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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

x

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

For the Quarterly Period Ended September 30, 2014

OR

¨

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 001-34030

 

HATTERAS FINANCIAL CORP.

(Exact name of registrant as specified in its charter)

 

 

Maryland

 

26-1141886

(State or other jurisdiction

of incorporation or organization)

 

(IRS Employer

Identification No.)

 

751 W. Fourth Street, Suite 400

Winston-Salem, North Carolina

 

27101

(Address of principal executive offices)

 

(Zip Code)

(336) 760-9347

(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 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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

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

 

Large accelerated filer

 

x

  

Accelerated filer

 

¨

 

 

 

 

Non-accelerated filer

 

¨  (Do not check if a smaller reporting company)

  

Smaller reporting company

 

¨

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

Class

  

Outstanding at October 31, 2014

Common Stock ($0.001 par value)

  

96,719,908

 

 

 

 

 

 


 

TABLE OF CONTENTS

 

 

  

 

Page

 

PART I

  

Financial Information

 

 

Item 1.

  

Financial Statements

3

 

Item 2.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

27

 

Item 3.

  

Quantitative and Qualitative Disclosures about Market Risk

51

 

Item 4.

  

Controls and Procedures

54

 

PART II

  

Other Information

 

 

Item 1.

  

Legal Proceedings

54

 

Item 1A.

  

Risk Factors

55

 

Item 2.

  

Unregistered Sales of Equity Securities and Use of Proceeds

56

 

Item 3.

  

Defaults Upon Senior Securities

56

 

Item 4.

  

Mine Safety Disclosures

56

 

Item 5.

  

Other Information

56

 

Item 6.

  

Exhibits

57

 

  

 

Signatures

58

 

 

 

2


 

PART I.  Financial Information

Item 1.  Financial Statements

 

Hatteras Financial Corp.

Consolidated Balance Sheets

 

 

(Dollars in thousands, except share related amounts)

 

 

 

 

 

 

 

 

(Unaudited)

 

 

 

 

 

 

September 30, 2014

 

 

December 31, 2013

 

Assets

 

 

 

 

 

 

 

Mortgage-backed securities, at fair value

 

 

 

 

 

 

 

(including pledged assets of $15,660,522 and $17,049,670, respectively)

$

16,890,424

 

 

$

17,642,532

 

Cash and cash equivalents

 

215,073

 

 

 

763,326

 

Restricted cash

 

226,764

 

 

 

225,379

 

Unsettled purchased mortgage-backed securities, at fair value

 

45,691

 

 

 

-

 

Receivable for securities sold

 

-

 

 

 

231,214

 

Accrued interest receivable

 

52,757

 

 

 

55,156

 

Principal payments receivable

 

128,041

 

 

 

95,021

 

Other investments

 

41,163

 

 

 

34,910

 

Derivative assets, at fair value

 

31,002

 

 

 

26,989

 

Other assets

 

16,998

 

 

 

2,833

 

Total assets

$

17,647,913

 

 

$

19,077,360

 

 

 

 

 

 

 

 

 

Liabilities and shareholders’ equity

 

 

 

 

 

 

 

Repurchase agreements

$

14,920,959

 

 

$

16,129,683

 

Dollar roll liability

 

-

 

 

 

351,826

 

Payable for unsettled securities

 

45,571

 

 

 

-

 

Accrued interest payable

 

2,841

 

 

 

8,279

 

Derivative liabilities, at fair value

 

175,322

 

 

 

167,607

 

Dividend payable

 

52,988

 

 

 

52,929

 

Accounts payable and other liabilities

 

5,740

 

 

 

2,935

 

Total liabilities

 

15,203,421

 

 

 

16,713,259

 

 

 

 

 

 

 

 

 

Shareholders’ equity:

 

 

 

 

 

 

 

7.625% Series A Cumulative Redeemable Preferred stock, $.001 par value, 25,000,000 shares authorized, 11,500,000 shares issued and outstanding, respectively ($287,500 aggregate liquidation preference)

 

278,252

 

 

 

278,252

 

Common stock, $.001 par value, 200,000,000 shares authorized, 96,719,908 and 96,601,523 shares issued and outstanding, respectively

 

97

 

 

 

97

 

Additional paid-in capital

 

2,453,698

 

 

 

2,453,018

 

Accumulated deficit

 

(438,319

)

 

 

(359,214

)

Accumulated other comprehensive income (loss)

 

150,764

 

 

 

(8,052

)

Total shareholders’ equity

 

2,444,492

 

 

 

2,364,101

 

Total liabilities and shareholders’ equity

$

17,647,913

 

 

$

19,077,360

 

See accompanying notes.

 

 

 

3


 

Hatteras Financial Corp.

Consolidated Statements of Income

(Unaudited)

 

 

(Dollars in thousands, except share related amounts)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended September 30

 

 

Nine Months Ended September 30

 

 

2014

 

 

2013

 

 

2014

 

 

2013

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income on mortgage-backed securities

$

80,969

 

 

$

107,040

 

 

$

266,734

 

 

$

346,396

 

Interest income on short-term cash investments

 

330

 

 

 

303

 

 

 

959

 

 

 

1,104

 

Total interest income

 

81,299

 

 

 

107,343

 

 

 

267,693

 

 

 

347,500

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest expense

 

31,950

 

 

 

51,599

 

 

 

105,529

 

 

 

156,955

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net interest margin

 

49,349

 

 

 

55,744

 

 

 

162,164

 

 

 

190,545

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Management fee

 

4,122

 

 

 

4,522

 

 

 

12,420

 

 

 

13,956

 

Share based compensation

 

890

 

 

 

637

 

 

 

2,592

 

 

 

1,893

 

General and administrative

 

2,113

 

 

 

1,538

 

 

 

6,584

 

 

 

4,509

 

Total operating expenses

 

7,125

 

 

 

6,697

 

 

 

21,596

 

 

 

20,358

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other income (loss):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net realized gain (loss) on sale of mortgage-backed securities

 

237

 

 

 

(225,635

)

 

 

3,089

 

 

 

(214,333

)

Impairment of mortgage-backed securities

 

-

 

 

 

(8,102

)

 

 

-

 

 

 

(8,102

)

Gain (loss) on derivative instruments, net

 

35,430

 

 

 

(77,456

)

 

 

(61,445

)

 

 

(71,920

)

Total other income (loss)

 

35,667

 

 

 

(311,193

)

 

 

(58,356

)

 

 

(294,355

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

77,891

 

 

 

(262,146

)

 

 

82,212

 

 

 

(124,168

)

Dividends on preferred stock

 

5,480

 

 

 

5,481

 

 

 

16,441

 

 

 

16,441

 

Net income (loss) available to common shareholders

$

72,411

 

 

$

(267,627

)

 

$

65,771

 

 

$

(140,609

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Earnings (loss) per share - common stock, basic

$

0.75

 

 

$

(2.72

)

 

$

0.68

 

 

$

(1.43

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Earnings (loss) per share - common stock, diluted

$

0.75

 

 

$

(2.72

)

 

$

0.68

 

 

$

(1.43

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Dividends per share of common stock

$

0.50

 

 

$

0.55

 

 

$

1.50

 

 

$

1.95

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding, basic

 

96,563,132

 

 

 

98,318,205

 

 

 

96,561,446

 

 

 

98,656,750

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average common shares outstanding, diluted

 

96,563,132

 

 

 

98,318,205

 

 

 

96,561,446

 

 

 

98,656,750

 

See accompanying notes.

 

 

 

4


 

Hatteras Financial Corp.

Consolidated Statements of Comprehensive Income

(Unaudited)

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended

September 30

 

 

Nine Months Ended

September 30

 

 

2014

 

 

2013

 

 

2014

 

 

2013

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

$

77,891

 

 

$

(262,146

)

 

$

82,212

 

 

$

(124,168

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive income:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net unrealized gains (losses) on securities available for sale

 

(31,382

)

 

 

191,227

 

 

 

83,790

 

 

 

(455,185

)

Net unrealized gains on derivative instruments

 

17,923

 

 

 

45,227

 

 

 

75,026

 

 

 

107,952

 

Other comprehensive income (loss)

 

(13,459

)

 

 

236,454

 

 

 

158,816

 

 

 

(347,233

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Comprehensive income (loss)

 

64,432

 

 

 

(25,692

)

 

 

241,028

 

 

 

(471,401

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Dividends on preferred stock

 

5,480

 

 

 

5,481

 

 

 

16,441

 

 

 

16,441

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Comprehensive income (loss) available to common shareholders

$

58,952

 

 

$

(31,173

)

 

$

224,587

 

 

$

(487,842

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Comprehensive income (loss) per share - common stock,

     basic and diluted

$

0.61

 

 

$

(0.32

)

 

$

2.33

 

 

$

(4.94

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

See accompanying notes.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

5


 

Hatteras Financial Corp.

Consolidated Statements of Changes in Shareholders’ Equity

Nine Months Ended September 30, 2014

(Unaudited)

 

 

(Dollars in thousands)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

7.625% Series A Cumulative Redeemable Preferred Stock

 

 

Common Stock

 

 

Additional Paid-in Capital

 

 

Accumulated Deficit

 

 

Accumulated Other Comprehensive Income (Loss)

 

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance at December 31, 2013

$

278,252

 

 

$

97

 

 

$

2,453,018

 

 

$

(359,214

)

 

$

(8,052

)

 

$

2,364,101

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Repurchase of common stock

 

-

 

 

 

-

 

 

 

(1,912

)

 

 

-

 

 

 

-

 

 

 

(1,912

)

Share based compensation expense

 

-

 

 

 

-

 

 

 

2,592

 

 

 

-

 

 

 

-

 

 

 

2,592

 

Dividends declared on preferred stock

 

-

 

 

 

-

 

 

 

-

 

 

 

(16,441

)

 

 

-

 

 

 

(16,441

)

Dividends declared on common stock

 

-

 

 

 

-

 

 

 

-

 

 

 

(144,876

)

 

 

-

 

 

 

(144,876

)

Net income

 

-

 

 

 

-

 

 

 

-

 

 

 

82,212

 

 

 

-

 

 

 

82,212

 

Other comprehensive income

 

-

 

 

 

-

 

 

 

-

 

 

 

-

 

 

 

158,816

 

 

 

158,816

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance at September 30, 2014

$

278,252

 

 

$

97

 

 

$

2,453,698

 

 

$

(438,319

)

 

$

150,764

 

 

$

2,444,492

 

See accompanying notes.

 

 

 

6


 

Hatteras Financial Corp.

Consolidated Statements of Cash Flows

(Unaudited)

(Dollars in thousands)

 

 

 

 

 

 

 

 

Nine Months Ended September 30

 

Operating activities

2014

 

 

2013

 

Net income

$

82,212

 

 

$

(124,168

)

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

 

 

Net amortization of premium related to mortgage-backed securities

 

76,374

 

 

 

139,205

 

Reclassification of deferred swap loss

 

67,413

 

 

 

-

 

Amortization related to interest rate swap agreements

 

184

 

 

 

239

 

Share based compensation expense

 

2,592

 

 

 

1,893

 

Hedge ineffectiveness

 

-

 

 

 

(205

)

Net (gain) loss on sale of mortgage-backed securities

 

(3,089

)

 

 

214,333

 

Impairment loss on mortgage-backed securities

 

-

 

 

 

8,102

 

Net loss on derivative instruments

 

61,445

 

 

 

44,593

 

Changes in operating assets and liabilities:

 

 

 

 

 

 

 

Decrease in accrued interest receivable

 

2,399

 

 

 

14,192

 

Increase in other assets

 

(13,211

)

 

 

(658

)

Decrease in accrued interest payable

 

(5,438

)

 

 

(3,691

)

Increase (decrease) in accounts payable and other liabilities

 

(814

)

 

 

842

 

Net cash provided by operating activities

 

270,067

 

 

 

294,677

 

 

 

 

 

 

 

 

 

Investing activities

 

 

 

 

 

 

 

Purchases of mortgage-backed securities

 

(3,541,220

)

 

 

(8,521,002

)

Principal repayments on mortgage-backed securities

 

2,559,882

 

 

 

4,823,759

 

Sales of mortgage-backed securities

 

1,942,004

 

 

 

8,027,113

 

Net payments on derivative instruments

 

(46,532

)

 

 

-

 

Purchase of equity investment

 

(6,000

)

 

 

-

 

Purchase of broker/dealer

 

(1,349

)

 

 

-

 

Net cash provided by investing activities

 

906,785

 

 

 

4,329,870

 

 

 

 

 

 

 

 

 

Financing activities

 

 

 

 

 

 

 

Repurchase of common stock

 

(1,912

)

 

 

(21,063

)

Cash dividends paid

 

(161,258

)

 

 

(223,978

)

Proceeds from repurchase agreements

 

122,704,915

 

 

 

186,080,168

 

Principal repayments on repurchase agreements

 

(123,913,639

)

 

 

(190,116,826

)

Proceeds from dollar roll financing

 

241,121

 

 

 

-

 

Repayments on dollar roll financing

 

(592,947

)

 

 

-

 

(Increase) decrease in restricted cash margin on derivatives

 

(1,385

)

 

 

39,168

 

Payment on termination of interest rate swaps

 

-

 

 

 

(2,904

)

Net cash used in financing activities

 

(1,725,105

)

 

 

(4,245,435

)

 

 

 

 

 

 

 

 

Net increase (decrease) in cash and cash equivalents

 

(548,253

)

 

 

379,112

 

Cash and cash equivalents, beginning of period

 

763,326

 

 

 

168,424

 

Cash and cash equivalents, end of period

$

215,073

 

 

$

547,536

 

 

 

 

 

 

 

 

 

Supplemental disclosure of cash flow information

 

 

 

 

 

 

 

Cash paid during the period for interest

$

131,614

 

 

$

52,471

 

 

 

 

 

 

 

 

 

Supplemental schedule of non-cash investing and financing activities

 

 

 

 

 

 

 

Obligation to brokers for purchase of unsettled mortgage-backed securities

$

45,571

 

 

$

986,828

 

Receivable for securities sold

$

-

 

 

$

548,942

 

Dividends accrued on preferred stock, not yet paid

$

4,628

 

 

$

4,628

 

Dividends accrued on common stock, not yet paid

$

48,360

 

 

$

53,850

 

See accompanying notes.

 

 

7


 

Hatteras Financial Corp.  

Notes to Consolidated Financial Statements

September 30, 2014

(Unaudited)

(Dollars in thousands except per share amounts)

 

1.       Organization and Business Description

Hatteras Financial Corp. (the “Company”) was incorporated in Maryland on September 19, 2007.  The Company invests in single-family residential mortgage assets, such as mortgage-backed securities (“MBS”), and other financial assets.  To date, the Company has primarily invested in MBS, issued or guaranteed by a U.S. Government agency, such as Ginnie Mae, or by a U.S. Government-sponsored entity, such as Fannie Mae and Freddie Mac (“agency securities”).  

The Company is externally managed and advised by its manager, Atlantic Capital Advisors LLC (“ACA”).  

The Company has elected to be taxed as a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986, as amended (the “Code”).  As a result, the Company does not pay federal income taxes on taxable income distributed to shareholders if certain REIT qualification tests are met.  It is the Company’s policy to distribute 100% of its taxable income, after application of available tax attributes, within the time limits prescribed by the Code, which may extend into the subsequent taxable year.  However, the Company may conduct certain activities that cause it to earn income which will not be qualifying income for REIT purposes.  The Company has designated certain of its subsidiaries as taxable REIT subsidiaries (“TRSs”) as defined in the Code to engage in such activities, and the Company may in the future form additional TRSs.  

 

2.       Summary of Significant Accounting Policies

Basis of Presentation and Use of Estimates

The accompanying unaudited consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X.  Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements.  In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included.  Operating results for the three and nine months ended September 30, 2014 are not necessarily indicative of the results that may be expected for the calendar year ending December 31, 2014.  These unaudited consolidated financial statements should be read in conjunction with the audited 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 consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period.  Actual results could differ from those estimates.  Significant estimates affecting the accompanying consolidated financial statements include the valuation of MBS and derivative instruments.  

Certain prior period amounts have been reclassified to conform to the current period presentation.

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and all of its subsidiaries.  The Company also considers the provisions of Financial Accounting Standards Board (“FASB”) Accounting Standard Codification (“ASC”) Topic 810 on Consolidation in determining whether consolidation is appropriate for any interests held in variable interest entities.  All significant intercompany balances and transactions have been eliminated.  

Financial Instruments

The Company considers its cash and cash equivalents, restricted cash, MBS (settled and unsettled), forward purchase commitments, debt security held-to-maturity, receivable for securities sold, accrued interest receivable, principal payments receivable, payable for unsettled securities, derivative instruments, repurchase agreements, dollar roll liability and accrued interest payable to meet the definition of financial instruments.  The carrying amount of cash and cash equivalents, restricted cash, receivable for securities sold, accrued interest receivable, dollar roll liability and payable for unsettled securities approximate their fair value due to the short maturities of these instruments and are valued using Level 1 inputs.  The carrying amount of repurchase agreements is deemed to approximate fair value given their short-term duration and would be valued using Level 2 inputs.  See Notes 4 and 7 for

8


 

discussion of the fair value of MBS and forward purchase commitments, respectively.  See Note 5 for discussion of the fair value of the held-to-maturity debt security.  See Note 7 for discussion of the fair value of derivative instruments.  

The Company limits its exposure to credit losses on its portfolio of securities by purchasing predominantly agency securities.  The portfolio is diversified to avoid undue exposure to loan originator, geographic and other types of concentration.  The Company manages the risk of prepayments of the underlying mortgages by creating a diversified portfolio with a variety of expected prepayment characteristics.  See Note 4 for additional information on MBS.  

The Company is engaged in various trading and brokerage activities including repurchase agreements, dollar roll transactions, interest rate swap agreements, interest rate swaptions and futures contracts in which counterparties primarily include broker-dealers, banks, and other financial institutions.  In the event counterparties do not fulfill their obligations, the Company may be exposed to risk of loss.  The risk of default depends on the creditworthiness of the counterparty and/or issuer of the instrument.  It is the Company’s policy to review, as necessary, the credit standing for each counterparty and retain collateral when appropriate.  See Note 6 for additional information on repurchase agreements and Note 7 for additional information on dollar roll transactions, interest rate swap agreements, interest rate swaptions and futures contracts.  

Mortgage-Backed Securities

The Company invests predominantly in agency securities representing interests in or obligations backed by pools of single-family residential mortgage loans.  Guidance under the FASB ASC Topic 320 on Investments requires the Company to classify its investments as either trading, available-for-sale or held-to-maturity securities.  Management determines the appropriate classifications of the securities at the time they are acquired and evaluates the appropriateness of such classifications at each balance sheet date.  The Company currently classifies all of its MBS as available-for-sale.  All assets that are classified as available-for-sale are carried at fair value and unrealized gains and losses are included in other comprehensive income (loss).  The estimated fair values of MBS are determined by management by obtaining valuations for its MBS from independent sources and averaging these valuations.  Security purchase and sale transactions are recorded on the trade date.  Gains or losses realized from the sale of securities are included in income and are determined using the specific identification method.  

Forward purchase commitments to acquire “when issued” or to-be-announced (“TBA”) securities are recorded at fair value in accordance with ASC Topic 815, Derivatives and Hedging (“ASC 815”).  The fair value of these forward purchase commitments is included in derivative assets or derivative liabilities in the accompanying consolidated balance sheets.  If the Company intends to take physical delivery of the securities, as is the case for forward purchase commitments to acquire TBA securities from mortgage originators, the commitment is designated as an all-in-one cash flow hedge and its unrealized gains and losses are recorded in other comprehensive income.  If the Company does not intend to take physical delivery of the securities, as is the case with most TBA dollar roll transactions, the commitment is not designated as an accounting hedge and unrealized gains and losses are recorded in “Gain (loss) on derivative instruments, net.” See Note 7 for additional information on forward purchase commitments.

The Company assesses its investment securities for other-than-temporary impairment on at least a quarterly basis.  When the fair value of an investment is less than its amortized cost at the balance sheet date the impairment is designated as either “temporary” or “other-than-temporary.” In deciding on whether or not a security is other-than-temporarily impaired, the Company uses a two-step evaluation process.  First, the Company determines whether it has made any decision to sell a security that is in an unrealized loss position, or, if not, the Company determines whether it is more likely than not that the Company will be required to sell the security prior to recovering its amortized cost basis.  If the answer to either of these questions is “yes” then the security is considered other-than-temporarily impaired. See Note 4 for discussion of an other-than temporary impairment recognized as of September 30, 2013.

Derivative Instruments

The Company manages economic risks, including interest rate, liquidity and credit risks, primarily by managing the amount, sources, cost, and duration of its debt funding.  The objectives of the Company’s risk management strategy are 1) to attempt to mitigate the risk of the cost of its variable rate liabilities increasing during a period of rising interest rates, and 2) to reduce fluctuations in net book value over a range of interest rate scenarios.  The principal instruments that the Company uses to achieve these objectives are interest rate swaps and Eurodollar Futures Contracts (“Futures Contracts”).  The Company uses Futures Contracts to approximate the economic hedging results achieved with interest rate swaps.  The Company does not enter into any of these transactions for speculative purposes.  

The Company accounts for derivative instruments in accordance with ASC 815, which requires an entity to recognize all derivatives as either assets or liabilities and to measure those instruments at fair value.  The accounting for changes in the fair value of derivative instruments depends on whether the instruments are designated and qualify as part of a hedging relationship pursuant to ASC 815.  Changes in fair value related to derivatives not in hedge designated relationships are recorded in “Gain (loss) on derivative instruments, net” in the Company’s consolidated statements of income, whereas changes in fair value related to derivatives in hedge designated relationships are initially recorded in other comprehensive income (loss) and later reclassified to income at the time that the

9


 

hedged transactions affect earnings.  Any portion of the changes in fair value due to hedge ineffectiveness is immediately recognized in the income statement.  

Derivative instruments in a gain position are reported as derivative assets and derivative instruments in a loss position are reported as derivative liabilities in the Company’s consolidated balance sheets.  In the Company’s consolidated statements of cash flows, cash receipts and payments related to derivative instruments are classified according to the underlying nature or purpose of the derivative transaction, generally in the operating section if the derivatives are designated as accounting hedges and in the investing section otherwise.  The use of derivatives creates exposure to credit risk relating to potential losses that could be recognized in the event that the counterparties to the instruments in an asset position fail to perform their obligations under the contracts.  The Company attempts to minimize this risk by limiting its counterparties to major financial institutions with acceptable credit ratings, monitoring positions with individual counterparties and adjusting posted collateral as required.  

All of the Company’s interest rate swaps have historically been accounted for as cash flow hedges under ASC 815.  However, on September 30, 2013, the Company discontinued hedge accounting for its interest rate swap agreements by de-designating the interest rate swaps as cash flow hedges.  No interest rate swaps were terminated in conjunction with this action, and the Company’s risk management and hedging practices were not impacted.  As a result of discontinuing hedge accounting, beginning October 1, 2013 changes in the fair value of the Company’s interest rate swap agreements are recorded in “Gain (loss) on derivative instruments, net” in the Company’s consolidated statements of income, rather than in other comprehensive income (loss).  Also, net interest paid or received under the interest rate swaps, which up through September 30, 2013 was recognized in “interest expense,” is instead recognized in “Gain (loss) on derivative instruments, net.” These interest rate swaps continue to be reported as assets or liabilities on the Company’s consolidated balance sheets at their fair value.  

As long as the forecasted transactions that were being hedged (i.e. rollovers of the Company’s repurchase agreement borrowings) are still expected to occur, the balance in accumulated other comprehensive income (AOCI) from interest rate swap activity up through September 30, 2013 will remain in AOCI and be recognized in the Company’s consolidated statements of income as “interest expense” over the remaining term of the interest rate swaps.  See Note 7 for further information.  

The Company may also enter into forward purchase commitments as a means of investing in and financing agency securities via TBA dollar roll transactions.  TBA dollar roll transactions involve moving the settlement of a TBA contract out to a later date by entering into an offsetting short position (referred to as a “pair off”), net settling the paired off positions for cash, and simultaneously purchasing a similar TBA contract for a later settlement date.  The agency securities purchased at the later settlement date are typically priced at a discount to securities for settlement in the current month. This difference is referred to as the “price drop.” The price drop represents compensation to the Company for foregoing net interest margin (interest income less repurchase agreement financing cost) and is referred to as “dollar roll income,” which the Company classifies in “Gain (loss) on derivative instruments, net.” Realized and unrealized gains and losses related to TBA dollar roll transactions are also recognized in “Gain (loss) on derivative instruments, net.”  TBA dollar roll transactions represent off-balance sheet financing.  

Repurchase Agreements

The Company finances the acquisition of its MBS through the use of repurchase agreements.  Under these repurchase agreements, the Company sells securities to a lender and agrees to repurchase the same securities in the future for a price that is higher than the original sales price.  The difference between the sale price that the Company receives and the repurchase price that the Company pays represents interest paid to the lender.  Although structured as a sale and repurchase obligation, a repurchase agreement operates as a financing under which the Company pledges its securities as collateral to secure a loan which is equal in value to a specified percentage of the estimated fair value of the pledged collateral.  The Company records repurchase agreements on the consolidated balance sheets at the amount of cash received (or contract value), with accrued interest recorded separately.  The Company retains beneficial ownership of the pledged collateral.  At the maturity of a repurchase agreement, the Company is required to repay the loan and concurrently receives back its pledged collateral from the lender or, with the consent of the lender, the Company may renew such agreement at the then prevailing financing rate.  These repurchase agreements may require the Company to pledge additional assets to the lender in the event the estimated fair value of the existing pledged collateral declines.  

Dollar Roll Liability

In addition to the TBA dollar roll transactions described above, the Company may from time to time execute dollar roll transactions on specified pools (“CUSIP dollar rolls”).  These transactions represent on-balance sheet financing, presented as “Dollar roll liability” in the Company’s consolidated balance sheets.  During the period of a CUSIP dollar roll, the financed security remains on the Company’s balance sheet, and the components of the net interest margin earned from the price drop are classified in “interest income on mortgage-backed securities” and “interest expense,” respectively.  

10


 

Offsetting of Assets and Liabilities

The Company’s derivative agreements and repurchase agreements generally contain provisions that allow for netting or the offsetting of receivables and payables with each counterparty.  The Company reports amounts in its consolidated balance sheets on a gross basis without regard for such rights of offset or master netting arrangements.  

Interest Income

Interest income is earned and recognized based on the outstanding principal amount of the investment securities and their contractual terms.  Premiums and discounts associated with the purchase of the investment securities are amortized or accreted into interest income over the actual lives of the securities using the effective interest method.  

Income Taxes

The Company has elected to be taxed as a REIT under the Code.  The Company will generally not be subject to federal income tax to the extent that it distributes 100% of its taxable income, after application of available tax attributes, within the time limits prescribed by the Code and as long as it satisfies the ongoing REIT requirements including meeting certain asset, income and stock ownership tests.  The Company has made an election to treat certain of its subsidiaries as TRSs.  These TRSs are taxable as domestic C corporations and are subject to federal, state and local income taxes based upon their taxable income.  

Share-Based Compensation

Share-based compensation is accounted for under the guidance included in the ASC Topic on Stock Compensation.  For share and share-based awards issued to employees, a compensation charge is recorded in earnings based on the fair value of the award.  For transactions with non-employees in which services are performed in exchange for the Company’s common stock or other equity instruments, the transactions are recorded on the basis of the fair value of the service received or the fair value of the equity instruments issued, whichever is more readily measurable at the date of issuance.  The Company’s share-based compensation transactions resulted in compensation expense of $890 and $637 for the three months ended September 30, 2014 and 2013, respectively.  Share-based compensation expense was $2,592 and $1,893 for the nine months ended September 30, 2014 and 2013, respectively.  

Earnings Per Common Share (EPS)

Basic EPS is computed by dividing net income less preferred stock dividends to arrive at net income available to holders of common stock by the weighted average number of shares of common stock outstanding during the period.  Diluted EPS is computed using the two class method, as described in the ASC Topic on Earnings Per Share, which takes into account certain adjustments related to participating securities.  Participating securities are unvested share-based awards that contain rights to receive nonforfeitable dividends, such as those awarded under the Company’s equity incentive plan.  Net income available to holders of common stock after deducting dividends on unvested participating securities if antidilutive, is divided by the weighted average shares of common stock and common equivalent shares outstanding during the period.  For the diluted EPS calculation, common equivalent shares outstanding includes the weighted average number of shares of common stock outstanding adjusted for the effect of dilutive unexercised stock options, if any.  

Recent Accounting Pronouncements

In June 2014, the FASB issued ASU 2014-11, Transfers and Servicing: Repurchase-to-Maturity Transaction, Repurchase Financings, and Disclosures (the “ASU”).  This guidance requires repurchase-to-maturity transactions to be accounted for as secured borrowings as if the transferor retains effective control, even though the transferred financial assets are not returned to the transferor at settlement. The ASU also eliminates existing guidance for repurchase financings and requires instead that entities consider the initial transfer and the related repurchase agreement separately when applying the derecognition requirements of ASC 860, Transfers and Servicing. New disclosures will be required for (1) certain transactions accounted for as secured borrowings and (2) transfers accounted for as sales when the transferor also retains substantially all of the exposure to the economic return on the transferred financial assets throughout the term of the transaction.  This guidance will take effect for periods beginning after December 15, 2014, and early adoption is prohibited.  Certain disclosures under this guidance do not take effect until the first period beginning after March 15, 2015.  This ASU is not expected to have any material impact on the Company’s financial statements.

 

3.       Financial Instruments

The Company’s valuation techniques for financial instruments are based on observable and unobservable inputs.  Observable inputs reflect readily obtainable data from independent sources, while unobservable inputs reflect the Company’s market assumptions.  The ASC Topic on Fair Value Measurements classifies these inputs into the following hierarchy:

Level 1 Inputs– Quoted prices for identical instruments in active markets.  

11


 

Level 2 Inputs– Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.  

Level 3 Inputs– Instruments with primarily unobservable value drivers.  

Other than the Futures Contracts, all of the Company’s MBS and other derivatives were valued using Level 2 inputs at September 30, 2014 and December 31, 2013.  The Futures Contracts were valued using Level 1 inputs at September 30, 2014 and December 31, 2013.  See Notes 4 and 7, respectively, for discussion on the valuation of MBS and derivatives.  

The carrying values and fair values of all financial instruments as of September 30, 2014 and December 31, 2013 were as follows.  

 

September 30, 2014

 

 

December 31, 2013

 

 

Carrying Value

 

 

Fair Value

 

 

Carrying Value

 

 

Fair Value

 

Assets

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Mortgage-backed securities

$

16,890,424

 

 

$

16,890,424

 

 

$

17,642,532

 

 

$

17,642,532

 

Cash and cash equivalents

 

215,073

 

 

 

215,073

 

 

 

763,326

 

 

 

763,326

 

Restricted cash

 

226,764

 

 

 

226,764

 

 

 

225,379

 

 

 

225,379

 

Unsettled purchased mortgage backed securities

 

45,691

 

 

 

45,691

 

 

 

-

 

 

 

-

 

Receivable for securities sold

 

-

 

 

 

-

 

 

 

231,214

 

 

 

231,214

 

Accrued interest receivable

 

52,757

 

 

 

52,757

 

 

 

55,156

 

 

 

55,156

 

Principal payments receivable

 

128,041

 

 

 

128,041

 

 

 

95,021

 

 

 

95,021

 

Debt security, held-to-maturity (1)

 

15,000

 

 

 

14,905

 

 

 

15,000

 

 

 

14,307

 

Interest rate swaps and swaptions (2)

 

27,815

 

 

 

27,815

 

 

 

15,841

 

 

 

15,841

 

Futures Contracts asset (2)

 

1,299

 

 

 

1,299

 

 

 

11,148

 

 

 

11,148

 

Short-term investments (1)

 

20,163

 

 

 

20,163

 

 

 

19,910

 

 

 

19,910

 

Forward purchase commitments (2)

 

1,888

 

 

 

1,888

 

 

 

-

 

 

 

-

 

Liabilities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Repurchase agreements

$

14,920,959

 

 

 

14,920,959

 

 

$

16,129,683

 

 

$

16,129,683

 

Dollar roll liability

 

-

 

 

 

-

 

 

 

351,826

 

 

 

351,826

 

Payable for unsettled securities

 

45,571

 

 

 

45,571

 

 

 

-

 

 

 

-

 

Accrued interest payable

 

2,841

 

 

 

2,841

 

 

 

8,279

 

 

 

8,279

 

Interest rate swap liability (3)

 

58,484

 

 

 

58,484

 

 

 

125,133

 

 

 

125,133

 

Futures Contracts liability (3)

 

96,867

 

 

 

96,867

 

 

 

36,733

 

 

 

36,733

 

Forward purchase commitments (3)

 

19,971

 

 

 

19,971

 

 

 

5,741

 

 

 

5,741

 

(1)  Included in other investments on the consolidated balance sheets.

(2)  Included in derivative assets on the consolidated balance sheets.

(3)  Included in derivative liabilities on the consolidated balance sheets.

 

4.      Mortgage-Backed Securities

All of the Company’s MBS were classified as available-for-sale and, as such, are reported at their estimated fair value.  The MBS market is primarily an over-the-counter market.  As such, there are no standard, public market quotations or published trading data for individual MBS.  The Company estimates the fair value of the Company’s MBS based on a market approach by obtaining values for its securities primarily from third-party pricing services and dealer quotes.  To ensure the Company’s fair value determinations are consistent with the ASC Topic on Fair Value Measurements and Disclosures, the Company regularly reviews the prices obtained and the methods used to derive those prices.  The Company evaluates the pricing information it receives taking into account factors such as coupon, prepayment experience, fixed/adjustable-rate, annual and life caps, coupon index, time to next reset and issuing agency, among other factors to ensure that estimated fair values are appropriate.  The Company reviews the methods and inputs used by providers of pricing data to determine the appropriate classification in the fair value hierarchy.  

The third-party pricing services gather trade data and use pricing models that incorporate such factors as coupons, primary mortgage rates, prepayment speeds, spread to the U.S. Treasury and interest rate swap curves, periodic and life caps and other similar factors.  Traders at broker-dealers function as market-makers for these securities, and these brokers have a direct view of the trading activity.  

12


 

Brokers do not receive compensation for providing pricing information to the Company.  The broker prices received are non-binding bids to trade.  The brokers receive data from traders that participate in the active markets for these securities and directly observe numerous trades of securities similar to the securities owned by the Company.  The Company’s analysis of fair value for these includes comparing the data received to other information, if available, such as repurchase agreement pricing or internal pricing models.  

If the fair value of a security is not available using the Level 2 inputs as described above, or such data appears unreliable, the Company may estimate the fair value of the security using a variety of methods including, but not limited to, other independent pricing services, repurchase agreement pricing, discounted cash flow analysis, matrix pricing, option adjusted spread models and other fundamental analysis of observable market factors.  At September 30, 2014 and December 31, 2013, all of the Company’s MBS values were based on third-party sources.  

The Company’s investment portfolio consists of MBS, including agency securities and non-agency securities (MBS not issued or guaranteed by a U.S. Government agency or a U.S. Government-sponsored entity).  The following table presents certain information about the Company’s MBS at September 30, 2014.  

 

Amortized Cost

 

 

Gross Unrealized Loss

 

 

Gross Unrealized Gain

 

 

Estimated Fair Value

 

Agency Securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fannie Mae Certificates

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

ARMs

$

9,217,059

 

 

$

(20,004

)

 

$

175,699

 

 

$

9,372,754

 

Fixed-Rate

 

569,736

 

 

 

(615

)

 

 

2,380

 

 

 

571,501

 

Total Fannie Mae

 

9,786,795

 

 

 

(20,619

)

 

 

178,079

 

 

 

9,944,255

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Freddie Mac Certificates

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

ARMs

 

6,667,896

 

 

 

(31,236

)

 

 

66,537

 

 

 

6,703,197

 

Fixed-Rate

 

166,394

 

 

 

(30

)

 

 

858

 

 

 

167,222

 

Total Freddie Mac

 

6,834,290

 

 

 

(31,266

)

 

 

67,395

 

 

 

6,870,419

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Agency Securities

 

16,621,085

 

 

 

(51,885

)

 

 

245,474

 

 

 

16,814,674

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Non-Agency ARMs

 

76,200

 

 

 

(450

)

 

 

-

 

 

 

75,750

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Mortgage-Backed Securities

$

16,697,285

 

 

$

(52,335

)

 

$

245,474

 

 

$

16,890,424

 

The following table presents certain information about the Company’s MBS at December 31, 2013.  

 

Amortized Cost

 

 

Gross Unrealized Loss

 

 

Gross Unrealized Gain

 

 

Estimated Fair Value

 

Agency Securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fannie Mae Certificates

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

ARMs

$

9,620,743

 

 

$

(44,871

)

 

$

167,848

 

 

$

9,743,720

 

Fixed-Rate

 

806,312

 

 

 

(1,798

)

 

 

3,832

 

 

 

808,346

 

Total Fannie Mae

 

10,427,055

 

 

 

(46,669

)

 

 

171,680

 

 

 

10,552,066

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Freddie Mac Certificates

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

ARMs

 

6,671,013

 

 

 

(70,752

)

 

 

57,808

 

 

 

6,658,069

 

Fixed-Rate

 

338,738

 

 

 

(1,600

)

 

 

21

 

 

 

337,159

 

Total Freddie Mac

 

7,009,751

 

 

 

(72,352

)

 

 

57,829

 

 

 

6,995,228

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Ginnie Mae Certificates

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

ARMs

 

-

 

 

 

-

 

 

 

-

 

 

 

-

 

Fixed-Rate

 

96,236

 

 

 

(998

)

 

 

-

 

 

 

95,238

 

Total Ginnie Mae

 

96,236

 

 

 

(998

)

 

 

-

 

 

 

95,238

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Mortgage-Backed Securities

$

17,533,042

 

 

$

(120,019

)

 

$

229,509

 

 

$

17,642,532

 

 

13


 

The components of the carrying value of available-for-sale MBS at September 30, 2014 and December 31, 2013 are presented below:  

 

September 30, 2014

 

 

December 31, 2013

 

Principal balance

$

16,236,142

 

 

$

17,044,190

 

Unamortized premium

 

461,143

 

 

 

488,854

 

Unamortized discount

 

-

 

 

 

(2

)

Gross unrealized gains

 

245,474

 

 

 

229,509

 

Gross unrealized losses

 

(52,335

)

 

 

(120,019

)

Carrying value/estimated fair value

$

16,890,424

 

 

$

17,642,532

 

The following table presents components of interest income on the Company’s MBS portfolio for the three months and nine months ended September 30, 2014 and 2013.

 

Three Months Ended September 30

 

 

Nine Months Ended September 30

 

 

2014

 

 

2013

 

 

2014

 

 

2013

 

Coupon interest

$

110,382

 

 

$

154,203

 

 

$

343,108

 

 

$

485,601

 

Net premium amortization

 

(29,413

)

 

 

(47,163

)

 

 

(76,374

)

 

 

(139,205

)

Interest income

$

80,969

 

 

$

107,040

 

 

$

266,734

 

 

$

346,396

 

 

Gross gains and losses from sales of MBS for the three months and nine months ended September 30, 2014 and 2013 were as follows:

 

Three Months Ended September 30

 

 

Nine Months Ended September 30

 

 

2014

 

 

2013

 

 

2014

 

 

2013

 

Gross gains

$

237

 

 

$

7,327

 

 

$

13,713

 

 

$

18,629

 

Gross losses

 

-

 

 

 

(232,962

)

 

 

(10,624

)

 

 

(232,962

)

Net gain (loss)

$

237

 

 

$

(225,635

)

 

$

3,089

 

 

$

(214,333

)

 

The Company monitors the performance and market value of its MBS portfolio on an ongoing basis, and on a quarterly basis reviews its MBS for impairment.  At September 30, 2014 and December 31, 2013, the Company had the following securities in a loss position presented below:

 

As of September 30, 2014

 

 

Less than 12 Months

 

 

Greater than 12 Months

 

 

Total

 

 

Fair Market

 

 

Unrealized

 

 

Fair Market

 

 

Unrealized

 

 

Fair Market

 

 

Unrealized

 

 

Value

 

 

Loss

 

 

Value

 

 

Loss

 

 

Value

 

 

Loss

 

Fannie Mae Certificates

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

ARMs

$

966,859

 

 

$

(2,084

)

 

$

1,467,791

 

 

$

(17,920

)

 

$

2,434,650

 

 

$

(20,004

)

Fixed-Rate

 

295,297

 

 

 

(615

)

 

 

-

 

 

 

-

 

 

 

295,297

 

 

 

(615

)

Freddie Mac Certificates

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

ARMs

 

875,078

 

 

 

(2,419

)

 

 

2,007,443

 

 

 

(28,817

)

 

 

2,882,521

 

 

 

(31,236

)

Fixed-Rate

 

8,692

 

 

 

(30

)

 

 

-

 

 

 

-

 

 

 

8,692

 

 

 

(30

)

Non-Agency ARMs

 

75,750

 

 

 

(450

)

 

 

-

 

 

 

-

 

 

 

75,750

 

 

 

(450

)

Total temporarily impaired securities

$

2,221,676

 

 

$

(5,598

)

 

$

3,475,234

 

 

$

(46,737

)

 

$

5,696,910

 

 

$

(52,335

)

Number of securities in an unrealized loss position

 

 

 

 

 

70

 

 

 

 

 

 

 

128

 

 

 

 

 

 

 

198

 

 

14


 

 

 

As of December 31, 2013

 

 

Less than 12 Months

 

 

Greater than 12 Months

 

 

Total

 

 

Fair Market

 

 

Unrealized

 

 

Fair Market

 

 

Unrealized

 

 

Fair Market

 

 

Unrealized

 

 

Value

 

 

Loss

 

 

Value

 

 

Loss

 

 

Value

 

 

Loss

 

Fannie Mae Certificates

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

ARMs

$

3,233,274

 

 

$

(44,871

)

 

$

-

 

 

$

-

 

 

$

3,233,274

 

 

$

(44,871

)

Fixed-Rate

 

281,760

 

 

 

(1,798

)

 

 

-

 

 

 

-

 

 

 

281,760

 

 

 

(1,798

)

Freddie Mac Certificates

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

ARMs

 

4,046,473

 

 

 

(70,752

)

 

 

-

 

 

 

-

 

 

 

4,046,473

 

 

 

(70,752

)

Fixed-Rate

 

316,835

 

 

 

(1,600

)

 

 

-

 

 

 

-

 

 

 

316,835

 

 

 

(1,600

)

Ginnie Mae Certificates

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

ARMs

 

-

 

 

 

-

 

 

 

-

 

 

 

-

 

 

 

-

 

 

 

-

 

Fixed-Rate

 

95,238

 

 

 

(998

)

 

 

-

 

 

 

-

 

 

 

95,238

 

 

 

(998

)

Total temporarily impaired securities

$

7,973,580

 

 

$

(120,019

)

 

$

-

 

 

$

-

 

 

$

7,973,580

 

 

$

(120,019

)

Number of securities in an unrealized loss position

 

 

 

 

 

279

 

 

 

 

 

 

 

-

 

 

 

 

 

 

 

279

 

 

The Company did not make the decision to sell the above securities as of September 30, 2014 and December 31, 2013, nor was it deemed more likely than not the Company would be required to sell these securities before recovery of their amortized cost basis.  The unrealized losses on the above securities are the result of market interest rates and are not considered to be credit related.  

The contractual maturity of the Company’s MBS ranges from 15 to 30 years.  Because of prepayments on the underlying mortgage loans, the actual weighted-average life is expected to be significantly less than the stated maturity.  

 

5.       Other Investments

Other investments consisted of the following items as of September 30, 2014 and December 31, 2013:

 

September 30, 2014

 

 

December 31, 2013

 

Short-term investments

$

20,163

 

 

$

19,910

 

Debt security, held-to-maturity

 

15,000

 

 

 

15,000

 

Equity investment

 

6,000

 

 

 

-

 

Total other investments

$

41,163

 

 

$

34,910

 

 

Short-term investments represent liquid deposits with original maturities greater than three months and less than one year.

The Company owns both a $15,000 debt security and a $6,000 equity investment in a non-public repurchase lending counterparty.  The debt security matures on March 24, 2019.  The Company has designated this debt security as a held-to-maturity investment, and as such it is carried at its cost basis.  The debt security pays interest quarterly at the rate of 4.0% above the three-month London Interbank Offered Rate (“LIBOR”).  The Company estimates the fair value of this debt security to be approximately $14,905 and $14,307 at September 30, 2014 and December 31, 2013, respectively, which was determined by calculating the present value of the projected future cash flows using a discount rate from a similar issuer and security.  The Company accounts for the equity investment under the cost method.

 

6.       Repurchase Agreements

At September 30, 2014 and December 31, 2013, the Company had repurchase agreements in place in the amount of $14,920,959 and $16,129,683, respectively, to finance MBS purchases.  As of September 30, 2014 and December 31, 2013, the weighted average interest rate on these borrowings was 0.32% and 0.37%, respectively.  The Company’s repurchase agreements are collateralized by the Company’s MBS and typically bear interest at rates that are closely related to LIBOR.  At September 30, 2014 and December 31, 2013, the Company had repurchase indebtedness outstanding with 26 and 25 counterparties, with a weighted average remaining contractual maturity of 1.1 and 0.8 months, respectively.  The following table presents contractual maturity information regarding the Company’s repurchase agreements:

15


 

 

September 30, 2014

 

 

December 31, 2013

 

 

 

 

 

 

Weighted Average

 

 

 

 

 

 

Weighted Average

 

 

Balance

 

 

Contractual Rate

 

 

Balance

 

 

Contractual Rate

 

Within 30 days

$

13,355,150

 

 

 

0.31

%

 

$

13,170,898

 

 

 

0.37

%

30 days to 3 months

 

565,809

 

 

 

0.32

%

 

 

2,958,785

 

 

 

0.40

%

3 months to 36 months

 

1,000,000

 

 

 

0.45

%

 

 

-

 

 

 

-

 

 

$

14,920,959

 

 

 

0.32

%

 

$

16,129,683

 

 

 

0.37

%

 

The fair value of securities, cash, and accrued interest the Company had pledged under repurchase agreements at September 30, 2014 and December 31, 2013 was $15,695,352 and $17,088,392, respectively.  

See Notes 2 and 7 for discussion of TBA dollar roll transactions, which represent off-balance sheet financing.

 

7.       Derivatives and Other Hedging Instruments

In connection with the Company’s risk management strategy, the Company hedges a portion of its interest rate risk by entering into derivative contracts.  The Company may enter into agreements for interest rate swaps, interest rate swaptions, interest rate cap or floor contracts and futures or forward contracts.  The Company’s risk management strategy attempts to manage the overall risk of the portfolio, reduce fluctuations in book value and generate additional income distributable to shareholders.  For additional information regarding the Company’s derivative instruments and its overall risk management strategy, please refer to the discussion of derivative instruments in Note 2.  

The fair values of interest rate swaps are determined using the market standard methodology of netting the discounted future fixed cash receipts (or payments) and the discounted expected variable cash payments (or receipts).  The variable cash payments (or receipts) are based on an expectation of future interest rates (forward curves) derived from observable market interest rate curves.  The fair values of interest rate swaptions are based on third-party broker quotations that are non-binding bids to trade.  The fair value of Futures Contracts is based on quoted prices from the exchange on which they trade.  The fair value of forward purchase commitments was determined using the same methodology as MBS as described in Note 4.  The table below presents the fair value of the Company’s derivative instruments as well as their classification on the consolidated balance sheets as of September 30, 2014 and December 31, 2013, respectively.  

Derivative Instruments

Balance Sheet Location

September 30, 2014

 

 

December 31, 2013

 

 

 

 

 

 

 

 

 

 

Interest rate swaps and swaptions

Derivative assets

$

27,815

 

 

$

15,841

 

Futures contracts

Derivative assets

 

1,299

 

 

 

11,148

 

Forward purchase commitments

Derivative assets

 

1,888

 

 

 

-

 

 

 

$

31,002

 

 

$

26,989

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate swaps

Derivative liabilities

$

58,484

 

 

$

125,133

 

Futures contracts

Derivative liabilities

 

96,867

 

 

 

36,733

 

Forward purchase commitments

Derivative liabilities

 

19,971

 

 

 

5,741

 

 

 

$

175,322

 

 

$

167,607

 

 

 Interest Rate Swaps and Swaptions

The Company finances its activities primarily through repurchase agreements, which are generally settled on a short-term basis, usually from one to three months.  At each settlement date, the Company refinances each repurchase agreement at the market interest rate at that time.  Since the Company is exposed to interest rates on its borrowings that change on a short-term basis, it enters into hedging agreements to mitigate the effect of these changes.  Interest rate swaps involve the receipt of variable-rate amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreement without exchange of the underlying notional amount.  The effect of these hedges is to synthetically lockup interest rates on a portion of the Company’s repurchase agreements for the terms of the interest rate swaps.  Although the Company’s objective is to hedge the risk associated with changing repurchase agreement rates, the Company’s interest rate swaps are benchmark interest rate swaps which perform with

16


 

reference to LIBOR.  Therefore, the Company remains at risk to the variability of the spread between repurchase agreement rates and LIBOR interest rates.  

Until September 30, 2013, the Company elected cash flow hedge accounting for its interest rate swaps.  Under cash flow hedge accounting, effective hedge gains or losses are initially recorded in other comprehensive income and subsequently reclassified into net income in the period that the hedged forecasted transaction affects earnings.  Ineffective hedge gains and losses are recorded on a current basis in earnings.  The hedge ineffectiveness is attributable primarily to differences in the reset dates on the Company’s interest rate swaps versus the refinancing dates of its repurchase agreements.  See “Financial Statement Presentation” below for quantification of gains and losses on interest rate swaps for the three months and nine months ended September 30, 2014 and 2013.  

On September 30, 2013, the Company de-designated its interest rate swaps as cash flow hedges, thus terminating cash flow hedge accounting.  As long as the forecasted rollovers of the related repurchase agreements are still expected to occur, amounts in AOCI related to the cash flow hedges through September 30, 2013 will remain in AOCI and will continue to be reclassified to interest expense as interest is accrued and paid on the related repurchase agreements.  During the next 12 months, the Company estimates that an additional $44,772 will be reclassified out of AOCI as an increase to interest expense.  

The Company continues to hedge its exposure to variability in future funding costs via interest rate swaps and other derivative instruments.  As a result of discontinuing hedge accounting, beginning October 1, 2013, changes in the fair value of the Company’s interest rate swaps are recorded in “Gain (loss) on derivative instruments, net” in the consolidated statements of income, consistent with the Company’s historical accounting for Futures Contracts, as described below.  Monthly net cash settlements under the interest rate swaps are also recorded in “Gain (loss) on derivative instruments, net” beginning October 1, 2013.  

The volume of activity for the Company’s interest rate swap instruments is shown in the table below.  

 

Notional Value

 

 

Nine Months Ended September 30

 

 

2014

 

 

2013

 

Beginning of period

$

10,500,000

 

 

$

10,700,000

 

Additions

 

-

 

 

 

800,000

 

Expirations and terminations

 

(1,300,000

)

 

 

(900,000

)

End of period

$

9,200,000

 

 

$

10,600,000

 

 

 

As of September 30, 2014, the weighted-average remaining term of the Company’s interest rate swaps is 17 months. Additional information regarding the Company’s interest rate swaps as of September 30, 2014 follows.  

 

 

 

 

 

 

 

 

 

Wtd. Avg.

 

 

 

 

 

 

 

 

 

 

 

Remaining

 

 

Weighted Average

 

 

 

Notional

 

 

Term

 

 

Fixed Interest

 

Maturity

 

Amount

 

 

in Months

 

 

Rate in Contract

 

 

 

 

 

 

 

 

 

 

 

 

 

 

12 months or less

 

$

4,000,000

 

 

 

7

 

 

 

1.70%

 

Over 12 months to 24 months

 

 

2,400,000

 

 

 

18

 

 

 

1.10%

 

Over 24 months to 36 months

 

 

2,200,000

 

 

 

30

 

 

 

0.88%

 

Over 36 months to 48 months

 

 

600,000

 

 

 

40

 

 

 

0.95%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

9,200,000

 

 

 

17

 

 

 

1.30%

 

 

 

 

 

17


 

A swaption is a derivative instrument that gives the holder the option to enter into a pay-fixed interest rate swap in the future, if it so desires.  As of September 30, 2014, the Company had four interest rate swaptions outstanding:

 

 

Options

 

 

Underlying Swaps

 

Swaptions

 

Original Cost

 

 

Fair Value

 

 

Wtd. Avg. Months to Expiration

 

 

Notional

 

 

Wtd. Avg. Fixed Pay Rate

 

 

Receive Rate

 

Wtd. Avg. Term (Years)

 

Fixed payer

 

$

20,081

 

 

$

16,098

 

 

 

9

 

 

$

992,300

 

 

 

2.74%

 

 

3 month LIBOR

 

 

7

 

The Company did not have any interest rate swaptions outstanding at December 31, 2013.

Eurodollar Futures Contracts

The Company uses Futures Contracts to 1) synthetically replicate an interest rate swap, or 2) offset the changes in value of its forward purchases of certain MBS.  As of September 30, 2014 and December 31, 2013, the fair value of all Futures Contracts was a liability of $(95,568) and $(25,585), respectively.  

 

Fair Value

 

 

September 30, 2014

 

 

December 31, 2013

 

Futures Contracts designed to replicate swaps

$

(96,383

)

 

$

(27,881

)

Futures Contracts designed to hedge value changes in forward purchases

 

815

 

 

 

2,296

 

Total fair market value of Futures Contracts

$

(95,568

)

 

$

(25,585

)

 

The volume of activity for the Company’s Futures Contracts is shown in the table below.  

 

Number of Contracts

 

 

Nine Months Ended September 30

 

 

2014

 

 

2013

 

Beginning of period

 

95,327

 

 

 

-

 

New positions opened

 

125,547

 

 

 

121,346

 

Early settlements

 

(83,444

)

 

 

(31,103

)

Settlements at maturity

 

(6,298

)

 

 

(608

)

End of period

 

131,132

 

 

 

89,635

 

 

Each Futures Contract embodies $1 million of notional value and is effective for a term of approximately three months.  

The Company has not designated its Futures Contracts as hedges for accounting purposes.  As a result, realized and unrealized changes in fair value thereon are recognized in net income in the period in which the changes occur.  See “Financial Statement Presentation” below for quantification of gains and losses on Futures Contracts for the three and nine months ended September 30, 2014 and 2013.  

To Be Announced Securities Purchases

The Company purchases certain of its investment securities in the forward market.  The Company purchases ARM TBA contracts and 15-year TBA contracts from dealers.  ARM TBA contracts are not a frequently-traded security and are generally used to acquire MBS for the portfolio.  15-year TBA contracts are a highly liquid security, and may be physically settled, net settled or traded as an investment.  The Company also has commitments with various mortgage origination companies to purchase their production as it becomes securitized.  Forward purchases do not qualify for trade date accounting and are considered derivatives for financial statement purposes, as described in Note 2.  The net fair value of the forward commitment is reported on the balance sheet as an asset (or liability).  Whether the unrealized gain (or loss) is recognized in net income or other comprehensive income depends on whether or not the commitment has been designated as an accounting hedge, as discussed in Note 2.

The Company had the following ARM securities forward purchase commitments:

 

18


 

 

Face

 

 

Cost

 

 

Fair Market Value

 

 

Net Asset (Liability)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

September 30, 2014

$

105,239

 

 

$

107,814

 

 

$

107,798

 

 

$

(16

)

December 31, 2013

$

-

 

 

$

-

 

 

$

-

 

 

$

-

 

15-year TBA contracts may be financed in the dollar roll market.  As demonstrated in the “Financial Statement Presentation” discussion below, income from dollar roll transactions and realized and unrealized gains and losses on TBA contracts are recognized in “Gain (loss) on derivative instruments, net.”

At September 30, 2014 and December 31, 2013, the Company had the following 15-year TBA dollar roll securities:

 

 

Face

 

 

Cost

 

 

Fair Market Value

 

 

Net Asset (Liability)

 

September 30, 2014

$

3,600,000

 

 

$

3,723,183

 

 

$

3,703,228

 

 

$

(19,955

)

December 31, 2013

$

600,000

 

 

$

632,270

 

 

$

627,187

 

 

$

(5,083

)

 

 

At September 30, 2014 and December 31, 2013, the Company also had estimated purchase commitments with mortgage originators with a net fair value in the amount of $1,888 and ($658), respectively that was recorded in AOCI.  

Financial Statement Presentation

The Company does not use either offsetting or netting to present any of its derivative assets or liabilities.  The following table shows the gross amounts associated with the Company’s derivative financial instruments and the impact if netting were used as of September 30, 2014.

 

Assets/(Liabilities)

 

 

Cash Collateral Posted (Held)

 

 

Net Asset/(Liability)

 

Interest rate swaps

$

11,716

 

 

$

-

 

 

$

11,716

 

Interest rate swaptions

 

16,099

 

 

 

(3,598

)

 

 

12,501

 

Futures contracts

 

1,299

 

 

 

-

 

 

 

1,299

 

Forward purchase commitments

 

1,888

 

 

 

-

 

 

 

1,888

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate swaps

$

(58,484

)

 

$

63,511

 

 

$

5,027

 

Forward purchase commitments

 

(19,971

)

 

 

9,263

 

 

 

(10,708

)

Futures contracts

 

(96,867

)

 

 

153,990

 

 

 

57,123

 

The following table shows the gross amounts associated with the Company’s derivative financial instruments and the impact if netting were used as of December 31, 2013.  

 

Assets/(Liabilities)

 

 

Cash Collateral Posted

 

 

Net Asset/(Liability)

 

Interest rate swaps

$

15,841

 

 

$

-

 

 

$

15,841

 

Futures contracts

 

11,148

 

 

 

-

 

 

 

11,148

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate swaps

$

(125,133

)

 

$

133,661

 

 

$

8,528

 

Futures contracts

 

(36,733

)

 

 

77,713

 

 

 

40,980

 

Forward purchase commitments

 

(5,741

)

 

 

14,005

 

 

 

8,264

 

 

19


 

 

The following table shows the components of “Gain (loss) on derivative instruments, net” for the three and nine months ended September 30, 2014 and 2013.  Impacts from the Company’s interest rate swaps subsequent to the September 30, 2013 hedge de-designation are included herein.  

 

Three Months Ended Sept. 30

 

 

Nine Months Ended Sept. 30

 

 

2014

 

 

2013

 

 

2014

 

 

2013

 

Interest rate swaps – fair value adjustments

$

38,136

 

 

$

-

 

 

$

62,524

 

 

$

-

 

Interest rate swaptions – fair value adjustments

 

(1,304

)

 

 

-

 

 

 

(3,983

)

 

 

-

 

Interest rate swaps – monthly net settlements

 

(29,079

)

 

 

-

 

 

 

(88,245

)

 

 

-

 

Futures Contracts – fair value adjustments

 

37,405

 

 

 

(50,129

)

 

 

(69,982

)

 

 

(44,593

)

Futures Contracts – realized gains (losses)

 

(1,810

)

 

 

(27,327

)

 

 

(24,063

)

 

 

(27,327

)

TBA dollar roll income

 

22,370

 

 

 

-

 

 

 

68,813

 

 

 

-

 

Net realized and unrealized losses on TBA dollar rolls

 

(30,288

)

 

 

-

 

 

 

(6,509

)

 

 

-

 

Gain (loss) on derivative instruments, net

$

35,430

 

 

$

(77,456

)

 

$

(61,445

)

 

$

(71,920

)

 

See Note 2 for discussion of TBA dollar roll transactions and TBA dollar roll income.  

As discussed above, effective September 30, 2013, the Company discontinued cash flow hedge accounting for its interest rate swaps.  The table below presents the effect of the interest rate swaps that were previously designated as cash flow hedges on the Company’s comprehensive income for the three and nine months ended September 30, 2014 and 2013.  

 

Three Months Ended September 30

 

 

Nine Months Ended September 30

 

 

2014

 

 

2013

 

 

2014

 

 

2013

 

Amount of gain (loss) recognized in OCI (effective

    portion)

$

-

 

 

$

(36,356

)

 

$

-

 

 

$

15,030

 

Amount of loss reclassified from OCI into net income as interest expense (effective portion)

 

(19,806

)

 

 

(30,954

)

 

 

(67,413

)

 

 

(91,470

)

Amount of gain (loss) recognized in net income as

    interest expense (ineffective portion)

 

-

 

 

 

109

 

 

 

-

 

 

 

205

 

 

The following table presents the impact of the Company’s interest rate swap agreements on the Company’s AOCI for the nine months ended September 30, 2014 and the year ended December 31, 2013.  

 

 

 

 

 

 

 

 

 

Nine Months Ended September 30, 2014

 

 

Year Ended December 31, 2013

 

Beginning balance

$

(111,174

)

 

$

(243,051

)

Unrealized gain on interest rate swaps

 

-

 

 

 

15,030

 

Reclassification of net losses included in income statement

 

67,413

 

 

 

116,847

 

Ending balance

$

(43,761

)

 

$

(111,174

)

 

 Credit-risk-related Contingent Features

The Company has agreements with its interest rate swap and swaption counterparties that contain a provision where if the Company defaults on any of its indebtedness, including default where repayment of the indebtedness has not been accelerated by the lender then the Company could also be declared in default on its derivative obligations.  

The Company has agreements with certain of its derivative counterparties that contain a provision where if the Company’s GAAP shareholders’ equity declines by a specified percentage over a specified time period, or if the Company fails to maintain a minimum shareholders’ equity threshold, then the Company could be declared in default on its derivative obligations.  The Company also has agreements with several of those counterparties that contain provisions regarding maximum leverage ratios.  The most restrictive of these leverage covenants is that if the Company exceeds a leverage ratio of 10 to 1 then the Company could be declared

20


 

in default on its derivative obligations with that counterparty.  At September 30, 2014, the Company was in compliance with these requirements.  

As of September 30, 2014, the fair value of derivatives in a net liability position related to the agreements described above was $30,669.  The Company has collateral posting requirements with each of its counterparties and all interest rate swap agreements were fully collateralized as of September 30, 2014.

 

8.       Capital Stock

Issuance of Common Stock- “At the Market” Programs

From time to time, the Company may sell shares of its common stock in “at-the-market” offerings.  Sales of shares of common stock, if any, may be made in private transactions, negotiated transactions or any method permitted by law deemed to be an “at the market” offering as defined in Rule 415 under the Securities Act of 1933, as amended, including sales made directly on the New York Stock Exchange or to or through a market maker other than on an exchange.  

On February 29, 2012, the Company entered into sales agreements (the “2012 Sales Agreements”) with Cantor Fitzgerald & Co.  (“Cantor”) and JMP Securities LLC (“JMP”) to establish a new “at-the-market” program (the “2012 Program”).  Under the terms of the 2012 Sales Agreements, the Company may offer and sell up to 10,000,000 shares of its common stock from time to time through Cantor or JMP, each acting as agent and/or principal.  The shares of common stock issuable pursuant to the 2012 Program are registered with the Securities and Exchange Commission on the Company’s Registration Statement on Form S-3 (No.  333-179805), which became effective upon filing on February 29, 2012.  

For the three and nine months ended September 30, 2014 and 2013, the Company did not issue any shares of stock under the 2012 Program.  

Stock Repurchase Program

On June 18, 2013, the Company’s board of directors authorized a stock repurchase program (the “Repurchase Program”) to acquire up to 10,000,000 shares of the Company’s common stock.  For the three and nine months ended September 30, 2014, the Company repurchased 0 and 100,000, respectively, of shares of common stock under the Repurchase Program in at-the-market transactions at a total cost of $0 and $1,912, respectively.  

During periods when the Company’s board of directors has authorized the Company to repurchase shares under the Repurchase Program, the Company will not be authorized to issue shares of common stock under the 2012 Program described above.  Similarly, during periods when the Company’s board of directors has authorized the Company to issue shares of common stock under the 2012 Program, the Company will not be authorized to repurchase shares under the Repurchase Program.  

 

 

21


 

9.      Earnings per Share

The following table details the Company’s calculation of earnings per share for the three and nine months ended September 30, 2014 and 2013.  

 

 

Three Months Ended September 30

 

 

Nine Months Ended September 30

 

 

 

2014

 

 

2013

 

 

2014

 

 

2013

 

Basic earnings (loss) per share:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

77,891

 

 

$

(262,146

)

 

$

82,212

 

 

$

(124,168

)

Less preferred stock dividends

 

 

(5,480

)

 

 

(5,481

)

 

 

(16,441

)

 

 

(16,441

)

Net income (loss) available to common shareholders

 

$

72,411

 

 

$

(267,627

)

 

$

65,771

 

 

$

(140,609

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares

 

 

96,563,132

 

 

 

98,318,205

 

 

 

96,561,446

 

 

 

98,656,750

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic earnings (loss) per share

 

$

0.75

 

 

$

(2.72

)

 

$

0.68

 

 

$

(1.43

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Diluted earnings (loss) per share:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

77,891

 

 

$

(262,146

)

 

$

82,212

 

 

$

(124,168

)

Less preferred stock dividends for antidilutive shares

 

 

(5,480

)

 

 

(5,481

)

 

 

(16,441

)

 

 

(16,441

)

Net income (loss) available to common shareholders

 

$

72,411

 

 

$

(267,627

)

 

$

65,771

 

 

$

(140,609

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares

 

 

96,563,132

 

 

 

98,318,205

 

 

 

96,561,446

 

 

 

98,656,750

 

Potential dilutive shares from exercise of stock options

 

 

-

 

 

 

-

 

 

 

-

 

 

 

-

 

Diluted weighted average shares

 

 

96,563,132

 

 

 

98,318,205

 

 

 

96,561,446

 

 

 

98,656,750

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Diluted earnings (loss) per share

 

$

0.75

 

 

$

(2.72

)

 

$

0.68

 

 

$

(1.43

)

 

There were no potentially dilutive shares for any of the periods presented.

 

10.      Transactions with Related Parties

Management Fees

The Company is externally managed by ACA pursuant to a management agreement (the “Management Agreement”).  All of the Company’s executive officers are also employees of ACA.  ACA manages the Company’s day-to-day operations, subject to the direction and oversight of the Company’s board of directors which includes five independent directors.  The Management Agreement expires on February 23, 2015 and is thereafter automatically renewed for an additional one-year term unless terminated under certain circumstances.  ACA must be provided 180 days prior notice of any such termination and will be paid a termination fee equal to four times the average annual management fee earned by ACA during the two year period immediately preceding termination, calculated as of the end of the most recently completed fiscal quarter prior to the date of termination.  

Under the terms of the Management Agreement, the Company reimburses ACA for certain operating expenses of the Company that are borne by ACA.  ACA is entitled to receive a management fee payable monthly in arrears in an amount equal to 1/12th of an amount determined as follows:

·

for the Company’s equity up to $250 million, 1.50% (per annum) of equity; plus

·

for the Company’s equity in excess of $250 million and up to $500 million, 1.10% (per annum) of equity; plus

·

for the Company’s equity in excess of $500 million and up to $750 million, 0.80% (per annum) of equity; plus

·

for the Company’s equity in excess of $750 million, 0.50% (per annum) of equity.  

22


 

For purposes of calculating the management fee, equity is defined as the value, computed in accordance with GAAP, of shareholders’ equity, adjusted to exclude the effects of unrealized gains or losses.  The following table presents amounts incurred for management fee, reimbursable expenses and share-based compensation expense related to the restricted common shares granted to management.  

 

 

 

Three Months Ended September 30

 

 

Nine Months Ended September 30

 

 

2014

 

 

2013

 

 

2014

 

 

2013

 

Management fee

$

4,122

 

 

$

4,522

 

 

$

12,420

 

 

$

13,956

 

Reimbursable expenses

 

715

 

 

 

701

 

 

 

2,403

 

 

 

1,869

 

Total

$

4,837

 

 

$

5,223

 

 

$

14,823

 

 

$

15,825

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Share-based compensation

$

890

 

 

$

637

 

 

$

2,592

 

 

$

1,893

 

 

 

 

 None of the reimbursement payments were specifically attributable to the compensation of the Company’s executive officers.  At September 30, 2014 and December 31, 2013, the Company owed ACA $1,672 and $2,752, respectively, for the management fee and reimbursable expenses, which is included in accounts payable and other liabilities.  

 

 

11.      Accumulated Other Comprehensive Income

The Company records unrealized gains and losses on its MBS and its forward purchase commitments securities as described in Note 4 and Note 7.  As discussed in Note 7, the Company ceased hedge accounting for its interest rate swaps effective September 30, 2013.  Beginning October 1, 2013, changes in the fair value of interest rate swaps are recorded directly to net income.  The cumulative unrealized loss on interest rate swaps in AOCI as of September 30, 2013 is being amortized to net income as the hedged forecasted transactions occur.  The following table rolls forward the components of AOCI, including reclassification adjustments, for the three months ended September 30, 2014.  

 

Unrealized gain/(loss) on available for sale MBS

 

 

Unrealized gain/(loss) on unsettled MBS

 

 

Unrealized gain/(loss) on other investments

 

 

Unrealized gain/(loss) on derivative instruments

 

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Accumulated other comprehensive income

    (loss) at July 1, 2014

$

223,948

 

 

$

582

 

 

$

(495

)

 

$

(59,812

)

 

$

164,223

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive income (loss) before

    reclassification

 

(30,572

)

 

 

120

 

 

 

(111

)

 

 

1,872

 

 

 

(28,691

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance Sheet Reclassification:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Amount reclassified to MBS available for sale

 

-

 

 

 

(582

)

 

 

-

 

 

 

(3,755

)

 

 

(4,337

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income Statement Reclassification:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Amounts reclassified to net gain on the sale

    of MBS

 

(237

)

 

 

-

 

 

 

-

 

 

 

-

 

 

 

(237

)

Amounts reclassified to interest expense

 

-

 

 

 

-

 

 

 

-

 

 

 

19,806

 

 

 

19,806

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net current period other comprehensive

    income (loss)

 

(30,809

)

 

 

(462

)

 

 

(111

)

 

 

17,923

 

 

 

(13,459

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Accumulated other comprehensive income

    (loss) at September 30, 2014

$

193,139

 

 

$

120

 

 

$

(606

)

 

$

(41,889

)

 

$

150,764

 

 

23


 

 

The following table rolls forward the components of AOCI, including reclassification adjustments, for the three months ended September 30, 2013.

 

 

Unrealized gain/(loss) on available for sale MBS

 

 

Unrealized gain/(loss) on unsettled MBS

 

 

Unrealized gain/(loss) on other investments

 

 

Unrealized gain/(loss) on derivative instruments

 

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Accumulated other comprehensive income

    (loss) at July 1, 2013

$

(142,678

)

 

$

(2,776

)

 

$

(505

)

 

$

(174,874

)

 

$

(320,833

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive income (loss) before

    reclassification

 

(48,294

)

 

 

2,926

 

 

 

82

 

 

 

(29,451

)

 

 

(74,737

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance Sheet Reclassification:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Amount reclassified to MBS available for sale

 

-

 

 

 

2,776

 

 

 

-

 

 

 

43,724

 

 

 

46,500

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income Statement Reclassification:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Amounts reclassified to net loss on the sale

    of MBS

 

225,635

 

 

 

-

 

 

 

-

 

 

 

-

 

 

 

225,635

 

Amounts reclassified for impairment loss on MBS

 

8,102

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

8,102

 

Amounts reclassified to interest expense

 

-

 

 

 

-

 

 

 

-

 

 

 

30,954

 

 

 

30,954

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net current period other comprehensive

    income (loss)

 

185,443

 

 

 

5,702

 

 

 

82

 

 

 

45,227

 

 

 

236,454

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Accumulated other comprehensive income

    (loss) at September 30, 2013

$

42,765

 

 

$

2,926

 

 

$

(423

)

 

$

(129,647

)

 

$

(84,379

)

 

24


 

The following table rolls forward the components of AOCI, including reclassification adjustments, for the nine months ended September 30, 2014.

 

Unrealized gain/(loss) on available for sale MBS

 

 

Unrealized gain/(loss) on unsettled MBS

 

 

Unrealized gain/(loss) on other investments

 

 

Unrealized gain/(loss) on derivative instruments

 

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Accumulated other comprehensive income

    (loss) at January 1, 2014

$

109,490

 

 

$

-

 

 

$

(627

)

 

$

(116,915

)

 

$

(8,052

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive income (loss) before

    reclassification

 

86,738

 

 

 

516

 

 

 

21

 

 

 

7,669

 

 

 

94,944

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance Sheet Reclassification:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Amount reclassified to MBS available for sale

 

-

 

 

 

(396

)

 

 

-

 

 

 

(5,139

)

 

 

(5,535

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income Statement Reclassification:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Amounts reclassified to net gain on the sale

    of MBS

 

(3,089

)

 

 

-

 

 

 

-

 

 

 

-

 

 

 

(3,089

)

Amounts reclassified for termination of all-

    in-one cash flow hedge accounting

    on dollar roll TBAs

 

-

 

 

 

-

 

 

 

-

 

 

 

5,083

 

 

 

5,083

 

Amounts reclassified to interest expense

 

-

 

 

 

-

 

 

 

-

 

 

 

67,413

 

 

 

67,413

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net current period other comprehensive

    income (loss)

 

83,649

 

 

 

120

 

 

 

21

 

 

 

75,026

 

 

 

158,816

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Accumulated other comprehensive income

    (loss) at September 30, 2014

$

193,139

 

 

$

120

 

 

$

(606

)

 

$

(41,889

)

 

$

150,764

 

 

25


 

 

The following table rolls forward the components of AOCI, including reclassification adjustments, for the nine months ended September 30, 2013.

 

Unrealized gain/(loss) on available for sale MBS

 

 

Unrealized gain/(loss) on unsettled MBS

 

 

Unrealized gain/(loss) on other investments

 

 

Unrealized gain/(loss) on derivative instruments

 

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Accumulated other comprehensive income

    (loss) at January 1, 2013

$

499,343

 

 

$

1,217

 

 

$

(107

)

 

$

(237,599

)

 

$

262,854

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive income (loss) before

    reclassification

 

(679,013

)

 

 

642

 

 

 

(316

)

 

 

(15,313

)

 

 

(694,000

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance Sheet Reclassification:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Amount reclassified to MBS available for sale

 

-

 

 

 

1,067

 

 

 

-

 

 

 

31,795

 

 

 

32,862

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income Statement Reclassification:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Amounts reclassified to net gain on the sale

    of MBS

 

214,333

 

 

 

-

 

 

 

-

 

 

 

-

 

 

 

214,333

 

Amounts reclassified for impairment loss on MBS

 

8,102

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

8,102

 

Amounts reclassified to interest expense

 

-

 

 

 

-

 

 

 

-

 

 

 

91,470

 

 

 

91,470

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net current period other comprehensive

    income (loss)

 

(456,578

)

 

 

1,709

 

 

 

(316

)

 

 

107,952

 

 

 

(347,233

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Accumulated other comprehensive income

    (loss) at September 30, 2013

$

42,765

 

 

$

2,926

 

 

$

(423

)

 

$

(129,647

)

 

$

(84,379

)

 

 

 

 

26


 

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

In this Quarterly Report on Form 10-Q, we refer to Hatteras Financial Corp.  as “we,” “us,” “our company,” or “our,” unless we specifically state otherwise or the context indicates otherwise.  The following defines certain of the commonly used terms in this quarterly report on Form 10-Q: “MBS” refers to mortgage-backed securities; “agency securities” refer to our residential MBS that are issued or guaranteed by a U.S. Government agency, such as Ginnie Mae, or by a U.S. Government-sponsored entity, such as Fannie Mae or Freddie Mac; “non-agency securities” refer to our residential MBS that are not issued or guaranteed by a U.S. Government agency or a U.S. Government-sponsored entity; and “ARMs” refer to adjustable-rate mortgage loans which typically either 1) at all times have interest rates that adjust periodically to an increment over a specified interest rate index; or 2) have interest rates that are fixed for a specified period of time and, thereafter, generally adjust annually to an increment over a specified interest rate index.  

The following discussion should be read in conjunction with our financial statements and accompanying notes included in Part 1, Item 1 of this Quarterly Report on Form 10-Q as well as our Annual Report on Form 10-K for the year ended December 31, 2013, filed with the Securities and Exchange Commission (“SEC”) on February 21, 2014.  

Amounts other than share-related amounts are presented in thousands, unless otherwise noted.

Forward-Looking Statements

When used in this Quarterly Report on Form 10-Q, in future filings with the SEC or in press releases or other written or oral communications, statements which are not historical in nature, including those containing words such as “believe,” “expect,” “may,” “will,” “anticipate,” “estimate,” “plan,” “continue,” “intend,” “should,” or the negative of these words and similar expressions, are intended to identify “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and, as such, may involve known and unknown risks, uncertainties and assumptions.  

The forward-looking statements in this report are based on our beliefs, assumptions and expectations of our future performance, taking into account all information currently available to us.  These beliefs, assumptions and expectations are subject to risks and uncertainties and can change as a result of many possible events or factors, not all of which are known to us.  If a change occurs, our business, financial condition, liquidity and results of operations may vary materially from those expressed in our forward-looking statements.  The following factors could cause actual results to vary from our forward-looking statements: changes in our investment, financing and hedging strategies and the new risks that those changes may expose us to; the adequacy of our cash flow from operations and borrowings to meet our short-term liquidity requirements; the liquidity of our portfolio; unanticipated changes in our industry, the credit markets, the general economy or the real estate market; changes in interest rates and the market value of our investments; changes in the prepayment rates on the mortgage loans securing our MBS; the timing of credit losses within our portfolio; the concentration of the credit risk we are exposed to; increases in payment delinquencies and defaults on the mortgage loans securing our MBS; our ability to build successful relationships with loan originators; our ability to acquire mortgage loans in connection with our securitization plans; our ability to securitize the mortgage loans that we acquire; our exposure to claims and litigation, including litigation arising from our involvement in securitization transactions; our ability to successfully diversify our business into new asset classes and manage the new risks they may expose us to; our ability to manage various operational and regulatory risks associated with our business; our ability to establish, adjust and maintain appropriate hedges for the risks in our portfolio; our ability to borrow to finance our assets; changes in government regulations affecting our business; our ability to maintain our qualification as a real estate investment trust (“REIT”) for federal income tax purposes; our ability to maintain our exemption from registration under the Investment Company Act of 1940, as amended (the “Investment Company Act”); and risks associated with investing in real estate assets, including changes in business conditions and the general economy.  These and other risks, uncertainties and factors, including those set forth under the section captioned “Risk Factors” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” herein and in our annual report on Form 10-K for the year ended December 31, 2013, as updated by our quarterly and current reports that we file with the SEC, could cause our actual results to differ materially from those projected in any forward-looking statements we make.  All forward-looking statements speak only as of the date on which they are made.  New risks and uncertainties arise over time and it is not possible to predict those events or how they may affect us.  Except as required by law, we are not obligated to, and do not intend to, update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.  

Overview

We are an externally-managed mortgage REIT that invests in single-family residential mortgage assets, such as MBS, and other financial assets.  To date, we have primarily invested in MBS issued or guaranteed by a U.S. Government agency, such as Ginnie Mae, or by a U.S. Government-sponsored entity, such as Fannie Mae and Freddie Mac.  We refer to these securities as “agency securities.”  We have recently begun an initiative to acquire and aggregate individual whole jumbo mortgage loans, with a goal of securitizing the loans into MBS not issued or guaranteed by a U.S. Government agency or a U.S. Government-sponsored entity.  We refer to these securities as “non-agency securities.”  See “New Business Initiatives” below.

27


 

We were incorporated in Maryland in September 2007 and commenced operations in November 2007.  We listed our common stock on the New York Stock Exchange (“NYSE”) in April 2008 and trade under the symbol “HTS.”

We are externally managed and advised by our manager, Atlantic Capital Advisors LLC.  

We are organized and conduct our operations to qualify as a REIT under the Internal Revenue Code of 1986, as amended (the “Code”), and generally are not subject to federal taxes on our income to the extent we currently distribute our income to our shareholders and maintain our qualification as a REIT.  

Our principal goal is to generate net income for distribution to our shareholders through regular quarterly dividends.  Our income is generated by the difference between the earnings on our investment portfolio and the costs of our borrowings and hedging activities and other expenses.  In general, our strategy focuses on managing the interest rate risk related to our mortgage assets with a bias towards minimizing our exposure to credit risk.  We believe that the best approach to generating a positive net income is to manage our liabilities in relation to the interest rate risks of our investments.  To help achieve this result, we employ financing, generally short-term, and combine our financings with various hedging techniques, such as interest rate swaps and futures contracts.  We may, subject to maintaining our REIT qualification, also employ other hedging instruments from time to time, including interest rate caps, collars, swaptions and “to-be-announced” (“TBA”) securities to protect against adverse interest rate movements.  

We focus on assets we identify as having short effective durations, which we believe limits the impact of changes in interest rates on the market value of our portfolio and on our net interest margin (interest income less financing costs).  However, because our investments vary in interest rate, prepayment speed and maturity, the leverage or borrowings that we employ to fund our asset purchases will never exactly match the terms or performance of our assets, even after we have employed our hedging techniques.  Based on our manager’s experience, the interest rates of our assets will change more slowly than the corresponding short-term rates on the borrowings used to finance our assets.  Consequently, changes in interest rates, particularly short-term interest rates, may significantly influence our net income and shareholders’ equity.  

Our manager’s approach to managing our portfolio is to take a longer term view of assets and liabilities; accordingly, our periodic earnings and mark-to-market valuations at the end of a period will not significantly influence our strategy of providing cash distributions to shareholders over the long term.  Our manager has invested and seeks to invest in real estate mortgage assets that it believes are likely to generate attractive risk-adjusted returns on capital invested, after considering (1) the amount and nature of anticipated cash flows from the asset, (2) our ability to borrow against the asset, (3) the capital requirements resulting from the purchase and financing of the asset, and (4) the costs of financing, hedging, and managing the asset.  

Our focus is to own assets with short durations and predictable prepayment characteristics.  Since our formation, essentially all of our invested assets have been in agency securities, and we currently intend that the majority of our investment assets will continue to be agency securities.  We invest in both adjustable-rate and fixed-rate MBS.  ARMs are mortgages that have floating interest rates that reset on a specific time schedule, such as monthly, quarterly or annually, based on a specified index, such as the 12-month moving average of the one-year constant maturity U.S. Treasury rate (“CMT”) or the London Interbank Offered Rate (“LIBOR”).  The ARMs we generally invest in, sometimes referred to as hybrid ARMs, have interest rates that are fixed for an initial period (typically three, five, seven or 10 years) and then reset annually thereafter to an increment over a pre-determined interest rate index.  All of our fixed-rate MBS purchased to date have been 10-year and 15-year amortizing fixed-rate securities.  As of September 30, 2014, our portfolio consisted of approximately $16.9 billion in market value of MBS, consisting of $16.2 billion of adjustable-rate securities and $0.7 billion of fixed-rate securities.  

We purchase a substantial portion of our agency securities through delayed delivery transactions (forward purchase commitments), including TBA securities.  At times when market conditions are conducive, we may choose to move the settlement of these TBA securities out to a later date by entering into an offsetting short position in the near month, which is then net settled for cash, and simultaneously entering into a substantially similar TBA contract for a later settlement date.  Such a set of transactions is referred to as a TBA “dollar roll” transaction.  The TBA securities purchased at the later settlement date are typically priced at a discount to securities for settlement in the current month.  This difference is referred to as the “price drop.”  The price drop represents compensation to us for foregoing net interest margin and is referred to as TBA “dollar roll income.” Specified pools can also be the subject of a dollar roll transaction, when market conditions allow.

28


 

The following table presents our company’s key data for the past 12 quarters:

As of

 

MBS

 

 

Repurchase Agreements

 

 

Equity

 

 

Shares Outstanding

 

 

Book Value

Per Share

 

 

Earnings Per Share

 

September 30, 2014

 

$

16,890,424

 

 

$

14,920,959

 

 

$

2,444,492

 

 

 

96,720

 

 

$

22.30

 

 

$

0.75

 

June 30, 2014

 

 

16,651,220

 

 

 

15,019,880

 

 

 

2,433,011

 

 

 

96,517

 

 

 

22.23

 

 

 

(0.19

)

March 31, 2014

 

 

17,137,956

 

 

 

15,183,457

 

 

 

2,392,714

 

 

 

96,515

 

 

 

21.81

 

 

 

0.12

 

December 31, 2013

 

 

17,642,532

 

 

 

16,129,683

 

 

 

2,364,101

 

 

 

96,602

 

 

 

21.50

 

 

 

(0.16

)

September 30, 2013

 

 

19,843,830

 

 

 

18,829,771

 

 

 

2,373,641

 

 

 

97,909

 

 

 

21.31

 

 

 

(2.72

)

June 30, 2013

 

 

25,256,043

 

 

 

23,077,252

 

 

 

2,479,089

 

 

 

98,830

 

 

 

22.18

 

 

 

0.66

 

March 31, 2013

 

 

25,162,730

 

 

 

22,586,932

 

 

 

3,072,265

 

 

 

98,830

 

 

 

28.18

 

 

 

0.62

 

December 31, 2012

 

 

23,919,251

 

 

 

22,866,429

 

 

 

3,072,864

 

 

 

98,822

 

 

 

28.19

 

 

 

1.02

 

September 30, 2012

 

 

26,375,137

 

 

 

23,583,180

 

 

 

3,212,556

 

 

 

98,809

 

 

 

29.60

 

 

 

0.83

 

June 30, 2012

 

 

22,367,121

 

 

 

20,152,860

 

 

 

2,692,261

 

 

 

98,074

 

 

 

27.45

 

 

 

0.91

 

March 31, 2012

 

 

18,323,972

 

 

 

16,556,630

 

 

 

2,669,300

 

 

 

97,779

 

 

 

27.30

 

 

 

0.89

 

December 31, 2011

 

 

17,741,873

 

 

 

16,162,375

 

 

 

2,080,188

 

 

 

76,823

 

 

 

27.08

 

 

 

0.92

 

Factors that Affect our Results of Operations and Financial Condition

Our results of operations and financial condition are affected by various factors, many of which are beyond our control, including, among other things, our net interest margin, the market value of our assets and the supply of and demand for such assets.  We invest in financial assets and markets, and recent events, including those discussed below, can affect our business in ways that are difficult to predict, and produce results outside of typical operating variances.  Our net interest margin varies primarily as a result of changes in interest rates, borrowing costs and prepayment speeds, the behavior of which involves various risks and uncertainties.  Prepayment rates, as reflected by the rate of principal paydown, and interest rates vary according to the type of investment, conditions in financial markets, government actions, competition and other factors, none of which can be predicted with any certainty.  In general, as prepayment rates on our MBS purchased at a premium increase, related purchase premium amortization increases, thereby reducing the net yield on such assets.  Because changes in interest rates may significantly affect our activities, our operating results depend, in large part, upon our ability to manage interest rate risks and prepayment risks effectively while maintaining our status as a REIT.  

We anticipate that, for any period during which changes in the interest rates earned on our assets do not coincide with interest rate changes on our borrowings, such asset coupon rates will reprice more slowly than the corresponding liabilities used to finance those assets.  Consequently, changes in interest rates, particularly short-term interest rates, may significantly influence our net interest margin.  With the maturities of our assets generally being longer term than those of our liabilities, interest rate increases will tend to decrease our net interest margin and the market value of our assets (and therefore our book value).  Such rate increases could possibly result in operating losses or adversely affect our ability to make distributions to our shareholders.  

Prepayments on MBS and the underlying mortgage loans may be influenced by changes in market interest rates and a variety of economic, geographic and other factors beyond our control; and consequently, prepayment rates cannot be predicted with certainty.  To the extent we have acquired MBS at a premium or discount to par, or face value, changes in prepayment rates may impact our anticipated yield.  In periods of declining interest rates, prepayments on our MBS are likely to increase.  If we are unable to reinvest the proceeds of these prepayments at comparable yields, our net interest margin may suffer.  The current climate of government intervention in the mortgage market significantly increases the risk associated with prepayments.  

While we intend to use hedging to mitigate some of our interest rate risk, we do not intend to hedge all of our exposure to changes in interest rates and prepayment rates, as there are practical limitations on our ability to insulate our portfolio from all potential negative consequences associated with changes in short-term interest rates in a manner that will allow us to seek attractive net spreads on our portfolio.  

In addition, a variety of other factors relating to our business may also impact our financial condition and operating performance.  These factors include:

·

our degree of leverage;

·

our access to funding and borrowing capacity;

·

our borrowing costs;

·

our hedging activities;

·

the market value of our investments; and

29


 

·

the REIT requirements, the requirements to qualify for an exemption under the Investment Company Act and other regulatory and accounting policies related to our business.  

Our manager is entitled to receive a management fee that is based on our equity (as defined in our management agreement), regardless of the performance of our portfolio.  Accordingly, the payment of our management fee may not decline in the event of a decline in our profitability and may cause us to incur losses.  

For a discussion of additional risks relating to our business see the section captioned “Risk Factors” in Part II, Item 1A of this Quarterly Report on Form 10-Q, and in our Annual Report on Form 10-K for the year ended December 31, 2013.  

Market and Interest Rate Trends and the Effect on our Portfolio

Developments at Fannie Mae and Freddie Mac

Payments on the agency securities in which we invest are guaranteed by Fannie Mae and Freddie Mac.  Because of the guarantee and the underwriting standards associated with mortgages underlying agency securities, agency securities historically have had high stability in value and have been considered to present low credit risk.  In 2008, Fannie Mae and Freddie Mac were placed under the conservatorship of the U.S. government due to the significant weakness of their financial condition.  

Since that time, there have been a number of proposals introduced, both from industry groups and by the U.S. Congress outlining alternatives for reforming the U.S. housing system, specifically Fannie Mae and Freddie Mac, and transforming the government’s involvement in the housing market, including the Housing Finance Reform and Taxpayer Protection Act of 2013, also known as the Corker-Warner bill, the Protecting American Taxpayers and Homeowners Act, and a reform bill introduced by Senators Tim Johnson (D-SD) and Mike Crapo (R-ID), the two most senior members of the Senate Banking Committee, known as the Johnson-Crapo bill, which is generally based on the Corker-Warner bill.  As the Federal Housing Finance Agency and both houses of Congress are each working on separate measures intended to restructure the U.S. housing finance system and the operations of Fannie Mae and Freddie Mac, we expect debate and discussion on the topic to continue throughout 2014.  It remains unclear whether these or any other proposals will become law or, should a proposal become law, what the effects would be.  It is unclear how the proposals would impact housing finance, and what impact, if any, it would have on mortgage REITs.  

U.S. Treasury and Agency Securities Market Intervention

One of the main factors impacting market prices of our investments has been the U.S. Federal Reserve’s programs to purchase U.S. Treasury and agency securities in the open market.  These programs, referred to as “quantitative easing” were aimed to improve the employment outlook and increase growth in the U.S. economy.  One effect of these purchases has been an increase in the prices of agency securities, which has contributed to the decrease of our net interest margin.  Since December 2013, the U.S. Federal Reserve has reduced its monthly purchases of both agency securities and U.S. Treasury securities.  On October 29, 2014, the U.S. Federal Reserve announced that it would conclude its monthly purchases of both agency securities and U.S. Treasury securities this month.  However, the U.S. Federal Reserve also stated it would continue its existing policy of reinvesting principal payments from its agency securities and rolling over maturing U.S. Treasury securities at auction, which should continue to create demand for agency securities.  The announcements on the tapering of the U.S. Federal Reserve’s purchases drove interest rates higher on U.S. Treasury and agency securities and resulted in large negative price movements in our assets.  The unpredictability and size of these programs has also injected additional volatility into the pricing and availability of our assets.  Due to the unpredictability in the markets for our securities in particular and yield generating assets in general, there is no pattern that can be implied with any certainty.  We believe the largest risk is that if the government decides to sell significant portions of its portfolio, then we may see additional price declines.  

Exposure to European Financial Counterparties

We have no direct exposure to any European sovereign credit.  We do finance the acquisition of our MBS with repurchase agreements, some of which are provided by European banks.  In connection with these financing arrangements, we pledge our securities as collateral to secure the borrowing.  The amount of collateral pledged will typically exceed the amount of the financing with the extent of over-collateralization ranging from 3%-6% of the amount borrowed.  While repurchase agreement financing results in us recording a liability to the counterparty in our consolidated balance sheet, we are exposed to the counterparty, if during the term of the repurchase agreement financing, a lender should default on its obligation and we are not able to recover our pledged assets.  The amount of this exposure is the difference between the amount loaned to us plus interest due to the counterparty and the fair value of the collateral pledged by us to the lender including accrued interest receivable on such collateral.  

In addition, we use interest rate swaps to manage interest rate risk exposure in connection with our repurchase agreement financings.  We will make cash payments or pledge securities as collateral as part of a margin arrangement in connection with interest rate swaps that are in an unrealized loss position.  In the event that a counterparty were to default on its obligation, we would be exposed to a loss to a swap counterparty to the extent that the amount of cash or securities pledged exceeded the unrealized loss on the associated swaps and we were not able to recover the excess collateral.  

30


 

During the past several years, several large European banks have experienced financial difficulty and have been either rescued by government assistance or by other large European banks.  Some of these banks have U.S. banking subsidiaries, which have provided financing to us, particularly repurchase agreement financing for the acquisition of MBS.  At September 30, 2014, we had entered into repurchase agreements and/or interest rate swaps with seven financial institution counterparties that are either domiciled in Europe or a U.S.-based subsidiary of a European domiciled financial institution.  Our total exposure to these banks was 7.1% of our equity at September 30, 2014.  At September 30, 2014, we did not use credit default swaps or other forms of credit protection to hedge these exposures, although we may in the future.  The following table shows our exposure by country to European banks.  

 

Number of

Counterparties

 

 

Exposure (1)

 

 

Exposure as a

Percentage of Equity

 

England

 

1

 

 

$

28,210

 

 

 

1.2

%

France

 

1

 

 

 

28,724

 

 

 

1.2

%

Germany

 

2

 

 

 

17,937

 

 

 

0.7

%

Netherlands

 

1

 

 

 

40,297

 

 

 

1.6

%

Scotland

 

1

 

 

 

17,940

 

 

 

0.7

%

Switzerland

 

1

 

 

 

41,298

 

 

 

1.7

%

 

 

7

 

 

$

174,406

 

 

 

7.1

%

(1)

Exposure represents our total assets pledged as collateral in excess of our obligations, including any accrued interest receivable on the pledged assets.  

Management monitors our exposure to our repurchase agreement and interest rate swap counterparties on a regular basis, using various methods, including review of recent rating agency actions or other developments and by monitoring the amount of cash and securities collateral pledged and the associated loan amount under repurchase agreements and/or the fair value of interest rate swaps with our counterparties.  We intend to make reverse margin calls on our counterparties to recover excess collateral as permitted by the agreements governing our financing arrangements, or take other necessary actions to reduce the amount of our exposure to a counterparty when such actions are considered necessary.  

Interest Rates

Mortgage markets in general, and our strategy in particular, are sensitive to changes in interest rates.  The relationship between several interest rates is generally determinant of the performance of our company.  Our borrowings in the repurchase market have historically closely tracked LIBOR and the U.S. Federal Funds Effective Rate.  Significant volatility in these rates or a divergence from the historical relationship among these rates could negatively impact our ability to manage our portfolio.  The mortgage assets we buy are affected by the shape of the yield curve, particularly along the area between the two year Treasury rate and the 10 year Treasury rate.  The following table shows the 30-day LIBOR as compared to these rates at each period end for the past 12 quarters:

 

 

30- 

Day LIBOR

 

 

Fed Funds
Effective Rate

 

 

Two Year
Treasury

 

 

10 Year
Treasury

 

September 30, 2014

 

0.16

%

 

 

0.07

%

 

 

0.58

%

 

 

2.52

%

June 30, 2014

 

0.16

%

 

 

0.09

%

 

 

0.47

%

 

 

2.53

%

March 31, 2014

 

0.15

%

 

 

0.06

%

 

 

0.44

%

 

 

2.73

%

December 31, 2013

 

0.17

%

 

 

0.07

%

 

 

0.38

%

 

 

3.04

%

September 30, 2013

 

0.18

%

 

 

0.06

%

 

 

0.33

%

 

 

2.64

%

June 30, 2013

 

0.19

%

 

 

0.07

%

 

 

0.36

%

 

 

2.49

%

March 31, 2013

 

0.20

%

 

 

0.09

%

 

 

0.24

%

 

 

1.85

%

December 31, 2012

 

0.21

%

 

 

0.09

%

 

 

0.25

%

 

 

1.78

%

September 30, 2012

 

0.21

%

 

 

0.09

%

 

 

0.23

%

 

 

1.63

%

June 30, 2012

 

0.25

%

 

 

0.09

%

 

 

0.30

%

 

 

1.65

%

March 31, 2012

 

0.24

%

 

 

0.09

%

 

 

0.33

%

 

 

2.21

%

December 31, 2011

 

0.30

%

 

 

0.04

%

 

 

0.24

%

 

 

1.88

%

Principal Repayment Rate

Our net interest income is primarily a function of the difference between the yield on our assets and the financing cost of owning those assets.  Since we tend to purchase assets at a premium to par, the main item that can affect the yield on our assets after they are purchased is the rate at which the mortgage borrowers repay the loan.  While the scheduled repayments, which are the principal portion of the homeowners’ regular monthly payments, are fairly predictable, the unscheduled repayments, which are generally refinancing of the mortgage, are less so.  Estimates of repayment rates are critical to the management of our portfolio, not only for estimating current yield but also to consider the rate of reinvestment of those proceeds into new securities, the yields which those new

31


 

securities may add to our portfolio, as well as the extent to which we extend the duration of our liabilities in connection with hedging activities.  

The following table shows the weighted average principal repayment rate and the one-month constant prepayment rate (“CPR”) for the last 12 quarters:

 

 

Weighted-Average Principal

Repayment Rate  (1)

 

 

Weighted-Average Principal

Repayment Rate

Annualized  (2)

 

 

One Month CPR  (3)

 

September 30, 2014

 

 

6.33%

 

 

 

25.31%

 

 

 

19.0

 

June 30, 2014

 

 

5.09%

 

 

 

20.36%

 

 

 

15.4

 

March 31, 2014

 

 

4.42%

 

 

 

17.66%

 

 

 

13.0

 

December 31, 2013

 

 

4.89%

 

 

 

19.55%

 

 

 

14.2

 

September 30, 2013

 

 

6.93%

 

 

 

27.72%

 

 

 

19.7

 

June 30, 2013

 

 

7.03%

 

 

 

28.10%

 

 

 

20.8

 

March 31, 2013

 

 

6.50%

 

 

 

26.01%

 

 

 

19.0

 

December 31, 2012

 

 

6.64%

 

 

 

26.55%

 

 

 

19.8

 

September 30, 2012

 

 

6.90%

 

 

 

27.61%

 

 

 

20.5

 

June 30, 2012

 

 

6.36%

 

 

 

25.42%

 

 

 

19.7

 

March 31, 2012

 

 

6.42%

 

 

 

25.67%

 

 

 

19.6

 

December 31, 2011

 

 

6.85%

 

 

 

27.39%

 

 

 

20.8

 

(1) 

Scheduled and unscheduled principal payments as a percentage of the weighted average portfolio.  

(2) 

Weighted average principal repayment rate annualized.  

(3) 

CPR measures one month of unscheduled repayments as a percentage of principal on an annualized basis.  

 Book Value per Share

As of September 30, 2014, our book value per share of common stock (total shareholders’ equity less the aggregate liquidation preference for our 7.625% Series A Cumulative Redeemable Preferred Stock divided by the number of shares of common stock outstanding) was $22.30, an increase of $0.80, from $21.50 at December 31, 2013.  The increase in our book value was primarily a result of the increase in the unrealized gain on our MBS and the decrease in the unrealized loss on our hedges, which was partially offset by dividends in excess of net income.  The following table shows the components of our book value on a per share basis at each period end:

As of

 

Common Equity

 

 

Undistributed Earnings

 

 

Unrealized Gain/(Loss) on MBS

 

 

Unrealized Gain/(Loss) on Interest Rate Swaps

 

 

Book Value Per Share

 

September 30, 2014

 

$

25.27

 

 

$

(4.53

)

 

$

2.01

 

 

$

(0.45

)

 

$

22.30

 

June 30, 2014

 

 

25.32

 

 

 

(4.79

)

 

 

2.36

 

 

 

(0.66

)

 

 

22.23

 

March 31, 2014

 

 

25.31

 

 

 

(4.11

)

 

 

1.50

 

 

 

(0.89

)

 

 

21.81

 

December 31, 2013

 

 

25.30

 

 

 

(3.72

)

 

 

1.07

 

 

 

(1.15

)

 

 

21.50

 

September 30, 2013

 

 

25.19

 

 

 

(3.02

)

 

 

0.53

 

 

 

(1.39

)

 

 

21.31

 

June 30, 2013

 

 

25.16

 

 

 

0.26

 

 

 

(1.91

)

 

 

(1.33

)

 

 

22.18

 

March 31, 2013

 

 

25.15

 

 

 

0.30

 

 

 

4.94

 

 

 

(2.21

)

 

 

28.18

 

December 31, 2012

 

 

25.15

 

 

 

0.38

 

 

 

5.12

 

 

 

(2.46

)

 

 

28.19

 

September 30, 2012

 

 

25.14

 

 

 

0.05

 

 

 

7.16

 

 

 

(2.75

)

 

 

29.60

 

June 30, 2012

 

 

25.25

 

 

 

0.02

 

 

 

4.73

 

 

 

(2.55

)

 

 

27.45

 

March 31, 2012

 

 

25.23

 

 

 

0.01

 

 

 

4.29

 

 

 

(2.23

)

 

 

27.30

 

December 31, 2011

 

 

24.79

 

 

 

0.03

 

 

 

5.11

 

 

 

(2.85

)

 

 

27.08

 

Investments

We invest in both adjustable and fixed-rate MBS.  At September 30, 2014 and December 31, 2013, we owned $16.9 billion and $17.6 billion, respectively, of MBS.  While our strategy focuses on ARM securities, we also own fixed-rate securities with estimated durations that we believe are beneficial to the overall mix of our assets.  As of September 30, 2014 and December 31, 2013, our MBS portfolio was purchased at a net premium to par, or face value, with a weighted-average amortized cost of 102.84 and 102.87,

32


 

respectively, of face value.  As of September 30, 2014 and December 31, 2013, we had approximately $461.1 million and $488.9 million, respectively, of unamortized premium included in the cost basis of our MBS.  

During the quarter ended September 30, 2014, we purchased approximately $1.4 billion of MBS with a weighted average coupon of 2.90%.  We also sold approximately $0.2 billion of MBS with a weighted average coupon of 2.21% for the three months ended September 30, 2014.  During the nine months ended September 30, 2014, we purchased approximately $3.7 billion of MBS with a weighted average coupon of 2.86%.  During the nine months ended September 30, 2014, we sold approximately $1.6 billion of MBS with a weighted average coupon of 2.85%.

We typically want to own a higher percentage of Fannie Mae ARMs than Freddie Mac ARMs as Fannie Mae has better cash flow to the security holder because Fannie Mae pays principal and interest sooner after accrual (54 days) as compared to Freddie Mac (75 days).  

Our investment portfolio consisted of the following types of MBS at September 30, 2014:

 

Amortized Cost

 

 

Gross Unrealized Loss

 

 

Gross Unrealized Gain

 

 

Estimated Fair Value

 

 

% of Total

 

Agency Securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fannie Mae Certificates

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

ARMs

$

9,217,059

 

 

$

(20,004

)

 

$

175,699

 

 

$

9,372,754

 

 

 

55.5

%

Fixed-Rate

 

569,736

 

 

 

(615

)

 

 

2,380

 

 

 

571,501

 

 

 

3.4

%

Total Fannie Mae

 

9,786,795

 

 

 

(20,619

)

 

 

178,079

 

 

 

9,944,255

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Freddie Mac Certificates

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

ARMs

 

6,667,896

 

 

 

(31,236

)

 

 

66,537

 

 

 

6,703,197

 

 

 

39.7

%

Fixed-Rate

 

166,394

 

 

 

(30

)

 

 

858

 

 

 

167,222

 

 

 

1.0

%

Total Freddie Mac

 

6,834,290

 

 

 

(31,266

)

 

 

67,395

 

 

 

6,870,419

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Agency Securities

 

16,621,085

 

 

 

(51,885

)

 

 

245,474

 

 

 

16,814,674

 

 

 

99.6

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Non-Agency ARMs

 

76,200

 

 

 

(450

)

 

 

-

 

 

 

75,750

 

 

 

0.4

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Mortgage-Backed Securities

$

16,697,285

 

 

$

(52,335

)

 

$

245,474

 

 

$

16,890,424

 

 

 

100.0

%

As of December 31, 2013, our investment portfolio consisted of the following types of securities:

 

Amortized Cost

 

 

Gross Unrealized Loss

 

 

Gross Unrealized Gain

 

 

Estimated Fair Value

 

 

% of Total

 

Agency Securities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fannie Mae Certificates

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

ARMs

$

9,620,743

 

 

$

(44,871

)

 

$

167,848

 

 

$

9,743,720

 

 

 

55.2

%

Fixed-Rate

 

806,312

 

 

 

(1,798

)

 

 

3,832

 

 

 

808,346

 

 

 

4.6

%

Total Fannie Mae

 

10,427,055

 

 

 

(46,669

)

 

 

171,680

 

 

 

10,552,066

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Freddie Mac Certificates

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

ARMs

 

6,671,013

 

 

 

(70,752

)

 

 

57,808

 

 

 

6,658,069

 

 

 

37.8

%

Fixed-Rate

 

338,738

 

 

 

(1,600

)

 

 

21

 

 

 

337,159

 

 

 

1.9

%

Total Freddie Mac

 

7,009,751

 

 

 

(72,352

)

 

 

57,829

 

 

 

6,995,228

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Ginnie Mae Certificates

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

ARMs

 

-

 

 

 

-

 

 

 

-

 

 

 

-

 

 

 

0.0

%

Fixed-Rate

 

96,236

 

 

 

(998

)

 

 

-

 

 

 

95,238

 

 

 

0.5

%

Total Ginnie Mae

 

96,236

 

 

 

(998

)

 

 

-

 

 

 

95,238

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total Mortgage-Backed Securities

$

17,533,042

 

 

$

(120,019

)

 

$

229,509

 

 

$

17,642,532

 

 

 

100.0

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

33


 

Adjustable-rate securities

As of September 30, 2014 our investment portfolio consisted of ARM securities as follows:

Months to Reset

% of ARM Portfolio

 

 

Current Face Value (1)

 

 

Weighted Avg. Coupon (2)

 

 

Wtd. Avg. Amortized Purchase Price (3)

 

 

Amortized Cost (4)

 

 

Weighted Avg. Market Price (5)

 

 

Market Value (6)

 

0-12

 

12.4

%

 

$

1,872,888

 

 

 

3.17

%

 

$

102.12

 

 

$

1,912,604

 

 

$

106.73

 

 

$

1,998,905

 

13-24

 

11.7

%

 

 

1,779,785

 

 

 

3.09

%

 

$

102.48

 

 

 

1,823,848

 

 

$

106.03

 

 

 

1,887,079

 

25-36

 

12.7

%

 

 

1,962,633

 

 

 

2.61

%

 

$

102.84

 

 

 

2,018,276

 

 

$

104.30

 

 

 

2,046,969

 

37-48

 

14.3

%

 

 

2,214,546

 

 

 

2.98

%

 

$

102.64

 

 

 

2,272,943

 

 

$

104.28

 

 

 

2,309,420

 

49-60

 

34.8

%

 

 

5,473,680

 

 

 

2.55

%

 

$

103.04

 

 

 

5,639,822

 

 

$

102.77

 

 

 

5,625,041

 

61-72

 

7.6

%

 

 

1,213,353

 

 

 

2.35

%

 

$

103.14

 

 

 

1,251,448

 

 

$

101.62

 

 

 

1,233,013

 

73-84

 

6.4

%

 

 

1,013,409

 

 

 

3.00

%

 

$

102.29

 

 

 

1,036,649

 

 

$

103.18

 

 

 

1,045,619

 

109-120

 

0.1

%

 

 

5,451

 

 

 

3.34

%

 

$

102.09

 

 

 

5,565

 

 

$

103.74

 

 

 

5,655

 

Total ARMS

 

100.0

%

 

$

15,535,745

 

 

 

2.77

%

 

$

102.74

 

 

$

15,961,155

 

 

$

103.96

 

 

$

16,151,701

 

As of December 31, 2013, our investment portfolio consisted of ARM securities as follows:

Months to Reset

% of ARM Portfolio

 

 

Current Face Value (1)

 

 

Weighted Avg. Coupon (2)

 

 

Wtd. Avg. Amortized Purchase Price (3)

 

 

Amortized Cost (4)

 

 

Weighted Avg. Market Price (5)

 

 

Market Value (6)

 

0-12

 

7.5

%

 

$

1,165,714

 

 

 

3.15

%

 

$

101.77

 

 

$

1,186,380

 

 

$

106.10

 

 

$

1,236,878

 

13-24

 

9.8

%

 

 

1,526,598

 

 

 

3.49

%

 

$

102.30

 

 

 

1,561,668

 

 

$

105.73

 

 

 

1,614,081

 

25-36

 

14.2

%

 

 

2,212,306

 

 

 

2.99

%

 

$

102.45

 

 

 

2,266,557

 

 

$

104.96

 

 

 

2,321,985

 

37-48

 

15.4

%

 

 

2,430,716

 

 

 

2.73

%

 

$

102.77

 

 

 

2,498,130

 

 

$

103.88

 

 

 

2,524,939

 

49-60

 

15.1

%

 

 

2,394,168

 

 

 

2.94

%

 

$

102.58

 

 

 

2,455,924

 

 

$

103.72

 

 

 

2,483,318

 

61-72

 

29.0

%

 

 

4,664,901

 

 

 

2.46

%

 

$

103.31

 

 

 

4,819,437

 

 

$

101.83

 

 

 

4,750,098

 

73-84

 

9.0

%

 

 

1,461,452

 

 

 

2.44

%

 

$

102.89

 

 

 

1,503,660

 

 

$

100.62

 

 

 

1,470,490

 

Total ARMS

 

100.0

%

 

$

15,855,855

 

 

 

2.80

%

 

$

102.75

 

 

$

16,291,756

 

 

$

103.44

 

 

$

16,401,789

 

(1) 

The current face is the current monthly remaining dollar amount of principal of a mortgage security.  We compute current face by multiplying the original face value of the security by the current principal balance factor.  The current principal balance factor is essentially a fraction, where the numerator is the current outstanding balance and the denominator is the original principal balance.  

(2) 

For a pass-through certificate, the coupon reflects the weighted average nominal rate of interest paid on the underlying mortgage loans, net of fees paid to the servicer and the agency.  The coupon for a pass-through certificate may change as the underlying mortgage loans are prepaid.  The percentages indicated in this column are the nominal interest rates that will be effective through the interest rate reset date and have not been adjusted to reflect the purchase price we paid for the face amount of security.  

(3) 

Amortized purchase price is the dollar amount, per $100 of current face, of our purchase price for the security, adjusted for amortization as a result of scheduled and unscheduled principal paydowns.  

(4) 

Amortized cost is our total purchase price for the mortgage security, adjusted for amortization as a result of scheduled and unscheduled principal paydowns.  

(5) 

Market price is the dollar amount of market value, per $100 of nominal, or face value, of the mortgage security.  

(6) 

Market value is the total market value for the mortgage security.  

As of September 30, 2014, excluding any fixed-rate securities, the ARMs underlying our adjustable-rate MBS had fixed interest rates for a weighted average period of approximately 43 months after which time the interest rates reset and become adjustable annually.  At September 30, 2014, 95.7% of our ARMs were still in their initial fixed-rate period and 4.3% of our ARMs have already reached their initial reset period and will reset annually for the life of the security.  As of September 30, 2014, an additional 8.1% of our ARMs will reach the end of their initial fixed-rate period in the next 12 months.  

After the reset date, interest rates on our ARMs float based on spreads over various indices, usually LIBOR or the one-year CMT.  These interest rate adjustments are subject to caps that limit the amount the applicable interest rate can increase during any year, known as an annual cap, and through the maturity of the security, known as a lifetime cap.  At the first reset date, our ARMs typically have a maximum initial one-time adjustment of either 2% or 5%, followed by annual interest rate increases (or decreases) of

34


 

up to a maximum change of 2% per year.  The average lifetime cap on increases (or decreases) to the interest rates on our MBS is 5% from the initial stated rate.  

Fixed-rate securities

In addition to adjustable-rate securities, we also invest in fixed-rate securities.  All of our fixed-rate MBS purchased to date have been 10-year and 15-year amortizing fixed-rate securities.  At September 30, 2014, we owned $738.7 million of 15-year fixed-rate MBS with a weighted average life, assuming a constant prepayment rate of 10, of 4.1 years.  The following table details our fixed-rate securities portfolio at September 30, 2014.  

Wtd. Avg

Months to Maturity

% of Fixed-Rate Portfolio

 

 

Current Face Value (1)

 

 

Weighted Avg. Coupon (2)

 

 

Wtd. Avg. Amortized Purchase Price (3)

 

 

Amortized Cost (4)

 

 

Weighted Avg. Market Price (5)

 

 

Market Value (6)

 

133-144

 

72.4

%

 

$

506,721

 

 

 

3.50

%

 

$

105.19

 

 

$

532,999

 

 

$

105.53

 

 

$

534,735

 

145-156

 

27.6

%

 

 

193,676

 

 

 

3.50

%

 

$

104.88

 

 

 

203,131

 

 

$

105.32

 

 

 

203,988

 

Total Fixed-Rate

 

100.0

%

 

$

700,397

 

 

 

3.50

%

 

$

105.10

 

 

$

736,130

 

 

$

105.47

 

 

$

738,723

 

 The following table details our fixed-rate securities portfolio at December 31, 2013.  

Wtd. Avg

Months to Maturity

% of Fixed-Rate Portfolio

 

 

Current Face Value (1)

 

 

Weighted Avg. Coupon (2)

 

 

Wtd. Avg. Amortized Purchase Price (3)

 

 

Amortized Cost (4)

 

 

Weighted Avg. Market Price (5)

 

 

Market Value (6)

 

133-144

 

6.1

%

 

$

72,252

 

 

 

3.50

%

 

$

105.40

 

 

$

76,154

 

 

$

104.76

 

 

$

75,693

 

145-156

 

38.5

%

 

 

456,585

 

 

 

3.50

%

 

$

104.82

 

 

 

478,592

 

 

$

104.59

 

 

 

477,544

 

157-168

 

7.7

%

 

 

93,198

 

 

 

3.00

%

 

$

103.26

 

 

 

96,237

 

 

$

102.19

 

 

 

95,238

 

169-180

 

47.7

%

 

 

566,299

 

 

 

3.50

%

 

$

104.24

 

 

 

590,303

 

 

$

104.59

 

 

 

592,268

 

Total Fixed-Rate

 

100.0

%

 

$

1,188,334

 

 

 

3.46

%

 

$

104.46

 

 

$

1,241,286

 

 

$

104.41

 

 

$

1,240,743

 

(1) 

The current face value is the current monthly remaining dollar amount of principal of a mortgage security.  We compute current face value by multiplying the original face value of the security by the current principal balance factor.  The current principal balance factor is essentially a fraction, where the numerator is the current outstanding balance and the denominator is the original principal balance.  

(2) 

For a pass-through certificate, the coupon reflects the weighted average nominal rate of interest paid on the underlying mortgage loans, net of fees paid to the servicer and the agency.  The coupon for a pass-through certificate may change as the underlying mortgage loans are prepaid.  The percentages indicated in this column have not been adjusted to reflect the purchase price we paid for the face amount of security.  

(3) 

Amortized purchase price is the dollar amount, per $100 of current face, of our purchase price for the security, adjusted for amortization as a result of scheduled and unscheduled principal paydowns.  

(4) 

Amortized cost is our total purchase price for the mortgage security, adjusted for amortization as a result of scheduled and unscheduled principal paydowns.  

(5) 

Market price is the dollar amount of market value, per $100 of nominal, or face value, of the mortgage security.  

(6) 

Market value is the total market value for the mortgage security.  

Forward Purchases

While most of our purchases of MBS are accounted for using trade date accounting, some forward purchases, such as certain TBA contracts, do not qualify for trade date accounting and are considered derivatives for financial statement purposes.  Our accounting for these forward purchases depends on whether or not we intend to take physical delivery of the securities.  In either case, the net fair value of the forward commitment is reported on the consolidated balance sheet as a derivative asset or derivative liability.  If we intend to take physical delivery of the securities, as in the case for forward purchase commitments to acquire TBA securities from mortgage originators, the commitment is designated as an all-in-one cash flow hedge and its unrealized gains and losses are recorded in other comprehensive income.  If we do not intend to take physical delivery of the securities, as is the case with most TBA dollar roll transactions, the commitment is not designated as an accounting hedge and unrealized gains and losses are recorded in “Gain (loss) on derivative instruments, net.”

 

35


 

 

 

The following table shows our 15-year TBA contracts at September 30, 2014 and December 31, 2013.

 

Face

 

 

Wtd. Avg. Coupon

 

 

Cost

 

 

Fair Market Value

 

 

Net Asset (Liability)

 

September 30, 2014

$

3,600,000

 

 

 

3.0%

 

 

$

3,723,183

 

 

$

3,703,228

 

 

$

(19,955

)

December 31, 2013

$

600,000

 

 

 

3.5%

 

 

$

632,270

 

 

$

627,187

 

 

$

(5,083

)

The following table shows the ARM TBA contracts at September 30, 2014 and December 31, 2013.

 

Face

 

 

Cost

 

 

Fair Market Value

 

 

Due to Brokers

 

September 30, 2014

$

105,239

 

 

$

107,814

 

 

$

107,798

 

 

$

107,814

 

December 31, 2013

$

-

 

 

$

-

 

 

$

-

 

 

$

-

 

We also enter into commitments with various mortgage originators for ARM securities.  The fair value of these commitments at September 30, 2014 was a net asset of $1,888 and at December 31, 2013 was a net liability of ($658).

Liabilities

We have entered into repurchase agreements to finance most of our MBS.  Our repurchase agreements are secured by our MBS and bear interest at rates that have historically moved in close relationship to LIBOR.  As of September 30, 2014, we had established 30 borrowing relationships with various investment banking firms and other lenders.  We had an outstanding balance under our repurchase agreements at September 30, 2014 of $14.9 billion with 26 counterparties.  We had an outstanding balance of $16.1 billion at December 31, 2013 with 25 different counterparties.  

Hedging Instruments

We generally intend to hedge, on an economic basis, as much of our interest rate risk as our manager deems prudent in light of market conditions.  No assurance can be given that our hedging activities will have the desired beneficial impact on our results of operations or financial condition.  Our policies do not contain specific requirements as to the percentages or amount of interest rate risk that our manager is required to hedge.  

Interest rate hedging may fail to protect or could adversely affect us because, among other things:

·

available interest rate hedging may not correspond directly with the interest rate risk for which protection is sought;

·

the duration of the hedge may not match the duration of the related liability;

·

fair value accounting rules could foster adverse valuation adjustments due to credit quality considerations that could impact both earnings and shareholder equity;

·

the party owing money in the hedging transaction may default on its obligation to pay;

·

the credit quality of the party owing money on the hedge may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction; and

·

the value of derivatives used for hedging may be adjusted from time to time in accordance with accounting rules to reflect changes in fair value.  Downward adjustments, or “mark-to-market losses,” would reduce our shareholders’ equity, and in the case of derivatives not subject to hedge accounting, our earnings as well.  

As of September 30, 2014, we had entered into 64 interest rate swap agreements with 13 counterparties to hedge (on an economic basis) a benchmark interest rate – LIBOR.  This portfolio of hedges is designed to lock in funding costs for specific funding activities associated with specific assets as a way to realize attractive net interest margins.  This hedging strategy incorporates an assumed prepayment schedule, which, if not realized, will cause our results to differ from expectations.  These interest rate swap agreements provide for fixed interest rates indexed off of one-month LIBOR and effectively fix the floating interest rates on $9.2 billion of borrowings under our repurchase agreements.  We also purchase Eurodollar Futures Contracts (“Futures Contracts”), which are based on three-month LIBOR, as part of our strategy to mitigate interest rate risk.  The effective notional amounts and rates of our interest rate swaps and Futures Contracts as of September 30, 2014 were as follows:

36


 

 

Wtd -Avg. Futures Contracts Notional

 

 

Wtd-Avg Futures Contracts Rate

 

 

Wtd.-Avg. Swap Notional

 

 

Wtd-Avg Swap Rate

 

 

Total

 

 

Wtd.  Avg. Rate

 

Effective 2014

$

1,874,000

 

 

 

0.38

%

 

$

8,900,000

 

 

 

1.29

%

 

$

10,774,000

 

 

 

1.13

%

Effective 2015

 

8,143,000

 

 

 

0.95

%

 

 

6,408,333

 

 

 

1.11

%

 

 

14,551,333

 

 

 

1.02

%

Effective 2016

 

7,538,500

 

 

 

1.97

%

 

 

3,500,000

 

 

 

0.91

%

 

 

11,038,500

 

 

 

1.64

%

Effective 2017

 

6,801,750

 

 

 

2.94

%

 

 

1,125,000

 

 

 

0.92

%

 

 

7,926,750

 

 

 

2.66

%

Effective 2018

 

4,477,500

 

 

 

3.62

%

 

 

50,000

 

 

 

0.95

%

 

 

4,527,500

 

 

 

3.59

%

Effective 2019

 

1,496,000

 

 

 

3.89

%

 

 

-

 

 

 

-

 

 

 

1,496,000

 

 

 

3.89

%

Effective 2020

 

1,483,750

 

 

 

4.04

%

 

 

-

 

 

 

-

 

 

 

1,483,750

 

 

 

4.04

%

Effective 2021

 

701,000

 

 

 

4.03

%

 

 

-

 

 

 

-

 

 

 

701,000

 

 

 

4.03

%

We also enter into swaptions as a method to offset a portion of the volatility in the value of our MBS.  As of September 30, 2014, we had four interest rate swaptions outstanding:

 

 

Options

 

 

Underlying Swaps

 

Swaptions

 

Original Cost

 

 

Fair Value

 

 

Wtd. Avg. Months to Expiration

 

 

Notional

 

 

Wtd. Avg. Fixed Pay Rate

 

 

Receive Rate

 

Wtd. Avg. Term (Years)

 

Fixed payer

 

$

20,081

 

 

$

16,098

 

 

 

9

 

 

$

992,300

 

 

 

2.74%

 

 

3 month LIBOR

 

 

7

 

We did not have any interest rate swaptions outstanding at December 31, 2013.

On September 30, 2013, we discontinued hedge accounting for our interest rate swap agreements by de-designating the interest rate swaps as cash flow hedges.  No interest rate swaps were terminated in conjunction with this action, and our risk management and hedging practices are unimpacted.  However, our accounting for these transactions was changed prospectively effective October 1, 2013.  All of our interest rate swaps had previously been accounted for as cash flow hedges under ASC Topic 815, Derivatives and Hedging.  As a result of discontinuing hedge accounting, beginning October 1 changes in the fair value of our interest rate swap agreements are recorded in “Gain (loss) on derivative instruments, net” in our consolidated statements of income, rather than in other comprehensive income.  Also, net interest paid or received under the interest rate swaps, which up through September 30 was recognized in “interest expense,” is now recognized in “Gain (loss) on derivative instruments, net.”

 

New Business Initiatives

We have begun an initiative to acquire and aggregate individual whole jumbo mortgage loans, with a goal of securitizing the loans into MBS not issued or guaranteed by a U.S. Government agency or U.S. Government-sponsored entity.  We would expect to initially retain all or a majority of the resulting MBS.  In connection with this initiative, we may enter into arrangements with certain mortgage loan originators whereby we agree to acquire the loans that they originate consistent with our guidelines.  We do not anticipate that the individual mortgage loans and resulting MBS would constitute a significant portion of our assets in the near future.  As of September 30, 2014, we have not yet acquired or entered into commitments to acquire any whole loans.

 

Summary Financial Data

This table includes non-GAAP financial measures.  See the section on non-GAAP measures under “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations” for important information about these non-GAAP measures and reconciliations to the most comparable GAAP measures.

37


 

 

(Unaudited)

Three Months Ended

September 30

 

 

(Unaudited)

Nine Months Ended

September 30

 

 

2014

 

 

2013

 

 

2014

 

 

2013

 

Statement of Income Data

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income on MBS

$

80,969

 

 

$

107,040

 

 

$

266,734

 

 

$

346,396

 

Interest income on short-term cash investments

 

330

 

 

 

303

 

 

 

959

 

 

 

1,104

 

Interest expense

 

(31,950

)

 

 

(51,599

)

 

 

(105,529

)

 

 

(156,955

)

Net interest margin

 

49,349

 

 

 

55,744

 

 

 

162,164

 

 

 

190,545

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating expenses

 

(7,125

)

 

 

(6,697

)

 

 

(21,596

)

 

 

(20,358

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other income (loss):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net realized gain (loss) on sale of MBS

 

237

 

 

 

(225,635

)

 

 

3,089

 

 

 

(214,333

)

Impairment of MBS

 

-

 

 

 

(8,102

)

 

 

-

 

 

 

(8,102

)

Gain (loss) on derivative instruments, net

 

35,430

 

 

 

(77,456

)

 

 

(61,445

)

 

 

(71,920

)

Total other income (loss)

 

35,667

 

 

 

(311,193

)

 

 

(58,356

)

 

 

(294,355

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

77,891

 

 

 

(262,146

)

 

 

82,212

 

 

 

(124,168

)

Dividends on preferred stock

 

(5,480

)

 

 

(5,481

)

 

 

(16,441

)

 

 

(16,441

)

Net income (loss) available to common shareholders

$

72,411

 

 

$

(267,627

)

 

$

65,771

 

 

$

(140,609

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Comprehensive income (loss) available to common

   shareholders

$

58,952

 

 

$

(31,173

)

 

$

224,587

 

 

$

(487,842

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Earnings (loss) per share of common stock, basic and diluted

$

0.75

 

 

$

(2.72

)

 

$

0.68

 

 

$

(1.43

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Comprehensive income (loss) available to common shareholders, basic and diluted

$

0.61

 

 

$

(0.32

)

 

$

2.33

 

 

$

(4.94

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding, basic and diluted

 

96,563,132

 

 

 

98,318,205

 

 

 

96,561,446

 

 

 

98,656,750

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Distributions per common share

$

0.50

 

 

$

0.55

 

 

$

1.50

 

 

$

1.95

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Selected Balance Sheet Data

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

MBS

$

16,890,424

 

 

$

19,843,830

 

 

$

16,890,424

 

 

$

19,843,830

 

Total assets

$

17,647,913

 

 

$

22,087,301

 

 

$

17,647,913

 

 

$

22,087,301

 

Repurchase agreements and dollar roll liability

$

14,920,959

 

 

$

18,829,771

 

 

$

14,920,959

 

 

$

18,829,771

 

Shareholders' equity

$

2,444,492

 

 

$

2,373,641

 

 

$

2,444,492

 

 

$

2,373,641

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Key Statistics  (1)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Average MBS

$

16,484,392

 

 

$

23,825,254

 

 

$

16,993,015

 

 

$

24,257,540

 

Average debt  (2)

$

14,806,602

 

 

$

21,989,907

 

 

$

15,310,810

 

 

$

22,343,437

 

Average equity

$

2,453,988

 

 

$

2,429,402

 

 

$

2,430,031

 

 

$

2,841,185

 

Average portfolio yield  (3)

 

1.96

%

 

 

1.80

%

 

 

2.09

%

 

 

1.90

%

Average cost of funds  (4)

 

0.86

%

 

 

0.94

%

 

 

0.92

%

 

 

0.94

%

Interest rate spread  (5)

 

1.10

%

 

 

0.86

%

 

 

1.17

%

 

 

0.96

%

TBA dollar roll income

$

22,370

 

 

$

-

 

 

$

68,813

 

 

$

-

 

Average TBA dollar roll position

$

3,257,935

 

 

$

-

 

 

$

3,196,737

 

 

$

-

 

Average portfolio yield, including TBA dollar roll income  (6)

 

2.09

%

 

 

1.80

%

 

 

2.22

%

 

 

1.90

%

Effective interest expense  (7)

$

41,630

 

 

$

51,599

 

 

$

126,768

 

 

$

156,955

 

Effective cost of funds  (7)

 

1.12

%

 

 

0.94

%

 

 

1.10

%

 

 

0.94

%

Effective net interest margin  (8)

$

62,039

 

 

$

55,744

 

 

$

209,738

 

 

$

190,545

 

Effective interest rate spread  (9)

 

0.97

%

 

 

0.86

%

 

 

1.12

%

 

 

0.96

%

Core earnings  (10)

$

49,434

 

 

$

43,566

 

 

$

171,701

 

 

$

153,746

 

Core earnings per share, basic and diluted  (10)

$

0.51

 

 

$

0.44

 

 

$

1.78

 

 

$

1.56

 

Average annual portfolio repayment rate  (11)

 

25.31

%

 

 

27.72

%

 

 

21.06

%

 

 

27.28

%

Debt to equity (at period end)  (12)

6.1:1

 

 

7.9:1

 

 

6.1:1

 

 

7.9:1

 

Debt to paid-in capital (at period end)  (13)

5.5:1

 

 

6.8:1

 

 

5.5:1

 

 

6.8:1

 

Effective debt to equity (at period end)  (14)

7.6:1

 

 

7.9:1

 

 

7.6:1

 

 

7.9:1

 

38


 

(1) 

The averages presented herein are computed from our books and records, using daily weighted values.  Percentages are annualized, as appropriate.

(2) 

Average debt includes borrowings under repurchase agreements and dollar roll liability as presented on the consolidated balance sheets.  It does not include off-balance sheet financing related to our TBA dollar roll position.

(3) 

Average portfolio yield was calculated by dividing our interest income on MBS, net of amortization, by our average MBS.

(4) 

Average cost of funds was calculated by dividing our total interest expense (including hedges) by the sum of our average balance outstanding under our repurchase agreements and our average dollar roll liability for the period.

(5) 

Interest rate spread was calculated by subtracting our average cost of funds from our average portfolio yield.

(6) 

Average portfolio yield, including TBA dollar roll income was calculated the same as average portfolio yield other than to include TBA dollar roll income in the numerator and our average TBA dollar roll position in the denominator.

(7) 

Effective interest expense includes certain interest rate swap adjustments.  Effective cost of funds is effective interest expense for the period divided by average repurchase agreements and dollar roll liability for the period.  See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations” for more information, including reconciliations for the periods presented.

(8) 

Effective net interest margin includes certain interest rate swap adjustments and TBA dollar roll income.  See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations” for more information including reconciliations for the periods presented.

(9) 

Effective interest rate spread was calculated by subtracting our effective cost of funds from our average portfolio yield including TBA dollar roll income.

(10) 

Core earnings was calculated by subtracting operating expenses and dividends on preferred stock from effective interest margin.  See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations” for more information, including reconciliations for the periods presented.

(11) 

Our average annual portfolio repayment rate was calculated by dividing our total principal payments received during the year (scheduled and unscheduled) by our average MBS.

(12) 

Debt to equity ratio was calculated by dividing the amounts outstanding under repurchase agreements and dollar roll liability at period end by our shareholders’ equity at period end.

(13) 

Debt to paid-in capital ratio was calculated by dividing the amounts outstanding under repurchase agreements and dollar roll liability at period end by the sum of the carrying value of our preferred stock, the par value of our common stock and additional paid in capital at period end.

(14) 

Effective debt to equity ratio was calculated the same as the debt to equity ratio other than to include off-balance sheet TBA dollar roll liability at period end in the numerator.  Our off-balance sheet TBA dollar roll liability was $3,718,924 as of September 30, 2014.  

Results of Operations

Use of GAAP and Non-GAAP Measures

In addition to our results presented in accordance with GAAP, the discussions of our results of operations and liquidity and capital resources include certain non-GAAP financial information.  We present these non-GAAP measures largely because of three developments during 2013: 1) our cessation of hedge accounting for our interest rates swaps effective September 30, 2013, as discussed elsewhere in this filing, 2) increased use of Futures Contracts as interest rate hedges, and 3) our use of dollar roll transactions, which generate non-traditional investment income and embody off-balance sheet financing.  These changes result in the recognition of material fair value adjustments in net income, as well as line item classifications that our management believes make it difficult to explain fully the economics of our results and strategies without supplemental disclosures. The non-GAAP measures we employ are effective interest expense, effective net interest margin, core earnings and core earnings per share, and financial metrics derived from these non-GAAP measures, such as effective cost of funds and effective leverage.  We use these measures internally to assess our results and financial condition.  Therefore, we believe that providing these measures gives users of financial information additional clarity regarding our performance and financial condition and better enables them to see “through the eyes of management.”

We define effective interest expense as our interest expense determined in accordance with GAAP, adjusted to exclude reclassification of deferred swap losses included in interest expense subsequent to our termination of hedge accounting, to include interest rate swap monthly net settlements subsequent to our termination of hedge accounting, and to include swap equivalent gains and losses related to our Futures Contracts.  

We similarly define effective net interest margin as our net interest margin determined in accordance with GAAP, adjusted to exclude reclassification of deferred swap losses included in interest expense subsequent to our termination of hedge accounting, to include interest rate swap monthly net settlements subsequent to our termination of hedge accounting, to include swap equivalent gains and losses related to our Futures Contracts, and to include TBA dollar roll income.  

39


 

We define core earnings as our effective net interest margin (as defined above) further adjusted to deduct operating expenses and dividends on preferred stock.  

Our interest expense and net interest margin determined in accordance with GAAP reflect monthly cash settlement under our interest rate swap agreements until September 30, 2013, but not thereafter.  We believe that our presentation of effective interest expense, effective net interest margin and core earnings, all of which adjust for this difference after September 30, 2013, provide a better basis for comparison between 2014 and 2013.  

We define our average cost of funds as our total net interest expense (including hedges) determined in accordance with GAAP divided by our average balance outstanding under our repurchase agreements and dollar roll liability computed from our books and records, using daily weighted values.  Similarly, we define effective cost of funds as our total effective interest expense divided by our average balance outstanding under our repurchase agreements and dollar roll liability computed from our books and records, using daily weighted values.  

These measures involve differences from results computed in accordance with GAAP, and should be considered supplementary to, and not as a substitute for, our results computed in accordance with GAAP.  None of the non-GAAP measures we present represents cash provided by operating activities determined in accordance with GAAP, and none is a measure of liquidity or an indicator of our ability to pay cash dividends.  Further, our definitions of these non-GAAP measures may not be comparable to similarly-titled measures of other companies.  Reconciliations of each non-GAAP measure to its nearest directly comparable measure calculated in accordance with GAAP are included below.  

Please see “Summary Financial Data” above for definitions of other metrics we use below, including average portfolio yield and average annual portfolio repayment rate.  

Overview

Our results for 2014 and 2013 have been largely dominated by U.S. Federal Reserve actions, primarily the discussion around the timing of the end of its quantitative easing program and the beginning of increases in the Fed Funds Target Rate.  In 2013, speculation as to the imminence and pace of these events steepened the yield curve, leading to a significantly slower pace of home loan refinancings and losses on our securities.  More specifically, the market dislocation that occurred late in the second quarter of 2013 carried forward into the third quarter of 2013, resulting in significantly higher interest rates and a significant decrease in the value of our investment assets.  In response to the elevated risk profile of our investments that existed at that time, in the third quarter of last year we rebalanced our portfolio to decrease the duration of our assets and our leverage.  This generated sizable realized losses in net income and related transfers of those losses out of other comprehensive income, thus impacting 2014 versus 2013 variances in net income and other comprehensive income.  In 2014, the yield curve generally flattened, leading to an increase in refinancings, particularly over the summer months.  Note, however, that comprehensive income is not impacted by the mere realization of previously recorded unrealized losses.  The primary drivers of our comprehensive income are 1) net investment earnings, and 2) the net impact of changes in the fair value of our earning assets and of our hedging instruments, both of which are driven primarily by changes in interest rates.  

40


 

Our summarized results of operations for the three and nine month periods ended September 30, 2014 and 2013, along with related key metrics, were as follows:

Comprehensive Income

 

Three Months Ended

September 30

 

 

Nine Months Ended

September 30

 

 

Change vs.

Prior Periods

 

 

2014

 

 

2013

 

 

2014

 

 

2013

 

 

Quarter

 

 

Year-to-

Date

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total interest income

$

81,299

 

 

$

107,343

 

 

$

267,693

 

 

$

347,500

 

 

 

-24

%

 

 

-23

%

Interest expense

 

(31,950

)

 

 

(51,599

)

 

 

(105,529

)

 

 

(156,955

)

 

 

38

%

 

 

33

%

Net interest margin

 

49,349

 

 

 

55,744

 

 

 

162,164

 

 

 

190,545

 

 

 

-11

%

 

 

-15

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating expenses

 

(7,125

)

 

 

(6,697

)

 

 

(21,596

)

 

 

(20,358

)

 

 

-6

%

 

 

-6

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other income (loss):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net realized gain (loss) on sale of MBS

 

237

 

 

 

(225,635

)

 

 

3,089

 

 

 

(214,333

)

 

 

100

%

 

 

101

%

Impairment of MBS

 

-

 

 

 

(8,102

)

 

 

-

 

 

 

(8,102

)

 

 

100

%

 

 

100

%

Gain (loss) on derivative instruments, net

 

35,430

 

 

 

(77,456

)

 

 

(61,445

)

 

 

(71,920

)

 

 

146

%

 

 

15

%

Total other income (loss)

 

35,667

 

 

 

(311,193

)

 

 

(58,356

)

 

 

(294,355

)

 

 

111

%

 

 

80

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income

 

77,891

 

 

 

(262,146

)

 

 

82,212

 

 

 

(124,168

)

 

 

130

%

 

 

166

%

Dividends on preferred stock

 

(5,480

)

 

 

(5,481

)

 

 

(16,441

)

 

 

(16,441

)

 

 

0

%

 

 

0

%

Net income available to common shareholders

$

72,411

 

 

$

(267,627

)

 

$

65,771

 

 

$

(140,609

)

 

 

127

%

 

 

147

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Earnings (loss)  per share of common stock, basic and diluted

$

0.75

 

 

$

(2.72

)

 

$

0.68

 

 

$

(1.43

)

 

 

128

%

 

 

148

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive income (loss)

$

(13,459

)

 

$

236,454

 

 

$

158,816

 

 

$

(347,233

)

 

 

-106

%

 

 

146

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Comprehensive income (loss) available to common shareholders

$

58,952

 

 

$

(31,173

)

 

$

224,587

 

 

$

(487,842

)

 

 

289

%

 

 

146

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Comprehensive income (loss) available to common shareholders, basic and diluted

$

0.61

 

 

$

(0.32

)

 

$

2.33

 

 

$

(4.94

)

 

 

293

%

 

 

147

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Core earnings

$

49,434

 

 

$

43,566

 

 

$

171,701

 

 

$

153,746

 

 

 

13

%

 

 

12

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Core earnings per share, basic and diluted

$

0.51

 

 

$

0.44

 

 

$

1.78

 

 

$

1.56

 

 

 

16

%

 

 

14

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding

 

96,563,132

 

 

 

98,318,205

 

 

 

96,561,446

 

 

 

98,656,750

 

 

 

-2

%

 

 

-2

%

3Q14 vs. 3Q13

Comprehensive income increased due primarily to higher net income driven by:

Significant realized losses on sales of MBS in 3Q13 as discussed in “Overview” above; and

The favorable swing in gain on derivative instruments in the current period.

These increases in net income were partially offset by:

The unfavorable swing in other comprehensive income in the current period, which was driven by the significant reclassification of unrealized losses into net income (which has a favorable impact on other comprehensive income) related to the realized losses that occurred in 3Q13.

41


 

Core earnings increased due primarily to:

Higher effective net interest margin, driven by higher average portfolio yield, including TBA dollar roll income, stemming from:

o

Substantially lower premium amortization on lower portfolio prepayments; and

o

Incremental earnings from our TBA dollar roll position in excess of the interest rate spread that would have been achieved had we invested in similar securities financed with repurchase agreements.

These increases to effective net interest margin were partially offset by:

The smaller average size of our earning assets portfolio, which includes our off-balance sheet TBA dollar roll assets.

Each of these factors is discussed further below.

YTD14 vs. YTD13

Comprehensive income increased due primarily to:

The significant favorable swing in other comprehensive income driven by gains in MBS valuation during YTD14 versus significant declines in MBS valuation during YTD13; and

·

The increase in core earnings, as described below.

These increases in comprehensive income were partially offset by:

The unfavorable swing in gain (loss) on derivative instruments in the current period.

Core earnings – See the quarter vs. quarter explanations above, which are directly applicable to the year-to-date results as well.

Total Interest Income

 

Three Months Ended

September 30

 

 

Nine Months Ended

September 30

 

 

Change vs.

Prior Periods

 

 

2014

 

 

2013

 

 

2014

 

 

2013

 

 

Quarter

 

 

Year-to-

Date

 

Coupon interest on MBS and short-term investments

$

110,712

 

 

$

154,506

 

 

$

344,067

 

 

$

486,705

 

 

 

-28

%

 

 

-29

%

Net premium amortization

 

(29,413

)

 

 

(47,163

)

 

 

(76,374

)

 

 

(139,205

)

 

 

-38

%

 

 

-45

%

Total interest income

$

81,299

 

 

$

107,343

 

 

$

267,693

 

 

$

347,500

 

 

 

-24

%

 

 

-23

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Average MBS

$

16,484,392

 

 

$

23,825,254

 

 

$

16,993,015

 

 

$

24,257,540

 

 

 

-31

%

 

 

-30

%

Weighted-average coupon on MBS

 

2.78

%

 

 

2.67

%

 

 

2.78

%

 

 

2.75

%

 

 

4

%

 

 

1

%

Average portfolio yield

 

1.96

%

 

 

1.80

%

 

 

2.09

%

 

 

1.90

%

 

 

9

%

 

 

10

%

Average annual portfolio repayment rate

 

25.31

%

 

 

27.72

%

 

 

21.06

%

 

 

27.28

%

 

 

-9

%

 

 

-23

%

The major drivers of our interest income are the coupons on the securities we own, the size of our MBS portfolio, and the rate of principal repayments.  The following are key components of the change between periods:

3Q14 vs. 3Q13

Total interest income decreased due primarily to:

The smaller average size of our MBS portfolio, which was a result of carrying lower average leverage.

The decrease in total interest income was partially offset by:

A lower rate of premium amortization, driven by lower prepayments on our MBS portfolio.

42


 

YTD14 vs. YTD13

See the quarter vs. quarter explanations above, which are directly applicable to the year-to-date results as well.

Interest Expense

 

Three Months Ended

September 30

 

 

Nine Months Ended

September 30

 

 

Change vs.

Prior Periods

 

 

2014

 

 

2013

 

 

2014

 

 

2013

 

 

Quarter

 

 

Year-to-

Date

 

Repurchase agreements and dollar roll liability

$

12,090

 

 

$

20,668

 

 

$

37,932

 

 

$

65,436

 

 

 

-42

%

 

 

-42

%

Swaps settlements and amortization

 

54

 

 

 

30,931

 

 

 

184

 

 

 

91,519

 

 

 

-100

%

 

 

-100

%

Reclassification of deferred hedge loss

 

19,806

 

 

 

-

 

 

 

67,413

 

 

 

-

 

 

NM

 

 

NM

 

Interest expense

$

31,950

 

 

$

51,599

 

 

$

105,529

 

 

$

156,955

 

 

 

-38

%

 

 

-33

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Effective interest expense

$

41,630

 

 

$

51,599

 

 

$

126,768

 

 

$

156,955

 

 

 

-19

%

 

 

-19

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Average debt

$

14,806,602

 

 

$

21,989,907

 

 

$

15,310,810

 

 

$

22,343,437

 

 

 

-33

%

 

 

-31

%

Average rate on debt

 

0.33

%

 

 

0.38

%

 

 

0.33

%

 

 

0.39

%

 

 

-13

%

 

 

-15

%

Average cost of funds

 

0.86

%

 

 

0.94

%

 

 

0.92

%

 

 

0.94

%

 

 

-8

%

 

 

-2

%

Effective cost of funds

 

1.12

%

 

 

0.94

%

 

 

1.10

%

 

 

0.94

%

 

 

20

%

 

 

18

%

The costs of financing we incur are primarily affected by the amount of our borrowings, the interest rates on those borrowings and the degree to which we hedge those rates.  Note that our cessation of hedge accounting for our interest rate swaps caused changes in the classification of monthly swaps settlements and changes in fair value, effective October 1, 2013.  The following are key components of the change between periods:

3Q14 vs. 3Q13

Interest expense decreased due primarily to:

·

The decrease in our average debt, as a result of lower average leverage in light of the prospect of rising interest rates and our increased use of dollar roll financing (which is accounted for as a derivative);

·

The lower average rate on our debt (primarily repurchase agreements); and

·

Lower swap expenses classified in interest expense in the current period, due to our termination of hedge accounting.

Effective interest expense decreased due primarily to:

·

Lower average debt partially offset by the higher effective cost of funds, which was driven by a higher hedge ratio.

YTD14 vs. YTD13

See the quarter vs. quarter explanations above, which are directly applicable to the year-to-date results as well.

43


 

Net Interest Margin and Interest Rate Spread

 

Three Months Ended

September 30

 

 

Nine Months Ended

September 30

 

 

Change vs.

Prior Periods

 

 

2014

 

 

2013

 

 

2014

 

 

2013

 

 

Quarter

 

 

Year-to-

Date

 

Net interest margin

$

49,349

 

 

$

55,744

 

 

$

162,164

 

 

$

190,545

 

 

 

-11

%

 

 

-15

%

Effective net interest margin

$

62,039

 

 

$

55,744

 

 

$

209,738

 

 

$

190,545

 

 

 

11

%

 

 

10

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Average portfolio yield

 

1.96

%

 

 

1.80

%

 

 

2.09

%

 

 

1.90

%

 

 

0.16

%

 

 

0.19

%

Average cost of funds

 

0.86

%

 

 

0.94

%

 

 

0.92

%

 

 

0.94

%

 

 

-0.08

%

 

 

-0.02

%

Average interest rate spread

 

1.10

%

 

 

0.86

%

 

 

1.17

%

 

 

0.96

%

 

 

0.24

%

 

 

0.21

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Average portfolio yield, including TBA dollar roll income

 

2.09

%

 

 

1.80

%

 

 

2.22

%

 

 

1.90

%

 

 

0.29

%

 

 

0.32

%

Effective cost of funds

 

1.12

%

 

 

0.94

%

 

 

1.10

%

 

 

0.94

%

 

 

0.18

%

 

 

0.17

%

Effective interest rate spread

 

0.97

%

 

 

0.86

%

 

 

1.12

%

 

 

0.96

%

 

 

0.11

%

 

 

0.15

%

The most important metric of our earnings power is our net interest margin, or our “spread” when referred to in percentage form.  Our spread combined with our leverage largely indicate our ability to earn distributable income.  Our interest rate spread increased versus the prior year for both the quarter and year-to-date periods.  See the discussions of total interest income and interest expense above for the key drivers of these changes. Effective net interest margin and effective interest rate spread include earnings from our TBA dollar roll securities, which are discussed under “Other Income (Loss)” below.

Other Income (Loss)

 

Three Months Ended

September 30

 

 

Nine Months Ended

September 30

 

 

Change vs.

Prior Periods

 

 

2014

 

 

2013

 

 

2014

 

 

2013

 

 

Quarter

 

 

Year-to-

Date

 

Other income (loss):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net realized gain (loss) on sale of MBS

$

237

 

 

$

(225,635

)

 

$

3,089

 

 

$

(214,333

)

 

 

-100

%

 

 

-101

%

Impairment of MBS

 

-

 

 

 

(8,102

)

 

 

-

 

 

 

(8,102

)

 

 

-100

%

 

 

-100

%

Gain (loss) on derivative instruments, net

 

35,430

 

 

 

(77,456

)

 

 

(61,445

)

 

 

(71,920

)

 

 

-146

%

 

 

-15

%

Total other income (loss)

$

35,667

 

 

$

(311,193

)

 

$

(58,356

)

 

$

(294,355

)

 

 

-111

%

 

 

-80

%

Our other income generally consists of realized gains and losses on our MBS and realized and unrealized gains and losses on derivative instruments.  Earnings related to these areas tend to be uneven, as can be seen in the table above.  The value of our derivative instruments generally moves inversely to the movement of interest rates. The following are key components of the change between periods:

3Q14 vs. 3Q13

Other income (loss) increased due primarily to:

·

In 3Q13, in response to a significant increase in interest rates, we sold a portion of our MBS portfolio which we had determined was likely to underperform in the future.  These MBS were we sold for a net loss.  We also recognized other-than-temporary impairments in 3Q13 on three bonds that we sold at a loss shortly after quarter end.

·

Our Futures Contracts performed better during the quarter.  Net realized and unrealized gains (losses) on these contracts were $35,595 and $(77,456) for 3Q14 and 3Q13, respectively, and are reflected in “Gain (loss) on derivative instruments, net.”  Interest rates increased in 3Q14 versus decreasing in 3Q13.

44


 

·

Effective September 30, 2013, we de-designated our interest rate swaps as cash flow hedges for accounting purposes.  As a result, beginning on October 1, 2013, monthly interest rate swap settlements and the change in fair value of our interest rate swaps, which amounted to a net gain of $9,057 for 3Q14, were recorded to “Gain (loss) on derivative instruments, net.”  Prior to the de-designation, monthly interest rate swap settlements were recorded to interest expense and changes in interest rate swap fair value were recorded to other comprehensive income.

The increase in other income (loss) was partially offset by:

·

Our TBA dollar roll securities generated a net loss of $(7,918) in 3Q14, consisting of realized and unrealized losses of $(30,288) and TBA dollar roll income of $22,370, both of which are reflected in “Gain (loss) on derivative instruments, net.” We did not begin financing TBA securities in the dollar roll markets until 4Q13.

YTD14 vs. YTD13

Other income (loss) increased due primarily to:

·

Realized losses and impairments on MBS incurred in YTD13, as described in the quarter vs. quarter explanations.

·

Our TBA dollar roll securities generated a net gain of $62,304 in YTD14, consisting of realized and unrealized losses of $(6,509) and TBA dollar roll income of $68,813, both of which are reflected in “Gain (loss) on derivative instruments, net.” We did not begin financing TBA securities in the dollar roll markets until 4Q13.

The increase in other income (loss) was partially offset by:

·

As interest rates have generally trended lower in YTD14, our Futures Contracts lost value.  Net realized and unrealized losses on these contracts were $(94,045) and $(71,920) for YTD14 and YTD13, respectively, and are reflected in “Gain (loss) on derivative instruments, net.”

·

Monthly interest rate swap settlements and the change in fair value of our interest rate swaps, which amounted to a net loss of $(25,721) for YTD14, were recorded to “Gain (loss) on derivative instruments, net.”  Prior to our September 30, 2013 accounting hedge de-designation, monthly interest rate swap settlements were recorded to interest expense and changes in interest rate swap fair value were recorded to other comprehensive income.

 

Operating Expenses

 

Three Months Ended

September 30

 

 

Nine Months Ended

September 30

 

 

Change vs.

Prior Periods

 

 

2014

 

 

2013

 

 

2014

 

 

2013

 

 

Quarter

 

 

Year-to-

Date

 

Management fee

$

4,122

 

 

$

4,522

 

 

$

12,420

 

 

$

13,956

 

 

 

-9

%

 

 

-11

%

Share-based compensation

 

890

 

 

 

637

 

 

 

2,592

 

 

 

1,893

 

 

 

40

%

 

 

37

%

General and administrative

 

2,113

 

 

 

1,538

 

 

 

6,584

 

 

 

4,509

 

 

 

37

%

 

 

46

%

Total

$

7,125

 

 

$

6,697

 

 

$

21,596

 

 

$

20,358

 

 

 

6

%

 

 

6

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Average equity

$

2,453,988

 

 

$

2,429,402

 

 

$

2,430,031

 

 

$

2,841,185

 

 

 

1

%

 

 

-14

%

Operating expenses as a percentage of average equity, annualized

 

1.16

%

 

 

1.10

%

 

 

1.18

%

 

 

0.96

%

 

 

5

%

 

 

24

%

We attempt to efficiently manage our operating expenses as they directly affect the return on investment.  Our total expenses grew as compared to the prior quarter and year-to-date periods as discussed below:

3Q14 vs. 3Q13

Operating expenses increased due primarily to:

·

Our share-based compensation increased as our manager has more employees receiving equity grants; and

·

Our general and administrative costs have increased, including expenses related to additional employees, increased technology (particularly software), insurance and professional fees. These increases are due in part to further enhancement of our risk management capabilities along with initiatives to add new asset classes and/or lines of business.

45


 

The increase in operating expenses was partially offset by:

·

The decline in our management fee.  Our management fee is calculated as a percentage of our equity, adjusted to exclude unrealized gains and losses.  Realized losses on MBS in 3Q13 and realized losses on derivatives from 3Q13 and forward have served to reduce the equity base on which the management fee is calculated.

YTD14 vs. YTD13

See the quarter vs. quarter explanations above, which are directly applicable to the year-to-date results as well.

Reconciliations of Non-GAAP Measures

The reconciliation of core earnings and effective net interest margin to their nearest comparable GAAP measure, net interest margin, is as follows for the three and nine months ended  September 30, 2014 and 2013:

 

Three Months Ended

September 30

 

 

Nine Months Ended

September 30

 

 

2014

 

 

2013

 

 

2014

 

 

2013

 

Net interest margin

$

49,349

 

 

$

55,744

 

 

$

162,164

 

 

$

190,545

 

Less: reclassification of deferred swap losses included in interest expense (after hedge de-designation)

 

19,806

 

 

 

-

 

 

 

67,413

 

 

 

-

 

Interest rate swaps – monthly net settlements (after hedge de-designation)

 

(29,079

)

 

 

-

 

 

 

(88,245

)

 

 

-

 

Losses on maturing Futures Contracts

 

(407

)

 

 

-

 

 

 

(407

)

 

 

-

 

TBA dollar roll income

 

22,370

 

 

 

-

 

 

 

68,813

 

 

 

-

 

Effective net interest margin

 

62,039

 

 

 

55,744

 

 

 

209,738

 

 

 

190,545

 

Total operating expenses

 

(7,125

)

 

 

(6,697

)

 

 

(21,596

)

 

 

(20,358

)

Dividends on preferred stock

 

(5,480

)

 

 

(5,481

)

 

 

(16,441

)

 

 

(16,441

)

Core earnings

$

49,434

 

 

$

43,566

 

 

$

171,701

 

 

$

153,746

 

The reconciliation of effective interest expense to its nearest comparable GAAP measure, interest expense, along with their respective cost of funds measures, is as follows for the three and nine months ended September 30, 2014 and 2013:

 

Three Months Ended September 30

 

 

Nine Months Ended September 30

 

 

2014

 

 

2013

 

 

2014

 

 

2013

 

 

Amount

 

% (1)

 

 

Amount

 

% (1)

 

 

Amount

 

% (1)

 

 

Amount

 

% (1)

 

Interest expense and cost of funds

$

31,950

 

 

0.86

%

 

$

51,599

 

 

0.94

%

 

$

105,529

 

 

0.92

%

 

$

156,955

 

 

0.94

%

Less: reclassification of deferred swap losses included in interest expense (after hedge de-designation)

 

(19,806

)

 

-0.54

%

 

 

-

 

 

-

 

 

 

(67,413

)

 

-0.59

%

 

 

-

 

 

-

 

Interest rate swaps – monthly net settlements (after hedge de-designation)

 

29,079

 

 

0.79

%

 

 

-

 

 

-

 

 

 

88,245

 

 

0.77

%

 

 

-

 

 

-

 

Losses on maturing Futures Contracts

 

407

 

 

0.01

%

 

 

-

 

 

-

 

 

 

407

 

 

0.00

%

 

 

-

 

 

-

 

Effective interest expense and effective cost of funds

$

41,630

 

 

1.12

%

 

$

51,599

 

 

0.94

%

 

$

126,768

 

 

1.10

%

 

$

156,955

 

 

0.94

%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Average repo and dollar roll liability

$

14,806,602

 

 

 

 

 

$

21,989,907

 

 

 

 

 

$

15,310,810

 

 

 

 

 

$

22,343,437

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(1) Dollar amount on an annualized basis as a percentage of average repurchase agreements and dollar roll liability

 

46


 

Contractual Obligations and Commitments

We had the following contractual obligations under repurchase agreements as of September 30, 2014:

 

 

September 30, 2014

 

 

 

Balance

 

 

Weighted Average Contractual Rate

 

 

Contractual Interest Payments

 

 

Total Contractual Obligation

 

Within 30 days

 

$

13,355,150

 

 

 

0.31

%

 

$

2,472

 

 

$

13,357,622

 

30 days to 3 months

 

 

565,809

 

 

 

0.32

%

 

 

154

 

 

 

565,963

 

Over 90 days

 

 

1,000,000

 

 

 

0.45

%

 

 

2,383

 

 

 

1,002,383

 

 

 

$

14,920,959

 

 

 

0.32

%

 

$

5,009

 

 

$

14,925,968

 

From time to time we may make forward commitments to purchase our agency securities.  The commitments require physical settlement with the sellers on settlement date, usually between 30 and 90 days from the date of trade.  We had no such forward purchase commitments as of September 30, 2014.

As of September 30, 2014 we had the following 15-year TBA dollar roll securities:

Face

 

 

Cost

 

 

Fair Market Value

 

 

Due to Brokers

 

$

3,600,000

 

 

$

3,723,183

 

 

$

3,703,228

 

 

$

3,718,924

 

 

As of September 30, 2014 we had the following ARM agency securities forward purchase commitments:

Face

 

 

Cost

 

 

Fair Market Value

 

 

Due to Brokers

 

$

105,239

 

 

$

107,814

 

 

$

107,798

 

 

$

107,814

 

 

In addition, we had contractual commitments under interest rate swap agreements as of September 30, 2014.  These agreements were for a total notional amount of $9.2 billion, had an average rate of 1.30% and a weighted average term of 17 months.

Off-Balance Sheet Arrangements

As of September 30, 2014 and December 31, 2013, we did not maintain any relationships with unconsolidated entities or financial partnerships, such as structured finance, special purpose or variable interest entities, established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.  Further, as of September 30, 2014 and December 31, 2013, we had not guaranteed any obligations of unconsolidated entities or entered into any commitment or intent to provide funding to any such entities.

As of September 30, 2014 and December 31, 2013, we had TBA dollar roll transactions outstanding with cost bases of $3,723,183 and $632,270, respectively.  Forward purchase commitments and TBA dollar roll transactions represent off-balance sheet financing.  Pursuant to ASC 815, Derivatives and Hedging, we account for these positions as derivative transactions and, consequently, they are not reflected in our on-balance sheet debt and leverage ratios.  

Liquidity and Capital Resources

Our primary sources of funds are borrowings under repurchase arrangements and dollar roll transactions, and monthly principal and interest payments on our investments.  Other sources of funds may include proceeds from debt and equity offerings and asset sales.  Since borrowings under most of our debt facilities are uncommitted, we maintain a large diverse set of counterparties in order to help increase our financial flexibility and ability to withstand periods of contracting liquidity in the credit markets.  At September 30, 2014, we had uncommitted repurchase facilities with 32 lending counterparties to finance our portfolio, subject to certain conditions, and have borrowings outstanding with 26 of these counterparties.  

We generally maintain liquidity to pay down borrowings under repurchase arrangements to reduce borrowing costs and otherwise efficiently manage our long-term investment capital.  Because the level of these borrowings can be adjusted on a daily basis, the level of cash and cash equivalents carried on the balance sheet is significantly less important than our potential liquidity available under our borrowing arrangements.  We currently believe that we have sufficient liquidity and capital resources available for the

47


 

acquisition of additional investments, repayments on borrowings and the payment of cash dividends as required for continued qualification as a REIT.  

Effects of Margin Requirements, Leverage and Credit Spreads

Our MBS have values that fluctuate according to market conditions and, as discussed above, the market value of our MBS will decrease as prevailing interest rates or credit spreads increase.  When the value of the securities pledged to secure a repurchase loan decreases to the point where the positive difference between the collateral value and the loan amount is less than the haircut, our lenders may issue a margin call, which means that the lender will require us to pay the margin call in cash or pledge additional collateral to meet that margin call.  Under our repurchase facilities, our lenders have full discretion to determine the value of the MBS we pledge to them.  Lenders also issue margin calls each month when the new factors (amount of principal remaining on the securities pledged as collateral) and scheduled and unscheduled paydowns are published by the issuing agency.  

Similar to the valuation margin calls that we receive on our repurchase agreements, we also receive margin calls on our derivative instruments when their value declines.  This typically occurs when prevailing market rates change adversely, with the severity of the change also dependent on the term of the derivatives involved.  The amount of any margin call will generally be dollar for dollar, on a daily basis.  Our posting of collateral with our counterparties can be done in cash or securities, and is generally bilateral, which means that if the value of our interest rate hedges increases, our counterparty will post collateral with us.  

We experience margin calls in the ordinary course of our business, and under certain conditions, such as during a period of declining market value for MBS, we may experience margin calls daily.  In seeking to manage effectively the margin requirements established by our lenders, we maintain a position of cash and unpledged securities.  We refer to this position as our liquidity.  The level of liquidity we have available to meet margin calls is directly affected by our leverage levels, our haircuts and the price changes on our securities.  If interest rates increase as a result of a yield curve shift or for another reason, such as if credit spreads widen, the prices of our collateral (and our unpledged assets that constitute our liquidity) will decline, we will likely experience margin calls, and we will use our liquidity to meet the margin calls.  There can be no assurance that we will maintain sufficient levels of liquidity to meet any margin calls.  If our haircuts increase, our liquidity will proportionately decrease.  In addition, if we increase our borrowings, our liquidity will decrease by the amount of additional haircut on the increased level of indebtedness.

We intend to maintain a level of liquidity in relation to our assets that enables us to meet reasonably anticipated margin calls but that also allows us to be substantially invested in MBS.  We may misjudge the appropriate amount of our liquidity by maintaining excessive liquidity, which would lower our investment returns, or by maintaining insufficient liquidity, which could force us to liquidate assets into unfavorable market conditions and harm our results of operations and financial condition.

Liquidity Sources—Repurchase Facilities

With repurchase facilities being an integral part of our financing strategy, and thus our financial condition, full understanding of the repurchase market is necessary to understand the risks and drivers of our business.  For example, we anticipate that, upon repayment of each borrowing under a repurchase agreement, we will use the collateral immediately for borrowing under a new repurchase agreement.  While we have borrowing capacity under our repurchase facilities well in excess of what is required for our operations, these borrowing lines are uncommitted and generally do not provide long-term excess liquidity.  Currently, we have not entered into any committed facilities under which the lender would be required to enter into new repurchase agreements during a specified period of time, nor do we presently plan to have liquidity facilities with commercial banks.  

The table below sets forth the average amount of repurchase agreements outstanding during each quarter and the amount of these repurchase agreements outstanding as of the end of each quarter for the last three years.  The amounts at a period end can be both above and below the average amounts for the quarter.  We do not manage our portfolio to have a pre-designated amount of borrowings at quarter end.  These numbers will differ as we implement our portfolio management strategies and risk management strategies over changing market conditions.  

48


 

 

 

Average Daily Repurchase Agreements

 

 

Repurchase Agreements at

Period End

 

 

Highest Daily Repurchase Balance During Quarter

 

 

Lowest Daily Repurchase Balance During Quarter

 

September 30, 2014

 

$

14,806,602

 

 

$

14,920,959

 

 

$

15,034,614

 

 

$

14,607,060

 

June 30, 2014

 

 

15,349,322

 

 

 

15,019,880

 

 

 

15,641,652

 

 

 

15,019,880

 

March 31, 2014

 

 

15,685,392

 

 

 

15,183,457

 

 

 

16,129,683

 

 

 

15,085,150

 

December 31, 2013

 

 

17,464,981

 

 

 

16,129,683

 

 

 

18,832,650

 

 

 

16,119,555

 

September 30, 2013

 

 

21,989,907

 

 

 

18,829,771

 

 

 

23,495,767

 

 

 

18,829,771

 

June 30, 2013

 

 

22,701,463

 

 

 

23,077,252

 

 

 

23,429,222

 

 

 

22,383,758

 

March 31, 2013

 

 

22,342,818

 

 

 

22,586,932

 

 

 

23,017,196

 

 

 

21,337,947

 

December 31, 2012

 

 

23,692,240

 

 

 

22,866,429

 

 

 

24,396,444

 

 

 

22,824,383

 

September 30, 2012

 

 

22,541,260

 

 

 

23,583,180

 

 

 

24,299,580

 

 

 

20,152,860

 

June 30, 2012

 

 

19,599,942

 

 

 

20,152,860

 

 

 

21,086,250

 

 

 

16,449,862

 

March 31, 2012

 

 

15,981,764

 

 

 

16,556,630

 

 

 

16,691,652

 

 

 

15,566,983

 

December 31, 2011

 

 

16,280,835

 

 

 

16,162,375

 

 

 

16,807,220

 

 

 

15,886,231

 

As of September 30, 2014 and December 31, 2013, the weighted average margin requirement, or the percentage amount by which the collateral value must exceed the loan amount, which we also refer to as the haircut, under all our repurchase agreements, was approximately 4.6% (weighted by borrowing amount).  This rate has remained fairly constant as lending conditions have been relatively stable.  

We commonly receive margin calls from our lenders.  We may receive margin calls daily, although we typically receive them once or twice per month.  We receive margin calls under our repurchase agreements for two reasons.  One of these is what is known as a “factor call” which occurs each month when the new factors (amount of principal remaining on the security) are published by the issuing agency, such as Fannie Mae.  The second type of margin call we may receive is a valuation margin call.  Both factor and valuation margin calls occur whenever the total value of our pledged assets drops beyond a threshold amount, which is usually between $100,000 and $250,000.  This threshold amount is generally set by each counterparty and does not vary based on the notional amount of the repurchase agreements outstanding with that counterparty.  Both of these margin calls require a dollar for dollar restoration of the margin shortfall.  The total amount of our unrestricted cash and cash equivalents, plus any unpledged securities, is available to satisfy margin calls, if necessary.  As of September 30, 2014 and December 31, 2013, we had approximately $1.6 billion and $1.6 billion, respectively in MBS, short-term investments, cash and cash equivalents available to satisfy future margin calls.  To date, we have maintained sufficient liquidity to meet margin calls, and we have never been unable to satisfy a margin call, although no assurance can be given that we will be able to satisfy requests from our lenders to post additional collateral in the future.  

One risk to our liquidity is the collateral, or haircut, held by our lenders.  In the event of insolvency by a repurchase agreement lender, our claim to our haircut becomes that of a general unsecured creditor.  

An event of default or termination event under the standard master repurchase agreement would give our counterparty the option to terminate all repurchase transactions existing with us and require any amount due by us to the counterparty to be payable immediately.  Our agreements for our repurchase facilities generally conform to the terms in the standard master repurchase agreement as published by the Securities Industry and Financial Markets Association (SIFMA) as to repayment, margin requirements and the segregation of all purchased securities covered by the repurchase agreement.  In addition, each lender may require that we include supplemental terms and conditions to the standard master repurchase agreement that are generally required by the lender.  Some of the typical terms which are included in such supplements and which supplement and amend terms contained in the standard agreement include changes to the margin maintenance requirements, purchase price maintenance requirements, the addition of a requirement that all controversies related to the repurchase agreement be litigated in a particular jurisdiction and cross default provisions.  These provisions differ for each of our lenders.  

As discussed above under “Market and Interest Rate Trends and the Effect on our Portfolio,” over the last few years the residential mortgage market in the United States has experienced difficult conditions including:

·

increased volatility of many financial assets, including agency securities and other high-quality MBS assets, due to news of potential security liquidations;

·

increased volatility and deterioration in the broader residential mortgage and MBS markets; and

·

significant disruption in financing of MBS.  

49


 

Although these conditions have lessened of late, if they increase and persist, our lenders may be forced to exit the repurchase market, become insolvent or further tighten lending standards or increase the amount of haircut, any of which could make it more difficult or costly for us to obtain financing.  

Liquidity Sources—Dollar Roll Transactions

We also enter into dollar roll transactions as a source of financing for our investments.  Dollar roll transactions represent a form of financing that may be on or off-balance sheet, depending on whether the financed security is a specified pool or a TBA contract.  TBA contracts that are financed using dollar rolls transactions are accounted for as derivatives and shown on our balance sheet at net fair market value.  Under certain market conditions it may be uneconomical for us to roll our TBA contracts and we may need to settle our obligations and take physical delivery of the underlying securities.  If we were required to take physical delivery to settle a TBA contract, we would have to fund our total purchase commitment with cash or other financing sources and our liquidity position could be negatively impacted.  Our TBA dollar roll transactions are also subject to margin requirements governed by our prime brokerage agreements.  In the event of a margin call, we must generally provide additional collateral on the same business day.  The table below sets forth information regarding the volume of dollar roll transactions (both specified pools and TBA contracts) during the quarters in which we have engaged in dollar roll transactions.

 

 

Average Daily Dollar Roll Liability

 

 

Gross Dollar Roll Liability at

Period End

 

 

Highest Daily Dollar Roll Balance During Quarter

 

 

Lowest Daily Dollar Balance During Quarter

 

September 30, 2014

 

$

3,257,935

 

 

$

3,718,924

 

 

$

3,718,924

 

 

$

2,961,749

 

June 30, 2014

 

 

3,393,046

 

 

 

2,961,749

 

 

 

3,549,363

 

 

 

2,961,749

 

March 31, 2014

 

 

2,935,689

 

 

 

3,159,801

 

 

 

3,699,859

 

 

 

1,037,879

 

December 31, 2013

 

 

1,275,595

 

 

 

1,037,879

 

 

 

2,134,370

 

 

 

-

 

The above table shows all dollar rolls at gross amounts.  Certain dollar roll transactions are shown gross as a liability on our balance sheet but the majority is shown in derivative asset or liability, net.

 Liquidity Sources—Capital Offerings

In addition to our repurchase facilities and dollar roll transactions, we also rely on follow-on securities offerings as a source of both short-term and long-term liquidity.  

From time to time, we may sell shares of our common stock in “at the market” offerings.  Sales of the shares of common stock, if any, may be made in private transactions, negotiated transactions or any method permitted by law deemed to be an “at the market” offering as defined in Rule 415 under the Securities Act, including sales made directly on the NYSE or to or through a market maker other than on an exchange.  

On February 29, 2012, we entered into sales agreements (the “2012 Sales Agreements”) with Cantor Fitzgerald & Co. (“Cantor”) and JMP Securities LLC (“JMP”) to establish a new “at-the-market” program (the “2012 Program”).  Under the terms of the 2012 Sales Agreements, we may offer and sell up to 10,000,000 shares of our common stock from time to time through Cantor or JMP, each acting as agent and/or principal.  The shares of our common stock issuable pursuant to the 2012 Program are registered with the SEC on our Registration Statement on Form S-3 (No. 333-179805), which became effective upon filing on February 29, 2012.

No shares of common or preferred stock have been issued since 2012 other than shares issued under our equity incentive plan.

Liquidity Uses—Share Buybacks

On June 18, 2013, our board of directors authorized a stock repurchase program (the “Repurchase Program”) to acquire up to 10,000,000 shares of our common stock.  Over the remainder of 2013, we repurchased 2,485,447 shares of common stock in at-the-market transactions.  During the first quarter of 2014, we repurchased 100,000 shares in at-the-market transactions at a total cost of $1,912, leaving 7,414,553 shares of repurchase capacity available under the Repurchase Program.  We may repurchase additional shares from time to time as liquidity and market conditions permit.

During periods when our board of directors has authorized us to repurchase shares under the Repurchase Program, we will not be authorized to issue shares of common stock under the 2012 Program described above.  Similarly, during periods when our board of directors has authorized us to issue shares of common stock under the 2012 Program, we will not be authorized to repurchase shares under the Repurchase Program.  

50


 

Forward-Looking Statements Regarding Liquidity

Based on our current portfolio, leverage rate and available borrowing arrangements, we believe that our cash flow from operations and available borrowing capacity will be sufficient to enable us to meet anticipated short-term (one year or less) liquidity requirements such as to fund our investment activities, to pay fees under our management agreement, to fund our distributions to shareholders and for general corporate expenses.  

Our ability to meet our long-term (greater than one year) liquidity and capital resource requirements will be subject to obtaining additional debt financing and equity capital.  We may increase our capital resources by obtaining long-term credit facilities or making public or private offerings of equity or debt securities, possibly including classes of preferred stock, common stock, and senior or subordinated notes.  Such financing will depend on market conditions for capital raises and for the investment of any proceeds.  If we are unable to renew, replace or expand our sources of financing on substantially similar terms, it may have an adverse effect on our business and results of operations.  

We generally seek to borrow (on a recourse basis) between six and 12 times the amount of our shareholders’ equity.  Some of our agreements with our derivative counterparties contain restrictive financial covenants, including covenants limiting our leverage levels, the most restrictive of which provide that if we exceed a leverage ratio of 10 to 1, then we could be declared in default on the applicable derivative obligations. At September 30, 2014 and December 31, 2013, our total on-balance sheet borrowings were approximately $14.9 billion and $16.5 billion (excluding accrued interest), respectively, which represented a leverage ratio of approximately 6.1:1 and 7.0:1, respectively.  Our effective leverage ratio (defined as our debt-to-shareholders equity ratio, including the effects of off-balance sheet TBA dollar roll liability) was approximately 7.6:1 and 7.3:1 as of September 30, 2014 and December 31, 2013, respectively.  

Inflation

Virtually all of our assets and liabilities are interest rate sensitive in nature.  As a result, interest rates and other factors directly influence our performance far more than inflation.  Although inflation is a primary factor in any interest rate, changes in interest rates do not necessarily correlate with changes in inflation rates, and these affects may be imperfect or lagging.  Our financial statements are prepared in accordance with GAAP and any distributions we may make will be determined by our board of directors based in part on our REIT taxable income as calculated according to the requirements of the Code; in each case, our activities and balance sheet are measured with reference to fair value without considering inflation.  

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

We seek to manage our risks related to the credit quality of our assets, interest rates, liquidity, prepayment speeds and market value while providing an opportunity to shareholders to realize attractive risk-adjusted returns through ownership of our capital stock.  While we do not seek to avoid risk completely, we believe the risk can be quantified from historical experience and we seek to actively manage that risk in order to earn sufficient compensation to justify taking the risks we undertake and to maintain capital levels consistent with taking such risks.

Interest Rate Risk

Interest rate risk is the primary component of our market risk.  Interest rates are highly sensitive to many factors, including fiscal and monetary policies and domestic and international economic and political considerations, as well as other factors beyond our control.  We are subject to interest rate risk in connection with our investments and our related financing obligations.

Interest Rate Effect on Net Interest Income

Our operating results depend in large part on differences between the yields earned on our investments and the cost of our borrowing and hedging activities.  The cost of our borrowings will generally be based on prevailing market interest rates.  During periods of rising interest rates, the borrowing costs associated with MBS tend to increase while the income earned on MBS may remain substantially unchanged until the interest rates reset.  This results in a narrowing of the net interest spread between the assets and related borrowings and may even result in losses.  The severity of any such decline would depend on our asset/liability composition at the time as well as the magnitude and duration of the interest rate increase.  Further, an increase in short-term interest rates could also have a negative impact on the market value of our investments.  If any of these events happen, we could experience a decrease in net income or incur a net loss during these periods, which could adversely affect our liquidity and results of operations.  

We seek to mitigate interest rate risk through utilization of longer term repurchase agreements and hedging instruments, primarily interest rate swaps and Futures Contracts.  These instruments are intended to serve as a hedge against future interest rate increases on our variable rate borrowings.  Hedging techniques are partly based on assumed levels of prepayments of our MBS.  If prepayments are slower or faster than assumed, the life of the MBS will be longer or shorter, which would reduce the effectiveness of any hedging strategies we may use and may cause losses on such transactions.  Hedging strategies involving the use of derivative

51


 

securities are highly complex and may produce volatile returns.  Hedging techniques are also limited by the rules relating to REIT qualification.  In order to preserve our REIT status, we may be forced to terminate a hedging transaction at a time when the transaction is most needed.  

Interest Rate Cap Risk

The ARMs that underlie our adjustable-rate MBS are typically subject to periodic and lifetime interest rate caps and floors, which limit the amount by which the security’s interest rate may change during any given period.  However, our borrowing costs pursuant to our financing agreements will not be subject to similar restrictions.  Therefore, in a period of increasing interest rates, interest rate costs on our borrowings could increase without limitation, while the interest-rate increases on our adjustable-rate and hybrid MBS could effectively be limited by caps.  MBS backed by ARMs may be subject to periodic payment caps that result in some portion of the interest being deferred and added to the principal outstanding.  This could result in our receipt of less cash from such investments than we would need to pay the interest cost on our related borrowings.  These factors could lower our net interest margin or cause a net loss during periods of rising interest rates, which would harm our financial condition, cash flows and results of operations.  

Interest Rate Mismatch Risk

We fund and hedge a substantial portion of our acquisition of MBS with borrowings that are based on, or move similarly to, LIBOR. The interest rates on our adjustable-rate MBS are generally indexed to LIBOR or another index rate, such as the one-year CMT rate.  However, our borrowing rate may increase relative to LIBOR or one-year CMT rates thus resulting in an increase in our borrowing costs that is not matched by a corresponding increase in the interest earnings on these investments.  Any such interest rate index mismatch could adversely affect our profitability, which may negatively impact distributions to our shareholders.  To seek to mitigate interest rate mismatches, we may utilize the hedging strategies discussed above.  

Our analysis of risks is based on our manager’s experience, estimates and assumptions, including estimates of fair value and interest rate sensitivity.  Actual economic conditions or implementation of investment decisions by our manager may produce results that differ significantly from our manager’s estimates and assumptions.  

Prepayment Risk

As we receive repayments of principal on our MBS from prepayments and scheduled payments, premiums paid on such securities are amortized against interest income and discounts are accreted to interest income.  Premiums arise when we acquire MBS at prices in excess of the principal balance of the mortgage loans underlying such MBS.  Conversely, discounts arise when we acquire MBS at prices below the principal balance of the mortgage loans underlying such MBS.  To date, substantially all of our MBS have been purchased at a premium.  

For financial accounting purposes, interest income is accrued based on the outstanding principal balance of the investment securities and their contractual terms.  In general, purchase premiums on investment securities are amortized against interest income over the lives of the securities using the effective yield method, adjusted for actual prepayment and cash flow activity.  An increase in the principal repayment rate will typically accelerate the amortization of purchase premiums and a decrease in the repayment rate will typically slow the accretion of purchase discounts, thereby reducing the yield/interest income earned on such assets.  

When we receive repayments of principal on our MBS from prepayments and scheduled payments, to maintain a similar rate of interest income, we may want to reinvest the proceeds from these repayments in similar yielding investments.  In addition, due to standard settlement conventions, it may take time to reinvest these proceeds and leave a gap in earnings until we can find and settle on suitable investment assets.  In times of market illiquidity or tight supply, we may have periods where similar types of assets are not available to replace those assets repaid to us.  A decrease in earnings could be significant in periods of high prepayments.  

Extension Risk

We invest in MBS that are either fixed-rate or backed by hybrid ARMs which have interest rates that are fixed for the early years of the loan (typically three, five, seven or 10 years) and thereafter reset periodically.  We compute the projected weighted-average life of our MBS based on assumptions regarding the rate at which the borrowers will prepay the underlying mortgage loans.  In general, when MBS are acquired with borrowings, we may, but are not required to, enter into an interest rate swap agreement or other hedging instrument that effectively fixes our borrowing costs for a period close to the anticipated weighted-average life of the fixed-rate portion of the related MBS.  This strategy is designed to protect us from rising interest rates by fixing a portion of our borrowing costs for the duration of the fixed-rate period of the mortgage loans underlying the related MBS.  

We may structure our interest rate hedges to expire in conjunction with the estimated weighted average life of the fixed period of the mortgage loans underlying our MBS.  However, in a rising interest rate environment, the weighted average life of the mortgage loans underlying our MBS could extend beyond the term of the interest rate swap or other hedging instrument.  This is sometimes

52


 

referred to as “tail risk.”  This could have a negative impact on our results from operations, as borrowing costs would no longer be fixed after the term of the hedging instrument while the income earned on the remaining MBS would remain fixed for a period of time.  This situation may also cause the market value of our MBS to decline, with little or no offsetting gain from the related hedging transactions.  In extreme situations, we may be forced to sell assets to maintain adequate liquidity, which could cause us to incur losses.  

Interest Rate Risk and Effect on Market Value Risk

Another component of interest rate risk is the effect changes in interest rates will have on the market value of our MBS.  We face the risk that the market value of our MBS will increase or decrease at different rates than that of our liabilities, including our hedging instruments.  

We primarily assess our market value interest rate risk by estimating the effective duration of our assets relative to the effective duration of our liabilities.  Effective duration essentially measures the market price volatility of financial instruments as interest rates change.  We generally estimate effective duration using various financial models and empirical data.  Different models and methodologies can produce different effective duration estimates for the same securities.  

The sensitivity analysis tables presented below show the estimated impact of an instantaneous parallel shift in the yield curve, up and down 50 and 100 basis points, on the market value of our interest rate-sensitive investments (“portfolio value”) and net annual interest income, at September 30, 2014 and December 31, 2013, assuming a static portfolio.  When evaluating the impact of changes in interest rates on net interest income, prepayment assumptions and principal reinvestment rates are adjusted based on our manager’s expectations.  The analysis presented utilized assumptions, models and estimates of the manager based on the manager’s judgment and experience.  

September 30, 2014

 

Change in Interest rates

  

Percentage Change in
Projected Net Interest
Income

  

Percentage Change in
Projected Portfolio
Value

+ 1.00%

  

(1.74%)

  

(4.20%)

+ 0.50%

  

(0.01%)

  

(1.74%)

- 0.50%

  

2.17%

  

0.65%

- 1.00%

  

(4.76%)

  

(0.17%)

December 31, 2013

 

Change in Interest rates

  

Percentage Change in
Projected Net Interest
Income

  

Percentage Change in
Projected Portfolio
Value

+ 1.00%

  

0.66%

  

(0.96%)

+ 0.50%

  

1.27%

  

(0.47%)

- 0.50%

  

6.34%

  

0.19%

- 1.00%

  

(2.28%)

  

0.61%

While the charts above reflect the estimated immediate impact of interest rate increases and decreases on a static portfolio, we rebalance our portfolio from time to time either to seek to take advantage of or reduce the impact of changes in interest rates.  It is important to note that the impact of changing interest rates on portfolio value and net interest income can change significantly when interest rates change beyond 100 basis points from current levels.  Therefore, the volatility in the market value of our assets could increase significantly when interest rates change beyond amounts shown in the table above.  In addition, other factors impact the portfolio value of and net interest income from our interest rate-sensitive investments and hedging instruments, such as the shape of the yield curve, market expectations as to future interest rate changes and other market conditions.  Accordingly, portfolio value and net interest income would likely differ from that shown above, and such difference might be material and adverse to our shareholders.  

The above table quantifies the potential changes in net interest income and portfolio value, which includes the value of interest rate swaps, interest rate swaptions, and Eurodollars Futures Contracts should interest rates immediately change.  Given the low level of short-term interest rates at September 30, 2014 and December 31, 2013, we applied a floor of 0%, for all anticipated interest rates included in our assumptions.  Due to presence of this floor, it is anticipated that any hypothetical interest rate decrease would have a limited positive impact on our funding costs beyond a certain level; however, because prepayments speeds are unaffected by this floor, it is expected that any increase in our prepayment speeds (occurring as a result of any interest rate decrease or otherwise) could result in an acceleration of our premium amortization and the reinvestment of such prepaid principal in lower yielding assets.  As a result, the presence of this floor limits the positive impact of any interest rate decrease on our funding costs.  

53


 

 

Credit Risk

We believe that our investment strategy will generally keep our risk of credit losses low to moderate.  However, we intend to retain the risk of potential credit losses on all of the loans underlying the non-agency securities we originate and on our mortgage loans.  With respect to our non-agency securities, credit support contained in MBS deal structures provide a level of protection from losses.  We seek to manage the remaining credit risk through our pre-acquisition due diligence process, and by factoring assumed credit losses into the purchase prices we pay for non-agency securities and mortgage loans.  In addition, with respect to any particular target asset, we evaluate relative valuation, supply and demand trends, shape of yield curves, prepayment rates, delinquency and default rates, recovery of various sectors and vintage of collateral.  We further mitigate credit risk in our mortgage loan portfolio through (1) selecting servicers whose specialties are well matched against the underlying attributes of the mortgage borrowers contained in the loan pools, and (2) an actively managed internal servicer oversight and surveillance program.  At times, we may enter into credit default swaps or other derivative instruments in an attempt to manage our credit risk.  Nevertheless, unanticipated credit losses could adversely affect our operating results.

 

Risk Management

To the extent consistent with maintaining our REIT status, we seek to manage our interest rate risk exposure to protect our portfolio of MBS and related debt against the effects of major interest rate changes.  We generally seek to manage our interest rate risk by:

·

attempting to structure our borrowing agreements to have a range of different maturities, terms, amortizations and interest rate adjustment periods;

·

using derivatives, financial futures, swaps, options, caps, floors and forward sales to adjust the interest rate sensitivity of our MBS and our borrowings;

·

actively managing, on an aggregate basis, the interest rate indices, interest rate adjustment periods, interest rate caps and gross reset margins of our MBS and the interest rate indices and adjustment periods of our borrowings; and

·

monitoring and managing, on an aggregate basis, our liquidity and leverage to maintain tolerance for market value changes.  

 

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures to ensure that material information relating to us is made known to the officers who certify our financial reports and to the members of senior management and the board of directors.  

Based on management’s evaluation as of September 30, 2014, our principal executive officer and principal financial officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) or 15d-15(e) under the Exchange Act) are effective to ensure that the information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in SEC rules and forms.  

Changes in Internal Control over Financial Reporting

There was no change to our internal control over financial reporting during the quarter ended September 30, 2014 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.  

 

PART II. Other Information

Item 1. Legal Proceedings

Our company and our manager are not currently subject to any material legal proceedings.

 

54


 

Item 1A. Risk Factors

Other than the following, there have been no material changes from the risk factors disclosed in the “Risk Factors” section of our Annual Report on Form 10-K for the year ended December 31, 2013 filed with the SEC on February 21, 2014.

 

We may engage in new business initiatives and invest in diverse types of assets and these activities could expose us to new, different or increased risks.

We frequently evaluate new business opportunities and investment strategies that would allow us to diversify our business.  We have invested in and may in the future invest in a variety of mortgage-related and other financial assets that may or may not be closely related to our current business.  Additionally, we may enter other operating businesses that may or may not be closely related to our current business.  These new assets or business operations may have new, different or increased risks than what we are currently exposed to in our business and we may not be able to manage these risks successfully.  Additionally, when investing in new assets or businesses we will be exposed to the risk that those assets, or income generated by those assets or businesses, will affect our ability to meet the requirements to maintain our REIT status or our status as exempt from registration under the Investment Company Act.  If we are not able to successfully manage the risks associated with new assets types or businesses, it could have an adverse effect on our business, results of operations and financial condition.

The expansion of our business into investments in and the securitization of non-agency securities may expose us to additional risks.

Our investments in and the securitizations of non-agency securities may subject us to risks related to its assets and operations, including the following:

·

We have limited experience acquiring mortgage loans in the secondary market and completing securitization transactions.  Our plans to acquire and securitize residential mortgage loans are subject to many of the same risks as those related to our other assets, including risks related to changes in interest rates, economic factors in general, prepayment speeds, hedging strategies and regulatory changes.  However, there can be no assurance that we will be able to continue our securitization program successfully, or at all.

·

We may not be able to acquire residential mortgage loans.

·

We are dependent on third-party service providers, including mortgage loan servicers, for a variety of services related to our business.  We are, therefore, subject to the risks associated with third-party service providers.

·

The purchase of residential mortgage loans in the secondary market requires us, in some circumstances, to maintain certain licenses and failure to maintain those licenses may adversely affect our ability to acquire mortgage loans and successfully operate our securitization program.  

·

Market conditions and other factors may affect our ability to securitize residential mortgage loans.  Our ability to securitize residential mortgage loans will be affected by a number of factors, including conditions in the securities markets, generally; conditions in the asset-backed securities markets, specifically; yields of our portfolio of mortgage loans; the credit quality of our portfolio of mortgage loans; and our ability to obtain any necessary credit enhancement.

·

Our ability to profitably execute or participate in future securitizations of residential mortgage loans is dependent on numerous factors, and if we are not able to achieve our desired level of profitability or if we incur losses in connection with executing or participating in future securitizations, it could materially and adversely impact our business and financial condition.

·

Rating agencies may affect our ability to execute future securitization transactions, or may reduce the returns we would otherwise expect to earn from securitization transactions.

·

We will be exposed to credit risk on the residential mortgage loans we acquire and securitize and we may not be able to successfully manage those risks and mitigate our losses.

·

Our securitization activities expose us to an increased risk of litigation, which may materially and adversely affect our business and financial condition.

55


 

·

We may be subject to counterparty exposure risk in connection with our plans to securitize residential mortgage loans and this risk could adversely affect our ability to operate profitably.

·

We may be subject to fines or other penalties based on the conduct of the mortgage loan originators and brokers that originated the residential mortgage loans that we subsequently acquire.

If we are not able to successfully manage these and other risks related to investing in and securitizing non-agency securities, it may adversely affect our business, results of operations and financial condition.

Our results may experience greater fluctuations by not electing hedge accounting treatment on our derivative instruments.

We have elected to not qualify for hedge accounting treatment under ASC 815, Derivatives and Hedging, for our current derivative instruments.  The economics of our derivative hedging transactions are not affected by this election; however, our GAAP earnings may be subject to greater fluctuations from period to period as a result of this accounting treatment for changes in fair value of certain interest rate swap agreements or for the accounting of the underlying hedged assets or liabilities in our financial statements, as it does not necessarily align with the accounting used for interest rate swap agreements.

 

Item 2. Unregistered Sales of Equity Securities and Use of Proceeds

Not applicable.

 

Item 3. Defaults Upon Senior Securities

None.

 

Item 4. Mine Safety Disclosures

Not Applicable.

 

Item 5. Other Information

None.

 

56


 

Item 6. Exhibits

 

Exhibit

Number

  

Description of Exhibit

 

  31.1

  

 

Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes – Oxley Act of 2002

 

  31.2

  

 

Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes – Oxley Act of 2002

 

  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

 

  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

 

101.INS XBRL

  

 

Instance Document (1)

 

101.SCH XBRL

  

 

Taxonomy Extension Schema Document (1)

 

101.CAL XBRL

  

 

Taxonomy Extension Calculation Linkbase Document (1)

 

101.DEF XBRL

  

 

Additional Taxonomy Extension Definition Linkbase Document Created (1)

 

101.LAB XBRL

  

 

Taxonomy Extension Label Linkbase Document (1)

 

101.PRE XBRL

  

 

Taxonomy Extension Presentation Linkbase Document (1)

 

(1) 

Submitted electronically herewith. Attached as Exhibit 101 to this report are the following documents formatted in XBRL (eXtensible Business Reporting Language): (i) Consolidated Balance Sheets at September 30, 2014 (Unaudited) and December 31, 2013 (Derived from the audited balance sheet at December 31, 2013); (ii) Consolidated Statements of Income (Unaudited) for the three and nine months ended September 30, 2014 and 2013; (iii) Consolidated Statements of Comprehensive Income (Unaudited) for the three and nine months ended September 30, 2014 and 2013; (iv) Consolidated Statements of Changes in Shareholders’ Equity (Unaudited) for the nine months ended September 30, 2014; (v) Consolidated Statements of Cash Flows (Unaudited) for the nine months ended September 30, 2014 and 2013; and (vi) Notes to the Consolidated Financial Statements (Unaudited) for the nine months ended September 30, 2014.

 

57


 

 

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.

 

 

HATTERAS FINANCIAL CORP.

Dated: October 31, 2014

 

BY:

 

/s/ KENNETH A. STEELE 

 

 

 

Kenneth A. Steele

 

 

 

Chief Financial Officer, Treasurer and Secretary

 

 

 

(Principal Financial Officer and Principal Accounting Officer)

 

 

EXHIBIT INDEX

 

Exhibit

Number

  

Description of Exhibit

 

  31.1

  

 

Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes – Oxley Act of 2002

 

  31.2

  

 

Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes – Oxley Act of 2002

 

  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

 

  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

 

101.INS XBRL

  

 

Instance Document (1)

 

101.SCH XBRL

  

 

Taxonomy Extension Schema Document (1)

 

101.CAL XBRL

  

 

Taxonomy Extension Calculation Linkbase Document (1)

 

101.DEF XBRL

  

 

Additional Taxonomy Extension Definition Linkbase Document Created (1)

 

101.LAB XBRL

  

 

Taxonomy Extension Label Linkbase Document (1)

 

101.PRE XBRL

  

 

Taxonomy Extension Presentation Linkbase Document (1)

 

(1)

Submitted electronically herewith. Attached as Exhibit 101 to this report are the following documents formatted in XBRL (eXtensible Business Reporting Language): (i) Consolidated Balance Sheets at September 30, 2014 (Unaudited) and December 31, 2013 (Derived from the audited balance sheet at December 31, 2013); (ii) Consolidated Statements of Income (Unaudited) for the three and nine months ended September 30, 2014 and 2013; (iii) Consolidated Statements of Comprehensive Income (Unaudited) for the three and nine months ended September 30, 2014 and 2013; (iv) Consolidated Statement of Changes in Shareholders’ Equity (Unaudited) for the nine months ended September 30, 2014; (v) Consolidated Statements of Cash Flows (Unaudited) for the nine months ended September 30, 2014 and 2013; and (vi) Notes to the Consolidated Financial Statements (Unaudited) for the nine months ended September 30, 2014.