The following discussion of our financial condition and results of operations
should be read in conjunction with our financial statements and related notes
included elsewhere in this report.
Overview
We are an externally-managed mortgage REIT incorporated in Maryland in September
2007 to invest in single-family residential mortgage pass-through securities
guaranteed or issued 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). Our
principal goal is to generate net income for distribution to our shareholders
through regular quarterly dividends and protect and grow our shareholders'
equity (which we also refer to as our "book value") through prudent interest
rate risk management. Our net income is determined primarily by the difference
between the interest income we earn on our agency securities net of premium or
discount amortization and the cost of our borrowings and hedging activities,
which we also refer to as our net interest spread or net interest margin. We
utilize substantial borrowings in financing our investment portfolio, which can
enhance potential returns but exacerbate losses. In general, our book value is
most affected by our issuance of shares of our common stock, our retained
earnings or losses, and changes in the value of our investment portfolio and our
hedging instruments.
In order to grow our company, we may from time to time raise additional capital
using various market based transactions. Accordingly, all of our financial
results and data should be viewed with the knowledge that our equity raises have
been significant for our company, and that some period to period comparisons may
not be meaningful or may produce comparisons that may be misleading to future
activity and results.
The following table represents key data regarding our company since the quarter
ending March 31, 2010:
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(in thousands except per share amounts) Quarterly Weighted
Repurchase Shares Book Value Average Earnings
As of Agency Securities (1) Agreements Equity Outstanding Per Share Per Share
December 31, 2012 $ 24,648,140 $ 22,866,429 $ 3,072,864 98,822 $ 28.19 $ 1.02
September 30, 2012 $ 27,931,504 $ 23,583,180 $ 3,212,556 98,809 $ 29.60 $ 0.83
June 30, 2012 $ 24,535,118 $ 20,152,860 $ 2,692,261 98,074 $ 27.45 $ 0.91
March 31, 2012 $ 22,562,895 $ 16,556,630 $ 2,669,300 97,779 $ 27.30 $ 0.89
December 31, 2011 $ 18,146,767 $ 16,162,375 $ 2,080,188 76,823 $ 27.08 $ 0.92
September 30, 2011 $ 19,014,997 $ 15,886,231 $ 2,015,003 76,547 $ 26.32 $ 1.04
June 30, 2011 $ 16,678,511 $ 14,800,594 $ 2,006,606 75,092 $ 26.72 $ 1.04
March 31, 2011 $ 14,811,137 $ 11,495,749 $ 1,894,540 72,572 $ 26.11 $ 0.96
December 31, 2010 $ 10,418,764 $ 8,681,060 $ 1,145,484 46,116 $ 24.84 $ 0.99
September 30, 2010 $ 9,581,916 $ 6,678,426 $ 1,190,313 46,085 $ 25.83 $ 1.12
June 30, 2010 $ 7,651,266 $ 5,982,998 $ 965,619 37,388 $ 25.83 $ 1.01
March 31, 2010 $ 7,125,065 $ 6,102,661 $ 929,433 36,472 $ 25.48 $ 1.21
(1) Includes unsettled purchases and forward commitments to purchase agency
securities.
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 income, 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 income 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 agency securities purchased at a premium increase,
related purchase premium amortization increases, thereby reducing the net yield
on such assets. Because changes in interest rates may significantly affect our
activities, our operating results depend, in large part, upon our ability to
manage interest rate risks and prepayment risks effectively while maintaining
our status as a REIT.
We anticipate that, for any period during which changes in the interest rates
earned on our assets do not coincide with interest rate changes on our
borrowings, such asset coupon rates will reprice more slowly than the
corresponding liabilities used to finance those assets. Consequently, changes in
interest rates, particularly short-term interest rates, may significantly
influence our net interest income. 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 income 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 agency securities 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 agency securities at a premium or discount to par, or face value,
changes in prepayment rates may impact our anticipated yield. In periods of
declining interest rates, prepayments on our agency securities will likely
increase. If we are unable to reinvest the proceeds of these prepayments at
comparable yields, our net interest income may suffer. The current climate of
government intervention in the mortgage market significantly increases the risk
associated with prepayments.
While we intend to use hedging to mitigate some of our interest rate risk, we do
not intend to hedge all of our exposure to changes in interest rates and
prepayment rates, as there are practical limitations on our ability to insulate
our portfolio from all potential negative consequences associated with changes
in short-term interest rates in a manner that will allow us to seek attractive
net spreads on our portfolio.
In addition, a variety of other factors relating to our business may also impact
our financial condition and operating performance. These factors include:
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• our degree of leverage;
• our access to funding and borrowing capacity;
• our borrowing costs;
• our hedging activities;
• the market value of our agency securities; and
• the REIT requirements, the requirements to qualify for an exemption
under the Investment Company Act and other regulatory and accounting
policies related to our business.
Our manager is entitled to receive a management fee that is based on our equity
(as defined in our management agreement), regardless of the performance of our
portfolio. Accordingly, the payment of our management fee may not decline in the
event of a decline in our profitability and may cause us to incur losses.
For a discussion of additional risks relating to our business see Item 1A-"Risk
Factors".
Market and Interest Rate Trends and the Effect on our Portfolio
Credit Market Disruption
Since 2007, the residential housing and mortgage markets in the United States
have experienced a variety of difficulties and challenging economic conditions
including historically high loan defaults and credit losses, as well as
decreased liquidity. Recently, the financial weakness of some of the European
Union sovereign nations has renewed concerns of the stability of financial
systems worldwide. Further increased volatility and deterioration in the overall
financial markets may adversely affect the performance and market value of the
agency securities in which we invest. In addition, we rely on the availability
of financing to acquire agency securities on a leveraged basis. If market
conditions deteriorate further, our lenders may exit the repurchase market,
further tighten lending standards, or increase the amount of equity capital (or
"haircut") required to obtain financing, any of which could make it more
difficult or costly for us to obtain financing.
Developments at Fannie Mae and Freddie Mac
Payments on the agency securities in which we invest are guaranteed by Fannie
Mae and Freddie Mac. Because of the guarantee and the underwriting standards
associated with mortgages underlying agency securities, agency securities
historically have had high stability in value and have been considered to
present low credit risk. In 2008, Fannie Mae and Freddie Mac were placed under
the conservatorship of the U.S. government due to the significant weakness of
their financial condition. The turmoil in the residential mortgage sector and
concern over the future role of Fannie Mae and Freddie Mac at the time generally
increased credit spreads and decreased price stability of agency securities. In
response to the credit market disruption and the deteriorating financial
condition of Fannie Mae and Freddie Mac, Congress and the U.S. Treasury
undertook a series of actions in 2008 aimed at stabilizing the financial markets
in general, and the mortgage market in particular. These actions include the
large-scale buying of MBS, significant equity infusions into banks and
aggressive monetary policy.
In February 2011, the U.S. Treasury along with the U.S. Department of Housing
and Urban Development released a report entitled "Reforming America's Housing
Finance Market" to Congress outlining alternatives for reforming the U.S.
housing system, specifically Fannie Mae and Freddie Mac, and transforming the
government's involvement in the housing market. Other industry groups, such as
the Mortgage Bankers Association and the National Association Home Builders,
have also issued proposals outlining their views of the path for housing reform.
It is unclear how future legislation may impact the
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housing finance market and the investing environment for agency securities, as
the method of reform is undecided and has not yet been defined by the
regulators. Without government support for residential mortgages, we may not be
able to execute our current business model in an efficient manner.
On October 4, 2012, the Federal Housing Finance Authority (the "FHFA") released
its white paper entitled "Building a New Infrastructure for the Secondary
Mortgage Market" (the "FHFA White Paper"). This release follows up on the FHFA's
February 21, 2012 Strategic Plan for Enterprise Conservatorships, which set
forth three goals for the next phase of the Fannie Mae and Freddie Mac
conservatorships. These three goals are to (i) build a new infrastructure for
the secondary mortgage market, (ii) gradually contract Fannie Mae and Freddie
Mac's presence in the marketplace while simplifying and shrinking their
operations, and (iii) maintain foreclosure prevention activities and credit
availability for new and refinanced mortgages.
The FHFA White Paper proposes a new infrastructure for Fannie Mae and Freddie
Mac that has two basic goals. The first goal is to replace the current, outdated
infrastructures of Fannie Mae and Freddie Mac with a common, more efficient
infrastructure that aligns the standards and practices of the two entities,
beginning with core functions performed by both entities such as issuance,
master servicing, bond administration, collateral management and data
integration. The second goal is to establish an operating framework for Fannie
Mae and Freddie Mac that is consistent with the progress of housing finance
reform and encourages and accommodates the increased participation of private
capital in assuming credit risk associated with the secondary mortgage market.
The FHFA recognizes that there are a number of impediments to their goals which
may or may not be surmountable, such as the absence of any significant secondary
mortgage market mechanisms beyond Fannie Mae, Freddie Mac and Ginnie Mae, and
that their proposals are in the formative stages. As a result, it is unclear if
the proposals will be enacted. If such proposals are enacted, it is unclear how
closely what is enacted will resemble the proposals from the FHFA White Paper or
what the effects of the enactment will be.
U.S. Treasury and Agency Securities Market Intervention
One of the main factors impacting market prices has been the U.S. Federal
Reserve's programs to purchase U.S. Treasury and agency securities in the open
market. On September 21, 2011, the U.S. Federal Reserve announced "Operation
Twist," which is a program by which it purchased, by the end of December 2012,
more than $650 billion of U.S. Treasury securities with remaining maturities
between six and 30 years and sold an equal amount of U.S. Treasury securities
with remaining maturities of three years or less. In December 2012, in an effort
to keep long-term interest rates at low levels, the U.S. Federal Reserve
announced an expansion of its asset buying program starting in January 2013, at
which time it would commence outright purchases of longer-term U.S. Treasury
securities at a pace of $45 billion per month. This new U.S. Treasury securities
purchase program replaces "Operation Twist," which expired in December 2012. On
January 30, 2013, the U.S. Federal Reserve affirmed its intention to continue
this policy. By reducing the available supply of longer term U.S. Treasury
securities in the market, these actions 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 securities. 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 September 2012, the U.S. Federal Reserve announced a third round of
"quantitative easing" aimed to improve the employment outlook and increase
growth in the U.S. economy. To accomplish this goal, it announced that it would
purchase at least $40 billion of agency securities per month on an "open-ended"
timeline, in addition to the reinvestment of the proceeds of principal
repayments from its existing MBS holdings. Additionally, it pledged to keep
short-term interest rates near zero for an extended period of time, currently
estimated by the U.S. Federal Reserve to be at least mid-2015.
These programs have had many effects on our assets. One effect of these
purchases has been an increase in the prices of agency securities, which has
contributed to the decrease of our net interest margin. The unpredictability of
these programs has also injected additional volatility into the pricing and
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availability of our assets. It is difficult to quantify the impact, as there are
many factors at work at the same time which affects the price of our securities
and, therefore, our yield and book value. Due to the unpredictability in the
markets for our securities in particular and yield generating assets in general,
there is no pattern that can be implied with any certainty. We believe the
largest risk is that if the government decides to sell significant portions of
its portfolio, then we may see meaningful price declines.
U.S. Government Credit Rating
The U.S. debt ceiling and budget deficit concerns in mid-2011 led to the
downgrade by Standard & Poor's of the U.S. government's credit rating for the
first time in history. Assets backed by Fannie Mae and Freddie Mac are
considered to have the credit of the U.S. government, and thus were also
downgraded at that time. While the other rating agencies have not downgraded the
U.S. government's rating, if they were to do so it would likely impact the
perceived credit risk associated with agency securities and, therefore, decrease
the value of the agency securities in our portfolio. In addition, further
downgrades of the U.S. government's credit rating or the credit ratings of
certain European countries would likely create broader financial turmoil and
uncertainty, which could have a serious negative impact on the global banking
system. This could have an adverse impact on our business, financial condition
and results of operations.
Regulatory Concerns
We believe that we conduct our business in a manner that allows us to avoid
being regulated as an investment company under the Investment Company Act
pursuant to the exemption provided by Section 3(c)(5)(C) for entities that are
primarily engaged in the business of purchasing or otherwise acquiring
"mortgages and other liens on and interests in real estate." On August 31, 2011,
the SEC issued a concept release (No. IC-29778; File No. SW7-34-11, Companies
Engaged in the Business of Acquiring Mortgages and Mortgage-Related Instruments)
pursuant to which it is reviewing whether certain companies that invest in MBS
and rely on the exemption from registration under Section 3(c)(5)(C) of the
Investment Company Act (such as us) should continue to be allowed to rely on
such exemption from registration. If we fail to continue to qualify for this
exemption from registration as an investment company, or the SEC determines that
companies that invest in MBS are no longer able to rely on this exemption, our
ability to use leverage would be substantially reduced and we would be unable to
conduct our business as planned, or we may be required to register as an
investment company under the Investment Company Act, either of which could
negatively affect the value of shares of our common stock and our ability to
make distributions to our shareholders.
Certain programs initiated by the U.S. Government, through the Federal Housing
Administration and the Federal Deposit Insurance Corporation ("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
securities could be that such holders would experience changes in the
anticipated yields of their agency securities due to (i) increased prepayment
rates and (ii) lower interest and principal payments.
On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and
Consumer Protection Act ("Dodd-Frank Act") into law. The Dodd-Frank Act is
extensive, complicated and comprehensive legislation that impacts practically
all aspects of banking, and 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 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 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 systemically important financial institutions (including nonbank
financial companies), as well as the implementation of the FDIC
resolution procedures for liquidation of large financial
companies to
avoid market disruption;
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• 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-basedeligibility,
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 securities and interest rate swaps
as much of the bill's implementation has not yet been defined by the regulators.
In addition, in 2010, the Group of Governors and Heads of Supervisors of the
Basel Committee on Banking Supervision, the oversight body of the Basel
Committee, published its "calibrated" capital standards for major banking
institutions ("Basel III"). Under these standards, when fully phased in on
January 1, 2019, banking institutions will be required to maintain heightened
Tier 1 common equity, Tier 1 capital and total capital ratios, as well as
maintaining a "capital conservation buffer." Beginning with the Tier 1 common
equity and Tier 1 capital ratio requirements, Basel III will be phased in
incrementally between January 1, 2013 and January 1, 2019. The final package of
Basel III reforms were approved by the G20 leaders in November 2010 and are
subject to individual adoption by member nations, including the United States by
January 1, 2013. It is unclear how the adoption of Basel III will affect our
business at this time.
In September 2011, the Administration announced it was working on a major plan
to allow certain homeowners who owe more on their mortgages than their homes are
worth to refinance. In October 2011, the FHFA announced changes to HARP to
expand access to refinancing for qualified individuals and families whose homes
have lost value, including increasing the HARP loan-to-value ratio above 125%.
However, this would only apply to mortgages guaranteed by the U.S.
government-sponsored entities. In addition, the expansion does not change the
time period which these loans were originated, maintaining the requirement that
the loans must have been guaranteed by Fannie Mae or Freddie Mac prior to June
2009. There are many challenging issues to this proposal, notably the question
as to whether a loan with a loan-to-value ratio of 125% qualifies as a mortgage
or an unsecured consumer loan. The chances of this initiative's success have
created additional uncertainty in the agency securities market, particularly
with respect to possible increases in prepayment rates. We do not expect this
announcement to have a significant impact on our results of operations.
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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
providing 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 securities
as the method of reform is undecided and has not yet been defined by the
regulators.
Exposure to European Financial Counterparties
We have no direct exposure to any European sovereign credit. We do finance the
acquisition of our agency securities with repurchase agreements, some of which
are provided by European banks. In connection with these financing arrangements,
we pledge our securities as collateral to secure the borrowing. The amount of
collateral pledged will typically exceed the amount of the financing with the
extent of over-collateralization ranging from 3%-6% of the amount borrowed.
While repurchase agreement financing results in us recording a liability to the
counterparty in our consolidated balance sheet, we are exposed to the
counterparty, if during the term of the repurchase agreement financing, a lender
should default on its obligation and we are not able to recover our pledged
assets. The amount of this exposure is the difference between the amount loaned
to us plus interest due to the counterparty and the fair value of the collateral
pledged by us to the lender including accrued interest receivable on such
collateral.
In addition, we use interest rate swaps to manage interest rate risk exposure in
connection with our repurchase agreement financings. We will make cash payments
or pledge securities as collateral as part of a margin arrangement in connection
with interest rate swaps that are in an unrealized loss position. In the event
that a counterparty were to default on its obligation, we would be exposed to a
loss to a swap counterparty to the extent that the amount of cash or securities
pledged exceeded the unrealized loss on the associated swaps and we were not
able to recover the excess collateral.
During the past several years, several large European banks have experienced
financial difficulty and have been either rescued by government assistance or by
other large European banks. Some of these banks have U.S. banking subsidiaries,
which have provided financing to us, particularly repurchase agreement financing
for the acquisition of agency securities. At December 31, 2012, we had entered
into repurchase agreements and/or interest rate swaps with seven financial
institution counterparties that are either domiciled in Europe or a U.S.-based
subsidiary of a European domiciled financial institution. Our total exposure to
these banks was 8.2% of our equity at December 31, 2012. At December 31, 2012,
we did not use credit default swaps or other forms of credit protection to hedge
these exposures, although we may in the future. The following table shows our
exposure by country to European banks.
Exposure
as a
Number of percentage
(Dollars in thousands) Counterparties Exposure (1) of equity
England 1 $ 43,424 1.4 %
France 1 42,898 1.4 %
Germany 2 49,107 1.6 %
Netherlands 1 36,630 1.2 %
Scotland 1 23,615 0.8 %
Switzerland 1 55,807 1.8 %
7 $ 251,481 8.2 %
(1) Exposure represents our total assets pledged as collateral in excess of our
obligations, including any accrued interest receivable on the pledged
assets.
If the European credit crisis continues to impact these major European banks,
there is the possibility that it will also impact the operations of their U.S.
banking subsidiaries. This could adversely affect our financing and operations
as well as those of the entire mortgage sector in general. Management monitors
our exposure to our repurchase agreement and 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 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.
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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. Our borrowings in the repurchase
market have historically closely tracked LIBOR and the U.S. Federal Funds Target
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 agency securities we buy are affected by the shape of the yield
curve, particularly along the area between two year Treasury rate and 10 year
Treasury rates. The following table shows the 30-day LIBOR as compared to these
rates at each period end:
30-day Fed Two Year 10 Year
LIBOR Funds Treasury Treasury December 31, 2012 0.21 % 0.09 % 0.25 % 1.78 %
September 30, 2012 0.21 % 0.09 % 0.23 % 1.63 %
June 30, 2012 0.25 % 0.09 % 0.30 % 1.65 %
March 31, 2012 0.24 % 0.09 % 0.33 % 2.21 %
December 31, 2011 0.30 % 0.25 % 0.24 % 1.88 %
September 30, 2011 0.24 % 0.25 % 0.25 % 1.92 %
June 30, 2011 0.19 % 0.25 % 0.46 % 3.16 %
March 31, 2011 0.24 % 0.25 % 0.83 % 3.47 %
December 31, 2010 0.26 % 0.25 % 0.60 % 3.30 %
September 30, 2010 0.26 % 0.25 % 0.43 % 2.51 %
June 30, 2010 0.35 % 0.25 % 0.61 % 2.93 %
March 31, 2010 0.25 % 0.25 % 1.02 % 3.83 %
Principal Repayment Rate
Our net income is primarily a function of the difference between the yield on
our assets and the financing cost of owning those assets. Since we tend to
purchase assets at a premium to par, the main item that can affect the yield on
our assets after they are purchased is the rate at which the mortgage borrowers
repay the loan. While the scheduled repayments, which are the principal portion
of the homeowners' regular monthly payments, are fairly predictable, the
unscheduled repayments, which are generally refinancing of the mortgage, are
less so. Estimates of repayment rates are critical to the management of our
portfolio, not only for estimating current yield but also to consider the rate
of reinvestment of those proceeds into new securities, the yields which those
new securities may add to our portfolio, as well as the extent to which we
extend the duration of our liabilities in connection with hedging activities.
The following table shows the weighted average principal repayment rate and the
one-month constant prepayment rate ("CPR") for the periods presented:
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Weighted
Weighted Average
Average Principal
Principal Repayment
Repayment Rate One-Month
Quarter ended Rate (1) Annualized (2) CPR (3)
December 31, 2012 6.64 % 26.55 % 19.8
September 30, 2012 6.90 % 27.61 % 20.5
June 30, 2012 6.36 % 25.42 % 19.7
March 31, 2012 6.42 % 25.67 % 19.6
December 31, 2011 6.85 % 27.39 % 20.8
September 30, 2011 7.14 % 28.55 % 21.7
June 30, 2011 4.64 % 18.54 % 14.9
March 31, 2011 5.61 % 22.44 % 17.5
December 31, 2010 7.81 % 31.26 % 23.9
September 30, 2010 8.48 % 33.91 % 25.5
June 30, 2010 11.27 % 45.08 % 29.1
(1) Scheduled and unscheduled principal payments as a percentage of the weighted
average portfolio.
(2) Weighted average principal repayment rate annualized.
(3) CPR measures one month of unscheduled repayments as a percentage of
principal on an annualized basis.
Investing the Proceeds of our Offerings
We began operations following the closing of our initial private offering on
November 5, 2007. The following is a summary of our common stock transactions:
(Dollars in thousands except per share amounts)
Number of
Shares of Offering
Common Price Net
Date of Offering Stock Sold Per Share Proceeds (1)
March 30, 2012 20,125,000 $ 26.81 (2) $ 539,327
March 18, 2011 16,675,000 $ 28.50 $ 468,765
January 5, 2011 11,500,000 $ 28.75 $ 325,707
September 21, 2010 7,475,000 $ 28.75 $ 205,642
December 15, 2008 9,409,090 $ 22.00 $ 196,463
April 30, 2008 (IPO) 11,500,000 $ 24.00 $ 255,440
February 5, 2008 6,900,000 $ 24.00 $ 158,743
November 5, 2007 8,203,937 $ 20.00 $ 157,054
(1) After deducting underwriting costs and other fees and costs associates with
issuance.
(2) Net price received by the company for shares of stock sold.
While our operations are affected in many ways by the issuance of additional
shares, the most significant immediate earnings impact is that we generally do
not invest all of the proceeds immediately. Depending on market conditions, and
the fact that normal trade settlement on agency securities is not based on the
trade date, we have averaged around two months to invest the proceeds from these
offerings. Since each capital raise was individually significant to the size of
our portfolio, our results from operations, and some statistics regarding such
results, may not be meaningful or portray the underlying fundamentals of our
investment portfolio.
We have issued both common and preferred equity during 2012. On March 30, 2012,
we issued 20,125,000 shares of common stock for net proceeds of approximately
$539.3 million. During 2012, we also issued 1,713,900 shares of common stock
under our at-the-market offering programs for net proceeds of approximately
$48.3 million.
On August 27, 2012, we issued 11,500,000 shares of our Series A Preferred Stock
for net proceeds of approximately $278.3 million. This was our first preferred
stock offering.
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Book Value per Share
As of December 31, 2012, our book value per share of common stock (total
shareholders' equity plus the aggregate liquidation preference for Series A
Preferred Stock divided by shares of common stock outstanding) was $28.19, an
increase of $1.11, from $27.08 at December 31, 2011. A portion of this increase,
$0.44 was the result of our additional offerings of common stock at prices that
were higher than our book value at the time. The decrease in the value of our
liabilities contributed $0.39 of the increase. Although we attempt to structure
our interest rate swap portfolio to offset the changes in asset prices, the
price movements of the swaps and MBS are not perfectly correlated, and depend on
a variety of market forces. Undistributed earnings contributed the remaining
portion of our book value gain. The following table shows the components of our
book value on a per share basis at each period end:
Unrealized
Unrealized Gain/(Loss) Book
Common Undistributed Gain/(Loss) on Interest Value
As of Equity Earnings on MBS Rate Swaps Per Share
December 31, 2012 $ 25.15 0.38 5.12 (2.46 ) $ 28.19
September 30, 2012 $ 25.14 0.05 7.16 (2.75 ) $ 29.60
June 30, 2012 $ 25.25 0.02 4.73 (2.55 ) $ 27.45
March 31, 2012 $ 25.23 0.01 4.29 (2.23 ) $ 27.30
December 31, 2011 $ 24.79 0.03 5.11 (2.85 ) $ 27.08
September 30, 2011 $ 24.79 0.01 4.56 (3.04 ) $ 26.32
June 30, 2011 $ 24.79 (0.03 ) 3.47 (1.51 ) $ 26.72
March 31, 2011 $ 24.67 (0.06 ) 1.67 (0.17 ) $ 26.11
December 31, 2010 $ 22.62 (0.08 ) 3.33 (1.03 ) $ 24.84
September 30, 2010 $ 22.63 (0.07 ) 5.66 (2.39 ) $ 25.83
June 30, 2010 $ 21.50 0.12 6.36 (2.15 ) $ 25.83
March 31, 2010 $ 21.32 0.24 5.25 (1.33 ) $ 25.48
Investments
Agency Securities
We invest in both adjustable and fixed-rate agency securities. At December 31,
2012 and 2011, we owned $23.9 billion and $17.7 billion, respectively, of agency
securities. While our strategy focuses on ARM securities, we also own fixed-rate
securities with estimated durations that we believe are beneficial to the
overall mix of our assets. As of December 31, 2012 and 2011, our agency
securities portfolio was purchased at a net premium to par, or face value, with
a weighted-average amortized cost of 102.85 and 102.47, respectively, of face
value. As of December 31, 2012 and 2011, we had approximately $648.2 million and
$418.1 million, respectively, of unamortized premium included in the cost basis
of our agency securities.
During the year ended December 31, 2012, we purchased approximately $16.1
billion of agency securities with a weighted average coupon of 2.48%. During the
year ended December 31, 2011, we purchased approximately $9.8 billion of agency
securities with a weighted average coupon of 3.18%
We typically want to own a higher percentage of Fannie Mae ARMs, than Freddie
Mac ARMs as Fannie Mae has better cash flow to the security holder because
Fannie Mae pays principal and interest sooner after accrual (45 days) as
compared to Freddie Mac (75 days).
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Our investment portfolio consisted of the following types of Fannie Mae and
Freddie Mac securities at December 31, 2012:
Agency
Securities Gross Gross
Amortized Unrealized Unrealized Estimated
Cost Loss Gain Fair Value % of Total
Agency Securities
Fannie Mae Certificates
ARMS $ 14,081,259 $ (100 ) $ 329,780 $ 14,410,939 60.3 %
Fixed Rate 743,299 9,296 752,595 3.1 %
Total Fannie Mae 14,824,558 (100 ) 339,076 15,163,534
Freddie Mac Certificates
ARMS 7,850,630 (21 ) 149,114 7,999,723 33.4 %
Fixed Rate 744,720 - 11,274 755,994 3.2 %
Total Freddie Mac 8,595,350 (21 ) 160,388 $ 8,755,717
Total Agency Securities $ 23,419,908 $ (121 ) $ 499,464 $ 23,919,251
Our investment portfolio consisted of the following types of Fannie Mae and
Freddie Mac securities at December 31, 2011:
Gross Gross
Amortized Unrealized Unrealized Estimated
(Dollars in thousands) Cost Loss Gain Fair Value % of Total
Agency Securities
Fannie Mae Certificates
ARMs $ 11,446,397 $ - $ 278,559 $ 11,724,956 66.1 %
Fixed Rate 493,648 (132 ) 1,076 494,592 2.8 %
Total Fannie Mae 11,940,045 (132 ) 279,635 12,219,548
Freddie Mac Certificates
ARMs 4,925,438 $ - 103,540 5,028,978 28.3 %
Fixed Rate 491,289 (6 ) 2,064 493,347 2.8 %
Total Freddie Mac 5,416,727 (6 ) 105,604 5,522,325
Total Agency Securities $ 17,356,772 $ (138 ) $ 385,239 $ 17,741,873
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Adjustable-rate securities
As of December 31, 2012 our investment portfolio consisted of ARM securities as
follows:
Weighted Avg.
(dollars in thousands) % of ARM Current Weighted Avg. Amortized Amortized Weighted Avg.
Months to Reset Portfolio Face value (1) Coupon (2) Purchase Price (3) Cost (4) Market Price (5) Market Value (6)
0-12 4.1 % $ 856,698 4.03 % $ 101.24 $ 867,348 $ 106.79 $ 914,832
13-24 4.3 % 911,412 3.88 % $ 102.28 932,202 $ 106.08 966,854
25-36 10.2 % 2,155,206 3.60 % $ 102.27 2,204,154 $ 105.55 2,274,763
37-48 14.3 % 3,059,130 3.06 % $ 102.38 3,132,043 $ 104.84 3,207,245
49-60 16.1 % 3,450,959 2.76 % $ 102.82 3,548,369 $ 104.81 3,616,891
61-72 13.5 % 2,868,337 3.26 % $ 102.55 2,941,356 $ 105.54 3,027,295
73-84 33.9 % 7,276,854 2.44 % $ 103.37 7,522,264 $ 104.54 7,607,359
85-96 0.6 % 126,924 3.08 % $ 103.47 131,327 $ 105.17 133,487
97-108 - - - $ - - $ - -
109-120 2.9 % 610,509 2.81 % $ 103.53 632,087 $ 105.00 641,013
121-140 0.1 % 19,995 2.69 % $ 103.72 20,739 $ 104.65 20,923
100.0 % $ 21,336,024 2.95 % $ 102.79 $ 21,931,889 $ 105.04 $ 22,410,662
As of December 31, 2011, our investment portfolio consisted of ARM securities as
follows:
Weighted Avg.
(dollars in thousands) % of Current
Weighted Avg. Amortized Purchase Amortized Weighted Avg.
Months to Reset
Portfolio Face value (1) Coupon (2) Price (3) Cost (4) Market Price (5) Market Value (6)
0-12 4.0 % $ 650,586 4.56 % $ 101.32 $ 659,186 $ 106.25 $ 691,225
13-24 4.6 % 721,594 4.93 % 101.30 730,975 106.60 769,239
25-36 5.9 % 940,651 3.93 % 102.02 959,684 105.55 992,880
37-48 21.9 % 3,495,234 3.65 % 102.42 3,579,660 104.98 3,669,359
49-60 26.5 % 4,253,901 3.06 % 102.46 4,358,429 104.36 4,439,416
61-72 12.4 % 1,980,929 3.41 % 102.83 2,036,946 104.58 2,071,610
73-84 23.7 % 3,795,037 3.28 % 102.61 3,894,106 104.48 3,965,045
85-96 0.1 % 9,330 4.33 % 101.83 9,501 105.74 9,866
97-108 0.9 % 138,314 3.93 % 103.64 143,349 105.05 145,294
Total MBS 100.0 % $ 15,985,576 3.49 % $ 102.42 $ 16,371,836 $ 104.81 $ 16,753,934
(1) The current face is the current monthly remaining dollar amount of principal
of a mortgage security. We compute current face by multiplying the original
face value of the security by the current principal balance factor. The
current principal balance factor is essentially a fraction, where the
numerator is the current outstanding balance and the denominator is the
original principal balance.
(2) For a pass-through certificate, the coupon reflects the weighted average
nominal rate of interest paid on the underlying mortgage loans, net of fees
paid to the servicer and the agency. The coupon for a pass-through
certificate may change as the underlying mortgage loans are prepaid. The
percentages indicated in this column are the nominal interest rates that
will be effective through the interest rate reset date and have not been
adjusted to reflect the purchase price we paid for the face amount of
security.
(3) Amortized purchase price is the dollar amount, per $100 of current face, of
our purchase price for the security, adjusted for amortization as a result
of scheduled and unscheduled principal paydowns.
(4) Amortized cost is our total purchase price for the mortgage security,
adjusted for amortization as a result of scheduled and unscheduled principal
paydowns.
(5) Market price is the dollar amount of market value, per $100 of nominal, or
face, value, of the mortgage security. Under normal conditions, we compute
market value by obtaining three valuations for the mortgage security from
three separate and independent sources and averaging the three valuations.
(6) Market value is the total market value for the mortgage security. Under
normal conditions, we compute market value by obtaining valuations for the
mortgage security from three separate and independent sources and averaging
the three valuations.
As of December 31, 2012, excluding any fixed-rate securities, the ARMs
underlying our adjustable rate agency securities had fixed interest rates for an
average period of approximately 59 months after which time the interest rates
reset and become adjustable annually. At December 31, 2012, 98.4% of our agency
ARMs were still in their initial fixed-rate period, and approximately 2.5% of
our agency securities will reach the end of their initial fixed-rate period in
the next 12 months. The balance of our agency ARMs, have already reached their
initial reset period and will reset annually for the life of the security.
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After the reset date, interest rates on our agency 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 agency ARMs typically
have a maximum initial one-time adjustment of 5%, and the average annual
interest rate increase (or decrease) to the interest rates on our agency
securities is 2% per year. The average lifetime cap on increases (or decreases)
to the interest rates on our agency securities 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 agency securities purchased to date have been
15-year amortizing fixed rate securities. At December 31, 2012, we owned $1.5
billion of 15-year fixed-rate agency securities with a weighted average life,
assuming a constant prepayment rate of 10, of 4.1 years. The following table
details our fixed rate portfolio at December 31, 2012.
% of Fixed Amortized
Rate Current Weighted Avg. Purchase Amortized Weighted Avg.
Portfolio Face value (1) Coupon (2) Price (3) Cost (4) Market Price (5) Market Value (6)
Wtd Avg Months to Maturity
155-167 6.8 % $ 95,979 3.00 % $ 103.36 $ 99,201 $ 106.44 $ 102,158
168-180 93.2 % 1,339,726 2.60 % $ 103.66 1,388,818 $ 104.98 1,406,431
Total Fixed Rate 100.0 % $ 1,435,705 2.62 % $ 103.64 $ 1,488,019 $ 105.08 $ 1,508,589
The following table details our fixed rate portfolio at December 31, 2011.
Weighted Avg.
% of Fixed Amortized
Rate Current Weighted Avg. Purchase Amortized Weighted Avg.
Portfolio Face value (1) Coupon (2) Price (3) Cost (4) Market Price (5) Market Value (6)
Wtd Avg Months to Maturity
168-180 100.0 % $ 953,134 3.05 % $ 103.34 $ 984,936 $ 103.65 $ 987,939
(1) The current face value is the current monthly remaining dollar amount of
principal of a mortgage security. We compute current face value by
multiplying the original face value of the security by the current principal
balance factor. The current principal balance factor is essentially a
fraction, where the numerator is the current outstanding balance and the
denominator is the original principal balance.
(2) For a pass-through certificate, the coupon reflects the weighted average
nominal rate of interest paid on the underlying mortgage loans, net of fees
paid to the servicer and the agency. The coupon for a pass-through
certificate may change as the underlying mortgage loans are prepaid. The
percentages indicated in this column have not been adjusted to reflect the
purchase price we paid for the face amount of security.
(3) Amortized purchase price is the dollar amount, per $100 of current face, of
our purchase price for the security, adjusted for amortization as a result
of scheduled and unscheduled principal paydowns.
(4) Amortized cost is our total purchase price for the mortgage security,
adjusted for amortization as a result of scheduled and unscheduled principal
paydowns.
(5) Market price is the dollar amount of market value, per $100 of nominal, or
face value, of the mortgage security. Under normal conditions, we compute
market value by obtaining valuations for the mortgage security from separate
and independent sources and averaging these valuations.
(6) Market value is the total market value for the mortgage security.
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Forward Purchases
While most of our purchases of agency securities are accounted for using trade
date accounting, some forward purchases, such as certain TBAs do not qualify for
trade date accounting and are considered derivatives for financial statement
purposes. Pursuant to ASC Topic 815, we account for these derivatives as
all-in-one cash flow hedges. The net fair value of the forward commitment is
reported on the balance sheet as an asset (or liability), with a corresponding
unrealized gain (or loss) recognized in other comprehensive income. Since we
purchase forward for the purposes of holding the securities for investment, we
consider all our agency securities, settled or unsettled, as part of our
portfolio for the purposes of cash flow and interest rate sensitivity, and
consequently hedging, duration measurement, and other related investment
management activity.
Liabilities
We have entered into repurchase agreements to finance most of our agency
securities. Our repurchase agreements are secured by our agency securities and
bear interest at rates that have historically moved in close relationship to
LIBOR. As of December 31, 2012, we had established 30 borrowing relationships,
respectively with various investment banking firms and other lenders. We had
outstanding balances under our repurchase agreements at December 31, 2012 of
$22.9 billion.
Hedging Instruments
We generally intend to hedge as much of our interest rate risk as our manager
deems prudent in light of market conditions. No assurance can be given that our
hedging activities will have the desired beneficial impact on our results of
operations or financial condition. Our policies do not contain specific
requirements as to the percentages or amount of interest rate risk that our
manager is required to hedge.
Interest rate hedging may fail to protect or could adversely affect us because,
among other things:
• available interest rate hedging may not correspond directly with the
interest rate risk for which protection is sought;
• the duration of the hedge may not match the duration of the related
liability;
• fair value accounting rules could foster adverse valuation adjustments due to credit quality considerations that could impact both earnings
and shareholder equity;
• the party owing money in the hedging transaction may default on its
obligation to pay;
• the credit quality of the party owing money on the hedge may be
downgraded to such an extent that it impairs our ability to sell or
assign our side of the hedging transaction; and
• the value of derivatives used for hedging may be adjusted from time to
time in accordance with accounting rules to reflect changes in fair
value. Downward adjustments, or "mark-to-market losses," would reduce
our shareholders' equity.
As of December 31, 2012, we had entered into 82 interest rate swap agreements
with 14 counterparties to hedge 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 $10.7
billion of borrowings under our repurchase agreements. 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.
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Results of Operations
2012 Compared to 2011
Our net income available to common shareholders for the year ended December 31,
2012 was $341.7 million, or $3.67 per weighted average share, a decrease of
$0.30 per share from earnings for the year ended December 31, 2011 of $284.4
million or $3.97 per weighted average share. In general, the increase in the
gross net income number was a result having a larger investment portfolio. We
increased our equity significantly by issuing additional common stock in March
2012 and issuing preferred stock in August 2012. In general this discussion will
not comment on the increase in gross numbers as this was primarily a function of
our increase in equity.
To understand the decrease on a per share basis requires a deeper look into the
components of our business model. Two of the main drivers of earnings in an
interest rate sensitive business are 1) the interest rate cycle and 2) the
steepness of the yield curve. Generally, as the falling interest rate part of
the cycle comes to an end, the difference between the amount we earn on our
assets and pay on our liabilities, or net interest spread, experiences
compression. While there is a wide range of reasons and timing aspects, this
trend is reflective of the yield curve in general. Often at the same time, this
compression is exacerbated by an increased rate of homeowner refinancing, or
prepayments, which occurs as mortgage rates fall. Prepayment rates trended
higher during 2012 due to interest rates remaining at historic lows, the
flattening of the yield curve, and continued actions by the U.S. Federal Reserve
and U.S. Treasury to make refinancing a mortgage economically attractive. In our
portfolio, higher prepayments contributed in three ways to lower interest
income: (1) higher premium amortization expense and lower asset yields;
(2) lower average earning assets; and (3) lower weighted average coupon as new
investments were at lower coupons.
While the relative difference between our interest income and interest expense
is more important to our net income than the absolute level of rates, the yield
on our assets is significantly affected by the coupon rate. Because of lower
overall mortgage rates, our weighted average coupon at December 31, 2012 was
2.93%, a 0.53% decrease from December 31, 2011, when our assets had a weighted
average coupon of 3.46%. These coupon rates declined throughout 2012 primarily
due to continued economic weakness, further declines in the U.S. housing market,
and continued pressure on mortgage rates from U.S. government policy. This
resulted in our asset purchases being on average at lower interest rates. Spread
compression is a normal part of an interest rate cycle, the affects of which
become more pronounced the longer that rates stay low and stable.
Our net interest income for the year ended December 31, 2012 was $309.2 million,
an increase compared to the year ended December 31, 2011 amount of $281.5
million. In 2012, our portfolio had an average yield of 2.28% and a cost of
funds (including hedges) of 0.96%. This resulted in a net interest margin (or
spread) of 1.32% for the year ended December 31, 2012. For the year ended
December 31, 2011, our portfolio had a yield of 2.84% and a cost of funds of
1.06%, generating a net interest rate spread of 1.78%.
After coupon rate, the yield on our assets is most directly affected by the rate
of repayments on our agency securities. The percentage rate of our portfolio
repayment for the year ended December 31, 2012 was 26.39% as compared to 24.54%
for the year ended December 31, 2011. While this rate of repayment was higher
than in 2011, it was in line with our expectations based on current market
conditions. At December 31, 2012, our portfolio had an average dollar price of
$102.85 per $100 of face value. Keeping the price of our portfolio close to par
helps us predict and manage the costs associated with the repayment speeds of
our assets, as changes in repayments speeds have a lesser affect on income than
a portfolio with a higher premium price.
Our weighted average cost of funds (not including hedges) for the year ended
December 31, 2012 was 0.39%, increasing from 0.29% for the year ended
December 31, 2011. While our repurchase agreement rates are often similar to,
and move in connection with, the corresponding LIBOR, that was not the case for
2012. LIBOR stayed consistently low throughout 2012, ending 2012 at 0.21% while
our repurchase agreement rates rose. In 2012, we incurred expense related to our
interest rate hedges of $117.3 million, as
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compared to $105.1 million for the year ended December 31, 2011. We increased
our total notional interest rate swap amount from $7.3 billion at December 31,
2011 to $10.7 billion at December 31, 2012. The additional capital raises during
the year allowed us to increase the notional amount of our interest rate swaps,
lower our average swap interest rate while maintaining the percentage of assets
hedge in a similar range with prior year. The overall rate on our hedges
resulted in an average cost of funds for the year ended December 31, 2012 of
0.96%, down from 1.06% for the year ended December 31, 2011. We ended 2012 with
a total $10.7 billion of interest rate swap contracts with a weighted average
rate of 1.47% and weighted average remaining term of 31 months.
We sold some of our agency securities in 2012 as part of normal adjustments to
our portfolio. Although we typically buy and hold our securities, as conditions
change in any year we may choose to dispose of certain securities. For example,
we may dispose of a security if it falls outside of our current desired asset
mix or we believe it to be at an increased risk of prepayment. We may also sell
securities as part of a broader strategy move to be more defensive in managing
the portfolio as market conditions change. In 2012, we disposed of $5.8 billion
face value of agency securities for a net gain of $64.3 million. In 2011, we
disposed of $1.6 billion face value of agency securities for a net gain of $
20.6 million.
Our total operating expenses increased for the year ended December 31, 2012
compared to the year ended December 31, 2011. However, when measured as a
percentage of average equity, they decreased meaningfully. Total operating
expenses were $24.3 million which represented 89 basis points on average daily
equity for the year ended December 31, 2012. The year ended December 31, 2011
total expenses were $17.7 million which represented 93 basis points on average
equity for the year. The main component of our operating expense is our
management fee, which is paid according to the management agreement and is based
on total equity excluding unrealized gains and losses. This comprised $17.4
million of the total expenses. The remaining expenses are share based
compensation of $1.9 million, which represents the amortization of stock awards
to certain officers and directors, and general and administrative expenses of
$5.0 million, which includes liability insurance, auditing fees, exchange fees,
and other administrative costs.
2011 Compared to 2010
Our net income for the year ended December 31, 2011 was $284.4 million, or $3.97
per weighted average share, a decrease of $0.33 per share from earnings for the
year ended December 31, 2010 of $169.5 million or $4.30 per weighted average
share. In general, the increase in the gross net income number was a result of
our significant capital raises early in 2011. In general this discussion will
not comment on the increase in gross numbers as this was primarily a function of
our increase in equity.
Prepayment rates trended higher during 2011 due to falling interest rates, a
flatter yield curve, and continued actions by the U.S. Federal Reserve and U.S.
Treasury to make refinancing a mortgage economically attractive. In our
portfolio, higher prepayments contributed in three ways to lower interest
income: (1) higher premium amortization expense and lower asset yields;
(2) lower average earning assets; and (3) lower weighted average coupon as new
investments were at lower coupons.
While the relative difference between our interest income and interest expense
is more important to our net income than the absolute level of rates, the yield
on our assets is significantly affected by the coupon rate. Because of lower
overall mortgage rates, our weighted average coupon at December 31, 2011 was
3.46%, a 0.48% decrease from December 31, 2010, when our assets had a weighted
average coupon of 3.94%. These coupon rates declined throughout 2011 primarily
due to continued economic weakness, further declines in the U.S. housing market,
and continued pressure on mortgage rates from U.S. government policy. This
resulted in our asset purchases being on average at lower interest rates. Spread
compression is a normal part of an interest rate cycle, the affects of which
become more pronounced the longer that rates stay low and stable.
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Our net interest income for the year ended December 31, 2011 was $281.5 million,
an increase compared to the year ended December 31, 2010 amount of $169.1
million. In 2011, our portfolio had an average yield of 2.84% and a cost of
funds (including hedges) of 1.06%. This resulted in a net interest margin (or
spread) of 1.78% for the year ended December 31, 2011. For the year ended
December 31, 2010, our portfolio had a yield of 3.74% and a cost of funds of
1.48%, generating a net interest rate spread of 2.26%.
After coupon rate, the yield on our assets is most directly affected by the rate
of repayments on our agency securities. The percentage rate of our portfolio
repayment for the year ended December 31, 2011 was 24.54% as compared to 36.27%
for the year ended December 31, 2010. While this rate of repayment was lower in
2011, it was still higher than expected, and in 2010 the U.S. government
instituted a one-time repurchase of delinquent mortgages, which skewed the rate
higher for that year. At December 31, 2011, our portfolio had an average dollar
price of $102.47 per $100 of face value. Keeping the price of our portfolio
close to par helps us predict and manage the costs associated with the repayment
speeds of our assets, as changes in repayments speeds have a lesser affect on
income than a portfolio with a higher premium price.
Our weighted average cost of funds (not including hedges) for the year ended
December 31, 2011 was 0.29%, decreasing from 0.42% year ended December 31, 2010.
The main indicator of our borrowing costs is the 30-day LIBOR, which generally
closely parallels the rates we pay on our repurchase agreements. The LIBOR rate
stayed consistently low throughout 2011, ending 2011 at 0.30%. In 2011, we
incurred expense related to our interest rate hedges of $105.1 million, as
compared to $68.9 million for the year ended December 31, 2010. We increased our
total notional interest rate swap amount from $4.4 billion at December 31, 2010
to $7.3 billion at December 31, 2011. Lower repurchase rates combined with a
lower overall rate on our hedges resulted in an average cost of funds for the
year ended December 31, 2011 of 1.06%, down from 1.48% for the year ended
December 31, 2010. We ended 2011 with a total $7.3 billion of interest rate swap
contracts with a weighted average rate of 1.78% and weighted average term of 34
months.
We sold some of our agency securities in 2011 as part of normal adjustments to
our portfolio. Although we typically buy and hold our securities, as conditions
change in any year we may choose to dispose of certain securities. For example,
we may dispose of a security if it falls outside of our current desired asset
mix or we believe it to be at an increased risk of prepayment. In 2011, we
disposed of $1.6 billion face value of agency securities for a net gain of $20.6
million. In 2010, we disposed of $540 million face value of agency securities
for a gain of $ 13.6 million.
Our total operating expenses increased for the year ended December 31, 2011
compared to the year ended December 31, 2010. However, when measured as a
percentage of average equity, they decreased meaningfully. Total operating
expenses were $17.7 million which represented 93 basis points on average daily
equity for the year ended December 31, 2011. The year ended December 31, 2010
total expenses were $13.1 million which represented 129 basis points on average
equity for the year. The main component of our operating expense is our
management fee, which is paid according to the management agreement and is based
on total equity excluding unrealized gains and losses. This comprised $13.8
million of the total expenses. The remaining expenses are share based
compensation of $1.2 million, which represents the amortization of stock awards
to certain officers and directors, and general and administrative expenses of
$2.7 million, which includes liability insurance, auditing fees, exchange fees,
and other administrative costs.
Contractual Obligations and Commitments
We had the following contractual obligations under repurchase agreements as of
December 31, 2012 and December 31, 2011 (dollar amounts in thousands):
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December 31, 2012
Weighted Average Contractual Total Contractual
(dollars in thousands) Balance Contractual Rate Interest Payments Obligation
Within 30 days $ 20,500,568 0.47 % $ 5,855 $ 20,506,423
30 days to 3 months 2,365,861 0.48 % 940 2,366,801
3 months to 36 months - - - -
$ 22,866,429 0.47 % $ 6,795 $ 22,873,224
December 31, 2011
Weighted Average Contractual Total Contractual
(dollars in thousands) Balance Contractual Rate Interest Payments Obligation
Within 30 days $ 16,162,375 0.37 % $ 3,820 $ 16,166,195
30 days to 3 months - - - -
3 months to 36 months - - - -
$ 16,162,375 0.37 % $ 3,820 $ 16,166,195
From time to time we may make forward commitments to purchase our agency
securities. The commitments require physical settlement with the sellers on
settlement date, usually between 30 and 90 days from the date of trade. The
following table shows the agency securities forward purchase commitments shown
as a net liability on the balance sheet as of December 31, 2012.
Fair Market Due to
Face Cost Value Brokers
$565,000 $ 585,100 $ 587,247 $ 585,100
We had contractual commitments under interest rate swap agreements as of
December 31, 2012. These agreements were for a total notional amount of $10.7
billion, had an average rate of 1.47% and a weighted average term of 31 months.
Liquidity and Capital Resources
Our primary sources of funds are borrowings under repurchase arrangements and
monthly principal and interest payments on our investments. Other sources of
funds may include proceeds from debt and equity offerings and asset sales. We
generally maintain liquidity to pay down borrowings under repurchase
arrangements to reduce borrowing costs and otherwise efficiently manage our
long-term investment capital. Because the level of these borrowings can be
adjusted on a daily basis, the level of cash and cash equivalents carried on the
balance sheet is significantly less important than our potential liquidity
available under our borrowing arrangements. We currently believe that we have
sufficient liquidity and capital resources available for the acquisition of
additional investments, repayments on borrowings and the payment of cash
dividends as required for continued qualification as a REIT.
In response to the growth of our agency securities portfolio and to recent
turbulent market conditions, we have aggressively pursued additional lending
counterparties in order to help increase our financial flexibility and ability
to withstand periods of contracting liquidity in the credit markets. At
December 31, 2012, we had uncommitted repurchase facilities with 30 lending
counterparties to finance this portfolio, subject to certain conditions, and
have borrowings outstanding with 24 of these counterparties.
Liquidity Sources-Repurchase Facilities
With repurchase facilities being an integral part of our financing strategy, and
thus our financial condition, full understanding of the repurchase market is
necessary to understand the risks and drivers of
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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. And 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 commitment
agreements under which the lender would be required to enter into new repurchase
agreements during a specified period of time, nor do we presently plan to have
liquidity facilities with commercial banks.
The table below sets forth the average amount of repurchase agreements
outstanding during each quarter and the amount of these repurchase agreements
outstanding as of the end of each quarter for the last three years. The amounts
at a period end can be both above and below the average amounts for the
quarter. We do not manage our portfolio to have a pre-designated amount of
borrowings at quarter end. These numbers will differ as we implement our
portfolio management strategies and risk management strategies over changing
market conditions.
Highest Daily Lowest Daily
Average Daily Repurchase Repurchase Repurchase
Repurchase Agreements at Balance Balance
(In thousands) Agreements Period End During Quarter During Quarter
December 31, 2012 $ 23,692,240 $ 22,866,429 $ 24,396,444 $ 22,824,383
September 30, 2012 22,541,260 23,583,180 24,299,580 20,152,860
June 30, 2012 19,599,942 20,152,860 21,086,250 16,449,862
March 31, 2012 15,981,764 16,556,630 16,691,652 15,566,983
December 31, 2011 16,280,835 16,162,375 16,807,220 15,886,231
September 30, 2011 14,884,196 15,886,231 15,907,289 14,334,014
June 30, 2011 13,540,291 14,800,594 14,800,594 11,401,240
March 31, 2011 9,983,197 11,495,749 11,495,749 8,566,200
December 31, 2010 7,326,776 8,681,060 8,681,060 6,633,989
September 30, 2010 6,302,601 6,678,426 6,736,759 5,934,419
June 30, 2010 6,092,328 5,982,998 6,218,628 5,956,811
March 31, 2010 6,222,923 6,102,661 6,346,518 6,047,628
As of December 31, 2012, 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 4.3% (weighted by borrowing amount). As of December 31, 2011, our
weighted average haircut was 4.4%. This rate remained constant as lending
conditions have been 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 assets drops beyond a threshold amount, which is usually
between $100,000 and $250,000. This threshold amount is generally set by each
counterparty and does not vary based on the notional amount of the repurchase
agreements outstanding with that counterparty. Both of these margin calls
require a dollar for dollar restoration of the margin shortfall. The total
amount of our unrestricted cash and cash equivalents, plus any unpledged
securities, is available to satisfy margin calls, if necessary. As of
December 31, 2012 and 2011, we had approximately $1.8 billion and $1.1 billion,
respectively in agency securities, 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.
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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. In October of 2011, MF
Global, Inc., one of our lending counterparties, filed for relief under Chapter
11 of the U.S. Bankruptcy Code. We were unable to recover approximately $0.8
million that was due us at that time under our repurchase agreement with MF
Global, Inc. Due to the complexity of this estate, it will likely be several
years before we receive any clarity as to any recovery, and therefore, we
recorded a loss allowance for the total amount due at that time.
An event of default or termination event under the standard master repurchase
agreement would give our counterparty the option to terminate all repurchase
transactions existing with us and require any amount due by us to the
counterparty to be payable immediately. Our agreements for our repurchase
facilities generally conform to the terms in the standard master repurchase
agreement as published by the Securities Industry and Financial Markets
Association (SIFMA) as to repayment, margin requirements and the segregation of
all purchased securities covered by the repurchase agreement. In addition, each
lender may require that we include supplemental terms and conditions to the
standard master repurchase agreement that are generally required by the lender.
Some of the typical terms which are included in such supplements and which
supplement and amend terms contained in the standard agreement include changes
to the margin maintenance requirements, purchase price maintenance requirements,
the addition of a requirement that all controversies related to the repurchase
agreement be litigated in a particular jurisdiction and cross default
provisions. These provisions differ for each of our lenders.
As discussed above under "-Market and Interest Rate Trends and the Effect on our
Portfolio," over the last few years the residential mortgage market in the
United States has experienced difficult conditions including:
• increased volatility of many financial assets, including agency
securities and other high-quality MBS assets, due to news of potential
security liquidations;
• increased volatility and deterioration in the broader residential
mortgage and MBS markets; and
• significant disruption in financing of MBS.
Although these conditions have lessened of late, if they increase and persist,
our lenders may be forced to exit the repurchase market, become insolvent or
further tighten lending standards or increase the amount of haircut, any of
which could make it more difficult or costly for us to obtain financing.
Effects of Margin Requirements, Leverage and Credit Spreads
Our agency securities have values that fluctuate according to market conditions
and, as discussed above, the market value of our agency securities will decrease
as prevailing interest rates or credit spreads increase. When the value of the
securities pledged to secure a repurchase loan decreases to the point where the
positive difference between the collateral value and the loan amount is less
than the haircut, our lenders may issue a margin call, which means that the
lender will require us to pay the margin call in cash or pledge additional
collateral to meet that margin call. Under our repurchase facilities, our
lenders have full discretion to determine the value of the agency securities we
pledge to them. Most of our lenders will value securities based on recent trades
in the market. Lenders also issue margin calls as the published current
principal balance factors change on the pool of mortgages underlying the
securities pledged as collateral when scheduled and unscheduled paydowns are
announced monthly.
Similar to the valuation margin calls that we receive on our repurchase
agreements, we also receive margin calls on our interest rate swaps when the
value of a hedge position declines. This typically occurs
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when prevailing market rates decrease, with the severity of the decrease also
dependent on the term of the hedges involved. The amount of any margin call will
be dollar for dollar, with a minimum transfer amount of between $100,000 and
$250,000. Our posting of collateral with our hedge 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 agency
securities, we experience margin calls at least monthly and often more
frequently. 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 or if credit spreads
widen, the prices of our collateral (and our unpledged assets that constitute
our liquidity) will decline, we will 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 agency securities. 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 would force us to liquidate assets into unfavorable market conditions and
harm our results of operations and financial condition.
As of December 31, 2012, the weighted average haircut under our repurchase
facilities was approximately 4.3%, and our leverage (defined as our
debt-to-shareholders equity ratio) was approximately 7.4:1.
Liquidity Sources-Capital Offerings
In addition to our repurchase borrowings, we also rely on primary securities
offerings as a source of both short-term and long-term liquidity. During the
year ended December 31, 2012, we received funds from sales of our common stock
under an "at-the-market" offering program and from fully underwritten offerings
we completed in March and August. In order to assure the continued availability
of liquidity from capital offerings, we amended our charter on March 30, 2012,
raising the total authorized shares of common stock to 200,000,000, as
authorized under Maryland General Corporate Law Section 2-105(a)(13). In
addition, we amended the charter again in August 2012, raising the total
authorized shares of preferred stock to 25,000,000.
At The Market Offerings
From time to time, we may sell shares of our common stock in "at the market"
offerings. Sales of the shares of common stock, if any, may be made in private
transactions, negotiated transactions or any method permitted by law deemed to
be an "at the market" offering as defined in Rule 415 under the Securities Act
of 1933, as amended, including sales made directly on the NYSE or to or through
a market maker other than on an exchange.
On February 29, 2012, we entered into sales agreements (the "2012 Sales
Agreements") with Cantor Fitzgerald & Co. ("Cantor") and JMP Securities LLC
("JMP") to establish a new "at-the-market" program (the "2012 Program"). Under
the terms of the 2012 Sales Agreements, we may offer and sell up to 10,000,000
shares of our common stock from time to time through Cantor or JMP, each acting
as agent and/or principal. The shares of our common stock issuable pursuant to
the 2012 Program are registered with the SEC on our Registration Statement on
Form S-3 (No. 333-179805), which became effective upon filing on February 29,
2012.
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For the year ended December 31, 2012, we issued 1,713,900 shares of common stock
in at-the-market transactions at an average price of $28.69 per share raising
net proceeds after sales commissions and expenses of approximately $48.3
million. We paid $0.5 million in sales commissions to Cantor and JMP during the
year ended December 31, 2012.
For the year ended December 31, 2011, we issued 2,361,500 shares of common stock
in at-the-market transactions at an average price of $28.48 per share raising
net proceeds, after sales commissions and expenses, of approximately $66.2
million. We paid $0.9 million in sales commissions to Cantor during the year
ended December 31, 2011.
Underwritten Offerings
On March 30, 2012, we completed an underwritten public offering of 20,125,000
shares of common stock, including 2,625,000 shares pursuant to the underwriters'
overallotment option, at a price to us of $26.81 per share, and received net
proceeds of approximately $539.3 million after the payment of underwriting
discounts and expenses.
On August 27, 2012, we completed an underwritten public offering of 11,500,000
shares of our Series A Preferred Stock, including 1,500,000 shares pursuant to
the underwriters' overallotment option, at a price to the public of $25.00 per
share, and received net proceeds of $278.3 million after the payment of
underwriting discounts and expenses.
On January 5, 2011, we completed an underwritten public offering of 11,500,000
shares of common stock, including 1,500,000 shares pursuant to the underwriters'
overallotment option, at a price to the public of $28.75 per share, and received
net proceeds of approximately $325.7 million after the payment of underwriting
discounts and expenses.
On March 18, 2011, we completed an underwritten public offering of 14,500,000
shares of common stock at a price to the public of $28.50 per share, and
received net proceeds of approximately $407.6 million after the payment of
underwriting discounts and expenses. As part of this transaction, we issued an
additional 2,175,000 shares of common stock pursuant to the underwriters'
overallotment option for net proceeds to us of approximately $61.2 million.
We used the proceeds of our stock offerings to purchase additional agency
securities, provide working capital, and to provide liquidity for our hedging
strategy.
Forward-Looking Statements Regarding Liquidity
Based on our current portfolio, leverage rate and available borrowing
arrangements, we believe that the net proceeds of our common equity offerings,
combined with 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.
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We generally seek to borrow (on a recourse basis) between six and 12 times the
amount of our shareholders' equity. At December 31, 2012 and December 31, 2011,
our total borrowings were approximately $22.9 billion and $16.2 billion
(excluding accrued interest), respectively, which represented a leverage ratio
of approximately 7.4:1 and 7.8:1, respectively.
Critical Accounting Policies
Our financial statements are prepared in conformity with GAAP. In preparing the
financial statements, management is required to make various judgments,
estimates and assumptions that affect the reported amounts. Changes in these
estimates and assumptions could have a material effect on our financial
statements. The following is a summary of our policies most affected by
management's judgments, estimates and assumptions.
Interest Income: Interest income is earned and recognized based on the
outstanding principal amount of the investment securities and their contractual
terms. Premiums and discounts associated with the purchase of the investment
securities are amortized or accreted into interest income over the actual lives
of the securities using the effective interest method.
Market Valuation of Investment Securities: We invest in agency securities
representing interests in or obligations backed by pools of single-family
adjustable-rate mortgage loans. Guidance under the Financial Accounting
Standards Board ("FASB") ASC Topic on Investments requires us to classify our
investments as either trading, available-for-sale or held-to-maturity
securities. Management determines the appropriate classifications of the
securities at the time they are acquired and evaluates the appropriateness of
such classifications at each balance sheet date. We currently classifies all of
our agency securities as available-for-sale. All assets that are classified as
available-for-sale are carried at fair value and unrealized gains and losses are
included in other comprehensive income.
The estimated fair values of MBS are determined by management by obtaining
valuations for our MBS from independent sources and averaging these valuations.
Security purchase and sale transactions are recorded on the trade date. Gains or
losses realized from the sale of securities are included in income and are
determined using the specific identification method. Firm purchase commitments
to acquire "when issued" or TBA securities are recorded at fair value in
accordance with ASC Topic 815, Derivatives and Hedging. The fair value of these
purchase commitments is included in other assets or liabilities in the
accompanying balance sheets.
Impairment of Assets: We assess our 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
of the reporting period for which impairment is assessed, the impairment is
designated as either "temporary" or "other-than-temporary." In deciding on
whether or not a security is other than temporarily impaired, we use a two step
evaluation process. First, we determine whether we have made any decision to
sell a security that is in an unrealized loss position, or, if not is it more
likely than not that we will be required to sell the security prior to
recovering its amortized cost basis. If we determine that the answer to either
of these questions is "yes" then the security is considered
other-than-temporarily impaired. There were no such impairment losses recognized
during the periods presented.
Derivative Instruments: We account for derivative instruments in accordance with
the guidance included in the ASC Topic 815, Derivatives and Hedging. This
guidance establishes accounting and reporting standards for derivative
instruments, including certain derivative instruments embedded in other
contracts (collectively referred to as derivatives), and for hedging activities.
The guidance requires that every derivative instrument be recorded in the
balance sheet as either an asset or liability measured at its fair value, and
that changes in the derivative's fair value be recognized currently in earnings
unless specific hedge accounting criteria are met. Special accounting for
qualifying hedges allows a derivative's gains and losses to either offset
related results on the hedged item in the statement of income or be accumulated
in other comprehensive income, and requires that a company formally document,
designate, and assess the effectiveness of transactions that receive hedge
accounting. We use derivative instruments to manage our exposure to changing
interest rates generally with interest rate swap agreements.
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Inflation
Virtually all of our assets and liabilities are interest rate sensitive in
nature. As a result, interest rates and other factors directly influence our
performance far more than inflation. Although inflation is a primary factor in
any interest rate, changes in interest rates do not necessarily correlate with
changes in inflation rates, and these affects may be imperfect or lagging. Our
financial statements are prepared in accordance with GAAP and any distributions
we may make will be determined by our board of directors based in part on our
REIT taxable income as calculated according to the requirements of the Code; in
each case, our activities and balance sheet are measured with reference to fair
value without considering inflation.
Off-Balance Sheet Arrangements
As of December 31, 2012 and 2011, we did not maintain any relationships with
unconsolidated entities or financial partnerships, such as entities often
referred to as structured finance, or 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
December 31, 2012 and 2011, we had not guaranteed any obligations of any
unconsolidated entities or entered into any commitment or intent to provide
funding to any such entities.
