UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
FORM 10-Q
☒ | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the Quarterly Period Ended September 30, 20122013
OR
☐ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 |
For the transition period from to
ARMOUR RESIDENTIAL REIT, INC.
(Exact name of registrant as specified in its charter)
Maryland | 001-34766 | 26-1908763 |
(State or other jurisdiction of incorporation or organization) | (Commission File Number) | (I.R.S. Employer Identification No.) |
3001 Ocean Drive, Suite 201, Vero Beach, FL 32963
(Address of principal executive offices)(zip code)
(772) 617-4340
(Registrant'sRegistrant’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 ☒ NO ☐
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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). YES ☒ NO ☐
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of "larger"large accelerated filer," "accelerated filer" and "smaller reporting company" in Rule 12b-2 of the Exchange Act.
Large accelerated filer ☐☒ Accelerated filer ☒filer☐ Non-accelerated filer ☐ Smaller reporting company☐company☐
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). YES ☐ NO☒ NO☒
The number of outstanding shares of the Registrant'sRegistrant’s common stock as of October 29, 201225, 2013 was 309,004,524.370,905,142.
ARMOUR Residential REIT, Inc.
TABLE OF CONTENTS
PART I. FINANCIAL INFORMATION | 3 |
Item 1. Financial Statements | 3 |
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations |
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Item 3. Quantitative and Qualitative Disclosures |
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Item 4. Controls and Procedures |
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PART II. OTHER INFORMATION |
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Item 1. Legal Proceedings |
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Item 1A. Risk Factors |
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Item 2. Unregistered Sales of Equity Securities and Use of Proceeds |
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Item 3. Defaults Upon Senior Securities |
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Item 4. Mine Safety Disclosures |
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Item 5. Other Information |
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Item 6. Exhibits |
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ARMOUR Residential REIT, Inc. and Subsidiary
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share amounts)
(Unaudited)
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
ARMOUR Residential REIT, Inc. and Subsidiary
CONDENSED CONSOLIDATED BALANCE SHEETS
(dollars in thousands, except share and per share amounts)
(Unaudited)
Assets September 30, 2012 December 31, 2011 Cash Restricted cash Agency securities, available for sale, at fair value (including pledged assets of $20,846,817 and $5,225,234) Receivable for unsettled securities Derivatives, at fair value Principal payments receivable Accrued interest receivable Prepaid and other assets Total Assets Liabilities and Stockholders' Equity Liabilities: Repurchase agreements Payable for unsettled securities Derivatives, at fair value Accrued interest payable Accounts payable and accrued expenses Dividends payable Total Liabilities Stockholders' Equity: Preferred stock, $0.001 par value, 25,000,000 shares authorized, 1,785,000 8.250% Series A Cumulative Preferred Stock issued and outstanding at September 30, 2012 and none issued and outstanding at December 31, 2011 Common stock, $0.001 par value, 500,000,000 shares authorized, 308,972,403 and 95,436,949 shares issued and outstanding at September 30, 2012 and December 31, 2011, respectively Additional paid-in capital Accumulated deficit ) ) Accumulated other comprehensive income Total Stockholders' Equity Total Liabilities and Stockholders' Equity $ 727,306 $ 252,372 237,789 147,199 22,114,875 5,393,675 357,218 382,931 8,069 - 10,799 12,493 60,548 18,637 742 440 $ 23,517,346 $ 6,207,747 $ 19,826,988 $ 5,335,962 1,036,450 117,885 198,398 121,727 9,302 2,154 3,157 2,663 103 750 21,074,398 5,581,141 2 - 309 95 2,220,417 678,641 (180,430 (100,878 402,650 48,748 2,442,948 626,606 $ 23,517,346 $ 6,207,747
See notes to condensed consolidated financial statements.
ARMOUR Residential REIT, Inc. and Subsidiary
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(dollars in thousands, except per share amounts)
(Unaudited)
For the Quarters Ended For the Nine Months Ended September 30, 2012 September 30, 2011 September 30, 2012 September 30, 2011 Interest Income: Interest income, net of amortization of premium Interest expense: Repurchase agreements ) ) ) ) Net interest income Other (Loss) Income: Realized gain on sale of agency securities Other income Subtotal Realized loss on derivatives(1) ) ) ) ) Unrealized loss on derivatives ) ) ) ) Subtotal ) ) ) ) Total other (loss) ) ) ) ) Expenses: Management fee Professional fees Insurance Compensation Other Total expenses Net income (loss) before taxes ) ) Income tax (expense) benefit ) ) ) Net Income (Loss) ) ) Dividends declared on preferred stock ) ) Net Income (Loss) available (related) to common stockholders ) ) Net income (loss) available (related) per share to common stockholders: Basic ) ) Diluted ) ) Dividends per common share Weighted average common shares outstanding: Basic Diluted $ 116,693 $ 39,665 $ 265,660 $ 82,293 (19,222 (3,451 (37,258 (7,158 97,471 36,214 228,402 75,135 15,062 6,444 20,110 6,444 - - 1,043 - 15,062 6,444 21,153 6,444 (18,914 (8,421 (41,055 (16,425 (31,486 (65,808 (84,265 (91,891 (50,400 (74,229 (125,320 (108,316 (35,338 (67,785 (104,167 (101,872 5,545 2,191 13,356 4,441 472 270 1,408 883 85 60 189 164 426 135 1,417 406 660 243 1,331 504 7,188 2,899 17,701 6,398 54,945 (34,470 106,534 (33,135 (3 (2 27 (14 $ 54,942 $ (34,472 $ 106,561 $ (33,149 (804 - (964 - $ 54,138 $ (34,472 $ 105,597 $ (33,149 $ 0.20 $ (0.44 $ 0.54 $ (0.63 $ 0.20 $ (0.44 $ 0.54 $ (0.63 $ 0.30 $ 0.36 $ 0.92 $ 1.06 269,325 78,360 195,272 52,863 270,010 78,360 196,287 52,863
|
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September 30, 2013 | December 31, 2012 | |||||||
Assets | ||||||||
Cash and cash equivalents | $ | 496,480 | $ | 771,282 | ||||
Cash collateral posted | 30,962 | 265,552 | ||||||
Agency Securities, available for sale, at fair value (including pledged securities of $15,811,765 and $18,578,690) | 16,664,917 | 19,096,562 | ||||||
Receivable for unsettled sales | - | 668,244 | ||||||
Derivatives, at fair value | 390,685 | 5,367 | ||||||
Principal payments receivable | 256 | 16,037 | ||||||
Accrued interest receivable | 45,985 | 55,430 | ||||||
Prepaid and other assets | 1,184 | 404 | ||||||
Total Assets | $ | 17,630,469 | $ | 20,878,878 | ||||
Liabilities and Stockholders’ Equity | ||||||||
Liabilities: | ||||||||
Repurchase agreements | $ | 14,917,525 | $ | 18,366,095 | ||||
Cash collateral held | 294,071 | - | ||||||
Payable for unsettled purchases | 143,894 | - | ||||||
Derivatives, at fair value | 110,017 | 190,540 | ||||||
Accrued interest payable | 7,816 | 10,064 | ||||||
Accounts payable and other accrued expenses | 3,697 | 4,395 | ||||||
Dividends payable | - | 9 | ||||||
Total Liabilities | $ | 15,477,020 | $ | 18,571,103 | ||||
Commitments and contingencies (Note 9) | ||||||||
Stockholders’ Equity: | ||||||||
Preferred stock, $0.001 par value, 50,000 shares authorized; | ||||||||
8.250% Series A Cumulative Preferred Stock; 2,181 and 2,006 issued and outstanding at September 30, 2013 and December 31, 2012 | 2 | 2 | ||||||
7.875% Series B Cumulative Preferred Stock; 5,650 and none issued and outstanding at September 30, 2013 and December 31, 2012 | 6 | - | ||||||
Common stock, $0.001 par value, 1,000,000 shares authorized, 370,905 and 309,013 shares issued and outstanding at September 30, 2013 and December 31, 2012 | 371 | 309 | ||||||
Additional paid-in capital | 2,786,559 | 2,226,198 | ||||||
Accumulated deficit | (42,635 | ) | (149,298 | ) | ||||
Accumulated other comprehensive income (loss) | (590,854 | ) | 230,564 | |||||
Total Stockholders’ Equity | $ | 2,153,449 | $ | 2,307,775 | ||||
Total Liabilities and Stockholders’ Equity | $ | 17,630,469 | $ | 20,878,878 |
See notes to condensed consolidated financial statements.
ARMOUR Residential REIT, Inc. and Subsidiary
CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOMEOPERATIONS
(dollars (in thousands)thousands, except per share amounts)
(Unaudited)
For the Quarters Ended | For the Nine Months Ended | |||||||||||||||
September 30, 2013 | September 30, 2012 | September 30, 2013 | September 30, 2012 | |||||||||||||
Interest income, net of amortization of premium on Agency Securities | $ | 112,418 | $ | 116,693 | $ | 384,215 | $ | 265,660 | ||||||||
Interest expense | (17,899 | ) | (19,222 | ) | (66,969 | ) | (37,258 | ) | ||||||||
Net interest income | $ | 94,519 | $ | 97,471 | $ | 317,246 | $ | 228,402 | ||||||||
Other Income (Loss): | ||||||||||||||||
Realized gain (loss) on sale of Agency Securities (reclassified from Other comprehensive income (loss)) | (300,960 | ) | 15,062 | (261,569 | ) | 20,110 | ||||||||||
Gain on short sale of U.S. Treasury Securities | 35,255 | - | 14,176 | - | ||||||||||||
Other income | - | - | - | 1,043 | ||||||||||||
Subtotal | $ | (265,705 | ) | $ | 15,062 | $ | (247,393 | ) | $ | 21,153 | ||||||
Realized loss on derivatives (1) | (37,262 | ) | (18,914 | ) | (105,173 | ) | (41,055 | ) | ||||||||
Unrealized gain (loss) on derivatives | (11,821 | ) | (31,486 | ) | 416,662 | (84,265 | ) | |||||||||
Subtotal | $ | (49,083 | ) | $ | (50,400 | ) | $ | 311,489 | $ | (125,320 | ) | |||||
Total Other Income (Loss) | $ | (314,788 | ) | $ | (35,338 | ) | $ | 64,096 | $ | (104,167 | ) | |||||
Expenses: | ||||||||||||||||
Management fee | 6,483 | 5,545 | 20,985 | 13,356 | ||||||||||||
Professional fees | 773 | 472 | 2,299 | 1,408 | ||||||||||||
Insurance | 188 | 85 | 355 | 189 | ||||||||||||
Compensation | 1,859 | 426 | 2,373 | 1,417 | ||||||||||||
Other | 381 | 660 | 1,608 | 1,331 | ||||||||||||
Total expenses | $ | 9,684 | $ | 7,188 | $ | 27,620 | $ | 17,701 | ||||||||
Income (loss) before taxes | (229,953 | ) | 54,945 | 353,722 | 106,534 | |||||||||||
Income tax benefit (expense) | 10 | (3 | ) | 10 | 27 | |||||||||||
Net Income (Loss) | $ | (229,943 | ) | $ | 54,942 | $ | 353,732 | $ | 106,561 | |||||||
Dividends declared on preferred stock | (3,905 | ) | (804 | ) | (10,308 | ) | (964 | ) | ||||||||
Net Income (Loss) available (related) to common stockholders | $ | (233,848 | ) | $ | 54,138 | $ | 343,424 | $ | 105,597 | |||||||
Net income (loss) available (related) per share to common stockholders(Note 12): | ||||||||||||||||
Basic | $ | (0.63 | ) | $ | 0.20 | $ | 1.28 | $ | 0.54 | |||||||
Diluted | $ | (0.63 | ) | $ | 0.20 | $ | 1.27 | $ | 0.54 | |||||||
Dividends declared per common share | $ | 0.21 | $ | 0.30 | $ | 0.66 | $ | 0.92 | ||||||||
Weighted average common shares outstanding: | ||||||||||||||||
Basic | 370,818 | 269,325 | 268,202 | 195,272 | ||||||||||||
Diluted | 372,256 | 270,010 | 269,636 | 196,287 |
For the Quarters Ended For the Nine Months Ended September 30, 2012 September 30, 2011 September 30, 2012 September 30, 2011 Net Income (Loss) ) ) Other comprehensive income : Reclassification adjustment for realized gain on sale of Agency Securities ) ) ) ) Net unrealized gain on available for sale securities Other comprehensive income Comprehensive Income (Loss) ) $ 54,942 $ (34,472 $ 106,561 $ (33,149 (15,062 (6,444 (20,110 (6,444 250,062 37,438 374,012 73,981 235,000 30,994 353,902 67,537 $ 289,942 $ (3,478 $ 460,463 $ 34,388
(1) Interest expense related to our interest rate swap contracts is recorded in realized loss on derivatives on the condensed consolidated statements of operations. For additional information, see Note 8 to the condensed consolidated financial statements.
See notes to condensed consolidated financial statementsstatements.
ARMOUR Residential REIT, Inc. and Subsidiary
CONDENSED CONSOLIDATED STATEMENTS of STOCKHOLDERS' EQUITYOF COMPREHENSIVE INCOME (LOSS)
(dollars in thousands)
(Unaudited)
For the Quarters Ended | For the Nine Months Ended | |||||||||||||||
September 30, 2013 | September 30, 2012 | September 30, 2013 | September 30, 2012 | |||||||||||||
Net Income (Loss) | $ | (229,943 | ) | $ | 54,942 | $ | 353,732 | $ | 106,561 | |||||||
Other comprehensive income (loss): | ||||||||||||||||
Reclassification adjustment for realized (gain) loss on sale of availablefor sale Agency Securities | 300,960 | (15,062 | ) | 261,569 | (20,110 | ) | ||||||||||
Net unrealized gain (loss) on available for sale Agency Securities | (51,778 | ) | 250,062 | (1,082,987 | ) | 374,012 | ||||||||||
Other comprehensive income (loss) | $ | 249,182 | $ | 235,000 | $ | (821,418 | ) | $ | 353,902 | |||||||
Comprehensive Income (Loss) | $ | 19,239 | $ | 289,942 | $ | (467,686 | ) | $ | 460,463 |
See notes to condensed consolidated financial statements.
Preferred Stock | Common Stock | |||||||||||||||||||||||||||||||||||||||
Shares | Par Amount | Additional Paid in Capital | Shares | Par Amount | Additional Paid in Capital | Total Additional Paid in Capital | Accumulated Deficit | Accumulated Other Comprehensive Income | Total | |||||||||||||||||||||||||||||||
Balance, December 31, 2011 | - | $ | - | $ | - | 95,437 | $ | 95 | $ | 678,641 | $ | 678,641 | $ | (100,878 | ) | $ | 48,748 | $ | 626,606 | |||||||||||||||||||||
Preferred dividends declared | - | - | - | - | - | - | - | (964 | ) | - | (964 | ) | ||||||||||||||||||||||||||||
Common dividends declared | - | - | - | - | - | - | - | (185,149 | ) | - | (185,149 | ) | ||||||||||||||||||||||||||||
Issuance of Preferred stock, net | 1,785 | 2 | 43,302 | - | - | - | 43,302 | - | - | 43,304 | ||||||||||||||||||||||||||||||
Issuance of common stock, net | - | - | - | 213,460 | 213 | 1,497,949 | 1,497,949 | - | - | 1,498,162 | ||||||||||||||||||||||||||||||
Stock based compensation, netof withholding requirements | - | - | - | 75 | 1 | 525 | 525 | - | - | 526 | ||||||||||||||||||||||||||||||
Net income | - | - | - | - | - | - | - | 106,561 | - | 106,561 | ||||||||||||||||||||||||||||||
Other comprehensive income | - | - | - | - | - | - | - | - | 353,902 | 353,902 | ||||||||||||||||||||||||||||||
Balance, September 30, 2012 | 1,785 | $ | 2 | $ | 43,302 | 308,972 | $ | 309 | $ | 2,177,115 | $ | 2,220,417 | $ | (180,430 | ) | $ | 402,650 | $ | 2,442,948 |
ARMOUR Residential REIT, Inc. and Subsidiary
CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
(in thousands, except per share amounts)
(Unaudited)
Preferred Stock | Common Stock | |||||||||||||||||||||||||||||||||||||||||||||||||||
8.250% Series A | 7.875% Series B | |||||||||||||||||||||||||||||||||||||||||||||||||||
Shares | Par Amount | Additional Paid in Capital | Shares | Par Amount | Additional Paid in Capital | Shares | Par Amount | Additional Paid in Capital | Total Additional Paid in Capital | (Accumulated Deficit) | Accumulated Other Comprehensive Income (Loss) | Total | ||||||||||||||||||||||||||||||||||||||||
Balance, January 1, 2013 | 2,006 | $ | 2 | $ | 48,792 | - | $ | - | $ | - | 309,013 | $ | 309 | $ | 2,177,406 | $ | 2,226,198 | $ | (149,298 | ) | $ | 230,564 | $ | 2,307,775 | ||||||||||||||||||||||||||||
Series A Preferred dividends declared | - | - | - | - | - | - | - | - | - | - | (3,356 | ) | - | (3,356 | ) | |||||||||||||||||||||||||||||||||||||
Series B Preferred dividends declared | - | - | - | - | - | - | - | - | - | - | (6,952 | ) | - | (6,952 | ) | |||||||||||||||||||||||||||||||||||||
Common stock dividends declared | - | - | - | - | - | - | - | - | - | - | (236,761 | ) | - | (236,761 | ) | |||||||||||||||||||||||||||||||||||||
Issuance of Series A Preferred stock, net | 175 | - | 4,380 | - | - | - | - | - | - | 4,380 | - | - | 4,380 | |||||||||||||||||||||||||||||||||||||||
Issuance of Series B Preferred stock, net | - | - | - | 5,650 | 6 | 136,547 | - | - | - | 136,547 | - | - | 136,553 | |||||||||||||||||||||||||||||||||||||||
Issuance of common stock, net | - | - | - | - | - | - | 65,056 | 65 | 438,470 | 438,470 | - | - | 438,535 | |||||||||||||||||||||||||||||||||||||||
Stock based compensation, net ofwithholding requirements | - | - | - | - | - | - | 232 | 1 | 1,220 | 1,220 | - | - | 1,221 | |||||||||||||||||||||||||||||||||||||||
Common stock repurchased | - | - | - | - | - | - | (3,396 | ) | (4 | ) | (20,256 | ) | (20,256 | ) | - | - | (20,260 | ) | ||||||||||||||||||||||||||||||||||
Net income | - | - | - | - | - | - | - | - | - | - | 353,732 | - | 353,732 | |||||||||||||||||||||||||||||||||||||||
Other comprehensive loss | - | - | - | - | - | - | - | - | - | - | - | (821,418 | ) | (821,418 | ) | |||||||||||||||||||||||||||||||||||||
Balance, September 30, 2013 | 2,181 | $ | 2 | $ | 53,172 | 5,650 | $ | 6 | $ | 136,547 | 370,905 | $ | 371 | $ | 2,596,840 | $ | 2,786,559 | $ | (42,635 | ) | $ | (590,854 | ) | $ | 2,153,449 |
See notes to condensed consolidated financial statements.
ARMOUR Residential REIT, Inc. and Subsidiary
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(Unaudited)
For the Nine Months Ended | ||||||||
September 30, 2013 | September 30, 2012 | |||||||
Cash Flows From Operating Activities: | ||||||||
Net income | $ | 353,732 | $ | 106,561 | ||||
Adjustments to reconcile net income to net cash provided by operating activities: | ||||||||
Net amortization of premium on Agency Securities | 140,091 | 71,168 | ||||||
Realized (gain) loss on sale of Agency Securities | 261,569 | (20,110 | ) | |||||
Gain on short sale of U.S. Treasury Securities | (14,176 | ) | - | |||||
Stock based compensation | 1,221 | 526 | ||||||
Changes in operating assets and liabilities: | ||||||||
Decrease (increase) in accrued interest receivable | 9,445 | (41,660 | ) | |||||
Increase in prepaid and other assets | (773 | ) | (333 | ) | ||||
Decrease (increase) in derivatives, at fair value | (447,943 | ) | 68,603 | |||||
Increase (decrease) in accrued interest payable | (2,248 | ) | 7,148 | |||||
Increase (decrease) in accounts payable and other accrued expenses | (698 | ) | 1,861 | |||||
Net cash provided by operating activities | $ | 300,220 | $ | 193,764 | ||||
Cash Flows From Investing Activities: | ||||||||
Purchases of Agency Securities | (12,392,749 | ) | (18,916,083 | ) | ||||
Principal repayments of Agency Securities | 2,795,559 | 1,574,116 | ||||||
Proceeds from sales of Agency Securities | 11,615,779 | 1,869,332 | ||||||
Disbursements on reverse repurchase agreements | (11,239,305 | ) | - | |||||
Receipts from reverse repurchase agreements | 11,239,305 | - | ||||||
Decrease (increase) in cash collateral | 528,661 | (90,590 | ) | |||||
Net cash provided by (used in) investing activities | $ | 2,547,250 | $ | (15,563,225 | ) | |||
Cash Flows From Financing Activities: | ||||||||
Issuance of Series A Preferred stock, net of expenses | 4,380 | 43,041 | ||||||
Issuance of Series B Preferred stock, net of expenses | 136,553 | - | ||||||
Issuance of common stock, net of expenses | 438,528 | 1,498,157 | ||||||
Proceeds from repurchase agreements | 99,907,622 | 92,966,646 | ||||||
Principal repayments on repurchase agreements | (103,356,193 | ) | (78,476,690 | ) | ||||
Proceeds from sales of U.S. Treasury Securities | 2,789,560 | - | ||||||
Purchases of U.S. Treasury Securities | (2,775,384 | ) | - | |||||
Series A Preferred stock dividends paid | (3,356 | ) | (964 | ) | ||||
Series B Preferred stock dividends paid | (6,952 | ) | - | |||||
Common stock dividends paid | (236,770 | ) | (185,795 | ) | ||||
Common stock repurchased | (20,260 | ) | - | |||||
Net cash provided by (used in) financing activities | $ | (3,122,272 | ) | $ | 15,844,395 | |||
Net increase (decrease) in cash | (274,802 | ) | 474,934 | |||||
Cash and cash equivalents - beginning of period | 771,282 | 252,372 | ||||||
Cash and cash equivalents- end of period | $ | 496,480 | $ | 727,306 | ||||
Supplemental Disclosure: | ||||||||
Cash paid during the period for interest | $ | 198,131 | $ | 61,245 | ||||
Non-Cash Investing and Financing Activities: | ||||||||
Receivable for unsettled sales | $ | - | $ | 357,218 | ||||
Payable for unsettled purchases | $ | 143,894 | $ | 1,036,450 | ||||
Net unrealized gain (loss) on available for sale Agency Securities | $ | (1,082,987 | ) | $ | 374,012 | |||
Amounts receivable for issuance of common stock | $ | 7 | $ | 5 | ||||
Amounts receivable for issuance of preferred stock | $ | - | $ | 263 |
See notes to condensed consolidated financial statements
ARMOUR Residential REIT, Inc. and Subsidiary
CONDENSED CONSOLIDATED STATEMENTS of CASH FLOWS
(dollars in thousands)
(Unaudited)
For the Nine Months Ended September 30, 2012 For the Nine Months Ended September 30, 2011 Cash Flows From Operating Activities: Net income (loss) ) Adjustments to reconcile net income (loss) to net cash provided by operating activities: Net amortization of premium on Agency Securities Unrealized loss on derivatives Realized gain on sale of Agency Securities ) ) Stock based compensation Changes in operating assets and liabilities: Increase in accrued interest receivable ) ) (Increase) decrease in prepaid income taxes and other assets ) Increase in accrued interest payable Increase in accounts payable and accrued expenses Net cash provided by operating activities Cash Flows From Investing Activities: Purchases of Agency Securities ) ) Principal repayments of Agency Securities Proceeds from sales of Agency Securities Increase in restricted cash ) ) Net cash used in investing activities ) ) Cash Flows From Financing Activities: Issuance of preferred stock, net of expenses Issuance of common stock, net of expenses Proceeds from repurchase agreements Principal repayments on repurchase agreements ) ) Preferred dividends paid ) Common dividends paid ) ) Net cash provided by financing activities Net increase in cash Cash - beginning of period Cash - end of period Supplemental Disclosure: Cash paid during the period for interest Non-Cash Investing and Financing Activities: Receivable for unsettled security sales Payable for unsettled security purchases Unrealized gain on investment in available for sale securities Amounts receivable for issuance of common stock Amounts receivable for issuance of preferred stock Common dividends declared, to be paid in subsequent period $ 106,561 $ (33,149 71,168 17,636 68,603 91,891 (20,110 (6,444 526 102 (41,660 (15,012 (333 388 7,148 16,823 1,861 994 193,764 73,229 (18,916,083 (5,352,969 1,574,116 426,474 1,869,332 512,657 (90,590 (125,244 (15,563,225 (4,539,082 43,041 - 1,498,157 489,401 92,966,646 28,660,677 (78,476,690 (24,410,828 (964 - (185,795 (58,255 15,844,395 4,680,995 474,934 215,142 252,372 35,344 $ 727,306 $ 250,486 $ 61,245 $ 5,844 $ 357,218 $ - $ 1,036,450 $ 475,109 $ 374,012 $ 67,536 $ 5 $ 4 $ 263 $ - $ - $ 9
See notes to condensed consolidated financial statements
ARMOUR Residential REIT, Inc. and Subsidiary
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 1 – Basis of Presentation
The accompanying unaudited financial statements have been prepared in accordance with U.S. generally accepted accounting principles in the United States (“GAAP”) for interim financial information and with the instructions to Form 10-Q and Rule 10-011001 of Regulation S-X promulgated by the Securities and Exchange Commission.Commission (the “SEC”). Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring accruals) considered necessary for a fair presentation have been included. Operating results for the quarter and nine months ended September 30, 20122013 are not necessarily indicative of the results that may be expected for the calendar year ending December 31, 2012.2013. These unaudited financial statements should be read in conjunction with the audited financial statements and notes thereto included in our annual report on Form 10-K for the year ended December 31, 2011.2012.
The condensed consolidated financial statements include the accounts of ARMOUR Residential REIT, Inc. and its subsidiary. All intercompany accounts and transactions have been eliminated. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates. Significant estimates affecting the accompanying condensed consolidated financial statements include the valuation of Agency Securities (as defined below) and derivative instruments.
Note 2 -– Organization and Nature of Business Operations
Business
References to “we”, “us”, “our”,“we,” “us,” “our,” "ARMOUR" or the “Company” are to ARMOUR Residential REIT, Inc. References to "ARRM" are to ARMOUR Residential Management LLC, a Delaware limited liability company. References to “Enterprise” are to Enterprise Acquisition Corp., which is a wholly-owned subsidiary of ARMOUR.
We are an externally managed Maryland corporation organized in 2008, managed by ARRM (see Note 14, “Related“Related Party Transactions”for additional discussion). We invest primarily in fixed rate, hybrid adjustable rate and adjustable rate residential mortgage backed securities. These securities are issued or guaranteed by a United States (“U.S.”) Government-sponsored entity (“GSE”), such as the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac) or guaranteed by the Government National Mortgage Administration (Ginnie Mae) (collectively, "Agency Securities"). As of September 30, 2013 and December 31, 2012, Agency Securities accountaccounted for 100% of our securities portfolio. It is expected that the percentage will continue to be 100% or close thereto. Our securities portfolio consists primarily of Agency Securities backed by fixed rate home loans. From time to time, a portion of our portfolioassets may be invested in Agency Securities backed by hybrid adjustable rate and adjustable rate home loans as well as unsecured notes and bonds issued by U.S. Government-chartered entities (collectively, “AgencyGSEs (“Agency Debt”), U.S. Treasuries and money market instruments, subject to certain income tests we must satisfy for our qualification as a real estate investment trust (“REIT”). On December 1, 2011, our stockholders approved an amendment to our charter to alter our investment asset class restriction in response to potential changes in Agency Securities to include non-AgencyNon-Agency Securities as well as Agency Securities in our investment asset class restriction. While we remain committed to investing in Agency Securities for so long as an adequate supply and pricing exists, we believe it is prudent for us to have the flexibility to invest in non-AgencyNon-Agency Securities and respond to changes in GSE policy.
We intend to qualify and have elected to be taxed as a REIT under the Internal Revenue Code (“the Code”). Our qualification as a REIT depends on our ability to meet, on a continuing basis, various complex requirements under the Code relating to, among other things, the sources of our gross income, the composition and values of our assets, our distribution levels and the concentration of ownership of our capital stock. We believe that we are organized in conformity with the requirements for qualification as a REIT under the Code and our manner of operations enables us to meet the requirements for taxation as a REIT for federal income tax purposes.
As a REIT, we will generally not be subject to federal income tax on the REIT taxable income that we currently distribute to our stockholders. If we fail to qualify as a REIT in any taxable year and do not qualify for certain statutory relief provisions, we will be subject to federal income tax at regular corporate rates. Even if we qualify as a REIT for federal income tax purposes, we may still be subject to some federal, state and local taxes on our income.
Note 3 -– Summary of Significant Accounting Policies
Cash and cash equivalents
Cash and cash equivalents includes cash on deposit with financial institutions and investments in high quality overnight money market funds, all of which have original maturities of three months or less, at the time of purchase. We may maintain deposits in federally insured financial institutions in excess of federally insured limits. However, management believes we are not exposed to significant credit risk due to the financial position and creditworthiness of the depository institutions in which those deposits are held.
ARMOUR Residential REIT, Inc. and Subsidiary
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Restricted Cash Collateral Posted/Held
The following table presents information related to margin collateral posted (held) posted for Agency Securities, interest rate swap contracts and Eurodollar Futures Contracts (“Futures Contracts”) which are included in restricted cash collateral on the accompanying condensed consolidated balance sheets as of September 30, 20122013 and December 31, 2011.2012.
September 30, 2012 December 31, 2011 (dollars in thousands) Fair Value (1) Fair Value (1) Agency Securities ) Interest rate swap contracts Futures Contracts TotalsSeptember 30, 2013 $ (14,426 $ - 247,278 141,326 4,937 5,873 $ 237,789 $ 147,199
(1) See Note 6, “Fair Value of Financial Instruments
Assets at Fair Value (1) | Liabilities at Fair Value (1) | |||||||
(in thousands) | ||||||||
Agency Securities | $ | 618 | $ | (61,276 | ) | |||
Interest rate swap contracts | 28,144 | (232,795 | ) | |||||
Futures Contracts | 2,200 | - | ||||||
Totals | $ | 30,962 | $ | (294,071 | ) |
(1) | See Note 5,“Fair Value of Financial Instruments” |
December 31, 2012
Assets at Fair Value (1) | Liabilities at Fair Value (1) | |||||||
(in thousands) | ||||||||
Interest rate swap contracts | $ | 261,364 | $ | - | ||||
Futures Contracts | 4,188 | - | ||||||
Totals | $ | 265,552 | $ | - |
(1) | See Note 5,“Fair Value of Financial Instruments” for additional discussion. |
Agency Securities, at Fair Value
We invest primarily in Agency Securities. A portion of our portfolio may be invested in Agency Debt, U.S. Treasuries and money market instruments, subject to certain income tests we must satisfy for our qualification as a REIT. As of September 30, 2012, all of our financial instrument investments consist of Agency Securities, hedging and other derivative instruments related to the foregoing investments.
We generally intend to hold most of our Agency Securities for long-term periods.extended periods of time. We may, from time to time, sell any of our Agency Securities as part of the overall management of our securities portfolio. Management determines the appropriate classifications of the securities at the time they are acquired and evaluates the appropriateness of such classifications at each balance sheet date. As of September 30, 2013 and December 31, 2012, all of our Agency Securities were classified as available for sale. Agency securitiesSecurities classified as available for sale are reported at their estimated fair values based on fair values obtained from third-party sources, with unrealized gains and losses excluded from earnings and reported as part of the separate condensed consolidated statements of comprehensive income. Agency securities transactions are recorded on the trade date and are valued using third-party pricing services and dealer quotes.income (loss).
We evaluate securitiesAgency Securities for other than temporary impairment at least on a quarterly basis and more frequently when economic or market concerns warrant such evaluation. We determineconsider an impairment to be other than temporary if we (1) have the intent to sell the Agency Securities, (2) believe it is more likely than not that we will be required to sell the securities before recovery (for example, because of liquidity requirements or contractual obligations) or (3) do not expect to recover the entire amortized cost basis of thea credit loss exists.
Accrued Interest Receivable and Payable
Accrued interest receivable includes interest accrued between payment dates on Agency Securities. There was no other than temporary impairment for the quarters and nine months ended September 30, 2012 and September 30, 2011.Accrued interest payable includes interest payable on our repurchase agreements.
Repurchase Agreements
We finance the acquisition of our Agency Securities through the use of repurchase agreements. Our repurchase agreements are secured by our Agency Securities and bear interest rates that have historically moved in close relationship to the Federal Funds Rate and the London Interbank Offered Rate (“LIBOR”). Under these repurchase agreements, we sell securitiesAgency Securities to a lender and agree to repurchase the same securitiesAgency Securities in the future for a price that is higher than the original sales price. The difference between the sales price that we receive and the repurchase price that we pay represents interest paid to the lender. A repurchase agreement operates as a financing arrangement under which we pledge our securitiesAgency Securities as collateral to secure a loan which is equal in value to a specified percentage of the estimated fair value of the pledged collateral. We retain beneficial ownership of the pledged collateral. At the maturity of a repurchase agreement, we are required to repay the loan and concurrently receive back our pledged collateral from the lender or, with the consent of the lender, we may renew such agreement at the then prevailing interest rate. The repurchase agreements may require us to pledge additional assets to the lender in the event the estimated fair value of the existing pledged collateral declines.
ARMOUR Residential REIT, Inc. and Subsidiary
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
In addition to the repurchase agreement financing discussed above, at certain times we have entered into reverse repurchase agreements with certain of our repurchase agreement counterparties. Under a typical reverse repurchase agreement, we purchase U.S. Treasury Securities from a borrower in exchange for cash and agree to sell the same securities in the future in exchange for a price that is higher than the original purchase price. The difference between the purchase price originally paid and the sale price represents interest received from the borrower. Reverse repurchase agreement receivables and repurchase agreement liabilities are presented net when they meet certain criteria, including being with the same counterparty, being governed by the same master repurchase agreement, settlement through the same brokerage or clearing account and maturing on the same day. We did not have any reverse repurchase agreements outstanding at September 30, 2013 or December 31, 2012.
Obligations to Return Securities Received as Collateral, at Fair Value
At certain times, we also sell to third parties the U.S. Treasury Securities received as collateral for reverse repurchase agreements and recognize the resulting obligation to return said U.S. Treasury Securities as a liability on our condensed consolidated balance sheets. Interest is recorded on the repurchase agreements, reverse repurchase agreements and U.S. Treasury Securities on an accrual basis and presented as net interest expense. Both parties to the transaction have the right to make daily margin calls based on changes in the fair value of the collateral received and/or pledged. We did not have any reverse repurchase agreements outstanding at September 30, 2013 or December 31, 2012.
Derivatives, at Fair Value
We recognize all derivative instrumentsderivatives as either assets or liabilities at fair value on our condensed consolidated balance sheets. We do not designate our derivative activitiesderivatives as cash flow hedges, which, among other factors, would require us to match the pricing dates of both derivative transactionsderivatives and repurchase agreements. Operational issues and credit market volatility make such matching impractical for us. Since we have not elected cash flow hedge accounting treatment as allowed by GAAP, all changes in the fair values of our derivatives are reflected in our condensed consolidated statements of operations currently.operations. Accordingly, our operating results may reflect greater volatility than otherwise would be the case, because gains or losses on derivatives may not be offset by changes in the fair value or cash flows of the transaction within the same accounting period or ever. Consequently, any declines in the fair value of our derivatives result in a charge to earnings. We will continue to designate derivative activitiesderivatives as hedges for tax purposes and any unrealized derivative gains or losses would not affect our distributable net taxable income.
Accrued Interest Receivable and Payable
Accrued interest receivable includes interest accrued between payment dates on Agency Securities. Accrued interest payable includes interest payable on our repurchase agreements.
Credit Risk
We have limited our exposure to credit losses on our securities portfolio of Agency Securities by only purchasing securities issued by Freddie Mac, Fannie Mae or Ginnie Mae.Securities. The payment of principal and interest on the Freddie Mac and Fannie Mae Agency Securities are guaranteed by those respective agencies and the payment of principal and interest on the Ginnie Mae Agency Securities are backed by the full faith and credit of the U.S. Government.
In September 2008, both Freddie Mac and Fannie Mae were placed in the conservatorship of the U.S. Government. While it is hoped that the conservatorship will help stabilize Freddie Mac's and Fannie Mae's losses and overall financial position, there can be no assurance that it will succeed or that, if necessary, Freddie Mac or Fannie Mae will be able to satisfy their guarantees of Agency Securities. On August 5, 2011, Standard & Poor'sPoor’s Corporation downgraded the U.S.'s Government’s credit rating from AAA to AA+ and on August 8, 2011, Fannie Mae and Freddie Mac'sMac’s credit ratings were downgraded from AAA to AA+. Because Fannie Mae and Freddie Mac areremain in conservatorship of the U.S. Government,Government. There can be no assurances as to how or when the U.S.'s credit rating downgrade and Government will end these conservatorships or how the future profitability of Fannie Mae and Freddie Mac'sMac and any future credit rating downgrades willactions may impact the credit risk associated with Agency Securities and, therefore, may decrease the value of the Agency Securities in our securities portfolio.
Market Risk
Weakness in the mortgage market may adversely affect the performance and market value of our investments. This could negatively impact our book value. Furthermore, if our lenders are unwilling or unable to provide additional financing, we could be forced to sell our Agency Securities at an inopportune time when prices are depressed.
ARMOUR Residential REIT, Inc. and Subsidiary
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Preferred Stock
At September 30, 2012,2013, we were authorized to issue up to 25,000,00050,000,000 shares of preferred stock, par value $0.001 per share with such designations, voting and other rights and preferences as may be determined from time to time by our Board of Directors (“Board”) or a committee thereof.
Series A Cumulative Preferred Shares (”Series A Preferred Stock”)
On June 6, 2012, we filed with the Maryland State Department of Assessments and Taxation to designate 1,610,000 shares of the 25,000,00050,000,000 authorized preferred stock as 8.250% Series A Cumulative Preferred Shares (“Series A Preferred Stock”)Stock with the powers, designations, preferences and other rights as set forth therein. On July 13, 2012, we entered into an At Market Issuance Sales Agreement with MLV & Co. LLC, as our agent, to offer and sell, from time to time, up to 6,000,000 shares of Series A Preferred Stock. On July 27, 2012, we entered into an Equity Distribution Agreement with Citadel Securities LLC, as our agent, to offer and sell, from time to time, up to 2,000,000 shares of Series A Preferred Stock. At September 30, 20122013, there were 9,610,000 shares designated as Series A Preferred Stock. At September 30, 2012, we
We had issued and outstanding 1,785,0002,180,572 shares of Series A Preferred Stock withissued and outstanding at September 30, 2013 and 2,005,611 shares of Series A Preferred Stock issued and outstanding at December 31, 2012. Our Series A Preferred Stock has a par value of $0.001 per share and a liquidation preference of $25.00 per share plus accrued and unpaid dividends. The Series A Preferred Stock is entitled to a dividend at a rate of 8.250% per year based on the $25.00 liquidation preference before the common stock is entitled to receive any dividends. The Series A Preferred Stock is redeemable at $25.00 per share plus accrued and unpaid dividends exclusively at our option commencing on June 7, 2017 (subject to our right under limited circumstances to redeem the Series A Preferred Stock earlier in order to preserve our qualification as a REIT). The Series A Preferred Stock is senior to our common stock and therefore in the event of liquidation, dissolution or winding up, the Series A Preferred Stock will receive a liquidation preference of $25.00 per share plus accumulated and unpaid dividends before distributions are paid to holders of our common stock, with no right or claim to any of our remaining assets thereafter. The Series A Preferred Stock generally does not have voting rights except if we fail to pay dividends on the Series A Preferred Stock for eighteen months, whether or not consecutive. Under such circumstances, the Series A Preferred Stock will be entitled to vote to elect two additional directors to the Board, until all unpaid dividends have been paid or declared and set aside for payment. The Series A Preferred Stock has no stated maturity, is not subject to any sinking fund or mandatory redemption and will remain outstanding indefinitely unless repurchased or redeemed by us or converted into our common stock in connection with a change of control by the holders of Series A Preferred Stock.
Series B Cumulative Preferred Shares (”Series B Preferred Stock”)
On February 11, 2013, we filed with the Maryland State Department of Assessments and Taxation to designate 6,210,000 shares of the 50,000,000 authorized preferred stock as 7.875% Series B Preferred Stock with the powers, designations, preferences and other rights as set forth therein.
We had 5,650,000 shares of Series B Preferred Stock issued and outstanding at September 30, 2013 and none issued and outstanding at December 31, 2012. Our Series B Preferred Stock has a par value of $0.001 per share and a liquidation preference of $25.00 per share plus accrued and unpaid dividends. The Series B Preferred Stock is entitled to a dividend at a rate of 7.875% per year based on the $25.00 liquidation preference before the common stock is entitled to receive any dividends. The Series B Preferred Stock is redeemable at $25.00 per share plus accrued and unpaid dividends exclusively at our option commencing on February 12, 2018 (subject to our right under limited circumstances to redeem the Series A Preferred Stock earlier in order to preserve our qualification as a REIT). The Series B Preferred Stock is senior to our common stock and rank on parity with the Series A Preferred Stock. In the event of liquidation, dissolution or winding up, the Series B Preferred Stock will receive a liquidation preference of $25.00 per share plus accumulated and unpaid dividends before distributions are paid to holders of our common stock, with no right or claim to any of our remaining assets thereafter. The Series B Preferred Stock generally does not have voting rights except if we fail to pay dividends on the Series B Preferred Stock for eighteen months, whether or not consecutive. Under such circumstances, the Series B Preferred Stock will be entitled to vote to elect two additional directors to the Board, until all unpaid dividends have been paid or declared and set aside for payment. The Series B Preferred Stock has no stated maturity, is not subject to any sinking fund or mandatory redemption and will remain outstanding indefinitely unless repurchased or redeemed by us or converted into our common stock in connection with a change of control by the holders of Series B Preferred Stock.
ARMOUR Residential REIT, Inc. and Subsidiary
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Common Stock
Common Stock and Warrants
At September 30, 2012,2013, we were authorized to issue up to 500,000,0001,000,000,000 shares of common stock, par value $0.001 per share, with such designations, voting and other rights and preferences as may be determined from time to time by our Board. We had 308,972,403370,905,142 shares of common stock issued and outstanding at September 30, 2013 and 309,013,984 shares of common stock issued and outstanding at December 31, 2012. At September 30, 2012, weWe had outstanding warrants whereby their holders have the right to purchase 32,500,000 shares of our common stock whichat September 30, 2013 and December 31, 2012. These warrants are exercisable at $11.00 per share and expire inon November 7, 2013. The warrants are listed on the NYSE MKT LLC which has determined that November 1, 2013, will be the final trading day for the warrants.
Common Stock Repurchased
On December 17, 2012, we announced that our Board had authorized a stock repurchase program of up to $100 million of shares of our common stock outstanding (the “Repurchase Program”). Under the Repurchase Program shares may be purchased in the open market, including block trades, through privately negotiated transactions, or pursuant to a trading plan separately adopted in the future. The timing, manner, price and amount of any repurchases will be at our discretion, subject to the requirements of the Securities Exchange Act of 1934, as amended, and related rules. We are not required to repurchase any shares under the Repurchase Program and it may be modified, suspended or terminated at any time for any reason. We do not intend to purchase shares from our Board or other affiliates. Under Maryland law, such repurchased shares are treated as authorized but unissued. As of September 30, 2013, we repurchased 3,395,603 shares of our common stock under the Repurchase Program for an aggregate of $20.3 million.
Revenue Recognition
Interest income is earned and recognized on Agency Securities based on their unpaid principal amounts and their contractual terms. Premiums and discounts associated with the purchase of Agency Securities are amortized or accreted into interest income over the actual lives of the securities.
Comprehensive Income (Loss)
Comprehensive income (loss) refers to changechanges in equity during a period from transactions and other events and circumstances from non-owner sources. It includes all changes in equity during a period except those resulting from investments by owners and distributions to owners.
Revenue Recognition
Interest income is earned and recognized based on the unpaid principal amount of the Agency Securities and their contractual terms. Premiums and discounts associated with the purchase of Agency Securities are amortized or accreted into interest income over the actual lives of the securities.
Income Taxes
We intend to qualify and have elected to be taxed as a REIT under the Code. We will generally not be subject to federal income tax to the extent that we distribute our taxable income to our stockholders and as long as we satisfy the ongoing REIT requirements under the Code including meeting certain asset, income and stock ownership tests.
Our management is responsible for determining whether a tax position taken by us is more likely than not to be sustained on its merits. We have no material unrecognized tax benefits and have not recognized in the accompanying condensed consolidated financial statements any interest or penalties related to income taxes. Should any such interest and penalties be recognized, they will be included in interest expense and other expenses, respectively. None of our income tax returns have been examined by federal, state or local authorities; therefore our 2009, 2010 and 2011 federal and state tax returns remain open for examination.
Note 4 -– Recent Accounting Pronouncements
Accounting Standards Adopted in 2012
We adopted recent amendments to authoritative guidance issued byIn January 2013, the Financial Accounting Standards Board (“FASB”) issuedASU 2013-01, Clarifying the Scope of Disclosures about Offsetting Assets and Liabilities, Balance Sheet (Topic 210). This update to ASU 2011-11 addressed implementation issues and applied to derivatives accounted for in April 2011 related to the accounting foraccordance with Topic 815, Derivatives and Hedging, including bifurcated embedded derivatives, repurchase agreements and other agreements that entitle and obligate a transferor to repurchase or redeem financial assets before their maturity. We maintain effective control of our assets financed byreverse repurchase agreements, therefore, this update had no effectand securities borrowing and securities lending transactions that are either offset in accordance with ASC 210-20-45 or ASC 815-10-45 or subject to an enforceable master netting arrangement or similar agreement. The guidance was effective January 1, 2013 and was applied retrospectively. This guidance did not affect the presentation of Derivatives, at fair value on our condensed consolidated balance sheets and therefore, did not affect our financial statements.
We adopted recent amendmentsIn February 2013, the FASB issuedASU 2013-02, Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income, Comprehensive Income (Topic 220).This update to authoritative guidance issued by FASB in May 2011 to establish common fair value measurement and disclosure requirements in GAAP and International Financial Reporting Standards. We generally do not hold Level 3 assets and therefore, this update had no significant effect on our condensed consolidated financial statements.
We adopted recent amendments to authoritative guidance issued by FASB in June and December 2011 providing forASU 2011-12 addressed improving the option to present the totalreporting of comprehensive income, the componentsreclassifications out of net income, and the components ofaccumulated other comprehensive income eitherby requiring reporting of the effect of significant reclassifications out of accumulated net income if the amount being reclassified is required under GAAP to be classified in a single continuous statement ofits entirety to net income. For amounts not required to be reclassified in their entirety to net income in the same reporting period, an entity is required to cross-reference other disclosures required under GAAP that provide additional detail about these amounts. The update did not change the current requirements for reporting net income or other comprehensive income or in two separate but consecutive statements. This updateand resulted in additional disclosure but had no significant effect on our condensed consolidated financial statements.
Accounting Standards to be Adopted in Future Periods
In December 2011, the FASB issued amendments to authoritative The guidance requiring entities that have financial instruments and derivative instruments to disclose information about offsetting and related arrangements. The disclosures required under this amended guidance are intended to enable users of an entity's financial statements to evaluate the effect or potential effect of netting arrangements on an entity's financial position, including the effect or potential effect of rights of offset associated with certain financial instruments and derivative instruments. The provisions of these amendments arewas effective for annualreporting periods beginning after January 1, 2013. We anticipate the adoption of these amendments may change the presentation of our financial statementsDecember 15, 2012 and related disclosures.was applied prospectively.
ARMOUR Residential REIT, Inc. and Subsidiary
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
In July 2013, the FASB issuedASU 2013-10, Derivatives and Hedging (Topic 815), Inclusion of the Fed Funds Effective Swap Rate (or Overnight Index Swap Rate) as a Benchmark Interest Rate for Hedge Accounting Purposes (a consensus of the FASB Emerging Issues Task Force).Because we do not currently use hedge accounting for our derivative positions this addition to Topic 815 will not affect our financial statements.
Note 5 – Fair Value of Financial Instruments
Our valuation techniques for financial instruments are based on observable and unobservable inputs. Observable inputs reflect readily obtainable data from third-party sources, while unobservable inputs reflect management’s market assumptions. The Accounting Standards Codification Topic No. 820“Fair Value Measurement” classifies these inputs into the following hierarchy:
Level 1Inputs - Quoted prices for identical instruments in active markets.
Level 2Inputs - Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.
Level 3Inputs - Instruments with primarily unobservable value drivers.
The following describes the valuation methodologies used for our assets and liabilities measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy.
Cash- Cash and cash equivalents includes cash on deposit with financial institutions and investments in high quality overnight money market funds, all of which have maturities of three months or less, at the time of purchase. The carrying amount of cash is deemed to be its fair value. Our cash balances are classified as Level 1. Cash balances posted to or held by counterparties as collateral are classified as Level 2.
Agency Securities Available for Sale - Fair value for the Agency Securities in our securities portfolio is based on obtaining a valuation for each Agency Security from third-party pricing services and dealer quotes. The third-party pricing services use common market pricing methods that may include pricing models that may incorporate such factors as coupons, prepayment speeds, spread to the Treasury curves and interest rate swap curves, duration, periodic and life caps and credit enhancement. If the fair value of an Agency Security is not available from the third-party pricing services or such data appears unreliable, we obtain valuations from up to three dealers who make markets in similar Agency Securities. In general, the dealers incorporate common market pricing methods, including a spread measurement to the Treasury curve or interest rate swap curve as well as underlying characteristics of the particular Agency Security including coupon, periodic and life caps, collateral type, rate reset period and seasoning or age of the Agency Security. Management reviews pricing used to ensure that current market conditions are properly reflected. This review includes, but is not limited to, comparisons of similar market transactions or alternative third-party pricing services, dealer quotes and comparisons to a third-party pricing model. Fair values obtained from the third-party pricing services for similar instruments are classified as Level 2 securities if the inputs to the pricing methods used are consistent with the Level 2 definition. If quoted prices for a security are not reasonably available from the third-party pricing service, but dealer quotes are, the security will be classified as a Level 2 security. If neither is available, management will determine the fair value based on characteristics of the security that we receive from the issuer and based on available market information received from dealers and classify it as a Level 3 security. At September 30, 2013 and December 31, 2012, all of our Agency Security fair values were based solely on third-party pricing services and dealer quotes and therefore were classified as Level 2.
AllRepurchase Agreements - The fair value of repurchase agreements reflects the present value of the contractual cash flows discounted at the estimated LIBOR based market interest rates at the valuation date for repurchase agreements with a term equivalent to the remaining term to interest rate repricing, which may be at maturity, of our Agency Securitiesrepurchase agreements. The fair value of the repurchase agreements approximates their carrying amount due to the short-term nature of these financial instruments. Our repurchase agreements are classified as available for saleLevel 2.
Derivative Transactions-Our Futures Contracts are traded on the Chicago Mercantile Exchange (“CME”) and are classified as such, are reported at their estimatedLevel 1. The fair value. As of September 30, 2012 and December 31, 2011, investments in Agency Securities accounted for 100%values of our portfolio.
As of September 30, 2012, we hadinterest rate swap contracts and interest rate swaptions are valued using third-party pricing services that incorporates common market pricing methods that may include current interest rate curves, forward interest rate curves and market spreads to interest rate curves. Management compares pricing used to dealer quotes to ensure that the following securities in an unrealized gain or loss position as presented below.current market conditions are properly reflected. The components of the carrying valuefair values of our Agency Securitiesinterest rate swap contracts and our interest rate swaptions are classified as of September 30, 2012 are also presented below.Level 2.
September 30, 2012 Fannie Mae Freddie Mac Ginnie Mae Total Agency Securities (dollars in thousands) Principal Amount Net unamortized premium Amortized cost Unrealized gains Unrealized losses ) ) ) Fair value $ 14,408,545 $ 5,899,771 $ 318,873 $ 20,627,189 755,692 314,606 14,738 1,085,036 15,164,237 6,214,377 333,611 21,712,225 274,057 122,875 6,985 403,917 (1,057 (210 - (1,267 $ 15,437,237 $ 6,337,042 $ 340,596 $ 22,114,875
September 30, 2012 Adjustable Rate Fixed Rate Total Agency Securities (dollars in thousands) Principal Amount Net unamortized premium Amortized cost Unrealized gains Unrealized losses ) ) ) Fair value $ 2,234,747 $ 18,392,442 $ 20,627,189 92,613 992,423 1,085,036 2,327,360 19,384,865 21,712,225 46,143 357,774 403,917 (9 (1,258 (1,267 $ 2,373,494 $ 19,741,381 $ 22,114,875
As of December 31, 2011, we had the following securities in an unrealized gain or loss position as presented below. The components of the carrying value of our Agency Securities as of December 31, 2011 are also presented below.
December 31, 2011 Fannie Mae Freddie Mac Ginnie Mae Total Agency Securities (dollars in thousands) Principal Amount Net unamortized premium Amortized cost Unrealized gains Unrealized losses ) ) ) ) Fair value $ 3,451,906 $ 1,283,848 $ 392,476 $ 5,128,230 144,337 54,059 18,301 216,697 3,596,243 1,337,907 410,777 5,344,927 33,558 13,657 5,439 52,654 (3,269 (613 (24 (3,906 $ 3,626,532 $ 1,350,951 $ 416,192 $ 5,393,675
ARMOUR Residential REIT, Inc. and Subsidiary
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
December 31, 2011 Adjustable Rate Fixed Rate Total Agency Securities (dollars in thousands) Principal Amount Net unamortized premium Amortized cost Unrealized gains Unrealized losses ) ) ) Fair value $ 2,681,911 $ 2,446,319 $ 5,128,230 107,641 109,056 216,697 2,789,552 2,555,375 5,344,927 26,157 26,497 52,654 (2,534 (1,372 (3,906 $ 2,813,175 $ 2,580,500 $ 5,393,675
Actual maturities of Agency Securities are generally shorter than stated contractual maturities because actual maturities of Agency Securities are affected by the contractual lives of the underlying mortgages, periodic payments of principal and prepayments of principal.
The following table summarizes the weighted average livestables provide a summary of our Agency Securitiesassets and liabilities that are measured at fair value on a recurring basis as of September 30, 20122013 and December 31, 2011.2012.
Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) | Balance at September 30, 2013 | |||||||||||||
(in thousands) | ||||||||||||||||
Assets at Fair Value: | ||||||||||||||||
Agency Securities, available for sale | $ | - | $ | 16,664,917 | $ | - | $ | 16,664,917 | ||||||||
Derivatives | $ | - | $ | 390,685 | $ | - | $ | 390,685 | ||||||||
Liabilities at Fair Value: | ||||||||||||||||
Derivatives | $ | 2,085 | $ | 107,932 | $ | - | $ | 110,017 |
September 30, 2012 December 31, 2011 (dollars in thousands) Weighted Average Life of all Agency Securities Fair Value Amortized Cost Fair Value Amortized Cost Less than one year Greater than one year and less than five years Greater than or equal to five years Total Agency Securities $ 11,083 $ 10,777 $ 179 $ 179 22,096,782 21,694,580 5,274,072 5,226,255 7,010 6,868 119,424 118,493 $ 22,114,875 $ 21,712,225 $ 5,393,675 $ 5,344,927
Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) | Balance at December 31, 2012 | |||||||||||||
(in thousands) | ||||||||||||||||
Assets at Fair Value: | ||||||||||||||||
Agency Securities, available for sale | $ | - | $ | 19,096,562 | $ | - | $ | 19,096,562 | ||||||||
Derivatives | $ | - | $ | 5,367 | $ | - | $ | 5,367 | ||||||||
Liabilities at Fair Value: | ||||||||||||||||
Derivatives | $ | 3,919 | $ | 186,621 | $ | - | $ | 190,540 |
We useThe following tables provide a third-party model to calculatesummary of the weighted average life of Agency Securities. Weighted average life is calculated based on expectations for estimated prepayments for the underlying mortgage loanscarrying values and fair values of our Agency Securities. These estimated prepayments are based on assumptions such as interest rates, currentfinancial assets and future home prices, housing policy and borrower incentives. The weighted average lives of the Agency Securitiesliabilities not carried at fair value but for which fair value is required to be disclosed as of September 30, 20122013 and December 31, 2011 in the table above are based upon market factors, assumptions, models and estimates from the third-party model and also incorporate management's judgment and experience. The actual weighted average lives of the Agency Securities could be longer or shorter than estimated.2012.
The following table presents the unrealized losses and estimated fair value of our Agency Securities by length of time that such securities have been in a continuous unrealized loss position as of September 30, 2012 and December 31, 2011.
At September 30, 2013 | Fair Value Measurements using: | |||||||||||||||||||
Carrying Value | Fair Value | Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) | ||||||||||||||||
(in thousands) | ||||||||||||||||||||
Financial Assets: | ||||||||||||||||||||
Cash and cash equivalents | $ | 496,480 | $ | 496,480 | $ | 496,480 | $ | - | $ | - | ||||||||||
Cash collateral posted | $ | 30,962 | $ | 30,962 | $ | - | $ | 30,962 | $ | - | ||||||||||
Principal payments receivable | $ | 256 | $ | 256 | $ | - | $ | 256 | $ | - | ||||||||||
Accrued interest receivable | $ | 45,985 | $ | 45,985 | $ | - | $ | 45,985 | $ | - | ||||||||||
Financial Liabilities: | ||||||||||||||||||||
Repurchase agreements | $ | 14,917,525 | $ | 14,917,525 | $ | - | $ | 14,917,525 | $ | - | ||||||||||
Cash collateral held | $ | 294,071 | $ | 294,071 | $ | - | $ | 294,071 | $ | - | ||||||||||
Payable for unsettled purchases | $ | 143,894 | $ | 143,894 | $ | - | $ | 143,894 | $ | - | ||||||||||
Accrued interest payable | $ | 7,816 | $ | 7,816 | $ | - | $ | 7,816 | $ | - |
Unrealized Loss Position For: (dollars in thousands) Less than 12 months 12 Months or More Total As of Fair Value Unrealized Losses Fair Value Unrealized Losses Fair Value Unrealized Losses September 30, 2012 ) ) ) December 31, 2011 ) ) ) $ 666,322 $ (1,257 $ 1,164 $ (10 $ 667,486 $ (1,267 1,173,098 (3,560 96,684 (346 1,269,782 (3,906
The decline in value of these securities is solely due to market conditions and not the credit quality of the assets. All of our Agency Securities are issued by the GSEs. The GSEs have a rating of AA+. The investments are not considered other than temporarily impaired because we currently have the ability and intent to hold the investments to maturity or for a period of time sufficient for a forecasted market price recovery up to or beyond the cost of the investments and we are not required to sell for regulatory or other reasons. Also, we are guaranteed payment of the principal amount of the securities by the GSEs that created them.
During the quarter and nine months ended September 30, 2012 we sold $1.6 billion and $1.9 billion of Agency Securities resulting in a realized gain of $15.1 million and $20.1 million, respectively. Of the $20.1 million $1.1 million is a loss due to the bankruptcy of a counterparty to a repurchase agreement. In addition, due to the bankruptcy we also recorded $1.0 million of other income resulting from the non-performance of the counterparty on the related repurchase agreement. During the quarter and nine months ended September 30, 2011 we sold $0.5 billion of Agency Securities resulting in a realized gain of $6.4 million.
ARMOUR Residential REIT, Inc. and Subsidiary
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
At December 31, 2012 | Fair Value Measurements using: | |||||||||||||||||||
Carrying Value | Fair Value | Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) | ||||||||||||||||
(in thousands) | ||||||||||||||||||||
Financial Assets: | ||||||||||||||||||||
Cash and cash equivalents | $ | 771,282 | $ | 771,282 | $ | 771,282 | $ | - | $ | - | ||||||||||
Cash collateral posted | $ | 265,552 | $ | 265,552 | $ | - | $ | 265,552 | $ | - | ||||||||||
Receivable for unsettled sales | $ | 668,244 | $ | 668,244 | $ | - | $ | 668,244 | $ | - | ||||||||||
Principal payments receivable | $ | 16,037 | $ | 16,037 | $ | - | $ | 16,037 | $ | - | ||||||||||
Accrued interest receivable | $ | 55,430 | $ | 55,430 | $ | - | $ | 55,430 | $ | - | ||||||||||
Financial Liabilities: | ||||||||||||||||||||
Repurchase agreements | $ | 18,366,095 | $ | 18,366,095 | $ | - | $ | 18,366,095 | $ | - | ||||||||||
Accrued interest payable | $ | 10,064 | $ | 10,064 | $ | - | $ | 10,064 | $ | - |
Note 6 - Fair Value of Financial Instruments
Our valuation techniques for financial instruments are based on observable and unobservable inputs. Observable inputs reflect readily obtainable data from third-party sources, while unobservable inputs reflect management's market assumptions. The ASC Topic No. 820“Fair Value Measurement” classifies these inputs into the following hierarchy:
Level 1Inputs- Quoted prices for identical instruments in active markets.
Level 2Inputs- Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.
Level 3Inputs- Instruments with primarily unobservable value drivers.
The following describes the valuation methodologies used for our assets and liabilities measured at fair value, as well as the general classification of such instruments pursuant to the valuation hierarchy.
Cash and restricted cash -Cash includes cash on deposit with financial institutions and investments in high quality overnight money market funds, all of which have maturities of three months or less, at the time of purchase. The carrying amount of cash is deemed to be its fair value. Restricted cash includes cash held by counterparties as collateral. Our cash balances are classified as Level 1 and our restricted cash balances are classified as Level 2.
– Agency Securities, Available for Sale - Fair value for the
All of our Agency Securities in our portfolio is based on obtaining a valuation for each Agency Security from third-party pricing services and dealer quotes. The third-party pricing services use common market pricing methods that may include pricing models that may incorporate such factors as coupons, prepayment speeds, spread to the Treasury curves and interest rate swap curves, duration, periodic and life caps and credit enhancement. If the fair value of a security is not available from the third-party pricing services or such data appears unreliable, we obtain valuations from up to three dealers who make markets in similar financial instruments. In general, the dealers incorporate common market pricing methods, including a spread measurement to the Treasury curve or interest rate swap curve as well as underlying characteristics of the particular security including coupon, periodic and life caps, collateral type, rate reset period and seasoning or age of the security. Management reviews pricing used to ensure that current market conditions are properly represented. This review includes, but is not limited to, comparisons of similar market transactions or alternative third-party pricing services, dealer quotes and comparisons to a pricing model. Values obtained from the third-party pricing services for similar instruments are classified as Level 2 securities if the pricing methods usedavailable for sale and, as such, are consistent with the Level 2 definition. If quoted prices for a security are not reasonably available from the pricing service, but dealer quotes are, the security will be classified as a Level 2 security. If neither is available, management will determine thereported at their estimated fair value based on characteristicsvalue. As of the security that we receive from the issuer and based on available market information received from dealers and classify it as a Level 3 security. At September 30, 20122013 and December 31, 2011, all2012, investments in Agency Securities accounted for 100% of our securities portfolio.
As of September 30, 2013, we had the following securities in an unrealized gain or loss position as presented below. The components of the carrying value of our Agency Security values were based solely on third-party sources and therefore were classified as Level 2.
Repurchase Agreements -The fair value of repurchase agreements reflects the present value of the contractual cash flows discounted at the estimated LIBOR based market interest rates at the valuation date for repurchase agreements with a term equivalent to the remaining term to interest rate repricing, which may be at maturity, of our repurchase agreements. The fair value of the repurchase agreements approximates their carrying amount due to the short-term nature of these financial instruments. Our repurchase agreements are classified as Level 1.
Derivative Transactions - The fair values of our Futures Contracts are based on closing prices on the Chicago Mercantile Exchange (“CME”). The fair values of our interest rate swap contracts and interest rate swaptions are valued using third-party pricing services that incorporates common market pricing methods that may include current interest rate curves, forward interest rate curves and market spreads to interest rate curves. Management compares pricing used to dealer quotes to ensure that the current market conditions are properly represented. Our Futures Contracts are classified as Level 1 and the fair values of our interest rate swap contracts and our interest rate swaptions are classified as Level 2.
ARMOUR Residential REIT, Inc. and Subsidiary
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
The following tables provide a summary of our assets and liabilities that are measured at fair value on a recurring basisSecurities as of September 30, 2012 and December 31, 2011. 2013 are also presented below.
September 30, 2013 | Fannie Mae | Freddie Mac | Ginnie Mae | Total Agency Securities | ||||||||||||
(in thousands) | ||||||||||||||||
Principal amount | $ | 11,696,494 | $ | 4,548,910 | $ | 178,783 | $ | 16,424,187 | ||||||||
Net unamortized premium | 582,561 | 240,297 | 8,726 | 831,584 | ||||||||||||
Amortized cost | 12,279,055 | 4,789,207 | 187,509 | 17,255,771 | ||||||||||||
Unrealized gains | 18,018 | 5,862 | 1,449 | 25,329 | ||||||||||||
Unrealized losses | (485,877 | ) | (130,242 | ) | (64 | ) | (616,183 | ) | ||||||||
Fair value | $ | 11,811,196 | $ | 4,664,827 | $ | 188,894 | $ | 16,664,917 |
Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) Balance at September 30, 2012 Assets at Fair Value: Agency Securities, available for sale Derivatives, at fair value Liabilities at Fair Value: Derivatives, at fair value(dollars in thousands) $ - $ 22,114,875 $ - $ 22,114,875 $ - $ 8,069 $ - $ 8,069 $ 4,656 $ 193,742 $ - $ 198,398
Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) Balance at December 31, 2011 Assets at Fair Value: Agency Securities, available for sale Liabilities at Fair Value: Derivatives, at fair value(dollars in thousands) $ - $ 5,393,675 $ - $ 5,393,675 $ 5,292 $ 116,435 $ - $ 121,727
September 30, 2013 | Adjustable and Hybrid Adjustable Rate | Fixed Rate | Total Agency Securities | |||||||||
(in thousands) | ||||||||||||
Principal amount | $ | 257,609 | $ | 16,166,578 | $ | 16,424,187 | ||||||
Net unamortized premium | 12,155 | 819,429 | 831,584 | |||||||||
Amortized cost | 269,764 | 16,986,007 | 17,255,771 | |||||||||
Unrealized gains | 3,164 | 22,165 | 25,329 | |||||||||
Unrealized losses | (136 | ) | (616,047 | ) | (616,183 | ) | ||||||
Fair value | $ | 272,792 | $ | 16,392,125 | $ | 16,664,917 |
The followingWe apply trade date accounting. Included in the above tables provide a summaryare unsettled purchases with an aggregate cost of the carrying values$126.0 million and estimated fair valuesvalue of our financial assets and liabilities as of$126.8 million at September 30, 2012 and December 31, 2011.
At September 30, 2012 Fair Value Measurements using: Carrying Value Fair Value Quoted Prices in Active Markets for Identical Assets (Level 1) Significant Observable Inputs (Level 2) Significant Unobservable Inputs (Level 3) (dollars in thousands) Financial Assets: Cash Restricted Cash Receivable for unsettled securities Principal payments receivable Accrued interest receivable Financial Liabilities: Repurchase agreements Payable for unsettled securities Accrued interest payable $ 727,306 $ 727,306 $ 727,306 $ - $ - 237,789 237,789 - 237,789 - 357,218 357,218 - 357,218 - 10,799 10,799 - 10,799 - 60,548 60,548 - 60,548 - $ 19,826,988 $ 19,826,988 $ - $ 19,826,988 $ - 1,036,450 1,036,450 - 1,036,450 - 9,302 9,302 - 9,302 -
2013.
ARMOUR Residential REIT, Inc. and Subsidiary
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
As of December 31, 2012, we had the following securities in an unrealized gain or loss position as presented below. The components of the carrying value of our Agency Securities as of December 31, 2012 are also presented below.
December 31, 2012 | Fannie Mae | Freddie Mac | Ginnie Mae | Total Agency Securities | ||||||||||||
(in thousands) | ||||||||||||||||
Principal amount | $ | 12,328,493 | $ | 5,305,071 | $ | 292,434 | $ | 17,925,998 | ||||||||
Net unamortized premium | 641,833 | 284,739 | 13,428 | 940,000 | ||||||||||||
Amortized cost | 12,970,326 | 5,589,810 | 305,862 | 18,865,998 | ||||||||||||
Unrealized gains | 169,227 | 66,904 | 6,466 | 242,597 | ||||||||||||
Unrealized losses | (9,815 | ) | (2,170 | ) | (48 | ) | (12,033 | ) | ||||||||
Fair value | $ | 13,129,738 | $ | 5,654,544 | $ | 312,280 | $ | 19,096,562 |
December 31, 2012 | Adjustable and Hybrid Adjustable Rate | Fixed Rate | Total Agency Securities | |||||||||
(in thousands) | ||||||||||||
Principal amount | $ | 2,037,778 | $ | 15,888,220 | $ | 17,925,998 | ||||||
Net unamortized premium | 84,255 | 855,745 | 940,000 | |||||||||
Amortized cost | 2,122,033 | 16,743,965 | 18,865,998 | |||||||||
Unrealized gains | 36,758 | 205,839 | 242,597 | |||||||||
Unrealized losses | (222 | ) | (11,811 | ) | (12,033 | ) | ||||||
Fair value | $ | 2,158,569 | $ | 16,937,993 | $ | 19,096,562 |
We apply trade date accounting. We did not have unsettled purchases at December 31, 2012.
Actual maturities of Agency Securities are generally shorter than stated contractual maturities because actual maturities of Agency Securities are affected by the contractual lives of the underlying mortgages, periodic payments of principal and prepayments of principal.
The following table summarizes the weighted average lives of our Agency Securities as of September 30, 2013 and December 31, 2012.
September 30, 2013 | December 31, 2012 | |||||||||||||||
(in thousands) | ||||||||||||||||
Weighted Average Life of all Agency Securities | Fair Value | Amortized Cost | Fair Value | Amortized Cost | ||||||||||||
Less than one year | $ | 4 | $ | 4 | $ | 2,647 | $ | 2,593 | ||||||||
Greater than or equal to one year and less than three years | 344,888 | 341,420 | 8,618,862 | 8,476,157 | ||||||||||||
Greater than or equal to three years and less than five years | 4,526,780 | 4,556,479 | 9,681,538 | 9,592,001 | ||||||||||||
Greater than or equal to five years | 11,793,245 | 12,357,868 | 793,515 | 795,247 | ||||||||||||
Total Agency Securities | $ | 16,664,917 | $ | 17,255,771 | $ | 19,096,562 | $ | 18,865,998 |
We use a third-party model to calculate the weighted average lives of our Agency Securities. Weighted average life is calculated based on expectations for estimated prepayments for the underlying mortgage loans of our Agency Securities. These estimated prepayments are based on assumptions such as interest rates, current and future home prices, housing policy and borrower incentives. The weighted average lives of our Agency Securities as of September 30, 2013 and December 31, 2012 in the table above are based upon market factors, assumptions, models and estimates from the third-party model and also incorporate management’s judgment and experience. The actual weighted average lives of our Agency Securities could be longer or shorter than estimated.
At December 31, 2011 | Fair Value Measurements using: | |||||||||||||||||||
Carrying Value | Fair Value | Quoted Prices in Active Markets for Identical Assets (Level 1) | Significant Observable Inputs (Level 2) | Significant Unobservable Inputs (Level 3) | ||||||||||||||||
(dollars in thousands) | ||||||||||||||||||||
Financial Assets: | ||||||||||||||||||||
Cash | $ | 252,372 | $ | 252,372 | $ | 252,372 | $ | - | $ | - | ||||||||||
Restricted Cash | 147,199 | 147,199 | - | 147,199 | - | |||||||||||||||
Receivable for unsettled securities | 382,931 | 382,931 | - | 382,931 | - | |||||||||||||||
Principal payments receivable | 12,493 | 12,493 | - | 12,493 | - | |||||||||||||||
Accrued interest receivable | 18,637 | 18,637 | - | 18,637 | - | |||||||||||||||
Financial Liabilities: | ||||||||||||||||||||
Repurchase agreements | $ | 5,335,962 | $ | 5,335,962 | $ | - | $ | 5,335,962 | $ | - | ||||||||||
Payable for unsettled securities | 117,885 | 117,885 | - | 117,885 | - | |||||||||||||||
Accrued interest payable | 2,154 | 2,154 | - | 2,154 | - |
ARMOUR Residential REIT, Inc. and Subsidiary
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
The following table presents the unrealized losses and estimated fair value of our Agency Securities by length of time that such securities have been in a continuous unrealized loss position as of September 30, 2013 and December 31, 2012.
Unrealized Loss Position For: (in thousands) | ||||||||||||||||||||||||
Less than 12 Months | 12 Months or More | Total | ||||||||||||||||||||||
As of | Fair Value | Unrealized Losses | Fair Value | Unrealized Losses | Fair Value | Unrealized Losses | ||||||||||||||||||
September 30, 2013 | $ | 13,726,984 | $ | (588,648 | ) | $ | 340,219 | $ | (27,535 | ) | $ | 14,067,203 | $ | (616,183 | ) | |||||||||
December 31, 2012 | $ | 1,521,052 | $ | (12,030 | ) | $ | 836 | $ | (3 | ) | $ | 1,521,888 | $ | (12,033 | ) |
We evaluated our Agency Securities with unrealized losses and determined that there was no other than temporary impairments as of September 30, 2013 or December 31, 2012. As of those dates, we did not intend to sell Agency Securities and believed it was more likely than not that we could meet our liquidity requirements and contractual obligations without selling Agency Securities. The decline in value of these Agency Securities is solely due to market conditions and not the credit quality of the assets. All of our Agency Securities are issued and guaranteed by the GSEs. The GSEs have a rating of AA+.
During the quarter and nine months ended September 30, 2013, we sold $6.0 billion and $11.0 billion of Agency Securities resulting in realized losses of $301.0 million and $261.6 million, respectively. During the quarter and nine months ended September 30, 2012, we sold $1.6 billion and $1.9 billion of Agency Securities resulting in realized gains of $15.1 million and $20.1 million, respectively. Of the $20.1 million gain, $1.1 million is due to the bankruptcy of a counterparty to a repurchase agreement. In addition, due to the bankruptcy we also recorded $1.0 million of other income resulting from the non-performance of the counterparty on the related repurchase agreement.
Note 7 -– Repurchase Agreements
The following table represents the contractual repricing regarding our repurchase agreements to finance Agency Security purchases as of September 30, 20122013 and December 31, 2011.2012.
September 30, 2013 | December 31, 2012 | |||||||
(in thousands) | ||||||||
Within 30 days | $ | 4,561,783 | $ | 7,771,444 | ||||
31 days to 60 days | 8,641,962 | 7,840,268 | ||||||
61 days to 90 days | 1,713,780 | 2,699,706 | ||||||
Greater than 90 days | - | 54,677 | ||||||
Total | $ | 14,917,525 | $ | 18,366,095 |
September 30, 2012 December 31, 2011 (dollars in thousands) Within 30 days 31 days to 60 days 61 days to 90 days Greater than 90 days Total $ 9,925,408 $ 4,068,197 5,679,332 1,111,480 2,933,517 156,285 1,288,731 - $ 19,826,988 $ 5,335,962
The following table represents the Master Repurchase Agreements (“MRAs”) and other information regarding our repurchase agreements to finance Agency Security purchases as of September 30, 20122013 and December 31, 2011.2012.
September 30, 2013 | December 31, 2012 | |||||||
Number of MRAs | 34 | 33 | ||||||
Number of counterparties with repurchase agreements outstanding | 26 | 26 | ||||||
Weighted average maturity in days | 39 | 34 | ||||||
Weighted average contractual rate | 0.40 | % | 0.49 | % | ||||
Haircut for repurchase agreements (1) | 5.0 | % | 4.8 | % |
September 30, 2012 December 31, 2011 (dollars in thousands) Number of MRA's Number of counterparties with repurchase agreements outstanding Weighted average maturity in days Weighted average contractual rate % % Haircut for repurchase agreements(1) % % 32 29 26 23 39 18 0.43 0.37 4.8 5.0
(1) |
|
ARMOUR Residential REIT, Inc. and Subsidiary
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
For the nine months ended September 30, 2013, we sold short $2.8 billion of U.S Treasury Securities acquired under reverse repurchase agreements. We had purchases of $1.8 billion and $2.8 billion, respectively, of U.S. Treasury Securities resulting in a gain of $35.3 million and $14.2 million, respectively, for the quarter and nine months ended September 30, 2013. During the quarter ended September 30, 2013 we did not sell any U.S. Treasury Securities. During the quarter and nine months ended September 30, 2012, we did not sell or purchase any U.S. Treasury Securities.
Note 8 -– Derivatives
We enter into transactions to manage our interest rate risk exposure. These transactions include entering into interest rate swap contracts and interest rate swaptions as well as purchasing or selling Futures Contracts. These transactions are designed to lock in funding costs for financing activitiesrepurchase agreements associated with our assets in such a way to help assure the realization of net interest margins. Such transactions are based on assumptions about prepayments which, if not realized, will cause transaction results to differ from expectations. Our derivative instrumentsderivatives are carried on our condensed consolidated balance sheets, as assets or as liabilities at their fair value. We do not designate our activitiesderivatives as cash flow hedges and as such, we recognize changes in the marketfair value of these transactionsderivatives through earnings. For the quarter and nine months ended September 30, 2012, we recognized unrealized losses of $31.5 million and $84.3 million, respectively related to our derivatives. For the quarter and nine months ended September 30, 2011, we recognized unrealized losses of $65.8 million and $91.9 million, respectively related to our derivatives.
We have agreements with our swap (including swaption) counterparties that provide for the posting of collateral based on the fair values of our interest rate swap contracts. Through this margin process, either we or our swap counterparty may be required to pledge cash or Agency Securities as collateral. Collateral requirements vary by counterparty and change over time based on the market value, notional amount and remaining term of the swap.contracts. Certain interest rate swap contracts provide for cross collateralization and cross default with repurchase agreements and other contracts with the same counterparty.
Interest rate swaptions generally provide us the option to enter into an interest rate swap agreement at a certain point of time in the future with a predetermined notional amount, stated term and stated rate of interest in the fixed leg and interest rate index on the floating leg.
Our Futures Contracts are traded on the CME which requires the use of daily mark-to-market collateral and the CME provides substantial credit support. The collateral requirements of the CME require us to pledge assets under a bi-lateral margin arrangement, including either cash or Agency Securities and these requirements may vary and change over time based on the market value, notional amount and remaining term of the Futures Contracts. In the event we are unable to meet a margin call under one of our Futures Contracts, the counterparty to such agreement may have the option to terminate or close-out all of the outstanding Futures Contracts with us. In addition, any close-out amount due to the counterparty upon termination of the counterparty'scounterparty’s transactions would be immediately payable by us pursuant to the applicable agreement.
ARMOUR Residential REIT, Inc. and Subsidiary
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
The following table presentstables present information about interest rate swap contracts, interest rate swaptions and Futures Contracts which are included in derivatives on the accompanying condensed consolidated balance sheets as of September 30, 20122013 and December 31, 2011.2012.
September 30, 2012 December 31, 2011 (dollars in thousands) Notional Amount Net Fair Value (1) Notional Amount Net Fair Value (1) Interest rate swap contracts ) ) Interest rate swaptions Futures Contracts ) ) Totals ) )September 30, 2013 $ 8,690,000 $ (192,120 $ 2,765,000 $ (116,435 1,050,000 6,447 - - 121,000 (4,656 131,000 (5,292 $ 9,861,000 $ (190,329 $ 2,896,000 $ (121,727
Notional Amount | Assets at Fair Value (1) | Liabilities at Fair Value (1) | ||||||||||
(in thousands) | ||||||||||||
Interest rate swap contracts | $ | 11,770,000 | $ | 327,174 | $ | (107,932 | ) | |||||
Interest rate swaptions | 2,300,000 | 63,511 | - | |||||||||
Futures Contracts | 74,000 | - | (2,085 | ) | ||||||||
Totals | $ | 14,144,000 | $ | 390,685 | $ | (110,017 | ) |
(1) | See Note |
We apply trade date accounting. Included in the above tables are unsettled purchases of interest rate swaptions with an aggregate cost of $16.6 million and estimated fair value of $15.3 million at September 30, 2013. Also included in payable for unsettled purchases on our condensed consolidated balance sheets is a payable for accrued interest on unsettled interest rate swap contracts sales of $1.3 million.
ARMOUR Residential REIT, Inc. and Subsidiary
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
December 31, 2012
Notional Amount | Assets at Fair Value (1) | Liabilities at Fair Value (1) | ||||||||||
(in thousands) | ||||||||||||
Interest rate swap contracts | $ | 8,670,000 | $ | 1,718 | $ | (186,621 | ) | |||||
Interest rate swaptions | 1,050,000 | 3,649 | - | |||||||||
Futures Contracts | 102,000 | - | (3,919 | ) | ||||||||
Totals | $ | 9,822,000 | $ | 5,367 | $ | (190,540 | ) |
(1) | See Note 5,“Fair Value of Financial Instruments” for additional discussion. |
We apply trade date accounting. We did not have unsettled purchases or sales at December 31, 2012.
The following tables present information about interest rate swap contracts, interest rate swaptions and Futures Contracts and the potential effects of netting if we were to offset the assets and liabilities of these financial instruments on the accompanying condensed consolidated balance sheets. Currently we present these financial instruments at their gross amounts and they are included in derivatives, at fair value on the accompanying condensed consolidated balance sheets as of September 30, 2013.
September 30, 2013
Gross Amounts Not Offset in the Condensed Consolidated Balance Sheet | ||||||||||||||||
Assets | Gross Amounts of Assets Presented in the Condensed Consolidated Balance Sheet | Financial Instruments | Cash Collateral Held (1) | Net Amount | ||||||||||||
(in thousands) | ||||||||||||||||
Interest rate swap contracts | $ | 327,174 | $ | (107,932 | ) | $ | (204,651 | ) | $ | 14,591 | ||||||
Interest rate swaptions | 63,511 | - | - | 63,511 | ||||||||||||
Totals | $ | 390,685 | $ | (107,932 | ) | $ | (204,651 | ) | $ | 78,102 |
(1) | This is net of $28,144 of cash collateral posted and $232,795 of cash collateral held. |
Gross Amounts Not Offset in the Condensed Consolidated Balance Sheet | ||||||||||||||||
Liabilities | Gross Amounts of Liabilities Presented in the Condensed Consolidated Balance Sheet | Financial Instruments | Cash Collateral Posted | Net Amount | ||||||||||||
(in thousands) | ||||||||||||||||
Interest rate swap contracts | $ | (107,932 | ) | $ | 107,932 | $ | - | $ | - | |||||||
Futures Contracts | (2,085 | ) | - | 2,200 | 115 | |||||||||||
Totals | $ | (110,017 | ) | $ | 107,932 | $ | 2,200 | $ | 115 |
ARMOUR Residential REIT, Inc. and Subsidiary
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
The following tables present information about interest rate swap contracts, interest rate swaptions and Futures Contracts and the potential effects of netting if we were to offset the assets and liabilities of these financial instruments on the accompanying condensed consolidated balance sheets. Currently we present these financial instruments at their gross amounts and they are included in derivatives, at fair value on the accompanying condensed consolidated balance sheets as of December 31, 2012.
December 31, 2012
Gross Amounts Not Offset in the Condensed Consolidated Balance Sheet | ||||||||||||||||
Assets | Gross Amounts of Assets Presented in the Condensed Consolidated Balance Sheet | Financial Instruments | Cash Collateral Held | Net Amount | ||||||||||||
(in thousands) | ||||||||||||||||
Interest rate swap contracts | $ | 1,718 | $ | (1,718 | ) | $ | - | $ | - | |||||||
Swaptions | 3,649 | - | - | 3,649 | ||||||||||||
Totals | $ | 5,367 | $ | (1,718 | ) | $ | - | $ | 3,649 |
Gross Amounts Not Offset in the Condensed Consolidated Balance Sheet | ||||||||||||||||
Liabilities | Gross Amounts of Liabilities Presented in the Condensed Consolidated Balance Sheet | Financial Instruments | Cash Collateral Posted | Net Amount | ||||||||||||
(in thousands) | ||||||||||||||||
Interest rate swap contracts | $ | (186,621 | ) | $ | 1,718 | $ | 261,364 | $ | 76,461 | |||||||
Futures Contracts | (3,919 | ) | - | 4,188 | 269 | |||||||||||
Totals | $ | (190,540 | ) | $ | 1,718 | $ | 265,552 | $ | 76,730 |
ARMOUR Residential REIT, Inc. and Subsidiary
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
The following table represents the location and information regarding our derivatives which are included in total other lossOther Income (Loss) in the accompanying condensed consolidated statements of operations for the quarters and nine months ended September 30, 20122013 and September 30, 2011.2012.
Loss Recognized in Income (dollars in thousands) For the Quarters Ended For the Nine Months Ended Derivatives Location on condensed consolidated statements of operations September 30, 2012 September 30, 2011 September 30, 2012 September 30, 2011 Interest rate swap contracts: Interest income Realized loss on derivatives Interest expense Realized loss on derivatives ) ) ) ) Realized (loss) Realized loss on derivatives ) Changes in fair value Unrealized loss on derivatives ) ) ) ) ) ) ) ) Interest rate swaptions: Changes in fair value Unrealized loss on derivatives ) ) ) ) Futures Contracts: Realized (loss) Realized loss on derivatives ) ) ) ) Changes in fair value Unrealized loss on derivatives ) ) ) ) ) ) Totals ) ) ) ) $ 2,562 $ 415 $ 5,421 $ 983 (20,832 (8,213 (44,779 (16,343 - (256 - (239 ) (25,153 (64,581 (66,831 (88,742 (43,423 (72,635 (106,189 (104,341 (6,593 - (18,070 - (6,593 - (18,070 - (644 (366 (1,697 (826 260 (1,228 636 (3,149 (384 (1,594 (1,061 (3,975 $ (50,400 $ (74,229 $ (125,320 $ (108,316
Note 9 - Share-Based Compensation
We adopted the 2009 Stock Incentive Plan (the "Plan") to attract, retain and reward directors, officers and other employees of ours and other persons who provide services to us in the course of operations. The Plan authorizes the Board to grant awards including common stock, restricted shares of common stock (“RSUs”), stock options, performance shares, performance units, stock appreciation rights and other equity and cash-based awards (collectively “Awards”), subject to terms as provided in the Plan.
On May 12, 2010, the Board allocated up to 250,000 shares to be available under the Plan. In considering such allocation, the Board considered the size of the Plan relative to our capital base and our current and potential future performance and capitalization. On July 18, 2011, our stockholders approved an amendment to the Plan to increase the number of shares issuable thereunder from 250,000 shares to 2,000,000 shares and the Plan was amended accordingly. During the nine months ended September 30, 2012, we awarded a total of 655,524 RSUs to members of our Board and employees of ARRM.
ARMOUR Residential REIT, Inc. and Subsidiary
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
RSU transactions for the nine months ended September 30, 2012 and September 30, 2011 are summarized below:
September 30, 2012 September 30, 2011 Number of Awards Weighted Average Grant Date Fair Value per Award Number of Awards Weighted Average Grant Date Fair Value per Award Unvested Awards Outstanding beginning of period Granted Vested ) ) Unvested Awards Outstanding end of period 153,980 $ 7.91 - - 655,524 7.13 192,500 7.91 (138,730 7.29 (28,890 7.91 670,774 $ 7.28 163,610 $ 7.91
As of September 30, 2012, there was approximately $5.3 million of unearned non-cash stock-based compensation related to the Awards (based on the September 30, 2012 stock price), that we expect to recognize as an expense over the remaining average service period of 3.7 years.
Note 10 - Stockholders' Equity
Dividends
The following tables present our common stock dividend transactions for the nine months ended September 30, 2012 and September 30, 2011.
September 30, 2012
Record Date Payment Date Rate per common share Aggregate amount paid to holders of record (in millions) January 15, 2012(1) January 30, 2012 February 15, 2012 February 28, 2012 March 15, 2012 March 29, 2012 April 16, 2012 April 27, 2012 May 15, 2012 May 30, 2012 June 15, 2012 June 28, 2012 July 16, 2012 July 30, 2012 August 15, 2012 August 30, 2012 September 14, 2012 September 27, 2012 $ 0.11 $ 11.6 0.11 15.3 0.11 19.9 0.10 17.8 0.10 18.1 0.10 18.6 0.10 23.5 0.10 30.0 0.10 31.0
(1) This amount included $0.006 per common share of taxable income related to the year ended December 31, 2011.
September 30, 2011
Record Date Payment Date Rate per common share Aggregate amount paid to holders of record (in millions) January 15, 2011(1) January 28, 2011 February 15, 2011 February 25, 2011 March 15, 2011 March 30, 2011 April 15, 2011 April 28, 2011 May 15, 2011 May 27, 2011 June 15, 2011 June 29, 2011 July 15, 2011 July 28, 2011 August 15, 2011 August 30, 2011 September 15, 2011 September 29, 2011 $ 0.12 $ 2.0 0.12 3.9 0.12 3.9 0.12 5.9 0.12 5.9 0.12 8.3 0.12 9.1 0.12 9.1 0.12 10.1
(1) This amount included $0.02 per common share of taxable income related to the year ended December 31, 2010.
ARMOUR Residential REIT, Inc. and Subsidiary
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
The following table presents our Series A Preferred Stock dividend transactions for the nine months ended September 30, 2012. There were no Series A Preferred Stock dividend transactions for the nine months ended September 30, 2011.
September 30, 2012
Record Date Payment Date Rate per Series A Preferred share Aggregate amount paid to holders of record (in millions) July 13, 2012(1) July 27, 2012 August 15, 2012 August 27, 2012 September 14, 2012 September 27, 2012 $ 0.286500 $ 0.4 0.171875 0.3 0.171875 0.3
(1) This amount included $0.2 million paid to holders of record on July 13, 2012 for the period of June 7, 2012 through June 30, 2012.
Equity Capital Raising Activities
The following tables present our equity transactions for the nine months ended September 30, 2012 and September 30, 2011.
September 30, 2012
Transaction Type Completion Date Number of Shares Per Share price Net Proceeds (in millions) Follow-on public offering January 13, 2012 Follow-on public offering February 8, 2012 Equity distribution agreement February 29, 2012 Follow-on public offering March 14, 2012 Issuance of Series A Preferred Stock June 7, 2012 Follow-on public offering July 13, 2012 Follow-on public offering August 8, 2012 Common equity distributionagreements January 1, 2012 to September 30, 2012 Preferred equity distributionagreements January 1, 2012 to September 30, 2012 Dividend Reinvestment andStock Purchase Plan January 1, 2012 to September 30, 2012 10,350,000 $ 6.80 $ 70.1 29,900,000 6.80 203.0 1,287,570 7.06 8.9 35,650,000 6.72 239.2 1,400,000 25.00 33.8 46,000,000 7.06 324.5 63,250,000 7.30 461.4 19,750,000 7.14 (1) 138.2 385,000 25.56 (1) 9.5 7,273,020 7.28 (1) 52.9
(1)Weighted average price
September 30, 2011
Transaction Type Completion Date Number of Shares Per Share price Net Proceeds (in millions) Follow-on public offering January 26, 2011 Follow-on public offering February 8, 2011 Equity distribution agreement February 28, 2011 to September 30, 2011 Follow-on public offering April 13, 2011 Follow-on public offering June 6, 2011 Dividend Reinvestment andStock Purchase Plan April 7, 2011 to September 30, 2011 6,900,000 $ 7.55 $ 49.0 8,912,500 7.60 64.0 5,212,430 7.39 (1) 37.5 17,000,000 7.40 121.1 18,400,000 7.40 131.0 11,879,844 7.30 (1) 86.8
(1) Weighted average price
ARMOUR Residential REIT, Inc. and Subsidiary
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 11 – Income per Common Share
The following table presents a reconciliation of the net income (loss) and the shares used in calculating basic and diluted earnings per share for the quarters and nine months ended September 30, 2012 and September 30, 2011.
For the Quarters Ended For the Nine Months Ended September 30, 2012 September 30, 2011 September 30, 2012 September 30, 2011 Net Income (Loss) ) ) Less: Preferred dividends ) ) Net Income (Loss) available (related) to common stockholders ) ) Weighted average common shares outstanding - basic Add: Effect of dilutive non-vested restricted stock awards, assumed vested Weighted average common shares outstanding - diluted $ 54,942 $ (34,472 $ 106,561 $ (33,149 (804 - (964 - $ 54,138 $ (34,472 $ 105,597 $ (33,149 269,325 78,360 195,272 52,863 685 - 1,015 - 270,010 78,360 196,287 52,863
32,500,000 warrants were outstanding and considered anti-dilutive as their exercise price exceeded the average stock price for the quarters and nine months ended September 30, 2012 and September 30, 2011.
Note 12 – Income Taxes
We intend to currently distribute all of our REIT taxable income. Accordingly, there is no provision required for ARMOUR's reported GAAP earnings.
We have elected to treat Enterprise as a taxable REIT subsidiary, which is a tax paying entity for income tax purposes and it is taxed separately from ARMOUR. Because Enterprise is inactive, its taxes are nominal.
Income (Loss) Recognized (in thousands) | ||||||||||||||||||
For the Quarters Ended | For the Nine Months Ended | |||||||||||||||||
Derivatives | Location on condensed consolidated statements of operations | September 30, 2013 | September 30, 2012 | September 30, 2013 | September 30, 2012 | |||||||||||||
Interest rate swap contracts: | ||||||||||||||||||
Realized gain | Realized loss on derivatives | $ | 380 | $ | - | $ | 380 | $ | - | |||||||||
Interest income | Realized loss on derivatives | 4,306 | 2,562 | 13,464 | 5,421 | |||||||||||||
Interest expense | Realized loss on derivatives | (43,725 | ) | (20,832 | ) | (119,456 | ) | (44,779 | ) | |||||||||
Changes in fair value | Unrealized gain (loss) on derivatives | (5,257 | ) | (25,153 | ) | 395,237 | (66,831 | ) | ||||||||||
(44,296 | ) | (43,423 | ) | 289,625 | (106,189 | ) | ||||||||||||
Interest rate swaptions: | ||||||||||||||||||
Realized gain | Realized loss on derivatives | 2,353 | - | 2,353 | - | |||||||||||||
Changes in fair value | Unrealized gain (loss) on derivatives | (7,049 | ) | (6,593 | ) | 19,591 | (18,070 | ) | ||||||||||
(4,696 | ) | (6,593 | ) | 21,944 | (18,070 | ) | ||||||||||||
Futures Contracts: | ||||||||||||||||||
Realized loss | Realized loss on derivatives | (576 | ) | (644 | ) | (1,914 | ) | (1,697 | ) | |||||||||
Changes in fair value | Unrealized gain (loss) on derivatives | 485 | 260 | 1,834 | 636 | |||||||||||||
(91 | ) | (384 | ) | (80 | ) | (1,061 | ) | |||||||||||
Totals | $ | (49,083 | ) | $ | (50,400 | ) | $ | 311,489 | $ | (125,320 | ) |
Note 13 -9 – Commitments and Contingencies
Management Agreement with ARRM
As discussed in Note 14 “Related Party Transactions,” we are externally managed by ARRM pursuant to a management agreement, as most recently amended and restated on June 18, 2012 (the “2012 Management Agreement”). The 2012 Management Agreement entitles ARRM to receive a management fee payable monthly in arrears in an amount equal to 1/12th of 1% of gross equity raised until gross equity raised was $50 million. Thereafter,arrears. Currently, the monthly management fee would beis 1/12th of the sum of (a) 1.5% of gross equity raised up to $1 billion plus (b) 0.75% of gross equity raised in excess of $1 billion. We are also obligatedThe cost of repurchased stock reduces the amount of gross equity raised used to reimburse certain expenses incurred by ARRM and its affiliates. ARRM is further entitled to receive a terminationcalculate the monthly management fee. As of September 30, 2013, the effective management fee from us under certain circumstances.was 1.016% based on gross equity raised. The ARRM monthly management fee is not calculated based on the performance of our portfolio.assets. Accordingly, the payment of our monthly management fee may not decline in the event of a decline in our earnings and may cause us to incur losses. We are also obligated to reimburse certain expenses incurred by ARRM and its subsidiary. ARRM is further entitled to receive a termination fee from us under certain circumstances.
Indemnifications and Litigation
We enter into certain contracts that contain a variety of indemnifications, to third-parties, principally with ARRM and brokers. The maximum potential amount of future payments we could be requiredunderwriters, against third-party claims for errors and omissions in connection with their services to make under these indemnification provisions is unknown.us. We have not incurred any costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the estimated fair value of these agreements, as well as the maximum amount attributable to past events, is minimal. Accordingly, we have no liabilities recorded for these agreements as of September 30, 20122013 and December 31, 2011.2012.
We are not party to any pending, threatened or contemplated litigation.
ARMOUR Residential REIT, Inc. and Subsidiary
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 10 – Stock Based Compensation
We adopted the 2009 Stock Incentive Plan (the “Plan”) to attract, retain and reward directors and other persons who provide services to us in the course of operations. The Plan authorizes the Board to grant awards including common stock, restricted shares of common stock (“Restricted Shares”), stock options, performance shares, performance units, stock appreciation rights and other equity and cash-based awards (collectively “Awards”), subject to terms as provided in the Plan.
On May 12, 2010, the Board allocated up to 250,000 shares to be available under the Plan. In considering such allocation, the Board considered the size of the Plan relative to our capital base and our current and potential future performance and capitalization. On July 18, 2011, our stockholders approved an amendment to the Plan to increase the number of shares issuable thereunder from 250,000 shares to 2,000,000 shares and the Plan was amended accordingly. During the nine months ended September 30, 2013, we awarded a total of 1,278,195 Restricted Shares to ARRM for its employees. Of these awards, 150,208 shares vesting in 2017 were awarded subject to stockholder approval by June 30, 2017 of an increase to the number of shares issuable under the Plan.
RSU transactions for the nine months ended September 30, 2013 are summarized below:
September 30, 2013 | ||||||||
Number of Awards | Weighted Average Grant Date Fair Value per Award | |||||||
Unvested Awards Outstanding beginning of period | 628,367 | $ | 7.28 | |||||
Granted | 1,127,987 | $ | 6.78 | |||||
Vested | (318,692 | ) | $ | 7.16 | ||||
Forfeited | (2,490 | ) | $ | 7.69 | ||||
Unvested Awards Outstanding end of period | 1,435,172 | $ | 6.95 |
As of September 30, 2013, there was approximately $7.5 million of unvested non-cash stock based compensation related to the Awards (based on the September 30, 2013 stock price of $4.20 per share), that we expect to recognize as an expense over the remaining average service period of 3.1 years.
Note 11 – Stockholders’ Equity
Dividends
The following table presents our common stock dividend transactions for the nine months ended September 30, 2013.
Record Date | Payment Date | Rate per common share | Aggregate amount paid to holders of record (in millions) | |||||||
January 15, 2013 | January 30, 2013 | $ | 0.08 | $ | 24.8 | |||||
February 15, 2013 | February 27, 2013 | $ | 0.08 | $ | 24.8 | |||||
March 15, 2013 | March 27, 2013 | $ | 0.08 | $ | 30.2 | |||||
April 15, 2013 | April 29, 2013 | $ | 0.07 | $ | 26.3 | |||||
May 15, 2013 | May 30, 2013 | $ | 0.07 | $ | 26.3 | |||||
June 14, 2013 | June 27, 2013 | $ | 0.07 | $ | 26.1 | |||||
July 15, 2013 | July 30, 2013 | $ | 0.07 | $ | 26.1 | |||||
August 15, 2013 | August 29, 2013 | $ | 0.07 | $ | 26.1 | |||||
September 16, 2013 | September 27, 2013 | $ | 0.07 | $ | 26.1 |
ARMOUR Residential REIT, Inc. and Subsidiary
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
The following table presents our Series A Preferred Stock dividend transactions for the nine months ended September 30, 2013.
Record Date | Payment Date | Rate per Series A Preferred Share | Aggregate amount paid to holders of record (in millions) | |||||||
January 15, 2013 | January 28, 2013 | $ | 0.17 | $ | 0.3 | |||||
February 15, 2013 | February 26, 2013 | $ | 0.17 | $ | 0.4 | |||||
March 15, 2013 | March 26, 2013 | $ | 0.17 | $ | 0.4 | |||||
April 15, 2013 | April 29, 2013 | $ | 0.17 | $ | 0.4 | |||||
May 15, 2013 | May 27, 2013 | $ | 0.17 | $ | 0.4 | |||||
June 14, 2013 | June 27, 2013 | $ | 0.17 | $ | 0.4 | |||||
July 15, 2013 | July 29, 2013 | $ | 0.17 | $ | 0.4 | |||||
August 15, 2013 | August 27, 2013 | $ | 0.17 | $ | 0.4 | |||||
September 15, 2013 | September 27, 2013 | $ | 0.17 | $ | 0.4 |
The following table presents our Series B Preferred Stock dividend transactions for the nine months ended September 30, 2013.
Record Date | Payment Date | Rate per Series B Preferred Share | Aggregate amount paid to holders of record (in millions) | |||||||
March 15, 2013 | March 27, 2013 | $ | 0.25 | $ | 1.4 | |||||
April 15, 2013 | April 29, 2013 | $ | 0.16 | $ | 0.9 | |||||
May 15, 2013 | May 27, 2013 | $ | 0.16 | $ | 0.9 | |||||
June 14, 2013 | June 27, 2013 | $ | 0.16 | $ | 0.9 | |||||
July 15, 2013 | July 29, 2013 | $ | 0.16 | $ | 0.9 | |||||
August 15, 2013 | August 27, 2013 | $ | 0.16 | $ | 0.9 | |||||
September 15, 2013 | September 27, 2013 | $ | 0.16 | $ | 0.9 |
Equity Capital Raising Activities
The following table presents our equity transactions for the nine months ended September 30, 2013.
Transaction Type | Completion Date | Number of Shares | Per Share price | Net Proceeds (in millions) | ||||||||||
Series A Preferred equity distribution agreements | January 2, 2013 through January 30, 2013 | 174,961 | $ | 25.51 | (1) | $ | 4.4 | |||||||
Common stock dividend reinvestment program | January 25, 2013 through September 27, 2013 | 55,537 | $ | 4.98 | (1) | $ | 0.1 | |||||||
Series B Preferred initial offering | February 12, 2013 | 5,650,000 | $ | 25.00 | $ | 136.6 | ||||||||
Common stock follow-on public offering | February 20, 2013 | 65,000,000 | $ | 6.75 | $ | 438.4 |
(1) | Weighted average price |
ARMOUR Residential REIT, Inc. and Subsidiary
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Common Stock repurchases
During May 2013, we repurchased 3,395,603 shares of our outstanding common stock under the Repurchase Program at a weighted average price of $5.94 per share for an aggregate of $20.3 million.
Note 12 – Net Income (Loss) per Common Share
The following table presents a reconciliation of net income (loss) and the shares used in calculating weighted average basic and diluted earnings per common share for the quarters and nine months ended September 30, 2013 and September 30, 2012.
For the Quarters Ended | For the Nine Months Ended | |||||||||||||||
September 30, 2013 | September 30, 2012 | September 30, 2013 | September 30, 2012 | |||||||||||||
(in thousands) | ||||||||||||||||
Net Income (loss) | $ | (229,943 | ) | $ | 54,942 | $ | 353,732 | $ | 106,561 | |||||||
Less: Preferred dividends | (3,905 | ) | (804 | ) | (10,308 | ) | (964 | ) | ||||||||
Net income (loss) available (related) to common stockholders | $ | (233,848 | ) | $ | 54,138 | $ | 343,424 | $ | 105,597 | |||||||
Weighted average common shares outstanding – basic | 370,818 | 269,325 | 268,202 | 195,272 | ||||||||||||
Add: Effect of dilutive non-vested restricted stock unit awards, assumed vested | 1,438 | 685 | 1,434 | 1,015 | ||||||||||||
Weighted average common shares outstanding – diluted | 372,256 | 270,010 | 269,636 | 196,287 |
We have 32,500,000 warrants outstanding which are anti-dilutive as their exercise price exceeded the average stock price for the quarters and nine months ended September 30, 2013 and September 30, 2012.
Note 13 – Income Taxes
We have elected to be taxed as a REIT under the Code. We will generally not be subject to federal income tax to the extent that we distribute our taxable income to our stockholders and as long as we satisfy the ongoing REIT requirements under the Code including meeting certain asset, income and stock ownership tests.
The following table reconciles our GAAP net income to estimated REIT taxable income for the quarters and nine months ended September 30, 2013 and September 30, 2012.
For the Quarters Ended | For the Nine Months Ended | |||||||||||||||
September 30, 2013 | September 30, 2012 | September 30, 2013 | September 30, 2012 | |||||||||||||
(in thousands) | ||||||||||||||||
GAAP net income (loss) | $ | (229,943 | ) | $ | 54,942 | $ | 353,732 | $ | 106,561 | |||||||
Book to tax differences: | ||||||||||||||||
Unrealized (gain) loss on derivatives | 11,821 | 31,486 | (416,662 | ) | 84,265 | |||||||||||
Net capital losses | 225,676 | - | 247,393 | - | ||||||||||||
Amortization of deferred hedging costs | (1,611 | ) | - | (1,119 | ) | - | ||||||||||
Realized gain on derivatives | (2,157 | ) | - | (2,157 | ) | - | ||||||||||
Other | (7 | ) | 12 | 8 | 64 | |||||||||||
Estimated taxable income | $ | 3,779 | $ | 86,440 | $ | 181,195 | $ | 190,890 |
The aggregate tax basis of our assets and liabilities is greater than our total Stockholders’ Equity at September 30, 2013 by approximately $278.5 million, or approximately $0.75 per common share (based on the 370,905,142 common shares then outstanding).
ARMOUR Residential REIT, Inc. and Subsidiary
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
We are required and intend to timely distribute substantially all of our REIT taxable income in order to maintain our REIT status under the Code. Total dividend payments to stockholders were $82.2 million and $247.1 for the quarter and nine months ended September 30, 2013, respectively. Our estimated REIT taxable income available to pay dividends was $3.8 million and $181.2 million for the quarter and nine months ended September 30, 2013, respectively. We also carried forward from the year ended December 31, 2012, undistributed REIT taxable income of $10.4 million. Our REIT taxable income and dividend requirements are determined on an annual basis. Dividends in excess of REIT taxable income for the year (including taxable income carried forward from the previous year) will generally not be taxable to common stockholders.
We have elected to treat Enterprise as a taxable REIT subsidiary, which is a tax paying entity for income tax purposes and it is taxed separately from ARMOUR. Because Enterprise is inactive, its taxes are nominal.
Our management is responsible for determining whether tax positions taken by us are more likely than not to be sustained on their merits. We have no material unrecognized tax benefits or material uncertain tax positions.
Note 14 -– Related Party Transactions
We are externally managed by ARRM pursuant to the 2012 Management Agreement. All of our executive officers are also employees of ARRM. ARRM manages our day-to-day operations, subject to the direction and oversight of the Board. The 2012 Management Agreement expires after an initial term of 10ten years on June 18, 2022 and is thereafter automatically renewed for an additional five-year term unless terminated under certain circumstances. Either party must provide 180 days prior written notice of any such termination.
Under the terms of the 2012 Management Agreement, ARRM is responsible for costs incident to the performance of its duties, such as compensation of its employees and various overhead expenses. ARRM is responsible for the following primary roles:
● | Advising us with respect to, |
● | Evaluating the duration risk and prepayment risk within the investment portfolio and arranging borrowing and hedging |
● | Coordinating capital raising |
● | Advising us on the formulation and implementation of operating strategies and policies, arranging for the acquisition of assets, monitoring the performance of those assets and providing administrative and managerial services in connection with our day-to-day |
● | Providing executive and administrative personnel, office space and other appropriate services required in rendering management services to us. |
In accordance with the 2012 Management Agreement, we incurred $6.5 million and $21.0 million, respectively in management fees for the quarter and nine months ended September 30, 2013 The $6.5 million of management fee expense for the quarter ended September 30, 2013, reflects an adjustment to reclassify $0.7 million of expense as compensation related to Restricted Shares awarded to ARRM for its employees previously classified as management fees.For the quarter and nine months ended September 30, 2012, we incurred $5.6 million and $13.4 million in management fees, respectively.
We are required to take actions as may be reasonably required to permit and enable ARRM to carry out its duties and obligations. We are also responsible for any costs and expenses that ARRM incurred solely on behalf of ARMOUR or its subsidiary other tjhanthan the various overhead expenses specified in the terms of the 2012 Management Agreement.
For the quarter and nine months ended September 30, 2013, we reimbursed ARRM $0.4 million and $1.2 million, respectively, for other expenses incurred on our behalf. We also reimbursed $0.2 million and $0.9 of compensation expense during the quarter and nine months ended September 30, 2013, respectively related to Restricted Shares for ARRM employees (see Note 10,“Stock Based Compensation” for additional discussion). For the quarter and nine months ended September 30, 2012, we incurred $5.6 milliondid not reimburse ARRM for any expenses.
Pursuant to a Sub-Management Agreement between ARMOUR, ARRM and $13.4 millionStaton Bell Blank Check LLC (the “Sub-Manager”), ARRM is responsible for the monthly payment of a sub-management fee to the Sub-Manager in an amount equal to 25% of the monthly management feesfee earned by ARRM, net of expenses. On November 6, 2014, the Sub-Manager has the option of terminating the Sub-Management Agreement. If the Sub-Management Agreement is terminated, we would be required to make a final payment to the Sub-Manager in the amount of 6.16 times the annualized rate of the sub-management fee for the prior three months. Thereafter, we will be entitled to receive the sub-management fee or, at the option of ARRM, respectively. Forreimbursement of the quarter and ninefinal payment by ARRM. The payments from ARRM to the Sub-Manager for the three months endedpreceding September 30, 2011, we incurred $2.2 million2013 totaled $1.5 million.
ARMOUR Residential REIT, Inc. and $4.4 million in management fees to ARRM, respectively.Subsidiary
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
Note 15 -– Interest Rate Risk
Our primary market risk is interest rate risk. Interest rates are highly sensitive to many factors, including governmental monetary and tax policies, domestic and international economic and political considerations and other factors beyond our control. Changes in the general level of interest rates can affect net interest income, which is the difference between the interest income earned and the interest expense incurred in connection with the liabilities, by affecting the spread between the interest-earning assets and interest-bearing liabilities. Changes in the level of interest rates also can affect the value of Agency Securities and our ability to realize gains from the sale of these assets. A decline in the value of the Agency Securities pledged as collateral for borrowings under repurchase agreements could result in the counterparties demanding additional collateral pledges or liquidation of some of the existing collateral to reduce borrowing levels.
Note 16 – Subsequent Events
Events subsequent to the balance sheet date have been evaluated for inclusion in the accompanying financial statements through the issuance date.
On October 29, 2012,28, 2013, a cash dividend of $0.171875$0.17 per outstanding share of Series A Preferred Stock, or $0.3$0.4 million in the aggregate, was paid to holders of record on October 15, 2012.2013. We have also announced cash dividends of $0.171875$0.17 per outstanding share of Series A Preferred Stock payable November 27, 20122013 to holders of record on November 15, 20122013 and payable December 27, 20122013 to holders of record on December 14, 2012.15, 2013.
On October 30, 2012,28, 2013, a cash dividend of $0.09$0.16 per outstanding common share of Series B Preferred Stock, or $27.9$0.9 million in the aggregate, was paid to holders of record on October 15, 2012.2013. We have also announced an expected fourth quarter cash dividend ratedividends of $0.09$0.16 per outstanding common share.share of Series B Preferred Stock payable November 27, 2013 to holders of record on November 15, 2013 and payable December 27, 2013 to holders of record on December 15, 2013.
On October 30, 2012 our Board approved an amendment28, 2013, a cash dividend of $0.05 per outstanding common share, or $18.6 million in the aggregate, was paid to our charter to increase our authorized sharesholders of record on October 15, 2013. We have also announced cash dividends of $0.05 per outstanding share of common stock from 500,000,000 sharespayable November 27, 2013 to 1,000,000,000 sharesholders of record on November 15, 2013 and payable December 27, 2013 to increase our authorized sharesholders of preferred stock from 25,000,000 shares to 50,000,000 shares. Pursuant to Maryland corporate law and Section 6.1 of our charter, the amendment was approved by our Board and did not require any action by our stockholders. Our charter was amended effectivelyrecord on October 31, 2012 to increase our authorized shares of common stock from 500,000,000 shares to 1,000,000,000 shares and to increase our authorized shares of preferred stock from 25,000,000 shares to 50,000,000 shares.December 16, 2013.
Item 2. Management'sManagement’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion of our financial condition and results of operations should be read in conjunction with our financial statements and related notes included elsewhere in this report. In addition, reference should be made to our audited financial statements and notes thereto and related Management's Discussion and Analysis of Financial Condition and Results of Operations included in our most recent Annual Report on Form 10-K.
References to “we”, “us”, “our”,“we,” “us,” “our,” “ARMOUR” or the “Company” are to ARMOUR Residential REIT, Inc. References to “ARRM” are to ARMOUR Residential Management LLC, a Delaware limited liability company.
CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
This report contains various “forward-looking statements.” Forward-looking statements relate to expectations, beliefs, projections, future plans and strategies, anticipated events or trends and similar expressions concerning matters that are not historical facts. In some cases, you can identify forward-looking statements by the use of forward-looking terminology such as “believes,” “expects,” “may,” “will,” “would,” “could,” “should,” “seeks,” “approximately,” “intends,” “plans,” “projects,” “estimates” or “anticipates” or the negative of these words and phrases or similar words or phrases. All forward-looking statements may be impacted by a number of risks and uncertainties, including statements regarding the following subjects:
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The forward-looking statements in this report are based on our beliefs, assumptions and expectations of our future performance, taking into account all information currently available to us. These beliefs, assumptions and expectations are subject to risks and uncertainties and can change as a result of many possible events or factors, not all of which are known to us. If a change occurs, our business, financial condition, liquidity and results of operations may vary materially from those expressed in our forward-looking statements. You should carefully consider these risks before you make an investment decision with respect to our stock.
We cannot guarantee future results, levels of activity, performance or achievements. You should not place undue reliance on forward-looking statements, which apply only as of the date of this report. We do not intend and disclaim any duty or obligation to update or revise any industry information or forward-looking statements set forth in this report to reflect new information, future events or otherwise, except as required under the U.S. Federal securities laws.
Overview
We are a Maryland corporation formed to invest primarily in hybrid adjustable rate, adjustable rate and fixed rate residentialmanage a leveraged portfolio of mortgage backed securities (“RMBS”MBS”). These and mortgage loans. The securities we invest in are issued or guaranteed by a United States (“U.S.”) Government-sponsored entity (“GSE”), such as the Federal National Mortgage Association (Fannie Mae), the Federal Home Loan Mortgage Corporation (Freddie Mac), or guaranteed by the Government National Mortgage Administration (Ginnie Mae) (collectively, “Agency Securities”). Our securities portfolio consists primarily of Agency Securities backed by fixed rate home loans. From time to time, a portion of our portfolioassets may be invested in Agency Securities backed by hybrid adjustable rate and adjustable rate home loans as well as unsecured notes and bonds issued by U.S. Government-charteredGovernment-sponsored entities (collectively,( “Agency Debt”), U.S. Treasuries and money market instruments, subject to certain income tests we must satisfy for our qualification as a real estate investment trust (“REIT”). Our charter permits us to invest in Agency Securities and Non-Agency Securities. As of September 30, 2012,2013, Agency Securities account for 100% of our securities portfolio. It is expected that the percentage will continue to be 100% or close thereto. On December 1, 2011, our stockholders approved an amendment to our charter to alter our investment asset class restriction in response to potential changes in Agency Securities to include non-Agency as well as Agency Securities in our investment asset class restriction. While we remain committed to investing in Agency Securities for so long as an adequate supply and pricing exists, we believe it is prudent for us to have the flexibility to invest in non-Agency Securities and respond to changes in GSE policy.
We are externally managed by ARRM, pursuant to a management agreement amended and restated on June 18, 2012 (the “2012 Management Agreement”). ARRM is an investment advisor registered with the Securities and Exchange Commission ("SEC"(“SEC”). ARRM is also the external manager of JAVELIN Mortgage Investment Corp. ("JAVELIN"(“JAVELIN”), a publicly traded REIT, which invests in and manages a leveraged portfolio of Agency Securities non-Agency Securities and other mortgage-related investments.Non-Agency Securities. Our Co-Chief Executive Officers ("Co-CEOs"), Scott J. Ulm and Jeffrey J. Zimmer, and Chief Financial Officer ("CFO"), James R. Mountain,executive officers also serve as the Co-CEOs and CFO of JAVELIN, respectively. ARRM is an entity affiliated with the executive officers of ARMOUR and JAVELIN.
We seek attractive long-term investment returns by investing our equity capital and borrowed funds in our targeted asset class of Agency Securities. We earn returns on the spread between the yield on our assets and our costs, including the interest cost of the funds we borrow, after giving effect to our hedges. We intend to qualify and have elected to be taxed as a REIT under the Internal Revenue Code (“the Code”). We will generally not be subject to federal income tax to the extent that we distribute our taxable income to our stockholders and as long as we satisfy the ongoing REIT requirements including meeting certain asset, income and stock ownership tests. Our business plan is to identify and acquire Agency Securities, finance our acquisitions with borrowings under a series of short-term repurchase agreements at the most competitive interest rates available to us and then cost-effectively hedge our interest rate and other risks based on our entire portfolio of assets, liabilities and derivatives and our management'smanagement’s view of the market. Successful implementation of our business planthis approach requires us to address interest rate risk, maintain adequate liquidity and effectively hedge interest rate risks. We believe that the residential mortgage market will undergo significant changes in the coming years as the role of GSEs, such as Fannie Mae and Freddie Mac, is diminished, which we expect will create attractive investment opportunities for us. We execute our business plan in a manner consistent with our intention of qualifying as a REIT under the Internal Revenue Code, (the “Code”) and avoid regulation as an investment company under the Investment Company Act of 1940 (the “1940 Act”).
We have elected to be taxed as a REIT under the Code. We will generally not be subject to federal income tax to the extent that we distribute our taxable income to our stockholders and as long as we satisfy the ongoing REIT requirements under the Code including meeting certain asset, income and stock ownership tests.
Factors that Affect our Results of Operations and Financial Condition
Our results of operations and financial condition are affected by various factors, many of which are beyond our control, including, among other things, our net interest income, the market value of our assets and the supply of and demand for such assets. We invest in financial assets and markets. Recent events, such as those discussed below, can affect our business in ways that are difficult to predict and may produce results outside of typical operating variances. Our net interest income varies primarily as a result of changes in interest rates, borrowing costs and prepayment speeds, the behavior of which involves various risks and uncertainties. Prepayment rates, as reflected by the rate of principal pay downs and interest rates vary according to the type of investment, conditions in financial markets, government actions, competition and other factors, none of which can be predicted with any certainty. In general, as prepayment rates on our Agency Securities purchased at a premium increase, related purchase premium amortization increases, thereby reducing the net yield on such assets. Because changes in interest rates may significantly affect our activities, our operating results depend, in large part, upon our ability to manage interest rate risks and prepayment risks effectively while maintaining our status as a REIT. In addition, since we have not elected to use cash flow hedge accounting, earnings reported in accordance with U.S. generally accepted accounting principles (“GAAP”) will fluctuate even in situations where our derivatives are operating as intended. As a result of this mark-to-market accounting treatment, our results of operations are likely to fluctuate far more than if we were to designate our derivative activities as cash flow hedges. Comparisons with companies that use cash flow hedge accounting for all or part of their derivative activities may not be meaningful.
We anticipate that, forFor any period during which changes in the interest rates earned on our assets do not coincide with interest rate changes on our borrowings, such assets will tend to reprice more slowly than the corresponding liabilities. Consequently, changes in interest rates, particularly short-term interest rates, may significantly influence our net interest income. With the maturities of our assets generally of longer term than those of our liabilities, interest rate increases will tend to decrease our net interest income and the market value of our assets (and therefore our book value). Such rate increases could possibly result in operating losses or adversely affect our ability to make distributions to our stockholders.
Prepayments on Agency Securities and the underlying mortgage loans may be influenced by changes in market interest rates and a variety of economic and geographic factors, beyond our control,policy decisions by regulators, as well as policy decisions by Fannie Mae, Freddie Mac, their regulator the Federal Housing Finance Agency (“FHFA”), Ginnie Mae and others.other factors beyond our control. Consequently prepayment rates cannot be predicted with certainty. To the extent we have acquiredhold Agency Securities acquired at a premium or discount to par, or face value, changes in prepayment rates may impact our anticipated yield. In periods of declining interest rates, prepayments on our Agency Securities will likely increase. If we are unable to reinvest the proceeds of such prepayments at comparable yields, our net interest income may suffer.decline. The recent climate of government intervention in the mortgage markets significantly increases the risk associated with prepayments.
While we intend to use strategies to economically hedge some of our interest rate risk, we do not intend to hedge all of our exposure to changes in interest rates and prepayment rates, as there are practical limitations on our ability to insulate our securities portfolio from all potential negative consequences associated with changes in short-term interest rates in a manner that will allow us to seek attractive net spreads on our securities portfolio. Also, since we have not elected to use cash flow hedge accounting, earnings reported in accordance with generally accepted accounting principles in the U.S. (“GAAP”) will fluctuate even in situations where our derivatives are operating as intended. As a result of this mark-to-market accounting treatment, our results of operations are likely to fluctuate far more than if we were to designate our derivative activities as cash flow hedges. Comparisons with companies that use cash flow hedge accounting for all or part of their derivative activities may not be meaningful. For these and other reasons more fully described under the section captioned “Derivative Instruments” below, no assurance can be given that our derivatives will have the desired beneficial impact on our results of operations or financial condition.
In addition to the use of derivatives to hedge interest rate risk, a variety of other factors relating to our business may also impact our financial condition and operating performance; these factors include,
● | our degree of leverage; |
| ● | our access to funding and borrowing capacity; |
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| ● | the requirements to qualify for an exemption under the 1940 Act and other regulatory and accounting policies related to our business. |
For a discussion of additional risks relating to our business see “Risk Factors” in Item 1A, the Risk Factors below, and in our Annual Report on Form 10-K for the year ended December 31, 2011.
Our Manager
We are externally managed by ARRM, pursuant to an amended and restated management agreement as further amended and restated on June 18,the 2012 (the “2012 Management Agreement”)Agreement (see Note 14 to the condensed consolidated financial statements). All of our executive officers are also employees of ARRM. ARRM manages our day-to-day operations, subject to the direction and oversight of the Board of Directors (“Board”). The 2012 Management Agreement expires after an initial term of 10ten years on June 18, 2022 and is thereafter automatically renewed for an additional five-year term unless terminated under certain circumstances. Either party must provide 180 days prior written notice of any such termination. ARRM is entitled to receive a termination fee from us under certain circumstances.
Pursuant to the 2012 Management Agreement, ARRM is entitled to receive a management fee payable monthly in arrears in an amount equal to 1/12th of 1% of gross equity raised until gross equity raised was $50 million. Thereafter,Currently, the monthly management fee would beis 1/12th of the sum of (a) 1.5% of gross equity raised up to $1 billion plus (b) 0.75% of gross equity raised in excess of $1 billion. We are also obligatedThe cost of repurchased stock reduces the amount of gross equity raised used to reimburse certain expenses incurred by ARRM and its affiliates. ARRM is further entitled to receive a terminationcalculate the monthly management fee. As of September 30, 2013, the effective management fee from us under certain circumstances.
was 1.016% based on gross equity raised. ARRM is entitled to receive a monthly management fee regardless of the performance of our securities portfolio. Accordingly, the payment of our monthly management fee may not decline in the event of a decline in our earnings and may cause us to incur losses. We incurred $6.5 million and $21.0 million, respectively in management fees for the quarter and nine months ended September 30, 2013. For the quarter and nine months ended September 30, 2012, we incurred $5.6 million and $13.4 million in management fees, respectively.
We are required to take actions as may be reasonably required to permit and enable ARRM to carry out its duties and obligations. We are also responsible for any costs and expenses that ARRM incurred solely on behalf of ARMOUR or its subsidiary other than the various overhead expenses specified in the terms of the 2012 Management Agreement. For the quarter and nine months ended September 30, 2013, we reimbursed ARRM $0.4 million and $1.2 million, respectively, for other expenses incurred on our behalf. We also reimbursed $0.2 and $0.9 of compensation expense during the quarter and nine months ended September 30, 2013, respectively related to restricted shares of common stock for ARRM employees (see Note 10 to the condensed consolidated financial statements). For the quarter and nine months ended September 30, 2012, we did not reimburse ARRM for any expenses.
Pursuant to a Sub-Management Agreement between ARMOUR, ARRM and Staton Bell Blank Check LLC (the “Sub-Manager”), ARRM is responsible for the payment of a monthly sub-management fee to the Sub-Manager in an amount equal to 25% of the monthly management fee earned by ARRM, net of expenses. On November 6, 2014, the Sub-Manager has the option of terminating the Sub-Management Agreement. If the Sub-Management Agreement is terminated, we would be required to make a final payment to the Sub-Manager in the amount of 6.16 times the annualized rate of the sub-management fee for the prior three months. Thereafter, we will be entitled to receive the sub-management fee or, at the option of ARRM, reimbursement of the final payment by ARRM. The payments from ARRM to the Sub-Manager for the three months preceding September 30, 2013 totaled $1.5 million.
Market and Interest Rate Trends and the Effect on our Securities Portfolio
The third quarter of 2013 represented a period of disruptivevolatility in the prices of Agency Securities as well as underlying mortgages and U.S. Treasury Securities. The 10-Year Treasury Rate rose from 2.49% on June 28, 2013 to as high as 3.00% on September 5, 2013 before tightening to 2.61% on September 30, 2013. The widely followed benchmark 3.5% Fannie Mae certificates fell from a price of 101.48 on June 28, 2013 to a low of 97.95 on September 5, 2013 and recovered to a price of 101.92 on September 30, 2013. The cause of this volatility was widely attributed to concern about the market impact of a reduction in the Fed’s overall bond buying program, and, particularly, a potential cut in its purchases of Agency Securities. On September 18th, the Fed announced its intention to continue purchasing both U.S. Treasury Securities and Agency Securities at their current level. Market prices for both U.S. Treasury Securities and Agency Securities both increased following that announcement.
The timing and impact of changes in the Fed’s bond buying program are unknown. We expect continued volatility in the market for Agency Securities until the Fed clarifies its plans and actually begins implementation.
We made adjustments to our securities portfolio as a result of the market volatility in the third quarter in order to reduce exposure to changes in Agency Securities prices. During the third quarter we sold $6.0 billion of Agency Securities resulting in a loss of $301.0 million. As a result of these sales, leverage expressed as debt to stockholders’ equity declined from 9.77:1 at June 30, 2013 to 6.93:1 at September 30, 2013. We did not reduce our hedge positions, which represented approximately 84.4% of our non-adjustable rate mortgages as of September 30, 2013. We still bear risk from changes in interest rates and, especially, from changes in the prices of Agency Securities relative to swap and Treasury prices.
We believe the current market environment offers attractive reinvestment opportunities. However, given the potential for further market volatility, we are likely to maintain a conservative posture on reinvestment, leverage, and hedging until we believe medium term risks have subsided.
Developments at Fannie Mae and Freddie Mac
Payments on the principal and interest on the Agency Securities in which we invest are guaranteed by Fannie Mae and Freddie Mac. Because of the guarantee and the underwriting standards associated with mortgages underlying Agency Securities, Agency Securities historically have had high stability in value and been considered to present low credit risk.
In February 2011, the U.S. Treasury along with the U.S. Department of Housing and Urban Development released a report entitled, “Reforming America'sAmerica’s Housing Finance Market” to the U.S. Congress outlining recommendations for reforming the U.S. housing system, specifically Fannie Mae and Freddie Mac and transforming the U.S. Government'sGovernment’s involvement in the housing market. It is unclear how future legislation may impact the housing finance market and the investing environment for Agency Securities as the method of reform is undecided and has not yet been defined by the regulators. Without U.S. Government support for residential mortgages, we may not be able to execute our current business model in an efficient manner.
In March 2011, the U.S. Treasury announced that it would begin the orderly wind down of Agency Securities it had purchased from Fannie Mae, Freddie Mac and Ginnie Mae to stabilize the housing market, with sales up to $10.0 billion per month, subject to market conditions. We are unable to predict the timing or manner in which the U.S. Treasury or the U.S. Federal Reserve (“the Fed”) will liquidate their holdings or make further interventions in the Agency Securities markets, or what impact, if any, such action could have on the Agency Securities market, the Agency Securities we hold, our business, results of operations and financial condition.
On June 25, 2013, a bipartisan group of U.S. senators introduced a draft bill titled, "Housing Finance Reform and Taxpayer Protection Act of 2013" to the U.S. Senate, which would wind down Fannie Mae and Freddie Mac over a period of five years and replace the public securitization market used by the GSEs with a public-private alternative market. On July 11, 2013, members of the U.S. House Committee on Financial Services introduced a similar draft bill titled, "Protecting American Taxpayers and Homeowners Act" to the U.S. House of Representatives. While distinguishable in some respects from the Senate version, the House bill would also eliminate Fannie Mae and Freddie Mac and seek to increase the opportunities for private capital to participate in, and consequently bear the risk of loss in connection with, government-guaranteed MBS.
The passage of any new legislation affecting Fannie Mae and Freddie Mac may create market uncertainty and reduce the actual or perceived credit quality of securities issued or guaranteed by the U.S. government through a new or existing successor entity to Fannie Mae and Freddie Mac. If Fannie Mae and Freddie Mac were reformed or wound down, it is unclear what effect, if any, this would have on the value of the existing Fannie Mae and Freddie Mac Agency Securities. It is also possible that the above-referenced proposed legislation, if made law, could adversely impact the market for securities issued or guaranteed by the U.S. government and the spreads at which they trade. The foregoing could materially adversely affect the pricing, supply, liquidity and value of the Agency Securities in which we invest and otherwise materially adversely affect our business, operations and financial condition.
We cannot predict whether or when new actions may occur, the timing and pace of current actions already implemented, or what impact if any, such actions, or future actions, could have on our business, results of operations and financial condition.
U.S. Government Mortgage Related Securities Market Intervention
The U.S. Federal Reserve's (“the Fed”) program to purchase Agency Securities which had commenced in January 2009 and was terminated on March 31, 2010 had a significant impact on market prices. In total, $1.3 trillion of Agency Securities were purchased. In addition, through the course of 2009, the U.S. Treasury purchased $250.0 billion of Agency Securities. An effect of these purchases has been an increase in the prices of Agency Securities, which has decreased our net interest margin. When these programs terminated, the market expectation was that it might cause a decrease in demand for these securities which would likely reduce their market price. However, this has not happened and we continue to see strong demand as these securities remain desirable assets in this rather volatile economic environment. It is difficult to quantify the impact, as there are many factors at work at the same time that affect the price of Agency Securities and, therefore, our yield and book value. Due to the unpredictability in the markets for our securities in particular and yield generating assets in general, there is no pattern that can be implied with any certainty. In March 2011, the U.S. Treasury announced that it will begin the orderly wind down of its remaining Agency Securities with sales up to $10.0 billion per month, subject to market conditions. It is unclear how these sales will affect market conditions and pricing. On September 21, 2011, the U.S. Federal Reserve announced that it will begin reinvesting principal payments from its holdings of Agency Debt and Agency Securities.In September 2012, the Fed announced a third quantitative easing program, popularly referred to as “QE3,” to purchase an additional $40 billion of Agency Securities per month until the unemployment rate and other economic indicators improve. QE3 plus its existing investment programs are expected to growgrew the Fed'sFed’s Agency Securities holding by approximately $85 billion per month at least through the end of 2012. TheOn December 12, 2012, the Fed also extended through at least mid-2015 its plan toannounced that it would keep the target range for the Federal Funds Rate between zero and 0.25%. The Fed expects these measures will put downward pressure on long-term interest rates. for at least as long as the unemployment rate remains above 6.5%, inflation between one and two years ahead was projected to be no more than 0.5% above the Fed’s 2% longer-run goal, and longer-term inflation expectations continued to be well anchored.
InOn May 22, 2013, Chairman Bernanke, responding to a question, stated “If we see continued improvement and we have confidence that that’s going to be sustained then we could in the short term,next few meetings take a step down in our pace of purchases.” At the Fed's actions have drivenJune 18-19, 2013 Federal Open Market Committee (“FOMC”) meeting, all but a few of the Committee members agreed to continue purchases of Agency Securities prices to record highs, thereby compressing interest rate spreads and reducingat their current pace.
On June 19, 2013, at the correlation between mortgage rates and rates on U.S. Treasuries and interest rate swaps. These factors have contributedFOMC Press Conference, Chairman Bernanke, responding to a challenging reinvestmentjournalist's question referring to a hypothetically optimistic economy, stated “In that case, we would expect probably to slow or moderate purchases some time later this year, and interest rate hedging environment.then through the middle of through the early part of next year, and ending, in that scenario, somewhere in the middle of the year.”
In a press conference on July 12, 2013, Chairman Bernanke stated that a “highly accommodative monetary policy for the foreseeable future is what's needed in the U.S. economy.” At the July 30-31, 2013 FOMC meeting, most of the Committee members agreed, and voted to continue purchases of Agency Securities at the current pace.At the September 18, 2013 FOMC meeting the Committee decided to continue purchasing additional Agency Securities at a pace of $40 billion per month and longer-term U.S. Treasury securities at a pace of $45 billion per month and to keep in place the highly accommodative stance of monetary policy described at its December 11-12, 2012 meeting. Lower prices of Agency Securities reduces our book value and the amounts that we can borrow under repurchase agreements.
Financial Regulatory Reform Bill and Other Government Activity
We believe that we conduct our business in a manner that allows us to avoid being regulated as an investment company under the 1940 Act pursuant to the exemptionexclusion provided by Section 3(c)(5)(C) of the 1940 Act for entities that are primarily engaged in the business of purchasing or otherwise acquiring “mortgages and other liens on and interests in real estate.” On August 31, 2011, the SEC issued a concept release (No. IC-29778; File No. SW7-34-11, Companies Engaged in the Business of Acquiring Mortgages and Mortgage-RelatedMortgage Related Instruments) pursuant to which it is reviewing whether certain companies that invest in mortgage backed securities (“MBS”)MBS and rely on the exemptionexclusion from registration under Section 3(c)(5)(C) of the 1940 Act (such as us) should continue to be allowed to rely on such exemptionexclusion from registration. If we fail to continue to qualify for this exemptionexclusion from registration as an investment company, or the SEC determines that companies that invest in MBS are no longer able to rely on this exemption,exclusion, our ability to use leverage would be substantially reduced and we would be unable to conduct our business as planned, or we may be required to register as an investment company under the 1940 Act, either of which could negatively affect the value of shares of our stock and our ability to make distributions to our stockholders.
Certain programs initiated by the U.S. Government, through the Federal Housing AdministrationFinance Agency (“FHFA”) and the Federal Deposit Insurance Corporation (“FDIC”), to provide homeowners with assistance in avoiding residential mortgage loan foreclosures are currently in effect. The programs may involve, among other things, the modification of mortgage loans to reduce the principal amount of the loans or the rate of interest payable on the loans, or to extend the payment terms of the loans. While the effect of these programs has not been as extensive as originally expected, the effect of such programs for holders of Agency Securities could be that such holders would experience changes in the anticipated yields of their Agency Securities due to (i) increased prepayment rates andand/or (ii) lower interest and principal payments.
In March 2009, the Home Affordable Modification Program (“HAMP”) was introduced to provide homeowners with assistance in avoiding residential mortgage loan foreclosures. HAMP is designed to help at risk homeowners, both those who are in default and those who are at imminent risk of default, by providing the borrower with affordable and sustainable monthly payments. In an effort to continue to provide meaningful solutions to the housing crisis, effective June 1, 2012, the Obama administration expanded the population of homeowners that may be eligible for HAMP.
On July 21, 2010, President Obama signed the Dodd-Frank Act into law. The Dodd-Frank Act is extensive, complicated and comprehensive legislation that impacts practically all aspects of banking, and a significant overhaul of many aspects of the regulation of the financial services industry. Although many provisions remain subject to further rulemaking, the Dodd-Frank Act implements numerous and far-reaching changes that affect financial companies, including our company, and other banks and institutions which are important to our business model. Certain notable rules are, among other things:
| ● | Requiring regulation and oversight of large, systemically important financial institutions by establishing an interagency council on systemic risk and implementation of heightened prudential standards and regulation by the Board of Governors of the |
| ● | Applying the same leverage and risk-based capital requirements that apply to insured depository institutions to most bank holding companies, savings and loan holding companies and systemically important nonbank financial companies; |
| ● | Limiting the |
| ● | Creating regimes for regulation of over-the-counter derivatives and non-admitted property and casualty insurers and reinsurers; |
| ● | Implementing regulation of hedge fund and private equity advisers by requiring such advisers to register with the SEC; |
| ● | Providing for the implementation of corporate governance provisions for all public companies concerning proxy access and executive compensation; and |
| ● | Reforming regulation of credit rating agencies. |
Many of the provisions of the Dodd-Frank Act, including certain provisions described above are subject to further study, rulemaking, and the discretion of regulatory bodies. As the hundreds of regulations called for by the Dodd-Frank Act are promulgated, we will continue to evaluate the impact of any such regulations. It is unclear how this legislation may impact the borrowing environment, investing environment for Agency Securities and interest rate swap contracts as much of the bill'sbill’s implementation has not yet been defined by the regulators.
In addition, in 2010, the Group of Governors and Heads of Supervisors of the Basel Committee on Banking Supervision, the oversight body of the Basel Committee, published its “calibrated” capital standards for major banking institutions (“Basel III”). Under these standards, when fully phased in on January 1, 2019, banking institutions will be required to maintain heightened Tier 1 common equity, Tier 1 capital and total capital ratios, as well as maintaining a “capital conservation buffer.” Beginning with the Tier 1 common equity and Tier 1 capital ratio requirements, Basel III will be phased in incrementally between January 1, 2013 and January 1, 2019. The final package of Basel III reforms were approved by the G20 leadersGroup of Twenty Finance Ministers and Central Bank Governors in November 2010 and are subject to individual adoption by member nations, including the United States by January 1, 2013. It is unclear how the adoption of Basel III will affect our business at this time.U.S.
In September 2011, the White House announced work on a major initiative to allow certain homeowners who owe more on their mortgages than their homes are worth to refinance. In October 2011, the FHFA announced changes to the Home Affordable Refinance Program (“HARP”) to expand access to refinancing for qualified individuals and families whose homes have lost value, including increasing the HARP loan-to-valueloan to value ratio above 125%. However, this would only apply to mortgages guaranteed by the GSEs. In addition, the expansion does not change the time period which these loans were originated, maintaining the requirement that the loans must have been guaranteed by Fannie Mae or Freddie Mac prior to June 2009. There are many challenging issues to this proposal, notably the question as to whether a loan with a loan-to-valueloan to value ratio of 125% qualifies as a mortgage or an unsecured consumer loan. The chances of this initiative'sinitiative’s success have created additional uncertainty in the Agency Securities market, particularly with respect to possible increases in prepayment rates. We do not expect this announcement to have a significant impact on our results of operations.
On January 4, 2012, the Fed releasedissued a report titled “The U.S. Housing Market: Current Conditionswhite paper outlining additional ideas with regard to refinancings and Policy Considerations” to Congress providing a framework for contemplating certain issues and tradeoffs that policy makers might consider.loan modifications. It is unclear howlikely that loan modifications would result in increased prepayments on some Agency Securities. These loan modification programs, as well as future legislationlegislative or regulatory actions, including amendments to the bankruptcy laws, that result in the modification of outstanding mortgage loans may impactadversely affect the value of, and the returns on, the Agency Securities in which we invest.
In an effort to continue to provide meaningful solutions to the housing finance market andcrisis, effective June 1, 2012, the investing environmentObama administration expanded the population of homeowners that may be eligible for Agency Securities as the method of reform is undecided and has not yet been defined by the regulators.HAMP.
On September 28, 2012, the United Kingdom Financial Services Authority (“FSA”) released the results of its review of the process for setting the London Interbank Offered Rate (“LIBOR”) interest rate for various currencies and maturities (“Wheatley Review”). Some of our derivative positions use various maturities of U.S. dollar LIBOR. Our borrowings in the repurchase market have also historically tracked these LIBOR rates. The Wheatley Review found, among other things, that potential conflicts of interests coupled with insufficient oversight and accountability resulted in some reported LIBOR rates that did not reflect the true cost of inter-bank borrowings they were meant to represent.
The Wheatley Review also proposes a number of remedial actions, including:
● | New statutory authority for the FSA to supervise and regulate the LIBOR setting |
● | Establishing a new independent oversight body to administer the LIBOR setting |
● | Eliminating LIBOR rates for certain currencies and maturities where markets are not sufficiently deep and |
● | Ceasing immediate reporting of rates submitted by individual participating |
● | Establishing controls to ensure that submitted rates represent actual transactions. |
There can be no assurance whether or whenIn April 2013, all the recommendations of the Wheatley Review recommendationscame into force through the Financial Services Act of 2012. In this new regulatory framework, the Financial Conduct Authority (“FCA") and the Prudential Regulation Authority (“PRA”) have replaced the Financial Services Authority (“FSA”), the Bank of England has overall responsibility for financial stability, and a new Financial Policy Committee (“FPC”) was created to assist the Bank in achieving its financial stability objective. Additionally, in September 2013, the European Commission proposed draft legislation that will be implemented in whole or in part. The company's derivativesenhance the robustness and reliability of benchmarks like LIBOR, facilitate the prevention and detection of their manipulation and clarify responsibility for and the supervision of benchmarks.
Our derivative and repurchase borrowings are conducted in U.S. dollars for maturities with historically deep and liquid markets. However, there can be no assurance whether theTo date, implementation of anythe Wheatley Review recommendations would have not had a material impact on the future reported levels of LIBOR rates relevant to the company's derivativesour derivative or repurchase borrowings.
On July 2, 2013, the Fed, in coordination with the FDIC and the Office of the Comptroller of the Currency (the "OCC"), approved a final rule that enhances bank regulatory capital requirements and implements certain elements of the Basel III capital reforms in the U.S. On July 9, 2013, the OCC approved the final rule and the FDIC approved the final rule as an interim rule. The final rule includes a new minimum ratio of common equity tier 1 capital to risk-weighted assets of 4.5 percent and a common equity tier 1 capital conservation buffer of 2.5 percent of risk-weighted assets that will apply to all supervised U.S. financial institutions. The final rule also raises the minimum ratio of tier 1 capital to risk-weighted assets from 4 percent to 6 percent and includes a minimum leverage ratio of 4 percent for all U.S. banking organizations. The final rule will continue to apply existing risk-based capital standards with respect to residential loans, including a 50 percent risk weight for safely underwritten first-lien mortgages that are not past due. "Advanced approaches banking organizations," those with $250 billion or more in total consolidated assets or $10 billion or more in foreign exposures, will be required to comply with the final rule starting on January 1, 2014. Other banking organizations will be required to comply with the final rule starting January 1, 2015.
On July 9, 2013, the Fed, the FDIC, and the OCC proposed a rule to change the leverage ratio standards for the largest U.S. banking organizations. Under the proposed rule, bank-holding companies with more than $700 billion in consolidated total assets or $10 trillion in assets under custody would be required to maintain a tier 1 capital leverage buffer of at least 5 percent, which is 2 percent above the minimum supplementary leverage ratio requirement of 3 percent adopted by these three agencies in their Basel III capital reform rules on July 2, 2013. In addition to the leverage buffer, the proposed rule would require insured depository institutions of such large bank-holding companies to meet a 6 percent supplementary leverage ratio to be considered "well capitalized." The proposed rule would apply starting January 1, 2018. Adoption of these rules may increase cost and reduce availability of repurchase funding provided by institutions subject to the rules.
Credit Market Disruption and Current Conditions
During the past few years, the residential housing and mortgage markets in the U.S. have experienced a variety of difficulties and changed economic conditions including loan defaults, credit losses and decreased liquidity. These conditions have resulted in volatility in the value of the Agency Securities we purchase and an increase in the average collateral requirements under our repurchase agreements we have obtained. While these markets have recovered significantly, further increased volatility and deterioration in the broader residential mortgage and RMBSresidential mortgage backed securities (“RMBS”) markets may adversely affect the performance and market value of the Agency Securities and other high quality RMBS.
Despite modest economic expansion during the first quarter of 2012, signs of decline remain evident in job growth, housing,Short-term Interest Rates and inflation. While the first quarter of 2012 U.S. economic performance reflected an upward trend in job growth and U.S. real gross domestic product, preliminary second quarter results reflect a slowing in the first quarter improvements, notably in job growth and the unemployment rate, which, in May, remained unchanged at 8.2% in March. Consumer price inflation also declined, reflecting decreases in crude oil and gasoline prices. Expectations of long-run inflation are projected to be subdued, at or below 2% due to a slightly increased unemployment rate as well as anchored long run inflation projections. Data suggests that the economy continues to grow modestly, however, not at the rate anticipated.
Interest RatesFunding Costs
The overall credit market deterioration since August 2007 has also affected prevailing interest rates. For example, interest rates have been unusually volatile between September of 2007 and October of 2008. Since September 18, 2007, the Fed has lowered the target for the Federal Funds Rate nine times from 4.75% to 1.00% in October 2008. In December 2008, the Fed stated that it was adopting a policy of “quantitative easing” and would target keeping the Federal Funds Rate between 0.00% and 0.25%. To date, the Fed has maintained that target range. Our funding costs, which traditionally have tracked the 30-day LIBOR have generally benefited by this easing of monetary policy, although to a somewhat lesser extent. Because of continued uncertainty in the credit markets and U.S. economic conditions, we expect that interest rates are likely to experience continued volatility, which will likely affect our financial results since our cost of funds is largely dependent on short-term rates.
Historically, 30-day LIBOR has closely tracked movements in the Federal Funds Rate and the Effective Federal Funds Rate. The Effective Federal Funds Rate can differ from the Federal Funds Rate in that the Effective index represents the volume weighted average of interest rates at which depository institutions lend balances at the Federal ReserveFed to other depository institutions overnight (actual transactions, rather than target rate).
Our borrowings in the repurchase market have also historically closely tracked the Federal Funds Rate and LIBOR. Traditionally, a lower Federal Funds Rate has indicated a time of increased net interest margin and higher asset values. However, since July 2007for the past several years, LIBOR and repurchase market rates have varied greatly and often have been significantly higher than the target and the Effective Federal Funds Rate. The difference between 30-day LIBOR and the Effective Federal Funds Rate has also been quite volatile, with the spread alternately returning to more normal levels and then widening out again. The continued volatility in these rates and divergence from the historical relationship among these rates could negatively impact our ability to manage our securities portfolio. If this were to occur, our net interest margin and the value of our securities portfolio might suffer as a result.
The following table shows 30-day LIBOR as compared to the Effective Federal Funds Rate for the quarterly periods presented.at September 30, 2013 and September 30, 2012.
30-Day LIBOR | Effective Federal Funds Rate | |||||||
September 30, 2013 | 0.18 | % | 0.06 | % | ||||
September 30, 2012 | 0.21 | % | 0.09 | % |
Quarter ended 30-Day LIBOR Effective Federal Funds Rate September 30, 2012 % % June 30, 2012 March 31, 2012 December 31, 2011 September 30, 2011 0.21 0.09 0.25 0.09 0.24 0.09 0.30 0.04 0.24 0.06
Results of Operations
As a result of our continued equity raising efforts, our earnings as reported in our condensed consolidated financial statements, particularly on a per share basis, may take time to reach a level in which we consider to be indicative of a full run-rate. Some period over period comparisons in the discussion below may not be meaningful.
Net Income Summary
Our primary source of income is the interest income we earn on our investmentsecurities portfolio. Our net income (loss) for the quarter and nine months ended September 30, 20122013 (related) available to common stockholders was ($233.8) million and $343.4 million, or ($0.63) and $1.28 per basic weighted average common share and ($0.63) and $1.27 per diluted weighted average common share, respectively. These results compare to net income of $54.1 million and $105.6 million respectively,available to common stockholders or $0.20 and $0.54 per basic and diluted weighted average common share. These results compare to net loss of ($34.5) million and ($33.1) million,share, respectively, related to common stockholders or, ($0.44) and ($0.63) per basic and diluted weighted average common share for the quarter and nine months ended September 30, 2011.2012. The main drivers offactors for the difference between the quarter and nine months ended 2012 to the corresponding periods in 2013, were the increased equity capital resources from 2011 through the nine months ended September 30, 2012 and the continued implementation of our investment strategy, offset by unrealized lossesin addition to changes in value from our derivatives and increased management fees.
As of September 30, 20122013 and December 31, 2011,2012, our Agency Securities in our securities portfolio waswere carried at a net premium to par value with a weighted average amortized cost of 105.26%105.06% and 104.23%105.24%, respectively, due to the average interest rates on these securities being higher than prevailing market rates.
The following table presents the components of the yield earned on our Agency Security portfolio for the quarterly periods presented.
Quarter Ended Asset Yield Cost of Funds Net Interest Margin Interest Expense on Repurchase Agreements September 30, 2012 % % % % June 30, 2012 March 31, 2012 December 31, 2011 September 30, 2011 2.70 0.89 1.82 0.45 2.97 0.82 2.15 0.39 3.04 0.81 2.23 0.34 2.60 0.98 1.62 0.35 3.11 0.93 2.18 0.27
For the Quarters Ended | For the Nine Months Ended | |||||||||||||||
September 30, 2013 | September 30, 2012 | September 30, 2013 | September 30, 2012 | |||||||||||||
Asset Yield | 2.60 | % | 2.70 | % | 2.47 | % | 2.86 | % | ||||||||
Cost of Funds | 1.36 | % | 0.89 | % | 1.15 | % | 0.99 | % | ||||||||
Net Interest Margin | 1.24 | % | 1.82 | % | 1.33 | % | 1.87 | % | ||||||||
Interest Expense on Repurchase Agreements | 0.41 | % | 0.45 | % | 0.44 | % | 0.47 | % |
The yield on our assets is most significantly affected by the rate of repayments on our Agency Securities. Our rate of portfolio repayment for the quarter ended September 30, 2012,2013, was 13.0%8.8% on a constant prepayment basis compared to 12.4%13.0% for the quarter ended September 30, 2011.2012.
Our repurchase agreements are secured by our Agency Securities and bear interest at rates that have historically moved in close relationship to the Federal Funds Rate and LIBOR. The Federal Funds Rate was 0.09%0.06% and LIBOR was 0.21%0.18% at September 30, 2012.2013. During the quarter and nine months ended September 30, 2013, we realized losses of $37.3 million, and $105.2 million, respectively, related to our derivatives. During the quarter and nine months ended September 30, 2012, we realized losses of $18.9 million, and $41.1 million, respectively, related to our derivatives. During the quarter and nine months ended September 30, 2011, we realized losses of $8.4 million and $16.4 million, respectively, related to our derivatives. We increased our total interest rate swap contracts aggregate notional balance from $2.8$8.7 billion at December 31, 20112012 to $8.7$11.8 billion at September 30, 2013. At September 30, 2013 and December 31, 2012, with,our interest rate swap contracts had a weighted average swap rate of 1.4% and 1.2%, respectively and a weighted average term of 67 months. During the quarter ended September 30, 2012, we entered into71 months and 64 months, respectively. We increased our total interest rate swaptions with an aggregate notional balance offrom $1.1 billion withat December 31, 2012 to $2.3 billion at September 30, 2013. Our swaptions had an underlying weighted average swap rate of 2.6% and 2.1%, respectively and a weighted average term of 8 months. We had not entered into any10 months and 5 months, respectively, at September 30, 2013 and December 31, 2012. The increased notional balance of our interest rate swap contracts and our swaptions as of December 31, 2011.is due to the growth in our securities portfolio and our repurchase agreement obligations, through June 30, 2013 and in response to the increased volatility in the market. Our total Eurodollar Futures Contracts (“Futures Contracts”) notional amount decreased from $131.0$102.0 million at December 31, 20112012 to $121.0$74.0 million at September 30, 20122013 due to the maturity of contracts. Our Futures Contracts had a weighted average swap equivalent rate of 2.1% and 1.8%, respectively and weighted average term of 2116 months and 20 months, respectively, as of September 30, 2013 and December 31, 2012.
Net Interest Income
Our net interest income for the quarter and nine months ended September 30, 2012,2013 was $94.5 million and $317.2 million, respectively, compared to $97.5 million and $228.4 million, respectively compared to $36.2 million and $75.1 million, respectively, for the quarter and nine months ended September 30, 2011.2012. The continued growth of our net interest income from year to year is due to the completion of equity raises in the nine months ended September 30, 2012.raises. The proceeds from these equity raises were invested in Agency Securities, creating a larger investment portfolio able to generate increasing levels of interest income. As of September 30, 20122013 and December 31, 2011,2012, our securities portfolio consisted of $16.7 billion and $19.1 billion of Agency Securities, consistedrespectively. In order to limit exposure to increasing volatility in the markets for U.S. Treasury and Agency Securities in the third quarter of $22.1 billion and $5.4 billion of securities, respectively.2013, we reduced our portfolio.
Gains and Losses on Sale of Agency Securities
During the quarter ended September 30, 2013, we sold $6.0 billion of Agency Securities, reducing our portfolio in order to limit our exposure to the increased volatility in the Agency Securities market, resulting in a realized loss of $301.0 million. During the nine months ended September 30, 2013, we sold $11.0 billion of Agency Securities resulting in a realized loss of $261.6 million. During the quarter and nine months ended September 30, 2012, we sold $1.6 billion and $1.9 billion of Agency Securities resulting in a realized gaingains of $15.1 million and $20.1 million, respectively. Of the $20.1 million gain, $1.1 million is a loss due to the bankruptcy of a counterparty to a repurchase agreement. In addition, due to the bankruptcy, we also recorded $1.0 million of other income resulting from the non-performance of the counterparty on the related repurchase agreement. During
Gains and Losses on U.S. Treasury Securities
For the quarter and nine months ended September 30, 2011,2013, we sold $0.5short $2.8 billion of AgencyU.S Treasury Securities acquired under reverse repurchase agreements. We had purchases of $1.8 billion and $2.8 billion, respectively, of U.S. Treasury Securities resulting in a realized gain of $6.5 million.
Operating Expenses
Our total operating expenses for the quarter and nine months ended September 30, 2012, were $7.2$35.3 million and $17.7 million, respectively as compared to $2.9 million and $6.4$14.2 million, respectively, for the quarter and nine months ended September 30, 2011.2013. During the quarter ended September 30, 2013 we did not sell any U.S. Treasury Securities. During the quarter and nine months ended September 30, 2012, we did not sell or purchase any U.S. Treasury Securities.
Expenses
Our total expenses for the quarter and nine months ended September 30, 2013 were $9.7 million and $27.6 million, respectively, as compared to $7.2 million and $17.7 million, respectively, for the quarter and nine months ended September 30, 2012. The increase in operating expenses from 2011year to 2012year is primarily due to two factors. The first factor beingis due to increased management fees. Our total management fee expense for the quarter and nine months ended September 30, 2012, were2013, was $6.5 million and $21.0 million as compared to $5.6 million and $13.4 million respectively as compared to $2.2 million and $4.4 million, respectively for the quarter and nine months ended September 30, 2011.2012. The $6.5 million of management fee expense for the quarter ended September 30, 2013, reflects an adjustment to reclassify $0.7 million of expense as compensation related to Restricted Stock awarded to ARRM for its employees previously classified as management fees. Management fees are determined based on gross equity raised. Therefore, as we continue to successfully raise capital our management fee continues to increase.increases when we raise capital and declines when we repurchase previously issued stock. However, because the management fee rate stepped downdecreased to 0.75% per annum for gross equity raised in excess of $1 billion;billion pursuant to the 2012 Management Agreement, the effective average management fee rate will continue to decline.has generally declined over time. The second factor is an increase in professional fees and operating costs to support our current securities portfolio.
Taxable Income
We have negative retained earnings (titled “Accumulated deficit” inelected to be taxed as a REIT under the stockholders' equity sectionCode. We will generally not be subject to federal income tax to the extent that we distribute our taxable income to our stockholders and as long as we satisfy the ongoing REIT requirements under the Code, including meeting certain asset, income and stock ownership tests.
The following table reconciles our GAAP net income to estimated REIT taxable income for the quarters and nine months ended September 30, 2013 and September 30, 2012.
For the Quarters Ended | For the Nine Months Ended | |||||||||||||||
September 30, 2013 | September 30, 2012 | September 30, 2013 | September 30, 2012 | |||||||||||||
(in thousands) | ||||||||||||||||
GAAP net income (loss) | $ | (229,943 | ) | $ | 54,942 | $ | 353,732 | $ | 106,561 | |||||||
Book to tax differences: | ||||||||||||||||
Unrealized (gain) loss on derivatives | 11,821 | 31,486 | (416,662 | ) | 84,265 | |||||||||||
Net capital losses | 225,676 | - | 247,393 | - | ||||||||||||
Amortization of deferred hedging costs | (1,611 | ) | - | (1,119 | ) | - | ||||||||||
Realized gain on derivatives | (2,157 | ) | - | (2,157 | ) | - | ||||||||||
Other | (7 | ) | 12 | 8 | 64 | |||||||||||
Estimated taxable income | $ | 3,779 | $ | 86,440 | $ | 181,195 | $ | 190,890 |
The aggregate tax basis of our accompanying condensed consolidated balance sheets) as ofassets and liabilities is greater than our total Stockholders’ Equity at September 30, 2012, due2013 by approximately $278.5 million, or approximately $0.75 per common share (based on the 370,905,142 common shares then outstanding).
We are required and intend to the consequencestimely distribute substantially all of our tax qualification as a REIT. Our dividends are based on our REIT taxable income as determinedin order to maintain our REIT status under the Code. Total dividend payments to stockholders were $82.2 million and $247.1 for federal income tax purposes and not our net income computed in accordance with GAAP as reported in our condensed consolidated financial statements. Accordingly, we may be required to pay out more in dividends than we have calculated in distributable earnings on a GAAP basis.
For the quarter and nine months ended September 30, 2012, our2013, respectively. Our estimated REIT taxable income available to pay dividends was approximately $86.4$3.8 million and $190.9$181.2 million respectively. Forfor the quarter and nine months ended September 30, 2011, our estimated2013, respectively. We also carried forward from the year ended December 31, 2012, undistributed REIT taxable income was approximately $31.3 million and $58.8 million, respectively. The most significant difference between GAAP and tax income was the unrealized loss on derivatives which is reflected in GAAP earnings but does not decreaseof $10.4 million. Our REIT taxable income.income and dividend requirements are determined on an annual basis. Dividends in excess of REIT taxable income for the year (including taxable income carried forward from the previous year) will generally not be taxable to common stockholders.
Our management is responsible for determining whether tax positions taken by us are more likely than not to be sustained on their merits. We have no material unrecognized tax benefits or material uncertain tax positions.
Financial Condition
Agency Securities
We typically purchase Agency Securities at premium prices. The premium price paid over par value on those assets is expensed as the underlying mortgages experience repayment or prepayment. The lower the constant prepayment rate, the lower the amount of amortization expense for a particular period. Accordingly, the yield on an asset and earnings, are higher. If prepayment rates increase, the amount of amortization expense for a particular period will go up. These increased prepayment rates would act to decrease the yield on an asset and would decrease earnings.
The tables below summarize certain characteristics of our Agency Securities for the periods presentedas of September 30, 2013 and December 31, 2012 (dollars in thousands).
Agency Securities:
As of | Principal Amount | Net Unamortized Premium | Amortized Cost | Amortized Cost divided by Principal | Fair Value | Fair Value divided by Principal | ||||||||||||||||||
September 30, 2013 | $ | 16,424,187 | $ | 831,584 | $ | 17,255,771 | 105.06 | % | $ | 16,664,917 | 101.47 | % | ||||||||||||
December 31, 2012 | $ | 17,925,998 | $ | 940,000 | $ | 18,865,998 | 105.24 | % | $ | 19,096,562 | 106.53 | % |
Quarter ended Principal Amount Net Unamortized Premium Amortized Cost Amortized Cost divided by Principal Fair Value Fair Value divided by Principal September 30, 2012 % % June 30, 2012 March 31, 2012 December 31, 2011 September 30, 2011 $ 20,627,189 $ 1,085,036 $ 21,712,225 105.26 $ 22,114,875 107.21 12,561,600 599,264 13,160,864 104.77 13,328,514 106.11 11,550,912 532,588 12,083,500 104.61 12,137,554 105.08 5,128,230 216,697 5,344,927 104.23 5,393,675 105.18 5,675,822 236,695 5,912,517 104.17 5,975,823 105.29
Adjustable and Hybrid Adjustable Rate Agency Securities:
As of | Principal Amount | Weighted Average Coupon | Weighted Average Months to Reset | Percentage of Total Agency Securities | ||||||||||||
September 30, 2013 | $ | 257,609 | 4.03 | % | 23 | 1.6 | % | |||||||||
December 31, 2012 | $ | 2,037,778 | 3.69 | % | 66 | 11.4 | % |
Quarter ended Principal Amount Weighted Average Coupon Weighted Average Months to Reset Percentage of Total Agency Securities September 30, 2012 % % June 30, 2012 March 31, 2012 December 31, 2011 September 30, 2011 $ 2,234,747 3.70 $ 68 10.8 2,685,281 3.71 75 21.4 2,514,725 3.72 73 21.8 2,681,911 3.72 76 52.2 2,858,964 3.71 75 50.4
Fixed Rate Agency Securities:
As of | Principal Amount | Weighted Average Coupon | Weighted Average Months to Maturity | Percentage of Total Agency Securities | ||||||||||||
September 30, 2013 | $ | 16,166,578 | 3.38 | % | 299 | 98.4 | % | |||||||||
December 31, 2012 | $ | 15,888,220 | 3.52 | % | 276 | 88.6 | % |
Quarter ended Principal Amount Weighted Average Coupon Weighted Average Months to Maturity Percentage of Total Agency Securities September 30, 2012 % % June 30, 2012 March 31, 2012 December 31, 2011 September 30, 2011 $ 18,392,442 3.52 271 89.2 9,876,319 3.62 217 78.6 9,036,187 3.64 219 78.2 2,446,319 3.97 188 47.8 2,816,858 4.00 172 49.6
The following table shows the average principal repayment rate for those securities which have settled Agency Securities for the quarterly periods presented.quarter ended September 30, 2013 was 8.8% compared to 13.0% for the quarter ended September 30, 2012.
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As of September 30, 2012,2013, our Agency Security portfolio consisted of approximately $22.1$16.7 billion in market value of Agency Securities with initial fixed-interest rate periods of three, five, seven, ten, fifteen, twenty, twenty-five and twentythirty years. As of September 30, 2013, we had investment related payables of $142.6 million with respect to unsettled purchases of Agency Securities and $1.3 million related to unsettled interest rate swap contract purchases. All investment related payables at September 30, 2013 were settled in October 2013. As of December 31, 2012, we had investment related receivables of $668.2 million with respect to unsettled sales of Agency Securities. We did not have any investment related payables as of December 31, 2012.
Our net income is primarily a function of the difference between the yield on our assets and the financing cost of owning those assets. Since we tend to purchase assetsAgency Securities at a premium to par, the main item that can affect the yield on our assetsAgency Securities after they are purchased is the rate at which the mortgage borrowers repay the loan. While the scheduled repayments, which are the principal portion of the homeowners'homeowners’ regular monthly payments, are fairly predictable, the unscheduled repayments, which are generally refinancing of the mortgage but can also result from repurchases of delinquent, defaulted, or modified loans, are less so. Being able to accurately estimate and manage these repayment rates is a critical portion of the management of our securities portfolio, not only for estimating current yield but also for considering the rate of reinvestment of those proceeds into new securities, the yields which those new securities may add to our securities portfolio and our hedging strategy. We expect that prepayment rates will be elevated due to repurchases of loans that reach 120 day or more delinquency by Freddie Mac and Fannie Mae on a continuing basis.
As of September 30, 20122013 and December 31, 2011,2012, the adjustable and hybrid adjustable rate mortgage loans underlying our Agency Securities have fixed-interest rates for an average period of approximately 6823 months and 7666 months, respectively, after which time the interest rates reset and become adjustable. After a reset date, interest rates on our adjustable and hybrid adjustable Agency Securities float based on spreads over various indices, typically LIBOR or the one-year Constant Maturity Treasury rate. These interest rates are subject to caps that limit the amount the applicable interest rate can increase during any year, known as an annual cap and through the maturity of the security, known as a lifetime cap.
We evaluated our Agency Securities with unrealized losses and determined that there was no other than temporary impairments as of September 30, 2013 and December 31, 2012. As of those dates, we did not intend to sell Agency Securities and believed it was more likely than not that we could meet our liquidity requirements and contractual obligations without selling Agency Securities. The decline in value of these Agency Securities is solely due to market conditions and not the credit quality of the assets. All of our Agency Securities are issued by the GSEs. The GSEs have a rating of AA+.
LiabilitiesRepurchase Agreements
We have entered into repurchase agreements to finance most of our Agency Securities. Our repurchase agreements are secured by our Agency Securities and bear interest at rates that have historically moved in close relationship to the Federal Funds Rate and LIBOR. We have established borrowing relationships with several investment banking firms and other lenders, 26 of which we had done repurchase trades with as of September 30, 20122013 and 2326 of which we had done repurchases trades with as of December 31, 2011.2012. We had outstanding balances under our repurchase agreements as of September 30, 2012 and2013 of $14.9 billion. Our outstanding repurchase agreements balance at December 31, 2011 of $19.8 billion and $5.3 billion, respectively.2012 was $18.4 billion.
Derivative Instruments
We generally intend to hedge as much of our interest rate risk as our managerARRM deems prudent in light of market conditions and the associated costs.costs with counterparties that have a high quality credit rating and with futures exchanges. We generally pay a fixed rate and receive a floating rate with the objective of fixing a portion of our borrowing costs and hedging the change in our book value to some degree. The floating rate we receive is generally the Federal Funds Rate or LIBOR. While our policies do not contain specific requirements as to the percentages or amount of interest rate risk that we are required to hedge, we maintain an overall target of hedging at least 40% of our non-adjustable rate mortgages. In order to limit exposure to increasing volatility in the markets for U.S. Treasury and Agency Securities in the third quarter of 2013, we reduced our portfolio. We did not reduce our hedge positions, which represented approximately 84.4% of our non-adjustable rate mortgages (“ARMs”).as of September 30, 2013. For interest rate risk mitigation purposes, we consider Agency Securities to be ARMsadjustable rate mortgages (“ARMs”) if their interest rate is either currently subject to adjustment according to prevailing rates or if they are within 18 months of the period where such adjustments will occur. No assurance can be given that our derivatives will have the desired beneficial impact on our results of operations or financial condition. We have not elected cash flow hedge accounting treatment as allowed by GAAP. Since we do not designate our derivative activities as cash flow hedges, realized as well as unrealized gains/losses from these transactions will impact our earnings.
Use of derivative instruments may fail to protect or could adversely affect us because, among other things:
| ● | available derivatives may not correspond directly with the interest rate risk for which protection is |
| ● | the duration of the derivatives may not match the duration of the related liability; |
| ● | the |
● | we may lose collateral we have pledged to secure our obligations under a derivative agreement if the associated counterparty becomes insolvent or files for bankruptcy; |
● | we may experience a termination event under one or more of our derivative agreements related to our REIT status, equity levels and performance, which could result in a payout to the associated counterparty and a taxable loss to us; |
| ● | the credit-quality of the party owing money on the derivatives may be downgraded to such an extent that it impairs our ability to sell or assign our side of the hedging transaction; and |
| ● | the value of derivatives may be adjusted from time to time in accordance with GAAP to reflect changes in fair value; downward adjustments, or “mark-to-market losses,” would reduce our net income or increase any net loss. |
As of September 30, 20122013 and December 31, 2011,2012, we had interest rate swap contracts with an aggregate notional balance of $8.7$11.8 billion and $2.8$8.7 billion, respectively. As of September 30, 2013 and December 31, 2012, we had entered into interest rate swaptions with an aggregate notional balance of $2.3 million and $1.1 billion. We had not entered into any interest rate swaptions as of December 31, 2011.billion, respectively. In addition, as of September 30, 20122013 and December 31, 20112012, we had purchased or sold Futures Contracts with an aggregate notional balance of $121.0$74.0 million and $131.0$102.0 million, respectively. Futures Contracts are traded on the Chicago Mercantile Exchange (“CME”). Counterparty risk of interest rate swap contracts, interest rate swaptions and Futures Contracts are limited to some degree because of daily mark-to-market and collateral requirements. In addition, substantial credit support for the Futures Contracts is provided by the CME. These derivative transactions are designed to lock in some funding costs for financing activities associated with our assets in such a way as to help assure the realization of attractive net interest margins and to vary inversely in value with our Agency Securities. Such contracts are based on assumptions about prepayments which, if not realized, will cause results to differ from expectations.
Although we attempt to structure our derivatives to offset the changes in asset prices, they are not perfectly correlated and depend on the corresponding durations and sections of the yield curve that moves to offset each other. ForWe recognized net (losses) gains of ($49.1) million and $311.5 million for the quarter and nine months ended September 30, 2013, respectively, and (losses) of ($50.4) million and ($125.3) million for the quarter and nine months ended September 30, 2012, respectively, related to our derivatives. For the change in the fair value of our derivative positions decreased by $68.6 millionquarters and nine months ended September 30, 2013, the unrealized change in the fair value of our Agency Securities increaseddecreased by ($51.8) million and ($1.1) billion, respectively, compared to an increase of $250.1 million and an increase of $374.0 million. Formillion for the quarter and nine months ended September 30, 2011,2012, respectively.
As required by the unrealized change inDodd-Frank Act, the fair valueCommodity Futures Trading Commission has adopted rules requiring certain interest rate swap contracts to be cleared through a derivatives clearing organization. We are required to clear certain new interest rate swap contracts as of our derivative positions decreased by $91.9 million and the unrealized change in the fair value of our Agency Securities increased by $74.0 million.June 2013. Cleared interest rate swaps may have higher margin requirements than un-cleared interest rate swaps previously had. We have established accounts with futures commission merchants for this purpose. To date, we have not entered into any cleared interest rate swap contracts.
Liquidity and Capital Resources
During the nine months ended September 30, 2012,2013, we issued 213,460,59065,055,537 shares of common stock and raised additional net common equityproceeds of approximately $1.5 billion.$438.5 million. During the nine months ended September 30, 2012,2013, we issued 1,785,000174,961 shares of 8.250% Series A Cumulative Redeemable Preferred Stock (“Series A Preferred Stock”) and raisedissued 5,650,000 shares of 7.875% Series B Cumulative Preferred Stock (“Series B Preferred Stock”) for a combined net preferred equityproceeds of approximately $43.3$140.9 million. As a result, we were able to acquire additional assets, arrange additional repurchase agreement funding and increase economies of scale. During the nine months ended September 30, 2013, we repurchased 3,395,603 shares of our outstanding common stock under our stock repurchase program (the “Repurchase Program”) for an aggregate of $20.3 million. At times, we purchased assets for forward settlement up to 90 days in the future to minimize purchase prices. Our management fee expense also increased in absolute terms under the provisions of our management agreement. However, pursuant to the 2012 Management Agreement, the average effective management fee rate declined because the management fee rate stepped down as the amounts of equity raised exceeded $1.0 billion.
As of September 30, 2013, we financed our portfolio with approximately $14.9 billion of borrowings under repurchase agreements. Our leverage ratio as of September 30, 2013, was 6.93 to 1. As of September 30, 2013, our liquidity totaled $1.3 billion, consisting of $0.5 billion of cash and cash equivalents plus $0.8 billion of unpledged Agency Securities (including Securities received as collateral). Our primary sources of funds are borrowings under repurchase arrangements, monthly principal and interest payments on our investmentsAgency Securities and cash generated from our operating results. Other sources of funds may include proceeds from equity and debt offerings and asset sales. We generally maintain liquidity to pay down borrowings under repurchase arrangements to reduce borrowing costs and otherwise efficiently manage our long-term investment capital. Because the level of our borrowings can be adjusted on a daily basis, the level of cash and cash equivalents carried on our balance sheet is significantly less important than our potential liquidity available under our borrowing arrangements.
In addition to the repurchase agreement financing discussed above, at certain times we have entered into reverse repurchase agreements with certain of our repurchase agreement counterparties. Under a typical reverse repurchase agreement, we purchase U.S. Treasury Securities from a borrower in exchange for cash and agree to sell the same securities back in the future. We then sell such U.S. Treasury Securities to third parties and recognize a liability to return the securities to the original borrower. Reverse repurchase agreement receivables and repurchase agreement liabilities are presented net when they meet certain criteria, including being with the same counterparty, being governed by the same master repurchase agreement, settlement through the same brokerage or clearing account and maturing on the same day. The practical effect of these transactions is to replace a portion of our repurchase agreement financing of our Agency Securities in our securities portfolio with short positions in U.S. Treasury Securities. We believe that this helps to reduce interest rate risk, and therefore counterparty credit and liquidity risk.
Both parties to the repurchase and reverse repurchase transactions have the right to make daily margin calls based on changes in the value of the collateral obtained and/or pledged.
We currently believe that we have sufficient liquidity and capital resources available for the acquisition of additional investments, repayments on repurchase borrowings, reacquisition of securities to be returned to borrowers and the payment of cash dividends as required for continued qualification as a REIT.
Our primary uses of cash are to purchase Agency Securities, pay interest and principal on our borrowings, fund our operations and pay dividends. During the nine months ended September 30, 2012,2013, we purchased $18.9$12.4 billion current face amount of Agency Securities using proceeds from equity raises, repurchase agreements and principal repayments. During the nine months ended September 30, 2012,2013, we received cash of $1.6$2.8 billion from prepayments and scheduled principal payments on our Agency Securities. We received net proceeds of $1.5 billion$438.5 million from common equity issuances, including our common stock dividend reinvestment and stock purchase plan (“common stock DRIP”) and $43.3$4.4 million of proceeds from the issuance of 1,785,000174,961 shares of Series A Preferred Stock and $136.6 million of proceeds from the issuance of 5,650,000 shares of Series B Preferred Stock during the nine months ended September 30, 2012.2013. We had a net cash increasedecrease from our repurchase agreements of $14.5$3.4 billion for the nine months ended September 30, 20122013 and made cash interest payments of approximately $61.2$198.1 million on our liabilities for the nine months ended September 30, 2012.2013. Part of funding our operations includes providing margin cash to offset liability balances on our derivatives. This required an additional $90.6We recovered $234.6 million of cash to be maintained in a restricted accountcollateral posted with counterparties and increased our counterpartiesliability by $294.1 million for the nine months endedcash collateral held as of September 30, 2012.2013.
In response to the growth of our Agency Securities in our securities portfolio and to the relatively weak financing market, we have continued to pursue additional lending counterparties in order to help increase our financial flexibility and ability to withstand periods of contracting liquidity in the credit markets.
Repurchase FacilitiesAgreements
The following table represents the contractual repricing regarding our repurchase agreements to finance Agency Security purchases as of September 30, 20122013 and December 31, 2011.2012.
September 30, 2012 | December 31, 2011 | September 30, 2013 | December 31, 2012 | |||||||||||||
(dollars in thousands) | (in thousands) | |||||||||||||||
Within 30 days | $ | 9,925,408 | $ | 4,068,197 | $ | 4,561,783 | $ | 7,771,444 | ||||||||
31 days to 60 days | 5,679,332 | 1,111,480 | 8,641,962 | 7,840,268 | ||||||||||||
61 days to 90 days | 2,933,517 | 156,285 | 1,713,780 | 2,699,706 | ||||||||||||
Greater than 90 days | 1,288,731 | - | - | 54,677 | ||||||||||||
Total | $ | 19,826,988 | $ | 5,335,962 | $ | 14,917,525 | $ | 18,366,095 |
The following table represents the Master Repurchase Agreements (“MRAs”) and other information regarding our repurchase agreements to finance Agency Security purchases as of September 30, 20122013 and December 31, 2011.2012.
September 30, 2013 | December 31, 2012 | |||||||
Number of MRAs | 34 | 33 | ||||||
Number of counterparties with repurchase agreements outstanding | 26 | 26 | ||||||
Weighted average maturity in days | 39 | 34 | ||||||
Weighted average contractual rate | 0.40 | % | 0.49 | % | ||||
Haircut for repurchase agreements (1) | 5.0 | % | 4.8 | % |
September 30, 2012 December 31, 2011 (dollars in thousands) Number of MRAs Number of counterparties with repurchase agreements outstanding Weighted average maturity in days Weighted average contractual rate % % Haircut for repurchase agreements % % 32 29 26 23 39 18 0.43 0.37 4.8 5.0
(1) | The Haircut represents the weighted average margin requirement, or the percentage amount by which the collateral value must exceed the loan amount. |
Declines in the value of our Agency Securities in our securities portfolio can trigger margin calls by our lenders under our repurchase agreements. An event of default or termination event under the standard MRA would give our counterparty the option to terminate all repurchase transactions existing with us and require any amount due to be payable immediately.
The residential mortgage market in the U.S. experienced difficult economic conditions over the last several years including:
| ● | increased volatility of many financial assets, including Agency Securities and other high-quality RMBS assets; |
| ● | increased volatility and deterioration in the broader residential mortgage and RMBS markets; and |
| ● | significant disruption in financing of RMBS. |
While conditions have improved, should there be a reoccurrence of difficulties in the residential mortgage market, our lenders may be forced to exit the repurchase market, become insolvent or further tighten lending standards or increase the amount of required equity capital or haircut, any of which could make it more difficult or costly for us to obtain financing.
Financial sector volatility can also lead to increased demand and prices for high quality debt securities, including Agency Securities. While increased prices may increase the value of our Agency Securities, higher values may also reduce the return on reinvestment of capital, thereby lowering our future profitability.
The following graph represents the month-end outstanding balances of our repurchase agreements (before the effect of netting reverse repurchase agreements), which finance most of our Agency Securities. Over time, the level of our repurchase agreement financing has grown in conjunction with the growth of Agency Securities in our securities portfolio, which in turn has been the result of successful equity capital raising efforts. The balance of repurchase agreements outstanding will fluctuate within any given month based on changes in the market value of the particular Agency Security pledged as collateral (including the effects of principal paydowns) and the level and timing of investment and reinvestment activity.
Effects of Margin Requirements, Leverage and Credit Spreads
Our Agency Securities have values that fluctuate according to market conditions and, as discussed above, the market value of our Agency Securities will decrease as prevailing interest rates or credit spreads increase. When the value of the securities pledged to secure a repurchase loanagreement decreases to the point where the positive difference between the collateral value and the loan amount is less than the haircut, our lenders may issue a margin call, which means that the lender will require us to pay the margin call in cash or pledge additional collateral to meet that margin call. Under our repurchase facilities, our lenders have full discretion to determine the value of the Agency Securities we pledge to them. Most of our lenders will value securities based on recent trades in the market. Lenders also issue margin calls as the published current principal balance factors change on the pool of mortgages underlying the securities pledged as collateral when scheduled and unscheduled principal repayments are announced monthly.
We experience margin calls in the ordinary course of our business and under certain conditions, such as during a period of declining market value for Agency Securities and we may experience margin calls monthly or more frequently.as frequently as daily. In seeking to effectively manage the margin requirements established by our lenders, we maintain a position of cash and unpledged securities. We refer to this position as our liquidity. The level of liquidity we have available to meet margin calls is directly affected by our leverage levels, our haircuts and the price changes on our securities. If interest rates increase as a result of a yield curve shift or for another reason or if credit spreads widen, the prices of our collateral (and our unpledged assets that constitute our liquidity) will decline and we may experience margin calls. We will use our liquidity to meet such margin calls. There can be no assurance that we will maintain sufficient levels of liquidity to meet any margin calls. If our haircuts increase, our liquidity will proportionately decrease. If we increase our borrowings, our liquidity will decrease by the amount of additional haircut on the increased level of indebtedness. In addition, certain of our MRAs contain a restriction that prohibits our leverage from exceeding twelve times our stockholders'stockholders’ equity as well as termination events in the case of significant reductions in equity capital.
We intend to maintain a level of liquidity in relation to our assets that enables us to meet reasonably anticipated margin calls but that also allows us to be substantially invested in Agency Securities. We may misjudge the appropriate amount of our liquidity by maintaining excessive liquidity, which would lower our investment returns, or by maintaining insufficient liquidity, which would force us to involuntarily liquidate assets into unfavorable market conditions and harm our results of operations and financial condition.
We generally seek to borrow (on a recourse basis) between six and ten times the amount of our total stockholders'stockholders’ equity. At September 30, 20122013 and December 31, 2011,2012, our total net borrowings were approximately $19.8$14.9 billion and $5.3$18.4 billion (excluding accrued interest), respectively, which representedrespectively. As of September 30, 2013 and December 31, 2012 we had a leverage ratio of approximately 8.12:6.93:1 and 8.52:7.96:1, respectively.
Forward-Looking Statements Regarding Liquidity
Based on our current portfolio, leverage rate and available borrowing arrangements, we believe that our equity, combined with cash flow from operations and available borrowing capacity,our ability to make timely portfolio adjustments, will be sufficient to enable us to meet anticipated short-term (one year or less) liquidity requirements such as to fund our investment activities, meet our financing obligations, pay fees under the 2012 Management Agreement and fund our distributions to stockholders and pay general corporate expenses.
We may increase our capital resources by obtaining long-term credit facilities or making public or private offerings of equity or debt securities, including classes of preferred stock, common stock and senior or subordinated notes to meet our long-term (greater than one year) liquidity. Such financing will depend on market conditions for capital raises and for the investment of any proceeds.proceeds and there can be no assurances that we will successfully obtain any such financing.
Stockholder'sStockholders’ Equity
Dividends
The following tables presenttable presents our common stock dividend transactions for the nine months ended September 30, 2012 and September 30, 2011.2013.
September 30, 2012
Record Date Payment Date Rate per common share Aggregate amount paid to holders of record (in millions) January 15, 2012(1) January 30, 2012 February 15, 2012 February 28, 2012 March 15, 2012 March 29, 2012 April 16, 2012 April 27, 2012 May 15, 2012 May 30, 2012 June 15, 2012 June 28, 2012 July 16, 2012 July 30, 2012 August 15, 2012 August 30, 2012 September 14, 2012 September 27, 2012 $ 0.11 $ 11.6 0.11 15.3 0.11 19.9 0.10 17.8 0.10 18.1 0.10 18.6 0.10 23.5 0.10 30.0 0.10 31.0
(1) This amount included $0.006 per common share of taxable income related to the year ended December 31, 2011.
September 30, 2011
Record Date Payment Date Rate per common share Aggregate amount paid to holders of record (in millions) January 15, 2011(1) January 28, 2011 February 15, 2011 February 25, 2011 March 15, 2011 March 30, 2011 April 15, 2011 April 28, 2011 May 15, 2011 May 27, 2011 June 15, 2011 June 29, 2011 July 15, 2011 July 28, 2011 August 15, 2011 August 30, 2011 September 15, 2011 September 29, 2011 $ 0.12 $ 2.0 0.12 3.9 0.12 3.9 0.12 5.9 0.12 5.9 0.12 8.3 0.12 9.1 0.12 9.1 0.12 10.1
(1) This amount included $0.02 per common share of taxable income related to the year ended December 31, 2010.
We have announced an expected fourth quarter cash dividend rate of $0.09 per outstanding common share.
Record Date | Payment Date | Rate per common share | Aggregate amount paid to holders of record (in millions) | |||||||
January 15, 2013 | January 30, 2013 | $ | 0.08 | $ | 24.8 | |||||
February 15, 2013 | February 27, 2013 | $ | 0.08 | $ | 24.8 | |||||
March 15, 2013 | March 27, 2013 | $ | 0.08 | $ | 30.2 | |||||
April 15, 2013 | April 29, 2013 | $ | 0.07 | $ | 26.3 | |||||
May 15, 2013 | May 30, 2013 | $ | 0.07 | $ | 26.3 | |||||
June 14, 2013 | June 27, 2013 | $ | 0.07 | $ | 26.1 | |||||
July 15, 2013 | July 30, 2013 | $ | 0.07 | $ | 26.1 | |||||
August 15, 2013 | August 29, 2013 | $ | 0.07 | $ | 26.1 | |||||
September 16, 2013 | September 27, 2013 | $ | 0.07 | $ | 26.1 |
The following table presents our Series A Preferred Stock dividend transactions for the nine months ended September 30, 2012. There were no2013.
Record Date | Payment Date | Rate per Series A Preferred Share | Aggregate amount paid to holders of record (in millions) | |||||||
January 15, 2013 | January 28, 2013 | $ | 0.17 | $ | 0.3 | |||||
February 15, 2013 | February 26, 2013 | $ | 0.17 | $ | 0.4 | |||||
March 15, 2013 | March 26, 2013 | $ | 0.17 | $ | 0.4 | |||||
April 15, 2013 | April 29, 2013 | $ | 0.17 | $ | 0.4 | |||||
May 15, 2013 | May 27, 2013 | $ | 0.17 | $ | 0.4 | |||||
June 14, 2013 | June 27, 2013 | $ | 0.17 | $ | 0.4 | |||||
July 15, 2013 | July 29, 2013 | $ | 0.17 | $ | 0.4 | |||||
August 15, 2013 | August 27, 2013 | $ | 0.17 | $ | 0.4 | |||||
September 15, 2013 | September 27, 2013 | $ | 0.17 | $ | 0.4 |
The following table presents our Series AB Preferred Stock dividend transactions for the nine months ended September 30, 2011.2013.
Record Date | Payment Date | Rate per Series B Preferred Share | Aggregate amount paid to holders of record (in millions) | |||||||
March 15, 2013 | March 27, 2013 | $ | 0.25 | $ | 1.4 | |||||
April 15, 2013 | April 29, 2013 | $ | 0.16 | $ | 0.9 | |||||
May 15, 2013 | May 27, 2013 | $ | 0.16 | $ | 0.9 | |||||
June 14, 2013 | June 27, 2013 | $ | 0.16 | $ | 0.9 | |||||
July 15, 2013 | July 29, 2013 | $ | 0.16 | $ | 0.9 | |||||
August 15, 2013 | August 27, 2013 | $ | 0.16 | $ | 0.9 | |||||
September 15, 2013 | September 27, 2013 | $ | 0.16 | $ | 0.9 |
September 30, 2012
Record Date Payment Date Rate per Series A Preferred share Aggregate amount paid to holders of record (in millions) July 13, 2012(1) July 27, 2012 August 15, 2012 August 27, 2012 September 14, 2012 September 27, 2012 $ 0.286500 $ 0.4 0.171875 0.3 0.171875 0.3
(1) This amount included $0.2 million paid to holders of record on July 13, 2012 for the period of June 7, 2012 through June 30, 2012
Series A Preferred Stock dividends will continue to be contractually payable without further declaration at the rate of $0.171875 per outstanding share per month.
Equity Capital Raising Activities
The following tables presenttable presents our equity transactions for the nine months ended September 30, 2012 and September 30, 2011.2013.
Transaction Type | Completion Date | Number of Shares | Per Share price | Net Proceeds (in millions) | ||||||||||
Series A Preferred equity distribution agreements | January 2, 2013 through January 30,2013 | 174,961 | $ | 25.51 | (1) | $ | 4.4 | |||||||
Common stock DRIP | January 25, 2013 through September 27, 2013 | 55,537 | $ | 4.98 | (1) | $ | 0.1 | |||||||
Series B Preferred initial offering | February 12, 2013 | 5,650,000 | $ | 25.00 | $ | 136.6 | ||||||||
Common stock follow-on public offering | February 20, 2013 | 65,000,000 | $ | 6.75 | $ | 438.4 |
(1) | Weighted average price |
September 30, 2012Common Stock repurchases
Transaction Type Completion Date Number of Shares Per Share price Net Proceeds (in millions) Follow-on public offering January 13, 2012 Follow-on public offering February 8, 2012 Equity distribution agreement February 29, 2012 Follow-on public offering March 14, 2012 Issuance of Series APreferred Stock June 7, 2012 Follow-on public offering July 13, 2012 Follow-on public offering August 8, 2012 Common equity distributionagreements January 1, 2012 to September 30, 2012 Preferred equity distributionagreements January 1, 2012 to September 30, 2012 Dividend Reinvestment andStock Purchase Plan January 1, 2012 to September 30, 2012 10,350,000 $ 6.80 $ 70.1 29,900,000 6.80 203.0 1,287,570 7.06 8.9 35,650,000 6.72 239.2 1,400,000 25.00 33.8 46,000,000 7.06 324.5 63,250,000 7.30 461.4 19,750,000 7.14 (1) 138.2 385,000 25.56 (1) 9.5 7,273,020 7.28 (1) 52.9
(1) WeightedDuring May 2013, we repurchased 3,395,603 shares of our outstanding common stock under the Repurchase Program at a weighted average price of $5.94 per share for an aggregate of $20.3 million.
September 30, 2011
Transaction Type Completion Date Number of Shares Per Share price Net Proceeds (in millions) Follow-on public offering January 26, 2011 Follow-on public offering February 8, 2011 Equity distribution agreement February 28, 2011 to September 30, 2011 Follow-on public offering April 13, 2011 Follow-on public offering June 6, 2011 Dividend Reinvestment andStock Purchase Plan April 7, 2011 to September 30, 2011 6,900,000 $ 7.55 $ 49.0 8,912,500 7.60 64.0 5,212,430 7.39 (1) 37.5 17,000,000 7.40 121.1 18,400,000 7.40 131.0 11,879,844 7.30 (1) 86.8
(1) Weighted average price
Off-Balance Sheet Arrangements
As of September 30, 20122013 and December 31, 2011,2012, we did not maintain any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance, or special purpose or variable interest entities, established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Further,Furthermore, as of September 30, 20122013 and December 31, 2011,2012, we had not guaranteed any obligations of any unconsolidated entities or entered into any commitment or intent to provide funding to any such entities.
Critical Accounting Policies
AOur financial statements are prepared in conformity with GAAP. In preparing the financial statements, management is required to make various judgments, estimates and assumptions that affect the reported amounts. Changes in these estimates and assumptions could have a material effect on our financial statements. The following is a summary of our critical accounting policies most affected by management’s judgments, estimates and assumptions.
Revenue Recognition: Interest income is earned and recognized based on the unpaid principal amount of the Agency Securities and their contractual terms. Premiums and discounts associated with the purchase of Agency Securities are amortized or accreted into interest income over the actual lives of the securities.
Fair Value of Agency Securities: We invest in Agency Securities representing interests in or obligations backed by pools of single-family fixed rate, hybrid adjustable rate and adjustable rate mortgage loans. The authoritative literature requires us to classify our investments as either trading, available for sale or held to maturity securities. Management determines the appropriate classifications of the securities at the time they are acquired and evaluates the appropriateness of such classifications at each balance sheet date. We currently classify all of our Agency Securities as available for sale. Agency Securities classified as available for sale are reported at their estimated fair values with unrealized gains and losses excluded from earnings and reported as part of the condensed consolidated statements of comprehensive income (loss). We utilize a third party pricing service to value our securities portfolio. The pricing service incorporates common market pricing methods including a spread measurement to the Treasury yield curve as well as underlying characteristics of the particular security including coupon, periodic and life caps, rate reset period and expected life of the security.
Security purchase and sale transactions, including purchase of when issued securities, are recorded on the trade date. Gains or losses realized from the sale of securities are included in Item 7income and are determined using the specific identification method.
Impairment of our Annual ReportAssets: We evaluate Agency Securities for other than temporary impairment at least on Form 10-K fora quarterly basis and more frequently when economic or market concerns warrant such evaluation. We consider an impairment to be other than temporary if we (1) have the year ended December 31, 2011. Thereintent to sell the Agency Securities, (2) believe it is more likely than not that we will be required to sell the securities before recovery (for example, because of liquidity requirements or contractual obligations) or (3) a credit loss exists. To date there have been no significantsuch impairment losses recognized.
Repurchase Agreements: We finance the acquisition of our Agency Securities through the use of repurchase agreements. Our repurchase agreements are secured by our Agency Securities and bear interest rates that have historically moved in close relationship to the Federal Funds Rate and LIBOR. Under these repurchase agreements, we sell Agency Securities to a lender and agree to repurchase the same Agency Securities in the future for a price that is higher than the original sales price. The difference between the sales price that we receive and the repurchase price that we pay represents interest paid to the lender. A repurchase agreement operates as a financing arrangement under which we pledge our Agency Securities as collateral to secure a loan which is equal in value to a specified percentage of the estimated fair value of the pledged collateral. We retain beneficial ownership of the pledged collateral. At the maturity of a repurchase agreement, we are required to repay the loan and concurrently receive back our pledged collateral from the lender or, with the consent of the lender, we may renew such agreement at the then prevailing interest rate. The repurchase agreements may require us to pledge additional assets to the lender in the event the estimated fair value of the existing pledged collateral declines.
In addition to the repurchase agreement financing discussed above, at certain times we have entered into reverse repurchase agreements with certain of our repurchase agreement counterparties. Under a typical reverse repurchase agreement, we purchase U.S. Treasury Securities from a borrower in exchange for cash and agree to sell the same securities in the future in exchange for a price that is higher than the original purchase price. The difference between the purchase price originally paid and the sale price represents interest received from the borrower. Reverse repurchase agreement receivables and repurchase agreement liabilities are presented net when they meet certain criteria, including being with the same counterparty, being governed by the same master repurchase agreement, settlement through the same brokerage or clearing account and maturing on the same day. For the nine months ended September 30, 2013, we sold short $2.8 billion of U.S Treasury Securities acquired under reverse repurchase agreements. We had purchases of $1.8 billion and $2.8 billion, respectively, of U.S. Treasury Securities resulting in a gain of $35.3 million and $14.2 million, respectively, for the quarter and nine months ended September 30, 2013.
Obligations to Return Securities Received as Collateral, at Fair Value: At certain times, we also sell to third parties the U.S. Treasury Securities received as collateral for reverse repurchase agreements and recognize the resulting obligation to return said U.S. Treasury Securities as a liability on our condensed consolidated balance sheet. Interest is recorded on the repurchase agreements, reverse repurchase agreements and U.S. Treasury Securities on an accrual basis and presented as net interest expense. Both parties to the transaction have the right to make daily margin calls based on changes in the fair value of the collateral received and/or pledged.
Derivative Instruments: We account for derivative instruments in accordance with GAAP, which establishes accounting and reporting standards for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to those policies during 2012.as derivatives) and for derivative activities. The guidance requires that every derivative instrument be recorded in the balance sheet as either an asset or liability measured at its fair value and that changes in the derivative’s fair value be recognized currently in earnings unless specific hedge accounting criteria are met.
We do not designate our derivative activities as cash flow hedges for GAAP purposes, which, among other factors, would require us to match the pricing dates of both derivative transactions and repurchase agreements. Operational issues and credit market volatility make such matching impractical for us. Since we have not elected cash flow hedge accounting treatment, our operating results may suffer because losses on the derivative instruments may not be offset by a changes in the fair value or cash flows of the related hedged transaction. Consequently, any declines in the hedged interest rates would result in a charge to earnings. We will continue to designate derivative transactions as hedges for tax purposes and any unrealized gains or losses should not affect our distributable net taxable income.
Inflation
Virtually all of our assets and liabilities are interest rate-sensitive in nature. As a result, interest rates and other factors influence our performance far more than inflation. Changes in interest rates do not necessarily correlate with inflation rates or changes in inflation rates. Our financial statements are prepared in accordance with GAAP and any distributions we may make will be determined by our Board based in part on our REIT taxable income as calculated according to the requirements of the Code; in each case, our activities and balance sheet are measured with reference to fair value without considering inflation.
Subsequent Events
See Note 16 to the condensed consolidated financial statements.
CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
This report contains various “forward-looking statements.” Forward-looking statements relate to expectations, beliefs, projections, future plans and strategies, anticipated events or trends and similar expressions concerning matters that are not historical facts. In some cases, you can identify forward-looking statements by the use of forward-looking terminology such as “believes,” “expects,” “may,” “will,” “would,” “could,” “should,” “seeks,” “approximately,” “intends,” “plans,” “projects,” “estimates” or “anticipates” or the negative of these words and phrases or similar words or phrases. All forward-looking statements may be impacted by a number of risks and uncertainties, including statements regarding the following subjects:
● | our business and investment strategy; |
● | our anticipated results of operations; |
● | statements about future dividends; |
● | our ability to obtain financing arrangements; |
● | our understanding of our competition and ability to compete effectively; |
● | market, industry and economic trends; and |
● | interest rates. |
The forward-looking statements in this report are based on our beliefs, assumptions and expectations of our future performance, taking into account all information currently available to us. These beliefs, assumptions and expectations are subject to risks and uncertainties and can change as a result of many possible events or factors, not all of which are known to us. If a change occurs, our business, financial condition, liquidity and results of operations may vary materially from those expressed in our forward-looking statements. You should carefully consider these risks before you make an investment decision with respect to our stock, along with the following factors that could cause actual results to vary from our forward-looking statements:
● | the factors referenced in this report and including those set forth under Item 1A “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2012; |
● | the impact of the federal conservatorship of Fannie Mae and Freddie Mac and related efforts, along with any changes in laws and regulations affecting the relationship between Fannie Mae and Freddie Mac and the federal government and the Fed system; |
● | the possible material adverse effect on our business if the U.S. Congress passed legislation reforming or winding down Fannie Mae or Freddie Mac; |
● | mortgage loan modification programs and future legislative action; | |
● | the impact of the continued delay or failure of the U.S. Government in reaching an agreement on the national debt ceiling or budget; |
● | availability, terms and deployment of capital; |
● | changes in economic conditions generally; |
● | changes in interest rates, interest rate spreads and the yield curve or prepayment rates; |
● | general volatility of the financial markets, including markets for mortgage securities; |
● | inflation or deflation; |
● | availability of suitable investment opportunities; |
● | the degree and nature of our competition, including competition for Agency Securities from the U.S. Treasury; |
● | changes in our business and investment strategy; |
● | our dependence on ARRM and ability to find a suitable replacement if ARRM were to terminate their management relationship with us; |
● | the existence of conflicts of interest in our relationship with ARRM, certain of our directors and our officers, which could result in decisions that are not in the best interest of our stockholders; |
● | changes in personnel at ARRM or the availability of qualified personnel at ARRM; |
● | limitations imposed on our business by our status as a REIT under the Code; |
● | changes in GAAP, including interpretations thereof; and |
● | changes in applicable laws and regulations. |
We cannot guarantee future results, levels of activity, performance or achievements. You should not place undue reliance on forward-looking statements, which apply only as of the date of this report. We do not intend and disclaim any duty or obligation to update or revise any industry information or forward-looking statements set forth in this report to reflect new information, future events or otherwise, except as required under the U.S. Federal securities laws.
Item 3. Quantitative and Qualitative Disclosures Aboutabout Market Risk
We seek to manage our risks related to the credit-quality of our assets, interest rates, liquidity, prepayment speeds and market value while, at the same time, seeking to provide an opportunity to stockholders to realize attractive risk adjusted returns through ownership of our capital stock. While we do not seek to avoid risk completely, we believe the risk can be quantified from historical experience and seek to actively manage that risk, to earn sufficient compensation to justify taking those risks and to maintain capital levels consistent with the risks we undertake.
Interest Rate, Cap and Mismatch Risk
We invest in fixed rate,A portion of our securities portfolio consists of hybrid adjustable rate and adjustable rate Agency Securities. Hybrid mortgages are ARMs that have a fixed-interest rate for an initial period of time (typically three years or greater) and then convert to an adjustable rate for the remaining loan term. Our debt obligations are generally repurchase agreements of limited duration that are periodically refinanced at current market rates.
ARM-related assetsARMs are typically subject to periodic and lifetime interest rate caps that limit the amount an ARM-related asset'sthe interest rate can change during any given period. ARM securitiesARMs are also typically subject to a minimum interest rate payable. Our borrowings are not subject to similar restrictions. Hence, in a period of increasing interest rates, interest rates on our borrowings could increase without limitation, while the interest rates on our mortgage related assets could be limited. This exposure would be magnified to the extent we acquire fixed rate Agency Securities or ARM securitiesARMs that are not fully indexed. Further,Furthermore, some ARM-related assetsARMs may be subject to periodic payment caps that result in some portion of the interest being deferred and added to the principal outstanding. These factors could lower our net interest income or cause a net loss during periods of rising interest rates, which would negatively impact our liquidity, net income and our ability to make distributions to stockholders.
We fund the purchase of a substantial portion of our ARM-related assetsARMs with borrowings that have interest rates based on indices and repricing terms similar to, but of shorter maturities than, the interest rate indices and repricing terms of our mortgage assets. Thus, we anticipate that in most cases the interest rate indices and repricing terms of our mortgage assets and our funding sources will not be identical, thereby creating an interest rate mismatch between assets and liabilities. During periods of changing interest rates, such interest rate mismatches could negatively impact our net interest income, dividend yield and the market price of our stock. Most of our adjustable rate assets are based on the one-year constant maturity treasury rate and the one-year LIBOR rate and our debt obligations are generally based on LIBOR. These indices generally move in the same direction, but there can be no assurance that this will continue to occur.
Our ARM-related assetsARMs and borrowings reset at various different dates for the specific asset or obligation. In general, the repricing of our debt obligations occurs more quickly than on our assets. Therefore, on average, our cost of funds may rise or fall more quickly than does our earnings rate on our assets.
Further,Furthermore, our net income may vary somewhat as the spread between one-month interest rates, the typical term for our repurchase agreements and six-month and twelve-month interest rates, the typical reset term of adjustable rate Agency Securities,ARMs, varies.
Prepayment Risk
As we receive repayments of principal on our Agency Securities from prepayments and scheduled payments, premiums paid on such securities are amortized against interest income and discounts are accreted to interest income as realized. Premiums arise when we acquire Agency Securities at prices in excess of the principal balance of the mortgage loans underlying such Agency Securities. Conversely, discounts arise when we acquire Agency Securities at prices below the principal balance of the mortgage loans underlying such Agency Securities. To date, all of our Agency Securities have been purchased at a premium.
Interest Rate Risk and Effect on Market Value Risk
Another component of interest rate risk is the effect changes in interest rates will have on the market value of our Agency Securities. We face the risk that the market value of our Agency Securities will increase or decrease at different rates than that of our liabilities, including our derivative instruments.instruments and obligations to return securities received as collateral.
We primarily assess our interest rate risk by estimating the effective duration of our assets and the effective duration of our liabilities and by estimating the time difference between the interest rate adjustment of our assets and the interest rate adjustment of our liabilities. Effective duration essentially measures the market price volatility of financial instruments as interest rates change. We generally estimate effective duration using various financial models and empirical data. Different models and methodologies can produce different effective duration estimates for the same securities.
The sensitivity analysis tables presented below reflect the estimated impact of an instantaneous parallel shift in the yield curve, up and down 50 and 100 basis points, on the market value of our interest rate-sensitive investments and net interest income, at September 30, 20122013 and December 31, 2011,2012, assuming a static securities portfolio. It assumes that the spread between the interest rates on Agency Securities and long term U.S. Treasury Securities remains constant. Actual interest rate movements over time will likely be different, and such differences may be material. When evaluating the impact of changes in interest rates, prepayment assumptions and principal reinvestment rates are adjusted based on our manager'sARRM’s expectations. The analysis presented utilized assumptions, models and estimates of the manager based on the manager'smanager’s judgment and experience.
As of September 30, 20122013
Change in Interest Rates Percentage Change in Projected Net Interest Income Percentage Change in Projected Portfolio Value Including Derivatives 1.00 % 7.02 % (1.76) % 0.50 % 3.97 % (0.88) % (0.50) % 6.81 % 0.68 % (1.00) % (1.58) % 1.14 %
Change in Interest Rates |
|
| Percentage Change in Projected Net Interest Income |
|
| Percentage Change in Projected Portfolio Value Including Derivatives |
| |||
| 1.00 | % |
|
| 9.01 | % |
|
| (0.46) | % |
| 0.50 |
|
|
| 12.81 |
|
|
| (0.41) |
|
| (0.50) |
|
|
| (3.97) |
|
|
| (1.38) |
|
| (1.00) |
|
|
| (24.79) |
|
|
| (2.10) |
|
As of December 31, 20112012
Change in Interest Rates |
|
| Percentage Change in Projected Net Interest Income |
|
| Percentage Change in Projected Portfolio Value Including Derivatives |
| |||
| 1.00 | % |
|
| (9.79) | % |
|
| 0.08 | % |
| 0.50 |
|
|
| 1.35 |
|
|
| 0.19 |
|
| (0.50) |
|
|
| 8.91 |
|
|
| (0.41) |
|
| (1.00) |
|
|
| (7.53) |
|
|
| (0.94) |
|
Change in Interest Rates |
| Percentage Change in Projected Net Interest Income |
| Percentage Change in Projected Portfolio Value Including Derivatives |
|
1.00 | % | 4.90 | % | (0.99) | % |
0.50 | % | 12.81 | % | (0.60) | % |
(0.50) | % | (6.38) | % | (1.31) | % |
(1.00) | % | (41.89) | % | (2.17) | % |
While the tables above reflect the estimated immediate impact of interest rate increases and decreases on a static securities portfolio, we rebalance our securities portfolio from time to time either to seek to take advantage of or reduce the impact of changes in interest rates. It is important to note that the impact of changing interest rates on market value and net interest income can change significantly when interest rates change beyond 100 basis points from current levels. Therefore, the volatility in the market value of our assets could increase significantly when interest rates change beyond amounts shown in the table above. In addition, other factors impact the market value of and net interest income from our interest rate-sensitive investments and derivative instruments, such as the shape of the yield curve, market expectations as to future interest rate changes and other market conditions. Accordingly, interest income would likely differ from that shown above and such difference might be material and adverse to our stockholders.
The above tables quantify the potential changes in net interest income and securities portfolio value, which includes the value of our derivatives, should interest rates immediately change. Given the low level of interest rates at September 30, 20122013 and December 31, 2011,2012, we applied a floor of 0% for all anticipated interest rates included in our assumptions. Due to the presence of this floor, it is anticipated that any hypothetical interest rate decrease would have a limited positive impact on our funding costs beyond a certain level; however, because prepayments speeds are unaffected by this floor, it is expected that any increase in our prepayment speeds (occurring as a result of any interest rate decrease or otherwise) could result in an acceleration of our premium amortization and the reinvestment of such prepaid principal in lower yielding assets. As a result, the presence of this floor limits the positive impact of any interest rate decrease on our funding costs. Therefore, at some point, hypothetical interest rate decreases could cause the fair value of our financial instruments and our net interest income to decline.
Market Value Risk
All of our Agency Securities are classified as available for sale assets. As such, they are reflected at fair value with the periodic adjustment to fair value (that is not considered to be an other than temporary impairment) reflectedreported as part of “Accumulated other comprehensive income”income (loss)” that is included in the stockholders'stockholders’ equity section of our condensed consolidated balance sheets. The market value of our assets can fluctuate due to changes in interest rates and other factors. Weakness in the mortgage market may adversely affect the performance and market value of our investments. This could negatively impact our book value. Furthermore, if our lenders are unwilling or unable to provide additional financing, we could be forced to sell our Agency Securities at an inopportune time when prices are depressed. The principal and interest payments are guaranteed by Freddie Mac, Fannie Mae, or Ginnie Mae on our Agency Securities.
Liquidity Risk
Our primary liquidity risk arises from financing long-maturity Agency Securities with short-term debt. The interest rates on our borrowings generally adjust more frequently than the interest rates on our adjustable rate Agency Securities.ARMs. Accordingly, in a period of rising interest rates, our borrowing costs will usually increase faster than our interest earnings from Agency Securities.
Item 4. Controls and Procedures
Our Co-CEOsCo-Chief Executive Officers (“Co-CEOs”) and CFOChief Financial Officer (“CFO”) participated in an evaluation by our management of the effectiveness of our disclosure controls and procedures as of the end of our fiscal quarter that ended on September 30, 2012. Based on their participation in that evaluation, our Co-CEOs and (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of our fiscal quarter that ended on September 30, 2013. Based on their participation in that evaluation, our Co-CEOs and CFO concluded that our disclosure controls and procedures were effective as of September 30, 20122013 to ensure that information required to be disclosed in our reports filed or submitted under the Securities Exchange Act, of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC'sSEC’s rules and forms, and to ensure that information required to be disclosed in our reports filed or furnished under the Securities Exchange Act, of 1934, as amended, is accumulated and communicated to our management, including our Co-CEOs and CFO, as appropriate, to allow timely decisions regarding required disclosures. Our Co-CEOs and CFO also participated in an evaluation by our management of any changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the quarter ended September 30, 2012.2013. That evaluation did not identify any changes that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
Our company and our manager areis not currently subject to any legal proceedings.proceedings, as described in Item 103 of Regulation S-K.
Item 1A. Risk Factors
There have been no material changes fromto the risk factors disclosed in the “Risk Factors” section of our Annual Report on Form 10-K for the year ended December 31, 2012, filed on March 6, 2012 with the SEC,February 22, 2013 except as set forth below.
There are conflicts of interest in our relationship with ARRM and its affiliates, which could result in decisions that are not in the best interestsPart II, Item 1A of our stockholders or warrant holders.
We are subject to conflicts of interest arising out of our relationship with JAVELIN, ARRM and their affiliates. Each of our executive officers and certain of our non-independent directors is also an employee or affiliated with JAVELIN and ARRM and they will not be exclusively dedicated to our business. Each of Mr. Ulm and Mr. Zimmer is a Co-Managing Member of ARRM and owner of equity interests in JAVELIN.
In addition, Daniel C. Staton and Marc H. Bell, two of our directors, are principal owners of Staton Bell Blank Check LLC, our Sub-Manager, which, in considerationQuarterly Report on Form 10-Q for services to be provided to ARRM under a sub-management agreement is entitled to receive a percentage of the net management fee earned by ARRM from us and JAVELIN. As a result, the Management Agreement with ARRM may create a conflict of interest and its terms, including fees payable to ARRM, may not be as favorable to us as if they had been negotiated with an unaffiliated third party. In addition, we may choose not to enforce, or to enforce less vigorously, our rights under the Management Agreement because of our desire to maintain our ongoing relationship with ARRM. ARRM maintains a contractual and fiduciary relationship with us. The Management Agreement with ARRM does not prevent ARRM and its affiliates from engaging in additional management or investment opportunities some of which will compete with us. ARRM and its affiliates may engage in additional management or investment opportunities that have overlapping objectives with ours and may thus face conflicts in the allocation of investment opportunities to these other investments. Such allocation is at the discretion of ARRM and there is no guarantee that this allocation would be made in the best interest of our stockholders or warrant holders. We are not entitled to receive preferential treatment as comparedquarter ended June 30, 2013, filed with the treatment given by ARRM or its affiliates to any investment company, fund or advisory account other than any fund or advisory account which contains only funds invested by ARRM (and not of any of its clients or customers) or its officers and directors. Additionally, the ability of ARRM and its respective officers and employees to engage in other business activities, including their activities related to JAVELIN, may reduce the time spent managing our activities.
In the future, we may enter, or ARRM may cause us to enter, into additional transactions with ARRM or its affiliates. In particular, we may purchase, or ARRM may cause us to purchase, assets from ARRM or its affiliates or make co-purchases alongside ARRM or its affiliates. These transactions may not be the result of arm's length negotiations and may involve conflicts between our interests and the interests of ARRM and/or its affiliates in obtaining favorable terms and conditions.
Members of our management team have competing duties to other entities, which could result in decisions that are not in the best interests of our stockholders or warrant holders.
Our executive officers and the employees of ARRM do not spend all of their time managing our activities and our investment portfolio. Our executive officers and the employees of ARRM allocate some, or a material portion, of their time to other businesses and activities. For example, each of our executive officers is also an officer of JAVELIN and an employee of ARRM. None of these individuals is required to devote a specific amount of time to our affairs. As a result of these overlapping responsibilities, there may be conflicts of interest among and reduced time commitments from our officers and the officers and employees of JAVELIN and our Manager that we will face in making investment decisionsSEC on behalf of ARMOUR. Accordingly, we will compete with both JAVELIN and ARRM, and their existing activities, other ventures and possibly other entities in the future for the time and attention of these officers.August 1, 2013.
We cannot predict the impact of QE3 on the prices and liquidity of Agency Securities or other securities in which we invest, although the Federal Reserve action could increase the prices of our target assets and reduce the spread on our investments.
On November 25, 2008, the Federal Reserve announced a program to purchase Agency Securities in the open market. The stated goal of this program was to provide support to mortgage and housing markets and to foster improved conditions in financial markets more generally. On March 18, 2009, this program was expanded to a target size of $1.25 trillion. The Federal Reserve completed this purchase program in March 2010. The Federal Reserve announced on November 3, 2010 that it intended to purchase an additional $600 billion of long-term securities by the end of the second quarter of 2011, at a pace of about $75 billion per month. On September 13, 2012, the Federal Reserve announced a program, popularly referred to as “QE3,” to purchase an additional $40 billion of Agency Securities per month until the unemployment rate and other economic indicators improve. QE3 plus its existing investment programs are expected to grow the Federal Reserve's Agency Securities holding by approximately $85 billion per month at least through the end of 2012. The Fed also extended through at least mid-2015 its plan to keep the Federal Funds Rate between zero and 0.25%. The Federal Reserve expects these measures will put downward pressure on long-term interest rates.
While the Federal Reserve hopes that QE3 will expedite an economic recovery, stabilize prices, reduce unemployment and restart business and household spending, we cannot predict the long-term impact of these programs or any future actions by the Federal Reserve on the prices and liquidity of Agency Securities or other securities in which we invest. In the short term, the Federal Reserve's actions have driven Agency Securities prices to record highs, thereby compressing interest rate spreads and reducing the correlation between mortgage rates and rates on U.S. Treasuries and interest rate swaps. These factors have contributed to a challenging reinvestment and interest rate hedging environment.
Failure to obtain and maintain an exemption from being regulated as a commodity pool operator could subject us to additional regulation and compliance requirements and may result in fines and other penalties which could materially adversely affect our business and financial condition.
Recently adopted rules under the Dodd-Frank Act establish a comprehensive new regulatory framework for derivative contracts commonly referred to as “swaps.” Under these recently adopted rules, any investment fund that trades in swaps may be considered a “commodity pool,” which would cause its directors to be regulated as “commodity pool operators” ("CPOs"). Under the new rules, which become effective on October 12, 2012 for those who become CPOs solely because of their use of swaps, CPOs must register with the National Futures Association (the "NFA"), which requires compliance with NFA's rules, and are subject to regulation by the U.S. Commodity Futures Trading Commission (the “CFTC”) including with respect to disclosure, reporting, recordkeeping and business conduct.
Our hedging strategies are designed to reduce the impact on our earnings caused by the potential adverse effects of changes in interest rates on our assets and liabilities. Subject to complying with REIT requirements, we use hedging techniques to limit the risk of adverse changes in interest rates on the value of our assets as well as the differences between the interest rate adjustments on our assets and borrowings. These techniques primarily consist of entering into interest rate swap contracts and purchasing or selling Futures Contracts and may also include entering into interest rate cap or floor agreements, purchasing put and call options on securities or securities underlying Futures Contracts, or entering into forward rate agreements. Although we are not legally limited to our use of hedging, we intend to limit our use of derivative instruments to only those techniques described above and to enter into derivative transactions only with counterparties that we believe have a strong credit rating to help limit the risk of counterparty default or insolvency. These transactions are not entered into for speculative purposes. We do not use these instruments for the purpose of trading in commodity interests, and we do not consider our company or its operations to be a commodity pool as to which CPO regulation or compliance is required. We, along with numerous other mortgage REITs, have submitted a no-action letter request to the CFTC seeking exemptive relief for our directors from CPO registration under these new rules. However, at this time, our directors do not intend to register as CPOs with the NFA. While we have reason to believe that the CFTC may provide us with exemptive relief prior to December 31, 2012, there can be no assurance that any such relief will be granted. If exemptive relief is granted, we may be restricted to operating within certain parameters discussed in the no-action letter we submitted to the CFTC. For example, exemptive relief might limit our ability to enter into interest rate hedging transactions if the amount of income we receive from such hedges will exceed five percent of our gross income or the initial margin and premiums for such hedges will exceed five percent of the fair market value of our total assets.
The CFTC has substantial enforcement power with respect to violations of the laws over which it has jurisdiction, including their anti-fraud and anti-manipulation provisions. Among other things, CFTC may suspend or revoke the registration of a person who fails to comply, prohibit such a person from trading or doing business with registered entities, impose civil money penalties, require restitution and seek fines or imprisonment for criminal violations. Additionally, a private right of action exists against those who violate the laws over which CFTC has jurisdiction or who willfully aid, abet, counsel, induce or procure a violation of those laws. In the event we fail to receive exemptive relief from the CFTC on this matter and our directors fail to comply with the regulatory requirements of these new rules, we may be subject to significant fines, penalties and other civil or governmental actions or proceedings, any of which could have a materially adverse effect on our business, financial condition and results of operations.
We cannot predict the impact, if any, on our earnings or cash available for distribution to our stockholders of the FHFA's proposed revisions to Fannie Mae's, Freddie Mac's and Ginnie Mae's existing infrastructures to align the standards and practices of the three entities.
On February 21, 2012, the FHFA released itsStrategic Plan for Enterprise Conservatorships, which set forth three goals for the next phase of the Fannie Mae and Freddie Mac conservatorships. These three goals are to (i) build a new infrastructure for the secondary mortgage market, (ii) gradually contract Fannie Mae and Freddie Mac's presence in the marketplace while simplifying and shrinking their operations, and (iii) maintain foreclosure prevention activities and credit availability for new and refinanced mortgages. On October 4, 2012, the FHFA released its white paper entitledBuilding a New Infrastructure for the Secondary Mortgage Market, which proposes a new infrastructure for Fannie Mae and Freddie Mac that has two basic goals.
The first such goal is to replace the current, outdated infrastructures of Fannie Mae and Freddie Mac with a common, more efficient infrastructure that aligns the standards and practices of the two entities, beginning with core functions performed by both entities such as issuance, master servicing, bond administration, collateral management and data integration. The second goal is to establish an operating framework for Fannie Mae and Freddie Mac that is consistent with the progress of housing finance reform and encourages and accommodates the increased participation of private capital in assuming credit risk associated with the secondary mortgage market.
The FHFA recognizes that there are a number of impediments to their goals which may or may not be surmountable, such as the absence of any significant secondary mortgage market mechanisms beyond Fannie Mae, Freddie Mac and Ginnie Mae, and that their proposals are in the formative stages. As a result, it is unclear if the proposals will be enacted. If such proposals are enacted, it is unclear how closely what is enacted will resemble the proposals from the FHFA White Paper or what the effects of the enactment will be in terms of our net asset value, earnings or cash available for distribution to our stockholders.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds
None.
Item 3. Defaults Upon Senior Securities
None.
Item 4. Mine Safety Disclosures
Not applicable.
Item 5. Other Information
On October 30, 2012, our Board approved an amendment to our charter to increase our authorized shares of common stock from 500,000,000 shares to 1,000,000,000 shares and to increase our authorized shares of preferred stock from 25,000,000 shares to 50,000,000 shares. Pursuant to Maryland corporate law and Section 6.1 of our charter, the amendment was approved by our Board and did not require any action by our stockholders. Accordingly, our charter was amended effectively on October 31, 2012 to increase our authorized shares of common stock from 500,000,000 shares to 1,000,000,000 shares and to increase our authorized shares of preferred stock from 25,000,000 shares to 50,000,000 shares. A copy of the Articles of Amendment is attached hereto as Exhibit 3.3 and is incorporated herein by reference.None.
Item 6. Exhibits
See Exhibit Index.
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Date: October 28, 2013 | |
| ARMOUR RESIDENTIAL REIT, INC. |
| /s/ James R. Mountain |
| James R. Mountain |
| Chief Financial Officer, Duly Authorized Officer and Principal Financial and Accounting Officer |
EXHIBIT INDEX
Exhibit Number |
| Description |
|
| |
|
| |
|
| |
31.1 |
| Certification of Chief Executive Officer Pursuant to SEC Rule 13a-14(a)/15d-14(a) |
31.2 |
| Certification of Chief Executive Officer Pursuant to SEC Rule 13a-14(a)/15d-14(a) |
31.3 | Certification of Chief Financial Officer Pursuant to SEC Rule 13a14(a)/15d-14(a) | |
32.1 |
| Certification of Chief Executive Officer Pursuant to 18 U.S.C. §1350 |
32.2 |
| Certification of Chief Executive Officer Pursuant to 18 U.S.C. §1350 |
32.3 | Certification of Chief Financial Officer Pursuant to 18 U.S.C. §1350 | |
|
| XBRL Instance Document (1) |
|
| XBRL Taxonomy Extension Schema Document (1) |
|
| XBRL Taxonomy Extension Calculation Linkbase Document (1) |
|
| XBRL Taxonomy Extension Definition Linkbase Document (1) |
|
| XBRL Taxonomy Extension Label Linkbase Document (1) |
|
| XBRL Taxonomy Extension Presentation Linkbase Document (1) |
(1) |
|
|
|
| Filed herewith |
| Furnished herewith |
|
|
42