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EX-32.1 - Invesco Mortgage Capital Inc.exhibit321-09302010.htm
EX-32.2 - Invesco Mortgage Capital Inc.exhibit322-09302010.htm
EX-31.2 - Invesco Mortgage Capital Inc.exhibit312-09302010.htm
EX-31.1 - Invesco Mortgage Capital Inc.exhibit311-09302010.htm
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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 September 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)  [Missing Graphic Reference]
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 November 9, 2010, there were 39,849,185 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 September 30, 2010 (unaudited)  and December 31, 2009
1
   
Unaudited Consolidated Statements of Operations for the three and nine months ended September 30, 2010 and 2009
2
   
Unaudited Consolidated Statement of Shareholders’ Equity and Comprehensive Income for the nine months ended September 30, 2010
3
   
Unaudited Consolidated Statements of Cash Flows for the nine months ended September 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
23
   
Item 3.        Quantitative and Qualitative Disclosures About Market Risk
38
   
Item 4.        Controls and Procedures
40
   
PART II – OTHER INFORMATION
41
   
Item 1.        Legal Proceedings
41
   
Item 1A.     Risk Factors
41
   
Item 2.         Unregistered Sales of Equity Securities and Use of Proceeds
41
   
Item 3.         Defaults Upon Senior Securities
41
   
Item 4.         Reserved
41
   
Item 5.         Other Information
41
   
Item 6.         Exhibits
43


 
 
 

 

PART I
ITEM 1.  FINANCIAL STATEMENTS
 
INVESCO MORTGAGE CAPITAL INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS



$ in thousands, except per share amounts
 
As of
 
ASSETS
 
September 30,
2010
   
December 31,
2009
 
   
(Unaudited)
       
 
Mortgage-backed securities, at fair value
    2,457,871       802,592  
Cash
    20,394       24,041  
Restricted cash
    40,235       14,432  
Principal paydown receivable
    1,138       2,737  
Investments in unconsolidated limited partnerships, at fair value
    61,290       4,128  
Accrued interest receivable
    10,950       3,518  
Prepaid insurance
    685       681  
Deferred offering costs
    237       288  
Other assets
    591       983  
Total assets
    2,593,391       853,400  
                 
LIABILITIES AND EQUITY
               
Liabilities:
               
Repurchase agreements
    1,748,969       545,975  
TALF financing
    151,757       80,377  
Derivative liability, at fair value
    46,265       3,782  
Dividends and distributions payable
    27,473       10,828  
Payable for investment securities purchased
    57,016        
Accrued interest payable
    1,601       598  
Accounts payable and accrued expenses
    931       665  
Due to affiliate
    2,301       865  
Total liabilities
    2,036,313       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, 26,047,682 and 8,887,212 shares issued and outstanding, at September 30, 2010 and December 31, 2009, respectively
    260       89  
Additional paid in capital
    514,423       172,385  
Accumulated other comprehensive income
    10,511       7,721  
Retained earnings
    771       320  
Total shareholders’ equity
    525,965       180,515  
                 
Non-controlling interest
    31,113       29,795  
Total equity
    557,078       210,310  
                 
Total liabilities and equity
    2,593,391       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
September 30,
   
Nine Months Ended
September 30,
 
$ in thousands, except per share data
 
2010
   
2009
   
2010
   
2009
 
Revenues
                       
Interest income
    36,067       10,983       83,284       10,983  
Interest expense
    8,873       2,070       18,904       2,070  
Net interest income
    27,194       8,913       64,380       8,913  
                                 
Other income (loss)
Gain (loss) on sale of investments, net
    (311 )             1,064        
Equity in earnings and fair value change in unconsolidated limited partnerships
    3,793               5,888        
Loss on other-than-temporarily impaired securities
    (124 )           (510 )      
Unrealized loss on interest rate swaps
    (9 )     (13 )     (44 )     (13 )
Total other income (loss)
    3,349       (13 )     6,398       (13 )
                                 
Expenses
                               
Management fee – related party
    2,039       753       5,094       753  
General and administrative
    263       245       729       349  
Insurance
    236       354       929       369  
Professional fees
    386       375       1,181       388  
Total expenses
    2,924       1,727       7,933       1,859  
Net income
    27,619       7,173       62,845       7,041  
                                 
Net income attributable to non-controlling interest
    1,433       970       3,860       970  
Net income attributable to common shareholders
    26,186       6,203       58,985       6,071  
 
Earnings per share:
                               
Net income attributable to common shareholders
    (basic/diluted)
     1.01        0.70       2.74    
NM
 
Dividends declared per common share
    1.00             2.52        
Weighted average number of shares of common stock:
                               
Basic
    26,047       8,886       21,552    
NM
 
Diluted
    27,478       10,311       22,981    
NM
 
                                 

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 nine months ended September 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
   
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
                            58,985       58,985       3,860       62,845       62,845  
Comprehensive income
                                                                       
Change in net unrealized gains and losses on available for sale securities
                      42,570             42,570       3,702       46,272       46,272  
Change in net unrealized gains and losses on derivatives
                      (39,780 )           (39,780 )     (2,658 )     (42,438 )     (42,438 )
Total comprehensive income
                                                                    93,149  
Net proceeds from issuance of common stock, net of offering costs 
    17,157,800       171       341,958                   342,129             342,129          
Stock awards to directors
    2,670                                                    
Common stock dividends
                            (58,534 )     (58,534 )           (58,534 )        
Common unit dividends
                                        (3,591 )     (3,591 )        
Amortization of equity-based compensation
                80                   80       5       85          
Balance at September 30, 2010
    26,047,682       260       514,423       10,511       771       525,965       31,113       557,078          


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)

   
Nine Months Ended September 30,
 
$ in thousands
 
2010
   
2009
 
 
Cash Flows from Operating Activities
           
Net income
    62,845       7,041  
Adjustments to reconcile net income to net cash provided by operating activities
               
Amortization of premiums and discounts, net – mortgage-backed securities
    (9,827 )     (609 )
Unrealized loss on derivatives
    44       13  
Gain on sale of mortgage-backed securities
    (1,064 )      
Loss on other-than-temporarily impaired securities
    510        
Equity in earnings and fair value change in unconsolidated limited partnerships
    (5,888 )      
Amortization of equity-based compensation
    85       19  
Changes in operating assets and liabilities
               
Increase in accrued interest
    (7,432 )     (3,893 )
Increase in prepaid insurance
    (5 )     (1,034 )
Increase in deferred offering costs
    (58 )      
(Increase) decrease in other assets
    393       (254 )
Increase in accrued interest payable
    1,003       541  
Increase in due to affiliate
    1,385       761  
  Increase in accounts payable and accrued expenses
    570       496  
Net cash provided by operating activities
    42,561       3,081  
                 
Cash Flows from Investing Activities
               
Purchase of mortgage-backed securities
    (2,022,403 )     (897,925 )
Investment in PPIP
    (50,890 )      
Principal payments of mortgage-backed securities
    265,904       26,982  
Proceeds from sale of mortgage-backed securities
    216,104        
Net cash used in investing activities
    (1,591,285 )     (870,943 )
                 
Cash Flows from Financing Activities
               
Proceeds from issuance of common stock
    341,986       174,441  
Increase in restricted cash
    (25,802 )     (9,158 )
Proceeds from private placement of OP Units
          28,500  
Proceeds from repurchase agreements
    11,092,883       1,981,153  
Principal repayments of repurchase agreements
    (9,889,889 )     (1,366,191 )
Proceeds from TALF financing
    71,525       64,837  
Principal payments of TALF financing
    (146 )     (30 )
Payments of dividends and distributions
    (45,480 )      
Net cash provided by financing activities
    1,545,077       873,552  
                 
Net change in cash
    (3,647 )     5,690  
Cash, beginning of period
    24,041       1  
                 
Cash, end of period
    20,394       5,691  
 
Supplement disclosure of cash flow information
               
Interest paid
    17,831       1,529  
                 
Non-cash investing and financing activities information
 
               
Net change in unrealized gain on available-for-sale securities and derivatives
    3,834       7,390  
Net change in investment in PPIP
    384        
Purchase of mortgage-backed securities, unsettled
    57,016       2,503  
Obligation to brokers incurred for purchase of mortgage-backed securities
    (57,016 )     (2,503 )
Dividends and distributions declared not paid
    27,473        
                 
 
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 September 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 elected 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 period ended September 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 September 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”). In addition, the Company recorded deferred offering costs of approximately $237,000 at September 30, 2010 related to a follow-on public offering completed on October 13, 2010 (the “October 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 a portion of its 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
 


 
 
6

 

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

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 as a 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 nine months ended September 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 elected 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.

 
9

 

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. 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 September 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 September 30, 2010 and December 31, 2009.
 
 
September 30, 2010
 
 
$ in thousands
 
Principal Balance
   
UnamortizedPremium (Discount)
   
Amortized Cost
   
Unrealized
Gain/
(Loss)
   
Fair
Value
   
Net Weighted Average Coupon (1)
   
Average Yield (2)
 
Agency RMBS:
                                         
15 year fixed-rate
    656,387       33,487       689,874       7,648       697,522       4.88 %     3.24 %
30 year fixed-rate
    652,555       44,993       697,548       9,568       707,116       5.82 %     3.87 %
ARM
    8,247       180       8,427       (245 )     8,182       3.04 %     2.23 %
Hybrid ARM
    33,112       1,081       34,193       630       34,823       4.08 %     3.14 %
Total Agency
    1,350,301       79,741       1,430,042       17,601       1,447,643       5.30 %     3.54 %
                                                         
MBS-CMO
    22,085       889       22,974       540       23,514       5.89 %     4.52 %
Non-Agency MBS
    1,078,638       (341,410 )     737,228       21,984       759,212       4.68 %     6.68 %
CMBS
    211,512       (2,899 )     208,613       18,889       227,502       5.17 %     5.45 %
Total
    2,662,536       (263,679 )     2,398,857       59,014       2,457,871       5.05 %     4.68 %
 
 
_____________________
(1)  Net weighted average coupon (“WAC”) is presented net of servicing and other fees.
(2)  Average yield incorporates future prepayment and loss assumptions.


 
 
10

 


December 31, 2009
 
 
$ in thousands
 
Principal Balance
   
UnamortizedPremium (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 September 30, 2010 and December 31, 2009 are presented below.

$ in thousands
 
September 30, 2010
   
December 31, 2009
 
Principal balance
    2,662,536       847,873  
Unamortized premium
    82,433       26,174  
Unamortized discount
    (346,112 )     (84,196 )
Gross unrealized gains
    71,150       14,595  
Gross unrealized losses
    (12,136 )     (1,854 )
Fair value
    2,457,871       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 September 30, 2010 and December 31, 2009:

$ in thousands
 
September 30, 2010
   
December 31, 2009
 
Less than one year
    42,502        
Greater than one year and less than five years
    1,881,136       483,540  
Greater than or equal to five years
    534,233       319,052  
Total
    2,457,871       802,592  

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 September 30, 2010 and December 31, 2009, respectively:

September 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
    135,021       (674 )                 135,021       (674 )
30 year fixed-rate
    79,653       (180 )                 79,653       (180 )
ARM
                                   
Hybrid ARM
                8,183       (244 )     8,183       (244 )
Total Agency
    214,674       (854 )     8,183       (244 )     222,857       (1,098 )
                                                 
MBS – CMO
                                   
Non-Agency MBS
    265,731       (10,932 )                 265,731       (10,932 )
CMBS
    11,147       (106 )                 11,147       (106 )
Total
    491,552       (11,892 )     8,183       (244 )     499,735       (12,136 )


 
11

 


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       (377 )                 18,281       (377 )
Total
    106,397       (1,854 )                 106,397       (1,854 )

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

$ in thousands
 
Three Months ended September 30, 2010
   
Nine Months ended September 30, 2010
 
Accumulated other comprehensive income from investment securities:
           
Unrealized gain on MBS at beginning of period
    33,921       12,741  
Unrealized gain on MBS, net
    25,093       46,273  
Balance at the end of period
    59,014       59,014  

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 nine months ended September 30, 2010.  We do not consider comparisons of the three and six months ended September 30, 2009 to be meaningful:

 
$ in thousands
 
Three Months ended September 30, 2010
   
Nine Months ended September 30, 2010
 
Credit related other-than-temporary impairments included in earnings
    124       510  
Non-credit related other-than-temporary impairments recognized in other comprehensive income
           
Total other-than-temporary impairment losses
    124       510  

The following table presents a roll-forward of the credit loss component of other-than-temporary impairments for the three and nine months ended September 30, 2010. We do not consider the comparisons of the three and nine month months ended September 30, 2009 to be meaningful:

 
$ in thousands
 
Three Months ended September 30, 2010
   
Nine Months ended September 30, 2010
 
Credit loss amount at the beginning of the period
    386        
Additions for credit losses for which other-than-temporary impairment had not been previously recognized
    124       510  
Credit loss amount at end of period
    510       510  


 
12

 

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

For the three months ended September 30, 2010
 
$ in thousands
 
Coupon Interest
   
Net (Premium Amortization)/Discount Accretion
   
Interest Income
 
Agency
    17,330       (4,304 )     13,026  
Non-Agency
    11,868       8,637       20,505  
CMBS
    2,458       69       2,527  
Other
    9             9  
Total
    31,665       4,402       36,067  

For the nine months ended September 30, 2010
 
$ in thousands
 
Coupon Interest
   
Net (Premium Amortization)/Discount Accretion
   
Interest Income
 
Agency
    41,328       (12,518 )     28,810  
Non-Agency
    25,050       22,105       47,155  
CMBS
    7,059       239       7,298  
Other
    21             21  
Total
    73,458       9,826       83,284  

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 stopped accepting investment subscriptions and was deemed closed. The Company began contributions to the Fund in October 2009.  In connection with the increase of the Company’s interest in the Fund and AIV, the Company is committed to fund approximately $45 million of additional capital at September 30, 2010. The Company realized approximately $2.0 million and $3.8 million of equity in earnings and $1.8 million and $2.1 million of unrealized appreciation from these investments for the three and nine months ended September 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 0.67% and 0.26% at September 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 September 30, 2010 and December 31, 2009:

$ in thousands
 
September 30, 2010
   
December 31, 2009
 
   
Amount Outstanding
   
Weighted Average Interest Rate
   
Amount Outstanding
   
Weighted Average Interest Rate
 
Agency RMBS
    1,296,368       0.30 %     545,975       0.26 %
Non-Agency RBS
    434,262       1.75 %            
CMBS
    18,339       1.29 %            
Total
    1,748,969       0.67 %     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 September 30, 2010 and December 31, 2009:

September 30, 2010
$ in thousands
Repurchase Agreement Counterparties
 
Amount Outstanding
   
Percent of Total Amount Outstanding
   
Company MBS Held as Collateral
 
Credit Suisse Securities (USA) LLC
    382,232       22 %     454,772  
Barclays Capital Inc.
    107,057       6 %     136,463  
RBS Securities Inc.
    134,124       8 %     161,202  
Deutsche Bank Securities Inc.
    140,161       8 %     149,946  
Goldman, Sachs & Co.
    230,439       13 %     244,852  
BNP Paribas Securities Corp.
    99,808       6 %     104,818  
Wells Fargo Securities, LLC
    255,755       15 %     316,573  
Morgan Stanley & Co. Incorporated
    108,898       6 %     121,696  
JP Morgan Securities Inc.
    163,484       9 %     176,228  
Mitsubishi UFJ Securities (USA), Inc.
    127,011       7 %     130,816  
Total
    1,748,969       100 %     1,997,366  
 
December 31, 2009
$ in thousands
Repurchase Agreement Counterparties
 
Amount Outstanding
   
Percent of Total Amount Outstanding
   
 
 
Company MBS Held as Collateral
 
Credit Suisse Securities (USA) LLC
    109,697       20 %     110,501  
Barclays 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 September 30, 2010 and December 31, 2009 was $30.0 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 September 30, 2010 and December 31, 2009, respectively. The TALF loans are non-recourse. However, they are secured by $206.0 million of CMBS and mature in February 2013, July 2014, August 2014, December 2014 and January 2015.

At September 30, 2010, the TALF financing agreements had the following remaining maturities:
 
 
$ in thousands
 
September 30, 2010
 
2011
     
2012
     
2013
    33,764  
2014
    64,739  
2015
    53,254  
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 nine months ended September 30, 2010, the Company recorded $9,000 and $44,000, 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.  For the three and nine months ended September 30, 2009, the Company recorded $13,000 of unrealized swap losses in earnings.
 
 
 
 
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 $19.1 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 58 months.
 
As of September 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 September 30, 2010 and December 31, 2009.

$ in thousands
Asset Derivatives
 
Liability Derivatives
As of September 30, 2010
 
As of December 31, 2009
 
As of September 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
 
46,265
 
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 nine months ended September 30, 2010.

Three months ended September 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
    19,663  
Interest Expense
    4,702  
Other Expense
    9  

Nine months ended September 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
    52,010  
Interest Expense
    9,572  
Other Expense
    44  
 

 
 
16

 
 
Three and nine months ended September 30, 2009

$ 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
    6,672  
Interest Expense
    1,172  
Other Expense
    13  

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 September 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 $47.0 million. The Company has minimum collateral posting thresholds with certain of its derivative counterparties and has posted collateral of approximately $10.2 million of cash and $45.7 million of Agency RMBS. If the Company had breached any of these provisions at September 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 September 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.
 

 
 
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The fair values at September 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:

   
September 30, 2010
       
   
Fair Value Measurements Using:
       
$ in thousands
 
Level 1
   
Level 2
   
Level 3
   
Total at Fair Value
 
Assets
                       
Mortgage-backed securities (1)
          2,457,871             2,457,871  
Investments in unconsolidated limited partnerships
                61,290       61,290  
Total
          2,457,871       61,290       2,519,161  
 
Liabilities
                               
Derivatives
          46,265             46,265  
Total
          46,265             46,265  

   
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
 
September 30, 2010
   
December 31, 2009
 
Beginning balance
    4,128        
Purchases, sales and settlements, net
    51,275       4,057  
Total net gains / (losses) included in net income
               
    Realized gains/(losses), net
    3,830       63  
    Unrealized gains/(losses), net
    2,057       8  
Unrealized gain/(losses), net included in other comprehensive income
           
Ending balance
    61,290       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 September 30, 2010, the TALF debt had a fair value of $158.4 million and a carrying value of $151.8 million and the repurchase agreements had a fair value of $1.75 billion and a carrying value of $1.75 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
 
 
 
18

 
 
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 nine months ended September 30, 2010, the Company incurred management fees of approximately $2.0 million and $5.1 million, respectively of which approximately $2.0 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 $0.6 million and $2.7 million for the three and nine months ended September 30, 2010, respectively, compared to approximately $0.7 million and $1 million for the three and nine months ended September 30 2009, respectively. Approximately $0.5 million and $1.8 million was expensed for the three and nine months ended September 30, 2010, respectively, compared to $0.2 million and $0.3 million for the three and nine months ended September 30, 2009, respectively. Approximately $0.1 million and $0.9 million and was charged against equity as a cost of raising capital for the three and nine months ended September 30, 2010, respectively, compared to $0.4 million and $0.6 million for the three and nine months ended September 30, 2009, respectively.  Approximately $0.1 million was capitalized to other assets for the three and nine months ended September 30, 2009.

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
 
 
 
 
19

 
 
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.

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 $162.4 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 $19,000 and $71,000 for the three and nine months ended September 30, 2010. During the nine months ended September 30, 2010, the Company issued 2,670 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 $14,000 for the three and nine months ended September 30, 2010, respectively, related to awards to officers and employees of the Manager.


 
20

 

Dividends

On September 20, 2010, the Company declared a dividend of $1.00 per share of common stock. The dividend was paid on October 27, 2010 to shareholders of record as of the close of business on September 30, 2010.

Note 10 – Earnings per Share

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

$ in thousands
 
Three Months Ended
September 30,
   
  Nine Months Ended
September 30, 
   
2010
   
2009
   
2010
Numerator (Income)
               
Basic Earnings
               
Net income available to common shareholders
    26,186       6,203       58,985    
Effect of dilutive securities:
                         
Income allocated to non-controlling interest
    1,433       970       3,860    
Dilutive net income available to shareholders
    27,619       7,173       62,845    
                           
Denominator (Weighted Average Shares)
                         
Basic Earnings:
                         
Shares available to common shareholders
    26,047       8,886       21,552    
Effect of dilutive securities:
                         
Restricted Stock Awards
    6             4    
OP Units
    1,425       1,425       1,425    
Dilutive Shares
    27,478       10,311       22,981    

For the nine months ended September 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 September 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 nine months ended September 30, 2010, was approximately $1.4 million and $3.9 million, respectively. Distributions paid and payable to the non-controlling interest were approximately $3.7 million and $1.4 million, respectively.

Note 12 – Subsequent Events

On October 13, 2010, the Company completed a public offering of 12,000,000 shares of common stock and an additional 1,800,000 shares of common stock pursuant to the underwriters’ full exercise of their over-allotment option at $20.75 per share. Net proceeds to the Company were approximately $274.7 million, net of issuance costs of approximately $11.7 million.
 
 
 
21

 
 
In November 2010, the Company exercised its right to prepay the TALF loans secured by CMBS.  The purpose for the prepayment was to obtain lower borrowing costs from other sources.  The Company obtained additional advances under existing repurchase agreement financing arrangements.

 
22

 

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 statements 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:

    ·  
the impact of any deficiencies in foreclosure practices of third parties and related delays in the foreclosure process;

    ·  
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;
 
 
 
 
 
23

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

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