FORM 10-Q
Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

(Mark One)

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

For the quarterly period ended June 30, 2012

OR

 

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

For the transition period from              to             

Commission file number 001-34385

 

 

INVESCO MORTGAGE CAPITAL INC.

(Exact Name of Registrant as Specified in Its Charter)

 

 

 

Maryland   26-2749336

(State or Other Jurisdiction of

Incorporation or Organization)

 

(I.R.S. Employer

Identification No.)

1555 Peachtree Street, N.E., Suite 1800

Atlanta, Georgia

  30309
(Address of Principal Executive Offices)   (Zip Code)

(404) 892-0896

(Registrant’s Telephone Number, Including Area Code)

 

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

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

 

Large Accelerated filer   x    Accelerated filer   ¨
Non-Accelerated filer   ¨  (Do not check if a smaller reporting company)    Smaller reporting company   ¨

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

As of August 3, 2012, there were 115,410,322 outstanding shares of common stock of Invesco Mortgage Capital Inc.

 

 

 


Table of Contents

INVESCO MORTGAGE CAPITAL INC.

TABLE OF CONTENTS

 

         Page  

PART I FINANCIAL INFORMATION

     1   

Item 1.

 

Consolidated Financial Statements

     1   
 

Consolidated Balance Sheets as of June 30, 2012 (unaudited) and December 31, 2011

     1   
 

Unaudited Consolidated Statements of Operations for the three and six months ended June 30, 2012 and 2011

     2   
 

Unaudited Consolidated Statement of Comprehensive Income (Loss) for the three and six months ended June 30, 2012 and 2011

     3   
 

Unaudited Consolidated Statement of Equity for the six months ended June 30, 2012

     4   
 

Unaudited Consolidated Statements of Cash Flows for the six months ended June 30, 2012 and 2011

     5   
 

Notes to Consolidated Financial Statements

     6   

Item 2.

 

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

     28   

Item 3.

 

Quantitative and Qualitative Disclosures About Market Risk

     45   

Item 4.

 

Controls and Procedures

     47   

PART II OTHER INFORMATION

     49   

Item 1.

 

Legal Proceedings

     49   

Item 1A.

 

Risk Factors

     49   

Item 2.

 

Unregistered Sales of Equity Securities and Use of Proceeds

     49   

Item 3.

 

Defaults Upon Senior Securities

     49   

Item 4.

 

Mine Safety Disclosures

     49   

Item 5.

 

Other Information

     49   

Item 6.

 

Exhibits

     51   


Table of Contents

PART I

ITEM 1. FINANCIAL STATEMENTS

INVESCO MORTGAGE CAPITAL INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

 

$ in thousands, except per share amounts    As of  
      June 30,
2012
    December 31,
2011
 
     (Unaudited)        
ASSETS     

Mortgage-backed securities, at fair value

     16,049,674       14,214,149  

Cash

     168,610       197,224  

Restricted cash

     14,696       74,496  

Investment related receivable

     16,234       160,424  

Investments in unconsolidated ventures, at fair value

     52,384       68,793  

Accrued interest receivable

     56,930       54,167  

Derivative assets, at fair value

     1,711       1,339  

Other assets

     1,988       1,575  
  

 

 

   

 

 

 

Total assets

     16,362,227       14,772,167  
  

 

 

   

 

 

 
LIABILITIES AND EQUITY     

Liabilities:

    

Repurchase agreements

     13,541,325       12,253,038  

Derivative liability, at fair value

     446,569       396,780  

Dividends and distributions payable

     75,942       75,933  

Investment related payable

     126,869       107,032  

Accrued interest payable

     11,159       12,377  

Accounts payable and accrued expenses

     1,501       556  

Due to affiliate

     8,949       9,038  
  

 

 

   

 

 

 

Total liabilities

     14,212,314       12,854,754  
  

 

 

   

 

 

 

Equity:

    

Preferred Stock: par value $0.01 per share; 50,000,000 shares authorized, 0 shares issued and outstanding

     —          —     

Common Stock: par value $0.01 per share; 450,000,000 shares authorized, 115,409,592 and 115,395,695 shares issued and outstanding, at June 30, 2012 and December 31, 2011, respectively

     1,154       1,154  

Additional paid in capital

     2,299,809       2,299,543  

Accumulated other comprehensive loss

     (175,767     (393,291

Distributions in excess of earnings

     (3,193     (15,068
  

 

 

   

 

 

 

Total shareholders’ equity

     2,122,003       1,892,338  

Non-controlling interest

     27,910       25,075  
  

 

 

   

 

 

 

Total equity

     2,149,913       1,917,413  
  

 

 

   

 

 

 

Total liabilities and equity

     16,362,227       14,772,167  
  

 

 

   

 

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

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Table of Contents

INVESCO MORTGAGE CAPITAL INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

 

     Three Months Ended
June 30,
    Six Months Ended
June 30,
 
$ in thousands, except per share data    2012     2011     2012     2011  

Revenues

        

Interest income

     139,004       108,981       280,964       177,517  

Interest expense

     56,700       34,207       111,985       49,785  
  

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income

     82,304       74,774       168,979       127,732  
  

 

 

   

 

 

   

 

 

   

 

 

 

Other income

        

Gain on sale of investments

     6,098       3,605       12,143       4,805  

Equity in earnings and fair value change in unconsolidated ventures

     1,961       1,873       2,970       3,731  

Unrealized loss on interest rate swaps and swaptions

     (1,533     (197     (2,043     (202

Realized and unrealized credit default swap income

     690       1,259       1,347       3,791  
  

 

 

   

 

 

   

 

 

   

 

 

 

Total other income

     7,216       6,540       14,417       12,125  
  

 

 

   

 

 

   

 

 

   

 

 

 

Expenses

        

Management fee – related party

     8,681       5,753       17,320       9,728  

General and administrative

     1,045       1,157       2,174       2,026  
  

 

 

   

 

 

   

 

 

   

 

 

 

Total expenses

     9,726       6,910       19,494       11,754  
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income

     79,794       74,404       163,902       128,103  
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income attributable to non-controlling interest

     973       1,406       1,999       2,857  
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income attributable to common shareholders

     78,821       72,998       161,903       125,246  
  

 

 

   

 

 

   

 

 

   

 

 

 

Earnings per share:

        

Net income attributable to common shareholders (basic/diluted)

     0.68       0.99       1.40       2.00  
  

 

 

   

 

 

   

 

 

   

 

 

 

Dividends declared per common share

     0.65       0.97       1.30       1.97  
  

 

 

   

 

 

   

 

 

   

 

 

 

Weighted average number of shares of common stock:

        

Basic

     115,409       73,486       115,402       62,731  
  

 

 

   

 

 

   

 

 

   

 

 

 

Diluted

     116,868       74,929       116,853       64,167  
  

 

 

   

 

 

   

 

 

   

 

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

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Table of Contents

INVESCO MORTGAGE CAPITAL INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME

(Unaudited)

 

     Three Months Ended     Six Months Ended  
     June 30,     June 30,  
$ in thousands, except per share data    2012     2011     2012     2011  

Net income

     79,794       74,404       163,902       128,103  
  

 

 

   

 

 

   

 

 

   

 

 

 

Other comprehensive income (loss)

        

Unrealized gains (losses) on available for sale securities, net

     60,413       (9,106     269,486       843  

Unrealized losses on derivatives, net

     (66,365     (147,086     (49,276     (116,885
  

 

 

   

 

 

   

 

 

   

 

 

 

Other comprehensive income (loss)

     (5,952     (156,192     220,210       (116,042
  

 

 

   

 

 

   

 

 

   

 

 

 

Comprehensive income (loss)

     73,842       (81,788     384,112       12,061  

Less: Comprehensive income (loss) attributable to non-controlling interest

     (901     1,685       (4,685     (668
  

 

 

   

 

 

   

 

 

   

 

 

 

Comprehensive income (loss) attributable to common shareholders

     72,941       (80,103     379,427       11,393  
  

 

 

   

 

 

   

 

 

   

 

 

 

The accompanying notes are an integral part of these consolidated statements.

 

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Table of Contents

INVESCO MORTGAGE CAPITAL INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF EQUITY

For the six months ended June 30, 2012

(Unaudited)

 

    Attributable to Common Shareholders              

$ in thousands, except per share amounts

  Common Stock     Additional
Paid in
    Accumulated
Other
Comprehensive
    Distributions in
excess of
    Total
Shareholders’
    Non-
Controlling
    Total  
  Shares     Amount     Capital     Income (loss)     earnings     Equity     Interest     Equity  

Balance at January 1, 2012

    115,395,695       1,154       2,299,543       (393,291     (15,068     1,892,338       25,075       1,917,413  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Net income

    —          —          —          —          161,903       161,903       1,999       163,902  

Other comprehensive income

    —          —          —          217,524       —          217,524       2,686       220,210  

Net proceeds from issuance of common stock, net of of offering costs

    6,478       —          113       —          —          113       —          113  

Stock awards

    7,419       —          —          —          —          —          —          —     

Common stock dividends

    —          —          —          —          (150,028     (150,028     —          (150,028

Common unit dividends

    —          —          —          —          —          —          (1,853     (1,853

Amortization of equity-based compensation

    —          —          153       —          —          153       3       156  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance at June 30, 2012

    115,409,592       1,154       2,299,809       (175,767     (3,193     2,122,003       27,910       2,149,913  
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The accompanying notes are an integral part of this consolidated financial statement.

 

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INVESCO MORTGAGE CAPITAL INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

 

$ in thousands    Six Months Ended June 30,  
     2012     2011  

Cash Flows from Operating Activities

    

Net income

     163,902       128,103  

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

    

Amortization of mortgage-backed securities premiums and discounts, net

     55,914       11,149  

Unrealized loss on interest rate swap and swaptions

     2,043       202  

Unrealized (gain) loss on credit default swap

     238       (1,685

Gain on sale of mortgage-backed securities

     (12,143     (4,805

Equity in earnings and fair value change in unconsolidated ventures

     (2,970     (3,731

Amortization of equity-based compensation

     156       93  

Changes in operating assets and liabilities

    

Increase in accrued interest

     (2,763     (23,792

Increase in other assets

     (413     (776

(Decrease) increase in accrued interest payable

     (1,218     7,274  

(Decrease) increase in due to affiliate

     (52     3,278  

Increase in accounts payable and accrued expenses

     987       533  
  

 

 

   

 

 

 

Net cash provided by operating activities

     203,681       115,843  
  

 

 

   

 

 

 

Cash Flows from Investing Activities

    

Purchase of mortgage-backed securities

     (3,635,203     (7,020,050

Distributions from investment in unconsolidated ventures, net

     16,884       11,710  

Principal payments from mortgage-backed securities

     1,144,380       491,577  

Proceeds from sale of mortgage-backed securities

     1,050,554       344,767  

Payment of premiums for interest rate swaption

     (2,140     —     
  

 

 

   

 

 

 

Net cash used in investing activities

     (1,425,525     (6,171,996
  

 

 

   

 

 

 

Cash Flows from Financing Activities

    

Proceeds from issuance of common stock

     34       886,929  

Restricted cash

     57,173       (26,944

Proceeds from repurchase agreements

     71,270,565       33,213,268  

Principal repayments of repurchase agreements

     (69,982,671     (27,997,161

Investment related payable

     —          18,044  

Payments of dividends and distributions

     (151,871     (101,469
  

 

 

   

 

 

 

Net cash provided by financing activities

     1,193,230       5,992,667  
  

 

 

   

 

 

 

Net change in cash

     (28,614     (63,486

Cash, beginning of period

     197,224       63,552  
  

 

 

   

 

 

 

Cash, end of period

     168,610       66  
  

 

 

   

 

 

 

Supplement disclosure of cash flow information

    

Interest paid

     113,203       42,511  
  

 

 

   

 

 

 

Non-cash investing and financing activities information

    

Net change in unrealized gain on available-for-sale securities and derivatives

     220,210       (116,043
  

 

 

   

 

 

 

Net change in unconsolidated ventures

     2,495       (1,431
  

 

 

   

 

 

 

Net change in restricted cash

     2,627       (5,949
  

 

 

   

 

 

 

Dividends and distributions declared not paid

     75,942       72,575  
  

 

 

   

 

 

 

Payable for mortgage-backed securities purchased

     (169,784     (399,233
  

 

 

   

 

 

 

Repurchase agreements, not settled

     393       —     
  

 

 

   

 

 

 

The accompanying notes are an integral part of these consolidated financial statements.

 

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Table of Contents

INVESCO MORTGAGE CAPITAL INC. AND SUBSIDIARIES

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

Note 1 – Organization and Business Operations

Invesco Mortgage Capital Inc. (the “Company”) is a Maryland corporation focused on investing in, financing and managing residential and commercial mortgage-backed securities and mortgage loans. The Company invests in residential mortgage-backed securities (“RMBS”) for which a U.S. Government Agency such as the Government National Mortgage Association (“Ginnie Mae”), the Federal National Mortgage Association (“Fannie Mae”) or the Federal Home Loan Mortgage Corporation (“Freddie Mac”) guarantees payments of principal and interest on the securities (collectively “Agency RMBS”). The Company’s Agency RMBS investments include mortgage pass-through securities and collateralized mortgage obligations (“CMOs”). The Company also invests in RMBS that are not issued or guaranteed by a U.S. government Agency (“non-Agency RMBS”), commercial mortgage-backed securities (“CMBS”), and residential and commercial mortgage loans. The Company is externally managed and advised by Invesco Advisers, Inc. (the “Manager”), a registered investment adviser and an indirect, wholly-owned subsidiary of Invesco Ltd. (“Invesco”), a global investment management company.

The Company conducts its business through IAS Operating Partnership LP (the “Operating Partnership”) as its sole general partner. As of June 30, 2012, the Company owned 98.8% of the Operating Partnership and Invesco Investments (Bermuda) Ltd., a direct, wholly-owned subsidiary of Invesco, owned the remaining 1.2%.

The Company finances its Agency RMBS, non-Agency RMBS and CMBS investments through short-term borrowings structured as repurchase agreements. The Company has secured commitments with a number of repurchase agreement counterparties. The Company has, in the past, contributed capital to the Invesco Mortgage Recovery Feeder Fund L.P. managed by the Company’s Manager (“Invesco IMRF Fund”) that received financing under the U.S. government’s Public Private Investment Program (“PPIP”). In March 2012, Invesco IMRF Fund returned substantially all of its proceeds and repaid all financing under the PPIP. The Company is awaiting final distribution from the Invesco IMRF Fund. In addition, the Company may use other sources of financing including committed borrowing facilities and other private financing.

The Company elected to be taxed as a real estate investment trust (“REIT”) for U.S. federal income tax purposes under the provisions of the Internal Revenue Code of 1986, as amended (“Code”), commencing with the Company’s taxable year ended December 31, 2009. To maintain the Company’s REIT qualification, the Company is generally required to distribute at least 90% of its taxable income to its shareholders annually.

Note 2 – Summary of Significant Accounting Policies

Basis of Quarterly Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X, promulgated by the Securities and Exchange Commission (the “SEC”). In the opinion of management, all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of the financial position and the results of operations of the Company for the interim periods presented have been included. Certain disclosures included in the Company’s annual report on Form 10-K are not required to be included on an interim basis in the company’s quarterly reports on Forms 10-Q. The Company has condensed or omitted these disclosures. The interim consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements and related notes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2011 which was filed with the SEC on February 29, 2012. The results of operations for the period ended June 30, 2012 are not necessarily indicative of the results to be expected for the full year or any other future period.

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and its subsidiaries. All intercompany balances and transactions have been eliminated.

 

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Use of Estimates

The accounting and reporting policies of the Company conform to U.S. GAAP. The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Examples of estimates include, but are not limited to, estimates of the fair values of financial instruments, interest income on mortgage-backed securities (“MBS”) and other-than-temporary impairment charges. Actual results may differ from those estimates.

Cash and Cash Equivalents

The Company considers all highly liquid investments that have original or remaining maturity dates of three months or less when purchased to be cash equivalents. At June 30, 2012, the Company had cash and cash equivalents, including amounts restricted, in excess of the FDIC deposit insurance limit of $250,000 per institution. The Company mitigates its risk of loss by actively monitoring the counterparties.

Restricted Cash

Restricted cash represents the Company’s cash held by its counterparties as collateral against the Company’s swaps and repurchase agreements. Restricted cash is not available for general corporate purposes but may be applied against amounts due to counterparties under the Company’s swap and repurchase agreements, or returned to the Company when the collateral requirements are exceeded or at the maturity of the swap or repurchase agreement.

Underwriting Commissions and Offering Costs

Underwriting commissions and direct costs incurred in connection with the Company’s initial public offering (“IPO”) and subsequent stock offerings are reflected as a reduction of additional paid-in-capital.

Repurchase Agreements

The Company finances its Agency RMBS, non-Agency RMBS and CMBS investment portfolio through the use of repurchase agreements. Repurchase agreements are treated as collateralized financing transactions and are carried at their contractual amounts, including accrued interest, as specified in the respective agreements.

In instances where the Company acquires Agency RMBS, non-Agency RMBS or CMBS through repurchase agreements with the same counterparty from whom such assets were purchased, the Company accounts for the purchase commitment and repurchase agreement on a net basis and records a forward commitment to purchase such assets as a derivative instrument if the transaction does not comply with the criteria for gross presentation. All of the following criteria must be met for gross presentation in the circumstance where the repurchase assets are financed with the same counterparty:

 

   

the initial transfer of and repurchase financing cannot be contractually contingent;

 

   

the repurchase financing entered into between the parties provides full recourse to the transferee and the repurchase price is fixed;

 

   

the financial asset has an active market and the transfer is executed at market rates; and

 

   

the repurchase agreement and financial asset do not mature simultaneously.

If the transaction complies with the criteria for gross presentation, the Company records the assets and the related financing on a gross basis on its balance sheet, and the corresponding interest income and interest expense in its statements of operations. Such forward commitments are recorded at fair value with subsequent changes in fair value recognized in income. Additionally, the Company records the cash portion of its investment in Agency RMBS and non-Agency RMBS as a mortgage related receivable from the counterparty on its balance sheet.

 

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Fair Value Measurements

In May 2011, the FASB issued Accounting Standards Update 2011-04, “Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRS” (ASU 2011-04). The guidance clarifies the Board’s intent about the application of existing fair value measurement requirements, and changes to a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements. The company adopted these provisions for the period ended March 31, 2012.

The adoption of this provision only affected the disclosure requirements for fair value measurements and as a result had no impact on the Company’s consolidated statements of operations and consolidated balance sheets.

The Company discloses the fair value of its financial instruments according to a fair value hierarchy (Levels 1, 2, and 3, as defined). In accordance with U.S. GAAP, the Company is required to provide enhanced disclosures regarding instruments in the Level 3 category (which require significant management judgment), including a separate reconciliation of the beginning and ending balances for each major category of assets and liabilities.

Additionally, U.S. GAAP permits entities to choose to measure many financial instruments and certain other items at fair value (the “fair value option”). Unrealized gains and losses on items for which the fair value option has been elected are irrevocably recognized in earnings at each subsequent reporting date.

The Company elected the fair value option for its investments in unconsolidated ventures. The Company has the one-time option to elect fair value for these financial assets on the election date. The changes in the fair value of these instruments are recorded in equity in earnings and fair value change in unconsolidated ventures in the consolidated statements of operations.

For assets representing available-for-sale investment securities any change in fair value is reported through consolidated other comprehensive income (loss) with the exception of impairment losses, which are recorded in the consolidated statement of operations.

Securities

The Company designates securities as held-to-maturity, available-for-sale, or trading depending on its ability and intent to hold such securities to maturity. Trading and securities available-for-sale are reported at fair value, while securities held-to-maturity are reported at amortized cost. Although the Company generally intends to hold most of its RMBS and CMBS until maturity, the Company may, from time to time, sell any of its RMBS or CMBS as part of its overall management of its investment portfolio and classifies its RMBS and CMBS as available-for-sale securities.

All securities classified as available-for-sale are reported at fair value, based on market prices from third-party sources, with unrealized gains and losses excluded from earnings and reported as a separate component of shareholders’ equity. When applicable, included with available-for-sale securities are forward purchase commitments on to-be-announced securities (“TBA”). The Company records TBA purchases on the trade date and the corresponding payable is recorded as an outstanding liability as a payable for investments purchased until the settlement date of the transaction. This payable is presented in the “Investment related payable” line item on the consolidated balance sheet.

The Company evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market conditions warrant such evaluation. The determination of whether a security is other-than-temporarily impaired involves judgments and assumptions based on subjective and objective factors. Consideration is given to (i) the length of time and the extent to which the fair value has been less than cost, (ii) the financial condition and near-term prospects of recovery in fair value of the security, and (iii) the Company’s intent and ability to retain its investment in the security for a period of time sufficient to allow for any anticipated recovery in fair value.

 

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For debt securities, the amount of the other-than-temporary impairment related to a credit loss or impairments on securities that the Company has the intent or for which it is more likely than not that the Company will need to sell before recovery are recognized in earnings and reflected as a reduction in the cost basis of the security. The amount of the other-than-temporary impairment on debt securities related to other factors is recorded consistent with changes in the fair value of all other available-for-sale securities as a component of consolidated shareholders’ equity in other comprehensive income or loss with no change to the cost basis of the security.

Interest Income Recognition

Interest income on available-for-sale MBS, which includes accretion of discounts and amortization of premiums on such MBS, is recognized over the life of the investment using the effective interest method. Management estimates, at the time of purchase, the future expected cash flows and determines the effective interest rate based on these estimated cash flows and the Company’s purchase price. As needed, these estimated cash flows are updated and a revised yield is computed based on the current amortized cost of the investment. In estimating these cash flows, there are a number of assumptions subject to uncertainties and contingencies, including the rate and timing of principal payments (prepayments, repurchases, defaults and liquidations), the pass through or coupon rate and interest rate fluctuations. In addition, management must use its judgment to estimate interest payment shortfalls due to delinquencies on the underlying mortgage loans. These uncertainties and contingencies are difficult to predict and are subject to future events that may impact management’s estimates and its interest income. Security transactions are recorded on the trade date. Realized gains and losses from security transactions are determined based upon the specific identification method and recorded as gain (loss) on sale of available-for-sale securities in the consolidated statement of operations.

Investments in Unconsolidated Ventures

The Company has investments in unconsolidated ventures. In circumstances where the Company has a non-controlling interest but is deemed to be able to exert significant influence over the affairs of the enterprise, the Company utilizes the equity method of accounting. Under the equity method of accounting, the initial investment is increased each period for additional capital contributions and a proportionate share of the entity’s earnings and decreased for cash distributions and a proportionate share of the entity’s losses.

The Company elected the fair value option for its investments in unconsolidated ventures. The election was made upon initial recognition in the financial statements. The Company has elected the fair value option for the purpose of enhancing the transparency of its financial condition. The Company measures the fair value on the basis of the net asset value per share of the investments.

Dividends and Distributions Payable

Dividends and distributions payable represent dividends declared at the balance sheet date which are payable to common shareholders and distributions declared at the balance sheet date which are payable to non-controlling interest common unit holders of the Operating Partnership, respectively.

Earnings per Share

The Company calculates basic earnings per share by dividing net income for the period by weighted-average shares of the Company’s common stock outstanding for that period. Diluted earnings per share takes into account the effect of dilutive instruments, such as units of limited partnership interest in the Operating Partnership (“OP Units”), and unvested restricted stock, but use the average share price for the period in determining the number of incremental shares that are to be added to the weighted-average number of shares outstanding.

 

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Comprehensive Income (Loss)

Comprehensive income (loss) is comprised of net income, as presented in the consolidated statements of operations, adjusted for changes in unrealized gains or losses on available for sale securities and changes in the fair value of derivatives accounted for as cash flow hedges.

Accounting for Derivative Financial Instruments

U.S. GAAP provides disclosure requirements for derivatives and hedging activities with the intent to provide users of financial statements with an enhanced understanding of: (i) how and why an entity uses derivative instruments; (ii) how derivative instruments and related hedged items are accounted for; and (iii) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. U.S. GAAP requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about the fair value of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative instruments.

The Company records all derivatives on the balance sheet at fair value. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether the Company has elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives designated and qualifying as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Derivatives may also be designated as hedges of the foreign currency exposure of a net investment in a foreign operation. Hedge accounting generally provides for the matching of the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk in a fair value hedge or the earnings effect of the hedged forecasted transactions in a cash flow hedge. The Company may enter into derivative contracts, such as credit default swaps, that are intended to economically hedge certain of its risk, even though hedge accounting does not apply or the Company elects not to apply hedge accounting under U.S. GAAP.

Income Taxes

The Company elected to be taxed as a REIT, commencing with the Company’s taxable year ended December 31, 2009. Accordingly, the Company will generally not be subject to U.S. federal and applicable state and local corporate income tax to the extent that the Company makes qualifying distributions to its shareholders, and provided the Company satisfies on a continuing basis, through actual investment and operating results, the REIT requirements including certain asset, income, distribution and stock ownership tests. If the Company fails to qualify as a REIT, and does not qualify for certain statutory relief provisions, it will be subject to U.S. federal, state and local income taxes and may be precluded from qualifying as a REIT for the subsequent four taxable years following the year in which the Company lost its REIT qualification. Accordingly, the Company’s failure to qualify as a REIT could have a material adverse impact on its results of operations and amounts available for distribution to its shareholders.

A REIT’s dividend paid deduction for qualifying dividends to the Company’s shareholders is computed using its taxable income as opposed to net income reported on the consolidated financial statements. Taxable income, generally, will differ from net income because the determination of taxable income is based on tax regulations and not financial accounting principles.

The Company may elect to treat certain of its future subsidiaries as taxable REIT subsidiaries (“TRS”). In general, a TRS may hold assets and engage in activities that the Company cannot hold or engage in directly and generally may engage in any real estate or non-real estate-related business. A TRS is subject to U.S. federal, state and local corporate income taxes.

While a TRS will generate net income, a TRS can declare dividends to the Company which will be included in its taxable income and necessitate a distribution to its shareholders. Conversely, if the Company retains

 

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earnings at a TRS level, no distribution is required and the Company can increase book equity of the consolidated entity. The Company has no adjustments regarding its tax accounting treatment of any uncertainties. The Company expects to recognize interest and penalties related to uncertain tax positions, if any, as income tax expense, which will be included in general and administrative expense.

Share-Based Compensation

The Company has adopted an equity incentive plan under which its independent directors, as part of their compensation for serving as directors, are eligible to receive quarterly restricted stock awards. In addition, the Company may compensate the officers and employees of the Manager and its affiliates under this plan pursuant to the management agreement.

Share-based compensation arrangements include share options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. Compensation costs relating to share-based payment transactions are recognized in the consolidated financial statements, based on the fair value of the equity or liability instruments issued on the date of grant, for awards to the Company’s independent directors. Compensation related to stock awards to officers and employees of the Manager and its affiliates are recorded at the estimated fair value of the award during the vesting period. The Company makes an upward or downward adjustment to compensation expense for the difference in the fair value at the date of grant and the date the award was earned.

Dividend Reinvestment Plan

The Company has implemented a dividend reinvestment and stock purchase plan (the “DRSPP”). Under the terms of the Plan, shareholders who participate in the Plan may purchase shares of common stock directly from the Company. Plan participants may also automatically reinvest all or a portion of their dividends for additional shares of stock.

Recent Accounting Pronouncements Not Yet Adopted

In December 2011, the FASB issued Accounting Standards Updated 2011-11, “Disclosures about Offsetting Assets and Liabilities” (ASU 2011-11). ASU 2011-11 amends Topic 210 to require additional disclosure information about offsetting and related arrangements. Entities will be 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 transaction subject to an agreement similar to a master netting arrangement. This scope would include derivatives, sale and repurchase agreements and reverse sale and repurchase agreements. The objective of this disclosure is to facilitate comparison between those entities that prepare their financial statements on a basis of US GAAP and those entities that prepare their financial statements on the basis of International Financial Reporting Standards (IFRS). The guidance is effective for periods beginning on or after January 1, 2013, and interim periods within those annual periods. The Company does not believe that the adoption of the amended guidance will have a significant effect on its consolidated financial statements.

 

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Note 3 – Mortgage-Backed Securities

All of the Company’s MBS are classified as available-for-sale and, as such, are reported at fair value, which is determined by obtaining valuations from an independent source. If the fair value of a security is not available from a dealer or third-party pricing service, or such data appears unreliable, the Company may estimate the fair value of the security using a variety of methods including other pricing services, repurchase agreement pricing, discounted cash flow analysis, matrix pricing, option adjusted spread models and other fundamental analysis of observable market factors. At June 30, 2012 and December 31, 2011, all of the Company’s MBS values were based on values obtained from third-party pricing services. The following tables present certain information about the Company’s investment portfolio at June 30, 2012 and December 31, 2011:

 

June 30, 2012                                                
$ in thousands   Principal
Balance
    Unamortized
Premium
(Discount)
    Amortized
Cost
    Unrealized
Gain/
(Loss), net
    Fair
Value
    Net
Weighted
Average
Coupon(1)
    Period-end
Weighted
Average
Yield(2)
    Quarterly
Weighted
Average
Yield(3)
 

Agency RMBS:

               

15 year fixed-rate

    2,197,081       116,495       2,313,576       58,562       2,372,138       4.12     2.73     2.60

30 year fixed-rate

    7,556,547       498,390       8,054,937       200,333       8,255,270       4.65     3.39     3.16

ARM

    164,436       4,413       168,849       3,747       172,596       3.21     2.65     2.66

Hybrid ARM

    1,142,784       29,897       1,172,681       27,952       1,200,633       3.26     2.53     2.73
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

       

Total Agency pass-through

    11,060,848       649,195       11,710,043       290,594       12,000,637       4.38     3.16     2.99
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

       

Agency-CMO(4)

    1,185,974       (732,664     453,310       1,769       455,079       2.91     3.18     2.50

Non-Agency RMBS(5)

    2,545,321       (241,461     2,303,860       (53,259     2,250,601       4.33     4.97     5.37

CMBS

    1,328,757       (14,565     1,314,192       29,165       1,343,357       5.48     5.58     5.32
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

       

Total

    16,120,900       (339,495     15,781,405       268,269       16,049,674       4.31     3.58     3.51
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

       

  

 

(1)

Net weighted average coupon as of June 30, 2012 (“WAC”) is presented net of servicing and other fees.

(2)

Average yield as of June 30, 2012 incorporates future prepayment and loss assumptions.

(3)

Average yield for the three months ended June 30, 2012 incorporates future prepayment and loss assumptions.

(4)

The Agency-CMO held by the Company is 14.5% interest only securities.

(5)

The non-Agency RMBS held by the Company is 84.5% variable rate, 10.3% fixed rate, and 5.2% floating rate based on fair value.

 

December 31, 2011                                                
$ in thousands   Principal
Balance
    Unamortized
Premium
(Discount)
    Amortized
Cost
    Unrealized
Gain/
(Loss), net
    Fair
Value
    Net
Weighted
Average
Coupon  (1)
    Period-end
Weighted
Average
Yield (2)
    Quarterly
Weighted
Average
Yield (3)
 

Agency RMBS:

               

15 year fixed-rate

    2,289,495       123,610       2,413,105       36,454       2,449,559       4.18     2.85     2.72

30 year fixed-rate

    6,055,045       410,257       6,465,302       116,309       6,581,611       4.95     3.66     3.46

ARM

    113,413       2,398       115,811       2,065       117,876       3.40     3.07     2.84

Hybrid ARM

    1,321,339       30,516       1,351,855       22,630       1,374,485       3.29     2.59     2.46
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

       

Total Agency pass-through

    9,779,292       566,781       10,346,073       177,458       10,523,531       4.53     3.33     3.15
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

       

Agency-CMO(4)

    765,172       (592,342     172,830       (4,368     168,462       2.86     3.52     1.39

Non-Agency RMBS(5)

    2,719,797       (252,135     2,467,662       (108,434     2,359,228       4.57     5.07     6.31

CMBS

    1,250,607       (21,805     1,228,802       (65,874     1,162,928       5.38     5.60     6.05
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

       

Total

    14,514,868       (299,501     14,215,367       (1,218     14,214,149       4.52     3.83     3.94
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

       

  

 

(1)

Net weighted average coupon as of December 31, 2011 (“WAC”) is presented net of servicing and other fees.

(2)

Average yield as of December 31, 2011 incorporates future prepayment and loss assumptions.

(3)

Average yield for the three months ended December 31, 2011 incorporates future prepayment and loss assumptions.

(4)

The Agency-CMO held by the Company is 28.3% interest only securities.

(5) The non-Agency RMBS held by the Company is 85.0% variable rate, 9.8% fixed rate, and 5.2% floating rate based on fair value.

The following table summarizes our non-Agency RMBS portfolio by asset type as of June 30, 2012 and December 31, 2011, respectively:

 

$ in thousands    June 30, 2012      % of Non-Agency     December 31, 2011      % of Non-Agency  

Re-REMIC Senior

     1,506,263        66.9     1,634,376        69.3

Prime

     489,143        21.7     482,113        20.4

Alt-A

     246,328        11.0     231,936        9.8

Subprime

     8,867        0.4     10,803        0.5
  

 

 

    

 

 

   

 

 

    

 

 

 

Total Non-Agency

     2,250,601        100.0     2,359,228        100.0
  

 

 

    

 

 

   

 

 

    

 

 

 

 

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The following table summarizes certain characteristics of our senior Re-REMIC Holdings as of June 30, 2012 and December 31, 2011:

 

     Percentage of Re-REMIC Holding at Fair Value  

Re-REMIC Subordination (1)

   June 30, 2012     December 31, 2011  

10-20

     3.1     3.0

20-30

     15.2     15.3

30-40

     20.9     19.3

40-50

     46.8     48.1

50-60

     8.4     8.3

60-70

     5.6     6.0
  

 

 

   

 

 

 

Total

     100.0     100.0
  

 

 

   

 

 

 

 

(1) Subordination refers to the credit enhancement provided to the senior Re-REMIC tranche by the junior Re-REMIC tranche or tranches in a resecuritization. This figure reflects the percentage of the balance of the underlying security represented by the junior tranche at the time of resecuritization. Generally, principal losses on the underlying security in excess of the subordination amount would result in principal losses on the senior Re-REMIC tranche.

The components of the carrying value of the Company’s investment portfolio at June 30, 2012 and December 31, 2011 are presented below:

 

$ in thousands    June 30, 2012     December 31, 2011  

Principal balance

     16,120,900       14,514,868  

Unamortized premium

     673,000       587,430  

Unamortized discount

     (1,012,495     (886,931

Gross unrealized gains

     366,050       203,965  

Gross unrealized losses

     (97,781     (205,183
  

 

 

   

 

 

 

Fair value

     16,049,674       14,214,149  
  

 

 

   

 

 

 

The following table summarizes certain characteristics of the Company’s investment portfolio, at fair value, according to estimated weighted average life classifications as of June 30, 2012 and December 31, 2011:

 

$ in thousands    June 30, 2012      December 31, 2011  

Less than one year

     73,053        68,217  

Greater than one year and less than five years

     13,204,349        12,150,472  

Greater than or equal to five years

     2,772,272        1,995,460  
  

 

 

    

 

 

 

Total

     16,049,674        14,214,149  
  

 

 

    

 

 

 

The following tables present the gross unrealized losses and estimated fair value of the Company’s MBS by length of time that such securities have been in a continuous unrealized loss position at June 30, 2012 and December 31, 2011, respectively:

 

June 30, 2012    Less than 12 Months     12 Months or More     Total  
$ in thousands    Fair Value      Unrealized
Losses
    Fair Value      Unrealized
Losses
    Fair Value      Unrealized
Losses
 

Agency RMBS:

               

15 year fixed-rate

     17,162        (144     —           —          17,162        (144

30 year fixed-rate

     271,918        (1,094     —           —          271,918        (1,094

ARM

     —           —          —           —          —           —     

Hybrid ARM

     —           —          —           —          —           —     
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total Agency pass-through

     289,080        (1,238     —           —          289,080        (1,238
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Agency-CMO

     34,111        (7,428     1,540        (526     35,651        (7,954

Non-Agency RMBS

     1,172,950        (25,061     415,793        (44,241     1,588,743        (69,302

CMBS

     181,764        (6,357     162,331        (12,930     344,095        (19,287
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total

     1,677,905        (40,084     579,664        (57,697     2,257,569        (97,781
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

 

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December 31, 2011    Less than 12 Months     12 Months or More     Total  
$ in thousands    Fair Value      Unrealized
Losses
    Fair Value      Unrealized
Losses
    Fair Value      Unrealized
Losses
 

Agency RMBS:

               

15 year fixed-rate

     149,092        (754     —           —          149,092        (754

30 year fixed-rate

     844,272        (5,563     —           —          844,272        (5,563

ARM

     25,508        (179     13,062        (52     38,570        (231

Hybrid ARM

     24,929        (73     —           —          24,929        (73
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total Agency pass-through

     1,043,801        (6,569     13,062        (52     1,056,863        (6,621
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Agency-CMO

     50,084        (8,362     —           —          50,084        (8,362

Non-Agency RMBS

     1,981,046        (104,813     46,193        (11,622     2,027,239        (116,435

CMBS

     796,965        (73,765     —           —          796,965        (73,765
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Total

     3,871,896        (193,509     59,255        (11,674     3,931,151        (205,183
  

 

 

    

 

 

   

 

 

    

 

 

   

 

 

    

 

 

 

Gross unrealized losses on the Company’s Agency RMBS were $1.2 million at June 30, 2012. Due to the inherent credit quality of Agency RMBS, the Company determined that at June 30, 2012, any unrealized losses on its Agency RMBS portfolio are temporary.

Gross unrealized losses on the Company’s Agency-CMO, non-Agency RMBS, and CMBS were $96.5 million at June 30, 2012. The Company does not consider these unrealized losses to be credit related, but rather due to non-credit related factors such as interest rate spreads, prepayment speeds, and market fluctuations. These investment securities are included in the Company’s assessment for other-than-temporary impairment on at least a quarterly basis.

The following table presents the impact of the Company’s MBS on its accumulated other comprehensive income for the three and six months ended June 30, 2012 and 2011:

 

$ in thousands    Three Months
ended
June 30, 2012
     Three Months
ended
June 30, 2011
    Six Months
ended
June 30, 2012
    Six Months
ended
June 30, 2011
 

Accumulated other comprehensive income from investment securities:

         

Unrealized gain on MBS at beginning of period

     207,856        41,216       (1,217     31,267  

Unrealized gain (loss) on MBS, net

     60,413        (9,106     269,486       843  
  

 

 

    

 

 

   

 

 

   

 

 

 

Balance at the end of period

     268,269        32,110       268,269       32,110  
  

 

 

    

 

 

   

 

 

   

 

 

 

During the three months ended June 30, 2012, the Company reclassified $1.1 million of net unrealized loss from other comprehensive income into loss on sale of investments as a result of the Company selling certain investments.

During the six months ended June 30, 2012, the Company reclassified $11.6 million of net unrealized gains from other comprehensive income into gain on sale of investments as a result of the Company selling certain investments.

The Company assesses its investment securities for other-than-temporary impairment on at least a quarterly basis. When the fair value of an investment is less than its amortized cost at the balance sheet date of the reporting period for which impairment is assessed, the impairment is designated as either “temporary” or “other-than-temporary.” In deciding on whether or not a security is other than temporarily impaired, the Company considers several factors, including the nature of the investment, communications from the trustees of securitizations regarding the credit quality of the security, the severity and duration of the impairment, the cause of the impairment, and the Company’s intent that it is more likely than not that the Company can hold the security until recovery of its cost basis.

 

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The Company did not have other than temporary impairments for the three and six months ended June 30, 2012 and 2011.

The following table presents a roll-forward of the credit loss component of other-than-temporary impairments for the three and six months ended June 30, 2012 and 2011:

 

$ in thousands    Three Months
ended
June 30, 2012
     Three Months
ended
June 30, 2011
     Six Months
ended
June 30, 2012
     Six Months
ended
June 30, 2011
 

Cumulative credit loss amount at the beginning of the period

     —           510        —           510  

Additions for credit losses for which other-than-temporary impairment had not been previously recognized

     —           —           —           —     

Reductions for securities sold

     —           —           —           —     
  

 

 

    

 

 

    

 

 

    

 

 

 

Cumulative credit loss amount at end of period

     —           510        —           510  
  

 

 

    

 

 

    

 

 

    

 

 

 

The following table presents components of interest income on the Company’s MBS portfolio for the three and six months ended June 30, 2012 and 2011:

 

For the three months ended June 30, 2012

   Coupon
Interest
    Net (Premium
Amortization)/Discount
Accretion
    Interest
Income
 
$ in thousands       

Agency

     127,392       (35,741     91,651  

Non-Agency

     25,143       5,126       30,269  

CMBS

     17,005       100       17,105  

Other

     (21     —          (21
  

 

 

   

 

 

   

 

 

 

Total

     169,519       (30,515     139,004  
  

 

 

   

 

 

   

 

 

 

For the six months ended June 30, 2012

   Coupon
Interest
    Net (Premium
Amortization)/Discount
Accretion
    Interest
Income
 
$ in thousands       

Agency

     249,706       (67,238     182,468  

Non-Agency

     53,426       11,054       64,480  

CMBS

     33,816       268       34,084  

Other

     (68     —          (68
  

 

 

   

 

 

   

 

 

 

Total

     336,880       (55,916     280,964  
  

 

 

   

 

 

   

 

 

 

For the three months ended June 30, 2011

   Coupon
Interest
    Net (Premium
Amortization)/Discount
Accretion
    Interest
Income
 
$ in thousands       

Agency

     78,954       (15,907     63,047  

Non-Agency

     25,455       9,967       35,422  

CMBS

     10,569       (35     10,534  

Other

     (22     —          (22
  

 

 

   

 

 

   

 

 

 

Total

     114,956       (5,975     108,981  
  

 

 

   

 

 

   

 

 

 

For the six months ended June 30, 2011

   Coupon
Interest
    Net (Premium
Amortization)/Discount
Accretion
    Interest
Income
 
$ in thousands       

Agency

     130,312       (30,129     100,183  

Non-Agency

     40,958       18,933       59,891  

CMBS

     17,377       47       17,424  

Other

     19       —          19  
  

 

 

   

 

 

   

 

 

 

Total

     188,666       (11,149     177,517  
  

 

 

   

 

 

   

 

 

 

 

15


Table of Contents

Note 4 – Investments in Unconsolidated Ventures

Invesco Mortgage Recovery Feeder Fund, L.P. and Invesco Mortgage Recovery Loans AIV, L.P.

The Company invested in certain non-Agency RMBS, CMBS and residential and commercial mortgage loans by contributing equity capital to the Invesco IMRF Fund that received financing under the PPIP. In March 2012, Invesco IMRF Fund returned substantially all of its proceeds and repaid all financing under the PPIP. The Company is awaiting final distribution from the Invesco IMRF Fund. In addition, the Manager identified a whole loan transaction for the Company, which resulted in the Company’s admission into an alternative investment vehicle, the Invesco Mortgage Recovery Loans AIV, L.P. (“AIV”). The Company’s initial commitment in the Invesco IMRF Fund and AIV was $25.0 million. During 2009 and 2010, the Invesco IMRF Fund and AIV accepted additional subscriptions and the Company increased its overall commitment to $100.0 million which effectively increased the Company’s initial ownership interest in the Invesco IMRF Fund and AIV. As of March 31, 2010, the Invesco IMRF Fund stopped accepting investment subscriptions and was deemed closed. The Company made its first contributions to the Invesco IMRF Fund in October 2009. The Company is committed to fund $17.1 million in aggregate of additional capital at June 30, 2012 for the Invesco IMRF Fund and AIV. The Company realized approximately $357,000 (2011: $3.5 million) and $709,000 (2011: $5.6 million) of equity in earnings for the three and six months ended June 30, 2012 related to these investments. The Company also realized $1.1 million (2011: $1.6 million loss) and $1.2 million (2011: $1.9 million loss) of unrealized gain from these investments for the three and six months ended June 30, 2012.

The Company’s non-controlling, unconsolidated ownership interests in these entities are accounted for under the equity method. Capital contributions, distributions, profits and losses of the Invesco IMRF Fund and AIV are allocated in accordance with the terms of the entities’ limited partnership agreements. Such allocations may differ from the stated percentage interests, if any, as a result of preferred returns and allocation formulas as described in such agreements. The Company has made the fair value election for its investments in both unconsolidated ventures. The fair value measurement for the investment in unconsolidated ventures is based on the net asset value per share of the investment, or its equivalent.

IMRF Loan Portfolio Member LLC

On September 30, 2011, the Company invested in a portfolio of commercial mortgage loans by contributing $16.9 million, net of distributions, of equity capital to IMRF Loan Portfolio Member LLC (“IMRF LLC”) a limited liability company managed by AIV. IMRF LLC acquired the mortgage portfolio on the same day. The Company has fully funded its commitment to IMRF LLC. The Company realized approximately $362,000 and $716,000 of equity in earnings and $155,000 and $307,000 of unrealized appreciation from these investments for the three and six months ended June 30, 2012, respectively.

The Company’s non-controlling, unconsolidated ownership interest in IMRF LLC is accounted for under the equity method. Capital contributions, distributions, profits and losses of IMRF LLC are allocated in accordance with the terms of the entity’s operating agreement. Such allocations may differ from the stated percentage interests, if any, as a result of preferred returns and allocation formulas as described in the agreement. The Company has made the fair value election for its investment in IMRF LLC. The fair value measurement for the investment in unconsolidated limited liability companies is based on the net asset value per share of the investment, or its equivalent.

 

16


Table of Contents

Note 5 – Borrowings

Repurchase Agreements

The Company has entered into repurchase agreements to finance the majority of its portfolio of investments. The repurchase agreements bear interest at a contractually agreed rate. The repurchase obligations mature and typically reinvest every thirty days to one year and have a weighted average aggregate interest rate of 0.65% and 0.68% at June 30, 2012 and December 31, 2011, respectively. Repurchase agreements are being accounted for as secured borrowings since the Company maintains effective control of the financed assets. The following table summarizes certain characteristics of the Company’s repurchase agreements at June 30, 2012 and December 31, 2011:

 

$ in thousands    June 30, 2012      December 31, 2011  
     Amount
Outstanding
     Weighted
Average
Interest
Rate
    Weighted
Average
Remaining
Maturity
(Days)
     Amount
Outstanding
     Weighted
Average
Interest
Rate
    Weighted
Average
Remaining
Maturity
(Days)
 

Agency RMBS

     10,927,821        0.40     19        9,491,538        0.38     22  

Non-Agency RMBS

     1,673,271        1.76     34        1,916,620        1.79     22  

CMBS

     940,233        1.55     20        844,880        1.55     22  
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Total

     13,541,325        0.65     21        12,253,038        0.68     22  
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Under the repurchase agreements, the respective lender retains the right to mark the underlying collateral to fair value. A reduction in the value of pledged assets would require the Company to provide additional collateral or fund margin calls. In addition, the repurchase agreements are subject to certain financial covenants. The Company is in compliance with these covenants at June 30, 2012.

The following tables summarize certain characteristics of the Company’s repurchase agreements at June 30, 2012 and December 31, 2011:

 

June 30, 2012

$ in thousands

Repurchase Agreement Counterparties

   Amount
Outstanding
     Percent of Total
Amount
Outstanding
    Company MBS
Held as Collateral
 

Credit Suisse Securities (USA) LLC

     1,285,857        9.5     1,555,579  

Nomura Securities International, Inc.

     1,278,874        9.5     1,379,726  

JP Morgan Securities Inc.

     1,030,912        7.6     1,157,209  

HSBC Securities (USA) Inc

     1,004,949        7.4     1,044,012  

Industrial and Commercial Bank of China Financial Services LLC

     867,987        6.4     929,521  

Mitsubishi UFJ Securities (USA), Inc.

     791,821        5.9     841,208  

ING Financial Market LLC

     775,060        5.7     837,789  

CitiGroup Global Markets Inc.

     723,430        5.3     784,132  

South Street Securities LLC

     717,474        5.3     752,680  

Goldman, Sachs & Co.

     679,170        5.0     740,641  

Morgan Stanley & Co. Incorporated

     626,649        4.6     723,289  

Banc of America Securities LLC

     567,231        4.2     620,219  

RBS Securities Inc.

     546,388        4.0     619,897  

Deutsche Bank Securities Inc.

     495,650        3.7     553,283  

Royal Bank of Canada

     486,051        3.6     560,293  

Wells Fargo Securities, LLC

     409,413        3.0     497,868  

BNP Paribas Securities Corp.

     316,415        2.3     343,380  

Gleacher and Company Securities Inc

     212,493        1.6     226,844  

TD Securities

     193,716        1.4     203,405  

Mizuho Securities USA Inc.

     172,243        1.3     194,569  

Guggenheim Liquidity Services, LLC

     129,348        1.0     137,296  

Daiwa Capital Markets America Inc

     96,281        0.7     101,349  

Barclays Capital Inc.

     94,279        0.7     99,330  

Cantor Fitzgerald & Co.

     39,634        0.3     42,181  
  

 

 

    

 

 

   

 

 

 

Total

     13,541,325        100.0     14,945,700  
  

 

 

    

 

 

   

 

 

 

 

December 31, 2011

$ in thousands

Repurchase Agreement Counterparties

   Amount
Outstanding
     Percent of Total
Amount
Outstanding
    Company MBS
Held as Collateral
 

Credit Suisse Securities (USA) LLC

     2,419,546        19.8     2,738,101  

Nomura Securities International, Inc.

     1,069,235        8.7     1,152,957  

Mitsubishi UFJ Securities (USA), Inc.

     925,863        7.6     979,907  

Industrial and Commercial Bank of China Financial Services LLC

     848,919        6.9     895,760  

South Street Securities LLC

     772,637        6.3     818,513  

JP Morgan Securities Inc.

     663,879        5.4     764,972  

Morgan Stanley & Co. Incorporated

     645,570        5.3     710,729  

Goldman, Sachs & Co.

     606,922        5.0     649,514  

RBS Securities Inc.

     593,051        4.8     671,073  

ING Financial Market LLC

     537,122        4.4     568,813  

Deutsche Bank Securities Inc.

     531,302        4.3     579,659  

Banc of America Securities LLC

     455,954        3.7     521,888  

CitiGroup Global Markets Inc.

     447,280        3.7     476,511  

Royal Bank of Canada

     422,700        3.4     482,988  

Wells Fargo Securities, LLC

     389,803        3.2     479,926  

BNP Paribas Securities Corp.

     348,707        2.8     372,876  

Mizuho Securities USA Inc.

     186,997        1.5     206,594  

Guggenheim Liquidity Services, LLC

     139,744        1.1     147,786  

Daiwa Capital Markets America Inc

     106,121        0.9     113,695  

UBS Securities Inc.

     80,083        0.7     84,561  

Cantor Fitzgerald & Co.

     61,603        0.5     63,999  
  

 

 

    

 

 

   

 

 

 

Total

     12,253,038        100.0     13,480,822  
  

 

 

    

 

 

   

 

 

 

 

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Table of Contents

Company MBS held by counterparties as security for repurchase agreements was $14.9 billion and $13.5 billion at June 30, 2012 and December 31, 2011, respectively. This represents a collateral ratio (Company MBS Held as Collateral/Amount Outstanding) of 110% and 110% respectively.

Cash collateral held by the counterparties at June 30, 2012 and December 31, 2011 was $0 and $37.5 million, respectively. The cash collateral was replaced by Agency RMBS.

Note 6 – Derivatives and Hedging Activities

Risk Management Objective of Using Derivatives

The Company is exposed to certain risks arising from both its business operations and economic conditions. The Company principally manages its exposures to a wide variety of business and operational risks through management of its core business activities. The Company manages economic risks, including interest rate, liquidity, and credit risk primarily by managing the amount, sources, and duration of its investments, debt funding, and the use of derivative financial instruments. Specifically, the Company enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future known and uncertain cash amounts, the value of which are determined by interest rates. The Company’s derivative financial instruments are used to manage differences in the amount, timing, and duration of the Company’s known or expected cash receipts and its known or expected cash payments principally related to the Company’s investments and borrowings.

The Company also utilizes credit derivatives such as credit default swaps (“CDS”) to provide credit event protection based on a financial index or specific security in exchange for receiving a fixed-rate fee or premium over the term of the contract. These instruments enable the Company to synthetically assume the credit risk of a reference security, portfolio of securities or index of securities. The counterparty pays a premium to the Company and the Company agrees to make a payment to compensate the counterparty for losses upon the occurrence of a specified credit event.

Although contract-specific, credit events generally include bankruptcy, failure to pay, restructuring, obligation acceleration, obligation default, or repudiation/moratorium. Upon the occurrence of a defined credit event, the difference between the value of the reference obligation and the CDS’s notional amount is recorded as a realized loss in the statement of operations.

The Company’s only CDS contract was entered into on December 31, 2010. The Company sold protection against losses on a specific pool of non-Agency RMBS in the event they exceed a specified loss limit of 25% of the balance of the non-Agency RMBS on the trade date. The maximum exposure is the remaining unpaid principal balance of the underlying RMBS in excess of the specified loss threshold. In exchange, the Company is paid a stated fixed rate fee of 3%. The Company is required to post cash collateral as security for potential loss payments.

At June 30, 2012 and December 31, 2011, the open CDS sold by the Company is summarized as follows:

 

$ in thousand    June 30, 2012      December 31, 2011  

Fair value amount

     1,101        1,339  

Notional amount

     94,905        112,128  

Maximum potential amount of future undiscounted payments

     94,905        112,128  

Recourse provisions with third parties

     —           —     

Collateral held by counterparty

     14,696        17,324  

 

18


Table of Contents

The Company purchased an interest rate swaption to help mitigate the potential impact of increases or decreases in interest rates on the performance of a portion of the Company’s investment portfolio. The interest rate swaption provides the Company the option to enter into an interest rate swap agreement for a predetermined notional amount, stated term and pay and receive interest rates in the future. The premium paid for interest rate swaptions is reported as an asset in the Company’s consolidated balance sheets. The premium is valued at an amount equal to the fair value of the swaption that would have the effect of closing the position adjusted for nonperformance risk, if any. The difference between the premium and the fair value of the swaption is reported in unrealized gain (loss) on interest rate swaps and swaptions, net in the Company’s consolidated statement of operations. If a swaption expires unexercised, the loss on the swaption would be equal to the premium paid. If we sell or exercise a swaption, the realized gain or loss on the swaption would be equal to the difference between the cash or the fair value of the underlying interest rate swap received and the premium paid. As of June 30, 2012, we had one swaption with an original cost of $2.1 million. The option expires in April 2013. The swaption covers $200 million notional value at a fixed pay rate of 1.85% for a term of five years.

Cash Flow Hedges of Interest Rate Risk

The Company finances its activities primarily through repurchase agreements, which are generally settled on a short-term basis, usually from one to twelve months. At each settlement date, the Company refinances each repurchase agreement at the market interest rate at that time. Since the interest rate on its repurchase agreements change on a one to twelve month basis, the Company is exposed to changing interest rates. The Company’s objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps as part of its interest rate risk management strategy. Interest rate swaps, designated as cash flow hedges, involve the receipt of variable-rate amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount.

During the three months ended June 30, 2012, the Company recorded $3,000 (2011: $197,000) of unrealized swap losses in earnings as hedge ineffectiveness attributable primarily to differences in the reset dates on the Company’s swaps versus the refinancing dates of certain of its repurchase agreements.

During the six months ended June 30, 2012, the Company recorded $513,000 (2011: $202,000) of unrealized swap losses in earnings as hedge ineffectiveness attributable primarily to differences in the reset dates on the Company’s swaps versus the refinancing dates of certain of its repurchase agreements.

Amounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest expense as interest is accrued and paid on the Company’s repurchase agreements. During the next twelve months, the Company estimates that an additional $135.5 million will be reclassified as an increase to interest expense.

The Company is hedging its exposure to the variability in future cash flows for forecasted transactions over a maximum period of 107 months.

As of June 30, 2012, the Company had the following interest rate derivatives outstanding, that were designated as cash flow hedges of interest rate risk:

 

$ in thousands

Counterparty

   Notional      Maturity Date      Fixed Interest Rate
in Contract
 

The Bank of New York Mellon

     175,000        8/5/2012         2.07

The Bank of New York Mellon

     100,000        5/24/2013         1.83

The Bank of New York Mellon

     200,000        6/15/2013         1.73

SunTrust Bank

     100,000        7/15/2014         2.79

Deutsche Bank AG

     200,000        1/15/2015         1.08

Deutsche Bank AG

     250,000        2/15/2015         1.14

Credit Suisse International

     100,000        2/24/2015         3.26

Credit Suisse International

     100,000        3/24/2015         2.76

Wells Fargo Bank, N.A.

     100,000        7/15/2015         2.85

Wells Fargo Bank, N.A.

     50,000        7/15/2015         2.44

Morgan Stanley Capital Services, Inc.

     300,000        1/24/2016         2.12

The Bank of New York Mellon

     300,000        1/24/2016         2.13

Morgan Stanley Capital Services, Inc.

     300,000        4/5/2016         2.48

Citibank, N.A.

     300,000        4/15/2016         1.67

The Bank of New York Mellon

     500,000        4/15/2016         2.24

Credit Suisse International

     500,000        4/15/2016         2.27

JPMorgan Chase Bank, N.A.

     500,000        5/16/2016         2.31

Goldman Sachs Bank USA

     500,000        5/24/2016         2.34

Wells Fargo Bank, N.A.

     250,000        6/15/2016         2.67

Goldman Sachs Bank USA

     250,000        6/15/2016         2.67

JPMorgan Chase Bank, N.A.

     500,000        6/24/2016         2.51

Citibank, N.A.

     500,000        10/15/2016         1.93

Deutsche Bank AG

     150,000        2/5/2018         2.90

Morgan Stanley Capital Services, Inc.

     100,000        4/5/2018         3.10

JPMorgan Chase Bank, N.A.

     200,000        5/15/2018         2.93

Wells Fargo Bank, N.A.

     200,000        3/15/2021         3.14

Citibank, N.A.

     200,000        5/25/2021         2.83
  

 

 

       

 

 

 

Total

     6,925,000           2.29
  

 

 

       

 

 

 

 

19


Table of Contents

At June 30, 2012, the Company’s counterparties held no cash margin deposits and $478.6 million in Agency RMBS as collateral against its swap contracts. Cash margin is classified as restricted cash and the Agency RMBS collateral is included in the total mortgage-backed securities on our consolidated balance sheet.

Tabular Disclosure of the Effect of Derivative Instruments on the Balance Sheet

The table below presents the fair value of the Company’s derivative financial instruments, as well as their classification on the balance sheet as of June 30, 2012 and December 31, 2011:

 

$ in thousands  
Asset Derivatives     Liability Derivatives  
As of June 30, 2012     As of December 31, 2011     As of June 30, 2012     As of December 31, 2011  
Balance
Sheet
  Fair Value     Balance
Sheet
  Fair Value     Balance
Sheet
  Fair Value     Balance
Sheet
  Fair Value  
Interest rate
swap asset
    —        Interest rate
swap asset
    —        Interest rate
swap liability
    446,569     Interest rate
swap liability
    396,780  
CDS     1,101     CDS     1,339          
Swaption     610     Swaption     —             

Tabular Disclosure of the Effect of Derivative Instruments on the Income Statement

The table below presents the effect of the Company’s derivative financial instruments on the statement of operations for the three and six months ended June 30, 2012 and 2011:

 

Three months ended June 30, 2012                          
$ in thousands                          

Derivative type for cash flow hedge

  Amount of loss recognized
in OCI on derivative
(effective portion)
    Location of loss
reclassified from
accumulated

OCI into
income
(effective
portion)
  Amount of loss
reclassified from
accumulated OCI into
income (effective
portion)
    Location of loss
recognized in
income  on
derivative
(ineffective
portion)
  Amount of loss
recognized in income
on derivative
(ineffective portion)
 

Interest Rate Swap

    102,233     Interest Expense     35,868     Other Expense     3  
Six months ended June 30, 2012                          
$ in thousands                          

Derivative type for cash flow hedge

  Amount of loss recognized
in OCI on derivative
(effective portion)
    Location of loss
reclassified from
accumulated

OCI into
income
(effective
portion)
  Amount of loss
reclassified from
accumulated OCI into
income (effective
portion)
    Location of loss
recognized in
income on
derivative
(ineffective
portion)
  Amount of loss
recognized in income
on derivative
(ineffective portion)
 

Interest Rate Swap

    120,564     Interest Expense     71,288     Other Expense     513  

 

20


Table of Contents
Three months ended June 30, 2011                               
$ in thousands                               

Derivative type for cash flow hedge

   Amount of loss recognized
in OCI on derivative
(effective portion)
     Location of loss
reclassified from
accumulated
OCI into

income
(effective
portion)
   Amount of loss
reclassified from
accumulated OCI into
income  (effective
portion)
     Location of loss
recognized in
income  on
derivative
(ineffective
portion)
   Amount of loss
recognized in income
on derivative
(ineffective portion
 

Interest Rate Swap

     170,915      Interest Expense      23,829      Other Expense      197  
Six months ended June 30, 2011   
$ in thousands                               

Derivative type for cash flow hedge

   Amount of loss recognized
in OCI on derivative
(effective portion)
     Location of loss
reclassified from
accumulated

OCI into
income
(effective
portion)
   Amount of loss
reclassified from
accumulated OCI into
income  (effective
portion)
     Location of loss
recognized  in

income on
derivative
(ineffective
portion)
   Amount of loss
recognized in income
on derivative
(ineffective portion
 

Interest Rate Swap

     149,041      Interest Expense      32,156      Other Expense      202  

 

          Amount of gain (loss) recognized in income on  derivative  

Derivative not designated as hedging
instrument

  

Location of unrealized gain
recognized in income

on derivative

   Three months
ended June 30, 2012
    Three months
ended June 30, 2011
 

CDS Contract

   Realized and unrealized credit default swap income      (69     240  

Swaption Contact

   Unrealized loss on interest rate swaps and swaptions      (1,530     —     
          Amount of gain recognized in income on derivative  

Derivative not designated as hedging
instrument

  

Location of gain

recognized in income

on derivative

   Six months ended
June 30, 2012
    Six months ended
June 30, 2011
 

CDS Contract

   Realized and unrealized credit default swap income      (238     1,685  

Swaption Contract

   Unrealized loss on interest rate swaps and swaptions      (1,530     —     

Credit-risk-related Contingent Features

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

The Company’s agreement with certain of its derivative counterparties provides that if the Company’s net asset value declines by certain percentages over specified time periods, then the Company could be declared in default on its derivative obligations with that counterparty. The Company’s agreement with certain of its derivative counterparties provides that if the Company’s shareholders’ equity declines by certain percentages over specified time periods, then the Company could be declared in default on its derivative obligations with that counterparty.

The Company’s agreement with certain of its derivative counterparties provides that if the Company fails to maintain a minimum shareholders’ equity or market value of $100 million and $80 million, respectively, then the Company could be declared in default on its derivative obligations with that counterparty.

As of June 30, 2012, the fair value of derivatives in a net liability position, which includes accrued interest but excludes any adjustment for non-performance risk, related to these agreements was $451.5 million. The Company has minimum collateral posting thresholds with certain of its derivative counterparties and has posted collateral of $478.6 million of Agency RMBS. If the Company had breached any of these provisions at June 30, 2012, it could have been required to settle its obligations under the agreements at their termination value.

 

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The Company was in compliance with all of the financial provisions of these agreements through June 30, 2012.

Note 7 – Financial Instruments

U.S. GAAP defines fair value, provides a consistent framework for measuring fair value under U.S. GAAP and Accounting Standards Codification (ASC) Topic 820 expands fair value financial statement disclosure requirements. ASC Topic 820 does not require any new fair value measurements and only applies to accounting pronouncements that already require or permit fair value measures, except for standards that relate to share-based payments.

Valuation techniques are based on observable and unobservable inputs. Observable inputs reflect readily obtainable data from independent sources, while unobservable inputs reflect the Company’s market assumptions. The three levels are defined as follows:

 

   

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

 

   

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

 

   

Level 3 Inputs – Instruments with primarily unobservable value drivers.

The fair values on a recurring basis of the Company’s MBS and interest rate hedges based on the level of inputs at June 30, 2012 and December 31, 2011 are summarized below:

 

     June 30, 2012
Fair Value Measurements Using:
        
$ in thousands    Level 1      Level 2      Level 3      Total at
Fair Value
 

Assets

           

Mortgage-backed securities(1)

     —           16,049,674        —           16,049,674  

Investments in unconsolidated ventures

     —           —           52,384        52,384  

Derivatives

     —           610         1,101        1,711  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

     —           16,050,284        53,485         16,103,769  
  

 

 

    

 

 

    

 

 

    

 

 

 

Liabilities

           

Derivatives

     —           446,569        —           446,569  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

     —           446,569        —           446,569  
  

 

 

    

 

 

    

 

 

    

 

 

 
     December 31, 2011
Fair Value Measurements Using:
        
$ in thousands    Level 1      Level 2      Level 3      Total at Fair
Value
 

Assets

           

Mortgage-backed securities(1)

     —           14,214,149        —           14,214,149  

Investments in unconsolidated ventures

     —           —           68,793        68,793  

Derivatives

     —           —           1,339        1,339  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

     —           14,214,149        70,132        14,284,281  
  

 

 

    

 

 

    

 

 

    

 

 

 

Liabilities

           

Derivatives

     —           396,780        —           396,780  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total

     —           396,780        —           396,780  
  

 

 

    

 

 

    

 

 

    

 

 

 

  

 

(1) For more detail about the fair value of our MBS and type of securities, see Note 3 in the unaudited consolidated financial statements.

 

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The following table presents additional information about the Company’s investments in unconsolidated ventures which are measured at fair value on a recurring basis for which the Company has utilized Level 3 inputs to determine fair value:

 

$ in thousands    June 30, 2012     December 31, 2011  

Beginning balance

     68,793       54,725  

Purchases

     3,986       74,365  

Sales and settlements

     (23,365     (63,598

Total net gains included in net income

    

Realized gains/(losses), net

     1,425       6,760  

Unrealized gains/(losses), net

     1,545       (3,459

Unrealized gain/(losses), net included in other comprehensive income

     —          —     
  

 

 

   

 

 

 

Ending balance

     52,384       68,793  
  

 

 

   

 

 

 

The following table presents additional information about the Company’s CDS contract which is measured at fair value on a recurring basis for which the Company has utilized Level 3 inputs to determine fair value:

 

$ in thousands    June 30, 2012     December 31, 2011  

Beginning balance

     1,339       —    

Purchases

     —         —    

Sales and settlements

     —         —    

Total net gains / (losses) included in net income

    

Realized gains/(losses), net

     —          —     

Unrealized gains/(losses), net

     (238     1,339  

Unrealized gain/(losses), net included in other comprehensive income

     —          —     
  

 

 

   

 

 

 

Ending balance

     1,101       1,339  
  

 

 

   

 

 

 

The following table summarizes quantitative information about Level 3 fair value measurements:

 

$ in thousands    Fair Value at
June 30, 2012
    

Valuation

Technique

  

Unobservable

Input

   Range    Weighted
Average
 

CDS Contract

     1,101      Discounted cash flow    Swap Rate         2.53
         Discount Rate         0.59
         Credit Spread         1.33
         Constant Prepayment Rate    2.3% - 51.2%      8.70
         Constant Default Rate    0.5% - 42.3%      8.64
         Loss Severity    21.9% - 66.8%      54.37

The significant unobservable inputs used in the fair value measurement of the CDS contract are swap rate, discount rate, credit spread, constant prepayment rate, constant default rate, and loss severity in the event of default. These inputs change according to market conditions and security performance expectations. Significant increases (decreases) in swap rate, discount rate, credit spread, constant prepayment rate, constant default rate or loss severity in isolation would result in a lower (higher) fair value measurement. Generally, a change in the assumption used for the constant default rate would likely be accompanied by a directionally similar change in the assumptions used for swap rate, credit spread and loss severity and a directionally opposite change in the assumption used for discount rate and constant prepayment rate. If the inputs had not changed during the quarter, the fair value of the CDS contact would have been $46,000 less than the actual fair value at June 30, 2012.

The fair value of the repurchase agreements is a Level 3 fair value measurement, based on an expected present value technique. This method discounts future estimated cash flows using rates the Company determined best reflect current market interest rates that would be offered for securities with similar characteristics and credit quality. At June 30, 2012 the repurchase agreements had a fair value of $13.5 billion and a carrying value of $13.5 billion. At December 31, 2011 the Company’s repurchase agreements had a fair value of $12.3 billion and a carrying value of $12.3 billion.

 

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Note 8 – Related Party Transactions

The Company is externally managed and advised by the Manager. Pursuant to the terms of the management agreement, the Manager and its affiliates provides the Company with its management team, including its officers, along with appropriate support personnel. Each of the Company’s officers is an employee of Invesco or one of Invesco’s affiliates. The Company does not have any employees. With the exception of the Company’s Chief Financial Officer and Controller, the Manager is not obligated to dedicate any of its employees exclusively to the Company, nor is the Manager or its employees obligated to dedicate any specific portion of its or their time to the Company’s business. The Manager is at all times subject to the supervision and oversight of the Company’s board of directors and has only such functions and authority as the Company delegates to it.

Management Fee

The Company pays the Manager a management fee equal to 1.50% of the Company’s shareholders’ equity per annum, which is calculated and payable quarterly in arrears. For purposes of calculating the management fee, shareholders’ equity is equal to the sum of the net proceeds from all issuances of equity securities since inception (allocated on a pro rata daily basis for such issuances during the fiscal quarter of any such issuance), plus retained earnings at the end of the most recently completed calendar quarter (without taking into account any non-cash equity compensation expense incurred in current or prior periods), less any amount paid to repurchase common stock since inception, and excluding any unrealized gains, losses or other items that do not affect realized net income (regardless of whether such items are included in other comprehensive income or loss, or in net income). This amount will be adjusted to exclude one-time events pursuant to changes in U.S. GAAP, and certain non-cash items after discussions between the Manager and the Company’s independent directors and approval by a majority of the Company’s independent directors.

The Manager has agreed to reduce (but not below zero) the management fee payable by the Company under the management agreement with respect to any equity investment managed by the Manager. The fee reduction occurs at the equity investment level.

For the three months ended June 30, 2012, the Company incurred management fees of $8.7 million (2011: $5.8 million), of which $8.7 million (2011: $5.8 million), was accrued but has not been paid.

For the six months ended June 30, 2012 and 2011, the Company incurred management fees of $17.3 million (2011: $9.7 million), of which $8.7 million (2011: $5.8 million), was accrued but has not been paid.

Expense Reimbursement

Pursuant to the management agreement, the Company is required to reimburse the Manager for operating expenses related to the Company incurred by the Manager, including directors and officers insurance, accounting services, auditing and tax services, filing fees, and miscellaneous general and administrative costs. The Company’s reimbursement obligation is not subject to any dollar limitation.

The Company incurred costs, originally paid by Invesco, of approximately $814,000 (2011: $1.3 million) and $1.4 million (2011: $2.7 million) for the three and six months ended June 30, 2012, respectively. Approximately $814,000 (2011: $1.0 million) and $1.4 million (2011: $2.2 million) was either prepaid or expensed for the three and six months ended June 30, 2012, respectively. Zero (2011: $383,000) and $42,000 (2011: $525,000) was charged against equity as a cost of raising capital for the three and six months ended June 30, 2012, respectively.

Termination Fee

A termination fee is due to the Manager upon termination of the management agreement by the Company equal to three times the sum of the average annual management fee earned by the Manager during the 24-month period prior to such termination, calculated as of the end of the most recently completed fiscal quarter.

 

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Note 9 – Shareholders’ Equity

Securities Convertible into Shares of Common Stock

The limited partner who holds units of the Operating Partnership (“OP Units”) has the right to cause the Operating Partnership to redeem their OP Units for cash equal to the market value of an equivalent number of shares of common stock, or at the Company’s option, the Company may purchase their OP Units by issuing one share of common stock for each OP Unit redeemed. The Company has also adopted an equity incentive plan which includes the ability of the Company to grant securities convertible into the Company’s common stock to the independent directors and the executive officers of the Company and the personnel of the Manager and its affiliates.

Registration Rights

The Company entered into a registration rights agreement with regard to the common stock and OP Units owned by the Manager and Invesco Investments (Bermuda) Ltd., respectively, upon completion of the Company’s IPO and any shares of common stock that the Manager may elect to receive under the management agreement or otherwise. Pursuant to the registration rights agreement, the Company has granted to the Manager and Invesco Investments (Bermuda) Ltd., (i) unlimited demand registration rights to have the shares purchased by the Manager or granted to it in the future and the shares that the Company may issue upon redemption of the OP Units purchased by Invesco Investments (Bermuda) Ltd. registered for resale, and (ii) in certain circumstances, the right to “piggy-back” these shares in registration statements the Company might file in connection with any future public offering so long as the Company retains the Manager under the management agreement.

Public Offerings

During the six months ended June 30, 2012, the Company issued 6,478 shares of common stock at an average price of $17.45 under the DRSPP with total proceeds to the Company of approximately $113,000, net of issuance costs.

Share-Based Compensation

The Company established the 2009 Equity Incentive Plan for grants of restricted common stock and other equity based awards to the independent directors and the executive officers of the Company and personnel of the Manager and its affiliates (the “Incentive Plan”). Under the Incentive Plan, a total of 1,000,000 shares of common stock are currently reserved for issuance. Unless terminated earlier, the Incentive Plan will terminate in 2019, but will continue to govern the unexpired awards. The Company recognized compensation expense of approximately $38,000 (2011: $34,000) for the three months ended June 30, 2012. The Company recognized compensation expense of approximately $75,000 (2011: $68,000) for the six months ended June 30, 2012. During the three months ended June 30, 2012, the Company issued 2,055 shares (2011: 1,467 shares) of restricted stock pursuant to the Incentive Plan to the Company’s non-executive directors. During the six months ended June 30, 2012, the Company issued 4,263 shares (2011: 2,895 shares) of restricted stock pursuant to the Incentive Plan to the Company’s non-executive directors. The fair market value of the shares granted was determined by the closing stock market price on the date of the grant.

On March 2, 2012, the Company issued 15,827 restricted stock units to non-executive employees of the Manager. The restricted stock units vest equally in four installments on the anniversary date of each award. Compensation related to stock awards to employees of the Manager is recorded at the estimated fair value of the award during the vesting period. The Company makes an upward or downward adjustment to compensation expense for the difference in fair value at the date of grant and date the award was earned.

On March 15, 2012 and March 19, 2012, the Company issued a total of 3,156 shares of common stock (net of tax withholding) to non-executive employees of the Manager in respect of restricted stock units which vested under the Incentive Plan.

 

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The Company recognized compensation expense of approximately $40,000 for the three months ended June 30, 2012 related to awards to non-executive employees of the Manager and its affiliates which is reimbursed by the Manager under the management agreement.

The Company recognized compensation expense of approximately $80,000 for the six months ended June 30, 2012 related to awards to officers and employees of the Manager and its affiliates which is reimbursed by the Manager under the management agreement.

Dividends

On June 14, 2012, the Company declared a dividend of $0.65 per share of common stock. The dividend was paid on July 27, 2012 to shareholders of record as of the close of business on June 26, 2012.

Note 10 – Earnings per Share

Earnings per share for the three and six months ended June 30, 2012 and 2011 is computed as follows:

 

$ in thousands    Three Months Ended
June 30,
     Six Months Ended
June 30,
 
     2012      2011      2012      2011  

Numerator (Income)

           

Basic Earnings

           

Net income available to common shareholders

     78,821        72,998        161,903        125,246  

Effect of dilutive securities:

           

Income allocated to non-controlling interest

     973        1,406        1,999        2,857  
  

 

 

    

 

 

    

 

 

    

 

 

 

Dilutive net income available to shareholders

     79,794        74,404        163,902        128,103  
  

 

 

    

 

 

    

 

 

    

 

 

 

Denominator (Weighted Average Shares)

           

Basic Earnings:

           

Shares available to common shareholders

     115,409        73,486        115,402        62,731  

Effect of dilutive securities:

           

Restricted Stock Awards

     34        18        26        11  

OP Units

     1,425        1,425        1,425        1,425  
  

 

 

    

 

 

    

 

 

    

 

 

 

Dilutive Shares

     116,868        74,929        116,853        64,167  
  

 

 

    

 

 

    

 

 

    

 

 

 

Note 11 – Non-controlling Interest - Operating Partnership

Non-controlling interest represents the aggregate OP Units in the Operating Partnership held by limited partners (the “Unit Holders”). Income allocated to the non-controlling interest is based on the Unit Holders’ ownership percentage of the Operating Partnership. The ownership percentage is determined by dividing the number of OP Units held by the Unit Holders by the total number of dilutive shares of common stock. The issuance of common stock (“Share” or “Shares”) or OP Units changes the percentage ownership of both the Unit Holders and the holders of common stock. Since an OP unit is generally redeemable for cash or Shares at the option of the Company, it is deemed to be equivalent to a Share. Therefore, such transactions are treated as capital transactions and result in an allocation between shareholders’ equity and non-controlling interest in the accompanying consolidated balance sheet to account for the change in the ownership of the underlying equity in the Operating Partnership. As of June 30, 2012, non-controlling interest related to the outstanding 1,425,000 OP Units represented a 1.2% interest (2011: 1.5%) in the Operating Partnership. Income allocated to the Operating Partnership non-controlling interest for the three months ended June 30, 2012 was approximately $973,000 (2011: $1.4 million). Income allocated to the Operating Partnership non-controlling interest for the six months ended June 30, 2012 was $2.0 million (2011: $2.9 million). For the three months ended June 30, 2012, distributions paid to the non-controlling interest were $926,000 (2011: $1.4 million). For the six months ended June 30, 2012, distributions paid to the non-controlling interest were $1.9 million (2011: $2.8 million). As of June 30, 2012, distributions payable to the non-controlling interest were approximately $926,000 (2011: $1.4 million).

 

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Note 12 – Subsequent Events

On July 26, 2012, the Company completed a public offering of 5.4 million shares of its 7.75% Series A Cumulative Redeemable Preferred Stock, or the Series A Preferred Stock, at the price of $25.00 per share. Net proceeds were approximately $130.7 million, net of issuance costs of $4.3 million. The Company granted the underwriters a 30-day option to purchase up to an additional 810,000 shares of the Series A Preferred Stock to cover over-allotments, if any. On August 2, 2012, the underwriters exercised their over-allotment option in part to purchase an additional 200,000 shares of the Series A Preferred Stock, for additional net proceeds of approximately $5.0 million.

 

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

In this quarterly report on Form 10-Q, or this “Report,” we refer to Invesco Mortgage Capital Inc. and its consolidated subsidiaries as “we,” “us,” “our Company,” or “our,” unless we specifically state otherwise or the context indicates otherwise. We refer to our external manager, Invesco Advisers, Inc., as our “Manager,” and we refer to the indirect parent company of our Manager, Invesco Ltd. (NYSE:IVZ,) together with its consolidated subsidiaries (other than us), as “Invesco.”

The following discussion should be read in conjunction with our consolidated financial statements and the accompanying notes to our consolidated financial statements, which are included in Item 1 of this report, as well as the information contained in our most recent Form 10-K filed with the Securities and Exchange Commission (the “SEC”).

Forward-Looking Statements

We make forward-looking statements in this Report and other filings we make with the SEC within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and such statements are intended to be covered by the safe harbor provided by the same. Forward-looking statements are subject to substantial risks and uncertainties, many of which are difficult to predict and are generally beyond our control. These forward-looking statements include information about possible or assumed future results of our business, investment strategies, financial condition, liquidity, results of operations, plans and objectives. When we use the words “believe,” “expect,” “anticipate,” “estimate,” “plan,” “continue,” “intend,” “should,” “may” or similar expressions and future or conditional verbs such as “will,” “may,” “could,” “should,” and “would,” and any other statement that necessarily depends on future events, we intend to identify forward-looking statements. Factors that could cause actual results to differ from those expressed in our forward-looking statements include, but are not limited to:

 

   

our business and investment strategy;

 

   

our investment portfolio;

 

   

our projected operating results;

 

   

actions and initiatives of the U.S. government and changes to U.S. government policies, including the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) and mortgage loan modification programs and our ability to respond to and comply with such actions, initiatives and changes;

 

   

our ability to obtain additional financing arrangements and the terms of such arrangements;

 

   

financing and advance rates for our target assets;

 

   

changes to our expected leverage;

 

   

general volatility of the securities markets in which we invest;

 

   

general volatility of foreign financial markets and their governments’ responses;

 

   

interest rate mismatches between our target assets and our borrowings used to fund such investments;

 

   

the adequacy of our cash flow from operations and borrowings to meet our short-term liquidity needs;

 

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our ability to maintain sufficient liquidity to meet any margin calls;

 

   

changes in the credit rating of the U.S. government;

 

   

changes in interest rates and interest rate spreads and the market value of our target assets;

 

   

changes in prepayment rates on our target assets;

 

   

the impact of any deficiencies in foreclosure practices of third parties and related uncertainty in the timing of collateral disposition;

 

   

effects of hedging instruments on our target assets;

 

   

rates of default or decreased recovery rates on our target assets;

 

   

modifications to whole loans or loans underlying securities;

 

   

the degree to which our hedging strategies may or may not protect us from interest rate volatility;

 

   

counterparty defaults;

 

   

changes in governmental regulations, tax law and rates, and similar matters and our ability to respond to such changes;

 

   

our ability to qualify as a REIT for U.S. federal income tax purposes;

 

   

our ability to maintain our exemption from registration under the Investment Company Act of 1940, as amended (the “1940 Act”);

 

   

availability of investment opportunities in mortgage-related, real estate-related and other securities;

 

   

availability of U.S. government Agency guarantees with regard to payments of principal and interest on securities;

 

   

availability of qualified personnel;

 

   

our understanding of our competition;

 

   

changes to accounting principles generally accepted in the United States of America (“US GAAP”); and

 

   

market trends in our industry, interest rates, real estate values, the debt securities markets or the general economy.

These forward-looking statements are based upon information presently available to our management and are inherently subjective, uncertain and subject to change. There can be no assurance that actual results will not differ materially from our expectations. We caution investors not to rely unduly on any forward-looking statements and urge you to carefully consider the risks identified under the captions “Risk Factors,” “Forward-Looking Statements” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Report and our most recent Form 10-K and subsequent Forms 10-Q, which are available on the SEC’s website at www.sec.gov.

All written or oral forward-looking statements that we make, or that are attributable to us, are expressly qualified by this cautionary notice. We expressly disclaim any obligation to update the information in any public disclosure if any forward-looking statement later turns out to be inaccurate, except as may otherwise be required by law.

 

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Overview

We are a Maryland corporation primarily focused on investing in, financing and managing residential and commercial mortgage-backed securities and mortgage loans. We are externally managed and advised by Invesco Advisers, Inc., our Manager, which is an indirect, wholly-owned subsidiary of Invesco Ltd. We elected to qualify to be taxed as a REIT commencing with our taxable year ended December 31, 2009. Accordingly, we generally will not be subject to U.S. federal income taxes on our taxable income that we distribute currently to our shareholders as long as we maintain our qualification as a REIT. We operate our business in a manner that will permit us to maintain our exclusion from the definition of “investment company” under the Investment Company Act of 1940, as amended (the “1940 Act”).

Our objective is to provide attractive risk-adjusted returns to our shareholders, primarily through dividends and secondarily through capital appreciation. To achieve this objective, we primarily invest in the following:

 

   

Agency RMBS, which are residential mortgage-backed securities, for which a U.S. government Agency such as the Government National Mortgage Association (“Ginnie Mae”) or a federally chartered corporation such as the Federal National Mortgage Association (“Fannie Mae”) or the Federal Home Loan Mortgage Corporation (“Freddie Mac”) guarantees payments of principal and interest on the securities;

 

   

Non-Agency RMBS, which are RMBS that are not issued or guaranteed by a U.S. government agency or a federally chartered corporation;

 

   

CMBS, which are commercial mortgage-backed securities; and

 

   

Residential and commercial mortgage loans.

We finance our investments in Agency RMBS, non-Agency RMBS and CMBS through short-term borrowings structured as repurchase agreements.

Recent Developments

On June 14, 2012, we declared a dividend of $0.65 per share of common stock. The dividend was paid on July 27, 2012 to shareholders of record as of the close of business on June 26, 2012.

On July 26, 2012, the Company completed a public offering of 5.4 million shares of its 7.75% Series A Cumulative Redeemable Preferred Stock, or the Series A Preferred Stock, at the price of $25.00 per share. Net proceeds were approximately $130.7 million, net of issuance costs of $4.3 million. The Company granted the underwriters a 30-day option to purchase up to an additional 810,000 shares of the Series A Preferred Stock to cover over-allotments, if any. On August 2, 2012, the underwriters exercised their over-allotment option in part to purchase an additional 200,000 shares of the Series A Preferred Stock, for additional net proceeds of approximately $5.0 million.

Factors Impacting Our Operating Results

Our operating results can be affected by a number of factors and primarily depend on, among other things, the level of our net interest income, the market value of our assets and the supply of, and demand for, the target assets in which we invest. Our net interest income, which includes the amortization of purchase premiums and accretion of purchase discounts, varies primarily as a result of changes in market interest rates and prepayment speeds, as measured by the constant prepayment rate (“CPR”) on our target assets. Interest rates and prepayment speeds 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.

 

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Market Conditions

Beginning in the summer of 2007, significant adverse changes in financial market conditions resulted in a deleveraging of the entire global financial system. As part of this process, residential and commercial mortgage markets in the United States experienced a variety of difficulties, including loan defaults, credit losses and reduced liquidity. As a result, many lenders tightened their lending standards, reduced lending capacity, liquidated significant portfolios or exited the market altogether, and therefore, financing with attractive terms was generally unavailable. In response to these unprecedented events, the U.S. government has taken a number of actions to stabilize the financial markets and encourage lending. Significant measures include the enactment of the Emergency Economic Stabilization Act of 2008 to, among other things, establish the Troubled Asset Relief Program (“TARP”), the enactment of the Housing and Economic Recovery Act of 2008 (“HERA”), which established a new regulator for Fannie Mae and Freddie Mac and the establishment of the Term Asset-Backed Securities Loan Facility (“TALF”) and the U.S. government’s Public Private Investment Program (“PPIP”). Some of these programs are beginning to expire and the impact of the wind-down of these programs on the financial sector and on the economic recovery is unknown. Increased volatility in the RMBS markets may have an adverse effect on the market value and performance of the RMBS in which we invest. Moreover, we rely on financing to acquire, on a leveraged basis, the target assets in which we invest. If market conditions deteriorate further, our lenders may exit the repurchase market, further tighten lending standards, or increase the amount of equity capital required to obtain financing making it more difficult and costly for us to obtain financing.

The Dodd-Frank Act enacted on July 21, 2010, contains numerous provisions affecting the financial and mortgage industries, many of which may have an impact on our operating environment and the target assets in which we invest. Consequently, the Dodd-Frank Act may affect our cost of doing business, may limit our investment opportunities and may affect the competitive balance within our industry and market areas.

On September 21, 2011, the U.S. Federal Reserve announced “Operation Twist,” which is a program by which it intends to purchase, by the end of June 2012, $400 billion of U.S. Treasury securities with remaining maturities between 6 and 30 years and sell an equal amount of U.S. Treasury securities with remaining maturities of 3 years or less. Operation Twist could result in a flattening in the yield curve and lower long-term interest rates. In June 2012, the Federal Open Market Committee released a statement that it intends to continue Operation Twist by purchasing Treasury securities with remaining maturities of 6 years to 30 years and sell or redeem an equal amount of Treasury securities with remaining maturities of approximately 3 years or less. This continuation of the maturity extension program should put downward pressure on longer –term interest rates. Lower long-term interest rates could result in increased prepayment rates and a narrowing of our net interest margin. Consequently, Operation Twist and any other future securities purchase programs and actions by the U.S. Federal Reserve could adversely affect our business, financial condition and results of operations and our ability to pay distributions to our shareholders.

The Federal Housing Finance Agency (“FHFA”) and the Department of the Treasury introduced the Home Affordable Refinance Program (“HARP”) in early 2009. HARP provides borrowers, who may not otherwise qualify for refinancing because of declining home values or reduced access to mortgage insurance, the ability to refinance their mortgages into a lower interest rate and/or more stable mortgage product. On October 24, 2011, the FHFA announced a series of changes to the rules regarding the HARP with the intent of increasing the number of borrowers eligible to refinance their mortgage under this program. The FHFA announced changes to the guidelines related to loan-to-value, appraisals, and certain fees, among other things, subject to a variety of qualifications and the extension of the end date for the HARP until December 31, 2013. It does not change the time period which these loans were originated, maintaining the requirement that the loans must have been guaranteed by Fannie Mae or Freddie Mac on or before May 31, 2009. We do not expect the current HARP or future modifications to have a material impact on our results of operations in future periods.

On August 1, 2012, the U.S. Federal Reserve announced that it would keep the target range for the federal funds rate at zero to  1/4 percent and it currently anticipates that economic conditions are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014. Low levels of federal funds rates may reduce our borrowing costs. However, there can be no assurance that federal funds rates will remain near zero percent, or that such low levels will reduce our cost of funds.

 

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Investment Activities

As of June 30, 2012, 52.6% of our equity was invested in Agency RMBS, 27.1% in non-Agency RMBS, 17.7% in CMBS, and 2.6% in other investments in unconsolidated ventures. We use leverage on our target assets to achieve our return objectives. For our total investment portfolio, we focus on securities we believe provide attractive returns when levered approximately 3 to 7 times. The leverage on classes of assets may periodically exceed the stated ranges as we adjust our borrowings to obtain the best available source and minimize total interest expense, while maintaining our overall portfolio leverage guidelines.

As of June 30, 2012, we had $8.3 billion in 30-year fixed rate Agency RMBS securities that offered higher coupons and call protection based on the collateral attributes. In addition, we held $2.4 billion in 15-year fixed rate Agency RMBS securities, $1.2 billion in hybrid adjustable-rate mortgage Agency RMBS (“ARMs”) and $172.6 million in Agency ARM RMBS we believe to have similar durations based on prepayment speeds. As of June 30, 2012, we held $2.3 billion non-Agency RMBS.

As of June 30, 2012, we owned $1.3 billion in CMBS and financed $940.2 million in repurchase agreements. In addition, as of June 30, 2012, we held $455.1 million in CMOs.

During the three months ended June 30, 2012, we purchased $3.8 billion of mortgage-backed securities. The average yield on these purchases as of June 30, 2012 is 3.2%.

Portfolio Characteristics

The table below represents the vintage of our credit assets as of June 30, 2012:

 

     2003     2004     2005     2006     2007     2008      2009     2010     2011     2012     Total  

Re-REMIC Senior (1)

     —          —          —          —          —          —           1.0     6.8     59.1     —          66.9

Prime

     0.9     1.9     1.2     3.2     13.7     —           —          —          0.8     —          21.7

Alt-A

     —          —          1.4     5.1     4.5     —           —          —          —          —          11.0

Subprime

     —          0.4     —          —          —          —           —          —          —          —          0.4
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total Non-Agency

     0.9     2.3     2.6     8.3     18.2     —           1.0     6.8     59.9     —          100.0
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

CMBS

     —          —          25.2     22.6     —          —           —          15.0     35.9     1.3     100.0
  

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

    

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) For Re-REMIC Seniors, the table reflects the year in which the resecuritizations were issued. The vintage distribution of the securities that collateralize the Company’s Re-REMIC Senior investments is 11.9% 2005, 37.0% 2006 and 51.1% 2007.

The tables below represent the geographic concentration of the underlying collateral for our MBS portfolio as of June 30, 2012:

 

Non-Agency RMBS

State

   Percentage  

California

     49.8

Florida

     7.7

New York

     5.7

Virginia

     3.2

Maryland

     3.0

Washington

     2.9

New Jersey

     2.9

Arizona

     2.7

Illinois

     2.2

Colorado

     2.1

Other

     17.8

CMBS

State

   Percentage  

California

     15.4

New York

     12.9

Texas

     9.8

Florida

     5.4

Illinois

     4.7

Pennsylvania

     4.0

New Jersey

     3.4

Massachusetts

     3.2

Ohio

     3.2

Virginia

     3.2

Other

     34.8
 

 

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The vintage and geographic concentrations have not significantly changed since March 31, 2012.

Financing and Other Liabilities. We enter into repurchase agreements to finance the majority of our Agency RMBS, non-Agency RMBS and CMBS. These agreements are secured by our Agency RMBS, non-Agency RMBS and CMBS and bear interest at rates that have historically moved in close relationship to the London Interbank Offer Rate (“LIBOR”). As of June 30, 2012, we had entered into repurchase agreements totalling $13.5 billion. We also committed to invest up to $100.0 million in the Invesco IMRF Fund and AIV, which, in turn, invests in our target assets. As of June 30, 2012, $82.9 million of our commitment to the Invesco IMRF Fund and AIV Fund has been called and we are committed to fund $17.1 million in additional capital.

The Company records the liability for mortgage-backed securities purchased for which settlement has not taken place as an investment related payable. As of June 30, 2012 and December 31, 2011, the Company had investment related payables of $126.9 million and $107.0 million, respectively, of which no items were outstanding greater than thirty days. The change in balance was primarily due to an increase in mortgage-backed security purchases at the quarter ended June 30, 2012.

Hedging Instruments. We generally hedge as much of our interest rate risk as we deem prudent in light of market conditions. No assurance can be given that our hedging activities will have the desired beneficial impact on our results of operations or financial condition. Our investment policies do not contain specific requirements as to the percentages or amount of interest rate risk that we are required to hedge.

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

the value of derivatives used for hedging may be adjusted from time to time in accordance with accounting rules to reflect changes in fair value. Downward adjustments or mark-to-market losses would reduce our shareholders’ equity.

As of June 30, 2012, we have entered into interest rate swap agreements designed to mitigate the effects of increases in interest rates under a portion of our repurchase agreements. These swap agreements provide for fixed interest rates indexed off of one-month LIBOR and effectively fix the floating interest rates on $6.9 billion of borrowings under our repurchase agreements as of June 30, 2012. We intend to continue to add interest rate hedge positions according to our hedging strategy.

Book Value per Share

Our book value per share was $18.40, $18.42 and $16.41 as of June 30, 2012, March 31, 2012 and December 31, 2011, respectively, on a fully diluted basis, after giving effect to our units of limited partnership interest in our operating partnership, which may be converted to common shares at the sole election of the Company. The change in our book value was primarily due to the change in valuation of our investment portfolio and our interest rate hedges that are recorded in Other Comprehensive Income (Loss) on our balance sheet. Refer to Note 3 -”Mortgage-Backed Securities” for the impact of changes in accumulated other comprehensive income on our investment portfolio. The value of our assets and liabilities change daily based on market conditions. Refer to Item 3. “Quantitative and Qualitative Disclosures About Market Risks” for interest rate risk and its impact on fair value.

 

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Critical Accounting Policies

Our consolidated financial statements are prepared in accordance with U.S. GAAP, which requires the use of estimates and assumptions that involve the exercise of judgment and use of assumptions as to future uncertainties. Our most critical accounting policies involve decisions and assessments that could affect our reported assets and liabilities, as well as our reported revenues and expenses. We believe that all of the decisions and assessments upon which our consolidated financial statements are based are reasonable at the time made and based upon information available to us at that time. We rely upon independent pricing of our assets at each quarter’s end to arrive at what we believe to be reasonable estimates of fair market value. The complete listing of our Critical Accounting Policies was disclosed in our 2011 annual report on Form 10-K as filed with the SEC on February 29, 2012, and there have been no material changes to our Critical Accounting Policies as disclosed therein.

Expected Impact of New Authoritative Guidance on Future Financial Information

In December 2011, the FASB issued Accounting Standards Updated 2011-11, “Disclosures about Offsetting Assets and Liabilities” (ASU 2011-11). ASU 2011-11 amends Topic 210 to require additional disclosure information about offsetting and related arrangements. Entities will be 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 transaction subject to an agreement similar to a master netting arrangement. This scope would include derivatives, sale and repurchase agreements and reverse sale and repurchase agreements. The objective of this disclosure is to facilitate comparison between those entities that prepare their financial statements on a basis of US GAAP and those entities that prepare their financial statements on the basis of International Financial Reporting Standards (IFRS). The guidance is effective for periods beginning on or after January 1, 2013, and interim periods within those annual periods. We do not believe that the adoption of the amended guidance will have a significant effect on our consolidated financial statements.

Results of Operations

The table below presents certain information from our Consolidated Statement of Operations for the three and six month periods ending June 30, 2012 and 2011:

 

     Three Months ended
June 30,
     Six Months ended
June 30,
 
$ in thousands, except per share data    2012      2011      2012      2011  

Revenues

           

Interest income

     139,004        108,981        280,964        177,517  

Interest expense

     56,700        34,207        111,985        49,785  
  

 

 

    

 

 

    

 

 

    

 

 

 

Net interest income

     82,304        74,774        168,979        127,732  
  

 

 

    

 

 

    

 

 

    

 

 

 

Other income

     7,216        6,540        14,417        12,125  
  

 

 

    

 

 

    

 

 

    

 

 

 

Expenses

           

Management fee – related party

     8,681        5,753        17,320        9,728  

General and administrative

     1,045        1,157        2,174        2,026  
  

 

 

    

 

 

    

 

 

    

 

 

 

Total expenses

     9,726        6,910        19,494        11,754  
  

 

 

    

 

 

    

 

 

    

 

 

 

Net income

     79,794        74,404        163,902        128,103  
  

 

 

    

 

 

    

 

 

    

 

 

 

Net income attributable to non-controlling interest

     973        1,406        1,999        2,857  
  

 

 

    

 

 

    

 

 

    

 

 

 

Net income attributable to common shareholders

     78,821        72,998        161,903        125,246  
  

 

 

    

 

 

    

 

 

    

 

 

 

Earnings per share:

           

Net income attributable to common shareholders (basic/diluted)

     0.68        0.99        1.40        2.00  
  

 

 

    

 

 

    

 

 

    

 

 

 

Dividends declared per common share

     0.65        0.97        1.30        1.97  
  

 

 

    

 

 

    

 

 

    

 

 

 

Weighted average number of shares of common stock:

           

Basic

     115,409        73,486        115,402        62,731  
  

 

 

    

 

 

    

 

 

    

 

 

 

Diluted

     116,868        74,929        116,853        64,167  
  

 

 

    

 

 

    

 

 

    

 

 

 

 

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     As of and for  the
Three Months ended
    As of and for  the
Six Months ended
 
     June 30,     June 30,  
$ in thousands    2012     2011     2012     2011  

Average Balances*:

        

Agency RMBS:

        

15 year fixed-rate, at fair value

     2,425,483       2,064,440       2,468,860       1,981,753  

30 year fixed-rate, at fair value

     7,975,031       4,128,583       7,553,780       3,228,217  

ARM, at fair value

     174,514       92,283       177,368       66,632  

Hybrid ARM, at fair value

     1,286,519       1,013,785       1,392,654       691,757  

MBS-CMO, at fair value

     455,063       64,272       426,967       52,408  

Non-Agency RMBS, at fair value

     2,252,836       1,957,483       2,283,792       1,582,960  

CMBS, at fair value

     1,286,018       845,069       1,252,760       696,341  
  

 

 

   

 

 

   

 

 

   

 

 

 

Average MBS portfolio

     15,855,464       10,165,915       15,556,181       8,300,068  
  

 

 

   

 

 

   

 

 

   

 

 

 

Average Portfolio Yields: (1)

        

Agency RMBS:

        

15 year fixed-rate,

     2.60     3.16     2.63     3.14

30 year fixed-rate

     3.16     3.64     3.30     3.55

ARM

     2.66     3.08     2.54     2.92

Hybrid ARM

     2.73     2.85     2.63     2.65

MBS-CMO

     2.50     7.25     2.19     6.23

Non-Agency RMBS

     5.37     7.24     5.65     7.57

CMBS

     5.32     4.99     5.44     5.00

Average MBS portfolio

     3.51     4.29     3.61     4.28

Average Borrowings*:

        

Agency RMBS

     10,862,133       6,784,196       10,590,714       5,502,683  

Non-Agency RMBS

     1,667,755       1,405,948       1,727,824       1,076,174  

CMBS

     919,852       703,485       894,978       571,413  
  

 

 

   

 

 

   

 

 

   

 

 

 

Total borrowed funds

     13,449,740       8,893,629       13,213,516       7,150,270  
  

 

 

   

 

 

   

 

 

   

 

 

 

Maximum borrowings during the period (2)

     13,799,710       9,560,766       13,799,710       9,560,766  
  

 

 

   

 

 

   

 

 

   

 

 

 

Average Cost of Funds: (3)

        

Agency RMBS

     0.36     0.23     0.34     0.25

Non-Agency RMBS

     1.77     1.29     1.79     1.35

CMBS

     1.54     1.12     1.56     1.20

Unhedged cost of funds

     0.62     0.47     0.62     0.49

Hedged cost of funds

     1.69     1.54     1.69     1.39

Average Equity: (4)

     2,171,664       1,567,126       2,127,086       1,362,798  

Average debt/equity ratio (average during period)

     6.19x        5.68x        6.21x        5.25x   

Debt/equity ratio (as of period end)

     6.30x        5.24x        6.30x        5.24x   

 

* Average amounts for each period are based on weighted month end balances, all percentages are annualized.

 

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(1) Average portfolio yield for the period was calculated by dividing interest income, including amortization of premiums and discounts, by our average of the investment balance at fair value.
(2) Amount represents the maximum borrowings at month-end during each of the respective periods.
(3) Average cost of funds is calculated by dividing interest expense, by our average borrowings.
(4) Average equity is calculated based on a weighted balance basis.

Net Income Summary

For the three months ended June 30, 2012, our net income attributable to common shareholders was $78.8 million (2011: $73.0 million) or $0.68 (2011: $0.99) basic and diluted income per weighted average share available to common shareholders.

For the six months ended June 30, 2012, our net income attributable to common shareholders was $161.9 million (2011: $125.2 million) or $1.40 (2011: $2.00) basic and diluted income per weighted average share available to common shareholders.

The increase in net income attributable to common shareholders and decrease in our earnings per share for the three and six month periods is primarily attributable to the growth in our investment portfolio resulting from our follow-on common stock offerings and change in the composition of our investment portfolio based on market conditions. The average MBS portfolio increased $5.7 million and $7.3 million for the three and six months ended June 30, 2012 compared to the three and six months ended June 30, 2011. Since June 30, 2011, we have raised $410.6 million in equity through two follow-on common stock offerings and the share purchase feature of the dividend reinvestment and stock purchase plan (the “DRSPP”).

Interest Income and Average Earning Asset Yield

Our primary source of income is interest earned on our investment portfolio. During the three months ended June 30, 2012, we had average earning assets of $15.9 billion (2011: $10.2 billion) and earned interest income of $139.0 million (2011: $109.0 million). The yield on our average investment portfolio was 3.51% (2011: 4.29%).

The change in our average assets and the portfolio yield for three months ended June 30, 2012 versus June 30, 2011 was primarily the result of the increase in our investment portfolio in connection with adding leverage and utilizing proceeds from our follow-on common stock offerings during 2011 and a change in our portfolio composition as we have allocated a higher amount of equity to Agency RMBS at lower yields and higher leverage.

We had average earning assets of $15.6 billion (2011: $8.3 billion) and earned interest income of $281.0 million (2011: $177.5 million) for the six months ended June 30, 2012. The yield on our average investment portfolio was 3.61% (2011: 4.28%) for the respective period. The change in our average assets and the portfolio yield was primarily the result of the change in our portfolio composition as we have allocated a higher amount of equity to Agency RMBS at lower yields and higher leverage.

Our interest income is subject to interest rate risk. Refer to Item 3. “Quantitative and Qualitative Disclosures about Market Risk” for more information relating to interest rate risk and its impact on our operating results.

 

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The CPR of our portfolio impacts the amount of premium and discount on the purchase of securities that is recognized into income. Our Agency and non-Agency RMBS had a weighted average CPR of 13.3 and 12.1 for the three months ended June 30, 2012 and March 31, 2012, respectively. The table below shows the three month CPR for our RMBS compared to bonds with similar characteristics (“Cohorts”):

 

     June 30, 2012      March 31, 2012  
     Company      Cohort      Company      Cohort  

15 year Agency RMBS

     11.3        21.6        10.3        21.7  

30 year Agency RMBS

     12.3        18.9        10.2        18.6  

Agency Hybrid ARM RMBS

     18.1        NA         16.2        NA   

Non-Agency RMBS

     16.2        NA         16.0        NA   
  

 

 

    

 

 

    

 

 

    

 

 

 

Overall

     13.3        NA         12.1        NA   
  

 

 

    

 

 

    

 

 

    

 

 

 

Interest Expense and the Cost of Funds

Our largest expense is the interest expense on borrowed funds. For the three months ended June 30, 2012, we had average borrowed funds of $13.4 billion (2011: $8.9 billion) and total interest expense of $56.7 million (2011: $34.2 million). The increase in average borrowed funds and interest expense was primarily the result of increasing the size of our investment portfolio and hedging costs from additional interest rate swaps.

We had average borrowed funds of $13.2 billion (2011: $7.2 billion) and total interest expense of $112.0 million (2011: $49.8 million) for the six months ended June 30, 2012. The increase in average borrowed funds and interest expense was primarily the result of increasing the size of our investment portfolio and hedging costs from additional interest rate swaps.

For the three months ended June 30, 2012, our average cost of funds was 1.69% (2011: 1.54%). Since a substantial portion of our repurchase agreements are short term, changes in market rates are directly reflected in our interest expense. Interest expense includes borrowing costs, as well as costs for our interest rate hedges.

Our average cost of funds was 1.69% and (2011: 1.39%) for the six months ended June 30, 2012. Since a substantial portion of our repurchase agreements are short term, changes in market rates are directly reflected in our interest expense. Interest expense includes borrowing costs, as well as any hedging costs.

Net Interest Income

Our net interest income, which equals interest income less interest expense, for the three months ended June 30, 2012, totaled $82.3 million (2011: $74.8 million). Our net interest rate margin, which equals the yield on our average assets for the period less the average cost of funds for the three months ended June 30, 2012, was 1.82% (2011: 2.75%). The increase in net interest income was primarily the result of increasing our investment portfolio with the proceeds of our follow-on common stock offerings. The decrease in net interest margin was primarily due to higher hedged cost of funds related to the increase in average borrowings and interest rate swaps and a decrease in portfolio yield.

Our net interest income totaled $169.0 million (2011: $127.7 million) for the six months ended June 30, 2012. Our net interest rate margin was 1.92% (2011: 2.89%) for the six months ended June 30, 2012. The increase in net interest income was primarily the result of increasing our investment portfolio while the decrease in our net interest margin was a direct result of our change in asset mix between Agency RMBS, non-Agency RMBS and CMBS. Refer to the average balance table in the “Results of Operations” section above for changes in average portfolio balance and asset mix.

Gain on Sale of Investments

As part of our investment process, all of our MBS are reviewed on a monthly basis to determine if they continue to meet our risk and return targets. This process involves looking at changing market assumptions and the impact those assumptions will have on the individual securities. As a result of our change in market assumptions, we sold securities and recognized net gain of $6.1 million for the three months ended June 30, 2012 (2011: $3.6 million).

 

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As a result of our change in market assumptions, we sold securities and recognized net gain of $12.1 million (2011: $4.8 million) for the six month periods ended June 30, 2012.

Equity in Earnings and Change in Fair Value of Unconsolidated Ventures

For the three months ended June 30, 2012, we recognized equity in earnings and unrealized gain on the change in fair value of our investment in the Invesco IMRF Fund of approximately $357,000 (2011: $3.5 million), and $1.1 million (2011: $1.6 million loss), respectively. The decrease in equity in earnings and increase in unrealized income on the change in fair value was primarily the result of realizing gains on investments sold during 2012.

For the six months ended June 30, 2012, we recognized equity in earnings of approximately $709,000 (2011: $5.6 million), and unrealized gain on the change in fair value of our investment in the Invesco IMRF Fund of $1.2 million (2011: $1.9 million loss). The net earnings from the unconsolidated ventures were primarily the result of a gain realized offset by a decrease in the fair value of the IMRF Fund.

On September 30, 2011, we invested in a portfolio of commercial mortgage loans by contributing $16.9 million, net of distributions, of equity capital to IMRF Loan Portfolio Member LLC (“IMRF LLC”). For the three months ended June 30, 2012, we recognized equity in earnings and unrealized appreciation on the change in fair value of our investment in the IMRF LLC of approximately $362,000 and $155,000, respectively.

For the six months ended June 30, 2012, we recognized equity in earnings and unrealized appreciation on the change in fair value of our investment in the IMRF LLC of approximately $716,000 and $307,000, respectively.

Other Income (Loss)

The Company finances its activities primarily through repurchase agreements, which are generally settled on a short-term basis, usually from one to twelve months. At each settlement date, the Company refinances each repurchase agreement at the market interest rate at that time. Since the interest rate on its repurchase agreements change on a one to twelve month basis, the Company is exposed to changing interest rates. The Company’s objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish these objectives, the Company primarily uses interest rate swaps and swaptions as part of its interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable-rate amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount. The interest rate swaption provides the company the option to enter into an interest rate swap agreement for a predetermined notional amount, stated term and pay and receive interest rates in the future. The premium paid for interest rate swaptions is reported as an asset in the company’s consolidated balance sheets. The premium is valued at an amount equal to the fair value of the swaption that would have the effect of closing the position adjusted for nonperformance risk, if any.

Our other income (loss) relates to the unrealized loss on interest rate swaps and swaptions of $1.5 million (2011: $197,000 loss) which represents the ineffective portion of the change in fair value of our interest rate swaps and change in fair value of interest rate swaptions contract which is recognized directly in earnings for the three months ended June 30, 2012 and 2011.

Our other income (loss) relates to the unrealized loss on interest rate swaps and swaptions of $2.0 million (2011: $202,000 loss) which represents the ineffective portion of the change in fair value of our interest rate swaps and change in fair value of interested rate swaptions contract which is recognized directly in earnings for the six months ended June 30, 2012 and 2011.

On December 30, 2010, we entered into a credit default swap (“CDS”) contract. For the three months ended June 30, 2012 we recognized income of $690,000 (2011: $1.3 million) on our investment in the CDS of which $69,000 (2011: $240,000 gain) is an unrealized loss based on change in the fair market value of the CDS and $759,000 (2011: $1.0 million) represents premium payments we receive for providing protection.

For the six months ended June 30, 2012 we recognized income of $1.3 million (2011: $3.8 million) on our investment in a CDS of which $238,000 (2011: $1.7 million gain) is an unrealized loss based on change in the fair market value of the CDS and $1.6 million (2011: $2.1 million) represents premium payments we receive for providing protection.

 

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Expenses

For the three months ended June 30, 2012, we incurred management fees of $8.7 million (2011: $5.8 million), which are payable to our Manager under our management agreement. The increase in management fees is attributable to an increase in shareholders’ equity resulting from our follow-on common stock offerings. The management fee and the relationship between the Company and the Manager are discussed further in our discussion of related party relationships.

We incurred management fees of $17.3 million (2011: $9.7 million) for the six months ended June 30, 2012, which are payable to our Manager under our management agreement. The increase in management fees is attributable to an increase in shareholders’ equity resulting from our follow-on common stock offerings in 2011 and 2012.

For the three months ended June 30, 2012, our general and administrative expenses of $1.0 million (2011: $1.2 million) includes operating expenses not covered under our management agreement. These expenses primarily consist of directors and officers insurance, accounting services, auditing and tax services, filing fees, and miscellaneous general and administrative costs.

Our general and administrative expenses were $2.2 million (2011: $2.0 million) for the six months ended June 30, 2012.

Net Income and Return on Average Equity

For the three months ended June 30, 2012, our net income was $79.8 million (2011: $74.4 million) and our annualized return on average equity was 14.70% (2011: 18.99%). The change in net income and average return on equity was primarily the result of increasing our investment portfolio from the proceeds of our common stock offerings and the changes in our portfolio composition during 2012 and 2011.

Our net income was $163.9 million (2011: $128.1 million) for the six months ended June 30, 2012. Our annualized return on average equity was 15.41% (2011: 18.80%) for the six months ended June 30, 2012. The change in net income and return on average equity was primarily the result of an increase in our net interest income following our portfolio growth.

Liquidity and Capital Resources

Liquidity is a measurement of our ability to meet potential cash requirements, including ongoing commitments to pay dividends, fund investments, repayment of borrowings and other general business needs. Our primary sources of funds for liquidity consists of the net proceeds from our common equity offerings, net cash provided by operating activities, cash from repurchase agreements and other financing arrangements and future issuances of equity and/or debt securities. We also have sought, and may continue to finance our assets under, and may otherwise participate in, programs established by the U.S. government.

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

 

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We held cash and cash equivalents of $168.6 million (2011: $66,000) at June 30, 2012. Our cash and cash equivalents increased due to normal fluctuations in cash balances related to the timing of principal and interest payments, repayments of debt, and asset purchases and sales.

Our operating activities provided net cash of $203.7 million (2011: $115.8 million) for the six month period ended June 30, 2012. The cash provided by operating activities increased due to the increase in net interest income earned by our portfolio, which increase in net income resulted from the increase in average interest earning assets of $15.6 billion at June 30, 2012 as compared to $8.3 billion at June 30, 2011.

Our investing activities used net cash of $1.4 billion (2011: $6.2 billion) for the six month period ended June 30, 2012. During the six month period ended June 30, 2012 we utilized cash to purchase $3.6 billion in securities which were offset by proceeds from asset sales of $1.1 billion and principal payments of $1.1 billion. During the six month period ended June 30, 2011 we utilized cash to purchase $7.0 billion of securities, sold $344.8 million of securities and received principal payments of $491.6 million. The increase in principal payments resulted from the larger portfolio at June 30, 2012 as compared to June 30, 2011.

Our financing activities for the six months ended June 30, 2012 consisted of net proceeds of $1.3 million from our repurchase agreements.

Our financing activities for the six months ended June 30, 2011 consisted of net proceeds from our follow-on public offerings in which we raised $886.9 million and $5.2 billion from our repurchase agreements.

The table below shows the allocation of our equity and debt-to-equity ratio as of June 30, 2012. The leverage on each class of assets may periodically exceed the stated ranges as we adjust our borrowings to obtain the best available source and minimize total interest expense while maintaining our overall portfolio leverage guidelines:

 

$ in thousands    Agency     Non-Agency     CMBS     Unconsolidated
Ventures
    Total  

Borrowings

     10,927,821       1,673,271       940,233       —          13,541,325  

Equity allocation

     1,132,661       582,169       380,204       54,879       2,149,913  

Debt / Equity Ratio

     9.6       2.9       2.5       —          6.3  

% of Total Equity

     52.6     27.1     17.7     2.6     100.0

As of June 30, 2012, the weighted average margin requirement, or the percentage amount by which the collateral value must exceed the loan amount, which we also refer to as the “haircut,” under our repurchase agreements for Agency RMBS was 4.70% (weighted by borrowing amount), under our repurchase agreements for non-Agency RMBS was 18.61% and under our repurchase agreements for CMBS was 19.55%. Across our repurchase facilities for Agency RMBS, the haircuts range from a low of 3% to a high of 7%, for non-Agency RMBS range from a low of 10% to a high of 35% and for CMBS range from a low of 12% to a high of 30%. Our hedged cost of funds was 1.69% and 1.64% as of June 30, 2012 and December 31, 2011, respectively. Declines in the value of our securities portfolio can trigger margin calls by our lenders under our repurchase agreements. An event of default or termination event would give some of our counterparties the option to terminate all repurchase transactions existing with us and require any amount due by us to the counterparties to be payable immediately.

As discussed above under “—Market Conditions,” the residential mortgage market in the United States has experienced difficult economic conditions including:

 

   

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

 

   

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

 

   

significant disruption in financing of RMBS.

 

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If these conditions persist, then our lenders may be forced to exit the repurchase market, become insolvent or further tighten lending standards or increase the amount of required equity capital or haircut, any of which could make it more difficult or costly for us to obtain financing. In addition, because Fannie Mae and Freddie Mac are in conservatorship of the U.S. government, if the U.S.’s credit rating is further downgraded, it may impact the credit risk associated with Agency RMBS and other assets, and, therefore, decrease the value of the Agency RMBS, non-Agency RBMS and CMBS in our portfolio, which could cause our repurchase counterparties to make margin calls on our borrowings and swaps, if our collateral is insufficient to cover the debt secured by our assets.

Effective as of August 27, 2010, we implemented the DRSPP, pursuant to which we registered and reserved for issuance 2,000,000 shares of our common stock. Under the terms of the DRSPP, shareholders who participate in the DRSPP may purchase shares of our common stock directly from us, in cash investments up to $10,000. At our sole discretion, we may accept optional cash investments in excess of $10,000 per month, which may qualify for a discount from the market price of 0% to 3%. The DRSPP participants may also automatically reinvest all or a portion of their dividends for additional shares of our stock. During the six months ended June 30, 2012, we issued 6,478 shares of common stock (2011: 1,275 shares) under the share purchase feature of our DRSPP.

On December 13, 2011, we announced a share repurchase program that was approved by our Board of Directors for up to 7 million shares of our common stock. The shares may be repurchased from time to time through privately negotiated transactions or open market transactions, including pursuant to a trading plan in accordance with Rules 10b5-1 and 10b-18 under the Exchange Act or by any combination of such methods. The manner, price, number and timing of share repurchases will be subject to a variety of factors, including market conditions and applicable SEC rules. As of June 30, 2012, we have not repurchased any shares under this program.

Effects of Margin Requirements, Leverage and Credit Spreads

Our securities have values that fluctuate according to market conditions and, as discussed above, the market value of our securities will decrease as prevailing interest rates or credit spreads increase. When the value of the securities pledged to secure a repurchase loan decreases to the point where the positive difference between the collateral value and the loan amount is less than the haircut, our lenders may issue a “margin call,” which means that the lender will require us to pay the margin call in cash or pledge additional collateral to meet that margin call. Under our repurchase facilities, our lenders have full discretion to determine the value of the securities we pledge to them. Most of our lenders will value securities based on recent trades in the market. Lenders also issue margin calls as the published current principal balance factors change on the pool of mortgages underlying the securities pledged as collateral when scheduled and unscheduled paydowns are announced monthly.

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

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

Forward-Looking Statements Regarding Liquidity

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

 

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

Contractual Obligations

On July 1, 2009, we entered into an agreement with our Manager pursuant to which our Manager is entitled to receive a management fee and the reimbursement of certain expenses, which was amended on May 24, 2011. The management fee is calculated and payable quarterly in arrears in an amount equal to 1.50% of our shareholders’ equity, per annum. Our Manager uses the proceeds from its management fee in part to pay compensation to its officers and personnel who, notwithstanding that certain of those individuals are also our officers, receive no cash compensation directly from us. We are required to reimburse our Manager for operating expenses related to us incurred by our Manager, including certain salary expenses and other expenses relating to legal, accounting, due diligence and other services. Expense reimbursements to our Manager are made in cash on a monthly basis following the end of each month. Our reimbursement obligation is not subject to any dollar limitation. Refer to Note 8 – “Related Party Transactions” for details of our reimbursements to our Manager.

Contractual Commitments

As of June 30, 2012, we had the following contractual commitments and commercial obligations:

 

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