10-K 1 a2013123110k.htm 10-K 2013.12.31 10K


UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549 
 
 
 
FORM 10-K
 
 
 
ý
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the fiscal year ended December 31, 2013
OR
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from                      to                     
Commission File Number: 001-35246 
 
 
 
APOLLO RESIDENTIAL MORTGAGE, INC.
(Exact name of registrant as specified in its charter)
 
 
 
Maryland
 
45-0679215
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
 
 
c/o Apollo Global Management, LLC
9 West 57th Street, 43rd Floor
New York, New York
(Address of principal executive offices)
 
10019
(Zip Code)
(212) 515–3200
(Registrant’s telephone number, including area code)
 
 
 
Securities registered pursuant to Section 12(b) of the Act:
Title of Each Class
 
Name of Each Exchange on Which Registered
Common Stock, $0.01 par value
 
New York Stock Exchange
8.0% Series A Cumulative Redeemable Perpetual Preferred Stock, $0.01 par value $25.00 mandatory liquidation preference
 
New York Stock Exchange
Securities registered pursuant to Section 12(g) of the Act:
None 
 
 
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.    Yes  ¨    No  ý
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Exchange Act.    Yes  ¨    No  ý
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  ý    No  ¨
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  ý    No  ¨
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§ 229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  ý
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.
Large accelerated filer
¨
 
 
Accelerated filer
ý
 
 
 
 
 
Non-accelerated filer
¨
(Do not check if a smaller reporting company)
 
Smaller reporting company
¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨    No  ý
As of June 28, 2013, the aggregate market value of the registrant’s common stock held by non-affiliates of the registrant was $522,264,007, based on the closing sales price of the registrant’s common stock on such date as reported on the New York Stock Exchange.
On February 18, 2014, the registrant had a total of 32,040,533 shares of common stock outstanding.
 
 
 
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the registrant’s proxy statement for the 2014 annual meeting of stockholders scheduled to be held on or about June 19, 2014 are incorporated by reference into Part III of this annual report on Form 10-K.




TABLE OF CONTENTS
 
 
Page
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Exhibits and Financial Statement Schedules
 
 



FORWARD-LOOKING INFORMATION
In this annual report on Form 10-K, 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 this annual report on Form 10-K. “Agency” or “Agencies” refer to a federally chartered corporation, such as Fannie Mae or Freddie Mac, or an agency of the United States (or, U.S.) Government, such as Ginnie Mae; “RMBS” refer to residential mortgage-backed securities, “Agency RMBS” refer to RMBS issued or guaranteed by an Agency 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; “Subprime” refers to mortgage loans that have been originated using underwriting standards that are less restrictive than those used to originate prime mortgage loans; “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; “Hybrids” refer to mortgage loans that have fixed interest rates for a period of time and, thereafter generally adjust annually based on an increment over a specified interest rate index; “Agency IOs” and “Agency Inverse IOs” refer to Agency interest-only and Agency inverse interest-only securities, respectively, 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 Short Contracts” refer to TBA Contracts for which we would be required to deliver certain Agency RMBS on a forward basis.
We make forward-looking statements in this annual report on Form 10-K and will make forward-looking statements in future filings with the Securities and Exchange Commission (or, SEC), press releases or other written or oral communications within the meaning of Section 27A of the Securities Act of 1933, as amended (or, Securities Act) and Section 21E of the Securities Exchange Act of 1934, as amended (or, Exchange Act). For these statements, we claim the protections of the safe harbor for forward-looking statements contained in such sections. 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 non-Agency RMBS; 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 rates 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 real estate investment trust (or, REIT) for U.S. federal income tax purposes; our ability to remain excluded from registration as an investment company under the Investment Company Act of 1940, as amended (or, 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 pay dividends 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 us. 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. Some of these factors are described in “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this annual report on Form 10-K. These and other risks, uncertainties and factors, including those described in the annual, quarterly and current reports that are filed 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. See ITEM 1A of this annual report on Form 10-K.


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PART I

ITEM 1.
Business
All currency figures are presented in thousands, except per share data or as otherwise noted.
GENERAL
We were organized as a Maryland corporation on March 15, 2011 and commenced operations on July 27, 2011, concurrent with the initial public offering of our common stock (or, IPO). 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 so as to continue to qualify to be taxed 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 ARM Manager, LLC (or, Manager), an indirect subsidiary of Apollo Global Management, LLC (together with its subsidiaries, Apollo). Founded in 1990, Apollo is a leading global alternative investment manager with a contrarian and value-oriented investment approach, with reported total assets under management of approximately $161.2 billion as of December 31, 2013. Apollo has significant and longstanding experience in residential real estate markets through a number of its funds’ investments. We believe that utilizing the extensive expertise of our Manager allows us to differentiate ourself from our peers in the acquisition of our target assets. Specifically, we believe that our Manager’s deep understanding of mortgage market fundamentals, as well as its ability to analyze, model and set value parameters around the individual mortgages that collateralize Agency RMBS and non-Agency RMBS, enables our Manager to selectively acquire assets for us that present attractive risk-adjusted return profiles and have the potential for capital appreciation.
We are primarily engaged in the business of investing, on a leveraged basis, in residential mortgage assets in the U.S. Our principal objective is to provide attractive risk-adjusted returns from our assets to our stockholders over the long term, primarily through dividend distributions and secondarily through capital appreciation.
INVESTMENT STRATEGY
We invest in residential mortgage assets throughout the U.S. As of December 31, 2013, we held investments in Agency RMBS, including Agency IOs and Agency Inverse IOs, non-Agency RMBS, securitized mortgage loans and other mortgage related investments. We believe that the diversification of our portfolio of assets over time, our expertise within our target asset classes and the flexibility of our strategy will enable us to achieve attractive risk-adjusted returns under a variety of market conditions and economic cycles. 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. Our board of directors may, without stockholder approval, amend our investment strategy at any time. 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 (or, CMOs), 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, Subprime mortgage loans or other mortgage-like financing arrangements. These mortgages may be performing, sub-performing or non-performing.
 
 
 
Other Residential Mortgage Related 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 servicing spreads (or, excess MSRs). In addition, we may own real estate incidental to our financing arrangements associated with such properties.
We rely on our Manager’s expertise in identifying assets within our target asset classes and to efficiently finance those assets. We expect that our Manager will make decisions based on a variety of factors, including expected risk-adjusted returns


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on our assets, credit fundamentals, liquidity, availability of adequate financing, borrowing costs and macroeconomic conditions, as well as maintaining our qualification as a REIT and our exclusion from registration as an investment company under the 1940 Act.
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 4.1 times at December 31, 2013. 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. We finance our Agency RMBS with repurchase agreements generally targeting, in the aggregate, a debt-to-equity ratio of approximately eight-to-one and finance our non-Agency RMBS with repurchase agreements generally targeting, in the aggregate, a debt-to-equity ratio of approximately three-to-one. Our target and actual leverage may vary from time to time based on market conditions and/or our assessment of market conditions. 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. In April 2013, we were able to extend certain of our repurchase borrowings collateralized by non-Agency RMBS with initial terms of up to 18 months. At December 31, 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 December 31, 2013, we had $3,034,058 of borrowings outstanding under our repurchase agreements with 17 counterparties collateralized by $2,125,767 of Agency RMBS, $11,515 of other investments securities and $1,256,250 of non-Agency RMBS, which included $47,057 of non-Agency RMBS that are eliminated from our balance sheet in consolidation with a VIE. (See Notes 6 - Receivables, 7 - Borrowings Under Repurchase Agreements, 8 - Collateral Positions and 9 - Offsetting Assets and Liabilities to the consolidated financial statements included under ITEM 8 of this annual report on Form 10-K.)
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 long-term 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 collateralized by the securitized mortgage loans. (See Notes 5 - Securitized Mortgage Loans and 13 - Use of Special Purpose Entities to the consolidated financial statements included under ITEM 8 of this annual report on Form 10-K.)
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. (See “Market Conditions and Our Strategy” included under ITEM 7 of this annual report on Form 10-K.)
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 taxable REIT subsidiary (or, TRS) that will generally be subject to U.S. 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 derivative instruments, which to date have been comprised of interest rate swaps (or, Swaps), interest rate swaptions (or, Swaptions) and TBA Short Contracts. Our Swaps and Swaptions mitigate the effects of increases in interest rates on a portion of our future repurchase borrowings; in addition, these derivative instruments may also mitigate the impact of increases in interest rates on the value of our Agency RMBS portfolio. At December 31, 2013, our Swaps had an aggregate notional balance of $1,587,000 with a weighted average fixed pay rate of 1.34% and a weighted average term to maturity of 5.1 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 the terms of our Swaps, we pay a fixed rate of interest and receive a variable rate of interest, generally based on the three-month London Interbank Offer Rate (or, 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


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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 December 31, 2013, our Swaptions had an aggregate stated notional balance of $1,375,000 and a weighted average term of five months until expiration; the Swaps underlying our Swaptions had a weighted average fixed pay rate of 3.64% and a weighted average term of 10 years.
TBA Short Contracts serve as an economic hedge against decreases in the value of Agency RMBS held in our portfolio, in an amount equivalent to the TBA Contract notional balance, with the same characteristics as those stipulated in the TBA Contract. At December 31, 2013, we had four TBA Short Contracts with an aggregate stated notional balance of $400,000, which provide that we settle such contracts at their maturity date of February 13, 2014, by either delivering the Agency RMBS as specified in the contract or net settling such contracts, whereby we would either pay or receive an amount equal to the fair value of the contract. For U.S. federal income tax purposes, although the law is not clear with respect to TBA transactions, we intend to take the position that settling TBA Short Contracts results in a gain or loss on the disposition of the securities delivered for the purpose of the REIT 75% and 95% gross income tests. In addition, we may also engage in other hedging transactions, including, but not limited to, 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 the net settling of 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 pursuant to accounting principles generally accepted in the U.S. (or, GAAP) 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.
Certain Swap trades entered into since June 10, 2013 are required to be cleared through a clearinghouse, in accordance with the Commodities Futures Trading Commission (or, CFTC) Swap clearing rules. Swaps cleared under the CFTC Swap clearing rules generally require that higher initial margin collateral be posted relative to Swaps transacted with individual counterparties. The change in Swap margin collateral requirement generally increases the inherent cost of cleared Swaps, as higher amounts of cash are required to be pledged to meet the initial margin requirement on such transactions. (For additional information about our derivative instruments, see Note 10 - Derivative Instruments to the consolidated financial statements included under ITEM 8 of this annual report on Form 10-K.)
CORPORATE GOVERNANCE
Our board of directors is composed of a majority of independent directors. The Audit, Nominating and Corporate Governance and Compensation Committees of the board are composed exclusively of independent directors.
In order to foster the highest standards of ethics and conduct in all business relationships, we have adopted a Code of Business Conduct and Ethics and Corporate Governance Guidelines, which cover a wide range of business practices and procedures that apply to all of our directors and officers. In addition, we have implemented Whistleblowing Procedures for Accounting and Auditing Matters (or, Whistleblower Policy) that set forth procedures by which any Covered Persons (as defined in the Whistleblower Policy) may raise, on a confidential basis, concerns regarding, among other things, any questionable or unethical accounting, internal accounting controls or auditing matters with the Audit Committee. Third parties, such as vendors, clients, stockholders or competitors may also report a good faith complaint regarding such matters under the Whistleblower Policy.
We have a trading policy in place that governs the purchase or sale of any securities of the Company by any of our directors or employees, or by the partners, directors and officers of Apollo, as well as others, and that prohibits any such persons from buying or selling our securities on the basis of material non-public information.
COMPETITION
Our net income depends, in part, on our ability to acquire assets at favorable spreads over our borrowing costs. In acquiring and financing our target assets, we compete with other REITs, specialty finance companies, savings and loan associations, banks, mortgage bankers, insurance companies, mutual funds, institutional investors, investment banking firms, financial institutions, governmental bodies and other entities. These competitors may be significantly larger than us, may have access to greater capital and other resources or may have other advantages. In addition, some competitors may have higher risk tolerances or different risk assessments, which could allow them to consider a wider variety of investments and establish more relationships than us. Market conditions may attract additional market competitors, which may further increase our competition for investments and sources of financing. An increase in the competition for sources of funding could adversely affect the availability and cost of our financing, and thereby adversely affect the market price of our common stock and preferred stock (collectively our “capital stock”).


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EMPLOYEES
We have no employees and are managed by our Manager pursuant to the management agreement between our Manager, us and ARM Operating LLC, dated as of July 21, 2011 (or, Management Agreement). Our officers, comprised of our Chief Executive Officer (or, CEO)/President and Chief Financial Officer (or, CFO)/Treasurer/Secretary are employees of our Manager or its affiliates.
AVAILABLE INFORMATION
We maintain a website at www.apolloresidentialmortgage.com and make available, free of charge, on our website (a) our annual report on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K (including any amendments thereto), proxy statements and other information (or, Company Documents) filed with, or furnished to, the SEC, as soon as reasonably practicable after such documents are so filed or furnished, (b) Corporate Governance Guidelines, (c) Code of Business Conduct and Ethics and (d) written charters of the Audit Committee, Compensation Committee and Nominating and Corporate Governance Committee of our board of directors. Our documents filed with, or furnished to, the SEC are also available for review and copying by the public at the SEC’s Public Reference Room at 100 F Street, NE., Washington, DC 20549 and at the SEC’s website at www.sec.gov. Information regarding the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. We provide copies of our Corporate Governance Guidelines and Code of Business Conduct and Ethics, free of charge, to stockholders who request it. Requests should be directed to Investor Relations — Apollo Residential Mortgage, Inc., c/o Apollo Global Management, LLC, 9 West 57th Street, 43rd Floor, New York, New York 10019.



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ITEM 1A.
Risk Factors
Our business and operations are subject to a number of risks and uncertainties, the occurrence of which could adversely affect our business, financial condition, results of operations and ability to pay dividends to our stockholders and could cause the value of our common stock and 8.0% Cumulative Redeemable Perpetual Preferred Stock (or, Preferred Stock), to decline.
Readers should carefully consider each of the following risks and all of the other information set forth in this annual report on Form 10-K. Based on the information currently known to us, we believe the following information identifies the most significant risk factors affecting us. However, the risks and uncertainties we face are not limited to those described below. Additional risks and uncertainties not presently known to us or that we currently believe to be immaterial may also have a material effect on our business, financial condition, results of operations, the market price of our capital stock and our ability to pay dividends to our stockholders.
Risks Related to Our Relationship with Our Manager
We depend on our Manager and certain key personnel of our Manager for success and upon their access to Apollo’s investment professionals and partners. We may not find a suitable replacement for our Manager if the Management Agreement is terminated or if key personnel leave the employment of our Manager or Apollo or otherwise become unavailable to us.
We do not have any employees or separate facilities and rely completely on our Manager to provide us with investment and advisory services. Our Manager has significant discretion as to the implementation of our operating policies and strategies. We depend on the diligence, skill and network of business contacts of our Manager. We benefit from the personnel, relationships and experience of our Manager’s executive team and other personnel and investors of Apollo. The executive officers and key personnel of our Manager evaluate, negotiate, purchase and monitor investments; therefore, our success depends on their continued service. We also depend, to a significant extent, on our Manager’s access to the investment professionals and partners of Apollo and the industry insight and deal flow generated by the Apollo investment professionals in the course of their investment and portfolio management activities.
The departure of any of the senior personnel of our Manager, or of a significant number of the investment professionals or partners of Apollo, could have a material adverse effect on our ability to achieve our investment objectives. In addition, we offer no assurance that our Manager will remain the investment manager or that it will continue to have access to its or Apollo’s executive officers and other investment professionals. The initial term of the Management Agreement with our Manager is through July 27, 2014, the third anniversary of the closing of the IPO. We did not provide notice of termination of the Management Agreement to our Manager and, as a result, the term of the Management Agreement was automatically extended to July 27, 2015, with automatic one year renewals thereafter. If the Management Agreement is terminated and no suitable replacement is found to manage us, we may not be able to continue to execute our business strategy.
The ability of our Manager and its officers and other personnel to engage in other business activities may reduce the time our Manager spends managing our business and may result in certain conflicts of interest.
Certain of our officers and directors, and the officers and other personnel of our Manager, also serve or may serve as officers, directors or partners of other Apollo vehicles. Further, the officers and other personnel of our Manager may be called upon to provide managerial assistance to other Apollo vehicles. These demands on their time may distract them or slow the rate of our investment activity. Furthermore, a private equity fund managed by Apollo has an investment in and controls Vantium Capital Markets, L.P. (or, Vantium), which is an entity that invests in residential mortgages and other related assets. Vantium is in the process of winding down its existing portfolio of mortgage assets and ceased acquiring assets in 2011. In addition to Vantium, other affiliates of Apollo, including certain separate accounts and funds managed by Apollo, source and/or manage RMBS and other mortgage related assets. It is possible that other Apollo vehicles, as well as existing or future portfolio companies or funds or separate accounts managed by Apollo, may from time to time, have the same target assets as ours as a part of their larger business strategies. To the extent such other Apollo vehicle, or other vehicles that may be organized in the future, seek to acquire the same target assets as us, the scope of opportunities otherwise available to us may be adversely affected and/or reduced.
We do not have a policy that expressly prohibits our directors, officers, security holders or affiliates from engaging in business activities of the types conducted by us for their own account.
We do not have a policy that expressly prohibits our directors, officers, security holders or affiliates from engaging in business activities of the types conducted by us for their own account. However, our Code of Business Conduct and Ethics contains a conflicts of interest policy that prohibits our directors and executive officers, as well as personnel of our Manager, from engaging in any transaction that involves an actual conflict of interest, except under guidelines approved by our board of directors. Directors, executive officers and personnel of our Manager who are employees of Apollo are also subject to Apollo’s Code of Business Conduct and Ethics. In addition, the Management Agreement with our Manager does not prevent our


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Manager and its affiliates from engaging in additional management or investment opportunities, some of which could compete with us.
The Management Agreement was negotiated between related parties and its terms, including fees payable to our Manager, may not be as favorable to us as if they had been negotiated with an unaffiliated third party.
The Management Agreement was negotiated between related parties and its terms, including fees payable to our Manager, may not be as favorable to us as if they had been negotiated with an unaffiliated third party. In addition, we may choose not to enforce, or to enforce less vigorously, our rights under the Management Agreement because of the desire to maintain our ongoing relationship with our Manager.
The termination of the Management Agreement may be difficult and require payment of a substantial termination fee or other amounts, including in the case of termination for unsatisfactory performance, which may adversely affect our inclination to end the relationship with our Manager.
Termination of the Management Agreement with our Manager without cause is difficult and requires payment of a substantial termination fee or other amounts. The term “cause” is limited to specific circumstances laid out in the Management Agreement. Termination for unsatisfactory financial performance does not constitute “cause” under the Management Agreement. The Management Agreement provides that, in the absence of cause, it may only be terminated at the expiration of the initial term or any renewal period, upon the vote of at least two-thirds of our independent directors based upon: (i) unsatisfactory performance by our Manager that is materially detrimental to us or (ii) a determination that the management fees payable to our Manager are not fair, subject to our Manager’s right to prevent termination based on unfair fees by accepting a reduction of management fees agreed to by at least two-thirds of our independent directors. We must provide our Manager with 180 days prior notice of any such termination. Additionally, upon non-renewal or a termination by us without cause (or upon a termination by our Manager due to our material breach), the Management Agreement provides that we will pay our Manager a termination payment equal to three times the average annual management fees earned by our Manager during the 24-month period prior to such termination, calculated as of the end of the most recently completed fiscal quarter. These provisions increase the effective cost to us of electing not to renew or to terminate (or defaulting in our obligations under) the Management Agreement, thereby adversely affecting our inclination to end our relationship with our Manager, even if we believe our Manager’s performance is not satisfactory.
The initial term of the Management Agreement with our Manager is through July 27, 2014, the third anniversary of the closing of the IPO. We did not provide notice of termination of the Management Agreement to our Manager and, as a result, the term of the Management Agreement was automatically extended to July 27, 2015, with automatic one-year renewals thereafter provided. However, as described above, under the certain limited circumstances we may terminate the Management Agreement annually upon 180 days prior notice to our Manager, which cancellation would require that we pay a fee to the Manager.
Our Manager’s and Apollo’s liability is limited under the Management Agreement and we have agreed to indemnify them against certain liabilities. As a result, we could experience poor performance or losses for which our Manager would not be liable.
Pursuant to the Management Agreement, our Manager will not assume any responsibility other than to render the services called for thereunder and will not be responsible for any action of our board of directors in following or declining to follow its advice or recommendations. Under the terms of the Management Agreement, our Manager, its officers, members, managers, directors, personnel, any person controlling or controlled by our Manager and any person providing services to our Manager (including Apollo) will not be liable to us, any subsidiary of ours, our stockholders or partners or any subsidiary’s stockholders or partners for acts or omissions performed in accordance with and pursuant to the Management Agreement, except by reason of acts constituting bad faith, willful misconduct, gross negligence, or reckless disregard of their duties under the Management Agreement. In addition, we have agreed to indemnify our Manager, its officers, stockholders, members, managers, directors, personnel, any person controlling or controlled by our Manager and any person providing services to our Manager (including Apollo) with respect to all expenses, losses, damages, liabilities, demands, charges and claims arising from acts of our Manager not constituting bad faith, willful misconduct, gross negligence, or reckless disregard of duties, performed in good faith in accordance with and pursuant to the Management Agreement.
Our Manager’s failure to make investments on favorable terms that satisfy our investment strategy and otherwise generate attractive risk-adjusted returns from our assets would materially and adversely affect us.
Our ability to achieve our investment objectives depends on our ability to grow, which depends in turn on the management team of our Manager and its ability to identify and make investments on favorable terms that meet our investment criteria, as well as on our access to financing on acceptable terms. Our ability to grow is also dependent upon our Manager’s ability to successfully hire, train, supervise and manage new personnel. We may not be able to manage growth effectively or to achieve growth at all. Any failure to manage our future growth effectively could have a material adverse effect on our business,


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financial condition, results of operations, the market price of our capital stock and our ability to pay dividends to our stockholders.
We do not own the Apollo name, but we may use the name pursuant to a license agreement with Apollo. Use of the name by other parties or the termination of our license agreement may harm our business.
We have entered into a license agreement with Apollo, pursuant to which it has granted us a non-exclusive, royalty-free license to use the name “Apollo.” Under this agreement, we have the right to use this name for so long as our Manager continues to serve us pursuant to the Management Agreement. Apollo retains the right to continue using the “Apollo” name. We cannot preclude Apollo from licensing or transferring the ownership of the “Apollo” name to third parties, some of whom may compete with us. Consequently, we would be unable to prevent any damage to goodwill that may occur as a result of the activities of Apollo or others. Furthermore, in the event that the license agreement is terminated, we will be required to change our name and cease using the name. Any of these events could disrupt our recognition in the market place, damage any goodwill we may have generated and otherwise harm our business. The license agreement will terminate concurrently with the termination of the Management Agreement.
The manner of determining the management fee may not provide sufficient incentive to our Manager to maximize risk-adjusted returns from our assets in our investment portfolio since it is based on our stockholders’ equity (as defined in the Management Agreement) and not on other measures of performance.
Our Manager is entitled to receive a management fee that is based on the amount of our stockholders’ equity (as defined in the Management Agreement) at the end of each quarter, regardless of our performance. Our stockholders’ equity for the purposes of calculating the management fee is not the same as, and could be greater than, the amount of stockholders’ equity shown on our consolidated financial statements. The possibility exists that significant management fees could be payable to our Manager for a given quarter despite the fact that we experienced a net loss during that quarter. Our Manager’s entitlement to such compensation (regardless of performance) may not provide sufficient incentive to our Manager to devote its time and effort to source and maximize risk-adjusted returns from our assets on our investment portfolio, which could in turn adversely affect our ability to pay dividends to our stockholders and the market price of our capital stock. Furthermore, the compensation payable to our Manager will increase as a result of future equity offerings, even if the offering is dilutive to existing stockholders.
Our Manager manages our portfolio pursuant to very broad investment guidelines and our board of directors does not approve each investment decision made by our Manager, which may result in us making riskier investments.
Our Manager is authorized to follow very broad investment guidelines. While our directors periodically review our investment guidelines and our investment portfolio, they do not review all of our proposed investments. In addition, in conducting periodic reviews, our directors may rely primarily on information provided to them by our Manager. Furthermore, our Manager may use complex strategies and transactions entered into by our Manager that may be difficult or impossible to unwind by the time they are reviewed by our directors. Our Manager has great latitude within the broad investment guidelines in determining the types of assets that are proper investments for us, which could result in investment returns that are substantially below expectations or that result in losses, which could materially and adversely affect our business, financial condition, results of operations, the market price of our capital stock and our ability to pay dividends to our stockholders. Decisions made and investments entered into by our Manager may not fully reflect our best interests.
There are various conflicts of interest in our relationship with Apollo, which could result in decisions that are not in the best interests of our stockholders.
We are subject to conflicts of interest arising out of our relationship with Apollo, including our Manager. In the future, we may enter into additional transactions with Apollo. In particular, we may invest in, or acquire, certain of our investments through other Apollo vehicles, including joint ventures with affiliates of Apollo, or purchase assets from, sell assets to or arrange financing from or provide financing to new affiliated potential pooled investment vehicles or managed accounts not yet established, whether managed or sponsored by Apollo’s affiliates or our Manager. Any such transactions will require approval by a majority of our independent directors. In certain instances we may invest alongside other Apollo vehicles in different parts of the capital structure of the same issuer. Depending on the size and nature of such investment, such transactions may require approval by a majority of our independent directors. There can be no assurance that any procedural protections will be sufficient to assure that these transactions will be made on terms that will be at least as favorable to us as those that would have been obtained in an arm’s length transaction.
Our Manager and Apollo have agreed that, for so long as the Management Agreement is in effect and Apollo controls our Manager, neither they nor any entity controlled by Apollo will sponsor or manage any U.S. publicly traded REIT that invests primarily in our target assets. However, our Manager, Apollo and their respective affiliates has and may in the future sponsor or manage additional U.S. publicly traded REITs that invest generally in real estate assets but not primarily in our target assets. Presently, a private equity fund managed by Apollo has an investment in and controls Vantium, which is an entity that invests in


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residential mortgages and other related assets. Vantium is in the process of winding down its existing portfolio of mortgage assets and ceased acquiring assets in 2011. In addition to Vantium, other affiliates of Apollo, including certain separate accounts and funds managed by Apollo, source and/or manage RMBS and other mortgage related assets. It is possible that other Apollo vehicles, as well as existing or future portfolio companies or funds or separate accounts managed by Apollo, may from time to time, have the same target assets as ours as a part of their larger business strategies. To the extent such other Apollo vehicles, or other vehicles that may be organized in the future, seek to acquire the same target assets as us, the scope of opportunities otherwise available to us may be adversely affected and/or reduced. Our Manager and Apollo have an investment allocation policy in place that is intended to ensure that every Apollo vehicle, including us, is treated in a manner that, over time, is fair and equitable.
According to this policy, investments may be allocated by taking into account factors, including but not limited to, available capital and net asset value of the investment vehicles, suitability of the investment, order size, investment objectives, permitted leverage and available financing, current income expectations, the size, liquidity and duration (i.e., the measure of sensitivity of the price of fixed income securities to changes in interest rates) of the available investment, seniority and other capital structure considerations and the tax implications of an investment. In certain circumstances, the allocation policy provides for the allocation of investments pursuant to a pre-defined arrangement that is other than pro-rata. The investment allocation policy may be amended by our Manager and Apollo at any time without our consent.
In addition to the fees payable to our Manager under the Management Agreement, our Manager and its affiliates may benefit from other fees paid to it in respect of our investments. In addition, an affiliate of Apollo may act as servicer for some of our mortgage loans or for any securitization vehicles we may establish. In any of these or other capacities, affiliates of Apollo and/or our Manager may receive market based fees for their roles, but only if approved by a majority of our independent directors.
Possession of material, non-public information could prevent us from undertaking advantageous transactions; Apollo could decide to establish information barriers.
Apollo generally follows an open architecture approach to information sharing within the larger Apollo organization and does not normally impose information barriers among Apollo and certain of its affiliates. If our Manager were to receive material non-public information about a particular real estate-related entity, or have an interest in investing in a particular mortgage-related asset, Apollo or its affiliates may be prevented from investing in such asset. Conversely, if Apollo or its affiliates were to receive material non-public information about a particular mortgage-related asset, or have an interest in investing in a particular mortgage-related asset, we may be prevented from investing in such asset. This risk affects us more than it does investment vehicles that are not related to Apollo, as Apollo generally does not use information barriers that many firms implement to separate persons who make investment decisions from others who might possess material, non-public information that could influence such decisions. Apollo’s approach to these barriers could prevent our Manager’s investment professionals from undertaking advantageous investments or dispositions that would be permissible for them otherwise. In addition, Apollo could in the future decide to establish information barriers, particularly as its business expands and diversifies. In such event, Apollo’s ability to operate as an integrated platform will be restricted and our Manager’s resources may be limited.
Our business may be adversely affected if our reputation, the reputation of our Manager or Apollo, or the reputation of counterparties with whom we associate is harmed.
We may be harmed by reputational issues and adverse publicity relating to us, our Manager or Apollo. Issues could include real or perceived legal or regulatory violations or could be the result of a failure in performance, risk-management, governance, technology or operations, or claims related to employee misconduct, conflict of interests, ethical issues or failure to protect private information, among others. Similarly, market rumors and actual or perceived association with counterparties whose own reputation is under question could harm our business. Such reputational issues may depress the market price of our capital stock or have a negative affect on our ability to attract counterparties for our transactions, or otherwise adversely affect us.
Investigations and reviews of Apollo affiliates’ use of placement agents could harm our reputation, depress the market price of our capital stock or have other negative consequences.
Affiliates of our Manager sometimes use placement agents to assist in marketing certain of the investment funds that they manage. Various state attorneys general and federal and state agencies have initiated industry-wide investigations into the use of placement agents in connection with the solicitation of investments, particularly with respect to investments by public pension funds. Certain affiliates of Apollo have received subpoenas and other requests for information from various government regulatory agencies and investors in Apollo’s funds, seeking information regarding the use of placement agents. Apollo is cooperating with all such investigations and other reviews. Any unanticipated developments from these or future investigations or changes in industry practice may adversely affect our business. Even if these investigations or changes in


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industry practice do not directly or indirectly affect Apollo’s or our respective businesses, adverse publicity could harm our reputation and may depress the market price of our capital stock or have other negative consequences.
Risks Related to Our Company
We have a limited operating history and may not be able to operate our business successfully, find suitable investments, or generate sufficient revenue to make or sustain dividend distributions to our stockholders.
We commenced operations on July 27, 2011 and have limited operating history. Our ability to provide attractive risk-adjusted returns from our assets to our stockholders over the long term is dependent on our ability both to generate sufficient cash flow to pay an attractive dividend and to achieve capital appreciation, and we may not do either on an on-going basis. We may not be able to generate sufficient revenue from operations to pay our operating expenses and to continue to pay dividends to stockholders. The results of our operations and the execution of our business strategy depend on several factors, including the availability of opportunities for investment in our target assets, the level and volatility of interest rates, the availability of adequate equity capital as well as short and long-term financing, conditions in the financial markets and economic conditions.
Difficult and volatile conditions in the mortgage and residential real estate markets, as well as the broader financial markets, may cause us to experience losses related to our asset portfolio and there can be no assurance that we will be successful in executing our business strategies amidst such conditions.
Our results of operations may be materially affected by conditions in the market for mortgages and mortgage-related assets, including RMBS, as well as the residential real estate market, the financial markets and the economy in general. Continuing concerns about the mortgage market and the real estate market, as well as inflation, energy costs, geopolitical issues, unemployment and the availability and cost of credit, have contributed to increased volatility and diminished expectations for the economy and markets going forward. In particular, the U.S. residential mortgage market has been severely affected by changes in the lending landscape and has experienced defaults, credit losses and significant liquidity concerns, and there is no assurance that these conditions have stabilized or that they will not worsen. In addition, there is a correlation between home price declines (which began with the global financial crisis in 2007, and have continued in certain states in the U.S. since such time, and, in some cases, worsened) and mortgage loan delinquencies. Further, there has been significant volatility in the price of residential mortgage assets. All of these factors have impacted investor perception of the risk associated with residential mortgage assets and had an impact on the value of existing real property and mortgages and new demand for homes and mortgages, which has weighed, and may continue to weigh, heavily on real estate and mortgage prices and performance. Further deterioration of the mortgage and residential real estate markets may affect our ability to identify target assets that will provide us with attractive return opportunities and may cause us to experience losses related to our assets. Declines in the value of our portfolio, or perceived market uncertainty about the value of our assets, would likely make it difficult for us to obtain financing on favorable terms or at all. Our profitability may be materially adversely affected if we are unable to obtain cost-effective financing. An increase in the volatility and deterioration in the broader residential mortgage and RMBS markets as well as the broader financial markets may adversely affect the performance and market value of our assets, which may reduce earnings and, in turn, cash available for distribution to our stockholders. Also, to the extent we invest in MSRs, deterioration of the residential real estate markets could increase delinquencies and defaults on the mortgage loans underlying the MSRs we acquire and increase the cost of servicing mortgage loans. Such increases in servicing costs could adversely affect our results of operations as revenues derived from the MSRs that would otherwise produce income may be diverted to pay servicers additional servicing fees or reimburse servicers for additional expenses from servicing. In addition, as default rates are a component of pricing MSRs, the market value of our MSRs may decrease, thereby decreasing the value we could obtain if we sold the MSRs.
We operate in a competitive market for investment opportunities and future competition may limit our ability to acquire desirable investments in our target assets and could also affect the pricing of these securities.
A number of entities compete with us in acquiring assets and obtaining financing. In acquiring target assets, we compete with other REITs, specialty finance companies, savings and loan associations, banks, mortgage bankers, insurance companies, mutual funds, institutional investors, investment banking firms, financial institutions, governmental bodies and other entities. In addition, other REITs with similar asset acquisition objectives, including a number that have been recently formed and others that may be organized in the future, compete with us in acquiring assets and obtaining financing. These competitors may be significantly larger than us, may have access to greater capital and other resources or may have other advantages. In addition, some competitors may have higher risk tolerances or different risk assessments, which could allow them to consider a wider variety of investments and establish more relationships than us. Current market conditions may attract more competitors, which may increase the competition for sources of financing. An increase in the competition for sources of funding could adversely affect the availability and cost of financing, and thereby adversely affect the market price of our capital stock. Many of our competitors are not subject to the operating constraints associated with REIT qualification or maintenance of our exclusion from registration as an investment company under the 1940 Act. Furthermore, competition for investments in our target assets may lead to the price of such assets increasing, which may further limit our ability to generate desired returns. We


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cannot assure you that the competitive pressures we face will not have a material adverse effect on our business, financial condition, results of operations, the market price of our capital stock and our ability to pay dividends to our stockholders. Also, as a result of this competition, we may not be able to take advantage of attractive investment opportunities from time to time, and we can offer no assurance that we will continue to be able to identify and make investments that are consistent with our investment objectives.
We may change our operational policies (including our investment guidelines, strategies and policies and the targeted assets in which we invest) with the approval of our board of directors but without stockholder consent or notice at any time, which may adversely affect the market value of our capital stock and our ability to pay dividends to our stockholders.
Our board of directors determines our operational policies and may amend or revise our policies (including our policies with respect to the targeted assets in which we invest, dispositions, growth, operations, indebtedness, capitalization and dividends) or approve transactions that deviate from these policies at any time, without a vote of, or notice to, our stockholders. We may change our investment guidelines and our strategy at any time with the approval of our board of directors, but without the consent of, or notice to, our stockholders, which could result in us making investments that are different in type from, and possibly riskier than, the investments we currently invest in.
We use leverage as part of our business strategy in order to increase potential returns to stockholders but we do not have a formal policy limiting the amount of debt we may incur.
We use leverage as part of our business strategy in order to increase potential returns to stockholders but we do not have a formal policy limiting the amount of debt we may incur. The amount of leverage we deploy for particular investments in our target assets depends 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 of those assets and the creditworthiness of our financing counterparties. Our charter and bylaws do not limit the amount of indebtedness we can incur.
Our ability to generate returns for our stockholders through our investment, finance and operating strategies is subject to then existing market conditions, and we may make significant changes to these strategies in response to changing market conditions.
In the future, to the extent that market conditions change and we have sufficient capital to do so, we may change our investment guidelines in response to opportunities available in different interest rate, economic and credit environments. As a result, we cannot predict the percentage of our equity that will be invested in any of our investment assets at any given time.
We depend on information systems and systems failures could significantly disrupt our business, which may, in turn, negatively affect the market price of our capital stock and our ability to pay dividends to our stockholders.
Our business depends on the communications and information systems of Apollo and other third-party service providers. Any failure or interruption of the systems of Apollo or any other counterparties that we rely on could cause delays or other problems in our securities trading activities and our operations, which could have a material adverse effect on our business, financial condition, results of operations, the market price of our capital stock and our ability to pay dividends to our stockholders.
Cybersecurity risk and cyber incidents may adversely affect our business by causing a disruption to our operations, a compromise or corruption of our confidential information and/or damage to our business relationships, all of which could negatively impact our financial results.
A cyber incident is considered to be any adverse event that threatens the confidentiality, integrity or availability of our information resources. These incidents may be an intentional attack or an unintentional event and could involve gaining unauthorized access to our information systems for purposes of misappropriating assets, stealing confidential information, corrupting data or causing operational disruption. The result of these incidents may include disrupted operations, misstated or unreliable financial data, liability for stolen assets or information, increased cybersecurity protection and insurance cost, litigation and damage to our investor relationships. As our reliance on technology has increased, so have the risks posed to both our information systems, both internal and those provided by Apollo and third-party service providers. Apollo has implemented processes, procedures and internal controls to help mitigate cybersecurity risks and cyber intrusions, but these measures, as well as our increased awareness of the nature and extent of a risk of a cyber incident, do not guarantee that our financial results, operations or confidential information will not be negatively impacted by such an incident.
We cannot at the present time predict the unintended consequences and market distortions that may stem from far-ranging, governmental intervention in the economic and financial system or from regulatory reform of the oversight of the financial markets.
The U.S. Government, the U.S. Federal Reserve (or, the Federal Reserve), the U.S. Treasury (or, the Treasury), the SEC and other governmental and regulatory bodies have taken or are taking various actions in an effort to address the underlying causes of, and to contain the fallout from, the recent global financial crisis. For example, on July 21, 2010 President Obama


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signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (or, the Dodd-Frank Act). The Dodd-Frank Act places restrictions on residential mortgage loan originations and reforms the asset-backed securitization markets, including the RMBS market, most notably by imposing credit risk retention requirements on securitizers. The Dodd-Frank Act also imposes requirements on originators to make reasonable, good faith determinations regarding a consumer’s ability to repay a loan, subject to certain exceptions for qualified mortgages. Many aspects of the Dodd-Frank Act are subject to rule making and will take effect over several years, making it difficult to anticipate the overall financial impact on us and, more generally, the financial services and mortgage industries.
The Dodd-Frank Act also creates a new regulator, the Consumer Financial Protection Bureau, which will now oversee many of the core laws that regulate the mortgage industry, including among others, the Real Estate Settlement Procedures Act and the Truth in Lending Act. We cannot predict what actions, if any, that the Consumer Financial Protection Bureau will take in the mortgage markets, nor what the impact of such actions will be on the mortgage markets or our results of operations, financial condition and business. In addition to the foregoing, the U.S. Government, Federal Reserve, Treasury and other governmental and regulatory bodies such as the Financial Stability Oversight Council, a panel comprising top U.S. financial regulators, may scrutinize or seek to implement changes to regulation which could negatively impact mortgage REITs, such as ourselves. For example, a number of local governmental authorities have announced that they are evaluating eminent domain as one of several potential alternatives to help resolve housing finance challenges. This type of legislation and action could have a severe negative impact on the mortgage markets and may introduce risks that are difficult, if not impossible, to quantify. There is no certainty as to whether any governmental bodies will take steps to acquire any mortgage loans under such programs, or ultimately pass other legislation that will affect the mortgage markets. However, such actions could have a dramatic impact on our business, results of operations and financial condition, and the cost of complying with any additional laws and regulations could have a material adverse effect on our business, financial condition, results of operations, the market price of our capital stock and our ability to pay dividends to our stockholders.
We cannot predict future actions by the Federal Reserve or the impact such actions will have on our business.
The Federal Reserve is a major participant in, and its actions significantly impact, the residential mortgage market. For example, quantitative easing, a strategy implemented by the Federal Reserve to keep long-term interest rates low and stimulate the U.S. economy, has had the effect of reducing the difference between short-term and long-term interest rates. As a result of the reduction in long-term interest rates prepayment speeds on certain RMBS increased. Purchases of Agency RMBS by the Federal Reserve has resulted in a narrowing of the returns earned on Agency RMBS. While the Federal Reserve has started to taper its quantitative easing, no assurance can be given as to when the Federal Reserve will completely discontinue quantitative easing. We cannot predict or control the impact future actions by regulators or government bodies, such as the Federal Reserve, will have on our business. Accordingly, future actions by regulators or government bodies, including the Federal Reserve, could have a material adverse effect on our business, financial condition, results of operations, the market price of our capital stock and our ability to pay dividends to our stockholders.
Mortgage loan modification and refinancing programs and future legislative action may adversely affect the value of, and our returns on, our other target assets.
The U.S. Government, through the Federal Reserve, the Federal Housing Administration (or, FHA), and the Federal Deposit Insurance Corporation, has implemented a number of federal programs designed to assist homeowners, including the Home Affordable Modification Program (which provides homeowners with assistance in avoiding residential mortgage loan foreclosures), the Hope for Homeowners Program (which allows certain distressed borrowers to refinance their mortgages into FHA-insured loans in order to avoid residential mortgage loan foreclosures) and the Home Affordable Refinance Program (or, HARP) which allows borrowers who are current on their mortgage payments to refinance and reduce their monthly mortgage payments without new mortgage insurance, up to an unlimited loan-to-value ratio for fixed rate mortgages). A number of these homeowners assistance programs have been enhanced or expanded. In addition, current administration officials and certain members of the U.S. Congress have indicated support for additional legislative relief for homeowners, including an amendment of the bankruptcy laws to permit the modification of mortgage loans in bankruptcy proceedings. Loan modifications are more likely to be used when borrowers are less able to refinance or sell their homes due to market conditions and when the potential recovery from a foreclosure is reduced due to lower property values. A significant number of loan modifications could result in a significant reduction in cash flows to the holders of the mortgage securities on an ongoing basis. Amendments to the bankruptcy laws that result in the modification of outstanding mortgage loans may adversely affect the value of, and the returns on, the assets that we intend to acquire and the assets we currently hold.


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We may be unable to operate within the parameters that allow us to be excluded from regulation as a commodity pool operator, which would subject us to additional regulation and compliance requirements, and could materially adversely affect our business and financial condition.
The enforceability of agreements underlying certain derivative transactions may depend on compliance with applicable statutory and other regulatory requirements and, depending on the identity of the counterparty, applicable international statutory and regulatory requirements. Recently, regulations have been promulgated by U.S. and foreign regulators attempting to strengthen oversight of derivative contracts. The Dodd-Frank Act established a comprehensive new regulatory framework for derivative contracts commonly referred to as “swaps” which requires that many swaps be executed on a regulated market and cleared through a central counterparty, which may result in increased margin requirements and costs. In addition, under the Dodd-Frank Act, any investment fund that trades in swaps may be considered a “commodity pool,” which would cause its operators to be regulated as a “commodity pool operator” (or, CPO). In December 2012, the Commodity Futures Trading Commission issued a no-action letter giving relief to operators of mortgage REITs from the requirements applicable to CPOs. In order to qualify, we must, among other non-operation requirements: (1) limit our initial margin and premiums for commodity interests (swaps and exchange-traded derivatives) to no more than 5% of the fair market value of our total assets; and (2) limit our net income from commodity interests that are not “qualifying hedging transactions” to less than 5% of our gross income. These parameters could limit the use of swaps by us below the level that our Manager would otherwise consider optimal or may lead to the registration of our Manager or directors as commodity pool operators, which will subject us to additional regulatory oversight, compliance and costs.
The diminished level of Agency participation in, and other changes in the role of the Agencies in, the mortgage market may adversely affect our business.
If Agency participation in the mortgage market were reduced or eliminated, or their structures were to change, our ability to acquire Agency RMBS could be adversely affected. These developments could also materially and adversely impact our then existing Agency RMBS portfolio. We could be negatively affected in a number of ways depending on the manner in which related events unfold for the Agencies. If Fannie Mae or Freddie Mac were eliminated, or their structures were to change radically (e.g., limitation or removal of the guarantee obligation), or their market share reduced because of required price increases or lower limits on the loans they can guarantee, we could be unable to acquire additional Agency RMBS and our then existing Agency RMBS could be materially and adversely impacted. A reduction in the supply of Agency RMBS could also negatively affect the pricing of our existing Agency RMBS. We rely on our Agency RMBS (as well as non-Agency RMBS and other investment securities) as collateral for our financings under our repurchase agreement borrowings. Any decline in their value, or perceived market uncertainty about their value, may make it more difficult for us to obtain financing on our Agency RMBS on acceptable terms or at all, or to maintain our compliance with the terms of any financing transactions. Further, the current support provided by the U.S. Treasury to Fannie Mae and Freddie Mac, and any additional support it may provide in the future, could have the effect of lowering the interest rates we expect to receive from Agency RMBS, thereby tightening the spread between the interest we earn on our Agency RMBS and the cost of financing those assets, and may increase the prices of Agency RMBS, thereby lowering the yields we would expect to receive on Agency RMBS that we purchase. In March 2013, the U.S. Federal Housing Finance Agency announced that it would establish a new institutional body, which later became known as the Federal Mortgage Insurance Currency (or, FMIC), to replace Fannie Mae and Freddie Mac once they wind down operations. In June 2013, in a draft bill entitled the “Secondary Mortgage Market Reform and Taxpayer Protection Act of 2013” it was proposed that the FMIC would be modeled after the Federal Deposit Insurance Corporation and provide catastrophic reinsurance in the secondary market for mortgage-backed securities. It would also take over multi-family guarantees as the existing portfolios of Fannie Mae and Freddie Mac are wound down by at least 15% annually until they are completely liquidated. Future legislation affecting the Agencies may create market uncertainty and have the effect of reducing the actual or perceived credit quality of the Agencies and the securities issued or guaranteed by them. As a result, such laws could increase the risk of loss on our investments in Agency RMBS. It also is possible that such laws could adversely impact the market for such securities and the spreads at which they trade. All of the foregoing could have a material adverse effect on our business, financial condition, results of operations, the market price of our capital stock and our ability to pay dividends to our stockholders.
Past and potential future credit rating downgrades of the U.S. and certain European countries and the failure to resolve issues related to the “fiscal cliff” and the U.S. debt ceiling may materially adversely affect our business, liquidity, financial condition and results of operations.
Financial markets have recently been affected by concerns over U.S. fiscal policy. Although the U.S. Government passed legislation at the beginning of 2013 averting the so-called ‘‘fiscal cliff’’ (which, in the absence of such legislation, would have resulted in automatic tax increases and spending cuts at the end of 2012), uncertainty remains relating to the stability of the U.S. fiscal and budgetary policy. This uncertainty, together with the continuing U.S. debt ceiling and budget deficit concerns, as well as recent issues relating to sovereign debt conditions in Europe, continue to contribute to the possibility of additional economic slowdowns and/or credit rating downgrades. The impact of U.S. fiscal uncertainty, or any further downgrades to the


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U.S. Government’s sovereign credit rating, or its perceived creditworthiness, or the impact of the recent crisis in Europe with respect to the ability of certain countries to continue to service their sovereign debt obligations, is inherently unpredictable and could adversely affect U.S. and global financial markets and economic conditions. In addition, any further downgrade of U.S. Government securities by credit rating agencies, and/or a worsening or expansion of the recent crisis in Europe, may have an adverse impact on fixed income markets, which in turn could cause our net income to decline or have a material adverse effect on our financial condition.
If the European economic situation were to worsen, or expand to other countries within Europe, we may be subject to enhanced risk of counterparty failure as well as related problems arising from a lack of liquidity in our markets. There can be no assurance that governmental or other measures to aid economic recovery will be effective. These developments and the government’s credit concerns in general could cause interest rates and borrowing costs to rise, which may negatively impact our ability to access the debt markets on favorable terms. In addition, any decreased credit rating of U.S. Government securities would likely impact the credit risk associated with Agency RMBS in our portfolio and could create broader financial turmoil and uncertainty, which may exert downward pressure on the price of our capital stock. Continued adverse economic conditions may negatively impact the value of the assets in our portfolio, our net income, liquidity and our ability to finance our assets on favorable terms.
Loss of our exclusion from registration under the 1940 Act would adversely affect us, the market price of shares of our capital stock and our ability to distribute dividends, and could result in the termination of the Management Agreement with our Manager.
Section 3(a)(1)(C) of the 1940 Act defines an investment company as any issuer that is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40% of the value of such issuer’s total assets (exclusive of government securities and cash items) on an unconsolidated basis (or, the 40% Test). We are organized as a holding company and conduct our businesses primarily through ARM Operating, LLC. Both Apollo Residential Mortgage, Inc. and ARM Operating, LLC conduct operations so that they comply with the 40% Test. In addition, certain of our subsidiaries rely upon the exclusion from registration as an investment company under the 1940 Act pursuant to Section 3(c)(5)(C) of the 1940 Act, which is available for entities “primarily engaged in the business of purchasing or otherwise acquiring mortgages and other liens on and interests in real estate.” This exclusion generally means that at least 55% of each such subsidiary’s total assets must be comprised of qualifying assets and at least another 25% of our total assets must be comprised of qualifying assets and real estate-related assets under the 1940 Act. We take the position that qualifying assets for this purpose include mortgage loans where 100% of the loan is secured by real estate when we acquire it and we have the unilateral right to foreclose on the loan and other assets, such as the entire ownership in whole-pool Agency and non-Agency RMBS, that the SEC staff in various no-action letters or other pronouncements has determined are the functional equivalent of whole mortgage loans for purposes of the 1940 Act. While the SEC staff has issued a no-action letter that permits the treatment of such interests in Agency whole-pool RMBS as qualifying assets, no such SEC staff guidance is available with respect to non-Agency whole-pool RMBS. Accordingly, we rely on our own judgment and analysis in treating non-Agency whole-pool RMBS as qualifying assets by analogy to Agency whole-pool RMBS. We expect each of our subsidiaries relying on Section 3(c)(5)(C) to rely on guidance published by the SEC staff or on our analyses of guidance published with respect to other types of assets to determine which assets are qualifying real estate assets and real estate-related assets.
In 2011, the SEC solicited public comment on a wide range of issues relating to Section 3(c)(5)(C) of the 1940 Act, including the nature of the assets that qualify for purposes of this exclusion. There can be no assurance that the laws and regulations governing the 1940 Act status of companies relying on Section 3(c)(5)(C) of the 1940 Act, including the SEC or its staff providing more specific or different guidance regarding this exclusion, will not change in a manner that adversely affects our operations. To the extent that the SEC staff provides more specific guidance regarding any of the matters bearing upon such exclusion, we may be required to adjust our strategy accordingly. Any additional guidance from the SEC staff could further inhibit our ability to pursue our strategies. If the SEC or its staff takes a position contrary to our analysis with respect to the characterization of our target assets, we may be deemed an unregistered investment company. In which case, in order not to be required to register as an investment company, we may need to dispose of a significant portion of our assets or acquire significant other additional assets, which may have lower returns than our expected portfolio, or we may need to modify our business strategy to register as an investment company, which would result in significantly increased operating expenses and would likely entail significantly reducing our borrowings, which could also require us to sell a significant portion of our assets. We cannot assure investors that we would be able to complete these dispositions or acquisitions of assets, or deleveraging, on favorable terms, or at all. Consequently, any modification of our business strategy could have a material adverse effect on us. Further, if the SEC determined that we were an unregistered investment company, we would be subject to monetary penalties and injunctive relief in an action brought by the SEC, we would potentially be unable to enforce contracts with third parties and third parties could seek to obtain rescission of transactions undertaken during the period for which it was established that we were an unregistered investment company. Any of these results would have a material adverse effect on us. To the extent that


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the SEC staff provides more specific guidance regarding any of the matters bearing upon such exclusions, we may be required to adjust our business strategy accordingly.
Rapid changes in the values of our target assets may make it more difficult for us to maintain our qualification as a REIT or our exclusion from registration under the 1940 Act.
If the market value or income potential of our target assets declines as a result of increased interest rates, prepayment rates, general market conditions, government actions or other factors, we may need to increase our real estate assets and income or liquidate our non-qualifying assets to maintain our REIT qualification or our exclusion from registration as an investment company under the 1940 Act. If the decline in real estate asset values or income occurs quickly, this may be especially difficult to accomplish. This difficulty may be exacerbated by the illiquid nature of any non-real estate assets we may own. We may have to make decisions that we otherwise would not make absent the REIT and 1940 Act considerations.
Risks Related to Our Financing
We use leverage in executing our business strategy, which may adversely affect the return on our assets and may reduce cash available for distribution to our stockholders, as well as increase losses when economic conditions are unfavorable.
Through December 31, 2013, we financed our Agency RMBS, non-Agency RMBS and other investment securities with repurchase agreements. 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 in general could adversely affect one or more of our lenders and could cause one or more of our lenders to be unwilling or unable to provide us with financing or to increase the costs of our financing. The return on our assets and cash available for distribution to our stockholders may be reduced to the extent that market conditions prevent us from leveraging our assets or increase the cost of our financing relative to the income that can be derived from our investments. Our financing costs will reduce cash available to pay dividends to stockholders. We may not be able to meet our financing obligations and, to the extent that we cannot, we risk the loss of some or all of our assets to liquidation or sale to satisfy the obligations.
We depend on repurchase agreements, and may in the future depend on the availability of securitizations, resecuritizations, warehouse facilities and bank credit facilities (including term loans and revolving facilities) to finance our investments. Our inability to access such funding could have a material adverse effect on our results of operations, financial condition and business. We rely on short-term financing and thus are especially exposed to changes in the availability and cost of financing.
Our ability to fund our asset acquisitions may be impacted by our ability to secure financing on acceptable terms. We rely on short-term financing and thus are especially exposed to changes in the availability and cost of financing. For example, the term of a repurchase transaction under our repurchase agreements is typically one to six months at inception; although in some cases the term may be shorter or longer.
It is possible that the lenders that provide our financing could experience changes in their ability to advance funds to us, independent of our performance or the performance of our investment portfolio. Furthermore, if many of our potential lenders are unwilling or unable to provide us with financing, we could be forced to sell our assets at an inopportune time when prices are depressed. Further, if we default on our financial covenants with a lender or are otherwise unable to access funds under any of these facilities, we may have to curtail our asset acquisition activities and/or dispose of assets under adverse market conditions. In addition, if the regulatory capital requirements imposed on our lenders change, they may be required to significantly increase the cost of the financing that they provide to us. Our lenders also may revise their eligibility requirements for the types of assets they are willing to finance or the terms of such financings, based on, among other factors, the regulatory environment and their management of perceived risk, particularly with respect to assignee liability.
Many lenders have continued to maintain tight lending standards, and have reduced their lending capacity in response to the difficulties and changed economic conditions that have adversely affected the mortgage market. In addition, certain lenders have been impacted by the European sovereign debt crisis. Further contraction among lenders, insolvency of lenders or other general market disruptions could adversely affect one or more of our existing or potential lenders and could cause one or more of our lenders to be unwilling or unable to provide us with financing on attractive terms or at all. This could increase our financing costs and reduce our access to liquidity, which could have a material adverse effect on our business, financial condition, results of operations, the market price of our capital stock and our ability to pay dividends to our stockholders.
An increase in our borrowing costs relative to the interest we receive on our leveraged assets may adversely affect our profitability and our cash available for dividends to our stockholders.
Borrowing rates are currently at low levels that may not be sustained in the future. As our repurchase agreements and other short-term borrowings mature, we are required either to enter into new borrowings or to sell certain of our assets. An increase in short-term interest rates at the time that we seek to enter into new borrowings would reduce the spread between the


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returns on our assets and the cost of our borrowings. This could adversely affect our earnings and, in turn, cash available for financing and investing purposes and to pay dividends to our stockholders.
Interest rate fluctuations could reduce the income on our investments and increase our financing costs.
Changes in interest rates will affect our operating results as such changes will affect the interest we receive on our floating rate interest bearing investments, the financing cost of our borrowings and the amount of interest we pay/receive on our Swaps, which we utilize for hedging purposes. Changes in interest rates may also affect borrower default rates, which may result in losses for us. See “Risks Related to Our Assets” below.
Interest rate caps on certain of the mortgages collateralizing certain of our RMBS may adversely affect our profitability on such investments.
The coupon rate of interest earned on RMBS collateralized by ARMs adjusts over time as interest rates change (typically after an initial fixed-rate period for Hybrids). However, the level of adjustment to the interest rates earned on our RMBS collateralized by ARMs is typically limited by contract or, in certain cases, by state or federal law. Interim and lifetime interest rate caps on the mortgages collateralizing our ARMs limit the amount by which the interest rates on such mortgages can adjust. Interim interest rate caps limit the amount interest rates on a particular ARM can adjust upward 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. Our repurchase transactions are not subject to similar restrictions, as the financial markets primarily determine the interest rates that we pay on borrowings under repurchase agreements used to finance our RMBS. Accordingly, in a sustained period of rising interest rates or a period in which interest rates rise rapidly, the interest income we earn on RMBS collateralized by ARMs could be less than the interest expense incurred to finance such assets.
If a counterparty to our repurchase transactions defaults on its obligation to resell the underlying security back to us at the end of the transaction term or if we default on our obligations under the repurchase agreement, we could incur losses.
When we engage in repurchase transactions, we generally transfer securities to lenders (i.e., repurchase agreement counterparties) and receive cash from such lenders. Because the cash/financing we receive from the lender is less than the value of the securities we pledge (this difference is referred to as the “haircut”), if the lender defaults on its obligation to transfer the same securities back to us, we would incur a loss on the transaction equal to the amount of the haircut (assuming there was no change in the value of the securities). See “Counterparty Risk,” included under ITEM 7A of this annual report on Form 10-K, for further discussion regarding risks related to exposure to financial institution counterparties by country. Our exposure to defaults by counterparties may be more pronounced during periods of significant volatility in the market conditions for mortgages and mortgage-related assets as well as the broader financial markets. In addition, generally, if we default on one of our obligations under a repurchase transaction with a particular lender, that lender can elect to terminate the transaction and cease entering into additional repurchase transactions with us. In addition, some of our repurchase agreements contain cross-default provisions, so that if a default occurs under any one agreement, the lenders under our other repurchase agreements could also declare a default. Any losses we incur on our repurchase transactions could materially adversely affect our earnings and thus our cash available for dividends to our stockholders.
Our rights under our repurchase agreements may be subject to the effects of the bankruptcy laws in the event of the bankruptcy or insolvency of us or our lenders under the repurchase agreements, which may allow our lenders to repudiate our repurchase agreements.
In the event of our insolvency or bankruptcy, certain repurchase agreements may qualify for special treatment under the U.S. Bankruptcy Code, the effect of which, among other things, would be to allow the lender under the applicable repurchase agreement to avoid the automatic stay provisions of the U.S. Bankruptcy Code and to foreclose on the pledged collateral without delay. In the event of the insolvency or bankruptcy of a lender during the term of a repurchase agreement, the lender may be permitted, under applicable insolvency laws, to repudiate the contract, and our claim against the lender for damages may be treated simply as that of an unsecured creditor. In addition, if the lender is a broker or dealer subject to the Securities Investor Protection Act of 1970, or an insured depository institution subject to the Federal Deposit Insurance Act, our ability to exercise our rights to recover our securities under a repurchase agreement or to be compensated for any damages resulting from the lender’s insolvency may be further limited by those statutes. These claims would be subject to significant delay and, if and when received, may be substantially less than the damages we actually incur.
The repurchase agreements that we use to finance our asset acquisitions may require us to provide additional collateral and may restrict us from leveraging our assets as fully as desired.
We use repurchase agreements and may in the future use other sources of financing, including securitizations, resecuritizations, warehouse facilities and bank credit facilities to finance our asset acquisitions. Our repurchase agreements are uncommitted and the counterparty may refuse to advance funds under such agreements to us. If the market value of the mortgage loans or securities pledged or sold by us to a funding source decline in value, the lending institution may have the right to initiate a margin call in its sole discretion, which would require us to provide additional collateral or pay down a


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portion of the funds advanced, but we may not have the funds available to do so. Posting additional collateral will reduce our liquidity and may reduce our ability to pay dividends to our stockholders and limit our ability to leverage our assets, which could adversely affect our business and could cause the value of our capital stock to decline.
We may be forced to sell assets at significantly depressed prices to meet margin calls to post additional collateral and/or to maintain adequate liquidity, which could cause us to incur losses. Moreover, to the extent we are forced to sell assets at such time, given market conditions, we may be selling at the same time as others facing similar pressures, which could exacerbate a difficult market environment and which could result in us incurring significantly greater losses on our sale of such assets. In an extreme case of market duress, a market may not even be present for certain of our assets at any price. In the event we do not have sufficient liquidity to meet margin calls and post additional collateral, lending institutions can accelerate repayment of our indebtedness, increase our borrowing rates, liquidate our collateral or terminate our ability to borrow. Such a situation would likely result in a rapid deterioration of our financial condition and possibly necessitate a filing for protection under the U.S. Bankruptcy Code. In the event of our bankruptcy, our borrowings may qualify for special treatment under the U.S. Bankruptcy Code. This special treatment would allow the lenders under these agreements to avoid the automatic stay provisions of the U.S. Bankruptcy Code and to liquidate the collateral under these agreements without delay. Further, financial institutions may require us to maintain a certain amount of cash that is not invested or to set aside non-leveraged assets sufficient to maintain a specified liquidity position which would allow us to satisfy our collateral obligations. As a result, we may not be able to leverage our assets as fully as we would choose, which could reduce our return on equity. If we are unable to meet these collateral obligations, as described above, our financial condition could deteriorate rapidly.
Certain of our financing facilities contain covenants that restrict our operations and may inhibit our ability to grow our business and increase revenues.
Certain of our financing facilities contain, or may contain in the future, restrictions, covenants, and representations and warranties that, among other things, may require us to satisfy specified financial, asset quality, loan eligibility and loan performance tests. If we fail to meet or satisfy any of these covenants or representations and warranties, we would be in default under these agreements and our lenders could elect to declare all amounts outstanding under the agreements to be immediately due and payable, enforce their respective interests against collateral pledged under such agreements and restrict our ability to make additional borrowings.
Certain of our financing agreements may also contain cross-default or other similar provisions. Under our financing agreements with such provisions, the lender could declare a default (or in certain cases, accelerate our debt obligations rather than declare a default) if a default (or other similar event) were to occur under our other financing or similar arrangements (whether with that lender, the affiliates of that lender or a third party lender) after the expiration of any cure periods under such other arrangements. The specific nature of these cross-defaults (or similar provisions) varies among our various financing agreements that contain such provisions.
The covenants and restrictions in our current and future financing facilities may restrict our ability to, among other things:
•
incur or guarantee additional debt;
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make certain investments or acquisitions;
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pay dividends on, repurchase or redeem our capital stock;
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engage in mergers or consolidations;
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reduce liquidity below certain levels,
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grant liens or incur operating losses for more than a specified period; and
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enter into transactions with affiliates.
These restrictions may interfere with our ability to obtain financing, to pay dividends, including dividends needed to maintain our qualification as a REIT, or to engage in other business activities, which may significantly limit or harm our business, financial condition, liquidity and results of operations. A default and resulting repayment acceleration could significantly reduce our liquidity, which could require us to sell our assets to repay amounts due and outstanding. This could also significantly harm our business, financial condition, results of operations and our ability to pay dividends, which could cause the value of our capital stock to decline. A default will also significantly limit our financing alternatives such that we will be unable to continue to pursue our strategy, which could curtail the returns on our assets.
If we acquire and subsequently re-sell any mortgage loans, we may be required to repurchase such loans or indemnify investors if we breach representations and warranties.
If we acquire and subsequently re-sell any mortgage loans, we would generally be required to make customary representations and warranties about such loans to the loan purchaser. Residential mortgage loan sale agreements and the terms of any securitizations into which we may sell loans will generally require us to repurchase or substitute loans in the event we


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breach a representation or warranty we provide to the loan purchaser. In addition, we may be required to repurchase loans as a result of borrower fraud or in the event of early payment default on a mortgage loan. The remedies available to a purchaser of mortgage loans are generally broader than those available to us against an originating broker or correspondent. Repurchased loans are typically worth only a fraction of the original price. Significant repurchase activity could materially adversely affect our business, financial condition, results of operations, the market price of our capital stock and our ability to pay dividends to our stockholders. See “Market Conditions and Our Strategy,” included under ITEM 7 of this annual report on Form 10-K.
Securitizations expose us to additional risks.
We have acquired and, based on our Manager’s assessment of market conditions, may continue to acquire residential mortgage loans with the intention of securitizing them and retaining all or a part of the securitized assets in our portfolio. To the extent that we securitize residential mortgage loans, we will often hold the most junior certificates associated with a securitization. As a holder of the most junior certificates, we are more exposed to losses on the portfolio investments because the interest we retain is subordinate to the more senior notes typically issued to investors and we would, therefore, absorb all of the losses sustained with respect to a securitized pool of assets before the owners of the more senior notes experience any losses. We cannot be assured that we will be able to access the securitization market in the future, or be able to do so at favorable rates. The inability to securitize our assets could hurt our performance and our ability to grow our business. See “Market Conditions and Our Strategy,” included under ITEM 7 of this annual report on Form 10-K.
Risks Related to Our Hedging
Our existing and future hedging transactions may expose us to contingent liabilities in the future and adversely impact our financial condition and results of operations.
Subject to maintaining our qualification as a REIT, part of our strategy involves entering into hedging transactions that could require us to fund cash payments in certain circumstances (e.g., the early termination of the hedging instrument caused by an event of default or other early termination event, or the decision by a counterparty to request margin securities it is contractually owed under the terms of the hedging instrument). The amount due from us would be equal to the unrealized loss of the open Swap positions with the respective counterparty and could also include other fees and charges. Such losses would be reflected in our results of operations as realized losses. Our ability to fund these obligations will depend on the liquidity of our assets and access to capital at the time. The need to fund these obligations could adversely impact our financial condition.
Hedging against interest rate exposure may adversely affect our earnings, which could reduce our cash available for distribution to our stockholders.
Our hedging activity varies in scope based on the level and volatility of interest rates, the type of assets held and other changing market conditions. Our hedging transactions, which are intended to limit losses, may actually adversely affect our earnings, which could reduce our cash available for dividends to our stockholders.
In addition, certain of our derivative instruments involve risk since they often are not traded on regulated exchanges, guaranteed by an exchange or its clearing house, or regulated by any U.S. or foreign governmental authorities. Consequently, there are no requirements with respect to record keeping, financial responsibility or segregation of customer funds and positions. Furthermore, the enforceability of agreements underlying hedging transactions may depend on compliance with applicable statutory, commodity and other regulatory requirements and, depending on the identity of the counterparty, applicable international requirements. The business failure of a hedging counterparty with whom we enter into a hedging transaction will most likely result in its default. Default by a party with whom we enter into a hedging transaction may result in the loss of unrealized profits and force us to cover our commitments, if any, at the then current market price. Although we generally seek to reserve the right to terminate our hedging positions, it may not always be possible to dispose of or close out a hedging position without the consent of the hedging counterparty and we may not be able to enter into an offsetting contract in order to cover our risk. We cannot assure stockholders that a liquid secondary market will exist for hedging instruments purchased or sold, and we may be required to maintain a position until exercise or expiration, which could result in losses.
Our operating results may suffer because losses on our derivatives may not be offset by a change in the fair value of our investment assets.
In order to mitigate interest rate risk associated with increases in interest rates we enter into interest rate derivative contracts. To date, we chose not to pursue hedge accounting for these or any of our other derivative instruments for GAAP purposes, and therefore we record the change in estimated fair value of such instruments in earnings. As a result, changes in the fair value of our derivative instruments may result in us incurring realized and unrealized losses on such instruments.


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To the extent that we invest in MSRs and excess MSRs in the future, the value of such MSRs and excess MSRs may be reduced substantially by changes in interest rates unless we are able to hedge against that uncertainty.
Changes in interest rates are a key driver of the performance of MSRs and excess MSRs since the values of such assets are highly sensitive to changes in interest rates. Historically, the value of MSRs and excess MSRs has generally increased when interest rates rise and generally decreased when interest rates decline due to the effect those changes in interest rates have on prepayment estimates. We may pursue various hedging strategies to seek to reduce our exposure to adverse changes in interest rates. Our hedging activity will vary in scope based on the level and volatility of interest rates, the type of assets held and other changing market conditions. Interest rate hedging may fail to protect us and/or could adversely affect us. To the extent we do not utilize derivatives to hedge against changes in fair value of the MSRs or excess MSRs that we may acquire, our balance sheet, financial condition and results of operations would be susceptible to volatility due to changes in the fair value of, or cash flows from, MSRs and excess MSRs as interest rates change.
Risks Related to Our Assets
We may not realize gains or earn income from our assets, which could cause the value of our capital stock to decline.
We seek to generate attractive risk-adjusted returns from our assets to our stockholders over the long term, primarily through dividend distributions and secondarily through capital appreciation. However, the assets we acquire may not appreciate in value and may in fact decline in value, as we experienced with our Agency RMBS during 2013, and the debt securities we acquire may default on interest and/or principal payments. Accordingly, we may not be able to realize gains or income from our assets. Any gains that we do realize may not be sufficient to offset any other losses we experience. Any income that we realize may not be sufficient to offset our expenses, which could cause the value of our capital stock to decline.
We acquire Alt-A and Subprime mortgage loans and Option ARMs and non-Agency RMBS collateralized by Alt-A, Subprime and Option ARM mortgage loans, which are subject to increased risks.
We have acquired, and expect to continue to acquire, Alt-A, Subprime mortgage loans and Option ARMs and invest in non-Agency RMBS backed by collateral pools of that contain these types of mortgage loans, as well. Subprime mortgages may have been originated using underwriting standards that are less strict than those used in underwriting “prime mortgage loans” and as a result include mortgage loans made to borrowers having imperfect or impaired credit histories, mortgage loans where the amount of the loan at origination is 80% or more of the value of the mortgage property, mortgage loans made to borrowers with low credit scores, mortgage loans made to borrowers who have other debt that represents a large portion of their income and mortgage loans made to borrowers whose income is not required to be disclosed or verified. Due to economic conditions, including increased interest rates and lower home prices, as well as aggressive lending practices, Alt-A, Subprime mortgage loans and Option ARMs have in recent periods experienced increased rates of delinquency, foreclosure, bankruptcy and loss, and they are likely to continue to experience delinquency, foreclosure, bankruptcy and loss rates that are higher, and that may be substantially higher, than those experienced by mortgage loans underwritten in a more traditional manner. Thus, because of the higher delinquency rates and losses associated with Alt-A and Subprime mortgage loans, the performance of RMBS backed by Alt-A and Subprime mortgage loans that we may acquire could be correspondingly adversely affected, which could have a material adverse effect on our business, financial condition, results of operations, the market price of our capital stock and our ability to pay dividends to our stockholders.
Our portfolio of assets may be concentrated and may be subject to risk of default.
Our portfolio is primarily comprised of Agency RMBS and non-Agency RMBS and to a significantly lesser extent, we have investments in securitized mortgage loans and other investment securities. Over time, we may continue to diversify our portfolio to cover a broader range of other residential mortgage and mortgage related assets, including, but not limited to, additional residential mortgage loans, which we may source through bulk acquisitions of pools of whole loans originated by third parties, bonds-for-title, MSRs and excess MSRs. However, we are not required to observe specific diversification criteria, except as may be set forth in the investment guidelines adopted by our board of directors. Therefore, our portfolio of assets may at times be concentrated in certain property types that are subject to higher risk of foreclosure, or secured by properties concentrated in a limited number of geographic locations. To the extent that our portfolio is concentrated in any one region or type of security, downturns relating generally to such region or type of security may result in defaults on a number of our assets within a short time period, which may reduce our net income and the value of our shares and accordingly reduce our ability to pay dividends to our stockholders. Difficult conditions in the markets for mortgages and mortgage-related assets as well as the broader financial markets have resulted in a significant contraction in liquidity for mortgages and mortgage-related assets, which may adversely affect the value of the assets in which we invest.


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Our Manager’s use of models in connection with the evaluation of our assets subjects us to potential risks in the event that such models are incorrect, misleading or based on incomplete information.
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. Models and data are used to value assets or potential assets and also in connection with hedging our acquisitions. Many of the models are based on historical trends. These trends may not be indicative of future results. Furthermore, the assumptions underlying the models may prove to be inaccurate, causing the models to also be incorrect. In the event models and data prove to be incorrect, misleading or incomplete, any decisions made in reliance thereon expose us to potential risks. For example, by relying on incorrect models and data, especially valuation models, our Manager may be induced to buy certain assets at prices that are too high, to sell certain other assets at prices that are too low or to miss favorable opportunities altogether. Similarly, hedging transactions based on faulty models and data may prove to be unsuccessful in mitigating unfavorable interest rate exposure.
Our investments in non-Agency RMBS or other investment assets of lower credit quality involve credit risk, which could materially adversely affect our results of operations.
The holder of a mortgage or non-Agency RMBS assumes a risk that the borrowers may default on their obligations to make full and timely payments of principal and interest. Pursuant to our investment guidelines, we have the ability to acquire non-Agency RMBS and other investments that involve credit risk. In general, non-Agency RMBS carry greater investment risk than Agency RMBS because they are not guaranteed as to principal and/or interest by the U.S. Government, any federal agency or any federally chartered corporation. Unexpectedly high rates of default (e.g., in excess of the default rates forecasted) and/or higher than expected loss severities on the mortgages collateralizing our non-Agency RMBS may adversely affect the value of such assets. Accordingly, non-Agency RMBS and other investment assets of lower credit quality could cause us to incur losses of income from, and/or losses in market value relating to, these assets if there are defaults of principal and/or interest on these assets.
We may have significant credit risk, especially on non-Agency RMBS, in certain geographic areas and may be disproportionately affected by adverse events specific to those markets.
A significant number of the mortgages collateralizing our RMBS may be concentrated in certain geographic areas. For example, with respect to our non-Agency RMBS portfolio, we have significantly higher exposure in California, New York, Florida, Texas and New Jersey. Certain markets within these states (particularly California and Florida) experienced significant decreases in residential home value during the recent housing crisis and continue to experience challenging economic and real estate conditions. Any event that adversely affects the economy or real estate market in these states could have a disproportionately adverse effect on our non-Agency RMBS portfolio. In general, any material decline in the economy or significant difficulties in the real estate markets would be likely to cause a decline in the value of residential properties securing the mortgages in the relevant geographic area. This, in turn, would increase the risk of delinquency, default and foreclosure on real estate collateralizing our non-Agency RMBS in this area. This may then materially adversely affect our credit loss experience on our non-Agency RMBS in such area if unexpectedly high rates of default (e.g., in excess of the default rates forecasted) and/or higher than expected loss severities on the mortgages collateralizing such securities were to occur.
Increases in interest rates could adversely affect the value of our assets and cause our interest expense to increase, which could result in reduced earnings or losses and negatively affect our profitability as well as the cash available for distribution to our stockholders.
We focus primarily on investing in, financing and managing Agency RMBS, non-Agency RMBS, residential mortgage loans and other residential mortgage assets in the U.S. In a normal yield curve environment, some of these types of assets will generally decline in value if long-term interest rates increase. Declines in market value may ultimately reduce earnings or result in losses to us, which may negatively affect cash available for dividends to our stockholders.
A significant risk associated with these assets is the risk that both long-term and short-term interest rates will increase significantly. If long-term rates increased significantly, the market value of these assets could decline, and the duration and weighted-average life of the assets could increase. We could realize a loss if the securities were sold. At the same time, an increase in short-term interest rates would increase the amount of interest owed on the repurchase agreements we may enter into to finance the purchase of these securities. Market values of our assets may decline without any general increase in interest rates for a number of reasons, such as increases or expected increases in defaults, increases or expected increases in voluntary prepayments for those assets that are subject to prepayment risk or widening of credit spreads or spreads to benchmark interest rates. During 2013, there was significant volatility in interest rates which led to decreases in the market value of our Agency RMBS, resulting in both unrealized and realized losses on such securities.
In addition, in a period of rising interest rates, our operating results will depend in large part on the difference between the income from our assets, net of credit losses, and financing costs. In most cases, the income from such assets will respond


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more slowly to interest rate fluctuations than the cost of our borrowings. Consequently, changes in interest rates, particularly short-term interest rates, may significantly influence our net income. Increases in these rates will tend to decrease our net income and the market value of our assets.
Interest rate fluctuations may adversely affect the value of our assets, net income and capital stock.
Interest rates are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond our control. Interest rate fluctuations present a variety of risks, including the risk of a narrowing of the difference between asset yields and borrowing rates, flattening or inversion of the yield curve and fluctuating prepayment rates, and may adversely affect our income and the value of our capital stock. Additionally, our operating results and prospects may be below the expectations of public market analysts and investors or may be lower than those of companies with comparable market capitalizations, which could lead to a material decline in the market price of our capital stock.
Our investments are recorded at fair value and there may be uncertainty as to the value of these assets.
The assets in our investment portfolio are comprised of securities that trade in a market that may experience periods of illiquidity or market dislocation. We value our investments at fair value, as defined by GAAP, which valuations may from time to time, require us to use assumptions that may not be observable in the marketplace, particularly in periods of market dislocation or illiquidity for such investments. Our assumptions, could cause our estimate of value for our investments to be subjective, with the fair value of such investments differing materially from the values in a liquid market. There can be no assurance that the values that we arrive at for our investments can be realized upon the sale of such investments in the marketplace, due both to the potential subjectivity of our valuations and the fact that market values of our investments can be become very volatile depending on market conditions and the performance of certain investments.
The failure of servicers to effectively service the mortgage loans underlying certain of the assets in our portfolio could materially and adversely affect our investments in non-Agency RMBS and mortgage loans.
Most residential mortgage loans and securitizations of residential mortgage loans require a servicer to manage collections on each of the underlying loans. Both default frequency and severity of loss experienced on mortgage loans may depend upon the quality of the servicer. If servicers are not vigilant in encouraging borrowers to make their monthly payments, the borrowers may be far less likely to make these payments, which could result in a higher frequency of default. If servicers take longer to liquidate non-performing assets, loss severities may tend to be higher than originally anticipated. The failure of servicers to effectively service the mortgage loans underlying certain assets in our portfolio could negatively impact the value of our investments and our performance. Many servicers have gone out of business in recent years, requiring a transfer of servicing to another servicer. This transfer takes time and loans may become delinquent because of confusion or lack of attention. In the case of pools of securitized loans, servicers may be required to advance interest on delinquent loans to the extent the servicer deems those advances recoverable. In the event the servicer does not advance, interest may be interrupted even on more senior securities. Servicers may also advance more interest than is in fact recoverable once a defaulted loan is disposed, and the loss to us may, as a result, be greater than the outstanding principal balance of that loan (greater than 100% loss severity).
Any credit ratings assigned to our assets will be subject to ongoing evaluations and revisions and we cannot assure investors that those ratings will not be downgraded.
Some of our assets are rated by nationally recognized statistical rating organizations. Any credit ratings on our assets are subject to ongoing evaluation by rating agencies, and we cannot assure investors that any such ratings will not be changed or withdrawn by a rating agency in the future if, in its judgment, circumstances warrant. If rating agencies assign a lower-than-expected rating or reduce or withdraw, or indicate that they may reduce or withdraw, their ratings of our assets in the future, the value of these assets could significantly decline, which would adversely affect the value of our portfolio and could result in losses to us.
A prolonged economic slowdown, a lengthy or severe recession or declining real estate values could impair our assets and harm our operations.
We believe the risks associated with our business will be more severe during periods of economic slowdown or recession, especially if these periods are accompanied by declining real estate values. Our non-Agency RMBS and residential mortgage loans will be particularly sensitive to these risks.
A decline in real estate values will likely reduce the level of new mortgage loan originations since borrowers often use appreciation in the value of their existing properties to support refinancing or moving to a new home. Borrowers may also be less able or inclined to continue to honor their mortgage obligations if the value of real estate weakens, particularly in situations where balance of the mortgage loan exceeds the value of the mortgaged property. As a result, a decline in real estate values significantly increases the likelihood that we will incur losses on our non-Agency RMBS and mortgage loans in the event of


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default because the value of property securing such investments may be insufficient for us to recover our investment. Any sustained period of increased payment delinquencies, foreclosures or losses could adversely affect both our net interest income from non-Agency RMBS and residential mortgage loans in our portfolio, as well as our Manager’s ability to acquire, sell and securitize residential mortgage loans, which would significantly harm our revenues, results of operations, financial condition, business prospects and our ability to pay dividends to our stockholders.
Prepayment rates may adversely affect the value of our portfolio of mortgage assets.
The value of our mortgage assets may be affected by prepayment rates on mortgage loans. If we purchase mortgage assets at a premium to par value, when borrowers prepay their 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 faster than we anticipated when we invested in such assets. Conversely, if we purchase mortgage assets at a discount to par value, when borrowers prepay their 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. Prepayment rates on mortgage loans may be affected by a number of factors including, but not limited to, market interest rates, the availability of mortgage credit, the relative economic vitality of the area in which the related properties are located, the servicing of the mortgage loans, possible changes in tax laws, other opportunities for investment, homeowner mobility and other economic, social, geographic, demographic and legal factors and other factors beyond our control. Consequently, such prepayment rates cannot be predicted with certainty and no strategy can completely insulate us from prepayment or other such risks. In periods of declining interest rates, prepayment rates on mortgage loans generally increase. In addition, prepayments received during periods of declining interest rates are likely to be reinvested by us in assets with yields that are lower than the investments that prepaid. In addition, the market value of the assets may, because of the risk of prepayment, benefit less than other fixed- income securities from declining interest rates.
We invest in Agency IO and Inverse IO securities and may in the future invest in non-Agency IO and Inverse IO securities, all of which are highly sensitive to prepayments and/or changes in interest rates. As the mortgages underlying an IO or Inverse IO are paid off, the future stream of interest on such securities is reduced. Faster prepayments than we anticipated on the underlying loans backing our IO and Inverse IO securities will have an adverse effect on our returns on these investments.
With respect to any MSRs in which we invest, prepayments eliminate the MSR on the mortgage loans being prepaid. If we purchase MSRs, we will base the price we pay and the rate of amortization of those assets on, among other things, our projection of the cash flows from the pool of mortgage loans underlying the related MSRs. Our expectation of prepayment speeds and recapture rates is a significant assumption underlying our cash flow projections and if prepayment speeds are significantly greater than expected or recapture rates significantly lower than expected, the carrying value of any MSRs that we acquire could exceed their estimated fair value.
The mortgage loans that we acquire, and the mortgage and other loans underlying the RMBS that we acquire, are subject to delinquency, foreclosure and loss, which could result in losses to us.
Residential mortgage loans are secured by one-to-four family residential properties and are subject to risks of delinquency, foreclosure and loss. The ability of a borrower to repay a loan secured by a residential property typically is dependent upon the income or assets of the borrower. A number of factors, including a general economic downturn, natural disasters, terrorism, social unrest and civil disturbances, may impair borrowers’ abilities to repay their loans. In addition, we intend to acquire non-Agency RMBS, which are backed by residential real property but, in contrast to Agency RMBS, their principal and interest are not guaranteed by federally chartered entities such as Fannie Mae and Freddie Mac and, in the case of Ginnie Mae, the U.S. Government. The ability of a borrower to repay these loans or other financial assets is dependent upon the income or assets of these borrowers.
In the event of any default under a mortgage loans or similar residential mortgage assets held directly by us, we bear a risk of loss of principal to the extent of any deficiency between the value of the collateral and the principal and accrued interest of the mortgage loans or other residential mortgage assets, which could have a material adverse effect on our cash flow from operations. In the event of the bankruptcy of a mortgage loan borrower, the mortgage loan to such borrower will be deemed to be secured only to the extent of the value of the underlying collateral at the time of bankruptcy (as determined by the bankruptcy court), and the lien securing the mortgage loan will be subject to the avoidance powers of the bankruptcy trustee or debtor-in-possession to the extent the lien is unenforceable under state law. Foreclosure of a mortgage loan can be an expensive and lengthy process, which could have a substantial negative effect on our anticipated return on the foreclosed mortgage loan.


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Certain investments in whole mortgage loans may require us to purchase less desirable mortgage assets as part of an otherwise desirable pool of mortgage assets, which could subject us to additional risks relating to the less desirable mortgage assets.
If we acquire whole mortgage loans, we may be required to purchase other types of mortgage assets as part of an available pool of mortgage assets in order to acquire the desired whole loans. These other mortgage assets may include mortgage assets that subject us to additional risks. Acquisition of less desirable mortgage assets may impair our performance and reduce the return on our investments.
We may be subject to liability for potential violations of predatory lending laws, which could adversely impact our results of operations, financial condition and business.
Various U.S. federal, state and local laws have been enacted that are designed to discourage predatory lending practices. If any of our mortgage loans or similar residential mortgage assets are found to have been originated in violation of predatory or abusive lending laws, we could incur losses, which could have a material adverse effect on our business, financial condition, results of operations, the market price of our capital stock and our ability to pay dividends to our stockholders.
We are subject to counterparty risk and may be unable to seek indemnity or require our counterparties to repurchase mortgage loans if they breach representations and warranties, which could cause us to suffer losses.
When selling mortgage loans, sellers typically make customary representations and warranties about such loans. Our residential mortgage loan purchase agreements may entitle us to seek indemnity or demand repurchase or substitution of the loans in the event our counterparty breaches a representation or warranty given to us. However, there can be no assurance that our mortgage loan purchase agreements will contain appropriate representations and warranties, that we will be able to enforce our contractual right to repurchase or substitution, or that our counterparty will remain solvent or otherwise be able to honor its obligations under its mortgage loan purchase agreements. Our inability to obtain indemnity or require repurchase of a significant number of loans could have a material adverse effect our business, financial condition, results of operations, the market price of our capital stock and our ability to pay dividends to our stockholders.
Our mortgage assets are subject to risks particular to real property, which may reduce our return from an affected property or asset and reduce or eliminate our ability to pay dividends to stockholders.
We own mortgage assets secured by real estate including the mortgages collateralizing our non-Agency RMBS. In addition, we may own real estate directly in the future, either through direct acquisitions or upon a default of mortgage loans. Real estate investments are subject to various risks, including:
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natural disasters, including earthquakes, floods and other natural disasters, which may result in uninsured losses;
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acts of war or terrorism, including the consequences of terrorist attacks, such as those that occurred on September 11, 2001;
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adverse changes in national and local economic and market conditions;
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changes in governmental laws and regulations, fiscal policies and zoning ordinances and the related costs of compliance with laws and regulations, fiscal policies and zoning ordinances;
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costs of remediation and liabilities associated with environmental conditions such as indoor mold; and
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the potential for uninsured or under-insured property losses.
If any of these or similar events occur, it may reduce our return from an affected property or asset and reduce or eliminate our ability to pay dividends to our stockholders. In particular, the occurrence of a natural disaster (such as an earthquake, tornado, hurricane or a flood) or a significant adverse climate change may cause a sudden decrease in the value of real estate and would likely reduce the value of the properties securing our mortgage loans and mortgages collateralizing our non-Agency RMBS. Since certain natural disasters may not typically be covered by the standard hazard insurance policies maintained by borrowers, the borrowers may have to pay for repairs due to the disasters. Borrowers may not repair their property or may stop paying their mortgages under those circumstances. This would likely cause defaults and credit loss severities to increase on the pool of mortgages securing our non-Agency RMBS which, unlike Agency RMBS, are not guaranteed as to principal and/or interest by the U.S. Government, any federal agency or federally chartered corporation.
Liability relating to environmental matters may impact the value of properties that we may acquire or the properties underlying our investments.
Under various U.S. federal, state and local laws, an owner or operator of real property may become liable for the costs of removal of certain hazardous substances released on its property. These laws often impose liability without regard to whether the owner or operator knew of, or was responsible for, the release of such hazardous substances.


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The presence of hazardous substances may adversely affect an owner’s ability to sell real estate or borrow using real estate as collateral. To the extent that an owner of a property underlying one of our debt investments becomes liable for removal costs, the ability of the owner to make payments to us may be reduced, which in turn may adversely affect the value of the relevant mortgage asset held by us and our ability to pay dividends to our stockholders.
In the course of our business, we may take title to real estate, and if so, could be subject to environmental liabilities with respect to these properties. The presence of hazardous substances, if any, on our properties may adversely affect our ability to sell the affected properties and incur substantial remediation costs, thus harming our financial condition. The discovery of material environmental liabilities attached to such properties could have a material adverse effect on our business, financial condition, results of operations, the market price of our capital stock and our ability to pay dividends to our stockholders.
To the extent that we invest in MSRs in the future, the value that we may realize from MSRs and excess MSRs may be significantly less than the fair values of such assets reflected on our balance sheet.
We may invest in MSRs, which arise from contractual agreements between us and the investors (or, their agents) in mortgage securities and mortgage loans. Excess MSRs are interests in mortgage servicing rights, representing a portion of the fee paid to mortgage servicers. The fee that a mortgage servicer is entitled to receive for servicing a pool of mortgages generally exceeds the reasonable compensation that would be charged in an arm’s-length transaction. For example, Fannie Mae and Freddie Mac generally require mortgage servicers to be paid a minimum servicing fee that significantly exceeds the amount a servicer would charge in an arm’s-length transaction. The portion of the fee in excess of what would be charged in an arm’s-length transaction is commonly referred to as the excess mortgage servicing fee. Subject to maintaining our qualification as a REIT and our exclusion from registration as an investment company under the 1940 Act, we may acquire MSRs from the sale of mortgage loans where we assume the obligation to service the loan in connection with the sale transaction or we may purchase MSRs and excess MSRs. Any MSRs and excess MSRs that we acquire will be recorded at fair value on our balance sheet. The determination of the fair value of MSRs and excess MSRs will require our Manager to make numerous estimates and assumptions. Such estimates and assumptions include, without limitation, estimates of future cash flows associated with MSRs based upon assumptions involving interest rates as well as the prepayment rates, delinquencies and foreclosure rates of the underlying serviced mortgage loans.
The ultimate realization of the value of MSRs and excess MSRs may be materially different than the fair values of such assets as reflected in our consolidated balance sheet as of any particular date. The use of different estimates or assumptions in connection with the valuation of these assets could produce materially different fair values for such assets, which could have a material adverse effect on our business, financial condition, results of operations, the market price of our capital stock and our ability to pay dividends to our stockholders. Accordingly, there may be material uncertainty about the fair value of any MSRs or excess MSRs we acquire.
Furthermore, MSRs, excess MSRs and the related servicing activities are subject to numerous U.S. federal, state and local laws and regulations and may be subject to various judicial and administrative decisions imposing various requirements and restrictions on our business. Our failure to comply, or the failure of the servicer to comply, with the laws, rules or regulations to which we or they are subjected by virtue of ownership of MSRs or excess MSRs, whether actual or alleged, could expose us to fines, penalties or potential litigation liabilities, including costs, settlements and judgments, any of which could have a material adverse effect on our business, financial condition, results of operations, the market price of our capital stock and our ability to pay dividends to our stockholders.
We may be affected by deficiencies in foreclosure practices of third parties, as well as related delays in the foreclosure process.
Allegations of deficiencies in foreclosure documentation and servicing and foreclosure practices by several large mortgage servicers have raised various concerns relating to foreclosure practices. As a result of these alleged deficiencies in foreclosure practices, a number of servicers temporarily suspended foreclosure proceedings beginning in the second half of 2010 while they evaluated their foreclosure practices. In addition, on February 9, 2012, a group consisting of state attorneys general and state bank and mortgage regulators in 49 states reached a settlement with the largest mortgage servicers regarding foreclosure practices in the states’ various jurisdictions. On January 7, 2013 the Office of the Comptroller of the Currency and the Board of Governors of the Federal Reserve System announced a settlement with a number of mortgage servicers in lieu of continuing a foreclosure review process, under which borrowers who believed they were financially harmed by the foreclosure process in 2009 and 2010 were able to request an independent review of the process. The settlement, which includes funds for both direct payments to eligible borrowers and for other assistance such as loan modifications and forgiveness of deficiency judgments, ended the case-by-case reviews. The extension of foreclosure timelines increases the inventory backlog of distressed homes on the market and creates greater uncertainty about housing prices. We may incur substantial legal fees and court costs in acquiring a property through contested foreclosure or bankruptcy proceedings. We intend to continue to monitor and review the issues raised by the alleged improper foreclosure practices. We cannot predict exactly how the servicing and


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foreclosure matters or the resulting litigation or settlement agreements will affect our business and cannot assure you that these matters will not impair our performance and reduce the return on our investments.
The lack of liquidity of our assets may adversely affect our business, including our ability to value and sell our assets.
We may acquire assets or other instruments that are not liquid, including securities and other instruments that are not publicly traded. Moreover, turbulent market conditions, could significantly and negatively impact the liquidity of our assets. Illiquid assets typically experience greater price volatility, as a ready market does not exist, and can be more difficult to value. In addition, validating third-party pricing for illiquid assets may be more subjective than more liquid assets. The illiquidity of our assets may make it difficult to sell such assets if the need or desire arises. In addition, if we are required to liquidate all or a portion of our portfolio quickly, we may realize significantly less than the value at which we had previously recorded such assets. To the extent that we utilize leverage to finance our purchase of assets that are or become illiquid, the negative impact on us related to trying to sell assets quickly could be greatly exacerbated. As a result, our ability to vary our portfolio in response to changes in economic and other conditions may be relatively limited, which could adversely affect our business, financial condition, results of operations, the market price of our capital stock and our ability to pay dividends to our stockholders.
We maintain cash balances in our bank accounts that exceed the Federal Deposit Insurance Corporation limitation.
We regularly maintain cash balances at a single bank domiciled in the U.S. in excess of the Federal Deposit Insurance Corporation insurance limit. The failure of such bank could result in the loss of a portion of such cash balances in excess of the federally insured limit, which could materially and adversely affect our business, financial condition, results of operations, the market price of our capital stock and our ability to pay dividends to our stockholders.
Risks Related to Our Capital Stock
Common stock and preferred stock eligible for future sale may have adverse effects on our share price.
Subject to applicable law, our board of directors has the power, without further stockholder approval, to authorize us to issue additional authorized shares of common stock and preferred stock on the terms and for the consideration it deems appropriate. We cannot predict the effect, if any, of future sales of our capital stock, or the availability of shares for future sales, on the market price of our common stock or preferred stock. The market price of our common stock may decline significantly when the restrictions on resale by certain of our stockholders lapse. Sales of substantial amounts of common stock, preferred stock or the perception that such sales could occur may adversely affect the prevailing market price for our common stock.
If our portfolio of assets generates insufficient income and cash flow, we could be required to sell assets, borrow funds, make a portion of our dividend distributions in the form of a taxable stock distribution or distribution of debt securities to meet our distribution requirements.
We are generally required to distribute to our stockholders at least 90% of our ordinary taxable income each year for us to qualify as a REIT under the Internal Revenue Code of 1986, as amended (or, the Internal Revenue Code), which requirement we currently satisfy through quarterly cash dividends. Our ability to pay dividends may be adversely affected by a number of factors. Although we pay quarterly dividends to our stockholders, our board of directors has the sole discretion to determine the timing, form and amount of any distributions to our stockholders. If our portfolio of assets generates insufficient income and cash flow to fund our dividends, we could be required to sell assets, borrow funds or make a portion of our dividend distributions in the form of a taxable stock distribution or distribution of debt securities. To the extent that we are required to sell assets in adverse market conditions or borrow funds at unfavorable rates, our results of operations could be materially and adversely affected. Our board of directors will make determinations regarding dividend distributions based upon various factors, including our ordinary taxable income, our financial condition, our liquidity, our debt and preferred stock covenants, maintenance of our REIT qualification, applicable provisions of the Maryland General Corporation Law (or, MGCL) and other factors as our board of directors may deem relevant from time to time. We believe that a change in any one of the following factors could adversely affect our results of operations and impair our ability to pay dividends to our stockholders:
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our ability to make profitable investments;
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margin calls or other expenses that reduce our cash flow;
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defaults in our asset portfolio or decreases in the value of our portfolio; and
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a significant increase in our operating expenses.
As a result, no assurance can be given that we will be able to pay dividends to our stockholders at any time in the future or that the level of any distributions we do make to our stockholders will achieve any expected market yield, increase or even be maintained over time, such that the value of our capital stock could be materially and adversely affected.


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In addition, dividend distributions that we make to our stockholders will generally be taxable to our stockholders as ordinary income. However, a portion of our distributions may be designated as long-term capital gains to the extent that they are attributable to capital gain income recognized by us or may constitute a return of capital to the extent that they exceed our earnings and profits as determined for tax purposes. A return of capital is not taxable, but has the effect of reducing the basis of a stockholder’s investment in shares of our common stock.
Future offerings of debt or equity securities, which may rank senior to our common stock, may adversely affect the market price of our common stock and result in dilution to owners of our common stock.
If we decide to issue debt securities in the future, which would rank senior to our common stock, it is likely that they will be governed by an indenture or other instrument containing covenants restricting our operating flexibility. In September 2012, we issued 6,900,000 shares of 8.0% cumulative redeemable Preferred Stock. No dividends may be paid on our common stock unless full cumulative dividends have been paid on our preferred stock. The issuance of additional shares of our common stock, including in connection with conversions of our outstanding Preferred Stock, or other future issuances of convertible securities, including outstanding options and warrants, or otherwise, will dilute the ownership interest of our common stockholders. Additionally, any equity securities or convertible or exchangeable securities that we issue in the future may have rights, preferences and privileges more favorable than those of our common stock and may result in dilution to owners of our common stock. We and, indirectly, our stockholders, will bear the cost of issuing and servicing such securities. Because our decision to issue debt or equity securities in any future offering will depend on market conditions and other factors beyond our control, we cannot predict or estimate the amount, timing or nature of our future offerings. Thus, holders of our common stock will bear the risk of our future offerings reducing the market price of our common stock and diluting the value of their stock holdings in us.
Risks Related to Our Organization and Structure
Certain provisions of the MGCL could inhibit changes in control.
Certain provisions of the MGCL may have the effect of deterring a third party from making a proposal to acquire us or of impeding a change in control under circumstances that otherwise could provide the holders of our common stock with the opportunity to realize a premium over the then-prevailing market price of our common stock. We are subject to the “business combination” provisions of the MGCL that, subject to limitations, prohibit certain business combinations (including a merger, consolidation, share exchange, or, in circumstances specified in the statute, an asset transfer or issuance or reclassification of equity securities) between us and an “interested stockholder” (defined generally as any person who beneficially owns 10% or more of our then outstanding voting stock or an affiliate or our associate who, at any time within the two-year period prior to the date in question, was the beneficial owner of 10% or more of our then outstanding voting stock) or an affiliate thereof for five years after the most recent date on which the stockholder becomes an interested stockholder. After the five-year prohibition, any business combination between us and an interested stockholder generally must be recommended by our board of directors and approved by the affirmative vote of at least (i) 80% of the votes entitled to be cast by holders of outstanding shares of our voting stock and (ii) two-thirds of the votes entitled to be cast by holders of our voting stock other than shares held by the interested stockholder with whom or with whose affiliate the business combination is to be effected or held by an affiliate or associate of the interested stockholder. These super-majority vote requirements do not apply if our common stockholders receive a minimum price, as defined under MGCL, for their shares in the form of cash or other consideration in the same form as previously paid by the interested stockholder for our shares. These provisions of the MGCL do not apply, however, to business combinations that are approved or exempted by a board of directors prior to the time that the interested stockholder becomes an interested stockholder. Pursuant to the statute, our board of directors has by resolution exempted business combinations (i) between us and any other person, provided that such business combination is first approved by our board of directors (including a majority of our directors who are not affiliates or associates of such person), (ii) between us and Apollo and its affiliates and associates and (iii) persons acting in concert with any of the foregoing. As a result, any person described above may be able to enter into business combinations with us that may not be in the best interests of our stockholders, without compliance by us with the super majority vote requirements and other provisions of the statute. There can be no assurance that our board of directors will not amend or revoke this exemption in the future.
The “control share” provisions of the MGCL provide that a holder of “control shares” of a Maryland corporation (defined as shares which, when aggregated with all other shares controlled by the stockholder, except solely by virtue of a revocable proxy, entitle the stockholder to exercise one of three increasing ranges of voting power in electing directors) acquired in a “control share acquisition” (defined as the direct or indirect acquisition of ownership or control of issued and outstanding “control shares”) has no voting rights with respect to such shares except to the extent approved by our stockholders by the affirmative vote of at least two-thirds of all the votes entitled to be cast on the matter, excluding votes entitled to be cast by the acquirer of control shares, our officers and personnel who are also directors. Our bylaws contain a provision exempting from the control share acquisition statute any and all acquisitions by any person of shares of our stock. There can be no assurance that this provision will not be amended or eliminated at any time in the future.


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The “unsolicited takeover” provisions of the MGCL permit our board of directors, without stockholder approval and regardless of what is currently provided in our charter or bylaws, to implement takeover defenses, some of which (for example, a classified board) we do not currently have. Our charter contains a provision whereby we have elected to be subject to the provisions of Title 3, Subtitle 8 of the MGCL relating to the filling of vacancies on our board of directors as a result of which, vacancies on our board of directors may be filled only by the remaining directors, even if the remaining directors do not constitute a quorum. These provisions may have the effect of inhibiting a third party from making an acquisition proposal for us or of delaying, deferring or preventing a change in control of us under the circumstances that otherwise could provide the holders of shares of common stock with the opportunity to realize a premium over the then current market price.
Our authorized but unissued shares of common and preferred stock may prevent a change in our control.
Our charter permits our board of directors to authorize us to issue additional shares of our authorized but unissued common or preferred stock. In addition, our board of directors may, without stockholder approval, amend our charter to increase the aggregate number of our shares of stock or the number of shares of stock of any class or series that we have the authority to issue and classify or reclassify any unissued shares of common or preferred stock and set the terms of the classified or reclassified shares. As a result, our directors may establish a series of shares of common or preferred stock that could delay or prevent a transaction or a change in control that might involve a premium price for shares of our common stock or otherwise be in the best interests of our stockholders.
Our rights and the rights of our stockholders to take action against our directors and officers are limited, which could limit recourse available to holders of our capital stock in the event of actions not in their best interests.
Our charter limits the liability of our present and former directors and officers to us and our stockholders for money damages to the maximum extent permitted under Maryland law. Under Maryland law, our present and former directors and officers do not have any liability to us and our stockholders for money damages other than liability resulting from:
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actual receipt of an improper benefit or profit in money, property or services; or
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active and deliberate dishonesty by the director or officer that was established by a final judgment and was material to the cause of action adjudicated.
Our charter authorizes us to indemnify our directors and officers for actions taken by them in those and other capacities to the maximum extent permitted by Maryland law. Our bylaws require us to indemnify each present and former director or officer, to the maximum extent permitted by Maryland law, in the defense of any proceeding to which he or she is made, or threatened to be made, a party by reason of his or her service to us. We have entered into indemnification agreements with each of our directors and officers pursuant to which we may be obligated to pay or reimburse the defense costs incurred by our present and former directors and officers without requiring a preliminary determination of their ultimate entitlement to indemnification.
Our charter contains provisions that make removal of our directors difficult, which could make it difficult for stockholders to effect changes to our management.
Our charter provides that, subject to the rights of any series of preferred stock, a director may be removed with or without cause upon the affirmative vote of at least two-thirds of the votes entitled to be cast generally in the election of directors. Vacancies may be filled only by a majority of the remaining directors in office, even if less than a quorum. These requirements make it more difficult to change our management by removing and replacing directors and may prevent a change in control of us that is in the best interests of stockholders.
Ownership limitations may restrict change of control or business combination opportunities in which our stockholders might receive a premium for their shares.
In order for us to qualify as a REIT, no more than 50% in value of our outstanding capital stock may be owned, directly or indirectly, by five or fewer individuals during the last half of any calendar year, and at least 100 persons must beneficially own our stock during at least 335 days of a taxable year of 12 months, or during a proportionate portion of a shorter taxable year. “Individuals” for this purpose include natural persons, private foundations, some employee benefit plans and trusts, and some charitable trusts. To preserve our REIT qualification, among other purposes, our charter generally prohibits any person from directly or indirectly owning more than 9.8% in value or in number of shares, whichever is more restrictive, of the outstanding shares of our capital stock or more than 9.8% in value or in number of shares, whichever is more restrictive, of the outstanding shares of our common stock. The Articles Supplementary for our Preferred Stock prohibits any stockholder from beneficially or constructively owning more than 9.8% in value or in number of shares, whichever is more restrictive, of our outstanding Preferred Stock. These ownership limits could have the effect of discouraging a takeover or other transaction in which holders of our common stock might receive a premium for their shares over the then prevailing market price or which holders might believe to be otherwise in their best interests. Our board of directors have established exemptions from the ownership limits which permit (i) Apollo and certain of its affiliates to collectively hold up to 25% of our common stock (ii)


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certain private fund investors to collectively hold (a) up to the greater of 1,540,500 shares of our common stock or 15% of our common stock, and (b) up to 25% of our Preferred Stock, and (iii) other private fund investors to collectively hold up to 20% of our Preferred Stock.
Risks Related to Our Taxation as a REIT
Qualifying as a REIT involves highly technical and complex provisions of the Internal Revenue Code, and our failure to qualify as a REIT or remain qualified as a REIT would subject us to U.S. federal income tax and applicable state and local taxes, which would reduce the amount of cash available to pay dividends to our stockholders.
We have elected to qualify as a REIT for U.S. federal income tax purposes commencing with our taxable year ended December 31, 2011. We have not requested and do not intend to request a ruling from the Internal Revenue Service (or, IRS) that we qualify as a REIT. The U.S. federal income tax laws governing REITs are complex, and judicial and administrative interpretations of the U.S. federal income tax laws governing REIT qualification are limited. To qualify as a REIT, we must meet, on an ongoing basis, various tests regarding the nature and diversification of our assets and our income, the ownership of our outstanding shares, and the amount of our dividend distributions. Even a technical or inadvertent violation could jeopardize our REIT qualification. Our ability to satisfy the REIT asset tests depends upon our analysis of the characterization and fair market values of our assets, some of which are not susceptible to a precise determination. Our compliance with the REIT income and quarterly asset requirements also depends upon our ability to successfully manage the composition of our income and assets on an ongoing basis. Moreover, new legislation, court decisions or administrative guidance, in each case possibly with retroactive effect, may make it more difficult or impossible for us to qualify as a REIT. In addition, our ability to satisfy the requirements to qualify as a REIT depends in part on the actions of third parties over which we have no control or only limited influence, including in cases where we own an equity interest in an entity that is classified as a partnership for U.S. federal income tax purposes. Thus, while we currently operate so that we will qualify as a REIT, given the highly complex nature of the rules governing REITs, the ongoing importance of factual determinations, and the possibility of future changes in our circumstances, no assurance can be given that we will qualify as a REIT for any particular year.
If we fail to qualify as a REIT in any taxable year, and we do not qualify for certain statutory relief provisions, we would be required to pay U.S. federal income tax on our taxable income, and distributions to our stockholders would not be deductible by us in determining our taxable income. In such a case, we might need to borrow money or sell assets in order to pay our taxes. Our payment of income tax would decrease the amount of our income available for distribution to our stockholders. Furthermore, if we fail to maintain our qualification as a REIT, we no longer would be required to distribute substantially all of our taxable income to stockholders. In addition, unless we were eligible for certain statutory relief provisions, we could not re-elect to qualify as a REIT for the subsequent four taxable years following the year in which we failed to qualify.
Complying with REIT requirements may force us to liquidate or forego otherwise attractive investments.
To qualify as a REIT, we must ensure that we meet the REIT gross income tests annually and that, at the end of each calendar quarter, at least 75% of the value of our assets consists of cash, cash items, government securities, shares in REITs and other qualifying real estate assets, including certain mortgage loans and certain kinds of mortgage-backed securities. The remainder of our investments in securities (other than government securities and REIT qualified real estate assets) generally cannot include more than 10% of the outstanding voting securities of any one issuer or more than 10% of the total value of the outstanding securities of any one issuer. In addition, in general, no more than 5% of the value of our assets (other than government securities and securities that are qualifying real estate assets) can consist of the securities of any one issuer, and no more than 25% of the value of our total securities can be represented by securities of one or more TRSs. If we fail to comply with these requirements at the end of any calendar quarter, we must correct the failure within 30 days after the end of the calendar quarter or qualify for certain statutory relief provisions to avoid losing our REIT qualification and suffering adverse tax consequences. As a result, we may be required to liquidate from our portfolio, or contribute to a TRS, otherwise attractive investments, and may be unable to pursue investments that would be otherwise advantageous to us in order to satisfy the source of income or asset diversification requirements for qualifying as a REIT. These actions could have the effect of reducing our income and amounts available for distribution to our stockholders.
REIT distribution requirements may cause us to forego attractive investment opportunities and/or may require us to incur debt or sell assets to make such dividend distributions.
In order to qualify as a REIT, we must distribute to our stockholders, each calendar year, at least 90% of our REIT taxable income including certain items of non-cash income, determined without regard to the deduction for dividends paid and excluding net capital gain. To the extent that we satisfy the 90% distribution requirement, but distribute less than 100% of our taxable income, we will be subject to U.S. federal corporate income tax on our undistributed income. In addition, we will incur a 4% nondeductible excise tax on the amount, if any, by which our dividend distributions in any calendar year are less than a minimum amount specified under U.S. federal income tax laws. We expect to distribute our net income to our stockholders in a manner intended to satisfy the REIT 90% distribution requirement and to avoid the 4% nondeductible excise tax.


28


Our taxable income may substantially exceed our net income as determined based on GAAP because, for example, realized capital losses will be deducted in determining our GAAP net income, but may not be deductible in computing our taxable income. In addition, we may invest in assets that generate taxable income in excess of economic income or in advance of the corresponding cash flow from the assets, referred to as phantom income. Although some types of phantom income are excluded in determining the 90% distribution requirement, we will incur corporate income tax and the 4% nondeductible excise tax with respect to any phantom income items if we do not distribute those items on an annual basis. In addition, our taxable income may substantially exceed our net income as determined in accordance with GAAP or differences in timing between the recognition of taxable income and the actual receipt of cash may occur. For example, for tax purposes we may be required to accrue interest and discount income on mortgage loans, RMBS, and other types of debt securities or interests in debt securities before we receive any payments of interest or principal on such assets. We may also acquire distressed debt instruments that are subsequently modified by agreement with the borrower. If the amendments to the outstanding debt are “significant modifications” under the applicable Treasury regulations, the modified debt may be considered to have been reissued to us at a gain in a debt-for-debt exchange with the borrower, with gain recognized by us to the extent that the principal amount of the modified debt exceeds our cost of purchasing it prior to modification. We may be required under the terms of the indebtedness that we incur, whether to private lenders or pursuant to government programs, to use cash received from interest payments to make principal payment on that indebtedness, with the effect that we will recognize income but will not have a corresponding amount of cash available for distribution to our stockholders.
As a result of the foregoing, we may generate less cash flow than taxable income in a particular year and find it difficult or impossible to meet the REIT distribution requirements in certain circumstances. In such circumstances, we may be required to: (i) sell assets in adverse market conditions, (ii) borrow on unfavorable terms, (iii) distribute amounts that would otherwise be invested in future acquisitions, capital expenditures or repayment of debt or (iv) make a taxable distribution of our shares as part of a distribution in which stockholders may elect to receive shares or (subject to a limit measured as a percentage of the total distribution) cash, in order to comply with the REIT distribution requirements and to avoid U.S. federal corporate income tax and the 4% nondeductible excise tax. Thus, compliance with the REIT distribution requirements may hinder our ability to grow, which could adversely affect the value of our common stock.
Even if we qualify as a REIT, we may face tax liabilities that reduce our cash flow.
Even if we qualify for taxation as a REIT, we may be subject to certain U.S. federal, state and local taxes on our income and assets, including taxes on any undistributed income, tax on income from some activities conducted as a result of a foreclosure, and state or local income, franchise, property and transfer taxes, including mortgage recording taxes. We also could, in certain circumstances, be required to pay an excise or penalty tax (which could be significant in amount) in order to utilize one or more relief provisions under the Internal Revenue Code to maintain our qualification as a REIT. In addition, our TRSs will be subject to U.S. federal, state and local corporate taxes. In order to meet the REIT qualification requirements, or to avoid the imposition of a 100% tax that applies to certain gains derived by a REIT from sales of inventory or property held primarily for sale to customers in the ordinary course of business, we hold some of our assets through TRSs. Any taxes paid by us or our TRSs would decrease the cash available for distribution to our stockholders.
The failure of mortgage loans or RMBS subject to a repurchase agreement to qualify as a real estate asset would adversely affect our ability to qualify as a REIT.
When we enter into repurchase agreements, we will nominally sell certain of our assets to a counterparty and simultaneously enter into an agreement to repurchase the sold assets. We believe that we are treated for U.S. federal income tax purposes as the owner of the assets that are the subject of any such agreements notwithstanding that such agreements may transfer record ownership of the assets to the counterparty during the term of the agreement. It is possible, however, that the IRS could assert that we did not own the assets during the term of the repurchase agreement, in which case we could fail to qualify as a REIT.
We may be required to report taxable income for certain investments in excess of the economic income we ultimately realize from them.
We have acquired and intend to continue to acquire non-Agency RMBS at prices that reflect significant market discounts on their unpaid principal balances. In particular, we have purchased junior tranches of certain non-Agency RMBS in which our right to cash distributions is subordinated to that of the holders of the senior tranches. The senior tranches participate in the cash flow from the underlying loan assets and distributions on the junior tranches are generally made only after all required payments are made to holders of the senior tranches. The amount of the discount at which we have acquired such non-Agency RMBS will generally be treated as “market discount” for U.S. federal income tax purposes. Accrued market discount is reported as income when, and to the extent that, any payment of principal of the debt instrument is made, unless we elect to include accrued market discount in income as it accrues. Principal payments on certain loans are made monthly, and consequently accrued market discount may have to be included in income each month as if the debt instrument were assured of ultimately being collected in full. If we collect less on the debt instrument than our purchase price plus the market discount we


29


had previously reported as income, we may not be able to benefit from any offsetting loss deductions. In addition, even if junior tranches of non-Agency RMBS that we hold continue to generate taxable income with no corresponding receipt of cash, we must continue to meet the REIT distribution requirements, which are based on our taxable income.
Similarly, some of the RMBS that we acquire have been issued with original issue discount (or, OID). We are required to report such OID based on a constant yield method and will be taxed based on the assumption that all future projected payments due on such RMBS will be made. If a portion of such RMBS turns out not to be fully collectible, an offsetting loss deduction will become available only in the later year that uncollectibility is provable. Finally, in the event that any debt instruments or RMBS acquired by us are delinquent as to mandatory principal and interest payments, or in the event payments with respect to a particular debt instrument are not made when due, we may nonetheless be required to continue to recognize the unpaid interest as taxable income as it accrues, despite doubt as to its ultimate collectibility. Similarly, we may be required to accrue interest income with respect to subordinate RMBS at its stated rate regardless of whether corresponding cash payments are received or are ultimately collectible. In each case, while we would in general ultimately have an offsetting loss deduction available to us when such interest is determined to be uncollectible, the utility of that deduction could depend on us having taxable income in that later year or thereafter.
We may acquire excess MSRs, which reflects the portion of an MSR that exceeds the arm’s length fee for services performed by the mortgage service. Based on IRS guidance concerning the classification of excess MSRs to the extent we acquire excess MSRs, we intend to treat such excess MSRs as ownership interests in the interest payments made on the underlying mortgage loans, akin to an “interest-only” strip. Under this treatment, for purposes of determining the amount and timing of taxable income, each excess MSR is treated as a bond that was issued with OID on the date we acquired such excess MSR. In general, we will be required to accrue OID based on the constant yield to maturity of each excess MSR, and to treat such OID as taxable income in accordance with the applicable U.S. federal income tax rules. The constant yield of an excess MSR will be determined, and we will be taxed, based on a prepayment assumption regarding future payments due on the mortgage loans underlying the excess MSR. If the mortgage loans underlying an excess MSR prepay at a rate different than that under the prepayment assumption, our recognition of OID will be either increased or decreased depending on the circumstances. Thus, in a particular taxable year, we may be required to accrue an amount of income with respect to an excess MSR that exceeds the amount of cash collected for such excess MSR. Furthermore, it is possible that, over the life of the investment in an excess MSR, the total amount we pay for, and accrue with respect to, the excess MSR may exceed the total amount we collect on such excess MSR. No assurance can be given that we will be entitled to a deduction for such excess, meaning that we may be required to recognize phantom income over the life of an excess MSR, which will impact our REIT distribution requirements.
The interest apportionment rules may affect our ability to comply with the REIT asset and gross income tests.
The interest apportionment rules under Treasury Regulation Section 1.856-5(c) provide that, if a mortgage is secured by both real property and other property, a REIT is required to apportion its annual interest income to the real property security based on a fraction, the numerator of which is the value of the real property securing the loan, determined when the REIT commits to acquire the loan, and the denominator of which is the highest “principal amount” of the loan during the year. IRS Revenue Procedure 2011-16 interprets the “principal amount” of the loan to be the face amount of the loan, despite the Internal Revenue Code requiring taxpayers to treat any market discount, that is the difference between the purchase price of the loan and its face amount, for all purposes (other than certain withholding and information reporting purposes) as interest rather than principal.
The interest apportionment regulations apply only if the mortgage loan in question is secured by both real property and other property. We expect that all or most of the mortgage loans that we acquire will be secured only by real property and no other property value is taken into account in our underwriting process. Accordingly, it is not contemplated that we will invest in mortgage loans to which the interest apportionment rules described above would apply. Nevertheless, if the IRS were to assert successfully that our mortgage loans were secured by property other than real estate, the interest apportionment rules applied for purposes of our REIT testing, and that the position taken in IRS Revenue Procedure 2011-16 should be applied to certain mortgage loans in our portfolio, then depending upon the value of the real property securing our mortgage loans and their face amount, and the sources of our gross income generally, we may fail to meet the 75% REIT gross income test. If we do not meet this test, we could potentially lose our REIT qualification or be required to pay a penalty to the IRS.
In addition, the Internal Revenue Code provides that a regular or a residual interest in a real estate mortgage investment conduit (or, REMIC) is generally treated as a real estate asset for the purpose of the REIT asset tests, and any amount includible in our gross income with respect to such an interest is generally treated as interest on an obligation secured by a mortgage on real property for the purpose of the REIT gross income tests. If, however, less than 95% of the assets of a REMIC in which we hold an interest consist of real estate assets (determined as if we held such assets), we will be treated as holding our proportionate share of the assets of the REMIC for the purpose of the REIT asset tests and receive directly our proportionate share of the income of the REMIC for the purpose of determining the amount of income from the REMIC that is treated as interest on an obligation secured by a mortgage on real property. In connection with the expanded HARP, the IRS issued


30


guidance providing that, among other things, if a REIT holds a regular interest in an “eligible REMIC,” or a residual interest in an “eligible REMIC” that informs the REIT that at least 80% of the REMIC’s assets constitute real estate assets, then (i) the REIT may treat 80% of the value of the interest in the REMIC as a real estate asset for the purpose of the REIT asset tests and (ii) the REIT may treat 80% of the gross income received with respect to the interest in the REMIC as interest on an obligation secured by a mortgage on real property for the purpose of the 75% REIT gross income test. For this purpose, a REMIC is an “eligible REMIC” if (i) the REMIC has received a guarantee from Fannie Mae or Freddie Mac that will allow the REMIC to make any principal and interest payments on its regular and residual interests and (ii) all of the REMIC’s mortgages and pass-through certificates are secured by interests in single-family dwellings (which includes one-to-four family dwellings). If we were to acquire an interest in an eligible REMIC of which less than 95% of the assets constitute real estate assets, the IRS guidance described above may generally allow us to treat 80% of our interest in such a REMIC as a qualifying asset for the purpose of the REIT asset tests and 80% of the gross income derived from the interest as qualifying income for the purpose of the 75% REIT gross income test. Although the portion of the income from such a REMIC interest that does not qualify for the 75% REIT gross income test would likely be qualifying income for the purpose of the 95% REIT gross income test, the remaining 20% of the REMIC interest generally would not qualify as a real estate asset, which could adversely affect our ability to satisfy the REIT asset tests. Accordingly, owning such a REMIC interest could adversely affect our ability to qualify as a REIT.
The “taxable mortgage pool” rules may increase the taxes that we or our stockholders may incur, and may limit the manner in which we effect future securitizations.
Securitizations by us or our subsidiaries could result in the creation of taxable mortgage pools for U.S. federal income tax purposes. As a result, we could have “excess inclusion income.” Certain categories of stockholders, such as non-U.S. stockholders eligible for treaty or other benefits, stockholders with net operating losses, and certain tax-exempt stockholders that are subject to unrelated business income tax, could be subject to increased taxes on a portion of their dividend income from us that is attributable to any such excess inclusion income. In the case of a stockholder that is a REIT, a regulated investment company (or, RIC), common trust fund or other pass-through entity, our allocable share of our excess inclusion income could be considered excess inclusion income of such entity. In addition, to the extent that our common stock is owned by tax-exempt “disqualified organizations,” such as certain government-related entities and charitable remainder trusts that are not subject to tax on unrelated business income, we may incur a corporate level tax on a portion of any excess inclusion income. Because this tax generally would be imposed on us, all of our stockholders, including stockholders that are not disqualified organizations, generally will bear a portion of the tax cost associated with the classification of us or a portion of our assets as a taxable mortgage pool. A RIC, or other pass-through entity owning our common stock in record name, will be subject to tax at the highest U.S. federal corporate tax rate on any excess inclusion income allocated to their owners that are disqualified organizations. Moreover, we could face limitations in selling equity interests in these securitizations to outside investors, or selling any debt securities issued in connection with these securitizations that might be considered to be equity interests for tax purposes. Finally, if we were to fail to qualify as a REIT, any taxable mortgage pool securitizations would be treated as separate taxable corporations for U.S. federal income tax purposes that could not be included in any consolidated U.S. federal corporate income tax return. Historically, we have not generated excess inclusion income; however, despite our efforts, we may not be able to avoid creating or distributing excess inclusion income to our stockholders in the future. In addition, we could face limitations in selling equity interests to outside investors in securitization transactions that are taxable mortgage pools or selling any debt securities issued in connection with these securitizations that might be considered to be equity interests for tax purposes. These limitations may prevent us from using certain techniques to maximize our returns from securitization transactions.
Although our use of TRSs may be able to partially mitigate the impact of meeting the requirements necessary to maintain our qualification as a REIT, our ownership of and relationship with our TRSs is limited and a failure to comply with the limits would jeopardize our REIT qualification and may result in the application of a 100% excise tax if our transaction with a TRS is not conducted on an arm’s length basis.
A REIT may own up to 100% of the stock of one or more entities that elect to be treated as a TRS for tax purposes. Subject to certain exceptions, a TRS may hold assets and earn income that would not be qualifying assets or income if held or earned directly by a REIT. Both the subsidiary and the REIT must jointly elect to treat the subsidiary as a TRS. A corporation of which a TRS directly or indirectly owns more than 35% of the voting power or value of the stock will automatically be treated as a TRS. Overall, no more than 25% of the value of a REIT’s total assets may consist of stock or securities of one or more TRS. In addition, the TRS rules limit the deductibility of interest paid or accrued by a TRS to its parent REIT to assure that the TRS is subject to an appropriate level of corporate taxation. The rules also impose a 100% excise tax on certain transactions between a TRS and its parent REIT that are not conducted on an arm’s-length basis. TRSs that we may form will pay U.S. federal, state and local income or franchise tax on their taxable income, and their after-tax net income will be available for distribution to us but will not be required to be distributed to us, unless necessary to maintain our REIT qualification. We will monitor the aggregate value of the securities of our TRSs and intend to conduct our affairs so that such securities will represent less than 25% of the value of our total assets. In addition, we will scrutinize our transactions with our


31


TRSs to ensure that they are entered into on arm’s length terms to avoid incurring the 100% excise tax. There can be no assurance however, that we will be able to comply with the TRS limitation or avoid the 100% excise tax in all situations.
Dividends payable by REITs generally do not qualify for the reduced tax rates on dividend income from regular corporations, which could adversely affect the value of our common stock.
The maximum U.S. federal income tax rate for certain qualified dividends payable to domestic stockholders that are individuals, trusts and estates is 20%. Dividends payable by REITs, however, are generally not eligible for the reduced rates and therefore may be subject to the maximum U.S. federal income tax rate on ordinary income. Although the reduced U.S. federal income tax rate applicable to dividend income from regular corporate dividends does not adversely affect the taxation of REITs or dividends paid by REITs, the more favorable rates applicable to regular corporate dividends could cause investors who are individuals, trusts and estates to perceive investments in REITs to be relatively less attractive than investments in the stocks of non-REIT corporations that pay dividends, which could adversely affect the value of the shares of REITs, including our shares.
Complying with REIT requirements may limit our ability to hedge effectively.
The REIT provisions of the Internal Revenue Code may limit our ability to hedge our assets and operations. Under these provisions, any income that we generate from transactions intended to hedge our interest rate exposure will be excluded from gross income for purposes of the REIT 75% and 95% gross income tests if the instrument hedges interest rate risk on liabilities used to carry or acquire real estate assets, or certain other specified types of risk, and such instrument is properly identified under applicable Treasury Regulations. Income from hedging transactions that do not meet these requirements will generally constitute non-qualifying income for purposes of both the REIT 75% and 95% gross income tests. As a result of these rules, we may have to limit our use of hedging techniques that might otherwise be advantageous or implement those hedges through a TRS. This could increase the cost of our hedging activities because our TRS would be subject to tax on gains or the limits on our use of hedging techniques could expose us to greater risks associated with changes in interest rates than we would otherwise want to bear. In addition, losses in our TRS will generally not provide any tax benefit to us, although such losses may be carried forward to offset future taxable income of the TRS.
The tax on prohibited transactions will limit our ability to engage in transactions, including certain methods of securitizing mortgage loans that would be treated as sales for U.S. federal income tax purposes.
A REIT’s net income from prohibited transactions is subject to a 100% tax. In general, prohibited transactions are sales or other dispositions of property, other than foreclosure property, but including mortgage loans, held as inventory or primarily for sale to customers in the ordinary course of business. We might be subject to this tax if we were to sell or securitize loans in a manner that was treated as a sale of the loans as inventory for U.S. federal income tax purposes. Therefore, in order to avoid the prohibited transactions tax, we may choose not to engage in certain sales of loans, other than through a TRS, and we may be required to limit the structures we use for our securitization transactions, even though such sales or structures might otherwise be beneficial for us.
We may be subject to adverse legislative or regulatory tax changes that could reduce the market price of shares of our common stock.
At any time, the U.S. federal income tax laws or regulations governing REITs or the administrative interpretations of those laws or regulations may be changed, possibly with retroactive effect. We cannot predict if or when any new U.S. federal income tax law, regulation or administrative interpretation, or any amendment to any existing U.S. federal income tax law, regulation or administrative interpretation, will be adopted, promulgated or become effective or whether any such law, regulation or interpretation may take effect retroactively. We and our stockholders could be adversely affected by any such change in, or any new, U.S. federal income tax law, regulation or administrative interpretation.
Liquidation of our assets may jeopardize our REIT qualification.
To qualify as a REIT, we must comply with requirements regarding our assets and our sources of income. If we are compelled to liquidate our assets to repay obligations to our lenders, we may be unable to comply with these requirements, thereby jeopardizing our qualification as a REIT, or we may be subject to a 100% tax on any resultant gain if we sell assets that are treated as inventory or property held primarily for sale to customers in the ordinary course of business.
Our qualification as a REIT and exemption from U.S. federal income tax with respect to certain assets may be dependent on the accuracy of legal opinions or advice rendered or given or statements by the issuers of assets that we acquire, and the inaccuracy of any such opinions, advice or statements may adversely affect our REIT qualification and result in significant corporate-level tax.
When purchasing securities, we may rely on opinions or advice of counsel for the issuer of such securities, or statements made in related offering documents, for purposes of determining whether such securities represent debt or equity securities for U.S. federal income tax purposes, and also to what extent those securities constitute REIT real estate assets for purposes of the


32


REIT asset tests and produce income which qualifies under the 75% REIT gross income test. In addition, when purchasing the equity tranche of a securitization, we may rely on opinions or advice of counsel regarding the qualification of the securitization for exemption from U.S. corporate income tax and the qualification of interests in such securitization as debt for U.S. federal income tax purposes. The inaccuracy of any such opinions, advice or statements may adversely affect our REIT qualification and result in significant corporate-level tax.
Our ability to invest in TBA Contracts could be limited by our REIT qualification, and we could fail to qualify as a REIT as a result of these investments.
We may purchase forward-settling Agency RMBS transactions through TBA Contracts. Pursuant to these TBAs, we will agree to purchase, for future delivery, Agency RMBS with certain principal and interest terms and certain types of underlying collateral, but the particular Agency RMBS to be delivered is not identified until shortly before the TBA settlement date. As with any forward purchase contract, the value of the underlying Agency RMBS may decrease between the contract date and the settlement date, which may result in the recognition of income or gains or loss. The law is unclear regarding whether TBAs are qualifying assets for the 75% REIT asset test.
Accordingly, our ability to purchase Agency RMBS through TBAs or to dispose of TBAs, through these transactions or otherwise, could be limited. We do not expect TBAs to comprise a significant portion of our assets and, therefore, do not expect TBAs to adversely affect our ability to meet the REIT assets tests. No assurance can be given that the IRS would treat TBAs as qualifying assets. In the event that such assets are determined to be non-qualifying, we could be subject to a penalty tax or we could fail to qualify as a REIT if the value of our TBAs, together with our non-qualifying assets for the 75% asset test, exceeded 25% of our total assets at the end of any calendar quarter or any income from the disposition of TBAs exceeded 25% of our gross income for any taxable year.

ITEM 1B.
Unresolved Staff Comments
None.

ITEM 2.
Properties
Our principal executive office is located at 9 West 57th Street, New York, NY 10019, telephone (212) 515-3200.

ITEM 3.
Legal Proceedings
From time to time, we may be involved in various claims and legal actions in the ordinary course of business. As of December 31, 2013, we were not involved in any legal proceedings.

ITEM 4.
Mine Safety Disclosures
Not applicable.


33


PART II

ITEM 5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
All currency amounts are presented in thousands, except per share amounts or as otherwise noted.
Market Information
Our common stock is listed on the New York Stock Exchange (or, NYSE), under the symbol “AMTG.” On February 19, 2014, the last sales price for our common stock on the NYSE was $16.47 per share. The following table presents the high and low sales prices per share of our common stock during each calendar quarter for the years ended December 31, 2013 and 2012:
Year
 
Quarter End Date
 
High
 
Low
2013
 
December 31, 2013
 
$
15.80

 
$
14.24

 
 
September 30, 2013
 
$
16.65

 
$
14.30

 
 
June 30, 2013
 
$
22.74

 
$
15.78

 
 
March 31, 2013
 
$
23.11

 
$
20.54

2012
 
December 31, 2012
 
$
22.97

 
$
18.05

 
 
September 30, 2012
 
$
23.59

 
$
19.12

 
 
June 30, 2012
 
$
19.68

 
$
17.60

 
 
March 31, 2012
 
$
19.59

 
$
15.40

Holders
As of February 18, 2014, we had 101 registered holders of our common stock. The 101 holders of record include Cede & Co., which holds shares as nominee for The Depository Trust Company, which holds shares on behalf of the beneficial owners of our common stock. Such information was obtained through our registrar and transfer agent.
Dividends
We elected to be taxed as a REIT for U.S. federal income tax purposes commencing with our taxable year ended December 31, 2011 and, as such, anticipate distributing annually at least 90% of our REIT taxable income. Although we may borrow funds to pay dividends, cash for such dividends is expected to be largely generated from our results of operations. Dividends are declared and paid at the discretion of our board of directors and depend on our taxable net income, cash available for distribution, financial condition, ability to maintain our qualification as a REIT and such other factors that our board of directors may deem relevant. From time to time a portion of our dividends on our capital stock may be characterized as capital gains or return of capital. For 2013, all of our common stock dividends were characterized as ordinary income to stockholders, as none were characterized as return of capital or capital gains. (See ITEM 1A and ITEM 7 of this annual report on Form 10-K for a discussion of factors which may adversely affect our ability to pay dividends and for information regarding the sources of funds used for dividends.)
On September 20, 2012, we issued 6,900,000 shares of Preferred Stock. No dividends may be paid on our common stock unless full cumulative dividends have been paid on the Preferred Stock. To date, we have paid full cumulative dividends on our Preferred Stock and we have declared cash dividends on our common stock on a quarterly basis.
The following table presents information with respect to our common stock dividends declared during the years ended December 31, 2013 and 2012:
Year
 
Declaration Date
 
Record Date
 
Payment Date
 
Amount per Share
2013
 
December 18, 2013
 
December 31, 2013
 
January 31, 2014
 
$
0.40

 
 
September 19, 2013
 
September 30, 2013
 
October 31, 2013
 
$
0.40

 
 
June 17, 2013
 
June 28, 2013
 
July 31, 2013
 
$
0.70

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

2012
 
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, 2012
 
$
0.75



34


Direct Stock Purchase and Dividend Reinvestment Plan
In November 2012, we initiated a Direct Stock Purchase and Dividend Reinvestment Plan (or, the Stock Purchase Plan) to provide new investors and existing stockholders of our common stock with a with a convenient and economical way to purchase shares of our common stock. By participating in the Stock Purchase Plan, individuals may purchase additional shares of our common stock by reinvesting some or all of the cash dividends that they receive on their shares of our common stock. In addition, the Stock Purchase Plan permits participants to make optional cash investments of up to $10,000 per month, and, with our prior approval, optional cash investments in excess of $10,000 per month, for the purchase of additional shares of our common stock. We may, in the future, offer a discount from the market price of our common stock ranging from 0% to 5%, including the payment by us of applicable brokerage fees, pursuant to the dividend reinvestment or optional cash investment features of the Stock Purchase Plan, at our sole discretion.
Wells Fargo Shareowner Services is the administrator of the Stock Purchase Plan (or, the Plan Administrator). Stockholders who own common stock that is registered in their own name and want to participate in the Stock Purchase Plan can join by enrolling online by accessing their shareowner account through the Plan Administrator’s website at www.shareowneronline.com or by completing an enrollment form and returning it to the Plan Administrator.
Individuals that are not existing stockholders and stockholders that hold shares of our common stock in “street name” in a brokerage, bank or other intermediary account, and do not wish to transfer their shares of common stock into their name, can enroll in the Stock Purchase Plan by: (1) enrolling online at www.shareowneronline.com and authorizing the Plan Administrator to make a one-time deduction from their bank account of at least $250; (2) completing and returning an enrollment form, together with an initial investment of at least $250; (3) enrolling online at www.shareowneronline.com and agreeing to make a one-time deduction from your bank account of at least $100 and authorizing future monthly or bi-monthly cash investments of at least $100; or; (4) completing and returning an enrollment form together with an initial investment of at least $100 authorizing future automatic monthly or bi-monthly cash investments of at least $100.
For additional information regarding the Stock Purchase Plan or additional assistance regarding the transfer of shares, individuals may telephone the Plan Administrator at 1-800-468-9716, or at 1-651-450-4064 if outside the U.S. Information may also be found on the Plan Administrator’s website at www.shareowneronline.com.
Stock Repurchase Program
On November 6, 2013, our Board of Directors authorized a stock repurchase program (or, Repurchase Program), to repurchase up to $50,000 of our outstanding common stock. Such authorization does not have an expiration date. Subject to applicable securities laws, repurchases of common stock under the Repurchase Program may be made at times and in amounts as we deem appropriate, using available cash resources. Shares of common stock repurchased by us under the Repurchase Program, if any, will be cancelled and, until reissued by us, will be deemed to be authorized but unissued shares of our common stock. The Repurchase Program may be suspended or discontinued by us at any time and without prior notice. We have not repurchased any shares of common stock under the Repurchase Program.
Stockholder Return Performance
The stock performance graph and table below shall not be deemed, under the Securities Act or the Exchange Act, to be (i) “soliciting material” or “filed” or (ii) incorporated by reference by any general statement into any filing made by us with the SEC, except to the extent that we specifically incorporate such stock performance graph and table by reference.


35


The following graph is a comparison of the cumulative total stockholder return on our common stock, the Russell 2000 Index (or, Russell 2000) and the SNL Finance REIT Index (or, SNL Finance REIT), a peer group index from July 22, 2011 (the day we commenced trading on the NYSE) to December 31, 2013. The graph assumes that $100 was invested on July 22, 2011 in our common stock, the Russell 2000 and the SNL Finance REIT and that all dividends were reinvested without the payment of any commissions. There can be no assurance that the performance of our shares will continue to be in line with the same or similar trends depicted in the following graph.
 
 
Period Ended
Index
 
7/22/2011
 
12/31/2011
 
6/30/2012
 
12/31/2012
 
6/30/2013
 
12/31/2013
Apollo Residential Mortgage, Inc.
 
$
100.00

 
$
83.43

 
$
114.02

 
$
130.43

 
$
114.57

 
$
108.35

Russell 2000
 
$
100.00

 
$
88.65

 
$
96.21

 
$
103.14

 
$
119.50

 
$
143.18

SNL Finance REIT(1)
 
$
100.00

 
$
93.66

 
$
110.61

 
$
112.48

 
$
109.75

 
$
108.63

(1) 
As of December 31, 2013, the SNL Finance REIT Index was comprised of the following companies: AG Mortgage Investment Trust, Inc.; American Capital Agency Corp.; American Capital Mortgage Investment Corp.; American Church Mortgage Company; Annaly Capital Management, Inc.; Anworth Mortgage Asset Corporation; Apollo Commercial Real Estate Finance, Inc.; Apollo Residential Mortgage, Inc.; Arbor Realty Trust, Inc.; Ares Commercial Real Estate Corporation; ARMOUR Residential REIT, Inc.; Bimini Capital Management, Inc.; Blackstone Mortgage Trust; BRT Realty Trust; Capstead Mortgage Corporation; Cherry Hill Mortgage; Chimera Investment Corporation; Colony Financial, Inc.; CV Holdings, Inc.; CYS Investments, Inc.; Dynex Capital, Inc.; Ellington Residential Mortgage; Five Oaks Investment Corp.; Hannon Armstrong Sustainable; Hatteras Financial Corp.; Invesco Mortgage Capital Inc.; iStar Financial Inc.; JAVELIN Mortgage Investment Corp.; JER Investors Trust Inc.; MFA Financial, Inc.; New Resdl Investment Corp.; New York Mortgage Trust, Inc.; Newcastle Investment Corp.; NorthStar Realty Finance Corp.; Orchid Island Capital Inc.; Origen Financial, Inc.; Owens Realty Mortgage Inc.; PennyMac Mortgage Investment Trust; PMC Commercial Trust; RAIT Financial Trust; Redwood Trust, Inc.; Resource Capital Corp.; Starwood Property Trust, Inc.; Two Harbors Investment Corp.; Western Asset Mortgage Capital Corporation; and Zais Financial Corp.


36


Securities Authorized For Issuance Under Equity Compensation Plans
During 2011, we adopted the Apollo Residential Mortgage, Inc. 2011 Equity Incentive Plan (or, LTIP). The LTIP provides for grants of restricted common stock, restricted stock units (or, RSUs) and other equity-based awards up to an aggregate of 5% of the issued and outstanding shares of our common stock. (For further discussion of the LTIP, see Note 14 - Equity Award Plan to the consolidated financial statements included under ITEM 8 of this annual report on Form 10-K.)
The following table presents certain information about the 2011 Plan as of December 31, 2013:
Award(1)
 
Number of securities
to be issued upon
exercise of
outstanding options,
warrants and rights
 
Weighted-average
exercise price of
outstanding options,
warrants and rights
 
Number of securities remaining available for future issuance under equity compensation plans (excluding securities reflected in the first column of this table)
Restricted Stock Units
 
183,922

 
N/A(2)

 
1,347,654

Total
 
183,922

 
$
—

 
1,347,654

(1) 
All equity based compensation granted to date has been granted pursuant to the LTIP, which was approved by our sole stockholder prior to our IPO.
(2) 
A weighted average exercise price is not applicable for our RSUs, as such equity awards result in the issuance of shares of our common stock provided that such awards vest and, as such, do not have an exercise price. At December 31, 2013, 56,681 RSUs were vested and 127,241 RSUs were subject to time based vesting.
Recent Sales of Unregistered Securities; Use of Proceeds from Registered Securities
None.
Recent Purchases of Equity Securities
None.



37


ITEM 6.
Selected Financial Data
All currency figures are presented in thousands, except per share amounts or as otherwise noted.
The selected financial data set forth has been derived from our audited consolidated financial statements.
This information should be read in conjunction with ITEM 1, ITEM 7 and the audited consolidated financial statements and notes thereto included under ITEM 8 of this annual report on Form 10-K.
 
 
Year Ended December 31,
 
 
Operating Data:
 
2013
 
2012
 
For the Period From July 27, 2011 through December 31, 2011
Interest income
 
$
154,713

 
$
94,369

 
$
10,733

Interest expense
 
(27,602
)
 
(14,631
)
 
(1,138
)
Net interest income
 
127,111

 
79,738

 
9,595

Realized gain/(loss) on sale of RMBS, net
 
(66,850
)
 
39,817

 
885

Unrealized gain/(loss) on RMBS, net
 
(147,375
)
 
100,402

 
2,482

Realized gain/(loss) on derivatives, net
 
9,203

 
(12,514
)
 
(630
)
Unrealized gain/(loss) on derivatives, net
 
50,373

 
(20,151
)
 
(3,246
)
Unrealized gain on securitized mortgage loans, net
 
3,950

 
—

 
—

Unrealized (loss) on securitized debt, net
 
(954
)
 
—

 
—

Unrealized gain/(loss) on other investment securities
 
335

 
—

 
—

Other, net
 
76

 
48

 
2

Operating expenses
 
(23,080
)
 
(14,584
)
 
(4,616
)
Net income/loss
 
$
(47,211
)
 
$
172,756

 
$
4,472

Preferred Stock dividends declared
 
(13,800
)
 
(5,022
)
 
—

Net income/(loss) allocable to common stock and participating securities
 
$
(61,011
)
 
$
167,734

 
$
4,472

Earnings/(loss) per common share - basic and diluted
 
$
(2.02
)
 
$
8.36

 
$
0.43

Dividends declared per share of common stock
 
$
2.20

 
$
3.40

 
$
0.30

Balance Sheet Data (at period end):
 
December 31, 2013
 
December 31, 2012
 
December 31, 2011
Agency pass-through RMBS
 
$
2,219,334

 
$
3,572,168

 
$
1,112,459

Agency IO securities
 
$
44,425

 
$
5,880

 
$
7,884

Agency Inverse IO securities
 
$
26,778

 
$
48,046

 
$
7,783

Non-Agency RMBS
 
$
1,212,789

 
$
605,197

 
$
112,346

Securitized mortgage loans
 
$
110,984

 
$
—

 
$
—

Other investments
 
$
11,515

 
$
—

 
$
—

Derivative instruments - assets
 
$
53,315

 
$
750

 
$
—

Cash
 
$
127,959

 
$
149,576

 
$
44,407

Total Assets
 
$
3,911,576

 
$
4,487,921

 
$
1,416,927

Borrowings under repurchase agreements
 
$
3,034,058

 
$
3,654,436

 
$
1,079,995

Non-recourse securitized debt
 
$
43,354

 
$
—

 
$
—

Derivative instruments - liabilities
 
$
4,610

 
$
23,184

 
$
3,481

Total Liabilities
 
$
3,153,975

 
$
3,771,138

 
$
1,212,341

Preferred Stock, liquidation preference
 
$
172,500

 
$
172,500

 
$
—

Total Stockholders’ Equity
 
$
757,601

 
$
716,783

 
$
204,586

Book value per share of common stock(1)
 
$
18.26

 
$
22.49

 
$
19.92

(1)
Reflects total stockholders’ equity less the preferred stock liquidation preference divided by total shares of common stock outstanding.



38


ITEM 7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion should be read in conjunction with our financial statements and accompanying notes included under ITEM 8 of this annual report on Form 10-K.
All currency amounts are presented in thousands, except per share amounts or as otherwise noted.
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 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.
We invest in residential mortgage assets throughout the U.S. At December 31, 2013, our portfolio was comprised of: (i) Agency RMBS (which include pass-through securities whose underlying collateral primarily includes fixed-rate mortgages), Agency IOs and Agency Inverse IOs; (ii) non-Agency RMBS; (iii) securitized mortgage loans and (iv) other mortgage related assets.
Over time, we expect that we may invest in other residential mortgage related assets. (For information about our target assets, see “Investment Strategy” included under ITEM 1 of this annual report on Form 10-K.) At December 31, 2013, our portfolio was comprised of $2,290,537 of Agency RMBS, $1,212,789 of non-Agency RMBS, $110,984 of securitized mortgage loans, and $11,515 of other mortgage related assets.
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 December 31, 2013, our derivatives included Swaps, Swaptions and TBA Short Contracts. We do not enter into derivatives instruments for speculative purposes.
Factors Impacting Our Operating Results
Our results of operations are driven by, among other things, our net interest income, changes in the market value of our investments and derivative instruments and, from time to time, realized gains and losses on the sale of our investments and termination of our derivative instruments. 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 constant prepayment rates (or, CPR) on our RMBS. The CPR measures the amount of unscheduled principal prepayments on 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 investment assets 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 to increase; and (vi) the value of our TBA Short Contracts, 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


39


low interest rates, such as the current environment, the impact of decreases in interest rates may be limited, given that we do not expect that interest rates will decrease 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, other investment securities and securitized mortgage loans, associated with delinquency, default and foreclosure and any resulting losses on disposing of the real estate underlying such assets. 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 substantially all of our non-Agency RMBS at a discount to par value; a portion of such discount may be viewed as a credit discount, which is not expected to be amortized into interest income. The amount designated as credit discount on a security may change over time based on the security’s performance and its anticipated future performance. (See “Credit Risk”, included under ITEM 7A of this annual report on Form 10-K.)
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 rates, 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 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 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 investments, we also note that such instruments serve as a partial 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 December 31, 2013, the value of and return on such instruments are highly sensitive to changes in interest rates and prepayments.
Market Conditions and Our Strategy
General:
Interest rates, which started 2013 on a relatively stable note, began to increase in the middle of January and continued on an upward trajectory through mid-March primarily based on what was perceived to be a strengthening U.S. economy, and that monetary policy may become less accommodative in the near future. In mid-March and throughout April, as economic data seemed to reflect renewed weakness in the economy, interest rates moved back down and the prices of Agency RMBS and U.S. Treasury securities rallied back to proximate highs for the year. However, the market sentiment changed markedly in early May based on a very strong employment report for the month of April. This coupled with comments from the Federal Reserve Chairman that the Federal Reserve may soon begin to taper securities purchases under its quantitative easing policy caused a significant sell-off in the fixed income markets in the late spring and early summer, resulting in a significant decline in the value of such securities. Strength in job creation and declines in the unemployment rate throughout the summer and early fall pushed interest rates higher, as many financial market participants assumed the tapering announcement was to come at the October 2013 meeting. However, the Federal Reserve’s policy actions remained unchanged and mixed signals followed from Federal Reserve board members with respect to when such monetary policy accommodations would begin to be tapered. Adding to this uncertainty were financial headlines about the state of the U.S. economy, speculation regarding the nomination of the next Federal Reserve Chairperson and the impact of political frictions on the budget deficit and debt ceiling. Against this backdrop, and fueled by record outflows of bond mutual funds, the last eight months of 2013 were marked by increased


40


volatility and generally higher interest rates. On December 18, 2013, the Federal Reserve announced its first tapering action, reducing the size of its quantitative easing program from $85 billion in monthly bond purchases to $75 billion. While the initial reaction in the fixed income market was muted, the combination of the tapering news combined with increasingly strong economic reports drove the yield on the 10-year note over 3.0% by year end 2013. (See Tables 1 and 2 below.)
The table below presents the high and low rates for ten-year U.S. Treasuries relative to ten-year Swap rates for each calendar quarter during the year ended December 31, 2013:
Table 1
 
Ten-Year Treasury Rate
 
Ten-Year Swap Rate
Quarter Ended
 
High
 
Low
 
High
 
Low
March 31, 2013
 
2.06
%
 
1.76
%
 
2.14
%
 
1.84
%
June 30, 2013
 
2.61
%
 
1.63
%
 
2.83
%
 
1.81
%
September 30, 2013
 
2.99
%
 
2.47
%
 
3.18
%
 
2.69
%
December 31, 2013
 
3.03
%
 
2.50
%
 
3.09
%
 
2.65
%
Late in the second quarter of 2013, we began to rebalance our investment portfolio seeking to reduce our net portfolio duration, increase liquidity and take advantage of market opportunities to invest in non-Agency RMBS. The shift in the portfolio has reduced our exposure to changes in interest rates while increasing our sensitivity to credit. During the last six months of 2013, we generally maintained higher cash balances, which resulted in reduced earnings, as we selectively redeployed proceeds from sales of Agency RMBS into non-Agency RMBS. In addition, during this period, we maintained lower leverage on our Agency RMBS portfolio and increased our use of derivative instruments. Our average debt-to-equity multiple during 2013, was 4.45 times compared to 5.16 times for 2012. A portion of the decrease in our leverage also reflects our shift in equity to non-Agency RMBS from Agency RMBS, as we employ less leverage when we finance non-Agency RMBS. At December 31, 2013 our investments were comprised of 63.1% of Agency RMBS (of which 61.2% were pass-through securities and 1.9% were Agency IOs and Agency Inverse IOs), 33.5% of non-Agency RMBS, 3.1% of securitized mortgage loans and 0.3% of other investments.
Agency RMBS Portfolio/Interest Rate Hedges:
For 2013, our Agency RMBS portfolio experienced a fair value weighted CPR of 6.4% comprised of 6.2% CPR on Agency pass-through securities and 17.4% on Agency IO and Agency Inverse IO securities, in the aggregate. During 2013, 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 2013, generic fixed-rate Fannie Mae RMBS prepaid at 19.2% CPR in the aggregate, with a high of 27.8% in January 2013.


41


Beginning in the second quarter of 2013, the market conditions, as discussed above, generally had a significant negative impact on our RMBS valuations. The following table presents the estimated fair value and unrealized gain/(loss) position with respect to our RMBS at the end of each calendar quarter in 2013:
Table 2
 
December 31, 2013
 
September 30, 2013
 
June 30, 2013
 
March 31, 2013
Collateral
 
Estimated Fair Value
 
Unrealized Gain/(Loss)
 
Estimated Fair Value
 
Unrealized Gain/(Loss)
 
Estimated Fair Value
 
Unrealized Gain/(Loss)
 
Estimated Fair Value
 
Unrealized Gain/(Loss)
30-Year Mortgages:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
ARM-RMBS
 
$
12,339

 
$
(62
)
 
$
13,089

 
$
(75
)
 
$
—

 
$
—

 
$
—

 
$
—

3.5% Coupon
 
301,068

 
(21,883
)
 
477,308

 
(22,218
)
 
805,988

 
(40,587
)
 
1,863,750

 
(5,336
)
4.0% Coupon
 
1,602,080

 
(77,499
)
 
1,587,384

 
(58,953
)
 
1,620,521

 
(67,904
)
 
2,002,782

 
6,774

4.5% & 5.0% Coupons
 
250,136

 
(3,257
)
 
58,624

 
(105
)
 
49,419

 
(429
)
 
266,438

 
10,787

 
 
2,165,623

 
(102,701
)
 
2,136,405

 
(81,351
)
 
2,475,928

 
(108,920
)
 
4,132,970

 
12,225

15-20 Year Mortgages:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
3.0% Coupon
 
53,711

 
(401
)
 
55,478

 
410

 
—

 
—

 
23,588

 
372

3.5% Coupon
 
—

 
—

 
—

 
—

 
—

 
—

 
77,475

 
560

 
 
53,711

 
(401
)
 
55,478

 
410

 
—

 
—

 
101,063

 
932

Agency IOs
 
44,425

 
2,904

 
43,272

 
310

 
30,184

 
2,387

 
7,974

 
85

Agency Inverse IOs
 
26,778

 
(895
)
 
25,367

 
(3,036
)
 
45,944

 
(6,157
)
 
57,557

 
69

Total Agency RMBS
 
2,290,537

 
(101,093
)
 
2,260,522

 
(83,667
)
 
2,552,056

 
(112,690
)
 
4,299,564

 
13,311

Non-Agency RMBS
 
1,212,789

 
77,609

 
1,117,820

 
62,118

 
751,024

 
60,250

 
595,838

 
67,059

Total RMBS
 
$
3,503,326

 
$
(23,484
)
 
$
3,378,342

 
$
(21,549
)
 
$
3,303,080

 
$
(52,440
)
 
$
4,895,402

 
$
80,370

The following table presents information with respect to our Swaps and Swaptions at the end of each calendar quarter in 2013:
Table 3
 
December 31, 2013
 
September 30, 2013
 
June 30, 2013
 
March 31, 2013
Swaps:
 
 
 
 
 
 
 
 
Notional amount
 
$
1,587,000

 
$
1,867,000

 
$
2,302,000

 
$
2,207,000

Estimated fair value
 
$
35,525

 
$
32,735

 
$
47,609

 
$
(24,101
)
Weighted average fixed pay rate
 
1.34
%
 
1.42
%
 
1.48
%
 
1.39
%
Weighted average term to maturity (years)
 
5.1

 
5.8

 
6.4

 
6.2

 
 
 
 
 
 
 
 
 
Swaptions:
 
 
 
 
 
 
 
 
Notional amount
 
$
1,375,000

 
$
1,175,000

 
$
775,000

 
$
225,000

Estimated fair value
 
$
12,430

 
$
13,757

 
$
18,447

 
$
1,641

Weighted average term to expiration (months)
 
5

 
8

 
11

 
10

Weighted average underlying Swap term (years)
 
10.0

 
10.0

 
10.0

 
10.0

Weighted average underlying Swap fixed pay rate
 
3.64
%
 
3.65
%
 
3.37
%
 
2.99
%
Credit Investments:
Yields available on non-Agency RMBS in the market place generally trended lower during 2013, as market valuations for such bonds generally continued to trend upward over the course of 2013. We believe non-Agency valuations continue to be driven by technicals, such as the continued lack of supply of newly issued non-Agency securities, as well as fundamentals, such as the recovering housing market, which should lead to better performance with respect to borrower defaults and loss severities in the future. During 2013, we continued to shift our investment allocation to credit sensitive assets, investing $748,032 in non-Agency RMBS with a weighted average unlevered yield of 5.34% and we purchased a pool of 755 residential mortgage loans, with an unpaid principal balance of approximately $155,001, and simultaneously completed a securitization transaction collateralized by these mortgage loans. At December 31, 2013, approximately 53.3% of our non-Agency portfolio was comprised of securities on which we receive both principal and interest on a monthly basis and approximately 46.7% were securities on which we currently receive only interest payments and will receive principal after the more senior securities in the capital structure are paid off. (See Tables 25 and 26 below.)


42


New Business Development:
We are exploring several new credit initiatives. In late December 2013, we entered into an agreement with a third party to assist us in sourcing seller-financing agreements and mortgage loans secured by properties purchased by such third party. No assurance can be provided that we will be able to successfully grow this business platform, or that such investments will be profitable.
Borrowings:
Borrowings under repurchase agreements remained readily available from an increasing number of counterparties for repurchase agreements collateralized by Agency and non-Agency RMBS. Over time, as market conditions change, in addition to repurchase borrowings we may use other forms of leverage, including, but not limited to, warehouse facilities, additional securitizations, resecuritizations, 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.
Regulatory Updates:
As broadly publicized, Fannie Mae and Freddie Mac are presently under federal conservatorship as the U.S. Government continues to evaluate the future of these entities and what role the U.S. Government should continue to play in the housing markets. On June 25, 2013, a bipartisan group of Senators introduced a draft bill titled the “Housing Finance Reform and Taxpayer Protection Act of 2013” to the U.S. Senate, which would wind down Fannie Mae and Freddie Mac over a period of five years and replace the public securitization market used by the government-sponsored enterprises with a public-private alternative market, where a new Federal Mortgage Insurance Corporation would provide a financial guarantee that can only be tapped after private capital has already stepped in. On July 11, 2013, members of the U.S. House Committee on Financial Services introduced a similar draft bill titled “Protecting American Taxpayers and Homeowners Act” to the U.S. House of Representatives. It also calls for the winding down of Fannie Mae and Freddie Mac, but would replace them with a National Mortgage Market Utility that facilitates private market mortgage securitization and does not provide a government guarantee.
Currently, it remains unclear whether these or any other proposals will become law and how these or other proposals to reform Fannie Mae and Freddie Mac would impact housing finance and our business. While both bills contemplate a diminished level of Agency participation in the mortgage market and changes in the nature and terms of Agency RMBS, they also seek to increase opportunities for private capital in the mortgage market, which could provide new opportunities for our business. We believe that our Manager’s deep understanding of RMBS market fundamentals, as well as its ability to analyze, model and set parameters around valuing individual mortgages will enable us to take advantage of regulatory changes and new financing opportunities that may emerge as a result of these changes in the mortgage market.
Results of Operations
Year Ended December 31, 2013 compared to the Year Ended December 31, 2012
General
For the year ended December 31, 2013, we had a net loss allocable to common stock and participating securities of $(61,011) or $(2.02) per basic and diluted weighted average common share, compared to net income allocable to common and participating securities of $167,734 and $8.36 per basic and diluted common share for the year ended December 31, 2012. Our results of operations for the year ended December 31, 2013 were significantly impacted by steep declines in the value of our Agency RMBS portfolio, some of which were realized through sales, which were partially offset by increases in the realized and unrealized gains on our derivative instruments and non-Agency RMBS. (See “Market Conditions and Our Strategy,” above.) Our results for the year ended December 31, 2012 were positively impacted by significant increases in the value of our Agency RMBS, some of which were realized through sales, which income was partially offset by decreases in the value of our derivatives.
Net Interest Income
For the year ended December 31, 2013 and December 31, 2012, we earned interest income of $154,713 and $94,369, respectively, and incurred interest expense, which was primarily related to our borrowings under repurchase agreements, of approximately $27,602 and $14,631, respectively. The increase in our interest income and interest expense was primarily driven by the significant growth in our investments and borrowings reflecting our investment, on a levered basis, of incremental capital raised since the second quarter of 2012. Our cost of funds increased to 0.79% for 2013, from 0.61% for 2012, reflecting higher borrowing costs associated with our portfolio shift toward credit sensitive investments, which borrowings bear higher interest rates compared to borrowing rates on Agency RMBS. In connection with our February 2013 securitization transaction, we had securitized debt with a contractual balance of $42,400 at December 31, 2013 which had a


43


fixed stated interest rate of 4.00%. Costs associated with our securitization transaction are amortized as a component of interest expense; as a result, our securitized debt had a cost of 4.27% for the year ended December 31, 2013.
The yield on our Agency RMBS increased to 2.92% for 2013 from 2.64% for 2012, primarily reflecting our migration to higher coupon bonds during 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. Investments in non-Agency RMBS made during 2013 generally generate lower yields than the yields on non-Agency RMBS previously purchased, reflecting the general increase in valuations in the non-Agency RMBS market during 2013. 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.
We had an interest rate spread and net interest margin of 3.02% and 3.13% for the year ended December 31, 2013, respectively, compared to 2.83% to 2.96%, respectively, for the year ended December 31, 2012. (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.) Over the course of 2013, our interest rate spread and net interest margin increased, generally reflecting our shift in investment allocation from Agency RMBS to non-Agency RMBS. The net interest rate spread and net interest margin do not reflect the total return on equity allocated to investment types, which is significantly impacted by the amount of leverage we use to finance our investments. We are generally able to utilize greater leverage on Agency RMBS than on non-Agency RMBS. Therefore, when making investment decisions we consider, among other things, the relative return on equity for each investment opportunity. Returns on investments will vary overtime based on market conditions at the time of purchase and changes in such conditions thereafter. The impact of our Swaps is not reflected in our net interest rate spread and net interest margin, as we have not elected hedge accounting for our derivative instruments. However, when making investment decisions, we consider our “effective cost of borrowings”, which non-GAAP measure includes the net interest component of our Swaps. (See Tables 4, 5, 6, 9, 19, 21, 22 and 23 below.)


44


The following table presents certain information regarding our interest-earning assets, interest bearing liabilities and the components of our net interest income for the years ended December 31, 2013 and December 31, 2012:
Table 4
 
For the Year Ended
 
 
December 31, 2013
 
December 31, 2012
 
 
Agency
 
Non-Agency and Other Investments(1)
 
Securitized Mortgage Loans
 
Total
 
Agency
 
Non-Agency
 
Total
Average balance(2)
 
$
3,176,294

 
$
783,195

 
$
99,020

 
$
4,058,509

 
$
2,345,193

 
$
348,333

 
$
2,693,526

Total interest income
 
$
92,729

 
$
53,717

 
$
8,267

 
$
154,713

 
$
63,052

 
$
31,317

 
$
94,369

Yield on average assets
 
2.92
%
 
6.86
%
 
8.35
%
 
3.81
%
 
2.64
%
 
8.84
%
 
3.45
%
Average balance of associated repurchase agreements
 
$
2,803,094

 
$
631,983

 
$
24,237

 
$
3,459,314

 
$
2,122,914

 
$
254,517

 
$
2,377,431

Average balance of securitized debt
 
$
—

 
$
—

 
$
41,998

 
$
41,998

 
$
—

 
$
—

 
$
—

Total interest expense
 
$
12,189

 
$
13,110

 
$
2,303

 
$
27,602

 
$
9,232

 
$
5,399

 
$
14,631

Average cost of funds(3)(4)
 
0.43
%
 
2.07
%
 
3.48
%
(5) 
0.79
%
 
0.43
%
 
2.12
%
 
0.61
%
Net interest income
 
$
80,540

 
$
40,607

 
$
5,964

 
$
127,111

 
$
53,820

 
$
25,918

 
$
79,738

Net interest rate spread
 
2.49
%
 
4.79
%
 
4.87
%
 
3.02
%
 
2.21
%
 
6.72
%
 
2.83
%
Total interest expense including net interest cost of Swaps(5)
 
$
33,767

 
$
13,110

 
$
2,759

 
$
49,636

 
$
17,037

 
$
5,399

 
$
22,436

Effective cost of funds(5)
 
1.20
%
 
2.07
%
 
4.17
%
 
1.42
%
 
0.80
%
 
2.12
%
 
0.94
%
Net interest income including net interest cost of Swaps
 
$
58,962

 
$
40,607

 
$
5,508

 
$
105,077

 
$
46,015

 
$
25,918

 
$
71,933

Effective net interest rate
spread(5)
 
1.71
%
 
4.79
%
 
4.18
%
 
2.39
%
 
1.84
%
 
6.72
%
 
2.50
%
(1)
At December 31, 2013, other investments were comprised of investments in Freddie Mac’s Structured Agency Credit Risk debt notes (or, STACR Notes). We had no other investment securities during the year ended December 31, 2012.
(2) 
Amount reflects amortized cost, which does not include unrealized gains and losses.
(3) 
Cost of funds by investment type is based on the underlying investment type of the assets pledged as collateral.
(4) 
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 statement of operations.
(5) 
The effective cost of funds for the securitized mortgage loans reflects the cost of our securitized debt and repurchase agreement borrowings collateralized by one of the subordinate securities that we retained in the securitization transaction. These subordinate bonds do not appear on our financial statements, as they are eliminated in consolidation. (See “Non-GAAP Financial Measures,” below.)


45


The following table presents certain information regarding our investment portfolio and borrowings for the quarterly periods presented:
Table 5
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Quarterly Period Ended:
 
Average
Balances(1)
 
Total
Interest
Income
 
Weighted Average CPR
 
Yield on Average Assets
 
Average Balance of Borrowings(2)
 
Total
Interest
Expense
 
Average Cost of Funds(3)(4)
 
Net Interest Income
 
Net
Interest
Rate
Spread
December 31, 2013
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency
 
$
2,401,550

 
$
20,546

 
4.90
%
 
3.42
%
 
$
2,039,398

 
$
2,224

 
0.43
%
 
$
18,322

 
2.99
%
Non-Agency and Other Investments(5)
 
1,090,158

 
17,861

 
4.00
%
 
6.55
%
 
884,853

 
4,499

 
1.99
%
 
13,362

 
4.56
%
Securitized Mortgage Loans
 
108,772

 
2,313

 
5.70
%
 
8.51
%
 
71,282

 
635

 
3.49
%
 
1,678

 
5.02
%
Total
 
$
3,600,480

 
$
40,720

 
4.65
%
 
4.52
%
 
$
2,995,533

 
$
7,358

 
0.96
%
 
$
33,362

 
3.56
%
September 30, 2013
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency
 
$
2,546,622

 
$
16,943

 
6.70
%
 
2.60
%
 
$
2,203,256

 
$
2,358

 
0.42
%
 
$
14,585

 
2.18
%
Non-Agency and Other Investments(5)
 
911,056

 
15,149

 
4.97
%
 
6.51
%
 
736,941

 
3,798

 
2.04
%
 
11,351

 
4.47
%
Securitized Mortgage Loans
 
110,049

 
2,324

 
1.53
%
 
8.26
%
 
73,175

 
633

 
3.43
%
 
1,691

 
4.83
%
Total
 
$
3,567,727

 
$
34,416

 
6.10
%
 
3.77
%
 
$
3,013,372

 
$
6,789

 
0.89
%
 
$
27,627

 
2.88
%
June 30, 2013
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency
 
$
4,167,139

 
$
28,388

 
7.10
%
 
2.69
%
 
$
3,762,949

 
$
4,048

 
0.43
%
 
$
24,340

 
2.26
%
Non-Agency
 
589,969

 
10,644

 
4.28
%
 
7.14
%
 
470,514

 
2,541

 
2.17
%
 
8,103

 
4.97
%
Securitized Mortgage Loans
 
111,257

 
2,297

 
1.41
%
 
8.16
%
 
75,407

 
648

 
3.45
%
 
1,649

 
4.71
%
Total
 
$
4,868,365

 
$
41,329

 
6.63
%
 
3.36
%
 
$
4,308,870

 
$
7,237

 
0.67
%
 
$
34,092

 
2.69
%
March 31, 2013
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency
 
$
3,621,734

 
$
26,853

 
7.00
%
 
2.97
%
 
$
3,226,408

 
$
3,558

 
0.45
%
 
$
23,295

 
2.52
%
Non-Agency
 
534,083

 
10,061

 
2.83
%
 
7.54
%
 
427,504

 
2,271

 
2.15
%
 
7,790

 
5.39
%
Securitized Mortgage Loans
 
65,099

 
1,333

 
2.54
%
 
8.19
%
 
44,459

 
388

 
3.54
%
 
945

 
4.65
%
Total
 
$
4,220,916

 
$
38,247

 
6.40
%
 
3.62
%
 
$
3,698,371

 
$
6,217

 
0.68
%
 
$
32,030

 
2.94
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2012
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency
 
$
3,531,012

 
$
23,267

 
5.80
%
 
2.58
%
 
$
3,184,479

 
$
3,840

 
0.48
%
 
$
19,427

 
2.10
%
Non-Agency
 
546,752

 
10,311

 
2.72
%
 
7.38
%
 
417,428

 
2,270

 
2.16
%
 
8,041

 
5.22
%
Total
 
$
4,077,764

 
$
33,578

 
5.39
%
 
3.22
%
 
$
3,601,907

 
$
6,110

 
0.67
%
 
$
27,468

 
2.55
%
September 30, 2012
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency
 
$
2,624,211

 
$
17,406

 
5.20
%
 
2.60
%
 
$
2,312,870

 
$
2,579

 
0.44
%
 
$
14,827

 
2.15
%
Non-Agency
 
430,337

 
9,032

 
3.40
%
 
8.21
%
 
312,185

 
1,710

 
2.17
%
 
7,322

 
6.04
%
Total
 
$
3,054,548

 
$
26,438

 
4.95
%
 
3.39
%
 
$
2,625,055

 
$
4,289

 
0.65
%
 
$
22,149

 
2.74
%
June 30, 2012
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency
 
$
2,362,290

 
$
14,015

 
3.70
%
 
2.35
%
 
$
1,995,103

 
$
1,913

 
0.38
%
 
$
12,102

 
1.96
%
Non-Agency
 
274,200

 
7,975

 
3.30
%
 
11.51
%
 
197,765

 
958

 
1.94
%
 
7,017

 
9.56
%
Total
 
$
2,636,490

 
$
21,990

 
3.66
%
 
3.30
%
 
$
2,192,868

 
$
2,871

 
0.53
%
 
$
19,119

 
2.77
%
March 31, 2012
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency
 
$
1,220,907

 
$
8,364

 
6.00
%
 
2.71
%
 
$
1,005,133

 
$
900

 
0.36
%
 
$
7,464

 
2.35
%
Non-Agency
 
138,902

 
3,999

 
3.10
%
 
11.39
%
 
94,012

 
461

 
1.97
%
 
3,538

 
9.42
%
Total
 
$
1,359,809

 
$
12,363

 
5.70
%
 
3.60
%
 
$
1,099,145

 
$
1,361

 
0.50
%
 
$
11,002

 
3.10
%
(1)
Amount reflects amortized cost, which does not include unrealized gains/(losses).
(2) 
Reflects borrowings under repurchase agreements and securitized debt.
(3) 
Cost of funds by investment type is based on the underlying investment type of the assets pledged as collateral.
(4) 
Cost of funds does not include accrual and settlement of interest associated with our Swaps and Swaptions, as we have not elected to apply hedge accounting. In accordance with GAAP, such costs are included in gain/(loss) on derivative instruments in the consolidated statement of operations.
(5) 
At December 31, 2013 and September 30, 2013, other investments were comprised of STACR Notes.


46


The following table presents information with respect to our repurchase agreement borrowings by type of collateral pledged as of December 31, 2013, and December 31, 2012 and the respective effective cost of funds for the periods presented:
Table 6
 
Year Ended
 
 
December 31, 2013
 
December 31, 2012
Collateral Pledged:
 
Cost of
Funds
 
Effective
Cost of
Funds(1)
 
Cost of
Funds
 
Effective
Cost of
Funds(1)
Agency
 
0.43
%
 
1.20
%
 
0.43
%
 
0.80
%
Non-Agency and other investments(2)
 
2.07

 
2.07

 
2.12

 
2.12

Securitized mortgage loans(3)
 
3.48

 
4.17

 
—

 
—

Total
 
0.79
%
 
1.42
%
 
0.61
%
 
0.94
%
(1)
The effective cost of funds for the periods presented include interest expense for the periods and the net interest component for Swaps during the periods of $22,034 and $7,805, 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.)
(2) 
At December 31, 2013, other investments were comprised of STACR Notes. We had no “other investments” during the year ended December 31, 2012.
(3) 
The securitized mortgage loans, in effect, collateralize our securitized debt and repurchase agreement borrowings that are collateralized by the non-Agency RMBS that were retained in our February 2013 securitization transaction. The non-Agency RMBS that we retained in the securitization are eliminated in consolidation, such that we consider that the securitized mortgage loans as indirectly collateralizing such repurchase agreements.
The repurchase borrowings associated with non-Agency RMBS that were legally retained in connection with our securitization are included with the cost of funds for our securitized mortgage loans.
Gains/(Losses) on Derivative Instruments
In the first half of 2013, we significantly increased our Swap and Swaption positions as we increased our investments in Agency RMBS and corresponding repurchase agreements to fund such incremental assets. Our Swaps and Swaptions are intended to mitigate the impact of increases in interest rates in the future, should such increases occur. The following table presents components of our gain/(loss) on derivative instruments for the periods presented:
Table 7
 
Year Ended
Components of Gain/(Loss) on Derivative Instruments
 
December 31, 2013
 
December 31, 2012
Net interest (payments/accruals) on Swaps(1)
 
$
(22,034
)
 
$
(7,805
)
Gain/(loss) on the termination of Swaps, net(1)
 
24,119

 
(4,709
)
Gain on the termination of Swaptions, net(1)
 
6,837

 
—

Gain on settlement of TBA Short Contracts, net(1)
 
281

 
—

Change in fair value of Swaps(2)
 
58,708

 
(19,937
)
Change in fair value of Swaptions(2)
 
(9,085
)
 
(214
)
Change in fair value of TBA Short Contracts(2)
 
750

 
—

Total
 
$
59,576

 
$
(32,665
)
(1) 
Amounts are realized.
(2) 
Amounts are unrealized.
During the year ended December 31, 2013, we entered into seven TBA Short Contracts with an aggregate notional balance of $725,000, of which $400,000 were outstanding at December 31, 2013 and were in a net unrealized gain position of $750. Our TBA Short Contracts outstanding at December 31, 2013, which settle on February 13, 2014, had a weighted average sales price of 102.93% with respect to 4.00% coupon Fannie Mae 30-year RMBS. We may terminate TBA Contracts prior to their final contractual settlement date as part of our portfolio management, which may result in realized gains or losses, the timing of which cannot be predicted with any certainty.
At December 31, 2013, we had Swaps with an aggregate notional amount of $1,587,000 a weighted average fixed pay rate of 1.34% and weighted average term to maturity of 5.1 years. At December 31, 2013, our Swaptions had an aggregate notional amount of $1,375,000 and a weighted average term of five months until expiration; Swaps underlying our Swaptions had a weighted average fixed pay rate of 3.64% and a weighted average term of 10.0 years. At December 31, 2013, we had gross unrealized gains of $40,135 and $849 on Swaps and Swaptions respectively, and gross unrealized losses of $4,610 and $10,148 on Swaps and Swaptions, respectively.


47


We expect that changes in the fair value of our derivative instruments will move inversely to changes in the fair value of our pass-through Agency RMBS, however we do not expect that the changes in valuations of such derivatives relative to our pass-through Agency RMBS will off-set entirely. We note that the terms and benchmark interest rates associated with our derivatives are not matched with our investments, that the notional amount of our derivatives is not equal to our investments and the value of our Swaps and Swaptions do not mitigate the impact of spread widening, which occurs when market spreads widen between the yield on RMBS relative to certain benchmark interest rates. The timing and amount of realized and unrealized gains/(losses) associated with our derivative instruments can not be predicted, as the value of such instruments generally moves inversely with changes in interest rates which can not be predicted with any certainty. (For more information about derivative instruments we held at December 31, 2013 and December 31, 2012, see Note 10 - Derivative Instruments to the consolidated financial statements included under ITEM 8 of this annual report on Form 10-K.)
The following table presents the notional amount and estimated fair value for each of our derivative instrument types at the dates presented:
Table 8
 
December 31, 2013
 
December 31, 2012
 
 
Notional Amount
 
Estimated Fair Value
 
Notional Amount
 
Estimated Fair Value
Swaps - assets
 
$
1,007,000

 
$
40,135

 
$
—

 
$
—

Swaptions - assets
 
1,375,000

 
12,430

 
75,000

 
750

Swaps - (liabilities)
 
580,000

 
(4,610
)
 
1,500,000

 
(23,184
)
TBA Short Contracts - assets
 
400,000

 
750

 
—

 
—

Total derivative instruments
 
$
3,362,000

 
$
48,705

 
$
1,575,000

 
$
(22,434
)
The following tables present 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 annual and quarterly periods presented: (See “Non-GAAP Financial Measures,” below.)
Table 9
 
Agency
 
Non-Agency and Other Investments(1)
 
Securitized Mortgage Loans
 
Total
Year Ended December 31, 2013
 
 
 
 
 
 
 
 
Effective interest expense
 
$
33,767

 
$
13,110

 
$
2,759

 
$
49,636

Effective cost of funds
 
1.20
%
 
2.07
%
 
4.17
%
 
1.42
%
Effective net interest income
 
$
58,962

 
$
40,607

 
$
5,508

 
$
105,077

Effective net interest rate spread
 
1.71
%
 
4.79
%
 
4.18
%
 
2.39
%
Year Ended December 31, 2012
 
 
 
 
 
 
 
 
Effective interest expense
 
$
17,037

 
$
5,399

 
$
—

 
$
22,436

Effective cost of funds
 
0.80
%
 
2.12
%
 
—
%
 
0.94
%
Effective net interest income
 
$
46,015

 
$
25,918

 
$
—

 
$
71,933

Effective net interest rate spread
 
1.84
%
 
6.72
%
 
—
%
 
2.50
%
Quarterly Period Ended December 31, 2013
 
 
 
 
 
 
 
 
Effective interest expense
 
$
6,651

 
$
4,499

 
$
772

 
$
11,922

Effective cost of funds
 
1.28
%
 
1.99
%
 
4.24
%
 
1.56
%
Effective net interest income
 
$
13,895

 
$
13,362

 
$
1,541

 
$
28,798

Effective net interest rate spread
 
2.15
%
 
4.56
%
 
4.27
%
 
2.97
%
Quarterly Period Ended September 30, 2013
 
 
 
 
 
 
 
 
Effective interest expense
 
$
9,118

 
$
3,799

 
$
766

 
$
13,683

Effective cost of funds
 
1.64
%
 
2.04
%
 
4.15
%
 
1.80
%
Effective net interest income
 
$
7,825

 
$
11,350

 
$
1,558

 
$
20,733

Effective net interest rate spread
 
0.96
%
 
4.45
%
 
4.12
%
 
1.97
%
(Table 9 and notes continued on next page.)


48


(Table 9 - continued.)
 
Agency
 
Non-Agency and Other Investments(1)
 
Securitized Mortgage Loans
 
Total
Quarterly Period Ended June 30, 2013
 
 
 
 
 
 
 
 
Effective interest expense
 
$
10,352

 
$
2,541

 
$
781

 
$
13,674

Effective cost of funds
 
1.10
%
 
2.17
%
 
4.15
%
 
1.27
%
Effective net interest income
 
$
18,036

 
$
8,103

 
$
1,516

 
$
27,655

Effective net interest rate spread
 
1.59
%
 
4.97
%
 
4.01
%
 
2.09
%
Quarterly Period Ended March 31, 2013
 
 
 
 
 
 
 
 
Effective interest expense
 
$
7,646

 
$
2,271

 
$
439

 
$
10,356

Effective cost of funds
 
0.96
%
 
2.15
%
 
4.00
%
 
1.14
%
Effective net interest income
 
$
19,207

 
$
7,790

 
$
894

 
$
27,891

Effective net interest rate spread
 
2.00
%
 
5.38
%
 
4.19
%
 
2.48
%
Quarterly Period Ended December 31, 2012
 
 
 
 
 
 
 
 
Effective interest expense
 
$
7,060

 
$
2,270

 
$
—

 
$
9,330

Effective cost of funds
 
0.88
%
 
2.16
%
 
—
%
 
1.03
%
Effective net interest income
 
$
16,169

 
$
8,041

 
$
—

 
$
24,210

Effective net interest rate spread
 
1.70
%
 
5.22
%
 
—
%
 
2.19
%
Quarterly Period Ended September 30, 2012
 
 
 
 
 
 
 
 
Effective interest expense
 
$
4,654

 
$
1,710

 
$
—

 
$
6,364

Effective cost of funds
 
0.80
%
 
2.17
%
 
—
%
 
0.96
%
Effective net interest income
 
$
12,752

 
$
7,322

 
$
—

 
$
20,074

Effective net interest rate spread
 
1.80
%
 
6.04
%
 
—
%
 
2.43
%
Quarterly Period Ended June 30, 2012
 
 
 
 
 
 
 
 
Effective interest expense
 
$
3,674

 
$
958

 
$
—

 
$
4,632

Effective cost of funds
 
0.73
%
 
1.94
%
 
—
%
 
0.84
%
Effective net interest income
 
$
10,379

 
$
7,017

 
$
—

 
$
17,396

Effective net interest rate spread
 
1.62
%
 
9.56
%
 
—
%
 
2.46
%
Quarterly Period Ended March 31, 2012
 
 
 
 
 
 
 
 
Effective interest expense
 
$
1,649

 
$
461

 
$
—

 
$
2,110

Effective cost of funds
 
0.66
%
 
1.97
%
 
—
%
 
0.77
%
Effective net interest income
 
$
6,715

 
$
3,538

 
$
—

 
$
10,253

Effective net interest rate spread
 
1.95
%
 
9.42
%
 
—
%
 
2.83
%
(1) 
For the periods ended December 31, 2013 and September 30, 2013, other investments were comprised of STACR Notes. We had no “other investment securities” during the year ended December 31, 2012.
Realized and Unrealized Gains/(Losses) on Investments and Securitized Debt
During the years ended December 31, 2013 and 2012, we sold Agency RMBS of $3,529,336 and $1,779,911, respectively, realizing net gains/(losses) of $(81,504) and $30,503, respectively and sold non-Agency RMBS of $94,307 and $66,886, respectively, realizing net gains of $14,654 and $9,314, respectively. During 2013, as we identified attractive investment opportunities in non-Agency RMBS, we sold Agency RMBS and reinvested such capital in non-Agency RMBS. The substantial majority of our RMBS sales during the year ended December 31, 2013 were made during the second quarter and were comprised primarily of sales of Agency RMBS, as we repositioned our portfolio in connection with the significant volatility in the fixed income market. (See “Market Conditions and Our Strategy,” above.) As we find attractive investment opportunities in non-Agency RMBS, whole loans and mortgage related assets, we may sell Agency and/or non-Agency RMBS to provide equity to fund such purchases. With respect to non-Agency RMBS, we continue to emphasize investments in seasoned securities, backed by Subprime, Alt-A and Option ARM mortgage loans.


49


We have elected the fair value option for all of our RMBS, securitized mortgage loans, other investment securities and securitized debt and, as a result, record changes in the 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 statement of operations for the years ended December 31, 2013 and December 31, 2012:
Table 10
 
Year Ended
 
 
December 31, 2013
 
December 31, 2012
Realized gain/(loss) on sale of RMBS, net
 
$
(66,850
)
 
$
39,817

Unrealized gain/(loss) on RMBS, net
 
(147,375
)
 
100,402

Unrealized gain on other investment securities
 
335

 
—

Unrealized gain on securitized mortgage loans
 
3,950

 
—

Unrealized (loss) on securitized debt
 
(954
)
 
—

Total
 
$
(210,894
)
 
$
140,219

Expenses
General and Administrative Expenses: We reimburse our Manager for our allocable share of the compensation of our Chief Financial Officer/Treasurer/Secretary based on the percentage of such individual’s 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, 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 $11,501 and $7,780 for the years ended December 31, 2013 and December 31, 2012, respectively. The increase in our general and administrative expenses was driven, in part, by significant growth in our assets resulting from our investment, on a levered basis, of incremental equity capital raised since the second quarter of 2012. Costs for our third-party investment accounting services and clearing costs we incur for security and repurchase transactions vary based on the size of our portfolio and transaction activity. Beginning in the third quarter of 2013, we reduced our use of a third-party accounting service provider, as our Manager directly assumed certain accounting functions previously outsourced. We anticipate that this change will allow us to better manage certain of our accounting related expenses in the future. To the extent that we continue to expand our portfolio to include a broader spectrum of investments, we expect that additional costs may be incurred for additional legal work and credit analysis.
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 adjusted 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 fees of $11,579 and $6,804 for the years ended December 31, 2013 and December 31, 2012, respectively. The increase in the management fee for the year ended December 31, 2013 reflects our growth in stockholders’ equity reflecting issuances of our capital stock since the second quarter of 2012. From April 20, 2012 to March 25, 2013, our most recent public issuance of capital stock, we raised additional net capital of approximately $587,704 from issuances of common and preferred stock.
The management fees, expense reimbursements and the relationship between our Manager and us are discussed further in Note 12 - Commitments and Contingencies to the consolidated financial statements included under ITEM 8 of this annual report Form 10-K.
Results of Operations
Year Ended December 31, 2012 compared to the Partial Period Ended December 31, 2011
From July 27, 2011 (our commencement of operations) through December 31, 2011, we had net income of $4,472 or $0.43 per basic and diluted weighted average common share. We were not fully invested in our target assets and were not levered in a manner consistent with our business plan during the period from July 27, 2011 through December 31, 2011 and, as such, the results of operations for such partial period are not comparable with the results of our operations for the full year ended December 31, 2012.


50


The following discussion of our results of operations highlights our performance for the year ended December 31, 2012. For 2012, we had net income available to common stock and participating securities of $167,734, or $8.36 per basic and diluted common share.
Net Interest Income
Interest rate spread and net interest margin are key performance metrics for us, as our operating performance is significantly driven by our 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 2.83% and 2.96% for the year ended December 31, 2012, respectively. Over the course of 2012, our interest rate spread and net interest margin compressed, generally reflecting tightened market spreads and slight increases in prepayments and expected prepayments on our Agency RMBS.
For the year ended December 31, 2012, we earned interest income of $94,369 and incurred interest expense of $14,631, resulting in net interest income of $79,738. The following tables present certain information regarding the components of our net interest income for the periods indicated:
Table 11
 
For the Year Ended December 31, 2012
 
For the Period From July 27, 2011 through December 31, 2011
 
 
Agency
 
Non-Agency
 
Total
 
Agency
 
Non-Agency
 
Total
Average RMBS held(1)
 
$
2,345,193

 
$
348,333

 
$
2,693,526

 
$
539,029

 
$
69,793

 
$
608,822

Total interest income
 
$
63,052

 
$
31,317

 
$
94,369

 
$
6,394

 
$
4,339

 
$
10,733

Yield on average RMBS
 
2.64
%
 
8.84
%
 
3.45
%
 
2.72
%
 
14.26
%
 
4.04
%
Average balance of repurchase agreements
 
$
2,122,914

 
$
254,517

 
$
2,377,431

 
$
462,148

 
$
47,647

 
$
509,795

Total interest expense
 
$
9,232

 
$
5,399

 
$
14,631

 
$
767

 
$
371

 
$
1,138

Average cost of funds(2)(3)
 
0.43
%
 
2.12
%
 
0.61
%
 
0.39
%
 
1.81
%
 
0.52
%
Net interest income
 
$
53,820

 
$
25,918

 
$
79,738

 
$
5,627

 
$
3,968

 
$
9,595

Net interest rate spread
 
2.21
%
 
6.72
%
 
2.83
%
 
2.33
%
 
12.45
%
 
3.52
%
(1) 
Amount reflects amortized cost, which does not include unrealized gains/(losses).
(2) 
Cost of funds by investment type is based on the underlying investment type of the RMBS pledged as collateral.
(3) 
Cost of funds does not include accrual and settlement of interest associated with our Swaps and Swaptions as we have not elected to apply hedge accounting. In accordance with GAAP, those costs are included in gain/(loss) on derivative instruments in the consolidated statement of operations.


51


Table 12
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Quarterly Period Ended:
 
Average
RMBS
Held(1)
 
Total
Interest
Income
 
Weighted Average
CPR
 
Yield on
Average
RMBS
 
Average
Balance of
Repurchase
Agreements
 
Total
Interest
Expense
 
Average
Cost of
funds(2)(3)
 
Net
Interest
Income
 
Net
Interest
Rate
Spread
December 31, 2012
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency
 
$
3,531,012

 
$
23,267

 
5.80
%
 
2.58
%
 
$
3,184,479

 
$
3,840

 
0.48
%
 
$
19,427

 
2.10
%
Non-Agency
 
546,752

 
10,311

 
2.72
%
 
7.38
%
 
417,428

 
2,270

 
2.16
%
 
8,041

 
5.22
%
Total
 
$
4,077,764

 
$
33,578

 
5.39
%
 
3.22
%
 
$
3,601,907

 
$
6,110

 
0.67
%
 
$
27,468

 
2.55
%
September 30, 2012
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency
 
$
2,624,211

 
$
17,406

 
5.20
%
 
2.60
%
 
$
2,312,870

 
$
2,579

 
0.44
%
 
$
14,827

 
2.15
%
Non-Agency
 
430,337

 
9,032

 
3.40
%
 
8.21
%
 
312,185

 
1,710

 
2.17
%
 
7,322

 
6.04
%
Total
 
$
3,054,548

 
$
26,438

 
4.95
%
 
3.39
%
 
$
2,625,055

 
$
4,289

 
0.65
%
 
$
22,149

 
2.74
%
June 30, 2012
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency
 
$
2,362,290

 
$
14,015

 
3.70
%
 
2.35
%
 
$
1,995,103

 
$
1,913

 
0.38
%
 
$
12,102

 
1.96
%
Non-Agency
 
274,200

 
7,975

 
3.30
%
 
11.51
%
 
197,765

 
958

 
1.94
%
 
7,017

 
9.56
%
Total
 
$
2,636,490

 
$
21,990

 
3.66
%
 
3.30
%
 
$
2,192,868

 
$
2,871

 
0.53
%
 
$
19,119

 
2.77
%
March 31, 2012
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Agency
 
$
1,220,907

 
$
8,364

 
6.00
%
 
2.71
%
 
$
1,005,133

 
$
900

 
0.36
%
 
$
7,464

 
2.35
%
Non-Agency
 
138,902

 
3,999

 
3.10
%
 
11.39
%
 
94,012

 
461

 
1.97
%
 
3,538

 
9.42
%
Total
 
$
1,359,809

 
$
12,363

 
5.70
%
 
3.60
%
 
$
1,099,145

 
$
1,361

 
0.50
%
 
$
11,002

 
3.10
%
(1)
Amount reflects amortized cost, which does not include unrealized gains/(losses).
(2)
Cost of funds by investment type is based on the underlying investment type of the RMBS pledged as collateral.
(3)
Cost of funds does not include accrual and settlement of interest associated with our Swaps and Swaptions as we have not elected to apply hedge accounting. In accordance with GAAP, those costs are included in gain/(loss) on derivative instruments in the consolidated statement of operations.
The following table presents information with respect to our repurchase agreement borrowings by type of collateral pledged as of December 31, 2012, and December 31, 2011 and the respective effective cost of funds for the periods presented:
Table 13
 
Year Ended December 31, 2012
 
For the Period From July 27, 2011 through December 31, 2011
Collateral Pledged:
 
Balance

 
Cost of
Funds
 
Effective
Cost of
Funds(1)
 
Balance

 
Cost of
Funds
 
Effective
Cost of
Funds(1)
Agency RMBS
 
$
3,223,577

 
0.43
%
 
0.80
%
 
$
1,002,626

 
0.39
%
 
0.75
%
Non-Agency RMBS
 
430,859

 
2.12

 
2.12

 
77,369

 
1.81

 
1.81

Total
 
$
3,654,436

 
0.61
%
 
0.94
%
 
$
1,079,995

 
0.52
%
 
0.85
%
(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 period of $7,805, and $715, 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.
Interest Rate Derivatives
Our Swaps are intended to mitigate the effects of increases in interest rates on a portion of our repurchase agreements, as they have the economic effect of modifying the repricing characteristics on repurchase borrowings equal to the aggregate notional balance of the Swaps. Pursuant to the terms of our Swaps, we pay a fixed rate of interest and receive a variable rate of interest, generally based on one-month or three-month LIBOR, on the notional amount of the Swap. In October 2012, we purchased a Swaption that provides us with the right to enter into a fixed-pay Swap at the expiration of the option period in October 2013. (For information about our Swaps and Swaption, see Note 10 - Derivative Instruments to the consolidated financial statements included under ITEM 8 of this annual report on Form 10-K.)
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


52


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.”)
The following table presents our interest expense including the net interest cost of Swaps, average cost of funds including net interest cost of Swaps, net interest income including net interest cost of Swaps and net interest rate spread including net interest cost of Swaps for the periods indicated:
Table 14
 
Agency
 
Non-Agency
 
Total
Year Ended December 31, 2012
 
 
 
 
 
 
Interest expense including net interest cost of Swaps
 
$
17,037

 
$
5,399

 
$
22,436

Average cost of funds including net interest cost of Swaps
 
0.80
%
 
2.12
%
 
0.94
%
Net interest income including net interest cost of Swaps
 
$
46,015

 
$
25,918

 
$
71,933

Net interest rate spread including net interest cost of Swaps
 
1.84
%
 
6.72
%
 
2.50
%
July 27, 2011 through December 31, 2011
 
 
 
 
 
 
Interest expense including net interest cost of Swaps
 
$
1,482

 
$
371

 
$
1,853

Average cost of funds including net interest cost of Swaps
 
0.75
%
 
1.81
%
 
0.85
%
Net interest income including net interest cost of Swaps
 
$
4,912

 
$
3,968

 
$
8,880

Net interest rate spread including net interest cost of Swaps
 
1.97
%
 
12.45
%
 
3.20
%
Quarterly Period Ended December 31, 2012
 
 
 
 
 
 
Interest expense including net interest cost of Swaps
 
$
7,060

 
$
2,270

 
$
9,330

Average cost of funds including net interest cost of Swaps
 
0.88
%
 
2.16
%
 
1.03
%
Net interest income including net interest cost of Swaps
 
$
16,169

 
$
8,041

 
$
24,210

Net interest rate spread including net interest cost of Swaps
 
1.70
%
 
5.22
%
 
2.19
%
Quarterly Period Ended September 30, 2012
 
 
 
 
 
 
Interest expense including net interest cost of Swaps
 
$
4,654

 
$
1,710

 
$
6,364

Average cost of funds including net interest cost of Swaps
 
0.80
%
 
2.17
%
 
0.96
%
Net interest income including net interest cost of Swaps
 
$
12,752

 
$
7,322

 
$
20,074

Net interest rate spread including net interest cost of Swaps
 
1.80
%
 
6.04
%
 
2.43
%
Quarterly Period Ended June 30, 2012
 
 
 
 
 
 
Interest expense including net interest cost of Swaps
 
$
3,674

 
$
958

 
$
4,632

Average cost of funds including net interest cost of Swaps
 
0.73
%
 
1.94
%
 
0.84
%
Net interest income including net interest cost of Swaps
 
$
10,379

 
$
7,017

 
$
17,396

Net interest rate spread including net interest cost of Swaps
 
1.62
%
 
9.56
%
 
2.46
%
Quarterly Period Ended March 31, 2012
 
 
 
 
 
 
Interest expense including net interest cost of Swaps
 
$
1,649

 
$
461

 
$
2,110

Average cost of funds including net interest cost of Swaps
 
0.66
%
 
1.97
%
 
0.77
%
Net interest income including net interest cost of Swaps
 
$
6,715

 
$
3,538

 
$
10,253

Net interest rate spread including net interest cost of Swaps
 
1.95
%
 
9.42
%
 
2.83
%
Realized and Unrealized Gains/(Losses) on Investments
During the year ended December 31, 2012, as part of managing our portfolio, we sold Agency RMBS with a carrying amount of $1,779,911 for $1,810,414, realizing net gains of $30,503, comprised of gross gains of $30,879 and gross losses of $376. We generally sold certain Agency RMBS collateralized by mortgages with higher coupons, 15 and 20-year terms and ARMs and reinvested 30-year fixed rate Agency RMBS. Agency RMBS were primarily sold in order to mitigate prepayment risk in our RMBS portfolio. In general, as we identified attractive investment opportunities in non-Agency RMBS, we sold Agency RMBS and reinvested such capital in non-Agency RMBS. During the year ended December 31, 2012, we sold non-Agency RMBS with a carrying amount of $66,886 for $76,200, realizing net gains of $9,314, comprised of gross gains of $9,360 and gross losses of $46. During 2012, we terminated Swaps with an aggregate notional of $180,000 and a weighted average fixed pay leg of 1.36%, realizing net losses of $4,709 on such terminations.


53


We have elected the fair value option for all of our RMBS and, as a result, record the change in estimated fair value related to RMBS in earnings. The following table presents amounts related to realized gains and losses as well as changes in the estimated fair value of our RMBS portfolio and derivative instruments, which were comprised of Swaps and Swaptions, that are included in our consolidated statement of operations for the quarterly periods presented:
Table 15
 
Quarterly Period Ended
 
 
December 31, 2012
 
September 30, 2012
 
June 30, 2012
 
March 31, 2012
Realized gain on RMBS
 
$
7,573

 
$
13,861

 
$
11,614

 
$
6,769

Unrealized gain on RMBS
 
24,941

 
54,913

 
14,598

 
5,950

Realized loss on derivatives(1)
 
(3,220
)
 
(6,822
)
 
(1,723
)
 
(749
)
Unrealized loss on derivatives
 
4,041

 
(9,831
)
 
(13,792
)
 
(569
)
Total
 
$
33,335

 
$
52,121

 
$
10,697

 
$
11,401

(1) 
Realized losses represent the net interest paid or accrued for Swaps and net termination gain/(loss) during the period.
The following table presents amounts related to realized gains and losses as well as changes in the estimated fair value of our RMBS portfolio and derivative instruments that are included in our consolidated statement of operations for the year ended December 31, 2012 and for the period from July 27, 2011 through December 31, 2011:
Table 16
 
Year Ended December 31, 2012
 
For the Period From July 27, 2011 through December 31, 2011
Realized gain on RMBS
 
$
39,817

 
$
885

Unrealized gain on RMBS
 
100,402

 
2,482

Realized loss on derivatives
 
(12,514
)
 
(630
)
Unrealized loss on derivatives
 
(20,151
)
 
(3,246
)
Total
 
$
107,554

 
$
(509
)
At December 31, 2012, we had Swaps with an aggregate notional amount of $1,500,000, a weighted average fixed pay rate of 1.20% and weighted average term to maturity of 5.3 years. We view our Swaps as an economic hedge on a portion of our borrowings under repurchase agreements. However, since we have not elected to apply hedge accounting for our Swaps, we record the change in estimated fair value related to such agreements in earnings as a component of loss on derivative instruments. Included in realized gain/(loss) on derivative instruments are net Swap payments (including accrued amounts) associated with our Swaps. We recognized a loss of $214 through earnings for the quarter and year ended December 31, 2012 related to the change in fair value of our Swaption. At December 31, 2012, all of our Swaps were in an unrealized loss position, which totaled $23,184.
Expenses
General and Administrative Expenses: We reimburse our Manager for our allocable share of the compensation of our Chief Financial Officer/Treasurer/Secretary 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 also required to reimburse our Manager for operating expenses paid by our Manager on our behalf to third parties, including 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 $7,780 for the year ended December 31, 2012.
Management Fee Expense: Pursuant to our Management Agreement, we incurred management fee expenses of $6,804 for the year ended December 31, 2012. 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 adjusted stockholders’ equity as defined in the Management Agreement, per annum. Our Manager uses the proceeds from its 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. The management fee for the year ended December 31, 2012 reflects the increase in stockholders’ equity resulting from our issuance of common stock and preferred stock in April 2012 and September 2012, respectively which increased our stockholders’ equity by $416,062.
The management fees, expense reimbursements and the relationship between our Manager and us are discussed further in Note 12 - Commitments and Contingencies to the consolidated financial statements included under ITEM 8 of this annual report Form 10-K.


54


Critical Accounting Policies and Use of Estimates
The preparation of our consolidated financial statements in accordance with GAAP requires our Manager to make estimates and assumptions that affect the amounts reported in the consolidated financial statements. In preparing these consolidated financial statements, our Manager has made estimates and judgments of certain amounts included in the consolidated financial statements, giving due consideration to materiality. Application of these accounting policies involves the exercise of judgment and use of assumptions as to future uncertainties and, as a result, actual results could differ materially from our estimates. Our accounting policies are described in Note 2 - Summary of Significant Accounting Policies to the consolidated financial statements included under ITEM 8 of this annual report on Form 10-K. The more significant of our accounting policies are as follows:
Basis of Presentation
We currently operate as one business segment. The consolidated financial statements include our accounts and those of our consolidated subsidiaries. All intercompany amounts have been eliminated. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ materially from those estimates.
Classification of RMBS and valuations of financial instruments
RMBS - Fair value election
To date, we have elected the fair value option for our investments at the time of purchase and, as a result, record the change 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 investments and securitized debt improves financial reporting, as it is consistent with presenting changes in the fair value of derivative instruments through earnings.
We generally intend to hold our RMBS to generate interest income; however, we have 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/(losses) on the sale of RMBS are recorded in earnings using the specific identification method.
Fair Value Measures 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. 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, 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 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.
Quoted market prices are not available for Agency RMBS, non-Agency RMBS, TBA Contracts, securitized debt and other investments. We receive a quote from an independent pricing service for all of our investment securities. With respect to our pass-through Agency RMBS, we generally receive two to three broker quotes per instrument and with respect to our Agency IO, Inverse IO, non-Agency RMBS and other investment securities we receive one or more broker quotes. We review and may challenge broker quotes and valuations from the pricing service to ensure that such quotes and valuations are indicative of fair value. As part of this process, we consider where we have observed transactions involving securities with similar characteristics that have occurred at or near the valuation date. We then estimate the fair value of each security based upon the average of the final broker quotes received. Broker quotes which, while non-binding, are indicative of fair value. However, adjustments to valuations may be made as deemed appropriate by the Manager to capture market information at the


55


valuation date. Further, broker quotes are only 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, our Manager 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 rates 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. There were no adjustments made to valuations determined based on broker quotes received and 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 pricing services are readily verifiable to observable market transactions, as such, we categorize Agency RMBS and TBA Contracts as Level II valuations. 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 are categorized as Level III.
In providing valuations for our Agency RMBS, we understand that our third party pricing service utilizes observable inputs such as: pool specific characteristics such as loan age, loan size, and credit quality of borrowers; yields for U.S. Treasury securities of various maturities; a range of spread and discount margin assumptions; floating rate indices such as LIBOR; prices for TBA securities; and recent trading and bidding activity for bonds with similar collateral characteristics. In providing valuations for our non-Agency RMBS and other investment securities, we understand that our third party pricing service utilizes both observable and unobservable inputs such as: pool specific characteristics such as loan age, loan size, credit quality of borrowers, servicer quality, structural and waterfall features of each bond; floating rate indices such as LIBOR; prepayment and default assumptions developed using the pricing service’s proprietary models. As a final step, we understand that the pricing service checks prices against recent trading and Bid Wanted in Competition (commonly known as “BWIC”) indications on each bond, bonds from the same securitization, bonds with similar underlying collateral or structural characteristics and bonds from the same manager and may make adjustments it considers appropriate based on such trading indications.
Securitized Mortgage Loans
The fair value of our securitized mortgage loans at December 31, 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 valuations in the fair value hierarchy.
Swaps and Swaptions
We determine the estimated fair value of our Swaps and Swaption based on market valuations obtained from a third party with expertise in valuing such instruments. With respect to Swaps, our third party valuation provider determines the expected amount of future cash flows and calculates discount factors to apply to those cash flows. For the fixed leg of a Swap, the coupon amounts are known upfront (since the notional and the fixed coupon rates are pre-defined as part of the Swap agreement). The floating leg of a Swap changes as interest rates change. The valuation provider uses the forward rates derived from raw yield curve data to determine the market’s expectation of the future cash flows on the floating leg. Finally, both the fixed and floating legs’ cash flows are discounted using the calculated discount factors. The fixed and floating leg valuations are then netted to arrive at a single valuation for the period. 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 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 we receive could differ substantially with 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.


56


Any changes to the valuation methodology will be reviewed by our Manager to ensure the changes are appropriate. As markets and products develop and the pricing for certain products becomes more transparent, we will continue to refine our valuation methodologies. The methods used by us may produce a fair value estimate 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 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 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.
Interest income recognition
Investment Securities
Interest income on Agency pass-through RMBS and other investment securities 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, non-Agency RMBS and other investment securities 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. For those securities, if prepayment levels differ, or are expected to differ in the future from our previous assessment, we adjust the amount of premium amortization recognized in the period such change is made, applying the retrospective method, resulting in a cumulative catch-up reflecting such change. To the extent that prepayment activity varies significantly from our previous prepayment estimates, we may experience volatility in our interest income. For pass-through Agency RMBS that we acquired subsequent to June 30, 2013, we do not estimate prepayments to determine premium amortization or discount accretion on such securities. Instead, the amount of premium amortization/discount accretion on pass-through Agency RMBS acquired subsequent to June 30, 2013 is based upon actual prepayment experience, which may vary significantly over time.
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 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


57


prospective change in the yield/interest income recognized on such loans and/or the recognition of other-than-temporary impairments (or, OTTI).
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 Short Contracts as part of our interest rate risk management. We view our Swaps and Swaptions as economic hedges, which we believe mitigate interest rate risk associated with our borrowings under repurchase agreements and do not use derivatives for speculative purposes. Our TBA Short Contracts also mitigate the impact that increases in interest rates would have on our Agency RMBS.
GAAP requires an entity to recognize all derivatives as either assets or liabilities in the balance sheet and to measure those instruments at estimated fair value. We have not elected hedge accounting for our derivative instruments and, as a result, the fair value adjustments for such 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. If our hedging activities do not achieve the desired results, our earnings may be adversely affected.
Although permitted under certain circumstances, we do not offset cash collateral receivables or payables against our net derivative positions.
Repurchase agreements
RMBS financed under repurchase agreements are treated as collateralized financing transactions, unless they meet sale treatment, or are deemed to be a linked transaction. Securities financed through a repurchase agreement remain on our consolidated balance sheet as an asset and cash received from the lender is recorded on our consolidated balance sheet as a liability. Interest paid in accordance with repurchase agreements will be recorded in interest expense.
Income taxes
Our financial results generally do not reflect provisions for current or deferred income taxes. We believe that we operate in, and intend to continue to operate in, a manner that allows and will continue to allow us to qualify as a REIT for tax purposes. Provided that we distribute all of our REIT taxable income annually and meet each of the requirements to maintain our status as a REIT, we do not generally expect to pay corporate level taxes and/or excise taxes. Many of the REIT requirements, however, are highly technical and complex. If we were to fail to meet certain of the REIT requirements, we would be subject to U.S. federal, state and local income taxes.
We currently have one TRS and may in the future elect to treat newly formed subsidiaries as TRSs, which may participate in non-real estate related activities. A TRS is subject to federal and state income tax at regular corporate tax rates.
Our major tax jurisdictions are U.S. Federal, New York State and New York City. The statute of limitations is open for all jurisdictions for the years 2011 through 2013. We do not have any unrecognized tax benefits and do not expect a change in our position for unrecognized tax benefits in the next twelve months.
Variances between GAAP Income and Taxable Income
Our net income for financial reporting purposes differs from our taxable income. Certain of the differences between our GAAP net income and our taxable income arise from variations among the methods prescribed under GAAP and the Internal Revenue Code for recognizing certain items of income and/or expense. Certain of these variations give rise to “timing differences” between GAAP net income and taxable income while other variations cause “permanent differences” between GAAP net income and taxable net income.
Timing differences between our GAAP and taxable net income arise as a result of temporary differences between when certain revenue or expense items are recognized in earnings. The differences are expected to reverse over time and may cause significant short-term variances between GAAP and taxable net income. For 2013, the primary differences between our GAAP and taxable income arose from the following: (1) unrealized gain/(losses) are recognized for GAAP purposes are not recognized for tax purposes; (2) purchase premiums on Agency RMBS were amortized faster for tax purposes than for GAAP; (3) discounts on non-Agency RMBS were recognized slower for tax purposes than for GAAP; and (4) gains and losses on the termination of Swaps and Swaptions were recognized in the period that the Swap or Swaption was terminated for GAAP purposes, while such gain/loss is recognized over the remaining term of the Swap or the term of the Swap underlying the Swaption for tax purposes. In addition, we hold certain securities that were issued with OID. We generally recognize OID in our current gross interest income over the term of the applicable securities as the OID accrues. The rate at which the OID is recognized into taxable income is calculated using a constant rate of yield to maturity, without a loss assumption provision. As a result, for tax purposes, REIT taxable income may be recognized in excess of GAAP income or in advance of the


58


corresponding cash flow from these assets. The differences discussed above with respect to our Agency and non-Agency RMBS may also impact the difference between net gains we recognized under GAAP compared to tax. In addition, certain permanent differences between our GAAP income and our taxable income arise when items are recognized for GAAP purposes which will never affect the calculation of taxable income.
As of December 31, 2013, for tax purposes we had estimated non-deductible net capital losses of $(63.2) million which may be carried forward and applied against future net capital gains for up to five years. This capital loss carryforward will reduce the amount of future capital gains, if any, that we would otherwise expect to distribute, as capital gains would first be reduced by capital loss carryforwards. In addition, as of December 31, 2013, we had estimated net deferred tax gains from terminated Swaps of $19.9 million and estimated net deferred gains from terminated Swaptions of $6.8 million which will be amortized into future ordinary taxable income over the remaining terms of the underlying Swaps.
Depending on the structure of securitization/resecuritization transactions, for tax purposes such transactions may be treated either as a sale or a financing of the underlying assets. Income recognized from securitization and resecuritization transactions will generally differ for tax and GAAP purposes. In February 2013, we purchased a pool of mortgage loans and concurrently executed a securitization transaction. This securitization was treated as a sale for tax purposes and, effectively, treated as financing for GAAP purposes, as we consolidate the securitization trust under GAAP. As a result of these differences, for the tax purposes no interest income is recognized on our securitized mortgage loans and no interest expense is recognized for our securitized debt; instead, interest income is recognized on the subordinated bonds received from our consolidated trust.
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 generally consist of borrowings under repurchase agreements, payments of principal and interest received on the 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. As part of managing our investment portfolio, we may also generate cash through sales of RMBS. Cash is needed to fund our ongoing obligations, make payments of principal and interest on repurchase agreement borrowings, purchase target assets, meet margin calls, make dividend distributions to stockholders and for other general business and operating purposes.
Our primary sources of cash for the year ended December 31, 2013 consisted of proceeds from repurchase facility borrowings, proceeds from sales of Agency RMBS, payments of principal and interest we received on our RMBS portfolio and proceeds from sales of our common stock. In addition, during the year ended December 31, 2013, we entered into a securitization transaction which effectively financed a portion of our securitized mortgage loans. We expect that in the future, subject to market conditions, that we may issue other types of debt and/or equity securities and engage in additional securitization/resecuritization transactions.
Under our repurchase agreements, lenders retain the right to mark the collateral pledged to estimated fair value. A reduction in the value of the collateral pledged will require us to provide additional securities or cash as collateral. 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 different economic and market developments.
We believe 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.


59


Public Offerings of Capital Stock
The following table presents shares we issued through public offerings for the years ended December 31, 2013 and December 31, 2012:
Table 17
 
 
 
 
 
 
 
 
Date of Issuance
 
Type of Capital Stock Issued
 
Number of Shares Issues
 
Offering Price Per Share
 
Net Proceeds
March 25, 2013
 
Common
 
1,020,000

 
$
22.00

 
$
22,430

March 13, 2013
 
Common
 
6,800,000

 
$
22.00

 
$
149,212

September 20, 2012
 
Preferred
 
6,900,000

 
$
25.00

 
$
166,572

April 20, 2012
 
Common
 
13,900,000

 
$
18.00

 
$
249,490

We primarily used the cash from these public offerings to invest on a levered basis in our target assets.
Share Repurchase Plan
On November 6, 2013, our Board of Directors authorized a Repurchase Program to repurchase up to $50,000 of our outstanding common stock. Such authorization does not have an expiration date. Subject to applicable securities laws, repurchases of common stock under the Repurchase Program may be made at times and in amounts as we deem appropriate, using available cash resources. Shares of common stock repurchased by us under the Repurchase Program are cancelled and, until reissued by us, are deemed to be authorized but unissued shares of our common stock. The Repurchase Program may be suspended or discontinued by us at any time and without prior notice. We have not repurchased any shares of common stock under the Repurchase Program through December 31, 2013.
Investing Activity
During the year ended December 31, 2013, we: (i) invested $2,629,934 in Agency pass-through RMBS with a weighted average purchase price of 107.0% of par value, $63,156 in Agency IOs and $42,993 in Inverse IOs, $748,032 in non-Agency RMBS, $113,038 in securitized mortgage loans and $12,000 in other investments; (ii) received prepayments and scheduled amortization of $256,341 for Agency RMBS, $117,411 for non-Agency RMBS, $6,038 on our securitized mortgage loans, and $820 for other investments; and (iii) sold Agency RMBS of $3,529,336 realizing a net loss of $81,504 and sold $94,307 of non-Agency RMBS realizing a net gain of $14,654. As of December 31, 2013, we had investment related receivables of $24,887 of which $21,978 was related to unsettled sales of Agency RMBS, and $2,909 was principal receivable from brokers on non-Agency RMBS. All investment related receivables at December 31, 2013 were settled in January 2014.
We receive interest-only payments 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 $44,425 with an aggregate notional balance of $410,187, 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 year ended December 31, 2013, we sold $20,993 of Agency IOs and $46,596 of Agency Inverse IO securities, realizing an aggregate net loss of $600.
In 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 under “Financing Activity,” below.
As of December 31, 2013, our non-Agency RMBS consisted primarily of RMBS backed by seasoned Subprime mortgages and, to a lesser extent, Alt-A and Option ARMs. The average cost basis of our non-Agency RMBS portfolio was 78.9% and 67.2% of par as of December 31, 2013 and December 31, 2012, respectively. (For additional information about our RMBS portfolios as of December 31, 2013, see Tables 26, 27, 28 and 29 included under ITEM 7A and Note 4 - Residential Mortgage-Backed Securities to the consolidated financial statements included under ITEM 8 of this annual report on Form 10-K.)


60


Financing Activity
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 December 31, 2013, we had outstanding repurchase agreement borrowings with 17 counterparties totaling $3,034,058. 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 December 31, 2013, we had master repurchase agreements with 23 counterparties, and as a matter of routine business may have discussions with other financial institutions in order to potentially provide us with additional repurchase agreement capacity.
During the first quarter of 2013, we engaged in our initial 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 following table presents certain information about our borrowings for the periods presented:
Table 18
 
Repurchase Agreements
 
Securitized Debt(1)
Quarter Ended
 
Quarterly Average Balance
 
End of Period
Balance
 
Maximum Balance at Month-End During the Period
 
Quarterly
Average Balance
 
End of Period
Balance
 
Maximum Balance at Month-End During the Period
December 31, 2013
 
$
2,951,265

 
$
3,034,058

 
$
3,034,058

 
$
44,268

 
$
42,400

 
$
44,567

September 30, 2013
 
$
2,967,123

 
$
2,881,680

 
$
3,045,769

 
$
46,249

 
$
45,590

 
$
46,776

June 30, 2013(2)
 
$
4,260,599

 
$
3,945,097

 
$
4,516,604

 
$
48,271

 
$
47,353

 
$
48,572

March 31, 2013(3)
 
$
3,669,630

 
$
4,343,341

 
$
4,343,341

 
$
28,742

 
$
48,980

 
$
49,525

 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2012
 
$
3,601,907

 
$
3,654,436

 
$
3,654,436

 
$
—

 
$
—

 
$
—

September 30, 2012(4)
 
$
2,625,055

 
$
3,709,684

 
$
3,709,684

 
$
—

 
$
—

 
$
—

June 30, 2012(5)
 
$
2,192,868

 
$
2,631,101

 
$
2,631,101

 
$
—

 
$
—

 
$
—

March 31, 2012
 
$
1,099,145

 
$
1,171,177

 
$
1,177,701

 
$
—

 
$
—

 
$
—

 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2011
 
$
782,835

 
$
1,079,995

 
$
1,079,995

 
$
—

 
$
—

 
$
—

September 30, 2011
 
$
129,194

 
$
392,573

 
$
392,573

 
$
—

 
$
—

 
$
—

(1) 
The balances presented for securitized debt reflect the balance of such debt, which does not reflect the impact of changes in the fair value of such liability.
(2) 
The end-of-period balance at June 30, 2013 includes repurchase agreement borrowings of $990,973, which amount was repaid in July 2013 upon settlement of Agency RMBS sold in June 2013.
(3) 
On March 25 and March 13, 2013, we raised net equity of approximately $22,430 and $149,212, respectively, which was invested on a levered 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.
(4) 
On September 20, 2012, we raised net equity of $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 period.
(5) 
On April 20, 2012, we raised net equity of $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 period.


61


The following table presents information about our borrowings by type of collateral pledged and the fair value of collateral pledged as of the dates presented and the weighted average interest rate, the cost of funds and effective cost of funds for the quarterly periods then ended:
Table 19
 
Principal Balance of Borrowing
 
Fair Value of Collateral Pledged(1)
 
Weighted Average Cost of Funds
 
Effective Cost of Funds(2)
December 31, 2013:
 
 
 
 
 
 
 
 
Agency RMBS repurchase borrowings
 
$
2,082,447

 
$
2,175,114

 
0.43
%
 
1.28
%
Non-Agency RMBS and Other Investment repurchase borrowing(3)
 
924,597

 
1,236,269

 
1.99

 
1.99

Securitized Mortgage Loans repurchase borrowings(4)
 
27,014

 
47,057

 
2.14

 
4.13

Total repurchase borrowings
 
3,034,058

 
3,458,440

 
0.91
%
 
1.52
%
Securitized debt
 
42,400

 
110,984

 
4.30

 
4.30

Total
 
$
3,076,458

 
$
3,569,424

 
0.96
%
 
1.56
%
September 30, 2013:
 
 
 
 
 
 
 
 
Agency RMBS repurchase borrowings
 
$
1,989,518

 
$
2,102,874

 
0.42
%
 
1.64
%
Non-Agency RMBS and Other Investment repurchase borrowings(3)
 
865,148

 
1,148,085

 
2.04

 
2.04

Securitized Mortgage Loans repurchase borrowings
 
27,014

 
45,023

 
2.11

 
4.07

Total repurchase borrowings
 
2,881,680

 
3,295,982

 
0.84
%
 
1.76
%
Securitized debt
 
45,590

 
109,586

 
4.19

 
4.19

Total
 
$
2,927,270

 
$
3,405,568

 
0.89
%
 
1.80
%
June 30, 2013:
 
 
 
 
 
 
 
 
Agency RMBS repurchase borrowings
 
$
3,367,445

 
$
3,533,248

 
0.43
%
 
1.10
%
Non-Agency RMBS repurchase borrowings
 
550,752

 
747,666

 
2.17

 
2.17

Securitized Mortgage Loans repurchase borrowings
 
26,900

 
44,834

 
2.07

 
4.04

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
 
419,645

 
594,052

 
2.15

 
2.15

Securitized Mortgage Loans repurchase borrowings
 
27,203

 
45,904

 
2.01

 
3.32

Total repurchase borrowings
 
4,343,341

 
4,736,345

 
0.65
%
 
1.11
%
Securitized debt
 
48,980

 
114,881

 
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
 
$
3,654,436

 
$
3,996,350

 
0.67
%
 
1.03
%
(Table 19 and notes continued on next page.)


62


(Table 19 - continued.)
 
Principal Balance of Borrowing
 
Fair Value of Collateral Pledged(1)
 
Weighted Average Cost of Funds
 
Effective Cost of Funds(2)
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
 
$
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
 
$
2,631,101

 
$
2,847,057

 
0.53
%
 
0.84
%
March 31, 2012:
 
 
 
 
 
 
 
 
Agency RMBS repurchase borrowings
 
$
1,040,848

 
$
1,094,737

 
0.36
%
 
0.66
%
Non-Agency RMBS repurchase borrowings
 
130,329

 
180,201

 
1.97

 
1.97

Total
 
$
1,171,177

 
$
1,274,938

 
0.50
%
 
0.77
%
(1) 
Includes cash collateral pledged for Agency RMBS and non-Agency RMBS. (See Note 8 - Collateral Positions to the consolidated financial statements included under ITEM 8 of this annual report on Form 10-K.)
(2) 
The effective cost of funds for the quarterly periods are calculated on an annualized basis and adjusts interest expense to include the net interest component for Swaps. (See “Non-GAAP Financial Measures,” below.)
(3) 
At December 31, 2013 and September 30, 2013, other investments were comprised of STACR Notes.
(4) 
Repurchase agreements collateralized by securitized mortgage loans represent borrowings associated with non-Agency RMBS acquired in connection with our February 2013 securitization transaction. Such non-Agency RMBS are eliminated in consolidation with the VIE associated with the securitization and as a result are not included in our consolidated balance sheet. (See Notes 5 - Securitized Mortgage Loans and 13 - Use of Special Purpose Entities to the consolidated financial statements included under ITEM 8 of this annual report on Form 10-K.)
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 December 31, 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% to a high of 50% 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 subject us to financial covenants. An event of default or termination event would give certain of our counterparties the option to terminate all existing repurchase transactions with us and require amounts due to the counterparties by us to be payable immediately. We were in compliance with all of our financial covenants at December 31, 2013. At December 31, 2013, RMBS pledged as collateral to lenders as security for repurchase agreements totaled $3,382,017 and, and RMBS held as a component of clearing margin totaled $4,059. Cash collateral held by counterparties at December 31, 2013 was $67,458, and is reported on our balance sheet as “restricted cash,” and was comprised of $64,908 provided in connection with repurchase borrowings and $2,550 provided in connection with Swaps.
Cash Flows and Liquidity for the Year Ended December 31, 2013
Our cash and cash equivalents decreased by $21,617 during the year ended December 31, 2013, reflecting $510,814 used by financing activities, $88,994 provided by operating activities and $400,203 provided by investing activities. We held cash of $127,959 at December 31, 2013. (See “Consolidated Statements of Cash Flows,” included under ITEM 8 of this annual report on Form 10-K.)



63


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 the periods presented:
Table 20
 
 
 
 
 
 
 
 
 
 
December 31, 2013
 
Less than 1
year
 
1 to 3 years
 
3 to 5
years
 
More than
5 years
 
Total
Borrowings under repurchase agreements
 
$
3,028,325

 
$
5,733

 
$
—

 
$
—

 
$
3,034,058

Interest on repurchase agreements borrowings(1)
 
12,632

 
176

 
—

 
—

 
12,808

Total
 
$
3,040,957

 
$
5,909

 
$
—

 
$
—

 
$
3,046,866

(1) 
Interest expense is calculated based on the interest rate in effect at December 31, 2013 and includes all interest expense incurred and expected to be incurred in the future through the contractual maturity of the associated repurchase agreement.
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 - Commitments and Contingencies and 15 - Stockholders’ Equity to the consolidated financial statements included under ITEM 8 of this annual report on Form 10-K for a discussion with respect to our Management Agreement and Preferred Stock.) At December 31, 2013, we had securitized debt with a balance of $42,400 (and a fair value of $43,354) with a contractual interest rate of 4.00%. Our securitized debt is not included in the table above, as such debt is non-recourse to us and is only paid to the extent that the mortgage loans (in the securitization trust) collateralizing the debt pay.
Management Agreement
Pursuant to 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 adjusted stockholders’ equity, as defined in the Management Agreement, per annum. Our management fee is used, in part, to pay compensation to officers and personnel of the Manager who may also be our officers, but 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/Treasurer/Secretary based on the percentage of their 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, 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 generally on a monthly basis in arrears. 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. We did not provide notice of termination of the Management Agreement to our Manager and, as a result, the term of the Management Agreement was automatically extended to July 27, 2015, with automatic one year renewals 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.
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.




64


Dividends on Our Capital Stock
We had outstanding 6,900,000 shares of Preferred Stock, which entitles holders to receive dividends at an annual rate of 8.0% of the liquidation preference of $25.00 per share, or $2.00 per share per annum. The dividends on 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 a redemption price of $25.00, 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 at least 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 debts payable. 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. (See “Variances between GAAP Income and Taxable Income,” above.)
Non-GAAP Financial Measures
We have included in this Form 10-K disclosures about our “operating earnings,” “operating earnings per common share” and “effective cost of funds” 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 the Company to more assess the results of our core business, which is to invest in mortgage assets on a levered basis using interest rate derivatives to protect us against increases in our borrowing rates.
While we have not elected hedge accounting under GAAP for our Swaps, such derivative instruments are viewed by us as an economic hedge against increases in future market interest rates. To present for investors how we view our Swaps, we provide the “effective cost of funds” which is comprised of GAAP interest expense plus the interest expense component for our Swaps. The interest expense component of our Swaps reflects the net interest payments made or accrued on our Swaps.
We believe that the non-GAAP measures we present provide investors and other readers of our annual report on Form 10-K 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/(losses) from investments and Swaps. 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.


65


A reconciliation of the GAAP items discussed above to their non-GAAP measures presented in this annual report on Form 10-K are as follows:
Table 21
 
Year Ended
 
 
 
 
December 31, 2013
 
December 31, 2012
 
For the Period From July 27, 2011 through December 31, 2011
 
 
Reconciliation
 
Cost of Funds/Effective Cost of Funds
 
Reconciliation
 
Cost of Funds/
Effective Cost of Funds
 
Reconciliation
 
Cost of Funds/Effective Cost of Funds
Interest expense
 
$
27,602

 
0.79
%
 
$
14,631

 
0.61
%
 
$
1,138

 
0.52
%
Adjustment:
 
 
 
 
 
 
 
 
 
 
 
 
Net interest component of Swaps
 
22,034

 
0.63
%
 
7,805

 
0.33
%
 
715

 
0.33
%
Effective cost of funds
 
$
49,636

 
1.42
%
 
$
22,436

 
0.94
%
 
$
1,853

 
0.85
%
Weighted average balance of borrowings
 
$
3,501,312

 
 
 
$
2,377,431

 
 
 
$
509,795

 
 
Table 22
 
Year Ended
 
 
 
 
December 31, 2013
 
December 31, 2012
 
For the Period From July 27, 2011 through December 31, 2011
 
 
Reconciliation
 
Cost of Funds/Effective Cost of Funds/Spread
 
Reconciliation
 
Cost of Funds/Effective Cost of Funds/Spread
 
Reconciliation
 
Cost of Funds/Effective Cost of Funds/Spread
Interest income
 
$
154,713

 
3.81
%
 
$
33,578

 
3.58
%
 
$
10,733

 
4.00
%
Less: effective interest expense/effective cost of funds(1)
 
49,636

 
1.42
%
 
22,436

 
0.94
%
 
1,853

 
0.85
%
Effective net interest income
 
$
105,077

 
2.39
%
 
$
11,142

 
2.64
%
 
$
8,880

 
3.15
%
Weighted average balance of interest earning assets
 
$
4,058,509

 
 
 
$
2,693,526

 
 
 
$
608,822

 
 
(1)
As reconciled above in Table 21.
Table 23
 
Reconciliation of Interest Expense to Effective Cost of  Funds for the Quarterly Periods Presented
 
 
 
 
GAAP
 
Adjustment
 
Non-GAAP
 
 
Weighted Average Balance of Borrowings
 
Interest
Expense
 
Cost of
Funds
 
Net Interest
Component of
Swaps
 
Effective Cost
of Borrowings
 
Effective
Cost of
Funds
2013:
 
 
 
 
 
 
 
 
 
 
 
 
December 31
 
$
2,995,533

 
$
7,358

 
0.96
%
 
$
4,564

 
$
11,922

 
1.56
%
September 30
 
$
3,013,372

 
$
6,789

 
0.89
%
 
$
6,894

 
$
13,683

 
1.80
%
June 30
 
$
4,308,870

 
$
7,237

 
0.67
%
 
$
6,437

 
$
13,674

 
1.27
%
March 31
 
$
3,698,371

 
$
6,217

 
0.68
%
 
$
4,139

 
$
10,356

 
1.14
%
2012:
 
 
 
 
 
 
 
 
 
 
 
 
December 31
 
$
3,601,907

 
$
6,110

 
0.67
%
 
$
3,220

 
$
9,330

 
1.03
%
September 30
 
$
2,625,055

 
$
4,289

 
0.65
%
 
$
2,075

 
$
6,364

 
0.96
%
June 30
 
$
2,192,868

 
$
2,871

 
0.53
%
 
$
1,762

 
$
4,633

 
0.84
%
March 31
 
$
1,099,145

 
$
1,361

 
0.50
%
 
$
749

 
$
2,110

 
0.77
%
2011:
 
 
 
 
 
 
 
 
 
 
 
 
December 31
 
$
782,835

 
$
995

 
0.50
%
 
$
600

 
$
1,595

 
0.81
%
September 30
 
$
129,194

 
$
143

 
0.62
%
 
$
115

 
$
258

 
1.12
%


66


The following table provides a reconciliation of our operating earnings to our net income/(loss) reported in accordance with GAAP for the periods presented:
Table 24
 
Year Ended
 
 
 
 
December 31, 2013
 
December 31, 2012
 
For the Period From July 27, 2011 through December 31, 2011
Net income/(loss) allocable to common stockholders
 
$
(61,416
)
 
$
167,123

 
$
4,451

Adjustments to arrive at operating earnings:
 
 
 
 
 
 
Realized (gain)/loss on sale of RMBS, net
 
66,850

 
(39,817
)
 
(885
)
Unrealized (gain)/loss on RMBS, net
 
147,375

 
(100,402
)
 
(2,482
)
Unrealized (gain)/loss on derivative contracts, net
 
(50,373
)
 
20,151

 
3,246

Unrealized (gain) on securitized mortgage loans
 
(3,950
)
 
—

 
—

Unrealized loss on securitized debt
 
954

 
—

 
—

Unrealized (gain) on other investment securities
 
(335
)
 
—

 
—

Non-cash stock-based compensation expense
 
1,047

 
444

 
143

Realized (gain)/loss on Swap and Swaption terminations, net
 
(30,956
)
 
4,709

 
—

Realized (gain) on TBA Short Contracts
 
(281
)
 
—

 
—

Preferred dividend declared related to future period
 
—

 
1,150

 
—

Total adjustments to arrive at operating earnings
 
130,331

 
(113,765
)
 
22

Operating earnings
 
$
68,915

 
$
53,358

 
$
4,473

Basic and diluted operating earnings per share of common stock
 
$
2.26

 
$
2.67

 
$
0.44

Basic and diluted weighted average common shares outstanding
 
30,444

 
19,984

 
10,301



67


ITEM 7A.
Quantitative and Qualitative Disclosures about Market Risk
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 returns 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 residential 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 the substantial majority of our non-Agency RMBS at a discount to par value, which is expected to further mitigate 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 losses. 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 December 31, 2013. Information presented with respect to weighted average loan to value, weighted average Fair Isaac Corporation (or, FICO) 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 25
 
Year of Origination
 
 
2008
 
2007
 
2006
 
2005
 
2004 & Prior
 
Total
Portfolio Characteristics:
 
 
 
 
 
 
 
 
 
 
 
 
Number of loans
 
69

 
646

 
14

 
6

 
2

 
737

Current unpaid principal balance
 
$
14,372

 
$
130,253

 
$
2,735

 
$
1,177

 
$
140

 
$
148,677

Loan Attributes:
 
 
 
 
 
 
 
 
 
 
 
 
Weighted average loan age (in months)
 
69

 
78

 
84

 
101

 
113

 
77

Weighted average original loan-to-value
 
74.59
%
 
79.83
%
 
81.80
%
 
80.58
%
 
100.00
%
 
79.39
%
Weighted average original FICO
 
600

 
632

 
625

 
610

 
668

 
628

Net weighted average coupon rate
 
6.99
%
 
5.69
%
 
5.62
%
 
6.00
%
 
7.74
%
 
5.82
%
Current Performance:
 
 
 
 
 
 
 
 
 
 
 
 
Current
 
63.06
%
 
74.00
%
 
78.83
%
 
100.00
%
 
—
%
 
73.19
%
30 day delinquent
 
17.93
%
 
11.26
%
 
5.13
%
 
—
%
 
56.28
%
 
11.74
%
60 days delinquent
 
3.90
%
 
3.69
%
 
11.23
%
 
—
%
 
43.72
%
 
3.85
%
90+ days delinquent
 
9.69
%
 
5.96
%
 
—
%
 
—
%
 
—
%
 
6.15
%
Bankruptcy/foreclosure
 
5.42
%
 
5.09
%
 
4.81
%
 
—
%
 
—
%
 
5.07
%


68


The following table presents information about our non-Agency RMBS and the mortgages underlying such securities at December 31, 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 26
 
Year of Securitization(1)
 
 
 
 
2007
 
2006
 
2005
 
2004
 
2003 & Prior
 
Total
Portfolio Characteristics:
 
 
 
 
 
 
 
 
 
 
 
 
Number of Securities
 
16

 
33

 
61

 
66

 
41

 
217

Carrying Value/Estimated Fair Value
 
$
112,984

 
$
224,164

 
$
345,948

 
$
387,224

 
$
142,469

 
$
1,212,789

Amortized Cost
 
$
101,708

 
$
200,088

 
$
324,762

 
$
373,267

 
$
135,355

 
$
1,135,180

Current Par Value
 
$
139,519

 
$
289,338

 
$
425,557

 
$
428,584

 
$
155,009

 
$
1,438,007

Carrying Value to Current Par
 
80.98
%
 
77.47
%
 
81.29
%
 
90.35
%
 
91.91
%
 
84.34
%
Amortized Cost to Current Par
 
72.90
%
 
69.15
%
 
76.31
%
 
87.09
%
 
87.32
%
 
78.94
%
Net Weighted Average Coupon
 
1.83
%
 
0.59
%
 
1.11
%
 
1.34
%
 
1.92
%
 
1.24
%
Collateral Attributes:
 
 
 
 
 
 
 
 
 
 
 
 
Weighted Average Loan Age (in months)
 
82

 
93

 
104

 
114

 
134

 
107

Weighted Average Original Loan-to-Value
 
77.22
%
 
79.08
%
 
78.80
%
 
79.69
%
 
80.51
%
 
79.19
%
Weighted Average Original FICO
 
667

 
649

 
632

 
619

 
617

 
632

Current Performance:
 
 
 
 
 
 
 
 
 
 
 
 
60+ Day Delinquencies
 
31.99
%
 
33.29
%
 
33.13
%
 
27.53
%
 
27.68
%
 
30.63
%
Average Credit Enhancement(2)
 
19.93
%
 
23.70
%
 
35.80
%
 
44.22
%
 
27.20
%
 
33.76
%
3 Month CPR(3)
 
3.23
%
 
2.83
%
 
4.30
%
 
4.80
%
 
3.36
%
 
4.00
%
(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.
(3) 
Information is based on loans for individual groups owned by us. Amounts presented reflect the weighted average monthly performance for the year ended December 31, 2013.
The following table presents the fair value of our non-Agency RMBS at December 31, 2013, by original purchase price as a percentage of our par value by year of acquisition:
Table 27
 
Year of Acquisition
Acquisition Price(1)
 
2011
 
2012
 
2013
 
Total
 
Percent of Total
>100%
 
$
—

 
$
—

 
$
16,070

 
$
16,070

 
1.3
%
100%-95%
 
—

 
525

 
46,535

 
47,060

 
3.9

<95% to 85%
 
5,256

 
53,210

 
390,184

 
448,650

 
37.0

<85% to 75%
 
15,973

 
118,595

 
186,977

 
321,545

 
26.5

<75% to 65%
 
19,669

 
91,677

 
68,374

 
179,720

 
14.8

<65%
 
24,746

 
166,252

 
8,746

 
199,744

 
16.5

Total
 
$
65,644

 
$
430,259

 
$
716,886

 
$
1,212,789

 
100.0
%
(1)
Prices are expressed as a percentage of par value.


69


The mortgages underlying our non-Agency RMBS are located in various geographic regions across the U.S. The following table presents the five largest geographic concentrations of the mortgages collateralizing our non-Agency RMBS at December 31, 2013 based on fair value:
Table 28
 
 
Property Location
 
Percent(1)
California
 
24.9
%
New York
 
9.8

Florida
 
8.6

Texas
 
6.6

New Jersey
 
3.8

Other(2)
 
46.3

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 state concentration exceeding 3.3% of the total.
The following table presents certain information about the mortgage loans underlying our non-Agency RMBS at December 31, 2013:
Table 29
 
 
 
 
Underlying Mortgage Loan Collateral Type
 
Market Value
 
Percent of Total
Subprime
 
$
964,740

 
79.5
%
Alt-A
 
139,425

 
11.5

Option ARMs
 
108,624

 
9.0

Total
 
$
1,212,789

 
100.0
%
To the extent we invest in residential mortgage loans, we may retain the risk of potential credit losses on the mortgage loans that we hold in our portfolio. With respect to any residential mortgage loans in which we may invest, we expect to seek to obtain representations and warranties from each seller stating that each loan was underwritten to our requirements or, in the event underwriting exceptions were made, that we are informed of the exceptions so that we may evaluate whether to accept or reject the loans. A seller who breaches these representations and warranties in making a loan that we purchase may be obligated to repurchase the loan from us. In the event we invest in residential mortgage loans, our Manager will seek to reduce downside risk related to unanticipated credit events through the use of active asset surveillance to evaluate collateral pool performance and will proactively manage positions.
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 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 investment assets 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


70


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 RMBS are collateralized by ARMs, which are generally subject to interest rate caps, which could cause such 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 derivative instruments.
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 estimated fair value of these securities fluctuates 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.
Nearly all of our pass-through Agency RMBS, which comprise the substantial majority of our Agency portfolio, are fixed-income securities. In general, as market interest rates increase the market prices for fixed-income securities generally decrease; conversely, as market interest rates decrease the market prices for fixed-income securities generally increase. 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 that we believe is prudent in the current or anticipated interest rate environment. In a rising interest rate environment, the weighted average life of our Agency RMBS could extend significantly beyond the terms of our Swaps or other hedging instruments. 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 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


71


rate derivatives, and net interest income at December 31, 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. For example, given the low level of interest rates at December 31, 2013, we have assumed a floor on repurchase agreement borrowing rates of 25 basis points and we have assumed a floor of six basis points with respect to the variable rate that we receive on our Swaps.
Table 30
 
 
 
 
Basis Point Change in Interest Rates
 
Percentage Change in Projected Portfolio
Value
 
Percentage Change in Projected Net Interest Income and Periodic Interest Settlements for Swaps
+100
 
2.08%
 
(2.50)%
+50
 
0.84%
 
(0.57)%
(50)
 
(0.54)%
 
(5.00)%
(100)
 
(1.08)%
 
(11.98)%
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 December 31, 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 rates on residential mortgage loans. 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 accrued interest receivable on such collateral. For additional information about our assets pledged as collateral as of December 31, 2013, see Note 8 - Collateral Positions to the consolidated financial statements included under ITEM 8 of this annual report on Form 10-K.
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 Contracts to the extent that we are not able to recover our 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 and could lose the amount by which the Swaption is in-the-money.


72


During the past several years, certain repurchase agreement and Swap counterparties in the U.S. and Europe have experienced financial difficulty and have been either rescued by government assistance or otherwise benefited from accommodative monetary policy of their respective central banks.
The following table summarizes our exposure to our repurchase agreements and derivative counterparties at December 31, 2013:
Table 31
 
Number of
Counterparties
 
Repurchase
Agreement
Borrowings
 
Swaps &
Swaption at
Fair Value
 
Exposure(1)
 
Exposure as
Percent of
Total Assets
North America:
 
 
 
 
 
 
 
 
 
 
U.S.
 
7

 
$
1,339,163

 
$
39,689

 
$
205,936

 
5.3
%
Canada(2)
 
2

 
464,574

 
—

 
85,500

 
2.2
%
 
 
9

 
1,803,737

 
39,689

 
291,436

 
7.5
%
Europe:(2)
 
 
 
 
 
 
 
 
 
 
Germany
 
1

 
103,237

 
—

 
7,933

 
0.2
%
Switzerland
 
1

 
113,573

 
—

 
32,826

 
0.8
%
United Kingdom
 
2

 
381,684

 
(1,966
)
 
77,796

 
2.0
%
Netherlands
 
1

 
189,631

 
—

 
9,852

 
0.3
%
 
 
5

 
788,125

 
(1,966
)
 
128,407

 
3.3
%
Asia:(2)
 
 
 
 
 
 
 
 
 
 
Japan
 
3

 
442,196

 
10,982

 
24,265

 
0.6
%
Total Counterparty Exposure
 
17

 
$
3,034,058

 
$
48,705

 
$
444,108

 
11.4
%
(1) 
Represents the amount of cash and/or securities pledged as collateral to counterparties less the aggregate of repurchase agreement borrowings, the unrealized loss on Swaps for each counterparty net of collateral pledged and the fair value of our Swaption.
(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 December 31, 2013, we had cash of $127,959 primarily comprised of cash on deposit with our prime broker that is domiciled in the U.S. Substantially all of our cash deposits exceeded applicable insurance limits.
We had outstanding balances under repurchase agreements with 17 counterparties at December 31, 2013. The following table presents information with respect to any counterparty for repurchase agreements for which we had greater than 5% of stockholders’ equity at risk in the aggregate at December 31, 2013:
Table 32
 
 
 
 
 
 
 
 
Counterparty
 
Counterparty Rating(1)
 
Amount of Risk(2)
 
Weighted Average Months to Maturity for Repurchase Agreements
 
Percent of Stockholders’ Equity
J.P. Morgan Securities LLC
 
A+/Aa3/A+
 
$
74,597

 
2

 
9.8
%
Royal Bank of Scotland PLC
 
A-/A3/A
 
$
57,083

 
1

 
7.5
%
Royal Bank of Canada
 
AA-/Aa3/AA
 
$
77,453

 
2

 
10.2
%
Wells Fargo(3)
 
AA-/Aa3/AA-
 
$
85,656

 
8

 
11.3
%
(1)
The counterparty rating presented is the long-term issuer credit rating as rated at December 31, 2013 by S&P, Moody’s and Fitch, Inc., respectively. 
(2)
The amount at risk reflects the difference between (a) the amount loaned to us through repurchase agreements, including interest payable, and (b) the cash and the fair value of the securities pledged by us as collateral, including accrued interest receivable on such securities.
(3) 
Includes amounts at risk with Wells Fargo Bank, N.A. and Wells Fargo Securities, LLC. Counterparty rating is the rating for Wells Fargo Bank, N.A. which represents $74,140 of the total exposure. The remaining exposure is to Wells Fargo Securities, LLC which was rated AA- by S&P as of December 31, 2013.
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


73


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.
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 does 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.


74


ITEM 8.
Financial Statements and Supplementary Data
Index to Consolidated Financial Statements and Schedule
All other schedules are omitted because they are not required or the required information is shown in the financial statements or notes thereto.


75


REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of
Apollo Residential Mortgage, Inc.
New York, New York
We have audited the accompanying consolidated balance sheets of Apollo Residential Mortgage, Inc. and subsidiaries (the “Company”) as of December 31, 2013 and 2012 and the related consolidated statements of operations, change in stockholders’ equity, and cash flows for the years ended December 31, 2013, 2012 and for the period from July 27, 2011 (commencement of operations) to December 31, 2011. We also have audited the Company’s internal control over financial reporting as of December 31, 2013, based on criteria established in Internal Control - Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission. The Company’s management is responsible for these financial statements, for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting, included in the accompanying Management Report on Internal Control over Financial Reporting. Our responsibility is to express an opinion on these financial statements and an opinion on the Company’s internal control over financial reporting based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement and whether effective internal control over financial reporting was maintained in all material respects. Our audits of the financial statements included examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, and evaluating the overall financial statement presentation. Our audit of internal control over financial reporting included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audits also included performing such other procedures as we considered necessary in the circumstances. We believe that our audits provide a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of Apollo Residential Mortgage, Inc. and subsidiaries as of December 31, 2013 and 2012 and the results of their operations and their cash flows for years ended December 31, 2013, 2012 and for the period from July 27, 2011 (commencement of operations) to December 31, 2011, in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2013, based on the criteria established in Internal Control - Integrated Framework (1992) issued by the Committee of Sponsoring Organizations of the Treadway Commission.

/s/ DELOITTE & TOUCHE LLP

New York, New York
February 20, 2014



76
Apollo Residential Mortgage, Inc. and Subsidiaries
Consolidated Balance Sheets
(in thousands - except share and per share data)


 
 
December 31, 2013
 
December 31, 2012
Assets:
 
 
 
 
Cash
 
$
127,959

 
$
149,576

Restricted cash
 
67,458

 
93,641

Residential mortgage-backed securities, at fair value (of which $3,317,060 and $3,940,913 pledged as collateral, respectively)
 
3,503,326

 
4,231,291

Securitized mortgage loans (transferred to a consolidated variable interest entity), at fair value
 
110,984

 
—

Other investment securities, at fair value (of which $11,515 and $0 pledged as collateral, respectively)
 
11,515

 
—

Investment related receivable (of which $21,959 and $0 pledged as collateral, respectively)
 
24,887

 
—

Interest receivable
 
10,396

 
11,341

Deferred financing costs, net
 
882

 
346

Derivative instruments, at fair value
 
53,315

 
750

Other assets
 
854

 
976

Total Assets
 
$
3,911,576

 
$
4,487,921

 
 
 
 
 
Liabilities and Stockholders’ Equity
 
 
 
 
Liabilities:
 
 
 
 
Borrowings under repurchase agreements
 
$
3,034,058

 
$
3,654,436

Non-recourse securitized debt, at fair value
 
43,354

 
—

Investment related payable
 
—

 
50,032

Obligation to return cash held as collateral
 
38,654

 
—

Accrued interest payable
 
8,708

 
6,774

Derivative instruments, at fair value
 
4,610

 
23,184

Payable to related party
 
5,444

 
4,295

Dividends payable
 
16,812

 
30,675

Accounts payable and accrued expenses
 
2,335

 
1,742

Total Liabilities
 
$
3,153,975

 
$
3,771,138

 
 
 
 
 
Commitments and Contingencies (Note 12)
 

 

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

 
$
69

Common stock, $0.01 par value, 450,000,000 shares authorized, 32,038,970 and 24,205,972 shares issued and outstanding, respectively
 
320

 
242

Additional paid-in capital
 
792,010

 
619,399

Retained earnings/(accumulated deficit)
 
(34,798
)
 
97,073

Total Stockholders’ Equity
 
$
757,601

 
$
716,783

Total Liabilities and Stockholders’ Equity
 
$
3,911,576

 
$
4,487,921


See notes to consolidated financial statements.
77
Apollo Residential Mortgage, Inc. and Subsidiaries
Consolidated Statements of Operations
(in thousands - except per share data)


 
 
Year Ended
 
 
 
 
December 31, 2013
 
December 31, 2012
 
For the Period From July 27, 2011 through
December 31, 2011
Interest income
 
 
 
 
 
 
Residential mortgage-backed securities
 
$
146,263

 
$
94,369

 
$
10,733

Securitized mortgage loans
 
8,267

 
—

 
—

Other investment securities
 
183

 
—

 
—

Total interest income
 
154,713

 
94,369

 
10,733

Interest expense
 
 
 
 
 
 
Repurchase agreements
 
(25,808
)
 
(14,631
)
 
(1,138
)
Securitized debt
 
(1,794
)
 
—

 
—

Total interest expense
 
(27,602
)
 
(14,631
)
 
(1,138
)
 
 
 
 
 
 
 
Net interest income
 
127,111

 
79,738

 
9,595

 
 
 
 
 
 
 
Other income/(loss):
 
 
 
 
 
 
Realized gain/(loss) on sale of residential mortgage-backed securities, net
 
(66,850
)
 
39,817

 
885

Unrealized gain/(loss) on residential mortgage-backed securities, net
 
(147,375
)
 
100,402

 
2,482

Unrealized (loss) on securitized debt
 
(954
)
 
—

 
—

Unrealized gain on securitized mortgage loans
 
3,950

 
—

 
—

Unrealized gain on other investment securities
 
335

 
—

 
—

Gain/(loss) on derivative instruments, net (includes $50,373, ($20,151) and ($3,246) of unrealized gains/(losses), respectively)
 
59,576

 
(32,665
)
 
(3,876
)
Other, net
 
76

 
48

 
2

Other income/(loss), net
 
(151,242
)
 
107,602

 
(507
)
 
 
 
 
 
 
 
Operating expenses:
 
 
 
 
 
 
General and administrative (includes ($1,047), ($444) and ($143) of non-cash stock based compensation, respectively)
 
(11,501
)
 
(7,780
)
 
(3,283
)
Management fee - related party
 
(11,579
)
 
(6,804
)
 
(1,333
)
Total operating expenses
 
(23,080
)
 
(14,584
)
 
(4,616
)
 
 
 
 
 
 
 
Net income/(loss)
 
$
(47,211
)
 
$
172,756

 
$
4,472

Preferred stock dividends declared
 
(13,800
)
 
(5,022
)
 
—

Net income/(loss) allocable to common stock and participating securities
 
$
(61,011
)
 
$
167,734

 
$
4,472

Earnings/(loss) per common share - basic and diluted
 
$
(2.02
)
 
$
8.36

 
$
0.43


See notes to consolidated financial statements.
78
Apollo Residential Mortgage, Inc. and Subsidiaries
Consolidated Statements of Changes in Stockholders’ Equity
(in thousands - except share data)


 
 
Preferred Stock
 
Common Stock
 
Additional
Paid-In
Capital
 
Retained
Earnings
 
Total
 
Shares
 
Par
 
Shares
 
Par
 
Balance at July 27, 2011 (commencement of operations)
 
—

 
$
—

 
—

 
$
—

 
$
1

 
$
—

 
$
1

Redemption of common stock
 
—

 
—

 
—

 
—

 
(1
)
 
—

 
(1
)
Issuance of common stock, net of expenses
 
—

 
—

 
10,000,000

 
100

 
197,961

 
—

 
198,061

Proceeds from private placement of common stock
 
—

 
—

 
250,000

 
3

 
4,997

 
—

 
5,000

Grant of restricted stock to independent directors
 
—

 
—

 
20,000

 
—

 
—

 
—

 
—

Issuance of common stock in settlement of vested restricted stock units
 
—

 
—

 
1,562

 
—

 
—

 
—

 
—

Equity based compensation expense
 
—

 
—

 
—

 
—

 
143

 
—

 
143

Net income
 
—

 
—

 
—

 
—

 
—

 
4,472

 
4,472

Dividends declared on common stock
 
—

 
—

 
—

 
—

 
—

 
(3,090
)
 
(3,090
)
Balance at December 31, 2011
 
—

 
—

 
10,271,562

 
103

 
203,101

 
1,382

 
204,586

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Issuance of common stock, net of expenses
 
—

 
—

 
13,900,000

 
139

 
249,351

 
—

 
249,490

Issuance of preferred stock, net of expenses
 
6,900,000

 
69

 
—

 
—

 
166,503

 
—

 
166,572

Grant of restricted stock to independent directors
 
—

 
—

 
28,160

 
—

 
—

 
—

 
—

Settlement of vested restricted stock units in common stock
 
—

 
—

 
6,250

 
—

 
—

 
—

 
—

Equity based compensation expense
 
—

 
—

 
—

 
—

 
444

 
—

 
444

Net income
 
—

 
—

 
—

 
—

 
—

 
172,756

 
172,756

Dividends declared on common stock
 
—

 
—

 
—

 
—

 
—

 
(72,043
)
 
(72,043
)
Dividends declared on preferred stock
 
—

 
—

 
—

 
—

 
—

 
(5,022
)
 
(5,022
)
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

 
171,564

 
—

 
171,642

Grant of restricted stock to independent directors
 
—

 
—

 
6,748

 
—

 
—

 
—

 
—

Settlement of vested restricted stock units in common stock
 
—

 
—

 
6,250

 
—

 
—

 
—

 
—

Equity based compensation expense
 
—

 
—

 
—

 
—

 
1,047

 
—

 
1,047

Net income
 
—

 
—

 
—

 
—

 
—

 
(47,211
)
 
(47,211
)
Dividends declared on common stock
 
—

 
—

 
—

 
—

 
—

 
(70,860
)
 
(70,860
)
Dividends declared on preferred stock
 
—

 
—

 
—

 
—

 
—

 
(13,800
)
 
(13,800
)
Balance at December 31, 2013
 
6,900,000

 
$
69

 
32,038,970

 
$
320

 
$
792,010

 
$
(34,798
)
 
$
757,601


See notes to consolidated financial statements.
79
Apollo Residential Mortgage, Inc. and Subsidiaries
Consolidated Statements of Cash Flows
(in thousands)


 
 
Year Ended
 
 
 
 
2013
 
2012
 
For the Period From July 27, 2011 through
December 31, 2011
Cash Flows from Operating Activities:
 
 
 
 
 
 
Net income/(loss)
 
$
(47,211
)
 
$
172,756

 
$
4,472

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


 


 

Premium amortization/(discount accretion), net
 
392

 
5,571

 
(820
)
Amortization of deferred financing costs
 
379

 
297

 
77

Equity based compensation expense
 
1,047

 
444

 
143

Unrealized (gain)/loss on mortgage-backed securities, net
 
147,375

 
(100,402
)
 
(2,482
)
Unrealized (gain) on securitized mortgage loans
 
(3,950
)
 
—

 
—

Unrealized (gain)/loss on derivative instruments, net
 
(50,373
)
 
20,151

 
3,246

Unrealized loss on securitized debt
 
954

 
—

 
—

Unrealized (gain) on other investment securities
 
(335
)
 
—

 
—

Realized (gain) on sales of mortgage-backed securities
 
(42,344
)
 
(40,239
)
 
(911
)
Realized loss on sales of mortgage-backed securities
 
109,194

 
422

 
26

Realized (gain) on derivative instruments
 
(31,236
)
 
—

 
—

Changes in operating assets and liabilities:
 


 


 

(Increase)/decrease in accrued interest receivable, less purchased interest
 
926

 
(7,384
)
 
(3,957
)
(Increase)/decrease in other assets
 
125

 
(401
)
 
(370
)
Increase in accrued interest payable
 
1,934

 
5,651

 
1,123

Increase/(decrease) in accounts payable and accrued expenses
 
888

 
(106
)
 
1,534

Increase in payable to related party
 
1,229

 
2,415

 
1,562

Net cash provided by operating activities
 
$
88,994

 
$
59,175

 
$
3,643

Cash Flows from Investing Activities:
 
 
 
 
 
 
Purchases of mortgage-backed securities
 
$
(3,534,147
)
 
$
(5,050,601
)
 
$
(1,327,521
)
Proceeds from sales of mortgage-backed securities
 
3,601,684

 
1,958,182

 
114,432

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

 
—

Purchase of other investment securities
 
(12,000
)
 
—

 
—

(Increase)/decrease in restricted cash related to investing activities
 
30,844

 
(28,558
)
 
—

Increase in collateral held related to investing activities
 
38,654

 
—

 
—

Principal payments received on mortgage-backed securities
 
370,844

 
236,749

 
26,334

Principal payments received on securitized mortgage loans
 
6,038

 
—

 
—

Principal payments received on other investment securities
 
820

 
—

 
—

Proceeds from sale of derivative instruments
 
34,153

 
—

 
—

Purchase of interest rate swaptions
 
(23,682
)
 
(964
)
 
—

Other, net
 
33

 
—

 
—

Net cash provided/(used) in investing activities
 
$
400,203

 
$
(2,885,192
)
 
$
(1,186,755
)
Cash Flows from Financing Activities:
 
 
 
 
 
 
Proceeds from repurchase agreement borrowings
 
$
18,734,904

 
$
13,459,366

 
$
1,944,678

Repayments of repurchase agreement borrowings
 
(19,355,283
)
 
(10,839,909
)
 
(909,698
)
(Increase) in restricted cash related to financing activities
 
(4,661
)
 
(54,681
)
 
(10,402
)
Proceeds from issuance of securitized debt
 
50,375

 
—

 
—

Principal payments on securitized debt
 
(7,975
)
 
—

 
—

Payments made for securitization/deferred financing costs
 
(826
)
 
—

 
—

Dividends paid on preferred stock
 
(15,372
)
 
—

 
—

Proceeds from issuance of preferred stock
 
—

 
172,500

 
—

Dividends paid on common stock
 
(83,151
)
 
(49,480
)
 
—

Proceeds from issuance of common stock
 
172,040

 
250,200

 
205,000

Redemption of common stock
 
—

 
—

 
(1
)
Payment of costs to issue preferred and common stock
 
(825
)
 
(6,582
)
 
(1,567
)
Deferred financing costs/offering costs expensed/(incurred) net
 
(40
)
 
(228
)
 
(492
)
Net cash provided/(used) by financing activities
 
$
(510,814
)
 
$
2,931,186

 
$
1,227,518

Net increase/(decrease) in cash
 
$
(21,617
)
 
$
105,169

 
$
44,406

Cash at beginning of period
 
149,576

 
44,407

 
1

Cash at end of period
 
$
127,959

 
$
149,576

 
$
44,407

Supplemental Disclosure of Operating Cash Flow Information:
 
 
 
 
 
 
Interest paid
 
$
25,769

 
$
9,643

 
$
1,657

Supplemental disclosure of non-cash financing/investing activities:
 
 
 
 
 
 
Residential mortgage-backed securities (purchased)/sold not settled, net
 
$
22,003

 
$
(50,032
)
 
$
49,530

Due from broker
 
$
2,909

 
$
—

 
$
—

Dividends and dividend equivalent rights declared, not yet paid
 
$
16,812

 
$
30,675

 
$
3,090

Payable for issuance of preferred and common stock
 
$
—

 
$
477

 
$
372

Deferred financing costs not yet paid
 
$
18

 
$
155

 
$
40


See notes to consolidated financial statements.
80
Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands - except per share data)

In these consolidated financial statements 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 United States (or, U.S.) Government, such as Ginnie Mae; “RMBS” refer to residential mortgage-backed securities, “Agency RMBS” refer to RMBS issued or guaranteed by an Agency 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; “Hybrids” refer to mortgage loans that have fixed interest rates for a period of time and, thereafter generally adjust annually based on an increment over a specified interest rate index; “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 Short Contracts” refer to TBA Contracts for which we would be required to sell certain Agency RMBS on a forward 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 U.S. Through December 31, 2013, our asset portfolio consisted of Agency RMBS, including Agency IOs and Agency Inverse IOs, non-Agency RMBS, securitized mortgage loans and other investment securities. 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
We currently operate as one business segment. The consolidated financial statements include our accounts and those of our consolidated subsidiaries. All intercompany amounts have been eliminated in consolidation. The preparation of financial statements in conformity with accounting principles generally accepted in the U.S. (or, GAAP) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ materially from those estimates.
(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 December 31, 2013, 2012 and 2011, our cash and cash equivalents were primarily comprised of cash on deposit with our prime broker (which is domiciled in the U.S.) substantially all of which were 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.


81
Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands - except per share data)

(d)
Restricted Cash
Restricted cash represents cash held by our counterparties as collateral against our interest rate swaps (or, Swaps), repurchase agreement borrowings or other derivative instruments. Restricted cash is not available for general corporate purposes, but 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 or termination of the derivative instrument or repurchase agreement.
(e)
Residential Mortgage-Backed Securities, Securitized Mortgage Loans, Other Investment Securities and Non-Recourse Securitized Debt
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.)
Determination of Accounting Policy
For purposes of determining the applicable accounting policy with respect to our investment securities, we review credit ratings available from each of the three major credit rating agencies (i.e. Moody’s Investors Services, Inc., Standard & Poor’s Corporation and Fitch, Inc.) for each investment security at the time of purchase and apply the lowest rating.
Designation and Fair Value Option Election
Our investment securities are designated as available for sale. To date, we have elected the fair value option for all of our investment securities at the time of purchase and, as a result, record the change 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 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/(losses) on the sale of RMBS are recorded in earnings using the specific identification method.
Our securitized 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 investment securities, securitized mortgage loans and securitized debt improves financial reporting, as such treatment is consistent with how we present the changes in the fair value of our Swaps, interest rate swaptions (or, Swaptions) and TBA Contracts, all of which are derivative instruments, through earnings.
Determination of Fair Value
To determine the fair value of our investment securities, TBA Contracts and non-recourse 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.
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 periods 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 categorized as Level III in the fair value hierarchy.


82
Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands - except per share data)

Impairments
RMBS and Other Investment Securities: 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 OTTI, 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 income and the collection 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.)
Other Investment Securities
At December 31, 2013, our other investment securities were comprised of investments in Freddie Mac’s Structured Agency Credit Risk debt notes (or, STACR Notes). The STACR Notes represent unsecured general obligations of Freddie Mac and are structured to be subject to the performance of a certain pool of residential mortgage loans. STACR Notes are included in “other investment securities, at fair value” on our consolidated balance sheet. Interest income on the STACR Notes is included in “interest income on other investment securities” and changes in the estimated fair value of the security are included in “unrealized gain on other investment securities” on our consolidated statement of operations.
(f)
Interest Income Recognition
Investment Securities
Interest income on Agency pass-through RMBS and other investment securities 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, non-Agency RMBS and other investment securities 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. For those securities, if prepayment levels differ, or are expected to differ in the future from our previous assessment, we adjust the amount of premium amortization recognized in the period such change is made, applying the retrospective method, resulting in a cumulative catch-up reflecting such change. To the extent that prepayment activity varies significantly from our previous prepayment estimates, we may experience volatility in our interest income. For pass-through Agency RMBS that we acquired subsequent to June 30, 2013, we do not estimate prepayments to determine premium amortization or discount accretion on such securities. Instead, the amount of premium amortization/discount accretion on pass-through Agency RMBS acquired subsequent to June 30, 2013 is based upon actual prepayment experience, which may vary significantly over time.
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


83
Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands - except per share data)

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 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 this 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. (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 debt. (See Note 13.)


84
Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(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. (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 derivative instruments as economic hedges, which we believe mitigate interest rate risk associated with our borrowings under repurchase agreements and/or 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 recognized in the consolidated statement of operations in the line item “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 applies: (i) when there is no other way to purchase or sell that security; (ii) if delivery of that security and settlement will occur within the shortest period possible for that type of security and (iii) 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 and realized gains or losses on settlement are recognized in the consolidated statements of operations in the line item “gain/(loss) on derivative instruments, net.”
(k)
Repurchase Agreements
Investment securities financed under repurchase agreements are treated as collateralized borrowings, unless they meet sale treatment or are deemed to be linked transactions. Through December 31, 2013, none of our repurchase agreements had been accounted for as components of linked transactions. With the exception of securities obtained in connection with our securitization that are eliminated in consolidation, through December 31, 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 was 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 amortized into 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 measure the fair value of our restricted stock units using the price of our common stock and other measurement assumptions including implied volatility and discount rates. 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


85
Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(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.
As of December 31, 2013, we had estimated non-deductible net capital losses of $(63.2) million which may be carried forward and applied against future net capital gains for up to five years. Our capital loss carryforward will reduce the amount of future capital gains, if any, that we would otherwise expect to distribute, as capital gains would first be reduced by capital loss carryforwards. In addition, as of December 31, 2013, we had estimated net deferred gains from terminated Swaps of $19.9 million and net deferred gains from terminated Swaptions of $6.8 million. These deferred gains are expected to be amortized into future ordinary taxable income over the remaining terms of the underlying Swaps.
We have elected to treat one wholly owned subsidiary as a taxable REIT subsidiary (or, TRS). A TRS may participate in non-real estate-related activities and is subject to U.S. federal, state and local income tax at regular corporate tax rates The TRS, was established in connection with the purchase of the pool of residential mortgage loans in February 2013 and the securitization transaction as discussed in Notes 5 and 13.
Our major tax jurisdictions are U.S. Federal, New York State and New York City. The statute of limitations is open for all jurisdictions for the years 2011 through 2013. We do not have any unrecognized tax benefits and do not expect a change in our position for unrecognized tax benefits in the next twelve months.
(n)
Recent Accounting Pronouncements
Accounting Standards Adopted
In December 2011, the Financial Accounting Standards Board (or, FASB) issued guidance to enhance disclosures about financial instruments and derivative instruments that are either (1) offset or (2) subject to an enforceable master netting arrangement or similar agreement, irrespective of whether they are offset. Under the guidance, an entity is required to disclose quantitative information relating to recognized assets and liabilities that are offset or subject to an enforceable master netting arrangement or similar agreement, including the gross amounts of those recognized assets and liabilities, the amounts offset to determine the net amount presented in the statement of financial position and the net amount presented in the statement of financial position. With respect to amounts subject to an enforceable master netting arrangement or similar agreement which are not offset, disclosure is required of the amounts related to recognized financial instruments and other derivative instruments, the amount related to financial collateral (including cash collateral), and the overall net amount after considering amounts that have not been offset. The guidance is effective for annual reporting periods beginning on or after January 1, 2013 and interim periods within those annual periods and retrospective application is required. As the amendments are limited to disclosure only, the adoption of this guidance did not have a material impact on our consolidated financial statements.
In January 2013, the FASB issued guidance to clarify the scope of disclosures about offsetting assets and liabilities. The amendments clarify that the scope of guidance issued in December 2011 to enhance disclosures around financial instruments and derivative instruments that are either (1) offset, or (2) subject to a master netting arrangement or similar agreement, irrespective of whether they are offset, applies to derivatives, including bifurcated embedded derivatives, repurchase agreements and reverse repurchase agreements, and securities borrowing and securities lending transactions that are either offset or subject to an enforceable master netting arrangement or similar agreement. The amendments are effective for interim and annual periods beginning on or after January 1, 2013. As the amendments are limited to disclosure only, the adoption of this guidance did not have a material impact on our consolidated financial statements. (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 Company


86
Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands - except per share data)

has evaluated the impact of the new guidance on its consolidated financial statements and has concluded that the new guidance does not apply to real estate investment trusts and is not intended to change current practice for real estate entities. Accordingly, the Company has determined that the new guidance does not impact its consolidated financial statements.
Note 3 - Fair Value of Financial Instruments
(a) General
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. 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, 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 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 and Apollo’s pricing group. 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.
(b) Agency RMBS, non-Agency RMBS, TBA Contracts, Securitized Debt and Other Investment Securities
To determine the fair value of our Agency RMBS, non-Agency RMBS, TBA Contracts, securitized debt and other investment securities 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


87
Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands - except per share data)

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 rates 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 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 or other investment securities 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 as Level II valuations. 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 are categorized as Level III.
(c) Securitized Mortgage Loans
The fair value of our securitized mortgage loans at December 31, 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.
(d) 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 are 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 based observable and, as such, their valuations are categorized as Level II in the fair value hierarchy.


88
Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands - except per share data)

(e) Fair Value Hierarchy
The following tables presents our financial instruments carried at estimated fair value as of December 31, 2013 and December 31, 2012, based upon the consolidated balance sheet by the valuation hierarchy:
 
 
December 31, 2013
 
 
Level I
 
Level II
 
Level III
 
Total
Assets:
 
 
 
 
 
 
 
 
RMBS
 
$
—

 
$
2,290,537

 
$
1,212,789

 
$
3,503,326

Securitized mortgage loans
 
—

 
—

 
110,984

 
110,984

Other investment securities
 
—

 
—

 
11,515

 
11,515

TBA Short Contracts
 
—

 
750

 
—

 
750

Swaps/Swaptions
 
—

 
52,565

 
—

 
52,565

Total
 
$
—

 
$
2,343,852

 
$
1,335,288

 
$
3,679,140

Liabilities:
 
 
 
 
 
 
 
 
Swaps
 
$
—

 
$
4,610

 
$
—

 
$
4,610

Non-recourse securitized debt
 
—

 
—

 
43,354

 
43,354

Total
 
$
—

 
$
4,610

 
$
43,354

 
$
47,964

 
 
 
 
 
 
 
 
 
 
 
December 31, 2012
 
 
Level I
 
Level II
 
Level III
 
Total
Assets:
 
 
 
 
 
 
 
 
RMBS
 
$
—

 
$
3,626,094

 
$
605,197

 
$
4,231,291

Swaps
 
—

 
750

 
—

 
750

Total
 
$
—

 
$
3,626,844

 
$
605,197

 
$
4,232,041

Liabilities:
 
 
 
 
 
 
 
 
Swaps
 
$
—

 
$
23,184

 
$
—

 
$
23,184

Total
 
$
—

 
$
23,184

 
$
—

 
$
23,184

(f) Level III Fair Value Measurement Disclosures
Our non-Agency RMBS, securitized mortgage loans, other investment securities 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 fair value of our non-Agency RMBS for the periods presented:
 
 
Year Ended
 
 
 
 
December 31, 2013
 
December 31, 2012
 
For the Period From July 27, 2011 through December 31, 2011
Beginning balance
 
$
605,197

 
$
112,346

 
$
—

Purchases
 
748,032

 
549,036

 
120,642

Sales
 
(94,307
)
 
(76,200
)
 
(2,766
)
Principal repayments
 
(117,411
)
 
(68,948
)
 
(6,218
)
Total net gains/(losses) included in net income:
 
 
 
 
 
 
Realized gains, net
 
14,654

 
9,314

 
91

Unrealized gains/(losses), net(1)
 
15,913

 
54,437

 
(3,263
)
Discount accretion
 
40,711

 
25,212

 
3,860

Ending balance
 
$
1,212,789

 
$
605,197

 
$
112,346

(1) 
Includes unrealized losses of $5,892, $3,003 and $1,627 that have been classified as other-than-temporary impairments as of December 31, 2013, December 31, 2012 and December 31, 2011, respectively.


89
Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands - except per share data)

The following table presents a summary of the changes in fair value of our securitized mortgage loans for the year ended December 31, 2013:
 
 
Year Ended December 31, 2013(1)
Beginning balance
 
$
—

Purchases
 
113,038

Principal repayments
 
(6,038
)
Unrealized gain/(loss)
 
3,950

Discount accretion and other adjustments
 
34

Ending balance
 
$
110,984

(1)
We did not have any investments in securitized mortgage loans prior to February 2013.
The following table presents a summary of the changes in fair value of our other investment securities for the year ended December 31, 2013:
 
 
Year Ended December 31, 2013(1)
Beginning balance
 
$
—

Purchases
 
12,000

Principal repayments
 
(820
)
Unrealized gain/(loss)
 
335

Ending balance
 
$
11,515

(1)
We did not have any investments in other investment securities prior to July 2013.
The following table presents a summary of the changes in fair value of our securitized debt for year ended December 31, 2013:
 
 
Year Ended December 31, 2013(1)
Beginning balance
 
$
—

Debt issued during the period
 
50,375

Principal paid
 
(7,975
)
Unrealized gain/(loss)
 
954

Ending balance
 
$
43,354

(1)
We did not have any securitized debt prior to February 2013.
The following table presents key unobservable inputs used in arriving at the estimated fair value of our securitized mortgage loans at December 31, 2013:
Assumption
 
Weighted Average
 
Range
Default rate
 
5.62
%
 
—
%
to
11.10
%
Loss severity
 
50.87
%
 
—
%
to
100.00
%
Voluntary prepayments
 
1.23
%
 
—
%
to
1.50
%
Discount rate
 
7.92
%
 
2.90
%
to
15.00
%


90
Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands - except per share data)

(g) Financial Instruments Not Carried at Fair Value
The following table presents the carrying value and estimated fair value of our financial instruments that are not carried at fair value on the consolidated balance sheet, at December 31, 2013 and December 31, 2012:
 
 
December 31, 2013
 
December 31, 2012
 
 
Carrying
Value
 
Estimated
Fair Value
 
Carrying
Value
 
Estimated
Fair Value
Financial assets
 
 
 
 
 
 
 
 
Investment related receivable(1)
 
$
24,887

 
$
24,887

 
$
—

 
$
—

Financial Liabilities:
 
 
 
 
 
 
 
 
Repurchase agreements
 
$
3,034,058

 
$
3,034,230

 
$
3,654,436

 
$
3,654,475

Investment related payable(1)
 
$
—

 
$
—

 
$
50,032

 
$
50,032

(1)
Carrying value approximates fair value due to the short-term nature of the item.
To determine estimated fair value of our borrowings under repurchase agreements, contractual cash flows from such borrowings are discounted at estimated market interest rates, which 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 December 31, 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.



91
Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands - except per share data)

Note 4 - Residential Mortgage-Backed Securities and Other Investments
(a) The following tables present certain information about our investment portfolio at December 31, 2013 and 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)
 
 
December 31, 2013
Agency RMBS - 30-Year Mortgages:
 
 
 
 
 
 
 
 
 
 
 
 
ARM - RMBS
 
$
11,619

 
$
782

 
$
12,401

 
$
12,339

 
$
—

 
$
(62
)
 
4.12
%
 
1.06
%
3.5% Coupon
 
303,026

 
19,925

 
322,951

 
301,068

 
—

 
(21,883
)
 
3.50
%
 
2.54
%
4.0% Coupon
 
1,558,943

 
120,636

 
1,679,579

 
1,602,080

 
—

 
(77,499
)
 
4.00
%
 
2.84
%
4.5% & 5.0% Coupons
 
235,127

 
18,266

 
253,393

 
250,136

 
—

 
(3,257
)
 
4.52
%
 
3.18
%
 
 
2,108,715

 
159,609

 
2,268,324

 
2,165,623

 
—

 
(102,701
)
 
3.99
%
 
2.82
%
Agency RMBS - 15-Year Mortgages:
 
 
 
 
 
 
 
 
 
 
 
 
3.0% Coupon
 
52,699

 
1,413

 
54,112

 
53,711

 
—

 
(401
)
 
3.00
%
 
2.50
%
Agency IOs(4)
 
—

 
—

 
41,521

 
44,425

 
3,254

 
(350
)
 
3.95
%
 
1.58
%
Agency Inverse IOs(4)
 
—

 
—

 
27,673

 
26,778

 
50

 
(945
)
 
6.16
%
 
15.16
%
Total Agency
 
2,161,414

 
161,022

 
2,391,630

 
2,290,537

 
3,304

 
(104,397
)
 
4.08
%
 
2.94
%
Non-Agency RMBS
 
1,438,007

 
(302,827
)
 
1,135,180

 
1,212,789

 
81,876

 
(4,267
)
 
1.24
%
 
6.73
%
Total RMBS
 
$
3,599,421

 
$
(141,805
)
 
$
3,526,810

 
$
3,503,326

 
$
85,180

 
$
(108,664
)
 
3.09
%
 
4.16
%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2012
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 $0 and $49,965 at December 31, 2013 and December 31, 2012 respectively, with an estimated fair value of $0 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. See table included in Note 4(f).
(2) 
Amortized cost is reduced by unrealized losses that are classified as other-than-temporary impairments. We recognized other-than-temporary impairments of $13,412 and $5,475 for the year ended December 31, 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 December 31, 2013 and December 31, 2012, our Agency IOs had a notional balance of $410,187 and $47,182, respectively and our Agency Inverse IOs had a notional balance of $145,650 and $257,187, respectively.


92
Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands - except per share data)

(b) Unrealized Loss Positions on RMBS
The following table presents information about our RMBS that were in an unrealized loss position at December 31, 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
 
$
1,844,021

 
$
(75,889
)
 
58

 
$
362,974

 
$
(27,151
)
 
5

Agency IOs
 
44,425

 
(350
)
 
3

 
—

 
—

 
—

Agency Inverse IOs
 
26,778

 
(945
)
 
8

 
—

 
—

 
—

ARM - RMBS
 
12,339

 
(62
)
 
2

 
—

 
—

 
—

Total Agency RMBS
 
1,927,563

 
(77,246
)
 
71

 
362,974

 
(27,151
)
 
5

Non-Agency RMBS
 
1,210,786

 
(4,194
)
 
66

 
2,003

 
(73
)
 
2

Total RMBS
 
$
3,138,349

 
$
(81,440
)
 
137

 
$
364,977

 
$
(27,224
)
 
7

(c) Interest Income on RMBS
The following table presents components of interest income on our Agency RMBS and non-Agency RMBS for the years ended December 31, 2013, December 31, 2012, and for the period from July 27, 2011 through December 31, 2011:
 
 
Year Ended December 31, 2013
 
Year Ended December 31, 2012
 
For the Period From July 27, 2011  through December 31, 2011
 
 
Coupon
Interest
 
(Premium
Amortization)/
Discount Accretion(1)
 
Interest
Income
 
Coupon
Interest
 
(Premium
Amortization)/
Discount Accretion(1)
 
Interest
Income
 
Coupon
Interest
 
(Premium
Amortization)/
Discount Accretion(1)
 
Interest
Income
Agency RMBS
 
$
133,900

 
$
(41,170
)
 
$
92,730

 
$
93,834

 
$
(30,782
)
 
$
63,052

 
$
9,434

 
$
(3,040
)
 
$
6,394

Non-Agency RMBS
 
12,822

 
40,711

 
53,533

 
6,105

 
25,212

 
31,317

 
479

 
3,860

 
4,339

Total
 
$
146,722

 
$
(459
)
 
$
146,263

 
$
99,939

 
$
(5,570
)
 
$
94,369

 
$
9,913

 
$
820

 
$
10,733

(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.
(d) Realized and Unrealized Gains and Losses on RMBS
The following table presents components of realized gains, net and the change in unrealized gains and losses, net on our RMBS portfolio for the periods presented:
 
 
For the Year Ended
December 31, 2013
 
For the Year Ended
December 31, 2012
 
For the Period from
July 27, 2011 through
December 31, 2011
 
 
Realized Gains/(Losses), net
 
Unrealized Gains/(Losses), net
 
Realized Gains/(Losses), net
 
Unrealized Gains/(Losses), net
 
Realized Gains/(Losses), net
 
Unrealized Gains/(Losses), net
Agency Pass-through
 
$
(80,904
)
 
$
(157,784
)
 
$
29,103

 
$
47,975

 
$
794

 
$
6,769

Agency IOs
 
1,599

 
1,939

 
909

 
(85
)
 
—

 
(745
)
Agency Inverse IOs
 
(2,199
)
 
(7,381
)
 
491

 
(1,925
)
 
—

 
(279
)
Agency ARM
 
—

 
(62
)
 
—

 
—

 
—

 
—

Non-Agency RMBS
 
14,654

 
15,913

 
9,314

 
54,437

 
91

 
(3,263
)
Total
 
$
(66,850
)
 
$
(147,375
)
 
$
39,817

 
$
100,402

 
$
885

 
$
2,482



93
Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands - except per share data)

(e) Contractual Maturities of RMBS
The following table presents the maturities of our RMBS, based on the contractual maturities of the underlying mortgages at December 31, 2013 and December 31, 2012:
 
 
December 31,
Contractual Maturities of RMBS(1)
 
2013
 
2012
< or equal to 10 years
 
$
—

 
$
—

> 10 years and < or equal to 20 years
 
189,243

 
431,880

> 20 years and < or equal to 30 years
 
2,861,028

 
3,732,596

> 30 years
 
453,055

 
66,815

Total
 
$
3,503,326

 
$
4,231,291

(1) 
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.
(f) Components of Discount on non-Agency RMBS
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 year ended December 31, 2013:
 
 
December 31, 2013
 
 
Discount
Designated as
Credit Reserve
and OTTI(1)
 
Accretable Discount
Balance at beginning of period
 
$
(123,026
)
 
$
(144,831
)
Accretion of discount
 
—

 
40,695

Realized credit losses
 
3,433

 
—

Purchases
 
(35,542
)
 
(89,601
)
Sales and other
 
42,836

 
8,943

OTTI recognized in earnings
 
(5,853
)
 
—

Transfers/release of credit reserve
 
8,853

 
(8,853
)
Balance at end of period
 
$
(109,299
)
 
$
(193,647
)
(1)
At December 31, 2013, our non-Agency RMBS had gross discounts of $302,946, which included credit discounts of $100,080 and OTTI of $9,219. 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.
In July 2013, we invested $12,000 in STACR Notes. STACR Notes represent an unsecured general obligation of Freddie Mac and are structured to be subject to the performance of a certain pool of residential mortgage loans. STACR Notes pay interest monthly at a rate of one-month London Interbank Offer Rate (or, LIBOR) plus 3.4%. At December 31, 2013, our STACR Notes had a coupon rate of 3.57%, a principal balance of $11,180 and an estimated fair value of $11,515.
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 December 31, 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, over time, modify certain provisions of the loans in order to mitigate losses. At the time of purchase through December 31, 2013, substantially all of the purchase discount associated with our securitized mortgage loans was considered to be credit related. At December 31, 2013, the amortized cost of our securitized mortgage loans was $107,034. (See Note 13.)


94
Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands - except per share data)

The following table presents a summary of the changes in the carrying value of securitized mortgage loans held for investment for the year ended December 31, 2013:
 
 
December 31, 2013(1)
Balance
 
$
—

Purchases
 
113,038

Principal repayments
 
(6,038
)
Discount accretion and other adjustments
 
34

Unrealized gain/(loss)
 
3,950

Ending balance
 
$
110,984

(1)
We did not have any investments in securitized mortgage loans prior to February 2013.
The following table presents the five largest states represented in our securitized mortgage loans at December 31, 2013 based on principal balance:
Property Location
 
Concentration
 
Principal Balance
California
 
21.0
%
 
$
31,282

Florida
 
13.9

 
20,725

Maryland
 
11.9

 
17,609

Texas
 
7.7

 
11,497

New Jersey
 
7.1

 
10,584

Other
 
38.4

 
56,980

Total
 
100.0
%
 
$
148,677


Note 6 - Receivables
(a) Interest Receivable
The following table presents our interest receivable by investment category at December 31, 2013 and December 31, 2012:
Asset
 
December 31, 2013
 
December 31, 2012
Agency RMBS, Fannie Mae
 
$
4,537

 
$
7,082

Agency RMBS, Freddie Mac
 
4,274

 
3,755

Agency RMBS, Ginnie Mae
 
—

 
108

Non-Agency RMBS
 
902

 
396

Total RMBS interest receivable
 
9,713

 
11,341

Securitized mortgage loans
 
676

 
—

Other investment securities
 
7

 
—

Total interest receivable
 
$
10,396

 
$
11,341

(b) Investment Related Receivables
The following table presents the components of our investment related receivables at December 31, 2013:
 
 
December 31, 2013
Unsettled sales of Agency RMBS
 
$
21,978

Principal payments due from broker for non-Agency RMBS
 
2,909

Total investment related receivables
 
$
24,887

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



95
Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands - except per share data)

Note 7 - Borrowings Under Repurchase Agreements
As of December 31, 2013, we had master repurchase agreements with 23 counterparties and had outstanding borrowings of $3,034,058 with 17 counterparties. At December 31, 2013 and December 31, 2012, we had $882 and $346, respectively of deferred financing costs, net of amortization, included on the consolidated balance sheet.
Our repurchase agreements bear interest at a contractually agreed-upon rate and typically have initial terms of one month to six months at inception, but in some cases may have initial terms that are shorter or longer. The following table presents certain characteristics of our repurchase agreements at December 31, 2013 and December 31, 2012:
 
 
December 31, 2013
 
December 31, 2012
 
 
Repurchase
Agreement
Borrowings
 
Weighted
Average
Borrowing
Rate
 
Weighted
Average
Remaining
Maturity
(days)
 
Repurchase
Agreement
Borrowings
 
Weighted
Average
Borrowing
Rate
 
Weighted
Average
Remaining
Maturity
(days)
Securities Financed:
 
 
 
 
 
 
 
 
 
 
 
 
Agency RMBS
 
$
2,082,447

 
0.42
%
 
19
 
$
3,223,577

 
0.47
%
 
15
Non-Agency RMBS(1)
 
942,091

 
2.00

 
94
 
430,859

 
2.06

 
58
Other investment securities
 
9,520

 
1.74

 
24
 
—

 
—

 
0
Total
 
$
3,034,058

 
0.91
%
 
42
 
$
3,654,436

 
0.65
%
 
20
(1)
Includes $27,014 of repurchase borrowings collateralized by non-Agency RMBS of $47,057 that are eliminated from our balance sheet in consolidation with the VIE associated with our securitization transaction.
The following table presents repricing information about our borrowings under repurchase agreements at December 31, 2013 and December 31, 2012:
 
 
December 31, 2013
 
December 31, 2012
Time Until Interest Rate Reset:
 
Balance
 
Weighted Average Interest Rate
 
Balance
 
Weighted Average Interest Rate
Within 30 days
 
$
2,349,800

 
0.83
%
 
$
3,461,595

 
0.60
%
Over 30 days to 60 days
 
534,487

 
0.95

 
110,670

 
1.30

Over 60 days to 90 days
 
55,950

 
2.06

 
28,197

 
2.12

Over 90 days to 120 days
 
13,406

 
2.05

 
29,602

 
2.07

Over 120 days to 360 days
 
74,682

 
2.21

 
24,372

 
2.08

Over 360 days
 
5,733

 
2.59

 
—

 
—

Total
 
$
3,034,058

 
0.91
%
 
$
3,654,436

 
0.65
%
The following table presents the contractual maturity of our repurchase agreements at December 31, 2013 and December 31, 2012:
 
 
December 31, 2013
 
December 31, 2012
Time Until Contractual Maturity:
 
Balance
 
Weighted Average Interest Rate
 
Balance
 
Weighted Average Interest Rate
Within 30 days
 
$
2,181,208

 
0.70
%
 
$
3,380,170

 
0.56
%
Over 30 days to 60 days
 
534,487

 
0.95

 
110,670

 
1.30

Over 60 days to 90 days
 
55,950

 
2.06

 
28,197

 
2.12

Over 90 days to 120 days
 
13,406

 
2.05

 
29,602

 
2.07

Over 120 days to 360 days
 
243,274

 
2.36

 
105,797

 
2.37

Over 360 days
 
5,733

 
2.59

 
—

 
—

Total
 
$
3,034,058

 
0.91
%
 
$
3,654,436

 
0.65
%



96
Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(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 we pledged and collateral we held, with respect to our borrowings under repurchase agreements, derivatives and clearing margin account at December 31, 2013 and December 31, 2012:
 
 
December 31, 2013
 
December 31, 2012
 
 
Assets Pledged as Collateral
 
Collateral Held
 
Assets Pledged as Collateral
 
Collateral Held
Derivatives:
 
 
 
 
 
 
 
 
Restricted cash/cash(1)
 
$
2,550

 
$
38,654

 
$
33,395

 
$
—

Repurchase agreement borrowings:
 
 
 
 
 
 
 
 
Agency RMBS(2)
 
2,125,767

 
—

 
3,335,472

 
—

Non-Agency RMBS(3)
 
1,256,250

 
—

 
600,632

 
—

Other investment securities
 
11,515

 
—

 
—

 
—

Restricted Cash
 
64,908

 
—

 
60,246

 
—

 
 
3,458,440

 
—

 
3,996,350

 
—

Clearing margin:
 
 
 
 
 
 
 
 
Agency RMBS
 
4,059

 
—

 
4,809

 
—

Total
 
$
3,465,049

 
$
38,654

 
$
4,034,554

 
$
—

(1)
Cash pledged as collateral is reported as “restricted cash” on our consolidated balance sheet. Cash held as collateral is unrestricted in use and, therefore is included in cash on our consolidated balance sheet.
(2) 
Includes Agency RMBS of $21,959 that were sold but unsettled at December 31, 2013.
(3) 
Includes non-Agency RMBS of $47,057 that are eliminated from our balance sheet in consolidation with the VIE associated with our securitization transaction.
The following tables present our collateral positions, reflecting assets pledged with respect to our borrowings under repurchase agreements, Swaps and clearing margin account at December 31, 2013 and December 31, 2012:
 
 
December 31, 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)
 
$
2,125,767

 
$
2,225,769

 
$
6,850

 
$
2,132,617

Non-Agency RMBS(2)
 
1,256,250

 
1,174,007

 
1,150

 
1,257,400

Other investment securities
 
11,515

 
11,180

 
7

 
11,522

Cash
 
64,908

 
—

 
—

 
64,908

 
 
3,458,440

 
3,410,956

 
8,007

 
3,466,447

Cash pledged for Swaps
 
2,550

 
—

 
—

 
2,550

Agency RMBS pledged for clearing margin
 
4,059

 
4,331

 
12

 
4,071

Total
 
$
3,465,049

 
$
3,415,287

 
$
8,019

 
$
3,473,068

(Tables and notes continued on next page.)


97
Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands - except per share data)

(Tables - continued.)
 
December 31, 2012
 
 
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
 
$
3,335,472

 
$
3,283,264

 
$
9,658

 
$
3,345,130

Non-Agency RMBS
 
600,632

 
544,975

 
393

 
601,025

Cash
 
60,246

 
—

 
—

 
60,246

 
 
3,996,350

 
3,828,239

 
10,051

 
4,006,401

Cash pledged for Swaps
 
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 $21,959 that were sold but unsettled at December 31, 2013.
(2) 
Includes a non-Agency RMBS from a consolidated VIE at December 31, 2013, that was eliminated from our consolidated balance sheet. This RMBS had a fair value of $47,057 and amortized cost of $42,400 and interest receivable of $141, all of which were eliminated in consolidation.
In February 2013, we engaged in a securitization transaction that resulted in us consolidating, as a VIE, the trust that was created to facilitate the transaction and to which the underlying mortgage loans in connection with the securitization were transferred. As a part of the securitization transaction, the most senior security created was sold to a third-party investor and as such, this senior security is presented on our consolidated balance sheet as “non-recourse securitized debt, at fair value.” The securitized mortgage loans held by the securitization trust are restricted in that they can only be used to fulfill the obligations of the securitization trust. As such, the fair value of the securitized mortgage loans is effectively viewed as collateralizing the non-recourse securitized debt on our consolidated balance sheet at December 31, 2013. (See Note 13.)
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 an event of default or trigger an early termination event occurs pursuant to one of our Swaps or repurchase agreements, the counterparty to such agreement may have the option to terminate all of its outstanding Swaps or repurchase agreements with us and, if applicable, any close-out amount due to the counterparty upon termination of the Swaps or repurchase agreements would be immediately payable by us. Through December 31, 2013, we remained in compliance with all of our financial covenants. (See Note 10.)



98
Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands - except per share data)

Note 9 - Offsetting Assets and Liabilities
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 agreements 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.
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 December 31, 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
December 31, 2013
 
 
 
 
 
 
 
 
 
 
 
 
Swaps and Swaptions, at fair value
 
$
52,565

 
$
—

 
$
52,565

 
$
(2,643
)
 
$
(38,016
)
 
$
11,906

TBA Short Contracts, at fair value
 
750

 
—

 
750

 
—

 
(638
)
 
112

 
 
$
53,315

 
$
—

 
$
53,315

 
$
(2,643
)
 
$
(38,654
)
 
$
12,018

December 31, 2012
 
 
 
 
 
 
 
 
 
 
 
 
Swaps and Swaptions, at fair value
 
$
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
December 31, 2013
 
 
 
 
 
 
 
 
 
 
 
 
Swaps and Swaptions, at fair value
 
$
4,610

 
$
—

 
$
4,610

 
$
(2,643
)
 
$
(1,967
)
 
$
—

Repurchase agreements
 
3,034,058

 
—

 
3,034,058

 
(3,034,058
)
 
—

 
—

 
 
$
3,038,668

 
$
—

 
$
3,038,668

 
$
(3,036,701
)
 
$
(1,967
)
 
$
—

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
)
 
—

 
—

 
 
$
3,677,620

 
$
—

 
$
3,677,620

 
$
(3,655,186
)
 
$
(22,434
)
 
$
—

(1)
Amounts represent derivative instruments in an asset position which could potentially be offset against derivative instruments in a liability position at December 31, 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, and derivative instruments.
(3)
The fair value of securities pledged against our borrowings under repurchase agreements was $3,393,532 (which includes $47,057 of RMBS that are not included in our consolidated balance sheet, as such assets are eliminated in consolidation with a VIE) and $3,936,104 at December 31, 2013 and December 31, 2012, respectively.
(4)
Total cash pledged against our Swaps was $2,550 and $33,395 at December 31, 2013 and December 31, 2012, respectively. Total cash collateral pledged against our borrowings under repurchase agreements was $64,908 and $60,246 at December 31, 2013 and December 31, 2012, respectively.



99
Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands - except per share data)

Note 10 - Derivative Instruments
We enter into derivative contracts, which through December 31, 2013 were comprised of Swaps, Swaptions, and TBA Short Contracts. We use derivative instruments to manage interest rate risk and, as such, view them as economic hedges. We have not elected hedge accounting for any of 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 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.
At December 31, 2013, we had four TBA Short Contracts with an aggregate notional balance of $400,000, which were in a net unrealized gain position of $750 at December 31, 2013. Our TBA Short Contracts, which settle on February 13, 2014, had a weighted average sales price of 102.93% for 4.0% coupon Fannie Mae 30-year RMBS with a face value of $400,000.
Information with respect to our derivative instruments as presented on the consolidated balance sheets at December 31, 2013 and December 31, 2012, were as follows:
 
 
December 31, 2013
 
December 31, 2012
 
 
Notional
Amount
 
Estimated
Fair Value
 
Notional
Amount
 
Estimated
Fair Value
Swaps - assets
 
$
1,007,000

 
$
40,135

 
$
—

 
$
—

Swaptions - assets
 
1,375,000

 
12,430

 
75,000

 
750

Swaps - (liabilities)
 
580,000

 
(4,610
)
 
1,500,000

 
(23,184
)
TBA Short Contracts - assets
 
400,000

 
750

 
—

 
—

Total derivative instruments
 
$
3,362,000

 
$
48,705

 
$
1,575,000

 
$
(22,434
)
The following table summarizes the average fixed pay rate and average maturity for our Swaps as of December 31, 2013 and December 31, 2012:
 
 
December 31, 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)
Greater than 1 year to 3 years
 
$
110,000

 
1.38
%
 
2.8
 
$
—

 
—
%
 
0
Greater than 3 years to 5 years
 
999,000

 
1.02
%
 
3.7
 
1,245,000

 
1.06
%
 
4.4
Greater than 5 years
 
478,000

 
1.98
%
 
8.7
 
255,000

 
1.90
%
 
9.6
Total
 
$
1,587,000

 
1.34
%
 
5.1
 
$
1,500,000

 
1.20
%
 
5.3
At December 31, 2013, the Swaps underlying our Swaptions had a weighted average fixed pay rate of 3.64%. The following table presents information about our Swaptions at December 31, 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%
 
$
2,178

 
6
 
$
100,000

 
10.0
3.26 - 3.50%
 
4,773

 
3
 
575,000

 
10.0
3.51 - 3.75%
 
2,026

 
4
 
375,000

 
10.0
3.76 - 4.00%
 
2,993

 
10
 
225,000

 
10.0
4.01 - 4.41%
 
460

 
8
 
100,000

 
10.0
 
 
$
12,430

 
5
 
$
1,375,000

 
10.0


100
Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands - except per share data)

The following table summarizes the amounts recognized on the consolidated statements of operations related to our derivative instruments for the years ended December 31, 2013 and December 31, 2012:
 
 
 
 
Year Ended
 
 
Character of Loss on Derivative Instruments
 
Location of Item on the
Consolidated Statements of Operations
 
December 31, 2013
 
December 31, 2012
 
For the Period From July 27, 2011 through December 31, 2011
Net interest payments/accruals on Swaps(1)
 
Gain/(loss) on derivative  instruments, net
 
$
(22,034
)
 
$
(7,805
)
 
$
(715
)
Gains/(losses) on the termination of Swaps, net(1)
 
Gain/(loss) on derivative  instruments, net
 
24,119

 
(4,709
)
 
85

Gains on the termination of Swaptions, net(1)
 
Gain/(loss) on derivative  instruments, net
 
6,837

 
—

 
—

Gains on settlement of TBA Short Contracts, net(1)
 
Gain/(loss) on derivative  instruments, net
 
281

 
—

 
—

Change in fair value of Swaps(2)
 
Gain/(loss) on derivative  instruments, net
 
58,708

 
(19,937
)
 
(3,246
)
Change in fair value of Swaptions(2)
 
Gain/(loss) on derivative  instruments, net
 
(9,085
)
 
(214
)
 
—

Change in fair value of TBA Short Contracts(2)
 
Gain/(loss) on derivative  instruments, net
 
750

 
—

 
—

Total
 
 
 
$
59,576

 
$
(32,665
)
 
$
(3,876
)
(1)
Amounts are realized.
(2)
Amounts are unrealized.
The following table provides information with respect to our derivative instruments activity for the periods presented:
 
 
TBA Short Contracts
 
Swaps
 
Swaptions
 
 
Notional Amount
 
Gain/Loss Realized
 
Notional Amount
 
Gain/Loss Realized
 
Notional Amount
 
Gain/Loss Realized
Balance at July 27, 2011
 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

 
$
—

Contracts entered
 
—

 
—

 
360,000

 
—

 
—

 
—

Contracts terminated
 
—

 
—

 
(15,000
)
 
85

 
—

 
—

Balance at December 31, 2011
 
—

 
—

 
345,000

 
85

 
—

 
—

Contracts entered
 
—

 
—

 
1,335,000

 
—

 
75,000

 
—

Contracts terminated
 
—

 
—

 
(180,000
)
 
(4,709
)
 
—

 
—

Balance at December 31, 2012
 
—

 
—

 
1,500,000

 
(4,709
)
 
75,000

 
—

Contracts entered
 
725,000

 
—

 
1,132,000

 
—

 
1,550,000

 
—

Contracts terminated
 
(325,000
)
 
281

 
(1,045,000
)
 
24,119

 
(250,000
)
 
6,837

Balance at December 31, 2013
 
$
400,000

 
$
281

 
$
1,587,000

 
$
24,119

 
$
1,375,000

 
$
6,837

Financial Covenants
Our agreements with certain of our derivative counterparties contain financial covenants. Through December 31, 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 Note 8.) If we had breached any of these provisions at December 31, 2013 we could have been required to settle our obligations under our Swaps at their termination value of $5,721, which amount reflects the estimated fair value of our Swaps that were in a liability position, plus accrued interest.



101


Note 11 - Interest Payable
The following table presents the components of our interest payable at December 31, 2013 and December 31, 2012:
 
 
December 31, 2013
 
December 31, 2012
Repurchase borrowings collateralized by Agency RMBS
 
$
2,091

 
$
3,896

Repurchase borrowings collateralized by non-Agency RMBS(1)
 
4,637

 
1,519

Repurchase borrowings collateralized by other investment securities
 
31

 
—

Securitized debt
 
141

 
—

Swaps
 
1,808

 
1,359

Total interest payable
 
$
8,708

 
$
6,774

(1)
Includes $182 of interest payable on repurchase borrowings collateralized by a non-Agency RMBS issued by a consolidated VIE at December 31, 2013, which RMBS is eliminated from our balance sheet in consolidation.

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 to 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 adjusted 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, such that our Manager is contractually committed to manage us through July 25, 2015. 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 $11,579 and $6,804 for the years ended December 31, 2013 and December 31, 2012, respectively and $1,333 from commencement of operations (July 27, 2011) through December 31, 2011. In addition to the management fee, we are also responsible for reimbursing our Manager for certain expenses paid by our Manager on behalf of us and for certain services provided by our Manager to us. We recorded expenses of $8,727 and $8,019 for the years ended December 31, 2013 and December 31, 2012, respectively, and $4,304 from July 27, 2011 through December 31, 2011, related to reimbursements for certain expenses paid by our Manager on our behalf. Expenses incurred by our Manager and reimbursed by us are typically included in our general and administrative expense on our consolidated statement of operations, or may be reflected on the consolidated balance sheet and associated consolidated statement of changes in stockholders’ equity, based on the nature of the item. At December 31, 2013 and December 31, 2012, $2,928 and $2,418, respectively, for management fees incurred but not yet paid were included in payable to related party on the 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. The substantial majority of these obligations exist for a period of twelve months from the closing date of our securitization transaction. We believe that a portion of the risk of loss due to loan repurchases would be recovered from the third-party entity from which we acquired the loans. In the event that such third-party becomes insolvent, or we are unable to make repurchase claims against such party, we may be exposed to losses as a result of the representations and warranties made in connection with our securitization transaction.


102
Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands - except per share data)

Through December 31, 2013, no repurchase claims had been made against us, and we do not believe that the amount of any future potential liability with respect to such item (the maximum of which would be the current unpaid principal balance of any such loan) is material to us. At December 31, 2013, we had no reserve established for repurchases of loans and were not aware of any repurchase claims that would require the establishment of such a reserve. (See Note 13.)

Note 13 - Use of Special Purpose Entities
Special purpose entities (or, SPEs) are entities designed to fulfill a specific limited need of the entity that organizes 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 unsecuritized 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(g) 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 December 31, 2013
 
$
42,400

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

Pass-through interest rate for senior security issued – fixed rate
 
4.00
%
(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 as collateral.
(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 as of December 31, 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


103
Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands - except per share data)

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 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 December 31, 2013, the aggregate fair value of our securitized mortgage loans was $110,984, and are 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 consolidated 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” which reflects the residential mortgage loans held by the trust that collateralize all of the securities issued from the trust.
At December 31, 2013, the securitized debt collateralized by residential mortgage loans had a principal balance of $42,400. 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 December 31, 2013, based on expected cash flows of the securitized residential mortgage loans, as adjusted for projected losses on such loans.
Estimated Maturity
 
December 31, 2013
Within one year
 
$
8,194

>One to three years
 
20,040

>Three to five years
 
14,166

>Five years
 
—

Total
 
$
42,400

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 more information about the mortgage loans collateralizing our securitized debt.)


104
Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(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 December 31, 2013:
 
 
December 31, 2013
Assets:
 
 
Securitized mortgage loans, at fair value
 
$
110,984

Interest receivable
 
$
676

Liabilities:
 
 
Non-recourse securitized debt, at fair value
 
$
43,354

Accrued interest payable
 
$
141

The following table reflects the income and expense amounts recorded in our consolidated statements of operations related to our consolidated VIE for the year ended December 31, 2013:
 
 
Year Ended December 31, 2013
Interest income - securitized mortgage loans
 
$
8,267

Interest expense - securitized debt
 
$
(1,794
)
Unrealized gain on securitized mortgage loans
 
$
3,950

Unrealized (loss) on securitized debt
 
$
(954
)
The following table reflects the amounts included on our consolidated statements of cash flows related to our consolidated VIE for the year ended December 31, 2013:
 
 
Year Ended December 31, 2013
Net income/(loss)
 
$
9,469

Premium amortization/(discount accretion), net
 
$
(68
)
Amortization of deferred financing costs
 
$
131

Unrealized (gain) on securitized mortgage loans
 
$
(3,950
)
Unrealized loss on securitized debt
 
$
954

Increase in accrued interest receivable, less purchased interest
 
$
(676
)
Increase in accrued interest payable
 
$
141

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

Principal payments on securitized mortgage loans
 
$
6,038

Proceeds from issuance of securitized debt
 
$
50,375

Principal payments on securitized debt
 
$
(7,975
)
Note 14 - Equity Award Plan
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 and all grants made under the LTIP. At December 31, 2013, 1,347,654 awards were available under the LTIP.
For the years ended December 31, 2013, December 31, 2012 and from July 27, 2011 through December 31, 2011, we recognized stock-based compensation expense of $1,047, $444 and $143, respectively, and granted 6,748, 28,160 and 20,000 shares of restricted stock, respectively and 25,851, 143,244 and 31,250 RSUs, respectively. To date, all awards made pursuant to the LTIP vest over a three year period in either quarterly or annual installments, provided that there has not been a termination of service of the grantee.


105
Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands - except per share data)

The following table presents expenses related to our equity-based compensation awards for the periods presented:
 
 
Year Ended
 
 
December 31, 2013
 
December 31, 2012
 
For the Period From July 27, 2011 through December 31, 2011
Restricted common stock
 
$
349

 
$
170

 
$
61

RSUs
 
698

 
274

 
82

Total
 
$
1,047

 
$
444

 
$
143

At December 31, 2013, we had unrecognized compensation expense of $2,468 and $571 related to restricted common stock and RSUs, respectively. The unrecognized compensation expense at December 31, 2013 is expected to be recognized over a weighted average period of 1.3 years. As of December 31, 2013, we had an expected average forfeiture rate of 0% with respect to restricted common stock and 5% with respect to RSUs. Through December 31, 2013 no cash was used in the settlement of awards issued pursuant to the LTIP.
The following table presents information about our equity awards for the periods presented:
 
 
December 31, 2013
 
December 31, 2012
 
For the Period From July 27, 2011 through December 31, 2011
 
 
Number of Awards
 
Weighted Average Grant Date Fair Value
 
Number of Awards
 
Weighted Average Grant Date Fair Value
 
Number of Awards
 
Weighted Average Grant Date Fair Value
RSUs outstanding at beginning of period
 
166,682

 
$
20.14

 
29,688

 
$
17.35

 
—

 
—

RSUs granted
 
25,851

 
14.73

 
143,244

 
20.62

 
31,250

 
17.38

RSUs canceled upon delivery of common stock
 
(6,250
)
 
17.95

 
(6,250
)
 
17.95

 
(1,562
)
 
17.95

RSUs canceled, forfeited or expired
 
(2,361
)
 
18.74

 
—

 
—

 
—

 
—

RSUs outstanding at end of period
 
183,922

 
$
19.47

 
166,682

 
$
20.14

 
29,688

 
17.35

 
 
 
 
 
 
 
 
 
 
 
 
 
Vested RSUs
 
56,681

 
$
19.93

 
5,425

 
$
16.47

 
1,037

 
16.53

Unvested RSUs
 
127,241

 
$
19.26

 
161,257

 
$
20.26

 
28,651

 
17.38

 
 
 
 
 
 
 
 
 
 
 
 
 
Restricted common stock awards outstanding at beginning of period
 
38,468

 
$
19.69

 
18,336

 
$
18.20

 
—

 
—

Restricted common stock granted
 
6,748

 
22.22

 
28,160

 
20.25

 
20,000

 
18.20

Restricted common stock forfeited
 
—

 
—

 
—

 
—

 
—

 
—

Restricted common stock vested
 
(17,176
)
 
19.58

 
(8,028
)
 
18.24

 
(1,664
)
 
18.20

Restricted common stock outstanding at end of period
 
28,040

 
$
20.37

 
38,468

 
$
19.69

 
18,336

 
18.20





106
Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands - except per share data)

Note 15 - Stockholders’ Equity
(a) Common Stock Dividends
The following table presents cash dividends declared by our board of directors on our common stock from our inception in July 2011 through December 31, 2013:
Declaration Date
 
Record Date
 
Payment Date
 
Dividend Per Share
December 18, 2013
 
December 31, 2013
 
January 31, 2014
 
$
0.40

September 19, 2013
 
September 30, 2013
 
October 31, 2013
 
$
0.40

June 17, 2013
 
June 28, 2013
 
July 31, 2013
 
$
0.70

March 18, 2013
 
March 28, 2013
 
April 30, 2013
 
$
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, 2012
 
$
0.75

December 15, 2011
 
December 31, 2011
 
January 12, 2012
 
$
0.30

(b) Common Stock
The following table presents information with respect to shares of our common stock issued through our IPO during 2011 and our public offerings of common stock during the years ended December 31, 2013 and December 31, 2012:
Share Settlement Date
 
Shares Issued
 
Gross Proceeds Per
Share
 
Gross Proceeds
March 25, 2013
 
1,020,000

 
$
22.00

 
$
22,440

March 13, 2013
 
6,800,000

 
$
22.00

 
$
149,600

April 20, 2012(1)
 
13,900,000

 
$
18.00

 
$
250,200

July 27, 2011(2)(3)
 
10,000,000

 
$
20.00

 
$
200,000

(1) 
We raised net equity capital of $249,490 after offering costs of $710.
(2) 
Reflects shares issued pursuant to our IPO, pursuant to which we raised equity capital of $198,061 after expenses of $1,939. Our Manager paid $8,000 of underwriting discounts and commissions related to our IPO.
(3) 
Private Placement of common stock.
In connection with our IPO, we completed a private placement, through which we sold 250,000 shares of our common stock to certain affiliates and personnel of Apollo at a price of $20.00 per share, and received gross proceeds of $5,000.
(c) Public Offering of Preferred Stock
On September 20, 2012, we completed a public offering of 6,900,000 shares of 8.0% Series A Preferred Stock (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 $5,928. Holders of our Preferred Stock are entitled to receive dividends at an annual rate of 8.0% 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 Securities and Exchange Commission (or, 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.
The Preferred Stock generally has no voting rights. However, if dividends on the Preferred Stock are in arrears for six quarterly dividend periods, whether or not consecutive, the holders of the Preferred Stock (voting together as a single class with the holders of any other class or series of parity preferred stock upon which like voting rights have been conferred and are exercisable) will have the right to elect two additional directors to our board until we pay (or declare and set aside for payment) all dividends that are then in arrears. In addition, the affirmative vote of at least two-thirds of the votes entitled to be cast by holders of outstanding shares of Preferred Stock (voting together as a single class with the holders of any other class or series of parity preferred stock upon which like voting rights have been conferred and are exercisable) is required for us to authorize, create or increase the number of any class or series of senior equity securities or to amend our charter (including the Articles


107
Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands - except per share data)

Supplementary designating the Preferred Stock, or the Articles Supplementary) in a manner that materially and adversely affects the rights of the Preferred Stock.
(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, 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. This registration statement was declared effective by the SEC on August 10, 2012. At December 31, 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 of 1933 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.
(f) Stock Repurchase Program
On November 6, 2013, our Board of Directors authorized a stock repurchase program (or, Repurchase Program), to repurchase up to $50,000 of our outstanding common stock. Such authorization does not have an expiration date. Subject to applicable securities laws, repurchases of common stock under the Repurchase Program may be made at times and in amounts as we deem appropriate, using available cash resources. Shares of common stock repurchased by us under the Repurchase Program, if any, will be cancelled and, until reissued by us, will be deemed to be authorized but unissued shares of our common stock. The Repurchase Program may be suspended or discontinued by us at any time and without prior notice. We have not repurchased any shares of common stock under the Repurchase Program.

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 years ended December 31, 2013 and December 31, 2012 and for the period from July 27, 2011 through December 31, 2011:
 
 
Year Ended
 
 
 
 
December 31, 2013
 
December 31, 2012
 
For the Period From July 27, 2011 through December 31, 2011
Numerator:
 
 
 
 
 
 
Net income/(loss)
 
$
(47,211
)
 
$
172,756

 
$
4,472

Less:
 
 
 
 
 
 
Dividends declared on Preferred Stock
 
13,800

 
5,022

 
—

Dividends, dividend equivalents and undistributed earnings allocated to participating securities
 
405

 
611

 
21

Net income/(loss) allocable to common stockholders - basic and diluted
 
$
(61,416
)
 
$
167,123

 
$
4,451

Denominator:
 
 
 
 
 
 
Weighted average common shares outstanding for basic and diluted earnings per share(1)
 
30,443,620

 
19,984,233

 
10,270,910

Earnings/(loss) per common share - basic and diluted
 
$
(2.02
)
 
$
8.36

 
$
0.43

(1) 
For the year ended December 31, 2013, we had an aggregate of 166,705 RSUs and 36,672 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.



108
Apollo Residential Mortgage, Inc. and Subsidiaries
Notes to Consolidated Financial Statements
(Dollars in thousands - except per share data)

Note 17 - Summarized Quarterly Results (Unaudited)
 
 
For the 2013 Quarter Ended
 
 
March 31
 
June 30
 
September 30
 
December 31
Interest income
 
$
38,247

 
$
41,329

 
$
34,416

 
$
40,721

Interest expense
 
(6,217
)
 
(7,237
)
 
(6,789
)
 
(7,359
)
Net interest income
 
32,030

 
34,092

 
27,627

 
33,362

Other income/(loss):
 
 
 
 
 
 
 
 
Realized gain/(loss) on sale of RMBS, net
 
15,795

 
(47,508
)
 
(16,596
)
 
(18,541
)
Unrealized gain/(loss) on RMBS, net
 
(33,048
)
 
(134,822
)
 
28,143

 
(7,648
)
Unrealized gain/(loss) on securitized debt
 
(872
)
 
887

 
(428
)
 
(541
)
Unrealized gain/(loss) on securitized mortgage loans
 
2,848

 
(3,473
)
 
537

 
4,038

Unrealized gain on other investment securities
 
—

 
—

 
116

 
219

Gain/(loss) on derivative instruments
 
(5,798
)
 
83,369

 
(21,687
)
 
3,692

Interest income on cash balances
 
25

 
43

 
4

 
4

Other income/(loss), net
 
(21,050
)
 
(101,504
)
 
(9,911
)
 
(18,777
)
Operating expenses:
 
 
 
 
 
 
 
 
General and administrative
 
(2,851
)
 
(2,434
)
 
(3,089
)
 
(3,127
)
Management fee - related party
 
(2,789
)
 
(2,921
)
 
(2,941
)
 
(2,928
)
Total operating expenses
 
(5,640
)
 
(5,355
)
 
(6,030
)
 
(6,055
)
Net income/(loss)
 
$
5,340

 
$
(72,767
)
 
$
11,686

 
$
8,530

Preferred Stock dividend declared
 
(3,450
)
 
(3,450
)
 
(3,450
)
 
(3,450
)
Net income/(loss) allocable to common stock and participating securities(1)
 
$
1,890

 
$
(76,217
)
 
$
8,236

 
$
5,080

Earnings/(loss) per common share - basic and diluted
 
$
0.07

 
$
(2.39
)
 
$
0.25

 
$
0.16

Dividends declared per share of common stock
 
$
0.70

 
$
0.70

 
$
0.40

 
$
0.40

 
 
For the 2012 Quarter Ended
 
 
March 31
 
June 30
 
September 30
 
December 31
Interest income
 
$
12,363

 
$
21,990

 
$
26,438

 
$
33,578

Interest expense
 
(1,361
)
 
(2,871
)
 
(4,289
)
 
(6,110
)
Net interest income
 
11,002

 
19,119

 
22,149

 
27,468

Other income:
 
 
 
 
 
 
 
 
Realized gain on sale of RMBS, net
 
6,769

 
11,614

 
13,861

 
7,573

Unrealized gain on RMBS, net
 
5,950

 
14,598

 
54,913

 
24,941

Gain/(loss) on derivative instruments
 
(1,318
)
 
(15,515
)
 
(16,653
)
 
821

Interest income on cash balances
 
2

 
7

 
16

 
23

Other income, net
 
11,403

 
10,704

 
52,137

 
33,358

Operating expenses:
 
 
 
 
 
 
 
 
General and administrative
 
(1,488
)
 
(1,865
)
 
(1,858
)
 
(2,569
)
Management fee - related party
 
(797
)
 
(1,558
)
 
(2,031
)
 
(2,418
)
Total operating expenses
 
(2,285
)
 
(3,423
)
 
(3,889
)
 
(4,987
)
Net income
 
$
20,120

 
$
26,400

 
$
70,397

 
$
55,839

Preferred Stock dividend declared
 
—

 
—

 
—

 
(5,022
)
Net income allocable to common stock and participating securities
 
$
20,120

 
$
26,400

 
$
70,397

 
$
50,817

Earnings per common share - basic and diluted
 
$
1.95

 
$
1.24

 
$
2.91

 
$
2.09

Dividends declared per share of common stock
 
$
0.75

 
$
0.75

 
$
0.85

 
$
1.05

(1)
Losses are not allocable to participating securities.



109


ITEM 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
None.
ITEM 9A.
Controls and Procedures
A review and evaluation was performed by the Company’s management, including the Company’s Chief Executive Officer (or, CEO) and Chief Financial Officer (or, CFO), of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act, as of the end of the period covered by this annual report on Form 10-K. Based on that review and evaluation, the CEO and CFO have concluded that the Company’s current disclosure controls and procedures, as designed and implemented, were effective. 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 the Company’s periodic reports.
Management Report on Internal Control over Financial Reporting
Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting for the Company. Internal control over financial reporting is defined in Rules 13a-15(f) and 15d-15(f) promulgated under the Exchange Act as a process designed by, or under the supervision of, the Company’s principal executive and principal financial officers and effected by the Company’s board of directors, management and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP and includes those policies and procedures that:
•
pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company;
•
provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and
•
provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Projections of any evaluation of effectiveness to future periods are subject to the risks that controls may become inadequate because of changes in conditions or that the degree of compliance with the policies or procedures may deteriorate.
The Company’s management assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2013. In making this assessment, the Company’s management used criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission in “Internal Control - Integrated Framework (1992).”
Based on its assessment and those criteria, the Company’s management believes that, as of December 31, 2013, the Company’s internal control over financial reporting was effective.
There have been no changes in the Company’s internal control over financial reporting that occurred during the three months ended December 31, 2013 that have materially affected, or are reasonably likely to materially affect, its internal control over financial reporting.
Our independent auditors, Deloitte & Touche LLP audited our internal controls over financial reporting as of December 31, 2013. Their report dated February 20, 2014, which is included under ITEM 8, expressed an unqualified opinion on our internal control over financial reporting.
The Company’s Chief Executive Officer and Chief Financial Officer, based on their evaluation of the Company’s 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 December 31, 2013, the Company’s 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.
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 the Company’s periodic reports.


110


ITEM 9B.
Other Information
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 December 31, 2013, we were not involved in any legal proceedings.
Disclosure Pursuant to Section 219 of the Iran Threat Reduction and Syria Human Rights Act
Section 219 of the Iran Threat Reduction and Syria Human Rights Act of 2012 (or, ITRA) added a new subsection (r) to section 13 of the Exchange Act, requiring an issuer to disclose in its annual and quarterly reports whether it or any of its affiliates have knowingly engaged in specified activities or transactions relating to Iran. We have been advised that, as of October 24, 2013, certain investment funds managed by affiliates of Apollo beneficially owned approximately 22% of the limited liability company interests of CEVA Holdings, LLC (or, CEVA). Under the limited liability company agreement governing CEVA, certain investment funds managed by affiliates of Apollo hold a majority of the voting power of CEVA and have the right to elect a majority of the board of CEVA. Because of the relationship with the Manager, which is an indirect subsidiary and is considered to be an affiliate of Apollo, we may be considered to be an affiliate of CEVA since CEVA and we may be deemed to be under the common control of Apollo. However, this disclosure is not meant to be an admission that such common control exists. As a result, it appears that we are required to provide the disclosures set forth below pursuant to Section 219 of ITRA and Section 13(r) of the Exchange Act.
Apollo has informed us that CEVA has provided it with the information below relevant to Section 13(r) of the Exchange Act. The disclosure below does not relate to any activities conducted by us and does not involve us, our management or the Manager. The disclosure relates solely to activities conducted by CEVA and its consolidated subsidiaries. We have not independently verified or participated in the preparation of the disclosure below. (Amounts presented below are in U.S. dollars and cents.)
“Through an internal review of its global operations, CEVA has identified the following transactions in an Initial Notice of Voluntary Self-Disclosure that CEVA filed with the U.S. Treasury Department Office of Foreign Assets Control (“OFAC”) on October 28, 2013. CEVA’s review is ongoing. CEVA will file a further report with OFAC after completing its review.
The internal review indicates that, in February 2013, CEVA Freight Holdings (Malaysia) SDN BHD (“CEVA Malaysia”) provided customs brokerage for export and local haulage services for a shipment of polyethylene resin to Iran shipped on a vessel owned and/or operated by HDS Lines, also an SDN. The revenues and net profits for these services were approximately $779.54 USD and $311.13 USD, respectively. In September 2013, CEVA Malaysia provided customs brokerage services for the import into Malaysia of fruit juice from Alifard Co. in Iran via HDS Lines. The revenues and net profits for these services were approximately $227.41 USD and $89.29 USD, respectively.
These transactions violate the terms of internal CEVA compliance policies, which prohibit transactions involving Iran. Upon discovering these transactions, CEVA promptly launched an internal investigation, and is taking action to block and prevent such transactions in the future. CEVA intends to cooperate with OFAC in its review of this matter.”



111


PART III

ITEM 10.
Directors, Executive Officers and Corporate Governance
The information regarding the Company’s directors, executive officers and certain other matters required by Item 401 of Regulation S-K is incorporated herein by reference to the Company’s proxy statement relating to its annual meeting of stockholders to be held on or about June 19, 2014 (or, Proxy Statement), to be filed with the SEC within 120 days after December 31, 2013.
The information regarding compliance with Section 16(a) of the Exchange Act required by Item 405 of Regulation S-K is incorporated herein by reference to the Proxy Statement to be filed with the SEC within 120 days after December 31, 2013.
The information regarding the Company’s Code of Business Conduct and Ethics required by Item 406 of Regulation S-K is incorporated herein by reference to the Proxy Statement to be filed with the SEC within 120 days after December 31, 2013.
The information regarding certain matters pertaining to the Company’s corporate governance required by Item 407(c)(3), (d)(4) and (d)(5) of Regulation S-K is incorporated by reference to the Proxy Statement to be filed with the SEC within 120 days after December 31, 2013.
ITEM 11.
Executive Compensation
The information regarding executive compensation and other compensation related matters required by Items 402 and 407(e)(4) and (e)(5) of Regulation S-K is incorporated herein by reference to the Proxy Statement to be filed with the SEC within 120 days after December 31, 2013.
ITEM 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
The tables on equity compensation plan information and beneficial ownership of the Company required by Items 201(d) and 403 of Regulation S-K are incorporated herein by reference to the Proxy Statement to be filed with the SEC within 120 days after December 31, 2013.
ITEM 13.
Certain Relationships and Related Transactions and Director Independence
The information regarding transactions with related persons, promoters and certain control persons and director independence required by Items 404 and 407(a) of Regulation S-K is incorporated herein by reference to the Proxy Statement to be filed with the SEC within 120 days after December 31, 2013.
ITEM 14.
Principal Accountant Fees and Services
The information concerning principal accounting fees and services and the Audit Committee’s pre-approval policies and procedures required by Item 9(e) of Schedule 14A is incorporated herein by reference to the Proxy Statement to be filed with the SEC within 120 days after December 31, 2013.


112


PART IV

ITEM 15.
Exhibits and Financial Statement Schedules
Documents filed as part of the report
The following documents are filed as part of this annual report on Form 10-K:
(1)Financial Statements:
The consolidated financial statements of the Company, together with the independent registered public accounting firm’s report thereon, are set forth in this annual report on Form 10-K and are incorporated herein by reference. See ITEM 8, filed herewith, for a list of financial statements.
(2)Financial Statement Schedules:
All financial statement schedules have been omitted because the required information is not applicable or deemed not material, or the required information is presented in the consolidated financial statements and/or in the notes to consolidated financial statements filed in response to ITEM 8 of this annual report on Form 10-K.
(3)Exhibits Files:
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.
 
 
10.1
Registration Rights Agreement, dated as of July 27, 2011, between Apollo Residential Mortgage, Inc. and the parties named therein, incorporated by reference to Exhibit 10.1 of the Registrant’s Form 10-Q for the period ended September 30, 2011.
 
 
10.2
Management Agreement, dated as of July 21, 2011 and effective as of July 27, 2011, between Apollo Residential Mortgage, Inc., ARM Operating, LLC and ARM Manager, LLC, incorporated by reference to Exhibit 10.2 of the Registrant’s Form 10-Q for the period ended September 30, 2011.
 
 
10.3
License Agreement dated as of July 21, 2011, between Apollo Residential Mortgage, Inc. and Apollo Global Management, LLC, incorporated by reference to Exhibit 10.3 of the Registrant’s Form 10-Q for the period ended September 30, 2011.
 
 
10.4
Apollo Residential Mortgage, Inc. 2011 Equity Incentive Plan, incorporated by reference to Exhibit 10.1 of the Registrant’s Form S-8 (Registration No. 333- 175824).
 
 
10.5
Form of Restricted Stock Award Agreement, incorporated by reference to Exhibit 10.3 of the Registrant’s Form S-11, as amended (Registration No. 333-172980).
 
 
10.6
Form of Restricted Stock Unit Award Agreement, incorporated by reference to Exhibit 10.4 of the Registrant’s Form S-11, as amended (Registration No. 333-172980).
 
 
21.1*
Subsidiaries of Registrant.
 
 
23.1*
Consent of Deloitte & Touche LLP.
 
 
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 the Chief Executive Officer, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 
32.2*
Certification of the Chief Financial Officer, pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.


113


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.
*
 Filed herewith.


114


SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
 
 
 
 
Date:
February 20, 2014
 
By:
 
/s/ Michael A. Commaroto
 
 
 
 
 
Name: Michael A. Commaroto
 
 
 
 
 
Title: President and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
Date:
February 20, 2014
 
By:
 
/s/ Michael A. Commaroto
 
 
 
 
 
Michael A. Commaroto
 
 
 
 
 
President and Chief Executive Officer,
 
 
 
 
 
(principal executive officer)
 
 
 
 
Date:
February 20, 2014
 
By:
 
/s/ Teresa D. Covello
 
 
 
 
 
Teresa D. Covello
 
 
 
 
 
Chief Financial Officer, Treasurer and Secretary
 
 
 
 
 
(principal financial officer and principal accounting officer)
 
 
 
 
Date:
February 20, 2014
 
By:
 
/s/ Frederick N. Khedouri
 
 
 
 
 
Frederick N. Khedouri
 
 
 
 
 
Director
 
 
 
 
Date:
February 20, 2014
 
By:
 
/s/ Marc E. Becker
 
 
 
 
 
Marc E. Becker
 
 
 
 
 
Director
 
 
 
 
Date:
February 20, 2014
 
By:
 
/s/ Mark C. Biderman
 
 
 
 
 
Mark C. Biderman
 
 
 
 
 
Director
 
 
 
 
Date:
February 20, 2014
 
By:
 
/s/ Thomas D. Christopoul
 
 
 
 
 
Thomas D. Christopoul
 
 
 
 
 
Director
 
 
 
 
Date:
February 20, 2014
 
By:
 
/s/ Frederick J. Kleisner
 
 
 
 
 
Frederick J. Kleisner
 
 
 
 
 
Director
 
 
 
 
 
 
 
Date:
February 20, 2014
 
By:
 
/s/ Justin Stevens
 
 
 
 
 
Justin Stevens
 
 
 
 
 
Director
 
 
 
 
 
 
 
 
Date:
February 20, 2014
 
By:
 
/s/ Hope S. Taitz
 
 
 
 
 
Hope S. Taitz
 
 
 
 
 
Director


115