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ITEM 2.
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MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
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The following discussion should be read in conjunction with our unaudited financial statements and the accompanying notes included in Part 1, Item 1. “Financial Statements” in this Quarterly Report on Form 10-Q and our audited financial statements and the accompanying notes included in Part II, Item 8 in our Annual Report on Form 10-K for the year ended December 31, 2017. References herein to “Dynex,” the “Company,” “we,” “us,” and “our” include Dynex Capital, Inc. and its consolidated subsidiaries, unless the context otherwise requires. In addition to current and historical information, the following discussion and analysis contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These statements relate to our future business, financial condition or results of operations. For a description of certain factors that may have a significant impact on our future business, financial condition or results of operations, see “Forward-Looking Statements” at the end of this discussion and analysis.
For more information about our business including our operating policies, investment philosophy and strategy, financing and hedging strategies, and other important information, please refer to Part I, Item 1 of our Annual Report on Form 10-K for the year ended December 31, 2017.
EXECUTIVE OVERVIEW
Company Overview
We are an internally managed mortgage real estate investment trust, or mortgage REIT, which primarily invests in residential and commercial mortgage-backed securities (“MBS”). We finance our investments principally with borrowings under repurchase agreements. Our common stock is traded on the New York Stock Exchange (“NYSE”) under the symbol “DX”. Our objective is to provide attractive risk-adjusted returns to our shareholders over the long term that are reflective of a leveraged, high quality fixed income portfolio with a focus on capital preservation. We seek to provide returns to our shareholders primarily through regular quarterly dividends and also through capital appreciation.
We also have two series of preferred stock outstanding, our 8.50% Series A Cumulative Redeemable Preferred Stock (the "Series A Preferred Stock") which is traded on the NYSE under the symbol "DXPRA", and our 7.625% Series B Cumulative Redeemable Preferred Stock (the "Series B Preferred Stock") which is traded on the NYSE under the symbol "DXPRB".
We invest in Agency and non-Agency MBS consisting of residential MBS (“RMBS”), commercial MBS (“CMBS”) and CMBS interest-only ("IO") securities. Agency MBS have a guaranty of principal payment by an agency of the U.S. government or a U.S. government-sponsored entity ("GSE") such as Fannie Mae and Freddie Mac. Non-Agency MBS have no such guaranty of payment. Our investments in non-Agency MBS are generally higher quality senior or mezzanine classes (typically rated 'A' or better by one or more of the nationally recognized statistical rating organizations) because they are typically more liquid (i.e., they are more easily converted into cash either through sales or pledges as collateral for repurchase agreement borrowings) and have less exposure to credit losses than lower-rated non-Agency MBS. We may also invest in debt securities issued by the United States Department of the Treasury (“the Treasury” and such securities, “U.S. Treasuries”).
RMBS.
The majority of our RMBS are Agency issued securities collateralized primarily by fixed-rate single family mortgage loans. The remainder of our RMBS portfolio is collateralized by adjustable-rate mortgage loans (“ARMs”), which have interest rates that generally adjust at least annually to an increment over a specified interest rate index, and hybrid ARMs, which are loans that have a fixed rate of interest for a specified period (typically three to ten years) and then adjust their interest rate at least annually to an increment over a specified interest rate index (primarily one-year LIBOR).
We also purchase to-be-announced securities (“TBAs” or “TBA securities”) as a means of investing in and financing non-specified fixed-rate Agency RMBS. A TBA security is a forward contract (“TBA contract”) for the purchase (“long position”) or sale (“short position”) of a fixed-rate Agency MBS at a predetermined price with certain principal and interest terms and certain types of collateral, but the particular Agency securities to be delivered are not identified until shortly before the settlement date. Our purchases of TBAs are financed
by executing a series of transactions which effectively delay the settlement of a forward purchase of a non-specified Agency RMBS by entering into an offsetting TBA short position, net settling the paired-off positions in cash, and simultaneously entering into an identical TBA long position with a later settlement date
. We refer to these net long
positions in TBAs as “dollar roll positions” and view them as economically equivalent to investing in and financing Agency RMBS using short-term repurchase agreements. TBAs purchased for a forward settlement month are generally priced at a discount relative to TBAs sold for settlement in the current month. This discount, often referred to as “drop income”,
represents the economic equivalent of net interest income (interest income less implied financing cost) on the underlying Agency security from trade date to settlement date.
We may also enter into short positions in TBAs as economic hedges. We account for all TBAs (whether dollar roll positions or economic hedges) as derivative instruments because we cannot assert that it is probable at inception and throughout the term of an individual TBA transaction that its settlement will result in physical delivery of the underlying Agency RMBS, or the individual TBA transaction will not settle in the shortest period possible.
CMBS.
The majority of our CMBS investments are fixed-rate Agency-issued securities backed by multifamily housing loans. The remainder of our CMBS portfolio contains non-Agency issued securities backed by multifamily housing as well as other commercial real estate property types such as office building, retail, hospitality, and health care. Loans underlying CMBS are generally fixed-rate, mature in eight to eighteen years, have amortization terms of up to 30 years, and are geographically dispersed. These loans typically have some form of prepayment protection provisions (such as prepayment lock-out) or prepayment compensation provisions (such as yield maintenance or prepayment penalty). Yield maintenance and prepayment penalty requirements are intended to create an economic disincentive for the loans to prepay.
CMBS IO
. CMBS IO are interest-only securities issued as part of a CMBS securitization and represent the right to receive a portion of the monthly interest payments (but not principal cash flows) on the unpaid principal balance of the underlying pool of commercial mortgage loans. We invest in both Agency-issued and non-Agency issued CMBS IO. The loans collateralizing CMBS IO pools are very similar in composition to the pools of loans that collateralize CMBS as discussed above. Since CMBS IO securities have no principal associated with them, the interest payments received are based on the unpaid principal balance of the underlying pool of mortgage loans, which is often referred to as the notional amount. Most loans in these securities have some form of prepayment protection from early repayment including absolute loan prepayment lock-outs, loan prepayment penalties, or yield maintenance requirements similar to CMBS described above. There are no prepayment protections, however, if the loan defaults and is partially or wholly repaid earlier because of loss mitigation actions taken by the underlying loan servicer, and therefore yields on CMBS IO investments are dependent upon the underlying loan performance. Because Agency-issued MBS generally contain higher credit quality loans, Agency CMBS IO are expected to have a lower risk of default than non-Agency CMBS IO. Our CMBS IO investments are investment grade-rated with the majority rated ‘AAA’ by at least one of the nationally recognized statistical rating organizations.
Financing.
We use leverage to enhance the returns on our invested capital by pledging our investments as collateral for borrowings primarily through the use of uncommitted repurchase agreements with major financial institutions and broker-dealers. These repurchase agreements generally have original terms to maturity of overnight to six months, though in some instances we may enter into longer-dated maturities depending on market conditions. We pay interest on our repurchase agreement borrowings at a rate usually based on a spread to a short-term interest rate such as LIBOR and fixed for the term of the borrowing. Borrowings under these repurchase agreements are renewable at the discretion of our lenders and do not contain guaranteed roll-over terms. One of our repurchase agreement lenders provides a committed repurchase agreement financing facility to us with an aggregate borrowing capacity of $400.0 million that expires in May 2019.
Hedging.
We use derivatives, primarily interest rate swaps, to hedge our exposure to changes in interest rates. Such exposure results from our ownership of investments which are primarily fixed-rate and financed with repurchase agreements which have adjustable rates and significantly shorter maturities than the weighted average life of our investments. Changes in interest rates can impact the market value of our investments and our net interest income, thereby ultimately impacting book value per common share. We frequently adjust our hedging portfolio based on our expectation of future interest rates, including the absolute level of rates and the slope of the yield curve versus market expectations.
Factors that Affect Our Financial Condition and Results of Operations
In assessing our financial performance, management primarily focuses on net interest income, net interest spread, net income, comprehensive income, book value per common share, and core net operating income to common shareholders (a non-GAAP measure) as measures of our financial performance. Our financial performance may be impacted by a number of factors, many of which are related to or influenced by macroeconomic conditions, market volatility, geopolitical conditions, U.S. Federal Reserve policy, U.S. fiscal and regulatory policy, and foreign central bank and government policy. Other factors that may impact
our financial performance include, but are not limited to, the absolute level of interest rates, the relative slope of interest rate curves, changes in interest rates and market expectations of future interest rates, actual and estimated future prepayment rates on our investments, supply of investments, competition for investments, economic conditions and their impact on the credit performance of our investments, and market required yields as reflected by market spreads. These factors are influenced by market forces beyond our control.
Our business model may also be impacted by the availability and cost of financing and the state of the overall credit markets. Reductions or limitations in the availability of financing for our investments could significantly impact our business or force us to sell assets, potentially at losses. Repurchase agreement lending markets have been stable for the last several years, but lending by larger U.S. domiciled banks has declined in recent years due to increased regulation and changes to regulatory capital requirements. Their repurchase market participation has been replaced by smaller independent broker dealers that are generally less regulated and by U.S. domiciled broker dealer subsidiaries of foreign financial institutions. It is uncertain how these relatively new participants will react during periods of market stress. Other factors that could also impact our business include changes in regulatory requirements, including requirements to qualify for registration under the 1940 Act, and REIT requirements.
We believe that regulatory impacts on financial institutions, many of which are our trading and financing counterparties, pose a potential threat to the overall liquidity in the capital markets. In 2017, the Federal Reserve began curtailing its reinvestment of principal payments received on its Agency RMBS portfolio. Prices in Agency RMBS generally have not been significantly impacted by the reduction, however prices may be more significantly impacted as the amount of curtailment increases each successive quarter. Market liquidity of our investments and the financing markets could be negatively impacted if the Federal Reserve's Federal Open Market Committee (or "FOMC") suddenly changes market expectations of the target Federal Funds Rate or takes other actions which have the effect of tightening monetary policy that are not anticipated by the market. And finally, there remains uncertainty as to the ultimate impact or outcome of certain regulations under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"), and restrictions on market-making activities of large U.S. financial institutions could result in reduced liquidity in times of market stress.
As discussed above, investing in mortgage-related securities (including on a leveraged basis) subjects us to many risks including interest rate risk, prepayment and reinvestment risk, credit risk, spread risk, and liquidity risk which are discussed in "Liquidity and Capital Resources" within this Item 2 and in Part I, Item 3, “Quantitative and Qualitative Disclosures About Market Risk” of this Quarterly Report on Form 10-Q as well as in Item 1A, "Risk Factors" of Part I of our Annual Report on Form 10-K for the year ended December 31, 2017. Please see these Items for a detailed discussion of these risks and the potential impact on our results of operations and financial condition.
Market Conditions and Recent Activity
Interest rates rose during the third quarter of 2018 approximately 25 basis points across the curve and modestly flattened. The difference in the 2-year U.S. Treasury and the 10-year U.S. Treasury stood at 24 basis points September 30, 2018 versus 33 basis points at June 30, 2018 and 52 basis points at December 31, 2017. A flattening yield curve puts pressure on the net interest spread we earn on our investments, reflecting the generally higher borrowing costs as interest rates rise. As of October 31, 2018, markets are pricing in three more increases in the Federal Funds target rate through 2019.
As we have noted in the past, we anticipate that economic data globally and in the U.S. will continue to be stable for the near term. Underlying fundamentals support continued economic growth, particularly in the U.S. However, interest rates have moved up significantly since the Federal Reserve began to raise the Federal Funds Rate in December 2015, and we believe potential negative side effects are already developing in the global economy and global capital markets. We continue to remain cautious given the fragile global economic environment which is dependent on ever increasing levels of debt and is exposed to a high potential for fiscal or monetary policy mistakes. Due to these and other macroeconomic challenges facing the U.S. and global markets today, we believe that interest rates cannot move above the current range of the 10-year U.S. Treasury for any meaningful amount of time without negative consequences to the economy.
Overall credit market volatility continued to be muted during the third quarter of 2018 and credit-sensitive assets remain near their highest prices. Spread widening that occurred in the second quarter of 2018 largely reversed itself in the third quarter of 2018.
The chart below shows the highest and lowest rates during the three months ended
September 30, 2018
as well as the rates as of
September 30, 2018
and
June 30, 2018
for the indicated U.S. Treasury securities:
The chart below shows the highest and lowest swap rates during the
three months ended
September 30, 2018
as well as the swap rates as of
September 30, 2018
and
June 30, 2018
:
Highlights of the Third Quarter of 2018
Comprehensive
income
to common shareholders was
$0.7 million
for the
third
quarter of 2018 versus $3.0 million for the
second
quarter of 2018. Higher interest rates principally drove the decline in comprehensive income as unrealized losses on MBS increased while gains on related hedges decreased. Net income to common shareholders increased
$9.9 million
to
$22.6 million
for the
third
quarter compared to
$12.7 million
for the
second
quarter of 2018 due primarily to lower loss on sales of investments. Net interest income increased $0.4 million from the second quarter of 2018 to the third quarter of 2018 due to improved effective yields on investments as a result of recent purchases of higher yielding fixed rate MBS and increased prepayment penalty compensation earned on CMBS IO.
Net interest spread was relatively flat, increasing 1 basis point to 1.08% for the
third
quarter of 2018 compared to 1.07% for the prior quarter. Though we had a larger average balance of higher yielding fixed-rate Agency RMBS and higher prepayment compensation on CMBS IO for the third quarter of 2018 compared to the prior quarter, those benefits were almost entirely offset by higher cost of repurchase agreement financing as a result of increasing short-term interest rates. As shown in the table below, there has been a downward trend in net interest spread for the majority of our investments as a result of increasing short-term borrowing rates:
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Agency MBS
(1)
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CMBS IO
(2)
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Non-Agency Other
(3)
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Quarter Ended
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Yield
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Cost
(4)
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Net Yield
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Yield
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Cost
(4)
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Net Yield
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Yield
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Cost
(4)
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Net Yield
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September 30, 2018
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3.12
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%
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2.13
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%
|
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0.99
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%
|
|
3.98
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%
|
|
2.76
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%
|
|
1.22
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%
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30.31
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%
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—
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%
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30.31
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%
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June 30, 2018
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2.94
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%
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|
1.93
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%
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1.01
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%
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3.78
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%
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2.59
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%
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1.19
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%
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30.67
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%
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—
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%
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30.67
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%
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March 31, 2018
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2.85
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%
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1.60
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%
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1.25
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%
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3.84
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%
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2.33
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%
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1.51
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%
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11.37
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%
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|
2.47
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%
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8.90
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%
|
December 31, 2017
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2.77
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%
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|
1.36
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%
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|
1.41
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%
|
|
3.82
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%
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2.13
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%
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|
1.69
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%
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|
10.21
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%
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|
2.24
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%
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7.97
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%
|
September 30, 2017
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|
2.51
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%
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|
1.27
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%
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|
1.24
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%
|
|
3.89
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%
|
|
2.10
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%
|
|
1.79
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%
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|
9.21
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%
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|
2.24
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%
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|
6.97
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%
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(1)
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Includes Agency RMBS and CMBS.
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(2)
Includes Agency and non-Agency issued securities.
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(3)
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Includes privately-issued RMBS and CMBS.
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(4)
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Excludes net periodic interest benefit/cost of interest rate swaps used to economically hedge the interest rate risk of using repurchase agreement borrowings to finance our investments.
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Core net operating income to common shareholders, a non-GAAP measure, increased to
$10.8 million
for the third quarter of 2018 from $10.4 million for the second quarter of 2018 due substantially to an increase in adjusted net interest income of
$0.5 million
. Adjusted net interest income, a non-GAAP measure, increased for the third quarter of 2018 compared to the prior quarter from the improved effective yields noted above, and also from a higher average volume of TBA dollar roll transactions that generated an increase in TBA drop income, partially offset by a lower benefit from net periodic interest on interest rate swaps for the third quarter of 2018 compared to the prior quarter.
Adjusted net interest spread for the
third
quarter of 2018 decreased 10 basis points compared to the second quarter of 2018 primarily because the Company's net receive rate on its interest rate swaps declined 9 basis points, resulting in a lower net periodic interest benefit. In addition, although TBA drop income was $0.6 million higher during the third quarter of 2018 compared to the second quarter of 2018 as a result of a larger volume of TBA dollar roll transactions, the implied financing rate on these transactions increased approximately 37 basis points from the second quarter of 2018 to the third quarter of 2018. As a result, the net yield from TBA dollar roll transactions declined 32 basis points to 1.61% for the third quarter of 2018 compared to 1.93% for the prior quarter. Please refer to “Non-GAAP Financial Measures” at the end of this section for additional important information.
Total economic return for the third quarter of 2018 was 0% as dividends declared of $0.18 were offset by the decline in book value of $(0.18) to $6.75 as of September 30, 2018 from $6.93 as of June 30, 2018. Year-to-date we have incurred a total economic loss on book value per common share of
(0.7)%
. Total economic return consists of the sum of dividends declared and change in book value per common share for the respective period.
Management Outlook
In prior quarters, we described the investing environment as being driven by global central bank policy. In the U.S, the Federal Reserve has been tightening monetary policy by increasing the targeted U.S. Federal Funds rate and removing quantitative easing (asset purchasing) support. Markets are currently pricing in approximately three more increases in the Fed Funds target rate through 2019. We believe the Federal Reserve will be data dependent, and the future path of short-term rates is largely tied to global economic outcomes. Given the pressures that are building globally as a result of already higher interest rates in the U.S., we believe the Federal Reserve is nearing the end of increasing the targeted Federal Funds rate. As tightening cycles end, typically the yield curve steepens, increasing returns on capital in marginal investment opportunities. Such a steepening may take a number of quarters to evolve, but even if the yield curve remains relatively flat, we anticipate that Agency RMBS spreads will provide leveraged returns on investment capital in the low teens, as they were at September 30, 2018. Part of the return opportunity in Agency RMBS stems from market concerns over the risk that the Federal Reserve accelerates its balance sheet reduction of these securities. We believe this risk is very low and view Agency RMBS as an attractive investment opportunity relative to other asset classes. We are also concerned about excess U.S. Treasury supply as that could cause interest rates to move higher; however, this would create an investment opportunity for us as we expect to see MBS reprice to a more appropriate risk/reward balance. Our goal is to manage through the transition to higher returns, seeking to preserve capital while providing shareholders with an adequate return in the interim.
Given the fragile economic environment as noted above, in the near term we may rapidly change our outlook for Federal Reserve policy, interest rates and/or credit spreads which could necessitate changes to our investment strategy, duration, overall risk profile, leverage target, or hedging strategy.
Non-GAAP Financial Measures
In addition to the Company's operating results presented in accordance with GAAP, the information presented within Item 2, "Management's Discussion and Analysis of Financial Condition and Results of Operations" of this Quarterly Report on Form 10-Q contains the following non-GAAP financial measures: core net operating income to common shareholders (including per common share), adjusted interest expense, adjusted net interest income, and the related metrics adjusted cost of funds and adjusted net interest spread. Because these measures are used in the Company's internal analysis of financial and operating performance, management believes that they provide greater transparency to our investors of management's view of our economic performance. Management also believes the presentation of these measures, when analyzed in conjunction with the Company's GAAP operating results, allows investors to more effectively evaluate and compare the performance of the Company to that of its peers, although the Company's presentation of its non-GAAP measures may not be comparable to other similarly-titled measures of other companies. Reconciliations of core net operating income to common shareholders, adjusted interest expense, and adjusted net interest income to the related GAAP financial measures are provided below and within “Results of Operations”.
Management views core net operating income to common shareholders as an estimate of the Company’s financial performance excluding changes in fair value of its investments and derivatives. In addition to the non-GAAP reconciliation set forth below, which derives core net operating income to common shareholders from GAAP net income to common shareholders as the nearest GAAP equivalent measure, core net operating income to common shareholders can also be determined by adjusting net interest income to include interest rate swap net periodic interest benefit/cost, drop income on TBA dollar roll positions, other operating income (expense), general and administrative expenses, and preferred dividends. Management includes drop income, which is included in "gain (loss) on derivatives instruments, net" on the Company's consolidated statements of comprehensive income, in core net operating income and in adjusted net interest income because TBA dollar roll positions are viewed by management as economically equivalent to holding and financing Agency RMBS using short-term repurchase agreements. Management also includes net periodic interest benefit/cost from its interest rate swaps, which are included in "gain (loss) on derivatives instruments, net", in adjusted net interest expense and in adjusted net interest income because interest rate swaps are used by the Company to economically hedge the impact of changing interest rates on its borrowing costs from repurchase agreements, and including net periodic interest benefit/cost from interest rate swaps is a helpful indicator of the Company’s total cost of financing in addition to GAAP interest expense. However, these non-GAAP measures do not provide a full perspective on our results of operations, and therefore, their usefulness is limited. For example, these non-GAAP measures do not include gains or losses from available-for-sale investments, changes in fair value of and costs of terminating interest rate swaps, as well as realized and unrealized gains or losses from any instrument used by management to economically hedge the
impact of changing interest rates on its portfolio and book value per common share, such as Eurodollar futures.
As a result, these non-GAAP measures should be considered as a supplement to, and not as a substitute for, the Company's GAAP results as reported on its consolidated statements of comprehensive income.
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|
|
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Three Months Ended
|
($ in thousands, except per share amounts)
|
September 30, 2018
|
|
June 30, 2018
|
GAAP net income to common shareholders
|
$
|
22,630
|
|
|
$
|
12,710
|
|
Less:
|
|
|
|
Change in fair value of derivative instruments, net
(1)
|
(13,460
|
)
|
|
(14,715
|
)
|
Loss on sale of investments, net
|
1,726
|
|
|
12,444
|
|
De-designated cash flow hedge accretion
(2)
|
(66
|
)
|
|
(48
|
)
|
Fair value adjustments, net
|
(12
|
)
|
|
(27
|
)
|
Core net operating income to common shareholders
|
$
|
10,818
|
|
|
$
|
10,364
|
|
|
|
|
|
Weighted average common shares outstanding
|
57,727
|
|
|
56,295
|
|
Core net operating income per common share
|
$
|
0.19
|
|
|
$
|
0.18
|
|
|
|
(1)
|
Amount represents net realized and unrealized gains and losses on derivatives and excludes net periodic interest benefits related to these instruments.
|
|
|
(2)
|
Amount recorded as a portion of "interest expense" in accordance with GAAP related to the accretion of the balance remaining in accumulated other comprehensive loss as a result of the Company's discontinuation of cash flow hedge accounting effective June 30, 2013.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
September 30, 2018
|
|
June 30, 2018
|
($ in thousands)
|
Amount
|
|
Rate
|
|
Amount
|
|
Rate
|
GAAP interest expense/cost of funds
|
$
|
14,751
|
|
|
2.25
|
%
|
|
$
|
14,175
|
|
|
2.06
|
%
|
Add: net periodic interest benefit
(1)
|
(1,777
|
)
|
|
(0.28
|
)%
|
|
(2,333
|
)
|
|
(0.35
|
)%
|
Less: de-designated cash flow hedge accretion
(2)
|
66
|
|
|
0.01
|
%
|
|
48
|
|
|
0.01
|
%
|
Adjusted interest expense/adjusted cost of funds
|
$
|
13,040
|
|
|
1.98
|
%
|
|
$
|
11,890
|
|
|
1.72
|
%
|
|
|
(1)
|
Amount represents net periodic interest benefit of effective interest rate swaps outstanding during the period and excludes realized and unrealized gains and losses from changes in fair value of derivatives.
|
|
|
(2)
|
Amount recorded as a portion of "interest expense" in accordance with GAAP related to the accretion of the balance remaining in accumulated other comprehensive loss as a result of the Company's discontinuation of cash flow hedge accounting effective June 30, 2013.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
September 30, 2018
|
|
June 30, 2018
|
($ in thousands)
|
Amount
|
|
Rate
|
|
Amount
|
|
Rate
|
Net interest income
|
$
|
12,174
|
|
|
1.08
|
%
|
|
$
|
11,747
|
|
|
1.07
|
%
|
Add: TBA drop income
|
4,262
|
|
|
0.06
|
%
|
|
3,619
|
|
|
0.10
|
%
|
Add: net periodic interest benefit
(1)
|
1,777
|
|
|
0.28
|
%
|
|
2,333
|
|
|
0.35
|
%
|
Less: de-designated cash flow hedge accretion
(2)
|
(66
|
)
|
|
(0.01
|
)%
|
|
(48
|
)
|
|
(0.01
|
)%
|
Adjusted net interest income
|
$
|
18,147
|
|
|
1.41
|
%
|
|
$
|
17,651
|
|
|
1.51
|
%
|
|
|
(1)
|
Amount represents net periodic interest benefit of effective interest rate swaps outstanding during the period and excludes realized and unrealized gains and losses from changes in fair value of derivatives.
|
|
|
(2)
|
Amount recorded as a portion of "interest expense" in accordance with GAAP related to the accretion of the balance remaining in accumulated other comprehensive loss as a result of the Company's discontinuation of cash flow hedge accounting effective June 30, 2013.
|
CRITICAL ACCOUNTING POLICIES
The discussion and analysis of our financial condition and results of operations are based in large part upon our consolidated financial statements, which have been prepared in accordance with GAAP. The preparation of our consolidated financial statements requires management to make estimates, judgments and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses and disclosure of contingent assets and liabilities. We base these estimates and judgments on historical experience and assumptions believed to be reasonable under current facts and circumstances. Actual results, however, may differ from the estimated amounts we have recorded.
Critical accounting policies are defined as those that require management's most difficult, subjective or complex judgments, and which may result in materially different results under different assumptions and conditions. Our critical accounting policies are discussed in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our Annual Report on Form 10-K for the year ended December 31, 2017 under “Critical Accounting Policies”. There have been no significant changes in our critical accounting policies during the three and six months ended
September 30, 2018
.
FINANCIAL CONDITION
Our investment portfolio is comprised mostly of fixed-rate investments. As of
September 30, 2018
, approximately
62%
of our investments are 30-year Agency RMBS including TBA dollar roll positions, which we continue to invest in given their more favorable risk-return profile and current liquidity in the market versus other types of MBS. Approximately
23%
of our investments are Agency CMBS, mainly in the multifamily sector. Relative to RMBS, CMBS have more predictable prepayment profiles and are therefore less costly to hedge.
The following table provides a summary of the amortized cost and fair value of our investment portfolio including TBA dollar roll positions used for investment purposes as of the dates indicated:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
September 30, 2018
|
|
December 31, 2017
|
($ in thousands)
|
Amortized Cost
|
|
Fair Value
|
|
Amortized Cost
|
|
Fair Value
|
Agency RMBS, fixed-rate
|
$
|
1,780,027
|
|
|
$
|
1,738,084
|
|
|
$
|
903,270
|
|
|
$
|
898,678
|
|
TBAs, fixed-rate
(1)
|
780,865
|
|
|
779,697
|
|
|
829,425
|
|
|
830,908
|
|
Agency RMBS, adjustable rate
|
36,339
|
|
|
37,068
|
|
|
289,304
|
|
|
285,583
|
|
Agency CMBS, fixed-rate
|
997,058
|
|
|
948,296
|
|
|
1,134,409
|
|
|
1,124,351
|
|
CMBS IO
(2)
|
562,327
|
|
|
564,826
|
|
|
683,833
|
|
|
692,522
|
|
Non-Agency other
(3)
|
4,833
|
|
|
6,236
|
|
|
23,536
|
|
|
25,855
|
|
U.S. Treasuries
|
—
|
|
|
—
|
|
|
148,267
|
|
|
146,530
|
|
Mortgage loans held for investment, net
(4)
|
12,342
|
|
|
9,165
|
|
|
15,738
|
|
|
12,973
|
|
Total investment portfolio including TBA dollar roll positions
|
$
|
4,173,791
|
|
|
$
|
4,083,372
|
|
|
$
|
4,027,782
|
|
|
$
|
4,017,400
|
|
|
|
(1)
|
Consists of long positions in TBAs used for investment purposes at their implied cost basis and implied market value, respectively, as if settled and excludes short positions in TBAs used for economic hedging purposes. All TBAs are accounted for as “derivative assets (liabilities)” on our consolidated balance sheet.
|
|
|
(2)
|
Includes Agency and non-Agency issued securities.
|
|
|
(3)
|
Includes non-Agency CMBS and RMBS.
|
|
|
(4)
|
Recorded on consolidated balance sheet at amortized cost.
|
The following table details the activity related to our MBS portfolio including TBA dollar roll positions during the
nine months ended
September 30, 2018
:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Agency RMBS
|
|
Agency CMBS
|
|
CMBS IO
(3)
|
|
Non-Agency Other
(4)
|
|
Total
|
($ in thousands)
|
30-Year Fixed
Rate
(1) (2)
|
|
Adjustable Rate
|
|
|
|
|
Balance as of December 31, 2017
|
$
|
1,729,586
|
|
|
$
|
285,583
|
|
|
$
|
1,124,351
|
|
|
$
|
692,522
|
|
|
$
|
25,855
|
|
|
$
|
3,857,897
|
|
Purchases
|
896,265
|
|
|
—
|
|
|
51,862
|
|
|
2,814
|
|
|
—
|
|
|
950,941
|
|
Principal payments
|
(64,712
|
)
|
|
(26,213
|
)
|
|
(26,680
|
)
|
|
—
|
|
|
(19,635
|
)
|
|
(137,240
|
)
|
Sales
|
—
|
|
|
(225,622
|
)
|
|
(160,767
|
)
|
|
(19,087
|
)
|
|
—
|
|
|
(405,476
|
)
|
(Amortization) accretion
|
(3,356
|
)
|
|
(1,130
|
)
|
|
(1,766
|
)
|
|
(105,233
|
)
|
|
932
|
|
|
(110,553
|
)
|
Change in fair value
|
(40,002
|
)
|
|
4,450
|
|
|
(38,704
|
)
|
|
(6,190
|
)
|
|
(916
|
)
|
|
(81,362
|
)
|
Balance as of September 30, 2018
|
$
|
2,517,781
|
|
|
$
|
37,068
|
|
|
$
|
948,296
|
|
|
$
|
564,826
|
|
|
$
|
6,236
|
|
|
$
|
4,074,207
|
|
|
|
(1)
|
Includes securities pending settlement as of dates indicated.
|
|
|
(2)
|
Includes long positions in TBAs used for investment purposes at their implied market value as if settled and excludes short positions in TBAs used for economic hedging purposes. All TBAs are accounted for as “derivative assets (liabilities)” on our consolidated balance sheet.
|
|
|
(3)
|
Includes Agency and non-Agency issued securities.
|
|
|
(4)
|
Includes non-Agency CMBS and RMBS.
|
RMBS
The following table provides information on our Agency RMBS investments including securities pending settlement and TBA dollar roll positions as of the dates indicated:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
September 30, 2018
|
|
|
|
|
|
|
|
|
Weighted Average Based on Par
|
Coupon
|
|
Par
|
|
Amortized Cost/
Implied Cost
Basis
(1)(3)
|
|
Fair
Value
(2)(3)
|
|
Average Original Loan
Balance
(4)
|
|
Loan Age
(in months)
(4)
|
|
3 Month
CPR
(4)(5)
|
|
Duration
(6)
|
|
|
($ in thousands)
|
|
|
|
|
|
|
30-year fixed-rate:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
3.0%
|
|
$
|
228,116
|
|
|
$
|
229,734
|
|
|
$
|
218,671
|
|
|
$
|
234,112
|
|
|
23
|
|
|
8.3
|
%
|
|
6.32
|
|
4.0%
|
|
1,339,668
|
|
|
1,386,905
|
|
|
1,356,169
|
|
|
264,330
|
|
|
9
|
|
|
4.5
|
%
|
|
4.81
|
|
4.5%
|
|
158,111
|
|
|
163,388
|
|
|
163,244
|
|
|
309,714
|
|
|
2
|
|
|
2.5
|
%
|
|
3.21
|
|
TBA 4.0%
|
|
211,000
|
|
|
214,365
|
|
|
213,060
|
|
|
n/a
|
|
|
n/a
|
|
|
n/a
|
|
|
4.50
|
|
TBA 4.5%
|
|
550,000
|
|
|
566,500
|
|
|
566,637
|
|
|
n/a
|
|
|
n/a
|
|
|
n/a
|
|
|
4.25
|
|
Total 30-year fixed-rate
|
|
$
|
2,486,895
|
|
|
$
|
2,560,892
|
|
|
$
|
2,517,781
|
|
|
$
|
264,494
|
|
|
10
|
|
|
4.8
|
%
|
|
4.70
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Adjustable-rate:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
4.1%
(7)
|
|
$
|
35,379
|
|
|
$
|
36,339
|
|
|
$
|
37,068
|
|
|
$
|
208,515
|
|
|
128
|
|
|
18.1
|
%
|
|
0.52
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total Agency RMBS (including TBA dollar roll positions)
|
|
$
|
2,522,274
|
|
|
$
|
2,597,231
|
|
|
$
|
2,554,849
|
|
|
$
|
263,369
|
|
|
12
|
|
|
5.0
|
%
|
|
4.64
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
December 31, 2017
|
|
|
|
|
|
|
|
|
Weighted Average Based on Par
|
Coupon
|
|
Par
|
|
Amortized Cost/
Implied Cost Basis
(1)(3)
|
|
Fair
Value
(2)(3)
|
|
Average Original Loan
Balance
(4)
|
|
Loan Age
(in months)
(4)
|
|
3 Month
CPR
(4)(5)
|
|
Duration
(6)
|
|
|
($ in thousands)
|
|
|
|
|
|
|
30-year fixed-rate:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
3.0%
|
|
$
|
244,374
|
|
|
$
|
246,155
|
|
|
$
|
244,818
|
|
|
$
|
233,584
|
|
|
13
|
|
|
5.0
|
%
|
|
6.30
|
|
4.0%
|
|
623,293
|
|
|
657,114
|
|
|
653,860
|
|
|
274,965
|
|
|
4
|
|
|
4.0
|
%
|
|
3.91
|
|
TBA 4.0%
|
|
795,000
|
|
|
829,425
|
|
|
830,908
|
|
|
n/a
|
|
|
n/a
|
|
|
n/a
|
|
|
2.95
|
|
Total 30-year fixed-rate
|
|
$
|
1,662,667
|
|
|
$
|
1,732,694
|
|
|
$
|
1,729,586
|
|
|
$
|
263,310
|
|
|
6
|
|
|
4.3
|
%
|
|
3.80
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Adjustable-rate:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
3.1%
(7)
|
|
$
|
278,886
|
|
|
$
|
289,305
|
|
|
$
|
285,583
|
|
|
$
|
271,516
|
|
|
74
|
|
|
16.0
|
%
|
|
2.28
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total Agency RMBS (including TBA dollar roll positions)
|
|
$
|
1,941,553
|
|
|
$
|
2,021,999
|
|
|
$
|
2,015,169
|
|
|
$
|
265,306
|
|
|
23
|
|
|
7.1
|
%
|
|
3.58
|
|
|
|
(1)
|
Implied cost basis of TBA dollar roll positions represents the forward price to be paid for the underlying Agency MBS as if settled.
|
|
|
(2)
|
Fair value of TBA dollar roll positions is the implied market value of the underlying Agency security as of the end of the period if settled.
|
|
|
(3)
|
The net carrying value of TBA dollar roll positions, which is the difference between their implied market value and implied cost basis, was
$(1.2) million
as of
September 30, 2018
and
$1.5 million
as of
December 31, 2017
and is included on the consolidated balance sheet within “derivative assets”.
|
|
|
(4)
|
TBA dollar roll positions are excluded from this calculation as they do not have a defined weighted-average loan balance or age until mortgages have been assigned to the pool.
|
|
|
(5)
|
Constant prepayment rate (“CPR”) represents the 3-month CPR of Agency RMBS held as of date indicated. Securities with no prepayment history are excluded from this calculation.
|
|
|
(6)
|
Duration measures the sensitivity of a security's price to the change in interest rates and represents the percent change in price of a security for a 100 basis point increase in interest rates. We calculate duration using third-party financial models and empirical data. Different models and methodologies can produce different estimates of duration for the same securities.
|
|
|
(7)
|
Coupon of adjustable-rate Agency RMBS represents the weighted average coupon based on amortized cost.
|
CMBS
Because Agency CMBS are guaranteed by the GSEs with respect to return of principal, our credit exposure is limited to any unamortized premium remaining on those securities. Because non-Agency CMBS are not guaranteed, our entire investment is exposed to credit losses from the underlying loans collateralizing the CMBS. The amortized cost of our non-Agency CMBS as of
September 30, 2018
declined to
$3.9 million
compared to
$22.5 million
as of December 31, 2017 due to significant prepayment activity during the first quarter of 2018. The non-Agency CMBS remaining as of
September 30, 2018
are comprised of securities collateralized by loans we originated prior to 2000.
The following table presents the par value, amortized cost, and weighted average months to estimated maturity of our CMBS investments as of the dates indicated by year of origination:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
September 30, 2018
|
|
December 31, 2017
|
($ in thousands)
|
Par Value
|
|
Amortized Cost
|
|
Months to Estimated Maturity
(1)
|
|
Par Value
|
|
Amortized Cost
|
|
Months to Estimated Maturity
(1)
|
Year of Origination:
|
|
|
|
|
|
|
|
|
|
|
|
2008 and prior
|
$
|
25,865
|
|
|
$
|
23,418
|
|
|
34
|
|
$
|
34,065
|
|
|
$
|
31,026
|
|
|
41
|
2009 to 2012
|
81,762
|
|
|
83,637
|
|
|
24
|
|
106,619
|
|
|
109,234
|
|
|
27
|
2013 to 2014
|
13,578
|
|
|
13,865
|
|
|
76
|
|
20,237
|
|
|
20,600
|
|
|
82
|
2015
|
301,746
|
|
|
303,877
|
|
|
101
|
|
468,296
|
|
|
469,657
|
|
|
103
|
2016
|
238,716
|
|
|
240,246
|
|
|
101
|
|
239,139
|
|
|
240,831
|
|
|
110
|
2017
|
280,945
|
|
|
284,078
|
|
|
109
|
|
282,112
|
|
|
285,527
|
|
|
118
|
2018
|
51,681
|
|
|
51,861
|
|
|
143
|
|
—
|
|
|
—
|
|
|
—
|
|
|
$
|
994,293
|
|
|
$
|
1,000,982
|
|
|
97
|
|
$
|
1,150,468
|
|
|
$
|
1,156,875
|
|
|
99
|
|
|
(1)
|
Months to estimated maturity is an average weighted by the amortized cost of the investment.
|
CMBS IO
As of
September 30, 2018
, our CMBS IO investments comprised approximately
14%
of our total portfolio, of which approximately 55% are Agency-issued, relatively unchanged since December 31, 2017. Given supply-demand imbalances in CMBS IO markets, which have lead to less attractive marginal returns, we have not actively purchased these securities in 2018.
Income earned from CMBS IO is based on interest payments received on the underlying commercial mortgage loan pools. Our return on these investments may be negatively impacted by any change in scheduled cash flows such as modifications of the mortgage loans or involuntary prepayments including defaults, foreclosures, and liquidations on or of the underlying mortgage loans prior to its contractual maturity date. In order to manage our exposure to credit performance, we generally invest in senior tranches of these securities and where we have evaluated the credit profile of the underlying loan pool and can monitor credit performance. In addition, to address changes in market fundamentals and the composition of mortgage loans collateralizing an investment, we consider the year of origination of the loans underlying CMBS IO in our selection of investments.
The following table presents our CMBS IO investments as of
September 30, 2018
by year of origination:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
September 30, 2018
|
|
December 31, 2017
|
($ in thousands)
|
Amortized Cost
|
|
Fair Value
|
|
Remaining WAL
(1)
|
|
Amortized Cost
|
|
Fair Value
|
|
Remaining WAL
(1)
|
Year of Origination:
|
|
|
|
|
|
|
|
|
|
|
|
2010
|
$
|
4,217
|
|
|
$
|
4,240
|
|
|
9
|
|
|
$
|
6,421
|
|
|
$
|
6,554
|
|
|
13
|
|
2011
|
18,638
|
|
|
19,322
|
|
|
14
|
|
|
25,652
|
|
|
26,720
|
|
|
18
|
|
2012
|
43,402
|
|
|
43,614
|
|
|
20
|
|
|
71,615
|
|
|
72,913
|
|
|
22
|
|
2013
|
77,948
|
|
|
77,890
|
|
|
24
|
|
|
103,730
|
|
|
104,568
|
|
|
28
|
|
2014
|
143,016
|
|
|
143,639
|
|
|
31
|
|
|
171,285
|
|
|
173,043
|
|
|
34
|
|
2015
|
149,935
|
|
|
151,017
|
|
|
36
|
|
|
170,663
|
|
|
172,974
|
|
|
40
|
|
2016
|
75,116
|
|
|
75,148
|
|
|
43
|
|
|
82,698
|
|
|
83,444
|
|
|
47
|
|
2017
|
47,504
|
|
|
47,455
|
|
|
49
|
|
|
51,769
|
|
|
52,306
|
|
|
53
|
|
2018
|
2,551
|
|
|
2,501
|
|
|
73
|
|
|
—
|
|
|
—
|
|
|
—
|
|
|
$
|
562,327
|
|
|
$
|
564,826
|
|
|
33
|
|
|
$
|
683,833
|
|
|
$
|
692,522
|
|
|
36
|
|
(1) Remaining weighted average life (“WAL”) represents an estimate of the number of months of interest earnings remaining for the investments by year of origination.
There have been no material changes to the characteristics or geographic distribution of collateral underlying our CMBS IO securities since December 31, 2017.
Derivative Assets and Liabilities
We regularly monitor and adjust our hedging portfolio in response to many factors including, but not limited to, changes in our investment portfolio, shifts in the yield curve, and our expectations with respect to the future path of interest rates and interest rate volatility. Please refer to “Quantitative and Qualitative Disclosures about Market Risk” in Part I, Item 3 of this
Quarterly
Report on Form
10-Q
for more information.
Interest rate derivatives.
As of
September 30, 2018
, we used interest rate swaps to hedge a portion of our earnings and book value exposure to fluctuations in interest rates. As of December 31, 2017, we held interest rate swaps as well as Eurodollar futures. The following graphs present the effective notional balance outstanding and weighted average net pay-fixed rate for our interest rate derivatives outstanding as of the periods indicated:
(1) Includes one receive-fixed interest rate swap at a notional amount of $100.0 million with a receive-fixed rate of 1.70% as of December 31, 2017.
During the
nine months ended
September 30, 2018
, we added interest rate swaps with a combined notional balance of
$1.0 billion
at a weighted average net pay-fixed rate of 2.86% in order to increase our protection from rising short-term interest rates. We had interest rate swaps with a notional balance of $2.3 billion and a weighted average pay-fixed rate of 1.29% mature during the nine months ended September 30, 2018. During that same period, we realized a gain of $2.1 million from terminated interest rate swaps with a notional balance of $0.4 billion and realized a gain of $2.6 million for Eurodollar futures with a notional balance of
$2.0 billion
that matured during that same period.
As of
September 30, 2018
, we held options on U.S. Treasury futures with an aggregate notional balance of $200.0 million and a fair value of
$1.0 million
, for which we paid a premium of $1.1 million. We entered the options to enhance returns if interest rates decline while limiting our downside to the premium paid if interest rates increase. During the nine months ended
September 30, 2018
, we realized a gain of $0.8 million from terminated options on U.S. Treasury futures with a notional balance of $300.0 million.
TBAs.
Please refer to “RMBS” above in this section of Part I, Item 2 for additional information about long positions in TBAs, or TBA dollar roll positions, which are used as a means of investing in and financing fixed-rate Agency RMBS. We may also periodically enter into short positions in TBAs to partially hedge the impact of adverse changes in interest rates on the fair value of our fixed-rate Agency RMBS. We did not hold any short positions in TBA securities as of
September 30, 2018
. As of December 31, 2017, we held one TBA short position with a coupon of 3.5% and an implied cost basis (if settled) of $(153.8) million, which is included in our derivative liabilities at that date at its net carrying value of $(0.3) million.
Repurchase Agreements
The majority of our repurchase agreement borrowings are collateralized with Agency MBS which have historically had lower liquidity risk than non-Agency MBS. The following table presents the amount pledged and leverage against the fair value of our non-Agency MBS investments by credit rating as of
September 30, 2018
and
December 31, 2017
:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
September 30, 2018
|
|
December 31, 2017
|
($ in thousands)
|
Fair Value
|
|
Amount Pledged
|
|
Related Borrowings
|
|
Fair Value
|
|
Amount Pledged
|
|
Related Borrowings
|
Non-Agency CMBS:
|
|
|
|
|
|
|
|
|
|
|
|
A
|
—
|
|
|
—
|
|
|
—
|
|
|
$
|
18,212
|
|
|
$
|
18,212
|
|
|
$
|
15,508
|
|
Below A/Not Rated
|
—
|
|
|
—
|
|
|
—
|
|
|
6,552
|
|
|
—
|
|
|
—
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
24,764
|
|
|
$
|
18,212
|
|
|
$
|
15,508
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Non-Agency CMBS IO:
|
|
|
|
|
|
|
|
|
|
|
|
AAA
|
$
|
209,400
|
|
|
$
|
209,395
|
|
|
$
|
177,712
|
|
|
$
|
259,155
|
|
|
$
|
259,151
|
|
|
$
|
218,995
|
|
AA
|
36,740
|
|
|
36,239
|
|
|
30,644
|
|
|
42,486
|
|
|
39,342
|
|
|
35,531
|
|
A
|
681
|
|
|
681
|
|
|
591
|
|
|
735
|
|
|
735
|
|
|
641
|
|
Below A/Not Rated
|
8,775
|
|
|
8,775
|
|
|
7,573
|
|
|
9,840
|
|
|
12,343
|
|
|
8,527
|
|
|
$
|
255,596
|
|
|
$
|
255,090
|
|
|
$
|
216,520
|
|
|
$
|
312,216
|
|
|
$
|
311,571
|
|
|
$
|
263,694
|
|
Please refer to
Note 3
of the Notes to the Unaudited Consolidated Financial Statements contained within this
Quarterly
Report on Form
10-Q
as well as “Results of Operations” and “Liquidity and Capital Resources” contained within this Item 2 for additional information relating to our repurchase agreement borrowings.
Accumulated Other Comprehensive Loss
We recorded other comprehensive loss of
$(77.1) million
for the
nine months ended
September 30, 2018
related primarily to declines in fair value of our available-for-sale debt securities as a result of increasing interest rates. The following table includes detail of the accumulated gain (loss) position and change in fair value by type of debt security as of and for the periods indicated:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
As of
December 31, 2017
|
|
Nine Months Ended
|
|
As of
September 30, 2018
|
|
September 30, 2018
|
|
($ in thousands)
|
|
Unrealized Gain (Loss)
|
|
Realized Gain (Loss)
(1)
|
|
Fixed-rate Agency RMBS
|
$
|
(4,592
|
)
|
|
$
|
(37,351
|
)
|
|
$
|
—
|
|
|
$
|
(41,943
|
)
|
Adjustable-rate Agency RMBS
|
(3,721
|
)
|
|
12,235
|
|
|
$
|
(7,785
|
)
|
|
729
|
|
Agency CMBS
|
(10,058
|
)
|
|
(34,933
|
)
|
|
(3,771
|
)
|
|
(48,762
|
)
|
CMBS IO
(2)
|
8,689
|
|
|
(6,368
|
)
|
|
178
|
|
|
2,499
|
|
Non-Agency other
(3)
|
2,319
|
|
|
(916
|
)
|
|
—
|
|
|
1,403
|
|
U.S. Treasuries
|
(1,737
|
)
|
|
8,304
|
|
|
(6,567
|
)
|
|
—
|
|
De-designated cash flow hedges
|
403
|
|
|
—
|
|
|
(162
|
)
|
|
241
|
|
Total
|
$
|
(8,697
|
)
|
|
$
|
(59,029
|
)
|
|
$
|
(18,107
|
)
|
|
$
|
(85,833
|
)
|
(1) Includes amounts reclassified from accumulated other comprehensive loss into net income as “gain (loss) on sale of investments, net” as well as amounts reclassified into “interest expense” related to the accretion of the balance remaining in accumulated other comprehensive loss as a result of the Company's discontinuation of cash flow hedge accounting effective June 30, 2013.
RESULTS OF OPERATIONS
The discussions below provide information on certain items on our consolidated statements of comprehensive income. These discussions include both GAAP and non-GAAP financial measures which management utilizes in its internal analysis of financial and operating performance. Please read the section “Non-GAAP Financial Measures” at the end of “Executive Overview” in Item 2 of this
Quarterly
Report on Form
10-Q
for additional important information about these measures.
Net Interest Income For the Three Months Ended
September 30, 2018
Compared to the Three Months Ended
September 30, 2017
Net interest income and net interest spread declined for the three months ended
September 30, 2018
compared to the same period in 2017 due to higher repurchase agreement borrowing costs as a result of significant increases in short-term interest rates. Repurchase agreement borrowing costs have increased as a result of increases in market borrowing rates such as LIBOR that are significantly influenced by changes in the targeted federal funds rate established by the Federal Reserve. The following tables present certain information about our interest-earning assets and interest-bearing liabilities and their performance for the three months ended
September 30, 2018
and
September 30, 2017
:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
September 30,
|
|
2018
|
|
2017
|
($ in thousands)
|
Interest Income/Expense
|
|
Average Balance
(1)(2)
|
|
Effective Yield/
Cost of
Funds
(3)(4)
|
|
Interest Income/Expense
|
|
Average Balance
(1)(2)
|
|
Effective Yield/
Cost of
Funds
(3)(4)
|
Interest-earning assets:
|
|
|
|
|
|
|
|
|
|
|
|
Agency RMBS-fixed rate
|
$
|
11,561
|
|
|
$
|
1,384,926
|
|
|
3.34
|
%
|
|
$
|
1,390
|
|
|
$
|
186,721
|
|
|
2.98
|
%
|
Agency CMBS-fixed rate
|
7,362
|
|
|
1,002,661
|
|
|
2.81
|
%
|
|
9,213
|
|
|
1,316,364
|
|
|
2.73
|
%
|
Agency RMBS-adjustable rate
|
283
|
|
|
37,634
|
|
|
3.12
|
%
|
|
3,159
|
|
|
668,845
|
|
|
1.95
|
%
|
CMBS IO
(5)
|
6,646
|
|
|
581,770
|
|
|
3.98
|
%
|
|
8,050
|
|
|
734,282
|
|
|
3.89
|
%
|
Non-Agency other
(6)
|
427
|
|
|
4,869
|
|
|
30.31
|
%
|
|
959
|
|
|
37,456
|
|
|
9.21
|
%
|
U.S. Treasuries
|
45
|
|
|
6,302
|
|
|
2.83
|
%
|
|
—
|
|
|
—
|
|
|
—
|
%
|
Other investments
(7)
|
601
|
|
|
13,226
|
|
|
4.25
|
%
|
|
332
|
|
|
16,927
|
|
|
3.92
|
%
|
Total:
|
$
|
26,925
|
|
|
$
|
3,031,388
|
|
|
3.33
|
%
|
|
$
|
23,103
|
|
|
$
|
2,960,595
|
|
|
2.95
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest-bearing liabilities:
|
|
|
|
|
|
|
|
|
|
|
|
Repurchase agreements
|
$
|
14,780
|
|
|
$
|
2,564,863
|
|
|
2.25
|
%
|
|
$
|
9,910
|
|
|
$
|
2,616,250
|
|
|
1.48
|
%
|
Non-recourse collateralized financing
|
37
|
|
|
4,260
|
|
|
3.01
|
%
|
|
27
|
|
|
5,817
|
|
|
1.97
|
%
|
De-designated cash flow hedge accretion
(8)
|
(66
|
)
|
|
n/a
|
|
|
(0.01
|
)%
|
|
(48
|
)
|
|
n/a
|
|
|
(0.01
|
)%
|
Total:
|
$
|
14,751
|
|
|
$
|
2,569,123
|
|
|
2.25
|
%
|
|
$
|
9,889
|
|
|
$
|
2,622,067
|
|
|
1.48
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net interest income/net interest spread
|
$
|
12,174
|
|
|
|
|
1.08
|
%
|
|
$
|
13,214
|
|
|
|
|
1.47
|
%
|
|
|
(1)
|
Average balance for assets is calculated as a simple average of the daily amortized cost and excludes unrealized gains and losses as well as securities pending settlement if applicable.
|
|
|
(2)
|
Average balance for liabilities is calculated as a simple average of the daily borrowings outstanding during the period.
|
|
|
(3)
|
Effective yield is calculated by dividing the sum of gross interest income and scheduled premium amortization/discount accretion (both of which are annualized for any reporting period less than 12 months) and prepayment compensation and premium amortization/discount accretion adjustments (collectively, "prepayment adjustments"), which are not annualized, by the average balance of asset type outstanding during the reporting period.
|
|
|
(4)
|
Cost of funds is calculated by dividing annualized interest expense by the total average balance of borrowings outstanding during the period with an assumption of 360 days in a year.
|
|
|
(5)
|
Includes Agency and non-Agency issued securities.
|
|
|
(6)
|
Includes privately-issued RMBS and CMBS.
|
|
|
(7)
|
Interest income for other investments consists of $139 from mortgage loans held for investment, net and $462 from cash and cash equivalents for the
three months ended
September 30, 2018
compared to $172 and $160 for the
three months ended
September 30, 2017
, respectively. Average balances and yields shown for other investments includes amortized cost of mortgage loans held for investment and excludes cash.
|
|
|
(8)
|
Amount recorded as a portion of "interest expense" in accordance with GAAP related to the accretion of the balance remaining in accumulated other comprehensive loss as a result of the Company's discontinuation of cash flow hedge accounting effective June 30, 2013.
|
Interest income increased
$3.8 million
for the three months ended
September 30, 2018
compared to the same period in 2017 due to the shift in our portfolio to 30-year fixed-rate Agency RMBS which have higher coupons and lower premium amortization than the adjustable-rate Agency RMBS held in our portfolio during the same period in 2017. The benefit of a higher average balance of higher yielding assets was partially offset by lower prepayment penalty compensation and lower discount accretion on our CMBS and CMBS IO for the three months ended
September 30, 2018
compared to the same period in 2017.
Interest expense increased $4.9 million for the three months ended
September 30, 2018
compared to the same period in 2017 due to higher borrowing rates on our repurchase agreements. Our borrowing rates are based largely on short-term market rates such as one-month LIBOR which averaged 2.11% for the three months ended
September 30, 2018
compared to 1.23% for the same period in 2017.
Rate/Volume Analysis.
The following table presents the estimated impact on our net interest income due to changes in rate (effective yield/cost of funds) and changes in volume (average balance) of our interest-earning assets and interest-bearing liabilities for the periods indicated:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
September 30, 2018 Compared to September 30, 2017
|
|
Increase (Decrease) Due to Change In
|
|
Total Change in Interest Income/Expense
|
($ in thousands)
|
Rate
|
|
Volume
|
|
Prepayment Adjustments
(1)
|
|
Interest-earning assets:
|
|
|
|
|
|
|
|
Agency RMBS-fixed rate
|
$
|
1,251
|
|
|
$
|
8,920
|
|
|
$
|
—
|
|
|
$
|
10,171
|
|
Agency CMBS-fixed rate
|
151
|
|
|
(2,184
|
)
|
|
183
|
|
|
(1,850
|
)
|
Agency RMBS-adjustable rate
|
112
|
|
|
(3,099
|
)
|
|
111
|
|
|
(2,876
|
)
|
CMBS IO
(2)
|
83
|
|
|
(1,422
|
)
|
|
(66
|
)
|
|
(1,405
|
)
|
Non-Agency other
(3)
|
246
|
|
|
(726
|
)
|
|
(52
|
)
|
|
(532
|
)
|
U.S. Treasuries
|
—
|
|
|
45
|
|
|
—
|
|
|
45
|
|
Other investments
(4)
|
15
|
|
|
263
|
|
|
(9
|
)
|
|
269
|
|
Total increase (decrease) in interest income
|
$
|
1,858
|
|
|
$
|
1,797
|
|
|
$
|
167
|
|
|
$
|
3,822
|
|
|
|
|
|
|
|
|
|
|
Interest-bearing liabilities:
|
|
|
|
|
|
|
|
|
Repurchase agreements
|
$
|
5,046
|
|
|
$
|
(194
|
)
|
|
$
|
—
|
|
|
$
|
4,852
|
|
Non-recourse collateralized financing, net of other
(5)
|
17
|
|
|
(7
|
)
|
|
—
|
|
|
10
|
|
Total increase (decrease) in interest expense
|
5,063
|
|
|
(201
|
)
|
|
—
|
|
|
4,862
|
|
|
|
|
|
|
|
|
|
Total net (decrease) increase in net interest income
|
$
|
(3,205
|
)
|
|
$
|
1,998
|
|
|
$
|
167
|
|
|
$
|
(1,040
|
)
|
|
|
(1)
|
Prepayment adjustments represent effective interest amortization adjustments related to changes in actual and projected prepayment speeds for adjustable-rate RMBS and prepayment compensation, net of amortization adjustments for CMBS and CMBS IO and are not annualized in the calculation of effective yield.
|
|
|
(2)
|
Includes Agency and non-Agency issued securities.
|
|
|
(3)
|
Includes privately-issued RMBS and CMBS.
|
|
|
(4)
|
Increase of $301 thousand in other interest income from cash and cash equivalents is included as a change in volume.
|
|
|
(5)
|
Includes decrease of $18 thousand in de-designated cash flow hedge accretion as a change in rate.
|
The increase of
$1.9 million
in interest income due to rate is primarily related to our sales of lower yielding hybrid Agency RMBS and the purchase of higher yielding fixed-rate Agency RMBS which resulted in the increase in the average effective yield on our investment portfolio to 3.33% for the three months ended
September 30, 2018
compared to 2.95% for the same period in 2017. The average effective yield for Agency CMBS and CMBS IO were also both up modestly primarily due to sales and pay downs of lower yielding assets within those groups as well as a $0.2 million increase in prepayment compensation on Agency CMBS for the three months ended
September 30, 2018
compared to the same period in 2017.
Adjusted Net Interest Income For the Three Months Ended
September 30, 2018
Compared to the Three Months Ended
September 30, 2017
Drop income from TBA dollar roll positions and net periodic interest benefit (cost) of interest rate swaps effective during the period are included in "gain on derivatives instruments, net" on the Company's consolidated statements of comprehensive income. Drop income is the difference in price between the near settling TBA contract and the price for the same contract with a later settlement date. Management believes drop income
represents the economic equivalent of net interest income (interest income less implied financing cost) on the underlying Agency security from trade date to settlement date.
Management also views net periodic interest benefit (cost) of effective interest rate swaps used to hedge interest rate risk as an additional benefit (cost) of using repurchase agreements to finance its investments. As such, management includes drop income from TBA dollar roll transactions and net periodic interest benefit (cost) of interest rate swaps in a non-GAAP financial measure “adjusted net interest income” when evaluating the economic performance of its investments and related financings. Please read the section “Non-GAAP Financial Measures” for additional important information about this non-GAAP financial measure.
The following table reconciles adjusted net interest income to GAAP net interest income for the periods indicated:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
September 30,
|
|
2018
|
|
2017
|
($ in thousands)
|
Amount
|
|
Rate
|
|
Amount
|
|
Rate
|
Net interest income
|
$
|
12,174
|
|
|
1.08
|
%
|
|
$
|
13,214
|
|
|
1.47
|
%
|
Add: TBA drop income
(1)
|
4,262
|
|
|
0.06
|
%
|
|
3,902
|
|
|
0.15
|
%
|
Add: net periodic interest benefit (cost)
(2)
|
1,777
|
|
|
0.28
|
%
|
|
(1,131
|
)
|
|
(0.17
|
)%
|
De-designated cash flow hedge accretion
(3)
|
(66
|
)
|
|
(0.01
|
)%
|
|
(48
|
)
|
|
(0.01
|
)%
|
Adjusted net interest income
|
$
|
18,147
|
|
|
1.41
|
%
|
|
$
|
15,937
|
|
|
1.44
|
%
|
|
|
1)
|
TBA drop income is calculated by multiplying the notional amount of the TBA dollar roll positions by the difference in price between two TBA securities with the same terms but different settlement dates.
|
|
|
(2)
|
Amount represents net periodic interest benefit (cost) of effective interest rate swaps outstanding during the period and excludes realized and unrealized gains and losses from changes in fair value of derivatives.
|
|
|
(3)
|
Amount recorded as a portion of "interest expense" in accordance with GAAP related to the accretion of the balance remaining in accumulated other comprehensive loss as a result of the Company's discontinuation of cash flow hedge accounting effective June 30, 2013.
|
Adjusted net interest income increased $2.2 million for the three months ended
September 30, 2018
compared to the same period in 2017 primarily because of higher TBA drop income in the third quarter of 2018 as well as a net periodic interest benefit from interest rate swaps during the third quarter of 2018 which partially offset the increase in interest expense from our repurchase agreements. The floating rate we receive on the majority of our pay-fixed interest rate swaps is based on 3-month LIBOR which averaged approximately 2.34% for the three months ended
September 30, 2018
compared to 1.31% for the same period in 2017. Please refer to “Gain (Loss) on Derivative Instruments, Net” for additional information on our interest rate swaps.
The following table summarizes information related to our drop income from TBA dollar roll transactions for the periods indicated:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
Three Months Ended September 30, 2018 Compared to Three Months Ended September 30, 2017
|
|
September 30,
|
|
|
2018
|
|
2017
|
|
Total Change
|
|
Due to Change In
|
($ in thousands)
|
Amount
|
|
Average Yield/Cost
|
|
Amount
|
|
Average Yield/Cost
|
|
|
Rate
|
|
Volume
|
TBA implied interest income
(1)
|
$
|
9,708
|
|
|
3.66
|
%
|
|
$
|
6,150
|
|
|
3.02
|
%
|
|
$
|
3,558
|
|
|
$
|
1,708
|
|
|
$
|
1,850
|
|
TBA implied interest expense
(2)
|
5,446
|
|
|
2.05
|
%
|
|
2,248
|
|
|
1.10
|
%
|
|
3,198
|
|
|
2,522
|
|
|
676
|
|
TBA drop income/net yield
(3)
|
$
|
4,262
|
|
|
1.61
|
%
|
|
$
|
3,902
|
|
|
1.92
|
%
|
|
$
|
360
|
|
|
$
|
(814
|
)
|
|
$
|
1,174
|
|
|
|
(1)
|
Average yield for TBA dollar roll positions is extrapolated by adding average cost (Note 2) to the net yield (Note 3). Implied interest income is calculated by multiplying the average yield by the TBA cost basis outstanding during the period.
|
|
|
(2)
|
Average funding cost for TBA dollar roll positions is determined using the “price drop” between the near settling TBA contract and the price for the same contract with a later settlement date and market-based assumptions regarding the “cheapest-to-
|
deliver” collateral that can satisfy the TBA contract, such as the security’s coupon, maturity, and projected prepayment rate anticipated for the collateral. TBA implied interest expense is calculated by multiplying the average funding cost by the average TBA cost basis outstanding during the period.
|
|
(3)
|
TBA net yield is calculated by dividing drop income by the average TBA cost basis outstanding during the period.
|
Net Interest Income For the
Nine Months Ended
September 30, 2018
Compared to the
Nine Months Ended
September 30, 2017
Net interest income and net interest spread declined for the
nine months ended
September 30, 2018
compared to the same period in 2017 due to higher borrowing costs as a result of significant increases in short-term interest rates and lower prepayment penalty compensation and discount accretion on our CMBS and CMBS IO during the
nine months ended
September 30, 2018
. The following tables present certain information about our interest-earning assets and interest-bearing liabilities and their performance for the
nine months ended
September 30, 2018
and
September 30, 2017
:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Nine Months Ended
|
|
September 30,
|
|
2018
|
|
2017
|
($ in thousands)
|
Interest Income/Expense
|
|
Average Balance
(1)(2)
|
|
Effective Yield/
Cost of
Funds
(3)(4)
|
|
Interest Income/Expense
|
|
Average Balance
(1)(2)
|
|
Effective Yield/
Cost of
Funds
(3)(4)
|
Interest-earning assets:
|
|
|
|
|
|
|
|
|
|
|
|
Agency RMBS-fixed rate
|
$
|
27,853
|
|
|
$
|
1,142,907
|
|
|
3.25
|
%
|
|
$
|
1,390
|
|
|
$
|
62,924
|
|
|
2.95
|
%
|
Agency CMBS-fixed rate
|
22,257
|
|
|
1,031,979
|
|
|
2.83
|
%
|
|
26,373
|
|
|
1,254,723
|
|
|
2.76
|
%
|
Agency RMBS-adjustable rate
|
3,205
|
|
|
190,854
|
|
|
2.23
|
%
|
|
11,710
|
|
|
934,524
|
|
|
1.73
|
%
|
CMBS IO
(5)
|
19,886
|
|
|
627,537
|
|
|
4.11
|
%
|
|
24,678
|
|
|
749,343
|
|
|
4.23
|
%
|
Non-Agency other
(6)
|
1,495
|
|
|
9,459
|
|
|
20.10
|
%
|
|
5,361
|
|
|
70,923
|
|
|
9.17
|
%
|
U.S. Treasuries
|
2,012
|
|
|
109,816
|
|
|
2.45
|
%
|
|
—
|
|
|
—
|
|
|
—
|
%
|
Other investments
(7)
|
1,329
|
|
|
14,407
|
|
|
4.11
|
%
|
|
866
|
|
|
17,876
|
|
|
3.94
|
%
|
Total:
|
$
|
78,037
|
|
|
$
|
3,126,959
|
|
|
3.25
|
%
|
|
$
|
70,378
|
|
|
$
|
3,090,313
|
|
|
2.97
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest-bearing liabilities:
|
|
|
|
|
|
|
|
|
|
|
|
Repurchase agreements
|
$
|
40,575
|
|
|
$
|
2,641,929
|
|
|
2.03
|
%
|
|
$
|
26,269
|
|
|
$
|
2,736,834
|
|
|
1.27
|
%
|
Non-recourse collateralized financing
|
108
|
|
|
4,879
|
|
|
2.82
|
%
|
|
73
|
|
|
6,058
|
|
|
1.63
|
%
|
De-designated cash flow hedge accretion
(8)
|
(162
|
)
|
|
n/a
|
|
|
(0.01
|
)%
|
|
(220
|
)
|
|
n/a
|
|
|
(0.01
|
)%
|
Total:
|
$
|
40,521
|
|
|
$
|
2,646,808
|
|
|
2.02
|
%
|
|
$
|
26,122
|
|
|
$
|
2,742,892
|
|
|
1.26
|
%
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net interest income/net interest spread
|
$
|
37,516
|
|
|
|
|
1.23
|
%
|
|
$
|
44,256
|
|
|
|
|
1.71
|
%
|
|
|
(1)
|
Average balance for assets is calculated as a simple average of the daily amortized cost and excludes unrealized gains and losses as well as securities pending settlement if applicable.
|
|
|
(2)
|
Average balance for liabilities is calculated as a simple average of the daily borrowings outstanding during the period.
|
|
|
(3)
|
Effective yield is calculated by dividing the sum of gross interest income and scheduled premium amortization/discount accretion (both of which are annualized for any reporting period less than 12 months) and prepayment compensation and premium amortization/discount accretion adjustments (collectively, "prepayment adjustments"), which are not annualized, by the average balance of asset type outstanding during the reporting period.
|
|
|
(4)
|
Cost of funds is calculated by dividing annualized interest expense by the total average balance of borrowings outstanding during the period with an assumption of 360 days in a year.
|
|
|
(5)
|
Includes Agency and non-Agency issued securities.
|
|
|
(6)
|
Includes privately-issued RMBS and CMBS.
|
|
|
(7)
|
Interest income for other investments consists of $444 thousand from mortgage loans held for investment, net and $885 thousand from cash and cash equivalents for the
nine months ended
September 30, 2018
compared to $533 and $333 for the
|
nine months ended
September 30, 2017
, respectively. Average balances and yields shown for other investments includes amortized cost of mortgage loans held for investment and excludes cash.
|
|
(8)
|
Amount recorded as a portion of "interest expense" in accordance with GAAP related to the accretion of the balance remaining in accumulated other comprehensive loss as a result of the Company's discontinuation of cash flow hedge accounting effective June 30, 2013.
|
Interest income increased
$7.7 million
for the
nine months ended
September 30, 2018
compared to the same period in 2017 due to the shift in our portfolio to 30-year fixed-rate Agency RMBS which have higher average effective yields than the adjustable-rate Agency RMBS held in our portfolio during the same period in 2017. The benefit of the higher average balance of higher yielding assets was partially offset by the lower prepayment penalty compensation and lower discount accretion on our CMBS and CMBS IO for the
nine months ended
September 30, 2018
compared to the same period in 2017.
Interest expense increased
$14.4 million
for the
nine months ended
September 30, 2018
compared to the same period in 2017 due to higher borrowing rates on our repurchase agreements. Our borrowing rates are based primarily on one-month LIBOR which averaged approximately 1.91% during the
nine months ended
September 30, 2018
compared to an average of 1.04% for the same period in 2017.
Rate/Volume Analysis.
The following table presents the estimated impact on our net interest income due to changes in rate (effective yield/cost of funds) and changes in volume (average balance) of our interest-earning assets and interest-bearing liabilities for the periods indicated:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Nine Months Ended
|
|
September 30, 2018 Compared to September 30, 2017
|
|
Increase (Decrease) Due to Change In
|
|
Total Change in Interest Income/Expense
|
($ in thousands)
|
Rate
|
|
Volume
|
|
Prepayment Adjustments
(1)
|
|
Interest-earning assets:
|
|
|
|
|
|
|
|
Agency RMBS-fixed rate
|
$
|
2,606
|
|
|
$
|
23,857
|
|
|
$
|
—
|
|
|
$
|
26,463
|
|
Agency CMBS-fixed rate
|
388
|
|
|
(4,623
|
)
|
|
120
|
|
|
(4,115
|
)
|
Agency RMBS-adjustable rate
|
409
|
|
|
(10,727
|
)
|
|
1,813
|
|
|
(8,505
|
)
|
CMBS IO
(2)
|
(2
|
)
|
|
(3,429
|
)
|
|
(1,361
|
)
|
|
(4,792
|
)
|
Non-Agency other
(3)
|
724
|
|
|
(2,930
|
)
|
|
(1,660
|
)
|
|
(3,866
|
)
|
Treasuries
|
—
|
|
|
2,012
|
|
|
—
|
|
|
2,012
|
|
Other investments
(4)
|
17
|
|
|
462
|
|
|
(17
|
)
|
|
462
|
|
Total increase (decrease) in interest income
|
$
|
4,142
|
|
|
$
|
4,622
|
|
|
$
|
(1,105
|
)
|
|
$
|
7,659
|
|
|
|
|
|
|
|
|
|
|
Interest-bearing liabilities:
|
|
|
|
|
|
|
|
|
Repurchase agreements
|
$
|
15,290
|
|
|
$
|
(926
|
)
|
|
$
|
—
|
|
|
$
|
14,364
|
|
Non-recourse collateralized financing, net of other
(5)
|
40
|
|
|
(5
|
)
|
|
—
|
|
|
35
|
|
Total increase (decrease) in interest expense
|
15,330
|
|
|
(931
|
)
|
|
—
|
|
|
14,399
|
|
|
|
|
|
|
|
|
|
Total net change in net interest income
|
$
|
(11,188
|
)
|
|
$
|
5,553
|
|
|
$
|
(1,105
|
)
|
|
$
|
(6,740
|
)
|
|
|
(1)
|
Prepayment adjustments represent effective interest amortization adjustments related to changes in actual and projected prepayment speeds for adjustable-rate RMBS and prepayment compensation, net of amortization adjustments for CMBS and CMBS IO and are not annualized in the calculation of effective yield.
|
|
|
(2)
|
Includes Agency and non-Agency issued securities.
|
|
|
(3)
|
Includes privately-issued RMBS and CMBS.
|
|
|
(4)
|
Increase of $551 thousand in other interest income from cash and cash equivalents is included as a change in volume.
|
|
|
(5)
|
Includes decrease of $58 thousand in de-designated cash flow hedge accretion as a change in rate.
|
The increase of
$4.1 million
in interest income due to rate is primarily related to our sales and pay downs of lower yielding MBS across most asset classes since
September 30, 2017
, which resulted in the average effective yield increasing for the remaining securities in our portfolio for the
nine months ended
September 30, 2018
compared to the same period in 2017. The proceeds from those sales and pay downs have been predominantly reinvested into higher yielding fixed-rate Agency RMBS since
September 30,
2017
. The average effective yield for CMBS IO declined 12 basis points, which was primarily due to lower prepayment penalty compensation during the
nine months ended
September 30, 2018
compared to the same period in 2017.
Adjusted Net Interest Income For the
Nine Months Ended
September 30, 2018
Compared to
Nine Months Ended
September 30, 2017
As discussed earlier, management includes drop income from TBA dollar roll transactions and net periodic interest benefit (cost) of interest rate swaps in a non-GAAP financial measure “adjusted net interest income” when evaluating the economic performance of its investments and financings. The following table reconciles adjusted net interest income to GAAP net interest income for the periods indicated:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Nine Months Ended
|
|
September 30,
|
|
2018
|
|
2017
|
($ in thousands)
|
Amount
|
|
Rate
|
|
Amount
|
|
Rate
|
Net interest income
|
$
|
37,516
|
|
|
1.23
|
%
|
|
$
|
44,256
|
|
|
1.71
|
%
|
Add: TBA drop income
(1)
|
11,614
|
|
|
0.05
|
%
|
|
5,253
|
|
|
0.04
|
%
|
Add: net periodic interest benefit (cost)
(2)
|
3,890
|
|
|
0.20
|
%
|
|
(3,099
|
)
|
|
(0.15
|
)%
|
De-designated cash flow hedge accretion
(3)
|
162
|
|
|
0.01
|
%
|
|
(220
|
)
|
|
(0.01
|
)%
|
Adjusted net interest income
|
$
|
53,182
|
|
|
1.49
|
%
|
|
$
|
46,190
|
|
|
1.59
|
%
|
|
|
(1)
|
TBA drop income is calculated by multiplying the notional amount of the TBA dollar roll positions by the difference in price between two TBA securities with the same terms but different settlement dates.
|
|
|
(2)
|
Amount represents net periodic interest benefit (cost) of effective interest rate swaps outstanding during the period and excludes realized and unrealized gains and losses from changes in fair value of derivatives.
|
|
|
(3)
|
Amount recorded as a portion of "interest expense" in accordance with GAAP related to the accretion of the balance remaining in accumulated other comprehensive loss as a result of the Company's discontinuation of cash flow hedge accounting effective June 30, 2013.
|
Adjusted net interest income increased $7.0 million for the
nine months ended
September 30, 2018
compared to the same period in 2017 primarily because of higher TBA drop income as well as a net periodic interest benefit from interest rate swaps which partially offset the increase in interest expense from our repurchase agreements during the
nine months ended
September 30, 2018
compared to the same period in 2017. The floating rate we receive on the majority of our pay-fixed interest rate swaps is based on 3-month LIBOR which averaged approximately 2.20% for the
nine months ended
September 30, 2018
compared to 1.20% for the same period in 2017.
The following table summarizes information related to our drop income from TBA dollar roll transactions for the periods indicated:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Nine Months Ended
|
|
Nine Months Ended September 30, 2018 Compared to Nine Months Ended September 30, 2017
|
|
September 30,
|
|
|
2018
|
|
2017
|
|
Total Change
|
|
Due to Change In
|
($ in thousands)
|
Amount
|
|
Average Yield/Cost
|
|
Amount
|
|
Average Yield/Cost
|
|
|
Rate
|
|
Volume
|
TBA implied interest income
(1)
|
$
|
23,483
|
|
|
3.51
|
%
|
|
$
|
8,077
|
|
|
2.98
|
%
|
|
$
|
15,406
|
|
|
$
|
3,502
|
|
|
$
|
11,904
|
|
TBA implied interest expense
(2)
|
11,869
|
|
|
1.77
|
%
|
|
2,824
|
|
|
1.04
|
%
|
|
9,045
|
|
|
4,883
|
|
|
4,162
|
|
TBA drop income/net yield
(3)
|
$
|
11,614
|
|
|
1.74
|
%
|
|
$
|
5,253
|
|
|
1.94
|
%
|
|
$
|
6,361
|
|
|
$
|
(1,381
|
)
|
|
$
|
7,742
|
|
|
|
(1)
|
Average yield for TBA dollar roll positions is extrapolated by adding average cost (Note 2) to the net yield (Note 3). Implied interest income is calculated by multiplying the average yield by the TBA cost basis outstanding during the period.
|
|
|
(2)
|
Average funding cost for TBA dollar roll positions is determined using the “price drop” between the near settling TBA contract and the price for the same contract with a later settlement date and market-based assumptions regarding the “cheapest-to-deliver” collateral that can satisfy the TBA contract, such as the security’s coupon, maturity, and projected prepayment rate anticipated for the collateral. TBA implied interest expense is calculated by multiplying the average funding cost by the average TBA cost basis outstanding during the period.
|
|
|
(3)
|
TBA net yield is calculated by dividing drop income by the average TBA cost basis outstanding during the period.
|
Gain on Derivative Instruments, Net
Changes in the fair value of derivative instruments and net periodic interest costs are impacted by changing market interest rates and adjustments that we may make to our derivative positions in any given period. Because of the changes made to our derivatives portfolio from one reporting period to the next, results of any given reporting period are generally not comparable to results of another.
The following table provides information on our financial instruments accounted for as derivative instruments for the periods indicated:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
Nine Months Ended
|
|
|
September 30,
|
|
September 30,
|
($ in thousands)
|
|
2018
|
|
2017
|
|
2018
|
|
2017
|
Interest rate derivatives:
|
|
|
|
|
|
|
|
|
Interest rate swaps:
|
|
|
|
|
|
|
|
|
Net periodic interest costs
|
|
$
|
1,777
|
|
|
$
|
(1,131
|
)
|
|
$
|
3,890
|
|
|
$
|
(3,099
|
)
|
Change in fair value
(1)
|
|
23,242
|
|
|
421
|
|
|
89,944
|
|
|
(14,954
|
)
|
Total interest rate swap gains (losses), net
|
|
25,019
|
|
|
(710
|
)
|
|
93,834
|
|
|
(18,053
|
)
|
Eurodollar futures:
|
|
|
|
|
|
|
|
|
Change in fair value
(1)
|
|
(189
|
)
|
|
—
|
|
|
1,886
|
|
|
—
|
|
TBA short positions (economic hedges):
|
|
—
|
|
|
—
|
|
|
—
|
|
|
—
|
|
Change in fair value
(2)
|
|
—
|
|
|
—
|
|
|
293
|
|
|
—
|
|
Total interest rate derivative gains (losses), net
|
|
24,830
|
|
|
(710
|
)
|
|
96,013
|
|
|
(18,053
|
)
|
|
|
|
|
|
|
|
|
|
TBA dollar roll positions:
|
|
|
|
|
|
|
|
|
TBA drop income
|
|
4,262
|
|
|
3,902
|
|
|
11,614
|
|
|
5,253
|
|
Change in fair value
(2)
|
|
(9,466
|
)
|
|
2,801
|
|
|
(29,870
|
)
|
|
3,166
|
|
Total TBA dollar roll (losses) gains, net
|
|
(5,204
|
)
|
|
6,703
|
|
|
(18,256
|
)
|
|
8,419
|
|
|
|
|
|
|
|
|
|
|
Other derivatives:
|
|
|
|
|
|
|
|
|
Options on U.S. Treasury futures
|
|
(127
|
)
|
|
—
|
|
|
763
|
|
|
—
|
|
|
|
|
|
|
|
|
|
|
Total gain (loss) on derivative instruments, net
|
|
$
|
19,499
|
|
|
$
|
5,993
|
|
|
$
|
78,520
|
|
|
$
|
(9,634
|
)
|
|
|
(1)
|
Changes in fair value for interest rate swaps and Eurodollar futures include unrealized gains (losses) from current and forward starting derivative instruments and realized gains (losses) from terminated derivative instruments.
|
|
|
(2)
|
Changes in fair value for TBA positions include unrealized gains (losses) from open TBA contracts and realized gains (losses) on paired off or terminated positions.
|
Gain on derivative instruments, net for the three months ended
September 30, 2018
included $2.6 million of realized gains on terminated interest rate swaps with a notional balance of $250.0 million, $2.0 million of realized losses on TBA dollar roll positions, and $0.8 million of realized gains resulting from $650.0 million of Eurodollar futures that matured during the third quarter of 2018. The increase in fair value of our interest rate swaps was the result of higher interest rates along the entire curve. The decline in fair value of TBA dollar roll positions of
$(9.5) million
was driven primarily by the increase in interest rates during the third quarter.
Gain on derivative instruments, net for the
nine months ended
September 30, 2018
included $2.1 million of realized gains on terminated interest rate swaps with a notional balance of $350 million, $15.6 million of realized losses on TBA dollar roll positions, and $2.6 million of realized gains resulting from $2.0 billion of Eurodollar futures that matured during the
nine months ended
September 30, 2018
. The decline in fair value of TBAs of
$(29.9) million
was driven primarily by the increase in interest rates during the same period.
The following table provides details on the effective interest rate swaps outstanding during the periods indicated:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
Nine Months Ended
|
|
September 30,
|
|
September 30,
|
($ in thousands)
|
2018
|
|
2017
|
|
2018
|
|
2017
|
Average repurchase agreement borrowings outstanding
|
$
|
2,564,863
|
|
|
$
|
2,616,250
|
|
|
$
|
2,641,929
|
|
|
$
|
2,736,834
|
|
Average net TBAs outstanding - at cost
(1)
|
982,665
|
|
|
745,270
|
|
|
856,531
|
|
|
353,060
|
|
Average borrowings and net TBAs outstanding
|
3,547,528
|
|
|
3,361,520
|
|
|
3,498,460
|
|
|
3,089,894
|
|
Average notional amount of interest rate swaps outstanding (excluding forward starting swaps)
|
2,502,609
|
|
|
3,007,609
|
|
|
2,830,824
|
|
|
2,176,300
|
|
Ratio of average interest rate swaps to average borrowings and net TBAs outstanding
(1)
|
0.7
|
|
|
0.9
|
|
|
0.8
|
|
|
0.7
|
|
|
|
|
|
|
|
|
|
Average interest rate swap net pay-fixed rate (excluding forward starting swaps)
(2)
|
2.09
|
%
|
|
1.43
|
%
|
|
1.84
|
%
|
|
1.35
|
%
|
Average interest rate swap net receive-floating rate
(2)
|
2.32
|
%
|
|
1.26
|
%
|
|
2.01
|
%
|
|
1.15
|
%
|
Average interest rate swap net pay/(receive) rate
|
(0.23
|
)%
|
|
0.17
|
%
|
|
(0.17
|
)%
|
|
0.20
|
%
|
|
|
(1)
|
Because the Company executes TBA dollar roll transactions, which economically represent the purchase and financing of fixed-rate Agency RMBS, the average TBAs outstanding are included in the ratio calculation.
|
|
|
(2)
|
Net rates include receive-fixed (pay-floating) interest rate swaps.
|
As mentioned in “Financial Condition” of Part I, Item 2 of this Quarterly Report on Form 10-Q, we hold long positions in TBA securities which management views as economically equivalent to investing in and financing Agency RMBS using short-term repurchase agreements. We execute a series of transactions which effectively delay the settlement of a forward purchase of a non-specified Agency RMBS by entering into an offsetting TBA short position, net settling the paired-off positions in cash, and simultaneously entering into an identical TBA long position with a later settlement date. A portion of the total change in fair value of TBAs is referred to by management as “drop income (loss)” and is calculated as the difference in price between the TBA security purchased for a forward settlement month and the price of a TBA security sold for settlement in the current month times its notional amount.
We may also periodically enter into short positions in TBAs to hedge the impact of adverse changes in interest rates on the fair value of our fixed-rate Agency RMBS. Unlike long positions in TBAs in which we execute dollar roll transactions, we do not simultaneously enter into an identical TBA short position with a later settlement date when we pair off initial short positions. Therefore, short positions in TBAs used as economic hedges do not generate drop income (loss). We did not have any short positions in TBAs used as economic hedges as of
September 30, 2018
.
Loss on Sale of Investments, Net
Sales of our investments occur in the ordinary course of business as we manage our risk, capital and liquidity profiles, and as we reallocate capital to various investments. The following tables provide information related to our loss on sale of investments, net for the periods indicated:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended
|
|
September 30,
|
|
2018
|
|
2017
|
($ in thousands)
|
Amortized cost basis sold
|
|
Loss on sale of investments, net
|
|
Amortized cost basis sold
|
|
Loss on sale of investments, net
|
Agency RMBS
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
398,662
|
|
|
$
|
(5,160
|
)
|
Agency CMBS
|
49,957
|
|
|
(1,720
|
)
|
|
13,484
|
|
|
(51
|
)
|
Agency CMBS IO
|
10,444
|
|
|
127
|
|
|
—
|
|
|
—
|
|
U.S. Treasuries
|
57,976
|
|
|
(133
|
)
|
|
—
|
|
|
—
|
|
|
$
|
118,377
|
|
|
$
|
(1,726
|
)
|
|
$
|
412,146
|
|
|
$
|
(5,211
|
)
|
|
|
|
|
|
|
|
|
|
Nine Months Ended
|
|
September 30,
|
|
2018
|
|
2017
|
($ in thousands)
|
Amortized cost basis sold
|
|
(Loss) gain on sale of investments, net
|
|
Amortized cost basis sold
|
|
(Loss) gain on sale of investments, net
|
Agency RMBS
|
$
|
225,622
|
|
|
$
|
(7,785
|
)
|
|
$
|
728,952
|
|
|
$
|
(12,392
|
)
|
Agency CMBS
|
160,766
|
|
|
(3,771
|
)
|
|
206,470
|
|
|
523
|
|
Agency CMBS IO
|
10,444
|
|
|
127
|
|
|
—
|
|
|
—
|
|
Non-Agency CMBS IO
|
8,644
|
|
|
51
|
|
|
—
|
|
|
—
|
|
Non-Agency CMBS
|
—
|
|
|
—
|
|
|
34,506
|
|
|
1,199
|
|
Non-Agency RMBS
|
—
|
|
|
—
|
|
|
16,365
|
|
|
42
|
|
U.S. Treasuries
|
225,369
|
|
|
(6,567
|
)
|
|
—
|
|
|
—
|
|
|
$
|
630,845
|
|
|
$
|
(17,945
|
)
|
|
$
|
986,293
|
|
|
$
|
(10,628
|
)
|
General and Administrative Expenses
General and administrative expenses increased to
$(4.0) million
for the three months ended
September 30, 2018
compared to
$(3.6) million
for the three months ended
September 30, 2017
. Other general and administrative expenses increased $0.7 million compared to the third quarter of 2017 due primarily to an increase in expenses related to the litigation discussed in Part II, Item 1 “Legal Proceedings”. Compensation and benefits expense declined $0.4 million due to primarily to lower stock-based compensation and incentive compensation expenses.
General and administrative expenses decreased $0.4 million for the
nine months ended
nine months ended
compared to the same period in 2017. Compensation and benefits expense declined $0.9 million primarily due to lower stock-based compensation expense. Partially offsetting that decline was a $0.5 million increase in legal expenses primarily related to the litigation discussed in Part II, Item 1 “Legal Proceedings” during the
nine months ended
September 30, 2018
compared to the same period in 2017.
LIQUIDITY AND CAPITAL RESOURCES
Our primary sources of liquidity include borrowings under repurchase arrangements and monthly principal and interest payments we receive on our investments. Additional sources may also include proceeds from the sale of investments, equity offerings, and payments received from counterparties from interest rate swap agreements. We use our liquidity to purchase investments and to pay our operating expenses and dividends on our common and preferred stock. We also use our liquidity to post initial and variation margins on our repurchase agreements and derivative transactions, including TBA contracts, when required under the terms of the related agreements. We may also use liquidity to repurchase shares of our stock periodically.
Our liquid assets fluctuate based on our investment activities, our financing and capital raising activities, and changes in the fair value of our investments and derivative instruments. We seek to maintain sufficient liquidity to support our operations and to meet our anticipated liquidity demands, including potential margin calls from lenders (as discussed further below). We measure, manage, and forecast our liquidity on a daily basis. Our most liquid assets include unrestricted cash and cash equivalents, U.S.
Treasuries and unencumbered Agency RMBS, CMBS, and CMBS IO. As of
September 30, 2018
, our most liquid assets were
$286.1 million
compared to $283.9 million as of
December 31, 2017
.
We perform sensitivity analysis on our liquidity based on changes in the fair value of our investments due to, among other things, changes in the absolute level of interest rates and the shape of the yield curve, credit spreads, lender haircuts, and prepayment speeds as well as changes in the fair value of our derivative instruments due to changes in the absolute level of interest rates and the shape of the yield curve. In performing this analysis we will also consider the current state of the fixed income markets and the repurchase agreement markets in order to determine if market forces such as supply-demand imbalances or structural changes to these markets could change the liquidity of MBS or the availability of financing. The objective of our analysis is to assess the adequacy of our liquidity to withstand potential adverse events. We may change our leverage targets based on market conditions and our perceptions of the liquidity of our investments.
We closely monitor our debt-to-invested equity ratio (which is the ratio of debt financing to invested equity for any investment) as part of our liquidity management process as well as our overall enterprise level debt-to-equity ratio. We also monitor the ratio of our available liquidity to outstanding repurchase agreement borrowings, which fluctuates due to changes in the fair value of collateral we have pledged to our lenders. Including our TBA dollar roll positions at cost (if settled), which was
$780.9 million
as of
September 30, 2018
, our leverage was 6.7 times shareholders’ equity. It is possible under certain market conditions that it may be uneconomical for us to roll our TBA dollar roll positions into future months, which may result in us having to take physical delivery of the underlying securities. Because under those circumstances we would have to fund our total purchase commitment with cash or other financing sources, which may impact our liquidity position, management includes our TBA dollar roll positions at cost (if settled) in evaluating the Company’s leverage.
The following table presents information regarding the balances of our repurchase agreement borrowings and our TBA dollar roll positions for the periods indicated:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Repurchase Agreements
|
|
TBA Dollar Roll Positions
(1)
|
($ in thousands)
|
Balance Outstanding As of Quarter End
|
|
Average Balance Outstanding For the Quarter Ended
|
|
Maximum Balance Outstanding During the Quarter Ended
|
|
Balance Outstanding As of Quarter End
|
|
Average Balance Outstanding For the Quarter Ended
|
September 30, 2018
|
$
|
2,690,858
|
|
|
$
|
2,564,863
|
|
|
$
|
2,701,797
|
|
|
$
|
780,865
|
|
|
$
|
982,665
|
|
June 30, 2018
|
2,514,984
|
|
|
2,716,097
|
|
|
2,844,225
|
|
|
782,408
|
|
|
722,005
|
|
March 31, 2018
|
2,613,892
|
|
|
2,645,714
|
|
|
2,716,729
|
|
|
844,941
|
|
|
863,615
|
|
December 31, 2017
|
2,565,902
|
|
|
2,557,573
|
|
|
2,677,894
|
|
|
829,425
|
|
|
928,329
|
|
September 30, 2017
|
2,519,230
|
|
|
2,616,250
|
|
|
2,801,418
|
|
|
683,813
|
|
|
745,270
|
|
|
|
(1)
|
Balance outstanding as of quarter end and average balance outstanding for the quarter ended includes TBA dollar roll positions as reported at cost (as if settled). Does not include short TBA positions used to hedge interest rate risk exposure from fixed-rate Agency RMBS in applicable periods.
|
Depending on our liquidity levels, investment opportunities, the condition of the credit markets, and other factors, we may from time to time consider the issuance of debt, equity, or other securities. We may also sell investments in order to provide additional liquidity for our operations. While we will attempt to avoid dilutive or otherwise costly issuances, depending on market conditions and in order to manage our liquidity, we could be forced to issue equity or debt securities which may be dilutive to our capital base or our profitability.
On June 29, 2018, the Company entered into a new equity distribution agreement pursuant to which we may offer and sell up to 10,000,000 shares of our common stock from time to time through sales agents in ATM offerings. We issued 1.4 million shares of common stock pursuant to this new equity distribution agreement during the three months ended September 30, 2018 for net cash proceeds of $13.4 million at a discount of approximately 6.2% to book value of $6.75 as of September 30, 2018. During the quarter ended
September 30, 2018
, we issued 32,660 shares of Series B Preferred Stock under our preferred stock ATM program at a discount of approximately 2.5% to its liquidation value of $25.00 per share. Cash proceeds were $0.8 million, net of 1.5% broker commissions and other fees.
Repurchase Agreements
Our repurchase agreement borrowings are generally renewable at the discretion of our lenders without guaranteed roll-over terms. Given the short-term and uncommitted nature of most of our repurchase agreement financing, we attempt to maintain unused capacity under our existing repurchase agreement credit lines with multiple counterparties which helps protect us in the event of a counterparty's failure to renew existing repurchase agreements either with favorable terms or at all. As of
September 30, 2018
, we had repurchase agreement borrowings outstanding with
17
of our
35
available repurchase agreement counterparties at a weighted average borrowing rate of
2.36%
compared to 1.67% as of
December 31, 2017
. Our repurchase agreement borrowings generally carry a rate of interest based on a spread to an index such as LIBOR.
For our repurchase agreement borrowings, we are required to post and maintain margin to the lender (i.e., collateral in excess of the repurchase agreement financing) in order to support the amount of the financing. This excess collateral is often referred to as a “haircut” (and which we also refer to as equity at risk) and is intended to provide the lender some protection against fluctuations in fair value of the collateral and/or the failure by us to repay the borrowing at maturity. The majority of the collateral pledged to our repurchase agreement counterparties is MBS, the fair value of which fluctuates depending on market conditions. If the fair value of the collateral falls below the haircut required by the lender, the lender has the right to demand additional margin, or collateral, to increase the haircut back to the initial amount. These demands are typically referred to as “margin calls”. Declines in the value of investments occur for any number of reasons including but not limited to changes in interest rates, changes in ratings on an investment, changes in actual or perceived liquidity of the investment, or changes in overall market risk perceptions. Additionally, values in Agency RMBS will also decline from the payment delay feature of those securities. Agency RMBS have a payment delay feature whereby Fannie Mae and Freddie Mac announce principal payments on Agency RMBS but do not remit the actual principal payments and interest for 20 days in the case of Fannie Mae and 40 days in the case of Freddie Mac. Because these securities are financed with repurchase agreements, the repurchase agreement lender generally makes a margin call for an amount equal to the product of their advance rate on the repurchase agreement and the announced principal payments on the Agency RMBS. A margin call made by a lender reduces our liquidity until we receive the principal payments and interest 20 to 40 days later.
If we fail to meet any margin call, our lenders also have the right to terminate the repurchase agreement and sell any collateral pledged. Therefore, we attempt to maintain cash and other liquid securities in sufficient amounts to manage our exposure to margin calls by lenders. The lender also has the right to change the required haircut at maturity of the repurchase agreement (if the term is renewed) which would require us to post additional collateral to the lender. The following table presents the weighted average minimum haircut contractually required by our counterparties for MBS pledged as collateral for our repurchase agreement borrowings as of the dates indicated:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
September 30, 2018
|
|
June 30, 2018
|
|
March 31, 2018
|
|
December 31, 2017
|
|
September 30, 2017
|
Agency CMBS and RMBS
|
4.8
|
%
|
|
4.9
|
%
|
|
4.8
|
%
|
|
4.9
|
%
|
|
5.0
|
%
|
Non-Agency CMBS and RMBS
|
—
|
%
|
|
—
|
%
|
|
—
|
%
|
|
15.0
|
%
|
|
15.0
|
%
|
CMBS IO
|
13.3
|
%
|
|
13.3
|
%
|
|
13.7
|
%
|
|
14.6
|
%
|
|
15.0
|
%
|
The counterparties with whom we have the greatest amounts of equity at risk may vary significantly during any given period due to the short-term and generally uncommitted nature of the repurchase agreement borrowings. Equity at risk represents the potential loss to the Company if the counterparty is unable or unwilling to return collateral securing the repurchase agreement borrowing at its maturity. Please refer to
Note 3
for information regarding counterparties with whom we have the greatest amount of equity at risk as of
September 30, 2018
.
The following table discloses our repurchase agreement amounts outstanding and the value of the related collateral pledged by geographic region of our counterparties as of the dates indicated:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
September 30, 2018
|
|
December 31, 2017
|
($ in thousands)
|
Amount Outstanding
|
|
Market Value of Collateral Pledged
|
|
Amount Outstanding
|
|
Market Value of Collateral Pledged
|
North America
|
$
|
1,849,184
|
|
|
$
|
1,994,027
|
|
|
$
|
1,551,758
|
|
|
$
|
1,700,582
|
|
Asia
|
457,221
|
|
|
479,730
|
|
|
489,376
|
|
|
515,593
|
|
Europe
|
384,453
|
|
|
404,229
|
|
|
524,768
|
|
|
548,924
|
|
|
$
|
2,690,858
|
|
|
$
|
2,877,986
|
|
|
$
|
2,565,902
|
|
|
$
|
2,765,099
|
|
Certain of our repurchase agreement counterparties require us to comply with various operating and financial covenants. The financial covenants include, among other things, requirements that we maintain minimum shareholders' equity (usually a set minimum, or a percentage of the highest amount of shareholders' equity since the date of the agreement), limits on maximum decline in shareholders' equity (expressed as a percentage decline in any given period), and limits on maximum leverage (as a multiple of shareholders' equity). Operating requirements include, among other things, requirements to maintain our status as a REIT and to maintain our listing on the NYSE. Violations of one or more of these covenants could result in the lender declaring an event of default which would result in the termination of the repurchase agreement and immediate acceleration of amounts due thereunder. In addition, some of the agreements contain cross default features, whereby default with one lender simultaneously causes default under agreements with other lenders. Violations could also restrict us from paying dividends or engaging in other transactions that are necessary for us to maintain our REIT status.
We monitor and evaluate on an ongoing basis the impact these customary financial covenants may have on our operating and financing flexibility. Currently, we do not believe we are subject to any covenants that materially restrict our financing flexibility.
Derivative Instruments
We are party to certain types of financial instruments that are accounted for as derivative instruments including interest rate swaps, Eurodollar futures and long and short positions in TBA securities. Certain of these derivative instruments may require us to post initial margin at inception and daily variation margin based on subsequent changes in their fair value. The collateral posted as margin by us is typically in the form of cash or Agency MBS. In addition, counterparties may have to post variation margin to us. Generally, as interest rates decline, we will be required to post collateral with counterparties on our interest rate derivatives, and vice versa as interest rates increase. As of
September 30, 2018
, we had cash of
$58.3 million
posted as collateral under these agreements.
As of
September 30, 2018
, approximately $160 million of the Company’s interest rate swaps were entered into under bilateral agreements which contain cross-default provisions with other agreements between the parties. In addition, these bilateral agreements contain financial and operational covenants similar to those contained in our repurchase agreements, as described above. Currently, we do not believe we are subject to any covenants that materially restrict our hedging flexibility.
Our TBA contracts are subject to master securities forward transaction agreements published by the Securities Industry and Financial Markets Association as well as supplemental terms and conditions with each counterparty. Under the terms of these agreements, we may be required to pledge collateral to, or have the right to receive collateral from, our counterparties when initiated or in the event the fair value of our TBA contracts declines. Declines in the fair value of TBA contracts are generally related to such factors as rising interest rates, increases in expected prepayment speeds, or widening spreads. Our TBA contracts generally provide that valuations for our TBA contracts and any pledged collateral are to be obtained from a generally recognized source agreed to by both parties. However, in certain circumstances, our counterparties have the sole discretion to determine the value of the TBA contract and any pledged collateral. In such instances, our counterparties are required to act in good faith in making determinations of value. In the event of a margin call, we must generally provide additional collateral on the same business day.
Dividends
As a REIT, we are required to distribute to our shareholders amounts equal to at least 90% of our REIT taxable income for each taxable year after consideration of our tax NOL carryforwards. We generally fund our dividend distributions through our cash flows from operations. If we make dividend distributions in excess of our operating cash flows during the period, whether for purposes of meeting our REIT distribution requirements or other strategic reasons, those distributions are generally funded either through our existing cash balances or through the return of principal from our investments (either through repayment or sale).
We have a net operating tax loss ("NOL") carryforward that we could use to offset our REIT taxable income distribution requirement. This NOL carryforward had an estimated balance of $89.8 million as of
September 30, 2018
. We also have deferred tax hedge losses on terminated derivative instruments, which will be recognized over the original periods being hedged by those terminated derivatives. These losses have already been recognized in our GAAP earnings but will reduce taxable income over the next ten years as noted in the following table:
|
|
|
|
|
($ in thousands)
|
Tax Hedge Loss Deduction
|
2018
|
$
|
19,149
|
|
2019
|
17,187
|
|
2020
|
5,134
|
|
2021 - 2028
|
2,865
|
|
|
$
|
44,335
|
|
If any of the deferred tax hedge losses for the years noted in the table above result in dividend distributions to our shareholders in excess of REIT taxable income, the excess dividends distributed will be considered a return of capital to the shareholder. Approximately 79% of our common stock dividends declared during the
nine months ended
September 30, 2018
will represent a return of capital to shareholders and not a distribution of REIT taxable income, principally as a result of the amount of the tax hedge loss deduction.
Contractual Obligations
The following table summarizes our contractual obligations by payment due date as of
September 30, 2018
:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
($ in thousands)
|
|
Payments due by period
|
Contractual Obligations:
|
|
Total
|
|
< 1 year
|
|
1-3 years
|
|
3-5 years
|
|
> 5 years
|
Repurchase agreements
(1)
|
|
$
|
2,754,448
|
|
|
$
|
2,754,448
|
|
|
$
|
—
|
|
|
$
|
—
|
|
|
$
|
—
|
|
Non-recourse collateralized financing
(2)
|
|
3,758
|
|
|
1,155
|
|
|
1,501
|
|
|
803
|
|
|
299
|
|
Operating lease obligations
|
|
329
|
|
|
109
|
|
|
220
|
|
|
—
|
|
|
—
|
|
Total
|
|
$
|
2,758,535
|
|
|
$
|
2,755,712
|
|
|
$
|
1,721
|
|
|
$
|
803
|
|
|
$
|
299
|
|
(1) Includes estimated interest payments calculated using interest rates in effect as of
September 30, 2018
.
(2) Amounts shown are for principal only and exclude interest obligations as those amounts are not significant. Non-recourse collateralized financing represents securitization financing that is payable solely from loans and securities pledged as collateral. Payments due by period were estimated based on the principal repayments forecasted for the underlying loans and securities, substantially all of which is used to repay the associated financing outstanding.
Other Matters
As of
September 30, 2018
, we do not believe that any off-balance sheet arrangements exist that are reasonably likely to have a material effect on our current or future financial condition, results of operations, or liquidity other than as discussed above. In addition, we do not have any material commitments for capital expenditures and have not obtained any commitments for funds to fulfill any capital obligations.
RECENT ACCOUNTING PRONOUNCEMENTS
There were no accounting pronouncements issued during the
nine months ended
September 30, 2018
that are expected to have a material impact on the Company’s financial condition or results of operations.
FORWARD-LOOKING STATEMENTS
Certain written statements in this
Quarterly
Report on Form
10-Q
that are not historical facts constitute “forward-looking statements” within the meaning of Section 27A of the 1933 Act and Section 21E of the Exchange Act. Statements in this report addressing expectations, assumptions, beliefs, projections, future plans and strategies, future events, developments that we expect or anticipate will occur in the future, and future operating results are forward-looking statements. Forward-looking statements are based upon management’s beliefs, assumptions, and expectations as of the date of this report regarding future events and operating performance, taking into account all information currently available to us, and are applicable only as of the date of this report. Forward-looking statements generally can be identified by use of words such as “believe”, “expect”, “anticipate”, “estimate”, “plan” “may”, “will”, “intend”, “should”, “could” or similar expressions. We caution readers not to place undue reliance on our forward-looking statements, which are not historical facts and may be based on projections, assumptions, expectations, and anticipated events that do not materialize. Except as required by law, we are not obligated to, and do not intend to, update or revise any forward-looking statement whether as a result of new information, future events, or otherwise.
Forward-looking statements in this
Quarterly
Report on Form
10-Q
may include, but are not limited to statements about:
|
|
•
|
Our business and investment strategy including our ability to generate acceptable risk-adjusted returns and our target investment allocations, and our views on the future performance of MBS and other investments;
|
|
|
•
|
Our views on conditions in the investment, credit, and derivatives markets;
|
|
|
•
|
Our views on the effect of actual or proposed actions of the U.S. Federal Reserve, the FOMC, or other central banks with respect to monetary policy (including the targeted Federal Funds Rate), and the potential impact of these actions on interest rates, inflation or unemployment;
|
|
|
•
|
The effect of regulatory initiatives of the Federal Reserve (including the FOMC), other financial regulators, and other central banks;
|
|
|
•
|
Our financing strategy including our target leverage ratios, our use of TBA dollar roll transactions, and anticipated trends in financing costs, and our hedging strategy including changes to the derivative instruments to which we are a party, and changes to government regulation of hedging instruments and our use of these instruments;
|
|
|
•
|
Our investment portfolio composition and target investments;
|
|
|
•
|
Our investment portfolio performance, including the fair value, yields, and forecasted prepayment speeds of our investments;
|
|
|
•
|
Our liquidity and ability to access financing, and the anticipated availability and cost of financing;
|
|
|
•
|
Our stock repurchase activity and the impact of stock repurchases;
|
|
|
•
|
Our use of and restrictions on using our tax NOL carryforward;
|
|
|
•
|
The status of pending litigation;
|
|
|
•
|
The competitive environment in the future, including competition for investments and the availability of financing;
|
|
|
•
|
Estimates of future interest expenses, including related to the Company’s repurchase agreements and derivative instruments;
|
|
|
•
|
The status and effect of legislative reforms and regulatory rule-making or review processes, and the status of reform efforts and other business developments in the repurchase agreement financing market;
|
|
|
•
|
Market, industry and economic trends, and how these trends and related economic data may impact the behavior of market participants and financial regulators; and
|
|
|
•
|
Market interest rates and market spreads.
|
Forward-looking statements are inherently subject to risks, uncertainties and other factors that could cause our actual results to differ materially from historical results or from any results expressed or implied by such forward-looking statements. Not all of these risks and other factors are known to us. New risks and uncertainties arise over time, and it is not possible to predict those events or how they may affect us. The projections, assumptions, expectations or beliefs upon which the forward-looking statements are based can also change as a result of these risks or other factors. If such a risk or other factor materializes in future periods, our business, financial condition, liquidity and results of operations may vary materially from those expressed or implied in our forward-looking statements.
While it is not possible to identify all factors that may cause actual results to differ from historical results or from any results expressed or implied by forward-looking statements, or that may cause our projections, assumptions, expectations or beliefs to change, some of those factors include the following:
|
|
•
|
the risks and uncertainties referenced in this
Quarterly
Report on Form
10-Q
, particularly those set forth under and incorporated by reference into Part II, Item 1A, “Risk Factors”;
|
|
|
•
|
our ability to find suitable reinvestment opportunities;
|
|
|
•
|
changes in domestic economic conditions;
|
|
|
•
|
changes in interest rates and interest rate spreads, including the repricing of interest-earning assets and interest-bearing liabilities;
|
|
|
•
|
our investment portfolio performance particularly as it relates to cash flow, prepayment rates and credit performance;
|
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Market risk is the exposure to losses resulting from changes in market factors. Our business strategy exposes us to a variety of market risks, including interest rate, spread, prepayment, reinvestment, credit, and liquidity risks. These risks can and do cause fluctuations in our comprehensive income and book value as discussed below.
Interest Rate Risk
Investing in interest-rate sensitive investments such as MBS and TBA securities subjects us to interest rate risk. Interest rate risk results from investing in securities that have a fixed coupon or when the coupon may not immediately adjust for changes in interest rates. Interest rate risk also results from the mismatch between the duration of our assets versus the duration of our liabilities and hedges.
The measures of an instrument’s price sensitivity to interest rate fluctuations are its duration and convexity. Duration measures the percentage change in projected market value of our investments and derivative instruments given a change in interest rates. The duration of RMBS and TBA securities tend to increase when interest rates rise and decrease when interest rates fall, which is commonly referred to as negative convexity. This occurs because prepayments of the mortgage loans underlying the RMBS tend to decline when interest rates rise (which extends the life of the security) and increase when interest rates fall (which shortens the life of the security). The fair value of TBA securities react similarly to RMBS to changes in interest rates as they are based on an underlying non-specified pool of fixed-rate RMBS securities. CMBS and CMBS IO, however, generally have little convexity because the mortgage loans underlying the securities contain some form of prepayment protection provision (such as prepayment lock-outs) or prepayment compensation provisions (such as yield maintenance or prepayment penalties) which create an economic disincentive for the loans to prepay.
We attempt to manage our exposure to changes in interest rates that results from the duration mismatch between our assets and liabilities by entering into interest rate swaps and other instruments to hedge this risk. We manage interest rate risk within tolerances set by our Board of Directors. Our portfolio duration changes based on the composition of our investment portfolio and our hedge positions as well as market factors. We calculate our portfolio duration based on modeled projected cash flows, and such calculated duration can be an imprecise measure of actual interest rate risk. In the case of Agency RMBS and TBA securities, the primary input to the calculated duration is the anticipated prepayment speed of the underlying mortgage loans, which is sensitive to future interest rates and borrowers’ behavior. Estimates of prepayment speeds can vary significantly by investor for the same security and therefore estimates of security and portfolio duration can vary significantly.
During a period of rising interest rates (particularly short term rates in a flattening yield curve environment), normally our borrowing costs will increase faster than our asset yields, negatively impacting our net interest income. The amount of the impact will depend on the composition of our portfolio, our hedging strategy, the effectiveness of our hedging instruments as well as the magnitude and the duration of the increase in interest rates.
As of
September 30, 2018
, we had a positive net duration gap in our investment portfolio. This indicates that our liabilities mature or reset sooner than our investments, and we have not fully hedged this difference. Therefore, increases in interest rates, particularly rapid increases, will negatively impact the market value of our investments, thereby reducing our book value. The table below shows the projected sensitivity of our net interest income (excluding TBA drop income) and net periodic interest costs on our interest rate swaps; the projected sensitivity of the market value of our investments and derivative instruments (including TBA securities); and the percentage change in shareholders’ equity based on an instantaneous parallel shift in market interest rates as of the dates indicated.
Changes in types of our investments, the returns earned on these investments, future interest rates, credit spreads, the shape of the yield curve, the availability of financing, and/or the mix of our investments and financings including derivative instruments may cause actual results to differ significantly from the modeled results. There can be no assurance that assumed events used for the model below will occur, or that other events will not occur, that will affect the outcomes; therefore, the tables below and all related disclosures constitute forward-looking statements.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
September 30, 2018
|
|
December 31, 2017
|
|
|
Percentage Change in
|
|
Percentage Change in
|
Parallel Shift in Interest Rates
|
|
Market Value of Investments
(1)
|
|
Shareholders’ Equity
|
|
Net Interest Income and Net Periodic Interest Costs
(2)
|
|
Market Value of Investments
(1)
|
|
Shareholders’ Equity
|
|
Net Interest Income and Net Periodic Interest Costs
(2)
|
+100
|
|
(1.8
|
)%
|
|
(11.0
|
)%
|
|
4.5
|
%
|
|
(1.7
|
)%
|
|
(10.0
|
)%
|
|
(8.1
|
)%
|
+50
|
|
(0.7
|
)%
|
|
(4.5
|
)%
|
|
2.7
|
%
|
|
(0.7
|
)%
|
|
(4.0
|
)%
|
|
(3.2
|
)%
|
-50
|
|
0.4
|
%
|
|
2.5
|
%
|
|
(5.9
|
)%
|
|
0.3
|
%
|
|
1.8
|
%
|
|
0.7
|
%
|
-100
|
|
0.3
|
%
|
|
1.9
|
%
|
|
(16.2
|
)%
|
|
0.3
|
%
|
|
1.6
|
%
|
|
2.3
|
%
|
|
|
(1)
|
Includes changes in market value of our investments and derivative instruments, including TBA securities, but excludes changes in market value of our financings because they are not carried at fair value on our balance sheet. The projections for market value do not assume any change in credit spreads.
|
|
|
(2)
|
Includes changes in net interest income as well as net periodic interest costs on our interest rate swaps recorded in “gain (loss) on derivatives instruments, net”. TBA drop income is not included in the sensitivity analysis for net interest income and net periodic interest costs.
|
We entered into additional interest rate swaps to hedge the interest rate risk resulting from the implied financing cost inherent in our TBA dollar roll positions; however, the projected sensitivity of TBA drop income (implied interest income less implied financing costs) are not included in the net interest income sensitivity analysis. Because we held a higher projected average notional balance of effective interest rate swaps for the 12-month projection as of
September 30, 2018
compared to the 12-month projection as of December 31, 2017, a parallel increase in interest rates is projected to increase our net interest income and net periodic benefit/cost (and decrease if interest rates decline) for the 12-month projection as of
September 30, 2018
compared to the 12-month projection as of December 31, 2017.
Management also considers changes in the shape of the interest rate curves in assessing and managing portfolio interest rate risk. Often interest rates do not move in a parallel fashion from quarter to quarter. The table below shows the percentage change in projected market value of our investment portfolio net of derivative instruments for instantaneous changes in the shape of the U.S. Treasury (“UST”) curve (with similar changes to the interest rate swap curves) as of the dates indicated:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
September 30, 2018
|
|
December 31, 2017
|
Basis Point Change in
|
|
Percentage Change in
|
2-year UST
|
|
10-year UST
|
|
Market Value of Investments
(1)
|
|
Shareholders’ Equity
|
|
Market Value of Investments
(1)
|
|
Shareholders’ Equity
|
+25
|
|
+50
|
|
(0.6
|
)%
|
|
(3.4
|
)%
|
|
(0.5
|
)%
|
|
(3.0
|
)%
|
+25
|
|
+0
|
|
(0.2
|
)%
|
|
(1.0
|
)%
|
|
(0.2
|
)%
|
|
(0.9
|
)%
|
+50
|
|
+25
|
|
(0.5
|
)%
|
|
(3.0
|
)%
|
|
(0.5
|
)%
|
|
(2.8
|
)%
|
+50
|
|
+100
|
|
(1.5
|
)%
|
|
(8.9
|
)%
|
|
(1.3
|
)%
|
|
(7.7
|
)%
|
-10
|
|
-50
|
|
0.2
|
%
|
|
1.3
|
%
|
|
0.1
|
%
|
|
0.8
|
%
|
|
|
(1)
|
Includes changes in market value of our investments and derivative instruments, including TBA securities, but excludes changes in market value of our financings because they are not carried at fair value on our balance sheet. The projections for market value do not assume any change in credit spreads.
|
Spread Risk
Spread risk is the risk of loss from an increase in the market spread between the yield on an investment versus its benchmark index. Changes in market spreads represent the market's valuation of the perceived riskiness of an asset relative to risk-free rates, and widening spreads reduce the market value of our investments as market participants require additional yield to hold riskier assets. Market spreads could change based on macroeconomic or systemic factors as well as the factors specific to a particular security such as prepayment performance or credit performance. Other factors that could impact credit spreads include technical issues such as supply and demand for a particular type of security or FOMC monetary policy. Likewise, most of our investments are fixed-rate or reset in rate over a period of time, and as interest rates rise, we would expect the market value of these investments to decrease.
Fluctuations in spreads typically vary based on the type of investment. Sensitivity to changes in market spreads is derived from models that are dependent on various assumptions, and actual changes in market value in response to changes in market spreads could differ materially from the projected sensitivity if actual conditions differ from these assumptions.
The table below is an estimate of the percentage change in projected market value of our investments (including TBA securities) given the indicated change in market spreads as of the dates indicated:
|
|
|
|
|
|
|
|
Basis Point Change in Market Spreads
|
|
Percentage Change in Projected
Market Value of Investments
|
|
|
September 30, 2018
|
|
December 31, 2017
|
+50
|
|
(3.0
|
)%
|
|
(3.1
|
)%
|
+25
|
|
(1.7
|
)%
|
|
(1.1
|
)%
|
-25
|
|
1.6
|
%
|
|
1.6
|
%
|
-50
|
|
3.2
|
%
|
|
3.2
|
%
|
Prepayment and Reinvestment Risk
Prepayment risk is the risk of an early, unscheduled return of principal on an investment. We are subject to prepayment risk from premiums paid on investments, which are amortized as a reduction in interest income using the effective yield method under GAAP. Principal prepayments on our investments are influenced by changes in market interest rates and a variety of economic, geographic, government policy, and other factors beyond our control.
Loans underlying our CMBS and CMBS IO securities typically have some form of prepayment protection provisions (such as prepayment lock-outs) or prepayment compensation provisions (such as yield maintenance or prepayment penalties). Yield maintenance and prepayment penalty requirements are intended to create an economic disincentive for the loans to prepay; however, the amount of the prepayment penalty required to be paid may decline over time, and as loans age, interest rates decline, or market values of collateral supporting the loans increase, prepayment penalties may lessen as an economic disincentive to the borrower. Generally, our experience has been that prepayment lock-out and yield maintenance provisions result in stable prepayment performance from period to period. There are no prepayment protections, however, if the loan defaults and is partially or wholly repaid earlier as a result of loss mitigation actions taken by the underlying loan servicer. Historically, we have experienced low default rates on loans underlying CMBS and CMBS IO.
Because CMBS IO consist of rights to interest on the underlying commercial mortgage loan pools and do not have rights to principal payments on the underlying loans, prepayment risk on these securities would be particularly acute without these prepayment protection provisions. CMBS IO prepayment protection and compensation provisions vary by issuer of the security (i.e. Freddie Mac, Fannie Mae, Ginnie Mae, or non-Agency). The majority of our Agency CMBS IO are issued by Freddie Mac and these securities generally have initial prepayment lock-outs followed by a defeasance period which on average extends to within six months of the stated maturities of the underlying loans. Non-Agency CMBS IO generally have prepayment protection in the form of prepayment lock-outs and defeasance provisions.
Prepayments on the loans underlying our RMBS generally accelerate in a declining interest rate environment, as the loans age, and, with respect to ARMS, as the loans near their respective interest rate reset dates, particularly the initial reset date,
or if expectations are that interest rates will rise in the future. Our prepayment models anticipate an acceleration of prepayments in these events. To the extent the actual prepayments exceed our modeled prepayments, or, with respect to adjustable-rate RMBS, if we change our future prepayment expectations, we will record adjustments to our premium amortization which may negatively impact our net interest income. In addition, changes in market expectations of prepayments could impact the fair value of our RMBS.
We seek to manage our prepayment risk on our MBS by diversifying our investments, seeking investments which we believe will have superior prepayment performance, and investing in securities which have some sort of prepayment prohibition or yield maintenance (as is the case with CMBS and CMBS IO). With respect to RMBS, when we invest in RMBS at a premium to the security’s par value, we tend to favor securities in which we believe the underlying borrowers have some disincentive to refinance as a result of the size of each loan’s principal balance, credit characteristics of the borrower, or geographic location of the property, among other factors.
We are also subject to reinvestment risk as a result of the prepayment, repayment and sales of our investments. In order to maintain our investment portfolio size and our earnings, we need to reinvest capital received from these events into new interest-earning assets or TBA securities. If we are unable to find suitable reinvestment opportunities or if yields on assets in which we reinvest are lower than yields on existing assets, our results and cash flows could be negatively impacted. In addition, based on market conditions, our leverage, and our liquidity profile, we may decide to not reinvest the cash flows we receive from our investment portfolio even when attractive reinvestment opportunities are available, or we may decide to reinvest in assets with lower yield but greater liquidity. If we retain capital or pay dividends to return capital to shareholders rather than reinvest capital, or if we invest capital in lower yielding assets for liquidity reasons, the size of our investment portfolio and the amount of income generated by our investment portfolio will likely decline.
Credit Risk
Credit risk is the risk that we will not receive all contractual amounts due on investments that we own due to default by the borrower or due to a deficiency in proceeds from the liquidation of the collateral securing the obligation. Agency RMBS and Agency CMBS have credit risk to the extent that Fannie Mae or Freddie Mac fails to remit payments on the MBS for which they have issued a guaranty of payment. Given the improved financial performance and conservatorship of these entities and the continued support of the U.S. government, we believe this risk is low. Since Agency CMBS IO represent the right to excess interest and not principal on the underlying loans, these securities are exposed to the loss of investment basis in the event a loan collateralizing the security liquidates without paying yield maintenance or prepayment penalty, which typically occurs when an involuntarily liquidating loan repays all or a portion of its related principal balance.
We are exposed to credit risk on our non-Agency securities and we attempt to mitigate our credit risk through asset selection and by purchasing higher quality non-Agency MBS. Our non-Agency MBS are typically investment grade rated securities which we believe will have strong credit performance. We do not currently seek to purchase heavily discounted, credit sensitive MBS. The majority of our non-Agency securities are CMBS IO and the return we earn on these securities is dependent on the credit performance of the underlying commercial loans. In particular, since investments in CMBS IO pay interest from the underlying commercial mortgage loan pools, returns generally are more negatively impacted by liquidations of loans in the underlying loan pool. Please refer to “Financial Condition-Repurchase Agreements” within Part I, Item 2 of this
Quarterly
Report on Form
10-Q
for information regarding the credit ratings on our non-Agency MBS.
Liquidity Risk
We have liquidity risk principally from the use of recourse repurchase agreements to finance our ownership of securities. In general, our repurchase agreements provide a source of uncommitted short-term financing for longer-term assets, thereby creating a mismatch between the maturities of the asset and the associated financing. Our repurchase agreements are renewable at the discretion of our lenders and do not contain guaranteed roll-over terms. If we fail to repay the lender at maturity, the lender has the right to immediately sell the collateral and pursue us for any shortfall if the sales proceeds are inadequate to cover the repurchase agreement financing. In addition, declines in the market value of our investments pledged as collateral for repurchase agreement borrowings may result in counterparties initiating margin calls for additional collateral.
Our use of TBA long positions as a means of investing in and financing Agency RMBS also exposes us to liquidity risk in the event that we are unable to roll or terminate our TBA contracts prior to their settlement date. If we are unable to roll or terminate our TBA long positions, we could be required to take physical delivery of the underlying securities and settle our obligations for cash, which could negatively impact our liquidity position or force us to sell assets under adverse conditions if financing is not available to us on acceptable terms.
For further information, including how we attempt to mitigate liquidity risk and monitor our liquidity position, please refer to “Liquidity and Capital Resources” in Part I, Item 2 of this
Quarterly
Report on Form
10-Q
.