ITEM 1A. RISK FACTORS
Set forth below are
the risks that we believe are material to stockholders. You should carefully consider the following risk factors identified in
or incorporated by reference into any other documents filed by us with the SEC in evaluating our company and our business. If any
of the following risks occur, our business, financial condition, results of operations and our ability to make distributions to
our stockholders could be adversely affected. In that case, the trading price of our stock could decline. The risk factors described
below are not the only risks that may affect us. Additional risks and uncertainties not presently known to us also may adversely
affect our business, financial condition, results of operations and our ability to make distributions to our stockholders.
Risks Related to Our Investment Strategies
and Our Businesses
We may not be able to operate our businesses
successfully or generate sufficient revenue to make or sustain distributions to our stockholders.
We cannot assure you that
we will be able to operate our businesses successfully or implement our operating policies and strategies. Our Manager may not
be able to successfully execute our investment, financing and hedging strategies as described in this Annual Report on Form 10-K,
which could result in a loss of some or all of your investment. The results of our operations depend on several factors, including
the availability of opportunities for the acquisition of target assets, the level and volatility of interest rates, the availability
of adequate short and long-term financing, conditions in the financial markets and economic conditions. Our revenues will depend,
in large part, on our ability to acquire assets at favorable spreads over our borrowing costs. If we are unable to acquire assets
that generate favorable spreads, our results of operations may be adversely affected, which could adversely affect our ability
to make or sustain distributions to our stockholders.
If we fail to develop, enhance and implement
strategies to adapt to changing conditions in the mortgage industry and capital markets, our business, financial condition, results
of operations and our ability to make distributions to our stockholders may be adversely affected.
The manner in which we
compete and the products for which we compete are affected by changing conditions, which can take the form of trends or sudden
changes in our industry, regulatory environment, changes in the role of GSEs, changes in the role of credit rating agencies or
their rating criteria or process, or the U.S. economy more generally. If we do not effectively respond to these changes, or if
our strategies to respond to these changes are not successful, our business, financial condition, results of operations and our
ability to make distributions to our stockholders may be adversely affected.
We may not realize gains or income from
our assets.
We seek to generate current
income and capital appreciation for our stockholders. However, the assets that we acquire may not appreciate in value and, in fact,
may decline in value, and the securities that we acquire may experience defaults of interest and/or principal payments. Accordingly,
we may not be able to realize gains or income from our assets. Any gains that we do realize may not be sufficient to offset other
losses that we experience.
We may continue to change our target
assets, investment or financing strategies and other operational policies without stockholder consent, which may adversely affect
our business, financial condition, results of operations and our ability to make distributions to our stockholders.
We may continue to change
any of our strategies, policies or procedures with respect to investments, acquisitions, growth, operations, indebtedness, capitalization,
distributions, financing strategy and leverage at any time without the consent of our stockholders, which could result in an investment
portfolio with a different, and possibly greater, risk profile. A change in our target assets, investment strategy or guidelines,
financing strategy or other operational policies may increase our exposure to interest rate risk, default risk and real estate
market fluctuations. Furthermore, a change in our asset allocation could result in our making investments in asset categories different
from those described in this Annual Report on Form 10-K. In addition, our charter provides that our board of directors may revoke
or otherwise terminate our REIT election, without approval of our stockholders, if it determines that it is no longer in our best
interests to maintain our REIT qualification. These changes could adversely affect our business, financial condition, results of
operations and our ability to make distributions to our stockholders.
Our portfolio of assets may be concentrated
in terms of credit risk.
Although as a general
policy we seek to acquire and hold a diverse portfolio of assets, we are not required to observe specific diversification criteria,
except as may be set forth in the investment guidelines adopted by our board of directors. Therefore, our asset portfolio may at
times be concentrated in certain property types that are subject to higher risk of foreclosure or secured by properties concentrated
in a limited number of geographic locations. To the extent that our portfolio is concentrated in any one region or type of security,
downturns relating generally to such region or type of security may result in defaults on a number of our assets within a short
time period, which could have a material adverse effect on our business, financial condition, results of operations and our ability
to make distributions to our stockholders. Our portfolio may contain other concentrations of risk, and we may fail to identify,
detect or hedge against those risks, resulting in large or unexpected losses. Lack of diversification can increase the correlation
of non-performance and foreclosure risks among our investments.
A significant portion of our Non-Agency
RMBS is secured by properties in a small number of geographic areas and may be disproportionately affected by economic or housing
downturns, natural disasters, terrorist events, adverse climate changes or other adverse events specific to those markets.
A significant
number of the mortgages underlying our Non-Agency RMBS are concentrated in certain geographic areas. For example, we
have significantly higher exposure in California, Washington, Massachusetts and Texas, (See Part II, Item 7A
“Quantitative and Qualitative Disclosures About Market Risk” in this Annual Report on Form 10-K). Certain markets
within these states (particularly California) experienced significant decreases in residential home values during the
financial crisis of 2007-2008 and the years thereafter. Any event that adversely affects the economy or real estate market in
any of these states could have a disproportionately adverse effect on our Non-Agency RMBS. In general, any material decline
in the economy or significant problems in a particular real estate market would likely cause a decline in the value of
residential properties securing the mortgages in that market, thereby increasing the risk of delinquency, default and
foreclosure of re-performing loans and the loans underlying our Non-Agency RMBS. This could, in turn, have a material adverse
effect on our credit loss experience on our Non-Agency RMBS in the affected market if higher-than-expected rates of default
and/or higher-than-expected loss severities on our re-performing loan investments or the mortgages underlying our Non-Agency
RMBS were to occur.
The occurrence of a natural
disaster (such as an earthquake, tornado, hurricane or a flood), terrorist attack or a significant adverse climate change may cause
a sudden decrease in the value of real estate in the area or areas affected and would likely reduce the value of the properties
securing the mortgages collateralizing our Non-Agency RMBS. Because certain natural disasters are not typically covered by the
standard hazard insurance policies maintained by borrowers, the affected borrowers may have to pay for any repairs themselves.
Borrowers may decide not to repair their property or may stop paying their mortgages under those circumstances. This would likely
cause defaults and credit loss severities to increase.
Changes in governmental
laws and regulations, fiscal policies, property taxes and zoning ordinances can also have a negative impact on property values,
which could result in borrowers’ deciding to stop paying their mortgages. This circumstance could cause credit loss severities
to increase, thereby adversely impacting our results of operations.
Lack of diversification in the number
of assets we acquire would increase our dependence on relatively few individual assets.
Our management objectives
and policies do not place a limit on the size of the amount of capital used to support, or the exposure to (by any other measure),
any individual asset or any group of assets with similar characteristics or risks. In addition, because we are a small company,
we may be unable to sufficiently deploy capital into a number of assets or asset groups. As a result, our portfolio may be concentrated
in a small number of assets or may be otherwise undiversified, increasing the risk of loss and the magnitude of potential losses
to us and our stockholders if one or more of these assets perform poorly.
Our investments may include subordinated
tranches of RMBS, which are subordinate in right of payment to more senior securities.
Our investments may include
subordinated tranches of RMBS, which are subordinated classes of securities in a structure of securities collateralized by a pool
of mortgage loans and, accordingly, are the first or among the first to bear the loss upon a restructuring or liquidation of the
underlying collateral and the last to receive payment of interest and principal. Additionally, estimated fair values of these subordinated
interests tend to be more sensitive to changes in economic conditions than more senior securities. As a result, such subordinated
interests generally are not actively traded and may not provide holders thereof with liquid investments.
We invest in Multi-Family MBS that are
subordinate to more senior securities issued by the applicable securitization, which entails certain risks.
We purchase principal-only
Multi-Family MBS that represent the first loss tranche of a multi-family mortgage loan securitization. These first loss principal
only securities are subject to the first risk of loss if any losses are realized on the underlying mortgage loans in the securitization.
We also purchase interest only securities issued by multi-family mortgage loan securitizations. However, these interest only Multi-Family
MBS typically only receive payments of interest to the extent that there are funds available in the securitization to make the
payments. Multi-Family MBS generally entitle the holders thereof to receive payments that depend primarily on the cash flow from
a specified pool of multi-family mortgage loans. Consequently, first loss principal only Multi-Family MBS, will be adversely affected
by payment defaults, delinquencies and losses on the underlying multi-family mortgage loans, each of which could have a material
adverse effect on our cash flows and results of operations.
Investments in non-investment grade MBS
may be illiquid, may have a higher risk of default and may not produce current returns.
We invest in MBS that
are non-investment grade or unrated, which means that major rating agencies rate them below the top four investment-grade rating
categories (i.e., “AAA” through “BBB”) or do not provide any rating for such MBS. Non-investment grade
MBS securities tend to be less liquid, may have a higher risk of default and may be more difficult to value than investment grade
bonds. Recessions or poor economic or pricing conditions in the markets associated with MBS may cause defaults or losses on loans
underlying such securities. Non-investment grade securities are considered speculative, and their capacity to pay principal and
interest in accordance with the terms of their issue is not certain.
Non-Agency MBS and Multi-Family MBS have
more price sensitivity than Agency MBS which can cause greater fluctuations in our book value. In addition, we finance our Non-Agency
MBS and Multi-Family MBS with a limited number of repurchase agreement lenders. A withdrawal by one or more of these lenders could
force us to sell our Non-Agency MBS and Multi-Family MBS at potentially distressed prices which could impact our profitability.
It could also cause other lenders to withdraw financing for our Agency MBS.
Non-Agency MBS and Multi-Family
MBS historically have been more price sensitive than Agency MBS which limits the number of lenders willing to provide repurchase
agreement financing for these securities. In a period of price volatility, we may be subject to margin calls which could adversely
impact our liquidity. These margin calls could result from price changes in Non-Agency MBS or Multi-Family MBS or from higher margin
requirements by the lender in order to provide additional collateral as a result of the price volatility. In addition, lenders
may no longer offer financing of Non-Agency MBS or Multi-Family MBS which could force us to sell some or all of these investments
if we could not find replacement financing. In either instance we may be required to sell assets which could negatively impact
our profitability. In an extreme situation, if we lost significant amounts of financing or if we received a significant amount
of margin calls on our Non-Agency MBS or Multi-Family MBS, other lenders may also seek to reduce their financing of our Agency
MBS. In such a case we would likely have to sell additional investments to maintain our liquidity.
We invest in Multi-Family MBS which is
secured by income producing properties. Such loans are typically made to single-asset entities, and the repayment of the loan is
dependent principally on the net operating income from performance and value of the underlying property. The volatility of income
performance results and property values may adversely affect our Multi-Family MBS.
Our Multi-Family MBS is
secured by multi-family property and is subject to risks of delinquency, foreclosure and loss. Commercial mortgage loans generally
have a higher principal balance and the ability of a borrower to repay a loan secured by an income-producing property typically
is dependent upon the successful operation of the property rather than upon the existence of independent income or assets of the
borrower. If the net operating income of the property is reduced, the borrower’s ability to repay the loan may be impaired.
Net operating income of an income-producing property can be affected by, among other things: tenant mix, success of tenant businesses,
property management decisions, property location and condition, competition from comparable types of properties, changes in laws
that increase operating expenses or limit rents that may be charged, any need to address environmental contamination at the property,
changes in national, regional or local economic conditions and/or specific industry segments, declines in regional or local real
estate values and declines in regional or local rental or occupancy rates, increases in interest rates, real estate tax rates and
other operating expenses, changes in governmental rules, regulations and fiscal policies, including environmental legislation,
and acts of God, terrorism, social unrest and civil disturbances.
Multi-family property
values and net operating income derived from them are subject to volatility and may be affected adversely by a number of factors,
including, but not limited to, national, regional and local economic conditions; local real estate conditions; changes or continued
weakness in specific industry segments; perceptions by prospective tenants, retailers and shoppers of the safety, convenience,
services and attractiveness of the property; the willingness and ability of the property’s owner to provide capable management
and adequate maintenance; construction quality, age and design; demographic factors; retroactive changes to building or similar
codes; and increases in operating expenses (such as energy costs).
Declines in the borrowers’
net operating income and/or declines in property values of collateral securing commercial mortgage loans could result in defaults
on such loans, declines in our book value from reduced earnings and/or reductions to the market value of the investment.
Current market conditions for our target
assets have been and may continue to be significantly influenced by U.S. Government and U.S. Federal Reserve intervention and attractive
opportunities for investment in our target assets may not continue, which could have a material adverse effect on our business,
financial condition, results of operations and our ability to make distributions to our stockholders.
Following the 2007-2008
financial crisis, the U.S. Government and U.S. Federal Reserve, or the Fed, took unprecedented actions to stabilize the market
for mortgage-related investments along with the broader economy. Such intervention has previously included maintenance of a near-zero
target of the federal funds rate by the U.S. Federal Reserve, or the Fed; U.S. Government programs, such as the Home Affordable
Modification Program, or HAMP, and the Home Affordable Refinance Program, or HARP; and quantitative easing, or QE, which was an
open-ended program designed to expand the Fed’s holdings of long-term securities by purchasing Agency RMBS. and long-term
Treasury bonds. Beginning in early 2014, the Fed gradually reduced its purchases of both Agency RMBS and Treasury bonds, and in
October 2014 ended its purchase program under its third round of quantitative easing, or QE3 (although it is still reinvesting
principal and interest it receives on the Agency RMBS and U.S. Treasuries held in its portfolio).
It is unclear what effect,
if any, the absence of the Fed’s monthly purchases, other than its reinvestment of principal and interest payments it receives
for Agency RMBS in its portfolio, will have on the value of the Agency RMBS in which we invest. However, it is possible that the
market for such securities, the price of such securities and, as a result, our book value and/or net interest margin could be negatively
affected.
Further, the mortgage
industry has and continues to undergo fundamental changes, such as the conservatorship and possible future changes in the nature
of participation in the mortgage market by Fannie Mae and Freddie Mac. While we believe that prices and yields for many of our
target assets have been more favorable than in the past, and the yield curve environment for a leveraged Agency portfolio is currently
very favorable, and that there are attractive opportunities for investment across our target asset classes, there is no way of
knowing what impact government intervention or any future actions by the Fed will have on the prices and liquidity of Agency RMBS
or other assets in which we may invest. The prices and yields of our target assets may be adversely affected, and could be subject
to significant volatility upon changes, or perceived future changes, to such policies. Further, such prices and yields may not
reflect the underlying value of our target assets and may be significantly inflated due to these policies and the uncertainty of
future changes to the mortgage industry. If current market conditions do not continue, and we are unable to structure or reposition
our investment portfolio accordingly, there could be a material adverse effect on our business, financial condition, results of
operations and our ability to make distributions to our stockholders.
Mortgage loan modification and refinancing
programs and future legislative action may adversely affect the supply of, value of, and our returns on, our target assets.
In addition, in recent
years, the U.S. Government, through the U.S. Federal Reserve, the Federal Housing Administration, or FHA, and the Federal Deposit
Insurance Corporation, has implemented a number of federal programs designed to assist homeowners or reduce the number of properties
going into foreclosure or going into non-performing status, including the Home Affordable Modification Program, or HAMP, which
provides homeowners with assistance in avoiding residential mortgage loan foreclosures, the Hope for Homeowners Program, or H4H
Program, which allows certain distressed borrowers to refinance their mortgages into FHA-insured loans in order to avoid residential
mortgage loan foreclosures, and the Home Affordable Refinance Program, or HARP, which allows Fannie Mae and Freddie Mac borrowers
who are current on their mortgage payments to refinance and reduce their monthly mortgage payments at loan-to-value ratios up to
125% (and, in some cases, above 125%) without new mortgage insurance. HAMP, the H4H Program, HARP and other loss mitigation programs
may involve, among other things, the modification of mortgage loans to reduce the principal amount of the loans (through forbearance
and/or forgiveness) and/or the rate of interest payable on the loans, or the extension of payment terms of the loans.
Especially with Non-Agency
RMBS, a significant number of loan modifications with respect to a given security, including, but not limited to, those related
to principal forgiveness and coupon reduction, could result in increased prepayment rates and thereby negatively impact the realized
yields and cash flows on such securities. These loan modification programs, future legislative or regulatory actions, including
possible amendments to the bankruptcy laws that result in the modification of outstanding residential mortgage loans, as well as
changes in the requirements necessary to qualify for refinancing mortgage loans with Fannie Mae, Freddie Mac or Ginnie Mae may
adversely affect the value of, and the returns on, Agency RMBS and other mortgage-related investments that we may purchase.
Other governmental actions
may affect our business by hindering the pace of foreclosures. Over the past few years, there has been a backlog of foreclosures
in certain jurisdictions, due to a combination of volume constraints and legal actions, including those brought by the U.S. Department
of Justice, or DOJ, HUD, State Attorneys General, the office of the Comptroller of the Currency, and the Federal Reserve Board
against mortgage servicers alleging wrongful foreclosure practices. Legal claims brought or threatened by the DOJ, HUD, the Consumer
Financial Protection Bureau, or the CFPB, and State Attorneys General against residential mortgage servicers have produced large
settlements. A portion of the funds from these settlements are directed to homeowners seeking to avoid foreclosure through mortgage
modifications, and servicers are required to adopt specified measures to reduce mortgage obligations in certain situations. It
is expected that the settlements will help many homeowners avoid foreclosures that would otherwise have occurred in the near-term.
It is also possible that other residential mortgage servicers will agree to similar settlements. These developments will reduce
the number of homes in the process of foreclosure and decrease the supply of properties and assets that meet our investment criteria.
Actions of the U.S. Government, including
the U.S. Congress, U.S. Federal Reserve, U.S. Treasury Department and other governmental and regulatory bodies, to stabilize or
reform the financial markets, or market responses to those actions, may not achieve the intended effect and may adversely affect
our business, financial condition, results of operations and our ability to make distributions to our stockholders.
In response to the financial
issues affecting the banking system and financial markets and going concern threats to commercial banks, investment banks and other
financial institutions, Congress, the Obama Administration and various regulatory agencies have taken numerous actions intended
to stabilize and restructure the financial system. Members of the Trump Administration have announced an intent to vary a number
of these actions. To the extent the markets do not respond favorably to any such actions by the U.S. Government or such actions
do not function as intended, there may be broad adverse market implications, and our business may be adversely affected.
In July 2010, the U.S.
Congress enacted the Dodd Frank Wall Street Reform and Consumer Protection Act, or the Dodd-Frank Act, in part to impose significant
investment restrictions and capital requirements on banking entities and other organizations that are significant to U.S. financial
markets. In part, it requires the retention of a portion of the credit risk inherent in the pool of securitized assets and by imposing
additional registration and disclosure requirements. Although certain of the new requirements and restrictions exempt Agency RMBS,
other government issued or guaranteed securities, or other securities, the Dodd-Frank Act imposes significant regulatory restrictions
on the origination and securitization of residential mortgage loans, which will affect Non-Agency RMBS.
Furthermore, the new regulation
of over-the-counter derivatives and the inclusion of swaps as an investment that can cause a pooled investment vehicle to be a
commodity pool would require us to register with and be regulated by the U.S. Commodity Futures Trading Commission, or the CFTC,
as a commodity pool operator, or CPO, unless an exemption or other relief is available. Our Manager relies for relief from registration
as a CPO based on a no-action letter issued on December 7, 2012 (the “No Action Letter”) by the CFTC staff that is
applicable to CPOs of mortgage REITs, subject to complying with certain criteria. Further, advisors to commodity pools, which could
potentially include our Manager, are required to register as commodity trading advisors, or CTAs, unless exemptive, no-action or
similar relief is available. We believe such relief is available to our Manager on the basis of the No-Action Letter and existing
regulations of the CFTC. If in the future our Manager does not meet the conditions set forth in the No-Action Letter for relief
from registration as a CPO, the relief provided by the No-Action letter from registration as a CPO becomes unavailable for any
other reason, or our belief regarding the availability of relief from registration as a CTA proves incorrect, and we or our Manager
are unable to rely upon or obtain other exemptions from registration as a CPO or CTA, we may be required to reduce or eliminate
our use of interest rate swaps or vary the manner in which we deploy interest rate swaps in our business, the interest-rate risk
associated with our investments may increase, our investment performance may be adversely affected or the cost associated with
employing other kinds of hedges against interest rate fluctuations could be higher. Alternatively, our Manager may be required
to register as a CPO. If our Manager is required to and does register as a CPO, we nevertheless expect it to remain exempt from
registration as a CTA with the CFTC because its advisory activities would relate only to its activities as CPO of the company.
The Commodity Exchange Act and CFTC regulations impose various requirements on CPOs and CTAs, including record keeping, reporting,
operational and marketing requirements, disclosure obligations and prohibitions on fraudulent activities. Complying with these
requirements could increase our expenses and negatively impact our business, financial condition, results of operations and our
ability to make distributions to our stockholders. It may also be difficult to comply with the reporting and disclosure requirements
with respect to the kinds of products that we offer.
While the full impact
of the Dodd-Frank Act cannot be assessed until all implementing regulations are released, the Dodd-Frank Act’s extensive
requirements have had a significant effect on the financial markets, and may affect the availability or terms of financing from
our lender counterparties, the availability or terms of swaps and swaptions into which we enter, and the availability or terms
of mortgage-backed securities, both of which may have an adverse effect on our business, financial condition, results of operations
and our ability to make distributions to our stockholders.
Even if certain of the
new statutes and regulations imposed by the Dodd-Frank Act are not directly applicable to us, they may still increase our costs
of entering into transactions with the parties to whom the requirements are directly applicable. Moreover, new exchange-trading
and trade reporting requirements may lead to reductions in the liquidity of derivative transactions, causing higher pricing or
reduced availability of derivatives, or the reduction of arbitrage opportunities for us, which could adversely affect the performance
of certain of our hedging strategies. Importantly, many key aspects of the changes imposed by the Dodd-Frank Act will be established
by various regulatory bodies and other groups over the next several years. As a result, we do not know how significantly the Dodd-Frank
Act will affect us. It is possible that the Dodd-Frank Act could, among other things, increase our costs of operating as a public
company, impose restrictions on our ability to securitize assets and reduce our investment returns on securitized assets.
Certain actions by the U.S. Federal Reserve
could cause a flattening of the yield curve, which could adversely affect our business, financial condition, results of operations
and our ability to make distributions to our stockholders.
On December
16, 2015, the Fed increased its target range for the federal funds rate to 1/4 to 1/2 percent, on December 14, 2016
increased the target range to 1/2 to 3/4 percent, and on March 15, 2017, further increased the target range to 3/4 to
1 percent, while indicating that it would likely contemplate additional rate increases in 2017 and beyond. While the timing
of the expected increases in short-term rates remains data dependent, any resultant flattening in the yield curve could
result in increased prepayment rates due to lower long-term interest rates and a narrowing of our net interest margin,
which could adversely affect our business, financial condition, results of operations and our ability to make distributions
to our stockholders.
The federal conservatorship of Fannie
Mae and Freddie Mac and related efforts, along with any changes in laws and regulations affecting the relationship between these
agencies and the U.S. Government, may adversely affect our business.
The payments of principal
and interest we receive on our Agency RMBS, which depend directly upon payments on the mortgages underlying such securities, are
guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae. Fannie Mae and Freddie Mac are GSEs, but their guarantees are not backed
by the full faith and credit of the United States. Ginnie Mae is part of a U.S. Government agency, and its guarantees are backed
by the full faith and credit of the United States.
In response to general
market instability and, more specifically, the financial conditions of Fannie Mae and Freddie Mac, in July 2008, the Housing and
Economic Recovery Act of 2008, or HERA, established the FHFA as the new regulator for Fannie Mae and Freddie Mac. In September
2008, the U.S. Treasury Department, the FHFA and the U.S. Federal Reserve announced a comprehensive action plan to help stabilize
the financial markets, support the availability of mortgage financing and protect taxpayers. Under this plan, among other things,
the FHFA was appointed as conservator of both Fannie Mae and Freddie Mac, allowing the FHFA to control the actions of the two GSEs,
without forcing them to liquidate, which would be the case under receivership. Importantly, the primary focus of the plan was to
increase the availability of mortgage financing by allowing these GSEs to continue to grow their guarantee business without limit,
while limiting the size of their retained mortgage and agency security portfolios and requiring that these portfolios be reduced
over time.
Although the U.S. Government
has committed to support the positive net worth of Fannie Mae and Freddie Mac, there can be no assurance that these actions will
be adequate for their needs. These uncertainties lead to questions about the availability of, and trading market for, Agency RMBS.
Despite the steps taken by the U.S. Government, Fannie Mae and Freddie Mac could default on their guarantee obligations, which
would adversely affect the value of our Agency RMBS. Accordingly, if these government actions are inadequate and the GSEs continue
to suffer losses or cease to exist, our business, financial condition, results of operations and our ability to make distributions
to our stockholders could be adversely affected.
In addition, the problems
faced by Fannie Mae and Freddie Mac resulting in their being placed into federal conservatorship and receiving significant U.S.
Government support have sparked serious debate among federal policy makers regarding the continued role of the U.S. Government
in providing liquidity for mortgage loans. The current Treasury Secretary has created additional uncertainty by expressing support
for ending government control of Fannie Mae and Freddie Mac, but varying his previous statements during his confirmation hearing.
The future roles of Fannie Mae and Freddie Mac could be significantly reduced and the nature of their guarantee obligations could
be considerably limited relative to historical measurements. Any such changes to the nature of their guarantee obligations could
redefine what constitutes an agency security and could have broad adverse implications for the market and our business, financial
condition, results of operations and our ability to make distributions to our stockholders. If Fannie Mae or Freddie Mac were eliminated,
or their structures were to change radically (i.e., limitation or removal of the guarantee obligation), or their market share reduced
because of required price increases or lower limits on the loans they can guarantee, we could be unable to acquire additional Agency
RMBS and our existing Agency RMBS could be adversely impacted.
We could be negatively
affected in a number of ways depending on the manner in which related events unfold for Fannie Mae and Freddie Mac. We rely on
our Agency RMBS (as well as Non-Agency RMBS) as collateral for our financings under our repurchase agreements. Any decline in their
value, or perceived market uncertainty about their value, would make it more difficult for us to obtain financing on our Agency
RMBS on acceptable terms or at all, or to maintain our compliance with the terms of any financing transactions. Further, the current
support provided by the U.S. Treasury Department to Fannie Mae and Freddie Mac, and any additional support it may provide in the
future, could have the effect of lowering the interest rates we expect to receive from Agency RMBS, thereby tightening the spread
between the interest we earn on our Agency RMBS and the cost of financing those assets. A reduction in the supply of Agency RMBS
could also negatively affect the pricing of Agency RMBS by reducing the spread between the interest we earn on our investment portfolio
of Agency RMBS and our cost of financing that portfolio.
As indicated above, recent
legislation has changed the relationship between Fannie Mae and Freddie Mac and the U.S. Government and the current Treasury Secretary
has indicated that the relationship may change again in the future. Future legislation that further changes the relationship between
Fannie Mae and Freddie Mac and the U.S. Government could also nationalize, privatize or eliminate such entities entirely. Any law
affecting these GSEs may create market uncertainty and have the effect of reducing the actual or perceived credit quality of securities
issued or guaranteed by Fannie Mae or Freddie Mac. As a result, such laws could increase the risk of loss on our investments in
Agency RMBS guaranteed by Fannie Mae and/or Freddie Mac. It also is possible that such laws could adversely impact the market for
such securities and spreads at which they trade. All of the foregoing could adversely affect our business, financial condition,
results of operations and our ability to make distributions to our stockholders.
Future legislation may, among other things,
revoke the charters of Fannie Mae and Freddie Mac, and we could be adversely affected if these proposed laws were enacted.
Bills calling for the
revocation of the charters of Fannie Mae and Freddie Mac and seeking to increase the opportunities for private capital to participate
in, and consequently bear the risk of loss in connection with, government- guaranteed MBS have been introduced in both the House
and the Senate. If the charters of Fannie Mae and Freddie Mac were revoked, it is unclear what effect, if any, this would have
on the value of our Agency RMBS guaranteed by Fannie Mae and Freddie Mac. It is also possible that the above-referenced proposed
legislation, if made law, could adversely impact the market for securities issued or guaranteed by the U.S. Government and the
spreads at which they trade. The foregoing could adversely affect the pricing, supply, liquidity and value of our target assets
and otherwise adversely affect our business, operations and financial condition.
Certain of the mortgage loans underlying
the RMBS assets may be subject to the new “know before you owe” TRID disclosures.
Mortgage loans underlying
the RMBS assets may be subject to the CFPB’s Know Before You Owe TILA – RESPA Integrated Disclosure, or TRID, rule,
which became effective for mortgage loans whose applications were received on or after October 3, 2015. The purpose of the TRID
rule was to reconcile overlapping disclosure obligations under TILA and the Real Estate Settlement Procedures Act, or RESPA, and
to provide for integrated closing disclosure and loan estimate forms that would satisfy those requirements under both TILA and
RESPA.
Regular instances of potential
non-compliance with the TRID rule have been reported in the marketplace since it became effective. Certain TILA-based disclosure
provisions of the TRID rule carry assignee liability. Violations of the TILA-based disclosure provisions of the TRID rule are limited
in individual actions to actual damages, statutory damages for certain violations of not more than $4,000 per mortgage loan plus
attorney’s fees and court costs, and can potentially result in liability for assignees where the violation is apparent on
the face of the disclosure and the assignment was voluntary. While the statute of limitations under TILA is generally one year
from the date of origination for most TRID violations, mortgagors may raise a violation of the TRID rules as a matter of defense
by recoupment or set-off to an action to collect the debt beyond the one year period, if permitted by state law. Further, for certain
mortgage loans, while not changed by TRID requirements, TILA’s right of rescission may be extended to three years from consummation
if there are errors in certain “material disclosures” such as the required disclosures of finance charges and payment
schedule, which are contained within the TRID closing disclosure.
Although the TRID rule
provides for multiple mechanisms to cure certain errors in the closing disclosure, uncertainties remain as to liability for violating
other requirements in the closing disclosure and in the loan estimate, including violations that may not be expressly covered by
the cure mechanisms of the TRID rule. On December 29, 2015, the Director of the CFPB released a letter that provides informal guidance
with respect to some of these uncertainties (the “CFPB Director’s Letter”). The CFPB Director’s Letter
is not binding upon the CFPB, any other regulator or the courts and does not necessarily reflect how courts and regulators, including
the CFPB, may view liability for TRID violations in the future.
On July 29, 2016, the
CFPB proposed amendments to the TRID rule, or the Proposed Rule. Comments on the Proposed Rule were due by October 18, 2016. The
CFPB stated in its Proposed Rule that it does not intend to further clarify the curative provisions contained in TRID, and the
Proposed Rule does not address any TILA liability issues. No assurance can be given that the results of any final rulemaking by
the CFPB will clarify the ambiguities of the requirements of the TRID rule, or that future CFPB rulemaking, if any, will be consistent
with the CFPB Director’s Letter.
Various state and local
jurisdictions may adopt similar or more onerous provisions in the future. No prediction can be made as to how these laws and regulations
relating to assignee liability may affect the market value of the RMBS assets. In addition, the TRID rule may adversely affect
the market generally for mortgage-backed securities, if investors are not willing to invest in securitizations with mortgage loans
originated with exceptions to the TRID rule, thereby reducing the liquidity of the certificates.
Drug, RICO and money
laundering violations could lead to property forfeitures.
Federal law provides that
property purchased or improved with assets derived from criminal activity or otherwise tainted, or used in the commission of certain
offenses, can be seized and ordered forfeited to the United States. The offenses which can trigger such a seizure and forfeiture
include, among others, violations of the Racketeer Influenced and Corrupt Organizations Act, the Bank Secrecy Act, the anti-money
laundering laws and regulations, including the USA Patriot Act of 2001 and the regulations issued pursuant to that act, as well
as the narcotic drug laws. In many instances, the United States may seize the property even before a conviction occurs.
In the event of a forfeiture
proceeding, a lender may be able to establish its interest in the property by proving that (i) its mortgage was executed and recorded
before the commission of the illegal conduct from which the assets used to purchase or improve the property were derived or before
the commission of any other crime upon which the forfeiture is based, or (ii) the lender, at the time of the execution of the mortgage,
did not know or was reasonably without cause to believe that the property was subject to forfeiture. However, there is no assurance
that such a defense would be successful and therefrom the related RMBS assets may be adversely affected.
Homeowner association super priority
liens, special assessment liens and energy efficiency liens may take priority over the mortgage loans underlying our RMBS assets.
In some states it is possible
that the first lien of the mortgages may be extinguished by super priority liens of homeowner associations, potentially resulting
in a loss of the mortgage loan’s outstanding principal balance. In at least 20 states, and the District of Columbia, homeowner
association, or HOA, or condominium association assessment liens can take priority over first lien mortgages under certain circumstances.
The number of these so called “super lien” states has increased in the past few decades and may increase further. Recent
rulings by the highest courts of Nevada and the District of Columbia have held that the “super lien statute” provides
the HOA or condominium association with a true lien priority rather than a payment priority from the proceeds of the sale, creating
the ability to extinguish the senior mortgage and greatly increasing the risk of losses on mortgage loans secured by homes whose
owners fail to pay HOA or condominium fees.
The laws of these “super
lien” states that provide for HOA super liens vary in terms of: (a) the duration of the priority period (with many at six
months and some with no limitations); (b) the assessments secured by the HOA lien (charges can include not only unpaid HOA assessments,
but also late charges, collection costs, attorney fees, foreclosure costs, fines, and interest); (c) whether the HOA must give
lenders with liens encumbering the mortgaged property notice of the homeowner’s failure to pay the assessment; and (d) the
statute of limitations on HOA foreclosure rights.
On May 28, 2015, Nevada
adopted a new law which took effect on October 1, 2015, that provides clarity to the superpriority statutes in Nevada with respect
to: (a) the type of notice that must be provided to lien holders by an HOA regarding the HOA deficiency and the HOA sale; (b) the
manner of notification of the HOA deficiency and HOA sale; (c) amounts that can lawfully be included in the superpriority amount
that can extinguish a first deed; and (d) the location of an HOA sale. The revised law also provides a 60-day redemption period
for the owner of the property and first lien holder following an HOA sale.
There is currently no
efficient mechanism available to loan servicers of RMBS securities to track the status of borrowers’ payments of HOA assessments
that are governed by state super lien statutes. In fact, there is neither a unified database for HOA information, nor a centralized
place for HOAs and loan servicers to contact one another. Consequently, in some of the super lien states there often is no practical,
systematic method for loan servicers to determine when an HOA assessment is unpaid or when the HOA initiates foreclosure of its
lien. In some circumstances the servicer may make servicing advances to pay delinquent homeowner association assessments or for
the costs of determining whether any mortgaged property is subject to a homeowner association assessment or a related lien. If
such servicing advances are not recovered from the related mortgagor or liquidation proceeds, they will be paid to the servicer
from collections on the mortgage loans and reduce amounts payable on the related RMBS asset.
If an HOA, or a purchaser
of an HOA super lien, completes a foreclosure on an HOA super lien on a mortgaged property, the underlying mortgage loan will be
extinguished. In those instances, the related RMBS assets could suffer a loss of the entire outstanding principal balance of the
mortgage loan, plus interest. A servicer might be able to attempt to recover on an unsecured basis by suing the borrower personally
for the balance, but recovery in these circumstances will be problematic if the borrower has no meaningful assets to recover against.
Mortgaged properties securing
the mortgage loans underlying the RMBS assets may also be subject to the lien of special property taxes and/or special assessments.
These liens may be superior to the liens securing the mortgage loans, irrespective of the date of the mortgage. In some instances,
individual borrowers may be able to elect to enter into contracts with governmental agencies for Property Assessed Clean Energy
(PACE) or similar assessments that are intended to secure the payment of energy and water efficiency and distributed energy generation
improvements that are permanently affixed to their properties, possibly without notice to or the consent of the mortgagee. These
assessments may also have lien priority over the mortgages securing mortgage loans. No assurance can be given that any mortgaged
property so assessed will increase in value to the extent of the assessment lien. Additional indebtedness secured by the assessment
lien would reduce the amount of the value of the mortgaged property available to satisfy the affected mortgage loan and thereby
reduce the amount available for distributions on the related underlying RMBS asset.
The increasing number of proposed U.S.
federal, state and local laws and regulations may affect certain mortgage-related assets in which we intend to invest and could
increase our cost of doing business.
Additional legislation
has been considered, proposed or adopted which, among other provisions, could further hinder the ability of a servicer to foreclose
promptly on defaulted mortgage loans or would permit limited assignee liability for certain violations in the mortgage loan origination
process. For example, the Dodd-Frank Act created the CFPB, which supervises consumer financial services companies (including bank
and non-bank mortgage lenders and mortgage servicers) and enforces U.S. federal consumer protection laws as they apply to banks,
credit unions and other financial services companies, including mortgage servicers, and which has issued many regulations regarding
mortgage origination and servicing. These regulations provide for special remedies in favor of consumer mortgage borrowers, particularly
upon default and foreclosure. It remains uncertain whether any of these measures will have a significant impact on foreclosure
volumes or what the timing of that impact would be, as well as whether these measures will remain in effect. If foreclosure volumes
were to decline significantly, we may experience difficulty in finding target assets at attractive prices, which will adversely
affect our business, financial condition, results of operations and our ability to make distributions to our stockholders.
We cannot predict whether
or in what form the U.S. Congress, the various state and local legislatures or the various federal, state or local regulatory agencies
may enact legislation affecting our business. We will evaluate the potential impact of any initiatives which, if enacted, could
affect our practices and results of operations. We are unable to predict whether U.S. federal, state or local authorities will
enact laws, rules or regulations that will require changes in our practices in the future, and any such changes could adversely
affect our business, financial condition, results of operations and our ability to make distributions to our stockholders.
We have identified
material weaknesses in our internal control over financial reporting as well as significant deficiencies in our disclosure
controls and procedures, and we may identify additional material weaknesses in internal controls or significant deficiencies
in
our disclosure controls and procedures in the future. If we fail to remediate the identified material
weaknesses, or if we otherwise fail to maintain effective internal control over financial reporting and disclosure controls
and procedures, we may not be able to accurately report our financial results, detect or prevent fraud, or file our periodic
reports in a timely manner, which may, among other adverse consequences, cause investors to lose confidence in our reported
financial information and lead to a decline in our stock price.
The
Sarbanes-Oxley Act of 2002, or SOX, requires, among other things, ongoing review of our disclosure controls and procedures and
internal control over financial reporting. Section 404 of SOX requires us to include a management report on our internal control
over financial reporting in our Annual Reports on Form 10-K, which report must include management’s assessment of the effectiveness
of our internal control over financial reporting. In addition, we are required, on a quarterly and annual basis, to disclose the
conclusions of our principal executive and principal financial officer on the effectiveness of our disclosure controls and procedures.
These
reviews and assessments have resulted in our identifying the material weaknesses in our internal control over financial reporting
and significant deficiencies in our disclosure controls and procedures described below. A “material weakness” is a
deficiency, or a combination of deficiencies, in internal control over financial reporting such that there is a reasonable possibility
that a material misstatement of our annual or interim financial statements will not be prevented or detected on a timely basis.
We believe the actions described below will be sufficient to remediate the identified material weaknesses that have not yet been
remediated, and strengthen our internal control over financial reporting as well as our disclosure controls and procedures. However,
while we believe meaningful progress has been made, certain of the new and enhanced systems and controls are not as yet fully
operational, and we may determine to take additional measures to address our control deficiencies or to modify the remediation
plans described below. The identified material weakness in our internal control over financial reporting will not be considered
remediated until the new controls are fully implemented, in operation for a sufficient period of time, tested and concluded by
management to be designed and operating effectively. We cannot currently estimate when all such remediation will be complete,
nor can we currently ascertain whether additional actions will be required, or the costs therefor.
2016
Determinations and Actions
. In connection with our determination of an inability to offset net gains realized on certain hedging
transactions in 2013 for federal income tax purposes with net capital losses realized in 2013 on the sale of certain securities,
during the quarter ended September 30, 2016, management and our Audit Committee identified a material weakness in our internal
control over financial reporting. The material weakness consisted of a failure to ensure adequate timely technical review of the
position proposed and analysis undertaken by our nationally recognized tax-consulting specialist and taken by us in calculating
our REIT taxable income for 2013. As a result, we declared on November 9, 2016, and paid on December 27, 2016, a deficiency dividend
to reduce our 2013 undistributed taxable income, as adjusted, and satisfy the REIT distribution requirements. We also recorded
a charge of $1.86 million in the third quarter of 2016 for interest charges expected to be payable to the IRS following the payment
of the dividend. The material weakness did not impact any prior period GAAP financial statements, and thus did not result in any
misstatements of our annual audited or interim financial statements. Nonetheless, when taken together with the material weakness
described below, management and our Audit Committee concluded that additional remediation measures described below are necessary
to enhance our control environment.
As
a consequence of this material weakness, management concluded that our internal control over financial reporting, and consequently
our disclosure controls and procedures, were not effective as of December 31, 2016, nor were they effective for the quarters ended
March 31, 2016, June 30, 2016 or September 30, 2016.
To
remediate this material weakness, we have implemented certain changes to the design of our internal controls. Specifically, for
any REIT tax matters that we have not previously addressed, we are now required to obtain a written technical review and conclusion
from a nationally recognized accounting firm or law firm, which must be presented to and approved by our Audit Committee prior
to our adoption of the related conclusion.
2015
Determinations and Actions
. In connection with the preparation of our financial statements for inclusion in our Annual Report
on Form 10-K for the year ended December 31, 2015, or the 2015 10-K, we identified a material weakness in our internal control
over financial reporting. Such material weakness did not result in any misstatements in our audited consolidated financial statements
included in our 2015 10-K, but did require adjustments during the 2015 annual audit with respect to net income (loss) attributable
to common stockholders, total other comprehensive income, and basic and diluted income (loss) per share in our preliminary 2015
consolidated financial statements, and required the restatement of the unaudited condensed consolidated financial statements for
the periods ended June 30, 2015 and September 30, 2015, originally included in our Quarterly Reports on Form 10-Q for the second
and third quarters of 2015, respectively.
The
material weakness consisted of a failure of our control over the critical timely review of account balances to determine whether
the appropriate accounting policy and methodology had been applied, which in turn resulted in the incorrect reporting of unrealized
losses on two Non-Agency RMBS IOs for which we had elected the fair value option at the inception of each transaction. Such losses
were incorrectly reported through other comprehensive income (OCI) instead of through our statements of operations for each of
the quarter and year-to-date periods ended June 30, 2015 and September 30, 2015, respectively. The first IO was acquired in the
Oaks Mortgage Trust Series 2015-1 transaction completed in April 2015, and the second IO was acquired in the Oaks Mortgage Trust
Series 2015-2 transaction completed in November 2015.
As
a consequence of this material weakness, management concluded that our internal control over financial reporting, and consequently
our disclosure controls and procedures, were not effective as of December 31, 2015, nor were they effective for the quarters ended
June 30, 2015 and September 30, 2015.
We
are actively engaged in implementing a remediation plan designed to address this material weakness in our internal control over
financial reporting, to improve the design of such controls. We have instituted additional procedures to ensure that any fair
value option security cannot be booked by our third party accounting services provider without affirmative income recognition
identification, including the appropriate accounting treatment, from the Company. We have also contracted with a nationally recognized
accounting systems and services provider to provide us with a more robust accounting system that will improve the effectiveness
of correct accounting treatment for transactions we enter into. We are also in the process, with the assistance of an internationally
recognized accounting firm, of formalizing enhanced written policies and procedures appropriate to the design and operation of
controls and procedures applicable to the new system.
2014
Determinations and Actions
. We had earlier implemented measures then-designed to remediate a previous material weakness and
two significant deficiencies in our internal control over financial reporting identified by our independent registered public
accounting firm prior to the filing of our registration statement on Form S-11 for our IPO, and in connection with the preparation
of our earlier financial statements as of and for the period from May 16, 2012 (commencement of operations) to July 31, 2012.
The earlier material weakness was fully remediated at December 31, 2013 and the two previous significant deficiencies were fully
remediated by December 31, 2014. Additionally our principal executive officer and principal financial officer had concluded that
as of December 31, 2015 our disclosure controls and procedures were ineffective for the year ended December 31, 2014 and for all
quarterly periods during 2015 by reason of our inadvertent omission of financial statements for our pre-IPO year from May 16,
2012 (date of commencement) to December 31, 2012 from our Annual Report on Form 10-K for the year ended December 31, 2014. This
ineffective disclosure control and procedure was fully remediated in the first quarter of 2016.
Because
of our status as an emerging growth company, our independent registered public accounting firm will not be required to attest
to the effectiveness of our internal control over financial reporting until after December 31, 2018.
Our independent registered public accounting firm will not be required to attest
to the effectiveness of our internal control over financial reporting until our Annual Report on Form 10-K following the date
on which we are no longer an “emerging growth company.” We will remain an emerging growth company until the earlier
of (a) December 31, 2018, (b) the last day of any fiscal year in which we have total annual gross revenue of at least $1.0 billion,
or (c) the last day of any fiscal year in which we are deemed to be a large accelerated filer, which means the market value of
our common stock that is held by non-affiliates exceeds $700 million as of the prior June 30th, and (d) the date on which we have
issued more than $1.0 billion in non-convertible debt during the prior three-year period. For as long as we remain an emerging
growth company, we intend to take advantage of the exemption permitting us not to comply with the independent registered public
accounting firm attestation requirement. At such time that an attestation is required, however, our independent registered public
accounting firm may issue a report that is qualified if it is not satisfied with our controls or the level at which our controls
are documented, designed, operated or reviewed, or if it interprets the relevant requirements differently from us. Material weaknesses
and significant deficiencies may be identified during the audit process or at other times. During the course of the evaluation,
documentation or attestation, we or our independent registered public accounting firm may identify weaknesses and deficiencies
that we may not be able to remedy in time to meet the deadline imposed by the Sarbanes-Oxley Act for compliance with Section 404,
or at all.
We depend on our accounting services
provider for assistance with the preparation of our financial statements, access to appropriate accounting technology and assistance
with portfolio valuation.
Pursuant to our agreement
with Stone Coast Fund Services LLC, or Stone Coast, Stone Coast currently provides a monthly calculation of our net asset
value, maintains our general ledger and all related accounting records, reconciles all broker and custodial statements we routinely
receive, provides us with monthly portfolio, cash and position reports, assists us with portfolio valuations, prepares draft quarterly
financial statements for our review and provides us with access to data and technology services to facilitate the preparation of
our annual financial statements. We have determined to terminate our agreement with Stone Coast in accordance with its terms and
to hire SS&C Technologies, Inc., or SS&C., as a successor to Stone Coast. We have substantially completed the transition
process and anticipate that SS&C will begin providing such services in lieu of Stone Coast during the first quarter of
2017. Our agreement with SS&C is terminable by us with cause during the first three years and thereafter without cause upon
90 days notice by either party. If our agreement with SS&C were to be terminated or if for any reason we encountered a problem
with the transition from Stone Coast to SS&C and no suitable replacement can be timely engaged, we may not be able to timely
and accurately prepare our financial statements.
We may be subject to fines or other penalties
based on the conduct of the mortgage loan originators and brokers that originated the residential mortgage loans that we previously
acquired, and the third-party servicers which service the loans we acquired.
Mortgage loan originators
and brokers are subject to strict and evolving consumer protection laws and other legal obligations with respect to the origination
of residential mortgage loans. These laws and regulations include the CFPB’s “ability-to-repay” and “qualified
mortgage” regulations, which became effective on January 10, 2014. In addition, there are various other federal, state and
local laws and regulations that are intended to discourage predatory lending practices by residential mortgage loan originators.
For example, the federal Home Ownership and Equity Protection Act of 1994, or HOEPA, requires lenders to make certain disclosures
and comply with certain limitations with respect to loans that are considered to be “high cost” loans. These requirements,
as well as certain standards set forth in the “ability-to-repay” and “qualified mortgage” regulations,
may be highly subjective and open to interpretation. As a result, a court may determine that a residential mortgage loan did not
meet an applicable standard or test even if the mortgage loan originator reasonably believed such standard or test had been satisfied.
Failure or alleged failure of residential mortgage loan originators to comply with these laws and regulations could subject us,
as an assignee or purchaser of these loans or securities backed by these loans, to delays in foreclosure proceedings, increased
litigation expenses, monetary penalties and defenses to foreclosure, including by recoupment or setoff of finance charges and fees
collected, and in some cases could also result in rescission of the affected residential mortgage loans, which could adversely
impact our business and financial results.
We may be required to make servicing
advances and may be exposed to a risk of loss if such advances become non-recoverable and such advances and risk could adversely
affect our liquidity or cash flow.
In connection with most
(as currently anticipated) securitization transactions wherein FOAC sells mortgage loans to the securitization trust and holds
the MSRs with respect to those mortgage loans, FOAC has entered into and expects to continue to enter into sub-servicing agreements
with one or more sub-servicers. Pursuant to the terms of the sub-servicing agreements, FOAC will be required to refund or to fund
any servicing advances that are obligated to be made by the sub-servicers. FOAC will therefore be exposed to the potential loss
of any servicing advance that becomes a non-recoverable. It is expected that the aggregate amount of servicing advances, and FOAC’s
exposure to the risk of loss related to such servicing advances, will increase as FOAC enters into additional securitization transactions.
Such advances and exposure going forward could adversely affect our liquidity or cash flow during a financial period.
When we have acquired and subsequently
re-sold any mortgage loans, we may be required to repurchase such loans or indemnify investors if we breach certain representations
and warranties.
When we have acquired
and subsequently re-sold any mortgage loans, we are generally required to make customary representations and warranties about such
loans to the loan purchaser. Residential mortgage loan sale agreements and the terms of any securitizations into which we have
sold or deposited loans generally require us to repurchase or substitute loans in the event that we breach a representation or
warranty given to the loan purchaser or the securitization trust. In addition, we may be required to repurchase loans as a result
of borrower fraud or in the event of an early payment default by a borrower. Repurchased loans are typically worth only a fraction
of the original price. Significant repurchase activity could adversely affect our business, financial condition and results of
operations and our ability to make distributions.
Government use of eminent domain to seize
underwater mortgages could materially adversely affect the value of, and the returns on, our RMBS.
The mortgages securing
our investments are located in many geographic regions across the United States, with significantly higher exposure in California,
Massachusetts and Washington. Several county and municipal governments have discussed using eminent domain to seize from mortgage
holders the mortgages of borrowers who are underwater, but not in default. Legislation enacted in 2014 prohibits the FHFA and the
Department of Housing and Urban Development from using federal funds to facilitate the seizure of mortgage loans by a state or
local municipality. However, if definitive action is taken by any local governments and such actions withstand Constitutional and
other legal challenges, resulting in mortgages securing certain of our investments being seized using eminent domain, the consideration
received from the seizing authorities for such mortgages may be substantially less than the outstanding principal balance, which
would result in a realized loss and a corresponding write-down of the principal balance of those mortgages. The result of these
seizures would be that the amounts we receive on our investments would be less than we would otherwise have received if the mortgage
loans had not been seized, which may result in a lower return on such assets or require charges for “other-than-temporary
impairment” or loan loss reserves. If governments ultimately adopt such plans and mortgages securing certain of our investments
are seized on a widespread scale, it could have an adverse effect on the value of and/or returns on our assets and our results
of operations more generally.
We operate in a highly competitive market
for investment opportunities and competition may limit our ability to acquire desirable investments in RMBS, Multi-Family MBS,
MSRs and other mortgage related investments and could also affect the pricing of these securities.
We operate in a highly
competitive market for investment opportunities. Our profitability depends, in large part, on our ability to acquire RMBS, Multi-Family
MBS, MSRs and other mortgage related investments at favorable prices. In acquiring these
assets, we will compete with a variety of institutional investors, including other REITs, specialty finance companies, public and
private funds, hedge funds, commercial and investment banks, commercial finance and insurance companies and other financial institutions.
Many of our competitors are substantially larger and have considerably greater financial, technical, marketing and other resources
than we do. New companies, including REITs, have recently raised, or are expected to raise, significant amounts of capital, and
may have investment objectives that overlap with ours, which may create additional competition for investment opportunities. Some
competitors may have a lower cost of funds and access to funding sources that may not be available to us, such as funding from
the U.S. Government. Many of our competitors are not subject to the operating constraints associated with REIT tax compliance or
maintenance of an exclusion from the Investment Company Act. In addition, some of our competitors may have higher risk tolerances
or different risk assessments, which could allow them to consider a wider variety of investments and establish more relationships
than us. Furthermore, competition for investments in RMBS, Multi-Family MBS, MSRs and other mortgage related investments may lead
to the price of such assets increasing, which may further limit our ability to generate desired returns. We cannot assure you that
the competitive pressures we face will not have a material adverse effect on our business, financial condition, results of operations
and our ability to make distributions to our stockholders. Also, as a result of this competition, desirable investments in these
assets may be limited in the future and we may not be able to take advantage of attractive investment opportunities from time to
time, as we can provide no assurance that we will be able to identify and make investments that are consistent with our investment
objectives.
Adverse developments in the broader residential
mortgage market may adversely affect the value of the assets in which we invest.
Since 2007, the residential
mortgage market in the United States has experienced a variety of unprecedented difficulties and significant adverse changes in
economic conditions, including defaults, credit losses and liquidity concerns. Certain commercial banks, investment banks and insurance
companies announced extensive losses from exposure to the residential mortgage market. These losses reduced financial industry
capital, leading to reduced liquidity for some institutions. These factors have impacted investor perception of the risk associated
with real estate-related assets, including Agency RMBS and other high-quality RMBS assets. As a result, values for RMBS assets,
including some Agency RMBS and other AAA-rated RMBS assets, have experienced a certain amount of volatility. Further increased
volatility and deterioration in the broader residential mortgage and RMBS markets may adversely affect the performance and market
value of the Agency and Non-Agency RMBS in which we invest. Accordingly, our results of operations may be materially affected by
conditions in the residential mortgage market, including MBS.
We invest in Agency and
Non-Agency RMBS. We rely on our securities as collateral for our financings. Any decline in their value, or perceived market uncertainty
about their value, would likely make it difficult for us to obtain financing on favorable terms or at all, or maintain our compliance
with terms of any financing arrangements already in place. The securities we acquire will be classified for accounting purposes
as available-for-sale. All assets classified as available-for-sale will be reported at fair value, based on market prices from
third-party sources, with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders’
equity. As a result, a decline in fair values may reduce the book value of our assets. Moreover, if the decline in fair value of
an available-for-sale security is other-than-temporarily impaired, such decline will reduce earnings. If market conditions result
in a decline in the fair value of our assets, our business, financial condition, results of operations and our ability to make
distributions to our stockholders could be adversely affected.
A prolonged economic recession and further
declining real estate values could impair our assets and harm our operations.
The risks associated with
our business are more severe during economic recessions and are compounded by declining real estate values. The Non- Agency RMBS
in which we invest part of our capital will be particularly sensitive to these risks. Declining real estate values
will likely reduce the level of new mortgage loan originations since borrowers often use appreciation in the value of their existing
properties to support the purchase of additional properties. Borrowers will also be less able to pay principal and interest on
loans underlying the securities in which we invest if the value of residential real estate weakens further. Further, declining
real estate values significantly increase the likelihood that we will incur losses on Non-Agency RMBS in the event of default because
the value of collateral on the mortgages underlying such securities may be insufficient to cover the outstanding principal amount
of the loan. Any sustained period of increased payment delinquencies, foreclosures or losses could adversely affect our net interest
income from Non-Agency RMBS in our portfolio, which could have an adverse effect on our business, financial condition, results
of operations and our ability to make distributions to our stockholders.
The lack of liquidity in our investments
may adversely affect our business.
We acquire assets that
are not liquid or publicly traded. A lack of liquidity may result from the absence of a willing buyer or an established market
for these assets, as well as legal or contractual restrictions on resale or the unavailability of financing for these assets. In
addition, mortgage- related assets generally experience periods of illiquidity, including the recent period of delinquencies and
defaults with respect to residential and commercial mortgage loans. Further, validating third-party pricing for illiquid assets
may be more subjective than for liquid assets. Any illiquidity of our investments may make it difficult for us to sell such investments
if the need or desire arises. In addition, if we are required to liquidate all or a portion of our portfolio quickly, we may realize
significantly less than the value at which we have previously recorded our investments. Further, we may face other restrictions
on our ability to liquidate an investment in a business entity to the extent that we or our Manager has or could be attributed
with material, non-public information regarding such business entity. If we are unable to sell our assets at favorable prices or
at all, it could adversely affect our business, financial condition and results of operations and our ability to make distributions
to our stockholders. Assets that are illiquid are more difficult to finance, and to the extent that we use leverage to finance
assets that become illiquid, we may lose that leverage or have it reduced. Assets tend to become less liquid during times of financial
stress, which is often the time that liquidity is most needed. As a result, our ability to vary our portfolio in response to changes
in economic and other conditions may be relatively limited, which could adversely affect our business, financial condition, results
of operations and our ability to make distributions to our stockholders.
Changes in the underwriting standards
by Freddie Mac or Fannie Mae could have an adverse impact on agency mortgage investments in which we may invest or make it more
difficult to acquire attractive Non-Agency mortgage investments.
In April 2010, Freddie
Mac and Fannie Mae announced tighter underwriting guidelines for ARMs and hybrid interest-only ARMs in particular. Specifically,
Freddie Mac announced that it would no longer purchase interest-only mortgages and Fannie Mae changed its eligibility criteria
for purchasing and securitizing ARMs to protect consumers from potentially dramatic payment increases. Our target assets include
ARMs and hybrid ARMs. Tighter underwriting standards by Freddie Mac or Fannie Mae could reduce the supply of ARMs, resulting in
a reduction in the availability of the asset class. More lenient underwriting standards could also substantially reduce the supply
and attractiveness of investments in Non-Agency RMBS.
We will be subject to the risk that U.S.
Government agencies and/or GSEs may not be able to fully satisfy their guarantees of Agency RMBS or that these guarantee obligations
may be repudiated, which may adversely affect the value of our assets and our ability to sell or finance these securities.
The interest and principal
payments we receive on the Agency RMBS in which we invest is guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae. Unlike the Ginnie
Mae securities in which we invest, the principal and interest on securities issued by Fannie Mae and Freddie Mac are not guaranteed
by the U.S. Government. All the Agency RMBS in which we invest depend on a steady stream of payments on the mortgages underlying
the securities.
As conservator of Fannie
Mae and Freddie Mac, the FHFA may disaffirm or repudiate contracts (subject to certain limitations for qualified financial contracts)
that Freddie Mac or Fannie Mae entered into prior to the FHFA’s appointment as conservator if it determines, in its sole
discretion, that performance of the contract is burdensome and that disaffirmation or repudiation of the contract promotes the
orderly administration of its affairs. HERA requires the FHFA to exercise its right to disaffirm or repudiate most contracts within
a reasonable period of time after its appointment as conservator. Fannie Mae and Freddie Mac have disclosed that the FHFA has disaffirmed
certain consulting and other contracts that these entities entered into prior to the FHFA’s appointment as conservator. Freddie
Mac and Fannie Mae have also disclosed that the FHFA has advised that it does not intend to repudiate any guarantee obligation
relating to Fannie Mae and Freddie Mac’s mortgage-related securities, because the FHFA views repudiation as incompatible
with the goals of the conservatorship. In addition, HERA provides that mortgage loans and mortgage-related assets that have been
transferred to a Freddie Mac or Fannie Mae securitization trust must be held for the beneficial owners of the related mortgage-related
securities and cannot be used to satisfy the general creditors of Freddie Mac or Fannie Mae.
If the guarantee obligations
of Freddie Mac or Fannie Mae were repudiated by the FHFA, payments of principal and/or interest to holders of Agency RMBS issued
by Freddie Mac or Fannie Mae would be reduced in the event of borrowers’ late payments or failure to pay or a servicer’s
failure to remit borrower payments to the trust. In that case, trust administration and servicing fees could be paid from mortgage
payments prior to distributions to holders of Agency RMBS. Any actual direct compensatory damages owed due to the repudiation of
Freddie Mac or Fannie Mae’s guarantee obligations may not be sufficient to offset any shortfalls experienced by holders of
Agency RMBS. The FHFA also has the right to transfer or sell any asset or liability of Freddie Mac or Fannie Mae, including its
guarantee obligation, without any approval, assignment or consent. If the FHFA were to transfer Freddie Mac or Fannie Mae’s
guarantee obligations to another party, holders of Agency RMBS would have to rely on that party for satisfaction of the guarantee
obligation and would be exposed to the credit risk of that party.
Our investments in Non-Agency RMBS and
Multi-Family MBS are generally subject to losses.
We acquire Non-Agency
RMBS and Multi-Family MBS. In general, losses on a mortgaged property securing a mortgage loan included in a securitization will
be borne first by the equity holder of the property, then by a cash reserve fund or letter of credit, if any, then by the holder
of a mezzanine loan or B-Note, if any, then by the “first loss” subordinated security holder and then by the holder
of a higher-rated security. In the event of default and the exhaustion of any equity support, reserve fund, letter of credit, mezzanine
loans or B-Notes, and any classes of securities junior to those in which we invest, we will not be able to recover all of our investment
in the securities we purchase. In addition, if the underlying mortgage portfolio has been overvalued by the originator, or if the
values subsequently decline, less collateral is available to satisfy interest and principal payments due on the related Non-Agency
RMBS or Multi-Family MBS. The prices of lower credit quality securities are generally less sensitive to interest rate changes than
more highly rated investments, but more sensitive to adverse economic downturns or individual issuer developments.
We have acquired RMBS collateralized
by subprime mortgage loans, which are subject to increased risks.
Among other assets, we
have acquired RMBS backed by collateral pools of subprime mortgage loans, which are mortgage loans that have been originated using
underwriting standards that are less conservative than those used in underwriting prime mortgage loans (mortgage loans that generally
conform to GSE underwriting guidelines) and Alt-A mortgage loans (mortgage loans made to borrowers whose qualifying mortgage characteristics
do not conform to GSE underwriting guidelines and generally allow homeowners to qualify for a mortgage loan with reduced or alternate
forms of documentation). These lower standards include mortgage loans made to borrowers having imperfect or impaired credit histories,
mortgage loans where the amount of the loan at origination is 80% or more of the value of the mortgage property, mortgage loans
made to borrowers with low credit scores, mortgage loans made to borrowers who have other debt that represents a large portion
of their income and mortgage loans made to borrowers whose income is not required to be disclosed or verified. Due to economic
conditions, including increased interest rates, lower home prices and the general economic downturn, as well as aggressive lending
practices, subprime mortgage loans have in recent periods experienced increased rates of delinquency, foreclosure, bankruptcy and
loss, and they are likely to continue to experience delinquency, foreclosure, bankruptcy and loss rates that may be substantially
higher than those experienced by mortgage loans underwritten in a more traditional manner. In the event of the bankruptcy of a
mortgage loan borrower, the mortgage loan to such borrower will be deemed to be secured only to the extent of the value of the
underlying collateral at the time of bankruptcy (as determined by the bankruptcy court), and the lien securing the mortgage loan
will be subject to the avoidance powers of the bankruptcy trustee or debtor in possession to the extent the lien is unenforceable
under state law. Foreclosure of a mortgage loan can be an expensive and lengthy process, which could have a substantial negative
effect on our anticipated return on the foreclosed mortgage loan. In acquiring these assets, we endeavor to factor the risk of
losses on the underlying mortgages into the purchase price of the asset. If we underestimate those losses the performance of RMBS
backed by subprime mortgage loans and any subprime mortgage loans that we acquire could be adversely affected, which could adversely
affect our business, financial condition, results of operations and our ability to make distributions to our stockholders.
To the extent that due diligence is conducted
on potential assets, such due diligence may not reveal all of the risks associated with such assets and may not reveal other weaknesses
in such assets, which could lead to losses.
Before acquiring certain
assets, such as prime jumbo residential whole loans, Multi-Family MBS or other mortgage-related assets, we or our Manager conducts
(either directly or using third parties) due diligence. Such due diligence may include (1) an assessment of the strengths and weaknesses
of the asset’s credit profile, (2) a review of all or merely a subset of the documentation related to the asset, or (3) other
reviews that we or our Manager may deem appropriate to conduct. There can be no assurance that we or our Manager will conduct any
specific level of due diligence, or that, among other things, the due diligence process will uncover all relevant facts and potential
liabilities or that any purchase will be successful, which could result in losses on these assets, which, in turn, could adversely
affect our financial condition and results of operations.
Our senior management and our external
managers utilize analytical models and data in connection with the valuation of certain of our assets, and any incorrect, misleading
or incomplete information used in connection therewith would subject us to potential risks.
Given the complexity of
certain of our target assets, such as Multi-Family MBS, our Manager must rely heavily on analytical models and information and
data supplied by third parties. Models and data are used to value potential target assets, potential credit risks and reserves
and also in connection with hedging our acquisitions. Many of the models are based on historical trends. These trends may not be
indicative of future results. Furthermore, the assumptions underlying the models may prove to be inaccurate, causing the models
to also be incorrect. In the event models and data prove to be incorrect, misleading or incomplete, any decisions made in reliance
thereon expose us to potential risks. For example, by relying on incorrect models and data, especially valuation models, our Manager
may be induced to buy for us certain target assets at prices that are too high, to sell certain other assets at prices that are
too low or to miss favorable opportunities altogether. Similarly, any hedging based on faulty models and data may prove to be unsuccessful.
Any credit ratings assigned to our investments
will be subject to ongoing evaluations and revisions and we cannot assure you that those ratings will not be downgraded.
Some of our investments
may be rated by Moody’s Investors Service, Fitch Ratings, Standard & Poor’s or other rating agencies. Any credit
ratings on our investments are subject to ongoing evaluation by credit rating agencies, and we cannot assure you that any such
ratings will not be changed or withdrawn by a rating agency in the future if, in its judgment, circumstances warrant. If rating
agencies assign a lower-than-expected rating or reduce or withdraw, or indicate that they may reduce or withdraw, their ratings
of our investments in the future, the value of these investments could significantly decline, which would adversely affect the
value of our investment portfolio and could result in losses upon disposition or the failure of borrowers to satisfy their debt
service obligations to us.
The mortgage loans underlying the Non-Agency
RMBS that we have acquired will be subject to defaults, foreclosure timeline extension, fraud and residential price depreciation
and unfavorable modification of loan principal amount, interest rate and amortization of principal, which could result in losses
to us.
Our investments in Non-Agency
RMBS and residential mortgage loans underlying the Non-Agency RMBS are subject to the risks of defaults, foreclosure timeline
extension, fraud and home price depreciation and unfavorable modification of loan principal amount, interest rate and amortization
of principal, which could result in loss to us. The ability of a borrower to repay a mortgage loan secured by a residential property
is dependent upon the income or assets of the borrower. A number of factors may impair borrowers’ abilities to repay their
loans, including:
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adverse changes in national and local economic and market
conditions;
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changes in governmental laws and regulations, fiscal policies
and zoning ordinances and the related costs of compliance with laws and regulations, fiscal policies and ordinances;
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costs of remediation and liabilities associated with environmental
conditions such as indoor mold;
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the potential for uninsured or under-insured property losses;
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acts of God, including earthquakes, floods and other natural
disasters, which may result in uninsured losses;
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acts of war or terrorism, including the consequences of
terrorist attacks; and
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social unrest and civil disturbances.
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In the event of defaults
on the residential mortgage loans that underlie our investments in Non-Agency RMBS and the exhaustion of any underlying or any
additional credit support, we may not realize our anticipated return on our investments and we may incur a loss on these investments.
In addition, our investments in Non-Agency RMBS are backed by residential real property but, in contrast to Agency RMBS, their
principal and interest are not guaranteed by a U.S. Government agency or a GSE. The ability of a borrower to repay these loans
or other financial assets is dependent upon the income or assets of these borrowers.
The failure of servicers to effectively
service the mortgage loans underlying the RMBS in our investment portfolio would adversely affect our business, financial condition,
results of operations and our ability to make distributions to our stockholders.
Most securitizations of
residential mortgage loans require a servicer to manage collections on each of the underlying loans. Both default frequency and
default severity of loans may depend upon the quality of the servicer. If servicers are not vigilant in encouraging borrowers to
make their monthly payments, the borrowers may be far less likely to make these payments, which could result in a higher frequency
of default. If servicers take longer to liquidate non-performing assets, loss severities may tend to be higher than originally
anticipated. The failure of servicers to effectively service the mortgage loans underlying the RMBS in our investment portfolio
or any mortgage loans we own could negatively impact the value of our investments and our performance. Servicer quality is of prime
importance in the default performance of RMBS. Many servicers have gone out of business in recent years, requiring a transfer of
servicing to another servicer. This transfer takes time and loans may become delinquent because of confusion or lack of attention.
When servicing is transferred, servicing fees may increase, which may have an adverse effect on the credit support of RMBS held
by us. In the case of pools of securitized loans, servicers may be required to advance interest on delinquent loans to the extent
the servicer deems those advances recoverable. In the event the servicer does not advance funds, interest may be interrupted even
on more senior securities. Servicers may also advance more than is in fact recoverable once a defaulted loan is disposed, and the
loss to the trust may be greater than the outstanding principal balance of that loan (greater than 100% loss severity).
We may be affected by deficiencies in
foreclosure practices of third parties, as well as related delays in the foreclosure process.
There continues to be
uncertainty around the timing and ability of servicers to remove delinquent borrowers from their homes, so that they can liquidate
the underlying properties and ultimately pass the liquidation proceeds through to owners of the mortgage loans or related RMBS.
Given the magnitude of the housing crisis, and in response to the well-publicized failures of many servicers to follow proper foreclosure
procedures (such as “robo-signing”), mortgage servicers are being held to much higher foreclosure-related documentation
standards than they previously were. However, because many mortgages have been transferred and assigned multiple times (and by
means of varying assignment procedures) throughout the origination, warehouse and securitization processes, mortgage servicers
may have difficulty furnishing the requisite documentation to initiate or complete foreclosures. This leads to stalled or suspended
foreclosure proceedings, and ultimately additional foreclosure-related costs. Foreclosure-related delays also tend to increase
ultimate loan loss severities as a result of property deterioration, amplified legal and other costs, and other factors. Many factors
delaying foreclosure, such as borrower lawsuits and judicial backlog and scrutiny, are outside of servicers’ control and
have delayed, and will likely continue to delay, foreclosure processing in both judicial states (where foreclosures require court
involvement) and non-judicial states. A servicer’s failure to remove delinquent borrowers from their homes in a timely manner
could increase our costs, adversely affect the value of the property and mortgage loans and have an adverse effect on our results
of operations and business.
Our investments may benefit from private
mortgage insurance, but this insurance may not be sufficient to cover losses.
In certain instances,
Non-Agency mortgage loans may have private insurance. This insurance is often structured to absorb only a portion of the loss if
a loan defaults and, as such, we may be exposed to losses on these loans in excess of the insured portion of the loans. The private
mortgage insurance industry has been adversely affected by the housing market decline and this may limit an insurer’s ability
to perform on its insurance. Lastly, rescission and denial of mortgage insurance has increased significantly, and this may affect
our ability to collect on our insurance. If private mortgage insurers fail to remit insurance payments to us for insured portions
of loans when losses are incurred and where applicable, whether due to breach of contract or to an insurer’s insolvency,
we may experience a loss for the amount that was insured by such insurers, though we may maintain claims against the insurers.
We may experience a decline in the market
value of our assets.
A decline in the market
value of our assets may require us to recognize an “other-than-temporary” impairment against such assets under GAAP
if we were to determine that, with respect to any assets in unrealized loss positions, we do not have the ability and intent to
hold such assets to maturity or for a period of time sufficient to allow for recovery to the amortized cost of such assets. If
such a determination were to be made, we would recognize unrealized losses through earnings and write down the amortized cost of
such assets to a new cost basis, based on the fair market value of such assets on the date they are considered to be other-than-temporarily
impaired. Such impairment charges reflect non-cash losses at the time of recognition; subsequent disposition or sale of such assets
could further affect our future losses or gains, as they are based on the difference between the sale price received and adjusted
amortized cost of such assets at the time of sale. If we experience a decline in the fair value of our assets, our business, financial
condition, results of operations and our ability to make distributions to our stockholders could be adversely affected.
The allocation of the net proceeds of
any equity offering among our target assets, and the timing of the deployment of these proceeds is subject to, among other things,
then prevailing market conditions and the availability of target assets.
Our allocation of the
net proceeds from any equity offering among our target assets is subject to our investment guidelines and maintenance of our REIT
qualification. Our Manager will make determinations as to the percentage of our equity that will be invested in each of our target
assets and the timing of the deployment of the net proceeds of our equity offerings. These determinations will depend on then prevailing
market conditions and may change over time in response to opportunities available in different interest rate, economic and credit
environments. Until appropriate assets can be identified, our Manager may decide to use the net proceeds of our offerings to pay
down our short-term debt or to invest the net proceeds in interest-bearing short-term investments, including funds which are consistent
with maintenance of our REIT qualification. These investments are expected to provide a lower net return than we seek to achieve
from our target assets. Prior to the time we have fully used the net proceeds of our offerings to acquire our target assets, we
may fund our monthly distributions out of such net proceeds.
Many of our investments are recorded
at fair value, and quoted prices or observable inputs may not be available to determine such value, resulting in the use of significant
unobservable inputs to determine value.
We expect that the values
of some of our investments may not be readily determinable. We will measure the fair value of these investments quarterly, in accordance
with guidance set forth in the Financial Accounting Standards Board Accounting Standards Codification, or ASC, Topic 820, Fair
Value Measurements and Disclosures. The fair value at which our assets may be recorded may not be an indication of their realizable
value. Ultimate realization of the value of an asset depends to a great extent on economic and other conditions that are beyond
the control of our Manager, us or our board of directors. Further, fair value is only an estimate based on good faith judgment
of the price at which an investment can be sold since market prices of investments can only be determined by negotiation between
a willing buyer and seller. If we were to liquidate a particular asset, the realized value may be more than or less than the amount
at which such asset is valued. Accordingly, the value of our equity securities could be adversely affected by our determinations
regarding the fair value of our investments, whether in the applicable period or in the future. Additionally, such valuations may
fluctuate over short periods of time.
In certain cases, our
Manager’s determination of the fair value of our investments will include inputs provided by third-party dealers and pricing
services. Valuations of certain investments in which we may invest are often difficult to obtain or unreliable. In general, dealers
and pricing services heavily disclaim their valuations. Dealers may claim to furnish valuations only as an accommodation and without
special compensation, and so they may disclaim any and all liability for any direct, incidental or consequential damages arising
out of any inaccuracy or incompleteness in valuations, including any act of negligence or breach of any warranty. Depending on
the complexity and illiquidity of a security, valuations of the same security can vary substantially from one dealer or pricing
service to another. Therefore, our results of operations for a given period could be adversely affected if our determinations regarding
the fair market value of these investments are materially different than the values that we ultimately realize upon their disposal.
The valuation process has been particularly challenging recently as market events have made valuations of certain assets more difficult,
unpredictable and volatile.
Because we acquire fixed-rate securities,
an increase in interest rates on our borrowings adversely affects our book value.
Increases in interest
rates negatively affect the market value of our assets. Any fixed-rate securities that we invest in generally are more negatively
affected by these increases than adjustable-rate securities or loans. In accordance with accounting rules, we are required to reduce
our book value by the amount of any decrease in the market value of our assets that are classified for accounting purposes as available-for-sale
or for which we have elected the fair value option. Our entire investment portfolio is priced by independent pricing providers
or by third- party brokers. If the fair value of a security is not available from a third- party pricing service or dealer, we
estimate the fair value of the security using a variety of models and analyses, taking into consideration aggregate characteristics
including, but not limited to, type of collateral, index, margin, periodic interest rate caps, lifetime interest rate caps, underwriting
standards, age and delinquency experience. However, the fair value reflects estimates and may not be indicative of the amounts
we would receive in a current market exchange. If we determine that a security is other-than- temporarily impaired, we would be
required to reduce the value of such security on our balance sheet by recording an impairment charge in our income statement and
our stockholders’ equity would be correspondingly reduced. Reductions in stockholders’ equity decrease the amounts
that we may borrow to purchase additional assets, which could restrict our ability to increase our net income.
An increase in interest rates may cause a decrease in the
volume of certain of our assets, which could adversely affect our ability to acquire assets that satisfy our investment objectives
and to generate income and make distributions to our stockholders.
Rising interest rates
generally reduce the demand for mortgage loans due to the higher cost of borrowing. A reduction in the volume of mortgage loans
originated may affect the volume of RMBS, Multi-Family MBS, MSRs and other mortgage related investments available to us, which
could adversely affect our ability to acquire assets that satisfy our investment objectives. Rising interest rates may also cause
our assets that were issued prior to an interest rate increase to provide yields that are below prevailing market interest rates.
If rising interest rates cause us to be unable to acquire a sufficient volume of RMBS, Multi-Family MBS, MSRs and other mortgage
related investments with a yield that is above our borrowing cost, our ability to satisfy our investment objectives and to generate
income and make distributions to our stockholders may be adversely affected.
The relationship between
short-term and longer-term interest rates is often referred to as the “yield curve.” Ordinarily, short-term interest
rates are lower than longer-term interest rates. If short-term interest rates rise disproportionately relative to longer-term interest
rates (a flattening of the yield curve), our borrowing costs may increase more rapidly than the interest income earned on our assets.
Because we expect our investments, on average, generally will bear interest based on longer-term rates than our borrowings, a flattening
of the yield curve would tend to decrease our net income and the market value of our net assets. Additionally, to the extent cash
flows from investments that return scheduled and unscheduled principal are reinvested, the spread between the yields on the new
investments and available borrowing rates may decline, which would likely decrease our net income. It is also possible that short-term
interest rates may exceed longer-term interest rates (a yield curve inversion), in which event our borrowing costs may exceed our
interest income and we could incur operating losses. Although a historically rare phenomenon, many countries in Europe have experienced
inverted yield curves in recent months. Given the volatile nature of the U.S. economy since the end of the third round of quantitative
easing, or QE3, and the Fed’s recent increase in short-term interest rates, there can be no guarantee that the yield curve
will not become and/or remain inverted.
Increases in interest rates typically
adversely affect the value of our investments and cause our interest expense to increase, which could result in reduced earnings
or losses and negatively affect our profitability as well as the cash available for distribution to our stockholders.
We invest in RMBS, Multi-Family
MBS, MSRs and other mortgage related investments. In a normal yield curve environment, an investment in the fixed-rate component
of such assets will generally decline in value if future long-term interest rates increase. Declines in market value may ultimately
reduce earnings or result in losses to us, which may negatively affect cash available for distribution to our stockholders.
A significant risk associated
with RMBS, Multi-Family MBS, MSRs and other mortgage related investments is the risk that both long-term and short- term interest
rates will increase significantly. If long-term rates increased significantly, the market value of these investments would decline,
and the duration and weighted average life of the investments would increase. We could realize a loss if the securities were sold.
At the same time, an increase in short-term interest rates would increase the amount of interest owed on any repurchase agreements
we may enter into.
Market values of our investments
may decline without any general increase in interest rates for a number of reasons, such as increases or expected increases in
defaults, or increases or expected increases in voluntary prepayments for those investments that are subject to prepayment risk
or widening of credit spreads.
In addition, in a period
of rising interest rates, our operating results will depend in large part on the difference between the income from our assets
and our financing costs. We anticipate that, in most cases, the income from such assets will respond more slowly to interest rate
fluctuations than the cost of our borrowings. Consequently, changes in interest rates, particularly short- term interest rates,
may significantly influence our net income. Increases in these rates will tend to decrease our net income and market value of our
assets.
Interest rate mismatches between our
RMBS backed by ARMs or hybrid ARMs and our borrowings used to fund our purchases of these assets may cause us to suffer losses.
We may fund our RMBS with
borrowings that have interest rates that adjust more frequently than the interest rate indices and repricing terms of RMBS backed
by ARMs or hybrid ARMs. Accordingly, if short-term interest rates increase, our borrowing costs may increase faster than the interest
rates on RMBS backed by ARMs or hybrid ARMs adjust. As a result, in a period of rising interest rates, we could experience a decrease
in net income or a net loss.
In most cases, the interest
rate indices and repricing terms of RMBS backed by ARMs or hybrid ARMs and our borrowings will not be identical, thereby potentially
creating an interest rate mismatch between our investments and our borrowings. While the historical spread between relevant short-term
interest rate indices has been relatively stable, there have been periods when the spread between these indices was volatile. During
periods of changing interest rates, these interest rate index mismatches could reduce our net income or produce a net loss and
adversely affect the level of our distributions to our stockholders and the market price of our equity securities.
In addition, RMBS backed
by ARMs or hybrid ARMs will typically be subject to lifetime interest rate caps that limit the amount an interest rate can increase
through the maturity of the RMBS. However, our borrowings under repurchase agreements typically will not be subject to similar
restrictions. Accordingly, in a period of rapidly increasing interest rates, the interest rates paid on our borrowings could increase
without limitation while caps could limit the interest rates on these types of RMBS. This problem is magnified for RMBS backed
by ARMs or hybrid ARMs that are not fully indexed. Further, some RMBS backed by ARMs or hybrid ARMs may be subject to periodic
payment caps that result in a portion of the interest being deferred and added to the principal outstanding. As a result, we may
receive less cash income on these types of RMBS than we need to pay interest on our related borrowings. These factors could reduce
our net interest income and cause us to suffer a loss during periods of rising interest rates.
Interest rate fluctuations may adversely
affect our business, financial condition, results of operations and our ability to make distributions to our stockholders.
Interest rates are highly
sensitive to many factors, including governmental, monetary and tax policies, domestic and international economic and political
considerations and other factors beyond our control. Our success will depend on our ability to analyze the relationship changing
interest rates may have on our financial position and results of operations in general and the impact such rate changes may have
on critical elements underlying our target assets and borrowings. In particular,
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Changes in interest rates typically inversely affect the fair value of our target assets, which consist of primarily RMBS, Multi-Family MBS, residential mortgage loans, MSRs and other mortgage related investments. When interest rates rise, the value of our fixed-rate target assets generally decline, and when interest rates fall, the value of our fixed-rate target assets generally increase.
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Changes in interest rates may inversely affect prepayment speeds. Typically, as interest rates rise, prepayments on the underlying mortgages tend to slow; conversely, as interest rates fall, prepayments on the underlying mortgages tend to accelerate. The effect that rising or falling interest rates has on these prepayments affects the price of our target assets, and the effect can be particularly pronounced with fixed-rate Agency RMBS.
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Changes in interest rates may create mismatches between our target assets, which will consist primarily of Agency RMBS, Non-Agency RMBS, Multi-Family MBS, residential mortgage loans and other mortgage-related investments, and our borrowings used to fund our purchases of those assets. The risk of these mismatches may be pronounced in that, should interest rates increase, interest rate caps on our hybrid ARMs and adjustable rate RMBS would limit the income stream on those investments while our borrowing would not be subject to similar restrictions.
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In accordance with accounting
rules, we are required to reduce our stockholders’ equity, or book value, by the amount of any decrease in the market value
of our securities that are classified for accounting purposes as available-for-sale. We are required to evaluate our securities
on a quarterly basis to determine their fair value by using third-party bid price indications provided by dealers who make markets
in these securities or by third-party pricing services. If the fair value of a security is not available from a dealer or third-party
pricing service, we will estimate the fair value of the security using a variety of methods including, but not limited to, discounted
cash flow analysis, matrix pricing, option-adjusted spread models and fundamental analysis. Aggregate characteristics taken into
consideration include, but are not limited to, type of collateral, index, margin, periodic cap, lifetime cap, underwriting standards,
age and delinquency experience. However, the fair value reflects estimates and may not be indicative of the amounts we would receive
in a current market sale transaction. If we determine that a security is other-than-temporarily impaired, we are required to reduce
the value of such security on our balance sheet by recording an impairment charge in our income statement, and our stockholders’
equity is correspondingly reduced. Reductions in stockholders’ equity decrease the amounts we may borrow to purchase additional
securities, which could restrict our ability to implement our investment strategy, which could adversely affect our business, financial
condition, results of operations and our ability to make distributions to our stockholders. In addition, rising interest rates
generally reduce the demand for consumer credit, including mortgage loans, due to the higher cost of borrowing. A reduction in
the volume of mortgage loans originated may affect the volume of RMBS available to us, which could affect our ability to acquire
assets that satisfy our investment objectives.
Changes in prepayment rates may adversely affect our profitability.
The RMBS assets we acquire
are backed by pools of residential mortgage loans. We also invest in residential mortgage loans. We receive payments, generally,
from the payments that are made on these underlying residential mortgage loans. When residential mortgage loans are prepaid (including
by way of voluntary prepayments by borrowers, loan buyouts and liquidations due to defaults and foreclosures) at rates that are
faster than expected, this results in prepayments that are faster than expected on the related RMBS. These faster than expected
payments may adversely affect our profitability. In addition, a decrease in prepayment rates may adversely affect our results of
operations. When residential mortgage loans are prepaid at slower than expected rates, prepayments on the RMBS may be slower than
expected. These slower than expected payments may adversely affect our profitability.
We purchase RMBS assets,
and purchase residential mortgage loans, that have a higher interest rate than the then prevailing market interest rate. In exchange
for this higher interest rate, we may pay a premium to par value to acquire the asset. In accordance with GAAP, we amortize this
premium over the expected term of the asset based on our prepayment assumptions or its contractual terms, depending on the type
of asset. If the asset is prepaid in whole or in part at a faster than expected rate or contractual term (as applicable), however,
we must expense all or a part of the remaining unamortized portion of the premium that was paid at the time of the purchase, which
will adversely affect our profitability.
We also purchase RMBS
assets or residential mortgage loans that have a lower interest rate than the then prevailing market interest rate. In exchange
for this lower interest rate, we may pay a discount to par value to acquire the asset. In accordance with GAAP, we accrete this
discount over the expected term of the asset based on our prepayment assumptions or its contractual terms. If the asset is prepaid
at a slower than expected rate, however, we must accrete the remaining portion of the discount at a slower than expected rate.
This will extend the expected life of the asset and result in a lower than expected yield on assets purchased at a discount to
par.
Prepayment rates generally
increase when interest rates fall and decrease when interest rates rise, but changes in prepayment rates are difficult to predict.
Prepayments can also occur when borrowers default on their residential mortgages and the mortgages are prepaid from the proceeds
of a foreclosure sale of the property, or when borrowers sell the property and use the sale proceeds to prepay the mortgage as
part of a physical relocation. Prepayment rates also may be affected by conditions in the housing and financial markets, general
economic conditions and the relative interest rates on fixed-rate mortgages and ARMs and increasing defaults on residential mortgage
loans, which could lead to an acceleration of the payment of the related principal. While we will seek to manage prepayment risk,
in selecting RMBS investments we must balance prepayment risk against other risks, the potential returns of each investment and
the cost of hedging our risks. No strategy can completely insulate us from prepayment or other such risks, and we may deliberately
retain exposure to prepayment or other risks.
Changing market conditions may upset
the historical relationship between interest rate changes and prepayment trends, which would make it more difficult for us to analyze
our portfolio.
Our success will depend
on our ability to analyze the relationship of changing interest rates and prepayments of the mortgages that underlie our target
assets. Changes in interest rates and prepayments will affect the market price of the target assets that we purchase and any target
assets that we hold at a given time. As part of our overall portfolio risk management, we analyze interest rate changes and prepayment
trends separately and collectively to assess their effects on our portfolio. In conducting our analysis, we depend on industry-
accepted assumptions with respect to the relationship between interest rates and prepayments under normal market conditions. If
the dislocation in the residential mortgage market or other developments change the way that prepayment trends have historically
responded to interest rate changes, our ability to assess the market value of our portfolio would be significantly affected and
could adversely affect our financial position and results of operations.
We are highly dependent on communications
and information systems and systems failures could significantly disrupt our operations, which may, in turn, negatively affect
the market price of our equity securities and our ability to make distributions.
Our business is highly
dependent on the communications and information systems of our Manager that allow it to monitor, value, buy, sell, finance and
hedge our investments. Any failure or interruption of our Manager’s systems could cause delays or other problems in our securities
trading activities, which could have a material adverse effect on our operating results and negatively affect the market price
of our equity securities and our ability to make distributions.
The occurrence of cyber-incidents, or
a deficiency in our cybersecurity or in those of any of our third party service providers, could negatively impact our business
by causing a disruption to our operations, a compromise of our confidential information or damage to our business relationships
or reputation, all of which could negatively impact our business and results of operations.
A cyber-incident is considered to be any adverse
event that threatens the confidentiality, integrity or availability of our information resources or those of our third party service
providers. A cyber-incident can be an intentional attack or an unintentional event and can include gaining unauthorized access
to system to disrupt operations, corrupt data or steal confidential information. The primary risks that could directly results
from a cyber-incident include operational interruption and private data exposure. We have implemented processes, procedures and
controls to help mitigate these risks, but these measures, as well as our increased awareness of the risk of a cyber-incident,
do not guarantee that our business and results of operations will not be negatively impacted by such an incident.
Rapid changes in the values of our real
estate-related assets may make it more difficult for us to maintain our qualification as a REIT or exclusion from registration
under the Investment Company Act.
If the market value or
income potential of our real estate-related assets declines as a result (i) of increased interest rates, prepayment rates or other
factors; or (ii) we determine based on subsequently available guidance from the SEC or SEC staff that our treatment as qualified
interests in real estate of certain subordinated certificates we acquire (a) in the secondary market issued by K-Series trusts,
or (b) from securitization trusts into which we sell residential mortgage loans, is no longer correct; we may need to increase
certain real estate investments and income and/or liquidate our non-qualifying assets in order to maintain our REIT qualification
or exclusion from registration under the Investment Company Act. If the decline in real estate asset values and/or income occurs
quickly, this may be especially difficult to accomplish. This difficulty may be exacerbated by the illiquid nature of our investments.
We may have to make investment decisions that we otherwise would not make absent our REIT and Investment Company Act considerations.
Any downgrades, or perceived potential
of downgrades, of the credit ratings of the U.S. Government, GSEs or certain European countries may adversely affect our business,
financial condition, results of operations and our ability to make distributions to our stockholders.
On August 5, 2011, Standard
&Poor’s downgraded the U.S. Government’s credit rating for the first time in history, and on October 15, 2013,
Fitch Ratings placed the ratings of all outstanding U.S. sovereign debt securities on Rating Watch Negative. Because Fannie Mae
and Freddie Mac are in conservatorship of the U.S. Government, downgrades to the U.S. Government’s credit rating could impact
the credit risk associated with our target assets and, therefore, decrease the value of the target assets in our portfolio. In
addition, downgrades of the credit ratings of the U.S. Government, GSEs and certain European countries could create broader financial
turmoil and uncertainty, which could weigh heavily on the global banking system. Therefore, any downgrades of the credit ratings
of the U.S. Government, GSEs or certain European countries may adversely affect the value of our target assets and our business,
financial condition, results of operations and our ability to make distributions to our stockholders.
Risks Related to Financing and Hedging
Our strategy involves significant leverage,
which may amplify losses; while we currently expect to incur approximately one to three times leverage on our New Issue Non-Agency
RMBS, approximately one to four times leverage on our Multi-Family MBS, approximately one to two times leverage on our Legacy Non-Agency
RMBS and approximately six to nine times leverage on our Agency RMBS there is no specific limit on the amount of leverage that
we may use.
We leverage our portfolio
investments in our target assets principally through borrowings under repurchase agreements. Our leverage (on both a GAAP and non-GAAP
basis) currently ranges, and we expect that it will continue to range, between three and six times the amount of our stockholders’
equity. Additionally, we currently borrow, and expect that we will continue to borrow, between one to three times when acquiring
New Issue Non-Agency RMBS, between one to four times when acquiring Multi-Family MBS, between one and two times when acquiring
Legacy Non-Agency RMBS and between six to nine times the amount of our stockholders’ equity in acquiring Agency RMBS. The
leverage our Manager is comfortable applying to each asset class at any point in time is a function of the yield profile across
housing environments and also a function of price or market values in environments of excessive volatility, which cannot be ruled
out. We will incur this leverage by borrowing against a substantial portion of the market value of our assets. Our leverage, which
is fundamental to our investment strategy, creates significant risks.
To the extent that we
incur significant leverage, we may incur substantial losses if our borrowing costs increase. Our borrowing costs may increase for
any of the following, or other, reasons:
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short-term interest rates increase;
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the market value of our securities decreases;
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interest rate volatility increases; or
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the availability of financing in the market decreases.
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Our return on our investments
and cash available for distributions may be reduced if market conditions cause the cost of our financing to increase relative to
the income that can be derived from the assets acquired, which could adversely affect the price of our equity securities. In addition,
our debt service payments will reduce cash flow available for distributions to stockholders. In addition, if the cost of our financing
increases, we may not be able to meet our debt service obligations. To the extent that we cannot meet our debt service obligations,
we risk the loss of some or all of our assets to satisfy our debt obligations. To the extent we are compelled to liquidate qualified
REIT assets to repay debts, our compliance with the REIT rules regarding our assets and our sources of income could be negatively
affected, which would jeopardize our qualification as a REIT. Losing our REIT status would cause us to lose tax advantages applicable
to REITs and would decrease our overall profitability and distributions to our stockholders.
We may continue to incur significant
additional debt in the future, which will subject us to increased risk of loss and may reduce cash available for distributions
to our stockholders.
Subject to market conditions
and availability, we may continue to incur significant additional debt in the future. Although we are not required to maintain
any particular assets-to-equity leverage ratio, the amount of leverage we may deploy for particular assets will depend upon our
Manager’s assessment of the credit and other risks of those assets. Our board of directors may establish and change our leverage
policy at any time without stockholder approval. Incurring debt could subject us to many risks that, if realized, would adversely
affect us, including the risk that:
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our cash flow from operations may be insufficient to make
required payments of principal of and interest on the debt or we may fail to comply with all of the other covenants contained
in the debt, which is likely to result in (1) acceleration of such debt (and any other debt containing a cross-default or cross-acceleration
provision) that we may be unable to repay from internal funds or to refinance on favorable terms, or at all, (2) our inability
to borrow unused amounts under our financing arrangements, even if we are current in payments on borrowings under those arrangements,
and/or (3) the loss of some or all of our assets to foreclosure or sale;
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our debt may increase our vulnerability to adverse economic
and industry conditions with no assurance that investment yields will increase with higher financing costs;
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we may be required to dedicate a substantial portion of
our cash flow from operations to payments on our debt, thereby reducing funds available for operations, investments, stockholder
distributions or other purposes; and
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we may not be able to refinance debt that matures prior
to the investment it was used to finance on favorable terms or at all.
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There can be no assurance that our Manager
will be able to prevent mismatches in the maturities of our assets and liabilities.
Because we employ financial
leverage in funding our portfolio, mismatches in the maturities of our assets and liabilities can create risk in the need to continually
renew or otherwise refinance our liabilities. Our net interest margins will be dependent upon a positive spread between the returns
on our asset portfolio and our overall cost of funding. Our Manager’s risk management tools include software and services
licensed or purchased from third parties, in addition to proprietary systems and analytical methods developed internally. There
can be no assurance that these tools and the other risk management techniques described above will protect us from asset/liability
risks.
We are subject to margin calls under
our master repurchase agreements, which could result in defaults or force us to sell assets under adverse market conditions or
through foreclosure.
We enter into master repurchase
agreements with various financial institutions and borrow under these master repurchase agreements to finance the acquisition of
assets for our investment portfolio. Pursuant to the terms of borrowings under our master repurchase agreements, a decline in the
value of the subject assets typically results in our lenders initiating margin calls. A margin call means that the lender requires
us to pledge additional collateral to re-establish the ratio of the value of the collateral to the amount of the borrowing. The
specific collateral value to borrowing ratio that would trigger a margin call is not set in the master repurchase agreements and
will not be determined until we engage in a repurchase transaction under these agreements. Our fixed-rate securities generally
are more susceptible to margin calls as increases in interest rates tend to more negatively affect the market value of fixed-rate
securities. If we are unable to satisfy margin calls, our lenders may foreclose on our collateral. The threat of or occurrence
of a margin call could force us to sell our assets, either directly or through a foreclosure, under adverse market conditions.
Because of the significant leverage we have, we may incur substantial losses upon the threat or occurrence of a margin call.
If a counterparty to our repurchase transactions
defaults on its obligation to resell the underlying security back to us at the end of the transaction term, or if the value of
the underlying security has declined as of the end of that term, or if we default on our obligations under the repurchase agreement,
we will lose money on our repurchase transactions.
When we engage in repurchase
transactions, we generally sell securities to lenders (repurchase agreement counterparties) and receive cash from these lenders.
The lenders are obligated to resell the same securities back to us at the end of the term of the transaction. Because the cash
we receive from the lender when we initially sell the securities to the lender is less than the value of those securities (this
difference is the haircut), if the lender defaults on its obligation to resell the same securities back to us we may incur a loss
on the transaction equal to the amount of the haircut (assuming there was no change in the value of the securities). We would also
lose money on a repurchase transaction if the value of the underlying securities has declined as of the end of the transaction
term, as we would have to repurchase the securities for their initial value but would receive securities worth less than that amount.
Further, if we default on one of our obligations under a repurchase transaction, the lender can terminate all of the outstanding
repurchase transactions with us and can cease entering into any other repurchase transactions with us. Our repurchase agreements
contain cross-default provisions, so that if a default occurs under any one agreement, the lenders under our other agreements could
also declare a default. Any losses we incur on our repurchase transactions could adversely affect our earnings and thus our cash
available for distribution to our stockholders.
Our use of derivative instruments and
repurchase agreements may expose us to counterparty risk.
We enter into transactions
to mitigate interest rate risks associated with our business with counterparties that have a high-quality credit rating or in the
assessment of our management team represent an acceptable counterparty risk. If counterparties cannot perform under the terms of
our futures contracts, for example, we would not receive payments due under those contracts, and may lose any unrealized gain associated
with such contracts, and the mitigated liability would cease to be mitigated by such contracts. We may also be at risk for any
collateral we have pledged to secure our obligations under a futures contract if the counterparty became insolvent or filed for
bankruptcy. Similarly, if an interest rate cap agreement counterparty fails to perform under the terms of the interest rate cap
agreement, in addition to not receiving payments due under that agreement that would offset our interest expense, we would also
incur a loss for all remaining unamortized premium paid for that agreement. Our derivative instrument agreements require our counterparties
to post collateral in certain events, generally related to their credit condition, to provide us some protection against their
potential failure to perform. We, in turn, are subject to similar requirements. In addition, we enter into repurchase agreements
to finance our target assets with certain counterparties. A failure or insolvency of any of these counterparties under such agreements
could result in a loss of our collateral pledged to the counterparty or a loss of the securities that have not yet been repurchased
from such counterparty, which, in either case, could adversely affect our business, financial condition, results of operations
and our ability to make distributions to our stockholders.
Failure to procure adequate repurchase
agreement financings, which generally have short terms, or to renew or replace such financing as it matures, would adversely affect
our results of operations.
We use repurchase agreements
as a strategy to increase the return on our investment portfolio. However, we may not be able to achieve our desired leverage ratio
for a number of reasons, including if the following events occur:
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our lenders do not make repurchase agreement financing
available to us at acceptable rates;
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certain of our lenders exit the repurchase market;
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our lenders require that we pledge additional collateral
to cover our borrowings, which we may be unable to do; or
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we determine that the leverage would expose us to excessive
risk.
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Indeed, our access to financing depends on
a number of factors over which we have no or little control, including:
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general market conditions;
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the lender’s view of the quality of our assets;
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the lender’s perception of the credit risk of the
Company;
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our current and potential earnings and cash distributions;
and
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the market prices for shares of our common stock.
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We cannot assure you that
any, or sufficient, repurchase agreement financing will continue to be available to us on terms that are acceptable to us. In recent
years, investors and financial institutions that lend in the securities repurchase market have tightened lending standards in response
to the difficulties and changed economic conditions that have adversely affected the RMBS and mortgage market. These market disruptions
have been pronounced in the Non-Agency RMBS market and loan market, and the impact has also extended to Agency RMBS, which has
made the value of these assets unstable and relatively illiquid compared to prior periods. Any decline in their value, or perceived
market uncertainty about their value, would make it more difficult for us to obtain financing on favorable terms, or at all, or
maintain our compliance with terms of any financing arrangements then in place. Additionally, the lenders from which we may seek
to obtain repurchase agreement financing may have owned or financed RMBS that have declined in value and caused the lender to suffer
losses as a result of the recent downturn in the residential mortgage market. If these conditions persist, these institutions may
be forced to exit the repurchase market, become insolvent or further tighten lending standards or increase the amount of equity
capital or haircut required to obtain financing, and in such event, could make it more difficult for us to obtain financing on
favorable terms or at all. In the event that we cannot obtain sufficient funding on acceptable terms, there may be a negative impact
on the value of our equity securities and our ability to make distributions, and you may lose part or all of your investment.
In addition, in response
to certain interest rate and investment environments or to changes in market liquidity, we could adopt a strategy of reducing our
leverage by selling assets or not reinvesting principal payments as RMBS amortize or prepay, thereby decreasing the outstanding
amount of our related borrowings. Such a strategy could reduce interest income, interest expense and net income, the extent of
which would be dependent on the level of reduction in assets and liabilities, as well as the sale prices for which the assets were
sold.
While the overall financing
environment has remained relatively stable over the last 12 months, further credit losses or mergers, acquisitions or bankruptcies
of investment banks and commercial banks that have historically acted as repurchase agreement counterparties may occur. This would
result in a fewer number of potential repurchase agreement counterparties operating in the market and could potentially impact
the pricing and availability of financing for our business.
Furthermore, because we
rely primarily on short-term borrowings, our ability to achieve our investment objective will depend not only on our ability to
borrow money in sufficient amounts and on favorable terms, but also on our ability to renew or replace on a continuous basis our
maturing short-term borrowings. If we are not able to renew or replace maturing borrowings, we will have to sell some or all of
our assets, possibly under adverse market conditions. In addition, if the regulatory capital requirements imposed on our lenders
change, as they are expected to under the Basel III standards adopted by the Basel Committee on Banking Supervision, they may be
required to significantly increase the cost of the financing that they provide to us. Our lenders also may revise their eligibility
requirements for the types of assets they are willing to finance or the terms of such financings, based on, among other factors,
the regulatory environment and their management of perceived risk, particularly with respect to assignee liability.
Our repurchase agreement financing may
require us to provide additional collateral and may restrict us from leveraging our assets as fully as desired.
We use repurchase agreements
to finance acquisitions of RMBS, Multi-Family MBS, MSRs and other mortgage related investments. If the market value of the asset
pledged or sold by us to a financing institution pursuant to a repurchase agreement declines, we may be required by the financing
institution to provide additional collateral or pay down a portion of the funds advanced, but we may not have the funds available
to do so, which could result in defaults. Posting additional collateral to support our credit will reduce our liquidity and limit
our ability to leverage our assets, which could adversely affect our business. In the event we do not have sufficient liquidity
to meet such requirements, financing institutions can accelerate repayment of our indebtedness, increase interest rates, liquidate
our collateral or terminate our ability to borrow. Such a situation would likely result in a rapid deterioration of our financial
condition and possibly necessitate a filing for bankruptcy protection.
Further, financial institutions
providing the repurchase facilities may require us to maintain a certain amount of cash uninvested or to set aside non-levered
assets sufficient to maintain a specified liquidity position which would allow us to satisfy our collateral obligations. As a result,
we may not be able to leverage our assets as fully as we would choose, which could reduce our return on equity. If we are unable
to meet these collateral obligations, our financial condition could deteriorate rapidly.
Lenders generally require us to enter
into restrictive covenants relating to our operations.
When we obtain financing,
lenders typically impose restrictions on us that would affect our ability to incur additional debt, our capability to make distributions
to stockholders and our flexibility to determine our operating policies. Loan documents we execute may contain negative covenants
that limit, among other things, our ability to repurchase stock, distribute more than a certain amount of our funds from operations
and employ leverage beyond certain amounts.
Our inability to meet certain financial
covenants related to our repurchase agreements could adversely affect our business, financial condition and results.
In connection with certain
of our repurchase agreements, we are required to maintain certain financial covenants with respect to our net worth, the most restrictive
of which requires that, on the last day of any fiscal quarter, our total stockholders’ equity shall not be less than the
greater of (1) $75,000,000 or (2) 50% of the highest stockholders equity on the last day of the preceding eight fiscal quarters.
Compliance with these financial covenants will depend on market factors and the strength of our business and operating results.
Various risks, uncertainties and events beyond our control could affect our ability to comply with our financial covenants. Failure
to comply with our financial covenants could result in an event of default, termination of the repurchase facility and acceleration
of all amounts owing under the repurchase facility and gives the counterparty the right to exercise certain other remedies under
the repurchase agreement, including the sale of the asset subject to repurchase at the time of default, unless we were able to
negotiate a waiver. Any such waiver could be conditioned on an amendment to the repurchase facility and any related guaranty agreement
on terms that may be unfavorable to us. If we are unable to negotiate a covenant waiver or replace or refinance our assets under
a new repurchase facility on favorable terms or at all, our financial condition, results of operations and cash flows could be
adversely affected.
Our rights under repurchase agreements
may be subject to the effects of the bankruptcy laws in the event of the bankruptcy or insolvency of us or our counterparties under
the repurchase agreements.
In the event of our insolvency
or bankruptcy, certain repurchase agreements may qualify for special treatment under Title 11 of the United States Code, as amended,
or the U.S. Bankruptcy Code, the effect of which, among other things, would be to allow the lender under the applicable repurchase
agreement to avoid the automatic stay provisions of the U.S. Bankruptcy Code and to take possession of and liquidate the assets
that we have pledged under their repurchase agreements. In the event of the insolvency or bankruptcy of a lender during the term
of a repurchase agreement, the lender may be permitted, under applicable insolvency laws, to repudiate the contract, and our claim
against the lender for damages may be treated simply as an unsecured creditor. In addition, if the lender is a broker or dealer
subject to the Securities Investor Protection Act of 1970, or an insured depository institution subject to the Federal Deposit
Insurance Act, our ability to exercise our rights to recover our securities under a repurchase agreement or to be compensated for
any damages resulting from the lender’s insolvency may be further limited by those statutes. These claims would be subject
to significant delay and, if and when received, may be substantially less than the damages we actually incur.
An increase in our borrowing costs relative
to the interest that we receive on investments in RMBS, Multi-Family MBS, MSRs and other mortgage related investments may adversely
affect our profitability and cash available for distribution to our stockholders.
As our financings mature,
we will be required either to enter into new borrowings or to sell certain of our investments. An increase in short-term interest
rates at the time that we seek to enter into new borrowings would reduce the spread between our returns on our assets and the cost
of our borrowings. This would adversely affect our returns on our assets, which might reduce earnings and, in turn, cash available
for distribution to our stockholders.
If a counterparty to one of our swap
agreements or TBAs defaults on its obligations, we may incur losses.
If a counterparty to one
of the swap agreements or TBAs that we enter into defaults on its obligations under the agreement, we may not receive payments
due under the agreement, and thus, we may lose any unrealized gain associated with the agreement. If any such swap agreement hedged
a liability, such liability could cease to be hedged upon the default of a counterparty. Additionally, we may also risk the loss
of any collateral we have pledged to secure our obligations under a swap agreement if the counterparty becomes insolvent or files
for bankruptcy.
Clearing facilities or exchanges upon
which some of our hedging instruments are traded may increase margin requirements on our hedging instruments in the event of adverse
economic developments.
In response to events
having or expected to have adverse economic consequences or which create market uncertainty, clearing facilities or exchanges upon
which some of our hedging instruments are traded may require us to post additional collateral against our hedging instruments.
For example, in response to the U.S. approaching its debt ceiling without resolution and the federal government shutdown in October
2013, the Chicago Mercantile Exchange announced that it would increase margin requirements by 12% for all over-the-counter interest
rate swap portfolios that its clearinghouse guaranteed. This increase was subsequently rolled back shortly thereafter upon the
news that Congress passed legislation to temporarily suspend the national debt ceiling, reopened the federal government, and provided
a time period for broader negotiations concerning federal budgetary issues. In the event that future adverse economic developments
or market uncertainty (including those due to governmental, regulatory, or legislative action or inaction) result in increased
margin requirements for our hedging instruments, it could adversely affect our liquidity position, business, financial condition
and results of operations.
We enter into hedging transactions that
expose us to contingent liabilities in the future, which may adversely affect our financial results or cash available for distribution
to stockholders.
We engage in hedging transactions
intended to hedge various risks to our portfolio, including the exposure to adverse changes in interest rates. Our hedging activity
varies in scope based on, among other things, the level and volatility of interest rates, the type of assets held and other changing
market conditions. Although these transactions are intended to reduce our exposure to various risks, hedging may fail to protect
or could adversely affect us because, among other things:
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hedging can be expensive, particularly during periods of
volatile or rapidly changing interest rates;
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available hedges may not correspond directly with the risks
for which protection is sought;
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the duration of the hedge may not match the duration of
the related liability;
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the amount of income that a REIT may earn from certain
hedging transactions is limited by U.S. federal income tax provisions governing REITs;
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the credit quality of a hedging counterparty may be downgraded
to such an extent that it impairs our ability to sell or assign our side of the hedging transaction; and
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the hedging counterparty may default on its obligation
to pay.
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Subject to maintaining
our qualification as a REIT, there are no current limitations on the hedging transactions that we may undertake. However, our Manager’s
reliance on the CFTC’s December 7, 2012 no action letter relieving CPOs of mortgage REITs from the obligation to register
with the CFTC as CPOs depends on the satisfaction of several conditions, including that we comply with additional limitations on
our hedging activity. The letter limits the initial margin and premiums required to establish our Manager’s commodity interest
positions to no more than 5% of the fair market value of our total assets and limits the net income derived annually from our commodity
interest positions that are not qualifying hedging transactions to less than 5% of our gross income.
Therefore, our and our
Manager’s reliance on this no action letter places additional restrictions on our hedging activity. Our hedging transactions
could require us to fund large cash payments in certain circumstances (e.g., the early termination of the hedging instrument caused
by an event of default or other early termination event or a demand by a counterparty that we make increased margin payments).
Our ability to fund these obligations will depend on the liquidity of our assets and access to capital at the time. The need to
fund these obligations could adversely affect our financial condition. Further, hedging transactions, which are intended to limit
losses, may actually result in losses, which would adversely affect our earnings and could in turn reduce cash available for distribution
to stockholders.
Hedging instruments involve
various kinds of risk because they are not always traded on regulated exchanges, guaranteed by an exchange or its clearinghouse
or regulated by any U.S. or foreign governmental authorities. The CFTC is still in the process of proposing rules under the Dodd-Frank
Act that may make our hedging more difficult or increase our costs. Furthermore, the enforceability of agreements underlying hedging
transactions may depend on compliance with applicable statutory and commodity and other regulatory requirements and, depending
on the identity of the counterparty, applicable international requirements. The business failure of a hedging counterparty will
most likely result in its default. Default by a hedging counterparty may result in the loss of unrealized profits and force us
to cover our commitments, if any, at the then current market price. Although we generally seek to reserve the right to terminate
our hedging positions, it may not always be possible to dispose of or close out a hedging position without the consent of the hedging
counterparty, and we may not be able to enter into an offsetting contract in order to cover our risk. We cannot assure you that
a liquid secondary market will exist for hedging instruments purchased or sold, and we may be required to maintain a position until
exercise or expiration, which could result in losses.
Hedging against interest rate exposure
may adversely affect our earnings, which could reduce our cash available for distribution to our stockholders, and such transactions
may fail to protect us from the losses that they were designed to offset.
Subject to maintaining
our qualification as a REIT and exemption from registration under the Investment Company Act, we employ techniques that limit the
adverse effects of rising interest rates on a portion of our short-term repurchase agreements and on a portion of the value of
our assets. In general, our interest rate risk mitigation strategy depend on our view of our entire portfolio, consisting of assets,
liabilities and derivative instruments, in light of prevailing market conditions. We could misjudge the condition of our portfolio
or the market. Our interest rate risk mitigation activity vary in scope based on the level and volatility of interest rates and
principal repayments, the type of securities held and other changing market conditions. Our actual interest rate risk mitigation
decisions are determined in light of the facts and circumstances existing at the time and may differ from our currently anticipated
strategy. These techniques may include purchasing or selling futures contracts, entering into interest rate swap, interest rate
cap or interest rate floor agreements, swaptions, purchasing put and call options on securities or securities underlying futures
contracts, or entering into forward rate agreements.
Because a mortgage borrower
typically has no restrictions on when a loan may be paid off either partially or in full, there are no perfect interest rate risk
mitigation strategies, and interest rate risk mitigation may fail to protect us from loss. Alternatively, we may fail to properly
assess a risk to our portfolio or may fail to recognize a risk entirely leaving us exposed to losses without the benefit of any
offsetting interest rate mitigation activities. The derivative instruments we select may not have the effect of reducing our interest
rate risk. The nature and timing of interest rate risk mitigation transactions may influence the effectiveness of these strategies.
Poorly designed strategies or improperly executed transactions could actually increase our risk and losses. In addition, interest
rate risk mitigation activities could result in losses if the event against which we mitigate does not occur.
Changes in regulations relating to swaps
activities may cause us to limit our swaps activity or subject us to additional disclosure, recordkeeping, and other regulatory
requirements.
The enforceability of
agreements underlying hedging transactions may depend on compliance with applicable statutory and commodity and other regulatory
requirements and, depending on the identity of the counterparty, applicable international requirements. New regulations have been
promulgated by U.S. and foreign regulators to strengthen oversight of derivative contracts. Any actions taken by regulators could
constrain our strategy and could increase our costs, either of which could adversely affect our business, financial condition and
results of operations and our ability to make distributions to our stockholders.
Our results may experience greater fluctuations
by not electing hedge accounting treatment on the derivatives that we enter into.
We have elected to not
qualify for hedge accounting treatment under ASC 815, Derivatives and Hedging, for our current derivative instruments. The economics
of our derivative hedging transactions are not affected by this election; however, our GAAP earnings may be subject to greater
fluctuations from period to period as a result of this accounting treatment for changes in fair value of certain interest rate
swap agreements or for the accounting of the underlying hedged assets or liabilities in our financial statements, if it does not
necessarily match the accounting used for interest rate swap agreements.
Our adoption of fair value option accounting
could result in income statement volatility, which in turn, could cause significant market price and trading volume fluctuations
for our securities.
We have determined that
the securitization trusts that have issued certain of our Multi-Family MBS and Non-Agency RMBS are variable interest entities,
or VIEs, of which we are the primary beneficiary, and elected the fair value option on the assets and liabilities held within
these securitization trusts. As a result, we are required to consolidate the underlying multi-family and residential mortgage
loans or securities, as applicable, related debt, interest income and interest expense of the securitization trusts in our financial
statements, although our actual investment in these securitization trusts generally represents a small percentage of the total
assets of the trusts. We historically accounted for the Multi-Family MBS and Non-Agency RMBS in our investment portfolio through
other comprehensive income, pursuant to which unrealized gains and losses on those MBS were reflected as an adjustment to stockholders’
equity. The fair value option, however, requires that changes in valuations in the assets and liabilities of those VIEs of which
we are the primary beneficiary be reflected through our consolidated earnings. As we continue to acquire subordinate Non-Agency
RMBS and additional Multi-Family MBS assets in the future that are similar in structure and form to the those already acquired,
we may be required to consolidate the assets and liabilities of the issuing or securitization trusts and would expect to elect
the fair value option for those assets. Because of this, our earnings may experience greater volatility in the future as a decline
in the fair value of the assets of any VIE that we consolidate in our financial statements could reduce both our earnings and
stockholders’ equity, which in turn, could cause significant market price and trading volume fluctuations for our securities.
We may be exposed to environmental liabilities
with respect to properties to which we take title.
In the course of our business,
we may take title to real estate, and, if we do take title, we could be subject to environmental liabilities with respect to these
properties. In such a circumstance, we may be held liable to a governmental entity or to third parties for property damage, personal
injury, investigation and clean-up costs incurred by these parties in connection with environmental contamination, or we may be
required to investigate or clean up hazardous or toxic substances or chemical releases at a property. The costs associated with
investigation or remediation activities could be substantial. If we ever become subject to significant environmental liabilities,
our business, financial condition, results of operations and our ability to make distributions to our stockholders could be adversely
affected.
Risks Associated with Our Relationship with
Our Manager
Our board of directors has approved very
broad investment guidelines for our Manager and will not approve each investment and financing decision made by our Manager.
Our Manager is authorized
to follow very broad investment guidelines. Our board of directors periodically reviews and updates our investment guidelines and
also reviews our investment portfolio but does not review or approve specific investments. In addition, in conducting periodic
reviews, our board of directors may rely primarily on information provided to them by our Manager. Furthermore, our Manager may
use complex strategies, and transactions entered into by our Manager may be costly, difficult or impossible to unwind by the time
they are reviewed by our board of directors. Our Manager will have great latitude within the broad parameters of our investment
guidelines in determining the types and amounts of RMBS, Multi-Family MBS, residential mortgage loans, MSRs and other mortgage
related investments it may decide are attractive investments for us, which could result in investment returns that are substantially
below expectations or that result in losses, which would adversely affect our business operations and results. In addition, our
Manager may invest in any investment on our behalf without restriction as to the dollar amount of such investment and without prior
approval of our board of directors. Our Manager is generally permitted to invest our assets in its discretion, provided that such
investments comply with our investment guidelines. Our Manager’s failure to generate attractive risk-adjusted returns on
an investment which represents a significant dollar amount would adversely affect us. Further, decisions made and investments and
financing arrangements entered into by our Manager may not fully reflect the best interests of our stockholders.
There are conflicts of interest in our
relationship with our Manager that could result in decisions that are not in the best interests of our stockholders.
We are subject to conflicts
of interest arising out of our relationship with our Manager. All of our officers are officers of our Manager. Our management agreement
with our Manager was negotiated between related parties and its terms, including fees and other amounts payable, may not be as
favorable to us as if it had been negotiated at arm’s length with an unaffiliated third-party.
We pay our Manager a management
fee that is not tied to our performance. The management fee may not sufficiently incentivize our Manager to generate attractive
risk-adjusted returns for us. This could hurt both our ability to make distributions to our stockholders and the market price of
our equity securities. Furthermore, the compensation payable to our Manager will increase as a result of future issuances of our
equity securities, including issuances upon exercise of the warrants, even if the issuances are dilutive to existing stockholders.
We are dependent on our Manager and its
key personnel for our success.
We have no separate facilities
and are completely reliant on our Manager. All of our officers are officers of our Manager. Our Manager has significant discretion
as to the implementation of our investment and operating policies and strategies. Accordingly, we believe that our success will
depend to a significant extent upon the efforts, experience, diligence, skill and network of business contacts of the officers
and key personnel of our Manager. The officers and key personnel of our Manager evaluate, negotiate, close and monitor our investments;
therefore, our success will depend on their continued service. The departure of any of the officers or key personnel of our Manager
could have a material adverse effect on our performance. In addition, there can be no assurance that our Manager will remain our
investment manager or that we will continue to have access to our Manager’s officers and professionals. The initial term
of our management agreement with our Manager only extends until May 16, 2014, with automatic one-year renewals thereafter. If the
management agreement is terminated and no suitable replacement is found to manage us, we may not be able to execute our business
plan.
The management agreement with our Manager
was not negotiated on an arm’s-length basis and may not be as favorable to us as if it had been negotiated with an unaffiliated
third-party and may be costly and difficult to terminate, including for our Manager’s poor performance.
Our management agreement
with our Manager was negotiated between related parties and its terms, including fees payable, may not be as favorable to us as
if it had been negotiated with an unaffiliated third-party.
Termination of the management
agreement with our Manager without cause, including for our Manager’s poor performance, is difficult and costly. The management
agreement may be terminated annually upon the affirmative vote of at least two-thirds of our independent directors based upon:
(1) our Manager’s unsatisfactory performance that is materially detrimental to us; or (2) our determination that any fees
payable to our Manager are not fair, subject to our Manager’s right to prevent termination based on unfair fees by accepting
a reduction of management fees agreed to by at least two-thirds of our independent directors. We will provide our Manager 180 days
prior notice of any such termination. Unless terminated for cause, we will pay our Manager a termination fee equal to three times
the average annual management fee earned by our Manager during the prior 24-month period immediately preceding such termination,
calculated as of the end of the most recently completed fiscal quarter before the date of termination. This provision increases
the effective cost to us of electing not to renew, or defaulting in our obligations under, the management agreement, thereby adversely
affecting our inclination to end our relationship with our Manager, even if we believe our Manager’s performance is not satisfactory.
Our Manager is only contractually
committed to serve us until May 16, 2017 and our management agreement is automatically renewable for one-year terms; provided,
however, that our Manager may terminate the management agreement annually upon 180 days prior notice. If the management agreement
is terminated and no suitable replacement is found to manage us, we may not be able to execute our business plan.
Our Manager’s liability is limited
under the management agreement and we have agreed to indemnify our Manager and its affiliates against certain liabilities. As a
result, we could experience poor performance or losses for which our Manager would not be liable.
Pursuant to the management
agreement, our Manager does not assume any responsibility other than to render the services called for thereunder and will not
be responsible for any action of our board of directors in following or declining to follow its advice or recommendations. Our
Manager maintains a contractual as opposed to a fiduciary relationship with us, although our officers who are also employees of
our Manager will have a fiduciary duty to us under the Maryland General Corporation Law, or the MGCL, as our officers. Under the
terms of the management agreement, our Manager, its officers, members, managers, directors, personnel, any person controlling or
controlled by our Manager and any person providing sub-advisory services to our Manager will not be liable to us, our directors,
our stockholders or any partners for acts or omissions performed in accordance with and pursuant to the management agreement, except
because of acts constituting bad faith, willful misconduct, gross negligence or reckless disregard of their duties under the management
agreement, as determined by a final non-appealable order of a court of competent jurisdiction. In addition, we have agreed to indemnify
our Manager, its officers, stockholders, members, managers, directors, personnel, any person controlling or controlled by our Manager
and any person providing sub-advisory services to our Manager with respect to all expenses, losses, damages, liabilities, demands,
charges and claims arising from acts of our Manager not constituting bad faith, willful misconduct, gross negligence or reckless
disregard of duties, performed in good faith in accordance with and pursuant to the management agreement. As a result, we could
experience poor performance or losses for which our Manager would not be liable.
Our Manager’s management fee is
payable regardless of our performance.
We pay our Manager a management
fee regardless of the performance of our portfolio. Our Manager’s entitlement to non-performance-based compensation might
reduce its incentive to devote its time and effort to seeking assets that provide attractive risk-adjusted returns for our portfolio.
This in turn could hurt both our ability to make distributions to our stockholders and the market price of our equity securities.
Our Manager is subject to extensive regulation
as an investment adviser, which could adversely affect its ability to manage our business.
Our Manager is an investment
adviser registered with the SEC and is subject to regulation by various regulatory authorities that are charged with protecting
the interests of its clients, including us. Our Manager could be subject to civil liability, criminal liability or sanction, including
revocation (after it has registered) or denial of its registration as an investment adviser, revocation of the licenses of its
employees, censures, fines or temporary suspension or permanent bar from conducting business, if it is found to have violated any
of laws or regulations applicable to it. Any such liability or sanction could adversely affect its ability to manage our business.
Risks Related to Our Securities
The market price and trading volume of
our securities may vary substantially.
Our common stock is listed
on the NYSE under the symbol “OAKS.” Our Series A Preferred Stock is listed on the NYSE under the symbol “OAKS
PrA.” Stock markets, including the NYSE, have experienced significant price and volume fluctuations over the past several
years. As a result, the market price of our securities has been and is likely to continue to be similarly volatile, and investors
in our securities have experienced since the initial offering of our securities and may continue to experience a decrease in the
value of their securities. Accordingly, no assurance can be given as to the ability of our stockholders to sell their securities
or the price that our stockholders may obtain for their securities.
Some of the factors that
negatively affect the market price of our securities include:
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actual or anticipated variations in our quarterly operating
results;
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changes in our earnings estimates or publication of research
reports about us or the real estate industry;
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changes in market valuations of similar companies;
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adverse market reaction to any increased indebtedness we
incur in the future;
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additions to or departures of our Manager’s key personnel;
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actions by our stockholders;
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speculation in the press or investment community;
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trading prices of common and preferred equity securities
issued by REITs and other similar companies;
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in the case of our Series A Preferred Stock, prevailing
interest rates, increases in which may have an adverse effect on the market price of the Series A Preferred Stock, and the annual
yield from distributions on the Series A Preferred Stock as compared to yields on other financial instruments;
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general economic and financial conditions;
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government action or regulation; and
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our issuance of additional preferred equity or debt securities.
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Market factors unrelated to our performance
could negatively impact the market price of our securities, and broad market fluctuations could also negatively impact the market
price of our securities.
Market factors unrelated
to our performance could negatively impact the market price of our securities. One of the factors that investors may consider in
deciding whether to buy or sell our securities is our distribution rate as a percentage of our stock price relative to market interest
rates. If market interest rates increase, prospective investors may demand a higher distribution rate or seek alternative investments
paying higher distributions or interest. As a result, interest rate fluctuations and conditions in the capital markets can affect
the market value of our securities. In addition, the stock market has experienced extreme price and volume fluctuations that have
affected the market price of many companies in industries similar or related to ours and that have been unrelated to these companies’
operating performances. These broad market fluctuations could reduce the market price of our securities. Furthermore, our operating
results and prospects may be below the expectations of public market analysts and investors or may be lower than those of companies
with comparable market capitalizations, which could lead to a material decline in the market price of our securities.
The performance of our securities may
be affected by the performance of our investments, which may be speculative and aggressive compared to other types of investments.
The investments we make
in accordance with our investment objectives may result in a greater amount of risk as compared to alternative investment options,
including relatively higher risk of volatility or loss of principal. Our investments may be speculative and aggressive, and therefore
an investment in our securities may not be suitable for someone with lower risk tolerance.
One of the factors that
investors may consider in deciding whether to buy or sell shares of our securities is our distribution rate as a percentage of
the trading price of our securities relative to market interest rates and distribution rates of our competitors. If the market
price of our securities is based primarily on the earnings and return that we derive from our investments and income with respect
to our investments and our related distributions to stockholders, and not from the market value of the investments themselves,
then interest rate fluctuations and capital market conditions are likely to affect adversely the market price of our securities.
For instance, if market rates rise without an increase in our distribution rate, the market price of our securities could decrease
as potential investors may require a higher distribution yield on our securities or seek other securities paying higher distributions
or interest. In addition, rising interest rates would result in increased interest expense on our variable rate debt, thereby reducing
cash flow and our ability to service our indebtedness and make distributions to our stockholders.
An increase in interest rates may have
an adverse effect on the market price of our stock and our ability to make distributions to our stockholders.
One of the factors that
investors may consider in deciding whether to buy or sell shares of our stock is our dividend rate, or our future expected dividend
rate, as a percentage of our common stock price, relative to market interest rates. If market interest rates increase, prospective
investors may demand a higher dividend rate on our shares or seek alternative investment paying higher dividends or interest. As
a result, interest rate fluctuations and capital market conditions can affect the market price of our stock independent of the
effects such conditions may have on our portfolio.
We have not established a minimum distribution
payment level on our common stock and we cannot assure you of our ability to make distributions in the future, or that our board
of directors will not reduce distributions in the future regardless of such ability.
We intend to continue
to announce in advance monthly dividends to be paid during each calendar quarter. If substantially all of our taxable income has
not been paid by the close of any calendar year, we intend to declare a special dividend to holders of our common stock prior to
September 15th of the following year, to achieve this result.
Even though our board
of directors has declared these dividends, we have not established a minimum distribution payment level on our common stock and
our ability to make distributions may be adversely affected by the risk factors described in this Annual Report on Form 10-K. All
distributions to our common stockholders will be made at the discretion of our board of directors and will depend on our earnings,
our financial condition, maintenance of our REIT status and such other factors as our board of directors may deem relevant from
time to time. There can be no assurance of our ability to make distributions to our common stockholders, or that our board of directors
will not determine to reduce such distributions, in the future. In addition, some of our distributions to our common stockholders
may continue to include a return of capital.
We may not be able to pay dividends or
other distributions on the Series A Preferred Stock.
Under Maryland law, no
distributions on capital stock may be made if, after giving effect to the distribution, (1) the corporation would not be able to
pay the indebtedness of the corporation as such indebtedness becomes due in the usual course of business or, (2) except in certain
limited circumstances when distributions are made from net earnings, the corporation’s total assets would be less than the
sum of the corporation’s total liabilities plus, unless the charter provides otherwise (which our charter does, with respect
to the Series A Preferred Stock), the amount that would be needed, if the corporation were to be dissolved at the time of the distribution,
to satisfy the preferential rights upon dissolution of stockholders whose preferential rights on dissolution are superior to those
receiving the distribution. There can be no guarantee that we will have sufficient cash to pay dividends on the Series A Preferred
Stock. In addition, payment of our dividends depends upon our earnings, our financial condition, maintenance of our REIT qualification
and other factors as our board of directors may deem relevant from time to time.
We cannot assure you that
our business will generate sufficient cash flow from operations or that future borrowings will be available to us in an amount
sufficient to enable us to make distributions on our securities, to pay our indebtedness or to fund our other liquidity needs.
Future offerings of debt or equity securities
that rank senior to our common stock may adversely affect the market price of our common stock.
If we decide to issue
additional equity securities or to issue debt in the future that rank senior to our common stock, it is likely that they will be
governed by an indenture or other instrument containing covenants restricting our operating flexibility. Additionally, any convertible
or exchangeable securities that we issue in the future may have rights, preferences and privileges more favorable than those of
our common stock and may result in dilution to owners of our common stock. We and, indirectly, our stockholders, will bear the
cost of issuing and servicing such securities. Because our decision to issue debt or equity securities in any future offering will
depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of
our future offerings. Thus holders of our common stock will bear the risk of our future offerings reducing the market price of
our common stock and diluting the value of their stock holdings in us. Furthermore, the compensation payable to our Manager will
increase as a result of future issuances of our equity securities even if the issuances are dilutive to existing stockholders.
The dilutive effect of future issuances
of our common stock could have an adverse effect on the future market price of our common stock or otherwise adversely affect the
interests of our common stockholders.
The warrants issued
to XL Investments on September 29, 2012 entitle XL Investments to purchase an aggregate of 3,753,492 shares of our common
stock (as adjusted for the issuance of stock pursuant to the deficiency dividend), have an adjusted exercise price of $13.11
per share of our common stock (subject to further adjustment and limitation on exercise in certain circumstances),
became exercisable on July 25, 2013 (120 days following the closing of our IPO) and are exercisable for seven years after the
date of the warrants’ issuance. The exercise of the warrants in the future would be dilutive to holders of our common
stock if our book value per share or the market price of our common stock is higher than the exercise price at the time
of exercise. The potential for dilution from the warrants could have an adverse effect on the future market price of our
common stock.
Risks Related to Our Organization and Structure
Maintenance of our exclusion from the
Investment Company Act will impose limits on our business; we have not sought formal guidance from the staff of the SEC as to our
treatment of loans in securitization trusts and there can be no assurance that the staff will not adopt a contrary interpretation
which could cause us to sell material amounts of our assets and to change our investment strategy.
We conduct our business
so as not to become regulated as an investment company under the Investment Company Act. If we were to fall within the definition
of an investment company, we would be unable to conduct our business as described in this Annual Report on Form 10-K. Section 3(a)(1)(A)
of the Investment Company Act defines an investment company as any issuer that is or holds itself out as being engaged primarily
in the business of investing, reinvesting or trading in securities. Section 3(a)(1)(C) of the Investment Company Act also defines
an investment company as any issuer that is engaged or proposes to engage in the business of investing, reinvesting, owning, holding
or trading in securities and owns or proposes to acquire investment securities having a value exceeding 40% of the value of the
issuer’s total assets (exclusive of U.S. Government securities and cash items) on an unconsolidated basis. Excluded from
the term “investment securities,” among other things, in Section 3(a)(1)(C) of the Investment Company Act are U.S.
Government securities and securities issued by majority owned subsidiaries that are not themselves investment companies and are
not relying on the exception from the definition of investment company set forth in Section 3(c)(1) or Section 3(c)(7) of the Investment
Company Act.
We conduct our business
so as not to become regulated as an investment company under the Investment Company Act in reliance on the exclusion provided by
Section 3(c)(5)(C) of the Investment Company Act. Section 3(c)(5)(C), as interpreted by the staff of the SEC, requires us to invest
at least 55% of our assets in “mortgages and other liens on and interest in real estate,” or “qualifying real
estate interests,” and at least 80% of our assets in qualifying real estate interests plus “real estate-related assets.”
In satisfying this 55% requirement, based on SEC staff guidance, we may treat Agency RMBS issued with respect to an underlying
pool of mortgage loans in which we hold all of the certificates issued by the pool as qualifying real estate interests. Neither
the SEC nor its staff has issued guidance with respect to whole pool Non-Agency RMBS. Accordingly, based on our own judgment and
analysis of the SEC staff’s guidance with respect to whole pool Agency RMBS, we may also treat Non-Agency RMBS issued with
respect to an underlying pool of mortgage loans in which we hold all of the certificates issued by the pool as qualifying real
estate interests. We may also treat whole mortgage loans that we acquire directly as qualifying real estate interests provided
that 100% of the loan is secured by real estate when we acquire it and we have the unilateral right to foreclose on the mortgage.
We currently treat partial pool Agency and Non-Agency RMBS as real estate-related assets. We treat any interest rate swaps or other
derivative hedging transactions we enter into as miscellaneous assets that will not exceed 20% of our total assets. We generally
rely on guidance published by the SEC or its staff or on our analyses of guidance published with respect to other types of assets
to determine which assets are qualifying real estate assets and real estate-related assets.
When we acquire (i) 100%
of the expected loss exposure and all of the directing certificate holder’s rights in a K-Series trust; or (ii) 100% of the
subordinated certificates issued by a securitization trust into which we sell loans, which certificates have the sole ability,
inter alia, to foreclose against defaulting loans and have all of the interests in the trust’s expected loss disclosure;
we treat the full amount of loans in the trust as qualifying real estate. When we acquire less than 100% of the subordinated certificates
in a K-Series trust (and accordingly have less than 100% of the trust’s expected loss exposure), we treat our net investment
amount in such trust as real estate related assets. We currently intend not to acquire subordinated certificates issued by any
securitization trust into which we sell loans that cause us as holders to have the ability, inter alia, to foreclose against defaulting
loans. As a result, we will treat our net investment amount in future securitization trusts as real-estate related assets, but
not qualifying real estate interests, even though we may acquire 100% of such subordinated certificates issued by such trusts.
The foregoing treatments
are not based on specific and particular guidance from the SEC staff. Accordingly, there can be no assurance that such treatments,
particularly as to the treatment of the loans in a trust described by “(i)” or “(ii)” above as qualified
real estate interests and in such amounts as described above, will continue to be appropriate. Additionally, we use our net investment
amount in any K-Series trust (rather than the amount of loans in such trust) that is not described by “(i)” above when
calculating whether we continue to meet the requirements of the exclusion provided by Section 3(c)(5)(C) of the Investment Company
Act. If we were required to use the aggregate face amount of loans in any such K-Series trust in making such calculation, it is
likely that the exclusion would no longer be available to us given the large amount of those loans vis a vis our current and expected
holdings of other qualifying real estate interests. Similarly, if we were required to use the aggregate face amount of loans in
future securitization trusts where we own 100% of the subordinated certificates but do not own the rights, inter alia, to foreclose
against defaulting loans, it is likely that the exclusion would no longer be available to us as the aggregate amount of the loans
in such securitization trust increases over time. If the SEC or its staff determines that any of these securities are not qualifying
real estate interests or real estate-related assets, adopts a contrary interpretation with respect to these securities or otherwise
believes we do not satisfy the above exclusions or changes its interpretation of the above exclusions based on our methodology
for calculating compliance or otherwise, we could be required to substantially restructure our activities including selling material
amounts of our assets and to adopt changes to our investment strategy.
Although we monitor our
portfolio for compliance with the Section 3(c)(5)(C) exclusion periodically and prior to each acquisition and disposition, there
can be no assurance that we will be able to maintain this exclusion.
To the extent that we
elect in the future to conduct our operations through majority owned subsidiaries, such business will be conducted in such a manner
as to ensure that we do not meet the definition of investment company under either Section 3(a)(1)(A) or Section 3(a)(1)(C) of
the 1940 Act, because less than 40% of the value of our total assets on an unconsolidated basis would consist of investment securities.
We intend to monitor our portfolio periodically to insure compliance with the 40% test, to the extent we have made such election.
In such case, we would be a holding company which conducts business exclusively through majority owned subsidiaries and we would
be engaged in the non-investment company business of our subsidiaries.
Loss of our exclusion from regulation
pursuant to the Investment Company Act would adversely affect us.
On August 31, 2011, the
SEC issued a concept release requesting comments to a number of matters relating to the Section 3(c)(5)(C) exclusion from the Investment
Company Act, including the nature of assets that qualify for purposes of the exclusion and whether mortgage-related REIT’s
should be regulated as investment companies. There can be no assurance that the laws and regulations governing the Investment Company
Act status of REITs, including guidance and interpretations from the SEC or its staff regarding the Section 3(c)(5)(C) exclusion,
will not change in a manner that adversely affects our operations or business. As a result of this release, the SEC or its staff
may issue new interpretations of the Section 3(c)(5)(C) exclusion causing us to change the way we conduct our businesses, including
changes that may adversely affect our ability to achieve our investment objective. We may be required at times to adopt less efficient
methods of financing certain of our mortgage related investments and we may be precluded from acquiring certain types of higher
yielding securities. The net effect of these factors would be to lower our net interest income. If we fail to qualify for an exemption
from registration as an investment company or an exclusion from the definition of an investment company, our ability to use leverage
would be substantially reduced. Our businesses will be adversely affected if we fail to qualify for an exemption or exclusion from
regulation under the Investment Company Act.
Our authorized but unissued shares of
common and preferred stock may prevent a change in our control.
Our charter authorizes
us to issue additional authorized but unissued shares of common or preferred stock. In addition, our board of directors may, without
stockholder approval, amend our charter to increase the aggregate number of our shares of stock or the number of shares of stock
of any class or series that we have authority to issue and classify or reclassify any unissued shares of common or preferred stock
and set the preferences, rights and other terms of the classified or reclassified shares. As a result, our board of directors may
establish a series of shares of common or preferred stock that could delay or prevent a transaction or a change in control that
might involve a premium price for our shares of common stock or otherwise be in the best interest of our stockholders.
Ownership limitations may restrict change
of control or business combination opportunities in which our stockholders might receive a premium for their shares.
In order for us to maintain
our REIT qualification for each taxable year after December 31, 2012, during the last half of any taxable year no more than 50%
in value of our outstanding capital stock may be owned, directly or indirectly, by five or fewer individuals. “Individuals”
for this purpose include natural persons, private foundations, some employee benefit plans and trusts, and some charitable trusts.
To assist us in maintaining our qualification as a REIT and subject to certain exceptions, our charter generally prohibits any
person from directly or indirectly owning more than 9.8% in value or in number of shares, whichever is more restrictive, of the
outstanding shares of our capital stock or more than 9.8% in value or in number of shares, whichever is more restrictive, of the
outstanding shares of our equity securities. This ownership limitation could have the effect of discouraging a takeover or other
transaction in which holders of our equity securities might receive a premium for their shares over the then prevailing market
price or which holders might believe to be otherwise in their best interests. Our board of directors has granted XL Investments
Ltd an exemption from the 9.8% ownership limitation. As of March 1, 2017, XL Investments Ltd, together with XL Global, Inc., owned
23.1% of our common stock (or 36.7% after giving effect to the exercise of warrants owned by XL Investments Ltd in full, which
became exercisable on July 25, 2013 (120 days following the closing of our IPO)).
Certain provisions of Maryland law may
limit the ability of a third-party to acquire control of our company.
Certain provisions of
the MGCL may have the effect of delaying, deferring or preventing a transaction or a change of control of our company that might
involve a premium price for holders of our equity securities or otherwise be in their best interests.
Subject to certain limitations,
provisions of the MGCL prohibit certain business combinations between us and an “interested stockholder” (defined generally
as any person who beneficially owns 10% or more of the voting power of our outstanding voting stock or an affiliate or associate
of ours who beneficially owned 10% or more of the voting power of our then outstanding stock during the two-year period immediately
prior to the date in question) or an affiliate of the interested stockholder for five years after the most recent date on which
the stockholder became an interested stockholder. After the five-year period, business combinations between us and an interested
stockholder or an affiliate of the interested stockholder must generally either provide a minimum price to our stockholders (as
defined in the MGCL) in the form of cash or other consideration in the same form as previously paid by the interested stockholder
or be recommended by our board of directors and approved by the affirmative vote of at least 80% of the votes entitled to be cast
by holders of our outstanding shares of voting stock and at least two-thirds of the votes entitled to be cast by stockholders other
than the interested stockholder and its affiliates and associates. These provisions of the MGCL relating to business combinations
do not apply, however, to business combinations that are approved or exempted by our board of directors prior to the time that
the interested stockholder becomes an interested stockholder. Pursuant to the statute, our board of directors has by resolution
exempted business combinations between us and any member of the XL group of companies, the parent of which is XL Group Ltd. Consequently,
the five-year prohibition and the supermajority vote requirements will not apply to business combinations with the XL group of
companies. As a result, the members of the XL group of companies may be able to enter into business combinations with us that may
not be in the best interest of our stockholders without compliance by us with the supermajority vote requirements and other provisions
of the statute. However, our board of directors may repeal or modify this exemption at any time in the future, in which case the
applicable provisions of this statute will become applicable to business combinations between us and the XL group of companies.
In addition, pursuant to the statute, our board of directors has by resolution irrevocably exempted the issuance of shares of common
stock to any member of the XL group of companies in connection with the exercise of the warrants issued to XL Investments on September
29, 2012 by any member of the XL group of companies.
The “control share”
provisions of the MGCL provide that holders of “control shares” of a Maryland corporation (defined as shares which,
when aggregated with other shares controlled by the stockholder (except solely by virtue of a revocable proxy), entitle the stockholder
to exercise one of three increasing ranges of voting power in electing directors) acquired in a “control share acquisition”
(defined as the direct or indirect acquisition of ownership or control of “control shares”) have no voting rights with
respect to such shares except to the extent approved by our stockholders by the affirmative vote of at least two-thirds of all
the votes entitled to be cast on the matter, excluding votes entitled to be cast by the acquiror of control shares, our officers
and our employees who are also our directors. Our bylaws contain a provision exempting from the control share acquisition statute
any and all acquisitions by any person of shares of our stock. There can be no assurance that this provision will not be amended
or eliminated at any time in the future.
Additionally, Title 3,
Subtitle 8 of the MGCL permits our board of directors, without stockholder approval and regardless of what is currently provided
in our charter or bylaws, to elect to be subject to certain provisions relating to corporate governance that may have the effect
of delaying, deferring or preventing a transaction or a change of control of our company that might involve a premium to the market
price of our equity securities or otherwise be in our stockholders’ best interests. Upon the completion of our IPO, we became
subject to some of these provisions, either by provisions of our charter and bylaws unrelated to Subtitle 8 or by reason of an
election in our charter to be subject to certain provisions of Subtitle 8.
Stockholders have limited control over
changes in our policies and operations.
Our board of directors
determines our major policies, including with regard to financing, growth, debt capitalization, REIT qualification and distributions.
Our board of directors may amend or revise these and other policies without a vote of the stockholders. Under our charter and the
MGCL, our common stockholders generally have a right to vote only on the following matters:
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the election or removal of directors;
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the amendment of our charter, except that our board of
directors may amend our charter without stockholder approval to:
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change the name or other designation or the par value of
any class or series of stock and the aggregate par value of our stock;
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increase or decrease the aggregate number of shares of
stock that we have the authority to issue; and
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increase or decrease the number of our shares of any class
or series of stock that we have the authority to issue;
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our liquidation and dissolution; and
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our being a party to a merger, consolidation, sale or other
disposition of all or substantially all of our assets or statutory share exchange.
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All other matters are subject to the discretion
of our board of directors.
Our charter contains provisions that
make removal of our directors difficult, which could make it difficult for stockholders to effect changes in management.
Our charter provides that,
subject to the rights of any series of preferred stock, a director may be removed only by the affirmative vote of at least two-thirds
of all the votes entitled to be cast generally in the election of directors. Our charter and bylaws provide that vacancies generally
may be filled only by a majority of the remaining directors in office, even if less than a quorum. These requirements make it more
difficult to change management by removing and replacing directors and may prevent a change in control that is in the best interests
of stockholders.
Our rights and stockholders’ rights
to take action against directors and officers are limited, which could limit recourse in the event of actions not in the best interests
of stockholders.
As permitted by Maryland
law, our charter eliminates the liability of our directors and officers to us and our stockholders for money damages, except for
liability resulting from:
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actual receipt of an improper benefit or profit in money,
property or services; or
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a final judgment based upon a finding of active and deliberate
dishonesty by the director or officer that was material to the cause of action adjudicated.
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In addition, our charter
requires us, to the maximum extent permitted by Maryland law, to indemnify and, without requiring a preliminary determination of
the ultimate entitlement to indemnification, pay or reimburse reasonable expenses in advance of final disposition of a proceeding
to any individual who is a present or former director or officer and who is made or threatened to be made a party to the proceeding
by reason of his or her service in that capacity or any individual who, while a director or officer and at our request, serves
or has served as a director, officer, partner, trustee of another corporation, REIT, partnership, joint venture, trust, employee
benefit plan or any other enterprise and who is made or threatened to be made a party to the proceeding by reason of his or her
service in that capacity. As part of these indemnification obligations, we may be obligated to fund the defense costs incurred
by our directors and officers.
We also are permitted
to purchase and maintain insurance or provide similar protection on behalf of any directors, officers, employees and agents, including
our Manager and its affiliates, against any liability asserted which was incurred in any such capacity with us or arising out of
such status. This may result in us having to expend significant funds, which will reduce the available cash for distribution to
our stockholders.
We have made, and in the future may make,
distributions of offering proceeds, borrowings or the sale of assets to the extent that distributions exceed earnings or cash flow
from our operations.
We have made, and in the
future may make, distributions of offering proceeds, borrowings or the sale of assets to the extent that distributions exceed earnings
or cash flow from our operations. Such distributions reduce the amount of cash we have available for investing and other purposes
and could be dilutive to our financial results. In addition, funding our distributions from our net proceeds may constitute a return
of capital to our investors, which would have the effect of reducing each stockholder’s basis in its shares of equity securities.
Because of its significant ownership
of our common stock, XL Investments has the ability to influence the outcome of matters that require a vote of our stockholders,
including a change of control.
XL Investments holds a
significant interest in our outstanding common stock. As of March 1, 2017, XL Investments, together with XL Global, Inc., owned
23.1% of our common stock (or 36.7% after giving effect to the exercise of warrants owned by XL Investments in full, which became
exercisable on July 25, 2013 (120 days following the closing of our IPO)). As a result, XL Investments potentially has the ability
to influence the outcome of matters that require a vote of our stockholders, including election of our board of directors and other
corporate transactions, regardless of whether others believe that the transaction is in our best interests. We have agreed with
XL Investments that, for so long as XL Investments and any other of the XL group of companies collectively beneficially owns at
least 9.8% of our issued and outstanding common stock (on a fully diluted basis), XL Investments will have the right to appoint
an observer to attend all board meetings, but such observer will have no right to vote at any board meeting. Furthermore, as of
March 1, 2017, XL Global, an affiliate of XL Investments, owns an additional 10,230 shares of our common stock and has a 34.6%
equity interest in our Manager and representatives of XL Global are members of the management committee of our Manager. The investment
management professionals of our Manager are solely responsible for all decisions involving the acquisition, disposition, financing
and hedging of our target assets. None of the XL group of companies nor any of their officers, directors or employees participate
in these decisions.
We are an “emerging growth company”
and the reduced disclosure requirements applicable to emerging growth companies may make it more difficult for you to evaluate
an investment in our company and may make our equity securities less attractive to investors.
In April 2012, President
Obama signed into law the Jumpstart Our Business Startups Act, or the JOBS Act. The JOBS Act contains provisions that, among other
things, relax certain reporting requirements for “emerging growth companies,” including certain requirements relating
to accounting standards and compensation disclosure. We are classified as an emerging growth company. For as long as we are an
emerging growth company, which may be up to December 31, 2018, unlike other public companies, we will not be required to (1) provide
an auditor’s attestation report on management’s assessment of the effectiveness of our system of internal control over
financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act, (2) comply with any new or revised financial accounting
standards applicable to public companies until such standards are also applicable to private companies under Section 102(b)(1)
of the JOBS Act, (3) comply with any new requirements adopted by the Public Company Accounting Oversight Board, or the PCAOB, requiring
mandatory audit firm rotation or a supplement to the auditor’s report in which the auditor would be required to provide additional
information about the audit and the financial statements of the issuer, (4) comply with any new audit rules adopted by the PCAOB
after April 5, 2012 unless the SEC determines otherwise, (5) provide certain disclosure regarding executive compensation required
of larger public companies or (6) hold shareholder advisory votes on executive compensation. We cannot predict if investors will
find our equity securities less attractive because we have chosen to rely on these exemptions. If some investors find our equity
securities less attractive as a result of any choices to reduce future disclosure, there may be a less active trading market for
our equity securities and the stock price of our equity securities may be more volatile.
Under the JOBS Act, emerging
growth companies can delay adopting new or revised accounting standards that have different effective dates for public and private
companies until such time as those standards apply to private companies. We have elected to take advantage of such extended transition
period. Since we will not be required to comply with new or revised accounting standards on the relevant dates on which adoption
of such standards are required for other public companies, our financial statements may not be comparable to the financial statements
of companies that comply with public company effective dates. Our election is irrevocable pursuant to Section 107 of the JOBS Act.
The JOBS Act allows us to postpone the
date by which we must comply with certain laws and regulations intended to protect investors and to reduce the amount of information
we have provided to you in this Annual Report on Form 10-K, which may have an adverse effect on the trading price of our equity
securities.
The JOBS Act is intended
to reduce the regulatory burden on “emerging growth companies.” As defined in the JOBS Act, a public company whose
initial public offering of common equity securities occurred after December 8, 2011 and whose annual gross revenues are less than
$1.0 billion will, in general, qualify as an “emerging growth company” until the earliest of:
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the last day of its fiscal year following the fifth anniversary
of the date of its initial public offering of common equity securities;
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the last day of its fiscal year in which it has annual
gross revenue of $1.0 billion or more;
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the date on which it has, during the previous three-year
period, issued more than $1.0 billion in non-convertible debt; and
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the date on which it is deemed to be a “large accelerated
filer,” which will occur at such time as the company (1) has an aggregate worldwide market value of common equity securities
held by non-affiliates of $700 million or more as of the last business day of its most recently completed second fiscal quarter,
(2) has been required to file annual and quarterly reports under the Exchange Act for a period of at least 12 months, and (3)
has filed at least one Annual Report on Form 10-K pursuant to the Exchange Act.
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Under this definition,
we are an “emerging growth company” and could remain an emerging growth company until as late as December 31, 2018.
The market value of our common stock held by non-affiliates was $66.1 million at December 31, 2016.
As a result, this Annual
Report on Form 10-K includes less information about us than would otherwise be required if we were not an “emerging growth
company,” which may make it more difficult for you to evaluate an investment in our company. We have elected to take advantage
of some or all of the reduced regulatory and reporting requirements applicable to reports and proxy statements that we file with
the SEC in the future, which will be available to us so long as we qualify as an “emerging growth company,” including,
but not limited to, not being required to comply with the auditor attestation requirements of Section 404 of the Sarbanes-Oxley
Act, reduced disclosure obligations regarding executive compensation in our periodic reports and proxy statements, and exemptions
from the requirements of holding a nonbinding advisory vote on executive compensation and shareholder approval of any golden parachute
payments not previously approved. Among other things, this means that our independent registered public accounting firm will not
be required to provide an attestation report on the effectiveness of our internal control over financial reporting so long as we
qualify as an emerging growth company, which may increase the risk that material weaknesses or other deficiencies in our internal
control over financial reporting go undetected. So long as we qualify as an “emerging growth company,” we may elect
not to provide you with certain information, including certain financial information and certain information regarding compensation
of our executive officers, that we would otherwise have been required to provide in filings we make with the SEC, which may make
it more difficult for investors and securities analysts to evaluate our company. As a result, investor confidence in our company
and the market price of our equity securities may be adversely affected.
We are subject to financial reporting
and other requirements for which our accounting, internal audit and other management systems and resources may not be adequately
prepared.
We are subject to reporting
and other obligations under the Exchange Act, including the requirements of Section 404 of the Sarbanes-Oxley Act. These reporting
and other obligations may place significant demands on our management, administrative, operational, internal audit and accounting
resources and cause us to incur significant expenses. We may need to upgrade our systems or create new systems, implement additional
financial and management controls, reporting systems and procedures, expand or outsource our internal audit function and hire additional
accounting, internal audit and finance staff. If we are unable to accomplish these objectives in a timely and effective fashion,
our ability to comply with the financial reporting requirements and other rules that apply to reporting companies could be impaired.
Any failure to maintain effective internal controls could have a material adverse effect on our business, financial condition and
results of operations and our ability to make distributions to our stockholders.
We are required to make critical accounting
estimates and judgments, and our financial statements may be materially affected if our estimates or judgments prove to be inaccurate.
Financial statements prepared
in accordance with GAAP require the use of estimates, judgments and assumptions that affect the reported amounts. Different estimates,
judgments and assumptions reasonably could be used that would have a material effect on our financial statements, and changes in
these estimates, judgments and assumptions are likely to occur from period to period in the future. Significant areas of accounting
requiring the application of management’s judgment include, but are not limited to (1) determining the fair value of our
investments, (2) assessing the adequacy of the allowance for loan losses or credit reserves and (3) appropriately consolidating
VIEs for which we have determined we are the primary beneficiary. These estimates, judgments and assumptions are inherently uncertain,
and, if they prove to be wrong, then we face the risk that charges to income will be required. In addition, because we have limited
operating history in some of these areas and limited experience in making these estimates, judgments and assumptions, the risk
of future charges to income may be greater than if we had more experience in these areas. Any such charges could significantly
harm our business, financial condition, results of operations and our ability to make distributions to our stockholders. See “Management’s
Discussion and Analysis of Financial Condition and Results of Operations-Critical Accounting Policies” for a discussion of
the accounting estimates, judgments and assumptions that we believe are the most critical to an understanding of our business,
financial condition and results of operations.
Tax Risks
If we fail to remain qualified as a REIT,
we will be subject to U.S. federal income tax as a regular corporation and could face a substantial tax liability, which would
reduce the amount of cash available for distribution to our stockholders.
We elected to be taxed
as a REIT commencing with our short taxable year ended December 31, 2012, and to comply with the provisions of the Internal Revenue
Code with respect thereto. Our continued qualification as a REIT will depend on our satisfaction of certain asset, income, organizational,
distribution, stockholder ownership and other requirements on a continuing basis. Our ability to satisfy the asset tests depends
upon our analysis of the characterization and fair market values of our assets, some of which are not susceptible to a precise
determination, and for which we will not obtain independent appraisals. Our compliance with the REIT income and quarterly asset
requirements also depends upon our ability to successfully manage the composition of our income and assets on an ongoing basis.
Further, there can be no assurance that the U.S. Internal Revenue Service, or the IRS, will not contend that our interests in subsidiaries
or in securities of other issuers will not cause a violation of the REIT requirements.
If we were to fail to
maintain our REIT qualification in any taxable year and were not able to qualify for certain statutory relief provisions, we would
be subject to U.S. federal income tax, including any applicable alternative minimum tax, on our taxable income at regular corporate
rates, and dividends paid to our stockholders would not be deductible by us in computing our taxable income. Any resulting corporate
tax liability could be substantial and would reduce the amount of cash available for distribution to our stockholders, which in
turn could have an adverse impact on the value of our equity securities. Unless we were entitled to relief under certain Internal
Revenue Code provisions, we also would be disqualified from re-electing to be taxed as a REIT for the four taxable years following
the year in which we failed to qualify as a REIT.
Dividends payable by REITs do not qualify
for the reduced tax rates available for some dividends.
The maximum tax rate applicable
to income from “qualified dividends” payable to U.S. stockholders that are individuals, trusts and estates is 20%,
exclusive of a 3.8% investment tax surcharge. Dividends payable by REITs, however, generally are not eligible for the reduced rates.
Thus, the more favorable rates applicable to regular corporate qualified dividends could cause investors who are individuals, trusts
and estates to perceive investments in REITs to be relatively less attractive than investments in the stocks of non-REIT corporations
that pay dividends, which could adversely affect the value of the stock of REITs, including our equity securities.
REIT distribution requirements could
adversely affect our ability to execute our business plan.
We generally must distribute
annually at least 90% of our REIT taxable income determined without regard to the deduction for dividends paid and excluding net
capital gain and 90% of our net income, if any, (after tax) from foreclosure property, in order for us to maintain our REIT qualification.
To the extent that we satisfy such distribution requirements but distribute less than 100% of our REIT taxable income we will be
subject to U.S. federal income tax on our undistributed taxable income. In addition, we will be subject to a 4% nondeductible excise
tax if the actual amount that we pay out to our stockholders in a calendar year is less than a minimum amount specified under U.S.
federal income tax laws. We intend to make distributions to our stockholders to comply with the REIT requirements of the Internal
Revenue Code.
From time to time, differences
in timing between our recognition of taxable income and our actual receipt of cash may occur. If we do not have other funds available
in these situations we could be required to borrow funds on unfavorable terms, sell investments at disadvantageous prices or distribute
amounts that would otherwise be invested in future acquisitions, capital expenditures or repayment of debt, make a taxable distribution
of our shares as part of a distribution in which stockholders may elect to receive shares or (subject to certain limits) cash or
use cash reserves, in order to make distributions sufficient to enable us to pay out enough of our taxable income to satisfy the
REIT distribution requirement and to avoid the U.S. federal income tax and the 4% excise tax in a particular year. These alternatives
could increase our costs or reduce our equity. Thus, compliance with the REIT requirements may hinder our ability to grow, which
could adversely affect the value of our equity securities.
Even if we remain qualified as a REIT,
we may face other tax liabilities that reduce our cash flow.
Even if we remain qualified
for taxation as a REIT, we may be subject to certain U.S. federal, state and local taxes on our income and assets, including taxes
on any undistributed income, tax on income from some activities conducted as a result of a foreclosure, and state or local income,
property and transfer taxes, such as mortgage recording taxes. Any of these taxes would decrease cash available for distribution
to our stockholders.
Complying with REIT requirements may
cause us to forgo otherwise attractive opportunities and may require us to dispose of our target assets sooner than originally
anticipated.
To maintain our qualification
as a REIT, we must satisfy five tests relating to the nature of our assets at the end of each calendar quarter. First, at least
75% of the value of our total assets must consist of cash, cash items, government securities and real estate assets, including
certain mortgage loans and securities and debt instruments issued by publicly offered REITs. Second, we may not own more than 10%
of any one issuer’s outstanding securities, as measured by either value or voting power. Third, no more than 5% of the value
of our total assets can consist of the securities of any one issuer. Fourth, with respect to taxable years beginning before January
1, 2018, no more than 25% of the value of our total assets can be represented by securities of one or more TRSs, and with respect
to taxable years beginning on and after January 1, 2018, no more than 20% of our total assets can be represented by securities
of one or more TRSs. Fifth, not more than 25% of our assets may consist of debt instruments issued by publicly offered REITs to
the extent that such debt instruments constitute “real estate assets” for purposes of the 75% asset test described
above only because of the express inclusion of “debt instruments issued by publicly offered REITs” in the definition.
If we fail to comply with these requirements at the end of any calendar quarter, we will lose our REIT qualification unless we
are able to qualify for certain statutory relief provisions, which may involve paying taxes and penalties. In order to comply with
the asset tests, we may be required to liquidate from our investment portfolio otherwise attractive investments. These actions
could have the effect of reducing our income and the amount available for distribution to our stockholders.
In addition to the asset
tests set forth above, to maintain our REIT qualification, we must continually satisfy tests concerning, among other things, the
sources of our income, the amounts we distribute to our stockholders and the ownership of our stock. We may be unable to pursue
investments that would be otherwise advantageous to us in order to satisfy the income test, the asset tests, and the other REIT
requirements. Thus, compliance with the REIT requirements may hinder our ability to make certain attractive investments.
We may be required to report taxable
income for certain investments in excess of the economic income we ultimately realize from them.
We may continue to acquire
mortgage-backed securities in the secondary market for less than their face amount. In addition, as a result of our ownership of
certain mortgage-backed securities, we may be treated for tax purposes as holding certain debt instruments acquired in the secondary
market for less than their face amount. The discount at which such securities or debt instruments are acquired may reflect doubts
about their ultimate collectability rather than current market interest rates. The amount of such discount will nevertheless generally
be treated as “market discount” for U.S. federal income tax purposes. Accrued market discount is generally reported
as income when, and to the extent that, any payment of principal of the mortgage-backed security or debt instrument is made. If
we collect less on the mortgage-backed security or debt instrument than our purchase price plus the market discount we had previously
reported as income, we may not be able to benefit from any offsetting loss deductions.
In addition, as a result
of our ownership of certain mortgage-backed securities, we may be treated for tax purposes as holding distressed debt investments
that are subsequently modified by agreement with the borrower. If the amendments to the outstanding debt are “significant
modifications” under applicable U.S. Treasury Department regulations, the modified debt may be considered to have been reissued
to us at a gain in a debt-for-debt exchange with the borrower. In that event, we may be required to recognize taxable gain to the
extent the principal amount of the modified debt exceeds our adjusted tax basis in the unmodified debt, even if the value of the
debt or the payment expectations have not changed.
Moreover, some of the
mortgage-backed securities that we acquire may have been issued with original issue discount. We will be required to report such
original issue discount based on a constant yield method and will be taxed based on the assumption that all future projected payments
due on such mortgage-backed securities will be made. If such mortgage-backed securities turn out not to be fully collectable, an
offsetting loss deduction will become available only in the later year that uncollectability is provable.
Finally, in the event
that mortgage-backed securities or any debt instruments we are treated for tax purposes as holding as a result of our investments
in mortgage-backed securities are delinquent as to mandatory principal and interest payments, we may nonetheless be required to
continue to recognize the unpaid interest as taxable income as it accrues, despite doubt as to its ultimate collectability. Similarly,
we may be required to accrue interest income with respect to subordinate mortgage-backed securities at the stated rate regardless
of whether corresponding cash payments are received or are ultimately collectable. In each case, while we would in general ultimately
have an offsetting loss deduction available to us when such interest was determined to be uncollectable, the utility of that deduction
could depend on our having taxable income in that later year or thereafter.
Certain apportionment rules may affect
our ability to comply with the REIT asset and gross income tests.
The Internal Revenue Code
provides that a regular or a residual interest in a real estate mortgage investment conduit, or REMIC, is generally treated as
a real estate asset for the purpose of the REIT asset tests, and any amount includible in our gross income with respect to such
an interest is generally treated as interest on an obligation secured by a mortgage on real property for the purpose of the REIT
gross income tests. If, however, less than 95% of the assets of a REMIC in which we hold an interest consist of real estate assets
(determined as if we held such assets), we will be treated as holding our proportionate share of the assets of the REMIC for the
purpose of the REIT asset tests and receiving directly our proportionate share of the income of the REMIC for the purpose of determining
the amount of income from the REMIC that is treated as interest on an obligation secured by a mortgage on real property. In connection
with the expanded Agency RMBS-backed HARP loan program , the IRS issued guidance providing that, among other things, if a REIT
holds a regular interest in an “eligible REMIC,” or a residual interest in an “eligible REMIC” that informs
the REIT that at least 80% of the REMIC’s assets constitute real estate assets, then the REIT may treat 80% of the interest
in the REMIC as a real estate asset for the purpose of the REIT income and asset tests. Although the portion of the income from
such a REMIC interest that does not qualify for purposes of the REIT 75% gross income test would likely be qualifying income for
the purpose of the 95% REIT gross income test, the remaining 20% of the REMIC interest generally would not qualify as a real estate
asset and the income therefrom generally would not qualify for purposes of the 75% REIT gross income test, which could adversely
affect our ability to satisfy the REIT income and asset tests. Accordingly, owning such a REMIC interest could adversely affect
our ability to maintain our REIT qualification.
The “taxable mortgage pool”
rules may increase the taxes that we or our stockholders may incur, and may limit the manner in which we effect future securitizations.
Securitizations by us
or our subsidiaries could result in the creation of taxable mortgage pools for U.S. federal income tax purposes, resulting in “excess
inclusion income.” As a REIT, so long as we own 100% of the equity interests in a taxable mortgage pool, we generally would
not be adversely affected by the characterization of the securitization as a taxable mortgage pool. Certain categories of stockholders,
however, such as non-U.S. stockholders eligible for treaty or other benefits, stockholders with net operating losses, and certain
tax-exempt U.S. stockholders that are subject to unrelated business income tax, could be subject to increased taxes on a portion
of their dividend income from us that is attributable to the excess inclusion income. In the case of a stockholder that is a REIT,
a regulated investment company, or RIC, common trust fund or other pass-through entity, our allocable share of our excess inclusion
income could be considered excess inclusion income of such entity. In addition, to the extent that our stock is owned by tax-exempt
“disqualified organizations,” such as certain government-related entities and charitable remainder trusts that are
not subject to tax on unrelated business income, we may incur a corporate level tax on a portion of any excess inclusion income.
Because this tax generally would be imposed on us, all of our stockholders, including stockholders that are not disqualified organizations,
generally would bear a portion of the tax cost associated with the classification of us or a portion of our assets as a taxable
mortgage pool. A RIC, or other pass-through entity owning our stock in record name will be subject to tax at the highest U.S. federal
corporate tax rate on any excess inclusion income allocated to their owners that are disqualified organizations. Moreover, we could
face limitations in selling equity interests in these securitizations to outside investors, or selling any debt securities issued
in connection with these securitizations that might be considered to be equity interests for tax purposes. Finally, if we were
to fail to maintain our REIT qualification, any taxable mortgage pool securitizations would be treated as separate taxable corporations
for U.S. federal income tax purposes that could not be included in any consolidated U.S. federal income tax return. These limitations
may prevent us from using certain techniques to maximize our returns from securitization transactions.
Our ability to invest in and dispose
of “to be announced” securities could be limited by our election to be subject to tax as a REIT.
We purchase agency mortgage
investments through TBAs and may recognize income or gains from the disposition of those TBAs, through dollar roll transactions
or otherwise. There is no direct authority with respect to the qualification of TBAs as real estate assets or U.S. Government securities
for purposes of the 75% asset test or the qualification of income or gains from dispositions of TBAs as gains from the sale of
real property (including interests in real property and interests in mortgages on real property) or other qualifying income for
purposes of the 75% gross income test, and we would not treat these items as qualifying assets or income (as the case may be) unless
we receive a reasoned, written opinion (within the meaning of applicable U.S. Treasury Department regulations) of our counsel that
such items should be treated as qualifying assets or income. Consequently, our ability to enter into dollar roll transactions and
other dispositions of TBAs could be limited. Moreover, even if we were to receive the opinion of counsel described above, it is
possible that the IRS could assert that such assets or income are not qualifying assets or income, which could cause us to fail
the 75% asset test or the 75% gross income test.
The failure of securities subject to
repurchase agreements to qualify as real estate assets could adversely affect our ability to maintain our REIT qualification.
We enter into financing
arrangements that are structured as sale and repurchase agreements pursuant to which we would nominally sell certain of our securities
to a counterparty and simultaneously enter into an agreement to repurchase these securities at a later date in exchange for a purchase
price. Economically, these agreements are financings which are secured by the securities sold pursuant thereto. We believe that
we would be treated for REIT asset and income test purposes as the owner of the securities that are the subject of any such sale
and repurchase agreement notwithstanding that such agreements may transfer record ownership of the securities to the counterparty
during the term of the agreement. It is possible, however, that the IRS could assert that we did not own the securities during
the term of the sale and repurchase agreement, in which case we could fail to maintain our REIT qualification.
Liquidation of our assets may jeopardize
our REIT qualification.
To maintain our qualification
as a REIT, we must comply with requirements regarding our assets and our sources of income. If we are compelled to liquidate our
investments to repay obligations to our lenders, we may be unable to comply with these requirements, ultimately jeopardizing our
qualification as a REIT, or we may be subject to a 100% tax on any resultant gain if we sell assets that are treated as dealer
property or inventory.
Complying with REIT requirements may
limit our ability to hedge effectively and may cause us to incur tax liabilities.
The REIT provisions of
the Internal Revenue Code substantially limit our ability to hedge our assets and liabilities. Under these provisions, any income
from a hedging transaction we enter into to manage risk of interest rate changes with respect to borrowings made or to be made
to acquire or carry real estate assets does not constitute “gross income” for purposes of the 75% or 95% gross income
tests, if certain requirements are met. To the extent that we enter into other types of hedging transactions, the income from those
transactions is likely to be treated as non-qualifying income for purposes of both of the REIT gross income tests.
Qualifying as a REIT involves highly
technical and complex provisions of the Internal Revenue Code.
Qualification as a REIT
involves the application of highly technical and complex Internal Revenue Code provisions for which only limited judicial and administrative
authorities exist. Even a technical or inadvertent violation could jeopardize our REIT qualification. Our qualification as a REIT
will depend on our satisfaction of certain asset, income, organizational, distribution, stockholder ownership and other requirements
on a continuing basis. In addition, our ability to satisfy the requirements to maintain our REIT qualification depends in part
on the actions of third parties over which we have no control or only limited influence, including in cases where we own an equity
interest in an entity that is classified as a partnership for U.S. federal income tax purposes. Thus, while we intend to continue
to operate so that we will qualify as a REIT, given the highly complex nature of the rules governing REITs, the ongoing importance
of factual determinations, and the possibility of future changes in our circumstances, no assurance can be given that we will maintain
our qualification for any particular year.
We may incur a significant tax liability
as a result of selling assets that might be subject to the prohibited transactions tax if sold directly by us.
A REIT’s net income
from “prohibited transactions” is subject to a 100% tax. In general, “prohibited transactions” are sales
or other dispositions of assets held primarily for sale to customers in the ordinary course of business. There is a risk that certain
loans that we are treating as owning for U.S. federal income tax purposes and certain property received upon foreclosure of these
loans will be treated as held primarily for sale to customers in the ordinary course of business. Although we expect to avoid the
prohibited transactions tax by contributing those assets to one of our TRSs and conducting the marketing and sale of those assets
through that TRS, no assurance can be given that the IRS will respect the transaction by which those assets are contributed to
our TRS. Even if those contribution transactions are respected, our TRS will be subject to U.S. federal, state and local corporate
income tax and may incur a significant tax liability as a result of those sales.
We may be subject to adverse legislative
or regulatory tax changes that could reduce the market price of shares of our equity securities.
At any time, the U.S.
federal income tax laws or regulations governing REITs or the administrative interpretations of those laws or regulations may be
changed, possibly with retroactive effect. We cannot predict if or when any new U.S. federal income tax law, regulation or administrative
interpretation, or any amendment to any existing U.S. federal income tax law, regulation or administrative interpretation, will
be adopted, promulgated or become effective or whether any such law, regulation or interpretation may take effect retroactively.
We and our stockholders could be adversely affected by any such change in, or any new, U.S. federal income tax law, regulation
or administrative interpretation.
Distributions to tax-exempt investors
may be classified as unrelated business taxable income, or UBTI, as defined under Section 512(a) of the Internal Revenue Code.
Neither ordinary nor capital
gain distributions with respect to our stock nor gain from the sale of stock should generally constitute UBTI to a tax-exempt investor.
However, there are certain exceptions to this rule, including: (1) part of the income and gain recognized by certain qualified
employee pension trusts with respect to our stock may be treated as UBTI if shares of our stock are predominantly held by qualified
employee pension trusts, and we are required to rely on a special look-through rule for purposes of meeting one of the REIT ownership
tests, and we are not operated in a manner to avoid treatment of such income or gain as UBTI; (2) part of the income and gain recognized
by a tax-exempt investor with respect to our stock would constitute UBTI if the investor incurs debt in order to acquire the stock;
(3) part or all of the income or gain recognized with respect to our stock by social clubs, voluntary employee benefit associations,
supplemental unemployment benefit trusts and qualified group legal services plans which are exempt from U.S. federal income taxation
under the Internal Revenue Code may be treated as UBTI; and (4) to the extent that we are (or a part of us, or a disregarded subsidiary
of ours, is) a “taxable mortgage pool,” or if we hold residual interests in a REMIC, a portion of the distributions
paid to a tax-exempt stockholder that is allocable to excess inclusion income may be treated as UBTI.
The value of our assets represented by
our TRS is required to be limited and a failure to comply with this and certain other rules governing transactions between a REIT
and its TRSs would jeopardize our REIT qualification and may result in the application of a 100% excise tax.
A REIT may own up to 100%
of the stock of one or more TRSs. Other than certain activities relating to lodging and healthcare facilities, a TRS generally
may engage in any business and may hold assets and earn income that would not be qualifying assets or income if held or earned
directly by a REIT. With respect to taxable years beginning prior to January 1, 2018, no more than 25% of the value of a REIT’s
assets may consist of stock or securities of one or more TRSs. With respect to taxable years beginning on and after January 1,
2018, no more than 20% of the value of a REIT’s assets may consist of stock or securities of one or more TRSs. In addition,
the TRS rules limit the deductibility of interest paid or accrued by a TRS to its parent REIT to assure that the TRS is subject
to an appropriate level of corporate taxation. The rules also impose a 100% excise tax on certain transactions between a TRS and
its parent REIT, or by a TRS on behalf of its parent REIT, that are not conducted on an arm’s-length basis.
Our current TRS, and any
future TRSs, will pay U.S. federal, state and local income tax on their respective taxable incomes, if any. We anticipate that
the aggregate value of the securities of our TRS will continue to be less than 25% of the value of our total assets (including
our TRS securities) with respect to taxable years beginning prior to January 1, 2018 and less than 20% of the value of our total
assets (including our TRS securities) with respect to taxable years beginning on and after January 1, 2018. Furthermore, we intend
to monitor the value of our investments in our TRS for the purpose of ensuring compliance with TRS-ownership limitations. In addition,
we will review all our transactions with our TRS to ensure that they are entered into on arm’s-length terms to avoid incurring
the 100% excise tax described above. There can be no assurance, however, that we will be able to continue to comply with the TRS-ownership
limitation or to avoid application of the 100% excise tax discussed above.
Your investment has various U.S. federal
income tax risks.
We urge you to consult
your tax advisor concerning the effects of U.S. federal, state, local and foreign tax laws to you with regard to an investment
in shares of our stock.