDENDS** | 3,890,625                         |   | 3,890,625                        |   | 11,671,875 |   | 11,671,875 |
|                          |                              |   |                             |   |   |   |   |
| **EARNINGS AVAILABLE TO**     |                              |   |                             |   |   |   |   |
| **COMMON STOCKHOLDER**        | $           699,134               |   | $           569,742              |   | $        2,017,720 |   | $        1,700,056 |
|                          |                              |   |                             |   |   |   |   |
| **AVERAGE COMMON SHARES**     | 100                               |   | 100                              |   | 100 |   | 100 |
|                          |                              |   |                             |   |   |   |   |
| **EARNINGS PER COMMON SHARE** | $          6,991.34               |   | $          5,697.42              |   | $        20,177.20 |   | $        17,000.56 |

 

 

 

 

 

 

 

 

 

 

 

 

See the accompanying Notes to Financial Statements.

 

-3-

 

**CHEVY CHASE PREFERRED CAPITAL CORPORATION**

**STATEMENT OF STOCKHOLDERS’ EQUITY**

(Unaudited)

 

 

|                           |  

 

Preferred

Stock |   |  

 

Common

Stock |   | Capital

Contributed

In Excess

of Par |   |  

 

Retained

Earnings |   |  

Stockholders’

Equity |
|--------------------------------|----------------------------------|--------|-------------------------------|--------|-----------------------------------------|--------|------------------------------------|--------|------------------------------------|
|                           |                             |   |                          |   |                                    |   |                               |   |                               |
| Balance, December 31, 2005     | $    15,000,000                  |   | $          100                |   | $    284,999,900                        |   | $         215,297                  |   | $      300,215,297                 |
|                           |                             |   |                          |   |                                    |   |                               |   |                               |
| Net income                     | -                                |   | -                             |   | -                                       |   | 13,689,595                         |   | 13,689,595                         |
| Dividends on 

Preferred Stock | -                                |   | -                             |   | -                                       |   | (11,671,875)                       |   | (11,671,875)                       |
| Dividends on Common Stock      | -                                |   | -                             |   | -                                       |   | (230,104)                          |   | (230,104)                          |
|                           |                             |   |                          |   |                                    |   |                               |   |                               |
| Balance, September 30, 2006    | $    15,000,000                  |   | $          100                |   | $    284,999,900                        |   | $      2,002,913                   |   | $      302,002,913                 |

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

See the accompanying Notes to Financial Statements.

 

-4-

 

**CHEVY CHASE PREFERRED CAPITAL CORPORATION**

**STATEMENTS OF CASH FLOWS**

(Unaudited)

|                                                                                         | Nine Months Ended

September 30, |
|----------------------------------------------------------------------------------------------|----------------------------------|
|                                                                                         |
|                                                                                         | 2006                             |   | 2005 |
| **Cash flows from operating activities:**                                                    |                             |   |   |
|                                                                                         |                             |   |   |
| Net income                                                                                   | $      13,689,595                |   | $      13,371,931 |
| Adjustments to reconcile net income to net cash

provided by (used in) operating activities: |                             |   |   |
| (Increase) decrease in accounts receivable from parent                                       | 988,858                          |   | (1,751,901) |
| Increase in accrued interest receivable                                                      | (40,724)                         |   | (152,701) |
| Increase in prepaid expenses                                                                 | (13,575)                         |   | (6,395) |
| Increase (decrease) in accounts payable to others and accrued 

expenses                     | 23,303                           |   | (34,313) |
| Increase in accrued interest payable to parent                                               | 26,396                           |   | 140,563 |
| **Net cash provided by operating activities**                                                | 14,673,853                       |   | 11,567,184 |
|                                                                                         |                             |   |   |
| **Cash flows from investing activities**:                                                    |                             |   |   |
| Purchases of residential mortgage loans                                                      | (65,133,686)                     |   | (102,080,073) |
| Repayments of residential mortgage loans                                                     | 75,627,817                       |   | 111,876,825 |
| **Net cash provided by investing activities**                                                | 10,494,131                       |   | 9,796,752 |
|                                                                                         |                             |   |   |
| **Cash flows from financing activities:**                                                    |                             |   |   |
| Repayment of loan payable to parent                                                          | (9,700,000)                      |   | - |
| Dividends paid on preferred stock                                                            | (11,671,875)                     |   | (11,671,875) |
| Dividends paid on common stock                                                               | (2,530,104)                      |   | (700,000) |
| **Net cash used in financing activities**                                                    | (23,901,979)                     |   | (12,371,875) |
|                                                                                         |                             |   |   |
| **Net increase in cash and cash equivalents**                                                | 1,266,005                        |   | 8,992,061 |
| **Cash and cash equivalents at beginning of period**                                         | 1,913,298                        |   | 2,318,102 |
| **Cash and cash equivalents at end of period**                                               | $        3,179,303               |   | $      11,310,163 |
|                                                                                         |                             |   |   |

 

 

 

 

 

 

 

 

 

See the accompanying Notes to Financial Statements.

 

-5-

 

**CHEVY CHASE PREFERRED CAPITAL CORPORATION**

**NOTES TO FINANCIAL STATEMENTS**

**(Unaudited)**

 

**NOTE 1 – ORGANIZATION AND BASIS OF PRESENTATION:**

 

The Company is a Maryland corporation which acquires, holds and manages real estate assets.  Chevy Chase Bank, F.S.B. (the “Bank”), a federally insured stock savings bank, owns all of the Company’s common stock.  The Bank is in compliance with its regulatory capital requirements.

 

The accompanying financial statements of the Company have been prepared in accordance with the instructions for Form 10-Q and, therefore, certain information and notes normally included in the financial statements prepared in accordance with accounting principles generally accepted in the United States have been condensed or omitted pursuant to such rules and regulations.  The accompanying financial statements should be read in conjunction with the audited financial statements included in the Form 10-K of the Company for the year ended December 31, 2005.

 

**NOTE 2 – RESIDENTIAL MORTGAGE LOANS:**

 

Residential mortgage loans consist of adjustable-rate mortgages (“ARMs”) and fixed-rate mortgages.  The ARMs have interest rates which are fixed for a period (one month, one year, three years, five years, seven years or ten years) and which adjust thereafter based on the margin, index and frequency, subject to interest rate adjustment caps, all as specified in the related mortgage notes.  Each of the mortgage loans is secured by a mortgage, deed of trust or other security instrument which created a first lien on a residential dwelling.  The following table shows the residential mortgage loan portfolio by type at the dates indicated:

 

|                      | September 30, 2006          |   | December 31, 2005       |
|---------------------------|-----------------------------|--------|-------------------------|
|                      | Aggregate Principal Balance |   | Weighted Average

Yield |   | Aggregate Principal Balance |   | Weighted Average

Yield |
| Payment Option ARMs       | $  43,595,967               |   | 8.13%                   |   | $    72,466,980 |   | 6.96% |
| One-year ARMs             | 5,942,333                   |   | 7.39%                   |   | 8,545,766 |   | 6.13% |
| Three-year ARMs           | 21,705,294                  |   | 6.89%                   |   | 25,589,269 |   | 6.06% |
| Five-year ARMs            | 217,922,576                 |   | 6.14%                   |   | 180,269,621 |   | 5.84% |
| 7/1 ARMs                  | 2,523,391                   |   | 7.56%                   |   | 3,559,239 |   | 6.72% |
| 10/1 ARMs                 | 10,047,111                  |   | 6.70%                   |   | 11,376,174 |   | 6.68% |
| Fixed-rate                | 64,624,026                  |   | 6.40%                   |   | 75,047,780 |   | 6.42% |
| Total                     | 366,360,698                 |   | 6.51%                   |   | 376,854,829 |   | 6.23% |
| Less:                     |                        |   |                    |   |   |   |   |
| Allowance for loan losses | 40,333                      |   |                    |   | 40,333 |   |   |
|                      |                        |   |                    |   |   |   |   |
| Total                     | $366,320,365                |   |                    |   | $  376,814,496 |   |   |

 

**NOTE 3 - PREFERRED STOCK:**

 

Cash dividends on the Company’s 10 3/8% Noncumulative Exchangeable Preferred Stock, Series A (the “Series A Preferred Shares”) are payable quarterly in arrears.  The liquidation value of each Series A Preferred Share is $50 plus accrued and unpaid dividends.  The Series A Preferred Shares are not redeemable until January 15, 2007 (except upon the occurrence of certain tax events) and are redeemable thereafter at the option of the Company.  Except under certain limited****circumstances, the holders of the Series A Preferred Shares have no voting rights.  The Series A Preferred Shares are automatically exchangeable for a new series of preferred stock of the Bank upon the occurrence of certain events relating to the Bank. 

 

-6-

 

**CHEVY CHASE PREFERRED CAPITAL CORPORATION**

**NOTES TO FINANCIAL STATEMENTS**

**(Unaudited)**

 

**NOTE 4 - DIVIDENDS:**

 

During the three and nine months ended September 30, 2006, the Company’s Board of Directors declared cash dividends of $3,890,625 and $11,671,875, respectively, on the Company's preferred stock out of the retained earnings of the Company.  Dividends were paid on April 17, 2006, July 17, 2006 and October 16, 2006.  

 

During the nine months ended September 30, 2006, the Company’s Board of Directors declared cash dividends of $230,104 on the Company’s common stock out of the retained earnings of the Company.  Dividends were paid on April 17, 2006.

 

**NOTE 5 – LOAN PAYABLE TO PARENT:**

 

The Company borrowed $75,000,000 from the Bank on December 20, 2004, and used the proceeds to purchase Residential Mortgage Loans from the Bank.  The loan is secured by a portion of the Residential Mortgage Loan portfolio, and the interest rate on the loan adjusts monthly based on changes in one-month LIBOR.  

 

The loan requires no payment of principal until it matures on August 31, 2007, but can be prepaid without penalty at any time.  During the September 2006 quarter, the Company repaid $9,700,000 of the loan to the Bank leaving an outstanding principal balance of $65,300,000.  Interest is payable monthly at a variable rate equal to the sum of one-month LIBOR plus 0.85%.  At September 30, 2006, the interest rate was 6.18%.

 

-7-

 

| **ITEM 2.** | **Management’s Discussion and Analysis of Financial Condition and Results of Operations** |
|-------------|------------------------------------------------------------------------------------------------|

 

**FINANCIAL CONDITION**

 

**Dividend Coverage**

 

Based on the outstanding balance of the Company’s Residential Mortgage Loans (as defined below) at September 30, 2006, and the interest rates on such loans, anticipated annual income on the Company’s loan portfolio, net of interest expense and operating expenses, was approximately 118.7% of the projected annual dividend of $15,562,500 on the Series A Preferred Shares.  As of September 30, 2006, the weighted average yield on the Residential Mortgage Loans included in the Company’s portfolio was 6.51%.

 

**Residential Mortgage Loans**

 

At September 30, 2006 and December 31, 2005, the Company had $366,320,365 and $376,814,496, respectively, invested in loans secured by first mortgages or deeds of trust on single-family residential real estate properties (“Residential Mortgage Loans”), net of allowance for loan losses.  During the nine months ended September 30, 2006, Residential Mortgage Loan purchases were $65,133,686 and principal collections were $75,627,817.  Management currently intends to use the proceeds received from future loan repayments to make additional payments of principal on the loan from the Bank or to purchase additional Residential Mortgage Loans from the Bank or its subsidiaries depending upon the level of the dividend coverage ratio. 

 

At September 30, 2006, the Company had three non-accrual loans (contractually past due 90 days or more or with respect to which other factors indicate that full payment of principal and interest is unlikely) with an aggregate principal balance of $375,088 (or 0.10% of loans).  At December 31, 2005, the Company had three non-accrual loans with an aggregate principal balance of $689,796 (or 0.18% of loans). 

 

At September 30, 2006, the Company had seven delinquent loans (delinquent 30-89 days) with an aggregate principal balance of $2,074,636 (or 0.57% of loans).  At December 31, 2005, the Company had six delinquent loans with an aggregate principal balance of $1,406,900 (or 0.37% of loans).

 

**Allowance for Loan Losses**

 

Management reviews the loan portfolio to establish an allowance for estimated losses if deemed necessary.  Management performs a quarterly analysis to determine whether an allowance for loan loss is required, and an allowance is provided after considering such factors as historical loss performance, delinquency status, current economic conditions and geographical concentrations.  The allowance for loan losses is based on estimates, and ultimate losses may vary from current estimates.  As adjustments to the allowance become necessary, provisions for loan losses are reported in operations.  There was no activity in the allowance for loan losses during the nine months ended September 30, 2006 and 2005.  The balance of the allowance for loan losses was $40,333 at September 30, 2006 and 2005.  Based on a review of various factors, including delinquent and non-accrual loans, management determined that the amountof the allowance remained appropriate.

 

**Interest Rate Risk**

 

The Company’s income consists primarily of interest income on Residential Mortgage Loans. If there is a decline in interest rates, then the Company will experience a decrease in income available to be distributed to its stockholders.  See “Risk Factors” in the 2005 10-K.

 

The Company took steps in prior years to increase the funds available to pay dividends on the Series A Preferred Shares.  In addition to a reduction in 2003 in the Bank’s servicing fee, the Company borrowed $75,000,000 from the Bank in December 2004 and used the proceeds to purchase Residential Mortgage Loans from the Bank.  The loan is secured by a portion of the Residential Mortgage Loan portfolio and the interest rate on the loan adjusts monthly based on changes in one-month LIBOR.  During the September 2006 quarter, the Company repaid 

 

-8-

 

principal amounting to $9,700,000, reducing the outstanding principal balance of the loan to $65,300,000 at September 30, 2006.

 

A decline in interest rates could adversely affect the Company’s ability to pay dividends on the Series A Preferred Shares or the Common Stock.  See “Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations – Financial Condition – Dividend Coverage.”  The Company, to date, has not used any derivative instruments to manage its interest rate risk.

 

There have been no material changes to the Company’s market risk disclosures from the disclosures made in the 2005 10-K.

 

**Significant Concentration of Credit Risk**

 

Concentration of credit risk exists when a number of customers are engaged in similar business activities, or activities in the same geographical region, or have similar economic features that would cause their ability to meet contractual obligations to be similarly affected by changes in economic conditions.  Concentration of credit risk indicates the relative sensitivity of the Company’s performance to both positive and negative developments affecting a particular industry.  The Company’s exposure to geographic concentrations directly affects the credit risk of the Residential Mortgage Loans within the portfolio.  

 

Residential Mortgage Loans secured by residential real estate properties located in the Washington, DC metropolitan area comprised of 46.6% of total loans at September 30, 2006.  In addition, 13.1% of the Residential Mortgage Loans are secured by residential real estate properties located in California.  Consequently, adverse economic, political or business developments in Washington, DC, Maryland, Virginia or California may affect the Company’s loan portfolio to a greater degree than a more diversified portfolio.

 

**Liquidity and Capital Resources**

 

The objective of liquidity management is to ensure the availability of sufficient cash flows to meet all of the Company’s financial commitments.  In managing liquidity, the Company takes into account various legal limitations placed on a real estate investment trust (a “REIT”), as discussed below in “Tax Status of the Company.”

 

The Company’s principal liquidity needs are to fund the acquisition of additional Mortgage Assets as current Mortgage Assets held by the Company are repaid and to pay dividends on the Series A Preferred Shares. The acquisition of such additional Mortgage Assets will be funded with the proceeds of principal repayments on its current portfolio of Mortgage Assets.  The Company does not anticipate that it will have any material capital expenditures.  The Company believes that the cash generated from the payment of principal and interest on its Mortgage Asset portfolio will provide sufficient funds to meet its operating requirements, to continue to make additional payments of principal on the loan from the Bank, and to pay dividends in accordance with the REIT qualification requirements discussed below for the foreseeable future.  As discussed earlier under “Item 2 Management’s Discussion andAnalysis of Financial Condition and Results of Operations – Financial Condition – Dividend Coverage,” anticipated annual income, based on the mortgage loan portfolio at September 30, 2006, is 118.7% of the projected annual dividend on the Series A Preferred Shares. 

 

The Company believes that it will be able to continue to meet the requirements to qualify as a REIT for income tax purposes for the foreseeable future.  

 

The Company has no off balance sheet transactions, contractual obligations, contingent liabilities, or commitments as of September 30, 2006.

 

**Tax Status of the Company**

 

The Company has elected to be taxed as a REIT under Sections 856 through 860 of the Code.  As a REIT, the Company generally will not be subject to federal income tax on its net income (excluding capital gains) provided 

 

-9-

 

that it distributes annually 100% of its REIT taxable income to its stockholders, meets certain organizational, stock ownership and operational requirements and meets certain income and asset tests. To remain qualified as a REIT, the Company must (a) distribute to stockholders each year at least 90% of its REIT taxable income (not including capital gains) for that year, (b) meet certain income tests, (c) meet certain asset tests and (d) meet certain ownership tests.  If in any taxable year the Company fails to qualify as a REIT, the Company would not be allowed a deduction for distributions to stockholders in computing its taxable income and would be subject to federal and state income tax (including any applicable alternative minimum tax) on its taxable income at regular corporate rates.  In addition, the Company would be disqualified from treatment as a REIT for the four taxable years following the yearduring which qualification was lost.  As of September 30, 2006, the Company met the requirements of all applicable tests.

 

The Company did not pay any income tax during either of the nine month periods ended September 30, 2006 or 2005.

 

**RESULTS OF OPERATIONS**

 

**Three Months Ended September 30, 2006 Compared to Three Months Ended June 30, 2005**

 

During the three months ended September 30, 2006 (the “2006 quarter”) and 2005 (the “2005 quarter”), the Company reported net income of $4,589,759 and $4,460,367, respectively, an increase of 2.9%.  The increase in net income is primarily attributable to increased interest income on Residential Mortgage Loans, which was mostly offset by increased interest expense.

 

Net interest income increased $157,687 (or 3.3%) in the 2006 quarter.  The Company would have recorded an additional $5,952 in interest income for the 2006 quarter had its non-accrual loans been current in accordance with their original terms.

 

Total interest income was $6,066,531 for the 2006 quarter compared to  $5,605,619 for the 2005 quarter, or an increase of 8.2%.  Interest income on Residential Mortgage Loans totaled $6,062,952 for the 2006 quarter compared to $5,604,297 for the 2005 quarter, or an increase of 8.2%.  The increase in interest income resulted from an increase in the average yield on such loans to 6.51% in the 2006 quarter from 6.09% in the 2005 quarter.  The average balance of the Residential Mortgage Loan portfolio also increased to $372,774,881 in the 2006 quarter from $368,306,175 in the 2005 quarter.  

 

Other interest income of $3,579 and $1,322 was recognized on the Company’s interest-bearing deposits during the 2006 and 2005 quarters, respectively.  The increase was primarily due to higher average yields and was partially offset by lower average balances of interest-bearing deposits during the 2006 period.

 

During the 2006 and 2005 quarters, the Company incurred interest expense totaling $1,147,388 and $844,163, respectively, an increase of 35.9%, related to the Company’s loan from the Bank.  The increase was due to an increase in the average rate paid on the loan payable to the Bank in the 2006 quarter to 6.21% from 4.36% in the 2005 quarter, partially offset by a decrease in the average balance to $69,900,000 as a result of a $9,700,000 principal payment in the 2006 quarter.

 

No provision for loan losses was recorded for the three months ended September 30, 2006 and 2005.

 

Operating expenses totaling $329,384 and $301,089 for the 2006 and 2005 quarters, respectively, were comprised of loan servicing fees paid to parent, advisory fees paid to parent, directors’ fees and general and administrative expenses.  Loan servicing fees paid to parent were $226,070 and $227,094 for the 2006 and 2005 quarters, respectively.  Advisory fees paid to parent for the three months ended September 30, 2006 and 2005 totaled $50,000 for each quarter.  Directors’ fees paid for the 2006 and 2005 quarters were $8,000 for each quarter, and represent compensation to the two independent members of the Board of Directors.  General and administrative expenses totaled $45,314 and $15,995 for the 2006 and 2005 quarters, respectively, or an increase of 183.3%, primarily due to increases in rating agency and external auditor fees.

 

-10-

 

 

During the 2006 quarter, the Company’s Board of Directors declared cash dividends of $3,890,625 on the Company's preferred stock out of the retained earnings of the Company.  Dividends were paid on October 16, 2006.  

 

**Nine Months Ended September 30, 2006 Compared to Nine Months Ended June 30, 2005**

 

During the nine months ended September 30, 2006 (the “2006 period”) and 2005 (the “2005 period”), the Company reported net income of $13,689,595 and $13,371,931, respectively, or an increase of 2.4%.  The increase in net income is primarily attributable to increased interest income on Residential Mortgage Loans, which was mostly offset by increased interest expense.

 

Net interest income increased $353,268 (or 2.5%) in the 2006 period.  The Company would have recorded an additional $34,757 in interest income for the 2006 period had its non-accrual loans been current in accordance with their original terms.

 

Total interest income was $17,935,755 for the 2006 period compared to $16,538,209 for the 2005 period, an increase of 8.5%.  Interest income on Residential Mortgage Loans totaled $17,918,388 for the 2006 period, compared to $16,530,739 for the 2005 period, an increase of 8.4%.  The increase in interest income resulted primarily from an increase in the average yield on those loans to 6.41% in the 2006 period from 5.94% in the 2005 period.  The average balance of the Residential Mortgage Loan portfolio was $372,980,927 in the 2006 period compared to $371,226,235 in the 2005 period. 

 

Other interest income of $17,367 and $7,470 was recognized on the Company’s interest-bearing deposits during the 2006 and 2005 periods, respectively.  The increase was primarily due to higher average yields and was partially offset by lower average balances of interest-bearing deposits during the 2006 period.

 

During the 2006 and 2005 periods, the Company incurred interest expense totaling $3,262,001 and $2,217,723, respectively, an increase of 47.1%, related to the Company’s loan from the Bank.  The increase was due to an increase in the average rate paid on the loan to 5.80% in the 2006 period from 3.88% in the 2005 period, partially offset by a decrease in the average balance to $73,300,000 for the 2006 period resulting from a $9,700,000 principal payment in the period. 

 

No provision for loan losses was recorded for the 2006 and 2005 periods.

 

Operating expenses totaling $984,159 and $948,555 for the 2006 and 2005 periods, respectively, were comprised of loan servicing fees paid to parent, advisory fees paid to parent, directors’ fees and general and administrative expenses.  Loan servicing fees paid to parent were $681,992 and $695,356 for the 2006 and 2005 periods, or a decrease of 1.9%.  Advisory fees paid to parent for the 2006 and 2005 periods totaled $150,000 for each period.  Directors’ fees paid for the 2006 and 2005 periods totaled $24,000 for each period, and represent compensation to the two independent members of the Board of Directors.  General and administrative expenses totaled $128,167 and $79,199 for the 2006 and 2005 periods, respectively, or an increase of 61.8%, primarily due to increases in rating agency and external auditor fees.  

 

During the 2006 period, the Company's Board of Directors declared cash dividends of $11,671,875 on the Company’s preferred stock, $3,890,625 of which was paid after the end of the period.  During the 2006 period, the Board also declared and paid cash dividends of $230,104 on the Company’s common stock. 

 

**ITEM 3.  Quantitative and Qualitative Disclosures about Market Risk**

 

Information required by this item is included in “Item 2. “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Interest Rate Risk,” which is hereby incorporated herein by reference.

 

**ITEM 4.  Controls and Procedures**

 

-11-

 

 

The Company maintains disclosure controls and procedures that are designed to provide reasonable assurance that information required to be disclosed in the Company's reports filed under SEC regulations is recorded, processed, summarized and reported within the time periods specified in the rules and forms adopted by the SEC, which the Company must comply with under SEC regulations, and that such information is accumulated and communicated to the Company's management, including its Chief Executive Officer and its Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure, based closely on the definition of "disclosure controls and procedures" in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended.  In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how welldesigned and operated, can provide only reasonable assurance of achieving the desired control objectives, and management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

 

The Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including its Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures as of September 30, 2006.  Based upon the foregoing, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective at the reasonable assurance level as of September 30, 2006.  

During the three months ended September 30, 2006, there were no changes in the Company’s internal control over financial reporting that materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 

-12-

 

**PART II - OTHER INFORMATION**

 

**ITEM 1.  Legal Proceedings**

 

The Company is not involved in any material litigation.  

 

**ITEM 1A.  Risk Factors**

 

There were no changes from the December 31, 2005 Form 10-K.

 

**ITEM 2.  Unregistered Sales of Equity Securities and Use of Proceeds**

 

None.

 

**ITEM 3.  Defaults Upon Senior Securities**

 

None.

 

**ITEM 4.  Submission of Matters to a Vote of Security Holders**

 

None.

 

**ITEM 5.  Other Information**

 

None.

 

**ITEM 6.  Exhibits and Reports on Form 8-K**

 

(a) Exhibits required by Item 601 of Regulation S-K are set forth below.

 

Exhibit

|   | No. | Exhibit   |
|--------|-----|----------------|

|   | 31.1 | Rule 13a-14(a) / 15d-14(a) Certification of Chief Executive Officer. |
|--------|------|----------------------------------------------------------------------|

|   | 31.2 | Rule 13a-14(a) / 15d-14(a) Certification of Chief Financial Officer. |
|--------|------|----------------------------------------------------------------------|

|   | 32.1 | Section 1350 Certification of Chief Executive Officer. |
|--------|------|--------------------------------------------------------|

|   | 32.2 | Section 1350 Certification of Chief Financial Officer. |
|--------|------|--------------------------------------------------------|

 

 

-13-

 

**SIGNATURES**

 

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

 

CHEVY CHASE PREFERRED CAPITAL CORPORATION

(Registrant)

 

| November 14, 2006 | By: | /s/ STEPHEN R. HALPIN, JR. |
|-------------------|-----|----------------------------|

|   | Stephen R. Halpin, Jr. |
|--------|------------------------|

|   | Executive Vice President and |
|--------|------------------------------|

|   | Chief Financial Officer |
|--------|-------------------------|

|   | (Principal Financial Officer) |
|--------|-------------------------------|

 

 

| November 14, 2006 | By: | /s/ JOEL A. FRIEDMAN |
|-------------------|-----|----------------------|

|   | Joel A. Friedman |
|--------|------------------|

|   | Senior Vice President and Controller |
|--------|--------------------------------------|

|   | (Principal Accounting Officer) |
|--------|--------------------------------|

 

 

Exhibit 31.1

 

**CERTIFICATION**

 

I, B. Francis Saul II, certify that:

|   | 1. | I have reviewed this quarterly report on Form 10-Q for the three months ended September 30, 2006 of Chevy Chase Preferred Capital Corporation; |
|--------|----|------------------------------------------------------------------------------------------------------------------------------------------------|

|   | 2. | Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; |
|--------|----|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | 3. | Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; |
|--------|----|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | 4. | The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: |
|--------|----|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

(a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b) evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures as of the end of the period covered by this report based on such evaluation; and 

(c) disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

|   | 5. | The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): |
|--------|----|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

(a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which  are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and

(b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.

 

| November 14, 2006 | /s/ B. FRANCIS SAUL II |
|-------------------|------------------------|

|   | B. Francis Saul II |
|--------|--------------------|

|   | Chairman and Chief Executive Officer |
|--------|--------------------------------------|

 

 

Exhibit 31.2

**CERTIFICATION**

 

I, Stephen R. Halpin, Jr., certify that:

|   | 1. | I have reviewed this quarterly report on Form 10-Q for the three months ended September 30, 2006 of Chevy Chase Preferred Capital Corporation; |
|--------|----|------------------------------------------------------------------------------------------------------------------------------------------------|

|   | 2. | Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; |
|--------|----|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | 3. | Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; |
|--------|----|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

|   | 4. | The registrant's other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: |
|--------|----|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

(a) designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b) evaluated the effectiveness of the registrant's disclosure controls and procedures and  presented in this report our conclusions about the effectiveness of the disclosure controls and procedures as of the end of the period covered by this report based on such evaluation; and 

(c) disclosed in this report any change in the registrant’s internal control over financial reporting that occurred during the registrant’s most recent quarter that has materially affected, or is reasonably likely to materially affect, the registrant’s internal control over financial reporting; and

|   | 5. | The registrant's other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors (or persons performing the equivalent functions): |
|--------|----|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|

(a) all significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and

(b) any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.

 

 

| November 14, 2006 | /s/ STEPHEN R. HALPIN, JR. |
|-------------------|----------------------------|

|   | Stephen R. Halpin, Jr. |
|--------|------------------------|

|   | Executive Vice President, Treasurer |
|--------|-------------------------------------|

|   | and Chief Financial Officer |
|--------|-----------------------------|

 

 

 

Exhibit 32.1

 

 

**CERTIFICATION OF CHIEF EXECUTIVE OFFICER**

 

**PURSUANT TO 18 U.S.C. SECTION 1350 AS ADOPTED PURSUANT TO**

**SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002**

 

The undersigned, B. Francis Saul II, the Chairman and Chief Executive Officer of Chevy Chase Preferred Capital Corporation (the "Company"), has executed this certification in connection with the filing with the Securities and Exchange Commission of the Company's Quarterly Report on Form 10-Q for the three months ended September 30, 2006 (the "Report").  The undersigned hereby certifies that:

 

|   | (1) | the Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and |
|--------|-----|-----------------------------------------------------------------------------------------------------------------------|

 

|   | (2) | the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. |
|--------|-----|------------------------------------------------------------------------------------------------------------------------------------------------------|

 

| November 14, 2006 | /s/ B. FRANCIS SAUL II |
|-------------------|------------------------|

|   | B. Francis Saul II |
|--------|--------------------|

|   | Chairman and Chief Executive Officer |
|--------|--------------------------------------|

 

 

 

 

 

 

 

 

 

 

Exhibit 32.2

 

 

**CERTIFICATION OF CHIEF FINANCIAL OFFICER**

 

**PURSUANT TO 18 U.S.C. SECTION 1350 AS ADOPTED PURSUANT TO**

**SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002**

 

The undersigned, Stephen R. Halpin, Jr., the Executive Vice President, Treasurer and Chief Financial Officer of Chevy Chase Preferred Capital Corporation (the "Company"), has executed this certification in connection with the filing with the Securities and Exchange Commission of the Company's Quarterly Report on Form 10-Q for the three months ended September 30, 2006 (the "Report").  The undersigned hereby certifies that:

 

|   | (1) | the Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and |
|--------|-----|-----------------------------------------------------------------------------------------------------------------------|

 

|   | (2) | the information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company. |
|--------|-----|------------------------------------------------------------------------------------------------------------------------------------------------------|

 

| November 14, 2006 | /s/ STEPHEN R. HALPIN, JR. |
|-------------------|----------------------------|

|   | Stephen R. Halpin, Jr. |
|--------|------------------------|

Executive Vice President, Treasurer

and Chief Financial Officer