Item 7. 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 consolidated financial statements and accompanying notes with a narrative from management to provide its 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 four sections:
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Results of Operations and
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Liquidity and Capital Resources.
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The following discussion should be read in conjunction with our consolidated financial statements and accompanying notes included in Item 8 of this Annual Report on Form 10-K.
Executive Overview
We are a specialty finance company created with the objective of achieving consistent risk-adjusted investment income. We seek to achieve this objective by investing on a leveraged basis 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 Fannie Mae, Freddie Mac, or by a U.S. government agency, such as Ginnie Mae(collectively referred to as "GSEs"). We may also invest in U.S. Treasuries, 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, currently comprised principally of Agency RMBS and U.S. Treasuries (collectively, "Debt Securities"). We finance our investments primarily through borrowings under repurchase agreements ("repo borrowings"), and, prior to the effective date of the Final Rule on January 19, 2016, loans from the Federal Home Loan Bank of Cincinnati ("FHLBC"), which provides short-term and long-term secured loans, called "advances," to its members. We use leverage to seek to enhance our returns, although leverage may also exacerbate losses. 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.
Economic Interest Expense is comprised of interest expense, as computed in accordance with GAAP, plus swap and cap interest expense used to hedge our cost of funds, a component of net gain (loss) on derivative instruments in the Company’s Consolidated Statements of Operations. The Company uses interest rate swaps to manage its exposure to changes in interest rates on its interest bearing liabilities by economically hedging cash flows associated with these borrowings. Presenting the contractual interest payments on interest rate swaps and caps with the interest paid on interest-bearing liabilities reflects the total contractual interest payments. Economic Interest Expense depicts the economic cost of our financing strategy.
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 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 influence 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. As with our repo borrowings, if the value of any assets pledged to FHLBC as collateral for advances decreased, the FHLBC could require posting of additional collateral. 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, during the year ended
December 31, 2016
the Company repaid all of its remaining outstanding FHLBC Advances. CYS Insurance's membership in the FHLBC will terminate on February 19, 2017.
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 some federal, state and local taxes on our income.
Factors that Affect our Results of Operations and Financial Condition
A variety of industry and economic factors may impact our results of operations and financial condition. These factors include:
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prepayment rates on mortgages underlying our Agency RMBS, and credit trends insofar as they affect prepayment rates;
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competition for investments in Agency RMBS;
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actions or inactions taken by the U.S. government, including the Fed and the U.S. Treasury;
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credit rating downgrades of the United States' and certain European countries' sovereign debt; and
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other market developments.
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In addition, a variety of factors relating to our business may also impact our results of operations and financial condition. These factors include:
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our degree of leverage;
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our access to funding and borrowing capacity;
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our hedging activities;
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the market value of our investments; and
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the REIT requirements and the requirements to qualify for a registration exemption under the Investment Company Act.
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Changes in interest rates may significantly influence our net income and book value, or stockholders' equity.
Prepayments on loans and securities may be influenced by changes in market interest rates and homeowners' ability and desire to refinance their mortgages. To the extent we have acquired assets at a premium or discount to face value, changes in prepayment rates will impact our anticipated yield.
Trends and Recent Market Activity
Overview
Our business is largely influenced by interest rates and credit conditions principally in the United States, and, to a lesser extent, by global financial conditions. Changes in trends in, and outlook for, economic growth and inflation, as well as global central bank policies, significantly impact short-term and long-term interest rates and the yield curve. Our earnings power benefits
from a steep yield curve, and the volatility of our book value is affected by the volatility of long-term interest rates, mortgage rates, and swap rates.
Interest rate trends changed several times during 2016, which will likely be remembered as a tale of two distinct periods: pre- and post-U.S. presidential election. The equity and bond markets started 2016 expecting a number of U.S. Federal Reserve ("Fed") funds interest rate hikes, but these hawkish expectations softened as growth and inflation outlooks evolved. Most of the year was marked by rates declining and then stabilizing in late summer. The surprise outcome of the U.K. referendum to exit the European Union further reduced expectations for global economic growth. As a result, interest rates fell through the first two quarters of 2016, then held steady at low levels until the fourth quarter, prior to the U.S. presidential election. In November, the widely unanticipated outcome of the U.S. presidential election caused a sharp reversal in interest rate expectations, resulting in a significant increase in rates through year-end. The outcome of the U.S. presidential election gave rise to broadly anticipated changes in fiscal policy including, but not limited to, tax reductions, provisions to incentivize domestic corporations to repatriate liquid assets held overseas, regulatory reform and measures to increase domestic production of energy, manufacturing, and infrastructure spending which are collectively broadly expected to increase domestic growth and inflation. Prior to the election, the markets were expecting a continuation of current fiscal policies and had priced in a very slow Fed tightening cycle, and continuing lower long-term interest rates, and low mortgage rates. Post-election through December 31, 2016, we experienced a dramatic increase in the 10-year U.S. treasury yield and a corresponding decline in the price of Agency RMBS. The steepening of the yield curve during the last quarter of 2016 has improved the near-term reinvestment outlook. As described below, money market reform during 2016 served as a tailwind for our business by supporting Agency RMBS repo funding costs, reducing our net hedging cost and increasing our book value.
The outcome of the U.S. presidential election created a meaningful change in expectations for domestic economic growth and inflation. The incoming administration (the “New Administration”) campaigned on a platform that includes significant personal and corporate tax cuts, significant regulatory relief, and a goal of renegotiating numerous trade agreements to benefit the U.S. in global trade. Further, the New Administration has signaled significant implementation of fiscal stimulus programs. Though few details of these programs are clear at this time, the markets anticipate that the New Administration’s fiscal policy measures will likely pull forward economic growth and increase the federal budget deficit. Whether this growth is durable remains to be seen. However, the markets anticipate that near-term domestic economic growth and inflation will be higher, necessitating an acceleration of the Fed’s interest rate normalization program. Thus, following the election, the markets rapidly repriced for an environment of higher near-term potential U.S. real gross domestic product ("GDP") growth and inflation. This abruptly reversed the bond market’s rally through the first three quarters of 2016.
After signaling multiple rate hikes at the beginning of 2016, the Fed raised short-term interest rates by 25 basis points ("bps") only once in December 2016. Prices of Agency RMBS rose throughout the first three quarters of the year as rates dropped. Additionally, the yield curve flattened during this period with the 10-year portion of the yield curve outperforming shorter-dated assets. For the first three quarters of 2016, the prices of our Agency RMBS holdings moved higher and outperformed our hedges. From December 31, 2015 through September 30, 2016, the yield on 5-year Treasury Securities ("U.S. Treasuries") fell 61 bps to 1.15% and the yield on 10-year U.S. Treasuries fell 68 bps to 1.59% on September 30, 2016. Prices of Agency RMBS followed and 30-year Agency RMBS 3.5% rose from $103.19 at December 31, 2015 to $105.53 at September 30, 2016.
The rally in the bond market during the first three quarters of 2016, however, was dramatically reversed following the U.S. presidential election as the capital markets adjusted to new expectations for growth-oriented fiscal policies. From September 30, 2016 through December 31, 2016 (the “Fourth Quarter”), the 5-year U.S. Treasury yield rose 78 bps, ending the year at 1.93%. Similarly, the yield on the 10-year U.S. Treasury rose by 85 bps, ending the year at 2.44%. For the same period, the price of Agency RMBS fell with the price of 30-year FNMA 3.5% RMBS falling from
$105.55
on September 30, 2016 to
$102.33
on December 31, 2016. Over the course of 2016, Agency RMBS prices fell with 30-year FNMA 3.5% RMBS falling by
0.87%
year-over-year.
While our Agency RMBS and hedge performance helped increase our book value per s hare fairly consistently during the first three quarters of 2016, during the Fourth Quarter our book value notably declined.
The charts below illustrate the interest rate and spread movements:
We anticipate continued volatility in Agency RMBS markets through 2017 as markets react to details of new fiscal policies proposed or implemented by the New Administration. As of December 31, 2016, despite reductions in the portfolio value during the Fourth Quarter, we had substantial available liquidity of
$0.9 billion
, or
61.0%
of our equity.
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Interest Rates, Unemployment and Other Macroeconomic Trends
A key focus of the markets in 2016 was the timing and magnitude of Fed rate hikes. During the year, the Fed continued guiding capital markets to anticipate several interest rate hikes in 2016; however, it was not until December 14, 2016 that the Fed actually raised the Federal Funds Rate by 25 bps. The FOMC's decision was based on its view of considerable improvement in labor market conditions in 2016 and a reasonably confident expectation that inflation will rise to its 2% objective. The FOMC indicated that three further 25 bps rate hikes in the Federal Funds Rate were likely during 2017; however, it also noted that there remains great uncertainty about the timing, magnitude, and likelihood of fiscal stimulus. By the time this rate hike was announced, the market had already priced in expectations of growth-oriented policies of the New Administration, which was reflected in both the prices of mortgages and higher borrowing costs.
Set forth below are graphs of yield curves showing trends from 2014 through 2016 and the four quarters of 2016:
U.S. economic performance was mixed and inconsistent throughout 2016. Following 2015, in which GDP showed overall growth of 2.2%, the first quarter of 2016 GDP of only 0.8% proved disappointing. The second quarter of 2016 GDP rebounded to 1.4%, while third quarter GDP was 3.5%, and fourth quarter of 2016 GDP is expected to be slower at around 2.9%, reflecting an uneven rec
overy. For 2016 as a whole, GDP growth is estimated at about 2.4%, only slightly better than the preceding five-year (2011-2015) average of 2.2%, a modest pace compared to prior growth periods and considerably lower than during the 1990s when the economy grew an average 3.4% per year.
One of the Fed's two mandates, inflation, has consistently tracked lower than the Fed's 2% target, with the core personal consumption expenditure inflation index around 1.6% for 2016. Weakening global economic conditions with moderate deflation continues to be present in Europe and Japan. The FOMC is encouraged that policymakers in Europe and elsewhere have responded with stimulus measures, and suggested that this could mitigate the risk of these economies dragging down the U.S economy. The 2017 economic outlook for growth in the U.S. is uncertain as the economic policies of the New Administration have not yet been fully defined, debated, or enacted. Nevertheless, the markets are building in expectations for several new policies, including, most significantly, tax cuts. The Tax Policy Center of the Urban Institute and Brookings Institution (the “Tax Policy Center”) estimates that the proposed tax cuts described could increase GDP by approximately 1% in the near term, but reduce GDP by 2026, as the interest costs of the increased deficit weigh on GDP. The Tax Policy Center did not account for any cuts in federal spending as these have not yet been specified by the New Administration. Additionally, the Tax Policy Center did not attempt to predict monetary policy in response to accelerating near-term GDP growth and inflationary pressures.
In addition to tax policy, several additional policy issues may be addressed by the New Administration. Some relevant to our industry include: review of the Dodd-Frank Act, banking regulations and how reforms may impact our lenders; the status of issues the Consumer Financial Protection Bureau (“CFPB”) and whether residential mortgage originators may be impacted; the status of the Federal Housing Finance Agency (“FHFA”) and whether any of its rules that impact our sector would be affected; the status and capital structure of the GSEs (i.e., Fannie Mae and Freddie Mac), and several others. At this moment, few details of policy reform proposals have been presented so it is not possible to judge what impacts they might have on our business.
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Interest Rate Spreads
The spread between Agency RMBS and interest rate swaps tightened modestly during 2016, as shown in the graph below, with the spread between Fannie Mae 30-year securities and 7-year interest rate swaps tightening 8 bps, and Fannie Mae 15-year and 5-year interest rate swaps tightening 8 bps. In general, this had a small positive impact on our asset values relative to our hedges but the change in the general level of interest rates had a much more significant effect on our portfolio performance. In addition, the spreads between our hedges and U.S Treasuries widened modestly throughout the year, as shown in the graph above in
Overview
, with resulting incremental benefits to our hedge book performance for the year ended December 31, 2016.
Generally, when spreads between Agency RMBS and swaps narrow, this has the effect of limiting our investment and reinvestment opportunities in the short-term. Also, if the long-end of the yield curve continues to flatten while the short-end rises, we expect that this will have the effect of reducing our yield on new investments. During the twelve months ended December 31, 2016, and December 31, 2015, the weighted-average yield on the Company's Debt Securities was 2.50% and 2.56%, respectively.
The table below shows potential Agency RMBS investments and their respective net interest margins as of January 29, 2017:
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Net Interest Margin
(1)
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30-Yr. 3.5%
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30-Yr. 4.0%
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15-Yr. 2.5%
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15-Yr. 3.0%
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15-Yr. 3.5%
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Asset Yield
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3.21
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%
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3.20
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%
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2.52
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%
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2.45
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%
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2.35
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%
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Financing Rate
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0.85
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%
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0.85
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%
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0.85
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%
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0.85
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%
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0.85
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%
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Hedge Cost
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0.80
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%
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0.57
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%
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0.63
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%
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0.43
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%
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0.38
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%
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Net interest margin
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1.56
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%
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1.78
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%
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1.04
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%
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1.17
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%
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1.12
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%
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Key Assumptions
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Swap
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7-Year
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7-Year
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5-Year
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5-Year
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5-Year
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Hedge Ratio
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50
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%
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50
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%
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50
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%
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50
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%
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50
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%
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_______________________________________
(1)
The examples in this table are for illustrative purposes only and do not reflect our projections or forecasts. Any assumptions and estimates used may not be accurate and cannot be relied upon. Our net interest margin for any given period may differ materially from these examples.
We benefited from a generally favorable financing environment throughout 2016. The Federal Funds Rate remained historically low throughout 2016, until late in the fourth quarter when the Fed raised the Federal Funds Rate by 25 bps, reflected in the table below. However, even after the December hike, the Federal Funds Rate remains at low levels. The Company generally borrows in the 30-180 day repo markets, which historically have been highly correlated to LIBOR. Access to repurchase agreements ("Repo Borrowings") collateralized with our Agency RMBS was stable during 2016, even after losing access to new advances from the FHLBC as a result of an FHFA ruling in January 2016. On January 12, 2016, the FHFA issued a Final Rule governing FHLB membership criteria for captive insurance companies (the “Final Rule”). The Final Rule defines "insurance company" to exclude "captive insurers". Under the 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, no new advances are available, and all FHLBC Advances
are required to be repaid no later than February 19, 2017. During 2016, the Company repaid more than $2.1 billion in FHLBC Advances outstanding at December 31, 2015 with financings from existing repo counterparties. CYS Insurance's membership in the FHLBC will terminate on February 19, 2017.
At December 31, 2016, the interest rates on our Repo Borrowings ranged from 0.71% to 1.15% for 30-180 day repo borrowings, with a weighted-average interest rate of
0.89%
and a weighted-average remaining maturity of
53
days. During 2016, our weighted-average cost of funds was
0.72%
, compared to
0.40%
in 2015, reflecting the higher interest rates environment and the expectation for rates to continue rising.
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Date
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1-Month LIBOR
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3-Month LIBOR
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6-Month LIBOR
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Federal Funds Rate
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December 31, 2016
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0.772
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%
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0.998
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%
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1.318
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%
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0.75
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%
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September 30, 2016
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0.531
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%
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0.854
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%
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1.240
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%
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0.50
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%
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June 30, 2016
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0.465
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%
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0.654
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%
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0.924
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%
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0.50
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%
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March 31, 2016
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0.437
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%
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0.629
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%
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0.900
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%
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0.50
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%
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December 31, 2015
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0.430
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%
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0.613
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%
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0.846
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%
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0.50
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%
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September 30, 2015
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0.193
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%
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0.325
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%
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0.534
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%
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0.25
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%
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June 30, 2015
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0.187
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%
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0.283
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%
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0.445
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%
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0.25
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%
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March 31, 2015
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0.176
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%
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0.271
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%
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0.401
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%
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0.25
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%
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December 31, 2014
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0.171
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%
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0.256
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%
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0.363
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%
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0.25
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%
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Money market reform became effective on October 14, 2016. This change had a considerable impact on LIBOR rates in the third quarter of 2016. In efforts to prevent a money market fund “breaking the buck,” when a money market fund’s net asset value falls below one dollar, the Securities and Exchange Commission ("SEC") requires that prime institutional and municipal money market funds be priced on floating net asset value ("NAV") instead of the $1 NAV that these funds had historically touted. As a result, over $700 billion transitioned out of prime funds into government funds. This is supportive of the Agency RMBS repo market and therefore favorable to our business. Accordingly, much of the bank LIBOR funding that had been funded by prime money funds evaporated and LIBOR rates rose by about 28 bps between the end of June 2016 and the mid-October 2016 money market reform effective date. The rise in LIBOR rates contributed to higher hedge-based cash flows as the receive-leg of our swaps is tied to 3-month LIBOR. In addition, swaps are linked by industry convention to 3-month LIBOR. An increase in 3-month LIBOR during 2016 contributed to an increase in swap spreads and book value. Consequently, money market reform during 2016 served as a tailwind for our business by supporting Agency RMBS repo funding costs, reducing our net hedging costs, and increasing book value.
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Investing and Reinvestment Environment and Agency RMBS Supply and Demand
The investing and reinvesting environment for Agency RMBS is characterized by tight supply, strong demand, and the continued Fed asset purchases. While home sales and new single-family and multi-family home construction improved in 2016, tight mortgage lending rules resulting from the Dodd-Frank Act and bank conservatism in efforts to prevent future mortgage "put-backs," continue to limit mortgage availability, particularly to less creditworthy borrowers. As mortgage rates continued to stay at historically low levels, mortgage originations increased in 2016, relative to 2015 and 2014; however, new Agency RMBS issuances generally remain low compared to 2012 through mid-2013. While the Fed officially ended its asset purchase program in October 2014, it continues to use principal and interest payments it receives from its Agency RMBS portfolio to purchase new Agency RMBS. The Fed continues to be a dominant player in the Agency RMBS universe, currently holding approximately $1.7 trillion, or 28%, of the $6.0 trillion Agency RMBS market as of December 31, 2016. The limited supply of Agency RMBS has been a factor in the TBA market, but so has the reduction of Fed purchases in 2016, which resulted in a slightly less attractive TBA market.
The modest incremental rise in Agency RMBS prices during the first three quarters of 2016 followed by the notable post-election decline is illustrated in the graph below by the movement in prices of securities commonly held in our portfolio:
Mortgage rates have generally lagged the longer end of the yield curve, but ratcheted down through the first half of 2016 to 3.4% as of July. These rates prompted relatively higher prepayment rates for Agency RMBS in the second and third quarters of the year. Consequently, our portfolio of Agency RMBS continued to experience modest increases in prepayments in 2016 prior to the U.S. presidential election. Subsequent to the U.S. presidential election, prepayments decelerated as mortgage rates rose and seasonal factors took effect. Throughout 2016, we strategically repositioned the portfolio by selling fast prepaying Agency RMBS and replacing them with new production bonds. In addition, as mortgage rates began to rise during the Fourth Quarter, we recycled out of lower coupon Agency RMBS into higher current production coupons. Due to the continued tight regulatory environment, absent any meaningful deregulation in the housing finance sector from the New Administration, and the recent increase in mortgage rates, we expect prepayments to remain subdued in 2017, and, therefore, Agency RMBS supply will likely also remain commensurately muted.
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Government Activity
Ongoing regulatory uncertainty and inconsistency continues to place a drag on home lending and related securitization activity. Although the New Administration made statements on its intentions to reform housing finance and tax policy, the majority of potential policy changes will require Congressional action. At this time the direction and extent of policy change cannot be foreseen.
Mortgage availability may somewhat improve due to changes to the FHFA's representation and warranty rules, but originators have not been given sufficient protection to originate loans that pose greater risk of defaults. We continue to believe that opportunities to promote housing recovery through originations will be limited, at best.
Factions in Congress continue to disagree on a common path to housing finance reform. The FHFA and both houses of Congress have discussed and considered separate measures to restructure the U.S. housing finance system and the operations of Fannie Mae and Freddie Mac.
We anticipate continued debate and discussion on residential housing and mortgage reform in 2017, and cannot be certain of any housing- and/or mortgage-related legislation, its Congressional approval, and or its ultimate effects.
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CYS Activity in Response to These Trends -
We continue to actively monitor, reposition, and manage our investment portfolio, the structure of our borrowings and our hedge positions. For example, as Agency RMBS prices rose during the first half of 2016, we identified certain holdings that were overpriced given their prepayment risks, and we sold and replaced these securities with better prepayment protected mortgages. When compelled by attractive financing opportunities, we purchased U.S. Treasuries, the ultimate prepayment protected securities. Throughout 2016, we strategically repositioned the investment portfolio by selling fast prepaying Agency RMBS and replacing them with new production bonds. In addition, subsequent to the U.S. presidential election, prepayments decelerated as mortgage rates rose and seasonal factors took effect. In response to this, during the Fourth Quarter, we recycled out of lower coupon Agency RMBS into higher current production coupon Agency RMBS. The steepening of the yield curve during the last quarter of 2016 has improved the near-term reinvestment outlook.
The size of our investment portfolio (inclusive of TBA Derivative positions with a net fair value of
$(308.8) million
) decreased to
$12.3 billion
at December 31, 2016 from
$13.0 billion
as of December 31, 2015. In addition, throughout 2016, we continued to take advantage of a favorable TBA market and marginally increased Drop Income to $32.9 million in 2016 from $32.6 million in 2015.
During 2016, we managed borrowing costs by utilizing our extensive sources of financing and our ability to effectively identify and capitalize on opportunities in our markets. Despite losing access to FHLBC Advances in connection with the Final Rule during 2016, we replaced approximately $2.1 billion of FHLBC Advances held at December 31, 2015 with Repo Borrowings from existing counterparties, with no material adverse effect on our core business and operations. We continue to maintain and grow our financing sources, ending 2016 with a broad and diverse group of nearly 50 lenders. Our extensive base of available sources of financing, combined with our collective years of experience with these sources, afford us an ability to understand the repo market and limits the possibility of paying a lender off-market rates. In addition, at various times during 2016, we identified and seized opportunities to finance our U.S. Treasuries at significant negative rates. Lastly, the financing side of our business continues to benefit from money market reforms put in place early in 2016, which served to increase cash in the financial system seeking government securities as collateral for short-term investments. This benefited our business by supporting Agency RMBS funding costs and reducing our net hedging costs relative to where we believe funding costs would have been absent the increased liquidity in the short-term borrowing markets.
During the second quarter of 2016, we took advantage of lower rates and a flatter yield curve by replacing $2.2 billion of short-dated swaps struck at a fixed pay rate of 1.43% with $1.7 billion of longer-dated swaps struck at a pay rate of 1.21%. This trade produced a $3.6 million annual decrease in swap and cap interest expense, which will continue well into the future. In addition, the rise in LIBOR rates during the year contributed to an increase in the receive-leg of our swaps, which is tied to 3-month LIBOR.
During 2016, as a result of an increase in interest rates during the Fourth Quarter, book value per share decreased by $1.03 per share to $8.33 per share, after declaring $1.01 per share in dividends. Leverage increased marginally year-over-year from 6.77:1 to 7.06:1, and we continued to maintain high levels of liquidity, generally in excess of 60% of our equity. We ended 2016 with a hedge ratio greater than 90%, consistent with where we began the year.
Financial Condition
Our Agency RMBS were purchased at a net premium to their face values, generally due to the average interest rates on these investments being higher than the prevailing market rates at the time of purchase. As of
December 31, 2016
and
December 31, 2015
we had approximately
$452.3 million
and
$462.6 million
, respectively, of net unamortized premium included in the cost basis of our investments. Our Debt Securities portfolio, including TBA Derivative positions (with a net fair value of
$(308.8) million
at December 31, 2016), consisted of the following assets as of
December 31, 2016
and
2015
(dollars in 000's):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted-Average
|
Coupon
|
|
Face Value
|
|
Fair Value
|
|
Amortized Cost Basis per Face Value
|
|
Loan Balance
(1)
|
|
Loan Age (in months)
(1)
|
|
3 Month CPR
(1)(2)
|
|
Duration
(3)
|
December 31, 2016
|
|
|
|
|
|
|
|
|
|
|
15-Year Agency RMBS
|
|
|
|
|
|
|
|
|
|
|
2.5%
|
|
$
|
1,046,887
|
|
|
$
|
1,049,504
|
|
|
$
|
102.78
|
|
|
$276
|
|
4
|
|
5.4%
|
|
3.94
|
TBA 2.5%
(5)*
|
|
$
|
(400,000
|
)
|
|
$
|
(400,633
|
)
|
|
$
|
99.73
|
|
|
n/a
|
|
n/a
|
|
n/a
|
|
3.75
|
3.0%
|
|
$
|
2,540,786
|
|
|
$
|
2,610,678
|
|
|
$
|
102.68
|
|
|
$263
|
|
27
|
|
13.0%
|
|
3.03
|
TBA 3.0%
*
|
|
200,000
|
|
|
205,174
|
|
|
102.86
|
|
|
n/a
|
|
n/a
|
|
n/a
|
|
2.83
|
3.5%
|
|
813,323
|
|
|
849,549
|
|
|
102.98
|
|
|
215
|
|
52
|
|
14.6
|
|
2.52
|
4.0%
|
|
108,173
|
|
|
114,207
|
|
|
101.03
|
|
|
167
|
|
70
|
|
14.7
|
|
2.27
|
4.5%
|
|
14,439
|
|
|
15,256
|
|
|
102.23
|
|
|
240
|
|
83
|
|
19.3
|
|
1.79
|
Subtotal
|
|
4,323,608
|
|
|
4,443,735
|
|
|
103.00
|
|
|
255
|
|
27
|
|
12.4
|
|
3.05
|
20-Year Agency RMBS
|
|
|
|
|
|
|
|
|
|
|
4.5%
|
|
39,328
|
|
|
42,348
|
|
|
102.66
|
|
|
209
|
|
77
|
|
19.6
|
|
2.16
|
30-Year Agency RMBS
|
|
|
|
|
|
|
|
|
|
|
3.0%
|
|
1,776
|
|
|
1,802
|
|
|
104.51
|
|
|
130
|
|
43
|
|
0.2
|
|
4.69
|
3.5%
|
|
4,934,357
|
|
|
5,062,330
|
|
|
104.48
|
|
|
338
|
|
8
|
|
9.5
|
|
4.48
|
TBA 3.5%
*
|
|
383,000
|
|
|
392,293
|
|
|
102.58
|
|
|
n/a
|
|
n/a
|
|
n/a
|
|
4.10
|
4.0%
|
|
1,247,116
|
|
|
1,314,969
|
|
|
104.93
|
|
|
244
|
|
30
|
|
22.0
|
|
3.30
|
TBA 4.0%
*
|
|
500,000
|
|
|
524,869
|
|
|
104.50
|
|
|
n/a
|
|
n/a
|
|
n/a
|
|
2.95
|
4.5%
|
|
113,274
|
|
|
122,361
|
|
|
106.63
|
|
|
282
|
|
68
|
|
21.7
|
|
2.32
|
Subtotal
|
|
7,179,523
|
|
|
7,418,624
|
|
|
104.34
|
|
|
319
|
|
13
|
|
13.1
|
|
4.12
|
Hybrid ARMs
|
|
|
|
|
|
|
|
|
|
|
2.8%
(4)
|
|
375,745
|
|
|
385,502
|
|
|
102.74
|
|
|
322
|
|
30
|
|
21.3
|
|
2.16
|
Subtotal Agency RMBS
|
|
11,918,204
|
|
|
12,290,209
|
|
|
103.80
|
|
|
293
|
|
20
|
|
13.1
|
|
3.66
|
U.S. Treasuries
|
|
|
|
|
|
|
|
|
|
|
0.6%
|
|
50,000
|
|
|
49,686
|
|
|
99.90
|
|
|
n/a
|
|
n/a
|
|
n/a
|
|
1.48
|
Total
|
|
$
|
11,968,204
|
|
|
$
|
12,339,895
|
|
|
$
|
103.78
|
|
|
$293
|
|
20
|
|
13.1%
|
|
3.66
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
December 31, 2015
|
|
|
|
|
|
|
|
|
|
|
15-Year Agency RMBS
|
|
|
|
|
|
|
|
|
|
|
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 RMBS
|
|
|
|
|
|
|
|
|
|
|
4.5%
|
|
51,664
|
|
|
56,102
|
|
|
102.79
|
|
|
215
|
|
65
|
|
16.4
|
|
2.95
|
30-Year Agency RMBS
|
|
|
|
|
|
|
|
|
|
|
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
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted-Average
|
Coupon
|
|
Face Value
|
|
Fair Value
|
|
Amortized Cost Basis per Face Value
|
|
Loan Balance
(1)
|
|
Loan Age (in months)
(1)
|
|
3 Month CPR
(1)(2)
|
|
Duration
(3)
|
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
|
Subtotal Agency RMBS
|
|
12,426,852
|
|
|
12,927,996
|
|
|
103.72
|
|
|
286
|
|
18
|
|
7.6
|
|
3.85
|
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 Constant Prepayment Rate ("CPR") represents the three-month CPR of the Company's Agency RMBS held at
December 31, 2016
and
December 31, 2015
. The actual CPR experienced by the Company during the period may differ. Securities with no prepayment history are excluded from this calculation.
|
|
|
(3)
|
Duration measures the market price volatility of financial instruments as interest rates change, using Dollar Value of One Basis Point, or "DV01", methodology. We generally calculate duration using various third-party financial models and empirical data. Different models and methodologies can produce different estimates of duration for the same securities. Analytics provided by the Yield Book
®
software.
|
|
|
(4)
|
Coupon represents the weighted-average coupon of Hybrid ARMs.
|
|
|
(5)
|
Includes
$400.6 million
of forward settling transactions at
December 31, 2016
.
|
* Includes TBA Derivatives comprised of forward purchase and sales with a net fair value of
$(308.8) million
at
December 31, 2016
.
In
January 2017
, the monthly weighted-average experienced CPR of the Company's Debt Securities declined to
11.1%
from
13.1%
in
December 2016
.
Hedging Instruments
We seek to hedge as much of the interest rate risk we determine is in the best interests of our stockholders. Our policies do not contain specific requirements as to the percentages or amount of interest rate risk we are required to hedge. No assurance can be given that our hedging activities will have the desired impact on our results of operations or financial condition.
Interest rate hedging may fail to protect or could adversely affect us because, among other things:
|
|
•
|
interest rate hedging can be expensive, particularly during periods of rising and volatile interest rates;
|
|
|
•
|
available interest rate hedging may not correspond directly with the interest rate risk for which protection is sought;
|
|
|
•
|
due to prepayments on assets and repayments of debt securing such assets, the duration of the hedge may not match the duration of the related liability or asset;
|
|
|
•
|
the credit quality of the hedging counterparty may be downgraded to such an extent that it may impair our ability to sell or assign our side of the hedging transaction; and
|
|
|
•
|
the hedging counterparty may default on its obligation to pay.
|
We engage in interest rate swaps and caps as a means of managing our interest rate risk on forecasted interest expense associated with repo borrowings for the term of the swap and cap contracts. An interest rate swap is a contractual agreement entered into by two counterparties under which each agrees to make periodic payments to the other for an agreed period of time based upon a notional amount of principal. Under the most common form of interest rate swap, commonly known as a fixed-floating interest rate swap, a series of fixed interest rate payments on a notional amount of principal are exchanged for a series of floating interest rate payments on such notional amount. In a simple interest rate cap, one investor pays a premium for a notional principal amount based on a capped interest rate (the "cap rate"). When the floating rate exceeds the cap rate, the investor receives a payment from the cap counterparty equal to the difference between the floating rate and the cap rate on the
same notional principal amount for a specified period of time. Alternatively, an investor may receive a premium and pay the difference in cap rate and floating rate. The fair value of interest rate swaps and caps is heavily dependent on the current market fixed rate, the corresponding term structure of floating rates (known as the yield curve), and the expectation of changes in future floating rates. Below is a summary of our interest rate swaps and caps as of
December 31, 2016
and
2015
:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted-Average
|
|
|
December 31, 2016
|
|
Number of Contracts
|
|
Notional (000's)
|
|
Rate
|
|
Maturity
|
|
Duration
|
|
Fair Value (000's)
|
Interest Rate Swaps
|
|
17
|
|
$
|
6,450,000
|
|
|
1.23
|
%
|
|
January 2020
|
|
(2.72
|
)
|
|
$
|
80,608
|
|
Interest Rate Caps
|
|
5
|
|
2,500,000
|
|
|
1.28
|
%
|
|
January 2020
|
|
(1.94
|
)
|
|
42,532
|
|
Total
|
|
22
|
|
8,950,000
|
|
|
1.24
|
%
|
|
January 2020
|
|
(2.50
|
)
|
|
123,140
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
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
|
|
Total
|
|
26
|
|
10,450,000
|
|
|
1.29
|
%
|
|
July 2019
|
|
(2.91
|
)
|
|
86,754
|
|
As of
December 31, 2016
, the Company had entered into interest rate swaps with an aggregate notional amount of
$6.5 billion
, a weighted-average fixed rate of
1.23%
, and a weighted-average expiration of
3.0
years. This compares with interest rate swaps with a notional amount of
$8.0 billion
, a weighted-average fixed rate of
1.29%
, and a weighted-average expiration of
3.4
years at
December 31, 2015
. The receive rate on the Company's interest rate swaps is 3-month LIBOR. At
December 31, 2016
, the Company had entered into interest rate caps with an aggregate notional amount of
$2.5 billion
, a weighted-average fixed rate of
1.28%
, and a weighted-average expiration of
3.0
years. This compares with interest rate caps with a notional amount of
$2.5 billion
, a weighted-average fixed rate of
1.28%
, and a weighted-average expiration of
4.0
years at
December 31, 2015
.
The Company does not consider TBA Derivatives to be hedging instruments.
Liabilities
We finance our assets through repo borrowings and FHLBC Advances (prior to the effective date of the Final Rule on January 19, 2016, which precluded us from securing new 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
December 31, 2016
and
2015
, we had repo borrowings and FHLBC Advances with
35
counterparties, which are summarized below (dollars in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
December 31, 2016
|
|
|
|
|
|
Weighted-Average
|
Original Days to Maturity by Collateral Type
|
|
Repo Borrowings Outstanding
|
|
Percentage of Total
|
|
Interest Rate
|
|
Remaining Days to Maturity
|
|
Original Days to Maturity
|
Agency RMBS
|
|
|
|
|
|
|
|
|
|
|
≤ 30 Days
|
|
$
|
651,032
|
|
|
7%
|
|
0.83%
|
|
5
|
|
11
|
> 30 to ≤ 60 Days
|
|
1,135,428
|
|
|
12%
|
|
0.89%
|
|
16
|
|
45
|
> 60 Days
|
|
7,905,084
|
|
|
81%
|
|
0.90%
|
|
63
|
|
139
|
Total
|
|
$
|
9,691,544
|
|
|
100%
|
|
0.89%
|
|
53
|
|
119
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
December 31, 2015
|
|
|
|
|
|
Weighted-Average
|
Original Days to Maturity by Collateral Type
|
|
Repo Borrowings and FHLBC Advances Outstanding
|
|
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
|
|
|
23%
|
|
0.48%
|
|
9
|
|
43
|
> 60 Days
|
|
7,480,731
|
|
|
67%
|
|
0.60%
|
|
87
|
|
145
|
Subtotal
|
|
$
|
10,739,524
|
|
|
97%
|
|
0.56%
|
|
63
|
|
113
|
|
|
|
|
|
|
|
|
|
|
|
U.S. Treasuries
|
|
|
|
|
|
|
|
|
|
|
> 30 to ≤ 60 Days
|
|
$
|
348,251
|
|
|
3%
|
|
(0.13)%
|
|
2
|
|
13
|
|
|
|
|
|
|
|
|
|
|
|
Total
|
|
$
|
11,087,775
|
|
|
100%
|
|
0.54%
|
|
61
|
|
110
|
As of
December 31, 2016
and
2015
, we had an aggregate payable for securities purchased as summarized below (in thousands).
|
|
|
|
|
|
|
|
|
|
December 31, 2016
|
|
|
|
|
Settle Date
|
|
Face Value
|
|
Payable
|
January 2017
|
|
$
|
1,376,248
|
|
|
$
|
1,418,658
|
|
February 2017
|
|
450,045
|
|
|
463,305
|
|
|
|
$
|
1,826,293
|
|
|
$
|
1,881,963
|
|
|
|
|
|
|
|
|
|
|
|
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
|
|
A portion of payable for securities purchased will be financed through repo borrowings, or FHLBC Advances to the extent they are financed prior to the January 19, 2016 effective date of the Final Rule.
Results of Operations
There are limitations associated with the use of our non-GAAP measures of Net Interest Income, Economic Interest Expense, and Core Earnings as measures of the Company's financial performance over any period. The Company's presentation of non-GAAP measures may not be comparable to similarly-titled measures of other companies, which may use different calculations. As a result, our non-GAAP measures should not be considered a substitute for the Company's GAAP net income (loss), net interest income (loss) or total interest expense, a measure of our financial performance or any measure of our liquidity under GAAP.
The following table provides GAAP measures of interest expense and net interest income and details with respect to reconciling the aforementioned line items on a non-GAAP basis for each respective period.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
December 31, 2016
|
|
December 31, 2015
|
|
December 31, 2014
|
Net interest income
|
|
$
|
220,258
|
|
|
$
|
285,066
|
|
|
$
|
283,251
|
|
Swap and cap interest expense
|
|
55,798
|
|
|
100,110
|
|
|
90,812
|
|
Economic net interest income
|
|
$
|
164,460
|
|
|
$
|
184,956
|
|
|
$
|
192,439
|
|
|
|
|
|
|
|
|
|
|
|
Total interest expense
|
|
$
|
74,279
|
|
|
$
|
46,129
|
|
|
$
|
33,825
|
|
Swap and cap interest expense
|
|
55,798
|
|
|
100,110
|
|
|
90,812
|
|
Economic interest expense
|
|
$
|
130,077
|
|
|
$
|
146,239
|
|
|
$
|
124,637
|
|
From the Company's inception through September 30, 2015, "Swap and cap interest expense" was recognized in "Interest expense", and was a component of "Net interest income" in the Consolidated Statements of Operations. Effective October 1, 2015, "Swap and cap interest expense" is recognized as a component of "Net gain (loss) on derivative instruments" in "Total Other income (loss)" in the Consolidated Statements of Operations. This presentation change was made in order to record income, expenses and changes in the fair value of derivatives in one line item in the financial statements, consistent with common industry practice. As a result of this change, the caption "Net interest income" no longer includes the swap and cap interest expense. Therefore, we present the new non-GAAP measures, "Economic Interest Expense", and "Economic Net Interest Income" to provide an economic measure of our interest income net of borrowing and hedge expense, which management uses to evaluate the Company's investment portfolio. By providing users of our financial information with such measures in addition to the related GAAP measures, we believe they give users additional transparency into the information used by our management in its financial and operational decision-making, and that it is meaningful information to consider in addition to the related GAAP measure as it reflects the economic costs of financing our investment portfolio.
Year Ended
December 31, 2016
Compared to the Year Ended
December 31, 2015
Net Income (loss)
Net income (loss) available to common stockholders increased
$21.2 million
to a net loss of
$(4.4) million
for the year ended
December 31, 2016
, compared to net loss of
$(25.6) million
for the year ended
December 31, 2015
. The increase in net income was primarily due to a decrease in swap and cap interest expense of
$44.3 million
, an increase in net realized and unrealized gain on derivative instruments of
$43.4 million
and a
$3.1 million
increase in net realized and unrealized gain (loss) on investments, offset by a
$36.7 million
decrease in interest income and a
$28.2 million
increase in total interest expense. The major components of the increase in net income (loss) available to common stockholders during 2016 are detailed below.
The results of our business are generally correlated with changes in the yield curve and interest rates. In general, U.S Treasury rates and swap rates ended the year at relatively similar levels to where they had started. For example, the 10-year U.S. Treasury rate increased
17
bps to
2.44%
at
December 31, 2016
while 5-year swap rates increased
24
bps to
1.98%
at
December 31, 2016
.
Interest Income and Asset Yield
Our principal source of income is the interest income that we earn on our Debt Securities portfolio. Interest income, which consists of interest income on our Debt Securities,
decreased
by
$36.7 million
to
$294.5 million
for the year ended
December 31, 2016
, as compared to
$331.2 million
for the year ended
December 31, 2015
. The factors driving this decrease are changes both in the size of our investment securities portfolio and the related yield, as shown below (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Change in Size
|
|
Change in Yield
|
|
Change in Size & Yield
|
Change in average settled
|
$
|
(1,180,420
|
)
|
|
Change in average yield
|
(0.06
|
)%
|
|
Change in average settled
|
$
|
(1,180,420
|
)
|
2015 average yield
|
2.56
|
%
|
|
2015 average settled
|
12,962,340
|
|
|
Change in average yield
|
(0.06
|
)%
|
Change
|
$
|
(30,160
|
)
|
|
Change
|
$
|
(7,149
|
)
|
|
Change
|
$
|
651
|
|
|
|
|
|
|
|
Total change
|
$
|
(36,658
|
)
|
Our annualized yield on average settled Debt Securities for the year ended
December 31, 2016
was
2.50%
, compared to
2.56%
for the year ended
December 31, 2015
. The decrease in average yield during 2016 largely resulted from an increase in prepayment speeds and a decline in average settled Debt Securities. The weighted-average actual experienced CPR for the year ended
December 31, 2016
increased to 12.1% from 10.4% for the year ended
December 31, 2015
, while amortization expense decreased
$6.3 million
to
$84.1 million
for the year ended
December 31, 2016
, compared to
$90.4 million
for the year ended
December 31, 2015
. Despite an increase in CPR during 2016, amortization decreased as a result of a $1.2 billion decrease in our average settled Debt Securities to
$11.8 billion
for the year ended
December 31, 2016
from
$13.0 billion
for the year ended
December 31, 2015
. In addition, our average settled Debt Securities included a larger amount of U.S. Treasuries during 2016, as we seized opportunities to finance U.S. Treasuries at negative rates.
Economic Net Interest Income
Our Economic Net Interest Income for the year ended
December 31, 2016
was
$164.5 million
, and our interest rate spread net of hedge was
1.24%
compared to net interest income of
$185.0 million
and an interest rate spread net of hedge of
1.28%
for the year ended
December 31, 2015
. The decrease in our Economic Net Interest Income was principally due to a decrease in average settled Debt Securities, a decline in the average yield and an increase in total interest expense, offset by a decrease in swap and cap interest expense during the year ended
December 31, 2016
. While our economic net interest income is a good measure of our earnings, we believe our interest rate spread net of hedge is an important performance indicator as it reflects the cost of hedging.
Economic Interest Expense and Cost of Funds
Economic Interest Expense for the year ended
December 31, 2016
, which consists of interest expense from repo borrowings, FHLBC Advances and swap and cap interest expense,
decreased
$16.1 million
to
$130.1 million
, from
$146.2 million
for the year ended
December 31, 2015
. The decrease in Economic Interest Expense was due to a decrease in our average repo borrowings and FHLBC Advances and a decrease in swap and cap interest expense, offset by an increase in the average cost of funds. Interest expense from repo borrowings and FHLBC Advances increased by
$28.2 million
to
$74.3 million
for the year ended
December 31, 2016
, from
$46.1 million
in the prior year due to a higher cost of funds. Our weighted-average cost of funds rose to
0.72%
for the year ended
December 31, 2016
from
0.40%
in the prior year as interest rates on our repo borrowings increased during 2016. Our average repo borrowings and FHLBC Advances
decreased
to
$10.3 billion
for the year ended
December 31, 2016
from
$11.4 billion
in the prior year, consistent with the decline in the average investment portfolio during 2016 as compared to
2015
. The table below illustrates the net result of changes to the average amount of repurchase agreements and FHLBC Advances outstanding and the increase in the cost of funds on interest expense during the year ended
December 31, 2016
(dollars in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Change in Size
|
|
Change in Rate
|
|
Change in Size & Rate
|
Change in average outstanding
|
$
|
(1,104,416
|
)
|
|
Change in average rate
|
0.32
|
%
|
|
Change in average outstanding
|
$
|
(1,104,416
|
)
|
2015 average rate
|
0.40
|
%
|
|
2015 average outstanding
|
11,395,383
|
|
|
Change in average rate
|
0.32
|
%
|
Change
|
$
|
(4,471
|
)
|
|
Change
|
$
|
36,122
|
|
|
Change
|
$
|
(3,501
|
)
|
|
|
|
|
|
|
Total change
|
$
|
28,150
|
|
Swap and cap interest expense decreased by
$44.3 million
to
$55.8 million
for the year ended
December 31, 2016
from
$100.1 million
in the prior year. The decrease in swap and cap interest expense was primarily attributable to the decrease in the average swap and cap rate to 0.59% in
2016
from 0.99% in the prior year, and a
$0.6 billion
decrease in the average aggregate swap and cap notional amount to
$9.5 billion
for the year ended
December 31, 2016
from
$10.2 billion
in the prior year, as shown in the table below (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Change in Size
|
|
Change in Rate
|
|
Change in Size & Rate
|
Change in average notional outstanding
|
$
|
(626,923
|
)
|
|
Change in average rate
|
(0.40
|
)%
|
|
Change in average notional outstanding
|
$
|
(626,923
|
)
|
2015 average rate
|
0.99
|
%
|
|
2015 average notional outstanding
|
10,153,846
|
|
|
Change in average rate
|
(0.40
|
)%
|
Change
|
$
|
(6,181
|
)
|
|
Change
|
$
|
(40,640
|
)
|
|
Change
|
$
|
2,509
|
|
|
|
|
|
|
|
Total change
|
$
|
(44,312
|
)
|
Our annualized weighted-average cost of funds including hedge was
1.26%
for the year ended
December 31, 2016
, as compared to
1.28%
for the prior year. The components of our cost of funds are (i) rates on our repo borrowings and FHLBC Advances (collectively "Total Outstanding Borrowings"), (ii) rates on our swaps and caps, (iii) the size of our Total Outstanding Borrowings, and (iv) the total notional amount of our swaps and caps.
Other Income (Loss)
For the year ended
December 31, 2016
, our total other income (loss) was
$(180.3) million
compared to
$(269.0) million
in the prior year. The major components contributing to the change in total other income (loss) during 2016 are discussed below.
Net Realized and Unrealized Gain (Loss) on Investments and Drop Income
During the year ended
December 31, 2016
, our net realized and unrealized (loss) on investments decreased by
$3.1 million
to a net loss of
$(113.0) million
, compared to a net loss of
$(116.1) million
in the prior year. This change was mainly driven by decreases in prices of Agency RMBS for the years ended
December 31, 2016
and 2015. During the year ended
December 31, 2016
, the price of a 15-year 3.5% Agency RMBS
decreased
$0.66
to
$104.11
, and during the year ended
December 31, 2015
, the price
decreased
$0.93
to
$104.77
. During the year ended
December 31, 2016
, the price of a 30-year 3.5% Agency RMBS
decreased
$0.90
, and during the year ended
December 31, 2015
the price
decreased
$1.07
.
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. During the years ended
December 31, 2016
and
2015
, we generated Drop Income of approximately
$32.9 million
and
$32.6 million
, respectively. The marginally higher Drop Income during the year ended
December 31, 2016
was due primarily to higher volumes of forward settling transactions from which we derive Drop Income. During the year ended
December 31, 2016
, the average gross balance in the combined TBA Securities and TBA Derivatives portfolio was
$1.4 billion
, a $0.2 billion increase compared to the average gross balance of
$1.2 billion
in the prior year. 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 Consolidated Statement of Operations and is therefore excluded from Core Earnings.
Net unrealized gain (loss) on long-term FHLBC advances
During the year ended
December 31, 2016
, the Company repaid $2.1 billion in FHLBC Advances outstanding at December 31, 2015. We held $425.0 million of FHLBC Advances with an initial maturity greater than one year and a weighted-average maturity of 2.8 years at December 31, 2015. For the year ended
December 31, 2016
the net unrealized loss on FHLBC Advances was
$(1.3) million
. The unrealized loss was due primarily to pricing FHLBC Advances with initial maturities greater than one year at par as a result of repaying all outstanding FHLBC Advances prior to September 30, 2016. For the year ended
December 31, 2015
, the net unrealized gain on FHLBC Advances of
$1.3 million
was due primarily to rising interest rates in which the value of our long-term liability decreased. 3-year swap rates increased from 1.21% on May 27, 2015 (the date on which the first FHLBC Advance was obtained) to 1.42% at December 31, 2015.
Net Realized and Unrealized Gain (Loss) on Derivative Instruments
Net realized and unrealized 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
$(11.5) million
(comprised of $9.1 million net realized and unrealized gain on swap and cap contracts, and $(20.6) million net realized and unrealized loss on TBA Derivatives) for the year ended
December 31, 2016
, compared to a loss of
$(54.9) million
(comprised entirely of a net realized and unrealized loss on swap and cap contracts) for the year ended
December 31, 2015
. The change in net realized and unrealized gain (loss) on derivative instruments for the year ended
December 31, 2016
was due primarily to an increase in interest rates, which caused our swap and caps to increase in value which was partially offset by a decrease in value of TBA Derivatives. A decrease in rates during the year ended
December 31, 2015
caused a decrease in the value of our derivative instruments. Our swaps and caps are designed principally to protect us in an environment of increasing interest rates. During the year ended
December 31, 2016
, 5-year and 7-year swap rates
increased
by
24
bps and
21
bps, respectively. During the year ended
December 31, 2015
, 5-year and 7-year swap rates
decreased
by
3
bps and
9
bps, respectively.
Operating Expenses
Operating expenses were
$23.6 million
and
$20.8 million
for the years ended
December 31, 2016
and
2015
, respectively representing an expense ratio of
1.39%
for
2016
, compared to
1.12%
for
2015
. The increase in operating expenses during 2016 was due primarily to an increase in compensation and benefits expense due to an increase in headcount, and $2.6 million of non-recurring charges, including a $1.7 million prior period tax charge. Excluding the effects of non-recurring expenses, the operating expense ratio was 1.23% for the year ended
December 31, 2016
.
Year Ended
December 31, 2015
Compared to the Year Ended
December 31, 2014
Net Income (loss)
Net income (loss) available to common stockholders decreased $(430.4) million to a net loss of $(25.6) million for the year ended December 31, 2015, compared to net income of $404.8 million in the prior year. The net loss in 2015 was largely attributable to a
$482.4 million
increase in the net realized and unrealized loss on investments, offset by a
$55.6 million
decrease in net gain (loss) on derivative instruments from the prior year. Changes in the value of our investments and derivative instruments during 2015 were directly related to changes in the yield curve and swaps rates. In general, U.S Treasury rates and swaps rates ended the year at relatively similar levels to where they had started. For example, the 10-year U.S. Treasury yield increased
10
bps during 2015 to
2.27%
at
December 31, 2015
. However, during 2015 there was volatility in the
yield curve, and swaps spreads generally tightened in the second half of the year, resulting in a decline in the value of our swaps and caps. 5-year swap spreads decreased 14 bps to (2) bps at December 31, 2015, and we recorded a net realized and unrealized gain (loss) of
$(54.9) million
for the year ended December 31, 2015. The major components of the decrease in net income during 2015 as compared to the prior year are detailed below.
Interest Income and Asset Yield
Our principal source of income is the interest income that we earn on our Debt Securities portfolio. Interest income, which consists of interest income on our Debt Securities, increased by $14.1 million to $331.2 million for the year ended December 31, 2015, as compared to $317.1 million in the prior year. This increase was attributable primarily to an increase in the average investment portfolio, which was offset partially by a decrease 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
|
$
|
764,162
|
|
|
Change in average yield
|
(0.04
|
)%
|
|
Change in average settled
|
$
|
764,162
|
|
2014 average yield
|
2.60
|
%
|
|
2014 average settled
|
12,198,178
|
|
|
Change in average yield
|
(0.04
|
)%
|
Change
|
$
|
19,864
|
|
|
Change
|
$
|
(5,406
|
)
|
|
Change
|
$
|
(339
|
)
|
|
|
|
|
|
|
Total change
|
$
|
14,119
|
|
Our average settled Debt Securities for the year ended December 31, 2015 was $13.0 billion, compared to $12.2 billion in the prior year. Our annualized yield on average settled Debt Securities for the year ended December 31, 2015 was 2.56%, as compared to 2.60% in the prior year. The yield on our assets is largely affected by the rate of prepayments on our Agency RMBS. The rate of amortization of unamortized premiums increases with the rate of prepayments. The decrease in yield during 2015 as compared to 2014 was primarily due to higher amortization expense. Our amortization expense was $90.4 million for the year ended December 31, 2015, compared to $52.5 million in the prior year as a result of an increase in CPR from 7.9% in 2014 to 10.4% in 2015.
Economic Net Interest Income
Our Economic Net Interest Income for the year ended December 31, 2015 was $185.0 million, and our interest rate spread net of hedge was 1.28%. For the year ended December 31, 2014, our Economic Net Interest Income was $192.4 million, and our interest rate spread net of hedge was 1.42%. The decrease in our interest rate spread net of hedge (yield minus financing and hedging costs) was due to a decrease in the portfolio yield, which was driven by an increase in amortization expense, and a higher average cost of funds and hedge, which increased to 1.28% for the year ended December 31, 2015, as compared to 1.18% in the prior year due primarily to higher rates on our repo borrowings and FHLBC Advances.
Economic Interest Expense and Cost of Funds
Economic Interest Expense for the year ended December 31, 2015 increased $21.6 million to $146.2 million, from $124.6 million in the prior year. The increase in Economic Interest Expense was due primarily to an increase in our average repo borrowings and FHLBC Advances, an increase in the average cost of funds, and an increase in our swap and cap interest expense during 2015. Our average repo borrowings and FHLBC Advances increased to $11.4 billion for the year ended December 31, 2015, from $10.6 billion in the prior year, consistent with the increase in the average investment portfolio during 2015 as compared to 2014. During 2015, the average interest rate on repo borrowings and FHLBC Advances increased to 0.40% from 0.32% in the prior year. The impact of the increase in average repo borrowings and FHLBC Advances and the related interest rates on our Economic Net Interest Expense for 2015 are shown below (dollars in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Change in Size
|
|
Change in Rate
|
|
Change in Size & Rate
|
Change in average outstanding
|
$
|
835,527
|
|
|
Change in average rate
|
0.08
|
%
|
|
Change in average outstanding
|
$
|
835,527
|
|
2014 average rate
|
0.32
|
%
|
|
2014 average outstanding
|
10,559,856
|
|
|
Change in average rate
|
0.08
|
%
|
Change
|
$
|
2,676
|
|
|
Change
|
$
|
8,922
|
|
|
Change
|
$
|
706
|
|
|
|
|
|
|
|
Total change
|
$
|
12,304
|
|
Swap and cap interest expense increased by $9.3 million to $100.1 million for the year ended December 31, 2015 from $90.8 million in 2014. The increase in swap and cap interest expense was largely due to a $257.6 million increase in the average aggregate swap and cap notional amount to $10.2 billion from $9.9 billion in the prior year, and by an increase in the average swap and cap net pay rate ("average rate") to 0.99% in 2015 from 0.92% in the prior year, as shown in the table below
(dollars in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Change in Size
|
|
Change in Rate
|
|
Change in Size & Rate
|
Change in average notional outstanding
|
$
|
257,692
|
|
|
Change in average rate
|
0.07
|
%
|
|
Change in average notional outstanding
|
$
|
257,692
|
|
2014 average rate
|
0.92
|
%
|
|
2014 average notional outstanding
|
9,896,154
|
|
|
Change in average rate
|
0.07
|
%
|
Change
|
$
|
2,365
|
|
|
Change
|
$
|
6,757
|
|
|
Change
|
$
|
176
|
|
|
|
|
|
|
|
Total change
|
$
|
9,298
|
|
Our annualized weighted-average cost of funds including hedge was 1.28% for the year ended December 31, 2015, as compared to 1.18% in the prior year. The components of our cost of funds 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.
Other Income (Loss)
For the year ended December 31, 2015, our total other income (loss) was a loss of $(269.0) million compared to income of $165.2 million in the prior year. The major components contributing to the decrease in total other income (loss) during 2015 are described below.
Net Realized and Unrealized Gain (Loss) on Investments and Drop Income
During the year ended December 31, 2015, our net realized and unrealized gain (loss) on investments decreased by $482.4 million to a net loss of $(116.1) million, compared to a net gain of $366.3 million in the prior year. This decrease was primarily driven by a substantial decrease in the prices of Agency RMBS during 2015. For example, during 2015, the price of a 30-year 4.0% Agency RMBS decreased $0.91, and during 2014 it increased $3.75. Additionally, our net realized and unrealized losses on investments were amplified by the impact of an increase in the average total Debt Securities of $14.2 billion for the year ended December 31, 2015 compared to $13.9 billion in the prior year.
During the years ended December 31, 2015 and 2014, we generated Drop Income of approximately $32.6 million and $60.7 million, respectively. The decrease in Drop Income during 2015 was due primarily to lower volumes of forward settling transactions from which we derive Drop Income. During the year ended December 31, 2015, the average balance in the TBA Securities portfolio was $1.2 billion, a decrease of $0.5 billion from the average balance of $1.7 billion in the prior year. The TBA market became slightly less attractive in 2015 and we settled more cash bonds in 2015.
Net unrealized gain (loss) on long-term FHLBC Advances
During the year ended December 31, 2015 we secured certain FHLBC Advances with an original term of three years, a weighted-average interest rate of 1.48%, that were callable after the one-year anniversary and thereafter every six months. We held $425.0 million of FHLBC Advances with an initial term greater than one year and a weighted-average maturity of 2.5 years at December 31, 2015. The net unrealized gain on FHLBC Advances of $1.3 million during 2015 was due primarily to rising interest rates in which the value of our long-term liability decreased. To illustrate, 3-year swap rates increased from 1.21% on May 27, 2015 (the date on which the first long-term FHLBC Advance was obtained) to 1.42% at December 31, 2015. At December 31, 2014, the Company had no long-term FHLBC Advances outstanding.
Net Realized and Unrealized Gain (Loss) on Derivative Instruments
Net realized and unrealized gain (loss) on derivative instruments decreased by $55.6 million to a net loss of $(54.9) million for the year ended December 31, 2015, from a loss of $(110.5) million in the prior year. The decrease in the net loss during 2015 was due principally to changes in swap rates during the year and the termination of cancelable swaps. Swap rates declined less in 2015 relative to 2014. The value of our swaps declines with declines in swap rates and vice-versa. To illustrate, during the year ended December 31, 2015, 5-year and 7-year swap rates decreased by 3 bps and 9 bps, respectively. During the year ended December 31, 2014, 5-year and 7-year swap rates decreased by 2 bps and 44 bps, respectively. In addition, during the year ended December 31, 2015 we terminated all cancelable swaps in response to lower rates during the first three quarters of 2015. Our decision to terminate the cancelable swaps resulted in a smaller loss than if we had terminated comparable 7-year generic swaps. During the years ended December 31, 2015 and 2014, our average aggregate interest rate swap and cap notional amount was $10.2 billion and $9.9 billion, respectively.
Operating Expenses
Operating expenses were $20.8 million and $22.9 million for the years ended December 31, 2015 and 2014, respectively, representing an expense ratio of 1.12% for 2015, compared to 1.19% for 2014. The decrease in operating expenses was largely due to a decrease in incentive compensation in 2015 as compared to the prior year.
Contractual Obligations and Commitments
The following table summarizes our contractual obligations for borrowings under repurchase agreements and FHLBC Advances, interest expense on such borrowings and the office lease at
December 31, 2016
and
2015
(dollars in thousands).
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
December 31, 2016
|
Within One Year
|
|
One to Three Years
|
|
Three to Five Years
|
|
Thereafter
|
|
Total
|
Repurchase agreements and FHLBC Advances
|
$
|
9,691,544
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
9,691,544
|
|
Interest expense on repurchase agreements and FHLBC Advances, based on rates at December 31, 2016
|
29,154
|
|
|
—
|
|
|
—
|
|
|
—
|
|
|
29,154
|
|
Long-term operating lease obligation
|
353
|
|
|
736
|
|
|
776
|
|
|
606
|
|
|
2,471
|
|
Total
|
$
|
9,721,051
|
|
|
$
|
736
|
|
|
$
|
776
|
|
|
$
|
606
|
|
|
$
|
9,723,169
|
|
At
December 31, 2016
and
December 31, 2015
, we had the following interest rate swaps and caps (in thousands):
As of
December 31, 2016
|
|
|
|
|
|
|
|
|
|
|
|
Interest Rate Swaps
|
|
Weighted-Average
|
|
Notional
|
|
Fair
|
Expiration Year
|
|
Fixed Pay Rate
|
|
Amount
|
|
Value
|
2017
|
|
0.82%
|
|
$
|
1,000,000
|
|
|
$
|
2,316
|
|
2018
|
|
1.00%
|
|
1,500,000
|
|
|
4,359
|
|
2020
|
|
1.45%
|
|
1,750,000
|
|
|
23,474
|
|
2021
|
|
1.21%
|
|
1,700,000
|
|
|
48,931
|
|
2022
|
|
1.98%
|
|
500,000
|
|
|
1,528
|
|
Total
|
|
1.23%
|
|
$
|
6,450,000
|
|
|
$
|
80,608
|
|
|
|
|
|
|
|
|
Interest Rate Caps
|
|
Weighted-Average
|
|
Notional
|
|
Fair
|
Expiration Year
|
|
Cap Rate
|
|
Amount
|
|
Value
|
2019
|
|
1.34%
|
|
$
|
800,000
|
|
|
$
|
8,051
|
|
2020
|
|
1.25%
|
|
1,700,000
|
|
|
34,481
|
|
Total
|
|
1.28%
|
|
$
|
2,500,000
|
|
|
$
|
42,532
|
|
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 contracts that contain a variety of indemnification obligations, principally with our brokers and counterparties to interest rate swap and cap contracts and repo borrowings. We have not incurred any costs to defend lawsuits 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
December 31, 2016
and
December 31, 2015
. In addition, as of
December 31, 2016
and
December 31, 2015
, we had
$1.9 billion
and
$1.5 billion
of payable for securities purchased, respectively, a portion of which either will be or was financed through repo borrowings and/or FHLBC Advances as it relates solely to amounts outstanding at
December 31, 2015
.
Off-Balance Sheet Arrangements
As of
December 31, 2016
and
2015
, we had no relationships with any significant 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
December 31, 2016
and
2015
, we had not guaranteed obligations of unconsolidated entities, entered into commitments or had any intent to provide funding to any such entities.
We may 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 (prior to the effective date of the Final Rule on January 19, 2016, which precluded us from securing new advances), asset sales and monthly principal and interest payments on our investment portfolio. Depending on market conditions, equity and debt offerings could also be a source of funds. Because the level of our borrowings may change on a daily basis, we believe that the level of cash and cash equivalents carried on our balance sheet is significantly less important than the 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 margin requirements and the payment of cash dividends required for our continued qualification as a REIT. To qualify as a REIT, we must distribute at least 90% of our net taxable income annually. To the extent that we 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
December 31, 2016
and 2015, we had approximately
$0.9 billion
and
$1.1 billion
, respectively, in Agency RMBS, U.S. Treasuries and cash available to satisfy future margin calls. We have consistently maintained sufficient liquidity to meet margin calls, and have historically satisfied all margin calls, although no assurance can be given that we will be able to satisfy margin calls in the future. During the year ended
December 31, 2016
, we maintained an average liquidity level of
59%
, but not less than
47%
, of stockholders' equity. The following table presents our unencumbered liquid assets as a percentage of stockholders' equity as of
December 31
:
|
|
|
|
|
|
|
|
|
|
|
|
Carrying Value as of
|
Unencumbered Liquid Assets
|
|
2016
|
|
2015
|
Cash and cash equivalents
|
|
$
|
1,260
|
|
|
$
|
9,982
|
|
U.S. Treasuries
|
|
32,494
|
|
|
29,257
|
|
Agency RMBS
|
|
903,548
|
|
|
1,080,990
|
|
Unencumbered liquid assets
|
|
$
|
937,302
|
|
|
$
|
1,120,229
|
|
Unencumbered liquid assets as % of total stockholders' equity
|
|
61.0
|
%
|
|
66.2
|
%
|
As of
December 31, 2016
, $34.2 million of assets were pledged to the Company under the Master Agreements, of which $2.7 million were pledged by the Company to other counterparties at
December 31, 2016
.
During the year ended
December 31, 2016
and
2015
, we had average repo borrowings and FHLBC Advances outstanding of
$10.3 billion
and
$11.4 billion
, respectively, with a weighted-average borrowing rate of
0.72%
and
0.40%
. The availability of repo borrowing financing was generally stable with interest rates between 0.71% and 1.15% for 30-180 day repo borrowings at
December 31, 2016
.
As a direct result of the Final Rule, prior to September 30, 2016, the Company repaid approximately $2.1 billion of FHLBC Advances with its existing repo counterparties. As with our repo borrowings, if the value of any assets pledged to FHLBC as collateral for advances decreased, the FHLBC could require posting of additional collateral. During 2016, the Company redeemed
$42.0 million
of FHLBC activity stock in connection with the repayment of FHLBC Advances.
We diversify our funding across multiple counterparties and by counterparty region to limit our exposure to counterparty credit risk. As of
December 31, 2016
and
December 31, 2015
, we had access to
50
and
48
counterparties, respectively, subject to certain conditions, located throughout North America, Europe and Asia. At December 31, 2016, we had no FHLBC Advances outstanding. At December 31, 2015, FHLBC Advances were 18.9% of the Total Outstanding Borrowings. For the years ended December 31, 2016 and 2015, repo borrowings and FHLBC Advances with any individual counterparty were less than
7.1%
and
5.1%
of the Total Outstanding Borrowings, respectively. The table below includes a summary of our outstanding repo borrowings and FHLBC Advances by number of counterparties and region as of
December 31, 2016
and
2015
:
|
|
|
|
|
|
|
|
December 31, 2016
|
Counterparty Region
|
|
Number of Repo Borrowings Counterparties
|
|
Percent of Total Outstanding Borrowings
|
North America
|
|
22
|
|
60.4%
|
Europe
|
|
8
|
|
22.8%
|
Asia
|
|
5
|
|
16.8%
|
|
|
35
|
|
100.0%
|
|
|
|
|
|
|
|
|
December 31, 2015
|
Counterparty Region
|
|
Number of Repo Borrowings and FHLBC Advances 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 standard 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 maintained FHLBC Advances (the "FHLBC Arrangement") involved observance by CYS Insurance of the rules of FHLBC membership, subject to the FHLBC's credit policy, and was governed by the terms and conditions of a blanket security agreement, and the consent and guaranty of the Company. The FHLBC Arrangement required CYS Insurance to transfer additional securities to the FHLBC in the event the value of the securities then held by the FHLBC fell below specified levels, and contained events of default in cases where we or the FHLBC breached 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.
We receive margin calls from our repurchase agreement counterparties in the ordinary course of business, similar to other special finance entities. We receive two types of margin calls under our repurchase agreements. The first type, which are known as "factor calls," are margin calls that occur each month and relate to the timing difference between the reduction of principal balances of our Agency RMBS due to monthly principal payments on the underlying mortgages, and the receipt of the corresponding cash. The second type of margin call we may receive is a "valuation call", which occurs due to market and interest rate movements. Both factor and valuation margin calls occur if the total value of our assets pledged as collateral to our counterparty drops beyond a threshold level, typically between $100,000 and $500,000 (although no such minimum applied under the FHLBC Arrangement). Both types of margin calls require a dollar for dollar restoration of the margin shortfall. Conversely, we may initiate margin calls to our counterparties when the value of our assets pledged as collateral with a counterparty increases above the threshold level, thereby increasing our liquidity. All unrestricted cash 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. 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 repurchase agreements 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 repo 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.
We also pledge collateral for our interest rate swaps, caps, and forward purchase transactions. We will receive margin calls on these transactions when the value of the swap or forward purchase transaction declines or when the value of any collateral pledged falls below a particular threshold level. All unrestricted cash and cash equivalents, plus any unpledged Agency RMBS or U.S. Treasuries, are available to satisfy margin calls.
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.
For our short-term (less than one year) and long-term (more than one year) liquidity and capital resource requirements, we rely on the cash flow from operations, primarily monthly principal and interest payments to be received on our Agency RMBS. During the years ended
December 31, 2016
and
2015
, we received
$1.92 billion
and
$1.90 billion
of principal repayments, respectively, and
$297.3 million
and
$334.5 million
of interest payments, respectively. We held cash of
$1.3 million
and
$10.0
million
at
December 31, 2016
and
December 31, 2015
, respectively. For the years ended
December 31, 2016
and
2015
, net cash provided by operating activities was
$167.9 million
and
$257.6 million
, respectively.
Based on our current portfolio, leverage and available borrowing capacity, we believe that our cash flow from operations and the utilization of borrowings will be sufficient to enable us to meet anticipated short-term liquidity requirements such as funding our investment activities, distributions to stockholders and general corporate expenses. However, an increase in prepayment rates substantially above our expectations may cause a temporary liquidity shortfall due to the timing of margin calls and the actual receipt of cash related to principal paydowns. If our cash resources are at any time insufficient to satisfy our liquidity requirements, we may be required to sell Agency RMBS in our portfolio or issue debt or equity securities, subject to market conditions. If required, the sale of Agency RMBS at prices lower than their amortized cost would result in realized losses. We believe that we have additional capacity through repurchase agreements to leverage our equity further should the need for additional short-term liquidity arise.
Our investment portfolio is comprised principally of highly-liquid Agency RMBS and U.S. Treasuries 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, we believe it remains one of the most secure creditors in the world as of
December 31, 2016
.
We may increase our capital resources by obtaining long-term credit facilities or making public or private offerings of equity or debt securities. Such financing will depend on market conditions for capital raises and for the investment of any proceeds. If we are unable to renew, replace or expand our sources of financing on substantially similar terms, it may have an adverse effect on our business and results of operations. On May 23, 2014, we filed an automatically effective shelf registration statement on Form S-3 with the Securities and Exchange Commission. 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
December 31, 2016
, we had not issued any shares of common stock, preferred stock or debt securities under the prospectus.
Effective May 15, 2014, the Company terminated that certain Equity Distribution Agreement by and between the Company and JMP Securities LLC ("JMP"), dated as of June 7, 2011 (the "JMP Agreement"), in connection with the expiration of the Company's prior shelf registration statement on Form S-3. Under the JMP Agreement, the Company could offer and sell, from time to time, up to 15.0 million shares of the Company's common stock through an "at the market" offering program with JMP. The Company sold 11.9 million shares of common stock under the JMP Agreement. For the year ended
December 31, 2016
and
2015
, the Company did not sell any shares of common stock under the JMP Agreement.
Another vehicle we may utilize 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. For the year ended
December 31, 2016
the Company issued
797
shares under the DSPP. We did not issue any shares under the plan during the year ended
December 31, 2015
. As of
December 31, 2016
and
2015
, there were approximately
4.1 million
shares available for issuance under the DSPP.
We also repurchase our capital stock from time to time. On November 15, 2012, the Company announced that its board of directors authorized the repurchase of shares of the Company's common stock having an aggregate value of up to $250 million. Pursuant to this program, through July 20, 2014 the Company repurchased approximately $115.7 million in aggregate value of its shares of common stock on the open market. On July 21, 2014, the Company announced that its board of directors authorized the repurchase of shares of the Company's common stock having an aggregate value of up to $250 million, which included approximately $134.3 million available for repurchase under the November 2012 authorization. Subsequently, during 2014 we repurchased 172,549 shares at a weighted-average purchase price of $8.88 per share, for an aggregate purchase price of approximately $1.5 million. In
2016
, we repurchased
673,166
shares of the Company's common stock at a weighted-average price of
$7.85
per share for an aggregate purchase price of approximately
$5.3 million
. Accordingly, the Company still had approximately
$155.5 million
authorized to repurchase shares of its common stock as of
December 31, 2016
.
For the year ended December 31, 2015, the Company repurchased 10,559,493 shares with a weighted-average purchase price of $8.28 per share for an aggregate purchase price of approximately $87.7 million. Accordingly, the Company was authorized to repurchase shares of its common stock approximating $160.8 million as of December 31, 2015.
Quantitative and Qualitative Disclosures about Short-Term Borrowings
The following table discloses quantitative data about our repo borrowings and FHLBC Advances with initial terms less than one year during the years ended
December 31, 2016
and
2015
:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
(In millions)
|
December 31, 2016
|
|
September 30, 2016
|
|
June 30, 2016
|
|
March 31, 2016
|
Outstanding at period end
|
$
|
9,692
|
|
|
$
|
9,621
|
|
|
$
|
10,075
|
|
|
$
|
10,307
|
|
Weighted-average rate at period end
|
0.89
|
%
|
|
0.77
|
%
|
|
0.65
|
%
|
|
0.73
|
%
|
Average outstanding during period
(1)
|
$
|
9,905
|
|
|
$
|
10,111
|
|
|
$
|
10,025
|
|
|
$
|
10,493
|
|
Weighted-average rate during period
|
0.81
|
%
|
|
0.68
|
%
|
|
0.69
|
%
|
|
0.68
|
%
|
Largest month end balance during period
|
$
|
10,873
|
|
|
$
|
10,787
|
|
|
$
|
10,363
|
|
|
$
|
11,088
|
|
|
|
(1)
|
Calculated based on the average month end balance of repurchase agreements and short-term FHLBC Advances during the period.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
(In millions)
|
December 31, 2015
|
|
September 30, 2015
|
|
June 30, 2015
|
|
March 31, 2015
|
Outstanding at period end
|
$
|
10,663
|
|
|
$
|
10,928
|
|
|
$
|
11,690
|
|
|
$
|
10,715
|
|
Weighted-average rate at period end
|
0.50
|
%
|
|
0.44
|
%
|
|
0.34
|
%
|
|
0.34
|
%
|
Average outstanding during period
|
$
|
10,947
|
|
|
$
|
11,245
|
|
|
$
|
11,573
|
|
|
$
|
10,954
|
|
Weighted-average rate during period
|
0.45
|
%
|
|
0.39
|
%
|
|
0.35
|
%
|
|
0.35
|
%
|
Largest month end balance during period
|
$
|
11,253
|
|
|
$
|
11,690
|
|
|
$
|
11,984
|
|
|
$
|
11,198
|
|
The Company's borrowing ability was generally stable during the years ended
December 31, 2016
and
2015
. From quarter to quarter, fluctuations occur in our short-term repo borrowings and FHLBC Advances that are fairly tightly correlated with the expansion and contraction of our investment portfolio. Though it varies by quarter, we generally maintain leverage between 6.4:1 and 7.1:1. The Company's borrowing rates were higher during 2016 compared to 2015, as a result of higher interest rates in advance of the increase in the Fed Funds Rate by 25 bps in December 2016.
At
December 31, 2016
and
2015
, our amount at risk with any individual counterparty related to our repo borrowings or FHLBC Advances was less than
2.6%
and
2.3%
of stockholders' equity.
Inflation
Virtually all our assets and liabilities are interest rate sensitive. As a result, interest rates and other factors tend to influence our performance more than inflation. Changes in interest rates do not necessarily correlate with inflation rates or changes in inflation rates. Our financial statements are prepared in accordance with GAAP and our distributions are determined by our board of directors based in part on our REIT taxable income as calculated according to the requirements of the Internal Revenue Code. In each case, our activities and balance sheet are measured with reference to fair value without considering inflation.
Critical Accounting Policies
We make complex and subjective decisions and assessments that could affect our reported assets and liabilities, as well as our reported interest income and expenses. We believe that all of the decisions and assessments upon which our financial statements are based were reasonable at the time made based upon information available at that time. We rely on our management's experience and analysis of historical and current market data in order to arrive at what we believe to be reasonable estimates.
See
Note 2,
Significant Accounting Policies
to the financial statements included in the Financial Statements section of this Annual Report on Form 10-K for a complete discussion of our significant accounting policies. The following has been identified as our most critical accounting policy:
Valuation
Agency RBMS and U.S. Treasuries are generally valued on the basis of valuations provided by highly reputed third party pricing services, derived from such services' pricing models. Inputs to these models may include, but are not limited to, reported trades, executable bid and asked prices, broker dealer quotations, prices or yields of securities with similar characteristics, benchmark curves or information pertaining to the issuer, as well as industry and economic events. The pricing services may utilize a matrix approach, which considers information related to securities with similar characteristics to determine the valuation for a security.
Interest rate swaps and caps are generally valued using valuations provided by dealer quotations. Such dealer quotations are based on the present value of fixed and projected floating rate cash flows over the term of the swap contract. Future cash flows are discounted to their present value using swap rates provided by electronic data services or brokers.
We price FHLBC Advances daily through a pricing service that employs a discounted cash flow model to value the debt. We periodically validate prices received through this process. Changes in fair market value were recorded in current period earnings on our Consolidated Statement of Operations as a component of net unrealized gain (loss) on FHLBC Advances. Electing the fair value option to value and recognize FHLBC Advances with initial maturities greater than one year permits the Company to record changes in the fair value of our long-term indebtedness along with that of our investments in our Consolidated Statement of Operations which, in management's view, more appropriately reflects the results of operations for a particular reporting period as all income producing assets and liabilities will be treated in a similar manner.
Glossary of Terms
Adjustable-Rate Mortgage ("ARM")
An ARM is an adjustable-rate residential mortgage loans that typically has an interest rate that adjust monthly to an increment over a specified interest rate index.
Advances
Short and long term secured loans provided by the 11 regional FHLBs to their members.
Agency
Refers to a federally chartered corporation, such as the Federal National Mortgage Association, or the Federal Home Loan Mortgage Corporation, or an agency of the U.S. Government, such as the Government National Mortgage Association.
Agency RMBS
Issued residential mortgage-backed securities which have the principal and interest guaranteed by a federally chartered corporation.
Amortization
Liquidation of a debt through installment payments. Amortization also refers to the process of systematically reducing a recognized asset or liability (e.g., a purchase premium or discount for a debt security) with an offset to earnings.
Basis Point ("bps")
One hundredth of one percent, used in expressing differences in interest rates. One basis point is 0.01% of yield. For example, a bond’s yield that changed from 2.50% to 3.00% would be said to have moved 50 basis points.
Bond
The written evidence of debt, bearing a stated rate or stated rates of interest, or stating a formula for determining that rate, and maturing on a date certain, on which date and upon presentation a fixed sum of money plus interest (usually represented by interest coupons attached to the bond) is payable to the holder or owner; For purposes of computations tied in to “per bond,” a $1,000 increment of an issue is used (no matter what the actual denominations are); Bonds are long-term securities with an original maturity of greater than one year.
Broker
Generic name for a securities firm engaged in both buying and selling securities on behalf of customers or its own account.
Caps
An interest rate cap is a series of European interest call options (called caplets), with a particular interest rate, each of which expire on the date the floating loan rate will be reset. At each interest payment date the holder decides whether to exercise or let that particular option expire. In an interest rate cap, the seller agrees to compensate the buyer for the amount by which an underlying short-term rate exceeds a specified rate on a series of dates during the life of the contract. Interest rate caps are used often by borrowers in order to hedge against floating rate risk.
Collateral
Securities, cash or property pledged by a borrower or party to a derivative contract to secure payment of a loan or derivative. If the borrower fails to repay the loan or defaults under the derivative contract, the secured party may take ownership of the collateral.
Collateralized Mortgage Obligation ("CMO")
A multi-class bond backed by a pool of mortgage pass-through securities or mortgage loans.
Commodity Futures Trading Commission ("CFTC")
An independent U.S. federal agency established by the Commodity Futures Trading Commission Act of 1974. The CFTC regulates the swaps, commodity futures and options markets. Its goals include the promotion of competitive and efficient futures markets and the protection of investors against manipulation, abusive trade practices and fraud.
Constant Prepayment Rate ("CPR")
The percentage of outstanding mortgage loan principal that prepays in one year, based on annualizing the Single Monthly Mortality, which reflects the outstanding mortgage loan principal that prepays in one month.
Core Earnings
Represents a non-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.
Counterparty
One of two entities in a transaction. For example, in the bond market a counterparty can be a broker-dealer, a state or local government or a corporation.
Coupon
The interest rate on a bond that is used to compute the amount of interest due on a periodic basis.
Counterparty Risk
Risk to earnings, capital or business, resulting from an obligor’s or counterparty's failure to meet the terms of any contract or otherwise failure to perform as agreed. Counterparty risk is present in lending, investing, funding and hedging activities.
Current Face
The current remaining monthly principal on a mortgage security. Current face is computed by multiplying the original face value of the security by the current principal balance factor.
Dealer
Person or organization that underwrites, trades and sells securities, e.g., a principal market-maker in securities.
Derivative
A financial product that derives its value from the price, price fluctuations and price expectations of an underlying instrument, index or reference pool (e.g. interest rate swaps, interest rate caps and certain TBA Securities).
Discount Price
When the dollar price is below face value, it is said to be selling at a discount.
Drop Income
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.
Duration
The weighted maturity of a fixed-income investment’s cash flows, used in the estimation of the price sensitivity of fixed-income securities for a given change in interest rates.
Economic Interest Expense
Non-GAAP financial measure that is composed of GAAP interest expense adjusted for realized gains or losses on interest rate swaps used to hedge cost of funds.
Economic Net Interest Income
Non-GAAP financial measure that is composed of GAAP net interest income adjusted for realized gains or losses on interest rate swaps used to hedge cost of funds.
Single Monthly Mortality
Percentage of the principal amount of mortgages that are prepaid in a given month.
Face Amount
The par value (i.e., principal or maturity value) of a security appearing on the face of the instrument.
Factor Calls
Margin calls under repurchase agreements that occur each month and relate to the timing difference between the reduction of principal balances of our Agency RMBS due to monthly principal prepayments on underlying mortgages, and receipt of the corresponding cash.
Fannie Mae ("FNMA")
Federal National Mortgage Association.
Federal Reserve Bank ("Fed")
The central bank of the United States. The Federal Reserve Bank was founded by the U.S. Congress in 1913 to provide the nation with a safe, flexible and stable monetary and financial system.
Federal Funds Rate
In the United States, the Federal Funds Rate is the interest rate at which depository institutions (banks and credit unions) lend reserve balances to other depository institutions overnight, on an uncollateralized basis.
Federal Deposit Insurance Corporation ("FDIC")
An independent agency created by the U.S. Congress to maintain stability and public confidence in the nation's financial system by insuring deposits, examining and supervising financial institutions for safety and soundness and consumer protection, and managing receiverships.
Federal Housing Administration ("FHA")
The Federal Housing Administration, generally known as "FHA", provides mortgage insurance on loans made by FHA-approved lenders throughout the United States and its territories. FHA insures mortgages on single family and multifamily homes including manufactured homes and hospitals.
Federal Home Loan Banks ("FHLB")
U.S. Government-sponsored banks that provide liquidity to member financial institutions to support housing finance and community investment.
Federal Housing Financing Agency ("FHFA")
The FHFA is an independent regulatory agency that oversees vital components of the secondary mortgage market including Fannie Mae, Freddie Mac and the Federal Home Loan Banks.
FHLBC
Federal Home Loan Bank of Cincinnati.
Fixed-Rate Mortgage
A mortgage featuring level monthly payments, determined at the outset, which remain constant over the life of the mortgage.
Floating Rate
Any interest rate that changes on a periodic basis. The change is usually tied to movement of an outside indicator, such as the LIBOR interest rate.
Freddie Mac
Federal Home Loan Mortgage Corporation.
GAAP
Accounting principles generally accepted in the United States of America.
Ginnie Mae ("GNMA")
Government National Mortgage Association.
Haircut
The percentage amounts by which the collateral value exceeds the amount borrowed. This percentage amount reflects the underlying risk of the specific collateral and protects the counterparty against a change in its value.
Hedge
An investment made with the intention of minimizing the impact of adverse movements in interest rates or securities prices.
Hedge Ratio
The ratio of swap and cap notional to repo borrowings and FHLBC Advances.
Hybrid Adjustable-Rate Residential Mortgage ("ARM")
Hybrid adjustable-rate residential mortgage loans that have interest rates that are fixed for a specified period of time and, thereafter, generally adjust annually to an increment over a specified interest or index.
Interest Rate Risk
The risk that an investment's value will change due to a change in the absolute level of interest rates, in the spread between two rates, in the shape of the yield curve or in any other interest rate relationship. As market interest rates rise, the value of current fixed income investment holdings declines. Diversifying, deleveraging and hedging techniques are utilized to mitigate this risk. Interest rate risk is a form of market risk.
Interest Rate Swap
A binding agreement between counterparties to exchange periodic interest payments on some predetermined dollar principal, which is called the notional principal amount. For example, one party will pay fixed and receive a variable rate
Investment Company Act
The Investment Company Act of 1940, as amended.
International Swaps and Derivatives Association (ISDA) Master Agreement
Standardized contract developed by ISDA, under which bilateral derivatives contracts are entered into.
Leverage
The use of borrowed money to increase investing power and economic returns.
Leverage Ratio
Calculated by dividing (i) the Company's repurchase agreements and FHLBC Advances balance plus payable for
securities purchased minus receivable for securities sold plus the net TBA Derivative positions by (ii) stockholders' equity.
London Interbank Offered Rate ("LIBOR")
The rate banks charge each other for short-term Eurodollar loans. LIBOR is frequently used as the base for resetting rates on floating-rate securities and the floating-rate legs of interest rate swaps.
Liquidity Risk
Risk to earnings, capital or business arising from our inability to meet our obligations when they come due without incurring unacceptable losses because of inability to liquidate assets or obtain adequate funding.
Market Risk
Risk to earnings, capital or business resulting in the decline in value of our assets caused from changes in market variables, such as interest rates, which affect the values of residential investment securities and other investment instruments.
Master Agreement
An agreement between two parties specifying the terms that will govern multiple transactions.
Monetary Policy
Action taken by the Board of Governors of the Federal Reserve system to influence the money supply or interest rates.
Mortgage-Backed Security ("MBS")
A security representing a direct interest in a pool of mortgage loans. The pass-through issuer or servicer collects the payments on the loans in the pool and "passes through" the principal and interest to the security holders on a pro rata basis.
Net Interest Income
Represents interest income earned on our portfolio investments, less interest expense paid for borrowings.
Notional Amount
A stated principal amount in a derivative contract on which the contract is based.
Original Face
The face value or original principal amount of a security on its issue date.
Over-The-Counter ("OTC") Market
A securities market that is conducted by dealers throughout the country through negotiation of price rather than through the use of an auction system as represented by a stock exchange.
Par
Price equal to the face amount of a bond, 100%.
Par Value
The principal amount of a bond or note due at maturity. Also known as par amount.
Pass Through Security
The securitization structure where a GSE or other entity “passes” the amount collected from the borrowers every month to the investor, after deducting fees and expenses.
Pool
A collection of mortgage loans assembled by an originator or master servicer as the basis for a security.
Premium
The amount by which the price of a security exceeds its principal amount. When the dollar price of a bond is above its face value, it is said to be selling at a premium.
Prepayment
The unscheduled partial or complete payment of the principal amount outstanding on a mortgage loan or other debt before it is due.
Prepayment Risk
The risk that falling interest rates will lead to heavy prepayments of mortgage or other loans, forcing the investor to reinvest at lower prevailing rates.
Principal and Interest
The term used to refer to regularly scheduled payments or prepayments of principal and payments of interest on a mortgage or other security.
Repurchase Agreements or "repo borrowings"
The sale of securities to investors with the agreement to buy them back at a higher price after a specified time period; a form of short-term borrowing. For the party on the other end of the transaction (buying the security and agreeing to sell in the future) it is a reverse repurchase agreement.
Residential Mortgage Backed Securities ("RMBS")
RMBS refers to whole-pool residential mortgage pass-through securities collateralized by residential mortgage loans; agency securities or Agency RMBS refers to our RMBS that are issued or guaranteed by a federally chartered corporation, such as "Fannie Mae" or "Freddie Mac", or an agency of the U.S. government, such as the "Ginnie Mae".
Securities and Exchange Commission ("SEC")
The Securities and Exchange Commission (SEC) is a government commission created by U.S. Congress with goals of protecting investors, maintaining fair and orderly functioning of securities markets, and facilitating the capital formation. The SEC promotes full public disclosure, protects investors against fraudulent and manipulative practices in the market, and monitors corporate takeover actions in the United States.
Secondary Market
Ongoing market for bonds previously offered or sold in the primary market.
Settlement Date
The date securities must be delivered and paid for to complete a transaction.
Single Monthly Mortality
Percentage of the principal amount of mortgages that are prepaid in a given month.
TBA Derivatives
TBA contracts with no contractual obligation to accept or make delivery.
To-Be-Announced ("TBA Securities")
A contract for the purchase or sale of a mortgage-backed security to be delivered at a predetermined price, face amount, issuer, coupon and stated maturity on an agreed-upon future date but does not include a specified pool number and number of pools.
Unencumbered Assets
Assets on our balance sheet which have not been pledged as collateral against an existing liability.
U.S. Government-Sponsored Enterprise ("GSE") Obligations
Obligations of Agencies originally established or chartered by the U.S. government to serve public purposes as specified by the U.S. Congress, such as Fannie Mae and Freddie Mac; these obligations are not explicitly guaranteed as to the timely payment of principal and interest by the full faith and credit of the U.S. government.
U.S. Treasury
Debt securities issued by the U.S. Department of the Treasury and backed by the full faith and credit of the U.S. government.
Valuation Calls
Margin calls under repurchase agreements that occur due to market and interest rate movements.
Volatility
A statistical measure of the variance of price or yield over time. Volatility is low if the price does not change very much over a short period of time, and high if there is a greater change.
Weighted-Average Coupon ("WAC")
The weighted-average interest rate of the underlying mortgage loans or pools that serve as collateral for a security, weighted by the size of the principal loan balances.
Weighted-Average Life ("WAL")
The assumed weighted-average amount of time that will elapse from the date of a security’s issuance until each dollar of principal is repaid to the investor. The WAL will change as the security ages and depending on the actual realized rate at which principal, scheduled and unscheduled, is paid on the loans underlying the MBS.
Whole-pool
Whole pools refer to mortgage certificates where ownership is represented by an undivided interest in entire pools of mortgages.
Yield-to-Maturity
The expected rate of return of a bond if it is held to its maturity date. It is calculated by taking into account the current market price, stated redemption value, coupon payments and time to maturity and assuming all coupons are reinvested at the same rate and is equivalent to the internal rate of return.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
As of
December 31, 2016
and
2015
, the primary component of our market risk was interest rate risk, as described below. We do not seek to completely avoid risk because we believe that certain risks based on historic experience can be quantified. Accordingly, we manage these risks to earn the commensurate compensation required to take them 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.
Interest Rate Risk
We are subject to interest rate risk in connection with our investments in Agency RMBS collateralized by ARMs, Hybrid ARMs and fixed rate mortgage loans and our related debt obligations, which are generally repurchase agreements of limited duration that are periodically refinanced at current market rates. We seek to manage this risk through utilization of derivative contracts, primarily interest rate swap and cap contracts.
Effect on Interest Income, Interest Expense and Swap and Cap Interest Expense
We fund our investments with repo borrowings and, prior to the January 19, 2016 effective date of the Final Rule, which precluded us from securing new FHLBC Advances, FHLBC Advances. During periods of rising interest rates, our borrowing costs tend to increase while the income earned on such investments may remain substantially unchanged. This results in a narrowing of the net interest spread between the related assets and borrowings and may even result in losses.
Hedging decisions 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.
Extension Risk
We have generally 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 realize losses.
Interest Rate Cap Risk
Both 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 or yield on our Agency RMBS would be fixed or 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 on our Agency RMBS than we need in order to pay the interest cost on our related borrowings. These factors could result in a decrease in our net income or cause a net loss during periods of rising interest rates, which could have an adverse effect on 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 the rate of earnings on our assets. During periods of changing interest rates, such interest rate mismatches could adversely affect 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, 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. Additionally, the majority of our Agency RMBS were purchased at a premium. The prepayment of such Agency RMBS at a rate faster than anticipated would result in amortization of any remaining unamortized premium faster than expected, which could adversely affect our financial condition and results of operations.
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 net income, exclusive of the effect on fair value. We face the risk that the fair value of our assets and net income, exclusive of the effect on fair value, 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 essentially measures the market price volatility of financial instruments as interest rates change. We generally calculate duration using various financial models and empirical data. Different models and methodologies can produce different durations for the same securities.
The following sensitivity analysis table estimates the impact of our interest rate-sensitive investments and repo borrowing liabilities on our net income, fair value of our assets, and change in stockholders' equity, exclusive of the effect of changes in fair value on our net income, at
December 31, 2016
and
December 31, 2015
, assuming a static portfolio and an instantaneous increase and decrease in rates of 25, 50 and 75 bps:
December 31, 2016
|
|
|
|
|
|
|
|
|
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
|
19.81
|
%
|
(2)
|
|
0.71%
|
|
5.78%
|
- 50 basis points
|
16.23
|
%
|
(2)
|
|
0.63%
|
|
5.13%
|
- 25 basis points
|
12.20
|
%
|
(2)
|
|
0.38%
|
|
3.10%
|
No Change
|
—
|
%
|
|
|
—%
|
|
—%
|
+ 25 basis points
|
(10.08
|
)%
|
|
|
(0.47)%
|
|
(3.83)%
|
+ 50 basis points
|
(20.16
|
)%
|
|
|
(1.01)%
|
|
(8.22)%
|
+ 75 basis points
|
(30.24
|
)%
|
|
|
(1.63)%
|
|
(13.21)%
|
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 December 31, 2016 and December 31, 2015, we reduced 3-month LIBOR and our repo borrowing rates by 10, 20 and 30 bps for the 25, 50, and 75 down net income scenarios at December 31, 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.
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While these tables above reflect the estimated immediate impact of interest rate increases and decreases on a static portfolio, we rebalance our portfolio from time to time to either take advantage of or minimize the impact of changes in interest rates. Generally, our interest rate swaps reset in the quarter following changes in interest rates. Interest rate changes beyond 75 bps from current levels could have a significant impact on the fair value of our assets and net income. Therefore, the volatility in the fair value of our assets and net income could increase significantly should 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, in the event of changes in actual interest rates, the change in the fair value of our assets and our net income would likely differ from that shown above, and such difference might have a material and adverse effect on our financial condition and results of operations.
Risk Management
Our board of directors exercises its oversight of risk management in many ways, including overseeing our senior management's risk-related responsibilities, including reviewing management policies and performance against these policies and related benchmarks.
As part of our risk management process, we actively manage the interest rate, liquidity, prepayment and counterparty risks associated with our Agency RMBS portfolio. This process includes monitoring various stress test scenarios on our 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 based on current market conditions and various other factors, including the health of the financial institutions that lend to us under repurchase agreements. 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 8. Financial Statements and Supplementary Data
Our financial statements and the related notes, together with the Report of Independent Registered Public Accounting Firm thereon, are set forth beginning on page F-1 of this Form 10-K.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.