News Column

HATTERAS FINANCIAL CORP - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

July 29, 2014

In this Quarterly Report on Form 10-Q, we refer to Hatteras Financial Corp. as "we," "us," "our company," or "our," unless we specifically state otherwise or the context indicates otherwise. The following defines certain of the commonly used terms in this quarterly report on Form 10-Q: "MBS" refers to mortgage-backed securities; and "agency securities" refer to our residential MBS that are issued or guaranteed by a U.S. Government sponsored entity, such as Fannie Mae or Freddie Mac, or an agency of the U.S. Government such as Ginnie Mae; "ARMs" refer to adjustable-rate mortgage loans which typically either 1) at all times have interest rates that adjust periodically to an increment over a specified interest rate index; or 2) have interest rates that are fixed for a specified period of time and, thereafter, generally adjust annually to an increment over a specified interest rate index. The following discussion should be read in conjunction with our financial statements and accompanying notes included in Part 1, Item 1 of this Quarterly Report on Form 10-Q as well as our Annual Report on Form 10-K for the year ended December 31, 2013, filed with the Securities and Exchange Commission ("SEC") on February 21, 2014.



Amounts other than share-related amounts are presented in thousands, unless otherwise noted.

Forward-Looking Statements

When used in this Quarterly Report on Form 10-Q, in future filings with the SEC or in press releases or other written or oral communications, statements which are not historical in nature, including those containing words such as "believe," "expect," "may," "will," "anticipate," "estimate," "plan," "continue," "intend," "should," or the negative of these words and similar expressions, are intended to identify "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended (the "Securities Act"), and Section 21E of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and, as such, may involve known and unknown risks, uncertainties and assumptions. The forward-looking statements in this report are based on our beliefs, assumptions and expectations of our future performance, taking into account all information currently available to us. These beliefs, assumptions and expectations are subject to risks and uncertainties and can change as a result of many possible events or factors, not all of which are known to us. If a change occurs, our business, financial condition, liquidity and results of operations may vary materially from those expressed in our forward-looking statements. The following factors could cause actual results to vary from our forward-looking statements: changes in our investment, financing and hedging strategies; the adequacy of our cash flow from operations and borrowings to meet our short-term liquidity requirements; the liquidity of our portfolio; unanticipated changes in our industry, the credit markets, the general economy or the real estate market; changes in interest rates and the market value of our investments; changes in the prepayment rates on the mortgage loans securing our agency securities; our ability to borrow to finance our assets; changes in government regulations affecting our business; our ability to maintain our qualification as a real estate investment trust ("REIT") for federal income tax purposes; our ability to maintain our exemption from registration under the Investment Company Act of 1940, as amended (the "Investment Company Act"); and risks associated with investing in real estate assets, including changes in business conditions and the general economy. These and other risks, uncertainties and factors, including those set forth under the section captioned "Risk Factors" "Management's Discussion and Analysis of Financial Condition and Results of Operations" herein and in our annual report on Form 10-K for the year ended December 31, 2013, as updated by our quarterly and current reports that we file with the SEC, could cause our actual results to differ materially from those projected in any forward-looking statements we make. All forward-looking statements speak only as of the date on which they are made. New risks and uncertainties arise over time and it is not possible to predict those events or how they may affect us. Except as required by law, we are not obligated to, and do not intend to, update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.



Overview

We are an externally-managed mortgage REIT that invests primarily in residential mortgage assets. To date, we have primarily invested in single-family residential mortgage pass-through securities issued or guaranteed by a U.S. Government agency (such as Ginnie Mae), or by a U.S. Government-sponsored entity (such as Fannie Mae and Freddie Mac). We refer to these securities as "agency securities." We were incorporated in Maryland in September 2007 and commenced operations in November 2007. We listed our common stock on the New York Stock Exchange ("NYSE") in April 2008 and trade under the symbol "HTS."



We are externally managed and advised by our manager, Atlantic Capital Advisors LLC.

We are organized and conduct our operations to qualify as a REIT under the Internal Revenue Code of 1986, as amended (the "Code"), and generally are not subject to federal taxes on our income to the extent we currently distribute our income to our shareholders and maintain our qualification as a REIT. Our principal goal is to generate net income for distribution to our shareholders through regular quarterly dividends. Our income is generated by the difference between the earnings on our investment portfolio and the costs of our borrowings and hedging activities and other expenses. In general, our strategy focuses on managing the interest rate risk related to our mortgage assets with a 26 -------------------------------------------------------------------------------- bias towards minimizing our exposure to credit risk. We believe that the best approach to generating a positive net income is to manage our liabilities in relation to the interest rate risks of our investments. To help achieve this result, we employ financing, generally short-term, and combine our financings with various hedging techniques, such as interest rate swaps and buying and selling futures contracts. We may, subject to maintaining our REIT qualification, also employ other hedging instruments from time to time, including interest rate caps, collars, swaptions and MBS TBA pools to protect against adverse interest rate movements. We focus on assets we identify as having short effective durations, which we believe limits the impact of changes in interest rates on the market value of our portfolio and on our net interest margin (interest income less financing costs). However, because our investments vary in interest rate, prepayment speed and maturity, the leverage or borrowings that we employ to fund our asset purchases will never exactly match the terms or performance of our assets, even after we have employed our hedging techniques. Based on our manager's experience, the interest rates of our assets will change more slowly than the corresponding short-term rates on the borrowings used to finance our assets. Consequently, changes in interest rates, particularly short-term interest rates, may significantly influence our net income and shareholders' equity. Our manager's approach to managing our portfolio is to take a longer term view of assets and liabilities; accordingly, our periodic earnings and mark-to-market valuations at the end of a period will not significantly influence our strategy of providing cash distributions to shareholders over the long term. Our manager has invested and seeks to invest in real estate mortgage assets that it believes are likely to generate attractive risk-adjusted returns on capital invested, after considering (1) the amount and nature of anticipated cash flows from the asset, (2) our ability to borrow against the asset, (3) the capital requirements resulting from the purchase and financing of the asset, and (4) the costs of financing, hedging, and managing the asset. Our focus is to own assets with short durations and predictable prepayment characteristics. Since our formation, essentially all of our invested assets have been in agency securities, and we currently intend that the majority of our investment assets will continue to be agency securities. We invest in both adjustable-rate and fixed-rate agency securities. ARMs are mortgages that have floating interest rates that reset on a specific time schedule, such as monthly, quarterly or annually, based on a specified index, such as the 12-month moving average of the one-year constant maturity U.S. Treasury rate ("CMT") or the London Interbank Offered Rate ("LIBOR"). The ARMs we generally invest in, sometimes referred to as hybrid ARMs, have interest rates that are fixed for an initial period (typically three, five, seven or 10 years) and then reset annually thereafter to an increment over a pre-determined interest rate index. All of our fixed-rate agency securities purchased to date have been 10-year and 15-year amortizing fixed rate securities. As of June 30, 2014, our portfolio consisted of approximately $16.7 billion in market value of agency securities, consisting of $16.2 billion of adjustable rate securities and $0.5 billion of fixed rate securities. We purchase a substantial portion of our agency securities through delayed delivery transactions (forward purchase commitments), including "to-be-announced" ("TBA") securities. At times when market conditions are conducive, we may choose to move the settlement of these TBA securities out to a later date by entering into an offsetting short position in the near month, which is then net settled for cash, and simultaneously entering into a substantially similar TBA contract for a later settlement date. Such a set of transactions is referred to as a TBA "dollar roll" transaction. Specified pools can also be the subject of a dollar roll transaction, when market conditions allow. The agency securities purchased at the later settlement date are typically priced at a discount to securities for settlement in the current month. This difference is referred to as the "price drop." The price drop represents compensation to us for foregoing net interest margin and is referred to as TBA "dollar roll income." The following table represents key data regarding the Company for the past 12 quarters: Agency Repurchase Shares Book Value Earnings Per As of Securities Agreements Equity Outstanding Per Share Share June 30, 2014 $ 16,651,220$ 15,019,880$ 2,433,011 96,517 $ 22.23$ (0.19 ) March 31, 2014 17,137,956 15,183,457 2,392,714 96,515 21.81 0.12 December 31, 2013 17,642,532 16,129,683 2,364,101 96,602 21.50 (0.16 ) September 30, 2013 19,843,830 18,829,771 2,373,641 97,909 21.31 (2.72 ) June 30, 2013 25,256,043 23,077,252 2,479,089 98,830 22.18 0.66 March 31, 2013 25,162,730 22,586,932 3,072,265 98,830 28.18 0.62 December 31, 2012 23,919,251 22,866,429 3,072,864 98,822 28.19 1.02 September 30, 2012 26,375,137 23,583,180 3,212,556 98,809 29.60 0.83 June 30, 2012 22,367,121 20,152,860 2,692,261 98,074 27.45 0.91 March 31, 2012 18,323,972 16,556,630 2,669,300 97,779 27.30 0.89 December 31, 2011 17,741,873 16,162,375 2,080,188 76,823 27.08 0.92 September 30, 2011 17,614,374 15,886,231 2,015,003 76,547 26.32 1.04 27

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Factors that Affect our Results of Operations and Financial Condition

Our results of operations and financial condition are affected by various factors, many of which are beyond our control, including, among other things, our net interest margin, the market value of our assets and the supply of and demand for such assets. We invest in financial assets and markets, and recent events, including those discussed below, can affect our business in ways that are difficult to predict, and produce results outside of typical operating variances. Our net interest margin varies primarily as a result of changes in interest rates, borrowing costs and prepayment speeds, the behavior of which involves various risks and uncertainties. Prepayment rates, as reflected by the rate of principal paydown, and interest rates vary according to the type of investment, conditions in financial markets, government actions, competition and other factors, none of which can be predicted with any certainty. In general, as prepayment rates on our agency securities purchased at a premium increase, related purchase premium amortization increases, thereby reducing the net yield on such assets. Because changes in interest rates may significantly affect our activities, our operating results depend, in large part, upon our ability to manage interest rate risks and prepayment risks effectively while maintaining our status as a REIT. We anticipate that, for any period during which changes in the interest rates earned on our assets do not coincide with interest rate changes on our borrowings, such asset coupon rates will reprice more slowly than the corresponding liabilities used to finance those assets. Consequently, changes in interest rates, particularly short-term interest rates, may significantly influence our net interest margin. With the maturities of our assets generally being longer term than those of our liabilities, interest rate increases will tend to decrease our net interest margin and the market value of our assets (and therefore our book value). Such rate increases could possibly result in operating losses or adversely affect our ability to make distributions to our shareholders. Prepayments on agency securities and the underlying mortgage loans may be influenced by changes in market interest rates and a variety of economic, geographic and other factors beyond our control; and consequently, prepayment rates cannot be predicted with certainty. To the extent we have acquired agency securities at a premium or discount to par, or face value, changes in prepayment rates may impact our anticipated yield. In periods of declining interest rates, prepayments on our agency securities are likely to increase. If we are unable to reinvest the proceeds of these prepayments at comparable yields, our net interest margin may suffer. The current climate of government intervention in the mortgage market significantly increases the risk associated with prepayments. While we intend to use hedging to mitigate some of our interest rate risk, we do not intend to hedge all of our exposure to changes in interest rates and prepayment rates, as there are practical limitations on our ability to insulate our portfolio from all potential negative consequences associated with changes in short-term interest rates in a manner that will allow us to seek attractive net spreads on our portfolio.



In addition, a variety of other factors relating to our business may also impact our financial condition and operating performance. These factors include:

our degree of leverage;

our access to funding and borrowing capacity;

our borrowing costs; our hedging activities;



the market value of our investments; and

the REIT requirements, the requirements to qualify for an exemption under the

Investment Company Act and other regulatory and accounting policies related

to our business.

Our manager is entitled to receive a management fee that is based on our equity (as defined in our management agreement), regardless of the performance of our portfolio. Accordingly, the payment of our management fee may not decline in the event of a decline in our profitability and may cause us to incur losses. For a discussion of additional risks relating to our business see the section captioned "Risk Factors" in Part II, Item 1A of this Quarterly Report on Form 10-Q, and in our Annual Report on Form 10-K for the year ended December 31, 2013. 28 --------------------------------------------------------------------------------



Market and Interest Rate Trends and the Effect on our Portfolio

Developments at Fannie Mae and Freddie Mac

Payments on the agency securities in which we invest are guaranteed by Fannie Mae and Freddie Mac. Because of the guarantee and the underwriting standards associated with mortgages underlying agency securities, agency securities historically have had high stability in value and have been considered to present low credit risk. In 2008, Fannie Mae and Freddie Mac were placed under the conservatorship of the U.S. government due to the significant weakness of their financial condition. Since that time, there have been a number of proposals introduced, both from industry groups and by the U.S. Congress outlining alternatives for reforming the U.S. housing system, specifically Fannie Mae and Freddie Mac, and transforming the government's involvement in the housing market. A recent bill in Congress that received serious consideration is the Housing Finance Reform and Taxpayer Protection Act of 2013, also known as the Corker-Warner bill. This legislation, among other things, would eliminate Freddie Mac and Fannie Mae and replace them with a new agency which would provide a financial guarantee that would only be tapped after private institutions and investors stepped in. In addition, on July 11, 2013, members of the U.S. House of Representatives introduced the Protecting American Taxpayers and Homeowners Act ("PATH"), a broad financing reform bill that would serve as a counterpart to the Corker-Warner bill. PATH would also revoke the charters of Fannie Mae and Freddie Mac and remove barriers to private investment. In the first quarter of 2014, Senators Tim Johnson (D-SD) and Mike Crapo (R-ID), the two most senior members of the Senate Banking Committee, released a proposed bill known as the Johnson-Crapo bill, which is generally based on the Corker-Warner bill. While the Corker-Warner bill was approved by the Committee, it failed to secure enough support for the bill to be considered by Congress. As the Federal Housing Finance Agency and both houses of Congress are each working on separate measures intended to restructure the U.S. housing finance system and the operations of Fannie Mae and Freddie Mac, we expect debate and discussion on the topic to continue throughout 2014. It remains unclear whether these or any other proposals will become law or, should a proposal become law, what the effects would be. It is unclear how the proposals would impact housing finance, and what impact, if any, it would have on mortgage REITs.



U.S. Treasury and Agency Securities Market Intervention

One of the main factors impacting market prices of our investments has been the U.S. Federal Reserve's programs to purchase U.S. Treasury and agency securities in the open market. These programs, referred to as "quantitative easing" are aimed to improve the employment outlook and increase growth in the U.S. economy. The third round of these purchases, commonly referred to as "QE3" was announced in September 2012. One effect of these purchases has been an increase in the prices of agency securities, which has contributed to the decrease of our net interest margin. On December 18, 2013, the U.S. Federal Reserve announced that it would reduce its purchases of both agency securities and U.S. Treasury securities by $5 billion each for the month of January. On January 29, 2014, the U.S. Federal Reserve announced additional $5 billion reductions to its monthly purchase of both agency securities and U.S. Treasury securities to take effect in February 2014, and on March 19, 2014, it announced a further reduction, bringing the current purchases for July down to $15 billion of agency securities and $20 billion of U.S. Treasury securities. In minutes from the U.S. Federal Reserve Open Market Committee meeting in June 2014, the U.S. Federal Reserve indicated that it will end its bond buying program in October 2014. In March 2014, the U.S. Federal Reserve also stated it would continue reinvesting principal payments from its agency securities and rolling over maturing U.S. Treasury securities at auction. The announcements on the tapering of the U.S. Federal Reserve's purchases drove interest rates higher on U.S. Treasury and agency securities and resulted in large negative price movements in our assets. The unpredictability and size of these programs has also injected additional volatility into the pricing and availability of our assets. Due to the unpredictability in the markets for our securities in particular and yield generating assets in general, there is no pattern that can be implied with any certainty. We believe the largest risk is that if the government decides to sell significant portions of its portfolio, then we may see additional price declines.



Exposure to European Financial Counterparties

We have no direct exposure to any European sovereign credit. We do finance the acquisition of our agency securities with repurchase agreements, some of which are provided by European banks. In connection with these financing arrangements, we pledge our securities as collateral to secure the borrowing. The amount of collateral pledged will typically exceed the amount of the financing with the extent of over-collateralization ranging from 3%-6% of the amount borrowed. While repurchase agreement financing results in us recording a liability to the counterparty in our consolidated balance sheet, we are exposed to the counterparty, if during the term of the repurchase agreement financing, a lender should default on its obligation and we are not able to recover our pledged assets. The amount of this exposure is the difference between the amount loaned to us plus interest due to the counterparty and the fair value of the collateral pledged by us to the lender including accrued interest receivable on such collateral. In addition, we use interest rate swaps to manage interest rate risk exposure in connection with our repurchase agreement financings. We will make cash payments or pledge securities as collateral as part of a margin arrangement in connection with interest rate swaps that are in an unrealized loss position. In the event that a counterparty were to default on its obligation, we would be exposed to a loss to a swap counterparty to the extent that the amount of cash or securities pledged exceeded the unrealized loss on the associated swaps and we were not able to recover the excess collateral. 29 -------------------------------------------------------------------------------- During the past several years, several large European banks have experienced financial difficulty and have been either rescued by government assistance or by other large European banks. Some of these banks have U.S. banking subsidiaries, which have provided financing to us, particularly repurchase agreement financing for the acquisition of agency securities. At June 30, 2014, we had entered into repurchase agreements and/or interest rate swaps with seven financial institution counterparties that are either domiciled in Europe or a U.S.-based subsidiary of a European domiciled financial institution. Our total exposure to these banks was 7.7% of our equity at June 30, 2014. At June 30, 2014, we did not use credit default swaps or other forms of credit protection to hedge these exposures, although we may in the future. The following table shows our exposure by country to European banks. Number of Exposure as a Counterparties Exposure (1) Percentage of Equity England 1 $ 31,369 1.3 % France 1 26,289 1.1 % Germany 2 18,560 0.7 % Netherlands 1 43,770 1.8 % Scotland 1 24,332 1.0 % Switzerland 1 43,708 1.8 % 7 $ 188,027 7.7 %



(1) Exposure represents our total assets pledged as collateral in excess of our

obligations, including any accrued interest receivable on the pledged

assets.

Management monitors our exposure to our repurchase agreement and interest rate swap counterparties on a regular basis, using various methods, including review of recent rating agency actions or other developments and by monitoring the amount of cash and securities collateral pledged and the associated loan amount under repurchase agreements and/or the fair value of interest rate swaps with our counterparties. We intend to make reverse margin calls on our counterparties to recover excess collateral as permitted by the agreements governing our financing arrangements, or take other necessary actions to reduce the amount of our exposure to a counterparty when such actions are considered necessary.



Interest Rates

Mortgage markets in general, and our strategy in particular, are sensitive to changes in interest rates. The relationship between several interest rates is generally determinant of the performance of our company. Our borrowings in the repurchase market have historically closely tracked LIBOR and the U.S. Federal Funds Effective Rate. Significant volatility in these rates or a divergence from the historical relationship among these rates could negatively impact our ability to manage our portfolio. The mortgage assets we buy are affected by the shape of the yield curve, particularly along the area between two year Treasury rate and 10 year Treasury rates. The following table shows the 30-day LIBOR as compared to these rates at each period end for the past 12 quarters: 30- Fed Funds Two Year 10 Year Day LIBOR Effective Rate Treasury Treasury June 30, 2014 0.16 % 0.09 % 0.47 % 2.53 % March 31, 2014 0.15 % 0.06 % 0.44 % 2.73 % December 31, 2013 0.17 % 0.07 % 0.38 % 3.04 % September 30, 2013 0.18 % 0.06 % 0.33 % 2.64 % June 30, 2013 0.19 % 0.07 % 0.36 % 2.49 % March 31, 2013 0.20 % 0.09 % 0.24 % 1.85 % December 31, 2012 0.21 % 0.09 % 0.25 % 1.78 % September 30, 2012 0.21 % 0.09 % 0.23 % 1.63 % June 30, 2012 0.25 % 0.09 % 0.30 % 1.65 % March 31, 2012 0.24 % 0.09 % 0.33 % 2.21 % December 31, 2011 0.30 % 0.04 % 0.24 % 1.88 % September 30, 2011 0.24 % 0.06 % 0.25 % 1.92 % Principal Repayment Rate Our net interest income is primarily a function of the difference between the yield on our assets and the financing cost of owning those assets. Since we tend to purchase assets at a premium to par, the main item that can affect the yield on our assets after they are purchased is the rate at which the mortgage borrowers repay the loan. While the scheduled repayments, which are the principal portion of the homeowners' regular monthly payments, are fairly predictable, the unscheduled repayments, which are generally refinancing of the mortgage, are less so. Estimates of repayment rates are critical to the management of our portfolio, not only for estimating current yield but also to consider the rate of reinvestment of those proceeds into new securities, the yields which those new 30

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securities may add to our portfolio, as well as the extent to which we extend the duration of our liabilities in connection with hedging activities.

The following table shows the weighted average principal repayment rate and the one-month constant prepayment rate ("CPR") for the last 12 quarters:

Weighted Average Weighted Average Principal Principal Repayment Rate Repayment Rate (1) Annualized (2) One Month CPR (3) June 30, 2014 5.09% 20.36% 15.4 March 31, 2014 4.42% 17.66% 13.0 December 31, 2013 4.89% 19.55% 14.2 September 30, 2013 6.93% 27.72% 19.7 June 30, 2013 7.03% 28.10% 20.8 March 31, 2013 6.50% 26.01% 19.0 December 31, 2012 6.64% 26.55% 19.8 September 30, 2012 6.90% 27.61% 20.5 June 30, 2012 6.36% 25.42% 19.7 March 31, 2012 6.42% 25.67% 19.6 December 31, 2011 6.85% 27.39% 20.8 September 30, 2011 7.14% 28.55% 21.7



(1) Scheduled and unscheduled principal payments as a percentage of the weighted

average portfolio. (2) Weighted average principal repayment rate annualized. (3) CPR measures one month of unscheduled repayments as a percentage of principal on an annualized basis.



Book Value per Share

As of June 30, 2014, our book value per share of common stock (total shareholders' equity less the aggregate liquidation preference for Series A Preferred Stock divided by shares of common stock outstanding) was $22.23, an increase of $0.73, from $21.50 at December 31, 2013. The increase in our book value was primarily a result of the increase in the unrealized gain on our assets partially offset by the impact of dividends declared in excess of GAAP earnings. The following table shows the components of our book value on a per share basis at each period end: Unrealized Unrealized Gain/(Loss) Undistributed Gain/(Loss) on on Interest Book Value As of Common Equity Earnings MBS Rate Swaps Per Share June 30, 2014 $ 25.32 $ (4.79 ) $ 2.36 $ (0.66 )$ 22.23 March 31, 2014 25.31 (4.11 ) 1.50 (0.89 ) 21.81 December 31, 2013 25.30 (3.72 ) 1.07 (1.15 ) 21.50 September 30, 2013 25.19 (3.02 ) 0.53 (1.39 ) 21.31 June 30, 2013 25.16 0.26 (1.91 ) (1.33 ) 22.18 March 31, 2013 25.15 0.30 4.94 (2.21 ) 28.18 December 31, 2012 25.15 0.38 5.12 (2.46 ) 28.19 September 30, 2012 25.14 0.05 7.16 (2.75 ) 29.60 June 30, 2012 25.25 0.02 4.73 (2.55 ) 27.45 March 31, 2012 25.23 0.01 4.29 (2.23 ) 27.30 December 31, 2011 24.79 0.03 5.11 (2.85 ) 27.08 September 30, 2011 24.79 0.01 4.56 (3.04 ) 26.32 Investments We invest in both adjustable and fixed-rate agency securities. At June 30, 2014 and December 31, 2013, we owned $16.7 billion and $17.6 billion, respectively, of agency securities. While our strategy focuses on ARM securities, we also own fixed-rate securities with estimated durations that we believe are beneficial to the overall mix of our assets. As of June 30, 2014 and December 31, 2013, our agency securities portfolio was purchased at a net premium to par, or face value, with a weighted-average 31 -------------------------------------------------------------------------------- amortized cost of 102.82 and 102.87, respectively, of face value. As of June 30, 2014 and December 31, 2013, we had approximately $450.7 million and $488.9 million, respectively, of unamortized premium included in the cost basis of our agency securities. During the quarter ended June 30, 2014, we purchased approximately $0.9 billion of agency securities with a weighted average coupon of 2.83%. We also sold approximately $0.9 billion of agency securities with a weighted average coupon of 2.59% for the three months ended June 30, 2014. During the six months ended June 30, 2014, we purchased approximately $2.2 billion of agency securities with a weighted average coupon of 2.83%. During the six months ended June 30, 2014, we sold approximately $1.4 billion of agency securities with a weighted average coupon of 2.92%. We typically want to own a higher percentage of Fannie Mae ARMs than Freddie Mac ARMs as Fannie Mae has better cash flow to the security holder because Fannie Mae pays principal and interest sooner after accrual (54 days) as compared to Freddie Mac (75 days).



Our investment portfolio consisted of the following types of Fannie Mae, Freddie Mac and Ginnie Mae securities at June 30, 2014:

Gross Gross Unrealized Unrealized Estimated Amortized Cost Loss Gain Fair Value % of Total Agency Securities Fannie Mae Certificates ARMs $ 9,458,568$ (17,277 )$ 189,611$ 9,630,902 57.8 % Fixed Rate 288,499 - 3,845 292,344 1.8 % Total Fannie Mae 9,747,067 (17,277 ) 193,456 9,923,246 Freddie Mac Certificates ARMs 6,514,037 (26,376 ) 72,439 6,560,100 39.4 % Fixed Rate 166,168 - 1,706 167,874 1.0 % Total Freddie Mac 6,680,205 (26,376 ) 74,145 6,727,974 Total Agency Securities $ 16,427,272$ (43,653 )$ 267,601$ 16,651,220 As of December 31, 2013, our investment portfolio consisted of the following types of securities: Gross Gross Unrealized Unrealized Estimated Amortized Cost Loss Gain Fair Value % of Total Agency Securities Fannie Mae Certificates ARMs $ 9,620,743$ (44,871 )$ 167,848$ 9,743,720 55.2 % Fixed Rate 806,312 (1,798 ) 3,832 808,346 4.6 % Total Fannie Mae 10,427,055 (46,669 ) 171,680 10,552,066 Freddie Mac Certificates ARMs 6,671,013 (70,752 ) 57,808 6,658,069 37.8 % Fixed Rate 338,738 (1,600 ) 21 337,159 1.9 % Total Freddie Mac 7,009,751 (72,352 ) 57,829 6,995,228 Ginnie Mae Certificates ARMs - - - - 0.0 % Fixed Rate 96,236 (998 ) - 95,238 0.5 % Total Ginnie Mae 96,236 (998 ) - 95,238 Total Agency Securities $ 17,533,042$ (120,019 )$ 229,509$ 17,642,532 32

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Adjustable-rate securities

As of June 30, 2014 our investment portfolio consisted of ARM securities as follows: Wtd. Avg. Amortized Weighted Avg. % of ARM Current Face Weighted Avg.



Purchase Price Amortized Market Price Months to Reset Portfolio Value (1) Coupon (2)

(3) Cost (4) (5) Market Value (6) 0-12 10.5 % $ 1,591,293 3.27 % $ 101.95$ 1,622,359$ 106.58$ 1,696,022 13-24 13.5 % 2,066,608 3.16 % $ 102.57 2,119,808 $ 105.89 2,188,287 25-36 12.0 % 1,858,932 2.60 % $ 102.71 1,909,376 $ 104.37 1,940,145 37-48 15.0 % 2,323,577 2.96 % $ 102.77 2,387,937 $ 104.73 2,433,548 49-60 30.9 % 4,831,543 2.65 % $ 102.95 4,974,046 $ 103.42 4,996,565 61-72 12.9 % 2,051,757 2.30 % $ 103.37 2,120,902 $ 101.91 2,090,887 73-84 5.2 % 808,625 2.88 % $ 102.34 827,584 $ 103.23 834,773 109-120 0.0 % 10,398 3.30 % $ 101.88 10,593 $ 103.63 10,775 Total ARMS 100.0 % $ 15,542,733 2.79 % $ 102.77$ 15,972,605$ 104.17$ 16,191,002 As of December 31, 2013, our investment portfolio consisted of ARM securities as follows: Wtd. Avg. Amortized Weighted Avg. % of ARM Current Face Weighted Avg.



Purchase Price Amortized Market Price Months to Reset Portfolio Value (1) Coupon (2)

(3) Cost (4) (5) Market Value (6) 0-12 7.5 % $ 1,165,714 3.15 % $ 101.77$ 1,186,380$ 106.10$ 1,236,878 13-24 9.8 % 1,526,598 3.49 % $ 102.30 1,561,668 $ 105.73 1,614,081 25-36 14.2 % 2,212,306 2.99 % $ 102.45 2,266,557 $ 104.96 2,321,985 37-48 15.4 % 2,430,716 2.73 % $ 102.77 2,498,130 $ 103.88 2,524,939 49-60 15.1 % 2,394,168 2.94 % $ 102.58 2,455,924 $ 103.72 2,483,318 61-72 29.0 % 4,664,901 2.46 % $ 103.31 4,819,437 $ 101.83 4,750,098 73-84 9.0 % 1,461,452 2.44 % $ 102.89 1,503,660 $ 100.62 1,470,490 Total ARMs 100.0 % $ 15,855,855 2.80 % $ 102.75$ 16,291,756$ 103.44$ 16,401,789



(1) The current face is the current monthly remaining dollar amount of principal

of a mortgage security. We compute current face by multiplying the original

face value of the security by the current principal balance factor. The current principal balance factor is essentially a fraction, where the numerator is the current outstanding balance and the denominator is the original principal balance.



(2) For a pass-through certificate, the coupon reflects the weighted average

nominal rate of interest paid on the underlying mortgage loans, net of fees

paid to the servicer and the agency. The coupon for a pass-through

certificate may change as the underlying mortgage loans are prepaid. The

percentages indicated in this column are the nominal interest rates that

will be effective through the interest rate reset date and have not been

adjusted to reflect the purchase price we paid for the face amount of

security.

(3) Amortized purchase price is the dollar amount, per $100 of current face, of

our purchase price for the security, adjusted for amortization as a result

of scheduled and unscheduled principal paydowns. (4) Amortized cost is our total purchase price for the mortgage security,



adjusted for amortization as a result of scheduled and unscheduled principal

paydowns.

(5) Market price is the dollar amount of market value, per $100 of nominal, or

face value, of the mortgage security. (6) Market value is the total market value for the mortgage security. As of June 30, 2014, excluding any fixed-rate securities, the ARMs underlying our adjustable rate agency securities had fixed interest rates for a weighted average period of approximately 45 months after which time the interest rates reset and become adjustable annually. At June 30, 2014, 96.3% of our ARMs were still in their initial fixed-rate period and 3.7% of our ARMs have already reached their initial reset period and will reset annually for the life of the security. At June 30, 2014, an additional 6.8% of our ARMs will reach the end of their initial fixed-rate period in the next 12 months. After the reset date, interest rates on our ARMs float based on spreads over various indices, usually LIBOR or the one-year CMT. These interest rate adjustments are subject to caps that limit the amount the applicable interest rate can increase during any year, known as an annual cap, and through the maturity of the security, known as a lifetime cap. At the first reset date, our ARMs typically have a maximum initial one-time adjustment of either 2% or 5%, followed by annual interest rate increases (or decreases) of 33 -------------------------------------------------------------------------------- up to a maximum change of 2% per year. The average lifetime cap on increases (or decreases) to the interest rates on our agency securities is 5% from the initial stated rate. Fixed-rate securities In addition to adjustable-rate securities, we also invest in fixed-rate securities. All of our fixed-rate agency securities purchased to date have been 10-year and 15-year amortizing fixed rate securities. At June 30, 2014, we owned $460.2 million of 15-year fixed-rate agency securities with a weighted average life, assuming a constant prepayment rate of 10, of 4.1 years. The following table details our fixed-rate securities portfolio at June 30, 2014. Wtd. Avg. Wtd. Avg Current Amortized Weighted



Months to % of Fixed Face Value Weighted Avg. Purchase Price Amortized Avg. Market Market Maturity Rate Portfolio (1) Coupon (2)

(3) Cost (4) Price (5) Value (6) 133-144 57.3 % $ 248,211 3.50 % $ 104.78$ 260,066$ 106.21$ 263,614 145-156 42.7 % 185,645 3.50 % $ 104.82 194,601 $ 105.90 196,604 Total Fixed Rate 100.0 % $ 433,856 3.50 % $ 104.80$ 454,667$ 106.08$ 460,218 The following table details our fixed-rate securities portfolio at December 31, 2013. Wtd. Avg. Wtd. Avg Amortized Weighted Avg.



Months to % of Fixed Current Face Weighted Avg. Purchase Price Amortized Market Price Market Value Maturity Rate Portfolio Value (1) Coupon (2)

(3) Cost (4) (5) (6) 133-144 6.1 % $ 72,252 3.50 % $ 105.40$ 76,154$ 104.76$ 75,693 145-156 38.5 % 456,585 3.50 % $ 104.82 478,592 $ 104.59 477,544 157-168 7.7 % 93,198 3.00 % $ 103.26 96,237 $ 102.19 95,238 169-180 47.7 % 566,299 3.50 % $ 104.24 590,303 $ 104.59 592,268 Total Fixed Rate 100.0 % $ 1,188,334 3.46 % $ 104.46$ 1,241,286$ 104.41$ 1,240,743 (1) The current face value is the current monthly remaining dollar amount of principal of a mortgage security. We compute current face value by



multiplying the original face value of the security by the current principal

balance factor. The current principal balance factor is essentially a fraction, where the numerator is the current outstanding balance and the denominator is the original principal balance.



(2) For a pass-through certificate, the coupon reflects the weighted average

nominal rate of interest paid on the underlying mortgage loans, net of fees

paid to the servicer and the agency. The coupon for a pass-through

certificate may change as the underlying mortgage loans are prepaid. The

percentages indicated in this column have not been adjusted to reflect the

purchase price we paid for the face amount of security.

(3) Amortized purchase price is the dollar amount, per $100 of current face, of

our purchase price for the security, adjusted for amortization as a result

of scheduled and unscheduled principal paydowns. (4) Amortized cost is our total purchase price for the mortgage security,



adjusted for amortization as a result of scheduled and unscheduled principal

paydowns.

(5) Market price is the dollar amount of market value, per $100 of nominal, or

face value, of the mortgage security. (6) Market value is the total market value for the mortgage security.



Forward Purchases

While most of our purchases of agency securities are accounted for using trade date accounting, some forward purchases, such as certain TBA contracts, do not qualify for trade date accounting and are considered derivatives for financial statement purposes. Our accounting for these forward purchases depends on whether or not we intend to take physical delivery of the securities. In either case, the net fair value of the forward commitment is reported on the consolidated balance sheet as an asset or liability. If the Company intends to take physical delivery of the security, the commitment is designated as an all-in-one cash flow hedge and its unrealized gains and losses are recorded in other comprehensive income. If the Company does not intend to take physical delivery, as is the case with most TBA dollar rolls, the commitment is not designated as an accounting hedge and unrealized gains and losses are recorded in "Gain (loss) on derivative instruments, net." 34 --------------------------------------------------------------------------------



The following table shows our 15-year TBA contracts at June 30, 2014 and December 31, 2013.

Fair Market Net Asset

Face Wtd. Avg. Coupon Cost



Value (Liability)

June 30, 2014 $ 2,850,000 3.0% $ 2,949,433$ 2,962,617$ 13,184 December 31, 2013 $ 600,000 3.5% $ 632,270$ 627,187$ (5,083 )



We also enter into commitments with various mortgage originators for ARM securities. The fair value of these commitments at June 30, 2014 was a net asset of $3,755 and at December 31, 2013 a net liability of ($658).

Liabilities

We have entered into repurchase agreements to finance most of our agency securities. Our repurchase agreements are secured by our agency securities and bear interest at rates that have historically moved in close relationship to LIBOR. As of June 30, 2014, we had established 30 borrowing relationships with various investment banking firms and other lenders. We had an outstanding balance under our repurchase agreements at June 30, 2014 of $15.0 billion with 26 counterparties. We had an outstanding balance of $16.1 billion at December 31, 2013 with 25 different counterparties.



Hedging Instruments

We generally intend to hedge, on an economic basis, as much of our interest rate risk as our manager deems prudent in light of market conditions. No assurance can be given that our hedging activities will have the desired beneficial impact on our results of operations or financial condition. Our policies do not contain specific requirements as to the percentages or amount of interest rate risk that our manager is required to hedge.



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

available interest rate hedging may not correspond directly with the interest

rate risk for which protection is sought;

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

fair value accounting rules could foster adverse valuation adjustments due to

credit quality considerations that could impact both earnings and shareholder

equity;

the party owing money in the hedging transaction may default on its

obligation to pay;

the credit quality of the party owing money on the hedge may be downgraded to

such an extent that it impairs our ability to sell or assign our side of the

hedging transaction; and

the value of derivatives used for hedging may be adjusted from time to time

in accordance with accounting rules to reflect changes in fair

value. Downward adjustments, or "mark-to-market losses," would reduce our

shareholders' equity, and in the case of derivatives not subject to hedge

accounting, our earnings as well.

As of June 30, 2014, we had entered into 71 interest rate swap agreements with 13 counterparties to hedge (on an economic basis) a benchmark interest rate - LIBOR. This portfolio of hedges is designed to lock in funding costs for specific funding activities associated with specific assets as a way to realize attractive net interest margins. This hedging strategy incorporates an assumed prepayment schedule, which, if not realized, will cause our results to differ from expectations. These interest rate swap agreements provide for fixed interest rates indexed off of one-month LIBOR and effectively fix the floating interest rates on $9.9 billion of borrowings under our repurchase agreements. We also purchase Eurodollar Futures Contracts ("Futures Contracts"), which are based on three-month LIBOR, as part of our strategy to mitigate interest rate risk. The effective notional amounts and rates of our interest rate swaps and Futures Contracts as of June 30, 2014 were as follows: Futures Futures Wtd. Avg. Contracts Contracts Rate Swap Notional Swap Rate Total Wtd. Avg. Rate Effective 2014 $ 1,914,000 0.35 % $ 8,750,000 1.31 % $ 10,664,000 1.14 % Effective 2015 7,590,500 0.72 % 5,825,000 1.28 % 13,415,500 0.96 % Effective 2016 7,104,250 1.99 % 3,100,000 0.71 % 10,204,250 1.60 % Effective 2017 6,544,000 2.96 % 850,000 0.90 % 7,394,000 2.72 % Effective 2018 4,260,000 3.65 % 50,000 0.98 % 4,310,000 3.62 % Effective 2019 1,218,750 4.00 % - - 1,218,750 4.00 % Effective 2020 1,060,250 4.18 % - - 1,060,250 4.18 % Effective 2021 347,250 4.25 % - - 347,250 4.25 % 35

-------------------------------------------------------------------------------- On September 30, 2013, we discontinued hedge accounting for our interest rate swap agreements by de-designating the interest rate swaps as cash flow hedges. No interest rate swaps were terminated in conjunction with this action, and our risk management and hedging practices are unimpacted. However, our accounting for these transactions was changed prospectively effective October 1, 2013. All of our interest rate swaps had previously been accounted for as cash flow hedges under ASC Topic 815, Derivatives and Hedging. As a result of discontinuing hedge accounting, beginning October 1 changes in the fair value of our interest rate swap agreements are recorded in "Gain (loss) on derivative instruments, net" in our consolidated statements of income, rather than in other comprehensive income. Also, net interest paid or received under the interest rate swaps, which up through September 30 was recognized in "interest expense," is now recognized in "Gain (loss) on derivative instruments, net."



New Business Initiatives

We have begun an initiative to acquire and aggregate individual whole jumbo mortgage loans, with a goal of securitizing the loans into MBS not guaranteed by a U.S. Government sponsored entity or a U.S. Government agency. We would expect to initially retain all or a majority of the resulting MBS. In connection with this initiative, we may enter into arrangements whereby we agree with parties to acquire the loans that they originate consistent with our guidelines. We do not anticipate that the individual mortgage loans and any resulting MBS would constitute a significant portion of our assets in the near future. 36



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