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Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

x      Quarterly Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the quarterly period ended September 30, 2015

 

o         Transition Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

 

For the transition period from         to        

 

Commission File Number:  001-35543

 

Western Asset Mortgage Capital Corporation

(Exact name of Registrant as specified in its charter)

 

Delaware

 

27-0298092

(State or other jurisdiction of
incorporation or organization)

 

(IRS Employer
Identification Number)

 

Western Asset Mortgage Capital Corporation

385 East Colorado Boulevard

Pasadena, California 91101

(Address of Registrant’s principal executive offices)

 

(626) 844-9400

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x  No 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 (§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 x  No o

 

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

 

Large accelerated filer o

 

Accelerated filer x

 

 

 

Non-accelerated filer o

 

Smaller reporting company o

(Do not check if a smaller reporting company)

 

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 under the Securities Exchange Act of 1934).  Yes  o  No x

 

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practical date.

 

As of November 3, 2015, there were 41,919,801 shares, par value $0.01, of the registrant’s common stock issued and outstanding.

 

 

 




Table of Contents

 

Western Asset Mortgage Capital Corporation and Subsidiaries

Consolidated Balance Sheets (Unaudited)

(in thousands—except share and per share data)

 

 

 

September 30, 2015

 

December 31, 2014

 

Assets:

 

 

 

 

 

Cash and cash equivalents

 

$

39,703

 

$

47,222

 

Mortgage-backed securities and other securities, at fair value ($3,343,683 and $4,362,532 pledged as collateral, at fair value, respectively)

 

3,352,509

 

4,385,723

 

Residential Whole-Loans, at fair value (amounts related to VIE of $150,486 and $7,220, respectively)

 

150,486

 

7,220

 

Linked transactions, net, at fair value

 

 

20,627

 

Receivable under reverse repurchase agreements

 

758,467

 

 

Investment related receivable

 

10,734

 

162,837

 

Accrued interest receivable (amounts related to VIE of $1,159 and $40, respectively)

 

21,415

 

27,309

 

Due from counterparties

 

236,525

 

184,757

 

Derivative assets, at fair value

 

56,985

 

73,256

 

Other assets

 

773

 

326

 

Total Assets

 

$

4,627,597

 

$

4,909,277

 

 

 

 

 

 

 

Liabilities and Stockholders’ Equity:

 

 

 

 

 

Liabilities:

 

 

 

 

 

Borrowings under repurchase agreements

 

$

3,010,268

 

$

3,875,721

 

Accrued interest payable

 

21,719

 

17,573

 

Investment related payables

 

10,742

 

166,608

 

Due to counterparties

 

771,784

 

12,180

 

Derivative liability, at fair value

 

227,158

 

180,280

 

Accounts payable and accrued expenses (including obligations of VIE of $5 and $153, respectively)

 

2,262

 

1,794

 

Payable to related party

 

2,797

 

2,705

 

Dividend payable

 

25,152

 

29,204

 

Total Liabilities

 

4,071,882

 

4,286,065

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

 

 

 

Stockholders’ Equity:

 

 

 

 

 

Common stock, $0.01 par value, 500,000,000 shares authorized, 41,919,801 and 41,719,801 shares issued and outstanding, respectively

 

419

 

417

 

Preferred stock, $0.01 par value, 100,000,000 shares authorized and no shares outstanding

 

 

 

Additional paid-in capital

 

762,935

 

760,925

 

Retained earnings (accumulated deficit)

 

(207,639

)

(138,130

)

Total Stockholders’ Equity

 

555,715

 

623,212

 

Total Liabilities and Stockholders’ Equity

 

$

4,627,597

 

$

4,909,277

 

 

See notes to unaudited consolidated financial statements.

 

2



Table of Contents

 

Western Asset Mortgage Capital Corporation and Subsidiaries

Consolidated Statements of Operations (Unaudited)

(in thousands—except share and per share data)

 

 

 

For the three
months ended
September 30,
2015

 

For the three
months ended
September 30,
2014

 

For the nine
months ended
September 30,
2015

 

For the nine
months ended
September 30,
2014

 

 

 

 

 

 

 

 

 

 

 

Net Interest Income:

 

 

 

 

 

 

 

 

 

Interest income

 

$

35,821

 

$

40,718

 

$

117,656

 

$

108,752

 

Interest expense

 

6,981

 

6,468

 

19,960

 

15,829

 

Net Interest Income

 

28,840

 

34,250

 

97,696

 

92,923

 

 

 

 

 

 

 

 

 

 

 

Other Income (Loss):

 

 

 

 

 

 

 

 

 

Interest income on cash balances and other income (loss), net

 

(29

)

942

 

1,744

 

954

 

Realized gain (loss) on sale of Mortgage-backed securities, other securities and Whole-Loans, net

 

(2,482

)

4,912

 

9,267

 

(2,650

)

Other loss on Mortgage-backed securities and other securities

 

(5,917

)

(2,857

)

(14,884

)

(7,565

)

Unrealized gain (loss) on Mortgage-backed securities, other securities and Whole-Loans, net

 

24,723

 

(4,453

)

10,284

 

140,755

 

Gain on linked transactions, net

 

 

(1,241

)

 

1,666

 

Loss on derivative instruments, net

 

(41,363

)

(401

)

(76,511

)

(126,984

)

Other Income (Loss), net

 

(25,068

)

(3,098

)

(70,100

)

6,176

 

 

 

 

 

 

 

 

 

 

 

Operating Expenses:

 

 

 

 

 

 

 

 

 

General and administrative (includes $509, $587, $1,969 and $1,654 non-cash stock based compensation, respectively)

 

2,863

 

2,253

 

8,862

 

6,703

 

Management fee — related party

 

2,761

 

2,763

 

8,133

 

7,127

 

Total Operating Expenses

 

5,624

 

5,016

 

16,995

 

13,830

 

 

 

 

 

 

 

 

 

 

 

Net income (loss) available to Common Stock and participating securities

 

$

(1,852

)

$

26,136

 

$

10,601

 

$

85,269

 

 

 

 

 

 

 

 

 

 

 

Net income (loss) per Common Share — Basic

 

$

(0.05

)

$

0.63

 

$

0.24

 

$

2.35

 

Net income (loss) per Common Share — Diluted

 

$

(0.05

)

$

0.63

 

$

0.24

 

$

2.35

 

Dividends Declared per Share of Common Stock

 

$

0.60

 

$

0.70

 

$

1.91

 

$

2.04

 

 

See notes to unaudited consolidated financial statements.

 

3



Table of Contents

 

Western Asset Mortgage Capital Corporation and Subsidiaries

Consolidated Statements of Changes in Stockholders’ Equity (Unaudited)

(in thousands—except shares and share data)

 

 

 

Common Stock

 

Additional Paid-

 

Retained
Earnings
(Accumulated)

 

 

 

 

 

Shares

 

Par

 

In Capital

 

Deficit

 

Total

 

Balance at December 31, 2014

 

41,719,801

 

$

417

 

$

760,925

 

$

(138,130

)

$

623,212

 

Grants of restricted stock

 

200,000

 

2

 

(2

)

 

 

Vesting of restricted stock

 

 

 

1,969

 

 

1,969

 

Net income

 

 

 

 

10,601

 

10,601

 

Dividends on common stock

 

 

 

43

 

(80,110

)

(80,067

)

Balance at September 30, 2015

 

41,919,801

 

$

419

 

$

762,935

 

$

(207,639

)

$

555,715

 

 

See notes to unaudited consolidated financial statements.

 

4



Table of Contents

 

Western Asset Mortgage Capital Corporation and Subsidiaries

Consolidated Statements of Cash Flows (Unaudited)

(in thousands)

 

 

 

For the nine months
ended September 30,
2015

 

For the nine months
ended September 30,
2014, as Revised (See
Note 2)

 

Cash flows from operating activities:

 

 

 

 

 

Net income

 

$

10,601

 

$

85,269

 

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

Premium amortization and (discount accretion) on Mortgage-backed securities, other securities and Whole-Loans, net

 

5,645

 

8,049

 

Interest income earned added to principal of Mortgage-backed securities and other securities

 

(141

)

 

Amortization of deferred financing costs

 

295

 

 

Restricted stock amortization expense

 

1,969

 

1,654

 

Premium amortization for MAC interest rate swaps

 

(1,075

)

(928

)

Interest payments and basis recovered on MAC interest rate swaps

 

1,443

 

(545

)

Premium on purchase of Residential Whole-Loans

 

(2,390

)

 

Unrealized loss on Mortgage-backed securities, other securities and Whole-Loans, net

 

(10,284

)

(140,755

)

Mark-to-market adjustments on linked transactions

 

 

1,339

 

Mark-to-market adjustments on derivative instruments

 

82,952

 

126,112

 

Other loss on Mortgage-backed securities and other securities

 

14,884

 

7,565

 

Realized (gain) loss on sale of Mortgage-backed securities, other securities and Whole-Loans, net

 

(9,267

)

2,650

 

Realized (gain) loss on sale of Interest-Only Strips accounted for as derivatives, net

 

(624

)

755

 

Realized loss on termination of MAC interest rate swaps containing an other-than-insignificant financing element

 

8,658

 

 

Realized (gain) loss on sale of TBAs, net

 

1,728

 

(25,169

)

Realized loss on sale of swaptions, net

 

3,873

 

5,908

 

Realized loss on forward contracts

 

980

 

1,182

 

Realized loss on futures

 

627

 

16,495

 

Realized gain on option derivatives

 

(684

)

 

Realized gain on linked transaction, net

 

 

(1,397

)

Gain on foreign currency transactions, net

 

(1,664

)

(1,119

)

Changes in operating assets and liabilities:

 

 

 

 

 

Decrease (increase) in accrued interest receivable

 

5,894

 

(23,365

)

Increase in other assets

 

(279

)

(279

)

Increase in accrued interest payable

 

4,146

 

12,036

 

Increase in accounts payable and accrued expenses

 

468

 

1,008

 

Increase in payable to related party

 

92

 

1,214

 

Net cash provided by operating activities

 

117,847

 

77,679

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

Purchase of Mortgage-backed securities and other securities

 

(570,441

)

(3,804,044

)

Purchase of securities underlying linked transactions

 

 

(38,224

)

Proceeds from sale of Mortgage-backed securities and other securities

 

2,087,678

 

2,240,338

 

Proceeds from sale of securities underlying linked transactions

 

 

6,214

 

Principal payments and basis recovered on Mortgage-backed securities and other securities

 

315,106

 

233,796

 

Principal payments and basis recovered on securities underlying linked transactions

 

 

4,408

 

Purchase of Residential Whole-Loans

 

(147,336

)

 

Principal payments on Residential Whole-Loans

 

9,077

 

 

Purchase of Commercial Whole-Loans

 

(8,750

)

 

Principal payments on Commercial Whole-Loans

 

8,750

 

 

Payment of premium for option derivatives

 

(10,864

)

(2,813

)

Premium received from option derivatives

 

11,548

 

 

Net settlements of TBAs

 

466

 

25,169

 

Payment on termination of futures

 

(627

)

(16,495

)

Proceeds from sale of interest rate swaptions

 

27,899

 

 

Premium for MAC interest rate swaps, net

 

(3,595

)

11,010

 

Payments on termination of MAC interest rate swaps

 

(190

)

 

Interest payments and basis recovered on MAC interest rate swaps

 

(1,041

)

 

Proceeds from (payments made) on reverse repurchase agreements, net

 

(758,467

)

 

Premium for interest rate swaptions, net

 

(34,751

)

1,615

 

Net cash provided by (used in) investing activities

 

924,462

 

(1,339,026

)

 

5



Table of Contents

 

Cash flows from financing activities:

 

 

 

 

 

Proceeds from issuance of common stock

 

 

205,380

 

Proceeds from private placement of common stock (concurrent with initial public offering)

 

 

9,653

 

Payment of offering costs

 

 

(409

)

Proceeds from repurchase agreement borrowings

 

13,645,855

 

18,161,433

 

Proceeds from repurchase agreement borrowings underlying linked transactions

 

 

142,530

 

Repayments of repurchase agreement borrowings

 

(14,541,717

)

(16,858,373

)

Repayments of repurchase agreement borrowings underlying linked transactions

 

 

(178,948

)

Proceeds from forward contracts

 

206,240

 

14,022

 

Repayments of forward contracts

 

(207,220

)

(15,205

)

Premium for MAC interest rate swaps containing an other-than-insignificant financing element

 

 

10,579

 

Payments on termination of MAC interest rate swaps containing an other-than-insignificant financing element

 

(18,655

)

 

Interest payments and basis recovered on MAC interest rate swaps containing an other-than-insignificant financing element

 

(402

)

545

 

Payments made for deferred financing costs

 

(463

)

 

Due from counterparties, net

 

(51,768

)

(94,232

)

Due to counterparties, net

 

2,251

 

(62,554

)

Dividends on common stock

 

(84,119

)

(65,532

)

Net cash (used in) provided by financing activities

 

(1,049,998

)

1,268,889

 

 

 

 

 

 

 

Effect of exchange rate changes on cash and cash equivalents

 

170

 

 

 

 

 

 

 

 

Net (decrease) increase in cash and cash equivalents

 

(7,519

)

7,542

 

Cash and cash equivalents beginning of period

 

47,222

 

48,525

 

Cash and cash equivalents end of period

 

$

39,703

 

$

56,067

 

 

 

 

 

 

 

Supplemental disclosure of operating cash flow information:

 

 

 

 

 

Interest paid

 

$

20,363

 

$

14,350

 

Supplemental disclosure of non-cash financing/investing activities:

 

 

 

 

 

Principal payments on Mortgage-backed securities and other securities, not settled

 

$

 

$

(317

)

Mortgage-backed securities and other securities purchased, not settled

 

$

 

$

(14,832

)

Mortgage-backed securities recorded upon unlinking of linked transactions

 

$

 

$

(69,838

)

Obligation to return collateral used to settle short sales

 

$

(757,353

)

$

 

Net unsettled TBAs

 

$

(8

)

$

 

Deferred offering costs payable

 

$

 

$

(8

)

Dividends and distributions declared, not paid

 

$

25,152

 

$

29,203

 

 

See notes to unaudited consolidated financial statements.

 

6



Table of Contents

 

Western Asset Mortgage Capital Corporation and Subsidiaries

Notes to Consolidated Financial Statements (Unaudited)

(in thousands- except share and per share data)

 

The following defines certain of the commonly used terms in these Notes to Consolidated Financial Statements: “Agency” or “Agencies” refer to a federally chartered corporation, such as the Federal National Mortgage Association (“Fannie Mae” or “FNMA”) or the Federal Home Loan Mortgage Corporation (“Freddie Mac” or “FHLMC”), or an agency of the U.S. Government, such as the Government National Mortgage Association (“Ginnie Mae” or “GNMA”); references to “MBS” refer to mortgage backed securities, including residential mortgage-backed securities or “RMBS”, commercial mortgage-backed securities or “CMBS”, and “Interest-Only Strips” (as defined herein);”Agency MBS” refer to RMBS, CMBS and Interest-Only Strips issued or guaranteed by the Agencies while “ Non-Agency MBS “ refer to RMBS, CMBS and Interest-Only Strips that are not issued or guaranteed by the Agencies; references to “ARMs” refers to adjustable rate mortgages; references to “Interest-Only Strips” refer to interest-only (“IO”) and inverse interest-only (“IIO”) securities issued as part of or collateralized with MBS; references to Residential Whole-Loans and Commercial Whole-Loans (collectively “Whole Loans”) refer to individual mortgage loans secured by single family and commercial properties, respectively.

 

Note 1 — Organization

 

Western Asset Mortgage Capital Corporation and subsidiaries (are collectively referred to throughout this report as the “Company”) are a real estate finance company.  At the Company’s launch in May 2012, its initial investment strategy focused primarily on Agency RMBS (including TBAs as defined herein).  Over time, the Company expanded its investment strategy to include Non-Agency RMBS and subsequently, Agency and Non-Agency CMBS, including Non U.S. CMBS and Whole-Loans.  In addition, and to a significantly lesser extent, the Company has invested in other securities including certain Agency obligations that are not technically MBS and in asset-backed securities (“ABS”).  These changes in the Company’s investment strategy, including future changes, are based on the Manager’s perspective of which mix of portfolio assets it believes provide the Company with the best risk-reward opportunities at any given time.

 

The Company is externally managed by Western Asset Management Company (“WAM”, or the “Manager”), an investment advisor registered with the Securities and Exchange Commission (“SEC”).  WAM is a wholly-owned subsidiary of Legg Mason, Inc.  The Company operates and has elected to be taxed as a real estate investment trust or “REIT” commencing with its taxable year ended December 31, 2012.

 

In light of the aforementioned developments and given the Manager’s current market outlook and investment view, while it can be expected that Agency RMBS will continue to be a significant part of the Company’s portfolio, Agency RMBS will not necessarily be our primary investment in the future.  Going forward, the Manager may vary the allocation among various asset classes subject to maintaining the Company’s qualification as a REIT and maintaining its exemption from the Investment Company Act of 1940 (the “1940 Act”).  These restrictions limit the Company’s ability to invest in non-real estate assets and/or assets which are not secured by real estate.  Accordingly, the Company’s portfolio will continue to be principally invested in MBS and other real estate related assets.

 

7



Table of Contents

 

Note 2 — Revision of Previously Issued Financial Statements for Errors Affecting Certain Items Presented in the Statements of Cash Flows and Notes to Financial Statements

 

As previously reported in the Company’s annual report on Form 10-K for the year ended December 31, 2014, during the process of preparing the Company’s 2014 financial statements, the Company discovered that the treatment of premiums received on the market agreed coupon (“MAC”) interest rate swaps and treatment of proceeds and repayment on rehypothecation of non-cash collateral in its Statements of Cash Flows and a voluntary disclosure surrounding the breakdown between realized and unrealized portion of the change in fair value for derivative instrument were not presented in accordance with GAAP.  The Company has evaluated the impact of these errors and has concluded that individually and in the aggregate, these errors were not material to any previously issued financial statements. However, the Company has elected to revise the Statement of Cash Flows for the nine months ended September 30, 2014 and the voluntary disclosure for the three and nine months ended September 30, 2014 in these quarterly financial statements on Form 10-Q to correct the aforementioned errors. The corrections resulted in a reclassification of premiums received and periodic interest payments on interest rate swaps previously reported in cash flows from operating activities and the reclassification of proceeds and repayments on rehypothecation of non-cash collateral previously reported as repurchase agreement proceeds and repayments (as indicated in the tables below). In accordance with the Company’s accounting policies, proceeds and repayments on rehypothecation of non-cash collateral is reported on a net basis in Due to counterparties, net.  These revisions had no effect on net income, shareholders’ equity, net change in cash, or total assets, of the Company reported for these periods.

 

Statements of Cash Flows (summarized) for the nine months ended September 30, 2014:

 

 

 

For the nine months ended September 30, 2014

 

Amounts in thousands

 

As Originally
Reported

 

Adjustments

 

Revised

 

 

 

 

 

 

 

 

 

Statement of Cash Flows (effect on individual line items)

 

 

 

 

 

 

 

Net income

 

$

85,269

 

$

 

$

85,269

 

Adjustments to reconcile net income to net cash provided by operating activities:

 

 

 

 

 

 

 

Premium amortization for MAC interest rate swaps

 

 

(928

)

(928

)

Interest payments and basis recovered on MAC interest rate swaps

 

 

(545

)

(545

)

Mark-to-market adjustments on derivative instruments

 

147,968

 

(21,856

)

126,112

 

All other items

 

(132,229

)

 

(132,229

)

Net cash provided by operating activities

 

101,008

 

(23,329

)

77,679

 

 

 

 

 

 

 

 

 

Cash flows from investing activities:

 

 

 

 

 

 

 

Premium for MAC interest rate swaps, net

 

(2,235

)

13,245

 

11,010

 

All other items

 

(1,350,036

)

 

(1,350,036

)

Net cash used in investing activities

 

(1,352,271

)

13,245

 

(1,339,026

)

Cash flows from financing activities:

 

 

 

 

 

 

 

Proceeds from repurchase agreement borrowings

 

18,164,190

 

(2,757

)

18,161,433

 

Repayments of repurchase agreement borrowings

 

(16,861,130

)

2,757

 

(16,858,373

)

Premium for MAC interest rate swaps containing an other-than-insignificant financing element

 

1,040

 

9,539

 

10,579

 

Interest payments and basis recovered on MAC interest rate swaps containing an other-than-insignificant financing element

 

 

545

 

545

 

All other items

 

(45,295

)

 

(45,295

)

Net cash provided by financing activities

 

1,258,805

 

10,084

 

1,268,889

 

 

 

 

 

 

 

 

 

Net increase (decrease) in cash and cash equivalents

 

7,542

 

 

7,542

 

Cash and cash equivalents beginning of period

 

48,525

 

 

48,525

 

Cash and cash equivalents end of period

 

$

56,067

 

$

 

$

56,067

 

 

8



Table of Contents

 

The tables below summarize the effect of interest rate swaps, interest rate swaptions, foreign currency swaps, foreign currency forwards, options, futures contracts, Agency and Non-Agency Interest-Only Strips as derivatives and TBAs reported in a voluntary disclosure surrounding the breakdown between realized and unrealized portion of the change in fair value for derivative instruments for the three and nine months ended September 30, 2014 (dollars in thousands - summarized):

 

As Originally Reported

 

 

 

Three months ended September 30, 2014

 

Description

 

Realized
Gain
(Loss), net

 

Contractual
interest
income
(expense),
net(1)

 

Return
(Recovery)
of Basis

 

Mark-to-
market
adjustments

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate swaps

 

$

23,798

 

$

(11,848

)

$

 

$

(14,767

)

$

(2,817

)

All other items with no changes

 

1,815

 

5,863

 

(4,187

)

(1,075

)

2,416

 

Total

 

$

25,613

 

$

(5,985

)

$

(4,187

)

$

(15,842

)

$

(401

)

 

Adjustments

 

Description

 

Realized
Gain
(Loss), net

 

Contractual
interest
income
(expense),
net(1)

 

Return
(Recovery)
of Basis

 

Mark-to-
market
adjustments

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate swaps

 

$

 

$

 

$

820

 

$

(820

)

$

 

All other items with no changes

 

 

 

 

 

 

Total

 

$

 

$

 

$

820

 

$

(820

)

$

 

 

Revised

 

Description

 

Realized
Gain
(Loss), net

 

Contractual
interest
income
(expense),
net(1)

 

Return
(Recovery)
of Basis

 

Mark-to-
market
adjustments

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate swaps

 

$

23,798

 

$

(11,848

)

$

820

 

$

(15,587

)

$

(2,817

)

All other items with no changes

 

1,815

 

5,863

 

(4,187

)

(1,075

)

2,416

 

Total

 

$

25,613

 

$

(5,985

)

$

(3,367

)

$

(16,662

)

$

(401

)

 


(1)         Contractual interest income (expense), net on derivative instruments includes interest settlement paid or received.

 

As Originally Reported

 

 

 

Nine months ended September 30, 2014

 

Description

 

Realized
Gain
(Loss), net

 

Contractual
interest
income
(expense),
net(1)

 

Return
(Recovery)
of Basis

 

Mark-to-
market
adjustments

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate swaps

 

$

39,796

 

$

(25,784

)

$

 

$

(144,882

)

$

(130,870

)

All other items with no changes

 

829

 

20,429

 

(14,286

)

(3,086

)

3,886

 

Total

 

$

40,625

 

$

(5,355

)

$

(14,286

)

$

(147,968

)

$

(126,984

)

 

Adjustments

 

Description

 

Realized
Gain
(Loss), net

 

Contractual
interest
income
(expense),
net(1)

 

Return
(Recovery)
of Basis

 

Mark-to-
market
adjustments

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate swaps

 

$

(22,784

)

$

 

$

928

 

$

21,856

 

$

 

All other items with no changes

 

 

 

 

 

 

Total

 

$

(22,784

)

$

 

$

928

 

$

21,856

 

$

 

 

Revised

 

Description

 

Realized
Gain
(Loss), net

 

Contractual
interest
income
(expense),
net(1)

 

Return
(Recovery)
of Basis

 

Mark-to-
market
adjustments

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest rate swaps

 

$

17,012

 

$

(25,784

)

$

928

 

$

(123,026

)

$

(130,870

)

All other items with no changes

 

829

 

20,429

 

(14,286

)

(3,086

)

3,886

 

Total

 

$

17,841

 

$

(5,355

)

$

(13,358

)

$

(126,112

)

$

(126,984

)

 


(1)         Contractual interest income (expense), net on derivative instruments includes interest settlement paid or received.

 

9



Table of Contents

 

Note 3 — Summary of Significant Accounting Policies

 

Basis of Presentation and Consolidation

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting periods.  Actual results could differ from those estimates.

 

The consolidated financial statements include the Company’s accounts and those of its consolidated subsidiary.   The consolidated financial statements also include the consolidation of certain trusts that each meet the definition of a variable interest entity (“VIE”) related to the acquisition of Residential Whole-Loans in which the Company has determined itself to be the primary beneficiary of each such trust. Each trust has issued a trust certificate to the Company which is collateralized by pools of Residential Whole-Loans held by such trust.  The Company includes the underlying Residential Whole-Loans owned by the trusts in Residential Whole-Loans at fair value on the Consolidated Balance Sheets and has eliminated the intercompany trust certificates in consolidation. The Company records interest income earned on the Residential Whole-Loans in Interest income on the Consolidated Statements of Operations. The Company records the initial underlying assets and liabilities of the consolidated trusts at their fair value upon consolidation into the Company and, as such, a gain or loss would be recorded upon consolidation if appropriate. Upon consolidation of the VIEs, the Company recorded no gain or loss upon consolidation.  Refer to Note 6 - “Variable Interest Entities” for additional information regarding the impact of consolidation of the trusts.   All intercompany amounts between the Company and its subsidiary and consolidated trusts have been eliminated in consolidation.

 

In the opinion of management, all adjustments (which include only normal recurring adjustments) necessary have been made to present fairly the Company’s financial position, results of operations and cash flows. Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted in accordance with Article 10 of Regulation S-X and the instructions to Form 10-Q. These consolidated financial statements should be read in conjunction with the Company’s annual report on Form 10-K for the year ended December 31, 2014, filed with the Securities and Exchange Commission (“SEC”) on March 16, 2015. The results of operations for the period ended September 30, 2015 are not necessarily indicative of the results to be expected for the full year or any future period.

 

The Company currently operates as one business segment.

 

Cash and Cash Equivalents

 

The Company considers all highly-liquid short term investments with original maturities of 90 days or less when purchased to be cash equivalents.  Cash and cash equivalents are exposed to concentrations of credit risk. The Company places its cash and cash equivalents with what it believes to be high credit quality institutions. At times such investments may be in excess of the Federal Deposit Insurance Corporation insurance limit.

 

Classification of mortgage-backed securities, other securities and Residential and Commercial Whole-Loans and valuations of financial instruments

 

Mortgage-backed securities, other securities and Residential and Commercial Whole-Loans - Fair value election

 

The Company has elected the fair value option for all of its MBS, other securities, and Residential and Commercial Whole-Loans at the date of purchase, which permits the Company to measure these securities and Whole-Loans at fair value with the change in fair value included as a component of earnings. In the Manager’s view, this election more appropriately reflects the results of the Company’s operations for a particular reporting period, as financial asset fair value changes are presented in a manner consistent with the presentation and timing of the fair value changes of economic hedging instruments.

 

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Table of Contents

 

Balance Sheet Presentation

 

The Company’s purchases and sales of mortgage-backed securities and other securities are recorded on the trade date, which results in an investment related payable (receivable) for MBS and other securities purchased (sold) for which settlement has not taken place as of the balance sheet date. In addition, the Company’s TBAs which have matured but have not settled as of the balance sheet date result in an investment related payable (receivable).  The Company’s MBS, other securities and Residential Whole-Loans are pledged as collateral against borrowings under repurchase agreements.  Other than MBS and other securities which were accounted for as linked transactions through December 31, 2014, described below, the Company’s MBS and other securities are included in Mortgage-backed securities and other securities at fair value and Investment related receivables on the Consolidated Balance Sheets, with the fair value of such MBS and other securities pledged disclosed parenthetically.  Residential and Commercial Whole-Loan purchases and sales are recorded on the settlement date and are included in Residential Whole-Loans at fair value and Commercial Whole-Loans at fair value on the Consolidated Balance Sheets, respectively, with the fair value of such Residential Whole-Loans pledged disclosed parenthetically.

 

Valuation of financial instruments

 

The Company discloses the fair value of its financial instruments according to a fair value hierarchy (Levels I, II, and III, as defined below). In accordance with GAAP, the Company is required to provide enhanced disclosures regarding instruments in the Level III category (which require significant management judgment), including a separate reconciliation of the beginning and ending balances for each major category of assets and liabilities.  GAAP establishes a framework for measuring fair value and expands financial statement disclosure requirements for fair value measurements. GAAP further specifies a hierarchy of valuation techniques, which is based on whether the inputs into the valuation technique are observable or unobservable. The hierarchy is as follows:

 

Level I — Quoted prices in active markets for identical assets or liabilities.

 

Level II — Quoted prices for similar assets and liabilities in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.

 

Level III — 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.

 

The level in the fair value hierarchy within which a fair value measurement in its entirety falls is based on the lowest level input that is significant to the fair value measurement in its entirety.  Transfers between levels are determined by the Company at the end of the reporting period.

 

When available, the Company uses quoted market prices to determine the fair value of an asset or liability. If quoted market prices are not available, the Company consults with independent pricing services or obtains third party broker quotes. If independent pricing service, or third party broker quotes are not available, the Company determines the fair value of the securities using valuation techniques that use, when possible, current market-based or independently-sourced market parameters, such as interest rates and when applicable, estimates of prepayment and credit losses.

 

Valuation techniques for MBS, Residential and Commercial Whole-Loans and other securities may be based upon models that consider the estimated cash flows of the security or the Whole-Loan. Depending on the asset and the underlying collateral, the primary inputs to the model may include yields for Agency To-Be-Announced securities (also known as “TBAs”), Agency MBS, the U.S. Treasury market and floating rate indices such as the London interbank offered rate or LIBOR, the Constant Maturity Treasury rate and the prime rate as a benchmark yield.  In addition, the model may incorporate the current weighted average maturity and additional pool level information such as prepayment speeds, default frequencies and default severities, if applicable. To the extent such inputs are observable and timely, these assets are categorized as Level II of the fair value hierarchy; otherwise, unless alternative pricing information as described above is available, they are categorized as Level III.

 

While linked transactions, described below, were treated as derivatives for GAAP through December 31, 2014, the securities underlying the Company’s linked transactions were valued using similar techniques to those used for the Company’s securities portfolio. The value of the underlying security was then netted against the carrying amount (which approximates fair value) of the repurchase agreement at the valuation date. Additionally, TBA instruments are similar in substance to the Company’s Agency RMBS portfolio, and the Company therefore estimates fair value based on similar methods.

 

11



Table of Contents

 

The Company determines the fair value of derivative financial instruments by obtaining quotes from third party pricing services, whose pricing is subject to review by the Manager’s pricing committee. In valuing its over-the-counter interest rate derivatives, such as swaps and swaptions, and its currency derivatives, such as swaps and forwards, the Company considers the creditworthiness of both the Company and its counterparties, along with collateral provisions contained in each derivative agreement, from the perspective of both the Company and its counterparties. The majority of the Company’s interest rate swaps are cleared through a central clearing house and subject to the clearing house margin requirements. The Company’s agreements with its derivative counterparties also contain netting provisions; however the Company has elected to report its interest rate swaps and swaptions and currency swaps and forwards on a gross basis.  No credit valuation adjustment was made in determining the fair value of interest rate and/or currency derivatives for the periods ended September 30, 2015 and December 31, 2014.

 

Fair value under GAAP represents an exit price in the normal course of business, not a forced liquidation price. If the Company is forced to sell assets in a short period to meet liquidity needs, the prices it receives can be substantially less than their recorded fair values. Furthermore, the analysis of whether it is more likely than not that the Company will not be required to sell assets in an unrealized loss position before recovery of its amortized cost basis, the amount of such expected required sales, and the projected identification of which assets will be sold is also subject to significant judgment, particularly in times of market illiquidity.

 

Any changes to the valuation methodology will be reviewed by the Company and its Manager to ensure the changes are appropriate. As markets and products develop and the pricing for certain products becomes more transparent, the Company will continue to refine its valuation methodologies.  The Company utilizes and follows the pricing methodology and fair value hierarchy employed by its Manager, including its review and challenge process.  The methods used by the Company may produce a fair value calculation that may not be indicative of net realizable value or reflective of future fair values. Furthermore, while the Company anticipates that its 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 can result in a different estimate of fair value at the reporting date. The Company uses inputs that are current as of the measurement date, which may include periods of market dislocation, during which price transparency may be reduced.

 

All valuations received from independent pricing services are non-binding.  The Company primarily utilizes independent third party pricing services as the primary source for valuing the Company’s assets.

 

The Company generally receives one independent pricing service price for each investment in the Company’s portfolio. The Manager has established a quarterly process to review and validate the pricing received from the independent pricing services and has a process for challenging prices received from the independent pricing services when necessary.  The Company utilizes its Manager’s policies in this regard for all securities.  The Company utilizes its own policies for the review of the pricing of Whole-Loans received from a third party vendor.  The Company’s and the Manager’s quarterly review of the independent third party pricing data may consist of a review of the daily change in the prices provided by the independent pricing vendor which exceed established tolerances or comparisons to executed transaction prices.  The Manager’s pricing group, which functions independently from its portfolio management personnel, corroborates the price differences or changes in price by comparing the vendor price to alternate sources including other independent pricing services or broker quotations.  If the price change or difference cannot be corroborated, the Manager’s pricing group consults with the portfolio management team for market color in reviewing such pricing data as warranted.  To the extent that the Manager has information, typically in the form of broker quotations that would indicate that a price received from the independent pricing service is outside of a tolerance range, our Manager generally challenges the independent pricing service price.

 

In addition, to ensure proper fair value hierarchy, The Company and the Manager review the methodology and data used by the third party pricing service to understand whether observable market data is being utilized in the vendor’s pricing methodology.  Generally, this review is conducted annually, however ad-hoc reviews of the pricing methodology and the data does occur.  The review of the assumptive data received from the vendor includes comparing key inputs.  In addition, as part of the Company’s regular review of pricing, the Manager’s pricing group may have informal discussions with the independent pricing vendor regarding their evaluation methodology or the market data utilized in their determination as well as performing back-testing with regard to the sale of securities. The conclusion that a price should be overridden in accordance with the Manager’s pricing methodology may impact the fair value hierarchy of the security for which such price has been adjusted.

 

12



Table of Contents

 

Interest income recognition and Impairment

 

Agency MBS, Non-Agency MBS and other securities, excluding Interest-Only Strips, rated AA and higher at the time of purchase

 

Interest income on mortgage-backed and other securities is accrued based on the respective outstanding principal balances and corresponding contractual terms. Premiums and discounts associated with Agency MBS, Non-Agency MBS and other securities, excluding Interest-Only Strips, rated AA and higher at the time of purchase, are amortized into interest income over the estimated life of such securities using the effective yield method. Adjustments to premium and discount amortization are made for actual prepayment activity.  The Company estimates prepayments at least quarterly for its securities and, as a result, if prepayments increase (or are expected to increase), the Company will accelerate the rate of amortization on premiums or discounts and make a retrospective adjustment to historical amortization.  Alternatively, if prepayments decrease (or are expected to decrease), the Company will reduce the rate of amortization on the premiums or discounts and make a retrospective adjustment to historical amortization.

 

The Company’s conversion to a new accounting system in the calculation methodology used to determine the amortization of bond premium as of April 1, 2014, resulted in a cumulative retrospective change in estimate of approximately $1.2 million.  The impact of the change in estimate had no impact on Net income and was limited to an increase of approximately $1.2 million to Interest income and an equal offsetting reduction to Unrealized gain (loss) on Mortgage-backed securities, other securities and Whole-Loans, net on the Consolidated Statement of Operations for the three months ended June 30, 2014. The Company does not believe the aforementioned change in estimate has had a material impact to subsequent periods or will in the future.

 

The Company assesses its Agency MBS, Non-Agency MBS and other securities, excluding Interest-Only Strips, rated AA and higher at the time of purchase, for other-than-temporary impairment on at least a quarterly basis. When the fair value of an investment is less than its amortized cost at the balance sheet date of the reporting period for which impairment is assessed, the impairment is designated as either “temporary” or “other-than-temporary.” In deciding on whether or not a security is other-than-temporarily impaired, the Company considers several factors, including the nature of the investment, communications (if any) from the trustee of securitization regarding the credit quality of the security, the severity and duration of the impairment, the cause of the impairment, and the Company’s intent not to sell the security and whether it is more likely than not that Company will not be required to sell the  security until recovery of its amortized cost basis.  An other-than-temporary impairment is deemed to have occurred when there is an adverse change in the expected cash flows (principal or interest) to be received and the fair value of the security is less than its carrying amount. In determining whether an adverse change in cash flows occurred, the present value of the remaining cash flows, as estimated at the initial transaction date (or the last date previously revised), is compared to the present value of the expected cash flows at the current reporting date.  The estimated cash flows reflect those a “market participant” would use and are discounted at a rate equal to the current yield used to accrete interest income. These adjustments are reflected in the Company’s Consolidated Statement of Operations as Other loss on Mortgage-backed securities and other securities.

 

The determination as to whether an other-than-temporary impairment exists is subject to management estimates based on consideration of both factual information available at the time of assessment as well as the Company’s estimates of the future performance and projected amount and timing of cash flows expected to be collected on the security. As a result, the timing and amount of an other-than-temporary impairment constitutes an accounting estimate that may change materially over time.

 

Finally, certain of the Company’s MBS and other securities that are in an unrealized loss position at September 30, 2015 are also not considered other-than-temporarily impaired because the Company has no intent to sell these investments, it is more likely than not that the Company will not be required to sell the investment before recovery of its amortized cost basis and the Company is not required to sell the security for regulatory or other reasons.

 

13



Table of Contents

 

Non-Agency MBS and other securities that are rated below AA at the time of purchase and Interest-Only Strips that are not classified as derivatives

 

Interest income on Non-Agency MBS and other securities that are rated below AA at the time of purchase and Interest-Only Strips that are not classified as derivatives are recognized based on the effective yield method.  The effective yield on these securities is based on the projected cash flows from each security, which is estimated based on the Company’s observation of the then current information and events, where applicable, and will include assumptions related to interest rates, prepayment rates and the timing and amount of credit losses.  On at least a quarterly basis, the Company reviews and, if appropriate, makes adjustments to its cash flow projections based on input and analysis received from external sources, internal models, and its judgment about interest rates, prepayment rates, the timing and amount of credit losses, and other factors. Where appropriate, the Company may include in its cash flow projections the U.S Department of Justice’s settlements with the major residential mortgage originators, regarding certain lending practices. Changes in cash flows from those originally projected, or from those estimated at the last evaluation, may result in a prospective change in the yield/interest income recognized on such securities. Actual maturities of the securities are affected by the contractual lives of the underlying collateral, periodic payments of scheduled principal, and prepayments of principal. Therefore, actual maturities of the securities will generally be shorter than stated contractual maturities.

 

Based on the projected cash flow of such securities purchased at a discount to par value, the Company may designate a portion of such purchase discount as credit protection against future credit losses and, therefore, not accrete such amount into interest income.  The amount designated as credit discount may be adjusted over time, based on the actual performance of the security, its underlying collateral, actual and projected cash flow from such collateral, economic conditions and other factors.  If the performance of a security with a credit discount is more favorable than forecasted, a portion of the amount designated as credit discount may be accreted into interest income prospectively.

 

In addition, an other-than-temporary impairment is deemed to have occurred when there is an adverse change in the expected cash flows (principal or interest) to be received and the fair value of the security is less than its carrying amount. In determining whether an adverse change in cash flows occurred, the present value of the remaining cash flows, as estimated at the initial transaction date (or the last date previously revised), is compared to the present value of the expected cash flows at the current reporting date.  The estimated cash flows reflect those a “market participant” would use and are discounted at a rate equal to the current yield used to accrete interest income. These adjustments are reflected in the Company’s Consolidated Statements of Operations as Other loss on Mortgage-backed securities and other securities.

 

Securities denominated in a foreign currency contain additional risk in that the amortized cost basis for those securities may not be recovered due to declines in currency exchange rates.  The Company considers the length of time that the security’s fair value has declined due to the decline in foreign exchange rates, when assessing other-than temporary impairment.

 

The determination as to whether an other-than-temporary impairment exists is subject to management estimates based on consideration of both factual information available at the time of assessment as well as the Company’s estimates of the future performance and projected amount and timing of cash flows expected to be collected on the security. As a result, the timing and amount of an other-than-temporary impairment constitutes an accounting estimate that may change materially over time.

 

Finally, certain of the Company’s MBS and other securities that are in an unrealized loss position at September 30, 2015 are also not considered other-than-temporarily impaired because the Company has no intent to sell these investments, it is more likely than not that the Company will not be required to sell the investment before recovery of its amortized cost basis and the Company is not required to sell the security for regulatory or other reasons.

 

Residential and Commercial Whole-Loans

 

The Company records its purchases of Residential and Commercial Whole-Loans as the amount paid to the seller plus any fees paid or less any fees received.  All other costs incurred in connection with acquiring Residential and Commercial Whole-Loans or committing to purchase Residential and Commercial Whole-Loans are charged to expense as incurred. The Company amortizes or accretes any premium or discount over the life of the related loan utilizing the effective interest method, based on the contractual payment terms of the loan. On at least a quarterly basis, the Company evaluates the collectability of both interest and principal of each loan, if circumstances warrant, to determine whether such loan is impaired. A loan is impaired when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the existing contractual terms. When a loan is impaired, the Company does not record a loss accrual as the Company has elected the fair value option. However, income recognition is suspended for loans at the earlier of the date at which payments become 90-days past due or when, in the opinion of management, a full recovery of income and principal becomes doubtful. When the ultimate collectability of the principal of an impaired loan is in doubt, all payments are applied to principal under the cost recovery method. When the ultimate collectability of the principal of an impaired loan is not in doubt, contractual interest is recorded as interest income when received, under the cash basis method until an accrual is resumed when the loan becomes contractually current and performance is demonstrated to be resumed. A loan is written off when it is no longer realizable and/or legally discharged.

 

14



Table of Contents

 

Sales of securities and Whole-Loans

 

Sales of securities and Whole-Loans are driven by the Company’s portfolio management process. The Company seeks to mitigate risks including those associated with prepayments and will opportunistically rotate the portfolio into securities and/or other assets the Company’s Manager believes have more favorable attributes. Strategies may also be employed to manage net capital gains, which need to be distributed for tax purposes. Realized gains or losses on sales of securities and Whole-Loans, including Agency Interest-Only Strips not characterized as derivatives, are included in the net Realized gain (loss) on sale of Mortgage-backed securities, other securities and Whole-Loans, net line item on the Consolidated Statements of Operations, and are recorded at the time of disposition.  Realized gains losses on Interest-Only Strips which are characterized as derivatives are included in Gain (loss) on derivative instruments, net line item in the Consolidated Statements of Operations.  Prior to January 1, 2015, realized gains or losses on sales of securities which were part of a linked transaction were included in Gain (loss) on linked transactions, net.  The cost of positions sold is calculated using the specific identification method.

 

Investments in an unrealized loss position at the end of each reporting period are evaluated by the Company’s Manager to determine whether the Company has the intent to sell such investments.  To the extent the Company has no intent as of the end of such reporting period to sell such investments and it is more likely than not that the Company will not be required to sell the investment before recovery of its amortized cost basis, such unrealized loss is included in Unrealized gain (loss) on Mortgage-backed securities, other securities and Whole-Loans, net in the Consolidated Statements of Operations.  Otherwise, when the Company has determined its intent to sell such securities, the unrealized loss is characterized as a realized loss and included in Other loss on Mortgage-backed securities and other securities on the Consolidated Statements of Operations.  The Company has no intent to sell any of its investments in an unrealized loss position at September 30, 2015.

 

Foreign currency transactions

 

The Company has and expects to continue to enter into transactions denominated in foreign currency from time to time.  At the date the transaction is recognized, the asset and/or liability will be measured and recorded using the exchange rate in effect at the date of the transaction.  At each balance sheet date, such foreign currency assets and liabilities are re-measured using the exchange rate in effect at the date of the balance sheet, resulting in unrealized foreign currency gains or losses.  Unrealized foreign currency gains or losses on MBS and other assets are recorded in Unrealized gain (loss) on Mortgage-backed securities, other securities and Whole-Loans, net on the Consolidated Statement of Operations. In addition, the Company evaluates whether an other-than-temporary impairment is deemed to have occurred on MBS and other assets denominated in a foreign currency.  Cash flows from MBS and other assets denominated in foreign currencies are received in a foreign currency, and as a result, the Company may incur a loss due to changes in foreign exchange rates even when all contractual cash flows are received.   These adjustments are reflected in the Consolidated Statements of Operations as Other loss on Mortgage-backed securities and other securities.  Unrealized and realized foreign currency gains or losses on borrowings under repurchase agreements are recorded in Interest income on cash balances and other income (loss), net on the Consolidated Statement of Operations. Interest income from investments denominated in a foreign currency and interest expense on borrowings denominated in a foreign currency are recorded at the average rate of exchange during the period.

 

Variable Interest Entities (“VIEs”)

 

VIEs are defined as entities in which 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. VIEs are required to be consolidated by their primary beneficiary. The primary beneficiary of a VIE is determined to be the party that has both the power to direct the activities of a VIE that most significantly impact the VIE’s economic performance and the obligation to absorb losses of the VIE that could potentially be significant to the VIE or the right to receive benefits from the VIE that could potentially be significant to the VIE. This determination of the requirement to consolidate a VIE and the requirement to disclose information about the Company’s involvement in a VIE can sometimes involve complex and subjective analyses. Ongoing assessments of whether an enterprise is the primary beneficiary of a VIE is required. The Company has been determined to be the primary beneficiary of two VIEs holding whole-loans.

 

15



Table of Contents

 

Due from counterparties/Due to counterparties

 

Due from counterparties represents cash posted by the Company with its counterparties as collateral for the Company’s interest rate and/or currency derivative financial instruments, repurchase agreements, and TBAs. Due to counterparties represents cash posted with the Company by its counterparties as collateral under the Company’s interest rate and/or currency derivative financial instruments, repurchase agreements, and TBAs. Included in the due from counterparties and/or due to counterparties are daily variation margin settlement amounts with counterparties which are based on the price movement of the Company’s futures contracts.  In addition, as provided below, Due to counterparties may include non-cash collateral, which the Company has the obligation to return, and which the Company has either sold or pledged. To the extent the Company receives collateral other than cash from its counterparties such assets are not included in the Company’s Consolidated Balance Sheets.  Notwithstanding the foregoing, if the Company either rehypothecates such assets or pledges the assets as collateral pursuant to a repurchase agreement, the cash received and the corresponding liability are reflected on the Consolidated Balance Sheets.

 

Derivatives and hedging activities

 

Subject to maintaining its qualification as a REIT for U.S. federal income tax purposes, the Company utilizes derivative financial instruments, including interest rate swaps, interest rate swaptions, mortgage put options, currency forwards, futures contracts, TBAs and Agency and Non-Agency Interest-Only Strips to hedge the interest rate and currency risk associated with its portfolio and related borrowings. Derivatives, subject to REIT requirements, are used for hedging purposes rather than speculation. The Company determines the fair value of its derivative positions and obtains quotations from third parties, including the Chicago Mercantile Exchange or CME, to facilitate the process of determining such fair values. If the Company’s hedging activities do not achieve the desired results, reported earnings may be adversely affected.

 

GAAP requires an entity to recognize all derivatives as either assets or liabilities and to measure those instruments at fair value. The accounting for changes in the fair value of derivatives depends on the intended use of the derivative, whether the Company has elected to designate a derivative in a hedging relationship and apply hedge accounting and whether the hedging relationship has satisfied the criteria necessary to apply hedge accounting. Derivatives are classified as either hedges of the fair value of a recognized asset or liability or of an unrecognized firm commitment (fair value hedge) or hedges of a forecasted transaction or the variability of cash flows to be received or paid related to a recognized asset or liability (cash flow hedge).  If the Company does not elect hedge accounting for a derivative instrument, which the Company has not, fair value adjustments are recorded in earnings immediately.

 

The Company elected not to apply hedge accounting for its derivative instruments.  Accordingly, the Company records, the change in fair value of its derivative instruments, which includes net interest rate swap payments (including accrued amounts) and net currency payments (including accrued amounts) related to interest rate swaps and currency swaps, respectively in Gain (loss) on derivative instruments, net in its Consolidated Statements of Operations. In the Company’s Consolidated Statements of Cash Flows, premiums received and paid on termination of its interest rate swaps, excluding interest rate swaps containing an other-than-insignificant financing element and the unamortized premium of market agreed coupon (“MAC”) interest rate swaps, are included in cash flows from operating activities. Notwithstanding the foregoing, proceeds and payments on settlement of swaptions, mortgage put options, futures contracts and TBAs are included in cash flows from investing activities.  Proceeds and payments on settlement of forward contracts are reflected in cash flows from financing activities in the Company’s Consolidated Statement of Cash Flows.  While payments made at the time of entering MAC interest rate swaps are included in cash flows from investing activities, payments received by the Company upon entering MAC interest rate swaps are included in either cash flows from investing activities or cash flows financing activities, depending on whether or not the derivative instrument includes an other-than-insignificant financing element.  For MAC interest rate swaps containing an other-than-insignificant financing element, all cash flows over the life of the derivative are treated as cash flows from financing activities.  Return and recovery of basis activity for MAC interest rate swaps is included in cash flows from investing activities for swaps not containing an other-than-insignificant financing element in the Company’s Consolidated Statement of Cash Flows.  For Agency and Non-Agency Interest-Only Strips accounted for as derivatives, the purchase, sale and recovery of basis activity is included with MBS and other securities under cash flows from investing activities in the Company’s Consolidated Statement of Cash Flows.

 

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The Company evaluates the terms and conditions of its holdings of Agency and Non-Agency Interest-Only Strips, interest rate swaptions, currency forwards, futures contracts and TBAs to determine if these instruments have the characteristics of an investment or should be considered a derivative under GAAP.  In determining the classification of its holdings of Interest-Only Strips, the Company evaluates the securities to determine if the nature of the cash flows has been altered from that of the underlying mortgage collateral. Generally, Interest-Only Strips for which the security represents a strip off of a mortgage pass through security will be considered a hybrid instrument classified as a MBS investment on the Consolidated Balance Sheets utilizing the fair value option. Alternatively, those Interest-Only Strips, for which the underlying mortgage collateral has been included into a structured security that alters the cash flows from the underlying mortgage collateral, are accounted for as derivatives at fair value. Accordingly, Agency and Non-Agency Interest-Only Strips, interest rate swaptions, currency forwards, futures contracts and TBAs having the characteristics of derivatives are accounted for at fair value with such changes recognized in Gain (loss) on derivative instruments, net in its Consolidated Statements of Operations, along with any interest earned or paid (including accrued amounts). The carrying value of the Agency and Non-Agency Interest-Only Strips, accounted for as derivatives, is included in Mortgage-backed securities on the Consolidated Balance Sheets.  The carrying value of interest rate swaptions, currency forwards, futures contracts and TBAs is included in Derivative assets or Derivative liabilities on the Consolidated Balance Sheets.

 

The Company evaluates all of its financial instruments to determine if such instruments are derivatives or contain features that qualify as embedded derivatives.  An embedded derivative is separated from the host contact and accounted for separately when all of the guidance criteria are met.  Hybrid instruments that are remeasured at fair value through earnings, including the fair value option are not bifurcated.  Derivative instruments, including derivative instruments accounted for as liabilities, are recorded at fair value and are re-valued at each reporting date, with changes in the fair value together with interest earned or paid (including accrued amounts) reported in the Gain (loss) on derivatives instruments, net in the Consolidated Statements of Operations. While accounted for as derivative instruments through December 31, 2014, linked transactions, including changes in fair value and interest earned or paid (including accrued amounts) were reported separately in our Consolidated Balance Sheets, Consolidated Statements of Operations and Consolidated Statements of Cash Flows. See “Warrants” below.

 

Repurchase agreements and Reverse Repurchase agreements

 

Mortgage-backed securities and other securities sold under repurchase agreements are treated as collateralized financing transactions, unless they meet sales treatment. Securities financed through a repurchase agreement remain on the Company’s Consolidated Balance Sheets as assets and cash received from the lender is recorded in the Company’s Consolidated Balance Sheets as a liability, unless such transaction was accounted for as a linked transaction prior to January 1, 2015, as described below. Interest payable in accordance with repurchase agreements is recorded as accrued interest payable on the Consolidated Balance Sheets.  Interest paid (including accrued amounts) in accordance with repurchase agreements is recorded as interest expense, unless the repurchase agreement was accounted for as a linked transaction prior to January 1, 2015, as described below.  The Company reflects all proceeds from repurchase agreement borrowings and repayment of repurchase agreement borrowings which are not linked transactions, including transactions pertaining to collateral received with respect to certain swap transactions, on a gross basis on the Consolidated Statements of Cash Flows.

 

The Company may borrow securities under reverse repurchase agreements to deliver a security owned and sold by the Company but pledged to a different counterparty under a separate repurchase agreement when in the Manager’s view terminating the outstanding repurchase agreement is not in the Company’s interest.  Cash paid to the borrower is recorded in the Company’s Consolidated Balance Sheets as an asset.  Interest receivable in accordance with reverse repurchase agreements is recorded as accrued interest receivable on the Consolidated Balance Sheets. The Company reflects all proceeds on reverse repurchase agreement and repayment of reverse repurchase agreement, on a net basis on the Consolidated Statements of Cash Flows.  Upon sale of a pledged security, the Company recognizes an obligation to return the borrowed security on the Consolidated Balance Sheet in Due to Counterparty.  The Company establishes haircuts to ensure the market value of the underlying asset remains sufficient to protect the Company in the event of default by the counterparty.  Realized gains and losses associated with the sale of the security are recognized in Realized gain (loss) on sale of Mortgage-backed securities, other securities and Whole-Loans, net on the Consolidated Statement of Cash Flows.

 

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Linked transactions

 

Prior to January 1, 2015, in instances where the Company acquired a security through a repurchase agreement with the same counterparty from which the security was purchased, the Company evaluated such transaction in accordance with GAAP.  This guidance in effect prior to January 1, 2015 required that if the initial transfer of a financial asset and repurchase financing were entered into contemporaneously with, or in contemplation of, one another, such purchase and financing would be considered linked unless all of the criteria found in the guidance were met at the inception of the transaction. If the transaction met all of the conditions, the initial transfer would be accounted for separately from the repurchase financing, and the Company would record the security and the related financing on a gross basis on its Consolidated Balance Sheets with the corresponding interest income and interest expense being reported in the Consolidated Statements of Operations.  If the transaction was determined to be linked, the Company would record the initial transfer and repurchase financing on a net basis and record a forward commitment to purchase the security as a derivative instrument. Through December 31, 2014, such forward commitment was recorded at fair value in Linked transactions, net, at fair value on the Consolidated Balance Sheets with subsequent changes through December 31, 2014 in fair value recognized in Gain (loss) on linked transactions, net on its Consolidated Statements of Operations. The Company refers to these transactions as Linked Transactions. Prior to January 1, 2015, when or if a transaction was no longer considered to be linked, the security and related repurchase financing were reported on a gross basis. The unlinking of a transaction caused a realized event in which the fair value of the security as of the date of unlinking, became the cost basis of the security. The difference between the fair value on the unlinking date and the existing cost basis of the security was the realized gain or loss.  Recognition of effective yield for such security was calculated prospectively using the new cost basis.  For linked transactions, the Company reflected purchases and sales of securities within the investing section of the Consolidated Statements of Cash Flows.  Proceeds from repurchase agreements borrowings and repayments of repurchase agreement borrowings were reflected in the financing section of the Consolidated Statements of Cash Flows.  Starting in 2015, GAAP no longer requires the segregation and treatment of linked transactions as derivatives.  Accordingly, starting in January 2015, the Company reports such securities and the corresponding repurchase agreement on a gross basis on its Consolidated Balance Sheets and with the corresponding interest income and interest expense reported in its Consolidated Statements of Operations.  See “Recent accounting pronouncements” for details.

 

Share-based compensation

 

The Company accounts for share-based compensation to its independent directors, to any employee, to its Manager and to employees of its Manager and its affiliates using the fair value based methodology prescribed by GAAP.  Compensation cost related to restricted common stock issued to the Company’s independent directors including any such restricted stock which is subject to a deferred compensation program, and any employee of the Company is measured at its fair value at the grant date, and amortized into expense over the service period on a straight-line basis. Compensation cost related to restricted common stock issued to the Manager and to employees of the Manager, including officers of the Company who are employees of the Manager and its affiliates is initially measured at fair value at the grant date, and amortized into expense over the vesting period on a straight-line basis and re-measured on subsequent dates to the extent the awards are unvested.

 

Warrants

 

For the Company’s warrants, the Company uses a variation of the adjusted Black-Scholes option valuation model to record the financial instruments at their relative fair values at issuance. The warrants issued with the Company’s common stock in the private placement to certain accredited institutional investors on May 15, 2012, were evaluated by the Company and were recorded at their relative fair value as a component of equity at the date of issuance.  See “Derivatives and hedging activities” above.

 

Income taxes

 

The Company operates and has elected to be taxed as a REIT commencing with its taxable year ended December 31, 2012. Accordingly, the Company will generally not be subject to corporate U.S. federal or state income tax to the extent that the Company makes qualifying distributions to stockholders, and provided that the Company satisfies, on a continuing basis, through actual investment and operating results, the REIT requirements including certain asset, income, distribution and stock ownership tests. If the Company fails to qualify as a REIT, and does not qualify for certain statutory relief provisions, the Company will be subject to U.S. federal, state and local income taxes and may be precluded from qualifying as a REIT for the subsequent four taxable years following the year in which the Company lost its REIT qualification. Accordingly, the failure to qualify as a REIT could have a material adverse impact on the Company’s results of operations and amounts available for distribution to stockholders.

 

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The dividends paid deduction for qualifying dividends paid to stockholders is computed using the Company’s taxable income as opposed to net income reported on the consolidated financial statements. Taxable income, generally, will differ from net income reported on the consolidated financial statements because the determination of taxable income is based on tax regulations and not GAAP.

 

The Company may create and elect to treat certain subsidiaries as Taxable REIT Subsidiaries (“TRS”). In general, a TRS may hold assets and engage in activities that the Company cannot hold or engage in directly and generally may engage in any real estate or non-real estate-related business. A TRS is subject to U.S. federal, state and local corporate income taxes, and its value may not exceed 25% of the value of the Company. While a TRS may generate net income, a TRS can declare dividends to the Company, which will be included in the Company’s taxable income and necessitate a distribution to its stockholders. Conversely, if the Company retains earnings at the TRS level, no distribution is required and it can increase book equity of the consolidated entity.  As of September 30, 2015, the Company has a single wholly owned subsidiary, which it has elected to treat as a TRS.

 

The Company evaluates uncertain tax positions, if any, and classifies interest and penalties, if any, related to unrecognized tax benefits, if any, as a component of the provision for income taxes.  In addition, the Company evaluates the performance of the TRS each period to determine the need for a provision for income taxes.

 

Offering costs

 

Offering costs borne by the Company in connection with its IPO and concurrent private placement completed on May 15, 2012 as well as its follow-on public stock offering completed on October 3, 2012 and its follow-on public stock offering and concurrent private placement completed on April 9, 2014 (inclusive of the partial exercise of the greenshoe which was completed on May 7, 2014) are reflected as a reduction of additional paid-in-capital.

 

Earnings per share

 

GAAP requires use of the two-class method of computing earnings per share for all periods presented for each class of common stock and participating securities as if all earnings for the period had been distributed.  Under the two-class method, during periods of net income, the net income is first reduced for dividends declared on all classes of securities to arrive at undistributed earnings.  During periods of net losses, the net loss is reduced for dividends declared on participating securities only if the security has the right to participate in the earnings of the entity and an objectively determinable contractual obligation to share in net losses of the entity.  The Company’s participating securities are not allocated a share of the net loss, as the participating securities do not have a contractual obligation to share in the net losses of the Company.

 

The remaining earnings are allocated to common stockholders and participating securities, to the extent that each security shares in earnings, as if all of the earnings for the period had been distributed.  Each total is then divided by the applicable number of shares to arrive at basic earnings per share.  For the diluted earnings, the denominator includes all outstanding common shares and all potential common shares assumed issued if they are dilutive.  The numerator is adjusted for any changes in income or loss that would result from the assumed conversion of these potential common shares.

 

Comprehensive Income (Loss)

 

The Company has none of the components of comprehensive income (loss) and therefore comprehensive income (loss) is not presented.

 

Accounting standards applicable to emerging growth companies

 

The JOBS Act contains provisions that relax certain requirements for “emerging growth companies”, which includes the Company. For as long as the Company is an emerging growth company, which may be up to five full fiscal years, unlike other public companies, the Company will not be required to: (i) comply with any new or revised financial accounting standards applicable to public companies until such standards are also applicable to private companies under Section 102(b)(1) of the JOBS Act; (ii) provide an auditor’s attestation report on management’s assessment of the effectiveness of the Company’s system of internal control over financial reporting pursuant to Section 404 of the Sarbanes-Oxley Act; (iii) comply with any new requirements adopted by the PCAOB requiring mandatory audit firm rotation or a supplement to the auditor’s report in which the auditor would be required to provide additional information about the audit and the financial statements of the issuer; or (iv) comply with any new audit rules adopted by the PCAOB after April 5, 2012, unless the SEC determines otherwise. The Company currently takes advantage of some of these exemptions. The Company’s qualification for remaining an emerging growth company under the five full fiscal years expires on December 31, 2017. However, the Company will no longer qualify for such exemption if its gross revenues for any year equals or exceeds $1.0 billion, the Company issues more than $1.0 billion in non-convertible debt during the three previous years, or if the Company is deemed to be a large accelerated filer.

 

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As noted above, under the JOBS Act, emerging growth companies can delay adopting new or revised accounting standards that have different effective dates for public and private companies until such time as those standards apply to private companies. The Company intends to take advantage of such extended transition period. Since the Company will not be required to comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for other public companies, its financial statements may not be comparable to the financial statements of companies that comply with public company effective dates. If the Company were to elect to comply with these public company effective dates, such election would be irrevocable pursuant to Section 107 of the JOBS Act.

 

Recent accounting pronouncements

 

Accounting Standards Adopted in 2015

 

In April 2014, the Financial Accounting Standards Board issued updated guidance that changes the requirements for reporting discontinued operations.  Under the new guidance, a discontinued operation is defined as a disposal of a component of an entity or group of components of an entity that is disposed of or is classified as held for sale and represents a strategic shift that has (or will have) a major effect on an entity’s operations and financial results.  The guidance is effective prospectively as of the first quarter of 2015 for a public company and for certain non-for-profit entities, with early adoption permitted for new disposals or new classifications as held-for-sale.  The guidance is effective for other entities for annual periods beginning on or after December 15, 2014 and interim periods within annual periods beginning on or after December 15, 2015. The new guidance does not have a material impact on the Company’s consolidated financial statements.

 

In June 2014, the Financial Accounting Standards Board issued guidance that changes the accounting for repurchase-to-maturity transactions and repurchase financing arrangements. The new guidance aligns the accounting for repurchase-to-maturity transactions and repurchase agreements executed as a repurchase financing with the accounting for other typical repurchase agreements. These transactions would all be accounted for as secured borrowings. The guidance eliminates sale accounting for repurchase-to-maturity transactions and supersedes the guidance under which a transfer of a financial asset and a contemporaneous repurchase financing could be accounted for on a combined basis as a forward agreement, which has resulted in outcomes referred to as off-balance-sheet accounting.  In addition, the guidance requires additional disclosures. The guidance for a public company is effective for the first interim or annual period beginning after December 15, 2014.  Other entities may elect to apply the requirements for interim periods beginning after December 31, 2014.  Certain disclosures under this guidance do not take effect for a public company until the first period beginning after March 15, 2015 and do not take effect for other companies beginning for annual periods commencing after December 31, 2014 and for interim periods beginning after December 15, 2015.  Through December 31, 2014, the Company accounted for certain transfers as forward agreements under the previous guidance, which were classified as linked transactions.  The new guidance requires the Company to record these transfers as secured borrowings. The implementation of the new guidance resulted in an increase to Mortgage-backed securities and other securities, at fair value of approximately $52.5 million, an increase in Borrowings under repurchase agreements of approximately $31.9 million and a decrease in Linked transactions, net, at fair value of approximately $20.6 million in the Company’s Consolidated Balance Sheets as of January 1, 2015.  Further, the implementation of the new guidance resulted in a cumulative-effect adjustment of zero to retained earnings as of January 1, 2015.

 

Accounting Standards to be Adopted in Future Periods

 

In May 2014, the Financial Accounting Standards Board issued guidance that changes an entity’s recognition of revenue from contracts with customers.  The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.  In addition, the new guidance requires improved disclosures to enable users of financial statements to understand the nature, amount, timing, and uncertainty of revenue and cash flows arising from contracts with customers. In applying the new guidance, an entity may use either a retrospective approach to each prior reporting period or a retrospective approach with the cumulative effect recognized at the date of initial application. For a public company, the standard is effective for annual reporting periods beginning after December 15, 2016, including interim periods within that reporting period. Early adoption is not permitted for a public entity. For all other entities, the standard is effective for annual reporting periods beginning after December 15, 2017, and interim periods within annual periods beginning after December 15, 2015. With certain restrictions, a nonpublic entity may elect to apply the guidance earlier. The new guidance is not expected to have a material impact on the Company’s consolidated financial statements.

 

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In August 2014, the Financial Accounting Standards Board issued guidance that will require an entity’s management to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern and to provide related footnote disclosures. According to the new guidance, substantial doubt exists when conditions and events, considered in the aggregate, indicate that it is probable that the entity will be unable to meet its obligations as they become due within one year after the date the financial statements are issued. The term “probable” is used consistently with its current use in U.S. GAAP for loss contingencies. Disclosures will be required if conditions give rise to substantial doubt about the entity’s ability to continue as a going concern, including whether management’s plans that are intended to mitigate those conditions will alleviate the substantial doubt when implemented. The guidance is effective for annual periods ending after December 15, 2016. The effective date is the same for both public companies and all other entities.  Early application is permitted. The Company’s first assessment under the new guidance will be completed for the year ending December 31, 2016.

 

In January 2015, the FASB issued guidance to simplify income statement presentation by eliminating the concept of extraordinary items. U.S. GAAP currently requires that a company separately classify, disclose and present extraordinary events and transactions. The guidance eliminates the concept of extraordinary items from U.S. GAAP.  Under the existing guidance, an entity is required to separately disclose extraordinary items, net of tax, in the income statement after income from continuing operations if an event or transaction is of an unusual nature and occurs infrequently. This separate, net-of-tax presentation (and corresponding earnings per share impact) will no longer be allowed. The existing requirement to separately present items that are of an unusual nature or occur infrequently on a pre-tax basis within income from continuing operations has been retained. The new guidance also requires similar separate presentation of items that are both unusual and infrequent. The standard is effective for periods beginning after December 15, 2015. The effective date is the same for both public companies and all other entities.  Early adoption is permitted, but only as of the beginning of the fiscal year of adoption. Upon adoption, a reporting entity may elect prospective or retrospective application. If adopted prospectively, both the nature and amount of any subsequent adjustments to previously reported extraordinary items must be disclosed.  The Company has not elected to early adopt this guidance.  The new guidance is not expected to have a material impact on the Company’s consolidated financial statements.

 

In February 2015, the FASB issued guidance to simplify and reduce the number of consolidation models through the elimination of an indefinite deferral for certain entities and by placing more emphasis on risk of loss when determining a controlling financial interest.  The guidance affects reporting entities that are required to evaluate whether they should consolidate certain legal entities.  All legal entities are subject to reevaluation under the revised consolidation model.  The standard is effective for a public company for fiscal years, and for interim periods within fiscal years beginning after December 15, 2015.  The standard is effective for other entities for fiscal years beginning after December 31, 2016, and for interim periods beginning after December 15, 2017.  Early adoption is permitted, including adoption in an interim period.  If an entity early adopts the amendments in an interim period, any adjustments should be reflected as of the beginning of the fiscal year that includes that interim period.   The Company has not elected to early adopt this guidance.   The new guidance is not expected to have a material impact on the Company’s consolidated financial statements.

 

In April 2015, the FASB issued guidance to amend the presentation of debt issuance cost related to a recognized debt liability. Under the new guidance, the debt issuance costs will be presented in the balance sheet as a direct deduction from the carrying amount of the recognized debt liability, consistent with debt discounts. The recognition and measurement guidance for debt issuance costs are not affected under the new guidance. The standard is effective for a public company for fiscal years beginning after December 15, 2015, and interim periods within those fiscal years.  The standard is effective for other entities for the fiscal years beginning after December 15, 2015, and interim periods within fiscal years beginning after December 15, 2016.  Early adoption is permitted. The guidance should be applied on a retrospective basis. The balance sheet of each individual period presented should be adjusted to reflect the period-specific effects of applying the new guidance. Upon adoption, an entity is required to comply with the applicable disclosures for a change in an accounting principle. These disclosures include the nature of and reason for the change in accounting principle, the transition method, a description of the prior-period information that has been retrospectively adjusted, and the effect of the change on the financial statement line items (i.e., debt issuance cost asset and the debt liability).  The Company has not elected to early adopt this guidance.   The new guidance is not expected to have a material impact on the Company’s consolidated financial statements.

 

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Note 4 — Fair Value of Financial Instruments

 

Fair Value Accounting Elections

 

The Company’s MBS and other securities are designated as available-for-sale and the Company has elected the fair value option for all of its MBS and other securities.  In addition, the Company has designated its Residential and Commercial Whole-Loans as held-for-investment and has elected the fair value option.  As a result, all changes in the fair value of MBS, other securities and Residential and Commercial Whole-Loans are reflected in the results of operations.

 

Financial Instruments carried at Fair Value

 

The following tables present the Company’s financial instruments carried at fair value as of September 30, 2015 and December 31, 2014, based upon the valuation hierarchy (dollars in thousands):

 

 

 

September 30, 2015

 

 

 

Fair Value

 

 

 

Level I

 

Level II

 

Level III

 

Total

 

Assets

 

 

 

 

 

 

 

 

 

Agency RMBS:

 

 

 

 

 

 

 

 

 

20-Year mortgage

 

$

 

$

817,496

 

$

 

$

817,496

 

30-Year mortgage

 

 

1,148,990

 

 

1,148,990

 

Agency RMBS Interest-Only Strips

 

 

105,533

 

 

105,533

 

Agency and Non-Agency Interest-Only Strips accounted for as derivatives, included in MBS

 

 

64,911

 

3,819

 

68,730

 

Non-Agency RMBS

 

 

297,530

 

244,751

 

542,281

 

Agency and Non-Agency CMBS

 

 

339,838

 

152,163

 

492,001

 

Other securities

 

 

113,949

 

63,529

 

177,478

 

Residential Whole-Loans

 

 

 

150,486

 

150,486

 

Subtotal

 

 

2,888,247

 

614,748

 

3,502,995

 

 

 

 

 

 

 

 

 

 

 

Derivative assets

 

 

56,985

 

 

56,985

 

Total

 

$

 

$

2,945,232

 

$

614,748

 

$

3,559,980

 

 

 

 

 

 

 

 

 

 

 

Liabilities

 

 

 

 

 

 

 

 

 

Derivative liabilities

 

$

57

 

$

227,101

 

$

 

$

227,158

 

Total

 

$

57

 

$

227,101

 

$

 

$

227,158

 

 

 

 

December 31, 2014

 

 

 

Fair Value

 

 

 

Level I

 

Level II

 

Level III

 

Total

 

Assets

 

 

 

 

 

 

 

 

 

Agency RMBS:

 

 

 

 

 

 

 

 

 

20-Year mortgage

 

$

 

$

1,120,031

 

$

 

$

1,120,031

 

30-Year mortgage

 

 

1,790,219

 

 

1,790,219

 

Agency RMBS Interest-Only Strips

 

 

188,506

 

 

188,506

 

Agency and Non-Agency Interest-Only Strips accounted for as derivatives, included in MBS

 

 

83,773

 

4,456

 

88,229

 

Non-Agency RMBS

 

 

490,093

 

176,479

 

666,572

 

Agency and Non-Agency CMBS

 

 

320,171

 

103,069

 

423,240

 

Other securities

 

 

101,523

 

7,403

 

108,926

 

Residential Whole-Loans

 

 

 

7,220

 

7,220

 

Subtotal

 

 

4,094,316

 

298,627

 

4,392,943

 

 

 

 

 

 

 

 

 

 

 

Derivative assets

 

451

 

72,805

 

 

73,256

 

Non-Agency RMBS linked transactions

 

 

 

1,596

 

1,596

 

Non-Agency CMBS linked transactions, including Non U.S.

 

 

 

16,152

 

16,152

 

Other securities linked transactions

 

 

 

2,879

 

2,879

 

Total

 

$

451

 

$

4,167,121

 

$

319,254

 

$

4,486,826

 

 

 

 

 

 

 

 

 

 

 

Liabilities

 

 

 

 

 

 

 

 

 

Derivative liabilities

 

$

1,191

 

$

179,089

 

$

 

$

180,280

 

Total

 

$

1,191

 

$

179,089

 

$

 

$

180,280

 

 

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The following tables present additional information about the Company’s financial instruments, which are measured at fair value on a recurring basis for which the Company has utilized Level III inputs to determine fair value:

 

 

 

Mortgage-backed securities and other securities

 

$ in thousands

 

Three months ended 
September 30, 2015

 

Three months ended
September 30, 2014

 

Nine months ended 
September 30, 2015

 

Nine months ended 
September 30, 2014

 

Beginning balance

 

$

452,387

 

$

130,584

 

$

291,407

 

$

15,681

 

Fair value of securities previously accounted for as linked transactions

 

 

 

52,484

 

 

Transfers into Level III from Level II

 

 

95,845

 

37,499

 

133,136

 

Transfers from Level III into Level II

 

 

(11,207

)

(3,996

)

(27,910

)

Purchases

 

34,568

 

52,050

 

190,893

 

165,468

 

Sales and settlements

 

(14,149

)

(3,204

)

(86,396

)

(26,646

)

Principal repayments

 

(4,259

)

(72

)

(8,968

)

(91

)

Total net gains / (losses) included in net income

 

 

 

 

 

 

 

 

 

Realized gains/(losses), net

 

(113

)

(13

)

4,348

 

2,848

 

Other loss on Mortgage-backed securities

 

(2,616

)

 

(5,357

)

 

Unrealized gains/(losses), net(1)

 

(138

)

4,912

 

(965

)

7,283

 

Premium and discount amortization, net

 

(1,418

)

(3,911

)

(6,687

)

(4,785

)

Ending balance

 

$

464,262

 

$

264,984

 

$

464,262

 

$

264,984

 

 


(1)         For Mortgage-backed securities and other securities classified as Level III at September 30, 2015, the Company recorded gross unrealized gains of approximately $5.2 million and $9.6 million and gross unrealized losses of approximately $5.3 million and $9.7 million, for the three and nine months ended September 30, 2015, respectively.  For Mortgage-backed securities and other securities classified as Level III at September 30, 2014, the Company recorded gross unrealized gains of approximately $5.0 million and $6.3 million and gross unrealized losses of approximately $112 thousand and $489 thousand, for the three and nine months ended September 30, 2014, respectively.  These gains and losses are included in Unrealized gain (loss) on Mortgage-backed securities, other securities and Whole-Loans, net on the Consolidated Statements of Operations.

 

 

 

Residential Whole-Loans

 

$ in thousands

 

Three months ended
September 30, 2015

 

Three months ended
September 30, 2014

 

Nine months ended
September 30, 2015

 

Nine months ended
September 30, 2014

 

Beginning balance

 

$

22,184

 

$

 

$

7,220

 

$

 

Transfers into Level III from Level II

 

 

 

 

 

Transfers from Level III into Level II

 

 

 

 

 

Purchases

 

129,026

 

 

145,562

 

 

Sales and settlements

 

 

 

 

 

Principal repayments

 

(3,192

)

 

(4,983

)

 

Total net gains / (losses) included in net income

 

 

 

 

 

 

 

 

 

Realized gains/(losses), net

 

 

 

 

 

Other loss on Mortgage-backed securities

 

 

 

 

 

Unrealized gains/(losses), net(1)

 

2,786

 

 

3,100

 

 

Premium and discount amortization, net

 

(318

)

 

(413

)

 

Ending balance

 

$

150,486

 

$

 

$

150,486

 

$

 

 


(1)         For Residential Whole-Loans classified as Level III at September 30, 2015, the Company recorded gross unrealized gains of approximately $2.8 million and $3.2 million and gross unrealized losses of approximately $11 thousand and $7 thousand, for the three and nine months ended September 30, 2015, respectively. These gains and losses are included in Unrealized gain (loss) on Mortgage-backed securities, other securities and Whole-Loans, net on the Consolidated Statements of Operations.  The Company did not hold any Residential Whole-Loans for the three and nine months ended September 30, 2014.

 

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Table of Contents

 

 

 

Commercial Whole-Loans

 

$ in thousands

 

Three months ended
September 30, 2015

 

Three months ended
September 30, 2014

 

Nine months ended
September 30, 2015

 

Nine months ended
September 30, 2014

 

Beginning balance

 

$

8,743

 

$

 

$

 

$

 

Transfers into Level III from Level II

 

 

 

 

 

Transfers from Level III into Level II

 

 

 

 

 

Purchases

 

 

 

 

 

Sales and settlements

 

 

 

 

 

Principal repayments

 

(8,750

)

 

 

 

Total net gains / (losses) included in net income

 

 

 

 

 

 

 

 

 

Realized gains/(losses), net

 

 

 

 

 

Other loss on Mortgage-backed securities

 

 

 

 

 

Unrealized gains/(losses), net(1)

 

7

 

 

 

 

Premium and discount amortization, net

 

 

 

 

 

Ending balance

 

$

 

$

 

$

 

$

 

 


(1)         The Company did not hold any Commercial Whole-Loans at September 30, 2015 and September 30, 2014.

 

 

 

Derivative assets

 

$ in thousands

 

Three months ended
September 30, 2015

 

Three months ended
September 30, 2014

 

Nine months ended 
September 30, 2015

 

Nine months ended 
September 30, 2014

 

Beginning balance

 

$

 

$

 

$

 

$

 

Transfers into Level III from Level II

 

 

 

 

126

 

Transfers out Level III into Level II

 

 

 

 

 

Purchases

 

 

2,813

 

 

2,813

 

Sales and settlements

 

 

 

 

 

Principal repayments

 

 

 

 

 

Total net gains/(losses) included in net income

 

 

 

 

 

 

 

 

 

Realized gains/(losses), net

 

 

 

 

(1,163

)

Other loss on Mortgage-backed securities

 

 

 

 

 

Unrealized gains/(losses), net

 

 

(340

)

 

697

 

Premium and discount amortization, net

 

 

 

 

 

Ending balance

 

$

 

$

2,473

 

$

 

$

2,473

 

 

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Table of Contents

 

 

 

Linked transactions

 

$ in thousands

 

Three months ended
September 30, 2015

 

Three months ended
September 30, 2014

 

Nine months ended
September 30, 2015

 

Nine months ended
September 30, 2014

 

Beginning balance

 

$

 

$

 

$

 

$

 

Transfers into Level III from Level II

 

 

9,348

 

 

9,348

 

Transfers out Level III into Level II

 

 

 

 

 

Purchases

 

 

2,840

 

 

2,840

 

Sales and settlements

 

 

 

 

 

Principal repayments

 

 

 

 

 

Total net gains/(losses) included in net income

 

 

 

 

 

 

 

 

 

Realized gains/(losses), net

 

 

 

 

 

Other loss on Mortgage-backed securities

 

 

 

 

 

Unrealized gains/(losses), net

 

 

(1

)

 

(1

)

Premium and discount amortization, net

 

 

11

 

 

11

 

Ending balance

 

$

 

$

12,198

 

$

 

$

12,198

 

 

 

 

Derivative liabilities

 

$ in thousands

 

Three months ended
September 30, 2015

 

Three months ended
September 30, 2014

 

Nine months ended
September 30, 2015

 

Nine months ended
September 30, 2014

 

Beginning balance

 

$

 

$

863

 

$

 

$

 

Transfers into Level III from Level II

 

 

 

 

 

Transfers out Level III into Level II

 

 

 

 

 

Purchases

 

 

 

 

 

Sales and settlements

 

 

(863

)

 

(863

)

Principal repayments

 

 

 

 

 

Total net gains/(losses) included in net income

 

 

 

 

 

 

 

 

 

Realized gains/(losses), net

 

 

 

 

 

Other loss on Mortgage-backed securities

 

 

 

 

 

Unrealized gains/(losses), net

 

 

 

 

863

 

Premium and discount amortization, net

 

 

 

 

 

Ending balance

 

$

 

$

 

$

 

$

 

 

Transfers between hierarchy levels during operations for the nine months ended September 30, 2015 and September 30, 2014 were based on the lack of availability of sufficient observable inputs to meet Level II versus Level III criteria.  The leveling of these assets was based on information received from a third party pricing service which utilized unobservable inputs, along with the back-testing of historical sales transactions performed by the Manager.

 

The Company primarily utilizes independent third party pricing services as the main source for valuing the Company’s assets.  All valuations received from independent pricing services are non-binding.  The Company generally receives one independent pricing service price for each investment in its portfolio.  The Manager has established a process to review and validate the pricing received from the independent pricing service on a quarterly basis and has a process for challenging prices received from the independent pricing service when necessary.  The Company utilizes its Manager’s policies in this regard for all securities.  The Company utilizes its own policies for the review of the pricing of Whole-Loans received from a third party vendor.  The Company’s and the Manager’s quarterly review of the independent third party pricing data may consist of a review of the daily change in the prices provided by the independent pricing vendor which exceed established tolerances or comparisons to executed transaction prices.  The Manager’s pricing group, which functions independently from its portfolio management personnel, corroborates the price differences or changes in price by comparing the vendor price to alternate sources including other independent pricing services or broker quotations.  If the price change or difference cannot be corroborated, the Manager’s pricing group consults with the portfolio management team for market color in reviewing such pricing data as warranted.  To the extent that the Manager has information, typically in the form of broker quotations that would indicate that a price received from the independent pricing service is outside of a tolerance range, the Manager generally challenges the independent pricing service price.  In addition, to ensure proper fair value hierarchy, the Company and the Manager review the methodology used by the third party pricing service to understand whether observable market data is being utilized in the vendor’s pricing methodology.  Such review is conducted no less than annually.  In addition, as part of the Company’s regular review of pricing, the Manager’s pricing group may throughout the year have incremental discussions with the independent pricing vendor regarding their evaluation methodology or the market data utilized in their determination as well as performing back testing with regard to the sale of certain assets.

 

25



Table of Contents

 

Other Fair Value Disclosures

 

Due from counterparties and Due to counterparties on the Company’s Consolidated Balance Sheets are reflected at cost which approximates fair value.

 

The fair value of the repurchase agreements is based on an expected present value technique. This method discounts future estimated cash flows using rates the Company determined best estimate current market interest rates that would be offered for loans with similar characteristics and credit quality. The use of different market assumptions or estimation methodologies could have a material effect on the fair value amounts. At September 30, 2015, the Company’s borrowings under repurchase agreements had a fair value of approximately $3.0 billion and a carrying value of approximately $3.0 billion.  At September 30, 2015, the Company’s receivable under reverse repurchase agreements had a fair value of approximately $758.5 million and a carrying value of approximately $758.5 million.  Inputs used to arrive at the fair value of the repurchase agreement borrowings and receivables under reverse repurchase agreements are generally observable, and therefore, they would be considered a Level II fair value measurement.

 

Note 5 — Mortgage-Backed Securities and other securities

 

The following tables present certain information about the Company’s investment portfolio at September 30, 2015 and December 31, 2014 (dollars in thousands).  Real estate securities and other securities that are accounted for as a component of linked transactions as of December 31, 2014 are not reflected in the tables set forth in this note. See Note 10 for further details.

 

 

 

September 30, 2015

 

 

 

Principal
Balance

 

Unamortized
Premium
(Discount),
net

 

Discount
Designated as
Credit Reserve and
OTTI

 

Amortized
Cost

 

Unrealized
Gain (Loss),
net

 

Estimated
Fair Value

 

Net
Weighted
Average
Coupon (1)

 

Agency RMBS:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

20-Year mortgage

 

$

764,144

 

$

40,949

 

$

 

$

805,093

 

$

12,403

 

$

817,496

 

3.8

%

30-Year mortgage

 

1,056,998

 

81,814

 

 

1,138,812

 

10,178

 

1,148,990

 

4.1

%

Agency RMBS Interest-Only Strips

 

N/A

 

N/A

 

N/A

 

98,680

 

6,853

 

105,533

 

3.5

%(2)

Agency and Non-Agency Interest-Only Strips, accounted for as derivatives (3)

 

N/A

 

N/A

 

N/A

 

N/A

 

N/A

 

68,730

 

2.7

%(2)

Non-Agency RMBS

 

604,367

 

(29,849

)

(125,755

)

448,763

 

9,507

 

458,270

 

3.7

%

Non-Agency RMBS Interest- Only Strips

 

N/A

 

N/A

 

N/A

 

69,420

 

14,591

 

84,011

 

6.1

%(2)

Agency and Non-Agency CMBS

 

566,717

 

(63,362

)

(10,706

)

492,649

 

(3,298

)

489,351