Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
CYS Investments, Inc. (the "Company", "we", "us", and "our") is a specialty finance company created with the objective of achieving consistent risk-adjusted investment income. Management’s Discussion and Analysis of Financial Condition and Results of Operations ("MD&A") is intended to provide the reader of the Company’s unaudited consolidated financial statements and accompanying notes with a narrative of management's perspective on the business underlying those financial statements and its financial condition and results of operations during the periods presented. The Company’s MD&A is comprised of six sections:
|
|
•
|
Forward-Looking Statements,
|
|
|
•
|
Trends and Recent Market Activity,
|
|
|
•
|
Results of Operations, and
|
|
|
•
|
Liquidity and Capital Resources.
|
The following discussion should be read in conjunction with our unaudited consolidated financial statements and accompanying notes included in Item 1 of this Quarterly Report on SEC Form 10-Q ("Quarterly Report"), as well as our Annual Report on Form 10-K for the fiscal year ended December 31, 2015, filed on February 17, 2016 (the "2015 Annual Report").
Forward Looking Statements
When used in this Quarterly Report, in future filings with the SEC or in press releases or other written or oral communications, statements which are not historical in nature, including those containing words such as "believe," "expect," "may," "will," "anticipate," "estimate," "plan," "continue," "intend," "should,” or the negative of these words and similar expressions, are intended to identify "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act"), and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and, as such, may involve known and unknown risks, uncertainties and assumptions. The forward-looking statements we make in this Quarterly Report include, but are not limited to, statements about the following:
• the effect of movements in interest rates on our assets and liabilities (including our hedging instruments) and our net income;
• our investment, financing and hedging strategies;
• the effect of U.S. government and foreign central bank actions on interest rates and the housing and credit markets;
• the effect of actual or proposed actions of the U.S. Federal Reserve Bank (the "Fed"), the Fed Open Market Committee ("FOMC"), the Federal Housing Finance Agency ("FHFA"), and the Federal Home Loan Bank system ("FHLB") or the FHLB of Cincinnati ("FHLBC");
• the supply of Agency residential mortgage backed securities ("RMBS") and U.S. Treasuries (collectively, "Debt Securities");
• the effect of increased prepayment rates on the value of our assets;
• expected trends in housing and rents/occupancy in assessing supply, demand and fair value in the housing markets;
• our ability to convert our assets into cash or extend the financing terms related to our assets;
• the effect of widening credit spreads or shifts in the yield curve on the value of our assets and investment strategy;
• the types of indebtedness we may incur;
• our ability to achieve anticipated benefits of interest rate swaps and caps;
• our ability to quantify risks based on historical experience;
• our ability to be taxed as a real estate investment trust ("REIT") and to maintain an exemption from registration under the Investment Company Act of 1940, as amended (the "Investment Company Act");
• our assessment of counterparty risk and/or the rise of counterparty defaults;
• our ability to meet short- and long-term liquidity requirements with our cash flow from operations and borrowings;
• the effect of rising interest rates on unemployment, inflation and mortgage supply and demand;
• our liquidity;
• our asset valuation policies; and
• our dividend distribution policy.
Forward-looking statements are based on our beliefs, assumptions and expectations of our future performance, taking
into account all information currently available to us. These beliefs, assumptions and expectations are subject to risks and
uncertainties and can change as a result of many possible events or factors, not all of which are known to us. If a change
occurs, our business, financial condition, liquidity and results of operations may vary materially from those expressed in our
forward-looking statements. The following factors could cause actual results to vary from our forward-looking statements:
• the factors referenced in this Quarterly Report;
• changes in our investment, financing and hedging strategies;
• the adequacy of our cash flow from operations and borrowings to meet our short- and long-term liquidity requirements;
• the liquidity of our portfolio;
• unanticipated changes in our industry, interest rates, the credit markets, the general economy or the real estate market;
• changes in interest rates and the market value of our Agency RMBS;
• changes in the prepayment rates on the mortgage loans underlying our Agency RMBS;
• changes in the value of our assets pledged as collateral;
• our ability to borrow to finance our assets;
• actions by the U.S. government, the Fed, the FOMC, the FHFA or the FHLB or the FHLBC that impact the value of our Agency RMBS or interest rates, or our access to borrowings at cost-effective rates;
• changes in government regulations affecting our business;
• changes in the U.S. government's credit rating or ability to pay its debts;
• the impact of an inability to reach an agreement on the national debt ceiling;
• our ability to maintain our qualification as a REIT for federal income tax purposes;
• our ability to maintain our exemption from registration under the Investment Company Act and the availability of such exemption in the future; and
• risks associated with investing in real estate assets, including changes in business conditions and the general economy.
These and other risks, uncertainties and factors, including those described elsewhere in this Quarterly Report, and in the Company's 2015 Annual Report, which has been filed with the Securities and Exchange Commission, could cause our actual results to differ materially from those projected in any forward-looking statements we make. All forward-looking statements speak only as of the date on which they are made. New risks and uncertainties arise over time and it is not possible to predict those events or how they may affect us. Except as required by law, we are not obligated to, and do not intend to, update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
Executive Overview
We seek to achieve our objective of earning consistent risk-adjusted investment income by investing on a leveraged basis primarily in Agency RMBS. These investments consist of residential mortgage pass-through securities for which the principal and interest payments are guaranteed by a government-sponsored enterprise, such as the Federal National Mortgage Association ("Fannie Mae") and the Federal Home Loan Mortgage Corporation ("Freddie Mac"), or by a U.S. government agency, such as the Government National Mortgage Association ("Ginnie Mae") (collectively referred to as "GSEs"). We also may invest in debt securities issued by the United States Department of Treasury ("U.S. Treasuries") and, in addition, our investment guidelines permit investments in collateralized mortgage obligations issued by a government agency or GSE that are collateralized by Agency RMBS ("CMOs"), or securities issued by a GSE that are not backed by collateral but, in the case of government agencies, are backed by the full faith and credit of the U.S. government, and, in the case of GSEs, are backed by the integrity and creditworthiness of the issuer ("U.S. Agency Debentures").
We commenced operations in February 2006, and completed our initial public offering in June 2009. Our common stock, our 7.75% Series A Cumulative Redeemable Preferred Stock, $25.00 liquidation preference (the "Series A Preferred Stock"), and our 7.50% Series B Cumulative Redeemable Preferred Stock, $25.00 liquidation preference (the "Series B Preferred Stock"), trade on the New York Stock Exchange under the symbols "CYS," "CYS PrA" and "CYS PrB," respectively.
We earn income from our investment portfolio which, as of
June 30, 2016
, was comprised principally of Debt Securities. We currently fund our investments primarily through borrowings under repurchase agreements ("repo borrowings"), and loans from the FHLBC. We use leverage to seek to enhance our returns. Our economic net interest income, a non-GAAP measure described in "Results of Operations" below, is generated primarily from the net spread, or difference, between the interest income we earn on our investment portfolio and the cost of our borrowings and hedging activities. The amount of economic net interest income we earn on our investments depends in part on our ability to control our financing costs, which
comprise a significant portion of our operating expenses. Although we leverage our portfolio investments in Debt Securities to seek to enhance our potential returns, leverage also may exacerbate losses.
While we use hedging to attempt to manage some of our interest rate risk, we do not hedge all of our exposure to changes in interest rates. Our investments vary in interest rate and maturity compared with the rates and duration of the hedges we employ. As a result, it is not possible to insulate our portfolio from all potential negative consequences associated with changes in interest rates in a manner that will allow us to achieve attractive spreads on our portfolio. Consequently, changes in interest rates, particularly short-term interest rates, may significantly affect our net income.
In addition to investing in issued pools of Agency RMBS, we regularly utilize forward settling transactions to purchase and sell certain securities, including forward settling purchases and sales of Agency RMBS where the pool is "to-be-announced" ("TBA"). Pursuant to a TBA, we agree to purchase or sell for future delivery, Agency RMBS with certain principal and interest terms and certain types of underlying collateral, but the particular Agency RMBS to be delivered is not specifically identified until shortly before the TBA settlement date. For TBA securities that meet the regular-way securities scope exception from derivative accounting under ASC 815 -
Derivatives and Hedging,
the Company records TBAs on the trade date utilizing information associated with the specified terms of the transaction. TBAs are carried at fair value and begin earning interest on the settlement date. At times, the Company may enter into TBA contracts without having the contractual obligation to accept or make delivery ("TBA Derivatives"), as a means of investing in and financing Agency RMBS via "dollar roll" transactions. TBA dollar roll transactions are accounted for as a series of derivative transactions. For other forward settling transactions, we agree to purchase or sell, for future delivery, Agency RMBS. However, unlike TBA Derivatives, these forward settling transactions reference an identified Agency RMBS.
In March 2015, our captive insurance subsidiary, CYS Insurance Services, LLC ("CYS Insurance"), was granted membership in the FHLBC and commenced obtaining FHLBC Advances from the FHLBC in the form of secured borrowings. Membership in the FHLBC permitted CYS Insurance to access a variety of products and services offered by the FHLBC, and obligated CYS Insurance to purchase FHLBC membership and activity stock, the latter being a percentage of the advances it obtains from the FHLBC. On January 12, 2016, the Federal Housing Finance Agency ("FHFA") issued a final rule (the "Final Rule") amending its regulations governing FHLB Membership criteria for captive insurance companies. The Final Rule defines "insurance company" to exclude "captive insurers". Under this Final Rule, which became effective on February 19, 2016, CYS Insurance's membership in the FHLBC must be terminated within one year of the effective date and it will not be permitted to secure any new advances. In response to this action, the Company has reduced outstanding FHLB Advances to
$575.0 million
as of
June 30, 2016
, and all outstanding advances are required to be repaid on or before February 19, 2017. As with our repo borrowings, if the value of any assets pledged to FHLBC as collateral for advances decreases, the FHLBC could require posting of additional collateral.
We have elected to be treated as a REIT for U.S. federal income tax purposes, and have complied with, and intend to continue to comply with, the provisions of the Internal Revenue Code of 1986, as amended (the "Internal Revenue Code"), with respect thereto. Accordingly, we generally do not expect to be subject to federal income tax on our REIT taxable income that we currently distribute to our stockholders if certain asset, income and ownership tests and recordkeeping requirements are fulfilled. Even if we maintain our qualification as a REIT, we may be subject to federal, state and local taxes on our income.
Trends and Recent Market Activity
Overview
In the second quarter of 2016 (the "Second Quarter"), longer-term interest rates moved lower, continuing the trends of the latter part of the first quarter of 2016 (the "First Quarter"). Short-term borrowing rates moved somewhat higher as the markets anticipated further Federal Reserve (the "Fed") rate hikes in 2016, though expectations are for the pace of these hikes to be very slow. However, despite the Fed's desire to normalize short-term interest rates, the emerging economic data continues to be below the Fed's expectations and the bond market continues to push out its expectations for rate hikes in 2016. Much of the concerns about slow growth stem from sluggish economic conditions in Europe and China. In a speech to the Economics Club of New York in April 2016 Janet Yellen, the Chair of the Fed, reiterated weak global conditions as a reason to adjust U.S. domestic monetary policy. Chair Yellen also highlighted the downside risks if the U.K. were to vote (the "British Referendum") to exit the European Union, though the surveys and polls at the time suggested even odds or a greater likelihood of a "remain" vote. Domestically, payroll growth appeared to have decelerated and inflation continued to run below the Fed's two percent target. As prospects for global economic growth continued to diminish, the bond market further pushed out its expectations for additional Fed rate hikes. Indeed, some market participants expected four rate hikes in 2016, but by the end of June 2016, general market expectations suggested no hikes in 2016. Additionally, lower oil prices, a strong U.S. dollar, and slower growth in China and other global economies present a growing risk of renewed deflationary pressures. Growth in the U.S. economy had already slowed to 0.9% in the First Quarter, and some economists now see Second Quarter growth at around 2.4%, but unlikely to accelerate in the second half of 2016. Thus, the U.S. economy, though apparently showing sustainable growth, is far from showing signs of accelerating above a 2% annual growth rate. Payrolls continued to rise in the First and Second Quarters,
though payroll gains have averaged below 150,000 jobs per month and wages continue to be stagnant. While the unemployment rate rose to 4.9% in June 2016 and the U-6 underemployment rate fell slightly to 9.6% as of
June 30, 2016
, inflation remains below the Fed’s 2% target. Although the FOMC continues to focus on its dual mandate of maximum employment and an inflation objective of 2%, it has expressed heightened awareness of the U.S. economy’s sensitivity to global economic conditions. During its June 2016 meeting, the FOMC voted to keep the federal funds rate at 0.25%, and as they did in March of 2016, specifically cited global economic and financial developments as influencing their decision and outlook on inflation. Current FOMC guidance provides that the pace of rate increases is likely to be slower with only two rate hikes in 2016, not the four anticipated in December 2015 and a terminal Fed Funds target rate of 3.25% by the end of 2018. The bond market and yield curve, however, suggest that market consensus is for no hikes in 2016, just two hikes in 2017, and a terminal Fed Funds target rate of 1.25% in 2019 and beyond.
Reflecting the diminishing prospects for accelerating growth, in the Second Quarter, the bond market rallied and the 10-year U.S. Treasury yield, which began the year at 2.27%, hit a low for the First Quarter of 1.66% in mid-February, closed at 1.77% on March 31, 2016, and rallied further in the Second Quarter to
1.47%
on June 30, 2016 following the unexpected outcome of the British Referendum to exit the European Union. This continued to drive Agency RMBS prices higher. Fannie Mae 30-year 3.5% RMBS prices rose by
0.60%
and Fannie Mae 15-year 3.0% RMBS prices rose by
0.33%
during the Second Quarter. Interest rates on swaps decreased during the Second Quarter and spreads widened slightly, resulting in a decrease in the value of our hedge book. Overall, the performance of Agency RMBS prices more than offset the decrease in the value of our hedges, and our book value increased. At the beginning of the First Quarter, our net duration gap was 0.74 years, declined to 0.30 years at March 31, 2016, and was virtually unchanged at
0.35
years on June 30, 2016.
While prepayments picked up slightly in the Second Quarter, the wave of refinancing activity was short-lived and CYS's portfolio prepaid at
12.9%
in the Second Quarter. Mortgage rates have continued to lag the drop in U.S. Treasury yields but we should anticipate a new round of prepayment activity. We expect homeowners to respond to the lower rates and expect prepayments on our portfolio assets to increase in the coming months, which would impact our portfolio yield. With the current Fed position of keeping interest rates lower for longer, we anticipate less volatility in the prices of Agency RMBS securities. As of June 30, 2016, we had substantial available liquidity of
$1.15 billion
, or
66.6%
of our equity, and leverage, on a debt to equity basis including TBA's as derivatives, increased slightly to
6.91:1
from the
March 31, 2016
level of
6.76:1
.
Government Activity
The FHFA and both houses of Congress have each discussed and considered separate measures intended to restructure the U.S. housing finance system and the operations of Fannie Mae and Freddie Mac.
We anticipate debate and discussion on residential housing and mortgage reform to continue throughout 2016 and well into 2017; however, we cannot be certain if any housing and/or mortgage-related legislation will emerge from committee, or be approved by Congress, and if so what the effect will be on our business. We also believe that it is unlikely that any reforms, legislation, or other significant movement on such legislation will occur during the current presidential administration.
Recent CYS Activity in Response to These Trends
In response to the conditions in and changes to the environment described above, the Company continues to monitor, reposition, and actively manage our investment portfolio, the structure of our borrowings and our hedge positions. During the First Quarter, in response to the FHFA Final Rule we replaced $1,450 million of FHLBC Advances with repo borrowings and leverage remained stable. Our duration gap increased marginally to 0.35 at June 30, 2016 from 0.30 at March 31, 2016. During the Second Quarter, our book value per common share increased to
$9.55
from $9.46 at the end of the First Quarter, after taking into account our $0.25 dividend per share in the Second Quarter. The increase in our book value during the Second Quarter was driven by an increase in RMBS prices, offset in part by a decrease in the value of our hedges. As markets reset to lower rates during the Second Quarter, we reduced our 30-Year 4.0% and 15-Year 3.0% holdings and purchased U.S. Treasuries and 15-Year 2.5% securities in anticipation of an increase in prepayments.
Financial Condition
The Agency RMBS in our portfolio were purchased at a net premium to their face value generally due to the average interest rates on these investments being higher than the prevailing market rates at the time of purchase. As of
June 30, 2016
and
December 31, 2015
we had approximately
$442.2 million
and
$462.6 million
, respectively, of unamortized premium included in the cost basis of our investments. TBA Agency RMBS, including those accounted for as derivatives, are included in the table below on a gross basis. Our Debt Securities portfolio including TBA Derivatives, consisted of the following assets:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted-Average
|
Coupon
|
|
Face Value (in 000's)
|
|
Fair Value (in 000's)
|
|
Amortized Cost Basis per Face Value
(in 000's)
|
|
Loan Balance (in 000's)
(1)
|
|
Loan Age (in months)
(1)
|
|
3 Month CPR
(1)(2)
|
|
Duration
(3)
|
June 30, 2016
|
|
|
|
|
|
|
|
|
|
|
|
|
15 Year Agency Mortgage Securities
|
|
|
|
|
|
|
|
|
|
|
2.5%
|
|
$
|
504,438
|
|
|
$
|
522,382
|
|
|
$
|
102.61
|
|
|
$
|
333
|
|
|
1
|
|
n/a
|
|
|
2.79
|
TBA 2.5%
|
|
1,115,000
|
|
|
1,153,567
|
|
|
102.69
|
|
|
n/a
|
|
|
n/a
|
|
n/a
|
|
|
2.62
|
3.0%
|
|
2,994,084
|
|
|
3,144,067
|
|
|
102.77
|
|
|
264
|
|
|
24
|
|
10.1
|
|
|
2.54
|
TBA 3.0%
*
|
|
41,000
|
|
|
43,010
|
|
|
104.69
|
|
|
n/a
|
|
|
n/a
|
|
n/a
|
|
|
2.07
|
3.5%
|
|
919,865
|
|
|
976,856
|
|
|
103.07
|
|
|
217
|
|
|
46
|
|
12.2
|
|
|
2.40
|
4.0%
|
|
122,956
|
|
|
131,028
|
|
|
101.08
|
|
|
168
|
|
|
64
|
|
16.8
|
|
|
2.38
|
4.5%
|
|
17,465
|
|
|
18,643
|
|
|
102.37
|
|
|
245
|
|
|
77
|
|
12.8
|
|
|
1.94
|
Subtotal
|
|
5,714,808
|
|
|
5,989,553
|
|
|
102.77
|
|
|
259
|
|
|
28
|
|
10.8
|
|
|
2.55
|
20 Year Agency Mortgage Securities
|
|
|
|
|
|
|
|
|
|
|
4.5%
|
|
45,186
|
|
|
49,494
|
|
|
102.75
|
|
|
216
|
|
|
71
|
|
17.1
|
|
|
2.18
|
30 Year Agency Mortgage Securities
|
|
|
|
|
|
|
|
|
|
|
3.5%
|
|
4,270,200
|
|
|
4,510,362
|
|
|
104.32
|
|
|
334
|
|
|
7
|
|
7.3
|
|
|
2.68
|
TBA 3.5%
*
|
|
(250,000
|
)
|
|
(263,914
|
)
|
|
104.02
|
|
|
n/a
|
|
|
n/a
|
|
n/a
|
|
|
2.47
|
4.0%
|
|
1,789,109
|
|
|
1,929,230
|
|
|
105.00
|
|
|
257
|
|
|
22
|
|
15.7
|
|
|
2.51
|
4.5%
|
|
130,138
|
|
|
142,667
|
|
|
106.71
|
|
|
284
|
|
|
62
|
|
17.7
|
|
|
2.37
|
Subtotal
|
|
5,939,447
|
|
|
6,318,345
|
|
|
104.59
|
|
|
311
|
|
|
12
|
|
10.6
|
|
|
2.63
|
Agency Hybrid ARMs
|
|
|
|
|
|
|
|
|
|
|
TBA 2.7%
*
|
|
25,000
|
|
|
26,011
|
|
|
102.69
|
|
|
n/a
|
|
|
n/a
|
|
n/a
|
|
|
1.85
|
2.9%
(4)
|
|
310,330
|
|
|
323,803
|
|
|
102.79
|
|
|
314
|
|
|
35
|
|
21.7
|
|
|
1.61
|
Subtotal
|
|
335,330
|
|
|
349,814
|
|
|
102.79
|
|
|
314
|
|
|
35
|
|
21.7
|
|
|
1.63
|
U.S. Treasuries
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
0.9%
|
|
880,000
|
|
|
884,213
|
|
|
100.12
|
|
|
n/a
|
|
|
n/a
|
|
n/a
|
|
|
2.84
|
Total
|
|
$
|
12,914,771
|
|
|
$
|
13,591,419
|
|
|
$
|
103.42
|
|
|
$
|
289
|
|
|
20
|
|
11.1
|
%
|
|
2.58
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
December 31, 2015
|
|
|
|
|
|
|
|
|
|
|
|
|
15-Year Agency Mortgage Securities
|
|
|
|
|
|
|
|
|
|
|
3.0%
|
|
$
|
4,840,936
|
|
|
$
|
4,994,705
|
|
|
$
|
103.16
|
|
|
$
|
283
|
|
|
16
|
|
7.2
|
%
|
|
3.46
|
TBA 3.0%
|
|
222,600
|
|
|
229,310
|
|
|
103.33
|
|
|
n/a
|
|
|
n/a
|
|
n/a
|
|
|
3.66
|
3.5%
|
|
1,014,790
|
|
|
1,064,726
|
|
|
103.15
|
|
|
220
|
|
|
41
|
|
9.8
|
|
|
3.05
|
4.0%
|
|
140,196
|
|
|
148,692
|
|
|
101.13
|
|
|
169
|
|
|
58
|
|
14.8
|
|
|
2.84
|
4.5%
|
|
20,152
|
|
|
21,432
|
|
|
102.51
|
|
|
243
|
|
|
71
|
|
14.7
|
|
|
2.45
|
Subtotal
|
|
6,238,674
|
|
|
6,458,865
|
|
|
103.12
|
|
|
270
|
|
|
22
|
|
7.9
|
|
|
3.38
|
20-Year Agency Mortgage Securities
|
|
|
|
|
|
|
|
|
|
|
4.5%
|
|
51,664
|
|
|
56,102
|
|
|
102.79
|
|
|
215
|
|
|
65
|
|
16.4
|
|
|
2.95
|
30-Year Agency Mortgage Securities
|
|
|
|
|
|
|
|
|
|
|
3.5%
|
|
2,741,525
|
|
|
2,830,295
|
|
|
103.70
|
|
|
328
|
|
|
7
|
|
3.3
|
|
|
4.88
|
TBA 3.5%
|
|
250,000
|
|
|
256,739
|
|
|
102.39
|
|
|
n/a
|
|
|
n/a
|
|
n/a
|
|
|
5.15
|
4.0%
|
|
2,321,917
|
|
|
2,461,698
|
|
|
105.20
|
|
|
277
|
|
|
16
|
|
9.6
|
|
|
4.01
|
TBA 4.0%
|
|
323,000
|
|
|
341,611
|
|
|
105.80
|
|
|
n/a
|
|
|
n/a
|
|
n/a
|
|
|
3.70
|
4.5%
|
|
143,081
|
|
|
154,869
|
|
|
106.78
|
|
|
283
|
|
|
56
|
|
16.3
|
|
|
3.65
|
Subtotal
|
|
5,779,523
|
|
|
6,045,212
|
|
|
104.44
|
|
|
304
|
|
|
12
|
|
6.2
|
|
|
4.44
|
Agency Hybrid ARMs
|
|
|
|
|
|
|
|
|
|
|
3.0%
(4)
|
|
356,991
|
|
|
367,817
|
|
|
102.80
|
|
|
315
|
|
|
33
|
|
17.7
|
|
|
2.48
|
U.S. Treasuries
|
|
|
|
|
|
|
|
|
|
|
0.9%
|
|
100,000
|
|
|
99,711
|
|
|
99.85
|
|
|
n/a
|
|
|
n/a
|
|
n/a
|
|
|
1.89
|
Total
|
|
$
|
12,526,852
|
|
|
$
|
13,027,707
|
|
|
$
|
103.69
|
|
|
$
|
286
|
|
|
18
|
|
7.6
|
%
|
|
3.83
|
__________________
|
|
(1)
|
TBAs are excluded from this calculation as they do not have a defined weighted-average loan balance or age until mortgages have been assigned to the pool.
|
|
|
(2)
|
The CPR ("Constant Prepayment Rate") represents the 3-month CPR of the Company’s Agency RMBS held at
June 30, 2016
and
December 31, 2015
. The CPR experienced by the Company during the period may differ. Securities with no prepayment history are excluded from this calculation.
|
|
|
(3)
|
Duration essentially measures the market price volatility of financial instruments as interest rates change, using DV01 methodology. We generally calculate duration using various third-party financial models and empirical data. Different models and methodologies can produce different results for the same securities. Source: The Yield Book
®
.
|
|
|
(4)
|
Coupon represents the weighted-average coupon of Agency Hybrid ARMs.
|
* Includes TBA Derivatives with a fair value of $827.3 million at
June 30, 2016
.
In July 2016, the weighted average experienced CPR of the Company's Debt Securities was
12.6%
.
Hedging Instruments
The Company utilizes interest rate swap and cap contracts (a "swap" or "cap", respectively) to hedge the interest rate risk associated with the financing of our Debt Securities portfolio. As of
June 30, 2016
, the Company held swaps with an aggregate notional of approximately
$6.95 billion
, a weighted-average fixed rate of
1.19%
, and a weighted-average expiration of
3.4
years. The receive rate on the Company's swaps is 3-month LIBOR. At
June 30, 2016
, the Company had entered into caps with a notional of
$2.50 billion
, a weighted-average cap rate of
1.28%
, and a weighted-average expiration of
3.5
years. Below is a summary of our interest rate swaps and caps as of
June 30, 2016
and
December 31, 2015
:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted-Average
|
|
|
June 30, 2016
|
|
Number of Contracts
|
|
Notional (000's)
|
|
Rate
|
|
Maturity
|
|
Duration
|
|
Fair Value (000's)
|
Interest Rate Swaps
|
|
18
|
|
|
$
|
6,950,000
|
|
|
1.19
|
%
|
|
November 2019
|
|
(3.15
|
)
|
|
$
|
(91,607
|
)
|
Interest Rate Caps
|
|
5
|
|
|
2,500,000
|
|
|
1.28
|
%
|
|
January 2020
|
|
(1.35
|
)
|
|
16,021
|
|
|
|
23
|
|
|
$
|
9,450,000
|
|
|
1.22
|
%
|
|
November 2019
|
|
(2.67
|
)
|
|
$
|
(75,586
|
)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
December 31, 2015
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest Rate Swaps
|
|
21
|
|
|
$
|
7,950,000
|
|
|
1.29
|
%
|
|
May 2019
|
|
(3.08
|
)
|
|
$
|
25,411
|
|
Interest Rate Caps
|
|
5
|
|
|
2,500,000
|
|
|
1.28
|
%
|
|
January 2020
|
|
(2.39
|
)
|
|
61,343
|
|
|
|
26
|
|
|
$
|
10,450,000
|
|
|
1.29
|
%
|
|
July 2019
|
|
(2.91
|
)
|
|
$
|
86,754
|
|
The Company seeks to manage its exposure to interest rate risk by expanding and/or lengthening its hedging, and reducing its pay rate, if possible, when doing so. During the
six
months ended
June 30, 2016
we terminated swaps with a combined notional of $2.70 billion with a weighted-average pay rate of 1.50%. The terminations resulted in a net realized loss of $(45.4) million for the
six
months ended
June 30, 2016
. After the repositioning, our weighted-average fixed pay rate on swaps decreased to
1.19%
at
June 30, 2016
compared to
1.29%
at
December 31, 2015
.
Our interest rate swap and cap notional was
$9.45 billion
at
June 30, 2016
compared to
$10.45 billion
at
December 31, 2015
, and as a percentage of our of the repo borrowings and FHLBC Advances (collectively "Total Outstanding Borrowings") decreased to
90.7%
at
June 30, 2016
from
94.3%
at
December 31, 2015
.
The Company does not consider TBA Derivatives to be hedging instruments.
Liabilities
We finance a majority of our assets through repo borrowings and FHLBC Advances. Repo borrowings and FHLBC Advances are secured by our assets and generally bear interest rates that have historically moved in close relationship to LIBOR. At
June 30, 2016
and
December 31, 2015
, we had liabilities pursuant to repo borrowings and FHLBC Advances with
35
counterparties which are summarized below:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
June 30, 2016
|
|
|
|
|
|
Weighted-Average
(1)
|
Original Days to Maturity by Collateral Type
|
|
Repo Borrowings and FHLBC Advances Outstanding (000's)
|
|
Percentage of Total
|
|
Interest Rate
|
|
Remaining Days to Maturity
|
|
Original Days to Maturity
|
Agency RMBS
|
|
|
|
|
|
|
|
|
|
|
≤ 30 Days
|
|
$
|
1,709,546
|
|
|
17%
|
|
0.66%
|
|
18
|
|
30
|
> 30 to ≤ 60 Days
|
|
3,042,650
|
|
|
29%
|
|
0.67%
|
|
23
|
|
38
|
> 60 Days
|
|
4,823,186
|
|
|
46%
|
|
0.80%
|
|
98
|
|
167
|
Subtotal
|
|
$
|
9,575,382
|
|
|
92%
|
|
0.73%
|
|
60
|
|
101
|
|
|
|
|
|
|
|
|
|
|
|
U.S. Treasuries
|
|
|
|
|
|
|
|
|
|
|
≤ 30 Days
|
|
$
|
849,119
|
|
|
8%
|
|
0.06%
|
|
15
|
|
30
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
$
|
10,424,501
|
|
|
100%
|
|
0.68%
|
|
56
|
|
96
|
|
|
(1)
|
Weighted-average maturity date is calculated with assumption of FHLBC Advances being repaid in full on or before February 19, 2017, as a direct result of the Final Rule.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
December 31, 2015
|
|
|
|
|
|
Weighted-Average
|
Original Days to Maturity by Collateral Type
|
|
Repo Borrowings and FHLBC Advances Outstanding (000's)
|
|
Percentage of Total
|
|
Interest Rate
|
|
Remaining Days to Maturity
|
|
Original Days to Maturity
|
Agency RMBS
|
|
|
|
|
|
|
|
|
|
|
≤ 30 Days
|
|
$
|
751,592
|
|
|
7%
|
|
0.49%
|
|
7
|
|
30
|
> 30 to ≤ 60 Days
|
|
2,507,201
|
|
|
24%
|
|
0.48%
|
|
9
|
|
43
|
> 60 Days
|
|
7,055,732
|
|
|
66%
|
|
0.54%
|
|
37
|
|
88
|
Total
|
|
$
|
10,314,525
|
|
|
97%
|
|
0.52%
|
|
28
|
|
73
|
|
|
|
|
|
|
|
|
|
|
|
U.S. Treasuries
|
|
|
|
|
|
|
|
|
|
|
> 30 to ≤ 60 Days
|
|
$
|
348,251
|
|
|
3%
|
|
(0.13)%
|
|
2
|
|
13
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
$
|
10,662,776
|
|
|
100%
|
|
0.50%
|
|
27
|
|
71
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted-Average
|
Original Days to Maturity
|
|
FHLBC Advances Outstanding (000's)
|
|
Percentage of Total
|
|
Interest Rate
|
|
Next Call Date
|
|
Maturity Date
|
Agency RMBS
|
|
|
|
|
|
|
|
|
|
|
> 360 Days
|
|
$
|
425,000
|
|
|
100%
|
|
1.48%
|
|
May 2016
|
|
July 2018
|
In addition, as of
June 30, 2016
, we had an aggregate payable for securities purchased, a portion of which will be or, in the case of
December 31, 2015
, was financed through repo borrowings and FHLBC Advances, as summarized below (in thousands).
|
|
|
|
|
|
|
|
|
|
June 30, 2016
|
|
|
|
|
Settle Date
|
|
Face Value
|
|
Payable
|
July 2016
|
|
$
|
527,014
|
|
|
$
|
547,186
|
|
August 2016
|
|
100,000
|
|
|
105,433
|
|
Total
|
|
$
|
627,014
|
|
|
$
|
652,619
|
|
|
|
|
|
|
|
|
|
|
|
December 31, 2015
|
|
|
|
|
Settle Date
|
|
Face Value
|
|
Payable
|
January 2016
|
|
$
|
963,097
|
|
|
$
|
1,008,133
|
|
February 2016
|
|
200,000
|
|
|
211,550
|
|
March 2016
|
|
250,000
|
|
|
256,291
|
|
|
|
$
|
1,413,097
|
|
|
$
|
1,475,974
|
|
Summary Financial Data
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended June 30,
|
|
Six Months Ended June 30,
|
(dollars in thousands, except per share data)
|
2016
|
|
2015
|
|
2016
|
|
2015
|
Income Statement Data:
|
|
|
|
|
|
|
|
Interest income
|
74,857
|
|
|
80,532
|
|
|
156,308
|
|
|
161,382
|
|
Interest expense
|
18,687
|
|
|
10,262
|
|
|
36,632
|
|
|
19,904
|
|
Net interest income
|
56,170
|
|
|
70,270
|
|
|
119,676
|
|
|
141,478
|
|
Other income (loss):
|
|
|
|
|
|
|
|
|
|
|
|
Net realized and unrealized gain (loss) on investments, FHLBC Advances and other income
|
65,213
|
|
|
(167,357
|
)
|
|
228,313
|
|
|
(73,375
|
)
|
Net gain (loss) on derivative instruments
|
(59,314
|
)
|
|
6,055
|
|
|
(218,236
|
)
|
|
(98,781
|
)
|
Total other income (loss)
|
5,899
|
|
|
(161,302
|
)
|
|
10,077
|
|
|
(172,156
|
)
|
Expenses:
|
|
|
|
|
|
|
|
Compensation and benefits
|
3,565
|
|
|
3,712
|
|
|
7,430
|
|
|
7,266
|
|
General, administrative and other
|
2,294
|
|
|
2,293
|
|
|
4,782
|
|
|
4,496
|
|
Total expenses
|
5,859
|
|
|
6,005
|
|
|
12,212
|
|
|
11,762
|
|
Net income (loss)
|
$
|
56,210
|
|
|
$
|
(97,037
|
)
|
|
$
|
117,541
|
|
|
$
|
(42,440
|
)
|
Dividend on preferred stock
|
(5,203
|
)
|
|
(5,203
|
)
|
|
(10,406
|
)
|
|
(10,406
|
)
|
Net income (loss) available to common stockholders
|
$
|
51,007
|
|
|
$
|
(102,240
|
)
|
|
$
|
107,135
|
|
|
$
|
(52,846
|
)
|
Net income (loss) per common share basic & diluted
|
$
|
0.34
|
|
|
$
|
(0.66
|
)
|
|
$
|
0.71
|
|
|
$
|
(0.34
|
)
|
Dividends per common share
|
$
|
0.25
|
|
|
$
|
0.28
|
|
|
$
|
0.51
|
|
|
$
|
0.58
|
|
|
|
|
|
|
|
|
|
Key Balance Sheet Metrics
|
|
|
|
|
|
|
|
Average settled Debt Securities
(1)
|
$
|
11,887,351
|
|
|
$
|
13,219,744
|
|
|
$
|
11,913,005
|
|
|
$
|
13,014,108
|
|
Average total Debt Securities
(2)
|
$
|
13,230,800
|
|
|
$
|
14,711,932
|
|
|
$
|
13,097,446
|
|
|
$
|
14,753,522
|
|
Average repurchase agreements and FHLBC Advances
(3)
|
$
|
10,412,784
|
|
|
$
|
11,610,144
|
|
|
$
|
10,473,530
|
|
|
$
|
11,363,312
|
|
Average Debt Securities liabilities
(4)
|
$
|
11,756,233
|
|
|
$
|
13,102,332
|
|
|
$
|
11,657,971
|
|
|
$
|
13,102,726
|
|
Average stockholders' equity
(5)
|
$
|
1,725,879
|
|
|
$
|
1,893,445
|
|
|
$
|
1,722,046
|
|
|
$
|
1,936,977
|
|
Average common shares outstanding
(6)
|
151,452
|
|
|
157,334
|
|
|
151,620
|
|
|
158,929
|
|
Leverage ratio (at period end)
(7)
|
6.91:1
|
|
|
7.06:1
|
|
|
6.91:1
|
|
|
7.06:1
|
|
Book value per common share (at period end)
(8)
|
$
|
9.55
|
|
|
$
|
9.62
|
|
|
$
|
9.55
|
|
|
$
|
9.62
|
|
Weighted average amortized cost of Agency RMBS and U.S. Treasuries
(9)
|
$
|
103.42
|
|
|
$
|
103.98
|
|
|
$
|
103.42
|
|
|
$
|
103.98
|
|
|
|
|
|
|
|
|
|
Key Performance Metrics*
|
|
|
|
|
|
|
|
Average yield on settled Debt Securities
(10)
|
2.52
|
%
|
|
2.44
|
%
|
|
2.62
|
%
|
|
2.48
|
%
|
Average yield on total Debt Securities including Drop Income
(11)
|
2.50
|
%
|
|
2.42
|
%
|
|
2.61
|
%
|
|
2.50
|
%
|
Average cost of funds
(12)
|
0.72
|
%
|
|
0.35
|
%
|
|
0.70
|
%
|
|
0.35
|
%
|
Average cost of funds and hedge
(13)
|
1.29
|
%
|
|
1.21
|
%
|
|
1.33
|
%
|
|
1.27
|
%
|
Adjusted average cost of funds and hedge
(14)
|
1.14
|
%
|
|
1.08
|
%
|
|
1.20
|
%
|
|
1.10
|
%
|
Interest rate spread net of hedge
(15)
|
1.23
|
%
|
|
1.23
|
%
|
|
1.29
|
%
|
|
1.21
|
%
|
Interest rate spread net of hedge including Drop Income
(16)
|
1.36
|
%
|
|
1.34
|
%
|
|
1.41
|
%
|
|
1.40
|
%
|
Operating expense ratio
(17)
|
1.36
|
%
|
|
1.27
|
%
|
|
1.42
|
%
|
|
1.21
|
%
|
Total stockholder return on common equity
(18)
|
3.59
|
%
|
|
(5.98
|
)%
|
|
7.48
|
%
|
|
(2.86
|
)%
|
Constant prepayment rate (weighted average experienced 1-month)
(19)
|
12.9
|
%
|
|
13.0
|
%
|
|
10.2
|
%
|
|
11.7
|
%
|
___________
|
|
(1)
|
The average settled Debt Securities is calculated by
averaging
the month end cost basis of settled Debt Securities during the period.
|
|
|
(2)
|
The average total Debt Securities is calculated by
averaging
the month end cost basis of total Debt Securities and all TBA contracts during the period.
|
|
|
(3)
|
The average repurchase agreements and FHLBC Advances are calculated by
averaging
the month end repurchase agreements and FHLBC Advances balances during the period.
|
|
|
(4)
|
The average Debt Securities liabilities are calculated by
adding
the average month end repurchase agreements and FHLBC Advances balances plus average unsettled Debt Securities (inclusive of TBA Derivatives) during the period.
|
|
|
(5)
|
The average stockholders' equity is calculated by
averaging
the month end stockholders' equity during the period.
|
|
|
(6)
|
The average common shares outstanding are calculated by
averaging
the daily common shares outstanding during the period.
|
|
|
(7)
|
The leverage ratio is calculated by
dividing
(i) the Company's repurchase agreements and FHLBC Advances balance plus payable for securities purchased
minus
receivable for securities sold
plus
gross TBA Derivatives positions by (ii) stockholders' equity.
|
|
|
(8)
|
Book value per common share is calculated by
dividing
total stockholders' equity
less
the liquidation value of preferred stock at period end
divided
by common shares outstanding at period end.
|
|
|
(9)
|
The weighted average amortized cost of Agency RMBS and U.S. Treasuries is calculated using the weighted average amortized cost by security
divided
by the current face at period end.
|
|
|
(10)
|
The average yield on settled Debt Securities for the period is calculated by
dividing
total interest income by average settled Debt Securities.
|
|
|
(11)
|
The average yield on total Debt Securities including Drop Income for the period is calculated by
dividing
total interest income plus Drop Income by average total Debt Securities. Drop Income was
$8.0 million
and
$8.6 million
for the three months ended
June 30, 2016
and
2015
, respectively. Drop Income was
$14.3 million
and
$22.7 million
for the
six
months ended
June 30, 2016
and
2015
, respectively. Drop Income is a component of our net realized and unrealized gain (loss) on investments and net realized and unrealized gain (loss) on derivative instruments in the accompanying unaudited consolidated statements of operations. Drop Income is the difference between the spot price and the forward settlement price for the same security on trade date. This difference is also the economic equivalent of the assumed net interest margin (yield
minus
financing costs) of the bond from trade date to settlement date. We derive Drop Income through utilization of forward settling transactions.
|
|
|
(12)
|
The average cost of funds for the period is calculated by
dividing
repurchase agreement and FHLBC Advances interest expense by average repurchase agreements and FHLBC Advances for the period.
|
|
|
(13)
|
The average cost of funds and hedge for the period is calculated by
dividing
repurchase agreement, FHLBC Advances and swap and cap interest expense by average repurchase agreements and FHLBC Advances.
|
|
|
(14)
|
The adjusted average cost of funds and hedge for the period is calculated by
dividing
repurchase agreement, FHLBC Advances and swap and cap interest expense by average Debt Securities liabilities.
|
|
|
(15)
|
The interest rate spread net of hedge for the period is calculated by
subtracting
average cost of funds and hedge from average yield on settled Debt Securities.
|
|
|
(16)
|
The interest rate spread net of hedge including Drop Income for the period is calculated by
subtracting
adjusted average cost of funds and hedge from average yield on total Debt Securities including Drop Income.
|
|
|
(17)
|
The operating expense ratio for the period is calculated by
dividing
operating expenses by average stockholders' equity.
|
|
|
(18)
|
The total stockholder return on common equity is calculated as the change in book value
plus
dividend distributions on common stock
divided
by book value per common share at the end of the prior period
.
|
|
|
(19)
|
T
he constant prepayment rate ("CPR") represents the weighted average 1-month CPR of the Company's Agency RMBS during the period.
|
|
|
*
|
All percentages are annualized except total stockholder return on common equity.
|
Core Earnings
"Core Earnings" represents a non-U.S. GAAP financial measure and is defined as net income (loss) available to common stockholders excluding net realized and unrealized gain (loss) on investments, net realized and unrealized gain (loss) on derivative instruments and net unrealized gain (loss) on FHLBC Advances. Management uses Core Earnings to evaluate the effective yield of the portfolio after operating expenses. In addition, management utilizes Core Earnings as a key metric in conjunction with other portfolio and market factors to determine the appropriate leverage and hedging ratios, as well as the overall structure of the portfolio. The Company believes that providing users of the Company's financial information with such measures, in addition to the related GAAP measures, gives investors greater transparency and insight into the information used by the Company's management in its financial and operational decision-making.
The primary limitation associated with Core Earnings as a measure of our financial performance over any period is that it excludes the effects of net realized and unrealized gain (loss) on investments and derivative instruments, and net unrealized gain (loss) on FHLBC Advances. In addition, our presentation of Core Earnings may not be comparable to similarly-titled measures used by other companies, which may employ different calculations. As a result, Core Earnings should not be considered a substitute for our U.S. GAAP net income (loss) as a measure of our financial performance or any measure of our liquidity under U.S. GAAP.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(In thousands)
|
Three Months Ended June 30,
|
|
Six Months Ended June 30,
|
Non-U.S. GAAP Reconciliation:
|
2016
|
|
2015
|
|
2016
|
|
2015
|
Net income (loss) available to common stockholders
|
$
|
51,007
|
|
|
$
|
(102,240
|
)
|
|
$
|
107,135
|
|
|
$
|
(52,846
|
)
|
Net realized (gain) loss on investments
|
(36,359
|
)
|
|
(9,435
|
)
|
|
(37,561
|
)
|
|
(27,688
|
)
|
Net unrealized (gain) loss on investments
|
(28,915
|
)
|
|
176,899
|
|
|
(191,201
|
)
|
|
101,210
|
|
Net realized and unrealized (gain) loss on derivative instruments
|
44,535
|
|
|
(31,047
|
)
|
|
185,059
|
|
|
46,321
|
|
Net unrealized (gain) loss on FHLBC Advances
|
448
|
|
|
11
|
|
|
1,299
|
|
|
11
|
|
Core Earnings
|
$
|
30,716
|
|
|
$
|
34,188
|
|
|
$
|
64,731
|
|
|
$
|
67,008
|
|
Results of Operations
Commencing with the report on Form 10-K for the year ended December 31, 2015, "Swap and cap interest expense", which was recognized as a separate component of "Total interest expense" in the consolidated statement of operations through September 30, 2015, is now recognized as a component of "Net gain (loss) on derivative instruments". This reclassification was made in order to record income, expenses and changes in fair value related to derivative instruments in one line item in the consolidated statements of operations, consistent with common industry practice. Prior period balances have been reclassified to conform to the current period presentation.
The following table provides GAAP measures of interest expense and net interest income and details with respect to reconciling these line items on a non-GAAP basis for each respective period.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended June 30,
|
|
2016
|
|
2015
|
|
$ Change
|
|
% Change
|
Net interest income
|
$
|
56,170
|
|
|
$
|
70,270
|
|
|
$
|
(14,100
|
)
|
|
(20.1
|
)%
|
Swap and cap interest expense
|
14,779
|
|
|
24,992
|
|
|
(10,213
|
)
|
|
(40.9
|
)%
|
Economic net interest income
|
$
|
41,391
|
|
|
$
|
45,278
|
|
|
$
|
(3,887
|
)
|
|
(8.6
|
)%
|
|
|
|
|
|
|
|
|
Total interest expense
|
$
|
18,687
|
|
|
$
|
10,262
|
|
|
$
|
8,425
|
|
|
82.1
|
%
|
Swap and cap interest expense
|
14,779
|
|
|
24,992
|
|
|
(10,213
|
)
|
|
(40.9
|
)%
|
Economic interest expense
|
$
|
33,466
|
|
|
$
|
35,254
|
|
|
$
|
(1,788
|
)
|
|
(5.1
|
)%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Six Months Ended June 30,
|
|
2016
|
|
2015
|
|
$ Change
|
|
% Change
|
Net interest income
|
$
|
119,676
|
|
|
$
|
141,478
|
|
|
$
|
(21,802
|
)
|
|
(15.4
|
)%
|
Swap and cap interest expense
|
33,177
|
|
|
52,460
|
|
|
(19,283
|
)
|
|
(36.8
|
)%
|
Economic net interest income
|
$
|
86,499
|
|
|
$
|
89,018
|
|
|
$
|
(2,519
|
)
|
|
(2.8
|
)%
|
|
|
|
|
|
|
|
|
Total interest expense
|
$
|
36,632
|
|
|
$
|
19,904
|
|
|
$
|
16,728
|
|
|
84.0
|
%
|
Swap and cap interest expense
|
33,177
|
|
|
52,460
|
|
|
(19,283
|
)
|
|
(36.8
|
)%
|
Economic interest expense
|
$
|
69,809
|
|
|
$
|
72,364
|
|
|
$
|
(2,555
|
)
|
|
(3.5
|
)%
|
Three Months Ended
June 30, 2016
Compared to the Three Months Ended
June 30, 2015
Net Income (Loss)
Net income available to common stockholders
increased
$153.2 million
to
$51.0 million
for the three months ended
June 30, 2016
, compared to a net loss of
$(102.2) million
for the
three months ended
June 30, 2015
, primarily due to lower swap and cap interest expense and net gains on investments in the
Second
Quarter compared to the
second
quarter of
2015
. The major components of this increase are detailed below.
Interest Income and Asset Yield
Our principal source of income is interest income that we earn on our investment securities portfolio. Interest income, which consists primarily of interest income on Debt Securities,
decreased
by
$5.6 million
to
$74.9 million
for the three months
ended
June 30, 2016
, as compared to
$80.5 million
for the three months ended
June 30, 2015
. Our interest income decreased primarily due to a decrease in average settled Debt Securities despite the average yield on settled Debt Securities increasing to
2.52%
at
June 30, 2016
from
2.44%
at
June 30, 2015
. The factors driving this decrease are changes both in the size of our portfolio and the related yield, as shown below (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Change in Size
|
|
Change in Yield
|
|
Change in Size & Yield
|
Change in average settled
|
$
|
(1,332,393
|
)
|
|
Change in average yield
|
0.082
|
%
|
|
Change in average settled
|
$
|
(1,332,393
|
)
|
2015 average yield
|
2.437
|
%
|
|
2015 average settled
|
$
|
13,219,744
|
|
|
Change in average yield
|
0.082
|
%
|
Change
|
$
|
(8,116
|
)
|
|
Change
|
$
|
2,715
|
|
|
Change
|
$
|
(274
|
)
|
|
|
|
|
|
|
Total change
|
$
|
(5,675
|
)
|
Our average settled Debt Securities for the
three months ended
June 30, 2016
was
$11.9 billion
, compared to
$13.2 billion
for the
three months ended
June 30, 2015
. Our annualized average yield on settled Debt Securities for the
three months ended
June 30, 2016
was
2.52%
, compared to
2.44%
for the
three months ended
June 30, 2015
. Our yield increase was primarily a function of lower amortization expense in the current quarter than in the comparable period and lower weighted average cost basis which was
$103.42
at
June 30, 2016
compared to
$103.98
at
June 30, 2015
. Our annualized rate of portfolio prepayment for the
three months ended
June 30, 2016
was
12.9%
, which was slightly lower than the rate of 13.0% for the
three months ended
June 30, 2015
. Our amortization expense was
$22.6 million
for the
three months ended
June 30, 2016
, a decrease of $5.0 million from $27.6 million for the
three months ended
June 30, 2015
.
Economic Interest Expense and Cost of Funds
Economic interest expense for the three months ended
June 30, 2016
, which consists of interest expense from repo borrowings, FHLBC Advances, and interest rate swap and cap contracts,
decreased
$1.8 million
to
$33.5 million
, as compared to
$35.3 million
for the
three months ended
June 30, 2015
. Interest expense from repo borrowings and FHLBC Advances
increased
by
$8.4 million
to
$18.7 million
for the three months ended
June 30, 2016
, compared to
$10.3 million
for the
three months ended
June 30, 2015
due to higher cost of funds. Our weighted-average cost of funds rose to
0.72%
in the
Second
Quarter from
0.35%
in the
second
quarter of
2015
. Our average repo borrowings and FHLBC Advances
decreased
to
$10,412.8 million
for the
three months ended
June 30, 2016
from
$11,610.1 million
for the
three months ended
June 30, 2015
, consistent with the decrease in settled Debt Securities during the quarter ended
June 30, 2016
as compared to the quarter ended
June 30, 2015
. The table below illustrates the result of changes to the amount outstanding and rates on repo borrowings and FHLBC Advances interest expense during the three months ended
June 30, 2016
and
2015
(in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Change in Size
|
|
Change in Rate
|
|
Change in Size & Yield
|
Change in average outstanding
|
$
|
(1,197,360
|
)
|
|
Change in average rate
|
0.364
|
%
|
|
Change in average outstanding
|
$
|
(1,197,360
|
)
|
2015 average rate
|
0.354
|
%
|
|
2015 average outstanding
|
$
|
11,610,144
|
|
|
Change in average rate
|
0.364
|
%
|
Change
|
$
|
(1,059
|
)
|
|
Change
|
$
|
10,574
|
|
|
Change
|
$
|
(1,090
|
)
|
|
|
|
|
|
|
Total change
|
$
|
8,425
|
|
Swap and cap interest expense
decreased
by
$10.2 million
to
$14.8 million
in the
three months ended
June 30, 2016
, compared to
$25.0 million
in the
three months ended
June 30, 2015
. The decrease in interest rate swap and cap expense was partially the result of a decrease in the average aggregate swap and cap notional by
$250.0 million
to
$9,700.0 million
in the
three months ended
June 30, 2016
from
$9,950.0 million
in the
three months ended
June 30, 2015
, and more significantly attributable to the decrease in the average swap and cap rate to 0.61% in the
three months ended
June 30, 2016
from 1.00% in the
three months ended
June 30, 2015
, as shown in the table below (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Change in Size
|
|
Change in Rate
|
|
Change in Size & Rate
|
Change in average notional outstanding
|
$
|
(250,000
|
)
|
|
Change in average rate
|
(0.395
|
)%
|
|
Change in average notional outstanding
|
$
|
(250,000
|
)
|
2015 average rate
|
1.005
|
%
|
|
2015 average notional outstanding
|
$
|
9,950,000
|
|
|
Change in average rate
|
(0.395
|
)%
|
Change
|
$
|
(628
|
)
|
|
Change
|
$
|
(9,832
|
)
|
|
Change
|
$
|
247
|
|
|
|
|
|
|
|
Total change
|
$
|
(10,213
|
)
|
Our annualized weighted-average cost of funds including hedge was
1.29%
for the
three months ended
June 30, 2016
, as compared to
1.21%
for the
three months ended
June 30, 2015
. The components of our cost of funds including hedge are (i) rates on our repo borrowings and FHLBC Advances, (ii) rates on our interest rate swaps and caps, (iii) the size of our repo borrowings and FHLBC Advances, and (iv) the total notional amount of the interest rate swaps and caps.
Economic Net Interest Income
Our economic net interest income for the
three months ended
June 30, 2016
was
$41.4 million
, and our interest rate spread, net of hedge, was
1.23%
, compared to economic net interest income of
$45.3 million
and an interest rate spread, net of hedge, of
1.23%
for the
three months ended
June 30, 2015
. The decrease in our economic net interest income was principally due to a decrease in average settled Debt Securities coupled with higher total interest expense, offset by a decrease in swap and cap interest expense in the
three months ended
June 30, 2016
compared to
June 30, 2015
. While our economic net interest income is influenced significantly by the size of our portfolio and overall interest rate levels, we believe our interest rate spread net of hedge is an important performance indicator.
Other Income (Loss)
For the
three months ended
June 30, 2016
, our total other income (loss) was
$5.9 million
compared to a loss of
$(161.3) million
for the
three months ended
June 30, 2015
. The major components contributing to the change in total other income (loss) are discussed below.
Gain (Loss) on Investments and Drop Income
During the
three months ended
June 30, 2016
, our net realized and unrealized gain (loss) on investments changed by
$232.8 million
to a
$65.3 million
net gain, compared to a net loss of
$(167.5) million
for the three months ended
June 30, 2015
. This change was driven by an increase in the prices of our Agency RMBS for the
three months ended
June 30, 2016
, as compared to a decrease in the prices of all our Agency RMBS for the
three months ended
June 30, 2015
. For example, during the three months ended
June 30, 2016
, the price of a 30-year 4.0% Agency RMBS
increased
$0.31
to
$107.23
, and during the
three months ended
June 30, 2015
, it
decreased
$1.12
to
$105.83
. During the three months ended
June 30, 2016
, the price of a 15-year 3.0% Agency RMBS
increased
$0.34
to
$104.86
, and during the
three months ended
June 30, 2015
, it
decreased
$1.35
to
$103.48
.
During the
three months ended
June 30, 2016
and
2015
, we generated Drop Income of approximately
$8.0 million
and
$8.6 million
, respectively. The lower Drop Income during the
three months ended
June 30, 2016
was primarily due to lower volumes of forward settling transactions from which we derive Drop Income and a less advantageous market. During the
three months ended
June 30, 2016
, the average balance in the combined TBA Securities and TBA Derivatives portfolio was
$1,290.8 million
, a
decrease
of
$177.7 million
compared to the average balance of
$1,468.5 million
for the
three months ended
June 30, 2015
. Drop Income is a component of our net realized and unrealized gain (loss) on investments and our net realized and unrealized gain (loss) on derivative instruments in the accompanying unaudited consolidated statements of operations and is therefore excluded from Core Earnings. Drop Income is the difference between the spot price and the forward settlement price for the same Agency RMBS on the trade date. This difference is also the economic equivalent of the assumed interest rate spread net of hedge (yield less financing costs) of the Agency RMBS from trade date to settlement date. The Company derives Drop Income through utilization of forward settling transactions of Agency RMBS. The TBA market became slightly less attractive in the
Second
Quarter and we settled more cash bonds than during the
second
quarter of 2015.
Net unrealized gain (loss) on FHLBC Advances
We held
$350.0 million
of FHLBC Advances that had an initial maturity greater than one year and a weighted average maturity of 0.6 years at
June 30, 2016
. We held $75.0 million of FHLBC Advances with an initial maturity more than one year and a weighted average maturity of 2.90 years at
June 30, 2015
. For the
three months ended
June 30, 2016
the net unrealized loss on FHLBC Advances was
$(0.4) million
. The unrealized loss was primarily due to pricing remaining long-term FHLBC Advances at par due to an expectation to repay the outstanding balance by August 2016. For the
three months ended
June 30, 2015
the net unrealized loss on FHLBC Advances was
$(0.01) million
. The loss was primarily due to decreasing interest rates in which the fair value of the liability decreased during the second quarter of 2015 as 3-year swap rates increased from 1.21% on May 27, 2015 to 1.25% at
June 30, 2015
.
Net Gain (Loss) on Derivative Instruments
Net gain (loss) on derivative instruments is comprised of swap and cap interest expense and net realized and unrealized gain (loss) on derivative instruments. Net realized and unrealized gain (loss) on derivative instruments was
$(44.5) million
(comprised of $(51.0) million net realized and unrealized loss on swap and cap contracts, and $6.5 million net realized and unrealized gain on TBA Derivatives) for the three months ended
June 30, 2016
, compared to a gain of
$31.0 million
(comprised of
$31.0 million
net realized and unrealized gain on swap and cap contracts, and $0.0 million net realized and unrealized gain on TBA Derivatives) for the three months ended
June 30, 2015
. The change in net realized and unrealized gain (loss) on derivative instruments for the three months ended
June 30, 2016
was primarily due to a decrease in interest rates during the
Second
Quarter, which caused the value of our derivative instruments to decrease. An increase in rates during the
second
quarter of 2015 caused the value of our derivative instruments to increase. Our swaps and caps are designed principally to protect us in an environment of increasing interest rates. In the
Second
Quarter we responded to declining interest rates by terminating some of our swaps, on which we realized a loss of
$(34.3) million
; however, a continued decrease in interest rates
and significant volatility resulted in unrealized losses on our outstanding swaps and caps. During the three months ended
June 30, 2016
and
2015
, 5-year swap rates
decreased
by
19
bps and
increased
by
26
bps, respectively.
Operating Expenses
Operating expenses were
$5.9 million
for the
three months ended
June 30, 2016
, compared to
$6.0 million
for the
three months ended
June 30, 2015
.
Six Months Ended June 30, 2016
Compared to the
Six Months Ended June 30, 2015
Net Income
Net income available to common stockholders
increased
$159.9 million
to
$107.1 million
for the
six months ended June 30, 2016
, compared to a net loss of
$(52.8) million
for the
six
months ended
June 30, 2015
. The increase in net income during the Second Quarter is primarily attributable to a
$292.4 million
increase in net unrealized gains on investments, a
$19.3 million
decrease in swap and cap interest expense, and an
$9.9 million
increase in net realized gains on investments, partially offset by a
$138.8 million
increase in net realized and unrealized losses on derivatives, a
$16.7 million
increase in interest expense, and a
$5.1 million
decrease in interest income. Details follow regarding each of the aforementioned components.
Interest Income and Asset Yield
Interest income
decreased
by
$5.1 million
to
$156.3 million
for the
six months ended June 30, 2016
, as compared to
$161.4 million
for the
six
months ended
June 30, 2015
. The decrease in our interest income is largely due to a decrease in average settled Debt Securities in the
six months ended June 30, 2016
, offset by an increase in the yield on our investments, as shown below (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Change in Size
|
|
Change in Yield
|
|
Change in Size & Yield
|
Change in average settled
|
$
|
(1,101,103
|
)
|
|
Change in average yield
|
0.144
|
%
|
|
Change in average settled
|
$
|
(1,101,103
|
)
|
2015 average yield
|
2.480
|
%
|
|
2015 average settled
|
$
|
13,014,108
|
|
|
Change in average yield
|
0.144
|
%
|
Change
|
$
|
(13,654
|
)
|
|
Change
|
$
|
9,373
|
|
|
Change
|
$
|
(793
|
)
|
|
|
|
|
|
|
Total change
|
$
|
(5,074
|
)
|
Our average settled Debt Securities for the
six months ended June 30, 2016
was
$11.9 billion
, compared to
$13.0 billion
for the
six months ended
June 30, 2015
. Our annualized yield on average settled Debt Securities for the
six months ended June 30, 2016
was
2.62%
, as compared to
2.48%
for the
six months ended
June 30, 2015
. The increase in our yield was primarily attributable to less amortization expense for the
six months ended June 30, 2016
compared to the
six months ended
June 30, 2015
. The annualized rate of portfolio prepayment for the
six months ended June 30, 2016
and
2015
was
10.2%
and
11.7%
, respectively. Our amortization expense was
$38.5 million
for the
six months ended June 30, 2016
, compared to
$49.0 million
for the
six months ended
June 30, 2015
.
Economic Interest Expense and Cost of Funds
Economic interest expense, which primarily consists of interest expense from repo borrowings, FHLBC Advances and interest rate swaps and caps,
decreased
$2.6 million
to
$69.8 million
for the
six
months ended
June 30, 2016
, from
$72.4 million
for the
six months ended
June 30, 2015
.
Interest expense from repo borrowings and FHLBC Advances increased by
$16.7 million
to
$36.6 million
for the
six
months ended
June 30, 2016
, compared to
$19.9 million
for the
six months ended
June 30, 2015
due to higher cost of funds. Our weighted-average cost of funds rose to
0.70%
during the
six
months ended
June 30, 2016
from
0.35%
for the
six months ended
June 30, 2015
. Our average repo borrowings and FHLBC Advances
decreased
to
$10,473.5 million
for the
six
months ended
June 30, 2016
from
$11,363.3 million
for the
six months ended
June 30, 2015
, consistent with the decrease in the settled Debt Securities portfolio at
June 30, 2016
as compared to the portfolio at
June 30, 2015
. The table below illustrates the result of changes to the amount outstanding and rates on repo borrowings and FHLBC Advances interest expense during the
six months ended
June 30, 2016
and
2015
(in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Change in Size
|
|
Change in Rate
|
|
Change in Size & Yield
|
Change in average outstanding
|
$
|
(889,782
|
)
|
|
Change in average rate
|
0.349
|
%
|
|
Change in average outstanding
|
$
|
(889,782
|
)
|
2015 average rate
|
0.350
|
%
|
|
2015 average outstanding
|
$
|
11,363,312
|
|
|
Change in average rate
|
0.349
|
%
|
Change
|
$
|
(1,558
|
)
|
|
Change
|
$
|
19,840
|
|
|
Change
|
$
|
(1,554
|
)
|
|
|
|
|
|
|
Total change
|
$
|
16,728
|
|
Swap and cap interest expense
decreased
by
$19.3 million
, to
$33.2 million
in the
six months ended June 30, 2016
, compared to
$52.5 million
in the
six months ended
June 30, 2015
. The decrease in the interest rate swap and cap expense was
attributable in part to the decrease in the average aggregate swap and cap notional by
$185.7 million
to
$9,878.6 million
for the
six months ended June 30, 2016
, from
$10,064.3 million
for the
six months ended
June 30, 2015
, and more significantly by the decrease in the average swap and cap rate to 0.67% in the
six months ended June 30, 2016
from 1.04% in the
six months ended
June 30, 2015
, as shown in the table below (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Change in Size
|
|
Change in Rate
|
|
Change in Size & Rate
|
Change in average notional outstanding
|
$
|
(185,715
|
)
|
|
Change in average rate
|
(0.371
|
)%
|
|
Change in average notional outstanding
|
$
|
(185,715
|
)
|
2015 average rate
|
1.042
|
%
|
|
2015 average notional outstanding
|
$
|
10,064,286
|
|
|
Change in average rate
|
(0.371
|
)%
|
Change
|
$
|
(969
|
)
|
|
Change
|
$
|
(18,658
|
)
|
|
Change
|
$
|
344
|
|
|
|
|
|
|
|
Total change
|
$
|
(19,283
|
)
|
Our annualized weighted-average cost of funds, including hedges, rose to
1.33%
for the
six months ended June 30, 2016
from
1.27%
for the
six months ended
June 30, 2015
. The components of our cost of funds including hedge are (i) rates on our repo borrowings and FHLBC Advances, (ii) rates on our interest rate swaps and caps, (iii) the size of our repo borrowings and FHLBC Advances, and (iv) the total notional amount of the interest rate swaps and caps.
Economic Net Interest Income
Our economic net interest income for the
six months ended June 30, 2016
was
$86.5 million
, and our interest rate spread, net of hedge, was
1.29%
compared to economic net interest income of
$89.0 million
and an interest rate spread net of hedge of
1.21%
for the
six months ended
June 30, 2015
. The decrease in our economic net interest income was principally due to a decrease in average settled Debt Securities and higher total interest expense which was offset by a
$19.3 million
decrease in swap and cap interest expense in the
six months ended June 30, 2016
compared to the
six months ended
June 30, 2015
.
Gain (Loss) on Investments and Drop Income
Net realized and unrealized gain on investments changed by
$302.3 million
to a gain of
$228.8 million
for the
six months ended June 30, 2016
, compared to a net loss of
$(73.5) million
for the
six
months ended
June 30, 2015
. This change was driven by an increase in the prices of our Agency RMBS for the
six months ended June 30, 2016
, as compared to a decrease in the prices of our Agency RMBS for the
six
months ended
June 30, 2015
. For example, during the
six
months ended
June 30, 2016
the price of a 30-Yr. 4.0% Agency RMBS
increased
$1.37
to
$107.23
, and during the
six
months ended
June 30, 2015
the price for the same security
decreased
$0.94
to
$105.83
. During the
six
months ended
June 30, 2016
, the price of a 15-year 3.0% Agency RMBS
increased
$1.78
to
$104.86
, and during the
six
months ended
June 30, 2015
, it
decreased
$0.50
to
$103.48
.
During the
six
months ended
June 30, 2016
and
2015
, we generated Drop Income of approximately
$14.3 million
and
$22.7 million
, respectively. The decrease in Drop Income during the
six months ended
June 30, 2016
as compared to the comparable prior year period was primarily attributable to more advantageous financing in the forward market to settle than to roll our TBA positions during the
six months ended
June 30, 2016
and, as a result, we executed a lower volume of forward settling transactions from which we derive Drop Income.
Net unrealized gain (loss) on FHLBC Advances
We held
$350.0 million
of FHLBC Advances that had an initial maturity greater than one year and a weighted average maturity of 0.6 years at
June 30, 2016
. We held $75.0 million of FHLBC Advances with an initial maturity more than one year and a weighted average maturity of 2.90 years at
June 30, 2015
. For the
six
months ended
June 30, 2016
the net unrealized loss on FHLBC Advances was
$(1.3) million
. The unrealized loss was primarily due to pricing remaining long-term FHLBC Advances at par due to an expectation to repay the outstanding balance by August 2016. For the
six
months ended
June 30, 2015
the net unrealized loss on FHLBC Advances was
$(0.01) million
. The loss was primarily due to a slight decrease in interest rates during the
six
months ended
June 30, 2015
as 3-year swap rates decreased from 1.30% on December 31, 2014 to 1.25% at
June 30, 2015
.
Net Gain (Loss) on Derivative Instruments
Net gain (loss) on derivative instruments is comprised of net realized and unrealized gain (loss) on swap and cap contracts and TBA Derivatives. Net realized and unrealized gain (loss) on derivative instruments was
$(185.1) million
(comprised of $(199.0) million net realized and unrealized loss on swap and cap contracts, and $13.9 million net realized and unrealized gain on TBA Derivatives) for the
six
months ended
June 30, 2016
, compared to a loss of
$(46.3) million
(comprised of
$(46.3) million
net realized and unrealized loss on swap and cap contracts, and $0.0 million net realized and unrealized gain on TBA Derivatives) for the
six
months ended
June 30, 2015
. The change in net realized and unrealized gain (loss) on derivative
instruments for the
six
months ended
June 30, 2016
and
2015
was primarily due to decrease in interest rates during the
six
months ended
June 30, 2016
which caused the value of our derivative instruments to decrease.
During the
six months ended June 30, 2016
and
2015
, 5-year swap rates
decreased
by
76
bps and
increased
by
2
bps, respectively. The average interest rate swap and cap notional amount was
$9,878.6 million
for the
six
months ended
June 30, 2016
compared to
$10,064.3 million
for the
six months ended
June 30, 2015
. In the six months ended June 30, 2015, interest rates fell significantly in the first quarter, then rose in the second quarter but less significantly, and as a result the modest interest rate swap and cap gains in the second quarter were offset by more significant swap and cap losses in the first quarter.
Operating Expenses
Operating expenses were
$12.2 million
and
$11.8 million
for the
six months ended June 30, 2016
and
2015
, respectively.
Contractual Obligations and Commitments
The following table summarizes the principal balances related to our contractual obligations for repo borrowings and FHLBC Advances and the related interest expense thereon, and office leases at
June 30, 2016
and
December 31, 2015
(in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
June 30, 2016
|
Within One Year
|
|
One to Three Years
|
|
Three to Five Years
|
|
Thereafter
|
|
Total
|
Repurchase agreements and FHLBC Advances
|
$
|
10,424,501
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
10,424,501
|
|
Interest expense on repurchase agreements and FHLBC Advances, based on rates at June 30, 2016
(1)
|
20,536
|
|
|
—
|
|
|
—
|
|
|
—
|
|
|
20,536
|
|
Long-term operating lease obligation
|
370
|
|
|
726
|
|
|
766
|
|
|
805
|
|
|
2,667
|
|
Total
|
$
|
10,445,407
|
|
|
$
|
726
|
|
|
$
|
766
|
|
|
$
|
805
|
|
|
$
|
10,447,704
|
|
|
|
(1)
|
Interest expense is calculated with the assumption of the FHLBC Advances maturing on or before February 19, 2017, as a direct result of the Final Rule.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
December 31, 2015
|
Within One Year
|
|
One to Three Years
|
|
Three to Five Years
|
|
Thereafter
|
|
Total
|
Repurchase agreements and FHLBC Advances
|
$
|
10,662,776
|
|
|
$
|
425,000
|
|
|
$
|
—
|
|
|
|
|
$
|
11,087,776
|
|
Interest expense on borrowings under repurchase agreements and FHLBC Advances, based on rates at December 31, 2015
|
17,972
|
|
|
9,564
|
|
|
—
|
|
|
|
|
27,536
|
|
Long-term operating lease obligation
|
327
|
|
|
716
|
|
|
756
|
|
|
999
|
|
|
2,798
|
|
Total
|
$
|
10,681,075
|
|
|
$
|
435,280
|
|
|
$
|
756
|
|
|
$
|
999
|
|
|
$
|
11,118,110
|
|
At
June 30, 2016
and
December 31, 2015
, we held the following interest rate swap and cap contracts (in thousands):
As of
June 30, 2016
|
|
|
|
|
|
|
|
|
|
|
|
Interest Rate Swaps
|
|
Weighted-Average
|
|
Notional
|
|
Fair
|
Expiration Year
|
|
Fixed Pay Rate
|
|
Amount
|
|
Value
|
2017
|
|
0.80%
|
|
$
|
1,500,000
|
|
|
$
|
(2,078
|
)
|
2018
|
|
1.00%
|
|
1,500,000
|
|
|
(7,018
|
)
|
2020
|
|
1.45%
|
|
1,750,000
|
|
|
(38,208
|
)
|
2021
|
|
1.21%
|
|
1,700,000
|
|
|
(18,091
|
)
|
2022
|
|
1.98%
|
|
500,000
|
|
|
(26,212
|
)
|
Total
|
|
1.19%
|
|
$
|
6,950,000
|
|
|
$
|
(91,607
|
)
|
|
|
|
|
|
|
|
Interest Rate Caps
|
|
Weighted-Average
|
|
Notional
|
|
Fair
|
Expiration Year
|
|
Cap Rate
|
|
Amount
|
|
Value
|
2019
|
|
1.34%
|
|
$
|
800,000
|
|
|
$
|
2,662
|
|
2020
|
|
1.25%
|
|
1,700,000
|
|
|
13,359
|
|
Total
|
|
1.28%
|
|
$
|
2,500,000
|
|
|
$
|
16,021
|
|
As of
December 31, 2015
|
|
|
|
|
|
|
|
|
|
|
|
Interest Rate Swaps
|
|
Weighted-Average
|
|
Notional
|
|
Fair
|
Expiration Year
|
|
Fixed Pay Rate
|
|
Amount
|
|
Value
|
2017
|
|
0.82%
|
|
$
|
2,250,000
|
|
|
$
|
8,968
|
|
2018
|
|
1.16%
|
|
2,000,000
|
|
|
2,913
|
|
2019
|
|
1.75%
|
|
800,000
|
|
|
(7,148
|
)
|
2020
|
|
1.49%
|
|
2,000,000
|
|
|
19,989
|
|
2022
|
|
1.93%
|
|
900,000
|
|
|
689
|
|
Total
|
|
1.29%
|
|
$
|
7,950,000
|
|
|
$
|
25,411
|
|
|
|
|
|
|
|
|
Interest Rate Caps
|
|
Weighted-Average
|
|
Notional
|
|
Fair
|
Expiration Year
|
|
Cap Rate
|
|
Amount
|
|
Value
|
2019
|
|
1.34%
|
|
$
|
800,000
|
|
|
$
|
13,811
|
|
2020
|
|
1.25%
|
|
1,700,000
|
|
|
47,532
|
|
Total
|
|
1.28%
|
|
$
|
2,500,000
|
|
|
$
|
61,343
|
|
We enter into certain agreements that contain a variety of indemnification obligations, principally with our brokers and counterparties for interest rate swap contracts and repo borrowings. We have not incurred any costs to defend a lawsuit or settle claims related to these indemnification obligations. The maximum potential future payment amount we could be required to pay under these indemnification obligations cannot be reasonably estimated. Accordingly, we recorded no liabilities for these agreements as of
June 30, 2016
and
December 31, 2015
. In addition, as of
June 30, 2016
and
December 31, 2015
, we had
$652.6 million
and
$1,476.0 million
of payable for securities purchased, respectively, a portion of which either will be or was financed through repo borrowings and/or FHLB Advances.
Off-Balance Sheet Arrangements
As of
June 30, 2016
and
December 31, 2015
, we did not maintain any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance, special purpose or variable interest entities, established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Further, as of
June 30, 2016
and
December 31, 2015
, we had not guaranteed any obligations of unconsolidated entities or entered into any commitment or had any intent to provide funding to any such entities.
We may also seek to obtain other sources of financing depending on market conditions. We may finance the acquisition of agency RMBS by entering into TBA dollar roll transactions in which we would sell a TBA contract for current
month settlement and simultaneously purchase a similar TBA contract for a forward settlement date. Prior to the forward settlement date, we may choose to roll the position out to a later date by entering into an offsetting TBA position, net settling the paired off positions for cash, and simultaneously entering into a similar TBA contract for a later settlement date. In such transactions, the TBA contract purchased for a forward settlement date is priced at a discount to the TBA contract sold for settlement/pair off in the current month. The discount is the difference between the spot price and the forward settlement price for the same Agency RMBS on trade date and is referred to by the Company as Drop Income. This difference is also the economic equivalent of the assumed net interest spread (yield less financing costs) of the Agency RMBS from trade date to settlement date. Consequently, dollar roll transactions accounted for as TBA Derivatives represent a form of off-balance sheet financing. In evaluating our overall leverage at risk, we consider both our on-balance and off-balance sheet financing.
Liquidity and Capital Resources
Our primary sources of funds are repo borrowings, FHLBC Advances, equity offerings, asset sales, and monthly principal and interest payments on our investment portfolio. Because the level of our borrowings can be adjusted on a daily basis, the level of cash carried on our balance sheet is significantly less important than the potential liquidity available under our borrowing arrangements. We currently believe that we have sufficient liquidity and capital resources available for the acquisition of additional investments, repayments on borrowings, maintenance of any margin requirements and the payment of cash dividends as required for our continued qualification as a REIT. To qualify as a REIT, we must distribute annually at least 90% of our net taxable income. To the extent that we annually distribute all of our net taxable income in a timely manner, we will generally not be subject to federal and state income taxes. We currently expect to distribute all or substantially all of our taxable income in a timely manner so that we are not subject to federal and state income taxation. This distribution requirement limits our ability to retain earnings and thereby replenish or increase capital from operations.
As of
June 30, 2016
and
December 31, 2015
, we had approximately
$1,145.8 million
and
$1,120.2 million
, respectively, in Agency RMBS, U.S. Treasuries, and cash available to satisfy future margin calls. The following table presents our unencumbered liquid assets as a percentage of stockholders' equity as of
June 30, 2016
:
|
|
|
|
|
|
|
|
|
|
|
|
Carrying Value as of
|
Unencumbered Liquid Assets
|
|
June 30, 2016
|
|
December 31, 2015
|
Cash
|
|
$
|
13,182
|
|
|
$
|
9,982
|
|
U.S. Treasuries
|
|
10,805
|
|
|
29,257
|
|
Agency RMBS
|
|
1,121,819
|
|
|
1,080,990
|
|
Total liquid assets
|
|
$
|
1,145,806
|
|
|
$
|
1,120,229
|
|
Unencumbered liquid assets as % of total stockholders' equity
|
|
66.6
|
%
|
|
66.2
|
%
|
To date, we have maintained sufficient liquidity to meet margin calls, and we have never been unable to satisfy a margin call, although no assurance can be given that we will be able to satisfy requests from our lenders to post additional collateral in the future. During the
six
months ended
June 30, 2016
, we maintained an average liquidity level of approximately 58% and never less than 47% of stockholders' equity.
During the Second Quarter, we had average repo borrowings and FHLBC Advances outstanding of $
10,412.8 million
with an average cost of funds of
0.72%
, and during the second quarter of
2015
we had average repo borrowings and FHLBC Advances of
$11,610.1 million
with an average cost of funds of
0.35%
. At
June 30, 2016
, repo borrowing financing was generally stable with interest rates between 0.55% and 0.84% for 30-90 day repo borrowings. At
June 30, 2016
, FHLBC Advances totaled
$575.0 million
, with a weighted average rate of 1.11% and remaining term of 143 days (which reflects a final maturity date of February 19, 2017). Certain FHLBC Advances had an original term of three years and were callable by the Company after the one-year anniversary of the advance and thereafter every six months. As with our repo borrowings, if the value of any assets pledged to FHLBC as collateral for advances decreases, the FHLBC could require posting of additional collateral. On January 12, 2016, the FHFA issued a Final Rule amending its regulations governing FHLB membership criteria for captive insurance companies, which has terminated our ability to access additional advances from the FHLBC. As a direct result of the Final Rule, the Company has reduced outstanding FHLBC Advances to $575 million as of June 30, 2016, and all outstanding advances with the FHLBC are required to be repaid on or before February 19, 2017. During the First Quarter the Company replaced $1,450.0 million of FHLBC Advances with its existing repo counterparties and expects that it will be able to replace the remaining FHLBC Advances with existing repo counterparties. The Company’s FHLBC membership and activity stock totaling
$23.0 million
at
June 30, 2016
is expected to be redeemed in full when FHLBC Advances are repaid. We expect to repay the remaining FHLBC Advances outstanding at
June 30, 2016
by August 2016.
To limit our exposure to counterparty credit risk, we diversify our funding across multiple counterparties and by counterparty region. As of
June 30, 2016
and
December 31, 2015
, we had access to
48
counterparties, subject to certain conditions, located throughout North America, Europe and Asia. At
June 30, 2016
, FHLBC Advances were
5.52%
of the Total
Outstanding Borrowings, and repo borrowings with any individual counterparty were less than
8%
of our Total Outstanding Borrowings. The table below includes a summary of the percent of total borrowings with counterparties by region as of
June 30, 2016
and
December 31, 2015
:
|
|
|
|
|
|
|
|
|
June 30, 2016
|
Counterparty Region
|
|
Number of Counterparties
|
|
Percent of Total Outstanding Borrowings
|
North America
|
|
22
|
|
61.7
|
%
|
Europe
|
|
8
|
|
21.1
|
%
|
Asia
|
|
5
|
|
17.2
|
%
|
|
|
35
|
|
100.0
|
%
|
|
|
|
|
|
|
|
|
|
December 31, 2015
|
Counterparty Region
|
|
Number of Counterparties
|
|
Percent of Total Outstanding Borrowings
|
North America
|
|
22
|
|
64.4
|
%
|
Europe
|
|
8
|
|
21.8
|
%
|
Asia
|
|
5
|
|
13.8
|
%
|
|
|
35
|
|
100.0
|
%
|
Our repurchase agreements contain typical provisions and covenants as set forth in the standard master repurchase agreement published by the Securities Industry and Financial Markets Association. Our repurchase agreements generally require us to transfer additional securities to the counterparty in the event the value of the securities then held by the counterparty in the margin account falls below specified levels and contain events of default in cases where we or the counterparty breaches our respective obligations under the agreement.
The credit arrangement pursuant to which CYS Insurance maintains FHLBC Advances (the "FHLBC Arrangement") involves observance by CYS Insurance of the rules of FHLBC membership, is subject to the FHLBC's credit policies, and is governed by the terms and conditions of a blanket security agreement, and the consent and guaranty of the Company. The FHLBC Arrangement requires CYS Insurance to transfer additional securities to the FHLBC in the event the value of the securities then held by the FHLBC falls below specified levels, and contains events of default in cases where we or the FHLBC breaches our respective obligations under the FHLBC Arrangement. An event of default or termination event under the FHLBC Arrangement would give the FHLBC the option to terminate all FHLBC Advances existing with us and make any amount due by us to the FHLBC immediately payable. As mentioned above
,
on January 12, 2016, the FHFA issued a Final Rule amending its regulations governing FHLB membership criteria for captive insurance companies, which has terminated our ability to access additional advances from the FHLBC.
We receive margin calls from our counterparties in the ordinary course of business similar to other entities in the specialty finance business. We receive two types of margin calls from our counterparties. The first, known as a "factor call", is a margin call that occurs periodically and relates to the timing difference between the reduction of principal balances of our Agency RMBS, due to monthly principal payments on the underlying mortgages, and the receipt of the corresponding cash. The second type of margin call we may receive is a "valuation call", which occurs due to market and interest rate movements. Both factor and valuation margin calls occur if the total value of our assets pledged as collateral to a counterparty drops beyond a threshold level, typically between $100,000 and $500,000 (although no such minimum applies under the FHLBC Arrangement). Both types of margin calls require a dollar for dollar restoration of the margin shortfall. Similarly, we may initiate a margin call to a counterparty when the value of our assets pledged as collateral with the counterparty increases above the threshold level, thereby increasing our liquidity upon receipt of the collateral. All unrestricted cash plus any unpledged securities are available to satisfy margin calls.
Our collateral is generally valued on the basis of prices provided by recognized bond market sources agreed to by the parties involved. Inputs to the models used by pricing sources may include, but are not necessarily limited to, reported trades, executable bid and asked prices, broker quotations, prices or yields of securities with similar characteristics, benchmark curves or information pertaining to the issuer, as well as industry and economic events. Our master agreements for repo borrowing transactions contain mostly standard provisions for the valuation of collateral. These agreements typically provide that both the repurchase seller (the borrower) and the repurchase buyer (the lender) value the collateral on a daily basis. Each party uses prices that it obtains from generally recognized pricing sources, or the most recent closing bid quotation from such a source. If the buyer, or the seller, as the case may be, determines that additional collateral is required, it may call for the delivery of such collateral. Under certain of our repurchase agreements, in limited circumstances, such as when a pricing source is not available, our lenders have the right to determine the value of the collateral we have provided to secure our repurchase borrowings. In instances where we have agreed to permit our lenders to make a determination of the value of such collateral, such lenders are expected to act reasonably and in good faith in making such valuation determinations.
An event of default or termination event under the standard master repurchase agreement would give our counterparty the option to terminate all repurchase transactions existing with us and make any amount due by us to the counterparty immediately payable.
During the
six months ended June 30, 2016
and
2015
, we recorded
$865.0 million
and
$1,034.7 million
of principal repayments, respectively, and received
$158.4 million
and
$161.7 million
of interest payments, respectively. We held cash of
$13.2 million
and
$10.0 million
at
June 30, 2016
and
December 31, 2015
, respectively. For the
six
months ended
June 30, 2016
and
2015
, net cash provided by operating activities was
$78.2 million
and
$129.8 million
, respectively. For the
six
months ended
June 30, 2016
and
2015
, net cash provided by (used in) investing activities was
$643.6 million
and
$(453.2) million
, respectively. For the
six
months ended
June 30, 2016
and
2015
, net cash provided by (used in) financing activities was
$(718.6) million
and
$369.1 million
, respectively.
Our investment portfolio is comprised principally of highly liquid Agency RMBS guaranteed by Freddie Mac or Fannie Mae, and Ginnie Mae RMBS and U.S. Treasuries both backed by the full faith and credit of the U.S. government. We regularly monitor the creditworthiness of the U.S. government. While the U.S. government has had its credit rating downgraded in recent years by one of the credit rating agencies, it is generally considered to be one of the most secure creditors in the world.
We may increase our capital resources by obtaining long-term credit facilities or making public or private offerings of equity or debt securities. Such financings will depend on market conditions for capital raises and for the investment of any proceeds. If we are unable to renew, replace or expand our sources of financing on substantially similar terms, it may have an adverse effect on our business and results of operations.
From time to time we raise capital through the sale and issuance of our capital stock. On May 23, 2014, we filed an automatically effective shelf registration statement on Form S-3 with the SEC. We may offer and sell, from time to time, shares of common stock, preferred stock and debt securities in one or more offerings pursuant to the prospectus that is a part of the registration statement. As of
June 30, 2016
, we had not issued any shares of common stock, preferred stock or debt securities under the prospectus.
Another vehicle to raise capital is our Direct Share Purchase Program ("DSPP"), through which stockholders may purchase additional shares of common stock by reinvesting some or all of the cash dividends received on shares of common stock. Stockholders may also make optional cash purchases of shares of common stock subject to certain limitations detailed in the plan prospectus. We did not issue any shares under the plan during the
six
months ended
June 30, 2016
and
2015
. As of
June 30, 2016
and
December 31, 2015
, there were approximately
4.1 million
shares available for issuance under the DSPP.
For the
six months ended June 30, 2016
, we repurchased
673,166
shares of the Company's common stock at a weighted-average purchase price of
$7.85
per share, for an aggregate of approximately
$5.3 million
. Accordingly, the Company was authorized to repurchase shares of its common stock approximating
$155.5 million
as of
June 30, 2016
pursuant to its stock repurchase program. For the six months ended June 30, 2015, we repurchased 5,436,157 shares of the Company's common stock at a weighted-average purchase price of $8.93 per share, for an aggregate of approximately $48.7 million. Accordingly, the Company was authorized to repurchase shares of its common stock approximating $199.8 million as of June 30, 2015.
Quantitative and Qualitative Disclosures about Short-Term Borrowings
The following table discloses quantitative data about our repo borrowings and short-term FHLBC advances during the
three months ended
June 30, 2016
and
2015
:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended June 30,
|
|
Six Months Ended June 30,
|
(In millions)
|
2016
|
|
2015
|
|
2016
|
|
2015
|
Outstanding at period end
|
$
|
10,075
|
|
|
$
|
11,690
|
|
|
$
|
10,075
|
|
|
$
|
11,690
|
|
Weighted-average rate at period end
|
0.65
|
%
|
|
0.34
|
%
|
|
0.65
|
%
|
|
0.34
|
%
|
Average outstanding during period
(1)
|
$
|
10,025
|
|
|
$
|
11,573
|
|
|
$
|
10,070
|
|
|
$
|
11,342
|
|
Weighted-average rate during period
|
0.69
|
%
|
|
0.35
|
%
|
|
0.67
|
%
|
|
0.35
|
%
|
Largest month end balance during period
|
$
|
10,363
|
|
|
$
|
11,984
|
|
|
$
|
10,663
|
|
|
$
|
11,984
|
|
_______________
|
|
(1)
|
Calculated based on the average month end balance of repurchase agreements and FHLBC Advances with initial maturities less than one year.
|
The Company's borrowing rates were higher in the
three months ended
June 30, 2016
than in the corresponding
three months ended
June 30, 2015
due primarily to the FOMC raising the federal funds rate by 25 bps on December 16, 2015.
Overall we continue to experience a stable borrowing environment. During the
six months ended June 30, 2016
the Company replaced $1,450.0 million of FHLBC Advances with repo borrowings from its existing counterparties. This change did not have a significant impact on our total interest expense. At
June 30, 2016
, the Company had
$575.0 million
of the FHLBC Advances that are required to be repaid on or prior to February 19, 2017. We expect to repay the remaining outstanding long-term FHLBC Advances by August 2016. From quarter to quarter, fluctuations occur in our repo borrowings and FHLBC Advances that are well correlated with the expansion and contraction of our investment portfolio. Though it varies by quarter, we currently expect borrowings for approximately 80-85 percent of our investment portfolio.
At
June 30, 2016
and
December 31, 2015
, our amount at risk with any individual counterparty related to our repo borrowings or FHLBC Advances was less than
2.1%
and
2.3%
of stockholders' equity, respectively, and our repo borrowings or FHLBC Advances with any individual counterparty were less than
6.3%
and
14.7%
of our total assets, respectively.
Inflation
Our assets and liabilities are sensitive to interest rate and other related factors to a greater degree than inflation. Changes in interest rates do not necessarily correlate with inflation rates or changes in inflation rates. Our financial statements are prepared in accordance with U.S. GAAP and our dividend distributions are determined by our Board of Directors based in part on our REIT taxable income as calculated according to the requirements of the Internal Revenue Code. In each case, our activities and balance sheet are measured with reference to fair value without considering inflation.
Item 3. Quantitative and Qualitative Disclosures about Market Risk
As of
June 30, 2016
and
December 31, 2015
, the primary component of our market risk was interest rate risk, as described below. While we do not seek to avoid risk completely, we do believe that risk can be quantified from historical experience, and actively managed, to earn sufficient compensation to justify taking risks and to maintain capital levels consistent with the risks we undertake. Our Board of Directors exercises oversight of risk management in many ways, including overseeing our senior management’s risk-related responsibilities and reviewing management and investment policies and performance against these policies and related benchmarks.
See
"Business
—
Risk Management Strategy" in our 2015 Annual Report for a further discussion of our risk management practices.
Interest Rate Risk
We are subject to interest rate risk in connection with our investments in Debt Securities and our related debt obligations, which are generally repo borrowings of limited duration that are periodically refinanced at current market rates. We seek to manage this risk through utilization of derivative contracts, primarily interest rate swap and cap contracts.
Effect on Net Interest Income.
We fund our investments in long-term Agency RMBS collateralized by ARMs, hybrid ARMs and fixed rate mortgage loans with short-term repo borrowings and FHLBC Advances. During periods of rising interest rates, the borrowing costs associated with those Agency RMBS tend to increase while the income earned on such Agency RMBS (during the fixed rate component of such securities) may remain substantially unchanged, assuming a static portfolio. This results in a narrowing of the net interest spread between the related assets and borrowings and may even result in losses.
We are a party to interest rate swap and cap contracts as of
June 30, 2016
and
December 31, 2015
described in detail under Item 2. "Management’s Discussion and Analysis of Financial Condition and Results of Operations
—
Contractual Obligations and Commitments" in this Quarterly Report.
Hedging techniques are partly based on assumed levels of prepayments of our Agency RMBS. If prepayments are slower or faster than assumed, the life of the Agency RMBS will be longer or shorter, which would reduce the effectiveness of any hedging strategies we may use and may cause losses on such transactions.
Effect on Fair Value.
Another component of interest rate risk is the effect changes in interest rates will have on the fair value of our assets, liabilities, and derivative instruments. We face the risk that the fair value of our assets will increase or decrease at different rates than that of our liabilities, including our hedging instruments.
We assess our interest rate risk primarily by estimating the duration of our assets and the duration of our liabilities. Duration, in its simplest form, measures the market price volatility of financial instruments as interest rates change. We generally calculate duration using third-party financial models and empirical data. Different models and methodologies can produce different durations for the same securities.
Extension Risk.
We invest in Agency RMBS collateralized by hybrid ARMs, which have interest rates that are fixed for the first few years of the loan (typically three, five, seven or ten years) and thereafter reset periodically on the same basis as Agency RMBS collateralized by ARMs. We compute the projected weighted-average life of our Agency RMBS collateralized by hybrid ARMs based on assumptions regarding the rate at which the borrowers will prepay the underlying mortgages. In general, when Agency RMBS collateralized by fixed rate or hybrid ARMs is acquired with borrowings, we may, but are not required to, enter into an interest rate swap contract or other hedging instrument that effectively fixes our borrowing costs for a period close to the anticipated weighted-average life of the fixed rate portion of the related Agency RMBS. This strategy is
designed to protect us from rising interest rates by fixing our borrowing costs for the duration of the fixed rate period of the collateral underlying the related Agency RMBS.
We have structured our swaps to expire in conjunction with the estimated weighted-average life of the fixed period of the mortgages underlying our Agency RMBS portfolio. However, in a rising interest rate environment, the weighted-average life of the fixed rate mortgages underlying our Agency RMBS could extend beyond the term of the swap agreement or other hedging instrument. This could have a negative impact on our results from operations, as borrowing costs would no longer be fixed after the term of the hedging instrument while the income earned on the remaining Agency RMBS would remain fixed for a period of time. This situation may also cause the market value of our Agency RMBS to decline with little or no offsetting gain from the related hedging transactions. In extreme situations, we may be forced to sell assets to maintain adequate liquidity, which could cause us to incur losses.
Interest Rate Cap Risk.
Both the ARMs and hybrid ARMs that collateralize our Agency RMBS are typically subject to periodic and lifetime interest rate caps and floors, which limit the amount by which the security’s interest yield may change during any given period. However, our borrowing costs will not be subject to similar restrictions. Therefore, in a period of increasing interest rates, the interest costs on our borrowings could increase without limitation by caps while the interest rate yields on our Agency RMBS would effectively be limited by caps. This problem will be magnified to the extent that we acquire Agency RMBS that are collateralized by hybrid ARMs that are not fully indexed. In addition, the underlying mortgages may be subject to periodic payment caps that result in some portion of the interest being deferred and added to the principal outstanding. This could result in our receipt of less cash income on our Agency RMBS than we need in order to pay the interest cost on our related borrowings. These factors could lower our net interest income or cause a net loss during periods of rising interest rates, which would harm our financial condition, cash flows and results of operations.
Interest Rate Mismatch Risk.
We intend to fund a substantial portion of our acquisitions of Agency RMBS with borrowings that, after the effect of hedging, have interest rates based on indices and repricing terms similar to, but of somewhat shorter maturities than, the interest rate indices and repricing terms of the Agency RMBS. Thus, we anticipate that in most cases the interest rate indices and repricing terms of our Agency RMBS and our funding sources will not be identical, thereby creating an interest rate mismatch between assets and liabilities. Therefore, our cost of funds would likely rise or fall more quickly than would our earnings rate on assets. During periods of changing interest rates, such interest rate mismatches could negatively impact our financial condition, cash flows and results of operations. To manage interest rate mismatches, we may utilize the hedging strategies discussed above.
Our analysis of risks is based on management’s experience, estimates, empirical models and assumptions. These analyses rely on models which utilize estimates of fair value and interest rate sensitivity. Actual economic conditions or implementation of investment decisions by our management may produce results that differ significantly from the estimates and assumptions used in our models and the projected results reflected herein.
Prepayment Risk
Prepayments are the full or partial repayment of principal prior to the original contractual maturity of a mortgage loan, and typically occur due to refinancing of mortgage loans. Prepayment rates for existing Agency RMBS generally increase when prevailing mortgage interest rates fall, and vice-versa. In addition, prepayment rates on Agency RMBS collateralized by ARMs and hybrid ARMs generally increase when the difference between long-term and short-term interest rates declines or becomes negative, and vice-versa. Additionally, we own Agency RMBS that were purchased at a premium. The prepayment of such Agency RMBS at a rate faster than anticipated would result in a write-off of any remaining unamortized premium.
We seek to manage our prepayment risk by investing in Agency RMBS with (i) a variety of prepayment characteristics, (ii) prepayment prohibitions and penalties and (iii) prepayment protections, as well as by balancing Agency RMBS purchased at a premium with Agency RMBS purchased at a discount.
Effect on Fair Value and Net Income
Another component of interest rate risk is the effect that changes in interest rates will have on the fair value of our assets and our net income exclusive of the effect on fair value. We face the risk that the fair value of our assets and net interest income will increase or decrease at different rates than that of our liabilities, including our hedging instruments.
We assess our interest rate risk primarily by estimating the duration of our assets and of our liabilities. Duration essentially measures the market price volatility of financial instruments as interest rates change. We generally calculate duration using third-party financial models and empirical data. Different models and methodologies can produce different durations for the same securities.
The following sensitivity analysis table estimates the impact of our interest rate-sensitive investments and repo borrowing liabilities on the fair value of our net income and our assets, exclusive of the effect of changes in fair value on our net income, at
June 30, 2016
and
December 31, 2015
, assuming a static portfolio and that rates instantaneously fall 25, 50 and 75 bps and rise 25, 50 and 75 bps:
June 30, 2016
|
|
|
|
|
|
|
|
|
|
|
Change in Interest Rates
|
Projected Change in Our Net Income
(1)
|
|
Projected Change in the Fair Value of Our Assets (including hedging instruments)
(1)
|
|
Projected Change in Stockholders' Equity
|
|
- 75 basis points
|
8.40
|
%
|
(2)
|
(0.25
|
)%
|
|
(1.99
|
)%
|
|
- 50 basis points
|
6.72
|
%
|
(2)
|
0.02
|
%
|
|
0.13
|
%
|
|
- 25 basis points
|
3.36
|
%
|
(2)
|
0.09
|
%
|
|
0.69
|
%
|
|
No Change
|
—
|
%
|
|
—
|
%
|
|
—
|
%
|
|
+ 25 basis points
|
(6.21
|
)%
|
|
(0.22
|
)%
|
|
(1.69
|
)%
|
|
+ 50 basis points
|
(14.61
|
)%
|
|
(0.57
|
)%
|
|
(4.47
|
)%
|
|
+ 75 basis points
|
(23.02
|
)%
|
|
(1.03
|
)%
|
|
(8.12
|
)%
|
|
December 31, 2015
|
|
|
|
|
|
|
|
|
|
|
Change in Interest Rates
|
Projected Change in Our Net Income
|
|
Projected Change in the Fair Value of Our Assets (including hedging instruments)
(1)
|
|
Projected Change in Stockholders' Equity
|
|
- 75 basis points
|
5.56
|
%
|
(2)
|
0.34
|
%
|
|
2.66
|
%
|
|
- 50 basis points
|
4.45
|
%
|
(2)
|
0.39
|
%
|
|
2.99
|
%
|
|
- 25 basis points
|
2.22
|
%
|
(2)
|
0.26
|
%
|
|
2.05
|
%
|
|
No Change
|
—
|
%
|
|
—
|
%
|
|
—
|
%
|
|
+ 25 basis points
|
(5.56
|
)%
|
|
(0.39
|
)%
|
|
(2.99
|
)%
|
|
+ 50 basis points
|
(11.12
|
)%
|
|
(0.89
|
)%
|
|
(6.87
|
)%
|
|
+ 75 basis points
|
(16.67
|
)%
|
|
(1.48
|
)%
|
|
(11.43
|
)%
|
|
_____________
|
|
(1)
|
Analytics provided by The Yield Book
®
Software.
|
|
|
(2)
|
Given the historically low level of interest rates at
June 30, 2016
and
December 31, 2015
, we reduced 3-month LIBOR and our repo borrowing rates by 10, 20 and 25 bps for the 25, 50, and 75 down net income scenarios at
June 30, 2016
, and 10, 25 and 35 bps, for the 25, 50, and 75 down net income scenarios at
December 31, 2015
. All other interest rate-sensitive instruments were calculated in accordance with the table.
|
While the tables above reflect the estimated immediate impact of interest rate increases and decreases on a static portfolio, we rebalance our portfolio periodically either to take advantage of, or minimize the impact of, changes in interest rates. Generally, our interest rate swaps reset in the quarter following rate changes. The impact of changing interest rates on fair value and net income can change significantly when interest rates change beyond 75 bps from current levels. Therefore, the volatility in the fair value of our assets could increase significantly when interest rates change beyond 75 bps. In addition, other factors impact the fair value of and net income from our interest rate-sensitive investments and hedging instruments, such as the shape of the yield curve, market expectations as to future interest rate changes and other market conditions. Accordingly, when actual interest rates change, the change in the fair value of our assets and our net income will likely differ from that shown above, and such difference may be material and adverse for our stockholders.
Risk Management
Our Board of Directors exercises its oversight of risk management in many ways, including overseeing our senior management’s risk-related responsibilities, and reviewing management policies and performance.
As part of our risk management process, we actively manage the interest rate, liquidity, prepayment and counterparty risks associated with our Agency RMBS portfolio. We seek to manage our interest rate risk exposure by entering into various hedging instruments in order to minimize our exposure to potential interest rate mismatches between the interest we earn on our investments and our borrowing costs.
We seek to manage our liquidity risks by monitoring our liquidity position on a daily basis and maintaining a prudent level of leverage, which we currently consider to be between five and ten times the amount of stockholders' equity in our overall portfolio, based on current market conditions and various other factors, including the health of the financial institutions
that lend to us under our repurchase agreements and the presence of special liquidity programs provided by domestic and foreign central banks, and by the FHLBC.
We seek to manage our prepayment risk by investing in Agency RMBS with a variety of prepayment characteristics as well as by balancing Agency RMBS purchased at a premium with Agency RMBS purchased at a discount.
We seek to manage our counterparty risk by (i) diversifying our exposure across a broad number of counterparties, (ii) limiting our exposure to any one counterparty, and (iii) monitoring the financial stability of our counterparties.
Item 4. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
Our management, with the participation of our Chief Executive Officer and our Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of
June 30, 2016
. The term "disclosure controls and procedures," as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the "Exchange Act"), means controls and other procedures of a company that are designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the SEC’s rules and forms. Disclosure controls and procedures include, without limitation, controls and procedures designed to ensure that information required to be disclosed by a company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure. Management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Based on the evaluation of our disclosure controls and procedures as of
June 30, 2016
, our Chief Executive Officer and Chief Financial Officer concluded that, as of such date, our disclosure controls and procedures were effective.
There have been no changes in our internal controls over financial reporting that occurred during the last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.