10-Q 1 mtgeform10-q9302012.htm 10-Q MTGE Form 10-Q 9/30/2012



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-Q
 
ý
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2012
OR
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF
THE SECURITIES EXCHANGE ACT OF 1934


Commission file number 001-35260
 

AMERICAN CAPITAL MORTGAGE INVESTMENT CORP.
(Exact name of registrant as specified in its charter)
 
Maryland
 
45-0907772
(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) 968-9220
(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  ý    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 ý   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
o
 
Accelerated filer
o
 
 
 
 
 
Non-accelerated filer
ý
(Do not check if a smaller reporting company)
Smaller Reporting Company
o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  ý
The number of shares of the issuer’s common stock, $0.01 par value, outstanding as of November 1, 2012 was 36,262,100.
 




AMERICAN CAPITAL MORTGAGE INVESTMENT CORP.
TABLE OF CONTENTS
 


1



PART I
Item 1. Financial Statements

AMERICAN CAPITAL MORTGAGE INVESTMENT CORP.
CONSOLIDATED BALANCE SHEETS
(in thousands, except per share amounts)

                     
 
September 30, 2012

December 31, 2011
 
(unaudited)
 
(audited)
Assets:
 
 
 
Agency securities, at fair value (including pledged securities of $6,183,812 and $1,535,388, respectively)
$
6,337,238

 
$
1,740,091

Non-agency securities, at fair value (including pledged securities of $352,840 and $8,626, respectively)
552,787

 
25,561

Linked transactions, at fair value

 
13,671

Cash and cash equivalents
156,269

 
57,428

Restricted cash and cash equivalents
15,756

 
3,159

Interest receivable
17,792

 
5,566

Derivative assets, at fair value
15,030

 
1,845

Receivable for securities sold
106,606

 
271,849

Receivable under reverse repurchase agreements
344,075

 
50,563

Other assets
746

 
589

Total assets
$
7,546,299

 
$
2,170,322

Liabilities:
 
 
 
Repurchase agreements
$
6,117,783

 
$
1,706,281

Payable for securities purchased
50,663

 
189,042

Derivative liabilities, at fair value
76,437

 
5,669

Dividend payable
32,636

 
8,005

Obligation to return securities borrowed under reverse repurchase agreements, at fair value
347,367

 
50,154

Accounts payable and other accrued liabilities
7,073

 
2,370

Total liabilities
6,631,959

 
1,961,521

Stockholders’ equity:
 
 
 
Preferred stock, $0.01 par value; 50,000 shares authorized, 0 shares issued and outstanding, respectively

 

Common stock, $0.01 par value; 300,000 shares authorized, 36,262 and 10,006 shares issued and outstanding, respectively
363

 
100

Additional paid-in capital
778,804

 
199,038

Retained earnings
135,173

 
9,663

Total stockholders’ equity
914,340

 
208,801

Total liabilities and stockholders’ equity
$
7,546,299

 
$
2,170,322

See accompanying notes to consolidated financial statements.


2



AMERICAN CAPITAL MORTGAGE INVESTMENT CORP.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
(unaudited)

 
 
For the Three Months Ended September 30, 2012
 
For the Nine Months Ended September 30, 2012
 
For the Period from August 9, 2011
(date operations commenced) through
September 30, 2011
Interest income:
 
 
 
 
 
Agency securities
$
37,311

 
$
82,938

 
$
4,039

Non-agency securities
6,949

 
12,518

 
65

Other
95

 
196

 
24

Interest expense
(7,329
)
 
(13,779
)
 
(383
)
Net interest income
37,026

 
81,873

 
3,745


 
 
 
 
 
Other gains (losses):
 
 
 
 
 
Realized gain on agency securities, net
23,566

 
46,633

 
2,392

Realized gain on non-agency securities, net
952

 
952

 

Realized loss on periodic settlements of interest rate swaps, net
(6,855
)
 
(11,711
)
 
(577
)
Realized loss on other derivatives and securities, net
(29,132
)
 
(45,957
)
 
(3,342
)
Unrealized gain on agency securities, net
95,477

 
164,994

 
1,970

Unrealized gain (loss) on non-agency securities, net
33,118

 
34,506

 
(747
)
Unrealized gain (loss) and net interest income on Linked Transactions, net

 
3,384

 
(813
)
Unrealized gain (loss) on other derivatives and securities, net
(3,118
)
 
(64,300
)
 
819

Total other gain (loss), net
114,008

 
128,501

 
(298
)

 
 
 
 
 
Expenses:
 
 
 
 
 
Management fees
2,945

 
6,633

 
431

General and administrative expenses
1,415

 
3,509

 
550

Total expenses
4,360

 
10,142

 
981


 
 
 
 
 
Income before excise tax
146,674

 
200,232

 
2,466

Excise tax
432

 
441

 

Net income
$
146,242

 
$
199,791

 
$
2,466


 
 
 
 
 
Net income per common share—basic and diluted
$
4.03

 
$
7.86

 
$
0.25

 
 
 

 
 
Weighted average number of common shares outstanding—basic and diluted
36,262

 
25,411

 
10,006

 
 
 

 

Dividends declared per common share
$
0.90

 
$
2.70

 
$
0.20

See accompanying notes to consolidated financial statements.


3



AMERICAN CAPITAL MORTGAGE INVESTMENT CORP.
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
(in thousands)

 
 
Preferred Stock
 
Common Stock
 
Additional
Paid-in
Capital
 
Retained
Earnings
 
Total
 
Shares
 
Amount
 
Shares
 
Amount
 
Balance, December 31, 2011 (audited)

 
$

 
10,006

 
$
100

 
$
199,038

 
$
9,663

 
$
208,801

Net income

 

 

 

 

 
199,791

 
199,791

Issuance of common stock

 

 
26,250

 
263

 
579,710

 

 
579,973

Issuance of restricted stock

 

 
6

 

 

 

 

Stock-based compensation

 

 

 

 
56

 

 
56

Common dividends declared

 

 

 

 

 
(74,281
)
 
(74,281
)
Balance, September 30, 2012 (unaudited)

 
$

 
36,262

 
$
363

 
$
778,804

 
$
135,173

 
$
914,340

See accompanying notes to consolidated financial statements.


4



AMERICAN CAPITAL MORTGAGE INVESTMENT CORP.
CONSOLIDATED STATEMENT OF CASH FLOWS
(in thousands, unaudited)
 
For the Nine Months Ended September 30, 2012
 
For the Period from August 9, 2011 (date operations commenced) through September 30, 2011
CASH FLOWS FROM OPERATING ACTIVITIES:

 
 
Net income
$
199,791

 
$
2,466

Adjustments to reconcile net income to net cash flows from operating activities:
 
 

Amortization of net premium on agency securities
23,816

 
1,316

Accretion of net discount on non-agency securities
(8,443
)
 
(97
)
Unrealized gain on securities and derivatives, net
(137,877
)
 
(1,074
)
Realized gain on agency securities, net
(46,633
)
 
(2,462
)
Realized gain on non-agency securities, net
(952
)
 

Realized loss on derivatives and securities, net
57,668

 
3,989

Stock-based compensation
56

 
5

Increase in interest receivable
(12,226
)
 
(5,133
)
Increase in other assets
(157
)
 
(634
)
Increase in accounts payable and other accrued liabilities
4,703

 
1,560

Net cash flows from (used in) operating activities
79,746

 
(64
)
CASH FLOWS USED IN INVESTING ACTIVITIES:


 
 
Purchases of agency securities
(7,825,160
)
 
(1,836,738
)
Purchases of non-agency securities
(458,384
)
 
(27,461
)
Proceeds from sale of agency securities
2,639,053

 
308,897

Principal collections on agency securities
803,635

 
5,650

Principal collections on non-agency securities
27,956

 
801

Purchases of non-agency securities underlying Linked Transactions
(6,589
)
 
(34,628
)
Proceeds from sale of non-agency securities
4,575

 

Principal collections on non-agency securities underlying Linked Transactions
1,987

 
428

Purchases of U.S. Treasury securities to cover short sale
(3,065,223
)
 
(410,951
)
Proceeds from short sale of U.S. Treasury securities
3,354,453

 
434,885

Payments of reverse repurchase agreements
(3,812,305
)
 
(499,857
)
Proceeds from reverse repurchase agreements
3,518,793

 
473,982

Purchases of U.S. Treasury securities
(50,166
)
 
(75,441
)
Proceeds from sale of U.S. Treasury securities
49,902

 
75,511

Payment of premiums for interest rate swaptions
(10,352
)
 

Increase in restricted cash and cash equivalents
(12,597
)
 
(11,241
)
Net payments on other derivatives
(45,754
)
 
(2,570
)
  Net cash flows used in investing activities
(4,886,176
)
 
(1,598,733
)
CASH FLOWS FROM FINANCING ACTIVITIES:

 
 
Dividends paid
(49,650
)
 

Proceeds from common stock offerings, net of offering costs
579,973

 
199,280

Proceeds from repurchase agreements
23,592,190

 
1,816,664

Repayments on repurchase agreements
(19,219,900
)
 
(382,138
)
Proceeds from repurchase agreements underlying Linked Transactions
91,735

 
26,387

Repayments of repurchase agreements underlying Linked Transactions
(89,077
)
 

Net cash flow from financing activities
4,905,271

 
1,660,193

Net increase in cash and cash equivalents
98,841

 
61,396

Cash and cash equivalents at beginning of the period
57,428

 

Cash and cash equivalents at end of period
$
156,269

 
$
61,396

Supplemental non-cash investing and financing activities:
 
 
 
Non-agency securities recorded upon de-linking of Linked Transactions
$
58,061

 
$

Repurchase agreements recorded upon de-linking of Linked Transactions
$
39,212

 
$

See accompanying notes to consolidated financial statements.

5



AMERICAN CAPITAL MORTGAGE INVESTMENT CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)

Note 1. Unaudited Interim Consolidated Financial Statements
The interim consolidated financial statements of American Capital Mortgage Investment Corp. (together with its consolidated subsidiary, American Capital Mortgage Investment TRS, LLC, is referred to 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 interim unaudited consolidated financial statements include the accounts of our wholly-owned subsidiary, American Capital Mortgage Investment TRS, LLC. As of September 30, 2012, there has been no activity in American Capital Mortgage Investment TRS, LLC.
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.
Note 2. Organization
We were incorporated in Maryland on March 15, 2011 and commenced operations on August 9, 2011 following the completion of our initial public offering (“IPO”). We are externally managed by American Capital MTGE Management, LLC (our “Manager”), an affiliate of American Capital, Ltd. ("American Capital"). We do not have any employees. Our common stock is traded on the NASDAQ Global Select Market under the symbol “MTGE.”
We invest in, finance and manage a leveraged portfolio of mortgage-related investments, which we define to include agency mortgage investments, non-agency mortgage investments and other mortgage-related investments. Agency mortgage investments include residential mortgage pass-through certificates and collateralized mortgage obligations (“CMOs”) structured from residential mortgage pass-through certificates for which the principal and interest payments are guaranteed by a government-sponsored entity (“GSE”), 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”). Non-agency mortgage investments include residential mortgage-backed securities (“RMBS”) backed by residential mortgages that are not guaranteed by a GSE or U.S. Government agency. Non-agency mortgage investments may also include prime and non-prime residential mortgage loans. Other mortgage-related investments may include commercial mortgage-backed securities (“CMBS”), commercial mortgage loans, mortgage-related derivatives and other mortgage-related investments.
Our objective is to provide attractive risk-adjusted returns to our stockholders over the long-term through a combination of dividends and net book value appreciation. In pursuing this objective, we rely on our Manager's expertise to construct and manage a diversified mortgage investment portfolio by identifying asset classes that, when properly financed and hedged, are designed to produce attractive returns across a variety of market conditions and economic cycles, considering the risks associated with owning such investments.
We have elected to be taxed as a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986, as amended (the “Internal Revenue Code”). As such, we are required to distribute annually at least 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. It is our intention to distribute 100% of our taxable income, after application of available tax attributes, within the time limits prescribed by the Internal Revenue Code, which may extend into the subsequent taxable year.


6



Note 3. Summary of Significant Accounting Policies
Fair Value of Financial Assets
We have elected the option to account for all of our financial assets, including all mortgage-related investments, at estimated fair value, with changes in fair value reflected in income during the period in which they occur. In management's view, this election more appropriately reflects the results of our operations for a particular reporting period, as financial asset fair value changes are presented in a manner consistent with the presentation and timing of the fair value changes of economic hedging instruments. See Note 8 - Fair Value Measurements.
Interest Income
Interest income is accrued based on the outstanding principal amount of the securities and their contractual terms. Premiums and discounts associated with the purchase of agency securities and non-agency securities of high credit quality are amortized or accreted into interest income over the projected lives of the securities, including contractual payments and estimated prepayments, using the effective interest method. 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 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 at least 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.
At the time we purchase non-agency securities and loans that are not of high credit quality, we determine an effective yield based on our estimate of the timing and amount of future cash flows and our cost basis. Our initial cash flow estimates for these investments are based on our observations of current information and events and include assumptions related to interest rates, prepayment rates and the timing and amount of credit losses. On at least a quarterly basis, we review the estimated cash flows and make appropriate adjustments, based on input and analysis received from external sources, internal models, and our judgment about interest rates, prepayment rates, the timing and amount of credit losses, and other factors. Any resulting changes in effective yield are recognized prospectively based on the current amortized cost of the investment as adjusted for credit impairment, if any.
Repurchase Agreements
We finance the acquisition of agency securities and certain non-agency securities for our investment portfolio through repurchase transactions under master repurchase agreements. We account for repurchase transactions, other than those treated as Linked Transactions (see Derivatives below), as collateralized financing transactions which are carried at their contractual amounts, including accrued interest, as specified in the respective transaction agreements. The contractual amounts approximate fair value due to their short-term nature.
Derivatives
We maintain a risk management strategy, under which we may use a variety of derivative instruments to economically hedge some of our exposure to market risks, including interest rate risk, prepayment risk and credit risk. The objective of our risk management strategy is to reduce fluctuations in net book value over a range of market conditions. The principal instruments that we currently use are interest rate swaps, to-be-announced forward contracts (“TBAs”), U.S. Treasury securities, and options to enter into interest rate swaps (“interest rate swaptions”). In the future, we may also use forward contracts for specified agency securities, U.S. Treasury futures contracts and put or call options on TBA securities. We may also invest in other types of mortgage derivatives, such as interest-only securities, credit default swaps and synthetic total return swaps.
We recognize all derivatives as either assets or liabilities on the balance sheet, measured at fair value. As we have not designated any derivatives as hedging instruments, all changes in fair value are reported in earnings in our consolidated statements of operations in unrealized loss on other derivatives and securities, net during the period in which they occur. Derivatives in a gain position are reported as derivative assets at fair value and derivatives in a loss position are reported as

7



derivative liabilities at fair value in our consolidated balance sheet. 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 investing section for derivatives not designated in hedging relationships.
Our derivative agreements and repurchase agreements generally contain provisions that allow for netting or setting off receivables and payables with each counterparty. We report amounts in our consolidated balance sheets on a gross basis without regard for such rights of offset or master netting arrangements.
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, monitoring positions with individual counterparties and adjusting posted collateral as required.
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 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 LIBOR rates and the pay rate on the interest rate swap. 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. The payment of periodic settlements of net interest on interest rate swaps are reported in realized gain (loss) on periodic settlements of interest rate swaps, net in our consolidated statements of operations. Cash payments received or paid for the early termination of an interest rate swap agreement are recorded as realized gain (loss) on other derivatives and securities, net in our consolidated statements of operations. Changes in fair value of our interest rate swap agreements are reported in unrealized gain (loss) on other derivatives and securities, net in our consolidated statements of operations.
Interest rate swaptions
We purchase interest rate swaptions to help mitigate the potential impact of increases or decreases in interest rates on the performance of our investment portfolio. 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 or receive interest rates in the future. The premium paid for interest rate swaptions is reported as a derivative asset in our consolidated balance sheets. 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. The difference between the premium and the fair value of the swaption is reported in unrealized gain (loss) on other derivatives and securities, net in our consolidated statements of operations. If a swaption expires unexercised, the loss on the swaption would be equal to the premium paid and reported in realized gain (loss) on other derivatives and securities, net in our consolidated statements of operations. If we exercise a swaption, the realized gain or loss on the swaption would be equal to the difference between the fair value of the underlying interest rate swap and the premium paid and reported in realized gain (loss) on other derivatives and securities, net in our consolidated statements of operations.
TBA securities
A TBA security is a forward 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 under the contract on the settlement date, which is published each month by the Securities Industry and Financial Markets Association, are not known at the time of the transaction. Realized gains and losses associated with our TBA contracts are recognized on our consolidated statements of operations in the line item realized gain (loss) on other derivatives and securities, net, and unrealized gains and losses are recognized in unrealized gain (loss) on other derivatives and securities, net, in the period in which they occur. We estimate the fair value of TBA securities based on methods used to value our agency securities, as well as the remaining length of time of the forward commitment.
Linked Transactions
If we finance the purchase of securities with repurchase agreements with the same counterparty from whom the securities are purchased and both transactions are entered into contemporaneously or in contemplation of each other, the transactions are presumed not to meet sale accounting criteria. We will account for the purchase of such securities and the repurchase agreement on a net basis and record a forward purchase commitment to purchase securities (each, a “Linked Transaction”) at fair value on our consolidated balance sheets in the line item Linked Transactions, at fair value. Changes in the fair value of the

8



assets and liabilities underlying the Linked Transactions and associated interest income and expense are reported as unrealized gain and net interest income on Linked Transactions, net on our consolidated statements of operations. If we subsequently finance the securities in a Linked Transaction with a different counterparty, we will regard it as an acquisition of a security and the repurchase financing as a collateralized financing transaction.
Forward commitments to purchase or sell specified securities
We may enter into a forward commitment to purchase or sell specified 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 securities are accounted for as derivatives if the delivery of the specified security and settlement extends beyond the period generally established by regulation or convention for that type of security. Realized gains and losses associated with forward commitments are recognized in the line item realized gain on other derivatives and securities, net and unrealized gains and losses are recognized in unrealized loss on other derivatives and securities, net on our consolidated statements of operations. We estimate the fair value of forward commitments to purchase or sell specified mortgage-backed securities based on methods used to value our mortgage-backed 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 our consolidated balance sheets based on the value of the underlying borrowed securities as of the reporting date. Realized gains and losses associated with purchases and short sales of U.S. Treasury securities are recognized in realized gain on other derivatives and securities, net, and unrealized gains and losses are recognized in unrealized loss on other derivatives and securities, net, on our consolidated statement of operations.
Recent Accounting Pronouncements

In December 2011, the FASB issued ASU No. 2011-11, Balance Sheet (Topic 210): Disclosures about Offsetting Assets and Liabilities (“ASU 2011-11”). The update requires new disclosures about balance sheet offsetting and related arrangements. For derivatives and financial assets and liabilities, the amendments require disclosure of gross asset and liability amounts, amounts offset on the balance sheet, and amounts subject to the offsetting requirements but not offset on the balance sheet. The guidance is effective January 1, 2013 and is to be applied retrospectively. This guidance does not amend the existing guidance on when it is appropriate to offset. As a result, we do not expect this guidance to have a material effect on our financial statements.

Reclassifications

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



9



Note 4. Agency Securities
The following tables summarize our investments in agency securities as of September 30, 2012 and December 31, 2011 (dollars in thousands):
 
As of September 30, 2012
 
Fannie Mae
 
Freddie Mac
 
Total
Fixed-rate agency securities:
 
 
 
 
 
Agency securities, par
$
4,970,551

 
$
885,768

 
$
5,856,319

Unamortized premium
254,095

 
48,013

 
302,108

Amortized cost
5,224,646

 
933,781

 
6,158,427

Gross unrealized gains
152,375

 
26,650

 
179,025

Gross unrealized losses
(156
)
 
(58
)
 
(214
)
Fixed-rate agency securities, at fair value
$
5,376,865

 
$
960,373

 
$
6,337,238

 
 
 
 
 
 
Weighted average coupon as of September 30, 2012
3.45
%
 
3.60
%
 
3.47
%
Weighted average yield as of September 30, 2012
2.40
%
 
2.61
%
 
2.43
%
Weighted average yield for the three months ended September 30, 2012
2.49
%
 
2.46
%
 
2.48
%
Weighted average yield for the nine months ended September 30, 2012
2.66
%
 
2.68
%
 
2.66
%

 
As of December 31, 2011
 
Fannie Mae

Freddie Mac

Total
Fixed-rate agency securities:





Agency securities, par
$
1,240,435


$
396,625


$
1,637,060

Unamortized premium
64,700


24,514


89,214

Amortized cost
1,305,135


421,139


1,726,274

Gross unrealized gains
11,260


2,923


14,183

Gross unrealized losses
(120
)

(246
)

(366
)
Fixed-rate agency securities, at fair value
$
1,316,275


$
423,816


$
1,740,091

 
 
 
 



Weighted average coupon as of December 31, 2011
3.95
%

4.19
%

4.01
%
Weighted average yield as of December 31, 2011
2.85
%

2.91
%

2.87
%
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 as of September 30, 2012 and December 31, 2011 according to their estimated weighted average life classification (dollars in thousands):

As of September 30, 2012
 
As of December 31, 2011
Weighted Average Life
Fair
Value
 
Amortized
Cost
 
Weighted
Average
Yield
 
Fair
Value
 
Amortized
Cost
 
Weighted
Average
Yield
Greater than one year and less than or equal to three years
$

 
$

 
%
 
$
55,582

 
$
55,260

 
2.17
%
Greater than three years and less than or equal to five years
2,366,106

 
2,308,621

 
1.92
%
 
425,251

 
422,406

 
2.49
%
Greater than five years and less than or equal to 10 years
3,949,518

 
3,828,590

 
2.74
%
 
1,259,258

 
1,248,608

 
3.02
%
Greater than 10 years
21,614

 
21,216

 
2.75
%
 

 

 
%
Total / weighted average
$
6,337,238

 
$
6,158,427

 
2.43
%
 
$
1,740,091

 
$
1,726,274

 
2.87
%

10



As of September 30, 2012 and December 31, 2011, the weighted average life of our agency security portfolio was 6.0 years and 5.9 years, respectively, which incorporates anticipated future prepayment assumptions. As of September 30, 2012 and December 31, 2011, our weighted average expected constant prepayment rate (“CPR”) over the remaining life of our aggregate agency investment portfolio was 12.7% and 11.5%, respectively. 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 using a third-party service and market data. This third-party service estimates 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 service 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 developing our estimates for different securities. Prepayments are dependent on many factors and actual prepayments could differ materially from our estimates. Various market participants could use materially different assumptions. Furthermore, changes in market conditions such as interest rates, housing prices, and broad economic factors such as employment can materially impact prepayments. Additionally, modifications to GSE underwriting criteria or programs, GSE policies surrounding the buyouts or modifications of delinquent loans or other factors could significantly change the prepayment landscape.
Realized Gains and Losses
The following table summarizes our net realized gains and losses from the sale of agency securities for the three and nine months ended September 30, 2012 and from the commencement of operations on August 9, 2011 through September 30, 2011 (dollars in thousands): 
 

For the Three Months Ended September 30, 2012

For the Nine Months Ended September 30, 2012
 
For the Period from August 9, 2011
(date operations commenced) through
September 30, 2011
Proceeds from agency securities sold

$
1,266,425


$
2,639,053

 
$
308,897

Increase (decrease) in receivable for agency securities sold

(328,216
)

(165,241
)
 
110,127

Less agency securities sold, at cost

(914,643
)

(2,427,179
)
 
(416,632
)
Net realized gains on sale of agency securities

$
23,566


$
46,633

 
$
2,392

 
 


 
 
 
 
Gross realized gains on sale of agency securities

$
31,223


$
54,309

 
$
2,481

Gross realized losses on sale of agency securities

(7,657
)

(7,676
)
 
(89
)
Net realized gains on sale of agency securities

$
23,566


$
46,633

 
$
2,392

Pledged Assets
The following tables summarize our agency securities pledged as collateral under repurchase agreements and derivative agreements by type as of September 30, 2012 and December 31, 2011 (dollars in thousands):
 
As of September 30, 2012
Agency Securities Pledged(1)
Fannie Mae
 
Freddie Mac
 
Total
Under Repurchase Agreements
 
 
 
 
 
Fair value
$
5,803,430

 
$
308,759

 
$
6,112,189

Amortized cost
5,639,481

 
299,523

 
5,939,004

Accrued interest on pledged agency securities
15,540

 
839

 
16,379

Under Derivative Agreements
 
 
 
 
 
Fair value
67,278

 
4,345

 
71,623

Amortized cost
65,036

 
4,160

 
69,196

Accrued interest on pledged agency securities
178

 
14

 
192

Total Fair Value of Agency Securities Pledged and Accrued Interest
$
5,886,426

 
$
313,957

 
$
6,200,383

—————— 
(1)  
Agency securities pledged do not include pledged amounts of $82.8 million under repurchase agreements related to agency securities sold but not yet settled as of September 30, 2012.


11



 
As of December 31, 2011
Agency Securities Pledged(1)
Fannie Mae
 
Freddie Mac
 
Total
Under Repurchase Agreements
 
 
 
 
 
Fair value
$
1,219,634

 
$
311,641

 
$
1,531,275

Amortized cost
1,208,426

 
309,958

 
1,518,384

Accrued interest on pledged agency securities
3,791

 
1,006

 
4,797

Under Derivative Agreements
 
 
 
 

Fair value
1,019

 
3,094

 
4,113

Amortized cost
1,006

 
3,072

 
4,078

Accrued interest on pledged agency securities
4

 
10

 
14

Total Fair Value of Agency Securities Pledged and Accrued Interest
$
1,224,448

 
$
315,751

 
$
1,540,199

—————— 
(1)  
Agency securities pledged do not include pledged amounts of $269.5 million under repurchase agreements related to agency securities sold but not yet settled as of December 31, 2011.

The following table summarizes our agency securities pledged as collateral under repurchase agreements by remaining maturity as of September 30, 2012 and December 31, 2011 (dollars in thousands):
 
As of September 30, 2012
 
As of December 31, 2011
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
$
2,856,758

 
$
2,779,162

 
$
7,536

 
$
961,430

 
$
952,684

 
$
3,052

31 - 59 days
1,052,643

 
1,023,952

 
2,832

 
441,167

 
437,969

 
1,347

60 - 90 days
1,477,909

 
1,434,235

 
3,967

 
53,265

 
53,082

 
129

Greater than 90 days
724,879

 
701,655

 
2,044

 
75,413

 
74,649

 
269

Total
$
6,112,189

 
$
5,939,004

 
$
16,379

 
$
1,531,275

 
$
1,518,384

 
$
4,797

Note 5. Non-Agency Securities
The following table summarizes our non-agency security investments as of September 30, 2012 (dollars in thousands):
Non-Agency Securities
 
 
Fair
  Value(1)
 
Amortized Cost
 
Par/ Current Face
 
Weighted Average
Category
 
 
 
 
Coupon (2)
 
Yield
Prime
 
$
120,826

 
$
115,256

 
$
151,684

 
3.38
%
 
6.41
%
Alt-A
 
287,906

 
275,576

 
459,468

 
2.08
%
 
7.28
%
Option-ARM
 
70,386

 
61,082

 
101,532

 
0.61
%
 
7.51
%
Subprime
 
73,669

 
65,982

 
166,358

 
0.38
%
 
8.32
%
Total/ Weighted Average
 
$
552,787

 
$
517,896

 
$
879,042

 
1.81
%
 
7.24
%
————————
(1)
As of September 30, 2012, the unrealized net gain of $34.9 million on non-agency securities is comprised of $36.4 million gross unrealized gain and $1.5 million gross unrealized loss.
(2) 
Weighted average coupon rates are floating, except for $11.3 million and $19.0 million fair value of prime and Alt-A non-agency securities, respectively, as of September 30, 2012.

12



The following tables summarize our non-agency security investments as of December 31, 2011 (dollars in thousands):
Non-Agency Securities
 
 
Fair
  Value(1)
 
Amortized Cost
 
Par/ Current Face
 
Weighted Average
Category
 
 
 
 
Coupon (2)
 
Yield
Prime
 
$
7,261

 
$
7,328

 
$
9,372

 
4.61
%
 
7.23
%
Alt-A
 
12,331

 
12,069

 
16,895

 
4.17
%
 
7.55
%
Subprime
 
5,969

 
6,597

 
20,884

 
0.50
%
 
10.09
%
Total/ Weighted Average
 
$
25,561

 
$
25,994

 
$
47,151

 
2.63
%
 
8.10
%
 
 
 
 
 
 
 
 
 
 
 
Non-Agency Securities Underlying Linked Transactions (3)
 
 
Fair
  Value(1)
 
Amortized Cost
 
Par/ Current Face
 
Weighted Average
Category
 
 
 
 
Coupon (2)
 
Yield
Prime
 
$
21,273

 
$
22,030

 
$
26,954

 
3.62
%
 
5.51
%
Alt-A
 
15,020

 
14,988

 
19,609

 
2.73
%
 
6.27
%
Option-ARM
 
6,702

 
6,567

 
12,522

 
0.66
%
 
11.31
%
Subprime
 
7,198

 
8,465

 
29,586

 
0.42
%
 
9.35
%
Total/ Weighted Average
 
$
50,193

 
$
52,050

 
$
88,671

 
1.94
%
 
7.08
%
————————
(1)
As of December 31, 2011, the unrealized net loss of $0.4 million on non-agency securities is comprised of $0.7 million gross unrealized loss and $0.3 million gross unrealized gain. As of December 31, 2011, the unrealized net loss of $1.9 million on non-agency securities underlying Linked Transactions is comprised of $2.2 million gross unrealized loss and $0.3 million gross unrealized gain.
(2) 
Weighted average coupon rates are floating, except for $3.8 million fair value of prime non-agency securities and $8.4 million fair value for prime securities underlying Linked Transactions as of December 31, 2011.
(3) 
See Note 7 - Derivatives for composition of Linked Transactions.

Our Prime securities include senior tranches in securitization trusts issued between 2004 and 2007 and securities with underlying prime collateral that were re-securitized in 2009. Prime mortgage loans are residential mortgage loans that are considered to have the most stringent underwriting standards within the non-agency mortgage market, but do not carry any credit guarantee from either a U.S. government agency or GSE. These loans were originated during a period when underwriting standards were generally weak and housing prices have dropped significantly subsequent to their origination. As a result, there is still material credit risk embedded in these vintages. As of September 30, 2012, our Prime securities have both floating-rate and fixed-rate coupons ranging from 2.5% to 6.5%, with weighted average coupons of underlying collateral ranging from 2.9% to 6.1%.

Our Alt-A securities include senior tranches in securitization trusts issued between 2004 and 2006 and securities with Alt-A collateral that were re-securitized in 2010 to add an additional layer of credit support. Alt-A, or alternative A-paper, mortgage loans are considered riskier than prime mortgage loans and less risky than sub-prime mortgage loans and are typically characterized by borrowers with less than full documentation, lower credit scores, higher loan-to-value ratios and a higher percentage of investment properties. As of September 30, 2012, our Alt-A securities have both fixed and floating rate coupons ranging from 0.3% to 6.0% with weighted average coupons of underlying collateral ranging from 2.9% to 6.0%.

Our Option-ARM securities include senior tranches in securitization trusts that are collateralized by residential mortgages that have origination and underwriting characteristics similar to Alt-A mortgage loans, with the added feature of providing underlying mortgage borrowers the option, within certain constraints, to make lower payments than otherwise required by the stated interest rate for a number of years, leading to negative amortization and increased loan balances. This additional feature can increase the credit risk of these securities. As of September 30, 2012, our Option-ARM securities have coupons ranging from 0.4% to 1.1% and have underlying collateral with weighted average coupons between 2.8% and 3.8%. The loans underlying our Option-ARM securities were originated between 2002 and 2007.

Subprime securities include floating rate, senior tranches in securitization trusts collateralized by residential mortgages originated during 2006 and 2007 that were originally considered to be of lower credit quality. As of September 30, 2012, our Subprime securities have floating rate coupons ranging from 0.3% to 0.5% and have underlying collateral with weighted-average coupons ranging from 4.5% to 7.9%.

13




Our non-agency securities are generally rated below investment grade or have not been rated by credit agencies as of September 30, 2012.

Pledged Assets
Non-agency securities with a fair value of $352.8 million and $8.6 million were pledged as collateral under repurchase agreements as of September 30, 2012 and December 31, 2011, respectively. As of September 30, 2012, there were no Linked Transactions. Additionally, as of December 31, 2011, there were non-agency securities with a fair value of $50.2 million underlying Linked Transactions.
Note 6. Repurchase Agreements
We pledge certain of our 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 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 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 September 30, 2012 and December 31, 2011, we have met all margin call requirements and had no repurchase agreements maturing overnight. Repurchase agreements are carried at cost, which approximates fair value due to their short-term nature.
The following tables summarize our borrowings under repurchase arrangements and weighted average interest rates classified by original maturities as of September 30, 2012 and December 31, 2011 (dollars in thousands): 


As of September 30, 2012

As of December 31, 2011




Weighted Average



Weighted Average
Original Maturity

Borrowings
Outstanding

Interest Rate
 
Days
to Maturity

Borrowings
Outstanding

Interest Rate
 
Days
to Maturity
Repurchase Agreements
30 days or less

$
304,154


0.68
%

19


$
77,073


0.40
%

10

31 - 60 days

725,974


0.56
%

22


346,201


0.43
%

19

61 - 90 days

1,218,770


0.45
%

42


372,217


0.39
%

31

91 - 180 days

2,882,307


0.51
%

55


774,594


0.34
%

37

Greater than 180 days

986,578


0.51
%

134


136,196


0.48
%

209

Total / Weighted Average

$
6,117,783


0.51
%

60


$
1,706,281


0.38
%

45




















Repurchase Agreements Underlying Linked Transactions
30 days or less

$


 
 
 

$
9,509


2.04
%

14

31 - 60 days



 
 
 

13,397


1.98
%

8

61 - 90 days



 
 
 

2,857


2.36
%

18

91 - 180 days



 
 
 

10,791


2.07
%

47

Total / Weighted Average

$


 
 
 

$
36,554


2.05
%

22

As of September 30, 2012 and December 31, 2011, we had repurchase agreements with 26 and 22 financial institutions, respectively. In addition, less than 7% and 6% of stockholders' equity was at risk with any one counterparty, with the top five counterparties representing less than 23% and 21% of our equity at risk as of September 30, 2012 and December 31, 2011, respectively.
We had agency securities with fair values of $6.1 billion and $1.5 billion and non-agency securities with fair values of $352.8 million and $8.6 million pledged as collateral against repurchase agreements, as of September 30, 2012 and December 31, 2011, respectively. Agency securities pledged do not include pledged amounts of $82.8 million and $269.5 million under repurchase agreements related to securities sold but not yet settled as of September 30, 2012 and December 31, 2011, respectively.

14




Note 7. Derivatives
In connection with our risk management strategy, we economically hedge a portion of our exposure to market risks, including interest rate risk and prepayment 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 derivative securities, including interest-only securities, synthetic total return swaps and credit default swaps. Our risk management strategy attempts to manage the overall risk of the portfolio and reduce fluctuations in book value. We do not use derivative or other hedging instruments for speculative purposes. Derivatives have not been designated as hedging instruments. We do not offset our derivatives and related cash collateral with the same counterparties under any master netting arrangements. For additional information regarding our derivative instruments and our overall risk management strategy, please refer to the discussion of derivatives in Note 3- Summary of Significant Accounting Policies.

The following table summarizes information about our outstanding derivatives and other hedging instruments for the nine months ended September 30, 2012 (in thousands):
Derivatives
December 31, 2011
Notional
Amount
Additions/ Long Positions
Expirations/
Terminations/ Short Positions
September 30, 2012
Notional
Amount
Interest rate swaps
$
875,000

2,740,000

(675,000
)
$
2,940,000

Interest rate swaptions
$
50,000

675,000

(225,000
)
$
500,000

TBA securities
$
(101,000
)
6,033,220

(5,821,214
)
$
111,006

Short sales of U.S. Treasuries
$
(50,000
)
3,076,000

(3,376,000
)
$
(350,000
)
U.S. Treasuries
$

50,168

(50,168
)
$

Linked Transactions (1)
$
88,671

10,920

(99,591
)
$

————————
(1) The notional amount of Linked Transaction is represented by the current face amount of the underlying securities.

The table below presents the balance sheet location and fair value information for our derivatives outstanding as of September 30, 2012 and December 31, 2011(in thousands):
Derivative Type
 
September 30, 2012
 
December 31, 2011
Interest rate swaps
 
$

 
$
348

Interest rate swaptions
 
4,607

 
828

TBA securities
 
10,423

 
669

Derivative assets, at fair value
 
$
15,030

 
$
1,845


 
 
 
 
Interest rate swaps
 
$
71,552

 
$
3,734

TBA securities
 
4,885

 
1,935

Derivative liabilities, at fair value
 
$
76,437

 
$
5,669



15



The following table summarizes the effect of our outstanding derivatives and other hedging instruments on our consolidated statements of operations for the three and nine months ended September 30, 2012 and the period from the commencement of operations on August 9, 2011 through September 30, 2011 (in thousands):
 
 
For the Three Months Ended September 30, 2012
 
For the Nine Months Ended September 30, 2012
 
 
Realized Loss on Periodic Settlements of Interest Rate Swaps, net
Realized Gain (Loss) on Other Derivatives and Securities, net
Unrealized Gain (Loss) on Other Derivatives and Securities, net
Unrealized Gain and
 Net Interest Income on Linked Transactions, net
 
Realized Loss on Periodic Settlements of Interest Rate Swaps, net
Realized Gain (Loss) on Other Derivatives and Securities, net
Unrealized Gain (Loss) on Other Derivatives and Securities, net
Unrealized Gain and
Net Interest Income on Linked Transactions, net
Interest rate swaps
 
$
(6,855
)
$
(18,430
)
$
(8,996
)
$

 
$
(11,711
)
$
(18,430
)
$
(62,586
)
$

Interest rate swaptions
 

(1,454
)
137


 

(1,725
)
(4,792
)

TBA securities
 

(2,903
)
7,598


 

(19,250
)
6,848


Short sales of U.S. Treasuries
 

(6,567
)
(1,857
)

 

(6,497
)
(3,770
)

U.S. Treasuries
 

222



 

(55
)


Linked Transactions
 




 



3,384

Total
 
$
(6,855
)
$
(29,132
)
$
(3,118
)
$

 
$
(11,711
)
$
(45,957
)
$
(64,300
)
$
3,384


 
 
For the Period from August 9, 2011
(date operations commenced) through
September 30, 2011
 
 
Realized Loss on Periodic Settlements of Interest Rate Swaps, net
Realized Gain (Loss) on Other Derivatives and Securities, net
Unrealized Gain (Loss) on Other Derivatives and Securities, net
Unrealized Loss and
 Net Interest Income on Linked Transactions, net
Interest rate swaps
 
$
(577
)
$

$
336

$

TBA securities
 

(1,844
)
521


Short sales of U.S. Treasuries
 

(1,568
)
(38
)

U.S. Treasuries
 




Linked Transactions
 



(813
)
Total
 
$
(577
)
$
(3,412
)
$
819

$
(813
)
Interest Rate Swap Agreements
As of September 30, 2012 and December 31, 2011, our derivative and other hedging instruments included 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 rate risk created by our use of short-term repurchase agreements. Under our interest rate swaps, we typically pay a fixed rate and receive a floating rate based on LIBOR with terms usually ranging up to ten years.

16



As of September 30, 2012 and December 31, 2011, we had interest rate swap agreements summarized in the tables below (dollars in thousands).
 
 
 
September 30, 2012
 
December 31, 2011
Interest Rate Swaps
Balance Sheet Location
 
Notional Amount
 
Fair Value
 
Notional Amount
 
Fair Value
Interest rate swap assets
Derivative assets, at fair value
 
$

 
$

 
$
200,000

 
$
348

Interest rate swap liabilities
Derivative liabilities, at fair value
 
2,940,000

 
(71,552
)
 
675,000

 
(3,734
)
 
 
 
$
2,940,000

 
$
(71,552
)
 
$
875,000

 
$
(3,386
)
September 30, 2012

Notional
Amount
 
Fair Value
 
Weighted Average
Current Maturity Date for Interest Rate Swaps (1)
 
 
Fixed
Pay Rate
 
Receive 
Rate
 

Maturity
(Years)
3 years or less
$
550,000


$
(6,048
)

0.81
%

0.47
%

2.5

Greater than 3 years and less than 5 years
940,000


(30,889
)

1.32
%

0.47
%

4.4

Greater than 5 years and less than 7 years
875,000


(18,500
)

1.30
%

0.42
%

6.1

Greater than 7 years
575,000


(16,115
)

1.90
%

0.46
%

9.7

Total / Weighted Average
$
2,940,000


$
(71,552
)

1.33
%

0.45
%

5.6

December 31, 2011
 
Notional
Amount
 
Fair Value
 
Weighted Average
Current Maturity Date for Interest Rate Swaps (2)
 
 
Fixed
Pay Rate
 
Receive 
Rate
 

Maturity
(Years)
3 years or less
$
100,000

 
$
217

 
0.64
%
 
0.50
%
 
2.7

Greater than 3 years and less than 5 years
700,000

 
(2,584
)
 
0.98
%
 
0.48
%
 
3.8

Greater than 5 years and less than 7 years
25,000

 
(257
)
 
1.73
%
 
0.47
%
 
6.8

Greater than 7 years
50,000

 
(762
)
 
2.07
%
 
0.53
%
 
8.5

Total / Weighted Average
$
875,000

 
$
(3,386
)
 
1.03
%
 
0.48
%
 
4.0

————————
(1) 
Includes swaps with an aggregate notional of $325.0 million with deferred start dates ranging from two to three months from September 30, 2012.
(2) 
Includes swaps with an aggregate notional of $50.0 million with deferred start dates ranging from two to five months from December 31, 2011.
Interest Rate Swaption Agreements
Our interest rate swaption agreements provide us the option to enter into interest rate swap agreements in the future where we would pay a fixed rate and receive LIBOR. The following table presents certain information about our interest rate swaption agreements as of September 30, 2012 and December 31, 2011 (dollars in thousands):
 
Option
 
Underlying Swap
 
Cost
 
Fair Value
 
Weighted Average Years to Expiration
 
Notional Amount
 
Pay Rate
 
Weighted Average Term (Years)
As of September 30, 2012
$
9,455

 
$
4,607

 
1.8
 
$
500,000

 
3.43
%
 
8.5
As of December 31, 2011
884

 
828

 
0.8
 
$
50,000

 
2.81
%
 
10.3

17



TBA Securities
As of September 30, 2012, and December 31, 2011, we had contracts to purchase (“long position”) and sell (“short position”) TBA securities on a forward basis. The following table presents a summary of our long and short TBA positions as of September 30, 2012 and December 31, 2011 (in thousands): 

As of September 30, 2012

As of December 31, 2011
Purchase and Sale Contracts for TBA Securities
Notional 
Amount

Fair
Value

Notional 
Amount

Fair
Value
Purchase of TBA securities
 
 
 
 
 
 
 
Assets
$
1,055,000

 
$
3,495

 
$
76,000

 
$
669

Liabilities

 

 

 

Sale of TBA securities
 
 
 
 
 
 
 
Assets
(164,848
)
 
6,928

 

 

Liabilities
(779,146
)
 
(4,885
)
 
(177,000
)
 
(1,935
)
Total, net
$
111,006

 
$
5,538

 
$
(101,000
)
 
$
(1,266
)
Linked Transactions
Our Linked Transactions are evaluated on a combined basis, reported as forward (derivative) instruments and are reported on our consolidated balance sheets at fair value.  The fair value of Linked Transactions reflect the value of the underlying non-agency securities, net of repurchase agreement borrowings and accrued interest receivable and payable on such instruments.  The change in the fair value of our Linked Transactions is reported as unrealized gain (loss) and net interest income on Linked Transactions, net, a component of other gain (loss), net in our consolidated statements of operations.
The following table presents the non-agency securities and repurchase agreements underlying our Linked Transactions as of September 30, 2012 and December 31, 2011 (in thousands):
 
 
September 30, 2012
 
December 31, 2011
Linked non-agency securities (1)
 
$

 
$
50,193

Linked repurchase agreements
 

 
(36,554
)
Accrued interest (payable) receivable, net
 

 
32

Linked Transactions, at fair value
 
$

 
$
13,671

————
(1)
See Note 5 - Non-Agency Securities for a description of the non-agency securities within Linked Transactions and Note 6 - Repurchase Agreements for a description of the repurchase agreements within Linked Transactions.

The following table presents the composition of unrealized gain (loss) and net interest income on Linked Transactions, net for the three and nine months ended September 30, 2012 and from the commencement of operations on August 9, 2011 through September 30, 2011(in thousands):
 
 
For the Three Months Ended September 30, 2012
 
For the Nine Months Ended September 30, 2012
 
For the Period from August 9, 2011
(date operations commenced) through
September 30, 2011
Coupon interest income
 
$

 
$
302

 
$
105

Discount accretion
 

 
590

 
91

Interest expense
 

 
(183
)
 
(40
)
Unrealized gain (loss), net
 

 
2,675

 
(969
)
Unrealized gain (loss) and net interest income on Linked Transactions, net
 
$

 
$
3,384

 
$
(813
)
Additionally, we had obligations to return treasury securities borrowed under reverse repurchase agreements accounted for as securities borrowing transactions with fair values of $347.4 million and $50.2 million as of September 30, 2012 and

18



December 31, 2011, respectively. The borrowed securities were collateralized by cash payments of $344.1 million and $50.6 million as of September 30, 2012 and December 31, 2011, respectively, which are presented as receivables under reverse repurchase agreements on the consolidated balance sheets. The change in fair value of the borrowed securities is recorded in unrealized gain (loss) on other derivatives and securities, net in our consolidated statements of operations.

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, both we and our counterparties 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 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 pledged as collateral for our derivative instruments is included in restricted cash and cash equivalents on our consolidated balance sheets.
Each of our ISDA Master Agreements contains provisions pursuant to 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 ISDA Master Agreements. We are 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 either our REIT status or certain minimum stockholders’ equity thresholds, or comply with limits on our leverage above certain specified levels.
We had agency securities with fair values of $71.6 million and $4.1 million and restricted cash and cash equivalents of $11.7 million and $3.1 million pledged as collateral against our interest rate swaps as of September 30, 2012 and December 31, 2011, respectively.
Note 8. Fair Value Measurements
We have elected the option to account for all of our financial assets, including mortgage-backed securities, at fair value, with changes in fair value reflected in income during the period in which they occur. We have determined that this presentation most appropriately represents our financial results and position. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date, based on the assumptions market participants would use when pricing an asset or liability.
We determine the fair value of our agency and non-agency securities including securities held as collateral, based upon fair value estimates obtained from multiple third-party pricing services and dealers. In determining fair value, third-party pricing sources use various valuation approaches, including market and income approaches. Factors used by third-party sources in estimating the fair value of an instrument may include observable inputs such as recent trading activity, credit data, volatility statistics, and other market data that are current as of the measurement date. The availability of observable inputs can vary by instrument and is affected by a wide variety of factors, including the type of instrument, whether the instrument is new and not yet established in the marketplace and other characteristics particular to the instrument. Third-party pricing sources may also use certain unobservable inputs, such as assumptions of future levels of prepayment, default and loss severity, especially when estimating fair values for securities with lower levels of recent trading activity. When possible, we make inquiries of third-party pricing sources to understand their use of significant inputs and assumptions.
We review the various third-party fair value estimates and perform procedures to validate their reasonableness, including an analysis of the range of third-party estimates for each position, comparison to recent trade activity for similar securities, and our Manager's review for consistency with market conditions observed as of the measurement date. While we do not adjust prices we obtain from third-party pricing sources, we will exclude third-party prices for securities from our determination of fair value if we determine (based on our validation procedures and our Manager's market knowledge and expertise) that the price is significantly different than observable market data would indicate and we cannot obtain an understanding from the third party source as to the significant inputs used to determine the price.

19



We utilize 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. We use the results of the validation procedures described above as part of our determination of the appropriate fair value measurement hierarchy classification. 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 -    Significant unobservable market inputs that are supported by little or no market activity. The unobservable inputs represent the assumptions that market participants would use to price the assets and liabilities.
The following tables present our financial instruments carried at fair value as of September 30, 2012 and December 31, 2011, on the consolidated balance sheets by the valuation hierarchy, as described above (in thousands):
 
 
As of September 30, 2012
 
 
Level 1
 
Level 2
 
Level 3
 
Total
Assets
 
 
 
 
 
 
 
 
Agency securities
 
$

 
$
6,337,238

 
$

 
$
6,337,238

Non-agency securities
 

 
479,118

 
73,669

 
552,787

Derivative assets
 

 
15,030

 

 
15,030

Total financial assets
 
$

 
$
6,831,386

 
$
73,669

 
$
6,905,055


 

 

 
 
 
 
Liabilities
 
 
 
 
 
 
 
 
Derivative liabilities
 
$

 
$
76,437

 
$

 
$
76,437

Obligation to return securities borrowed under repurchase agreements
 
347,367

 

 

 
347,367

Total financial liabilities
 
$
347,367

 
$
76,437

 
$

 
$
423,804

 
 
As of December 31, 2011
 
 
Level 1
 
Level 2
 
Level 3
 
Total
Assets
 
 
 
 
 
 
 
 
Agency securities
 
$

 
$
1,740,091

 
$

 
$
1,740,091

Non-agency securities
 

 
19,592

 
5,969

 
25,561

Linked transactions
 

 
11,925

 
1,746

 
13,671

Derivative assets
 

 
1,845

 

 
1,845

Total financial assets
 
$

 
$
1,773,453

 
$
7,715

 
$
1,781,168

 
 
 
 
 
 
 
 
 
Liabilities
 
 
 
 
 
 
 
 
Derivative liabilities
 
$

 
$
5,669

 
$

 
$
5,669

Obligation to return securities borrowed under repurchase agreements
 
50,154

 

 

 
50,154

Total financial liabilities
 
$
50,154

 
$
5,669

 
$

 
$
55,823


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There were no transfers between hierarchy levels during the nine months ended September 30, 2012. The following table presents a summary of the changes in fair value for the three and nine months ended September 30, 2012 of Level 3 assets carried at fair value as of September 30, 2012 (dollars in thousands):
 
 
For the Three Months Ended
September 30, 2012
 
 
Non-Agency Securities
 
Linked Transactions
 
Total
Balance as of June 30, 2012
 
$
33,362

 
$

 
$
33,362

 
 
 
 
 
 
 
Unrealized gain
 
8,177

 

 
8,177

Unrealized loss
 

 

 

Total unrealized gain, net (1)
 
8,177

 

 
8,177

 
 
 
 
 
 
 
Purchases of securities
 
36,645

 

 
36,645

Principal repayments on securities
 
(5,382
)
 

 
(5,382
)
Discount accretion
 
867

 

 
867

Balance as of September 30, 2012
 
$
73,669

 
$

 
$
73,669

 
 
For the Nine Months Ended
September 30, 2012
 
 
Non-Agency Securities
 
Linked Transactions
 
Total
Balance as of December 31, 2011
 
$
5,969

 
$
1,746

 
$
7,715

 
 
 
 
 
 
 
Unrealized gain
 
9,479

 
827

 
10,306

Unrealized loss
 
(723
)
 

 
(723
)
Total unrealized gain, net (1)
 
8,756

 
827

 
9,583

 
 
 
 
 
 
 
Purchases of securities
 
56,124

 

 
56,124

Principal repayments on securities
 
(6,744
)
 
(291
)
 
(7,035
)
Securities recorded upon de-linking of Linked Transactions
 
7,893

 
(7,893
)
 

Net change in borrowings underlying Linked Transactions
 

 
5,445

 
5,445

Discount accretion
 
1,671

 
159

 
1,830

Accrued interest on Linked Transactions
 

 
7

 
7

Balance as of September 30, 2012
 
$
73,669

 
$

 
$
73,669

—————— 
(1) Unrealized gains and losses on non-agency securities are included in the consolidated statements of operations in the line item unrealized gain (loss) on non-agency securities, net and unrealized gains and losses on Linked Transactions are included on the consolidated statements of operations in the line item unrealized gain and net interest income on Linked Transactions, net.
Our agency securities and Prime, Alt-A and Option-ARM non-agency securities are valued using the various market data described above, which include inputs determined to be observable or whose significant value drivers are observable. Accordingly, our agency securities and prime, Alt-A and Option-ARM non-agency securities are classified as Level 2 in the fair value hierarchy. While our Subprime non-agency securities are valued using the same process with similar inputs, a significant amount of inputs have been determined to be unobservable due to relatively low levels of market activity and a wider range of external fair value estimates. Accordingly, our Subprime non-agency securities are classified as Level 3 in the fair value hierarchy.
The significant unobservable inputs used by external pricing sources in the fair value measurement of our Level 3 non-agency securities include assumptions for underlying loan collateral default rates and loss severities in the event of default, as well as discount rates. As discussed above, we review the various third-party fair value estimates used to determine the fair

21



value of our securities by performing procedures to validate their reasonableness. In reviewing the fair values of our Level 3 non-agency securities, we use internal models and our own estimates of cumulative defaults and loss severities on the loans underlying our Subprime securities to estimate the range of discount rates implied by third-party pricing. The following table presents the range of our estimates of cumulative default and loss severities, together with the discount rates implicit in our Level 3 non-agency security fair values totaling $73.7 million as of September 30, 2012:
Unobservable Level 3 Input
 
Minimum
 
Weighted
Average
 
Maximum
Cumulative default percentage
 
63%
 
69%
 
71%
Loss severity
 
48%
 
66%
 
72%
Discount rate
 
4.2%
 
6.1%
 
8.2%
An increase in any one of these individual inputs in isolation would likely result in a decrease in fair value measurement. However, given our use of a market-based approach to estimating fair values and the interrelationship between loss estimates and the discount rate, overall Subprime non-agency security market conditions would likely have a more significant impact on our Level 3 fair values than changes in any one unobservable input.
The fair value of Linked Transactions is comprised of the fair value of the underlying securities, reduced by the repurchase agreement final settlement amount.  The fair value of Linked Transactions also includes accrued interest receivable on the non-agency securities and accrued interest payable on the underlying repurchase agreement borrowings. The non-agency securities underlying our Linked Transactions are valued using similar techniques to those used for our other non-agency securities, and as such, Linked Transactions are classified in the fair value hierarchy, based on the classification of the underlying category of non-agency securities.
We determine the fair value of our interest rate swaps and other derivatives considering valuations obtained from a third-party pricing service and such valuations are tested with internally developed models that apply readily observable market parameters.  In valuing our derivatives, we consider both our counterparties' and our creditworthiness, along with collateral provisions contained in each derivative agreement.  No credit valuation adjustments are made in determining the fair value for derivative agreements subject to bilateral collateral arrangements.  Our interest rate swaps and other derivatives are classified as Level 2 in the fair value hierarchy.
The fair value of our obligation to return securities borrowed under reverse repurchase agreements is based upon the value of the underlying borrowed U.S. Treasury securities as of the reporting date. Our obligation to return the borrowed securities is classified as Level 1 in the fair value hierarchy.
Note 9. Stockholders’ Equity
Equity Offerings
During the nine months ended September 30, 2012, we issued the following shares of common stock (amounts in thousands except per share amounts):
Public Offering Date
 
Price Received Per Share (1)
 
Number of Shares
 
Net Proceeds (2)
March 2012 (3)
 
$
21.55

 
13,600

 
$
292,797

May 2012
 
$
22.74

 
12,650

 
$
287,176

—————— 
(1) Price received per share is net of underwriters' discount, if applicable.
(2) Net Proceeds are net of any underwriters' discount and other offering costs.
(3) Includes 1.6 million shares related to the over-allotment which was exercised in April 2012.
Dividends
During the nine months ended September 30, 2012, we declared dividends of $2.70 per share.


22



Note 10. Subsequent Events

In October 2012, our Board of Directors adopted a plan that may provide for stock repurchases of up to $50 million of our outstanding shares of common stock through December 31, 2013. Shares of our common stock may be purchased in the open
market, including through block purchases, or through privately negotiated transactions, or pursuant to any trading plan that may be adopted in accordance with Rule 10b5-1 of the Securities and Exchange Commission. The timing, manner, price and amount of any repurchases will be determined at our discretion and the program may be suspended, terminated or modified at any time for any reason. We intend to repurchase shares only when the purchase price is less than our estimate of our current net asset value per share of our common stock. Generally, when we repurchase our common stock at a discount to our net asset value, the net asset value of our remaining shares of common stock outstanding increases. In addition, we do not intend to repurchase any shares from directors, officers or other affiliates. The program does not obligate us to acquire any specific number of shares, and all repurchases will be made in accordance with SEC Rule 10b-18, which sets certain restrictions on the method, timing, price and volume of stock repurchases.



23



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”) provides readers of American Capital Mortgage Investment Corp.’s ("MTGE", the “Company”, “we”, “us” and “our”) consolidated financial statements a narrative from the perspective of management, and should be read in conjunction with the consolidated financial statements and accompanying notes included in this Quarterly Report on Form 10-Q as well as our Annual Report on Form 10-K for the year ended December 31, 2011. Our MD&A is presented in five sections:
Executive Overview
Financial Condition
Results of Operations
Liquidity and Capital Resources
Forward-Looking Statements
EXECUTIVE OVERVIEW
We were incorporated in Maryland on March 15, 2011 and commenced operations on August 9, 2011 following the completion of our IPO. We invest in, finance and manage a leveraged portfolio of mortgage-related investments, which we define to include agency mortgage investments, non-agency mortgage investments and other mortgage-related investments. Agency mortgage investments include residential mortgage pass-through certificates and collateralized mortgage obligations (“CMOs”) structured from residential mortgage pass-through certificates for which the principal and interest payments are guaranteed by a government-sponsored entity (“GSE”), 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”). Non-agency mortgage investments include residential mortgage-backed securities (“RMBS”) backed by residential mortgages that are not guaranteed by a GSE or U.S. Government agency. Non-agency mortgage investments may also include prime and non-prime residential mortgage loans. Other mortgage-related investments may include commercial mortgage-backed securities (“CMBS”), commercial mortgage loans, mortgage-related derivatives and other mortgage-related investments.
We operate so as to qualify to be taxed as a real estate investment trust (“REIT”) under the Internal Revenue Code of 1986, as amended (the “Internal Revenue Code”). As such, we are required to, among other things, distribute annually at least 90% of our taxable net income. As long as we qualify as a REIT, we will generally not be subject to U.S. federal 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 MTGE Management, LLC (our “Manager”), an affiliate of American Capital, Ltd. ("American Capital"). We do not have any employees.
Our Investment Strategy
Our objective is to provide attractive risk-adjusted returns to our stockholders over the long-term through a combination of dividends and net book value appreciation. In pursuing this objective, we rely on our Manager's expertise to construct and manage a diversified mortgage investment portfolio by identifying asset classes that, when properly financed and hedged, are selected to produce attractive returns across a variety of market conditions and economic cycles, considering the risks associated with owning such investments. Specifically, our investment strategy is designed to:
manage a leveraged portfolio of mortgage-related investments to generate attractive risk-adjusted returns;