News Column

PENNYMAC MORTGAGE INVESTMENT TRUST - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 11, 2014

We are a specialty finance company that invests primarily in residential mortgage loans and mortgage-related assets. Our objective is to provide attractive risk-adjusted returns to our investors over the long-term, principally through dividends and secondarily through capital appreciation. We intend to achieve this objective largely by investing in distressed mortgage assets and mortgage-related assets and acquiring, pooling and selling newly originated prime credit quality residential mortgage loans ("correspondent production").



We are externally managed by PCM, an indirect subsidiary of PFSI and an investment adviser that specializes in and focuses on residential mortgage loans. Most of our mortgage loan portfolio is serviced by PLS, an indirect subsidiary of PFSI.

During the quarter and six months ended June 30, 2014, we purchased loans with fair values totaling $7.3 billion and $12.3 billion, respectively, in furtherance of our correspondent production business. To the extent that we purchase loans that are insured by the U.S. Department of Housing and Urban Development ("HUD"), through the Federal Housing Administration ("FHA") or insured or guaranteed by the Veterans Administration ("VA"), we and PLS have agreed that PLS will fulfill and purchase such loans, as PLS is a Ginnie Mae-approved issuer and servicer and we are not. This arrangement has enabled us to compete with other correspondent lenders that purchase both government and conventional loans. We receive a sourcing fee from PLS of three basis points on the unpaid principal balance of each loan that we sell to PLS under such arrangement, and earn interest income on the loan for the time period we hold the loan prior to the sale to PLS. We received sourcing fees totaling $1.1 million and $2.0 million, recorded in Net gain on mortgage loans acquired for sale, relating to $4.0 billion and $7.1 billion of loans at fair value we sold to PLS for the quarter and six months ended June 30, 2014, compared to $1.3 million and $2.4 million relating to $4.7 billion and $8.3 billion of fair value loans we sold to PLS for the quarter and six months ended June 30, 2013, respectively. We seek to maximize the value of the distressed mortgage loans that we acquire using means that are appropriate for the particular loan, including both proprietary and nonproprietary loan modification programs, special servicing and other initiatives focused on avoiding foreclosure, when possible. When we are unable to effect a cure for a mortgage delinquency, our objective is to effect timely acquisition and/or liquidation of the property securing the loan through the use, in part, of short sales and deed-in-lieu of foreclosure programs. During the quarter and six months ended June 30, 2014, we acquired distressed mortgage loans with fair values totaling $27.2 million and $287.5 million, and we received proceeds from sales, liquidation, and payoffs from our portfolio of distressed mortgage loans and REO totaling $191.1 million and $476.6 million, respectively.



We supplement these activities through participation in other mortgage-related activities, including:

Acquisition of MSRs or ESS from MSRs. We believe that MSR and ESS investments may allow us to earn attractive current returns and to leverage the loan servicing and origination capabilities of PLS to improve the assets' value. During the quarter and six months ended June 30, 2014, we purchased ESS with a fair value totaling $52.9 million and $73.4 million, respectively.



We also intend to continue to retain the MSRs that we receive as a portion of the proceeds from our sale or securitization of mortgage loans through our correspondent production operation. During the quarter and six months ended June 30, 2014, we retained MSRs with a fair value at initial recognition totaling $28.7 million and $49.6 million, respectively, compared to $51.1 million and $107.3 million during the quarter and six months ended June 30, 2013.

To the extent that we transfer correspondent production loans into private label securitizations, retention of a portion of the securities created in the securitization transaction. Acquisition of REIT-eligible mortgage-backed or mortgage-related securities. Providing inventory financing of mortgage loans for mortgage lenders. We believe this activity may result in attractive investment assets and will supplement and make our correspondent production business more attractive to lenders from which we acquire newly originated loans. 58



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We conduct substantially all of our operations, and make substantially all of our investments, through our Operating Partnership and its subsidiaries. We are the sole limited partner and one of our subsidiaries is the sole general partner of our Operating Partnership. We believe that we qualify to be taxed as a REIT. We believe that we will not be subject to federal income tax on that portion of our income that is distributed to shareholders as long as we meet certain asset, income and share ownership tests. If we fail to qualify as a REIT, and do not qualify for certain statutory relief provisions, our profits will be subject to income taxes and we may be precluded from qualifying as a REIT for the four tax years following the year we lose our REIT qualification. A portion of our activities, including our correspondent production business, is conducted in a taxable REIT subsidiary ("our TRS"), which is subject to corporate federal and state income taxes. Accordingly, we make a provision for income taxes with respect to the operations of our TRS. We expect that the effective rate for the provision for income taxes may be volatile in future periods. Our goal is to manage the business to take full advantage of the tax benefits afforded to us as a REIT.



Observations on Current Market Opportunities

Our business is affected by macroeconomic conditions in the United States, including economic growth, unemployment rates, the residential housing market and interest rate levels and expectations. During the second quarter of 2014, real U.S. gross domestic product expanded at an annual rate of 4.0% compared to a revised 2.1% decrease for the first quarter of 2014 and a 2.5% increase for the second quarter of 2013. The national unemployment rate was 6.1% at June 30, 2014 and compares to a revised seasonally adjusted rate of 7.5% at June 30, 2013 and 6.7% at March 31, 2014. While delinquency rates on residential real estate loans continue to decrease, they remain elevated compared to historical rates. As reported by the Federal Reserve Bank, during the first quarter of 2014, the delinquency rate on residential real estate loans held by commercial banks was 7.8%, a reduction from 9.7% during the first quarter of 2013. The seasonally adjusted annual rate of existing home sales for June 2014 was 2.3% lower than for June 2013 and the national median existing home price for all housing types was $223,300, a 4.3% increase from June 2013. On a national level, foreclosure filings during the second quarter of 2014 decreased by 19% as compared to the second quarter of 2013. Foreclosure activity across the country is on a decreasing trend; however, it is expected to remain above historical average levels through 2014 and beyond. Thirty-year fixed mortgage interest rates ranged from a low of 4.16% to a high of 4.34% during the second quarter of 2014. During the second quarter of 2013, thirty-year fixed mortgage interest rates ranged from a low of 3.45% to a high of 4.07% (Source: the Federal Home Loan Mortgage Corporation's Weekly Primary Mortgage Market Survey). Changes in fixed rate residential mortgage loan interest rates generally follow changes in long term U.S. Treasury yields. Toward the end of the second quarter of 2013, an increase in these Treasury yields led to an increase in mortgage loan interest rates. As a result of this increase in mortgage loan interest rates, market volumes for mortgage originations have decreased led by a reduction in refinance activity. Mortgage lenders originated an estimated $295 billion of home loans during the quarter ended June 30, 2014, down 52.9% from the quarter ended June 30, 2013. Mortgage originations are forecast to continue to decline, with current industry estimates for 2014 totaling $1.2 trillion compared to $1.9 trillion for 2013 (Source: Average of Fannie Mae, Freddie Mac and Mortgage Bankers Association forecasts). In recent periods, we have seen increased competition from new and existing market participants in our correspondent production business, as well as reductions in the overall level of refinancing activity. We believe that this change in supply and demand within the marketplace has been driving lower production margins in recent periods, which is reflected in our results of operations in our gains on mortgage loans acquired for sale. During the first several months of 2013, gains on mortgage loans acquired for sale benefited from wider secondary spreads (the difference between interest rates charged to borrowers and yields on mortgage-backed securities in the secondary market); however, secondary spreads narrowed in subsequent months and we expect them to continue to normalize toward their long-term averages in 2014. 59



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We believe there is significant long-term market opportunity in non-Agency jumbo mortgage loans. Pricing for non-Agency AAA rated bonds has steadily improved since the beginning of the year, however liquidity is fairly limited. During the six months ended June 30, 2014, prime jumbo MBS issuance totaled $2.1 billion in unpaid principal balance compared to $7.9 billion during the six months ended June 30, 2013. During the six months ended June 30, 2014, we produced approximately $93.4 million in unpaid principal balance ("UPB") of jumbo loans, compared to $115.5 million in UPB of jumbo loans produced during the six months ended June 30, 2013. Our Manager continues to see substantial volumes of distressed residential mortgage loan sales (sales of loan pools that consist of either nonperforming loans, troubled but performing loans or a combination thereof) offered for sale by a limited number of sellers. During the second quarter of 2014, our Manager reviewed 57 mortgage loan pools with UPB totaling approximately $18.2 billion. This compares to our Manager's review of 36 mortgage loan pools with unpaid principal balances totaling approximately $11.1 billion and one pool of real estate acquired in settlement of loans totaling approximately $108 million during the second quarter of 2013. During the quarter and six months ended June 30, 2014, we acquired distressed loans with fair value totaling $27.2 million and $287.5 million, respectively, and $242.7 million and $443.2 million during the same periods in 2013. While we expect to see a continued supply of distressed whole loans, we believe the pricing for recent transactions has been less attractive for buyers. We remain patient and selective in making new investments in distressed whole loans and we continue to monitor the market to assess best execution opportunities for our existing distressed portfolio investments. 60



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Results of Operations

The following is a summary of our key performance measures:

Six months ended Quarter ended June 30, June 30, 2014 2013 2014 2013 (in thousands except per share amounts) Net investment income $ 120,556$ 115,553



$ 197,151$ 223,369

Income before provision for income taxes by segment: Correspondent production $ 2,397$ 28,103$ 5,544$ 36,983 Investment activities 70,907 39,806 104,048 90,145 Other (1) - - - (3,284 ) $ 73,304$ 67,909$ 109,592$ 123,844 Net income $ 75,211$ 54,497$ 113,084$ 107,793

Earnings per share: Basic $ 1.01$ 0.92$ 1.54$ 1.81 Diluted $ 0.93$ 0.86$ 1.44$ 1.75 Dividends per share: Declared $ 0.59$ 0.57$ 1.18$ 1.14 Paid $ 0.59$ 0.57$ 1.18$ 1.14 Investment activities: Distressed mortgage loans and REO: Purchases $ 27,233$ 243,198$ 287,520$ 443,671 Cash proceeds from liquidation activities $ 200,764$ 104,814$ 486,324$ 198,259 MBS: Purchases $ 19,638 $ - $ 19,638 $ - Cash proceeds from repayment and sales $ 3,441 $ - $ 5,419 $ - ESS: Purchases from PFSI $ 52,867 $ - $ 73,393 $ - Cash proceeds from repayments $ 9,081 $ - $ 16,494 $ - Per share prices during the period: High $ 24.15$ 26.07$ 24.44$ 28.73 Low $ 20.78$ 19.17$ 20.78$ 16.75 At period end $ 21.94$ 22.95$ 21.94$ 19.73 At period end: Total assets $ 4,869,745$ 3,443,384 Book value per share $ 21.27$ 21.06



(1) Represents corporate absorption of fulfillment fees for transition adjustment

relating to the amended and restated mortgage banking and warehouse services

agreement effective February 1, 2013.

During the quarter and six months ended June 30, 2014, we recorded net income of $75.2 million and $113.1 million, or $0.93 and $1.44 per diluted share, respectively. Our net income for the quarter and six months ended June 30, 2014 reflects net gains on our investments in financial instruments (comprised of net gain on investments and net gain on mortgage loans acquired for sale) totaling $83.4 million and $135.9 million, including $63.7 million and $96.9 million of valuation gains on mortgage loans at fair value, and mortgage loans under forward purchase agreements at fair value. These gains were supplemented by $26.7 million and $46.2 million of net interest income, respectively. During the quarter and six months ended June 30, 2014, we purchased $7.3 billion and $12.3 billion in fair value of newly originated mortgage loans. We recognized gains on such loans totaling approximately $10.2 million and $20.2 million. At June 30, 2014, we held mortgage loans acquired for sale with fair values totaling $909.1 million, including $304.7 million that were pending sale to PLS. 61



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During the quarter and six months ended June 30, 2013, we recorded net income of $54.5 million and $107.8 million, or $0.86 and $1.75 per diluted share, respectively. Our net income for the quarter and six months ended June 30, 2013 reflects net gains on our investments in financial instruments totaling $91.3 million and $184.5 million (comprised of net gain on investments and net gain on mortgage loans acquired for sale), including $38.8 million and $94.4 million of valuation gains on mortgage loans at fair value and mortgage loans under forward purchase agreements at fair value. These gains were supplemented by $12.7 million and $18.3 million of net interest income. During the quarter and six months ended June 30, 2013, we purchased $8.9 billion and $17.8 billion, respectively, in fair value of newly originated mortgage loans. We recognized gains on such loans totaling approximately $44.4 million and $73.7 million, respectively. At June 30, 2013, we held mortgage loans acquired for sale with fair values totaling $1.3 billion, including $290.6 million that were pending sale to PLS. Our net income increased during the quarter and six months ended June 30, 2014 due to increased pretax income in our investment activities segment partially offset by decreased pre-tax income in our correspondent production segment. In our investment activities, our average investment portfolio was approximately $3.1 billion and $3.0 billion during the quarter and six months ended June 30, 2014, an increase of $1.8 billion, or 136%, and $1.8 billion, or 141%, over the quarter and six months ended June 30, 2013, respectively. During the quarter and six months ended June 30, 2014, we recognized net investment income totaling approximately $105.1 million and $169.4 million in our investment activities segment, an increase of $40.5 million, or 63%, and $32.4 million, or 24%, from the quarter and six months ended June 30, 2013. During the quarter and six months ended June 30, 2013, we recognized net investment income totaling approximately $64.6 million and $137.0 million, respectively. In our correspondent production activities, we received proceeds of $2.8 billion and $4.8 billion during the quarter and six months ended June 30, 2014, from the sale of mortgage loans to nonaffiliates and issued $3.8 billion and $6.0 billion of IRLCs relating to Agency and jumbo mortgage loans, a decrease of $1.8 billion, or 32% and $3.9 billion, or 39%, from the same period in 2013. During 2014, rising interest rates negatively affected demand for mortgage loans as well as increased competition in the mortgage market, reducing both the volume of loans we purchased and the margins on our net gain on mortgage loans acquired for sale. As a result, we sold fewer loans during 2014 as compared to 2013, and our net gain on loans acquired for sale decreased by $34.2 million, or 77% and $53.5 million, or 73% during the quarter and six months ended June 30, 2014.



Net Investment Income

During the quarter and six months ended June 30, 2014, we recorded net investment income of $120.6 million and $197.2 million, respectively, comprised primarily of net gain on investments of $73.1 million and $115.7 million, supplemented by $26.7 million and $46.2 million of net interest income, $10.2 million and $20.2 million of net gain on mortgage loans acquired for sale, $8.8 million and $16.2 million of net loan servicing fees, and $4.5 million and $6.8 million of loan origination fees, partially offset by $5.3 million and $12.0 million of losses from results of REO, respectively. This compares to net investment income of $115.6 million and $223.4 million recognized during the quarter and six months ended June 30, 2013, comprised primarily of net gains on investments of $46.8 million and $110.8 million supplemented by gain on sale of loans acquired for sale of $44.4 million and $73.7 million, $12.7 million and $18.3 million of net interest income, $4.8 million and $10.2 million of loan origination fees and $7.9 million and $13.9 million of net loan servicing fees, partially offset by $1.9 million and $5.2 million from results of REO, respectively. Net investment income includes non-cash fair value adjustments. Because we have elected to record our mortgage loan investments (which include mortgage loans at fair value and mortgage loans under forward purchase agreements at fair value), a substantial portion of the income we record with respect to such loans results from non-cash changes in fair value. Net investment income also includes non-cash fair value adjustments related to mortgage loans acquired for sale at fair value, IRLCs, and the related derivatives we use to hedge such assets and non-cash interest income arising from capitalization of delinquent interest on mortgage loans upon completion of the modification of such loans and accrual of unearned discounts relating to mortgage loans held in a VIE, as well as non-cash fair value adjustments relating to MSRs and ESS. 62



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The amounts of non-cash fair value and interest income adjustments are as follows: Quarter ended June 30, Six months ended June 30, 2014 2013 2014 2013 (in thousands) Net gain on mortgage loans acquired for sale Mortgage loans acquired for sale $ 6,660$ (34,572 )$ 8,073$ (36,994 ) IRLCs 7,816 (28,020 ) 9,838 (36,446 ) Hedging derivatives (10,051 ) 97,026 (17,202 ) 96,360 4,425 34,434 709 22,920 Net interest income Capitalization of interest pursuant to mortgage loan modifications 17,883 6,584 30,353 11,814 Accrual of unearned discounts relating to loans held in a variable interest entity 223 - 553 - 18,106 6,584 30,906 11,814 Net gain (loss) on investments Mortgage-backed securities: Agency 4,081 - 6,734 - Non Agency 184 - 184 - Mortgage loans: at fair value 72,871 39,484 115,951 95,100 at fair value under forward purchase agreements 1,842 (690 ) 463 (690 ) 74,713 38,794 116,414 94,410 ESS (7,537 ) - (10,438 ) - 71,441 38,794 112,894 94,410 Net loan servicing fees - MSR valuation adjustments (5,860 ) 1,534 (7,720 ) 4,010 $ 88,112$ 81,346$ 136,789$ 133,154 Cash is generated when mortgage loan investments are monetized through payoffs or sales, when payment of principal and interest occur on such loans, generally after they are modified, or upon the sale of the property securing a mortgage loan that has been settled through acquisition of the property securing the loan has been sold. We receive proceeds on the sale of mortgage loans acquired for sale that include both cash and the fair value of MSRs and we recognize a liability for potential losses relating to representations and warranties created in the loan sales transactions. Cash flows relating to hedging instruments are generally produced when the instruments mature or when we effectively cancel the transactions through an offsetting trade. 63



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Cash flows and gains from liquidation of distressed mortgage loan investments and REO are summarized below: Quarter ended June 30, Six months ended June 30, 2014 2013 2014 2013 (in thousands) Proceeds $ 191,129$ 104,351$ 476,584$ 198,259 Accumulated net gains (1) $ 30,809$ 11,844$ 87,024$ 19,884 Net gains on liquidation (2) $ 13,694$ 11,088



$ 22,707$ 22,289

Average investment in mortgage loans and REO $ 2,785,185$ 1,272,947$ 2,727,750$ 1,264,067



(1) Represents valuation gains and losses recognized during the period we held

the respective asset but excludes the gain or loss recorded upon sale or

repayment of the respective asset.

(2) Represents the gain or loss recognized upon sale or repayment of the

respective asset.

The increase in net investment income during the quarter ended June 30, 2014, as compared to the quarter ended June 30, 2013, primarily reflects the increase in net fair value gains in our investments in mortgage loans at fair value partially offset by reductions in net gain on mortgage loans acquired for sale during 2014 as compared to 2013. Increases in gain on our investments in mortgage loans are due primarily to portfolio growth and observed increased marketplace demand for performing mortgage loans in our investment portfolio, partially tempered by an increase in the projected loss severity for long-held severely delinquent loans. The decrease in gains on mortgage loans acquired for sale is due to both the decrease in volume of mortgage loans sold and reduced margin on the loans sold as a result increasing competition as well as to the generally rising interest rate environment that prevailed during the quarter and six months ended June 30, 2014 when compared to the same periods in 2013. 64



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Net Gain on Mortgage Loans Acquired for Sale

Our net gains on mortgage loans acquired for sale are summarized below:

Quarter ended June 30, Six months ended June 30, 2014 2013 2014 2013 (in thousands) Cash gain (loss): Sales proceeds, net $ (3,173 )$ (71,706 )$ (6,067 )$ (98,952 ) Hedging activities (18,749 ) 32,092 (22,299 ) 45,705 (21,922 ) (39,614 ) (28,366 ) (53,247 ) Non cash gain: Receipt of MSRs in loan sale transactions 28,741 51,055 49,616 107,271 Provision for losses relating to representations and warranties provided in loan sales (1,022 ) (1,437 ) (1,766 ) (3,227 ) Change in fair value relating to IRLCs, mortgage loans and hedging derivatives held at period end: IRLCs 7,816 (28,020 ) 9,838 (36,446 ) Mortgage loans 6,660 (34,572 ) 8,073 (36,994 ) Hedging derivatives (10,051 ) 97,026 (17,202 ) 96,360 4,425 34,434 709 22,920 $ 10,222$ 44,438$ 20,193$ 73,717 Notional (Loan) amount of IRLCs issued $ 3,784,024$ 5,543,256$ 6,015,404$ 9,893,621 Purchases of mortgage loans acquired for sale At fair value $ 7,302,157$ 8,904,708$ 12,345,381$ 17,753,860 Unpaid principal balance $ 6,986,131$ 8,585,531$ 11,815,719$ 17,111,151 Proceeds from sales of mortgage loans acquired for sale: Cash: Sales to nonaffiliated investors $ 2,763,138$ 3,909,743$ 4,789,444$ 9,044,479 Sales of government-insured and guaranteed loans to PFSI 3,955,329 4,733,767 7,085,859 8,282,163 $ 6,718,467$ 8,643,510$ 11,875,303$ 17,326,642 Increase (decrease) in gain on mortgage loans acquired for sale due to: Change in fair value of IRLCs $ 35,836$ (36,645 )$ 46,284$ (43,608 ) Change in volume of loans sold (16,376 ) 25,223 (35,437 ) 73,574 Change in gain margin (53,452 ) 36,926 (64,029 ) 10,677 Change in sourcing fees received from PFSI (224 ) 888 (342 ) 1,658 $ (34,216 )$ 26,392$ (53,524 )$ 42,301 Our net gain on mortgage loans acquired for sale includes both cash and non-cash elements. We receive proceeds on sale that include both cash and our estimate of the fair value of MSRs. We also recognize a liability for potential losses relating to representations and warranties created in the loan sales transactions. The change in our cash loss on mortgage loans acquired for sale during the quarter ended June 30, 2014 reflects the decreased volume of mortgage loan sales during the quarter ended June 30, 2014 as compared to the quarter ended June 30, 2013 as a result of reductions in the size of the mortgage market resulting from rising interest rates beginning in the second half of 2013. 65



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We recognize a substantial portion of our net gain on mortgage loans acquired for sale at fair value before we purchase the loan. In the course of our correspondent production activities, we make contractual commitments to correspondent lenders to purchase loans at specified terms. We call these commitments interest rate lock commitments, or IRLCs. We recognize the value of IRLCs at the time we make the commitment to the correspondent lender and adjust the fair value of such IRLCs as the loan approaches the point of purchase or the transaction is canceled. An active, observable market for IRLCs does not exist. Therefore, we measure the fair value of IRLCs using methods and assumptions we believe that market participants use in pricing IRLCs. We estimate the fair value of an IRLC based on quoted Agency MBS prices, our estimates of the fair value of the MSRs we expect to receive in the sale of the loans and the probability that the mortgage loan will be purchased as a percentage of the commitment we have made (the "pull-through rate"). Pull-through rates and MSR fair values are based on our estimates as these inputs are difficult to observe in the mortgage marketplace. Changes in our estimate of the probability that a mortgage loan will fund and changes in interest rates are updated as the mortgage loans move through the purchase process and may result in significant changes in the estimates of the value of the IRLCs. Such changes are reflected in the change in fair value of IRLCs which is a component of our Gain on mortgage loans acquired for sale in the period of the change. The financial effects of changes in these assumptions are generally inversely correlated. Increasing interest rates have a positive effect on the fair value of the MSR component of IRLC value but increase the pull-through rate for loans that decrease in fair value. Following is a quantitative summary of key unobservable inputs used in the valuation of IRLCs: Range (Weighted average) Key inputs June 30, 2014 December 31, 2013 Pull-through rate 49.0% - 98.0% 64.8% - 98.0% (81.6%) (86.4%) MSR value expressed as: Servicing fee multiple 1.7 - 5.0 1.4 - 5.1 (3.9) (4.1)



Percentage of unpaid principal balance 0.4% - 1.3% 0.4% - 1.3%

(1.0%) (1.0%) MSRs represent the value of a contract that obligates us to service mortgage loans on behalf of the purchaser of the loan in exchange for servicing fees and the right to collect certain ancillary income from the borrower. We recognize MSRs initially at our estimate of the fair value of the contract to service the loans. As economic fundamentals influencing the loans we sell with servicing rights retained change, our estimate of the cash we expect to generate from the MSRs and, therefore, the fair value of MSRs will also change. As a result, we will record changes in fair value as a component of Net loan servicing fees for the MSRs we carry at fair value and we may recognize changes in fair value relating to our MSRs carried at the lower of amortized cost or fair value depending on the relationship of the asset's fair value to its carrying value at the measurement date. 66



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Following are the key inputs used in estimating the fair value of MSRs at the time of initial recognition:

Quarter ended June 30, 2014 2013 Range (Weighted average) Key inputs Amortized cost Fair value Amortized cost Fair value (MSR recognized and unpaid principal balance of underlying loan amounts in thousands) MSR recognized $ 13,356 $ 15,385 $ 50,978 $ 77 Unpaid principal balance of underlying mortgage loans $ 1,244,538 $ 1,458,400 $ 3,840,110 $ 27,346 Weighted-average annual servicing fee rate (in basis points) 25 25 28 27 Pricing spread (1) 6.3% - 14.3% 8.5% - 10.3% 5.4% - 13.5% 6.6% - 11.9% (8.7%) (9.1%) (6.5%) (7.5%) Life (in years) 1.3 - 7.3 3.2 - 7.3 2.6 - 6.9 6.3 - 6.9 (6.1) (7.1) (6.4) (6.8) Annual total prepayment speed (2) 7.6% - 50.9% 8.1% - 25.4% 8.5% - 23.6% 8.8% - 13.6% (10.4%) (9.6%) (9.1%) (9.3%) Annual per-loan cost of servicing $68 - $100$68 - $68$68 - $140$68 - $68 ($68) ($68) ($68) ($68) Six months ended June 30, 2014 2013 Range (Weighted average) Key inputs Amortized cost Fair value Amortized cost Fair value (MSR recognized and unpaid principal balance of underlying loan amounts in thousands) MSR recognized $ 22,474 $ 27,142 $ 107,167 $ 104 Unpaid principal balance of underlying mortgage loans $ 2,095,087 $ 2,550,114 $ 8,843,667 $ 29,946 Weighted-average annual servicing fee rate (in basis points) 25 25 26 27 Pricing spread (1) 6.3% - 14.3% 8.5% - 12.3% 5.4% - 14.4% 6.6% - 14.4% (8.6%) (9.0%) (6.8%) (7.6%) Life (in years) 1.1 - 7.3 2.8 - 7.3 2.6 - 6.9 2.8 - 6.9 (6.0) (7.1) (6.4) (6.7) Annual total prepayment speed (2) 7.6% - 56.4% 8.0% - 25.4% 8.5% - 23.6% 8.8% - 27.0% (10.4%) (9.5%) (9.1%) (9.7%) Annual per-loan cost of servicing $68 - $100$68 - $68$68 - $140$68 - $68 ($68) ($68) ($68) ($68)



(1) Pricing spread represents a margin that is applied to a reference interest

rate's forward rate curve to develop periodic discount rates. The Company

applies a pricing spread to the United States Dollar LIBOR curve for purposes

of discounting cash flows relating to MSRs acquired as proceeds from the sale

of mortgage loans.

(2) Annual total prepayment speed is measured using Life Total Conditional

Prepayment Rate ("CPR").

We also provide for our estimate of the future losses that we may be required to incur as a result of our breach of representations and warranties provided to the purchasers of the loans we sold. Our agreements with the Agencies include representations and warranties related to the loans we sell to the Agencies. The representations and warranties require adherence to Agency origination and underwriting guidelines, including but not limited to the validity of the lien securing the loan, property eligibility, borrower credit, income and asset requirements, and compliance with applicable federal, state and local law. 67



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In the event of a breach of our representations and warranties, we may be required to either repurchase the mortgage loans with the identified defects or indemnify the investor or insurer. In such cases, we bear any subsequent credit loss on the mortgage loans. Our credit loss may be reduced by any recourse we have to correspondent lenders that, in turn, had sold such mortgage loans to us and breached similar or other representations and warranties. In such event, we have the right to seek a recovery of related repurchase losses from that correspondent lender.



Following is a summary of the repurchase activity and unpaid principal balance of mortgage loans subject to representations and warranties:

Quarter ended June 30, Six months ended June 30, 2014 2013 2014 2013 (in thousands) During the period: Unpaid principal balance of mortgage loans repurchased $ 2,623$ 292$ 4,411$ 1,208 Unpaid principal balance of repurchased mortgage loans repurchased by correspondent lenders $ 1,922$ 394$ 2,811$ 1,104 At end of period: Unpaid principal balance of mortgage loans subject to pending claims for repurchase $ 19,805$ 824 Unpaid principal balance of mortgage loans subject to representations and warranties $ 29,806,058$ 19,829,437 During the quarter and six months ended June 30, 2014, we repurchased mortgage loans with unpaid principal balances totaling $2.6 million and $4.4 million, respectively, and incurred no losses relating to such repurchases primarily as a result of our ability to recover any losses inherent in the repurchased loan from the selling correspondent lender. As the outstanding balance of loans we purchase and sell subject to representations and warranties increases and the loans sold season, we expect the level of repurchase activity to increase. As economic fundamentals change, and as investor and Agency evaluation of their loss mitigation strategies (including claims under representations and warranties) change and as the mortgage market and general economic changes affect our correspondent lenders, the level of repurchase activity and ensuing losses will change, which may be material to our financial condition and results of operations. The method used to estimate the liability for representations and warranties is a function of estimated future defaults, loan repurchase rates, the potential severity of loss in the event of defaults and the probability of reimbursement by the correspondent loan seller. We establish a liability at the time loans are sold and review our liability estimate on a periodic basis. 68



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Following is a summary of our liability for representations and warranties in the consolidated balance sheets:

Quarter ended June 30, Six months ended June 30, 2014 2013 2014 2013 (in thousands) Balance, beginning of period $ 10,854$ 6,231

$ 10,110$ 4,441 Provision for losses 1,022 1,437 1,766 3,227 Incurred losses - - - - Balance, end of period $ 11,876$ 7,668$ 11,876$ 7,668 The level of the recourse liability is difficult to estimate and requires considerable management judgment. The level of mortgage loan repurchase losses is dependent on economic factors, investor loss mitigation strategies, our ability to recover any losses inherent in the repurchased loan from the selling correspondent lender and other external conditions that may change over the lives of the underlying loans. Our representations and warranties are generally not subject to stated limits of exposure. However, we believe that the current unpaid principal balance of loans sold by us to date represents the maximum exposure to repurchases related to representations and warranties. We believe the amount and range of reasonably possible losses in relation to the recorded liability is not material to our financial condition or results of operations. Our hedging activities relating to correspondent production primarily involve forward sales and purchases of our IRLCs and mortgage loans acquired for sale as well as purchases of put and call MBS options. Following is a summary of the notional activity in our hedging derivatives for our investment activities related to our IRLCs and inventory of mortgage loans acquired for sale: Quarter ended June 30, 2014 Balance, Balance, beginning Dispositions/ end of Period/Instrument of period Additions expirations period (in thousands) Forward purchase contracts 1,777,353 11,967,081 (10,685,830 ) 3,058,604 Forward sales contracts 2,497,960 15,282,582 (13,594,909 ) 4,185,633 MBS put option 235,000 290,000 (255,000 ) 270,000 MBS call option - 25,000 - 25,000 Quarter ended June 30, 2013 Balance, Balance, beginning Dispositions/ end Period/Instrument of period Additions expirations of period (in thousands) Forward purchase contracts 1,890,960 15,323,298 (11,802,474 ) 5,411,784 Forward sales contracts 3,224,190 20,418,956 (15,915,080 ) 7,728,066 MBS put options 225,000 1,545,000 (1,310,000 ) 460,000 MBS call options 350,000 1,000,000 (625,000 ) 725,000 Six months ended June 30, 2014 Balance, Balance, beginning Dispositions/ end of Period/Instrument of period Additions expirations period (in thousands) Forward purchase contracts 2,781,066 18,364,898 (18,087,360 ) 3,058,604 Forward sales contracts 3,463,027 24,051,521 (23,328,915 ) 4,185,633 MBS put option 55,000 695,000 (480,000 ) 270,000 MBS call option 110,000 25,000 (110,000 ) 25,000 Six months ended June 30, 2013 Balance, Balance, beginning Dispositions/ end Period/Instrument of period Additions expirations of period (in thousands) Forward purchase contracts 2,206,539 27,765,642 (24,560,397 ) 5,411,784 Forward sales contracts 4,266,983 38,269,229 (34,808,146 ) 7,728,066 MBS put options 495,000 3,025,000 (3,060,000 ) 460,000 MBS call options - 1,900,000 (1,175,000 ) 725,000 69



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Loan Origination Fees

Loan origination fees represent fees we charge correspondent lenders relating to our purchase of loans from those lenders. The decrease in fees during 2014 compared to 2013 is due to a decrease in production volume.

Net Gain on Investments

During the quarter and six months ended June 30, 2014, we recognized net gains on MBS, mortgage loans and ESS totaling $73.1 million and $115.7 million, respectively. This compares to recognized net gains on investments totaling $46.8 million and $110.8 million during the quarter and six months ended June 30, 2013, respectively. The increase is primarily due to increased valuation gains in our portfolio of mortgage loans, including mortgage loans under forward purchase agreements. The average portfolio balance of distressed mortgage loan investments (mortgage loans at fair value excluding mortgage loans at fair value held in a VIE and mortgage loans under forward purchase agreements at fair value) increased $1.4 billion, or 111%, and $1.4 billion, or 115%, during the quarter and six months ended June 30, 2014 as compared to the same period in 2013.



Net gains on mortgage loans at fair value and mortgage loans under forward purchase agreements at fair value are summarized below:

Quarter ended June 30, Six months ended June 30, 2014 2013 2014 2013 (in thousands) Valuation changes: Performing loans $ 39,123$ 4,700$ 38,882$ 27,684 Nonperforming loans 24,587 34,094 58,001 66,726 63,710 38,794 96,883 94,410 Payoffs 7,490 8,040 13,109 16,404 Sales 2,395 - 3,520 - $ 73,595$ 46,834$ 113,512$ 110,814 Average portfolio balance $ 2,570,533$ 1,219,196$ 2,537,168$ 1,177,454 Because we have elected to record our mortgage loans and mortgage loans under forward purchase agreements at fair value, a substantial portion of the income we record with respect to such loans results from changes in fair value. Valuation changes amounted to $63.7 million and $38.8 million in the quarters ended June 30, 2014 and 2013, respectively, and $96.9 million and $94.4 million in the six months ended June 30, 2014 and 2013, respectively. The valuation changes on performing loans is affected by the capitalization of delinquent interest on loans we modify. When we capitalize interest in a loan modification, we increase the carrying value of the loan. However, the modification may not result in an immediate increase in the loan's fair value. As a result, the interest income we recognize is generally offset by a valuation loss. Valuation gains on loans with capitalized interest generally accrue as the borrower demonstrates performance in the periods following the capitalization. During the quarter and six months ended June 30, 2014, we capitalized interest totaling $18.1 million and $30.4 million compared to $6.6 and $11.8 for the quarter and six months ended June 30, 2013. The increase in valuation gains reflects portfolio growth and observed and realized increases in demand for performing mortgage loans that resulted in a reduction of the discount rate we apply to our estimate of cash flows to be generated by our performing loans and an increase in such loans' valuations. The increase in the valuation gains for performing loans was partially tempered by an increase in the projected loss severity for long-held severely delinquent loans. Cash is generated when mortgage loans and mortgage loans under forward purchase agreements are monetized through payoffs or sales, when we receive payments of principal and interest on such loans, generally after they are modified, or when the property securing a mortgage loan that has been settled through transfer of the 70



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property to us has been sold.

During the quarters ended June 30, 2014 and 2013, we received proceeds from liquidation of mortgage loans and REO of $191.1 million and $104.4 million, respectively, and during the six-month periods ended June 30, 2014 and 2013, we received proceeds from liquidation of mortgage loans and REO of $476.6 million and $198.3 million, respectively. These proceeds include $70.3 million and $264.3 million from the sale of $81.3 million and $313.4 million in unpaid principal balance of mortgage loans during the quarter and six months ended June 30, 2014, respectively. For each period's liquidations, we had recorded accumulated gains on the liquidated assets during the period we held those assets totaling $30.8 million and $11.8 million for the quarters ended June 30, 2014 and 2013, respectively, and $87.0 million and $19.9 million for the six-month periods ended June 30, 2014 and 2013, respectively, and we recorded additional gains of $13.7 million and $11.1 million for the quarters ended June 30, 2014 and 2013, respectively, and $22.7 million and $22.3 million for the six months ended June 30, 2014 and 2013, respectively, when the assets were liquidated.



During the quarters ended June 30, 2014 and 2013, we recognized gains on mortgage loan payoffs as summarized below:

Quarter ended June 30, Six months ended June 30, 2014 2013 2014 2013 (dollars in thousands) Number of loans 353 349 681 642 Unpaid principal balance $ 98,360$ 94,313$ 178,076$ 174,956 Gain recognized at payoff $ 7,489$ 8,040$ 13,109$ 16,404



Gains on sales of distressed mortgage loans are summarized below:

Quarter ended June 30, Six months ended June 30, 2014 2013 2014 2013 (dollars in thousands) Number of loans 396 - 1,362 - Unpaid principal balance $ 81,294 $ - $ 313,420 $ - Gain recognized at sale $ 2,395 $ - $ 3,520 $ - 71



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The following tables present a summary of loan modifications completed:

Quarter ended June 30, Six months ended June 30, 2014 2013 2014 2013 Number Balance Number Balance Number Balance Number Balance of of of of of of of of Modification type (1) loans loans (2) loans loans (2) loans loans (2) loans loans (2) (dollars in thousands) Rate reduction 412 $ 100,752 149 $ 32,226 766 $ 180,641 272 $ 59,131 Term extension 482 122,371 127 28,816 870 216,040 238 51,396 Capitalization of interest and fees 615 155,083 250 54,442 1,116 273,352 468 100,627 Principal forbearance 218 65,245 60 16,157 369 112,172 109 25,088 Principal reduction 288 73,228 122 28,056 542 137,046 196 48,397 Total 615 155,083 250 54,442 1,116 273,352 468 100,627 Defaults of mortgage loans modified in the prior year period $ 2,388$ 2,796$ 6,197$ 7,134 As a percentage of balance of loans before modification 6 % 10 % 9 % 9 % Defaults during the period of mortgage loans modified since acquisitions(3) $ 21,140$ 11,060$ 49,648$ 20,983 As a percentage of balance of loans before modification 7 % 6 % 18 % 11 % Repayments and sales of mortgage loans modified in the prior year period $ 13,153$ 6,438$ 36,654$ 17,997 As a percentage of balance of loans before modification 25 % 18 % 37 % 18 %



(1) Modification type categories are not mutually exclusive and a modification of

a single loan may be counted in multiple categories, if applicable. The total

number of modifications noted in the table is therefore lower than the sum of

all of the categories. (2) Before modification.



(3) Represents defaults of mortgage loans during the period that have been

modified by us at any point since acquisition.

The following table summarizes the average impact of the modifications noted above to the terms of the loans modified:

Quarter ended June 30, Six months ended June 30, 2014 2013 2014 2013 Before After Before After Before After Before After Category modification modification modification modification modification modification modification modification (dollars in thousands) Loan balance $ 252 $ 256 $ 218 $ 197 $ 245 $ 246 $ 215 $ 197 Remaining term (months) 327 417 311 447 323 417 312 445 Interest rate 5.30 % 3.68 % 5.89 % 4.18 % 5.44 % 3.71 % 5.93 % 4.17 %

Forbeared principal $ - $ 15 $ - $ 7 $ - $ 13 $ - $ 6 Implementing long-term, sustainable loan modification is one means by which we endeavor to increase the value of the distressed mortgage loans which we have typically purchased at discounts to their unpaid principal balance. Before the disruption of the mortgage securitization markets in 2008, an active market in securitizations of reperforming and modified mortgage loans existed. As a result of the disruptions that occurred in 2008, the market for securities backed by such loans has become illiquid. As discussed above, during the quarter and six months ended June 30, 2014, we had our first significant sales of reperforming mortgage assets. We received proceeds of $70.3 million and $264.3 million from the sale of $81.3 million and $313.4 million in unpaid principal balance of mortgage loans during the quarter and six months ended June 30, 2014, respectively. There can be no assurance that this form of monetization will continue to be a reliable means of liquidating reperforming mortgage assets in the future. We continue to monitor and explore the market for loan sales or securitizations backed by reperforming and modified mortgage loans as a means of recovering our investment in such loans in the future. 72



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Absent sale or securitization of reperforming and modified mortgage loans, and unlike liquidation of a defaulted mortgage loan, we expect that recovery of our investment in a performing modified mortgage loan will take place generally over a period of several years, during which we earn and collect interest income on the loan. Our current expectations are that we will receive cash on modified mortgage loans through monthly borrower payments, HAMP incentive payments, payoffs or acquisition of the property securing the loans and liquidation of the property in the event the borrower subsequently defaults. Due to the recent addition of new modification programs, both through HAMP and proprietary programs, trends in default performance are difficult to discern. However, the addition of these new modification programs resulted in an increase in the volume of our modification activity to date during 2014. Large-scale refinancing of modified mortgage loans is not expected to occur for several years. Borrowers who have recently modified their mortgage loans typically have credit profiles that do not qualify them for refinancing or have loans on properties whose loan-to-value ratios exceed current underwriting guidelines for new mortgage loans. Further, modified mortgage loans require a period of acceptable borrower performance, generally 12 months of timely mortgage payments, for consideration in most Agency refinance programs. Certain programs such as the FHA's Negative Equity Refinance Program allow homeowners whose modified mortgage amount exceeds the fair value of the property securing the loan to refinance immediately following a modification. Our utilization of this program remains consistent in 2014 as compared to 2013. We continue to explore methods of accelerating recovery of our investment of modified mortgage loans through solicitations of refinancings of such loans into Agency-eligible loans which result in a full or partial repayment of our investment. During the quarter and six months ended June 30, 2014, we recognized gains on MBS of $1.5 million and $2.2 million, respectively, net of hedging activities. The gains we recognized were due to decreases in market yields during the quarter. We did not hold any MBS during the six-month period ended June 30, 2013. 73



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Net Interest Income

Net interest income is summarized below:

Quarter ended June 30, 2014 Interest income/expense Annualized % Discount/ Average interest Coupon fees (1) Total balance yield/cost (dollars in thousands) Assets: Correspondent production: Mortgage loans acquired for sale at fair value $ 5,574 $ - $ 5,574$ 514,344 4.29 % Investment activities: Short-term investments 172 - 172 136,116 0.50 % Mortgage -backed securities: Agency 1,712 83 1,795 193,802 3.66 % Non-Agency prime jumbo 95 71 166 19,668 3.34 % 1,807 154 1,961 213,470 3.63 % Mortgage loans: at fair value 36,008 223 36,231 2,472,804 5.80 % under forward purchase agreements at fair value 1,430 - 1,430 97,729 5.79 % 37,438 223 37,661 2,570,533 5.79 % ESS 3,139 - 3,139 155,515 7.98 % Total investment activities 42,556 377 42,933 3,075,634 5.52 % Other interest 11 - 11 - $ 48,141$ 377$ 48,518$ 3,589,978 5.35 % Liabilities: Assets sold under agreements to repurchase $ 12,547$ 2,596$ 15,143$ 2,253,127 2.66 % Borrowings under forward purchase agreements 783 - 783 109,793 2.82 % Asset backed secured financing 1,481 80 1,561 165,495 3.73 % Exchangeable senior notes 3,359 228 3,587 250,000 5.68 % 18,170 2,904 21,074 2,778,415 3.03 % Other interest - Servicing 791 - 791 - 18,961 2,904 21,865 2,778,415 3.10 % Net interest income $ 29,180$ (2,527 )$ 26,653 Net interest margin 2.97 % Net interest spread 2.25 %



(1) Amounts in this column represent accrual of unearned discounts and

amortization of facility commitment fees for liabilities. 74



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Table of Contents Quarter ended June 30, 2013 Interest income/expense Annualized % Discount/ Average interest Coupon fees (1) Total balance yield/cost (dollars in thousands) Assets: Correspondent production: Mortgage loans acquired for sale at fair value $ 9,292 $ - $ 9,292$ 1,042,735 3.52 % Investment activities: Short-term investments 57 - 57 82,450 0.27 % Mortgage loans: at fair value 17,052 - 17,052 1,186,186 5.69 % under forward purchase agreements at fair value 260 - 260 33,010 3.12 % 17,312 - 17,312 1,219,196 5.62 % Total investment activities 17,369 - 17,369 1,301,646 5.34 % Other Interest 136 - 136 - $ 26,797 $ - $ 26,797$ 2,344,381 4.52 % Liabilities: Assets sold under agreements to repurchase $ 8,561$ 2,253$ 10,814$ 1,385,350 3.12 % Borrowings under forward purchase agreements 251 - 251 33,096 3.00 % Exchangeable senior notes 2,240 144 2,384 170,330 3.39 % 11,052 2,397 13,449 1,588,776 3.39 % Other interest - Servicing 695 - 695 - 11,747 2,397 14,144 1,588,776 3.52 % Net interest income $ 15,050$ (2,397 )$ 12,653 Net interest margin 2.16 % Net interest spread 1.00 %



(1) Amounts in this column represent accrual of unearned discounts and

amortization of facility commitment fees for liabilities. 75



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Table of Contents Six months ended June 30, 2014 Interest income/expense Annualized % Discount/ Average interest Coupon fees (1) Total balance yield/cost (dollars in thousands) Assets: Correspondent production: Mortgage loans acquired for sale at fair value $ 9,199 $ - $ 9,199$ 424,890 4.31 % Investment activities: Short-term investments 324 - 324 116,458 0.55 % Mortgage -backed securities: Agency 3,440 116 3,556 194,977 3.63 % Non-Agency prime jumbo 95 71 166 19,668 5.45 % 3,535 187 3,722 214,645 3.45 % Mortgage loans: at fair value 64,459 553 65,012 2,386,352 5.42 % under forward purchase agreements at fair value 3,584 - 3,584 150,816 4.73 % 68,043 553 68,596 2,537,168 5.42 % ESS 6,001 - 6,001 145,891 8.18 % Total investment activities 77,903 740 78,643 3,014,162 5.19 % Other interest 22 - 22 - $ 87,124$ 740$ 87,864$ 3,439,052 5.08 % Liabilities: Assets sold under agreements to repurchase $ 22,462$ 5,220$ 27,682$ 2,025,678 2.72 % Borrowings under forward purchase agreements 2,363 - 2,363 165,471 2.84 % Asset backed secured financing 2,974 204 3,178 166,190 3.80 % Exchangeable senior notes 6,718 453 7,171 250,000 5.71 % 34,517 5,877 40,394 2,607,339 3.08 % Other interest - Servicing 1,246 - 1,246 - 35,763 5,877 41,640 2,607,339 3.18 % Net interest income $ 51,361$ (5,137 )$ 46,224 Net interest margin 2.67 % Net interest spread 1.91 %



(1) Amounts in this column represent accrual of unearned discounts and

amortization of facility commitment fees for liabilities. 76



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Table of Contents Six months ended June 30, 2013 Interest income/expense Annualized % Discount/ Average interest Coupon fees (1) Total balance yield/cost (dollars in thousands) Assets: Correspondent production: Mortgage loans acquired for sale at fair value $ 15,615 $ - $ 15,615$ 937,707 3.33 % Investment activities: Short-term investments 88 - 88 73,224 0.24 % Mortgage loans: at fair value 27,549 - 27,549 1,160,858 4.75 % under forward purchase agreements at fair value 260 - 260 16,596 3.12 % 27,809 - 27,809 1,177,454 4.72 % Total investment activities 27,897 - 27,897 1,250,678 4.46 % Other Interest 160 - 160 - $ 43,672 $ - $ 43,672$ 2,188,385 3.97 % Liabilities: Assets sold under agreements to repurchase $ 16,862$ 4,664$ 21,526$ 1,304,010 3.30 % Borrowings under forward purchase agreements 251 - 251 16,640 3.00 % Exchangeable senior notes 2,240 144 2,384 85,635 5.54 % 19,353 4,808 24,161 1,406,285 3.42 % Other interest - Servicing 1,219 - 1,219 - 20,572 4,808 25,380 1,406,285 3.59 % Net interest income $ 23,100$ (4,808 )$ 18,292 Net interest margin 1.67 % Net interest spread 0.38 %



(1) Amounts in this column represent accrual of unearned discounts and

amortization of facility commitment fees for liabilities. 77



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The effects of changes in the composition of our investments on our interest income are summarized below:

Quarter ended June 30, 2014 Six months ended June 30, 2014 vs. vs. Quarter ended June 30, 2013 Six months ended June 30, 2013 Increase (decrease) Increase (decrease) due to changes in due to changes in Total Total Rate Volume change Rate Volume change (in thousands) Correspondent production: Mortgage loans acquired for sale at fair value $ 1,704$ (5,422 )$ (3,718 )$ 3,778$ (10,194 )$ (6,416 ) Investment activities: Money market investment 64 51 115 163 73 236 Mortgage -backed securities: Agency - 1,795 1,795 - 3,556 3,556 Non-Agency prime jumbo - 166 166 - 166 166 - 1,961 1,961 - 3,722 3,722 Mortgage loans: at fair value 334 18,845 19,179 4,606 32,857 37,463 under forward purchase agreements 356 814 1,170 200 3,124 3,324 Total mortgage loans 690 19,659 20,349 4,806 35,981 40,787 ESS - 3,139 3,139 - 6,001 6,001 Total investment activities 754 24,810 25,564 4,969 45,777 50,746 Other interest - (125 ) (125 ) - (138 ) (138 ) 2,458 19,263 21,721 8,747 35,445 44,192 Assets sold under agreements to repurchase: (843 ) 5,172 4,329 (1,161 ) 7,317 6,156 Borrowings under forward purchase agreement (16 ) 548 532 (14 ) 2,126 2,112 Asset backed secured financing - 1,561 1,561 - 3,178 3,178 Exchangeable senior notes 61 1,142 1,203 75 4,712 4,787 Interest bearing liabilities (798 ) 8,423 7,625



(1,100 ) 17,333 16,233

Other interest - servicing - 96 96 - 27 27 (798 ) 8,519 7,721 (1,100 ) 17,360 16,260 Net interest income $ 3,256$ 10,744$ 14,000$ 9,847$ 18,085$ 27,932 In the quarter and six months ended June 30, 2014, we earned net interest income of $26.7 million and $46.2 million, respectively, compared to $12.7 million and $18.3 million for the same periods in 2013. The increase in net interest income between the quarters was primarily due to an increase in average interest-earning assets for the quarter and six months ended June 30, 2014 as compared to the same periods in 2013 supplemented by a 53% and 65% increase in our yield-cost spread.



We earned interest income on our portfolio of Agency MBS totaling $2.0 million and $3.7 million for the quarter and six months ended June 30, 2014, respectively. We did not hold Agency MBS during the quarter ended June 30, 2013.

In the quarter and six months ended June 30, 2014, we recognized interest income on mortgage loans at fair value and mortgage loans under forward purchase agreements at fair value totaling $37.7 million and $68.6 million, respectively, including $18.1 million and $30.4 million, respectively, of interest capitalized pursuant to loan modifications, which compares to $17.3 million and $27.8 million, including $6.6 million and $11.8 million of interest capitalized pursuant to loan modifications, in the quarter and six months ended June 30, 2013. The increases in interest income are due primarily to growth in the average balance of our mortgage loan portfolio of $1.4 billion, or 111%, and $1.4 billion, or 115%, for the quarter and six months ended June 30, 2014 when compared to the same period in 2013. 78



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At June 30, 2014, approximately 72% of the fair value of our distressed mortgage loan portfolio was nonperforming, as compared to 67% at June 30, 2013. We do not accrue interest on nonperforming loans and generally do not recognize revenues during the period we hold REO. We calculate the yield on our mortgage loan portfolio based on the portfolio's average fair value, which most closely reflects our investment in the mortgage loans. Accordingly, the yield we realize on our distressed mortgage loans is substantially higher than would be recorded based on the loans' unpaid principal balances as we typically purchase our distressed mortgage loans at substantial discounts to their UPB. Nonperforming loans and REO generally take longer to generate cash flow than performing loans due to the time required to work with borrowers to resolve payment issues through our modification programs and to acquire and liquidate the property securing the mortgage loans. The value and returns we realize from these assets are determined by our ability to assist borrowers in curing defaults, or when curing of borrower defaults is not a viable solution, by our ability to effectively manage the liquidation process. As a participant in HAMP, we are required to comply with the process specified by the HAMP program before liquidating a loan, and this may extend the resolution process. At June 30, 2014, we held $1.5 billion in fair value of nonperforming loans and $240.5 million in carrying value of REO. During the quarter and six months ended June 30, 2014, we incurred interest expense totaling $21.9 million and $41.6 million, respectively, as compared to $14.1 million and $25.4 million, respectively, during the quarter and six months ended June 30, 2013. Our interest cost on interest bearing liabilities was 3.03% and 3.08% for the quarter and six months ended June 30, 2014 as compared to 3.39% and 3.42% during the quarter and six months ended June 30, 2013. The increase in interest expense reflects our increased use of borrowings in support of growth of our balance sheet, partially offset by the effect of lower borrowing costs relating to our mortgage loans at fair value during 2014 as compared to 2013.



Net Loan Servicing Fees

When we sell mortgage loans, we generally enter into a contract to service the mortgage loans and recognize the fair value of such contracts as MSRs. Under these contracts, we are required to perform loan servicing functions in exchange for fees and the right to other compensation. The servicing functions, which are performed on our behalf by PLS, typically include, among other responsibilities, collecting and remitting loan payments; responding to borrower inquiries; accounting for principal and interest, holding custodial (impound) funds for payment of property taxes and insurance premiums; counseling delinquent mortgagors; and supervising foreclosures and property dispositions.



Net loan servicing fees are summarized below:

Quarter ended June 30, Six months ended June 30, 2014 2013 2014 2013 (in thousands) Servicing fees (1) $ 19,156$ 12,307$ 36,688$ 22,724 MSR recapture fee receivable from PFSI 1 367 9 498 Effect of MSRs: Carried at lower of amortized cost or fair value Amortization (7,697 ) (6,264 ) (15,061 ) (11,232 ) (Provision for) reversal of impairment (2,224 ) 1,222 (2,851 ) 3,708 Carried at fair value - change in fair value (4,764 ) 260 (6,792 ) 193 Gains (losses) on hedging derivatives 4,286 - 4,186 (1,988 ) (10,399 ) (4,782 ) (20,518 ) (9,319 ) Net loan servicing fees $ 8,758$ 7,892$ 16,179$ 13,903



(1) Includes contractually specified servicing and ancillary fees.

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Net loan servicing fees increased $900,000 and $2.3 million during the quarter and six months ended June 30, 2014 compared to the same periods in 2013. The increase was primarily due to a $6.8 million and $14.0 million increase, respectively, in servicing fees, offset by a $5.6 million and $11.2 million increase, respectively, in the effect of MSRs on net loan servicing fees. The increase in servicing fees is attributable to continued growth in our mortgage loan servicing portfolio. Offsetting the increase in servicing fees was MSR activity which included increased amortization arising from growth in the MSR asset along with the recognition of fair value decreases and impairment as compared to net increases in fair value in the prior period. Effective February 1, 2013, we entered into an MSR recapture agreement that requires PLS to transfer to us the increases MSRs with respect to new mortgage loans originated in refinancing transactions where PLS refinances a mortgage loan for which we previously held the MSRs. PLS is generally required to transfer MSRs relating to such mortgage loans (or, under certain circumstances, other mortgage loans) that have an aggregate unpaid principal balance that is not less than 30% of the aggregate unpaid principal balance of all the loans so originated. Where the fair value of the aggregate MSRs to be transferred for the applicable month is less than $200,000, PLS may, at its option, settle in cash with PMT in an amount equal to such fair market value in lieu of transferring such MSRs. We recognized approximately $9,000 of such income during the six months ended June 30, 2014. As our investment in MSRs grows, we expect that the effect of amortization, impairment and changes in fair value will have an increasing influence on our net income. MSRs have a significant effect on net loan servicing fees, driven primarily by our monthly re-measurement of the fair value of MSRs. The fair value of MSRs is difficult to determine because MSRs are not actively traded in observable standalone markets and are sensitive to changes in interest rate levels and marketplace expectations of future interest rates. Considerable judgment is required to estimate the fair values of these assets and the exercise of such judgment can significantly affect our income. Our MSR valuation process combines the use of a discounted cash flow model and analysis of current market data to arrive at an estimate of fair value at each balance sheet date. The cash flow and prepayment assumptions used in our Manager's discounted cash flow model are based on market factors and include the historical performance of its managed MSRs, which our Manager believes are consistent with assumptions and data used by market participants valuing similar MSRs. The key inputs used in the valuation of MSRs include mortgage prepayment speeds and discount rates. These variables can, and generally do, change from period to period as market conditions change. Therefore, the fair value of MSRs changes from period to period. PCM's valuation committee reviews and approves the fair value estimates of our MSRs. We account for MSRs either at the asset's fair value with changes in fair value recorded in current period earnings or by using the amortization method with the MSRs carried at the lower of amortized cost or fair value based on whether we view the underlying mortgages as being sensitive to prepayments resulting from changing market interest rates. We have identified an initial mortgage interest rate of 4.5% as the threshold for whether such mortgage loans are sensitive to changes in interest rates:

Our risk management efforts in connection with MSRs relating to mortgage loans with initial interest rates of more than 4.5% are aimed at moderating the effects of changes in interest rates on the assets' fair values. For MSRs relating to mortgage loans with initial interest

rates of less than or equal to 4.5%, we have concluded that such assets present different risks than MSRs relating to mortgage loans with initial interest rates of more than 4.5% and therefore require a different risk management approach. Our risk management efforts relating to these assets are aimed at moderating the effects of non-interest rate risks on fair value, such as the effect of changes in home prices on the assets' fair values. We have



identified these

assets to be accounted for using the amortization method. 80



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Our MSRs are summarized by the basis on which we account for the assets below: June 30, December 31, 2014 2013 (in thousands) MSRs carried at fair value $ 46,802$ 26,452 MSR carried at lower of amortized cost or fair value: Amortized cost $ 274,110$ 266,697 Valuation allowance (5,428 ) (2,577 ) Carrying value $ 268,682$ 264,120 Fair value $ 289,226$ 289,737 Total MSR: Carrying value $ 315,484$ 290,572 Fair value $ 336,028$ 316,189 Unpaid principal balance of mortgage loans underlying MSRs $ 29,268,039



$ 25,792,933

Average servicing fee rate (in basis points) MSRs carried at lower of amortized cost or fair value 26 26 MSRs carried at fair value 25 26 Average note interest rate MSRs carried at lower of amortized cost or fair value 3.72 % 3.68 % MSRs carried at fair value 4.79 % 4.78 % 81



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Key assumptions used in determining the fair value of MSRs and estimates of the sensitivity of MSR values to changes in these assumptions are as follows:

June 30, 2014 December 31, 2013 Range (Weighted average) Amortized cost Fair value Amortized cost Fair value (Carrying value, unpaid principal balance and effect on value amounts in thousands) Carrying value $ 268,682 $ 46,802 $ 264,120 $ 26,452 Key inputs: Unpaid principal balance of underlying mortgage loans $ 24,639,750 $ 4,758,331 $ 23,399,612 $ 2,393,321 Weighted-average annual servicing fee rate (in basis points) 26 25 26 26 Weighted-average note interest rate 3.72% 4.79% 3.68% 4.78% Pricing spread (1) (2) 6.3% - 17.5% 7.6% - 15.3% 6.3% - 17.5% 7.3% - 15.3% (7.4%) (9.2%) (6.7%) (8.6%) Effect on fair value of a: 5% adverse change $ (5,302 ) $ (827 ) $ (5,490 ) $ (488 ) 10% adverse change $ (10,427 ) $ (1,627 ) $ (10,791 ) $ (959 ) 20% adverse change $ (20,177 ) $ (3,149 ) $ (20,861 ) $ (1,855 ) Weighted average life (in years) 1.1 - 7.2 2.4 - 7.2 1.3 - 7.3 2.8 - 7.3 (6.4) (7.0) (6.7) (7.2) Prepayment speed (1) (3) 7.7% - 58.9% 8.0% - 30.6% 7.7% - 51.9% 8.0% - 20.0% (8.6%) (10.2%) (8.2%) (8.9%) Effect on fair value of a: 5% adverse change $ (5,495 ) $ (1,160 ) $ (5,467 ) $ (568 ) 10% adverse change $ (10,821 ) $ (2,277 ) $ (10,765 ) $ (1,117 ) 20% adverse change $ (20,993 ) $ (4,390 ) $ (20,886 ) $ (2,160 ) Annual per-loan cost of servicing $68 - $140$68 - $140$68 - $140$68 - $140 ($68) ($68) ($68) ($68) Effect on fair value of a: 5% adverse change $ (1,761 ) $ (290 ) $ (1,695 ) $ (158 ) 10% adverse change $ (3,522 ) $ (580 ) $ (3,390 ) $ (316 ) 20% adverse change $ (7,043 ) $ (1,159 ) $ (6,780 ) $ (633 )



(1) The effect on value of an adverse change in one of the above-mentioned key

inputs may result in recognition of MSR impairment. The extent of impairment

recognized will depend on the relationship of fair value to the carrying

value of MSRs.

(2) Pricing spread represents a margin that is added to a reference interest

rate's forward rate curve to develop periodic discount rates. The Company

applies a pricing spread to the United States Dollar LIBOR curve for purposes

of discounting cash flows relating to MSRs acquired as proceeds from the sale

of mortgage loans and purchased MSRs not backed by pools of distressed

mortgage loans.

(3) Prepayment speed is measured using Life Total CPR.

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Significant changes to any of the key assumptions shown above in isolation could result in a significant change in the MSR fair value measurement. Changes in these key assumptions are not necessarily directly related. The preceding sensitivity analyses are limited in that they were performed as of a particular point in time; only contemplate the movements in the indicated variables; do not incorporate changes in the variables in relation to other variables; are subject to the accuracy of various models and inputs used; and do not take into account other factors that would affect our overall financial performance in such scenarios, including operational adjustments made by our Manager to account for changing circumstances. For these reasons, the preceding estimates should not be viewed as earnings forecasts.



Results of Real Estate Acquired in Settlement of Loans

Results of REO includes the gains or losses we record upon sale of the properties as well as valuation adjustments we record during the period we hold those properties. During the quarter and six months ended June 30, 2014, we recorded net losses of $5.3 million and $12.0 million, respectively, in Results of real estate acquired in settlement of loans as compared to net losses of $1.9 million and $5.2 million, respectively, for the quarter and six months ended June 30, 2013.



Results of REO are summarized below:

Quarter ended June 30, Six months ended June 30, 2014 2013 2014 2013 (dollars in thousands) During the period: Proceeds from sales of REO $ 48,874$ 30,993$ 82,268$ 63,017 Results of real estate acquired in settlement of loans: Valuation adjustments, net (9,159 ) (4,978 ) (18,052 ) (11,067 ) Gain on sale, net 3,811 3,049 6,078 5,885 $ (5,348 )$ (1,929 )$ (11,974 )$ (5,182 ) Number of properties sold 489 288 813 546 Average carrying value of REO $ 214,652$ 86,761



$ 190,582$ 86,613

Period end: Carrying value $ 240,471$ 88,771 Number of properties in inventory 1,619 640 The increase in losses from REOs during the quarter and six months ended June 30, 2014 compared to the same periods in 2013 was due to slower property value appreciation during the quarter ended June 30, 2014 as compared to the quarter ended June 30, 2013, along with growth in the inventory of properties held between the periods. Since REO is carried at the lower of cost or fair value, we recognize valuation losses on properties where decreases in fair value are indicated but are generally unable to record fair value increases until the date of sale of properties. 83



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Expenses

Our expenses are summarized below:

Quarter ended June 30, Six months ended June 30, 2014 2013 2014 2013 (in thousands) Expenses payable to PFSI: Loan fulfillment fees $ 12,433$ 22,054$ 21,335$ 50,298 Loan servicing fees 14,180 8,787 28,771 16,513 Management fees 8,912 8,455 16,986 14,947 Professional services 2,690 1,339 4,421 3,723 Compensation 1,883 1,438 4,825 3,527 Other 7,154 5,571 11,221 10,517 $ 47,252$ 47,644$ 87,559$ 99,525 Expenses decreased $392,000, or 1%, and $12.0 million, or 12%, during the quarter and six months ended June 30, 2014, respectively, compared to the same periods in 2013. This decrease was primarily a result of lower fulfillment fees, reflecting decreased correspondent production activities, partially offset by increased servicing fees reflecting growth in both our investments in mortgage loans at fair value and our MSR portfolio.



Loan Fulfillment Fees

Loan fulfillment fees represent fees we pay to PFSI for the services it performs on our behalf in connection with our acquisition, packaging and sale of mortgage loans. The fee is calculated as a percentage of the UPB of the mortgage loans purchased. Loan fulfillment fees and related fulfillment volume are summarized below: Quarter ended June 30, Six months ended June 30, 2014 2013 2014 2013 (in thousands) Fulfillment fee expense $ 12,433$ 22,054$ 21,335$ 50,298 UPB of loans fulfilled by PFSI $ 2,991,764$ 4,323,885



$ 4,911,342$ 9,110,711

The decrease in loan fulfillment fees of $9.6 million and $29.0 million during the quarter and six months ended June 30, 2014, respectively, compared to the same periods in 2013 is primarily due to the decrease in the volume of Agency-eligible and jumbo mortgage loans we purchased in our correspondent production activities.



Loan Servicing Fees

Loan servicing fees increased by $5.4 million, or 61%, and $12.3 million, or 74%, during the quarter and six months ended June 30, 2014, respectively, compared to the same periods in 2013. Loan servicing fees increase as our investment in mortgage loans and MSRs increases. During the quarter ended June 30, 2014, our average investment in mortgage loans increased by 111%, compared to the quarter ended June 30, 2013. Our servicing portfolio increased to $29.3 billion at June 30, 2014 from $19.9 billion at June 30, 2013. Included in loan servicing fees are activity-based fees, which increased by $3.2 million during the quarter ended June 30, 2014, generally relating to the increase in loan resolution activities during the quarter and six months ended June 30, 2014. We amended our servicing agreement with PFSI effective January 1, 2014, to limit the supplemental fees we pay PFSI to no more than $700,000 per quarter. During the quarter and six months ended June 30, 2014, we paid PFSI $700,000 and $1.4 million, respectively, in supplemental servicing fees relating to our MSR servicing portfolio. Supplemental servicing fees are a component of the total base servicing fee and compensate PFSI for providing certain services that servicers generally do not provide but are required by us because we have no employees or infrastructure. 84



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Loan servicing fees payable to PFSI and subsidiaries are summarized below:

Quarter ended June 30, Six months ended June 30, 2014 2013 2014 2013 (in thousands) Mortgage loans acquired for sale at fair value: Base $ 29 $ 90 $ 46 $ 169 Activity-based 51 111 77 183 80 201 123 352 Distressed mortgage loans: Base 4,975 3,699 9,941 7,572 Activity-based 5,746 2,447 12,132 4,324 10,721 6,146 22,073 11,896 MSRs: Base 3,323 2,363 6,471 4,126 Activity-based 56 77 104 139 3,379 2,440 6,575 4,265 $ 14,180$ 8,787$ 28,771$ 16,513



The components of our management fee payable to PFSI are summarized below:

Quarter ended June 30, Six months ended June 30, 2014 2013 2014 2013 (in thousands) Management fee: Base $ 5,838$ 4,575$ 11,359$ 8,940 Performance incentive 3,074 3,880 5,627 6,007 $ 8,912$ 8,455$ 16,986$ 14,947 Management Fees Management fees increased by $457,000 and $2.0 million during the quarter and six months ended June 30, 2014, respectively, due to the effect of growth in shareholders' equity on the base management fee we pay to PFSI and recognition of performance incentive fees in 2014, which only were incurred beginning February 1, 2013. The increase in performance incentive fees resulted in part from a change in our management agreement with PFSI. Effective February 1, 2013, the management agreement was amended to adjust the basis on which both the base management fee and performance incentive fee are determined. Specifically, we amended: The base management fee rate from 1.5% per year of shareholders' equity to a base management fee schedule based on tiered



management

fee rates beginning with a rate of 1.5% per year of



shareholders'

equity for the first $2.0 billion of shareholders' equity



and

reduced rates as the balance of shareholders' equity



increases. Our

shareholders' equity did not reach a level that would have resulted in a reduced base management fee rate. The definition of "net income" for purposes of



determining the

performance incentive fee to net income as determined in compliance with U.S. GAAP. Previously, "net income" for purposes of determining the performance incentive fee began with net income as determined in compliance with U.S. GAAP and was adjusted for non-cash gains and losses included in our income. 85



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We expect our management fees to fluctuate in the future based on: (1) changes in our shareholders' equity with respect to our base management fee; and (2) the level of our profitability in excess of the return thresholds specified in our management agreement with respect to the performance incentive fee.



Professional Services

Professional services expense increased during the quarter and six months ended June 30, 2014 as compared to the quarter and six months ended June 30, 2013 by $1.4 million and $698,000, respectively, due to increased legal fees including those relating to the sales of reperforming loans during the quarter and six months ended June 30, 2014, partially offset by reduced due diligence expenses reflecting reduced distressed mortgage loan acquisition activity.



Other Expenses

Other expenses are summarized below:

Quarter ended June 30, Six months ended June 30, 2014 2013 2014 2013 (in



thousands)

Common overhead allocation from PFSI $ 2,638$ 2,974$ 5,216$ 5,266 Servicing and collection costs

3,114 (30 ) 3,745 333 Loan origination 397 1,468 435 2,446 Insurance 252 218 491 429 Technology 227 235 474 354 Other expenses 526 706 860 1,689 $ 7,154$ 5,571$ 11,221$ 10,517 Other expenses increased during the quarter and six months ended June 30, 2014 as compared to the quarter and six months ended June 30, 2013 by $1.6 million and $704,000, respectively, primarily due to higher servicing and collection costs associated with the administration and sale of seasoned distressed loans, partially offset by decreased expenses associated with certain of our correspondent production activities.



Income Taxes

We have elected to treat PMC as a TRS. Income from a TRS is only included as a component of REIT taxable income to the extent that the TRS makes dividend distributions of income to the REIT. No such dividend distributions have been made to date.



A TRS is subject to corporate federal and state income tax. Accordingly, a provision for income taxes for PMC is included in the accompanying Consolidated Statements of Income.

The provision for income taxes decreased by $15.3 million and $19.5 million for the quarter and six months ended June 30, 2014 compared to the same periods in 2013. The Company had a tax benefit of $1.9 million and $3.5 million for the quarter and six months ended June 30, 2014 and a tax expense of $13.4 million and $16.1 million for the quarter and six months ended June 30, 2013. The Company's effective tax rate was (2.6)% and (3.2)% for the quarter and six months ended June 30, 2014 compared to 19.8% and 13.0% for the same periods in 2013. The decrease in the Company's effective tax rate for the quarter and six months ended June 30, 2014 compared to the prior periods in 2013 is due primarily to a loss in the company's taxable REIT subsidiary for the quarter and six months ended June 30, 2014 compared to income in that entity for the same periods in 2013. The primary difference between the Company's effective tax rate and the statutory tax rate is non-taxable REIT income resulting from the deduction for dividends paid.



In general, cash dividends declared by us will be considered ordinary income to shareholders for income tax purposes. Some portion of the dividends may be characterized as capital gain distributions or a return of capital.

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