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EX-32.2 - EXHIBIT 32.2 - CreXus Investment Corp.a6714361_ex322.htm
EX-31.2 - EXHIBIT 31.2 - CreXus Investment Corp.a6714361_ex312.htm
EX-32.1 - EXHIBIT 32.1 - CreXus Investment Corp.a6714361_ex321.htm
EX-31.1 - EXHIBIT 31.1 - CreXus Investment Corp.a6714361_ex311.htm
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

[X]             QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED:  MARCH 31, 2011

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:  1-34451

CREXUS INVESTMENT CORP.
(Exact name of Registrant as specified in its Charter)
 
MARYLAND 26-2652391
(State or other jurisdiction of incorporation or organization)  (IRS Employer Identification No.)
 
1211 AVENUE OF THE AMERICAS, SUITE 2902
NEW YORK, NEW YORK
(Address of principal executive offices)

10036
 (Zip Code)

(646) 829-0160
(Registrant’s telephone number, including area code)

Indicate by check mark whether the Registrant (1) has filed all documents and 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 þ No o

Indicate by check mark whether the Registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (Section 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).
Yes o No o

Indicate by check mark whether the Registrant is a large accelerated filer, an accelerated filer, non-accelerated filer, or a smaller reporting company. See definition of “accelerated filer,” “large accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer o Accelerated filer þ Non-accelerated filer o  Smaller reporting company o

Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes o No þ

APPLICABLE ONLY TO CORPORATE ISSUERS:

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the last practicable date:
 
Class Outstanding at May 9, 2011
Common Stock, $.01 par value 76,620,112
 
 
 

 
 
CREXUS INVESTMENT CORP.
FORM 10-Q
TABLE OF CONTENTS

 
 
 
 
1
   
2
   
3
   
4
   
5
   
20
   
40
   
45
   
   
 
   
46
   
46
   
52
   
53
   
CERTIFICATIONS
54
 
i

 
 

 
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
(dollars in thousands, except per share data)
 
   
March 31, 2011
   
December 31, 2010
 
Assets:
 
(unaudited)
      (1)  
Cash and cash equivalents
  $ 30,579     $ 31,019  
Available-for-sale:
               
   Commercial mortgage-backed securities, at fair value,
   pledged as collateral
    224,427       224,112  
   Agency mortgage-backed securities, at fair value
    210,434       -  
Held for investment:
               
   Commercial mortgage loans, mezzanine loans and
   preferred equity, net of allowance
   for loan losses ($369 and $242)
    188,709       188,869  
Accrued interest receivable
    3,310       2,774  
Receivable from affiliate, follow-on offering
    57,500       -  
Receivable from follow-on offering
    543,375       -  
Other assets
    558       1,661  
   Total assets
  $ 1,258,892     $ 448,435  
                 
Liabilities:
               
Secured financing agreements
  $ 172,470     $ 172,837  
Accrued interest payable
    311       290  
Accounts payable for investments
    210,809       -  
Accounts payable and other liabilities
    4,653       2,637  
Dividends payable
    4,168       3,986  
Investment management fees payable to affiliate
    680       650  
   Total liabilites
    393,091       180,400  
                 
Stockholders' Equity:
               
Common stock, par value $0.01 per share, 1,000,000,000
               
 authorized, 73,120,112 and 18,120,112 issued and outstanding
    731       181  
Additional paid-in-capital
    853,196       257,014  
Accumulated other comprehensive income
    11,116       10,475  
Retained earnings
    758       365  
   Total stockholders' equity
    865,801       268,035  
   Total liabilities and stockholders' equity
  $ 1,258,892     $ 448,435  
 
(1) Derived from the audited consolidated statement of financial condition at December 31, 2010.
           
See notes to consolidated financial statements.
         
 
 
1

 
 
CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME
(dollars in thousands, except share and per share data)
 
   
For the
quarter ended
March 31, 2011 (unaudited)
   
For the
quarter ended
March 31, 2010 (unaudited)
 
             
Net interest income:
           
Interest income
  $ 7,381     $ 2,898  
Interest expense
    1,532       584  
   Net interest income
    5,849       2,314  
                 
Realized gains on sale of investments
    -       623  
                 
Other expenses:
               
Provision for loan losses
    127       15  
Management fee
    680       317  
General and administrative expenses
    480       777  
   Total other expenses
    1,287       1,109  
                 
Net income before income tax
    4,562       1,828  
Income tax
    1       -  
Net income
  $ 4,561     $ 1,828  
                 
Net income per share-basic and diluted
  $ 0.23     $ 0.10  
Weighted average number of shares outstanding-
  basic and diluted
    19,953,445       18,120,112  
                 
Comprehensive income:
               
Net income
  $ 4,561     $ 1,828  
Other comprehensive income:
               
Unrealized gain  on securities available-for-sale
    641       1,729  
Reclassification adjustment for realized gains
  included in net income
    -       (623 )
  Total other comprehensive income
    641       1,106  
Comprehensive income
  $ 5,202     $ 2,934  
                 
See notes to consolidated financial statements.
               
 
 
2

 
 
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(dollars in thousands, except per share data)
(unaudited)
 
               
Accumulated
             
   
Common
   
Additional
   
Other
             
   
Stock Par
   
Paid-in
   
Comprehensive
   
Retained
       
   
Value
   
Capital
   
Income
   
Earnings
   
Total
 
Balance, December 31, 2010
  $ 181     $ 257,014     $ 10,475     $ 365     $ 268,035  
                                         
Net income
    -       -       -       4,561       4,561  
Other comprehensive income
    -       -       641       -       641  
Net proceeds from common stock
                                 
   follow-on offerings
    550       596,182       -       -       596,732  
Common dividends declared,
   $0.23 per share
    -       -       -       (4,168 )     (4,168 )
Balance, March 31, 2011
  $ 731     $ 853,196     $ 11,116     $ 758     $ 865,801  
                                         
Balance, December 31, 2009
  $ 181     $ 257,029     $ (373 )   $ (1,010 )   $ 255,827  
                                         
Net income
    -       -               1,828       1,828  
Other comprehensive income
    -       -       1,107       -       1,107  
Net proceeds (expenses) from
                                       
   common stock offering
    -       (23 )     -       -       (23 )
Common dividends declared,
   $0.07 per share
    -       -       -       (1,269 )     (1,269 )
Balance, March 31, 2010
  $ 181     $ 257,006     $ 734     $ (451 )   $ 257,470  
                                         
See notes to consolidated financial statements.
                         
 
 
3

 
 
CONSOLIDATED STATEMENTS OF CASH FLOWS
(dollars in thousands)
 
   
For the
quarter ended
March 31, 2011
(unaudited)
   
For the
quarter ended
March 31, 2010
(unaudited)
 
             
Cash Flows From Operating Activites:
           
Net income
  $ 4,561     $ 1,828  
Adjustments to reconcile net income to net cash provided by operating acitvities:
         
     Net amortization of investment premiums and discounts
    (123 )     38  
     Realized gain on sale of investments
    -       (623 )
     Provision for loan losses
    127       15  
Changes in operating assets:
               
     Increase in accrued interest receivable
    (536 )     (1,022 )
     Increase (decrease) in other assets
    (3,041     135  
Changes in operating liabilities:
               
     Increase (decrease) in accounts payable and other liabilities
    2,392       (166 )
     Increase (decrease) in investment management fee payable
     to affiliate
    30       (37 )
    Increase in accrued interest payable
    22       175  
Net cash provided by operating activities
    3,432       343  
Cash Flows From Investing Activities:
               
Mortgage-backed securities portfolio:
               
     Purchases
    -       (244,221 )
     Sales
    -       61,194  
     Principal payments
    283       106  
Loans held for investment portfolio:
               
     Purchases
    -       (27,300 )
     Principal payments
    199       -  
Net cash provided by (used in) investing activities
    482       (210,221 )
Cash Flows From Financing Activities:
               
     Net proceeds from common stock offerings
    -       (23 )
     Proceeds from secured financing
    -       148,381  
     Payments on secured financing
    (368 )     -  
     Dividends paid
    (3,986 )     -  
Net cash (used in) provided by financing activities
    (4,354 )     148,358  
Net decrease in cash and cash equivalents
    (440 )     (61,520 )
Cash and cash equivalents at beginning of period
    31,019       212,133  
Cash and cash equivalents at end of period
  $ 30,579     $ 150,613  
Supplemental disclosure of cash flow information:
               
   Interest paid
  $ 1,511     $ 407  
   Taxes paid
  $ 1     $ -  
Non cash investing activities:
               
   Net change in unrealized gain on available-for-sale securities
  $ 9,364     $ 1,106  
Non cash financing activities:
               
   Common dividends declared, not yet paid
  $ 4,168     $ 1,268  
   Common stock follow-on offerings, not yet settled
  $ 596,732     $ -  
                 
See notes to consolidated financial statements.
               
 
 
4

 
 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE QUARTER ENDED MARCH 31, 2011
 (Unaudited)

 
1.   Organization

CreXus Investment Corp. (the “Company”) was organized in Maryland on January 23, 2008.  The Company commenced operations on September 22, 2009 upon completion of its initial public offering.  The Company, directly or through its subsidiaries, acquires, manages and finances an investment portfolio of commercial real estate loans, commercial mortgage-backed securities (“CMBS”) and Agency residential mortgage-back securities (“Agency RMBS”) and has elected to be taxed as a real estate investment trust (“REIT”), under the Internal Revenue Code of 1986, as amended.  As a REIT, the Company will generally not be subject to U.S. federal or state corporate taxes on its income to the extent that qualifying distributions are made to stockholders and the REIT requirements, including certain asset, income, distribution and stock ownership tests are met. The Company’s wholly-owned subsidiaries, CreXus S Holdings, LLC, CreXus S Holdings (Grand Cayman) LLC, CreXus F Asset Holdings, LLC and CreXus TALF Holdings, LLC (collectively, the “subsidiaries”), are qualified REIT subsidiaries.  As of March 31, 2011, Annaly Capital Management, Inc. (“Annaly”) owned approximately 13% of the Company’s common shares.  The Company is managed by Fixed Income Discount Advisory Company (“FIDAC”), an investment advisor registered with the Securities and Exchange Commission (“SEC”).  FIDAC is a wholly-owned subsidiary of Annaly.

2.  Summary of the Significant Accounting Policies

(a) Basis of Presentation
The accompanying unaudited consolidated financial statements have been prepared in conformity with the instructions to Form 10-Q and Article 10, Rule 10-01 of Regulation S-X for interim financial statements.  Accordingly, they may not include all of the information and footnotes required by accounting principles generally accepted in the United States of America (“GAAP”). The consolidated interim financial statements are unaudited; however, in the opinion of the Company's management, all adjustments, consisting only of normal recurring accruals, necessary for a fair presentation of the financial position, results of operations, and cash flows have been included.   These unaudited consolidated financial statements should be read in conjunction with the audited consolidated financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010.  The nature of the Company's business is such that the results of any interim period are not necessarily indicative of results for a full year.  The consolidated interim financial statements include the accounts of the Company and its wholly-owned subsidiaries.  All intercompany balances and transactions have been eliminated.
 
(b) Cash and Cash Equivalents
Cash and cash equivalents include cash on hand and in money market accounts with original maturities less than 90 days.

(c) Commercial Mortgage-Backed Securities
The Company invests in CMBS representing interests in obligations backed by pools of commercial mortgage loans and carries those securities at fair value estimated using a pricing model. Management reviews the fair values generated by this model to determine that prices are reflective of the current market. Management performs a validation of the fair value calculated by this model by the pricing model by comparing its results to independent prices provided by dealers in the securities and/or third party pricing services. If dealers or independent pricing services are unable to provide a price for an asset or if the Company deems the price provided by such dealers or independent pricing services to be unreliable, then the Company will determine the fair value of the asset in good faith.   In the current market, it may be difficult or impossible to obtain third party pricing on certain of the investments the Company purchases. In addition, validating third party pricing for the Company's investments may be more subjective as fewer participants may be willing to provide this service to the Company. Moreover, the current market is more illiquid than in the past for certain investments the Company purchases. Illiquid investments typically experience greater price volatility as a readily available market does not exist. As volatility increases or liquidity decreases, the Company may have greater difficulty financing its investments which may negatively impact its earnings and the execution of its investment strategy.
 
 
5

 
 
The Company classifies its CMBS as available-for-sale investments. The Company intends to hold its CMBS but may sell any of its CMBS as part of its overall management of its portfolio. All assets classified as available-for-sale are reported at estimated fair value, with unrealized gains and losses included in other comprehensive income (loss).

If the fair value of an investment security is less than its amortized cost at the date of the consolidated statement of financial condition, the Company analyzes the investment security for other-than-temporary impairment (“OTTI”).  Management evaluates the Company’s CMBS for OTTI at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation.  Consideration is given to (1) the length of time and the extent to which the fair value has been lower than carrying value, (2) the intent of the Company to sell the investment prior to recovery in fair value (3) whether the Company will be more likely than not required to sell the investment before the expected recovery in fair value, and  (4) the expected future cash flows of the investment in relation to its amortized cost.  Unrealized losses on assets that are considered other-than-temporary credit impairments are recognized in income and the cost basis of the asset is adjusted.

CMBS transactions are recorded on the trade date. Realized gains and losses from CMBS transactions are determined based on the specific identification method and recorded as a gain (loss) on sale of available-for-sale securities in the consolidated statement of operations. Accretion of discounts or amortization of premiums on available-for-sale securities and mortgage loans is computed using the effective interest yield method and is included as a component of interest income in the consolidated statement of operations.

(c) Agency Residential Mortgage-Backed Securities
The Company invests in Agency RMBS representing interests in obligations backed by pools of mortgage loans.  Agency RMBS are mortgage pass-through certificates, collateralized mortgage obligations (“CMOs”), and other mortgage-backed securities representing interests in or obligations backed by pools of mortgage loans issued or guaranteed as to principal and/or interest repayment by agencies of the U.S. Government or federally chartered corporations such as Government National Mortgage Association (“Ginnie Mae”), the Federal Home Loan Mortgage Corporation (“Freddie Mac”) or the Federal National Mortgage Association (“Fannie Mae”).

The Company holds its Agency RMBS as available-for-sale, records investments at estimated fair value as described in Note 7 of these consolidated financial statements, and includes unrealized gains and losses in other comprehensive income (loss) in the consolidated statements of operations and comprehensive income. From time to time, as part of the overall management of its portfolio, the Company may sell certain of its Agency RMBS investments and recognize a realized gain or loss as a component of earnings in the consolidated statements of operations and comprehensive income utilizing the specific identification method.

Interest income on Agency RMBS is computed on the remaining principal balance of the investment security. Premium or discount amortization/accretion on Agency RMBS is recognized over the life of the investment using the effective interest method.   Changes to the Company’s assumptions subsequent to the purchase date may increase or decrease the amortization/accretion of premiums and discounts which affects interest income. Changes to assumptions that decrease expected future cash flows may result in other-than-temporary impairment.

Agency RMBS transactions are recorded on the trade date. Realized gains and losses from CMBS transactions are determined based on the specific identification method and recorded as a gain (loss) on sale of available-for-sale securities in the consolidated statement of operations. Accretion of discounts or amortization of premiums on available-for-sale securities and mortgage loans is computed using the effective interest yield method and is included as a component of interest income in the consolidated statement of operations.

 
6

 
 
(d) Loans Held for Investment
The Company's commercial mortgages, mezzanine loans and preferred equity interests are comprised of fixed-rate and adjustable-rate loans. Mortgages and loans are designated as held for investment and are carried at their principal balance outstanding, plus any premiums or discounts which are amortized or accreted over the estimated life of the loan, less allowances for loan losses.

(e) Allowance for Loan Losses and Reserve for Probable Credit Losses
The allowance for loan losses is a valuation allowance for probable losses inherent in the loan portfolio.  The Company evaluates the adequacy of the allowances for loan losses balance on a quarterly basis.  When additional allowances are necessary, a provision for loan losses is charged to earnings.  The Company’s methodology for assessing the appropriateness of the allowance for loan losses consists of: (1) a specific valuation allowance on identified problem loans; (2) a general valuation allowance on the remainder of the loan portfolio; and (3) an unallocated component.  Although we determine the amount of each element of the allowance separately, the entire allowance for loan losses is available to absorb losses in the loan portfolio.  The Company charges-off the collateral deficiency on all loans at 90 days past due and, as a result, no specific valuation allowance was maintained at March 31, 2011.

The expense for probable credit losses in connection with mortgage loans is the charge to earnings to increase the allowance for probable credit losses to the level that management estimates to be adequate considering delinquencies, loss experience and collateral quality. Other factors considered relate to geographic trends and product diversification, the size of the portfolio and current economic conditions. Based upon these factors, the Company will establish the provision for probable credit losses by category of asset. When it is probable that the Company will be unable to collect all amounts contractually due, the account is considered impaired.

Where impairment is indicated, a valuation write-down or write-off will be measured based upon the excess of the recorded investment amount over the net fair value of the collateral, as reduced by selling costs. Any deficiency between the carrying amount of an asset and the net sales price of repossessed collateral will be charged to the allowance for loan losses.

(f) Income Taxes
The Company has qualified and elected to be taxed as a REIT, and therefore it generally will not be subject to corporate federal or state income tax to the extent that the Company makes qualifying distributions to stockholders and provided we satisfy 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, the Company would be subject to 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 REIT qualification was lost.

(g) Net Income per Share
The Company calculates basic net income per share by dividing net income for the period by the weighted-average shares of its common stock outstanding for that period.  Diluted net income per share takes into account the effect of dilutive instruments, such as stock options, 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.  The Company had no potentially dilutive securities outstanding during the periods presented.

(h) Use of Estimates
The preparation of the financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities in reporting period. Actual results could differ from those estimates.

 
7

 

(i) Recent Accounting Pronouncements

Assets

Receivables (ASC 310)

In July 2010, the FASB released Accounting Standard Update (“ASU”) 2010-20, which addresses disclosures about the credit quality of financing receivables and the allowance for credit losses.  The purpose of this update is to provide greater transparency regarding the allowance for credit losses and the credit quality of financing receivables as well as to assist in the assessment of credit risk exposures and evaluation of the adequacy of allowances for credit losses.   Additional disclosures must be provided on a disaggregated basis.  The update defines two levels of disaggregation – portfolio segment and class of financing receivable.  Additionally, the update requires disclosure of credit quality indicators, past due information and modifications of financing receivables.   The update is not applicable to mortgage banking activities (loans originated or purchased for resale to investors); derivative instruments such as debt securities;  a transferors interest in securitization transactions accounted for as sales under ASC 860; and purchased beneficial interests in securitized financial assets.  This update was effective for the Company for interim or annual periods ending on or after December 15, 2010.    Adoption of this update resulted in additional disclosures in the Company’s consolidated financial statements.

In April 2011, the FASB released ASU 2011-02, “A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring”.  In evaluating whether a restructuring constitutes a troubled debt restructuring, a creditor must separately conclude that both of the following exist: 1) The restructuring constitutes a concession and 2) The debtor is experiencing financial difficulties.  Modifications determined to be troubled debt restructurings that have any credit losses previously measured under a general allowance for credit losses methodology will be impaired individually pursuant to the loan impairment guidelines.  This update is effective for interim and annual periods beginning on or after June 15, 2011 with early adoption permitted.  The Company has elected early adoption as of January 1, 2011.  Adoption of this update had no material effect on the Company’s consolidated financial statements this reporting period.

Broad Transactions

Fair Value Measurements and Disclosures (ASC 820)

In January 2010, FASB issued guidance (ASU 2010-06) which increases disclosure regarding the fair value of assets.  A majority of this update was effective for the Company for all interim and annual reporting periods beginning after December 15, 2009.  However, the guidance also required that the disclosures on any Level 3 assets present separately information about purchases, sales, issuances and settlements.  In other words, Level 3 assets are presented on a gross basis rather than as one net number.  This portion of the guidance was effective for the Company on January 1, 2011.  Adoption of this portion of the guidance results in increased footnote disclosure to the extent the Company owns Level 3 assets.

Transfers and Servicing (ASC 860)

In April 2011, FASB issued ASU 2011-03 regarding repurchase agreements.  In a typical repurchase agreement transaction, an entity transfers financial assets to a counterparty in exchange for cash with an agreement for the counterparty to return the same or equivalent financial assets for a fixed price in the future.  Prior to this update, one of the factors in determining whether sale treatment could be used was whether the transferor maintained effective control of the transferred assets and in order to do so, the transferor must have the ability to repurchase such assets. Based on this update, FASB concluded that the assessment of effective control should focus on a transferor’s contractual rights and obligations with respect to transferred financial assets, rather than whether the transferor has the practical ability to perform in accordance with those rights or obligations.  Therefore, this update removes the transferor’s ability criterion from consideration of effective control.  This update is effective for the first interim or annual period beginning on or after December 15, 2011.  As the Company records repurchase agreements as secured borrowings and not sales, this update will have no material effect on the Company’s consolidated financial statements.

 
8

 
 
3. Cash and Cash Equivalents

The Company had $30.6 million and $31.0 million in money market funds held at an independent national banking institution for the quarters ended March 31, 2011 and December 31, 2010, respectively, and earned $800 and $6,000 for the quarters ended March 31, 2011 and December 31, 2010, respectively.  The average cash balance was $30.2 million and $38.2 million with annualized yields on average cash balances of 0.01% and 0.06% for the quarters ended March 31, 2011 and December 31, 2010, respectively.

4.   Commercial Mortgage Backed Securities

The following table represents the Company's available-for-sale CMBS portfolio as of March 31, 2011 and December 31, 2010 at fair value.
 
   
March 31, 2011
   
December 31, 2010
 
   
(dollars in thousands)
 
CMBS, Gross
  $ 210,539     $ 210,822  
Unamortized discount
    (131 )     (136 )
Unamortized premium
    2,903       2,951  
Amortized cost
    213,311       213,637  
                 
Unrealized gain
    11,174       10,475  
Unrealized losses
    (58 )     -  
                 
Fair value
  $ 224,427     $ 224,112  
 
The following table presents the gross unrealized losses and estimated fair value of the Company's CMBS by length of time that such securities have been in a continuous unrealized loss position at March 31, 2011 and December 31, 2010.
 
   
Unrealized Loss Position For:
 
   
Less than 12 Months
   
12 Months or More
 
Total
 
   
Estimated
   
Unrealized
   
Estimated
 
Unrealized
 
Estimated
   
Unrealized
 
   
Fair Value
   
Losses
   
Fair Value
 
Losses
   
Fair Value
   
Losses
 
                   
(dollars in thousands)
       
CMBS
  $ 12,579     $ (58 )   $ -     $ -     $ 12,579     $ (58 )
Total March 31, 2011
  $ 12,579     $ (58 )   $ -     $ -     $ 12,579     $ (58 )
                                                 
CMBS
  $ -     $ -     $ -     $ -     $ -     $ -  
Total December 31, 2010
  $ -     $ -     $ -     $ -     $ -     $ -  
 
The decline in value of these securities is due to market conditions and not the credit performance of the assets. The investments are not considered other-than-temporarily impaired because the Company currently does not intend to sell and has the ability and intent to hold the investments to maturity or for a period of time sufficient for a forecasted market price recovery up to or beyond the cost of the investments.

Actual maturities of CMBS are generally shorter than stated contractual maturities. Actual maturities of the Company's mortgage-backed securities are affected by the contractual lives of the underlying mortgages, periodic payments of principal and prepayments of principal.

The following table summarizes the Company's available-for-sale CMBS at March 31, 2011 and December 31, 2010 according to their weighted-average life classifications:
 
 
9

 
 
   
March 31, 2011
   
(dollars in thousands)
Weighted Average Life
 
Fair Value
   
Amortized Cost
   
Weighted
Average Coupon
                   
Less than one year
  $ -     $ -       -  
Greater than one year
                       
  less than five years
    224,427       213,311       5.37 %
Greater than five years
    -       -       -  
                         
Total
  $ 224,427     $ 213,311       5.37 %
                         
   
December 31, 2010
   
(dollars in thousands)
Weighted Average Life
 
Fair Value
   
Amortized Cost
   
Weighted
Average Coupon
                         
Less than one year
  $ -     $ -       -  
Greater than one year
                       
  less than five years
    224,112       213,637       5.37 %
Greater than five years
    -       -       -  
                         
Total
  $ 224,112     $ 213,637       5.37 %
 
The overall statistics for the Company’s CMBS investments calculated on a weighted average basis assuming no early prepayments or defaults as of March 31, 2011 and December 31, 2010, are as follows:
 
   
March 31, 2011
   
December 31, 2010
 
             
Credit Ratings (1)
 
AAA
   
AAA
 
Coupon
    5.37 %     5.37 %
Yield
    5.06 %     5.12 %
Weighted Average Life
 
4.1 years
   
4.3 years
 
(1) Ratings per Fitch, Moody’s or S&P.
         
 
The rating, vintage, property type, and location of the collateral securing the Company’s CMBS investments calculated on a weighted average basis as of March 31, 2011 and December 31, 2010 are as follows:
 
 
10

 
 
           
March 31, 2011
             
Property
         
Geographic Break Down 5% or Greater
             
Type
 
Percentage
   
State
 
Percentage
   
Vintage
 
Percentage
 
Office
   
33.0
%
 
NY
   
14.2
%
 
2006
   
77.0
%
Retail
   
32.3
%
 
CA
   
12.0
%
 
2005
   
16.9
%
Multifamily
   
5.5
%
 
TX
   
7.0
%
 
2004
   
6.1
%
Hospitality
   
8.4
%
 
FL
   
6.7
%
       
100.0
%
Industrial
   
4.9
%
 
MA
   
5.7
%
           
Other
   
15.9
%
 
Other
   
54.4
%
           
Total
   
100.0
%
 
Total
   
100.0
%
           
                                 
           
December 31, 2010
             
Property
     
Geographic Break Down 5% or Greater
             
Type
 
Percentage
   
State
 
Percentage
   
Vintage
 
Percentage
 
Office
   
33.9
%
 
NY
   
14.1
%
 
2006
   
77.0
%
Retail
   
30.1
%
 
CA
   
11.9
%
 
2005
   
16.9
%
Multifamily
   
7.3
%
 
TX
   
6.9
%
 
2004
   
6.1
%
Industrial
   
4.9
%
 
FL
   
6.7
%
       
100.0
%
Hospitality
   
5.3
%
 
MA
   
5.6
%
           
Other
   
18.5
%
 
Other
   
54.8
%
           
Total
   
100.0
%
 
Total
   
100.0
%
           
 
The Company did not sell any CMBS during the quarters ended March 31, 2011 and December 31, 2010.

5.   Agency Mortgage Backed Securities, Available-for-Sale

The following table represents the Company's available-for-sale Agency RMBS portfolio as of March 31, 2011 which are carried at their fair value.  The Company held no Agency RMBS prior to the quarter ended March 31, 2011.
 
    March 31, 2011  
   
(dollars in thousands)
 
Agency RMBS, Gross
  $ 200,790  
Unamortized premium
    9,644  
Amortized cost
    210,434  
         
Unrealized gain
    -  
Unrealized losses
    -  
         
Fair value
  $ 210,434  
 
Actual maturities of Agency RMBS are generally shorter than stated contractual maturities. Actual maturities of the Company's mortgage-backed securities are affected by the contractual lives of the underlying mortgages, periodic payments of principal and prepayments of principal.
 
The following table summarizes the Company's available-for-sale Agency RMBS at March 31, 2011 according to their weighted-average life classifications:
 
 
11

 
 
   
March 31, 2011
 
   
(dollars in thousands)
 
Weighted Average Life
 
Fair Value
   
Amortized Cost
   
Weighted
Average Coupon
 
                   
Less than one year
  $ -     $ -       -  
Greater than one year
                       
  less than five years
    210,434       210,434       4.78 %
Greater than five years
    -       -       -  
                         
Total
  $ 210,434     $ 210,434       4.78 %
 
The weighted-average lives of the Agency RMBS in the tables above are based on data provided through dealer quotes, assuming constant prepayment rates to the balloon or reset date for each security. The prepayment model considers current yield, forward yield, steepness of the curve, current mortgage rates, mortgage rate of the outstanding loan, loan age, margin and volatility.

At March 31, 2011 the Company held no Agency RMBS at an unrealized loss.

6.   Mortgages, Loans and Preferred Equity Held for Investment

The following table represents the Company's commercial mortgage loans classified as held for investment at March 31, 2011 and December 31, 2010, which are carried at their principal balance outstanding less an allowance for loan losses:
 
   
March 31, 2011
   
December 31, 2010
 
   
(dollars in thousands)
 
Beginning balance
  $ 198,208     $ 39,998  
Purchases, principal balance
    -       158,417  
Net remaining premium and discount
    (8,931 )     (9,099 )
Principal payments
    (199 )     (207 )
Less: allowance for loan losses
    (369 )     (240 )
Mortgages, loans and preferred equity held
  for investment
  $ 188,709     $ 188,869  
 
The following table summarizes the changes in the allowance for loan losses for the commercial mortgage loan portfolio for the quarters ended March 31, 2011 and December 31, 2010:
 
   
March 31, 2011
   
December 31, 2010
 
   
(dollars in thousands)
 
             
Balance, beginning of period
  $ 242     $ 2  
Provision for loan loss
    127       240  
Charge-offs
    -       -  
                 
Balance, end of period
  $ 369     $ 242  
 
 
12

 
 
The following tables present certain characteristics of the Company’s commercial mortgage loan portfolio as of March 31, 2011 and December 31, 2010.
 
March 31, 2011
 
Geographic Distribution
 
Remaining Balance
         
Property
 
Top 5 States
 
(dollars in thousands)
   
% of Loans
 
Count
 
Illinois
  $ 66,369       33.5 %     5  
Texas
    32,070       16.2 %     4  
California
    30,240       15.3 %     5  
Pennsylvania
    25,283       12.8 %     4  
Colorado
    18,890       9.6 %     2  
                         
December 31, 2010
 
Geographic Distribution
 
Remaining Balance
           
Property
 
Top 5 States
 
(dollars in thousands)
   
% of Loans
 
Count
 
Illinois
  $ 66,449       33.5 %     5  
Texas
    32,099       16.2 %     4  
California
    30,240       15.3 %     5  
Pennsylvania
    25,311       12.8 %     4  
Colorado
    18,951       9.5 %     2  
 
On a quarterly basis, the Company evaluates the adequacy of its allowance for loan losses.  Based on this analysis, the Company recorded a general provision for loan losses of $127,000 for the quarter ended March 31, 2011 compared to $127,000 for the quarter ended December 31, 2010, representing 1.5% of the Company's mortgage loan portfolio over the life of the loan.  At March 31, 2011, there were no loans 90 days or more past due and all loans were accruing interest.

7.  Fair Value Measurements

GAAP defines fair value, establishes a framework for measuring fair value, establishes a three-level valuation hierarchy for disclosure of fair value measurement and enhances disclosure requirements for fair value measurements.  The valuation hierarchy is based upon the transparency of inputs to the valuation of an asset or liability as of the measurement date.  The three levels are defined as follows:
 
Level 1 – inputs to the valuation methodology are quoted prices (unadjusted) for identical assets and liabilities in active markets.
 
Level 2 – inputs to the valuation methodology include quoted prices for similar assets and liabilities in active markets, and inputs that are observable for the asset or liability, either directly or indirectly, for substantially the full term of the financial instrument.
 
Level 3 – inputs to the valuation methodology are unobservable and significant to fair value.
 
The following discussion describes the methodologies to be utilized by the Company to fair value its financial instruments by instrument class.
 
Short-term Instruments

The carrying value of cash and cash equivalents, accrued interest receivable, dividends payable, accounts payable, and accrued interest payable generally approximates estimated fair value due to the short term nature of these financial instruments.

 
13

 

CMBS and RMBS

The Company determines the fair value of its investment securities utilizing a pricing model that incorporates such factors as coupon, prepayment speeds, weighted average life, collateral composition, borrower characteristics, expected interest rates, life caps, periodic caps, reset dates, collateral seasoning, expected losses, expected default severity, credit enhancement, and other pertinent factors.  Management will review the fair values generated by the model to determine whether prices are reflective of the current market.  Management will perform a validation of the fair value calculated by the pricing model by comparing its results to independent prices provided by dealers in the securities and/or third party pricing services.

During times of market dislocation, as has been experienced for some time, the observability of prices and inputs can be reduced for certain instruments.  If dealers or independent pricing services are unable to provide a price for an asset or if the Company deems the price provided by such dealers or independent pricing services to be unreliable, then the Company will determine the fair value of the asset in good faith.  In addition, validating third party pricing for the Company’s investments may be more subjective as fewer participants may be willing to provide this service to the Company.  Illiquid investments typically experience greater price volatility as a ready market does not exist.  As fair value is not an entity specific measure and is a market based approach which considers the value of an asset or liability from the perspective of a market participant, observability of prices and inputs can vary significantly from period to period.  A condition such as this can cause instruments to be reclassified from Level 1 to Level 2 or Level 2 to Level 3 when the Company is unable to obtain third party pricing verification.

If at the valuation date, the fair value of an investment security is less than its amortized cost at the date of the consolidated statement of financial condition, the Company will analyze the investment security for other-than-temporary impairment.  Management will evaluate the Company’s CMBS and RMBS for OTTI at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluation.  Consideration will be given to (1) the length of time and the extent to which the fair value has been lower than carrying value, (2) the intent of the Company to sell the investment prior to recovery in fair value (3) whether the Company will be more likely than not required to sell the investment before the expected recovery, (4) and the expected future cash flows of the investment in relation to its amortized cost.    If a credit portion of OTTI exists, the cost basis of the security is written down to the then-current fair value, and the unrealized loss is transferred from accumulated other comprehensive income (loss) as an immediate reduction of current earnings.

As of March 31, 2011, the Company has classified its CMBS and Agency RMBS as "Level 2".

The Company's financial assets and liabilities carried at fair value on a recurring basis are valued at March 31, 2011 and December 31, 2010 as follows:
 
   
March 31, 2011
 
   
Level 1
   
Level 2
   
Level 3
 
   
(dollars in thousands)
 
Assets:
                 
   Commercial mortgage-backed securities
  -     224,427     -  
   Agency RMBS
    -       210,434       -  
                         
   
December 31, 2010
 
   
Level 1
   
Level 2
   
Level 3
 
   
(dollars in thousands)
 
Assets:
                       
   Commercial mortgage-backed securities
  -     224,112     -  
   Agency RMBS
    -       -       -  
 
 
14

 
 
Commercial mortgage loan assets totaled $188.7 million and $188.9 million at March 31, 2011 and December 31, 2010, respectively.  These loans are held for investment and are recorded at amortized cost less an allowance for loan losses which approximates fair value.  Secured financing liabilities totaled $172.5 million and $172.8 million at March 31, 2011 and December 31, 2010.  Due to the stable interest rate environment, the fair value of the assets and liabilities remain as recorded.

8.   Secured Financing Agreements

Commercial Mortgage-Backed Securities

The Company had outstanding $172.5 million and $172.8 million of CMBS structured financing agreements with weighted average borrowing rate of 3.60% and 3.60% and weighted average remaining maturities of 3.8 years and 4.0 years as of March 31, 2011 and December 31, 2010, respectively.  Investment securities pledged as collateral under these secured financing agreements had an estimated fair value of $224.4 million and $224.1 million at March 31, 2011 and December 31, 2010, respectively.  The interest rates of these structured financing agreements are fixed to the 5 year or 3 year swap curve plus 100 basis points depending on duration.

At March 31, 2011 and December 31, 2010, the structured financing agreements had the following remaining maturities:

   
Secured Financing Carrying Value
 
   
March 31, 2011
   
December 31, 2010
 
   
(dollars in thousands)
 
2011
  $ -     $ -  
2012
    -       -  
2013
    10,762       10,995  
2014
    25,574       25,574  
2015 and thereafter
    136,134       136,268  
Total
  $ 172,470     $ 172,837  
 
At March 31, 2011 the Company had at risk 19.9% of its equity with the Federal Reserve Bank of New York (“FRBNY”).  The following tables present the debt and collateral carrying value of the Company’s secured financing by maturity date as of March 31, 2011 and December 31, 2010:
 
 
15

 
 
As of March 31, 2011
 
   
TALF Borrowing
   
CMBS
 
   
Amount
   
Fair Value
 
   
(dollars in thousands)
 
             
March 26, 2010, TALF loans, fixed rate 3.63%, mature March 2015
  $ 76,059     $ 99,615  
February 25, 2010, TALF loans, fixed rate 3.69%, mature February 2015
  $ 29,868     $ 38,094  
February 25, 2010, TALF loans, fixed rate 2.74%, mature February 2013
  $ 10,762     $ 12,579  
January 28, 2010, TALF loans, fixed rate 3.73%, mature January 2015
  $ 30,207     $ 39,344  
December 22, 2009, TALF loans, fixed rate 3.62%, mature December 2014
  $ 25,574     $ 34,795  
                 
Total
  $ 172,470     $ 224,427  
                 
As of December 31, 2010
 
   
TALF Borrowing
   
CMBS
 
   
Amount
   
Fair Value
 
   
(dollars in thousands)
 
                 
March 26, 2010, TALF loans, fixed rate 3.63%, mature March 2015
  $ 76,118     $ 99,082  
February 25, 2010, TALF loans, fixed rate 3.69%, mature February 2015
  $ 29,868     $ 38,122  
February 25, 2010, TALF loans, fixed rate 2.74%, mature February 2013
  $ 10,995     $ 13,271  
January 28, 2010, TALF loans, fixed rate 3.73%, mature January 2015
  $ 30,282     $ 38,895  
December 22, 2009, TALF loans, fixed rate 3.62%, mature December 2014
  $ 25,574     $ 34,742  
                 
Total
  $ 172,837     $ 224,112  
 
9.  Common Stock
 
During the quarter ended March 31, 2011, the Company declared dividends to common shareholders totaling $4.2 million or $0.23 per share, which were paid on April 21, 2011.
 
On March 28, 2011, the Company announced the sale of 50,000,000 shares of common stock at $11.50 per share for estimated proceeds, less the underwriters’ discount and offering expenses, of $539 million.  Concurrently with the sale of these shares Annaly purchased 5,000,000 shares at the same price per share as the public offering, for proceeds of approximately $58 million.  These sales settled on April 1, 2011.  On April 5, 2011, the underwriters exercised their option to purchase an additional 3,500,000 shares of common stock at $11.50 per share for estimated proceeds, less the underwriters’ discount and offering expenses, of $38 million.  In total, the Company raised net proceeds of approximately $635 million in these offerings.

The Company’s Consolidated Statement of Financial Condition as of March 31, 2011, reflects the sale of 50,000,000 shares of common stock and the concurrent purchase by  Annaly of 5,000,000 shares.  It does not reflect the common shares sold pursuant to the underwriters’ overallotment option, which was not exercised as of March 31, 2011.

There was no preferred stock issued or outstanding as of March 31, 2011.

10.  Equity Incentive Plan

The Company has adopted an equity incentive plan to provide incentives to our independent directors, employees of FIDAC and its affiliates, including Annaly, and other service providers to stimulate their efforts toward our continued success, long-term growth and profitability and to attract, reward and retain personnel.  The equity incentive plan is administered by the compensation committee of the board of directors.  Unless terminated earlier, the equity incentive plan will terminate in 2019, but will continue to govern unexpired awards.  The equity incentive plan provides for grants of restricted common stock and other equity-based awards up to an aggregate amount, at the time of the award, of (i) 2.5% of the issued and outstanding shares of the Company’s common stock less (ii) 250,000 shares, subject to an aggregate ceiling of 25,000,000 shares available for issuance under the plan.  The Company has issued 9,000 shares of restricted stock under the equity incentive plan to its independent directors, which vested immediately.

 
16

 
 
11.  Income Taxes

As a REIT, the Company will generally not be subject to U.S. federal or state corporate taxes on its income to the extent that qualifying distributions are made to stockholders and the REIT requirements, including certain asset, income, distribution and stock ownership tests are met.  During the quarters ended March 31, 2011 and December 31, 2010, the Company recorded zero income tax expense related to state taxes and federal taxes on undistributed income.

In general, common stock cash dividends declared by the Company will be considered ordinary income to stockholders for income tax purposes.  From time to time, a portion of the Company’s dividends may be characterized as capital gains or return of capital.

The Company files tax returns in several U.S. jurisdictions, including New York State, and New York City.  The 2009 and 2010 tax years remain open to U.S. federal, state and local examinations.

12.  Credit Risk and Interest Rate Risk

The Company's primary risks are credit risk and interest rate risk.  The Company is subject to credit risk in connection with its investments in commercial mortgage loans and credit sensitive CMBS.  When the Company assumes credit risk, it attempts to minimize interest rate risk through asset selection, hedging and matching the income earned on mortgage assets with the cost of related liabilities.  The Company attempts to manage credit risk through pre-acquisition due diligence processes including, but not limited to, analysis of the sponsor/borrower, the structure of the investment, property information including tenant composition, the property’s historical operating performance and evaluation of the market in which the property is located.  These factors are considered to be important indicators of credit risk.  The Company is subject to interest rate risk, primarily in connection with its investments in CMBS, commercial mortgage loans, Agency RMBS and borrowings under repurchase agreements.

13.  Management Agreement and Related Party Transactions

The Company has entered into a management agreement with FIDAC, a wholly owned subsidiary of Annaly, which provides for an initial term through December 31, 2013 with an automatic one-year extension option and is subject to certain termination rights.  The Company pays FIDAC a quarterly management fee equal to 1.50% per annum of our stockholders’ equity (as defined in the management agreement) of the Company.  Management fees accrued and subsequently paid to FIDAC were $680,000 and $317,000 for the quarters ended March 31, 2011 and 2010, respectively.

Upon termination without cause, the Company will pay FIDAC a termination fee.  The Company may also terminate the management agreement with 30-days’ prior notice from the Company’s board of directors, without payment of a termination fee, for cause or upon a change of control of Annaly or FIDAC, each as defined in the management agreement.  FIDAC may terminate the management agreement if the Company or any of its subsidiaries become required to register as an investment company under the Investment Company Act of 1940, as amended, or the 1940 Act, with such termination deemed to occur immediately before such event, in which case the Company would not be required to pay a termination fee.  FIDAC may also decline to renew the management agreement by providing the Company with 180-days written notice, in which case the Company would not be required to pay a termination fee.

 
17

 
 
The Company is obligated to reimburse FIDAC for its costs incurred under the management agreement.  In addition, the management agreement permits FIDAC to require the Company to pay for its pro rata portion of rent, telephone, utilities, office furniture, equipment, machinery and other office, internal and overhead expenses of FIDAC incurred in the operation of the Company.  These expenses are allocated between FIDAC and the Company based on the ratio of the Company’s proportion of gross assets compared to all remaining gross assets managed by FIDAC as calculated at each quarter end.   FIDAC and the Company will modify this allocation methodology, subject to the Company’s board of directors’ approval if the allocation becomes inequitable (i.e., if the Company becomes very highly leveraged compared to FIDAC’s other funds and accounts).  FIDAC has waived its right to request reimbursement from the Company of these expenses until such time as it determines to rescind that waiver.

Annaly purchased 4,527,778 shares of stock at the same price per share paid by other investors in the Company’s initial public offering and an additional 5,000,000 shares of stock at the same price per share paid by other investors concurrently in the Company’s March 2011 secondary offering.  As of March 31, 2011 Annaly owned approximately 13% of the Company’s outstanding shares as an equity investment.

The Company uses RCap Securities Inc., or RCap, a SEC registered broker-dealer and a wholly-owned subsidiary of Annaly, to clear its CMBS trades and RCap receives customary market-based fees and charges in return for such services.

14.  Commitments and Contingencies

From time to time, the Company may become involved in various claims and legal actions arising in the ordinary course of business none of which are currently material to the Company.

The Company has agreed to pay the underwriters of its initial public offering $0.15 per share for each share sold in the initial public offering if during any full four calendar quarter period during the 24 full calendar quarters after the consummation of the initial public offering our Core Earnings (as described below) for any such four-quarter period exceeds an 8% performance hurdle rate (as described below).  The performance hurdle rate will be met if during any full four calendar quarter period during the 24 full calendar quarters after the consummation of the Company’s initial public offering its Core Earnings for any such four-quarter period exceeds the product of (x) the weighted average of the issue price per share of all public offerings of its common stock, multiplied by the weighted average number of shares outstanding (including any restricted stock units, any restricted shares of common stock and any other shares of common stock underlying awards granted under our equity incentive plans) in such four-quarter period and (y) 8%.  Core Earnings is a non-GAAP measure and is defined as GAAP net income (loss) excluding non-cash equity compensation expense, depreciation and amortization (to the extent that we foreclose on any properties underlying our target assets), any unrealized gains, losses or other non-cash items recorded for the period, regardless of whether such items are included in other comprehensive income or loss, or in net income. The amount will be adjusted to exclude one-time events pursuant to changes in GAAP and certain other non-cash charges after discussions between FIDAC and the Company’s independent directors and after approval by a majority of the Company’s independent directors.

15. Subsequent Events

On March 18, 2011, the Company entered into a definitive asset purchase and sale agreement, or Asset Purchase Agreement, with Barclays Capital Real Estate Inc. and certain of its affiliates (collectively referred to as the Seller, which are affiliates of Barclays Capital Inc.).  Pursuant to the Asset Purchase Agreement, the Seller agreed to sell, and we agreed to purchase, a portfolio of 30 commercial real estate assets, including commercial mortgage loans, subordinate notes and mezzanine loans, relating to 17 underlying properties or groups of properties (the ‘‘Portfolio’’).  The aggregate purchase price of the Portfolio was approximately $586.0 million, payable in cash, which was adjusted based on the outstanding principal balance due at the closing of each asset in the Portfolio.  One of the assets has since been prepaid by the borrower. The aggregate purchase price for the remaining 29 assets was approximately $570 million.  On April 8, 2011, the Company purchased 28 of the remaining 29 assets, for approximately $530 million in cash. The Company and the Seller are working toward consummating the sale of the remaining asset, and expect to purchase this asset in the second quarter of 2011.

 
18

 
 
On March 28, 2011, the Company announced the sale of 50,000,000 shares of common stock at $11.50 per share for estimated proceeds, less the underwriters’ discount and offering expenses, of $539 million.  Concurrently with the sale of these shares Annaly purchased 5,000,000 shares at the same price per share as the public offering, for proceeds of approximately $58 million.  These sales settled on April 1, 2011.  On April 5, 2011, the underwriters exercised their option to purchase an additional 3,500,000 shares of common stock at $11.50 per share for estimated proceeds, less the underwriters’ discount and offering expenses, of $38 million.  In total, the Company raised net proceeds of approximately $635 million in these offerings.

 
19

 

 
Special Note Regarding Forward-Looking Statements

We make forward-looking statements in this report that are subject to risks and uncertainties. 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,’’ ‘‘would,’’ “will,” or similar expressions, we intend to identify forward-looking statements.  Statements regarding the following subjects, among others, are forward-looking by their nature:
 
 
·
our business and strategy;
 
 
·
our projected financial and operating results;
 
 
·
our ability to obtain and maintain financing arrangements and the terms of such arrangements;
 
 
·
financing and advance rates for our targeted assets;
 
 
·
general volatility of the markets in which we acquire assets;
 
 
·
the implementation, timing and impact of, and changes to, various government programs;
 
 
·
our expected assets;
 
 
·
changes in the value of our assets;
 
 
·
market trends in our industry, interest rates, the debt securities markets or the general economy;
 
 
·
rates of default or decreased recovery rates on our assets;
 
 
·
our continuing or future relationships with third parties;
 
 
·
prepayments of the mortgage and other loans underlying our mortgage-backed or other asset-backed securities;
 
 
·
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, accounting guidance, and similar matters;
 
 
·
our ability to maintain our qualification as a REIT for federal income tax purposes;
 
 
·
ability to maintain our exemption from registration under the Investment Company Act of 1940, as amended;
 
 
·
the availability of opportunities in real estate-related and other securities;
 
 
·
the availability of qualified personnel;
 
 
·
estimates relating to our ability to make distributions to our stockholders in the future;
 
 
·
our understanding of our competition;
 
 
·
interest rate mismatches between our assets and our borrowings used to finance purchases of such assets;
 
 
·
changes in interest rates and mortgage prepayment rates;
 
 
·
the effects of interest rate caps on our adjustable-rate mortgage-backed securities;
 
 
·
our ability to integrate a large portfolio acquired assets into our existing portfolio; and
 
 
·
our ability to realize our expectations of the advantages of acquiring the assets in the planned acquisition.
 
 
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The forward-looking statements are based on our beliefs, assumptions and expectations of our future performance, taking into account all information currently available to us. You should not place undue reliance on these forward-looking statements. These beliefs, assumptions and expectations can change as a result of many possible events or factors, not all of which are known to us.  For a discussion of the risks and uncertainties which could cause actual results to differ from those contained in forward looking statements, see our most recent Annual Report on Form 10-K and any subsequent Form 10-Q.  If a change occurs, our business, financial condition, liquidity and results of operations may vary materially from those expressed in our forward-looking statements.  Any forward-looking statement speaks only as of the date on which it is made. New risks and uncertainties arise from time to time, and it is impossible for us to predict those events or how they may affect us. Except as required by law, we are not obligated to, and do not intend to, update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.
 
Executive Summary

We are a commercial real estate finance company that acquires, manages, and finances, directly or through our subsidiaries, commercial mortgage loans and other commercial real estate debt, commercial mortgage-backed securities, or CMBS, and other commercial real estate-related assets.  We expect that the commercial real estate loans we acquire will be fixed and floating rate first mortgage loans secured by commercial properties.  We may also acquire subordinated commercial mortgage loans and mezzanine loans.  We intend to acquire CMBS which are rated AAA through BBB as well as CMBS that are below investment grade or are non-rated.  The other commercial real estate-related securities and other commercial real estate asset classes will consist of commercial real property, debt and equity tranches of commercial real estate collateralized debt obligations, or CRE CDOs, loans to real estate companies including real estate investment trusts, or REITs, and real estate operating companies, or REOCs, commercial real estate securities and commercial real property.  In addition, we expect to acquire residential mortgage-backed securities, or RMBS, for which a U.S. Government agency such as Ginnie Mae, or a federally chartered corporation such as Fannie Mae and Freddie Mac, guarantees payments of principal and interest on the securities.  We refer to these securities as Agency RMBS.  We refer to Ginnie Mae, Fannie Mae, and Freddie Mac collectively as the Agencies.

We are externally managed by Fixed Income Discount Advisory Company, which we refer to as FIDAC.  FIDAC is a wholly owned subsidiary of Annaly.

We have elected to be taxed as a REIT for federal income tax purposes commencing with our taxable year ending on December 31, 2009.  Our targeted asset classes and the principal investments we expect to make in each include:

Asset Class
 
Principal Assets
 
Commercial Mortgage Loans
 
 
First mortgage loans that are secured by commercial properties
 
Construction loans
 
Subordinated Debt
 
“B-notes,” “C-notes,” and other subordinated notes
 
Mezzanine loans
 
Preferred Equity
 
Commercial Mortgage-Backed Securities, or CMBS
 
CMBS rated AAA through BBB
 
CMBS that are rated below investment grade or are non-rated
 
Commercial Real Property
 
Office buildings
 
Hotels
 
Retail
 
Industrial
 
Multifamily residential condominiums
 
Other commercial real property including land
 
Other Commercial Real Estate Assets
 
Debt and equity tranches of CRE CDOs
 
Loans to real estate companies including REITs and REOCs
 
Commercial real estate securities
     
Agency RMBS
  Single-family residential mortgage pass-through certificates representing interests in “pools” of mortgage loans secured by residential real property where payments of both interest and principal are guaranteed by a U.S. Government agency or federally chartered corporation
 
 
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We completed our initial public offering on September 22, 2009.  In that offering, and in a concurrent private offering, we raised net proceeds of approximately $257.3 million.  On April 1, 2011, we settled the sale of 50,000,000 shares of common stock at $11.50 per share for estimated proceeds, less the underwriters’ discount and offering expenses, of $539 million.  Concurrently with the sale of these shares Annaly purchased 5,000,000 shares at the same price per share as the public offering, for proceeds of approximately $58 million.  On April 5, 2011, the underwriters exercised their option to purchase an additional 3,500,000 shares of common stock at $11.50 per share for estimated proceeds, less the underwriters’ discount and offering expenses, of $38 million.  In total, we raised net proceeds of approximately $635 million in these offerings.  We refer to this capital raise as the March 2011 Offering.

Since we commenced operations in September 2009, we have focused our investment activities on acquiring CMBS and on purchasing commercial mortgage loans that have been originated by select high-quality originators.    We expect that over the near term our investment portfolio will be weighted toward commercial real estate loans and other commercial real estate debt, subject to maintaining our REIT qualification and our 1940 Act exemption.

Our principal business objective is to capitalize on the fundamental changes that have occurred and are occurring in the commercial real estate finance industry to provide attractive risk adjusted returns to our stockholders over the long term, primarily through dividends and secondarily through capital appreciation.  In order to capitalize on the changing sets of opportunities that may be present in the various points of an economic cycle, we may expand or refocus our strategy by emphasizing assets in different parts of the capital structure and different real estate sectors.  In the near to medium term, we expect to continue to deploy our capital through the origination and acquisition of commercial first mortgage loans, CMBS, mezzanine financings and other commercial real-estate debt instruments at attractive risk-adjusted yields as well as directly in commercial real property.  We expect to allocate our capital within our targeted asset classes opportunistically based upon our Manager’s assessment of the risk-reward profiles of particular assets.  Our strategy may be amended from time to time, if recommended by our Manager and approved by our board of directors.  If we amend our asset strategy, we are not required to seek stockholder approval.

We use borrowings as part of our financing strategy.  Although we are not required to maintain any particular leverage ratio, the amount of leverage we incur is determined by our Manager, taking into account a variety of factors, which may include the anticipated liquidity and price volatility of the assets in our portfolio, the potential for losses and extension risk in our portfolio, the gap between the duration of our assets and liabilities, including hedges, the availability and cost of financing our assets, the creditworthiness of our financing counterparties, the health of the U.S. economy and commercial and residential mortgage markets, the outlook for the level, slope, and volatility of interest rate movement, the credit quality of our target assets and the collateral underlying our target assets.  We seek to enhance the returns on our commercial mortgage loan assets, especially loan acquisitions, through securitizations.  If possible, we securitize the senior portion, expected to be equivalent to investment grade rated CMBS, while retaining the subordinate securities in our portfolio.  We use repurchase agreements to finance acquisitions of Agency RMBS with a number of counterparties.  In the future, we may also use other sources of financing to fund the acquisition of our targeted assets, including warehouse facilities and other secured and unsecured forms of borrowing.  We may also seek to raise further equity capital or issue debt securities to fund our future asset acquisitions.

 
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Subject to maintaining our qualification as a REIT, we may, from time to time, utilize derivative financial instruments to mitigate the effects of fluctuations in interest rates and its effects on our asset valuations.  We also may engage in a variety of interest rate management techniques that seek to mitigate changes in interest rates or other potential influences on the values of our assets.  We may attempt to reduce interest rate risk and to minimize exposure to interest rate fluctuations through the use of match funded financing structures, when appropriate.  We expect these instruments will allow us to minimize, but not eliminate, the risk that we have to refinance our liabilities before the maturities of our assets and to reduce the impact of changing interest rates on our earnings.

All ratios using average equity calculations for the quarter ended March 31, 2011 are calculated using the equity balance excluding the follow-on offerings proceeds.

Current Environment
 
We believe that the current market environment presents a compelling opportunity to achieve attractive risk adjusted returns in commercial real estate assets. We estimate that approximately $1.6 trillion of commercial and multifamily mortgage debt remain on bank balance sheets and, accordingly, due to years of mandatory de-leveraging, markets are likely to face a void of several hundred billion dollars over this period that must be filled by new mortgage lenders since the supply of debt from traditional lending sources is anticipated to be less than the volume necessary to refinance maturing real estate loans. The volume of issuances of newly created CMBS dropped from $228.6 billion in 2007 to $2.7 billion in 2009 and was recorded at $11.6 billion in 2010. This decline has had a concomitant impact on the supply of capital for new commercial mortgage lending since the net proceeds from newly created CMBS issuances are applied to purchase commercial mortgage loans from loan originators.

Factors Impacting our Operating Results
In addition to the prevailing market conditions, our operations are affected by a number of factors and primarily depend on, among other things, the level of our net interest income, the market value of our assets and the supply of, and demand for, commercial mortgage loans, commercial real estate debt, CMBS and other financial assets in the marketplace. Our net interest income, includes the actual payments we receive and is also impacted by the amortization of purchase premiums and accretion of purchase discounts. Our net interest income varies over time, primarily as a result of changes in interest rates, prepayment rates on our mortgage loans and prepayment speeds, as measured by the Constant Prepayment Rate, or CPR, on our CMBS and RMBS assets. Interest rates and prepayment rates vary according to the type of asset, conditions in the financial markets, credit worthiness of our borrowers, competition and other factors, none of which can be predicted with any certainty. Our operating results may also be impacted by credit losses in excess of initial anticipations or unanticipated credit events experienced by borrowers whose mortgage loans are held directly by us or are included in our CMBS.

Change in Fair Value of our Assets. It is our business strategy to hold our targeted assets as long-term investments. As such, we expect that the majority of our Mortgage-Backed Securities, or MBS,  will be carried at their fair value, as available-for-sale securities in accordance with ASC 320 Investments in Debt and Equity Securities, with changes in fair value recorded through accumulated other comprehensive income/(loss), a component of stockholders’ equity, rather than through earnings. As a result, we do not expect that changes in the fair value of the assets will normally impact our operating results. At least on a quarterly basis, however, we will assess both our ability and intent to continue to hold such assets as long-term investments. As part of this process, we will monitor our targeted assets for other-than-temporary impairment, or OTTI. A change in our ability or intent to continue to hold any of our investment securities could result in our recognizing an impairment charge or realizing losses upon the sale of such securities.

Credit Risk. We may be exposed to various levels of credit risk depending on the nature of our underlying assets and the nature and level of credit enhancements, if any, supporting our assets. FIDAC and FIDAC’s Investment Committee will approve and monitor credit risk and other risks associated with each investment. We will seek to manage this risk through our pre-acquisition due diligence processes including, but not limited to, analysis of the sponsor/borrower, the structure of the investment, property information including tenant composition, the property’s historical operating performance and evaluation of the market in which the property is located.

Size of Portfolio. The size of our portfolio, as measured by the aggregate unpaid principal balance of our mortgage loans and aggregate principal balance of our mortgage related securities and the other assets we own is also a key revenue driver. Generally, as the size of our portfolio grows, the amount of interest income we receive increases. The larger portfolio, however, drives increased expenses as we incur additional interest expense to finance the purchase of our assets.

 
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Changes in Market Interest Rates. With respect to our business operations, increases in interest rates, in general, may over time cause:

 
·
the interest expense associated with our borrowings to increase;
 
 
·
the value of our adjustable rate mortgage loans and adjustable rate MBS, to decline;
 
 
·
coupons on our adjustable rate mortgage loans to reset, although on a delayed basis, to higher interest rates;
 
 
·
to the extent applicable under the terms of our investments, prepayments on our mortgage loan portfolio, MBS and Agency RMBS to slow, thereby slowing the amortization of our purchase premiums and the accretion of our purchase discounts; and
 
 
·
to the extent we enter into interest rate swap agreements as part of our hedging strategy, the value of these agreements to increase.
 
Conversely, decreases in interest rates, in general, may over time cause:
 
 
·
to the extent applicable under the terms of our investments, prepayments on our mortgage loan and Agency  RMBS portfolio to increase, thereby accelerating the amortization of our purchase premiums and the accretion of our purchase discounts;
 
 
·
the interest expense associated with our borrowings to decrease;
 
 
·
the value of our mortgage loan, MBS and Agency RMBS portfolio to increase;
 
 
·
to the extent we enter into interest rate swap agreements as part of our hedging strategy, the value of these agreements to decrease; and
 
 
·
coupons on our adjustable-rate mortgage loans, MBS and Agency RMBS to reset, although on a delayed basis, to lower interest rates
 
Since changes in interest rates may significantly affect our activities, our operating results depend, in large part, upon our ability to effectively manage interest rate risks and prepayment risks while maintaining our status as a REIT.

Critical Accounting Policies

Our consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States of America, or GAAP.  These accounting principles may require us to make some complex and subjective decisions and assessments.  Our most critical accounting policies will involve decisions and assessments that could affect our reported assets and liabilities, as well as our reported revenues and expenses.  We believe that all of the decisions and assessments upon which our consolidated financial statements are based will be reasonable at the time made and based upon information available to us at that time.  The following are or will be our most critical accounting policies:

Loans and Securities Held for Investment

We purchase CMBS, commercial real estate loans, commercial real estate-related securities and Agency RMBS, a portion of which may be held for investment.  Loans or securities held for investment are intended to be held to maturity and, accordingly, will be reported at amortized cost less an allowance for loan losses.

Securities Held as Available-for-Sale

Our CMBS, commercial real estate-related securities and Agency RMBS may be held as available-for-sale. In accordance with Accounting Standards Codification (“ASC”) 320, Investments – Debt and Equity Securities, assets classified as available-for-sale are reported at fair value, and unrealized gains and losses included in other comprehensive income.  We analyze assets for impairment and any credit impairment is reflected in the consolidated statements of operations.

 
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Valuation of Financial Instruments
 
 ASC 820, Fair Value Measurements and Disclosure, establishes a framework for measuring fair value, and expands related disclosures.  This guidance establishes a hierarchy of valuation techniques based on the observability of inputs utilized in measuring financial instruments at fair values.   It also establishes market based or observable inputs as the preferred source of values, followed by valuation models using management assumptions in the absence of market inputs.  The three levels of the hierarchy are described below:

Level 1 – Quoted prices in active markets for identical assets or liabilities.
 
Level 2 – Prices are determined using other significant observable inputs. Observable inputs are inputs that other market participants would use in pricing a security. These may include quoted prices for similar securities, interest rates, prepayment speeds, credit risk and others.
 
Level 3 – Prices are determined using significant unobservable inputs. In situations where quoted prices or observable inputs are unavailable (for example, when there is little or no market activity for an investment at the end of the period), unobservable inputs may be used.
 
Unobservable inputs reflect our own assumptions about the factors that market participants would use in pricing an asset or liability, and would be based on the best information available. We anticipate that a portion of our future asset purchases may be classified as Level 3 in the valuation hierarchy.

FASB has provided guidance for the valuation of assets when the market is not active and when the volume and level of activity have significantly decreased, along with guidance on identifying transactions that are not orderly. This guidance allows the use of management’s internal cash flow and discount rate assumptions when relevant observable data does not exist and clarifies how observable market information and market quotes should be considered when measuring fair value in an inactive market.   Additionally, FASB provided guidance on determining fair value when the volume and level of activity for the asset or liability have significantly decreased when compared with normal market activity for the asset or liability (or similar assets or liabilities). This guidance provides factors to evaluate if there has been a decrease in normal market activity and if so, provides a methodology to analyze transactions or quoted prices and make necessary adjustments to fair value.  The objective is to determine the point within a range of fair value estimates that is most representative of fair value under current market conditions.

FIDAC determines the value of our securities on a quarterly basis using third party pricing models and its proprietary models.  FIDAC receives independent dealer quotes for each of its securities, and compares these quotes to evaluate the reasonableness of the FIDAC determined values.  Any changes to the valuation methodology will be reviewed by management to ensure the changes are appropriate. As markets and products develop and the pricing for certain products becomes more transparent, we will continue to refine our valuation methodologies. The methods used by us may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. Furthermore, while we anticipate that our valuation methods will be appropriate and consistent with other market participants, the use of different methodologies, or assumptions, to determine the fair value of certain financial instruments could result in a different estimate of fair value at the reporting date. We will use inputs that are current as of the measurement date, which may include periods of market dislocation, during which price transparency may be reduced.

Loan Impairment

Loans held for investment are valued quarterly to determine if an impairment exists. Impairment occurs when it is deemed probable that we will not be able to collect all amounts due according to the contractual terms of the loan. If upon completion of the valuation, the fair value of the underlying collateral securing the impaired loan is less than the net carrying value of the loan, an allowance will be created with a corresponding charge to the provision for losses.  An allowance for each loan is maintained at a level believed adequate by management to absorb probable losses. We may elect to sell a loan held for investment due to adverse changes in credit fundamentals. Once the determination has been made by us that we will no longer hold the loan for investment, we will account for the loan at the lower of amortized cost or estimated fair value. The reclassification of the loan and recognition of impairments could adversely affect our reported earnings.

 
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Impairment of Securities

Securities are valued quarterly to determine if OTTI exists. Impairment occurs when the fair value of the investment is less than its amortized cost basis. The securities are evaluated based on the intent to sell the security or if it is more likely than not that we will be required to sell the debt security before its anticipated recovery. If the intention is not to sell (and we are not required to sell), the credit loss, if any, will be recognized in the statement of earnings and the balance of impairment related to other factors recognized in Other Comprehensive Income, or OCI.  Credit loss is determined by comparing the difference between the present value of cash flows expected to be collected and the amortized cost basis.  If the intention is to sell the security (or we are required to sell) before its anticipated recovery, the full OTTI will be recognized in the statement of earnings. The recognition of impairments could adversely affect our reported earnings.

Classifications of Investment Securities

We expect our assets to consist primarily of commercial real estate debt instruments, CMBS and Agency RMBS that we will classify as either available-for-sale or held-to-maturity.  As such, our assets are classified as available-for-sale will be carried at their fair value in accordance with ASC 320, with changes in fair value recorded through accumulated other comprehensive income/(loss), a component of stockholders’ equity, rather than through earnings.  Assets held for investment will be stated at their amortized cost, net of deferred fees and costs with income recognized using the effective interest method.  When the estimated fair value of an available-for-sale security is less than amortized cost, we will consider whether there is OTTI in the value of the security. Unrealized losses on securities considered to be other-than-temporary will be recognized in earnings. The determination of whether a security is other-than-temporarily impaired will involve judgments and assumptions based on subjective and objective factors.  Consideration will be 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) our intent to sell our investment in the security, or whether it is more likely than not we will be required to sell the security before its anticipated recovery in fair value. Investments with unrealized losses will not be considered other-than-temporarily impaired if we have the ability and intent to hold the investments for a period of time, to maturity if necessary, sufficient for a forecasted market price recovery up to or beyond the amortized cost of the investments and if a credit loss does not exist.

Investment Consolidation

When acquiring assets, we evaluate the underlying entity that issued the securities we intend to acquire, or to which we will make a loan to determine the appropriate accounting. We refer, initially, to guidance in ASC 860-Transfers and Servicing and ASC 810, Consolidation, in performing our analysis. ASC 810 addresses consolidation of certain entities in which voting rights are not effective in identifying an investor with a controlling financial interest. An entity is subject to consolidation analysis under this guidance if it is determined that the entity is a Variable Interest Entity, or VIE.  In a VIE, the equity investors either do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support, are unable to direct the entity’s activities, or are not exposed to the entity’s losses or entitled to its residual returns proportional to their ownership.  Variable interest entities within the scope of this guidance are required to be consolidated by their primary beneficiary. The primary beneficiary of a VIE has a controlling interest in the VIE.  The assessment of controlling interest shall consider the VIEs purpose and design.  A controlling interest is defined as (a) the power to direct the activities of a VIE that most significantly impact the VIEs economic performance and (b) the obligation to absorb losses of the VIE that could potentially be significant to the VIE and/or the right to receive benefits from the VIE that could potentially be significant to the VIE.  The exemption for a Qualifying Special Purpose Entity or QSPE was eliminated by the January 1, 2010 update to this guidance and implemented ongoing analysis to assess the primary beneficiary.  Currently, this guidance has no material effect on our consolidated financial.

 
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Securitizations

We may periodically enter into transactions in which we sell financial assets, such as commercial mortgage loans, CMBS and other assets. Upon a transfer of financial assets, we may retain or acquire senior or subordinated interests in the related assets. Gains and losses on such transactions will be recognized using the guidance in ASC 860-Transfers and Servicing, which is based on a financial components approach that focuses on control. Under this approach, after a transfer of financial assets that meets the criteria for treatment as a sale--legal isolation, ability of transferee to pledge or exchange the transferred assets without constraint, and transferred control--an entity recognizes the financial and servicing assets it acquired or retained and the liabilities it has incurred, derecognizes financial assets it has sold, and derecognizes liabilities when extinguished. We will determine the gain or loss on sale of mortgage loans by allocating the carrying value of the underlying mortgage between securities or loans sold and the interests retained based on their fair values. The gain or loss on sale is the difference between the total proceeds from the sale and the amount allocated to the securities or loans sold. From time to time, we may securitize mortgage loans we hold if such financing is available. These transactions will be recorded in accordance with ASC 860 and will be accounted for as either a “sale” and the loans will be removed from our balance sheet or as a “financing” and will be classified as “securitized loans” on our balance sheet, depending upon the structure of the securitization transaction.

Valuations of Available-for-Sale Securities

Our available-for-sale securities have fair values as determined by FIDAC with reference to price estimates provided by independent pricing services and dealers in the securities. FIDAC will evaluate available-for-sale securities estimates by conducting its own analysis at least on a quarterly basis, and more frequently when economic or market conditions warrant such evaluation. The pricing is subject to various assumptions which could result in different presentations of value.

When the fair value of an available-for-sale security is less than its amortized cost for an extended period, we will consider whether there is OTTI in the value of the security. If, based on our analysis, a credit portion of  OTTI exists, the cost basis of the security is written down to the then-current fair value, and the unrealized loss is transferred from accumulated other comprehensive loss as an immediate reduction of current earnings as if the loss had been realized in the period of OTTI.  The determination of OTTI is a subjective process, and different judgments and assumptions could affect the timing of loss realization.

We will consider the following factors when determining OTTI for a security or investment:

 
·
The length of time and the extent to which the market value has been less than the amortized cost;
 
 
·
Whether the security has been downgraded by a rating agency; and
 
 
·
Whether we have the intent to sell the security or will be required to sell the security before any anticipated recovery in market value to amortized cost.
 
The determination of OTTI is made at least quarterly. If we determine an impairment to be other than temporary we will need to realize a loss that would have an impact on future income.

Interest Income Recognition

Interest income on available-for-sale securities and loans held for investment will be recognized over the life of the investment using the effective interest method. Interest income on mortgage-backed securities is recognized using the effective interest method.  Interest income on loans held for investment is recognized based on the contractual terms of the loan instruments. Income recognition will be suspended for loans when, in the opinion of management, a full recovery of income and principal becomes doubtful.  Income recognition will be resumed when the loan becomes contractually current and performance is demonstrated to be resumed. Any loan fees or acquisition costs on originated loans or securities will be capitalized and recognized as a component of interest income over the life of the investment using the effective interest method.

 
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Management estimates, at the time of purchase, the future expected cash flows and determine the effective interest rate based on these estimated cash flows and our purchase price. As needed, these estimated cash flows will be updated and a revised yield computed based on the current amortized cost of the investment. In estimating these cash flows, there will be a number of assumptions that will be subject to uncertainties and contingencies. These include the rate and timing of principal payments (including prepayments, repurchases, defaults and liquidations), the pass-through or coupon rate and interest rate fluctuations. In addition, interest payment shortfalls due to delinquencies on the underlying mortgage loans, and the timing of the magnitude of credit losses on the mortgage loans underlying the securities have to be judgmentally estimated. These uncertainties and contingencies are difficult to predict and are subject to future events that may impact management’s estimates and our interest income.

Security transactions will be recorded on the trade date. Realized gains and losses from security transactions will be determined based upon the specific identification method and recorded as gain (loss) on sale of available-for-sale securities and loans held for investment in the consolidated statement of operations.

We account for accretion of discounts or amortization of premiums on available-for-sale securities and real estate loans using the effective interest method.  Such amounts will be included as a component of interest income in the consolidated statement of operations.

Accounting For Derivative Financial Instruments

Our policies permit us to enter into derivative contracts, including interest rate swaps and interest rate caps, as a means of mitigating our interest rate risk. We may use interest rate derivative instruments to mitigate interest rate risk rather than to enhance returns.

We will account for derivative financial instruments in accordance with ASC 815, Derivatives and Hedging. ASC 815 requires us to recognize all derivatives as either assets or liabilities in the consolidated statement of financial condition and to measure those instruments at fair value. Additionally, fair value adjustments will affect either other comprehensive income in stockholders’ equity until the hedged item is recognized in earnings or net income depending on whether the derivative instrument qualifies as a hedge for accounting purposes and, if so, the nature of the hedging activity.

In the normal course of business, we may use a variety of derivative financial instruments to manage, or hedge, interest rate risk. When the terms of an underlying transaction are modified, or when the underlying hedged item ceases to exist, all changes in the fair value of the instrument are marked-to-market with changes in value included in net income for each period until the derivative instrument matures or is settled. Any derivative instrument used for risk management that does not meet the hedging criteria is marked-to-market with the changes in value included in net income.   Qualitative disclosures about objectives and strategies for using derivatives, quantitative disclosures about fair value amounts of gains and losses on derivative instruments, and disclosures about credit-risk-related contingent features in derivative agreements shall be included in future financial reporting.

Derivatives will be used for hedging purposes rather than speculation. We will rely on quotations from a third party to determine their fair values.  FIDAC will evaluate the quotations provided by third parties by conducting its own analysis at least on a quarterly basis, and more frequently when economic or market conditions warrant such evaluation. If our hedging activities do not achieve our desired results, our reported earnings may be adversely affected.

Reserve for Probable Credit Losses

The expense for probable credit losses in connection with debt investments is the charge to earnings to increase the allowance for probable credit losses to the level that management estimates to be adequate considering delinquencies, loss experience and collateral quality. Other factors considered relate to geographic trends and product diversification, the size of the portfolio and current economic conditions. Based upon these factors, we will establish the provision for probable credit losses by category of asset. When it is probable that we will be unable to collect all amounts contractually due, the account is considered impaired.

 
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Where impairment is indicated, a valuation write-down or write-off will be measured based upon the excess of the recorded investment amount over the net fair value of the collateral, as reduced by selling costs. Any deficiency between the carrying amount of an asset and the net sales price of repossessed collateral will be charged to the allowance for credit losses.

Income Taxes

We have elected and are qualified to be taxed as a REIT beginning with our taxable year ending on December 31, 2009. Accordingly, we will generally not be subject to corporate federal income tax (or applicable state or local taxes) to the extent that we make qualifying distributions to our stockholders, and provided we satisfy on a continuing basis, through actual investment and operating results, the REIT requirements including certain asset, income, distribution and stock ownership tests. If we fail to qualify as a REIT, and do not qualify for certain statutory relief provisions, we will be subject to U.S. federal income tax (and applicable state and local taxes) and may be precluded from qualifying as a REIT for the subsequent four taxable years following the year in which we lost our REIT qualification. Accordingly, our failure to qualify as a REIT could have a material adverse impact on our results of operations and amounts available for distribution to our stockholders.

The dividends paid deduction of a REIT for qualifying dividends to its stockholders is computed using our taxable income as opposed to net income reported on the financial statements. Taxable income, generally, will differ from net income reported on the financial statements because the determination of taxable income is based on tax provisions and not financial accounting principles.

We may elect to treat certain of our subsidiaries as taxable REIT subsidiaries (TRS). In general, a TRS may hold assets and engage in activities that a REIT cannot hold or engage in directly and generally may engage in any real estate or non-real estate-related business. A domestic TRS is subject to U.S. federal income tax (and applicable state and local taxes). We presently have not elected TRS status for any of our subsidiaries.
 
Should we establish a TRS, as such entity generated net income, it could declare dividends to us which would be included in our taxable income and necessitate a distribution to our stockholders.  Conversely, to avoid a distribution requirement, the TRS could retain its earnings and we would increase book equity of the consolidated entity by the amount of the retained earnings.
 
Financial Condition

At March 31, 2011, our investment portfolio consisted of $623.6 million of securities and loans.
 
The following table summarizes certain characteristics of our portfolio at the quarter ended March 31, 2011 and December 31, 2010:
 
 
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Quarter ended
March 31, 2011
   
Quarter ended
December 31, 2010
 
   
(dollars in thousands)
   
(dollars in thousands)
 
Investment portfolio at quarter-end
  $ 623,570     $ 412,981  
Interest bearing liabilities at quarter-end
    172,470       172,837  
Leverage at quarter-end (Debt:Equity)
 
0.2:1
   
0.6:1
 
Fixed-rate investments as percentage of portfolio
    96 %     94 %
Adjustable-rate investments as percentage of portfolio
    4 %     6 %
Fixed-rate investments
               
    Agency mortgage-backed securities as percentage
     of fixed-rate assets
    34 %     -  
    Commercial mortgage-backed securities as percentage
     of fixed-rate assets
    36 %     55 %
    Commercial mortgage loans as percentage of fixed-rate assets
    26 %     40 %
    Commercial preferred equity loans as percentage of fixed-rate assets
    4 %     5 %
Adjustable-rate investments
               
    Commercial mortgage loans as percentage of adjustable-rate assets
    100 %     100 %
Weighted average yield on interest earning assets at quarter-end
    6.47 %     7.75 %
Weighted average cost of funds at quarter-end
    3.60 %     3.60 %
 
The following table summarizes certain characteristics of each class in our portfolio at March 31, 2011 and December 31, 2010:
 
   
Quarter ended
   
Quarter ended
 
   
March 31, 2011
   
December 31, 2010
 
   
CMBS
   
Loans(1)
   
Agency
   
CMBS
   
Loans(1)
   
Agency
 
Weighted average cost basis
  $ 101.4     $ 96.1     $ 104.8     $ 101.4     $ 96.1       -  
Weighted average fair value
  $ 106.6     $ 96.3     $ 104.8     $ 106.3     $ 96.2       -  
Weighted average coupon
    5.37 %     9.10 %     4.78 %     5.37 %     9.10 %     -  
Fixed-rate percentage of asset class
    100 %     87 %     100 %     100 %     87 %     -  
Adjustable-rate percentage of asset class
    -       13 %     -       -       13 %     -  
Weighted average yield on assets at period-end
    5.06 %     10.46 %     3.87 %     5.12 %     10.40 %     -  
Weighted average cost of funds at period-end
    3.60 %     -       -       3.60 %     -       -  
                                                 
(1) Includes commercial mortgage loans and commercial preferred equity loans.
                         
 
Results of Operations
 
Net Income Summary
 
Our net income for the quarter ended March 31, 2011 was $4.6 million, or $0.23 per weighted average share.  Our net income for the quarter ended March 31, 2010 was $1.8 million, or $0.10 per weighted average share. Our revenue was generated primarily by interest income.  We attribute the increase in net income to the continued deployment of capital and duration of investments held.   The table below presents the net income summary for the quarters ended March 31, 2011 and 2010:
 
 
30

 
 
Net Income  Summary
 
(dollars in thousands, except share and per share data)
 
             
   
For the
Quarter ended
March 31, 2011
(unaudited)
   
For the
Quarter ended
March 31, 2010
(unaudited)
 
             
Net interest income:
           
Interest income
  $ 7,381     $ 2,898  
Interest expense
    1,532       584  
   Net interest income
    5,849       2,314  
                 
Realized gains on sale of investments
    -       623  
                 
Other expenses:
               
Provision for loan losses
    127       15  
Management fee
    680       317  
General and administrative expenses
    480       777  
   Total other expenses
    1,287       1,109  
Net income before income tax
    4,562       1,828  
Income tax
    1       -  
Net income
  $ 4,561     $ 1,828  
Net income per share-basic and diluted
  $ 0.23     $ 0.10  
Weighted average number of shares outstanding-basic and
  diluted
    19,953,445       18,120,112  
Comprehensive income:
               
Net income
    4,561       1,828  
Other comprehensive income:
               
Unrealized gain on securities available for sale
    641       1,729  
Reclassification adjustment for realized (losses) gains included in income
    -       (623 )
   Total other comprehensive income
    641       1,106  
Comprehensive income
  $ 5,202     $ 2,934  
                 
Interest Income and Average Earning Asset Yield
 
We had average earning assets of $415.5 million and $165.1 million for the quarters ended March 31, 2011 and 2010, respectively.  Our interest income was $7.4 million and $2.9 million for the quarters ended March 31, 2011 and 2010, respectively.  The annualized yield on our portfolio was 7.10% and 7.01% for the quarters ended March 31, 2011 and 2010, respectively.  We attribute the increase in interest income to the purchase additional assets and the duration that they were held.

Interest Expense and the Cost of Funds
 
We had average borrowed funds of $172.6 million and total interest expense of $1.5 million for the quarter ended March 31, 2011.  Our average cost of funds was 3.60% for the quarter ended March 31, 2011.  We had average borrowed funds of $65.6 million and interest expense of $584,000 for the quarter ended March 31, 2010.  Our average cost of funds was 3.60% for the quarter ended March 31, 2010.   We attribute the increase in interest expense to the increase of financing to purchase additional assets.

 
31

 
 
Net Interest Income
 
Our net interest income, which equals interest income less interest expense, totaled $5.8 million and $2.3 million for the quarters ended March 31, 2011 and 2010, respectively. Our net interest spread, which equals the yield on our average assets for the quarter less the average cost of funds was 3.51% and 3.41% for the quarters ended March 31, 2011 and March 31, 2010, respectively.  We attribute the increase in net interest spread to the additional purchases of interest earning assets without the use of financing.
 
The table below shows our average assets held, total interest income, weighted average yield on average interest earning assets at period end, average balance of secured financing agreements, interest expense, weighted average cost of funds at period end, net interest income, and net interest rate spread for the quarters ended March 31, 2011, the year ended December 31, 2010 and the four quarters of 2010.
 
Net Interest Income
(Ratios have been annualized, dollars in thousands)
         
Yield on
               
   
Average
   
Average
             
Net
   
Earning
 
Interest
Interest
 
Average
   
Average
 
Net
Interest
   
Assets
 
Earned on
Earning
 
Debt
 
Interest
Cost
 
Interest
Rate
   
Held*
 
Assets
Assets*
 
Balance
 
Expense
of Funds
 
Income
Spread
Quarter ended March 31, 2011
$
  415,519
$
        7,380
7.10%
$
  172,612
$
     1,532
3.60%
$
      5,848
3.50%
For the year ended December 31, 2010
$
  290,150
$
      20,675
7.13%
$
  173,341
$
     5,279
3.60%
$
    15,395
3.53%
Quarter ended December 31, 2010
$
  398,285
$
        7,289
7.32%
$
  172,947
$
     1,569
3.60%
$
      5,721
3.72%
Quarter ended September 30, 2010
$
  318,188
$
        5,685
7.15%
$
  173,226
$
     1,569
3.60%
$
      4,116
3.55%
Quarter ended June 30, 2010
$
  279,020
$
        4,809
6.89%
$
  173,678
$
     1,557
3.61%
$
      3,252
3.28%
Quarter ended March 31, 2010
$
  165,107
$
        2,892
7.01%
$
    65,633
$
        584
3.60%
$
      2,308
3.41%
                           
*Excludes cash and cash equivalents.
                         
 
The secured financing balances were $172.5 million and $174.0 million for the quarters ended March 31, 2011 and March 31, 2010, respectively.
 
Gains and Losses on Sales
 
During the quarter ended March 31, 2011, we had no sales of investments.  We sold assets with a carrying value of $60.6 million resulting in realized gains of $623,000 for the ended March 31, 2010.
 
Management Fee and General and Administrative Expenses
 
We paid FIDAC a management fee of $680,000 and $317,000 for the quarters ended March 31, 2011 and 2010, respectively.  The management fee is based on stockholders’ equity.
 
General and administrative, or G&A, and management fee expenses were $1.2 million and $1.1 million for the quarters ended March 31, 2011 and 2010, respectively.
 
Total expenses as a percentage of average total assets were 0.54% and 1.23% for the quarters ended March 31, 2011 and 2010, respectively.  The difference is primarily due to the receivable from the March 2011 Offering and the purchase of Agency RMBS.  G&A excluding the March 2011 Offering and including the Agency RMBS is 0.84%.
 
FIDAC has currently waived its right to require us to pay our pro rata portion of rent, telephone, utilities, office furniture, equipment, machinery and other office, internal and overhead expenses of FIDAC and its affiliates required for our operations.
 
 
32

 

The table below shows our total management fee and G&A expenses as compared to average total assets and average equity for the quarters ended March 31, 2011, the year ended December 31, 2010 and the four quarters of 2010.
 
Management Fees and G&A Expenses and Operating Expense Ratios
 
(Ratios have been annualized, dollars in thousands)
 
                   
   
Total Management
   
Total Management
   
Total Management
 
   
Management Fee
   
Fee and G&A
   
Fee and G&A
 
   
and G&A
   
Expenses/Average
   
Expenses/Average
 
   
Expenses
   
Total Assets
   
Equity
 
For the quarter ended March 31, 2011
  $ 1,160       0.54 %     1.73 %
For the year ended December 31, 2010
  $ 3,949       0.93 %     1.51 %
For the quarter ended December 31, 2010
  $ 1,142       1.02 %     1.69 %
For the quarter ended September 30, 2010
  $ 861       0.77 %     1.29 %
For the quarter ended June 30, 2010
  $ 852       0.78 %     1.31 %
For the quarter ended March 31, 2010
  $ 1,094       1.22 %     1.70 %
 
Net Income and Return on Average Equity
 
Our net income was $4.6 million for the quarter ended March 31, 2011 compared to a net income of $1.8 million for the quarter ended March 31, 2010.  We attribute the increase in net income to continued deployment of capital resulting in an increase in net interest income.   The table below shows our net interest income, total expenses and realized gain, each as a percentage of average equity, and the return on average equity for the quarters ended March 31, 2011, the year ended December 31, 2010 and the four quarters of 2010.
 
Components of Return on Average Equity
 
(Ratios have been annualized)
 
                         
   
Net
                 
   
Interest
 
Total
 
Realized
 
Return
   
Income/
 
Expenses(1)/
 
Gain/
 
on
   
Average
 
Average
 
Average
 
Average
   
Equity
 
Equity
 
Equity
 
Equity
For the quarter ended March 31, 2011
    8.71 %     (1.91 %)     0.00 %     6.80 %
For the year ended December 31, 2010
    5.89 %     (1.60 %)     0.24 %     4.53 %
For the quarter ended December 31, 2010
    8.48 %     (1.88 %)     0.00 %     6.60 %
For the quarter ended September 30, 2010
    6.20 %     (1.39 %)     0.00 %     4.82 %
For the quarter ended June 30, 2010
    5.05 %     (1.47 %)     0.00 %     3.68 %
For the quarter ended March 31, 2010
    3.60 %     (1.73 %)     0.97 %     2.85 %
                                 
(1) Includes provision for loan loss.
                       
 
Liquidity and Capital Resources

Liquidity measures our ability to meet potential cash requirements, including ongoing commitments to repay borrowings, fund and maintain our assets and operations, make distributions to our stockholders and other general business needs.  We will use significant cash to purchase our targeted assets, repay principal and interest on our borrowings, make distributions to our stockholders and fund our operations.  Our primary sources of cash will generally consist of the net proceeds equity offerings, payments of principal and interest we receive on our portfolio of assets, cash generated from our operating results and unused borrowing capacity under our financing sources.

 
33

 
 
We have financed our CMBS portfolio with non-recourse financings under the TALF, and based on market conditions we intend to utilize structural leverage through securitizations of commercial real estate loans or CMBS. We, however, also finance the acquisition of Agency RMBS using repurchase agreements with counterparties, which are recourse.  With regard to leverage available under the TALF, the maximum level of allowable leverage is 6.7:1.  With regard to securitizations, the leverage will depend on the market conditions for structuring such transactions.  We anticipate that leverage for Agency RMBS will not exceed 8:1.  Based on current market conditions, we expect to operate within and maintain the leverage levels described above in the near and long term.  We can provide no assurance that we will be able to obtain financing on favorable terms, or at all.

Securitizations

We may seek to enhance the returns on our commercial mortgage loan investments, especially loan acquisitions, through securitization. If available, we may securitize the senior portion, expected to be equivalent to AAA-rated CMBS, while retaining the subordinate securities in our portfolio.

Other Sources of Financing

We may use repurchase agreements with a number of counterparties to finance acquisitions of Agency RMBS. In the future, we may also use other sources of financing to fund the acquisition of our targeted assets, including warehouse facilities and other secured and unsecured forms of borrowing. We may also seek to raise further equity capital or issue debt securities in order to fund our future asset acquisitions.
For our short-term (one year or less) and long-term liquidity, which include investing and compliance with collateralization requirements under our repurchase agreements (if the pledged collateral decreases in value or in the event of margin calls created by prepayments of the pledged collateral), we also rely on the cash flow from investments, primarily monthly principal and interest payments to be received on our CMBS and mortgage loans, cash flow from the sale of securities as well as any primary securities offerings authorized by our board of directors.

           Based on our current portfolio, leverage ratio and available borrowing arrangements, we believe our assets will be sufficient to enable us to meet anticipated short-term (one year or less) liquidity requirements such as to fund our investment activities, pay fees under our management agreement, fund our distributions to stockholders and pay general corporate expenses. However, a decline in the value of our collateral or an increase in prepayment rates substantially above our expectations could cause a temporary liquidity shortfall due to the timing of the necessary margin calls on the financing arrangements and the actual receipt of the cash related to principal paydowns. If our cash resources are at any time insufficient to satisfy our liquidity requirements, we may have to sell debt or additional equity securities in a common stock offering. If required, the sale of CMBS or mortgage loans at prices lower than their carrying value would result in losses and reduced income.

           Our ability to meet our long-term (greater than one year) liquidity and capital resource requirements will be subject to obtaining additional debt financing and equity capital. Subject to our maintaining our qualification as a REIT, we expect to use a number of sources to finance our investments, including repurchase agreements, warehouse facilities, securitization, commercial paper and term financing CDOs. Such financing will depend on market conditions for capital raises and for the investment of any proceeds. If we are unable to renew, replace or expand our sources of financing on substantially similar terms, it may have an adverse effect on our business and results of operations. Upon liquidation, holders of our debt securities and shares of preferred stock and lenders with respect to other borrowings will receive a distribution of our available assets prior to the holders of our common stock.
 
We held cash and cash equivalents of approximately $30.6 million and $150.6 million at March 31, 2011 and March 31, 2010, respectively.
 
Our operating activities used net cash of approximately $3.4 million for the quarter ended March 31, 2011 and provided proceeds of $343,000 for the quarter ended March 31, 2010.
 
 
34

 
 
Our investing activities provided net cash of $482,000 and used net cash of $210.2 million for the quarters ended March 31, 2011 and March 31, 2010, respectively.

Our financing activities for the quarter ended March 31, 2011 used $4.4 million primarily for paying our fourth quarter 2010 dividend. Our financing activities for the period ended December 31, 2010 used $3.3 million primarily to pay our third quarter 2010 dividend. We currently have established uncommitted repurchase agreements for RMBS we may acquire with 8 counterparties.

At March 31, 2011 and December 31, 2010, the secured financing agreements for CMBS had the following remaining maturities:
 
   
March 31, 2011
   
December 31, 2010
 
   
(dollars in thousands)
 
Overnight
  $ -     $ -  
1-30 days
    -       -  
30 to 59 days
    -       -  
60 to 89 days
    -       -  
90 to 119 days
    -       -  
Greater than or equal to 120 days
    172,470       172,837  
Total
  $ 172,470     $ 172,837  
 
We are not required to maintain any specific debt-to-equity ratio as we believe the appropriate leverage for the particular assets we are financing depends on the credit quality and risk of those assets. At March 31, 2011 our total debt was approximately $172.5 million which represented a debt-to-equity ratio of approximately 0.2:1.

Stockholders’ Equity

During the quarter ended March 31, 2011 we declared dividends to common shareholders totaling $4.2 million or $0.23 per share, all of which were paid on April 21, 2011.  During the quarter ended March 31, 2010 we declared dividends to common shareholders totaling $1.3 million or $0.07 per share, all of which were paid April 28, 2010.

On April 1, 2011, we completed the sale of 50,000,000 shares of common stock at $11.50 per share for estimated proceeds, less the underwriters’ discount and offering expenses, of $539 million.  Concurrently with the sale of these shares Annaly purchased 5,000,000 shares at the same price per share as the public offering, for proceeds of approximately $58 million.  On April 5, 2011, the underwriters exercised their option to purchase an additional 3,500,000 shares of common stock at $11.50 per share for estimated proceeds, less the underwriters’ discount and offering expenses, of $38 million.  In total, we raised net proceeds of approximately $635 million in the March 2011 Offering.

There was no preferred stock issued or outstanding as of March 31, 2011.

Related Party Transactions

Management Agreement

On August 31, 2009, we entered into a management agreement with FIDAC and subsequently amended on September 16, 2009, pursuant to which FIDAC is entitled to receive a management fee and, in certain circumstances, a termination fee and reimbursement of certain expenses as described in the management agreement.  Such fees and expenses do not have fixed and determinable payments.  The management fee is payable quarterly in arrears, and was in an amount equal to 0.50% per annum for the first twelve months of operations, 1.00% per annum for the period after the first twelve months through the eighteenth month of operations, and currently is 1.50% per annum, calculated quarterly, of our stockholders’ equity (as defined in the management agreement).  FIDAC uses the proceeds from its management fee in part to pay compensation to its officers and employees who, notwithstanding that certain of them also are our officers, receive no cash compensation directly from us.

 
35

 
 
Upon termination without cause, we will pay FIDAC a termination fee.  We may also terminate the management agreement with 30-days’ prior notice from our board of directors, without payment of a termination fee, for cause or upon a change of control of Annaly or FIDAC, each as defined in the management agreement.  FIDAC may terminate the management agreement if we or any of our subsidiaries become required to register as an investment company under the 1940 Act, with such termination deemed to occur immediately before such event, in which case we would not be required to pay a termination fee.  FIDAC may also decline to renew the management agreement by providing us with 180-days’ written notice, in which case we would not be required to pay a termination fee.

We are obligated to reimburse FIDAC for its costs incurred under the management agreement.  In addition, the management agreement permits FIDAC to require us to pay for our pro rata portion of rent, telephone, utilities, office furniture, equipment, machinery and other office, internal and overhead expenses of FIDAC incurred in our operation.  These expenses are allocated between FIDAC and us based on the ratio of our proportion of gross assets compared to all remaining gross assets managed by FIDAC as calculated at each quarter end.  We and FIDAC will modify this allocation methodology, subject to our board of directors’ approval if the allocation becomes inequitable (i.e., if we become very highly leveraged compared to FIDAC’s other funds and accounts).  FIDAC has waived its right to request reimbursement from us of these expenses until such time as it determines to rescind that waiver. 

Purchases of Common Stock by Affiliates

In connection with our March 2011 Offering we sold Annaly 5,000,000 shares of our common stock at the same price per share paid by other investors in our public offering and as of March 31, 2011 Annaly owned approximately 13% of our outstanding shares of common stock.

Clearing Fees

We use RCap Securities Inc., or RCap, a SEC registered broker-dealer and a wholly-owned subsidiary of Annaly, to clear trades for us and RCap is paid customary market-based fees and charges in return for such services.

Contractual Obligations and Commitments

We have not entered into any lease or operating obligations.

On March 18, 2011, we entered into the Asset Purchase Agreement with Barclays Capital Real Estate Inc. and certain of its affiliates (the “Seller”), pursuant to which the Seller has agreed to sell, and we have agreed to purchase a portfolio of 30 commercial real estate assets, including commercial mortgage loans, subordinate notes and mezzanine loans, relating to 17 underlying properties or groups of properties, on the terms and subject to the conditions set forth in the Asset Purchase Agreement. One of the assets has since been prepaid by the borrower.  At the initial closing of the remaining 29 assets on April 8, 2011, the required consents for one of the assets had not yet been obtained.

As of March 31, 2011 we financed our CMBS portfolio with non-recourse financings under the TALF.  Pursuant to our non-recourse financing under the TALF, we have entered into a long term debt obligation with the FRBNY.  The table below summarizes our contractual obligation at March 31, 2011 and December 31, 2010.
 
 
36

 
 
   
March 31, 2011
 
   
Within One
Year
 
One to Three
Years
 
Three to
Five Years
 
Greater Than
Five Years
 
Total
 
Contractual Obligations
 
(dollars in thousands)
 
Secured financing
  $ -     $ 10,762     $ 161,708     $ -     $ 172,470  
Interest expense on secured financing
    6,194       12,117       5,378       -       23,689  
Total
  $ 6,194     $ 22,879     $ 167,086     $ -     $ 196,159  
                                         
   
December 31, 2010
 
   
Within One
Year
 
One to Three
Years
 
Three to
Five Years
 
Greater Than
Five Years
 
Total
 
Contractual Obligations
 
(dollars in thousands)
 
Secured financing
  $ -     $ 10,995     $ 161,842     $ -     $ 172,837  
Interest expense on secured financing
    6,205       18,111       939       -       25,255  
Total
  $ 6,205     $ 29,106     $ 162,781     $ -     $ 198,092  
 
We have agreed to pay the underwriters of our initial public offering $0.15 per share for each share sold in the initial public offering if during any full four calendar quarter period during the 24 full calendar quarters after the consummation of our initial public offering our Core Earnings (as described below) for any such four-quarter period exceeds an 8% performance hurdle rate (as described below).  The performance hurdle rate will be met if during any full four calendar quarter period during the 24 full calendar quarters after the consummation of our initial public offering our Core Earnings for any such four-quarter period exceeds the product of (x) the weighted average of the issue price per share of all public offerings of our common stock, multiplied by the weighted average number of shares outstanding (including any restricted stock units, any restricted shares of common stock and any other shares of common stock underlying awards granted under our equity incentive plans) in such four-quarter period and (y) 8%.  Core Earnings is a non-GAAP measure and is defined as GAAP net income (loss) excluding non-cash equity compensation expense, depreciation and amortization (to the extent that we foreclose on any properties underlying our target assets), any unrealized gains, losses or other non-cash items recorded for the period, regardless of whether such items are included in other comprehensive income or loss, or in net income. The amount will be adjusted to exclude one-time events pursuant to changes in GAAP and certain other non-cash charges after discussions between FIDAC and our independent directors and after approval by a majority of our independent directors.

Off-Balance Sheet Arrangements

We do not have any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.  Further, we have not guaranteed any obligations of unconsolidated entities nor do we have any commitment or intent to provide funding to any such entities.  As such, we are not materially exposed to any market, credit, liquidity or financing risk that could arise if we had engaged in such relationships.

Dividends

To qualify as a REIT, we must pay annual dividends to our stockholders of at least 90% of our taxable income, determined without regard to the deduction for dividends paid and excluding any net capital gains. We intend to pay regular quarterly dividends to our stockholders. Before we pay any dividend, whether for U.S. federal income tax purposes or otherwise, which would only be paid out of available cash to the extent permitted under our warehouse and repurchase facilities, we must first meet both our operating requirements and scheduled debt service on our warehouse lines and other debt payable.

During the quarter ended March 31, 2011, we declared dividends to common shareholders totaling $4.2 million or $0.23 per share, which were paid on April 21, 2011.

 
37

 

Capital Resources

At March 31, 2011 we had no material commitments for capital expenditures.

Inflation

Virtually all of our assets and liabilities are interest rate sensitive in nature. As a result, interest rates and other factors will influence our performance far more so than does inflation. Changes in interest rates do not necessarily correlate with inflation rates or changes in inflation rates. Our consolidated financial statements are prepared in accordance with GAAP and our distributions will be determined by our board of directors consistent with our obligation to distribute to our stockholders at least 90% of our REIT taxable income on an annual basis in order to maintain our REIT qualification; in each case, our activities and balance sheet are measured with reference to historical cost and/or fair market value without considering inflation.

Subsequent Events

On March 18, 2011, we entered into a definitive asset purchase and sale agreement, or Asset Purchase Agreement, with Barclays Capital Real Estate Inc. and certain of its affiliates (collectively referred to as the Seller, which are affiliates of Barclays Capital Inc.).  Pursuant to the Asset Purchase Agreement, the Seller has agreed to sell, and we agreed to purchase, a portfolio of 30 commercial real estate assets, including commercial mortgage loans, subordinate notes and mezzanine loans, relating to 17 underlying properties or groups of properties (the “Portfolio”).  The aggregate purchase price of the Portfolio was approximately $586.0 million, payable in cash, which was adjusted based on the outstanding principal balance due at the closing of each asset in the Portfolio.  One of the assets has since been prepaid by the borrower. The aggregate purchase price for the remaining 29 assets was approximately $570 million.  On April 8, 2011, we purchased 28 of the remaining 29 assets, for approximately $530 million in cash. The assets purchased include commercial mortgage loans, subordinate notes and mezzanine loans related to the properties in the portfolio. We and the Seller are working toward consummating the sale of the remaining asset, and expect to purchase this asset in the second quarter of 2011.

The following tables present certain characteristics of the Portfolio as of April 8, 2011 and assumes the consummation of the sale of the remaining asset.
 
 
38

 
 
Type of Asset
 
Number of Assets
   
Current
Balance
   
Weighted Average
Coupon
Rate
   
% of
Total
 
   
(dollars in thousands)
 
Mortgage Loans
    12     $ 473,406       2.69 %     66 %
Subordinate Notes
    7       65,738       2.69 %     9 %
Mezzanine Loans
    10       179,186       3.02 %     25 %
Total
    29       718,330               100 %
 
Property Type
 
Number
of Assets
 
Current
Balance
 
% of
Total
   
Geography
   
Number
of Assets
 
Current
Balance
 
% of
Total
 
   
(dollars in thousands)
               
(dollars in thousands)
       
Hotel
    9     $ 352,682       49 %  
Various (1)
      9       207,376       29 %
Office
    9     $ 102,056       14 %  
NY
      9       230,726       33 %
Condominium
    4     $ 28,867       4 %  
CA
      4       128,316       18 %
Multi-family
    6     $ 232,928       33 %  
NJ
      3       13,141       2 %
Retail
    1     $ 1,797       0 %  
Off shore
      1       46,000       6 %
Total
    29       718,330       100 %  
DC
      1       2,771       0 %
                           
TX
      1       44,000       6 %
                           
GA
      1       46,000       6 %
                           
Total
      29       718,330       100 %
                                                       
Year of Origination
 
Number
of Assets
 
Current
Balance
 
% of
Total
   
Year of
Termination
 
Number
of Assets
 
Current
Balance
 
% of
Total
 
   
(dollars in thousands)
                 
(dollars in thousands)
         
2004
    2       4,568       1 %   2011       15       413,973       58 %
2005
    5       41,271       6 %   2012       12       190,853       26 %
2006
    15       393,037       54 %   2013       -       -       0 %
2007
    6       235,454       33 %   2014       2       113,504       16 %
2008
    -       -       -    
Total
      29       718,330       100 %
2009
    1       44,000       6 %                              
Total
    29       718,330       100 %                              
                                                       
(1) These assets are secured by portfolios of properties located across multiple states.
                         
 
 
39

 
 
 
The primary components of our market risk are related to credit risk, interest rate risk, prepayment risk and market value risk. While we do not seek to avoid risk completely, we believe the risk can be quantified from historical experience and seek to actively manage that risk, to earn sufficient compensation to justify taking those risks and to maintain capital levels consistent with the risks we undertake.

Credit Risk

We will be subject to credit risk, which is the risk of loss due to a borrower’s failure to repay principal or interest on a loan, a security or otherwise fail to meet a contractual obligation, in connection with our assets and will face more credit risk on assets we own which are rated below “AAA”. The credit risk related to these assets pertains to the ability and willingness of the borrowers to pay, which is assessed before credit is granted or renewed and periodically reviewed throughout the loan or security term. We believe that residual loan credit quality is primarily determined by the borrowers’ credit profiles and loan characteristics.

FIDAC uses a comprehensive credit review process. FIDAC’s analysis of loans includes borrower profiles, as well as valuation and appraisal data.  FIDAC’s resources include a proprietary portfolio management system, as well as third party software systems.  FIDAC selects loans for review predicated on risk-based criteria such as loan-to-value, a property’s operating history and loan size. FIDAC rejects loans that fail to conform to our standards. FIDAC accepts only those loans which meet our underwriting criteria. Once we own a loan, FIDAC’s surveillance process includes ongoing analysis and oversight by our third-party servicer and us. Additionally, CMBS, other commercial real estate-related securities and RMBS which we acquire for our portfolio will be reviewed by FIDAC to ensure that we acquire CMBS, other commercial real estate-related securities and RMBS which satisfy our risk based criteria. FIDAC’s review of CMBS, other commercial real estate-related securities and RMBS includes utilizing its proprietary portfolio management system. FIDAC’s review of CMBS, other commercial real estate-related securities and RMBS is based on quantitative and qualitative analysis of the risk-adjusted returns such securities present.

Interest Rate Risk

Interest rates are highly sensitive to many factors, including fiscal and monetary policies and domestic and international economic and political considerations, as well as other factors beyond our control. We are subject to interest rate risk in connection with our assets and any related financing obligations. In general, we may finance the acquisition of our targeted assets through financings in the form of borrowings under programs established by the U.S. government, warehouse facilities, bank credit facilities (including term loans and revolving facilities), resecuritizations, securitizations and repurchase agreements. We may mitigate interest rate risk through utilization of hedging instruments, primarily interest rate swap agreements. Interest rate swap agreements are intended to serve as a hedge against future interest rate increases on our borrowings. Another component of interest rate risk is the effect changes in interest rates will have on the market value of the assets we acquire. We will face the risk that the market value of our assets will increase or decrease at different rates than that of our liabilities, including our hedging instruments. We may acquire floating rate mortgage assets. These are assets in which the mortgages are typically subject to periodic and lifetime interest rate caps and floors, which limit the amount by which the asset’s interest yield may change during any given period. Our borrowing costs pursuant to our financing agreements, however, will not be subject to similar restrictions. Therefore, in a period of increasing interest rates, interest rate costs on our borrowings could increase without limitation by caps, while the interest-rate yields on our floating rate mortgage assets would effectively be limited. In addition, floating rate mortgage assets may be subject to periodic payment caps that result in some portion of the interest being deferred and added to the principal outstanding. This could result in our receipt of less cash income on such assets than we would need to pay the interest cost on our related borrowings. These factors could lower our net interest income or cause a net loss during periods of rising interest rates, which would harm our financial condition, cash flows and results of operations.

Our analysis of interest rate risk is based on FIDAC’s experience, estimates, models and assumptions. These analyses rely on models which utilize estimates of fair value and interest rate sensitivity. Actual economic conditions or implementation of asset allocation decisions by our management may produce results that differ significantly from the estimates and assumptions used in our models and the projected results described in this Form 10-Q.
 
 
40

 

Interest Rate Effect on Net Interest Income

Our operating results depend, in part, on differences between the income from our investments and our borrowing costs. Most of our warehouse facilities and repurchase agreements would provide financing based on a floating rate of interest calculated on a fixed spread over LIBOR.  Our structured financing through the TALF is at a fixed rate for the life of the loan based on swap rates at the submission date of the loan.  The fixed spread varies depending on the type of underlying asset which collateralizes the financing. Accordingly, if a portion of our portfolio consisted of floating interest rate assets would be match-funded utilizing our expected sources of short-term financing, while our fixed interest rate assets will not be match-funded. During periods of rising interest rates, the borrowing costs associated with our investments tend to increase while the income earned on our fixed interest rate investments may remain substantially unchanged, excluding the fixed rate borrowing with the TALF.  This will result in a narrowing of the net interest spread between the related assets and borrowings and may even result in losses. Further, during this portion of the interest rate and credit cycles, defaults could increase and result in credit losses to us, which could adversely affect our liquidity and operating results. Such delinquencies or defaults could also have an adverse effect on the spread between interest-earning assets and interest-bearing liabilities. Hedging techniques are partly based on assumed levels of prepayments of fixed-rate and hybrid adjustable-rate mortgage loans and CMBS. If prepayments are slower or faster than assumed, the life of the mortgage loans and CMBS will be longer or shorter, which would reduce the effectiveness of any hedging strategies we may use and may cause losses on such transactions. Hedging strategies involving the use of derivative securities are highly complex and may produce volatile returns.

Interest Rate Effects on Fair Value

Another component of interest rate risk is the effect changes in interest rates have on the fair value of the assets we acquire. We face the risk that the fair value of our assets will increase or decrease at different rates than that of our liabilities, including our hedging instruments. We primarily assess our interest rate risk by estimating the duration of our assets and the duration of our liabilities. Duration essentially measures the market price volatility of financial instruments as interest rates change. We generally calculate duration using various financial models and empirical data. Different models and methodologies can produce different duration numbers for the same securities.
 
It is important to note that the impact of changing interest rates on fair value can change significantly when interest rates change beyond 100 basis points from current levels. Therefore, the volatility in the fair value of our assets could increase significantly when interest rates change beyond 100 basis points. In addition, other factors impact the fair value of our interest rate-sensitive investments and hedging instruments, such as the shape of the yield curve, market expectations as to future interest rate changes and other market conditions. Accordingly, in the event of changes in actual interest rates, the change in the fair value of our assets would likely differ from that shown below and such difference might be material and adverse to our stockholders.

Interest Rate Cap Risk
 
We may invest in adjustable-rate mortgage loans and CMBS. These are mortgages or CMBS in which the underlying mortgages are typically subject to periodic and lifetime interest rate caps and floors, which limit the amount by which the security's interest yield may change during any given period. However, our borrowing costs pursuant to our financing agreements will not be subject to similar restrictions. Therefore, in a period of increasing interest rates, interest rate costs on our borrowings could increase without limitation by caps, while the interest-rate yields on our adjustable-rate mortgage loans and CMBS would effectively be limited. This problem will be magnified to the extent we acquire adjustable-rate CMBS that are not based on mortgages which are fully indexed. In addition, the mortgages or the underlying mortgages in a CMBS may be subject to periodic payment caps that result in some portion of the interest being deferred and added to the principal outstanding. This could result in our receipt of less cash income on our adjustable-rate mortgages or CMBS than we need in order to pay the interest cost on our related borrowings. These factors could lower our net interest income or cause a net loss during periods of rising interest rates, which would harm our financial condition, cash flows and results of operations.
 
 
41

 

Interest Rate Mismatch Risk

We may fund a portion of our acquisitions of hybrid adjustable-rate mortgages and RMBS and CMBS with borrowings that, after the effect of hedging, have interest rates based on indices and repricing terms similar to, but of somewhat shorter maturities than, the interest rate indices and repricing terms of the mortgages and MBS. Thus, we anticipate that in most cases the interest rate indices and repricing terms of our mortgage assets and our funding sources will not be identical, thereby creating an interest rate mismatch between assets and liabilities. Therefore, our cost of funds would likely rise or fall more quickly than would our earnings rate on assets. During periods of changing interest rates, such interest rate mismatches could negatively impact our financial condition, cash flows and results of operations. To mitigate interest rate mismatches, we may utilize the hedging strategies discussed above. Our analysis of risks is based on FIDAC’s experience, estimates, models and assumptions. These analyses rely on models which utilize estimates of fair value and interest rate sensitivity. Actual economic conditions or implementation of investment decisions by our management may produce results that differ significantly from the estimates and assumptions used in our models and the projected results shown in this Form 10-Q.

Our profitability and the value of our portfolio (including interest rate swaps) may be adversely affected during any period as a result of changing interest rates. The following table quantifies the potential changes in net interest income, portfolio value should interest rates go up or down 25, 50, and 75 basis points, assuming the yield curves of the rate shocks will be parallel to each other and the current yield curve. All changes in income and value are measured as percentage changes from the projected net interest income and portfolio value at the base interest rate scenario. The base interest rate scenario assumes interest rates at March 31, 2011 and various estimates regarding prepayment and all activities are made at each level of rate shock. Actual results could differ significantly from these estimates.
 
   
Projected Percentage Change in
   
Projected Percentage Change in
 
Change in Interest Rate
 
Net Interest Income
   
Portfolio Value
 
-75 Basis Points
    (0.56 %)     2.89 %
-50 Basis Points
    (0.37 %)     1.93 %
-25 Basis Points
    (0.19 %)     0.96 %
Base Interest Rate
    -       -  
+25 Basis Points
    0.19 %     (0.96 %)
+50 Basis Points
    0.37 %     (1.93 %)
+75 Basis Points
    0.56 %     (2.89 %)

Prepayment Risk

As we receive prepayments of principal on our assets, premiums paid on such assets will be amortized against interest income. In general, an increase in prepayment rates will accelerate the amortization of purchase premiums, thereby reducing the interest income earned on the assets. Conversely, discounts on such investments are accreted into interest income. In general, an increase in prepayment rates will accelerate the accretion of purchase discounts, thereby increasing the interest income earned on our assets. For commercial real estate loans, the risk of prepayment is mitigated by call protection, which includes defeasance, yield maintenance premiums and prepayment charges.

Extension Risk

For CMBS and Agency RMBS, FIDAC computes the projected weighted-average life of our assets based on assumptions regarding the rate at which the borrowers will prepay the underlying mortgages. In general, when a fixed-rate or hybrid adjustable-rate asset is acquired with borrowings, we may, but are not required to, enter into an interest rate swap agreement or other hedging instrument that effectively fixes our borrowing costs for a period close to the anticipated average life of the fixed-rate portion of the related assets. This strategy is designed to protect us from rising interest rates because the borrowing costs are fixed for the duration of the fixed-rate portion of the related mortgage-backed security.
 
 
42

 

If prepayment rates decrease in a rising interest rate environment, however, the life of the fixed-rate portion of the related assets could extend beyond the term of the swap agreement or other hedging instrument. This could have a negative impact on our results from operations, as borrowing costs would no longer be fixed after the end of the hedging instrument while the income earned on the hybrid adjustable-rate assets would remain fixed. This situation may also cause the market value of our hybrid adjustable-rate assets to decline, with little or no offsetting gain from the related hedging transactions. In extreme situations, we may be forced to sell assets to maintain adequate liquidity, which could cause us to incur losses.

Market Risk

Market Value Risk

Our available-for-sale securities are reflected at their estimated fair value with unrealized gains and losses excluded from earnings and reported in other comprehensive income. The estimated fair value of these securities fluctuates primarily due to changes in interest rates and other factors. Generally, in a rising interest rate environment, the estimated fair value of these securities would be expected to decrease; conversely, in a decreasing interest rate environment, the estimated fair value of these securities would be expected to increase. As market volatility increases or liquidity decreases, the fair value of our assets may be adversely impacted. If we are unable to readily obtain independent pricing to validate our estimated fair value of the securities in our portfolio, the fair value gains or losses recorded in other comprehensive income may be adversely affected.

Real Estate Risk

Commercial property values are subject to volatility and may be affected adversely by a number of factors, including, but not limited to, national, regional and local economic conditions (which may be adversely affected by industry slowdowns and other factors); local real estate conditions (such as an oversupply of housing); changes or continued weakness in specific industry segments; construction quality, age and design; demographic factors; and retroactive changes to building or similar codes. In addition, decreases in property values reduce the value of the collateral and the potential proceeds available to a borrower to repay our loans, which could also cause us to suffer losses.

Risk Management

To the extent consistent with maintaining our REIT status, we will seek to manage risk exposure to protect our portfolio of commercial mortgage loans, CMBS, commercial mortgage securities, Agency RMBS and related debt against the credit and interest rate risks. We generally seek to manage our risk by:

·  
analyzing the borrower profiles, as well as valuation and appraisal data, of the loans we acquire. We expect that FIDAC’s resources include a proprietary portfolio management system, as well as third party software systems;

·  
using FIDAC’s proprietary portfolio management system to review our MBS and other commercial real estate-related securities;

·  
monitoring and adjusting, if necessary, the reset index and interest rate related to our targeted assets and our financings;

·  
attempting to structure our financings agreements to have a range of different maturities, terms, amortizations and interest rate adjustment periods;

·  
using derivatives, financial futures, swaps, options, caps, floors and forward sales to adjust the interest rate sensitivity of our targeted assets and our borrowings;

·  
using securitization financing to lower average cost of funds relative to short-term financing vehicles further allowing us to receive the benefit of attractive terms for an extended period of time in contrast to short term financing and maturity dates of the assets included in the securitization; and

·  
actively managing, on an aggregate basis, the interest rate indices, interest rate adjustment periods, and gross reset margins of our targeted assets and the interest rate indices and adjustment periods of our financings.
 
 
43

 
 
Our efforts to manage our assets and liabilities are concerned with the timing and magnitude of the repricing of assets and liabilities. We attempt to control risks associated with interest rate movements. Methods for evaluating interest rate risk include an analysis of our interest rate sensitivity "gap", which is the difference between interest-earning assets and interest-bearing liabilities maturing or repricing within a given time period. A gap is considered positive when the amount of interest-rate sensitive assets exceeds the amount of interest-rate sensitive liabilities. A gap is considered negative when the amount of interest-rate sensitive liabilities exceeds interest-rate sensitive assets. During a period of rising interest rates, a negative gap would tend to adversely affect net interest income, while a positive gap would tend to result in an increase in net interest income. During a period of falling interest rates, a negative gap would tend to result in an increase in net interest income, while a positive gap would tend to affect net interest income adversely. Because different types of assets and liabilities with the same or similar maturities may react differently to changes in overall market rates or conditions, changes in interest rates may affect net interest income positively or negatively even if an institution were perfectly matched in each maturity category.

The following table sets forth the estimated maturity or repricing of our interest-earning assets and interest-bearing liabilities at March 31, 2011. The amounts of assets and liabilities shown within a particular period were determined in accordance with the contractual terms of the assets and liabilities, except adjustable-rate loans, and securities are included in the period in which their interest rates are first scheduled to adjust and not in the period in which they mature and includes the effect of the interest rate swaps. The interest rate sensitivity of our assets and liabilities in the table could vary substantially if based on actual prepayment experience.
 
   
Within 3
    3-12    
1 Year to
   
Greater than
       
   
Months
   
Months
   
3 Years
   
3 Years
   
Total
 
                                 
Rate sensitive assets, principal balance
  $ 25,000     $ -     $ 406,317     $ 178,024     $ 609,341  
Cash equivalents
    30,579       -       -       -       30,579  
Total rate sensitive assets
    55,579       -       406,317       178,024       639,920  
                                         
Rate sensitive liabilities
    -       -       10,762       161,707       172,469  
                                         
Interest rate sensitivity gap
  $ 55,579     $ -     $ 395,555     $ 16,317     $ 467,451  
                                         
Cumulative rate sensitivity gap
  $ 55,579     $ 55,579     $ 451,134     $ 467,451          
                                         
Cumulative interest rate sensitivity
                                       
   gap as a percentage of total rate
                                       
   sensitive assets
    8.69 %     8.69 %     70.50 %     73.05 %        

Our analysis of risks is based on FIDAC’s experience, estimates, models and assumptions. These analyses rely on models which utilize estimates of fair value and interest rate sensitivity. Actual economic conditions or implementation of investment decisions by FIDAC may produce results that differ significantly from the estimates and assumptions used in our models and the projected results shown in the above tables and in this Form 10-Q. These analyses contain certain forward-looking statements and are subject to the safe harbor statement set forth under the heading, "Special Note Regarding Forward-Looking Statements."
 
 
44

 

 
Our management, including our Chief Executive Officer, or CEO, and Chief Financial Officer, or CFO, reviewed and evaluated the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended (the “Securities Exchange Act”)) as of the end of the period covered by this quarterly report.  Based on that review and evaluation, the CEO and CFO have concluded that our current disclosure controls and procedures, as designed and implemented, (1) were effective in ensuring that information regarding the Company and its subsidiaries is made known to our management, including our CEO and CFO, as appropriate to allow timely decisions regarding required disclosure and (2) were effective in providing reasonable assurance that information the Company must disclose in its periodic reports under the Securities Exchange Act is recorded, processed, summarized and reported within the time periods prescribed by the SEC’s rules and forms.
 
There have been no changes in our “internal control over financial reporting” (as defined in Rule 13a-15(f) under the Securities Exchange Act) that occurred during the period covered by this quarterly report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
 
 
45

 

 
 
From time to time, we may be involved in various claims and legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on our consolidated financial statements.


In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2010, which could materially affect our business, financial condition or future results.  The materialization of any risks and uncertainties identified in our forward looking statements contained in this report together with those previously disclosed in the Form 10-K or subsequent Form 10-Q or those that are presently unforeseen could  result in significant adverse effects on our financial condition, results of operations and cash flows. See Item 2. “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Special Note Regarding Forward-Looking Statements” in this quarterly report on Form 10-Q.  The information presented below updates and should be read in conjunction with the risk factors and information disclosed in our Annual Report on Form 10-K for the year ended December 31, 2010.

Risk Associated with Asset Purchase Agreement and the Portfolio

Our acquisition of the Portfolio is on an “as is, where is” basis containing limited representations, warranties and covenants.

On March 18, 2011, we entered into the Asset Purchase Agreement with Barclays Capital Real Estate Inc. and certain of its affiliates (the “Seller”), pursuant to which the Seller agreed to sell, and we agreed to purchase, a portfolio of 30 commercial real estate assets, including commercial mortgage loans, subordinate notes and mezzanine loans, relating to 17 underlying properties or groups of properties on the terms and subject to the conditions set forth in the Asset Purchase Agreement.  We refer to these assets as the Portfolio and to the acquisition of the Portfolio as the Acquisition.

Our acquisition of the Portfolio was primarily on an “as is, where is” basis, which means we bought the assets as they are with limited representations, warranties and covenants being made by the Seller with respect to the condition of the assets and the properties underlying certain of those assets. In addition, the indemnification obligations of the Seller are limited to losses in excess of $10.0 million and are capped, in the aggregate, at $82.1 million. As a result of these limited representations, warranties and covenants, and the monetary limitations on indemnification, we bear a significant amount of the risk associated with the Portfolio and losses associated with the Portfolio, including for conditions existing on the date we acquired the Portfolio. Any related losses could have a material adverse effect on our business and results of operations.

We did not obtain consents necessary to transfer all of the assets in the Portfolio on the initial closing date of the Acquisition, and it is possible one of the assets may never be transferred to us.

Certain assets in the Portfolio require that the Seller obtain a consent from the borrower or another third party in order to transfer the particular asset to us.  At the initial closing of the Acquisition on April 8, 2011, the required consents for one of the assets had not yet been obtained.  The Asset Purchase Agreement obligates the Seller to continue to pursue obtaining the required consents for those excluded assets, and once any required consents are obtained, our purchase of the relevant assets is required to be closed within five business days thereafter.

Further, the Asset Purchase Agreement provides that if any required consents are not obtained by August 1, 2011, then the given asset or assets will not be transferred to us. Thus, it is possible that one asset may not ever be transferred from the Seller to us. Under these circumstances, we would expect to deploy the unused proceeds of the offering and the concurrent private placement to one or more alternative investments, and our decisions in respect of these investments would not be subject to shareholder approval. These alternative investments may not be readily available to us or may yield lower returns than the Portfolio assets, and our growth prospects may be materially impeded.  We may invest proceeds from the offering in short term investments pending our purchase of any assets not purchased on the initial closing date.  These short term investments would likely generate lower returns than we expect to receive from the Portfolio assets.
 
 
46

 

A large percentage of the assets in the Portfolio are subject to near term maturities, which may require the borrowers to refinance the loans, thus increasing the near term risk of borrower default. In addition, if these assets are repaid on or before their maturity dates, then there is reinvestment risk.

Of the assets we are purchasing in the Portfolio, approximately 58% (by unpaid principal balance as of April 8, 2011) are scheduled to mature before the end of 2011 and an additional 26% (by unpaid principal balance as of April 8, 2011) are scheduled to mature in 2012. Accordingly, the borrowers under those assets will need to either refinance the assets, agree with us to extend the maturities of the assets, or find some other method of repaying the assets.  If a borrower fails to pay the principal amount or extend the maturity of the asset, it would default under the asset, which would expose us to all of the costs, risks and uncertainties inherent in any enforcement action against the borrower, including those in connection with foreclosing on the collateral securing the asset.

If the borrower is successful in repaying or refinancing an asset, then we will have to redeploy the proceeds we receive in repayment.  It is possible that we will fail to identify reinvestment options that would provide returns or a risk profile that is comparable to the asset that was repaid.  We would expect to redeploy the proceeds we receive in our target assets including CMBS, commercial real estate loans, commercial real property and various other commercial real estate asset classes and Agency RMBS.  To the extent we acquire Agency RMBS, we would expect to use leverage on these assets through repurchase agreements. If we fail to redeploy the proceeds we receive in repayment of a loan in equivalent or better alternatives, our financial performance and returns to investors could suffer.

Assets in the Portfolio may become non-performing and sub-performing assets in the future, which are subject to increased risks relative to performing loans.

Assets in the Portfolio may in the near or the long term become non-performing and sub-performing assets, which are subject to increased risks relative to performing assets. Loans may become non-performing or sub-performing for a variety of reasons, such as the underlying property being too highly leveraged, decreasing income generated from the underlying property, or the financial distress of the borrower, in each case, that results in the borrower being unable to meet its debt service and/or repayment obligations. Such non-performing or sub-performing assets may require a substantial amount of workout negotiations and/or restructuring, which may involve substantial cost and divert the attention of our Manager and management from other activities and entail, among other things, a substantial reduction in interest rate, the capitalization of interest payments and a substantial write-down of the principal of the loan. Even if a restructuring were successfully accomplished, the borrower may not be able or willing to maintain the restructured payments or refinance the restructured mortgage upon maturity.

In the future, it is possible that we may find it necessary or desirable to foreclose on some, if not many, of the loans we acquire, and the foreclosure process may be lengthy and expensive. Borrowers may resist foreclosure actions by asserting numerous claims, counterclaims and defenses to payment against us (such as lender liability claims and defenses) even when such assertions may have no basis in fact or law, in an effort to prolong the foreclosure action and force the lender into a modification of the loan or a favorable buy-out of the borrower’s position. In some states, foreclosure actions can take several years or more to litigate. At any time prior to or during the foreclosure proceedings, the borrower may file for bankruptcy, which would have the effect of staying the foreclosure actions and further delaying the resolution of our claims. Foreclosure may create a negative public perception of the related property, resulting in a diminution of its value. Even if we are successful in foreclosing on a loan, the liquidation proceeds upon sale of the underlying real estate may not be sufficient to recover our cost basis in the loan, resulting in a loss to us. Furthermore, any costs or delays involved in the foreclosure of a loan or a liquidation of the underlying property will further reduce the proceeds and thus increase our loss. Any such reductions could materially and adversely affect the value of the commercial loans in which we invest.
 
 
47

 

Whether or not our Manager has participated in the negotiation of the terms of a mortgage, there can be no assurance as to the adequacy of the protection of the terms of the loan, including the validity or enforceability of the loan and the maintenance of the anticipated priority and perfection of the applicable security interests. Furthermore, claims may be asserted that might interfere with enforcement of our rights. In the event of a foreclosure, we may assume direct ownership of the underlying real estate. The liquidation proceeds upon sale of that real estate may not be sufficient to recover our cost basis in the loan, resulting in a loss to us. Any costs or delays involved in the effectuation of a foreclosure of the loan or a liquidation of the underlying property will further reduce the proceeds and increase our loss.

Whole loan mortgages are also subject to “special hazard” risk (property damage caused by hazards, such as earthquakes or environmental hazards, not covered by standard property insurance policies), and to bankruptcy risk (reduction in a borrower’s mortgage debt by a bankruptcy court). In addition, claims may be assessed against us on account of our position as mortgage holder or property owner, including responsibility for tax payments, environmental hazards and other liabilities, which could have a material adverse effect on our results of operations, financial condition and our ability to make distributions to our stockholders.

If we foreclose on an asset, we may come to own and operate the property securing the loan, which would expose us to the risks inherent in that activity.

If we foreclose on an asset, we may take title to the property securing that asset, and if we do not or cannot sell the property, we would then come to own and operate it as “real estate owned.” Owning and operating real property involves risks that are different (and in many ways more significant) than the risks faced in owning an asset secured by that property. In addition, we may end up owning a property that we would not otherwise have decided to acquire directly at the price of our original investment or at all. Further, some of the property underlying the assets we are acquiring is of a different type or class than property our Manager has had experience owning directly, including properties such as hotels. Accordingly, we may not manage these properties as well as they might be managed by another owner, and our returns to investors could suffer.  If we foreclose on and come to own property, our financial performance and returns to investors could suffer.

A portion of the assets in the Portfolio are mezzanine loans which involve greater risks of loss than senior loans secured by income-producing properties.

A portion of the assets in the Portfolio are mezzanine loans, which take the form of subordinated loans secured by second mortgages on the underlying property or loans secured by a pledge of the ownership interests of either the entity owning the property or a pledge of the ownership interests of the entity that owns the interest in the entity owning the property. These types of assets involve a higher degree of risk than long-term senior mortgage lending secured by income-producing real property, because the loan may become unsecured as a result of foreclosure by the senior lender. In the event of a bankruptcy of the entity providing the pledge of its ownership interests as security, we may not have full recourse to the assets of such entity, or the assets of the entity may not be sufficient to satisfy our mezzanine loan. If a borrower defaults on our mezzanine loan or debt senior to our loan or equity, or in the event a borrower files bankruptcy, our mezzanine loan will be satisfied only after the senior debt. As a result, we may not recover some or all of our initial investment. In addition, mezzanine loans may have higher loan-to-value ratios than conventional mortgage loans, resulting in less equity in the property and increasing the risk of loss of principal. Significant losses related to our mezzanine loans would result in operating losses for us and may limit our ability to make distributions to our stockholders.

Our Manager’s and third party service providers’ due diligence of the Portfolio may not reveal all of the liabilities or negative conditions associated with the assets in the Portfolio, which could lead to losses.

Our Manager has assessed various factors and characteristics that are material to the performance of the Portfolio. In making the assessment and otherwise conducting customary due diligence, our Manager will rely on the resources and information available to it. There can be no assurance that our Manager’s due diligence process will uncover all relevant facts or risks. It is possible that negative conditions will be revealed after the Acquisition that adversely affect the value of our portfolio and financial performance.
 
 
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A portion of the assets in the Portfolio are loans having a subordinated security interest in the applicable underlying collateral (often referred to as B Notes, C Notes, or as Subordinated Notes), and thus are subject to additional risks related to this junior position and the privately negotiated structure and terms of the particular transaction.

A portion of the assets in the Portfolio are B Notes and C Notes, or other Subordinate Notes. A Subordinate Note is a mortgage loan typically (1) secured by a first mortgage on a single large commercial property or group of related properties and (2) subordinated to an A Note (and in the case of a C Note, subordinated to a B Note, and so forth) secured by the same first mortgage on the same collateral. As a result, if a borrower defaults, there may not be sufficient funds remaining for Subordinate Note holders after payment to more senior note holders. Further, because each transaction is privately negotiated, Subordinate Notes vary in their structural characteristics and subordination terms and risks. For example, the rights of holders of Subordinate Notes to control the collection and/or foreclosure process following a borrower default varies from transaction to transaction. Significant losses related to our Subordinate Notes would result in operating losses for us and may limit our ability to make distributions to our stockholders.

If our Manager has overestimated the yields or incorrectly priced the risks of the Portfolio, we may experience losses.

Our Manager has valued the Portfolio based on expected yields and risks, taking into account estimated future losses on the mortgage loans and the underlying collateral, and the estimated impact of these losses on expected future cash flows and returns. Our Manager’s loss estimates may not prove accurate, as actual results may vary from estimates. In the event that our Manager has underestimated the asset level losses relative to the price we pay for a particular asset in the Portfolio, we may experience losses with respect to such asset.

The lack of liquidity of the Portfolio assets may adversely affect our business.

The illiquidity of the assets in the Portfolio may make it difficult for us to sell these assets if the need or desire arises. Certain assets such as Subordinate Notes, mezzanine loans and other loans are also particularly illiquid assets due to their short life, their potential unsuitability for securitization and the greater difficulty of recovery in the event of a borrower’s default. Moreover, turbulent market conditions, such as those recently experienced, could significantly and negatively impact the liquidity of assets in the Portfolio. A lack of liquidity would make it difficult or impossible to obtain third party pricing on the assets we purchase. Illiquid assets typically experience greater price volatility, as a ready market does not exist, and the assets can be more difficult to value. In addition, validating third party pricing for illiquid assets may be more subjective than for more liquid assets. As a result, if we are required to quickly monetize one or more illiquid assets, we may realize significantly less than the value at which we have previously recorded those assets. Further, we may face other restrictions on our ability to liquidate an asset in a business entity to the extent that we or our Manager has or could be attributed with material, nonpublic information regarding such business entity. As a result, our ability to vary our portfolio in response to changes in economic and other conditions may be relatively limited, which could adversely affect our results of operations and financial condition.

The Acquisition significantly increased the size and change the mix of our portfolio of assets, and we may be unable to successfully integrate the new assets or manage our growth effectively, which could have a material adverse effect on our results of operations and financial condition.

We used a significant amount of the proceeds from the March 2011Offering to consummate the Acquisition. The Acquisition significantly increased the size and change the mix of our portfolio of assets, and we may use any remaining proceeds from the offering to acquire additional assets which would further increase the size of our portfolio. We may be unable to successfully and efficiently integrate the newly-acquired assets into our existing portfolio or otherwise effectively manage our assets or our growth effectively (including incurring higher operating costs). We may prove to lack the resources required to effectively manage our assets, particularly to the extent the assets become stressed. Under these circumstances, our results of operations and financial condition may be materially adversely affected.
 
 
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Risk Related to Recent Unsolicited Acquisition Proposal

Starwood Property Trust, Inc.’s offer creates certain risks for our equity investors.

Starwood Property Trust, Inc.’s (“Starwood”) unsolicited offer to acquire us and our board’s decision to decline that offer creates certain risks for current and future investors in our common stock. Our board’s decision to decline the offer may be negatively received by our existing shareholders, which could result in negative consequences for us and have an adverse effect on our future stock price. It is possible that we end up in protracted interactions with Starwood, which could be costly and could divert our management’s time and attention from the operation of our business. Further, investors should not assume that Starwood’s offer is an indication that it, or any other party, will seek to acquire us in the future, and investors should not ascribe incremental value to our shares as a result of the Starwood offer.

Risks Related To Our Business

Our reserves for loan losses may prove inadequate, which could have a material adverse effect on our financial results.

We maintain financial reserves to protect against potential losses and conduct a review of the adequacy of these reserves on a quarterly basis. Our reserves reflect management’s current judgment of the probability and severity of losses within our overall portfolio, based on this quarterly review. However, estimation of ultimate loan losses, projected expenses and loss reserves is a complex process and there can be no assurance that management’s judgment will prove to be correct and that reserves will be adequate over time to protect against future losses. Such losses could be caused by factors including, but not limited to, unanticipated adverse changes in the economy or events adversely affecting specific assets, co-venturers, borrowers, industries in which our borrowers operate or markets in which our borrowers or their properties are located. In particular, some of the loans we have acquired or will acquire in the Acquisition may become non-performing in the future in part because of the weak economy and the disruption of the credit markets which have adversely impacted the ability and willingness of many borrowers to service their debt and refinance loans at maturity. If our reserves for credit losses prove inadequate we may suffer additional losses which would have a material adverse effect on our financial performance and results of operations.

We may suffer losses when a borrower defaults on a loan and the underlying collateral value is less than the amount due.

If a borrower defaults on a non-recourse loan, we will only have recourse to the real estate-related assets collateralizing the loan. If the underlying collateral value is less than the loan amount, we will suffer a loss. Some of our loans are unsecured or are senior only to equity interests in the borrowing entities. These loans are subject to the risk that other lenders in the capital structure may be directly secured by the real estate assets of the borrower or may otherwise have a superior right to repayment. Upon a default, those collateralized lenders would have priority over us with respect to the proceeds of a sale of the underlying real estate. In cases described above, we may lack control over the underlying asset collateralizing our loan or the underlying assets of the borrower before a default, and, as a result, the value of the collateral may be reduced by acts or omissions by owners or managers of the assets. In addition, the value of the underlying real estate may be adversely affected by some or all of the risks referenced above with respect to our owned real estate.

Some of our loans are backed by individual or corporate guarantees from borrowers or their affiliates. If these guarantees are not fully or partially secured, we typically rely on financial covenants from borrowers and guarantors, which are designed to require the borrower or guarantor to maintain certain levels of creditworthiness. Where we do not have recourse to specific collateral pledged to satisfy such guarantees, we will only have recourse as an unsecured creditor to the general assets of the borrower or guarantor, some or all of which may be pledged as collateral for other lenders. There can be no assurance that a borrower or guarantor will comply with its financial covenants, or that sufficient assets will be available to pay amounts owed to us under our loans and guarantees. As a result of these factors, we may suffer additional losses which could have a material adverse effect on our financial performance.
 
 
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Upon a borrower bankruptcy, we may not have full recourse to the assets of the borrower to satisfy our loan. In addition, certain of our loans are subordinate to other debt of certain borrowers. If a borrower defaults on our loan or on debt senior to our loan, or upon a borrower bankruptcy, our loan will be satisfied only after the senior debt receives payment. Where debt senior to our loan exists, the presence of intercreditor arrangements may limit our ability to amend our loan documents, assign our loans, accept prepayments, exercise our remedies (through “standstill” periods) and control decisions made in bankruptcy proceedings. Bankruptcy and borrower litigation can significantly increase collection costs and the time needed for us to acquire title to the underlying collateral (if applicable), during which time the collateral and/or a borrower’s financial condition may decline in value, causing us to suffer additional losses.

If the value of the collateral underlying a loan declines or interest rates increase during the term of a loan, a borrower may not be able to obtain the necessary funds to repay our loan at maturity through refinancing because the underlying property revenue cannot satisfy the debt service coverage requirements necessary to obtain new financing. If a borrower is unable to repay our loan at maturity, we could suffer additional loss which may adversely impact our financial performance.

We are subject to additional risks associated with loan participations.

Some of our loans are participation interests or co-lender arrangements in which we share the rights, obligations and benefits of the loan with other lenders.  We may need the consent of these parties to exercise our rights under such loans, including rights with respect to amendment of loan documentation, enforcement proceedings upon a default and the institution of, and control over, foreclosure proceedings.  Similarly, certain participants may be able to take actions to which we object but to which we will be bound if our participation interest represents a minority interest. We may be adversely affected by this lack of control.
 
 
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Exhibits:

The exhibits required by this item are set forth on the Exhibit Index attached hereto
 
EXHIBIT INDEX
   
Exhibit
Number
Description
2.1
Asset Purchase Agreement, dated March 18, 2011, among CreXus S Holdings LLC, CreXus S Holdings (Grand Cayman) LLC, Barclays Capital Real Estate Inc. and Barclays Capital Real Estate Finance Inc. (filed as exhibit 2.1 to the Company's Current Report on Form 8-K (filed on March 21, 2011) and incorporated herein by reference).
3.1
Articles of Amendment and Restatement of CreXus Investment Corp. (filed as Exhibit 3.1 to the Company’s Registration Statement on Amendment No. 5 to Form S-11 (File No. 333-160254) filed on September 14, 2009 and incorporated herein by reference).
3.2
Amended and Restated Bylaws of CreXus Investment Corp.  (filed as exhibit 3.2 to the Company’s Quarterly Report on Form 10-Q (filed on November 6, 2009) and incorporated herein by reference).
4.1
Specimen Common Stock Certificate of CreXus Investment Corp. (filed as Exhibit 4.1 to the Company’s Registration Statement on Amendment No. 3 to Form S-11 (File No. 333-160254) filed on August 31, 2009 and incorporated herein by reference).
31.1
Certification of Kevin Riordan, Chief Executive Officer and President of the Registrant, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2
Certification of Daniel Wickey, Chief Financial Officer of the Registrant, pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1
Certification of  Kevin Riordan, Chief Executive Officer and President of the Registrant, pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2
Certification of Daniel Wickey, Chief Financial Officer of the Registrant, pursuant to 18 U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
 
 
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Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 
 
CREXUS INVESTMENT CORP.
     
     
     
 
By:
/s/ Kevin Riordan
    Kevin Riordan 
    Chief Executive Officer and President (Principal Executive Officer) 
    May 09, 2011 
     
     
     
 
By:
/s/ Daniel Wickey
   
Daniel Wickey
    Chief Financial Officer (Principal Financial Officer) 
    May 09, 2011 
 
 


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