10-K 1 hts-10k_20151231.htm 10-K hts-10k_20151231.htm

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-K

 

x

ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Fiscal Year Ended December 31, 2015

OR

¨

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

For the transition period from ______ to ______.

Commission file number 001-34030

 

HATTERAS FINANCIAL CORP.

(Exact name of registrant as specified in its charter)

 

 

Maryland

 

26-1141886

(State or other jurisdiction

of incorporation or organization)

 

(IRS Employer

Identification No.)

 

 

 

751 W. Fourth Street, Suite 400

Winston Salem, North Carolina

 

27101

(Address of principal executive offices)

 

(Zip Code)

 

(336) 760-9347

(Registrant’s telephone number, including area code)

Securities registered pursuant to Section 12(b) of the Act:

 

Title of each class

 

Name of each exchange on

which registered

Common stock, $0.001 par value

 

New York Stock Exchange

7.625% Series A Cumulative Redeemable

Preferred stock, $0.001 par value

 

New York Stock Exchange

Securities registered pursuant to Section 12(g) of the Act:  None

 

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  x    No  ¨

Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.    Yes  ¨    No  x

Indicate by check mark whether the registrant (1) has filed all reports required 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 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 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 if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of the registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

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 the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  Check one:

 

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 aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant was approximately $1,577,685,818 based on the closing price on the New York Stock Exchange as of June 30, 2015.

Number of the registrant’s common stock outstanding as of February 23, 2016:  94,533,206

 

DOCUMENTS INCORPORATED BY REFERENCE

Portions of the registrant’s definitive Proxy Statement with respect to its 2016 Annual Meeting of Shareholders to be filed not later than 120 days after the end of the registrant’s fiscal year are incorporated by reference into Part II, Item 5 and Part III, Items 10,11,12,13 and 14 hereof as noted therein.

 

 

 

 

 

 


 

HATTERAS FINANCIAL CORP.

INDEX

 

Item

No.

 

 

Form

10-K
Report
Page

 

 

PART I

 

Item 1.

 

 

Business

3

Item 1A.

 

 

Risk Factors

7

Item 1B.

 

 

Unresolved Staff Comments

27

Item 2.

 

 

Properties

27

Item 3.

 

 

Legal Proceedings

27

Item 4.

 

 

Mine Safety Disclosures

27

 

 

PART II

 

 

Item 5.

 

 

Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

27

Item 6.

 

 

Selected Financial Data

29

Item 7.

 

 

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

32

Item 7A.

 

 

Quantitative and Qualitative Disclosures About Market Risk

55

Item 8.

 

 

Financial Statements and Supplementary Data

58

Item 9.

 

 

Changes in and Disagreements with Accountants on Accounting and Financial Disclosure

58

Item 9A.

 

 

Controls and Procedures

58

Item 9B.

 

 

Other Information

59

 

 

PART III

 

Item 10.

 

 

Directors, Executive Officers and Corporate Governance

59

Item 11.

 

 

Executive Compensation

59

Item 12.

 

 

Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters

59

Item 13.

 

 

Certain Relationships and Related Transactions, and Director Independence

59

Item 14.

 

 

Principal Accountant Fees and Services

59

 

 

PART IV

 

Item 15.

 

 

Exhibits and Financial Statement Schedules

59

 

 

 

 


 

Cautionary Note Regarding Forward-Looking Statements

This report contains various “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”), and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).  Such statements include, in particular, statements about our plans, intentions, expectations, beliefs, and strategies as they relate to our business as described herein.  You can identify forward-looking statements by the use of forward-looking terminology such as “believes,” “expects,” “may,” “will,” “would,” “could,” “should,” “seeks,” “approximately,” “intends,” “plans,” “projects,” “estimates” or “anticipates” or the negative of these words and phrases or similar words or phrases.  Forward‑looking statements in this report include, among others, statements about our future financial condition, results of operations, our investment, financing and hedging strategies and objectives, the effects of movements in interest rates on our assets and liabilities (including our hedging instruments) and our net income, the effect of increased prepayment rates on the value of our assets, and expected liquidity needs and sources (including our ability to obtain financing or raise capital).

Although we believe that our plans, intentions, expectations and beliefs reflected in or suggested by such forward-looking statements are reasonable, we cannot assure you that our plans, intentions, expectations or beliefs will be achieved.  If a change occurs, our business, financial condition, liquidity and results of operations may vary materially from those expressed in our forward-looking statements.  The following factors could cause actual results to vary from our forward-looking statements:

 

·

changes in interest rates, interest rate spreads or the yield curve;

 

·

changes in prepayment rates of mortgages underlying our assets;

 

·

the occurrence, extent and timing of credit losses within our portfolio;

 

·

the concentration of the credit risks to which we are exposed;

 

·

legislative and regulatory actions affecting our business;

 

·

increases in payment delinquencies and defaults on the mortgages comprising and underlying our target assets;

 

·

changes in liquidity in the market for real estate securities, the re-pricing of credit risk in the capital markets, inaccurate ratings of securities by rating agencies, rating agency downgrades of securities, and increases in the supply of real estate securities available-for-sale;

 

·

changes in our investment, financing and hedging strategies and the new risks to which those changes may expose us;

 

·

changes in the competitive landscape within our industry, including changes that may affect our ability to attract and retain personnel;

 

·

our ability to build and maintain successful relationships with loan originators;

 

·

our ability to acquire mortgage loans in connection with our mortgage loan conduit program;

 

·

our ability to securitize the mortgage loans we acquire;

 

·

our exposure to legal and regulatory claims, including litigation arising from our involvement in securitization transactions and investments in mortgage servicing rights (“MSR”);

 

·

our ability to acquire MSR and successfully operate our seller-servicer subsidiary and oversee our subservicers; and

 

·

our ability to borrow or raise capital to finance our assets.

These and other risks, uncertainties and factors, including those set forth under the sections captioned “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” herein, as updated by our quarterly and current reports that we file with the Securities and Exchange Commission (“SEC”), could cause our actual results to differ materially from those projected in any forward-looking statements we make.

We cannot guarantee future results, levels of activity, performance or achievements.  You should not place undue reliance on forward-looking statements, which apply only as of the date of this report.  We do not intend and disclaim any duty or obligation to update or revise any industry information or forward-looking statements set forth in this report to reflect new information, future events or otherwise, except as required under the U.S. federal securities laws.

 

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PART I

Item 1.

Business

In this report, unless the context suggests otherwise, references to “our company,” “we,” “us” and “our” refers to Hatteras Financial Corp., a Maryland corporation, and its consolidated subsidiaries, and “manager” refers to Atlantic Capital Advisors LLC, a North Carolina limited liability company (“ACA”).

Our Company

We are an externally-managed mortgage real estate investment trust (“REIT”) that invests primarily in single-family residential mortgage real estate assets, such as mortgage-backed securities (“MBS”), MSR, residential mortgage loans and other financial assets.  MBS are pass-through securities consisting of a pool of mortgage loans.  To date, the majority of our investments have been MBS issued or guaranteed by a U.S. Government agency, such as Ginnie Mae, or by a U.S. Government-sponsored enterprise, such as Fannie Mae or Freddie Mac.  We refer to these securities as “agency securities.”  We were incorporated in Maryland in September 2007.  We listed our common stock on the New York Stock Exchange (“NYSE”) in April 2008 and trade under the symbol “HTS.”

Our business operations are primarily comprised of the following:

Hatteras Financial Corp., the parent company

Invests primarily in various types of residential mortgage assets with a focus on agency securities.

Onslow Bay Financial LLC

Wholly owned subsidiary formed to acquire, invest in, securitize and manage non-agency mortgage loans.

First Winston Securities, Inc.

Wholly owned subsidiary that operates as a broker-dealer, and is a member of the Financial Industry Regulatory Authority.

Wind River TRS LLC

Wholly owned subsidiary which invests in and manages MSR, both for us and for third parties, via its acquisition of Pingora Asset Management LLC (“PAM”) and Pingora Loan Servicing LLC (“PLS”).

We are organized and conduct our operations to qualify as a REIT under the Internal Revenue Code of 1986, as amended (the “Code”), and generally are not subject to federal taxes on our income to the extent we timely distribute our income to our shareholders and maintain our qualification as a REIT.

Our Strategy

Our principal goal is to provide an attractive risk-adjusted total return to our shareholders over the long term, primarily through dividends and secondarily through capital appreciation. We selectively acquire and manage an investment portfolio of real estate financial assets, with the aim of generating attractive returns throughout interest rate cycles. We focus on asset selection and implement a relative value investment approach across various sectors within the residential mortgage market. Our primary investment assets include the following:

 

·

Agency MBS, meaning MBS whose principal and interest payments are guaranteed by Ginnie Mae, Fannie Mae, or Freddie Mac;

 

·

Other agency issued securities, such as credit-risk transfer (“CRT”) bonds;

 

·

MSR;

 

·

Non-agency securities, meaning MBS that are not issued or guaranteed by Ginnie Mae, Fannie Mae, or Freddie Mac;

 

·

Residential mortgage loans; and

 

·

Other real estate related assets as permitted by our investment guidelines and REIT requirements.

Our primary business since inception has been owning and managing agency securities, with a primary focus on adjustable-rate mortgage (“ARM”) securities.  We currently intend for agency securities to continue to be the majority of our investment assets.  As part of this strategy we employ financing, or leverage, to increase our returns. Much of this financing is short-term, which exposes us to interest rate risk. To reduce this risk to levels we believe are acceptable, we use various hedges, such as interest rate swaps, swaptions and futures contracts.  We may, subject to maintaining our REIT qualification, also employ other hedging instruments from time to time, including interest rate caps, collars, and “to-be-announced” (“TBA”) securities to protect against adverse interest rate movements.

In August of 2015, Wind River TRS LLC, our wholly owned subsidiary, acquired PAM and PLS (together, “Pingora”).  Pingora owns and manages our MSR portfolio as well as MSR portfolios for third parties.  As an investor in MSR, we purchase the right to

 

3


 

control the servicing of mortgage loans from high-quality originators. We do not directly service the mortgage loans we acquire, nor the mortgage loans underlying the MSR we acquire; rather, we contract with licensed third-party subservicers to handle substantially all servicing functions.  In addition to allowing us to own and manage MSR as an additional asset class, we believe Pingora provides attractive synergies with our other lines of business.

In general, our strategy focuses on managing the interest rate risk related to our mortgage assets along with our exposure to credit risk.  The table below shows the percentage of our capital allocated to each of our investment strategies as of December 31, 2015:

 

December 31, 2015

 

 

 

 

 

Agency investments

 

78.4

%

Non-agency investments

 

7.6

%

Mortgage servicing rights

 

14.0

%

Total

 

100.0

%

Prior to 2015, we had allocated essentially all of our capital to investing in agency securities.  We believe the diversification of our investment strategy will provide us with a more efficient portfolio and additional flexibility to allocate capital to our investments opportunistically based on our expectation of market conditions.

Due to our significant exposure to interest rate risk from our investments, we focus on constructing a portfolio with a short effective duration, which we believe limits the impact of changes in interest rates on the market value of our portfolio and on our net interest margin (interest income less financing costs).  However, because our investments vary in interest rate, prepayment speed and maturity, the leverage or borrowings that we employ to fund our asset purchases will never exactly match the terms or performance of our assets, even after we have employed our hedging techniques.  Based on our manager’s experience, the interest rates of our assets will change more slowly than the corresponding short-term rates on the borrowings used to finance our assets.  Consequently, changes in interest rates, particularly short-term interest rates, may significantly influence our net income and shareholders’ equity.

Our manager’s approach to managing our investment portfolio is to take a longer term view of assets and liabilities; accordingly, our periodic earnings and mark-to-market valuations at the end of a period will not significantly influence our strategy of providing cash distributions to shareholders over the long term. Our manager has invested and seeks to invest in mortgage assets that it believes are likely to generate attractive risk-adjusted returns on capital invested, after considering (1) the amount and nature of anticipated cash flows from the asset, (2) our ability to borrow against the asset, (3) the capital requirements resulting from the purchase and financing of the asset, and (4) the costs of financing, hedging, and managing the asset.

Our Assets

Agency Securities – The majority of our invested assets have been in agency MBS, and we currently intend that the majority of our investment assets will continue to be agency MBS.  We invest in both adjustable-rate and fixed-rate MBS.  ARMs are mortgage loans that have floating interest rates that reset on a specific time schedule, such as monthly, quarterly or annually, based on a specified index, such as the 12-month moving average of the one-year constant maturity U.S. Treasury rate (“CMT”) or the London Interbank Offered Rate (“LIBOR”).  The ARMs we generally invest in, sometimes referred to as hybrid ARMs, have interest rates that are fixed for an initial period (typically three, five, seven or 10 years) and then reset annually thereafter to an increment over a pre-determined interest rate index.  Until late 2015, all of our fixed-rate MBS have been 10-year and 15-year amortizing fixed-rate securities.  Late in 2015, we began purchasing 30-year fixed-rate securities.  We also invest in CRT securities issued by Fannie Mae and Freddie Mac (“agency CRT securities”).  As of December 31, 2015, our investment portfolio consisted of approximately $14.4 billion in market value of MBS and agency CRT securities, consisting of $13.4 billion of adjustable rate securities and $1.0 billion of fixed-rate securities.  

We purchase a substantial portion of our agency securities through delayed delivery transactions (forward purchase commitments), including TBA securities.  At times when market conditions are conducive, we may choose to move the settlement of these TBA securities out to a later date by entering into an offsetting short position in the near month, which is then net settled for cash, and simultaneously entering into a substantially similar TBA contract for a later settlement date.  Such a set of transactions is referred to as a TBA “dollar roll” transaction.  The TBA securities purchased at the later settlement date are typically priced at a discount to securities for settlement in the current month.  This difference is referred to as the “price drop.”  The price drop represents compensation to us for foregoing net interest margin and is referred to as TBA “dollar roll income.”  Specified pools of mortgage loans can also be the subject of a dollar roll transaction, when market conditions allow.

Non-agency Investments – We own non-agency investments both in the form whole loans and, at times, MBS.  We invest in prime non-conforming residential whole mortgage loans through our wholly owned subsidiary, Onslow Bay Financial LLC (“Onslow”).  Onslow acquires such loans from select mortgage loan originators and secondary market institutions with the intent to securitize the loans through the issuance of non-agency MBS.  Our intention is to generally retain the related subordinated securities, representing the credit risk tranche associated with these securitization transactions, as well as portions of the AAA tranches.  While we purchase loans

 

4


 

with the intent of securitization, depending on our view of the securitization market, we may decide to retain some amount of the whole loans as a direct investment.  We do not originate loans or provide direct financing to lenders; rather, through our mortgage loan conduit we contract with originators to acquire loans they originate that meet our purchase criteria.  We completed our first securitization during the fourth quarter of 2015 and we may complete additional securitizations in the coming year, subject to market conditions.

Mortgage Servicing Rights – We invest in the income from MSR through ownership interests in our wholly owned subsidiary, PLS.  We view MSR income as a complimentary asset to our overall investment portfolio.  As an asset that is generally inverse in nature to interest rate changes when compared to our agency securities, we believe that the inclusion of MSR in our strategic mix is beneficial not only in providing earnings stability, but also as an offset to value changes in our interest-earning portfolio.  The MSR we own are all on agency loans, and almost all of these loans are fixed-rate in nature.

Our Borrowings

We use leverage as part of our investment strategy.  Borrowing against our assets can increase returns, but also increases the risk associated with our portfolio.  Our primary source of debt is repurchase agreements, which are collateralized borrowings. Our repurchase agreements generally have maturities that range from one month to one year, although occasionally we may enter into longer term borrowing agreements to more closely match the rate adjustment period of our securities.  We also borrow against our mortgage loans using warehouse lines of credit structured as repurchase agreements.  These warehouse lines will generally have annual maturities, with various covenants regarding the amount, type and time that various mortgage loans can remain on the line.  Another source of borrowing that we have for our mortgage loans is our securitization debt.  By securitizing and selling certain portions of the securitization trust, we effectively achieve long-term funding for a portion of our loan portfolio.

We intend that our borrowings will generally be between six and nine times the amount of our shareholders’ equity.  The level of our borrowings may vary periodically above or below this range depending on market conditions.  In addition, dollar roll transactions, as described above, represent a form of financing that can be either on or off balance sheet, depending on whether the security being rolled is a specified pool (results in on-balance sheet financing) or a TBA security (results in off-balance sheet financing).

Our Hedging

Our hedging strategies are designed to reduce the impact on our income and shareholders’ equity caused by the potential adverse effects of changes in interest rates on our assets and liabilities.  Subject to complying with REIT requirements, we use hedging techniques to seek to mitigate the differences between the interest rate adjustments on our assets and borrowings as well as the risk of adverse changes in interest rates on the value of our assets.  These techniques primarily consist of entering into interest rate swap agreements and buying and selling futures contracts.  We may also enter into interest rate cap, floor or collar agreements, purchase put and call options on securities or securities underlying futures contracts, or enter into forward rate agreements.  As of September 30, 2013, we no longer pursue hedge accounting treatment for our interest rate swaps.  As a result, our net income may suffer because losses on the derivatives we enter into may not be offset in net income by changes in the cash flows or fair value of the related hedged transaction, if the hedged item is an available-for-sale security.  Consequently, any declines in the hedged interest rates of available-for-sale securities would result in a charge to net income.

Purpose of and Changes in Strategies

Our investment, financing and hedging strategies are designed to:

 

·

limit credit risk;

 

·

manage cash flows so as to provide for regular quarterly distributions to our shareholders;

 

·

manage financing risks;

 

·

mitigate the fluctuations in the market value of our mortgage assets due to changing interest rates;

 

·

reduce the impact that changing interest rates have on our net interest margin;

 

·

maintain our qualification as a REIT; and

 

·

comply with available exemptions from regulation as an investment company under the Investment Company Act of 1940, as amended (the “Investment Company Act”).

Our board of directors has adopted a policy that currently requires the majority of our investments to be agency securities.  Due to changes in market conditions, the market value and duration of our securities will fluctuate from time to time and may cause our investment portfolio allocations to be inconsistent with the investment strategies described in this report.  In such event, in consultation with our board of directors, our manager may recommend that we reallocate our investment portfolio.  Subject to our intent to qualify for an exemption from registration under the Investment Company Act and to maintain our qualification as a REIT, our board of directors,

 

5


 

with the approval of a majority of our independent directors, may vary our investment strategy, our financing strategy or our hedging strategy at any time.

Our Manager

We are externally-managed and advised by our manager, Atlantic Capital Advisors LLC.  We believe our relationship with our manager enables us to leverage our manager’s infrastructure, business relationships and management expertise to execute our investment strategy effectively.  We believe that our manager’s expertise in mortgage REIT operations, agency securities, whole loans and leveraged finance markets enhances our ability to acquire assets opportunistically and to finance those assets in a manner designed to generate consistent risk-adjusted returns for our shareholders.

Pursuant to the terms of the management agreement, our manager provides us with our management team, including a chief executive officer and a chief financial officer (each of whom also serves as an officer of our manager) along with appropriate support personnel.  Our manager is responsible for our operations and the performance of all services and activities relating to the management of our assets and operations, subject to the direction of our board of directors.

ACA manages both our company and ACM Financial Trust (“ACM”), a privately-held mortgage REIT founded in 1998.  Michael R. Hough, our chief executive officer, is also the chief executive officer of our manager and ACM.  Our president Benjamin M. Hough, chief financial officer Kenneth A. Steele and chief investment officer Frederick J. Boos, II are all also executives of our manager and of ACM.  As of December 31, 2015, ACM owned approximately $1.1 billion in MBS.  We do not own any interest in ACM.  

The Management Agreement

Our management functions are provided by our manager, ACA.  Our relationship with ACA is controlled by a management agreement.  The management agreement requires our manager to manage our business affairs in conformity with policies and investment guidelines that are approved by a majority of our independent directors and monitored by our board of directors.  Our manager is subject to the direction and oversight of our board of directors.  Our manager is responsible for (1) the identification, selection, purchase and sale of our investments, (2) our financing and risk management activities, and (3) providing us with investment advisory services.  In addition, our manager is responsible for our day-to-day operations.

The term of the management agreement expires on February 23, 2017.  Under the terms of the agreement, it will automatically renew for an additional one year term on February 23 of each year thereafter unless terminated or otherwise renegotiated.

Our manager is entitled to receive a management fee payable monthly in arrears in an amount equal to 1/12th of an amount determined as follows:

 

·

for our equity up to $250 million, 1.50% (per annum) of equity; plus

 

·

for our equity in excess of $250 million and up to $500 million, 1.10% (per annum) of equity; plus

 

·

for our equity in excess of $500 million and up to $750 million, 0.80% (per annum) of equity; plus

 

·

for our equity in excess of $750 million, 0.50% (per annum) of equity.

For purposes of calculating the management fee, we define equity as the value, computed in accordance with U.S. generally accepted accounting principles (“GAAP”), of our shareholders’ equity, adjusted to exclude the effects of unrealized gains or losses. Under the terms of the management agreement, we also reimburse ACA for certain expenses relating to our operations.

There is no incentive compensation payable to our manager pursuant to the management agreement, although from time to time we may issue long-term equity incentive compensation to employees of ACA, including those that are executive officers of our company.

Competition

Our success depends, in large part, on our ability to acquire assets at favorable spreads over our borrowing costs.  In acquiring mortgage assets, we compete with other mortgage REITs, mortgage finance and specialty finance companies, savings and loan associations, banks, mortgage bankers, insurance companies, mutual funds, institutional investors, investment banking firms, governmental bodies and other entities.  In addition, there are numerous mortgage REITs with similar asset acquisition objectives, including ACM, and others may be organized in the future.  The effect of the existence of additional REITs may be to increase competition for the available supply of mortgage assets suitable for purchase.

Operating Segments

We manage our business on an aggregated, single segment basis for purposes of assessing performance and making operating decisions, and accordingly, have only one reporting and operating segment.  

 

6


 

Employees

We are managed by ACA pursuant to the management agreement between ACA and us.  As of the date of this report, we have 44 employees in our operating subsidiaries and our manager has an additional 17 employees.

Additional Information

Our principal offices are located at 751 W. Fourth Street, Suite 400, Winston-Salem, North Carolina 27101.  Our telephone number is (336) 760-9347.

We have made available any materials we file with the SEC, including our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports, on our website at www.hatfin.com free of charge. Copies of these documents are available in print to any shareholder who requests them.  Requests should be sent to Hatteras Financial Corp., 751 W. Fourth Street, Suite 400, Winston-Salem, North Carolina 27101, Attention: Corporate Secretary.  Also posted on our website, and available in print upon request, are charters of each committee of our board of directors, our code of business conduct and ethics, our corporate governance guidelines and our whistleblower policy. Within the time period required by the SEC, we will post on our website any amendment to our code of business conduct and ethics and any waiver applicable to any executive officer, director or senior financial officer.  However, the information located on, or accessible from, our website is not, and should not be deemed to be, part of this report or incorporated into any other filing that we submit to the SEC.

All reports, proxy and information statements and other information we file with the SEC may also be read and copied at the SEC’s public reference room at 100 F Street, N.E., Washington, D.C. 20549.  Further information regarding the operation of the public reference room may be obtained by calling 1-800-SEC-0330.  In addition, all materials we file with the SEC can be obtained at the SEC’s website at www.sec.gov.

Item 1A.Risk Factors

Investment in our stock involves significant risks.  If any of the risks discussed in this report occur, our business, financial condition, liquidity and results of operations could be materially and adversely affected.  The risk factors set forth below are not the only risks that may affect us.  Additional risks and uncertainties not presently known to us, or not identified below, may also materially affect our business, financial condition, liquidity and results of operations.  Some statements in this report, including statements in the following risk factors, constitute forward-looking statements.  Please refer to the section entitled “Cautionary Note Regarding Forward-Looking Statements.”

The risk factors below are broken into five broad categories:

 

·

Risks Related to Our Management and Conflicts of Interest

 

·

Risks Related to Our Business

 

·

Risks Related to Debt Financing

 

·

Risks Related to Our Corporate Structure

 

·

Federal Income Tax Risks

Risks Related to Our Management and Conflicts of Interest

We are dependent upon key employees of our manager, and we may not find suitable replacements if these key personnel are no longer available to us.

Our success depends to a significant degree upon the contributions of Messrs. Michael and Benjamin Hough and Messrs. Steele and Boos, whose continued service is not guaranteed, and each of whom would be difficult to replace.  Because these key personnel collectively have a substantial amount of experience in the fixed income markets and prior experience managing a mortgage REIT, we depend on their experience and expertise to manage our day-to-day operations and our strategic business direction.  In addition, many of these individuals have strong industry reputations, which aid us in identifying and financing investment opportunities.  The loss of the services of these key personnel could diminish our relationships with lenders, and industry personnel and harm our business and our prospects.  We cannot assure you that these individuals can be replaced with equally skilled and experienced professionals.

Termination by us of our management agreement with our manager without cause is difficult and costly.

Our management agreement is automatically renewed each year on February 23 for a one-year term unless terminated or otherwise renegotiated.  Our independent directors review our manager’s performance periodically and the management agreement may be terminated upon the affirmative vote of at least two-thirds of our independent directors, or by a vote of the holders of a majority of our

 

7


 

outstanding common stock, based upon:  (1) unsatisfactory performance by our manager that is materially detrimental to us or (2) a determination that the management fees payable to our manager are not fair, subject to our manager’s right to prevent such a termination by accepting a reduction of management fees agreed to by at least two-thirds of our independent directors and our manager.

We must provide 180 days’ prior notice of any such termination.  Our manager will be paid a termination fee equal to four times the average annual management fee earned by our manager during the two years immediately preceding termination.  The termination fee may make it more difficult for us to terminate the management agreement.  These provisions increase the cost to us of terminating the management agreement, thereby adversely affecting our ability to terminate our manager without cause.

Our manager may allocate mortgage-related opportunities to ACM, and thus may divert attractive investment opportunities away from us.

Each of our executive officers and some of our directors also serve as officers and owners of our manager.  Our manager is also the external manager of ACM, a private mortgage REIT with investment objectives that are similar to ours.  Furthermore, two of our executive officers, Messrs. Michael and Benjamin Hough are also executive officers and directors of ACM.  Mr. Steele serves as our chief financial officer and also as chief financial officer of ACM.  Mr. Boos serves as our chief investment officer and also as chief investment officer of ACM.  Our executive officers, who as of December 31, 2015, collectively and beneficially owned approximately 0.7% of the outstanding common stock of ACM on a diluted basis, intend to continue in such capacities with ACM.  Most investment opportunities that are suitable for us are also suitable for ACM; therefore, these dual responsibilities create conflicts of interest for these officers in the event they are presented with opportunities that may benefit either us or ACM.  Our management agreement requires our manager to allocate investments between us and ACM by determining the entity for which they believe the investment opportunity is most suitable.  In making this determination, our manager considers the investment strategy and guidelines of each entity with respect to acquisition of assets, portfolio needs, market conditions, cash flow and other factors that they deem appropriate.  However, our manager generally has no obligation to make any specific investment opportunities available to us, and the above mentioned conflicts of interest may result in decisions or allocations of securities that may benefit one entity more than the other.  Thus, the executive officers of our manager could direct attractive investment opportunities to ACM instead of to us.  Such events could result in us investing in investments that provide less attractive returns, reducing the level of distributions we may be able to pay to our shareholders.

Furthermore, in the future our manager may sponsor or provide management services to other investment vehicles with investment objectives that overlap with ours.  Accordingly, we may further compete for access to the benefits that we expect our relationship with our manager to provide and for the time of its key employees.

Our manager and its key employees, who are our executive officers, face competing demands relating to their time and this may adversely affect our operations.

We rely on our manager and its employees, including Messrs. Michael and Benjamin Hough and Messrs. Steele and Boos, for the day-to-day operation of our business.  Our manager is also the manager of ACM and each of the key employees of our manager are executive officers of ACM.  As a result of their interests in ACM, Messrs. Michael and Benjamin Hough and Messrs. Steele and Boos face conflicts of interest in allocating their time among us and ACM.

Because our manager has duties to ACM as well as to our company, we do not have the undivided attention of the management team of our manager and our manager faces conflicts in allocating management time and resources between our company and ACM. Further, during turbulent market conditions or other times when we need focused support and assistance from our manager, ACM or other entities for which our manager also acts as an investment manager will likewise require greater focus and attention, placing competing high levels of demand on our manager’s limited resources.  In such situations, we may not receive the necessary support and assistance we require or would otherwise receive if we were internally managed or if our manager did not act as a manager for other entities.

Our board of directors approved broad investment guidelines for our manager and do not approve each investment decision made by our manager; as a result, our manager may cause us to acquire or sell assets such that our investment portfolio produces investment returns that are below expectations or that result in net operating losses.

Our manager is authorized to follow broad investment guidelines.  Our board of directors, including our independent directors, periodically reviews our investment guidelines and our investment policies.  However, our board of directors does not review each proposed investment.  In addition, in conducting periodic reviews, the board of directors relies primarily on information provided to it by our manager.  Furthermore, purchases and sales of investments entered into by our manager may be difficult or impossible to unwind by the time they are reviewed by the board of directors.  Our manager has great latitude within the investment guidelines in determining the types of assets it may decide are proper investments for us.

 

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Because our board of directors could change our investment policies without shareholder approval to permit us to invest more heavily in investments other than agency securities, we may invest in assets that bear greater credit, interest rate, prepayment or passive investment risks.

Our board of directors has adopted a policy that currently requires that the majority of our investments be agency securities.  Due to changes in market conditions, subject to our intent to qualify for an exemption from registration under the Investment Company Act and to maintain our qualification as a REIT, our board of directors, with the approval of a majority of our independent directors and without shareholder approval, may vary our investment strategy, our financing strategy or our hedging strategy at any time.  For example, recently we have made investments in MSR and individual prime jumbo whole loans with a goal of securitizing them into non-agency MBS.  Our board of directors could further change our investment policies to permit us to invest more heavily in investments other than agency securities, such as other investment-grade mortgage assets, other real estate-related investments (which may not be investment grade) that management determines are consistent with our asset allocation policy and with our tax status as a REIT, and the securities of other REITs.  If we acquire investments of lower credit quality, our profitability may decline and we may incur losses if there are defaults on assets underlying those investments or if the rating agencies downgrade the credit quality of those investments.

Investing in other REITs involves obtaining interests in real estate-related investments indirectly, which carries several risks, including the following:

 

·

returns on our investments are not directly linked to returns on the assets of the REITs in which we invest;

 

·

we may have no ability to affect the management, investment decisions or operations of the REITs in which we invest;

 

·

prices of publicly-traded securities are likely to be volatile; and

 

·

the disposition value of investments is dependent upon general and specific market conditions.

Each of these risks could cause the performance of our investments in other REITs to be lower than anticipated, which would adversely impact the overall returns for our investment portfolio.

Our manager’s management fee is payable regardless of the performance of our portfolio.

Our manager is entitled to receive a management fee from us that is based on the amount of our equity (as defined in the management agreement), regardless of the performance of our investment portfolio.  For example, we would pay our manager a management fee for a specific period even if we experienced a net loss during the same period.  Our manager’s entitlement to this compensation might reduce its incentive to devote its time and effort to seeking investments that provide attractive risk-adjusted returns for our investment portfolio.  This in turn could adversely affect our ability to make distributions to our shareholders and the market price of our stock.

Risks Related to Our Business

Difficult conditions in the residential mortgage and real estate markets as well as the broader financial markets and economy generally may adversely affect our business, results of operations and financial condition.

Our results of operations are materially affected by conditions in the residential mortgage and real estate markets, including the market for MBS, as well as the broader financial markets and the economy generally.  In recent years, concerns about the mortgage market, significant declines in home prices, increases in home foreclosures, high unemployment, the availability and cost of financing, and rising government debt levels, as well as inflation, energy costs, U.S. budget debates and European sovereign debt issues, have contributed to increased volatility and uncertainty for the economy and financial markets.  In particular, the residential mortgage market in the United States has experienced a variety of difficulties and changed economic conditions, including defaults, credit losses and liquidity concerns.  Certain commercial banks, investment banks and insurance companies have announced extensive losses from exposure to the residential mortgage market.  These factors have impacted investor perception of the risk associated with MBS in which we invest.  As a result, values for MBS in which we invest have experienced volatility.  Any decline in the value of our investments, or perceived market uncertainty about their value, would likely make it difficult for us to obtain financing on favorable terms or at all, or maintain our compliance with terms of any financing arrangements already in place.  Further increased volatility or stagnation in, or deterioration of, the residential mortgage and MBS markets may adversely affect the performance and market value of our investments.

The federal conservatorship of Fannie Mae and Freddie Mac and related efforts, along with any changes in laws and regulations affecting the relationship between Fannie Mae and Freddie Mac and the federal government, may adversely affect our business.

The payments we expect to receive on the agency securities in which we invest depend upon a steady stream of payments on the mortgages underlying the securities and are guaranteed by Ginnie Mae, Fannie Mae and Freddie Mac.  Ginnie Mae is part of a U.S. Government agency and its guarantees are backed by the full faith and credit of the United States.  Fannie Mae and Freddie Mac are U.S. Government-sponsored enterprises, but their guarantees are not backed by the full faith and credit of the United States.

In 2008, after Fannie Mae and Freddie Mac were placed in federal conservatorship, the Secretary of the U.S. Treasury noted that the guarantee payment structure of Fannie Mae and Freddie Mac required examination, and that changes in the structures of the entities

 

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were necessary.  The future roles of Fannie Mae and Freddie Mac, if any, could be significantly reduced and the nature of their guarantees could be eliminated or considerably limited relative to historical measurements.  Any changes to the nature of the guarantees provided by Fannie Mae and Freddie Mac, if any, could redefine what constitutes an agency security and could have broad adverse market implications as well as negatively impact us.

The problems faced by Fannie Mae and Freddie Mac resulting in their being placed into federal conservatorship have stirred debate among some federal policy makers regarding the continued role of the U.S. Government in providing liquidity for the residential mortgage market.  Following expiration of the current authorization, each of Fannie Mae and Freddie Mac could be dissolved and the U.S. Government could decide to stop providing liquidity support of any kind to the mortgage market. If Fannie Mae or Freddie Mac were eliminated, or their structures were to change radically, we would not be able to acquire agency securities from these companies, which would drastically reduce the amount and type of agency securities available for investment, which are our primary targeted investments.

Our income could be negatively affected in a number of ways depending on the manner in which related events unfold.  For example, the current credit support provided by the U.S. Treasury to Fannie Mae and Freddie Mac, and any additional credit support it may provide in the future, could have the effect of lowering the interest rate we expect to receive from agency securities, thereby tightening the spread between the interest we earn on our portfolio of targeted assets and our cost of financing that portfolio. A reduction in the supply of agency securities could also negatively affect the pricing of agency securities we seek to acquire by reducing the spread between the interest we earn on our portfolio of targeted assets and our cost of financing that portfolio.

Future actions could further change the relationship between Fannie Mae and Freddie Mac and the federal government, and could also nationalize or eliminate such entities entirely.  Any law affecting these government-sponsored enterprises may create market uncertainty and have the effect of reducing the actual or perceived credit quality of securities issued or guaranteed by Fannie Mae or Freddie Mac.  As a result, such laws could increase the risk of loss on investments in Fannie Mae and/or Freddie Mac agency securities.  It also is possible that such laws could adversely impact the market for such securities and spreads at which they trade.  All of the foregoing could materially adversely affect our business, operations and financial condition.

Mortgage loan modification programs and future legislative action may adversely affect the value of, and the returns on, the MBS and MSR in which we invest.

Since 2008, the U.S. Government, through the Federal Housing Authority and the Federal Deposit Insurance Corporation, commenced implementation of programs designed to provide homeowners with assistance in avoiding residential mortgage loan foreclosures.  The programs involve, among other things, the modification of mortgage loans to reduce the principal amount of the loans or the rate of interest payable on the loans, or to extend the payment terms of the loans.  From time to time, additional programs have been proposed to assist severely trouble borrowers with their mortgage by way of loan modification.  These loan modification programs, as well as future legislative or regulatory actions, including amendments to the bankruptcy laws, that result in the modification of outstanding mortgage loans may adversely affect the value of, and the returns on, the MBS and MSR in which we invest.

We cannot predict the impact, if any, on our earnings or cash available for distribution to our shareholders of the FHFA’s proposed revisions to Fannie Mae’s and Freddie Mac’s existing infrastructures to align the standards and practices of the three entities.

On February 21, 2012, the Federal Housing Finance Agency (“FHFA”) released its Strategic Plan for Enterprise Conservatorships, which set forth three goals for the next phase of the Fannie Mae and Freddie Mac conservatorships. These three goals are to (i) build a new infrastructure for the secondary mortgage market, (ii) gradually contract Fannie Mae and Freddie Mac’s presence in the marketplace while simplifying and shrinking their operations, and (iii) maintain foreclosure prevention activities and credit availability for new and refinanced mortgages. On October 4, 2012, the FHFA released its white paper entitled Building a New Infrastructure for the Secondary Mortgage Market, which proposes a new infrastructure for Fannie Mae and Freddie Mac that has two basic goals.

The first such goal is to replace the current, outdated infrastructures of Fannie Mae and Freddie Mac with a common, more efficient infrastructure that aligns the standards and practices of the two entities, beginning with core functions performed by both entities such as issuance, master servicing, bond administration, collateral management and data integration.  The FHFA has taken steps to establish a common securitization platform (“CSP”) for residential MBS reflecting the feedback from a broad cross-section of industry participants.  In September 2015, the FHFA released an update on the CSP, detailing progress made in the development of a new infrastructure for the securitization of single-family mortgages by Fannie Mae and Freddie Mac.  The update looks ahead to the anticipated announcement in 2016 of an implementation date for the initial software release that will allow use of the CSP by Freddie Mac, followed by the second software release that will enable both Freddie Mac and Fannie Mae to use the CSP to issue MBS.

The second goal is to establish an operating framework for Fannie Mae and Freddie Mac that is consistent with the progress of housing finance reform and encourages and accommodates the increased participation of private capital in assuming credit risk associated with the secondary mortgage market.

The FHFA recognizes that there are a number of impediments to their goals which may or may not be surmountable, such as the absence of any significant secondary mortgage market mechanisms beyond Fannie Mae, Freddie Mac and Ginnie Mae, and that their proposals are in the formative stages. As a result, it is unclear if the proposals will be enacted. If such proposals are enacted, it is unclear

 

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how closely what is enacted will resemble the proposals from the FHFA White Paper or what the effects of the enactment will be in terms of our net asset value, earnings or cash available for distribution to our shareholders

If we are unable to find suitable investments, we may not be able to achieve our investment objectives or pay dividends.

The availability of mortgage-related assets meeting our criteria depends upon, among other things, the level of activity and quality of and demand for securities in the mortgage securitization and secondary markets.  The market for MBS depends upon various factors including the level of activity in the residential real estate market, the level of and difference between short-term and long-term interest rates, incentives for issuers to securitize mortgage loans and demand for MBS by institutional investors.  The size and level of activity in the residential real estate lending market depends on various factors, including the level of interest rates, regional and national economic conditions and real estate values.  To the extent we are unable to acquire a sufficient volume of mortgage-related assets meeting our criteria, our results of operations would be adversely affected.  Furthermore, we cannot assure you that we will be able to acquire sufficient mortgage-related assets at spreads above our costs of funds.

A disproportionate rise in short-term interest rates as compared to longer-term interest rates may adversely affect our income.

The relationship between short-term and longer-term interest rates is often referred to as the “yield curve.”  Ordinarily, short-term interest rates are lower than longer-term interest rates.  If short-term interest rates rise disproportionately relative to longer-term interest rates (a flattening of the yield curve), our borrowing costs may increase more rapidly than the interest income earned on our assets.  Because we expect our investments, on average, generally will bear interest based on longer-term rates than our borrowings, a flattening of the yield curve would tend to decrease our net interest margin and the market value of our net assets.  Additionally, to the extent cash flows from investments that return scheduled and unscheduled principal are reinvested, the spread between the yields on the new investments and available borrowing rates may decline, which would likely decrease our net interest margin.  It is also possible that short-term interest rates may exceed longer-term interest rates (a yield curve inversion), in which event our borrowing costs may exceed our interest income and we could incur operating losses.

A flat or inverted yield curve may adversely affect MBS and mortgage loan prepayment rates and supply.

Our net interest margin varies primarily as a result of changes in interest rates as well as changes in the shape of the yield curve.  We believe that when the yield curve is relatively flat, borrowers have an incentive to refinance into mortgage loans with longer initial fixed rate periods and fixed rate mortgage loans, causing our adjustable-rate securities to experience faster prepayments.  In addition, a flatter yield curve generally leads to fixed-rate mortgage rates that are closer to the interest rates available on adjustable-rate mortgages, possibly decreasing the supply of adjustable-rate securities.  At times, short-term interest rates may increase and exceed long-term interest rates, causing an inverted yield curve.  When the yield curve is inverted, fixed-rate mortgage loan rates may approach or be lower than adjustable-rate mortgage loan rates, further exacerbating these conditions.  Increases in prepayments on our investment portfolio will cause our premium amortization to accelerate, lowering the yield on such assets.  If this happens, we could experience a decrease in net income or incur a net loss during these periods, which may negatively impact our distributions to shareholders.

Interest rate mismatches between our interest-earning investments and the borrowings used to fund our purchases of these securities may reduce our income during periods of changing interest rates.

Historically, we have funded most of our investments with borrowings that have interest rates that adjust more frequently than the interest rate indices and repricing terms of our investments.  Accordingly, if short-term interest rates increase, our borrowing costs may increase faster than the interest rates on our securities adjust.  As a result, in a period of rising interest rates, we could experience a decrease in net income or a net loss.  Interest rates are highly sensitive to many factors, including governmental, monetary and tax policies, domestic and international economic and political considerations and other factors, all of which are beyond our control.

Interest rate caps on our adjustable-rate MBS and mortgage loans may reduce our income or cause us to suffer a loss during periods of rising interest rates.

The mortgage loans underlying our adjustable-rate securities typically will be subject to periodic and lifetime interest rate caps.  Additionally, we may invest in ARMs with an initial “teaser” rate that will provide us with a lower than market interest rate initially, which may accordingly have lower interest rate caps than ARMs without such teaser rates.  Periodic interest rate caps limit the amount an interest rate can increase during a given period.  Lifetime interest rate caps limit the amount an interest rate can increase through maturity of a mortgage loan.  If these interest rate caps apply to the mortgage loans underlying our adjustable-rate securities, the interest distributions made on the related securities will be similarly impacted.  Our borrowings may not be subject to similar interest rate caps.  Accordingly, in a period of rapidly increasing interest rates, the interest rates paid on our borrowings could increase without limitation while caps would limit the interest distributions on our adjustable-rate MBS and mortgage loans.  Further, some of the mortgage loans underlying our adjustable-rate MBS may be subject to periodic payment caps that result in a portion of the interest on those loans being deferred and added to the principal outstanding.  As a result, we could receive less interest distributions on adjustable-rate MBS, particularly those with an initial teaser rate, than we need to pay interest on our related borrowings.  These factors could lower our net

 

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interest margin, cause us to suffer a net loss or cause us to incur additional borrowings to fund interest payments during periods of rising interest rates or sell our investments at a loss.

Because we own MBS with periods of fixed rates, an increase in interest rates may adversely affect our book value.

Increases in interest rates may negatively affect the market value of our MBS and mortgage loans.  If an investment has a fixed rate, or is in a period where the rate is fixed, such as our hybrid ARMs, it generally will be more negatively affected by these increases than an investment with a currently adjustable-rate.  In accordance with accounting rules, we are required to reduce our shareholders’ equity, or book value, by the amount of any decrease in the market value of our mortgage-related assets.  Reductions in shareholders’ equity decrease the amounts we may borrow to purchase additional securities, which could restrict our ability to increase our net interest margin.

Our delayed delivery transactions, including TBA securities and dollar roll transactions, subject us to certain risks, including price risks and counterparty risks.

We purchase a substantial portion of our agency securities through delayed delivery transactions, including TBA securities and dollar roll transactions.  In a delayed delivery transaction, we enter into a forward purchase agreement with a counterparty to purchase either (1) identified agency securities or (2) to-be-issued (or “to-be-announced”) agency securities with certain terms. As with any forward purchase contract, the value of the underlying agency securities may decrease between the contract date and the settlement date. Furthermore, a transaction counterparty may fail to deliver the underlying agency securities at the settlement date. If any of the above risks were to occur, our financial condition and results of operations may be materially adversely affected.

Because we acquire MBS that are backed by hybrid ARMs and fixed-rate securities, an increase in interest rates may adversely affect our profitability.

Most of our investments currently consist of MBS that are backed by hybrid ARMs, which have a fixed rate for an initial period of time before becoming adjustable-rate securities, or fixed-rate mortgage securities.  As we typically hedge less than 100 percent of our funding cost exposure, during a period of rising interest rates the interest payments on our borrowings could increase, while the interest payments we earn on our hybrid mortgage securities and fixed-rate mortgage securities would not change.  As a result, our returns would be reduced.

Changes in prepayment rates on our MBS may decrease our net interest margin.

Pools of mortgage loans underlie the MBS that we acquire.  We receive principal distributions as payments are made on these underlying mortgage loans.  Prepayment rates are influenced by changes in current interest rates and a variety of economic, geographic and other factors, all of which are beyond our control.  Prepayment rates generally increase when interest rates fall and decrease when interest rates rise, but changes in prepayment rates are difficult to predict.  Prepayment rates also may be affected by conditions in the housing and financial markets, government actions, general economic conditions and the relative interest rates on fixed-rate and adjustable-rate mortgage loans.  Furthermore, specific government programs to support the housing market and U.S. economy, such as the Home Affordable Refinance Program and the three rounds of quantitative easing could cause variability in prepayment rates.  Variations in our expected prepayments could adversely affect our profitability, including in the following ways:

 

·

We may purchase MBS that have a higher interest rate than the market interest rate at the time of purchase.  In exchange for this higher interest rate, we would be required to pay a premium over the face amount of the security to acquire the security.  In accordance with accounting rules, we would amortize this premium over the term of the mortgage security.  If principal distributions are received faster than anticipated, we would be required to expense the premium faster.  

 

·

We may not be able to reinvest the principal distributions received on MBS in similar new MBS.  Further, to the extent that we are able to reinvest, the effective interest rates on the new MBS may be lower than the yields on the mortgages that were prepaid.

We also may acquire MBS at a discount.  If the actual prepayment rates on a discount mortgage security are slower than anticipated at the time of purchase, we would be required to recognize the discount as income more slowly than anticipated.  This would adversely affect our profitability.  Slower than expected prepayments also may adversely affect the market value of a discount mortgage security.

Fannie Mae, Freddie Mac or Ginnie Mae guarantees of principal and interest related to agency securities do not protect us against prepayment risks.

Competition may prevent us from acquiring MBS at favorable yields and that would negatively impact our profitability.

Our net interest margin largely depends on our ability to acquire MBS at favorable spreads over our borrowing costs.  In acquiring MBS, we compete with other mortgage REITs, mortgage finance and specialty finance companies, savings and loan associations, banks, mortgage bankers, insurance companies, mutual funds, institutional investors, investment banking firms, other lenders and other entities that purchase mortgage-related assets.  Many of our competitors are substantially larger and have considerably greater financial,

 

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technical and marketing resources than we do.  Other REITs have raised, or may be expected to raise, significant amounts of capital, and may have investment objectives that overlap with ours, which may create competition for investment opportunities.  As a result, we may not in the future be able to acquire sufficient MBS at favorable spreads over our borrowing costs which would adversely affect our profitability.

Rapid changes in the values of our real estate-related investments may make it difficult for us to maintain our qualification as a REIT or exemption from the Investment Company Act.

We may acquire non-real estate related assets in the event our independent directors change our investment strategies.  If the market value or income potential of real estate-related investments declines as a result of increased interest rates, prepayment rates or other factors, we may need to increase our real estate investments and income and/or liquidate our non-qualifying assets in order to maintain our REIT qualification or exemption from the Investment Company Act.  If the decline in real estate asset values and/or income occurs quickly, this may be especially difficult to accomplish.  This difficulty may be exacerbated by the illiquid nature of any non-real estate assets that we may own.  We may have to make investment decisions that we otherwise would not make absent the REIT and Investment Company Act considerations.

Because assets we expect to acquire may experience periods of illiquidity, we may lose profits or be prevented from earning capital gains if we cannot sell mortgage-related assets at an opportune time.

We bear the risk of being unable to dispose of our mortgage-related assets at advantageous times or in a timely manner because mortgage-related assets generally experience periods of illiquidity, including during periods of delinquencies and defaults with respect to residential mortgage loans.  The lack of liquidity may result from the absence of a willing buyer or an established market for these assets, as well as legal or contractual restrictions on resale or the unavailability of financing for these assets.  As a result, our ability to vary our investment portfolio in response to changes in economic and other conditions may be relatively limited, which may cause us to incur losses.

Hedging against interest rate exposure may adversely affect our earnings.

Subject to complying with REIT requirements, we employ techniques that limit, or “hedge,” the adverse effects of rising interest rates on our short-term repurchase agreements and on the value of our assets.  Our hedging activity will vary in scope based on the level and volatility of interest rates and principal repayments, the type of securities held and other changing market conditions. These techniques may include entering into interest rate swap and swaption agreements or interest rate cap or floor agreements, purchasing or selling futures contracts, purchasing put and call options on securities or securities underlying futures contracts, or entering into forward rate agreements. We have implemented a policy to limit our use of hedging instruments to only those techniques described above and to only enter into hedging transactions with counterparties that have a high-quality credit rating.  However, there are no perfect hedging strategies, and interest rate hedging may fail to protect us from loss.  In addition, these hedging strategies may adversely affect us because hedging activities involve an expense that we will incur regardless of the effectiveness of the hedging activity. Hedging activities could result in losses if the event against which we hedge does not occur. Additionally, interest rate hedging could fail to protect us or adversely affect us because, among other things:

 

·

available interest rate hedging may not correspond directly with the interest rate risk for which protection is sought;

 

·

the duration of the hedge may not match the duration of the related asset or liability;

 

·

fair value accounting rules could foster adverse valuation adjustments due to credit quality considerations that could impact both earnings and shareholders’ equity;

 

·

the party owing money in the hedging transaction may default on its obligation to pay;

 

·

the credit quality of the party owing money on the hedge may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction; and

 

·

the value of derivatives used for hedging is adjusted at each reporting date in accordance with accounting rules to reflect changes in fair value.  Downward adjustments, or “mark-to-market losses,” would reduce our shareholders’ equity.

Clearing facilities or exchanges upon which some of our hedging instruments are traded may increase margin requirements on our hedging instruments in the event of adverse economic developments.

In response to events having or expected to have adverse economic consequences or which create market uncertainty, clearing facilities or exchanges upon which some of our hedging instruments, such as interest rate swaps and Eurodollar futures contracts, are traded may require us to post additional collateral. In the event that future adverse economic developments or market uncertainty result in increased margin requirements for our hedging instruments, it could materially adversely affect our liquidity position, business, financial condition and results of operations.

 

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Failure to obtain and maintain an exemption from being regulated as a commodity pool operator could subject us to additional regulation and compliance requirements and may result in fines and other penalties which could materially adversely affect our business and financial condition.

The Dodd-Frank Wall Street Reform and Consumer Act (the “Dodd-Frank Act”) established a comprehensive new regulatory framework for derivative contracts commonly referred to as “swaps.” As a result, any investment fund, including a mortgage REIT, that trades in swaps may be considered a “commodity pool,” which would cause its directors to be regulated as “commodity pool operators” (“CPOs”). Under the rules, funds that are considered CPOs solely because of their use of swaps must register with the National Futures Association (the “NFA”), which requires compliance with NFA’s rules, and are subject to regulation by the U.S. Commodity Futures Trading Commission (the “CFTC”) including with respect to disclosure, reporting, recordkeeping and business conduct. However, the CFTC's Division of Swap Dealer and Intermediary Oversight issued a no-action letter saying, although it believes that mortgage REITs are properly considered commodity pools, it would not recommend that the CFTC take enforcement action against the operator of a mortgage REIT who does not register as a CPO if, among other things, the mortgage REIT limits the initial margin and premiums required to establish its swaps, futures and other commodity interest positions to not more than five percent of its total assets, the mortgage REIT limits the net income derived annually from those commodity interest positions that are not qualifying hedging transactions to less than five percent of its gross income and interests in the mortgage REIT are not marketed to the public as or in a commodity pool or otherwise as or in a vehicle for trading in the commodity futures, commodity options or swaps markets.

We use hedging instruments in conjunction with our investment portfolio and related borrowings to reduce or mitigate risks associated with changes in interest rates. We do not currently engage in any speculative derivatives activities or other non-hedging transactions using swaps, swaptions, futures or options on futures. We do not use these instruments for the purpose of trading in commodity interests, and we do not consider our company or its operations to be a commodity pool as to which CPO regulation or compliance is required. We have submitted the required filing to claim the no-action relief afforded by the no-action letter described above. Consequently, we will be restricted to operating within the parameters discussed in the no-action letter and will not enter into hedging transactions covered by the no-action letter if they would cause us to exceed the limits set forth in the no-action letter.

The CFTC has substantial enforcement power with respect to violations of the laws over which it has jurisdiction, including their anti-fraud and anti-manipulation provisions. For example, CFTC may suspend or revoke the registration of a person who fails to comply, prohibit such a person from trading or doing business with registered entities, impose civil money penalties, require restitution and seek fines or imprisonment for criminal violations. Additionally, a private right of action exists against those who violate the laws over which CFTC has jurisdiction or who willfully aid, abet, counsel, induce or procure a violation of those laws. In the event that we fail to comply with statutory requirements relating to derivatives or with the CFTC's rules thereunder, including the no-action letter described above, we may be subject to significant fines, penalties and other civil or governmental actions or proceedings, any of which could have a materially adverse effect on our business, financial condition and results of operations.

It may be uneconomical to “roll” our TBA dollar roll transactions or we may be unable to meet margin calls on our TBA contracts, which could negatively affect our financial condition and results of operations.

We may utilize TBA dollar roll transactions as a means of investing in and financing agency securities. TBA contracts enable us to purchase or sell, for future delivery, agency securities with certain principal and interest terms and certain types of collateral, but the particular agency securities to be delivered are not identified until shortly before the TBA contract settlement date. Prior to settlement of the TBA contract we may choose to move the settlement of the securities out to a later date by entering into an offsetting position (referred to as a “pair off”), net settling the paired off positions for cash, and simultaneously purchasing a similar TBA contract for a later settlement date, collectively referred to as a “dollar roll.” The agency securities purchased for a forward settlement date under the TBA contract are typically priced at a discount to agency securities for settlement in the current month. This difference (or discount) is referred to as the “price drop.” The price drop is the economic equivalent of net interest carry income on the underlying agency securities over the roll period (interest income less implied financing cost) and is commonly referred to as “dollar roll income.” Consequently, dollar roll transactions and such forward purchases of agency securities represent off-balance sheet financing and increase our “at risk” leverage.

Under certain market conditions, TBA dollar roll transactions may result in negative carry income whereby the agency securities purchased for a forward settlement date under the TBA contract are priced at a premium to agency securities for settlement in the current month. Under such conditions, it would generally be uneconomical to roll our TBA contracts prior to the settlement date and we could have to take physical delivery of the underlying securities and settle our obligations for cash. We may not have sufficient funds or alternative financing sources available to settle such obligations. In addition, pursuant to the margin provisions established by the Mortgage-Backed Securities Division (“MBSD”) of the Fixed Income Clearing Corporation we are subject to margin calls on our TBA contracts. Further, our prime brokerage agreements may require us to post additional margin above the levels established by the MBSD. Negative carry income on TBA dollar roll transactions or failure to procure adequate financing to settle our obligations or meet margin calls under our TBA contracts could result in defaults or force us to sell assets under adverse market conditions or through foreclosure and adversely affect our financial condition and results of operations.

 

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We are highly dependent on information and communications systems.  Any systems failures could significantly disrupt our business, which may, in turn, negatively affect our operations and the market price of our stock and our ability to pay dividends to our shareholders.

Our business is highly dependent on communications and information systems.  Any failure or interruption of our manager’s systems or cyber-attacks or security breaches of our manager’s networks or systems could cause delays or other problems in our portfolio trading activities, which could have a material adverse effect on our operating results, the market price of our stock and our ability to pay dividends to our shareholders. In addition, we also face the risk of operational failure, termination or capacity constraints of any of the third parties with which we do business or that facilitate our business activities, including clearing agents or other financial intermediaries we use to facilitate our portfolio transactions.

Computer malware, viruses, and computer hacking and phishing attacks have become more prevalent in our industry and may occur on our systems in the future. We rely heavily on our manager’s financial, accounting and other data processing systems. It is difficult to determine what, if any, negative impact may directly result from any specific interruption or cyber-attacks or security breaches of our manager’s networks or systems or any failure to maintain performance, reliability and security of our technical infrastructure. As a result, any such computer malware, viruses, and computer hacking and phishing attacks may negatively affect our operations.

Declining real estate values could impair our assets and harm our operations.

Some risks associated with our business are more severe during periods of economic slowdown or recession, especially if these periods are accompanied by declining real estate values. The ability of a borrower to repay a loan secured by a residential property typically is dependent upon the income or assets of the borrower. During an economic slowdown, unemployment rises and increasing numbers of borrowers have difficulty in making payments on their debts, including on mortgage loans. When a recession is combined with declining real estate values, as was the case in the recession that started in 2008, defaults on mortgages may increase dramatically.

Owners of agency securities are protected from the risk of default on the underlying mortgages by guarantees from Fannie Mae, Freddie Mac or, in the case of the Ginnie Mae, the U.S. Government. However, we also may acquire non-agency securities, which are backed by residential real property but, in contrast to agency securities, the principal and interest payments are not guaranteed by Fannie Mae or Freddie Mac. Our non-agency securities investments are therefore particularly sensitive to recessions and declining real estate values.

In the event of a default on a mortgage loan that we hold in our portfolio or a mortgage loan underlying non-agency securities in our portfolio, we bear the risk of loss as a result of the potential deficiency between the value of the collateral and the debt owed on the mortgage, as well as the costs and delays of foreclosure or other remedies, and the costs of maintaining and ultimately selling a property after foreclosure.

Any sustained period of increased payment delinquencies, defaults, foreclosures or losses on our non-agency securities or mortgage loans could adversely affect our revenues, results of operations, financial condition, business prospects and ability to make distributions to shareholders.

We may engage in new business initiatives and invest in diverse types of assets and these activities could expose us to new, different or increased risks.

We frequently evaluate new business opportunities and investment strategies that would allow us to diversify our business.  We have invested in and may in the future invest in a variety of mortgage-related and other financial assets that may or may not be closely related to our current business.  Additionally, we may enter other operating businesses that may or may not be closely related to our current business.  These new assets or business operations may have new, different or increased risks than what we are currently exposed to in our business and we may not be able to manage these risks successfully.  Additionally, when investing in new assets or businesses we will be exposed to the risk that those assets, or income generated by those assets or businesses, will affect our ability to meet the requirements to maintain our REIT status or our status as exempt from registration under the Investment Company Act.  If we are not able to successfully manage the risks associated with new assets types or businesses, it could have an adverse effect on our business, results of operations and financial condition.

We may not be able to raise the capital required to finance our assets and grow our business.

The growth of our operating businesses may require access to debt and equity capital that may or may not be available on favorable terms or at the desired times, or at all. In addition, we invest in certain assets, such as MSR, for which financing has historically been difficult or costly to obtain. Our inability to obtain financing for our target assets could require us to seek debt or equity capital that may be more costly or unavailable to us. We cannot assure you that we will have access to any debt or equity capital on favorable terms or at the desired times, or at all. Our inability to raise such capital or obtain financing on favorable terms could materially adversely affect our liquidity position, business, results of operations and financial condition.

In addition, as discussed in the notes to our consolidated financial statements, the acquisition of Pingora on August 31, 2015 was accounted for using the acquisition method.  Substantially all of the $23.5 million purchase price for Pingora was allocated to intangible

 

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assets including approximately $4.0 million of goodwill. Pingora’s inability to raise debt or equity capital or obtain financing on favorable terms could materially adversely affect its business and profitability, and could require us to recognize an impairment on these intangible assets.

The expansion of our business into investments in and the securitization of non-agency securities may expose us to additional risks.

We have limited experience acquiring mortgage loans in the secondary market and completing securitization transactions.  Our investments in and the securitization of residential mortgage loans are subject to many of the same risks as those related to our other assets, including risks related to changes in interest rates, economic factors in general, prepayment speeds, hedging strategies and regulatory changes.  However, there can be no assurance that we will be able to continue our securitization program successfully, or at all.  In addition, the purchase of residential mortgage loans in the secondary market requires us, in some circumstances, to maintain certain licenses and failure to maintain those licenses may adversely affect our ability to acquire mortgage loans and successfully operate our securitization program.  If we are not able to successfully manage these and other risks related to investing in and securitizing non-agency securities, it may adversely affect our business, results of operations and financial condition.

We may not be able to acquire residential mortgage loans.

The success of our mortgage loan conduit program depends upon sourcing a large volume of desirable residential mortgage loans. We may be unable to do so for many reasons. We may be unable to locate originators that are able or willing to originate mortgage loans that meet our standards and we may not be able to source acquisitions of bulk pools of mortgage loans from originators, banks and other sellers, in either case, on terms and conditions favorable to us. Additionally, competition for mortgage loans may drive down supply or drive up prices, making it uneconomical to purchase the loans. General economic factors, such as recession, declining home values, unemployment and high interest rates, may limit the supply of available loans. As a result, we may incur additional costs to acquire a sufficient volume of mortgage loans or be unable to acquire mortgage loans at a reasonable price. If we cannot source an adequate volume of desirable loans, our mortgage loan conduit program may be unprofitable, and we may hold individual loans for long periods, increasing our exposure to the credit of the borrowers and requiring capital that might be better used elsewhere in our business.

Market conditions and other factors may affect our ability to securitize residential mortgage loans.

Our ability to securitize residential mortgage loans is affected by a number of factors, including:

 

·

conditions in the securities markets, generally;

 

·

conditions in the asset-backed securities markets, specifically;

 

·

yields of our portfolio mortgage loans;

 

·

the credit quality of our portfolio of mortgage loans; and

 

·

our ability to obtain any necessary credit enhancement.

In recent years, the asset-backed securitization markets have experienced disruptions and reductions in securitization volumes. Recent conditions in the securitization markets have included reduced liquidity, increased risk premiums for issuers, reduced investor demand, financial distress among financial guaranty insurance providers, and a general tightening of credit. These conditions may increase our cost of funding and reduce or even eliminate our access to the securitization market. As a result, these conditions may result in our inability to sell securities in the asset-backed securities market.  Further, our lending facilities may not be adequate to fund our mortgage purchasing activities until such disruptions in the securitization markets subside. Any future disruptions in this market or any adverse change or delay in our ability to access the market could have a material adverse effect on our financial position, liquidity and results of operations. Low investor demand for asset-backed securities could force us to hold mortgage loans until investor demand improves, but our capacity to hold such mortgage loans is not unlimited. Adverse market conditions could also result in increased costs and reduced margins earned in connection with our planned securitization transactions.

Our ability to execute securitizations of residential mortgage loans could be delayed, limited, or precluded by legislative and regulatory reforms applicable to asset-backed securities and the institutions that sponsor, service, rate, or otherwise participate in, or contribute to, the successful execution of a securitization transaction. These factors could limit, delay, or preclude our ability to execute securitization transactions and could also reduce the returns we would otherwise expect to earn in connection with securitization transactions.

Provisions of the Dodd-Frank Act require significant revisions to the legal and regulatory framework which apply to the asset-backed securities markets and securitizations. We cannot predict how the Dodd-Frank Act and the other regulations that have been proposed will affect our ability to execute securitizations of residential mortgage loans. These laws and regulations could effectively preclude us from executing securitization transactions, could delay our execution of these types of transactions, or could reduce the returns we would otherwise expect to earn from executing securitization transactions.

 

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Other matters, such as (i) accounting standards applicable to securitization transactions and (ii) capital and leverage requirements applicable to banks and other regulated financial institutions that traditionally purchase and hold asset-backed securities, could result in less investor demand for securities issued through securitization transactions we plan to execute or increased competition from other institutions that execute securitization transactions.

Our ability to profitably execute or participate in future securitizations of residential mortgage loans is dependent on numerous factors, and if we are not able to achieve our desired level of profitability or if we incur losses in connection with executing or participating in future securitizations, it could materially and adversely impact our business and financial condition.

There are a number of factors that can impact whether a securitization transaction that we execute or participate in is profitable. One of these factors is the price we pay for the mortgage loans that we securitize, which in the case of residential mortgage loans, is impacted by the level of competition in the marketplace and the relative desirability to originators of retaining residential mortgage loans as investments or selling them to third parties such as us. Another factor that impacts the profitability of a securitization transaction is the cost of the short-term debt used to finance our holdings of mortgage loans prior to securitization. Such cost is affected by a number of factors, including the availability of this type of financing, interest rates, the duration of the financing, and the extent to which third parties are willing to provide short-term financing.

After we acquire mortgage loans that we intend to securitize, we can also suffer losses if the value of those loans declines prior to securitization. Such declines can be due to, among other things, changes in interest rates and changes in the credit quality of the loan. To the extent we seek to hedge against a decline in loan value due to changes in interest rates, there is a cost of hedging that also affects whether a securitization is profitable.

Rating agencies have historically played a central role in the securitization markets. Many purchasers of asset-backed securities require that a security be rated by the agencies at or above a specific grade before they will consider purchasing it. The rating agencies could adversely affect our ability to execute securitization transactions by deciding not to publish ratings for our securitization transaction, deciding not to consent to the inclusion of those ratings in the prospectuses, or by assigning ratings that are below the thresholds investors require. Further, rating agencies could alter their ratings processes or criteria after we have accumulated loans for securitization in a manner that reduces the value of previously acquired loans or that requires us to incur additional costs to comply with those processes and criteria.

The price that investors will pay for securities issued in our securitization transactions also has a significant impact on the profitability of the transactions to us. In addition, transaction costs incurred in executing transactions impact the profitability of our securitization transactions and any liability that we may incur, or may be required to reserve for, in connection with executing a transaction can reduce the profitability of a transaction or cause a loss to us. To the extent that we are not able to profitably execute future securitizations of residential mortgage loans, it could materially and adversely impact our business and financial condition.

We are exposed to credit risk on the residential mortgage loans we acquire and securitize and we may not be able to successfully manage those risks and mitigate our losses.

Despite our efforts to manage credit risk related to the residential mortgage loans we acquire and securitize, there are many aspects of credit risk that we cannot control. In addition, our portfolio of mortgage assets may be concentrated in terms of credit risk. Our due diligence, underwriting, quality control and loss mitigation policies and procedures may not be effective at preventing or limiting compliance violations or borrower delinquencies and defaults, and the loan servicing companies that service the mortgage loans may not comply with loss mitigation regulations or applicable investor requirements. Prior to acquiring loans, we perform due diligence, including re-underwriting and compliance with applicable laws, and we rely on resources and data available to us from the seller, which may be limited. Our underwriting and due diligence efforts may not reveal matters that could lead to losses. If our underwriting process is not adequate, and we fail to detect certain loan defects or compliance issues related to origination or servicing, we may incur losses. We could also incur losses if a counterparty that sold us a loan is unwilling or unable (e.g., due to its financial condition) to repurchase that loan or asset or pay damages to us if we determine subsequent to purchase that one or more of the representations or warranties made to us in connection with the sale was inaccurate. As a result, we could incur losses that would materially and adversely affect our financial condition and results of operations.

Our past and future securitization activities expose us to an increased risk of litigation, which may materially and adversely affect our business and financial condition.

In connection with our mortgage loan conduit program, we prepare disclosure documentation, including term sheets and offering memorandums, which include disclosures regarding the securitization transactions and the assets being securitized. If our disclosure documentation is alleged or found to contain inaccuracies or omissions, we may be liable under federal securities laws, state securities laws or other applicable laws for damages to third parties that invest in these securitization transactions, including in circumstances in which we relied on a third party in preparing accurate disclosures, or we may incur other expenses and costs in connection with disputing these allegations or settling claims. We may also sell or contribute residential mortgage loans to third parties who, in turn, securitize those loans. In these circumstances, we may also prepare disclosure documentation, including documentation that is included in term sheets and offering memorandums relating to those securitization transactions. We could be liable under federal securities laws, state

 

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securities laws, or other applicable laws for damages to third parties that invest in these securitization transactions, including liability for disclosures prepared by third parties or with respect to loans that we did not sell or contribute to the securitization.

In recent years, there has also been debate as to whether there are defects in the legal process and legal documents governing transactions in which securitization trusts and other secondary purchasers take legal ownership of residential mortgage loans and establish their rights as first priority lien holders on underlying mortgaged property. To the extent there are problems with the manner in which title and lien priority rights were established or transferred, securitization transactions that we sponsored and third-party sponsored securitizations that we hold investments in, we may experience losses.

Defending a lawsuit can consume significant resources and may divert management’s attention from our operations. We may be required to establish reserves for potential losses from litigation, which could be material. To the extent we are unsuccessful in our defense of any lawsuit, we could suffer losses which could be in excess of any reserves established relating to that lawsuit and these losses could be material.

We may be subject to counterparty risk in connection with our mortgage loan conduit program and our acquisitions of MSR.

When engaging in securitization transactions and MSR acquisitions, we may be required to make representations and warranties to the purchasers of the underlying residential mortgage loans regarding, among other things, certain characteristics of those mortgage loans. If our representations and warranties are inaccurate, we may be obligated to repurchase certain mortgage loans, which may result in a loss. Even if we obtain representations and warranties from the loan originator or other parties from whom we acquired the mortgage loans or MSR, as applicable, they may not correspond with the representations and warranties we make or may otherwise not protect us from losses. For example, if representations and warranties we obtain from those parties do not exactly align with the representations and warranties we make, or if the representations and warranties made to us are not enforceable or if we cannot collect damages for a breach (e.g., due to the financial condition of the party that made the representation or warranty to us or statutes of limitations), we may incur losses.

We may be subject to fines or other penalties based on the conduct of the mortgage loan originators and brokers that originated the residential mortgage loans that we subsequently acquire and the third-party servicers who service the loans underlying the MSR we acquire.

We are dependent on third-party mortgage originators to originate mortgage loans that comply with applicable law and on third-party mortgage servicers to perform the actual day-to-day servicing obligations on the mortgage loans underlying the MSR. Mortgage loan originators and brokers are subject to strict and evolving consumer protection laws and other legal obligations with respect to the origination of residential mortgage loans. These laws and regulations include the “ability-to-repay” and “qualified mortgage” regulations of the Consumer Financial Protection Bureau (“CFPB”), which became effective in 2014.  In addition, there are various other federal, state, and local laws and regulations that are intended to discourage predatory lending practices by residential mortgage loan originators.  These laws may be highly subjective and open to interpretation and, as a result, a regulator or court may determine that that there has been a violation where an originator or servicer of mortgage loans reasonably believed that the law or requirement had been satisfied. Failure or alleged failure by originators or servicers to comply with these laws and regulations could subject us, as an assignee or purchaser of these loans or as an investor in MSR or securities backed by these loans, to delays in foreclosure proceedings, increased litigation expenses, monetary penalties and defenses to foreclosure, including by recoupment or setoff of finance charges and fees collected, and in some cases could also result in rescission of the affected residential mortgage loans, which could adversely impact our business and financial results.

The final servicing rules promulgated by the CFPB to implement certain sections of the Dodd-Frank Act include provisions relating to periodic billing statements and disclosures, responding to borrower inquiries and complaints, force-placed insurance, and adjustable rate mortgage interest rate adjustment notices. Further, the mortgage servicing rules require servicers to, among other things, make good faith early intervention efforts to notify delinquent borrowers of loss mitigation options, to implement specified loss mitigation procedures, and if feasible, exhaust all loss mitigation options before proceeding to foreclosure. Proposed updates to further refine these rules have been published and will likely lead to further changes in requirements applicable to servicing mortgage loans.

While some of these laws may not explicitly hold us responsible for the legal violations of these third parties, federal and state agencies and private litigants have increasingly sought to impose such liability. In addition, various regulators and plaintiffs’ lawyers have sought to hold assignees of mortgage loans liable for the alleged violations of the originating lender under theories of express or implied assignee liability. Further, it is possible that a third-party servicer’s failure to comply with the new and evolving servicing protocols could adversely affect the value of our MSR. Accordingly, we may be subject to fines, penalties or civil liability based upon the conduct of the mortgage lenders that originated the mortgage loans we hold and the third-party servicers who service the loans for which we own the MSR.

 

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Investments in MSR may expose us to additional risks.

Our investments in MSR may subjects us to certain additional risks, including the following:

 

·

We have limited experience acquiring MSR and operating a servicer and while ownership of MSR and the operation of a servicer includes many of the same risks as our other target assets, including risks related to prepayments, borrower credit, defaults, interest rates, hedging, and regulatory changes, there can be no assurance that we will be able to successfully operate a servicer subsidiary and integrate it into our business operations.

 

·

Our subsidiary’s status a Fannie Mae, Freddie Mac and Ginnie Mae approved servicer is subject to compliance with each of their respective selling and servicing guidelines, minimum capital requirements and other conditions they may impose from time to time at their discretion.  The failure to meet such guidelines and conditions could result in the unilateral termination of our subsidiary’s status as an approved servicer.

 

·

Our subsidiary is presently licensed in all states to hold MSR, and to purchase whole loans, where a license is necessary to carry on such activities, with the exception of New York.  Such state licenses may be revoked by a state regulatory authority, and we may lose MSR under the regulatory jurisdiction of such state regulatory authority for which we will have little or no recourse.

 

·

Our rights to the excess servicing spread are subordinate to the interests of Fannie Mae and Freddie Mac and are subject to extinguishment.  Fannie Mae and Freddie Mac each require approval of the sale of excess servicing spreads pertaining to their respective MSR.  A condition to the grant of such consent is the execution of an acknowledgement agreement or subordination of interest agreement.  Under such agreements, our rights and interest in the excess servicing spread is subject and subordinate to the interests of Fannie Mae and Freddie Mac and are subject to extinguishment.

 

·

Changes in minimum servicing amounts for agency loans could occur at any time and could negatively impact the value of the income derived from MSR.

 

·

Investments in MSR are highly illiquid and subject to numerous restrictions on transfer and, as a result, there is risk that we would be unable to locate a willing buyer or get approval to sell MSR in the future should we desire to do so.

If we are not able to successfully manage these and other risks related to investing and managing MSR, it may adversely affect our business, results of operations and financial condition.

The assets in our portfolio are recorded at fair value, but there may be substantial uncertainty as to the value of certain assets.

Some of the assets in our portfolio are not publicly traded. The fair value of securities and other assets that are not publicly traded may not be readily determinable. We value these assets quarterly at fair value, as determined in accordance with the Financial Accounting Standards Board Accounting Standard Codification 820, Fair Value Measurements and Disclosures, which may include unobservable inputs. Because such valuations are subjective, the fair value of certain of our assets may fluctuate over short periods of time and our determinations of fair value may differ materially from the values that would have been used if a ready market for these securities existed. In addition, the mortgage loans held for investment and MSR we acquire are recorded at fair value on our balance sheet based upon significant estimates and assumptions. The determination of the fair value of mortgage loans held for investment and MSR requires management to make numerous estimates and assumptions. Such estimates and assumptions include, without limitation, estimates of future cash flows associated with the assets based upon assumptions involving interest rates as well as the prepayment rates, delinquency levels and foreclosure rates of the underlying mortgage loans. The ultimate realization of the value of mortgage loans held for investment and MSR may be materially different than the fair values of such assets as may be reflected in our consolidated balance sheet as of any particular date. The use of different estimates or assumptions in connection with the valuation of these assets could produce materially different fair values for such assets, which could have a material adverse effect on our business, results of operations and financial condition. Accordingly, there may be material uncertainty about the fair value of any mortgage loans and MSR we acquire.

Our results may experience greater fluctuations by not electing hedge accounting treatment on our derivative instruments.

We have elected to not qualify for hedge accounting treatment under the Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 815 (“ASC 815”), Derivatives and Hedging, for our current derivative instruments.  The economics of our derivative hedging transactions are not affected by this election; however, our GAAP net income may be subject to greater fluctuations from period to period as a result of this accounting treatment for changes in fair values of the derivatives.

 

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Risks Related to Debt Financing

We incur significant debt to finance our investments, which subjects us to increased risk of loss.

We generally borrow between six and nine times the amount of our shareholders’ equity, although our borrowings may at times be above or below this amount.  As of December 31, 2015, our borrowings were approximately $13.6 billion, and our debt-to-shareholders’ equity ratio was approximately 6.3:1, while our effective leverage ratio, which includes the impact of off-balance sheet financing related to TBA dollar roll transactions, was 7.6:1.  We incur leverage by borrowing against our MBS and mortgage loans.  Incurring debt subjects us to many risks, including the risks that:

 

·

our cash flow from operations will be insufficient to make required payments of principal and interest, resulting in the loss of some or all of our securities due to foreclosure or sale in order to satisfy our debt obligations;

 

·

our debt may increase our vulnerability to adverse economic and industry conditions;

 

·

we may be required to dedicate a substantial portion of our cash flow from operations to payments on our debt, thereby reducing funds available for distribution to shareholders, funding our operations, future business opportunities or other purposes;

 

·

the terms of any refinancing will not be as favorable as the terms of the debt being refinanced;

 

·

the use of leverage could adversely affect our ability to make distributions to our shareholders and could reduce the market price of our common stock;

 

·

a default under a mortgage loan could result in an involuntary liquidation of the securities pledged for such mortgage loan, including any cross-collateralized securities, which would result in a loss to us equal to the difference between the value of the securities upon liquidation and the carrying value of the securities; and

 

·

to the extent we are compelled to liquidate assets to repay debts, such an event could jeopardize (1) our REIT status, or (2) our exemption from registration under the Investment Company Act, the loss of either of which could decrease our overall profitability and our ability to make distributions to our shareholders.

A decrease in the value of assets financed through repurchase agreements may lead our lenders to require us to pledge additional assets as collateral.  If our assets are insufficient to meet the collateral requirements, then we may be compelled to liquidate particular assets at an inopportune time.

A majority of our borrowings are and will be secured by our securities, generally under repurchase agreements.  The amount borrowed under a repurchase agreement is based on the market value of the security pledged to secure the borrowings.  Our repurchase agreements allow our lenders to revise the market value of the securities pledged as collateral from time to time to reflect then–current market conditions.  Possible market developments, including a sharp rise in interest rates, a change in prepayment rates or increasing market concern about the value or liquidity of one or more types of securities in which our investment portfolio is concentrated, may cause a decline in the market value of the securities used to secure these debt obligations, which could limit our ability to borrow or result in lenders requiring us to pledge additional collateral to secure our borrowings or repay a portion of the outstanding borrowings, on minimal notice.  In that situation, we could be required to sell securities under adverse market conditions in order to obtain the additional collateral required by the lender or to pay down our borrowings.  If these sales are made at prices lower than the carrying value of the securities, we would experience losses, thus adversely affecting our operating results and net profitability.  In recent years, a number of companies owning mortgage securities have been required by lenders to pledge additional collateral as the market value of their mortgage securities declined.  In the ordinary course of our business, we experience margin calls, which require us to pledge additional collateral or pay down our borrowings.  See “Management’s Discussion and Analysis of Financial Condition and Results of Operations — Liquidity and Capital Resources.”

Further, financial institutions may require us to maintain a certain amount of cash that is not invested or to set aside non-leveraged assets sufficient to maintain a specified liquidity position which would allow us to satisfy our collateral obligations.  As a result, we may not be able to leverage our assets as fully as we would choose, which could reduce our return on equity.  In the event that we are unable to meet these collateral obligations, then, as described above, our financial condition could deteriorate rapidly.

Failure to procure adequate debt financing, or to renew or replace existing debt financing as it matures, would adversely affect our results and may, in turn, negatively affect the value of our stock and our ability to distribute dividends.

We use debt financing as a strategy to increase our return on investments.  However, we may not be able to achieve our desired debt-to-equity ratio for a number of reasons, including the following:

 

·

our lenders do not make debt financing available to us at acceptable rates; or

 

·

our lenders require that we pledge additional collateral to cover our borrowings, which we may be unable to do.

 

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The dislocations in the residential mortgage market and credit markets have led lenders, including the financial institutions that provide financing for our investments, to heighten their credit review standards, and, in some cases, to reduce or eliminate loan amounts available to borrowers.  As a result, we cannot assure you that any, or sufficient, debt funding will be available to us in the future on terms that are acceptable to us.  In the event that we cannot obtain sufficient funding on acceptable terms, there may be a negative impact on the value of our stock and our ability to make distributions, and you may lose part or all of your investment.

Furthermore, because we rely primarily on short-term borrowings, our ability to achieve our investment objective depends not only on our ability to borrow money in sufficient amounts and on favorable terms, but also on our ability to renew or replace on a continuous basis our maturing short-term borrowings. As of December 31, 2015, a majority of our borrowings bore maturities of 30 days or less. If we are not able to renew or replace maturing borrowings, we will have to sell some or all of our assets, possibly under adverse market conditions.

Lenders may require us to enter into restrictive covenants relating to our operations.

When we obtain financing, lenders could impose restrictions on us that would affect our ability to incur additional debt, our capability to make distributions to shareholders and our flexibility to determine our operating policies.  Loan documents we execute may contain negative covenants that limit, among other things, our ability to repurchase stock, distribute more than a certain amount of our funds from operations, and employ leverage beyond certain amounts.

If the counterparties to our repurchase transactions default on their obligations to resell the underlying security back to us at the end of the transaction term, or if the value of the underlying security has declined as of the end of that term or if we default on our obligations under the repurchase agreement, we will lose money on our repurchase transactions.

When we engage in a repurchase transaction, we generally sell securities to the transaction counterparty and receive cash from the counterparty.  The counterparty is obligated to resell the securities back to us at the end of the term of the transaction, which is typically from 30 days to less than one year, but which may have terms in excess of one year.  The cash we receive from the counterparty when we initially sell the securities to the counterparty is less than the value of those securities, which is referred to as the haircut.  If the counterparty defaults on its obligation to resell the securities back to us we would incur a loss on the transaction equal to the amount of the haircut (assuming there was no change in the value of the securities).  See Item 7 – “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this report for further discussion regarding risks related to exposure to foreign-owned financial institution counterparties in light of recent market conditions. We would also lose money on a repurchase transaction if the value of the underlying securities has declined as of the end of the transaction term, as we would have to repurchase the securities for their initial value but would receive securities worth less than that amount.  Any losses we incur on our repurchase transactions could adversely affect our earnings, and thus our cash available for distribution to our shareholders.

If we default on one of our obligations under a repurchase transaction, the counterparty can terminate the transaction and cease entering into any other repurchase transactions with us.  In that case, we would likely need to establish a replacement repurchase facility with another repurchase dealer in order to continue to leverage our investment portfolio and carry out our investment strategy.  There is no assurance we would be able to establish a suitable replacement facility on acceptable terms or at all.

Our use of repurchase agreements to borrow funds may give our lenders greater rights in the event that either we or a lender file for bankruptcy.

Our borrowings under repurchase agreements may qualify for special treatment under the bankruptcy code, giving our lenders the ability to avoid the automatic stay provisions of the bankruptcy code and to take possession of and liquidate our collateral under the repurchase agreements without delay in the event that we file for bankruptcy.  Furthermore, the special treatment of repurchase agreements under the bankruptcy code may make it difficult for us to recover our pledged assets in the event that a lender files for bankruptcy.  Thus, our use of repurchase agreements will expose our pledged assets to risk in the event of a bankruptcy filing by either a lender or us.

Risks Related to Our Corporate Structure

Failure to maintain an exemption from the Investment Company Act would adversely affect our results of operations.

We believe that we conduct our business in a manner that allows us to avoid having to register as an investment company under the Investment Company Act. Under Section 3(c)(5)(C), the Investment Company Act exempts entities that are primarily engaged in the business of purchasing or otherwise acquiring “mortgages and other liens on and interests in real estate.” The staff of the SEC has provided guidance on the availability of this exemption. Specifically, the staff’s position generally requires us to maintain at least 55% of our assets directly in qualifying real estate interests and 80% in real estate-related investments (including our qualifying real estate interests). We refer to this exemption as the “Mortgage Exemption.” In order to constitute a qualifying real estate interest under the 55% requirement, a real estate interest must meet various criteria. Mortgage securities that do not represent all of the certificates issued with respect to an underlying pool of mortgages may be treated as securities separate from the underlying mortgage loans and, thus, may not

 

21


 

qualify for purposes of the 55% requirement. Our ownership of these mortgage securities, therefore, is limited by the provisions of the Investment Company Act. Accordingly, we intend to maintain at least 55% of our assets in whole pools of agency and non-agency securities. However, competition for investments may prevent us from acquiring mortgage securities that meet the 55% requirement at favorable yields or from acquiring sufficient qualifying securities to comply with the Mortgage Exemption under the Investment Company Act.

In addition, on August 31, 2011, the SEC issued a concept release (No. IC-29778; File No. SW7-34-11, Companies Engaged in the Business of Acquiring Mortgages and Mortgage-Related Instruments) pursuant to which it is reviewing whether certain companies that invest in MBS and rely on the exemption from registration under Section 3(c)(5)(C) of the Investment Company Act (such as us) should continue to be allowed to rely on such exemption from registration. If we fail to continue to qualify for this exemption from registration as an investment company, or the SEC determines that companies that invest in MBS are no longer able to rely on this exemption, our ability to use leverage would be substantially reduced and we would be unable to conduct our business as planned, or we may be required to register as an investment company under the Investment Company Act, either of which could negatively affect the value of our stock and our ability to make distributions to our shareholders.

Our policies are determined by our board of directors, and our shareholders have limited rights.

Our board of directors is responsible for our strategic business direction.  Our major policies, including our policies with respect to acquisitions, leasing, financing, growth, operations, debt limitation and distributions, are determined by our board of directors.  Our board of directors may amend or revise these and other policies from time to time without a vote of our shareholders.  Our board’s broad discretion in setting policies and shareholders’ inability to exert control over those policies increases the uncertainty and risks you face as a shareholder.

Our board of directors may approve the issuance of capital stock with terms that may discourage a third party from acquiring us and may increase or decrease our authorized capital stock without shareholder approval.

Subject to the rights of holders of our 7.625% Series A Cumulative Redeemable Preferred Stock (“Series A Preferred Stock”) to approve the classification or issuance of any class or series of stock ranking senior to our Series A Preferred Stock, our charter permits our board of directors to issue shares of preferred stock, issuable in one or more classes or series.  We may issue a class of preferred stock to individual investors in order to comply with the various REIT requirements.  Our charter further permits our board of directors to amend our charter to increase or decrease the aggregate number of shares of our authorized stock or the number of shares of stock of any class or series without shareholder approval.  Subject to the rights of holders of Series A Preferred Stock discussed above, our board of directors may also classify or reclassify any unissued shares of preferred or common stock and establish the preferences and rights (including the right to vote, participate in earnings and to convert into shares of our common stock) of any such shares of stock, which rights may be superior to those of shares of our common stock.  Thus, our board of directors could authorize the issuance of shares of preferred or common stock with terms and conditions that could have the effect of discouraging a takeover or other transaction in which holders of some or a majority of the outstanding shares of our common stock might receive a premium for their shares over the then current market price of our common stock.  Furthermore, to the extent we issue additional equity interests, your percentage ownership interest in us will be diluted.  In addition, depending on the terms and pricing of any additional offerings, you may also experience dilution in the book value and fair value of your shares.

Our ownership limitations may restrict business combination opportunities.

To qualify as a REIT under the Code, no more than 50% of the value of our outstanding shares of capital stock may be owned, directly or under applicable attribution rules, by five or fewer individuals (as defined by the Code to include certain entities) during the last half of each taxable year (other than our first REIT taxable year).  To preserve our REIT qualification, our charter generally prohibits direct or indirect ownership by any person of either (1) more than the aggregate stock ownership limit or (2) more than the common stock ownership limit.  In addition, the articles supplementary for our Series A Preferred Stock provide that generally no person may own, or be deemed to own by virtue of the attribution provisions of the Code, either more than 9.8% in value or in number of shares, whichever is more restrictive, of our outstanding Series A Preferred Stock. Generally, shares owned by affiliated owners will be aggregated for purposes of the ownership limits.  Any transfer of shares of our stock that would violate the ownership limits will result in the shares that would otherwise be held in violation of the ownership limits being designated as “shares-in-trust” and transferred automatically to a trust effective on the day before the purported transfer or other event giving rise to such excess ownership.  The intended transferee will acquire no rights in such shares.  The beneficiary of the trust will be one or more charitable organizations named by us.  The ownership limits could have the effect of delaying, deferring or preventing a change in control or other transaction in which holders of shares of common stock might receive a premium for their shares of common stock over the then current market price or that such holders might believe to be otherwise in their best interests.  The ownership limit provisions also may make our shares an unsuitable investment vehicle for any person seeking to obtain, either alone or with others as a group, ownership of either (1) more than 9.8% of the number or value of our outstanding shares of common stock or Series A Preferred Stock or (2) more than 9.8% of the number or value of our outstanding shares of all classes.

 

22


 

Provisions of Maryland law and other provisions of our organizational documents may limit the ability of a third party to acquire control of our company.

Certain provisions of the Maryland General Corporation Law (“MGCL”) may have the effect of delaying, deferring or preventing a transaction or a change in control of our company that might involve a premium price for holders of our common stock or otherwise be in their best interests, including:

 

·

“business combination” provisions that, subject to limitations, prohibit certain business combinations between us and an “interested stockholder” (defined generally as any person who beneficially owns 10% or more of the voting power of our shares or an affiliate thereof) for five years after the most recent date on which the shareholder becomes an interested stockholder, and thereafter impose special shareholder voting requirements on these combinations; and

 

·

“control share” provisions that provide that “control shares” of our company (defined as shares which, when aggregated with other shares controlled by the acquiring shareholder, entitle the shareholder to exercise one of three increasing ranges of voting power in electing directors) acquired in a “control share acquisition” (defined as the direct or indirect acquisition of ownership or control of “control shares”) have no voting rights except to the extent approved by our shareholders by the affirmative vote of at least two-thirds of all the votes entitled to be cast on the matter, excluding all interested shares.

Our bylaws provide that we are not subject to the “control share” provisions of the MGCL.  However, our board of directors may elect to make the “control share” statute applicable to us at any time, and may do so without shareholder approval.

Title 3, Subtitle 8 of the MGCL permits our board of directors, without shareholder approval and regardless of what is currently provided in our charter or bylaws, to elect on behalf of our company to be subject to statutory provisions that may have the effect of delaying, deferring or preventing a transaction or a change in control of our company that might involve a premium price for holders of our common stock or otherwise be in their best interest.  Pursuant to Title 3, Subtitle 8 of the MGCL, our charter provides that our board of directors will have the exclusive power to fill vacancies on our board.  As a result, unless all of the directorships are vacant, our shareholders will not be able to fill vacancies with nominees of their own choosing.  Our board of directors may elect to opt in to additional provisions of Title 3, Subtitle 8 of the MGCL without shareholder approval at any time.

Additionally, our charter and bylaws contain other provisions that may delay or prevent a change of control of our company.  For example, our charter and bylaws provide that the number of directors constituting our full board may be fixed only by our directors, that our bylaws may only be amended by our directors and that a special meeting of shareholders may not be called by holders of our common stock holding less than a majority of our outstanding shares entitled to vote at such meeting.

Our rights and the rights of our shareholders to take action against our directors and officers are limited, which could limit your recourse in the event of actions not in shareholders’ best interests.

Our charter limits the liability of our directors and officers for money damages, except for liability resulting from actual receipt of an improper benefit or profit in money, property or services, or a final judgment based upon a finding of active and deliberate dishonesty by the director or officer that was material to the cause of action adjudicated.

Our charter also authorizes us to indemnify our directors and officers for actions taken by them in those capacities to the extent permitted by Maryland law, and our bylaws obligate us, to the maximum extent permitted by Maryland law, to indemnify any present or former director or officer of our company from and against any claim or liability to which he or she may become subject by reason of his or her service in that capacity.  In addition, we may be obligated to fund the defense costs incurred by our directors and officers.  Finally, we have entered into agreements with our directors and officers pursuant to which we have agreed to indemnify them to the maximum extent permitted by Maryland law.

Future offerings of debt securities, which would rank senior to our common stock upon liquidation, and future offerings of equity securities, which would dilute our existing shareholders and may be senior to our common stock for the purposes of dividend and liquidating distributions, may adversely affect the market price of our common stock.

Our common stock is ranked junior to our Series A Preferred Stock.  Our outstanding Series A Preferred Stock also has or will have a preference upon our dissolution, liquidation or winding up in respect of assets available for distribution to our shareholders. Holders of our common stock are not entitled to preemptive rights or other protections against dilution. In the future, we may attempt to increase our capital resources by making offerings of debt or additional offerings of equity securities, including commercial paper, senior or subordinated notes and series of preferred stock or common stock.  Upon liquidation, holders of our debt securities and shares of preferred stock, if any, and lenders with respect to other borrowings will receive a distribution of our available assets prior to the holders of our common stock.  Additional equity offerings may dilute the holdings of our existing shareholders or reduce the market price of our common stock, or both.  Preferred stock could have a preference on liquidating distributions or a preference on dividend payments or both that could limit our ability to make a dividend distribution to the holders of our common stock.  Because our decision to issue securities in any future offering will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings.  Thus, holders of our common stock bear the risk of our future offerings reducing the market price of our common stock and diluting their stock holdings in us.

 

23


 

We have not established a minimum dividend payment level and there are no assurances of our ability to pay dividends in the future.

We intend to pay quarterly dividends and to make distributions to our shareholders in amounts such that all or substantially all of our taxable income in each year, subject to certain adjustments, is distributed.  This, along with other factors, should enable us to qualify for the tax benefits accorded to a REIT under the Code.  However, we have not established a minimum dividend payment level and our ability to pay dividends may be adversely affected by the risk factors described in this report.  All distributions will be made at the discretion of our board of directors and will depend on our earnings, our financial condition, maintenance of our REIT status and such other factors as our board of directors may deem relevant from time to time.  There are no assurances of our ability to pay dividends in the future.  In addition, some of our distributions may include a return of capital.

Broad market fluctuations could negatively impact the market price of our stock.

We cannot assure you that the market price of our common stock will not fluctuate or decline significantly in the future.  Some of the factors that could affect our stock price or result in fluctuations in the price or trading volume of our common stock include:

 

·

actual or anticipated variations in our quarterly operating results;

 

·

changes in our operations or earnings estimates or publication of research reports about us or the industry;

 

·

increases in market interest rates may lead purchasers of our stock to demand a higher yield;

 

·

changes in market valuations of similar companies;

 

·

adverse market reaction to any increased indebtedness we incur in the future;

 

·

additions or departures of key management personnel;

 

·

actions by institutional shareholders;

 

·

speculation in the press or investment community; and

 

·

general market and economic conditions.

In addition, the stock market has experienced price and volume fluctuations that have affected the market prices of many companies in industries similar or related to ours and may have been unrelated to operating performances of these companies.  These broad market fluctuations could reduce the market price of our common stock.

Future issuances or sales of shares could cause our share price to decline.

Sales of substantial numbers of shares of our common stock in the public market, or the perception that such sales might occur, could adversely affect the market price of our common stock.  In addition, the sale of these shares could impair our ability to raise capital through a sale of additional equity securities.

Other issuances of our common stock could have an adverse effect on the market price of our common stock.  In addition, future issuances of our common stock may be dilutive to existing shareholders.

Federal Income Tax Risks

If we do not qualify as a REIT, we will be subject to tax as a regular corporation and face substantial tax liability.

We expect to continue to operate so as to qualify as a REIT under the Code.  However, qualification as a REIT involves the application of highly technical and complex Code provisions for which only a limited number of judicial or administrative interpretations exist.  Even a technical or inadvertent mistake could jeopardize our REIT status.  Furthermore, new tax legislation, administrative guidance or court decisions, in each instance potentially with retroactive effect, could make it more difficult or impossible for us to qualify as a REIT.  If we fail to qualify as a REIT in any tax year, then we would be taxed as a regular domestic corporation, which, among other things, means being unable to deduct distributions to shareholders in computing taxable income and being subject to federal income tax, including any applicable alternative minimum tax, on our taxable income at regular corporate rates.  Any resulting tax liability could be substantial and would reduce the amount of cash available for distribution to shareholders, which could in turn have an adverse impact on the value of our stock.  Furthermore, unless we were entitled to relief under applicable statutory provisions, we would be disqualified from treatment as a REIT for the subsequent four taxable years following the year during which we lost our qualification, and thus, our cash available for distribution to shareholders would be reduced for each of the years during which we did not qualify as a REIT.

Even if we remain qualified as a REIT, we may face other tax liabilities that reduce our cash flow.

Even if we remain qualified for taxation as a REIT, we may be subject to certain federal, state and local taxes on our income and assets. Any of these taxes would decrease cash available for distribution to our shareholders.

 

24


 

Complying with REIT requirements may cause us to forego otherwise attractive opportunities.

In order to maintain our qualification as a REIT for federal income tax purposes, we must continually satisfy tests concerning, among other things, the sources of our income, the nature and diversification of our assets, the amounts we distribute to our shareholders and the ownership of our stock.  We may be required to make distributions to shareholders at disadvantageous times or when we do not have funds readily available for distribution.  Thus, compliance with the REIT requirements may hinder our ability to operate solely on the basis of maximizing profits.

Complying with REIT requirements may limit our ability to hedge effectively.

The REIT provisions of the Code may limit our ability to hedge our assets and operations.  Under these provisions, any income that we generate from transactions intended to hedge our interest rate, inflation and/or currency risks will be excluded from gross income for purposes of the REIT 75% and 95% gross income tests if the instrument hedges (1) interest rate risk on liabilities incurred to carry or acquire real estate assets or (2) risk of currency fluctuations with respect to any item of income or gain that would be qualifying income under the REIT 75% or 95% gross income tests, and such instrument is properly identified under applicable regulations of the U.S. Treasury.  Income from hedging transactions entered into prior to July 31, 2008 that hedge interest rate risk on liabilities incurred to carry or acquire real estate assets will be excluded from gross income for purposes of the REIT 95% gross income test, but will not be qualifying income for purposes of the REIT 75% gross income test.  Income from hedging transactions that do not meet these requirements will generally constitute nonqualifying income for purposes of both the REIT 75% and 95% gross income tests.  As a result of these rules, we may have to limit our use of hedging techniques that might otherwise be advantageous, which could result in greater risks associated with interest rate or other changes than we would otherwise incur.

The failure of MBS subject to a repurchase agreement to qualify as real estate assets would adversely affect our ability to qualify as a REIT.

We have entered and intend to continue to enter into repurchase agreements under which we will nominally sell certain of our MBS to a counterparty and simultaneously enter into an agreement to repurchase the sold assets. We believe that for U.S. federal income tax purposes these transactions will be treated as secured debt and we will be treated as the owner of the MBS that are the subject of any such agreement notwithstanding that such agreement may transfer record ownership of such assets to the counterparty during the term of the agreement. It is possible, however, that the Internal Revenue Service (“IRS”) could successfully assert that we do not own the MBS during the term of the repurchase agreement, in which case we could fail to qualify as a REIT.

Complying with REIT requirements may force us to liquidate otherwise attractive investments.

In order to maintain our qualification as a REIT, we must also ensure that at the end of each calendar quarter at least 75% of the value of our assets consists of cash, cash items, government securities and qualified REIT real estate assets.  The remainder of our investment in securities (other than government securities and qualified real estate assets) generally cannot include more than 10% of the outstanding voting securities of any one issuer or more than 10% of the total value of the outstanding securities of any one issuer.  In addition, in general, no more than 5% of the value of our assets (other than government securities and qualified real estate assets) can consist of the securities of any one issuer and no more than 25% of the value of our total securities can be represented by securities of one or more taxable REIT subsidiaries.  If we fail to comply with these requirements at the end of any calendar quarter, we must correct such failure within 30 days after the end of the calendar quarter in order to avoid losing our REIT status and suffering adverse tax consequences.  As a result, we may be required to liquidate otherwise attractive investments.

Complying with REIT requirements may force us to borrow to make distributions to shareholders or otherwise depend on external sources of capital to fund such distributions.

As a REIT, we must distribute at least 90% of our REIT taxable income (subject to certain adjustments) to our shareholders.  To the extent that we satisfy the distribution requirement, but distribute less than 100% of our taxable income, we will be subject to federal corporate income tax on our undistributed taxable income.  In addition, we will be subject to a 4% nondeductible excise tax if the actual amount that we pay out to our shareholders in a calendar year is less than a minimum amount specified under federal tax laws.  While we generally intend to make distributions so that no income or excise taxes are due, we may from time to time, consistent with maintaining our REIT qualification, elect to pay taxes in lieu of making current distributions if we decide that strategy is more favorable to our shareholders.

From time to time, we may generate taxable income greater than our net income for financial reporting purposes due to, among other things, amortization of capitalized purchase premiums, or our taxable income may be greater than our cash flow available for distribution to shareholders.  If we do not have other funds available in these situations, we could be required to borrow funds, sell a portion of our portfolio at disadvantageous prices or find another alternative source of funds in order to make distributions sufficient to enable us to pay out enough of our taxable income to satisfy the distribution requirement and to avoid corporate income tax and the 4% excise tax in a particular year.  These alternatives could increase our costs or reduce our equity.

 

25


 

Because of the distribution requirement, it is unlikely that we will be able to fund all future capital needs, including capital needs in connection with investments, from cash retained from operations.  As a result, to fund future capital needs, we likely will have to rely on third-party sources of capital, including both debt and equity financing, which may or may not be available on favorable terms or at all.  Our access to third-party sources of capital will depend upon a number of factors, including the market’s perception of our growth potential and our current and potential future earnings and cash distributions and the market price of our stock.

Our ability to invest in and dispose of TBA contracts could be limited by our REIT status, and we could lose our REIT status as a result of these investments.

We regularly purchase agency securities through TBA contracts. In certain instances, rather than take delivery of the agency securities subject to a TBA contract, we will dispose of the TBA contract through a dollar roll transaction in which we agree to purchase similar securities in the future at a predetermined price or otherwise, which may result in the recognition of income or gains. We account for dollar roll transactions as purchases and sales. The law is unclear regarding whether TBA contracts will be qualifying assets for the 75% asset test and whether income and gains from dispositions of TBA contracts will be qualifying income for the 75% gross income test.

Until such time as we seek and receive a favorable private letter ruling from the IRS, or we are advised by counsel that TBA contracts should be treated as qualifying assets for purposes of the 75% asset test, we will limit our investment in TBA contracts and any non-qualifying assets to no more than 25% of our assets at the end of any calendar quarter. Further, until such time as we seek and receive a favorable private letter ruling from the IRS or we are advised by counsel that income and gains from the disposition of TBA contracts should be treated as qualifying income for purposes of the 75% gross income test, we will limit our gains from dispositions of TBA contracts and any non-qualifying income to no more than 25% of our gross income for each calendar year. Accordingly, our ability to purchase agency securities through TBA contracts and to dispose of TBA contracts, through dollar roll transactions or otherwise, could be limited.

Moreover, even if we are advised by counsel that TBA contracts should be treated as qualifying assets or that income and gains from dispositions of TBA contracts should be treated as qualifying income, it is possible that the IRS could successfully take the position that such assets are not qualifying assets and such income is not qualifying income. In that event, we could be subject to a penalty tax or we could fail to qualify as a REIT if (i) the value of our TBA contracts, together with our non-qualifying assets for the 75% asset test, exceeded 25% of our gross assets at the end of any calendar quarter or (ii) our income and gains from the disposition of TBA contracts, together with our non-qualifying income for the 75% gross income test, exceeded 25% of our gross income for any taxable year.

The tax on prohibited transactions will limit our ability to engage in certain methods of securitizing mortgage loans that would be treated as sales for federal income tax purposes.

A REIT’s net income from prohibited transactions is subject to a 100% tax. In general, prohibited transactions are sales or other dispositions of property, other than foreclosure property, but including mortgage loans, held primarily for sale to customers in the ordinary course of business. We might be subject to this tax if we were to securitize mortgage loans in a manner that was treated as a sale of the loans for federal income tax purposes (such as a securitization using a real estate mortgage investment conduit (“REMIC”) structure). Therefore, in order to avoid the prohibited transactions tax, we may limit the structures we utilize for our securitization transactions, even though such sales or structures might otherwise be beneficial to us.

 

Certain financing activities may subject us to federal income tax and could have negative tax consequences for our stockholders.

We could recognize “excess inclusion income” if we hold a residual interest in a REMIC. In addition, we could also generate excess inclusion income if we issue liabilities with two or more maturities and the terms of the payments of those liabilities bear a relationship to the payments that we receive on mortgage loans or MBS securing those liabilities.

We currently do not intend to hold any REMIC residual interests or to enter into any transactions that could result in our, or a portion of our assets, being treated as a taxable mortgage pool for federal income tax purposes. If we hold REMIC residual interests or enter into such a transaction in the future, we will be taxable at the highest corporate income tax rate on any excess inclusion income that is allocable to the percentage of our stock held in record name by disqualified organizations (generally tax-exempt entities that are exempt from the tax on unrelated business taxable income, such as state pension plans, charitable remainder trusts and government entities).

If we were to realize excess inclusion income, IRS guidance indicates that the excess inclusion income would be allocated among our stockholders in proportion to our dividends paid. Excess inclusion income cannot be offset by losses of our stockholders. If the stockholder is a tax-exempt entity and not a disqualified organization, then this income would be fully taxable as unrelated business taxable income under Section 512 of the Code. If the stockholder is a foreign person, it would be subject to federal income tax at the maximum tax rate and withholding will be required on this income without reduction or exemption pursuant to any otherwise applicable income tax treaty.

 

26


 

Item 1B.Unresolved Staff Comments 

None.

Item 2.Properties

We do not own any properties.  Our executive and administrative office is located at 751 W. Fourth Street, Suite 400, Winston-Salem, NC 27101.  As part of our management agreement, our manager is responsible for providing the office space required in rendering services to us, and accordingly, any direct rent responsibilities belong to our manager.

Item 3.Legal Proceedings

We and our manager are not currently subject to any material legal proceedings.

Item 4.Mine Safety Disclosures

Not applicable.

PART II

Item 5.Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities

Information about our equity compensation plans and other related shareholder matters is incorporated by reference to our definitive Proxy Statement for our 2016 Annual Shareholders’ Meeting.

Market Information

Our common stock has been listed on the NYSE under the symbol “HTS” since April 30, 2008.  The following table presents the high and low sales prices for our common stock as reported by the NYSE for the periods indicated.

 

High

 

  

Low

 

Quarter ended March 31, 2014

$

19.85

  

  

$

16.82

  

Quarter ended June 30, 2014

 

20.40

  

  

 

18.74

  

Quarter ended September 30, 2014

 

19.90

  

  

 

17.96

  

Quarter ended December 31, 2014

 

19.29

  

  

 

18.14

  

Quarter ended March 31, 2015

 

18.82

  

  

 

17.58

  

Quarter ended June 30, 2015

 

18.79

  

  

 

16.30

  

Quarter ended September 30, 2015

 

17.17

  

  

 

15.07

  

Quarter ended December 31, 2015

 

15.95

  

  

 

13.15

 

The per-share closing price for our common stock, as reported by the NYSE on February 16, 2016, was $12.48.

Holders of Our Common Stock

As of February 17, 2016, there were approximately 30 record holders of our common stock, including shares held in “street name” by nominees who are record holders.

 

27


 

Dividends

We intend to continue to pay quarterly dividends to holders of shares of common stock.  Future dividends will be at the discretion of our board of directors and will depend on our earnings and financial condition, maintenance of our REIT qualification, restrictions on making distributions under Maryland law and such other factors as our board of directors deems relevant.  For 2015, we paid $1.90 per share of common stock in dividends, all of which represented ordinary income for tax purposes.  For 2014, we paid $2.00 per share of common stock in dividends, all of which represented ordinary income for tax purposes.  The following table sets forth, for the periods indicated, the dividends declared per share of common stock.

 

Common Dividends Declared Per Share

 

Quarter ended March 31, 2014

$

0.50

  

Quarter ended June 30, 2014

 

0.50

  

Quarter ended September 30, 2014

 

0.50

  

Quarter ended December 31, 2014

 

0.50

  

Quarter ended March 31, 2015

 

0.50

  

Quarter ended June 30, 2015

 

0.50

  

Quarter ended September 30, 2015

 

0.45

  

Quarter ended December 31, 2015

 

0.45

  

Performance Graph

The following graph provides a comparison of the cumulative total return on our common stock from December 31, 2010 to the NYSE closing price per share on December 31, 2015 with the cumulative total return on the Standard & Poor’s 500 Composite Stock Price Index (the “S&P 500”) and the FTSE National Association of Real Estate Investment Trusts Mortgage REIT Index (the “FTSE NAREIT MREIT Index”).  Total return values were calculated assuming a $100 investment on December 31, 2010 with reinvestment of all dividends in (i) the common stock, (ii) the S&P 500 and (iii) the FTSE NAREIT MREIT Index.

The actual returns shown on the graph above are as follows:

Index

12/31/10

12/31/11

12/31/12

12/31/13

12/31/14

12/31/15

Hatteras Financial Corp.

100.00

100.28

106.20

78.24

97.96

78.63

S&P 500

100.00

102.11

118.45

156.82

178.28

180.75

NAREIT Mortgage REIT

100.00

97.58

116.99

114.70

135.21

123.21

 

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Issuer Purchases of Equity Securities

On June 18, 2013, our board of directors authorized a share repurchase program (the “Repurchase Program”), which allowed us to repurchase up to 10,000,000 shares of our common stock as liquidity and market conditions permit. During the year ended December 31, 2015, we repurchased 1,443,283 shares of common stock under the Repurchase Program in at-the-market transactions at a total cost of approximately $20.8 million.  From inception to December 31, 2015, we had repurchased 4,028,730 shares under the Repurchase Program for a total cost of $66.5 million.  The timing, manner, price and actual number of shares repurchased will be subject to a variety of factors, including price, corporate and regulatory requirements, market conditions, applicable SEC rules and other corporate liquidity requirements and priorities.  The Repurchase Program does not include specific price targets or an expiration date and may be suspended, modified or terminated at any time for any reason without prior notice.  The Repurchase Program does not obligate us to acquire any specific number of shares, and all open market repurchases will be made in accordance with applicable rules and regulations setting forth certain restrictions on the method, timing, price and volume of open market share repurchases.

 

Period

Total Number of Shares Purchased(1)

 

Average Price Paid per Share(2)

 

Total Number of Shares Purchased as Part of Publicly Announced Plans or Programs

 

Maximum Number of Shares that May Yet Be Purchased Under the Plans or Programs(3)

October 1, 2015 – October 31, 2015

         -      

 

$          -     

 

                -      

 

          7,040,670

November 1, 2015 – November 30, 2015

         197,400

 

$       13.98

 

           197,400

 

          6,843,270

December 1, 2015 – December 31, 2015

          872,000

 

$       13.41

 

            872,000

 

         5,971,270

Total

        1,069,400

 

$       13.51

 

        1,069,400

 

        5,971,270

 

(1)

During the fourth quarter of 2015, we repurchased 1,069,400 shares of common stock under the Repurchase Program in at-the-market transactions at a total cost of $14,472.

 

(2)

Excludes commissions.

 

(3)

On June 18, 2013, we announced that our board of directors authorized the Repurchase Program to acquire up to 10,000,000 shares of our common stock as liquidity and market conditions permit.  The timing, manner, price and actual number of shares repurchased will be subject to a variety of factors, including price, corporate and regulatory requirements, market conditions, applicable SEC rules and other corporate liquidity requirements and priorities.  The Repurchase Program does not include specific price targets or an expiration date and may be suspended, modified or terminated at any time for any reason without prior notice.  We are currently authorized by our board of trustees to repurchase or offer to repurchase shares of common stock under the Repurchase Program.

Item 6.Selected Financial Data

The following table sets forth our selected historical operating and financial data.  The selected historical operating and financial data for the five years ended December 31, 2015 have been derived from our historical financial statements.

The information presented below is only a summary and does not provide all of the information contained in our historical financial statements, including the related notes.  You should read the information below in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our historical financial statements, including the related notes.  This table includes non-GAAP financial measures.  See the section on non-GAAP measures under “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations” for important information about these non-GAAP measures and reconciliations to the most comparable GAAP measures.

 

 

29


 

(Dollars in thousands, except share-related amounts)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Years Ended December 31

 

 

2015

 

 

2014

 

 

2013

 

 

2012

 

 

2011

 

Statement of Income Data

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income on securities

$

305,717

 

 

$

354,436

 

 

$

450,708

 

 

$

504,800

 

 

$

424,713

 

Interest income on mortgage loans

 

5,509

 

 

 

35

 

 

 

-

 

 

 

-

 

 

 

-

 

Interest income on mortgage loans in securitization trusts

 

446

 

 

 

-

 

 

 

-

 

 

 

-

 

 

 

-

 

Interest income on short-term cash investments

 

1,367

 

 

 

1,283

 

 

 

1,560

 

 

 

1,508

 

 

 

1,407

 

Total interest expense

 

(91,438

)

 

 

(132,495

)

 

 

(197,709

)

 

 

(197,064

)

 

 

(144,662

)

Net interest margin

 

221,601

 

 

 

223,259

 

 

 

254,559

 

 

 

309,244

 

 

 

281,458

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other income (loss):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Servicing income

 

20,111

 

 

 

-

 

 

 

-

 

 

 

-

 

 

 

-

 

Management fee income

 

2,027

 

 

 

-

 

 

 

-

 

 

 

-

 

 

 

-

 

Net realized gain (loss) on sale of securities

 

32,731

 

 

 

5,196

 

 

 

(283,012

)

 

 

64,347

 

 

 

20,576

 

Impairment of MBS

 

-

 

 

 

-

 

 

 

(8,102

)

 

 

-

 

 

 

-

 

Net gain on mortgage loans, MSRs and other

 

10,451

 

 

 

8

 

 

 

-

 

 

 

-

 

 

 

-

 

Net gain (loss) on derivative instruments

 

(188,416

)

 

 

(141,433

)

 

 

(69,715

)

 

 

-

 

 

 

-

 

Total other income (loss)

 

(123,096

)

 

 

(136,229

)

 

 

(360,829

)

 

 

64,347

 

 

 

20,576

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Servicing expenses

 

(3,022

)

 

 

-

 

 

 

-

 

 

 

-

 

 

 

-

 

Securitization deal costs

 

(1,473

)

 

 

-

 

 

 

-

 

 

 

-

 

 

 

-

 

Other operating expenses

 

(42,390

)

 

 

(30,669

)

 

 

(27,866

)

 

 

(24,346

)

 

 

(17,661

)

Total expenses

 

(46,885

)

 

 

(30,669

)

 

 

(27,866

)

 

 

(24,346

)

 

 

(17,661

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

51,620

 

 

 

56,361

 

 

 

(134,136

)

 

 

349,245

 

 

 

284,373

 

Dividends on preferred stock

 

(21,922

)

 

 

(21,922

)

 

 

(21,922

)

 

 

(7,551

)

 

 

-

 

Net income (loss) available to common shareholders

$

29,698

 

 

$

34,439

 

 

$

(156,058

)

 

$

341,694

 

 

$

284,373

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Comprehensive income (loss) available to

   common shareholders

$

(77,409

)

 

$

248,256

 

 

$

(426,964

)

 

$

431,226

 

 

$

351,804

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Earnings (loss) per share of common stock, basic and diluted

$

0.31

 

 

$

0.36

 

 

$

(1.59

)

 

$

3.67

 

 

$

3.97

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Comprehensive income (loss) per share of common stock,

   basic and diluted

$

(0.80

)

 

$

2.57

 

 

$

(4.34

)

 

$

4.63

 

 

$

4.91

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding, basic and diluted

 

96,665,489

 

 

 

96,603,634

 

 

 

98,337,362

 

 

 

93,185,520

 

 

 

71,708,058

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Distributions per common share

$

1.90

 

 

$

2.00

 

 

$

2.45

 

 

$

3.30

 

 

$

3.90

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Selected Balance Sheet Data

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest-earning portfolio

$

14,755,382

 

 

$

17,618,470

 

 

$

17,642,532

 

 

$

23,919,251

 

 

$

17,741,873

 

Total assets

$

16,137,526

 

 

$

18,516,800

 

 

$

19,077,360

 

 

$

26,404,118

 

 

$

18,586,719

 

Total borrowings

$

13,575,722

 

 

$

15,759,831

 

 

$

16,481,509

 

 

$

22,866,429

 

 

$

16,162,375

 

Shareholders' equity

$

2,143,357

 

 

$

2,420,796

 

 

$

2,364,101

 

 

$

3,072,864

 

 

$

2,080,188

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Key Statistics (1)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Average interest-earning portfolio

$

16,302,242

 

 

$

16,943,788

 

 

$

23,010,281

 

 

$

22,167,760

 

 

$

14,932,378

 

Average borrowings

$

14,823,829

 

 

$

15,291,888

 

 

$

21,249,868

 

 

$

20,468,353

 

 

$

13,692,704

 

Average equity

$

2,348,657

 

 

$

2,433,070

 

 

$

2,731,439

 

 

$

2,732,423

 

 

$

1,899,211

 

Average interest-earning portfolio yield  (2)

 

1.91

%

 

 

2.09

%

 

 

1.96

%

 

 

2.28

%

 

 

2.84

%

Average cost of funds  (3)

 

0.62

%

 

 

0.87

%

 

 

0.93

%

 

 

0.96

%

 

 

1.06

%

Interest rate spread  (4)

 

1.29

%

 

 

1.22

%

 

 

1.03

%

 

 

1.32

%

 

 

1.78

%

TBA dollar roll income

$

83,397

 

 

$

92,008

 

 

$

5,605

 

 

$

-

 

 

$

-

 

 

30


 

(Dollars in thousands, except share-related amounts)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Years Ended December 31

 

 

2015

 

 

2014

 

 

2013

 

 

2012

 

 

2011

 

Average TBA dollar roll position

$

3,652,988

 

 

$

3,320,499

 

 

$

185,451

 

 

$

-

 

 

$

-

 

Average interest-earning yield,

   including TBA dollar roll income (5)

 

1.98

%

 

 

2.20

%

 

 

1.97

%

 

 

2.28

%

 

 

2.84

%

Effective interest expense  (6)

$

163,907

 

 

$

166,315

 

 

$

204,366

 

 

$

197,064

 

 

$

144,662

 

Effective cost of funds  (6)

 

1.11

%

 

 

1.09

%

 

 

0.96

%

 

 

0.96

%

 

 

1.06

%

Effective net interest margin  (7)

$

232,529

 

 

$

281,447

 

 

$

253,507

 

 

$

309,244

 

 

$

281,458

 

Effective interest rate spread  (8)

 

0.87

%

 

 

1.11

%

 

 

1.01

%

 

 

1.32

%

 

 

1.78

%

Core earnings  (9)

$

188,501

 

 

$

228,856

 

 

$

203,719

 

 

$

277,347

 

 

$

263,797

 

Core earnings per share, basic and diluted  (9)

$

1.95

 

 

$

2.37

 

 

$

2.07

 

 

$

2.98

 

 

$

3.68

 

Average annual securities portfolio repayment rate  (10)

 

24.98

%

 

 

20.93

%

 

 

25.70

%

 

 

26.39

%

 

 

24.54

%

Debt to equity (at period end)  (11)

6.3:1

 

 

6.5:1

 

 

7.0:1

 

 

7.4:1

 

 

7.8:1

 

Debt to paid-in capital (at period end)  (12)

5.0:1

 

 

5.8:1

 

 

6.0:1

 

 

8.2:1

 

 

8.5:1

 

Effective debt to equity (at period end)  (13)

7.6:1

 

 

8.0:1

 

 

7.3:1

 

 

7.4:1

 

 

7.8:1

 

 

 

(1)

The averages presented herein are computed from our books and records, using daily weighted values.  Percentages are annualized, as appropriate.

 

(2)

Average interest-earning portfolio yield was calculated by dividing our interest income on MBS, agency CRT securities and mortgage loans held for investment, net of amortization as applicable, by our average MBS, agency CRT securities and mortgage loans held for investment.

 

(3)

Average cost of funds was calculated by dividing our total interest expense (including hedges) by the sum of our average balance outstanding under our borrowings for the period.

 

(4)

Interest rate spread was calculated by subtracting our average cost of funds from our average interest-earning portfolio yield.

 

(5)

Average interest-earning portfolio yield, including TBA dollar roll income was calculated the same as average interest-earning portfolio yield other than to include TBA dollar roll income in the numerator and our average TBA dollar roll position in the denominator.

 

(6)

Effective interest expense includes certain interest rate swap adjustments and gains/losses on maturities of Eurodollar futures.  Effective cost of funds is effective interest expense for the period divided by average borrowings for the period.  See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations” for more information, including reconciliations for 2015, 2014 and 2013.  For 2011 through 2012, effective interest expense is identical to interest expense determined in accordance with GAAP.

 

(7)

Effective net interest margin includes certain interest rate swap adjustments, gains/losses on maturities of Eurodollar futures and TBA dollar roll income. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations” for more information including reconciliations for 2015, 2014 and 2013.  For 2011 and 2012, effective net interest margin is identical to net interest margin determined in accordance with GAAP.

 

(8)

Effective interest rate spread was calculated by subtracting our effective cost of funds from our average interest-earning portfolio yield including TBA dollar roll income.

 

(9)

Core earnings consists of effective interest margin plus servicing income net of amortization, management fee income and gain from mortgage loans held for sale, reduced by adjusted operating expenses and dividends on preferred stock for the period.  See “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Results of Operations” for more information, including reconciliations for 2015, 2014 and 2013.  For 2011 and 2012, core earnings consists of net interest margin determined in accordance with GAAP reduced by operating expenses and dividends on preferred stock, as applicable.

 

(10)

Our average annual portfolio repayment rate was calculated by dividing our total principal payments received during the year on securities (scheduled and unscheduled) by our average securities.

 

(11)

Our debt to equity ratio was calculated by dividing the amounts outstanding under our repurchase agreements and dollar roll liability at period end by our shareholders’ equity at period end.

 

(12)

Our debt to paid-in capital ratio was calculated by dividing the amounts outstanding under our repurchase agreements and dollar roll liability at period end by the sum of the carrying value of our preferred stock, the par value of our common stock and additional paid in capital at period end.

 

(13)

Our effective debt to equity ratio was calculated the same as our debt to equity ratio other than to include our off-balance sheet TBA dollar roll liability at period end in the numerator.  Our off-balance sheet TBA dollar roll liability was $2,730,705, $3,518,289 and $684,484 as of December 31, 2015, 2014 and 2013, respectively.  For 2011 and 2012, effective debt to equity is identical to our debt to equity ratio determined in accordance with GAAP.

 

31


 

Item 7.Management’s Discussion and Analysis of Financial Condition and Results of Operations 

The following discussion of our financial condition and results of operations should be read in conjunction with our financial statements and related notes included elsewhere in this report.

Dollar amounts other than share-related amounts are presented in thousands, unless otherwise noted.

Overview

We are an externally-managed mortgage REIT incorporated in Maryland in September 2007 to invest in single-family residential mortgage real estate assets. Currently, the majority of these assets consist of mortgage pass-through securities guaranteed or issued by a U.S. Government agency (such as Ginnie Mae), or by a U.S. Government-sponsored enterprise (such as Fannie Mae or Freddie Mac). Our principal goal is to generate net income for distribution to our shareholders through regular quarterly dividends and protect and grow our shareholders’ equity (which we also refer to as our “book value”) through prudent interest rate risk management. Our net income is determined primarily by the difference between the interest income we earn on our mortgage assets, net of premium or discount amortization as applicable and the cost of our borrowings and hedging activities, which we also refer to as our net interest spread or net interest margin. We utilize substantial borrowings in financing our investment portfolio, which can enhance potential returns but can also exacerbate losses. In general, our book value is most affected by our issuance or purchase of shares of our common stock, our retained earnings or losses, and changes in the value of our investment portfolio and our hedging instruments.

We define “earning assets” as the sum of our MBS, agency CRT securities, mortgage loans held for investment (including those held in securitization trusts) and MSR.  The following table represents key quarterly data regarding our company for the three years ended December 31, 2015:

As of

 

Earning

Assets

 

 

Borrowings

 

 

Equity

 

 

Shares Outstanding

 

 

Book Value

Per Share

 

 

Earnings Per Share

 

December 31, 2015

 

$

15,025,308

 

 

$

13,575,722

 

 

$

2,143,357

 

 

 

95,774

 

 

$

19.38

 

 

$

1.45

 

September 30, 2015

 

 

15,908,308

 

 

 

14,288,113

 

 

 

2,192,442

 

 

 

96,771

 

 

 

19.69

 

 

 

(0.93

)

June 30, 2015

 

 

16,852,703

 

 

 

14,993,065

 

 

 

2,326,187

 

 

 

96,791

 

 

 

21.06

 

 

 

0.20

 

March 31, 2015

 

 

17,048,305

 

 

 

15,108,538

 

 

 

2,422,142

 

 

 

96,791

 

 

 

22.05

 

 

 

(0.41

)

December 31, 2014

 

 

17,618,470

 

 

 

15,759,831

 

 

 

2,420,796

 

 

 

96,771

 

 

 

22.05

 

 

 

(0.32

)

September 30, 2014

 

 

16,890,424

 

 

 

14,920,959

 

 

 

2,444,492

 

 

 

96,720

 

 

 

22.30

 

 

 

0.75

 

June 30, 2014