10-Q 1 d10q.htm FORM 10-Q Form 10-Q

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934

For the quarterly period ended June 30, 2011

OR

 

¨ TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934

Commission file number 001-34057

 

 

LOGO

AMERICAN CAPITAL AGENCY CORP.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   26-1701984

(State or Other Jurisdiction of

Incorporation or Organization)

 

(I.R.S. Employer

Identification No.)

2 Bethesda Metro Center, 14th Floor

Bethesda, Maryland 20814

(Address of principal executive offices)

(301) 968-9300

(Registrant’s telephone number, including area code)

 

 

Indicate by check mark whether the registrant (1) has filed all reports to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter earlier period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer   x      Accelerated filer   ¨
Non-accelerated filer   ¨   (Do not check if a smaller reporting company)    Smaller Reporting Company   ¨

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x

The number of shares of the issuer’s common stock, $0.01 par value, outstanding as of July 31, 2011 was 178,511,759

 

 

 


AMERICAN CAPITAL AGENCY CORP.

TABLE OF CONTENTS

 

PART I. FINANCIAL INFORMATION

  

Item 1.

   Financial Statements      2   

Item 2.

   Management’s Discussion and Analysis of Financial Condition and Results of Operations      30   

Item 3.

   Quantitative and Qualitative Disclosures About Market Risk      45   

Item 4.

   Controls and Procedures      47   
PART II. OTHER INFORMATION   

Item 1.

   Legal Proceedings      48   

Item 1A.

   Risk Factors      48   

Item 2.

   Unregistered Sales of Equity Securities and Use of Proceeds      50   

Item 3.

   Defaults Upon Senior Securities      50   

Item 4.

   Removed and Reserved      50   

Item 5.

   Other Information      50   

Item 6.

   Exhibits      51   

Signatures

  

 

1


ITEM 1. Financial Statements

AMERICAN CAPITAL AGENCY CORP.

CONSOLIDATED BALANCE SHEETS

(in thousands, except per share data)

 

     June 30, 2011      December 31, 2010  
     (Unaudited)         

Assets:

     

Agency securities, at fair value (including pledged assets of $35,117,998 and $12,270,909, respectively)

   $ 39,925,707       $ 13,510,280   

Cash and cash equivalents

     625,850         173,258   

Restricted cash

     188,772         76,094   

Interest receivable

     139,265         56,485   

Derivative assets, at fair value

     86,064         76,593   

Receivable for agency securities sold

     1,251,624         258,984   

Principal payments receivable

     29,254         75,524   

Receivable under reverse repurchase agreements

     1,388,188         247,438   

Other assets

     1,846         1,173   
  

 

 

    

 

 

 

Total assets

   $ 43,636,570       $ 14,475,829   
  

 

 

    

 

 

 

Liabilities:

     

Repurchase agreements

   $ 33,505,142       $ 11,680,092   

Other debt

     61,757         72,927   

Payable for agency securities purchased

     3,336,485         727,374   

Derivative liabilities, at fair value

     290,286         78,590   

Dividend payable

     180,360         90,798   

Obligation to return securities borrowed under reverse repurchase agreements, at fair value

     1,459,298         245,532   

Accounts payable and other accrued liabilities

     26,596         8,452   
  

 

 

    

 

 

 

Total liabilities

     38,859,924         12,903,765   
  

 

 

    

 

 

 

Stockholders’ equity:

     

Preferred stock, $0.01 par value; 10,000 shares authorized, 0 shares issued and outstanding, respectively

     —           —     

Common stock, $0.01 par value; 300,000 and 150,000 shares authorized, 178,509 and 64,856 shares issued and outstanding, respectively

     1,785         649   

Additional paid-in capital

     4,682,070         1,561,908   

Retained earnings

     73,841         78,116   

Accumulated other comprehensive income (loss)

     18,950         (68,609
  

 

 

    

 

 

 

Total stockholders’ equity

     4,776,646         1,572,064   
  

 

 

    

 

 

 

Total liabilities and stockholders’ equity

   $ 43,636,570       $ 14,475,829   
  

 

 

    

 

 

 

See accompanying notes to consolidated financial statements.

 

2


AMERICAN CAPITAL AGENCY CORP.

CONSOLIDATED STATEMENTS OF OPERATIONS

AND COMPREHENSIVE INCOME

(Unaudited)

(in thousands, except per share data)

 

     For the three months ended June 30,     For the six months ended June 30,  
             2011                     2010                     2011                     2010          

Interest income:

        

Interest income

   $ 264,728      $ 50,589      $ 429,221      $ 89,386   

Interest expense

     63,816        17,348        99,464        32,858   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income

     200,912        33,241        329,757        56,528   
  

 

 

   

 

 

   

 

 

   

 

 

 

Other (loss) income, net:

        

Gain on sale of agency securities, net

     93,892        29,585        98,112        56,993   

Loss on derivative instruments and trading securities, net

     (100,013     (21,867     (88,484     (15,947
  

 

 

   

 

 

   

 

 

   

 

 

 

Total other (loss) income, net

     (6,121     7,718        9,628        41,046   
  

 

 

   

 

 

   

 

 

   

 

 

 

Expenses:

        

Management fees

     12,423        2,314        20,877        4,098   

General and administrative expenses

     4,546        1,787        7,143        3,468   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total expenses

     16,969        4,101        28,020        7,566   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income

   $ 177,822      $ 36,858      $ 311,365      $ 90,008   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income per common share—basic and diluted

   $ 1.36      $ 1.23      $ 2.82      $ 3.28   
  

 

 

   

 

 

   

 

 

   

 

 

 

Weighted average number of common shares outstanding—basic and diluted

     130,467        29,872        110,496        27,451   
  

 

 

   

 

 

   

 

 

   

 

 

 

Dividends declared per common share

   $ 1.40      $ 1.40      $ 2.80      $ 2.80   
  

 

 

   

 

 

   

 

 

   

 

 

 

Comprehensive income:

        

Net income

   $ 177,822      $ 36,858      $ 311,365      $ 90,008   
  

 

 

   

 

 

   

 

 

   

 

 

 

Other comprehensive income:

        

Unrealized gain on available-for-sale securities, net

     318,899        59,484        279,097        61,417   

Unrealized loss on derivative instruments, net

     (252,664     (38,906     (191,538     (52,382
  

 

 

   

 

 

   

 

 

   

 

 

 

Other comprehensive income

     66,235        20,578        87,559        9,035   
  

 

 

   

 

 

   

 

 

   

 

 

 

Comprehensive income

   $ 244,057      $ 57,436      $ 398,924      $ 99,043   
  

 

 

   

 

 

   

 

 

   

 

 

 

See accompanying notes to consolidated financial statements.

 

3


AMERICAN CAPITAL AGENCY CORP.

CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY

(in thousands)

 

    Preferred Stock     Common Stock     Additional
Paid-in

Capital
    Retained
Earnings
    Accumulated
Other
Comprehensive

(Loss) Income
    Total  
    Shares     Amount     Shares     Amount          

Balance, December 31, 2010

    —        $ —          64,856      $ 649      $ 1,561,908      $ 78,116      $ (68,609   $ 1,572,064   

Net income

    —          —          —          —          —          133,543        —          133,543   

Other comprehensive income (loss):

               

Unrealized loss on available- for-sale securities, net

    —          —          —          —          —          —          (39,802     (39,802

Unrealized gain on designated derivative instruments, net

    —          —          —          —          —          —          61,126        61,126   

Issuance of common stock

    —          —          63,964        639        1,752,173        —          —          1,752,812   

Issuance of restricted stock

    —          —          9        —          —          —          —          —     

Stock-based compensation

    —          —          —          —          38        —          —          38   

Common dividends declared

    —          —          —          —          —          (135,280     —          (135,280
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, March 31, 2011 (Unaudited)

    —          —          128,829        1,288        3,314,119        76,379        (47,285     3,344,501   

Net income

    —          —          —          —          —          177,822        —          177,822   

Other comprehensive income (loss):

               

Unrealized gain on available- for-sale securities, net

    —          —          —          —          —          —          318,899        318,899   

Unrealized loss on derivative instruments, net

    —          —          —          —          —          —          (252,664     (252,664

Issuance of common stock

    —          —          49,680        497        1,367,907        —          —          1,368,404   

Stock-based compensation

    —          —          —          —          44        —          —          44   

Common dividends declared

    —          —          —          —          —          (180,360     —          (180,360
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Balance, June 30, 2011 (Unaudited)

    —        $ —          178,509      $ 1,785      $ 4,682,070      $ 73,841      $ 18,950      $ 4,776,646   
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

See accompanying notes to consolidated financial statements.

 

4


AMERICAN CAPITAL AGENCY CORP.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in thousands)

 

     For the six months ended June 30,  
     2011     2010  

Operating activities:

    

Net income

   $ 311,365      $ 90,008   

Adjustments to reconcile net income to net cash provided by operating activities:

    

Amortization of agency securities premiums and discounts, net

     126,942        35,192   

Amortization of interest rate swap termination fee

     —          6,278   

Stock-based compensation

     82        42   

Gain on sale of agency securities, net

     (98,112     (56,993

Loss on derivative instruments and trading securities, net

     88,484        15,947   

Increase in interest receivable

     (82,780     (13,060

Increase in other assets

     (673     (382

Increase (decrease) in accounts payable and other accrued liabilities

     18,144        (1,263
  

 

 

   

 

 

 

Net cash provided by operating activities

     363,452        75,769   
  

 

 

   

 

 

 

Investing activities:

    

Purchases of agency securities

     (37,811,048     (8,191,504

Proceeds from sale of agency securities

     11,489,300        4,534,061   

Purchases of trading securities

     (3,021,675     (279,164

Proceeds from sale of trading securities

     3,050,224        280,607   

Proceeds from U.S. Treasury securities sold, not yet purchased

     8,552,609        —     

Purchase of U.S. Treasury securities sold, not yet purchased

     (7,338,951     —     

Proceeds from reverse repurchase agreements

     15,920,855        —     

Payments made on reverse repurchase agreements

     (17,061,605     —     

Net proceeds from (payments on) other derivative instruments not designated as qualifying hedges

     (109,274     (6,122

Principal collections on agency securities

     1,822,367        599,776   
  

 

 

   

 

 

 

Net cash used in investing activities

     (24,507,198     (3,062,346
  

 

 

   

 

 

 

Financing activities:

    

Cash dividends paid

     (226,079     (71,515

Increase in restricted cash

     (112,678     (18,249

Proceeds from repurchase arrangements, net

     21,825,050        2,792,508   

Repayments on other debt

     (11,170     —     

Net proceeds from common stock issuances

     3,121,215        231,111   
  

 

 

   

 

 

 

Net cash provided by financing activities

     24,596,338        2,933,855   
  

 

 

   

 

 

 

Net change in cash and cash equivalents

     452,592        (52,722

Cash and cash equivalents at beginning of period

     173,258        202,803   
  

 

 

   

 

 

 

Cash and cash equivalents at end of period

   $ 625,850      $ 150,081   
  

 

 

   

 

 

 

See accompanying notes to consolidated financial statements.

 

5


AMERICAN CAPITAL AGENCY CORP.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1. Unaudited Interim Consolidated Financial Statements

The interim consolidated financial statements of American Capital Agency Corp. (together with its consolidated subsidiary, is referred throughout this report as the “Company”, “we”, “us” and “our”) are prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information and pursuant to the requirements for reporting on Form 10-Q and Article 10 of Regulation S-X. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of income and expenses during the reporting period. Actual results could differ from those estimates.

Our unaudited consolidated financial statements include the accounts of our wholly-owned subsidiary, American Capital Agency TRS, LLC, and variable interest entities for which the Company is the primary beneficiary. Significant intercompany accounts and transactions have been eliminated. In the opinion of management, all adjustments, consisting solely of normal recurring accruals, necessary for the fair presentation of financial statements for the interim period have been included. The current period’s results of operations are not necessarily indicative of results that ultimately may be achieved for the year. Through June 30, 2011, there has been no activity in American Capital Agency TRS, LLC.

Note 2. Organization

We were organized in Delaware on January 7, 2008, and commenced operations on May 20, 2008 following the completion of our initial public offering (“IPO”). Our common stock is traded on The NASDAQ Global Select Market under the symbol “AGNC”.

We have elected to be taxed as a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986, as amended (the “Code”). As such, we are required to distribute annually 90% of our taxable net income. As long as we qualify as a REIT, we will generally not be subject to U.S. federal or state corporate taxes on our taxable net income to the extent that we distribute all of our annual taxable net income to our stockholders. We are externally managed by American Capital AGNC Management, LLC (our “Manager”), an affiliate of American Capital, Ltd. (“American Capital”).

We earn income primarily from investing in residential mortgage pass-through securities and collateralized mortgage obligations (“CMOs”) on a leveraged basis. These investments consist of securities for which the principal and interest payments are guaranteed by government-sponsored entities (“GSEs”), such as the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”), or by a U.S. Government agency, such as the Government National Mortgage Association (“Ginnie Mae”). We refer to these types of securities as agency securities and the specific agency securities in which we invest as our investment portfolio.

Our principal objective is to preserve our net asset value while generating attractive risk-adjusted returns for distribution to our stockholders through regular quarterly dividends from our net interest income, which is the spread between the interest income earned on our interest earning assets and the interest costs of our borrowings and hedging activities, and net realized gains and losses on our investments and other supplemental hedging activities. We fund our investments primarily through short-term borrowings structured as repurchase agreements.

 

6


Note 3. Summary of Significant Accounting Policies

Investments in Agency Securities

Accounting Standards Codification (“ASC”) Topic 320, Investments—Debt and Equity Securities (“ASC 320”), requires that at the time of purchase, we designate a security as held-to-maturity, available-for-sale or trading, depending on our ability and intent to hold such security to maturity. Securities classified as trading and available-for-sale are reported at fair value, while securities classified as held-to-maturity are reported at amortized cost. We may, from time to time, sell any of our agency securities as part of our overall management of our investment portfolio. Accordingly, we typically designate our agency securities as available-for-sale. All securities classified as available-for-sale are reported at fair value, with unrealized gains and losses reported in other comprehensive income (loss) (“OCI”), a component of stockholders’ equity. Upon the sale of a security, we determine the cost of the security and the amount of unrealized gains or losses to reclassify out of accumulated OCI into earnings based on the specific identification method.

Interest-only securities and inverse interest-only securities (collectively referred to as “interest-only securities”) represent our right to receive a specified proportion of the contractual interest flows of specific agency and CMO securities. Principal-only securities represent our right to receive the contractual principal flows of specific agency and CMO securities. Interest-only and principal-only securities are measured at fair value through earnings in gain (loss) on derivative instruments and trading securities, net in our consolidated statements of operations and comprehensive income. Our investments in interest-only and principal-only securities are included in agency securities, at fair value on the accompanying consolidated balance sheets.

We estimate the fair value of our agency securities based on a market approach using Level 2 inputs from third-party pricing services and dealer quotes. The third-party pricing services use pricing models that incorporate such factors as coupons, primary and secondary mortgage rates, prepayment speeds, spread to the Treasury and interest rate swap curves, convexity, duration, periodic and life caps and credit enhancements. The dealer quotes incorporate common market pricing methods, including a spread measurement to the Treasury or interest rate swap curve as well as underlying characteristics of the particular security including coupon, periodic and life caps, rate reset period, issuer, additional credit support and expected life of the security.

We evaluate securities for other-than-temporary impairment (“OTTI”) on at least a quarterly basis, and more frequently when economic or market conditions warrant such evaluation. Based on the criteria in ASC 320, the determination of whether a security is other-than-temporarily impaired involves judgments and assumptions based on subjective and objective factors. When an agency security is impaired, an OTTI is considered to have occurred if (i) we intend to sell the agency security (i.e. a decision has been made as the reporting date) or (ii) it is more likely than not that we will be required to sell the agency security before recovery of its amortized cost basis. If we intend to sell the security or if it is more likely than not that we will be required to sell the agency security before recovery of its amortized cost basis, the entire amount of the impairment loss, if any, is recognized in earnings as a realized loss and the cost basis of the security is adjusted to its fair value.

We did not recognize any OTTI charges on any of our agency securities for six months ended June 30, 2011 and 2010.

Interest Income

Interest income is accrued based on the outstanding principal amount of the agency securities and their contractual terms. Premiums and discounts associated with the purchase of agency securities are amortized or accreted into interest income over the projected lives of the securities, including contractual payments and estimated prepayments using the interest method in accordance with ASC Subtopic 310-20, Receivables—Nonrefundable Fees and Other Costs (“ASC 310-20”).

We estimate long-term prepayment speeds using a third-party service and market data. The third-party service estimates prepayment speeds using models that incorporate the forward yield curve, current mortgage rates, current mortgage rates of the outstanding loans, loan age, volatility and other factors. We review the

 

7


prepayment speeds estimated by the third-party service and compare the results to market consensus prepayment speeds, if available. We also consider historical prepayment speeds and current market conditions to validate the reasonableness of the prepayment speeds estimated by the third-party service and based on our Manager’s judgment we may make adjustments to their estimates. Actual and anticipated prepayment experience is reviewed quarterly and effective yields are recalculated when differences arise between the previously estimated future prepayments and the amounts actually received plus current anticipated future prepayments. If the actual and anticipated future prepayment experience differs from our prior estimate of prepayments, we are required to record an adjustment in the current period to the amortization or accretion of premiums and discounts for the cumulative difference in the effective yield through the reporting date.

In addition, pursuant to ASC 310-20, the yield on our adjustable rate securities assumes that the securities reset at a rate equal to the underlying index rate in effect as of the date we acquired the security plus the stated margin. Consequently, future reset rate assumptions incorporated in our asset yields may differ materially from future reset rates implied by the forward yield curve and the actual reset rates ultimately achieved. Further, notwithstanding changes to our actual and projected constant prepayment rate (“CPR”) assumptions, the lower our reset rate assumption is pursuant to ASC 310-20 than the current fixed rate in effect, the greater the rate of premium amortization we will recognize over the initial fixed rate period.

Our adjustable rate portfolio was acquired for a premium above par value and most securities were acquired during a period of historically low index rates. Accordingly, the majority of the premium balance on our adjustable rate securities will be amortized prior to their first reset date, regardless of actual or forecasted prepayment speeds and changes in the underlying index rates prior to actual reset. Adjustable rate securities acquired during a different interest rate environment may experience a different premium amortization pattern even as current index rates remain near their historical lows.

Derivative and other Hedging Instruments

We maintain a risk management strategy, under which we use a variety of strategies to hedge some of our exposure to interest rate risk. The objective of our risk management strategy is to reduce fluctuations in book value and generate additional income distributable to stockholders. In particular, we attempt to mitigate the risk of the cost of our variable rate liabilities increasing during a period of rising interest rates. The principal instruments that we use are interest rate swaps and options to enter into interest rate swaps (“interest rate swaptions”). We also purchase or sell to-be-announced forward contracts (“TBAs”), forward contracts for specified agency securities, U.S. Treasury securities and U.S. Treasury futures contracts, purchase or write put or call options on TBA securities and invest in other types of mortgage derivatives, such as interest-only securities, and synthetic total return swaps, such as the Markit IOS Synthetic Total Return Swap Index (“Markit IOS Index”).

We account for derivative instruments in accordance with ASC Topic 815, Derivatives and Hedging (“ASC 815”). ASC 815 requires an entity to recognize all derivatives as either assets or liabilities in the balance sheet and to measure those instruments at fair value. Hedging instruments that are not derivatives under ASC 815 are accounted for in accordance with ASC 320.

The accounting for changes in the fair value of derivatives depends on the intended use of the derivative and the resulting designation. Derivatives that are intended to hedge exposure to variability in expected future cash flows are considered cash flow hedges. For derivatives designated in qualifying cash flow hedging relationships, the effective portion of the fair value adjustments is initially recorded in OCI (a component of stockholders’ equity) and reclassified to income at the time that the hedged transactions affect earnings. The ineffective portion of the fair value adjustments is immediately recognized in gain (loss) on derivative instruments and trading securities, net. When the underlying hedged transaction ceases to exist, any amounts that have been previously recorded in accumulated OCI would be reclassified to net income and all subsequent changes in the fair value of the instrument would be included in gain (loss) on derivative instruments and trading securities, net for each period until the derivative instrument matures or is settled. For derivatives not designated in hedging

 

8


relationships under ASC 815, the fair value adjustments are recorded in gain (loss) on derivative instruments and trading securities, net. Derivatives in a gain position are reported as derivative assets at fair value and derivatives in a loss position are reported as derivative liabilities at fair value in our consolidated balance sheets. In our consolidated statements of cash flows, cash receipts and payments related to derivative instruments are classified according to the underlying nature or purpose of the derivative transaction, generally in the operating section for derivatives designated in hedging relationships and the investing section for derivatives not designated in hedging relationships.

The use of derivatives creates exposure to credit risk relating to potential losses that could be recognized in the event that the counterparties to these instruments fail to perform their obligations under the contracts. We attempt to minimize this risk by limiting our counterparties to major financial institutions with acceptable credit ratings and monitoring positions with individual counterparties.

Interest rate swap agreements

We use interest rate swaps to hedge the variable cash flows associated with short-term borrowings made under our repurchase agreement facilities. We generally enter into such derivatives with the intention of qualifying for hedge accounting under ASC 815.

We estimate the fair value of interest rate swaps based on inputs from a third-party pricing model. The third-party pricing model incorporates such factors as the Treasury curve, LIBOR rates, and the pay rate on the interest rate swaps. We also incorporate both our own and our counterparties’ nonperformance risk in estimating the fair value of our interest rate swap and swaption agreements. In considering the effect of nonperformance risk, we consider the impact of netting and credit enhancements, such as collateral postings and guarantees, and have concluded that our own and our counterparty risk is not significant to the overall valuation of these agreements.

Interest rate swaptions

We may purchase interest rate swaptions to help mitigate the potential impact of increases or decreases in interest rates on the performance of our investment portfolio (referred to as “convexity risk”). The interest rate swaptions provide us the option to enter into an interest rate swap agreement for a predetermined notional amount, stated term and pay and receive interest rates in the future. The premium paid for interest rate swaptions is reported as an asset in our consolidated balance sheets. The premium is valued at an amount equal to the fair value of the swaption that would have the effect of closing the position adjusted for nonperformance risk, if any. The difference between the premium and the fair value of the swaption is reported in gain (loss) on derivative instruments and trading securities, net in our consolidated statement of operations and comprehensive income. If a swaption expires unexercised, the loss on the swaption would be equal to the premium paid. If we sell or exercise a swaption, the realized gain or loss on the swaption would be equal to the difference between the cash or the fair value of the underlying interest rate swap received and the premium paid.

We estimate the fair value of interest rate swaptions based on the fair value of the future interest rate swap that we have the option to enter into as well as the remaining length of time that we have to exercise the option.

TBA securities

A TBA security is a futures contract for the purchase or sale of agency securities at a predetermined price, face amount, issuer, coupon and stated maturity on an agreed-upon future date. The specific agency securities delivered into the contract upon the settlement date, published each month by the Securities Industry and Financial Markets Association, are not known at the time of the transaction. TBA securities are exempt from ASC 815 and are accounted for under ASC 320 if there is no other way to purchase or sell that security, if delivery of that security and settlement will occur within the shortest period possible for that type of security and if it is probable at inception and throughout the term of the individual contract that physical delivery of the

 

9


security will occur (referred to as the “regular-way” exception). Alternatively, we may designate the TBA security as a qualifying cash flow hedge under ASC 815 if the regular-way exception is not met and at the time of the purchase or sale of the security, and throughout the term of the individual contract, it is probable that the forecasted transaction will occur and the hedging relationship is expected to be highly effective. For TBA security contracts that we have entered into, we have generally not asserted that physical settlement is probable or that the forecasted transaction is probable of occurring and, therefore, we typically have not designated these forward commitments as hedging instruments. Realized and unrealized gains and losses associated with TBA contracts not subject to the regular-way exception or not designated as hedging instruments are recognized in our consolidated statement of operations and comprehensive income in the line item gain (loss) on derivative instruments and trading securities, net.

We estimate the fair value of TBA securities based on similar methods used to value agency securities.

Put and call options on TBA securities

We may purchase put and call options on TBA securities to hedge against short-term changes in interest rates. Under a purchased put option, we have the right to sell to the counterparty a specified TBA security at a predetermined price on the option exercise date in exchange for a premium at execution. Under a purchased call option, we have the right to purchase from the counterparty a specified TBA security at a predetermined price on the option exercise date in exchange for a premium at execution. The premium paid for a put or call option is reported as an asset in our consolidated balance sheets. The premium is valued at an amount equal to the fair value of the option that would have the effect of closing the position adjusted for nonperformance risk, if any. The difference between the premium and the fair value of the option is reported in gain (loss) on derivative instruments and trading securities, net in our consolidated statement of operations and comprehensive income. When a purchased put or call option expires unexercised, a realized loss is reported in our consolidated statement of operations and comprehensive income equal to the premium paid. When a purchased put or call option is exercised, a realized gain or loss is reported in our consolidated statement of operations and comprehensive income equal to the difference between the premium paid and the fair value of the exercised put or call option. In addition, a derivative asset is recorded in our consolidated balance sheet for the TBA security resulting from the put or call option exercise.

We may also write put and call options on TBA securities. Under a written put option, the counterparty has the right to sell us a specified TBA security at a predetermined price on the option exercise date in exchange for a premium at execution. Under a written call option, the counterparty has the right to purchase from us a specified TBA security at a predetermined price on the option exercise date in exchange for a premium at execution. The premium received from writing a put or call option is reported as a liability in our consolidated balance sheets. The premium is valued at an amount equal to the fair value of the option that would have the effect of closing the position adjusted for nonperformance risk, if any. The difference between the premium and the fair value of the option is reported in gain (loss) on derivative instruments and trading securities, net in our consolidated statement of operations and comprehensive income. When a written put or call option expires unexercised, a realized gain is reported in our consolidated statement of operations equal to the premium received. When we terminate a written put or call option, a realized gain or loss is reported in our consolidated statement of operations equal to the difference between the termination payment and the premium received. When a written put or call option is exercised, a realized gain or loss is reported in our consolidated statement of operations equal to the difference between the premium received and the fair value of the exercised put or call option. In addition, a derivative asset or liability is recorded in our consolidated balance sheet for the TBA security resulting from the put or call option exercise.

We estimate the fair value of put and call options on TBA securities based on the fair value of the underlying TBA security as well as the remaining length of time to exercise the option.

 

10


Forward commitments to purchase or sell specified agency securities

We may enter into a forward commitment to purchase or sell specified agency securities as a means of acquiring assets or as a hedge against short-term changes in interest rates. Contracts for the purchase or sale of specified agency securities are accounted for as derivatives if the delivery of the specified agency security and settlement extends beyond the shortest period possible for that type of security. We may designate the forward commitment as a qualifying cash flow hedge if at the time of the purchase or sale of the security, and throughout the term of the individual contract, it is probable that physical delivery of the security will occur. Realized and unrealized gains and losses associated with forward commitments not designated as hedging instruments are recognized in our consolidated statement of operations and comprehensive income in the line item gain (loss) on derivative instruments and trading securities, net.

We estimate the fair value of forward commitments to purchase or sell specified agency securities based on similar methods used to value agency securities as well as the remaining length of time of the forward commitment.

U.S. Treasury securities

We may purchase or sell short U.S. Treasury securities and U.S. Treasury futures contracts to help mitigate the potential impact of changes in interest rates on the performance of our portfolio. We may borrow securities to cover short sales of U.S. Treasury securities under reverse repurchase agreements. We account for these as securities borrowing transactions and recognize an obligation to return the borrowed securities at fair value on the balance sheet based on the value of the underlying borrowed securities as of the reporting date. Realized and unrealized gains and losses associated with purchases and short sales of U.S. Treasury securities are recognized in gains (losses) on derivative instruments and trading securities, net in our consolidated statements of operations and comprehensive income.

Total return swaps

We may enter into total return swaps to obtain exposure to a security or market sector without owning such security or investing directly in that market sector. Total return swaps are agreements in which there is an exchange of cash flows whereby one party commits to make payments based on the total return (coupon plus the mark-to-market movement) of an underlying instrument or index in exchange for fixed or floating rate interest payments. To the extent the total return of the instrument or index underlying the transaction exceeds or falls short of the offsetting interest rate obligation, we will receive a payment from or make a payment to the counterparty.

The primary total return swap index in which we invest is the Markit IOS Index. Total return swaps based on the Markit IOS index are intended to synthetically replicate the performance of interest-only securities. We determine the fair value of our total return swaps based on published index prices. Realized and unrealized gains and losses associated with changes in market value of the underlying index and coupon interest are recognized in gain (loss) on derivative instruments and trading securities, net in our consolidated statements of operations and comprehensive income.

Variable Interest Entities

ASC Topic 810, Consolidation (“ASC 810”), requires a qualitative assessment in determining the primary beneficiary of a variable interest entities (“VIEs”) and ongoing assessments of control over such entities as well as additional disclosures for entities that have variable interests in VIEs.

We may enter into transactions involving a CMO trust (e.g. a VIE) whereby we transfer agency securities to an investment bank in exchange for cash proceeds and at the same time enter into a commitment with the same investment bank to purchase to-be-issued securities collateralized by the agency securities transferred. We will consolidate a CMO trust (as it relates to the assets transferred or contributed by us and the related liabilities issued by the trust) if we are the CMO trust’s primary beneficiary; that is, if we have a variable interest (or

 

11


combination of variable interests) that provides us with a controlling financial interest in the CMO trust. An entity is deemed to have a controlling financial interest if the entity has the power to direct the activities of a VIE that most significantly impacts the VIE’s economic performance and the obligation to absorb losses of or right to receive benefits from the VIE that could potentially be significant to the VIE. In determining if we have a controlling financial interest, we evaluate whether we share the power to control the selection of financial assets transferred to the CMO trust with an unrelated party. We may share power in the selection of assets for certain CMO trusts (i.e., both we and the unrelated party must consent to the transfer of such assets to the CMO trust); however, if our economic interest in the CMO trust is disproportionate to the shared power, we may be deemed to be the primary beneficiary.

Recent Accounting Pronouncements

In April 2011, the Financial Accounting Standards Board (“FASB”) issued ASU No. 2011-03, Transfers and Servicing (Topic 860): Reconsideration of Effective Control for Repurchase Agreements (“ASU 2011-03”), which is intended to improve the accounting for repurchase agreements by removing from the assessment of effective control the criterion requiring the transferor to have the ability to repurchase or redeem the financial assets on substantially the agreed terms, even in the event of default by the transferee, as well as implementation guidance related to that criterion. ASU 2011-03 is effective for the first interim or annual period beginning on or after December 15, 2011 and the guidance should be applied prospectively to transactions or modifications of existing transactions that occur on or after the effective date. Early adoption is not permitted. We do not believe the adoption of ASU 2011-03 will have a material impact on our consolidated financial statements.

In May 2011, the FASB issued ASU No. 2011-04, Fair Value Measurement (Topic 820): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (“ASU 2011-04”) which largely aligns fair value measurement and disclosure requirements between International Financial Reporting Standards and US GAAP. For US GAAP, the update mainly represents clarifications to Topic 820 as well as some instances where a particular principle or requirement for measuring fair value or disclosing information about fair value measurements has changed. ASU 2011-04 clarifies that (i) the highest and best use concept only applies to nonfinancial assets (ii) an instrument classified in shareholders’ equity should be measured from the perspective of a market participant holding that instrument as an asset and (iii) quantitave disclosure is required for unobservable inputs used in Level 3 measurements. ASU 2011-04 changes the guidance in Topic 820 so that (i) the fair value of a group of financial assets and financial liabilities with similar risk exposures may be measured on the basis of the entity’s net risk exposure (ii) premiums or discounts may be applied in a fair value measurement under certain circumstances but blockage factors are not permitted and (iii) additional Level 3 disclosures are required, including a narrative description of the sensitivity of the fair value measurement to changes in unobservable inputs. ASU 2011-04 is effective for interim and annual periods beginning after December 15, 2011. Early application by public entities is not permitted. We do not believe the adoption of ASU 2011-04 will have a material impact on our consolidated financial statements.

In June 2011, the FASB issued ASU No. 2011-05, Comprehensive Income (Topic 220): Presentation of Comprehensive Income (“ASU 2011-05”), which is intended to make the presentation of items within OCI more prominent. ASU 2011-05 requires companies to present comprehensive income in either one continuous statement or two separate but consecutive financial statements. Upon the effectiveness of ASU 2011-05, companies will no longer be allowed to present OCI in the statement of stockholders’ equity. In addition, reclassification adjustments between OCI and net income must be presented seperately on the face of the financial statements. The new guidance does not change the components of OCI or the calculation of earnings per share. ASU 2011-05 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Early adoption is permitted and the amendments should be applied retrospectively. We do not believe the adoption of ASU 2011-05 will have a material impact on our consolidated financial statements.

Reclassifications

 

Certain prior period amounts in the consolidated financial statements have been reclassified to conform to the current period presentation.

 

12


Note 4. Agency Securities

The following tables summarize our investments in agency securities as of June 30, 2011 (dollars in thousands):

 

     As of June 30, 2011  
     Fannie Mae     Freddie Mac     Ginnie Mae     Total  

Available-for-sale securities:

        

Agency securities, par

   $ 23,109,832      $ 14,729,370      $ 107,989      $ 37,947,191   

Unamortized discount

     (989     (1,074     —          (2,063

Unamortized premium

     915,068        563,089        4,227        1,482,384   
  

 

 

   

 

 

   

 

 

   

 

 

 

Amortized cost

     24,023,911        15,291,385        112,216        39,427,512   

Gross unrealized gains

     219,434        113,221        1,613        334,268   

Gross unrealized losses

     (51,171     (31,926     (20     (83,117
  

 

 

   

 

 

   

 

 

   

 

 

 

Available-for-sale securities, at fair value

     24,192,174        15,372,680        113,809        39,678,663   
  

 

 

   

 

 

   

 

 

   

 

 

 

Agency securities remeasured at fair value through earnings:

        

Interest-only and principal-only securities, amortized cost(1)

     154,706        84,940        —          239,646   

Gross unrealized gains

     5,879        5,975        —          11,854   

Gross unrealized losses

     (2,160     (2,296     —          (4,456
  

 

 

   

 

 

   

 

 

   

 

 

 

Agency securities measured at fair value through earnings, at fair value

     158,425        88,619        —          247,044   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total agency securities, at fair value

   $ 24,350,599      $ 15,461,299      $ 113,809      $ 39,925,707   
  

 

 

   

 

 

   

 

 

   

 

 

 

Weighted average coupon as of June 30, 2011(2)

     4.47     4.39     4.16     4.44

Weighted average yield as of June 30, 2011(3)

     3.44     3.47     2.15     3.45

Weighted average yield for the three months ended

        

June 30, 2011(3)

     3.36     3.35     2.15     3.35

 

(1) Interest-only securities represent the right to receive a specified portion of the contractual interest flows of the underlying unamortized principal balance (“UPB” or “par value”) of specific CMO securities. Principal-only securities represent the right to receive contractual principal flows of the UPB of specific CMO securities. The UPB of our interest-only securities was $1.3 billion and the weighted average contractual interest we are entitled to receive was 5.58% of this amount as of June 30, 2011. The UPB of our principal-only securities was $46 million as of June 30, 2011.
(2) The weighted average coupon includes the interest cash flows from our interest-only securities taken together with the interest cash flows from our fixed-rate, adjustable-rate and CMO securities as a percentage of the par value of our agency securities (excluding the UPB of our interest-only securities) as of June 30, 2011.
(3) Incorporates an average future constant prepayment rate assumption of 10% based on forward rates as of June 30, 2011 and an average reset rate for adjustable rate securities of 2.72%, which is equal to the average underlying index rate of 0.91% based on the current spot rate in effect as of the date we acquired the securities and an average margin of 1.81%.

 

     As of June 30, 2011  
     Amortized
Cost
     Gross
Unrealized
Gain
     Gross
Unrealized
Loss
    Fair Value  

Fixed-Rate

   $ 34,605,297       $ 274,763       $ (79,436   $ 34,800,624   

Adjustable-Rate

     4,563,144         53,477         (3,681     4,612,940   

CMO

     259,071         6,028         —          265,099   

Interest-only and principal-only securities

     239,646         11,854         (4,456     247,044   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total agency securities

   $ 39,667,158       $ 346,122       $ (87,573   $ 39,925,707   
  

 

 

    

 

 

    

 

 

   

 

 

 

 

13


The following tables summarize our investments in agency securities as of December 31, 2010 (dollars in thousands):

 

     As of December 31, 2010  
     Fannie Mae     Freddie Mac     Ginnie Mae     Total  

Agency securities classified as available-for-sale:

        

Agency securities, par

   $ 8,207,464      $ 4,599,712      $ 100,408      $ 12,907,584   

Unamortized discount

     (930     (1,044     —          (1,974

Unamortized premium

     350,747        220,465        4,670        575,882   
  

 

 

   

 

 

   

 

 

   

 

 

 

Amortized cost

     8,557,281        4,819,133        105,078        13,481,492   

Gross unrealized gains

     56,181        11,929        384        68,494   

Gross unrealized losses

     (53,893     (42,356     (196     (96,445
  

 

 

   

 

 

   

 

 

   

 

 

 

Available-for-sale securities, at fair value

     8,559,569        4,788,706        105,266        13,453,541   
  

 

 

   

 

 

   

 

 

   

 

 

 

Agency securities remeasured at fair value through earnings:

        

Interest-only securities, amortized cost(1)

     18,957        33,447        —          52,404   

Gross unrealized gains

     1,559        3,356        —          4,915   

Gross unrealized losses

     (91     (489     —          (580
  

 

 

   

 

 

   

 

 

   

 

 

 

Agency securities measured at fair value through earnings, at fair value

     20,425        36,314        —          56,739   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total agency securities, at fair value

   $ 8,579,994      $ 4,825,020      $ 105,266      $ 13,510,280   
  

 

 

   

 

 

   

 

 

   

 

 

 

Weighted average coupon as of December 31, 2010(2)

     4.63     4.83     4.37     4.70

Weighted average yield as of December 31, 2010(3)

     3.34     3.28     2.14     3.31

Weighted average yield for the year ended December 31, 2010(3)

     3.49     3.42     2.22     3.44

 

(1) Interest-only securities represent the right to receive a specified portion of the contractual interest flows of the UPB of specific CMO securities. The UPB of our interest-only securities was $0.5 billion and the weighted average contractual interest we are entitled to receive was 4.95% of this amount as of December 31, 2010.
(2) The weighted average coupon includes the interest cash flows from our interest-only securities taken together with the interest cash flows from our fixed-rate, adjustable-rate and CMO securities as a percentage of the par value of our agency securities (excluding the UPB of our interest-only securities) as of December 31, 2010.
(3) Incorporates an average future constant prepayment rate assumption of 12% based on forward rates as of December 31, 2010 and an average reset rate for adjustable rate securities of 2.76%, which is equal to the average underlying index rate of 0.94% based on the current spot rate in effect as of the date we acquired the securities and an average margin of 1.82%.

 

     As of December 31, 2010  
     Amortized
Cost
     Gross
Unrealized
Gain
     Gross
Unrealized
Loss
    Fair Value  

Fixed-Rate

   $ 9,144,352       $ 39,844       $ (82,717   $ 9,101,479   

Adjustable-Rate

     3,942,937         20,955         (13,728     3,950,164   

CMO

     394,203         7,695         —          401,898   

Interest-only securities

     52,404         4,915         (580     56,739   
  

 

 

    

 

 

    

 

 

   

 

 

 

Total agency securities

   $ 13,533,896       $ 73,409       $ (97,025   $ 13,510,280   
  

 

 

    

 

 

    

 

 

   

 

 

 

 

14


Actual maturities of agency securities are generally shorter than the stated contractual maturities. Actual maturities are affected by the contractual lives of the underlying mortgages, periodic principal payments and principal prepayments. The following table summarizes our agency securities classified as available-for-sale as of June 30, 2011 and December 31, 2010, according to their estimated weighted average life classification (dollars in thousands):

 

    As of June 30, 2011     As of December 31, 2010  

Weighted Average Life

  Fair Value     Amortized
Cost
    Weighted
Average
Coupon
    Fair Value     Amortized
Cost
    Weighted
Average
Coupon
 

Less than or equal to one year

  $ 43,212      $ 43,350        3.81   $ —        $ —          —  

Greater than one year and less than or equal to three years

    1,056,763        1,035,249        4.95     133,123        132,520        5.05

Greater than three years and less than or equal to five years

    4,188,329        4,134,240        4.48     3,841,282        3,821,992        4.92

Greater than five years

    34,390,359        34,214,673        4.19     9,479,136        9,526,980        4.31
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

Total

  $ 39,678,663      $ 39,427,512        4.24   $ 13,453,541      $ 13,481,492        4.49
 

 

 

   

 

 

   

 

 

   

 

 

   

 

 

   

 

 

 

The weighted average life of our interest-only securities was 5.4 and 6.2 years as of June 30, 2011 and December 31, 2010, respectively. The weighted average life of our principal-only securities was 4.0 years as of June 30, 2011.

The weighted average lives of the agency securities as of June 30, 2011 and December 31, 2010 incorporates anticipated future prepayment assumptions. As of June 30, 2011, our weighted average expected constant prepayment rate (“CPR”) over the remaining life of our aggregate investment portfolio is 10%. Our estimates differ materially for different types of securities and thus individual holdings have a wide range of projected CPRs. We estimate long-term prepayment assumptions for different securities using third-party services and market data. These third-party services estimate prepayment speeds using models that incorporate the forward yield curve, current mortgage rates, mortgage rates of the outstanding loans, loan age, volatility and other factors. We review the prepayment speeds estimated by the third-party services and compare the results to market consensus prepayment speeds, if available. We also consider historical prepayment speeds and current market conditions to validate reasonableness. As market conditions may change rapidly, we use our judgment in making adjustments for different securities. Various market participants could use materially different assumptions.

Our agency securities classified as available-for-sale are reported at fair value, with unrealized gains and losses excluded from earnings and reported in OCI, a component of stockholders’ equity. The following table summarizes changes in accumulated OCI for available-for-sale securities for the three and six months ended June 30, 2011 and 2010 (in thousands):

 

     Beginning
Balance
    Unrealized Gains
and (Losses)
     Reversal of Prior
Period Unrealized
(Gains) and Losses
on Realization
    Ending
Balance
 

Three months ended June 30, 2011

   $ (67,751     412,252         (93,350   $ 251,151   

Three months ended June 30, 2010

   $ 37,951        88,547         (29,063   $ 97,435   

Six months ended June 30, 2011

   $ (27,950     376,671         (97,570   $ 251,151   

Six months ended June 30, 2010

   $ 36,018        117,888         (56,471   $ 97,435   

 

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The following table presents the gross unrealized loss and fair values of our available-for-sale agency securities by length of time that such securities have been in a continuous unrealized loss position as of June 30, 2011 and December 31, 2010 (in thousands):

 

     Unrealized Loss Position For  
     Less than 12 Months     12 Months or More      Total  
     Estimated Fair
Value
     Unrealized
Loss
    Estimated
Fair Value
     Unrealized
Loss
     Estimated Fair
Value
     Unrealized
Loss
 

June 30, 2011

   $ 12,995,097       $ (83,117   $ —         $ —         $ 12,995,097       $ (83,117

December 31, 2010

   $ 7,498,384       $ (96,445   $ —         $ —         $ 7,498,384       $ (96,445

As of June 30, 2011, we did not intend to sell any of these agency securities and we believe it is not more likely than not we will be required to sell the agency securities before recovery of their amortized cost basis. The unrealized losses on these agency securities are not due to credit losses given the government-sponsored entity or government guarantees but are rather due to changes in interest rates and prepayment expectations.

Gains and Losses

The following table is a summary of our net gain from sale of agency securities for the three and six months ended June 30, 2011 and 2010 (in thousands):

 

     Three Months Ended     Six Months Ended  
     June 30, 2011     June 30, 2010     June 30, 2011     June 30, 2010  

Agency securities sold, at cost

   $ (10,448,371   $ (2,624,277   $ (12,383,828   $ (4,741,787

Proceeds from agency securities sold(1)

     10,542,263        2,653,862        12,481,940        4,798,780   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net gains on sale of agency securities

   $ 93,892      $ 29,585      $ 98,112      $ 56,993   
  

 

 

   

 

 

   

 

 

   

 

 

 

Gross gains on sale of agency securities

   $ 95,684      $ 31,327      $ 109,233      $ 61,381   

Gross losses on sale of agency securities

     (1,792     (1,742     (11,121     (4,388
  

 

 

   

 

 

   

 

 

   

 

 

 

Net gains on sale of agency securities

   $ 93,892      $ 29,585      $ 98,112      $ 56,993   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Proceeds include cash received during the period, plus receivable for agency securities sold during the period as of period end.

For the three and six months ended June 30, 2011, we recognized an unrealized gain of $0.3 and $3.1 million, and for the three and six months ended June 30, 2010 we recognized an unrealized loss of $9.0 and $8.0 million, respectively, in gain (loss) on derivative instruments and trading securities, net in our consolidated statements of operations and comprehensive income for the change in value of investments in interest-only and principal-only securities. For the three and six months ended June 30, 2011, we recognized a realized gain of $0.5 and $0.5 million in gain on agency securities, respectively, net in our consolidated statements of operations and comprehensive income for the sales of interest-only and principal-only securities. There were no sales of interest-only or principal-only securities during the six months ended June 30, 2010.

 

16


Pledged Assets

The following tables summarize our agency securities pledged as collateral under repurchase agreements, other debt, derivative agreements and prime broker agreements by type as of June 30, 2011 and December 31, 2010 (in thousands):

 

     As of June 30, 2011  

Agency Securities Pledged(1)

   Fannie Mae      Freddie Mac      Ginnie Mae      Total  

Under Repurchase Agreements

           

Fair value

   $ 21,323,526       $ 13,795,825       $ 108,778       $ 35,228,129   

Amortized cost

     21,145,673         13,713,743         107,269         34,966,685   

Accrued interest on pledged agency securities

     71,278         45,431         357         117,066   

Under Other Debt Agreements

           

Fair value

     66,143         —           —           66,143   

Amortized cost

     65,158         —           —           65,158   

Accrued interest on pledged agency securities

     270         —           —           270   

Under Derivative Agreements

           

Fair value

     96,737         196,953         —           293,690   

Amortized cost

     95,510         195,220         —           290,730   

Accrued interest on pledged agency securities

     941         1,470         —           2,411   

Under Prime Broker Agreements

           

Fair value

     46,181         56,828         —           103,009   

Amortized cost

     45,698         56,020         —           101,718   

Accrued interest on pledged agency securities

     166         193         —           359   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Fair Value of Agency Securities Pledged and Accrued Interest

   $ 21,605,242       $ 14,096,700       $ 109,135       $ 35,811,075   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) Agency securities pledged include pledged amounts of $573.0 million related to agency securities sold but not yet settled as of June 30, 2011.

 

     As of December 31, 2010  

Agency Securities Pledged(2)

   Fannie Mae      Freddie Mac      Ginnie Mae      Total  

Under Repurchase Agreements

           

Fair value

   $ 7,707,046       $ 4,554,541       $ 95,066       $ 12,356,653   

Amortized cost

     7,709,785         4,591,245         94,860         12,395,890   

Accrued interest on pledged agency securities

     27,589         15,642         332         43,563   

Under Other Debt Agreements

           

Fair value

     77,906         —           —           77,906   

Amortized cost

     77,460         —           —           77,460   

Accrued interest on pledged agency securities

     325         —           —           325   

Under Derivative Agreements

           

Fair value

     36,651         30,306         —           66,957   

Amortized cost

     36,343         30,382         —           66,725   

Accrued interest on pledged agency securities

     156         118         —           274   

Under Prime Broker Agreements

           

Fair value

     6,061         5,997         2,032         14,090   

Amortized cost

     6,061         6,061         2,024         14,146   

Accrued interest on pledged agency securities

     28         21         8         57   
  

 

 

    

 

 

    

 

 

    

 

 

 

Total Fair Value of Agency Securities Pledged and Accrued Interest

   $ 7,855,762       $ 4,606,625       $ 97,438       $ 12,559,825   
  

 

 

    

 

 

    

 

 

    

 

 

 

 

(2) Agency securities pledged include pledged amounts of $244.7 million related to agency securities sold but not yet settled as of December 31, 2010.

 

17


The following table summarizes our agency securities pledged as collateral under repurchase agreements and other debt by remaining maturity as of June 30, 2011 and December 31, 2010 (dollars in thousands):

 

     As of June 30, 2011(1)      As of December 31, 2010(1)  

Remaining Maturity

   Fair Value      Amortized
Cost
     Accrued
Interest on
Pledged

Agency
Securities
     Fair Value      Amortized
Cost
     Accrued
Interest  on
Pledged

Agency
Securities
 

30 days or less

   $ 32,110,768       $ 31,862,025       $ 106,734       $ 9,909,121       $ 9,943,239       $ 35,151   

31 - 59 days

     3,179,965         3,166,352         10,587         2,525,438         2,530,111         8,737   

60 - 90 days

     —           —           —           —           —           —     

Greater than 90 days

     3,539         3,466         15         —           —           —     
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

Total

   $ 35,294,272       $ 35,031,843       $ 117,336       $ 12,434,559       $ 12,473,350       $ 43,888   
  

 

 

    

 

 

    

 

 

    

 

 

    

 

 

    

 

 

 

 

(1) Agency securities pledged include pledged amounts of $573.0 million and $244.7 million related to agency securities sold but not yet settled as of June 30, 2011 and December 31, 2010, respectively.

Securitizations

All of our CMO securities are backed by fixed or adjustable-rate agency securities and Fannie Mae or Freddie Mac guarantees the payment of interest and principal and acts as the trustee and administrator of their respective securitization trusts. Our involvement with the consolidated CMO trust described below is limited to the agency securities transferred to the trust by the investment bank and the CMO securities subsequently held by us. Accordingly, we are not required to provide the beneficial interest holders of the CMO securities any financial or other support. Whether or not we were involved with the formation of the CMO or purchased the securities from third parties in separate transactions, our maximum exposure to loss related to our involvement with CMO trusts is the fair value of the CMO securities and interest-only securities held by us. As of June 30, 2011 and December 31, 2010, the fair value of all of our CMO securities, interest-only securities and principal-only securities, excluding the consolidated CMO trust discussed below, was $512.1 million and $458.6 million, respectively, or $516.4 million and $463.6 million, respectively, including the net asset value of the consolidated CMO trust discussed below.

During fiscal year 2010, we entered into a CMO transaction whereby we transferred agency securities with a cost basis of $85.9 million to an investment bank in exchange for cash proceeds of $80.8 million and at the same time entered into a commitment with the same investment bank to purchase a to-be-issued interest-only strip collateralized by the agency securities transferred for $5.1 million. The investment bank contributed the transferred agency securities to a securitization trust held by Fannie Mae in exchange for CMO securities issued by the trust. Once the transferred agency securities were transferred to the securitization trust, Fannie Mae may only remove such securities upon certain events. Pursuant to the pre-existing commitment, the investment bank transferred to us the interest-only security issued by the trust. Our primary purpose for entering into this transaction was to eliminate the need to finance the principal class by transferring it to third parties, while still retaining the underlying economics of a financed transaction for the transferred securities, which we viewed as favorable. We concluded that we were the primary beneficiary of the CMO trust based on our disproportionate economic interest and, accordingly, we consolidated the CMO trust as it related to the agency securities transferred by us and the related liabilities issued by the trust. The effect of consolidating the CMO trust was that the interest-only security received was eliminated and we continued to recognize the assets transferred to the securitization trust in our total agency securities held and recorded a corresponding liability for the debt issued by the securitization trust, which is classified as other debt in our accompanying consolidated balance sheets. As of June 30, 2011, we recognized agency securities with a total fair value of $66.1 million and a principal balance of $62.3 million collateralized the remaining debt outstanding issued by the securitization trust of $61.8 million. As of December 31, 2010, we recognized agency securities with a total fair value of $77.9 million and a principal balance of $73.5 million collateralized the remaining debt outstanding issued by the securitization trust of $72.9 million. Such agency securities can only be used to settle this debt and the holder(s) of the debt issued by the

 

18


securitization trust have no recourse to us. Further, there are no arrangements that could require us to provide financial support to this securitization trust. The consolidation did not materially impact our accompanying consolidated statements of operations and comprehensive income and consolidated statements of cash flows.

Note 5. Repurchase Agreements and Other Debt

We pledge certain of our agency securities as collateral under repurchase arrangements with financial institutions, the terms and conditions of which are negotiated on a transaction-by-transaction basis. Interest rates on these borrowings are generally based on LIBOR plus or minus a margin and amounts available to be borrowed are dependent upon the fair value of the agency securities pledged as collateral, which fluctuates with changes in interest rates, type of security and liquidity conditions within the banking, mortgage finance and real estate industries. In response to declines in fair value of pledged agency securities, lenders may require us to post additional collateral or pay down borrowings to re-establish agreed upon collateral requirements, referred to as margin calls. As of June 30, 2011 and December 31, 2010, we have met all margin call requirements. Due to their short-term nature, repurchase agreements are carried at cost, which approximates fair value.

The following table summarizes our borrowings under repurchase arrangements and weighted average interest rates classified by original maturities as of June 30, 2011 and December 31, 2010 (dollars in thousands):

 

     As of June 30, 2011      As of December 31, 2010  

Original Maturity

   Borrowings
Outstanding
     Average
Interest
Rate
    Weighted
Average Days
to Maturity
     Borrowings
Outstanding
     Average
Interest
Rate
    Weighted
Average Days
to Maturity
 

30 days or less

   $ 13,475,727         0.23     13       $ 3,306,175         0.32     12   

31 - 60 days

     11,844,846         0.23     28         5,648,155         0.31     20   

61 - 90 days

     4,202,460         0.24     22         1,496,452         0.29     33   

Greater than 90 days

     3,982,109         0.25     15         1,229,310         0.29     43   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Total / Weighted Average

   $ 33,505,142         0.23     20       $ 11,680,092         0.31     22   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

As of June 30, 2011 and December 31, 2010, we did not have an amount at risk with any counterparty greater than 10% of our stockholders’ equity. We do not anticipate any defaults by our repurchase agreement counterparties.

Other debt of $61.8 million and $72.9 million as of June 30, 2011 and December 31, 2010, respectively, consists of other variable rate debt outstanding at LIBOR plus 25 basis points in connection with the consolidation of a structured transaction for which we are the primary beneficiary in our accompanying financial statements (see Note 4).

Note 6. Derivative and Other Hedging Instruments

In connection with our risk management strategy, we hedge a portion of our interest rate risk by entering into derivative and other hedging instrument contracts. We may enter into agreements for interest rate swap agreements, interest rate swaptions, interest rate cap or floor contracts and futures or forward contracts. We may also purchase or short TBA and U.S. Treasury securities, purchase or write put or call options on TBA securities or we may invest in other types of mortgage derivative securities, such as interest-only securities, and synthetic total return swaps, such as the IOS Index. Our risk management strategy attempts to manage the overall risk of the portfolio, reduce fluctuations in book value and generate additional income distributable to stockholders. For additional information regarding our derivative instruments and our overall risk management strategy, please refer to the discussion of derivative and other hedging instruments in Note 3.

As of June 30, 2011 and December 31, 2010, our derivative and other hedging instruments were comprised primarily of interest rate swaps, which have the effect of modifying the repricing characteristics of our repurchase agreements and cash flows on such liabilities. Our interest rate swaps are used to manage the interest

 

19


rate risk created by our variable rate short-term repurchase agreements. Under our interest rate swaps, we typically pay a fixed-rate and receive a floating rate based on one-month LIBOR with terms usually ranging up to 5 years. Our interest rate swaps are generally designated as cash flow hedges under ASC 815.

Derivative and other hedging instruments entered into in addition to interest rate swap agreements are intended to supplement our use of interest rate swaps and we do not currently expect our use of these instruments to be the primary protection against interest rate risk for our portfolio. These instruments are accounted for as either derivatives, but are not typically designated as hedges under ASC 815, or trading securities. Therefore, any changes in the fair values of the contracts prior to their settlement date are included in earnings. We do not use derivative or other hedging instruments for speculative purposes.

Derivatives Designated as Hedging Instruments

As of June 30, 2011 and December 31, 2010, we had net interest rate swap liabilities of $233.1 million and $37.7 million, respectively. The tables below summarize information about our outstanding interest rate swaps as of June 30, 2011 and December 31, 2010 (dollars in thousands):

 

          As of  

Interest Rate Swaps Designated
as Hedging Instruments

  

Balance Sheet Location

   June 30,
2011
    December 31,
2010
 

Interest rate swap assets

   Derivative assets, at fair value    $ 30,321      $ 33,695   

Interest rate swap liabilities

   Derivative liabilities, at fair value      (263,443     (71,417
     

 

 

   

 

 

 
      $ (233,122   $ (37,722
     

 

 

   

 

 

 

 

     As of June 30, 2011  

Remaining Term for Interest Rate Swaps

Designated as Hedging Instruments(1)

   Notional
Amount
     Average
Fixed
Pay Rate
    Average
Receive Rate
    Net
Estimated
Fair Value
    Average
Maturity
(Years)
 

1 year or less

   $ 900,000         1.72     0.19   $ (8,794     0.6   

Greater than 1 year and less than 3 years

     6,100,000         1.22     0.19     (59,576     2.3   

Greater than 3 years and less than 5 years

     11,600,000         1.76     0.19     (127,063     4.0   

Greater than 5 years

     3,400,000         2.25     0.19     (37,689     5.1   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Total

   $ 22,000,000         1.69     0.19   $ (233,122     3.5   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

 

(1) Remaining term includes the effect of deferred start dates for forward starting swaps of $7.9 billion ranging from one to six months from June 30, 2011.

 

     As of December 31, 2010  

Remaining Term for Interest Rate Swaps
Designated as Hedging Instruments

   Notional
Amount
     Average
Fixed
Pay Rate
    Average
Receive Rate
    Net
Estimated
Fair Value
    Average
Maturity
(Years)
 

1 year or less

   $ 750,000         1.40     0.26   $ (5,595     0.7   

Greater than 1 year and less than 3 years

     2,850,000         1.54     0.26     (32,865     2.5   

Greater than 3 years and less than 5 years

     2,850,000         1.78     0.26     738        4.3   

Greater than 5 years

     —           —          —          —          —     
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

Total

   $ 6,450,000         1.63     0.26   $ (37,722     3.1   
  

 

 

    

 

 

   

 

 

   

 

 

   

 

 

 

 

20


The following table summarizes information about our outstanding interest rate swaps designated as hedging instruments for the three and six months ended June 30, 2011 and 2010 (in thousands):

 

Interest Rate Swaps Designated
as Hedging Instruments

   Beginning
Notional
Amount
     Additions      Expirations/
Terminations
    Ending
Notional
Amount
 

Three months ended June 30, 2011

   $ 14,950,000         7,300,000         (250,000   $ 22,000,000   

Three months ended June 30, 2010

   $ 2,350,000         650,000         —        $ 3,000,000   

Six months ended June 30, 2011

   $ 6,450,000         15,800,000         (250,000   $ 22,000,000   

Six months ended June 30, 2010

   $ 2,050,000         950,000         —        $ 3,000,000   

The table below summarizes the effect of interest rate swaps designated as hedges under ASC 815 on our consolidated statement of operations for the three and six months ended June 30, 2011 and 2010 (in thousands):

 

Interest Rate Swaps in Cash Flow
Hedging Relationships

  Amount of
Gain or (Loss)
Recognized in
OCI
(Effective
Portion)
   

Location of Gain
or (Loss)
Reclassified from
OCI into
Earnings (Effective
Portion)

  Amount of Gain or
(Loss) Reclassified
from OCI into
Earnings
(Effective Portion)
   

Location of Gain or (Loss)
Recognized in Earnings
(Ineffective Portion and
Amount Excluded from
Effectiveness Testing)

  Amount of Gain
or (Loss)
Recognized in
Earnings
(Ineffective
Portion and
Amount
Excluded from
Effectiveness
Testing)
 

Three months ended June 30, 2011

  $ (252,664   Interest Expense   $ (46,109  

Loss on derivative

instruments and trading

securities, net

  $ (507

Three months ended June 30, 2010

  $ (42,271   Interest Expense   $ (13,744  

Loss on derivative

instruments and trading

securities, net

  $ (123

Six months ended June 30, 2011

  $ (194,763   Interest Expense   $ (69,220  

Loss on derivative

instruments and trading

securities, net

  $ (638

Six months ended June 30, 2010

  $ (59,605   Interest Expense   $ (27,071  

Loss on derivative

instruments and trading

securities, net

  $ (314

As of June 30, 2011, the amount of net interest expense expected to flow through our statement of operations over the next twelve months due to expected net settlements on our interest rate swaps is $282.4 million.

Additionally, during the six months ended June 30, 2011 and the three and six months ended June 30, 2010, we entered into or held forward contracts to purchase TBA and specified agency securities that were designated as cash flow hedges pursuant to ASC 815. We did not enter into such agreements during the three month period ended June 30, 2011. The following table summarizes information about our outstanding forward contracts designated as hedging instruments for the three and six months ended June 30, 2011 and 2010 (dollars in thousands):

 

Purchases of TBAs and Forward

Settling Agency Securities Designated

as Hedging Instruments

   Beginning
Notional Amount
     Additions      Settlement /
Expirations
    Ending
Notional  Amount
     Fair Value
as of
Period End
     Average
Maturity

as of
Period End
(Months)
 

Three months ended June 30, 2011

   $ —           —           —        $ —         $ —           —     

Three months ended June 30, 2010

   $ 66,300         80,000         (66,300   $ 80,000       $ 629         2   

Six months ended June 30, 2011

   $ 245,000         —           (245,000   $ —         $ —           —     

Six months ended June 30, 2010

   $ —           146,300         (66,300   $ 80,000       $ 629         2   

The effective portion of gains or losses for TBAs and forward settling specified agency securities is initially recognized in OCI for designated cash flow hedges and is subsequently reclassified within OCI for available-for-sale securities upon acquisition of the underlying hedged item. The ineffective portion of gains or losses is recognized in earnings in gain (loss) on derivative instruments and trading securities, net.

 

21


The table below summarizes the effect of purchases of TBAs and forward settling securities designated as hedges under ASC 815 on our consolidated statement of operations and comprehensive income for the three and six months ended June 30, 2011 and 2010 (in thousands).

 

Purchases of TBAs and Forward
Settling Securities in Cash Flow
Hedging Relationships

  Amount of Gain or
(Loss) Recognized
in OCI for Cash
Flow Hedges
(Effective Portion)
    Amount of Gain or
(Loss) Recognized in
OCI for Cash Flow
Hedges and
Reclassified to OCI for
Available-for-Sale
Securities
(Effective Portion)
   

Location of Gain or (Loss)
Recognized in Earnings
(Ineffective Portion and Amount
Excluded from Effectiveness
Testing)

  Amount of Gain or
(Loss) Recognized
in Earnings
(Ineffective Portion
and Amount
Excluded from
Effectiveness
Testing)
 

Three months ended June 30, 2011

  $ —        $ —        Gain on derivative instruments and trading securities, net   $ —     

Three months ended June 30, 2010

  $ 629      $ —        Gain on derivative instruments and trading securities, net   $ —     

Six months ended June 30, 2011

  $ 12      $ (3,213   Gain on derivative instruments and trading securities, net   $ —     

Six months ended June 30, 2010

  $ 629      $ —        Gain on derivative instruments and trading securities, net   $ —     

Derivatives Not Designated as Hedging Instruments

As of June 30, 2011 and December 31, 2010, we had contracts to purchase (“long position”) and sell (“short position”) TBA and specified agency securities on a forward basis. Following is a summary of our long and short TBA and forward settling positions as of June 30, 2011 and December 31, 2010 (in thousands).

 

     As of June 30, 2011     As of December 31, 2010  

Purchase and Sale Contracts for TBAs and Forward Settling
Securities Not Designated as Hedging Instruments

   Notional Amount     Fair
Value
    Notional Amount     Fair Value  

15 year TBA securities:

        

Purchase

   $ 1,245,700      $ 4,837      $ 1,532,000      $ 10,297   

Sale

     (19,825     (515     (1,454,500     (3,127
  

 

 

   

 

 

   

 

 

   

 

 

 

15 year TBA securities, net

     1,225,875        4,322        77,500        7,170   
  

 

 

   

 

 

   

 

 

   

 

 

 

30 year TBA securities:

        

Purchase

     1,480,000        720        750,000        3,213   

Sale

     (4,261,700     (19,976     (1,835,700     6,738   
  

 

 

   

 

 

   

 

 

   

 

 

 

30 year TBA securities, net

     (2,781,700     (19,256     (1,085,700     9,951   
  

 

 

   

 

 

   

 

 

   

 

 

 

Purchase of 20 year TBA securities

     —          —          125,000        (2,116

Purchase of specified ARM securities

     706,665        3,518        34,303        296   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total, Net

   $ (849,160   $ (11,416   $ (848,897   $ 15,301   
  

 

 

   

 

 

   

 

 

   

 

 

 

As of June 30, 2011 and December 31, 2010, we had interest rate swap agreements outstanding that were not designated as hedges under ASC 815 consisting of interest rate swap agreements where we pay a fixed rate (“payer interest rate swaps”) and interest rate swap agreements where we receive a fixed rate (“receiver interest rate swaps”), summarized in the tables below (dollars in thousands).

 

     As of June 30, 2011  

Interest Rate Swaps Not Designated

as Hedging Instruments

   Maturity      Notional
Amount
     Average
Fixed Pay
(Receive)
Rate
    Average
Receive
(Pay)
Rate
    Fair
Value
     Average
Maturity
(Years)
 

Payer interest rate swaps

     2015       $ 250,000         1.66     0.19   $ 174         4.4   

Receiver interest rate swaps

     2015       $ 100,000         (2.50 %)      (0.19 %)    $ 3,659         4.3   

 

22


     As of December 31, 2010  

Interest Rate Swaps Not

Designated as Hedging Instruments

   Maturity      Notional
Amount
     Average
Fixed Pay
(Receive)
Rate
    Average
Receive
(Pay)
Rate
    Fair Value      Average
Maturity
(Years)
 

Payer interest rate swaps

     2015       $ 250,000         1.66     0.26   $ 4,140         4.9   

Receiver interest rate swaps

     2015       $ 200,000         (2.26 %)      (0.26 %)    $ 2,743         4.7   

As of June 30, 2011 and December 31, 2010, we had interest rate swaption agreements outstanding consisting of options to enter into interest rate swaps in the future where we would pay a fixed rate (“payer swaptions”) as summarized in the tables below (dollars in thousands):

 

     As of June 30, 2011  
     Option      Underlying Swap  

Swaption

   Cost      Fair
Value
     Average
Months to
Expiration
     Notional
Amount
     Pay
Rate
    Average
Receive

Rate
     Average
Term

(Years)
 

Payer

   $  53,079       $  36,353         9       $  4,050,000         3.56     1M LIBOR         7.0   
     As of December 31, 2010  
     Option      Underlying Swap  

Swaption

   Cost      Fair
Value
     Average
Months to
Expiration
     Notional
Amount
     Pay
Rate
    Average
Receive
Rate
     Average
Term
(Years)
 

Payer

   $ 4,596       $ 16,766         4       $ 850,000         2.28     1M LIBOR         5.6   

 

23


As of June 30, 2011, we had total return swaps outstanding linked to the Markit IOS Index, summarized in the table below. Under these swap agreements, we are either entitled to receive (“long position”) or pay (“short position”) a stated coupon linked to the index, net of an implied financing cost equal to one-month LIBOR, plus/(minus) increases/(decreases) in the index market value. Long positions are intended to synthetically replicate the performance of interest-only securities. Therefore, as interest rates rise and prepayment expectations decline, the index will typically increase in value and, as interest rates fall and prepayment expectations rise, the index will typically decrease in value. As the holder of the long position, we are required to pay a monthly periodic cash settlement equal to a decrease in the index value and, conversely, we are entitled to receive a periodic cash settlement equal to an increase in the index value. Changes, or mark-to-market movements, in the index are measured from the preceding periodic measurement date. Periodic cash settlements of the index mark-to-market movements are netted against periodic cash settlements of the stated coupon, less the implied financing costs. As of June 30, 2011, the linked index values of our total return swaps totaled $75.7 million. As of June 30, 2011, the fair value of these total return swaps reported in derivative assets, at fair value on our consolidated balance sheet was $0.1 million and represents the unrealized mark-to-market change in the linked index value since the preceding measurement date through June 30, 2011. Realized and unrealized gains and losses associated with changes in the underlying linked index value and net coupon interest are recognized in gain (loss) on derivative instruments and trading securities, net in our consolidated statements of operations and comprehensive income. We did not have any total return swaps outstanding as of December 31, 2010.

 

          As of June 30, 2011
(in thousands)
 

Position

  

Markit IOS Sub-Index

   Notional
Amount
    Expiration
Date
     Fair
Value
 

Long

   5.0%, 30-Year, Fixed Rate, Fannie Mae MBS Pools    $ 74,757        January 2040       $ 467   
  

5.5%, 30-Year, Fixed Rate, Fannie Mae MBS Pools

     403,965        January 2039         433   
  

6.0%, 30-Year, Fixed Rate, Fannie Mae MBS Pools

     203,933        January 2039         (518
     

 

 

      

 

 

 
        682,655           382   
     

 

 

      

 

 

 

Short

   5.0%, 30-Year, Fixed Rate, Fannie Mae MBS Pools      (74,758     January 2040         (362
  

5.5%, 30-Year, Fixed Rate, Fannie Mae MBS Pools

     (234,546     January 2039         110   
     

 

 

      

 

 

 
        (309,304        (252
     

 

 

      

 

 

 

Net

      $ 373,351         $ 130   
     

 

 

      

 

 

 

 

24


The table below summarizes fair value information about our derivatives outstanding that were not designated as hedging instruments as of June 30, 2011 and December 31, 2010 (in thousands).

 

        As of  

Derivatives Not Designated as Hedging Instruments

 

Balance Sheet Location

  June 30, 2011     December 31, 2010  

Purchase of TBA and forward settling agency securities

  Derivative assets, at fair value   $ 10,653      $ 2,929   

Sale of TBA and forward settling agency securities

  Derivative assets, at fair value     2,818        16,320   

Markit IOS total return swaps - long

  Derivative assets, at fair value     1,540        —     

Payer interest rate swaps

  Derivative assets, at fair value     720        4,140   

Receiver interest rate swaps

  Derivative assets, at fair value     3,659        2,743   

Payer swaptions

  Derivative assets, at fair value     36,353        16,766   
   

 

 

   

 

 

 
    $ 55,743      $ 42,898   
   

 

 

   

 

 

 

Purchase of TBA and forward settling agency securities

  Derivative liabilities, at fair value   $ (1,578   $ (2,193

Sale of TBA and forward settling agency securities

  Derivative liabilities, at fair value     (23,309     (1,755

Payer interest rate swaps

  Derivative liabilities, at fair value     (546     —     

Markit IOS total return swaps - long

  Derivative liabilities, at fair value     (253     —     

Markit IOS total return swaps - short

  Derivative liabilities, at fair value     (1,157     —     
   

 

 

   

 

 

 
    $ (26,843   $ (3,948
   

 

 

   

 

 

 

Additionally, as of June 30, 2011 and December 31, 2010, we had obligations to return treasury securities borrowed under reverse repurchase agreements accounted for as securities borrowing transactions for a fair value of $1.46 billion and $245.5 million, respectively. The borrowed securities were used to cover short sales of treasury securities from which we received total proceeds of $1.47 billion and $244.8 million, respectively. The change in fair value of the borrowed securities is recorded in gain (loss) on derivative instruments and trading securities, net in our consolidated statement of operations and comprehensive income.

 

25


The tables below summarize the effect of derivative instruments not designated as hedges under ASC 815 on our consolidated statement of operations and comprehensive income for the three and six months ended June 30, 2011 and 2010 (in thousands):

 

    For the Three Months Ended June 30, 2011  

Derivatives Not Designated as

Hedging Instruments

  Notional
Amount
as of
March 31, 2011
    Additions     Settlement,
Expiration or
Exercise
    Notional
Amount
as of
June 30, 2011
    Amount of
Gain/(Loss)
Recognized in
Income on
Derivatives(1)
 

Purchase of TBA and forward settling agency securities

  $ 4,316,100        10,073,472        (10,957,207   $ 3,432,365      $ 61,045   

Sale of TBA and forward settling agency securities

  $ 5,400,035        32,607,920        (33,726,430   $ 4,281,525        (165,199

Payer interest rate swaps

  $ 250,000        —          —        $ 250,000        (6,852

Receiver interest rate swaps

  $ 100,000        —          —        $ 100,000        2,699   

Payer swaptions

  $ 2,100,000        2,650,000        (700,000   $ 4,050,000        (20,844

Receiver swaptions

  $ 250,000        —          (250,000   $ —          (369

Short sales of U.S. government securities

  $ —          5,609,000        (4,145,000   $ 1,464,000        (674

Treasury futures

  $ —          50,000        (50,000   $ —          248   

Markit IOS total return swaps - long

  $ 1,015,314        —          (332,659   $ 682,655        2,884   

Markit IOS total return swaps - short

  $ —          (312,659     3,356      $ (309,303     (545
         

 

 

 
          $ (127,607
         

 

 

 

 

(1) This amount excludes $0.4 million recorded as a gain for interest-only and principal-only securities re-measured at fair value through earnings, a loss of $0.5 million for hedge ineffectiveness on our outstanding interest rate swaps designated as hedging instruments and a gain of $27.7 million from trading securities in gain on derivative instruments and trading securities, net in our consolidated statement of operations and comprehensive for the three months ended June 30, 2011.

 

    For the Three Months Ended June 30, 2010  

Derivatives Not Designated as

Hedging Instruments

  Notional
Amount
as of
March 31, 2010
    Additions     Settlement,
Expiration or
Exercise
    Notional
Amount
as of
June 30, 2010
    Amount of
Gain/(Loss)
Recognized in
Income on
Derivatives(2)
 

Purchase of TBA and forward settling agency securities

  $ 184,668        253,213        (256,739   $ 181,142      $ 8,196   

Sale of TBA and forward settling agency securities

  $ 335,000        1,851,094        (1,916,094   $ 270,000        (23,623

Put options

  $ 75,000        —          (75,000   $ —          (365

Payer interest rate swaps

  $ —          50,000        (50,000   $ —          (280

Payer swaptions

  $ 200,000        —          —        $ 200,000        (591

Receiver swaptions

  $ 100,000        200,000        —        $ 300,000        2,502   
         

 

 

 
          $ (14,161
         

 

 

 

 

(2) This amount excludes $8.5 million recorded as a loss for interest-only securities re-measured at fair value through earnings, a loss of $0.1 million for hedge ineffectiveness on our outstanding interest rate swaps and a gain of $1.4 million from trading securities in (loss) gain on derivative instruments and trading securities, net in our consolidated statement of operations and comprehensive for the three months ended June 30, 2011.

 

26


    For the Six Months Ended June 30, 2011  

Derivatives Not Designated as

Hedging Instruments

  Notional
Amount as of
December 31, 2010
    Additions     Settlement,
Expiration or
Exercise
    Notional
Amount
as of
June 30, 2011
    Amount of
Gain/(Loss)
Recognized in
Income on
Derivatives(3)
 

Purchase of TBA and forward settling agency securities

  $ 512,303        22,341,165        (19,421,103   $ 3,432,365      $ 45,250   

Sale of TBA and forward settling agency securities

  $ 1,361,200        50,928,690        (48,008,365   $ 4,281,525        (146,336

Put options

  $ —          (200,000     200,000      $ —          1,133   

Payer interest rate swaps

  $ 250,000        —          —        $ 250,000        (5,887

Receiver interest rate swaps

  $ 200,000        —          (100,000   $ 100,000        926   

Payer swaptions

  $ 850,000        4,200,000        (1,000,000   $ 4,050,000        (25,880

Receiver swaptions

  $ —          250,000        (250,000   $ —          (736

Short sales of U.S. government securities

  $ 250,000        8,524,000        (7,310,000   $ 1,464,000        195   

Treasury futures

  $ —          50,000        (50,000   $ —          248   

Markit IOS total return swaps - long

  $ —          1,089,420        (406,765   $ 682,655        12,440   

Markit IOS total return swaps - short

  $ —          (312,659     3,356      $ (309,303     (545
         

 

 

 
          $ (119,192
         

 

 

 

 

(3) This amount excludes $3.1 million recorded as a gain for interest-only securities re-measured at fair value through earnings, a loss of $0.6 million for hedge ineffectiveness on our outstanding interest rate swaps and a gain of $28.3 million from trading securities in (loss) gain on derivative instruments and trading securities, net in our consolidated statement of operations and comprehensive for the six months ended June 30, 2011.

 

     For the Six Months Ended June 30, 2010  

Derivatives Not Designated as

Hedging Instruments

   Notional
Amount as of
December 31,
2009
     Additions      Settlement,
Expiration
or Exercise
    Notional
Amount as
of June 30,
2010
     Amount of
Gain/(Loss)
Recognized in
Income on
Derivatives(4)
 

Purchase of TBA and forward settling agency securities

   $ 596,516         1,089,089         (1,504,463   $ 181,142       $ 12,434   

Sale of TBA and forward settling agency securities

   $ 616,747         2,817,260         (3,164,007   $ 270,000         (20,877

Put options

   $ —           75,000         (75,000   $ —           (328

Payer interest rate swaps

        150,000         (150,000   $ —           (1,111

Payer swaptions

   $ 200,000         —           —        $ 200,000         (2,382

Receiver swaptions

   $ 100,000         300,000         (100,000   $ 300,000         2,126   
             

 

 

 
              $ (10,138
             

 

 

 

 

(4) This amount excludes $6.4 million recorded as a loss for interest-only securities re-measured at fair value through earnings, a loss of $0.3 million for hedge ineffectiveness on our outstanding interest rate swaps and a gain of $1.4 million from trading securities in (loss) gain on derivative instruments and trading securities, net in our consolidated statement of operations and comprehensive for the six months ended June 30, 2010.

Credit Risk-Related Contingent Features

The use of derivatives creates exposure to credit risk relating to potential losses that could be recognized in the event that the counterparties to these instruments fail to perform their obligations under the contracts. We minimize this risk by limiting our counterparties to major financial institutions with acceptable credit ratings and monitoring positions with individual counterparties. In addition, we may be required to pledge assets as collateral for our derivatives, whose amounts vary over time based on the market value, notional amount and remaining

 

27


term of the derivative contract. In the event of a default by a counterparty we may not receive payments provided for under the terms of our derivative agreements, and may have difficulty obtaining our assets pledged as collateral for our derivatives. The cash and cash equivalents and agency securities pledged as collateral for our derivative instruments is included in restricted cash and agency securities, respectively, on our consolidated balance sheets.

Each of our ISDA Master Agreements contains provisions under which we are required to fully collateralize our obligations under the swap instrument if at any point the fair value of the swap represents a liability greater than the minimum transfer amount contained within our agreements. We were also required to post initial collateral upon execution of certain of our swap transactions. If we breach any of these provisions, we will be required to settle our obligations under the agreements at their termination values.

Further, each of our ISDA Master Agreements also contains a cross default provision under which a default under certain of our other indebtedness in excess of a certain threshold causes an event of default under the agreement. Threshold amounts vary by lender. Following an event of default, we could be required to settle our obligations under the agreements at their termination values. Additionally, under certain of our ISDA Master Agreements, we could be required to settle our obligations under the agreements at their termination values if we fail to maintain certain minimum shareholders’ equity thresholds or our REIT status or comply with limits on our leverage above certain specified levels.

As of June 30, 2011, the fair value of our interest rate swaps in a liability position related to these agreements was $265.4 million. We had agency securities with fair values of $293.7 million, and restricted cash of $188.8 million, or $482.5 million in total agency securities and restricted cash, pledged as collateral against our interest rate swaps, including initial collateral posted upon execution of interest rate swap and total return swap transactions, as of June 30, 2011. Termination values of interest rate swaps in a liability position totaled $271.2 million as of June 30, 2011. The difference between the fair value liability and the termination liability represents accrued interest and an adjustment for nonperformance risk of our counterparties.

Note 7. Fair Value Measurements

ASC 820 provides for a three-level valuation hierarchy for disclosure of fair value measurement. The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date. A financial instrument’s categorization within the hierarchy is based upon the lowest level of input that is significant to the fair value measurement. There were no transfers between hierarchy levels during the six months ended June 30, 2011 and 2010. The three levels of hierarchy are defined as follows:

 

   

Level 1 Inputs —Quoted prices (unadjusted) for identical unrestricted assets and liabilities in active markets that are accessible at the measurement date.

 

   

Level 2 Inputs —Quoted prices for similar assets and liabilities in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.

 

   

Level 3 Inputs —Instruments with primarily unobservable market data that cannot be corroborated.

All of our agency securities and derivative and hedging assets and liabilities were valued based on the income or market approach using Level 2 inputs as of June 30, 2011 and December 31, 2010.

 

28


Note 8. Stockholders’ Equity

Equity Offerings

During the six months ended June 30, 2011, we completed three follow-on public offerings of shares of our common stock summarized in the table below (in thousands, except per share amounts):

 

Public Offering

   Public
Offering Price
Per Share(1)
     Shares      Net Proceeds(2)  

January 2011

   $ 28.00         26,910       $ 719,250   

March 2011

   $ 27.72         32,200         892,242   

June 2011

   $ 27.56         49,680         1,368,756   
     

 

 

    

 

 

 

Total

        108,790       $ 2,980,248   
     

 

 

    

 

 

 

 

(1) Public offering price per share is gross of underwriters’ discount, if applicable
(2) Net proceeds are net of the underwriters’ discount, if applicable and other offering costs

Controlled Equity OfferingSM Program

We have a sales agreement with an underwriter to, from time to time, publicly offer and sell up to 15 million shares of our common stock in privately negotiated and/or at-the-market transactions. During the three month period ended June 30, 2011, there were no sales under the sales agreement. During the six month period ended June 30, 2011, we sold 4.3 million shares of our common stock under the sales agreement at an average offering price of $29.41 per share for proceeds, net of the underwriter’s discount and other program costs, of $126.1 million. As of June 30, 2011, 6.3 million shares of our common stock remain under the sales agreement.

Dividend Reinvestment and Direct Stock Purchase Plan

We sponsor a dividend reinvestment and direct stock purchase plan through which stockholders may purchase additional shares of our common stock by reinvesting some or all of the cash dividends received on shares of our common stock. Stockholders may also make optional cash purchases of shares of our common stock subject to certain limitations detailed in the plan prospectus. During the three month period ended June 30, 2011, there were no shares issued under the plan. During the six month period ended June 30, 2011, we issued 0.5 million shares under the plan for net cash proceeds of $14.9 million. As of June 30, 2011, there were 4.7 million shares available for issuance under the plan.

 

29


Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is designed to provide a reader of American Capital Agency Corp.’s consolidated financial statements with a narrative from the perspective of management. Our MD&A is presented in five sections:

 

   

Executive Overview

 

   

Financial Condition

 

   

Results of Operations

 

   

Liquidity and Capital Resources

 

   

Forward-Looking Statements

EXECUTIVE OVERVIEW

American Capital Agency Corp. (“AGNC”, the “Company”, “we”, “us” and “our”) was organized on January 7, 2008 and commenced operations on May 20, 2008 following the completion of our initial public offering (“IPO”). Our common stock is traded on The NASDAQ Global Select Market under the symbol “AGNC”.

We earn income primarily from investing in residential mortgage pass-through securities and collateralized mortgage obligations (“CMOs”) on a leveraged basis. These investments consist of securities for which the principal and interest payments are guaranteed by U.S. Government-sponsored entities (“GSEs”), such as the Federal National Mortgage Association (“Fannie Mae”) and the Federal Home Loan Mortgage Corporation (“Freddie Mac”), or by a U.S. Government agency, such as the Government National Mortgage Association, (“Ginnie Mae”). We refer to these types of securities as agency securities and the specific agency securities in which we invest as our investment portfolio.

Our principal objective is to preserve our net asset value while generating attractive risk-adjusted returns for distribution to our stockholders through regular quarterly dividends from our net interest income, which is the spread between the interest income earned on our interest earning assets and the interest costs of our borrowings and hedging activities, and net realized gains and losses on our investments and other supplemental hedging activities. We fund our investments primarily through short-term borrowings structured as repurchase agreements.

We have elected to be taxed as a real estate investment trust, or REIT, under the Internal Revenue Code of 1986, as amended (the “Code”). As such, we are required to distribute annually 90% of our taxable net income. As long as we qualify as a REIT, we will generally not be subject to U.S. federal or state corporate taxes on our taxable net income to the extent that we distribute all of our annual taxable net income to our stockholders. We are externally managed by American Capital AGNC Management, LLC (“our Manager”), an affiliate of American Capital, Ltd. (“American Capital”).

Our Investment Strategy

Our investment strategy is to manage an investment portfolio consisting exclusively of agency securities (other than for hedging purposes) that seeks to generate attractive, risk-adjusted returns. Specifically, our investment strategy is designed to:

 

   

manage an investment portfolio consisting of agency securities that seeks to generate attractive risk-adjusted returns;

 

   

capitalize on discrepancies in the relative valuations in the agency securities market;

 

   

manage financing, interest and prepayment rate risks;

 

   

preserve our net asset value;

 

30


   

provide regular quarterly distributions to our stockholders;

 

   

qualify as a REIT; and

 

   

remain exempt from the requirements of the Investment Company Act of 1940, as amended (the “Investment Company Act”).

FINANCIAL CONDITION

As of June 30, 2011 and December 31, 2010, our investment portfolio consisted of $39.9 billion and $13.5 billion, respectively, of agency securities. The following tables summarize certain characteristics of our investment portfolio as of June 30, 2011 (dollars in thousands):

 

     As of June 30, 2011  
      Par Value      Amortized
Cost
     Amortized
Cost Basis
    Fair Value      Weighted Average  
              Coupon     Yield(1)  

Agency Securities Classified as Available-For-Sale:

               

Fannie Mae

   $ 23,109,832       $ 24,023,911         104.0   $ 24,192,174         4.28     3.41

Freddie Mac

     14,729,370         15,291,385         103.8     15,372,680         4.18     3.42

Ginnie Mae

     107,989         112,216         103.9     113,809         4.16     2.15
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

Total / Weighted Average Available-For-Sale Agency Securities

   $ 37,947,191       $ 39,427,512         103.9   $ 39,678,663         4.24     3.41
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

Fixed-Rate

   $ 33,293,597       $ 34,605,297         103.9   $ 34,800,624         4.25     3.51

Adjustable-Rate

     4,401,190         4,563,144         103.7     4,612,940         4.18     2.74

CMO

     252,404         259,071         102.6     265,099         3.79     2.72
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

Total / Weighted Average Available- For-Sale Securities

   $ 37,947,191       $ 39,427,512         103.9   $ 39,678,663         4.24     3.41
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

 

     As of June 30, 2011  
     Underlying
Unamortized

Principal
Balance
     Amortized
Cost
     Fair Value      Weighted Average  
            Coupon     Yield
(1)
 

Agency Securities Remeasured at Fair Value Through Earnings:

             

Interest-Only Strips

             

Fannie Mae

   $ 791,479       $ 114,547       $ 118,210         5.57     8.24

Freddie Mac

     555,896         84,940         88,619         5.60     12.38

Principal-Only Strips

             

Fannie Mae

     46,411         40,159         40,215         0.00     4.00
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total / Weighted Average Agency Securities Remeasured at Fair Value Through Earnings

   $ 1,393,786       $ 239,646       $ 247,044         5.39     9.00
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

 

(1) Incorporates an average future constant prepayment rate assumption of 10% based on forward rates as of June 30, 2011 and an average reset rate for adjustable rate securities of 2.72%, which is equal to the average underlying index rate of 0.91% based on the current spot rate in effect as of the date we acquired the securities and an average margin of 1.81%.

Interest-only securities represent the right to receive a specified portion of the contractual interest flows of the underlying unamortized principal balance (“UPB” or “par value”) of specific CMO securities. Principal-only securities represent the right to receive contractual principal flows of the UPB of specific CMO securities. The

 

31


interest cash flows from our interest-only securities taken together with interest cash flows from our fixed-rate, adjustable-rate and CMO securities, total 4.44% of the combined par value our agency securities (excluding the UPB of our interest-only securities) as of June 30, 2011. The combined weighted average yield of our agency portfolio was 3.45% as of June 30, 2011.

The following table summarizes certain characteristics of our investment portfolio as of December 31, 2010 (dollars in thousands):

 

     As of December 31, 2010  
     Par Value      Amortized
Cost
     Amortized
Cost Basis
    Fair Value      Weighted Average  
              Coupon     Yield(1)  

Agency Securities Classified as Available-For-Sale:

               

Fannie Mae

   $ 8,207,464       $ 8,557,281         104.3   $ 8,559,569         4.51     3.31

Freddie Mac

     4,599,712         4,819,133         104.8     4,788,706         4.45     3.11

Ginnie Mae

     100,408         105,078         104.7     105,266         4.37     2.14
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

Total / Weighted Average Available-For-Sale Agency Securities

     12,907,584       $ 13,481,492         104.4   $ 13,453,541         4.49     3.23
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

Fixed-Rate

     8,779,691       $ 9,144,352         104.2   $ 9,101,479         4.29     3.45

Adjustable-Rate

     3,745,363         3,942,937         105.3     3,950,164         4.96     2.69

CMO

     382,530         394,203         103.1     401,898         4.27     3.52
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

Total / Weighted Average Available- For-Sale Agency Securities

   $ 12,907,584       $ 13,481,492         104.4   $ 13,453,541         4.49     3.23
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

   

 

 

 

 

     As of December 31, 2010  
     Underlying
Unamortized
Principal
Balance
     Amortized
Cost
     Fair Value      Weighted Average  
            Coupon     Yield(1)  

Agency Securities Remeasured at Fair Value Through Earnings:

             

Interest-Only Securities

             

Fannie Mae

   $ 229,980       $ 18,957       $ 20,425         4.18     15.48

Freddie Mac

     314,705         33,447         36,314         5.52     27.23
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

Total / Weighted Average Agency Securities Remeasured at Fair Value Through Earnings

   $ 544,685       $ 52,404       $ 56,739         4.95     22.98
  

 

 

    

 

 

    

 

 

    

 

 

   

 

 

 

 

(1) Incorporates an average future constant prepayment rate assumption of 12% based on forward rates as of December 31, 2010 and an average reset rate for adjustable rate securities of 2.76%, which is equal to the average underlying index rate of 0.94% based on the current spot rate in effect as of the date we acquired the securities and an average margin of 1.82%.

As of December 31, 2010, the interest cash flows from our interest-only securities taken together with interest cash flows from our fixed-rate, adjustable-rate and CMO securities, total 4.70% of the combined par value our agency securities (excluding the UPB of our interest-only securities). The combined weighted average yield of our agency portfolio was 3.31% as of December 31, 2010.

 

32


As of June 30, 2011 and December 31, 2010, we held fixed-rate pass-through agency securities, pass-through agency securities collateralized by ARMs and hybrid ARMs, with coupons linked to various indices. The following tables detail the characteristics of our ARMs and hybrid ARMs portfolio by index as of June 30, 2011 and December 31, 2010 (dollars in thousands):

 

    As of June 30, 2011     As of December 31, 2010  
    Six-Month
Libor
    One-Year
Libor
    One-Year
Treasury
    Twelve-Month
Treasury
Average
    Six-Month
Libor
    One-Year
Libor
    One-Year
Treasury
    Twelve-Month
Treasury

Average
 

Weighted average term to next reset (months)

    40        80        44        31        39        75        48        35   

Weighted average margin

    1.59     1.80     1.91     1.84     1.53     1.75     2.14     1.83

Weighted average annual period cap

    1.09     2.00     1.58     1.00     1.23     2.00     1.86     1.00

Weighted average lifetime cap

    10.60     9.11     9.91     10.10     10.86     9.88     10.28     10.13

Principal amount

  $ 105,180      $ 3,820,758      $ 244,365      $ 230,887      $ 141,318      $ 2,683,203      $ 659,825      $ 261,017   

Percentage of investment portfolio at par value

    0     10     1     1     1     21     5     2

The following table details the number of months to the next reset for our pass-through securities collateralized by ARMs and hybrid ARMs as of June 30, 2011 and December 31, 2010 (dollars in thousands):

 

     As of June 30, 2011      As of December 31, 2010  
     Fair Value      % Total     Average
Reset
     Fair Value      % Total     Average
Reset
 

Less than one year

   $ 22,907         0     7       $ 25,803         1     7   

Greater than or equal to one year and less than two years

     91,900         2     19         218,928         5     18   

Greater than or equal to two years and less than three years

     601,892         13     30         737,130         19     33   

Greater than or equal to three years and less than five years

     445,186         10     44         1,010,349         26     47   

Greater than or equal to five years

     3,451,055         75     88         1,957,954         49     94   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Total / Weighted Average

   $ 4,612,940         100     74       $ 3,950,164         100     66   
  

 

 

    

 

 

   

 

 

    

 

 

    

 

 

   

 

 

 

Actual maturities of agency securities are generally shorter than stated contractual maturities primarily as a result of prepayments of principal of the underlying mortgages. The stated contractual final maturity of the mortgage loans underlying our portfolio of agency securities ranges up to 40 years, but the expected maturity is subject to change based on the actual and expected future prepayments of the underlying loans. As of June 30, 2011 and December 31, 2010, the average final contractual maturity of the agency securities in our investment portfolio was 21 and 22 years, respectively. The estimated weighted average months to maturity of the agency securities in the table below are based upon our prepayment expectations, which are estimated based on assumptions for different securities using a combination of third-party services, market data and internal models. The third-party services estimate prepayment speeds using models that incorporate the forward yield curve, mortgage rates, current mortgage rates of the outstanding loans, loan age, volatility and other factors. As market conditions are changing rapidly, we use judgment in making adjustments to our models for some products. Various market participants could use materially different assumptions.

 

33


The following table summarizes our agency securities classified as available-for-sale, at fair value, according to their estimated weighted average life classifications as of June 30, 2011 and December 31, 2010 (in thousands):

 

     As of June 30, 2011     As of December 31, 2010  

Weighted Average Life

   Fair Value      Amortized
Cost
     Weighted
Average
Coupon
    Fair Value      Amortized
Cost
     Weighted
Average
Coupon
 

Less than or equal to one year

   $ 43,212       $ 43,350         3.81   $ —         $ —           —     

Greater than one year and less than or equal to three years

     1,056,763         1,035,249         4.95     133,123         132,520         5.05

Greater than three years and less than or equal to five years

     4,188,329         4,134,240         4.48     3,841,282         3,821,992         4.92

Greater than five years

     34,390,359         34,214,673         4.19     9,479,136         9,526,980         4.31
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 

Total

   $ 39,678,663       $ 39,427,512         4.24   $ 13,453,541       $ 13,481,492         4.49
  

 

 

    

 

 

    

 

 

   

 

 

    

 

 

    

 

 

 

The weighted average life of our interest-only and principal-only securities was 5.2 and 6.2 years as of June 30, 2011 and December 31, 2010, respectively.

The constant prepayment rate (“CPR”) reflects the percentage of principal that is prepaid over a period of time on an annualized basis. In general, while there are various factors that impact the rate of prepayments, as interest rates rise, the rate of refinancings typically declines, which may result in lower rates of prepayment and, as a result, a lower portfolio CPR. Conversely, as interest rates fall, the rate of refinancings typically increases, which may result in higher rates of prepayment and, as a result, a higher portfolio CPR. As of June 30, 2011, our portfolio was purchased at a net premium.

In determining the estimated weighted average months to maturity of our agency securities and the yield on our agency securities, we have assumed that the CPR over the remaining projected life of our aggregate investment portfolio is 10% as of June 30, 2011. We make different prepayment assumptions for the individual securities that comprise the investment portfolio and these individual assumptions can differ materially from the average. There is also considerable uncertainty around prepayment speeds in this environment and actual speeds could differ materially from our estimates. Furthermore, GSE buyouts of loans in imminent risk of default, loans that have been modified, or loans that have defaulted will generally be reflected as prepayments on agency securities and also increase the uncertainty around these estimates. In addition, securities were purchased with different amounts of premiums and therefore the yield on some securities is more sensitive to changes in prepayment speeds.

 

34


RESULTS OF OPERATIONS

The following analysis of our financial condition and results of operations should be read in conjunction with our interim consolidated financial statements and the notes thereto. The tables below present our condensed consolidated balance sheets as of June 30, 2011 and December 31, 2010 and our consolidated statements of operations and key statistics for the three and six months ended June 30, 2011 and 2010 (in thousands, except per share amounts):

 

     As of  
Balance Sheet Data:    June 30, 2011      December 31, 2010  

Investment portfolio, at fair value

   $ 39,925,707       $ 13,510,280   

Total assets

   $ 43,636,570       $ 14,475,829   

Repurchase agreements and other debt

   $ 33,566,899       $ 11,753,019   

Total liabilities

   $ 38,859,924       $ 12,903,765   

Total stockholders’ equity

   $ 4,776,646       $ 1,572,064   

Net asset value per common share as of period end(1)

   $ 26.76       $ 24.24   

 

     For the three months
ended June 30,
    For the six months
ended June 30,
 
Consolidated Statement of Operations Data:    2011     2010     2011     2010  

Interest income

   $ 264,728      $ 50,589      $ 429,221      $ 89,386   

Interest expense

     63,816        17,348        99,464        32,858   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net interest income

     200,912        33,241        329,757        56,528   
  

 

 

   

 

 

   

 

 

   

 

 

 

Gain from sale of agency securities, net

     93,892        29,585        98,112        56,993   

Loss from derivative instruments and trading securities, net

     (100,013     (21,867     (88,484     (15,947
  

 

 

   

 

 

   

 

 

   

 

 

 

Total other income, net

     (6,121     7,718        9,628        41,046   
  

 

 

   

 

 

   

 

 

   

 

 

 

Management fees

     12,423        2,314        20,877        4,098   

General and administrative expenses

     4,546        1,787        7,143        3,468   
  

 

 

   

 

 

   

 

 

   

 

 

 

Total expenses

     16,969        4,101        28,020        7,566   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income

   $ 177,822      $ 36,858      $ 311,365      $ 90,008   
  

 

 

   

 

 

   

 

 

   

 

 

 

Net income per common share—basic and diluted

   $ 1.36      $ 1.23      $ 2.82      $ 3.28   
  

 

 

   

 

 

   

 

 

   

 

 

 

Weighted average number of common shares outstanding—basic and diluted

     130,467        29,872        110,496        27,451   
  

 

 

   

 

 

   

 

 

   

 

 

 

Dividends declared

   $ 1.40      $ 1.40      $ 2.80      $ 2.80   
  

 

 

   

 

 

   

 

 

   

 

 

 

 

35


     For the three months ended
June 30,
    For the six months
ended June 30,
 
Other Data:    2011     2010     2011     2010  

Average agency securities, at cost

   $ 31,552,263      $ 5,886,806      $ 25,480,054      $ 4,993,331   

Average agency securities, at cost—percent of par value

     104.4     104.1     104.4     104.0

Average total assets, at fair value

   $ 34,442,961      $ 6,498,247      $ 27,519,559      $ 5,545,264   

Average repurchase agreements and other debt(2)

   $ 28,668,011      $ 5,548,225      $ 23,205,847      $ 4,670,611   

Average stockholders’ equity(3)

   $ 3,785,199      $ 705,466      $ 3,102,208      $ 643,107   

Average coupon(4)

     4.55     5.20     4.55     5.19

Average asset yield(5)

     3.35     3.44     3.37     3.58

Average cost of funds(6)

     0.89     1.07     0.86     1.15

Average cost of funds—terminated swap amortization expense(7)

     —          0.19     —          0.27

Average net interest rate spread(8)

     2.46     2.18     2.51     2.16

Average actual CPR for securities held during the period

     9     28     10     24

Average forecasted CPR as of period end

     10     20     10     20

Leverage (average during the period)(9)

     7.6:1        7.9:1        7.5:1        7.3:1   

Leverage (as of period end)(10)

     7.5:1        8.2:1        7.5:1        8.2:1   

Annualized expenses % of average assets(11)

     0.20     0.25     0.21     0.28

Annualized expenses % of average equity(12)

     1.80     2.33     1.82     2.37

Net return on average stockholders’ equity(13)

     18.8     21.0     20.2     28.2

Annualized economic return(14)

     34.0     35.5     44.3     34.6

 

* Average numbers for each period are weighted based on days on our books and records, all percentages are annualized.
(1) Net asset value per common share was calculated by dividing our total stockholders’ equity by our number of shares outstanding.
(2) Average repurchase agreement and other debt represents their daily weighted average balances, less amounts used to fund short-term investments in U.S. treasury securities.
(3) Average stockholders’ equity calculated as the average month-end stockholders’ equity balance outstanding during the period.
(4) Weighted average coupon for the period was calculated by dividing our total coupon (or cash) interest income on our agency securities by our daily weighted average agency securities.
(5) Weighted average asset yield for the period was calculated by dividing our total interest income on our agency securities, including amortization of premiums and discounts, by our daily weighted average agency securities.
(6) Weighted average cost of funds for the period was calculated by dividing our total interest expense by our daily weighted average repurchase agreements and other debt. Total interest expense excludes amortization expense related to the costs of the previously terminated interest rate swaps during the periods presented.
(7) Represents amortization expense associated with interest rate swaps terminated in a prior period of $2.6 million and $6.3 million for the three and six months ended June 30, 2010, respectively,
(8) Average net interest rate spread for the period was calculated by subtracting our weighted average cost of funds, net of interest rate swaps and terminated swap amortization expense, from our weighted average asset yield.
(9) Leverage during the period was calculated by dividing the our daily weighted average repurchase agreements and other debt outstanding, less repurchase agreements for treasury securities, for the period by our average month-ended stockholders’ equity for the period. Average leverage for the three month period ended June 30, 2011 was 8.3x, pro forma, when average equity is adjusted to exclude the June 2011 follow-on equity offering that closed on June 28, 2011.
(10)

Leverage at period end was calculated by dividing the sum of the amount outstanding under our repurchase

 

36


  agreements, net receivable/payable for unsettled agency securities and other debt by our total stockholders’ equity at period end.
(11) Annualized expenses as a percentage of average total assets was calculated by dividing our total expenses by our average total assets on an annualized basis.
(12) Annualized expenses as a percentage of average stockholders’ equity was calculated by dividing our total expenses by our average stockholders’ equity on an annualized basis.
(13) Annualized net return on average stockholders’ equity for the period was calculated by dividing our net income by our average stockholders’ equity on an annualized basis.
(14) Annualized economic return represents the sum of the change in net asset value over the period and dividends declared during the period over the beginning net asset value on an annualized basis.

Interest Income and Asset Yield

Interest income was $264.7 million and $50.6 million for the three months ended June 30, 2011 and 2010, respectively. Interest income was $429.2 million and $89.4 million for the six months ended June 30, 2011 and 2010, respectively. The year-over-year increases were due to an increase in our average investment portfolio, partially offset by a decline in our average asset yield.

Our average asset yield declined to 3.35% for the current three month period from 3.44% for the prior year three month period and to 3.37% for the current six month period from 3.58% for the prior year six month period as a result of acquiring lower yielding securities due to changes in portfolio composition. The average coupon of our investment portfolio declined to 4.55% for each of the current year periods from approximately 5.20% for the prior year periods, while the average amortized cost basis of our investment portfolio remained largely unchanged at 104.4% of par value for each of the current year periods compared to approximately 104.1% of par value for the prior year periods.

We amortize premiums and discounts associated with agency securities into interest income over the life of such securities using the effective yield method. The effective yield (or asset yield) on our agency securities is based on actual CPRs realized for individual securities in our investment portfolio through the reporting date and assumes a CPR over the remaining projected life of our aggregate investment portfolio of 10% and 20% as of June 30, 2011 and 2010, respectively. The actual CPR realized for individual securities in our investment portfolio was approximately 9% and 28% for the current and prior year three month periods, respectively, and 10% and 24% for the current and prior year six month periods, respectively. The year-over-year decrease in the actual CPR realized is due to the impact of buyouts of accumulated delinquent loans by the GSEs from mortgage pools collateralizing agency securities (“GSE Buyouts”) during the first half of 2010, which had the impact of increasing the average prepayment speed of our portfolio during the prior year period. The decrease in the forecasted CPR is primarily due a higher percentage of securities held that are collateralized by loans with favorable prepayment attributes as of June 30, 2011 relative to the prior period.

Additionally, pursuant to ASC 310-20, the yield on our adjustable rate securities assumes that the securities reset at a rate equal to the underlying index rate in effect as of the date we acquired the security plus the stated margin. Consequently, future reset rate assumptions incorporated in our asset yields may differ materially from future reset rates implied by the forward yield curve and the actual reset rates ultimately achieved. Further, notwithstanding changes to our actual and projected CPR assumptions, the lower our reset rate assumption is pursuant to ASC 310-20 than the current fixed rate in effect, the greater the rate of premium amortization we will recognize over the initial fixed rate period. Our adjustable rate portfolio was acquired for a premium above par value and most securities were acquired during a period of historically low index rates. Accordingly, the majority of the premium balance on our adjustable rate securities will be amortized prior to their first reset date, regardless of actual or forecasted prepayment speeds and changes in the underlying index rates prior to actual reset. Adjustable rate securities acquired during a different interest rate environment may experience a different premium amortization pattern even as current index rates remain near their historical lows. For adjustable rate securities held as of June 30, 2011, the weighted average coupon rate was 4.18%, the weighted average months to reset was 74 months and the weighted average reset rate assumption was 2.72%, which is based on a weighted average underlying index rate of 0.91% as of the date we acquired the securities and a weighted average margin of 1.81%.

 

37


Interest income for the current and prior year three month period is net of $78.9 million and $22.9 million, respectively, and for the current and prior year six month period is net of $126.9 million and $35.2 million, respectively, for net amortization of premiums and discounts on our investment portfolio. The unamortized premium balance of our aggregate investment portfolio, including the unamortized cost basis of our interest-only securities and net of discounts, was $1.7 billion and $626.3 million as of June 30, 2011 and December 31, 2010, respectively.

Leverage

Our leverage as of June 30, 2011 and December 31, 2010 was 7.0 and 7.5 times our stockholders’ equity, respectively. When adjusted for the net payable for agency securities purchased but not yet settled, our leverage ratio was 7.5 and 7.8 times our stockholders’ equity as of June 30, 2011 and December 31, 2010, respectively. Our actual leverage will vary from time to time based on various factors, including our Manager’s opinion of the level of risk of our assets and liabilities, our liquidity position, our level of unused borrowing capacity, over-collateralization levels required by lenders when we pledge agency securities to secure our borrowings and the current market value of our investment portfolio. In addition, certain of our master repurchase agreements and master swap agreements contain a restriction that prohibits our leverage from exceeding certain levels.

The table below presents our quarterly average and quarter end repurchase agreement and other debt balances outstanding and average leverage ratios for the three and six months ended June 30, 2011 and 2010 and December 31, 2010 (dollars in thousands):

 

    Repurchase Agreements and Other Debt     Average
Daily
Interest
Rate on
Amounts
Outstanding
    Average
Interest
Rate on
Ending
Amount
Outstanding
    Average
Leverage(1)
    Leverage
as of Period
End(2)
    Leverage
as of
Period
End,
Net of
Unsettled
Trades(3)
 

Quarter Ended

  Average Daily
Amount
Outstanding
    Maximum
Daily Amount
Outstanding
    Ending
Amount
Outstanding
           

March 31, 2010

  $ 3,787,583      $ 4,651,115      $ 4,651,115        0.22     0.21     6.5:1        7.6:1        7.9:1   

June 30, 2010

  $ 5,548,225      $ 6,634,342      $ 6,634,342        0.26     0.28     7.9:1        8.4:1        8.2:1   

December 31, 2010(5)

  $ 10,813,568      $ 12,340,635      $ 11,753,019        0.29     0.31     8.4:1        7.5:1        7.8:1   

March 31, 2011(4)(5)

  $ 17,755,790      $ 22,147,273      $ 22,061,884        0.28     0.28     7.4:1        6.6:1        7.6:1   

June 30, 2011(4)(5)

  $ 28,668,011      $ 33,566,899      $ 33,566,899        0.25     0.23     7.6:1        7.0:1        7.5:1   

 

(1) Average leverage for the period was calculated by dividing our daily weighted average repurchase agreements and other debt outstanding, less repurchase agreements for treasury securities, by the Company’s average month-ended stockholders’ equity for the period.
(2) Leverage as of period end was calculated by dividing the amount outstanding under our repurchase agreements and other debt by our stockholders’ equity at period end.
(3) Leverage as of period end, net of unsettled trades was calculated by dividing the sum of the amount outstanding under our repurchase agreements, net liabilities and receivables for unsettled agency securities and other debt by our total stockholders’ equity at period end.
(4) Average leverage for the three months ended March 31 and June 30, 2011 was 8.2x and 8.3x, pro forma, when average equity is adjusted to exclude the March and June 2011 follow-on equity offering that closed on March 25 and June 28, 2011, respectively.
(5) Average leverage for the period was higher than leverage as of period end because we had not fully invested net proceeds raised from follow-on equity offerings occurring late in the period.

 

38


Interest Expense and Cost of Funds

Interest expense was $63.8 million and $17.3 million for the three months ended June 30, 2011 and 2010, respectively. Interest expense was $99.5 million and $32.9 million for the six months ended June 30, 2011 and 2010, respectively. The year-over-year increase in interest expense was due to an increase in our average repurchase agreement and other debt balance outstanding, partially offset by a decline in swap interest expense due to timing differences between asset settlements and the initiation of new interest rate swap agreements and a reduction of swap interest expense of $2.6 million and $6.3 million for terminated swap amortization expense recorded during the three and six month prior year periods, respectively.