10-K 1 mtge20171231form10k.htm 10-K Document



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-K
 
þ
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the year ended December 31, 2017

Commission file number 001-35260
mtgeinvestmentcorplogoa05.jpg

MTGE INVESTMENT CORP.
(Exact name of registrant as specified in its charter)
Maryland
 
45-0907772
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
2 Bethesda Metro Center
12th Floor
Bethesda, Maryland 20814
(Address of principal executive offices)
 
(301) 968-9220
(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 per share
 
The Nasdaq Global Select Market
8.125% Series A Cumulative Redeemable Preferred Stock
 
The Nasdaq Global Select Market
 
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 þ.        No ¨.
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or 15(d) of the Act.   Yes  ¨.   No þ.

Indicate by check mark whether the registrant (1) has filed all reports to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter 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 þ.        No ¨.
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes þ.        No ¨.





Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of 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.     ¨
 
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 definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
Large accelerated filer
þ
 
Accelerated filer
o
Non-accelerated filer
o
(Do not check if a smaller reporting company)
Smaller Reporting Company
o
Emerging growth company
o
 
 
 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ¨

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

As of June 30, 2017, the aggregate market value of the Registrant's common stock held by non-affiliates of the Registrant was approximately $665.0 million based upon the closing price of the Registrant's common stock of $18.80 per share as reported on The Nasdaq Global Select Market on that date. (For this computation, the Registrant has excluded the market value of all shares of its common stock reported as beneficially owned by executive officers and directors of the Registrant and certain other stockholders; such an exclusion shall not be deemed to constitute an admission that any such person is an “affiliate” of the Registrant.)  

DOCUMENTS INCORPORATED BY REFERENCE. The Registrant's definitive proxy statement for the 2018 Annual Meeting of Shareholders is incorporated by reference into certain sections of Part III herein. Certain exhibits previously filed with the Securities and Exchange Commission are incorporated by reference into Part IV of this report.

The number of shares of the issuer’s common stock outstanding as of February 1, 2018 was 45,797,687





MTGE INVESTMENT CORP.
TABLE OF CONTENTS
 

PART I.
 
 
 
 
Item 1.
Business
Item 1A.
Risk Factors
Item 1B.
Unresolved Staff Comments
Item 2.
Properties
Item 3.
Legal Proceedings
Item 4.
Mine Safety Disclosures
 
 
 
PART II.
 
 
 
 
 
Item 5.
Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Item 6.
Selected Financial Data
Item 7.
Management's Discussion and Analysis of Financial Condition and Results of Operations
Item 7A.
Quantitative and Qualitative Disclosures about Market Risk
Item 8.
Financial Statements and Supplementary Data
Item 9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Item 9A.
Controls and Procedures
Item 9B.
Other Information
 
 
 
PART III.
 
 
 
 
 
Item 10.
Directors, Executive Officers and Corporate Governance
Item 11.
Executive Compensation
Item 12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Item 13.
Certain Relationships and Related Transactions, and Director Independence
Item 14.
Principal Accountant Fees and Services
 
 
 
PART IV.
 
 
 
 
 
Item 15.
Exhibits and Financial Statement Schedules
 
 
 
Signatures
 


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PART I
Item 1. Business
Our Company
MTGE Investment Corp. (“MTGE”, the “Company”, “we”, “us”, and “our”) was incorporated in Maryland on March 15, 2011 and commenced operations on August 9, 2011 following the completion of our initial public offering (“IPO”). We are externally managed by MTGE Management, LLC (our “Manager”), a wholly owned subsidiary of AGNC Investment Corp. (“AGNC”). Our common stock is traded on the Nasdaq Global Select Market under the symbol “MTGE.”

We invest in, finance and manage a leveraged portfolio of real estate-related investments, which includes agency residential mortgage-backed securities (“agency RMBS”), non-agency securities, other mortgage-related investments and other real estate investments. Agency RMBS include residential mortgage pass-through certificates and collateralized mortgage obligations (“CMOs”) structured from residential mortgage pass-through certificates for which the principal and interest payments are guaranteed by a government-sponsored enterprise (“GSE”), such as Federal National Mortgage Association (“Fannie Mae”) and Federal Home Loan Mortgage Corporation (“Freddie Mac”), or by a U.S. Government agency, such as Government National Mortgage Association (“Ginnie Mae”). Non-agency securities include securities backed by residential mortgages that are not guaranteed by a GSE or U.S. Government agency and credit risk transfer securities (“CRT”). Other mortgage-related investments may include mortgage servicing rights (“MSR”), commercial mortgage-backed securities (“CMBS”), prime and non-prime residential mortgage loans, commercial mortgage loans and mortgage-related derivatives. Other real estate investments may include equity and debt investments in healthcare real estate, including skilled nursing, assisted living and independent living facilities, operated by third party operators.
We operate to qualify to be taxed as a (“REIT”) under the Internal Revenue Code of 1986, as amended (the “Internal Revenue Code”). As as REIT, we are required to distribute annually at least 90% of our taxable income. So long as we continue to qualify as a REIT, we will generally not be subject to U.S. Federal or state corporate taxes on our REIT taxable income to the extent that we distribute all of our annual REIT taxable income to our stockholders. It is our intention to distribute 100% of our taxable income, after application of available tax attributes, within the time limits prescribed by the Internal Revenue Code, which may extend into the subsequent taxable year.
Investment Strategy
Our principal investment objective is to generate attractive risk-adjusted returns for our stockholders through a combination of quarterly dividends and net asset value appreciation. In pursuing this objective, we rely on our Manager's expertise to construct and manage a diversified investment portfolio by identifying asset classes that, when properly financed and hedged, are selected to produce attractive returns across a variety of market conditions and economic cycles, considering the risks associated with owning such investments. Specifically, our investment strategy is designed to:
manage an investment portfolio of real estate-related investments;
capitalize on discrepancies in relative market valuations for real estate-related investments;
manage financing, interest rate, prepayment, extension and credit risks;
provide regular quarterly distributions to our stockholders;
qualify as a REIT;
remain exempt from the requirements of the Investment Company Act of 1940 (the “Investment Company Act”);
generate attractive risk-adjusted returns; and
manage our net asset value risk within reasonable bands.
Targeted Investments
We invest in, finance and manage real estate-related investments, including agency RMBS, non-agency mortgage investments, other mortgage-related investments and other real estate investments, including those set forth in each of the following asset classes:
Agency Securities
Agency RMBS. Our primary agency securities investments consist of agency pass-through certificates representing interests in “pools” of mortgage loans secured by residential real property. Monthly payments of principal and interest made by the individual borrowers on the mortgage loans underlying the securities, which are guaranteed by

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a GSE to holders of the securities, are in effect “passed through,” to the holders of the securities, after deducting guarantee and servicer fees. In general, mortgage pass-through certificates distribute cash flows from the underlying collateral on a pro rata basis among the holders of the securities. Holders of the securities also receive guarantor advances of principal and interest on delinquent loans in the mortgage pools. We also invest in agency CMOs, which are structured instruments representing interests in agency residential pass-through certificates, and interest-only, inverse interest-only and principal-only securities, which represent the right to receive a specified proportion of the contractual interest or principal flows of specific agency CMO securities.
To-Be-Announced Forward Contracts (TBA). TBAs are forward contracts to purchase or sell agency RMBS. TBA contracts specify the coupon rate, issuer, term, and face value of the bonds to be delivered, with the actual bonds to be delivered only identified shortly before the TBA settlement date.
Non-Agency Securities
Non-agency RMBS. Non-agency RMBS are securities issued by a private institution such as a commercial bank and are backed by residential mortgages, for which the payment of principal and interest is not guaranteed by a GSE or government agency. As such, non-agency RMBS can carry a significantly higher level of credit exposure than agency RMBS. Non-agency RMBS may benefit from credit enhancement derived from structural elements, such as subordination, overcollateralization or insurance. We may purchase highly-rated instruments that benefit from credit enhancement or non-investment grade instruments that absorb credit risk. We focus primarily on non-agency RMBS where the underlying mortgages are secured by residential properties within the United States. Non-agency RMBS are backed by residential mortgages that can be prime mortgage or non-prime mortgage loans.
CRT. CRT securities transfer a portion of the risk associated with credit losses incurred by pools of conventional residential mortgage loans from the GSEs and/or third parties to private investors. Unlike Agency RMBS, full repayment of the original principal balance of CRT securities is not guaranteed by a GSE or other third party; rather, “credit risk transfer” is achieved by writing down the outstanding principal balance of the CRT securities if credit losses on the related pool of loans exceed certain thresholds. By reducing the amount that issuers are obligated to repay to holders of CRT securities, they offset credit losses on the related pool of loans.
Other Mortgage-Related Investments
CMBS. CMBS are securities that are structured utilizing collateral pools comprised of commercial mortgage loans. CMBS can be structured as pass-through securities, where the cash flows generated by the collateral pool are passed on pro rata to investors after netting servicer or other fees, or where cash flows are distributed to numerous classes of securities following a predetermined waterfall, which may give priority to selected classes while subordinating other classes. We may invest across the capital structure of these securities and focus on CMBS where underlying collateral is secured by commercial properties located within the United States.
Mortgage servicing rights. MSR represent the right to service mortgage loans, which involves activities such as collecting mortgage payments, escrowing and paying taxes and insurance premiums, and forwarding principal and interest payments to the mortgage lender. In return for providing these services, the holder of an MSR is entitled to receive a servicing fee, typically specified as a percentage (expressed in basis points) of the serviced loan's unpaid principal balance. We may invest in MSR associated with either agency or non-agency mortgage loans.
Mortgage-related derivatives. As part of our investment and risk management strategy, we may enter into derivative transactions as a method of enhancing our risk/return profile and/or hedging existing or emerging risks within our investment portfolio. These transactions may include, but are not limited to, buying or selling forward positions and credit default swaps. Our Manager's implementation of this strategy is based upon overall market conditions, the level of volatility in the mortgage market, the size of our investment portfolio and our qualification as a REIT.
Other mortgage-related investments may also include mortgage REIT equity securities, residential and commercial mortgage loans, excess interest-only instruments and other investments that may arise as the mortgage market evolves.

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Other Real Estate Investments
Our other real estate investments include equity investments in healthcare and other senior living facilities which are leased to or operated by third parties who conduct all business operations of the facilities and debt investments secured by such facilities. We would expect such facilities to consist of the following:
Skilled Nursing Facilities. Skilled nursing facilities (“SNF”) are licensed healthcare facilities that provide restorative, rehabilitative and nursing care for people not requiring the more extensive and sophisticated treatment available at acute care hospitals. Treatment programs include physical, occupational, speech, respiratory and other therapies, including sub-acute clinical protocols such as wound care and intravenous drug treatment. Charges for these services are generally paid by a combination of government reimbursement and private sources.
Assisted Living Facilities. Assisted living facilities (“ALF”) are licensed healthcare facilities that provide personal care services, support and housing for those who need help with activities of daily living, such as bathing, eating and dressing, yet require limited medical care. The programs and services may include transportation, social activities, exercise and fitness programs, beauty or barber shop access, hobby and craft activities, community excursions, meals in a dining room setting and other activities sought by residents. These facilities are often in apartment-like buildings with private residences ranging from single rooms to large apartments. Certain ALFs may offer higher levels of personal assistance for residents requiring memory care as a result of Alzheimer’s disease or other forms of dementia. Levels of personal assistance are based in part on local regulations.
Independent Living Facilities. Independent living facilities (“ILF”), also known as retirement communities or senior apartments, typically consist of entirely self-contained apartments, complete with their own kitchens, baths and individual living spaces, as well as parking for tenant vehicles. They are most often rented unfurnished, and generally can be personalized by the tenants, typically an individual or a couple over the age of 55. These facilities offer various services and amenities such as laundry, housekeeping, meal plans, exercise and wellness programs, transportation, social, cultural and recreational activities, on-site security and emergency response programs.

Active Portfolio Management Strategy

Our Manager employs an active management strategy on our behalf designed to achieve our principal objectives of generating attractive risk-adjusted returns for our stockholders through a combination of quarterly dividends and net asset value appreciation. Our Manager selects investments based on its assessment of relative risk-return profiles and the ability to effectively hedge a portion of the investments' exposure to market risks. The composition of our portfolio will vary based on our Manager's view of prevailing market conditions and the availability of suitable investment, hedging and funding opportunities. As a result, we may experience investment gains or losses when we sell investments that we believe no longer provide attractive risk-adjusted returns, when we believe more attractive alternatives exist elsewhere, or when we believe it is prudent to reduce aggregate exposure or a particular type of risk embedded in the portfolio. We may also experience gains or losses from our hedging strategies or due to credit losses on our non-agency securities or other real estate related investments.
Financing Strategy
As part of our investment strategy, we use leverage in our investment portfolio to increase potential returns to our stockholders. We may finance our securities investments, subject to market conditions, through a combination of financing arrangements, including, but not limited to, repurchase agreements, warehouse facilities, securitizations, term financing facilities and dollar roll transactions. We finance our securities investments primarily by entering into master repurchase agreements. A repurchase transaction acts as a financing arrangement under which we effectively pledge our investment assets as collateral to secure a loan. Our borrowings pursuant to these repurchase transactions generally have maturities that range from 30 to 180 days, but may have maturities of fewer than 30 days or more than one year. Under our repurchase agreements, our financing rate typically tracks short term rates such as the one, three or six month London Interbank Offered Rate, or LIBOR, plus or minus a fixed spread.

We seek to finance the acquisition of our healthcare real estate primarily through long term mortgage debt provided by Fannie Mae, Freddie Mac, and the Department of Housing Development (“HUD”). We may also finance our healthcare properties through the use of shorter term secured debt or bridge-loan financing obtained from other lenders.
Our leverage varies depending on market conditions, our portfolio composition and our Manager's assessment of risks and returns. We finance different asset classes through the most efficient means available for a particular asset class at any given time. Therefore, our overall leverage is highly dependent on our investment portfolio composition. We generally expect our

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leverage to be within four to seven times the amount of our stockholders' equity. However, under certain market conditions, we may operate at leverage levels outside of this range for extended periods of time.
We seek to diversify our funding exposure by entering into repurchase agreements with multiple counterparties. We had master repurchase agreements with 34 financial institutions as of December 31, 2017. The terms of our master repurchase agreements generally conform to the terms in the standard master repurchase agreement as published by the Securities Industry and Financial Markets Association (“SIFMA”) with respect to repayment, margin requirements and the segregation of all securities sold under the repurchase transaction. In addition, each lender may require that we include supplemental terms and conditions to the standard master repurchase agreement. Typical supplemental terms and conditions include additional margin maintenance requirements, requirements that all controversies related to the repurchase agreement be litigated in a particular jurisdiction and cross default provisions. These provisions may differ for each lender and certain of these terms may not be determined until we engage in a specific repurchase transaction.

We also finance the acquisition of agency RMBS by entering into TBA dollar roll transactions in which we would sell a TBA contract for current month settlement and simultaneously purchase a similar, but not identical, TBA contract for a forward settlement date. Prior to the forward settlement date, we may choose to roll the position to a later date by entering into an offsetting TBA position, net settling the paired off positions for cash, and simultaneously entering into a similar TBA contract for a later settlement date. In such transactions, the TBA contract purchased for a forward settlement date is priced at a discount to the TBA contract sold for settlement/pair off in the current month. This difference (or discount) is referred to as the “price drop.” The price drop is the economic equivalent of net interest carry income on the underlying agency RMBS over the roll period (interest income less implied financing cost) and is commonly referred to as “dollar roll income.” We recognize TBA contracts as derivative instruments on our consolidated financial statements at their net carrying value (fair value less the purchase price to be paid or received under the TBA contract). Consequently, dollar roll transactions represent a form of off-balance sheet financing. In evaluating our overall leverage at risk, our Manager considers both our on-balance and off-balance sheet financing.
Risk Management Strategy
We use a variety of strategies to reduce our exposure to market risks, including interest rate, prepayment, extension and credit risks to the extent that our Manager believes is prudent, taking into account our investment strategy, the cost of hedging transactions and our intention to qualify as a REIT. Our hedging strategies are generally not designed to protect our net asset value from “spread risk,” or “basis risk”, which is the risk that the yield differential between our investments and our hedges fluctuates. In addition, while we use interest rate swaps and other supplemental hedges to attempt to protect our net asset value against moves in interest rates, we may not hedge certain interest rate, prepayment or extension risks if we believe that bearing such risks enhances our return profile, or if the hedging transaction would negatively impact our REIT status.
Interest Rate Risk. The vast majority of our investments have fixed rates of interest and can have average expected lives in excess of five years. Because a majority of our funding costs fluctuate based on short-term interest rate indices, such as the London Interbank Offered Rate (“LIBOR”), the net interest income that we earn on these leveraged investments can vary significantly along with changes in market interest rates. As such, we may experience reduced income, losses, or a significant reduction in our net asset value due to adverse interest rate movements. To attempt to mitigate a portion of such risk, we utilize certain hedging techniques to attempt to lock in a portion of the net spread between the interest we earn on our assets and the interest we pay on our financing.
Additionally, because prepayments on residential mortgages generally accelerate when interest rates decrease and slow when interest rates increase, mortgage securities typically have “negative convexity.” In other words, certain mortgage securities in which we invest may increase in price more slowly than similar duration bonds, or even fall in value, as interest rates decline. Conversely, certain mortgage securities in which we invest may decrease in value more quickly than similar duration bonds as interest rates increase. To manage this risk, we monitor, among other things, the “duration gap” between our mortgage assets and our hedge portfolio as well as our convexity exposure. Duration is an estimate of the relative expected percentage change in market value of our mortgage assets or our hedge portfolio that would be caused by a parallel change in short and long-term interest rates. Convexity exposure relates to the way the duration of our mortgage assets or our hedge portfolio changes when the interest rate or prepayment environment changes.

The value of our mortgage assets may also be adversely impacted by fluctuations in the shape of the yield curve or by changes in the market's expectation about the volatility of future interest rates. We analyze our exposure to non-parallel changes in interest rates and to changes in the market's expectation of future interest rate volatility and take actions to attempt to mitigate these risks.

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Prepayment Risk. Because residential borrowers have the option to prepay their mortgage loans at par at any time, we face the risk that we will experience a return of principal on our investments faster than anticipated. Prepayment risk generally increases when interest rates decline. In this scenario, our financial results may be adversely affected as we may have to reinvest that principal at lower yields.

Extension Risk. Because residential borrowers have the option to make only scheduled payments on their mortgage loans, rather than prepay their mortgage loans, we face the risk that a return of capital on our investment will occur slower than anticipated. Extension risk generally increases when interest rates rise. In this scenario, our financial results may be adversely affected as we may have to finance our investments at potentially higher costs without the ability to reinvest principal into higher yielding securities because borrowers prepay their mortgages at a slower pace than originally expected.
Credit Risk. We accept mortgage credit exposure at levels our Manager deems prudent within the context of our diversified investment strategy. Therefore, we may retain all or a portion of the credit risk on the loans underlying our non-agency RMBS, as well as any future investments in CMBS and individual residential and commercial mortgages. We seek to manage this risk through prudent asset selection, pre-acquisition due diligence, post-acquisition performance monitoring, and sale of assets where we identify negative credit trends. We may also manage credit risk with credit default swaps or other financial derivatives that our Manager believes are appropriate.
Spread Risk. When the spread between the market yield on our investments and benchmark interest rates widens, our net asset value could decline if the value of our investments falls by more than the offsetting fair value increases on our hedging instruments, creating what we refer to as “spread risk” or “basis risk.” The spread risk associated with our agency and non-agency securities and the resulting fluctuations in the fair value of these securities can occur independent of changes in benchmark interest rates and may relate to other factors impacting the mortgage and fixed income markets, such as actual or anticipated monetary policy actions by the Federal Reserve (“the Fed”), market liquidity, or changes in required rates of return on different assets. Our strategies are generally not specifically designed to protect our net asset value from spread risk.
Risks Related to Healthcare Real Estate Investments. Our healthcare real estate investments, including independent living facilities, are exposed to counterparty risk, including, for equity investments, the ongoing ability of the operator to satisfy its lease obligations, or for potential debt investments, the ongoing ability of the borrower (the facility owner) to make principal and interest payments. As such, our healthcare real estate investments are heavily dependent upon the successful operation of the facilities by our counterparties. These operations may be impacted by factors specific to the healthcare sector, including, but not limited to, regulatory changes, government reimbursement reductions and revisions to licensure or certification requirements. Additionally, healthcare real estate is relatively illiquid, generally cannot be sold quickly and may be subject to impairment charges based on factors such as market conditions and operator performance. We seek to manage these risks through detailed pre-transaction due diligence of target properties and associated operators, prudent asset selection, and active post-acquisition monitoring.

The principal instruments that we use to hedge a portion of our exposure to interest rate, prepayment and extension risks are interest rate swaps, options to enter into interest rate swaps (“swaptions”), U.S. Treasury securities and U.S. Treasury futures contracts. We also use TBA forward contracts to periodically reduce our exposure to Agency RMBS.

Our hedging instruments are generally not designed to protect our net asset value from spread risk. Consequently, while we use interest rate swaps and other supplemental hedges to attempt to protect our net asset value against moves in interest rates, such instruments typically will not protect our net asset value against spread risk and, therefore, our net asset value could decline.
While our risk management strategy has the objective of maintaining attractive levels of earnings and dividends over the long term, the actions we take may lower our earnings and dividends in the short term. In addition, some of our hedges are intended to provide protection against larger rate moves and as a result may be relatively ineffective for smaller changes in interest rates.
Income from hedging transactions that we enter into to manage risk may not constitute qualifying gross income under one or both of the gross income tests applicable to REITs. Therefore, we may have to limit our use of certain hedging techniques, which could expose us to greater risks than we would otherwise want to bear, or implement those hedging techniques through a

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taxable REIT subsidiary (“TRS”). Implementing our hedges through a TRS could increase the cost of our hedging activities because a TRS would be subject to tax on income and gains.
Our Manager
Pursuant to the terms of a management agreement, our Manager is responsible for administering our business activities and day-to-day operations, subject to the supervision and oversight of our Board of Directors. All of our officers, the members of our investment team and other support personnel, other than employees of Residential Credit Solutions, Inc. (“RCS”), are employees of the parent company of our Manager.
The management agreement has a current renewal term through August 9, 2018 and automatic one-year extension options thereafter. The management agreement may be terminated by us without cause, as defined in the management agreement, upon 90 days’ prior written notice to the Manager. Our Manager may terminate the management agreement without cause, as defined in the management agreement, after the completion of the current renewal term, or the expiration of any automatic subsequent renewal term, provided that our Manager provides us 180 days' prior written notice of non-renewal of the management agreement. If we were to terminate the management agreement without cause, we must pay a termination fee on the last day of the applicable term, equal to three times the average annual management fee earned by our Manager during the prior 24-month period immediately preceding the most recently completed month prior to the effective date of termination. We may only terminate the management agreement with or without cause with the consent of a majority of our independent directors. Our Manager is responsible for, among other things, performing all of our day-to-day functions, determining investment criteria in conjunction with our Board of Directors, sourcing, analyzing and executing investments, asset sales and financings and performing asset management duties.
We pay our Manager a base management fee payable monthly in arrears in an amount equal to 1/12 of 1.50% of our month-end stockholders' equity, adjusted to exclude the effect of any unrealized gains or losses included in retained earnings, each as computed in accordance with GAAP. There is no incentive compensation payable to our Manager pursuant to the management agreement. We reimburse our Manager for expenses directly related to our operations incurred by our Manager, excluding employment-related expenses.
Exemption from Regulation Under the Investment Company Act
We conduct our business so as not to become regulated as an investment company under the Investment Company Act (the “Act”), in reliance on the exemption provided by Section 3(c)(5)(C) of the Act. So long as we qualify for this exemption, we will not be subject to leverage and other restrictions imposed on regulated investment companies, which would significantly reduce our ability to use leverage. Section 3(c)(5)(C), as interpreted by the staff of the Securities and Exchange Commission (“SEC”), requires us to invest at least 55% of our assets in “mortgages and other liens on and interest in real estate” or “qualifying real estate interests” and at least 80% of our assets in qualifying real estate interests and “real estate-related assets.” In satisfying this 55% requirement, based on pronouncements of the SEC staff and in certain instances our own judgment, we treat agency RMBS issued with respect to an underlying pool of mortgage loans in which we hold all of the certificates issued by the pool (“whole pool” securities) as qualifying real estate interests. We typically treat “partial pool” and other mortgage securities where we hold less than all of the certificates issued by the pool as real estate-related assets.
Real Estate Investment Trust Requirements
We have elected to be taxed as a REIT under the Internal Revenue Code. So long as we qualify as a REIT, we generally will not be subject to U.S. Federal or state corporate income tax on our taxable income to the extent that we annually distribute all of our taxable income to stockholders within the time limits prescribed by the Internal Revenue Code. Qualification and taxation as a REIT depends on our ability to continually meet requirements imposed upon REITs by the Internal Revenue Code, including satisfying certain organizational requirements, an annual distribution requirement and quarterly asset and annual income tests. The REIT asset and income tests are of significance to our operations as they restrict the extent to which we can invest in certain types of securities and conduct certain hedging activities within the REIT. Consequently, we may be required to limit these activities or conduct them through a TRS. We believe that we have been organized and operate in such a manner as to qualify for taxation as a REIT.
Income Tests
To continue to qualify as a REIT, we must satisfy two gross income requirements on an annual basis.
1.
At least 75% of our gross income for each taxable year generally must be derived from investments in real property or mortgages on real property.

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2.
At least 95% of our gross income in each taxable year generally must be derived from some combination of income that qualifies under the 75% gross income test described above, as well as other dividends, interest, and gains from the sale or disposition of stock or securities, which need not have any relation to real property.
Interest income from obligations secured by mortgages on real property (such as agency and non-agency securities) generally constitutes qualifying income for purposes of the 75% gross income test described above to the extent that the obligation upon which such interest is paid is secured by a mortgage on real property. We expect that substantially all of our income from our agency and non-agency MBS will continue to be qualifying income for purposes of the 75% gross income test. Income from CRT securities is treated as non-qualifying income for the 75% gross income test, which potentially limits our ability to invest in CRT securities.
There is no direct authority with respect to the qualification of income or gains from TBAs for the 75% gross income test; however, we treat these as qualifying income for this purpose based on an opinion of legal counsel.
Income and gains from instruments that we use to hedge the interest rate risk associated with our borrowings, or to be incurred, to acquire real estate assets will generally be excluded from both the numerator and the denominator for the 75% and 95% gross income tests, provided that specified requirements are met.
Asset Tests
At the close of each calendar quarter, we must satisfy the following tests relating to the nature of our assets.
1.
At least 75% of the value of our total assets must be represented by some combination of “real estate assets,” cash, cash items, U.S. Government securities, and, under some circumstances, stock or debt instruments purchased with new capital. For this purpose, mortgage-backed securities and mortgage loans are generally treated as “real estate assets.” Assets that do not qualify for purposes of the 75% asset test are subject to the additional asset tests described below.
2.
The value of any one issuer's securities that we own may not exceed 5% of the value of our total assets.
3.
We may not own more than 10% of any one issuer's outstanding securities, as measured by either voting power or value. The 5% and 10% asset tests do not apply to securities of a TRS or a Qualified REIT Subsidiary (“QRS”) and the 10% asset test does not apply to “straight debt” having specified characteristics and to certain other securities described below.
4.
The aggregate value of all securities of all TRSs that we hold may not exceed 20% of the value of total assets.
5.
No more than 25% of the total value of our assets may be represented by certain non-mortgage debt instruments issued by publicly offered REITs (even though such debt instruments qualify under the 75% asset test).

If we should fail to satisfy the income or asset tests, such a failure would not cause us to lose our REIT qualification if we were able to eliminate the discrepancy within a 30 day cure period, in the case of the asset test, or satisfy certain relief provisions and pay any applicable penalty taxes and other fines. Please also refer to the “Risks Related to Our Taxation as a REIT” in “Item 1A. Risk Factors” of this Form 10-K for further discussion of REIT qualification requirements and related items.
 
Corporate Information
Our executive offices are located at Two Bethesda Metro Center, 12th Floor, Bethesda, MD 20814 and our telephone number is (301) 968-9220.
We make available all of our Annual Reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to such reports as well as our Code of Ethics and Conduct free of charge on our internet website at www.MTGE.com as soon as reasonably practical after such material is electronically filed with or furnished to the SEC. These reports are also available on the SEC internet website at www.sec.gov.
Competition
Our success depends, in large part, on our ability to acquire assets at favorable spreads over our borrowing costs. In acquiring our investments, we compete with other REITs, mortgage finance and specialty finance companies, savings and loan associations, banks, mortgage bankers, insurance companies, mutual funds, institutional investors, investment banking firms, other lenders, governmental bodies and other entities. These entities and others that may be organized in the future may have similar asset acquisition objectives and increase competition for the available supply of mortgage assets suitable for purchase.

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Additionally, our investment strategy is dependent on the amount of financing available to us in the repurchase agreement market, which may also be impacted by the overall supply of repurchase agreement funding and competing borrowers. Our investment strategy will be adversely impacted if we are not able to secure financing on favorable terms, if at all.
Employees
We are managed pursuant to the management agreement with our Manager. Other than employees of RCS, we do not have any employees. As of December 31, 2017, RCS had 7 employees.

Item 1A. Risk Factors

You should carefully consider the risks described below and all other information contained in this Annual Report on Form 10-K, including our annual consolidated financial statements and the related notes thereto before deciding to purchase our securities. If any of the following risks were to occur, our business, financial condition or results of operations could be materially adversely affected. If that happens, the trading price of our securities could decline, and you may lose all or part of your investment. The risks and uncertainties described below are not the only ones facing us. Additional risks and uncertainties not presently known to us, or not presently deemed material by us, may also impair our operations and performance.

Risks Related to Our Investing, Portfolio Management and Financing Activities

An increase in our borrowing costs would adversely affect our financial condition and results of operations.
    
Our borrowing costs may be adversely affected by several factors, including increases in short-term interest rates, increases in the “haircuts” applied to our assets under repurchase agreements, interest rate volatility, decreases in the value of our assets or reduced availability of financing generally. An increase in our borrowing costs could reduce the difference, or spread, that we may earn between the yields on the investments we make and the borrowings we use to finance such investments. Moreover, due to the short-term or adjustable rate nature of most of the financing for our securities investments, our borrowing costs are particularly sensitive to increases in short-term interest rates, as well as other factors. It is possible that due to higher borrowing costs, the spread on investments could be reduced to a point at which the profitability from investments would be significantly reduced or eliminated. This would adversely affect our results of operations and financial condition and could require us to liquidate assets.

Changes to the pace of the Fed’s purchases or sales of agency mortgage-backed securities may adversely affect the price and return associated with agency securities.
    
In October 2017, the Fed began to taper its reinvestments of principal payments from its U.S. Treasury, agency debt and agency RMBS portfolios acquired as a function of its quantitative easing programs. We cannot predict the impact that these or future actions will have on the prices and liquidity of agency RMBS or on mortgage spreads relative to interest rate hedges tied to benchmark interest rates. During periods in which the Fed further reduces or ceases reinvestment of principal or undertakes outright sales of its securities portfolio, the price of agency RMBS and U.S. Treasury securities could decline, mortgage spreads could widen, refinancing volumes could be lower and market volatility could be considerably higher than would have been the case absent such actions and our results of operations and financial condition could be adversely affected.

We may change our targeted investments, investment guidelines and other operational policies without stockholder consent, which may adversely affect the market price of our common stock and our ability to make distributions to stockholders.

We may change our targeted investments and investment guidelines at any time without the consent of our stockholders, which could result in our making investments that are different from, and possibly riskier than, the investments described herein. Our Board of Directors also determines our other operational policies and may amend or revise such policies, including our policies with respect to our REIT qualification, acquisitions, dispositions, operations, indebtedness and distributions, or approve transactions that deviate from these policies, without a vote of, or notice to, our stockholders. A change in our targeted investments, investment guidelines or other operational policies may increase our exposure to interest rate, spread, default, credit, prepayment, extension, liquidity and other risks as well as exposure to real estate market fluctuations, all of which could adversely affect our results of operations, financial condition and ability to make distributions to our common and preferred stockholders.


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Our active portfolio management strategy may expose us to significant realized gains or losses.

We employ an active management strategy to achieve our principal objective of preserving our net asset value while generating attractive risk-adjusted returns. The composition of our investment portfolio will vary as we believe changes to market conditions, risks and valuations warrant. Consequently, we may experience significant investment gains or losses when we sell investments that we no longer believe provide attractive risk-adjusted returns or when we believe more attractive alternatives are available. We may be incorrect in our assessment and select an investment portfolio that could generate lower returns than a more static management strategy. Also, investors may be less able to assess the changes in our valuation and performance by observing changes in the mortgage market since we may have changed our strategy and portfolio from the last publicly available data. Our leverage may also fluctuate as we pursue our active management strategy.

Our strategy involves significant leverage, which increases the risk that we may incur substantial losses.

We expect our leverage to vary with market conditions and our assessment of the risks and returns on our investments. We incur leverage by borrowing against a substantial portion of the market value of our assets. While leverage is fundamental to our investment strategy, it also creates significant risks. For example, we may incur substantial losses if our borrowing costs increase or if the value of our investments declines.

Failure to procure adequate financing or to renew or replace existing financing as it matures (to which risk we are specifically exposed due to the short-term nature of most of our financing arrangements) could adversely affect our financial condition and results of operations.

We use debt financing as a strategy to increase our return on equity, and because we rely primarily on short-term borrowings to finance our mortgage investments, our ability to achieve our investment objectives depends not only on our ability to borrow funds in sufficient amounts and on favorable terms, but also on our ability to renew or replace our maturing short-term borrowings on a continuous basis. However, we may be unable to borrow sufficient funds to achieve our desired leverage ratio for several reasons, including the following:

our lenders do not make repurchase or other financing agreements available to us at acceptable rates and terms;
our lenders exit the market;
our lenders require additional collateral to cover our borrowings, which we may be unable to deliver; or
we determine that the leverage would expose us to excessive risk.
    
If we are unable to renew or replace maturing borrowings, we may have to sell assets, possibly 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. Consequently, we cannot provide any assurance that any, or sufficient, financing will be available to us in the future on terms that are acceptable to us. If we cannot obtain sufficient funding on acceptable terms, our financial condition and results of operations could be adversely affected and there may be a negative impact on the value of our common and preferred stock and our ability to make distributions to our stockholders.

Differences in the stated maturity of our fixed rate assets and borrowings, or in the timing of interest rate adjustments on our adjustable-rate assets and borrowings may adversely affect our profitability.

We rely primarily on short-term and/or variable rate borrowings to acquire fixed-rate securities with long-term maturities. In addition, we may have adjustable rate assets with interest rates that vary over time based upon changes in an objective index, such as LIBOR or the U.S. Treasury rate. These indices generally reflect short-term interest rates but these assets may not reset in a manner that matches our borrowings.

The relationship between short-term and longer-term interest rates is often referred to as the “yield curve.” Ordinarily, short-term interest rates are lower than longer-term interest rates. If short-term interest rates rise disproportionately relative to longer-term interest rates (a “flattening” of the yield curve), our borrowing costs may increase more rapidly than the interest income earned on our assets. Because our investments typically earn interest at longer-term rates than we pay on our borrowings, a flattening of the yield curve would tend to decrease our net interest income and the market value of our investment portfolio. Additionally, to the extent cash flows from investments that return scheduled and unscheduled principal are reinvested, the spread between the yields on the new investments and available borrowing rates may decline, which would likely decrease our net interest

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income. It is also possible that short-term interest rates could exceed longer-term interest rates (a yield curve “inversion”) and our borrowing costs could exceed our interest income. In this event we could incur operating losses and our ability to make distributions to our stockholders could be adversely affected.

Fair value declines on the assets in which we invest will adversely affect our financial condition and results of operations, and make it costlier to finance these assets.

We use our investments as collateral for our financings. A decline in their fair value, or perceived market uncertainty about their value, could make it difficult for us to obtain financing on favorable terms or at all, or maintain our compliance with terms of any financing arrangements already in place. Fixed-rate securities will generally be more negatively affected by increases in interest rates than adjustable-rate securities. Our investments in mortgage-related securities are recorded at fair value with changes in fair value reported in net income. As a result, a decline in the fair value of our investments could reduce both our net income and stockholders' equity. If market conditions result in a decline in the fair value of our assets it will decrease the amounts we may borrow to purchase additional investments, which may restrict our ability to increase our net income, and our financial condition and results of operations could be adversely affected.

Our hedging strategies may not be successful in mitigating the risks associated with changes in interest rates.

Subject to complying with REIT tax requirements, we employ techniques that are intended to limit, or “hedge,” the adverse effects of changes in interest rates on our net income and net asset value. In general, our hedging strategy depends on our Manager's view of our entire investment portfolio, consisting of assets, liabilities and derivative instruments, considering prevailing market conditions. Our hedging activities are generally designed to limit certain exposures, not to eliminate them. In addition, these strategies may be unsuccessful and we could misjudge the condition of our investment portfolio or the market. Our hedging activity will vary in scope based on the level and volatility of interest rates and principal repayments, credit market conditions, the type of assets held and other market conditions. Our hedging decisions will be determined considering the facts and circumstances existing at the time and may differ from our current hedging strategy. Our hedging strategies may include entering into interest rate swap agreements, interest rate swaptions, TBAs, short sales, caps, collars, floors, forward contracts, options, futures, credit default swaps or other types of hedging transactions. We may conduct certain hedging transactions through a TRS, which may subject those transactions to Federal, state and local income tax.

There are no perfect hedging strategies, and interest rate hedging may fail to protect us from loss. Additionally, our business model calls for accepting certain amounts of interest rate, mortgage spread, prepayment, extension, credit and liquidity risks and other exposures and thus some risks will generally not be hedged. Our Manager could fail to properly assess a risk to our investment portfolio or fail to recognize a risk entirely, leaving us exposed to losses without the benefit of any offsetting hedges gains. The derivative financial instruments we select may not have the effect of reducing our risk. The nature and timing of hedging transactions may influence the effectiveness of these strategies. Poorly designed hedging strategies or improperly executed transactions could increase our risk and losses. In addition, hedging activities could result in losses if the event against which we hedge does not occur. For example, interest rate hedging could fail to protect us or adversely affect us because, among other things:

interest rate hedging can be expensive, particularly during periods of rising and volatile interest rates;
available interest rate hedges may not correspond directly with the interest rate risk for which protection is sought;
the duration of the hedge may not match the duration of the related asset or liability;
the amount of income that a REIT may earn from hedging transactions other than hedging transactions that satisfy certain requirements of the Internal Revenue Code or that are done through a TRS is limited by Federal tax provisions governing REITs;
the party in the hedging transaction owing money to us may default on its obligation to pay;
the credit quality of the party owing money to us on the hedge may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction; and
the value of our interest rate hedges declines due to interest rate fluctuations, lapse of time or other factors.

Furthermore, our hedging activities involve costs that we incur regardless of the effectiveness of the hedging activity. These costs may be higher in periods of market volatility, both because the counterparties to our derivative agreements may demand a higher payment for taking risks, and because repeated adjustments of our hedges during periods of interest rate changes also may increase costs. Consequently, we could incur significant hedging-related costs without any corresponding economic benefits.


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Our hedging strategies are generally not designed to mitigate spread risk.

When the spread between the market yield on our mortgage assets and benchmark interest rates widens, our net asset value could decline. We refer to this as “spread risk” and we generally do not seek to hedge this risk. The spread risk associated with our mortgage assets and the resulting fluctuations in fair value of these securities is a risk inherent to our business and can occur independent of changes in benchmark interest rates. Spread risk may relate to other factors impacting the mortgage and fixed income markets, such as actual or anticipated monetary policy actions by the Fed, market liquidity, or changes in required rates of return on different assets. Consequently, while we use interest rate swaps and other supplemental hedges to attempt to protect against moves in interest rates, such instruments typically will not protect our net asset value against spread risk. If the value of our mortgage assets falls by more than the offsetting fair value increases on our hedging instruments tied to the underlying benchmark interest rates, our financial condition and results of operations could be adversely affect.

Changes in prepayment rates may adversely affect our profitability and are difficult to predict.

Our investment portfolio includes securities backed by pools of mortgage loans which receive payments related to the underlying mortgage loans. When borrowers prepay their mortgage loans at rates that are faster or slower than expected, it results in prepayments that are faster or slower than expected on our assets.

We may purchase securities or loans that have a higher coupon interest rate than the then prevailing market interest rate. In exchange for this higher interest rate, we may pay a premium to par value to acquire the security or loan. In accordance with GAAP, we amortize this premium over the expected term of the security or loan based on our prepayment expectations. However, if a security or loan is prepaid in whole or in part at a faster than expected rate, we must expense the remaining unamortized portion of the premium more quickly than previously expected. We may also be unable to identify acceptable investments to reinvest the proceeds into on a timely basis. Either of these conditions could adversely affect our profitability.

We also may purchase securities or loans that have a lower coupon interest rate than the then prevailing market interest rate. In exchange for this lower interest rate, we may receive a discount to par value to acquire the security or loan. We accrete this discount over the expected term of the security or loan based on our prepayment assumptions. If a security or loan is prepaid at a slower than expected rate, we must accrete the remaining portion of the discount at a slower than expected rate, which would result in a lower than expected yield on securities and loans purchased at a discount to par.

Additionally, if prepayment rates decrease due to a rising interest rate environment, the average life or duration of our fixed-rate assets or the fixed-rate portion of our hybrid ARMs and other assets will generally extend. This could have a negative impact on our results from operations, as our interest rate swap maturities are fixed and will, therefore, cover a smaller percentage of our funding exposure on our mortgage assets to the extent that their average lives increase due to slower prepayments. This situation may also cause the market value of our assets to decline, while most of our hedging instruments would not receive any incremental offsetting gains. We may also be forced to sell assets to maintain adequate liquidity, which could cause us to incur realized losses.

Although prepayment rates generally increase when interest rates fall and decrease when interest rates rise, changes in prepayment rates are difficult to predict. Prepayments also occur when borrowers sell the property and use the sale proceeds to prepay the mortgage or when borrowers default on their mortgages and the mortgages are prepaid from the proceeds of a foreclosure sale of the property. Fannie Mae and Freddie Mac will generally purchase mortgages that are 120 days or more delinquent from RMBS trusts when the cost of guarantee payments to security holders, including advances of interest at the security coupon rate, exceeds the cost of holding the nonperforming loans in their portfolios. Consequently, prepayment rates can be affected by conditions in the housing and financial markets that impact delinquencies on mortgage loans, GSE's cost of capital and their decisions as to when to repurchase delinquent loans, general economic conditions and the relative interest rates on fixed and adjustable rate loans, which could impact refinancing rates.

In addition, the introduction of new government programs, or changes to existing programs, could increase the availability of mortgage credit to homeowners in the United States, which could impact prepayment rates, particularly for Fannie Mae and Freddie Mac agency RMBS. To the extent that actual prepayment speeds differ from our expectations, our operating results could be adversely affected.

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Market conditions may disrupt the historical relationship between interest rate changes and prepayment trends, which may make it more difficult for our Manager to analyze our investment portfolio.

Our success depends, in part, on our Manager's ability to analyze the relationship of changing interest rates on prepayments of the mortgage loans that underlie securities we may own. Changes in interest rates and prepayments affect the market price of the assets that we purchase and any assets that we may hold. As part of our overall portfolio risk management, our Manager analyzes interest rate changes and prepayment trends separately and collectively to assess their effects on our investment portfolio. In conducting its analysis, our Manager depends on certain assumptions based upon historical trends with respect to the relationship between interest rates and prepayments under normal market conditions. Dislocations in the residential mortgage market and other developments may disrupt the relationship between the way that prepayment trends have historically responded to interest rate changes and, consequently, may negatively impact our Manager's ability to (i) assess the market value of our investment portfolio, (ii) implement our hedging strategies and (iii) implement techniques to reduce our prepayment rate volatility, which could materially adversely affect our financial condition and results of operations.

Recent changes to the U.S. Federal income tax code could have a material impact on the residential mortgage market, which could impact the pricing of RMBS.

On December 22, 2017, the President signed the Tax Cuts and Jobs Act (TCJA), which provides for substantial changes to the taxation of individuals and business entities, generally with an effective date of January 1, 2018. For individual taxpayers, the changes included, among others, lower ordinary income tax rates, higher standard deductions, and suspension or modification of several itemized deductions. The changes to the categories of itemized deductions include a limit on deductions of state and local income and property taxes of $10,000 and a modification to the amount of residential mortgage interest that would be deductible. The new rule would limit the deduction available for mortgage interest by reducing the amount of debt that can qualify from $1 million to $750,000, however mortgage debt borrowed prior to December 15, 2017 would not be affected by the reduction. In addition, home equity mortgage interest is no longer deductible. Many of the changes affecting individual taxpayers would cease to apply after December 31, 2025 and would revert to their pre-2018 form with future legislation required to make the provisions effective beyond 2025. As a result of these changes, it is expected that the number of individual taxpayers that itemize deductions will decrease significantly causing the income tax benefits of residential home ownership to decline materially. It is likely that these factors could result in a decline in the pricing of residential real estate as well as alter the prepayment patterns of residential mortgages, which could have a significant impact on the pricing and returns of RMBS.

The mortgage loans referenced by the CRT securities or underlying the non-agency securities in which we invest may be subject to delinquency, foreclosure and loss, which could result in significant losses to us.

Investments in mortgage-related securities, such as CRT securities and non-agency RMBS, where repayment of principal and interest is not guaranteed by a GSE or U.S. Government agency, subject us to the potential risk of loss of principal and/or interest due to delinquency, foreclosure and related losses on the underlying mortgage loans.

CRT securities are risk sharing instruments issued by Fannie Mae and Freddie Mac and similarly structured transactions arranged by third party market participants. The CRT securities issued by Fannie Mae and Freddie Mac are designed to synthetically transfer mortgage credit risk from the entities to private investors. The transactions are structured as unsecured and unguaranteed bonds issued by the GSEs whose principal payments are determined by the delinquency and prepayment experience of a reference pool of mortgages guaranteed by the GSE. CRT transactions arranged by third party market participants are similarly structured to reference a specific pool of loans that have been securitized by Fannie Mae or Freddie Mac and synthetically transfer mortgage credit risk related to those loans to the purchaser of the securities. The holder of CRT securities bears the risk that the borrowers may default on their obligations to make full and timely payments of principal and interest. The return of the principal invested in CRT securities is dependent on the level of borrower defaults on the underlying pool of mortgages. An investor in CRT securities bears the risk that the borrowers in the reference pool of loans may default on their obligations to make full and timely payments of principal and interest.

Residential mortgage loans underlying non-agency RMBS are secured by residential property and are subject to risks of delinquency, foreclosure and loss. The ability of a borrower to repay a loan secured by residential property is dependent upon the income or assets of the borrower. A number of factors may impair a borrower's ability to repay the loan, including: loss of employment; divorce; illness; acts of God; acts of war or terrorism; adverse changes in national and local economic and market conditions; changes in laws and regulations, fiscal policies and zoning ordinances and the related costs of complying with such

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laws and regulations, fiscal policies and ordinances; costs of remediation and liabilities associated with environmental conditions such as mold; and the potential for uninsured or under-insured property losses.

Commercial mortgage loans underlying CMBS are generally secured by multifamily or other commercial property and are subject to risks of delinquency and foreclosure, and risks of loss that are greater than similar risks associated with loans made on the security of residential property. The ability of a borrower to repay a loan secured by an income-producing property typically is dependent primarily upon the successful operation of such property rather than upon the existence of independent income or assets of the borrower. If the net operating income of the property is reduced, the borrower's ability to repay the loan may be impaired. Net operating income of an income producing property can be affected by, among other things: tenant mix; success of tenant businesses; property management decisions; property location and condition; competition from comparable types of properties; changes in laws that increase operating expense or limit rents that may be charged; any need to address environmental contamination at the property; the occurrence of any uninsured casualty at the property; changes in national, regional or local economic conditions or specific industry segments; declines in regional or local real estate values; declines in regional or local rental or occupancy rates; increases in interest rates; real estate tax rates and other operating expenses; changes in governmental rules, regulations and fiscal policies, including environmental legislation; acts of God, acts of war or terrorism, social unrest and civil disturbances.

Our investments in a mortgage servicer and MSR may expose us to additional risks.

The mortgage servicing business is heavily regulated, including regulation by the Consumer Financial Protection Bureau and other Federal and state agencies, and subject to significant litigation. Our failure or alleged failure to follow applicable laws and regulations could subject us to substantial costs and liabilities related to regulatory inquiries and investigations, fines or penalties, court proceedings and litigation settlements.

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

We depend on third-party service providers, including mortgage servicers, for a variety of services related to our non-agency RMBS. We are, therefore, subject to the risks associated with third-party service providers.

We depend on a variety of third-party service providers related to our non-agency RMBS. We rely on the mortgage servicers who service the mortgage loans backing our RMBS to, among other things, collect principal and interest payments on the underlying mortgages and perform loss mitigation services. Mortgage servicers and other service providers to our RMBS, such as trustees, bond insurance providers and custodians, may not perform in a manner that promotes our interests.

Legislation intended to reduce or prevent foreclosures through, among other things, loan modifications may reduce the value of mortgage loans underlying our RMBS. Mortgage servicers may be incentivized by the Federal government to pursue such loan modifications, as well as forbearance plans and other actions intended to prevent foreclosure, even if such loan modifications and other actions are not in the best interests of the beneficial owners of the mortgage loans. Similarly, legislation delaying the initiation or completion of foreclosure proceedings on specified types of residential mortgage loans or otherwise limiting the ability of mortgage servicers to take actions that may be essential to preserve the value of the mortgage loans may also reduce the value of mortgage loans underlying our RMBS. Any such limitations are likely to cause delayed or reduced collections from mortgagors and generally increase servicing costs. As a consequence of the foregoing matters, our business, financial condition and results of operations may be adversely affected.

The failure of servicers to effectively service the mortgage loans underlying the non-agency RMBS in our investment portfolio could materially and adversely affect us.

Most securitizations of residential mortgage loans require a servicer to manage collections on each of the underlying loans. Both default frequency and default severity of 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. Additionally, servicers can perform loan modifications, which could potentially impact the value of our securities. The failure of servicers to effectively service the mortgage loans underlying the RMBS in our investment portfolio could negatively impact the value of our investments and our performance. Servicer quality is of prime importance in the default performance of RMBS. If a servicer goes out of business, the transfer of servicing takes time and loans may become delinquent because of confusion or lack of attention. When servicing is transferred, previously advanced principal and interest is often recaptured rapidly by the new servicer, which may have an adverse effect on

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RMBS credit support. 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 funds, interest may be interrupted, even on more senior securities. Servicers may also advance more than is in fact recoverable once a defaulted loan is disposed, and the loss to the trust may be greater than the outstanding principal balance of that loan (greater than 100% loss severity).

Our investments may benefit from private mortgage insurance, but this insurance may not be sufficient to cover losses.
    
In certain instances, non-agency mortgage loans may have private insurance. This insurance is often structured to absorb only a portion of the loss if a loan defaults and, as such, we may be exposed to losses on these loans. If private mortgage insurers fail to remit insurance payments to us for insured portions of loans when losses are incurred and where applicable, whether due to breach of contract or to an insurer's insolvency, we may experience a loss for the amount that was insured by such insurers, though we may maintain claims against the insurers.

Our investments may include subordinated tranches of non-agency securities or CMBS, which are subordinate in right of payment to more senior securities.

Our investments may include subordinated tranches of non-agency securities or CMBS, which are subordinated classes of securities in a structure collateralized by a pool of mortgage loans and, accordingly, are among the first to bear the loss upon a restructuring or liquidation of the underlying collateral and the last to receive payment of interest and principal. Additionally, estimated fair values of these subordinated interests tend to be more sensitive to changes in economic conditions than more senior securities. As a result, such subordinated interests generally are less actively traded and may not provide holders thereof with liquid investments. When we invest in securities that are illiquid, are unrated, have a higher risk of default or are difficult to value, such securities may be considered speculative, and their capacity to pay principal and interest in accordance with the terms of their issue is not certain.

Our investment portfolio may be concentrated in terms of credit risk.

Our investment portfolio 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 asset, downturns relating generally to such region or type of asset 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. Our portfolio may contain other concentrations of risk, and we may fail to identify, detect or hedge against those risks, resulting in large or unexpected losses.

Any credit ratings assigned to our investments will be subject to ongoing evaluations and revisions and we cannot assure you that those ratings will not be downgraded.

Some of our investments are rated by Moody's Investors Service, Fitch Ratings or Standard & Poor's. Any credit ratings on our investments are subject to ongoing evaluation by credit rating agencies, and we cannot assure you that any such ratings will not be changed or withdrawn by a rating agency in the future. 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 investments in the future, the value of these investments could significantly decline, which would adversely affect the value of our investment portfolio and could result in losses upon disposition.

Our Manager's due diligence of potential investments may not reveal all potential liabilities and other weaknesses associated with such investments, which could lead to investment losses.

Before making an investment, our Manager assesses the strengths and weaknesses of the originators, borrowers and the underlying property values, as well as other factors and characteristics that are material to the performance of the investment. In making the assessment and otherwise conducting customary due diligence, our Manager relies on resources available to it and, in some cases, information provided by third parties. There can be no assurance that our Manager's due diligence process will uncover all relevant facts or that any investment will be successful.

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We may be adversely affected by risks affecting borrowers or the asset or property types in which our investments may be concentrated at any given time, as well as from unfavorable changes in the related geographic regions.

Our assets are not subject to any geographic, diversification or concentration limitations and we expect our assets to be concentrated in mortgage-related investments. Accordingly, our investment portfolio may be concentrated by geography, asset, property type and/or borrower, increasing the risk of loss to us if the concentration in our investment portfolio is subject to greater risks or undergoing adverse developments. In addition, adverse conditions in the areas where the properties securing or otherwise underlying our investments are located (including business layoffs or downsizing, industry slowdowns, changing demographics and other factors) and local real estate conditions (such as oversupply or reduced demand) may have an adverse effect on the value of our investments. A material decline in the demand for real estate in these areas may materially and adversely affect us. Lack of diversification can increase the correlation of non-performance and foreclosure risks among our investments.

Changes in credit spreads may adversely affect our profitability.

A significant component of the fair value of CRT and non-agency securities and other credit risk oriented investments is attributable to the credit spread, or the difference between the value the credit instrument and the value of a financial instrument with similar interest rate exposure, but with no credit risk, such as a U.S. Treasury note, and the credit instrument. Credit spreads are subject to market factors and can be highly volatile. In addition, hedging fair value changes associated with credit spreads can be inefficient and our hedging strategies are generally not designed to mitigate credit spread risk. Consequently, changes in credit spreads could adversely affect our profitability and financial condition.

Actions of the U.S. Government, including the U.S. Congress, Fed, U.S. Treasury, Federal Housing Finance Administration (“FHFA”) and other governmental and regulatory bodies may adversely affect our business.

U.S. Government actions may have an adverse impact on the financial markets. To the extent the markets do not respond favorably to any such actions or such actions do not function as intended, they could have broad adverse market implications and could negatively impact our financial condition and results of operations.

New regulatory requirements could adversely affect the availability or terms of financing from our lender counterparties, could impose more stringent capital rules on financial institutions, could restrict the origination of residential mortgage loans and the formation of new issuances of mortgage-backed securities and could limit the trading activities of certain banking entities and other systemically significant organizations that are important to our business. Together or individually these new regulatory requirements could materially affect our financial condition or results of operations in an adverse way.

Pursuant to the terms of borrowings under master repurchase agreements, we are subject to margin calls that could result in defaults or force us to sell assets under adverse market conditions or through foreclosure.

We enter into master repurchase agreements with a number of financial institutions. We borrow under these agreements to finance the assets for our investment portfolio. Pursuant to the terms of borrowings under our master repurchase agreements, a decline in the value of the collateral may result in our lenders initiating margin calls, where the lender requires us to pledge additional collateral. The specific collateral value to borrowing ratio that would trigger a margin call is not set in the master repurchase agreements and is not determined until we engage in a repurchase transaction under these agreements. Our fixed-rate collateral generally may be more susceptible to margin calls as increases in interest rates tend to affect more negatively the market value of fixed-rate securities. In addition, some collateral may be less liquid than other instruments, which could cause them to be more susceptible to margin calls in a volatile market environment. Moreover, collateral that prepays more quickly increases the frequency and magnitude of potential margin calls as there is a significant time lag between when the prepayment is reported (which reduces the market value of the security) and when the principal payment is received. If we are unable to satisfy margin calls, our lenders may foreclose on our collateral. The threat of or occurrence of a margin call could force us to sell, either directly or through a foreclosure, our collateral under adverse market conditions and we could incur substantial losses.

Our derivative agreements expose us to margin calls that could result in defaults or force us to sell assets under adverse market conditions.

As with repurchase agreements, our derivative agreements typically require that we pledge collateral to our counterparties. Our counterparties, or the central clearing agency, typically have the sole discretion to determine the value of the derivative

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instruments and the value of the collateral securing such instruments. In the event of a margin call, we must generally provide additional collateral on the same business day. Furthermore, our derivative agreements may also contain cross default provisions under which a default under certain of our other indebtedness above a certain threshold amount causes an event of default under the derivative agreement. Following an event of default, we could be required to settle our obligations under the agreements at their termination values. The threat of or occurrence of margin calls or the forced settlement of our obligations under our derivative agreements at their termination values could force us to sell our investments under adverse market conditions and we could incur substantial losses.

Regulations adopted by the U.S. Commodity Futures Trading Commission (CFTC) and regulators of other countries could impose increased margin requirements and require additional operational and compliance costs, which could negatively affect our financial condition and results of operations.

The CFTC subjects certain swaps to clearing and exchange trading requirements, margin requirements, reporting and record keeping requirements and derivative counterparties to business conduct rules. Current and future rules and regulations promulgated by the CFTC and regulators of other countries may adversely affect our ability to engage in derivative transactions or may increase the cost of our hedging activity. Increased costs and potentially higher collateral requirements could have an adverse impact on our business and results of operations.

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

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

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

Defaults by our repurchase agreement counterparties on their obligations to resell the underlying collateral back to us at the end of the transaction term, declines in the value of our collateral, or defaults by us on our obligations under the transaction, could cause us to lose money on repurchase transactions.
    
When we engage in a repurchase transaction, we initially transfer securities to the financial institution under one of our master repurchase agreements in exchange for cash, and our counterparty is obligated to resell such assets to us at the end of the term of the transaction, which is typically from 30 days to one year, but which may have terms from one day to up to five years or more. The cash we receive when we initially sell the collateral is less than the value of that collateral, and this difference is referred to as the “haircut.” As a result, we borrow a smaller amount than the collateral we initially sell in these transactions. The haircut rates under our master repurchase agreements are not set until we engage in a specific repurchase transaction. If a counterparty defaults on an obligation to resell collateral to us, we could incur a loss on the transaction equal to the amount of the haircut (assuming there was no change in the value of the securities), which could adversely affect our earnings, and, thus, our cash available for distribution to our stockholders.

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If we default on one of our obligations under a repurchase transaction, the counterparty could terminate the transaction and cease entering into other repurchase transactions with us. In that case, we would likely need to establish a replacement repurchase facility with another financial institution to continue to leverage our investment portfolio and carry out our investment strategy. We may not be able to secure a suitable replacement facility on acceptable terms or at all.

Further, financial institutions providing the repurchase agreements may require us to maintain a certain amount of cash or to set aside non-leveraged assets sufficient to maintain a specified liquidity position which would allow us to satisfy our collateral obligations should the fair value of our collateral decline. As a result, we may not be able to leverage our assets as fully as we would otherwise choose, which could reduce our return on equity. If we are unable to meet these collateral obligations, our financial condition could deteriorate rapidly and our counterparties could choose to cease entering into further repurchase transactions with us.

Our rights under repurchase agreements are subject to the effects of bankruptcy laws in the event of our or our lender’s bankruptcy or insolvency.

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 collateral agreement 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 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 recover our assets 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 could be subject to significant delay and, if received, could be substantially less than the damages we incur.

Our use of derivative agreements may expose us to counterparty risk.

Certain hedging instruments are not traded on regulated exchanges or guaranteed by an exchange or its clearinghouse and consequently, there may not be the same level of protections with respect to margin requirements, record keeping, segregation of customer funds and positions and other requirements designed to protect both us and our counterparties. Furthermore, the enforceability of agreements underlying hedging transactions may depend on compliance with applicable statutory, commodity and other regulatory requirements and, depending on the domicile of the counterparty, applicable international requirements. Consequently, if a counterparty fails to perform under a derivative agreement we could incur a significant loss.

For example, if an interest rate swaption counterparty fails to perform under the terms of the swaption agreement, not only could we lose potential gains because of being unable able to exercise or otherwise cash settle the agreement, we could incur a loss for the premium paid for that swaption.

Our investments in and acquisitions of healthcare and senior housing properties may be unsuccessful or fail to meet our expectations.

We are exposed to the risk that some of our healthcare real estate acquisitions may not prove to be successful. We could encounter unanticipated difficulties and expenditures relating to any acquired properties, including contingent liabilities, and acquired properties might require significant management attention that would otherwise be devoted to other areas of our business. Furthermore, there can be no assurance that our anticipated acquisitions and investments, the completion of which is subject to various conditions, will be consummated in accordance with anticipated timing, on anticipated terms, or at all.  We also may be unable to quickly and efficiently integrate new acquisitions, particularly acquisitions of portfolios of properties, into our existing operations, and this could have an adverse effect on our results of operations and financial condition.

Decreases in the revenues or increases in the expenses of our operators or tenants could affect their ability to make payments to us.

The revenues of our operators and tenants are primarily driven by occupancy, private pay rates, and Medicare and Medicaid reimbursement, if applicable. Expenses for these facilities are primarily driven by the costs of labor, food, utilities, taxes, insurance and rent. Revenues from government reimbursement may come under pressure while operating costs continue to increase for our operators. To the extent that any decrease in revenues or increase in operating expenses result in a property not generating enough

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cash to make payments to us, we would have to rely upon the creditworthiness of the operator and the value of other collateral or guarantees. To the extent the value of such property is reduced, we may need to record an impairment charge. Furthermore, if we determine to dispose of an underperforming property, such sale may result in a loss. Any such impairment or loss on sale could adversely affect our results of operations and financial condition.

Increased competition may affect the ability of our operators or tenants to meet their obligations to us.  

The healthcare industry is highly competitive. The operators of our properties compete on a local and regional basis with other properties and healthcare providers that provide comparable services. We cannot be certain that the operators of our facilities will be able to achieve and maintain occupancy levels and rental rates that will enable them to meet their obligations to us. The occupancy levels at, and rental income from, our facilities are dependent on the ability of our operators to successfully compete with other providers. In addition, our operators face an increasingly competitive labor market for skilled management personnel, nurses and other staff. An inability to attract and retain sufficient skilled management personnel and nurses and other trained personnel could negatively impact the ability of our tenants, operators and other obligors to meet their obligations to us. Any increase in labor costs and other operating expenses or any failure by our tenants or operators to attract and retain residents and qualified personnel could adversely affect our business, results of operations and financial condition.

We or our healthcare real estate operators may face litigation and may experience rising liability and insurance costs.

Litigation brought by individual patients and advocacy groups against operators of healthcare facilities can result in large damage awards for alleged abuses and may result in a material increase in the costs incurred by our operators for monitoring and reporting quality of care compliance. In addition, their cost of liability and medical malpractice insurance can be significant and may increase or not be available at a reasonable cost. Cost increases could cause our operators to be unable to make their lease or mortgage payments, potentially decreasing our revenues and increasing our collection and litigation costs and could adversely affect our results of operations and financial condition.

From time to time, we may be subject to claims brought against us in lawsuits and other legal or regulatory proceedings arising out of our alleged actions or the alleged actions of our operators for which such operators may have agreed to indemnify, defend and hold us harmless. An unfavorable resolution of any such litigation or proceeding could materially adversely affect our liquidity, financial condition and results of operations.

The amount and scope of insurance coverage provided by our policies and the policies maintained by our tenants and operators may not adequately insure against losses.

We maintain or require that our tenants and operators maintain all applicable lines of insurance on our properties and their operations. However, these insurance policies may not fully cover all losses on our properties upon the occurrence of a material judgment or catastrophic event, nor can we make any guaranty as to the future financial viability of the insurers that underwrite these policies. In addition, we may be named as a defendant in lawsuits arising from the alleged actions of our healthcare facility tenants or operators, for which claims such tenants and operators have agreed to indemnify us, but which may require our unanticipated expenditures. Should an uninsured loss or a loss in excess of insured limits occur, we could incur substantial liability or lose all or a portion of the capital we have invested in a property, as well as the anticipated future revenues from the property. Following the occurrence of such an event, we might nevertheless remain obligated for any mortgage debt or other financial obligations related to the property, which could adversely affect our results of operations and financial condition.

The failure of our operators or tenants to comply with federal, state, local, and industry-regulated licensure, certification and inspection laws, regulations, and standards could adversely affect their operations and their ability to meet their obligations to us.

Our operators and tenants generally are subject to varying levels of federal, state, local, and industry-regulated licensure, certification and inspection laws, regulations, and standards. The failure to comply with any of these laws, regulations, or standards could result in loss of accreditation, denial of reimbursement, imposition of fines, suspension, decertification or exclusion from federal and state healthcare programs, loss of license or closure of the facility. Federal, state and local laws and regulations affecting the healthcare industry include those relating to, among other things, licensure, conduct of operations, ownership of facilities, addition of facilities and equipment, allowable costs, services, prices for services, qualified beneficiaries, quality of care, patient rights, fraudulent or abusive behavior, and financial and other arrangements that may be entered into by healthcare providers. Federal and state government enforcement efforts can include inspections, citations of regulatory deficiencies and other regulatory sanctions, including terminations from the Medicare and Medicaid programs, bars on Medicare and Medicaid payments for new admissions, civil monetary penalties and even criminal penalties. We are unable to predict the scope of future federal, state and

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local regulations and legislation, including the Medicare and Medicaid statutes and regulations, or the intensity of enforcement efforts with respect to such regulations and legislation, and any changes in the regulatory framework could have a material adverse effect on our tenants and operators, which, in turn, could adversely affect our business, results of operations and financial condition.
    
If our tenants or operators fail to comply with the extensive laws, regulations and other requirements applicable to their businesses and the operation of our properties, they could become ineligible to receive reimbursement from governmental and private third-party payor programs, face bans on admissions of new patients or residents, suffer civil or criminal penalties or be required to make significant changes to their operations. Our tenants and operators also could face increased costs related to healthcare regulation or be forced to expend considerable resources in responding to an investigation or other enforcement action under applicable laws or regulations. In such event, our tenants and operators could be adversely affected, which, in turn, could adversely affect our business, results of operations and financial condition.

Occupancy of our senior housing properties could be adversely affected.

The occupancy of our senior housing properties could significantly decrease in the event of a severe cold and flu season, an epidemic or any other widespread illness or other factors.  Such a decrease could affect the ability of our tenants and operators to make payments to us which could adversely affect our business, results of operations and financial condition.

If our tenants do not renew their existing leases, or we have the need to replace them due to their insolvency or bankruptcy, we may be unable to reposition the properties on as favorable terms, or at all, and we could be subject to delays, limitations and expenses, which could adversely affect our business, results of operations and financial condition.

We are exposed to the risk that our tenants, operators, or other obligors may not be able to meet the lease or other payments due us. Although our lease and management agreements give us the right to exercise certain remedies in the event of a default on the obligations owed to us or upon the occurrence of certain insolvency events, federal bankruptcy and insolvency laws afford certain rights to a party that has filed for bankruptcy or reorganization. For example, we cannot evict a tenant or operator solely because of its bankruptcy filing and a debtor-lessee may reject our lease in a bankruptcy proceeding, in which case our claims for unpaid and future rents could be limited by the statutory cap of the U.S. Bankruptcy Code. This statutory cap could be substantially less than the remaining rent owed under the lease, and any claim we have for unpaid rent might not be paid in full.

If existing leases are terminated or not renewed, we would be required to find other tenants to occupy those properties or sell them. There can be no assurance that we would be able to identify suitable replacement tenants or enter into leases with new tenants on terms as favorable to us as the current leases or that we would be able to lease those properties at all. Our ability to reposition our properties with a suitable replacement tenant or operator could be significantly delayed or limited by state licensing, receivership or other laws, as well as by the Medicare and Medicaid change-of-ownership rules, and we could incur substantial additional expenses in connection with any licensing, receivership or change-of-ownership proceedings. Our ability to locate and attract suitable replacement tenants also could be impaired by the specialized healthcare uses or contractual restrictions on use of the properties, and we may be forced to spend substantial amounts to adapt the properties to other uses. If we are not successful in identifying suitable replacements on a timely basis we may be required to fund certain expenses and obligations (e.g., real estate taxes, debt costs and maintenance expenses) to preserve the value of, and avoid the imposition of liens on, our properties while they are being repositioned. In addition, we may incur certain obligations and liabilities, including obligations to indemnify the replacement tenant or operator, which could adversely affect our business, results of operations and financial condition.

Changes in the reimbursement rates or methods of payment from third-party payors, including insurance companies and the Medicare and Medicaid programs, could have a material adverse effect on certain of our tenants and operators and on us.

Certain of our tenants and operators rely on reimbursement from third-party payors, including the Medicare (both traditional Medicare and “managed” Medicare/Medicare Advantage) and Medicaid programs, for their revenues. Federal and state legislators and regulators have adopted or proposed various cost-containment measures that would limit payments to healthcare providers, and budget crises and financial shortfalls have caused states to implement or consider Medicaid rate freezes or cuts. Private, third-party payors also have continued their efforts to control healthcare costs. There is no assurance that our tenants and operators who currently depend on governmental or private payor reimbursement will be adequately reimbursed for the services they provide. Significant limits by governmental and private payors on the scope of services reimbursed or on reimbursement rates and fees, whether from legislation, administrative actions or private payor efforts, could have a material adverse effect on the liquidity, financial condition and results of operations of certain of our tenants and operators, which could affect adversely their ability to comply with the terms of our leases and could adversely affect our business, results of operations and financial condition.


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Healthcare industry trends away from a traditional fee for service reimbursement model towards value-based payment approaches may negatively impact the revenues and profitability of our tenants and operators.

Certain of our tenants are subject to the broad trend in the healthcare industry toward value-based purchasing of healthcare services, including public reporting of data on quality and preventable adverse events. Medicare, Medicaid and certain large commercial insurance payors require healthcare facilities, including hospitals and skilled nursing facilities, to report certain quality data to receive full reimbursement. In addition, Medicare does not reimburse for care related to certain preventable adverse events (also called “never events”). Many large commercial payors also require healthcare facilities to report quality data, and certain commercial payors do not reimburse hospitals for certain preventable adverse events.

We expect value-based purchasing programs, including programs that condition reimbursement on patient outcome measures, to become more common and to involve a higher percentage of reimbursement amounts. While we are unable to predict how this trend will affect the revenues and profitability of our tenants, if this trend significantly and adversely affects their profitability, it could in turn negatively affect their ability or willingness to comply with the terms of their leases with us or renew those leases upon expiration, which could adversely affect our business, results of operations and financial condition.

Controls imposed on providers of healthcare services that are reimbursed by Medicare, Medicaid and other third-party payors to reduce admissions and length of stay could adversely affect our healthcare facility operators.

Controls imposed by Medicare, Medicaid and commercial third-party payors designed to reduce admissions and lengths of stay, commonly referred to as “utilization reviews,” could affect certain of our healthcare facilities. A utilization review entails the review of the admission and course of treatment of a patient by managed care plans. Inpatient utilization, average lengths of stay and occupancy rates continue to be negatively affected by payor-required preadmission authorization and utilization reviews and by payor pressures to maximize outpatient and alternative healthcare delivery services for less acutely ill patients. Efforts to impose more stringent cost controls are expected to continue, which could negatively impact the financial condition of our healthcare tenants. If so, this could adversely affect their ability and willingness to comply with the terms of their leases with us or renew those leases upon expiration, which could adversely affect our business, results of operations and financial condition.

Events that adversely affect the ability of seniors and their families to afford daily resident fees at our senior housing facilities could cause our occupancy rates, resident fee revenues and results of operations to decline.

Assisted and independent living services generally are not reimbursable under government reimbursement programs, such as Medicare and Medicaid. A large majority of the resident fee revenues generated by our senior living operations, therefore, are derived from private pay sources consisting of the income or assets of residents or their family members. In light of the significant expense associated with building new properties and staffing and other costs of providing services, typically only seniors with income or assets that meet or exceed the comparable region median can afford the daily resident and care fees at our senior housing facilities, and a weak economy, depressed housing market or changes in demographics could adversely affect their continued ability to do so. If the managers of our senior housing facilities are unable to attract and retain seniors that have sufficient income, assets or other resources, resident fee revenues and results of operations of our senior living operations could decline, which, in turn, could adversely affect our business, results of operations and financial condition.

Illiquidity of real estate investments could significantly impede our ability to respond to adverse changes in the performance of our properties.

Real estate investments are relatively illiquid. Our ability to quickly sell or exchange any of our properties in response to changes in economic and other conditions will be limited. No assurances can be given that we will recognize full value for any property that we are required to sell for liquidity reasons. Our inability to respond rapidly to changes in the performance of our investments could adversely affect our financial condition and results of operations. A downturn in the real estate industry could adversely affect the value of our properties and our ability to sell properties for a price or on terms acceptable to us and could adversely affect our business, results of operations and financial condition.

We could incur substantial liabilities and costs if any of our properties are found to be contaminated with hazardous substances or we become involved in any environmental disputes.

Under federal and state environmental laws and regulations, a current or former owner or operator of real property may be liable for property damage, personal injuries or penalties that result from environmental contamination or exposure to hazardous substances in connection with such property. Owners of real property may also face other environmental liabilities, including government fines and penalties imposed by regulatory authorities. Environmental laws and regulations often impose liability

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without regard to whether the owner was aware of, or was responsible for, the presence, release or disposal of hazardous or toxic substances or other environmental contaminants. In certain circumstances, environmental liability may result from the activities of a former operator of the property. Although we generally have indemnification rights against the current operators of our properties for contamination caused by them, such indemnification may not adequately cover all environmental costs. As such, environmental liabilities may be present in our properties and we may incur costs to remediate contamination, which could adversely affect our business, results of operations and financial condition.

We are subject to covenants in our debt agreements that may restrict or limit our operational flexibility, and a covenant breach could have an adverse impact on our business, results of operations and financial condition.

Our debt agreements contain various covenants, restrictions and events of default. Our continued ability to incur additional debt and to conduct business in general may be subject to our compliance with these covenants, which may limit our operational flexibility. Among other things, these provisions may require us or our subsidiaries to maintain certain financial ratios and minimum net worth and impose certain limits on our ability to incur indebtedness, create liens and make investments or acquisitions. Breaches of these covenants could result in defaults under the instruments governing the applicable indebtedness, in addition to any other indebtedness cross-defaulted against such instruments. These defaults could have an adverse impact on our business, results of operations and financial condition.

Tenants that fail to adhere to HIPAA and the HITECH Act’s privacy and security requirements expose themselves to significant risk that could result in their inability to meet their financial and other contractual obligations to us.

Potentially significant legal exposure exists for healthcare operators under state and federal laws which govern the use and disclosure of confidential patient health information and patients’ rights to access and amend their own health information. The Administrative Simplification Requirements of the Health Insurance Portability and Accountability Act of 1996 (“HIPAA”) established national standards to facilitate the electronic exchange of Protected Health Information (“PHI”) and to maintain the privacy and security of PHI. These standards have a major effect on healthcare providers which transmit PHI in electronic form (e.g., healthcare claims). In particular, HIPAA established standards governing: (1) electronic transactions and code sets; (2) privacy; (3) security; and (4) national identifiers. Failure of our operators to comply could result in criminal and civil penalties, which could have a material adverse effect on the ability of our tenants to meet their obligations to us.

Title XIII of the Affordable Care Act, otherwise known as the Health Information Technology for Economic and Clinical Health Act (the “HITECH Act”), provides for an investment of almost $20 billion in public monies for the development of a nationwide health information technology (“HIT”) infrastructure. The HIT infrastructure is intended to improve healthcare quality, reduce costs and facilitate access to certain information. The HITECH Act also expands the scope and application of the administrative simplification provisions of HIPAA, and its implementing regulations, (i) imposing a written notice obligation upon covered entities for security breaches involving “unsecured” PHI, (ii) expanding the scope of a provider’s electronic health record disclosure tracking obligations, (iii) substantially limiting the ability of healthcare providers to sell PHI without patient authorization, (iv) increasing penalties for violations, and (v) providing for enforcement of violations by state attorneys general. While the effects of the HITECH Act cannot be predicted, the obligations imposed thereunder could have a material adverse effect on the financial condition of our operators, which could have an adverse effect on the ability of our tenants to meet their obligations to us.

Our securities investments are recorded at fair value, which may not be readily determinable or may be materially different from the value that we ultimately realize upon their disposal.

We measure the fair value of our securities investments quarterly, in accordance with guidance set forth in Accounting Standards Codification Topic 820, Fair Value Measurements and Disclosures. Fair value is only an estimate based on good faith judgment of the price at which an investment can be sold since market prices of investments can only be determined by negotiation between a willing buyer and seller.
    
Our Manager's determination of the fair value of our investments includes inputs provided by third-party dealers and pricing services. Valuations of certain investments in which we invest may be difficult to obtain or unreliable. In general, dealers and pricing services heavily disclaim their valuations. Dealers may claim to furnish valuations only as an accommodation and without special compensation, and so they may disclaim liability for any direct, incidental, or consequential damages arising out of any inaccuracy or incompleteness in valuations, including any act of negligence or breach of any warranty. Depending on the complexity and illiquidity of a security, valuations of the same security can vary substantially from one dealer or pricing service to another. For these reasons, the fair value at which our investments are recorded may not be an indication of their realizable value. Furthermore, the ultimate realization of the value of an asset

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depends on economic and other conditions that are beyond our control. Consequently, if we were to liquidate an asset, particularly in a forced liquidation, the realized value may be less than the amount at which such asset is recorded, which would negatively affect our results of operations and financial condition.

The Federal conservatorship of Fannie Mae and Freddie Mac and related efforts, along with any changes in laws and regulations affecting the relationship between these agencies and the U.S. Government, may adversely affect our business.

The payments of principal and interest we receive on the agency mortgage investments in which we invest are guaranteed by Fannie Mae, Freddie Mac or Ginnie Mae. The guarantees on agency securities created by Fannie Mae and Freddie Mac are not backed by the full faith and credit of the United States, whereas guarantees on securities created by Ginnie Mae are backed by the full faith and credit of the United States.

The future roles of Fannie Mae and Freddie Mac could be significantly reduced and the nature of their guarantee obligations could be considerably limited relative to historical measurements. Any such changes to the nature of their guarantee obligations could re-define what constitutes an agency security and could have broad adverse implications for the market and our business, operations and financial condition.

Future changes to Fannie Mae or Freddie Mac may create market uncertainty and may reduce the actual or perceived credit quality of securities issued or guaranteed by these agencies. If the guarantee obligations of Freddie Mac or Fannie Mae were repudiated by FHFA, payments of principal and/or interest to holders of agency RMBS issued by Freddie Mac or Fannie Mae would be reduced in the event of any borrower delinquencies or a servicer's failure to remit borrower payments to the trust and trust administration and servicing fees could be paid from mortgage payments prior to distributions to holders of agency RMBS. Any actual direct compensatory damages owed due to the repudiation of Freddie Mac or Fannie Mae's guarantee obligations may not be sufficient to offset any shortfalls experienced by holders of agency RMBS.

As a result, such laws or changes could increase the risk of loss on our investments in agency mortgage investments guaranteed by Fannie Mae or Freddie Mac or adversely impact the market for such securities and spreads at which they trade and could materially and adversely affect our financial condition and results of operations.

We may be affected by deficiencies in foreclosure practices of third parties, as well as related delays in the foreclosure process.

Prior to making investments in RMBS, we carefully consider many factors, including housing prices and foreclosure timelines, and estimate loss assumptions. Any extension of foreclosure timelines can increase the inventory backlog of distressed homes on the market and creates greater uncertainty about housing prices. Concerns about deficiencies in foreclosure practices of servicers and related delays in the foreclosure process may impact our loss assumptions and affect the values of, and our returns on, our investments in RMBS.

The lack of liquidity in our investments may adversely affect our business.

We may invest in securities, whole loans or other instruments that are not liquid or that could become illiquid. It may be difficult or impossible to obtain third party valuations on these investments and validating pricing for these instruments may be more subjective than more liquid investments. The lack of liquidity for certain asset classes may make it difficult for us to sell such investments should the need or desire arise. In addition, if we are required to liquidate all or a portion of our investment portfolio quickly, we may realize significant losses. As a result, our ability to change our investment portfolio in response to changing market conditions may be limited, which could adversely affect our results of operations and financial condition.

Additionally, legislation and regulations could limit certain market participants' abilities to make markets in certain securities, including non-agency RMBS, which could significantly reduce liquidity within these markets, making it more difficult for us to sell such investments.

We rely on information technology in our operations, and any material failure, inadequacy or interruption could disrupt our business and result in the loss of confidential information.

We rely on information technology networks and systems to process, transmit and store electronic information, and to manage or support a variety of business processes. We purchase some of our information technology from vendors and rely on commercially available systems, software, tools and monitoring to provide security for the processing, transmission and storage of confidential data. While we select third-party vendors carefully, we do not control their actions. Any problems caused by

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these third parties, including those resulting from breakdowns or other disruptions in communication services, failure to handle current or higher volumes, cyber-attacks and other security breaches could adversely affect our ability to conduct our business.

While we employ measures to protect the security of our information systems and data, it is possible that these measures will not prevent the systems’ improper functioning or damage, or the improper access or disclosure of information in the event of cyber-attacks. In some cases, it may be difficult to anticipate or immediately detect a security breach and the damage caused. Any failure to maintain proper function, security and availability of our information systems could interrupt our operations, damage our reputation, subject us to liability claims or regulatory penalties and could have a materially adverse effect on our business, financial condition and results of operations.

Risks Related to Our Relationship with Our Manager

There are conflicts of interest in our relationship with our Manager.

Because we have no employees except for employees of our wholly-owned subsidiary RCS, our Manager is responsible for making our investment decisions. Certain of our Manager's employees do not devote their time exclusively to us, as our Manager is a wholly-owned subsidiary of AGNC, a publicly-traded mortgage REIT that invests in similar asset classes, including agency and non-agency mortgage investments, and may compete with us for investment opportunities.

As of February 22, 2018, AGNC owned 5.7% of our outstanding shares of common stock.  As a stockholder, AGNC also has the right to receive dividends and vote in a manner that it determines in its sole discretion on any matter that comes before our stockholders for vote.  In evaluating investments and other management strategies, our Manager may seek to maximize our distributable income at the expense of other criteria, such as preservation of capital or risk mitigation. Such an emphasis could result in increased risk to the value of our invested portfolio.  Although there is no assurance that it will do so, AGNC may acquire additional shares of our stock or sell its shares in us at any time.  To the extent AGNC sells some of its shares, our Manager’s interests may be less aligned with our interests.
    
Although our Manager and its affiliates have policies in place that seek to mitigate the effects of conflicts of interest, including any potential conflict relating to the allocation of certain types of securities that meet our investment objectives and those of affiliates of our Manager, these policies do not eliminate the conflicts of interest that our officers and the officers of our Manager and its affiliates face in making investment decisions. Accordingly, we may compete for access to the benefits that we expect from our relationship with our Manager.

We are completely dependent upon our Manager and we may not find a suitable replacement if the management agreement is terminated.

Because we have no employees or separate facilities other than those at RCS, we are completely dependent on our Manager and its affiliates to conduct our investment operations pursuant to the management agreement. Our Manager does not have any employees and relies upon certain employees of its parent company to conduct our day-to-day operations. We do not have any recourse to the parent company of our Manager. The parent company of our Manager has entered into employment agreements with certain of its officers. However, none of these individuals' continued service is guaranteed. Furthermore, if the management agreement is terminated or these individuals leave the parent company of our Manager, we may be unable to execute our business plan.

If we elect to terminate our management agreement without cause, we would be required to pay our Manager a substantial termination fee. We would also be restricted from employing employees of our Manager and any of its affiliates. These and other provisions in our management agreement make termination of our management agreement difficult and costly.

Electing to terminate the management agreement without cause would be difficult and costly for us. With the consent of the majority of the independent members of our Board of Directors, we may terminate our management agreement upon 90 days' prior written notice. If we elect to terminate the management agreement because of a decision by our Board of Directors that the management fee is unfair, our Manager has the right, but not the obligation, to renegotiate a mutually agreeable management fee. If we elect to terminate the management agreement without cause, we are required to pay our Manager a termination fee equal to three times the average annual management fee earned by our Manager during the prior 24-month period immediately preceding the most recently completed month prior to the effective date of termination. These provisions may increase the effective cost to us of electing to not renew the management agreement.


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Furthermore, if we terminate the management agreement without cause, we may not, without the consent of our Manager, employ any employee of the Manager or any of its affiliates, or any person who has been employed by our Manager or any of its affiliates at any time within the two-year period immediately preceding the termination date, for two years after such termination of the management agreement. We believe that the successful implementation of our investment, financing and hedging strategies depends upon the experience of certain of our Manager's officers; therefore, if the management agreement is terminated without cause, we may be unable to execute our business plan.

Our management agreement was not originally negotiated on an arm's-length basis and the terms, including fees payable, may not be as favorable to us as if they were negotiated with an unaffiliated third party.

The management agreement was originally negotiated between related parties, and we did not have the benefit of arm's-length negotiations of the type normally conducted with an unaffiliated third party. The terms of the management agreement, including fees payable, may not reflect the terms that we may have received if it were negotiated with an unrelated third party. In addition, we may choose not to enforce, or to enforce less vigorously, our rights under the management agreement because of our desire to maintain our ongoing relationship with our Manager.

Our Manager's management fee is based on the amount of our Equity and is payable regardless of our performance, which could result in a conflict of interest between our Manager and our stockholders with respect to the timing and terms of our equity issuances, share repurchases and the realization of gains and losses on our investment portfolio.

Our Manager is entitled to receive a monthly management fee from us that is based on the amount of our “Equity” (as defined in our management agreement), regardless of the performance of our investment portfolio. For example, we would pay our Manager a management fee for a specific period even if we experienced a net unrealized loss during that period. The amount of the monthly management fee is equal to one-twelfth of 1.50% of our Equity and, therefore, is only increased or decreased by changes in our Equity. Increases to our Equity, and a corresponding increase to our management fee, will primarily result from equity issuances and realization of gains from our investment portfolio, whereas decreases to our Equity, and a corresponding decrease to our management fee, will primarily result from repurchases of our common stock and realization of losses on our investment portfolio, each of which could result in a conflict of interest between our Manager and our stockholders with respect to the timing and terms of our equity issuances, share repurchases and realization of gains and losses on our investment portfolio. Thus, while our stockholders bear the risk of our future equity issuances reducing the price of our common stock and diluting the value of their stock holdings in us, the compensation payable to our Manager will increase as a result of future issuances of our equity securities. Similarly, the value of our common stock could potentially increase if we repurchase shares at a discount to our net asset value per common share and the compensation payable to our Manager would be reduced if we execute share repurchases, creating a conflict of interest. This conflict of interest could harm the market price of our common stock.

Our Manager's liability is limited under the management agreement, and we have agreed to indemnify our Manager against certain liabilities.

The management agreement provides that our Manager will not assume any responsibility other than to provide the services specified in the management agreement. The agreement further provides that our Manager is not responsible for any action of our Board of Directors in following or declining to follow its advice or recommendations. In addition, our Manager and its respective affiliates, managers, officers, directors and employees will be held harmless from, and indemnified by us against, certain liabilities on customary terms.

Our results are dependent upon the efforts of our Manager.

Our Manager's success, which is determinative of our own success, depends on many factors, including the availability of attractive risk-adjusted investment opportunities that satisfy our targeted investment strategies and then identifying and consummating them on favorable terms, the level and volatility of interest rates, its ability to access on our behalf short-term and long-term financing on favorable terms and conditions in the financial markets, real estate market and the economy, as to which no assurances can be given. In addition, our Manager may face substantial competition for attractive investment opportunities. Our Manager may not be able to successfully cause us to make investments with attractive risk-adjusted returns.


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Risks Related to Our Taxation as a REIT

Our failure to qualify as a REIT would have adverse tax consequences.
    
We believe that we operate in a manner that allows us to qualify as a REIT for federal income tax purposes under Sections 856 through 860 of the Internal Revenue Code of 1986, as amended, and Treasury Regulations promulgated thereunder (or the Code).  We plan to continue to meet the requirements for taxation as a REIT.  The determination that we are a REIT requires an analysis of various factual matters and circumstances that may not be totally within our control and our compliance with the annual REIT income and quarterly asset requirements depends upon our ability to successfully manage the composition of our income and assets on an ongoing basis. For example, to qualify as a REIT, at least 75% of our gross income must come from real estate sources and 95% of our gross income must come from real estate sources and certain other sources that are itemized in the REIT tax laws.
    
Additionally, 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, and for which we will not obtain independent appraisals. Furthermore, the proper classification of an instrument as debt or equity for federal income tax purposes may be uncertain in some circumstances, which could affect the application of the REIT asset requirements. We are also required to distribute to stockholders at least 90% of our REIT taxable income (determined without regard to the deduction for dividends paid and by excluding any net capital gain).
    
If we fail to qualify as a REIT in any tax year, we would be subject to U.S. federal and state corporate income tax on our taxable income at regular corporate rates, and dividends paid to our stockholders would not be deductible by us in computing our taxable income.  Also, unless the IRS granted us relief under certain statutory provisions, we would remain disqualified as a REIT for four years following the year we first fail to qualify.  If we fail to qualify as a REIT, we would have to pay significant income taxes and would, therefore, have less money available for investments or for distributions to our stockholders.  This would likely have a significant adverse effect on the value of our equity.  In addition, the tax law would no longer require us to make distributions to our stockholders.
    
If we should fail to satisfy one or more requirements for REIT qualification, we may still qualify as a REIT if there is reasonable cause for the failure and not due to willful neglect and other applicable requirements are met, including completion of applicable IRS filings. It is not possible to state whether we would be entitled to the benefit of these relief provisions in all circumstances. If these relief provisions are inapplicable, we will not qualify as a REIT. Furthermore, if we satisfy the relief provisions and maintain our qualification as a REIT, we may be still subject to a penalty tax. The amount of the penalty tax will be at least $50,000 per failure, and, in the case of certain asset test failures, will be determined as the amount of net income generated by the assets in question multiplied by the highest U.S. Federal corporate tax rate in effect at the time of the failure if that amount exceeds $50,000 per failure, and, in case of income test failures, will be a 100% tax on an amount based on the magnitude of the failure, as adjusted to reflect the profit margin associated with our gross income.

Distributions payable by REITs do not qualify for the reduced tax rates available for some dividends.

The maximum tax rate applicable to income from “qualified dividends” payable to domestic stockholders that are individuals, trusts and estates is currently 20%. Distributions of ordinary income payable by REITs, however, generally are not eligible for the reduced rates. Although this legislation does not adversely affect the taxation of REITs or distributions payable by REITs, the more favorable rates applicable to regular corporate qualified 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 stock of REITs, including our common stock.

New legislation or administrative or judicial action, in each instance potentially with retroactive effect, could make it more difficult or impossible for us to remain qualified as a REIT or it could otherwise adversely affect REITs and their stockholders.

The present federal income tax treatment of REITs may be modified, possibly with retroactive effect, by legislative, judicial or administrative action at any time, which could affect the federal income tax treatment of an investment in us. The federal income tax rules dealing with REITs constantly are under review by persons involved in the legislative process, the IRS and the U.S. Treasury Department, which results in statutory changes as well as frequent revisions to regulations and interpretations.


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The recently enacted TCJA makes substantial changes to the Internal Revenue Code. Among those changes are a significant permanent reduction in the generally applicable corporate tax rate, a temporary reduction in the highest marginal income tax rate applicable to individuals subject to a "sunset" provision, the elimination or modification of various currently allowed deductions (including substantial limitations on the deductibility of interest), certain additional limitations on the deduction of net operating losses, and preferential rates of taxation on most ordinary REIT dividends and certain business income derived by non-corporate taxpayers in comparison to other ordinary income recognized by such taxpayers. The effect of these, and the many other, changes made in the TCJA is highly uncertain, both in terms of their direct effect on the taxation of an investment in our common stock and their indirect effect on the value of our assets or shares of our common stock or market conditions generally. Furthermore, many of the provisions of the TCJA will require guidance through the issuance of Treasury regulations in order to assess their effect. There may be a substantial delay before such regulations are promulgated, increasing the uncertainty as to the ultimate effect of the statutory amendments on us. There may also be technical corrections legislation proposed with respect to the TCJA, the effect and timing of which cannot be predicted and which may be adverse to us or our stockholders.

Revisions in Federal tax laws and interpretations thereof could affect or cause us to change our investments and affect the tax considerations of an investment in us.

REIT distribution requirements could adversely affect our ability to execute our business plan.

We generally must distribute annually at least 90% of our taxable income, subject to certain adjustments and excluding any net capital gain, for U.S. federal and state corporate income tax not to apply to earnings that we distribute. Distributions of our taxable income must generally occur in the taxable year to which they relate, or in the following taxable year if declared before we timely file our tax return for the year and if paid with or before the first regular dividend payment after such declaration.  We may also elect to retain, rather than distribute, our net long-term capital gains and pay tax on such gains if required. In this case, we could elect for our stockholders to include their proportionate share of such undistributed long-term capital gains in income, and to receive a corresponding credit for their share of the tax that we paid. Our stockholders would then increase the adjusted basis of their stock by the difference between (a) the amounts of capital gain dividends that we designated and that they include in their taxable income, minus (b) the tax that we paid on their behalf with respect to that income. We intend to make distributions to our stockholders to comply with the REIT qualification requirements of the Internal Revenue Code.
    
To the extent that we satisfy this distribution requirement, but distribute less than 100% of our taxable income, we will be subject to U.S. federal and state corporate income tax on our undistributed taxable income. Furthermore, if we should fail to distribute during each calendar year at least the sum of (a) 85% of our REIT ordinary income for such year, (b) 95% of our REIT capital gain net income for such year, and (c) any undistributed taxable income from prior periods, we would be subject to a non-deductible 4% excise tax on the excess of such required distribution over the sum of (x) the amounts actually distributed, (y) the amounts of income we retained and on which we have paid corporate income tax and (z) any excess distributions from prior periods.
    
From time to time, we may generate taxable income greater than our income for financial reporting purposes prepared in accordance with GAAP, or differences in timing between the recognition of taxable income and the actual receipt of cash, or the deductibility of expenses and the actual payment of cash in respect of those expenses, may occur. For example, if we purchase mortgage securities at issuance with a discount, we are generally required to accrete the discount into taxable income prior to receiving the cash proceeds. In addition, we generally will be required to take certain amounts into income no later than the time such amounts are reflected on certain financial statements. The application of this rule may require the accrual of, among other categories of income, income with respect to certain debt instruments or mortgage-backed securities, such as original issue discount or market discount, earlier than would be the case under the general tax rules, although the precise application of this rule is unclear at this time. This rule generally will be effective for tax years beginning after December 31, 2017 or, for debt instruments or mortgage-backed securities issued with original issue discount, for tax years beginning after December 31, 2018. Moreover, we are not allowed to reduce our taxable income for a net capital loss incurred; instead, the net capital loss may be carried forward for a period of up to five years and applied against future capital gains subject to our ability to generate sufficient capital gains, which cannot be assured. If we do not have funds available in these situations, we could be required to borrow funds on unfavorable terms, sell investments at disadvantageous prices or distribute amounts that would otherwise be invested in future acquisitions to make distributions sufficient to maintain our qualification as a REIT or avoid corporate income tax and the 4% excise tax in a particular year. These alternatives could increase our costs and reduce our stockholders' equity. Thus, compliance with the REIT requirements may hinder our ability to grow, which could adversely affect the value of our common stock.

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We may in the future choose to pay dividends in our own stock, in which case stockholders may be required to pay income taxes in excess of cash dividends received.

We may in the future distribute taxable dividends that are payable in cash and shares of our common stock at the election of each stockholder. Taxable stockholders receiving such dividends will be required to include the full amount of the dividend as ordinary income to the extent of our current and accumulated earnings and profits for U.S. Federal income tax purposes. As a result, stockholders may be required to pay income taxes with respect to such dividends in excess of the cash dividends received. If a U.S. stockholder sells the stock that it receives as a dividend to pay this tax, the sales proceeds may be less than the amount included in income with respect to the dividend, depending on the market price of our stock at the time of the sale. Furthermore, with respect to certain non-U.S. stockholders, we may be required to withhold U.S. tax with respect to such dividends, including in respect of all or a portion of such dividend that is payable in stock. In addition, if a significant number of our stockholders determine to sell shares of our common stock to pay taxes owed on dividends, it may put downward pressure on the trading price of our common stock.

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

Even if we remain qualified for taxation as a REIT, we may nonetheless be subject to certain federal, state and local taxes on our income and assets, including, but not limited to, the following items. Any of these or other taxes we may incur would decrease cash available for distribution to our stockholders.
Regular U.S. federal and state corporate income taxes on any undistributed taxable income, including undistributed net capital gains.
A non-deductible 4% excise tax if the actual amount distributed to our stockholders in a calendar year is less than a minimum amount specified under federal tax laws.
Corporate income taxes on the earnings of subsidiaries, to the extent that such subsidiaries are subchapter C corporations and are not qualified REIT subsidiaries or other disregarded entity for federal income tax purposes.
A 100% tax on certain transactions between us and our TRSs that do not reflect arm's-length terms.  
If we acquire appreciated assets from a corporation that is not a REIT (i.e., a corporation taxable under subchapter C of the Internal Revenue Code) in a transaction in which the adjusted tax basis of the assets in our hands is determined by reference to the adjusted tax basis of the assets in the hands of the subchapter C corporation, we may be subject to tax on such appreciation at the highest corporate income tax rate then applicable if we subsequently recognize a gain on a disposition of any such assets during the five-year period following their acquisition from the subchapter C corporation.
A 100% tax on net income and gains from “prohibited transactions.”
Penalty taxes and other fines for failure to satisfy one or more requirements for REIT qualification.

Complying with REIT requirements may cause us to forgo otherwise attractive opportunities.
    
To remain qualified as a REIT for Federal income tax purposes, we must continually satisfy tests concerning, among other things, the sources of our income, the nature and diversification of our assets, the amounts that we distribute to our stockholders and the ownership of our stock. We may be required to make distributions to stockholders at disadvantageous times or when we do not have funds readily available for distribution, and may be unable to pursue investments that would be otherwise advantageous to us to remain qualified as a REIT. Thus, compliance with the REIT requirements may hinder our ability to make and, in certain cases, to maintain ownership of, certain attractive investments.

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

To remain qualified as a REIT, we must ensure that, at the end of each calendar quarter, at least 75% of the value of our assets consists of cash, cash items, government securities and qualified real estate assets. The remainder of our investments in securities (other than government securities and qualified real estate assets) generally cannot include more than 10% of the outstanding voting securities of any one issuer or more than 10% of the total value of the outstanding securities of any one issuer. In addition, in general, no more than 5% of the value of our assets (other than government securities and qualified real estate assets) can consist of the securities of any one issuer, and, no more than 20% of the value of our total assets 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 remove otherwise attractive investments from our investment portfolio. These actions could have the effect of reducing our income and amounts available for distribution to our stockholders.

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The failure of assets subject to repurchase agreements to qualify as real estate assets could adversely affect our ability to remain qualified as a REIT.

We enter into financing arrangements that are structured as sale and repurchase agreements pursuant to which we nominally sell assets to a counterparty and simultaneously enter into an agreement to repurchase these assets at a later date in exchange for a purchase price. Economically, these agreements are financings that are secured by the assets sold pursuant thereto. We believe that we would be treated for REIT asset and income test purposes as the owner of the assets that are the subject of any such sale and repurchase agreement notwithstanding that such agreement 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 sale and repurchase agreement, in which case we could fail to remain qualified as a REIT.

Liquidation of assets may jeopardize our REIT qualification or create additional tax liability for us.

To remain qualified as a REIT, we must comply with requirements regarding the composition of our assets and our sources of income. If we are compelled to liquidate our investments to repay obligations to our lenders, we may be unable to comply with these requirements, ultimately 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 dealer property or inventory.

Complying with REIT requirements may limit our ability to hedge effectively and may cause us to incur tax liabilities.

The REIT provisions of the Internal Revenue Code could substantially limit our ability to hedge our liabilities. Any income from a properly designated hedging transaction to manage risk of interest rate changes with respect to borrowings made or to be made, or ordinary obligations incurred or to be incurred, to acquire or carry real estate assets generally does not constitute “gross income” for purposes of the 75% or 95% gross income tests. To the extent that we enter into other types of hedging transactions, the income from those transactions is likely to be treated as non-qualifying income for purposes of both gross income tests. As such, we may have to limit our use of advantageous hedging techniques or implement those hedges through our TRS. This could increase the cost of our hedging activities as our TRS would be subject to tax on gains, or 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, except for being carried forward against future taxable income in the TRS.

Uncertainty exists with respect to the treatment of our TBAs for purposes of the REIT asset and income tests.

We purchase and sell agency RMBS through TBAs and recognize income or gains from the disposition of those TBAs, through dollar roll transactions or otherwise, and may continue to do so in the future. There is no direct authority with respect to the qualification of TBAs as real estate assets or U.S. Government securities for purposes of the 75% asset test or the qualification of income or gains from dispositions of TBAs as gains from the sale of real property or other qualifying income for purposes of the 75% gross income test. However, we treat our TBAs as qualifying assets for purposes of the REIT 75% asset test, and we treat income and gains from our TBAs as qualifying income for purposes of the 75% gross income test, based on an opinion of Skadden, Arps, Slate, Meagher & Flom LLP substantially to the effect that (i) for purposes of the REIT asset tests, our ownership of a TBA should be treated as ownership of the underlying agency RMBS, and (ii) for purposes of the 75% REIT gross income test, any gain recognized by us in connection with the settlement of our TBAs should be treated as gain from the sale or disposition of the underlying agency RMBS. Opinions of counsel are not binding on the IRS, and no assurance can be given that the IRS will not successfully challenge the conclusions set forth in such opinions. In addition, it must be emphasized that the opinion of Skadden, Arps, Slate, Meagher & Flom LLP is based on various assumptions relating to our TBAs and is conditioned upon fact-based representations and covenants made by our management regarding our TBAs. No assurance can be given that the IRS would not assert that such assets or income are not qualifying assets or income. If the IRS were to successfully challenge the opinion of Skadden, Arps, Slate, Meagher & Flom LLP, we could be subject to a penalty tax or we could fail to remain qualified as a REIT if a sufficient portion of our assets consists of TBAs or a sufficient portion of our income consists of income or gains from the disposition of TBAs.

Qualifying as a REIT involves highly technical and complex provisions of the Internal Revenue Code.

Qualification as a REIT involves the application of highly technical and complex Internal Revenue Code provisions for which only limited judicial and administrative authorities exist. Even a technical or inadvertent violation could jeopardize our REIT qualification. Our qualification as a REIT depends on our satisfaction of certain asset, income, organizational, distribution, stockholder ownership and other requirements on a continuing basis. In addition, our ability to satisfy the requirements to remain qualified as a REIT depends in part on the actions of third parties over which we have no control or

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only limited influence, including cases where we own an equity interest in an entity that is classified as a partnership for Federal income tax purposes.

The tax on prohibited transactions could limit our ability to engage in certain transactions.

Net income that we derive from a prohibited transaction is subject to a 100% tax. The term “prohibited transaction” generally includes a sale or other disposition of property that is held primarily for sale to customers in the ordinary course of a trade or business by us or by a borrower that has issued a shared appreciation mortgage or similar debt instrument to us. We could be subject to this tax if we were to dispose of or structure CMOs in a manner that was treated as a prohibited transaction for Federal income tax purposes.

We intend to conduct our operations so that no asset that we own (or are treated as owning) at the REIT level will be treated as, or as having been, held for sale to customers, and that a sale of any such asset will not be treated as having been in the ordinary course of our business. As a result, we may choose not to engage in certain transactions at the REIT level that might otherwise be beneficial to us. In addition, whether property is held “primarily for sale to customers in the ordinary course of a trade or business” depends on the particular facts and circumstances. No assurance can be given that any property that we sell will not be treated as property held for sale to customers, or that we can comply with certain safe-harbor provisions of the Internal Revenue Code that would prevent such treatment. The 100% tax does not apply to gains from the sale of property that is held through a TRS or other taxable corporation, although such income will be subject to tax in the hands of the corporation at regular corporate rates. We intend to structure our activities to avoid prohibited transaction characterization.

Distributions to tax-exempt investors may be classified as unrelated business taxable income.

Neither dividend distributions with respect to our common stock nor gain from the sale of common stock should generally constitute unrelated business taxable income to a tax-exempt investor. However, there are certain exceptions to this rule. In particular:

part of the income and gain recognized by certain qualified employee pension trusts with respect to our common stock may be treated as unrelated business taxable income if shares of our common stock are predominantly held by qualified employee pension trusts, and we are required to rely on a special look-through rule for purposes of meeting one of the REIT ownership tests, and we are not operated in a manner to avoid treatment of such income or gain as unrelated business taxable income;
part of the income and gain recognized by a tax-exempt investor with respect to our common stock would constitute unrelated business taxable income if the investor incurs debt to acquire the common stock;
part or all of the income or gain recognized with respect to our common stock by social clubs, voluntary employee benefit associations, supplemental unemployment benefit trusts and qualified group legal services plans which are exempt from federal income taxation may be treated as unrelated business taxable income; and
to the extent that we are (or a part of us, or a disregarded subsidiary of ours, is) a “taxable mortgage pool,” or if we hold residual interests in a REMIC, a portion of the distributions paid to a tax-exempt stockholder that is allocable to excess inclusion income may be treated as unrelated business taxable income.

The taxable mortgage pool rules may increase the taxes that we or our stockholders may incur, and may limit the form of future securitizations.

Securitizations could result in the creation of taxable mortgage pools for Federal income tax purposes. As a REIT, so long as we own 100% of the equity interests in a taxable mortgage pool, we generally would not be adversely affected by the characterization of the securitization as a taxable mortgage pool. Certain categories of stockholders, however, such as foreign 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 distribution income from us that is attributable to the taxable mortgage pool. In addition, to the extent that our 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 our income from the taxable mortgage pool. In that case, we will reduce the amount of our distributions to any disqualified organization whose stock ownership gave rise to the tax. Moreover, we would be precluded from 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. These limitations may prevent us from using certain techniques to maximize our returns from securitization transactions.


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The failure of a mezzanine loan to qualify as a real estate asset could adversely affect our ability to remain qualified as a REIT.

We may acquire mezzanine loans, for which the IRS has provided a safe harbor but not rules of substantive law. Pursuant to the safe harbor, if a mezzanine loan meets certain requirements, it will be treated by the IRS as a real estate asset for purposes of the REIT asset tests, and interest derived from the mezzanine loan will be treated as qualifying mortgage interest for purposes of the REIT 75% income test. We may acquire mezzanine loans that do not meet all of the requirements of this safe harbor. In the event we own a mezzanine loan that does not meet the safe harbor and the IRS successfully challenges such loan's treatment as a real estate asset for purposes of the REIT asset and income tests, then we could fail to remain qualified as a REIT.

The lease of qualified healthcare properties to a taxable REIT subsidiary is subject to special requirements.

We may lease qualified healthcare properties to a TRS, which hires a manager to manage the healthcare operations at these properties. The lease revenues from this structure are treated as rents from real property if (1) they are paid pursuant to an arms-length lease of a qualified healthcare property with a TRS and (2) the manager qualifies as an eligible independent contractor, as defined in the Code. If any of these conditions are not satisfied, then the rents may not be treated as revenues from real property.

If certain sale-leaseback transactions are not characterized by the Internal Revenue Service as “true leases,” we may be subject to adverse tax consequences.

We have purchased certain properties and leased them back to the sellers of such properties, and we may enter into similar transactions in the future. We intend for any such sale-leaseback transaction to be structured in such a manner that the lease will be characterized as a “true lease,” thereby allowing us to be treated as the owner of the property for U.S. federal income tax purposes. However, depending on the terms of any specific transaction, the Internal Revenue Service might take the position that the transaction is not a “true lease” but is more properly treated in some other manner. In the event any sale-leaseback transaction is challenged and successfully re-characterized by the Internal Revenue Service, we would not be entitled to claim the deductions for depreciation and cost recovery generally available to an owner of property. Furthermore, if a sale-leaseback transaction were so re-characterized, we might fail to satisfy the REIT asset tests or income tests and, consequently, could lose our REIT status effective with the year of re-characterization.

Risks Related to Our Business Structure

Loss of our exemption from regulation pursuant to the Investment Company Act would adversely affect us.

We conduct our business so as not to become regulated as an investment company under the Investment Company Act in reliance on the exemption provided by Section 3(c)(5)(C) of the Investment Company Act. Section 3(c)(5)(C), as interpreted by the staff of the SEC, requires that: (i) at least 55% of our investment portfolio consists of “mortgages and other liens on and interest in real estate,” or “qualifying real estate interests,” and (ii) at least 80% of our investment portfolio consists of qualifying real estate interests plus “real estate-related assets.”

The specific real estate related assets that we acquire are limited by the provisions of the Investment Company Act and the rules and regulations promulgated thereunder. In satisfying the 55% requirement, we treat agency RMBS issued with respect to an underlying pool of mortgage loans in which we hold all of the certificates issued by the pool (“whole pool” securities) as qualifying real estate interests based on pronouncements of the SEC staff. We treat partial pool securities, CRT and other mortgage related securities as real estate-related assets. If the SEC determines that any of these securities are not qualifying interests in real estate or real estate-related assets, adopts a contrary interpretation with respect to these securities or otherwise believes we do not satisfy the above exceptions or changes its interpretation of the above exceptions, we could be required to restructure our activities or sell certain of our assets. Our compliance with these requirements may at times lead us to adopt less efficient methods of financing certain of our investments, and we may be precluded from acquiring higher yielding securities. Most importantly, if we fail to qualify for this exemption, our ability to use leverage would be substantially reduced and we would be unable to conduct our business as we currently conduct it, which could materially and adversely affect our business.


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Risks Related to Our Common Stock

The market price and trading volume of our common stock may be volatile.

The market price and trading volume of our common stock may be highly volatile and subject to wide fluctuations. Price variations may be unrelated to our operating performance. If the market price of our common stock declines significantly, stockholders may be unable to resell shares at a gain. Further, fluctuations in the trading price of our common stock may adversely affect the liquidity of the trading market for our common stock and our ability to raise additional equity capital.
    
Some of the factors that could negatively affect our share price or result in fluctuations in the price or trading volume of our common stock include:

actual or anticipated variations in our quarterly operating results or distributions;
changes in our earnings estimates or publication of research reports about us or the real estate or specialty finance industry;
increases in market interest rates that lead purchasers of our shares of common stock to demand a higher yield;
changes in market valuations of similar companies;
adverse market reaction to any increased indebtedness we incur in the future;
issuance of additional equity securities;
our repurchases of shares of our common stock;
actions by institutional stockholders;
additions or departures of key management personnel, or changes in our relationship with our Manager;
speculation in the press or investment community;
price and volume fluctuations in the stock market from time to time, which are often unrelated to our operating performance;
changes in regulatory policies, tax laws and financial accounting and reporting standards, particularly with respect to REITs, or applicable exemptions from the Investment Company Act of 1940, as amended;
decreases in our net asset value per share;
loss of major repurchase agreement providers; and
general market and economic conditions.

In addition, the price of our common stock may be below our reported net asset value per common share. We cannot assure you that the market price of our common stock will not fluctuate or decline significantly in the future.

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

In the future, we may raise capital through the issuance of debt or equity securities. Upon liquidation, holders of our debt securities, if any, preferred stock and lenders with respect to other borrowings will be entitled to our available assets prior to the holders of our common stock. Additional equity offerings may dilute the holdings of our existing stockholders or reduce the market price of our common stock, or both. Our preferred stock has a preference on liquidating distributions and a preference on dividend payments that could limit our ability to pay dividends to the holders of our common stock. Sales of substantial amounts of our common stock, or the perception that these sales could occur, could have a material adverse effect on the price of our common stock. 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 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.

Future sales of shares of our common stock may depress the price of our shares.

We cannot predict the effect, if any, of future sales of our common stock or the availability of shares for future sales on the market price of our common stock. Any sales of a substantial number of our shares in the public market, or the perception that sales might occur, may cause the market price of our shares to decline.

We have not established a minimum dividend payment level and we cannot assure you of our ability to pay dividends in the future.

We intend to pay quarterly dividends to our common stockholders in an amount that all or substantially all of our taxable income is distributed within the limits prescribed by the Internal Revenue Code. However, we have not established a minimum

32


dividend payment level and the amount of our dividend will fluctuate. Our ability to pay dividends may be adversely affected by the risk factors described herein. All distributions will be made at the discretion of our Board of Directors and will depend on our earnings, our financial condition, the requirements for REIT qualification and such other factors as our Board of Directors may deem relevant from time to time. We may not be able to make distributions in the future or our Board of Directors may change our dividend policy. In addition, some of our distributions may include a return of capital. To the extent that we decide to pay dividends in excess of our current and accumulated tax earnings and profits, such distributions would generally be considered a return of capital for Federal income tax purposes. A return of capital reduces the basis of a stockholder's investment in our common stock to the extent of such basis and is treated as capital gain thereafter.

An increase in market interest rates may cause a material decrease in the market price of our common stock.

Market interest rate fluctuations and capital market conditions can have a significant adverse effect on the market price of our common stock. For instance, if market interest rates rise without an increase in our distribution rate, the market price of our common stock could decrease as potential investors may require a higher distribution yield on our common stock or seek other investments paying higher distributions or interest. In addition, rising interest rates would result in increased interest expense on our variable rate debt, thereby reducing cash flow and our ability to service our indebtedness and pay distributions.

The stock ownership limit imposed by the Internal Revenue Code for REITs and our charter may restrict our business combination opportunities.

To qualify as a REIT under the Internal Revenue Code, not more than 50% of our outstanding stock may be
owned, directly or indirectly, by five or fewer individuals (as defined in the Internal Revenue Code to include certain entities) at
any time during the last half of each taxable year in which we qualify as a REIT. Our charter, with certain exceptions, authorizes our Board of Directors to take the actions that are necessary and desirable to qualify as a REIT. Pursuant to our charter, no person may beneficially or constructively own more than 9.8% in value or in number of shares, whichever is more restrictive, of our common or capital stock.

Our Board of Directors may grant an exemption from this 9.8% stock ownership limitation, in its sole discretion, subject
to such conditions, representations and undertakings as it may determine are reasonably necessary. Pursuant to our charter, our Board of Directors has the power to increase or decrease the percentage of common or capital stock that a person may beneficially or constructively own. However, any decreased stock ownership limit will not apply to any person whose percentage ownership of our common or capital stock, is in excess of such decreased stock ownership limit until that person's percentage ownership of our common or capital stock, equals or falls below the decreased stock ownership limit. Until such a person's percentage ownership of our common or capital stock, falls below such decreased stock ownership limit, any further acquisition of our common or capital stock will be in violation of the decreased stock ownership limit.

The ownership limits imposed by the tax law are based upon direct or indirect ownership by “individuals,” but only during the last half of a tax year. The ownership limits contained in our charter apply to the ownership at any time by any “person,” which term includes entities. Any attempt to own or transfer shares of our common stock or capital stock in violation of these restrictions may result in the shares being transferred to a charitable trust or may be void. These ownership limitations are intended to assist us in complying with the tax law requirements, and to minimize administrative burdens. However, these ownership limits might also delay or prevent a transaction or a change in our control that might involve a premium price for our common stock or otherwise be in the best interest of our stockholders.

The stock ownership limitation contained in our charter generally does not permit ownership in excess of 9.8% of our common or capital stock, and attempts to acquire our common or capital stock in excess of these limits will be ineffective unless an exemption is granted by our Board of Directors.

As described above, our charter generally prohibits beneficial or constructive ownership by any person of more than 9.8% (by value or by number of shares, whichever is more restrictive) of our common or capital stock, unless exempted by our Board of Directors. Our charter's constructive ownership rules are complex and may cause the outstanding stock owned by a group of related individuals or entities to be deemed to be constructively owned by one individual or entity. As a result, the acquisition of less than these percentages of the outstanding stock by an individual or entity could cause that individual or entity to own constructively in excess of these percentages of the outstanding stock and thus be subject to our charter's ownership limit. Any attempt to own or transfer shares of our common or preferred stock in excess of the ownership limit without the consent of the Board of Directors will result in the shares being automatically transferred to a charitable trust or, if the transfer to a charitable trust would not be effective, such transfer being treated as invalid from the outset.


33


Anti-takeover provisions in our charter and bylaws could discourage a change of control that our stockholders may favor, which could also adversely affect the market price of our common stock.

Provisions in our charter and bylaws may make it more difficult and expensive for a third party to acquire control of us, even if a change of control would be beneficial to our stockholders. We could issue a series of preferred stock to impede the completion of a merger, tender offer or other takeover attempt. These anti-takeover provisions in our charter and bylaws may impede takeover attempts, or other transactions, that may be in the best interests of our stockholders and, in particular, common stockholders. In addition, the market price of our common stock could be adversely affected to the extent that provisions of our charter and bylaws discourage potential takeover attempts, or other transactions, that our stockholders may favor.

Certain provisions of Maryland law may limit the ability of a third party to acquire control of our company.

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

Subject to certain limitations, provisions of the MGCL prohibit certain business combinations between us and an “interested stockholder” (defined generally as any person who beneficially owns 10% or more of the voting power of our outstanding voting stock or an affiliate or associate of ours who beneficially owned 10% or more of the voting power of our then outstanding stock during the two-year period immediately prior to the date in question) or an affiliate of the interested stockholder for five years after the most recent date on which the stockholder became an interested stockholder. After the five-year period, business combinations between us and an interested stockholder or an affiliate of the interested stockholder must generally either provide a minimum price to our stockholders (as defined in the MGCL) in the form of cash or other consideration in the same form as previously paid by the interested stockholder or be recommended by our Board of Directors and approved by the affirmative vote of at least 80% of the votes entitled to be cast by holders of our outstanding shares of voting stock and at least two-thirds of the votes entitled to be cast by stockholders other than the interested stockholder and its affiliates and associates. These provisions of the MGCL relating to business combinations do not apply, however, to business combinations that are approved or exempted by our 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 between us and any other person, provided that in the latter case the 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). However, our Board of Directors may repeal or modify this resolution at any time in the future, in which case the applicable provisions of this statute will become applicable to business combinations between us and interested stockholders.

The “control share” provisions of the MGCL provide that holders of “control shares” of a Maryland corporation (defined as shares which, when aggregated with 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 “control shares”) have 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 our employees who are also our 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.

Additionally, Title 3, Subtitle 8 of the MGCL permits our Board of Directors, without stockholder approval and regardless of what is currently provided in our charter or bylaws, to elect to be subject to certain provisions relating to corporate governance that may have the effect of delaying, deferring or preventing a transaction or a change of control of our company that might involve a premium to the market price of our common stock or otherwise be in our stockholders' best interests. We are subject to some of these provisions, either by provisions of our charter and bylaws unrelated to Subtitle 8 or by reason of an election in our charter to be subject to certain provisions of Subtitle 8.

Our Board of Directors has the power to cause us to issue additional shares of our stock without stockholder approval.

Our charter authorizes us to issue additional authorized but unissued shares of 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 authority to issue and classify or reclassify any unissued shares of common or preferred stock and set the preferences, rights and other terms of the classified or reclassified shares. As a result, our Board of Directors may establish a series of shares of common or preferred stock that could delay or

34


prevent a transaction or a change in control that might involve a premium price for our shares of common stock or otherwise be in the best interest of our stockholders.
Item 1B. Unresolved Staff Comments
 
None.
Item 2. Properties
 
Our wholly-owned subsidiary, Capital Healthcare Investments, LLC (“CHI”) owns investment properties in Texas, Louisiana, Minnesota, Wisconsin, Utah, Virginia and Georgia with a total investment of $267.8 million. RCS operates from leased office space in Fort Worth, Texas.

Our executive and administrative office is located in Bethesda, Maryland in office space shared with our Manager.
Item 3. 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, 2017, we are not party to any material litigation or legal proceedings, or to the best of our knowledge, any threatened litigation or legal proceedings, which, in our opinion, individually or in the aggregate, would have a material adverse effect on our results of operations or financial condition.
Item 4. Mine Safety Disclosures
Not applicable.



35



PART II
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
 
Quarterly Stock Prices
Our common stock is listed on The Nasdaq Global Select Market under the symbol “MTGE.” As of February 1, 2018, we had 82 stockholders of record. Most of the shares of our common stock are held by brokers and other institutions on behalf of stockholders.
The following table sets forth the range of quarterly high and low sales prices of our common stock as reported on The Nasdaq Global Select Market for the years ended December 31, 2017 and 2016.
 
 
Common Stock
Period
 
High
 
Low
2017
 
 
 
 
Fourth Quarter
 
$
19.90

 
$
17.65

Third Quarter
 
$
20.00

 
$
18.45

Second Quarter
 
$
19.65

 
$
16.35

First Quarter
 
$
17.05

 
$
15.50

 
 
 
 
 
2016
 
 
 
 
Fourth Quarter
 
$
17.40

 
$
15.40

Third Quarter
 
$
17.77

 
$
15.45

Second Quarter
 
$
16.11

 
$
14.31

First Quarter
 
$
14.79

 
$
12.01

Dividends Declared
The following table summarizes quarterly dividends declared on our common stock for the years ended December 31, 2017 and 2016 and their related tax characterization (in thousands except per share data):
 
 
 
 
 
 
 
 
Tax Characterization of Dividends
Declaration Date
 
Record Date
 
Payment Date
 
Dividend Per Share
 
Ordinary Income
Per Share
 
Qualified Dividends
 
Capital Gains Per Share
December 14, 2017
 
December 29, 2017
 
January 9, 2018
 
$
0.50

 
$
0.50

 
$

 
$

September 13, 2017
 
September 29, 2017
 
October 27, 2017
 
0.45

 
0.45

 

 

June 15, 2017
 
June 30, 2017
 
July 27, 2017
 
0.45

 
0.45

 

 

March 16, 2017
 
March 31, 2017
 
April 27, 2017
 
0.45

 
0.45

 

 

December 15, 2016
 
December 30, 2016
 
January 27, 2017
 
0.40

 
0.40

 

 

September 15, 2016
 
September 30, 2016
 
October 27, 2016
 
0.40

 
0.40

 

 

June 13, 2016
 
June 30, 2016
 
July 27, 2016
 
0.40

 
0.40

 

 

March 17, 2016
 
March 31, 2016
 
April 27, 2016
 
0.40

 
0.40

 

 

We intend to pay quarterly dividends on our common stock and to distribute to our stockholders all of our annual taxable income in a timely manner. This will enable us to qualify for the tax benefits accorded to a REIT under the Internal Revenue Code. We have not established a minimum dividend payment level and our ability to pay dividends may be adversely affected for the reasons described under the caption “Risk Factors.” In addition, holders of our 8.125% Series A Cumulative Redeemable Preferred Stock (“Series A Preferred Stock”) are entitled to receive cumulative cash dividends at a rate of 8.125% per annum of the $25.00 per share liquidation preference before holders of our common stock are entitled to receive any dividends. Under certain circumstances upon a change of control, the Series A Redeemable Preferred Stock is convertible to shares of our common stock. All distributions will be made at the discretion of our Board of Directors and will depend on our

36



earnings, our financial condition, maintenance of our REIT status and such other factors as our Board of Directors may deem relevant from time to time.
Our stock transfer agent and registrar is Computershare Investor Services. Requests for information from Computershare can be sent to Computershare Investor Services, P.O. Box 43078, Providence, RI 02940-3078 and their telephone number is 1-800-733-5001.
Equity Compensation Plan Information
We have adopted the American Capital Mortgage Investment Corp. Amended and Restated Equity Incentive Plan, or Incentive Plan, to provide for the issuance of equity-based awards, including stock options, restricted stock units and unrestricted stock awards to eligible participants.
The following table provides information as of December 31, 2017 concerning shares of our common stock authorized for issuance under our existing Incentive Plan.
Plan Category
 
Number of Securities to be Issued Upon Exercise of Outstanding Options, Warrants and Rights (1)
 
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)
Equity compensation plans approved by security holders
 
17,415

 
 
 
862,277

Equity compensation plans not approved by security holders
 

 

 

Total
 
17,415

 
$

 
862,277

__________
(1) Represents unvested restricted stock units awarded to our independent directors including accrued dividend equivalent shares.

37



Performance Graph
The following graph compares a stockholder's cumulative total return, assuming $100 invested at December 31, 2012, with the reinvestment of all dividends, as if such amounts had been invested in: (i) our common stock; (ii) the stocks included in the Standard & Poor's 500 Stock Index (“S&P 500”); (iii) the stocks included in the FTSE NAREIT Mortgage REIT Index; and (iv) an index of selected issuers in our residential mortgage-related REIT Peer Group composed of AG Mortgage Investment Trust Inc, Chimera Investment Corporation, Dynex Capital Inc., Invesco Mortgage Capital Inc., MFA Financial, Inc., Two Harbors Investment Corp and Western Asset Mortgage Capital Corp. (collectively, the “Peer Group”).

chart-40d5f308990529bb00f.jpg
Date
 
MTGE Investment Corp.
 
S&P 500
 
FTSE NAREIT Mortgage REITS
 
Peer Group
12/31/2012
 
$
100.00

 
$
100.00

 
$
100.00

 
$
100.00

12/31/2013
 
$
86.08

 
$
132.39

 
$
98.04

 
$
104.58

12/31/2014
 
$
106.05

 
$
150.51

 
$
115.57

 
$
127.21

12/31/2015
 
$
87.95

 
$
152.59

 
$
105.31

 
$
116.69

12/31/2016
 
$
109.41

 
$
170.84

 
$
129.38

 
$
153.10

12/31/2017
 
$
142.40

 
$
208.14

 
$
154.98

 
$
186.82




38



Item 6. Selected Financial Data
The following selected financial data are derived from our audited consolidated financial statements for the five years ended December 31, 2017. The selected financial data should be read in conjunction with the more detailed information contained in the Consolidated Financial Statements and Notes thereto and “Management's Discussion and Analysis of Financial Condition and Results of Operations” included elsewhere in this Annual Report on Form 10-K (in thousands, except per share amounts).
 
 
 
 
December 31,
 
 
2017
 
2016
 
2015
 
2014
 
2013
Balance sheet data:
 
 
 
 
 
 
 
 
 
 
Agency securities, at fair value
 
$
3,758,181

 
$
2,803,168

 
$
3,217,252

 
$
4,384,139

 
$
5,641,682

Non-agency securities, at fair value
 
$
872,084

 
$
1,134,469

 
$
1,557,671

 
$
1,168,834

 
$
1,011,217

Healthcare real estate assets (1)
 
$
262,833

 
$
93,266

 
$

 
$

 
$

Total assets
 
$
5,953,036

 
$
4,797,155

 
$
5,482,402

 
$
7,031,252

 
$
8,397,865

Financing arrangements
 
$
4,050,219

 
$
3,311,043

 
$
4,107,615

 
$
5,423,630

 
$
7,158,192

Total liabilities
 
$
4,947,414

 
$
3,864,110

 
$
4,491,290

 
$
5,855,283

 
$
7,295,145

Total stockholders' equity
 
$
1,005,107

 
$
932,730

 
$
991,112

 
$
1,175,969

 
$
1,102,720

Net asset value per common share
 
$
20.75

 
$
19.17

 
$
19.66

 
$
21.91

 
$
21.47

 
 
 
 
 
 
 
 
 
 
 
 
 
For the Year Ended December 31,
 
 
2017
 
2016
 
2015
 
2014
 
2013
Statement of operations data:
 
 
 
 
 
 
 
 
 
 
Interest income
 
$
143,648

 
$
147,770

 
$
174,118

 
$
183,358

 
$
255,699

Interest expense
 
(52,526
)
 
(39,582
)
 
(30,800
)
 
(28,631
)
 
(38,754
)
Net interest income
 
91,122

 
108,188

 
143,318

 
154,727

 
216,945

Net servicing loss
 
(5,337
)
 
(17,690
)
 
(17,367
)
 
(15,213
)
 
(4,139
)
Net healthcare investment income
 
5,862

 
659

 

 

 

Other gains (losses)
 
90,158

 
(23,844
)
 
(139,062
)
 
45,265

 
(270,676
)
Expenses
 
(21,029
)
 
(23,767
)
 
(25,205
)
 
(25,362
)
 
(25,921
)
Benefit from (provision for) income tax, net
 
550

 
125

 
(42
)
 
(238
)
 
(679
)
Net income (loss)
 
161,326

 
43,671

 
(38,358
)
 
159,179

 
(84,470
)
Dividend on preferred stock
 
(4,468
)
 
(4,468
)
 
(4,468
)
 
(2,718
)
 

Noncontrolling interest in net income
 
9

 
(2
)
 

 

 

Net income (loss) to common shareholders
 
$
156,867

 
$
39,201

 
$
(42,826
)
 
$
156,461

 
$
(84,470
)
 
 
 
 
 
 
 
 
 
 
 
Net income (loss) per common share - basic and diluted
 
$
3.42

 
$
0.85

 
$
(0.85
)
 
$
3.06

 
$
(1.59
)
Weighted average common shares - basic
 
45,805

 
46,005

 
50,506

 
51,176

 
53,015

Weighted average common shares - diluted
 
45,811

 
46,008

 
50,519

 
51,192

 
53,015

 
 
 
 
 
 
 
 
 
 
 
Dividends declared per common share
 
$
1.85

 
$
1.60

 
$
1.80

 
$
2.60

 
$
3.05

————————
(1) 
Includes $5.8 million of goodwill recorded in other assets on the consolidated balance sheets.

39



Key Statistics
The table below presents key statistics for the five years ended December 31, 2017 (dollars in thousands, except per share amounts):
 
 
For the Years Ended December 31,
 
 
2017
 
2016
 
2015
 
2014
 
2013
Ending agency securities, at fair value
 
$
3,758,181

 
$
2,803,168

 
$
3,217,252

 
$
4,384,139

 
$
5,641,682

Ending agency securities, at cost
 
$
3,793,080

 
$
2,836,564

 
$
3,235,938

 
$
4,374,729

 
$
5,820,194

Ending agency securities, at par
 
$
3,602,606

 
$
2,703,884

 
$
3,073,198

 
$
4,190,407

 
$
5,573,593

Average agency securities, at cost
 
$
3,297,347

 
$
3,028,307

 
$
3,817,686

 
$
4,759,753

 
$
7,352,882

Average agency securities, at par
 
$
3,138,987

 
$
2,879,328

 
$
3,641,760

 
$
4,562,017

 
$
6,996,922

 
 
 
 
 
 
 
 
 
 
 
Ending non-agency securities, at fair value
 
$
872,084

 
$
1,134,469

 
$
1,557,671

 
$
1,168,834

 
$
1,011,217

Ending non-agency securities, at cost
 
$
779,629

 
$
1,079,363

 
$
1,543,113

 
$
1,111,123

 
$
927,131

Ending non-agency securities, at par
 
$
911,707

 
$
1,265,040

 
$
1,759,482

 
$
1,373,652

 
$
1,526,918

Average non-agency securities, at cost
 
$
862,369

 
$
1,270,040

 
$
1,361,149

 
$
971,412

 
$
788,260

Average non-agency securities, at par
 
$
1,011,942

 
$
1,469,365

 
$
1,602,128

 
$
1,458,861

 
$
1,334,104

 
 
 
 
 
 
 
 
 
 
 
Net TBA portfolio - as of period end, at fair value
 
$
1,733,152

 
$
900,316

 
$
44,988

 
$
271,617

 
$
(774,840
)
Net TBA portfolio - as of period end, at cost
 
$
1,731,401

 
$
918,805

 
$
44,181

 
$
259,985

 
$
(775,859
)
Average net TBA portfolio, at cost
 
$
1,729,240

 
$
562,934

 
$
112,907

 
$
685,683

 
$
559,724

 
 
 
 
 
 
 
 
 
 
 
Average total assets, at fair value
 
$
5,533,147

 
$
4,949,469

 
$
6,460,150

 
$
7,231,528

 
$
9,706,830

Average agency and non-agency repurchase agreements and advances
 
$
3,524,792

 
$
3,677,854

 
$
4,500,978

 
$
4,989,896

 
$
7,222,101

Average stockholders' equity
 
$
978,699

 
$
962,440

 
$
1,120,068

 
$
1,165,952

 
$
1,208,812

 
 
 
 
 
 
 
 
 
 
 
Average coupon
 
3.56
%
 
3.33
%
 
3.17
%
 
2.96
%
 
3.11
%
Average asset yield
 
3.43
%
 
3.42
%
 
3.36
%
 
3.19
%
 
3.14
%
Average asset yield excluding “catch-up” premium amortization
 
3.48
%
 
3.47
%
 
3.34
%
 
3.25
%
 
3.03
%
Average cost of funds (1)
 
1.70
%
 
1.35
%
 
1.05
%
 
0.98
%
 
1.10
%
Average net interest rate spread
 
1.73
%
 
2.07
%
 
2.31
%
 
2.21
%
 
2.03
%
Average net interest rate spread, excluding “catch-up” premium amortization
 
1.78
%
 
2.12
%
 
2.29
%
 
2.27
%
 
1.93
%
Average net interest rate spread, including TBA dollar roll, excluding “catch-up” premium amortization
 
1.87
%
 
2.16
%
 
2.35
%
 
2.34
%
 
1.91
%
Average coupon as of period end
 
3.67
%
 
3.35
%
 
3.31
%
 
3.06
%
 
2.94
%
Average asset yield as of period end
 
3.44
%
 
3.70
%
 
3.60
%
 
3.24
%
 
3.18
%
Average repurchase agreement/ FHLB funding rate as of period end
 
1.71
%
 
1.26
%
 
0.88
%
 
0.61
%
 
0.56
%
Effective swap net pay rate as of period end
 
0.20
%
 
0.43
%
 
0.93
%
 
1.01
%
 
0.94
%

40



 
 
For the Years Ended December 31,
 
 
2017
 
2016
 
2015
 
2014
 
2013
Average actual CPR for agency securities held during the period
 
9.6
%
 
11.4
%
 
9.4
 %
 
7.6
%
 
6.5
 %
Average projected life CPR for agency securities as of period end
 
8.4
%
 
8.1
%
 
8.5
 %
 
8.2
%
 
7.3
 %
 
 
 
 
 
 
 
 
 
 
 
Leverage - average during the period (2)
 
4.0x

 
4.1x

 
4.3x

 
4.7x

 
6.0x

Leverage - average during the period, including net TBA position
 
5.9x

 
4.7x

 
4.4x

 
5.3x

 
6.3x

Leverage - as of period end (3)
 
4.2x

 
3.7x

 
4.4x

 
4.4x

 
5.9x

Leverage - as of period end, including net TBA position
 
6.2x

 
4.8x

 
4.5x

 
4.6x

 
5.1x

 
 
 
 
 
 
 
 
 
 
 
Expenses % of average total assets - annualized
 
0.4
%
 
0.5
%
 
0.4
 %
 
0.4
%
 
0.3
 %
Expenses % of average stockholders' equity - annualized
 
2.1
%
 
2.5
%
 
2.3
 %
 
2.2
%
 
2.1
 %
Net asset value per common share as of period end
 
$
20.75

 
$
19.17

 
$
19.66

 
$
21.91

 
$
21.47

Dividends declared per common share
 
$
1.85

 
$
1.60

 
$
1.80

 
$
2.60

 
$
3.05

Economic return (loss) on common equity - annualized
 
17.9
%
 
5.6
%
 
(2.1
)%
 
13.7
%
 
(7.0
)%
————————  
(1) 
Average cost of funds includes periodic settlements of interest rate swaps and excludes U.S. Treasury repurchase agreements and healthcare real estate financing.
(2) 
Leverage during the period was calculated by dividing the Company's daily weighted average agency and non-agency financing agreements for the period by the Company's average month-ended stockholders' equity for the period less investments in RCS and healthcare real estate. Leverage excludes U.S. Treasury repurchase agreements.
(3) 
Leverage at period end was calculated by dividing the sum of the amount outstanding under the Company's agency and non-agency financing agreements, and the net receivable/payable for unsettled securities at period end by the Company's stockholders' equity at period end less investments in RCS and healthcare real estate. Leverage excludes U.S. Treasury repurchase agreements.


41


Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) provides readers of our consolidated financial statements a narrative from the perspective of management, and should be read in conjunction with the consolidated financial statements and accompanying notes included in this Annual Report on Form 10-K for the year ended December 31, 2017. Our MD&A is presented in the following sections:
Executive Overview
Financial Condition
Results of Operations
Liquidity and Capital Resources
Off-Balance Sheet Arrangements
Aggregate Contractual Obligations
Forward-Looking Statements
EXECUTIVE OVERVIEW
Our principal objective is to provide our stockholders with attractive risk-adjusted returns through a combination of monthly dividends and net asset value appreciation. We generate income from the interest earned on our investments, net of associated borrowing and hedging costs, and net realized gains and losses on our investment and hedging activities.
The size and composition of our investment portfolio depend on investment strategies implemented by our Manager, the accessibility of investment capital and overall market conditions, including the availability of attractively priced investments and suitable financing to leverage our investment portfolio appropriately. Market conditions are influenced by, among other things, current levels of and expectations for future levels of interest rates both domestically and globally, mortgage prepayments, market liquidity, housing prices, unemployment rates, general economic conditions, government participation in the mortgage market, and regulations or legal requirements that impact other real estate-related activities.
Trends and Recent Market Impacts
Economic conditions in the U.S. and abroad continued to improve throughout 2017, and long-term interest rates remained remarkably stable. Against this backdrop, investors generally favored higher risk assets, as evidenced by the strong performance of equities and tighter credit spreads throughout much of the fixed income market. Agency RMBS spreads, on the other hand, widened modestly during the first three quarters of the year versus benchmark interest rates in anticipation of the Fed's reduction of its agency RMBS holdings. In September 2017, the Fed announced the details of its plan to gradually reduce the reinvestment of proceeds from its agency RMBS holdings beginning in October 2017. Following the announcement, the price of our agency RMBS appreciated relative to our hedge instruments, causing spreads to narrow somewhat in the fourth quarter of the year.
Favorable U.S. residential housing market fundamentals and significant investor demand for credit-centric assets led to the strong performance of our non-agency securities during 2017. In response to improved valuations and the corresponding downward revision to projected returns, we sold a subset of our non-agency securities and re-allocated the capital to more attractive investment opportunities in the agency RMBS and healthcare real estate sectors. As such, the percentage of capital allocated to non-agency investments declined to 29% at year-end from 41% as of December 31, 2016. Our capital allocated to agency RMBS increased to 62% as of December 31, 2017, up from 52% as of December 31, 2016, while our capital allocated to healthcare assets increased to 9% as of December 31, 2017, up from 3% as of December 31, 2016.
In response to generally favorable investment opportunities, we increased our agency RMBS leverage to 8.1x as of December 31, 2017 from 6.9x as of December 31, 2016. Our aggregate mortgage securities portfolio leverage was 6.2x as of December 31, 2017, up from 4.8x as of December 31, 2016
The strong performance of both agency and non-agency RMBS during the year increased our net asset value to $20.75 per common share as of December 31, 2017, from $19.17 per common share at the beginning of the year, an increase of 8.2% for 2017. Combining the $1.58 per common share increase in net asset value with the $1.85 of dividends paid per common share, MTGE generated an economic return on common equity of 17.9% for the year.
Throughout 2017, the Fed continued to gradually increase short-term interest rates, raising the federal funds rate three times for a total of 75 basis points. Over the same period, the yield on the 10-year U.S. Treasury note was relatively stable, declining just 2 basis points. As a result, the yield differential between short term Treasury rates and long-term Treasury rates narrowed, or flattened, significantly. This yield curve flattening and our reduced capital allocation to non-agency securities led

42



to a reduction in our average net interest margin to 1.87% for 2017 from 2.16% for 2016, inclusive of our TBA position and excluding "catch-up" premium amortization due to changes in our constant prepayment rate forecasts.
Within the healthcare sector, skilled nursing and senior living facilities continue to benefit from favorable demographic trends, including the substantial growth in the U.S. population aged 75 and older. This growth in the elderly population, coupled with the already high utilization rates at these facilities, provides a strong foundation for this sector. In addition, investments in these facilities benefit from a stable supply of long term, fixed rate funding from GSEs and HUD. Our wholly-owned subsidiary, Capital Healthcare Investments, LLC (“CHI”) has completed healthcare real estate acquisitions with a combined asset value of $282 million as of December 31, 2017.
Our funding position remained favorable during 2017, as generally higher borrowing costs following the Fed’s rate increases were partially offset by lower costs on our interest rate swap position. Our aggregate cost of funds, which includes our repo cost, the implied funding cost associated with our TBA position and our swap costs, was 1.46% for 2017, up from 1.25% for 2016.
During 2017, we generally believed interest rates were likely to increase, given improving underlying economic fundamentals and a reduction in quantitative easing measures by central banks. As such, we reduced our exposure to higher interest rates by lowering our net duration gap, which is a measure of the mismatch between the interest rate sensitivity of our assets and the interest rate sensitivity of our liabilities and hedges, to 0.6 years as of December 31, 2017, from 1.1 years as of December 31, 2016. As part of our interest rate risk management strategy, we also maintained a relatively large interest rate hedge position, with our interest rate hedges totaling 86% of our funding liabilities and net TBA position as of December 31, 2017. Given the likelihood of further Fed Funds rate increases, we expect to maintain a relatively high interest rate hedge ratio and a modest duration gap over the near to intermediate term.
During the first quarter of 2017, our mortgage servicing subsidiary, Residential Credit Solutions, Inc. (“RCS”), sold its portfolio of MSR and commenced winding down operations. During 2017, RCS recorded $2.8 million in servicing revenues and $8.1 million in servicing expenses.
Looking ahead, we believe strong underlying fundamentals in the U.S. conforming housing market, such as low unemployment levels, low mortgage rates, expanding credit availability, and favorable demographics, will continue to benefit our non-agency investment portfolio. Additionally, while agency RMBS investments appear attractively priced relative to other fixed income instruments, we believe Agency RMBS spreads could widen further and interest rates could trend somewhat higher. We will continue to opportunistically increase our leverage when we believe the risk-adjusted returns are appropriate. Finally, we expect MTGE’s investments in the healthcare sector to represent an increasing share of our capital as these investments continue offer attractive risk-adjusted returns.

43



The table below summarizes interest rates and prices for generic agency RMBS as of the end of each respective quarter since December 31, 2016:
Interest Rate / Security (1)
 
December
31, 2017
 
September 30, 2017
 
June 30, 2017
 
March 31, 2017
 
December 31, 2016
LIBOR:
 
 
 
 
 
 
 
 
 
 
1-Month
 
1.56
%
 
1.23
%
 
1.22
%
 
0.98
%
 
0.77
%
3-Month
 
1.69
%
 
1.33
%
 
1.30
%
 
1.15
%
 
1.00
%
U.S. Treasury Securities:
 
 
 
 
 
 
 
 
 
 
2-Year U.S. Treasury
 
1.89
%
 
1.48
%
 
1.38
%
 
1.26
%
 
1.20
%
5-Year U.S. Treasury
 
2.21
%
 
1.93
%
 
1.89
%
 
1.93
%
 
1.92
%
10-Year U.S. Treasury
 
2.41
%
 
2.33
%
 
2.30
%
 
2.39
%
 
2.43
%
Interest Rate Swap Rates:
 
 
 
 
 
 
 
 
 
 
2-Year Swap Rate
 
2.08
%
 
1.73
%
 
1.61
%
 
1.62
%
 
1.46
%
5-Year Swap Rate
 
2.24
%
 
2.00
%
 
1.95
%
 
2.06
%
 
1.96
%
10-Year Swap Rate
 
2.40
%
 
2.28
%
 
2.27
%
 
2.39
%
 
2.32
%
30-Year Fixed Rate Agency Price:
 
 
 
 
 
 
 
 
 
 
3.5%
 
$
102.70

 
$
103.09

 
$
102.70

 
$
102.29

 
$
102.50

4.0%
 
$
104.59

 
$
105.27

 
$
105.12

 
$
104.90

 
$
105.13

4.5%
 
$
106.40

 
$
107.33

 
$
107.27

 
$
107.24

 
$
107.51

15-Year Fixed Rate Agency Price:
 
 
 
 
 
 
 
 
 
 
2.5%
 
$
99.88

 
$
100.69

 
$
100.53

 
$
100.03

 
$
100.20

3.0%
 
$
101.88

 
$
102.75

 
$
102.64

 
$
102.51

 
$
102.62

3.5%
 
$
103.23

 
$
104.14

 
$
104.06

 
$
104.06

 
$
104.17

 ________________________
(1) 
Price information is for generic instruments only and is not reflective of our specific portfolio holdings. Price information can vary by source. Prices in the table above were obtained from a combination of Bloomberg and dealer indications. Interest rates were obtained from Bloomberg.
For the estimated impact of changes in interest rates and mortgage spreads on our net asset value please refer to “Quantitative and Qualitative Disclosures about Market Risk” under Item 7A of this Annual Report on Form 10-K.

The table below summarizes pay-ups on specified pools over the corresponding generic agency RMBS as of the end of each respective quarter for a select sample of specified securities. Price information provided in the table below is for illustrative purposes only and is not meant to be reflective of our specific portfolio holdings. Actual pay-ups are dependent on specific securities held in our portfolio and prices can vary depending on the source.
Specified Mortgage Pool Pay-ups over Generic TBA Price (1)(2)
 
December
31, 2017
 
September 30, 2017
 
June
30, 2017
 
March
31, 2017
 
December 31, 2016
30-Year Lower Loan Balance (3):
 
 
 
 
 
 
 
 
 
 
3.0%
 
$
0.41

 
$
0.45

 
$
0.41

 
$
0.38

 
$
0.23

3.5%
 
$
0.81

 
$
0.89

 
$
0.83

 
$
0.72

 
$
0.72

4.0%
 
$
1.69

 
$
1.69

 
$
1.47

 
$
1.20

 
$
1.08

30-Year HARP (4):
 
 
 
 
 
 
 
 
 
 
3.5%
 
$
0.03

 
$
0.16

 
$
0.16

 
$
0.16

 
$
0.16

4.0%
 
$
0.17

 
$
0.50

 
$
0.50

 
$
0.47

 
$
0.44

 ________________________ 
(1) 
Source: Bloomberg and dealer indications.
(2) 
“Pay-ups” represent the value of the price premium of specified securities over generic TBA pools. The table above includes pay-ups for newly originated specified pools. Price information is provided for information only and is not meant to be reflective of our specific portfolio holdings. Prices can vary materially depending on the source.
(3) 
Lower loan balance pay-ups for pools with original loan balances from $85,000 to $110,000.
(4) 
HARP pay-ups for pools backed by 100% refinance loans with original loan-to-value ratios between 95% and 100%.


44



Share Repurchases
Under our stock repurchase plan, the Company is authorized to repurchase up to $100 million of its outstanding shares of common stock through December 31, 2018. The Company may repurchase shares in the open market or privately negotiated transactions or pursuant to a trading plan that may be adopted in accordance with Rule 10b5-1 of the Securities and Exchange Act of 1934, as amended. The Company intends to only repurchase shares under the stock repurchase plan when the repurchase price is less than its estimate of its then current net asset value per common share.

At-the-Market Offering Program

During August 2017, we entered into agreements with sales agents to publicly offer and sell shares of our common stock in privately negotiated and/or at-the-market transactions from time-to-time up to an aggregate amount of $125 million of shares of our common stock.
Summary of Critical Accounting Estimates

Our critical accounting estimates relate to the fair value of our investments and derivatives and the recognition of interest income. Certain of these items involve estimates that require our manager to make judgments that are subjective in nature. We rely on our Manager's experience and analysis of historical and current market data in order to arrive at what we believe to be reasonable estimates. Under different conditions, we could report materially different amounts based on such estimates. Our significant accounting policies are described in Note 2 to the consolidated financial statements included under Item 8 of this Annual Report on Form 10-K.

We have not designated any derivatives as hedging instruments and therefore all changes in fair value are reflected in income during the period in which they occur. We also have elected the option to account for all of our financial assets, including all mortgage-related investments, at fair value, with changes in fair value reflected in income during the period in which they occur. In management's view, this election more appropriately reflects the results of our operations for a particular reporting period, as financial asset fair value changes are presented in a manner consistent with the presentation and timing of the fair value changes of economic hedging instruments.

Fair Value of Investments
We estimate the fair value of our investments in financial assets based on inputs from multiple third-party pricing services and dealer quotes. The third-party pricing services use pricing models which incorporate such factors as coupons, primary and secondary mortgage rates, prepayment speeds, spread to the U.S. Treasury and interest rate swap curves, convexity, duration, periodic and life caps, default and severity rates and credit enhancements. The dealer quotes incorporate common market pricing methods, including a spread measurement to the U.S. Treasury or interest rate swap curve as well as underlying characteristics of the particular security including coupon, periodic and life caps, rate reset period, issuer, additional credit support and expected life of the security. Our Manager observes market information relevant to our specific investment portfolio by trading in the market for mortgage related investments. Our Manager uses this observable market information in reviewing the inputs to and the estimates derived from the valuation process for reasonableness. Changes in the market environment and other events that may occur over the life of our investments may cause the gains or losses ultimately realized on these investments to be different than the valuations currently estimated. See Note 9 to the consolidated financial statements included under Item 8 of this Annual Report on Form 10-K.

Interest Income
Interest income is accrued based on the outstanding principal amount of the securities and their contractual terms. Premiums and discounts associated with the purchase of agency RMBS and non-agency securities of high credit quality are amortized or accreted into interest income over the projected lives of the securities, including contractual payments and estimated prepayments, using the effective interest method. We estimate long-term prepayment speeds using a third-party service and market data.

The third-party service estimates prepayment speeds using models that incorporate the forward yield curve, current mortgage rates, current mortgage rates of the outstanding loans, loan age, volatility and other factors. We review the prepayment speeds estimated by the third-party service and compare the results to market consensus prepayment speeds, if available. We also consider historical prepayment speeds and current market conditions to validate the reasonableness of the prepayment speeds estimated by the third-party service, and based on our Manager's judgment, we may make adjustments to their estimates. Actual and anticipated prepayment experience is reviewed at least quarterly and effective yields are

45



recalculated when differences arise between the previously estimated future prepayments and the amounts actually received plus current anticipated future prepayments. If the actual and anticipated future prepayment experience differs from our prior estimate of prepayments, we are required to record an adjustment in the current period to the amortization or accretion of premiums and discounts for the cumulative difference in the effective yield through the reporting date.

At the time we purchase non-agency securities and loans that are not of high credit quality, we determine an effective interest rate based on our estimate of the timing and amount of cash flows and our cost basis. On at least a quarterly basis, we review the estimated cash flows and make appropriate adjustments, based on input and analysis received from external sources, internal models, and our judgment about interest rates, prepayment rates, the timing and amount of credit losses, and other factors. Any resulting changes in effective yield are recognized prospectively based on the current amortized cost of the investment as adjusted for credit impairment, if any. Our cash flow estimates for these investments are based on our Manager's judgment and observations of current information and events. These estimates include assumptions related to interest rates, prepayment rates and the timing and amount of credit losses. Furthermore, other market participants could use materially different assumptions with respect to default rates, severities, loss timing, or prepayments. Our assumptions are subject to future events that may impact our estimates and interest income, and as a result, actual results may differ significantly from these estimates.

Derivatives
We utilize risk management strategies, under which we may use a variety of derivative instruments to economically hedge some of our exposure to market risks, including interest rate risk, prepayment risk, extension risk and credit risk. Our risk management objective is to reduce fluctuations in net asset value over a range of interest rate scenarios. The principal instruments that we currently use are interest rate swaps and options to enter into interest rate swaps (“interest rate swaptions”). We also utilize forward contracts for the purchase or sale of agency RMBS on a generic pool, or a TBA contract, basis and on a non-generic, specified pool basis, and we utilize U.S. Treasury securities and U.S. Treasury futures contracts, primarily through short sales. We may also purchase or write put or call options on TBA securities and we may invest in other types of mortgage derivatives, such as interest-only securities, and synthetic total return swaps.
We recognize all derivative instruments as either assets or liabilities on the balance sheets, measured at fair value. As we have not designated any derivatives as hedging instruments, all changes in fair value are reported in earnings in our consolidated statements of operations in unrealized gain (loss) on other derivatives and securities, net during the period in which they occur. Derivatives in a gain position are reported as derivative assets at fair value and derivatives in a loss position are reported as derivative liabilities at fair value in our consolidated balance sheets. Cash receipts and payments related to derivative instruments are classified in our consolidated statements of cash flows according to the underlying nature or purpose of the derivative transaction, generally in the investing section.

The use of derivatives creates exposure to credit risk relating to potential losses that could be recognized in the event that the counterparties to these instruments fail to perform their obligations under the contracts. We attempt to minimize this risk by limiting our counterparties to major financial institutions with acceptable credit ratings, monitoring positions with individual counterparties and adjusting posted collateral as required. See Notes 2 and 7 to the consolidated financial statements included under Item 8 of this Annual Report on Form 10-K.

46



FINANCIAL CONDITION
As of December 31, 2017, our investment portfolio with a notional fair value of $6.6 billion was comprised of $3.8 billion of agency RMBS, $1.7 billion of net long TBA securities, $0.9 billion of non-agency securities and $0.3 billion of healthcare real estate investments.
 
 
December 31,
 
 
2017
 
2016
Securities investments:
 
 
 
 
Agency RMBS
 
$
3,758,181

 
$
2,803,168

TBA notional fair value
 
1,733,152

 
900,316

Non-agency securities
 
872,084

 
1,134,469

Total securities investments
 
$
6,363,417

 
$
4,837,953

Agency and non-agency securities funding
 
$
3,863,719

 
$
3,244,516

At risk securities leverage
 
6.2x

 
4.8x

 
 
 
 
 
Healthcare investments:
 
 
 
 
Real estate related assets, including net working capital
 
$
281,827

 
$
102,868

Notes payable, net of deferred financing costs
 
$
186,500

 
$
66,527

Healthcare leverage
 
2.0x

 
1.9x

 
 
 
 
 
Total assets
 
$
5,953,036

 
$
4,797,155

Total liabilities
 
$
4,947,414

 
$
3,864,110

Total stockholders' equity
 
$
1,005,107

 
$
932,730

Net asset value per common share
 
$
20.75

 
$
19.17

The following tables summarize certain characteristics of our mortgage securities portfolio by issuer and investment category as of December 31, 2017 and 2016 (dollars in thousands):

 
December 31, 2017
  
 
Fair Value
 
Amortized Cost Basis
 
Par Value
 
Weighted Average
Coupon
 
Yield (1)
Fannie Mae

$
2,587,575


$
2,612,063


$
2,485,055


3.63
%

2.78
%
Freddie Mac

1,170,606


1,181,017


1,117,551


3.75
%

2.89
%
Agency RMBS total

3,758,181


3,793,080


3,602,606


3.67
%

2.82
%
Non-agency securities

872,084


779,629


911,707


3.73
%

6.59
%
Total

$
4,630,265


$
4,572,709


$
4,514,313


3.67
%

3.44
%
 
 
 
 
 
 
 
 
 
 
 
 
 
December 31, 2016
 
 
Fair Value
 
Amortized Cost Basis
 
Par Value
 
Weighted Average
 
 
Coupon
 
Yield (1)
Fannie Mae
 
$
2,177,517

 
$
2,201,824

 
$
2,103,244

 
3.49
%
 
2.71
%
Freddie Mac
 
625,651

 
634,740

 
600,640

 
3.60
%
 
2.69
%
Agency RMBS total
 
2,803,168

 
2,836,564

 
2,703,884

 
3.52
%
 
2.71
%
Non-agency securities
 
1,134,469

 
1,079,363

 
1,265,040

 
3.00
%
 
6.31
%
Total
 
$
3,937,637

 
$
3,915,927

 
$
3,968,924

 
3.35
%
 
3.70
%
 
————————
(1) 
The weighted average agency security yield incorporates an average future CPR assumption of 8.4% and 8.1% as of December 31, 2017 and 2016, respectively, based on forward rates. For non-agency securities, the weighted average yield is based on estimated cash flows that incorporate expected credit losses.

47




Agency RMBS
As detailed in the tables below, the weighted average agency RMBS portfolio yield increased 11 basis points from December 31, 2016 to December 31, 2017. The increase in average agency yield was due primarily to an increased allocation to 30-year securities.
The following table summarizes certain characteristics of our agency RMBS portfolio by term and coupon as of December 31, 2017 (dollars in thousands):
 
 
December 31, 2017
 
 
Fair Value
 
Amortized Cost Basis
 
Par Value
 
Weighted Average
 
 
Yield
 
Projected CPR
Fixed rate
 
 
 
 
 
 
 
 
 
 
≤ 15-year
 
 
 
 
 
 
 
 
 
 
2.5%
 
$
31,438

 
$
31,421

 
$
31,405

 
2.44
%
 
8.8
%
3.0%
 
169,991

 
171,384

 
166,572

 
2.17
%
 
9.4
%
3.5%
 
141,410

 
142,448

 
136,503

 
2.30
%
 
10.4
%
4.0%
 
93,679

 
94,528

 
89,635

 
2.17
%
 
11.4
%
4.5%
 
7,841

 
7,883

 
7,457

 
2.58
%
 
10.8
%
≤ 15-year total
 
444,359

 
447,664

 
431,572

 
2.24
%
 
10.1
%
20-year
 
 
 
 
 
 
 
 
 
 
3.0%
 
55,360

 
55,876

 
54,349