Table of Contents
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2012
OR
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from to
Commission File Number: 1-13991
MFA FINANCIAL, INC.
(Exact name of registrant as specified in its charter)
Maryland
(State or other jurisdiction of
incorporation or organization)
13-3974868
(I.R.S. Employer
Identification No.)
350 Park Avenue, 20th Floor, New York, New York
10022
(Address of principal executive offices)
(Zip Code)
(212) 207-6400
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer x
Accelerated filer o
Non-accelerated filer o
Smaller reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
357,548,609 shares of the registrant’s common stock, $0.01 par value, were outstanding as of October 25, 2012.
TABLE OF CONTENTS
Page
PART I
FINANCIAL INFORMATION
Item 1.
Financial Statements
Consolidated Balance Sheets as of September 30, 2012 (Unaudited) and December 31, 2011
1
Consolidated Statements of Operations (Unaudited) for the Three and Nine Months Ended September 30, 2012 and September 30, 2011
2
Consolidated Statements of Comprehensive Income/(Loss) (Unaudited) for the Three and Nine Months Ended September 30, 2012 and September 30, 2011
3
Consolidated Statement of Changes in Stockholders’ Equity (Unaudited) for the Nine Months Ended September 30, 2012
4
Consolidated Statements of Cash Flows (Unaudited) for the Nine Months Ended September 30, 2012 and September 30, 2011
5
Notes to the Unaudited Consolidated Financial Statements
6
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
38
Item 3.
Quantitative and Qualitative Disclosures about Market Risk
66
Item 4.
Controls and Procedures
73
PART II OTHER INFORMATION
Legal Proceedings
74
Item 1A.
Risk Factors
Item 6.
Exhibits
Signatures
75
CONSOLIDATED BALANCE SHEETS
September 30,
December 31,
(In Thousands, Except Per Share Amounts)
2012
2011
(Unaudited)
Assets:
Mortgage-backed securities (“MBS”):
Agency MBS, at fair value ($6,902,954 and $6,666,963 pledged as collateral, respectively)
$
7,476,848
7,137,531
Non-Agency MBS, at fair value ($1,489,463 and $692,534 pledged as collateral, respectively)
2,541,846
1,492,376
Non-Agency MBS transferred to consolidated variable interest entities (“VIEs”) (1)
2,655,129
2,283,070
Securities obtained and pledged as collateral, at fair value
509,704
306,401
Cash and cash equivalents
450,442
394,022
Restricted cash
7,013
15,502
MBS linked transactions, net (“Linked Transactions”), at fair value
12,767
55,801
Interest receivable
44,980
42,837
Derivative hedging instruments, at fair value
—
26
Goodwill
7,189
Prepaid and other assets
29,251
15,879
Total Assets
13,735,169
11,750,634
Liabilities:
Repurchase agreements
8,832,326
7,813,159
Securitized debt (2)
749,471
875,520
Obligation to return securities obtained as collateral, at fair value
8% Senior Notes due 2042 (“Senior Notes”)
100,000
Accrued interest payable
14,117
9,112
78,169
114,220
Dividends and dividend equivalents rights (“DERs”) payable
76,051
97,525
Payable for unsettled purchases
126,035
27,056
Accrued expenses and other liabilities
10,142
9,881
Total Liabilities
10,496,015
9,252,874
Commitments and contingencies (Note 10)
Stockholders’ Equity:
Preferred stock, $.01 par value; series A 8.50% cumulative redeemable; 5,000 shares authorized; 3,840 shares issued and outstanding ($96,000 aggregate liquidation preference)
Common stock, $.01 par value; 895,000 shares authorized; 357,013 and 356,112 issued and outstanding, respectively
3,570
3,561
Additional paid-in capital, in excess of par
2,804,688
2,795,925
Accumulated deficit
(255,591
)
(243,061
Accumulated other comprehensive income/(loss)
686,449
(58,703
Total Stockholders’ Equity
3,239,154
2,497,760
Total Liabilities and Stockholders’ Equity
(1) Non-Agency MBS transferred to consolidated VIEs represent assets of the consolidated VIEs that can be used only to settle the obligations of each respective VIE.
(2) Securitized Debt represents third-party liabilities of consolidated VIEs and excludes liabilities of the VIEs acquired by the Company that eliminate in consolidation. The third-party beneficial interest holders in the VIEs have no recourse to the general credit of the Company. (See Notes 10 and 15 for further discussion.)
The accompanying notes are an integral part of the consolidated financial statements.
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
Three Months Ended
Nine Months Ended
Interest Income:
Agency MBS
47,198
59,957
150,048
186,114
Non-Agency MBS
37,087
24,379
95,555
76,098
Non-Agency MBS transferred to consolidated VIEs
40,812
46,405
128,502
110,435
Cash and cash equivalent investments
25
84
106
Interest Income
125,135
130,766
374,189
372,753
Interest Expense:
39,317
34,924
111,639
102,513
Securitized debt
4,477
3,828
13,186
8,087
Senior Notes
2,007
3,791
Interest Expense
45,801
38,752
128,616
110,600
Net Interest Income
79,334
92,014
245,573
262,153
Other-Than-Temporary Impairments:
Total other-than-temporary impairment losses
(14,913
(879
(15,550
Portion of loss recognized in/(reclassified from) other comprehensive income
10,922
(321
9,167
Net Impairment Losses Recognized in Earnings
(3,991
(1,200
(6,383
Other Income, net:
Unrealized net gains and net interest income from Linked Transactions
3,177
733
11,444
9,970
Gains on sales of MBS
4,279
4,196
7,232
Revenue from operations of real estate held-for-sale
390
1,146
Other, net
(898
(886
Other Income, net
7,457
4,421
18,678
14,426
Operating and Other Expense:
Compensation and benefits
5,984
5,477
16,752
15,591
Other general and administrative expense
2,666
3,031
8,679
7,981
Real estate held-for-sale operating expense
237
774
Operating and Other Expense
8,650
8,745
25,431
24,346
Net Income
78,141
83,699
237,620
245,850
Less: Preferred Stock Dividends
2,040
6,120
Net Income Available to Common Stock and Participating Securities
76,101
81,659
231,500
239,730
Earnings per Common Share - Basic and Diluted
0.21
0.23
0.65
0.71
Dividends Declared per share of Common Stock
0.25
0.68
0.74
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME/(LOSS)
(In Thousands)
Other Comprehensive Income/(Loss):
Unrealized gain on Agency MBS, net
61,999
12,035
47,169
50,092
Unrealized gain/(loss) on Non-Agency MBS, net
409,742
(109,294
666,287
(250,845
Reclassification adjustment for MBS sales included in net income
(3,130
(4,525
(5,529
(4,869
Reclassification adjustment for other-than-temporary impairments included in net income
3,991
1,200
6,383
Unrealized gain/(loss) on derivative hedging instruments, net
11,654
(10,255
36,025
4,483
Other Comprehensive Income/(Loss)
480,265
(108,048
745,152
(194,756
Comprehensive income/(loss) before preferred stock dividends
558,406
(24,349
982,772
51,094
Dividends declared on preferred stock
(2,040
(6,120
Comprehensive Income/(Loss) Available to Common Stock and Participating Securities
556,366
(26,389
976,652
44,974
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS’ EQUITY
September 30, 2012
Dollars
Shares
Preferred Stock, Series A 8.50% Cumulative Redeemable — Liquidation Preference $25.00 per Share:
Balance at September 30, 2012 and December 31, 2011
3,840
Common Stock, Par Value $.01:
Balance at December 31, 2011
356,112
Issuance of common stock
9
901
Balance at September 30, 2012
357,013
Additional Paid-in Capital, in excess of Par:
Issuance of common stock, net of expenses
4,389
Equity-based compensation expense
4,374
Accumulated Deficit:
Net income
Dividends declared on common stock
(242,970
Dividends attributable to DERs
(1,060
Accumulated Other Comprehensive Income:
Change in unrealized gains on MBS, net
709,127
Change in unrealized losses on derivative hedging instruments
Total Stockholders’ Equity at September 30, 2012
CONSOLIDATED STATEMENTS OF CASH FLOWS
Cash Flows From Operating Activities:
Adjustments to reconcile net income to net cash provided by operating activities:
Gain on sales of MBS
(7,232
(4,196
Other-than-temporary impairment charges
Accretion of purchase discounts on MBS
(28,173
(33,159
Amortization of purchase premiums on MBS
38,175
26,779
Increase in interest receivable
(1,998
(6,125
Depreciation and amortization on real estate and other assets
2,471
2,263
Unrealized (gains)/losses and other on Linked Transactions
(8,851
4,831
Increase in prepaid and other assets
(10,342
(47
Increase in accrued expenses and other liabilities
344
37
Increase/(decrease) in accrued interest payable
5,005
(529
2,983
Net cash provided by operating activities
232,593
245,070
Cash Flows From Investing Activities:
Principal payments on MBS
1,977,366
1,688,520
Proceeds from sale of MBS
137,079
76,495
Purchases of MBS
(2,896,359
(4,430,941
Additions to leasehold improvements, furniture, fixtures and real estate investment
(367
(2,004
Net cash used in investing activities
(782,281
(2,667,930
Cash Flows From Financing Activities:
Principal payments on repurchase agreements
(48,911,503
(43,843,055
Proceeds from borrowings under repurchase agreements
49,930,670
45,821,751
Proceeds from issuance of securitized debt
186,691
963,255
Principal payments on securitized debt
(312,740
(225,782
Payments made for resecuritization related costs
(1,814
(6,981
Proceeds from issuance of Senior Notes
Payments made for Senior Notes related costs
(3,415
Cash disbursements on financial instruments underlying Linked Transactions
(513,418
(2,051,908
Cash received from financial instruments underlying Linked Transactions
390,363
1,464,965
Payments made for margin calls on repurchase agreements and interest rate swap agreements (“Swaps”)
(2,390
(8,460
Proceeds from reverse margin calls on repurchase agreements and Swaps
10,890
25,914
Payment made to purchase interest rate swaption (“Swaption”)
(915
Proceeds from issuances of common stock
4,398
605,765
Dividends paid on preferred stock
Dividends paid on common stock and DERs
(265,504
(239,786
Net cash provided by financing activities
606,108
2,498,643
Net increase in cash and cash equivalents
56,420
75,783
Cash and cash equivalents at beginning of period
345,243
Cash and cash equivalents at end of period
421,026
Non-cash Investing and Financing Activities:
MBS recorded upon de-linking of Linked Transactions
174,940
744,231
Repurchase agreements recorded upon de-linking of Linked Transactions
46,698
Securities obtained as collateral
203,303
Dividends and DERs declared and unpaid
90,200
NOTES TO THE UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS
SEPTEMBER 30, 2012
1. Organization
MFA Financial, Inc. (the “Company”) was incorporated in Maryland on July 24, 1997 and began operations on April 10, 1998. The Company has elected to be treated as a real estate investment trust (“REIT”) for federal income tax purposes. In order to maintain its qualification as a REIT, the Company must comply with a number of requirements under federal tax law, including that it must distribute at least 90% of its annual REIT taxable income to its stockholders. (See Note 11(b))
2. Summary of Significant Accounting Policies
(a) Basis of Presentation and Consolidation
The interim unaudited financial statements of the Company have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission (“SEC”). Certain information and note disclosures normally included in financial statements prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) have been condensed or omitted according to these SEC rules and regulations. Management believes that the disclosures included in these interim financial statements are adequate to make the information presented not misleading. The accompanying financial statements should be read in conjunction with the financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2011. In the opinion of management, all normal and recurring adjustments necessary to present fairly the financial condition of the Company at September 30, 2012 and results of operations for all periods presented have been made. The results of operations for the nine months ended September 30, 2012 should not be construed as indicative of the results to be expected for the full year.
The consolidated financial statements of the Company have been prepared on the accrual basis of accounting in accordance with GAAP. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Although the Company’s estimates contemplate current conditions and how it expects them to change in the future, it is reasonably possible that actual conditions could be worse than anticipated in those estimates, which could materially impact the Company’s results of operations and its financial condition. Management has made significant estimates in several areas, including other-than-temporary impairment (“OTTI”) on Agency and Non-Agency MBS (Note 3), valuation of Agency and Non-Agency MBS (Notes 3 and 14), derivative hedging instruments (Notes 4 and 14), and income recognition on certain Non-Agency MBS purchased at a discount (Note 3). Actual results could differ from those estimates.
The consolidated financial statements of the Company include the accounts of all subsidiaries; significant intercompany accounts and transactions have been eliminated. Certain prior period amounts have been reclassified to conform to the current period presentation.
(b) Agency and Non-Agency MBS (including Non-Agency MBS transferred to a consolidated VIE)
The Company has investments in residential MBS that are issued or guaranteed as to principal and/or interest by a federally chartered corporation, such as Fannie Mae or Freddie Mac, or any agency of the U.S. Government, such as Ginnie Mae (collectively, “Agency MBS”), and residential MBS that are not guaranteed by any U.S. Government agency or any federally chartered corporation (“Non-Agency MBS”), as described in Note 3.
Designation
The Company generally intends to hold its MBS until maturity; however, from time to time, it may sell any of its securities as part of the overall management of its business. As a result, all of the Company’s MBS are designated as “available-for-sale” and, accordingly, are carried at their fair value with unrealized gains and losses excluded from earnings (except when an OTTI is recognized, as discussed below) and reported in accumulated other comprehensive income/(loss), a component of stockholders’ equity.
Upon the sale of an investment security, any unrealized gain or loss is reclassified out of accumulated other comprehensive income/(loss) to earnings as a realized gain or loss using the specific identification method.
Revenue Recognition, Premium Amortization and Discount Accretion
Interest income on securities is accrued based on the outstanding principal balance and their contractual terms. Premiums and discounts associated with Agency MBS and Non-Agency MBS rated AA and higher at the time of purchase are amortized into interest income over the life of such securities using the effective yield method. Adjustments to premium amortization are made for actual prepayment activity.
Interest income on the Non-Agency MBS that were purchased at a discount to par value and/or are considered to be of less than high credit quality is recognized based on the security’s effective interest rate. The effective interest rate on these securities is based on management’s estimate from each security of the projected cash flows, which are estimated based on the Company’s observation of current information and events and include assumptions related to fluctuations in interest rates, prepayment speeds and the timing and amount of credit losses. On at least a quarterly basis, the Company reviews and, if appropriate, makes adjustments to its cash flow projections based on input and analysis received from external sources, internal models, and its judgment about interest rates, prepayment rates, the timing and amount of credit losses, and other factors. Changes in cash flows from those originally projected, or from those estimated at the last evaluation, may result in a prospective change in the yield/interest income recognized on these securities or in the recognition of OTTI impairments. (See Note 3)
Based on the projected cash flows from the Company’s Non-Agency MBS purchased at a discount to par value, a portion of the purchase discount may be designated as non-accretable purchase discount (“Credit Reserve”), which effectively mitigates the Company’s risk of loss on the mortgages collateralizing such MBS and is not expected to be accreted into interest income. The amount designated as Credit Reserve may be adjusted over time, based on the actual performance of the security, its underlying collateral, actual and projected cash flow from such collateral, economic conditions and other factors. If the performance of a security with a Credit Reserve is more favorable than forecasted, a portion of the amount designated as Credit Reserve may be reallocated to accretable discount and recognized into interest income over time. Conversely, if the performance of a security with a Credit Reserve is less favorable than forecasted, the amount designated as Credit Reserve may be increased, or impairment charges and write-downs of such securities to a new cost basis could result.
Determination of MBS Fair Value
In determining the fair value of its MBS, management considers a number of observable market data points, including prices obtained from pricing services, brokers and repurchase agreement counterparties, dialogue with market participants, as well as management’s observations of market activity. (See Note 14)
Impairments/OTTI
When the fair value of an investment security is less than its amortized cost at the balance sheet date, the security is considered impaired. The Company assesses its impaired securities on at least a quarterly basis and designates such impairments as either “temporary” or “other-than-temporary.” If the Company intends to sell an impaired security, or it is more likely than not that it will be required to sell the impaired security before its anticipated recovery, then the Company must recognize an OTTI through charges to earnings equal to the entire difference between the investment’s amortized cost and its fair value at the balance sheet date. If the Company does not expect to sell an other-than-temporarily impaired security, only the portion of the OTTI related to credit losses is recognized through charges to earnings with the remainder recognized through other accumulated comprehensive income/(loss) on the consolidated balance sheet. Impairments recognized through other comprehensive income/(loss) do not impact earnings. Following the recognition of an OTTI through earnings, a new cost basis is established for the security and may not be adjusted for subsequent recoveries in fair value through earnings. However, OTTIs recognized through charges to earnings may be accreted back to the amortized cost basis of the security on a prospective basis through interest income. The determination as to whether an OTTI exists and, if so, the amount of credit impairment recognized in earnings is subjective, as such determinations are based on factual information available at the time of assessment as well as the Company’s estimates of the future performance and cash flow projections. As a result, the timing and amount of OTTIs constitute material estimates that are susceptible to significant change. (See Note 3)
Non-Agency MBS that are purchased at significant discounts to par and/or are otherwise assessed to be of less than high credit quality on which impairments are recognized have experienced, or are expected to experience, credit-related adverse cash flow changes. The Company’s estimate of cash flows for its Non-Agency MBS is based on its review of the underlying mortgage loans securing the MBS. The Company considers information available about the past and expected future performance of underlying mortgage loans, including timing of expected future cash flows, prepayment rates, default rates, loss severities, delinquency rates, percentage of non-performing loans, Fair Isaac Corporation (“FICO”) scores at loan origination, year of origination, loan-to-value ratios, geographic concentrations, as well as reports by credit rating agencies, such as Moody’s Investors Services, Inc. (“Moody’s”), Standard & Poor’s Corporation (“S&P”), or Fitch, Inc. (collectively, “Rating Agencies”), general market assessments, and dialogue with market participants. As a result, significant judgment is used in the Company’s analysis to determine the expected cash flows for its Non-Agency MBS. In determining the OTTI related to credit losses for securities that were purchased at significant discounts to par and/or are considered to be of less than high credit quality, the Company compares the present value of the remaining cash flows expected to be collected at the purchase date (or last date previously revised) against the present value of the cash flows expected to be collected at
7
the current financial reporting date. The discount rate used to calculate the present value of expected future cash flows is the current yield used for income recognition purposes. Impairment assessment for Non-Agency MBS that were purchased at prices close to par and are considered to be of high credit quality involves comparing the present value of the remaining cash flows expected to be collected against the amortized cost of the security at the assessment date. The discount rate used to calculate the present value of the expected future cash flows is based on the instrument’s effective interest rate.
Balance Sheet Presentation
The Company’s MBS pledged as collateral against repurchase agreements and Swaps are included in MBS on the consolidated balance sheets with the fair value of the MBS pledged disclosed parenthetically. Purchases and sales of securities are recorded on the trade date. However, if on the purchase settlement date, a repurchase agreement is used to finance the purchase of an MBS with the same counterparty and such transactions are determined to be linked, then the MBS and linked repurchase borrowing will be reported on the same settlement date as Linked Transactions. (See Notes 2(n) and 4)
(c) Securities Obtained and Pledged as Collateral/Obligation to Return Securities Obtained as Collateral
The Company has obtained securities as collateral under collateralized financing arrangements in connection with its financing strategy for Non-Agency MBS. Securities obtained as collateral in connection with these transactions are recorded on the Company’s consolidated balance sheet as an asset along with a liability representing the obligation to return the collateral obtained, at fair value. While beneficial ownership of securities obtained remains with the counterparty, the Company has the right to sell the collateral obtained or to pledge it as part of a subsequent collateralized financing transaction. (See Note 2(i) for Repurchase Agreements and Reverse Repurchase Agreements)
(d) Cash and Cash Equivalents
Cash and cash equivalents include cash on deposit with financial institutions and investments in money market funds, all of which have original maturities of three months or less. Cash and cash equivalents may also include cash pledged as collateral to the Company by its repurchase agreement and/or Swap counterparties as a result of reverse margin calls (i.e., margin calls made by the Company). The Company did not hold any cash pledged by its counterparties at September 30, 2012 or December 31, 2011. At September 30, 2012 and December 31, 2011, all of the Company’s cash investments were comprised of overnight money market funds, which are not bank deposits and are not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. (See Notes 8 and 14)
(e) Restricted Cash
Restricted cash represents the Company’s cash held by its counterparties as collateral against the Company’s Swaps and/or repurchase agreements. Restricted cash, which earns interest, is not available to the Company for general corporate purposes, but may be applied against amounts due to counterparties to the Company’s repurchase agreements and/or Swaps, or returned to the Company when the collateral requirements are exceeded or at the maturity of the Swap or repurchase agreement. The Company had aggregate restricted cash held as collateral against its Swaps of $7.0 million and $15.5 million at September 30, 2012 and December 31, 2011, respectively. (See Notes 4, 7, 8 and 14)
(f) Goodwill
At September 30, 2012 and December 31, 2011, the Company had goodwill of $7.2 million, which represents the unamortized portion of the excess of the fair value of its common stock issued over the fair value of net assets acquired in connection with its formation in 1998. Goodwill is tested for impairment at least annually, or more frequently under certain circumstances, at the entity level. Through September 30, 2012, the Company had not recognized any impairment against its goodwill.
(g) Depreciation
Real Estate
During 2011 the Company had 100% of the ownership interest in Lealand Place, a 191-unit apartment property located in Lawrenceville, Georgia, through Lealand Place, LLC (“Lealand”), an indirect, wholly-owned subsidiary. This property was acquired through a tax-deferred exchange under Section 1031 of the Internal Revenue Code of 1986, as amended (the “Code”). This investment was sold for cash proceeds of $11.4 million, resulting in a gain on sale in the fourth quarter of 2011 of $430,000. (See Note 6)
8
The property, capital improvements and other assets held in connection with this investment were carried at cost, net of accumulated depreciation and amortization. Maintenance, repairs and minor improvements were expensed in the period incurred, while real estate assets, except land, and capital improvements were depreciated over their useful life using the straight-line method. The estimated life was 27.5 years for buildings and five to seven years for furniture and fixtures.
Leasehold Improvements and Other Depreciable Assets
Depreciation is computed on the straight-line method over the estimated useful life of the related assets or, in the case of leasehold improvements, over the shorter of the useful life or the lease term. Furniture, fixtures, computers and related hardware have estimated useful lives ranging from five to eight years at the time of purchase.
(h) Resecuritization and Senior Notes Related Costs
Resecuritization related costs are costs associated with the issuance of beneficial interests by consolidated VIEs and incurred by the Company in connection with various resecuritization transactions completed by the Company. Senior Notes related costs are costs incurred by the Company in connection with the issuance of its Senior Notes in April, 2012. These costs may include underwriting, rating agency, legal, accounting and other fees. Such costs, which reflect deferred charges, are included on the Company’s consolidated balance sheet in prepaid and other assets. These deferred charges are amortized as an adjustment to interest expense using the effective interest method, based upon the actual repayments of the associated beneficial interests issued to third parties and over the stated legal maturity of the Senior Notes.
(i) Repurchase Agreements and Reverse Repurchase Agreements
The Company finances the acquisition of a significant portion of its MBS with repurchase agreements. Under repurchase agreements, the Company sells securities to a lender and agrees to repurchase the same securities in the future for a price that is higher than the original sale price. The difference between the sale price that the Company receives and the repurchase price that the Company pays represents interest paid to the lender. Although legally structured as sale and repurchase transactions, the Company accounts for repurchase agreements as secured borrowings, with the exception of certain repurchase agreements accounted for as components of Linked Transactions. (See Note 2(n) below) Under its repurchase agreements, the Company pledges its securities as collateral to secure the borrowing, which is equal in value to a specified percentage of the fair value of the pledged collateral, while the Company retains beneficial ownership of the pledged collateral. At the maturity of a repurchase financing, unless the repurchase financing is renewed with the same counterparty, the Company is required to repay the loan including any accrued interest and concurrently receives back its pledged collateral from the lender. With the consent of the lender, the Company may renew a repurchase financing at the then prevailing financing terms. Margin calls, whereby a lender requires that the Company pledge additional securities or cash as collateral to secure borrowings under its repurchase financing with such lender, are routinely experienced by the Company when the value of the MBS pledged as collateral declines as a result of principal amortization and prepayments or due to changes in market interest rates, spreads or other market conditions. The Company also may make margin calls on counterparties when collateral values increase.
The Company’s repurchase financings typically have terms ranging from one month to six months at inception, but may also have longer or shorter terms. Should a counterparty decide not to renew a repurchase financing at maturity, the Company must either refinance elsewhere or be in a position to satisfy the obligation. If, during the term of a repurchase financing, a lender should default on its obligation, the Company might experience difficulty recovering its pledged assets which could result in an unsecured claim against the lender for the difference between the amount loaned to the Company plus interest due to the counterparty and the fair value of the collateral pledged by the Company to such lender, including accrued interest receivable on such collateral. The Company enters into repurchase agreements with multiple counterparties with a maximum loan from any lender of no more than three times the Company’s stockholders’ equity. (See Notes 2(n), 4, 7, 8 and 14)
In addition to the repurchase agreement financing arrangements discussed above, as part of its financing strategy for Non-Agency MBS, the Company has entered into contemporaneous repurchase and reverse repurchase agreements with a single counterparty. Under a typical reverse repurchase agreement, the Company buys securities from a borrower for cash and agrees to sell the same securities in the future for a price that is higher than the original purchase price. The difference between the purchase price the Company originally paid and the sale price represents interest received from the borrower. In contrast, the contemporaneous repurchase and reverse repurchase transactions effectively resulted in the Company pledging Non-Agency MBS as collateral to the counterparty in connection with the repurchase agreement financing and obtaining U.S. Treasury securities as collateral from the same counterparty in connection with the reverse repurchase agreement. No net cash was exchanged between the Company and counterparty at the inception of the transactions. Securities obtained and pledged as collateral are recorded as an asset on the Company’s consolidated balance sheet. Interest income is recorded on the reverse
repurchase agreement and interest expense is recorded on the repurchase agreement on an accrual basis. Both the Company and the counterparty have the right to make daily margin calls based on changes in the value of the collateral obtained and/or pledged. The Company’s liability to the counterparty in connection with this financing arrangement is recorded on the Company’s consolidated balance sheet and disclosed as “Obligation to return securities obtained as collateral.” (See Note 2(c))
(j) Equity-Based Compensation
Compensation expense for equity based awards is recognized ratably over the vesting period of such awards, based upon the fair value of such awards at the grant date. With respect to awards granted in 2009 and prior years, the Company has applied a zero forfeiture rate for these awards, as they were granted to a limited number of employees, and historical forfeitures have been minimal. Forfeitures, or an indication that forfeitures are expected to occur, may result in a revised forfeiture rate and would be accounted for prospectively as a change in estimate.
During 2010, the Company granted certain restricted stock units (“RSUs”) that vest after either two or four years of service and provided that certain criteria are met, which are based on a formula that includes changes in the Company’s closing stock price over a two- or four-year period and dividends declared on the Company’s common stock during those periods. During 2011 and 2012, the Company granted certain RSUs that vest annually over a three-year period, provided that certain criteria are met, which are based on a formula that includes changes in the Company’s closing stock price over the annual vesting period and dividends declared on the Company’s common stock during those periods. Such criteria constitute a “market condition” which impacts the amount of compensation expense recognized for these awards. Specifically, the uncertainty regarding whether the market condition will be achieved is reflected in the grant date fair valuation of the RSUs, which in addition to estimates regarding the amount of RSUs expected to be forfeited during the associated service period, determines the amount of compensation expense that is recognized. Compensation expense is not reversed should the market condition not be achieved, while differences in actual forfeiture experience relative to estimated forfeitures will result in adjustments to the timing and amount of compensation expense recognized.
The Company has awarded DERs that may be attached to or awarded separately from other equity based awards. Compensation expense for separately awarded DERs is based on the grant date fair value of such awards and is recognized over the vesting period. Payments pursuant to these DERs are charged to stockholders’ equity. Payments pursuant to DERs that are attached to equity based awards are charged to stockholders’ equity to the extent that the attached equity awards are expected to vest. Compensation expense is recognized for payments made for DERs to the extent that the attached equity awards do not or are not expected to vest and grantees are not required to return payments of dividends or DERs to the Company. (See Notes 2(k) and 13)
(k) Earnings per Common Share (“EPS”)
Basic EPS is computed using the two-class method, which includes the weighted-average number of shares of common stock outstanding during the period and other securities that participate in dividends, such as the Company’s unvested restricted stock and RSUs that have non-forfeitable rights to dividends and DERs attached to/associated with RSUs and vested stock options to arrive at total common equivalent shares. In applying the two-class method, earnings are allocated to both shares of common stock and securities that participate in dividends based on their respective weighted-average shares outstanding for the period. For the diluted EPS calculation, common equivalent shares are further adjusted for the effect of dilutive unexercised stock options and RSUs outstanding that are unvested and have dividends that are subject to forfeiture using the treasury stock method. Under the treasury stock method, common equivalent shares are calculated assuming that all dilutive common stock equivalents are exercised and the proceeds, along with future compensation expenses associated with such instruments, are used to repurchase shares of the Company’s outstanding common stock at the average market price during the reported period. (See Note 12)
(l) Comprehensive Income/(Loss)
The Company’s comprehensive income/(loss) available to common stock and participating securities includes net income, the change in net unrealized gains/(losses) on its MBS and its derivative hedging instruments, currently comprised of Swaps, (to the extent that such changes are not recorded in earnings), adjusted by realized net gains/(losses) reclassified out of accumulated other comprehensive income/(loss) for MBS and is reduced by dividends declared on the Company’s preferred stock.
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(m) U.S. Federal Income Taxes
The Company has elected to be taxed as a REIT under the provisions of the Code and the corresponding provisions of state law. The Company expects to operate in a manner that will enable it to continue to be taxed as a REIT. A REIT is not subject to tax on its earnings to the extent that it distributes at least 90% of its annual REIT taxable income to its stockholders. As such, no provision for current or deferred income taxes has been made in the accompanying consolidated financial statements. To the extent that the Company incurs interest and/or penalties in connection with its tax obligations, such amounts shall be classified as income tax expense on the Company’s consolidated statements of operations.
(n) Derivative Financial Instruments
Hedging Activity
As part of the Company’s interest rate risk management, it periodically hedges a portion of its interest rate risk using derivative financial instruments, currently comprised of Swaps. Hedge accounting is used to account for these instruments.
The Company documents its risk-management policies, including objectives and strategies, as they relate to its hedging activities and the relationship between the hedging instrument and the hedged liability. The Company assesses, both at inception of a hedge and on a quarterly basis thereafter, whether or not the hedge is “highly effective.”
The Company discontinues hedge accounting on a prospective basis and recognizes changes in the fair value through earnings when: (i) it is determined that the derivative is no longer effective in offsetting cash flows of a hedged item (including forecasted transactions); (ii) it is no longer probable that the forecasted transaction will occur; or (iii) it is determined that designating the derivative as a hedge is no longer appropriate.
Although permitted under certain circumstances, the Company does not offset cash collateral receivables or payables against its net derivative positions. (See Notes 4, 8 and 14)
Swaps
Swaps are carried on the Company’s balance sheet at fair value, as assets, if their fair value is positive, or as liabilities, if their fair value is negative. Changes in the fair value of the Company’s Swaps are recorded in other comprehensive income/(loss) provided that the hedge remains effective. Changes in fair value for any ineffective amount of a Swap are recognized in earnings. The Company has not recognized any change in the value of its existing Swaps through earnings as a result of hedge ineffectiveness.
Swaptions
As part of its strategy to hedge its exposure to increases in interest rates, the Company in 2011 purchased a Swaption, which gave it the right, but not the obligation, to enter into a Swap at a future date. This contract expired unexercised in early 2012. Swaptions are carried as assets on the Company’s balance sheet at fair value. Changes in the intrinsic value of the Swap underlying the Swaption are recorded in other comprehensive income/(loss), a component of stockholders’ equity, provided that the hedge remains effective, while changes in the time value of the Swaption are recorded as gains/losses through earnings as a component of other income during the option period. The Company uses the cumulative dollar-offset ratio to assess the hedge effectiveness of its Swaptions.
Non-Hedging Activity/Linked Transactions
It is presumed that the initial transfer of a financial asset (i.e., the purchase of an MBS by the Company) and contemporaneous repurchase financing of such MBS with the same counterparty are considered part of the same arrangement, or a “linked transaction,” unless certain criteria are met. The two components of a linked transaction (MBS purchase and repurchase financing) are not reported separately but are evaluated on a combined basis and reported as a forward (derivative) contract and are presented as “Linked Transactions” on the Company’s consolidated balance sheet. Changes in the fair value of the assets and liabilities underlying Linked Transactions and associated interest income and expense are reported as “unrealized net gains/(losses) and net interest income from Linked Transactions” on the Company’s consolidated statements of operations and are not included in other comprehensive income/(loss). However, if certain criteria are met, the initial transfer (i.e., the purchase of a security by the Company) and repurchase financing will not be treated as a Linked Transaction and will be evaluated and reported separately, as an MBS purchase and repurchase financing. When or if a transaction is no longer considered to be linked, the MBS and repurchase financing will be reported on a gross basis. In this case, the fair value of the MBS at the time the transactions are no longer considered linked will become the cost basis of the MBS, and the income recognition yield for such MBS will be calculated prospectively using this new cost basis. (See Notes 4 and 14)
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(o) Fair Value Measurements and the Fair Value Option for Financial Assets and Financial Liabilities
The Company’s presentation of fair value for its financial assets and liabilities is determined within a framework that stipulates that the fair value of a financial asset or liability is an exchange price in an orderly transaction between market participants to sell the asset or transfer the liability in the market in which the reporting entity would transact for the asset or liability, that is, the principal or most advantageous market for the asset or liability. The transaction to sell the asset or transfer the liability is a hypothetical transaction at the measurement date, considered from the perspective of a market participant that holds the asset or owes the liability. This definition of fair value is based on a consistent definition of fair value which focuses on exit price and prioritizes the use of market-based inputs over entity-specific inputs when determining fair value. In addition, the framework for measuring fair value establishes a three-level hierarchy for fair value measurements based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. (See Note 14)
Although permitted under GAAP to measure many financial instruments and certain other items at fair value, the Company has not elected the fair value option for any of its assets or liabilities. If the fair value option is elected, unrealized gains and losses on such items for which fair value is elected would be recognized in earnings at each subsequent reporting date. A decision to elect the fair value option for an eligible financial instrument, which may be made on an instrument by instrument basis, is irrevocable.
(p) Variable Interest Entities
An entity is referred to as a VIE if it meets at least one of the following criteria: (1) the entity has equity that is insufficient to permit the entity to finance its activities without additional subordinated financial support of other parties; or (2) as a group, the holders of the equity investment at risk lack (a) the power to direct the activities of an entity that most significantly impact the entity’s economic performance; (b) the obligation to absorb the expected losses; or (c) the right to receive the expected residual returns; or (3) have disproportional voting rights and the entity’s activities are conducted on behalf of the investor that has disproportionally few voting rights.
The Company consolidates a VIE when it has both the power to direct the activities that most significantly impact the economic performance of the VIE and a right to receive benefits or absorb losses of the entity that could be potentially significant to the VIE. The Company is required to reconsider its evaluation of whether to consolidate a VIE each reporting period, based upon changes in the facts and circumstances pertaining to the VIE.
The Company has entered into resecuritization transactions which result in the Company consolidating the VIEs that were created to facilitate the transactions and to which the underlying assets in connection with the resecuritizations were transferred. In determining the accounting treatment to be applied to these resecuritization transactions, the Company evaluated whether the entities used to facilitate these transactions were VIEs and, if so, whether they should be consolidated. Based on its evaluation, the Company concluded that the VIEs should be consolidated. If the Company had determined that consolidation was not required, it would have then assessed whether the transfer of the underlying assets would qualify as a sale or should be accounted for as secured financings under GAAP.
Prior to the completion of its initial resecuritization transaction in October 2010, the Company had not transferred assets to VIEs or Qualifying Special Purpose Entities (“QSPEs”) and other than acquiring MBS issued by such entities, had no other involvement with VIEs or QSPEs. (See Note 15)
(q) New and Proposed Accounting Standards and Interpretations
Accounting Standards Adopted in 2012
Transfers and Servicing
In April 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2011-03, Reconsideration of Effective Control for Repurchase Agreements, (“ASU 2011-03”), which changes the assessment of whether repurchase agreement transactions should be accounted for as sales or secured financings. In a typical repurchase agreement transaction, an entity transfers financial assets to the counterparty in exchange for cash with an agreement for the counterparty to return the same or equivalent financial assets for a fixed price in the future. Prior to this update, one of the factors in determining whether sale treatment could be used was whether the transferor maintained effective control of the transferred assets and in order to do so, the transferor must have the ability to repurchase such assets. This ASU changes the assessment of effective control by focusing on a transferor’s contractual rights and obligations with respect to transferred financial assets, rather than whether the transferor has the practical ability to perform in accordance with those rights or obligations. ASU 2011-03 was effective for the Company for the first interim or annual period beginning on or after December 15, 2011. With the exception of Linked Transactions, the Company records repurchase agreements as secured borrowings and not sales,
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and accordingly, the adoption of this update on January 1, 2012 did not have a material impact on the Company’s consolidated financial statements.
Fair Value Measurements and Disclosures
In May 2011, the FASB issued ASU 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs, (“ASU 2011-04”) further converging U.S. GAAP and International Financial Reporting Standards (“IFRS”) by providing common fair value measurement and disclosure requirements. The amendments in this update change the wording used to describe many of the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements. These include those that clarify the FASB’s intent about the application of existing fair value measurement and disclosure requirements and those that change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements. ASU 2011-04 was effective for the Company for interim and annual reporting periods beginning after December 15, 2011 and upon adoption on January 1, 2012, did not have a material impact on the Company’s consolidated financial statements.
Comprehensive Income
In June 2011, the FASB issued ASU 2011-05, Presentation of Comprehensive Income, (“ASU 2011-05”) which allows an entity to present the total of comprehensive income, the components of net income, and the components of other comprehensive income (“OCI”) either in a single continuous statement of comprehensive income or in two separate but consecutive statements. Either presentation requires the presentation on the face of the financial statements any reclassification adjustments for items that are reclassified from OCI to net income in the statement(s) where the components of net income and the components of OCI are presented. There is no change in what must be reported in OCI or when an item of OCI must be reclassified to net income. ASU 2011-05 requires retrospective application and is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. In December 2011, the FASB issued ASU 2011-12, Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05, (“ASU 2011-12”) which defers certain aspects of ASU 2011-05. Specifically, ASU 2011-12 defers the effective date for the requirements of ASU 2011-05 to present on the face of the financial statements the effects of reclassifications out of accumulated other comprehensive income on the components of net income and OCI for all periods presented. All other requirements of ASU 2011-05 are not affected by this update. ASU 2011-12 requires retrospective application and was effective for the Company for fiscal years, and interim periods within those years, beginning after December 15, 2011. The Company’s adoption of ASU 2011-05 and ASU 2011-12 beginning on January 1, 2012 did not have a material impact on the Company’s consolidated financial statements.
Intangibles — Goodwill and Other
In September 2011, the FASB issued ASU 2011-08, Testing Goodwill for Impairment, (“ASU 2011-08”) which simplifies how entities test goodwill for impairment. Under ASU 2011-08, an entity has the option to first assess qualitative factors to determine whether the existence of events or circumstances leads the entity to determine that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If, after assessing the totality of events or circumstances, an entity determines that it is not more likely than not that the fair value of a reporting unit is less than its carrying amount, then performing the two-step impairment test is unnecessary. If the entity concludes otherwise, then it is required to test goodwill for impairment under the currently prescribed two-step process. ASU 2011-08 was effective for annual and interim goodwill impairment tests performed for fiscal years beginning after December 15, 2011. The Company’s adoption of ASU 2011-08 beginning on January 1, 2012, did not have a material impact on its consolidated financial statements.
Recent Accounting Standards to be Adopted in Future Periods
Balance Sheet
In December 2011, the FASB issued ASU 2011-11, Disclosures about Offsetting Assets and Liabilities, (“ASU 2011-11”) regarding disclosures concerning the offsetting of assets and liabilities. Under ASU 2011-11, an entity is required to disclose both gross information and net information about both instruments and transactions eligible for offset in the statement of financial position and instruments and transactions subject to an agreement similar to a master netting arrangement. The scope would include derivatives, sale and repurchase agreements and reverse sale and repurchase agreements, and securities borrowing and securities lending arrangements. This disclosure is intended to support further the convergence of U.S. GAAP and IFRS requirements. ASU 2011-11 is effective for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods. The adoption of this ASU is not expected to have a material impact on the Company’s consolidated financial statements.
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Proposed Accounting Standards
The FASB has recently issued or discussed a number of proposed standards on such topics as investment companies and investment property entities, financial statement presentation, repurchase agreements and similar transactions, revenue recognition, leases, financial instruments, hedging, measurement of credit impairment and disclosures about liquidity risk and interest rate risk. Some of the proposed changes are potentially significant and could have a material impact on the Company’s reporting. The Company has not yet fully evaluated the potential impact of these proposals but will make such an evaluation as the standards are finalized.
3. MBS
The Company’s MBS are comprised of Agency MBS and Non-Agency MBS. These MBS are secured by: (i) hybrid mortgages (“Hybrids”), which 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; (ii) adjustable-rate mortgages (“ARMs”); (iii) mortgages that have interest rates that reset more frequently (collectively, “ARM-MBS”); and (iv) 15-year and longer-term fixed rate mortgages. MBS do not have a single maturity date, and further, the mortgage loans underlying ARM-MBS do not all reset at the same time.
The Company pledges a significant portion of its MBS as collateral against its borrowings under repurchase agreements and Swaps. Non-Agency MBS that are accounted for as components of Linked Transactions are not reflected in the tables set forth in this note, as they are accounted for as derivatives. (See Notes 4 and 8)
Agency MBS: Agency MBS are guaranteed as to principal and/or interest by a federally chartered corporation, such as Fannie Mae or Freddie Mac, or an agency of the U.S. Government, such as Ginnie Mae. The payment of principal and/or interest on Ginnie Mae MBS is explicitly backed by the full faith and credit of the U.S. Government. Since the third quarter of 2008, Fannie Mae and Freddie Mac have been under the conservatorship of the Federal Housing Finance Agency, which significantly strengthened the backing for these government-sponsored entities.
Non-Agency MBS (including Non-Agency MBS transferred to consolidated VIEs): The Company’s Non-Agency MBS are secured by pools of residential mortgages, which are not guaranteed by an agency of the U.S. Government or any federally chartered corporation. Non-Agency MBS may be rated by one or more Rating Agencies or may be unrated (i.e., not assigned a rating by any Rating Agency). The rating indicates the opinion of the Rating Agency as to the creditworthiness of the investment, indicating the obligor’s ability to meet its full financial commitment on the obligation. A rating of “D” is assigned when a security has defaulted on any of its contractual terms.
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The following tables present certain information about the Company’s MBS at September 30, 2012 and December 31, 2011:
Discount
Designated
Accretable
as Credit
Gross
Net
Current
Purchase
Reserve
Amortized
Unrealized
Face
Premiums
Discounts
and OTTI (1)
Cost (2)
Fair Value
Gains
Losses
Gain/(Loss)
Agency MBS:
Fannie Mae
6,357,355
204,196
(70
6,561,481
6,792,421
231,889
(949
230,940
Freddie Mac
615,976
20,996
642,312
668,748
26,448
(12
26,436
Ginnie Mae
14,902
257
15,159
15,679
520
Total Agency MBS
6,988,233
225,449
7,218,952
258,857
(961
257,896
Non-Agency MBS: (3)
Rated AAA
35,908
179
(938
35,149
36,259
1,110
Rated AA
46
47
39
(8
Rated A
22,713
644
23,357
22,214
(1,143
Rated BBB
32,049
29
(2,123
(378
29,577
31,391
1,981
(167
1,814
Rated BB
120,010
41
(8,802
(1,724
109,525
110,928
2,456
(1,053
1,403
Rated B
307,488
15
(27,539
(18,879
261,085
275,878
17,036
(2,243
14,793
Rated CCC
1,155,928
(86,864
(203,508
865,556
969,810
107,609
(3,355
104,254
Rated CC
647,499
(27,799
(128,181
491,519
533,770
42,923
(672
42,251
Rated C
1,104,962
(44,439
(225,212
835,311
916,709
83,075
(1,677
81,398
Unrated and D-rated (4)
3,030,468
(109,572
(881,769
2,039,127
2,299,977
263,737
(2,887
260,850
Total Non-Agency MBS
6,457,071
909
(308,076
(1,459,651
4,690,253
5,196,975
519,927
(13,205
506,722
Total MBS
13,445,304
226,358
(308,146
11,909,205
12,673,823
778,784
(14,166
764,618
December 31, 2011
5,981,834
154,809
(135
6,136,508
6,329,925
194,997
(1,580
193,417
743,517
22,717
768,572
791,085
22,677
(164
22,513
15,920
275
16,195
16,521
326
6,741,271
177,801
6,921,275
218,000
(1,744
216,256
12,258
245
12,503
(245
48
34
(14
28,950
765
(624
(5
29,086
24,911
341
(4,516
(4,175
46,593
42
(3,020
(582
43,033
38,352
(4,681
100,513
33
(10,749
(3,223
86,574
81,789
2,232
(7,017
(4,785
355,930
17
(30,584
(25,004
300,359
277,438
2,729
(25,650
(22,921
1,031,407
(68,174
(203,185
760,048
741,028
27,767
(46,787
(19,020
687,664
(33,478
(142,777
511,409
487,619
14,209
(37,999
(23,790
2,128,919
(64,963
(487,397
1,576,559
1,503,737
44,988
(117,810
(72,822
1,022,072
(38,887
(366,593
616,592
608,280
34,934
(43,246
(8,312
5,414,353
1,103
(250,479
(1,228,766
3,936,211
3,775,446
127,200
(287,965
(160,765
12,155,624
178,904
(250,614
10,857,486
10,912,977
345,200
(289,709
55,491
(1) Discount designated as Credit Reserve and amounts related to OTTI are generally not expected to be accreted into interest income. Amounts disclosed at September 30, 2012 reflect Credit Reserve of $1.409 billion and OTTI of $50.3 million. Amounts disclosed at December 31, 2011 reflect Credit Reserve of $1.174 billion and OTTI of $54.5 million.
(2) Includes principal payments receivable of $5.3 million and $2.3 million at September 30, 2012 and December 31, 2011, respectively, which are not included in the Current Face.
(3) Non-Agency MBS, including Non-Agency MBS transferred to consolidated VIEs, are reported based on the lowest rating issued by a Rating Agency, if more than one rating is issued on the security, at the date presented.
(4) Includes 214 Non-Agency MBS that were D-rated and had an aggregate amortized cost and fair value of $2.025 billion and $2.281 billion, respectively, at September 30, 2012 and 78 Non-Agency MBS that were D-rated and had an aggregate amortized cost and fair value of $602.0 million and $593.8 million, respectively, at December 31, 2011.
Unrealized Losses on MBS and Impairments
The following table presents information about the Company’s MBS that were in an unrealized loss position at September 30, 2012:
Unrealized Loss Position For:
Less than 12 Months
12 Months or more
Total
Fair
Number of
Value
Securities
117,361
214
23
45,376
735
162,737
949
2,757
48,133
747
165,494
961
Non-Agency MBS:
1,143
1,282
167
30,000
1,053
97,342
2,243
6,955
18
72,474
3,337
79,429
3,355
48,847
672
74,379
1,677
Unrated and other
136,871
2,887
483,448
13,187
50
490,403
13,205
124,316
232
24
531,581
13,934
61
655,897
14,166
At September 30, 2012, the Company did not intend to sell any of its MBS that were in an unrealized loss position, and it is “more likely than not” that the Company will not be required to sell these MBS before recovery of their amortized cost basis, which may be at their maturity. With respect to Non-Agency MBS held by consolidated VIEs, the ability of any entity to cause the sale by the VIE prior to the maturity of these Non-Agency MBS is either specifically precluded, or is limited to specified events of default, none of which have occurred to date.
Gross unrealized losses on the Company’s Agency MBS were $961,000 at September 30, 2012. Given the credit quality inherent in Agency MBS, the Company does not consider any of the current impairments on its Agency MBS to be credit related. In assessing whether it is more likely than not that it will be required to sell any impaired security before its anticipated recovery, which may be at their maturity, the Company considers the significance of each investment, the amount of impairment, the projected future performance of such impaired securities, as well as the Company’s current and anticipated leverage capacity and liquidity position. Based on these analyses, the Company determined that at September 30, 2012 any unrealized losses on its Agency MBS were temporary.
Unrealized losses on the Company’s Non-Agency MBS (including Non-Agency MBS transferred to consolidated VIEs) were $13.2 million at September 30, 2012. Based upon the most recent evaluation, the Company does not consider these unrealized losses to be indicative of OTTI and does not believe that these unrealized losses are credit related, but are rather due to non-credit related factors. The Company has reviewed its Non-Agency MBS that are in an unrealized loss position to identify those securities with losses that are other-than-temporary based on an assessment of changes in expected cash flows for such MBS, which considers recent bond performance and expected future performance of the underlying collateral.
The Company did not recognize credit-related OTTI losses through earnings during the three months ended September 30, 2012 and recognized approximately $1.2 million of credit-related OTTI losses on Non-Agency MBS during the nine months ended September 30, 2012. The Company recognized credit-related OTTI losses through earnings of approximately $4.0 million and $6.4 million on Non-Agency MBS during the three and nine months ended September 30, 2011, respectively.
MBS on which OTTI is recognized have experienced, or are expected to experience, credit-related adverse cash flow changes. The Company’s estimate of cash flows for its Non-Agency MBS is based on its review of the underlying mortgage loans securing these MBS. The Company considers information available about the structure of the securitization, including structural credit enhancement, if any, and the past and expected future performance of underlying mortgage loans, including timing of expected future cash flows, prepayment rates, default rates, loss severities, delinquency rates, percentage of non-performing loans, FICO scores at loan origination, year of
16
origination, loan-to-value ratios, geographic concentrations, as well as Rating Agency reports, general market assessments, and dialogue with market participants. Significant judgment is used in both the Company’s analysis of the expected cash flows for its Non-Agency MBS and any determination of the credit component of OTTI.
The following table presents the composition of OTTI charges recorded by the Company for the three and nine months ended September 30, 2012 and 2011:
Total OTTI losses
OTTI recognized in/(reclassified from) other comprehensive income
OTTI recognized in earnings
The following table presents a roll-forward of the credit loss component of OTTI on the Company’s Non-Agency MBS for which a non-credit component of OTTI was previously recognized in other comprehensive income. Changes in the credit loss component of OTTI are presented based upon whether the current period is the first time OTTI was recorded on a security or a subsequent OTTI charge was recorded.
Credit loss component of OTTI at beginning of period
36,115
34,915
Additions for credit related OTTI not previously recognized
458
Subsequent additional credit related OTTI recorded
742
Credit loss component of OTTI at end of period
The significant inputs considered and assumptions made at time of impairment in determining the measurement of the component of OTTI recognized in earnings for the Company’s Non-Agency MBS for the three and nine months ended September 30, 2012 and 2011 are summarized as follows:
Credit enhancement (1) (2)
Weighted average (3)
2.70%
3.26%
3.02%
Range (4)
0.00-10.40%
0.00-16.50%
0.00-13.30%
Projected CPR (2) (5)
11.00%
9.90%
10.90%
6.90-12.20%
9.10-13.30%
1.90-12.20%
Projected Loss Severity (2) (6)
56.10%
55.50%
53.60%
46.10-70.00%
45.90-60.00%
41.90-70.00%
60+ days delinquent (2) (7)
21.40%
24.40%
21.30%
9.10-36.70%
18.20-32.40%
7.30-36.70%
(1) Represents a level of protection for these securities, expressed as a percentage of total current underlying loan balance.
(2) Information provided is based on loans for all groups that provide credit enhancement for MBS with credit enhancement. If an MBS no longer has credit enhancement, information provided is based on loans for the individual group owned by the Company.
(3) Calculated by weighting the relevant input/assumptions for each individual security by current outstanding face of the security.
(4) Represents the range of inputs/assumptions based on individual securities.
(5) CPR - conditional prepayment rate.
(6) Projected loss severity represents the projected amount of loss realized on liquidated properties as a percentage of the principal balance.
(7) Includes, for each security, underlying loans 60 or more days delinquent, foreclosed loans and other real estate owned.
Purchase Discounts on Non-Agency MBS
The following tables present the changes in the components of the Company’s purchase discount on its Non-Agency MBS between purchase discount designated as Credit Reserve and OTTI and accretable purchase discount for the three and nine months ended September 30, 2012 and 2011:
September 30, 2011
Designated as
Credit Reserve
Discount (1) (2)
Balance at beginning of period
(1,440,752
(265,137
(1,174,890
(222,930
Accretion of discount
8,816
10,785
Realized credit losses
49,314
10,735
Purchases
(122,266
4,554
(29,141
(16,198
Net impairment losses recognized in earnings
Unlinking of Linked Transactions
(2,256
(10,419
(61
Transfers/release of credit reserve
54,053
(54,053
11,305
(11,305
Balance at end of period
(1,196,401
(239,709
and OTTI (3)
Discount (2) (3)
(746,678
(228,966
28,107
33,107
107,229
20,612
(370,649
(3,883
(360,655
(19,035
Reclass discount for OTTI
866
(866
101
(101
(38,662
(9,424
(116,489
(11,623
71,531
(71,531
13,091
(13,091
(1) In addition, the Company reallocated $54,000 of purchase discount designated as Credit Reserve to accretable purchase discount on Non-Agency MBS underlying Linked Transactions during the three months ended September 30, 2012. The Company reallocated $1.1 million of purchase discount designated as accretable purchase discount to Credit Reserve on Non-Agency MBS underlying Linked Transactions during the three months ended September 30, 2011.
(2) Together with coupon interest, accretable purchase discount is recognized as interest income over the life of the security.
(3) In addition, the Company reallocated $575,000 and $309,000 of purchase discount designated as accretable purchase discount to Credit Reserve on Non-Agency MBS underlying Linked Transactions during the nine months ended September 30, 2012 and 2011, respectively.
Impact of MBS on Accumulated Other Comprehensive Income/(Loss)
The following table presents the impact of the Company’s MBS on its accumulated other comprehensive income for the three and nine months ended September 30, 2012 and 2011:
Accumulated other comprehensive income from MBS:
Unrealized gain on MBS at beginning of period
296,007
292,376
393,822
Reclassification adjustment for OTTI included in net income
Change in accumulated other comprehensive income/(loss) from MBS
468,611
(97,793
(199,239
194,583
Sales of MBS
During the three and nine months ended September 30, 2012, the Company sold certain Agency MBS for $66.0 million and $137.1 million, realizing gross gains of $4.3 million and $7.2 million, respectively. During the first nine months of 2011, the Company sold certain Agency MBS for $76.5 million, realizing gross gains of $4.2 million; all of these sales occurred during the third quarter of 2011.
MBS Interest Income
The following table presents the components of interest income on the Company’s Agency MBS for the three and nine months ended September 30, 2012 and 2011:
Coupon interest
61,978
70,654
187,963
212,703
Effective yield adjustment (1)
(14,780
(10,697
(37,915
(26,589
Agency MBS interest income
(1) Includes amortization of premium paid net of accretion of purchase discount. For Agency MBS, interest income is recorded at an effective yield, which reflects net premium amortization based on actual prepayment activity.
The following table presents components of interest income for the Company’s Non-Agency MBS (including MBS transferred to consolidated VIEs) for the three and nine months ended September 30, 2012 and 2011:
69,139
60,038
196,144
153,563
8,760
10,746
27,913
32,970
Non-Agency MBS interest income
77,899
70,784
224,057
186,533
(1) The effective yield adjustment is the difference between the net interest income calculated using the net yield, which is based on management’s estimates of future cash flows for Non-Agency MBS, less the current coupon yield.
19
4. Derivatives
The Company’s derivatives are comprised of Swaps, which are designated as cash flow hedges against the interest rate risk associated with its borrowings, and Linked Transactions, which are not designated as hedging instruments. The following table presents the fair value of the Company’s derivative instruments and their balance sheet location at September 30, 2012 and December 31, 2011:
Derivative Instrument
Location
Swaps, at fair value ($0 notional at September 30, 2012)
Hedging
Assets
Linked Transactions, at fair value
Non-Hedging
Swaps, at fair value ($2.761 billion notional at September 30, 2012)
Liabilities
(78,169
(114,220
Linked Transactions
The Company’s Linked Transactions are evaluated on a combined basis, reported as forward (derivative) instruments and presented as assets on the Company’s consolidated balance sheets at fair value. The fair value of Linked Transactions reflect the value of the underlying Non-Agency MBS, linked repurchase agreement borrowings and accrued interest receivable/payable on such instruments. The Company’s Linked Transactions are not designated as hedging instruments and, as a result, the change in the fair value and net interest income from Linked Transactions is reported in other income on the Company’s consolidated statements of operations.
The following tables present certain information about the Non-Agency MBS and repurchase agreements underlying the Company’s Linked Transactions at September 30, 2012 and December 31, 2011:
Linked Transactions at September 30, 2012
Linked Repurchase Agreements
Linked MBS
Weighted
Average
Maturity or Repricing
Interest
Par/Current
Coupon
(Dollars in Thousands)
Balance
Rate
Cost
Within 30 days
36,423
1.61
%
14,544
13,728
14,120
5.00
3,137
2,641
3,486
0.79
8,210
7,340
9,022
2.61
7,257
6,855
7,639
2.74
Rated D
15,910
15,094
20,423
5.81
49,058
45,658
54,690
4.32
Linked Transactions at December 31, 2011
141,719
1.89
29,057
29,917
30,675
3.31
>30 days to 90 days
29,178
1.81
17,427
16,858
17,297
170,897
1.88
41,825
42,419
49,781
2.81
20,782
20,988
26,680
4.42
43,644
47,060
61,470
6.00
32,870
36,934
45,857
5.20
Unrated
40,364
43,419
57,776
5.54
225,969
237,595
289,536
4.74
At September 30, 2012, Linked Transactions also included approximately $195,000 of associated accrued interest receivable and $63,000 of accrued interest payable. At December 31, 2011, Linked Transactions also included $1.1 million of associated accrued interest receivable and $412,000 of accrued interest payable.
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The following table presents certain information about the components of the unrealized net gains and net interest income from Linked Transactions included in the Company’s consolidated statements of operations for the three and nine months ended September 30, 2012 and 2011:
Components of Unrealized Net Gains and Net Interest
Income from Linked Transactions
Interest income attributable to MBS underlying Linked Transactions
812
4,631
4,386
21,475
Interest expense attributable to linked repurchase agreement borrowings underlying Linked Transactions
(168
(864
(965
(3,938
Change in fair value of Linked Transactions included in earnings
2,533
(3,034
8,023
(7,567
Derivative Hedging Instruments
Consistent with market practice, the Company has agreements with its Swap counterparties that provide for the posting of collateral based on the fair values of its derivative contracts. Through this margining process, either the Company or its derivative counterparty may be required to pledge cash or securities as collateral. Collateral requirements vary by counterparty and change over time based on the market value, notional amount and remaining term of the derivative contract. Certain derivative contracts provide for cross collateralization with repurchase agreements with the same counterparty.
A number of the Company’s derivative contracts include financial covenants, which, if breached, could cause an event of default or early termination event to occur under such agreements. If the Company were to cause an event of default or trigger an early termination event pursuant to one of its derivative contracts, the counterparty to such agreement may have the option to terminate all of its outstanding derivative contracts with the Company and, if applicable, any close-out amount due to the counterparty upon termination of the derivative contracts would be immediately payable by the Company. The Company was in compliance with all of its financial covenants through September 30, 2012. At September 30, 2012, the aggregate fair value of assets needed to immediately settle derivative contracts that were in a liability position to the Company, if so required, was $81.5 million, including accrued interest payable of approximately $3.3 million.
The following table presents the assets pledged as collateral against the Company’s derivative contracts at September 30, 2012 and December 31, 2011:
Agency MBS, at fair value
84,150
117,687
Total assets pledged against derivative contracts
91,163
133,189
The use of derivative hedging instruments exposes the Company to counterparty credit risk. In the event of a default by a derivative counterparty, the Company may not receive payments to which it is entitled under its derivative agreements, and may have difficulty recovering its assets pledged as collateral against such agreements. If, during the term of a derivative contract, a counterparty should file for bankruptcy, the Company may experience difficulty recovering its assets pledged as collateral which could result in the Company having an unsecured claim against such counterparty’s assets for the difference between the fair value of the derivative and the fair value of the collateral pledged to such counterparty. At September 30, 2012, all of the Company’s derivative counterparties were rated A or better by a Rating Agency.
The Company’s derivative hedging instruments, or a portion thereof, could become ineffective in the future if the associated repurchase agreements or securitized debt that such derivatives hedge fail to exist or fail to have terms that match those of the derivatives that hedge such borrowings. At September 30, 2012, all of the Company’s derivatives were deemed effective for hedging purposes and no derivatives were terminated during the three and nine months ended September 30, 2012 and September 30, 2011.
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The Company’s Swaps have the effect of modifying the repricing characteristics of the Company’s repurchase agreements and securitized debt and cash flows for such liabilities. To date, no cost has been incurred at the inception of a Swap, pursuant to which the Company agrees to pay a fixed rate of interest and receive a variable interest rate, generally based on one-month or three-month London Interbank Offered Rate (“LIBOR”), on the notional amount of the Swap. The Company has not recognized any change in the value of its derivative hedging instruments in earnings as a result of the hedge or a portion thereof being ineffective during the three and nine months ended September 30, 2012 and September 30, 2011.
At September 30, 2012, the Company had Swaps with an aggregate notional amount of $2.761 billion, which had gross unrealized losses of $78.2 million, and extended 16 months on average with a maximum term of approximately 40 months. During the three and nine months ended September 30, 2012, the Company did not enter into any new Swaps, and had Swaps amortize and/or expire with an aggregate notional amount of $187.7 million and $617.2 million, respectively. The following table presents information about the Company’s Swaps at September 30, 2012 and December 31, 2011:
Maturity (1)
Notional
Fixed-Pay
Average Variable
Amount
Interest Rate
Interest Rate (2)
129,533
4.56
0.24
34,056
4.05
0.37
Over 30 days to 3 months
211,618
4.35
0.41
120,001
4.43
0.38
Over 3 months to 6 months
56,013
3.92
0.34
275,351
2.54
0.33
Over 6 months to 12 months
884,287
2.66
528,894
0.39
Over 12 months to 24 months
598,372
2.16
974,352
2.78
0.30
Over 24 months to 36 months
830,892
2.17
685,042
2.28
0.31
Over 36 months to 48 months
50,000
2.13
0.22
710,170
1.96
0.29
Over 48 months to 60 months
Total Swaps
2,760,715
2.64
3,377,866
2.80
0.32
(1) Each maturity category reflects contractual amortization and/or maturity of notional amounts.
(2) Reflects the benchmark variable rate due from the counterparty at the date presented, which rate adjusts monthly or quarterly based on one-month or three-month LIBOR, respectively.
The following table presents the net impact of the Company’s derivative hedging instruments on its interest expense and the weighted average interest rate paid and received for such Swaps for the three and nine months ended September 30, 2012 and 2011:
Interest expense attributable to Swaps
18,138
24,322
58,275
73,091
Weighted average Swap rate paid
2.72
2.88
3.24
Weighted average Swap rate received
0.27
In June 2011, the Company purchased a Swaption, for which it paid a premium of $915,000, that provided the Company with the right to enter into a fixed-pay Swap at termination of the option period in January 2012. The terms of the Swap that the Company could have entered into were as follows: $100.0 million notional; four-year term; fixed strike rate 1.90%; variable index equal to one month LIBOR. Swaptions are used as a hedge against the risk of changes in the interest component above a specified level on a portion of forecasted one-month fixed rate borrowings. At the termination of the option period in January 2012, the Company allowed the Swaption to expire. At September 30, 2011, the Company’s Swaption had a fair value of $28,000. During the three months ended September 30, 2011, the Company’s Swaption decreased in value by $227,000, which was reflected in other comprehensive income, reflecting changes in the intrinsic value component of the Swaption, and $899,000 of expense in other income, reflecting changes in the time-value component of the Swaption. For the nine months ended September 30, 2011, the Company recognized $887,000 of expense in other income, reflecting changes in the time-value component of the Swaption.
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Impact of Hedging Instruments on Accumulated Other Comprehensive Income/(Loss)
The following table presents the impact of the Company’s derivative hedging instruments on its accumulated other comprehensive income/(loss) for the three and nine months ended September 30, 2012 and 2011:
Accumulated other comprehensive loss from derivative hedging instruments:
(89,823
(124,404
(114,194
(139,142
Unrealized gain/(loss) on Swaps, net
(10,028
Unrealized loss on Swaptions
(227
(134,659
Counterparty Credit Risk
By using derivative hedging instruments, the Company is exposed to counterparty credit risk if counterparties to the derivative contracts do not perform as expected. If a counterparty fails to perform, the Company’s counterparty credit risk is equal to the amount reported as a derivative asset on its balance sheet to the extent that amount exceeds collateral obtained from the counterparty or, if in a net liability position, the extent to which collateral posted exceeds the liability to the counterparty. The amounts reported as a derivative asset/(liability) are derivative contracts in a gain/(loss) position, and to the extent subject to master netting arrangements, net of derivatives in a loss/(gain) position with the same counterparty and collateral received/(pledged). The Company attempts to minimize counterparty credit risk through credit approvals, limits, monitoring procedures, executing master netting arrangements and obtaining collateral, where appropriate. Counterparty credit risk related to the Company’s derivative hedging instruments is considered in determining fair value of such derivatives and its assessment of hedge effectiveness.
5. Interest Receivable
The following table presents the Company’s interest receivable by investment category at September 30, 2012 and December 31, 2011:
MBS interest receivable:
18,881
19,774
2,425
3,179
32
23,649
19,850
Total MBS interest receivable
44,979
42,835
Money market investments
Total interest receivable
6. Real Estate
In December 2011, the Company completed the sale of its investment in Lealand, which had been classified as held-for-sale on the consolidated balance sheet since March 31, 2011. The following table presents the summary of assets and liabilities of Lealand at September 30, 2012 and December 31, 2011:
Real Estate Assets and Liabilities:
Land and buildings, net of accumulated depreciation
Cash and other assets
941
Accrued interest and other payables (1)
(95
(1) The Company had a loan to Lealand which had a balance of $445,000 at December 31, 2011. This loan and the related interest accounts were eliminated in consolidation. The loan was paid-off during the quarter ended March 31, 2012.
The following table presents the summary results of operations for Lealand for the three and nine months ended September 30, 2012 and 2011:
Revenue from operations of real estate
Other real estate operating expense
(237
(660
Depreciation and amortization expense (1)
(114
Gain from real estate operations, net
153
372
(1) On March 31, 2011, the Company classified its investment in Lealand as held-for-sale and accordingly ceased depreciating assets related to this investment as of such date.
7. Repurchase Agreements
The Company’s repurchase agreements are collateralized by the Company’s MBS and U.S. Treasury securities (obtained as part of a reverse repurchase agreement) and cash and bear interest that is generally LIBOR-based. (See Note 8) At September 30, 2012, the Company’s borrowings under repurchase agreements had a weighted average remaining term-to-interest rate reset of 29 days and an effective repricing period of six months, including the impact of related Swaps. At December 31, 2011, the Company’s borrowings under repurchase agreements had a weighted average remaining term-to-interest rate reset of 31 days and an effective repricing period of nine months, including the impact of related Swaps.
The following table presents information with respect to the Company’s borrowings under repurchase agreements and associated assets pledged as collateral at September 30, 2012 and December 31, 2011:
Repurchase agreement borrowings secured by Agency MBS
6,460,037
6,198,829
Fair Value of Agency MBS pledged as collateral under repurchase agreements
6,818,804
6,549,276
Weighted average haircut on Agency MBS (1)
4.77
4.78
Repurchase agreement borrowings secured by Non-Agency MBS (2)
1,869,175
1,313,336
Fair Value of Non-Agency MBS pledged as collateral under repurchase agreements (2) (3)
3,215,875
2,067,221
Weighted average haircut on Non-Agency MBS (1)
30.38
30.97
Repurchase agreements secured by U.S. Treasuries
503,114
300,994
Fair value of U.S. Treasuries pledged as collateral under repurchase agreements
Weighted average haircut on U.S. Treasuries (1)
1.59
2.00
(1) Haircut represents the percentage amount by which the collateral value is contractually required to exceed the loan amount on the Company’s repurchase agreements borrowings.
(2) Does not reflect Non-Agency MBS and repurchase agreement borrowings that are components of Linked Transactions.
(3) Includes $1.726 billion and $1.375 billion of Non-Agency MBS acquired from consolidated VIEs at September 30, 2012, and December 31, 2011, respectively, that are eliminated from the Company’s consolidated balance sheet.
The following table presents repricing information about the Company’s borrowings under repurchase agreements, which does not reflect the impact of associated derivative hedging instruments, at September 30, 2012 and December 31, 2011:
Time Until Interest Rate Reset
Balance (1)
6,821,216
0.62
5,220,740
0.54
1,859,753
1.27
2,570,119
0.77
151,357
2.45
22,300
3.15
0.78
(1) At September 30, 2012 and December 31, 2011, the Company had repurchase agreements of $36.4 million and $170.9 million, respectively, that were linked to Non-Agency MBS purchases and accounted for as Linked Transactions, and as such, the linked repurchase agreements are not included in the above table. (See Note 4)
The following table at September 30, 2012 presents contractual maturity information about the Company’s borrowings under repurchase agreements and does not reflect the impact of derivative contracts that hedge such repurchase agreements:
Contractual Maturity
Weighted Average
Overnight
6,679,373
0.58
Over 30 days to 90 days
1,441,613
0.94
Over 90 days to 12 months
240,479
1.60
Over 12 months
470,861
(1) At September 30, 2012, the Company had repurchase agreements of $36.4 million that were linked to Non-Agency MBS purchases and were accounted for as Linked Transactions, and as such, the linked repurchase agreements are not included in the above table. (See Note 4)
The Company had repurchase agreements with 26 counterparties at September 30, 2012 and 25 counterparties at December 31, 2011. The following table presents information with respect to any counterparty for repurchase agreements and/or Linked Transactions for which the Company had greater than 5% of stockholders’ equity at risk in the aggregate at September 30, 2012:
Counterparty
Amount at
Weighted Average Months to Maturity for Repurchase
Percent of Stockholders’
Rating (1)
Risk (2)
Agreements
Equity
Credit Suisse
A/Aa2/A
593,219
18.3
UBS (3) (4)
A/A2/A
305,865
9.4
Wells Fargo (5)
A+/A2/AA-
268,430
8.3
Deutsche Bank
A+/A2/A+
214,607
6.6
(1) As rated at September 30, 2012 by S&P, Moody’s and Fitch, Inc., respectively. The counterparty rating presented is the lowest published for these entities.
(2) The amount at risk reflects the difference between (a) the amount loaned to the Company through repurchase agreements and repurchase agreements underlying Linked Transactions, including interest payable, and (b) the cash and the fair value of the securities pledged by the Company as collateral and MBS underlying Linked Transactions, including accrued interest receivable on such securities.
(3) Includes $297.7 million at risk with UBS AG and $8.2 million at risk with UBS Securities LLC.
(4) Includes Non-Agency MBS pledged as collateral in connection with contemporaneous repurchase and reverse repurchase agreements.
(5) Includes $184.0 million with Wells Fargo Bank, NA and $84.4 million at risk with Wells Fargo Securities LLC.
8. Collateral Positions
The Company pledges securities or cash as collateral to its counterparties pursuant to its borrowings under repurchase agreements and its derivative contracts that are in an unrealized loss position, and it receives securities or cash as collateral pursuant to financing provided under reverse repurchase agreements and its derivative contracts in an unrealized gain position. The Company exchanges collateral with its counterparties based on changes in the fair value, notional amount and term of the associated repurchase and reverse repurchase agreements and derivative contracts, as applicable. Through this margining process, either the Company or its counterparty may be required to pledge cash or securities as collateral. When the Company’s pledged collateral exceeds the required margin, the Company may initiate a reverse margin call, at which time the counterparty may either return the excess collateral, or provide collateral to the Company in the form of cash or high-quality securities.
The following table summarizes the fair value of the Company’s collateral positions, which includes collateral pledged and collateral held, with respect to its borrowings under repurchase agreements, reverse repurchase agreements and derivative hedging instruments at September 30, 2012 and December 31, 2011:
Assets Pledged
Collateral Held
Derivative hedging instruments:
Cash (1)
Repurchase Agreement Borrowings:
Non-Agency MBS (2)(3)
U.S. Treasury securities
10,544,383
8,922,898
Reverse Repurchase Agreements:
10,635,546
9,056,087
(1) Cash pledged as collateral is reported as “restricted cash” on the Company’s consolidated balance sheets.
(2) Includes $1.726 billion and $1.375 billion of Non-Agency MBS acquired in connection with resecuritization transactions from consolidated VIEs at September 30, 2012 and December 31, 2011, respectively, that are eliminated from the Company’s consolidated balance sheet.
(3) In addition, $797.3 million and $448.4 million of Non-Agency MBS are pledged as collateral in connection with contemporaneous repurchase and reverse repurchase agreements entered into with a single counterparty at September 30, 2012 and December 31, 2011, respectively.
The following table presents detailed information about the Company’s assets pledged as collateral pursuant to its borrowings under repurchase agreements and derivative hedging instruments at September 30, 2012:
MBS Pledged Under Repurchase Agreements
MBS Pledged Against Derivative Hedging Instruments
Total Fair Value of
Amortized Cost
Accrued Interest on Pledged MBS
MBS Pledged and Accrued Interest
513,316
6,254,273
6,032,905
17,715
65,883
62,901
185
6,338,056
562,372
538,205
2,156
8,949
8,563
573,514
2,159
2,102
9,318
8,994
11,495
6,573,212
19,874
80,458
6,923,065
33,619
32,534
108
33,727
21,164
22,217
59
21,223
13,442
12,337
13,503
330,200
307,753
1,187
331,387
99,176
89,421
327
99,503
273,113
245,188
1,066
274,179
237,426
215,418
1,090
238,516
171,079
156,944
910
171,989
668,121
609,303
3,629
671,750
Not Rated
1,368,535
1,159,898
7,805
1,376,340
Non-Agency MBS (1) (2)
2,851,013
16,242
3,232,117
9,937,541
36,116
10,664,886
(1) Includes $1.726 billion of Non-Agency MBS acquired in connection with resecuritization transactions from consolidated VIEs at September 30, 2012, that are eliminated from the Company’s consolidated balance sheet.
(2) Reported based on the lowest rating issued by a Rating Agency, if more than one rating is issued on the security, at the date presented.
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9. Senior Notes
On April 11, 2012 the Company issued $100.0 million in aggregate principal amount of its Senior Notes in an underwritten public offering. The total net proceeds to the Company from the offering of the Senior Notes were approximately $96.6 million, after deducting offering expenses and the underwriting discount. The Senior Notes bear interest at a fixed rate of 8.00% per year, paid quarterly in arrears on January 15, April 15, July 15 and October 15 of each year and will mature on April 15, 2042. The Company may redeem the Senior Notes, in whole or in part, at any time on or after April 15, 2017 at a redemption price equal to 100% of the principal amount redeemed plus accrued and unpaid interest to, but not excluding, the redemption date.
The Senior Notes are the Company’s senior unsecured obligations and are subordinate to all of the Company’s secured indebtedness, which includes the Company’s repurchase agreements, securitized debt, obligation to return securities obtained as collateral, and other financing arrangements, to the extent of the value of the collateral securing such indebtedness.
10. Commitments and Contingencies
(a) Lease Commitments
The Company pays monthly rent pursuant to two operating leases. The lease term for the Company’s headquarters in New York, New York extends through May 31, 2020. The lease provides for aggregate cash payments ranging over time from approximately $2.4 million to $2.5 million per year, paid on a monthly basis, exclusive of escalation charges. In addition, as part of this lease agreement, the Company has provided the landlord a $785,000 irrevocable standby letter of credit fully collateralized by cash. The letter of credit may be drawn upon by the landlord in the event that the Company defaults under certain terms of the lease. In addition, the Company has a lease through December 31, 2016 for its off-site back-up facility located in Rockville Centre, New York, which provides for, among other things, cash payments ranging over time from $27,000 to $30,000 per year, paid on a monthly basis.
(b) Representations and Warranties in Connection with Resecuritization Transactions
In connection with the resecuritization transactions engaged in by the Company (See Note 15 for further discussion), the Company has the obligation under certain circumstances to repurchase assets from its VIEs upon breach of certain representations and warranties.
(c) MBS Purchase Commitments
At September 30, 2012, the Company had commitments to purchase Agency MBS at an estimated purchase price of $126.0 million. This commitment is included in the Agency MBS balances presented at fair value on the Company’s consolidated balance sheet.
11. Stockholders’ Equity
(a) Dividends on Preferred Stock
At September 30, 2012, the Company had issued and outstanding 3.8 million shares of Series A preferred stock, with a par value of $0.01 per share and a liquidation preference of $25.00 per share. Beginning April 27, 2009, the Company’s preferred stock became redeemable at $25.00 per share plus accrued and unpaid dividends (whether or not declared) exclusively at the Company’s option. The preferred stock is entitled to receive a dividend at a rate of 8.50% per year on the $25.00 liquidation preference before the Company’s common stock is paid any dividends and is senior to the common stock with respect to distributions upon liquidation, dissolution or winding up. The preferred stock generally does not have any voting rights, subject to an exception in the event the Company fails to pay dividends on the preferred stock for six or more quarterly periods (whether or not consecutive). Under such circumstances, the preferred stock will be entitled to vote to elect two additional directors to the Company’s Board of Directors (“Board”), until all unpaid dividends have been paid or declared and set apart for payment. In addition, certain material and adverse changes to the terms of the preferred stock cannot be made without the affirmative vote of holders of at least 66 2/3% of the outstanding shares of preferred stock.
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From the time of original issuance of the preferred stock through September 30, 2012, the Company has declared and paid all required quarterly dividends on such stock. The following table presents the relevant dates with respect to such quarterly cash dividends, of $0.53125 per share, from January 1, 2011 through September 30, 2012:
Declaration Date
Record Date
Payment Date
August 22, 2012
September 4, 2012
October 1, 2012
May 18, 2012
June 1, 2012
July 2, 2012
February 17, 2012
March 1, 2012
April 2, 2012
November 21, 2011
December 1, 2011
December 30, 2011
August 22, 2011
September 1, 2011
May 20, 2011
June 1, 2011
June 30, 2011
February 18, 2011
March 1, 2011
March 31, 2011
(b) Dividends on Common Stock
The following table presents cash dividends declared by the Company on its common stock from January 1, 2011 through September 30, 2012:
Dividend Per Share
September 28, 2012
October 12, 2012
October 31, 2012
0.210
(1)
June 27, 2012
July 13, 2012
July 31, 2012
0.230
March 23, 2012
April 4, 2012
April 30, 2012
0.240
December 14, 2011
January 31, 2012
0.270
(2)
September 26, 2011
October 11, 2011
October 31, 2011
0.250
July 14, 2011
July 29, 2011
April 11, 2011
April 29, 2011
0.235
(1) At September 30, 2012 the Company had accrued dividends and DERs payable of $76.1 million related to the common stock dividend declared on September 28, 2012.
(2) Includes a special dividend of $0.02 per share.
(c) Discount Waiver, Direct Stock Purchase and Dividend Reinvestment Plan (“DRSPP”)
On November 22, 2011, the Company filed a shelf registration statement on Form S-3 with the SEC under the Securities Act of 1933, as amended (“1933 Act”), for the purpose of registering additional common stock for sale through its DRSPP. Pursuant to Rule 462(e) of the 1933 Act, this shelf registration statement became effective automatically upon filing with the SEC and, when combined with the unused portion of the Company’s previous DRSPP shelf registration statements, registered an aggregate of 10 million shares of common stock. The Company’s DRSPP is designed to provide existing stockholders and new investors with a convenient and economical way to purchase shares of common stock through the automatic reinvestment of dividends and/or optional cash investments. At September 30, 2012, 9.4 million shares of common stock remained available for issuance pursuant to the DRSPP shelf registration statement.
During the three and nine months ended September 30, 2012, the Company issued 75,454 shares and 596,079 shares of common stock through the DRSPP, raising net proceeds of $603,519 and $4.4 million, respectively. From the inception of the DRSPP in September 2003 through September 30, 2012, the Company issued 15,146,939 shares pursuant to the DRSPP, raising net proceeds of $132.7 million.
(d) Controlled Equity Offering Program
On August 20, 2004, the Company initiated a controlled equity offering program (the “CEO Program”) through which it may, from time to time, publicly offer and sell shares of common stock through Cantor Fitzgerald & Co. (“Cantor”) in privately negotiated and/or at-the-market transactions. During the nine months ended September 30, 2012, the Company did not issue any shares through the CEO Program. From inception of the CEO Program through September 30, 2012, the Company issued 30,144,815 shares of common stock in at-the-market transactions through the CEO Program, raising net proceeds of $194,908,570. In connection with such transactions, the Company paid Cantor aggregate fees and commissions of $4,189,247. Shares for the CEO Program are issued through the automatic shelf registration statement on Form S-3 that was filed on October 22, 2010, as amended by Post-Effective Amendment No. 1 thereto, which was filed on April 2, 2012.
On December 12, 2008, the Company entered into its most recent Sales Agreement (the “Agreement”) with Cantor, as sales agent. In accordance with the terms of the Agreement, the Company may offer and sell up to 40 million shares of common stock (the “CEO Shares”) from time to time through Cantor. Sales of the CEO Shares, if any, may be made in privately negotiated transactions and/or by any other method permitted by law, including, but not limited to, sales at other than a fixed price made on or through the facilities of the New York Stock Exchange (“NYSE”), or sales made to or through a market maker or through an electronic communications network, or in any other manner that may be deemed to be an “at-the-market offering” as defined in Rule 415 of the 1933 Act. Cantor will make all sales on a best efforts basis using commercially reasonable efforts consistent with its normal trading and sales practices on mutually agreed terms between the Company and Cantor.
(e) Stock Repurchase Program
On August 11, 2005, the Company announced the implementation of a stock repurchase program (the “Repurchase Program”). At September 30, 2012, the Company was authorized to repurchase 4.0 million shares of its outstanding common stock under the Repurchase Program. Subject to applicable securities laws, repurchases of common stock under the Repurchase Program are made at times and in amounts as the Company deems appropriate, using available cash resources. Shares of common stock repurchased by the Company under the Repurchase Program are cancelled and, until reissued by the Company, are deemed to be authorized but unissued shares of the Company’s common stock. The Repurchase Program may be suspended or discontinued by the Company at any time and without prior notice. The Company has not repurchased any shares of its common stock under the Repurchase Program since April 2006.
(f) Accumulated Other Comprehensive Income/(Loss)
The following table presents the components of the Company’s accumulated other comprehensive income/(loss) at September 30, 2012 and December 31, 2011:
Net Unrealized
Total Accumulated
Gain on
Other Comprehensive
Available-for-Sale MBS
(Loss)/Gain on Swaps
(Loss)/Income
Current period other comprehensive income (1)
(1) For further information regarding changes in current period other comprehensive income, see the Company’s consolidated statements of comprehensive income/(loss).
At September 30, 2012 and December 31, 2011, the Company had OTTI recognized in accumulated other comprehensive income/(loss) of $5.0 million and $65.4 million, respectively.
12. EPS Calculation
The following table presents a reconciliation of the earnings and shares used in calculating basic and diluted EPS for the three and nine months ended September 30, 2012 and 2011:
Numerator:
Dividends, DERs and undistributed earnings allocated to participating securities
(360
(446
(1,168
(1,195
Net income to common stockholders - basic and diluted
75,741
81,213
230,332
238,535
Denominator:
Weighted average common shares for basic and diluted earnings per share (1)
356,921
355,964
356,563
336,756
Basic and diluted earnings per share
(1) At September 30, 2012, the Company had an aggregate of 2.0 million equity instruments outstanding that were not included in the calculation of diluted EPS for the three and nine months ended September 30, 2012, as their inclusion would have been anti-dilutive. These equity instruments were comprised of 432,000 stock options with a weighted average exercise price of $10.11 and a weighted average remaining contractual life of 1.1 years, approximately 536,000 shares of restricted common stock with a weighted average grant date fair value of $7.42 and approximately 995,000 RSUs with a weighted average grant date fair value of $7.04. These equity instruments may have a dilutive impact on future EPS.
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13. Equity Compensation, Employment Agreements and Other Benefit Plans
(a) 2010 Equity Compensation Plan
In accordance with the terms of the Company’s Amended and Restated 2010 Equity Compensation Plan (the “2010 Plan”), directors, officers and employees of the Company and any of its subsidiaries and other persons expected to provide significant services for the Company and any of its subsidiaries are eligible to receive grants of stock options (“Options”), restricted stock, RSUs, DERs and other stock-based awards under the 2010 Plan.
Subject to certain exceptions, stock-based awards relating to a maximum of 13.5 million shares of common stock may be granted under the 2010 Plan; forfeitures and/or awards that expire unexercised do not count towards such limit. At September 30, 2012, approximately 9.6 million shares of common stock remained available for grant in connection with stock-based awards under the 2010 Plan. A participant may generally not receive stock-based awards in excess of 1,500,000 shares of common stock in any one-year and no award may be granted to any person who, assuming exercise of all Options and payment of all awards held by such person, would own or be deemed to own more than 9.8% of the outstanding shares of the Company’s common stock. Unless previously terminated by the Board, awards may be granted under the 2010 Plan until May 20, 2020.
DERs
A DER is a right to receive a distribution equal to the dividend distributions that would be paid on a share of the Company’s common stock. DERs may be granted separately or together with other awards and are paid in cash or other consideration at such times and in accordance with such rules, as the Compensation Committee of the Board (the “Compensation Committee”) shall determine at its discretion. Payments made on the Company’s existing DERs are charged to stockholders’ equity when the common stock dividends are declared to the extent that such DERs are expected to vest. The Company made DER payments of approximately $357,000 and $418,000 during the three months ended September 30, 2012 and 2011, respectively, and approximately $1.2 million and $1.1 million during the nine months ended September 30, 2012 and 2011. At September 30, 2012, the Company had 1,544,933 DERs outstanding, of which 409,500 were attached to common stock options and 1,135,433 were awarded in connection with, or attached to, RSUs. At September 30, 2012, the average forfeiture rate on DERs outstanding attached to RSUs was 18.9%. On the remaining DERs outstanding that are not attached to RSUs, a 0% forfeiture rate was assumed at September 30, 2012. At September 30, 2012, all outstanding DERs were entitled to receive non-forfeitable distributions and are scheduled to elapse over a weighted average period of 1.9 years.
Options
Pursuant to Section 422(b) of the Code, in order for Options granted under the 2010 Plan and vesting in any one calendar year to qualify as an incentive stock option (“ISO”) for tax purposes, the market value of the common stock to be received upon exercise of such Options as determined on the date of grant shall not exceed $100,000 during such calendar year. The exercise price of an ISO may not be lower than 100% (110% in the case of an ISO granted to a 10% stockholder) of the fair market value of the Company’s common stock on the date of grant. The exercise price for any other type of Option issued under the 2010 Plan may not be less than the fair market value on the date of grant. Each Option is exercisable after the period or periods specified in the award agreement, which will generally not exceed ten years from the date of grant.
The Company did not grant any stock options during the nine months ended September 30, 2012 and September 30, 2011. There were 50,000 stock options cancelled during the nine months ended September 30, 2012, and 55,000 stock options cancelled during the nine months ended September 30, 2011. At September 30, 2012, 432,000 stock options were outstanding, all of which were vested and exercisable, with a weighted average exercise price of $10.11. As of September 30, 2012, the aggregate intrinsic value of total Options outstanding was approximately $10,000.
Restricted Stock
The Company awarded zero and 81,439 shares of restricted common stock during the three and nine months ended September 30, 2012, respectively, and awarded zero and 37,255 shares of restricted common stock during the three and nine months ended September 30, 2011, respectively. At September 30, 2012 and December 31, 2011, the Company had unrecognized compensation expense of $2.7 million and $5.5 million, respectively, related to the unvested shares of restricted common stock. The Company had accrued dividends payable of $722,000 and $886,000 on unvested shares of restricted common stock at September 30, 2012 and December 31, 2011, respectively. The unrecognized compensation expense at September 30, 2012 is expected to be recognized over a weighted average period of 1.1 years.
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Restricted Stock Units and Associated DERs
Under the terms of the 2010 Plan, RSUs are instruments that provide the holder with the right to receive, subject to the satisfaction of conditions set by the Compensation Committee at the time of grant, a payment of a specified value, which may be a share of the Company’s common stock, the fair market value of a share of the Company’s common stock, or such fair market value to the extent in excess of an established base value, on the applicable settlement date. Although the 2010 Plan permits the Company to issue RSUs settleable in cash, all of the Company’s outstanding RSUs as of September 30, 2012 are designated to be settled in shares of the Company’s common stock. The Company granted 72,500 RSUs during the three and nine months ended September 30, 2012, respectively, and granted 87,500 RSUs during the three and nine months ended September 30, 2011, respectively. All RSUs outstanding at September 30, 2012 had DERs attached or issued as separate associated instruments in connection with RSUs. At September 30, 2012 and December 31, 2011, the Company had unrecognized compensation expense of $2.8 million and $4.0 million, respectively, related to RSUs and DERs. The unrecognized compensation expense at September 30, 2012 is expected to be recognized over a weighted average period of 2.7 years. As of September 30, 2012, the Company had an expected average forfeiture rate of 15.4% with respect to unvested RSUs.
Expense Recognized for Equity-Based Compensation Instruments
The following table presents the Company’s expenses related to its equity-based compensation instruments for the three and nine months ended September 30, 2012 and 2011:
Restricted shares of common stock
1,445
560
3,362
1,944
RSUs
289
407
835
976
60
177
1,793
1,027
(b) Employment Agreements
At September 30, 2012, the Company had employment agreements with six of its officers, with varying terms that provide for, among other things, base salary, bonus and change-in-control payments upon the occurrence of certain triggering events.
(c) Deferred Compensation Plans
The Company administers deferred compensation plans for its senior officers and non-employee directors (collectively, the “Deferred Plans”), pursuant to which participants may elect to defer up to 100% of certain cash compensation. The Deferred Plans are designed to align participants’ interests with those of the Company’s stockholders.
Amounts deferred under the Deferred Plans are considered to be converted into “stock units” of the Company. Stock units do not represent stock of the Company, but rather are a liability of the Company that changes in value as would equivalent shares of the Company’s common stock. Deferred compensation liabilities are settled in cash at the termination of the deferral period, based on the value of the stock units at that time. The Deferred Plans are non-qualified plans under the Employee Retirement Income Security Act of 1974 and, as such, are not funded. Prior to the time that the deferred accounts are settled, participants are unsecured creditors of the Company.
The Company’s liability for stock units in the Deferred Plans is based on the market price of the Company’s common stock at the measurement date. The following table presents the Company’s expenses related to its Deferred Plans for its non-employee directors and senior officers for the three and nine months ended September 30, 2012 and 2011:
Non-employee directors
(21
76
(17
Officers
(1
(18
The following table presents the aggregate amount of income deferred by participants of the Deferred Plans through September 30, 2012 and December 31, 2011 that had not been distributed and the Company’s associated liability for such deferrals at September 30, 2012 and December 31, 2011:
Undistributed Income
Liability Under
Deferred (1)
Deferred Plans
199
309
209
254
(1) Represents the cumulative amounts that were deferred by participants through September 30, 2012 and December 31, 2011, which had not been distributed through such date.
(d) Savings Plan
The Company sponsors a tax-qualified employee savings plan (the “Savings Plan”), in accordance with Section 401(k) of the Code. Subject to certain restrictions, all of the Company’s employees are eligible to make tax deferred contributions to the Savings Plan subject to limitations under applicable law. Participant’s accounts are self-directed and the Company bears the costs of administering the Savings Plan. The Company matches 100% of the first 3% of eligible compensation deferred by employees and 50% of the next 2%, subject to a maximum as provided by the Code. The Company has elected to operate the Savings Plan under the applicable safe harbor provisions of the Code, whereby among other things, the Company must make contributions for all participating employees and all matches contributed by the Company immediately vest 100%. For the three months ended September 30, 2012 and 2011, the Company recognized expenses for matching contributions of $60,000 and $43,000, respectively, and $179,000 and $128,000 for the nine months ended September 30, 2012 and 2011, respectively.
14. Fair Value of Financial Instruments
A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement. The three levels of valuation hierarchy are defined as follows:
Level 1 — inputs to the valuation methodology are quoted prices (unadjusted) for identical assets or liabilities in active markets.
Level 2 — inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.
Level 3 — inputs to the valuation methodology are unobservable and significant to the fair value measurement.
The following describes the valuation methodologies used for the Company’s financial instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy.
Securities Obtained and Pledged as Collateral/Obligation to Return Securities Obtained as Collateral
The fair value of U.S. Treasury securities obtained as collateral and the associated obligation to return securities obtained as collateral are based upon prices obtained from a third-party pricing service, which are indicative of market activity. Securities obtained as collateral are classified as Level 1 in the fair value hierarchy.
Agency MBS, Non-Agency MBS and Securitized Debt
The Company determines the fair value of its Agency MBS, based upon prices obtained from third-party pricing services, which are indicative of market activity and repurchase agreement counterparties.
For Agency MBS, the valuation methodology of the Company’s third-party pricing services incorporate commonly used market pricing methods, incorporates trading activity observed in the marketplace and other data inputs. The methodology also considers the underlying characteristics of each security, which are also observable inputs, including: collateral vintage; coupon; maturity date; loan age; reset date; collateral type; periodic and life cap; geography; and prepayment speeds. Management analyzes pricing data received from third-party pricing services and compares it to other indications of fair value including data received from repurchase agreement counterparties and its own observations of trading activity observed in the marketplace.
In determining the fair value of its Non-Agency MBS and securitized debt, management considers a number of observable market data points, including prices obtained from pricing services and brokers, as well as dialogue with market participants. In valuing Non-Agency MBS, the Company understands that pricing services use observable inputs that include, in addition to trading activity observed in the marketplace, loan delinquency data, credit enhancement levels and vintage, which are taken into account to assign pricing factors such as spread and
prepayment assumptions. For tranches that are cross-collateralized, performance of all collateral groups involved in the tranche are considered. The Company collects and considers current market intelligence on all major markets, including benchmark security evaluations and bid-lists throughout the day from various sources, when available.
The Company’s MBS and securitized debt are valued using various market data points as described above, which management considers directly or indirectly observable parameters. Accordingly, the Company’s MBS and securitized debt are classified as Level 2 in the fair value hierarchy.
The Non-Agency MBS underlying the Company’s Linked Transactions are valued using similar techniques to those used for the Company’s other Non-Agency MBS. The value of the underlying MBS is then netted against the carrying amount (which approximates fair value) of the repurchase agreement borrowing at the valuation date. The fair value of Linked Transactions also includes accrued interest receivable on the MBS and accrued interest payable on the underlying repurchase agreement borrowings. The Company’s Linked Transactions are classified as Level 2 in the fair value hierarchy.
Derivative Hedging Instruments (Swaps)
The Company determines the fair value of its derivative hedging instruments considering valuations obtained from a third-party pricing service and such valuations are tested with internally developed models that apply readily observable market parameters. In valuing its derivative hedging instruments, the Company considers the creditworthiness of both the Company and its counterparties, along with collateral provisions contained in each derivative agreement, from the perspective of both the Company and its counterparties. All of the Company’s derivative hedging instruments are subject to bilateral collateral arrangements. Consequently, no credit valuation adjustment was made in determining the fair value of such instruments. The Company’s derivative hedging instruments are classified as Level 2 in the fair value hierarchy.
The following table presents the Company’s financial instruments carried at fair value as of September 30, 2012, on the consolidated balance sheet by the valuation hierarchy, as previously described:
Fair Value at September 30, 2012
Level 1
Level 2
Level 3
Non-Agency MBS, including MBS transferred to consolidated VIEs
Securities obtained and pledged as collateral
Total assets carried at fair value
12,686,590
13,196,294
Derivative hedging instruments
Obligation to return securities obtained as collateral
Total liabilities carried at fair value
587,873
Changes to the valuation methodologies used with respect to the Company’s financial instruments are reviewed by management to ensure any such changes result in appropriate exit price valuations. As markets and products develop and the pricing for certain products becomes more transparent, the Company continues to refine its valuation methodologies. The methods described above may produce fair value estimates that may not be indicative of net realizable value or reflective of future fair values. Furthermore, while the Company believes its valuation methods are appropriate and consistent with those used by market participants, the use of different methodologies, or assumptions, to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. The Company uses inputs that are current as of the measurement date, which may include periods of market dislocation, during which price transparency may be reduced. The Company reviews the classification of its financial instruments within the fair value hierarchy on a quarterly basis, which could cause its financial instruments to be reclassified to a different level.
The following table presents the carrying value and estimated fair value of the Company’s financial instruments, at September 30, 2012 and December 31, 2011:
Carrying
Estimated
Financial Assets:
Financial Liabilities:
8,832,751
7,812,652
749,022
859,506
103,920
In addition to the methodologies used to determine the fair value of the Company’s financial assets and liabilities reported at fair value, as previously described, the following methods and assumptions were used by the Company in arriving at the fair value of the Company’s other financial instruments presented in the above table:
Cash and Cash Equivalents and Restricted Cash: Cash and cash equivalents and restricted cash are comprised of cash held in overnight money market investments and demand deposit accounts. At September 30, 2012 and December 31, 2011, the Company’s money market funds were invested in securities issued by the U.S. Government, or its agencies, instrumentalities, and sponsored entities, and repurchase agreements involving the securities described above. Given the overnight term and assessed credit risk, the Company’s investments in money market funds are determined to have a fair value equal to their carrying value.
Repurchase Agreements: The fair value of repurchase agreements reflects the present value of the contractual cash flows discounted at market interest rates at the valuation date for repurchase agreements with a term equivalent to the remaining term to interest rate repricing, which may be at maturity. Such interest rates are estimated based on LIBOR rates observed in the market. The Company’s repurchase agreements are classified as Level 2 in the fair value hierarchy.
Senior Notes: The fair value of the Senior Notes is determined using the end of day market price quoted on the NYSE at the reporting date. The Company’s Senior Notes are classified as Level 1 in the fair value hierarchy.
15. Use of Special Purpose Entities and Variable Interest Entities
A Special Purpose Entity (“SPE”) is an entity designed to fulfill a specific limited need of the company that organized it. SPEs are often used to facilitate transactions that involve securitizing financial assets or resecuritizing previously securitized financial assets. The objective of such transactions may include obtaining non-recourse financing, obtaining liquidity or refinancing the underlying securitized financial assets on improved terms. Securitization involves transferring assets to a SPE to convert all or a portion of those assets into cash before they would have been realized in the normal course of business, through the SPE’s issuance of debt or equity instruments. Investors in an SPE usually have recourse only to the assets in the SPE and depending on the overall structure of the transaction, may benefit from various forms of credit enhancement, such as over-collateralization in the form of excess assets in the SPE, priority with respect to receipt of cash flows relative to holders of other debt or equity instruments issued by the SPE, or a line of credit or other form of liquidity agreement that is designed with the objective of ensuring that investors receive principal and/or interest cash flow on the investment in accordance with the terms of their investment agreement.
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Resecuritization transactions
Since October 2010, the Company entered into several resecuritization transactions that resulted in the Company consolidating as VIEs the SPEs that were created to facilitate the transactions and to which the underlying assets in connection with the resecuritizations were transferred. See Note 2(p) for a discussion of the accounting policies applied to the consolidation of VIEs and transfers of financial assets in connection with resecuritization transactions.
The following table summarizes the key details of the resecuritization transactions the Company has been involved in to date:
February 2012
June 2011
February 2011
October 2010
Name of Trust (Consolidated as a VIE)
WFMLT Series 2012-RR1
CSMC Series 2011-7R
CSMC Series 2011-1R
DMSI 2010-RS2
Principal value of Non-Agency MBS sold
433,347
1,283,422
1,319,969
985,228
Face amount of Senior Bonds issued by the VIE and purchased by 3rd party investors
474,866
488,389
246,307
Outstanding amount of Senior Bonds at September 30, 2012
155,125
275,189
266,632
52,525
Pass-through rate for Senior Bonds issued
2.85
One-month LIBOR plus 125 basis points
One-month LIBOR plus 100 basis points
Face amount of Senior Support Certificates received by the Company (1)
246,656
808,556
831,580
738,921
Cash received
Notional amount acquired of non-rated, interest only senior certificates
Expenses incurred (2)
3,230
3,527
3,562
(1) Provides credit support for the sequential Senior Non-Agency MBS sold to third-party investors in resecuritization transactions (“Senior Bonds”).
(2) Amortized to interest expense based upon the actual repayments of the associated beneficial interests issued to third parties.
The Company engaged in these transactions primarily for the purpose of obtaining non-recourse financing on a portion of its Non-Agency MBS portfolio, as well as refinancing a portion of its Non-Agency MBS portfolio on improved terms. As a result of engaging in these transactions, the risks facing the Company are largely unchanged as the Company remains economically exposed to the first loss position on the underlying MBS transferred to the VIEs.
The activities that can be performed by an entity created to facilitate a resecuritization transaction are predominantly specified in the entity’s formation documents. Those documents do not permit the entity, any beneficial interest holder in the entity, or any other party associated with the entity to cause the entity to sell or replace the assets held by the entity, or to limit such ability to specific events of default.
The Company concluded that the entities created to facilitate these transactions are VIEs. The Company then completed an analysis of whether each VIE created to facilitate the resecuritization transaction should be consolidated by the Company, based on consideration of its involvement in each VIE, including the design and purpose of the SPE, and whether its involvement reflected a controlling financial interest that resulted in the Company being deemed the primary beneficiary of each VIE. In determining whether the Company would be considered the primary beneficiary, the following factors were assessed:
· Whether the Company has both the power to direct the activities that most significantly impact the economic performance of the VIE; and
· Whether the Company has a right to receive benefits or absorb losses of the entity that could be potentially significant to the VIE.
Based on its evaluation of the factors discussed above, including its involvement in the purpose and design of the entity, the Company determined that it was required to consolidate each VIE created to facilitate these resecuritization transactions.
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As of September 30, 2012 and December 31, 2011, the aggregate fair value of the Non-Agency MBS that were resecuritized as described above was $2.655 billion and $2.283 billion, respectively. These assets are included in the Company’s consolidated balance sheet and disclosed as “Non-Agency MBS transferred to consolidated VIEs.” As of September 30, 2012 and December 31, 2011, the aggregate outstanding balance of Senior Bonds issued by consolidated VIEs was $749.5 million and $875.5 million, respectively. These Senior Bonds are included in the Company’s consolidated balance sheet and disclosed as “Securitized debt.” The holders of the Senior Bonds have no recourse to the general credit of the Company, but the Company does have the obligation, under certain circumstances to repurchase assets from the VIE upon the breach of certain representations and warranties in relation to the Non-Agency MBS sold to the VIE. In the absence of such a breach, the Company has no obligation to provide any other explicit or implicit support to any VIE.
Prior to the completion of the Company’s first resecuritization transaction in October 2010, the Company had not transferred assets to VIEs or QSPEs and other than acquiring MBS issued by such entities, had no other involvement with VIEs or QSPEs.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
In this Quarterly Report on Form 10-Q, we refer to MFA Financial, Inc. and its subsidiaries as “we,” “us,” or “our,” unless we specifically state otherwise or the context otherwise indicates.
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 year ended December 31, 2011.
Forward Looking Statements
When used in this Quarterly Report on Form 10-Q, in future filings with the SEC or in press releases or other written or oral communications, statements which are not historical in nature, including those containing words such as “will,” “believe,” “expect,” “anticipate,” “estimate,” “plan,” “continue,” “intend,” “should,” “could,” “would,” “may” or similar expressions, are intended to identify “forward-looking statements” within the meaning of Section 27A of the 1933 Act and Section 21E of the Securities Exchange Act of 1934, as amended (or the 1934 Act), and, as such, may involve known and unknown risks, uncertainties and assumptions.
These forward-looking statements include information about possible or assumed future results with respect to our business, financial condition, liquidity, results of operations, plans and objectives. Statements regarding the following subjects, among others, may be forward-looking: changes in interest rates and the market value of our MBS; changes in the prepayment rates on the mortgage loans securing our MBS, an increase of which could result in a reduction of the yield on MBS in our portfolio and an increase of which could require us to reinvest the proceeds received by us as a result of such prepayments in MBS with lower coupons; changes in the default rates and management’s assumptions regarding default rates of our Non-Agency MBS; our ability to borrow to finance our assets and the terms, including the cost, maturity and other terms, of any such borrowings; implementation of or changes in government regulations or programs affecting our business; our ability to maintain our qualification as a REIT for federal income tax purposes; our ability to maintain our exemption from registration under the Investment Company Act of 1940, as amended (or the Investment Company Act), including statements regarding the concept release issued by the SEC relating to interpretive issues under the Investment Company Act with respect to the status under the Investment Company Act of certain companies that are in engaged in the business of acquiring mortgages and mortgage-related interests; 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 in the annual, quarterly and current reports that we file with the SEC, could cause our actual results to differ materially from those projected in any forward-looking statements we make. All forward-looking statements are based on beliefs, assumptions and expectations of our future performance, taking into account all information currently available. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date 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.
Business/General
We are a REIT primarily engaged in the business of investing, on a leveraged basis, in residential Agency MBS and Non-Agency MBS. Our principal business objective is to generate net income for distribution to our stockholders resulting from the difference between the interest and other income we earn on our investments and the interest expense we pay on the borrowings that we use to finance our leveraged investments and our operating costs.
At September 30, 2012, we had total assets of approximately $13.735 billion, of which $12.674 billion, or 92.3%, represented our MBS portfolio. At such date, our MBS portfolio was comprised of $7.477 billion of Agency MBS and $5.197 billion of Non-Agency MBS. Our remaining investment-related assets were primarily comprised of cash and cash equivalents, restricted cash, collateral obtained in connection with reverse repurchase agreements, Linked Transactions and other MBS-related receivables.
The results of our business operations are affected by a number of factors, many of which are beyond our control, and primarily depend on, among other things, the level of our net interest income, the market value of our assets, the supply and demand for MBS in the marketplace, the terms and availability of adequate financing, general economic and real estate conditions (both on national and local level), the impact of government actions in the real estate and mortgage sector, and the credit performance of our Non-Agency MBS. Our net interest income varies primarily as a result of changes in interest rates, the slope of the yield curve (i.e., the differential between long-term and short-term interest rates), borrowing costs (i.e., our interest expense) and prepayment speeds on our MBS, the behavior of which involves various risks and uncertainties. Interest rates and CPRs (which measure the amount of
unscheduled principal prepayment on a bond as a percentage of the bond balance), vary according to the type of investment, conditions in the financial markets, competition and other factors, none of which can be predicted with any certainty.
With respect to our business operations, increases in interest rates, in general, may over time cause: (i) the interest expense associated with our borrowings to increase; (ii) the value of our MBS portfolio and, correspondingly, our stockholders’ equity to decline; (iii) coupons on our ARM-MBS to reset, on a delayed basis, to higher interest rates; (iv) prepayments on our MBS to decline, thereby slowing the amortization of our MBS purchase premiums and the accretion of our purchase discounts; and (v) the value of our derivative hedging instruments and, correspondingly, our stockholders’ equity to increase. Conversely, decreases in interest rates, in general, may over time cause: (i) the interest expense associated with our borrowings to decrease; (ii) the value of our MBS portfolio and, correspondingly, our stockholders’ equity to increase; (iii) coupons on our ARM-MBS to reset, on a delayed basis, to lower interest rates; (iv) prepayments on our MBS to increase, thereby accelerating the amortization of our MBS purchase premiums and the accretion of our purchase discounts; and (v) the value of our derivative hedging instruments and, correspondingly, our stockholders’ equity to decrease. In addition, our borrowing costs and credit lines are further affected by the type of collateral we pledge and general conditions in the credit market.
We are exposed to credit risk in our Non-Agency MBS portfolio, generally meaning that we are subject to credit losses in our Non-Agency MBS portfolio that correspond to the risk of delinquency, default and foreclosure on the real estate collateralizing our Non-Agency MBS. In particular we have significantly higher exposure in our Non-Agency MBS portfolio in California, Florida, New York, Virginia and New Jersey. However, the remaining credit support built into Non-Agency MBS transaction structures is designed to mitigate the extent of expected credit losses. In addition, we believe the discounted purchase prices paid on certain of our Non-Agency MBS effectively mitigates our risk of loss in the event, as we expect on most, that we receive less than 100% of the par value of these securities. Our Non-Agency MBS investment process involves analysis focused primarily on quantifying and pricing credit risk. Interest income on Non-Agency MBS purchased at a significant discount are recorded at an effective yield, based on management’s estimate of expected cash flows from each security, which estimate is based on our observation of current information and events and include assumptions related to fluctuations in interest rates, prepayment speeds and the timing and amount of credit losses.
Premiums arise when we acquire MBS at a price in excess of the principal balance of the mortgages securing such MBS (i.e., par value). Conversely, discounts arise when we acquire MBS at a price below the principal balance of the mortgages securing such MBS. Premiums paid on our MBS are amortized against interest income and accretable purchase discounts on our MBS are accreted to interest income. Purchase premiums on our MBS, which are primarily carried on our Agency MBS, are amortized against interest income over the life of each security using the effective yield method, adjusted for actual prepayment activity. An increase in the prepayment rate, as measured by the CPR, will typically accelerate the amortization of purchase premiums, thereby reducing the yield/interest income earned on such assets. Generally, if prepayments on our Non-Agency MBS are less than anticipated, we expect that the income recognized on such assets would be reduced and impairments could result.
CPR levels are impacted by, among other things, conditions in the housing market, new regulations, government and private sector initiatives, interest rates, availability of credit to home borrowers, underwriting standards and the economy in general. In particular, CPR reflects the conditional repayment rates (or CRR), which measures voluntary prepayments of mortgages collateralizing a particular MBS, and the conditional default rates (or CDR), which measures involuntary prepayments resulting from defaults. CPRs on Agency MBS and Non-Agency MBS may differ significantly. For the three months ended September 30, 2012, our Agency MBS portfolio experienced a weighted average CPR of 21.6%, and our Non-Agency MBS portfolio (including Non-Agency MBS underlying our Linked Transactions) experienced a CPR of 15.4%. For the three months ended June 30, 2012 our Agency MBS portfolio experienced a weighted average CPR of 20.4% and our Non-Agency MBS portfolio (including Non-Agency MBS underlying our Linked Transactions) experienced a CPR of 14.9%. Over the last consecutive eight quarters, ending with September 30, 2012, the monthly fair value weighted average CPR on our MBS portfolio ranged from a high of 23.9% experienced during the quarter ended December 31, 2010 to a low of 15.2%, experienced during the quarter ended June 30, 2011, with an average CPR over such quarters of 18.1%.
When we purchase Non-Agency MBS at significant discounts to par value, we make certain assumptions with respect to each security. These assumptions include, but are not limited to, future interest rates, voluntary prepayment rates, default rates, mortgage modifications and loss severities. As part of our Non-Agency MBS surveillance process, we track and compare each security’s actual performance over time to the performance expected at the time of purchase or, if we have modified our original purchase assumptions, to our revised
performance expectations. To the extent that actual performance of our Non-Agency MBS deviates materially from our expected performance parameters, we may revise our performance expectations, such that the amount of purchase discount designated as credit discount may be increased or decreased over time. Nevertheless, credit losses greater than those anticipated or in excess of the recorded purchase discount could occur, which could materially adversely impact our operating results.
It is our business strategy to hold our MBS as long-term investments. On at least a quarterly basis, we assess our ability and intent to continue to hold each security and, as part of this process, we monitor our securities for other-than-temporary impairment. A change in our ability and/or intent to continue to hold any of our securities that are in an unrealized loss position, or a deterioration in the underlying characteristics of these securities, could result in our recognizing future impairment charges or a loss upon the sale of any such security. At September 30, 2012, we had net unrealized gains of $257.9 million on our Agency MBS, comprised of gross unrealized gains of $258.9 million and gross unrealized losses of $961,000, and had net unrealized gains on our Non-Agency MBS of $506.7 million, comprised of gross unrealized gains of $519.9 million and gross unrealized losses of $13.2 million. At September 30, 2012, we did not intend to sell any of our MBS that were in an unrealized loss position, and we believe it is more likely than not that we will not be required to sell those MBS before recovery of their amortized cost basis, which may be at their maturity. (See following discussion on “Recent Market Conditions and Our Strategy.”)
We rely primarily on borrowings under repurchase agreements to finance our Agency MBS and Non-Agency MBS. Our MBS have longer-term contractual maturities than our borrowings under repurchase agreements. We have also engaged in resecuritization transactions with respect to our Non-Agency MBS, which provide access to non-recourse financing. Even though most of our MBS have interest rates that adjust over time based on short-term changes in corresponding interest rate indices (typically following an initial fixed-rate period for our Hybrids), the interest rates we pay on our borrowings and securitized debt will typically change at a faster pace than the interest rates we earn on our MBS. In order to reduce this interest rate risk exposure, we may enter into derivative hedging instruments, which are currently comprised of Swaps.
Our derivative hedging instruments are designated as cash-flow hedges against a portion of our current and forecasted LIBOR-based repurchase agreements and securitized debt. Our Swaps do not extend the maturities of our repurchase agreements and/or securitized debt; they do, however, lock in a fixed rate of interest over their term for the notional amount of the Swap corresponding to the hedged item. During the nine months ended September 30, 2012, we did not enter into any new Swaps and had Swaps with an aggregate notional amount of $617.2 million and a weighted average fixed-pay rate of 3.56% amortize and/or expire. At September 30, 2012, we had Swaps with an aggregate notional amount of $2.761 billion with a weighted average fixed-pay rate of 2.64% and a weighted average variable interest rate of 0.25%.
Recent Market Conditions and Our Strategy
During the third quarter of 2012, we continued to invest in both Agency and Non-Agency MBS, as reflected by the increase in size of our MBS portfolio at September 30, 2012. During the three months ended September 30, 2012, we acquired approximately (i) $1.025 billion of Agency MBS at a weighted average purchase price of 105.2% of par value and (ii) $295.3 million of Non-Agency MBS (none of which were reported as a component of Linked Transactions) at a weighted average purchase price of 71.5% of par value. During the nine months ended September 30, 2012, we acquired approximately (i) $1.899 billion of Agency MBS at a weighted average purchase price of 104.8% of par value and (ii) $1.096 billion of Non-Agency MBS (none of which were reported as a component of Linked Transactions) at a weighted average purchase price of 74.5% of par value. At September 30, 2012, our combined MBS portfolio was approximately $12.674 billion compared to $10.913 billion at December 31, 2011.
Our MBS portfolio acquisitions during the third quarter of 2012 reflected attractive investment opportunities and the continued availability of financing. We were able to selectively find relative value in the Agency MBS market due, in part, to the positively-sloped U.S. Treasury and LIBOR yield curves and low funding costs. Additionally, Non-Agency MBS were available in the marketplace at discounts to par value.
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We continue to believe that loss-adjusted returns on Non-Agency MBS represent attractive investment opportunities. The yields on our Non-Agency MBS that were purchased at a discount are generally positively impacted if prepayment rates on these securities exceed our prepayment assumptions. Given rising multifamily rents, limited housing construction, capital flows into rent-to-own foreclosure purchases and demographic-driven U.S. household formation, there have been increasing signs of home price stabilization. However, we do continue to appropriately factor in the uncertainty regarding housing fundamentals into our cash flow projection and credit reserve analysis. We expect that the majority of our assets will remain in Agency MBS.
At September 30, 2012, $5.197 billion, or 41.0% of our MBS portfolio, was invested in Non-Agency MBS. In addition, we had $49.1 million of Non-Agency MBS that were reported as a component of our Linked Transactions. During the three months ended September 30, 2012, we experienced an increase of $409.7 million in the market value of our Non-Agency MBS. In addition, we recognized unrealized gains of $2.5 million on Non-Agency MBS underlying our Linked Transactions.
With $450.4 million of cash and cash equivalents and $568.6 million of unpledged Agency MBS at September 30, 2012, we believe that we are positioned to continue to take advantage of investment opportunities within the residential MBS marketplace. During the remainder of 2012 we intend to continue to selectively acquire Agency and Non-Agency MBS. We believe that our Non-Agency assets will be positively impacted going forward as the existing private label MBS universe continues to decline in size due to prepayments, defaults and limited issuance. In addition, while most Non-Agency MBS in our portfolio will not return their full face value due to loan defaults, we believe that they will deliver attractive loss adjusted yields due to our discounted average amortized cost of 73% of face value.
To finance the growth of our portfolio, we continue to pursue diversified financing sources, including longer term forms of repurchase agreement financing and resecuritizations. During the third quarter of 2012, we extended by 13 months through January 2016 the maturity of our multi-year collateralized financing arrangements that effectively provides financing for approximately $500 million Non-Agency MBS. The financing obtained under these arrangements was increased by approximately $200 million in the first quarter of 2012. During the second quarter of 2012, we added a $350.0 million three-year repurchase agreement and a $90.0 million 18-month repurchase agreement to finance Non-Agency MBS assets, and we issued $100.0 million aggregate principal amount of Senior Notes in an underwritten public offering. The total net proceeds from the offering were approximately $96.6 million, after deducting offering expenses and the underwriting discount. On February 9, 2012, we sold $433.3 million in principal amount of Non-Agency MBS as a part of a resecuritization. In connection with this transaction, $186.7 million of senior bonds rated “AAA” by DBRS, Inc. were issued to third-party investors via a trust. These bonds, with an average life of 1.9 years, were priced at a 2.75% yield. While funding obtained under our multi-year collateralized financing arrangements is incrementally more expensive than short-term repurchase agreement financing by approximately 100-150 basis points, we believe the certainty of the committed term outweighs the additional cost. Consequently, we anticipate that the net interest spread for the portion of the portfolio financed using these multi-year financing arrangements will be lower in future periods. See “Liquidity and Capital Resources” below for more information regarding our financing sources and strategies.
We believe the financial environment continues to be favorably impacted by accommodative U.S. monetary policy. Repurchase agreement funding for both Agency MBS and Non-Agency MBS continues to be available to us from multiple counterparties. Typically, repurchase agreement funding involving Non-Agency MBS is available from fewer counterparties, at terms requiring higher collateralization and higher interest rates, than for repurchase agreement funding involving Agency MBS. At September 30, 2012, we had borrowings under repurchase agreements with 26 counterparties, securitized debt and Senior Notes outstanding, payable for unsettled MBS purchases, and obligation to return securities obtained as collateral, resulting in a debt-to-equity multiple of 3.2x. (See table on page 55 under Results of Operations that presents our quarterly leverage multiples since September 30, 2011.)
In the third quarter of 2012, the U.S. Federal Reserve announced that it intends to keep the target range for the Federal Funds rate at 0% to 0.25% and anticipates that exceptionally low levels are likely to be warranted at least through mid-2015. The U.S. Federal Reserve also announced that it will increase its holdings of Agency MBS by $40 billion per month until the labor market improves. It is also continuing its policy of reinvesting principal payments from existing Agency holdings, bringing total monthly purchases near $85 billion. These actions have put downward pressure on Agency MBS yields.
Information About Our Assets
The table below presents certain information about our asset allocation at September 30, 2012:
ASSET ALLOCATION
GAAP Basis
At September 30, 2012
Non-Agency
MBS
Portfolio
Other, net (2)
457,455
(6,123
12,360,537
Market Value
13,125,155
Less Payable for Unsettled Purchases
(126,035
Less Repurchase Agreements
(6,460,037
(2,372,289
(8,832,326
Less Securitized Debt
(749,471
Less Senior Notes
(100,000
Equity Allocated
890,776
2,075,215
2,965,991
(106,123
3,317,323
Less Swaps at Market Value
Net Equity Allocated
(184,292
Debt/Net Equity Ratio (3)
7.39
1.50
3.19
Non-GAAP Adjustments
MBS (4)
Other, net (4)
(12,635
33,023
Repurchase Agreements
466,691
Multi-year Collateralized Financing Agreements (5)
(503,114
12,635
Non-GAAP Basis
Other, net (6)
4,735,911
11,954,863
(18,758
12,393,560
5,246,033
12,722,881
13,161,578
(1,905,598
(8,365,635
Less Multi-year Collateralized Financing Agreements (5)
2,087,850
2,978,626
(118,758
(196,927
1.51
3.20
(1) Includes cash, cash equivalents and restricted cash.
(2) Includes securities obtained and pledged as collateral, Linked Transactions, interest receivable, goodwill, prepaid and other assets, obligation to return securities obtained as collateral, Senior Notes, interest payable, derivative hedging instruments at fair value, dividends payable and accrued expenses and other liabilities.
(3) Represents the sum of borrowings under repurchase agreements, multi-year collateralized financing arrangements, payable for unsettled purchases, obligation to return securities obtained as collateral of $509.7 million, securitized debt and Senior Notes as a multiple of net equity allocated.
(4) Includes Non-Agency MBS and repurchase agreements underlying Linked Transactions. The purchase of a Non-Agency MBS and repurchase borrowing of this MBS with the same counterparty are accounted for under GAAP as a “linked transaction.” The two components of a linked transaction (MBS purchase and associated borrowings under a repurchase agreement) are evaluated on a combined basis and are presented net as “Linked Transactions” on our consolidated balance sheet.
(5) Multi-year collateralized financing arrangements are viewed by management as having an effective term of 3.3 years, but for GAAP reporting purposes are disclosed within repurchase agreements and as having a contractual term of over 30 days to 90 days.
(6) Includes securities obtained and pledged as collateral, interest receivable, goodwill, prepaid and other assets, obligation to return securities obtained as collateral of $509.7 million, Senior Notes, interest payable, derivative hedging instruments at fair value, dividends payable and accrued expenses and other liabilities.
The following table presents certain information regarding the composition of our Agency MBS portfolio as of September 30, 2012:
Current Face
Weighted Average Purchase Price
Weighted Average Market Price
Fair Value (1)
Weighted Average Loan Age (Months) (2)
Weighted Average Coupon (2)
Weighted Average 3 Month CPR
1 Month CPR (October 2012) (3)
15-Year Fixed Rate:
Low Loan Balance (4)
1,475,467
104.3
107.6
1,587,401
3.47
12.1
8.9
HARP (5)
170,714
104.8
107.2
182,956
5.9
3.4
Other (Post June 2009) (6)
362,981
103.2
107.0
388,499
4.17
24.4
28.7
Other (Pre June 2009) (7)
2,549
104.9
107.7
2,746
4.50
14.7
45.4
Total 15-Year Fixed Rate
2,011,711
104.1
107.5
2,161,602
3.58
14.4
12.3
Hybrid:
2,877,251
103.9
106.4
3,060,914
3.28
23.7
20.0
1,894,055
101.4
107.4
2,034,802
67
4.22
26.0
21.3
Total Hybrid
4,771,306
102.9
106.8
5,095,716
3.65
24.6
20.5
CMO/Other
205,216
102.4
104.4
214,190
143
2.48
10.2
11.2
Total Portfolio
106.9
7,471,508
3.60
21.6
18.0
(1) Does not include principal payments receivable of $5.3 million at September 30, 2012.
(2) Weighted average is based on MBS current face at September 30, 2012.
(3) Weighted average one-month CPR realized in October 2012 for Agency MBS settled as of September 30, 2012.
(4) Low loan balance represents MBS collateralized by mortgages with original loan balance of less than or equal to $175,000.
(5) Home Affordable Refinance Program (or HARP) MBS are backed by refinanced loans with loan-to-value ratio (or LTV) greater than or equal to 80% at origination.
(6) MBS issued in June 2009 or later. Majority of underlying loans are ineligible to refinance through the HARP program.
(7) MBS issued before June 2009.
The following table presents certain information regarding our 15-year fixed-rate Agency MBS as of September 30, 2012:
Coupon (Dollars in Thousands)
Weighted Average Loan Rate
Low Loan Balance and/or HARP (3)
1 Month CPR (October 2012) (4)
2.5
290,274
105.3
305,671
3.04
99
1.5
1.2
3.0
492,007
105.8
106.7
524,920
3.48
100
3.5
23,865
103.5
25,684
4.16
29.4
4.0
1,007,141
108.3
1,090,623
4.40
78
17.0
17.4
4.5
198,424
105.2
108.2
214,704
4.87
18.9
20.2
4.02
82
(1) Does not include principal payments receivable at September 30, 2012.
(3) Low Loan Balance represents MBS collateralized by mortgages with original loan balance less than or equal to $175,000. HARP MBS are backed by refinanced loans with LTV greater than or equal to 80% at origination.
(4) Weighted average one-month CPR realized in October 2012 for Agency MBS settled as of September 30, 2012.
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The following table presents certain information regarding our Hybrid Agency MBS as of September 30, 2012:
Weighted Average Months to Reset (3)
Interest Only (4)
1 Month CPR (October 2012) (5)
Hybrid Post June 2009:
Agency 5/1
1,304,556
103.3
106.1
1,384,365
3.43
28.1
23.0
Agency 7/1
1,532,890
106.6
1,634,255
3.17
69
17.8
Agency 10/1
39,805
106.3
42,294
2.94
116
4.3
9.9
Total Hybrids Post June 2009
54
Hybrid Pre June 2009:
Coupon < 4.5% (6)
864,603
101.6
107.1
926,311
2.79
53
14.5
13.1
Coupon >= 4.5% (7)
1,029,452
101.2
1,108,491
5.42
34.6
28.4
Total Hybrids Pre June 2009
Total Hybrids
(3) Weighted average months to reset is the number of months remaining before the coupon interest rate resets. At reset, the MBS coupon will adjust based upon the underlying benchmark interest rate index, margin and periodic or lifetime caps. The months to reset do not reflect scheduled amortization or prepayments.
(4) Interest only represents MBS backed by mortgages currently in their interest only period. Percentage is based on MBS current face at September 30, 2012.
(5) Weighted average one-month CPR realized in October 2012 for Agency MBS settled as of September 30, 2012.
(6) Agency 3/1, 5/1, 7/1 and 10/1 Hybrid ARM MBS with coupon less than 4.5%.
(7) Agency 3/1, 5/1, 7/1 and 10/1 Hybrid ARM MBS with coupon greater than or equal to 4.5%.
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The following table presents information with respect to our Non-Agency MBS: (i) excluding Linked Transactions and reported in accordance with GAAP; (ii) underlying our Linked Transactions and reflected consistent with GAAP reporting requirements; and (iii) on a combined basis as of September 30, 2012 and December 31, 2011:
(i) Non-Agency MBS (GAAP - excluding Linked Transactions)
Face/Par
Purchase (Discount) Designated as Credit Reserve and OTTI
)(1)
)(2)
Purchase (Discount) Designated as Accretable
Purchase Premiums
(ii) Non-Agency MBS Underlying Linked Transactions
Purchase (Discount) Designated as Credit Reserve
(6,646
(45,735
(2,386
(6,206
(iii) Combined Non-Agency MBS and MBS Underlying Linked Transactions (Non-GAAP)
6,511,761
5,703,889
4,001,415
4,173,806
(1,466,297
)(3)
(1,274,501
)(4)
(310,462
(256,685
(1) Includes discount designated as Credit Reserve of $1.409 billion and OTTI of $50.3 million.
(2) Includes discount designated as Credit Reserve of $1.174 billion and OTTI of $54.5 million.
(3) Includes discount designated as Credit Reserve of $1.416 billion and OTTI of $50.3 million.
(4) Includes discount designated as Credit Reserve of $1.220 billion and OTTI of $54.5 million.
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Purchase Discounts on Non-Agency MBS and Securities Underlying Linked Transactions
The following tables present the changes in the components of purchase discount on Non-Agency MBS with respect to purchase discount designated as Credit Reserve and OTTI, and accretable purchase discount, including securities underlying Linked Transactions, for the three months ended September 30, 2012 and 2011 on both a GAAP and Non-GAAP basis.
GAAP Basis (In Thousands)
Discount Designated as Credit Reserve and OTTI
Accretable Discount (1)
Balance at the end of period
Non-GAAP Adjustments (In Thousands)
(7,152
(5,541
(60,804
(3,711
173
452
374
(6,106
862
3,036
10,419
(1,928
(54
(1,107
1,107
(57,224
(3,628
Non-GAAP Basis (In Thousands)
(1,447,904
(270,678
(1,235,694
(226,641
8,989
10,827
49,766
11,109
(35,247
(15,336
780
(1,989
54,107
(54,107
10,198
(10,198
(1,253,625
(243,337
(1) Together with coupon interest, accretable purchase discount is recognized as interest income over the life of the security.
The following tables present the changes in the components of purchase discount on Non-Agency MBS with respect to purchase discount designated as Credit Reserve and OTTI, and accretable purchase discount, including securities underlying Linked Transactions, for the nine months ended September 30, 2012 and 2011 on both a GAAP and Non-GAAP basis.
(99,094
(45,756
826
2,737
1,002
499
(74,809
4,892
38,662
2,419
116,489
34,190
(575
575
(309
(845,772
(274,722
28,933
35,844
108,231
21,111
(435,464
(14,143
(7,005
22,567
70,956
(70,956
12,782
(12,782
The following table presents information with respect to the yield components of our Non-Agency MBS: (i) excluding Linked Transactions and reported in accordance with GAAP; (ii) underlying our Linked Transactions and (iii) combined with the securities underlying Linked Transactions (Non-GAAP) for the three months ended September 30, 2012 and 2011:
Non-Agency MBS (GAAP - excluding Linked Transactions)
Coupon Yield (1)
5.90
6.15
Effective Yield Adjustment (2)
0.75
1.10
Net Yield
6.65
7.25
Non-Agency MBS Underlying Linked Transactions
6.37
1.34
0.05
6.34
6.42
Combined Non-Agency MBS and MBS Underlying Linked Transactions (Non-GAAP)
5.89
6.17
0.76
1.03
7.20
(1) Reflects the annualized coupon interest income divided by the average amortized cost. The discounted purchase price on Non-Agency MBS causes the coupon yield to be higher than the pass-through coupon interest rate.
(2) The effective yield adjustment is the difference between the net yield, calculated utilizing management’s estimates of future cash flows for Non-Agency MBS, less the current coupon yield.
The information in the above tables, on pages 45-48, includes certain underlying Non-Agency MBS and the associated repurchase agreement borrowings that are disclosed both separately and/or on a combined basis with our Non-Agency MBS portfolio. However, for GAAP financial reporting purposes, these items are required to be accounted for by us as Linked Transactions. Consequently, the presentation of this information in the above tables constitutes Non-GAAP financial measures within the meaning of Regulation G, as promulgated by the SEC.
In assessing the performance of the Non-Agency MBS portfolio, we do not view these transactions as linked, but rather view the performance of the linked Non-Agency MBS and the related repurchase agreement borrowings as we would any other Non-Agency MBS that is not part of a linked transaction. Accordingly, we consider that the Non-GAAP information disclosed in the above tables enhances the ability of investors to analyze the performance of our Non-Agency MBS in the same way that we assess such assets.
In addition, in connection with our financing strategy for Non-Agency MBS, we have entered into contemporaneous repurchase agreement and reverse repurchase agreement transactions with a single counterparty. The transactions effectively result in us pledging Non-Agency MBS as collateral to the counterparty in connection with the repurchase agreement financing and obtaining U.S. Treasury securities as collateral in connection with the reverse repurchase agreement. Both the repurchase agreement and the reverse repurchase agreement have a contractual maturity of January 2016 with no net exchange of cash at inception. The U.S. Treasury collateral obtained is pledged as collateral in a subsequent repurchase agreement transaction with a different counterparty for cash. This subsequent repurchase transaction had a term of 90 days at inception. For purposes of presentation of its repurchase agreement financing liabilities in the Non-GAAP Asset Allocation table on page 42, we offset our reverse repurchase agreement receivable that is secured by U.S. Treasuries received from the first counterparty against the repurchase agreement liability with the second counterparty for which we pledged those U.S. Treasury securities as collateral, as we believe net presentation is consistent with the economic substance of the transactions. However, GAAP prohibits offsetting of this asset and liability for a number of reasons, including the fact that the counterparties to these transactions are different, and there is no legal right of offset. For GAAP presentation purposes, the repurchase agreement liability against which we have pledged U.S. Treasuries is reported based on its legal contractual maturity. However, based on an evaluation of the economic substance of these collateralized financing arrangements, management considers that the Non-GAAP Asset Allocation table presented on page 42
more appropriately reflects the effective economic term of the financing obtained. Consequently, this presentation constitutes a Non-GAAP financial measure within the meaning of Regulation G, as promulgated by the SEC.
Exposure to Financial Counterparties
We finance the acquisition of a significant portion of our MBS with repurchase agreements. 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 1 - 6% of the amount borrowed (U.S. Treasury and Agency MBS collateral) to up to 63% (Non-Agency MBS collateral). Consequently, 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, certain of our repurchase agreement counterparties in the United States and Europe have experienced financial difficulty and have been either rescued by government assistance or otherwise benefitted from accommodative monetary policy of Central Banks.
The table below summarizes our exposure to our financial counterparties at September 30, 2012:
Country (Dollars in Thousands)
Number of Counterparties
Repurchase Agreement Financing
Swaps at Fair Value
Exposure (1)
Exposure as a Percentage of MFA Total Assets
European Countries: (2)
Germany
554,345
(18,313
217,732
1.58
Switzerland
1,411,410
899,084
6.53
France
418,823
23,467
0.17
Holland
346,611
17,003
0.12
United Kingdom
1,017,474
(25,809
62,942
0.46
3,748,663
(44,122
1,220,228
8.86
Other Countries:
United States
4,264,033
(34,047
631,781
4.59
Japan
788,047
53,167
Other
568,006
158,742
1.17
5,620,086
843,690
Total Counterparty Exposure
9,368,749
(3)(4)
2,063,918
15.01
(1) Represents for each counterparty the amount of cash and/or securities pledged as collateral less the aggregate of repurchase agreement financing, Swaps at fair value, and net interest receivable/payable on all such instruments.
(2) Includes European-based counterparties as well as U.S.-domiciled subsidiaries of the European parent entity.
(3) Includes $500.0 million of repurchase agreements entered into in connection with contemporaneous repurchase and reverse repurchase agreements with a single counterparty.
(4) Includes $36.4 million of repurchase agreements which are a component of our Linked Transactions.
At September 30, 2012, we did not use credit default swaps or other forms of credit protection to hedge the exposures summarized in the table above.
If the European credit crisis continues to impact our major European financial counterparties, there is the possibility that it will also impact the operations of their U.S. domiciled 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
49
collateral pledged and the associated loan amount under repurchase agreements and/or the fair value of swaps with our counterparties. We intend to make reverse margin calls on our counterparties to recover excess collateral as permitted by the agreements governing our financing arrangements, or take other necessary actions to reduce the amount of our exposure to a counterparty when such actions are considered necessary.
Tax Considerations
Variances between GAAP and Tax Income
Due to the potential timing differences in the recognition of GAAP net income compared to REIT taxable income on our investments, our net income and the unamortized amount of purchase discounts and premiums calculated in accordance with GAAP may differ significantly from such amounts calculated for purposes of determining our REIT taxable income. At September 30, 2012, net premiums on our Agency MBS portfolio (excluding net premiums on MBS purchased but not yet settled) were $217.7 million compared to $214.4 million for tax purposes. In accordance with GAAP, a portion of the purchase discounts on our Non-Agency MBS are allocated to a Credit Reserve and, as such, are not expected to be accreted into interest income. In addition, under GAAP, certain Non-Agency MBS underlying our Linked Transactions are not reported as MBS; however, for purposes of determining our REIT taxable income, all Non-Agency MBS, including those underlying Linked Transactions, are treated as being owned and the purchase discounts associated with these securities are accreted into taxable income over the life of the applicable security. Under GAAP, we had net purchase discounts on our Non-Agency MBS portfolio of $1.767 billion, which when combined with purchase discounts of $9.0 million related to securities underlying our Linked Transactions, resulted in total net purchase discounts on Non-Agency MBS of $1.776 billion at September 30, 2012. Our total Non-Agency MBS portfolio for tax differs from our portfolio reported for GAAP. These differences are primarily due to the fact that for tax purposes; (i) certain of the MBS contributed to the VIEs used to facilitate resecuritization transactions were deemed to be sold; (ii) the tax portfolio includes certain securities issued by these VIEs; and (iii) Non-Agency MBS underlying Linked Transactions are included in our tax portfolio. In addition, for bonds common to both tax and GAAP reported portfolios, potential timing differences arise with respect to the accretion of market discount into income for tax purposes as compared to GAAP. These differences result in net purchase discounts for tax on our Non-Agency MBS at September 30, 2012 of $1.507 billion. We currently anticipate that our REIT taxable income and GAAP net income will trend closer during the remainder of 2012.
Resecuritizations
For tax purposes, depending on the transaction structure, a resecuritization transaction may be treated either as a sale or a financing of the underlying MBS. Income recognized from resecuritization transactions will differ for tax and GAAP. For tax purposes, we own and may in the future acquire interests in resecuritization trusts, in which several of the classes of securities are or will be issued with Original Issue Discount (or OID). As the holder of the retained interests in the trust, we generally will be required to include OID in our current gross interest income over the term of the applicable securities as the OID accrues. The rate at which the OID is recognized into taxable income is calculated using a constant rate of yield to maturity, without a loss assumption provision. For tax purposes, REIT taxable income may be recognized in excess of economic income (i.e., OID) or in advance of the corresponding cash flow from these assets, thereby effecting our dividend distribution requirement to stockholders.
Regulatory Developments
The U.S. Congress, Board of Governors of the Federal Reserve System, U.S. Treasury, Federal Deposit Insurance Corporation, SEC and other governmental and regulatory bodies have taken and continue to consider additional actions in response to the financial crisis. In particular, the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act (or the Dodd-Frank Act) created a new regulator housed within the Federal Reserve System, an independent bureau known as the Consumer Financial Protection Bureau (or the CFPB), which has broad authority over a wide range of consumer financial products and services, including mortgage lending. Another portion of the Dodd-Frank Act, the Mortgage Reform and Anti-Predatory Lending Act (or the Mortgage Reform Act), contains new underwriting and servicing standards for the mortgage industry, as well as restrictions on compensation for mortgage originators. In addition, the Mortgage Reform Act grants broad discretionary regulatory authority to the CFPB to prohibit or condition terms, acts or practices relating to residential mortgage loans that the CFPB finds abusive, unfair, deceptive or predatory, as well as to take other actions that the CFPB finds are necessary or proper to ensure responsible affordable mortgage credit remains available to consumers. The Dodd-Frank Act also affects the securitization of mortgages (and other assets) with requirements for risk retention by securitizers and requirements for regulating credit rating agencies.
The implementation of the Dodd-Frank Act requires implementing numerous regulations, many of which (including those mentioned above regarding underwriting and risk retention requirements) have been proposed for public comment. However, a large number of the Dodd-Frank Act rulemakings have yet to be finalized. Thus, we are unable to fully predict at this time how the Dodd-Frank Act, as well as other laws that may be adopted in the future, will impact our business, results of operations and financial condition, or the environment for repurchase financing and other forms of borrowing, the investing environment for Agency MBS, Non-Agency MBS and/or residential mortgage loans, the securitization industry, Swaps and other derivatives. However, at a minimum, we believe that the Dodd-Frank Act and the regulations to be promulgated thereunder are likely to increase the economic and compliance costs for participants in the mortgage and securitization industries, including us.
In addition to the regulatory actions being implemented under the Dodd-Frank Act, on August 31, 2011, the SEC issued a concept release under which it is reviewing interpretive issues related to Section 3(c)(5)(C) of the Investment Company Act. Section 3(c)(5)(C) excludes from the definition of “investment company” entities that are primarily engaged in, among other things, “purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.” Many companies that engage in the business of acquiring mortgages and mortgage-related instruments, including us, seek to rely on an existing interpretation of the SEC Staff with respect to Section 3(c)(5)(C) so as not to become an investment company for the purpose of regulation under the Investment Company Act. The SEC has requested comments on, among other things, whether it should reconsider its existing interpretation of Section 3(c)(5)(C) on which we rely.
The potential timetable and outcome of the SEC’s review are unclear. However, if the SEC determines to narrow or eliminate the interpretive exemption under Section 3(c)(5)(C) upon which we rely, we could be required to significantly restructure our operations in order to maintain our investment company exemption. Under these circumstances, our ability to use leverage could be substantially reduced, which would require us to change the way we conduct our business. For additional discussion of the SEC’s concept release and its potential impact on us, please see “Other Matters” below.
Results of Operations
Quarter Ended September 30, 2012 Compared to the Quarter Ended September 30, 2011
For the third quarter of 2012, we had net income available to common stock and participating securities of $76.1 million, or $0.21 per basic and diluted common share, compared to net income available to common stock and participating securities of $81.7 million, or $0.23 per basic and diluted common share, for the third quarter of 2011. The decrease in net income available to our common stock and participating securities, and the decrease of this item on a per share basis, were generally influenced by the impact of declining net interest spreads on interest bearing assets and liabilities. These declining spreads were primarily attributable to lower net yields on both Agency and Non-Agency MBS. Yields on Agency MBS were impacted by the lower interest rate environment and higher CPRs, while yields on Non-Agency MBS were primarily impacted by the addition of lower yielding assets and changes in expected future interest rates. In addition, we have also increased the amount of higher cost longer-term financing for our Non-Agency MBS portfolio consistent with our overall financing strategy.
Interest income on our Agency MBS for the third quarter of 2012 decreased $12.8 million, or 21.3%, to $47.2 million from $60.0 million for the third quarter of 2011. This change primarily reflects a decrease in the net yield on our Agency MBS to 2.66% for the third quarter of 2012 from 3.37% for the third quarter of 2011, and, to a lesser extent, a decrease of $12.5 million in the average amortized cost of our Agency MBS portfolio to $7.094 billion for the third quarter of 2012 from $7.106 billion for the third quarter of 2011. During the third quarter of 2012, our Agency MBS portfolio experienced a 21.6% CPR and we recognized $14.8 million of net premium amortization compared to a CPR of 19.3% and $10.7 million of net premium amortization for the third quarter of 2011. At the end of the third quarter of 2012, the average coupon on mortgages underlying our Agency MBS was lower compared to the end of the third quarter of 2011, due to acquisition of assets in the marketplace at generally lower coupons reflecting current market conditions and as a result of prepayments on higher yielding assets and resets on Hybrid and ARM-MBS within the portfolio. As a result, the coupon yield on our Agency MBS portfolio declined 49 basis points to 3.49% for the third quarter of 2012 from 3.98% for the third quarter of 2011. At September 30, 2012, we had net purchase premiums on our Agency MBS of $225.4 million, or 3.2% of current par value, compared to net purchase premiums of $177.7 million and 2.6% of par value at December 31, 2011.
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Interest income on our Non-Agency MBS (which includes Non-Agency MBS transferred to consolidated VIEs) increased $7.1 million, or 10.1%, for the third quarter of 2012 to $77.9 million compared to $70.8 million for the third quarter of 2011, principally due to the increase in the amortized cost of our Non-Agency MBS portfolio. For the third quarter of 2012, the average amortized cost of our Non-Agency MBS increased by $780.8 million, or 20.0%, to $4.685 billion, from $3.904 billion for the third quarter of 2011. The growth in our Non-Agency MBS has primarily been funded with longer term forms of repurchase agreement financings. In addition, certain of our Non-Agency MBS underlying Linked Transactions became delinked during the third quarter of 2012, due to the repayment of the repurchase agreement financing. These delinkings resulted in Non-Agency MBS of $16.8 million, previously included as a component of Linked Transactions, being recognized as Non-Agency MBS on our consolidated balance sheet at September 30, 2012. Our Non-Agency MBS portfolio yielded 6.65% for the third quarter of 2012 compared to 7.25% for the third quarter of 2011. The decrease in the yield on our Non-Agency MBS is primarily due to the flattening (downward movement in the later years) of the forward yield curve, which causes us to lower the projected future coupons and therefore the expected yields on our Hybrid Non-Agency MBS and the addition of newly acquired assets at yields less than our overall portfolio yield. During the third quarter of 2012, we recognized net purchase discount accretion of $8.8 million on our Non-Agency MBS compared to $10.7 million for the third quarter of 2011. At September 30, 2012, we had net purchase discounts of $1.767 billion, including Credit Reserve and previously recognized OTTI of $1.460 billion, on our Non-Agency MBS, or 27.4% of par value.
The following table presents the components of the coupon yield and net yields earned on our Agency MBS and Non-Agency MBS and weighted average CPRs experienced for such MBS for the quarterly periods presented:
Agency MBS (1)
Non-Agency MBS (1)
Total MBS (1)
Quarter Ended
Yield (2)
Yield (3)
CPR
3.49
21.62
15.42
4.45
4.25
19.08
June 30, 2012
3.68
2.95
20.39
6.77
14.87
4.57
4.47
18.20
March 31, 2012
3.78
17.90
6.02
6.95
14.05
4.62
16.48
3.79
3.14
19.35
6.07
7.02
13.07
4.60
4.51
17.19
3.98
3.37
19.29
14.66
4.75
17.97
(1) Yields presented throughout this Quarterly Report on Form 10-Q are calculated using average amortized cost data. For GAAP reporting purposes, MBS purchases and sales are reported on the trade date. Average amortized cost data used to determine yields is calculated based on the settlement date of the associated purchase or sale as interest income is not earned on purchased bonds and continues to be earned on sold bonds until settlement date.
(2) Reflects the annualized coupon interest income divided by the average amortized cost. The discounted purchase price on Non-Agency MBS causes the coupon yield to be higher than the pass-through coupon interest rate. (Does not include MBS underlying our Linked Transactions. See Note 4 to the accompanying consolidated financial statements, included under Item 1 of this Quarterly Report on Form 10-Q.)
(3) Reflects annualized interest income divided by average amortized cost.
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The following table presents information about average balances of our MBS portfolio by category and associated income for the quarters ended September 30, 2012 and September 30, 2011:
MBS Category
Net Asset
Cost (1)
Income
Quarter Ended September 30, 2012
7,093,871
Non-Agency MBS, including transfers to consolidated VIEs
4,685,068
4.34
11,778,939
125,097
4.00
Quarter Ended September 30, 2011
7,106,377
4.15
3,904,309
11,010,686
130,741
(1) Includes principal payments receivable.
(3) Reflects annualized interest income divided by the average amortized cost.
Interest income from our cash investments, which are comprised of money market investments and are not a material source of income as the yields on such funds remain at historically low levels, increased to $38,000 for the third quarter of 2012 from $25,000 for the 2011 period. Our average cash investments were $406.5 million and yielded 0.04% for the third quarter of 2012 compared to average cash investments of $548.3 million that yielded 0.02% for the third quarter of 2011. In general, we manage our cash investments relative to our investing, financing and operating requirements, investment opportunities and current and anticipated market conditions.
At September 30, 2012, we had repurchase agreement borrowings of $8.832 billion and securitized debt of $749.5 million, of which $2.761 billion was hedged with Swaps. At September 30, 2012, our Swaps had a weighted average fixed-pay rate of 2.64% and extended 16 months on average with a maximum remaining term of approximately 40 months.
Our interest expense for the third quarter of 2012 increased by $7.0 million, or 18.2%, to $45.8 million from $38.8 million for the third quarter of 2011. This increase primarily reflects the combined impact of an increase in our average borrowings and the higher effective interest rate paid on such borrowings. The following table presents information regarding the components of our interest expense for the quarters ended September 30, 2012 and September 30, 2011:
Average Cost
Average Balance
of Funds (1)
Agency Repurchase Agreements
6,398,410
24,651
1.53
Non-Agency Repurchase Agreements
2,342,610
14,666
2.49
Total Repurchase Agreements
8,741,020
1.78
Securitized Debt
819,361
Senior Notes (2)
8.03
9,660,381
6,416,498
28,127
1.74
1,590,845
6,797
1.69
8,007,343
1.73
1,026,701
1.48
9,034,044
1.70
(1) Reflects the annualized interest expense divided by the average balance and includes the cost of Swaps designated as hedges against repurchase agreements.
(2) We did not have any Senior Notes during the 2011 period.
The following table presents information about our securitized debt at September 30, 2012:
Benchmark Interest Rate
30 Day LIBOR + 100 basis points
1.21
30 Day LIBOR + 125 basis points
327,714
1.46
Fixed
1.66
The effective interest rate paid on our borrowings increased to 1.89% for the quarter ended September 30, 2012 from 1.70% for the quarter ended September 30, 2011. This increase reflects additional higher cost longer-term financing associated with our Non-Agency MBS portfolio, the issuance of fixed-rate securitized debt in February 2012, the issuance of our Senior Notes in April 2012 partially offset by the maturity of Swaps with higher fixed-pay rates. Payments made and/or received on our Swaps are a component of our borrowing costs and accounted for interest expense of $18.1 million, or 75 basis points, for the third quarter of 2012, compared to interest expense of $24.3 million, or 107 basis points, for the third quarter of 2011. Certain of our Swaps have fixed interest rates that are significantly higher than current market interest rates. As these Swaps continue to amortize and/or expire, the Swap component of our borrowing costs is expected to continue to decrease. The weighted average fixed-pay rate on our Swaps decreased to 2.72% for the quarter ended September 30, 2012 from 2.88% for the quarter ended September 30, 2011. The weighted average variable interest rate received on our Swaps increased to 0.27% for the quarter ended September 30, 2012 from 0.21% for the quarter ended September 30, 2011. During the quarter ended September 30, 2012, we did not enter into any new Swaps and had Swaps with an aggregate notional amount of $187.7 million and a weighted average fixed-pay rate of 4.41% amortize and/or expire.
We expect that our interest expense and funding costs for the remainder of 2012 will be impacted by market interest rates, the amount of our borrowings, our existing and future interest rates on our hedging instruments and the extent to which we execute additional financing transactions, such as resecuritizations. As a result of these variables, our future borrowing costs cannot be predicted with any certainty. (See Notes 4, 7 and 15 to the accompanying consolidated financial statements, included under Item 1 of this Quarterly Report on Form 10-Q.)
The following table presents our leverage multiples, as measured by debt-to-equity, at the dates presented:
GAAP
Non-GAAP
Leverage
At the Period Ended
Multiple (1)
Multiple (2)
3.2
(3)
3.6
(4)
(5)
(6)
3.7
(1) Represents the sum of borrowings under repurchase agreements, securitized debt, payable for unsettled MBS purchases, obligation to return securities obtained as collateral, and Senior Notes, divided by stockholders’ equity.
(2) The Non-GAAP Leverage Multiple reflects the sum of our borrowings under repurchase agreements, securitized debt, payable for unsettled MBS purchases, obligation to return securities obtained as collateral, Senior Notes and borrowings that are reported on our consolidated balance sheet as a component of Linked Transactions of $36.4 million, $51.2 million, $84.8 million, $170.9 million, and $193.0 million at September 30, 2012, June 30, 2012, March 31, 2012, December 31, 2011, and September 30, 2011, respectively. We present a Non-GAAP leverage multiple since repurchase agreement borrowings that are a component of Linked Transactions may not be linked in the future and, if no longer linked, will be reported as repurchase agreement borrowings, which will increase our leverage multiple. (See Note 4 to the accompanying consolidated financial statements, included under Item 1 of this Quarterly Report on Form 10-Q.)
(3) The decrease in our leverage multiple from 3.6x at June 30, 2012 to 3.2x at September 30, 2012 primarily reflects an increase in the market value of our Non-Agency MBS.
(4) The increase in our leverage multiple from 3.4x at March 31, 2012 to 3.6x to June 30, 2012 primarily reflects a higher use of financing structures and the issuance of Senior Notes during the quarter.
(5) The decrease in our leverage multiple from 3.6x at December 31, 2011 to 3.4x at March 31, 2012 primarily reflects an increase in the market value of our Non-Agency MBS.
(6) The increase in our leverage multiple from 3.4x at September 30, 2011 to 3.6x at December 31, 2011 primarily reflects a decline in the market value of our Non-Agency MBS and increased use of structured financing to acquire Non-Agency MBS.
For the third quarter of 2012, our net interest income decreased by $12.7 million, or 13.8%, to $79.3 million from $92.0 million for the third quarter of 2011. This decrease primarily reflects the impact of additional lower yielding MBS and increases in our average borrowings and the higher effective interest rate paid on such borrowings. Our net interest spread and margin for the third quarter of 2012 were 2.22% and 2.61%, respectively, compared to a net interest spread and margin of 2.83% and 3.20%, respectively, for the third quarter of 2011.
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The following table presents information regarding our average balances, interest income and expense, yields on average interest-earning assets, average cost of funds and net interest income for the quarters presented:
Yield on
Interest-
Balance of
Income on
Earning
Financing
Cost of
of MBS (1)
Cash (2)
Assets (3)
Arrangements (4)
Expense
Funds
406,488
4.11
11,219,055
125,504
292,302
125,531
4.36
8,981,553
42,688
1.91
82,843
10,819,531
123,504
424,691
123,523
4.39
8,721,868
40,127
1.85
83,396
11,000,704
123,964
402,958
123,994
8,899,013
38,811
85,183
548,339
4.53
(1) Unrealized gains and losses are not reflected in the average amortized cost of MBS.
(2) Includes average interest-earning cash, cash equivalents and restricted cash.
(3) Reflects annualized interest income divided by average amortized cost of interest-earning assets.
(4) Includes repurchase agreements, securitized debt and Senior Notes.
The following table presents our net interest spread and net interest margin for the quarters presented:
Total Interest-Earning Assets and Interest-Bearing Liabilities
Net Interest
Spread (1)
Margin (2)
2.22
2.87
2.96
2.62
3.00
2.83
(1) Reflects the difference between the yield on average interest-earning assets and average cost of funds.
(2) Annualized net interest income divided by average interest-earning assets.
The following table presents the components of the net interest spread earned on our Agency MBS and Non-Agency MBS for the quarters presented:
Yield (1)
Funding (2)
Spread (3)
1.13
2.41
4.24
1.82
2.43
1.63
1.32
2.32
1.71
1.44
1.43
5.24
5.64
3.05
(1) Annualized interest income on MBS divided by average amortized cost of MBS.
(2) Annualized interest expense divided by average balance of repurchase agreements and securitized debt.
(3) Reflects the difference between the net yield on average MBS and average cost of funds on MBS.
During the third quarter of 2012, we did not recognize any OTTI charges through earnings against our Non-Agency MBS compared to $4.0 million during the third quarter of 2011. The impairment charges for the 2011 period reflected changes in our estimated cash flows for such securities based on an updated assessment of the estimated future performance of the underlying collateral, including the expected principal loss over the term of the
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security and changes in the expected timing of receipt of cash flows. At September 30, 2012, we had 51 Non-Agency MBS with a gross unrealized loss of $13.2 million and 34 Agency MBS with a gross unrealized loss of $961,000. Impairments on Agency MBS in an unrealized loss position at September 30, 2012 are considered temporary and not credit related. Unrealized losses on Non-Agency MBS for which no OTTI was recorded during the quarter are considered temporary based on an assessment of changes in the expected cash flows for such MBS, which considers recent bond performance and expected future performance of the underlying collateral. Significant judgment is used both in the Company’s analysis of expected cash flows for its Non-Agency MBS and any determination of the credit component of OTTI.
For the third quarter of 2012, we had other income, net of $7.5 million. This income primarily reflects net gains of $3.2 million on our Linked Transactions and $4.3 million of gains realized on the sale of certain Agency MBS. The gains on Linked Transactions for the three months ended September 30, 2012 included interest income of $812,000 on the underlying Non-Agency MBS, interest expense of $168,000 on the borrowings under repurchase agreements and an increase of $2.5 million in the fair value of the underlying securities. The gains on our Linked Transactions of $733,000 for the three months ended September 30, 2011 included interest income of $4.6 million on the underlying Non-Agency MBS, interest expense of $864,000 on the borrowings under repurchase agreements and a decline of $3.0 million in the fair value of the underlying securities. Changes in the market value of the securities underlying our Linked Transactions, the amount of bond purchases recorded as Linked Transactions in the future and the amount of Linked Transactions that become unlinked in the future, none of which can be predicted with any certainty, will impact future gains/(losses) on our Linked Transactions. During the three months ended September 30, 2012, certain of our Linked Transactions became unlinked, resulting in our recording Non-Agency MBS with a fair value of $16.8 million on our consolidated balance sheet.
During the quarter ended September 30, 2012 we realized $4.3 million of gains on the sale of certain Agency MBS for proceeds of $66.0 million. During the quarter ended September 30, 2011, we realized $4.2 million of gains on the sale of certain Agency MBS for proceeds of $76.5 million.
For the third quarter of 2012, we had compensation and benefits and other general and administrative expense of $8.7 million, or 1.15% of average equity, compared to $8.5 million, or 1.23% of average equity, for the third quarter of 2011. The increase in our compensation and benefits expense to $6.0 million for the third quarter of 2012 compared to $5.5 million for the third quarter of 2011, primarily reflects vesting of equity-based compensation awards. Our other general and administrative expenses decreased by $365,000 to $2.7 million for the quarter ended September 30, 2012 compared to $3.0 million for the quarter ended September 30, 2011. The decrease was primarily comprised of lower recruitment and legal costs.
Nine-Month Period Ended September 30, 2012 Compared to the Nine-Month Period Ended September 30, 2011
For the nine months ended September 30, 2012, we had net income available to common stock and participating securities of $231.5 million, or $0.65 per basic and diluted common share, compared to net income available to common stock and participating securities of $239.7 million, or $0.71 per basic and diluted common share, for the nine months ended September 30, 2011. The decrease in net income available to our common stock and participating securities, and the decrease of this item on a per share basis were generally influenced by the impact of declining net interest spreads on interest bearing assets and liabilities. These declining spreads were primarily attributable to lower net yields on both Agency and Non-Agency MBS. Yields on Agency MBS were impacted by the lower interest rate environment and higher CPRs, while yields on Non-Agency MBS were primarily impacted by the addition of lower yielding assets and changes in expected future interest rates. In addition, we have also increased the amount of higher cost longer-term financing for our Non-Agency MBS portfolio, consistent with our overall financing strategy.
Interest income on our Agency MBS for the first nine months of 2012 decreased $36.1 million, or 19.4%, to $150.0 million from $186.1 million, for the first nine months of 2011. This change reflects a decrease in the net yield on our Agency MBS to 2.91% for the first nine months of 2012 from 3.62% for the first nine months of 2011, which was partially offset by an increase in the average amortized cost of our Agency MBS portfolio to $6.868 billion for the first nine months of 2012 from $6.855 billion for the first nine months of 2011. During the first nine months of 2012, our Agency MBS portfolio experienced a 20.0% CPR and we recognized $37.9 million of net premium amortization compared to a CPR of 18.8% and $26.6 million of net premium amortization for the first nine months of 2011. At the end of the third quarter of 2012, the average coupon on mortgages underlying our Agency MBS was lower compared to the end of the third quarter of 2011, due to acquisition of assets in the marketplace at generally lower coupons reflecting current market conditions and as a result of prepayments on higher yielding
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assets and resets on Hybrid and ARM-MBS within the portfolio. As a result, the coupon yield on our Agency MBS portfolio declined 49 basis points to 3.65% for the first nine months of 2012 from 4.14% for the first nine months of 2011. At September 30, 2012 we had net purchase premiums on our Agency MBS of $225.4 million, or 3.2% of current par value, compared to net purchase premiums of $177.7 million and 2.6% of par value at December 31, 2011.
Interest income on our Non-Agency MBS (which includes Non-Agency MBS transferred to consolidated VIEs) increased $37.5 million, or 20.1%, to $224.1 million for the first nine months of 2012 compared to $186.5 million for the first nine months of 2011, principally due to the increase in the amortized cost of our Non-Agency portfolio. Certain of our Non-Agency MBS are reported as a component of Linked Transactions, rather than as MBS. (See Note 4 to the accompanying consolidated financial statements, included under Item 1 of this Quarterly Report on Form 10-Q.) For the first nine months of 2012, the average amortized cost of our Non-Agency MBS increased by $1.204 billion, or 37.6%, to $4.406 billion, from $3.202 billion for the first nine months of 2011. The growth in our Non-Agency MBS has primarily been funded with longer term forms of repurchase agreement financings and securitized debt in connection with our resecuritization transactions. In addition, certain of our Non-Agency MBS underlying Linked Transactions became delinked during the first nine months of 2012, primarily in connection with our amended multi-year financing arrangement with one of our counterparties in January 2012. These delinkings resulted in Non-Agency MBS of $175.2 million, previously included as a component of Linked Transactions, being recognized as Non-Agency MBS on our consolidated balance sheet at September 30, 2012. Our Non-Agency MBS portfolio yielded 6.78% for the first nine months of 2012 compared to 7.77% for the first nine months of 2011. The decrease in the yield on our Non-Agency MBS is primarily due to the flattening (downward movement in the later years) of the forward yield curve, which causes us to lower the projected future coupons and therefore the expected yields on our Hybrid Non-Agency MBS and the addition of newly acquired assets at yields less than our overall portfolio yield. During the first nine months of 2012, we recognized net purchase discount accretion of $27.9 million on our Non-Agency MBS, compared to $33.0 million for the first nine months of 2011. At September 30, 2012, we had net purchase discounts of $1.767 billion, including Credit Reserve and previously recognized OTTI of $1.460 billion, on our Non-Agency MBS, or 27.4% of par value.
The following table presents information about average balances of our MBS portfolio by category and associated income for the nine months ended September 30, 2012 and September 30, 2011:
Nine Months Ended September 30, 2012
6,867,940
3.82
2.91
4,406,416
5.94
6.78
11,274,356
374,105
4.08
4.54
Nine Months Ended September 30, 2011
6,854,773
4.31
4.14
3.62
3,202,455
4.70
6.39
7.77
10,057,228
372,647
4.86
4.94
Interest income from our cash investments, which are comprised of money market investments and are not a material source of income as the yields on such funds are at historically low levels, decreased to $84,000 for the first nine months of 2012 from $106,000 for the 2011 period. Our average cash investments were $374.6 million and yielded 0.03% for the first nine months of 2012 compared to average cash investments of $478.4 million that yielded 0.03% for the first nine months of 2011. In general, we manage our cash investments relative to our investing, financing and operating requirements, investment opportunities and current and anticipated market conditions.
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At September 30, 2012, we had repurchase agreements of $8.832 billion and securitized debt of $749.5 million, of which $2.761 billion was hedged with Swaps. At September 30, 2012, our Swaps had a weighted average fixed-pay rate of 2.64% and extended 16 months on average with a maximum term of approximately 40 months. We expect interest expense and funding costs for the remainder of 2012 will be impacted by market interest rates, the amount of our borrowings, our existing and future interest rates on our hedging instruments and the extent to which we execute additional financing transactions, such as resecuritizations. As a result of these variables, our borrowing costs cannot be predicted with any certainly. (See Notes 4, 7 and 15 to the accompanying consolidated financial statements, included under Item 1 of this Quarterly Report on Form 10-Q.)
Our interest expense for the first nine months of 2012 increased by $18.0 million, or 16.3%, to $128.6 million from $110.6 million for the first nine months of 2011. This increase primarily reflects the $933.0 million increase in our average borrowings. The following table presents information regarding the components of our interest expense for the first nine months ended September 30, 2012 and September 30, 2011:
6,175,813
75,011
1.62
1,984,486
36,628
2.47
8,160,299
1.83
899,797
63,139
8.00
9,123,235
6,089,385
85,453
1.87
1,365,820
17,060
1.67
7,455,205
1.84
735,015
1.47
8,190,220
The effective interest rate paid on our borrowings increased slightly to 1.88% for the nine months ended September 30, 2012 compared to 1.81% for the first nine months of 2011. The increase reflects additional higher cost longer-term financing associated with our Non-Agency MBS portfolio, the issuance of fixed-rate securitized debt in February 2012, the issuance of our Senior Notes in April 2012, partially offset by the maturity of Swaps with fixed-pay rates higher than the overall average for our Swaps, which positively impacted the funding cost for our Agency MBS portfolio. Payments made and/or received on our Swaps are a component of our borrowing costs and accounted for interest expense of $58.3 million, or 85 basis points, for the nine months ended September 30, 2012, compared to interest expense of $73.1 million, or 119 basis points, for the first nine months of 2011. Certain of our Swaps have fixed interest rates that are significantly higher than current market interest rates. As these Swaps continue to amortize and/or expire, the Swap component of our borrowing costs is expected to continue to decrease. The weighted average fixed-pay rate on our Swaps decreased to 2.74% for the first nine months of 2012 from 3.24% for the first nine months of 2011. The weighted average variable interest rate received on our Swaps increased to 0.29% for the first nine months of 2012 from 0.24% for the first nine months of 2011. During the nine months ended September 30, 2012, we did not enter into any new Swaps and had Swaps with a notional amount of $617.2 million and a weighted average fixed-pay rate of 3.56% amortize and/or expire.
For the first nine months of 2012, our net interest income decreased by $16.6 million, or 6.3%, to $245.6 million from $262.2 million for the first nine months of 2011. This decrease primarily reflects an increase in our average borrowings and the higher effective rate paid on such borrowings partially offset by a $1.217 billion increase in the average amortized cost of our MBS portfolio. Our net interest spread and margin for the first nine months of 2012 were 2.40% and 2.81%, respectively, compared to a net interest spread and margin of 2.91% and 3.31%, respectively, for the first nine months of 2011.
During the first nine months of 2012, we recognized OTTI charges through earnings of $1.2 million compared to $6.4 million during the first nine months of 2011. These impairment charges reflect changes in our estimated cash flows for such securities based on an updated assessment of the estimated future performance of the underlying collateral, including the expected principal loss over the term of the security and changes in the expected timing of receipt of cash flows.
For the nine months ended September 30, 2012, we had other income, net of $18.7 million. This income primarily reflects $11.4 million of net gains on our Linked Transactions and $7.2 million of gains realized on the sale of certain Agency MBS. The gains on our Linked Transactions for the nine months of 2012 included interest income of $4.4 million on the underlying Non-Agency MBS, interest expense of $965,000 on the underlying repurchase agreement borrowings and an increase of $8.0 million in the fair value of the underlying securities. The gains on our Linked Transactions of $10.0 million for the nine months ended September 30, 2011 included interest income of $21.5 million on the underlying Non-Agency MBS, interest expense of $3.9 million on the underlying repurchase financings and a decline of $7.6 million in the fair value of the underlying MBS. Changes in the market value of the securities underlying our Linked Transactions, the amount of bond purchases recorded as Linked Transactions in the future and the amount of Linked Transactions that become unlinked in the future, none of which can be predicted with any certainty, will impact future gains/(losses) on our Linked Transactions. During the nine months ended September 30, 2012, certain of our Linked Transactions became unlinked, resulting in our recording Non-Agency MBS with a fair value of $175.2 million on our consolidated balance sheet.
During the nine months ended September 30, 2012, we realized $7.2 million of gains on the sale of certain Agency MBS for proceeds of $137.1 million. During the nine months ended September 30, 2011, we realized $4.2 million of gains on the sale of certain Agency MBS for proceeds of $76.5 million.
During the first nine months of 2012, we had compensation and benefits and other general and administrative expense of $25.4 million, or 1.20% of average equity compared to $23.6 million, or 1.15% of average equity, for the first nine months of 2011. The $1.2 million increase in our compensation expense to $16.8 million for the first nine months of 2012, compared to $15.6 million for the first nine months of 2011, primarily reflects vesting of equity-based compensation awards, additional salary expense for new hires, and salary increases. Our other general and administrative expenses increased by $698,000 to $8.7 million for the first nine months of 2012, compared to $8.0 million for the first nine months of 2011. The increase was primarily comprised of increases in office rent and related occupancy costs, expenses related to director stock awards, shareholder services and the cost of data and analytical systems, which primarily reflects expenses to expand our investment analytic capability, associated primarily with our investments in Non-Agency MBS, and data system upgrades.
Liquidity and Capital Resources
General
Our principal sources of cash generally consist of borrowings under repurchase agreements, payments of principal and interest we receive on our MBS portfolio, cash generated from our operating results and, depending on market conditions, proceeds from capital market and resecuritization transactions. Our most significant uses of cash are generally to pay principal and interest on our borrowings under repurchase agreements and securitized debt, to purchase MBS, to make dividend payments on our capital stock, to fund our operations and to make other investments that we consider appropriate.
We seek to employ a diverse capital raising strategy under which we may issue capital stock. To the extent we raise additional equity through capital market transactions, we currently anticipate using the proceeds from such transactions to purchase additional MBS, to make scheduled payments of principal and interest on our repurchase agreement and other borrowings, for working capital and for other general corporate purposes. We may also acquire other investments consistent with our investment strategies and operating policies. There can be no assurance, however, that we will be able to raise additional equity capital at any particular time or on any particular terms. We have available for issuance an unlimited amount (subject to the terms and limitations of our charter) of common stock, preferred stock, depositary shares representing preferred stock, warrants, debt securities, rights and/or units pursuant to our automatic shelf registration statement and, at September 30, 2012, we had 9.4 million shares of common stock available for issuance pursuant to our DRSPP shelf registration statement. During the nine months ended September 30, 2012, we issued 596,079 shares of common stock through our DRSPP, raising net proceeds of $4.4 million.
Our borrowings under repurchase agreements are uncommitted and renewable at the discretion of our lenders and, as such, our lenders could determine to reduce or terminate our access to future borrowings at virtually any time. The terms of the repurchase transaction borrowings under our master repurchase agreements as such terms relate to repayment, margin requirements and the segregation of all securities that are the subject of repurchase transactions generally conform to the terms in the standard master repurchase agreement as published by the Securities Industry and Financial Markets Association (or SIFMA) or the global master repurchase agreement published by SIFMA and the International Capital Market Association. In addition, each lender typically requires that we include supplemental terms and conditions to the standard master repurchase agreement. Typical supplemental terms and conditions, which differ by lender, may include changes to the margin maintenance requirements, required haircuts (as defined below), purchase price maintenance requirements, requirements that all controversies related to the repurchase agreement be litigated in a particular jurisdiction and cross default and setoff provisions.
With respect to margin maintenance requirements for repurchase agreements with Non-Agency MBS as collateral, margin calls are typically determined by our counterparties based on their assessment of changes in the fair value of the underlying collateral and in accordance with the agreed upon haircuts specified in the transaction confirmation with the counterparty. We address margin call requests in accordance with the required terms specified in the applicable repurchase agreement and such requests are typically satisfied by posting additional cash or collateral on the same business day. We review margin calls made by counterparties and assess them for reasonableness by comparing the counterparty valuation against our valuation determination. When we believe that a margin call is unnecessary based on an inappropriate counterparty valuation, we typically hold discussions with the counterparty and are able to resolve the matter. In the unlikely event that resolution cannot be reached, we will look to resolve the dispute based on the remedies available to us under the terms of the repurchase agreement, which in some instances may include the engagement of a third party to review collateral valuations. For other agreements that do not include such provisions, we could resolve the matter by substituting collateral as permitted in accordance with the agreement or otherwise request the counterparty to return the collateral in exchange for cash to unwind the financing.
The following table presents information regarding the margin requirements, or the percentage amount by which the collateral value is contractually required to exceed the loan amount (this difference is referred to as the “haircut”), on our repurchase agreements at September 30, 2012 and December 31, 2011:
Haircut
Low
High
Repurchase agreement borrowings secured by:
10.00
63.00
1.00
7.00
The weighted average haircut requirements for the respective underlying collateral types for our repurchase agreements have not significantly changed since December 31, 2011.
During the first nine months of 2012, the financial market environment was impacted by continued accommodative monetary policy. Repurchase agreement funding for both Agency MBS and Non-Agency MBS has been available to us at attractive market terms from multiple counterparties. Typically, due to the credit risk inherent to Non-Agency MBS, repurchase agreement funding involving Non-Agency MBS is available from fewer counterparties, at terms requiring higher collateralization and higher interest rates, than does repurchase agreement funding secured by Agency MBS and U.S. Treasury securities. Therefore, we generally expect to be able to finance our acquisitions of Agency MBS (which we expect will continue to comprise the majority of our assets) on more favorable terms than financing for Non-Agency MBS.
We maintain cash and cash equivalents, unpledged Agency MBS and collateral in excess of margin requirements held by our counterparties (or collectively, our Cushion) to meet routine margin calls and protect against unforeseen reductions in our borrowing capabilities. Our ability to meet future margin calls will be impacted by our Cushion, which varies based on the market value of our securities, our cash position and margin requirements. Our cash position fluctuates based on the timing of our operating, investing and financing activities and is managed based on our anticipated cash needs. (See our consolidated statements of cash flows, included under Item 1 of this Quarterly Report on Form 10-Q and “Interest Rate Risk” included under Item 3 of this Quarterly Report on Form 10-Q.)
At September 30, 2012, we had a total of $10.629 billion of MBS and U.S. Treasury securities and $7.0 million of restricted cash pledged against our repurchase agreements and Swaps. At September 30, 2012, we had a Cushion of $1.071 billion available to meet potential margin calls, comprised of cash and cash equivalents of $450.4 million, unpledged Agency MBS of $568.6 million and excess collateral on Agency MBS of $51.9 million. In addition, at September 30, 2012, we had unpledged Non-Agency MBS with a fair value of $255.0 million and Non-Agency MBS with a fair value of $281.4 million pledged in excess of contractual requirements.
During the nine months ended September 30, 2012, we entered into a resecuritization transaction that resulted in us consolidating as a VIE, the SPE that was created to facilitate this transaction, and to which the underlying assets in connection with the resecuritization was transferred. As part of this resecuritization transaction, we sold Non-Agency MBS to Wells Fargo Mortgage Loan Trust, LLC (or WFMLT), who subsequently transferred the underlying certificates to a separate trust established under the laws of the State of New York, which we consolidate as a VIE. (See Note 15 to the accompanying consolidated financial statements, included under Item 1 of this Quarterly Report on Form 10-Q.)
The following table summarizes the key details of the resecuritization transactions we have been involved in to date:
(1) Provides credit support for the sequential Senior Non-Agency MBS sold to third-party investors in resecuritization transactions (or Senior Bonds).
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For financial statement reporting purposes, we consolidate the underlying trusts in our resecuritization transactions and, as such, no gain or loss is recorded. Since the underlying trusts are consolidated, we take the view that the resecuritization is effectively a financing of the Non-Agency MBS sold resulting in the Senior Bonds being presented in our consolidated financial statements as securitized debt.
During the nine months ended September 30, 2012, we issued $100.0 million aggregate principal amount of Senior Notes in an underwritten public offering. The total net proceeds to us from the offering of the Senior Notes were approximately $96.6 million, after deducting offering expenses and the underwriting discount. The Senior Notes bear interest at the rate of 8.00% per year, paid quarterly in arrears on January 15, April 15, July 15 and October 15 of each year and will mature on April 15, 2042. We may redeem the Senior Notes, in whole or in part, at any time on or after April 15, 2017 at a redemption price equal to 100% of the principal amount redeemed plus accrued and unpaid interest. (See Note 9 to the accompanying consolidated financial statements, included under Item 1 of this Quarterly Report on Form 10-Q.)
The table below presents certain information about our borrowings under repurchase agreements and securitized debt:
Quarter Ended (In Thousands)
Quarterly Average Balance
End of Period Balance
Maximum Balance at Any Month-End
September 30, 2012 (1)
821,256
June 30, 2012 (1)
7,961,497
8,368,407
931,045
861,255
935,051
7,772,000
7,908,932
949,868
967,422
1,000,787
7,969,178
7,996,749
929,836
932,239
8,017,663
8,084,098
958,406
1,027,701
(1) The information presented in the table above excludes Senior Notes issued in April 2012. The quarterly average balance, end of period balance and maximum balance at any month-end for Senior Notes was $100.0 million.
(2) The higher end of the period balance reflects the securitized debt from our resecuritization transaction in February 2012.
Cash Flows and Liquidity For the Nine Months Ended September 30, 2012
Our cash and cash equivalents increased by $56.4 million during the nine months ended September 30, 2012, reflecting: $606.1 million provided by our financing activities; $782.3 million used through our investing activities, primarily to purchase MBS; and $232.6 million provided by our operating activities.
At September 30, 2012, our debt-to-equity multiple was 3.2x compared to 3.6x at December 31, 2011. At September 30, 2012, we had borrowings under repurchase agreements of $8.832 billion with 26 counterparties, of which $6.460 billion was secured by Agency MBS, $1.869 billion was secured by Non-Agency MBS and $503.1 million was secured by U.S. Treasuries. In addition, at such date, we had $36.4 million of borrowings under repurchase agreements that were a component of our Linked Transactions. (See Note 4 to the consolidated financial statements, included under Item 1 of this Quarterly Report on Form 10-Q.) We continue to have available capacity under our repurchase agreement credit lines. At December 31, 2011, we had borrowings under repurchase agreements of $7.813 billion with 25 counterparties and had borrowings under repurchase agreements of $170.9 million that were a component of our Linked Transactions.
At September 30, 2012, we had aggregate securitized debt of $749.5 million, resulting from our resecuritization transactions. During the nine months ended September 30, 2012, we used cash of $312.7 million to make principal payments on our securitized debt, which had a weighted average expected remaining term of 1.22 years at September 30, 2012. During the nine months ended September 30, 2012, we increased the financing obtained under multi-year collateralized financing arrangements by approximately $200.0 million. At September 30, 2012, approximately $500.0 million of financing had been obtained under these arrangements.
During the nine months ended September 30, 2012, we issued $100.0 million aggregate principal amount of Senior Notes in an underwritten public offering. The total net proceeds from the offering of the Senior Notes were approximately $96.6 million, after deducting offering expenses and the underwriting discount.
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During the nine months ended September 30, 2012 we used $782.3 million through our investing activities. During this period, we received cash of $1.977 billion from prepayments and scheduled amortization on our MBS portfolio, of which $1.434 billion was attributable to Agency MBS and $543.4 million was from Non-Agency MBS. During the nine months ended September 30, 2012, we purchased $1.774 billion of Agency MBS and $1.123 billion of Non-Agency MBS funded with cash and repurchase agreement borrowings. While we generally intend to hold our MBS as long-term investments, we may sell certain MBS in order to manage our interest rate risk and liquidity needs, meet other operating objectives and adapt to market conditions. During the nine months ended September 30, 2012 we sold certain of our Agency MBS for proceeds of $137.1 million, realizing gross gains of $7.2 million.
In connection with our repurchase agreement borrowings and Swaps, we routinely receive margin calls from our counterparties and make margin calls to our counterparties. Margin calls and reverse margin calls, which requirements vary over time, may occur daily between us and any of our counterparties when the value of collateral pledged changes from the amount contractually required. The value of securities pledged as collateral fluctuates reflecting changes in: (i) the face (or par) value of our MBS; (ii) market interest rates and/or other market conditions; and (iii) the market value of our Swaps. Margin calls/reverse margin calls are satisfied when we pledge/receive additional collateral in the form of additional securities and/or cash. We have maintained compliance with all of our financial covenants to date.
The table below summarizes our margin activity with respect to our repurchase agreement financings (including underlying Linked Transactions) and derivative hedging instruments for the quarterly periods presented:
Collateral Pledged to Meet Margin Calls
Cash and Securities
Net Assets Received/
For the Quarter Ended (In Thousands)
Fair Value of Securities Pledged
Cash Pledged
Aggregate Assets Pledged For Margin Calls
Received For Reverse Margin Calls
(Pledged) For Margin Activity
429,201
461,123
31,922
334,536
800
335,336
318,723
(16,613
277,415
1,590
279,005
333,753
54,748
451,838
10,901
462,739
463,791
1,052
719,639
2,660
722,299
657,785
(64,514
During the nine months ended September 30, 2012, we paid $265.5 million for cash dividends on our common stock and DERs, and paid cash dividends of $6.1 million on our preferred stock. On September 28, 2012, we declared our third quarter 2012 dividend on our common stock of $0.21 per share; on October 31, 2012, we paid this dividend which totaled $75.3 million, including DERs of approximately $324,000.
We believe that we have adequate financial resources to meet our current obligations, including margin calls, as they come due, to fund dividends we declare and to actively pursue our investment strategies. However, should the value of our MBS suddenly decrease, significant margin calls on our repurchase agreement borrowings could result and our liquidity position could be materially and adversely affected. Further, should market liquidity tighten, our repurchase agreement counterparties may increase our margin requirements on new financings, reducing our ability to use leverage. Access to financing may also be negatively impacted by the ongoing volatility in the world financial markets, potentially adversely impacting our current or potential lenders’ ability or willingness to provide us with financing. In addition, there is no assurance that favorable market conditions will continue to permit us to consummate additional securitization transactions if we determine to seek that form of financing.
Off-Balance Sheet Arrangements
We do not have any material off-balance-sheet arrangements. Our Linked Transactions are comprised of MBS, associated repurchase agreements and interest receivable/payable on such accounts. The extent to which these transactions become unlinked in the future, the underlying MBS and the borrowings under repurchase agreements and associated interest income and expense will be presented on a gross basis on our consolidated balance sheet and statement of operations, prospectively. (See page 55 for information about our leverage multiple and Note 4 to the accompanying consolidated financial statements, included under Item 1 of this Quarterly Report on Form 10-Q.)
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Inflation
Substantially all of our assets and liabilities are financial in nature. As a result, changes in interest rates and other factors impact our performance far more than does inflation. Our financial statements are prepared in accordance with GAAP and dividends declared are based upon net ordinary income as calculated for tax purposes. In each case, our results of operations and reported assets, liabilities and equity are measured with reference to historical cost or fair value without considering inflation.
Other Matters
Our objective has been to conduct our business so as not to become regulated as an investment company under the Investment Company Act. Section 3(c)(5)(C) of the Investment Company Act exempts from the definition of “investment company” entities that are “primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.” Under current interpretations of the SEC staff, this exemption generally means that at least 55% of our assets must be comprised of “qualifying real estate assets” and at least 80% of our portfolio must be comprised of qualifying real estate assets and real estate-related assets under the Investment Company Act. We primarily rely on an existing interpretation of the SEC Staff that “whole pool certificates” that are issued or guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae (or Agency Whole Pool Certificates) are considered qualifying real estate assets under Section 3(c)(5)(C). We treat as real estate-related assets MBS that do not represent all of the certificates issued with respect to the entire pool of mortgages. Compliance with this exemption inherently limits the types of assets we may acquire from time to time.
On August 31, 2011, the SEC issued a concept release under which it is reviewing interpretive issues related to the Section 3(c)(5)(C) exemption, including requesting comments on whether it should reconsider whether Agency Whole Pool Certificates may be treated as interests in real estate (and presumably Qualifying Real Estate Assets) and whether companies, such as us, whose primary business consists of investing in Agency Whole Pool Certificates, are the type of entities that Congress intended to be covered by the exclusion provided by Section 3(c)(5)(C).
The potential timetable and outcome of the SEC’s review are unclear. However, if the SEC determines that Agency Whole Pool Certificates are not interests in real estate (and therefore not Qualifying Real Estate Assets), adopts an otherwise adverse interpretation with respect to Agency Whole Pool Certificates, issues different guidance regarding any of the matters bearing upon the exemption under Section 3(c)(5)(C) or otherwise believes we do not satisfy an Investment Company Act exemption, we would be required to significantly restructure our operations in order to maintain our investment company exemption. Under these circumstances, our ability to use leverage and our access to more favorable methods of financing would be substantially reduced, and we would be unable to conduct our business as we currently conduct it. We may also be required to sell certain of our assets and/or limit the types of assets we acquire. Under the circumstances described above, it is likely that our net interest income would be significantly reduced, which would materially and adversely affect our business.
65
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
We seek to manage our risks related to interest rates, liquidity, prepayment speeds, market value and the credit quality of our assets while, at the same time, seeking to provide an opportunity to stockholders to realize attractive total returns through ownership of our capital stock. While we do not seek to avoid risk, we seek, consistent with our investment policies, to: assume risk that can be quantified from historical experience and actively manage such risk; earn sufficient returns to justify the taking of such risks; and maintain capital levels consistent with the risks that we undertake.
Interest Rate Risk
We primarily invest in residential ARM-MBS on a leveraged basis. We take into account both anticipated coupon resets on our ARM-MBS and expected prepayments on all of our MBS when measuring the sensitivity of our MBS portfolio to changes in interest rates. Our Repricing Gap measures the difference between: (a) the weighted average months until the next coupon adjustment or projected prepayment on our MBS portfolio, including Non-Agency MBS underlying our Linked Transactions; and (b) the months remaining to repricing for our repurchase financings (reflecting the impact of Swaps), including repurchase financings underlying our Linked Transactions and securitized debt. A CPR is applied in order to reflect, to a certain extent, the prepayment characteristics inherent in our interest-earning assets and interest-bearing liabilities. Over the last consecutive eight quarters, ending with September 30, 2012, the monthly fair value weighted average CPR on our MBS portfolio ranged from a high of 23.9% experienced during the quarter ended December 31, 2010 to a low of 15.2% experienced during the quarter ended June 30, 2011, with an average CPR over such quarters of 18.1%.
The following table presents information at September 30, 2012 about our Repricing Gap based on contractual maturities (i.e., 0 CPR), and applying CPRs of 15%, 20% and 25% to our MBS portfolio, including MBS underlying our Linked Transactions:
Estimated Months to
Asset Reset or
Repricing Gap
CPR Assumptions
Expected Prepayment
Liabilities Reset (1)
in Months (1)
0
%(2)
(1) Reflects the effect of our Swaps.
(2) 0% CPR reflects only scheduled amortization and contractual maturities.
At September 30, 2012, our financing obligations under repurchase agreements and repurchase agreement borrowings underlying our Linked Transactions had a weighted average remaining contractual term of 73 days and a weighted average term to interest rate reset of 29 days, or an effective repricing period of six months, including the impact of our Swaps. Upon contractual maturity or an interest reset date, these borrowings are typically refinanced at prevailing market rates. We use Swaps as part of our overall interest rate risk management strategy. Our Swaps are intended to act as a hedge against future interest rate increases on our repurchase financings, which rates are typically LIBOR based.
While our Swaps do not extend the maturities of our borrowings under repurchase agreements, they do, however, in effect, lock in a fixed rate of interest over their term for a corresponding amount of our repurchase agreements that such Swaps hedge. For the quarter ended September 30, 2012, our Swaps accounted for $18.1 million, or 75 basis points, of our borrowing costs. At September 30, 2012, we had borrowings under repurchase agreements of $8.832 billion and borrowings under repurchase agreements of $36.4 million underlying Linked Transactions. At such date, we had Swaps with a notional amount of $2.761 billion with a weighted average fixed-pay rate of 2.64%, which extended 16 months on average with a maximum term of approximately 40 months.
At September 30, 2012, our Swaps were in an unrealized loss position of $78.2 million, compared to a net unrealized loss position of $114.2 million at December 31, 2011. We expect that over time the unrealized losses on our Swaps will continue to decrease, as our Swaps with higher fixed-pay rates amortize and their remaining term shortens. (See Note 4 to the accompanying consolidated financial statements, included under Item 1 of this Quarterly Report on Form 10-Q.)
The interest rates for most of our ARM-MBS, once in their adjustable rate period, primarily reset based on LIBOR and the one-year constant maturity treasury rate (or CMT) while our borrowings, comprised of repurchase agreements and securitized debt, are generally priced off of LIBOR. While LIBOR and CMT generally move together, there can be no assurance that the movement of one index will match that of the other index and, in fact, have at times moved inversely. The returns on our Non-Agency MBS, a significant portion of which were purchased at a discount, are impacted by the timing and amount of prepayments, credit performance and the benchmark rate to which the underlying mortgages are indexed.
Loans underlying Agency ARM-MBS generally reset based on the same benchmark index, Non-Agency MBS may be collateralized by mortgage loans that reset based on various benchmark indices and may contain fixed-rate mortgages. The ARMs collateralizing our Agency MBS are primarily comprised of Hybrids; which have interest rates that are typically fixed for three to ten years at origination and, thereafter, generally adjust annually to an increment over a specified interest rate index; and, to a lesser extent, ARMs, which have interest rates that generally adjust annually (although some may adjust more frequently) to an increment over a specified interest rate index.
Because the expected yields on our Non-Agency MBS are significantly greater than those on non-credit sensitive assets, we believe that changes in Non-Agency MBS prices are generally not correlated to changes in market interest rates and are impacted by general economic conditions and housing specific performance. The extent to which the yield on our Non-Agency MBS is impacted by the accretion of purchase discounts will vary over time, by security, based upon the amount of purchase discount, the actual credit performance and CPRs experienced on each MBS.
The amount by which our Agency ARM-MBS can reset is limited by the interim and lifetime caps on the underlying mortgages. The following table presents information about the interim and lifetime caps on our Agency ARM-MBS portfolio at September 30, 2012:
Lifetime Interest Rate Caps on Agency ARMs (1)
Interim Interest Rate Caps on Agency ARMs (2)
Maximum Lifetime Interest Rate
% of Total
Maximum Interim Change in Rate
6.0% to 8.0%
15.6
<1.0%
1.3
>8.0% to 10.0 %
53.2
>1.0% and <3.0%
17.6
>10.0% to 12.0%
28.8
>3.0% and <5.0%
78.5
>12.0%
2.4
>5.0%
0.1
100.0
No interim caps
(1) Lifetime interest rate caps limit the amount interest rates can adjust upward from inception through maturity of a particular ARM.
(2) Interim interest rate caps limit the amount interest rates on a particular ARM can adjust during the next adjustment period.
We generally acquire interest-rate sensitive assets and fund them with interest-rate sensitive liabilities, a portion of which are hedged with Swaps. Our adjustable-rate assets reset on various dates that are not matched to the reset dates on our repurchase agreement borrowings. In general, the repricing of our repurchase agreements occurs more quickly, including the impact of Swaps, than the repricing of our assets. Therefore, on average, our cost of borrowings generally rises or falls more quickly in response to changes in market interest rates than would the yield on our interest-earning assets.
At September 30, 2012, MFA’s $12.723 billion of Agency MBS and Non-Agency MBS, which includes MBS underlying Linked Transactions, were backed by Hybrid, adjustable and fixed-rate mortgages. Additional information about these MBS, including months to reset and three-month average CPR, is presented below:
Months to
Reset (2)
CPR (3)
Time to Reset:
< 2 years (4)
1,621,052
20.6
2,955,601
14.3
4,576,653
16.6
2-5 years
2,414,580
30.4
664,114
18.7
3,078,694
28.0
> 5 years
1,279,614
16.2
ARM-MBS Total
5,315,246
24.0
3,619,715
15.1
8,934,961
15-year fixed
12,165
2,173,767
30-year fixed
1,607,696
16.0
40-year fixed
6,457
13.3
Fixed Rate Total
1,626,318
16.1
3,787,920
15.2
MBS Total
15.4
19.1
(1) Information presented based on data available at time of loan origination.
(2) Months to reset is the number of months remaining before the coupon interest rate resets. At reset, the MBS coupon will adjust based upon the underlying benchmark interest rate index, margin and periodic or lifetime caps. The months to reset do not reflect scheduled amortization or prepayments.
(3) Average CPR weighted by positions as of the beginning of each month in the quarter.
(4) Includes floating rate MBS that may be collateralized by fixed-rate mortgages.
The information presented in the following “Shock Table” projects the potential impact of sudden parallel changes in interest rates on our net interest income and portfolio value, including the impact of derivative hedging instruments, over the next 12 months based on the assets in our investment portfolio at September 30, 2012. All changes in income and value are measured as the percentage change from the projected net interest income and portfolio value at the base interest rate scenario at September 30, 2012.
Shock Table
Change in Interest Rates (Dollars in Thousands)
Estimated Value of MBS (1)
Estimated Value of Derivative Hedging Instruments
Estimated Value of Financial Instruments Carried at Fair Value (2)
Estimated Change in Fair Value
Percentage Change in Net Interest Income (3)
Percentage Change in Portfolio Value
+100 Basis Point Increase
12,649,286
(43,183
12,606,103
(38,609
(7.44
)%
(0.31
+ 50 Basis Point Increase
12,689,166
(60,676
12,628,490
(16,222
(4.06
(0.13
Actual at September 30, 2012
12,644,712
- 50 Basis Point Decrease
12,750,432
(95,662
12,654,770
10,058
0.10
0.08
-100 Basis Point Decrease
12,771,819
(113,155
12,658,664
13,952
(5.52
0.11
(1) Includes linked MBS that are reported as a component of our Linked Transactions on our consolidated balance sheet. Such MBS may not be linked in future periods.
(2) Does not include cash investments, which typically have overnight maturities and are not expected to change in value as interest rates change.
(3) Includes underlying interest income and interest expense associated with MBS and repurchase agreement borrowings underlying our Linked Transactions. Such MBS and repurchase agreements may not be linked in future periods.
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Certain assumptions have been made in connection with the calculation of the information set forth in the Shock Table and, as such, there can be no assurance that assumed events will occur or that other events will not occur that would affect the outcomes. The base interest rate scenario assumes interest rates at September 30, 2012. The analysis presented utilizes assumptions and estimates based on management’s judgment and experience. Furthermore, while we generally expect to retain such assets and the associated interest rate risk to maturity, future purchases and sales of assets could materially change our interest rate risk profile. It should be specifically noted that the information set forth in the above table and all related disclosure constitute forward-looking statements within the meaning of Section 27A of the 1933 Act and Section 21E of the 1934 Act. Actual results could differ significantly from those estimated in the Shock Table above.
The Shock Table quantifies the potential changes in net interest income and portfolio value, which includes the value of our derivative hedging instruments (which are carried at fair value), should interest rates immediately change (i.e., shocked). The Shock Table presents the estimated impact of interest rates instantaneously rising 50 and 100 basis points, and falling 50 and 100 basis points. The cash flows associated with our portfolio of MBS for each rate shock are calculated based on assumptions, including, but not limited to, prepayment speeds, yield on replacement assets, the slope of the yield curve and composition of our portfolio. Assumptions made on the interest rate sensitive liabilities, which are assumed to be repurchase financings and securitized debt, include anticipated interest rates, collateral requirements as a percent of the repurchase agreement, amount and term of borrowing. Given the low level of interest rates at September 30, 2012, we applied a floor of 0% for all anticipated interest rates included in our assumptions. Due to this floor, it is anticipated that any hypothetical interest rate shock decrease would have a limited positive impact on our funding costs; however, because prepayments speeds are unaffected by this floor, it is expected that any increase in our prepayment speeds (occurring as a result of any interest rate shock decrease or otherwise) could result in an acceleration of our premium amortization on our Agency MBS and discount accretion on our Non-Agency MBS and the reinvestment of principal repayments in lower yielding assets. As a result, because the presence of this floor limits the positive impact of interest rate decrease on our funding costs, hypothetical interest rate shock decreases could cause the fair value of our financial instruments and our net interest income to decline.
At September 30, 2012, the impact on portfolio value was approximated using the calculated effective duration (i.e., the price sensitivity to changes in interest rates), including the effect of derivative hedging instruments, of 0.21 which is the weighted average of 0.82 for our Agency MBS, (1.30) for our derivative hedging instruments and zero for our Non-Agency MBS, and expected convexity (i.e., the approximate change in duration relative to the change in interest rates) of (0.19), which is the weighted average of (0.33) for our Agency MBS, zero for our derivative hedging instruments and zero for our Non-Agency MBS. Because the expected yields on our Non-Agency MBS are significantly greater than those on non-credit sensitive assets, we believe that changes in Non-Agency MBS prices are generally not correlated to changes in market interest rates and are impacted by general economic conditions and housing specific performance. The impact on our net interest income is driven mainly by the difference between portfolio yield and cost of funding of our repurchase agreements (including those underlying our Linked Transactions), which includes the cost and/or benefit from derivative hedging instruments. Our asset/liability structure is generally such that an increase in interest rates would be expected to result in a decrease in net interest income, as our borrowings are generally shorter in term than our interest-earning assets. When interest rates are shocked, prepayment assumptions are adjusted based on management’s expectations along with the results from the prepayment model.
Market Value Risk
Our MBS are designated as “available-for-sale” and, as such, are reported at their fair value. The difference between amortized cost and fair value of our MBS is reflected in accumulated other comprehensive income/(loss), a component of Stockholders’ Equity, except that credit related impairments that are identified as other-than-temporary are recognized through earnings. Changes in the fair value of our Linked Transactions are reported in earnings. At September 30, 2012, our investment portfolio was comprised of Agency MBS and Non-Agency MBS. While changes in the fair value of our Agency MBS are generally not credit-related, changes in the fair value of our Non-Agency MBS and Linked Transactions may reflect both market and interest rate conditions as well as credit risk. At September 30, 2012, our Non-Agency MBS had a fair value of $5.197 billion and an amortized cost of $4.690 billion, comprised of gross unrealized losses of $13.2 million and gross unrealized gains of $519.9 million. At September 30, 2012, our Linked Transactions included MBS with a fair value of $49.1 million, including net unrealized gains of $3.4 million, which have been reflected through earnings to date as a component of unrealized net gains and net interest income from Linked Transactions.
Generally, in a rising interest rate environment, the fair value of our MBS would be expected to decrease; conversely, in a decreasing interest rate environment, the fair value of such MBS would be expected to increase. If the fair value of MBS collateralizing our repurchase agreements decreases, we may receive margin calls from our repurchase agreement counterparties for additional MBS collateral or cash due to such decline. If such margin calls are not met, our lender could liquidate the securities collateralizing our repurchase agreements with such lender, potentially resulting in a loss to us. To avoid forced liquidations, we could apply a strategy of reducing borrowings and assets, by selling assets or not replacing securities as they amortize and/or prepay. Such an action would likely reduce our interest income, interest expense and net income, the extent of which would be dependent on the level of reduction in assets and liabilities as well as the price at which such assets are sold. Such a decrease in our net interest income could negatively impact cash available for dividend distributions, which in turn could reduce the market price of our issued and outstanding common stock and preferred stock.
In evaluating our asset/liability management and Non-Agency MBS credit performance, we consider the credit characteristics underlying our Non-Agency MBS, including those that are a component of our Linked Transactions. The following table presents certain information about our Non-Agency MBS portfolio and Non-Agency MBS underlying our Linked Transactions at September 30, 2012. Information presented with respect to weighted average loan to value, weighted average FICO scores and other information aggregated based on information reported at the time of mortgage origination are historical and, as such, does not reflect the impact of the general decline in home prices or changes in a borrower’s credit score or the current use of the mortgaged property.
70
The information in the table below is presented as of September 30, 2012.
Securities with Average Loan
FICO of 715 or Higher (1)
FICO Below 715 (1)
Year of Securitization (2)
2005
2007
2006
and Prior
Number of securities
93
94
102
377
MBS current face
2,137,267
1,484,937
1,450,098
204,645
580,940
653,874
Total purchase discount, net
(557,384
(440,559
(293,602
(90,448
(230,028
(163,829
(1,775,850
Purchase discount designated as Credit Reserve and OTTI (3)
(499,327
(333,638
(206,133
(74,341
(227,720
(125,138
Purchase discount designated as Credit Reserve and OTTI as percentage of current face
MBS amortized cost
1,579,883
1,044,378
1,156,496
114,197
350,912
490,045
MBS fair value
1,733,628
1,181,858
1,233,317
140,326
397,832
559,072
Weighted average fair value to current face
81.1
79.6
85.1
68.6
68.5
85.5
80.6
Weighted average coupon (4)
4.80
3.66
3.71
Weighted average loan age (months) (4) (5)
88
77
90
Weighted average current loan size (4) (5)
547
537
362
466
293
306
454
Percentage amortizing (6)
38.2
44.9
66.0
44.0
55.9
65.7
50.4
Weighted average FICO score at origination (4) (7)
734
730
728
702
704
706
725
Owner-occupied loans
89.2
89.3
86.3
82.9
83.5
85.0
87.5
Rate-term refinancings
26.6
15.9
13.8
Cash-out refinancings
33.0
32.8
26.1
40.6
39.6
37.7
32.7
3 Month CPR (5)
18.1
16.4
13.9
14.8
14.1
3 Month CRR (5) (8)
9.1
7.3
7.6
5.3
8.0
7.8
3 Month CDR (5) (8)
8.7
11.0
10.7
3 Month loss severity
49.6
50.3
47.1
56.2
63.3
56.4
51.8
60+ days delinquent (7)
20.1
19.7
29.5
26.5
19.8
Percentage of always current borrowers (Lifetime) (9)
52.8
50.9
56.8
35.6
34.1
43.0
50.1
Percentage of always current borrowers (12M) (10)
68.1
68.0
74.3
55.5
64.7
67.6
Weighted average credit enhancement (7) (11)
1.1
2.0
6.9
(1) FICO score is used by major credit bureaus to indicate a borrower’s creditworthiness at time of loan origination.
(2) Information presented based on the initial year of securitization of the underlying collateral. Certain of our Non-Agency MBS have been resecuritized. The historical information presented in the table is based on the initial securitization date and data available at the time of original securitization (and not the date of resecuritization). No information has been updated with respect to any MBS that have been resecuritized.
(3) Purchase discounts designated as Credit Reserve and OTTI are not expected to be accreted into interest income.
(4) Weighted average is based on MBS current face at September 30, 2012.
(5) Information provided is based on loans for individual groups owned by us.
(6) Percentage of face amount for which the original mortgage note contractually calls for principal amortization in the current period.
(7) Information provided is based on loans for all groups that provide credit enhancement for MBS with credit enhancement.
(8) CRR represents voluntary prepayments and CDR represents involuntary prepayments.
(9) Percentage of face amount of loans for which the borrower has not been delinquent since origination.
(10) Percentage of face amount of loans for which the borrower has not been delinquent in the last twelve months.
(11) Credit enhancement for a particular security is expressed as a percentage of all outstanding mortgage loan collateral. A particular security will not be subject to principal loss as long as its credit enhancement is greater than zero. As of September 30, 2012, a total of 153 Non-Agency MBS in our portfolio representing approximately $2.815 billion or 43% of the current face amount of the portfolio had no credit enhancement.
71
The mortgages securing our Non-Agency MBS are located in many geographic regions across the United States. The following table presents the six largest geographic concentrations of the mortgages collateralizing our Non-Agency MBS, including Non-Agency MBS underlying our Linked Transactions, at September 30, 2012:
Property Location
Percent
Southern California
28.3
Northern California
Florida
7.9
New York
Virginia
New Jersey
Liquidity Risk
The primary liquidity risk for us arises from financing long-maturity assets, including ARM-MBS that are subject to interim and lifetime interest rate adjustment caps, with shorter-term borrowings primarily in the form of repurchase agreements. We pledge MBS and cash to secure our repurchase agreements, including repurchase agreements that are reported as a component to our Linked Transactions, and Swaps. At September 30, 2012, we had a Cushion of $1.071 billion available to meet potential margin calls, comprised of cash and cash equivalents of $450.4 million, unpledged Agency MBS of $568.6 million and excess collateral on Agency MBS of $51.9 million. In addition, at September 30, 2012, we had unpledged Non-Agency MBS with a fair value of $255.0 million and Non-Agency MBS with a fair value of $281.4 million pledged in excess of contractual requirements. Should the value of our MBS pledged as collateral suddenly decrease, margin calls relating to our repurchase agreements could increase, causing an adverse change in our liquidity position. As such, we cannot be assured that we will always be able to roll over our repurchase agreements. Further, should market liquidity tighten, our repurchase agreement counterparties may increase our margin requirements on new financings, including repurchase agreement borrowings that we roll with the same counterparty, reducing our ability to use leverage.
Credit Risk
Although we do not believe that we are exposed to credit risk in our Agency MBS portfolio, we are exposed to credit risk in our Non-Agency MBS portfolio. In the event of the return of less than 100% of par on our Non-Agency MBS, credit support contained in the MBS deal structures and the discount purchase prices we paid mitigate our risk of loss on these investments. Over time, we expect the level of credit support remaining in MBS deal structures to decrease, which will result in an increase in the amount of realized credit loss experienced by our Non-Agency MBS portfolio. Our Non-Agency investment process involves analysis focused primarily on quantifying and pricing credit risk. When we purchase Non-Agency MBS, we assign certain assumptions to each of the MBS, including but not limited to, future interest rates, voluntary prepayment rates, mortgage modifications, default rates and loss severities, and generally allocate a portion of the purchase discount as a Credit Reserve which provides credit protection for such securities. As part of our surveillance process, we review our Non-Agency MBS by tracking their actual performance compared to the security’s expected performance at purchase or, if we have modified our original purchase assumptions, compared to our revised performance expectations. To the extent that actual performance of a Non-Agency MBS is less favorable than the expected performance of the security, we may revise our performance expectations. As a result, we could reduce the accretable discount on such security and/or recognize an other-than-temporary impairment through earnings, which could have a material adverse impact on our operating results. In addition, as discussed in Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” of this Quarterly Report on Form 10-Q, we are potentially exposed to repurchase agreement counterparties should they default on their obligations, and we are unable to recover any excess collateral pledged to them.
Prepayment and Reinvestment Risk
72
Item 4. Controls and Procedures
A review and evaluation was performed by our management, including our Chief Executive Officer (or CEO) and Chief Financial Officer (or CFO), of the effectiveness of the design and operation of our disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the 1934 Act) as of the end of the period covered by this Quarterly Report. Based on that review and evaluation, the CEO and CFO have concluded that our disclosure controls and procedures, as designed and implemented, were effective as of September 30, 2012. Notwithstanding the foregoing, a control system, no matter how well designed, implemented and operated, can provide only reasonable, not absolute, assurance that it will detect or uncover failures within the Company to disclose material information otherwise required to be set forth in our periodic reports.
There have been no changes in our internal control over financial reporting that occurred during the quarter ended September 30, 2012 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
There are no material pending legal proceedings to which we are a party or any of our assets are subject.
Item 1A. Risk Factors
For a discussion of the Company’s risk factors, see Part I, Item 1A. “Risk Factors” of the Company’s Annual Report on Form 10-K for the year ended December 31, 2011, and Part II, Item 1A. “Risk Factors” of the Company’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2012. There are no material changes from the risk factors set forth in such Annual Report and such Quarterly Report. However, the risks and uncertainties that the Company faces are not limited to those set forth in such Annual Report and Quarterly Report. Additional risks and uncertainties not presently known to the Company or that it currently believes to be immaterial may also adversely affect the Company’s business and the trading price of its securities.
Item 6. Exhibits
The list of exhibits required to be filed as exhibits to this report are listed on page E-1 hereof, under “Exhibit Index,” which is incorporated herein by reference.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Date: November 6, 2012
(Registrant)
By:
/s/
Stewart Zimmerman
Chairman and Chief Executive Officer
Stephen D. Yarad
Chief Financial Officer
(Principal Financial Officer)
EXHIBIT INDEX
The following exhibits are filed as part of this Quarterly Report:
Exhibit
Description
10.1
Amendment No.1, dated October 19, 2012, to Second Amended and Restated Employment Agreement, dated as of June 7, 2010, between MFA Financial, Inc. and Stewart Zimmerman (incorporated herein by reference to Exhibit 10.1 to the Company’s Form 8-K, dated October 22, 2012, as amended by the Company’s Form 8-K/A (Amendment No. 1), dated October 22, 2012 (Commission File No. 1-13991)).
Third Amended and Restated 2003 Non-Employee Directors’ Deferred Compensation Plan (as amended through November 1, 2012)
31.1
Certification of the Chief Executive Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2
Certification of the Chief Financial Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1
Certification of the Chief Executive Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2
Certification of the Chief Financial Officer, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
101.INS*
XBRL Instance Document
101.SCH*
XBRL Taxonomy Extension Schema Document
101.CAL*
XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF*
XBRL Taxonomy Extension Definition Linkbase Document
101.LAB*
XBRL Taxonomy Extension Label Linkbase Document
101.PRE*
XBRL Taxonomy Extension Presentation Linkbase Document
*These interactive data files are furnished and deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, deemed not filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.
E-1