News Column

ELLINGTON FINANCIAL LLC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 8, 2014

In this Quarterly Report on Form 10-Q, except where the context suggests otherwise, "EFC," "we," "us," and "our" refer to Ellington Financial LLC and its subsidiaries, our "Manager" refers to Ellington Financial Management LLC, our external manager, and "Ellington" refers to Ellington Management Group, L.L.C. and its affiliated investment advisory firms. SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS When used in this Quarterly Report on Form 10-Q, in future filings with the Securities and Exchange Commission ("SEC") or in press releases or other written or oral communications issued or made by us, statements which are not historical in nature, including those containing words such as "believe," "expect," "anticipate," "estimate," "project," "plan," "continue," "intend," "should," "would," "could," "goal," "objective," "will," "may," "seek," or similar expressions, are intended to identify "forward-looking statements" within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and, as such, may involve known and unknown risks, uncertainties, and assumptions. Forward-looking statements 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 or implied in our forward-looking statements. The following factors are examples of those that could cause actual results to vary from our forward-looking statements: changes in interest rates and the market value of our securities; market volatility; changes in the prepayment rates on the mortgage loans underlying our agency securities; increased rates of default and/or decreased recovery rates on our assets; the availability and costs of financing to fund our assets; changes in government regulations affecting our business; our ability to maintain our exemption from registration under the Investment Company Act of 1940, as amended (the "Investment Company Act"); and risks associated with investing in real estate assets, including changes in business conditions and the general economy. These and other risks, uncertainties and factors, including the risk factors described under Item 1A of our Annual Report on Form 10-K for the fiscal year ended December 31, 2013 as filed with the SEC, could cause our actual results to differ materially from those projected or implied in any forward-looking statements we make. All forward-looking statements speak only as of the date on which they are made. New risks and uncertainties arise over time and it is not possible to predict those events or how they may affect us. Except as required by law, we are not obligated to, and do not intend to, update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise. Executive Summary We are a specialty finance company that acquires and manages mortgage-related assets, including residential mortgage-backed securities, or "RMBS," backed by prime jumbo, Alt-A, manufactured housing, and subprime residential mortgage loans, RMBS for which the principal and interest payments are guaranteed by a U.S. government agency or a U.S. government-sponsored enterprise, residential mortgage loans, mortgage-related derivatives, commercial mortgage-backed securities, or "CMBS," commercial mortgage loans and other commercial real estate debt, as well as corporate debt and equity securities, and derivatives. We also may opportunistically acquire and manage other types of financial asset classes, such as securities backed by consumer and commercial assets, or "ABS," non-mortgage-related derivatives, and real property. We are externally managed and advised by our Manager, an affiliate of Ellington. Ellington is a registered investment adviser with a 19-year history of investing in a broad spectrum of mortgage-backed securities, or "MBS," and related derivatives. We conduct all of our operations and business activities through Ellington Financial Operating Partnership LLC, our consolidated operating partnership subsidiary (the "Operating Partnership"). As of June 30, 2014, we have an ownership interest of approximately 99.2% in the Operating Partnership. The interest of approximately 0.8% not owned by us represents the interest in the Operating Partnership that is owned by an affiliate of our Manager and certain related parties, and is reflected in our financial statements as a non-controlling interest. Our primary objective is to generate attractive, risk-adjusted total returns for our shareholders. We seek to attain this objective by utilizing an opportunistic strategy to make investments, without restriction as to ratings, structure, or position in the capital structure, that we believe compensate us appropriately for the risks associated with them rather than targeting a specific yield. Our evaluation of the potential risk-adjusted return of any potential investment typically involves weighing the potential returns of such investment under a variety of economic scenarios against the perceived likelihood of the various scenarios. Potential investments subject to greater risk (such as those with lower credit ratings and/or those with a lower position in the capital structure) will generally require a higher potential return to be attractive in comparison to investment alternatives with lower potential return and a lower degree of risk. However, at any particular point in time, depending on how we perceive the market's pricing of risk both generally and across sectors, we may favor higher-risk assets or we may favor lower-risk assets, or a combination of the two in the interests of portfolio diversification or other considerations. 56



--------------------------------------------------------------------------------

Table of Contents

Through June 30, 2014, our non-Agency RMBS strategy has been the primary driver of our risk and return, and we expect that this will continue in the near term. However, while we believe opportunities in U.S. MBS remain, we believe other asset classes offer attractive returns as well as asset diversification. These asset classes include residential and commercial mortgage loans, which can be performing, non-performing or sub-performing; collateral loan obligations, or "CLOs"; European non-dollar denominated investments; and other structured investments comprised of or backed by real estate or consumer receivables. These asset classes along with our non-Agency MBS and real estate owned are collectively referred to as our non-Agency portfolio. We believe that Ellington's proprietary research and analytics allows our Manager to identify attractive assets in these classes, value these assets, monitor and forecast the performance of these assets, and opportunistically hedge our risk with respect to these assets. We continue to maintain a highly leveraged portfolio of Agency RMBS to take advantage of opportunities in that market sector and to maintain our exclusion from regulation as an investment company under the Investment Company Act. Unless we acquire very substantial amounts of whole mortgage loans or there are changes to the rules and regulations applicable to us under the Investment Company Act, we expect that we will always maintain some core amount of Agency RMBS. We also use leverage in our non-Agency strategy, albeit significantly less leverage than that used in our Agency RMBS strategy. Through June 30, 2014, we financed our asset purchases almost exclusively through reverse repurchase agreements, or "reverse repos," which we account for as collateralized borrowings. In January 2012, we completed a small resecuritization transaction using one of our non-Agency RMBS assets; this transaction is accounted for as a collateralized borrowing and is classified on our Consolidated Statement of Assets, Liabilities, and Equity as "Securitized debt." This securitized debt represents long-term financing for the related asset, in contrast to our reverse repos collateralized by non-Agency assets, which typically have 30 to 180 day terms. However, we expect to continue to obtain the vast majority of our financing through the use of reverse repos. The strategies that we employ are intended to capitalize on opportunities in the current market environment. We intend to adjust our strategies to changing market conditions by shifting our asset allocations across various asset classes as credit and liquidity trends evolve over time. We believe that this flexibility, combined with Ellington's experience, will help us generate more consistent returns on our capital throughout changing market cycles. In the latter part of the second quarter of 2013, we increased our level of cash holdings, both as a buffer against increased market volatility and so as to be able to take advantage of potential investment opportunities. While as of June 30, 2014, we continue to maintain a higher level of cash, we reduced the amount held relative to March 31, 2014 and prior periods. As of June 30, 2014, outstanding borrowings under reverse repos and securitized debt were $1.2 billion and our debt-to-equity ratio was 1.89 to 1. Our debt-to-equity ratio does not account for liabilities other than debt financings. Of our total borrowings outstanding as of June 30, 2014, approximately 74.9%, or $891.0 million, relates to our Agency RMBS holdings. The remaining outstanding borrowings relate to our non-Agency MBS and other ABS. We opportunistically hedge our credit risk, interest rate risk, and foreign currency risk; however, at any point in time we may choose not to hedge all or a portion of these risks, and we will generally not hedge those risks that we believe are appropriate for us to take at such time, or that we believe would be impractical or prohibitively expensive to hedge. We believe that we have been organized and have operated so that we have qualified, and will continue to qualify, to be treated for U.S. federal income tax purposes as a partnership and not as an association or a publicly traded partnership taxable as a corporation. As of June 30, 2014, our diluted book value per share was $24.14 as compared to $24.10 as of March 31, 2014 and $23.99 as of December 31, 2013. Trends and Recent Market Developments Key trends and recent market developments for the U.S. mortgage market include the following: Federal Reserve and Monetary Policy-Since December 2013, the U.S. Federal



Reserve, or "Federal Reserve," has announced six incremental reductions of

its purchases of Agency RMBS and U.S. Treasury securities under its accommodative monetary policies. Thus far, taper announcements by the Federal Reserve have each been in increments of $10 billion, with the monthly asset purchasing pace now standing at $25 billion per month, down from a pace of $85 billion per month in late 2013;



Housing and Mortgage Market Statistics-Data released by S&P Indices for its

S&P/Case-Shiller Home Price Indices for May 2014 showed, consistent with

recent months, that the pace of home price appreciation slowed; meanwhile

the Freddie Mac survey 30-year mortgage rate ended the second quarter at 4.14%, down from 4.40% at March 31, 2014; 57



--------------------------------------------------------------------------------

Table of Contents

Government Sponsored Enterprise, or "GSE," Developments-While several

proposals have been put forth, no definitive legislation has yet been

enacted to replace or eliminate the GSEs or materially revise their current

roles in the U.S. mortgage market. In May 2014, Federal Housing Finance

Agency, or "FHFA," Director Mel Watt presented the 2014 Strategic Plan for

the Conservatorship of Fannie Mae and Freddie Mac, and the 2014

Conservatorship Scorecard for Fannie Mae and Freddie Mac, providing new

strategic goals reflective of his tendency to favor policies that promote

affordability and the expansion of credit availability;

Bank Regulatory Capital-Proposed changes will increase regulatory capital

requirements for the largest, most systemically significant U.S. banks and

their holding companies. While these changes could ultimately alter these

institutions' appetite for various risk-taking activities, and could

ultimately affect the terms and availability of our repo financing, thus

far repo financing has remained readily available and in fact, competition

among banks and other lending institutions to provide repo financing has actually increased;



Portfolio Overview and Outlook-Both non-Agency and Agency assets rallied

during the second quarter, as interest rates declined and volatility

remained relatively muted. In addition, non-Agency RMBS continued to be

supported by overall positive trends in home prices as well as a declining

level of foreclosure inventory. Agency RMBS were supported by low prepayment activity (in spite of lower mortgage rates) and relatively low production of Agency mortgages. Federal Reserve and Monetary Policy Since December 2013, the Federal Reserve has announced six incremental reductions in its purchases of Agency RMBS and U.S. Treasury securities under its accommodative monetary policies. Prior to these "taper" announcements, and since September 2012, the Federal Reserve had been purchasing long-dated U.S. Treasury securities and Agency RMBS assets at the pace of $85 billion per month, comprised of $45 billion of U.S. Treasury securities and $40 billion of Agency RMBS. Based on the announcements, the combined monthly reduction in asset purchases currently amounts to $60 billion, split evenly between Agency RMBS and U.S. Treasury securities, leaving current monthly purchases of Agency RMBS at $10 billion and U.S. Treasury securities at $15 billion. The Federal Reserve has stated that it will further reduce its monthly purchases if conditions continue to broadly improve as anticipated, although it expects to continue to reinvest principal payments from its holdings into additional asset purchases. Notwithstanding its view that the broader economy has strengthened considerably, the Federal Reserve continues to express concern that inflation persistently below its 2% objective could pose risks to economic performance. In its July 2014 statement, in addition to announcing its intention to further reduce its monthly asset purchases, the Federal Open Market Committee, or "FOMC," reiterated its intention to maintain the target range for the federal funds rate at 0% to 0.25%. The FOMC also indicated that it continues to anticipate, based on its assessment of labor market conditions, inflationary pressures and expectations, and other factors that it will likely maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends. Since the Federal Reserve's initial taper announcement in December 2013, long-term interest rates have declined. As of June 30, 2014, the 10-year U.S. Treasury yield was 2.53% as compared to 2.72% as of March 31, 2014 and 3.03% as of December 31, 2013. Prices of Agency RMBS have also rallied. For example, the price of TBA 30-year Fannie Mae 3.5s, a widely traded Agency RMBS, rose to 102.78 as of June 30, 2014, up from 100.66 at March 31, 2014 and 99.34 as of December 31, 2013. Notwithstanding the recent decline in interest rates, we believe that there remains substantial risk that interest rates could begin to rise again. Market speculation has shifted from the tapering of asset purchases by the Federal Reserve to the timing of a tightening of monetary policy through interest rate increases by the Federal Reserve. This reinforces the importance of our ability to hedge interest rate risk in both our Agency RMBS and non-Agency MBS portfolios using a variety of tools, including TBAs, interest rate swaps, and various other instruments. Housing and Mortgage Market Statistics The following table demonstrates the decline in residential mortgage delinquencies and foreclosure inventory on a national level, as reported by CoreLogic in its June 2014 National Foreclosure Report: As of Number of Units(1) June 2014 June 2013



Seriously Delinquent Mortgages 1,679 2,224 Foreclosure Inventory

648 998



(1) Shown in thousands of units.

58



--------------------------------------------------------------------------------

Table of Contents

Note: Seriously Delinquent Mortgages are ninety days and over in delinquency and include foreclosures and Real Estate Owned, or "REO," property. As the above table indicates, both the number of seriously delinquent mortgages and the number of homes in foreclosure have declined significantly over the past year. This decline supports the thesis that as many homeowners have re-established equity in their homes through recovering real estate prices, they have become less likely to become delinquent and default on their mortgages. Monthly housing starts provide another indicator of market fundamentals. The following table shows the trailing three-month average housing starts for the periods referenced: June 2014 May 2014 June 2013 Single-family(1) 619 639 596 Multi-family(1) 351 350 256 (1) Shown in thousands of units. Source: U.S. Census Bureau As of June 2014, average single-family housing starts during the trailing three months fell 3.1% as compared to May 2014, to 619,000 units. Multi-family housing starts were essentially unchanged during the same period. On a year-over-year basis, while multi-family housing starts during the trailing three months increased over 37% from June 2013, single-family housing starts essentially remained flat, as continuing tight residential mortgage loan underwriting standards have likely impacted demand for new single-family homes. Even though home prices have recovered meaningfully over the last few years, this recovery has not translated into growth in single-family housing starts. This suggests that the recovery in home prices may have been driven more by the active purchase of foreclosure inventory by institutional investors, as opposed to by an increase in demand for traditional owner-occupied single-family housing. Data released by S&P Indices for its S&P/Case-Shiller Home Price Indices for May 2014 showed that, on average, home prices had increased from May 2013 by 9.4% and 9.3% for its 10- and 20-City Composites, respectively, rising at their slowest pace since February 2013. Recently, the home price indices have flattened out, suggesting that the pace of home price appreciation in 2013 will likely not be repeated in 2014. Compared to December 2013, the 10- and 20-City Composites increased 2.9% and 3.0%, respectively. According to the report, home prices remain below the peak levels of 2006, but, on average, are back to their summer 2004 levels for both the 10- and 20-City Composites. Finally, as indicated in the table above, as of June 2014, the national inventory of foreclosed homes fell to 648,000 units, a 25% decline when compared to June 2013; this represented the thirty-second consecutive month with a year-over-year decline and the lowest level since November 2008. As a result, there are much fewer unsold foreclosed homes overhanging the housing market than there were a year ago. We believe that near-term home price trends are more likely to be driven by fundamental factors such as economic growth, mortgage rates, and affordability, rather than by technical factors such as shadow inventory. Shadow inventory represents the number of properties that are seriously delinquent, in foreclosure, or held as REO by mortgage servicers, but not currently listed on multiple listing services. The Freddie Mac survey 30-year fixed mortgage rate ended the second quarter at 4.14%, a 26 basis point decline from the end of the first quarter. The Refinance Index published by the Mortgage Bankers Association, or "MBA," fell approximately 4.8% over the second quarter on a seasonally adjusted basis, and similarly the MBA's Market Composite Index, a measure of mortgage application volume, fell 2.6% over the second quarter on a seasonally adjusted basis. The decreases in the indices in the second quarter reversed much of the gains during the first quarter and continued the 2013 trend whereby both indices declined. 59



--------------------------------------------------------------------------------

Table of Contents

The table below illustrates the relationship between the Freddie Mac survey 30-year fixed mortgage rate and the MBA Refinance Index since September 2012. Generally speaking, over the period from September 2012 through September 2013, mortgage rates and the level of refinancing activity were nearly linearly correlated. However, following September 2013 and through June 2014, there has been a decoupling of these two time series. As the figure below shows, by June 2014 the MBA Refinance Index was meaningfully lower than one might have expected given the nearly linear relationship that had existed between the two indices from September 2012 to September 2013. One possible explanation for this divergence is that because mortgage rates were so low for so long before finally increasing in mid-2013, many borrowers may now believe that they have missed the opportunity to refinance. It is a central question in the Agency RMBS market whether these subdued refinancing speeds will continue to persist, and if so, for how long. [[Image Removed]] On August 1, 2014, the U.S. Bureau of Labor Statistics, or "BLS," reported that, as of July 2014 the U.S. unemployment rate increased slightly to 6.2%. Another, perhaps more relevant, measure of labor market conditions is employment growth, which has been relatively robust in recent months. The BLS also reported that non-farm payrolls rose by 209,000 during July, a level that is considered reflective of improving labor market conditions. While it is difficult to quantify the relationship between employment data and the housing and mortgage markets, we believe that current levels of unemployment and job creation no longer represent a significant impediment to a continuing housing recovery. However, the continued recovery of the housing market, while supported by still-historically-low mortgage rates and the momentum of improving home prices, faces a number of potential headwinds. These include volatility in interest rates, the sluggish rate of growth in housing starts and new loan origination, and the uneven pace of the recovery of the U.S. economy. GSE Developments On May 13, 2014, Mel Watt, director of FHFA, presented the FHFA's 2014 Strategic Plan for the Conservatorships of Fannie Mae and Freddie Mac, or "Strategic Plan," and the 2014 Conservatorship Scorecard for Fannie Mae and Freddie Mac. The Strategic Plan outlines the FHFA's plan to clarify and refine representation and warranty guidelines. Examples offered by Watt include the GSE's relaxation of payment history requirements and elimination of automatic repurchases when mortgage insurance is rescinded. Reflective of his tendency to favor policies that promote affordability through expanded credit, Watt announced that the FHFA will maintain conforming loan limits for GSEs rather than implementing the reductions that were proposed in late 2013 by former FHFA director Ed DeMarco. Credit risk transfers to private investors, which increase capital flows while reducing tax payer risk, are to grow to $90 billion per agency, triple the amount required in 2013. The FHFA continues to re-evaluate the implementation of DeMarco's proposed initiative to raise guarantee fees, or "g-fees," on new Fannie Mae and Freddie Mac business. G-fees are the fees charged by the GSEs to include mortgage loans in Agency pools, 60



--------------------------------------------------------------------------------

Table of Contents

and thereby insure the mortgage loan against loss. Since these fees are passed on to borrowers whose loans are originated for inclusion in Agency pools, increased g-fees have the effect of reducing housing affordability for GSE borrowers, but potentially make it more attractive for private lenders to replace the GSEs. Decreased expectations of g-fee increases are suggestive of potentially faster prepayment speeds. Under Watt, the FHFA has reinvigorated the Home Affordable Finance Program, or "HARP," outreach effort by hosting town hall-style meetings in areas with high concentrations of borrowers eligible for the program, which targets high loan-to-value loans owned or guaranteed by GSEs. We believe this may result in only marginally higher refinancings for higher coupon loans to pre-HARP borrowers. To date, no definitive legislation has been enacted with respect to a possible unwinding of the GSEs or a material reduction in their roles in the U.S. mortgage market. There have been several proposals offered by members of Congress, including the Corker-Warner bill introduced in June 2013, the Johnson-Crapo bill introduced in March 2014, and the Partnership to Strengthen Homeownership Act, which was introduced in July 2014. Though it appears unlikely that one of these bills will be passed in its current form, features may be incorporated into future proposals. The Johnson-Crapo bill would create a new regulator, the Federal Mortgage Insurance Corp., or "FMIC." The FMIC's backing for MBS would come in the form of a Mortgage Insurance Fund, which would be designed to protect investors' losses beyond a 10% first-loss position held by private investors. The FMIC would supervise private-sector participants in the mortgage sector and provide additional means of support to the mortgage market during economic downturns. The FMIC would also be responsible for establishing securitization standards and underwriting requirements for any loans that are included in securities guaranteed by the FMIC. The Johnson-Crapo bill also details how regulators would wind down Fannie Mae and Freddie Mac, and begin the transition to the new housing finance system. The plan provides for the process to take place over a five-year period, at the end of which the FMIC would be required to have met several benchmarks, including establishing a new securitization platform and approving a "sufficient number" of guarantors, aggregators, private mortgage insurers, and multi-family guarantors. The Partnership to Strengthen Homeownership Act proposes a Ginnie Mae insurance program whereby private investors would own a minimum 5% first-loss position in all pools guaranteed by the agency, with Ginnie Mae and a private reinsurer sharing the remaining 95% of the risk on a pari passu basis. Provisions for the wind-down and potential privatization and recapitalization of Fannie Mae and Freddie Mac are also provided. Passage of any GSE reform bill before the upcoming mid-term elections in November will be challenging. Ultimately, we believe that a reduced role for (or elimination of) the GSEs would present many opportunities for us and other private investors to fill the resulting void. Bank Regulatory Capital Changes Upcoming changes in banking regulations could impact MBS and ABS pricing, as well as the availability and cost of financing of MBS and ABS assets. The Federal Reserve's current implementation of the Basel III rules on bank Supplementary Leverage Ratios, or "SLRs," will significantly curtail the extent to which banks will be permitted to net certain repo and reverse repo agreements against each other when calculating their capital requirements. In addition, rules recently adopted by the Federal Reserve, the Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency will require the largest U.S. bank holding companies to hold capital equal to 5% of total assets, thus going beyond the 3% minimum set by Basel III rules. As a consequence, in an effort to maximize return on equity, banks may be incentivized to reduce their repo financing operations, especially for lower-profit-margin financings such as those involving U.S. Treasury securities and Agency RMBS. U.S. banking regulators also released a notice of proposed rulemaking outlining some minor changes to the SLR rules that would make the U.S. SLR definitions more similar to those currently used in Europe. In particular, these proposed rules would result in slightly more stringent capital treatment of repo lending activities. In addition, full implementation of Basel III regulations, in particular the carve-out rules related to accumulated other comprehensive income, or "AOCI," are likely to reduce bank demand for assets with higher duration, and as a result could hurt the liquidity of the tradable MBS market. Under the AOCI carve-out rules, banks with more than $250 billion in assets will be required to include mark-to-market gains and losses on available-for-sale, or "AFS," securities when calculating their Tier 1 capital. This incentivizes banks to classify Agency RMBS as held-to-maturity and other illiquid assets, effectively locking more bank-held Agency RMBS out of the tradable market, and thus reducing market liquidity. In addition, banks will likely want to reduce the risk of their AFS securities holdings, which will incentivize them to hold lower duration assets such as 15-year Agency RMBS. While our access to repo financing continues to not be negatively impacted, it is still possible that certain of our lending institutions could, in the future, decide to curtail their repo lending activities in response to these developments, particularly in connection with repo financing on Agency RMBS. However, it is also possible that these changes will create opportunities for smaller banks and/or non-bank 61



--------------------------------------------------------------------------------

Table of Contents

lenders to enter the repo financing market, and in fact we continue to see smaller broker-dealers becoming more active in the Agency pool repo financing market. Portfolio Overview and Outlook Non-Agency As of June 30, 2014, the value of our long non-Agency portfolio was $657.7 million, as compared to $637.9 million as of March 31, 2014, representing an increase of 3.1%. Over the course of the second quarter, we increased our holdings of CLOs, European non-dollar denominated RMBS, and non-performing/sub-performing residential loans. Our holdings of non-Agency RMBS and CMBS declined slightly. Credit spreads on non-Agency RMBS continued to tighten over the course of the second quarter, as strong investor appetite, propelled in large part by retail bond fund inflows, has fueled demand for higher yielding assets among fixed income products. While non-Agency RMBS credit spreads have tightened, we are still finding attractive buying opportunities, for example in sectors where we believe defaults have finally "burned out," but where market prices have yet to reflect much default burnout. At the same time, we have taken advantage of the spread tightening by opportunistically selling assets that we believe have become overvalued, since we continue to believe that certain non-Agency RMBS sectors may now have limited remaining upside potential. For example, we believe that the recent increases in home prices have led the market to ascribe too much value to certain later vintage sub-prime RMBS securities. In fact, we believe that the combination of longer resolution timelines and adverse selection of the remaining delinquent loans within these securities implies that loss severities may not come down at all. As yields continue to compress in the non-Agency RMBS market, factors such as these make prudent and careful security selection, based on loan level analysis performed on a security by security basis, of paramount importance. While we believe that fundamental factors, such as home price appreciation and a declining foreclosure inventory, remain relatively positive for non-Agency RMBS, we believe that on the technical side the non-Agency MBS market remains vulnerable, especially to a resumption of increases in long-term interest rates. The non-Agency MBS market has become dominated by large bond mutual funds, and is therefore now driven indirectly by the large-scale behavior of retail investors. This behavior tends to be much more momentum-driven, as evidenced in mid-2013 when the increase in U.S. Treasury yields was followed by substantial retail bond fund outflows, thereby putting downward pressure on prices as redemptions forced bond mutual fund managers to sell assets. This technical vulnerability has been heightened further by the fact that dealers, faced with regulatory requirements such as Basel III and the Volcker Rule, are no longer willing to hold large inventories of non-Agency MBS, and thus are no longer able to absorb large-scale selling by bond funds into their inventories. In the meantime, however, demand for non-Agency MBS assets remains strong. While CMBS new issuance volume declined approximately 3% to $25.8 billion during the six months ended June 30, 2014 as compared to same period of 2013, CMBS assets performed very well during the second quarter as credit spreads have generally continued to tighten in this sector as well. We expect that new issuance of CMBS may pick up in the second half of 2014, as volume has increased significantly in the month of July. We continue to find attractive opportunities in CMBS "B-pieces," which are the most subordinated (and therefore the highest yielding and riskiest) tranches. Ellington is among the most active participants in this market, and we believe that these assets represent an attractive complement to our legacy CMBS holdings, which tend to be lower yielding, but more actively traded. We are also actively sourcing various private transactions in the commercial real estate space. As of June 30, 2014, our investment in CMBS was $28.0 million, as compared to $32.6 million as of March 31, 2014. We continue see compelling opportunities in distressed small balance commercial loans. As of June 30, 2014, we had investments in ten loans with a value of $37.4 million, compared to twelve loans valued at $39.0 million as of March 31, 2014. The number and value of our loans held may fluctuate significantly from period to period, especially as these distressed loans are resolved or sold. Our investments in this asset class have performed extremely well, and we are continuing to source new opportunities. Our European non-dollar denominated RMBS holdings have also performed well, and as mentioned above, during the second quarter we increased our holdings within this asset class. As of June 30, 2014, we had investments in European non-dollar denominated RMBS of $29.2 million, up from $26.1 million as of March 31, 2014. Our holdings include RMBS denominated in British pounds as well as in euros, and include mezzanine as well as senior tranches. Our strategy of focusing on smaller, undervalued securities paid off during the second quarter, as we were able to sell some of our first quarter purchases at attractive profits. We expect that the volume of asset sales from European banks will increase significantly in 2014, as regulators continue to put pressure on these banks to reduce the overall size of their balance sheets, increase capital ratios and divest non-core activities. 62



--------------------------------------------------------------------------------

Table of Contents

The rally in residential non-performing/sub-performing loans, or "residential NPLs," continued in the second quarter, with whole loan prices reaching new post-crisis highs on improved financing, rising home prices, and broad institutional demand outweighing supply. In general, residential NPL prices are up several points in 2014, with residential NPLs from large national banks generally trading, as a percentage of underlying property value, in the mid-to-high 60%'s in judicial foreclosure states and high-70%'s to low 80%'s in non-judicial foreclosure states. The positive price performance is largely due to increased institutional interest in and support for the sector. The U.S. Department of Housing and Urban Development's, or "HUD's," June 2014 NPL auction drew bids from 27 different institutional investors, as compared to only 16 bidders for a HUD NPL pool offered one year ago. Bidders in the June 2014 auction included hedge funds, private equity funds, REITs, and investment banks. After a slow first quarter, transaction volume increased notably during the second quarter, although these transactions were highly concentrated, with roughly two-thirds of the quarter's volume attributable to HUD activity. During the second quarter, we purchased just one small pool of residential NPLs. Given the run-up in prices of assets in this sector, we have acquired residential NPLs at a slower pace than we originally anticipated. However, with Freddie Mac entering the market in July as a seller, in its first ever auction of residential NPLs, we remain optimistic that we will continue to see a heavy volume of residential NPLs, and that this will ultimately generate additional opportunities for us. Meanwhile, we are focusing our efforts on acquiring smaller pools. These opportunities typically originate from smaller community banks, and we have found that these smaller transactions may offer not only better potential returns in our view, but also more attractive terms. We also continue to find attractive investment opportunities in CLOs, particularly legacy CLOs. We have been active in this sector since early 2013. The new issue CLO market has been very robust, with 2014 on pace to be a record year. As a result of this increased supply, yield spreads on mezzanine tranches of new issue CLOs widened significantly in the second quarter, despite general yield spread tightening in most other fixed income sectors. Meanwhile, investor and dealer selling of legacy CLOs, to make room for new issuance, has been quite heavy, thereby forcing spreads wider for legacy product. This has enabled us to acquire legacy CLOs, where we prefer the return profile, at attractive prices. Over the course of the second quarter, we significantly increased our holdings of CLOs to $81.3 million as of June 30, 2014, up from $47.5 million as of March 31, 2014. As of June 30, 2014, CLOs represented 12.4% of our non-Agency portfolio. Active portfolio trading is a key element of our strategy. Our non-Agency portfolio turnover during the second quarter, as measured by sales, excluding principal paydowns, was 18%. We actively trade our portfolio not only for the generation of total return, but also to enhance the composition of our portfolio. During the second quarter of 2014, we continued to hedge our non-Agency portfolio against credit-related risks, primarily using hedging instruments that we believe will provide greater protection in the event of a macro-economic downturn. These hedging instruments include, among others, short positions (through credit default swaps, or "CDS,") on corporate bond indices, and short positions (through total return swaps) in certain publicly traded REITs. Over the second quarter, we increased our short position in CDS on corporate bond indices, which are principally related to high-yield corporate credits. During the second quarter, high yield corporate credit spreads also continued to tighten, in many cases to record levels. Agency As of June 30, 2014, we held Agency RMBS with a value of $961.8 million, compared to $927.7 million as of March 31, 2014. Agency RMBS rallied in the second quarter, continuing the first quarter trend. Our Agency RMBS portfolio is principally comprised of "specified pools." Specified pools are fixed rate Agency pools with special prepayment characteristics, such as pools comprised of low loan balance mortgages, pools comprised of mortgages backed by investor properties, pools containing mortgages originated through the government-sponsored "Making Homes Affordable" refinancing programs, and pools containing mortgages with various other prepayment characteristics. As discussed above in "-Federal Reserve and Monetary Policy," the Federal Reserve has continued to taper its monthly purchases of Agency RMBS and U.S. Treasury securities. While the Federal Reserve will likely cease its monthly bond purchases by the fall of this year, it has stated that it will continue to reinvest paydown proceeds from its held portfolio into additional Agency RMBS and U.S. Treasury securities. Similar to the first quarter, the additional supply of Agency RMBS that resulted from the taper was readily absorbed during the second quarter by other market participants. As the Federal Reserve continues to taper its purchases, its market dominance will further wane, which we believe will create additional opportunities for us and other private investors. During the second quarter, our Agency RMBS purchasing activity continued to focus primarily on higher coupon specified pools. As in the first quarter, pay-ups (price premiums for specified pools relative to their generic pool "TBA" counterparts) increased during the second quarter, thus continuing the reversal of the pay-up declines of the second half of 2013. Notwithstanding these increases of the past two quarters, pay-ups for many specified pool sectors remain well below their previous highs. Yield spreads on fixed rate reverse mortgage pools, which had tightened about 30 basis points during the 63



--------------------------------------------------------------------------------

Table of Contents

first quarter, continued this trend and tightened an additional 10-15 basis points in the second quarter, as issuance of reverse mortgage pools continued to slow. Prepayment rates increased only marginally in the second quarter, and they remain low by historical standards relative to the current level of mortgage rates. However, based on observations in the beginning of the third quarter, we believe that prepayments may soon begin to increase. As a result, we are still finding it attractive to buy pools with prepayment protection, particularly in those sectors that are more susceptible to increased prepayments. For the second consecutive quarter, and despite an approximate 25 basis point drop in mortgage rates during April and May, our Agency interest only securities performed well during the quarter, as prepayments increased but remained relatively low. While Agency RMBS prices generally increased in the second quarter, over the near term we believe that the combined effects of continued Federal Reserve tapering and a potential rise in mortgage originations may ultimately put pressure on valuations of Agency RMBS. We also think it is unlikely that interest rate volatility will remain as subdued as it was in the first and second quarters. While both of these factors may weigh on the performance of Agency RMBS relative to U.S. Treasury securities, we believe that each of these factors should weigh more heavily on TBAs as compared to specified pools, so they should actually support specified pool pay-ups. As the Federal Reserve continues to taper its Agency RMBS purchases, which are concentrated in purchases of TBAs, specified pools should outperform TBAs. The effects of the taper can already be observed in the TBA roll market: TBA roll prices in early July were noticeably weaker than they were at the beginning of the second quarter. We have also noted that as dealer balance sheets contract in light of regulatory changes and risk appetite decreases, the depth of the Agency RMBS market has weakened somewhat. Essentially, this means that the amount of a particular asset that can be bought or sold without materially impacting its price has declined. At the same time, however, the decline in competition from dealers is helping us to find attractive opportunities to purchase assets. We continue to target pools that, taking into account their particular composition and based on our prepayment projections: (1) should generate attractive yields relative to other Agency RMBS and U.S. Treasury securities, (2) should have less prepayment sensitivity to government policy shocks, and/or (3) create opportunities for trading gains once the market recognizes their value, which for newer pools may come only after several months, when actual prepayment experience can be observed. We believe that our research team, our proprietary prepayment models, and our extensive databases remain essential tools in our implementation of this strategy. We also believe that as the Federal Reserve gradually reduces its dominance of the Agency RMBS market over time, we will be presented with a variety of additional opportunities. Notwithstanding the opportunities that volatility may create to buy and sell assets, the presence of volatility also underscores the importance of our flexibility in hedging our risks using a variety of tools, including TBAs, as we adapt to changing market conditions. We also believe that our active trading style, coupled with our ability to dynamically alter the mix of TBAs and interest rate derivatives that we use to hedge interest rate risk, is of great benefit to our Agency RMBS strategy. Over the course of the second quarter and consistent with our strategy, we continued to hedge against the risk of rising interest rates, primarily with interest rate swaps and TBAs. Since long-term interest rates declined during the quarter, our interest rate hedges generated net losses, thereby partially reducing the impact of increasing asset prices. Notwithstanding the recent trend of declining interest rates and the relatively muted level of volatility, we believe the risk of higher near-term volatility in the Agency RMBS market remains. This reinforces the importance of our ability to hedge our risks using a variety of tools, including TBAs. Active trading of both assets and hedges has, and continues to be, a key element of our Agency RMBS strategy. Financing During the second quarter, we have continued to find repo financing to be readily available for both Agency RMBS and non-Agency MBS. In fact, dealers have actually increased their appetite for providing repo financing for both Agency and non-Agency MBS. As a result of this increased competition, our average repo borrowing costs declined for the three month period ended June 30, 2014 as compared to March 31, 2014, with our non-Agency repo average borrowing costs declining by 2 basis points to 1.92%, and with our Agency repo average borrowing costs declining by 2 basis points to 0.36%. In addition, other repo terms have improved, including a modest decline in our required haircuts. As of June 30, 2014, our outstanding reverse repos were with 16 different counterparties. Critical Accounting Policies Our unaudited consolidated financial statements have been prepared in conformity with accounting principles generally accepted in the United States for investment companies. In June 2007, the AICPA issued Amendments to ASC 946-10 ("ASC 946-10"), Clarification of the Scope of the Audit and Accounting Guide Investment Companies and Accounting by Parent Companies and Equity Method Investors for Investments in Investment Companies. ASC 946-10 was effective for fiscal years beginning on or after December 15, 2007 with earlier application encouraged. After we adopted ASC 946-10, the FASB issued guidance which effectively delayed indefinitely the effective date of ASC 946-10. However, this additional guidance explicitly 64



--------------------------------------------------------------------------------

Table of Contents

permitted entities that early adopted ASC 946-10 before December 31, 2007 to continue to apply the provisions of ASC 946-10. We have elected to continue to apply the provisions of ASC 946-10. ASC 946-10 provides guidance for determining whether an entity is within the scope of the AICPA Audit and Accounting Guide for Investment Companies, or the "Guide." The Guide provides guidance for determining whether the specialized industry accounting principles of the Guide should be retained in the financial statements of a parent company, of an investment company or of an equity method investor in an investment company. Effective August 17, 2007, we adopted ASC 946-10 and follow its provisions which, among other things, requires that investments be reported at fair value in the financial statements. Although we conduct our operations so that we are not required to register as an investment company under the Investment Company Act, for financial reporting purposes, we have elected to continue to apply the provisions of ASC 946-10. In June 2013, the FASB issued ASU 2013-08, Financial Services-Investment Companies ("ASC 946"). This update modifies the guidance for ASC 946 for determining whether an entity is an investment company for U.S. GAAP purposes. It requires entities that adopted Statement of Position 07-1 prior to its deferral to reassess whether they continue to meet the definition of an investment company for U.S. GAAP purposes. The guidance is effective for interim and annual reporting periods in fiscal years that began after December 15, 2013, with retrospective application; earlier application is prohibited. We have determined that we still meet the definition of an investment company under ASC 946 and, as a result, the presentation of our financial statements will not change upon the effective date of this ASU. Certain of our critical accounting policies require us to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. We believe that all of the decisions and assessments upon which our consolidated financial statements are based were reasonable at the time made based upon information available to us at that time. We rely on the experience of our Manager and Ellington and analysis of historical and current market data in order to arrive at what we believe to be reasonable estimates. See Note 2 of the notes to the consolidated financial statements for a complete discussion of our significant accounting policies. We have identified our most critical accounting policies to be the following: Valuation: We adopted a three-level valuation hierarchy for disclosure of fair value measurements on January 1, 2008. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. Financial instruments include investments, derivatives, and repurchase agreements. A financial instrument's categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement. The inputs or methodology used for valuing financial instruments are not necessarily an indication of the risk associated with investing in these securities. The following is a description of the valuation methodologies used for our financial instruments: Level 1 valuation methodologies include the observation of quoted prices (unadjusted) for identical assets or liabilities in active markets, often received from widely recognized data providers. Level 2 valuation methodologies include the observation of (i) quoted prices for similar assets or liabilities in active markets, (ii) inputs other than quoted prices that are observable for the asset or liability (for example, interest rates and yield curves) in active markets and (iii) quoted prices for identical or similar assets or liabilities in markets that are not active. Level 3 valuation methodologies include (i) the solicitation of valuations from third parties (typically, pricing services and broker-dealers), (ii) the use of proprietary models that require the use of a significant amount of judgment and the application of various assumptions including, but not limited to, prepayment assumptions and default rate assumptions, and (iii) the assessment of observable or reported recent trading activity. We utilize such information to assign a good faith fair value (the estimated price that would be received to sell an asset or paid to transfer a liability in an orderly transaction at the valuation date) to each such financial instrument. We seek to obtain at least one third-party indicative valuation for each instrument, and often obtain multiple indicative valuations when available. Third-party valuation providers often utilize proprietary models that are highly subjective and also require the use of a significant amount of judgment and the application of various assumptions including, but not limited to, prepayment assumptions and default rate assumptions. We have been able to obtain third-party valuations on the vast majority of our assets and expect to continue to solicit third-party valuations on substantially all of our assets in the future to the extent practical. Generally, we value each financial instrument at the average of all third-party valuations received and not rejected as described below. Third-party valuations are not binding on us, and while we generally do not adjust such valuations, we may challenge or reject a valuation when, based on validation criteria, we determine that such valuation is unreasonable or erroneous. Furthermore, we may determine, based on our validation criteria, that for a given instrument the average of the third-party valuations received does not result in what we believe to be fair value, and in such circumstances we may override this average with our own good faith valuation. Our validation criteria include the use of our own models, recent trading 65



--------------------------------------------------------------------------------

Table of Contents

activity in the same or similar instruments, and valuations received from third parties. Our valuation process, including the application of validation criteria, is overseen by the Manager's valuation committee. Because of the inherent uncertainty of valuation, these estimated values may differ significantly from the values that would have been used had a ready market for the financial instruments existed and the differences could be material to the consolidated financial statements. See the notes to our consolidated financial statements for more information on valuation. Securities Transactions and Investment Income: Securities transactions are generally recorded on trade date. Realized and unrealized gains and losses are calculated based on identified cost. Interest income, which includes accretion of discounts and amortization of premiums on MBS, ABS, commercial mortgage loans, U.S. Treasury securities, and securitized debt, is recognized over the life of the investment using the effective interest method. For purposes of determining the effective interest rate, management estimates the future expected cash flows of its investment holdings based on assumptions including, but not limited to, prepayment and default rate assumptions. These assumptions are re-evaluated not less than quarterly and require the use of a significant amount of judgment. Principal write-offs are generally treated as realized losses. For non-performing commercial mortgage loans, purchase discounts are generally not amortized. Recent Accounting Pronouncements Refer to the notes to our consolidated financial statements for a description of relevant recent accounting pronouncements. 66



--------------------------------------------------------------------------------

Table of Contents

Financial Condition The following table summarizes our investment portfolio as of June 30, 2014 and December 31, 2013. For more detailed information about the investments in our portfolio, please refer to the Consolidated Condensed Schedule of Investments as of these dates contained in our consolidated financial statements. June 30, 2014 December 31, 2013 (In Average Average Cost Average Average Cost



thousands) Current Principal Fair Value Price (1) Cost

(1) Current Principal Fair Value Price (1) Cost (1) Non-Agency RMBS and Residential Mortgage Loans $ 747,911 $ 504,864$ 67.50$ 459,362$ 61.42 $ 885,145 $ 600,835$ 67.88$ 546,616$ 61.75 Non-Agency CMBS and Commercial Mortgage Loans 130,774 65,462 50.06 65,703 50.24 97,332 56,880 58.44 56,366 57.91 Other ABS 70,139 67,635 96.43 67,980 96.92 38,422 36,287 94.44 36,786 95.74 Total Non-Agency MBS, Mortgage loans, and, Other ABS 948,824 637,961 67.24 593,045 62.50 1,020,899 694,002 67.98 639,768 62.67 Agency RMBS: Floating 23,277 24,592 105.65 24,662 105.95 28,746 30,618 106.51 30,274 105.31 Fixed 783,461 841,489 107.41 828,252 105.72 778,295 801,060 102.92 813,677 104.55 Reverse Mortgages 54,328 59,473 109.47 59,855 110.17 56,154 61,308 109.18 62,708 111.67 Total Agency RMBS 861,066 925,554 107.49 912,769 106.00 863,195 892,986 103.45 906,659 105.03 Total Non-Agency and Agency MBS, Mortgage loans, and Other ABS $ 1,809,890$ 1,563,515$ 86.39$ 1,505,814$ 83.20$ 1,884,094$ 1,586,988$ 84.23$ 1,546,427$ 82.08 Agency Interest Only RMBS n/a $ 36,240 n/a $ 35,538 n/a n/a $ 40,504 n/a $ 39,826 n/a Non-Agency Interest Only and Principal Only MBS and Other(2) n/a $ 18,089 n/a $ 17,384 n/a n/a $ 5,782 n/a $ 5,313 n/a TBAs: Long $ 136,038 $ 134,347$ 98.76$ 132,854$ 97.66 $ 101,150 $ 96,856$ 95.76$ 96,691$ 95.59 Short (750,647 ) (797,705 ) 106.27 (792,172 ) 105.53 (784,888 ) (811,957 ) 103.45 (813,757 ) 103.68 Net Short TBAs $ (614,609 )$ (663,358 )$ 107.93$ (659,318 )$ 107.27$ (683,738 )$ (715,101 )$ 104.59$ (717,066 )$ 104.87 Short U.S. Treasury Securities $ (5,000 ) $ (4,961 )$ 99.23$ (4,977 )$ 99.55 $ (20,000 ) $ (19,607 )$ 98.03$ (19,899 )$ 99.49 Short European Sovereign Bond $ (22,062 ) $ (24,457 )$ 110.85$ (23,143 )$ 104.90 $ (7,337 ) $ (7,681 )$ 104.68$ (7,633 )$ 104.04 Repurchase Agreements $ 30,537 $ 30,537$ 100.00$ 30,537$ 100.00 $ 27,962 $ 27,962$ 100.00$ 27,943$ 99.93 Short Common Stock n/a $ (25,723 ) n/a $ (25,925 ) n/a n/a $ (6,369 ) n/a $ (6,313 ) n/a Real Estate Owned n/a $ 1,641 n/a $ 1,658 n/a n/a $ - n/a $ - n/a Total Net Investments $ 931,523$ 877,568$ 912,478$ 868,598



(1) Represents the dollar amount (not shown in thousands) per $100 of current

principal of the price or cost for the security.

(2) Includes equity tranches and similar securities.

67



--------------------------------------------------------------------------------

Table of Contents

The following table summarizes our financial derivatives portfolio as of June 30, 2014 and December 31, 2013. For more detailed information about the financial derivatives in our portfolio, please refer to the Consolidated Condensed Schedule of Investments as of these dates contained in our consolidated financial statements.

June 30, 2014 December 31, 2013 (In thousands) Notional Value Fair Value Notional Value Fair Value Mortgage-Related Derivatives: Long CDS on RMBS and CMBS Indices(1) $ 17,763$ (4,298 )$ 46,072$ (11,805 ) Short CDS on RMBS and CMBS Indices(2) (72,146 ) 2,882 (72,422 ) 4,876 Short CDS on Individual RMBS(2) (23,524 ) 13,812 (26,426 ) 16,296 Net Mortgage-Related Derivatives (77,907 ) 12,396 (52,776 ) 9,367 Long CDS on Corporate Bond Indices 116,034 20,700 74,425 13,226 Short CDS on Corporate Bond Indices (271,561 ) (25,901 ) (337,815 ) (23,902 ) Long CDS on Corporate Bonds 4,395 (2,287 ) - - Written Options on CDS on Corporate Bond Indices(3) (20,790 ) (76 ) 22,588 190 Long Total Return Swaps on Corporate Equities (4) 31,506 20 51,018 4 Short Total Return Swaps on Corporate Equities (4) (13,450 ) (40 ) (10,397 ) (67 ) Interest Rate Derivatives: Long Interest Rate Swaps (5) 633,640 11,497 387,700 (879 ) Short Interest Rate Swaps (6) (1,118,141 ) (4,851 ) (1,164,400 ) 19,368 Long U.S. Treasury Note Futures (7) 33,700 200 227,200 (2,370 ) Long Eurodollar Futures (8) 4,000 - - - Short Eurodollar Futures (8) (763,000 ) (321 ) (14,000 ) (3 ) Short U.S. Treasury Note Futures (9) (17,600 ) (15 ) - - Purchased Payer Swaptions (10) 8,300 (486 ) 15,000 61 Written Payer Swaptions (11) (17,300 ) 492 (4,000 ) (84 ) Purchased Receiver Swaptions (12) 25,000 2 - - Purchased Straddle Options (13) 30,000 (144 ) - - Written Straddle Options (14) (37,000 ) 168 - - Total Net Interest Rate Derivatives 6,542 16,093 Other Derivatives: Long Foreign Currency Forwards (15) 8,640 52 - - Short Foreign Currency Forwards (16) (40,900 ) (314 ) (6,575 ) (38 ) Total Net Derivatives $ 11,092$ 14,873



(1) Long mortgage-related derivatives represent transactions where we sold credit

protection to a counterparty.

(2) Short mortgage-related derivatives represent transactions where we purchased

credit protection from a counterparty.

(3) Represents the option on our part to enter into a CDS on a corporate bond

index whereby we would pay a fixed rate and receive credit protection

payments.

(4) Notional value represents number of underlying shares or par value times the

closing price of the underlying security.

(5) For long interest rate swaps, a floating rate is being paid and a fixed rate

is being received.

(6) For short interest rate swaps, a fixed rate is being paid and a floating rate

is being received.

(7) Notional value represents the total face amount of U.S. Treasury Notes

underlying all contracts held. As of June 30, 2014 and December 31, 2013, a

total of 337 and 1,847 contracts were held, respectively.

(8) Every $1,000,000 in notional value represents one Eurodollar future contract.

(9) Notional value represents the total face amount of U.S. Treasury Notes

underlying all contracts held. As of June 30, 2014 a total of 88 contracts

were held.

(10) Represents the option on our part to enter into an interest rate swap

whereby we would pay a fixed rate and receive a floating rate.

(11) Represents the option on the part of the counterparty to enter into an

interest rate swap with us whereby we would receive a fixed rate and pay a

floating rate.

(12) Represents the option on our part to enter into an interest rate swap with a

counterparty whereby we would receive a fixed rate and pay a floating rate.

(13) Represents the combination of a purchased payer swaption and a purchased

receiver swaption on the same underlying swap.

(14) Represents the combination of a written payer swaption and a written

receiver swaption on the same underlying swap.

(15) Notional amount represents U.S. Dollars to be paid by us at the maturity of

the forward contract.

(16) Notional amount represents U.S. Dollars to be received by us at the maturity of the forward contract. 68



--------------------------------------------------------------------------------

Table of Contents

As of June 30, 2014, our Consolidated Statement of Assets, Liabilities, and Equity reflects total assets of $2.9 billion as compared to $3.0 billion as of December 31, 2013. Total liabilities as of both June 30, 2014 and December 31, 2013 were $2.3 billion. Our portfolios of investments and financial derivatives included in total assets were $1.8 billion as of both June 30, 2014 and December 31, 2013, respectively, while our investments sold short and financial derivatives included in total liabilities were $901.2 million and $890.4 million as of June 30, 2014 and December 31, 2013, respectively. Investments sold short are primarily comprised of short positions in TBAs, which we primarily use to hedge the risk of rising interest rates on our investment portfolio. Typically, we hold a net short position in TBAs. The amounts of net short TBAs, as well as other hedging instruments, may fluctuate according to the size of our investment portfolio as well as according to how we view market dynamics as favoring the use of one hedging instrument or another. As of June 30, 2014, we had a net short TBA position of $663.4 million as compared to $715.1 million as of December 31, 2013. TBA-related assets include TBAs and receivables for TBAs sold short, and TBA-related liabilities include TBAs sold short and payables for TBAs purchased. As of June 30, 2014, total assets included $134.3 million of TBAs as well as $792.0 million of a receivable for securities sold relating to unsettled TBA sales. As of December 31, 2013, total assets included $96.9 million of TBAs as well as $813.9 million of a receivable for securities sold relating to unsettled TBA sales. As of June 30, 2014, total liabilities included $797.7 million of TBAs sold short as well as $133.0 million of payable for securities purchased relating to unsettled TBA purchases. As of December 31, 2013, total liabilities included $812.0 million of TBAs sold short as well as $96.8 million of a payable for securities purchased relating to unsettled TBA purchases. Open TBA purchases and sales involving the same counterparty, the same underlying deliverable Agency pass-throughs, and the same settlement date are reflected in our consolidated financial statements on a net basis. For a more detailed discussion of our investment portfolio, see "-Trends and Recent Market Developments-Portfolio Overview and Outlook" above. As of June 30, 2014, our holdings of net short mortgage-related derivatives increased as compared to December 31, 2013. We use mortgage-related credit derivatives primarily to hedge credit risk in our non-Agency MBS portfolio, although we also may from time to time take net long positions in certain CDS on RMBS and CMBS indices. Our CDS on individual RMBS represent "single-name" positions whereby we have synthetically purchased credit protection on specific non-Agency RMBS bonds. The overall outstanding notional value of our short CDS contracts on individual RMBS declined to $23.5 million as of June 30, 2014 from $26.4 million as of December 31, 2013. As there is no longer an active market for CDS on individual RMBS, our portfolio continues to run off. As of June 30, 2014, the net short notional value of our holdings of CDS on RMBS and CMBS indices was $54.4 million as compared to $26.4 million as of December 31, 2013. Over the same period, we decreased our net short position in CDS on corporate bond indices. As of June 30, 2014, our net short CDS on corporate bond indices decreased to a notional amount of $155.5 million from $263.4 million as of December 31, 2013. In addition, as of the end of both periods, we held an option to enter into a short CDS on a corporate bond index. As market conditions change, especially as the pricing of various credit hedging instruments changes in relation to our outlook on future credit performance, we continuously re-evaluate both the extent to which we hedge credit risk and the particular mix of instruments that we use to hedge credit risk. As of June 30, 2014 and December 31, 2013, we held short and long positions in corporate equities. Our short positions were held either directly or through total return swaps, while our long positions were entirely held through total return swaps. Our short and long positions in corporate equities currently reference publicly traded REITs, and can serve either as portfolio hedges or as relative value opportunities. We use a variety of instruments to hedge interest rate risk in our portfolio, including non-derivative instruments such as TBAs, U.S. Treasury securities and sovereign debt instruments and derivative instruments such as interest rate swaps, Eurodollar and U.S. Treasury futures, and options on the foregoing. The mix of instruments that we use to hedge interest rate risk may change materially from one quarter to the next. As of June 30, 2014, the net notional value of our net short interest rate swaps decreased to $484.5 million from $776.7 million as of December 31, 2013. Including net short TBAs, U.S. Treasury securities and sovereign debt instruments, in the aggregate and based on notional value, our total interest rate hedges were $1.1 billion as of June 30, 2014 as compared to $1.5 billion as of December 31, 2013. We have also entered into foreign currency forward contracts in order to hedge risks associated with foreign currency fluctuations. We have entered into reverse repos to finance some of our assets. As of each of June 30, 2014 and December 31, 2013, indebtedness outstanding on our reverse repos was approximately $1.2 billion. As of June 30, 2014, we had total Agency RMBS financed with reverse repos of $944.6 million as compared to $881.4 million as of December 31, 2013. As of June 30, 2014, we had total non-Agency assets financed with reverse repos of $438.3 million as compared to $576.0 million as of December 31, 2013. Outstanding indebtedness under reverse repos for Agency RMBS as of June 30, 2014 and December 31, 2013 was $891.0 million and $842.3 million, respectively, while outstanding indebtedness under reverse repos for our non- 69



--------------------------------------------------------------------------------

Table of Contents

Agency portfolio as of June 30, 2014 and December 31, 2013 was $297.8 million and $393.9 million, respectively. Our reverse repos bear interest at rates that have historically moved in close relationship to LIBOR. We account for our reverse repos as collateralized borrowings. As of June 30, 2014, our debt-to-equity ratio was 1.89 to one and as of December 31, 2013, our debt-to-equity ratio was 1.98 to one. See the discussion in "-Liquidity and Capital Resources" below for further information on our reverse repos. In connection with our derivative and TBA transactions, in certain circumstances we may require that counterparties post collateral with us. When we exit a derivative or TBA transaction for which a counterparty has posted collateral, we may be required to return some or all of the related collateral to the respective counterparty. As of June 30, 2014 and December 31, 2013, our derivative and TBA counterparties posted an aggregate value of approximately $27.4 million and $19.8 million of collateral with us, respectively as of each date. This collateral posted with us is included in Due to brokers on our Consolidated Statement of Assets, Liabilities, and Equity. TBA Market We generally do not settle our purchases and sales of TBAs. If, for example, we wish to maintain a short position in a particular TBA as a hedge, we may "roll" the short TBA transaction. In a hypothetical roll transaction, we might have previously entered into a contract to sell a specified amount of 30-year FNMA 4.5% TBA pass-throughs to a particular counterparty on a specified settlement date. As this settlement date approaches, because we generally do not intend to settle the sale transaction, but we wish to maintain the short position, we enter into a roll transaction whereby we purchase the same amount of 30-year FNMA 4.5% TBA pass-throughs (but not necessarily from the same counterparty) for the same specified settlement date, and we sell the same amount of 30-year FNMA 4.5% TBA pass-throughs (potentially to yet another counterparty) for a later settlement date. In this way, we have essentially "flattened out" our 30-year FNMA 4.5% TBA pass-through position for the earlier settlement date (i.e., offset the original sale with a corresponding purchase), and established a new short position for the later settlement date, hence maintaining our short position. By rolling our transaction, we maintain our desired short position in 30-year FNMA 4.5% securities without settling the original sale transaction. In the case where the counterparty from whom we purchase (or to whom we sell) for the earlier settlement date is the same as the counterparty to whom we sell (or from whom we purchase) for the later settlement date, and when the purchase and sale are transacted simultaneously, the pair of simultaneous purchase and sale is often referred to as a "TBA roll" transaction. In some instances, to avoid taking or making delivery of TBA securities, we will "pair off" an open purchase or sale transaction with an offsetting sale or purchase with the same counterparty. Alternatively, we will "assign" open transactions from counterparties from whom we have purchased to other counterparties to whom we have sold. In either case, no securities are actually delivered, but instead the net difference in trade proceeds of the offsetting transactions is calculated and a money wire representing such difference is sent to the appropriate party. For the six month period ended June 30, 2014, as disclosed on our Consolidated Statement of Cash Flows, the aggregate TBA activity, or volume of closed transactions based on the sum of the absolute value of buy and sell transactions, was $13.4 billion as compared to $10.0 billion for the six month period ended June 30, 2013. Our TBA activity has principally consisted of: (a) sales (respectively purchases) of TBAs as hedges in connection with purchases (respectively sales) of certain other assets (especially fixed rate Agency whole pools); (b) TBA roll transactions (as described above) effected to maintain existing TBA short positions; and (c) TBA "sector rotation" transactions whereby a short TBA position in one TBA security is replaced with a short position in a different TBA security. Since we have actively turned over our portfolio of fixed rate Agency whole pools, the volume of TBA hedging transactions has also been correspondingly high. Moreover, our fixed rate Agency whole pool portfolio is typically larger in gross size than our equity capital base, and so we tend to hold large short TBA positions relative to our equity capital base at any time. Finally, the entire amount of short TBA positions held at each monthly TBA settlement date is typically rolled to the following month, and since the amount of short TBA positions tends to be large relative to our equity capital base, TBA roll transaction volume over multi-month periods can represent a multiple of our equity capital base. Equity As of June 30, 2014, our equity increased by approximately $5.1 million to $631.1 million from $626.0 million as of December 31, 2013. This increase principally consisted of a net increase in equity resulting from operations for the six months ended June 30, 2014 of approximately $44.0 million, an increase related to the contribution from our non-controlling interests of approximately $1.2 million, and an increase for LTIP awards and common shares issued to our Manager in connection with incentive fee payment of approximately $0.4 million offset by a decrease for dividends paid of approximately $40.1 million and approximately $0.5 million in distributions to a joint venture partner. Shareholders' equity, which excludes the non-controlling interests related to the minority interest in the Operating Partnership as well the minority interest of a joint venture partner, was $624.1 million as of June 30, 2014. 70



--------------------------------------------------------------------------------

Table of Contents

As of December 31, 2013, our equity increased by approximately $119.7 million to $626.0 million from $506.4 million as of December 31, 2012. This increase principally consisted of net proceeds from our May 2013 secondary share offering of approximately $125.3 million, a net increase in equity resulting from operations for the year ended December 31, 2013 of approximately $79.4 million, an increase related to the contribution from our non-controlling interests of approximately $5.9 million, and an increase for LTIP awards and common shares issued to our Manager in connection with incentive fee payments of approximately $1.4 million, offset by a decrease for dividends paid of approximately $92.1 million. Shareholders' equity, which excludes the non-controlling interests related to the minority interest in the Operating Partnership as well the minority interest of a joint venture partner, was $620.4 million as of December 31, 2013. Results of Operations for the Three Month Periods Ended June 30, 2014 and 2013 The table below represents the net increase in equity resulting from operations for the three month periods ended June 30, 2014 and 2013. Three Month Period Ended June 30, (In thousands except per share amounts) 2014 2013 Interest income $ 20,996$ 20,335 Expenses: Base management fee 2,368 2,405 Incentive fee - 1,182 Interest expense 2,416 2,582 Other investment related expenses 1,232 327 Other operating expenses 1,974 1,671 Total expenses 7,990 8,167 Net investment income 13,006 12,168 Net realized and change in unrealized gain (loss) on investments 14,399 (17,373 ) Net realized and change in unrealized gain (loss) on financial derivatives (6,588 )



16,910

Net foreign currency gain (loss) 387 - Net increase in equity resulting from operations 21,204



11,705

Less: Net increase in equity resulting from operations attributable to non-controlling interests 257 105 Net increase in shareholders' equity resulting from operations $ 20,947$ 11,600 Net increase in shareholders' equity resulting from operations per share $ 0.81



$ 0.49

Summary of Net Increase in Shareholders' Equity from Operations Our net increase in shareholders' equity from operations ("net income") for the three months ended June 30, 2014 and 2013 was $20.9 million and $11.6 million, respectively. The increase in our net income period over period was primarily driven by an increase in net realized and unrealized gains on our investments, net foreign currency gains, and a slight increase in net investment income, partially offset by an increase in net realized and unrealized losses on our financial derivatives. Total return based on changes in "net asset value" or "book value" for our common shares was 3.36% for the three months ended June 30, 2014 as compared to 1.57% for the three months ended June 30, 2013. Average equity for the three months ended June 30, 2014 was $628.5 million as compared to $581.6 million for the comparable period of 2013. Total return on our common shares is calculated based on changes in net asset value per share or book value per share and assumes reinvestment of dividends. Net Investment Income Net investment income was $13.0 million for the three months ended June 30, 2014 as compared to $12.2 million for the three months ended June 30, 2013. Net investment income consists of interest income less total expenses. The period-over-period increase in net investment income was primarily due to higher interest income as well as lower incentive fees for the three month period ended June 30, 2014 as compared to the three month period ended June 30, 2013. Interest Income Interest income was $21.0 million for the three month period ended June 30, 2014 as compared to $20.3 million for the three month period ended June 30, 2013. Interest income includes coupon payments received and accrued on our holdings, the net accretion and amortization of purchase discounts and premiums on those holdings and interest on our cash balances, 71



--------------------------------------------------------------------------------

Table of Contents

including those balances held by our counterparties as collateral. On a period-over-period basis, interest income from both our non-Agency and Agency portfolios increased slightly. Our non-Agency holdings benefited from an increase in yields period over period, while our Agency portfolio benefited from both an increase in size and yield. Each period, our interest income on our Agency RMBS included a benefit associated with declines in prepayments, thereby positively impacting yields on held securities as well. For the three month period ended June 30, 2014, interest income from our non-Agency portfolio was $13.0 million while for the three month period ended June 30, 2013, interest income was $12.7 million. For the three month period ended June 30, 2014, interest income from our Agency RMBS was $8.0 million while for the three month period ended June 30, 2013, interest income was $7.6 million. The following table details our interest income, average holdings, and average yields based on amortized cost for the three month periods ended June 30, 2014 and 2013: Non-Agency(1) Agency Total(1) Interest Average Interest Average Interest Average (In thousands) Income Holdings Yield Income Holdings Yield Income Holdings Yield Three month period ended June 30, 2014 $ 12,971$ 571,646 9.08 % $ 8,009$ 949,292 3.37 % $ 20,980$ 1,520,938 5.52 % Three month period ended June 30, 2013 $ 12,684$ 583,496 8.70 % $ 7,641$ 856,932 3.57 % $ 20,325$ 1,440,428 5.64 %



(1) Amounts exclude non-performing loans, for which interest income is not

generally accrued.

Base Management Fees For each of the three month periods ended June 30, 2014 and 2013, base management fee incurred, which is based on total equity at the end of each quarter, was $2.4 million. Interest Expense Interest expense includes interest on funds borrowed under reverse repos, securitized debt, coupon interest on securities sold short, the related net accretion and amortization of purchase discounts and premiums on those short holdings, and interest on our counterparties' cash collateral held by us. We had average borrowed funds under reverse repos of $1.2 billion and $1.1 billion for the three month periods ended June 30, 2014 and 2013, respectively. The increase in average borrowed funds under reverse repos was driven mainly by our financing of larger non-Agency and Agency portfolios. Our total interest expense, inclusive of interest expense on securitized debt and on our counterparties' cash collateral held by us, decreased to $2.4 million for the three month period ended June 30, 2014 as compared to $2.6 million for the three month period ended June 30, 2013. Our total average borrowing cost under our reverse repos was 0.77% for the three month period ended June 30, 2014 as compared to 0.89% for the three month period ended June 30, 2013. For the three month period ended June 30, 2014, 26.3% of our average borrowings under reverse repos were related to our non-Agency portfolio. For the three month period ended June 30, 2013, 29.1% of our average borrowings were related to our non-Agency portfolio. Increasing competition among repo dealers has led to lower rates on our borrowings. The tables below show our average borrowed funds, interest expense, average cost of funds, and average one-month and average six-month LIBOR rates under our reverse repos for the three month periods ended June 30, 2014 and 2013. Agency Securities Average Average Average Borrowed Average Cost One-Month Six-Month (In thousands) Funds Interest Expense of Funds LIBOR LIBOR For the three month period ended June 30, 2014 $ 864,934 $ 776 0.36 % 0.15 % 0.32 % For the three month period ended June 30, 2013 $ 770,252 $ 797 0.41 % 0.20 % 0.42 % Non-Agency Securities Average Average Average Borrowed Interest Average Cost One-Month Six-Month (In thousands) Funds Expense of Funds LIBOR LIBOR For the three month period ended June 30, 2014 $ 307,964$ 1,471 1.92 % 0.15 % 0.32 % For the three month period ended June 30, 2013 $ 315,851$ 1,603 2.04 % 0.20 % 0.42 % 72



--------------------------------------------------------------------------------

Table of Contents

Agency and Non-Agency Securities

Average Average Average Interest Average Cost One-Month Six-Month (In thousands) Borrowed Funds Expense of Funds LIBOR LIBOR For the three month period ended June 30, 2014 $ 1,172,898$ 2,247 0.77 % 0.15 % 0.32 % For the three month period ended June 30, 2013 $ 1,086,103$ 2,400 0.89 % 0.20 % 0.42 % Among other instruments, we use interest rate swaps to hedge our portfolios against the risk of rising interest rates. If we were to include actual and accrued periodic payments on our interest rate swaps as a component of our cost of funds, our total average cost of funds would increase to 1.18% and 1.32% for the three month periods ended June 30, 2014 and 2013, respectively. Our net interest margin, defined as the yield on our portfolio (See-Interest Income above), less our cost of funds (including actual and accrued periodic payments on interest rate swaps) was 4.34% and 4.32% for the three month periods ended June 30, 2014 and 2013, respectively. This metric does not include the costs associated with other instruments that we use to hedge interest rate risk, such as TBAs and futures. Incentive Fees In addition to the base management fee, our Manager is also entitled to a quarterly incentive fee if, our performance (as measured by adjusted net income, as defined in the management agreement) over the relevant rolling four quarter calculation period exceeds a defined return hurdle for the period. No incentive fee was incurred for the three month period ended June 30, 2014. Incentive fee incurred for the three month period ended June 30, 2013 was $1.2 million. The return hurdle for each calculation period was based on a 9% annual rate. Because our operating results can vary materially from one period to another, incentive fee expense can also be highly variable. Other Investment Related Expenses Other investment related expenses consist of dividend expense on our short common stock, disposition fees paid to a joint venture partner upon the sale/resolution of certain distressed mortgage loans, as well as various other expenses and fees directly related to our financial assets. For the three month period ended June 30, 2014 and June 30, 2013 other investment related expenses were $1.2 million and $0.3 million, respectively. The increase is principally due to increased dividends paid in connection with a larger portfolio of short equities for the three months ended June 30, 2014 as compared to the same period of 2013. Other Operating Expenses Other operating expenses consist of professional fees, compensation expense related to our dedicated or partially dedicated personnel, share-based LTIP expense, insurance expense, and various other operating expenses necessary to run our business. Other operating expenses exclude management and incentive fees, interest expense, and other investment related expenses. Other operating expenses for the three month period ended June 30, 2014 were $2.0 million as compared to $1.7 million for the three month period ended June 30, 2013. The increase in our other operating expenses was primarily related to increased professional fees and custody and other fees. Net Realized and Unrealized Gains on Investments During the three month period ended June 30, 2014, we had net realized and unrealized gains on investments of $14.4 million as compared to net realized and unrealized losses of $17.4 million for the three month period ended June 30, 2013. Net realized and unrealized gains on investments of $14.4 million for the three month period ended June 30, 2014 resulted principally from net realized and unrealized gains on both our non-Agency and Agency RMBS portfolios, as well as on CMBS, distressed commercial loans, and residential mortgage loans, partially offset by net realized and unrealized losses on our net short TBAs, short government debt, CLOs, and real estate owned properties. Our net short TBAs and government debt securities were used primarily to hedge interest rate and/or prepayment risk with respect to our investment holdings. For the three month period ended June 30, 2014 net gains on our non-Agency and Agency MBS portfolios, commercial mortgage loans, and residential mortgage loans were $31.1 million, while net losses on our net short TBAs and government debt, CLOs, and real estate owned properties were $16.8 million. During the three month period ended June 30, 2014, non-Agency RMBS and CMBS rallied as credit spreads continued to tighten during the period. This was due, at least in part, to strong investor appetite, as demonstrated by significant retail investor bond fund inflows, which have fueled demand for higher yielding assets among fixed-income products. Non-Agency RMBS assets have also benefited from rising home prices and declining foreclosure inventory. Agency RMBS benefited from declining long-term interest rates and relatively low volatility during the period. We actively traded both our non-Agency and Agency portfolios, thereby monetizing gains. As of June 30, 2014, the yield on the benchmark 10-year U.S. Treasury was 2.53% as compared to 2.72% as of March 31, 2014. 73



--------------------------------------------------------------------------------

Table of Contents

Net realized and unrealized losses on investments of $17.4 million for the three month period ended June 30, 2013 resulted principally from net realized and unrealized losses on our Agency RMBS and our non-Agency portfolio, partially offset by net realized and unrealized gains on our net short TBAs and U.S. Treasury securities. Net Realized and Unrealized Gains and Losses on Financial Derivatives During the three month period ended June 30, 2014, we had net realized and unrealized losses on our financial derivatives of $6.6 million as compared to net realized and unrealized gains of $16.9 million for the three month period ended June 30, 2013. Our financial derivatives consist of interest rate derivatives, which we use primarily to hedge interest rate risk, and of credit derivatives and total return swaps, both of which we use primarily to hedge credit risk, but also for non-hedging purposes. Non-hedging credit derivatives and total return swaps include both long and short positions. We began purchasing European non-dollar denominated RMBS in late 2013, and so since that time we have also been transacting in foreign exchange derivatives such as forwards, which we use to hedge foreign currency risk. Our interest rate derivatives are primarily in the form of net short positions in interest rate swaps, and to a lesser extent short and/or long positions in Eurodollar futures and U.S. Treasury Note futures, as well as purchased and written swaptions. We also use certain non-derivative instruments, such as TBAs, U.S. Treasury securities and sovereign debt instruments, to hedge interest rate risk. Our credit hedges are in the form of credit default swaps where we have purchased credit protection on non-Agency MBS, as well as total return swaps and CDS on corporate bond indices, which we use to take short positions in various corporate equity and debt securities. We also use total return swaps to take synthetic long or short positions in certain mortgage- or real estate-related corporate entities. Net realized and unrealized losses of $6.6 million on our financial derivatives for the three month period ended June 30, 2014 resulted primarily from net losses of $7.3 million related to our interest rate hedges other than futures, as interest rates declined during the quarter, and net losses of $2.4 million related to our CDS on corporate bond indices, CDS on RMBS and CMBS indices, and CDS on corporate bonds, partially offset by net realized and unrealized gains of $3.1 million related to our net long positions on total return swaps, our net short position in futures, and our short positions in CDS on individual RMBS. Our net long total return swaps on equities of mortgage- and real estate-related corporate entities were the primary contributor of our net gains during the quarter. The benchmark 5-year swap rate ended the period slightly lower than where it began at approximately 1.70% as compared to 1.80% as of March 31, 2014, but it ranged even lower over the course of most of the period, falling as low as 1.58%. Net realized and unrealized gains on our financial derivatives of $16.9 million for the three month period ended June 30, 2013 resulted principally from net realized and unrealized gains on our interest rate swaps and CDS on RMBS and CMBS indices, partially offset by net realized and unrealized losses on our futures, CDS on corporate bond indices, and total return swaps. 74



--------------------------------------------------------------------------------

Table of Contents

Results of Operations for the Six Month Periods Ended June 30, 2014 and 2013 The table below represents the net increase in equity resulting from operations for the six month periods ended June 30, 2014 and 2013. Six Month Period Ended June 30, (In thousands except per share amounts) 2014 2013 Interest income $ 42,493$ 38,717 Expenses: Base management fee 4,733 4,373 Incentive fee - 3,237 Interest expense 5,043 4,724 Other investment related expenses 1,662 327 Other operating expenses 3,968 3,319 Total expenses 15,406 15,980 Net investment income 27,087 22,737 Net realized and change in unrealized gain (loss) on investments 24,095



19,464

Net realized and change in unrealized gain (loss) on financial derivatives (7,809 )



10,250

Net foreign currency gain (loss) 669 - Net increase in equity resulting from operations 44,042



52,451

Less: Net increase in equity resulting from operations attributable to non-controlling interests 460 516 Net increase in shareholders' equity resulting from operations $ 43,582$ 51,935 Net increase in shareholders' equity resulting from operations per share $ 1.69



$ 2.35

Summary of Net Increase in Shareholders' Equity from Operations Our net increase in shareholders' equity from operations ("net income") for the six months ended June 30, 2014 and 2013 was $43.6 million and $51.9 million, respectively. The decrease in our net income period over period was primarily driven by a decline in net realized and unrealized gains on our investments and financial derivatives, partially offset by an increase in our net investment income. Total return based on changes in "net asset value" or "book value" for our common shares was 7.03% for the six months ended June 30, 2014 as compared to 9.57% for the six months ended June 30, 2013. Average equity for the six months ended June 30, 2014 was $628.2 million as compared to $556.3 million for the comparable period of 2013. Total return on our common shares is calculated based on changes in net asset value per share or book value per share and assumes reinvestment of dividends. Net Investment Income Net investment income was $27.1 million for the six month period ended June 30, 2014 as compared to $22.7 million for the six month period ended June 30, 2013. Net investment income consists of interest income less total expenses. The period-over-period increase in net investment income was primarily due to higher interest income as well as lower incentive fees for the six month period ended June 30, 2014 as compared to the six month period ended June 30, 2013. Interest Income Interest income was $42.5 million for the six month period ended June 30, 2014 as compared to $38.7 million for the six month period ended June 30, 2013. Interest income includes coupon payments received and accrued on our holdings, the net accretion and amortization of purchase discounts and premiums on those holdings and interest on our cash balances, including those balances held by our counterparties as collateral. On a period-over-period basis, interest income from both our non-Agency and Agency portfolios increased, mainly in connection with the increase in size of each portfolio. Additionally, our Agency portfolio has benefited from higher yielding assets relative to one year ago, as purchase yields have increased substantially. Each period included a benefit associated with declines in prepayments on our Agency RMBS, thereby positively impacting yields on held securities as well. For the six month period ended June 30, 2014, interest income from our non-Agency portfolio was $26.5 million while for the six month period ended June 30, 2013, interest income was $24.8 million. For the six month period ended June 30, 2014, interest income from our Agency RMBS was $16.0 million while for the six month period ended June 30, 2013, interest income was $13.9 million. For the six month period ended June 30, 2014, interest income from our Agency RMBS included the positive impact of a $0.3 million adjustment to premium amortization, which in turn was 75



--------------------------------------------------------------------------------

Table of Contents

caused by declines in prepayments brought on by higher interest rates. This adjustment for the comparable period of 2013 was $2.1 million. The following table details our interest income, average holdings, and average yields based on amortized cost for the six month periods ended June 30, 2014 and 2013: Non-Agency(1) Agency Total(1) Interest Average Interest Average Interest Average (In thousands) Income Holdings Yield Income Holdings Yield Income Holdings Yield Six month period ended June 30, 2014 $ 26,486$ 578,492 9.16 % $ 15,956$ 936,168 3.41 % $ 42,442$ 1,514,660 5.60 % Six month period ended June 30, 2013 $ 24,802$ 548,941 9.04 % $ 13,903$ 845,047 3.29 % $ 38,705$ 1,393,988 5.55 %



(1) Amounts exclude non-performing loans, for which interest income is not

generally accrued.

Base Management Fees For the six month periods ended June 30, 2014 and 2013, base management fee incurred, which is based on total equity at the end of each quarter, was $4.7 million and $4.4 million, respectively. The increase in the base management fee was due to our larger capital base period over period. Interest Expense Interest expense includes interest on funds borrowed under reverse repos, securitized debt, coupon interest on securities sold short, the related net accretion and amortization of purchase discounts and premiums on those short holdings, and interest on our counterparties' cash collateral held by us. We had average borrowed funds under reverse repos of $1.2 billion and $1.0 billion for the six month periods ended June 30, 2014 and 2013, respectively. The increase in average borrowed funds under reverse repos was driven mainly by our financing of larger non-Agency and Agency portfolios. Our total interest expense, inclusive of interest expense on securitized debt and on our counterparties' cash collateral held by us, increased to $5.0 million for the six month period ended June 30, 2014 as compared to $4.7 million for the six month period ended June 30, 2013. Our total average borrowing cost under our reverse repos was 0.80% and 0.85% for the six month periods ended June 30, 2014 and 2013, respectively. For the six month period ended June 30, 2014, 27.8% of our average borrowings under reverse repos were related to our non-Agency portfolio. For the six month period ended June 30, 2013, 26.6% of our average borrowings were related to our non-Agency portfolio. Increasing competition among repo dealers has led to lower rates on our borrowings. The tables below show our average borrowed funds, interest expense, average cost of funds, and average one-month and average six-month LIBOR rates under our reverse repos for the six month periods ended June 30, 2014 and 2013. Agency Securities Average Average Average Borrowed Interest Average Cost One-Month Six-Month (In thousands) Funds Expense of Funds LIBOR LIBOR For the six month period ended June 30, 2014 $ 844,687$ 1,551 0.37 % 0.15 % 0.33 % For the six month period ended June 30, 2013 $ 758,187$ 1,576 0.42 % 0.20 % 0.45 % Non-Agency Securities Average Average Average Borrowed Interest Average Cost One-Month Six-Month (In thousands) Funds Expense of Funds LIBOR LIBOR For the six month period ended June 30, 2014 $ 325,539$ 3,111 1.93 % 0.15 % 0.33 % For the six month period ended June 30, 2013 $ 275,015$ 2,767 2.03 % 0.20 % 0.45 % 76



--------------------------------------------------------------------------------

Table of Contents

Agency and Non-Agency Securities

Average Average Average Interest Average Cost One-Month Six-Month (In thousands) Borrowed Funds Expense of Funds LIBOR LIBOR For the six month period ended June 30, 2014 $ 1,170,226$ 4,662 0.80 % 0.15 % 0.33 % For the six month period ended June 30, 2013 $ 1,033,202$ 4,343 0.85 % 0.20 % 0.45 % Among other instruments, we use interest rate swaps to hedge our portfolios against the risk of rising interest rates. If we were to include actual and accrued periodic payments on our interest rate swaps as a component of our cost of funds, our total average cost of funds would increase to 1.28% and 1.22% for the six month periods ended June 30, 2014 and 2013, respectively. Our net interest margin, defined as the yield on our portfolio (See-Interest Income above), less our cost of funds (including actual and accrued periodic payments on interest rate swaps) was 4.32% and 4.33% for the six month periods ended June 30, 2014 and 2013, respectively. This metric does not include the costs associated with other instruments that we use to hedge interest rate risk, such as TBAs and futures. Incentive Fees In addition to the base management fee, our Manager is also entitled to a quarterly incentive fee if our performance (as measured by adjusted net income, as defined in the management agreement) over the relevant rolling four quarter calculation period exceeds a defined return hurdle for the period. No incentive fee was incurred for the six month period ended June 30, 2014. Incentive fee incurred for the six month period ended June 30, 2013 was $3.2 million. The return hurdle for each calculation period was based on a 9% annual rate. Because our operating results can vary materially from one period to another, incentive fee expense can also be highly variable. Other Investment Related Expenses Other investment related expenses consist of dividend expense on our short common stock, disposition fees paid to a joint venture partner upon the sale/resolution of certain distressed mortgage loans, as well as various other expenses and fees directly related to our financial assets. For the six month period ended June 30, 2014 and 2013 other investment related expenses were $1.7 million and $0.3 million, respectively. The increase was primarily due to increased dividends paid in connection with a larger portfolio of short equities for the six months ended June 30, 2014 as compared to the same period of 2013. Other Operating Expenses Other operating expenses consist of professional fees, compensation expense related to our dedicated or partially dedicated personnel, share-based LTIP expense, insurance expense, and various other operating expenses necessary to run our business. Other operating expenses exclude management and incentive fees, interest expense, and other investment related expenses. Other operating expenses for the six month period ended June 30, 2014 were $4.0 million as compared to $3.3 million for the six month period ended June 30, 2013. The increase in our other operating expenses was primarily related to increased professional fees and custody and other fees. Net Realized and Unrealized Gains on Investments During the six month period ended June 30, 2014, we had net realized and unrealized gains on investments of $24.1 million as compared to net realized and unrealized gains of $19.5 million for the six month period ended June 30, 2013. Net realized and unrealized gains on investments of $24.1 million for the six month period ended June 30, 2014 resulted principally from net realized and unrealized gains on both our non-Agency and Agency RMBS portfolios, as well as on CMBS, residential mortgage loans, commercial mortgage loans, and CLOs, partially offset by net realized and unrealized losses on our net short TBAs and short government debt. Our net short TBAs and government debt securities were used primarily to hedge interest rate and/or prepayment risk with respect to our investment holdings. For the six month period ended June 30, 2014 net gains on our non-Agency and Agency MBS portfolios, residential mortgage loans, commercial mortgage loans, and CLOs were $50.8 million, while net losses on our net short TBAs and government debt were $26.8 million. During the three month period ended June 30, 2014, non-Agency RMBS and CMBS rallied as credit spreads continued to tighten. This was due, at least in part, to strong investor appetite, as demonstrated by significant retail investor bond fund inflows, which have fueled demand for higher yielding assets among fixed-income products. Non-Agency RMBS assets have also benefited from rising home prices and declining foreclosure inventory. Agency RMBS benefited from declining long-term interest rates and relatively low volatility during the period. Over the six month period, Agency RMBS also benefited from greater market clarity around the actions of the Federal Reserve, which in January began its anticipated tapering of monthly asset purchases under its accommodative monetary policies. We actively traded both our non-Agency and Agency portfolios, thereby monetizing gains. After the December 2013 initial taper announcement by the Federal Reserve, Agency RMBS rallied, and have continued to do so through 77



--------------------------------------------------------------------------------

Table of Contents

June 30, 2014. As of June 30, 2014, the yield on the benchmark 10-year U.S. Treasury was 2.53% as compared to 3.03% as of December 31, 2013. Net realized and unrealized gains on investments of $19.5 million for the six month period ended June 30, 2013 resulted principally from net realized and unrealized gains on our non-Agency portfolio, net short TBAs, and U.S. Treasury securities, partially offset by net realized and unrealized losses on our Agency RMBS. Net Realized and Unrealized Gains and Losses on Financial Derivatives During the six month period ended June 30, 2014, we had net realized and unrealized losses on our financial derivatives of $7.8 million as compared to net realized and unrealized gains of $10.3 million for the six month period ended June 30, 2013. Our financial derivatives consist of interest rate derivatives, which we use primarily to hedge interest rate risk, and of credit derivatives and total return swaps, both of which we use primarily to hedge credit risk, but also for non-hedging purposes. Non-hedging credit derivatives and total return swaps include both long and short positions. We began purchasing European non-dollar denominated RMBS in late 2013, and so since that time we have also been transacting in foreign exchange derivatives such as forwards, which we use to hedge foreign currency risk. Our interest rate derivatives are primarily in the form of net short positions in interest rate swaps, and to a lesser extent short and/or long positions in Eurodollar futures and U.S. Treasury Note futures, as well as purchased and written swaptions. We also use certain non-derivative instruments, such as TBAs, U.S. Treasury securities and sovereign debt instruments, to hedge interest rate risk. Our credit hedges are in the form of credit default swaps where we have purchased credit protection on non-Agency MBS, as well as total return swaps and CDS on corporate bond indices, which we use to take short positions in various corporate equity and debt securities. We also use total return swaps to take synthetic long or short positions in certain mortgage- or real estate-related corporate entities. Net realized and unrealized losses of $7.8 million on our financial derivatives for the six month period ended June 30, 2014 resulted primarily from net losses of $17.7 million related to our interest rate swaps, foreign currency forwards, and our net short positions in CDS on RMBS and CMBS indices and CDS on corporate bond indices, partially offset by net realized and unrealized gains of $10.0 million related to our net long positions on total return swaps and our net short position in futures. Our net long total return swaps on equities of mortgage- and real estate-related corporate entities were the primary contributor of our net gains during the six month period ended June 30, 2014. The benchmark 5-year swap rate ended the period at 1.70% as compared to 1.79% as of December 31, 2013, but it ranged even lower over the course of most of the period, falling as low as 1.56%. Net realized and unrealized gains on our financial derivatives of $10.3 million for the six month period ended June 30, 2013 resulted principally from net realized and unrealized gains on our interest rate swaps, partially offset by net realized and unrealized losses on our CDS on corporate bond indices, CDS on individual RMBS, and futures. Liquidity and Capital Resources Liquidity refers to our ability to meet our cash needs, including repaying our borrowings, funding and maintaining positions in MBS and other assets, making distributions in the form of dividends, and other general business needs. Our short-term (one year or less) and long-term liquidity requirements include acquisition costs for assets we acquire, payment of our base management fee and incentive fee, compliance with margin requirements under our repurchase agreement, or "repo," reverse repo, TBA, and financial derivative contracts, repayment of reverse repo borrowings to the extent we are unable or unwilling to extend our reverse repos, payment of our general operating expenses, and payment of our quarterly dividend. Our capital resources primarily include cash on hand, cash flow from our investments (including monthly principal and interest payments received on our investments and proceeds from the sale of investments), borrowings under reverse repos, and proceeds from equity offerings. We expect that these sources of funds will be sufficient to meet our short-term and long-term liquidity needs. The following summarizes our reverse repos: Reverse Repurchase Agreements Average Borrowed Funds Borrowed Funds During Outstanding at End of (In thousands) the Period the Period Six Month Period Ended June 30, 2014 $ 1,170,226 $



1,188,831

Six Month Period Ended June 30, 2013 $ 1,033,202 $ 1,287,992 78



--------------------------------------------------------------------------------

Table of Contents

The following summarizes our borrowings under reverse repos by remaining maturity: (In thousands) As of June 30, 2014 Remaining Days to Maturity Outstanding Borrowings % 30 Days or Less $ 368,522 31.0 % 31 - 60 Days 348,115 29.3 % 61 - 90 Days 292,692 24.6 % 91 - 120 Days 3,828 0.3 % 121 - 150 Days 28,875 2.4 % 151 - 180 Days 146,799 12.4 % $ 1,188,831 100.0 % Reverse repos involving underlying investments that we sold prior to June 30, 2014, for settlement following June 30, 2014, are shown using their original maturity dates even though such reverse repos may be expected to be terminated early upon settlement of the sale of the underlying investment. Not included are any reverse repos that we may have entered into prior to June 30, 2014 for which delivery of the borrowed funds is not scheduled until after June 30, 2014. The amounts borrowed under our reverse repo agreements are generally subject to the application of "haircuts." A haircut is the percentage discount that a repo lender applies to the market value of an asset serving as collateral for a repo borrowing, for the purpose of determining whether such repo borrowing is adequately collateralized. As of June 30, 2014, the weighted average contractual haircut applicable to the assets that serve as collateral for our outstanding repo borrowings was 32.1% with respect to non-Agency assets, 5.5% with respect to Agency RMBS assets and 13.9% overall. As of December 31, 2013 these respective weighted average contractual haircuts were 31.5%, 5.8%, and 16.0%. We expect to continue to borrow funds in the form of reverse repos as well as other similar types of financings. The terms of these borrowings under our master repurchase agreements generally conform to the terms in the standard master repurchase agreement as published by the Securities Industry and Financial Markets Association, or "SIFMA," as to repayment and margin requirements. In addition, each lender typically requires that we include supplemental terms and conditions to the standard master repurchase agreement. Typical supplemental terms and conditions include the addition of or changes to provisions relating to margin calls, net asset value requirements, cross default provisions, certain key person events, changes in corporate structure, and requirements that all controversies related to the repurchase agreement be litigated in a particular jurisdiction. These provisions may differ for each of our lenders. We also have entered into an "evergreen" repurchase agreement with one lender that provides for an original term of 180 days, and which is automatically extended every day for an additional day (so as to maintain a remaining term of 180 days) unless notified otherwise by the lender. The agreement is not based on the SIFMA form, but its terms and conditions are similar to the terms and conditions of our other master repurchase agreements including with respect to events of default and remedies upon default. As of both June 30, 2014 and December 31, 2013, we had $1.2 billion of borrowings outstanding under our reverse repos. As of June 30, 2014, the remaining terms on our reverse repos ranged from 1 to 180 days, with an average remaining term of 62 days. As of December 31, 2013, the remaining terms on our reverse repos ranged from 2 to 180 days, with an average remaining term of 56 days. Our reverse repo borrowings were with a total of sixteen counterparties as of both June 30, 2014 and fourteen counterparties as of December 31, 2013. As of June 30, 2014 and December 31, 2013, our reverse repos had a weighted average borrowing rate of 0.74% and 0.90%, respectively. As of June 30, 2014, our reverse repos had interest rates ranging from 0.26% to 2.25%. As of December 31, 2013, our reverse repos had interest rates ranging from 0.32% to 2.27%. Investments transferred as collateral under the reverse repos had an aggregate estimated fair value of $1.4 billion and $1.5 billion as of June 30, 2014 and December 31, 2013, respectively. The interest rates of our reverse repos have historically moved in close relationship to short-term LIBOR rates, and in some cases are explicitly indexed to short-term LIBOR rates and reset accordingly. It is expected that amounts due upon maturity of our reverse repos will be funded primarily through the roll/re-initiation of reverse repos and, if we are unable or unwilling to roll/re-initiate our reverse repos, through free cash and proceeds from the sale of securities. 79



--------------------------------------------------------------------------------

Table of Contents

Amount at risk represents the aggregate excess, if any, for each counterparty of the fair value of collateral held by such counterparty over the amounts outstanding under reverse repos. The following tables reflect counterparties for which the amounts at risk relating to our reverse repos was greater than 5% of total equity as of June 30, 2014 and December 31, 2013: As of June 30, 2014: Weighted Average Remaining Days Percentage Counterparty Amount at Risk to Maturity of Equity (In thousands) Credit Suisse First Boston LLC $ 40,171 32 6.4% Wells Fargo Bank, N.A. $ 34,315 180 5.4% As of December 31, 2013: Weighted Average Remaining Days Percentage Counterparty Amount at Risk to Maturity of Equity (In thousands) Wells Fargo Bank, N.A. $ 48,979 180 7.8% Credit Suisse First Boston LLC $ 46,016 46 7.4% Barclays Capital Inc. $ 45,278 48 7.2% Although we typically finance most of our holdings of Agency RMBS, as of June 30, 2014 and December 31, 2013, we held unencumbered Agency pools, on a settlement date basis, in the amount of $3.9 million and $11.5 million, respectively. We held cash and cash equivalents of approximately $145.0 million and $183.5 million as of June 30, 2014 and December 31, 2013, respectively. Since the latter part of the second quarter of 2013, we have increased our level of cash holdings, both as a buffer against the increased market volatility and so as to be able to take advantage of potential investment opportunities. We may declare dividends based on, among other things, our earnings, our financial condition, our working capital needs, and new opportunities. Dividends are declared and paid on a quarterly basis in arrears. The declaration of dividends to our shareholders and the amount of such dividends are at the discretion of our Board of Directors. During the six month period ended June 30, 2014, we paid total dividends in the amount of $40.1 million related to the three month periods ended December 31, 2013 and March 31, 2014. In August 2014, our Board of Directors approved a dividend related to the second quarter of 2014 in the amount of $0.77 per share, or approximately $20.1 million, payable on September 15, 2014 to shareholders of record as of August 29, 2014. During the six month period ended June 30, 2013, we paid total dividends in the amount of $52.0 million related to the three month period and year ended December 31, 2012 and the three month period ended March 31, 2013. The following tables set forth the dividend distributions authorized by the Board of Directors payable to shareholders and LTIP holders for the periods indicated below: Six Month Period Ended June 30, 2014 (In thousands except per share amounts) Dividend Per Share Dividend Amount Record Date Payment Date First Quarter $0.77 $ 20,070 May 30, 2014 June 16, 2014 Second Quarter $0.77 $ 20,070 * August 29, 2014 September 15, 2014 * Estimated Six Month Period Ended June 30, 2013 (In thousands except per share amounts) Dividend Per Share Dividend Amount Record Date Payment Date First Quarter $0.77 $ 20,036 May 31, 2013 June 17, 2013 Second Quarter $0.77 $ 20,040 August



30, 2013 September 16, 2013

For the six month period ended June 30, 2014, our operating activities provided net cash in the amount of $48.4 million, and our reverse repo activity used to finance many of our investments (including repayments, in conjunction with the sales of 80



--------------------------------------------------------------------------------

Table of Contents

investments, of amounts borrowed under our reverse repo agreements) used net cash of $47.3 million. Thus our operating activities, when combined with our reverse repo financings, provided net cash of $1.1 million for the six month period ended June 30, 2014. In addition, net contributions from non-controlling interests provided cash of $1.2 million. We used $40.1 million to pay dividends, $0.5 million for distributions to a non-controlling interest (our joint venture partner), and $0.1 for other financing activities. As a result there was a decrease in our cash holdings of $38.5 million from $183.5 million as of December 31, 2013 to $145.0 million as of June 30, 2014. For the six month period ended June 30, 2013, our operating activities used net cash of $317.4 million. Our reverse repo activity used to finance many of our investments (including repayments, in conjunction with the sales of investments, of amounts borrowed under our reverse repo agreements) provided net cash of $382.3 million. Thus our operating activities, when combined with our reverse repo financings, provided net cash of $64.9 million for the six month period ended June 30, 2013. In addition we received proceeds from issuance of common shares of $125.3 million, net of offering costs, and contributions from a non-controlling interest member provided cash of $4.7 million. We used $52.0 million to pay dividends and $0.2 million for other non-operating activity-related uses. As a result there was an increase in our cash holdings of $142.7 million from $59.1 million as of December 31, 2012 to $201.8 million as of June 30, 2013. Based on our current portfolio, amount of free cash on hand, debt-to-equity ratio, and current and anticipated availability of credit, we believe that our capital resources will be sufficient to enable us to meet anticipated short-term and long-term liquidity requirements. However, the unexpected inability to finance our Agency RMBS portfolio would create a serious short-term strain on our liquidity and would require us to liquidate much of that portfolio, which in turn would require us to restructure our portfolio to maintain our exclusion from regulation as an investment company under the Investment Company Act. Steep declines in the values of our RMBS assets financed using reverse repos, or in the values of our derivative contracts, would result in margin calls that would significantly reduce our free cash position. Furthermore, a substantial increase in prepayment rates on our assets financed by reverse repos could cause a temporary liquidity shortfall, because we are generally required to post margin on such assets in proportion to the amount of the announced principal paydowns before the actual receipt of the cash from such principal paydowns. If our cash resources are at any time insufficient to satisfy our liquidity requirements, we may have to sell assets or issue debt or additional equity securities. We are not required by our investment guidelines to maintain any specific debt-to-equity ratio, and we believe that the appropriate leverage for the particular assets we hold depends on the credit quality and risk of those assets, as well as the general availability and terms of stable and reliable financing for those assets. Contractual Obligations and Commitments We are a party to a management agreement with our Manager. Pursuant to that agreement, our Manager is entitled to receive a base management fee, an incentive fee, reimbursement of certain expenses and, in certain circumstances, a termination fee. Such fees and expenses do not have fixed and determinable payments. For a description of the management agreement provisions, see Note 7 of the notes to our consolidated financial statements. We enter into reverse repos with third-party broker-dealers whereby we sell securities to such broker-dealers at agreed-upon purchase prices at the initiation of the reverse repos and agree to repurchase such securities at predetermined repurchase prices and termination dates, thus providing the broker-dealers with an implied interest rate on the funds initially transferred to us by the broker-dealers. We enter into repos with third-party broker-dealers whereby we purchase securities under agreements to resell at an agreed-upon price and date. In general, we most often enter into repo transactions in order to effectively borrow securities that we can then deliver to counterparties to whom we have made short sales of the same securities. The implied interest rates on the repos and reverse repos we enter into are based upon competitive market rates at the time of initiation. Repos and reverse repos that are conducted with the same counterparty may be reported on a net basis if they meet the requirements of ASC 210-20, Balance Sheet, Offsetting. See "-Liquidity and Capital Resources" for a summary of our borrowings on reverse repos. As of June 30, 2014 and December 31, 2013 there were no repurchase agreements or reverse repos reported net on the Consolidated Statement of Assets, Liabilities, and Equity. As of June 30, 2014, we had an aggregate amount at risk under our reverse repos with sixteen counterparties of approximately $206.1 million and as of December 31, 2013, we had an aggregate amount at risk under our reverse repos with fourteen counterparties of approximately $244.7 million. Amounts at risk represent the aggregate excess, if any, for each counterparty of the fair value of collateral held by such counterparty over the amounts outstanding under reverse repos. If the amounts outstanding under repos and reverse repos with a particular counterparty are greater than the collateral held by the counterparty, there is no amount at risk for the particular counterparty. Amount at risk as of June 30, 2014 and December 31, 2013 does not include approximately $4.0 million and $2.8 million, respectively, of net accrued interest, which is defined as accrued interest on securities held as collateral less interest payable on cash borrowed. 81



--------------------------------------------------------------------------------

Table of Contents

Our derivatives are predominantly subject to bilateral collateral arrangements or clearing in accordance with the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. We may be required to deliver or receive cash or securities as collateral upon entering into derivative transactions. Changes in the relative value of derivative transactions may require us or the counterparty to post or receive additional collateral. Entering into derivative contracts involves market risk in excess of amounts recorded on our balance sheet. In the case of cleared derivatives, the clearinghouse becomes our counterparty and the futures commission merchant, or "FCM," acts as an intermediary between us and the clearinghouse with respect to all facets of the related transaction, including the posting and receipt of required collateral. As of June 30, 2014, we had an aggregate amount at risk under our derivative contracts with thirteen counterparties of approximately $21.0 million. We also had $10.1 million of initial margin for cleared OTC derivatives posted to central clearinghouses as of that date. As of December 31, 2013, we had an aggregate amount at risk under our derivatives contracts with eleven counterparties of approximately $23.4 million. We also had $10.1 million of initial margin for cleared OTC derivatives posted to central clearinghouses as of that date. Amounts at risk under our derivatives contracts represent the aggregate excess, if any, for each counterparty of the fair value of our derivative contracts plus our collateral held directly by the counterparty less the counterparty's collateral held by us. If a particular counterparty's collateral held by us is greater than the aggregate fair value of the financial derivatives plus our collateral held directly by the counterparty, there is no amount at risk for the particular counterparty. We are party to a tri-party collateral arrangement under one of our International Swaps and Derivatives Association, or "ISDA," trading agreements whereby a third party holds collateral posted by us. Pursuant to the terms of the arrangement, the third party must follow certain pre-defined actions prior to the release of the collateral to the counterparty or to us. Due from Brokers on the Consolidated Statement of Assets, Liabilities, and Equity includes, at June 30, 2014 and December 31, 2013, collateral posted by us and held by a third-party custodian in the amount of approximately $20.6 million and $22.6 million, respectively. We purchase and sell TBAs and Agency pass-through certificates on a when-issued or delayed delivery basis. The delayed delivery for these securities means that these transactions are more prone to market fluctuations between the trade date and the ultimate settlement date, and thereby are more vulnerable, especially in the absence of margining arrangements with respect to these transactions, to increasing amounts at risk with the applicable counterparties. As of June 30, 2014, in connection with our forward settling TBA and Agency pass-through certificates, we had an aggregate amount at risk with seven counterparties of approximately $3.6 million. As of December 31, 2013, in connection with our forward settling TBA and Agency pass-through certificates, we had an aggregate amount at risk with ten counterparties of approximately $7.8 million. Amounts at risk in connection with our forward settling TBA and Agency pass-through certificates represent the aggregate excess, if any, for each counterparty of the net fair value of the forward settling securities plus our collateral held directly by the counterparty less the counterparty's collateral held by us. If a particular counterparty's collateral held by us is greater than the aggregate fair value of the forward settling securities plus our collateral held directly by the counterparty, there is no amount at risk for the particular counterparty. Off-Balance Sheet Arrangements As of June 30, 2014 and December 31, 2013, we did not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Further, we have not guaranteed any obligations of unconsolidated entities nor do we have any commitment or intent to provide funding to any such entities. As such, we are not materially exposed to any market, credit, liquidity, or financing risk that could arise if we had engaged in such relationships. Inflation 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 so than does inflation. Changes in interest rates do not necessarily correlate with inflation rates or changes in inflation rates. Our activities and balance sheet are measured with reference to historical cost and/or fair market value without considering inflation. Item 3. Quantitative and Qualitative Disclosures about Market Risk The primary components of our market risk at June 30, 2014 and December 31, 2013 are related to credit risk, prepayment risk, and interest rate risk. We seek to actively manage these and other risks and to acquire and hold assets that we believe justify bearing those risks, and to maintain capital levels consistent with those risks. 82



--------------------------------------------------------------------------------

Table of Contents

Credit Risk We are subject to credit risk in connection with many of our assets, especially non-Agency MBS and mortgage loans. Credit losses on real estate loans can occur for many reasons, including, but not limited to, poor origination practices, fraud, faulty appraisals, documentation errors, poor underwriting, legal errors, poor servicing practices, weak economic conditions, decline in the value of homes, businesses or commercial properties, special hazards, earthquakes and other natural events, over-leveraging of the borrower on the property, reduction in market rents and occupancies and poor property management services, changes in legal protections for lenders, reduction in personal income, job loss, and personal events such as divorce or health problems. Property values are subject to volatility and may be affected adversely by a number of factors, including, but not limited to, national, regional, and local economic conditions (which may be adversely affected by industry slowdowns and other factors), local real estate conditions (such as an oversupply of housing), changes or continued weakness in specific industry segments, construction quality, age and design, demographic factors, and retroactive changes to building or similar codes. For mortgage-related instruments, the two primary components of credit risk are default risk and severity risk. Default Risk Default risk is the risk that borrowers will fail to make principal and interest payments on their mortgage loans. We may attempt to mitigate our default risk by, among other things, opportunistically entering into credit default swaps and total return swaps. These instruments can reference various MBS indices, corporate bond indices, or corporate entities, such as publicly traded REITs. We also rely on third-party mortgage servicers to mitigate our default risk, but such third-party mortgage servicers may have little or no economic incentive to mitigate loan default rates. Severity Risk Severity risk is the risk of loss upon a borrower default on a mortgage loan underlying our RMBS. Severity risk includes the risk of loss of value of the property underlying the mortgage loan as well as the risk of loss associated with taking over the property, including foreclosure costs. We rely on third-party mortgage servicers to mitigate our severity risk, but such third-party mortgage servicers may have little or no economic incentive to mitigate loan loss severities. Such mitigation efforts may include loan modification programs and prompt foreclosure and property liquidation following a default. Much of the uncertainty as to the timing and magnitude of loan loss severities can be attributed to the uncertainty in foreclosure timelines. Because of the magnitude of the housing crisis, and in response to the well-publicized failures of many servicers to follow proper foreclosure procedures (such as involving "robo-signing"), mortgage servicers are being held to much higher foreclosure-related documentation standards than they previously were. However, because many mortgages have been transferred and assigned multiple times (and by means of varying assignment procedures) throughout the origination, warehouse and securitization processes, mortgage servicers are generally having much more difficulty furnishing the requisite documentation to initiate or complete foreclosures. This leads to stalled or suspended foreclosure proceedings and ultimately additional foreclosure-related costs. Foreclosure-related delays also tend to increase ultimate loan loss severities as a result of property deterioration, amplified legal and other costs, and other factors. The risk of extended foreclosure timelines is very difficult to quantify, and uncertainty has often been magnified by court cases with conflicting outcomes. Prepayment Risk Prepayment risk is the risk of change, whether an increase or a decrease, in the rate at which principal is returned in respect of mortgage loans underlying RMBS, including both through voluntary prepayments and through liquidations due to defaults and foreclosures. This rate of prepayment is affected by a variety of factors, including the prevailing level of interest rates as well as economic, demographic, tax, social, legal, and other factors. Changes in prepayment rates will have varying effects on the different types of securities in our portfolio, and we attempt to take these effects into account in making asset management decisions. Additionally, increases in prepayment rates may cause us to experience losses on our interest only securities and inverse interest only securities, as those securities are extremely sensitive to prepayment rates. In the current relatively low interest rate environment, one might typically expect higher prepayment rates; however, as mortgage originators have tightened their lending standards and have also made the refinancing process far more cumbersome, the current level of prepayments is not nearly what would otherwise be expected. Prepayment rates, besides being subject to interest rates and borrower behavior, are also substantially affected by government policy and regulation. For example, prepayment risk has been heightened by the Federal Reserve's stated commitment to keep interest rates low in order to spur increased growth in the U.S. economy. The government sponsored HARP program, designed to encourage mortgage refinancings, has also become a factor in prepayment risk. Mortgage rates remain very low by historical standards, and as a result, prepayments continue to represent a meaningful risk, especially with respect to our Agency RMBS. 83



--------------------------------------------------------------------------------

Table of Contents

Interest Rate Risk Interest rates are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations, and other factors beyond our control. We are subject to interest rate risk in connection with most of our assets and liabilities. For some securities in our portfolio, the coupon interest rates on, and therefore also the values of, such securities are highly sensitive to interest rate movements, such as inverse floating rate RMBS, which benefit from falling interest rates. We selectively hedge our interest rate risk by entering into interest rate swaps, TBAs, U.S. Treasury securities, Eurodollar futures, U.S. Treasury futures, and other instruments. In general, such hedging instruments are used to offset the large majority of the interest rate risk we estimate to arise from our Agency RMBS positions. Hedging instruments may also be used to offset a portion of the interest rate risk arising from certain non-Agency MBS positions. The following sensitivity analysis table shows the estimated impact on the value of our portfolio segregated by certain identified categories as of June 30, 2014, assuming a static portfolio and immediate and parallel shifts in interest rates from current levels as indicated below. Estimated Change in value for a Decrease Estimated Change in value for an (In thousands) in Interest Rates by Increase in Interest Rates by 100 Basis Category of Instruments 50 Basis Points 100 Basis Points 50 Basis Points Points Agency RMBS $ 4,311 $



5,385 $ (7,550 )$ (18,335 ) Non-Agency RMBS, CMBS, Other ABS, and Mortgage Loans

6,265 12,694 (6,100 ) (12,037 ) U.S. Treasury Securities, and Interest Rate Swaps, Options, and Futures (11,326 ) (23,308 ) 10,669 20,680 Mortgage-Related Derivatives (366 ) (482 ) 616 1,482 Corporate Securities and Derivatives on Corporate Securities 896 2,076 (611 ) (937 ) Repurchase Agreements and Reverse Repurchase Agreements (515 ) (644 ) 694 1,387 Total $ (735 )$ (4,279 )$ (2,282 )$ (7,760 ) The preceding analysis does not show sensitivity to changes in interest rates for instruments for which we believe that the effect of a change in interest rates is not material to the value of the overall portfolio and/or cannot be accurately estimated. In particular, this analysis excludes certain of our holdings of corporate securities and derivatives on corporate securities, and reflects only sensitivity to U.S. interest rates. Our analysis of interest rate risk is derived from Ellington's proprietary models as well as third-party information and analytics. Many assumptions have been made in connection with the calculations set forth in the table above and, as such, there can be no assurance that assumed events will occur or that other events will not occur that would affect the outcomes. For example, for each hypothetical immediate shift in interest rates, assumptions have been made as to the response of mortgage prepayment rates, the shape of the yield curve, and market volatilities of interest rates; each of the foregoing factors can significantly and adversely affect the fair value of our interest rate-sensitive instruments. The above analysis utilizes assumptions and estimates based on management's judgment and experience, and relies on financial models, which are inherently imperfect; in fact, different models can produce different results for the same securities. While the table above reflects the estimated impacts of immediate parallel interest rate increases and decreases on specific categories of instruments in our portfolio, we actively trade many of the instruments in our portfolio, and therefore our current or future portfolios may have risks that differ significantly from those of our June 30, 2014 portfolio estimated above. Moreover, the impact of changing interest rates on fair value can change significantly when interest rates change by a greater amount than the hypothetical shifts assumed above. Furthermore, our portfolio is subject to many risks other than interest rate risks, and these additional risks may or may not be correlated with changes in interest rates. For all of the foregoing reasons and others, the table above is for illustrative purposes only and actual changes in interest rates would likely cause changes in the actual fair value of our portfolio that would differ from those presented above, and such differences might be significant and adverse. See "Management's Discussion and Analysis of Financial Condition and Results of Operations-Special Note Regarding Forward-Looking Statements." Item 4. Controls and Procedures Disclosure Controls and Procedures We maintain disclosure controls and procedures that are designed to ensure that information required to be disclosed in the reports that we file or submit under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized 84



--------------------------------------------------------------------------------

Table of Contents

and reported within the time periods specified in the rules and forms of the SEC, and that such information is accumulated and communicated to our management as appropriate to allow timely decisions regarding required disclosures. An evaluation was performed under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) as of June 30, 2014. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of June 30, 2014. Internal Control Over Financial Reporting There have been no changes in our internal control over financial reporting that occurred during the three month period ended June 30, 2014 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.


For more stories on investments and markets, please see HispanicBusiness' Finance Channel



Source: Edgar Glimpses


Story Tools






HispanicBusiness.com Facebook Linkedin Twitter RSS Feed Email Alerts & Newsletters