In this Quarterly Report on Form 10-Q, we refer to CYS Investments, Inc. 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: RMBS refers to residential
mortgage-backed securities; agency securities or Agency RMBS refers to our RMBS
that are issued or whose principal and interest payments are guaranteed by a
federally chartered corporation, such as the Federal National Mortgage
Association ("Fannie Mae") or the Federal Home Loan Mortgage Corporation
("Freddie Mac"), or an agency of the U.S. government, such as the Government
National Mortgage Association ("Ginnie Mae"); ARMs refers to adjustable-rate
mortgage loans that typically have interest rates that adjust annually to an
increment over a specified interest rate index; and hybrids refers to ARMs that
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 Item 1 of this Quarterly Report on
Form 10-Q as well as our Annual Report on Form 10-K for the fiscal year ended
December 31, 2011, filed on February 13, 2012.
Forward Looking Statements
When used in this Quarterly Report on Form 10-Q, in future filings with the
Securities and Exchange Commission ("SEC") or in press releases or other written
or oral communications, statements which are not historical in nature, including
those containing words such as "believe," "expect," "anticipate," "estimate,"
"plan," "continue," "intend," "should," "may" or similar expressions, are
intended to identify "forward-looking statements" within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended, and, as such, may involve known and
unknown risks, uncertainties and assumptions. The forward-looking statements we
make in this Quarterly Report on Form 10-Q include, but are not limited to,
statements about the following:
• the effect of movements in interest rates on our assets and
liabilities (including our hedging instruments) and our net income;
• our investment, financing and hedging strategy and the success of
these strategies;
• the effect of increased prepayment rates on our portfolio;
• our ability to convert our assets into cash or extend the financing
terms related to our assets;
• the effect of widening credit spreads on the value of our assets and
investment strategy;
• the types of indebtedness we may incur;
• our ability to quantify risks based on historical experience;
• our ability to be taxed as a real estate investment trust ("REIT")
and to maintain an exemption from registration under the Investment
Company Act of 1940, as amended (the "Investment Company Act");
• our assessment of counterparty risk;
• our ability to meet short term liquidity requirements with our cash
flow from operations and borrowings;
• our liquidity;
• our asset valuation policies;
• our distribution policy; and
• the effect of recent U.S. Government actions on interest rates and
the housing and credit markets.
Forward-looking statements are based on our beliefs, assumptions and
expectations of our future performance, taking into account all information
currently available to us. These beliefs, assumptions and expectations are
subject to risks and uncertainties and can change as a result of many possible
events or factors, not all of which are known to us. If a change occurs, our
business, financial condition, liquidity and results of operations may vary
materially from those expressed in our forward-looking statements. The following
factors could cause actual results to vary from our forward-looking statements:
• the factors referenced in this Quarterly Report on Form 10-Q;
• changes in our investment, financing and hedging strategy;
• the adequacy of our cash flow from operations and borrowings to meet
our short term liquidity requirements;
• the liquidity of our portfolio;
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• unanticipated changes in our industry, interest rates, the credit
markets, the general economy or the real estate market;
• changes in interest rates and the market value of our Agency RMBS;
• changes in the prepayment rates on the mortgage loans
underlying our
Agency RMBS;
• our ability to borrow to finance our assets;
• changes in government regulations affecting our business;
• our ability to maintain our qualification as a REIT for federal
income tax purposes;
• our ability to maintain our exemption from registrationunder the
Investment Company Act and the availability of such exemption in the
future; and
• risks associated with investing in real estate assets,including
changes in business conditions and the general economy.
These and other risks, uncertainties and factors, including those described
elsewhere in this report, could cause our actual results to differ materially
from those projected in any forward-looking statements we make. All
forward-looking statements speak only as of the date on which they are made. New
risks and uncertainties arise over time and it is not possible to predict those
events or how they may affect us. Except as required by law, we are not
obligated to, and do not intend to, update or revise any forward-looking
statements, whether as a result of new information, future events or otherwise.
Overview
We are a specialty finance company created with the objective of achieving
consistent risk-adjusted investment income. We seek to achieve this objective by
investing, on a leveraged basis, in Agency RMBS. In addition, our investment
guidelines permit investments in collateralized mortgage obligations issued by a
government agency or government sponsored entity that are collateralized by
Agency RMBS ("CMOs"), although we had not invested in any CMOs as of June 30,
2012. We commenced operations in February 2006, and completed our initial public
offering in June 2009. Our common stock is traded on the New York Stock Exchange
under the symbol "CYS".
We earn investment income from our investment portfolio, and we use leverage to
seek to enhance our returns. Our net investment income is generated primarily
from the difference, or net spread, between the interest income we earn on our
investment portfolio and the cost of our borrowings and hedging activities. The
amount of net investment income we earn on our investments depends in part on
our ability to control our financing costs, which comprise a significant portion
of our operating expenses. Although we leverage our portfolio investments in
Agency RMBS to seek to enhance our potential returns, leverage also may
exacerbate losses.
While we use hedging to mitigate some of our interest rate risk, we do not hedge
all of our exposure to changes in interest rates. This is because 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 achieve attractive spreads on our
portfolio.
In addition to investing in issued pools of Agency RMBS, we regularly utilize
forward settling transactions, including forward-settling purchases of Agency
RMBS where the pool is "to-be-announced" ("TBAs"). Pursuant to these TBAs, we
agree to purchase, for future delivery, Agency RMBS with certain principal and
interest terms and certain types of underlying collateral, but the particular
Agency RMBS to be delivered is not identified until shortly before the TBA
settlement date. For our other forward settling transactions, we agree to
purchase, for future delivery, Agency RMBS. However, unlike our TBAs, these
forward settling transactions reference an identified Agency RMBS.
We have elected to be taxed as a REIT and have complied, and intend to continue
to comply, with the provisions of the Internal Revenue Code of 1986, as amended
(the "Internal Revenue Code"), with respect thereto. Accordingly, we generally
do not expect to be subject to federal income tax on our REIT taxable income
that we currently distribute to our stockholders if certain asset, income and
ownership tests and recordkeeping requirements are fulfilled. Even if we
maintain our qualification as a REIT, we may be subject to some federal, state
and local taxes on our income.
Factors that Affect our Results of Operations and Financial Condition
A variety of industry and economic factors may impact our results of operations
and financial condition. These factors include:
• interest rate trends;
• prepayment rates on mortgages underlying our Agency RMBS, and credit
trends insofar as they affect prepayment rates;
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• competition for investments in Agency RMBS;
• actions taken by the U.S. Government, including the U.S. Federal Reserve
and the U.S. Treasury;
• credit rating downgrades of the United States' and certain European
countries' sovereign debt; and
• other market developments.
In addition, a variety of factors relating to our business may also impact our
results of operations and financial condition. These factors include:
• our degree of leverage;
• our access to funding and borrowing capacity;
• our borrowing costs;
• our hedging activities;
• the market value of our investments; and
• the REIT requirements and the requirements to qualify for a registration
exemption under the Investment Company Act.
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 the
corresponding liabilities, such assets will likely change in value more slowly
than the corresponding liabilities. Consequently, changes in interest rates,
particularly short term interest rates, may significantly influence our net
investment income.
Our net investment income may be affected by a difference between actual
prepayment rates and our projections. Prepayments on loans and securities may be
influenced by changes in market interest rates and homeowners' ability and
desire to refinance their mortgages. To the extent we have acquired assets at a
premium or discount to par value, changes in prepayment rates may impact our
anticipated yield.
Trends and Recent Market Impacts
The volatility in the U.S. interest rate markets in 2011 and early 2012 has
produced opportunities in our markets. While the performance of the U.S. economy
in 2011 was disappointing primarily due to a lack of significant job growth, the
first quarter of 2012 appeared to show some improvement in job growth and U.S.
real gross domestic product ("GDP") growth, however, this trend has not been
sustained and GDP growth expectations have declined in the second quarter of
2012. The U.S. Federal Reserve (the "Fed") announced in March 2012 that it
intended to keep the Federal Funds Target Rate near zero through late-2014,
which has had a positive effect on the markets for Agency RMBS. The U.S.
unemployment rate declined in recent months from 8.5% in December 2011 to 8.2%
in March 2012, however, this downward trend has not continued into the second
quarter of 2012, with the rate still at 8.2% in June 2012. Uncertainty in the
marketplace surrounding the longer-term pace of job creation continues to be a
concern for the U.S. economy and likely will remain a primary focus in the
upcoming presidential election. While existing home sales have increased
recently, with some regions showing a small increase in average home prices, the
residential construction sector remains depressed. The over hang of the European
debt crisis and the recent downgrading of a significant number of U.S. banks by
Moody's also adds pressure to the U.S. economy and consumer confidence.
Overall inflation and wage pressures have remained relatively muted in recent
months despite prices of crude oil and gasoline increasing in the first quarter
of 2012 and fluctuating more in the second quarter of 2012. This environment and
the $400 billion maturity extension, program "operation twist," which was
increased in size in June 2012 by $267 billion and extended through the end of
2012, described below in "- Government Activity," have created strong demand for
U.S. government guaranteed assets, and valuations of Agency RMBS have increased
due to such demand.
The following trends and recent market impacts may also affect our business:
Interest Rates
During the six months ended June 30, 2012, the U.S. employment picture worsened
causing long term interest rates to fall with the 10 Year U.S. Treasury rate
(the "10 Year") decreasing from 1.88% at December 31, 2011 to 1.64% at June 30,
2012.
The demand for consumer credit, specifically mortgage loans has been strong.
This demand has come primarily from banks because of the favorable treatment of
Agency RMBS under bank risk based capital guidelines. In addition to banks,
demand for mortgage loans has come from the Fed, which in September 2011
announced it would reinvest principal and
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interest received from its holdings of Agency RMBS. Conversely, the supply of
mortgage loans continues to be subdued.
While we had recently seen a slightly more positive trend in U.S. employment and
housing data, the U.S. economy still appears to be in a period of slow growth
with little inflationary pressure. The U.S. Federal Funds Target Rate remains at
0-0.25%, with no change since mid-December 2008. Since December 2010, 30-Day
LIBOR has also remained low with a rate of 0.25% at June 30, 2012, up six basis
points from a year ago. However, 3-Month LIBOR increased by 21 basis points to
0.46% at June 30, 2012. The availability of repurchase agreement financing is
stable with interest rates between 0.32% and 0.43% for 30-90 day repurchase
agreements at June 30, 2012. Several of our repurchase agreement counterparties
were downgraded by Moody's in June 2012. We believe that these downgrades
resulted in slightly higher financing costs, and this modestly-incremental cost
is likely to remain in place for the foreseeable future. The following table
presents 30-Day LIBOR, 3-Month LIBOR and the U.S. Federal Funds Target Rate at
the end of each respective fiscal quarter:
Date 30-Day LIBOR 3-Month LIBOR Federal Funds Target Rate
June 30, 2012 0.246 % 0.461 % 0.25 %
March 31, 2012 0.241 % 0.468 % 0.25 %
December 31, 2011 0.295 % 0.581 % 0.25 %
September 30, 2011 0.239 % 0.374 % 0.25 %
June 30, 2011 0.186 % 0.246 % 0.25 %
March 31, 2011 0.243 % 0.303 % 0.25 %
December 31, 2010 0.261 % 0.303 % 0.25 %
Source: Bloomberg
Longer-term interest rates fell sharply in 2011, and have continued to decrease
in the six months ended June 30, 2012. The yield on five year U.S. Treasury
notes was 2.01% at the beginning of 2011 and 0.83% at December 31, 2011. During
the six months ended June 30, 2012, the yield on five year U.S. Treasury notes
decreased 11 basis points to 0.72%, while the yield on par-priced Fannie Mae
Agency RMBS backed by 15 year fixed rate mortgage loans decreased 39 basis
points from 2.10% to 1.71%. Rates on three year interest rate swaps, currently
one of our primary hedging vehicles, decreased by 20 and 46 basis points during
the six months ended June 30, 2012 and year ended December 31, 2011,
respectively, with the three year swap rate at 0.624% at June 30, 2012.
Meanwhile, the 3-Month LIBOR, which is the rate used to calculate the interest
payments we receive on interest rate swaps and interest rate caps, if any,
decreased by 12 basis points during the six months ended June 30, 2012, to
0.461%. During the three months ended June 30, 2012, the Company purchased
$6,317.3 million of Agency RMBS with a weighted average yield of 2.01%.
The following table illustrates this market environment by comparing market
levels for three benchmark securities or rates, the yield on five year U.S.
Treasury Notes, the three year interest rate swap rate and the price of 15 year
Fannie Mae 3.5% Agency RMBS:
Market Prices of 15
Five Year U.S. Three Year Interest Year Fannie Mae
Date Treasury Note Rate Swap Rates 3.5% Agency RMBS
June 30, 2012 0.718 % 0.624 % $ 105.703
March 31, 2012 1.039 % 0.758 % $ 104.922
December 31, 2011 0.832 % 0.820 % $ 104.578
September 30, 2011 0.952 % 0.736 % $ 104.422
June 30, 2011 1.761 % 1.147 % $ 101.828
March 31, 2011 2.277 % 1.571 % $ 100.078
December 31, 2010 2.006 % 1.279 % $ 100.328
Source: Bloomberg
The increase in market prices of Agency RMBS during 2011 and the first six
months of 2012 was impacted by weak economic data and the various programs of
the U.S. Federal Reserve, including the September 2011 announcement of the $400
billion maturity extension program, now increased by $267 billion and extended
through the end of 2012, as described below in "-Government Activity." In 2012,
the yield curve has flattened slightly. Below is a graph of the yield curve at
June 30, 2012, December 31, 2011 and December 31, 2010.
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[[Image Removed]]
Prepayment Rates and Loan Buy-back Programs
Prepayment rates were very low in the summer of 2011 but have begun to increase
as mortgages rates continue to push against historical lows. According to data
provided by Freddie Mac, the weighted average commitment rate on a 30 year fixed
rate mortgage was 3.68% in June 2012, compared to 3.96% in December 2011.
However, the continued weak U.S. housing market and high unemployment have
reduced many U.S. homeowners' ability to refinance their mortgages. The
following table presents the prepayment rates for Fannie Mae Agency RMBS backed
by 15 year and 30 year fixed rate mortgages:
Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11
Aug-11 Sep-11 Oct-11 Nov-11 Dec-11
15 Year 17.8 % 13.6 % 13.7 % 12.2 % 12.2 % 14.7 % 15.6 % 18.4 % 23.0 % 25.2 % 23.2 % 20.8 %
30 Year 19.5 % 15.5 % 15.4 % 13.4 % 13.0 % 14.9 % 14.9 %
16.8 % 21.4 % 24.4 % 25.2 % 23.6 %
Jan-12 Feb-12 Mar-12 Apr-12 May-12 Jun-12
15 Year 18.8 % 20.9 % 21.6 % 18.7 % 18.5 % 19.2 %
30 Year 21.6 % 25.0 % 25.8 % 23.7 % 24.8 % 25.8 %
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[[Image Removed]]
Source: eMBS
The CPR of the Company's Agency RMBS portfolio was approximately 17.8% for the
month of July 2012.
Government Activity
On January 4, 2012, the U.S. Federal Reserve released a report titled "The U.S.
Housing Market: Current Conditions and Policy Considerations" to Congress, which
provided a framework for thinking about certain issues and tradeoffs that policy
makers might consider. It is unclear how future legislation may impact the
housing finance market and the investing environment for Agency RMBS as the
method of reform is undecided and has not yet been defined by the regulators.
On September 21, 2011, the U.S. Federal Reserve announced its maturity extension
program whereby it intended to sell $400 billion of shorter-term U.S. Treasury
securities by the end of June 2012 and use the proceeds to buy longer-term U.S.
Treasury securities. This program is intended to extend the average maturity of
the securities in the Federal Reserve's portfolio. By reducing the supply of
longer-term U.S. Treasury securities in the market, this action should put
downward pressure on longer-term interest rates, including rates on financial
assets that investors consider to be close substitutes for longer-term U.S.
Treasury securities, like certain types of Agency RMBS. The reduction in
longer-term interest rates, in turn, may contribute to a broad easing in
financial market conditions that the U.S. Federal Reserve hopes will provide
additional stimulus to support the economic recovery. In response to lagging
economic growth, in June 2012, the U.S Federal Reserve announced it was adding
another $267 billion and extending the duration of the program aimed at
lengthening the maturity of its portfolio through the end of 2012 in an effort
to put additional downward pressure on long-term interest rates. The US. Federal
Reserve also reaffirmed its policy to reinvest payments of principal and
interest from its holdings of Agency RMBS.
In September 2011, the White House announced it is working on a major plan to
allow some of the 11 million homeowners who owe more on their mortgages than
their homes are worth to refinance. Consequently, in October 2011 the Federal
Housing Finance Agency ("FHFA") announced changes to the Home Affordable
Refinance Program ("HARP") to expand access to refinancing for qualified
individuals and families whose homes have lost value. One such change is to
increase the HARP loan-to-value ceiling above 125%. However, this would only
apply to mortgages guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae. There
are many challenging issues to this proposal, notably the question as to whether
a loan with a 125% or greater loan-to-value ratio qualifies as a mortgage or an
unsecured consumer loan. The chances of this initiative's success and other
ideas proposed by the U.S. Federal Reserve's white paper, have created
additional uncertainty in the RMBS market, particularly with respect to possible
increases in prepayment rates. According to information published by the U.S.
Department of Housing and Urban Development, 180,200 distressed homeowners have
been refinanced in the first three months of 2012.
In February 2011, the U.S. Department of the Treasury along with the U.S.
Department of Housing and Urban Development released a report titled "Reforming
America's Housing Finance Market" to Congress outlining recommendations
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for reforming the U.S. housing system, specifically Fannie Mae and Freddie Mac,
and transforming government involvement in the housing market. It is unclear how
future legislation may impact the housing finance market and the investing
environment for Agency RMBS as the method of reform is undecided and has not yet
been defined by the regulators.
On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and
Consumer Protection Act (the "Dodd-Frank Act") into law. The Dodd-Frank Act is
extensive, complicated and comprehensive legislation that impacts practically
all aspects of banking and represents a significant overhaul of many aspects of
the regulation of the financial services industry. Although many provisions
remain subject to further rulemaking, the Dodd-Frank Act implements numerous and
far-reaching regulatory changes that affect financial companies, including our
Company, and other banks and institutions which are important to our business
model. Certain notable rules are, among other things:
• Requiring regulation and oversight of large, systemically important
financial institutions ("SIFI") by establishing an interagency council on
systemic risk and implementation of heightened prudential standards and
regulation by the Board of Governors of the U.S. Federal Reserve for SIFI
(including nonbank financial companies), as well as the implementation of
the Federal Deposit Insurance Corporation ("FDIC") resolution procedures
for liquidation of large financial companies to avoid market disruption;
• applying the same leverage and risk-based capital requirements that apply
to insured depository institutions to most bank holding companies,
savings and loan holding companies and systemically important nonbank
financial companies;
• limiting the U.S. Federal Reserve's emergency authority to lend to
nondepository institutions to facilities with broad-based eligibility,
and authorizing the FDIC to establish an emergency financial
stabilization fund for solvent depository institutions and their holding
companies, subject to the approval of Congress, the Secretary of the U.S.
Treasury and the U.S. Federal Reserve;
• creating regimes for regulation of over-the-counter derivatives and
non-admitted property and casualty insurers and reinsurers;
• implementing regulation of hedge fund and private equity advisers by
requiring such advisers to register with the SEC;
• providing for the implementation of corporate governance provisions for
all public companies concerning proxy access and executive compensation;
and
• reforming regulation of credit rating agencies.
Many of the provisions of the Dodd-Frank Act, including certain provisions
described above are subject to further study, rulemaking, and the discretion of
regulatory bodies. As the hundreds of regulations called for by the Dodd-Frank
Act are promulgated, we will continue to evaluate the impact of any such
regulations. It is unclear how this legislation may impact the borrowing
environment, investing environment for Agency RMBS and interest rate swaps as
much of the bill's implementation has not yet been defined by the regulators.
Certain programs initiated by the U.S. Government, through the Federal Housing
Administration ("FHA") and the FDIC, to provide homeowners with assistance in
avoiding residential mortgage loan foreclosures are currently in effect. The
programs may involve, among other things, the modification of mortgage loans to
reduce the principal amount of the loans or the rate of interest payable on the
loans, or to extend the payment terms of the loans. While the effect of these
programs has not been as extensive as originally expected, the effect of such
programs for holders of Agency RMBS could be that such holders would experience
changes in the anticipated yields of their Agency RMBS due to (i) increased
prepayment rates on their Agency RMBS and (ii) lower interest and principal
payments on their Agency RMBS.
Credit Spreads
Over the past few years, the credit markets generally experienced tightening
credit spreads (specifically, spreads between U.S. Treasury securities and other
securities that are identical in all respects except for ratings) mainly due to
the strong demand for lending opportunities. Generally, when credit spreads
tighten, the value of Agency RMBS increases, which results in an increase in our
book value. Due to these tightening credit spreads our book value has increased.
If credit spreads were to widen, we expect the market value of Agency RMBS would
decrease, which could reduce our book value, but also create an attractive
opportunity to reinvest principal and interest from our existing portfolio as
well as deploy new capital into higher-yielding Agency RMBS.
For a discussion of additional risks relating to our business see "Risk Factors"
disclosed in our Annual Report on Form 10-K for the fiscal year ended
December 31, 2011, filed on February 13, 2012.
Financial Condition
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As of June 30, 2012 and December 31, 2011, the Agency RMBS in our portfolio were
purchased at a net premium to their par value due to the average interest rates
on these investments being higher than the prevailing market rates at the time
of purchase. As of June 30, 2012 and December 31, 2011, we had approximately
$463.9 million and $223.5 million, respectively, of unamortized premium included
in the cost basis of our investments.
As of June 30, 2012 and December 31, 2011, our Agency RMBS portfolio consisted
of the following assets:
June 30, 2012
Par Value Fair Value Weighted Average
Fair
Asset Type (in thousands) Cost/Par Value/Par MTR(1) Coupon CPR(2)
10 Year Fixed $ 253,746 $ 103.79
Rate $ 239,966 $ 105.74 N/A 3.50 % 15.7 %
15 Year Fixed 8,130,084 103.34 105.48 N/A 3.38 % 14.4 %
Rate 8,575,298
20 Year Fixed 138,700 103.14 107.92 N/A 4.50 % 21.1 %
Rate 149,688
30 Year Fixed 1,832,303 1,937,542 105.43 105.74
N/A 3.87 % - %
Rate
Hybrid ARMs 3,015,667 3,161,861 102.63 104.85
67.4 3.09 % 18.6 %
Total/Weighted
Average $ 13,356,720$ 14,078,135$ 103.47$ 105.40
67.4 (3) 3.40 % 15.8 %
__________________
December 31, 2011
Par Value Fair Value Weighted Average
Fair
Asset Type (in thousands) Cost/Par Value/Par MTR(1) Coupon CPR(2)
10 Year Fixed
Rate $ 272,115 $ 284,948 $ 103.96 $ 104.72 N/A 3.50 % 13.6 %
15 Year Fixed
Rate 4,763,965 5,010,121 102.53 105.17 N/A 3.79 % 17.8 %
20 Year Fixed
Rate 551,766 585,103 102.32 106.04 N/A 4.14 % 28.1 %
30 Year Fixed
Rate 239,747 259,123 103.09 108.08 N/A 5.00 % 26.3 %
Hybrid ARMs 3,098,024 3,233,159 102.31 104.36 64.0 3.29 % 20.3 %
Total/Weighted
Average $ 8,925,617 $ 9,372,454 $ 102.50 $ 105.01 64.0 (3) 3.66 % 19.5 %
__________________(1) MTR, or "Months to Reset" is the number of months remaining before the
fixed rate on a hybrid ARM becomes a variable rate. At the end of the
fixed period, the variable rate will be determined by the margin and the pre-specified caps of the ARM. After the fixed period, 100% of the hybrid
ARMS in the portfolio reset annually.
(2) CPR, or "Constant Prepayment Rate" is a method of expressing the
prepayment rate for a mortgage pool that assumes that a constant fraction
of the remaining principal is prepaid each month or year. Specifically,
the constant prepayment rate is an annualized version of the prior three
month prepayment rate. Securities with no prepayment history are excluded
from this calculation.
(3) Weighted average months to reset of our ARM portfolio.
Actual maturities of Agency RMBS are generally shorter than stated contractual
maturities (which range up to 30 years), as they are affected by the contractual
lives of the underlying mortgages, periodic payments and prepayments of
principal. As of June 30, 2012 and December 31, 2011, the average final
contractual maturity of the mortgage portfolio is in year 2032 and 2031,
respectively. The average expected life of our Agency RMBS reflects the
estimated average period of time the securities in the portfolio will remain
outstanding. The average expected lives of our Agency RMBS do not exceed five
years, based upon the prepayment model obtained through subscription-based
financial information service providers. The prepayment model considers current
yield, forward yield, the steepness of the yield curve, current mortgage rates,
the mortgage rate of the outstanding loan, loan age, margin and volatility. The
actual lives of the Agency RMBS in our investment portfolio could be longer or
shorter than those estimates depending on the actual prepayment rates
experienced over the lives of the applicable securities.
As of June 30, 2012 and December 31, 2011, we had CLOs with a fair value of
$17.9 million and $18.7 million, respectively.
Hedging Instruments
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We seek to hedge as much of the interest rate risk we determine is in the best
interests of our stockholders. Our policies do not contain specific requirements
as to the percentages or amount of interest rate risk we are required to hedge.
No assurance can be given that our hedging activities will have the desired
beneficial impact on our results of operations or financial condition.
Interest rate hedging may fail to protect or could adversely affect us because,
among other things:
• interest rate hedging can be expensive, particularly during periods of
rising and volatile interest rates;
• available interest rate hedging may not correspond directly with the
interest rate risk for which protection is sought;
• due to prepayments on assets and repayments of debt securing such
assets, the duration of the hedge may not match the duration of the
related liability or asset;
• the credit quality of the hedging counterparty may be downgraded to such
an extent that it impairs our ability to sell or assign our side of the
hedging transaction; and
• the hedging counterparty may default on its obligation to pay.
We engage in interest rate swaps and caps as a means of mitigating our interest
rate risk on forecasted interest expense associated with repurchase agreements
for the term of the swap contract. An interest rate swap is a contractual
agreement entered into by two counterparties under which each agrees to make
periodic payments to the other for an agreed period of time based upon a
notional amount of principal. Under the most common form of interest rate swap,
commonly known as a fixed-floating interest rate swap, a series of fixed
interest rate payments on a notional amount of principal is exchanged for a
series of floating interest rate payments on such notional amount. In a simple
interest rate cap, one investor pays a premium for a notional principal amount
based on a capped interest rate (the "cap rate"). When the floating interest
rate (the "floating rate") exceeds the cap rate, the investor receives a payment
from the cap counterparty equal to the difference between the floating rate and
the cap rate on the same notional principal amount for a specified period of
time. Alternatively, an investor may receive a premium and pay the difference in
cap rate and floating rate.
At June 30, 2012, we were a party to 16 interest rate swaps and seven interest
rate caps (whereby we will receive interest payments when three-month LIBOR
exceeds the applicable cap rate) with maturities between May 2013 and July 2019,
aggregate notional amount of $7,140.0 million and a fair value of approximately
$(49.5) million. At December 31, 2011, we were a party to 15 interest rate swaps
and three interest rate caps with maturities between May 2013 and December 2016,
aggregate notional amount of $5,440.0 million and a fair value of approximately
$(73.5) million. As of June 30, 2012 and December 31, 2011, the weighted average
fixed rate on our interest rate swaps was 1.462% and 1.478%, respectively. As of
June 30, 2012 and December 31, 2011, the weighted average cap rate on our
interest rate caps was 1.653% and 1.593%, respectively.
The current fair value of interest rate swaps and caps is heavily dependent on
the prevailing market fixed rate, the corresponding term structure of floating
rates (known as the yield curve) as well as the expectation of changes in future
floating rates.
Liabilities
We have entered into repurchase agreements to finance some of our purchases of
Agency RMBS. Borrowings under these agreements are secured by our Agency RMBS
and bear interest at rates that have historically moved in close relationship to
LIBOR. At June 30, 2012, we had approximately $9,763.3 million of liabilities
pursuant to repurchase agreements with 24 counterparties that had weighted
average interest rates of approximately 0.39%, and a weighted average maturity
of 27.3 days. In addition, as of June 30, 2012, we had approximately $3,058.3
million in payable for securities purchased, a portion of which will be financed
through repurchase agreements. At December 31, 2011, we had approximately
$7,880.8 million of liabilities pursuant to repurchase agreements with 24
counterparties that had weighted average interest rates of approximately 0.36%,
and a weighted average maturity of 27.6 days. In addition, as of December 31,
2011 we had approximately $463.3 million in payable for securities purchased, a
portion of which was financed through repurchase agreements. Below is a summary
of our payable for securities purchased as of June 30, 2012 and December 31,
2011 (in thousands).
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June 30, 2012
Forward Settling Purchases Settle Date Par Value Payable
Interest rate cap 1.5% 7/2/2012 $ 300,000 $ 11,130
FNMA - 30 Year 5.0% Fixed(a) 7/12/2012 - 70
FNMA - 30 Year 2.59% Hybrid ARM 7/23/2012 35,000 36,367
FNMA - 30 Year 2.44% Hybrid ARM 7/23/2012 50,000 51,543
FNMA - 30 Year 2.44% Hybrid ARM 7/23/2012 50,000 51,487
FNMA - 30 Year 4.0% Fixed 8/13/2012 800,000 846,598
FNMA - 15 Year 3.0% Fixed 8/16/2012 1,125,000 1,173,332
FNMA - 30 Year 3.5% Fixed 9/13/2012 650,000 679,861
FNMA - 30 Year 2.50% Hybrid ARM 9/25/2012 100,000 103,518
FNMA - 30 Year 3.5% Fixed 10/11/2012 100,000 104,394
$ 3,210,000 $ 3,058,300
December 31, 2011
Forward Settling Purchases Settle Date Par Value Payable
FNMA - 15 Year 3.5% Fixed 1/18/2012$ 225,000$ 232,977
FNMA - 30 Year 2.84% Hybrid ARM 1/24/2012 21,000 21,478
FNMA - 30 Year 2.85% Hybrid ARM 1/24/2012 16,000 16,579
FNMA - 30 Year 2.94% Hybrid ARM 1/24/2012 15,000 15,499
FNMA - 30 Year 3.12% Hybrid ARM 1/24/2012 50,000 51,807
FNMA - 30 Year 2.84% Hybrid ARM 1/24/2012 15,000 15,452
FNMA - 30 Year 3.17% Hybrid ARM 1/27/2012 36,000 37,389
FNMA - 30 Year 2.90% Hybrid ARM 2/23/2012 50,000 51,479
FNMA - 30 Year 2.82% Hybrid ARM 3/22/2012 20,000 20,642
$ 448,000$ 463,302
__________________
(a) A corresponding sale of $150.0 million par value was made with the same
counterparty with the same settlement date leaving the disclosed net
payable for securities purchased.
Summary Financial Data
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Three Months Ended June 30, Six Months Ended June 30,
(In thousands, except per share
numbers) 2012 2011 2012 2011
INVESTMENT INCOME:
Interest income from Agency RMBS $ 70,352 $ 64,681 $ 134,499 $ 104,715
Other income 1,395 1,039 2,617 1,985
Total investment income 71,747 65,720 137,116 106,700
EXPENSES:
Interest 8,993 4,470 15,846 7,574
Operating expenses 5,279 4,865 10,398 9,284
Total expenses 14,272 9,335 26,244 16,858
Net investment income 57,475 56,385 110,872 89,842
Net gain (loss) from investments 68,586 129,225 101,736 149,044
GAINS AND (LOSSES) FROM SWAP AND
CAP CONTRACTS:
Net swap and cap interest income
(expense) (12,687 ) (14,875 ) (24,193 ) (26,733 )
Net gain (loss) on termination of
swap contracts - (3,493 ) - (3,492 )
Net unrealized appreciation
(depreciation) on swap and cap
contracts (11,669 ) (67,820 ) (17,592 ) (57,142 )
Net gain (loss) from swap and cap
contracts (24,356 ) (86,188 ) (41,785 ) (87,367 )
NET INCOME $ 101,705 $ 99,422 $ 170,823 $ 151,519
Net income per common share
(diluted) $ 0.87 $ 1.20 $ 1.54 $ 1.97
Distributions per common share $ 0.50 $ 0.60 $ 1.00 $ 1.20
Key Metrics*
Average Agency RMBS(1) $ 10,737,980 $ 7,699,364 $ 10,052,857 $ 6,364,652
Average repurchase agreements (2) $ 9,497,267 $ 6,831,941 $ 8,932,952 $ 5,541,810
Average net assets (3) $ 1,591,432 $ 1,013,990 $ 1,494,876 $ 920,153
Average common shares outstanding
(4) 116,881 82,578 110,751 76,754
Average yield on Agency RMBS (5) 2.62 % 3.37 % 2.68 % 3.32 %
Average cost of funds and hedge (6) 0.91 % 1.14 % 0.90 % 1.25 %
Interest rate spread net of hedge
(7) 1.71 % 2.23 % 1.78 % 2.07 %
Operating expense ratio (8) 1.33 % 1.92 % 1.39 % 2.02 %
Leverage ratio (at period end) (9) 7.6:1 7.6:1 7.6:1 7.6:1
__________________
(1) Our average Agency RMBS for the period was calculated by averaging the
month end cost basis of our settled Agency RMBS during the period.
(2) Our average repurchase agreements for the period were calculated by averaging the month end repurchase agreement balance during the period.
(3) Our average net assets for the period were calculated by averaging the
month end net assets during the period.
(4) Our average common shares outstanding was calculated by averaging the
daily common shares outstanding during the period.
(5) Our average yield on Agency RMBS for the period was calculated by dividing
our interest income from Agency RMBS by our average Agency RMBS.
(6) Our average cost of funds and hedge for the period was calculated by
dividing our total interest expense, including our net swap and cap
interest income (expense), by our average repurchase agreements.
(7) Our interest rate spread net of hedge for the period was calculated by subtracting our average cost of funds and hedge from our average yield on
Agency RMBS.
(8) Our operating expense ratio is calculated by dividing operating expenses
by average net assets.
(9) Our leverage ratio was calculated by dividing (i) our repurchase
agreements plus payable for securities purchased minus receivable for
securities sold by (ii) net assets.
* All percentages are annualized.
Core Earnings
Core Earnings represents a non-GAAP financial measure and is defined as net
income (loss) excluding net gain (loss) from investments, net gain (loss) on
termination of swap contracts and net unrealized appreciation (depreciation) on
swap and cap contracts. In order to evaluate the effective yield of the
portfolio, management uses Core Earnings to reflect the net investment income of
our portfolio as adjusted to reflect the net swap and cap interest income
(expense). Core Earnings allows management to isolate the interest income
(expense) associated with our swaps and caps in order to monitor and project our
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borrowing costs and interest rate spread. In addition, management utilizes Core
Earnings as a key metric in conjunction with other portfolio and market factors
to determine the appropriate leverage and hedging ratios, as well as the overall
structure of the portfolio.
We adopted Accounting Standards Codification ("ASC") 946, Clarification of the
Scope of Audit and Accounting Guide Investment Companies ("ASC 946"), prior to
its deferral in February 2008, while most, if not all, other public companies
that invest only in Agency RMBS have not adopted ASC 946. Under ASC 946, we use
the financial reporting specified for investment companies, and accordingly, our
investments are carried at fair value with changes in fair value included in
earnings. Most other public companies that invest only in Agency RMBS include
most changes in the fair value of their investments within shareholders' equity,
not in earnings. As a result, investors are not able to readily compare our
results of operations to those of most of our competitors. We believe that the
presentation of our Core Earnings is useful to investors because it provides a
means of comparing our Core Earnings to those of our competitors. In addition,
because Core Earnings isolates the net swap and cap interest income (expense),
it provides investors with an additional metric to identify trends in our
portfolio as they relate to the interest rate environment.
The primary limitation associated with Core Earnings as a measure of our
financial performance over any period is that it excludes the effects of net
realized gain (loss) from investments. In addition, our presentation of Core
Earnings may not be comparable to similarly-titled measures of other companies,
who may use different calculations. As a result, Core Earnings should not be
considered as a substitute for our GAAP net income (loss) as a measure of our
financial performance or any measure of our liquidity under GAAP.
(In thousands) Three Months Ended June 30, Six Months Ended June 30,
Non-GAAP Reconciliation: 2012 2011 2012 2011
NET INCOME $ 101,705 $ 99,422 $ 170,823 $ 151,519
Net (gain) loss from investments (68,586 ) (129,225 ) (101,736 ) (149,044 )
Net (gain) loss on termination of swap
contracts - 3,493 - 3,492
Net unrealized (appreciation)
depreciation on swap and cap contracts 11,669 67,820 17,592 57,142
Core Earnings $ 44,788 $ 41,510 $ 86,679 $ 63,109
Results of Operations
Three Months Ended June 30, 2012 Compared to the Three Months Ended June 30,
2011
Net Income. Net income increased $2.3 million to $101.7 million for the three
months ended June 30, 2012, compared to net income of $99.4 million for the
three months ended June 30, 2011. The major components of this increase are
detailed below.
Investment Income. Investment income, which consists of interest income on
Agency RMBS, subordinated tranches of CLOs and short term investments, increased
by $6.0 million to $71.7 million for the three months ended June 30, 2012, as
compared to $65.7 million for the three months ended June 30, 2011. The change
in interest income was primarily due to the increased size of our portfolio.
During the three months ended June 30, 2012, our average Agency RMBS portfolio
was $10,738.0 million, compared to $7,699.4 million during the three months
ended June 30, 2011. However, the increased income due to the size of our
portfolio was partially offset by the decrease in the average yield on Agency
RMBS. During the three months ended June 30, 2012 and 2011, our average yield on
Agency RMBS was 2.62% and 3.37%, respectively.
Interest Expense. Interest expense increased $4.5 million to $9.0 million for
the three months ended June 30, 2012, as compared to $4.5 million for the three
months ended June 30, 2011. The increase was due to the increase in our average
amounts outstanding under our repurchase agreements. During the three months
ended June 30, 2012 and 2011, our average repurchase agreements were $9,497.3
million and $6,831.9 million, respectively. In addition, we had an average rate
on our repurchase agreements of 0.38% and 0.26% during the three months ended
June 30, 2012 and 2011, respectively.
Operating Expenses. For the three months ended June 30, 2012, operating expenses
increased by $0.4 million to $5.3 million compared to $4.9 million for the three
months ended June 30, 2011. However, expenses as a percentage of net assets
decreased significantly during the three months ended June 30, 2012 to 1.33%
compared to 1.92% during the three months ended June 30, 2011. The primary
reason for the decrease in expenses as a percentage of net assets was that we
had a larger asset base. Our average net assets were $1,591.4 million and
$1,014.0 million during the three months ended June 30, 2012 and 2011,
respectively. In addition, we are experiencing the benefit of the
Internalization of management which took effect in September 2011.
Net Gain (Loss) From Investments. Net gain from investments decreased by $60.6
million to $68.6 million for the three months ended June 30, 2012, compared to
$129.2 million for the three months ended June 30, 2011. This decrease was the
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result of the change in the price of Agency RMBS and the increase in our average
Agency RMBS portfolio. During the three months ended June 30, 2012 and 2011, the
price of Agency RMBS backed by 15 year 3.5% mortgages increased by $0.781 and
$1.750, respectively. During the three months ended June 30, 2012 and 2011, our
average Agency RMBS was $10,738.0 million and $7,699.4 million, respectively.
Net Gain (Loss) from Swap and Cap Contracts. Net loss from swap and cap
contracts decreased by $61.8 million to a loss of $24.4 million for the three
months ended June 30, 2012, compared to a loss of $86.2 million for the three
months ended June 30, 2011. The decrease in net loss on swap contracts was
primarily due to the change in swap rates combined with the change in the size
of our interest rate swap and cap portfolio. During the three months ended June
30, 2012 and 2011, our average interest rate swap and cap notional amount was
$6,265.0 million and $5,290.0 million, respectively. During the three months
ended June 30, 2012 and 2011, three year swap rates decreased by 13 and 42 basis
points, respectively.
Six Months Ended June 30, 2012 Compared to the Six Months Ended June 30, 2011
Net Income. Net income increased $19.3 million to $170.8 million for the six
months ended June 30, 2012, compared to net income of $151.5 million for the six
months ended June 30, 2011. The major components of this increase are detailed
below.
Investment Income. Investment income, which consists of interest income on
Agency RMBS, subordinated tranches of CLOs and short term investments, increased
by $30.4 million to $137.1 million for the six months ended June 30, 2012, as
compared to $106.7 million for the six months ended June 30, 2011. The change in
interest income was primarily due to the increased size of our portfolio. During
the six months ended June 30, 2012, our average Agency RMBS portfolio was
$10,052.9 million, compared to $6,364.7 million during the six months ended June
30, 2011. However, the increased income due to the size of our portfolio was
partially offset by the decrease in the average yield on Agency RMBS. During the
six months ended June 30, 2012 and 2011, our average yield on Agency RMBS was
2.68% and 3.32%, respectively.
Interest Expense. Interest expense increased $8.2 million to $15.8 million for
the six months ended June 30, 2012, as compared to $7.6 million for the six
months ended June 30, 2011. The increase was due to the increase in our average
amounts outstanding under our repurchase agreements. During the six months ended
June 30, 2012 and 2011, our average repurchase agreements were $8,933.0 million
and $5,541.8 million, respectively. In addition, we had an average rate on our
repurchase agreements of 0.35% and 0.27% during the six months ended June 30,
2012 and 2011, respectively.
Operating Expenses. For the six months ended June 30, 2012, operating expenses
increased by $1.1 million to $10.4 million compared to $9.3 million for the six
months ended June 30, 2011. However, expenses as a percentage of net assets
decreased significantly during the six months ended June 30, 2012 to 1.39%
compared to 2.02% during the six months ended June 30, 2011. The primary reason
for the decrease in expenses as a percentage of net assets was that we had a
larger asset base. Our average net assets were $1,494.9 million and $920.2
million during the six months ended June 30, 2012 and 2011, respectively. In
addition, we are experiencing the benefit of the Internalization of management
which took effect in September 2011.
Net Gain (Loss) From Investments. Net gain from investments decreased by $47.3
million to $101.7 million for the six months ended June 30, 2012, compared to
$149.0 million for the six months ended June 30, 2011. This decrease was the
result of the change in the price of Agency RMBS and the increase in our average
Agency RMBS portfolio. During the six months ended June 30, 2012 and 2011, the
price of Agency RMBS backed by 15 year 3.5% mortgages increased by $1.125 and
$1.500, respectively. During the six months ended June 30, 2012 and 2011, our
average Agency RMBS was $10,052.9 million and $6,364.7 million, respectively.
Net Gain (Loss) from Swap and Cap Contracts. Net loss from swap and cap
contracts decreased by $45.6 million to a loss of $41.8 million for the six
months ended June 30, 2012, compared to a loss of $87.4 million for the six
months ended June 30, 2011. The decrease in net loss on swap contracts was
primarily due to the change in swap rates combined with the change in the size
of our interest rate swap and cap portfolio. During the six months ended June
30, 2012 and 2011, our average interest rate swap and cap notional amount was
$5,911.4 million and $4,975.7 million, respectively. During the six months ended
June 30, 2012 and 2011, three year swap rates decreased by 20 and 13 basis
points, respectively.
Contractual Obligations and Commitments
The following table summarizes our contractual obligations for repurchase
agreements, interest expense on repurchase agreements and the office lease at
June 30, 2012 and December 31, 2011 (dollars in thousands).
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Within One One to Three Three to
June 30, 2012 Year Years Five Years Total
Repurchase agreements $ 9,763,313 $ - $ - $ 9,763,313
Interest expense on repurchase
agreements, based on rates at
June 30, 2012 6,706 - - 6,706
Long term operating lease obligation 317 324 - 641
Total $ 9,770,336 $ 324 $ - $ 9,770,660
Within One One to three Three to
December 31, 2011 Year Years Five Years Total
Repurchase agreements $ 7,880,814 $ - $ - $ 7,880,814
Interest expense on repurchase
agreements, based on rates at
December 31, 2011 5,852 - - 5,852
Long term operating lease obligation 313 482 - 795
Total $ 7,886,979 $ 482 $ - $ 7,887,461
We enter into interest rate swap and cap contracts as a means of mitigating our
interest rate risk on forecasted interest expense associated with repurchase
agreements for the term of the swap or cap contract. At June 30, 2012 and
December 31, 2011, we had the following interest rate swap and cap contracts
(dollars in thousands):
As of June 30, 2012
Weighted
Amount Average
Total Fair Accrued Maturity
Counterparty Notional Value Interest At Risk (1) in Years
Credit Suisse
International $ 800,000 $ 3,217 $ - $ 5,935 5.6
Deutsche Bank 840,000 (11,331 ) (1,396 ) 13,663 1.9
Goldman Sachs 1,800,000 (37,463 ) (5,782 ) 20,067 2.0
ING Capital Markets, LLC 300,000 11,441 - 11,441 7.0
Morgan Stanley Capital
Markets 250,000 (5,117 ) - 1,727 4.5
Nomura Global Financial
Products, Inc. 550,000 (19,739 ) (2,034 ) 5,476 3.1
The Royal Bank of
Scotland plc 2,000,000 (12,218 ) (2,565 ) 10,136 1.9
UBS AG 300,000 11,702 - 572 7.0
Wells Fargo Bank, N.A. 300,000 10,043 - 1,012 6.9
Total $ 7,140,000 $ (49,465 ) $ (11,777 ) $ 70,029
As of December 31, 2011
Weighted
Amount Average
Total Fair Accrued Maturity
Counterparty Notional Value Interest At Risk (1) in Years
Deutsche Bank $ 840,000 $ (10,275 ) $ (1,436 ) $ 11,846 2.4
Goldman Sachs 1,800,000 (36,205 ) (5,705 ) 18,025 2.5
Morgan Stanley Capital
Markets 250,000 (723 ) - 1,236 5.0
Nomura Global Financial
Products, Inc. 550,000 (17,176 ) (2,085 ) 4,679 3.6
The Royal Bank of
Scotland plc 2,000,000 (9,131 ) (2,644 ) 6,965 2.4
Total $ 5,440,000 $ (73,510 ) $ (11,870 ) $ 42,751
__________________
(1) Equal to the fair value of pledged securities plus accrued interest
income, minus the fair value of the interest rate swap and cap and accrued
interest income and expense.
We enter into certain contracts that contain a variety of indemnification
obligations, principally with our brokers and counterparties to interest rate
swap contracts and repurchase agreements. The maximum potential future payment
amount we could be required to pay under these indemnification obligations is
unlimited. We have not incurred any costs to defend lawsuits or settle claims
related to these indemnification obligations. As a result, the estimated fair
value of these agreements is
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minimal. Accordingly, we recorded no liabilities for these agreements as of June
30, 2012 and December 31, 2011. In addition, as of June 30, 2012 and
December 31, 2011, we had a $3,058.3 million and $463.3 million payable for
securities purchased, respectively, a portion of which either was or will be
financed through repurchase agreements. A summary of our payable for securities
purchased as of June 30, 2012 and December 31, 2011 is included in the
"Financial Condition-Liabilities" section.
Off-Balance Sheet Arrangements
As of June 30, 2012 and December 31, 2011, we did not maintain any relationships
with unconsolidated entities or financial partnerships, such as entities often
referred to as structured finance, special purpose or variable interest
entities, established for the purpose of facilitating off-balance sheet
arrangements or other contractually narrow or limited purposes. Further, as of
June 30, 2012 and December 31, 2011, we had not guaranteed any obligations of
unconsolidated entities or entered into any commitment or had any intent to
provide funding to any such entities.
Liquidity and Capital Resources
Our primary sources of funds are borrowings under repurchase arrangements and
monthly principal repayments and interest payments on our investments. Other
sources of funds may include proceeds from debt and equity offerings and asset
sales. As of June 30, 2012 and December 31, 2011, we had repurchase agreements
totaling $9,763.3 million and $7,880.8 million, respectively, with a weighted
average borrowing rate of 0.39% and 0.36%, respectively. In addition, during the
six months ended June 30, 2012 and 2011, we received $1,194.9 million and $415.4
million of principal repayments and $129.5 million and $95.0 million of interest
payments, respectively. We held cash and cash equivalents of $13.8 million and
$11.5 million at June 30, 2012 and December 31, 2011, respectively.
During the six months ended June 30, 2012 and 2011, our operations used net cash
of $2,319.8 million and $4,331.0 million, respectively. During the six months
ended June 30, 2012 and 2011, we had net purchases of securities (net of
purchases, sales and principal repayments) of $4,634.6 million and $2,393.8
million, respectively. The increase in net purchases of securities was the
result of investing the $498.1 million of total net proceeds from the
(i) February 1, 2012 public offering when we issued and sold 28,750,000 shares
of common stock, raising approximately $377.3 million of net proceeds, and
(ii) the issuances of shares under the dividend reinvestment and direct stock
purchase plan ("DSPP") and Equity Placement Program ("EPP"), while maintaining
our leverage ratio.
Through the DSPP, stockholders may purchase additional shares of common stock by
reinvesting some or all of the cash dividends received on shares of common
stock. Stockholders may also make optional cash purchases of shares of common
stock subject to certain limitations detailed in the plan prospectus. For the
six months ended June 30, 2012 and 2011 we issued 3,020,306 and 6,957 shares
under the plan, respectively, raising approximately $41.1 million and $87,452 of
net proceeds, respectively. As of June 30, 2012 and December 31, 2011, there
were approximately 6.4 million and 9.4 million shares, respectively available
for issuance under the DSPP.
On June 7, 2011 we established the EPP whereby, from time to time, we may
publicly offer and sell up to 15.0 million shares of our common stock in
at-the-market transactions and/or privately negotiated transactions with JMP
Securities LLC acting as sales agent. For the six months ended June 30, 2012 the
Company issued 5,874,936 shares under the plan raising approximately $79.6
million. As of June 30, 2012 and December 31, 2011, there were approximately 9.1
million and 15.0 million shares of common stock, respectively, remained
available for issuance to be sold under the EPP.
The following tables present certain information regarding our risk exposure on
our repurchase agreements as of June 30, 2012 and December 31, 2011 (dollars in
thousands):
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June 30, 2012
Weighted
Total Average
Outstanding % of Amount Maturity in
Counterparty Borrowings Total At Risk (1) Days
Bank of America Securities LLC $ 509,687 5.2 % $ 28,867 29
Bank of Nova Scotia 477,432 4.9 17,592 42
Barclays Capital, Inc. 455,563 4.7 24,499 28
BNP Paribas Securities Corp 321,138 3.3 18,030 17
Cantor Fitzgerald & Co. 206,794 2.1 12,098 11
Citigroup Global Markets, Inc. 507,343 5.2 30,171 19
Credit Suisse Securities (USA) LLC 623,242 6.4 30,245 16
Daiwa Securities America, Inc. 239,800 2.5 14,820 23
Deutsche Bank Securities, Inc. 481,491 4.9 29,094 51
Goldman Sachs & Co. 657,611 6.7 36,581 34
Guggenheim Liquidity Services, LLC 261,811 2.7 16,236 21
Industrial and Commercial Bank of
China Financial Services LLC 640,825 6.6 33,614 42
ING Financial Markets LLC 314,466 3.2 17,643 11
Jefferies & Company, Inc. 89,842 0.9 5,049 46
LBBW Securities LLC 186,363 1.9 10,496 52
Mitsubishi UFJ Securities (USA),
Inc. 518,833 5.3 28,475 31
Mizuho Securities USA, Inc. 333,394 3.4 19,852 25
Morgan Stanley & Co. Inc. 295,705 3.0 16,237 39
Nomura Securities International,
Inc. 251,848 2.6 12,906 23
RBC Capital Markets, LLC 461,531 4.7 27,512 31
South Street Securities LLC 398,060 4.1 24,472 18
The Royal Bank of Scotland PLC 167,529 1.7 10,020 11
UBS Securities LLC 658,336 6.8 37,477 17
Wells Fargo Securities, LLC 704,669 7.2 24,467 18
$ 9,763,313 100.0 % $ 526,453
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December 31, 2011
Weighted
Total Amount at Average
Outstanding % of Maturity in
Counterparty Borrowings Total Risk (1) Days
Bank of America Securities LLC $ 242,641 3.1 % $ 13,845 19
Bank of Nova Scotia 416,381 5.3 13,927 33
Barclays Capital, Inc. 414,103 5.3 22,235 52
BNP Paribas Securities Corp 282,544 3.6 15,142 13
Cantor Fitzgerald & Co. 411,499 5.2 23,156 36
Citigroup Global Markets, Inc. 244,284 3.1 14,065 20
Credit Suisse Securities (USA) LLC 414,021 5.2 20,060 47
Daiwa Securities America, Inc. 288,960 3.6 16,082 30
Deutsche Bank Securities, Inc. 557,902 7.1 32,141 11
Goldman Sachs & Co. 543,768 6.9 30,168 22
Guggenheim Liquidity Services, LLC 151,530 1.9 8,472 23
Industrial and Commercial Bank of
China Financial Services LLC 415,863 5.3 24,429 30
ING Financial Markets LLC 419,837 5.3 23,858 19
Jefferies & Company, Inc. 101,235 1.3 5,851 17
LBBW Securities LLC 206,734 2.6 11,257 45
Mitsubishi UFJ Securities (USA),
Inc. 482,404 6.1 26,354 35
Mizuho Securities USA, Inc. 297,917 3.8 16,528 20
Morgan Stanley & Co. Inc. 172,063 2.2 10,320 45
Nomura Securities International,
Inc. 281,998 3.6 15,257 41
RBC Capital Markets, LLC 223,831 2.8 14,008 12
South Street Securities LLC 336,394 4.3 22,261 18
The Royal Bank of Scotland PLC 143,628 1.8 7,746 10
UBS Securities LLC 328,368 4.2 18,683 47
Wells Fargo Securities, LLC 502,909 6.4 18,302 10
Total $ 7,880,814 100.0 % $ 424,147
____________________
(1) Equal to the fair value of pledged securities plus accrued interest
income, minus the sum of repurchase agreement liabilities and accrued
interest expense.
Our repurchase agreements contain typical provisions and covenants as set forth
in the standard master repurchase agreement published by the Securities Industry
and Financial Markets Association. Our repurchase agreements generally require
us to transfer additional securities to the counterparty in the event the value
of the securities then held by the counterparty in the margin account falls
below specified levels and contain events of default in cases where we or the
counterparty breaches our respective obligations under the agreement.
We receive margin calls from our repurchase agreement counterparties from time
to time in the ordinary course of business similar to other entities in the
specialty finance business. We receive two types of margin calls under our
repurchase agreements. The first type, which are known as "factor calls," are
margin calls that occur each month and relate to the timing difference between
the reduction of principal balances of our Agency RMBS, due to monthly principal
payments on the underlying mortgages, and the receipt of the corresponding cash.
The second type of margin call we may receive is a "valuation call", which
occurs due to market and interest rate movements. Both factor and valuation
margin calls occur if the total value of our assets pledged as collateral to a
counterparty drops beyond a threshold level, typically between $100,000 and
$500,000. Both types of margin calls require a dollar for dollar restoration of
the margin shortfall. Conversely, we may initiate margin calls to our
counterparties when the value of our assets pledged as collateral with a
counterparty increases above the threshold level, thereby increasing our
liquidity. All unrestricted cash and cash equivalents, plus any unpledged
securities, are available to satisfy margin calls
As of June 30, 2012 and December 31, 2011, we had approximately $1,039.6 million
and $580.0 million, respectively, in
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Agency RMBS, U.S. Treasury securities and 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.
An event of default or termination event under the standard master repurchase
agreement would give our counterparty the option to terminate all repurchase
transactions existing with us and make any amount due by us to the counterparty
to be payable immediately.
We have made and intend to continue to make regular quarterly distributions of
all or substantially all of our REIT taxable income to holders of our common
stock. On June 8, 2012, we declared a quarterly dividend of $0.50 per share of
common stock for the first quarter of 2012, which was paid on July 18, 2012 to
stockholders of record on June 25, 2012. In order to qualify as a REIT and to
avoid federal corporate income tax on the income that we distribute to our
stockholders, we are required to distribute at least 90% of our REIT taxable
income, determined without regard to the deduction for dividends paid and
excluding net capital gain, on an annual basis. This requirement can impact our
liquidity and capital resources.
For our short term (one year or less) and long term liquidity and capital
resource requirements, we also rely on the cash flow from operations, primarily
monthly principal and interest payments to be received on our Agency RMBS, as
well as any securities offerings authorized by our board of directors.
Based on our current portfolio, leverage rate and available borrowing
arrangements, we believe that our cash flow from operations and the utilization
of borrowings will be sufficient to enable us to meet anticipated short term
(one year or less) liquidity requirements such as funding our investment
activities, funding our distributions to stockholders and for general corporate
expenses. However, an increase in prepayment rates substantially above our
expectations could cause a temporary liquidity shortfall due to the timing of
the necessary margin calls on the financing arrangements and the actual receipt
of the cash related to principal paydowns. If our cash resources are at any time
insufficient to satisfy our liquidity requirements, we may have to issue debt or
additional equity securities or sell Agency RMBS in our portfolio. If required,
the sale of Agency RMBS at prices lower than their amortized cost would result
in realized losses. We believe that we have additional capacity through
repurchase agreements to leverage our equity further should the need for
additional short term (one year or less) liquidity arise.
We may increase our capital resources by obtaining long term credit facilities
or making public or private offerings of equity or debt securities. 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.
Qualitative and Quantitative Disclosures about Short Term Borrowings
The following table discloses quantitative data about our short term borrowings
under repurchase agreements during the three and six months ended June 30, 2012
and 2011.
Three Months Ended June 30, Six Months Ended June 30,
(In millions) 2012 2011 2012 2011
Outstanding at period end $ 9,763 $ 7,548 $ 9,763 $ 7,548
Weighted average rate at period end 0.39 % 0.25 % 0.39 % 0.25 %
Average outstanding during period (1) $ 9,497 $ 6,832
$ 8,933 $ 5,542
Weighted average rate during period 0.38 % 0.26 % 0.35 % 0.28 %
Largest month end balance during period $ 9,996 $ 7,548
$ 9,996 $ 7,548
_______________
(1) Calculated based on the average month end balance during the period.
During the three months ended June 30, 2012, our repurchase agreement balance
and rate remained relatively stable. During the six months ended June 30, 2012
our repurchase agreement balance increased due to our February 1, 2012 public
offering that allowed us to finance additional asset purchases. Our net assets
as of June 30, 2012 were $1,629.9 million compared to the average during the six
months ended June 30, 2012 of $1,494.9 million, respectively. During the six
months ended June 30, 2012, the rate on our repurchase agreements remained
relatively stable. During the three and six months ended June 30, 2011, our
repurchase agreement balance increased during the end of the period due to
forward settling purchases made with the net proceeds from our February 2011
equity offering settling and being financed through repurchase agreements.
During the three and six months ended June 30, 2011, the weighted average rate
on our repurchase agreements remained relatively stable at 0.26% and 0.28%,
respectively.
Inflation
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Virtually all of our assets and liabilities are interest rate sensitive in
nature. As a result, interest rates and other factors influence our performance
far more than inflation. Changes in interest rates do not necessarily correlate
with inflation rates or changes in inflation rates. Our financial statements are
prepared in accordance with GAAP and our distributions are determined by our
board of directors based in part on our REIT taxable income as calculated
according to the requirements of the Internal Revenue 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
As of June 30, 2012 and December 31, 2011, the primary component of our market
risk was interest rate risk, as described below. While we do not seek to avoid
risk completely, we do believe that risk can be quantified from historical
experience and seek to actively manage risk, to earn sufficient compensation to
justify taking risks and to maintain capital levels consistent with the risks we
undertake. Our board of directors exercises oversight of risk management in many
ways, including overseeing our senior management's risk-related responsibilities
and reviewing management and investment policies and performance against these
policies and related benchmarks. See "Business-Risk Management" in our annual
report on Form 10-K for the fiscal year ended December 31, 2011 for a further
discussion of our risk mitigation practices.
Interest Rate Risk
We are subject to interest rate risk in connection with our investments in
Agency RMBS collateralized by ARMs, hybrid ARMs and fixed rate mortgage loans
and our related debt obligations, which are generally repurchase agreements of
limited duration that are periodically refinanced at current market rates. We
seek to mitigate this risk through utilization of derivative contracts,
primarily interest rate swap and cap agreements.
Effect on Net Investment Income. We fund our investments in long term Agency
RMBS collateralized by ARMs, hybrid ARMs and fixed rate mortgage loans with
short term borrowings under repurchase agreements. During periods of rising
interest rates, the borrowing costs associated with those Agency RMBS tend to
increase while the income earned on such Agency RMBS (during the fixed rate
component of such securities) may remain substantially unchanged. This results
in a narrowing of the net interest spread between the related assets and
borrowings and may even result in losses.
We are a party to the interest rate swap and contracts as of June 30, 2012 and
December 31, 2011 described in detail under Item 2. "Management's Discussion and
Analysis of Financial Condition and Results of Operations-Contractual
Obligations and Commitments" in this quarterly report on Form 10-Q.
Hedging techniques are partly based on assumed levels of prepayments of our
Agency RMBS. If prepayments are slower or faster than assumed, the life of the
Agency RMBS will be longer or shorter, which would reduce the effectiveness of
any hedging strategies we may use and may cause losses on such transactions.
Occasionally we invest in Agency RMBS collateralized by ARMs which are based on
mortgages whose coupon rates reset monthly based on the Monthly Treasury Average
("MTA"). However, our borrowing costs pursuant to our repurchase agreements are
generally based on 30-day LIBOR, which may change more quickly than the MTA
index. Hence, in a rapidly rising interest rate environment, we would expect our
net interest margin to decrease, temporarily. In a falling interest rate
environment, we would expect our net interest margin to rise temporarily. For a
discussion of the effects of interest rate changes on our Agency RMBS
collateralized by hybrid ARMs and fixed-rate mortgages, see "-Extension Risk."
Effect on Fair Value. Another component of interest rate risk is the effect
changes in interest rates will have on the fair value of our assets. We face the
risk that the fair value of our assets will increase or decrease at different
rates than that of our liabilities, including our hedging instruments.
We primarily assess our interest rate risk by estimating the duration of our
assets and the duration of our liabilities. Duration essentially measures the
market price volatility of financial instruments as interest rates change. We
generally calculate duration using various third-party financial models and
empirical data. Different models and methodologies can produce different
duration numbers for the same securities.
Extension Risk. We invest in Agency RMBS collateralized by hybrid ARMs, which
have interest rates that are fixed for the first few years of the loan
(typically three, five, seven or 10 years) and thereafter reset periodically on
the same basis as Agency RMBS collateralized by ARMs. We compute the projected
weighted average life of our Agency RMBS collateralized by hybrid ARMs based on
assumptions regarding the rate at which the borrowers will prepay the underlying
mortgages. In general, when Agency RMBS collateralized by fixed rate or hybrid
ARMs is 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 Agency RMBS. This strategy is designed
to protect us from rising interest rates by fixing our borrowing costs for the
duration of the fixed rate period of the collateral underlying the related
Agency RMBS.
We have structured our swaps to expire in conjunction with the estimated
weighted average life of the fixed period of the
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mortgages underlying our Agency RMBS portfolio. However, in a rising interest
rate environment, the weighted average life of the fixed rate mortgages
underlying our Agency RMBS could extend beyond the term of the swap agreement or
other hedging instrument. 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 Agency RMBS would
remain fixed for a period of time. This situation may also cause the market
value of our Agency RMBS 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 Cap Risk. Both the ARMs and hybrid ARMs that collateralize our
Agency RMBS are typically subject to periodic and lifetime interest rate caps
and floors, which limit the amount by which the security's interest yield may
change during any given period. However, our borrowing costs will not be subject
to similar restrictions. Therefore, in a period of increasing interest rates,
the interest costs on our borrowings could increase without limitation by caps
while the interest rate yields on our Agency RMBS would effectively be limited
by caps. This problem will be magnified to the extent that we acquire Agency
RMBS that are collateralized by hybrid ARMs that are not fully indexed. In
addition, the underlying mortgages 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 income on our Agency
RMBS than we need in order to pay the interest cost on our related borrowings.
These factors could lower our net investment income 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 intend to fund a substantial portion of our
acquisitions of Agency RMBS with borrowings that, after the effect of hedging,
have interest rates based on indices and repricing terms similar to, but of
somewhat shorter maturities than, the interest rate indices and repricing terms
of the Agency RMBS. Thus, we anticipate that in most cases the interest rate
indices and repricing terms of our Agency RMBS and our funding sources will not
be identical, thereby creating an interest rate mismatch between assets and
liabilities. Therefore, our cost of funds would likely rise or fall more quickly
than would our earnings rate on assets. During periods of changing interest
rates, such interest rate mismatches could negatively impact our financial
condition, cash flows and results of operations. To mitigate interest rate
mismatches, we may utilize the hedging strategies discussed above.
Our analysis of risks is based on management's experience, estimates, models and
assumptions. These analyses rely on models which utilize estimates of fair value
and interest rate sensitivity. Actual economic conditions or implementation of
investment decisions by our management may produce results that differ
significantly from the estimates and assumptions used in our models and the
projected results reflected herein.
Prepayment Risk
Prepayments are the full or partial repayment of principal prior to the original
contractual maturity of a mortgage loan and typically occur due to refinancing
of mortgage loans. Prepayment rates for existing Agency RMBS generally increase
when prevailing mortgage interest rates fall. In addition, prepayment rates on
Agency RMBS collateralized by ARMs and hybrid ARMs generally increase when the
difference between long term and short term interest rates declines or becomes
negative. Additionally, we currently own Agency RMBS that were purchased at a
premium. The prepayment of such Agency RMBS at a rate faster than anticipated
would result in a write-off of any remaining capitalized premium amount.
We seek to mitigate our prepayment risk by investing in Agency RMBS with (i) a
variety of prepayment characteristics, (ii) prepayment prohibitions and
penalties and (iii) prepayment protections, as well as by balancing Agency RMBS
purchased at a premium with Agency RMBS purchased at a discount.
Effect on Fair Value and Net Income
Another component of interest rate risk is the effect changes in interest rates
will have on the fair value of our assets and our net income exclusive of the
effect on fair value. We face the risk that the fair value of our assets and net
investment income will increase or decrease at different rates than that of our
liabilities, including our hedging instruments.
We primarily assess our interest rate risk by estimating the duration of our
assets and the duration of our liabilities. Duration essentially measures the
market price volatility of financial instruments as interest rates change. We
generally calculate duration using various financial models and empirical data.
Different models and methodologies can produce different duration numbers for
the same securities.
The following sensitivity analysis table shows the estimated impact of our
interest rate-sensitive investments and repurchase agreement liabilities on the
fair value of our assets and our net income, exclusive of the effect of changes
in fair value on our net income, at June 30, 2012 and December 31, 2011,
assuming a static portfolio and that rates instantaneously fall 25, 50 and 75
basis points and rise 25, 50 and 75 basis points.
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June 30, 2012
Projected Change in
Projected Change in the Our Net
Change in Interest Rates Fair Value of Our Assets* Income
- 75 basis points 0.33 % 9.68 %
- 50 basis points 0.43 % 7.75 %
- 25 basis points 0.33 % 3.87 %
No Change - % - %
+ 25 basis points (0.52 )% (9.68 )%
+ 50 basis points (1.20 )% (19.36 )%
+ 75 basis points (2.00 )% (29.04 )%
December 31, 2011
Projected Change in
Projected Change in the Our Net
Change in Interest Rates Fair Value of Our Assets* Income
- 75 basis points 0.42 % 5.52 %
- 50 basis points 0.34 % 4.41 %
- 25 basis points 0.20 % 2.18 %
No Change - % - %
+ 25 basis points (0.39 )% (5.61 )%
+ 50 basis points (0.93 )% (11.17 )%
+ 75 basis points (1.59 )% (16.74 )%
* Analytics provided by The Yield Book® Software
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 take advantage or minimize the impact of changes in
interest rates. Additionally, the effects of interest rate changes on our
portfolio illustrated in the above chart do not take into account the effect
that our hedging instruments, mainly interest rate swaps and caps, would have on
the fair value of our portfolio, but do take into account the effect that our
hedging instruments, would have on our net income exclusive of the effect on
fair value. Generally, our interest rate swaps reset in the quarter following
changes in interest rates. It is important to note that the impact of changing
interest rates on fair value and net income can change significantly when
interest rates change beyond 75 basis points from current levels. Therefore, the
volatility in the fair value of our assets could increase significantly when
interest rates change beyond 75 basis points. In addition, other factors impact
the fair value of and net income from our interest rate-sensitive investments
and hedging instruments, such as the shape of the yield curve, market
expectations as to future interest rate changes and other market conditions.
Accordingly, in the event of changes in actual interest rates, the change in the
fair value of our assets and our net income would likely differ from that shown
above, and such difference might be material and adverse to our stockholders.
Risk Management
Our board of directors exercises its oversight of risk management in many ways,
including overseeing our senior management's risk-related responsibilities,
including reviewing management policies and performance against these policies
and related benchmarks.
As part of our risk management process, we actively manage the interest rate,
liquidity, prepayment and counterparty risks associated with our Agency RMBS
portfolio. We seek to mitigate our interest rate risk exposure by entering into
various hedging instruments in order to minimize our exposure to potential
interest rate mismatches between the interest we earn on our investments and our
borrowing costs.
We seek to mitigate our liquidity risks by monitoring our liquidity position on
a daily basis and maintaining a prudent level of leverage, which we currently
consider to be between six and 10 times the amount of net assets in our overall
portfolio, based on current market conditions and various other factors,
including the health of the financial institutions that lend to us under our
repurchase agreements and the presence of special liquidity programs provided by
domestic and foreign central banks.
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We seek to mitigate our prepayment risk by investing in Agency RMBS with (i) a
variety of prepayment characteristics, (ii) prepayment prohibitions and
penalties and (iii) prepayment protections, as well as by balancing Agency RMBS
purchased at a premium with Agency RMBS purchased at a discount.
We seek to mitigate our counterparty risk by (i) diversifying our exposure
across a broad number of counterparties, (ii) limiting our exposure to any one
counterparty and (iii) monitoring the financial stability of our
counterparties.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Our management, with the participation of our Chief Executive Officer and our
Chief Financial Officer, evaluated the effectiveness of our disclosure controls
and procedures as of June 30, 2012. The term "disclosure controls and
procedures," as defined in Rules 13a-15(e) and 15d-15(e) under the Securities
Exchange Act of 1934, as amended (the "Exchange Act"), means controls and other
procedures of a company that are designed to ensure that information required to
be disclosed by a company in the reports that it files or submits under the
Exchange Act is recorded, processed, summarized and reported, within the time
periods specified in the SEC's rules and forms. Disclosure controls and
procedures include, without limitation, controls and procedures designed to
ensure that information required to be disclosed by a company in the reports
that it files or submits under the Exchange Act is accumulated and communicated
to the company's management, including its principal executive and principal
financial officers, as appropriate to allow timely decisions regarding required
disclosure. Management recognizes that any controls and procedures, no matter
how well designed and operated, can provide only reasonable assurance of
achieving their objectives and management necessarily applies its judgment in
evaluating the cost-benefit relationship of possible controls and procedures.
Based on the evaluation of our disclosure controls and procedures as of June 30,
2012, our Chief Executive Officer and Chief Financial Officer concluded that, as
of such date, our disclosure controls and procedures were effective.
There have been no changes in our internal controls over financial reporting
that occurred during the last fiscal quarter that have materially affected, or
are reasonably likely to materially affect, our internal controls over financial
reporting.
