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

 

FORM 10-Q

 

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

For the quarterly period ended June 30, 2014

OR

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

For the transition period from             to            

Commission File Number: 001-34374

 

ARLINGTON ASSET INVESTMENT CORP.

(Exact name of Registrant as specified in its charter)

 

Virginia		54-1873198
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification No.)

1001 Nineteenth Street North Arlington, VA		22209
(Address of Principal Executive Offices)		(Zip Code)

(703) 373-0200

(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 o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Sec. 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No 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 definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o		Accelerated filer x		Non-accelerated filer o		Smaller reporting company o

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

Number of shares outstanding of each of the registrant’s classes of common stock, as of July 31, 2014:

Title		Outstanding
Class A Common Stock		19,263,688 shares
Class B Common Stock		449,228 shares

TABLE OF CONTENTS

ARLINGTON ASSET INVESTMENT CORP.
 
FORM 10-Q
FOR THE QUARTER ENDED JUNE 30, 2014
INDEX

		Page
PART I — FINANCIAL INFORMATION
Item 1. Consolidated Financial Statements and Notes — (unaudited)			1
Consolidated Balance Sheets — June 30, 2014 and December 31, 2013			1
Consolidated Statements of Comprehensive Income — Three and Six Months Ended June 30, 2014 and 2013			2
Consolidated Statements of Changes in Equity — Six Months Ended June 30, 2014 and Year Ended December 31, 2013			3
Consolidated Statements of Cash Flows — Six Months Ended June 30, 2014 and 2013			4
Notes to Consolidated Financial Statements			5
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			22
Item 3. Quantitative and Qualitative Disclosures about Market Risk			38
Item 4. Controls and Procedures			43
PART II — OTHER INFORMATION
Item 1. Legal Proceedings			44
Item 1A. Risk Factors			44
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			44
Item 3. Defaults Upon Senior Securities			44
Item 4. Mine Safety Disclosures			44
Item 5. Other Information			44
Item 6. Exhibits			45
Signatures			47

TABLE OF CONTENTS

PART I
FINANCIAL INFORMATION

Item 1. Financial Statements (unaudited)

ARLINGTON ASSET INVESTMENT CORP.
 
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands)
(Unaudited)

		June 30, 2014				December 31, 2013
ASSETS
Cash and cash equivalents		$	26,954			$	48,628
Receivables
Interest			8,908				5,173
Other			212				212
Mortgage-backed securities, at fair value
Available-for-sale			314,189				341,346
Trading			2,813,983				1,576,452
Other investments			2,057				2,065
Derivative assets, at fair value			2,556				8,424
Deferred tax assets, net			151,669				165,851
Deposits			109,680				45,504
Prepaid expenses and other assets			1,530				1,311
Total assets		$	3,431,738			$	2,194,966
LIABILITIES AND EQUITY
Liabilities:
Repurchase agreements		$	2,666,251			$	1,547,630
Interest payable			871				774
Accrued compensation and benefits			2,857				5,584
Dividend payable			17,348				14,630
Derivative liabilities, at fair value			80,487				33,129
Accounts payable, accrued expenses and other liabilities			1,292				1,391
Long-term debt			40,000				40,000
Total liabilities			2,809,106				1,643,138
Commitments and contingencies			—				—
Equity:
Preferred stock, $0.01 par value, 25,000,000 shares authorized, none issued and outstanding			—				—
Class A common stock, $0.01 par value, 450,000,000 shares authorized, 19,263,688 and 16,047,965 shares issued and outstanding, respectively			193				160
Class B common stock, $0.01 par value, 100,000,000 shares authorized, 449,228 and 554,055 shares issued and outstanding, respectively			4				6
Additional paid-in capital			1,810,297				1,727,398
Accumulated other comprehensive income, net of taxes of $7,914 and $9,436, respectively			49,848				53,190
Accumulated deficit			(1,237,710	)			(1,228,926	)
Total equity			622,632				551,828
Total liabilities and equity		$	3,431,738			$	2,194,966

 
 
See notes to consolidated financial statements.

TABLE OF CONTENTS

ARLINGTON ASSET INVESTMENT CORP.
 
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(Dollars in thousands, except per share data)
(Unaudited)

		Three Months Ended June 30,								Six Months Ended June 30,
		2014				2013				2014				2013
Interest income		$	30,063			$	23,145			$	53,930			$	41,473
Interest expense
Interest on short-term debt			2,124				1,814				3,858				3,303
Interest on long-term debt			552				406				1,103				521
Total interest expense			2,676				2,220				4,961				3,824
Net interest income			27,387				20,925				48,969				37,649
Other income (loss), net
Investment gain (loss), net			7,910				(11,253	)			1,999				(24,782	)
Other loss			(4	)			(4	)			(7	)			(8	)
Total other income (loss), net			7,906				(11,257	)			1,992				(24,790	)
Operating income before other expenses			35,293				9,668				50,961				12,859
Other expenses
Compensation and benefits			3,185				2,643				6,146				4,992
Professional services			395				555				911				1,676
Business development			56				30				87				62
Occupancy and equipment			120				111				219				232
Communications			52				46				99				93
Other operating expenses			572				535				1,073				641
Total other expenses			4,380				3,920				8,535				7,696
Income before income taxes			30,913				5,748				42,426				5,163
Income tax provision (benefit)			12,074				2,554				16,554				(1,208	)
Net income		$	18,839			$	3,194			$	25,872			$	6,371
Basic earnings per share		$	0.95			$	0.19			$	1.42			$	0.42
Diluted earnings per share		$	0.94			$	0.19			$	1.39			$	0.41
Weighted-average shares outstanding (in thousands)
Basic			19,740				16,655				18,282				15,299
Diluted			20,060				16,832				18,579				15,470
Other comprehensive income, net of taxes
Unrealized gains (losses) for the period on available-for-sale securities (net of taxes of $(619), $5,927, $(1,235), and $9,255, respectively)		$	3,081			$	8,528			$	5,425			$	13,318
Reclassification
Included in investment gains (loss), net, in the statement of comprehensive income related to sales of available-for-sale securities (net of taxes of $175, $2,215, $318, and $2,370, respectively)			(4,368	)			(3,187	)			(8,816	)			(3,410	)
Included in investment gain (loss), net, in the statement of comprehensive income related to other-than-temporary impairment charges on available-for-sale securities (net of taxes of $31, $298, $31, and $365, respectively)			49				430				49				525
Comprehensive income		$	17,601			$	8,965			$	22,530			$	16,804

 
 
See notes to consolidated financial statements.

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ARLINGTON ASSET INVESTMENT CORP.
 
CONSOLIDATED STATEMENTS OF CHANGES IN EQUITY
(Dollars in thousands)
(Unaudited)

		Class A Common Stock (#)				Class A Amount ($)				Class B Common Stock (#)				Class B Amount ($)				Additional Paid-In Capital				Accumulated Other Comprehensive Income				Accumulated Deficit				Total
Balances, December 31, 2012			12,560,970			$	126				554,055			$	6			$	1,638,061			$	39,006			$	(1,219,906	)		$	457,293
Net income			—				—				—				—				—				—				49,461				49,461
Issuance of Class A common stock			3,492,667				34				—				—				86,930				—				—				86,964
Forfeitures of Class A common stock			(5,672 )				—				—				—				(142 )				—				—				(142 )
Amortization of Class A common shares issued as stock-based awards			—				—				—				—				2,549				—				—				2,549
Other comprehensive income
Net change in unrealized gain on available-for-sale investment securities, (net of taxes of $9,029)			—				—				—				—				—				14,184				—				14,184
Dividends declared			—				—				—				—				—				—				(58,481	)			(58,481	)
Balances, December 31, 2013			16,047,965				160				554,055				6				1,727,398				53,190				(1,228,926	)			551,828
Net income			—				—				—				—				—				—				25,872				25,872
Conversion of Class B shares to Class A shares			104,827				2				(104,827 )				(2 )				—				—				—				—
Issuance of Class A common stock			3,118,098				31				—				—				81,638				—				—				81,669
Forfeitures of Class A common stock			(7,202 )				—				—				—				(195 )				—				—				(195 )
Amortization of Class A common shares issued as stock-based awards			—				—				—				—				1,456				—				—				1,456
Other comprehensive income
Net change in unrealized gain on available-for-sale investment securities, (net of taxes of $(1,522))			—				—				—				—				—				(3,342 )				—				(3,342 )
Dividends declared			—				—				—				—				—				—				(34,656	)			(34,656	)
Balances, June 30, 2014			19,263,688			$	193				449,228			$	4			$	1,810,297			$	49,848			$	(1,237,710	)		$	622,632

 
 
See notes to consolidated financial statements.

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ARLINGTON ASSET INVESTMENT CORP.
 
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
(Unaudited)

		Six Months Ended June 30,
		2014				2013
Cash flows from operating activities:
Net income		$	25,872			$	6,371
Adjustments to reconcile net income to net cash provided by operating activities
Net investment (gain) loss			(1,999	)			24,782
Net discount accretion on mortgage-backed securities			(6,725	)			(3,878	)
Deferred tax provision			15,704				1,851
Other			1,264				943
Changes in operating assets
Interest receivable			(3,735	)			(1,098	)
Other receivables			—				391
Prepaid expenses and other assets			(7,997	)			(467	)
Changes in operating liabilities
Accounts payable and other liabilities			(2	)			(3,241	)
Accrued compensation and benefits			(2,727	)			1,051
Net cash provided by operating activities			19,655				26,705
Cash flows from investing activities:
Purchases of available-for-sale mortgage-backed securities			—				(122,840	)
Purchases of trading mortgage-backed securities			(1,253,498	)			(964,033	)
Proceeds from sales of available-for-sale mortgage-backed securities			37,231				27,798
Proceeds from sales of trading mortgage-backed securities			—				500,303
Receipt of principal payments on available-for-sale mortgage-backed securities			1,389				2,997
Receipt of principal payments on trading mortgage-backed securities			78,422				81,285
Proceeds from sold securities receivable			—				26,773
(Payments for) proceeds from derivatives and deposits, net			(73,238	)			48,823
Other			13				85
Net cash used in investing activities			(1,209,681	)			(398,809	)
Cash flows from financing activities:
Proceeds from repurchase agreements, net			1,118,621				278,125
Proceeds from stock issuance, net			81,669				86,964
Proceeds from long-term debt issuance, net			—				24,038
Dividends paid			(31,938	)			(14,587	)
Net cash provided by financing activities			1,168,352				374,540
Net (decrease) increase in cash and cash equivalents			(21,674	)			2,436
Cash and cash equivalents, beginning of period			48,628				35,837
Cash and cash equivalents, end of period		$	26,954			$	38,273
Supplemental cash flow information
Cash payments for interest		$	4,813			$	3,579
Cash payments for taxes		$	789			$	345

 
 
See notes to consolidated financial statements.

TABLE OF CONTENTS

ARLINGTON ASSET INVESTMENT CORP.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

1. Basis of Presentation:

The consolidated financial statements of Arlington Asset Investment Corp. (Arlington Asset) and its subsidiaries (unless the context otherwise provides, collectively, the Company) have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) for interim financial information and with the instructions to Form 10-Q. Therefore, they do not include all information required by GAAP for complete financial statements. The interim financial statements reflect all adjustments (consisting only of normal recurring adjustments) which are, in the opinion of management, necessary for a fair statement of the results for the periods presented. All significant intercompany accounts and transactions have been eliminated in consolidation. The results of operations for the three and six months ended June 30, 2014 are not necessarily indicative of the operating results for the entire year or any other subsequent interim period. The Company’s unaudited consolidated financial statements and notes thereto should be read in conjunction with the Company’s audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013.

The preparation of the Company’s financial statements in conformity with GAAP requires the Company to make estimates and assumptions affecting the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Although the Company based the estimates and assumptions on historical experience, when available, market information, and on various other factors that the Company believes to be reasonable under the circumstances, management exercises significant judgment in the final determination of the estimates. Actual results may differ from these estimates.

Certain amounts in the consolidated financial statements and notes for prior periods have been reclassified to conform to the current period presentation. These reclassifications had no effect on the results of operations of the Company.

2. Financial Instruments:

Fair Value of Financial Instruments

The accounting principles related to fair value measurements define fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, not adjusted for transaction costs. Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 820, Fair Value Measurements and Disclosures (ASC 820), establishes a fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair value into three broad levels giving the highest priority to quoted prices in active markets for identical assets or liabilities (Level 1) and the lowest priority to unobservable inputs (Level 3) as described below:

The Company determines fair values for the following assets and liabilities:

Mortgage-backed securities (MBS), at fair value — 

Agency-backed MBS — The Company’s agency-backed MBS, the principal and interest payments on which are guaranteed by the Federal National Mortgage Association (Fannie Mae) or the Federal Home Loan Mortgage Corporation (Freddie Mac), are generally classified within Level 2 of the fair value hierarchy as they are valued after considering quoted market prices provided by a broker or dealer, or alternative pricing

TABLE OF CONTENTS

ARLINGTON ASSET INVESTMENT CORP.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

2. Financial Instruments:  – (continued)

sources with reasonable levels of price transparency. The Company reviews broker or pricing service quotes to determine whether the quotes are relevant, for example, whether an active market exists to provide price transparency or whether the quote is an indicative price or a binding offer. The independent brokers and dealers providing market prices are those who make markets in or specialists with expertise in the valuation of these financial instruments.

Private-label MBS — The Company classifies non-agency-backed, or private-label, MBS within Level 3 of the fair value hierarchy because they trade infrequently and, therefore, have little or no price transparency. The Company utilizes present value techniques based on estimated cash flows of the instrument taking into consideration various assumptions derived by management and other assumptions used by other market participants. These assumptions are corroborated by evidence such as historical data, risk characteristics, transactions in similar instruments, and completed or pending transactions, when available. The significant inputs in the Company’s valuation process include default rate, loss severity, prepayment rate and discount rate. In general, significant increases (decreases) in default rate, loss severity or discount rate, in isolation, would result in a significantly lower (higher) fair value measurement. However, significant increases (decreases) in prepayment rate may result in a significantly higher (lower) fair value measurement. It is difficult to generalize the interrelationships between these significant inputs as the actual results could differ considerably on an individual security basis. For example, an increase in the default rate may not increase the loss severity rate if actual losses are lower than the average. Also, changes in discount rates may be greatly influenced by market expectation at any given point based upon many variables not directly related to the MBS market. Therefore, each significant input is closely analyzed to ascertain the reasonableness for the Company’s valuation purposes.

Establishing fair value is inherently subjective given the volatile and sometimes illiquid markets for these private-label MBS and requires management to make a number of assumptions, including assumptions about the future of interest rates, prepayment rates, discount rates, credit loss rates, and the timing of cash flows and credit losses. The assumptions the Company applies are specific to each security. Although the Company relies on its internal calculations to compute the fair value of these private-label MBS, the Company requests and considers indications of value, or the mark, from third-party dealers and the actual sales of private-label MBS to assist in the valuation process and calibrate our model.

Other investments — The Company’s other investments, which are classified within Level 3 of the fair value hierarchy, consist of investments in equity securities, investment funds and other MBS-related securities, such as interest-only MBS.

Derivative instruments — In the normal course of the Company’s operations, the Company is a party to various financial instruments that are accounted for as derivatives in accordance with ASC 815, Derivatives and Hedging (ASC 815). The derivative instruments that trade in active markets or exchanges are classified within Level 1 of the fair value hierarchy because they are valued using quoted market prices. Other derivative instruments are generally classified within Level 2 of the fair value hierarchy because they are valued using broker or dealer quotations, which are model-based calculations based on market-based inputs, including, but not limited to, contractual terms, market prices, yield curves, credit curves, measures of volatility, prepayment rates and correlations of such inputs.

Other — Cash and cash equivalents, interest receivable, deposits, other receivable, interest payable, accounts payable, accrued expenses and other liabilities are reflected in the consolidated balance sheets at their amortized cost (which approximates fair value because of the short term nature of these instruments) and classified within Level 1 of the fair value hierarchy, except for certain cash equivalents that are held in money market funds that are classified within Level 2 of the fair value hierarchy.

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ARLINGTON ASSET INVESTMENT CORP.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

2. Financial Instruments:  – (continued)

        Sold securities receivable, repurchase agreements and purchased securities payable are reflected in the consolidated balance sheets at the cost basis, which approximates fair value because of the short term nature of these instruments, and classified within Level 2 of the fair value hierarchy.

        Long-term debt represents remaining balances of trust preferred debt and senior debt issued by the Company. Trust preferred debt is classified within Level 3 of the fair value hierarchy as the fair value is determined after considering quoted market prices provided by a broker or dealer. The independent brokers or dealers providing market prices are those who make markets in or specialists with expertise in the valuation of these financial instruments. The Company’s senior debt, which is publicly traded on the New York Stock Exchange, is classified within Level 1 of the fair value hierarchy.

The estimated fair values of the Company’s financial instruments are as follows:

		June 30, 2014								December 31, 2013
		Carrying Amount				Estimated Fair Value				Carrying Amount				Estimated Fair Value
Financial assets
Cash and cash equivalents		$	26,954			$	26,954			$	48,628			$	48,628
Interest receivable			8,908				8,908				5,173				5,173
Other receivables			212				212				212				212
MBS
Agency-backed MBS			2,814,024				2,814,024				1,576,499				1,576,499
Private-label MBS
Senior securities			—				—				7,066				7,066
Re-REMIC securities			314,148				314,148				334,233				334,233
Derivative assets			2,556				2,556				8,424				8,424
Other investments			2,057				2,057				2,065				2,065
Deposits			109,680				109,680				45,504				45,504
Financial liabilities
Repurchase agreements			2,666,251				2,666,251				1,547,630				1,547,630
Interest payable			871				871				774				774
Long-term debt			40,000				39,500				40,000				36,620
Derivative liabilities			80,487				80,487				33,129				33,129
Accounts payable, accrued expenses and other liabilities			1,292				1,292				1,391				1,391

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ARLINGTON ASSET INVESTMENT CORP.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

2. Financial Instruments:  – (continued)

Fair Value Hierarchy

The following tables set forth financial instruments accounted for under ASC 820 by level within the fair value hierarchy as of June 30, 2014 and December 31, 2013. As required by ASC 820, assets and liabilities that are measured at fair value are classified in their entirety based on the lowest level of input that is significant to the fair value measurement.

Financial Instruments Measured at Fair Value on a Recurring Basis

		June 30, 2014
		Total				Level 1				Level 2				Level 3
MBS, at fair value
Trading
Agency-backed MBS		$	2,813,983			$	—			$	2,813,983			$	—
Available-for-sale
Agency-backed MBS			41				—				41				—
Private-label MBS
Senior securities			—				—				—				—
Re-REMIC securities			314,148				—				—				314,148
Total available-for-sale			314,189				—				41				314,148
Total MBS			3,128,172				—				2,814,024				314,148
Derivative assets, at fair value			2,556				701				1,855				—
Derivative liabilities, at fair value			(80,487	)			(79,225	)			(1,262	)			—
Interest-only MBS, at fair value			237				—				—				237
Total		$	3,050,478			$	(78,524	)		$	2,814,617			$	314,385

		December 31, 2013
		Total				Level 1				Level 2				Level 3
MBS, at fair value
Trading
Agency-backed MBS		$	1,576,452			$	—			$	1,576,452			$	—
Available-for-sale
Agency-backed MBS			47				—				47				—
Private-label MBS
Senior securities			7,066				—				—				7,066
Re-REMIC securities			334,233				—				—				334,233
Total available-for-sale			341,346				—				47				341,299
Total MBS			1,917,798				—				1,576,499				341,299
Derivative assets, at fair value			8,424				8,088				336				—
Derivative liabilities, at fair value			(33,129	)			(32,156	)			(973	)			—
Interest-only MBS, at fair value			298				—				—				298
Total		$	1,893,391			$	(24,068	)		$	1,575,862			$	341,597

TABLE OF CONTENTS

ARLINGTON ASSET INVESTMENT CORP.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

2. Financial Instruments:  – (continued)

The total financial assets measured and reported at fair value on a recurring basis and classified within Level 3 were $314,385, or 9.16%, and $341,597, or 15.56%, of the Company’s total assets as of June 30, 2014 and December 31, 2013, respectively.

There were no transfers of securities in or out of Levels 1, 2 or 3 during the three and six months ended June 30, 2014 or the year ended December 31, 2013.

Level 3 Financial Assets and Liabilities

Financial Instruments Measured at Fair Value on a Recurring Basis

The fair value of the Company’s Level 3, available-for-sale, private-label MBS was $314,148 and $341,299 as of June 30, 2014 and December 31, 2013, respectively. The private-label MBS are primarily senior and re-REMIC tranches in securitization trusts issued between 2005 and 2010. The senior securities represent interests in securitizations that have the first right to cash flows and absorb losses last. The re-REMIC securities represent interests in re-securitizations of senior MBS and pro-rata mezzanine securities. For re-REMIC securities, the cash flows from, and any credit losses absorbed by, the underlying MBS are allocated among the re-REMIC securities issued in the re-securitization transactions based on the re-REMIC structure. For example, prime and non-prime residential senior securities have been resecuritized to create a two-tranche structure with a re-REMIC senior security and a re-REMIC subordinated security. In these re-REMIC securities, all principal payments from the underlying securities are directed to the re-REMIC senior security until the face value is fully paid off. Thereafter, all principal payments are directed to the re-REMIC subordinated security. For pro-rata mezzanine securities, principal payments from the underlying MBS are typically allocated concurrently and proportionally to the mezzanine securities along with senior securities. The re-REMIC subordinated and mezzanine securities absorb credit losses, if any, first; however, these credit losses occur only when credit losses exceed the credit protection provided to the underlying securities. Senior, re-REMIC and mezzanine securities receive interest while any face value is outstanding.

The Company’s private-label MBS were collateralized by residential prime and Alt-A mortgage loans and had the following weighted average characteristics, based on face value, as of the dates indicated:

		June 30, 2014				December 31, 2013
Original loan-to-value			68	%			69	%
Original FICO score			724				725
Three-month prepayment rate			11	%			14	%
Three-month loss severities			32	%			37	%
Weighted average coupon			3.00	%			3.34	%

The significant unobservable inputs for the valuation model include the following weighted-averages, based on face value, as of the dates indicated:

		June 30, 2014								December 31, 2013
		Senior Securities(1)				Re-REMIC Securities				Senior Securities				Re-REMIC Securities
Discount rate			—	%			6.51	%			6.00	%			6.55	%
Default rate			—	%			3.13	%			9.30	%			3.62	%
Loss severity rate			—	%			42.12	%			50.00	%			44.82	%
Prepayment rate			—	%			11.29	%			16.30	%			11.69	%

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ARLINGTON ASSET INVESTMENT CORP.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

2. Financial Instruments:  – (continued)

The ranges of the significant unobservable inputs for the valuation model were as follows as of the dates indicated:

		June 30, 2014								December 31, 2013
		Senior Securities(1)				Re-REMIC Securities				Senior Securities				Re-REMIC Securities
Discount rate			—	%			6.00 – 10.00	%			6.00	%			6.00 – 10.00	%
Default rate			—	%			1.00 – 8.80	%			9.30	%			0.95 – 9.60	%
Loss severity rate			—	%			29.29 – 57.50	%			50.00	%			29.15 – 57.50	%
Prepayment rate			—	%			7.40 – 17.70	%			16.30	%			6.40 – 19.00	%

The tables below set forth a summary of changes in the fair value and gains and losses of the Company’s Level 3 financial assets and liabilities that are measured at fair value on a recurring basis for the three and six months ended June 30, 2014 and 2013.

		Three Months Ended June 30, 2014
		Senior Securities				Re-REMIC Securities				Total
Beginning balance, April 1, 2014		$	—			$	329,846			$	329,846
Total net gains (losses)
Included in earnings			6				4,759				4,765
Included in other comprehensive income			—				(2,019	)			(2,019	)
Purchases			—				—				—
Sales			78				(21,576	)			(21,498	)
Payments, net			(104	)			(3,711	)			(3,815	)
Accretion of discount			20				6,849				6,869
Ending balance, June 30, 2014		$	—			$	314,148			$	314,148
The amount of net gains (losses) for the period included in earnings attributable to the change in unrealized gains (losses) relating to Level 3 assets still held at the reporting date		$	—			$	(51	)		$	(51	)

		Three Months Ended June 30, 2013
		Senior Securities				Re-REMIC Securities				Total
Beginning balance, April 1, 2013		$	7,400			$	268,456			$	275,856
Total net gains (losses)
Included in earnings			—				6,342				6,342
Included in other comprehensive income			(123	)			9,936				9,813
Purchases			—				59,325				59,325
Sales			—				(23,019	)			(23,019	)
Payments, net			(255	)			(5,752	)			(6,007	)
Accretion of discount			224				6,386				6,610
Ending balance, June 30, 2013		$	7,246			$	321,674			$	328,920
The amount of net gains (losses) for the period included in earnings attributable to the change in unrealized gains (losses) relating to Level 3 assets still held at the reporting date		$	—			$	(728	)		$	(728	)

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ARLINGTON ASSET INVESTMENT CORP.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

2. Financial Instruments:  – (continued)

		Six Months Ended June 30, 2014
		Senior Securities				Re-REMIC Securities				Total
Beginning balance, January 1, 2014		$	7,066			$	334,233			$	341,299
Total net gains (losses)
Included in earnings			1,690				7,842				9,532
Included in other comprehensive income			(1,654	)			(3,210	)			(4,864	)
Purchases			—				—				—
Sales			(7,029	)			(30,202	)			(37,231	)
Payments, net			(319	)			(8,288	)			(8,607	)
Accretion of discount			246				13,773				14,019
Ending balance, June 30, 2014		$	—			$	314,148			$	314,148
The amount of net gains (losses) for the period included in earnings attributable to the change in unrealized gains (losses) relating to Level 3 assets still held at the reporting date		$	—			$	(51	)		$	(51	)

		Six Months Ended June 30, 2013
		Senior Securities				Re-REMIC Securities				Total
Beginning balance, January 1, 2013		$	7,519			$	191,567			$	199,086
Total net gains (losses)
Included in earnings			—				7,790				7,790
Included in other comprehensive income			(87	)			17,803				17,716
Purchases			—				131,203				131,203
Sales			—				(27,798	)			(27,798	)
Payments, net			(638	)			(10,758	)			(11,396	)
Accretion of discount			452				11,867				12,319
Ending balance, June 30, 2013		$	7,246			$	321,674			$	328,920
The amount of net gains (losses) for the period included in earnings attributable to the change in unrealized gains (losses) relating to Level 3 assets still held at the reporting date		$	—			$	(890	)		$	(890	)

Gains and losses included in earnings for the three and six months ended June 30, 2014 and 2013 are reported in the following statement of comprehensive income line descriptions:

		Other Income (Loss), Investment Gain (Loss), net
		Three Months Ended June 30,								Six Months Ended June 30,
		2014				2013				2014				2013
Total gains (losses) included in earnings for the period		$	4,765			$	6,342			$	9,532			$	7,790
Change in unrealized gains (losses) relating to Level 3 assets still held at reporting date		$	(51	)		$	(728	)		$	(51	)		$	(890	)

Level 3 Financial Instruments Measured at Fair Value on a Non-Recurring Basis

The Company also measures certain financial assets at fair value on a non-recurring basis. Adjustments to the fair value of these assets usually result from the application of lower-of-cost-or-market accounting or write-downs of individual assets due to impairments. Due to the nature of these financial assets, enterprise values are primarily used to value these financial assets. In determining the enterprise value, the Company analyzes various financial, performance and market factors to estimate fair value, including where applicable,

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ARLINGTON ASSET INVESTMENT CORP.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

2. Financial Instruments:  – (continued)

market trading activity. As a result, these financial assets are classified within Level 3 of the fair value hierarchy. As of June 30, 2014 and December 31, 2013, these financial assets are classified within the other investments category, represent the Company’s interest in non-public equity securities and investment funds and are valued at $1,820 and $1,767, respectively. For the six months ended June 30, 2013, the Company recorded losses of $138 in the carrying value of these financial assets. For the three months ended June 30, 2013 and for the three and six months ended June 30, 2014, there were no changes to the carrying value of these financial assets.

MBS, at Fair Value

MBS, at fair value⁽¹⁾⁽²⁾, consisted of the following as of the dates indicated:

		June 30, 2014																				December 31, 2013
		Fair Value				Net Unamortized Premium (Discount)				Percent of Total Fair Value				Weighted Average Life				Weighted Average Rating(3)				Fair Value				Net Unamortized Premium (Discount)				Percent of Total Fair Value				Weighted Average Life				Weighted Average Rating(3)
Trading
Fannie Mae		$	1,661,538			$	—				53.12	%			9.1				AAA			$	997,488			$	—				52.01	%			9.4				AAA
Freddie Mac			1,152,445				—				36.84	%			9.3				AAA				578,964				—				30.19	%			9.6				AAA
Available-for-sale:
Agency-backed
Fannie Mae			41				—				—				5.3				AAA				47				—				—				5.8				AAA
Private-label
Senior securities			—				—				—				—				—				7,066				(4,789	)			0.37	%			4.8				C-
Re-REMIC securities			314,148				(167,491	)			10.04	%			10.9				NR				334,233				(202,450	)			17.43	%			11.4				NR
		$	3,128,172			$	(167,491	)			100.00	%										$	1,917,798			$	(207,239	)			100.00	%

The Company has generally purchased private-label MBS at a discount. The Company, at least on a quarterly basis, estimates the future expected cash flows based on the Company’s observation of current information and events and applies a number of assumptions related to prepayment rates, interest rates, default rates, loss severity rates, and the timing and amount of cash flows and credit losses. These assumptions are difficult to predict as they are subject to uncertainties and contingencies related to future events that may impact the Company’s estimates and its interest income.

Interest income on the private-label MBS that were purchased at a discount to face value is recognized based on the security’s expected effective interest rate. At acquisition, the accretable yield is calculated as the difference between the undiscounted expected cash flows and the purchase price which is expected to be

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ARLINGTON ASSET INVESTMENT CORP.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

2. Financial Instruments:  – (continued)

accreted into interest income over the remaining life of the security on a level-yield basis. The difference between the contractually required payments and the undiscounted expected cash flows represents the non-accretable difference. Based on actual payment activities and changes in estimates of undiscounted expected future cash flows, the accretable yield and the non-accretable difference can change over time. Significant increases in the amount or timing of undiscounted expected future cash flows are recognized prospectively as an adjustment to the accretable yield.

The following table presents the changes in the accretable yield on available-for-sale, private-label MBS for the three and six months ended June 30, 2014 and 2013:

		Three Months Ended June 30,								Six Months Ended June 30,
		2014				2013				2014				2013
Beginning balance		$	310,933			$	261,391			$	326,330			$	207,853
Accretion of discount			(6,869	)			(6,610	)			(14,019	)			(12,319	)
Reclassifications, net			8,727				28,702				13,372				32,609
Acquisitions			—				50,871				—				113,745
Sales			(21,663	)			(16,659	)			(34,555	)			(24,193	)
Ending balance		$	291,128			$	317,695			$	291,128			$	317,695

For the available-for-sale, private-label MBS acquired during the three and six months ended June 30, 2014 and 2013, the contractually required payments receivable, the cash flow expected to be collected, and the fair value at the acquisition date were as follows for the dates indicated:

		Three Months Ended June 30,								Six Months Ended June 30,
		2014				2013				2014				2013
Contractually required payments receivable		$	—			$	148,689			$	—			$	332,860
Cash flows expected to be collected			—				110,195				—				244,948
Basis in acquired securities			—				59,324				—				131,203

The Company’s available-for-sale MBS are carried at fair value in accordance with ASC 320, Debt and Equity Securities (ASC 320), with resulting unrealized gains and losses reflected as other comprehensive income or loss. Gross unrealized gains and losses on these securities were the following as of the dates indicated:

		June 30, 2014
		Amortized Cost/Cost Basis(1)				Unrealized								Fair Value
						Gains				Losses
Agency-backed MBS		$	37			$	4			$	—			$	41
Private-label MBS
Senior securities			—				—				—				—
Re-REMIC securities			256,389				57,783				(24	)			314,148
Total		$	256,426			$	57,787			$	(24	)		$	314,189

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ARLINGTON ASSET INVESTMENT CORP.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

2. Financial Instruments:  – (continued)

		December 31, 2013
		Amortized Cost/Cost Basis(1)				Unrealized								Fair Value
						Gains				Losses
Agency-backed MBS		$	43			$	4			$	—			$	47
Private-label MBS
Senior securities			5,412				1,654				—				7,066
Re-REMIC securities			273,264				60,970				(1	)			334,233
Total		$	278,719			$	62,628			$	(1	)		$	341,346

For the three and six months ended June 30, 2014, the Company recorded other-than-temporary impairment charges of $51 as a component of investment gain (loss), net on the consolidated statements of comprehensive income related to deterioration in credit quality on available-for-sale, private-label MBS with a cost basis of $2,174, prior to recognizing the other-than-temporary impairment charges. For the three and six months ended June 30, 2013, the Company recorded other-than-temporary impairment charges of $728 and $890, respectively, as a component of investment gain (loss), net on the consolidated statements of comprehensive income related to deterioration in credit quality on available-for-sale, private-label MBS with a cost basis of $1,341 and $1,584, respectively, prior to recognizing the other-than-temporary impairment charges.

The following table presents a summary of other-than-temporary impairment charges included in earnings for the periods indicated and cumulative other-than-temporary impairment charges recognized on the MBS held as of the dates indicated:

		Three Months Ended June 30,								Six Months Ended June 30,
		2014				2013				2014				2013
Cumulative other-than-temporary impairment, beginning balance		$	21,027			$	22,555			$	23,663			$	23,768
Additions
Other-than-temporary impairments not previously recognized			51				—				51				—
Increases related to other-than-temporary impairments on securities with previously recognized other-than-temporary impairments			—				728				—				890
Reductions
Decreases related to other-than-temporary impairments on sold securities			(1,391	)			—				(4,027	)			(1,375	)
Cumulative other-than-temporary impairment, ending balance		$	19,687			$	23,283			$	19,687			$	23,283

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ARLINGTON ASSET INVESTMENT CORP.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

2. Financial Instruments:  – (continued)

The following table presents the results of sales of MBS for the periods indicated:

		Three Months Ended June 30,																Six Months Ended June 30,
		2014								2013								2014								2013
		Agency-Backed MBS				Private-Label MBS				Agency-Backed MBS				Private-Label MBS				Agency-Backed MBS				Private-Label MBS				Agency-Backed MBS				Private- Label MBS
Proceeds from sales		$	—			$	21,499			$	196,113			$	23,020			$	—			$	37,231			$	527,738			$	27,798
Gross gains			—				4,690				529				6,928				—				9,359				531				8,489
Gross losses			—				—				1,655				—				—				—				6,973				—

Other Investments

The Company’s other investments consisted of the following as of the dates indicated:

		June 30, 2014				December 31, 2013
Interest-only MBS		$	237			$	298
Non-public equity securities			975				975
Investment funds			845				792
Total other investments		$	2,057			$	2,065

3. Borrowings:

Repurchase Agreements

The Company has entered into repurchase agreements to fund its investments in MBS. Securities sold under agreements to repurchase, which are treated as financing transactions for financial reporting purposes, are collateralized by MBS and are carried at their contractual amounts, including accrued interest, as specified in the respective agreements. Under the repurchase agreements, the Company pledges its securities as collateral to secure the borrowing, which is equal in value to a specified percentage of the fair value of the pledged collateral, while the Company retains beneficial ownership of the pledged collateral. The counterparty to the repurchase agreements may require that the Company pledge additional securities or cash as additional collateral to secure borrowings when the value of the collateral declines.

As of June 30, 2014 and December 31, 2013, the Company had no amount at risk with a single repurchase agreement counterparty or lender greater than 10% of equity. The following tables provide information regarding the Company’s outstanding repurchase agreement borrowings as of the dates and for the periods indicated:

		June 30, 2014				December 31, 2013
Outstanding balance		$	2,666,251			$	1,547,630
Value of assets pledged as collateral
Agency-backed MBS			2,763,301				1,556,763
Private-label MBS			113,292				117,148
Net amount(1)			210,342				126,281
Weighted-average rate			0.36	%			0.45	%
Weighted-average term to maturity			14.0 days				13.2 days

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ARLINGTON ASSET INVESTMENT CORP.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

3. Borrowings:  – (continued)

		June 30, 2014				June 30, 2013
Weighted-average outstanding balance during the three months ended		$	2,300,868			$	1,660,108
Weighted-average rate during the three months ended			0.37	%			0.43	%
Weighted-average outstanding balance during the six months ended		$	1,990,904			$	1,466,485
Weighted-average rate during the six months ended			0.39	%			0.45	%

Long-Term Debt

As of June 30, 2014 and December 31, 2013, the Company had $40,000 of outstanding long-term debentures. The Company’s long-term debentures consisted of the following as of the dates indicated:

June 30, 2014

December 31, 2013

Senior Notes

Trust Preferred Debt

Senior Notes

Trust Preferred Debt

Outstanding Principal

$

25,000

$

15,000

$

25,000

$

15,000

Annual Interest Rate

6.625%

LIBOR + 2.25 – 3.00%

6.625%

LIBOR + 2.25 – 3.00%

Interest Payment Frequency

Quarterly

Quarterly

Quarterly

Quarterly

Weighted-Average Interest Rate

6.625%

2.98%

6.625%

2.99%

Maturity

May 1, 2023

2033 – 2035

May 1, 2023

2033 – 2035

Early Redemption Date

May 1, 2016

2008 – 2010

May 1, 2016

2008 – 2010

4. Derivative Financial Instruments and Hedging Activities:

In the normal course of its operations, the Company is a party to financial instruments that are accounted for as derivative financial instruments in accordance with ASC 815. These instruments may include interest rate swaps, Eurodollar futures, swap futures, and U.S. Treasury futures contracts, put options and certain commitments to purchase and sell MBS. The exchange traded derivatives such as Eurodollar futures and swap futures are cash settled on a daily basis. The Company may be required to pledge collateral for margin requirements with third-party custodians in connection with certain derivative transactions. These transactions are not under master netting agreements.

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ARLINGTON ASSET INVESTMENT CORP.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

4. Derivative Financial Instruments and Hedging Activities:  – (continued)

During the three and six months ended June 30, 2014 and 2013, the Company entered into various financial contracts to hedge certain MBS and related borrowings and other long-term debt. These financial contracts are not designated as hedges under ASC 815. The changes in fair value on these derivatives are recorded to net investment gain or loss in the statement of comprehensive income. For the three and six months ended June 30, 2014, the Company recorded net losses of $46,585 and $70,065, respectively, on these derivatives. For the three and six months ended June 30, 2013, the Company recorded net gains of $57,776 and $59,034, respectively, on these derivatives. The Company held the following derivative instruments as of the dates indicated:

		June 30, 2014								December 31, 2013
		Notional Amount				Fair Value				Notional Amount				Fair Value
No hedge designation
Eurodollar futures
Derivative assets		$	1,488,000			$	701			$	8,758,000			$	4,361
Derivative liabilities			27,772,000				(52,216	)			6,787,000				(30,638	)
Total Eurodollar futures(1)			29,260,000				(51,515	)			15,545,000				(26,277	)
10-year swap futures
Derivative assets			—				—				635,500				3,727
Derivative liabilities			895,000				(27,009	)			31,000				(18	)
Total 10-year swap futures(2)			895,000				(27,009	)			666,500				3,709
5-year U.S. Treasury note futures			—				—				100,000				(1,500	)
Commitment to purchase MBS(3)			75,000				1,855				169,511				(973	)
Commitment to sell MBS(4)			125,000				(1,262	)			125,000				336

5. Income Taxes:

The total income tax provision for the three and six months ended June 30, 2014 was $12,074 and $16,554, respectively. The total income tax provision (benefit) for the three and six months ended June 30, 2013 was $2,554 and $(1,208), respectively. The Company generated pre-tax book income of $30,913 and $42,426 for the three and six months ended June 30, 2014, respectively. The Company generated pre-tax book income of $5,748 and $5,163 for the three and six months ended June 30, 2013, respectively.

The Company’s effective tax rate for the six months ended June 30, 2014 and 2013 was 39.0% and (23.4%), respectively. The effective tax rate during the six months ended June 30, 2014 approximated the

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ARLINGTON ASSET INVESTMENT CORP.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

5. Income Taxes:  – (continued)

statutory rate. The effective tax rate during the six months ended June 30, 2013 was lower than the statutory tax rate due to the realization of previously unrecognized tax benefits, including related accrued interest, that were fully reserved.

As of June 30, 2014, the Company had a net deferred tax asset of $151,669. The Company continues to provide a valuation allowance against the portion of the capital loss carryforwards which the Company believes is more likely than not that the benefits will not be realized prior to expiration. The Company will continue to assess the need for a valuation allowance at each reporting date.

As of June 30, 2014, the Company has assessed the need for a reserve against any uncertain tax position and has made the determination that such reserve is not necessary.

The Company is subject to examination by the U.S. Internal Revenue Service (IRS) and state and local taxing jurisdictions where the Company has significant business operations. As of June 30, 2014, there are no on-going examinations.

6. Earnings Per Share:

Basic earnings per share includes no dilution and is computed by dividing net income or loss applicable to common stock by the weighted-average number of common shares outstanding for the respective period. Diluted earnings per share includes the impact of dilutive securities such as stock options, unvested shares of restricted stock, and performance share units. The following tables present the computations of basic and diluted earnings per share for the periods indicated:

		Three Months Ended June 30,
		2014								2013
(Shares in thousands)		Basic				Diluted				Basic				Diluted
Weighted-average shares outstanding
Common stock			19,740				19,740				16,655				16,655
Stock options, performance share units, and unvested restricted stock			—				320				—				177
Weighted-average common and common equivalent shares outstanding			19,740				20,060				16,655				16,832
Net income applicable to common stock		$	18,839			$	18,839			$	3,194			$	3,194
Net income per common share		$	0.95			$	0.94			$	0.19			$	0.19

		Six Months Ended June 30,
		2014								2013
(Shares in thousands)		Basic				Diluted				Basic				Diluted
Weighted-average shares outstanding
Common stock			18,282				18,282				15,299				15,299
Stock options, performance share units, and unvested restricted stock			—				297				—				171
Weighted-average common and common equivalent shares outstanding			18,282				18,579				15,299				15,470
Net income applicable to common stock		$	25,872			$	25,872			$	6,371			$	6,371
Net income per common share		$	1.42			$	1.39			$	0.42			$	0.41

TABLE OF CONTENTS

ARLINGTON ASSET INVESTMENT CORP.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

6. Earnings Per Share:  – (continued)

The diluted earnings per share for the three and six months ended June 30, 2014 did not include the antidilutive effect of 22,667 and 24,897 shares, respectively, of stock options, unvested shares of restricted stock, and performance share units. The diluted earnings per share for the three and six months ended June 30, 2013 did not include the antidilutive effect of 9,005 and 13,733 shares, respectively, of stock options, unvested shares of restricted stock, and performance share units.

7. Equity:

Equity Offering

During the six months ended June 30, 2014, the Company completed a public offering of its Class A Common Stock as follows:

Closing date of the offering			March 28, 2014
Shares sold to public			2,750,000
Shares sold pursuant to the underwriter over-allotment option			312,500
Total shares of Class A common stock sold in the offering			3,062,500
Public offering price per share			$27.40
Net proceeds(1)			$81,669

Dividends

Pursuant to the Company’s variable dividend policy, the Board of Directors evaluates dividends on a quarterly basis and, in its sole discretion, approves the payment of dividends. The Company’s dividend payments, if any, may vary significantly from quarter to quarter. The Board of Directors has approved and the Company has declared the following dividends to date in 2014:

Quarter Ended

Dividend Amount

Declaration Date

Record Date

Pay Date

June 30

$

0.875

June 11

June 30

July 31

March 31

0.875

March 13

March 31

April 30

The Board of Directors approved and the Company declared and paid the following dividends for 2013:

Quarter Ended

Dividend Amount

Declaration Date

Record Date

Pay Date

December 31

$

0.875

December 19

December 31

January 31, 2014

September 30

0.875

September 18

September 30

October 31

June 30

0.875

June 17

June 28

July 31

March 31

0.875

March 15

March 28

April 30

Long-Term Incentive Plan

On April 13, 2011, the Board of Directors adopted the Arlington Asset Investment Corp. 2011 Long-Term Incentive Plan (2011 Plan). The 2011 Plan was approved by the Company’s shareholders and became effective on June 2, 2011. Under the 2011 Plan, shares of Class A common stock of the Company may be issued to employees, directors, consultants and advisors of the Company and its affiliates. As of June 30, 2014 and December 31, 2013, 393,716 and 443,504 shares, respectively, remained available for issuance under the 2011 Plan.

Performance-Based Long-Term Incentive Program

On August 13, 2012, the Compensation Committee of the Board of Directors of the Company adopted a performance-based long-term incentive program (Performance-based Program) that provides for the issuance of two types of performance share units (PSUs) pursuant to the Company’s 2011 Plan.

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ARLINGTON ASSET INVESTMENT CORP.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

7. Equity:  – (continued)

The Compensation Committee established performance goals under the Performance-based Program. Two types of PSUs may be awarded under the Performance-based Program: Book Value PSUs and Total Shareholder Return Units (TSR PSUs). The Book Value PSUs are eligible to vest based on the compound annualized growth in the Company’s book value per share (i.e., book value change with such adjustments as determined and approved by the Compensation Committee plus dividends on a reinvested basis) during the applicable performance period. The TSR PSUs are eligible to vest based on the Company’s compound annualized total shareholder return (i.e., share price change plus dividends on a reinvested basis) during the applicable performance period.

The Company recorded $468 and $848, in compensation expenses related to the Performance-based Program during the three and six months ended June 30, 2014, respectively. The Company recorded $237 and $517 in compensation expenses related to the Performance-based Program during the three and six months ended June 30, 2013, respectively.

Restricted Stock

The following tables present the activities and balances related to restricted stock for the dates and periods indicated:

		Three Months Ended June 30,								Six Months Ended June 30,
		2014				2013				2014				2013
Shares granted			36,102				36,000				36,102				36,000
Weight-average share price		$	27.70			$	26.74			$	27.70			$	26.74
Compensation expense recognized during the period		$	203			$	100			$	395			$	209

		June 30, 2014				December 31, 2013
Restricted Class A shares outstanding, unvested			77,109				57,673
Unrecognized compensation cost related to unvested shares			$1,443				$838
Weighted-average vesting period remaining			2.22 years				2.04 years

Conversion of Class B Common Stock to Class A Common Stock

During the three months ended June 30, 2014, a holder of the Company’s common stock converted an aggregate of 104,827 shares of Class B common stock into 104,827 shares of Class A common stock. Holders of shares of Class A common stock are entitled to one vote for each share on all matters voted on by shareholders, and the holders of shares of Class B common stock are entitled to three votes per share on all matters voted on by shareholders. Under the Company’s Articles of Incorporation, shares of Class B common stock are convertible into shares of Class A common stock on a one-for-one basis.

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ARLINGTON ASSET INVESTMENT CORP.
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Dollars in thousands, except per share data)
(Unaudited)

8. Recent Accounting Pronouncements:

On April 10, 2014, the FASB issued Accounting Standards Update (ASU) No. 2014-08, Reporting Discontinued Operations and Disclosures of Disposals of Components of an Entity, which changes the criteria for determining which disposals can be presented as discontinued operations and modifies related disclosure requirements. This standard will be effective for the Company on January 1, 2015, and the Company does not expect it to have a significant impact on the Company’s financial statements upon implementation.

On May 28, 2014, the FASB issued ASU No. 2014-09, Revenue from Contracts with Customers, which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. ASU No. 2014-09 will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. The new standard will be effective for the Company on January 1, 2017. Early application is not permitted. The Company does not expect ASU No. 2014-09 to have a significant impact on the Company’s financial statements upon implementation.

9. Subsequent Events:

On July 1, 2014, the Company granted Book Value PSUs and TSR PSUs to the participants in the Performance-based Program (2014 PSU Grants). For the 2014 PSU Grants, the Compensation Committee awarded PSUs with an aggregate grant date fair value equal to 100% of the awardee’s base salary, with 50% of the total grant date fair value represented by Book Value PSUs and 50% of the total grant date fair value represented by TSR PSUs. The 2014 PSU Grants have a three-year performance period.

The actual number of shares of Class A common stock that will be issued to each participant at the end of the applicable performance period will vary between 0% and 250% of the number of PSUs granted, depending on performance results. If the threshold level of performance goals are not achieved, no PSUs are earned. Participants will earn 50% of the granted PSUs for Company performance at the threshold level, 100% of the granted PSUs for Company performance at the target level and 250% of the granted PSUs for Company performance at the maximum level, with linear interpolation for achievement falling between the performance levels.

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

Unless the context otherwise requires or provides, references in this Quarterly Report on Form 10-Q to “we,” “us,” “our” and “our company” refer to Arlington Asset Investment Corp. (Arlington Asset) and its subsidiaries. This discussion and analysis should be read in conjunction with our financial statements and accompanying notes included in Item 1 of this Quarterly Report on Form 10-Q, as well as our audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2013.

The discussion of our consolidated financial condition and results of operations below may contain forward-looking statements. These statements, which reflect management’s beliefs and expectations, are subject to risks and uncertainties that may cause actual results to differ materially. For a discussion of the risks and uncertainties that may affect our future results, please see “Cautionary Statement About Forward-Looking Statements” immediately following Item 4 of Part I of this Quarterly Report on Form 10-Q and the risk factors included in Item 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2013.

Our Company

We are a principal investment firm that currently acquires and holds primarily mortgage-related assets. We acquire residential mortgage-backed securities (MBS), either issued by U.S. government agencies or guaranteed as to principal and interest by U.S. government agencies or U.S. government-sponsored entities (agency-backed MBS). We also acquire MBS issued by private organizations (private-label MBS), subject to maintaining our exemption from regulation as an investment company under the Investment Company Act of 1940, as amended (1940 Act). In the future, we may acquire and hold other types of assets, including commercial MBS, asset backed securities, other structured securities, commercial mortgage loans, commercial loans, residential mortgage loans, and other real estate-related loans and securities. In addition, we also may pursue other business activities that will utilize our experience in analyzing investment opportunities and applying similar portfolio management skills. We are a Virginia corporation and taxed as a C corporation for federal income tax purposes. We operate in the United States.

Factors that Affect our Results of Operations and Financial Condition

Our business is materially affected by a variety of industry and economic factors, including:

Adverse market conditions and actions by governmental authorities could adversely affect our business in many ways, including but not limited to making it more difficult for us to analyze our investment portfolio, reducing the market value of our MBS portfolio, adversely affecting our ability to maintain targeted amounts of leverage on our MBS portfolio and successfully implement our hedging strategy, and limiting our ability to follow our current investment and financing strategies. While uncertain, these potentially adverse market conditions and actions by governmental authorities may adversely affect our liquidity, financial position and results of operations. We have been evaluating, and will continue to evaluate, the potential impact of recent government actions, including developments relating to various state and federal government actions affecting the market price of MBS, related derivative securities, and interest rates. For further discussions on how market conditions and government actions may adversely affect our business, see “Item 1A — Risk Factors” of our Annual Report on Form 10-K for the year ended December 31, 2013.

Our MBS portfolio is affected by general U.S. residential real estate market conditions and the overall U.S. economic environment. In particular, our MBS strategy and the performance of our MBS portfolio is

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influenced by the specific characteristics of these markets, including prepayment rates, credit losses, interest rates and the interest rate yield curve. Our results of operations with respect to our MBS portfolio primarily depend on, among other things, the level of our interest income, the amount and cost of borrowings we may obtain by pledging our investment portfolio as collateral for the borrowings and the cost and impact of our hedges. Our borrowing cost varies based on changes in interest rates and changes in the amount we can borrow, which is generally based on the fair value of the MBS portfolio and the advance rate the lenders are willing to lend against the collateral provided. We have entered into various hedging transactions to mitigate the interest rate sensitivity which directly impacts our cost of borrowing and the market value of our agency-backed MBS. The market value of these hedge instruments is expected to fluctuate inversely relative to the value of the agency-backed MBS portfolio and decrease in value during periods of declining interest rates and/or widening mortgage spreads. Conversely, during periods of increasing rates and/or tightening mortgage spreads, these instruments are expected to increase in value.

The payment of principal and interest on the agency-backed MBS that we acquire and hold is guaranteed by the Federal Home Loan Mortgage Corporation (Freddie Mac) or the Federal National Mortgage Association (Fannie Mae). The payment of principal and interest on agency-backed MBS issued by Freddie Mac or Fannie Mae is not guaranteed by the U.S. government. Any failure to honor its guarantee of agency-backed MBS by Freddie Mac or Fannie Mae or any downgrade of securities issued by Freddie Mac or Fannie Mae by the rating agencies could cause a significant decline in the value of and cash flow from any agency-backed MBS we own that are guaranteed by such entity.

Current Market Conditions and Trends

The U.S. Federal Reserve continued its reductions of its monthly purchases of agency-backed MBS and U.S. Treasury bonds during the second quarter of 2014. These reductions are commonly referred to as “tapering.” As of July 2014, the Federal Reserve had reduced its purchases to $20 billion of U.S. Treasury bonds and $15 billion in agency-backed MBS per month. On July 30, 2014, the Federal Reserve announced that purchases would be further reduced to $15 billion of U.S. Treasury bonds and $10 billion in agency-backed MBS per month beginning in August 2014. In minutes from the U.S. Federal Reserve’s Open Market Committee (FOMC) June 2014 meeting, the U.S. Federal Reserve indicated that it anticipates ending its bond buying program in October 2014. On June 18, 2014, the FOMC reiterated its continuing long-term goals of reaching maximum employment and inflation of 2% before adjusting the target Fed Funds Rate. The FOMC reiterated these sentiments on July 30, 2014, although it noted that the employment and inflation were moving closer to its objectives.

Given the low inflation projections, we believe that the U.S. government’s monetary policy, including the timing of tapering asset purchases, will likely be dependent on actual growth in employment rather than inflation concerns. It is important to note that over the past several years, actual employment growth has been consistently below the U.S. Federal Reserve’s projections. While there are signs of a recovery, uncertainty continues to dominate the market, due to the continued low interest rate environment and actions by the U.S. Federal Reserve. We believe the general business environment will continue to be challenging in 2014 and future periods. Our growth outlook is dependent, in part, on the strength of the financial markets, the impact of fiscal and monetary policy actions by the United States and other countries, the overall market value of U.S. equities and liquidity in the financial system. Depending on recent market developments and movements, we may seek to re-align our strategy and our portfolio. We will continue to closely monitor the developments in the market and evaluate the opportunities across the spectrum in the mortgage industry and other types of assets and seek the highest risk-adjusted returns for our capital.

We believe the limited liquidity and volatility in the credit markets will continue while the markets seek to determine the right equilibrium levels for benchmark interest rates as the U.S. Federal Reserve stimulus leaves the market place.

Recent Government Activity

In June of 2013, Senators Bob Corker (R-TN) and Mark Warner (D-VA) introduced the Housing Finance Reform and Taxpayer Protection Act of 2013 (the Corker-Warner Bill) into the U.S. Senate. The proposed bill has served as a basis of discussion for congressional efforts to reform Fannie Mae and Freddie Mac.

GSE reform lost momentum in the second quarter of 2014 when the Johnson-Crapo Bill, which is closely based on the Corker-Warner Bill, failed to secure enough support to be considered by Congress even though it

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was approved by the Senate Banking Committee. The fate of the proposed legislation is unclear, as reports indicate that the U.S. House Republican leadership appears to favor a very different approach to reform. There is no way to know if this proposal will become law, how this proposal would impact housing finance, and what impact, if any, it would have on companies that invest in MBS. The passage of any new legislation affecting Fannie Mae and Freddie Mac may create market uncertainty and reduce the actual or perceived credit quality of securities issued or guaranteed by the U.S. government through a new or existing successor entity to Fannie Mae and Freddie Mac. If the charters of Fannie Mae and Freddie Mac were revoked, it is unclear what effect, if any, this would have on the value of the existing Fannie Mae and Freddie Mac agency-backed MBS. It is also possible that the above-referenced proposed legislation, if made law, could adversely impact the market for securities issued or guaranteed by the U.S. government and the spreads at which they trade. The foregoing could materially adversely affect the pricing, supply, liquidity and value of our target assets and otherwise materially adversely affect our business, operations and financial condition.

Executive Summary

On June 11, 2014, the Company’s Board of Directors appointed J. Rock Tonkel, Jr. as the Company’s Chief Executive Officer effective immediately. Mr. Tonkel succeeds Eric F. Billings as Chief Executive Officer, who is retiring from this position in order to focus on his other business activities. Mr. Tonkel has served as President and Chief Operating Officer, a member of the Company’s Board of Directors and a member of the Company’s Investment Committee since 2007. Mr. Tonkel will also continue to serve as President of the Company, as a director and as a member of the Investment Committee. Mr. Billings will continue to serve as Executive Chairman of the Board as well as the Chairman of the Company’s Investment Committee.

During the second quarter of 2014, markets continued to adjust to the Federal Reserve’s tapering policy. The FOMC communicated that it was seeing an improvement in economic activity and labor market conditions. As a result, the FOMC continued its tapering program of reducing its monthly purchases of agency-backed MBS and U.S. Treasury securities. On June 18, 2014, the Federal Reserve announced that it planned to decrease its monthly purchases to $20 billion of U.S. Treasury bonds and $15 billion of agency-backed MBS per month beginning in July 2014. On July 30, 2014, the Federal Reserve announced that purchases would be further reduced to $15 billion of U.S. Treasury bonds and $10 billion in agency-backed MBS per month beginning in August 2014. Additionally, the FOMC has stated it would continue to reinvest principal payments from its holdings of these securities in agency-backed MBS and rolling over maturing U.S. Treasury securities at auction.

Actions taken by the Federal Reserve so far in 2014 have been in line with market expectations. In recent months, growth in economic activity has rebounded and labor market indicators generally showed further improvement. The unemployment rate, though lower, remains elevated relative to pre-recession levels. Household spending appears to be rising moderately and business fixed investment resumed its advance, while the recovery in the housing sector remained slow. We believe that fiscal policy is restraining economic growth, although the extent of this restraint is diminishing. Inflation has been running below the FOMC’s longer-run objective, but longer-term inflation expectations have remained stable.

During the second quarter of 2014, yields have continued to fall and the yield curve has flattened since December 31, 2013. The 10-year Treasury decreased 21 basis points and the 5-year to 10-year Treasury curve flattened by 10 basis points. In addition, the spread between agency-backed MBS and interest rate swaps tightened during the quarter ended June 30, 2014, with the spread between Fannie Mae 30-year par priced securities and 5-year interest rate swaps tightening approximately 16 basis points.

Based on current economic indicators and trends in underlying credit and housing data, we continue to review the allocation of our available capital in an effort to maximize return to our shareholders. As of June 30, 2014, our MBS portfolio consisted of $3.1 billion in fair value, with $2.8 billion of agency-backed MBS and $0.3 billion of private-label MBS. Our combined MBS portfolio performed in line with our expectations in the second quarter of 2014. Our private-label MBS portfolio value increased due to continued demand for these assets and the continued improvement in their credit metrics. The agency-backed MBS values increased during the second quarter of 2014 due to lower rates and tighter spreads. This resulted in an incremental increase in the performance of our assets when compared to the change in value of the hedges that we have against this portfolio. Our hedge design and structure is intended to offset substantially the change in value of our assets due to changes in interest rates. Other factors, such as the steepness or flatness of the yield curve, will potentially have an effect on the value of our hedges as compared to the assets.

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For the three months ended June 30, 2014, we had net income of $18.8 million, or $0.94 per share (diluted). As of June 30, 2014, our book value per share was $31.51.

In addition to the financial results reported in accordance with generally accepted accounting principles as consistently applied in the United States (GAAP), we calculated non-GAAP core operating income for the three and six months ended June 30, 2014. Our non-GAAP core operating income for the three and six months ended June 30, 2014 was $24.4 million and $44.5 million, respectively. In determining core operating income, we excluded certain legacy litigation expenses and the following non-cash expenses: (1) compensation costs associated with stock-based awards, (2) accretion of MBS purchase discounts adjusted for contractual interest and principal repayments in excess of proportionate invested capital, (3) other-than-temporary impairment charges recognized, (4) non-cash income tax provisions, and (5) benefit from the reversal of previously accrued federal and state tax liability and accrued interest related to uncertain tax positions. Additionally, starting in 2014, the Company has excluded both realized and unrealized gains and losses on the agency-backed MBS and all related hedge instruments, and has presented prior periods on a consistent basis. These adjustments are only for the purpose of calculating our non-GAAP core operating income; therefore, they do not change our GAAP book value as reported.

The Company’s portfolio strategy on the agency-backed MBS portfolio is to generate a net interest margin on the leveraged assets and hedge the market value of the assets, expecting that the fluctuations in the market value of the agency-backed MBS and related hedges should largely offset each other over time. As a result, the Company excludes both the realized and unrealized fluctuations in the gains and losses in the assets and hedges on its hedged, agency-backed MBS portfolio, when assessing the underlying core operating income of the Company. However, the Company’s portfolio strategy on the private-label MBS is to generate a total cash return comprised of both interest income and the cash return realized when the private-label MBS are sold which equals the difference between the sale price and the discount to par paid at acquisition. Therefore, the Company excludes non-cash accretion of private-label MBS purchase discounts from core operating income, but includes realized cash gains or losses on its private-label MBS portfolio in core operating income to reflect the total cash return on those securities over their holding period.

This non-GAAP core operating income measurement is used by management to analyze and assess the Company’s operating results on its portfolio and assist with the determination of the appropriate level of dividends. We believe that this non-GAAP measurement assists investors in understanding the impact of these non-core items and non-cash expenses on our performance and provides additional clarity around our earnings capacity and trends. A limitation of utilizing this non-GAAP measure is that the GAAP accounting effects of these events do in fact reflect the underlying financial results of our business and these effects should not be ignored in evaluating and analyzing our financial results. Therefore, we believe net income on a GAAP basis and core operating income on a non-GAAP basis should be considered together.

The following is a reconciliation of GAAP net income to non-GAAP core operating income for the three and six months ended June 30, 2014 and 2013 (dollars in thousands):

		Three Months Ended June 30,
		2014				2013 Revised				2013 As Previously Reported
GAAP net income		$	18,839			$	3,194			$	3,194
Adjustments
Adjusted expenses			—				—				2,371
Legacy litigation expenses(1)			43				293				—
Non-cash income tax provisions			11,782				2,078				—
Stock compensation			779				442				442
Non-cash interest income related to purchase discount accretion(2)			(3,934	)			(464	)			(464	)
Net realized and unrealized (gain) loss on trading MBS and hedge instruments			(3,199	)			17,569				12,584
Other-than-temporary impairment charges			80				728				728
Non-GAAP core operating income		$	24,390			$	23,840			$	18,855

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		Six Months Ended June 30,
		2014				2013 Revised				2013 As Previously Reported
GAAP net income		$	25,872			$	6,371			$	6,371
Adjustments
Adjusted expenses			—				—				2,872
Legacy litigation expenses(1)			54				576				—
Non-cash income tax provisions			15,986				2,299				—
Stock compensation			1,456				937				940
Non-cash interest income related to purchase discount accretion(2)			(6,378	)			(1,176	)			(1,176	)
Net realized and unrealized loss on trading MBS and hedge instruments			7,434				32,353				27,322
Benefit from the reversal of federal tax liability and accrued interest related to uncertain tax position			—				(3,744	)			(3,744	)
Other-than-temporary impairment charges			80				890				890
Non-GAAP core operating income		$	44,504			$	38,506			$	33,475