The following discussion of our financial condition and results of operations
should be read in conjunction with our condensed consolidated financial
statements and related notes included elsewhere in this report.
References to "we," "us," "our," "ARMOUR" or the "Company" are to
ARMOUR Residential REIT, Inc.References to "ARRM" are to ARMOUR Residential Management LLC, a Delawarelimited liability company. Refer to the Glossary of Terms for definitions of capitalized terms and abbreviations used in this report.
Dollar amounts are presented in thousands, except per share amounts or as otherwise noted.
We are a
Marylandcorporation formed to invest in and manage a leveraged portfolio of MBS and mortgage loans. The securities we invest in are issued or guaranteed by a GSE, such as Fannie Mae, the Freddie Mac, or guaranteed by Ginnie Mae(collectively, Agency Securities). Our securities portfolio consists primarily of Agency Securitiesbacked by fixed rate home loans. From time to time, a portion of our assets may be invested in Agency Securitiesbacked by hybrid adjustable rate and adjustable rate home loans as well as unsecured notes and bonds issued by GSE's, U.S. Treasuries and money market instruments, subject to certain income tests we must satisfy for our qualification as a REIT. Our charter permits us to invest in Agency Securitiesand Non-Agency Securities. At June 30, 2014and December 31, 2013, Agency Securitiesaccount for 100% of our securities portfolio. It is expected that the percentage will continue to be 100% or close thereto. We are externally managed by ARRM, pursuant to the Management Agreement, which was most recently amended on February 25, 2014. ARRM is an investment advisor registered with the SEC. ARRM is also the external manager of JAVELIN, a publicly traded REIT, which invests in and manages a leveraged portfolio of Agency Securitiesand Non-Agency Securities. Our executive officers also serve as the executive officers of JAVELIN. We seek attractive long-term investment returns by investing our equity capital and borrowed funds in our targeted asset class of Agency Securities. We earn returns on the spread between the yield on our assets and our costs, including the interest cost of the funds we borrow, after giving effect to our hedges. We identify and acquire Agency Securities, finance our acquisitions with borrowings under a series of short-term repurchase agreements at the most competitive interest rates available to us and then cost-effectively hedge our interest rate and other risks based on our entire portfolio of assets, liabilities and derivatives and our management's view of the market. Successful implementation of this approach requires us to address interest rate risk, maintain adequate liquidity and effectively hedge interest rate risks. We believe that the residential mortgage market will undergo significant changes in the coming years as the role of GSEs, such as Fannie Mae and Freddie Mac, is diminished, which we expect will create attractive investment opportunities for us. We execute our business plan in a manner consistent with our intention of qualifying as a REIT under the Code and avoiding regulation as an investment company under the 1940 Act. We have elected to be taxed as a REIT under the Code. We will generally not be subject to federal income tax to the extent that we distribute our taxable income to our stockholders and as long as we satisfy the ongoing REIT requirements under the Code including meeting certain asset, income and stock ownership tests.
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 income, the market value of our assets and the supply of and demand for such assets. We invest in financial assets and markets. Recent events, such as those discussed below, can affect our business in ways that are difficult to predict and may produce results outside of typical operating variances. Our net interest income 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 pay downs 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 Securitiesthat are 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. 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 assets will tend to reprice more slowly than the corresponding liabilities. Consequently, changes in interest rates, particularly short-term interest rates, may significantly influence our net interest income. With the maturities of our assets 28 -------------------------------------------------------------------------------- generally of longer term than those of our liabilities, interest rate increases will tend to decrease our net interest income 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 stockholders. Prepayments on Agency Securitiesand the underlying mortgage loans may be influenced by changes in market interest rates and a variety of economic and geographic factors, policy decisions by regulators, as well as other factors beyond our control. Consequently, prepayment rates cannot be predicted with certainty. To the extent we hold Agency Securitiesacquired 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 Securitieswill likely increase. If we are unable to reinvest the proceeds of such prepayments at comparable yields, our net interest income may decline. The recent climate of government intervention in the mortgage markets significantly increases the risk associated with prepayments. While we use strategies to economically hedge some of our interest rate risk, we do not hedge all of our exposure to changes in interest rates and prepayment rates, as there are practical limitations on our ability to insulate our securities 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 securities portfolio. Also, since we have not elected to use cash flow hedge accounting, earnings reported in accordance with GAAP will fluctuate even in situations where our derivatives are operating as intended. As a result of this mark-to-market accounting treatment, our results of operations are likely to fluctuate far more than if we were to designate our derivative activities as cash flow hedges. Comparisons with companies that use cash flow hedge accounting for all or part of their derivative activities may not be meaningful. For these and other reasons more fully described under the section captioned "Derivative Instruments" below, no assurance can be given that our derivatives will have the desired beneficial impact on our results of operations or financial condition. In addition to the use of derivatives to hedge interest rate risk, 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;
• the REIT requirements under the Code; and
• the requirements to qualify for an exemption under the 1940 Act and other regulatory and accounting policies related to our business.
We are externally managed by ARRM, pursuant to the Management Agreement (see Note 14 to the condensed consolidated financial statements). All of our executive officers are also employees of ARRM. ARRM manages our day-to-day operations, subject to the direction and oversight of the Board. The Management Agreement expires after an initial term of ten years on
June 18, 2022and is thereafter automatically renewed for an additional five-year term unless terminated under certain circumstances. Either party must provide 180 days prior written notice of any such termination. ARRM is entitled to receive a termination fee from us under certain circumstances. Pursuant to the Management Agreement, ARRM is entitled to receive a management fee payable monthly in arrears. Currently, the monthly management fee is 1/12th of the sum of (a) 1.5% of gross equity raised up to $1.0 billionplus (b) 0.75% of gross equity raised in excess of $1.0 billion.The cost of repurchased stock and any dividend representing a return of capital for tax purposes will reduce the amount of gross equity raised used to calculate the monthly management fee. At June 30, 2014, the effective management fee was 1.03% based on gross equity raised. ARRM is entitled to receive a monthly management fee regardless of the performance of our securities portfolio. Accordingly, the payment of our monthly management fee may not decline in the event of a decline in our earnings and may cause us to incur losses. Our total management fee expense for the quarter and six months ended June 30, 2014, was $6,964and $13,929, respectively, compared to $7,869and $14,502for the quarter and six months ended June 30, 2013. We are required to take actions as may be reasonably required to permit and enable ARRM to carry out its duties and obligations. We are also responsible for any costs and expenses that ARRM incurred solely on behalf of ARMOUR other than the various overhead expenses specified in the terms of the Management Agreement. For the quarter and six months ended June 30, 2014, we reimbursed ARRM $419and $878, respectively, for other expenses incurred on our behalf and $244and $477, respectively, of stock based compensation expense. For the quarter and six months ended June 30, 2013, we reimbursed ARRM $387and $783, respectively, for expenses incurred on our behalf and $264and $636, respectively, for stock based compensation expense (see Note 10 to the condensed consolidated financial statements). 29 -------------------------------------------------------------------------------- Pursuant to a Sub-Management Agreement between ARMOUR, ARRM and SBBC, ARRM is responsible for the payment of a monthly sub-management fee to SBBC in an amount equal to 25% of the monthly management fee earned by ARRM, net of expenses. On November 6, 2014, SBBC has the option of terminating the Sub-Management Agreement. If the Sub-Management Agreement is terminated, we would be required to make a final payment to SBBC in the amount of 6.16 times the annualized rate of the sub-management fee for the prior three months. Thereafter, we will be entitled to receive the sub-management fee or, at the option of ARRM, reimbursement of the final payment by ARRM. The payments from ARRM to SBBC for the three months preceding June 30, 2014totaled $1,361. If the Sub-Management Agreement had been terminated on June 30, 2014, the payment due from ARMOUR would have been $33,535.
Market and Interest Rate Trends and the Effect on our Securities Portfolio
Developments at Fannie Mae and Freddie Mac
Payments of principal and interest on the
Agency Securitiesin 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 Securitieshistorically have had high stability in value and been considered to present low credit risk. In February 2011, the U.S. Treasury along with the U.S. Department of Housing and Urban Developmentreleased a report titled, "Reforming America's Housing Finance Market" to the U.S. Congressoutlining recommendations for reforming the U.S. housing system, specifically Fannie Mae and Freddie Mac and transforming the U.S. Government'sinvolvement in the housing market. It is unclear how future legislation may impact the housing finance market and the investing environment for Agency Securitiesas the method of reform is undecided and has not yet been defined by the regulators. Without U.S. Governmentsupport for residential mortgages, we may not be able to execute our current business model in an efficient manner. In March 2011, the U.S. Treasury announced that it would begin the orderly wind down of Agency Securitiesit had purchased from Fannie Mae, Freddie Mac and Ginnie Maeto stabilize the housing market, with sales up to $10.0 billionper month, subject to market conditions. We are unable to predict the timing or manner in which the U.S. Treasury or the Fed will liquidate their holdings or make further interventions in the Agency Securitiesmarkets, or what impact, if any, such action could have on the Agency Securitiesmarket, the Agency Securitieswe hold, our business, results of operations and financial condition. On June 25, 2013, a bipartisan group of U.S. senators introduced a draft bill titled, "Housing Finance Reform and Taxpayer Protection Act of 2013" to the U.S. Senate, which would wind down Fannie Mae and Freddie Mac over a period of five years and replace the public securitization market used by the GSEs with a public-private alternative market. On July 11, 2013, members of the U.S. House Committee on Financial Servicesintroduced a similar draft bill titled, "Protecting American Taxpayers and Homeowners Act" to the U.S. House of Representatives. While distinguishable in some respects from the Senateversion, the House bill would also eliminate Fannie Mae and Freddie Mac and seek to increase the opportunities for private capital to participate in, and consequently bear the risk of loss in connection with, government guaranteed MBS. In March 2014, a bipartisan group of U.S. senators led by members of the U.S. Senate Banking Committeeannounced that they had agreed on a bill to overhaul the nation's housing finance system and eliminate Fannie Mae and Freddie Mac. The bill would replace Fannie Mae and Freddie Mac with a new federal regulator, called the Federal Mortgage Insurance Corporation, to provide guarantees for government mortgages and regulate the system. As the insurer of last resort, the Federal Mortgage Insurance Corporationwould require 10% in private capital reserves. The guarantee, provided for a fee equivalent to 0.1% interest, would not kick in until the private reserves were exhausted. The bill would also set a minimum down payment of 5% for home buyers, except for first-time home buyers, who would instead be required to put down 3.5% for the mortgage to qualify for the guarantee. In May 2014, the U.S. Senate Banking Committeeapproved the bill. While it is unlikely the bill will be brought to the Senatefloor this year, we are unable to predict the effect the passage of this bill could have on our business, results of operations and financial condition. The passage of any new legislation affecting Fannie Mae and Freddie Mac may create market uncertainty and reduce the actual or perceived credit quality of securities issued or guaranteed by the U.S. government through a new or existing successor entity to Fannie Mae and Freddie Mac. If Fannie Mae and Freddie Mac were reformed or wound down, it is unclear what effect, if any, this would have on the value of the existing Fannie Mae and Freddie Mac Agency Securities. It is also possible that the above-referenced proposed legislation, if made law, could adversely impact the market for securities issued or guaranteed by the U.S. Governmentand the spreads at which they trade. The foregoing could materially adversely affect the pricing, supply, liquidity and value of the Agency Securitiesin which we invest and otherwise materially adversely affect our business, operations and financial condition. 30 -------------------------------------------------------------------------------- We cannot predict whether or when new actions may occur, the timing and pace of current actions already implemented, or what impact if any, such actions, or future actions, could have on our business, results of operations and financial condition.
U.S. Government Mortgage Related Securities Market Intervention
September 2012, the Fed announced QE3, to purchase an additional $40.0 billionof Agency Securitiesper month until the unemployment rate and other economic indicators improved. QE3 plus its existing investment programs grew the Fed's U.S. Treasury Securitiesand Agency Securitiesholdings by approximately $85.0 billionper month at least through the end of 2013. At its January 29, 2014and March 19, 2014meetings, the Fed decided to trim its monthly Agency Securitiespurchases to $30.0 billionfor February and March 2014, and $25.0 billionfor April 2014, respectively, down from $40.0 billionin 2013. Longer term U.S. Treasury Securitiespurchases were trimmed at a pace of $35.0 billionfor February and March 2014, and $30.0 billionfor April 2014, respectively, down from $45.0 billionin 2013. At its most recent meeting on July 30, 2014, the Fed decided to further trim its monthly Agency Securitiespurchases to $10.0 billionfor August 2014, down from $15.0 billionin July 2014and $20.0 billionin May and June 2014. Longer term U.S. Treasury Securitiesmonthly purchases were also trimmed again to $15.0 billionfor August 2014, down from $20.0 billionin July 2014and $25.0 billionin May and June 2014. These actions were to keep in place the Fed's highly accommodative stance of monetary policy. As part of that policy, the Fed announced at its July 30, 2014meeting that it would keep the target range for the Federal Funds Rate between 0.0% and 0.25% toward its objectives of achieving maximum employment and curbing inflation to 2%. Reduced purchase levels by the Fed may result in lower overall demand and therefore lower prices for Agency Securities. Lower Agency Securitiesprices will reduce our book value and the amounts that we can borrow under repurchase agreements.
Financial Regulatory Reform Bill and Other Government Activity
We believe that we conduct our business in a manner that allows us to avoid being regulated as an investment company pursuant to the exclusion provided by Section 3(c)(5)(C) of the 1940 Act for entities that are primarily engaged in the business of purchasing or otherwise acquiring "mortgages and other liens on and interests in real estate." On
August 31, 2011, the SECissued a concept release (No. IC-29778; File No. SW7-34-11, Companies Engaged in the Business of Acquiring Mortgages and Mortgage Related Instruments) pursuant to which it is reviewing whether certain companies that invest in MBS and rely on the exclusion from registration under Section 3(c)(5)(C) of the 1940 Act (such as us) should continue to be allowed to rely on such exclusion from registration. If we fail to continue to qualify for this exclusion from registration as an investment company, or the SECdetermines that companies that invest in MBS are no longer able to rely on this exclusion, our ability to use leverage would be substantially reduced and we would be unable to conduct our business as planned, or we may be required to register as an investment company under the 1940 Act, either of which could negatively affect the value of shares of our stock and our ability to make distributions to our stockholders. Certain programs initiated by the U.S. Government, through FHFA and FDIC, to provide homeowners with assistance in avoiding residential mortgage loan foreclosures are currently in effect. The programs may involve, among other things, the modification of mortgage loans to reduce the principal amount of the loans or the rate of interest payable on the loans, or to extend the payment terms of the loans. While the effect of these programs has not been as extensive as originally expected, the effect of such programs for holders of Agency Securitiescould be that such holders would experience changes in the anticipated yields of their Agency Securitiesdue to (i) increased prepayment rates and/or (ii) lower interest and principal payments. In March 2009, HAMP was introduced to provide homeowners with assistance in avoiding residential mortgage loan foreclosures. HAMP is designed to help at risk homeowners, both those who are in default and those who are at imminent risk of default, by providing the borrower with affordable and sustainable monthly payments. On July 21, 2010, President Obamasigned the Dodd-Frank Act into law. The Dodd-Frank Act is extensive, complicated and comprehensive legislation that impacts practically all aspects of banking, and a significant overhaul of many aspects of the regulation of the financial services industry. Although many provisions remain subject to further rulemaking, the Dodd-Frank Act implements numerous and far-reaching changes that affect financial companies, including our company, and other banks and institutions which are important to our business model. Certain notable rules are, among other things:
• Requiring regulation and oversight of large, systemically important
financial institutions by establishing an interagency council on
systemic risk and implementation of heightened prudential standards and
regulation by the
Board of Governorsof the Fed for systemically important financial institutions (including nonbank financial companies), as well as the implementation of the FDICresolution procedures for liquidation of large financial companies to avoid market disruption; 31
• Applying the same leverage and risk-based capital requirements that apply to insured depository institutions to most bank holding companies, savings and loan holding companies and systemically important nonbank financial companies; • Limiting the Fed's emergency authority to lend to nondepository institutions to facilities with broad-based eligibility, and
fund for solvent depository institutions and their holding companies,
subject to the approval of
and the Fed; • Creating regimes for regulation of over-the-counter derivatives and non-admitted property and casualty insurers and reinsurers;
• Implementing regulation of hedge fund and private equity advisers by
requiring such advisers to register with the
• Providing for the implementation of corporate governance provisions for
all public companies concerning proxy access and executive
• Reforming regulation of credit rating agencies.
Many of the provisions of the Dodd-Frank Act, including certain provisions described above are subject to further study, rulemaking, and the discretion of regulatory bodies. As the hundreds of regulations called for by the Dodd-Frank Act are promulgated, we will continue to evaluate the impact of any such regulations. It is unclear how this legislation may impact the borrowing environment, investing environment for
Agency Securitiesand interest rate swap contracts as much of the bill's implementation has not yet been defined by the regulators. In addition, in 2010, the Group of Governors and Heads of Supervisorsof the Basel Committee on Banking Supervision, the oversight body of the Basel Committee, published Basel III. Under which, when fully phased in on January 1, 2019, banking institutions will be required to maintain heightened Tier 1 common equity, Tier 1 capital and total capital ratios, as well as maintaining a "capital conservation buffer." Beginning with the Tier 1 common equity and Tier 1 capital ratio requirements, Basel III will be phased in incrementally between January 1, 2013and January 1, 2019. The final package of Basel III reforms were approved by the Group of Twenty Finance Ministersand Central Bank Governorsin November 2010and are subject to individual adoption by member nations, including the U.S. In October 2011, the FHFA announced changes to HARP to expand access to refinancing for qualified individuals and families whose homes have lost value, including increasing the HARP loan to value ratio above 125%. However, this would only apply to mortgages guaranteed by the GSEs. There are many challenging issues to this proposal, notably the question as to whether a loan with a loan to value ratio of 125% qualifies as a mortgage or an unsecured consumer loan. The chances of this initiative's success have created additional uncertainty in the Agency Securitiesmarket, particularly with respect to possible increases in prepayment rates. On January 4, 2012, the Fed issued a white paper outlining additional ideas with regard to refinancings and loan modifications. It is likely that loan modifications would result in increased prepayments on some Agency Securities. These loan modification programs, as well as future legislative or regulatory actions, including amendments to the bankruptcy laws, that result in the modification of outstanding mortgage loans may adversely affect the value of, and the returns on, the Agency Securitiesin which we invest.
In an effort to continue to provide meaningful solutions to the housing crisis, effective
September 28, 2012, the FSA released the Wheatley Review. Some of our derivative positions use various maturities of U.S. dollar LIBOR. Our borrowings in the repurchase market have also historically tracked these LIBOR rates. The Wheatley Review found, among other things, that potential conflicts of interests coupled with insufficient oversight and accountability resulted in some reported LIBOR rates that did not reflect the true cost of inter-bank borrowings they were meant to represent.
The Wheatley Review also proposes a number of remedial actions, including:
• New statutory authority for the FSA to supervise and regulate the LIBOR
setting process; • Establishing a new independent oversight body to administer the LIBOR setting process; • Eliminating LIBOR rates for certain currencies and maturities where markets are not sufficiently deep and liquid; • Ceasing immediate reporting of rates submitted by individual participating banks; and • Establishing controls to ensure that submitted rates represent actual transactions. In
April 2013, all the recommendations of the Wheatley Review came into force through the Financial Services Act of 2012. In this new regulatory framework, the FCA and the PRA have replaced the FSA, the Bank of Englandhas overall responsibility 32 -------------------------------------------------------------------------------- for financial stability, and a new FPC was created to assist the Bank in achieving its financial stability objective. Additionally, in September 2013, the European Commissionproposed draft legislation that will enhance the robustness and reliability of benchmarks like LIBOR, facilitate the prevention and detection of their manipulation and clarify responsibility for and the supervision of benchmarks.
Our derivative and repurchase borrowings are conducted in U.S. dollars for maturities with historically deep and liquid markets. To date, implementation of the Wheatley Review recommendations have not had a material impact on the reported levels of LIBOR rates relevant to our derivative or repurchase borrowings.
July 2, 2013, the Fed, in coordination with the FDICand the OCC, approved a final rule that enhances bank regulatory capital requirements and implements certain elements of the Basel III capital reforms in the U.S. On July 9, 2013, the OCC approved the final rule and the FDICapproved the final rule as an interim rule. The final rule includes a new minimum ratio of common equity Tier 1 capital to risk-weighted assets of 4.5% and a common equity Tier 1 capital conservation buffer of 2.5% of risk-weighted assets that will apply to all supervised U.S. financial institutions. The final rule also raises the minimum ratio of Tier 1 capital to risk-weighted assets from 4.0% to 6.0% and includes a minimum leverage ratio of 4.0% for all U.S. banking organizations. The final rule will continue to apply existing risk-based capital standards with respect to residential loans, including a 50.0% risk weight for safely underwritten first-lien mortgages that are not past due. "Advanced approaches banking organizations," those with $250.0 billionor more in total assets or $10.0 billionor more in foreign exposures, were required to comply with the final rule starting on January 1, 2014. Other banking organizations will be required to comply with the final rule starting January 1, 2015. On July 9, 2013, the Fed, the FDIC, and the OCC proposed a rule to change the leverage ratio standards for the largest U.S. banking organizations. Under the proposed rule, bank-holding companies with more than $700.0 billionin consolidated total assets or $10.0 trillionin assets under custody would be required to maintain a Tier 1 capital leverage buffer of at least 5.0%, which is 2.0% above the minimum supplementary leverage ratio requirement of 3.0% adopted by these three agencies in their Basel III capital reform rules on July 2, 2013. In addition to the leverage buffer, the proposed rule would require insured depository institutions of such large bank-holding companies to meet a 6.0% supplementary leverage ratio to be considered "well capitalized." The proposed rule would apply starting January 1, 2018. Adoption of these rules may increase cost and reduce availability of repurchase funding provided by institutions subject to the rules.
Credit Market Disruption and Current Conditions
The residential housing and mortgage markets in the U.S. have experienced a variety of difficulties and changed economic conditions including loan defaults, credit losses and decreased liquidity. These conditions have resulted in volatility in the value of the
Agency Securitieswe purchase and an increase in the average collateral requirements under our repurchase agreements we have obtained. While these markets have recovered significantly, further increased volatility and deterioration in the broader residential mortgage and RMBS markets may adversely affect the performance and market value of the Agency Securitiesand other high quality RMBS.
Short-term Interest Rates and Funding Costs
December 2008, the Fed stated that it was adopting a policy of "quantitative easing" and would target keeping the Federal Funds Rate between 0.00% and 0.25%. To date, the Fed has maintained that target range. Our funding costs, which traditionally have tracked the 30-day LIBOR have generally benefited by this easing of monetary policy, although to a somewhat lesser extent. Because of continued uncertainty in the credit markets and U.S. economic conditions, we expect that interest rates are likely to experience continued volatility, which will likely affect our financial results since our cost of funds is largely dependent on short-term rates. Historically, 30-day LIBOR has closely tracked movements in the Federal Funds Rate and the Effective Federal Funds Rate. The Effective Federal Funds Rate can differ from the Federal Funds Rate in that the Effective index represents the volume weighted average of interest rates at which depository institutions lend balances at the Fed to other depository institutions overnight (actual transactions, rather than target rate). Our borrowings in the repurchase market have also historically closely tracked the Federal Funds Rate and LIBOR. Traditionally, a lower Federal Funds Rate has indicated a time of increased net interest margin and higher asset values. However, for the past several years, LIBOR and repurchase market rates have varied greatly and often have been significantly higher than the target and the Effective Federal Funds Rate. The difference between 30-day LIBOR and the Effective Federal Funds Rate has also been quite volatile, with the spread alternately returning to more normal levels and then widening out again. The continued volatility in these rates and divergence from the historical relationship among these rates could negatively impact our ability to 33 --------------------------------------------------------------------------------
manage our securities portfolio. If this were to occur, our net interest margin and the value of our securities portfolio might suffer as a result.
The following graph shows 30-day LIBOR as compared to the Effective Federal Funds Rate on a monthly basis from
[[Image Removed]] Results of Operations Net Income (Loss) Summary Our primary source of income is the interest income we earn on our securities portfolio. Our net loss for the quarter and six months ended
June 30, 2014related to common stockholders was $(74,095)and $(97,780), or $(0.21)and $(0.27)per basic and diluted weighted average common share. These results compare to net income of $477,480and $577,272available to common stockholders or $1.28and $1.62per basic and diluted weighted average common share, respectively, for the quarter and six months ended June 30, 2013. The main factors for the difference between the periods in 2013 to the corresponding periods in 2014, were the changes in value from our derivatives and increased management fees, which were partially offset by gains on the sale of Agency Securities(which gains represent partial recovery of write-downs recorded in the fourth quarter of 2013). At June 30, 2014and December 31, 2013, our Agency Securitiesin our securities portfolio were carried at a net premium to par value with a weighted average amortized cost of 104.59% and 102.57%, respectively, due to the average interest rates on these securities being higher than prevailing market rates. 34 --------------------------------------------------------------------------------
The following table presents the components of the yield earned on our Agency Security portfolio for the quarterly periods presented.
Interest Expense on Cost of Net Interest Repurchase Quarter Ended Asset Yield Funds Margin Agreements June 30, 2014 2.86 % 1.40 % 1.46 % 0.39 % March 31, 2014 3.19 % 1.37 % 1.82 % 0.41 % December 31, 2013 2.98 % 1.38 % 1.60 % 0.43 % September 30, 2013 2.60 % 1.36 % 1.24 % 0.41 % June 30, 2013 2.52 % 1.14 % 1.38 % 0.43 %
The yield on our assets is most significantly affected by the rate of repayments on our
[[Image Removed]] During the quarter and six months ended
June 30, 2014, we realized (losses) of $(34,498)and $(46,236), respectively, related to our derivatives. During the quarter and six months ended June 30, 2013, we realized (losses) of $(38,858)and $(67,911), respectively, related to our derivatives. We decreased our total interest rate swap contracts aggregate notional balance from $10,220,000at December 31, 2013to $10,030,000at June 30, 2014. At June 30, 2014and December 31, 2013, our interest rate swap contracts had a weighted average swap rate of 1.50% and a weighted average term of 64 months and 69 months, respectively. We decreased our total interest rate swaptions notional balance from $5,750,000at December 31, 2013to $5,250,000at June 30, 2014. Our interest rate swaptions had an underlying weighted average swap rate of 2.94% and 2.86%, respectively, and a weighted average term of 3 months and 8 months, respectively, at June 30, 2014and December 31, 2013. Our total Futures Contracts notional amount was $25,000at December 31, 2013and June 30, 2014. Our Futures Contracts had a weighted average swap equivalent rate of 2.13% and weighted average term of 11 months and 13 months at June 30, 2014and December 31, 2013. Unrealized (losses) on derivatives totaled $(116,273)and $(292,629), respectively, for the quarter and six months ended June 30, 2014. Unrealized gains on derivatives totaled $412,183and $428,484, respectively, for the quarter and six months and June 30, 2013. The losses for the quarter and six months ended June 30, 2014were primarily the result of the decline in the reference interest rates. 35 --------------------------------------------------------------------------------
Net Interest Income
Our net interest income for the quarter and six months ended
June 30, 2014was $94,650and $202,985, respectively. Our net interest income for the quarter and six months ended June 30, 2013was $117,564and $222,727, respectively. Interest income, net of amortization of premium on Agency Securitieswas $113,892and $236,974for the quarter and six months ended June 30, 2014, compared to $141,159and $271,797for the quarter and six months ended June 30, 2013. At June 30, 2014and December 31, 2013, our securities portfolio consisted of $16,962,134and $14,648,178of Agency Securities, respectively. Interest expense for repurchase agreements was $14,979and $29,726for the quarter and six months ended June 30, 2014, compared to $23,595and $49,070for the quarter and six months ended June 30, 2013. At June 30, 2014and December 31, 2013, the net balance on our repurchase agreements was $14,393,580and $13,151,504, respectively. Interest expense for U.S. Treasury Securitiessold short was $4,263for the quarter and six months ended June 30, 2014. There was no interest expense for U.S. Treasury Securitiessold short for the quarter and six months ended June 30, 2013. We sold short $1,011,705and $2,789,560of U.S. Treasury Securitiesat June 30, 2014and June 30, 2013, respectively.
Gains and Losses on Sale of
During the quarter and six months ended
June 30, 2014, we sold $1,206,494and $6,782,481of Agency Securities, which resulted in realized gains of $11,167and $81,036, respectively. These sales completed the previously announced repositioning of our portfolio from 30-year fixed rate Agency Securitiesand 25-year fixed rate Agency Securitiesto 15-year fixed rate Agency Securitiesand 20-year fixed rate Agency Securities. During the quarter and six months ended June 30, 2013, we sold $2,696,655and $4,935,258of Agency Securitiesto repositioning our portfolio resulting in realized gains of $20,876and $39,390, respectively.
Gains and Losses on
During the quarter and six months ended
June 30, 2014, we sold short $1,011,705of U.S. Treasury Securities, as a part of our interest rate risk management strategy, resulting in a net unrealized loss of $15,781. During the quarter and six months ended June 30, 2013, we sold short $2,789,560of U.S. Treasury Securities. During the quarter and six months ended June 30, 2013, we purchased $935,340resulting in a realized gain of $639. The outstanding balance resulted in an unrealized loss of $(21,717)for the quarter and six months ended June 30, 2013.
Other Than Temporary Impairment of
We evaluated our
Agency Securitieswith unrealized losses at June 30, 2014, June 30, 2013and December 31, 2013, to determine whether there was an other than temporary impairment. The decline in value of our Agency Securitiesin 2013, was solely due to market conditions and not the credit quality of the assets. All of our Agency Securitiesare issued and guaranteed by GSEs or Ginnie Mae. The GSEs have a long term credit rating of AA+. At June 30, 2014, June 30, 2013and December 31, 2013, we also considered whether we intended to sell Agency Securitiesand whether it was more likely than not that we could meet our liquidity requirements and contractual obligations without selling Agency Securities. There was no other than temporary impairment recognized for the quarters ended June 30, 2014and June 30, 2013. At December 31, 2013, anticipating portfolio repositioning sales in the first quarter of 2014, we concluded that the December 31, 2013unrealized losses on our 25-year and 30-year fixed rate Agency Securitiesrepresented an other than temporary impairment. Accordingly, at December 31, 2013, we recognized losses totaling $401,500in our 2013 statements of operations, thereby establishing a new cost basis for those Agency Securitieswith aggregate fair value of $6,800,000at December 31, 2013. We also determined that at December 31, 2013, there was no other than temporary impairment of our other Agency Securities, which are primarily 20-year and 15-year fixed rate securities.
Our total expenses for the quarter and six months ended
June 30, 2014were $9,455and $19,343, respectively, as compared to $9,302and $17,937, respectively, for the quarter and six months ended June 30, 2013. Our total management fee expense for the quarter and six months ended June 30, 2014, was $6,964and $13,929, respectively, compared to $7,869and $14,502for the quarter and six months ended June 30, 2013. Management fees are determined based on gross equity raised. Therefore, our management fee increases when we raise capital and declines when we repurchase previously issued stock. However, because the management fee rate decreased to 0.75% per annum for gross equity raised in excess of $1.0 billionpursuant to the Management Agreement, the effective average management fee rate has generally declined over time. Professional fees were $901and $2,175, respectively, for the quarter and six months ended June 30, 2014compared to $522and $1,526for the quarter and six months ended June 30, 2013. The increase in professional fees represents legal and advisory expenses associated with shareholder value activities and potential new financing and investment opportunities. 36 --------------------------------------------------------------------------------
We have elected to be taxed as a REIT under the Code. We will generally not be subject to federal income tax to the extent that we distribute our taxable income to our stockholders and as long as we satisfy the ongoing REIT requirements under the Code including meeting certain asset, income and stock ownership tests.
The following table reconciles our GAAP net income to estimated REIT taxable income for the quarter and six months ended
For the Quarter Ended For the Six Months Ended June 30, 2014 June 30, 2013 June 30, 2014 June 30, 2013 GAAP net income (loss)
$ (70,190 ) $ 481,385 $ (89,968 ) $ 583,675Book to tax differences: Changes in interest rate contracts 116,273 (412,183 ) 269,311 (428,484 ) (Gains) Losses on Security Sales 4,614 21,717 (65,255 ) 21,717 Amortization of deferred hedging gains 461 492 755 492 Net premium amortization differences (266 ) - (5,609 ) - Other 5 7 11 16 Estimated taxable income $ 50,897 $ 91,418 $ 109,245 $ 177,416The aggregate tax basis of our assets and liabilities was less than our total Stockholders' Equity at June 30, 2014by approximately $226,338, or approximately $0.63per common share (based on the 357,189 common shares then outstanding). We are required and intend to timely distribute substantially all of our REIT taxable income in order to maintain our REIT status under the Code. Total dividend payments to stockholders were $57,679and $115,438for the quarter and six months ended June 30, 2014. Our estimated REIT taxable income available to pay dividends was $50,897and $109,245for the quarter and six months ended June 30, 2014. Realized losses on derivatives for the six months ended June 30, 2014include realized gains on swaptions of $23,318which are amortized for tax purposes over the ten year terms of the referenced interest rate swap contract. There were no realized gains on swaptions for the quarter ended June 30, 2014. Our taxable REIT income and dividend requirements to maintain our REIT status are determined on an annual basis. Dividends in excess of taxable REIT income for the year (including amounts carried forward from prior years) will generally not be taxable to common stockholders. Net capital losses realized in 2013 and 2014 totaling $(579,322)and $(314,896)will be available to offset future capital gains realized through 2018 and 2019, respectively. Our management is responsible for determining whether tax positions taken by us are more likely than not to be sustained on their merits. We have no material unrecognized tax benefits or material uncertain tax positions.
Comprehensive Income (Loss)
Comprehensive income (loss) includes all changes in equity during a period, except those resulting from investments by owners and distributions to owners. During the quarter and six months ended
June 30, 2014, other comprehensive income (loss) totaled $210,600and $256,895, respectively, reflecting net unrealized gains or losses on available for sale Agency Securitiesnet of amounts reclassified upon sale. During the quarter and six months ended June 30, 2013, other comprehensive income (loss) totaled $(872,031)and $(1,070,600), respectively, reflecting net unrealized gains or losses on available for sale Agency Securitiesnet of amounts reclassified upon sale. The 2013 other comprehensive loss resulted from significant price declines in our Agency Securities. 37 --------------------------------------------------------------------------------
Agency SecuritiesWe typically purchase Agency Securitiesat premium prices. The premium price paid over par value on those assets is expensed as the underlying mortgages experience repayment or prepayment. The lower the constant prepayment rate, the lower the amount of amortization expense for a particular period. Accordingly, the yield on an asset and earnings, are higher. If prepayment rates increase, the amount of amortization expense for a particular period will go up. These increased prepayment rates would act to decrease the yield on an asset and would decrease earnings.
The tables below summarize certain characteristics of our
June 30, 2014Weighted Average Weighted Month to % of Total Average Reset or Agency Asset Type Principal Amount Fair Value Coupon CPR (1) Maturity Securities ARMs & Hybrids $ 176,725 $ 186,3743.80 % 20.34 % 11 1.10 % Multi-Family MBS 463,434 485,728 3.44 % 0.00 % 133 2.90 % 10 Year Fixed 4,424 4,834 4.96 % 18.90 % 109 0.00 % 15 Year Fixed 11,002,810 11,561,219 3.25 % 4.63 % 171 68.10 % 20 Year Fixed 4,506,362 4,723,979 3.53 % 6.18 % 211 27.90 % Total or Weighted Average $ 16,153,755 $ 16,962,1343.34 % 5.12 % 179 100.00 % (1) Weighted average for all prepayments during the quarter ended June 30, 2014, including prepayments related to Agency Securitiespurchased or sold during the quarter. December 31, 2013 Weighted Average Weighted Month to % of Total Average Reset or Agency Asset Type Principal Amount Fair Value Coupon CPR (1) Maturity Securities ARMs & Hybrids $ 208,216 $ 220,6933.95 % 20.43 % 16 1.40 % 10 Year Fixed 1,469 1,572 5.35 % 14.52 % 101 0.00 % 15 Year Fixed 2,713,689 2,832,899 3.46 % 4.27 % 170 18.80 % 20 Year Fixed 4,709,297 4,797,001 3.53 % 5.07 % 217 32.60 % 25 Year Fixed 276,765 275,382 3.52 % 4.87 % 279 1.90 % 30 Year Fixed 6,557,784 6,520,631 3.53 % 4.32 % 345 45.30 % Total or Weighted Average $ 14,467,220 $ 14,648,1783.52 % 4.83 % 263 100.00 %
(1) Weighted average for all prepayments during the quarter ended
June 30, 2014, we had investment related payables of $38,816with respect to unsettled purchases of Agency Securities. All investment related payables at June 30, 2014were settled in July 2014. At December 31, 2013, we had investment related payables of $159,159with respect to unsettled purchases of Agency Securities. We did not have any investment related receivables at December 31, 2013. Our net interest income (loss) 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 Agency Securitiesat a premium to par, the main item that can affect the yield on our Agency Securitiesafter 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 but can also result from repurchases of delinquent, 38 -------------------------------------------------------------------------------- defaulted, or modified loans, are less so. Being able to accurately estimate and manage these repayment rates is a critical portion of the management of our securities portfolio, not only for estimating current yield but also for considering the rate of reinvestment of those proceeds into new securities, the yields which those new securities may add to our securities portfolio and our hedging strategy. At June 30, 2014and December 31, 2013, the adjustable and hybrid adjustable rate mortgage loans underlying our Agency Securitieshave fixed-interest rates for an average period of approximately 11 months and 16 months, respectively, after which time the interest rates reset and become adjustable. After a reset date, interest rates on our adjustable and hybrid adjustable Agency Securitiesfloat based on spreads over various indices, typically LIBOR or the one-year Constant Maturity Treasury rate. These interest rates 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.
We have entered into repurchase agreements to finance most of our
Agency Securities. Our repurchase agreements are secured by our Agency Securitiesand bear interest at rates that have historically moved in close relationship to the Federal Funds Rate and LIBOR. We have established borrowing relationships with several investment banking firms and other lenders, 30 of which we had done repurchase trades with at June 30, 2014and 27 of which we had done repurchases trades with at December 31, 2013. We had outstanding balances under our repurchase agreements at June 30, 2014and December 31, 2013of $14,393,580and $13,151,504, respectively, consistent with the increase in our Agency Securitiesin our securities portfolio. Derivative Instruments We generally hedge our interest rate risk as we deem prudent in light of market conditions and the associated costs with counterparties that have a high quality credit rating and with futures exchanges. We generally pay a fixed rate and receive a floating rate with the objective of fixing a portion of our borrowing costs and hedging the change in our book value to some degree. The floating rate we receive is generally the Federal Funds Rate or LIBOR. While our policies do not contain specific requirements as to the percentages or amount of interest rate risk that we are required to hedge, we maintain an overall target of hedging at least 40% of our non-adjustable rate mortgages. At June 30, 2014and December 31, 2013, the notional value of our derivatives was 91.23% and 110.69%, respectively, of the fair market value of our non-adjustable rate mortgages. For interest rate risk mitigation purposes, we consider Agency Securitiesto be adjustable rate mortgages ARMs if their interest rate is either currently subject to adjustment according to prevailing rates or if they are within 18 months of the period where such adjustments will occur. No assurance can be given that our derivatives will have the desired beneficial impact on our results of operations or financial condition. We have not elected cash flow hedge accounting treatment as allowed by GAAP. Since we do not designate our derivative activities as cash flow hedges, realized as well as unrealized gains/losses from these transactions will impact our earnings.
Use of derivative instruments may fail to protect or could adversely affect us because, among other things:
• available derivatives may not correspond directly with the interest
rate risk for which protection is sought (e.g., the difference in
interest rate movements for long-term
Agency Securities); • the duration of the derivatives may not match the duration of the related liability; • the counterparty to a derivative agreement with us may default on its obligation to pay or not perform under the terms of the agreement and the collateral posted may not be sufficient to protect against any consequent loss;
• we may lose collateral we have pledged to secure our obligations under
a derivative agreement if the associated counterparty becomes insolvent
or files for bankruptcy; • we may experience a termination event under one or more of our derivative agreements related to our REIT status, equity levels and performance, which could result in a payout to the associated counterparty and a taxable loss to us; • the credit-quality of the party owing money on the derivatives 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 may be adjusted from time to time in accordance with GAAP to reflect changes in fair value; downward
adjustments, or "mark-to-market losses," would reduce our net income or
increase any net loss.
June 30, 2014and December 31, 2013, we had interest rate swap contracts with an aggregate notional balance of $10,030,000and $10,220,000, respectively. At June 30, 2014and December 31, 2013, we had entered into interest rate swaptions with an aggregate notional balance of $5,250,000and $5,750,000, respectively. In addition, at June 30, 2014and December 31, 2013, we had purchased or sold Futures Contracts with an aggregate notional balance of $25,000. Futures Contracts are traded on the CME. Counterparty risk of interest rate swap contracts, interest rate swaptions and Futures Contracts are limited to some degree because of daily mark-to-market and collateral requirements. In addition, substantial credit support for the Futures Contracts is 39 -------------------------------------------------------------------------------- provided by the CME. These derivative transactions are designed to lock in a portion of funding costs for financing activities associated with our assets in such a way as to help assure the realization of attractive net interest margins and to vary inversely in value with our Agency Securities. Such contracts are based on assumptions about prepayments which, if not realized, will cause results to differ from expectations. Although we attempt to structure our derivatives to offset the changes in asset prices, they are not perfectly correlated and depend on the corresponding durations and sections of the yield curve that moves to offset each other. We recognized net losses of $(150,771)and $(338,865), respectively, for the quarter and six months ended June 30, 2014, related to our derivatives. We recognized net gains of $373,325and $360,573, respectively, for the quarter and six months ended June 30, 2013, related to our derivatives. For the quarter and six months ended June 30, 2014, the net unrealized change in the fair value of our Agency Securitiesincreased by $221,767and $337,931, respectively. This compares to an decrease of $(851,155)and $(1,031,210), respectively, for the quarter and six months ended June 30, 2013. As required by the Dodd-Frank Act, the Commodity Futures Trading Commissionhas adopted rules requiring certain interest rate swap contracts to be cleared through a derivatives clearing organization. We are required to clear certain new interest rate swap contracts. Cleared interest rate swaps may have higher margin requirements than un-cleared interest rate swaps we previously had. We have established an account with a futures commission merchant for this purpose. To date, we have not entered into any cleared interest rate swap contracts.
Liquidity and Capital Resources
During the six months ended
June 30, 2014, we issued 37 shares of common stock under our common stock DRIP and raised additional net proceeds of approximately $154. During the six months ended June 30, 2014, we repurchased 600 shares of our outstanding common stock under our Repurchase Program for an aggregate cost of $2,585. At times, we purchased assets for forward settlement up to 90 days in the future to minimize purchase prices. Our management fee expense also increased in absolute terms under the provisions of the Management Agreement. However, pursuant to the Management Agreement, the average effective management fee rate declined because the management fee rate stepped down as the amounts of equity raised exceeded $1.0 billion. At June 30, 2014, we financed our securities portfolio with approximately $14,393,580of net borrowings under repurchase agreements. Our leverage ratio at June 30, 2014, was 7.90 to 1. At June 30, 2014, our liquidity totaled $1,072,941, consisting of $433,149of cash plus $639,792of unpledged Agency Securities(including securities received as collateral). Our primary sources of funds are borrowings under repurchase arrangements, monthly principal and interest payments on our Agency Securitiesand cash generated from our operating results. Other sources of funds may include proceeds from equity and debt offerings and asset sales. We generally maintain liquidity to pay down borrowings under repurchase arrangements to reduce borrowing costs and otherwise efficiently manage our long-term investment capital. Because the level of our borrowings can be adjusted on a daily basis, the level of cash carried on our balance sheet is significantly less important than our potential liquidity available under our borrowing arrangements. In addition to the repurchase agreement financing discussed above, from time to time we have entered into reverse repurchase agreements with certain of our repurchase agreement counterparties. Under a typical reverse repurchase agreement, we purchase U.S. Treasury Securitiesfrom a borrower in exchange for cash and agree to sell the same securities back in the future. We then sell such U.S. Treasury Securitiesto third parties and recognize a liability to return the securities to the original borrower. Reverse repurchase agreement receivables and repurchase agreement liabilities are presented net when they meet certain criteria, including being with the same counterparty, being governed by the same MRA, settlement through the same brokerage or clearing account and maturing on the same day. The practical effect of these transactions is to replace a portion of our repurchase agreement financing of our Agency Securitiesin our securities portfolio with short positions in U.S. Treasury Securities. We believe that this helps to reduce interest rate risk, and therefore counterparty credit and liquidity risk.
Both parties to the repurchase and reverse repurchase transactions have the right to make daily margin calls based on changes in the value of the collateral obtained and/or pledged.
We currently believe that we have sufficient liquidity and capital resources available for the acquisition of additional investments, repayments on repurchase borrowings, reacquisition of securities to be returned to borrowers and the payment of cash dividends as required for continued qualification as a REIT. Our primary uses of cash are to purchase
Agency Securities, pay interest and principal on our borrowings, fund our operations and pay dividends. During the quarter ended June 30, 2014, we purchased $9,640,164of Agency Securitiesusing proceeds from repurchase agreements and principal repayments. During the quarter ended June 30, 2014, we received cash of 40 -------------------------------------------------------------------------------- $733,237from prepayments and scheduled principal payments on our Agency Securities. We received net proceeds of $154from common equity issuances under our common stock DRIP. We had a net cash increase from our repurchase agreements of $2,270,737for the six months ended June 30, 2014and made cash interest payments of approximately $101,956on our liabilities for the six months ended June 30, 2014. Part of funding our operations includes providing margin cash to offset liability balances on our derivatives. We recovered $21,783of cash collateral posted with counterparties and decreased our liability by $259,677for cash collateral held at June 30, 2014.
We have continued to pursue additional lending counterparties in order to help increase our financial flexibility and ability to withstand periods of contracting liquidity in the credit markets.
Repurchase Agreements, net
The following table represents the contractual repricing regarding our repurchase agreements, net to finance Agency Security purchases at
June 30, 2014and December 31, 2013. June 30, 2014 December 31, 2013 Repurchase Weighted Average Repurchase Weighted Average Agreements Contractual Rate Agreements Contractual Rate Within 30 days (net of reverse repurchase agreements of $1,028,661at June 30, 2014) $ 4,259,4850.42 % $ 3,990,4340.41 % 31 days to 60 days 5,375,136 0.35 % 7,098,298 0.41 % 61 days to 90 days 1,725,911 0.38 % 1,226,694 0.44 % Greater than 90 days 3,033,048 0.41 % 836,078 0.43 % Total or Weighted Average $ 14,393,5800.39 % $ 13,151,5040.42 % The following table represents the MRAs and other information regarding our repurchase agreements to finance Agency Security purchases at June 30, 2014and December 31, 2013. June 30, 2014 December 31, 2013 Number of MRAs 37 35
Number of counterparties with repurchase agreements outstanding
30 27 Weighted average maturity in days 58 45 Haircut for repurchase agreements (1) 4.89 % 4.96 %
(1) The Haircut represents the weighted average margin requirement, or the
percentage amount by which the collateral value must exceed the loan amount.
We have 7 repurchase agreement counterparties that individually account for between 5% and 10% of our aggregate borrowings. In total, these counterparties accounted for approximately 45.72% of our repurchase agreement borrowings outstanding at
Obligations to return securities received as collateral associated with the reverse repurchase agreements of
Declines in the value of our
Agency Securitiesportfolio can trigger margin calls by our lenders under our repurchase agreements. An event of default or termination event under the standard MRA would give our counterparty the option to terminate all repurchase transactions existing with us and require any amount due to be payable immediately.
The residential mortgage market in the U.S. continues to experience difficult economic conditions including:
• increased volatility of many financial assets, including Agency Securities and other high-quality RMBS assets;
• increased volatility and deterioration in the broader residential
mortgage and RMBS markets; and 41
• significant disruption in financing of RMBS.
While conditions have improved, should there be a reoccurrence of difficulties in the residential mortgage market, our lenders may be forced to exit the repurchase market, become insolvent or further tighten lending standards or increase the amount of required equity capital or haircut, any of which could make it more difficult or costly for us to obtain financing. Financial sector volatility can also lead to increased demand and prices for high quality debt securities, including
Agency Securities. While increased prices may increase the value of our Agency Securities, higher values may also reduce the return on reinvestment of capital, thereby lowering our future profitability. The following graph represents the month-end outstanding balances of our repurchase agreements (before the effect of netting reverse repurchase agreements), which finance most of our Agency Securities. Our repurchase agreements balance will fluctuate based on our change in capital, leverage targets and the market prices of our assets. Over time, the level of our repurchase agreement financing has grown in conjunction with the growth of Agency Securitiesin our securities portfolio, which in turn has been the result of successful equity capital raising efforts. In 2013, declining security values and our decision to reduce leverage resulted in a substantial decline in our repurchase agreements. The balance of repurchase agreements outstanding will fluctuate within any given month based on changes in the market value of the particular Agency Security pledged as collateral (including the effects of principal paydowns) and the level and timing of investment and reinvestment activity. [[Image Removed]] 42
Effects of Margin Requirements, Leverage and Credit Spreads
Agency Securitieshave values that fluctuate according to market conditions and, as discussed above, the market value of our Agency Securitieswill decrease as prevailing interest rates or credit spreads increase. When the value of the securities pledged to secure a repurchase agreement decreases to the point where the positive difference between the collateral value and the loan amount is less than the haircut, our lenders may issue a margin call, which means that the lender will require us to pay the margin call in cash or pledge additional collateral to meet that margin call. Under our repurchase facilities, our lenders have full discretion to determine the value of the Agency Securitieswe pledge to them. Most of our lenders will value securities based on recent trades in the market. Lenders also issue margin calls as the published current principal balance factors change on the pool of mortgages underlying the securities pledged as collateral when scheduled and unscheduled principal repayments are announced monthly. We experience margin calls in the ordinary course of our business and under certain conditions, such as during a period of declining market value for Agency Securitiesand we may experience margin calls as frequently as daily. In seeking to effectively manage the margin requirements established by our lenders, we maintain a position of cash and unpledged securities. We refer to this position as our liquidity. The level of liquidity we have available to meet margin calls is directly affected by our leverage levels, our haircuts and the price changes on our securities. If interest rates increase as a result of a yield curve shift or for another reason or if credit spreads widen, the prices of our collateral (and our unpledged assets that constitute our liquidity) will decline and we may experience margin calls. We will use our liquidity to meet such margin calls. There can be no assurance that we will maintain sufficient levels of liquidity to meet any margin calls. If our haircuts increase, our liquidity will proportionately decrease. If we increase our borrowings, our liquidity will decrease by the amount of additional haircut on the increased level of indebtedness. In addition, certain of our MRAs contain a restriction that prohibits our leverage from exceeding twelve times our stockholders' equity as well as termination events in the case of significant reductions in equity capital. We intend to maintain a level of liquidity in relation to our assets that enables us to meet reasonably anticipated margin calls but that also allows us to be substantially invested in Agency Securities. We may misjudge the appropriate amount of our liquidity by maintaining excessive liquidity, which would lower our investment returns, or by maintaining insufficient liquidity, which would force us to involuntarily liquidate assets into unfavorable market conditions and harm our results of operations and financial condition. We generally seek to borrow (on a recourse basis) between six and ten times the amount of our total stockholders' equity. At June 30, 2014and December 31, 2013, our total net borrowings were approximately $14,393,580and $13,151,504(excluding accrued interest), respectively. At June 30, 2014and December 31, 2013, we had a leverage ratio of approximately 7.90:1 and 6.92:1, respectively.
Forward-Looking Statements Regarding Liquidity
Based on our current portfolio, leverage rate and available borrowing arrangements, we believe that our cash flow from operations and our ability to make timely portfolio adjustments, will be sufficient to enable us to meet anticipated short-term (one year or less) liquidity requirements such as to fund our investment activities, meet our financing obligations, pay fees under the Management Agreement and fund our distributions to stockholders and pay general corporate expenses. We may increase our capital resources by obtaining long-term credit facilities or making public or private offerings of equity or debt securities, including classes of preferred stock, common stock and senior or subordinated notes to meet our long-term (greater than one year) liquidity. Such financing will depend on market conditions for capital raises and for the investment of any proceeds and there can be no assurances that we will successfully obtain any such financing. 43 --------------------------------------------------------------------------------
Stockholders' Equity Dividends The following table presents our common stock dividend transactions for the six months ended
June 30, 2014. Aggregate amount paid to Rate per common holders of Record Date Payment Date share record January 15, 2014 January 30, 2014 $ 0.05 $ 17,954February 14, 2014 February 27, 2014 $ 0.05 $ 17,954March 17, 2014 March 28, 2014 $ 0.05 $ 17,945April 15, 2014 April 29, 2014 $ 0.05 $ 17,925May 15, 2014 May 29, 2014 $ 0.05 $ 17,924June 16, 2014 June 27, 2014 $ 0.05 $ 17,924Total dividends paid $ 107,626
The following table presents our Series A Preferred Stock dividend transactions for the six months ended
Rate per Series A Aggregate Preferred amount paid to Record Date Payment Date Share holders of record January 15, 2014 January 27, 2014
$ 0.17$ 375 February 15, 2014 February 27, 2014 $ 0.17$ 375 March 15, 2014 March 27, 2014 $ 0.17$ 375 April 15, 2014 April 28, 2014 $ 0.17$ 375 May 15, 2014 May 27, 2014 $ 0.17$ 375 June 15, 2014 June 27, 2014 $ 0.17$ 375 Total dividends paid $ 2,250
The following table presents our Series B Preferred Stock dividend transactions for the six months ended
Rate per Series B Aggregate Preferred amount paid to Record Date Payment Date Share holders of record January 15, 2014 January 27, 2014
$ 0.16$ 927 February 15, 2014 February 27, 2014 $ 0.16$ 927 March 15, 2014 March 27, 2014 $ 0.16$ 927 April 15, 2014 April 28, 2014 $ 0.16$ 927 May 15, 2014 May 27, 2014 $ 0.16$ 927 June 15, 2014 June 27, 2014 $ 0.16$ 927 Total dividends paid $ 5,562 44
Equity Capital Raising Activities
The following table presents our equity transactions for the six months ended
June 30, 2014. Number of Per Share Transaction Type Completion Date Shares price (1) Net Proceeds Common stock dividend January 27, 2014 through reinvestment program June 27, 2014 37 $ 4.20$ 154 (1) Weighted average price Common Stock repurchases The following table presents our common stock repurchases for the six months ended June 30, 2014. Number of Per Share Transaction Type Completion Date Shares price (1) Net Cost March 12, 2014 through Repurchased common shares March 14, 2014 600 4.31 $ 2,585(1) Weighted average price
Off-Balance Sheet Arrangements
June 30, 2014and December 31, 2013, we had not maintained 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. Furthermore, at June 30, 2014and December 31, 2013, we had not guaranteed any obligations of any unconsolidated entities or entered into any commitment or intent to provide funding to any such entities.
Critical Accounting Policies
Our condensed consolidated financial statements are prepared in conformity with GAAP. In preparing the financial statements, management is required to make various judgments, estimates and assumptions that affect the reported amounts. Changes in these estimates and assumptions could have a material effect on our financial statements. The following is a summary of our policies most affected by management's judgments, estimates and assumptions. Revenue Recognition: Interest income is earned and recognized based on the unpaid principal amount of the
Agency Securitiesand their contractual terms. Premiums and discounts associated with the purchase of Agency Securitiesare amortized or accreted into interest income over the actual lives of the securities. Fair Value of Agency Securities: We invest in Agency Securitiesrepresenting interests in or obligations backed by pools of fixed rate, hybrid adjustable rate and adjustable rate mortgage loans. The authoritative literature requires us to classify our investments as either trading, available for sale or held to maturity securities. Management determines the appropriate classifications of the securities at the time they are acquired and evaluates the appropriateness of such classifications at each balance sheet date. We currently classify all of our Agency Securitiesas available for sale. Agency Securitiesclassified as available for sale are reported at their estimated fair values with unrealized gains and losses excluded from earnings and reported as part of the statements of comprehensive income (loss). We utilize a third party pricing service to value our securities portfolio. The third party pricing service incorporates common market pricing methods including a spread measurement to the Treasury yield curve as well as underlying characteristics of the particular security including coupon, periodic and life caps, rate reset period and expected life of the security. Security purchase and sale transactions, including purchase of when issued securities, are recorded on the trade date. Gains or losses realized from the sale of securities are included in income and are determined using the specific identification method. Impairment of Assets: We evaluate Agency Securitiesfor other than temporary impairment at least on a quarterly basis and more frequently when economic or market concerns warrant such evaluation. We consider an impairment to be other than temporary if we (1) have the intent to sell the Agency Securities, (2) believe it is more likely than not that we will be required to 45 --------------------------------------------------------------------------------
sell the securities before recovery (for example, because of liquidity requirements or contractual obligations) or (3) a credit loss exists. Impairment losses recognized establish a new cost basis for the related
Repurchase Agreements, net: We finance the acquisition of our
Agency Securitiesthrough the use of repurchase agreements. Our repurchase agreements are secured by our Agency Securitiesand bear interest rates that have historically moved in close relationship to the Federal Funds Rate and LIBOR. Under these repurchase agreements, we sell Agency Securitiesto a lender and agree to repurchase the same Agency Securitiesin the future for a price that is higher than the original sales price. The difference between the sales price that we receive and the repurchase price that we pay represents interest paid to the lender. A repurchase agreement operates as a financing arrangement under which we pledge our Agency Securitiesas collateral to secure a loan which is equal in value to a specified percentage of the estimated fair value of the pledged collateral. We retain beneficial ownership of the pledged collateral. At the maturity of a repurchase agreement, we are required to repay the loan and concurrently receive back our pledged collateral from the lender or, with the consent of the lender, we may renew such agreement at the then prevailing interest rate. The repurchase agreements may require us to pledge additional assets to the lender in the event the estimated fair value of the existing pledged collateral declines. In addition to the repurchase agreement financing discussed above, at certain times we have entered into reverse repurchase agreements with certain of our repurchase agreement counterparties. Under a typical reverse repurchase agreement, we purchase U.S. Treasury Securitiesfrom a borrower in exchange for cash and agree to sell the same securities in the future in exchange for a price that is higher than the original purchase price. The difference between the purchase price originally paid and the sale price represents interest received from the borrower. Reverse repurchase agreement receivables and repurchase agreement liabilities are presented net when they meet certain criteria, including being with the same counterparty, being governed by the same MRA, settlement through the same brokerage or clearing account and maturing on the same day. Obligations to Return Securities Received as Collateral, at Fair Value: At certain times, we also sell to third parties the U.S. Treasury Securitiesreceived as collateral for reverse repurchase agreements and recognize the resulting obligation to return said U.S. Treasury Securitiesas a liability on our balance sheet. Interest is recorded on the repurchase agreements, reverse repurchase agreements and U.S. Treasury Securitieson an accrual basis and presented as net interest expense. Both parties to the transaction have the right to make daily margin calls based on changes in the fair value of the collateral received and/or pledged. Derivative Instruments: We recognize all derivatives as either assets or liabilities at fair value on our condensed consolidated balance sheets. We have not elected cash flow hedge accounting treatment as allowed by GAAP, all changes in the fair values of our derivatives are reflected in our statements of operations. Accordingly, our operating results may reflect greater volatility than otherwise would be the case, because gains or losses on derivatives may not be offset by changes in the fair value or cash flows of the transaction within the same accounting period or ever. Consequently, any declines in the fair value of our derivatives result in a charge to earnings. We will continue to designate derivatives as hedges for tax purposes and any unrealized derivative gains or losses would not affect our distributable net taxable income.
Virtually all of our assets and liabilities are interest rate-sensitive in nature. As a result, interest rates and other factors influence our performance far more than inflation. Changes in interest rates do not necessarily correlate with inflation rates or changes in inflation rates. Our financial statements are prepared in accordance with GAAP and any distributions we may make will be determined by our Board based in part on our REIT taxable income as calculated according to the requirements of the Code; in each case, our activities and balance sheet are measured with reference to fair value without considering inflation.
See Note 16 to the condensed consolidated financial statements.
CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS This report contains various "forward-looking statements." Forward-looking statements relate to expectations, beliefs, projections, future plans and strategies, anticipated events or trends and similar expressions concerning matters that are not historical facts. In some cases, you can identify forward-looking statements by the use of forward-looking terminology such as "believes," "expects," "may," "will," "would," "could," "should," "seeks," "approximately," "intends," "plans," "projects," "estimates" or "anticipates" or the negative of these words and phrases or similar words or phrases. All forward-looking statements may be impacted by a number of risks and uncertainties, including statements regarding the following subjects:
• our business and investment strategy;
• our anticipated results of operations;
• statements about future dividends;
• our ability to obtain financing arrangements;
• our understanding of our competition and ability to compete effectively;
• market, industry and economic trends; and
• interest rates. 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. You should carefully consider these risks before you make an investment decision with respect to our stock, along with the following factors that could cause actual results to vary from our forward-looking statements: • the impact of the federal conservatorship of Fannie Mae and Freddie Mac and related efforts, along with any changes in laws and regulations affecting the relationship between Fannie Mae and Freddie Mac and the federal government and the Fed system; • the possible material adverse effect on our business if the U.S.
Congresspassed legislation reforming or winding down Fannie Mae or Freddie Mac;
• mortgage loan modification programs and future legislative action;
• the impact of the continued delay or failure of the
reaching an agreement on the national debt ceiling;
• availability, terms and deployment of capital;
• changes in economic conditions generally;
• changes in interest rates, interest rate spreads and the yield curve or prepayment rates; • general volatility of the financial markets, including markets for mortgage securities;
• inflation or deflation;
• availability of suitable investment opportunities;
• the degree and nature of our competition, including competition for
Agency Securitiesfrom the U.S. Treasury;
• changes in our business and investment strategy;
• our dependence on ARRM and ability to find a suitable replacement if
ARRM were to terminate their management relationship with us;
• the existence of conflicts of interest in our relationship with ARRM,
certain of our directors and our officers, which could result in decisions that are not in the best interest of our stockholders; • changes in personnel at ARRM or the availability of qualified personnel at ARRM;
• limitations imposed on our business by our status as a REIT under the Code;
• changes in GAAP, including interpretations thereof; and
• changes in applicable laws and regulations.
We cannot guarantee future results, levels of activity, performance or achievements. You should not place undue reliance on forward-looking statements, which apply only as of the date of this report. We do not intend and disclaim any duty or obligation to update or revise any industry information or forward-looking statements set forth in this report to reflect new information, future events or otherwise, except as required under the U.S. Federal securities laws. 47
-------------------------------------------------------------------------------- GLOSSARY OF TERMS "
Agency Securities" means securities issued or guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae; interests in or obligations backed by pools of adjustable rate, hybrid adjustable rate and fixed rate mortgage loans
"ARMs" means Adjustable Rate Mortgage backed securities
"Basel III" means "calibrated" capital standards for major banking institutions
"Board" means ARMOUR's Board of Directors
"common stock DRIP" means the Company's dividend reinvestment and stock purchase plan
"CME" means the
"Code" means the Internal Revenue Code
"CPR" means constant prepayment rate
"Fannie Mae" means the Federal National Mortgage Association
"FCA" means the
"FDIC" means the
"Fed" means the U.S. Federal Reserve
"FHFA" means the
"FPC" means the
"Freddie Mac" means the Federal Home Loan Mortgage Corporation
"FSA" means the
"Futures Contracts" means Eurodollar Futures Contracts
"GAAP" means accounting principles generally accepted in
"Ginnie Mae" means the
"GSE" means U.S. Government Sponsored Entity. Obligations of agencies originally established or chartered by the U.S. government to serve public purposes as specified by the
U.S. Congress; these obligations are not explicitly guaranteed as to the timely payment of principal and interest by the full faith and credit of the U.S. government.
"HAMP" means the Home Affordable Modification Program
"HARP" means the Home Affordable Refinance Program
"JAVELIN" means JAVELIN Mortgage Investment Corp.
"LIBOR" means the London Interbank Offered Rate
"Management Agreement" means the management agreement between ARR and ARRM whereby ARRM performs certain services for ARR in exchange for a specified fee
"MBS" means mortgage backed securities, a security representing a direct interest in a pool of mortgage loans. The pass-through issuer or servicer collects the payments on the loans in the pool and "passes through" the principal and interest to the security holders on a pro rata basis.
"MRA" means master repurchase agreement. A document that outlines standard terms between the Company and counterparties for repurchase agreement transactions.
"OCC" means the
"PRA" means the
"QE3" means the Fed's third quantitative easing program
"REIT" means Real Estate Investment Trust. A special purpose investment vehicle that provides investors with the ability to participate directly in the ownership or financing of real-estate related assets by pooling their capital to purchase and manage mortgage loans and/or income property.
"Repurchase Program" means the Company's common stock repurchase program
"RMBS" means residential mortgage backed securities
"SEC" means the
"Sub-Management Agreement" means a Sub-Management Agreement between ARMOUR, ARRM and SBBC. ARRM is responsible for the payment of a monthly sub-management fee.
"1940 Act" means the Investment Company Act of 1940
"Wheatley Review" means the results of FSA's review of the process for setting LIBOR interest rate for various currencies and maturities