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EX-32.2 - Invesco Mortgage Capital Inc.exhibit32-208132010.htm
EX-10 - Invesco Mortgage Capital Inc.exhibit10-108132010.htm
EX-31.1 - Invesco Mortgage Capital Inc.exhibit31-108132010.htm
EX-32.1 - Invesco Mortgage Capital Inc.exhibit32-108132010.htm
EX-31.2 - Invesco Mortgage Capital Inc.exhibit31-208132010.htm
 

 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 

FORM 10-Q

 (Mark One)
 
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the quarterly period ended June 30, 2010
 
OR

¨
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the transition period from                                                                     to                      
 
Commission file number 001-34385
 

 
 
INVESCO MORTGAGE CAPITAL INC.
(Exact Name of Registrant as Specified in Its Charter)

 
Maryland
26-2749336
(State or Other Jurisdiction of
Incorporation or Organization)
(I.R.S. Employer
Identification No.)
 
1555 Peachtree Street, N.E., Suite 1800
Atlanta, Georgia
 
 
30309
(Address of Principal Executive Offices)
(Zip Code)
 
(404) 892-0896
(Registrant’s Telephone Number, Including Area Code) 

 
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months(or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).      Yes  ¨    No  ¨
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large Accelerated filer  ¨                                                      Accelerated filer  ¨
 
                                       Non-Accelerated filer x                                                             Smaller reporting company   ¨
 
                                       (Do not check if a smaller reporting company)
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).   Yes  ¨    No  x

As of August 9, 2010, there were 26,047,682 outstanding shares of common stock of Invesco Mortgage Capital Inc.
 
 
 
 
 

 

INVESCO MORTGAGE CAPITAL INC.
TABLE OF CONTENTS

Page
PART I FINANCIAL INFORMATION
  1
     
Item 1.
Consolidated Financial Statements
  1
     
 
Consolidated Balance Sheets as of June 30, 2010 (unaudited ) and December 31, 2009
  1
     
 
Unaudited Consolidated Statements of Operations for the three and six months ended
June 30, 2010 and 2009
 
2
     
 
Unaudited Consolidated Statement of Shareholders’ Equity and Comprehensive Income for the six months ended June 30, 2010
3
     
 
Unaudited Consolidated Statements of Cash Flows for the six months ended June 30, 2010 and 2009
4
     
 
Notes to Consolidated Financial Statements
 5
     
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
  21
     
Item 3. 
Quantitative and Qualitative Disclosures About Market Risk
  35
     
Item 4. 
Controls and Procedures
  37
     
PART II OTHER INFORMATION
  38
     
Item 1
Legal Proceedings
  38
     
Item1A.
Risk Factors
  38
     
Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds
  38
     
Item 3.
Defaults Upon Senior Securities
  38
     
Item 4
Reserved
  38
     
Item 5.
Other Information
  38
     
Item 6.
Exhibits
  40

 
 



 
 

 

PART I
ITEM 1.   FINANCIAL STATEMENTS


INVESCO MORTGAGE CAPITAL INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS



$ in thousands, except per share amounts
 
As of
 
ASSETS
 
June 30,
2010
   
December 31,
2009
 
   
(Unaudited)
       
 
Mortgage-backed securities, at fair value
    2,315,492       802,592  
Cash
    16,235       24,041  
Restricted cash
    30,877       14,432  
Principal paydown receivable
    21,752       2,737  
Investments in unconsolidated limited partnerships, at fair value
    42,585       4,128  
Accrued interest receivable
    10,477       3,518  
Prepaid insurance
    921       681  
Deferred offering costs
          288  
Other assets
    568       983  
Total assets
    2,438,907       853,400  
                 
LIABILITIES AND EQUITY
               
Liabilities:
               
Repurchase agreements
    1,676,348       545,975  
TALF financing
    151,757       80,377  
Derivative liability, at fair value
    31,294       3,782  
Dividends and distributions payable
    20,329       10,828  
Payable for investment securities purchased
    7,548        
Accrued interest payable
    1,343       598  
Accounts payable and accrued expenses
    1,420       665  
Due to affiliate
    2,090       865  
Total liabilities
    1,892,129       643,090  
                 
Equity:
               
Preferred Stock: par value $0.01 per share; 50,000,000 shares authorized, 0 shares issued and outstanding
           
Common Stock: par value $0.01 per share; 450,000,000 shares authorized, 26,046,767 and 8,887,212 shares issued and outstanding, at June 30, 2010 and December 31, 2009, respectively
    261       89  
Additional paid in capital
    514,400       172,385  
Accumulated other comprehensive income
    904       7,721  
Retained earnings
    633       320  
Total shareholders’ equity
    516,198       180,515  
                 
Non-controlling interest
    30,580       29,795  
Total equity
    546,778       210,310  
                 
Total liabilities and equity
    2,438,907       853,400  

The accompanying notes are an integral part of these consolidated financial statements.
 
 

 
 
1

 

INVESCO MORTGAGE CAPITAL INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)
  
   
Three Months Ended
June 30,
   
Six Months Ended
June 30,
 
$ in thousands, except per share data
 
2010
   
2009
   
2010
   
2009
 
Revenues
                       
Interest income
    29,207             47,217        
Interest expense
    6,379             10,031        
Net interest income
    22,828             37,186        
                                 
Other income (loss)
Gain on sale of investments, net
     642               1,375        
Equity in earnings and fair value change in unconsolidated limited partnerships
     1,649               2,095        
Loss on other-than-temporarily impaired securities
    (262 )           (386 )      
Unrealized loss on interest rate swaps
    (10 )           (35 )      
Total other income
    2,019             3,049        
                                 
Expenses
                               
Management fee – related party
    1,771             3,055        
General and administrative
    284       59       466       104  
Insurance
    347       15       693       15  
Professional Fees
    386       10       795       13  
Total expenses
    2,788       84       5,009       (132 )
Net income (loss)
    22,059       (84 )     35,226       (132 )
                                 
Net income attributable to non-controlling interest
    1,309             2,427        
Net income (loss) attributable to common shareholders
    20,750       (84 )     32,799       (132 )
Earnings per share:
                               
Net income attributable to common shareholders (basic/diluted)
     0.91    
NM
      1.70    
NM
 
Dividends declared per common share
    0.74             1.52        
Weighted average number of shares of common stock:
                               
Basic
    22,808    
NM
      19,266    
NM
 
Diluted
    24,239             20,695        
                                 

NM = not meaningful

The accompanying notes are an integral part of these consolidated financial statements.


 
2

 

INVESCO MORTGAGE CAPITAL INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF SHAREHOLDERS’ EQUITY AND COMPREHENSIVE INCOME
For the six months ended June 30, 2010
(Unaudited)

   
Attributable to Common Shareholders
                   
$ in thousands, except per share amounts
 
Common Stock
Shares Amount
   
Additional Paid in Capital
   
Accumulated Other Comprehensive Income (Loss)
   
Retained Earnings (Deficit)
   
Total Shareholders’
Equity
   
Non-Controlling Interest
   
Total Equity
   
Comprehensive Income (Loss)
 
Balance at January 1, 2010
    8,887,212       89       172,385       7,721       320       180,515       29,795       210,310       26,470  
Net income
                            32,799       32,799       2,427       35,226       35,226  
Comprehensive income
                                                                       
Change in net unrealized gains and losses on available for sale securities
                      18,778             18,778       2,401       21,179       21,179  
Change in net unrealized gains and losses on derivatives
                      (25,595 )           (25,595 )     (1,882 )     (27,477 )     (27,477 )
Total comprehensive income
                                                                    55,398  
Net proceeds from common stock, net of offering costs
    17,157,800       172       341,959                   342,131             342,131          
Stock awards to directors
    1,755                                                    
Common stock dividends
                            (32,486 )     (32,486 )           (32,486 )        
Common unit dividends
                                        (2,166 )     (2,166 )        
Amortization of equity-based compensation
                56                   56       5       61          
Balance at June 30, 2010
    26,046,767       261       514,400       904       633       516,198       30,580       546,778          


The accompanying notes are an integral part of this consolidated financial statement.


 
3

 

INVESCO MORTGAGE CAPITAL INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

   
Six Months Ended June 30,
 
$ in thousands
 
2010
   
2009
 
Cash Flows from Operating Activities
           
Net income (loss)
    35,225       (132 )
Adjustments to reconcile net income (loss) to net cash provided by operating activities
               
Amortization of premiums and discounts, net – mortgage-backed securities
    (5,423 )      
Unrealized loss on derivatives
    35        
Gain on sale of mortgage-backed securities
    (1,375 )      
Loss on other-than-temporarily impaired securities
    386        
Equity in earnings and fair value change in unconsolidated limited partnerships
    (2,095 )      
Amortization of equity-based compensation
    61        
Changes in operating assets and liabilities
             
Increase in accrued interest
    (6,959 )      
Increase in prepaid insurance
    (240 )      
(Increase) decrease in deferred offering costs
    146       (1,436 )
(Increase) decrease in other assets
    415       (1,388 )
Increase in accrued interest payable
    745        
Increase in due to affiliate
    1,033       327  
Increase in accounts payable and accrued expenses
    1,085       2,629  
Net cash provided by operating activities
    23,039        
                 
Cash Flows from Investing Activities
               
Purchase of mortgage-backed securities
    (1,826,855 )      
Investment in PPIP
    (36,134 )      
Principal payments of mortgage-backed securities
    160,835        
Proceeds from sale of mortgage-backed securities
    169,016        
Net cash used in investing activities
    (1,533,138 )      
                 
Cash Flows from Financing Activities
               
Proceeds from issuance of common stock
    342,136        
Increase in restricted cash
    (16,445 )      
Proceeds from repurchase agreements
    6,720,307        
Principal repayments of repurchase agreements
    (5,589,934 )      
Proceeds from TALF financing
    71,525        
Principal payments of TALF financing
    (145 )      
Payments of dividends and distributions
    (25,151 )      
Net cash provided by financing activities
    1,502,293        
                 
Net change in cash
    (7,806 )      
Cash, Beginning of Period
    24,041       1  
                 
Cash, End of Period
    16,235       1  
Supplement disclosure of cash flow information
               
Interest paid
    9,247        
                 
Non-cash investing and financing activities information
               
Net change in unrealized gain (loss) on available-for-sale securities and derivatives
    (6,298 )      
Net change in investment in PPIP
    228        
Purchase of mortgage-backed securities, unsettled
          (184,333 )
Obligation to brokers incurred for purchase of mortgage-backed securities
          184,333  
                 
Common stock subscribed – 8,575,000 shares at $20 per share
          171,500  
Subscription receivable – 8,500,000 shares at $20 per share
          (170,000 )
Subscription receivable, related party – 75,000 shares at $20 per share
          (1,500 )
Dividends and distributions declared not paid
    20,329        
                 
The accompanying notes are an integral part of these consolidated financial statements.
 
 
 

 
 
4

 


 
INVESCO MORTGAGE CAPITAL INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
 
Note 1 – Organization and Business Operations

Invesco Mortgage Capital Inc. (the “Company”) is a Maryland corporation focused on investing in, financing and managing residential and commercial mortgage-backed securities and mortgage loans. The Company invests in residential mortgage-backed securities (“RMBS”) for which a U.S. Government agency such as the Government National Mortgage Association (“Ginnie Mae”), the Federal National Mortgage Association (“Fannie Mae”) or the Federal Home Loan Mortgage Corporation (“Freddie Mac”) guarantees payments of principal and interest on the securities (collectively “Agency RMBS”). The Company’s Agency RMBS investments include mortgage pass-through securities and collateralized mortgage obligations (“CMOs”). The Company also invests in residential mortgage-backed securities that are not issued or guaranteed by a U.S. government agency (“Non-Agency RMBS”), commercial mortgage-backed securities (“CMBS”), and residential and commercial mortgage loans. The Company is externally managed and advised by Invesco Advisers, Inc. (the “Manager”), a registered investment adviser and an indirect, wholly-owned subsidiary of Invesco Ltd. (“Invesco”), a global investment management company.

The Company conducts its business through IAS Operating Partnership LP (the “Operating Partnership”) as its sole general partner. As of June 30, 2010, the Company owned 94.8% of the Operating Partnership and Invesco Investments (Bermuda) Ltd., a direct, wholly-owned subsidiary of Invesco, owned the remaining 5.2%.
 
The Company finances its Agency RMBS and Non-Agency RMBS investments through short-term borrowings structured as repurchase agreements. The Manager has secured commitments for the Company with a number of repurchase agreement counterparties. In addition, the Company has financed its CMBS portfolio with financings under the U.S. government’s Term Asset-Backed Securities Loan Facility (“TALF”). The Company has also financed, and may do so again in the future, investments in CMBS through short-term borrowings structured as repurchase agreements. The Company also finances its investments in certain Non-Agency RMBS, CMBS and residential and commercial mortgage loans by contributing capital to a partnership that invests in public-private investment funds (“PPIF”) managed by the Company’s Manager. In addition, the Company may use other sources of financing including committed borrowing facilities and other private financing.

The Company intends to elect and qualify to be taxed as a real estate investment trust (“REIT”) for U.S. federal income tax purposes under the provisions of the Internal Revenue Code of 1986, as amended (“Code”), commencing with the Company’s taxable year ended December 31, 2009. To maintain the Company’s REIT qualification, the Company is generally required to distribute at least 90% of its taxable income (excluding net capital gains) to its shareholders annually. 

Note 2 – Summary of Significant Accounting Policies

Basis of Quarterly Presentation

The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information and with the instructions to Form 10-Q and Rule 10-01 of Regulation S-X. In the opinion of management, all adjustments (consisting of normal recurring adjustments) necessary for a fair presentation of the financial position and the results of operations of the Company for the interim periods presented have been included. The interim consolidated financial statements should be read in conjunction with the Company’s consolidated financial statements and related notes thereto included in the Company’s annual report on Form 10-K for the year ended December 31, 2009 which was filed with the Securities and Exchange Commission (the “SEC”) on March 24, 2010 and amended on April 29, 2010. The results of operations for the interim period ended June 30, 2010 are not necessarily indicative of the results to be expected for the full year or any other future period.


 
5

 

Principles of Consolidation

The consolidated financial statements include the accounts of the Company and its subsidiaries. All intercompany balances and transactions have been eliminated.

Use of Estimates
 
The accounting and reporting policies of the Company conform to U.S. GAAP. The preparation of consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Examples of estimates include, but are not limited to, estimates of the fair values of financial instruments, interest income on mortgage-backed securities (“MBS”) and other-than-temporary impairment charges. Actual results may differ from those estimates.
 
Cash and Cash Equivalents

The Company considers all highly liquid investments that have original or remaining maturity dates of three months or less when purchased to be cash equivalents. At June 30, 2010, the Company had cash and cash equivalents, including amounts restricted, in excess of the Federal Deposit Insurance Corporation, or FDIC, deposit insurance limit of $250,000 per institution. The Company mitigates its risk of loss by placing cash and cash equivalents with numerous major financial institutions.

Deferred Offering Costs
 
The Company records costs associated with stock offerings as a reduction in additional paid in capital. At December 31, 2009, deferred offering costs consisted of legal and other costs of approximately $288,000 related to the follow-on public offering which was completed on January 15, 2010 (the “January Offering”).

Underwriting Commissions and Costs

Underwriting commissions and direct costs incurred in connection with the Company’s initial public offering (“IPO”) and the subsequent follow-on offerings are reflected as a reduction of additional paid-in-capital.

Repurchase Agreements
 
The Company finances its Agency RMBS, Non-Agency RMBS and CMBS investment portfolio through the use of repurchase agreements. Repurchase agreements are treated as collateralized financing transactions and are carried at their contractual amounts, including accrued interest, as specified in the respective agreements.

In instances where the Company acquires Agency RMBS, Non-Agency RMBS or CMBS through repurchase agreements with the same counterparty from whom the Agency RMBS, Non-Agency RMBS or CMBS were purchased, the Company accounts for the purchase commitment and repurchase agreement on a net basis and records a forward commitment to purchase Agency RMBS, Non-Agency RMBS or CMBS as a derivative instrument if the transaction does not comply with the criteria for gross presentation. All of the following criteria must be met for gross presentation in the circumstance where the repurchase assets are financed with the same counterparty:

       ·  
the initial transfer of and repurchase financing cannot be contractually contingent;

       ·  
the repurchase financing entered into between the parties provides full recourse to the transferee and the repurchase price is fixed;

       ·  
the financial asset has an active market and the transfer is executed at market rates; and

       ·  
the repurchase agreement and financial asset do not mature simultaneously.
 
 
 

 
 
6

 
 
 
 
If the transaction complies with the criteria for gross presentation, the Company records the assets and the related financing on a gross basis on its balance sheet, and the corresponding interest income and interest expense in its statements of operations. Such forward commitments are recorded at fair value with subsequent changes in fair value recognized in income. Additionally, the Company records the cash portion of its investment in Agency RMBS and Non-Agency RMBS as a mortgage related receivable from the counterparty on its balance sheet.

For assets representing available-for-sale investment securities any change in fair value is reported through consolidated other comprehensive income (loss) with the exception of impairment losses, which are recorded in the consolidated statement of operations.

Fair Value Measurements
 
In January 2010, the FASB updated guidance entitled, “Improving Disclosures about Fair Value Measurements.” The guidance required a number of additional disclosures regarding fair value measurements. Specifically, entities should disclose: (1) the amount of significant transfers between Level 1 and Level 2 of the fair value hierarchy and the reasons for these transfers; (2) the reasons for any transfers in or out of Level 3; and (3) information in the reconciliation of recurring Level 3 measurements about purchases, sales, issuances and settlements on a gross basis. Except for the requirement to disclose information about purchases, sales, issuances, and settlements in the reconciliation of recurring Level 3 measurements on a gross basis, all the amendments are effective for interim and annual reporting periods beginning after December 15, 2009. The Company adopted these provisions in preparing the Consolidated Financial Statements for the period ended March 31, 2010. The adoption of these provisions only affected the disclosure requirements for fair value measurements and as a result had no impact on the Company’s consolidated statements of operations and consolidated balance sheets.

The Company discloses the fair value of its financial instruments according to a fair value hierarchy (levels 1, 2, and 3, as defined). In accordance with U.S. GAAP, the Company is required to provide enhanced disclosures regarding instruments in the level 3 category (which require significant management judgment), including a separate reconciliation of the beginning and ending balances for each major category of assets and liabilities.
 
Additionally, U.S. GAAP permits entities to choose to measure many financial instruments and certain other items at fair value (the “fair value option”). Unrealized gains and losses on items for which the fair value option has been elected are irrevocably recognized in earnings at each subsequent reporting date.

During 2009, the Company elected the fair value option for its investments in unconsolidated limited partnerships. The Company has the one-time option to elect fair value for these financial assets on the election date. The changes in the fair value of these instruments are recorded in equity in earnings and fair value change in unconsolidated limited partnerships in the consolidated statements of operations.

Securities

The Company designates securities as held-to-maturity, available-for-sale, or trading depending on its ability and intent to hold such securities to maturity. Trading and securities available-for-sale are reported at fair value, while securities held-to-maturity are reported at amortized cost. Although the Company generally intends to hold most of its RMBS and CMBS until maturity, the Company may, from time to time, sell any of its RMBS or CMBS as part of its overall management of its investment portfolio and as such will classify its RMBS and CMBS as available-for-sale securities.
 
All securities classified as available-for-sale are reported at fair value, based on market prices from third-party sources, with unrealized gains and losses excluded from earnings and reported as a separate component of shareholders’ equity. When applicable, included with available-for-sale securities are forward purchase commitments on to be announced securities (“TBA”). The Company records TBA purchases on the trade date and the corresponding payable is recorded as an outstanding liability in payable for investments purchased until the settlement date of the transaction.
 
 
 

 
 
7

 
 
 
 
The Company evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market conditions warrant such evaluation. The determination of whether a security is other-than-temporarily impaired involves judgments and assumptions based on subjective and objective factors. Consideration is given to (i) the length of time and the extent to which the fair value has been less than cost, (ii) the financial condition and near-term prospects of recovery, in fair value of the security, and (iii) the Company’s intent and ability to retain its investment in the security for a period of time sufficient to allow for any anticipated recovery in fair value. For debt securities, the amount of the other-than-temporary impairment related to a credit loss or impairments on securities that the Company has the intent or for which it is more likely than not that the Company will need to sell before recovery are recognized in earnings and reflected as a reduction in the cost basis of the security. The amount of the other-than-temporary impairment on debt securities related to other factors is recorded consistent with changes in the fair value of all other available-for-sale securities as a component of consolidated shareholders’ equity in other comprehensive income or loss with no change to the cost basis of the security. 

Interest Income Recognition
 
Interest income on available-for-sale MBS, which includes accretion of discounts and amortization of premiums on such MBS, is recognized over the life of the investment using the effective interest method. Management estimates, at the time of purchase, the future expected cash flows and determines the effective interest rate based on these estimated cash flows and the Company’s purchase price. As needed, these estimated cash flows are updated and a revised yield is computed based on the current amortized cost of the investment. In estimating these cash flows, there are a number of assumptions subject to uncertainties and contingencies, including the rate and timing of principal payments (prepayments, repurchases, defaults and liquidations), the pass through or coupon rate and interest rate fluctuations. In addition, management must use its judgment to estimate interest payment shortfalls due to delinquencies on the underlying mortgage loans. These uncertainties and contingencies are difficult to predict and are subject to future events that may impact management’s estimates and its interest income. Security transactions are recorded on the trade date. Realized gains and losses from security transactions are determined based upon the specific identification method and recorded as gain (loss) on sale of available-for-sale securities in the consolidated statement of operations.

Investments in Unconsolidated Limited Partnerships

The Company has investments in unconsolidated limited partnerships. In circumstances where the Company has a non-controlling interest but is deemed to be able to exert influence over the affairs of the enterprise the Company utilizes the equity method of accounting. Under the equity method of accounting, the initial investment is increased each period for additional capital contributions and a proportionate share of the entity’s earnings and decreased for cash distributions and a proportionate share of the entity’s losses.

The Company elected the fair value option for its investments in unconsolidated limited partnerships. The election for investments in unconsolidated limited partnerships was made upon their initial recognition in the financial statements. The Company has elected the fair value option for the investments in unconsolidated limited partnerships for the purpose of enhancing the transparency of its financial condition.

The Company measures the fair value of the investments in unconsolidated limited partnerships on the basis of the net asset value per share of the investments as permitted in guidance effective for the interim and annual periods ended after December 15, 2009.

Dividends and Distributions Payable

Dividends and distributions payable represent dividends declared at the balance sheet date which are payable to common shareholders and distributions declared at the balance sheet date which are payable to non-controlling interest common unit holders of the Operating Partnership, respectively.
 
 
 

 
 
8

 
 
 
 
 
Earnings per Share
 
The Company calculates basic earnings per share by dividing net income for the period by weighted-average shares of the Company’s common stock outstanding for that period. Diluted income per share takes into account the effect of dilutive instruments, such as units of limited partnership interest in the Operating Partnership (“OP Units”), stock options and unvested restricted stock, but uses the average share price for the period in determining the number of incremental shares that are to be added to the weighted-average number of shares outstanding. For the three and six months ended June 30, 2009, earnings per share is not presented because it is not a meaningful measure of the Company’s performance.

Comprehensive Income

Comprehensive income is comprised of net income, as presented in the consolidated statements of operations, adjusted for changes in unrealized gains or losses on available for sale securities and changes in the fair value of derivatives accounted for as cash flow hedges.

Accounting for Derivative Financial Instruments
 
U.S. GAAP provides disclosure requirements for derivatives and hedging activities with the intent to provide users of financial statements with an enhanced understanding of: (i) how and why an entity uses derivative instruments; (ii) how derivative instruments and related hedged items are accounted for; and (iii) how derivative instruments and related hedged items affect an entity’s financial position, financial performance, and cash flows. U.S. GAAP requires qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about the fair value of and gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative instruments.

The Company records all derivatives on the balance sheet at fair value. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether the Company has elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives designated and qualifying as a hedge of the exposure to changes in the fair value of an asset, liability, or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges. Derivatives designated and qualifying as a hedge of the exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Derivatives may also be designated as hedges of the foreign currency exposure of a net investment in a foreign operation. Hedge accounting generally provides for the matching of the timing of gain or loss recognition on the hedging instrument with the recognition of the changes in the fair value of the hedged asset or liability that are attributable to the hedged risk in a fair value hedge or the earnings effect of the hedged forecasted transactions in a cash flow hedge. The Company may enter into derivative contracts that are intended to economically hedge certain of its risk, even though hedge accounting does not apply or the Company elects not to apply hedge accounting under U.S. GAAP.

Income Taxes
 
The Company intends to elect and qualify to be taxed as a REIT, commencing with the Company’s taxable year ended December 31, 2009. Accordingly, the Company will generally not be subject to U.S. federal and applicable state and local corporate income tax to the extent that the Company makes qualifying distributions to its shareholders, and provided the Company satisfies on a continuing basis, through actual investment and operating results, the REIT requirements including certain asset, income, distribution and stock ownership tests. If the Company fails to qualify as a REIT, and does not qualify for certain statutory relief provisions, it will be subject to U.S. federal, state and local income taxes and may be precluded from qualifying as a REIT for the subsequent four taxable years following the year in which the Company lost its REIT qualification. Accordingly, the Company’s failure to qualify as a REIT could have a material adverse impact on its results of operations and amounts available for distribution to its shareholders.
 
A REIT’s dividend paid deduction for qualifying dividends to the Company’s shareholders is computed using its taxable income as opposed to net income reported on the consolidated financial statements.

 
9

 
 
 
 
Taxable income, generally, will differ from net income reported on the consolidated financial statements because the determination of taxable income is based on tax regulations and not financial accounting principles.
 
The Company may elect to treat certain of its future subsidiaries as taxable REIT subsidiaries (“TRS”). In general, a TRS may hold assets and engage in activities that the Company cannot hold or engage in directly and generally may engage in any real estate or non-real estate-related business. A TRS is subject to U.S. federal, state and local corporate income taxes.
 
While a TRS will generate net income, a TRS can declare dividends to the Company which will be included in its taxable income and necessitate a distribution to its shareholders. Conversely, if the Company retains earnings at a TRS level, no distribution is required and the Company can increase book equity of the consolidated entity. The Company has no adjustments regarding its tax accounting treatment of any uncertainties. The Company expects to recognize interest and penalties related to uncertain tax positions, if any, as income tax expense, which will be included in general and administrative expense.

Share-Based Compensation
 
Share-based compensation arrangements include share options, restricted share plans, performance-based awards, share appreciation rights, and employee share purchase plans. Compensation costs relating to share-based payment transactions are recognized in the consolidated financial statements, based on the fair value of the equity or liability instruments issued on the date of grant, for awards to the Company’s independent directors. Compensation related to stock awards to officers and employees of the Manager are recorded at the estimated fair value of the award during the vesting period. The Company makes an upward or downward adjustment to compensation expense for the difference in the fair value at the date of grant and the date the award was earned.
 
On July 1, 2009, the Company adopted an equity incentive plan under which its independent directors, as part of their compensation for serving as directors, are eligible to receive quarterly restricted stock awards. In addition, the Company may compensate its officers and employees of the Manager under this plan pursuant to the management agreement.
 
Note 3 – Mortgage-Backed Securities

 
All of the Company’s MBS are classified as available-for-sale and, as such, are reported at fair value, determined by obtaining valuations from an independent source. If the fair value of a security is not available from a dealer or third-party pricing service, or such data appears unreliable, the Company may estimate the fair value of the security using a variety of methods including other pricing services, repurchase agreement pricing, discounted cash flow analysis, matrix pricing, option adjusted spread models and other fundamental analysis of observable market factors. At June 30, 2010, all of the Company’s MBS values were based on third-party values. The following tables present certain information about the Company’s investment portfolio at June 30, 2010 and December 31, 2009.  
 
 
 
 
10

 
 
 
 

                                
June 30, 2010
 
 
$ in thousands
 
Principal Balance
   
Unamortized Premium (Discount)
   
Amortized Cost
   
Unrealized
Gain/
(Loss)
   
Fair
Value
   
Net
Weighted Average Coupon (1)
   
Average Yield (2)
 
Agency RMBS:
                                         
15 year fixed-rate
    583,542       28,577       612,119       10,074       622,193       4.88 %     3.36 %
30 year fixed-rate
    651,633       44,251       695,884       11,977       707,861       5.79 %     3.86 %
ARM
    8,787       192       8,979       (257 )     8,722       2.86 %     2.06 %
Hybrid ARM
    57,004       2,459       59,463       702       60,165       4.77 %     2.29 %
Total Agency
    1,300,966       75,479       1,376,445       22,496       1,398,941       5.32 %     3.56 %
                                                         
MBS – CMO
    25,727       1,076       26,803       254       27,057       6.00 %     4.59 %
Non-Agency MBS
    1,050,642       (359,278 )     691,364       (1,255 )     690,109       4.42 %     9.84 %
CMBS
    189,512       (2,552 )     186,960       12,425       199,385       5.02 %     5.29 %
Total
    2,566,847       (285,275 )     2,281,572       33,920       2,315,492       4.93 %     5.62 %


December 31, 2009
$ in thousands
 
Principal Balance
   
Unamortized Premium (Discount)
   
Amortized Cost
   
Unrealized
Gain/
(Loss)
   
Fair
Value
   
Net
Weighted Average Coupon (1)
   
Average Yield (2)
 
Agency RMBS:
                                         
15 year fixed-rate
    251,752       9,041       260,793       1,023       261,816       4.82 %     3.80 %
30 year fixed-rate
    149,911       10,164       160,075       990       161,065       6.45 %     5.02 %
ARM
    10,034       223       10,257       (281 )     9,976       2.52 %     1.99 %
Hybrid ARM
    117,163       5,767       122,930       597       123,527       5.14 %     3.55 %
Total Agency
    528,860       25,195       554,055       2,329       556,384       5.31 %     4.07 %
                                                         
MBS – CMO
    27,819       978       28,797       936       29,733       6.34 %     4.83 %
Non-Agency MBS
    186,682       (79,341 )     107,341       7,992       115,333       4.11 %     17.10 %
CMBS
    104,512       (4,854 )     99,658       1,484       101,142       4.93 %     5.97 %
Total
    847,873       (58,022 )     789,851       12,741       802,592       5.03 %     6.10 %
_____________________

(1) Net weighted average coupon (“WAC”) is presented net of servicing and other fees.
(2) Average yield incorporates future prepayment and loss assumptions.

The components of the carrying value of the Company’s investment portfolio at June 30, 2010 and December 31, 2009 are presented below.

$ in thousands
 
June 30, 2010
   
December 31, 2009
 
Principal balance
    2,566,847       847,873  
Unamortized premium
    78,106       26,174  
Unamortized discount
    (363,381 )     (84,196 )
Gross unrealized gains
    55,592       14,595  
Gross unrealized losses
    (21,672 )     (1,854 )
Fair value
    2,315,492       802,592  

The following table summarizes certain characteristics of the Company’s investment portfolio, at fair value, according to estimated weighted average life classifications as of June 30, 2010 and December 31, 2009:

$ in thousands
 
June 30, 2010
   
December 31, 2009
 
Less than one year
    30,441        
Greater than one year and less than five years
    1,651,524       483,540  
Greater than or equal to five years
    633,527       319,052  
Total
    2,315,492       802,592  
 
 
 

 
11

 

The following tables present the gross unrealized losses and estimated fair value of the Company’s MBS by length of time that such securities have been in a continuous unrealized loss position at June 30, 2010 and December 31, 2009, respectively:

June 30, 2010
 
Less than 12 Months
   
12 Months or More
   
Total
 
$ in thousands
 
Fair Value
   
Unrealized Losses
   
Fair Value
   
Unrealized Losses
   
Fair Value
   
Unrealized Losses
 
Agency RMBS:
                                   
15 year fixed-rate
    13,473       (13 )                 13,473       (13 )
30 year fixed-rate
    15,751       (49 )                 15,751       (49 )
ARM
    8,722       (257 )                 8,722       (257 )
Hybrid ARM
                                   
Total Agency
    37,946       (319 )                 37,946       (319 )
                                                 
MBS – CMO
    7,313       (427 )                 7,313       (427 )
Non-Agency MBS
    419,215       (20,926 )                 419,215       (20,926 )
CMBS
                                   
Total
    464,474       (21,672 )                 464,474       (21,672 )

December 31, 2009
 
Less than 12 Months
   
12 Months or More
   
Total
 
$ in thousands
 
Fair Value
   
Unrealized Losses
   
Fair Value
   
Unrealized Losses
   
Fair Value
   
Unrealized Losses
 
Agency RMBS:
                                   
15 year fixed-rate
    42,446       (82 )                 42,446       (82 )
30 year fixed-rate
    22,195       (70 )                 22,195       (70 )
ARM
    9,976       (281 )                 9,976       (281 )
Hybrid ARM
                                   
Total Agency
    74,617       (433 )                 74,617       (433 )
                                                 
MBS – CMO
                                   
Non-Agency MBS
    13,499       (1,044 )                 13,499       (1,044 )
CMBS
    18,281       (376 )                 18,281       (376 )
Total
    106,397       (1,853 )                 106,397       (1,853 )

The following table presents the impact of the Company’s MBS on its accumulated other comprehensive income for the three and six months ended June 30, 2010. The Company does not consider comparisons of the three and six months ended June 30, 2009 to be meaningful.

$ in thousands
 
Three Months ended June 30, 2010
   
Six Months ended June 30, 2010
 
Accumulated other comprehensive income from investment securities:
           
Unrealized gain on MBS at beginning of period
    18,307       12,741  
Unrealized gain on MBS, net
    15,613       21,179  
Balance at the end of period
    33,920       33,920  

The Company assesses its investment securities for other-than-temporary impairment on at least a quarterly basis. When the fair value of an investment is less than its amortized cost at the balance sheet date of the reporting period for which impairment is assessed, the impairment is designated as either “temporary” or “other-than-temporary.” In deciding on whether or not a security is other than temporarily impaired, the Company considers several factors, including the nature of the investment, communications from the trustees of securitizations regarding the credit quality of the security, the severity and duration of the impairment, the cause of the impairment, and the Company’s intent that it is more likely than not that the Company can hold the security until recovery of its cost basis.

The following table presents the other-than-temporary impairments for the three and six months ended June 30, 2010. We do not consider comparisons of the three and six months ended June 30, 2009 to be meaningful:

 
$ in thousands
 
Three Months ended June 30, 2010
   
Six Months ended June 30, 2010
 
Credit related other-than-temporary impairments included in earnings
    262       386  
Non-credit related other-than-temporary impairments recognized in other comprehensive income
           
Total other-than-temporary impairment losses
    262       386  
 
    The following table presents a roll-forward of the credit loss component of other-than-temporary impairments for the three and six months ended June 30, 2010.  We do not consider the comparisons of the three and six month months ended June 30, 2009 to be meaningful:

 
$ in thousands
 
Three Months ended June 30, 2010
   
Six Months ended June 30, 2010
 
Credit loss amount at the beginning of the period
    124        
Additions for credit losses for which other-than-temporary impairment had not been previously recognized
    262       386  
Credit loss amount at end of period
    386       386  

 
12

 

 
The following table presents components of interest income on the Company’s agency and non-agency portfolio for the three and six months ended June 30, 2010. We do not consider comparisons of the three and six months ended June 30, 2009 to be meaningful:

For the three months ended June 30, 2010
 
$ in thousands
 
Coupon Interest
   
Net (Premium Amortization)/Discount Accretion
   
Interest Income
 
Agency
    14,385       (4,895 )     9,490  
Non-Agency
    8,756       8,334       17,090  
CMBS
    2,564       59       2,623  
Other
    4             4  
Total
    25,709       3,498       29,207  

For the six months ended June 30, 2010
 
$ in thousands
 
Coupon Interest
   
Net (Premium Amortization)/Discount Accretion
   
Interest Income
 
Agency
    23,999       (8,215 )     15,784  
Non-Agency
    13,182       13,468       26,650  
CMBS
    4,601       170       4,771  
Other
    12             12  
Total
    41,794       5,423       47,217  

Note 4 – Investments in Unconsolidated Limited Partnerships

Invesco Mortgage Recovery Feeder Fund, L.P. and Invesco Mortgage Recovery Loans AIV, L.P.

The Company invested in certain Non-Agency RMBS, CMBS and residential and commercial mortgage loans by contributing equity capital to a legacy securities PPIF established and managed by the Manager or one of its affiliates, Invesco Mortgage Recovery Feeder Fund, L.P. (the “Fund”) that receives financing under the U.S. government’s Public-Private Investment Program (“PPIP”). In addition the Manager identified a whole loan transaction for the Company, which resulted in the Company’s admission into an alternative investment vehicle, the Invesco Mortgage Recovery Loans AIV, L.P. (“AIV”). The Company’s initial commitment in the Fund and AIV was $25.0 million. The Fund and AIV limited partnership agreements provided for additional subscriptions of limited partners within six months of the initial closing. During 2009 and 2010 the Fund and AIV accepted additional subscriptions and the Company increased its overall commitment to $100.0, million which effectively increased the Company’s initial ownership interest in the Fund and AIV. As of March 31, 2010, the Fund no longer accepts investment subscriptions and is deemed closed. In connection with the increase of the Company’s interest in the Fund and AIV, the Company is committed to fund approximately $60.0 million of additional capital at June 30, 2010. The Company realized approximately $1.6 million and $1.8 million of equity in earnings and $44,000 and $260,000 of unrealized appreciation from these investments for the three and six months ended June 30, 2010.

The Company’s non-controlling, unconsolidated ownership interests in these entities are accounted for under the equity method. Capital contributions, distributions, profits and losses of the Fund and AIV are allocated in accordance with the terms of the entities’ limited partnership agreements. Such allocations may differ from the stated percentage interests, if any, as a result of preferred returns and allocation formulas as described in such agreements. The Company has made the fair value election for its investment in both unconsolidated limited partnerships. The fair value measurement for the investment in unconsolidated limited partnerships is based on the net asset value per share of the investment, or its equivalent.
 
 
 
 
 
13

 
 
 
 
Note 5 – Borrowings

Repurchase Agreements

The Company has entered into repurchase agreements to finance a portion of its portfolio of investments. The repurchase agreements bear interest at a contractually agreed rate. The repurchase obligations mature and typically reinvest every thirty to ninety days and have a weighted average aggregate interest rate of 0.62% and 0.26% at June 30, 2010 and December 31, 2009, respectively. During the second quarter of 2010, the Company entered into a repurchase agreement with a one year maturity. The facility expires in April 2011. These repurchase agreements are being accounted for as secured borrowings since the Company maintains effective control of the financed assets. The following table summarizes certain characteristics of the Company’s repurchase agreements at June 30, 2010 and December 31, 2009:

$ in thousands
 
June 30, 2010
   
December 31, 2009
 
   
Amount Outstanding
   
Weighted Average
   
Amount Outstanding
   
Weighted Average
 
Agency RMBS
    1,306,680       0.29 %     545,975       0.26 %
Non-Agency RBS
    369,668       1.80 %            
Total
    1,676,348       0.62 %     545,975       0.26 %

Under the repurchase agreements, the respective lender retains the right to mark the underlying collateral to fair value. A reduction in the value of pledged assets would require the Company to provide additional collateral or fund margin calls.  In addition, the repurchase agreements are subject to certain financial covenants. The Company is in compliance with these covenants.

The following tables summarize certain characteristics of the Company’s repurchase agreements at June 30, 2010 and December 31, 2009:

June 30, 2010
$ in thousands
Purchase Agreement Counterparties
 
Amount Outstanding
   
Percent of Total Amount Outstanding
   
Company MBS Held as Collateral
 
Credit Suisse Securities (USA) LLC
    385,430       23 %     455,561  
Barclays Capital Inc.
    97,849       6 %     121,163  
RBS Securities Inc.
    88,255       5 %     105,311  
Deutsche Bank Securities Inc.
    132,842       8 %     142,427  
Goldman, Sachs & Co.
    237,293       14 %     251,181  
BNP Paribas Securities Corp.
    56,705       3 %     59,493  
Wells Fargo Securities, LLC
    252,268       15 %     310,170  
Morgan Stanley & Co. Incorporated
    122,518       8 %     144,862  
JP Morgan Securities Inc.
    170,878       10 %     184,849  
Mitsubishi UFJ Securities (USA), Inc.
    132,310       8 %     139,814  
Total
    1,676,348       100 %     1,914,831  
 
December 31, 2009
$ in thousands
Purchase Agreement Counterparties
 
Amount Outstanding
   
Percent of Total Amount Outstanding
   
 
 
Company MBS Held as Collateral
 
Credit Suisse Securities (USA) LLC
    109,697       20 %     110,501  
Barclay s Capital Inc.
    62,279       12 %     64,228  
RBS Securities Inc.
    83,093       15 %     86,503  
Deutsche Bank Securities Inc.
    115,764       21 %     113,804  
Goldman, Sachs & Co.
    175,142       32 %     182,731  
Total
    545,975       100 %     557,767  

Cash collateral held by the counterparties at June 30, 2010 and December 31, 2009 was $24.0 million and $14.0 million, respectively.
 
 

 
14

 

TALF Financing

Under the TALF, the Federal Reserve made non-recourse loans to borrowers to fund purchases of asset-backed securities (“ABS”). The TALF facility ceased making loans collateralized by newly issued and legacy ABS on March 31, 2010. The Company has secured borrowings of $151.8 million and $80.4 million under the TALF at a weighted average interest rate of 3.56% and 3.82% at June 30, 2010 and December 31, 2009, respectively. The TALF loans are non-recourse. However, they are secured by $199.4 million of CMBS and mature in February 2013, July 2014, August 2014, December 2014 and January 2015.

At June 30, 2010, the TALF financing agreements had the following remaining maturities:
 
 
$ in thousands
 
June 30, 2010
 
2011
     
2012
     
2013
    33,764  
2014
    80,309  
2015
    37,684  
Thereafter
     
Total
    151,757  

Note 6 Derivatives and Hedging Activities

Risk Management Objective of Using Derivatives

The Company is exposed to certain risks arising from both its business operations and general economic conditions. The Company principally manages its exposure to a wide variety of business and operational risks through management of its core business activities. The Company manages economic risks, including interest rate, liquidity, and credit risk primarily by managing the amount, source, and duration of its investments, debt funding, and the use of derivative financial instruments. Specifically, the Company enters into derivative financial instruments to manage exposures that arise from business activities that result in the receipt or payment of future unknown and uncertain cash amounts, the value of which are determined by interest rates. The Company’s derivative financial instruments are used to manage differences in the amount, timing, and duration of the Company’s known or expected cash receipts and its known or expected cash payments principally related to the Company’s investments and borrowings.

Cash Flow Hedges of Interest Rate Risk

The Company finances its investment activities primarily through repurchase agreements, which are generally settled on a short-term basis, usually from one to three months. At each settlement date, the Company refinances each repurchase agreement at the market interest rate at that time. Since the interest rate on its repurchase agreements change on a monthly basis, the Company is exposed to changing interest rates. The Company’s objectives in using interest rate derivatives are to add stability to interest expense and to manage its exposure to interest rate movements. To accomplish this objective, the Company primarily uses interest rate swaps as part of its interest rate risk management strategy. Interest rate swaps designated as cash flow hedges involve the receipt of variable-rate amounts from a counterparty in exchange for the Company making fixed-rate payments over the life of the agreements without exchange of the underlying notional amount.

The effective portion of changes in the fair value of derivatives designated and qualifying as cash flow hedges is recorded in accumulated other comprehensive income and is subsequently reclassified into earnings in the period that the hedged forecasted transaction affects earnings. The ineffective portion of the change in fair value of the derivatives is recognized directly in earnings. During the three and six months ended June 30, 2010, the Company recorded $10,000 and $35,000, respectively, of unrealized swap losses in earnings as hedge ineffectiveness attributable primarily to differences in the reset dates on the Company’s swaps versus the refinancing dates of certain of its repurchase agreements.
 
 
 
15

 
 
 
 
 
Amounts reported in accumulated other comprehensive income related to derivatives will be reclassified to interest expense as interest is accrued and paid on the Company’s repurchase agreements. During the next twelve months, the Company estimates that an additional $16.3 million will be reclassified as an increase to interest expense.
 
The Company is hedging its exposure to the variability in future cash flows for forecasted transactions over a maximum period of 61 months.
 
As of June 30, 2010, the Company had the following interest rate derivatives outstanding, that were designated as cash flow hedges of interest rate risk:

Counterparty
 
Notional Amount
$ in thousands
 
Maturity Date
 
Fixed Interest Rate
in Contract
 
The Bank of New York Mellon
    175,000  
8/5/2012
    2.07%  
SunTrust Bank
    100,000  
7/15/2014
    2.79%  
Credit Suisse International
    100,000  
2/24/2015
    3.26%  
Credit Suisse International
    100,000  
3/24/2015
    2.76%  
The Bank of New York Mellon
    100,000  
5/24/2013
    1.83%  
Wells Fargo Bank, N.A.
    100,000  
7/15/2015
    2.85%  
The Bank of New York Mellon
    200,000  
7/15/2013
    1.73%  
Wells Fargo Bank, N.A.
    50,000  
7/15/2015
    2.44%  
Total/Weighted Average
    925,000         2.35%  

Tabular Disclosure of the Effect of Derivative Instruments on the Balance Sheet

The table below presents the fair value of the Company’s derivative financial instruments, as well as their classification on the balance sheet as of June 30, 2010 and December 31, 2009.

$ in thousands
Asset Derivatives
 
Liability Derivatives
As of June 30, 2010
 
As of December 31, 2009
 
As of June 30, 2010
 
As of December 31, 2009
Balance Sheet
 
Fair Value
 
Balance Sheet
 
Fair Value
 
Balance Sheet
 
Fair Value
 
Balance Sheet
 
Fair Value
Interest rate swap asset
 
 
Interest rate swap asset
 
 
Interest rate swap liability
 
31,294
 
Interest rate swap liability
 
3,782

Tabular Disclosure of the Effect of Derivative Instruments on the Income Statement
 
The table below presents the effect of the Company’s derivative financial instruments on the statement of operations for the three and six months ended June 30, 2010.

Three months ended June 30, 2010

$ in thousands
                     
Derivative
type for
cash flow
hedge
 
Amount of loss recognized
in OCI on derivative
(effective portion)
 
Location of loss
reclassified from
accumulated
OCI into
income
(effective
portion)
 
Amount of loss
reclassified from
accumulated OCI into
income (effective
portion)
 
Location of loss
recognized in
income on
derivative
(ineffective
portion)
 
Amount of loss
recognized in income
on derivative
(ineffective portion)
 
Interest Rate Swap
    25,201  
Interest Expense
    3,070  
Other Expense
    10  

Six months ended June 30, 2010

$ in thousands
                     
Derivative
type for
cash flow
hedge
 
Amount of loss recognized
in OCI on derivative
(effective portion)
 
Location of loss
reclassified from
accumulated
OCI into
income
(effective
portion)
 
Amount of loss
reclassified from
accumulated OCI into
income (effective
portion)
 
Location of loss
recognized in
income on
derivative
(ineffective
portion)
 
Amount of loss
recognized in income
on derivative
(ineffective portion)
 
Interest Rate Swap
    32,347  
Interest Expense
    4,870  
Other Expense
    35  
 
 
 

 
 
16

 
 
 
 
Credit-risk-related Contingent Features

The Company has agreements with each of its derivative counterparties. Some of these agreements contain a provision where if the Company defaults on any of its indebtedness, including default where repayment of the indebtedness has not been accelerated by the lender, then the Company could also be declared in default on its derivative obligations.
 
The Company has an agreement with one of its derivative counterparties that contains a provision where if the Company’s net asset value declines by certain percentages over specified time periods, then the Company could be declared in default on its derivative obligations. The Company also has agreements with certain of its derivative counterparties that contain provisions where if the Company’s shareholders’ equity declines by certain percentages over specified time periods, then the Company could be declared in default on its derivative obligations.

The Company has an agreement with certain of its derivative counterparties that contain provisions where if the Company fails to maintain a minimum shareholders’ equity or market value of $100 million and $80 million, respectively, then the Company could be declared in default on its derivative obligations.

As of June 30, 2010, the fair value of derivatives in a net liability position, which includes accrued interest but excludes any adjustment for nonperformance risk, related to these agreements was $31.9 million. The Company has minimum collateral posting thresholds with certain of its derivative counterparties and has posted collateral of approximately $6.9 million of cash and $33.6 million of agency RMBS. If the Company had breached any of these provisions at June 30, 2010, it could have been required to settle its obligations under the agreements at their termination value.  The Company was in compliance with all of its financial provisions through June 30, 2010.

Note 7 – Financial Instruments

U.S. GAAP defines fair value, provides a consistent framework for measuring fair value under U.S. GAAP and Accounting Standards Codification (ASC) Topic 820 expands fair value financial statement disclosure requirements. ASC Topic 820 does not require any new fair value measurements and only applies to accounting pronouncements that already require or permit fair value measures, except for standards that relate to share-based payments.

Valuation techniques are based on observable and unobservable inputs. Observable inputs reflect readily obtainable data from independent sources, while unobservable inputs reflect the Company’s market assumptions. These inputs into the following hierarchy:

·  
Level 1 Inputs – Quoted prices for identical instruments in active markets.

·  
Level 2 Inputs – Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.

·  
Level 3 Inputs – Instruments with primarily unobservable value drivers.
 
 
 

 
 
17

 

     The fair values at June 30, 2010 and December 31, 2009, on a recurring basis, of the Company’s MBS and interest rate hedges based on the level of inputs are summarized below:

   
June 30, 2010
       
   
Fair Value Measurements Using:
       
$ in thousands
 
Level 1
   
Level 2
   
Level 3
   
Total at Fair Value
 
Assets
                       
Mortgage-backed securities (1)
          2,315,492             2,315,492  
Investments in unconsolidated limited partnerships
                42,585       42,585  
Total
          2,315,492       42,585       2,358,077  
 
Liabilities
                               
Derivatives
          31,294             31,294  
Total
          31,294             31,294  

   
December 31, 2009
       
   
Fair Value Measurements Using:
       
$ in thousands
 
Level 1
   
Level 2
   
Level 3
   
Total at Fair Value
 
Assets
                       
Mortgage-backed securities (1)
          802,592             802,592  
Investments in unconsolidated limited partnerships
                4,128       4,128  
Total
          802,592       4,128       806,720  
 
Liabilities
                               
Derivatives
          3,782             3,782  
Total
          3,782             3,782  
_____________________

(1)  For more detail about the fair value of our MBS and type of securities, see Note 3 in the unaudited consolidated financial statements.

The following table presents additional information about the Company’s investments in unconsolidated limited partnerships which are measured at fair value on a recurring basis for which the Company has utilized level 3 inputs to determine fair value:

$ in thousands
 
June 30, 2010
   
December 31, 2009
 
Beginning balance
    4,128        
Purchases, sales and settlements, net
    36,362       4,057  
Total net gains / (losses) included in net income
               
Realized gains/(losses), net
    1,835       63  
Unrealized gains/(losses), net
    260       8  
Unrealized gain/(losses), net included in other comprehensive income
           
Ending balance
    42,585       4,128  

The fair value of the TALF debt and repurchase agreements are based on an expected present value technique. This method discounts future estimated cash flows using rates the Company determined best reflect current market interest rates that would be offered for loans with similar characteristics and credit quality. At June 30, 2010, the TALF debt had a fair value of $155.9 million and a carrying value of $151.8 million and the repurchase agreements had a fair value of $1.7 billion and a carrying value of $1.7 billion. At December 31, 2009, the TALF debt had a fair value of $80.0 million and a carrying value of $80.4 million and the repurchase agreements had a fair value of $546.1 million and a carrying value of $546.0 million.

Note 8 – Related Party Transactions
 
The Company is externally managed and advised by the Manager. Pursuant to the terms of the management agreement, effective July 1, 2009, the Manager provides the Company with its management team, including its officers, along with appropriate support personnel. Each of the Company’s officers is an employee of Invesco or one of Invesco’s affiliates. The Company does not have any employees. With the exception of the Company’s Chief Financial Officer, the Manager is not obligated to dedicate any of its employees exclusively to the Company, nor is the Manager or its employees obligated to dedicate any specific portion of its or their time to the Company’s business. The Manager is at all times subject to the supervision and oversight of the Company’s board of directors and has only such functions and authority as the Company delegates to it.
 
Management Fee

The Company pays the Manager a management fee equal to 1.50% of the Company’s shareholders’ equity per annum, which is calculated and payable quarterly in arrears. For purposes of calculating the management fee, shareholders’ equity is equal to the sum of the net proceeds from all issuances of equity securities since inception (allocated on a pro rata daily basis for such issuances during the fiscal quarter of any such issuance), plus retained earnings at the end of the most recently completed calendar quarter (without taking into account any non-cash equity compensation expense incurred in current or prior periods), less any amount paid to repurchase common stock since inception, and excluding any unrealized gains, losses or other items that do not affect realized net income (regardless of whether such items are included in other comprehensive income or loss, or in net income). This amount will be adjusted to exclude one-time events pursuant to changes in U.S. GAAP, and certain non-cash items after discussions between the Manager and the Company’s independent directors and approval by a majority of the Company’s independent directors.

A termination fee is due to the Manager upon termination of the management agreement by the Company equal to three times the sum of the average annual management fee earned by the Manager during the 24-month period prior to such termination, calculated as of the end of the most recently completed fiscal quarter.

The Manager has agreed to reduce (but not below zero) the management fee payable by the Company under the management agreement with respect to any equity investment the Company may make in the Fund managed by the Manager or any of its affiliates. In addition, the Company may include any stock-based compensation awarded to personnel of the Manager as a component of the Manger’s compensation.

For the three and six months ended June 30, 2010, the Company incurred management fees of approximately $1.8 million and $3.1 million, respectively of which approximately $1.8 million was accrued but had not been paid.

Expense Reimbursement

Pursuant to the management agreement, the Company is required to reimburse the Manager for operating expenses related to the Company incurred by the Manager, including certain salary expenses and other expenses related to legal, accounting, due diligence and other services. The Company’s reimbursement obligation is not subject to any dollar limitation.

The Company incurred costs, originally paid by Invesco, of approximately $2.1 million and $327,000 for the six months ended June 30, 2010 and 2009, respectively. Approximately $1.2 million and $92,000 was expensed for the six months ended June 30, 2010 and 2009, respectively, and approximately $856,000 was charged against equity as a cost of raising capital for the six months ended June 30, 2010. During the six months ended June 30, 2009, $235,000 of such costs were capitalized as deferred offering costs.

Note 9 – Shareholders’ Equity

Securities Convertible into Shares of Common Stock

As of the completion of the Company’s IPO on July 1, 2009, (i) the limited partners who hold units of the Operating Partnership (“OP Units”) have the right to cause the Operating Partnership to redeem their OP Units for cash equal to the market value of an equivalent number of shares of common stock, or at the Company’s option, the Company may purchase their OP Units by issuing one share of common stock for each OP Unit redeemed, and (ii) the Company adopted an equity incentive plan which includes the ability for the Company to grant securities convertible into the Company’s common stock to the independent directors and the executive officers of the Company and the personnel of the Manager.
 
 
 
 
 
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Registration Rights
 
The Company entered into a registration rights agreement with regard to the common stock and OP Units owned by the Manager and Invesco Investments (Bermuda) Ltd., respectively, upon completion of the Company’s IPO and any shares of common stock that the Manager may elect to receive under the management agreement or otherwise. Pursuant to the registration rights agreement, the Company has granted to the Manager and Invesco Investments (Bermuda) Ltd., (i) unlimited demand registration rights to have the shares purchased by the Manager or granted to it in the future and the shares that the Company may issue upon redemption of the OP Units purchased by Invesco Investments (Bermuda) Ltd. registered for resale, and (ii) in certain circumstances, the right to “piggy-back” these shares in registration statements the Company might file in connection with any future public offering so long as the Company retains the Manager under the management agreement. The registration rights of the Manager and Invesco Investments (Bermuda) Ltd., with respect to the common stock and OP Units that they purchased simultaneously with the Company’s IPO, will apply on and after June 25, 2010.

Public Offerings

On January 15, 2010, the Company completed a follow-on public offering of 7,000,000 shares of common stock and an issuance of an additional 1,050,000 shares of common stock pursuant to the underwriters’ full exercise of their over-allotment option at $21.25 per share. Net proceeds to the Company were $162.6 million, net of issuance costs of approximately $8.6 million.

On May 3, 2010, the Company completed an additional follow-on public offering of 9,000,000 shares of common stock at $20.75 per share. The net proceeds to the Company were $177.4 million, net of issuance costs of approximately $9.2 million.

 On June 2, 2010, the underwriters purchased an additional 107,800 shares of common stock at $20.75 per share pursuant to an over-allotment option. The net proceeds to the Company were $2.1 million, net of issuance costs of approximately $106,000.

Share-Based Compensation

The Company established the 2009 Equity Incentive Plan for grants of restricted common stock and other equity based awards to the independent directors and the executive officers of the Company and personnel of the Manager (the “Incentive Plan”). Under the Incentive Plan, a total of 1,000,000 shares of common stock are currently reserved for issuance. Unless terminated earlier, the Incentive Plan will terminate in 2019, but will continue to govern the unexpired awards. The Company recognized compensation expense of approximately $34,000 and $53,000 for the three and six months ended June 30, 2010. During the six months ended June 30, 2010, the Company issued 1,755 shares of restricted stock pursuant to the Incentive Plan to the Company’s non-executive directors. The fair market value of the shares granted was determined by the closing stock market price on the date of the grant.

On March 17, 2010, the Company awarded 5,725 restricted stock units to the executive officers of the Company who are employees of the Manager. The restricted stock units vest equally in four installments on the anniversary date of each award. Compensation related to stock awards to officers and employees of the Manager are recorded at the estimated fair value of the award during the vesting period. The Company makes an upward or downward adjustment to compensation expense for the difference in the fair value at the date of grant and the date the award was earned. The Company recognized compensation expense of approximately $6,000 and $8,000 for the three and six months ended June 30, 2010, respectively, related to awards to officers and employees of the Manager.

Dividends

On June 21, 2010, the Company declared a dividend of $0.74 per share of common stock. The dividend was paid on July 27, 2010 to shareholders of record as of the close of business on June 30, 2010.
 
 
 

 
 
19

 
 
Note 10 – Earnings per Share

Earnings per share for the three and six months ended June 30, 2010 is computed as follows:

$ in thousands
 
Three Months Ended June 30, 2010
   
Six Months Ended
June 30, 2010
 
Numerator (Income)
           
Basic Earnings
           
Net income available to common shareholders
    20,750       32,799  
Effect of dilutive securities:
               
Income allocated to non-controlling interest
    1,309       2,427  
Dilutive net income available to shareholders
    22,059       35,226  
                 
Denominator (Weighted Average Shares)
               
Basic Earnings:
               
Shares available to common shareholders
    22,808       19,266  
Effect of dilutive securities:
               
OP Units
    1,431       1,429  
Dilutive Shares
    24,239       20,695  

For the three and six months ended June 30, 2009, earnings per share is not presented because it is not a meaningful measure of the Company’s performance.

Note 11 – Non-controlling Interest - Operating Partnership

Non-controlling interest represents the aggregate OP Units in the Operating Partnership held by limited partners (the “Unit Holders”). Income allocated to the non-controlling interest is based on the Unit Holders ownership percentage of the Operating Partnership. The ownership percentage is determined by dividing the number of OP Units held by the Unit Holders by the total number of dilutive shares of common stock. The issuance of common stock (“Share” or “Shares”) or OP Units changes the percentage ownership of both the Unit Holders and the holders of common stock. Since an OP unit is generally redeemable for cash or Shares at the option of the Company, it is deemed to be equivalent to a Share. Therefore, such transactions are treated as capital transactions and result in an allocation between shareholders’ equity and non-controlling interest in the accompanying consolidated balance sheet to account for the change in the ownership of the underlying equity in the Operating Partnership. As of June 30, 2010, non-controlling interest related to the outstanding 1,425,000 OP units represented a 5.2% interest in the Operating Partnership. Income allocated to the Operating Partnership non-controlling interest for the three and six months ended June 30, 2010, was approximately $1.3 million and $2.4 million, respectively. Distributions paid and payable to the non-controlling interest were approximately $2.6 million and $1.1 million, respectively.

Note 12 – Subsequent Events
 
None.

 
20

 


ITEM 2.
MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

In this quarterly report on Form 10-Q, or this “Report,” we refer to Invesco Mortgage Capital Inc. and its consolidated subsidiaries as “we,” “us,” “our Company,” or “our,” unless we specifically state otherwise or the context indicates otherwise. We refer to our external manager, Invesco Advisers, Inc., as our “Manager,” and we refer to the indirect parent company of our Manager, Invesco Ltd., together with its consolidated subsidiaries (other than us), as “Invesco.”

The following discussion should be read in conjunction with our consolidated financial statements and the accompanying notes to our consolidated financial statements, which are included in Item 1 of this report, as well as the information contained in our most recent Form 10-K, as amended filed with the Securities and Exchange Commission (the “SEC”).

Forward-Looking Statements
 
 
We make forward-looking statements in this Report and other filings we make with the SEC within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, and such statement are intended to be covered by the safe harbor provided by the same. Forward-looking statements are subject to substantial risks and uncertainties, many of which are difficult to predict and are generally beyond our control. These forward-looking statements include information about possible or assumed future results of our business, financial condition, liquidity, results of operations, plans and objectives. When we use the words “believe,” “expect,” “anticipate,” “estimate,” “plan,” “continue,” “intend,” “should,” “may” or similar expressions, we intend to identify forward-looking statements. Factors that could cause actual results to differ from those expressed in the Company’s forward-looking statements include, but are not limited to:

       ·  
actions and initiatives of the U.S. government and changes to U.S. government policies, including the recently enacted Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) and our ability to respond to and comply with such actions, initiatives and changes;

       ·  
our ability to obtain additional financing arrangements and the terms of such arrangements;

       ·  
financing and advance rates for our target assets;

       ·  
changes to our expected leverage;

       ·  
general volatility of the securities markets in which we invest;

       ·  
interest rate mismatches between our target assets and our borrowings used to fund such investments;

       ·  
changes in interest rates and the market value of our target assets;

       ·  
changes in prepayment rates on our target assets;

       ·  
effects of hedging instruments on our target assets;

       ·  
rates of default or decreased recovery rates on our target assets;

       ·  
modifications to whole loans or loans underlying securities;

       ·  
the degree to which our hedging strategies may or may not protect us from interest rate volatility;
 
 
 
 

 
 
21

 
 
 
 
 
       ·  
changes in governmental regulations, tax law and rates, and similar matters and our ability to respond to such changes;

       ·  
our ability to qualify as a REIT for U.S. federal income tax purposes;

       ·  
our ability to maintain our exclusion from the definition of “investment company” under the 1940 Act;

       ·  
availability of investment opportunities in mortgage-related, real estate-related and other securities;

       ·  
availability of U.S. government agency guarantees with regard to payments of principal and interest on securities;

       ·  
availability of qualified personnel;

       ·  
our understanding of our competition;

       ·  
changes to accounting principles generally accepted in the United States of America (“US GAAP”); and

       ·  
market trends in our industry, interest rates, real estate values, the debt securities markets or the general economy.

 
These forward-looking statements are based upon information presently available to our management and are inherently subjective, uncertain and subject to change. There can be no assurance that actual results will not differ materially from our expectations. We caution investors not to rely unduly on any forward-looking statements and urge you to carefully consider the risks identified under the captions “Risk Factors,” “Forward-Looking Statements” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Report and the most recent Form 10-K, as amended, which is available on the SEC’s website at www.sec.gov.
 
All written or oral forward-looking statements that we make, or that are attributable to us, are expressly qualified by this cautionary notice. We expressly disclaim any obligation to update the information in any public disclosure if any forward-looking statement later turns out to be inaccurate, except as may otherwise be required by law.

Overview

We are a Maryland corporation focused on investing in, financing and managing residential and commercial mortgage-backed securities and mortgage loans. We are externally managed and advised by Invesco Advisers, Inc. (our “Manager”), which is an indirect, wholly-owned subsidiary of Invesco Ltd. (NYSE:IVZ) (“Invesco”). We intend to qualify to be taxed as a REIT commencing with our taxable year ended December 31, 2009. Accordingly, we generally will not be subject to U.S. federal income taxes on our taxable income that we distribute currently to our shareholders as long as we maintain our qualification as a REIT. We operate our business in a manner that will permit us to maintain our exclusion from the definition of “investment company” under the Investment Company Act of 1940, as amended (the “1940 Act”).
 
Our objective is to provide attractive risk-adjusted returns to our shareholders, primarily through dividends and secondarily through capital appreciation. To achieve this objective, we invest in the following securities:

       ·  
Agency RMBS, which are residential mortgage-backed securities, for which a U.S. government agency such as the Government National Mortgage Association (“Ginnie Mae”) or a federally chartered corporation such as the Federal National Mortgage Association (“Fannie Mae”) or the Federal Home Loan Mortgage Corporation (“Freddie Mac”) guarantees payments of principal and interest on the securities;
 
 
 
 
 
 
 
 
22