UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

For the Quarterly Period Ended September 30, 2015

OR

For the transition period from                      to                     .

Commission file number 001-34030

 

HATTERAS FINANCIAL CORP.

(Exact name of registrant as specified in its charter)

 

 

(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:

 

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.

 

 

 

 

 

 

---

 

TABLE OF CONTENTS

 

 

 

 

2

---

 

PART I.  Financial Information

Item 1.  Financial Statements

 

Hatteras Financial Corp.

Consolidated Balance Sheets

 

 

See accompanying notes.

 

3

---

 

Hatteras Financial Corp.

Consolidated Statements of Income

(Unaudited)

 

See accompanying notes.

 

4

---

 

Hatteras Financial Corp.

Consolidated Statements of Comprehensive Income

(Unaudited)

 

 

 

 

5

---

 

Hatteras Financial Corp.

Consolidated Statements of Changes in Shareholders’ Equity

Nine Months Ended September 30, 2015

(Unaudited)

 

 

See accompanying notes.

 

6

---

 

Hatteras Financial Corp.

Consolidated Statements of Cash Flows

(Unaudited)

7

---

 

See accompanying notes.

 

8

---

 

Hatteras Financial Corp.  

Notes to Consolidated Financial Statements

September 30, 2015

(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 adjustable-rate (“ARMs”) and fixed rate 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.  

On August 31, 2015, the Company closed on its acquisition of Pingora Asset Management, LLC (“PAM”) and Pingora Loan Servicing, LLC (“PLS,” and together, “Pingora”), a specialized asset manager focused on investing in new-production performing mortgage servicing rights (“MSR”) and master-servicing residential mortgage loans sourced primarily from direct, ongoing relationships with loan originators.  PAM is a registered investment advisor and PLS is an approved servicer with Fannie Mae, Freddie Mac and Ginnie Mae that is managed by PAM.  The acquisition provides the Company with MSR portfolio management and master-servicing oversight capabilities to the Company, accelerating the Company’s entry into investing in MSR (see Note 6 for further discussion).  In addition to being an income-producing investment, the Company expects that MSR will serve as a natural hedge against the impact of changes in interest rates on the fair value of the Company’s MBS portfolio.  The Company acquired 100% of the voting interests of Pingora for cash consideration of approximately $23.5 million.  In conjunction with the transaction, the Company also issued approximately $4.4 million of equity interests to Pingora management, a significant portion of which is subject to future vesting.  The Company has accounted for the transaction as a business combination in accordance with ASC 805, Business Combinations.  The acquisition did not have a material effect on the Company’s revenues, net income, total assets, financial condition or liquidity for the periods presented.

The opening balance sheet of Pingora as of the acquisition date consisted of the following assets and liabilities:

The acquisition is subject to certain post-closing adjustments and the Company’s allocation of the purchase price to the assets and liabilities acquired may be adjusted accordingly.  

 

9

---

 

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, 2015 are not necessarily indicative of the results that may be expected for the calendar year ending December 31, 2015.  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, 2014.  

The preparation of 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 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 classification.

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.  

PLS has been determined to be a variable interest entity (“VIE”) pursuant to ASC 810, Consolidation.  An owner of a variable interest in a VIE must consolidate the VIE if that owner has: (i) the power to direct the activities that most significantly impact the VIE’s economic performance (“power”), and (ii) the obligation to absorb losses of, or to receive benefits from, the VIE that could potentially be significant to the VIE.  Further, PLS has structured its operations, and the funding and capitalization thereof, into pools of assets and liabilities referred to as “silos.”  Owners of variable interests in a given PLS silo are entitled to all of the returns and risk of loss on the investments and operations in that silo and have no substantive recourse to assets contained in any other silo.  While the Company has power over all PLS silos because it owns 100% of the voting interests of PLS, it only has variable interests in two of the three silos.  In the two silos in which it has a variable interest, the Company holds 100% of the variable interests, making it the primary beneficiary thereof.  These silos have been included in the Company’s consolidated financial statements.  The Company’s consolidated financial statements exclude the PLS silo in which the Company has no variable interest.  The Company is required to reassess the consolidation of VIEs quarterly, and changes in facts and circumstances may change the Company’s determination.  This could result in a material impact to the Company’s consolidated financial statements during subsequent reporting periods.

The following table presents the assets and liabilities of PLS that have been included in the Company’s consolidated balance sheets:

 

10

---

 

Cash and Cash Equivalents

The Company considers all highly liquid investments with original maturities of three months or less to be cash equivalents.  The carrying amounts of cash equivalents approximate their fair value.  Cash and cash equivalents includes pledged cash held in margin accounts at various counterparties as collateral on interest rate swaps, Eurodollar futures contracts and forward commitments to purchase TBA securities (as defined below).

Financial Instruments

The Company considers its cash and cash equivalents, MBS (settled and unsettled), mortgage loans, forward purchase commitments, debt security held-to-maturity, receivable for securities sold, accrued interest receivable, principal payments receivable, payable for unsettled securities, derivative instruments, borrowings and accrued interest payable to meet the definition of financial instruments.  The carrying amount of cash and cash equivalents, receivable for securities sold, accrued interest receivable and payable for unsettled securities approximate their fair value due to the short maturities of these instruments and would be valued using Level 1 inputs.  The carrying amount of borrowings are deemed to approximate fair value given their short-term duration and would be valued using Level 2 inputs. See Note 4 for discussion of the fair value of MBS. See Note 5 for discussion of the fair value of mortgage loans.  See Note 7 for discussion of the fair value of the held-to-maturity debt security.  See Note 9 for discussion of the fair value of derivative instruments, including forward purchase commitments.  See Note 3 for a summary of all the Company’s financial instruments.

The Company limits its exposure to credit losses on its portfolio of securities by purchasing predominantly agency securities.  The Company’s investments are 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 8 for additional information on repurchase agreements and Note 9 for additional information on dollar roll transactions, interest rate swap agreements, interest rate swaptions and futures contracts.  

Mortgage-Backed Securities

The Company invests in MBS representing interests in or obligations backed by pools of single-family residential mortgage loans.  Other than securities for which the fair value option is elected, GAAP requires the Company to classify its investment securities 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.  Other than its investments in credit risk transfer bonds issued by Fannie Mae and Freddie Mac (“GSE CRT bonds”), the Company currently classifies all of its MBS as available-for-sale.  All MBS 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 Company accounts for its GSE CRT bonds under the fair value option.  Under the fair value option, these bonds are carried at fair value and unrealized gains and losses are included in “Net unrealized loss on mortgage backed securities” in the consolidated statements of income.  All the Company’s security purchase and sale transactions are recorded on the trade date.  Gains or losses realized from the sale of securities are included in “Net realized gain on sale of mortgage-backed securities” in the consolidated statements of 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 “Loss on derivative instruments, net.”  See Note 9 for additional information on forward purchase commitments.

The Company assesses its available-for-sale 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

11

---

 

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. No other-than temporary impairments were recognized during the periods presented herein.

Mortgage Loans Held for Investment

The Company purchases individual prime jumbo adjustable-rate whole mortgage loans with the intention of holding them as investments.  In order to finance its investment in the loans, the Company may securitize the loans into MBS not issued or guaranteed by a U.S. Government agency or U.S. Government-sponsored entity.  The Company would then purchase the majority of the MBS that the securitization trusts would issue, and would expect to consolidate the trusts pursuant to GAAP.  The Company has elected to account for these loans under the fair value option, pursuant to ASC Topic 825.  As a result of electing the fair value option, the mortgage loans are carried at fair value with changes therein reflected in consolidated net income (loss), consistent with the accounting for the related hedging instruments, thereby enhancing the usefulness of the Company’s financial statements.  See “Interest Income” below for discussion of the recognition of interest income on mortgage loans.  Other changes in fair value are reported in “Net gain on mortgage loans” in the consolidated statements of income.

Given the Company’s intent to hold the mortgage loans as investments, purchases and sales or paydowns of mortgage loans held for investment are classified as investing cash flows in the consolidated statements of cash flows.

Mortgage Loans Held for Sale

The Company purchases certain individual whole mortgage loans with the intention of selling them to Ginnie Mae for inclusion in securitizations.  The Company has elected to account for these loans under the fair value option, pursuant to ASC Topic 825, because it better reflects the short-term nature of the Company’s holdings in these loans.  As a result of electing the fair value option, the mortgage loans are carried at fair value with changes therein reflected in consolidated net income (loss).  See “Interest Income” below for discussion of the recognition of interest income on mortgage loans.  Other changes in fair value are reported in “Net gain on mortgage loans” in the consolidated statements of income.

Mortgage Servicing Rights

The Company purchases MSR with the intention of holding them as investments.  The Company and its subsidiaries do not originate or directly service mortgage loans.  Rather, it utilizes duly licensed subservicers to perform substantially all servicing functions for the loans underlying the MSR.  The Company has elected to account for its investments in MSR at fair value pursuant to ASC 860, Transfers and Servicing.  As a result, MSR are carried at fair value with changes therein reported in “Net loss on mortgage servicing rights” in the consolidated statements of income.  Servicing fee income and expense are reported on a net basis in “Net mortgage servicing rights income” in the consolidated statements of income.  

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, measured 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 “Net gain (loss) on derivative instruments” 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 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 these instruments in an asset position fail to perform their obligations under the contracts.  The

12

---

 

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.  

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 “Net gain (loss) on derivative instruments” 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 “Net gain (loss) on derivative instruments.”  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 remains in AOCI and is recognized in the Company’s consolidated statements of income as “interest expense” over the remaining term of the interest rate swaps.  See Note 9 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 “Net gain (loss) on derivative instruments.”  Realized and unrealized gains and losses related to TBA dollar roll transactions are also recognized in “Net gain (loss) on derivative instruments.”  TBA dollar roll transactions represent off-balance sheet financing.  

Repurchase Agreements

The Company finances the acquisition of its MBS primarily 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.  

Warehouse Lines of Credit

Warehouse lines of credit include borrowings under mortgage loan warehouse facilities with various counterparties that expire within one year.  These borrowings are collateralized by mortgage loans.  If the value of the underlying collateral (as determined by the counterparty) securing these borrowings decreases, the Company may be subject to margin calls during the period the borrowing is outstanding.  To satisfy these margin calls, the Company may have to pledge additional collateral or repay portions of the borrowings.

Federal Home Loan Bank Advances

During the third quarter of 2015, a wholly-owned subsidiary of the Company became a member of the Federal Home Loan Bank of Atlanta (the “FHLB”).  The FHLB offers a variety of products and services, including short-term and long-term secured advances.  FHLB advances are carried at their contractual amounts.

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.  

13

---

 

Interest Income

Interest income on MBS 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.  

The Company recognizes interest income on mortgage loans held based on their stated coupon rates.  If a loan becomes 90 days past due, it is considered non-performing and is placed in non-accrual status; accrual of interest income ceases and any existing interest receivables are reversed.  Any cash received while a loan is in non-accrual status is first applied to unpaid principal and then to unpaid interest.  In general, non-performing loans are only restored to accrual status when no principal or interest remains due and unpaid.

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 $966 and $890 for the three months ended September 30, 2015 and 2014, respectively.  Share-based compensation expense was $3,045 and $2,592 for the nine months ended September 30, 2015 and 2014, 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.

Other Comprehensive Income (Loss)

Other comprehensive income refers to revenue, expenses, gains, and losses that are recorded directly as an adjustment to shareholders’ equity.  Other comprehensive income for the Company generally arises from unrealized gains or losses generated from changes in market values of available-for-sale securities and derivative instruments that have been designated as accounting hedges.

Recent Accounting Pronouncements

In February 2015, the FASB issued ASU 2015-02, Consolidation (Topic 810): Amendments to the Consolidation Analysis (the “ASU”).  This ASU modifies the principals for consolidation of limited partnerships and similar legal entities (such as limited liability companies) including whether such entities represent variable interest entities or voting interest entities.  The ASU eliminates the presumption that a general partner (or a managing member, in the case of an LLC) should consolidate a limited partnership.  It also changes the conditions under which fees paid to a decision maker or a service provider by a legal entity represent a variable interest in that legal entity.  The ASU is effective January 1, 2016 for calendar year companies and early adoption is permitted.  The Company early adopted this standard effective July 1, 2015.  The adoption of this standard did not have any impact on previous consolidation evaluations.

14

---

 

 

3.       Financial Value Measurements

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.  

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.  

The Company’s Futures Contracts were valued using Level 1 inputs.  The Company’s MBS, mortgage loans held for sale and derivatives other than Futures Contracts were valued using Level 2 inputs.  Mortgage loans held for investment along with related purchase commitments and MSR were valued using Level 3 inputs.  See Notes 4, 5, 6 and 9, respectively, for a discussion of the valuation of MBS, mortgage loans, MSR and derivatives.  

The carrying values and fair values of assets and liabilities that are required to be reported or disclosed at fair value as of September 30, 2015 and December 31, 2014 were as follows.  

⁽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, other than GSE CRT bonds, are classified as available-for-sale and, as such, are reported at their estimated fair value.  The GSE CRT bonds are accounted for under the fair value option as discussed in Note 2.  The MBS market is primarily an over-the-counter market.  As such, there are no standard, public market quotations for individual MBS.  The Company estimates the fair value of its MBS based on a market approach by obtaining values for its securities from third-party pricing services.  The third-party pricing services gather trade data and use pricing models that incorporate such factors as coupons, primary mortgage

15

---

 

rates, prepayment speeds, spread to the U.S. Treasury and interest rate swap curves, periodic and life caps and other similar factors. The third-party pricing services also receive data from traders at broker-dealers 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 regularly reviews the prices obtained and the methods used to derive those prices.  As part of this evaluation, the Company considers security-specific 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’s analysis of pricing information obtained also includes comparing the data received to other available information, such as 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.

In addition to agency securities, the Company’s MBS portfolio includes MBS not issued or guaranteed by a U.S. Government agency or a U.S. Government-sponsored entity (“non-agency securities”) and GSE CRT bonds.  The following table presents the composition of the Company’s MBS at September 30, 2015.

The following table presents the composition of the Company’s MBS at December 31, 2014.  

16

---

 

The components of the carrying value of MBS at September 30, 2015 and December 31, 2014 are presented below:  

The following table presents components of interest income on the Company’s MBS portfolio for the three and nine months ended September 30, 2015 and 2014.

 

Gross gains and losses from sales of MBS for the three and nine months ended September 30, 2015 and 2014 were as follows:

 

 

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, 2015 and December 31, 2014, the Company had the following securities in a loss position as presented in the following two tables:

17

---

 

 

 

The Company did not make the decision to sell the above securities as of September 30, 2015 and December 31, 2014, 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.  No impairment losses were recognized during the periods presented herein.

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.       Mortgage Loans

Mortgage Loans Held for Investment

The Company purchases individual jumbo adjustable-rate whole mortgage loans with the intention of holding them as investments.  The loans are being accounted for under the fair value option.  See Note 2 for further discussion.  As of September 30, 2015, the unpaid principal balance and the fair value of the Company’s mortgage loans held for investment were $259,165 and $265,281, respectively.  As of December 31, 2014, the unpaid principal balance and the fair value of the Company’s mortgage loans held for investment were $30,792 and $31,460, respectively.  The Company did not invest in mortgage loans prior to the fourth quarter of 2014.

The following table provides the geographic distribution of mortgage loans held for investment at September 30, 2015 and December 31, 2014, based on unpaid principal balance.

The following table provides additional data on the Company’s mortgage loans held for investment portfolio at September 30, 2015 and December 31, 2014.

18

---

 

 

No loans were 90 days or more past due and none were on nonaccrual status at September 30, 2015 or December 31, 2014.

The following table presents the rollforward of mortgage loans held for investment for the periods presented.

The portion of the change in the fair value that was attributable to changes in credit risk was immaterial for the three and nine months ended September 30, 2015.

The Company classifies its mortgage loans held for investment as Level 3 in the fair value hierarchy.  Prices for these instruments are obtained from third-party pricing providers which use significant unobservable inputs in their valuations.  These valuations are prepared on an instrument-by-instrument basis and primarily use discounted cash flow models that include unobservable market data inputs including prepayment rates, delinquency levels, and credit losses.  Model valuations are then compared to external indicators such as market price quotations from market makers for similar instruments and recent transactions in the same or similar instruments.  These valuations may also be discounted to reflect illiquidity and/or non-transferability, with the amount of such discount estimated by the third-party pricing provider in the absence of market information.  The valuation of mortgage loans held for investment requires significant judgment by the third-party pricing provider and management.  Assumptions used by the third-party pricing provider due to lack of observable inputs may significantly impact the resulting fair value and therefore the Company’s financial statements.  Management reviews the valuations received from the third-party pricing provider.  As part of this review, prices are compared against other pricing along with internal valuation expertise to ensure assumptions and pricing is reasonable.

The following table provides information about the significant unobservable inputs used in the Level 3 valuation of the Company’s mortgage loans held for investment at September 30, 2015 and December 31, 2014.

Mortgage Loans Held for Sale

The Company purchases individual whole mortgage loans with the intention of selling them to Ginnie Mae for inclusion in securitizations.  As of September 30, 2015, the unpaid principal balance and the fair value of the Company’s mortgage loans held for sale were $9,493 and $9,572, respectively.  The Company did not invest in mortgage loans held for sale prior to the acquisition of Pingora on August 31, 2015.

The Company classifies its mortgage loans held for sale as Level 2 in the fair value hierarchy.  Prices for these instruments are obtained from third-party pricing providers and other applicable market data.  If observable market prices are not available or

19

---

 

insufficient to determine fair value due principally to illiquidity in the marketplace, then fair value is based upon cash flow models that are primarily based on observable market-based inputs but also include unobservable market data inputs, including prepayment speeds, delinquency levels, and credit losses.

 

 

6.       Mortgage Servicing Rights

Through its acquisition of Pingora, as discussed in Note 1, the Company began investing in MSR during the third quarter of 2015.  As discussed in Note 2, MSR are carried at fair value.  The following table presents the rollforward of MSR for the periods presented.

 

The Company classifies its MSR as Level 3 in the fair value hierarchy.  Prices for these instruments are obtained from internal models and third-party pricing providers, both of which use significant unobservable inputs in their valuations.  These valuations are prepared on an instrument-by-instrument basis and primarily use discounted cash flow models that include unobservable market data inputs including prepayment rates, delinquency levels, and discount rates.  Model valuations are then compared to external indicators such as market price quotations from market makers for similar instruments and recent transactions in the same or similar instruments.  These valuations may also be discounted to reflect illiquidity and/or non-transferability, with the amount of such discount estimated by the third-party pricing provider in the absence of market information.  The valuation of MSR requires significant judgment by management and the third-party pricing provider.  Assumptions used for which there is a lack of observable inputs may significantly impact the resulting fair value and therefore the Company’s financial statements.  Management reviews the valuations received from the third-party pricing provider and uses them as a point of comparison to its internally modeled values.  As part of this review, prices are compared against other pricing indicators to ensure assumptions and pricing are reasonable.

The following table provides information about the significant unobservable inputs used in the Level 3 valuation of the Company’s MSR at September 30, 2015 and December 31, 2014.

 

The Company’s mortgage servicing income and mortgage servicing expenses were as follows for the three and nine months ended September 30, 2015 and 2014.

20

---

 

A decline in interest rates could lead to higher-than-expected prepayments of mortgages underlying the Company’s MSR, which would result in a decline in the value of the MSR.  The Company’s investment in MBS mitigates the impact of such a decline on the Company’s total portfolio as a decline in interest rates generally leads to an increase in the value of the Company’s MBS.

7.       Other Investments

Other investments consisted of the following items as of September 30, 2015 and December 31, 2014:

 

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 $14,620 and $14,853 at September 30, 2015 and December 31, 2014, 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 (which represent Level 2 inputs).  The Company accounts for the equity investment in the non-public repurchase lending counterparty under the cost method and concluded there have been no identified events or circumstances that would have a significant adverse effect on the fair value of the investment since the purchase date. As a member of the FHLB, the Company also has an equity investment of $603 in FHLB.  The amount of investment required is partially dependent on the level of advances taken.  This investment is accounted for under the cost method, because the stock can only be sold at its par value, and only to the FHLB.

8.       Borrowings

The Company uses repurchase agreements and FHLB advances to finance MBS purchases.  Repurchase agreements and FHLB advances are collateralized by the Company’s MBS and typically bear interest at rates that are closely related to LIBOR.  At September 30, 2015 and December 31, 2014, the Company had repurchase indebtedness outstanding with 26 and 25 counterparties with a weighted average remaining contractual maturity of 0.9 and 1.0 months, respectively.  

The following table presents contractual maturity information regarding the Company’s repurchase agreements:

 

The fair value of securities and accrued interest the Company had pledged under repurchase agreements at September 30, 2015 and December 31, 2014 was $14,936,324 and $16,575,106, respectively.  

As of September 30, 2015, the Company had $14,132 in advances outstanding with the FHLB at a borrowing rate of 0.2% with a maturity date of October 2015.  The advances are secured by the pledge of agency MBS with a fair value of $15,714.  The Company’s aggregate borrowing capacity with the FHLB is $1 billion.

The Company has access to warehouse lines of credit with three financial institutions to finance purchases of whole mortgage loans.  Borrowings under these facilities are charged interest at a specified margin over the one-month LIBOR interest rate.  At September 30, 2015, the Company has outstanding borrowings with two counterparties totaling $33,172 with maturity dates between November 2015 and March 2016.  The Company has pledged mortgage loans with a fair value of $37,407 as collateral pursuant to these lines of credit.  The borrowing limit under these lines of credit is $300 million.

See Notes 2 and 9 for discussion of TBA dollar roll transactions, which represent off-balance sheet financing.

21

---

 

9.       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 estimated based on the fair value of the underlying interest rate swaps that the Company has the option to enter, and are based on estimates from the counterparty and pricing models.  The fair value of Futures Contracts is based on quoted prices from the exchange on which they trade.  The fair value of MBS forward purchase commitments was determined using the same methodology as MBS as described in Note 4.  The fair value of forward purchase commitments for whole loans was determined using the same methodology as mortgage loans held for investment as described in Note 5.  The Company applies fallout assumptions to the third-party pricing of forward purchase commitments in order to adjust for loans that the counterparties may not successfully issue.  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, 2015 and December 31, 2014, respectively.  

 

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

22

---

 

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 AOCI 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 and nine months ended September 30, 2015 and 2014.  

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 $4,842 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 “Net gain (loss) on derivative instruments” 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 “Net gain (loss) on derivative instruments” beginning October 1, 2013.  

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

 

During the second quarter of 2015, the Company terminated swaps with $1,400,000 of notional value for a payment of $5,210.  The terminated swaps had original maturities extending through December 31, 2015.

Information regarding the Company’s interest rate swaps as of September 30, 2015 and December 31, 2014 follows.  

 

23

---

 

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, 2015, the Company had six interest rate swaptions outstanding, which were entered into during 2015:

 

 

As of December 31, 2014, the Company had four interest rate swaptions outstanding:

 

During the first quarter of 2015, the Company terminated the swaptions held as of December 31, 2014 and received proceeds of $2,049.

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 and mortgage loans.  The following table presents the composition of the Company’s Futures Contracts as of September 30, 2015 and December 31, 2014, respectively.  

 

 

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

 

24

---

 

Each Futures Contract embodies $1 million of notional value and corresponds to a Eurodollar contract for a specific three month timeframe.  The effective dates of the Eurodollar contracts underlying the Company’s Futures Contracts range from 2015 through 2022.  

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, 2015 and 2014.  

To Be Announced Securities Purchases and Mortgage Loan Commitments

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.  15-year TBA contracts may also be financed in the dollar roll market.  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 following table summarizes the Company’s forward purchase commitments as of September 30, 2015.

 

 

The following table summarizes the Company’s forward purchase commitments as of December 31, 2014.

 

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, 2015.

 

25

---

 

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, 2014.

 

The following table shows the components of “Net gain (loss) on derivative instruments” for the three and nine months ended September 30, 2015 and 2014.  

 

 

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

The table below presents the effect of the interest rate swaps that were previously designated as cash flow hedges on the Company’s AOCI for the three and nine months ended September 30, 2015 and 2014.  

 

 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

26

---

 

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.  At September 30, 2015, the Company was in compliance with these requirements.  

As of September 30, 2015, the fair value of derivatives in a net liability position related to these agreements was $22,964.  The Company has collateral posting requirements with each of its counterparties and all interest rate swap agreements were fully collateralized as of September 30, 2015.

10.       Capital Stock

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, 2015, the Company repurchased 373,883 shares of common stock under the Repurchase Program in at-the-market transactions at a total cost of $6,280.  For the three and nine months ended September 30, 2014, the Company repurchased 100,000 shares of common stock at a total cost of $1,912.  As of September 30, 2015, there are 7,040,670 shares of repurchase capacity available under the Repurchase Program.

11.      Earnings per Share

The following table details the Company’s calculation of earnings per share for the three and nine months ended September 30, 2015 and 2014.  

 

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

12.      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 six independent directors.  The Management Agreement expires on February 23, 2016 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

27

---

 

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 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.  

 

 

None of the reimbursement payments were specifically attributable to the compensation of the Company’s executive officers.  Reimbursable expenses above includes rent paid by ACA for the Company’s office space.  As of October 2014, the Company’s office space is rented from a real estate partnership in which some of the Company’s executive officers have a financial interest, at an annual rate of approximately $300.  At September 30, 2015 and December 31, 2014, the Company owed ACA $1,947 and $3,198, respectively, for the management fee and reimbursable expenses, which is included in accounts payable and other liabilities.

28

---

 

13.      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 9.  As discussed in Note 9, 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, 2015.  

 

 

29

---

 

 

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

 

 

30

---

 

The following table rolls forward the components of AOCI, including reclassification adjustments, for the nine months ended September 30, 2015.

 

 

31

---

 

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

 

 

 

 

32

---

 

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; “GSE CRT bonds” refer to credit risk transfer bonds issued by Fannie Mae and Freddie Mac; “MSR” refer to mortgage servicing rights; 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, 2014, filed with the Securities and Exchange Commission (“SEC”) on February 24, 2015.  

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

Cautionary Note Regarding Forward-Looking Statements

This report contains various “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”).  Such statements include, in particular, statements about our plans, intentions, expectations, beliefs, and strategies as they relate to our business as described herein.  You can identify forward-looking statements by the use of forward-looking terminology such as “believes,” “expects,” “may,” “will,” “would,” “could,” “should,” “seeks,” “approximately,” “intends,” “plans,” “projects,” “estimates” or “anticipates” or the negative of these words and phrases or similar words or phrases.  

Although we believe that our plans, intentions, expectations and beliefs reflected in or suggested by such forward-looking statements are reasonable, we cannot assure you that our plans, intentions, expectations or beliefs will be achieved.  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:

33

---

 

These and other risks, uncertainties and factors, including those set forth under the sections captioned “Risk Factors” and “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, 2014, 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.

We cannot guarantee future results, levels of activity, performance or achievements.  You should not place undue reliance on forward-looking statements, which apply only as of the date of this report.  We do not intend and disclaim any duty or obligation to update or revise any industry information or forward-looking statements set forth in this report to reflect new information, future events or otherwise, except as required under the U.S. federal securities laws.

Overview

We are an externally-managed mortgage real estate investment trust (“REIT”) that invests in single-family residential mortgage assets, such as MBS, MSR, residential mortgage loans 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 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 provide an attractive risk-adjusted total return to our shareholders over the long term, primarily through dividends and secondarily through capital appreciation. We selectively acquire and manage an investment portfolio of real estate assets, with the aim of generating attractive returns throughout interest rate cycles. We focus on asset selection and implement a relative value investment approach across various sectors within the residential mortgage market. Our primary investment assets include the following:

Our primary business since inception has been owning and managing agency securities, with a primary focus on ARM securities.  We currently intend for agency securities to continue to be the majority of our investment assets.  As part of this strategy we employ financing, or leverage, to increase our returns. Much of this financing is short-term, which exposes us to interest rate risk. To reduce this risk to levels we believe are acceptable, we use various hedges, such as interest rate swaps, swaptions 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, and “to-be-announced” (“TBA”) securities to protect against adverse interest rate movements.

In August of 2015, we Pingora Asset Management LLC (“PAM”) and acquired Pingora Loan Servicing LLC (“PLS” and together, “Pingora”).  Pingora owns and manages MSR for our own portfolio as well as for third parties.  As the owner of MSR, we purchase the right to control the servicing of mortgage loans from high-quality originators. We do not directly service the mortgage loans we acquire, nor the mortgage loans underlying the MSR we acquire; rather, we contract with licensed third-party subservicers to handle substantially all servicing functions.  In addition to allowing us to own and manage MSR as an additional asset class, we believe Pingora provides attractive synergies with our other lines of business.

We invest in prime nonconforming residential whole mortgage ARM loans through our subsidiary, Onslow Bay Financial LLC (“Onslow”).  Onslow acquires such loans from select mortgage loan originators and secondary market institutions with the intent to securitize the loans through the issuance of non-agency MBS.  Our intention is to generally retain the related subordinated securities, representing the credit risk piece associated with these deals as well as portions of the AAA tranches.  While we purchase loans with the intent of securitization, depending on our view of the securitization market, we may decide to retain a portion of the whole loans as a direct investment.  We do not originate loans or provide direct financing to lenders; rather, through our mortgage loan conduit we

34

---

 

contract with originators to acquire loans they originate that meet our purchase criteria. We expect to complete our first securitization during the fourth quarter of 2015, subject to market conditions.  

In general, our strategy focuses on managing the interest rate risk related to our mortgage assets and our exposure to credit risk.  The table below shows the percentage of our assets in each of our investment strategies as of September 30, 2015 and December 31, 2014:

Prior to September 30, 2014, we generally had no exposure to credit risk.  We believe our new strategy will provide us additional flexibility to allocate capital to our investments opportunistically based on our expectation of market conditions.  Currently, we expect the asset allocations to our non-agency and MSR strategies to grow meaningfully over the coming year.  Specifically, we currently expect to allocate 10-20% of our capital to each of these activities.

Due to our significant exposure to interest rate risk from our investments, we focus on constructing a portfolio with a short effective duration, 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.  

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 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 borrowing rates for the 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, such 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 current and future yields on those MBS.  In periods of declining interest rates, prepayments on our MBS will likely 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.  

35

---

 

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

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, 2014 and subsequent Quarterly Reports on Form 10-Q.  

Market and Interest Rate Trends and the Effect on our Portfolio

Interest Rates

Mortgage markets in general, and our strategy in particular, are interest-rate sensitive.  The relationship between several interest rates is generally determinant of the performance of our company.  In the United States, interest rates are highly determined by the U.S. Federal Reserve actions and outlooks for setting their benchmark rate.  Current speculation about when the U.S. Federal Reserve will increase short term interest rates has increased volatility in asset pricing and nervousness among fixed-rate investors.  The lack of certainty about the rate environment tends to decrease the value of our assets.

Our borrowings in the repurchase agreement 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 investments we buy are affected by the shape of the yield curve, particularly along the area between two-year Treasury rates and 10-year Treasury rates.  The following table shows the 30-day LIBOR as compared to these rates at each period end:

While short-term rates have been relatively stable over this period, long-term rates have been more volatile.  This primarily affects the values of our investments and hedges, and prepayment rates on our investments.

Principal Repayment Rate

Our net interest margin on MBS 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 MBS at a premium to par, the main item that can affect the yield on our MBS after

36

---

 

they are purchased is the rate at which the mortgage borrowers repay the underlying loans.  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 MBS, 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 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”) on our MBS for the periods presented:

 Book Value per Share

As of September 30, 2015, 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 $19.69, down $2.36 from $22.05 at December 31, 2014, largely due to our comprehensive loss along with dividends declared on our common and preferred stock.  Due to volatility in the interest rate markets, the value of our hedges declined as did the value of our investments, a relationship that is normally inversely correlated.  The following table shows the components of our book value on a per share basis at each period end:

Mortgage-backed Securities

We invest in both adjustable-rate and fixed-rate MBS.  At September 30, 2015 and December 31, 2014, we owned $15.5 billion and $17.6 billion, respectively, of MBS.  While our strategy focuses on ARM securities, we also own fixed-rate securities with

37

---

 

estimated durations that we believe are beneficial to the overall mix of our assets.  As of September 30, 2015 and December 31, 2014, our MBS portfolio was purchased at a net premium to par, or face value, with a weighted-average amortized cost of 102.81 and 102.91, respectively, of face value.  As of September 30, 2015 and December 31, 2014, we had approximately $416.7 million and $490.2 million, respectively, of unamortized net premium included in the cost basis of our MBS.  

During the quarter ended September 30, 2015, we purchased approximately $0.9 billion of MBS and TBA securities with a weighted average coupon of 2.85%.  We also sold approximately $0.6 billion of MBS and TBA securities with a weighted average coupon of 2.85% for the three months ended September 30, 2015.  During the nine months ended September 30, 2015, we purchased approximately $2.9 billion of MBS and TBA securities with a weighted average coupon of 2.63% and sold approximately $1.3 billion of MBS and TBA securities with a weighted average coupon of 2.98%.  These actions were taken to better position the portfolio for the expected interest rate environment.

We typically 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).  

In addition to agency securities, our MBS portfolio includes non-agency securities, which are not issued or guaranteed by a U.S. Government agency or a U.S. Government entity, and GSE CRT bonds issued by Fannie Mae and Freddie Mac.  While GSE CRT bonds are debt obligations of Fannie Mae and Freddie Mac, the payment of principal on these securities is not guaranteed and we may incur a loss if the loans in the associated reference pool experience delinquencies exceeding specified thresholds. We assess the credit risk associated with our investment in GSE CRT bonds by assessing the current performance of the loans in the associated reference pool.  Over time, we expect our investments in non-agency securities and GSE CRT bonds to increase further, given our view of the attractive risk-return attributes of these instruments.

Our MBS portfolio consisted of the following securities at September 30, 2015:

38

---

 

As of December 31, 2014, our MBS portfolio consisted of the following securities:

Adjustable-rate securities

As of September 30, 2015 our investment portfolio included ARM securities as follows:

As of December 31, 2014, our investment portfolio included ARM securities as follows:

39

---

 

As of September 30, 2015, excluding any fixed-rate securities, the ARMs underlying our adjustable-rate MBS had fixed interest rates for an average period of approximately 41 months after which time the interest rates reset and become adjustable annually.  At September 30, 2015, 91.7% of our ARMs were still in their initial fixed-rate period and 8.3% of our ARMs have already reached their initial reset period and will reset annually for the life of the security.  As of September 30, 2015, an additional 8.5% 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.  Our ARMs typically have a maximum initial one-time adjustment of 2% or 5%, and the average annual increase (or decrease) to the interest rates is limited to 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, 2015, we owned $1.2 billion 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, 2015.  

 The following table details our fixed-rate securities portfolio at December 31, 2014.  

40

---

 

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 liability.  If we intend 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 we do not intend to take physical delivery of the securities, as is the case with most of our TBA dollar roll transactions, the commitment is not designated as an accounting hedge and the unrealized gains and losses are recorded in “Net loss on derivative instruments.”

The following table shows MBS forward purchases as of September 30, 2015.

The following table shows MBS forward purchases as of December 31, 2014.

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, 2015, we had established 37 borrowing relationships with various investment banking firms and other lenders.  We had an outstanding balance under our repurchase agreements at September 30, 2015 of $14.2 billion with 26 counterparties.  We had an outstanding balance of $15.8 billion at December 31, 2014 with 25 different counterparties.

During the third quarter of 2015, our wholly-owned subsidiary became a member of the Federal Home Loan Bank of Atlanta (the “FHLB”).  The FHLB offers a variety of products and services, including short-term and long-term secured advances.  During the third quarter of 2015, we began funding a portion of our MBS with FHLB advances and a portion of our mortgage loans with warehouse lines of credit, as discussed further under “Liquidity Sources—Borrowings.”

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:

41

---

 

As of September 30, 2015, we had entered into 25 interest rate swap agreements with 8 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 swap agreements provide for fixed interest rates indexed off of one-month LIBOR and effectively fix the floating interest rates on $4.8 billion of borrowings under our repurchase agreements.  We also use 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, 2015 were as follows:

If the rates on our repurchase agreements do not move in tandem with LIBOR, we will be less effective at fixing this cost and our results will differ from expectations.

We also enter into swaptions as a method to offset a portion of the volatility in the value of our MBS.  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, 2015, we had six interest rate swaptions outstanding:

As of December 31, 2014, we had four interest rate swaptions outstanding:

42

---

 

 

Summary Financial Data

The following 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.

43

---

 

44

---

 

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, amortization on MSR, 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 and effective net interest margin as their respective GAAP measure 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 gains and losses on maturities of our Futures Contracts.  

Amortization on MSR represents the portion of the change in MSR fair value that is attributable to the realization of cash flows, and is a non-GAAP measure because we account for MSR under the fair value option.

45

---

 

We define core earnings as our effective net interest margin (as defined above) plus MSR income net of amortization, management fee income and gain from mortgage loans held for sale, less operating expenses and dividends on preferred stock.  For purposes of core earnings, operating expenses are adjusted to exclude transaction expenses and amortization of intangibles stemming from business combinations.

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 across the periods presented.  

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 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 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” for definitions of other metrics we use below, including average portfolio yield and average portfolio repayment rate.  

Overview

Our results since 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 federal funds target rate.  During second quarter of 2015, interest rates rose and the interest rate spread between our MBS and treasury rates widened.  Although rates fell during the third quarter of 2015, the spread between our MBS and treasury rates widened further, offsetting the gain from lower rates.  In addition, interest rate spreads between our hedging instruments (interest rate swaps and Futures Contracts) and treasury rates tightened significantly, causing erosion in the value of our hedges without a corresponding increase in the value of our investments.  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.  In addition, changes in the composition and strategies of our hedge portfolio between periods can cause differing financial results across different periods even if interest rate movements were similar in those periods

We began acquiring individual prime jumbo adjustable-rate whole mortgage loans in the fourth quarter of 2014. As of September 30, 2015, the unpaid principal balance and the fair value of our mortgage loans held for investment were $259,165 and $265,281, respectively.  See Note 5 of our consolidated financial statements, contained in this Form 10-Q, for further information regarding whole mortgage loans owned as of September 30, 2015 and December 31, 2014.

On August 31, 2015, we closed on our acquisition of Pingora, a specialized asset manager focused on investing in new-production performing MSR and master-servicing residential mortgage loans sourced primarily from direct, ongoing relationships with loan originators.  PAM is a registered investment advisor and PLS is an approved servicer with Fannie Mae, Freddie Mac and Ginnie Mae that is managed by PAM.  We acquired 100% of the voting interests of Pingora for cash consideration of approximately $23.5 million.  In conjunction with the transaction, we also issued approximately $4.4 million of equity interests, a significant portion of which is subject to future vesting, to Pingora management. Pingora currently manages an MSR portfolio with over $65 billion of unpaid principal balance including over $50 billion for unrelated third-party investors.  

Through our acquisition of Pingora, we began investing in MSR and purchased $171 million of MSR though Pingora in the third quarter of 2015.  Over time, we expect that incorporating MSRs into our investment portfolio will benefit us in several ways, including further improvement to the risk profile of our balance sheet by providing an income generating asset with a fair value that is inversely correlated to interest rates and our MBS portfolio. See Note 6 of our consolidated financial statements for further information.  

We anticipate growth within our residential whole mortgage loan and MSR initiatives in the coming years, which will impact future operating trends through diversification of our invested assets.  

46

---

 

Our summarized results of operations for the three and nine month periods ended September 30, 2015 and 2014, along with related key metrics, were as follows:

Comprehensive Income

3Q15 vs. 3Q14

Comprehensive income decreased due primarily to:

47

---

 

Core earnings decreased due primarily to:

These decreases to core earnings were partially offset by:

 

Each of these factors is discussed further below.

YTD15 vs. YTD14

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

Total Interest Income

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

3Q15 vs. 3Q14

Total interest income decreased due primarily to:

 

YTD15 vs. YTD14

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

 

48

---

 

Interest Expense

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.  The following are key components of the change between periods:

3Q15 vs. 3Q14

Interest expense decreased due primarily to:

Partially offset by:

Effective interest expense declined as the decline in interest rate swap payments exceeded the increase in losses on maturities of Futures Contracts.  The reduction in swap payments and increase in losses on maturities of Futures Contracts are trends that are expected to continue under existing interest rates, as our interest rate swaps continue to run off and our Futures Contracts portfolio continues to grow.  Further, the cost of our Futures Contracts is not straight-line, meaning that the longer dated contracts are typically more expensive to purchase than near-term contracts.  As a result, this component of our effective interest expense may increase in future periods.  A reconciliation of interest expense and cost of funds to effective interest expense and effective cost of funds is provided under “Reconciliations of Non-GAAP Measures” below.

 

YTD15 vs. YTD14

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

49

---

 

Net Interest Margin and Interest Rate Spread  

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 due to lower deferred swap loss reclassifications.  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.  A reconciliation of net interest margin to effective net interest margin is provided under “Reconciliations of Non-GAAP Measures” below.

Other Income (Loss)

Our other income has historically consisted 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, varying with interest rate movements and/or management actions to re-position our portfolio.  The values of our derivative instruments are positively correlated with movements in interest rates. Beginning in the third quarter of 2015, other income also includes our earnings from MSR investments and other revenues from Pingora.  The following are key components of the change between periods:

50

---

 

3Q15 vs. 3Q14

Other income (loss) swung to a loss due primarily to:

These items were partially offset by:

 

YTD15 vs. YTD14

Other income (loss) swung to a loss due primarily to:

These items were partially offset by:

Operating Expenses

51

---

 

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:

3Q15 vs. 3Q14

Operating expenses increased due primarily to:

 

YTD15 vs. YTD14

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, 2015 and 2014:

⁽¹⁾ Excludes $(290) change in representation and warranty reserve on MSR and includes $(520) of MSR fair value change that represents estimated amortization of the MSR asset for the three and nine months ended September 30, 2015.

⁽²⁾ Excludes $1,132 and $687 of gain (loss) on mortgage loans for the three and nine months ended September 30, 2015.

⁽³⁾ Excludes $805 and $1,721 of transaction expenses related to our acquisition of Pingora for the three and nine months ended September 30, 2015, and $189 of amortization of intangible assets for both periods.

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, 2015 and 2014:

52

---

 

Contractual Obligations and Commitments

We had the following contractual obligations under repurchase agreements as of September 30, 2015:

In addition, we had contractual commitments under interest rate swap agreements as of September 30, 2015.  These agreements were for a total notional amount of $4.8 billion, had an average rate of 0.94% and a weighted average term of 15 months.

From time to time we may make forward commitments to purchase our agency securities.  These commitments generally require physical settlement with the sellers on settlement date, usually between 30 and 90 days from the date of trade.  We purchase 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.  Fifteen-year fixed TBA securities are a highly liquid security, and may be physically settled, net settled or traded as an investment.  Fifteen-year TBA contracts may also be financed in the dollar roll market.  We also purchase ARM agency securities and mortgage loans directly from loan originators.  Such purchase commitments are entered into on a “best-efforts” basis, which allows for the fact that such originators cannot guarantee that the loans in their pipelines (or the resulting agency securities such loans will be packaged into, if applicable) will actually come to fruition.  As of September 30, 2015, we had the following contractual obligations related to such forward purchases of investments:

Off-Balance Sheet Arrangements

As of September 30, 2015 and December 31, 2014, 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

53

---

 

off-balance sheet arrangements or other contractually narrow or limited purposes.  Further, as of September 30, 2015 and December 31, 2014, we had not guaranteed any obligations of unconsolidated entities or entered into any commitment or intent to provide funding to any such entities.

As described in Note 2 of our consolidated financial statements, PLS has been determined to be a variable interest entity (“VIE”) and is structured into silos (separate pools of assets and liabilities).  Owners of variable interests in a given PLS silo are entitled to all of the returns and risk of loss on the investments and operations in that silo and have no substantive recourse to assets contained in any other silo.  Our consolidated financial statements exclude a PLS silo in which we have no variable interest.

As of September 30, 2015 and December 31, 2014, we had TBA dollar roll transactions outstanding of $2,736,748 and $3,509,871, 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, FHLB advances, warehouse lines, 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, 2015, we had uncommitted repurchase facilities with 36 lending counterparties to finance our portfolio, subject to certain conditions, and have borrowings outstanding with 26 of these counterparties.  We also have three warehouse lines supporting our whole loan investment activities, as discussed further under “—Liquidity Sources—Borrowings—Warehouse Lines of Credit.”

We generally maintain liquidity to pay down our borrowings thereby reducing our financing 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 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 loan decreases to the point where the positive difference between the collateral value and the loan amount exceeds a negotiated threshold, 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 borrowing facilities, our lenders have full discretion to determine the value of the collateral we pledge to them.  Lenders also issue margin calls each month when the new factors (amount of principal remaining on the assets 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 borrowing 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.

54

---

 

Liquidity Sources—Borrowings

We utilize repurchase facilities, lines of credit with financial institutions and advances from the FHLB as part of our financing strategy with the most significant being repurchase facilities.

The table below sets forth the average amount of borrowings outstanding during each quarter and the amount of borrowings 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.  

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.  At September 30, 2015 and December 31, 2014, we had repurchase agreement borrowings outstanding of $14,240,809 and $15,759,831, respectively.  As of September 30, 2015 and December 31, 2014, 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 4.4% (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 pledged cash and cash equivalents, plus any unpledged securities, is available to satisfy margin calls, if necessary.  As of September 30, 2015 and December 31, 2014, we had approximately $1.3 billion and $1.5 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.  Because of this risk, we monitor the credit quality of our lenders and diversify our lenders to mitigate risk.  Due to the varying stability of some sovereigns, part of our risk management includes regional monitoring.  We have no direct exposure to any non-U.S. credit, but some of our lenders are subsidiaries of foreign-owned parents.

55

---

 

The following table shows our exposure by region to foreign banks as of September 30, 2015. 

⁽¹⁾ Exposure represents our total assets pledged as collateral in excess of our obligations, including any accrued interest receivable on the pledged assets.

We also have interest rate hedging relationships with subsidiaries of foreign-owned banks.  We make cash payments or pledge securities as collateral as part of a margin arrangement in connection with these hedges that are in a loss position.  In the event that a counterparty were to default on its obligation, we would be exposed to a loss 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.  

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 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.  

Warehouse Lines of Credit

We maintain three warehouse lines of credit in support of our whole loan investment activities: one related to mortgage loans held for investment and two related to mortgage loans held for sale.  These lines of credit are with three different counterparties.  They expire within one year and are collateralized by mortgage loans that we own.  These borrowings are charged interest at a specified margin over the one-month LIBOR interest rate.  At September 30, 2015, we had $33,172 of borrowings outstanding under our warehouse lines of credit, and $266,828 of unused borrowing capacity under these lines.  We did not utilize warehouse lines of credit in 2014.  

If the value of the underlying collateral (as determined by the counterparty) securing these borrowings decreases, we may be subject to margin calls during the period the borrowing is outstanding.  To satisfy these margin calls, we may have to pledge additional collateral or repay portions of the borrowings.

FHLB Advances

Also during the third quarter of 2015, one of our wholly-owned subsidiaries became a member of the FHLB.  FHLB offers a variety of products and services, including secured advances, which charge interest and a specified margin over the one-month LIBOR interest rate.  At September 30, 2015, we had $14,132 of borrowings outstanding with the FHLB, and $985,868 of unused borrowing capacity under this facility.

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.

56

---

 

The above table shows all dollar rolls at gross amounts.  As discussed above, TBA dollar rolls represent off-balance sheet financing.

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, preferred stock, debt securities, depositary shares or warrants under our Registration Statement on Form S-3 (No. 333-204935), which became effective upon filing with the SEC on June 12, 2015, including sales of common stock made in “at the market” offerings.  In an “at the market” offering, 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. 

No shares of common or preferred stock have been issued since 2012 other than shares issued under our equity incentive plan and in connection with our acquisition of Pingora.

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.  During third quarter of 2015, we repurchased 373,883 shares in at-the-market transactions at a total cost of $6,280.  As of September 30, 2015, there is repurchase capacity available under the Repurchase Program of 7,040,670 shares.  We are authorized by our board of directors to repurchase or offer to repurchase shares of common stock under the Repurchase Program and may repurchase additional shares from time to time as liquidity and market conditions permit.

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.  If such limits are exceeded we could be declared in default on the applicable derivative obligations.  At September 30, 2015 we were in compliance with these requirements. At September 30, 2015 and December 31, 2014, our total on-balance sheet borrowings were approximately $14.3 billion and $15.8 billion (excluding accrued interest), respectively, which represented a leverage ratio of approximately 6.5:1 and 6.5:1, respectively.  Our effective leverage ratio (defined as our debt-to-shareholders equity

57

---

 

ratio, including the effects of off-balance sheet TBA dollar roll liability) was approximately 7.8:1 and 8.0:1 as of September 30, 2015 and December 31, 2014, respectively.  

Inflation

Virtually all of our assets and liabilities are interest rate sensitive in nature.  Although changes in expected inflation are an important determinant of changes in interest rates, the two are not perfectly correlated.  Therefore, the impact of inflation on our balance sheet and operating results may be imperfect or lagging.  As a result, interest rates and other factors directly influence our performance far more than inflation.  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 under 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 Margin

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, our borrowing costs 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 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

58

---

 

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 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 margin, at September 30, 2015 and December 31, 2014, assuming a static portfolio.  When evaluating the impact of changes in

59

---

 

interest rates on net interest margin, 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, 2015

 

December 31, 2014

 

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 margin 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 margin 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 margin 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 margin and portfolio value, which includes the value of interest rate swaps, interest rate swaptions, and Futures Contracts should interest rates immediately change.  Given the low level of short-term interest rates at September 30, 2015 and December 31, 2014, 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.  

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 our non-agency securities, GSE CRT bonds, and 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, shapes 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.

60

---

 

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:

 

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, 2015, 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, 2015 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.

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, 2014 filed with the SEC on February 24, 2015 and our subsequent Quarterly Reports on Form 10-Q.

Our investments in mortgage servicing rights may expose us to additional risks.

Our investments in mortgage servicing rights may subjects us to certain additional risks, including the following:

61

---

 

If we are not able to successfully manage these and other risks related to investing and managing mortgage servicing rights, it may adversely affect our business, results of operations and financial condition.

We may not be able to raise the capital required to finance our assets and grow our business.

The growth of our operating businesses may require access to debt and equity capital that may or may not be available on favorable terms or at the desired times, or at all. In addition, we invest in certain assets, such as MSR, for which financing has historically been difficult or costly to obtain. Our inability to obtain financing for our target assets could require us to seek debt or equity capital that may be more costly or unavailable to us. We cannot assure you that we will have access to any debt or equity capital on favorable terms or at the desired times, or at all. Our inability to raise such capital or obtain financing on favorable terms could materially adversely affect our liquidity position, business, results of operations and financial condition.

In addition, as discussed in the notes to our consolidated financial statements, the acquisition of Pingora on August 31, 2015 was accounted for using the acquisition method.  Substantially all of the $23.5 million purchase price for Pingora was allocated to intangible assets including approximately $4.0 million of goodwill. Pingora’s inability to raise debt or equity capital or obtain financing on favorable terms could materially adversely affect its business and profitability, and could require us to recognize an impairment on these intangible assets.

The assets in our portfolio are recorded at fair value, but there may be substantial uncertainty as to the value of certain assets.

Some of the assets in our portfolio are not publicly traded. The fair value of securities and other assets that are not publicly traded may not be readily determinable. We value these assets quarterly at fair value, as determined in accordance with the Financial Accounting Standards Board Accounting Standard Codification 820, Fair Value Measurements and Disclosures, which may include unobservable inputs. Because such valuations are subjective, the fair value of certain of our assets may fluctuate over short periods of time and our determinations of fair value may differ materially from the values that would have been used if a ready market for these securities existed. In addition, the mortgage loans held for investment and MSR we acquire are recorded at fair value on our balance sheet based upon significant estimates and assumptions. The determination of the fair value of mortgage loans held for investment and MSR requires management to make numerous estimates and assumptions. Such estimates and assumptions include, without limitation, estimates of future cash flows associated with the assets based upon assumptions involving interest rates as well as the prepayment rates, delinquency levels and foreclosure rates of the underlying mortgage loans. The ultimate realization of the value of mortgage loans held for investment and MSR may be materially different than the fair values of such assets as may be reflected in our consolidated balance sheet as of any particular date. The use of different estimates or assumptions in connection with the valuation of these assets could produce materially different fair values for such assets, which could have a material adverse effect on our business, results of operations and financial condition. Accordingly, there may be material uncertainty about the fair value of any mortgage loans and MSR we acquire.

62

---

 

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

Issuer Purchases of Equity Securities

Item 3. Defaults Upon Senior Securities

None.

Item 4. Mine Safety Disclosures

Not Applicable.

Item 5. Other Information

None.

 

63

---

 

Item 6. Exhibits

 

 

 

 

64

---

 

 

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.

 

 

 

EXHIBIT INDEX