Item 2.
Management’s Discussion and Analysis o
f Financial Condition and Results of Operations
Unless the context otherwise requires or provides, references in this Quarterly Report on Form 10-Q to “we,” “us,” “our” and the “Company” refer to Arlington Asset Investment Corp. (“Arlington Asset”) and its subsidiaries. This discussion and analysis should be read in conjunction with our financial statements and accompanying notes included in Item 1 of this Quarterly Report on Form 10-Q, as well as our audited consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2015.
The discussion of our consolidated financial condition and results of operations below may contain forward-looking statements. These statements, which reflect management’s beliefs and expectations, are subject to risks and uncertainties that may cause actual results to differ materially. For a discussion of the risks and uncertainties that may affect our future results, please see “Cautionary Statement About Forward-Looking Information” in Item 3 of Part I of this Quarterly Report on Form 10-Q and the risk factors included in Item 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2015.
Our Company
We are a principal investment firm that currently acquires and holds a levered portfolio of residential mortgage-backed securities (“MBS”), consisting of agency MBS and private-label MBS. Agency MBS include residential mortgage pass-through certificates for which the principal and interest payments are guaranteed by a U.S. government agency or government sponsored enterprise (“GSE”), such as the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”). Private-label MBS, or non-agency MBS, include residential MBS that are not guaranteed by a GSE or the U.S. government.
We leverage prudently our investment portfolio so as to increase potential returns to our shareholders. We fund our investments primarily through short-term financing arrangements, principally through repurchase agreements. We enter into various hedging transactions to mitigate the interest rate sensitivity of our cost of borrowing and the value of our MBS portfolio.
We are a Virginia corporation and taxed as a C corporation for U.S. federal tax purposes. We are an internally managed company and do not have an external investment advisor.
Factors that Affect our Results of Operations and Financial Condition
Our business is materially affected by a variety of industry and economic factors, including:
|
·
|
conditions in the global financial markets and economic conditions generally;
|
|
·
|
changes in interest rates and prepayment rates;
|
|
·
|
actions taken by the U.S. government, U.S. Federal Reserve, the U.S. Treasury and foreign central banks;
|
|
·
|
changes in laws and regulations and industry practices; and
|
|
·
|
other market developments.
|
Current Market Conditions and Trends
During the three months ended March 31, 2016, market conditions were characterized by significant continued volatility. Lower global demand and inventory buildups continued to exert downward pressure on oil prices, hedge fund redemptions put pressure on the leveraged credit market generally, and weak international trade data and uncertainty as to bank liquidity added to uncertainty for global growth for the rest of the year. Global economic growth remains tepid, but it is expected the global environment will stabilize and slowly expand over the course of 2016 with many indicators of global manufacturing activity showing signs that global trade and industrial activity may have bottomed.
On December 16, 2015, the Federal Open Market Committee of the U.S. Federal Reserve (the “Federal Reserve”) announced that it was increasing the target Federal Funds rate by 0.25%. In its announcement, the Federal Reserve cautioned capital markets to anticipate the possibility of additional increases in the Federal Funds rate in 2016, depending upon future growth in inflation and other economic indicators. On April 27, 2016, the Federal Reserve announced that it was maintaining a target Federal Funds rate range of 0.25% and 0.50%, initially set in December 2015. Unlike prior statements released after recent committee meetings, the Federal Reserve did not indicate in its April 27, 2016 release that it views global economic and financial developments and conditions as posing immediate risks. Foreign central banks have taken an increasingly accommodative stance over the past few quarters, and many
27
market participants are increasingly skeptical of the number and amount of any increases in the Federal Funds rate in the foreseeable future. We cannot predict the actions of the Federal Reserve for the rest of 2016, but
we believe that any additional increases to the Federal Funds rate will be subject to economic, fiscal and monetary data developments.
We believe that the housing market will continue its slow and steady recovery driven by years of under production, tight inventory levels, attractive interest rates, reasonable affordability levels, high rental occupancy rates and the lowest unemployment levels since 2008 despite recent global economic concerns and volatility in the stock market. The new home market continues to have significant pent-up demand, which we believe positions us well for years to come. Notwithstanding these positive trends, home sales and new single-family home construction remain relatively below pre-financial crisis levels due, in part, to mortgage lending rules implemented under the Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) and bank conservatism in efforts to, among other things, prevent future MBS repurchase requests. These factors have created a decline in new home mortgage origination, resulting in low agency MBS issuance. The Federal Reserve’s purchases of agency MBS through reinvesting principal and interest payments it receives on its existing agency MBS portfolio have continued to influence the agency MBS markets, where many participants perceive a lack of liquidity. While the Federal Reserve has not indicated when it will cease or reduce its agency MBS purchases by reinvesting principal and interest payments, private banks have less incentive to purchase MBS issued by Freddie Mac and Fannie Mae, as the Basel III liquidity coverage ratio rules provide lower quality liquid asset credit for such securities on their balance sheet than for cash, U.S. Treasuries and MBS issued by the Government National Mortgage Association (“Ginnie Mae”).
While there are signs that slow and steady economic growth will continue to persist in the United States, uncertainty continues to dominate the market. We believe the general business environment will continue to be challenging for the rest of 2016. Our growth outlook is dependent, in part, on the strength of the financial markets, the impact of fiscal and monetary policy actions by the United States and other countries, and liquidity in the financial system. We will continue to closely monitor the developments in the market and evaluate the opportunities across the spectrum in the mortgage industry and other types of assets in a continuing effort to seek the highest risk-adjusted returns for our capital.
Recent Government Activity
On January 12, 2016, the Federal Housing Finance Agency (“FHFA”) issued a final rule - RIN 2590-AA39, Members of Federal Home Loan Banks. The final rule, among other things, expressly excludes captive insurance companies, such as our wholly-owned captive insurance subsidiary, Key Bridge Insurance, LLC (“Key Bridge”), from being eligible for membership in the Federal Home Loan Bank (“FHLB”) system. Under the final rule, there is a one-year transition period from the effective date of the final rule of February 19, 2016 within which the FHLBs must wind down their relationships with any captive insurance companies that had been admitted to membership on or after September 12, 2014, including Key Bridge. The final rule also precludes the FHLBs from making any new advances or extending existing advances. In addition, upon the termination of membership, the FHLBs must liquidate all outstanding advances to captive insurance companies, settle all other business transactions, and repurchase or redeem all FHLB stock held by the terminated captive insurance company in accordance with the final rule. Therefore, Key Bridge, along with all other captive insurance companies, must completely wind down all business relationships with the FHLB of Cincinnati (“FHLBC”), including the repayment of all outstanding advances, prior to or simultaneously with the termination of Key Bridge’s membership with the FHLBC. As of March 31, 2016, Key Bridge has repaid all of its outstanding FHLBC advances.
We expect debate and discussion on residential housing and mortgage reform to continue over the next few years; however, we cannot be certain if or when any housing finance reform bill will emerge from committee or be approved by Congress, and if so, what the effects may be. Historically, significant legislation has been difficult to pass in a presidential election year, and we cannot predict what effect the 2016 election cycle will have on the progress of housing finance reform legislation.
Executive Summary
In the first quarter, the Company changed its accounting policy for recognizing interest income on its investments in agency MBS by amortizing purchase premiums as an adjustment to interest income in accordance with the interest method permitted by GAAP. The Company believes that this change in accounting policy results in a reported interest income measure that better reflects the economic yield of its investments, including a better reflection of the economic effect of principal prepayments in the period in which those prepayments occur, and that this change in accounting policy enhances the comparability of its reported financial results to those of its peers. Also during the first quarter, the Company revised its presentation of non-GAAP core operating income, which now reflects the change in accounting policy for recognizing interest income. The Company believes that its non-GAAP core operating income provides investors with additional insight into the current performance of its investment portfolio and is a key measure used by the Company’s Board of Directors in determining the appropriate level of dividends to shareholders.
Since the Company’s fixed-rate agency MBS have generally been purchased at a premium to par value, high prepayments can have a meaningful negative impact on the Company’s asset yields and interest income, while slow prepayments can have a meaningful
28
positive impact. In order to manage our exposure to prepayment risk on our agency MBS, the Company continues to invest in specified agency MBS that are speci
fically selected for their relatively lower propensity for prepayment.
The actual constant prepayment rate (“CPR”) for the Company’s agency MBS was 8.14% for the first quarter of 2016, resulting in an average asset yield of 2.93%
.
The Company also continues to have ample repurchase agreement financing available to fund its agency MBS from multiple counterparties at rates we continue to consider to be attractive.
In addition to investing in specified agency MBS, the Company also purchases to-be-announced (“TBA”) forward contracts as a means of investing in and financing non-specified agency MBS, commonly referred to as TBA “dollar roll” transactions. TBA dollar roll income is considered the economic equivalent of the net interest income that results from investing in specified agency MBS financed with a repurchase agreement. Under GAAP, the Company accounts for its TBA securities as derivative instruments and, as a result, TBA dollar roll income is not included in net interest income determined in accordance with GAAP. However, the Company includes TBA dollar roll income in its computation of non-GAAP core operating income. During the first quarter of 2016, the Company increased the allocation of its agency TBAs within its overall agency investment portfolio, resulting in a greater amount of TBA dollar roll income as compared to prior periods. For the first quarter of 2016, the Company reported TBA dollar roll income of $3.8 million.
The Company constantly monitors its allocation of its available capital between agency MBS and private-label MBS in an effort to maximize returns to its shareholders. As of March 31, 2016, the Company’s available capital was allocated approximately 77% to agency MBS and 23% to private-label MBS, compared to 80% to agency MBS and 20% to private-label MBS as of December 31, 2015. During the first quarter of 2016, the Company’s private-label MBS generated interest income of $3.0 million and an average asset yield of 10.3%.
As a result of the relatively benign prepayment environment and the resulting strong and stable yield generated by the Company’s investments, the Company reported non-GAAP core operating income of $0.80 per diluted share for the first quarter of 2016. The consistent returns generated by its investment portfolio enabled the Company to continue to pay a distribution to shareholders of $0.625 per share for the first quarter of 2016 despite a $0.05 per diluted share increase in the Company’s cost of short-term funding relative to the prior quarter following the Federal Reserve’s December rate increase.
During the first quarter, the market experienced persistent interest rate volatility and widening of MBS spreads. The 10-year U.S. Treasury rate experienced its largest quarterly decline in 15 quarters, decreasing from 2.27% as of December 31, 2015 to 1.78% as of March 31, 2016, and experienced significant volatility within the quarter. While the Company maintains a portfolio of interest rate hedging instruments designed and structured to protect the fair value of its agency MBS portfolio from a rise in interest rates, the Company’s hedging instruments are not generally designed to protect the Company’s net book value from spread risk, which is the risk of an increase of the market spread between the yield on agency MBS and the benchmark yield on U.S. Treasury securities or interest rate swaps. The option-adjusted spread (“OAS”), a common measure of the spread between a fixed income security yield and a risk-free rate that takes into consideration the impact of interest rate volatility and prepayment risk in residential MBS, widened significantly during the quarter. For example, the Fannie Mae 4.0% 30-year OAS widened approximately 15 basis points during the quarter.
Due primarily to the significant decrease in long-term interest rates and widening of MBS spreads that occurred during the quarter, the Company experienced a decline in book value. As of March 31, 2016, the Company’s book value was $18.86 per share compared to $21.05 per share as of December 31, 2015. The Company’s tangible book value, which is calculated as shareholders’ equity less the Company’s net deferred tax asset, was $14.45 per share as of March 31, 2016 compared to $16.81 per share as of December 31, 2015.
The Company continues execute on its consistent interest rate hedging strategy that is well-positioned for a rise in interest rates and is best situated to protect the Company’s book value and earnings potential over the long-term. In a falling interest rate and a rising spread environment such as this past quarter, this hedging strategy will likely result in a temporary decline in book value; however, the Company would expect that the temporary decline in book value would be recovered over time either through higher future spread earnings if rates remain low and spreads are wide, or through a reversal of this temporary decline in book value if rates rise and spreads narrow. Conversely, if the Company did not have an adequate interest rate hedge position in a rising interest rate environment, the Company would experience both a substantial decline in book value and higher future cost of funding resulting in a potential permanent loss of book value.
Consistent with its hedging strategy, the Company modified some of the components of its hedge position during the first quarter by purchasing put options on 10-year U.S. Treasury note futures that will continue to provide the Company with protection against a significant rise in interest rates while also reducing future book value volatility in a falling interest rate environment.
Non-GAAP Core Operating Income
In addition to the Company’s results of operations determined in accordance with generally accepted accounting principles as consistently applied in the United States (“GAAP”), the Company computed “non-GAAP core operating income” for the three months
29
ended March 31, 2016. Beginning in the first quarter of 2016, the Company defines core operating income as “economic net interest income” less “core general and administra
tive expenses.”
Economic Net Interest Income
Economic net interest income is comprised of the following: periodic (i) net interest income determined in accordance with GAAP, (ii) TBA agency MBS “dollar roll” income, and (iii) net interest income or expense incurred from interest rate swap agreements.
|
·
|
Net interest income determined in accordance with GAAP
. Net interest income determined in accordance with GAAP primarily represents the interest income recognized from the Company’s investments in specified agency MBS and private-label MBS (including the amortization of purchase premiums and accretion of purchase discounts), net of the interest expense incurred from repurchase agreement financing arrangements or other short- and long-term borrowing transactions. In the first quarter of 2016, the Company implemented a change in its accounting policy for recognizing interest income on its investments in agency MBS classified as trading securities by amortizing purchase premiums (or accreting purchase discounts) as an adjustment to interest income in accordance with the “interest method” permitted by GAAP.
|
|
·
|
TBA agency MBS dollar roll income
. Dollar roll income represents the economic equivalent of net interest income (implied interest income net of financing costs) generated from the Company’s investments in non-specified fixed-rate agency MBS, executed through sequential series of forward-settling purchase and sale transactions that are settled on a net basis (known as “dollar roll” transactions). Dollar roll income is generated as a result of delaying, or “rolling,” the settlement of a forward-settling purchase of a TBA agency MBS by entering into an offsetting “spot” sale prior to the settlement date, net settling the “paired-off” positions in cash, and contemporaneously entering another forward-settling purchase of a TBA agency MBS of the same essential characteristics for a later settlement date at a price discount relative to the “spot” sale. The price discount of the forward-settling purchase relative to the “spot” sale represents the economic equivalent of net interest income that is earned ratably over the period beginning on the settlement date of the sale and ending on the settlement date of the forward-settling purchase. In the Company’s consolidated statements of comprehensive income prepared in accordance with GAAP, TBA agency MBS dollar roll income is reported as a component of the overall periodic change in the fair value of TBA forward commitments within the line item “gain (loss) from derivative instruments, net” of the “investment gain (loss), net” section.
|
|
·
|
Net interest income or expense incurred from interest rate swap agreements
. The Company utilizes centrally-cleared interest rate swap agreements to economically hedge a portion of its exposure to variability in future interest cash flows, attributable to changes in benchmark interest rates, associated with future roll-overs of its short-term financing arrangements. Accordingly, the net interest income or expense (commonly referred to as “net interest carry”) incurred from the Company’s interest rate swap agreements in combination with interest expense recognized in accordance with GAAP represents the Company’s effective “economic interest expense.” In the Company’s consolidated statements of comprehensive income prepared in accordance with GAAP, the net interest income or expense incurred from interest rate swap agreements is reported as a component of the overall periodic change in the fair value of derivative instruments within the line item “gain (loss) from derivative instruments, net” of the “investment gain (loss), net” section.
|
Core General and Administrative Expenses
Core general and administrative expenses are non-interest expenses reported within the line item “total other expenses” of the consolidated statements of comprehensive income less stock-based compensation expense. For the three months ended March 31, 2016, core general and administrative expenses also exclude non-recurring expenses related to the 2016 proxy contest that are in excess of those normally incurred for an annual meeting of shareholders. For information about the 2016 proxy contest, refer to “Item 1A. Risk Factors” within this quarterly report.
30
Non-GAAP Core Operating Income
for the Three Months Ended March 31, 201
6
The following table presents the Company’s computation of core operating income for the three months ended March, 31, 2016 (amounts in thousands, except per share amounts):
|
|
Three Months Ended
|
|
|
|
March 31, 2016
|
|
GAAP net interest income
|
|
$
|
22,061
|
|
TBA dollar roll income
|
|
|
3,795
|
|
Interest rate swap net interest expense
|
|
|
(3,997
|
)
|
Economic net interest income
|
|
|
21,859
|
|
Core general and administrative expenses
|
|
|
(3,420
|
)
|
Non-GAAP core operating income
|
|
$
|
18,439
|
|
|
|
|
|
|
Non-GAAP core operating income per diluted share
|
|
$
|
0.80
|
|
Weighted average diluted shares outstanding
|
|
|
23,040
|
|
The following table provides a reconciliation of GAAP pre-tax net income to non-GAAP core operating income for the three months ended March 31, 2016 (amounts in thousands):
|
|
Three Months Ended
|
|
|
|
March 31, 2016
|
|
GAAP loss before income taxes
|
|
$
|
(32,164
|
)
|
Less:
|
|
|
|
|
Total investment loss, net
|
|
|
49,890
|
|
Stock-based compensation expense
|
|
|
517
|
|
Non-recurring proxy contest related expenses
|
|
|
398
|
|
Add back:
|
|
|
|
|
TBA dollar roll income
|
|
|
3,795
|
|
Interest rate swap net interest expense
|
|
|
(3,997
|
)
|
Non-GAAP core operating income
|
|
$
|
18,439
|
|
Non-GAAP core operating income is used by management to evaluate the financial performance of the Company’s long-term investment strategy and core business activities over periods of time as well as assist with the determination of the appropriate level of periodic dividends to stockholders. The Company believes that non-GAAP core operating income assists investors in understanding and evaluating the financial performance of the Company’s long-term investment strategy and core business activities over periods of time as well as its earnings capacity. A limitation of utilizing this non-GAAP financial measure is that the effect of accounting for “non-core” events or transactions in accordance with GAAP does, in fact, reflect the financial results of our business and these effects should not be ignored when evaluating and analyzing our financial results. For example, the economic cost or benefit of hedging instruments other than interest rate swap agreements, such as U.S. Treasury note futures or options on U.S. Treasury note futures, do not affect the computation of non-GAAP core operating income. Therefore, the Company believes that net income and comprehensive income determined in accordance with GAAP should be considered in conjunction with non-GAAP core operating income.
Non-GAAP Core Operating Income for Fiscal Year 2015
The Company retrospectively applied its revised definition of core operating income to the quarterly and annual periods of fiscal year 2015. The Company notes, however, that the non-GAAP core operating income measures computed for prior year periods are not directly comparable to the results computed for the first quarter of 2016, as the Company solely utilized hedging instruments other than interest rate swap agreements prior to November 2015. The economic costs or benefits of hedging instruments other than interest rate swap agreements do not affect the computation of non-GAAP core operating income.
31
The results of the Company’s retrospective application of its revised definition of core o
perating income to fiscal year 2015 are presented in the following table (amounts in thousands, except per share amounts):
|
|
Fiscal Year 2015
|
|
|
|
Total Year
|
|
|
Fourth Quarter
|
|
|
Third Quarter
|
|
|
Second Quarter
|
|
|
First Quarter
|
|
GAAP net interest income
|
|
$
|
102,374
|
|
|
$
|
25,807
|
|
|
$
|
26,074
|
|
|
$
|
23,711
|
|
|
$
|
26,782
|
|
TBA dollar roll income
|
|
|
6,743
|
|
|
|
2,353
|
|
|
|
1,896
|
|
|
|
2,235
|
|
|
|
259
|
|
Interest rate swap net interest expense
|
|
|
(1,282
|
)
|
|
|
(1,282
|
)
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
Economic net interest income
|
|
|
107,835
|
|
|
|
26,878
|
|
|
|
27,970
|
|
|
|
25,946
|
|
|
|
27,041
|
|
Core general and administrative expenses
|
|
|
(13,642
|
)
|
|
|
(3,121
|
)
|
|
|
(3,639
|
)
|
|
|
(3,575
|
)
|
|
|
(3,307
|
)
|
Non-GAAP core operating income
|
|
$
|
94,193
|
|
|
$
|
23,757
|
|
|
$
|
24,331
|
|
|
$
|
22,371
|
|
|
$
|
23,734
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Non-GAAP core operating income per diluted share
|
|
$
|
4.08
|
|
|
$
|
1.03
|
|
|
$
|
1.05
|
|
|
$
|
0.97
|
|
|
$
|
1.03
|
|
Weighted average diluted shares outstanding
|
|
|
23,088
|
|
|
|
23,066
|
|
|
|
23,065
|
|
|
|
23,098
|
|
|
|
23,096
|
|
The following table provides a reconciliation of GAAP pre-tax net income to non-GAAP core operating income for fiscal year 2015 (amounts in thousands):
|
|
Fiscal Year 2015
|
|
|
|
Total Year
|
|
|
Fourth Quarter
|
|
|
Third Quarter
|
|
|
Second Quarter
|
|
|
First Quarter
|
|
GAAP income (loss) before income taxes
|
|
$
|
(30,842
|
)
|
|
$
|
23,486
|
|
|
$
|
(37,133
|
)
|
|
$
|
12,248
|
|
|
$
|
(29,443
|
)
|
Less:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total investment (gain) loss, net
|
|
|
118,429
|
|
|
|
(1,653
|
)
|
|
|
59,757
|
|
|
|
7,518
|
|
|
|
52,807
|
|
Stock-based compensation expense
|
|
|
1,145
|
|
|
|
853
|
|
|
|
(189
|
)
|
|
|
370
|
|
|
|
111
|
|
Add back:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
TBA dollar roll income
|
|
|
6,743
|
|
|
|
2,353
|
|
|
|
1,896
|
|
|
|
2,235
|
|
|
|
259
|
|
Interest rate swap net interest expense
|
|
|
(1,282
|
)
|
|
|
(1,282
|
)
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
Non-GAAP core operating income
|
|
$
|
94,193
|
|
|
$
|
23,757
|
|
|
$
|
24,331
|
|
|
$
|
22,371
|
|
|
$
|
23,734
|
|
Portfolio Overview
The following table summarizes our MBS investment portfolio at fair value as of March 31, 2016 and December 31, 2015 (dollars in thousands):
|
|
March 31, 2016
|
|
|
December 31, 2015
|
|
Agency MBS
|
|
$
|
3,417,850
|
|
|
$
|
3,865,316
|
|
Private-label MBS
|
|
|
129,231
|
|
|
|
130,435
|
|
Private-label interest-only MBS
|
|
|
105
|
|
|
|
118
|
|
Net long TBA positions
(1)
|
|
|
729,844
|
|
|
|
389,258
|
|
Total MBS investments portfolio
|
|
$
|
4,277,030
|
|
|
$
|
4,385,127
|
|
(1)
|
Net long TBA positions are reflected on the consolidated balance sheets as a component of “derivative assets, at fair value” and “derivative liabilities, at fair value,” with a net asset carrying value of $4,054 and a net liability carrying value of $553 as of March 31, 2016 and December 31, 2015, respectively.
|
Our agency MBS consisted of the following as of March 31, 2016 (dollars in thousands):
|
|
Face Amount
|
|
|
Fair Value
|
|
|
Market Price
|
|
|
Coupon
|
|
|
Weighted
Average Life
|
|
30-year fixed rate:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
3.5%
|
|
$
|
961,398
|
|
|
$
|
1,012,562
|
|
|
$
|
105.32
|
|
|
|
3.50
|
%
|
|
|
6.0
|
|
4.0%
|
|
|
2,162,322
|
|
|
|
2,329,172
|
|
|
|
107.72
|
|
|
|
4.00
|
%
|
|
|
4.9
|
|
4.5%
|
|
|
69,422
|
|
|
|
76,091
|
|
|
|
109.61
|
|
|
|
4.50
|
%
|
|
|
4.1
|
|
5.5%
|
|
|
22
|
|
|
|
25
|
|
|
|
112.68
|
|
|
|
5.50
|
%
|
|
|
4.8
|
|
Total/weighted-average
|
|
$
|
3,193,164
|
|
|
$
|
3,417,850
|
|
|
|
107.04
|
|
|
|
3.86
|
%
|
|
|
5.2
|
|
32
|
|
Face Amount
|
|
|
Fair Value
|
|
|
Market Price
|
|
|
Coupon
|
|
|
Weighted
Average Life
|
Fannie Mae
|
|
$
|
1,765,160
|
|
|
$
|
1,889,749
|
|
|
$
|
107.06
|
|
|
|
3.85
|
%
|
|
5.2
|
Freddie Mac
|
|
|
1,428,004
|
|
|
|
1,528,101
|
|
|
|
107.01
|
|
|
|
3.87
|
%
|
|
5.1
|
Total/weighted-average
|
|
$
|
3,193,164
|
|
|
$
|
3,417,850
|
|
|
|
107.04
|
|
|
|
3.86
|
%
|
|
5.2
|
The actual CPR for the Company’s agency MBS was 8.14% for the three months ended March 31, 2016. As of March 31, 2016, the Company’s agency MBS was comprised of securities specifically selected for their relatively lower propensity for prepayment including approximately 60% in specified pools backed by lower loan balances, approximately 13% in specified pools of loans refinanced through the U.S. Government sponsored Home Affordable Refinance Program (“HARP”), while the remainder includes specified pools of loans originated in certain geographic areas, with low FICO scores or with other characteristics selected for their relatively lower propensity for prepayment.
As of March 31, 2016, we had $3.0 billion of outstanding repurchase agreement financing secured by $3.2 billion of agency MBS with a weighted-average cost of funding of 0.66%. During the three months ended March 31, 2016, we sold agency MBS with a face value of $875.5 million for total proceeds of $933.9 million, realizing net gains of $5.6 million.
Our agency MBS investment portfolio also includes net long TBA positions, which are primarily the result of executing sequential series of “dollar roll” transactions. We execute dollar roll transactions as a means of investing in and financing non-specified fixed-rate agency MBS. Such transactions involve effectively delaying (or “rolling”) the settlement of a forward purchase of a TBA agency MBS by entering into an offsetting short position prior to the settlement date, net settling the “paired-off” positions in cash, and contemporaneously entering another forward purchase of a TBA agency MBS of the same characteristics for a later settlement date. TBA securities purchased or sold for a forward settlement month are generally priced at a discount relative to TBA securities purchased for settlement in the current month. This “discount,” often referred to as the dollar roll “price drop,” reflects compensation for the net interest income (interest income less financing costs) that is foregone as a result of relinquishing beneficial ownership of the MBS for the duration of the dollar roll. Forward purchases and sales of TBA securities are accounted for as derivative instruments in our financial statements prepared in accordance with GAAP. Accordingly, dollar roll income is recognized as a component of “investment gains (losses), net” along with all other unrealized and realized gains (losses) on TBA transactions. Information about the Company’s net long TBA positions consisted of the following as of March 31, 2016 (dollars in thousands):
|
|
Notional Amount:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net Long (Short)
|
|
|
Implied
|
|
|
Implied
|
|
|
Net Carrying
|
|
|
|
Position
(1)
|
|
|
Cost Basis
(2)
|
|
|
Fair Value
(3)
|
|
|
Amount
(4)
|
|
30-year 3.5% coupon
|
|
$
|
350,000
|
|
|
$
|
364,073
|
|
|
$
|
366,734
|
|
|
$
|
2,661
|
|
30-year 4.0% coupon
|
|
|
340,000
|
|
|
|
361,717
|
|
|
|
363,110
|
|
|
|
1,393
|
|
Total
|
|
$
|
690,000
|
|
|
$
|
725,790
|
|
|
$
|
729,844
|
|
|
$
|
4,054
|
|
(1)
|
“Notional amount” represents the unpaid principal balance of the underlying agency MBS.
|
(2)
|
“Implied cost basis” represents the contractual forward price for the underlying agency MBS.
|
(3)
|
“Implied fair value” represents the current fair value of the underlying agency MBS.
|
(4)
|
“Net carrying amount” represents the difference between the implied cost basis and the current fair value of the underlying MBS. This amount is reflected on the Company’s consolidated balance sheets as a component of “derivative assets, at fair value” and “derivative liabilities, at fair value.”
|
Our private-label MBS, excluding our interest-only MBS, consisted of the following as of March 31, 2016 (dollars in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
Gross Unrealized
|
|
|
|
|
|
|
Weighted-Average
|
|
Face Amount
|
|
|
Net Discounts
|
|
|
Amortized Cost
|
|
|
Gains
|
|
|
Losses
|
|
|
Fair Value
|
|
|
Coupon
|
|
|
GAAP Yield
|
|
$
|
172,969
|
|
|
$
|
(51,797
|
)
|
|
$
|
121,172
|
|
|
$
|
8,059
|
|
|
$
|
—
|
|
|
$
|
129,231
|
|
|
|
3.01
|
%
|
|
|
10.32
|
%
|
As of March 31, 2016, the private-label MBS portfolio consists primarily of “re-REMIC” securities. The Company’s investments in re-REMIC securities represent “mezzanine” interests in underlying, re-securitized senior class MBS issued by private-label Real Estate Mortgage Investment Conduit (“REMIC”) securitization trusts. The senior class REMIC securities that serve as collateral to the Company’s investments in re-REMIC securities represent beneficial interests in pools of prime or Alt-A residential
33
mortgag
e loan collateral that hold the first right to cash flows and absorb credit losses only after their respective subordinate REMIC classes have been fully extinguished. The majority of the trusts that issued the Company’s investments in re-REMIC securities e
mploy a “sequential” principal repayment structure, while a minority of the issuing trusts employ a “pro-rata” principal repayment structure. Accordingly, the majority of the Company’s mezzanine class re-REMIC securities are not entitled to receive princip
al repayments until the principal balance of the senior interest in the respective collateral group has been reduced to zero. Principal shortfalls are allocated on a “reverse sequential” basis. Accordingly, any principal shortfalls on the underlying senior
class REMIC securities are first absorbed by the Company’s mezzanine class re-REMIC securities, to the extent of their respective principal balance, prior to being allocated to the senior interest in the respective collateral pool. Periodic interest accru
es on each re-REMIC security’s outstanding principal balance at its contractual coupon rate.
Our private-label MBS have approximately
1.8
% in remaining structural credit enhancement provided by collateral-level subordinate interests, on a weighted-average
basis, which, in addition to the substantial discount to par value at which the securities were purchased, provides protection to our invested capital.
As of March 31, 2016, we had $32.5 million of outstanding repurchase agreement financing secured by $57.5 million of private-label MBS with a weighted-average cost of funding of 2.45%. We did not sell private-label MBS during the three months ended March 31, 2016. During the three months ended March 31, 2016, we purchased private-label MBS for $5.4 million with a face amount of $5.2 million.
The Company attempts to hedge a portion of its exposure to interest rate fluctuations associated with its agency MBS primarily through the use of interest rate derivatives. Specifically, these interest rate derivatives are intended to economically hedge changes, attributable to changes in benchmark interest rates, in agency MBS fair values and future interest cash flows on the Company’s short-term financing arrangements. As of March 31, 2016, the interest rate derivative instruments used by the Company were centrally cleared interest rate swap agreements, exchange-traded 10-year U.S. Treasury note futures, and put options on 10-year U.S. Treasury note futures.
The Company’s interest rate swap agreements represent agreements to make semiannual interest payments based upon a fixed interest rate and receive quarterly variable interest payments based upon the prevailing three-month LIBOR rate on the date of reset. Information about the Company’s outstanding centrally cleared interest rate swap agreements as of March 31, 2016 is as follows (dollars in thousands):
|
|
March 31, 2016
|
|
|
|
Notional Amount
|
|
|
Average Fixed
Pay Rate
|
|
|
Average Remaining
Maturity (Years)
|
|
|
Fair Value
|
|
Years to maturity:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Less than 2 years
|
|
$
|
750,000
|
|
|
|
1.04
|
%
|
|
|
1.7
|
|
|
$
|
(4,983
|
)
|
2 to 10 years
|
|
|
1,000,000
|
|
|
|
2.03
|
%
|
|
|
9.8
|
|
|
|
(39,717
|
)
|
Total / weighted-average
|
|
$
|
1,750,000
|
|
|
|
1.61
|
%
|
|
|
6.3
|
|
|
$
|
(44,700
|
)
|
The Company’s exchange-traded 10-year U.S. Treasury note futures are short positions that mature on a quarterly basis. Upon the maturity date of these futures contracts in June 2016, the Company has the option to either net settle each contract in cash in an amount equal to the difference between the current fair value of the underlying 10-year U.S. Treasury note and the contractual sale price inherent to the futures contract, or to physically settle the contract by delivering the underlying 10-year U.S. Treasury note. Information about the Company’s outstanding 10-year U.S. Treasury note futures contracts as of March 31, 2016 is as follows (dollars in thousands):
Maturity Date
|
|
Notional Amount
|
|
|
Net Fair Value
|
|
June 2016
|
|
$
|
375,000
|
|
|
$
|
733
|
|
34
The Company’s exchange-traded put options on 10-year U.S. Treasury note futures held as of March 31, 2016 provide the Company with the right, but not the obligation, to sell underlying 10-year
U.S. Treasury note futures contracts which have an aggregate notional amount of $2.0 billion. These put options were acquired in exchange for aggregate option premiums of $2.7 million and have a weighted-average strike price that equates to a 10-year U.S.
Treasury note rate
of
approximately
2.4
5%.
These
options may be exercised at any time prior to their expiry, which occurs in May 2016, and, if exercised, will be settled in cash. Put options on 10-year U.S. Treasury note futures are intended to offset decl
ines in the market value of the Company’s agency MBS portfolio attributable to a significant rise in interest rates. On an on-going basis, the Company will evaluate the economic costs and benefits of rolling-forward this hedge position. Based on its analys
is, the Company may elect to roll-forward this hedge position with any adjustments to the notional amount
based on the changes in the Company’s agency MBS portfolio and/or
adjustments to the strike price based upon the Company’s evaluation of the potential
economic benefit of the options relative to their quoted premiums.
Information about the Company’s outstanding put options on 10-year U.S. Treasury note futures contracts as of March 31, 2016 is as follows (dollars in thousands):
Maturity Date
|
|
Notional Amount
|
|
|
Net Fair Value
|
|
May 2016
|
|
$
|
2,000,000
|
|
|
$
|
781
|
|
Results of Operations
Net Interest Income
Net interest income determined in accordance with GAAP primarily represents the interest income recognized from the our investments in specified agency MBS and private-label MBS (including the amortization of purchase premiums and accretion of purchase discounts), net of the interest expense incurred from repurchase agreement financing arrangements or other short- and long-term borrowing transactions. In the first quarter of 2016, we implemented a change in our accounting policy for recognizing interest income on our investments in agency MBS classified as trading securities by amortizing purchase premiums (or accreting purchase discounts) as an adjustment to interest income in accordance with the “interest method” permitted by GAAP. Prior to January 1, 2016, interest income from trading agency MBS was reported based upon each security’s stated coupon rate. Refer to “Note 2. Summary of Significant Accounting Policies” within the notes to the consolidated financial statements for further information about our accounting policies for recognizing interest income for our investments in MBS.
Net interest income determined in accordance with GAAP does not include TBA agency MBS dollar roll income, which represents the economic equivalent of net interest income generated from our investments in non-specified fixed-rate agency MBS, nor does it include the implied net interest income or expense of our interest rate derivative hedging instruments, which are not designated as hedging instruments for financial reporting purposes. In the our consolidated statements of comprehensive income prepared in accordance with GAAP, TBA agency MBS dollar roll income and the implied net interest income or expense incurred from our interest rate derivative instruments are reported as a component of the overall periodic change in the fair value of derivative instruments within the line item “gain (loss) from derivative instruments, net” of the “investment gain (loss), net” section.
Investment Gain (Loss), Net
“Investment gain (loss), net” primarily consists of periodic changes in the fair value (whether realized or unrealized) of investments in MBS classified as trading securities, periodic changes in the fair value (whether realized or unrealized) of derivative instruments, gains (losses) realized upon the sale of investments in MBS classified as available-for-sale, and other-than-temporary impairment charges for investments in MBS classified as available-for-sale.
We evaluate available-for-sale securities for other-than-temporary impairment on a quarterly basis. When the fair value of an available-for-sale security is less than its amortized cost at the reporting date, the security is considered impaired. When evaluating whether an impairment is other-than-temporary, consideration is given to (1) the length of time and the extent to which the fair value has been lower than amortized cost, (2) the severity of the decline in fair value, (3) the financial condition and near-term prospects of the issuer, (4) our intent to sell the security, and (5) whether it is more-likely-than-not we would be required to sell the security before anticipated recovery of our amortized cost basis.
For private-label MBS, on a quarterly basis, we re-estimate the amount and timing of cash flows expected to be collected based upon current information and events. For available-for-sale private-label MBS that are impaired, we compare the present value of our revised estimate of the amount and timing of expected cash flows, discounted at the security’s existing effective interest rate used for interest income recognition, to the security’s amortized cost basis. Any shortfall between the present value of cash flows expected to be collected and the security’s amortized cost basis is recognized as an other-than-temporary impairment charge in net income as a component of “investment gain (loss), net.”
35
Expenses
“Compensation and benefits expense” includes base salaries, annual incentive cash compensation, and non-cash stock-based compensation. Salaries, payroll taxes, and employee benefits are relatively fixed in nature. Annual cash incentive compensation is based on meeting estimated annual performance measures and discretionary components. Non-cash stock-based compensation includes expenses associated with all stock-based awards granted to employees, including the Company’s performance share units to named executive officers.
“Other expenses” primarily consists of the following:
|
·
|
professional services expenses, including accounting, legal, and consulting fees;
|
|
·
|
insurance expenses, including liability and property insurance;
|
|
·
|
occupancy and equipment expense, including rental costs for our facilities, and depreciation and amortization of equipment and software;
|
|
·
|
Board of Director fees; and
|
|
·
|
other operating expenses, including communication expenses, business development costs, printing and copying, business licenses and taxes, offices supplies, and other miscellaneous office expenses.
|
Three months ended March 31, 2016 compared to three months ended March 31, 2015
We reported a net loss of $31.6 million, or a loss of $1.38 per diluted share, for the three months ended March 31, 2016 compared to a net loss of $42.2 million, or a loss of $1.84 per diluted share, for the three months ended March 31, 2015 which included the following results for the periods indicated (dollars in thousands, except per share amounts):
|
|
Three Months Ended March 31,
|
|
|
|
2016
|
|
|
2015
|
|
Interest income
|
|
$
|
28,754
|
|
|
$
|
30,510
|
|
Interest expense
|
|
|
6,693
|
|
|
|
3,728
|
|
Net interest income
|
|
|
22,061
|
|
|
|
26,782
|
|
Investment loss, net
|
|
|
(49,890
|
)
|
|
|
(52,807
|
)
|
Other expenses
|
|
|
4,335
|
|
|
|
3,418
|
|
Loss before income taxes
|
|
|
(32,164
|
)
|
|
|
(29,443
|
)
|
Income tax (benefit) provision
|
|
|
(546
|
)
|
|
|
12,742
|
|
Net loss
|
|
$
|
(31,618
|
)
|
|
$
|
(42,185
|
)
|
Diluted loss per share
|
|
$
|
(1.38
|
)
|
|
$
|
(1.84
|
)
|
Weighted-average diluted shares outstanding
|
|
|
22,994
|
|
|
|
22,973
|
|
36
Net Interest Income
Net interest income determined in accordance with GAAP (“GAAP net interest income”) decreased $4.7 million, or 17.5%, from $26.8 million for the three months ended March 31, 2015 to $22.1 million for the three months ended March 31, 2016. The decrease is primarily due to (i) sales of private-label MBS, (ii) a substantial increase in our net long TBA position, and (ii) a 27 basis point, or 71%, increase in the average interest costs of our short-term financing arrangements due primarily to an increase in prevailing benchmark interest rates. As previously noted, TBA dollar roll income is not included in net interest income determined in accordance with GAAP.
The components of GAAP net interest income from our MBS investments portfolio, excluding interest expense on unsecured long-term debt, are summarized in the following table (dollars in thousands):
|
|
Three Months Ended March 31,
|
|
|
|
2016
|
|
|
2015
|
|
|
|
Average
|
|
|
Income
|
|
|
Yield
|
|
|
Average
|
|
|
Income
|
|
|
Yield
|
|
|
|
Balance
|
|
|
(Expense)
|
|
|
(Cost)
|
|
|
Balance
|
|
|
(Expense)
|
|
|
(Cost)
|
|
Agency-backed MBS
|
|
$
|
3,499,784
|
|
|
$
|
25,655
|
|
|
|
2.93
|
%
|
|
$
|
3,352,083
|
|
|
$
|
25,460
|
|
|
|
3.04
|
%
|
Private-label MBS
|
|
|
115,127
|
|
|
|
2,971
|
|
|
|
10.32
|
%
|
|
|
211,233
|
|
|
|
5,043
|
|
|
|
9.55
|
%
|
Interest-only MBS
|
|
|
162
|
|
|
|
3
|
|
|
|
7.52
|
%
|
|
|
203
|
|
|
|
6
|
|
|
|
10.96
|
%
|
|
|
$
|
3,615,073
|
|
|
|
28,629
|
|
|
|
3.17
|
%
|
|
$
|
3,563,519
|
|
|
|
30,509
|
|
|
|
3.42
|
%
|
Other
|
|
|
|
|
|
|
125
|
|
|
|
|
|
|
|
|
|
|
|
1
|
|
|
|
|
|
|
|
|
|
|
|
|
28,754
|
|
|
|
|
|
|
|
|
|
|
|
30,510
|
|
|
|
|
|
Repurchase agreements
|
|
$
|
3,222,396
|
|
|
|
(5,365
|
)
|
|
|
(0.66
|
)%
|
|
$
|
3,219,172
|
|
|
|
(3,080
|
)
|
|
|
(0.38
|
)%
|
FHLB advances
|
|
|
140,458
|
|
|
|
(135
|
)
|
|
|
(0.38
|
)%
|
|
|
—
|
|
|
|
—
|
|
|
|
—
|
|
|
|
$
|
3,362,854
|
|
|
|
(5,500
|
)
|
|
|
(0.65
|
)%
|
|
$
|
3,219,172
|
|
|
|
(3,080
|
)
|
|
|
(0.38
|
)%
|
Net interest income/spread
|
|
|
|
|
|
$
|
23,254
|
|
|
|
2.52
|
%
|
|
|
|
|
|
$
|
27,430
|
|
|
|
3.04
|
%
|
Net interest margin
|
|
|
|
|
|
|
|
|
|
|
2.57
|
%
|
|
|
|
|
|
|
|
|
|
|
3.08
|
%
|
The effects of changes in the composition of our investments on our GAAP net interest income from our MBS investment activities are summarized below (dollars in thousands):
|
|
Three Months Ended March 31, 2016
|
|
|
|
vs.
|
|
|
|
Three Months Ended March 31, 2015
|
|
|
|
Rate
(1)
|
|
|
Volume
(1)
|
|
|
Total Change
|
|
MBS:
|
|
|
|
|
|
|
|
|
|
|
|
|
Agency MBS
|
|
$
|
(905
|
)
|
|
$
|
1,100
|
|
|
$
|
195
|
|
Private-label MBS
|
|
|
379
|
|
|
|
(2,451
|
)
|
|
|
(2,072
|
)
|
Total MBS
|
|
|
(526
|
)
|
|
|
(1,351
|
)
|
|
|
(1,877
|
)
|
Interest-only MBS and other
|
|
|
—
|
|
|
|
121
|
|
|
|
121
|
|
Repurchase agreements
|
|
|
(2,319
|
)
|
|
|
34
|
|
|
|
(2,285
|
)
|
FHLB advances
|
|
|
—
|
|
|
|
(135
|
)
|
|
|
(135
|
)
|
|
|
$
|
(2,845
|
)
|
|
$
|
(1,331
|
)
|
|
$
|
(4,176
|
)
|
(1)
|
The change in interest income and interest expense due to both rate and volume has been allocated to rate and volume changes in proportion to the relationship of the absolute dollar amounts of the change in each.
|
As previously noted, the decrease in GAAP net interest income from our MBS portfolio of $4.1 million to $23.3 million for the three months ended March 31, 2016 from $27.4 for the comparative period of 2015 is primarily due to a reduction in our private-label MBS portfolio, a substantial increase in our TBA agency MBS portfolio, and an increase the average interest costs of our short-term financing arrangements. The decrease in yield in the overall MBS portfolio is primarily related to the decrease in the higher yielding unlevered private-label MBS portfolio from the prior period.
As a result of the substantial increase in our TBA agency MBS portfolio, TBA dollar roll income increased $3.5 million to $3.8 million for the three months ended March 31, 2016 from $0.3 million for the comparative period of 2015. When adjusting our interest income determined in accordance with GAAP (“GAAP interest income”) to include TBA dollar roll income (which is net of implied financing costs), the total revenue earned from our aggregate investments portfolio for the three months ended March 31, 2016
37
increased by $1.8 million, or 5.8%, relative to the comparative period from 2015. However, the increase in aggregate revenue was more than offset by a $2.4 million increase in the interest cos
ts of our short-term financing arrangements. The following table provides a comparison of GAAP interest income, GAAP net interest income (excluding interest expense from long-term debt), and TBA dollar roll income for the three month periods ended March 31
, 2016 and March 31, 2015
(dollars in thousands)
:
|
|
Three Months Ended March 31,
|
|
|
Increase (Decrease) Expressed in:
|
|
|
|
2016
|
|
|
2015
|
|
|
Amount
|
|
|
Percentage
|
|
GAAP interest income
|
|
$
|
28,754
|
|
|
$
|
30,510
|
|
|
$
|
(1,756
|
)
|
|
|
(5.76
|
)%
|
TBA dollar roll income
(1)
|
|
|
3,795
|
|
|
|
259
|
|
|
|
3,536
|
|
|
|
1365.25
|
%
|
GAAP interest income plus TBA dollar roll income
|
|
|
32,549
|
|
|
|
30,769
|
|
|
|
1,780
|
|
|
|
5.79
|
%
|
Interest expense on short-term debt
|
|
|
5,500
|
|
|
|
3,080
|
|
|
|
2,420
|
|
|
|
78.57
|
%
|
Net interest income plus TBA dollar roll income
|
|
$
|
27,049
|
|
|
$
|
27,689
|
|
|
$
|
(640
|
)
|
|
|
(2.31
|
)%
|
(1)
|
TBA dollar roll income is net of implied financing costs.
|
Interest expense related to long-term debt was $1.2 million and $0.6 million for the three months ended March 31, 2016 and 2015, respectively. The increase in interest expense on long-term debt is primarily attributable to the issuance of $35.3 million of Senior Notes in March 2015.
Investment Loss, Net
“Total investment loss, net” decreased $2.9 million from a loss of $52.8 million for the three months ended March 31, 2015 to a loss of $49.9 million for the three months ended March 31, 2016. In each of these periods, decreases in interest rates resulted in a net increase in the fair value of our agency MBS and a net decrease in the fair value of our interest rate derivative instruments. MBS spread widening occurred within each of these periods, which resulted in the recognition of net losses on our interest rate derivative instruments (intended to economically hedge our interest rate risk) that exceeded the net gains recognized on our agency MBS investments and TBA transactions, as illustrated in the table to follow (dollars in thousands):
|
|
Three Months Ended March 31,
|
|
|
|
2016
|
|
|
2015
|
|
Realized gains on sale of available-for-sale investments, net
|
|
$
|
-
|
|
|
$
|
3,348
|
|
OTTI charges on available-for-sale securities
|
|
|
(99
|
)
|
|
|
-
|
|
Gains on trading investments, net
|
|
|
50,950
|
|
|
|
19,745
|
|
Gains from commitments to purchase and sell MBS, net
|
|
|
11,319
|
|
|
|
1,147
|
|
Interest rate swap net interest expense
(1)
|
|
|
(3,997
|
)
|
|
|
-
|
|
Losses from interest rate derivative instruments, net
|
|
|
(108,082
|
)
|
|
|
(77,159
|
)
|
Other, net
|
|
|
19
|
|
|
|
112
|
|
Investment loss, net
|
|
$
|
(49,890
|
)
|
|
$
|
(52,807
|
)
|
(1)
|
Represents the periodic net interest settlement incurred during the period (often referred to as "net interest carry").
|
Available-for-sale investments substantially consist of our private-label MBS acquired prior to 2015. The realized gains on the sale of available-for-sale investments, net, recognized for the three months ended March 31, 2015 were the result of $20.9 million of proceeds received from the sales of private-label MBS resulting in a realized gain of $3.3 million. There were no sales of private-label MBS for the three months ended March 31, 2016.
We recorded credit related other-than-temporary impairment charges of $0.1 million for the three months ended March 31, 2016 on available-for-sale, private-label MBS. We recorded no other-than-temporary impairment charges for the three months ended March 31, 2015 on available-for-sale, private-label MBS. Credit related other-than-temporary impairment charges represent the excess of the amortized cost basis over the present value of expected future cash flows discounted at the security’s existing effective interest rate used for interest income recognition.
Investments classified as trading securities primarily consist of agency MBS. The $51.0 million and $19.7 million of gains on trading investments, net, recognized for the three months ended March 31, 2016 and March 31, 2015, respectively were primarily the result of net unrealized holding gains as well as net realized gains from sales of trading investments. The key drivers in the net gains on trading investments for each of these periods were decreases in long-term interest rates, partially offset by MBS spread widening. As long-term interest rates decline, the price of fixed-rate agency MBS generally increases. During the three months ended March 31,
38
2016 and March 31, 2015, the 10-year U.S. Treasury rate decreased by 49 basis points and 23 basis points, respectively
. However, MBS mortgage spreads widened during
each of these periods
,
which partially offset the rise in the fair value of fixed-rate
agency MBS attributable to the decline in interest rates.
Commitments to purchase and sell MBS consist primarily of forward-settling purchases of TBA agency MBS. We generally utilize TBA dollar roll transactions to finance agency MBS purchases and may also, from time to time, enter into TBA contracts as a means of acquiring and disposing of agency MBS. We recognized net gains from commitments to purchase and sell MBS of $11.3 million and $1.1 million for the three months ended March 31, 2016 and 2015, respectively, which consists of both dollar roll income and mark-to-market gains and losses on the TBA transactions.
Our interest rate derivative instruments consist primarily of interest rate swaps, U.S. Treasury note futures, put options on U.S. Treasury note futures, and have historically also included Eurodollar futures, interest rate swap futures, and other put options on futures. While we use interest rate derivatives to economically hedge a portion of our interest rate risk, we have not designated such contracts as hedging instruments for financial reporting purposes. As a result, the implied economic financing costs of our interest rate derivatives are included in the change in fair value of the instruments recognized in “investment loss, net” rather than in net interest income. During periods of falling interest rates, we will generally experience losses on our interest rate derivative instruments and during periods of rising interest rates, we will generally experience gains on our interest rate derivative instruments.
The $108.1 million and $77.2 million of losses from interest rate derivative instruments, net, recognized for the three months ended March 31, 2016 and the comparative period from 2015, respectively, were the result of net realized and unrealized mark-to-market adjustments. The key drivers in the net losses from interest rate derivatives for the three months ended March 31, 2016 and the comparative period from 2015, respectively, were (i) the implied economic financing costs of certain of the interest rate derivatives and (ii) the decrease in interest rates during those periods.
The fair value of our hedging instruments is expected to fluctuate inversely relative to the change in fair value of the agency MBS portfolio. However, the degree of correlation between the price movements of our hedging instruments and those of our agency MBS portfolio may vary. While our hedging instruments are designed to protect our agency MBS portfolio from interest rate risk, they are not generally designed to protect our net book value from spread risk, which is the risk of an increase of the market spread between the yield on our agency MBS and the benchmark yield on U.S. Treasury securities or interest rate swaps.
Other Expenses
Other expenses increased by $0.9 million, or 26.5%, from $3.4 million for the three months ended March 31, 2015 to $4.3 million for the three months ended March 31, 2016, primarily due to an increase in expenses for legal and proxy related services as well as the reversal of stock-based compensation recognized in the prior year due to the Company’s results falling short of certain performance measurements. During the three months ended March 31, 2016, we incurred $0.4 million in expenses stemming from the 2016 proxy contest that are in excess of the level of expenses normally incurred for an annual meeting of shareholders. For information about the 2016 proxy contest, refer to “Item 1A. Risk Factors” within this quarterly report. In addition, the compensation and benefits expense for the three months ended March 31, 2015 included the reversal of $0.3 million of expense recognized in prior years due to a reduction in the expected number of performance share units expected to vest.
Income Tax Benefit and Provision
We recognized an income tax benefit of $0.5 million and an income tax provision of $12.7 million for the three months ended March 31, 2016 and 2015, respectively. The income tax benefit and provision recognized for the three months ended March 31, 2016 and 2015, respectively, are net of increases in the valuation allowance against the deferred tax assets of $12.0 million and $25.4 million, respectively, primarily due to net capital losses generated during those periods. The net capital losses for the three months ended March 31, 2016 and 2015 were attributable primarily to realized and unrealized losses on certain of our economic interest rate hedging instruments. The valuation allowance represents the portion of our net capital loss carryforward that is more-likely-than-not to expire unutilized.
Other Comprehensive Loss
Other comprehensive income (loss) represents periodic unrealized holding gains and losses related to our investments in MBS classified as available-for-sale. Accumulated unrealized holding gains and losses for available-for-sale MBS are reclassified into net income as a component of “investment gain (loss), net” upon (i) sale or realization, or (ii) the occurrence of an other-than-temporary impairment. Other comprehensive loss was $4.9 million and $7.9 million for the three months ended March 31, 2016 and 2015, respectively. For the three months ended March 31, 2016, other comprehensive loss included net unrealized holding losses of $8.1 million on the available-for-sale MBS portfolio, net of a tax benefit of $3.2 million, and $99.2 thousand of other-than-temporary
39
impairment
charges on available-for-sale securities, net of a
tax provision
of $
38.6
thousand. For the three months
ended March 31, 2015, other
comprehensive loss included net unreal
ized
holding
losses
of $
7.2
million
on the available-for-sale MBS portfolio, net of a tax
benefit
of $
2.7
million
and
$
3.7
million of reversal of prior period net unrealized gains upon the sale of available-for-sale MBS, net of a tax benefit of $
0.4
millio
n.
Liquidity and Capital Resources
Liquidity is a measurement of our ability to meet potential cash requirements including ongoing commitments to repay borrowings, fund investments, meet margin calls on our short-term borrowings and hedging instruments, and for other general business purposes. Our primary sources of funds for liquidity consist of existing cash balances, short-term borrowings (for example, repurchase agreements), principal and interest payments from our investments in MBS, and proceeds from sales of MBS. Other sources of liquidity include proceeds from the offering of common stock, preferred stock, debt securities, or other securities registered pursuant to our effective shelf registration statement filed with the Securities and Exchange Commission (“SEC”).
Liquidity, or ready access to funds, is essential to our business. Perceived liquidity issues may affect our counterparties’ willingness to engage in transactions with us. Our liquidity could be impaired due to circumstances that we may be unable to control, such as a general market disruption or an operational problem that affects us or third parties. Further, our ability to sell assets may be impaired if other market participants are seeking to sell similar assets at the same time. If we cannot obtain funding from third parties or from our subsidiaries, our results of operations could be negatively impacted.
As of March 31, 2016, our debt-to-equity leverage ratio was 7.2 to 1. As of March 31, 2016, our “at risk” leverage ratio was 9.9 to 1. Our “at risk” leverage is measured as the ratio of the sum of our total debt (excluding any unamortized issuance costs) and net payable for unsettled securities compared to our tangible stockholders’ equity. Tangible stockholders’ equity is measured as our stockholders’ equity less our net deferred tax asset.
Cash Flows
As of March 31, 2016, our cash and cash equivalents totaled $43.2 million, representing a net increase of $6.2 million from $37.0 million as of December 31, 2015. Cash provided by operating activities of $21.2 million during the three months ended March 31, 2016 was attributable primarily to net interest income less our expenses. Cash provided by investing activities of $558.7 million during the three months ended March 31, 2016 was primarily generated by sales of agency MBS and the receipt of principal payments from agency MBS, partially offset by purchases of new agency MBS and funding of deposits for margin calls on our interest rate derivative instruments. Cash used in financing activities of $573.7 million during the three months ended March 31, 2016 relates primarily to net repayments of FHLBC advances and dividend payments to common stockholders, partially offset by proceeds obtained from repurchase agreements used to finance a portion of our MBS investments portfolio.
Sources of Funding
We believe that our existing cash balances, net investments in MBS, cash flows from operations, borrowing capacity, and other sources of liquidity will be sufficient to meet our cash requirements for at least the next twelve months. We may, however, seek debt or equity financings, in public or private transactions, to provide capital for corporate purposes and/or strategic business opportunities, including possible acquisitions, joint ventures, alliances or other business arrangements which could require substantial capital outlays. Our policy is to evaluate strategic business opportunities, including acquisitions and divestitures, as they arise. There can be no assurance that we will be able to generate sufficient funds from future operations, or raise sufficient debt or equity on acceptable terms, to take advantage of investment opportunities that become available. Should our needs ever exceed these sources of liquidity, we believe that most of our investments could be sold, in most circumstances, to provide cash. However, we may be required to sell our assets in such instances at depressed prices.
As of March 31, 2016, liquid assets consisted primarily of cash and cash equivalents of $43.2 million and net investments in MBS of $326.4 million. Cash equivalents consist primarily of money market funds invested in debt obligations of the U.S. government. The Company’s net investments in MBS is calculated as the sum of the Company’s total MBS investments at fair value and receivable for sold MBS, less the sum of the repurchase agreements outstanding and payable for purchased MBS. The $326.4 million net investment in MBS includes $71.8 million of unpledged private-label MBS.
Long-Term Debt
As of March 31, 2016, we had $73.5 million of total long-term debt, net of unamortized debt issuance costs of $1.8 million. Our trust preferred debt obligations with an aggregate principal amount of $15.0 million outstanding as of March 31, 2016 accrue and
40
require
the
payment of interest quarterly at three-month LIBOR plus 2.25% to 3.00% and mature between 2033 and 2035. Our 6.625% Senior Notes due 2023 with a principal amount
of $25.0
million outstanding as
of
March
3
1
, 201
6
accrue and require payment of interest quarterly at an annual rate
of 6.625
% and mature on May 1, 2023. Our 6.75% Senior Notes due 2025 with a principal amount of
$35.3
million outstanding as of
March
3
1
, 201
6
accrue and require payment of interest quarterly at an annual rate of 6.75% and mature on March 15, 2025.
Repurchase Agreements
We have short-term financing facilities that are structured as repurchase agreements with various financial institutions to fund our investments in MBS. We have obtained, and believe we will be able to continue to obtain, short-term financing in amounts and at interest rates consistent with our financing objectives. Funding for MBS through repurchase agreements continues to be available to us at rates we consider to be attractive from multiple counterparties.
During 2015, as part of our continuous effort to further expand our funding sources to increase liquidity, flexibility, and profitability, we completed the steps necessary to begin executing repurchase agreements directly with cash lenders rather than through a broker/dealer intermediary. We executed our first direct repurchase agreement borrowing during the fourth quarter of 2015. In addition to expanding our existing pool of funding sources, having the ability to execute repurchase agreements directly with cash lenders provides us with the potential for reduced funding costs and increased profitability by eliminating the “bid/ask spread” generally retained by the broker/dealer intermediary in a traditional repurchase agreement execution.
Our repurchase agreements include provisions contained in the standard master repurchase agreement as published by the Securities Industry and Financial Markets Association and may be amended and supplemented in accordance with industry standards for repurchase facilities. Our repurchase agreements include financial covenants, with which the failure to comply would constitute an event of default under the applicable repurchase agreement. Similarly, each repurchase agreement includes events of insolvency and events of default on other indebtedness as similar financial covenants. As provided in the standard master repurchase agreement as typically amended, upon the occurrence of an event of default or termination, the applicable counterparty has the option to terminate all repurchase transactions under such counterparty’s repurchase agreement and to demand immediate payment of any amount due from us to the counterparty.
Under our repurchase agreements, we may be required to pledge additional assets to our repurchase agreement counterparties in the event the estimated fair value of the existing pledged collateral under such agreements declines and such lenders demand additional collateral (commonly referred to as a “margin call”), which may take the form of additional securities or cash. Margin calls on repurchase agreements collateralized by our MBS investments primarily result from events such as declines in the value of the underlying mortgage collateral caused by factors such as rising interest rates or prepayments. Our repurchase agreements generally provide that valuations for MBS securing our repurchase agreements are to be obtained from a generally recognized source agreed to by both parties. However, in certain circumstances and under certain of our repurchase agreements, our lenders have the sole discretion to determine the value of the MBS securing our repurchase agreements. In such instances, our lenders are required to act in good faith in making determinations of value. Our repurchase agreements generally provide that in the event of a margin call, we must provide additional securities or cash on the same business day that the margin call is made if the lender provides us notice prior to the margin notice deadline on such day.
To date, we have not had any margin calls on our repurchase agreements that we were not able to satisfy with either cash or additional pledged collateral. However, should we encounter increases in interest rates or prepayments, margin calls on our repurchase agreements could result in a material adverse change in our liquidity position.
Our repurchase agreements generally mature within 30 to 90 days, but may have maturities as short as one day and as long as one year. In the event that market conditions are such that we are unable to continue to obtain repurchase agreement financing for our investments in MBS in amounts and at interest rates consistent with our financing objectives, we may liquidate such investments and may incur significant losses on any such sales of MBS.
In the event that market conditions are such that we are unable to obtain financing for our investments in MBS in amounts and at interest rates consistent with our financing objectives, to the extent deemed appropriate, we may use cash to finance our investments or we may liquidate such investments. Accordingly, depending upon market conditions, we may incur significant losses on any such sales of MBS.
41
The following table provides information regarding our outstanding repurchase agreement borrowings as of d
ates and periods indicated (dollars in thousands):
|
|
March 31, 2016
|
|
|
December 31, 2015
|
|
Pledged with agency MBS:
|
|
|
|
|
|
|
|
|
Repurchase agreements outstanding
|
|
$
|
3,029,877
|
|
|
$
|
2,797,561
|
|
Agency MBS collateral, at fair value
|
|
|
3,200,829
|
|
|
|
2,946,684
|
|
Net amount
(1)
|
|
|
170,952
|
|
|
|
149,123
|
|
Weighted-average rate
|
|
|
0.66
|
%
|
|
|
0.61
|
%
|
Weighted-average term to maturity
|
|
16.0 days
|
|
|
12.8 days
|
|
Pledged with private-label MBS:
|
|
|
|
|
|
|
|
|
Repurchase agreements outstanding
|
|
$
|
32,504
|
|
|
$
|
37,219
|
|
Private-label MBS collateral, at fair value
|
|
|
57,463
|
|
|
|
70,511
|
|
Net amount
(1)
|
|
|
24,959
|
|
|
|
33,292
|
|
Weighted-average rate
|
|
|
2.45
|
%
|
|
|
2.42
|
%
|
Weighted-average term to maturity
|
|
2.9 days
|
|
|
16.9 days
|
|
Total MBS:
|
|
|
|
|
|
|
|
|
Repurchase agreements outstanding
|
|
$
|
3,062,381
|
|
|
$
|
2,834,780
|
|
MBS collateral, at fair value
|
|
|
3,258,292
|
|
|
|
3,017,195
|
|
Net amount
(1)
|
|
|
195,911
|
|
|
|
182,415
|
|
Weighted-average rate
|
|
|
0.68
|
%
|
|
|
0.64
|
%
|
Weighted-average term to maturity
|
|
15.9 days
|
|
|
12.8 days
|
|
Maximum amount outstanding at any month-end
during the period
|
|
$
|
3,520,978
|
|
|
$
|
3,911,987
|
|
(1)
|
Net amount represents the value of collateral in excess of corresponding repurchase obligation. The amount of collateral at-risk is limited to the outstanding repurchase obligation and not the entire collateral balance.
|
To limit our exposure to counterparty risk, we diversify our repurchase agreement funding across multiple counterparties and by counterparty region. As of March 31, 2016, we had outstanding repurchase agreement balances with 16 counterparties. We currently have master repurchase agreements in place with a total of 18 counterparties located throughout North America, Europe and Asia. As of March 31, 2016, less than 6% of our stockholders’ equity was at risk with any one counterparty, with the top five counterparties representing approximately 21% of our stockholders’ equity. The table below includes a summary of our repurchase agreement funding by number of counterparties and counterparty region as of March 31, 2016 (dollars in thousands):
|
|
Number of
|
|
|
Percentage of Repurchase
|
|
|
|
Counterparties
|
|
|
Agreement Funding
|
|
North America
|
|
|
11
|
|
|
|
66.9
|
%
|
Europe
|
|
|
2
|
|
|
|
12.9
|
%
|
Asia
|
|
|
3
|
|
|
|
20.2
|
%
|
|
|
|
16
|
|
|
|
100.0
|
%
|
Federal Home Loan Bank Advances
In September 2015, our wholly-owned captive insurance subsidiary, Key Bridge Insurance, LLC (“Key Bridge”), was granted membership to the FHLB of Cincinnati (“FHLBC”). The FHLBC, like each of the 11 regional FHLBs, is a cooperative that provides its member financial institutions with a number of financial products and services, including short and long-term secured borrowings that are known as “advances.” FHLBC advances may be collateralized by a number of real estate related assets, including agency MBS. Similar to a repurchase agreement borrowing, we would pledge agency MBS as collateral to secure the advance to Key Bridge, the amount of which is equal to a specified percentage of the fair value of the pledged collateral. We would retain beneficial ownership of the pledged collateral throughout the term of the advance arrangement.
On January 12, 2016, the regulator of the FHLB system, the Federal Housing Finance Agency (“FHFA”), released a final rule that amends regulations governing FHLB membership, including an amendment which prevents captive insurance companies from being eligible for FHLB membership. Under the terms of the final rule, Key Bridge is required to terminate its membership and repay its existing advances within one year following the final rule’s effective date of February 19, 2016. In addition, Key Bridge is
42
prohibited from obtaining new advances during the one year transition period.
As of March 31, 2016
,
Key Bridge
repaid all of its outstanding FHLBC advances, funded primarily through pro
ceeds
the Company
obtained from traditional repurchase agreement financing arrangements.
Derivative Instruments
In the normal course of our operations, we are a party to financial instruments that are accounted for as derivative financial instruments including interest rate swaps, Eurodollar futures, interest rate swap futures, U.S. Treasury note futures, put options and forward TBA purchases and sales.
We exchange collateral with the counterparties to our interest rate derivative instruments at least on a daily basis based upon daily changes in fair value (also known as “variation margin”) as measured by the central clearinghouse through which those derivatives are cleared. In addition, the central clearinghouse requires market participants to deposit and maintain an “initial margin” amount which is determined by the clearinghouse and is generally intended to be set at a level sufficient to protect the clearinghouse from the maximum estimated single-day price movement in that market participant’s contracts. The clearing exchanges have the sole discretion to determine the value of derivative instruments. In the event of a margin call, we must generally provide additional collateral on the same business day. To date, we have not had any margin calls on our derivative agreements that we were not able to satisfy. However, if we encounter significant decreases in long-term interest rates, margin calls on our derivative agreements could result in a material adverse change in our liquidity position
As of March 31, 2016, we had outstanding centrally cleared interest rate swaps and exchange traded 10-year U.S. Treasury note futures with the following aggregate notional amount, net fair value and corresponding margin held in collateral deposit with the custodian (in thousands):
|
|
March 31, 2016
|
|
|
|
Notional
|
|
|
Net Fair
|
|
|
Collateral
|
|
|
|
Amount
|
|
|
Value
|
|
|
Deposit
|
|
Interest rate swaps
|
|
$
|
1,750,000
|
|
|
$
|
(44,700
|
)
|
|
$
|
77,088
|
|
10-year U.S. Treasury note futures
|
|
|
375,000
|
|
|
|
733
|
|
|
|
4,280
|
|
Share Repurchase Program
In October 2015, the Board of Directors authorized an increase in our share repurchase program pursuant to which the Company may repurchase up to 2.0 million shares of its Class A common stock. As of March 31, 2016, 1.95 million shares of Class A common stock remained available for repurchase under the repurchase program.
Dividends
Pursuant to our variable dividend policy, our Board of Directors evaluates dividends on a quarterly basis and, in its sole discretion, approves the payment of dividends. Our dividend payments, if any, may vary significantly quarter to quarter. The Board of Directors has approved and the Company has declared and paid the following dividends to date in 2016:
|
|
Dividend
|
|
|
|
|
|
|
|
Quarter Ended
|
|
Amount
|
|
|
Declaration Date
|
|
Record Date
|
|
Pay Date
|
March 31
|
|
$
|
0.625
|
|
|
March 15
|
|
March 31
|
|
April 29
|
The Board of Directors approved and the Company declared and paid the following dividends for 2015:
|
|
Dividend
|
|
|
|
|
|
|
|
Quarter Ended
|
|
Amount
|
|
|
Declaration Date
|
|
Record Date
|
|
Pay Date
|
December 31
|
|
$
|
0.625
|
|
|
December 17
|
|
December 31
|
|
January 29, 2016
|
September 30
|
|
|
0.625
|
|
|
September 17
|
|
September 30
|
|
October 30
|
June 30
|
|
|
0.875
|
|
|
June 17
|
|
June 30
|
|
July 31
|
March 31
|
|
|
0.875
|
|
|
March 10
|
|
March 31
|
|
April 30
|
Off-Balance Sheet Arrangements
As of March 31, 2016 and December 31, 2015, we did not maintain any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance, or special purpose or variable interest entities, established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Further, as of March 31, 2016
43
and December 31, 201
5
, we
had not guaranteed any obligations of unconsolidated entities or entered into any commitment or intent t
o provide funding to any such entities.