10-Q 1 a0630201310q.htm 10-Q 06.30.2013 10Q


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
_________________________________________
        
FORM 10-Q
_________________________________________
  (Mark One)
Q
Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended June 30, 2013
 
£
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: 001-35246
____________________________________________________ 
Apollo Residential Mortgage, Inc.
(Exact name of Registrant as specified in its charter)
____________________________________________________
Maryland
 
45-0679215
(State or other jurisdiction of
incorporation or organization)
 
(IRS Employer
Identification Number)
Apollo Residential Mortgage, Inc.
c/o Apollo Global Management, LLC
9 West 57th Street, 43rd Floor
New York, New York 10019
(Address of Registrant’s principal executive offices)
(212) 515–3200
(Registrant’s telephone number, including area code)
  ____________________________________________________
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  Q    No  £
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  Q    No  £
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See 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
 
£
  
Accelerated filer
 
Q
 
 
 
 
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 under the Securities Exchange Act of 1934).    Yes  £    No  Q
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practical date. As of August 4, 2013, there were 32,037,408 shares, par value $0.01, of the registrant’s common stock issued and outstanding.




TABLE OF CONTENTS


2



Apollo Residential Mortgage, Inc. and Subsidiaries
Consolidated Balance Sheets
(in thousands—except share and per share data)
 
 
June 30,
2013
 
December 31,
2012
 
 
(Unaudited)
 
 
Assets:
 
 
 
 
Cash
 
$
195,699

 
$
149,576

Restricted cash
 
205,854

 
93,641

Residential mortgage-backed securities, at fair value ($3,102,135 and $3,940,913 pledged as collateral, respectively)
 
3,303,080

 
4,231,291

Securitized mortgage loans (transferred to a consolidated variable interest entity), at fair value
 
110,278

 
—

Investment related receivables ($977,726 and $0 pledged as collateral, respectively)
 
986,157

 
—

Interest receivable
 
13,117

 
11,341

Deferred financing costs, net
 
983

 
346

Derivative instruments, at fair value
 
68,906

 
750

Other assets
 
686

 
976

Total Assets
 
$
4,884,760

 
$
4,487,921

 
 
 
 
 
Liabilities and Stockholders’ Equity
 
 
 
 
Liabilities:
 
 
 
 
Borrowings under repurchase agreements
 
$
3,945,097

 
$
3,654,436

Non-recourse securitized debt, at fair value
 
47,338

 
—

Investment related payables
 
14,316

 
50,032

Obligation to return cash held as collateral
 
66,571

 
—

Accrued interest payable
 
7,157

 
6,774

Derivative instruments, at fair value
 
3,673

 
23,184

Payable to related party
 
3,177

 
4,295

Dividends payable
 
26,261

 
30,675

Accounts payable and accrued expenses
 
1,694

 
1,742

Total Liabilities
 
$
4,115,284

 
$
3,771,138

 
 
 
 
 
Commitments and Contingencies (Note 12)
 
—

 
—

 
 
 
 
 
Stockholders’ Equity:
 
 
 
 
Preferred stock, $0.01 par value, 50,000,000 shares authorized, 6,900,000 shares issued and outstanding ($172,500 aggregate liquidation preference)
 
$
69

 
$
69

Common stock, $0.01 par value, 450,000,000 shares authorized, 32,035,845 and 24,205,972 shares issued and outstanding, respectively
 
320

 
242

Additional paid-in capital
 
791,412

 
619,399

Retained earnings/(accumulated deficit)
 
(22,325
)
 
97,073

Total Stockholders’ Equity
 
$
769,476

 
$
716,783

Total Liabilities and Stockholders’ Equity
 
$
4,884,760

 
$
4,487,921



See notes to unaudited consolidated financial statements.

3


Apollo Residential Mortgage, Inc. and Subsidiaries
Consolidated Statements of Operations (Unaudited)
(in thousands—except per share data)
 
 
Three Months Ended June 30,
 
Six Months Ended 
 June 30,
 
 
2013
 
2012
 
2013
 
2012
Interest income – residential mortgage-backed securities
 
$
39,032

 
$
21,990

 
$
75,946

 
$
34,353

Interest income – securitized mortgage loans
 
2,297

 
—

 
3,630

 
—

Interest Income
 
41,329

 
21,990

 
79,576

 
34,353

Interest expense – repurchase agreements
 
(6,729
)
 
(2,871
)
 
(12,636
)
 
(4,232
)
Interest expense – securitized debt
 
(508
)
 
—

 
(818
)
 
—

Interest Expense
 
(7,237
)
 
(2,871
)
 
(13,454
)
 
(4,232
)
 
 
 
 
 
 
 
 
 
Net Interest Income
 
34,092

 
19,119

 
66,122

 
30,121

 
 
 
 
 
 
 
 
 
Other Income/(Loss):
 
 
 
 
 
 
 
 
Realized gain/(loss) on sale of residential mortgage-backed securities, net
 
(47,508
)
 
11,614

 
(31,713
)
 
18,383

Unrealized gain/(loss) on residential mortgage-backed securities, net
 
(134,822
)
 
14,598

 
(167,870
)
 
20,548

Unrealized gain on securitized debt
 
887

 
—

 
15

 
—

Unrealized (loss) on securitized mortgage loans
 
(3,473
)
 
—

 
(625
)
 
—

Gain/(loss) on derivative instruments, net (includes $79,778, ($13,792), $78,119 and ($14,362) of unrealized gains/(losses), respectively)
 
83,369

 
(15,515
)
 
77,571

 
(16,833
)
Other, net
 
43

 
7

 
68

 
9

Other Income/(Loss), net
 
(101,504
)
 
10,704

 
(122,554
)
 
22,107

 
 
 
 
 
 
 
 
 
Operating Expenses:
 
 
 
 
 
 
 
 
General and administrative (includes $146, $90, $545 and $168 of non-cash stock based compensation, respectively)
 
(2,434
)
 
(1,865
)
 
(5,285
)
 
(3,353
)
Management fee – related party
 
(2,921
)
 
(1,558
)
 
(5,710
)
 
(2,355
)
Total Operating Expenses
 
(5,355
)
 
(3,423
)
 
(10,995
)
 
(5,708
)
 
 
 
 
 
 
 
 
 
Net Income/(Loss)
 
$
(72,767
)
 
$
26,400

 
$
(67,427
)
 
$
46,520

Preferred Stock Dividends Declared
 
(3,450
)
 
—

 
(6,900
)
 
—

Net Income/(Loss) Allocable to Common Stock and Participating Securities
 
(76,217
)
 
26,400

 
(74,327
)
 
46,520

Earnings/(Loss) per Common Share – Basic and Diluted
 
$
(2.39
)
 
$
1.24

 
$
(2.59
)
 
$
2.94

 
 
 
 
 
 
 
 
 
Dividends Declared per Share of Common Stock
 
$
0.70

 
$
0.75

 
$
1.40

 
$
1.50



See notes to unaudited consolidated financial statements.

4


Apollo Residential Mortgage, Inc. and Subsidiaries
Consolidated Statement of Changes in Stockholders’ Equity (Unaudited)
(in thousands—except share data)
 
 
Preferred Stock
 
Common Stock
 
Additional
Paid- In
Capital
 
Retained Earnings/(Accumulated Deficit)
 
Total
 
 
Shares
 
Par
 
Shares
 
Par
 
Balance at December 31, 2012
 
6,900,000

 
$
69

 
24,205,972

 
$
242

 
$
619,399

 
$
97,073

 
$
716,783

Issuance of common stock, net of expenses
 
—

 
—

 
7,820,000

 
78

 
171,468

 
—

 
171,546

Grant of restricted common stock to independent directors
 
—

 
—

 
6,748

 
—

 
—

 
—

 
—

Issuance of vested stock
 
—

 
—

 
3,125

 
—

 
—

 
—

 
—

Equity based compensation expense
 
—

 
—

 
—

 
—

 
545

 
—

 
545

Net (loss)
 
—

 
—

 
—

 
—

 
—

 
(67,427
)
 
(67,427
)
Dividends on preferred stock
 
—

 
—

 
—

 
—

 
—

 
(6,900
)
 
(6,900
)
Dividends on common stock
 
—

 
—

 
—

 
—

 
—

 
(45,071
)
 
(45,071
)
Balance at June 30, 2013
 
6,900,000

 
$
69

 
32,035,845

 
$
320

 
$
791,412

 
$
(22,325
)
 
$
769,476



See notes to unaudited consolidated financial statements.

5


Apollo Residential Mortgage, Inc. and Subsidiaries
Consolidated Statements of Cash Flows (Unaudited)
(in thousands)
 
 
Six Months Ended June 30,
 
 
2013
 
2012
Cash Flows from Operating Activities:
 
 
 
 
Net income/(loss)
 
$
(67,427
)
 
$
46,520

Adjustments to reconcile net income (loss) to net cash provided by operating activities:
 
 
 
 
Premium amortization/(discount accretion), net
 
6,627

 
400

Amortization of deferred financing costs
 
199

 
105

Equity based compensation expense
 
545

 
168

Unrealized (gain)/loss on mortgage-backed securities, net
 
167,870

 
(20,548
)
Unrealized loss on securitized mortgage loans
 
625

 
—

Unrealized (gain)/loss on derivative instruments, net
 
(78,119
)
 
14,362

Unrealized (gain) on securitized debt
 
(15
)
 
—

Realized gains on sales of mortgage-backed securities
 
(35,572
)
 
(18,478
)
Realized losses on sales of mortgage-backed securities
 
67,285

 
95

Realized gain on derivative instruments
 
(10,028
)
 
—

Changes in operating assets and liabilities:
 
 
 
 
Increase in accrued interest receivable, less purchased interest
 
(1,970
)
 
(5,003
)
Decrease/(increase) in other assets
 
117

 
262

Increase in accrued interest payable
 
383

 
1,584

Increase in accounts payable and accrued expenses
 
162

 
448

Decrease/(increase) in payable to related party
 
(884
)
 
1,010

Net cash provided by operating activities
 
$
49,798

 
$
20,925

Cash Flows from Investing Activities:
 
 
 
 
Purchases of mortgage-backed securities
 
$
(2,328,588
)
 
$
(2,770,574
)
Proceeds from sales of mortgage-backed securities
 
1,830,267

 
920,957

Purchases of mortgage loans, simultaneously securitized
 
(113,038
)
 
—

Decrease/(increase) in restricted cash related to investing activities
 
32,787

 
(19,074
)
Increase in collateral held related to investing activities
 
66,571

 
—

Principal payments received on mortgage-backed securities
 
205,373

 
78,879

Principal payments on securitized mortgage loans
 
2,051

 
—

Proceeds from sale of derivative instruments
 
4,312

 
—

Purchase of interest rate swaptions
 
(10,512
)
 
—

Other, net
 
33

 
—

Net cash used in investing activities
 
$
(310,744
)
 
$
(1,789,812
)
Cash Flows from Financing Activities:
 
 
 
 
Proceeds from repurchase agreement borrowings
 
$
12,264,466

 
$
5,922,581

Repayments of repurchase agreement borrowings
 
(11,973,805
)
 
(4,326,460
)
Increase in restricted cash related to financing activities
 
(145,000
)
 
(8,985
)
Proceeds from issuance of securitized debt
 
50,375

 
—

Principal payments on securitized debt
 
(3,022
)
 
—

Payments made for securitization/deferred financing costs
 
(777
)
 
(61
)
Dividends paid on preferred stock
 
(8,472
)
 
—

Dividends paid on common stock
 
(47,911
)
 
(10,787
)
Proceeds from issuance of common stock
 
172,040

 
250,200

Payment of costs to issue equity
 
(825
)
 
(377
)
Net cash provided by financing activities
 
$
307,069

 
$
1,826,111

Net increase in cash
 
46,123

 
57,224

Cash at beginning of period
 
149,576

 
44,407

Cash at end of period
 
$
195,699

 
$
101,631

Supplemental Disclosure of Operating Cash Flow Information:
 
 
 
 
Interest paid
 
$
13,666

 
$
3,378

Supplemental disclosure of non-cash investing/financing activities:
 
 
 
 
Residential mortgage-backed securities (purchased)/sold not settled, net
 
$
963,603

 
$
(10,151
)
Due from broker
 
$
1,558

 
$
545

Dividends and dividend equivalent rights declared, not yet paid
 
$
26,261

 
$
18,176

Equity offering costs payable
 
$
96

 
$
476

Deferred financing costs not yet paid
 
$
56

 
$
77

Derivative termination fee receivable, unsettled trades
 
$
6,680

 
$
—


See notes to unaudited consolidated financial statements.

6


Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
(Dollars in thousands—except per share data)
References to “we”, “us”, “our”, “AMTG” or “Company” refer to Apollo Residential Mortgage, Inc., as consolidated with its subsidiaries and variable interest entity (or, VIE). The following defines certain of the commonly used terms in these Notes to Consolidated Financial Statements: “Agency” or “Agencies” refer to a federally chartered corporation, such as Fannie Mae or Freddie Mac, or an agency of the U.S. Government, such as Ginnie Mae; “RMBS” refer to residential mortgage-backed securities, “Agency RMBS” refer to RMBS issued or guaranteed by the Agencies while “non-Agency RMBS” refer to RMBS that are not issued or guaranteed by the Agencies; “ARMs” refer to adjustable rate mortgages; “Alt-A” refer to residential mortgage loans made to borrowers whose qualifying mortgage characteristics do not conform to Agency underwriting guidelines and generally allow homeowners to qualify for a mortgage loan with reduced or alternate forms of documentation; “Option ARMs” refer to mortgages that provide the mortgagee payment options, which may initially include a specified minimum payment, an interest-only payment, a 15-year fully amortizing payment or a 30-year fully amortizing payment; “ARM-RMBS” refer to RMBS collateralized by ARMs; “Agency IOs” and “Agency Inverse IOs,” refer to Agency interest-only and Agency inverse interest-only securities, which receive some or all of the interest payments, but no principal payments, made on a related series of Agency RMBS, based on a notional principal balance; “TBA Contracts” refer to to-be-announced contracts to purchase or sell certain Agency RMBS on a forward basis; and “TBA Shorts” refer to TBA Contracts for which we would be required to sell certain Agency RMBS on a foward basis.
Note 1– Organization
We were organized as a Maryland corporation on March 15, 2011 and commenced operations on July 27, 2011. We are externally managed and advised by ARM Manager, LLC (or, Manager), an indirect subsidiary of Apollo Global Management, LLC (together with its subsidiaries, Apollo).
We operate and have elected to qualify as a real estate investment trust (or, REIT) under the Internal Revenue Code of 1986, as amended (or, Internal Revenue Code), commencing with the taxable year ended December 31, 2011. We also operate our business in a manner that allows us not to register as an investment company as defined under the Investment Company Act of 1940 (or, 1940 Act).
We invest on a leveraged basis in residential mortgage and mortgage-related assets in the United States. Through June 30, 2013, our asset portfolio consisted of Agency RMBS, including Agency IOs and Agency Inverse IOs, non-Agency RMBS and securitized mortgage loans. Over time, we may invest in a broader range of other residential mortgage and mortgage related assets.
Note 2 – Summary of Significant Accounting Policies
(a) Basis of Presentation and Consolidation
The interim unaudited consolidated financial statements include our accounts and those of our consolidated subsidiaries and a VIE in which we are the primary beneficiary. All intercompany amounts have been eliminated in consolidation.
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (or, GAAP) requires that we make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates.
In the opinion of management, all adjustments have been made (which include only normal recurring adjustments) necessary to present fairly our financial position, results of operations and cash flows. Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted in accordance with Article 10 of Regulation S-X and the instructions to Form 10-Q. These consolidated financial statements should be read in conjunction with our annual report on Form 10-K for the year ended December 31, 2012 which was filed with the Securities and Exchange Commission (or, the SEC) on March 7, 2013. Our results of operations for the quarterly period ended June 30, 2013 are not necessarily indicative of the results to be expected for the full year or any other future period.
We currently operate as one business segment.


7

Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
(Dollars in thousands—except per share data)
 


(b) Cash and Cash Equivalents
We consider all highly liquid short term investments with original maturities of 90 days or less when purchased to be cash equivalents. Cash and cash equivalents are exposed to concentrations of credit risk. We deposit our cash with what we believe to be high credit quality institutions. From time to time, our cash may include amounts pledged to us by our counterparties as collateral for our derivative instruments. At June 30, 2013 and December 31, 2012, our cash and cash equivalents were primarily comprised of cash on deposit with our prime broker domiciled in the United States, substantially all of which was in excess of applicable insurance limits.
(c) Obligation to Return Cash held as Collateral
From time to time, we may hold cash pledged as collateral to us by certain of our derivative counterparties as a result of margin calls made by us. Cash pledged to us is unrestricted in use and, accordingly, is included as a component of cash on our consolidated balance sheets. In addition, a corresponding liability is reported as an obligation to return cash held as collateral.
(d) Restricted Cash
Restricted cash represents cash held by our counterparties as collateral against our interest rate swaps (or, Swaps), repurchase agreement borrowings and TBA Shorts. Restricted cash is not available for general corporate purposes but borrowings may be applied against amounts due to counterparties under our Swaps and repurchase agreement borrowings, or returned to us when our collateral requirements are exceeded or at the maturity of the Swap or repurchase agreement.
(e) Residential Mortgage-Backed Securities and Securitized Mortgage Loans
Our RMBS portfolio is comprised of mortgage pass-through certificates, collateralized mortgage obligations, including Agency IO securities and Agency Inverse IO securities representing interests in or obligations backed by pools of mortgage loans. Our securitized mortgage loan portfolio is comprised of a pool of performing, re-performing and non performing mortgage loans that we purchased at a discount to principal balance.
Balance Sheet Presentation
Our RMBS purchases and sales are recorded on the trade date. Our RMBS pledged as collateral against borrowings under repurchase agreements are included in “residential mortgage-backed securities” on the consolidated balance sheet, with the fair value of securities pledged disclosed parenthetically.
The aggregate fair value of the mortgage loans that we securitized are presented on our consolidated balance sheet as “securitized mortgage loans (transferred to a consolidated variable interest entity), at fair value.” Such assets can be used only to settle obligations of the consolidated VIE. (See Notes 5 and 13.)
Designation and Fair Value Option Election
Our RMBS are designated as available-for-sale. We have elected the fair value option for all of our RMBS at the time of purchase and, as a result, record changes in the estimated fair value of such assets in earnings as unrealized gains/(losses). We generally intend to hold our RMBS to generate interest income; however, we have sold and may continue to sell certain of our RMBS as part of the overall management of our assets and liabilities and operating our business. Realized gains and losses on the sale of RMBS are recorded in earnings using the specific identification method.
Our securitized residential mortgage loans are considered held for investment purposes, as we expect that we will be required to continue to consolidate the VIE in which such loans are held and generally do not have the authority to sell the mortgage loans held in such VIE. Consistent with our investments in RMBS, we have elected the fair value option for our securitized mortgage loans and, as a result, we record changes in the estimated fair value of such assets in earnings as unrealized gains/(losses).
We believe that our election of the fair value option for our RMBS, securitized mortgage loans, TBA Contracts and securitized debt improves financial reporting, as such treatment is consistent with how we present changes in the fair value of our Swaps and interest rate swaptions (or, Swaptions) (or, collectively “interest rate derivatives”) through earnings.
Determination of Fair Value
To determine the fair value of our Agency RMBS, non-Agency RMBS and securitized debt we obtain third party broker quotes which, while non-binding, are indicative of fair value. To validate the reasonableness of the broker quotes obtained, we compare such quotes to valuations received from a third party pricing service.


8

Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
(Dollars in thousands—except per share data)
 


We estimate the fair value of our securitized mortgage loans based upon an estimated price that would be received for the mortgage loans if sold into a securitization, which was considered to be the most advantageous market for such assets for the period presented. To value our securitized mortgage loans, we estimate the cash flows for the securitized mortgage loans using observable inputs, such as loan balances and loan interest rates and certain unobservable inputs, such as estimated future prepayment speeds, default rates and loss severities, which inputs are significant in arriving at the estimate of cash flows. Given the significance of unobservable inputs in arriving at the fair value of our securitized mortgage loans, we consider such valuations to be Level III fair values.
Impairments
RMBS: We have elected the fair value option for our RMBS. As such, all changes in the market value of our RMBS are recorded through earnings, including other-than-temporary impairments (or, OTTI), if any. When the fair value of an investment security is less than its amortized cost at the balance sheet date, the security is considered impaired. We assess our impaired securities on at least a quarterly basis and designate such impairments as either “temporary” or “other-than-temporary.” If we intend to sell an impaired security, or it is more likely than not that we will be required to sell an impaired security before its anticipated recovery, then we recognize an OTTI, which reduces the amortized cost basis of the impaired security. Following the recognition of an OTTI, a new cost basis is established for the security. Changes in the fair value of the security on which an OTTI charge was made will be reflected in unrealized gains/(losses) but will not result in a change to the amortized cost of the impaired security. Increases in interest income may be recognized on a security that an OTTI charge was taken, if the performance of such security subsequently improves. The determination as to whether an OTTI exists is subjective, given that such determination is based on information available at the time of assessment as well as our Manager’s estimate of the future performance and cash flow projections for the individual security. (See Note 4.)
Securitized Mortgage Loans: We have elected the fair value option for our securitized mortgage loans. As such, all changes in the estimated fair value of our securitized mortgage loans are recorded through earnings, including other-than-temporary impairments, if any. On at least a quarterly basis, we evaluate the collectability of both interest and principal, to determine whether loans presented as securitized mortgage loans are impaired. A loan is impaired when, based on current information and events, it is probable that we will be unable to collect all cash flows expected at the time of acquisition plus all additional cash flows expected to be collected arising from changes in assumptions subsequent to acquisition. When a loan is impaired, the amount of the loss accrual is calculated and recorded accordingly. Income recognition is suspended for loans at the earlier of the date at which payments become 90-days past due or when it becomes doubtful that income and the amortized cost basis of the loan becomes doubtful. When the ultimate collectability of the principal of an impaired loan is in doubt, all payments received are applied to principal under the cost recovery method. When the ultimate collectability of the principal of an impaired loan is not in doubt, contractual interest is recorded as interest income when received, under the cash basis method until an accrual is resumed when the loan becomes contractually current and performance is demonstrated to be resumed. A loan is written off when it is no longer realizable and/or legally discharged. (See Note 5.)
(f) Interest Income Recognition
RMBS
Interest income on Agency pass-through RMBS is accrued based on the outstanding principal balance and the current coupon interest rate on each security. In addition, premiums and discounts associated with Agency RMBS and non-Agency RMBS rated AA and higher at the time of purchase are amortized into interest income over the life of such securities using the effective yield method. In order to determine the effective yield we estimate prepayments for each security. If prepayment levels differ, or are expected to differ in the future from our previous assessment, we adjust the amount of premium amortization recognized applying the retrospective method. To the extent that prepayment activity varies significantly from our previous prepayment estimates, we may experience volatility in our interest income.
For Agency IO and Agency Inverse IO securities, income is accrued based on the amortized cost and the effective yield. Cash received on Agency IO and Agency Inverse IO securities is first applied to accrued interest and then to reduce the amortized cost. At each reporting date, the effective yield is adjusted prospectively based on the current cash flow projections, which reflect prepayment estimates and the contractual terms of the security.
Interest income on non-Agency RMBS rated below AA by a nationally recognized statistical rating organization is recognized based on the effective yield method. The effective yield on these securities is based on the projected cash flows from each security, which are estimated based on our observation of current information and events and include assumptions related to the future path of interest rates, prepayment speeds and the timing and amount of credit losses. On at least a quarterly basis, we review and, if appropriate, make adjustments to our cash flow projections based on input and analysis received from external sources, internal models, and our judgment about interest rates, prepayment speeds, the timing and amount of credit


9

Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
(Dollars in thousands—except per share data)
 


losses, and other factors. Changes in cash flows from those originally projected, or from those estimated at the last evaluation, may result in a prospective change in the yield/interest income recognized on such securities. Actual maturities of the securities are affected by the contractual lives of the associated mortgage collateral, periodic payments of principal, prepayments of principal, and the payment priority structure of the security; therefore actual maturities are generally shorter than the stated contractual maturities of the underlying mortgages. Based on the projected cash flows for our non-Agency RMBS, we generally expect that a portion of the purchase discount on such securities will not be recognized as interest income, and is instead viewed as a credit discount. The credit discount mitigates our risk of loss on our non-Agency securities. The amount considered to be credit discount may change over time, based on the actual performance of the underlying mortgage collateral, actual and projected cash flows from such collateral, economic conditions and other factors. If the performance of a non-Agency RMBS with a credit discount is more favorable than forecasted, we may accrete more discount into interest income than expected at the time of purchase or when performance was last assessed. Conversely, if the performance of a non-Agency RMBS with a credit discount is less favorable than forecasted, the amount of discount accreted into income may be less than expected at the time of purchase or when performance was last assessed and/or impairment and write-downs of such securities to a new lower cost basis could result.
Securitized Mortgage Loans
Interest income on securitized mortgage loans is recognized based on the effective interest method, whereby we accrete the portion of purchase discount that is not considered to be credit discount into income over the life of the related loan. The effective yield on securitized mortgage loans is based on projected cash flows, which are estimated based on our observation of current information and events and include assumptions related to interest rates, prepayment speeds, the timing and amount of expected credit losses, and other factors. On at least a quarterly basis, our Manager reviews and, if appropriate, makes adjustments to cash flow projections based on input and analysis received from external sources, internal models, and our Manager’s judgment about interest rates, prepayment speeds, home prices, the timing and amount of credit losses, and other factors. Changes in cash flows from those originally projected, or from those estimated at the last evaluation, may result in a prospective change in the yield/interest income recognized on such loans and/or the recognition of an OTTI.
(g) Variable Interest Entities
VIEs are defined as entities in which equity investors (i) do not have the characteristics of a controlling financial interest, and/or (ii) do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. The entity that consolidates a VIE is known as its primary beneficiary, and is generally the entity with (i) the power to direct the activities that most significantly impact the VIE’s economic performance, and (ii) the right to receive benefits from the VIE or the obligation to absorb losses of the VIE that could be significant to the VIE. For VIEs that do not have substantial on going activities, the power to direct the activities that most significantly impact the VIE’s economic performance may be determined by an entity’s involvement with the design of the VIE.
We consolidate a VIE when we determine that we are the primary beneficiary of such VIE. We are required to re-evaluate whether to consolidate a VIE each reporting period, based upon the facts and circumstances pertaining to the VIE during such period.
In February 2013, we purchased a pool of residential mortgage loans and simultaneously completed a securitization transaction collateralized by such mortgage loans. In determining the accounting treatment to be applied to our February 2013 securitization transaction, we evaluated whether the trust used to facilitate the transaction was a VIE and, if so, whether it should be consolidated. Based on our evaluation, we concluded that the trust was a VIE which should be consolidated by us.
Prior to the completion of our initial securitization transaction in February 2013, we had not transferred assets to any VIE and other than acquiring the RMBS issued by such entities. (See Note 13.)
(h) Deferred Financing Costs
Costs incurred in connection with securing our financings are capitalized and amortized using the effective interest rate method over the respective financing term with such amortization reflected on our consolidated statements of operations as a component of interest expense. We incurred such costs in connection with our repurchase agreements and, beginning in February 2013, in connection with our whole-loan securitization transaction and issuance of beneficial interests by the consolidated VIE. Our deferred financing costs may include legal, accounting and other related fees. These deferred charges are included on our consolidated balance sheet as a component of “deferred financing costs, net.” The amortization of deferred charges associated with our securitized debt is adjusted to reflect actual repayments of the securitized trust. (See Note 13.)



10

Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
(Dollars in thousands—except per share data)
 


(i) Earnings Per Share
Basic earnings per share is computed using the two-class method, which includes the weighted-average number of shares of common stock outstanding during the period and other securities that participate in dividends, such as our unvested restricted stock and restricted stock units (or, RSUs) to arrive at total common equivalent shares. In applying the two-class method, earnings are allocated to both shares of common stock and securities that participate in dividends based on their respective weighted-average shares outstanding for the period. During periods of net loss, losses are allocated only to the extent that the participating securities are required to absorb their share of such losses. Our basic and diluted earnings per share are the same, as we did not have any dilutive securities outstanding for any of the periods presented. (See Note 16.)
(j) Derivative Instruments
Subject to maintaining our qualification as a REIT for U.S. federal income tax purposes, we utilize derivative financial instruments, currently comprised of Swaps, Swaptions, and TBA Contracts, as part of our interest rate risk management. We view our interest rate derivatives as economic hedges, which we believe mitigate interest rate risk associated with our borrowings under repurchase agreements and the fair value of our RMBS portfolio. We do not enter into derivative instruments for speculative purposes.
All derivatives are reported as either assets or liabilities on the balance sheet at estimated fair value. We have not elected hedge accounting for our derivative instruments and, as a result, changes in the fair value for our derivatives are recorded in earnings. The fair value adjustments, along with the related interest income or interest expense, are reported as gain/(loss) on derivative instruments, net.
To-Be-Announced Securities
TBA Contracts are forward contracts for the purchase or sale of Agency RMBS, by a specified issuer and for a specified face amount, coupon and stated maturity, at a predetermined price on the date stated in the contract. The particular Agency RMBS (i.e., Committee on Uniform Securities Identification Procedures, or CUSIP) delivered into the contract upon the settlement date are not known at the time of the transaction. We recognize in earnings unrealized gains and losses associated with TBA Contracts that are not subject to the regular-way exception, which exception is provided if there is no other way to purchase or sell that security, if delivery of that security and settlement will occur within the shortest period possible for that type of security and if it is probable at inception and throughout the term of the individual contract that physical delivery of the security will occur. Changes in the value of our TBA Contracts are recognized in the consolidated statements of operations in the line item “gain/(loss) on derivative instruments, net.”
(k) Repurchase Agreements
RMBS financed under repurchase agreements are treated as collateralized borrowings, unless they meet sale treatment or are deemed to be linked transactions. With the exception of securities obtained in connection with our securitization which are eliminated in consolidation, through June 30, 2013, all securities financed through a repurchase agreement have remained on our consolidated balance sheet as an asset (with the fair value of the securities pledged as collateral disclosed parenthetically) and cash received from the lender recorded on our consolidated balance sheet as a liability. Interest paid and accrued in connection with our repurchase agreements is recorded as interest expense.  
(l) Share-based Payments
We account for share-based compensation to our independent directors, to our Manager and to employees of our Manager and our affiliates using the fair value based methodology prescribed by GAAP. Expense related to restricted common stock issued to our independent directors is based on the fair value of our common stock on the grant date and is amortized to expense over the award vesting period on a straight-line basis. Expense related to restricted stock units issued to our Manager and to employees of our Manager and its affiliates are based on the estimated fair value of such award at the grant date and are remeasured quarterly for unvested awards. We use the graded vesting attribution method to amortize expense related to RSUs granted to our Manager and its affiliates.
(m) Income Taxes
We elected to be taxed as a REIT for U.S. federal income tax purposes, commencing with our taxable year ended December 31, 2011. Pursuant to the Internal Revenue Code, a REIT that distributes at least 90% of its net taxable income, excluding net capital gains, as a dividend to its stockholders each year and which meets certain other conditions, will not be taxed on the portion of its taxable income that is distributed to its stockholders. We expect to meet the conditions required to


11

Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
(Dollars in thousands—except per share data)
 


enable us to continue to operate as a REIT and to distribute all of our taxable income, including net gains for the periods presented and therefore we have not recorded any provisions for income taxes on our consolidated statements of operations.
We have elected to treat one subsidiary as a taxable REIT subsidiary (or, TRS). A TRS may participate in non-real estate-related activities and are subject to federal and state income tax at regular corporate tax rates. The TRS, which is a wholly owned subsidiary, was established in connection with its loan pool purchase and securitization transaction as discussed in Notes 5 and 13.
(n) Recent Accounting Pronouncements
Accounting Standards Adopted by us During the Six Months Ended June 30, 2013
In December 2011, the Financial Accounting Standards Board (or, FASB) issued guidance regarding disclosures about the offsetting of assets and liabilities. Under the guidance, an entity is required to disclose both gross information and net information about both instruments and transactions eligible for offset in the statement of financial position and instruments and transactions subject to an agreement similar to a master netting arrangement. The scope includes derivatives, sale and repurchase agreements and reverse sale and repurchase agreements, and securities borrowing and securities lending arrangements. This disclosure is intended to support further the convergence of U.S. GAAP and International Financial Reporting Standards requirements. The guidance was effective for annual reporting periods beginning on or after January 1, 2013, and interim periods within those annual periods.
In January 2013, the FASB issued additional guidance, Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities. The main objective of the update is to limit the scope of the new balance sheet and offsetting disclosure requirements of the FASB’s previously issued guidance to certain derivatives (including bifurcated embedded derivatives), repurchase agreements and reverse repurchase agreements, and securities borrowing and securities lending transactions. The amendments of the clarifying guidance should be applied for fiscal years beginning on or after January 1, 2013, and interim periods within those annual periods. An entity should provide the required disclosures retrospectively for all comparative periods presented.
Our adoption of the above guidance beginning on January 1, 2013 did not have a material impact on our consolidated financial statements; however, it resulted in certain additional disclosures. (See Note 9.)
Accounting Standards Issued but Not Yet Adopted
In June 2013, the FASB issued guidance to change the assessment of whether an entity is an investment company by developing a new two-tiered approach that requires an entity to possess certain fundamental characteristics while allowing judgment in assessing certain typical characteristics. The fundamental characteristics that an investment company is required to have include the following: (1) it obtains funds from one or more investors and provides the investor(s) with investment management services; (2) it commits to its investor(s) that its business purpose and only substantive activities are investing the funds solely for returns from capital appreciation, investment income or both; and (3) it does not obtain returns or benefits from an investee or its affiliates that are not normally attributable to ownership interests. The typical characteristics of an investment company that an entity should consider before concluding whether it is an investment company include the following: (1) it has more than one investment; (2) it has more than one investor; (3) it has investors that are not related parties of the parent or the investment manager; (4) it has ownership interests in the form of equity or partnership interests; and (5) it manages substantially all of its investments on a fair value basis. The new approach requires an entity to assess all of the characteristics of an investment company and consider its purpose and design to determine whether it is an investment company. The guidance includes disclosure requirements about an entity's status as an investment company and financial support provided or contractually required to be provided by an investment company to its investees. The guidance is effective for interim and annual reporting periods in fiscal years beginning after December 15, 2013 and earlier application is prohibited. The ASU prohibits REITs from qualifying for investment company accounting under ASC 946; as such, we have determined that we will not meet the definition of an investment company under this ASU when adopted.
Note 3 – Fair Value of Financial Instruments
We disclose the estimated fair value of our financial instruments according to a fair value hierarchy (Levels I, II, and III, as defined below). We are required to provide enhanced disclosures regarding instruments in the Level III category, including a separate reconciliation of the beginning and ending balances for each major category of assets and liabilities. GAAP provides a framework for measuring estimated fair value and for providing financial statement disclosure requirements for fair value measurements. A financial instrument’s categorization within the valuation hierarchy is based upon the lowest level of input that is significant to the fair value measurement.


12

Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
(Dollars in thousands—except per share data)
 


The three levels of valuation hierarchy are defined as follows:
Level I — Inputs are quoted prices (unadjusted) in active markets for identical assets or liabilities.
Level II — Fair values are determined using other significant observable inputs. Observable inputs are inputs that other market participants would use in pricing a security. These inputs may include quoted prices for similar securities, interest rates, historical prepayment speeds, credit risk and others.
Level III — Fair values are determined using significant unobservable inputs. In situations where quoted prices or observable inputs are unavailable (for example, when there is little or no market activity for an investment at the end of the period), unobservable inputs may be used.
The level in the fair value hierarchy, within which a fair measurement falls in its entirety, is based on the lowest level (i.e., with Level III being the lowest) input that is significant to the fair value measurement. When available, we use quoted market prices to determine the estimated fair value of an asset or liability.
Fair value under GAAP represents an exit price in the normal course of business, not a forced liquidation price. If we were forced to sell assets in a short period to meet liquidity needs, the prices received for such assets could be substantially less than their recorded fair values. Furthermore, the analysis of whether it is more likely than not that we will be required to sell securities in an unrealized loss position prior to an expected recovery in value (if any), the amount of such expected required sales and the projected identification of which securities would be sold are also subject to significant judgment, particularly in times of market illiquidity.
We have controls over our valuation processes that are intended to ensure that the valuations for our financial instruments are fairly presented in accordance with GAAP on a consistent basis. Our Manager and our Chief Executive Officer oversee our valuation process, which is carried out by our Manager. Our audit committee has final oversight for the valuation process for all of our financial instruments and, on a quarterly basis, reviews and provides final approval for such process.
Any changes to our valuation methodology will be reviewed by our Manager to ensure the changes are appropriate. We may refine our valuation methodologies as markets and products develop. The methods used by us may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. Furthermore, while we anticipate that our valuation methods are appropriate and are believed to result in valuations consistent with other market participants, the use of different methodologies, or assumptions, to determine the estimated fair value of certain financial instruments could result in a different estimate of estimated fair value at the reporting date. We use inputs that are current as of the measurement date, which may include periods of market dislocation, during which price transparency may be reduced.
The following describes the valuation methodologies used for our financial instruments measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy.
Agency, non-Agency RMBS, TBA Contracts, and Securitized Debt
To determine the fair value of our Agency RMBS, non-Agency RMBS, TBA Contracts, and securitized debt, we obtain third party broker quotes which, while non-binding, are indicative of fair value. To validate the reasonableness of the broker quotes, our Manager obtains and compares the broker quotes to valuations received from a third party pricing service and reviews the range of quotes received for outliers, compares quotes to recent market activity observed for similar securities and reviews significant changes in quarterly price levels. We generally do not adjust the prices we obtain from brokers; however, adjustments to valuations may be made as deemed appropriate to capture observable market information at the valuation date. Further, broker quotes are used provided that there is not an ongoing material event that affects the issuer of the securities being valued or the market thereof. If there is such an ongoing event, we will determine the estimated fair value of the securities using valuation techniques that use, when possible, current market-based or independently-sourced market parameters, such as interest rates and prepayment speeds and, with respect to non-Agency RMBS, default rates and loss severities. Valuation techniques for RMBS may be based on models that consider the estimated cash flows of each debt tranche of the issuer, establish a benchmark yield and develop an estimated tranche-specific spread to the benchmark yield based on the unique attributes of the tranche including, but not limited to, assumptions related to prepayment speed, the frequency and severity of defaults and attributes of the collateral underlying such securities. To the extent the inputs are observable and timely, the values would be categorized in Level II of the fair value hierarchy; otherwise they would be categorized as Level III. We consider our Agency RMBS as Level II valuations and non-Agency RMBS and securitized debt as Level III valuations, given their relative price transparency in the market place. There were no events that resulted in us using internal models to value our Agency and non-Agency RMBS in our consolidated financial statements for the periods presented. Given the high level of liquidity and price transparency for Agency RMBS and TBA Contracts, prices obtained from brokers and pricings services are readily verifiable to observable market transactions; as such, we categorize Agency RMBS and TBA Contracts as Level II valuations.


13

Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
(Dollars in thousands—except per share data)
 


While market liquidity exists for non-Agency RMBS, periods of less liquidity or even illiquidity may also occur periodically for certain of these assets. As a result of this market dynamic and that observable market transactions may or may not exist from time to time, our non-Agency RMBS and securitized debt are categorized as Level III.
Securitized Mortgage Loans
The fair value of our securitized mortgage loans at June 30, 2013 is based upon an estimated exit price in the securitization market, as that was determined to be the most advantageous market for such assets. As part of the valuation process, we estimated cash flows for the securitized mortgage loans using observable inputs, such as loan balances and loan interest rates. In addition, we used certain unobservable inputs, which are significant in arriving at the estimate of fair value, such as prepayment speeds, default rates and loss severities. We then determined where our mortgage pool would price on a securitized basis at the time of valuation. Given the significance of unobservable inputs in arriving at the fair value of our securitized mortgage loans, we consider such valuations to be Level III.
Swaps and Swaptions
We determine the estimated fair value of our Swaps and Swaptions based on market valuations obtained from a third party with expertise in valuing such instruments. With respect to Swap valuations, the expected future cash flows are determined for the fixed and floating rate leg of the Swap. To arrive at the expected cash flows for the fixed leg of a Swap, the coupon rate stated in the Swap agreement is used and to arrive at the expected cash flows for the floating leg, the forward rates derived from raw yield curve data is used. Finally, both the fixed and floating legs’ cash flows are discounted using the calculated discount factors and the fixed and floating leg valuations are netted to arrive at a single valuation for the Swap at the valuation date. Swaptions require the same market inputs as Swaps with the addition of implied Swaption volatilities quoted by the market. The valuation inputs for Swaps and Swaptions are observable and, as such, their valuations are categorized as Level II in the fair value hierarchy.
Fair Value Accounting Elections
The following tables present our financial instruments carried at estimated fair value as of June 30, 2013 and December 31, 2012 on our consolidated balance sheet by the valuation hierarchy:
 
 
Estimated Fair Value at June 30, 2013
 
 
Level I
 
Level II
 
Level III
 
Total
Assets:
 
 
 
 
 
 
 
 
RMBS
 
$
—

 
$
2,552,056

 
$
751,024

 
$
3,303,080

Securitized mortgage loans
 
—

 
—

 
110,278

 
110,278

TBA Shorts
 
—

 
100

 
—

 
100

Swaps/Swaptions
 


 
68,806

 
—

 
68,806

Total
 
$
—

 
$
2,620,962

 
$
861,302

 
$
3,482,264

Liabilities:
 
 
 
 
 
 
 
 
Swaps
 
$
—

 
$
2,750

 
$
—

 
$
2,750

Non-recourse securitized debt
 
—

 
—

 
47,338

 
47,338

TBA Shorts
 
—

 
923

 
—

 
923

Total
 
$
—

 
$
3,673

 
$
47,338

 
$
51,011

 
 
Estimated Fair Value at December 31, 2012
 
 
Level I
 
Level II
 
Level III
 
Total
Assets:
 
 
 
 
 
 
 
 
RMBS
 
$
—

 
$
3,626,094

 
$
605,197

 
$
4,231,291

Swaption
 
—

 
750

 
—

 
750

Total
 
$
—

 
$
3,626,844

 
$
605,197

 
$
4,232,041

Liabilities:
 
 
 
 
 
 
 
 
Swaps
 
$
—

 
$
23,184

 
$
—

 
$
23,184

Total
 
$
—

 
$
23,184

 
$
—

 
$
23,184



14

Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
(Dollars in thousands—except per share data)
 


Our non-Agency RMBS, securitized mortgage loans and securitized debt are measured at fair value and are considered to be Level III measurements of fair value. The following table presents a summary of changes in the carrying value of our non-Agency RMBS for the periods presented:
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2013
 
2012
 
2013
 
2012
Beginning balance
 
$
595,838

 
$
178,969

 
$
605,197

 
$
112,346

Purchases
 
186,464

 
199,984

 
231,478

 
301,131

Sales
 
(7,575
)
 
(1,850
)
 
(65,563
)
 
(38,058
)
Principal repayments
 
(25,194
)
 
(14,560
)
 
(48,609
)
 
(22,870
)
Total net gains/(losses) included in net income:
 
 
 
 
 
 
 
 
Realized gains/(losses), net
 
1,442

 
2,702

 
9,730

 
3,532

Unrealized gains/(losses), net (1) 
 
(8,035
)
 
(4,343
)
 
2,915

 
1,374

Discount accretion
 
8,084

 
6,923

 
15,876

 
10,370

Ending balance
 
$
751,024

 
$
367,825

 
$
751,024

 
$
367,825

 
(1) 
Includes unrealized losses of $1,531 and $2,755 and $1,227 and $1,596 that have been classified as other-than-temporary impairments for the six months and three months ended June 30, 2013 and June 30, 2012, respectively.
The following table presents a summary of the changes in the carrying value of our securitized mortgage loans for the periods presented:
 
 
Three Months Ended June 30, 2013
 
Six Months Ended June 30, 2013
Beginning balance
 
$
114,881

 
$
—

Purchases
 
—

 
113,038

Principal repayments
 
(1,054
)
 
(2,051
)
Unrealized gain/(loss)
 
(3,473
)
 
(625
)
Discount adjustment
 
(76
)
 
(84
)
Ending balance
 
$
110,278

 
$
110,278

The following table presents the key unobservable inputs used in arriving at the estimated fair value of our securitized mortgage loans at June 30, 2013:
Assumption
 
Weighted    
Average    
 
Range    
Default rate
 
5.50
%
 
—
%
 
to
 
10.95
%
Loss severity
 
48.83
%
 
—
%
 
to
 
64.50
%
Voluntary prepayments
 
1.50
%
 
—
%
 
to
 
1.84
%
Discount rate
 
9.25
%
 
3.90
%
 
to
 
15.00
%
The following table presents a summary of the changes in the carrying value of our securitized debt for the periods presented: 
 
 
Three Months Ended June 30, 2013
 
Six Months Ended June 30, 2013
Beginning balance
 
$
49,852

 
$
—

Debt issued during the period
 
—

 
50,375

Principal paid
 
(1,627
)
 
(3,022
)
Unrealized gain/(loss) during the period
 
(887
)
 
(15
)
Ending balance
 
$
47,338

 
$
47,338




15

Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
(Dollars in thousands—except per share data)
 


The following table presents the carrying value and estimated fair value of our financial instruments that are not carried at fair value on our consolidated balance sheet, at June 30, 2013 and December 31, 2012: 
 
 
June 30, 2013
 
December 31, 2012
 
 
Carrying Value
 
Estimated  Fair
Value
 
Carrying Value
 
Estimated  Fair
Value
Financial assets:
 
 
 
 
 
 
 
 
Investment related receivable (1)
 
986,157

 
986,157

 
—

 
—

Financial liabilities:
 
 
 
 
 
 
 
 
Repurchase agreements
 
3,945,097

 
3,945,395

 
3,654,436

 
3,654,475

Investment related payable (1)
 
14,316

 
14,316

 
50,032

 
50,032

(1) 
Carrying value approximates fair value due to the short-term nature of the item.
To determine the estimated fair value of our borrowings under repurchase agreements, the remaining contractual cash flows from such borrowings are discounted at interest rates that are reflective of interest rates in the market place for repurchase borrowings at the valuation date. Such rates may be based upon actual transactions executed by us or indicative rates quoted by brokers. The estimated fair values are not necessarily indicative of the amount we would realize on disposition of the financial instruments. Our borrowings under repurchase agreements had a weighted average remaining term to maturity of 42 days and 20 days at June 30, 2013 and December 31, 2012, respectively. Adjustments to valuations may be made as deemed appropriate to capture market information at the valuation date. Inputs used to arrive at the fair value of our repurchase agreement borrowings are generally observable and therefore the fair value of our repurchase agreement borrowings are classified as Level II valuations in the fair value hierarchy.



16

Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
(Dollars in thousands—except per share data)
 


Note 4 – Residential Mortgage-Backed Securities
The following tables present certain information about our RMBS portfolio at June 30, 2013 and December 31, 2012:
 
 
June 30, 2013
 
 
Principal
Balance
 
Unamortized
Premium
(Discount) (1)
 
Amortized
Cost  (2) 
 
Estimated
Fair Value
 
Gross
Unrealized
Gain
 
Gross
Unrealized
Losses
 
Net
Weighted
Average
Coupon
 
Weighted
Average
Yield (3)
Agency RMBS - 30-Year Mortgages:
 
 
 
 
 
 
 
 
 
 
 
 
3.5% Coupon
 
$
793,628

 
$
52,947

 
$
846,575

 
$
805,988

 
$
—

 
$
(40,587
)
 
3.50
%
 
2.55
%
4.0% Coupon
 
1,551,118

 
137,307

 
1,688,425

 
1,620,521

 
—

 
(67,904
)
 
4.00
%
 
2.60
%
4.5% Coupon
 
46,239

 
3,609

 
49,848

 
49,419

 
—

 
(429
)
 
4.50
%
 
3.08
%
 
 
2,390,985

 
193,863

 
2,584,848

 
2,475,928

 
—

 
(108,920
)
 
3.84
%
 
2.59
%
Agency IOs (4) 
 
—

 
—

 
27,797

 
30,184

 
2,387

 
—

 
3.92
%
 
8.99
%
Agency Inverse IOs (4)
 
—

 
—

 
52,101

 
45,944

 
—

 
(6,157
)
 
6.41
%
 
15.35
%
Total Agency
 
2,390,985

 
193,863

 
2,664,746

 
2,552,056

 
2,387

 
(115,077
)
 
4.09
%
 
2.91
%
Non-Agency RMBS
 
946,294

 
(255,520
)
 
690,774

 
751,024

 
66,476

 
(6,226
)
 
1.29
%
 
7.27
%
Total RMBS
 
$
3,337,279

 
$
(61,657
)
 
$
3,355,520

 
$
3,303,080

 
$
68,863

 
$
(121,303
)
 
3.39
%
 
3.81
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2012
 
 
Principal
Balance
 
Unamortized
Premium
(Discount) (1)
 
Amortized
Cost  (2) 
 
Estimated
Fair Value
 
Gross
Unrealized
Gain
 
Gross
Unrealized
Losses
 
Net
Weighted
Average
Coupon
 
Weighted
Average
Yield (3)
Agency RMBS - 30-Year Mortgages:
 
 
 
 
 
 
 
 
 
 
 
 
3.5% Coupon
 
$
1,228,402

 
$
78,623

 
$
1,307,025

 
$
1,318,375

 
$
11,396

 
$
(46
)
 
3.50
%
 
2.40
%
4.0% Coupon
 
1,406,138

 
113,864

 
1,520,002

 
1,543,258

 
23,860

 
(604
)
 
4.00
%
 
2.62
%
4.5% & 5.0% Coupons
 
271,764

 
17,016

 
288,780

 
302,156

 
13,376

 
—

 
4.53
%
 
3.08
%
 
 
2,906,304

 
209,503

 
3,115,807

 
3,163,789

 
48,632

 
(650
)
 
3.84
%
 
2.53
%
Agency RMBS - 15-20 Year Mortgages:
 
 
 
 
 
 
 
 
 
 
 
 
3.0% Coupon
 
159,605

 
7,181

 
166,786

 
169,172

 
2,386

 
—

 
3.00
%
 
1.98
%
3.5% Coupon
 
221,949

 
12,883

 
234,832

 
239,207

 
4,375

 
—

 
3.50
%
 
2.30
%
 
 
381,554

 
20,064

 
401,618

 
408,379

 
6,761

 
—

 
3.29
%
 
2.17
%
Agency IOs (4)
 
—

 
—

 
5,709

 
5,880

 
226

 
(56
)
 
3.84
%
 
3.39
%
Agency Inverse IOs (4)
 
—

 
—

 
48,287

 
48,046

 
312

 
(552
)
 
6.33
%
 
14.43
%
Total Agency
 
3,287,858

 
229,567

 
3,571,421

 
3,626,094

 
55,931

 
(1,258
)
 
3.96
%
 
2.69
%
Non-Agency RMBS
 
817,250

 
(267,857
)
 
549,393

 
605,197

 
56,260

 
(456
)
 
1.19
%
 
7.86
%
Total RMBS
 
$
4,105,108

 
$
(38,290
)
 
$
4,120,814

 
$
4,231,291

 
$
112,191

 
$
(1,714
)
 
3.45
%
 
3.38
%
Note: We apply trade-date accounting. Included in the above table are unsettled purchases with an aggregate cost of $14,313 and $49,965 at June 30, 2013 and December 31, 2012, respectively, and estimated fair value of $14,268 and $50,043, respectively at such dates.
(1) 
A portion of the purchase discount on non-Agency RMBS is not expected to be recognized as interest income, and is instead viewed as a credit discount. At June 30, 2013, our non-Agency RMBS had gross discounts of $256,222, which included credit discounts of $106,286 and OTTI of $4,858. At December 31, 2012, our non-Agency RMBS had gross discounts of $267,857 which included credit discounts of $119,276 and OTTI of $3,750.
(2) 
Amortized cost is reduced by unrealized losses that are classified as other-than-temporary impairments. We recognized other-than-temporary impairments of $2,015 and $1,784 for the three months ended June 30, 2013 and 2012, respectively, and $4,952 and $2,755 for the six months ended June 30, 2013 and 2012, respectively.
(3) 
Weighted average yield at the date presented incorporates estimates for future prepayment assumptions on all RMBS and loss assumptions on non-Agency RMBS.
(4) 
Agency IOs and Agency Inverse IOs have no principal balance and bear interest based on a notional balance. The notional balance is used solely to determine interest distributions on such securities. At June 30, 2013 and December 31, 2012, our Agency IOs had a notional balance of $180,220 and $47,182, respectively and our Agency Inverse IOs had a notional balance of $270,110 and $257,187, respectively.


17

Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
(Dollars in thousands—except per share data)
 


The following table presents information about our RMBS that were in an unrealized loss position at June 30, 2013:
 
 
Unrealized Loss Position for Less than
12 Months
 
Unrealized Loss Position for 12
Months or More
 
 
Fair Value
 
Unrealized
Losses
 
Number
of
Securities
 
Fair Value
 
Unrealized
Losses
 
Number
of
Securities
Agency RMBS
 
$
2,475,928

 
$
(108,920
)
 
66

 
$
—

 
$
—

 
—

Agency IOs
 
—

 
—

 
—

 
—

 
—

 
—

Agency Inverse IOs
 
37,825

 
(6,157
)
 
23

 
—

 
—

 
—

Total Agency RMBS
 
2,513,753

 
(115,077
)
 
89

 
—

 
—

 
—

Non-Agency RMBS
 
202,432

 
(6,041
)
 
58

 
3,718

 
(185
)
 
1

Total RMBS
 
$
2,716,185

 
$
(121,118
)
 
147

 
$
3,718

 
$
(185
)
 
1

The following table presents components of interest income on our Agency RMBS and non-Agency RMBS for the periods presented:
 
 
Three Months Ended June 30, 2013
 
Six Months Ended June 30, 2013
 
 
Coupon
Interest
 
(Premium
Amortization)/
Discount
Accretion, net (1)
 
Interest
Income
 
Coupon
Interest
 
(Premium
Amortization)/
Discount
Accretion, net (1)
 
Interest
Income
Agency RMBS
 
$
41,887

 
$
(13,499
)
 
$
28,388

 
$
77,691

 
$
(22,450
)
 
$
55,241

Non-Agency RMBS
 
2,560

 
8,084

 
10,644

 
4,829

 
15,876

 
20,705

Total
 
$
44,447

 
$
(5,415
)
 
$
39,032

 
$
82,520

 
$
(6,574
)
 
$
75,946

 
 
Three Months Ended June 30, 2012
 
Six Months Ended June 30, 2012
 
 
Coupon
Interest
 
(Premium
Amortization)/
Discount
Accretion, net (1)
 
Interest
Income
 
Coupon
Interest
 
(Premium
Amortization)/
Discount
Accretion, net (1)
 
Interest
Income
Agency RMBS
 
$
21,559

 
$
(7,543
)
 
$
14,016

 
$
33,149

 
$
(10,770
)
 
$
22,379

Non-Agency RMBS
 
1,051

 
6,923

 
7,974

 
1,604

 
10,370

 
11,974

Total
 
$
22,610

 
$
(620
)
 
$
21,990

 
$
34,753

 
$
(400
)
 
$
34,353

(1) 
The amount of premium amortization on Agency RMBS reflects our estimates of prepayments for such securities, which estimates are adjusted to reflect actual prepayments to date. The amount of discount accretion on non-Agency RMBS reflects our estimates of future cash flows for such securities, which estimates are reviewed, and may be revised, on at least a quarterly basis.


18

Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
(Dollars in thousands—except per share data)
 


The following tables present components of net realized gains/(losses), and the change in unrealized gains and losses, net on our RMBS portfolio for the periods presented:
 
 
Three Months Ended June 30, 2013
 
Six Months Ended June 30, 2013
 
 
Realized
Gains/(Losses)
 
Unrealized
Gains/(Losses)
 
Realized
Gains/(Losses)
 
Unrealized
Gains/(Losses)
Agency Pass-throughs
 
$
(49,204
)
 
$
(122,074
)
 
$
(41,850
)
 
$
(163,663
)
Agency IOs
 
—

 
2,302

 
60

 
2,161

Agency Inverse IOs
 
254

 
(7,014
)
 
347

 
(9,283
)
Non-Agency RMBS
 
1,442

 
(8,036
)
 
9,730

 
2,915

Total
 
$
(47,508
)
 
$
(134,822
)
 
$
(31,713
)
 
$
(167,870
)
 
 
Three Months Ended June 30, 2012
 
Six Months Ended June 30, 2012
 
 
Realized
Gains/(Losses)
 
Unrealized
Gains/(Losses)
 
Realized
Gains
 
Unrealized
Gains/(Losses)
Agency Pass-throughs
 
$
11,324

 
$
17,212

 
$
14,537

 
$
19,152

Agency IOs
 
209

 
(1,391
)
 
192

 
(404
)
Agency Inverse IOs
 
(23
)
 
579

 
122

 
483

Non-Agency RMBS
 
104

 
(1,802
)
 
3,532

 
1,317

Total
 
$
11,614

 
$
14,598

 
$
18,383

 
$
20,548

The following table presents the changes in the components of our purchase discount on non-Agency RMBS between purchase discount designated as credit reserve and OTTI versus accretable purchase discount for the periods presented:

 
Six Months Ended June 30, 2013
 
 
Discount
Designated as
Credit Reserve
and OTTI
 
Accretable Discount
Balance at beginning of period
 
$
(123,026
)
 
$
(144,831
)
Accretion of discount
 
—

 
15,876

Realized credit losses
 
1,809

 
—

Purchases
 
(13,195
)
 
(27,137
)
Sales and other
 
24,480

 
11,333

OTTI recognized in earnings
 
(1,531
)
 
—

Transfers/release of credit reserve
 
319

 
(319
)
Balance at end of period
 
$
(111,144
)
 
$
(145,078
)

Note 5 – Securitized Mortgage Loans
Securitized mortgage loans are carried at estimated fair value. Amortized cost reflects the principal balance of the securitized mortgage loans less purchase discounts. In February 2013, we purchased a pool of 755 mortgage loans with an unpaid principal balance of $155,001 for $113,038; prior to February 2013, we did not have any securitized mortgage loans. Our securitized mortgage loan pool at June 30, 2013 was comprised of seasoned, fully amortizing, negatively amortizing and balloon, fixed-rate and adjustable-rate mortgage loans, secured by first liens on one-to-four family residential properties. We appointed the servicer who is responsible for servicing our securitized mortgage loans, which servicer may, overtime, modify certain provisions of the loans in order to mitigate losses. At the time of purchase through June 30, 2013, substantially all of the purchase discount associated with our securitized mortgage loans was considered to be credit related. At June 30, 2013, the amortized cost of our securitized mortgage loans was $110,903. (See Note 13.)


19

Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
(Dollars in thousands—except per share data)
 


The following table presents a summary of the changes in the carrying value of securitized loans held for investment for the periods presented:
 
 
Three Months Ended June 30, 2013
 
Six Months Ended June 30, 2013
Balance beginning of period
 
$
114,881

 
$
—

Purchases during the period
 
—

 
113,038

Principal repayments
 
(1,054
)
 
(2,051
)
Purchase and discount adjustments, net
 
(76
)
 
(84
)
Unrealized loss during the period
 
(3,473
)
 
(625
)
Balance at end of period
 
$
110,278

 
$
110,278

The following table presents the five largest states represented in our securitized mortgage loans at June 30, 2013 based on principal balance:
Property Location
 
Concentration
 
Principal Balance
California
 
20.9
%
 
$
31,952

Florida
 
13.7

 
20,883

Maryland
 
12.0

 
18,384

Texas
 
7.7

 
11,775

New Jersey
 
7.3

 
11,159

Other
 
38.4

 
58,797

Total
 
100.0
%
 
$
152,950

Note 6 – Receivables
Interest Receivable
The following table presents our interest receivable by investment category at June 30, 2013 and December 31, 2012:
Asset
 
June 30, 2013
 
December 31, 2012
Agency RMBS:
 
 
 
 
Fannie Mae
 
$
7,447

 
$
7,082

Freddie Mac
 
4,210

 
3,755

Ginnie Mae
 
63

 
108

Non-Agency RMBS
 
644

 
396

Total RMBS interest receivable
 
12,364

 
11,341

Securitized mortgage loans
 
753

 
—

Total interest receivable
 
$
13,117

 
$
11,341

Investment Related Receivables
The following table presents the components of our investment related receivables at June 30, 2013:
 
 
June 30, 2013
 
 
Total Receivable
Unsettled sales of Agency RMBS
 
$
977,919

Unsettled terminations of Swaps
 
6,680

Principal payments due from broker for non-Agency RMBS
 
1,558

Total investment related receivables
 
$
986,157

We had no investment related receivables at December 31, 2012.



20

Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
(Dollars in thousands—except per share data)
 


Note 7 – Borrowings Under Repurchase Agreements
As of June 30, 2013, we had master repurchase agreements with 23 counterparties and had outstanding borrowings of $3,945,097 with 19 counterparties. At June 30, 2013 and December 31, 2012, we had approximately $203 and $346, respectively, of deferred financing costs associated with repurchase borrowings, which amounts are included on our balance sheet as a component of deferred financing costs, net.
Our repurchase agreements bear interest at a contractually agreed-upon rate and typically have initial terms ranging from one to six months, but in some cases have initial terms that are longer or shorter. The following table presents certain characteristics of our repurchase agreements at June 30, 2013 and December 31, 2012:
 
 
June 30, 2013
 
December 31, 2012
RMBS Financed
 
Repurchase Agreement Borrowings
 
Weighted Average Borrowing Rate
 
Weighted Average Remaining Maturity (days)
 
Repurchase Agreement Borrowings
 
Weighted Average Borrowing Rate
 
Weighted Average Remaining Maturity (days)
Agency RMBS
 
$
3,367,445

 
0.42
%
 
25
 
$
3,223,577

 
0.47
%
 
15
Non-Agency RMBS
 
550,752

 
2.05

 
146
 
430,859

 
2.06

 
58
Repo – Securitization (1)
 
26,900

 
2.05

 
72
 
—

 
—

 
0
Total
 
$
3,945,097

 
0.66
%
 
42
 
$
3,654,436

 
0.65
%
 
20
(1) 
Repo – Securitization reflects the balance of repurchase agreement borrowings that is collateralized by a non-Agency RMBS that we retained in connection with our securitization transaction. While the RMBS that we retained in connection with our securitization transaction do not appear on our balance sheet, as they are eliminated in consolidation with the securitization trust, we legally own such securities and therefore are legally permitted to pledge such securities as collateral.
The following table presents repricing information about our borrowings under repurchase agreements, which does not reflect the impact of our interest rate derivatives, at June 30, 2013 and December 31, 2012:
 
 
June 30, 2013
 
December 31, 2012
Time Until Interest Rate Reset
 
Balance
 
Weighted Average Interest Rate
 
Balance
 
Weighted Average Interest Rate
Within 30 days
 
$
2,812,163

 
0.59
%
 
$
3,461,595

 
0.60
%
> 30 days to 60 days
 
689,382

 
0.59

 
110,670

 
1.30

> 60 days to 90 days
 
146,192

 
1.37

 
28,197

 
2.12

> 90 days to 120 days
 
238,276

 
0.75

 
29,602

 
2.07

> 120 days to 360 days
 
43,496

 
2.27

 
24,372

 
2.08

> 360 days
 
$
15,588

 
2.25

 
$
—

 
—

Total
 
$
3,945,097

 
0.66
%
 
$
3,654,436

 
0.65
%
The following table presents the contractual maturity of our repurchase agreements at June 30, 2013, which does not reflect the impact of our interest rate derivatives:
Time Until Contractual Maturity:
 
Balance
 
Weighted Average Interest Rate
Within 30 days
 
$
2,716,079

 
0.53
%
> 30 days to 60 days
 
689,382

 
0.59

> 60 days to 90 days
 
146,192

 
1.37

> 90 days to 120 days
 
238,276

 
0.75

> 120 days to 360 days
 
43,496

 
2.27

> 360 days
 
111,672

 
2.42

Total
 
$
3,945,097

 
0.66
%



21

Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
(Dollars in thousands—except per share data)
 


Note 8 – Collateral Positions
The following table presents the fair value of our collateral positions, which includes collateral pledged and collateral held, with respect to our borrowings under repurchase agreements, derivatives, and clearing margin account for the periods presented:
 
 
June 30, 2013
 
December 31, 2012
 
 
Assets Pledged as Collateral
 
Collateral Held
 
Assets Pledged as Collateral
 
Collateral Held
Derivatives:
 
 
 
 
 
 
 
 
Restricted cash/cash (1)
 
$
609

 
$
66,571

 
$
33,395

 
$
—

 
 
609

 
66,571

 
33,395

 
—

Repurchase agreement borrowings:
 
 
 
 
 
 
 
 
Agency RMBS
 
3,339,925

 
—

 
3,335,472

 
—

Non-Agency RMBS (2)
 
780,578

 
—

 
600,632

 
—

Restricted cash
 
205,245

 
—

 
60,246

 
—

 
 
4,325,748

 
—

 
3,996,350

 
—

Clearing margin:
 
 
 
 
 
 
 
 
Agency RMBS
 
4,192

 
—

 
4,809

 
—

Total
 
$
4,330,549

 
$
66,571

 
$
4,034,554

 
$
—

(1) 
Cash pledged as collateral is reported as “restricted cash” on our consolidated balance sheet.
(2) 
Includes $44,834 of non-Agency RMBS acquired in connection with resecuritization transactions from consolidated VIEs at June 30, 2013 that is eliminated from our consolidated balance sheet.


22

Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
(Dollars in thousands—except per share data)
 


The following tables present information about our collateral pledged, with respect to our borrowings under repurchase agreements, derivatives and clearing margin account at June 30, 2013 and December 31, 2012:
 
 
June 30, 2013
 
 
Assets Pledged at
Fair Value
 
Amortized
Cost
 
Accrued
Interest
 
Fair Value of Assets Pledged and Accrued Interest
Assets pledged for borrowings under repurchase agreements:
 
 
 
 
 
 
 
 
Agency RMBS (1)
 
$
3,339,925

 
$
3,443,397

 
$
10,802

 
$
3,350,727

Non-Agency RMBS
 
735,744

 
675,459

 
635

 
736,379

Non-Agency RMBS acquired through securitization transaction (2)
 
44,834

 
45,495

 
231

 
45,065

Cash (3)
 
205,245

 
—

 
—

 
205,245

Total
 
$
4,325,748

 
4,164,351

 
11,668

 
4,337,416

Cash pledged for derivatives (3)
 
609

 
—

 
—

 
609

Agency RMBS pledged for clearing margin
 
4,192

 
4,390

 
12

 
4,204

Total
 
$
4,330,549

 
$
4,168,741

 
$
11,680

 
$
4,342,229

 
 
December 31, 2012
 
 
Assets Pledged-
Fair Value
 
Amortized
Cost
 
Accrued
Interest
 
Fair Value of Assets Pledged and Accrued Interest
Assets pledged for borrowings under repurchase agreements:
 
 
 
 
 
 
 
 
Agency RMBS
 
$
3,335,472

 
$
3,283,264

 
$
9,658

 
$
3,345,130

Non-Agency RMBS
 
600,632

 
544,975

 
393

 
601,025

Cash (3)
 
60,246

 
—

 
—

 
60,246

Total
 
$
3,996,350

 
$
3,828,239

 
$
10,051

 
$
4,006,401

Cash pledged for derivatives (3)
 
33,395

 
—

 
—

 
33,395

Agency RMBS pledged for clearing margin
 
4,809

 
4,780

 
13

 
4,822

Total
 
$
4,034,554

 
$
3,833,019

 
$
10,064

 
$
4,044,618

 
(1) 
Includes Agency RMBS of $977,726 that were sold but unsettled at June 30, 2013.
(2) 
Reflects a non-Agency RMBS that was acquired in connection with our securitization transaction. This security, which we may pledge as collateral, is eliminated from our balance sheet in consolidation with the VIE.
(3) 
Cash pledged as collateral is reported as “restricted cash” on our consolidated balance sheets.
A reduction in the value of pledged assets may result in the repurchase agreement counterparty initiating a margin call. If a margin call is made, we are required to provide additional collateral or repay a portion of the borrowing. Certain repurchase agreements and Swaps are subject to financial covenants, which if breached could cause an event of default or early termination event to occur under such agreements. If we were to cause an event of default or trigger an early termination event pursuant to one of our Swaps, the counterparty to such agreement may have the option to terminate all of its outstanding Swaps with us and, if applicable, any close-out amount due to the counterparty upon termination of the Swaps would be immediately payable by us. Through June 30, 2013, we remained in compliance with all of all our financial covenants. (See Note 10.)
 


23

Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
(Dollars in thousands—except per share data)
 


Note 9 – Offsetting Assets and Liabilities
The following tables present information about certain assets and liabilities that are subject to master netting arrangements (or similar agreements) and can potentially be offset on our consolidated balance sheet at June 30, 2013 and December 31, 2012:
Offsetting of Financial Assets and Derivative Assets
 
 
 
 
 
 
 
 
Gross Amounts Not Offset
in the Consolidated
Balance Sheet
 
 
Gross
Amounts of
Recognized
Assets
 
Gross Amounts
Offset in  the
Consolidated
Balance Sheet
 
Net Amounts
 of Assets  Presented
in the
Consolidated
Balance Sheet
 
Financial
Instruments (1)
 
Cash
Collateral
Received
 
Net
Amount
June 30, 2013
 
 
 
 
 
 
 
 
 
 
 
 
Swaps and Swaptions, at fair value
 
$
68,806

 
$
—

 
$
68,806

 
$
(1,980
)
 
$
(66,571
)
 
$
255

TBA Shorts, at fair value
 
100

 
—

 
100

 
(100
)
 
—

 
—

Total
 
$
68,906

 
$
—

 
$
68,906

 
$
(2,080
)
 
$
(66,571
)
 
$
255

December 31, 2012
 
 
 
 
 
 
 
 
 
 
 
 
Swaps and Swaptions, at fair value
 
$
750

 
$
—

 
$
750

 
$
(750
)
 
$
—

 
$
—

Total
 
$
750

 
$
—

 
$
750

 
$
(750
)
 
$
—

 
$
—

Offsetting of Financial Liabilities and Derivative Liabilities
 
 
 
 
 
 
 
 
Gross Amounts Not Offset
in the Consolidated
Balance Sheet
 
 
Gross
Amounts of
Recognized
Liabilities
 
Gross Amounts
Offset in the
Consolidated
Balance Sheet
 
Net Amounts of
Liabilities
Presented in the
Consolidated
Balance Sheet
 
Financial Instruments (2) (3)
 
Cash
Collateral
Pledged  (2) (4)
 
Net
Amount
June 30, 2013
 
 
 
 
 
 
 
 
 
 
 
 
Swaps and Swaptions, at fair value
 
$
2,750

 
$
—

 
$
2,750

 
$
(1,980
)
 
$
(349
)
 
$
421

TBA Shorts, at fair value
 
923

 
—

 
923

 
(100
)
 
(260
)
 
563

Repurchase agreements
 
3,945,097

 
—

 
3,945,097

 
(3,945,097
)
 
—

 
—

Total
 
$
3,948,770

 
$
—

 
$
3,948,770

 
$
(3,947,177
)
 
$
(609
)
 
$
984

December 31, 2012
 
 
 
 
 
 
 
 
 
 
 
 
Swaps and Swaptions, at fair value
 
$
23,184

 
$
—

 
$
23,184

 
$
(750
)
 
$
(22,434
)
 
$
—

Repurchase agreements
 
3,654,436

 
—

 
3,654,436

 
(3,654,436
)
 
—

 
—

Total
 
$
3,677,620

 
$
—

 
$
3,677,620

 
$
(3,655,186
)
 
$
(22,434
)
 
$
—

(1) 
Amounts represent interest rate derivatives or TBA Shorts in an asset position which could potentially be offset against interest rate derivatives or TBA Shorts in a liability position at June 30, 2013 and December 31, 2012, subject to a netting arrangement.
(2) 
Amounts represent collateral pledged that is available to be offset against liability balances associated with repurchase agreements, interest rate derivatives and TBA Shorts.
(3) 
The fair value of securities pledged against our borrowings under repurchase agreements was $4,120,503 and $3,936,104 at June 30, 2013 and December 31, 2012, respectively.
(4) 
Total cash pledged against our Swaps was $609 and $33,395 at June 30, 2013 and December 31, 2012, respectively. Total cash collateral pledged against our borrowings under repurchase agreements was $205,245 and $60,246 at June 30, 2013 and December 31, 2012, respectively.


24

Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
(Dollars in thousands—except per share data)
 


Nature of Setoff Rights
In our consolidated balance sheets, all balances associated with the repurchase agreement and derivatives transactions are presented on a gross basis.
Certain of our repurchase agreement and derivative transactions are governed by underlying agreements that generally provide for a right of set off in the event of default or in the event of a bankruptcy of either party to the transaction.
Note 10 – Derivative Instruments
We are exposed to changing interest rates, which affect the cash flows associated with our borrowings. We enter into interest rate derivative contracts, which through June 30, 2013 were comprised of Swaps, Swaptions, and TBA Shorts to mitigate our exposure to changes in interest rates, whereby we make/receive payments to/from our interest rate derivative contract counterparties. We use derivative instruments to manage interest rate risk and, as such, view them as economic hedges. We have not elected hedge accounting for our derivative instruments and, as a result, the fair value adjustments on such instruments are recorded in earnings. The fair value adjustments for our derivatives, along with the related interest income, interest expense and gains/(losses) on termination of such instruments, are reported as a net gain/(loss) on derivative instruments on our consolidated statements of operations.
Pursuant to our Swaps, we agree to pay a fixed rate of interest and receive a variable-rate of interest based on the notional amount of the Swap. The variable amount that we pay to our Swap counterparties is based on three-month London Interbank Offer Rate (or, LIBOR). We pay a premium to our Swaption counterparties to purchase a Swaption. Each of our Swaptions gives us the right, at the expiration of the option period, to either: (i) enter into a Swap under which we would pay a fixed interest rate and receive a variable rate of interest on the notional amount or (ii) cash settle if the Swaption is in-the-money, as prescribed in the Swaption confirmation.
During the quarter ended June 30, 2013, we entered into three TBA Shorts with an aggregate notional balance of $325,000, which were in a net unrealized loss position of $823 at June 30, 2013. Our TBA Shorts, which settle on August 12, 2013, had a weighted average sales price of 100.99% for 3.5% coupon Fannie Mae 30-year RMBS with a face value of $325,000.
The following table presents information with respect to our derivative instruments as presented on our consolidated balance sheets at June 30, 2013 and December 31, 2012:
 
 
June 30, 2013
 
December 31, 2012
 
 
Notional
Amount
 
Estimated
Fair Value
 
Notional
Amount
 
Estimated
Fair Value
Swaps - assets
 
$
1,547,000

 
$
50,359

 
$
—

 
$
—

Swaptions - assets
 
775,000

 
18,447

 
75,000

 
750

Swaps - (liabilities)
 
485,000

 
(2,750
)
 
1,500,000

 
(23,184
)
TBA Shorts - assets
 
150,000

 
100

 
—

 
—

TBA Shorts - (liabilities)
 
175,000

 
(923
)
 
—

 
—

Total Derivative Instruments
 
$
3,132,000

 
$
65,233

 
$
1,575,000

 
$
(22,434
)
The following table presents information about our Swaps as of June 30, 2013 and December 31, 2012:
 
 
June 30, 2013
 
December 31, 2012
Term to Maturity
 
Notional
Amount
 
Average
Fixed Pay
Rate
 
Average
Maturity
(Years)
 
Notional
Amount
 
Average
Fixed Pay
Rate
 
Average
Maturity
(Years)
> Three to five years
 
$
1,159,000

 
1.06
%
 
4.1
 
$
1,245,000

 
1.06
%
 
4.4
> Five years
 
873,000

 
2.04

 
9.5
 
255,000

 
1.90

 
9.6
Total
 
$
2,032,000

 
1.48
%
 
6.4
 
$
1,500,000

 
1.20
%
 
5.3


25

Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
(Dollars in thousands—except per share data)
 


Each of our Swaptions gives us the right, at the expiration of the option period, to either: (i) enter into a Swap under which we would pay a fixed interest rate and receive a variable rate of interest on the notional amount or (ii) cash settle if the Swaption is in-the-money, as prescribed in the Swaption confirmation. At June 30, 2013, our Swaptions had an aggregate fair value of $18,447. The following table presents information about our Swaptions at June 30, 2013:
 
 
Option
 
Underlying Swap
Fixed Pay Rate for Underlying Swap
 
Fair
Value
 
Weighted Average Months Until Option Expiration
 
Notional
Amount
 
Weighted Average Swap Term (Years)
3.00 - 3.25%
 
$
8,161

 
10
 
$
275,000

 
10.0
3.26 - 3.50%
 
7,923

 
11
 
375,000

 
10.0
3.51 - 3.64%
 
2,363

 
12
 
125,000

 
10.0

 
$
18,447

 
11
 
$
775,000

 
10.0
 
The following table presents amounts recognized on our consolidated statements of operations related to our derivative instruments for the periods presented:
 
 
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
Character of Loss on Derivative Instruments
 
Location of Item on the
Consolidated Statements of Operations
 
2013
 
2012
 
2013
 
2012
Net interest payments/accruals on Swaps (1)
 
Gain/(loss) on derivative  instruments, net
 
$
(6,437
)
 
$
(1,762
)
 
$
(10,576
)
 
$
(2,510
)
Gains/(losses) on the termination of Swaps, net
 
Gain/(loss) on derivative  instruments, net
 
8,589

 
39

 
8,589

 
39

Gain/(losses) on the termination of Swaptions, net
 
Gain/(loss) on derivative  instruments, net
 
1,439

 
—

 
1,439

 
—

Change in fair value of Swaps (2)
 
Gain/(loss) on derivative  instruments, net
 
71,713

 
(13,792
)
 
70,793

 
(14,362
)
Change in fair value of Swaptions (2)
 
Gain/(loss) on derivative  instruments, net
 
8,888

 
—

 
8,149

 
—

Change in fair value of TBA Shorts
 
Gain/(loss) on derivative  instruments, net
 
(823
)
 
—

 
(823
)
 
—

Total
 
 
 
$
83,369

 
$
(15,515
)
 
$
77,571

 
$
(16,833
)
(1) 
Amounts are realized.
(2) 
Amounts are unrealized.
Financial Covenants
Our agreements with certain of our derivative counterparties contain financial covenants. Through June 30, 2013, we were in compliance with the terms of all such financial covenants. We have minimum collateral posting thresholds with certain of our Swap counterparties, for which we typically pledge cash. (See Notes 8 and 9.) If we had breached any of these provisions at June 30, 2013 we could have been required to settle our obligations under our Swaps at their termination value of $1,310, which amount reflects the estimated fair value of our Swaps that were in a liability position, plus accrued interest.



26

Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
(Dollars in thousands—except per share data)
 


Note 11 – Interest Payable
The following table presents the components of our interest payable at June 30, 2013 and December 31, 2012: 
 
 
June 30, 2013
 
December 31, 2012
Repurchase borrowings collateralized by Agency RMBS
 
$
2,600

 
$
3,896

Repurchase borrowings collateralized by non-Agency RMBS
 
2,214

 
1,519

Repurchase borrowings collateralized by securitization security (1)
 
32

 
—

Securitized debt
 
158

 
—

Swaps
 
2,153

 
1,359

Total interest payable
 
$
7,157

 
$
6,774

(1) 
Reflects interest payable on repurchase borrowings collateralized by non-Agency RMBS that we retained in connection with our securitization transaction. The securities we retained are not presented on our balance sheet, as they are eliminated in consolidation with the securitization trust.
Note 12 – Commitments and Contingencies
(a) Management Agreement – Related Party Transactions
In connection with our initial public offering (or, IPO) in July 2011, we entered into a management agreement with our Manager (or, Management Agreement), which describes the services to be provided for us by our Manager and compensation for such services. Our Manager is responsible for managing our day-to-day operations, subject to the direction and oversight of our board of directors.
Pursuant to the terms of the Management Agreement, our Manager is paid a management fee equal to 1.5% per annum of our stockholders’ equity (as defined in the Management Agreement), calculated and payable (in U.S. dollars) quarterly in arrears.
The initial term of the Management Agreement expires on July 27, 2014 and is automatically renewed for one-year terms on each anniversary thereafter. Following the initial term, the Management Agreement may be terminated upon the affirmative vote of at least two-thirds of our independent directors, based upon (1) unsatisfactory performance by our Manager that is materially detrimental to us; or (2) a determination that the management fee payable to our Manager is not fair, subject to our Manager’s right to prevent such a termination based on unfair fees by accepting a mutually acceptable reduction of management fees agreed to by at least two-thirds of our independent directors. Our Manager must be provided with written notice of any such termination at least 180 days prior to the expiration of the then existing term and will be paid a termination fee equal to three times the sum of the average annual management fee during the 24-month period immediately preceding the date of termination, calculated as of the end of the most recently completed fiscal quarter prior to the date of termination.
We incurred management fees of $2,921 and $1,558 for the three months ended June 30, 2013 and 2012, respectively, and $5,710 and $2,355 for the six months ended June 30, 2013 and 2012, respectively. In addition to the management fee, we are responsible for reimbursing our Manager for certain expenses paid by our Manager on our behalf and for certain services provided by our Manager or its affiliates for us. We recorded expenses of $1,953 and $1,519 for the three months ended June 30, 2013 and 2012, respectively, and $4,317 and $2,604 for the six months ended June 30, 2013 and 2012, respectively, related to reimbursements for certain expenses paid by Apollo on our behalf and for certain services provided by Apollo for us. Expenses paid by our Manager and reimbursed by us are typically included in our general and administrative expense on our consolidated statements of operations, or may be reflected on our consolidated balance sheet and associated consolidated statement of changes in stockholders’ equity, based on the nature of the item. At June 30, 2013 and December 31, 2012, $2,921 and $2,418, respectively, for management fees incurred but not yet paid were included in “payable to related party” on our consolidated balance sheet.
(b) Representations and Warranties in Connection with Securitization
In connection with our securitization transaction, we have the obligation under certain circumstances to repurchase assets from the VIE upon breach of certain representations and warranties. (See Note 13.)



27

Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
(Dollars in thousands—except per share data)
 


Note 13 – Use of Special Purpose Entities
Special purpose entities (or, SPEs) are entities designed to fulfill a specific limited need of the company that organized it. SPEs are often used to facilitate transactions that involve securitizing financial assets. The objective of such transactions may include obtaining non-recourse financing, obtaining liquidity or refinancing the underlying securitized financial assets on more favorable terms than available on such assets on an un-securitized basis. Securitization involves transferring assets to an SPE to convert all or a portion of those assets into cash before they would have been realized in the normal course of business, through the SPE’s issuance of debt or equity instruments. Investors in an SPE usually have recourse only to the assets in the SPE and, depending on the overall structure of the transaction, may benefit from various forms of credit enhancement, such as over-collateralization in the form of excess assets in the SPE, priority with respect to receipt of cash flows relative to holders of other debt or equity instruments issued by the SPE, or a line of credit or other form of liquidity agreement that is designed with the objective of ensuring that investors receive principal and/or interest cash flow on the investment in accordance with the terms of their investment agreement.
(a) Securitization Transaction
In February 2013, we engaged in a securitization transaction that resulted in us consolidating, as a VIE, the SPE/trust that was created to facilitate the transaction and to which the underlying mortgage loans in connection with the securitization were transferred. (See Note 2(f) for a discussion of our accounting policies applied to the consolidation of the VIE and transfer of the financial assets in connection with the securitization.)
The mortgage loans in the securitization trust are comprised of performing and re-performing mortgage loans with characteristics similar to the mortgage loans underlying our non-Agency RMBS.
The following table presents certain information about our securitization transaction at the time of securitization unless otherwise indicated:
Principal value of mortgage loans sold into the securitization trust
 
$
155,001

Face amount of senior security issued by the VIE and sold to a third party investor
 
$
50,375

Outstanding amount of senior security at June 30, 2013
 
$
47,353

Pass-through interest rate for senior security issued – fixed rate
 
4.00
%
Face/Par value of certificates received by us (1)
 
$
104,626

Cash received from sale of the senior security sold
 
$
50,375

Gross expenses incurred (2)
 
$
829

(1) 
The certificates we received are subordinate to and provide credit support for the sequential senior security sold to a third-party investor in the securitization transaction. While the RMBS that we retained in connection with our securitization transaction do not appear on our balance sheet, as they are eliminated in consolidation with the VIE/securitization trust, we legally own such securities and therefore are legally permitted to pledge such securities.
(2) 
Expenses incurred were capitalized as deferred charges and are amortized to interest expense based upon the actual repayments of the associated senior security sold to a third party.
On a quarterly basis, we complete an analysis to determine whether the VIE should be consolidated by us. As part of this analysis, we consider our involvement in the creation of the VIE, including the design and purpose of the VIE, and whether our involvement reflects a controlling financial interest that results in us being deemed the primary beneficiary of the VIE. In determining whether we would be considered the primary beneficiary, we consider: (i) whether we have both the power to direct the activities that most significantly impact the economic performance of the VIE; and (ii) whether we have a right to receive benefits or absorb losses of the entity that could be potentially significant to the VIE. Based on our evaluation of these factors, including our involvement in the design of the VIE, we determined that we were required to consolidate the VIE created to facilitate the securitization transaction from inception through June 30, 2013.
For financial statement reporting purposes, given that we consolidate the securitization trust, no gain or loss was reported on the sale of the mortgage loans to the securitization trust. Since the underlying trust is consolidated, the securitization is effectively viewed as a financing of the mortgage loans that were “sold” to enable the senior security to be created and sold to a third party investor. As such, the senior security is presented on our consolidated balance sheet as “non-recourse securitized debt, at fair value.” The third-party beneficial interest holders in the VIE have no recourse against us, except that we have an obligation to repurchase assets from the VIE in the event that we breach certain representations and warranties in relation to the mortgage loans sold to the VIE. In the absence of such a breach, we have no obligation to provide any other explicit or implicit


28

Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
(Dollars in thousands—except per share data)
 


support to any VIE. As previously stated, we are not obligated to provide, nor have we provided, any financial support to these consolidated securitization vehicles.
As of June 30, 2013, the aggregate fair value of the mortgage loans that were securitized as described above was $110,278, and is presented on our consolidated balance sheet as “securitized mortgage loans (transferred to a consolidated variable interest entity), at fair value.”
The securitization trust receives principal and interest on the underlying mortgage loans and distributes those payments to the certificate holders. The assets and other instruments held by the securitization trust are restricted in that they can only be used to fulfill the obligations of the securitization trust. The risks associated with our involvement with the VIE is limited to the risks and rights as a certificate holder of the securities we retained.  
The activities of the trust are substantially set forth in the securitization transaction documents, primarily the mortgage loan trust agreement, the trust agreement, the indenture and the securitization servicing agreement (collectively, the “Securitization Agreements”). Neither the trust nor any other entity may sell or replace any assets of the trust except in connection with: (i) certain loan defects or breaches of certain representations and warranties which have a material adverse effect on the value of the related assets; (ii) loan defaults; (iii) certain trust events of default or (iv) an optional termination of the trust, each as specifically permitted under the Securitization Agreements.
(b) Securitized Debt
We consolidate the VIE created as a result of our securitization transaction in February 2013. As a result, on our consolidated balance sheet we report: (i) “non-recourse securitized debt, at fair value” which reflects the senior security sold to third party investors and (ii) “securitized mortgage loans (transferred to a consolidated VIE), at fair value” the residential mortgage loans held by the trust that collateralize all of the securities issued from the trust.
At June 30, 2013, the securitized debt collateralized by residential mortgage loans had a principal balance of $47,353. The senior security, which has a final contractual maturity in 2047, has a fixed coupon rate of 4.00%. The 4.00% rate reflects the coupon rate on the senior security held by third party investors. In addition, we capitalized (as deferred financing costs) expenses associated with the securitization transaction and amortize such costs to interest expense over the life of the securitized debt.
Our securitized debt is carried at fair value, which is based on the fair value of the senior security held by third parties. The following table presents the estimated principal repayment schedule of the par value of the securitized debt at June 30, 2013, based on expected cash flows of the securitized residential mortgage loans, as adjusted for projected losses on such loans.
Estimated Maturity
 
June 30, 2013
Within one year
 
$
7,906

> One to three years
 
22,951

> Three to five years
 
16,496

> Five years
 
—

Total
 
$
47,353

Repayment of our securitized debt will be dependent upon the cash flows generated by the mortgage loans in the securitization trust that collateralize such debt. The actual cash flows from the securitized mortgage loans are comprised of coupon interest, scheduled principal payments, prepayments and liquidations of the underlying mortgage loans. The actual term of the securitized debt may differ significantly from our estimate given that actual interest collections, mortgage prepayments and/or losses on liquidation of mortgages may differ significantly from those expected. (See Note 5, for a more detailed discussion of the mortgage loans collateralizing our securitized debt.)


29

Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
(Dollars in thousands—except per share data)
 


(c) VIE Impact on the Consolidated Financial Statements
The following table reflects the assets and liabilities recorded in our consolidated balance sheet related to our consolidated VIE as of June 30, 2013:
 
 
June 30, 2013
Assets:
 
 
Securitized mortgage loans, at fair value
 
$
110,278

Interest receivable
 
$
753

Liabilities:
 
 
Non-recourse securitized debt, at fair value
 
$
47,338

Accrued interest payable
 
$
158

The following table reflects the income and expense amounts recorded in our consolidated statements of operations related to our consolidated VIE for the period presented:
 
 
Three Months Ended June 30, 2013
 
Six Months Ended June 30, 2013
Interest income - securitized mortgage loans
 
$
2,297

 
$
3,630

Interest expense - securitized debt
 
$
(508
)
 
$
(818
)
Unrealized (loss) on securitized mortgage loans
 
$
(3,473
)
 
$
(625
)
Unrealized gain on securitized debt
 
$
887

 
$
15

The following table reflects the amounts included on our consolidated statements of cash flows related to our consolidated VIE for the period presented:
 
 
Six Months Ended June 30, 2013
Net income/(loss)
 
$
2,202

Premium amortization/(discount accretion), net
 
$
51

Amortization of deferred financing costs
 
$
50

Unrealized loss on securitized mortgage loans
 
$
625

Unrealized gain on securitized debt
 
$
(15
)
Increase in accrued interest receivable, less purchased interest
 
$
(753
)
Increase in accrued interest payable
 
$
158

Purchase of mortgage loans, simultaneously securitized
 
$
(113,038
)
Other, net
 
$
33

Principal payments on securitized mortgage loans
 
$
2,051

Proceeds from issuance of securitized debt
 
$
50,375

Principal payments on securitized debt
 
$
(3,022
)
Note 14 – Share-based Payments
On July 21, 2011, our board of directors approved the Apollo Residential Mortgage, Inc. 2011 Equity Incentive Plan (or, LTIP). The LTIP provides for grants of restricted common stock, RSUs and other equity-based awards up to an aggregate of 5% of the issued and outstanding shares of our common stock (on a fully diluted basis). The LTIP is administered by the compensation committee of our board of directors, which also must approve grants made under the LTIP. At June 30, 2013, 1,363,919 awards were available under the LTIP.
As of June 30, 2013, a total of 54,908 shares of restricted common stock and 180,744 RSUs were granted and outstanding pursuant to the LTIP, of which 14,384 and 20,047, respectively, were vested at such date. At June 30, 2013, we had unrecognized compensation expense of $821 and $2,385 related to restricted common stock and RSUs, respectively. The unrecognized compensation expense at June 30, 2013 is expected to be recognized over a weighted average period of 1.4 years.


30

Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
(Dollars in thousands—except per share data)
 


As of June 30, 2013, we had an expected average forfeiture rate of 0% with respect to restricted common stock and 5% with respect to RSUs.
The following table presents expenses related to our equity-based compensation awards for the periods presented:
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2013
 
2012
 
2013
 
2012
Restricted Common Stock
 
$
91

 
$
42

 
$
168

 
$
74

RSUs
 
55

 
48

 
377

 
94

Total
 
$
146

 
$
90

 
$
545

 
$
168

The following table presents information about our equity awards for the periods presented:
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2013
 
2012
 
2013
 
2012
RSUs outstanding at beginning of period:
 
165,119

 
28,125

 
166,682

 
29,688

RSUs granted
 
6,250

 
5,000

 
6,250

 
5,000

RSUs canceled upon delivery of common stock
 
(1,562
)
 
(1,562
)
 
(3,125
)
 
(3,125
)
RSUs canceled, forfeited or expired
 
—

 
—

 
—

 
—

RSUs outstanding at end of period:
 
169,807

 
31,563

 
169,807

 
31,563

 
 
 
 
 
 
 
 
 
Restricted common stock awards outstanding at beginning of period:
 
48,160

 
20,000

 
48,160

 
20,000

Restricted common stock granted
 
6,748

 
8,160

 
6,748

 
8,160

Restricted common stock forfeited
 
—

 
—

 
—

 
—

Restricted common stock outstanding at end of period:
 
54,908

 
28,160

 
54,908

 
28,160

Note 15 – Stockholders’ Equity
(a) Dividends Declared
The following table presents cash dividends declared by our board of directors on our common stock from January 1, 2012 through June 30, 2013:
Declaration Date
 
Record Date
 
Payment Date
 
Dividend Per
Share
June 17, 2013
 
June 28, 2013
 
July 31, 2013
 
$
0.70

March 18, 2013
 
March 28, 2013
 
April 30, 2012
 
$
0.70

December 14, 2012
 
December 31, 2012
 
January 31, 2013
 
$
1.05

September 14, 2012
 
September 28, 2012
 
October 31, 2012
 
$
0.85

June 12, 2012
 
June 29, 2012
 
July 31, 2012
 
$
0.75

March 6, 2012
 
March 31, 2012
 
April 30, 2013
 
$
0.75



31

Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
(Dollars in thousands—except per share data)
 


(b) Common Stock
The following table presents information with respect to shares of our common stock issued through public offerings from January 1, 2012 through June 30, 2013:
Share Settlement Date
 
Shares Issued
 
Gross Proceeds  Per
Share
 
Gross Proceeds  (1)
March 25, 2013
 
1,020,000

 
$
22.00

 
$
22,440

March 13, 2013
 
6,800,000

 
$
22.00

 
$
149,600

April 20, 2012
 
13,900,000

 
$
18.00

 
$
250,200

(1) 
We raised net equity capital of $22,417, $149,129, and $249,490 after offering costs of $23, $471, and $710 for the shares issued on March 25, 2013, March 13, 2013 and April 20, 2012, respectively.
(c) Preferred Stock
On September 20, 2012, we completed a public offering of 6,900,000 shares of 8.00% Series A Cumulative Redeemable Perpetual Preferred Stock, liquidation preference $25.00 per share, par value $0.01 per share (or, Preferred Stock) at the price of $25.00 per share for net proceeds of $166,572, after deducting the underwriting discount and expenses payable by us of approximately $5,928. Holders of our Preferred Stock are entitled to receive dividends at an annual rate of 8.00% of the liquidation preference of $25.00 per share, or $2.00 per share per annum. These dividends are cumulative and payable quarterly in arrears. Generally, we may not redeem the Preferred Stock until September 20, 2017, except under certain limited circumstances intended to preserve our qualification as a REIT and upon the occurrence of a change in control as defined in the final prospectus supplement related to the Preferred Stock filed with the SEC on September 17, 2012. After September 20, 2017, we may, at our option, redeem the shares at a redemption price of $25.00, plus any accrued unpaid distribution through the date of the redemption. Upon assessing the characteristics of the Preferred Stock, we determined that such instruments are distinguished as equity instruments.
(d) Shelf Registration
On July 23, 2012, we filed a shelf registration statement on Form S-3 with the SEC under the Securities Act of 1933, as amended (or, the Securities Act), with respect to up to $750,000 of common stock, preferred stock, depositary shares, warrants and/or rights that may be sold by us from time to time pursuant to Rule 415 of the Securities Act. The number of shares of capital stock that may be issued pursuant to this registration statement is limited by the number of shares of capital stock authorized but unissued under our charter. This registration statement was declared effective by the SEC on August 10, 2012 and at June 30, 2013, we had $405,460 available under this shelf registration statement.
(e) Direct Stock Purchase and Dividend Reinvestment Plan
On November 13, 2012, we filed a Registration Statement on Form S-3 with the SEC under the Securities Act reserving 2,000,000 shares of common stock available under the terms of our Direct Stock Purchase and Dividend Reinvestment Plan (or, Stock Purchase Plan). Under the Stock Purchase Plan, stockholders who participate may purchase shares of our common stock directly from us. Stockholders may also automatically reinvest all or a portion of their dividends for additional shares of our stock. During the six months ended June 30, 2013, all shares issued to Stock Purchase Plan participants were purchased in the open market by the Stock Purchase Plan administrator.



32



Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements (Unaudited)
(Dollars in thousands—except per share data)
 


Note 16 – Earnings per Common Share
The following table presents basic and diluted net earnings per share of common stock using the two-class method for the periods presented:
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2013
 
2012
 
2013
 
2012
Numerator:
 
 
 
 
 
 
 
 
Net Income/(Loss)
 
$
(72,767
)
 
$
26,400

 
$
(67,427
)
 
$
46,520

Less:
 
 
 
 
 
 
 
 
Preferred Stock dividends declared
 
3,450

 
—

 
6,900

 
—

Dividends, dividend equivalents and undistributed earnings allocated to participating securities
 
139

 
55

 
273

 
141

Net income/(loss) allocable to common stock – basic and diluted
 
$
(76,356
)
 
$
26,345

 
$
(74,600
)
 
$
46,379

Denominator:
 
 
 
 
 
 
 
 
Weighted average common shares outstanding for basic and diluted earnings per share (1)
 
31,995,321

 
21,257,489

 
28,858,241

 
15,759,612

Earnings/(Loss) per common share - basic and diluted
 
$
(2.39
)
 
$
1.24

 
$
(2.59
)
 
$
2.94

(1) 
For the three and six months ended June 30, 2013, we had an aggregate of 166,557 RSUs and 33,776 shares of restricted stock which were not included in the calculation of earnings per common share, as their inclusion would have been anti-dilutive. These instruments may have a dilutive impact on future EPS.


33




ITEM 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations.
(Dollars in thousands, except share and per share data or as otherwise noted)
FORWARD-LOOKING INFORMATION
We make forward-looking statements in this Quarterly Report on Form 10-Q and will make forward-looking statements in future filings with the SEC, press releases or other written or oral communications within the meaning of Section 27A of the Securities Act and Section 21E of the Securities Exchange Act of 1934, as amended (or, the Exchange Act). For these statements, we claim the protections of the safe harbor for forward-looking statements contained in such Section. Forward-looking statements are subject to substantial risks and uncertainties, many of which are difficult to predict and are generally beyond our control. These forward-looking statements include information about possible or assumed future results of our business, financial condition, liquidity, results of operations, plans and objectives. When we use the words “believe,” “expect,” “anticipate,” “estimate,” “plan,” “continue,” “intend,” “should,” “may,” or similar expressions, we intend to identify forward-looking statements. Statements regarding the following subjects, among others, may be forward-looking: market trends in our industry, interest rates, real estate values, the debt securities markets, the U.S. housing market or the general economy or the demand for residential mortgage loans; our business and investment strategy; our operating results and potential asset performance; actions and initiatives of the U.S. Government and changes to U.S. Government policies and the execution and impact of these actions, initiatives and policies; the state of the U.S. economy generally or in specific geographic regions; economic trends and economic recoveries; our ability to obtain and maintain financing arrangements, including securitizations; the favorable Agency RMBS return dynamics available; the level of government involvement in the U.S. mortgage market; the anticipated default rates on non-Agency RMBS; the return of the non-Agency RMBS securitization market; general volatility of the securities markets in which we participate; changes in the value of our assets; our expected portfolio of assets; our expected investment and underwriting process; interest rate mismatches between our target assets and any borrowings used to fund such assets; changes in interest rates and the market value of our target assets; prepayment speeds on our target assets; effects of hedging instruments on our target assets; rates of default or decreased recovery rates on our target assets; the degree to which our hedging strategies may or may not protect us from interest rate volatility; the impact of and changes in governmental regulations, tax law and rates, accounting guidance and similar matters; our ability to maintain our qualification as a REIT for U.S. federal income tax purposes; our ability to maintain our exclusion from registration as an investment company under the 1940 Act; availability of opportunities to acquire Agency RMBS, non-Agency RMBS, residential mortgage loans and other residential mortgage assets; availability of qualified personnel; estimates relating to our ability to make distributions to our stockholders in the future; and our understanding of our competition.
The forward-looking statements are based on our beliefs, assumptions and expectations of our future performance, taking into account all information currently available to it. Forward-looking statements are not predictions of future events. These beliefs, assumptions and expectations can change as a result of many possible events or factors, not all of which are known to us. See Item “1A - Risk Factors” of our annual report on Form 10-K for the year ended December 31, 2012. These and other risks, uncertainties and factors, including those described in the annual, quarterly and current reports that we file with the SEC, could cause our actual results to differ materially from those included in any forward-looking statements we make. All forward-looking statements speak only as of the date they are made. New risks and uncertainties arise over time and it is not possible to predict those events or how they may affect us. Except as required by law, we are not obligated to, and do not intend to, update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
The following discussion should be read in conjunction with our consolidated financial statements and the accompanying notes to our consolidated financial statements, which are included in Item 1 of this Quarterly Report on Form 10-Q, as well as the information contained in our annual report on Form 10-K filed for the year ended December 31, 2012.
General
We were incorporated in Maryland on March 15, 2011 and began operations on July 27, 2011. We are structured as a holding company and conduct our business primarily through ARM Operating, LLC and our other operating subsidiaries. We have elected and operate to qualify as a REIT for U.S. federal income tax purposes commencing with our taxable year ended December 31, 2011. We also operate our business in a manner that we believe will allow us to remain excluded from registration as an investment company under the 1940 Act. We are externally managed and advised by our Manager, an indirect subsidiary of Apollo Global Management, LLC.


34


We invest on a leveraged basis in residential mortgage and related assets in the United States. At June 30, 2013, our portfolio was comprised of: (i) Agency RMBS, which include pass-through securities (whose underlying collateral includes fixed-rate mortgages), Agency IOs and Agency Inverse IOs, (ii) non-Agency RMBS and (iii) securitized mortgage loans.
Over time, we expect that we may invest in other residential mortgage related assets included in our target assets. (See “Target Assets,” below.) At June 30, 2013, we had $2,552,056 of Agency RMBS, $751,024 of non-Agency RMBS and $110,278 of securitized mortgage loans.
We use leverage as part of our business strategy in order to increase potential returns to our stockholders and not for speculative purposes. The amount of leverage we choose to employ for particular assets will depend upon our Manager’s assessment of a variety of factors, which include the availability of particular types of financing and our Manager’s assessment of the credit, liquidity, price volatility and other risks inherent in those assets and the creditworthiness of our financing counterparties.
We use derivatives to hedge a portion of our interest rate risk. As of June 30, 2013, our derivatives included Swaps, Swaptions and TBA Shorts. We do not enter into derivative instruments for speculative purposes.
Factors Impacting Our Operating Results
Our results of operations are primarily driven by, among other things, our net interest income, changes in the market value of our investments and interest rate derivatives and realized gains and losses on the sale of our investments and, from time to time termination of our interest rate derivative contracts. The supply and demand for RMBS in the market place, the terms and availability of financing for our RMBS, general economic and real estate conditions, the impact of U.S Government actions that impact the real estate and mortgage sector and the credit performance of our non-Agency RMBS impact our overall performance. Our net interest income varies primarily as a result of changes in market interest rates and the slope of the yield curve (i.e., the differential between long-term and short-term interest rates) and the constant prepayment speeds (or, CPR) on our RMBS. The CPR measures the amount of unscheduled principal prepayments on an RMBS as a percentage of the principal balance, and includes the conditional repayment rate (or, CRR), which measures voluntary prepayments of mortgages collateralizing a particular RMBS and conditional default rates (or, CDR), which measures involuntary prepayments resulting from defaults of the underlying mortgage loans. CPRs vary according to the type of investment, conditions in the financial markets, competition and other factors, none of which can be predicted with any certainty. In addition, our borrowing costs and available credit are further affected by the collateral pledged and general conditions in the credit market.
With respect to our results of operations and financial condition, increases in interest rates are generally expected to cause: (i) the interest expense associated with our borrowings to increase; (ii) the value of our pass-through Agency RMBS and Agency Inverse IO securities to decline; (iii) coupons on our variable rate non-Agency RMBS to reset to higher interest rates; (iv) prepayments on our RMBS to decline, thereby slowing the amortization of our Agency RMBS purchase premiums and the accretion of purchase discounts on our non-Agency RMBS; (v) the value of our Agency IO securities and TBA Shorts to increase; and (vi) the performance of our Swaps and Swaptions to improve. Conversely, decreases in interest rates are generally expected to have the opposite impact as those stated above. The timing and extent to which interest rates change, the specific terms of the mortgage loans underlying our RMBS, such as periodic and life-time caps and floors on ARMs as well as other conditions in the market place will further impact our results of operations and financial condition. In addition, in periods with low interest rates, such as the current environment, the impact of decreases in interest rates may be limited, given that we do not foresee interest rates decreasing to zero.
Premiums arise when we purchase a security at a price in excess of the security’s par value and discounts arise when we purchase a security at a price below the security’s par value. Premiums on our RMBS are amortized against interest income over the life of the security, while discounts (excluding credit discounts, as discussed below) are accreted to income over the life of the security. The speeds at which premiums are amortized and discounts are accreted are significantly impacted by the CPR for each security. CPR levels are impacted by, among other things, conditions in the housing market, new regulations, government and private sector initiatives, interest rates, availability of credit to home borrowers, underwriting standards and the economy in general. CPRs on Agency RMBS and non-Agency RMBS may differ significantly.
We are exposed to credit risk with respect to our non-Agency RMBS portfolio, associated with delinquency, default and foreclosure and any resulting losses on disposing of the real estate underlying such securities. (See Quantitative and Qualitative Disclosures about Market Risk – Credit Risk, included under Item 3 of Part I of this Quarterly Report on Form 10-Q.) The credit risk on our non-Agency RMBS is generally mitigated by the credit support built into non-Agency RMBS structures and the purchase discounts on such securities, which provides a level of credit protection in the event that we receive less than 100% of the par value of these securities. To date we purchased all of our non-Agency RMBS at a discount to par value; a portion such discount may be viewed as a credit discount, which is not expected to be amortized into interest income. The


35


amount designated as credit discount on a security may change over time based on the security’s performance and its anticipated future performance.
Our non-Agency RMBS investment process involves analysis focused primarily on quantifying and pricing credit risk. Interest income on our non-Agency RMBS is recorded at an effective yield, which reflects an estimate of expected cash flows for each security. In forecasting cash flows on our non-Agency RMBS, our Manager makes certain assumptions about the underlying mortgage loans which assumptions include, but are not limited to, future interest rates, voluntary prepayment speeds, default rates, modifications and loss severities. As part of our non-Agency RMBS surveillance, we review, on at least a quarterly basis, each security’s performance. To the extent that actual performance and our current assessment of future performance differs from our prior assessment, such changes are reflected in the yield/income recognized on such securities prospectively. Credit losses greater than those anticipated or in excess of purchase discount on a given security could occur, which could materially adversely impact our operating results.
We receive interest payments only with respect to the notional amount of Agency IOs and Agency Inverse IOs. Therefore, the performance of such instruments is extremely sensitive to prepayments on the underlying pool of mortgages. Unlike Agency pass-through RMBS, the market prices of Agency IOs generally have a positive correlation to increases in interest rates. Generally, as market interest rates increase, prepayments on the mortgages underlying an Agency IO are generally expected to decrease, which in turn is expected to extend/increase the cash flow and the value of such securities; we expect the inverse to occur with respect to decreases in market interest rates. In addition to viewing Agency IOs as attractive investments, we also consider such instruments as an economic hedge against the impact that an increase in market interest rates would have on the value of our Agency RMBS in the marketplace. While Agency IOs and Agency Inverse IOs comprised a relatively small portion of our investments at June 30, 2013, the value of and return on such instruments are highly sensitive to changes in interest rates and prepayments.
Target Assets
As of June 30, 2013, we held investments in Agency RMBS, including Agency IOs and Agency Inverse IOs, non-Agency RMBS and securitized mortgage loans. In the future we may invest in assets other than our target assets listed below, in each case subject to maintaining our qualification as a REIT for U.S. federal income tax purposes and our exclusion from registration as an investment company under the 1940 Act. The following is a summary of our target assets:
Asset Classes
  
Principal Assets
 
 
Agency RMBS
  
Agency RMBS, primarily comprised of whole pool RMBS, collateralized mortgage obligations, Agency IO, Agency Inverse IO and Agency principal-only (or, Agency PO) securities.
 
 
Non-Agency RMBS
  
Non-Agency RMBS, including highly rated, as well as non-investment grade and unrated, tranches backed by Alt-A mortgage loans, Option ARMs, subprime mortgage loans and prime mortgage loans.
 
 
Residential Mortgage Loans
  
Prime mortgage loans, jumbo mortgage loans, Alt-A mortgage loans, Option ARMs and subprime mortgage loans. These mortgages may be performing, sub-performing or non-performing.
 
 
Other Residential Mortgage Assets
  
Non-Agency RMBS comprised of interest-only (or, non-Agency IO), principal-only (or, non-Agency PO), floating rate inverse interest-only (or, non-Agency Inverse IO), and floating rate securities, and other Agency and non-Agency RMBS derivative securities, as well as other financial assets, including, but not limited to, common stock, preferred stock and debt of other real estate-related entities, mortgage servicing rights (or, MSRs), and excess MSRs.



36


Financing Strategy
We use leverage primarily for the purpose of financing our investment portfolio and increasing potential returns to our stockholders and not for speculative purposes. The amount of leverage we choose to employ for particular assets will depend upon a variety of factors, which include the availability of particular types of financing and our Manager’s assessment of the credit, liquidity, price volatility and other risks inherent in those assets and the creditworthiness of our financing counterparties. We had aggregate debt-to-equity of 5.2 times at June 30, 2013, which included net repurchase agreement borrowings of $990,973 on unsettled sales of RMBS. Had such sales and purchases settled at June 30, 2013, our debt-to-equity multiple would have been 3.9 times, reflecting the net reduction in our repurchase borrowings upon settlement. Our debt-to-equity multiple reflects the aggregate of our borrowings under repurchase agreements and securitized debt to our total stockholders’ equity.
We continue to have available capacity under our master repurchase agreements. However, such agreements are generally uncommitted and are renewable at the discretion of our lenders. During the six months ended June 30, 2013, we financed our Agency RMBS with repurchase agreements generally targeting, in the aggregate, a debt-to-equity ratio of approximately eight-to-one leverage and financed our non-Agency RMBS with repurchase agreements generally targeting, in the aggregate, a debt-to-equity ratio of approximately three-to-one leverage. The terms of our repurchase agreements are typically one to six months at inception, but in some cases may have initial terms that are shorter or longer. Beginning in late April, we were able to extend certain of our repurchase borrowings collateralized by non-Agency RMBS with terms up to 18 months. At June 30, 2013, we had master repurchase agreements with 23 counterparties and, as a matter of routine business may have discussions with additional financial institutions with respect to expanding our repurchase agreement capacity. As of June 30, 2013, we had $3,945,097 of borrowings outstanding under our repurchase agreements with 19 counterparties collateralized by $3,339,925 of Agency RMBS, and $780,578 of non-Agency RMBS, which includes $44,834 of non-Agency RMBS that are eliminated from our balance sheet in consolidation with a VIE. (See Notes 8 and 9 to the consolidated financial statements, included under Item 1 in this Quarterly Report on Form 10-Q.)
In February 2013, in connection with our purchase of a pool of performing and re-performing mortgage loans, we engaged in a securitization transaction. One objective of this transaction, as well as potential future securitization transactions, is to obtain permanent non-recourse financing on the underlying securitized assets with more favorable terms than those available on whole loans. For financial statement reporting purposes, the sale of the senior security created in the securitization is presented on our consolidated balance sheet as non-recourse securitized debt, which is in effect collateralized by the securitized mortgage loans. (See Notes 5 and 13 to the consolidated financial statements, included under Item 1 in this Quarterly Report on Form 10-Q.)
In addition to repurchase borrowings and securitized debt, subject to market conditions, we may utilize other sources of leverage in the future, including, but not limited to, securitized debt associated with resecuritizations, warehouse facilities, bank credit facilities (including term loans and revolving facilities), and public and private equity and debt issuances, in addition to transaction or asset-specific funding arrangements. Our future use of these alternative forms of financing is subject to market conditions.
Hedging Strategy
Subject to maintaining our qualification as a REIT for U.S. federal income purposes, we pursue various hedging strategies with the objective of reducing our exposure to increases in interest rates. The U.S. federal income tax rules applicable to REITs may necessitate that we implement certain of these techniques through a domestic TRS that is fully subject to federal and state income taxation. Our hedging activity may vary in scope based on the level and volatility of interest rates, the type of assets held and other changing market conditions.
We use interest rate derivatives, primarily comprised of Swaps and Swaptions, to mitigate the effects of increases in interest rates on a portion of our future repurchase borrowings and decreases in the value of our Agency RMBS portfolio. As of June 30, 2013, we had Swaps with a notional of $2,032,000 with a weighted average fixed pay rate of 1.48% and a weighted average term to maturity of 6.4 years. Our Swaps have the economic effect of modifying the repricing characteristics on repurchase borrowings equal to the aggregate notional balance of the Swaps. Pursuant to our Swaps, we pay a fixed rate of interest and receive a variable rate of interest, generally based on three-month LIBOR, on the notional amount of the Swap. Our Swaptions provide that at the expiration of the option period, we: (i) may enter into a Swap under which we would pay a fixed interest rate and receive a variable rate of interest on the notional amount or (ii) cash settle if the Swaption is in-the-money. The method of settlement at expiration of the option period is prescribed in each Swaption confirmation. At June 30, 2013, we held Swaptions with an aggregate notional of $775,000. In June 2013, we entered into TBA Shorts, with an aggregate notional balance of $325,000, which provide that we settle such contracts at their maturity date of August 12, 2013 by either delivering the Agency RMBS as specified in the contract or net settle such contracts, whereby we would either pay or receive an amount equal to the fair value of the contract. TBA Shorts serve as an economic hedge against decreases in the value of


37


Agency RMBS held in our portfolio, in an amount equivalent to the TBA Contract notional, with the same characteristics as those stipulated in the TBA Contract. (See Note 10 to the consolidated financial statements, included under Item 1 in this Quarterly Report on Form 10-Q.) For U.S. federal income tax purposes, although the law is not clear with respect to such transactions, we intend to take the position that settling such TBA Shorts will be treated as resulting in a gain or loss on the disposition of the securities delivered for purpose of the REIT 75% and 95% gross income tests. In addition, we may also engage in TBA Shorts or other TBA transactions that we identify as a hedge of indebtedness incurred or to be incurred to acquire real estate assets in which case any gain recognized in connection with net settling such a contract would not constitute gross income for purposes of the REIT 75% and 95% gross income tests.
To date, we have not elected to apply hedge accounting for our derivatives and, as a result, we record changes in the estimated fair value of such instruments along with the associated net Swap interest in earnings, as a component of the net gain/(loss) on derivatives instruments in our consolidated statement of operations.
Beginning June 10, 2013, certain Swap trades were required to be cleared through a clearinghouse, in accordance with the new Commodities Futures Trading Commission (or, CFTC) Swap clearing rules. Swaps cleared through the CFTC generally require that higher initial margin collateral be posted relative to Swaps cleared with individual counterparties. Through June 30, 2013, we did not enter into Swaps that were subject to CFTC clearing. The change in Swap margin collateral requirement may, in effect, increase the inherent cost of future Swaps, as we will be required to pledge higher amounts of cash to meet the initial margin requirement on such instruments. We cannot predict with any certainty the amount of our future Swap additions and, accordingly, the amount of collateral we will be required to pledge.
The following table presents information about our Swaps as of June 30, 2013:
Table 1
 
 
 
 
 
 
Remaining Interest Rate Swap Term
 
Notional Amount
 
Average Fixed  Pay
Rate
 
Average
Maturity
(Years)
> Three to five years
 
$
1,159,000

 
1.06
%
 
4.1

> Five to ten years
 
873,000

 
2.04
%
 
9.5

Total
 
$
2,032,000

 
1.48
%
 
6.4

Critical Accounting Policies and Use of Estimates
Our accounting policies are described in Note 2 to the consolidated financial statements, included under Item 1 in this Quarterly Report on Form 10-Q. A summary of our critical accounting policies is set forth in our annual report on Form 10-K for the year ended December 31, 2012 under Part II, Item 7 – Management Discussion and Analysis – Critical Accounting Policies.
Recent Market Conditions and Our Strategy during the Quarter Ended June 30, 2013
General:
The second quarter of 2013 began with a continuation of the decrease in interest rates that started in mid-March 2013. A weak non-farm payroll report for March 2013, that was announced in early April 2013, served as a catalyst for interest rates to retrace their first quarter rise, and by the end of April 2013 the ten-year U.S. Treasury (or, Treasury) note was yielding 1.70%. However, in early May 2013 a much stronger than consensus estimate for the April 2013 non-farm payroll report caused market interest rates to start increasing.
The increase in interest rates gathered momentum over the course of May 2013 as market participants became increasingly concerned about the Federal Open Markets Committee (or, FOMC) potentially tapering purchases of Treasuries and Agency RMBS, a component of the FOMC's third round of quantitative easing known as “QE3”. FOMC Chairman Bernanke's testimony to Congress at the end of May 2013, rather than stabilizing markets as many participants hoped, resulted in additional volatility as his testimony was generally viewed as reflecting a belief that there was underlying strength in the economy, thereby implying support for tapering of bond purchases earlier than previously expected.
The negative tone in the fixed-income market continued following another stronger than consensus non-farm payroll report released in June 2013, which caused Treasury bonds to sell off further. Interest rates continued their upward climb during the second quarter of 2013 following both the release of the FOMC statement from its June 2013 meeting and comments made by FOMC Chairman Bernanke, regarding the potential timing of tapering for bond purchases. From the near-term low in rates on May 2, 2013 to the peak on June 25, 2013, the ten-year Treasury note rate increased 94 basis points from 1.66% to


38


2.60%. The ten-year Treasury note rate ended the June 30, 2013 quarter slightly lower at 2.52%, as a result of follow up commentary by several FOMC Governors stating that the market had severely misunderstood Chairman Bernanke's testimony.
During the second quarter of 2013, the fixed income market sold off heavily, negatively impacting the value of Agency RMBS. While market yields on Treasury notes and Swaps increased during the second quarter of 2013, the magnitude of changes in market yields on Agency RMBS increased to an even greater extent. This caused our Agency RMBS prices to decline considerably more than our Swap valuations increased, negatively impacting the value of our portfolio, as reflected in the net loss for the three and six months ended June 30, 2013.
Amid this backdrop of extreme and rapid changes in the fixed income market during the second quarter of 2013, we rebalanced our investment portfolio aimed at reducing our net portfolio duration (or, the price sensitivity to changes in RMBS yields relative to other benchmark interest rates, such as Swaps and Swaptions), increasing liquidity in light of market volatility and taking advantage of market opportunities to invest in non-Agency RMBS. To achieve these objectives, we sold certain of our Agency RMBS, increased our aggregate positions in longer term fixed-pay Swaps and Swaptions, added short positions in Agency TBAs, reduced leverage and increased our purchases of non-Agency RMBS.
Our book value per common share was $18.63 at June 30, 2013 compared to $21.72 at March 31, 2013. This decline in book value primarily reflects the net impact of $126,786, $66,872, and $8,036 of depreciation in the value of or Agency RMBS, realized losses on sales of Agency RMBS and depreciation in the value of our non-Agency RMBS, respectively, which losses were partially off-set by net unrealized appreciation in our Swap and Swaptions of $80,601.
Agency RMBS Portfolio/Interest Rate Hedges:
As a result of the market movements described above, the emphasis on mitigating prepayment risk for Agency RMBS was replaced with concerns over the acceleration of the timing of tapering of the FOMC security purchase program and extension risk. Accordingly, Agency RMBS valuations moved with magnified sensitivity to interest rates. As a result of these concerns around the extension risk, specified pools, in which we have significant holdings, fell further than generic pools, as mortgage spreads widened and specified pool values contracted sharply. During the second quarter of 2013, we sold $2,210,911 of Agency RMBS and increased our net Swap and Swaption positions by $375,000 of notional amount, while extending the terms, and added an aggregate notional balance of $325,000 in TBA Shorts.
The table below presents the composition of sales from our Agency RMBS portfolio, which does not include accrued interest, during the quarter ended June 30, 2013:
Table 2
 
 
 
 

 
Sale Price (1)
 
Net Realized Loss
30- Year Mortgages:
 
 
 
 
3.5% Coupon
 
$
1,339,624

 
$
(55,675
)
4.0% Coupon
 
548,230

 
(4,438
)
4.5% Coupon
 
190,924

 
9,252

5.0% Coupon
 
19,131

 
916

 
 
2,097,909

 
(49,945
)
15-Year Mortgages
 
64,375

 
956

20-Year Mortgages
 
34,343

 
(215
)
Agency IOs
 
—

 
—

Agency IIOs
 
14,284

 
254

Total Agency RMBS sold
 
$
2,210,911

 
$
(48,950
)
(1) 
Includes $977,726 of Agency RMBS which were sold but unsettled at June 30, 2013.


39


The following table presents the composition of our Agency RMBS portfolio at June 30, 2013 compared to March 31, 2013:
Table 3
 
June 30, 2013
 
March 31, 2013
 
 
Principal Balance
 
Amortized Cost
 
Estimated Fair Value
 
Principal Balance
 
Amortized Cost
 
Estimated Fair Value
30-Year Mortgages:
 
 
 
 
 
 
 
 
 
 
 
 
3.5% Coupon
 
$
793,628

 
$
846,575

 
$
805,988

 
$
1,757,588

 
$
1,869,086

 
$
1,863,750

4.0% Coupon
 
1,551,118

 
1,688,425

 
1,620,521

 
1,841,597

 
1,996,008

 
2,002,782

4.5% & 5.0% Coupons
 
46,239

 
49,848

 
49,419

 
240,651

 
255,651

 
266,438

 
 
2,390,985

 
2,584,848

 
2,475,928

 
3,839,836

 
4,120,745

 
4,132,970

15-20 Year Mortgages:
 
 
 
 
 
 
 
 
 
 
 
 
3.0% Coupon
 
—

 
—

 
—

 
22,236

 
23,216

 
23,588

3.5% Coupon
 
—

 
—

 
—

 
72,565

 
76,915

 
77,475

 
 
—

 
—

 
—

 
94,801

 
100,131

 
101,063

Agency IOs
 
—

 
27,797

 
30,184

 
—

 
7,889

 
7,974

Agency Inverse IOs
 
—

 
52,101

 
45,944

 
—

 
57,488

 
57,557

Total Agency RMBS
 
$
2,390,985

 
$
2,664,746

 
$
2,552,056

 
$
3,934,637

 
$
4,286,253

 
$
4,299,564

The following table presents information with respect to our Swaps and Swaptions at June 30, 2013 compared to March 31, 2013 and December 31, 2012:
Table 4
 
June 30, 2013
 
March 31, 2013
 
December 31,
2012
Swaps:
 
 
 
 
 
 
Notional amount
 
$
2,032,000

 
$
2,207,000

 
$
1,500,000

Estimated fair value
 
$
47,609

 
$
(24,104
)
 
$
(23,184
)
Weighted average fixed pay rate
 
1.48
%
 
1.39
%
 
1.20
%
Weighted average term to maturity (years)
 
6.4
 
6.2

 
5.3

 
 
 
 
 
 
 
Swaptions:
 
 
 
 
 
 
Notional amount
 
$
775,000

 
$
225,000

 
$
75,000

Estimated fair value
 
$
18,447

 
$
1,641

 
$
750

Weighted average term to expiration (months)
 
11
 
10
 
10

Weighted average underlying Swap term (years)
 
10.0
 
10.0
 
10.0

Weighted average underlying Swap fixed pay rate
 
3.37
%
 
2.99
%
 
2.65
%
For the second quarter of 2013, our Agency RMBS portfolio had a fair value weighted CPR of 7.1% comprised of 6.9% CPR on Agency pass-through securities and 20.0% on Agency IO and Agency Inverse IO securities, in the aggregate. During the quarter, the maximum average monthly CPR of our Agency RMBS was experienced in May 2013, with an overall Agency CPR of 7.7% comprised of 7.5% on Agency pass-through securities and 21.8% on Agency IO and Agency Inverse IO securities in the aggregate. During the second quarter, generic fixed-rate Fannie Mae RMBS prepaid at 23.9% CPR in the aggregate, with a high of 25.1% experienced in May 2013.
Non-Agency RMBS:
While the net change in non-Agency valuations comparing June 30, 2013 to March 31, 2013 appear more muted than Agency RMBS, non-Agency bonds experienced significant volatility during the quarter despite positive home price appreciation reports. We shifted a greater portion of our equity into non-Agency RMBS, as volatility, particularly in June 2013, provided an investment opportunity for such securities. We invested $186,464 in non-Agency RMBS with a weighted average unleveraged yield of 5.05% during the second quarter.
Performance of the non-Agency RMBS portfolio remained stable during the second quarter, with voluntary prepayments ranging between 4.2% to 4.4% CRR. At June 30, 2013, approximately 58% of our non-Agency portfolio was comprised of securities that we receive both principal and interest on a monthly basis and approximately 42% were seasoned securities, on which


40


we currently receive interest only, and we will receive principal after the more senior securities in the capital structure are paid off.
Borrowings:
On the funding side, interest expense related to our repurchase agreements remained relatively unchanged during the second quarter of 2013 compared to the first quarter of 2013.
In connection with our sales of Agency RMBS, we repaid repurchase borrowings, as reflected in our lower repurchase borrowing balance of $3,945,097 at June 30, 2013, compared to $4,343,341 at March 31, 2013. At June 30, 2013 we had an aggregate debt-to-equity leverage multiple of 5.2 times, which was further reduced when our June RMBS trades settled in early July. Had all of our June sales and purchases of RMBS settled in June, our debt-to-equity multiple would have been 3.9 times at June 30, 2013, reflecting the simultaneous repayment of borrowings under our repurchase agreements.
Results of Operations
Three Months Ended June 30, 2013 compared to the Three Months Ended June 30, 2012
For the three months ended June 30, 2013, we had a net loss allocable to common stock of $76,217, or a loss of $2.39 per basic and diluted common share, compared to net income available to common and participating securities of $26,400, or $1.24 per basic and diluted common share for the three months ended June 30, 2012. Our results of operations for the three months ended June 30, 2013 were significantly impacted by steep declines in the value of our Agency RMBS portfolio and declines in the value of our non-Agency RMBS portfolio, of which $47,508 were realized on sales, which were partially offset by increases in the value of our derivatives. (See “Recent Market Conditions and Our Strategy during the Quarter Ended June 30, 2013,” above.)
Net Interest Income
Interest rate spread and net interest margin are key performance metrics for us, as our core performance is significantly driven by net interest income. Interest rate spread measures the difference between the yield on interest-earning assets and the cost of interest-bearing liabilities, while net interest margin reflects net interest income divided by average interest-earning assets. We had an interest rate spread and net interest margin of 2.69% and 2.77% for the three months ended June 30, 2013, respectively, compared to 2.77%, and 2.87%, respectively, for the three months ended June 30, 2012.
The increase in our interest income and interest expense, discussed below, was primarily driven by the significant growth in our investments and borrowings resulting from our investment, on a leveraged basis, of incremental capital raised since the second quarter of 2012. For the three months ended June 30, 2013 and June 30, 2012, we earned interest income of $41,329 and $21,990, respectively, and incurred interest expense of approximately $7,237 and $2,871, respectively, which was primarily related to our borrowings under repurchase agreements. In connection with our February 2013 securitization transaction, we had securitized debt with a contractual balance of $47,353 at June 30, 2013 and a fixed stated interest rate of 4.00%. Costs associated with our securitization are amortized as a component of interest expense; as a result, our securitized debt had a cost of 4.22% for the three months ended June 30, 2013.
Our interest income was positively impacted by slower prepayment speeds on Agency RMBS, which improved yields on such portfolio for the three months ended June 30, 2013. Actual prepayments and changes in expectations about prepayment rates, which reflect market fundamentals at the time of assessment, may cause future premium amortization on our Agency RMBS to vary significantly over time. In addition, changes in the performance, or performance expectations, with respect to our non-Agency RMBS may significantly impact the amount of income recognized in future periods on such investments.


41


The following table presents certain information regarding our interest-earning assets, interest-bearing liabilities and the components of our net interest income for the three months ended June 30, 2013 and 2012:
Table 5
 
Three Months Ended
 
 
June 30, 2013
 
June 30, 2012
 
 
Agency
 
Non-Agency
 
Securitized
Mortgage
Loans
 
Total
 
Agency
 
Non-Agency
 
Total
Average balance (1)
 
$
4,167,139

 
$
589,969

 
$
111,257

 
$
4,868,365

 
$
2,362,290

 
$
274,200

 
$
2,636,490

Total interest income
 
$
28,388

 
$
10,644

 
$
2,297

 
$
41,329

 
$
14,016

 
$
7,974

 
$
21,990

Yield on average assets
 
2.69
%
 
7.14
%
 
8.16
%
 
3.36
%
 
2.35
%
 
11.51
%
 
3.30
%
Average balance of repurchase agreements
 
$
3,762,949

 
$
497,650

 
$
—

 
$
4,260,599

 
$
1,995,103

 
$
197,765

 
$
2,192,868

Average balance of securitized debt
 
$
—

 
$
—

 
$
48,271

 
$
48,271

 
$
—

 
$
—

 
$
—

Total interest expense
 
$
4,048

 
$
2,681

 
$
508

 
$
7,237

 
$
1,913

 
$
958

 
$
2,871

Average cost of funds (2) (3)
 
0.43
%
 
2.16
%
 
4.22
%
(4) 
0.67
%
 
0.38
%
 
1.94
%
 
0.53
%
Net interest income
 
$
24,340

 
$
7,963

 
$
1,789

 
$
34,092

 
$
12,103

 
$
7,016

 
$
19,119

Net interest rate spread
 
2.26
%
 
4.98
%
 
3.94
%
 
2.69
%
 
1.97
%
 
9.57
%
 
2.77
%
Total interest expense including net interest cost of Swaps (5)
 
$
10,352

 
$
2,814

 
$
508

 
$
13,674

 
$
3,675

 
$
958

 
$
4,633

Average cost of funds including net interest cost of Swaps (5)
 
1.10
%
 
2.27
%
 
4.22
%
 
1.27
%
 
0.73
%
 
1.94
%
 
0.84
%
Net interest income including net interest cost of Swaps
 
$
18,036

 
$
7,830

 
$
1,789

 
$
27,655

 
$
10,341

 
$
7,016

 
$
17,357

Effective net interest rate spread (5)
 
1.59
%
 
4.87
%
 
3.94
%
 
2.09
%
 
1.62
%
 
9.57
%
 
2.46
%
(1) 
Amount reflects amortized cost, which does not include changes in unrealized gains and losses.
(2) 
Cost of funds by investment type is based on the underlying investment type of the RMBS assigned as collateral.
(3) 
Cost of funds does not include accrual and settlement of interest associated with derivative instruments. In accordance with GAAP, those costs are included in gain/(loss) on derivative instruments in our consolidated statements of operations.
(4) 
The average cost of funds for the securititized mortgage loans only reflects the cost of our securitized debt. We have repurchase agreement borrowings collateralized by one of the subordinate securitities that we retained in the securitization transaction. These subordinate bonds do not appear on our financial statements, as they are eliminated in consolidation. The corresponding repurchase borrowings and related interest expense are included with repurchase borrowings collateralized by our non-Agency RMBS.
(5) 
See Table 6 below and Tables 19 and 20 included under “Non-GAAP Financial Measures.”


42


The following table presents information with respect to our borrowing costs and effective cost of funds by type of collateral pledged for the three months ended June 30, 2013 and June 30, 2012:
Table 6
 
Three Months Ended
  
 
June 30, 2013
 
June 30, 2012
Collateral Pledged
 
Cost of
Funds
 
Effective
Cost  of
Funds (1)
 
Cost of
Funds
 
Effective
Cost  of
Funds (1)
Agency
 
0.43
%
 
1.10
%
 
0.38
%
 
0.73
%
Non-Agency (1)
 
2.16

 
2.27

 
1.94

 
1.94

Securitized mortgage loans (2)
 
4.22

 
4.22

 
—

 
—

Total
 
0.67
%
 
1.27
%
 
0.53
%
 
0.84
%
 
(1) 
The effective cost of funds for the periods presented are calculated on an annualized basis and include interest expense for the periods and the net interest component for Swaps during the periods of $6,437 and $1,762, respectively. While we have not elected to apply hedge accounting for our Swaps, we view such instruments as an economic hedge against the impact of increases in interest rates on our borrowing costs. See “Non-GAAP Financial Measures” below, including Tables 19 and 20.
The repurchase borrowings associated with non-Agency RMBS that we retained in connection with our securitization are included with the cost of funds on non-Agency RMBS.
(2) 
The securitized mortgage loans, in effect, collateralize our securitized debt associated with our 2013 securitization transaction.
Swaps
Our Swaps are intended to mitigate the impact of increases in interest rates on a portion of our repurchase agreement borrowings, as they have the economic effect of modifying the repricing characteristics on repurchase borrowings equal to the aggregate notional balance of our Swaps. Pursuant to our Swaps, we pay a fixed rate of interest and receive a variable rate of interest, generally based on three-month LIBOR, on the notional amount of the Swap. In addition, we purchase Swaptions, each of which provides that, at the expiration of the option period, we: (i) may enter into a Swap under which we would pay a fixed interest rate and receive a variable rate of interest on the notional amount or (ii) cash settle if the Swaption is in-the-money. The method of settlement at expiration of the option period is prescribed in each Swaption confirmation. (See Note 10 to the consolidated financial statements, included under Item 1 in this Quarterly Report on Form 10-Q.)
While we view our Swaps as an economic hedge against increases in future market interest rates associated with our repurchase agreement borrowings, we have not elected hedge accounting under GAAP. Alternatively, we present the “effective cost of funds” to reflect our interest expense adjusted to include the interest component for our Swaps that would be reported had we elected and qualified for hedge accounting for such instruments. We believe that the presentation of our effective cost of funds, which is a non-GAAP financial measure, is useful for investors as it presents our borrowing costs as viewed by management. (See “Non-GAAP Financial Measures,” below, Table 1 above and Note 10 to the consolidated financial statements, included under Item 1 in this Quarterly Report on Form 10-Q.)


43


The following table presents our effective interest expense, effective cost of funds, effective net interest income and effective net interest rate spread, which amounts are non-GAAP financial measures as they include the net interest component of our Swaps, for three months ended June 30, 2013 and June 30, 2012: (See Tables 19 and 20, included under “Non-GAAP Financial Measures” below.
Table 7
 
Agency
 
Non-Agency
 
Securitized
Mortgage
Loans
 
Total
Three Months Ended June 30, 2013
 
 
 
 
 
 
 
 
Effective interest expense
 
$
10,352

 
$
2,814

 
$
508

 
$
13,674

Effective cost of funds
 
1.10
%
 
2.27
%
 
4.22
%
 
1.27
%
Effective net interest income
 
$
18,036

 
$
7,830

 
$
1,789

 
$
27,655

Effective net interest rate spread
 
1.59
%
 
4.87
%
 
3.94
%
 
2.09
%
Three Months Ended June 30, 2012
 
 
 
 
 
 
 
 
Effective interest expense
 
$
3,675

 
$
958

 
$
—

 
$
4,633

Effective cost of funds
 
0.73
%
 
1.94
%
 
—

 
0.84
%
Effective net interest income
 
$
10,341

 
$
7,016

 
$
—

 
$
17,357

Effective net interest rate spread
 
1.62
%
 
9.57
%
 
—

 
2.46
%
Realized and Unrealized Gain/(Loss)
During the three months ended June 30, 2013 and 2012, we sold Agency RMBS of $2,210,911 and $612,452, respectively, realizing net gains/(losses) of $(48,950) and $11,510, respectively. While we sell RMBS as part of managing our portfolio, our RMBS sales during the second quarter of 2013 were comprised primarily of Agency RMBS as we repositioned our portfolio in connection with the significant changes in the market place, as previously discussed. As we find attractive investment opportunities in non-Agency RMBS and whole loans and mortgage-related assets, we may sell additional Agency RMBS to fund such purchases. During the three months ended June 30, 2013 and June 30, 2012, we sold non-Agency RMBS of $7,574 and $1,850, realizing net gains of $1,442 and $104, respectively. With respect to non-Agency RMBS, we continue to emphasize investment in seasoned securities, backed by subprime mortgage loans, targeting securities at the top of the capital structure.
We have elected the fair value option for our RMBS, securitized mortgage loans and securitized debt and, as a result, we record the change in estimated fair value of such instruments in earnings. The following table presents amounts related to realized gains and losses as well as changes in estimated fair value of our RMBS, securitized mortgage loans, securitized debt and derivative instruments, all of which are included in our consolidated statements of operations, for the three months ended June 30, 2013 and June 30, 2012:
Table 8
 
Three Months Ended
 
 
June 30, 2013
 
June 30, 2012
Realized gain/(loss) on sale of RMBS, net
 
$
(47,508
)
 
$
11,614

Unrealized gain/(loss) on RMBS, net
 
(134,822
)
 
14,598

Realized gain/(loss) on derivatives, net (1)
 
3,591

 
(1,723
)
Unrealized gain/(loss) on derivatives, net
 
79,778

 
(13,792
)
Unrealized gain/(loss) on securitized mortgage loans
 
(3,473
)
 
—

Unrealized gain/(loss) on securitized debt
 
887

 
—

Total
 
$
(101,547
)
 
$
10,697

 
(1) 
Realized losses, net represent the net interest paid or due for Swaps and net termination gain/loss during the period, if any.
Included in “realized gain/(loss), net on derivative instruments” are net interest payments, including accrued amounts, associated with our Swaps. We recognized net unrealized gains/(losses) of $71,713, $8,888 and $(823) through earnings for the second quarter of 2013 related to changes in fair value of our Swaps, Swaptions, and TBA Shorts respectively. At June 30, 2013, we had gross unrealized gains of $50,359, $7,935 and $100 on our Swaps, Swaptions and TBA Shorts, respectively, and had gross unrealized losses of $2,750 and $923 on Swaps and TBA Shorts, respectively.


44


Expenses
General and Administrative Expenses: We reimburse our Manager for our allocable share of the compensation of our Chief Financial Officer based on the percentage of his time spent on our affairs and for other corporate finance, tax, accounting, legal, risk management, operations, compliance and other non-investment professional personnel of our Manager or its affiliates who spend all or a portion of their time managing our affairs. We are responsible for our operating expenses, which include the cost of data and analytical systems, legal, outsourced accounting, due diligence, prime brokerage and banking fees, professional services, including auditing and legal fees, board of director fees and expenses, compliance related costs, corporate insurance, and miscellaneous other operating costs. We incurred general and administrative expenses of $2,434 and $1,865 for the three months ended June 30, 2013 and June 30, 2012, respectively. The increase in our general and administrative expenses was driven by significant growth in our assets resulting from our investment, on a leveraged basis, of incremental equity capital raised since the second quarter of 2012. Costs for our third party accounting administrator and transaction costs we incur for security and repurchase transactions vary based on the size of our portfolio and transaction activity.
Management Fee Expense: Under the terms of the Management Agreement, our Manager is entitled to a management fee calculated and payable quarterly in arrears in an amount equal to 1.5% of our stockholders’ equity (as defined in the Management Agreement), per annum. Our Manager uses the proceeds from the management fee, in part, to pay compensation to certain of its officers and personnel who, notwithstanding that certain of them also are our officers, will receive no cash compensation directly from us. Pursuant to our Management Agreement, we incurred management fee expenses of $2,921 and $1,558 for the three months ended June 30, 2013 and June 30, 2012, respectively. The increase in the management fee for the three months ended June 30, 2013 reflects our growth in stockholders’ equity reflecting issuances of our capital stock since the second quarter of 2012. From June 30, 2012 to March 25, 2013, our most recent public issuance of capital stock, we raised additional net capital of approximately $338,118 from the issuance of common and preferred stock.
The management fees, expense reimbursements and the relationship with our Manager are discussed further in Note 12 to the consolidated financial statements, included under Item 1 in this Quarterly Report on Form 10-Q.
Results of Operations
Six Months Ended June 30, 2013 compared to the Six Months June 30, 2012
For the six months ended June 30, 2013, we had a net loss allocable to common stock and participating securities of $74,327 or a loss of $2.59 per basic and diluted common share, compared to net income available to common and participating securities of $46,520, or $2.94 per basic and diluted common share for the six months ended June 30, 2012. Our results of operations for six months ended June 30, 2013 were significantly impacted by steep declines in the value of our Agency RMBS portfolio, which were partially offset by increases in the value of our derivatives. (See “Recent Market Conditions and Our Strategy during the Quarter Ended June 30, 2013,” above.)
Net Interest Income
Interest rate spread and net interest margin are key performance metrics for us, as our core performance is significantly driven by net interest income. Interest rate spread measures the difference between the yield on interest-earning assets and the cost of interest-bearing liabilities, while net interest margin reflects net interest income divided by average interest-earning assets. We had an interest rate spread and net interest margin of 2.80% and 2.89% for the six months ended June 30, 2013, respectively, compared to 2.88% and 2.98%, respectively, for the six months ended June 30, 2012.
The increase in our interest income and interest expense, discussed below, was primarily driven by the significant growth in our investments and borrowings resulting from our investment, on a leveraged basis, of incremental capital raised since the second quarter of 2012. For the six months ended June 30, 2013 and June 30, 2012, we earned interest income of $79,576 and $34,353, respectively, and incurred interest expense of approximately $13,454 and $4,232, respectively, which was primarily related to our borrowings under repurchase agreements. In connection with our February 2013 securitization transaction, we had securitized debt with a contractual balance of $47,353 at June 30, 2013 and a fixed stated interest rate of 4.00%. Costs associated with our securitization are amortized as a component of interest expense; as a result, our securitized debt had a cost of 4.28% for the six months ended June 30, 2013.
Our interest income was positively impacted by slower prepayment speeds on Agency RMBS during the first six months of 2013 which improved yields and increased interest income on our Agency portfolio. Actual prepayments and changes in expectations about prepayment rates, which reflect market fundamentals at the time of assessment, may cause future premium amortization on our Agency RMBS to vary significantly over time. In addition, changes in the performance, or performance expectations, with respect to our non-Agency RMBS may significantly impact the amount of income recognized in future periods on such investments.


45


The following table presents certain information regarding our interest-earning assets, interest-bearing liabilities and the components of our net interest income for the six months ended June 30, 2013 and 2012:
Table 9
 
Six Months Ended
 
 
June 30, 2013
 
June 30, 2012
 
 
Agency
 
Non-Agency
 
Securitized
Mortgage
Loans
 
Total
 
Agency
 
Non-Agency
 
Total
Average balance (1)
 
$
3,895,942

 
$
562,181

 
$
88,306

 
$
4,546,429

 
$
1,791,600

 
$
207,537

 
$
1,999,137

Total interest income
 
$
55,241

 
$
20,705

 
$
3,630

 
$
79,576

 
$
22,379

 
$
11,974

 
$
34,353

Yield on average assets
 
2.82
%
 
7.33
%
 
8.17
%
 
3.48
%
 
2.47
%
 
11.41
%
 
3.40
%
Average balance of repurchase agreements
 
$
3,496,161

 
$
470,586

 
$
—

 
$
3,966,747

 
$
1,500,118

 
$
145,889

 
$
1,646,007

Average balance of securitized debt
 
$
—

 
$
—

 
$
38,556

 
$
38,556

 
$
—

 
$
—

 
$
—

Total interest expense
 
$
7,606

 
$
5,030

 
$
818

 
$
13,454

 
$
2,814

 
$
1,418

 
$
4,232

Average cost of funds (2) (3)
 
0.44
%
 
2.16
%
 
4.28
%
(4) 
0.68
%
 
0.38
%
 
1.95
%
 
0.52
%
Net interest income
 
$
47,635

 
$
15,675

 
$
2,812

 
$
66,122

 
$
19,565

 
$
10,556

 
$
30,121

Net interest rate spread
 
2.38
%
 
5.17
%
 
3.89
%
 
2.80
%
 
2.09
%
 
9.46
%
 
2.88
%
Total interest expense including net interest cost of Swaps (5)
 
$
17,999

 
$
5,213

 
$
818

 
$
24,030

 
$
5,324

 
$
1,418

 
$
6,742

Average cost of funds including net interest cost of Swaps (5)
 
1.04
%
 
2.23
%
 
4.28
%
 
1.21
%
 
0.71
%
 
1.95
%
 
0.82
%
Net interest income including net interest cost of Swaps
 
$
37,242

 
$
15,492

 
$
2,812

 
$
55,546

 
$
17,055

 
$
10,556

 
$
27,611

Effective net interest rate spread (5)
 
1.78
%
 
5.10
%
 
3.90
%
 
2.27
%
 
1.76
%
 
9.46
%
 
2.58
%
(1) 
Amount reflects amortized cost, which does not include changes in unrealized gains and losses.
(2) 
Cost of funds by investment type is based on the underlying investment type of the RMBS assigned as collateral.
(3) 
Cost of funds does not include accrual and settlement of interest associated with derivative instruments. In accordance with GAAP, those costs are included in gain/(loss) on derivative instruments in our consolidated statements of operations.
(4) 
The average cost of funds for the securititized mortgage loans only reflects the cost of our securitized debt. We have repurchase agreement borrowings collateralized by one of the subordinate securitities that we retained in the securitization transaction. These subordinate bonds do not appear on our financial statements, as they are eliminated in consolidation. The corresponding repurchase borrowings and related interest expense are included with repurchase borrowings collateralized by our non-Agency RMBS.
(5) 
See Table 10 below and Tables 19 and 20 included under “Non-GAAP Financial Measures.”


46


The following table presents information with respect to our borrowing costs and effective cost of funds by type of collateral pledged for the six months ended June 30, 2013 and June 30, 2012:
Table 10
 
Six Months Ended
  
 
June 30, 2013
 
June 30, 2012
Collateral Pledged
 
Cost of
Funds
 
Effective
Cost  of
Funds (1)
 
Cost of
Funds
 
Effective
Cost of
Funds (1)
Agency
 
0.44
%
 
1.04
%
 
0.38
%
 
0.71
%
Non-Agency (1)
 
2.16

 
2.23

 
1.95

 
1.95

Securitized mortgage loans (2)
 
4.28

 
4.28

 
—

 
—

Total
 
0.68
%
 
1.21
%
 
0.52
%
 
0.82
%
(1) 
The effective cost of funds for the periods presented are calculated on an annualized basis and include interest expense for the periods and the net interest component for Swaps during the periods of $10,576 and $2,510, respectively. While we have not elected to apply hedge accounting for our Swaps, we view such instruments as an economic hedge against the impact of increases in interest rates on our borrowing costs. See “Non-GAAP Financial Measures” below, including Tables 19 and 20.
The repurchase borrowings associated with non-Agency RMBS that were legally retained in connection with our securitization are included with the cost of funds on non-Agency RMBS.
(2) 
The securitized mortgage loans, in effect, collateralize our securitized debt associated with our 2013 securitization transaction.
Swaps
While we view our Swaps as an economic hedge against increases in future market interest rates associated with our repurchase agreement borrowings, we have not elected hedge accounting under GAAP. Alternatively, we present the “effective cost of funds” to reflect our interest expense adjusted to include the interest component for our Swaps that would be reported had we elected and qualified for hedge accounting for such instruments. We believe that the presentation of our effective cost of funds, which is a non-GAAP financial measure, is useful for investors as it presents our borrowing costs as viewed by us. (See “Non-GAAP Financial Measures,” below, Table 1, above and Note 10 to the consolidated financial statements, included under Item 1 in this Quarterly Report on Form 10-Q.)
The following table presents our effective interest expense, effective cost of funds, effective net interest income and effective net interest rate spread, which amounts are non-GAAP financial measures as they include the net interest component of our Swaps, for the six months ended June 30, 2013 and June 30, 2012: (See Tables 19 and 20, included under “Non-GAAP Financial Measures” below.
Table 11
 
 
 
 
 
 
 
 

 
Agency
 
Non-Agency
 
Securitized
Mortgage
Loans
 
Total
Six months ended June 30, 2013
 
 
 
 
 
 
 
 
Effective interest expense
 
$
17,999

 
$
5,213

 
$
818

 
$
24,030

Effective cost of funds
 
1.04
%
 
2.23
%
 
4.28
%
 
1.21
%
Effective net interest income
 
$
37,242

 
$
15,492

 
$
2,812

 
$
55,546

Effective net interest rate spread
 
1.78
%
 
5.10
%
 
3.90
%
 
2.27
%
Six months ended June 30, 2012
 
 
 
 
 
 
 
 
Effective interest expense
 
$
5,324

 
$
1,418

 
$
—

 
$
6,742

Effective cost of funds
 
0.71
%
 
1.95
%
 
—

 
0.82
%
Effective net interest income
 
$
17,055

 
$
10,556

 
$
—

 
$
27,611

Effective net interest rate spread
 
1.76
%
 
9.46
%
 
—

 
2.58
%
Realized and Unrealized Gain/(Loss)
During the six months ended June 30, 2013 and 2012, we sold RMBS of $2,807,993 and $1,005,237, respectively, realizing net (losses)/gains of $(31,713) and $18,383, respectively. The substantial majority of our RMBS sales during the six months ended June 30, 2013 were made during the second quarter of 2013 and were comprised primarily of sales of Agency RMBS as we repositioned our portfolio in connection with the extreme changes in the market place. (See “Recent Market Conditions and Our Strategy during the Quarter Ended June 30, 2013.”) As we find attractive investment opportunities in non-


47


Agency RMBS and whole loans and mortgage-related assets, we may sell additional Agency RMBS to fund such purchases. During the six months ended June 30, 2013 and June 30, 2012, we sold non-Agency RMBS of $65,562 and $38,058, respectively, realizing net gains of $9,730 and $3,532, respectively. With respect to non-Agency RMBS, we continue to emphasize investment in seasoned securities, backed by subprime mortgage loans, targeting securities at the top of the capital structure.
We have elected the fair value option for all of our RMBS, securitized mortgage loans and securitized debt and, as a result, we record the change in estimated fair value of such instruments in earnings. The following table presents amounts related to realized gains and losses as well as changes in estimated fair value of our RMBS, securitized mortgage loans, securitized debt and derivative instruments, all of which are included in our consolidated statements of operations, for the six months ended June 30, 2013 and June 30, 2012:
Table 12
 
Six Months Ended
 
 
June 30, 2013
 
June 30, 2012
Realized gain/(loss) on sale of RMBS, net
 
$
(31,713
)
 
$
18,383

Unrealized gain/(loss) on RMBS, net
 
(167,870
)
 
20,548

Realized gain/(loss) on derivatives (1)
 
(548
)
 
(2,471
)
Unrealized gain/(loss) on derivatives, net
 
78,119

 
(14,362
)
Unrealized loss on securitized mortgage loans
 
(625
)
 
—

Unrealized gain on securitized debt
 
15

 
—

Total
 
$
(122,622
)
 
$
22,098

(1) 
Realized losses represent the net interest paid or due for Swaps and net termination gain/loss during the period, if any.
At June 30, 2013, we had Swaps with an aggregate notional amount of $2,032,000, a weighted average fixed pay rate of 1.48% and a weighted average term to maturity of 6.4 years. Included in realized gain/(loss) on derivative instruments are net interest payments (including accrued amounts) associated with our Swaps. We recognized net unrealized gains/(losses) of $70,793 and $8,149 and $(823) through earnings for the six months ended June 30, 2013 related to changes in fair value of our Swaps, Swaptions and TBA Shorts, respectively. At June 30, 2013, we had gross unrealized gains of $50,359, $7,935 and $100 on Swaps, Swaptions and TBA Shorts, respectively, and gross unrealized losses of $2,750 and $923 on Swaps and TBA Shorts, respectively.
Expenses
General and Administrative Expenses: We reimburse our Manager for our allocable share of the compensation of our Chief Financial Officer based on the percentage of his time spent on our affairs and for other corporate finance, tax, accounting, legal, risk management, operations, compliance and other non-investment professional personnel of our Manager or its affiliates who spend all or a portion of their time managing our affairs. We are responsible for our operating expenses, which include the cost of data and analytical systems, legal, outsourced accounting, due diligence, prime brokerage and banking fees, professional services, including auditing and legal fees, board of director fees and expenses, compliance related costs, corporate insurance, and miscellaneous other operating costs. We incurred general and administrative expenses of $5,285 and $3,353 for the six months ended June 30, 2013 and June 30, 2012, respectively. The increase in our general and administrative expenses was driven by significant growth in our assets resulting from our investment, on a leveraged basis, of incremental equity capital raised since the second quarter of 2012. Costs for our third party accounting administrator and transaction costs we incur for security and repurchase transactions vary based on the size of our portfolio and transaction activity.
Management Fee Expense: Under the terms of the Management Agreement, our Manager is entitled to a management fee calculated and payable quarterly in arrears in an amount equal to 1.5% of our stockholders’ equity (as defined in the Management Agreement), per annum. Our Manager uses the proceeds from the management fee, in part, to pay compensation to certain of its officers and personnel who, notwithstanding that certain of them also are our officers, will receive no cash compensation directly from us. Pursuant to our Management Agreement, we incurred management fee expenses of $5,710 and $2,355 for the six months ended June 30, 2013 and June 30, 2012, respectively. The increase in the management fee for six months ended June 30, 2013 reflects our growth in stockholders’ equity reflecting issuances of our capital stock since the second quarter of 2012. From June 30, 2012 to March 25, 2013, our most recent public issuance of capital stock, we raised additional net capital of approximately $338,118 from the issuance of common and preferred stock.
The management fees, expense reimbursements and the relationship with our Manager are discussed further in Note 12 to the consolidated financial statements, included under Item 1 in this Quarterly Report on Form 10-Q.



48


Dividends
We have had 6,900,000 shares of Preferred Stock outstanding since September 20, 2012. No dividends may be paid on our common stock unless full cumulative dividends have been paid on our Preferred Stock, all of which have been paid to date. The following table presents cash dividends we have declared on our Preferred Stock from issuance through June 30, 2013:
Table 13
 
 
 
 
 
 
Declaration Date
 
Record Date
 
Payment Date
 
Dividend per Share
June 17, 2013
 
June 28, 2013
 
July 31, 2013
 
$
0.50

March 18, 2013
 
March 28, 2013
 
April 30, 2013
 
$
0.50

December 14, 2012 (1)
 
December 31, 2012
 
January 31, 2013
 
$
0.73

(1) 
Reflects dividend from September 20, 2012, the date of original issuance of the Preferred Stock, through January 31, 2013.
The following table presents cash dividends we declared on our common stock for the quarterly periods presented:
Table 14
 
 
 
 
 
 
Declaration Date
 
Record Date
 
Payment Date
 
Dividend per Share
June 17, 2013
 
June 28, 2013
 
July 31, 2013
 
$
0.70

March 18, 2013
 
March 28, 2013
 
April 30, 2012
 
$
0.70

December 14, 2012 (1)
 
December 31, 2012
 
January 31, 2013
 
$
1.05

September 14, 2012
 
September 28, 2012
 
October 31, 2012
 
$
0.85

June 12, 2012
 
June 29, 2012
 
July 31, 2012
 
$
0.75

(1) 
Includes a special dividend of $0.35 per share.
Liquidity and Capital Resources
General
To maintain our qualification as a REIT under the Internal Revenue Code, we must distribute annually at least 90% of our net taxable income, excluding net capital gains. These distribution requirements limit our ability to retain earnings and thereby replenish or increase capital for operations.
Our principal sources of cash typically consist of borrowings under repurchase agreements, payments of principal and interest received on our RMBS portfolios, cash generated from operating results and, depending on market conditions, proceeds from capital market transactions, which to date have reflected issuances of our capital stock and proceeds from our securitization transaction. As part of managing our investment portfolio, we may also generate cash from sales of our investments. Cash is used to fund our on-going obligations, make payments of principal and interest on repurchase agreement borrowings, purchase target assets, meet margin calls for repurchase agreement borrowings and derivatives, make dividend distributions to stockholders and for other general business and operating purposes.
In February 2013, we engaged in a securitization transaction that resulted in us consolidating as a VIE, the SPE that was created to facilitate this transaction and to which the underlying mortgage loans in connection with the securitization were transferred. Since the underlying trusts were consolidated, we take the view that the securitization is effectively a financing of the securitized mortgage loans sold, resulting in the senior security sold being presented in our consolidated balance sheet as non-recourse securitized debt. (See Note 13 to the consolidated financial statements, included under Item 1 in this Quarterly Report on Form 10-Q.) We expect that in the future, subject to market conditions, we may issue other types of debt and/or equity securities, execute additional securitization transactions and utilize resecuritization transactions.
Under our repurchase agreements, lenders retain the right to mark the collateral pledged to estimate fair value. A reduction in the value of the collateral pledged will require us to provide additional securities or cash as collateral. In addition, we are required to pledge cash or securities as collateral in connection with our Swaps and TBA Contracts. Margin requirements vary by counterparty. New CFTC Swap clearing rules became effective on June 10, 2013, which rules, among other things, provide that certain Swaps entered into from such date are required to be cleared through a clearinghouse.  Swaps cleared through the CFTC generally have higher initial margin collateral requirements relative to Swaps previously cleared with individual counterparties. Through June 30, 2013, we did not enter into Swaps that were subject to CFTC clearing.  The change in Swap margin collateral requirement may increase the amount of cash that we are required to pledge to meet the initial margin requirement for certain Swaps that we enter into in the future. 


49


As part of our risk management process, our Manager closely monitors our liquidity position and subjects our balance sheet to scenario testing designed to assess our liquidity in the face of stressed market conditions. We believe that we have adequate financial resources to meet our obligations, including margin calls, as they come due, to actively hold and acquire our target assets, to fund dividends we declare on our capital stock and to pay our operating expenses. However, should the value of our RMBS suddenly decrease, significant margin calls on repurchase agreement borrowings could result and our liquidity position could be materially and adversely affected. Further, should market liquidity tighten, our repurchase agreement counterparties could increase the percentage by which the collateral value is required to exceed the loan amount on new financings, reducing our ability to use leverage. Access to financing may also be negatively impacted by the ongoing volatility in the global financial markets, potentially adversely impacting our current or potential lenders’ ability to provide us with financing.
Public Offerings of Capital Stock
The following table presents shares we issued through public offerings for the twelve months ended June 30, 2013:
Table 15
 
 
 
 
 
 
 
 
Date of Issuance
 
Type of Capital
Stock Issued
 
Number of
Shares
Issued
 
Offering
Price Per
Share
 
Net Proceeds
March 25, 2013
 
Common
 
1,020,000

 
$
22.00

 
$
22,417

March 13, 2013
 
Common
 
6,800,000

 
$
22.00

 
$
149,129

September 20, 2012
 
Preferred (1)
 
6,900,000

 
$
25.00

 
$
166,572

April 20, 2012
 
Common
 
13,900,000

 
$
18.00

 
$
249,490

(1) 
We may generally not redeem our Preferred Stock, which has a stated dividend rate of 8.00%, until September 20, 2017, except under certain limited circumstances intended to preserve our qualification as a REIT and upon the occurrence of a change in control as defined in articles supplementary designating the Preferred Stock. After September 20, 2017, we may, at our option, redeem the Preferred Stock at a redemption price of $25, plus any accrued unpaid distribution through the date of redemption.
We primarily used the cash generated from these public offerings to invest on a leveraged basis in Agency RMBS.
Investing Activity
Our investment activity for the first six months of 2013 reflects the deployment of approximately $172,000 of equity capital raised in March 2013, on a leveraged basis. As previously discussed, in response to extreme and rapid changes in the fixed income market in June 2013, we rebalanced our portfolio aimed at reducing our net portfolio duration (or, the price sensitivity to changes in RMBS spreads relative to other benchmark interest rates, such as Swaps and Swaptions), protecting our net asset value/book value, increasing liquidity in light of market volatility and taking advantage of market opportunities to invest in non-Agency RMBS.  To achieve these objectives, among other things, we sold certain of our Agency RMBS, reduced leverage and increased our purchases of non-Agency RMBS.  The impact of our rebalancing strategy is reflected in our investment activity below.
During the three and six months ended June 30, 2013, we: (i) invested $709,182 and $2,005,555 in Agency pass-through RMBS, respectively, at a weighted average purchase price of 108.0% and 107.6% of par value, respectively, $20,582 and $26,629 in Agency IOs, respectively, and $12,303 and $29,210 in Inverse IOs, respectively, $186,464 and $231,478 in non-Agency RMBS, respectively and $0 and $113,038 in securitized mortgage loans, respectively; (ii) received prepayments and scheduled amortization of $89,428 and $158,322 for Agency RMBS, respectively, $25,194 and $48,609 for non-Agency RMBS, respectively, and $1,054 and $2,051 on our securitized mortgage loans, respectively; and (iii) sold Agency RMBS of $2,210,911 and $2,742,431, respectively, realizing aggregate loss of $(48,950) and $(41,443), respectively, and sold $7,574 and $65,562 of non-Agency RMBS realizing gains of $1,442 and $9,730, respectively. As of June 30, 2013, we had investment related payables of $14,316 with respect to unsettled purchases of non-Agency RMBS and investment related receivables of $986,157 of which $977,919 was related to unsettled sales of Agency RMBS, $6,680 was related to unsettled terminations of Swaps and $1,558 was principal receivable from brokers on non-Agency RMBS. All investment related payables and receivables at June 30, 2013 were settled in July 2013.
During the three and six months ended June 30, 2012, we: (i) acquired $2,109,617 and $2,514,451 of Agency RMBS, respectively, and $199,984 and $301,131 of non-Agency RMBS, respectively, (ii) received prepayments and scheduled amortization of $32,897 and $56,508 for Agency RMBS, respectively, and $14,559 and $22,869 for non-Agency RMBS, respectively; and (iii) sold Agency RMBS of $612,452 and $967,179, respectively, realizing net gains of $11,510 and $14,851, respectively, and sold $1,850 and $38,058 of non-Agency RMBS, respectively, realizing gains of $104 and $3,532, respectively.


50


We receive interest payments only with respect to the notional amount of Agency IOs and Agency Inverse IOs. Therefore, the performance of such instruments is extremely sensitive to prepayments on the underlying pool of mortgages. Unlike Agency RMBS, the market prices of Agency IOs generally have a positive correlation to changes in interest rates. Generally, as market interest rates increase, prepayments on the mortgages underlying an Agency IO will decrease, which in turn is expected to increase the cash flow and the value of such securities; inverse results are expected with respect to decreases in market interest rates. In addition to viewing Agency IOs as attractive investments, we also view such instruments as an economic hedge, in part, against the impact that an increase in market interest rates would have on our Agency RMBS. However, given that we had Agency IOs of $30,184 with an aggregate notional balance of $180,220, the overall impact of Agency IOs in off-setting the impact of increases in interest rates on the value of our Agency RMBS portfolio is limited. During the three and six months ended June 30, 2013, we sold $0 and $2,579 of Agency IOs, respectively and $14,284 and $17,759 of Agency Inverse IO securities, respectively, realizing aggregate net gains of $254 and $407, respectively.
During February 2013, we purchased a pool of 755 residential mortgage loans with an unpaid principal balance of $155,001 and simultaneously completed a securitization transaction collateralized by such loans. As part of the securitization, we sold, through a private placement, an aggregate of $50,375 in principal value non-Agency RMBS at par value, which, in effect, financed a portion of such assets, as discussed below.
Financing Activity
Our financing activity for the first six months of 2013 reflects the deployment of approximately $172,000 of equity capital, raised in March 2013, on a leveraged basis and the subsequent rebalancing of our portfolio in June 2013, as previously discussed. The impact of our rebalancing strategy is reflected in our financing activity below. In addition, included in our repurchase agreement balances at June 30, 2013, were borrowings of $990,973 collateralized by Agency RMBS sold but unsettled and restricted cash. Had such sales, net of unsettled purchases of non-Agency RMBS at June 30, 2013, settled by June 30, 2013, our debt-to equity multiple would have been 3.9 times, compared to 5.2 times as reported at June 30, 2013. This pro-forma leverage multiple reflects the impact of the net reduction in our repurchase borrowings that occurred upon the settlement of such trades.
We use repurchase agreements to finance a substantial majority of our Agency RMBS and non-Agency RMBS with such securities pledged as collateral to secure such borrowings. At June 30, 2013, we had outstanding repurchase agreement borrowings with 19 counterparties totaling $3,945,097. We continue to have available capacity under our repurchase agreements; however, our repurchase agreements are generally uncommitted and renewable at the discretion of our lenders. As of June 30, 2013, we had master repurchase agreements with 23 counterparties and as a matter of routine business have had discussions with other financial institutions regarding potentially providing us with additional repurchase agreement capacity.


51


During the first quarter of 2013, we engaged in our first securitization transaction in connection with the purchase of a pool of mortgage loans. The securitization, in effect, allowed us to obtain a combination of long-term financing (securitized debt) and short-term financing (repurchase borrowings) on the mortgage loan pool we purchased. The table below presents certain information about our borrowings for the periods presented:
Table 16
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Repurchase Agreements
 
Securitized Debt
Quarter Ended
 
Quarterly
Average
Balance
 
End of Period
Balance
 
Maximum
Balance at
Month-End
 
Quarterly
Average
Balance
 
End of Period
Balance
 
Maximum
Balance at
Month-End
June 30, 2013(4)
 
$
4,260,599

 
$
3,945,097

 
$
4,516,604

 
$
48,271

 
$
47,338

 
$
49,559

March 31, 2013 (1)
 
$
3,669,630

 
$
4,343,341

 
$
4,343,341

 
$
28,742

 
$
49,852

 
$
49,852

December 31, 2012
 
$
3,601,907

 
$
3,654,436

 
$
3,654,436

 
$
—

 
$
—

 
$
—

September 30, 2012 (2)
 
$
2,625,055

 
$
3,709,684

 
$
3,709,684

 
$
—

 
$
—

 
$
—

June 30, 2012 (3)
 
$
2,192,868

 
$
2,631,101

 
$
2,631,101

 
$
—

 
$
—

 
$
—

(1) 
On March 25 and March 13, 2013, we raised net equity of approximately $22,417 and $149,129, respectively, which was invested on a leveraged basis and, as a result, increased our borrowings under repurchase agreements at the period end relative to the average balance during the quarterly period. The amount reported under securitized debt reflects the fair value of the debt associated with our initial securitization transaction which was completed in February 2013.
(2) 
On September 20, 2012, we raised net equity of approximately $166,572, which was invested on a leveraged basis and, as a result, increased our borrowings under repurchase agreements at the period end relative to the average balance during the quarterly period.
(3) 
On April 20, 2012, we raised net equity of approximately $249,490, which was invested on a leveraged basis and, as a result, increased our borrowings under repurchase agreements at the period end relative to the average balance during the quarterly period.
(4) 
The end of period balance at June 30, 2013 includes repurchase agreement borrowings of $990,973, which amount was repaid in July 2013 upon the settlement of Agency RMBS sold in June 2013.


52


The following table presents information about our borrowings by the type of collateral pledged, and the fair value of such collateral as of the dates presented along with the corresponding weighted average interest rate and the effective cost of funds for the quarterly periods then ended:
Table 17
 
 
 
 
 
 
 
 
Quarterly Period Ended
 
Principal
Balance  of
Borrowing
 
Fair Value
of
Collateral
Pledged (1)
 
Weighted
Average
Interest
Rate
 
Effective
Cost  of
Funds (2)
June 30, 2013
 
 
 
 
 
 
 
 
Agency RMBS repurchase borrowings
 
$
3,367,445

 
$
3,533,248

 
0.43
%
 
1.10
%
Non-Agency RMBS repurchase borrowings (3)
 
577,652

 
792,500

 
2.16

 
2.27

Total repurchase borrowings
 
$
3,945,097

 
$
4,325,748

 
0.63
%
 
1.24
%
Securitized Debt
 
47,353

 
110,278

 
4.22
%
 
4.22
%
Total
 
$
3,992,450

 
$
4,436,026

 
0.67
%
 
1.27
%
March 31, 2013
 
 
 
 
 
 
 
 
Agency RMBS repurchase borrowings
 
$
3,896,493

 
$
4,096,389

  
0.45
%
 
0.96
%
Non-Agency RMBS repurchase borrowings (3)
 
446,848

 
639,956

  
2.15

 
2.20

Total repurchase borrowings
 
$
4,343,341

 
$
4,736,345

  
0.65
%
 
1.11
%
Securitized Debt
 
48,980

 
114,881

(4) 
4.37
%
 
4.37
%
Total
 
$
4,392,321

 
$
4,851,226

  
0.68
%
 
1.14
%
December 31, 2012
 
 
 
 
 
 
 
 
Agency RMBS repurchase borrowings
 
$
3,223,577

 
$
3,389,701

  
0.48
%
 
0.88
%
Non-Agency RMBS repurchase borrowings
 
430,859

 
606,649

  
2.16

 
2.16

Total repurchase borrowings
 
$
3,654,436

 
$
3,996,350

  
0.67
%
 
1.03
%
September 30, 2012
 
 
 
 
 
 
 
 
Agency RMBS repurchase borrowings
 
$
3,314,990

 
$
3,491,639

  
0.44
%
 
0.80
%
Non-Agency RMBS repurchase borrowings
 
394,694

 
542,698

  
2.17

 
2.17

Total repurchase borrowings
 
$
3,709,684

 
$
4,034,337

  
0.65
%
 
0.96
%
June 30, 2012
 
 
 
 
 
 
 
 
Agency RMBS repurchase borrowings
 
$
2,376,543

 
$
2,503,509

  
0.38
%
 
0.73
%
Non-Agency RMBS repurchase borrowings
 
254,558

 
343,548

  
1.94

 
1.94

Total repurchase borrowings
 
$
2,631,101

 
$
2,847,057

  
0.53
%
 
0.84
%
(1) 
Includes cash collateral pledged for Agency RMBS and non-Agency RMBS.
(2) 
The effective cost of funds for the quarterly periods presented above is calculated on an annualized basis and includes the interest component for Swaps of $6,437, $4,139, $3,220, $2,075, and $1,762 for the quarterly period presented, respectively. While Swaps are not accounted for using hedge accounting, such instruments are viewed by us as an economic hedge against increases in interest rates.
(3) 
The principal balance of repurchase borrowings includes $26,900 of repurchase borrowings collateralized by $44,834 of non-Agency RMBS, which are included in the fair value of collateral pledged, that were acquired in connection with the February 2013 securitization transaction. Such non-Agency RMBS are eliminated from our consolidated balance sheet in consolidation with the VIE. (See Notes 5 and 13 to the consolidated financial statements, included under Item 1 in this Quarterly Report on Form 10-Q.)
(4) 
Represents the fair value of the securitized mortgage loans held by the consolidated VIE, which loans in effect collateralize all of the securities issued in connection with the February 2013 securitization. The senior security, which was sold to a third party is presented on our consolidated balance sheet as securitized debt. (See Notes 5 and 13 to the consolidated financial statements, included under Item 1 in this Quarterly Report on Form 10-Q.)
With respect to our repurchase agreement borrowings, the “haircut” represents the percentage by which the collateral value is contractually required to exceed the loan amount. At June 30, 2013, haircuts ranged from a low of 3.0% to a high of 5.3% for our repurchase borrowings secured by Agency RMBS, and a low of 10.0% to a high of 50.0% for repurchase borrowings secured by non-Agency RMBS. Under our repurchase agreements, each respective lender retains the right to mark the underlying collateral to fair value. A reduction in the value of pledged assets generally results in the lender initiating a margin call. Margin calls are satisfied when we pledge additional collateral in the form of securities and/or cash to the lender. We have met all margin calls to date.
Certain repurchase agreements are subject to financial covenants. An event of default or termination event would give some of our counterparties the option to terminate all existing repurchase transactions with us and require any amount due to


53


the counterparties by us to be payable immediately. We were in compliance with all of our financial covenants through June 30, 2013. At June 30, 2013, we had RMBS of $4,120,503 and cash of $205,245 pledged as collateral to lenders as security for repurchase agreements. The total of the RMBS pledged for repurchase borrowings included a non-Agency RMBS with a fair value of $44,834 that was acquired in connection with our securitization transaction and are not included on our balance sheet, as such RMBS was eliminated in consolidation with the securitization trust. Cash collateral held by counterparties is reported on our balance sheet as a component of “restricted cash.”
Cash Flows and Liquidity for the Six Months Ended June 30, 2013
Our cash and cash equivalents increased by $46,123 during the six months ended June 30, 2013, primarily reflecting $307,069 provided by financing activities, $49,798 provided by operating activities and $310,744 used for investing activities. We maintain cash and cash equivalents at levels that we believe will enable us to meet margin calls and other obligations as they come due. We held cash of approximately $195,699 at June 30, 2013. (For detailed information with respect to our operating, investing and financing activities, see “Consolidated Statements of Cash Flows,” included with our consolidated Financial Statements in this Quarterly Report on Form 10-Q.)
Contractual Obligations and Commitments
The following table summarizes the effect on our liquidity and cash flows of our contractual obligations for principal and interest as of June 30, 2013:
Table 18
 
 
 
 
 
 
 
 
 
 
  
 
Less than  1
year
 
1 to 3
years
 
3 to 5
years
 
More than
5 years
 
Total
Borrowings under repurchase agreements
 
$
3,833,426

 
111,671

 
—

 
—

 
$
3,945,097

Interest on repurchase agreements borrowings (1) 
 
2,664

 
3,652

 
—

 
—

 
6,316

Total
 
$
3,836,090

 
115,323

 
—

 
—

 
$
3,951,413

(1) 
Interest expense is calculated based on the interest rate in effect at June 30, 2013.
The table above does not include amounts due under the Management Agreement as such obligations, discussed below, do not have fixed and determinable payments, or our anticipated dividend on our Preferred Stock. (See Notes 12 and 15 to the consolidated financial statements, included under Item 1 in this Quarterly Report on Form 10-Q for a discussion with respect to our Management Agreement and Preferred Stock.) At June 30, 2013, we had securitized debt with a balance of $47,353 (and a fair value of $47,338) with a contractual interest rate of 4.00%. Our securitized debt is only paid to the extent that the mortgage loans (in the securitization trust) collateralizing the debt pay and, as such the securitized debt is non-recourse to us. As such, we have not included the securitized debt in the table above.
Management Agreement
Pursuant to the terms of the Management Agreement, our Manager is entitled to a management fee calculated and payable quarterly in arrears in an amount equal to 1.5% of our stockholders’ equity (as defined in the Management Agreement), per annum. Our Manager will use the proceeds from the management fee in part to pay compensation to its officers and personnel who, notwithstanding that certain of them also serve as our officers, will receive no cash compensation directly from us. We reimburse our Manager and/or its affiliates for the allocable share of the compensation of (1) our Chief Financial Officer based on the percentage of his time spent on our affairs and (2) other corporate finance, tax, accounting, legal, risk management, operations, compliance and other non-investment professional personnel of our Manager or its affiliates who spend all or a portion of their time managing our affairs based on the percentage of time devoted by such personnel to our affairs. We are responsible for our operating expenses, which include the cost of data and analytical systems, legal, outsourced accounting, due diligence, prime brokerage and banking fees, professional services, including auditing and legal fees, board of director fees and expenses, compliance related costs, corporate insurance, and miscellaneous other operating costs. To the extent that our Manager or its affiliates pay for services provided on our behalf, we are required to reimburse our Manager and/or its affiliates for such items. Expense reimbursements to our Manager and/or its affiliates are made in cash on a monthly basis following the end of each month. Our reimbursement obligation is not subject to any dollar limitation.
The initial term of the Management Agreement expires on July 27, 2014 (the third anniversary of the closing of our IPO) and it is automatically renewed for one-year terms on each anniversary thereafter. Following the initial term, the Management Agreement may be terminated upon the affirmative vote of at least two-thirds of the independent directors of our board of directors, based upon (1) unsatisfactory performance by our Manager that is materially detrimental to us or (2) a determination that the management fee payable to our Manager is not fair, subject to our Manager’s right to prevent such a termination based


54


on unfair fees by accepting a mutually acceptable reduction of management fees agreed to by at least two-thirds of our independent directors. Our Manager must be provided with written notice of any such termination at least 180 days prior to the expiration of the then existing term and will be paid a termination fee equal to three times the sum of the average annual management fee during the 24-month period immediately preceding the date of termination, calculated as of the end of the most recently completed fiscal quarter prior to the date of termination.
Off-Balance Sheet Arrangements
We do not have any material off-balance sheet arrangements. Further, we have not guaranteed any obligations of unconsolidated entities or entered into any commitment to provide additional funding to any such entities.
Dividends on Our Capital Stock
We have outstanding 6,900,000 shares of Preferred Stock, which entitles holders to receive dividends at an annual rate of 8.00% (paid quarterly, in arrears) based on the liquidation preference of $25.00 per share, or $2.00 per share per annum. The dividends on the Preferred Stock are cumulative and payable quarterly in arrears. Except under certain limited circumstances, the Preferred Stock is generally not convertible into or exchangeable for any other property or any other of our securities at the election of the holders. After September 20, 2017, we may, at our option, redeem the shares at $25.00 per share, plus any accrued unpaid distribution through the date of the redemption.
We intend to make regular quarterly dividend distributions to holders of our capital stock. U.S. federal income tax law generally requires that a REIT distribute annually at least 90% of its net taxable income, excluding net capital gains and without regard to the deduction for dividends paid, and that it pay tax at regular corporate rates to the extent that it annually distributes less than 100% of its net taxable income. We intend to pay regular quarterly dividends to our stockholders in an amount equal to our net taxable income, if and to the extent authorized by our board of directors. Before we pay any dividend, whether for U.S. federal income tax purposes or otherwise, we must first meet both our operating requirements and debt service on our repurchase agreements and other contractual obligations. If our cash available for distribution is less than our net taxable income, we could be required to sell assets or borrow funds to make cash distributions or we may make a portion of the required distribution in the form of a taxable stock distribution or distribution of debt securities.
Non-GAAP Financial Measures
We have included in this Form 10-Q disclosures about our “operating earnings,” “operating earnings per common share,” “effective cost of funds,” “effective interest expense,” “effective interest income” and “effective net interest rate spread” which disclosures constitute non-GAAP financial measures within the meaning of Regulation G promulgated by the Securities and Exchange Commission. We believe that the non-GAAP financial measures presented, when considered together with GAAP financial measures, provide information that is useful to investors in understanding our operating results. An analysis of any non-GAAP financial measures should be made in conjunction with results presented in accordance with GAAP.
Operating earnings and operating earnings per common share presented exclude, as applicable: (i) realized and unrealized gains and losses recognized through earnings; (ii) non-cash equity compensation; (iii) one time events pursuant to changes in GAAP; and (iv) certain other non-cash charges. Operating earnings is a non-GAAP financial measure that is used by our Manager to assess the results of our core business, which is to invest in mortgage assets on a levered basis using interest rate hedges to protect us against increases in our borrowing rates.
To determine our effective cost of funds, we adjust interest expense to include the net interest component related to our Swaps. While we have not elected hedge accounting for our Swaps, such derivative instruments are viewed by us as an economic hedge against increases in future market interest rates. Therefore, we present the effective cost of funds to reflect interest expense as adjusted to include a portion of the realized loss (i.e., the interest expense component) for our Swaps. We believe that the presentation of effective cost of funds is useful for investors as it presents our borrowing costs as viewed by management.
We believe that the non-GAAP measures we present provide investors and other readers of our annual report on Form 10-K and our quarterly reports on Form 10-Q with a useful measure to assess the performance of our ongoing business and useful supplemental information to both management and investors in evaluating our financial results. The primary limitation associated with operating earnings as a measure of our financial performance over any period is that it excludes the effects of net realized and unrealized gains and losses from investments and interest rate derivatives. In addition, our presentation of operating earnings may not be comparable to similarly-titled measures of other companies, who may use different definitions or calculations for such term. As a result, operating earnings should not be considered as a substitute for our GAAP net income as a measure of our financial performance or any measure of our liquidity under GAAP.


55


A reconciliation of the GAAP items discussed above to their non-GAAP measures presented in this Quarterly Report on Form 10-Q are as follows:
Table 19
 
Three Months Ended
 
 
June 30, 2013
 
June 30, 2012
 
 
Reconciliation
 
Cost of Funds/Effective Cost of Funds
 
Reconciliation
 
Cost of Funds/Effective Cost of Funds
Interest expense
 
$
7,237

 
0.67
%
 
$
2,871

 
0.53
%
Adjustment:
 
 
 
 
 
 
 
 
Net interest paid for Swaps
 
6,437

 
0.60
%
 
1,762

 
0.31
%
Effective interest expense/effective cost of funds
 
$
13,674

 
1.27
%
 
$
4,633

 
0.84
%
Weighted average balance of borrowings
 
$
4,308,870

 
 
 
$
2,192,868

 
 
 

 
Six Months Ended
 
 
June 30, 2013
 
June 30, 2012
 
 
Reconciliation
 
Cost of Funds/Effective Cost of Funds
 
Reconciliation
 
Cost of Funds/Effective Cost of Funds
Interest expense
 
$
13,454

 
0.68
%
 
$
4,232

 
0.52
%
Adjustment:
 
 
 
 
 
 
 
 
Net interest paid for Swaps
 
10,576

 
0.53
%
 
2,510

 
0.30
%
Effective interest expense/effective cost of funds
 
$
24,030

 
1.21
%
 
$
6,742

 
0.82
%
Weighted average balance of borrowings
 
$
4,005,303

 
 
 
$
1,646,007

 
 
Table 20
 
Three Months Ended
 
 
June 30, 2013
 
June 30, 2012
 
 
Reconciliation
 
Yield/Effective Cost of Funds/Spread
 
Reconciliation
 
Cost of Funds/Effective Cost of Funds/Spread
Interest income
 
$
41,329

 
3.36
%
 
$
21,990

 
3.30
%
Less: effective interest expense/effective cost of funds (1)
 
13,674

 
1.27
%
 
4,633

 
0.84
%
Effective net interest income
 
$
27,655

 
2.09
%
 
$
17,357

 
2.46
%
Weighted average balance of interest-earning assets
 
$
4,868,365

 
 
 
$
2,636,490

 
 
 
 
 
Six Months Ended
 
 
June 30, 2013
 
June 30, 2012
 
 
Reconciliation
 
Yield/Effective Cost of Funds/Spread
 
Reconciliation
 
Cost of Funds/Effective Cost of Funds/Spread
Interest income
 
$
79,576

 
3.48
%
 
$
34,353

 
3.40
%
Less: effective interest expense/effective cost of funds (1)
 
24,030

 
1.21
%
 
6,742

 
0.82
%
Effective net interest income
 
$
55,546

 
2.27
%
 
$
27,611

 
2.58
%
Weighted average balance of interest-earning assets
 
$
4,546,429

 
 
 
$
1,999,137

 
 
(1) 
As reconciled in Table 19, above.


56


The following table presents the reconciliation from net income allocable to common stockholders to operating earnings:
Table 21
 
 
 
 
 
 
Three Months Ended June 30,
 
Six Months Ended June 30,
 
 
2013
 
2012
 
2013
 
2012
Net income/(loss) allocable to common stockholders
 
$
(76,356
)
 
$
26,345

 
$
(74,600
)
 
$
46,379

Adjustments: to arrive at operating earnings:
 
 
 
 
 
 
 
 
Realized (gain)/loss on sale of RMBS, net
 
47,508

 
(11,614
)
 
31,713

 
(18,383
)
Unrealized (gain)/loss on RMBS, net
 
134,822

 
(14,598
)
 
167,870

 
(20,548
)
Unrealized (gain)/loss on derivatives, net
 
(79,778
)
 
13,792

 
(78,119
)
 
14,362

Unrealized loss on securitized mortgage loans, net
 
3,473

 
—

 
625

 
—

Unrealized (gain) on securitized debt, net
 
(887
)
 
—

 
(15
)
 
—

Non-cash stock-based compensation expense
 
146

 
90

 
545

 
168

Realized (gain)/loss on Swap/Swaption terminations, net
 
(10,028
)
 
(39
)
 
(10,028
)
 
(39
)
Total adjustments to arrive at operating earnings
 
95,256

 
(12,369
)
 
112,591

 
(24,440
)
Operating earnings
 
$
18,900

 
$
13,976

 
$
37,991

 
$
21,939

Basic and diluted operating earnings per common share
 
$
0.59

 
$
0.66

 
$
1.32

 
$
1.39

Basic and diluted weighted average common shares outstanding
 
31,995,321

 
21,257,489

 
28,858,241

 
15,759,612



57


ITEM 3.
Quantitative and Qualitative Disclosures about Market Risk.
(Amounts in thousands – except share and per share data and percentages)
We seek to manage our risks related to the credit quality of our assets, interest rates, liquidity, prepayment speeds and market value while, at the same time, seeking to provide an opportunity to stockholders to realize attractive risk-adjusted returns from our assets through ownership of our capital stock. While we do not seek to avoid risk completely, we believe that risk can be quantified from historical experience and seek to actively manage risk, to earn sufficient compensation to justify taking such risks and to maintain capital levels consistent with the risks we undertake.
Credit Risk
We are subject to varying degrees of credit risk in connection with our assets. Although we do not expect to encounter credit risk in our Agency RMBS, we do expect to encounter credit risk related to non-Agency RMBS and securitized mortgage loans and other mortgage related assets we may acquire. The credit support built into non-Agency RMBS transaction structures is designed to mitigate credit losses. In addition, to date, we have purchased our non-Agency RMBS at a discount to par value, which we believe further mitigates our risk of loss in the event that less than 100% of the par value of such securities is received. However, credit losses greater than those anticipated or in excess of the recorded purchase discount could occur, which could materially adversely impact our operating results. With respect to our securitized mortgage loans, we retain the risk of potential credit. Our Manager seeks to reduce downside risk related to unanticipated credit events through the use of active asset surveillance to evaluate collateral pool performance and overseeing the servicer.
Investment decisions are made following a bottom-up credit analysis and specific risk assumptions. As part of the risk management process our Manager uses detailed proprietary models to evaluate, depending on the asset class, house price appreciation and depreciation by region, prepayment speeds and foreclosure frequency, cost and timing.
The following table presents certain characteristics about our securitized mortgage loans, all of which are first liens, at June 30, 2013. Information presented with respect to weighted average loan to value, weighted average FICO (or, Fair Isaac Corporation) score, which is a credit score used by major credit bureaus to indicate a borrower’s credit worthiness) and other information is aggregated based on information reported at the time of mortgage origination and, as such, do not reflect the impact of the general decline in home prices or changes in a mortgagee’s credit score.
Table 22
 
Year of Origination
 
 
 
 
2008
 
2007
 
2006
 
2005
 
2004 & Prior
 
Total
Portfolio Characteristics:
 
 
 
 
 
 
 
 
 
 
 
 
Number of loans
 
69

 
658

 
14

 
6

 
2

 
749

Current unpaid principal balance
 
$
14,505

 
$
134,368

 
$
2,751

 
$
1,184

 
$
142

 
$
152,950

Loan Attributes:
 
 
 
 
 
 
 
 
 
 
 
 
Weighted average loan age
 
63

 
72

 
78

 
95

 
107

 
71

Weighted average original loan-to-value
 
74.60
%
 
79.78
%
 
81.80
%
 
80.53
%
 
100.00
%
 
79.35
%
Weighted average original FICO
 
600

 
630

 
625

 
610

 
668

 
627

Net weighted average coupon rate
 
6.98
%
 
5.76
%
 
5.62
%
 
5.16
%
 
6.63
%
 
5.87
%
Current Performance:
 
 
 
 
 
 
 
 
 
 
 
 
Current
 
84.56
%
 
80.73
%
 
95.21
%
 
52.78
%
 
100.00
%
 
81.15
%
30 day delinquent
 
10.32
%
 
11.42
%
 
—
%
 
13.20
%
 
—
%
 
11.12
%
60 days delinquent
 
4.70
%
 
2.83
%
 
—
%
 
34.02
%
 
—
%
 
3.20
%
90+ days delinquent
 
0.42
%
 
4.04
%
 
4.79
%
 
—
%
 
—
%
 
3.68
%
Bankruptcy/foreclosure
 
—
%
 
0.97
%
 
—
%
 
—
%
 
—
%
 
0.86
%


58


The following table presents information about our non-Agency RMBS and the mortgages underlying such securities at June 30, 2013. Information presented with respect to weighted average loan to value, weighted average FICO score and other information is aggregated based on information reported at the time of mortgage origination and, as such, do not reflect the impact of the general decline in home prices or changes in a mortgagee’s credit score.
Table 23
 
Year of Securitization (1)
 
 
 
 
2007
 
2006
 
2005
 
2004
 
2003 & Prior
 
Total
Portfolio Characteristics:
 
 
 
 
 
 
 
 
 
 
 
 
Number of securities
 
14

 
30

 
40

 
44

 
25

 
153

Carrying value/estimated fair value
 
$
101,247

 
$
183,144

 
$
191,741

 
$
198,484

 
$
76,408

 
$
751,024

Amortized cost
 
$
92,091

 
$
162,199

 
$
175,427

 
$
189,825

 
$
71,232

 
$
690,774

Current par value
 
$
131,345

 
$
255,688

 
$
247,979

 
$
225,511

 
$
85,771

 
$
946,294

Carrying value to current par
 
77.08
%
 
71.63
%
 
77.32
%
 
88.02
%
 
89.08
%
 
79.36
%
Amortized cost to current par
 
70.11
%
 
63.44
%
 
70.74
%
 
84.18
%
 
83.05
%
 
73.00
%
Net weighted average security coupon
 
1.97
%
 
0.68
%
 
1.05
%
 
1.53
%
 
2.16
%
 
1.32
%
Loan Attributes:
 
 
 
 
 
 
 
 
 
 
 
 
Weighted average loan age (months)
 
76

 
88

 
99

 
110

 
128

 
99

Weighted average original loan-to-value
 
57.95
%
 
71.52
%
 
67.48
%
 
74.13
%
 
69.48
%
 
69.14
%
Weighted average original FICO
 
668

 
643

 
643

 
623

 
617

 
638

Current Performance:
 
 
 
 
 
 
 
 
 
 
 
 
60+ day delinquencies
 
32.89
%
 
38.53
%
 
35.68
%
 
30.24
%
 
25.68
%
 
33.54
%
Average credit enhancement (2)
 
17.64
%
 
19.14
%
 
35.47
%
 
34.61
%
 
28.29
%
 
28.13
%
3 month CRR (3)
 
4.43
%
 
4.04
%
 
3.23
%
 
5.04
%
 
5.22
%
 
4.28
%
(1) 
Certain of our non-Agency RMBS have been resecuritized; however, the vintage and information presented is based on the initial year of securitization and the data available at that time.
(2) 
Credit enhancement is expressed as a percentage of all outstanding mortgage loan collateral. Our RMBS may incur losses if credit enhancement is reduced to zero. Information is based on loans for individual groups owned by us.
(3) 
Amounts presented reflect the weighted average monthly performance for the three months ended June 30, 2013. Information is based on loans for individual groups owned by us.
The mortgages underlying our non-Agency RMBS are located in various states across the United States. The following table presents the five largest states represented in the mortgages collateralizing our non-Agency RMBS at June 30, 2013 based on fair value:
Table 24
 
 
Property Location
 
Percent (1)
California
 
23.5
%
New York
 
9.3
%
Florida
 
9.3
%
Texas
 
6.2
%
New Jersey
 
3.7
%
Other (2) 
 
48.0
%
Total
 
100.0
%
(1) 
Percentages are weighted to reflect our proportional share for each of the securities we own.
(2) 
Includes mortgages on properties located in each of the remaining 45 states and the District of Columbia, with no concentration exceeding 3.34% of the total.
Interest Rate Risk
Interest rates are highly sensitive to many factors, including fiscal and monetary policies, domestic and international economic and political considerations, as well as other factors beyond our control. We are subject to interest rate risk in connection with our assets and our related financing obligations. In general, we expect to finance the acquisition of our assets through financings in the form of repurchase agreements, warehouse facilities, securitizations, resecuritizations, bank credit


59


facilities (including term loans and revolving facilities) and public and private equity and debt issuances, in addition to transaction or asset specific funding arrangements.
Subject to maintaining our qualification as a REIT for U.S. federal income tax purposes, we utilize derivative financial instruments to mitigate the impact of increases in interest rates. Increases in interest rates may impact the cost of our repurchase borrowings and reduce the value of our Agency RMBS. Our hedges are not designed to protect against market value fluctuations in our assets caused by changes in the spread between our investments and other benchmark rates such as Swaps and Treasury bonds. Therefore, the risk of adverse spread changes is inherent to our business. Our asset composition and general market conditions may cause the amount of interest rate protection provided by our derivatives to vary considerably over time. We also may utilize a variety of interest rate management techniques that seek to mitigate changes in interest rates or other potential influences on the values of our assets.
With respect to our results of operations and financial condition, increases in interest rates are generally expected to cause: (i) the interest expense associated with our borrowings to increase; (ii) the value of our pass-through Agency RMBS and Agency Inverse IO securities to decline; (iii) coupons on our variable rate non-Agency RMBS to reset to higher interest rates; (iv) prepayments on our RMBS to decline, thereby slowing the amortization of our Agency RMBS purchase premiums and the accretion of purchase discounts on our non-Agency RMBS; (v) the value of our Agency IO to increase; and (vi) the performance of our Swaps and Swaptions to improve. Conversely, decreases in interest rates are generally expected to have the opposite impact as those stated above. The timing and extent to which interest rates change, the specific terms of the mortgage loans underlying our RMBS, such as periodic and life-time caps and floors on ARMs, as well as other conditions in the market place will further impact our results of operations and financial condition.
Interest Rate Cap Risk
Certain of our non-Agency RMBS are collateralized by ARMs, which are generally subject to interest rate caps, which could cause such non-Agency RMBS to acquire characteristics similar to fixed-rate securities if interest rates were to rise above the cap levels. Interim interest rate caps limit the amount interest rates on a particular ARM can adjust during the next adjustment period. Lifetime interest rate caps limit the amount interest rates can adjust upward from inception through maturity of a particular ARM. These caps could result in us receiving less income on such assets than we would incur for interest expense on borrowings to finance such investments. To mitigate interest rate mismatches, we may utilize the hedging strategies discussed above under “Interest Rate Risk.”
Interest Rate Effects on Estimated Fair Value
Another component of interest rate risk is the effect that changes in interest rates will have on the market value of the assets that we acquire. We face the risk that the market value of our assets will increase or decrease differently from our interest rate derivatives.
The impact of changing interest rates on estimated fair value can change significantly when interest rates change materially. Accordingly, changes in actual interest rates may have a material adverse effect on us. Therefore, the volatility in the estimated fair value of our assets could increase significantly in the event that interest rates change materially. In addition, other factors impact the estimated fair value of our interest rate-sensitive investments and hedging instruments, such as the shape of the yield curve, market expectations as to future interest rate changes and other market conditions.
Our RMBS are carried at their estimated fair value with unrealized gains and losses included in earnings. The fair value of RMBS can generally expect to fluctuate primarily due to changes in interest rates, and with respect to our non-Agency RMBS credit changes, and other factors. Generally, in a rising interest rate environment, the estimated fair value of our RMBS portfolio, on a net basis, would generally be expected to decrease; conversely, in a decreasing interest rate environment, the estimated fair value of these securities would generally be expected to increase.
Our securitized mortgage loans are carried at their estimated fair value with unrealized gains and losses included in earnings. Such assets, which are credit sensitive, are comprised of both ARM and fixed-rate mortgage loans. As a result, changes in the fair value of our securitized mortgage loans are expected to be impacted by delinquencies, changes in housing prices, jobless rates and other factors to a greater extent than by changes in interest rates.
Our pass-through Agency RMBS, which comprise the substantial majority of our investment portfolio, are fixed-income securities. In general, as market interest rates increase, the market prices for fixed-income securities generally decrease and the duration of such assets extend; conversely, as market interest rates decrease, the market prices for fixed-income securities generally increase and the duration of such assets is reduced. Duration measures the sensitivity of the price of fixed-income securities to a change in interest rates and is expressed as a number of years. We monitor the duration of our Agency RMBS and derivatives, including Swaps, using empirical data as well as third party models and may adjust our portfolio to maintain duration at a level we believe is prudent in the current or anticipated interest rate environment. In a rising interest rate


60


environment, the weighted average life of the fixed rate mortgages underlying our Agency RMBS could extend significantly beyond the terms of our Swaps or other hedging instrument. This could have a negative impact on our results from operations, as borrowing costs would no longer be fixed beyond the term of the hedging instrument while the income earned on the remaining Agency RMBS would remain fixed for a period of time. This situation may also cause the market value of our Agency RMBS to decline with little, insufficient or no offsetting gain from the related hedging transactions. In extreme situations, we may be forced to sell assets to maintain adequate liquidity, which could cause us to incur losses. Variations in models and methodologies in measuring duration may produce differing results for the same securities or portfolio.
The value of our non-Agency RMBS and securitized mortgage loans, which may be backed by Hybrid, ARM and fixed rate mortgage loans, are more significantly impacted by the performance of the underlying collateral (i.e., credit) than by changes in interest rates.
Under our repurchase agreements, each respective lender retains the right to mark the underlying collateral to fair value. A reduction in the value of pledged assets generally results in the lender initiating a margin call, which we satisfy by pledging additional collateral in the form of securities and/or cash to the lender. In general, decreases in the fair value of our RMBS will reduce the amount we are able to borrow.
The sensitivity analysis table presented below shows the estimated impact of an instantaneous parallel shift in the yield curve, up and down 50 and 100 basis points, on the market value of our interest rate-sensitive investments, including interest rate derivatives and net interest income at June 30, 2013, assuming a static portfolio of assets. When evaluating the impact of changes in interest rates, prepayment assumptions and principal reinvestment rates are adjusted based on our Manager’s expectations. The analysis presented utilizes our Manager’s assumptions, models and estimates, which are based on our Manager’s judgment and experience.
Table 25
 
 
 
 
Basis Point Change in Interest Rates
 
Percentage Change in Projected 
Net Interest Income
 
Percentage Change in Projected
Portfolio Value
+100
 
(7.44)%
 
(0.32)%
+50
 
(3.14)%
 
(0.17)%
(50)
 
2.35%
 
0.03%
(100)
 
(0.89)%
 
(0.53)%
Certain assumptions have been made in connection with the calculation of the information set forth in the table above and, as such, there can be no assurance that assumed events will occur or that other events will not occur that would affect the outcomes. The base interest rate scenario assumes interest rates at June 30, 2013. The analysis presented utilizes assumptions and estimates based on our Manager’s judgment and experience. Furthermore, while we generally expect to retain such assets and the associated interest rate risk, future purchases and sales of assets could materially change our interest rate risk profile.
Prepayment Risk
The value of our assets may be affected by prepayment speeds on mortgage loans underlying such investments. If we acquire residential mortgage loans and mortgage related securities, we anticipate that the residential mortgage loans or the underlying residential mortgages will prepay at a projected rate generating an expected yield. If we purchase assets at a premium to par value, when borrowers prepay their residential mortgage loans faster than expected, the corresponding prepayments on the mortgage-related securities may reduce the expected yield on such securities because we will have to amortize the related premium on an accelerated basis. Conversely, if we purchase assets at a discount to par value, when borrowers prepay their residential mortgage loans slower than expected, the decrease in corresponding prepayments on the mortgage-related securities may reduce the expected yield on such securities because we will not be able to accrete the related discount as quickly as originally anticipated.
Counterparty Risk
We finance the acquisition of a significant portion of our RMBS with repurchase agreements. The aggregate of our repurchase agreement financings are reflected as a liability in our consolidated balance sheet. In connection with these financing arrangements, we pledge our securities as collateral to secure the borrowing. The amount of collateral pledged will typically exceed the amount of the borrowing (i.e., the haircut) such that the borrowing will be over-collateralized. As a result, we are exposed to the counterparty if, during the term of the repurchase agreement financing, a lender should default on its obligation and we are not able to recover our pledged assets. The amount of this exposure is the difference between the amount loaned to us plus interest due to the counterparty and the fair value of the collateral pledged by us to the lender including


61


accrued interest receivable on such collateral. For additional information about our assets pledged as collateral as of June 30, 2013, see Note 8 to the consolidated financial statements included under Item in this Quarterly Report on Form 10-Q.
We enter into Swaps, Swaptions and TBA Contracts to manage our interest rate risk. We are required to pledge cash or securities as collateral as part of a margin arrangement in connection with Swaps and TBA Contracts. The amount of margin that we are required to post will vary by counterparty and generally reflects collateral posted with respect to Swaps and TBA Contracts that are in an unrealized loss position to us and a percentage of the aggregate notional amount of Swaps per counterparty. In the event that a Swap or TBA Contract counterparty were to default on its obligation, we would be exposed to a loss to the extent that the amount of cash or securities pledged by us exceeds the unrealized loss on the associated Swaps or TBA Contract to the extent that we are not able to recover such excess collateral. In addition, if a counterparty to a Swap cannot perform under the terms of the Swap, we may not receive payments due under that agreement, and thus, may lose any unrealized gain associated with the Swap or, be unable to collect the cash value, if any, at expiration. Therefore, upon a default by a Swap counterparty, the Swap would no longer mitigate the impact of changes in interest rates as intended. If a counterparty to a Swaption cannot perform under the terms of a Swaption, we would lose our ability to exercise our option to enter into a Swap or could lose the amount by which the Swaption is in-the-money.
During the past several years, certain of our repurchase agreement and Swap counterparties in the United States and Europe have experienced financial difficulty and have been either rescued by government assistance or otherwise benefitted from accommodative monetary policy of Central Banks.
The following table summarizes our exposure to our repurchase agreements and derivative counterparties at June 30, 2013:
Table 26
 
 
 
 
 
 
 
 
 
 
 
 
Number of
Counter-
parties
 
Repurchase
Agreement
Borrowings
 
Derivatives at
Fair Value
 
Exposure (1)
 
Exposure
as Percent
of Total
Assets
North America:
 
 
 
 
 
 
 
 
 
 
United States
 
9

 
$
1,854,399

 
$
55,164

 
$
197,854

 
4.1
%
Canada (2)
 
2

 
418,307

 
—

 
71,891

 
1.5
%

 
11

 
2,272,706

 
55,164

 
269,745

 
5.6
%
Europe :(2)
 
 
 
 
 
 
 
 
 
 
Germany
 
1

 
259,524

 
—

 
18,322

 
0.4
%
Switzerland
 
1

 
162,757

 
—

 
33,856

 
0.7
%
United Kingdom
 
2

 
320,222

 
(1,593
)
 
20,577

 
0.4
%
Netherlands
 
1

 
236,030

 
—

 
13,668

 
0.3
%
 
 
5

 
978,533

 
(1,593
)
 
86,423

 
1.8
%
Asia :(2)
 
 
 
 
 
 
 
 
 
 
Japan
 
3

 
693,858

 
11,662

 
32,729

 
0.7
%
Total Counterparty Exposure
 
19

 
$
3,945,097

 
$
65,233

 
$
388,897

 
8.1
%
 
(1) 
Represents the amount of cash and/or securities pledged as collateral to counterparties and associated accrued interest receivable less the aggregate of repurchase agreement borrowings and associated accrued interest payable and unrealized loss on Swaps for each counterparty net of collateral pledged to us, the fair value of our Swaptions.
(2) 
Includes foreign based counterparties as well as U.S. domiciled subsidiaries of such counterparties, as such transactions are generally entered into with a U.S. domiciled subsidiary of such counterparties.
We maintain cash deposits with what we believe to be high credit quality financial institutions. At June 30, 2013, we had cash of $195,699, primarily comprised of cash on deposit with our prime broker domiciled in the United States, substantially all of which was in excess of applicable insurance limits.
Funding Risk
We have financed a substantial majority of our RMBS with repurchase agreement borrowings. Over time, as market conditions change, in addition to these financings, we may use other forms of leverage. Weakness in the financial markets, the residential mortgage markets and the economy generally could adversely affect one or more of our potential lenders and could cause one or more of our potential lenders to be unwilling or unable to provide us with financing or to increase the costs of that financing.


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Liquidity Risk
The assets that comprise our asset portfolio are not traded on an exchange. A portion of these assets may be subject to legal and other restrictions on resale or will otherwise be less liquid than exchange-traded securities. Certain of our assets may from time to time become illiquid, making it difficult for us to sell such assets if the need or desire arises, or sell such assets at prices that are detrimental to us, including in response to changes in economic and other conditions.
Inflation
Substantially all of our assets and liabilities are financial in nature. As a result, changes in interest rates and other factors impact our performance far more than inflation. Our financial statements are prepared in accordance with GAAP and dividends are based upon net ordinary income as calculated for tax purposes; in each case, our results of operations and reported assets, liabilities and equity are measured with reference to historical cost or fair value without considering inflation.


63


ITEM 4.
Controls and Procedures.
The Company’s Chief Executive Officer and Chief Financial Officer, based on their evaluation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) required by paragraph (b) of Rule 13a-15 or Rule 15d-15, have concluded that as of June 30, 2013, our disclosure controls and procedures were effective to give reasonable assurances to the timely collection, evaluation and disclosure of information relating to the Company that would potentially be subject to disclosure under the Exchange Act and the rules and regulations promulgated thereunder.
During the period ended June 30, 2013, there was no change in our internal control over financial reporting that has materially affected, or was reasonably likely to materially affect, our internal control over financial reporting.
Notwithstanding the foregoing, a control system, no matter how well designed and operated, can provide only reasonable, not absolute assurance that it will detect or uncover failures within the Company to disclose material information otherwise required to be set forth in our periodic reports.


64


PART II – OTHER INFORMATION
ITEM 1.
Legal Proceedings
From time to time, we may be involved in various claims and legal actions arising in the ordinary course of business. As of June 30, 2013, we were not involved in any legal proceedings.

ITEM 1A.
Risk Factors
There were no material changes to the Risk Factors disclosed in our Annual Report on Form 10-K for the year ended December 31, 2012.
ITEM 2.
Unregistered Sales of Equity Securities and Use of Proceeds
None.
ITEM 3.
Defaults Upon Senior Securities
None.
ITEM 4.
Mine Safety Disclosures
Not Applicable.
ITEM 5.
Other Information
None.


65



ITEM 6.
Exhibits
Exhibit No.
  
Description
 
 
3.1

  
Articles of Amendment and Restatement of Apollo Residential Mortgage, Inc., incorporated by reference to Exhibit 3.1 of the Registrant’s Form S-8 (Registration No. 333- 175824).
 
 
3.2

  
Articles Supplementary designating Apollo Residential Mortgage, Inc.’s 8.00% Series A Cumulative Redeemable Perpetual Preferred Stock, liquidation preference $25.00 per share, par value $0.01 per share, incorporated by reference to Exhibit 3.2 of the Registrant’s Form 8-A (File No.: 001-35246), filed on September 19, 2012.
 
 
3.3

  
Amended and Restated Bylaws of Apollo Residential Mortgage, Inc., incorporated by reference to Exhibit 3.2 of the Registrant’s Form S-8 (Registration No. 333- 175824).
 
 
4.1

  
Specimen Common Stock Certificate of Apollo Residential Mortgage, Inc., incorporated by reference to Exhibit 4.1 of the Registrant’s Form S-11, as amended (Registration No. 333-172980).
 
 
4.2

  
Specimen Preferred Stock Certificate of Apollo Residential Mortgage, Inc., incorporated by reference to Exhibit 4.2 of the Registrant’s Form 10-Q for the period ended September 30, 2012.
 
 
31.1

  
Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
 
31.2

  
Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
 
 
32.1

  
Certification of Chief Executive Officer and Chief Financial Officer pursuant to Section 906 of 18 U.S.C. Section 1350 as adopted pursuant to the Sarbanes-Oxley Act of 2002.
 
 
101.INS*
  
XBRL Instance Document
 
 
101.SCH*
  
XBRL Taxonomy Extension Schema Document
 
 
101.CAL*
  
XBRL Taxonomy Extension Calculation Linkbase Document
 
 
101.DEF*
  
XBRL Taxonomy Extension Definition Linkbase Document
 
 
101.LAB*
  
XBRL Taxonomy Extension Label Linkbase Document
 
 
101.PRE*
  
XBRL Taxonomy Extension Presentation Linkbase Document
*
 These interactive data files are furnished and not deemed filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act, and are not deemed filed for purposes of Section 18 of the Exchange Act, and otherwise are not subject to liability under those sections.



66


SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
 
 
 
 
 
 
 
 
 
 
 
APOLLO RESIDENTIAL MORTGAGE, INC.
 
 
 
 
 
 
 
 
August 7, 2013
 
 
 
 
 
 
 
 
By:
 
/s/ Michael A. Commaroto
 
 
 
 
Michael A. Commaroto
 
 
 
 
President and Chief Executive Officer
 
 
 
 
(Principal Executive Officer)
 
 
 
 
 
 
 
 
By:
 
/s/ Stuart A. Rothstein
 
 
 
 
Stuart A. Rothstein
 
 
 
 
Chief Financial Officer, Treasurer and Secretary
 
 
 
 
(Principal Financial Officer and Principal Accounting Officer)


67